Ok I'm back again after some time. Had to take a break from writing because of project pressures. Today I'm going to discuss an interesting topic - Hedge Funds.
Infact one of the major reasons for the latest debacle of the financial industry can be attributed to the Hedge Funds. So what exactly are Hedge funds? In simple words, Hedge Funds are privately owned investment houses. Hedge funds manage money for the so called super riches.You won't see Hedge fund adverts on your tele or magazine, as you see for a regular mutual funds. Hedge Funds maintain their exclusivity by targetting only the wealth for the riches or to professional investors such as insurance companies and pension funds. According to the SEC, an accredited investor is an individual person with a minimum net worth of US $1,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.
Hedge funds are typically managed by highly talented high-profile investment professionals with long track records in the business.
Varied strategies
So what do they actually do?
The simple answer is that they invest money - in anything that they think will make profits. Typically they focus on generating positive "absolute returns" (or returns greater than zero).
Hedge funds embrace a wide variety of skills and strategies, generally grouped under the four following headings:
Long/short equity - they aim to profit from superior research and stock picking skills by buying the best ideas and reducing the resulting stock market exposure by shorting (selling stocks they do not own) those they believe will perform less well.
Relative value - typically they use computer systems to calculate the "fair" value of one asset relative to another and then shorting (selling) the more expensive asset and buying the cheaper one.
Event-driven - they seek investment opportunities surrounding corporate events, for example, investing in bankrupt or merging companies.
Trading strategies - for example, taking positions on the direction of markets, currencies and commodities.
So, hedge fund managers are essentially a group of active investment managers who invest in a variety of asset classes, with the licence to invest in a very flexible way. The flexibility comes from the fact that hedge funds are not regulated as strictly as a normal pension fund or mutual fund by the SEC (in the US) or the FSA (in the UK). Hedge funds are not obligated to share with their clients their investment strategy.Typically mutual funds or pension funds need to declare their portfolio of investments with the investor, as guided by the regulatory authorities.Each hedge fund manager decides his/her own fees and mandates the time when a investor is allowed to withdraw his money from the fund, free from any regulatory obligations.
It has been claimed that these privately owned investment companies are responsible for half the daily turnover of shares on the London/NewYork stock market. Industry experts calculate that there are around 8,000 hedge funds operating globally, mainly in the USA, with hundreds based in the UK - primarily in the West End.
Hope you like the short primer on hedge funds. Next will be how hedge funds actually lead to the collapse of the economy across the globe.ciao
Monday, 25 May 2009
Monday, 19 January 2009
Quantitative Easing
Last week I discussed about the problems with printing money, as it drives up inflation. Today I'm going to discuss a method called quantitative easing - or a situation in which the government resorts to printing money to restore growth in an economy. But to understand quantitative easing we need to understand something new beyond inflation and interest rates. In this example I will use the case of the US economy which is currently employing quatitative easing as means to ease recessionary pressure.
Government Securities: In simple words these are debts sold by the government of a country . I won't go much into too much detail about government securities in this post and will dedicate a complete post on them later. For the time being just think of government securities as collateral against which the government borrows money from the public. Since these are guaranteed by the government of a country, they generally carry lower rate of interest or net yield.In US such government bonds are known as treasury bonds.
Fed short term lending rates: The 'Fed' or Federal Reserve is the central bank of the US.The Fed short term lending rate is the interest rate at which banks borrow money from each other. The current Fed lending rate is hovering between 0-0.25%, the lowest since its inception.
Banks borrow from other banks: A bank's main source of income is from interest earnings from the loans it gives out to its customers. A part of this money that the bank lends comes from your and my my money that we deposit in it. However depositor's money alone isn't the only way for a bank to generate liquidity.It also borrows funds from other banks and lend it out to its customers at a higher rate. The interest rate at which it borrows is governed by the FED funds rate a.k.a. the short term lending rates.
Credit crunch (More on this later) : A situation where banks stop or reduces lending to each other. Now for a bank it becomes increasingly difficult for arranging money to lend out to its customers. The result - businesses don't get the money as loans from banks for expanding their businesses, consumers won't get the money to spend on a new home or a car. The net effect - the economy goes into a recession.
