The case for SEBI to permit traded long term listed equity options(LEAPs)

With Indian equity markets still inefficient, there is ample value for active investing strategies. In that regard, long term equity options would be a great vehicle, also to give more impetus to activist long term investors who cannot adopt leveraged strategies. Abroad, LEAPs( Long Term Equity Anticipation Security) exist to allow investors to take a long term call on stocks(either put or call). As Keynes rightly said(and firms like LTCM/Lehmann realized), the market can stay irrational for longer than you can stay solvent. Even a three month option is quite risky for an investor, but for a long term option(say 1yr/2yrs), there is reasonable hope for market prices to correct by then.

1. Court cases take upto 2-5yrs(at the minimum even at the apex level) and therefore LEAPs would be a great way for investors with legal acumen to take a considered bet on the outcome. For example, Bajaj Auto's right to purchase 24% of Maharashtra Scooters at a bargain basement price from the Maharashtra state government, is under dispute at the Supreme Court. An adverse outcome for Bajaj Auto could send the Maharashtra Scooters price skyrocketing as investors finally see value unlocking. Another example is the RIL-RNRL dispute over pricing of natural gas, on which LEAPs on RIL could have been profitable. 
2. To attract activist investors like hedge funds to improve corporate governance and encourage long term value creation, LEAPs are needed to encourage those investors to improve the company instead of voting with their feet and exiting.
3. While companies DO issue warrants, that is usually done as a preferential allotment to investors, restricted to 18months and need 25% advance(not option premium but advance), and can have only one minimum conversion price at allotment time-that fixed by the SEBI DIP guidelines.
4. If we want to encourage the long term informed investing culture, LEAPs are good because it could make investors bet on long term trends and their awareness of stock specific factors. 
5. Insider information could be used much better, because insiders can trade on LEAPs(provided they hold it to maturity/for atleast fixed period post silent period of trade) without affecting the share price, yet they could provide valuable pricing signals. 

What I suggest would need changes in SCRA Act, SEBI Act, FDI guidelines etc, and is easier said that done. But it could really give the equity markets a boost, and effort is still worth it. 

How banks price their loans and products

When I googled this title, guess how many results I got? Zero.zilch.nada. That in itself spurred me on to write something on which there is little organized information. I am not(yet!) an expert on pricing but from what I have seen of the structuring, trading and risk sides of banks, I think I can venture some informed views on this manner. More knowledgeable readers are welcome to comment on this primer in FAQ form.

1. Every business needs to price its products. What is so exotic about banks? Other businesses may view increased volumes as a success of their pricing strategy. But for a bank, a spurt in volumes may merely mean that is pricing model is broken, and that others are taking advantage of that till the bug is fixed! Hence, risk pricing is error prone, yet important.
2. How is risk priced in? We do not have(yet) that one universal calculator which will spit out an integrated figure for all risks. So often the systems are fragmented. Credit risk calculations are often bifurcated into counterparty(interbank/other FIs) and client risk(normal corporate transactions). And there are many ways to splice other transactions. So finally, an excel/other manual systems are needed to make sense of this mess of figures
3. But why does not some one automate it? It is a control issue. Given the high sensitivity of prices, and the subjective adjustments needed, there is a limit to everything-even for flow trading! 
4. We learn this in marketing 101. Do those principles apply here? Yes and no. Yes because the exact pricing decision will depend on how well the pricer knows the client, which is again related to marketing. But no because the performance management system of banks ensure that the cost of funds charged to the trader, is often determined post facto, and so there need to be relatively accurate and robust models available for trade negotiation and evaluation. And while geeks/quants can design it, the end users need to know the ins and outs of the model, including its limitations, so that for extreme cases they can use modifications. For example, while executing a large trade which will move the ALM curve and the market, the liquidity adjustments among others would need to be made upfront. 
5. Floating or fixed rate? Depends totally on the risk appetite of the bank and the relationship/focus on that client. For example, Indian banks give fixed rate education loans to IIT/IIM/other top colleges students, while the ordinary student is exposed to floating rate risk.

The essential legal distinction between CDS and 'credit insurance'.

During the subprime crisis, some investment banks who purchased CDS from 'professional counterparties', were accused of using insider information on the underlying security's credit risk(from the commercial/investment banking side). The implication was that by not disclosing the conflict of interest/insider information, the banks were able to purchase CDS at lower prices, which they then profitably exited around the time of the subprime crisis.

