The Next Midterm Will Cover Chapters 13, 16 and 17

Lecture Notes – 14 November 2012

Several details – we are going to finish with chapter 13 today. I’ve put homework exercises on the web – note none of these homework exercises are from the chapter.

We are going to move on to chapter 17 in the book after this. I will aim to get the homework exercises for chapter 17 on the web before vacation and answers to all of the homework exercises on the web before vacation.

The next midterm will cover chapters 13, 16 and 17.

I’d like to finish with equity markets talking about costs and also talking about how one goes short a stock. Finally I will talk about a particular strategy used by hedge funds called long-short.

Basics of Trading Stocks

We’ve talked a bit about orders. We are now going to talk about various issues involved in trading.

Costs of Trading

First there are some explicit costs:

• Commissions – these are generally completely negotiable – although we won’t see that with our little trades at the discount broker.
• Custodial Fees – these are the costs of holding the stock position for us. This includes the cost of handling dividends, corporate actions etc for us.
• Soft Dollars – these are implicit costs in trading. For example you might be willing to pay slightly higher commissions in order to have access to better research. If you had paid explicitly for access to the research you would call this a “hard dollar.” Generally this matters more in the institutional trading world. For example if you are a large institutional trading house then your order flow is worth a lot to a brokerage house. You might agree to send 20% of your business through a particular broker in order to have access to certain research.
• The SEC has restricted what can be paid for via soft dollars. Investment advisors also have to disclose products or services that are received through soft dollars. This method of payment is open to abuse – you would not be very happy with your investment advisor if you found out that they were using a higher cost brokerage firm in exchange for free vacations.

Implicit Costs

There are several implicit costs that we could discuss but the one worth mentioning is impact cost.

Impact Costs – this is the change in market price caused by the presence of your trade. If your trade is large relative to normal market size then it can move the market.

Timing Costs – this is the change in price between the time the that one directs a broker to execute a trade and when they actually complete the trade.

Opportunity Costs – this is the cost of securities not traded. This can be either because of the market has moved prior to the trade being executed or the market moving while the trade is being executed.

Short Selling

Imagine an investor believes a stock is overvalued but does not own the stock. He can arrange to “short” the stock. The process for doing so looks something like the following slide.

1 – The investor contacts his broker to “locate” shares for shorting. This involves the broker confirming that he has a source to borrow the shares from. A broker keeps a “Box list” which contains the inventory of shares available for shorting.

2 – Execute a short sale. The trader can now execute a short sale of the stock. It will settle on a T+3 basis.

3 – On the morning of T+3 the stock lending department will determine the actual delivery requirements for the day. If they no longer have the shares available on their box-list they will consult with other brokers etc to arrange the borrow.

It is important to note that there are times when the shares can be borrowed on T but no longer on T+3. At that point the short sale will fail. If this is the case then a “forced buy-in” will occur where the broker buys shares on behalf of the trader to settle the transaction.

4 – Cash from the short sale is used as collateral for the borrowed shares. When the trade settles the cash from the short sale is used by the broker as collateral against the borrowed stock. This cash is invested by the broker

5 – Interest is paid – A portion of the interest paid to the broker may be paid to the trader. On the other hand the trader will pay administration fees and also interest on the borrowed stock. Generally small short sellers will not earn interest but larger ones may. In addition the stock borrow fees may be large and thus the trader may have to pay these additional costs.

6 – Dividends – If the stock in the short sale pays dividends then the trader is responsible to pay these to the true owner of the stock.

Note, if at some point during the trade the lender of the stock decides they want the stock back (for example they chose to sell the stock), then the broker will have to arrange another borrow. If this is not possible to do then they will notify the trader that the position must be covered. Generally they may buy-in the stock automatically.

Now let’s do a simple example. If you view that a particular stock is over-priced say at $100 you can instruct your broker to sell 100 shares of stock X and borrow 100 shares of stock X from someone else. When the sale of the stock completes the proceeds are not given to you but instead retained by the broker as you are now short 100 shares of X.