Why the banks won't lend money to each other?: Will you lend money to a friend who you're not sure how solvent he/she is? Similarly given the amount of losses the financial institutions are suffering from sub-prime losses (remember Lehman Brothers got bankrupt), banks are increasingly becoming skeptical and are reluctant to lend money to each other.Given such a scenario just reducing the short term interest rates by the FED won't help. In good times, lower short term lending rates would have increased interbank lending (banks get easy money from each other and can lend out the same at higher interest to its borrowers) and would have boosted the economy in turn. Given such a scenario where low short term interest rates are not helping (Fed cannot lower the rates further as they are already near zero - and the rate of lending cannot be negative), the Fed has moved to a technique called quantitative easing.
So if banks are not lending, what are they doing with their money? Banks are run by clever people. In a low interest regime like the current one in the US, whatever money they could borrow (inter-bank lending has slowed but is still there to a lesser extent), banks are increasingly investing their money in safe investments like government securities. The 10 year T note (Treasury Bond) in the US earns you an interest rate of about 2%. So borrow money at 0.25% and invest them at a place which earns you an interest of 2%. This way the effective interest earning for the banks is 1.75%. Banks find it safer to invest this money in government securities than in lending out, because in a economy in recession they are increasingly skeptical of businesses/consumers doing well and repaying their debts.
Quantitative Easing: By employing quantitative easing the Fed plans to print more money. But hold on, this money is not for distribution to the public. What the Fed plans to do with this money is buy back the government securities (the T Notes that the banks are on a buying spree). By doing so the Fed is trying to reduce the effective yield on Government securities (bond yield goes down as demand for bonds increases). So as yield will go down banks will be repulsive towards buying new government securities.To boost profits then they will turn towards lending money to the public. Lending will increase and the Fed thus expects to give the shrinking economy the much needed life support.
Will Quantitative Easing Work? Well no one knows. Quantitative easing was used by the central bank of Japan when Japan was going into recession. Over a period of 6 years (2000-2006) the Bank of Japan maintained a super low interest rate (0.15%) and used quantitative lending to flood banks with excess liquidity for them to lend to businesses and individuals.
Hope I'm able to explain Scenario-2 (carry over from my previous post) and show you how printing money can sometimes be beneficiary to the economy.
Government Securities: In simple words these are debts sold by the government of a country . I won't go much into too much detail about government securities in this post and will dedicate a complete post on them later. For the time being just think of government securities as collateral against which the government borrows money from the public. Since these are guaranteed by the government of a country, they generally carry lower rate of interest or net yield.In US such government bonds are known as treasury bonds.
Fed short term lending rates: The 'Fed' or Federal Reserve is the central bank of the US.The Fed short term lending rate is the interest rate at which banks borrow money from each other. The current Fed lending rate is hovering between 0-0.25%, the lowest since its inception.
Banks borrow from other banks: A bank's main source of income is from interest earnings from the loans it gives out to its customers. A part of this money that the bank lends comes from your and my my money that we deposit in it. However depositor's money alone isn't the only way for a bank to generate liquidity.It also borrows funds from other banks and lend it out to its customers at a higher rate. The interest rate at which it borrows is governed by the FED funds rate a.k.a. the short term lending rates.
Credit crunch (More on this later) : A situation where banks stop or reduces lending to each other. Now for a bank it becomes increasingly difficult for arranging money to lend out to its customers. The result - businesses don't get the money as loans from banks for expanding their businesses, consumers won't get the money to spend on a new home or a car. The net effect - the economy goes into a recession.
Why the banks won't lend money to each other?: Will you lend money to a friend who you're not sure how solvent he/she is? Similarly given the amount of losses the financial institutions are suffering from sub-prime losses (remember Lehman Brothers got bankrupt), banks are increasingly becoming skeptical and are reluctant to lend money to each other.Given such a scenario just reducing the short term interest rates by the FED won't help. In good times, lower short term lending rates would have increased interbank lending (banks get easy money from each other and can lend out the same at higher interest to its borrowers) and would have boosted the economy in turn. Given such a scenario where low short term interest rates are not helping (Fed cannot lower the rates further as they are already near zero - and the rate of lending cannot be negative), the Fed has moved to a technique called quantitative easing.
