Tuesday, January 20, 2015

This article appeared in The Edge on Nov 17th, 2014

Negative yield in bonds
In September this year, Khazanah Nasional Berhad issued a USD500 million exchangeable sukuk, the third of its kind within the last two years. What is interesting about these sukuks are that they were zero coupon sukuks with negative yields.  
Negative yield in bonds are not common in the market, but it may become more frequent. In this article I define negative yield and show how it is computed. The motivation of investors to invest in such bonds is explored. Finally the article discusses the mechanics of convertible and exchangeable bonds.
Understanding negative yield to maturity
When an investor buys a coupon-paying bond, he is promised a series of regular coupons and the
This article appeared in The Edge on June 16th 2014
Will you be paying more for your coffee soon? The answer lies in hedging tactics

In our everyday lives of coping with financial markets and home life, we need our coffees to keep us going. But brewing in the corner is a steady, dramatic rise in coffee prices since the start of the year. Chart 1 shows prices of the DEC 2014 Arabica coffee futures listed in the ICE Futures in the U.S. Since January, the prices have increased by over 50% !

Chart 1
Source: ICE, USA

A futures price reflects thousands of market players’ (hedgers and speculators who buy and sell the contracts) reactions towards the expectation of the spot coffee prices in the future.  Taking the example of the KCZ12 futures contract above, the expectation is that the price of coffee by end-December will be 177.95 cents per pound. In comparison, the spot or physical price is gathered by agents from numerous localized auction markets in coffee producing countries. Futures tend to be a

Wednesday, July 30, 2014

Investors, beware of conversion ratio in warrants

This article appeared in The Edge on Apr 28, 2014

I was intrigued by BFM’s 9.30am Wednesday show with Salvatore Dali on the 2nd of April.  It was about warrants, specifically the frustration around the conversion ratio in the Datasonic call warrants. I would like to take this opportunity to deliberate further on this subject to alert investors, especially novices, about the conversion ratio in warrants.

When we speak of warrants, we are frequently concerned about the moneyness of the warrant (i.e. its exercise price vs. the underling share price), the time to maturity and the volatility of the underlying share price. We expect market players to react to these key parameters, which result in the warrant price in the market. However hidden somewhere in the term sheet is the conversion ratio of warrants, which if missed by investors, will lead to an inaccurate expectation of the profits upon settlement. The conversion ratio is the number of warrants needed in order to buy (or sell) one share. Therefore, if the conversion ratio (warrant : share) to buy a share is 3:1, the holder needs three warrants in order to purchase one share.

In this article I wish to explain the logic for having conversion ratios in certain kinds of warrants. This is followed by a worked out real life example showing how the profits and gearing of warrants

Monday, January 27, 2014

Credit Hedging Agency vs. Credit Default Swaps
This article appeared in The Edge, Malaysia on Nov 25, 2013

Some time back in September 2013, this newspaper published a convincing case of a Credit Hedging Agency model as an alternative to Credit Default Swaps to hedge credit risk in the Malaysian credit market. This initiative would allow investors to hedge the default risk in lower rated corporate bonds and hence promote the credit market segment. In this article, I examine the Credit Hedging Agency model and discuss its suitability as an alternative to the well-established credit default swap product.

Credit Hedging Agency: The potential business model

The establishment of Danajamin, a Financial Guarantee Insurer was to promote the issuing of lower
rated bonds, typically by small & medium enterprises (SME). The insurer guarantees payments to investors in the event of default of the bond issuer. The guarantee enhances the credit rating of the bonds to typically an investment grade type, and attracts investors to subscribe for the bonds.
However the above scheme does not tackle the issue of the general lack of appetite in lower rated bonds in the Malaysian credit market. Now with a Credit Hedging Agency in place, investors who otherwise would be wary of the default risk in lower rated bonds could potentially pay a premium to the Agency as a protection against default risk. Should there be a default, the investor delivers the

Monday, July 22, 2013

Islamic Derivatives: Practical problems in valuing profit rate swaps

By Jasvin Josen
This article appeared in The Edge, Malaysia on June 10, 2013
Islamic derivatives have achieved impressive growth over the years worldwide and in Malaysia. The Islamic profit rate swap, for example is commonly used for risk management as well as for investment. It is frequently associated with the conventional interest rate swap.

