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Below Zero: Negative Yields, Negative Rates And The Price Of Baked Beans

The Japanese did it. The Europeans did it. Even the educated Swedes did it. So will the Fed ever lower interest rates below zero? Markets fell out of bed last week on fears the Fed might shift from a Zero-Interest Rate Policy (“ZIRP”) that alleviated the pain of the financial crisis to a Negative Interest Rate Policy (“NIRP”) to keep the monetary stimulus to the economy alive. Why does it matter The “feasibility study” being undertaken at this stage is a long way from a policy announcement, but would indicate a very different interest rate path to December’s announcement. This volte face alone would query the Fed’s credibility. Add to that the known unknown of how markets might operate in this Through the Looking Glass world where you pay to lend money to the lender of last resort, and some basic assumptions around the supply of, and return on, capital have to be adapted. How does it “work”? The short answer is: we’ll see. In theory, by charging financial institutions to sit on surplus cash, they are forced to put that cash to work, for example lending to corporates to keep their wheels turning. In this way, negative rates act as a stimulus to the velocity of money, rather than the quantum of money supply. What are the issues? Issue number one is that it turns the fundamental relationship between providers and users of capital on its head. Aside from that are the legal and technical issues around how NIRP can be implemented in any jurisdiction. But, as we have seen so far – where there’s a will there’s a way. The sector most vulnerable is the banking sector as negative interest rates wreak havoc on Net Interest Margins – the spread between banks’ borrowing and lending rates that is the cornerstone of their profitability. Hence the rather brutal round of price discovery that took place in the banking sector as a response to this new known unknown. From negative yields to negative rates Short-term real yields on government debt (i.e. nominal yields, adjusted for inflation) went negative in 2008 during the financial crisis. Short-term nominal yields on government bonds, issued by, for example, the US and Germany, have dipped in and out of negative territory thereafter, as a safety/fear trade signaling that those investors would rather pay governments to guarantee a return OF their capital, than demand corporates to promise a return ON their capital. So economically speaking, negative yields are not new. But what is new is that negative interest rates are being adopted as a central bank policy. How have markets reacted? Markets hates grappling with new concepts where there is no empirical data from the past on which to make hypotheses. Hence the “shock” increase in risk premia despite the ostensible further lowering of the cost of capital. Renewed interest in gold is the natural reflex for those scratching their head as monetary policy grows “curiouser and curiouser”. What next? Central b anks are adding NIRP to the armory of “unorthodox” levers at their disposal to achieve orthodox aims. To what extent this new weapon is deployed will depend on the underlying development in fundamentals around growth, jobless rates and inflation targeting. Those targets set the course to which monetary policy will steer. Whether the new policy levers have more efficacy than the old remains to be seen. Baked beans, anyone? The UK’s baked bean price war of the mid 1990s, provides a parallel to the topsy turvey economics of negative pricing. To gain and retain customer market share, the big three British supermarkets slashed baked bean prices to around 10p a tin. Tesco’s then broke ranks and slashed prices further to 3p a tin (subject to max 4 cans per customer per day). Not to be outdone by its bigger rivals, Chris Sanders of Sanders supermarket in Lympsham, Weston Super Mare made history by selling baked beans for MINUS Two Pence (subject to max 1 can per customer per day). Janet Yellen – you now know whom to call. While it didn’t alter the fundamentals of the retail sector, it did mark the end of an irrational era of skewed economics. For the optimists out there, perhaps NIRP heralds the same? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

CFA Institute Study: Disclosing Fees, Conflicts Vital To Adviser-Client Relationship

