MFI - Ase 2013 - Mitroi

MFI, ASE, 2013
Investment Management and

International Financial Markets

A Psi Finance Perspective

Adrian Mitroi

The Course

The MACRO CONTEXT

The CORPORATE CONTEXT
Real Economy. Jobs do matter
Nominal Economy. Financial markets, banks

The INDIVIDUAL CONTEXT
Individual Investment Portfolios
Individual Financial Behavior

The TRENDS in Investment Management
Wrap Up, Q&A, Case Studies

Investment Management and International Financial Markets, ASE, 2013

Investment and Capital Finance in unusual
uncertain times:

Macro: Systemic vs. Unique Risks
Corporate: Risk vs. Return
Individual: Survive vs. Succeed
Decision making: Psi-Factors vs. Rational

3

The Course
FACULTY
Faculty Name: Dr. Adrian T. Mitroi, CFA, MBA
Contact Information: adrian.mitroi@cityu.edu; adrian.mitroi0@gmail.com

COURSE DESCRIPTION
Students will learn the role of modern finance in business development and management. Students will
learn how banks and capital market function. Special topics will include investment banks and the function
of IMF, WB, ECB.
The course prepares learners to understand the flow of capital affect the businesses where they work and
the communities in which they live. Current economic context will be a core topic.
The course will address in detail the subject of Behavioral Finance and its relevance in todays financial and
business environment

The content of this course aligns with the following program outcomes:
Communicate effectively both orally and in writing with internal and external stakeholders
Lead individuals and organizations to achieve business missions in a global environment
Build, lead and participate in productive and diverse teams
Leverage managerial effectiveness through recognition of individual strengths, values, business philosophy
Use people skills to manage diverse work environments and navigate organizational politics.
Capitalize on business opportunities in a rapidly changing environment by thinking critically and applying
quantitative procedures and tools
Recognize when information is needed; find, evaluate and use it to support continuous professional and
organizational development.
4

LEARNING GOALS

This course supports the following learning goals:

Professional Competency
Professional Identity
Strong Communication and Interpersonal Skills
Critical Thinking
Commitment to Ethical Practice and Service
Lifelong Learning
Graduate better prepared for a (better) job

5

The Course

The MACRO CONTEXT





The age of the machines


7

8

Macroeconomics of Crisis
Buying time
Decreased
correlation
Correlation: stocks, growth, inflation, deficits, exchange and interest rates
Cyclical vs. countercyclical; conventional vs. non conventional policies
Financial sector, a pro cyclical indicator of real economy
Lending to negative equity; solvability vs. liquidity
Real estate market; LT real assets vs. ST financial liabilities
A PsiFinance Perspective into
the New Normal Economics
Borrowing (lesser) time
Change in
paradigm
Propensity to spend, save or invest in highly volatile markets
Risk aversion vs. loss aversion in economic recession
Decrease in bear markets correlation; only local black swans
Net wealth effect can be substituted for net income effect
Ultralow/easy money leads always to bubbles
9

Macro policies and markets
Learning by doing
Conventional
Cyclical: pro cyclical, correlated with overall state of the economy; ex.
tightening monetary policy in recession (hawkish); higher than equilibrium-
appropriate exchange rate, fiscal tightening (VAT increase)

Conventional: monetary rate, (ex. strong Ron = tightening but decreased
MRR = softening), open market; higher bound for repo interest = dovish

Countercyclical: activist (vs. laissez faire), against current economic
tendency, lower monetary rate (dovish), simulative in economic downturn;
ex: progressive tax, unemployment
Terra Incognita in Macroeconomics
Trial and error
FX appreciation
limited effect on
inflation

Unchartered
territory
Non conventional: easing cost and availability of funds; fiscal monetization:

aimed at reduced risk spreads, affecting longer term rate across the board,
independently of their liquidity and credit risk, affecting the market for risk
free assets, government bonds (QE- quantitative easing); BCE repos

targeted on the risk spread across assets classes, between those whose
markets are particularly impaired (PIGs junks as collateral) and those that
are more functioning (CE- credit easing); EU/IMF/EC Stability Fund

10

One size monetary without fiscal policy
Not sure working
Combination
of reasons
Common to all major crises, is a combination of reasons: overleverage, real
estate boom, loose fiscal and monetary policies, overspending - debt difficult
decisions: higher tax or lower spending/expenses?

ECB: one size fits all monetary policy has drawbacks, mostly in a downturn
economy. Front runners (G) in recovery would rather enjoy an % increase once the
growth picks up, but laggards (P, S) would rather see very low % for a longer term
From 2 big to fail to 2 big to bail
Probably working
Bail outs
equals bail ins
Moral hazard introduced by EU/IMF/EC stand by PIGs bailout was a necessary
evil (write off). Probably, restructuring would have been better, but EU is not yet
prepared to accept, manage, convince; China capitalizes Spanish Banks

Europes financial tribulations reflect investors concern that governments have
borrowed too much to revive their economies; how do US manage?

