Concept: Ring-Fence

#23

I came across this concept when working on a supply chain problem, where one of the requirements was to 'ring-fence the inventory so no other businesses can access it.' Turns out, it has a connotation in finance too.

What?

• A virtual barrier segregating a portion of an individual's or company's financial assets from all else
• Usually done to reserve money for some reason, reduce taxes on the individual or company, or to protect the assets from losses incurred by other activities
• Can also be used as a method for mitigating liquidation risk or to improve a corporate credit rating

Example

Moving a portion of assets offshore to reduce an investor's net worth

History

When Warren Hastings took charge as the Governor-General (1772-1785) at a critical period of British rule when the British were to encounter the powerful combination of the Marathas, Mysore and Hyderabad, he introduced a ring-fence policy, aimed at creating buffer zones to defend the East India Company's frontiers

Related

Ring-fencing in banking - a new regulation requiring the largest UK banks to separate their core retail banking services from their investment banking and international banking activities

Concept: Golden Parachute

#22

What?

• Contracts in the form of substantial benefits given to key executives who have been laid off after a takeover
• Form of poison pill 

Concept

• Used as a type of anti-takeover measure
• Named so because their aim is to provide a soft landing for employees at higher levels who have lost their jobs
• Benefits may include cash bonus, insurance, stock option, severance pay, pension package
• Compensation is usually thrice the annual basic salary of top executives

Disadvantages

• Controversial practice 
• Lucrative for short-lived CEOs and low-performance executives, who get paid large sums for less or poor work
• The target company becomes less attractive when the Golden Parachute cost is a lot higher for the acquiring company

Examples

• Dell Inc.'s merger with EMC Corporation compensated EMC's CEO with $27 million
• CEO Meg Whitman of HP may receive over $9 million if there is a change of control at the company and more than $51 million if she is terminated
• If in May 2016, the federal court had not blocked the merger, Staples Inc. and Office Depot Inc's merger would have resulted in Office Depot's CEO collecting $39 million

Similar Terms

• Golden Handshake
• A contract clause wherein the employer provides a significant severance package to the employees who have lost their jobs
• Golden Coffin
• A death benefit package awarded to the heirs of high-ranking executives who pass away during employment
• Silver Parachute
• Special compensation for specific employees when their position becomes redundant in the company 

The fall of Lehman Brothers

#21

What?

Collapse of Lehman Brothers, a financial services firm, in the 2008 financial crisis

Related Concepts

• Subprime mortgage crisis
• Mortgage-backed security (MBS) 
• Collateralized debt obligation (CDO)
• Too big to fail

Timeline of events

• In 2004, amidst the housing bubble, Lehman acquired five mortgage lenders and dealt with loans without documenting the numbers
• Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006
• In 2007, the firm announced $4.2 billion in net income on $19.3 billion in revenue
• When Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion, defaults on subprime mortgages began to rise to a seven-year high
• Things started going downhill from then on
• On June 7, 2008, Lehman announced a Q2 (2nd quarter) loss of $2.8 billion
• Lehman's stock plunged by 45% while the firm's debt saw a 66% increase in credit-default swaps
• Lehman Brothers filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt

Impact

• A company that had been alive for more than a century and a half was forced to file for bankruptcy, the largest bankruptcy filing in US history
• The failure of the fourth-largest investment bank in the US had severe ramifications for the global economy
• The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average (DJIA)

Aftermath

• President Bush announced a $700 billion bail-out plan to help salvage the remaining pieces of the financial sector
• The Dodd-Frank Act was implemented to help increase financial regulation

Related Movies

Too big to fail, The big short

Notes

Subprime mortgage crisis:

• Occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market
• When the Federal Reserve increased the rate, it resulted in increased mortgage interest rates which in turn caused home prices to plummet, and borrowers to default on their loans

Mortgage-backed security (MBS):