Valuation of financial products is always challenging and Islamic derivatives are no exception. In this article I begin with how profit rate swaps can be used for risk management or investment and then discuss some practical problems in valuing the product.

The profit rate swap for risk management: an example
When companies finance their transactions by using Shariah compliant contracts, they may be exposed to the changing rental rates or profit rates over the contract term. These companies may want to hedge the uncertainty they face in these rates.

Leveraged Super Seniors – the valuation question

By Jasvin Josen
This article appeared in The Edge, Malaysia on Feb 11, 2013
In the last article, I explained what a Leveraged Super Senior trade is and the accompanying trigger points. It is important to note that Deutsche Banks’ alleged miss reporting of the losses from these products, stems from a valuation stand point. There were no cases of actual defaults or unwinding of the trades. The main issue was how these trades were priced in the books at the height of the crisis.
In this article I describe the main principles in valuing the trade and what can go wrong.

Leveraged Super Seniors of the pre credit crisis

By Jasvin Josen
This article appeared in The Edge, Malaysia on Feb 4, 2013

December 2012 wormed out another account of an interesting innovation in the financial world with the “Leveraged Super Senior” product. Deutsche Bank is being blamed of not having valued these products correctly in its financial statements, that otherwise would have recognised a loss about USD12 billion .

I would like to enlighten readers, as plainly as possible, on what a Leveraged Super Senior is and the complexities that could follow.

First, the Synthetic CDO
A Leveraged Super Senior is a credit derivative product. It is a part of a Collateralised Debt Obligation (“CDO”). A CDO is simply a basket of credit products (bonds and loans) where investors share the returns (i.e. the coupons and interest income) but also take hits when any of the credit products default. Not all investors share the losses proportionately, as the CDO basket is divided (or “tranched”) to cater for very risky investors, the not so risky investors and so on.

Tuesday, April 2, 2013

Converting Swaps into Futures

This article appeared in The Edge, Malaysia on September 10, 2012

“Regulators win as ICE converts swaps to futures” – read the Thompson Reuters Westlaw’s headline on Aug 6. The Intercontinental Exchange (ICE) had announced that all its over-the-counter (OTC)  cleared energy swaps would be converted to futures contracts from January 2013.
A “cleared swap” is a term introduced in 2009 as part of an effort to standardise the OTC derivatives in order to bring them on to exchanges, and be subjected to mark-to-market and margining rules.  Cleared swaps are swaps that are traded and settled with the exchanges. Hence, when a party enters a cleared swap, the other side of the trade is the Exchange.
Once a standardised swap trades on the exchange, they quite resemble futures. In this article, I show how a swap can be converted into futures. The trade is chosen from one of the trades published by the CFTC (the U.S. Commodity Futures Trading Commission) in the U.S. Federal Register in Nov 2010.
The Swap
We have a fixed for floating WTI (West Texas Intermediate) Crude Oil swap with features shown in Table 1. This swap will have cash flows as shown in Chart 1, with Party A paying a fixed rate of $80 per barrel for 100,000 barrels every month and receiving the floating rate for 100,000 barrels each month. The floating rate is the settlement rate of the one-month futures expiring on the 22nd of the preceding month.
Table 1

Wednesday, February 6, 2013

LIBOR and Derivatives – how close are they?

LIBOR and Derivatives – how close are they?
By Jasvin Josen
This article appeared in The Edge on Dec 3, 2012

We are quite familiar with the recent LIBOR (London Interbank Offered Rate) scandal in the financial markets. The obvious effect of the manipulation of the LIBOR is to mortgage loans and corporate loans. However, there was a bigger concern that LIBOR was integrated into approximately USD350 trillion worth of derivative contracts globally.
LIBOR affects derivatives in more that one way. Firstly, interest rate derivatives use LIBOR to determine their payoffs at certain dates. Secondly, all derivative positions are priced using LIBOR, where LIBOR is used as the discounting rate.