No matter how smart and big is the bailout (EU Stabilization Fund), most
important stakeholders have to buy in: population (to sacrifice) and private
investors (to roll over next debt, at reasonable prices)

11

Conventional vs. nonconventional policies Which one is better?
Debt
transportation
Too much debt is dangerous. During boom, central banks, investment bankers
and politicians all signed up to the cult of debt; SE Asia is the least levered, best
prepared for sustained economic growth (financial and commercial)

Companies went for balance-sheet "efficiency" - and homeowners, piled on huge
mortgages, were caught out, then discover that it is much harder to deleverage
than to leverage up; basically, only rented home from the bank

When the Fed stops buying Treasuries, does the private sector take the baton
and run the last leg of the relay race?
New Normal Global Economics
Crisis or recession?
Change in
paradigm
Globalization doesn't work smoothly by itself. Free movement of capital has
facilitated rapid shifts in cross-border capital flows, currency values and prices of
commodities; insufficient financial depth (savings and investments/GDP) makes a
country vulnerable; first: save; then: invest; only then: spend

Most probable we all, insufficiently saved, inadequately invested and irrationally
spent future cash flows (governments, corporations, individuals)
12

Central Banks matter
Armada of measures, inflated BS
Decreased
correlation
During a normal recession, the Fed, ECB and other central banks
responded with non conventional monetary policies by buying short-term
government/quality (except for PIIGs junks) debt from banks

Process drives rates on government debt down; investors seeking a
higher rate move into other assets, driving other rates down; normally
these lower rates will lead to economic bounceback; in recession, fiscal
also matters
Interchangeable fiscal, monetary
Borrowing time; how/when to exit?
Change in
paradigm
A lower bound to rates advocates higher government spending: when
monetary policy is ineffective and private sector cant be persuaded to
spend, the public sector must take its place in supporting the economy

Probably the fiscal stimulus is Keynesian answer to current economic
situation and a good mix with monetary policy. New normal recession
requires CBs to be less concerned on inflation? Milton Friedman for
growth and John Maynard Keynes for recession?
13

Central banks; monetary and fiscal policies look interchangeable
ECB (Feb 2013):
Marginal lending facility: 1.50 %
Main refinancing operations: 0.75 %
Deposit facility: 0.00 %
NBR (Feb. 2013):
Deposit: 1.25%
Policy rate: 5.25%
Lend facility: 9.25%
MRR FX: 20%
FED (Feb 2013):
Discount: 50 bp
Fed Funds: 0-25
14
11 July 2012
0.75%
30 March 2012
5.25%
0
2
4
6
8
10
12
BNR
ECB
FED

Systemic risk
Old answers to new questions
Monetary solution work only partially
Monetary medication needs fiscal diet
Decreased
correlation
A bubble in G bonds avoided, but yields will rise, inflation, oversupply
ECB: need to print money to pay interest on new debt; result: a slower
recovery; growth is a key determinant for deficits
Add corporate and private debt to government debt / GDP, the prospect
of economic growth paying all that off is moving further in time
Area has structural deficiencies that questions viability of status quo
Sovereign debt pressure
Public loss vs. private gains
Change in
paradigm
Debt restructuring, could be the new currency devaluation in zone
Higher borrowing cost (LT) could lead to higher deficits;
Creditors are also massive debtors
If the value of their assets declines, the only way to stay solvent is by
reducing debt, sell assets, pushes price down further, exacerbating and
spreading it to other securities/currency
15

BANKS

SOVEREIGN

MARKETS
CENTRAL
BANKs
ZIRP, NIRP,
QE, TWIST
LOCAL
EXTERNAL
N
O
M
I
N
A
L

E
C
O
N
O
M
Y

R
E
A
L

E
C
O
N
O
M
Y

CORPORATE /
RETAIL CREDIT
CORPORATE /
RETAIL SAVINGS
+ INVESTMENTS
return of capital vs return
on capital

SOVEREIGN
BANKS
sovereign vs banks
disentangling

CORPORATE /
RETAIL CREDIT

Gov. bonds' mkt value fall / yld. Increase
Increase in bank funding costs
Low room for official support
Mkt value of Gov. bonds held by foreign
Banks fall / yld. Increase
Similar sovereigns come under pressure
Contagion channels (, & )

Rise in counterparty credit risk
Withdrawal of funding for risky banks
Increase in contingent liabilities of Gov.
Effect of crowding-out
Financial repression

Political
(save PIIGS,
rift North vs. South)

Fiscal
(possible stimulus and
automatic stabilizers)

Monetary
(price stability)

Financial
(clean up banking system
in decisive and rapid
steps- higher cost of
dealing with systematic
risk)

Banking union
(power to supervise all
lenders)

United States of Europe

Countercyclical stimulus

Support market with few
macro instruments-
interest rate and quantity
of money-and trade off
btw inflation
/unemployment

Crisis
prevention/management
of systematic risk

ECB single supervisory
mechanism; macro-
prudential supervisor
EU-wide deposit
guarantee scheme;

EUropean dream

2013 - Good news in Eurozone (1)
18
Before 2012 - bailout
LTRO
Liquidity
matters
ECB - two-tranche long-term refinancing operation (LTRO) to stabilize

End of 2nd LTRO (Feb 2012) - 1.1 trillion of three-year money (interest
rate of 75 %) - injected into more than 800 of the region's banks.

