Asset prices have crashed globally due to the financial mess on Wall Street. It is in times such as these that asset management firms peddle products that allay investors’ fears and encourage them to regain exposure to the stock market.
One of our clients was recently offered such a product, similar in structure to the principal-protection notes (PPNs).
This article discusses the characteristics of PPNs, also called as capital-guarantee products, and shows why the plain-vanilla version may not be optimal for investors.
It also shows how asset management firms can custom-tailor products to enable investors fulfil their horizon objectives.
Principal-protection notes
The product plays on an important behavioural bias that Kahneman and Tversky called as the Prospect Theory.
These two psychologists found that people suffer more pain for losing money than they enjoy from gaining the same amount.
The PPNs moderate this bias by guaranteeing the return of capital. The guarantee, of course, comes at the cost of lower return.
Suppose an asset management firm offers a five-year plain-vanilla PPN for a minimum investment of Rs 25,000.
The portfolio manager will invest a proportion in zero-coupon (zeros) bonds and the balance in equity.
If the five5-year bond-equivalent yield is 10 per cent, Rs 15,400 will be invested in five-year zeros. This amount will grow to Rs 25,000 in five years to provide the capital protection.
The balance Rs 9,600 will be invested in an instrument that mirrors the Nifty index.
Some asset management firms provide a participation rate on the equity instrument. If the Nifty index moves up 10 per cent, a 75 per cent participation rate means that investor will receive only 7.5 per cent of Rs 9,600.
This plain-vanilla PPN is not an optimal investment. The reason is that the investor can replicate the payoffs at lower costs.
Of course, zeros are not available for retail investors. Such an investor can instead take 60 per cent exposure to a 10 per cent interest-bearing cumulative bank deposit and invest the rest in index funds. The exposure in term deposits will mature with a face value of Rs 25,000. The index funds provide a low-cost market exposure.
Replicating PPNs with cumulative deposits and index funds could generate a higher return for two reasons.
One, the investor gets 100 per cent participation on the Nifty index. And two, the cost of replicating the PPN structure (management fees) is lower.
Structured PPNs
Asset management firms can structure PPNs that carry exposure to select stocks or replicate payoffs custom-tailored to meet certain investment objectives.
Suppose a class of investors wants to buy a house five years hence. The primary risk is that house prices may go up in five years because of increase in real estate prices and/or hike in input costs such as cement and steel.
Assuming a five-year BEY of 10 per cent, the portfolio manager will invest Rs 15,400 for every Rs 25,000 in zeros.
The balance of Rs 9,600 can be used to take exposure in such stocks that help the investor hedge the risk of rising house prices.
This could mean exposure to the infrastructure sector. Specifically, the portfolio could contain stocks such as DLF, Tata Steel and ACC.
Of course, the assumption is that the rise in real estate, steel and cement prices would improve the revenue streams of these companies.
And that, in turn, will prompt the market to revise upward the asset prices of these companies.
As an alternative strategy, firms can also provide alpha returns on the equity exposure. Suppose the firm has an asset size of Rs 10 crore.
About 60 per cent would be invested in zeros at the five-year BEY of 10 per cent. The balance Rs 4 crore can be used to set-up a market-neutral equity portfolio.
Assume that the portfolio manager is positive on certain stocks in the mid-cap space.
The objective would be to take exposure to the excess returns that these stocks provide over the mid-cap index. An exposure to the select mid-cap stocks gives the portfolio manager two returns — mid-cap index returns (beta exposure) and the excess returns (alpha returns).
Buying select mid-cap stocks and shorting a certain number of mid-cap futures subtracts the beta exposure from these stocks. The residual returns will be the alpha returns- the objective of this strategy.
Conclusion
The sharp decline in asset prices in recent times encourages asset management firms to offer PPNs to investors fearful of regaining exposure to the stock market. This article shows that plain-vanilla PPN is not an optimal investment choice, as investors can replicate the payoffs at a lower cost.
It also shows how asset management firms could custom-tailor exposure to suit investors’ needs. Such products may carry high management fees but could enable investors achieve their horizon objectives.
Monday, October 6, 2008
What is Credit Default Swap(CDS)
He called them “the financial weapons of mass destruction”. ‘He’ was ‘Warren Buffet’ and ‘them’ was ‘Derivatives’. Boy, the world’s smartest investor could not have been more right.
For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).
What is a CDS?
We explain with a simple example.
Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.
To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.
Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.
So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!
Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.
The growing chain
The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.
This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.
The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.
AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.
After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.
A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.
For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).
What is a CDS?
We explain with a simple example.
Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.
To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.
Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.
So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!
Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.
The growing chain
The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.
This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.
The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.
AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.
After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.
A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.
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