Quants - A place to consider?

Yesterday evening shortly before I left the office, I received a trader's email asking if he could go ahead with dealing in a transaction involving a variation of a cross currency swap. In GMR, our stance is that if a deal can be hedged properly without loopholes and the level of risk undertaken by the bank is within the stipulated VaR limit, the green light will be given. However, the CCS he wanted to engage in posed a problem of proper hedging due to the uncertainty of some figures.

For about close to an hour, our team was debating about the various hedging methods and instruments for this deal. Finally, we decided to escalate this issue to the Quants team. However, the Quants were off for the weekend and the earliest we can expect a reply from them is Monday. Well, I wasn't convinced that I could not solve this hedging problem, so I went home and drew out the deal using models and graphs but still to no avail. I gave up thinking and will see what the Quants can provide on Monday. On the other hand, I became very interested in the pricing and hedging methodology. Perhaps Quants could be another department I could consider in the bank if I don't get an opportunity to be in the front office? Hmm......

Anyway, here's the complex CCS the trader wanted to engage in. To ensure confidentiality, I've changed the currencies, reference curves and the figures while retaining the trading mechanism. Maybe some quants analyst might know the answer?

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Initial: Client pays USD50m (USD notional) to Bank; Bank pays SGD72.5m (SGD notional) to Client --> USD/SGD spot: 1.45, 5yr tenor. CCS coupon pays semi-annually.

Each coupon payment date (T): USD notional remains unchanged while SGD notional revalued to spot rate as of T-2 days. Client pays USD 3 mths LIBOR + 10bps on USD notional valued at T to Bank while Bank pays SGD O/N SIBOR on SGD notional to Client.

Termination date: Client pays SGD72.5m to Bank while Bank pays USD50m to Client. Spot rate fixed at initial, so notionals are just simply swapped back to original parties.
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For those familiar with CCS, the traditional CCS fixes the 2 notionals on initial date. The problem now lies in having 1 of the notionals left as a floating leg at each coupon date, thereby not allowing us to hedge our risks fully. The idea of using spot forward rates to hedge the FX risk can be incorporated in the hedging transaction but this only solves the SGD notional revaluation risk but not the payment amount risk on the Bank's end for the SGD O/N SIBOR, which also depends on the revalued SGD notional at each coupon payment date. Hence, there is a need to find a proper hedge to hedge the FX risk as well as the payment amount risk.

Anyone wanna attempt to hedge this deal? Haha......

I did it again!

Can't believe that I did it again! Sold SIA again at the highest price of the day and at 12.64 again! Captured the highest price 2 days in a row... History seems to repeat itself... Hmm... Haha...

The 1 and only lot

This has gotta be my day. Sold my SIA shares at the highest price for the day and it's the only transacted lot for that price!


Only 1 lot traded at $12.64 and that's mine! Haha...


A double-confirmation of today's highest price...


Yes, and my order is done!

Summary update

A quick summary of the past week's events:

04-06 Jun: Switched occupation from risk officer to professional mugger.

07 Jun: Whole day spent at Expo for CFA Level 1. AM paper wasn't too bad but PM was a goner, with a bad headache setting in 20 mins after the PM paper commenced. The medical point had all the advanced equipment to revive life-threatening conditions but did not stock up on simple medication such as panadol! Anyway, just gonna look forward to retaking it in Dec.

08 Jun: Went back for IPPT. More of a wayang show. Clocked my worst record in 2.4km. Rest of the day spent resting my aching body.

09-10 Jun: Lots of work waiting to be cleared during my absence. While clearing the mountainous workload, I was indirectly involved in some internal arguments in the office. Thankfully, it was resolved within 2 days and I can carry on with my backlog of work.

11-12 Jun: I finally had a chance to take a breather and have a proper lunch break as I did not take my lunch for the first 2 days after going back to work. Backlog finally cleared on 12 Jun and I'm back on pace!

13 Jun: Went to pray my grandmother to mark her last "birthday" as it's a custom for a deceased who just passed away to be prayed on his/her birthday as the last birthday before the first death anniversary.

Case of the missing dollar

3 guys went to buy a gift for $90. However, the stallholder realised that he overcharged them by $5, so he asked his assistant to return the $5 to the 3 guys. Since the assistant is unable to split $5 equally among the 3 guys, he decided to pocket $2 himself and return $1 to each of the 3 guys.