Now: payback time
After bailout
Early repayment of LTRO
Solvability
matters
Banks - early repayment window to refund borrowings (LTRO)

ECB confirmed 278 banks repaid 137 billion (28% of the first LTRO)
by 30 Jan 2013: the Draghi effect

Reasons for early repayment:
Improved access to alternative funding (retail deposits; markets)
Improve balance sheet efficiency (no excess liquidity)
Reduce funding stress that could arise in 2015 (LTRO maturity)


2013 - Good news in Eurozone (2)
19
GDP growth trends: Portugal, Spain, and EU-27


Real vs. financial/virtual economy
Wealth effect vs. income effect
Commercial
vs.
Financial
Governments have borrowed too much to revive economies, causing
(2013) volatility, pushing the limits of fiscal and monetary stimulation;
financial prosperity, however, takes time

Financial sector, a lagging, pro cyclical indicator of real economy;
GDP growth is not enough

Banks will not give loans to negative equity; pro cyclical attitude: the
more credit you need, less able you are. Unemployment is key indicator
The weak/strong Dollar syndrome
Easy FED takes $ from savers
Bernanke's floor and put
$ 15% yoy
decrease - big
loss for China
Post real estate boom market: real assets vs. financial liabilities

Financial stability: bail out countries (PIIGs) is to keep financing
banks sovereign exposure solvable; money-printing is just another
way for governments to silently default on their debt

ChIndia, probably best market capitalists have socialist ideology and
US will not make it easier for EU; EU does not make it easier for EU
20

Liquidity
Bail out
Decreased
correlation
Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not
inter changeable. Interest rate risk vs. credit/counterparty risk

Liquidity provided by CBs can make a difference on ST but not on a LT;
markets are becoming completely dependent on Central Banks. Dark
side of : one size fits all could be suboptimal in times of crisis

Negative equity: market value of assets < present value of liabilities.
Deleveraging is a must, when real rate of assets < real rate of liabilities
Solvency
Bail in
Change in
paradigm
Solvability (LT, renewable ability to borrow) vs. liquidity (short term)
High debt/GDP, high deficit/GDP, low growth LT endangered species
An absolute economic pecking order:
1: recovery
2: growth
3: expansion
4: prosperity
What if Oil does not decrease till Q4? What when FED stops buying?
New species: depositors as budget deficit sponsors
21

22

Carry trade the easy money
Ultralow monetary for net wealth
Decreased
correlation
Then (2008): reverse correlation; when the dollar would fall, stocks
would rise and vice versa; strong, EM currencies under pressure

Why: CT investors were using a currency that cost almost nothing to
borrow ($,) to buy undervalued stocks, bias toward EMs (2010,12,13)

Central banks in countries such as Switzerland and Sweden have also
used negative nominal rates as a policy tool to get people to invest to
boost economic growth. For overseas depositors, the betting is simply
on currency appreciation, however, and they are often prepared to
accept negative interest rate returns (Aug. 2011, Mar 2013)

Currencies and stocks
Competitive re(de)valuation
Change in
paradigm
Now (2013): stocks and the dollar are moving up in tandem again, but
not down (weak from B/Outs?); a signal for investors to put more
money into $ denominated assets? a signal to sell denominated
assets and buy into emerging markets (Ron?)

Countercyclical Dollar and Yen are now less favorite CT currencies,
due to strengthening and overall volatility; with $, , and volatility up

Never ending story of stronger CHF and weaker renminbi
23 Investment Management and International Financial Markets, ASE, 2013

Dollar
Cyclical tailwind
Decreased
correlation
Typical paradigm for an export oriented Europe was that a strong dollar
/ weak is good for trade, for both US and China. A weakening (a
political not economic currency) is of benefit to PIIGS, alleviating some
excessive deficits and making their products more competitive

Raw materials, mostly denominated in dollars are making inputs prices
more expensive adding additional strain on expected growth differential
vs. US. This will lead probably to an earlier interest rate hike, make now
dollar assets attractive; now: strong CHF, J, ; undervalued C
Euro
Structural headwind
Cyclical or
countercyclical
During the toughest part of recession, the dolar weakend against most
of other currencies. A depreciating currency is a good antirecessonary
tool; a low $ exports recession and a strong $ imports growth

Banks are a lagging economic conditions. CBs, trying to protect
currency stability and debtors, would rather sacrifice future, potential
debtors/present depositors than curent debtors solvability position

Main risks to fiscal consolidation stem from too optimistic assumptions
and lack of specification; if EU didnt have common currency, it would
have bigger problems or vice versa?
24

25

Risk appetite increases at the wrong moment and for the wrong
reason, just when risk capacity decreases; net wealth effect
(market) compensates for net income effect (lower wage)
26

Double Dip
Rebalance is an euphemism
for standard of living transfer
Reprofiling
Europe
Multispeed world (China carbon trucks usually run at 130 km/hour)