Now, CDS is essentially a bet that the security will default. And credit insurance is pretty much the same thing(economically). The crucial difference between insurance and put option is that

1. Insurance, in most cases, covers only actual loss and also known as 'contract of indemnity'. But in case of CDS/put options, the person purchasing protection need not physically own the security.
2. To solve the perennial information asymmetry problem, insurance laws deem insurance to be a 'contract of utmost good faith' and mandate full disclosure of all risks.  But in financial products, unless the bank is deemed to owe a fiduiciary duty to its client/counterparty(which all banks invariably disclaim to the fullest extent allowed), they are not subject to such fair dealing norms. And regulators consider these players to be 'big boys' not in need of such protection
3. In CDS, one can hedge partially without penalty but in insurance, there are penalties for under-insurance where the average clause is applied. 

Hence, before accusing the CDS buyers of sparking moral hazard etc, it would be good to know that different structures have varying obligations despite having the same economic consequences. Another example of regulatory arbitrage maybe.

Do banks have that alpha in managing/profiting from commodities market risk?

While reading HSBCs Global Market's business May-11 strategy day transcript(http://www.hsbc.com/1/content/assets/investor_relations/strategy_day/2011/110511_strategy_day_cust_group_transcripts.pdf), I noticed that they had collaborated with Total(French oil and gas company) for a product where Total manages market risk and physical delivery and HSBC manage the sales and offering and the credit risk. That is, each party remains in its core competency zone. Given the recent blockbuster IPO of Glencore, one of the few independent commodity processors, I thought this trend needs some elaboration on.

Unlike most traders, Glencore has a substantial physical presence in procurement, processing, storage and shipping. That is why besides financial arbitrage apart, it can exploit physical inefficiencies(like say crude oil trading at less than the refined price-GRMs). Also, by being in the spot market, its on the ground intelligence would be more than even the most intelligent financial markets trader.

When I spoke to a few commodity traders/structurers/risk managers, my suspicion was confirmed when they said that the oil majors/commodity majors were not their preferred customers, margin wise, as they were likely to be informed traders, resulting in a negative NPV transaction for the counterparty.  Still, because these majors rarely speculate, they do not pose problems/competition for banks. Still, banks do recognize this talent pool, and snap up leavers from those companies.

Moral:- If you want to be the best commodities trader/structurer/risk manager out there, you are probably better off starting your career with a company in that sector(preferably one like Glencore), than an investment bank.

Will IFRS kill pre-IPO convertible bond financing in India?

If there was ever the case of the 'tail wagging the dog', this is it. Take the example of pre IPO financing by a strategic investor. Typical covenants include:-

1. Debt security with nominal interest(or even zero interest)
2. Call option-to convert the debt to equity at the IPO price/other reference price. This may even be adjusted with the performance of the company.
3. Put option-promoters/company to buyback the debt at a fixed IRR

Earlier, Indian companies were permitted to account for these securities as debt. But now IAS-39 mandates that the embedded derivatives(call option/put option)should be separately valued-even if not accounted for separately on balance sheet. And given the typical deal sweeteners, the option value by any model is likely to be high. And as the IPO approaches, the increase in option value will need to be expensed out by the company('issuer'). This may render it ineligible for listing/fetch low price on listing, due to the MTM losses on the derivatives issued by it.

Of course, the company could argue that investors should consider a proforma picture ignoring this adjustment, analogous to ignoring 'credit value adjustments' on own debt. But if this loss leads to an enhanced call option for investors/exercise of put option due to triggering earnings based covenants, then the company has a problem. This calls for top notch investor relations and legal experts to help cover all such bases during financing. But despite that, such transactions would need to be structured much more carefully because more the protective covenants, likelier is it that more embedded options exist.

FAQ on Islamic Finance

1. What is the big fuss about anyway? Finance should look the same in whatever form-ultimately the objective is to earn money That is correct-although the Shariah prohibits interest, banks still get their way around it by artful structuring/'sale and buyback' etc. But still, the main prohibitions are respected-no explicit interest, no investment in banned sectors etc
2. Why has it become so important all of a sudden? Because the wealthy Middle East/African investors are there(many of them conservative Muslims) seeking Shariah Compliant investments. So like in any free market, supply follows demand
3. But why are banks so fascinated with this market? One because of the lesser(so far) competition. Two because in this world of capital starved banks, Islamic finance with its primarily asset backed nature(thus low Risk Weighted Assets requirements for banks) is very attractive. Three because this allows entry into previously untapped markets, and at good profit margins AND to depict themselves as good corporate citizens
4. Give some examples of Islamic finance:- Suppose you need a loan but are prohibited from paying interest. No problem. Just arrange with a bank to sell it a commodity X and buyback at X+Y(Y represents the 'profit'-effectively interest. Or else you want to earn interest on a deposit. Just deposit the funds with a bank, which will give you close to market rates voluntarily to preserve its own reputation.
5. But why are you so cynical? So many people cannot be so absurd at the same time:- Well, like socially responsible investing, Islamic Finance has certainly helped society. But it is an open question whether the investors are better off in this mode or not. Certainly, the noble objective of investors sharing risk is diluted with investments in microfinance, subordinated debt, embedded options etc.
6. If this is so attractive, there would be risks also:- Yes there are. The same structure may be approved by one Islamic scholar but another may issue a fatwa against it. The sale and buyback transactions prevalent here may lead to indirect tax consequences for banks and/or make them residents for direct tax purposes. Or like in the Dubai bonds case, some structures have been legally untested, and may hold unpleasant surprises for investors.