While walking back to the shop, the assistant suddenly thought to himself, since each guy paid $29 ($30 per share minus the $1 returned), the 3 guys would have paid $87 ($29 X 3) and together with the $2 the assistant had pocketed, it only adds up to $89! Where's the missing $1???

Why shouldn't we use historical returns to value investments?

Many of us would often come across some investment return numbers or annual reports by public listed companies. I would usually digest these numbers with many pinches of salt (or even a whole bottle of salt) *Pun intended*. In this post, I shall discuss the cons of using historical returns to determine if you would wanna invest in a product.

Historical returns are presented with the concept of arithmetic mean. Each year's return is calculated based on the percentage difference between the last market day of the current year vs the last market day of the previous year. Many would think that it's normal for us to interpret the returns using this method and it's a fair method. I shall use an example to prove otherwise.

Let's begin with a hypothetical scenario of $10,000 which you have saved so hard from your regular income and you decide to make this $10k work harder for you by placing it in a mutual fund. Let's not look back but look forward instead. By next year (2010), the fund has achieved superb returns as the economy might have recovered and reports a 90% return on equity. You're happy and decide to let it remain and accumulate more returns. However, a major worldwide disaster caused the world to plunge into recession sooner than expected and in 2011, the fund reports a -75% return. With the arithmetic mean concept, at 2011, one would compute the average annual return of the fund to be 7.5% by taking (90%-75%)/2. It still looks healthy to the average onlooker who intends to buy into this fund but you, an investor of the fund over the last 2 years, will be extremely sad! You're only left with $4,750 and not $11,500 (7.5% X 2 years X $10k) as what you expect to get!

After the first year, your investment achieved 90% returns, so the paper value of your investment is $19,000. However, the fund experienced a 75% loss during the 2nd year and this loss is applied to the fund value as of the end of year 1. Hence, your $19,000 would experience a 75% loss and you would be left with $4,750! Overall, you would have experienced a net loss of 52.5% after 2 years (or an annualized loss of 23.49%) instead of the reported 7.5% annual gain! The second way of computing your return is more accurate and this is the concept of geometric mean or holding period return which is more relevant to an investor computing the expected return of an investment.

Hence, whenever I'm presented with a set of historical returns for an investment, I would apply the concept of geometric mean and reprocess these numbers. For example, if the returns in chronological order is 12%, 6%, -5%, -11%, 7%, I would take the 5th root of (1.12 X 1.06 X 0.95 X 0.89 X 1.07) - 1 and obtain an answer of 1.44% return as opposed to 1.8% return using the arithmetic mean (simple average) concept. Always remember that the arithmetic mean is always higher than the geometric mean in all cases (except when there's no deviation i.e. all returns are the same). The geometric mean is the return we would expect to receive if we really invest in a product.

So anyone followed?

Thanks to the person with the alias km.coaching for his accurate answer. Yup, the person who sent you his analysis isn't some saint. You're just plain unfortunate to be his victim!

Assuming he has started with a target client base of 160 people, he will send out to half of the 160 people that the stock will rise while at the same time, sending to the other half that the stock will fall. After week 1, 80 of the clients will believe in his first week's analysis. Hence, he will send out to half of these 80 people that the stock will rise in week 2 and the other half that it will fall. The cycle repeats till week 4. At the end of week 4, there will be 10 people who are very convinced that the market prediction is accurate and from there, this guy markets his superb analysis proposal to these 10 people. Conclusion: You're just one of the 10 people and if you subscribe to his analysis, you're just plain foolish!

Will you follow an accurate stock market prediction?

Let's say you've got to know a person who claims that he can predict the direction of a particular stock (eg.: Singtel) and gives you a free 4 weeks trial of his prediction analysis. Over each of the next 4 weekends, he emails you his analysis and tells you whether Singtel will go up or down for the coming week, so in other words, his analysis came in before the start of the market week and the outcome is based on the closing price of the last market day for the week (i.e. Friday) vs the closing price of the previous week.

After the 4 weeks trial is over, you discovered that this guy's analysis is very accurate. He's spot on as to which week Singtel goes up and which week it goes down. You're convinced that his analysis is accurate. Now this guy comes back to you and offers you a proposal. You just have to pay $100 per year for him to continue giving you his analysis every week. Hey, $100 per year is less than $2 per week! I'm sure your profits would exceed $2 if you've invested in Singtel (even for 1 lot) and followed his accurate analysis!

Now, the question is: Will you sign up for the analysis subscription?