Need to transfer standard of living to other more economic agile

Excess liabilities from cyclical/liquidity to structural/solvency

Value and quantity of public goods have to decrease

Social disparities (income and wealth) will grow larger

Competitive deficit is the mother of all headaches, deficits

Deux ex machina
(big daddy government and big mama central bank)
Vigilantes vs. Indignados
Stagflation
wind and
returns
compression
Bond vigilantes are still relaxed; active inertia, lend and pray is over

Economic Capital Sin: let them go from unemployed to unemployable

Accommodate the ? Tradables will dominate non-tradables

Negative interest rates all over the world imposed by governments

How to? Portfolio management conversion differentiate b/w:
Good asset price inflation (wealth effect) vs. bad inflation (commodities)
27

Who we are up against to
Luck (ST) vs. ability (LT)
Reprofiling
Investments
By fear of losing opportunity, investors do not keep temper, act
impulsively, extrapolate ST trend into a LT investment attraction. Risk
profile is changed, investors appear to be able to bear more risk that
would be otherwise reasonable, advisable and rational

Investors overestimate their individual abilities in terms of luck,
education, intellect and aptitude to process, disseminate and
understand Mrs. Market; she fools most of us, most of the time

Although there is a low correlation between professional abilities
and investment success, investors have high confidence that
somehow, someday they will succeed in beating the markets

Budget: a mathematical confirmation of suspicions

You may delay, but time will not
Future can
switch from
being a
promise to
being a threat
Price is supported and resisted by a multitude of educated, determined,
intelligent, psychologically tough individuals that act for single scope, to
maintain fun and privilege, to survive as market player

Job security is the most important argument and constraint that prevails in
the decision mind of investment managers. We have met the enemy and
he is us. Pogo, cartoon character

Beating the index by outsmart moves, ahead of competition, finding
undervalued/overvalued securities and implementing the buying and selling
decision at right time is difficult, if not impossible, in the long run

28

Investor financial behavior under stress
World of negative rates
Promises
make debt,
and debt
makes
promises
Investors put too much weight into most recent financial experiences
and ignore a longer term, larger perspective. Other players
decisions as discretional and non-rational; our decision are logical
and rational, and in conformity with all existing information

The fusion b/w classical analysis and behavioral evaluation should
help investors to a larger, more informed perspective of the market.

What competitors do is equally important with what you do
Contrarian decisions w/ negative results are penalized more
severely that are rewarded those with positive results
Addiction to action (debt)
Investors almost indifferent to buying opportunities at incipient phase
of a bull; they start to be interested when upside trend is obvious;
buying spree makes a clear upward. Is it the same on the downward

Nobody wants to be just a spectator of the game; everybody wants
a piece of action - a non-rational herd instinct

To compound the problem, the objects of investor affection is
represented by those stocks that performed dearly lately and are
obvious most exposed to the eventual correction

29

Chimps Score:
Sophisticated vs. Chimps

1. Moneys top Advisors
Picking Stocks 0 X

2. Best Analysts 0 X
Sell vs. Buy or Hold

3. Top 50 Economists 0 X

4. Top business Professors 0 X

Score 0 4

30

Decisions are heavily informed by emotions
Apothekers headache
Reprofiling
Debt
Major difficulty of investing is that we are all our worst enemies: buy
high and sell low, do worst possible thing at worst possible time

Feasibility of an investment decision is critical. People do what is
feasible/doable not what is theoretically sound and attractive

Critical is not what investors ought to do to get optimal results but
what they can do, what is feasible for them to do
Auto investment can help avoid misallocations or bad timing
Psyche actions -
wealth destruction
Worldwide
mass
unhappiness
A good investing advice is not theoretically ideal by psychologically
practical. Investors need something to do; i.e., impulse urge for the
illusion of control

Why we push the elevator button several times after we have pushed
it first - we think we can make it arrive more quickly

Younger investors arent replacing their retiring counterparts

Everything in the world may be endured except continual prosperity

31

32
32

Too big to fail but fit enough to
carry trade the easy money

Paper out the crisis to the future
33

Markets to ECB, FED: pls paper
out this also for the later
Austerity is here to stay and
the investor exodus
34

The power of strategic discipline

Success means that people or teams gear an organizations to survive long
enough to need maintenance, repairs, and reinvestment
Winners undergo natural aging processes, as people get older, slow down,
leave. Facilities, tools, and bags of tricks get older, deteriorate, run down
Newcomers might get less rigorous training while long-timers forget what
they learned. As momentum runs down, people and buildings run down
Erosion begins by removing a process or discipline:
Let's defer those roof repairs for another year...
Let's cut out one practice; we already have so many...
Let's save time by eliminating the weekly team meeting...
The Chernobyl nuclear plant disaster was said to be caused by engineers
neglecting small portions of routine safety checks because they had done
so before, and nothing had happened
Bad things can insinuate slowly, almost inconsequential

35

The power of investment discipline
In general, those that succeed in the run, make small gains,
systematically (or wins extra and more times than they loose)

Success is not a result of a continuous stream of rational and
correct material decisions, but of a disciplined and focused
approach. How do we stay alive in this market?