So if banks are not lending, what are they doing with their money? Banks are run by clever people. In a low interest regime like the current one in the US, whatever money they could borrow (inter-bank lending has slowed but is still there to a lesser extent), banks are increasingly investing their money in safe investments like government securities. The 10 year T note (Treasury Bond) in the US earns you an interest rate of about 2%. So borrow money at 0.25% and invest them at a place which earns you an interest of 2%. This way the effective interest earning for the banks is 1.75%. Banks find it safer to invest this money in government securities than in lending out, because in a economy in recession they are increasingly skeptical of businesses/consumers doing well and repaying their debts.
Quantitative Easing: By employing quantitative easing the Fed plans to print more money. But hold on, this money is not for distribution to the public. What the Fed plans to do with this money is buy back the government securities (the T Notes that the banks are on a buying spree). By doing so the Fed is trying to reduce the effective yield on Government securities (bond yield goes down as demand for bonds increases). So as yield will go down banks will be repulsive towards buying new government securities.To boost profits then they will turn towards lending money to the public. Lending will increase and the Fed thus expects to give the shrinking economy the much needed life support.
Will Quantitative Easing Work? Well no one knows. Quantitative easing was used by the central bank of Japan when Japan was going into recession. Over a period of 6 years (2000-2006) the Bank of Japan maintained a super low interest rate (0.15%) and used quantitative lending to flood banks with excess liquidity for them to lend to businesses and individuals.
Hope I'm able to explain Scenario-2 (carry over from my previous post) and show you how printing money can sometimes be beneficiary to the economy.
Sunday, 11 January 2009
Inflation revisited
I discussed inflation in my last post. I thought of discussing it in a little more detail to give you the complete picture.
As a child I always used to wonder why the world has so much of poverty. Can't the Central Banks simply print more money and donate it to the poor? Pretty simple way to remove poverty after all. But inflation or value of money helped me understand this paradox.Here are reasons why printing of money may not always work.
Scenario 1: Imagine the Indian economy is in good shape and the government starts printing money and donates it among its poor (by poor I mean people below the poverty line).The aim is to remove poverty.Now imagine because of this government action everybody in the country is loaded with fair amount of cash (I assume people above the poverty line don't receive any monetary benefits from the government and are substantially well-off compared to the ones below the poverty line).What would these formerly poor people do with their new found wealth? An obvious choice would be to find a shelter for themselves. The result- demand for real estate or new houses would drive up. Indirectly since there will be so many new buyers in the market, with fewer homes to sell, the real estate market will inflate with exorbitant rise in prices. But it's not only real estate, other sectors will get affected too. Imagine the truck drivers in our country who gets a paltry sum of say Rs. 5000 a month.Now the government has just donated each of them Rs. 100000 as part of its poverty eviction drive. A truck driver now with loads of cash might deny to work with the same paltry salary any more. He demands a raise which the trucker company has to agree to. But how will the trucker company arrange these extra cash to be given to its drivers? After all the trucker company was not beneficiary to any Government gifts. The company will in exchange charge more to its customers for their freights. Remember trucks in our country are vital for moving daily food supplies across the states.If the truckers inflate prices, so would the daily price of your food would inflate.
So did you see inflation working in the above two examples? To raise the living standards of a certain section of the society, Government donates excess of cash among them. Now with extra money in the economy, demand for goods increases which in turn raises prices of daily items. People who were relatively well-off before the government started distributing this money now see a drop in the value of their savings - a kg of apple now costs Rs. 10 which was Rs. 5 a month ago before the government decided of charity. So the idea of removing poverty just by printing money doesn't seem to be a good one.
As a child I always used to wonder why the world has so much of poverty. Can't the Central Banks simply print more money and donate it to the poor? Pretty simple way to remove poverty after all. But inflation or value of money helped me understand this paradox.Here are reasons why printing of money may not always work.