Interest rate Derivatives
Interest rate derivatives have payoffs depending on interest rate levels. For example if an investor buys the CME Eurodollar Future, his profit from this derivative will depend on what level the 3-month USD LIBOR is.

Other common interest rate derivatives are interest rate forwards (also known as forward rate agreements or FRAs), interest rate swaps, interest rate options and structured rate products. In this 2-part article series, I demonstrate how LIBOR can affect interest rate swaps, interest rate options and structured rate products.

Tuesday, September 11, 2012

Measuring Delta in Derivative Portfolios

By Jasvin Josen

This article appeared in TheEdge Malaysia on June 23, 2012

In the previous article, I explained what delta is in the market risk context and illustrated the case of a bond dealer measuring the delta in a bond portfolio. After knowing his delta exposure, he next decides how to manage the delta.
In this article, I expand the previous example by introducing interest rate swaps to hedge the delta. Next I illustrate the delta measurement for options.

Bond and Swap Portfolio

Let us assume that the bond dealer mentioned in the previous article decides to hedge his simple 3-type bond portfolio with interest rate swaps. He decides only to hedge the delta in the 5-year maturity bucket. He enters into a 5-year bullet interest rate swap (IRS) with the following terms:

5 year bullet IRS:
Pay Fixed Rate:                       4.4%
Receive Floating Rate:             6m LIBOR + margin
Notional:                                  $50,000

Monday, September 10, 2012

Measuring Market Risk – The Delta

By Jasvin Josen
This article appeared in The Edge, Malaysia on June 18, 2012

Maintaining a portfolio of financial instruments is an everyday thing for financial market investors, fund managers, dealers and traders at commercial banks and investment banks. Hand in hand with maintaining the portfolio is managing the risk that the portfolio will incur losses from fluctuation in the securities prices in the portfolio. This is market risk.

Say a trader holds a portfolio of palm oil futures. She knows what its market value is today, but she is uncertain as to its market value a week from today. The trader wants to identify this risk and reduce any exposures that she considers excessive. In other words, she wants manage the market risk. How does she do it?

Tuesday, June 5, 2012

Pricing the probability of a rare event

This article appeared in The Edge in April 2012
By Jasvin Josen
In the previous article, I mentioned the convenience of utilising cat bonds to distribute catastrophic risk out of the insurance industry. The market for cat bonds however has not taken off very satisfactorily and I cited some research that attempted to understand investors’ reluctance to invest in this product. In a nutshell, investors find high loss and highly improbable events, very unsettling.
In this article, I describe the expected loss and some basic thoughts in pricing the probability of a rare event.

Catastrophe Bonds – fear of the unknown?

This article appeared in the Edge in March 2012

By Jasvin Josen

Our planet Earth has experienced a major change since the 1990s. Before the 90s, occurrences of natural disasters like hurricanes, floods, earthquakes and tsunamis were occasional and less severe. After this period however, the occurrence and severity of these catastrophic events increased drastically.
Following this dramatic change, losses caused by catastrophic events have also spiked sharply. Chart 1 illustrates this historical pattern.

Chart 1: World Catastrophe Losses, 1970-2010

Insurance companies have suffered major losses following the protection given against these “Act of God” events. As these events become more common, insurance companies naturally get nervous and tend to increase their rates. Indirectly the burden is passed back to consumers. At the same time, insurance companies also have the other alternative, to “exclude” protection against these disasters, depriving society from protecting their livelihood and trade.