Disciplined approach of investment management relies on
common sense: full diversification of the portfolio, investment
horizon elongation, efficient mix of different investment styles
rebalancing asset composition, event-driven timing

Investment managers have to prove repeatable professional
ability and sustainable value-adding capability continuously to
their employers, employees and investment public

36

The power of strategic discipline (contd)
A successful, disciplined strategist remembers to:

Keep up the essential disciplines every day, not skipping one
Keep checking everything carefully
Repair, renew, relearn, and reinvest regularly
Don't rejoice in others' misery, because he could be next
Thank anyone who points out flaws
Listen to disgruntled customers or disaffected constituencies
Treat even small setbacks as occasions for redoubled efforts
Nothing ventured nothing gained.
Constant over many skilled competitors, in a free market, is difficult

37

From Return ON Capital to Return OF Capital
De la Rentabilitatea Capitalului la Returnarea Capitalului

Over optimism is a basic
tenet of human
species

People do not spend time
understanding bad
news

Investors would rather
prefer to focus on the
bright side of the
moon and they do not
see things that they do
not expect to see

What you see is what you
look for

Where are we now?
38

Wiki/Twitter/FB
Economy
Standard of living transfer
From Risk Free Rate of Return to Return Free Risk

Actionable
strategies
I get great enjoyment out of disproving my best loved theories W. Buffett
The team that sees reality most clearly wins. J. Welch
Never give in. Never give in. Never, never, never, never in nothing, great or
small, large or petty never give in, except to convictions of honor and good
sense. Never yield to force. Never yield to the apparently overwhelming might of
the enemy W. Churchill

Financial Repression
Indignados vs. shortage of
Chinese would-be-wife misses
Say Yes
(or I Do)
Goliath was too big to hit; David thought he was too big to miss
Deliver to the world what you would buy if you were on the other end
If someone does offer you a job, say yes. You can always quit later. Then at
least you'll be one of the unemployed as opposed to one of the never-employed
Nothing looks worse on a resume than nothing
39

40
Outdoor lifestyles
Individuals (16-74) who have never used the internet (% of pop.)

41

The Course

The MACRO CONTEXT





Extend and Pretend is Wall Street best friend, but now it comes to an end.
Main Street (real economy, jobs and cash flow) is different from Wall Street
(nominal economy, GDP, banking, markets)
43

Macro level:
Systemic
vs.
Unique Risks

44
Systemic risk: sovereign debt pressure
A bubble in government bonds has been deflated but yields will rise,
inflation, oversupply. Need to print money to pay interest on new debt;
result: a slower recovery; growth is a key determinant for deficits

Add corporate and private debt to government debt / GDP, the prospect
of economic growth paying all that off is moving further in time

Debt restructuring, could be the new currency devaluation in the
euro zone if not proper measure taken; higher borrowing cost (LT)
could lead to higher deficits; EU Stabilization Plan targets MT/LT rates

What is a CDS:
Credit-default swaps pay the buyer cash should company fail its debt
agreements. Increase signals deterioration in credit quality perception

A basis point (0.01%) on a credit-default swap contract protecting 10
million Euros of debt (except principal) from default for five years is
equivalent to 1,000 Euros a year (e.g. on May 7, CDS on European bank
bonds temporarily soared above levels triggered by the collapse of LB)
45

Stratgique Gouvernement conomique:
transition to a more competitive economy
The new normal Romanian consumer society skewed industrial structures
away from exporters to domestic market (sheltered from foreign competition)
Dependence on foreign capital; reason and result of poor competitiveness
Service FX debts from export; policy at shifting resources to exporters
Increase/reduce VAT/benefits, and reduce taxes on jobs can shift economy
from domestic demand to export (mimicking a non inflationary
devaluation); increase tax of properties (fiscal and financial inefficient)
Separate the new brothers in arms: monetary and fiscal policy; government
borrowing up for LT, fiscal policy will direct impact on the yield curve (MT/LT)

Automatic Shock absorbers could be helpful:
Monetary absorber: FX and % policies could be adjusted as needed (vs.)
Real economy absorber: flexible labor markets, balance to private vs. budget
Fiscal redistribution absorber to balance out economic shocks to exports
W/out fiscal discipline is doomed; ST compromise has LT drawbacks

46

Probably over economic recession but still
under solvability and financial crisis

2013, Over recession but still under crisis: Equity Risk
and Credit Premiums, Apr 2013

Real GDP
Growth
Real
Earnings
Growth +
Dividend
Yield =
Expected
Real
Return -
Real
Bond
Yield =
Implied
ERP
Expected
Inflation
Expected
Nominal
Return
US 3,0 3,0 1,8 4,8 1,5 3,3 2,0 6,8
Japan 1,5 1,5 1,7 3,2 0,8 2,4 0,5 3,7
UK 2,8 2,8 3,2 6,0 -1,0 7,0 2,0 8,0
Romania -1 -1 3 2,0 3,0 -1,0 4,0 6,0
-2,5 -2,5 3 0,5 3,5 -3,0 4,5 5,0
-5 -5 2,5 -2,5 3,75 -6,3 5,0 2,5
Europe 2,3 2,3 2,9 5,2 -1,0 6,1 2,0 7,2
World 2,5 2,5 2,3 4,8 0,4 4,4 1,8 6,6
47