What do investors want? It’s an issue of critical importance — and concern — to CFA Institute, an organization committed to the highest standards of ethics, education, and professional excellence in the investment profession. And at no time in the history of the investment management industry has this question mattered more. Longstanding business practices are under scrutiny, stoked by acrimonious debates in the United States over the duty owed by the person giving investment advice, and by the availability of low-cost automated financial advice globally. These issues are poised to change the investment industry as we know it. Simply put, understanding the needs of investors is critical to strengthening client satisfaction and loyalty in a rapidly evolving industry. For these reasons, CFA Institute partnered with global PR firm Edelman on From Trust to Loyalty: A Global Survey of What Investors Want . In it, we investigate trust within the investment community, surveying retail investors and institutional investors around the world to examine how much they trust the financial services industry, and comparing this to the general population surveyed in the annual cross-sector Edelman Trust Barometer . While investors have a slightly more positive view than the public, our survey shows there is much more room for improvement. When asked if they trust the financial services industry to do what’s right, 61% of retail investors agreed, 57% of institutional investors agreed, and only 51% of the public agreed. Moreover, the number from the public is up 8% from five years ago — an improvement, but hardly impressive in absolute terms. These findings have practical implications for the investment management profession. The survey also explored what dimensions influence that level of trust by giving respondents actions to rank in importance and satisfaction. The gaps are eye-opening and provide a roadmap for firms who wish to strengthen their value proposition and build loyalty with investors. Paul Smith, CFA, president and CEO of CFA Institute, has argued that shortcomings like these and a lack of trust are factors that hold the investment industry back. “Building trust requires truly demonstrating your commitment to clients’ well-being, not empty performance promises or tick-the-box compliance exercises,” he has said. “Effectively doing so will help advance the investment management profession at a time when the public questions its worth and relevance.” Assessing the Gaps Between What Investors Want and What They Get Both retail and institutional investors share the view that financial professionals are falling short on issues of fees, transparency, and performance. Among retail investors, the most important actions from an investment firm are that it “fully discloses fees and other costs” and “has reliable security measures.” These even surpass protecting their portfolio from losses. Among institutional investors, “acts in an ethical manner” rated as the most important attribute, followed by “fully discloses fees and other costs.” That’s not to say that performance is unimportant — 53% of retail investors and 60% of institutional investors cited “underperformance” as the biggest factor that would lead them to switch firms. This was followed by “increases in fees,” “data/confidentiality breach,” and “lack of communication/responsiveness.” Fee Transparency Even More Important Than Returns The survey reveals that the biggest gaps between investor expectations and what they receive relate to fees and performance. For many investors, understanding fees — how much they are paying and what they are paying for — ranks above returns in their priorities. Seventy-nine percent of retail investors said it was important to them that their investment firm clearly explain all fees before they were charged, and 73% said generating returns similar to or better than other firms was important. Click to enlarge Retail investors say they are prepared to pay fees, even higher fees, if they feel these costs will add value or deepen existing services. In what areas are retail investors willing to pay more? Better protection from portfolio losses (38% say they would pay more for this) Reliable security measures to protect their data (35%) Investors also want more context to understand specific portfolio management strategies, reflecting their increasing desire to be engaged. The top client service action retail investors want is that a firm “helps me understand why my portfolio is positioned the way it is.” This is expected by 70% of retail investors, but only 46% say investment firms are adequately delivering on this — a large gap that firms should close. Disclose Conflicts of Interest Investors surveyed also want upfront conversations about conflicts of interest, with fees structured to align with their interests. They want to be sure that their managers are acting in their best interest at all times, and it is in the best interest of investment managers to clearly communicate their commitment to conflict management and resolution. As regulators and industry professionals alike grapple with the conflicts of interest associated with a variety of investment advice business models, investor preferences are clear: They want the best solutions for their unique needs, and not just the lineup of products that the adviser can receive compensation for selling. Retail investors surveyed prefer to have access to the best product for their unique needs (76%), rather than choosing from a constrained set of products, even if choosing from constrained offerings would lower their out-of-pocket expenses for investment management (24%). Click to enlarge Institutional investors had similar priorities and concerns, and in addition, they identified gaps related to the depth of understanding an investment firm has in helping them solve their problems. For these investors, they expect a firm they hire to think beyond a specific mandate and show they truly understand their organization’s priorities, liability structure, and political dynamics. Rise of Robo-Advising The study reveals key regional and demographic differences in what investors value from financial professionals, with implications for robo-advisors. Looking ahead three years, the majority of investors in Canada (81%), the US (73%), and the UK (69%) say they will still value the guidance of an investment professional to help them versus having the latest technology and tools. However, the majority of retail investors in India (64%) and China (55%) and half of investors in Singapore believe having access to the latest tech platforms and tools will be more important to executing their investment strategies. Younger respondents also strongly preferred technology to human guidance, so this is an important trend for the future. What does this mean for financial professionals? It’s simple: Investors expect more than just performance. While markets may be uncertain, there are many factors that investment professionals can control in how they conduct their business and work with clients — and these are very valuable. From transparency around fees and investment decisions to aligning their interests with their clients’, investment firms have great potential to build greater trust among investors. Show your commitment to advancing ethics and trust:

Black-Scholes Pricing Model: Is The Hedging Argument Correct?