OTC and exchange traded derivatives-does any significant difference remain for clients?

Open a college financial textbook and you read the distinctions between OTC and exchange traded contract.I reproduce some of them below with my comments in italics.

1. OTC contracts give more flexibility and offer scope for customization. This is correct but purchasing a portfolio of 'vanilla' products can achieve the same result in most cases, subject to market access  and other constraints. 
2. No margin needs to be posted. This is incorrect. Open any ISDA contract and you notice provision for posting margin even in ordinary repo contracts!! Banks have got scared post Lehmann default and other Black swan events
3. OTC has counterparty risk unlike exchange contracts. With the tendency to demand collateral/other funding for derivatives contract, this fact may stay only for interbank transactions/transactions with A+ rated counterparties-with others having to give some security. Also, this is mitigated(specially where cross banking relationships exist) by the right of setoff, from the perspective of the bank/FI.

So stripped of the margin/collateral benefits, the only remaining feature is customization, for which the client pays a hefty fee, and is subject to opaque valuations if early exit is desired. The benefits of OTC contracts do sound more tenuous now.

Why banks & their clients deserve the poor accounting standards they have

By now, post the infamous Lehmann 105 repo/Bear Sterns portfolio valuation etc, many laymen(and a not insignificant number of industry veterans) blame accounting for the subprime crisis. They argue that if financial instruments were required to be valued consistently at MTM(mark to market), the sudden earnings shock would not have happened.

This argument is flawed given that  the widening CDS spreads(insurance premium for insuring the bonds against default) were widening for the overall market quite early on-so there was enough of early warning. That said, the standards ARE a hogmash of inconsistent principles and valuation basis. But for that, the banks/their clients have themselves to blame.

1. Many of the cumbersome provisions in these standards(like hedge documentation, anti tainting provisions) were inserted to prevent financial engineering led abuse by structuring transactions to achive unintended results. 
2. And the standards are quite vague because when you give 'bright line' guidance, the effort goes to achieve the bare minimum effort necessary to do so. 
3. Also, when the standard setters wanted to apply a consistent fair value framework, doing so for financial assets was easier because of the excellent markets there. But banks lobbied the EU to prevent macro hedging and other rules from coming into place. And when politics enters the equation, good practice does tend to go out
4. Also, response to the discussion papers tends to be skewed and repetitive. As any reader of the various response letters would attest to, each take their own parochial limited views and argue for a rule benefiting them, instead of a rule which is fair, transparent and workable. In that context, even the standard setter has limited options to work with.

 Hopefully, my own future interactions with the standard setters will not commit the above mistakes.

Structuring-the art of making the 'impossible' into reality

People managing the Sales & Distribution functions in a complex indirect tax environment (like India) like India, have long known that sometimes you sacrifice commercial rationale to achieve the most efficient post tax outcome. Luckily, such sub optimal structures are less common in financial structuring, where the client and bank jointly work to tailor existing products to the client needs. To use an analogy, a structurer does not create value out of thin air, he merely stitches the threads of accounting, legal, tax, financial, capital etc together to obtain a structured product. While structured products were blamed for the financial crisis, and are still accused as being too complex(and thus hard to value), we should note that their purpose is to solve a client problem. And that basic need does not change even for structures aimed at regulatory arbitrage.

So how does the impossible become possible? Lets see some examples

1. You are a mutual fund prohibited from investing in certain asset classes, which would aid your strategy. Try investing in a structured note(seemingly debt) that mirrors your investment view. The payoff diagram would then hopefully achieve what was earlier prohibited
2. As an investor, you cannot exceed your ownership limits in listed securities without making an open offer. Try a total return swap to get economic ownership without the hassle of legal title
3. You want principal protection yet need a good upside-which conventional debt products do not permit. Take a principal protected note which is a zero coupon bond(or variants) with the balance invested in very risky instruments to achieve the upside for the entire amount
4. You would like to participate in a derivative product but the dealers will only deal with other banks/or margin requirements may be too high. The bank would therefore package this into a structured note.
5. As a bank/private company, you want to reward your top people with market linked incentives but cannot/do not want to issue shares. Offer performance shares/restricted stock etc

 I can go on and on but the message is clear. The job of Structuring is to design a way for an investor to express his investment view. Where restrictions/internal issues do not permit for conventional products, then structured products prevail. Some of them get internalized into every day jargon like convertible bond, repo etc.