Political Accounting and Machinations
Banks do not trade toxic assets (except with CBs); any trade could trigger a
fair valuation of whole portfolio; ok as long as interest rates go down

Fair value is history (FAS 157, IAS 39); bad loans of the past 10 years;
capitalization by accounting - easy but not enough

Goldman Sachs lesson:
SEC: .. built a conveyer belt of mortgage deals and then bet against
them, The toxins that Goldman Sachs and others helped inject into our
financial system have done incalculable harm to people who have never
heard of a synthetic CDO and who have no defenses against the harm that
such exotic Wall Street creations can cause (as Morgan Stanley did also)

GS: We didnt have a massive short against the housing market and we
certainly did not bet against our clients. It made money every single day of
Q1/10, a feat the firm has never accomplished before (as JPMorgan did)

48

Dollar Euro
The typical paradigm for an export oriented Europe was that a strong dollar
/ weak euro is good for trade, for both US and China. A weakening euro (a
political not economic currency) is of benefit to PIIGS, alleviating some of
their excessive deficits and making their products more competitive

Raw materials, mostly denominated in dollars are making inputs prices
more expensive adding additional strain on the expected growth differential
vs. US. This, in turn, will lead probably to an earlier interest rate hike, make
now dollar assets more attractive (Apr 2013: /$=1.32)

During the toughest part of the recession, the dolar weakend against most
of other currencies. A depreciating currency is a good antirecessonary tool;
a low $ exports recession and a strong $ imports growth

Banks are a lagging indicator of economic conditions. Central banks, trying
to protect currency stability and debtors, would rather sacrifice future,
potential debtors/present depositors than curent debtors solvability position

Main risks to fiscal consolidation stem from plethora of too optimistic
assumptions and lack of specification of consolidating measures; if EU
didnt have common currency, it would have bigger problems or vice versa?

49

Some capital lessons from the crisis

When inflation was low and GDP growth steady, many economists thought
all was right. Proceeds of trade surpluses invested in global markets -
helped make credit cheap and economies vulnerable to financial disruption.
Increasingly imbalanced asset prices and incomes proved dangerous

Too much debt is dangerous. Everybody signed up to the cult of debt,
B/S"efficiency" - piling on debt simply for buybacks - and homeowners piled
on mortgages. It is harder to deleverage than to leverage up an economy

Globalisation doesn't work by itself. Free movement of capital has facilitated
rapid shifts of capital flows, currency, commodities. Trade binds countries,
but shifting terms of trade - and turn growth into decline

Liquidity and solvency are not interchangeable. A world of negative equity

Governments and central banks are pushing the limits of fiscal and
monetary stimulation. The current mix of monetary and fiscal policies
probably will be enough to bring the recession to a soon end

50

The immediate effects of the current
economic downturn are still highly visible

Rising unemployment and bankruptcies depressed consumer
confidence, decreased in wealth and purchasing power
Volatile stock markets and feeble banks have damaged public trust
in the financial system
The financial crisis has wreaked havoc on retirement plans of all
varieties, inflicting damage both to DB and DC, which have
gradually come to replace state pension provision
The number of people contributing to pension savings through DC to
overtake those who are contributing to DB run by their employers
People are more knowledgeable and interested in managing their
money (facebook, twitter, blogging; finance. Yahoo; Google.finance)

51

Tough choices for everyone

Pensioners hit hardest - heavily dependent on DC, saved to build up a
personal fund, those near retirement, those invested in equities

Younger workers have time to repair the damage, since their losses
are smaller compared with their annual contributions; additionally,
those with DB private pensions are not immune from potential losses,
as companies are increasingly restricting the amounts paid

Meanwhile workers themselves, who have built up a lifetime of savings
in pension funds, are being forced to rethink their pension plans and
even defer their retirement

In planning for retirement, everyone faces profound personal choices:
how much to save, how to invest, when to retire, use of autopilot
mechanisms, such as mandatory participation, life-cycle investing, and
annuitizing investment balances

52

We like weekends, but we dont like Mondays
EU/FMI financial assistance of 750 billion
Euros to counter severe tensions by
purchasing government and private debt
and restarted a dollar-swap line with FED
ECB said it will conduct interventions to
ensure depth and liquidity in markets
Probably this will lead all central banks
(apart from China) to have a looser
monetary policy for longer
Spains benchmark stock index, the IBEX
35, rose the most on record

53

Corporate level:
Risk
vs.
Return
54

What is a business model?