Reinsurance vs. securitisation of catastrophic risk
To avoid a major loss, insurers have traditionally utilised reinsurance contracts. Briefly, this is

Pricing Convertible Securitie

This article appeared in The Edge in Jan 2012

By Jasvin Josen

Convertible securities are traded widely in global debt markets. The most common convertible securities are convertible bonds and convertible preferred stocks. The Convertible Bond (CB) is an equity-linked instrument that gives the holder of the bond the right to convert the bond into a predetermined number of common stock in the future. It is attractive to investors as it provides downside protection of a straight bond with coupons and principal payback at maturity plus the upside return of equities.

Being a hybrid of a bond and equity, the price behaviour of a CB is rather unique. The pricing of CBs is also not very clear-cut. In this article, I describe the features of the CB and its pricing behaviour and illustrate two common pricing methods in the market.

Features of a Convertible Bond
Suppose Company Q issues a convertible bond with a conversion ratio of 25.32 shares. The par value of the bond is $1000. This means that for each $1000 of the par value of this issue that the bondholder exchanges for Company Q’s stock, he will receive 25.32 shares.

The stated conversion price is therefore:
= Par Value of the CB / Conversion Ratio
= $1000 / 25.32
= $39.49

If this CB pays an annual coupon of 6% with a maturity of 5 years, the CB has an investment value. Assuming the risk free discounting rate is 2.5% and the credit spread is zero, the Investment Value of the bond can be derived by discounting its cash flows at the risk free discount rate, as shown in Chart 1.

Sunday, December 18, 2011

Delta One: What Does it Do?

This article appeared in The Edge, Malaysia on Nov 14, 2012
Delta One – What do they do?
By Jasvin Josen
After the episodes of the “rogue trading scandals” in Societe Generale in 2008 and UBS this year, one begins to wonder if the trouble lies with the bank trading strategies rather than the traders themselves. Both Mr Kerviel and Mr Adoboli were traders in the “Delta One” trading desk.
Terry Smith, a veteran London City broker seems to think that Delta One trading strategies are frighteningly complex. He told the Financial Times, “Management doesn’t understand what goes on in the Delta One desks. If you sat down with a CEO and asked them to explain what happens they would try but they couldn’t give you an accurate answer because they don’t understand.”
Recent efforts in re-regulation have curtailed investment banks’ involvement in hedge fund activities, private equities and proprietary trading. However many market players will concur that investment banks have found another outlet in the name of “flow prop” trading within its Delta One trading division. Yet, other industry players maintain that proprietary trading in Delta One is not new in the market, as market-making activities naturally involves hedging. Any trading desk will want to find the cheapest hedge and will have to create innovative hedges to maximise its own profits. Hence the traders will engage in all kinds of trading and arbitrage activities in various derivatives, which could be seen as proprietary trading. Although trading is done on behalf of clients and arbitrage is necessary to smoothen prices in the market, the bank is in control of how to manage its portfolio. These conducts only further blurs the definition of proprietary trading.
In this article I will describe some common trading strategies of the Delta One desk that have been prevalent in recent times.
Futures and Index Arbitrage

Structured Repo: The Emerging Norm

This article appreared in The Edge, Malysia, Sep 12, 2011
Structured Repos: The Emerging Norm
By: Jasvin Josen

Repurchase Agreements, better known as “Repos” have been around the global market for nearly a century now, as a financing tool. After all the years, it is only natural to find that Repos now  exist in many forms and are being “structured” in many ways. In this article, I will explain some interesting forms of the structured repo and conclude with some additional forms of risks that the market bears with these products.
In the most classic form, a repo is essentially a cash loan backed by collateral. The cash borrower becomes the “repo seller” who “sells” collateral to the “repo buyer” and receives cash. At the maturity of the loan (which is traditionally only a few days to a week), the repo seller “buys” back his securities and returns the cash to the repo buyer. Off course, there will be an interest element which is added on. Since it is backed by high quality collateral, the interest rate is typically lower than other forms of unsecured financing in money markets. Chart 1 illustrates this classic repo.
Chart 1 – The classic repo