• An investment similar to a bond 
• Constitutes a bundle of home loans bought from the banks that issued them
• Put simply, they are shares of a home loan sold to investors
• Working:
• A bank lends a borrower the money to buy a house and collects monthly payments on the loan
• This loan, one of many, is then sold to a larger bank 
• This bank ties the loans together into a mortgage-backed security and issues shares aka tranches (French for "slices") to investors
• Investors collect the dividends in the form of monthly mortgage payments

Collateralized debt obligations (CDOs):

• In the above working of an MBS, the shares or tranches can be repackaged and resold as other securities aka CDOs 

Too big to fail:

• A financial organization so massive to the global economy that the central bank must prevent it from going bankrupt

Analysis of Franklin Templeton's Closure

 #17

Overview

• Franklin Templeton Mutual Fund closed 6 of its debt schemes in India:
• Franklin India Low Duration Fund (62.8% of assets invested in bonds rated below A+, 45.76% rated AA)
• Ultra Short Bond Fund (82.8% in AA rated, 23.9% in A rated)
• Short Term Income Plan (58.6% in AA rated, 57.5% in A rated)
• Credit Risk Fund (60% AA rated, 49.6% in A rated)
• Dynamic Accrual Fund (52.7% in AA rated, 44% in A rated)
• Income Opportunities Fund (63.97% in AA rated, 41% in A rated)

Reasons

• Illiquidity in bond markets
• Severe redemption pressure
• SEBI's opening of a window for AMCs to borrow to meet redemptions

Cause

COVID-19

What happened?

• The above 6 schemes of Franklin Templeton Mutual Fund (FTMF) took aggressive credit calls in their portfolios in the recent past
• Despite getting higher returns by taking on these high risks, the debt funds and a few liquid funds (safest of the lot) experienced tremendous volatility
• In the last 18 months due to COVID, worried investors withdrew money and exacerbated the problem

Which led to

• Shrinking of the portfolios
• Funds left with a higher proportion of less liquid (riskier) investments
• FTMF having to keep borrowing money to pay off the redemptions but reached the borrowing limit as per regulations

Outcome

Investors unable to:

• Withdraw or transfer their existing investments
• Start any SIP in those schemes
• Make fresh investments

Let's talk numbers

Debt funds:

• Outflow: Rs 1.94 lakh crore (March 2020)
• Inflow: Rs 43,431.55 crore into liquid schemes, corporate bond funds, banking and PSU funds, overnight funds, and gilt funds (April 2020)

Category-wise outflows:

• Medium duration funds: Rs 6,363.53 crore
• Short duration funds: Rs 2,309.05 crore
• Money market funds: Rs 1,210.35 crore
• Low duration funds: Rs 6,841.07 crore
• Ultra-short duration funds: Rs 3,419.32 crore

Credit risk funds:

• Outflow: Rs 19,238.98 crore (April 2020)
• Inflow: Rs 6,279.23 crore (March 2020)

What all did FT try before winding up?

Borrow

• FTMF AMC borrowed continuously to fund redemption requirements
• But were unable to repay the borrowings by selling bonds
• Will lead to gross asset-liability mismatch in the long run

Restrict redemptions

• Current terms for restrictions under the regulatory framework:
• Maximum suspension period of 10 working days limited to once in a 90-day cycle
• AMC needs to honour redemptions up to Rs 2 lakh per day per investor
• The above terms made this approach infeasible

Elongate redemption payments

• Redemptions pay-outs were being made on a T+1 basis with a maximum of 10 working days
• This approach too was unviable because it would only handle the short-term liquidity issues and not the sustained impact of the crisis

Distress Sale

• In a distress sale, the AMC would have to sell the securities at a discount to meet redemption requests
• If so, investors staying invested would have borne significant losses

Winding up was the only forced choice for FTMF.

So, when will the investors get their money?

Once:

• The macroeconomic situation improves
• Cash-flow pains will be relieved
• FTMF makes good on their debts
• Investors are allowed to withdraw their investments
• FT does an orderly sale of their investments in order to return the money to investors
• FTMF communicates an exit strategy for their schemes

Bright side

Debt fund redemptions slowed after RBI announced a Rs 50,000 crore credit support for MFs

FT can attempt to retrieve the value invested in those schemes either by selling the underlying assets (e.g. corporate bonds), or wait for them to reach maturity, when those companies will have to pay back what is owed to them.