Does the idea target niche or mass ? Is it an occasional or frequent
purchase? What channel would support the target price point? What
kind of support would be necessary given the purchase frequency?
"What size matters?" In other words, how big does an
opportunity have to be to matter inside a company?
"What is a simple calculation that crosses that bar?"
"What leads you to believe that calculation is plausible?"
Any marketer can quickly express the so-called "4 Ps" of marketing
(product, price, place, and promotion)
Innovators should also be able to quickly recite the 4 Ps that capture
idea's potential: population, penetration, price, purchase frequency
Ability to withstand downturn economy, sector, industry is key

55

Valuation does matter (assets and liabilities)

How to measure the value of pension obligations in todays
assets? what investment returns that will be earned from funds
set aside today?
Generous assumptions on returns - higher discount rates, lead
to smaller liabilities; returns may never be earned
Aggressive discounting dramatically shrinks liabilities; when it
is too good to be true, it is
P/Es may decline under significantly lower as well as higher
real interest rates, and under falling rates
Pensions in real terms could experience a drop in funded ratios
declining asset values and rising liabilities

56

Mismatching Assets and Liabilities
If A and L do not have same growth, deficit has to be made
up by higher contributions, but how you value liabilities?
market indexes do not reflect pensioner unique liability
schedule, true investment objective
The funded ratio: market value of A/market value of L
(custom not market); mismatch can lead to large deficit,
distorted, inadequate asset allocation; in loss domain,
people assume undue risk
By using the wrong benchmark the portfolio returns
inadequate information ratio; can still beat a market index
with assets but still underfund with liabilities; the pension
objective should be liability driven not asset driven

57

Rational Strategic Analysis in
Financial Management: 4 facets
58

Dire Straits of 2008/9/10/11/12/13..
Dire Straits of last period: deeper, longer than expected recession

The rational expectations are form by two methods:
-Intellectual reasoning and evaluation, logical processing of information
(sector, specific, market) construction of opinion on intrinsic value of asset

-Estimation of psychological reasoning of other participants behavior; their
actions can have a decisive effect on own success or failure; formation of
expectations is subjected to time pressure and omniscient uncertainty

Even-driven investor perception is shaped by the autobiographic
memory; the memory register records events in a highly organized and
selective manner, based on their emotional significance and relevance

The outcome of the events is perceived in the light of experience and
possible repercussions of an eventual decision

Information processing is performed at the semantic level (personal
knowledge accumulated during lifetime) and then at emotional level
(autobiographic memory and personal experiences during lifetime)
59

Investment is a risky business
Financial behavior analysis relaxes the fundamental analysis
requirement for convergence of price and value.
The difference between the two is seldom systematic, so it
can be exploited by a rational and disciplined investor
Can an informed investor make money systematically by
exploitation of behavioral, cognitive and psychological
inefficiencies of the market?
There can be no reward, without risk. Gaining an advantage
over so many skilled and knowledgeable competitors, in a
free market, is extraordinary difficult
Managing in bear market is the skill. Bear correlations can
easily destroy the hard earned return

60

Sayonara
That crashing sound we hear is not an accident caused by sudden
acceleration of a hybrid car; it is the continuing toppling of idols, off their
pedestals (Nokia, Toyota, GM, AIG, Merrill Lynch, BofA, LB, BP, GS)
Toyota, the world's leading auto company, faces a series of product
problems causing recall, investigation and an exasperating loss of face for a
company from face-conscious Japan
This follows its first annual financial loss in 50 years, with profitability
regained partly through cost-cutting
Sayonara for a while to Toyota's reputation for quality, control, invincibility
All too often, long periods of continued success are undermined not by the
competition but by self-inflicted wounds
Winners become sinners, when confidence turns into complacency and
arrogance, over-estimate invincibility and under-value discipline
Winner are tempted to neglect the very fundamentals that helped them
succeed in the first place

61

The power of strategic discipline (contd)
A successful, disciplined strategist remembers to:

Keep up the disciplines every single day, not skipping a single one
Keep checking everything carefully
Repair, renew, relearn, and reinvest regularly
Don't rejoice in others' misery, because he could be next
Thank anyone who points out flaws
Listen to disgruntled customers or disaffected constituencies
Treat even small setbacks as occasions for redoubled efforts
There is no reward, without risk. Gaining a sustainable advantage
over so many skilled and knowledgeable competitors, in a free
market, is difficult

62

Diversification along sectors, assets, managers

Economy (2011-2013) Probability A (energy sector) B (financials sector)
Boom 0.25. 20% 5%
Normal 0.50 10% 10%
Recession 0.25 0% 15%

R
a
= (0.25) (0.20) + (0.50) (0.10) + (0.25) (0.00) = 0.10

R
b
= (0.25) (0.05) + (0.5) (0.10) + (0.25) (0.15) = 0.10

2
a
= (0.25) (0.20-0.10)
2
+ (0.5) (0.10-0.10)
2
+ (0.25) (0.00-0.10)
2
= 0.005

2
b
= (0.25)(0.05-0.10)
2
+ (0.5)(0.10-0.10)
2
+ (0.25)(0.15-0.10)
2
= 0.00125

a
= (0.005)
1/2
= 0.07071 = 7.071%

b
= (0.00125)
1/2
= 0.03536 = 3.536 %

Cov
ab
= (0.25)[(0.20-0.10)(0.05-0.10)]+ (0.50)[(0.10-0.10)]+ (0.25)[(0.00-0.10)(0.15-0.10)]=
- 0.0025
(
a,b
) = cov (a,b) /
2
a