Black-Scholes Pricing Model: Is the Hedging Argument Correct? Preface Many are familiar with the works of Myron Scholes and Fisher Black in the late 1970s. Their contributions revolutionized the way we price options. Out of the many sections of their proof, the most interesting one in my opinion is the hedging argument given midway through the paper. The reason for which I find it so intriguing is due to the fact that it is the one section that is criticized the most. This leads us to a now popularized question, is such argument valid? Flashback Time As we pull out the proof written more than four decades ago, we notice that the traditional Black-Scholes hedging argument strictly assumes that: markets are frictionless, there is no arbitrage, there is a constant interest rate denoted as “r”, no dividends are paid out and that the stock price process respects the Geometric Brownian Motion. Let’s not forget that GBM (Geometric Brownian Motion) is a continuous time-stochastic process that models stock prices in the Black Scholes Model and other similar works. Click to enlarge If we denote the following as a European Call Price process: We must then further assume the following: As being in conjunction with some “C^2,1″ function C (S, t). When applying Itô’s Lemma we observe the following: Click to enlarge Let us also not forget that Itô’s Lemma is an identity to find the differential of a time-dependent function of a stochastic process. Now let’s consider a portfolio with the goal of long one call and short the following shares. (The goal is therefore what the portfolio consequently consists of.) If we short shares , then we must presume the following: By extracting the textbook argument we can observe the following steps: STEP 1. (**Highlighted**) STEP 2. Click to enlarge STEP 3. Click to enlarge Recalling that arbitrage is not part of the environment of the model we may equate coefficients on ” dt” yields the Black Scholes PDE. (We don’t need to go as far as to solve PDE) Click to enlarge This brings to mind a fascinating question, was the previously highlighted step (Step 1) correct? Gains Process Solution? Let’s remember that the tradition argument that if: Then: Although this seems appropriate, if we integrate by parts, we are then required to obtain the second equation as: Click to enlarge In order to maintain the strategy, two terms must be added representing additional investment. Both terms are differentials processes which have unbounded variation. We therefore cannot claim that ” dHt” is riskless. Since the math to find PDE takes too long I referred to Peter Carr’s solution to this problem in his 1999 paper discussing the proposed question. Carr had found that by doing the math right, PDE could not be found. Carr as well as many other critics, use this position in order to claims that perhaps the Black Scholes Model is wrong. The popular belief is that if the result is right, but the derivation is wrong, then the argument cannot stand. Many have proposed however, that it is possible to derive PDE by a more complicated means and achieve “tenure” therefore making the argument safe from derivations. Although this seems like a solution we must not forget that there are some that believe the contrary. Others have argued that the derivation is indeed correct since the number of shares held is referred to being “instantaneously constant”. (Sort of like instantaneous speed or velocity) In the eyes of mathematicians this two sided argument is difficult since the total variation of the number of shares held by any finite time interval must be in fact infinite. From Carr’s response, it can actually be observed that the number of shares is changing so fast that the ordinary rules of calculus do not apply. (Crazy Right?) So Is the Derivation Right..? No, well kinda… I believe that the derivation is in fact wrong since it is only correct up to some discrepancy or “typo”. If we assume the hedge portfolio value at time ” t” represented by: Then the gain “gHt” in the hedge portfolio is observed as: Click to enlarge It can be thought that “gHt” is riskless and therefore should grow at the risk-free rate in order to cancel out arbitrage. (Risk Free Rate is usually US Treasury Bill Yield) In Carr’s examples, equating coefficients on “dt” does in fact yield the Black Scholes PDE. To make the theoretical world “error free” for derivatives, the above argument replaces the need of computing a total derivative with the financial operation of determining a gain. The portfolio in question of an option and a stock is not self-financing. This is like the positions with regard to riskless assets. Essentially by showing that the gains between two non-self-financing strategies are always equal under no arbitrage, the derivative value of the security can be determined. So why say no? I believe that the solution does bring validity but also brings forward inconsistency. This inefficient manner of providing the solution takes away from the integrity of the model. I do not disagree with the hedging argument, I simply criticise the need for extra material to prove a factor that should be safeguarded in pricing models such as BSM. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.