Lessons from Freakonomics

#15

While you’ll find my latest book summary on the key takeaways from the book Freakonomics here, which I’ve also recommended as a good book here, let’s understand some of the other lessons mentioned in the book via simple anecdotes.

Lesson 1:

Economics is mostly about incentives, which can backfire if you don’t understand how they work

Anecdote 1:

There was a daycare that was subject to late pickups. Despite sending home notes and arguing in favour of having respect of children and their caretakers at home, there was no change. So, the daycare decided to send another note one day, saying that a financial penalty would be levied for late pickups. Instead of remedying the situation, the number of late pickups increased exponentially! This was because the guilt had been removed and the financial penalty was so low that the late pickup was now a perk accessible to most parents.

Lesson 2:

Men will lie about their height on dating websites due to information asymmetry

Anecdote 2:

Asymmetry of power refers to someone having or knowing considerably more than the another party. The ability to awe, intimidate, lie, or otherwise affect the outcome of a decision is vast. Susie’s love life moved from real life to the Internet. What was once known upfront became reported information. Though Susie checked several boxes declaring that she didn’t care about height, income, weight, or race, deep down she knew she did to some extent, just like the old times. Looks like her man too, adjusted his online response accordingly! What he lacked in reported stature, he made up for with charm and wit in person, as we would assume. Did Susie go on a second date? I guess we’ll never know.

Lesson 3:

Parenting experts are fear mongers who moonlight in product placement

Anecdote 3:

When experts rely on not knowing and use intimidation to defend their theory, some poor clueless parents fall prey to such tactics, as outlined below:

Bob and Lucy bought car seats for $200! Statistics clearly show that despite buying expensive car seats, this does not actually save more lives. 

They then purchased a 'family bed', since the salesman convinced them that they were the only parents who really cared. Unfortunately for them, they were unaware that all they had to do was advocate a parenting style that nurtured self-reliance and self-soothing. They were also oblivious to the below factors which do and do not correlate to higher test scores:

Factors correlating to higher test scores

1. Highly educated English-speaking parents with high socioeconomic status
2. Low birth weight of their child
3. Adopted child
4. Parents involved in PTA
5. Mother being 30+ at the time of their first child’s birth
6. Child surrounded by books at home

Factors not correlating with higher test scores

1. Intact family who moved to a better neighbourhood recently
2. Child watching television daily
3. Regularly spanked child
4. Mother not having gone to work between birth and kindergarten
5. Parents reading to their child often

Barbell strategy

#14

What?

• Formed when a trader invests in long- and short-duration bonds, but not in intermediate-duration bonds
• Focuses on the maturities of the securities in the portfolio by ensuring the maturity dates are either very close or at a distant date

Philosophy

• The best way to strike balance between risk and reward by investing in both extremes of high risk vs no risk assets while avoiding middle-of-the-road choices
• Be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative

When?

• Useful when interest rates are rising
• More frequently applied to bond portfolios

How?

• When short term maturities are rolled over they receive a higher interest rate, raising the value
• If an investor's money is tied up in a long-term high-quality bond, he or she won't be able to put that money in a higher-yielding bond if one becomes available in the meantime

Benefits

• Allows for a quick turnover of a significant amount of the assets in the portfolio at one time
• Reduces interest rate risk since short-term bonds can be reinvested
• Includes long-term bonds, which usually deliver higher yields than short-term bonds
• Offers diversification between short-term and long-term maturities
• Can be customized to hold a mix of equities and bonds

Limitations

• Long-term bonds held till maturity tie up funds and limit cash flow
• Inflation risk exists if prices are rising at a faster pace than the yield of the portfolio
• Mixing equities and bonds can increase market risk and volatility

Etymology

Investment strategy looks like a barbell with bonds heavily weighted at both ends of the maturity timeline

Example

Portfolio created with: 

• Speculative stocks (high risk): initial public offerings (IPOs)
• Blue-chip stocks (less risky): unprotected against ups and downs of the economy
• Bonds (safer)
• Bank certificates of deposit aka CDs (safest)

Asset allocation based on types of investors:

• Risk-loving:
• 40% in speculative stocks
• 40% in blue-chip stocks
• 20% in bonds
• Risk-averse:
• 80% in bonds
• 20% in blue-chip stocks

Related

• Contrast: bullet strategy
• Involves investing only in intermediate-term bonds
• This approach allowed Nassim Taleb, an essayist and mathematician to thrive during the 2008 economic recession while his fellow Wall Streeters floundered

Article: Intro to Debt Funds

#13

What is a bond?