The many variations
Repos are now designed to be flexible and efficient to cater for the investor’s needs, fitting in nicely as a funding element in structured deals. The following two structures will show how repos are used by investors to hedge (or in reverse, gain access to) interest rate risk and credit risk.
The Callable Repo

Auditing Derivatives: Model Validation

This article appeared in The Malaysian Accountant journal, Sep-Oct 2011 issue
Auditing Derivatives: Think of what can go wrong - Model Validation
By Jasvin Josen
Auditing derivatives, in all likelihood, is one of the most challenging areas for an auditor. I focus on thinking of what can go wrong rather than just a standard review, for, derivatives are very flexible products and thus have a great potential to flourish in a reckless way when unguarded by proper supervision and regulation.
In the last five articles, we have observed the different issues that can surface as a derivative instrument moves along the trading floor and the Controlling Group, under the watchful eyes of Risk Management (with its Value-at-Risk model) and the Valuation team.
I must introduce a last function called Model Validation. This function has long been established in investment banks in the U.S. and Europe but possibly only now taking root in Asian investment banks.

Wednesday, August 3, 2011

Valuation of derivatives: So what do we do?

This article appeared in The Edge (Malaysia) on 24 July 2011
In the previous article, we identified the need to pay attention to some valuation aspects of derivatives as derivative prices can easily go the other way if certain aspects are not taken care of. This article will present some possible approaches and best practises to help in addressing the valuation issue.
§   Independent Valuation Department

Valuation of Derivatives: The importance of getting it right

This article appeared in The Edge (Malaysia) on 16 July 2011

The valuation of derivatives has become a common discussion theme since the financial crisis. Complex and structured derivatives like credit debt obligations (CDO) that were believed to be priced at “fair values” barely came close to their realisable values when unwound in the extremely volatile market of 2007 and 2008.
Prior to the crisis, it was not a common practice for the clients of investment banks (e.g. corporations and fund management companies) to question or challenge the valuation of derivatives that were done over the counter (OTC) with the banks. On the other hand, the investment banks were equipped with state of the art models to price these OTC derivatives; however they overlooked some important issues that come with complex models.

This article will zoom into some problematic areas around the valuation of OTC derivatives to illustrate how valuations can go awfully wrong if certain issues are overlooked.

§  Pricing OTC Instruments

Auditing Derivatives: Think of what can go wrong Middle Office (Valuation)

 This article appeared in the Malaysian Accounting Journal, May-June 2011

In the previous issues, we were introduced to different functions of an investment bank (the Trading Floor, P/L Control Group and Risk Management) with the focus being the auditor’s mindset in auditing derivatives in these areas – thinking of what can go wrong.

In this article I introduce the Valuation Group, also referred to as the “Independent Price Valuation” (IPV), the “Price Verification” or “Price Testing” group. The IPV function can exist within the P/L Control group or it can stand alone to maintain its independence.

The IPV function
The valuation function should not be confused with the Accounting role in the investment bank. The latter operates on a higher level in determining adherence to accounting standards in booking trades into the financial statements.

The IPV team in an investment bank reviews the value of all trades recorded by the P/L Control Group. The duty of this team is to tell management every month, if the trades in the books have “fair values”. In other words, if the bank was forced to liquidate the trades, the bank would be able to realise those values on the books. This assumption is closely connected to liquidity and we will observe later that this is a challenge for bespoke (custom-made) trades.  

Trades are normally categorised in a few groups for price verification to take place:
§  Trades which prices come straight from the market – for example shares, bonds and “flow” derivatives like futures. The only focus here is that the products are recorded at the correct market prices taken at the end of day with appropriate bids or offer rates, depending on the positions – long or short.
§  Trades which are not as liquid – for example illiquid bonds and derivatives (traded over-the counter) written on illiquid credit names where market prices are not always readily available.
§  Bespoke trades – trades that are highly customised for the individual customer and traded over the counter. Most of these are structured derivative deals.

The IPV group will break down each trade by its parameters and assesses if the parameters are accurate and observable in the market.

What can go wrong?