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Friday, October 28, 2011

Risks associated with equity inflation

Equity inflation is an increase in the price of stock, but a decrease in the purchasing power and actual underlying value of that stock. Like monetary inflation, equity inflation gives the impression of more money, but in actuality means lower wealth. This is a financial phenomenon also described in the Quarterly Journal of Economics as “The Money Illusion Hypothesis”.

Stock value and inflation risk
Stock exposure yields more than  investment risk

Risk #1: Currency devaluation deflates increases in stock price

According to The Money Illusion Hypothesis investors can lose track of actual purchasing power of liquid assets such as stock via corresponding financial events such as monetary inflation. In other words, for each unit rise of stock prices with corresponding increases in market values, this increase loses actual value in proportion to the value of money. This however, is just one of several explanations and risks associated with the occurrence of equity inflation.

Risk #2: Stock investing expenses rise

Another cost associated with investing that may be overlooked are commissions, fees, margin interest, option contract premiums and management expenses. With a rise in the value of equities, fund managers, brokerage firms and investing services may find it easier to justify higher brokerage account costs. Yet if these costs amount to just 1% more, added to monetary inflation the total cost could be 3-4% off the total unadjusted yield of stock not including capital gains taxes.

Risk #3: Decline in business financial fundamentals

A corresponding decline in currency value and increase in equity related costs are not the only way equity inflation can occur however. This is because worth is determined by more than just yields and the currency  in which a stock is valuated. Moreover, if a company's revenue declines 5%, but earnings increase 7%, a business has essentially shrunk in size especially if the increase in earnings is due to downsizing, accounting techniques such as mark-to-market accounting, and sales of assets. These methods are further elaborated upon by Aswath  Damadoran of the Stern School of Business

Risk #4:  Increased potential for future devaluation

Eventually, investors are believed to price in shorter-term inconsistencies in price valuation such as in an asset bubble  according to the 'Efficient Market Hypothesis' described by Burton G. Malkiel of Princeton University.  One reason for this is because equity inflation is not sustainable unless underlying growth in revenue, and/or improvements in a company's operational assets occurs. Moreover, business that have products and services with clearly defined increases in revenue, market share, and competitive positioning are more justified in valuating assets in a way that can increase equity prices, than those that do not.

Image source: Value Stream CC0 1.0-PD

Thursday, October 27, 2011

Pros and cons of Constant Proportion Portfolio Insurance (CPPI)

Consant Proportion Portfolio Insurance (CPPI)
Risk management via asset allocation optimizes portfolio investing
Constant proportion portfolio insurance is a form of investment risk management that is based on asset allocation. In other words, it is investment insurance however it is not insured by a company that provides the insurance. According to Rama Cont and Peter Tankov of the University of Columbia Center for Financial Engineering, constant proportion portfolio insurance allows investors to make risky investments that can grow by using multiples i.e. having more 'risk-free' assets to counterbalance the riskier assets.

How of constant proportion portfolio insurance works

To insure against risky investments constant proportion portfolio insurance requires the following three  amounts and one allocation per Investment Week. In other words, one has to first define how much capital one has to invest, then decide how much is an acceptable amount to lose, then assign a percentage loss to the risky allocation of assets. These measurements are entered into a formula to arrive at an amount for asset allocation.

1. Capital              Ex. $200,000 (C)
2. Risk metric       Ex. $20,000   (D)
3. Maximum loss  Ex 75%          (M)
4. Asset structure. Ex. $26,000 in Stocks, $174,000 in Treasury Bonds

In order to arrive at #4's asset structure numbers 1-3 have to be entered into the CPPI formula. This formula basically determines how much money is allowed to be invested in a high-risk asset in order to not exceed more than $20,000 loss with a maximum asset price drop of 75%. In other words, 75% of $26,000 is equal to $20,000 using the formula  (1/M)x (D)=(1/.75) x ($20,000)= $26,000. 

To illustrate further, suppose Mr. A has $200,000 and wishes to lose no more than $20,000 and expects the riskiest assets can fall as much as 75% in value. Given these parameters constant proportion portfolio insurance can be calculated using the aforementioned formula. This however, is only half the process, as there is still the question of return on investment, and asset instruments. That is to say, what investment instruments will yield a high enough return to justify a 75% risk. First it is a good idea to look at the advantages and disadvantages of CPPI.

Advantages of constant proportion portfolio insurance

1. Does not require derivatives

Since constant proportion portfolio insurance is more of a formula or technique the financial instruments used to fulfill the requirements of that technique are flexible. This means an investor can choose investments he or she feels comfortable with rather than something more complicated or unknown.

2. Fewer management expenses

Since derivatives are not required and flexibility is allowable within the CPPI formula, financial instruments that have lower management expenses, commissions and fees can be selected to optimize the portfolios cost effectiveness.

3. Adjustable risk and reward

Another advantage of constant proportion portfolio insurance is it can be periodically adjusted. For example, if an investors risk level or total investment capital changes, the formula can easily be recalculated and assets reapportioned to suit that change.