• Not James or covalent, but fixed-income instruments!
• It’s like a certificate of deposit or IOU
• Issued by the borrower to the lender
• Similar to setting up a fixed deposit in a bank
• When you make an FD with a bank, you are essentially lending money to the bank

Types

Corporate bonds, Government bonds, corporate debt securities

What is a debt fund?

• A fund that invests in bonds or other debt securities
• Can be contrasted with stock funds or money funds
• Usually pay periodic dividends that include interest payments on the fund’s underlying securities + periodic realized capital appreciation

Advantages:

• Relatively stable returns
• Relatively high liquidity
• Reasonable safety
• Low cost structure

Who should invest?

• Investors aiming for regular income
• Risk-averse folks - because they are less volatile and hence less risky than equity funds or stocks

How do debt funds work?

• They are similar to other mutual funds, but they lend money and earn interest on it
• Interest earned determines the basis for the returns generated for investors

Why debt funds?

• They are able to invest in many types of bonds that are not available to individuals
• For example, the Government of India, (largest borrower and bond issuer in the country) issues bonds which individuals cannot purchase
• Mutual funds also invest in bonds issued by large and medium-sized businesses
• The funds pass on the interest income they receive from the bonds they invest in

Notes:

Additional info on bond prices

Reasons for bond prices to rise or fall:

• Change in interest rates
• Expectation of change in interest rates!

Example:

If:

• A bond pays out interest at a rate of 9% p.a.
• Interest rate in the economy falls 

Then:

• Newer bonds start getting issued with a lower rate (e.g. 8% p.a.)
• Old bond would now be worth more than before
• Its price will accordingly rise 
• Investors will see the value of their investments go up

Implications:

Mutual funds that hold this bond will find their holdings worth more, allowing them to make additional profits by selling it.

The reverse is true as well. 

If interest rates rise, mutual funds holding older bonds would see the value of their investments fall and they could lose money.

Article: SIPs and rupee cost averaging

#11

Concepts

Rupee cost averaging

• Approach wherein you invest a fixed amount of money at regular intervals
• Ensures that you buy more shares of an investment when prices are low and less when they are high
• You avoid the manual, complex task of researching the best time to invest
• Averages out the costs of your units 
• Lessens the results of short-term market fluctuation on your investments

SIP

• Systematic Investment Plan
• Facility offered by mutual funds to investors
• Helps you invest in a disciplined manner
• You invest a fixed amount of money at pre-defined intervals in the selected mutual fund scheme
• Amount can be as low as Rs. 500
• Intervals can be weekly, monthly, quarterly, semi-annually, or annually 
• Investor need not worry about market dynamics or timing
• Stands to benefit in the long-term due to average costing and power of compounding

Gist

• SIPs help you lower your investment cost and hence maximize returns
• When you invest through SIPs, you automatically experience the benefit of rupee cost averaging
• When you invest, you accumulate units at various prices called net asset value aka NAV
• You get more units when the market is down and the fund's NAV is lower and vice-versa

Why it works

Markets are volatile, hence it makes sense to spread your investments over a period of time to benefit from the lows that frequently occur

How it works

• Say you invest Rs 10,000 in a fund at each of these NAVs: Rs 100, 150, 200, 250, and 300
• Number of units accumulated (amount/NAV): 100, 66.66, 50, 40, and 33.33
• Total amount invested = Rs 50,000
• Total units = 289.99
• Average NAV = Rs 172.41 (This amount is less than three of the five NAVs at which you bought the fund!)