Scenario 1: Imagine the Indian economy is in good shape and the government starts printing money and donates it among its poor (by poor I mean people below the poverty line).The aim is to remove poverty.Now imagine because of this government action everybody in the country is loaded with fair amount of cash (I assume people above the poverty line don't receive any monetary benefits from the government and are substantially well-off compared to the ones below the poverty line).What would these formerly poor people do with their new found wealth? An obvious choice would be to find a shelter for themselves. The result- demand for real estate or new houses would drive up. Indirectly since there will be so many new buyers in the market, with fewer homes to sell, the real estate market will inflate with exorbitant rise in prices. But it's not only real estate, other sectors will get affected too. Imagine the truck drivers in our country who gets a paltry sum of say Rs. 5000 a month.Now the government has just donated each of them Rs. 100000 as part of its poverty eviction drive. A truck driver now with loads of cash might deny to work with the same paltry salary any more. He demands a raise which the trucker company has to agree to. But how will the trucker company arrange these extra cash to be given to its drivers? After all the trucker company was not beneficiary to any Government gifts. The company will in exchange charge more to its customers for their freights. Remember trucks in our country are vital for moving daily food supplies across the states.If the truckers inflate prices, so would the daily price of your food would inflate.
So did you see inflation working in the above two examples? To raise the living standards of a certain section of the society, Government donates excess of cash among them. Now with extra money in the economy, demand for goods increases which in turn raises prices of daily items. People who were relatively well-off before the government started distributing this money now see a drop in the value of their savings - a kg of apple now costs Rs. 10 which was Rs. 5 a month ago before the government decided of charity. So the idea of removing poverty just by printing money doesn't seem to be a good one.
The above examples also explain one more paradox - unemployment rate quoted as part of inflation rate. Why unemployment rates of a country are generally quoted with inflation rates? Because a high unemployment rate would mean more people without jobs, which in turn means more and more people with less money in the country's economy. This would lead to a decrease in demand and therefore a drop in prices of goods (opposite of inflation or deflation). On the other hand if all the people in a country are employed that would mean a rise in demand of goods and thereby rise in prices leading to inflation. The government of a country therefore always tries to maintain a healthy balance of unemployment rates. Unemployment rates of zero though sounds good is actually not good for a country's economy.
In my next post I will talk about Scenario 2 where it becomes necessary for Central Banks to print money, a pratice also known as 'Quantitative Easing'.
Friday, 2 January 2009
Groundwork
Ok all set. But before we start, few important terminologies that we need to understand. Some of you might be already Guru's in finance and can skip this part, but as I said the sole purpose of this blog is to explain Finance in a very simplified way for people with no background in the subject.
Today I will talk about inflation.
What is Inflation afterall? It's a pretty familiar term these days, isn't it?
Let me explain.
According to investopedia inflation is - "The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling."
As inflation rises, every rupee will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a Rs. 1 pack of gum will cost Rs. 1.02 in a year. On the other hand as prices of goods increase, you and me get the crunch on our savings as we have to shell out more for the same item than we did a year ago.
How are inflation rates determined?
I will direct you to the following blog for an idea on how inflation is calculated in India:
http://www.thefinblog.com/2008/06/inflation-rates-of-india.html.
In the US, CPI is followed as a means to calculate inflation.
What Does Consumer Price Index - CPI Mean? (Excerpt from Investopedia)A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
Sometimes this is also referred to as "headline inflation".
The U.S. Bureau of Labor Statistics measures two kinds of CPI statistics: CPI for urban wage earners and clerical workers (CPI-W), and the chained CPI for all urban consumers (C-CPI-U). Of the two types of CPI, the C-CPI-U is a better representation of the general public, because it accounts for about 87% of the population.
CPI is one of the most frequently used statistics for identifying periods of inflation or deflation. This is because large rises in CPI during a short period of time typically denote periods of inflation and large drops in CPI during a short period of time usually mark periods of deflation.
What is the current inflation rate in India?
Please refer to http://www.thefinblog.com/2008/06/inflation-rates-of-india.html
What are the different types of inflation?
There are basically two types:
- Demand - Pull Inflation : This type of inflation is a result of strong consumer demand. When many individuals are trying to purchase the same good, the price will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation.
- Cost-Push Inflation : A phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials.Cost-push inflation develops because the higher costs of production factors decreases in aggregate supply (the amount of total production) in the economy. Because there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).