Disadvantages of constant proportion portfolio insurance

There are a few disadvantages to constant proportion portfolio insurance. These disadvantages can be minimized with effective decision making, and accurate assessment of market risk but should be addressed to properly meet financial objectives, risk tolerance and goals.

1. Upside ROI may be unknown

Risky investments tend to not have fixed rates of return which means the portfolio could lose value and not gain a cent. For someone seeking steady consistent growth this type of asset insurance allocation is less likely to be acceptable. However, this does not have to be the case, CPPI can still be used with fixed rates of return and very low risk levels but then becomes somewhat pointless as there is nothing to really insure against.

2. Risk level estimate may be wrong

Another potential problem with CPPI is the risk level estimate may be wrong. For example, the market may drop more than the investor expects for a given asset. Moreover, a faulty risk assessment can dampen the potential ROI or cause the investor to lose more than thought possible. In light of this, it is important to balance realistic expectation  about what the market can do, and what is also most likely to occur.

3. Opportunity cost of insurance

A third problem with constant proportion portfolio insurance is the opportunity cost. Money used to insure risky assets is money not invested in other risky assets. Granted that opportunity cost may actually amount to opportunity savings if those risky assets do not perform. However, there may also be safer assets with higher returns that increase the cost of financial opportunity provided by CPPI.

Image license: US-PD

Wednesday, October 26, 2011

CEO Resignations on The Rise?

In the last few months there has been a glut of business executive resignations sweeping the market. This multitude of corporate resignations has showered the news headlines indicating possibly hazardous business conditions. It appears the markets have tested the wherewithal or oversight ability of some of the best senior executives and managers to the point of no confidence, lack of fortitude and resignation.

If there is no index measuring executive resignations maybe there should be. An executive resignation index could serve as an economic and business performance indicator, especially if the reasons for the executive resignations are also documented. For example, of the companies below several resignations are directly linked to performance failure whether that be related to scandal, insider trading or operational shortcomings.

An executive resignation index cross-referenced to profit margins, earnings per share etc. might actually have a reasonably correlated beta coefficient worth consideration in investments decisions. This would make such an index a useful investment decision making tool. Granted the employee turnover-ratio does measure employee turnover and is an  indicator of possible internal problems, but it is not quite the same as an executive resignation index which may serve to measure not just corporate volcanic activity, but total eruptions.

Tuesday, October 25, 2011

Why finance for A is not always finance for B

Finance like most things can be as simple or as complicated as one chooses to make it. With roots stretching back in history, finance began when things of value began to be equivocated with wealth. However, financial management does not have to be about wealth at all, it also pertains to debt management and the valuation of resources considered essential in day to day life.

How assets and debts are measured, utilized, exchanged and valued also differ considerably from individual to individual and society to society, in part because of an aspect of behavioral finance called behavioral heuristics, but also because of variances among individual and cultural values, and knowledge systems.

Money Transfer from person A to B: Each have different financial goals
Image attribution: Horatius License: Public Domain

Financial measurement is constructed

As with many modernizations, finance is a socially constructed reality that makes use of a selectively chosen deductive knowledge. For example, our numerical system is 'base 10' which according to Kenny Felder of North Carolina University really only means that all numbers larger than 9 are created using the original numbers 0-9. In a base 5 system, all numbers larger than 4 are derived from the numbers 0-4 and 5-9 are not used. Thus, numbers are only the result of meaning we as human allow them to have.

Different financial systems represent the same things

Multiple financial meanings can also be construed from exactly the same phenomenon. To illustrate, a commodity futures contract for the delivery of 5 tons of seal meat  may represent a present value of future cash flow to an investor, but absolutely nothing to a traditional Inuit who's currency consists of seal meat and not a derivative financial instrument. Both realities are the same, i.e. 5 tons of seal meat, but the former creates things based on other things whereas the latter simply deals with what is easily accounted for.

Financial management is linked to cultural values

In addition to the system used to measure things of value, and the extent to which that system derives meaning, finance also has cultural values associated with it. In a post-apocalyptic or purely agrarian culture, non-technological culture with limited products, currency may still exist, but may play a considerably smaller role in civilization. For example, a culture with no factories, automobiles, laboratories etc. is more likely to be indicative of one with less materialistic goals, and consequently, less products and services. Such being the case, finance and economics is less elaborate and are less likely to be a priority in that society.

The goals of finance are not always the same

Another inconsistency in finance is that financial goals are not always the same. Investing for one person may both be a completely different activity and may even serve antithetical purposes. To illustrate, suppose a farmer plants a seed that is intended to grow into an apple tree that will provide fruit for his family and livestock. That seed is an investment and has no affiliation with money because it was traded for a different kind of seed. Yet, another person may invest $100 which itself is a digital concept because it was transferred  through an Automated Clearinghouse, an electronic funds transfer service managed by the Department of the Treasury. Moreover, the goal of that investment is for it to appreciate in value alone.