Life insurance should be a component of any financial plan. Life insurance protects loved ones against financial hardship should death occur before our financial goals are met. The death benefit paid by the insurance company can help pay medical bills and funeral expenses and provide cash that family members can use to maintain their lifestyle, retire debt, or invest for future needs (for example, children’s education, spouse retirement). Therefore, one of the first steps in developing a financial plan is to purchase adequate life insurance coverage.
Insurance can also serve more immediate purposes, including being a means to meet long- term goals, such as retirement planning. On reaching retirement age, you can receive the cash or surrender value of your life insurance policy and use the proceeds to supplement your retirement lifestyle or for estate planning purposes.
You can choose among several basic life insurance contracts. Term life insurance provides only a death benefit; the premium to purchase the insurance changes every renewal period. Term insurance is the least expensive life insurance to purchase, although the premium will rise as you age to reflect the increased probability of death. Universal and variable life policies, although technically different from each other, are similar in that they each provide both a death benefit and a savings plan to the insured. The premium paid on such policies exceeds the cost to the insurance company of providing the death benefit alone; the excess premium is invested in a number of investment vehicles chosen by the insured. The policy’s cash value grows over time, based on the size of the excess premium and on the performance of the underlying investment funds. Insurance companies may restrict the ability to withdraw funds from these policies before the policyholder reaches a certain age.
Insurance coverage also provides protection against other uncertainties. Health insurance helps to pay medical bills. Disability insurance provides continuing income should you become unable to work. Automobile and home (or rental) insurances provide protection against accidents and damage to cars or residences.
Although nobody ever expects to use his or her insurance coverage, a first step in a sound financial plan is to have adequate coverage “just in case.” Lack of insurance coverage can ruin the best-planned investment program.
Insurance
November 16, 2010 No comments »Movements along the SML
November 14, 2010 No comments »Investors place alternative investments somewhere along the SML based on their perceptions of the risk of the investment. Obviously, if an investment’s risk changes due to a change in one of its risk sources (business risk, and such), it will move along the SML. For example, if a firm increases its financial risk by selling a large bond issue that increases its financial leverage, investors will perceive its common stock as riskier and the stock will move up the SML to a higher risk position. Investors will then require a higher rate of return. As the common stock becomes riskier, it changes its position on the SML. Any change in an asset that affects its fundamental risk factors or its market risk (that is, its beta) will cause the asset to move along the SML.
Types of Orders
November 13, 2010 No comments »When an investor wants to buy or sell a share of common stock, the price and conditions under which the order is to be executed must be communicated to a broker. The simplest type of order is the market order, an order to be executed at the best price available in the market.
The danger of a market order is that an adverse move may take place between the time the investor places the order and the time the order is executed. To avoid this danger, the investor can place a limit order that designates a price threshold for the execution of the trade. The key disadvantage of a limit order is that there is no guarantee that it will be executed at all; the designated price may simply not be obtain- able. The limit order is a conditional order: It is executed only if the limit price or a better price can be obtained.
Another type of conditional order is the stop order, which specifies that the order is not to be executed until the market moves to a designated price, at which time it becomes a market order. There are two dangers associated with stop orders. Stock prices sometimes exhibit abrupt price changes, so the direction of a change in a stock price may be quite temporary, resulting in the premature trading of a stock. Also, once the designated price is reached, the stop order becomes a market order and is subject to the uncertainty of the execution price noted ear- lier for market orders. A stop-limit order, a hybrid of a stop order and a limit order, is a stop order that designates a price limit. In contrast to the stop order, which becomes a market order if the stop is reached, the stop-limit order becomes a limit order if the stop is reached. The stop- limit order can be used to cushion the market impact of a stop order. The investor may limit the possible execution price after the activation of the stop. As with a limit order, the limit price may never be reached after the order is activated, which therefore defeats one purpose of the stop order—to protect a profit or limit a loss.
TECHNICAL ANALYSIS
November 12, 2009 No comments »Technical analysis constitutes an alternative approach to trading than that provided by arbitrage and fundamental analysis. The underlying rationale for technical analysis is that markets are human systems and that prices of instruments traded in these markets are determined to a large extent by mass psychology.