Let’s say 1 week later you are proven correct and the share price of X falls to 75. You can now arrange to buy 100 shares of X and ignoring commissions you will make

$100*100 – $100*75 = $2,500

Now let’s look at the opposite situation. If the share price of X rises to 150 then you might arrange to buy back your short.

Now

$100*100 - $100*150 = -$5,000

and you have lost money. In fact you have quite a bit more downside than you do upside. If the company goes bankrupt and trades down to zero you make $10,000. If the stock triples in value tomorrow then you lose $20,000.

Equity Long-Short Trading

I want to describe to you a particular equity trading strategy. The theory behind this is that if you have a view on the relative performance of two stocks then you can profit from this regardless of whether the market goes up or down. How does one go about this? First you have stock selection. Different traders will specialize in different types of trades but the typical trade would involve stocks in similar business lines. Most often the trade would be done after fundamental analysis was carried out on each firm. The trader would form a view on the relative performance of the two companies.

Thus the easiest type of trade would be to have two stocks in the same general market – for example J.P. Morgan and Citibank. Here are the yahoo finance details for the two banks.

The simplest long-short trading idea would be to buy $1m of JP Morgan shares and sell $1m of Citibank shares. In this trade I would profit if JP Morgan outperformed Citibank.

Thus JP Morgan shares are at $40.25 and Citibank shares are at $36.16. If after executing the shares JP Morgan is up 5% and Citibank is down 5% then my trade profits by 10%. Equally if JP Morgan is down 5% and Citibank is down 10% then my trade profits by 5%. I lose if Citibank outperforms JP Morgan.

Note this isn’t the only way this trade might get executed. If you look at the yahoo data you see that the beta to the market of Citibank and JP Morgan are 2.6 and 1.3 respectively. This means that on average if the market moves 1% then Citibank moves 2.6% and JP Morgan moves 1.3%.

This means that the first strategy is not market neutral. If the betas hold then if the market goes up 1% you will see Citibank go up 2.3% and JP Morgan go up 1.3%. In order to be market neutral you need to hold twice as much JP Morgan shares as Citibank shares. Thus a better strategy might be to hold $500,000 shares of Citibank and $1,000,000 shares of JP Morgan. Now if the market moves up or down 1% the strategy will not lose money. One will only profit if JP Morgan outperforms the market and Citibank underperforms the market.

There are all sorts of other ways that one executes a strategy like this. There are 130-30 hedge funds that are long 130% of its assets and short 30% of its assets under management. The idea here is that the equity market trends upwards on average and thus you want to be long. On the other hand you can profit from selling shares you believe are going to fall.

Questions about Going Short

Optional section depending on what time it is at. At the height of the financial crisis various governments banned going short banking stock or even shorting any stocks in the market. The view is that this will limit selling pressure on various companies.

Banks

More work on institutions

We have touched on banks and their balance sheets a little bit as we talked about T-accounts and the monetary base, M1 etc.

We should spend a bit more time on this subject. I would expect that we will cover this chapter over the next couple of lectures.

Bank Balance Sheets.

We are going to start by talking about a commercial Bank’s Balance Sheet.We introduced this idea when we talked about checkable deposits etc. The items that we talked about on the balance sheet so far were:

• Checkable deposits
• Money Market accounts
• Loans
• Vault Cash and
• Reserves

The following table identifies the major contributors to a typical commercial bank’s balance sheet. (SHOW SLIDE)

What we have not discussed at this point are several key items:

• government securities
• Non-transaction accounts
• Borrowing
• bank capital

Let’s start by talking about the liabilities:

Checkable deposits

We have already talked quite a bit about these already. We should note that these are now around 4% of all bank liabilities and are the cheapest form of liability. Individuals hold funds in these accounts or ease of access and do not demand high returns (any returns) on these funds. Historically these might have been up to around 60% of liabilities for banks (1960).

non-transaction accounts

are the primary source of bank funds. These are accounts that holders cannot write checks against. These include:

• Savings Accounts
• Time Deposits –
• small denomination time deposits – deposits of less than $100,000
• large denomination time deposits – deposits greater than $100,000. These are also known as negotiable CDs and are seen as alternative assets to Treasury Bills. These are known as money market instruments.