Declining interest rates yet profitable

I believe most of us during some point in time, will experience some telemarketer sales calls from banks, soliciting for balance transfers or loans. For the majority, I suppose you will just hang up without saying much more. However, I beg to differ and would usually listen to the offers they have up their sleeves.

The offers may sound lucrative even to those who have no need for short-term loans. 2 years ago, you may never find any balance transfers with an effective annual rate (EAR) of less than 3% (it was around 6% or more those days). Now, it is relatively easy to hunt for a loan with EAR < 3% (or you may not even need to hunt for it, as in my case). I took up a balance transfer from Citibank with an EAR of 2.99% just from a solicited call. But why did I take up a loan when I have no need for it? An EAR of 2.99% (or 3% to be simple) means that if I take the loan proceeds and place it in some investments yielding at least 3% or more annually, I have effectively covered my interest costs. Any excess returns would be profits! So 3% per annum seems easy to achieve? Haha, that was in the past! A money market fund (MMF) would yield 3% on average 2 years ago but it's only yielding 0.7% now. Equity markets may seem to be en route to recovery but is it worth the risk? I'm using borrowed funds, so capital preservation is the first objective in mind, hence plain vanilla equity investments would be out. Did I mention only plain vanilla equity investments? Yup, so the idea here is to align the investment objectives with the banks, that is to repackage plain vanilla equity investments into structured products or hedging derivatives and this would allow me to achieve over 3% returns with significant lower risks! I shan't go into the details for it might turn many of you off. If you're interested, I'd be happy to discuss with you privately.

After reading a long paragraph, what has the content gotta do with the post title? Well, this is the main content. The previous paragraph was just an introduction and sharing of a personal experience regarding interest rates. So how on earth are the banks profiting when they offer loans with interest rates as low as 3%? The logic is very simple. Interest rates are declining, so banks use the declining SIBOR rates to lower their deposit rates. We're getting only a paltry 0.125% per annum for the savings we have in our bank accounts but to them, it's a VERY CHEAP source of funds! Customer deposits make up over 50% of the bank's source of funds and imagine half of your funds come with a cost of capital of 0.125%. I would gladly take up a million dollars loan if I can get such a lending rate! Besides bank deposits, many banks have also made use of the recession to raise more equity from the capital markets via rights issues. That's also a cheap source of funds, but not as cheap as customer deposits. On average, the cost of capital for equity and debt issues is about 3% in current economic conditions (using the DDM or post-tax bond yield calculation). For those familiar with the concept of WACC, the WACC for the bank assuming 50% customer deposits and the remaining from capital markets, would be 1.5625%! How can they not be profiting when their average cost of funds is just over 1.5% and they lend out these funds at 3%?! They can still profit even if they lend the funds out at 2% per annum!

Much as most of us are borrowers from the banks, many of us fail to look at it from another perspective that we are also lenders to the banks! It's just that we lend to them at a much lower rate than we borrow from them, resulting in us being slaves of our debts. The illustration of a 3% balance transfer is just one of the least profiting avenues of revenue for the bank. What about term loans that charge about 10% per annum, revolving credit lines that charge 18% per annum and credit cards that charge 24% per annum? These are the high profit margin business lines for the banks!

I don't wish to advocate any propaganda here. Hence, I don't intend to impose any of my beliefs via my blog. If you manage to figure your thoughts out or have been somehow enlightened by this post, congratulations to you. Other than that, I shall rest my case here.

Only on food & clothing

I've received several responses via email and the tag board. At least, I know there are people still reading the rubbish I've posted. Haha...

Anyway, to address some of the responses, my previous post only refers to expenses incurred on food & clothing on a personal capacity. It does not include other expenses such as loan repayment, buying of gifts for occasions nor giving money to parents out of filial piety or helping with the household expenses. I'm aware those expenses and many others not mentioned also form a very huge portion of many of my friends' total monthly expenses. If this is indeed so, then all the more those who indulge in spending excessively on food & clothing should cut down on these expenses and channel the savings into those areas mentioned!

I'm also not addressing on the fact that many of them are complaining that their income is not enough despite drawing much higher salaries than me. I know each and every one of them have their own burden of expenses and it differs from individual to individual. Hence, I only picked out the 2 most common expenses across most of us: that is food & clothing. Although I can't convincing point out that by maintaining low expenditure in these 2 areas may lower the total expenses significantly, I am of the view that if a person can keep a low expenditure on these 2 necessities, there may be a high chance that this person is able to control his/her finances well in other areas.