Fundamental equity analysts work alongside economists and technical analysts. They respect the methods used by economists while retaining a healthy skepticism about their forecasts. Most are duty bound to mistrust the methods used by technical analysts but, if they are honest, accord their conclusions with a degree of respect. A fundamental analyst will hesitate before putting out a report advocating a strong buy on a stock where the technical analyst says that technical indicators are strongly indicative of a likely sharp stock correction. Among the features of technical analysis are the following:
Prices move in cycles, and in cycles within cycles. Prices move in a series of “waves” and trends can be distinguished from cyclical effects. Specific price levels can be identified that act as resistance levels (for rising prices) or as support levels (for falling prices).
Identifiable patterns can be recognized in prices tracked over time and likely turning points can be identified in advance.
Specific factors that technical analysts take into account are:
The current market price versus moving averages of prices over defined time intervals, typically 30 days, 90 days, 180 days and one year.
Daily opening and closing prices and intra-day highs and lows. Charts showing these are referred to as “candlestick” charts by virtue of their appearance.
Trading volumes and whether these are rising or falling.
Technical analysis is diametrically opposed to widely accepted mainstream dogma on market efficiencies which claim that in efficient markets price changes are essentially random and that it is impossible to predict future prices from historic prices.
Technical analysis is better at explaining past price behavior than predicting future price movements (isn’t that always the way). It is easier to see price patterns with the benefit of hindsight and most forecasts are qualified in some way. A support level, for example, may be tested. If the support level is breached then technical analysis can be used to identify the next support level. If on the other hand it is tested but fails to break the support level this may lead to a new resistance level. If technical analysis provided a guaranteed way to make money then there would be more technical analysts working for their own account and less employed by brokerages and speculators.
Most financial academics studiously avoid any mention of technical analysis, treating it much as scientists would treat alchemy. A variation on Shakespeare comes from David Mamet, an American dramatist: “The poker player learns that sometimes both science and common-sense are wrong; that the bumblebee can fly; that, perhaps one should never trust an expert; that there are more things in heaven and earth than are dreamt of by those with an academic bent.”
Capital Inflows and Real Exchange Rate Appreciation – practice
July 6, 2009 No comments »During much of 2000, the National Bank of Poland tightened monetary policy by hiking interest rates to squash inflation. Towards the end of that year, with the NBP’s 28-day intervention rate having peaked at around 19%, nominal and real interest rates peaked, as did inflation. The result was irresistible to fixed income investors, attracted both by extremely high interest yields and the prospect of capital gains. As the NBP began cautiously to relax its monetary policy, this triggered an increasing tide of capital inflows. Asset managers reduced or even eliminated their currency hedges. Dedicated emerging market investors raised their asset allocation in Polish bonds, while cross-over investors increased their exposure to what was an off-index investment.
Capital Inflows and Real Exchange Rate Appreciation – theory
July 5, 2009 No comments »Under a pegged exchange rate, capital flows are attracted by the perception of exchange rate stability created by the peg itself. Conversely, under freely floating exchange rates, such capital flows are attracted by the prospect of high returns, either of income or capital gain. Fundamental flows are attracted to a currency, attracted both by currency and underlying asset market-related valuation considerations. Such capital inflows force the currency to appreciate and simultaneously force nominal interest rates lower. As a result, during this period, the correlation between the asset markets and the currency increases. Capital flows lead to both nominal and real exchange rate appreciation.
MEASURING CURRENCY RISK — VAR AND BEYOND
July 4, 2009 No comments »Value at risk is defined as:
The maximum loss for a given exposure over a given time horizon with x% confidence
VaR helps a user to define the maximum loss on an exposure for a given confidence level and has helped investors and corporations in managing their risk. VaR is on the face of it an excellent risk management tool, which can be used to measure a variety of risk types.
However, it should be noted that:
VaR does not define the worst case scenario
It may give the maximum loss for an exposure with 99% confidence using a 3000-iteration Monte Carlo simulation. The question remains however, what happens to the exposure for that 1% point of confidence? The frank truth is a VaR model is incapable of answering that question. Thus, a degree of both care and common sense is needed. The more sophisticated corporate Treasuries frequently seek to refine their VaR model to go beyond the natural confidence level limit to try and define the maximum loss with 100% confidence. A practical way of trying to achieve this is to impose operational limits (such as in terms of number of contracts, nominal amount, sensitivities or stop loss orders) in addition to VaR limits. That relates to the aspect of care. The common sense aspect relates to never trusting your risk to a computer model alone. If you cannot quantify it itself without use of the model, you have a problem.