Conclusion

• SIPs: psychological tool of discipline
• By nature, investors are tempted to invest more when the market is racing and stop investing altogether when it is falling, which hurts returns
• SIPs automate the entire investment process and delink sentiment from investing
• Via SIPs, you benefit from rupee cost averaging to get a good return

Article: How ELSS scores over other tax saving avenues

#7

Fact

Under Indian tax laws, savers have a complete range of tax-saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits (FDs), National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others

Question

Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

Answer

There is a confusion of goals between saving tax and making investments.

Equity Options

There are two options other than ELSS that give equity-linked returns - Unit-Linked Insurance Plans (ULIPs) and the National Pension System (NPS)

ULIPs

Longer lock-in period of 5 years, coupled with high costs and poor transparency.

Traps:

1. Mix of investment + insurance 
2. Savers don't have clear cost-vs-benefit understanding of either 
3. Both transparency and liquidity relinquished
4. Terminating the policy early affects returns adversely (instead of 5-year lock-in, it becomes a 10-15-year commitment)

ULIPs aren't suitable for investment due to:

1. High costs
2. Difficulty in evaluation
3. Lack of transparency
4. Low liquidity

NPS

Retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age.

ELSS

3-year lock-in period

Short-term vs long-term: 

1. Equity investment carry higher risk over the short-term. 
2. However, for investment periods of five years or more, the risk on equity investments is considerably lower. 
3. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation.

The best way of investing in an ELSS is through monthly SIPs (Systematic Investment Plan) throughout the year. SIPs also give the dual advantage of avoiding any last-minute rush.

 

At the beginning of every year, estimate the amount you have leftover from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP. 

Simple.

 

Good Books to Explore

#2

Welcome to the post that encourages readers to explore the below books, all of which I have read. For some books, I will humbly attempt to summarize them, so as to give you a gist of what you can expect when you decide to invest your time reading them.

Each book is written with a different purpose in mind, and for a different group of audiences.

Some are technical, some are fun and lightweight, while others are pure textbooks. I have also enlisted recommended books which I am yet to read.
Additionally, I've listed two videos I have watched umpteen times because they are crisp and clear in their explanation of their respective concepts.

Books:

Fooled by Randomness
Nassim Nicholas Taleb

Freakonomics

Steven Levitt

Rich Dad Poor Dad
Robert Kiyosaki

Stocks to Riches: Insights on Investor Behavior

Parag Parikh

The Big Short
Michael Lewis

The Undercover Economist

Tim Harford

Think and Grow Rich
Napoleon Hill

Thinking, Fast and Slow
Daniel Kahneman
(Genre: behavioural economics)

Too Big to Fail
Andrew Sorkin
(Although I haven't read the book yet, I've seen the movie several times)

Textbooks:

Damodaran on Valuation

Aswath Damodaran

Options, Futures, and Other Derivatives

John Hull

Principles of Economics
George Mankiw

Recommendations:

An Inquiry Into the Nature and Causes of the Wealth of Nations
Adam Smith

Misbehaving
Richard Thaler

Post-Capitalist Society
Peter F. Drucker

The Intelligent Investor
Benjamin Graham

The Upside of Inequality
Edward Conrad

Videos:

Credit crisis explanation
Jonathan Jarvis

How the economic machine works
Ray Dalio

Introduction

#1

Welcome to a world of Money, Money, Money!

This blog contains posts on various topics related to finance, such as the following:

1. Accounting basics
2. Derivatives
3. Econometrics
4. Economics basics
5. Good books to explore
6. Famous folks in finance
7. Miscellaneous concepts
8. Scandals
9. Security analysis
10. Valuation

In this blog, I do not plan to talk about theories and concepts in a verbose manner.

What I'd rather attempt is to achieve a fun-filled way to approach the world of finance, a 'finance made easy' concept, if you will.

If you find the topics and the approach I've chosen interesting, you might retain some of them for a long time, and that's all I hope for.

If you do wish to read further on some of the topics, Investopedia is a great site, to begin with.

Cheers!