Borrowing

There are two main sources for borrowing by banks. The first is the Fed Reserve in the form of discount loans. As discussed many times banks will not generally look to these to meet everyday funding requirements. The second are loans of reserves from other banks and institutions at the Fed Funds rate. These would generally be a good source of additional funds but currently the banking system is awash in excess reserves.

Bank Capital

Bank capital is the bank’s net worth or the difference between the total assets and liabilities. Bank capital can be raised by issuing new equity or from retained earnings. Bank capital can be seen as a cushion against a drop in the value of its assets which could force the bank into insolvency.

On the asset side we have not talked about

Government securities

A bank’s holdings in government securities is an important income earning asset. These account for around 17% of a typical bank’s assets and provide about 10% of their income. US government and agency securities are also called secondary reserves as they can be exchanged into cash very easily.

Basics of Bank Management

There are many things that a bank manager must keep in mind when managing the bank. These include:

• liquidity management – the need to ensure that a bank has sufficient liquid assets to meet its cash management needs
• asset management – it needs to pursue an acceptable level of risk versus return on its assests
• liability management – the need to accumulate funds at a low cost
• capital management – the need to have enough capital to cover potential losses in its asset base.

Let’s take these each in turn.

Liquidity Management

A bank needs to be able to meet its deposit outflows on a daily basis. These can take the form of checks/transfers from their bank accounts and cash being withdrawn from tellers and ATMs. A bank will keep a certain proportion of its assets as cash in its vault for cash but it also needs to keep a certain proportion of its assets as very liquid so that it can easily handle these outflows. There are two assets that can be turned into cash very easily: these are the excess reserves held at the Fed and government securities – especially T-Bills. If a bank did not have any of either of these assets then a customer withdrawing funds would have to change other parts of the balance sheet. Let’s look at an example:

We are going to look at a bank with reserves of $20m of which $10m are required. If there is a $10m deposit outflow then the reserves will drop to $10m. This is still fine for the bank. If the bank started with only $10m in reserves then such an outflow would cause a $9m shortfall in reserves.

There would be several ways of fulfilling this shortfall. For example,

• borrow from other banks or corporations – if this were banks then the rate would be the Fed Funds rate.
• sell securities,
• borrow from the Fed
• call in or sell off loans.

Calling loans is usually the last resort. At this point you are potentially wrecking a relationship with a customer. Selling off the loan can have the same effect – a customer wants to have a long-term relationship.

Asset and Liability Management

The main focus of banks is asset and liability mgmt. On the liability side the asset mix of banks have changed significantly over the past 50 years. In 1960 checkable deposits were around 60% of a bank’s liabilities. Now they are more like 4%. Banks can raise funds through borrowing in the interbank market (fed funds for example) very easily and thus if a bank wants to increase lending it can do so without having to attract additional deposits.

On the asset side a bank is trying to make money. The very liquid assets necessary to manage a bank’s liquidity do not earn great returns. Thus a bank is forced to balance risk against the return on its assets.

Note, there is a concept of Confidence-Sensitive Money – this refers to any source of bank fundsthat relies on confidence in either the bank itself or in the banking industry.

If you consider the sources of bank liabilities you see that checkable deposits in the narrowest sense are not particularly sensitive to confidence. The FDIC insurance significantly reduces the risk that issues with a bank’s solvency will cause account holders to lose money. On the other hand a bank lending reserves unsecured is very sensitive to confidence in the banking industry and also in a particular bank.

Capital Management

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