Trend-Following Strategy
July 3, 2009 No comments »A second popular strategy for active currency managers is the “trend-following” strategy, which involves using several technical moving averages to provide trading or hedging signals. Active currency managers can use this strategy to either trade around their benchmark in order to add alpha, or alternatively to provide a hedging signal. The academic backing for trend-following strategies is as deep as that for the differential forward strategy, including works by Bilson (1990, 1993), Taylor (1990), LeBaron (1991) and Levich and Thomas (1993), which showed that these strategies can indeed produce consistent excess returns over sustained periods of time. I would suggest however that the seminal breakthrough in this area came in the form of the note by Lequeux and Acar (1998), which gave the strategy more specific properties by suggesting that in order to be representative of the various durations followed by investors an equally weighted portfolio based on three moving averages of 32, 61 and 117 days would be most appropriate. Simply put, the core idea behind this strategy is to go long the currency pair when the price is above a moving average of a given length and to go short the currency pair when it is below. More specifically, if the spot exchange rate is above all three moving averages, hedge the foreign currency exposure 100%. If it is above only two out of the three moving averages, hedge one-third of the position. In all other cases, leave the position unhedged.
Differential Forward Strategy
July 2, 2009 No comments »The core idea behind this is that of “forward rate bias”, or the reality that forward rates are poor predictors of future spot exchange rates, in contrast to the theories of covered interest rate parity and unbiased forward parity. We have looked at some of the academic backing for this admission earlier in this blog, notably by Fama (1984), Kritzman (1993) and finally Bansal and Dahlquist (2000), who suggested that the negative correlation presented by Fama between future exchange rate changes and current interest rate differentials is crucially linked to changes in macroeconomic variables.
As outlined by Acar and Maitra (2000), the differential forward strategy seeks to take advantage of the apparent market inefficiencies as represented by “forward rate bias” by hedging the currency risk only when the interest rate differential is in favour of the hedger. That is to say, only when the forward points are at a discount. Conversely, the currency manager should not hedge currency risk when the forward points are at a premium and consequently the interest rate differential would reflect a cost. More specifically, when the interest rate differential pays the investor to hedge, the currency manager should have a hedge ratio of 100%. Conversely, when the interest rate differential costs the investor to hedge, the hedge ratio should be zero. Thus, if the currency manager is operating under a symmetrical benchmark, the manager would go overweight the hedge by 50% when the interest rate differential is in their favour and underweight by 50% when it represents a cost.
The results of this strategy have proved to be extremely robust and have been tested across some 91 currency pairs.
Of necessity, when the interest rate differential is favourable, the differential forward strategy will have the same returns as a full forward hedge. Equally, when the interest rate differential represents a cost, the differential forward strategy will have the same returns as an unhedged strategy. Thus, overall, the returns of the differential forward strategy will be a function of both fully hedged and fully unhedged strategies. The advantages of such a strategy are the following:
As established, it has consistently added alpha for active currency managers.
Equally, it has also reduced risk relative to benchmarks.
The strategy combines the decisiveness of a full hedge with significant flexibility when used with a symmetrical benchmark.
The expected returns of the differential forward strategy are a function both of the expected returns of the fully hedged and fully unhedged strategies.
Given that the differential forward strategy is based on exploiting the principle of “forward rate bias”, it must follow to an extent that its expected returns are also a function in turn of the extent of that forward rate bias and thus of the interest rate differential relative to the expected future interest rate differential. For any given interest rate differential, the hedging strategy will perform best when the correlation between the hedged and unhedged returns is more negative.
EXAMPLES OF ACTIVE CURRENCY MANAGEMENT STRATEGIES
July 1, 2009 No comments »There are a wide variety of active currency management strategies that are used in the market, varying at one end of the spectrum from entirely discretionary-based trading to strict rule-based strategies. Three prominent strategies that we will look at in this series of posts are closer to the latter rather than the former end of this spectrum:
Differential forward strategy
Simple trend-following strategy
Optimization of the carry trade
All three of these strategies have consistently added alpha to a portfolio if followed rigorously and interestingly have also proven to be risk reducing compared to unhedged benchmarks. Thus, they also help to boost significantly the portfolio’s Sharpe ratio. With what follows, the contributions and advice of Henrik Pedersen of the CitiFX Risk Advisory Group and Emmanuel Acar of Bank of America’s Risk Management Advisory Group are gratefully acknowledged.