Here's is a good primer on the difference between the two types of inflation.
Can't we control inflation so that it doesn't rise?
The answer is yes. Every country has something known as the central bank which decides the monetary policy for that country. For India this onus lies on the Reserve Bank Of India (RBI). The RBI takes appropriate measures whenever the inflation rate goes beyond its comfort level (which is around 5-7%).
What does the RBI do when inflation rate rises?
Imagine 2008 when crude oil prices touched a historic $147.Price of oil is a significant benchmark for inflation as it determines the price of goods reaching the consumers.For example if oil prices increase, the transportation costs of goods will also increase as the truckers will increase their fees. The traders indirectly will charge more to the consumers to levy this increase in transportation costs.In other words the price of goods will increase leading to inflation.This was what exactly happened in 2008 with inflation in India touching a whopping 12%. The RBI rightfully stepped in to check inflation at this time. It has tools with it called the "Repo rate","Reverse repo rate" and the "CRR" (Cash Reserve Ratio). By manipulating these rates RBI tries to control the inflation within its comfort levels.
What are "Repo", "Reverse repo" and CRR?
Repo Rate - Your bank needs money for their day to day operations.Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. So when inflation is northward, the RBI generally increases the repo rate. This actually increases the cost of borrowing for the banks and decreases the supply of money in the market. Inversely when inflation rates are southward, RBI might decrease the repo rate which makes it easier for banks to borrow.
Reverse Repo - The reverse repo rate is the return banks earn on excess funds parked with the central bank against Government securities. When inflation rises, RBI can increase the reverse repo, so banks are more tempted to park their money with RBI and earn higher returns. As more and more banks will follow the same, the indirect effect is that it will suck out excess liquidity in the market.When inflation falls, the RBI may decide to reduce the reverse repo rates, which in turn will discourage banks to park their money with the central bank and instead lend it to consumers at higher interest rates.
CRR (Cash Reserve Ratio) - "The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank, which in the U.S. is the Federal Reserve. The reserve ratio affects the money supply in a country. " - source Investopedia. For example if you deposit Rs 100 in a bank in India, and the RBI determined CRR rate is say 10%, then the bank can lend a maximum of Rs. 90 as loans to consumers from your Rs. 100. What we need to understand here is that for a bank its main source of income is earnings from interests earned on the loans given out to borrowers. A portion of this earning is then shared to you as interests earned on your savings account. How a bank gets the money to lend out is actually the money it collects from you and me as deposits. It's a huge pool of depositor's money which the bank then utilises to shell out loans (car loans, home loans, commercial loans, etc.) The CRR is a safeguard in place which restricts banks from lending out your entire deposit amount.This ensures that the bank has a sufficient pool of money in case a depositor withdraws money from his/her account.
Now imagine when RBI will increase the CRR, this will automatically put chains in the amount of money from a depositors account that a bank will be able to leand as consumer loans.Indirectly this will decrease the liquidity available in the market and thereby help to reduce inflation. Inversely, by decreasing the CRR, RBI can choose to increase the liquidity in the market.
As I speak, the RBI today has cut key rates to stimulate the Indian economy.
"The Reserve Bank of India on Friday cut key policy rates. The repo and the reserve repo rate under the liquidity adjustment facility (LAF) has been cut by 100 basis points while cash reserve ratio (CRR) has been reduced by 50 bps. Following this move, reverse repo stands at 4%, repo stands at 5.5% and CRR now stands at 5%. The cut in CRR will infuse Rs 20,000 crore in the system." - source Economic Times. The new rates are effective from Jan 17th 2009. And in case you're wondering what "bps" is, it means basis points. 100 basis points is equivalent to 1 percentage point.
flag counter
blog counter
A gory 2008
I happen to work in the technology sector, but has a niche for finance. Well I'm not an expert by any means, but couldn't ignore the current market histrionics either. So I decided to dig more on this subject and explore what led us to this sudden debacle of the world markets.Over my next few posts I will try to explain the chronicle of events (and explain them in lay man's terms) that has formulated one of the biggest financial crises of the century.
Subscribe to:
Posts (Atom)