2
b
= - 1

63

2013 Portfolio diversification: 50% stocks + 50% bonds

Probability

Equity fund %

Bond fund %

50% equity +
50 % bond

Recession

1/3

- 7

17

+ 5

Normal

1/3

+ 12

+ 7

+ 9.5

Boom

1/3

+ 28

- 3

+12.5

Expected return

11

7

9

Variance

204.7

66.7

9.5

Standard deviation

14.3

8.2

3.1

Cov(s,b) = 0,3333(-7-11)(17-7)+0.3333(12-11)(7-7)+0.3333(28-11)(-3-7) = -116.67
(s,b) = cov (s,b) / ab= -116.66 / [(14.3) (8,2)] = - 0.99
64

Highest velocity ever of a market reaction, May 6, 2010
(the panic, the fat finger and the revenge of the machines)
A big block of P&G (2:30), followed by another huge
block, right before the market crashed, then, nothing,
probably sell orders, big enough to blow all the bids,
for a few minutes, buyers just disappeared
Existing stop-loss orders on P&G forced selling into a
no-bid market
Every $1 change in price in a stock, results in a 7.56
(1/0.132319125) change in DJIA
Worst timing: stocks had started selling off earlier,
panicked. The velocity/severity triggered stop-loss
selling, feeding on itself
Even as P&Gs share price was recovering, bids
were falling rapidly in the other 29 Dow components;
at one point was down 997
65

Five fundamental forces have transformed
the financial services market today
1. Deregulation/re-regulation
2. Financial innovation
3. Securitization
4. Globalization
5. Advances in technology.
The latter factors actually represent
responses to deregulation and
re-regulation.
66

The fundamental forces of change
increased competition
Competition for deposits
Competition for loans
Competition for payment services
Competition for other financial services

Discussion:
What do you think is the result of this increased competition?
What do you think is the result of current crisis for banking system?

67

Investment vs. commercial banking

Commercial banks consider investment banking
attractive because most investment banks:
already offer many banking services to prime
commercial customers and high net worth
individuals and
sell a wide range of products not available through
banks
can compete in any geographic market without the
heavy regulation, earn extraordinarily high fees for
certain types of transactions and can put their own
capital at risk in selected investments.
68

Investment banking
Investment banking encompasses three
broad functions:
underwriting public offerings of new
securities
trading existing securities
advising and
financing mergers
and acquisitions
69

Response of banks
One competitive response to asset quality
problems and earnings pressure has been to
substitute fee income for interest income

Banks also lower their required capital and
reduce credit risk by selling assets and
servicing the payments between borrower and
lender rather than holding the same assets to
earn interest

This process of converting assets into
marketable securities is called securitization
70

Securitization
Securitization is the process of converting
assets into marketable securities.
It enables banks to move assets off-balance
sheet and increase fee income.
It increases competition for standardized
products such as:
mortgages and other credit-scored loans
Eventually lowers the prices paid by consumers
by increasing the supply and liquidity of these
products.
71

Globalization
Gradual evolution of markets and institutions so
that geographic boundaries do not restrict
financial transactions.

Financial markets and institutions are becoming
increasingly global in scope.

Firms must recognize that businesses in other
countries as well as their own are competitors,
and that international events affect domestic
operations.
72

ANALYZING BANK PERFORMANCE
Bank Assets

Loans
The major asset, generate the greatest amount of
income, exhibit the highest default risk and are relatively
illiquid.

Investment Securities
Securities held to earn interest and help meet liquidity
needs.

Cash and due from banks
Vault cash, deposits held at the Fed and other financial
institutions, and cash items in the process of collection.

Other assets
Bank premises and equipment, interest receivable,
prepaid expenses, other real estate owned, and
customers' liability to the bank
73

Bank liabilities
Demand deposits
Transactions accounts that pay no interest

Negotiable orders of withdrawal (NOWs) and
automatic transfers from savings (ATS) accounts
Pay interest set by each bank without federal
restrictions

Money market deposit accounts (MMDAs)
Pay market rates, but a customer is limited to
no more than six checks or automatic
transfers each month

Savings and time deposits represent the bulk of
interest-bearing liabilities at banks.
74

Bank liabilities (continued)
Two general time deposits categories exist:
Time deposits, certificates of deposit (CDs).
Small CDs, considered core deposits which
tend to be stable deposits that are typically
not withdrawn over short periods of time.
Deposits held in foreign offices
Balances issued by a bank subsidiary located
outside the country of domicile
Purchased liabilities, (rate-sensitive borrowings):
Central Bank/Money market funds purchased
Repos
Other borrowings less than one year

75

Stockholders equity
Subordinated notes and debentures:
Notes and bonds with maturities in excess of
one year.

Stockholders' equity
Ownership interest in the bank.
Common and preferred stock are listed at par
Surplus account represents the amount of
proceeds received by the bank in excess of
par when it issued the stock.
Retained earnings equals accumulated net
income not paid out as cash dividends
76

The income statement
Interest income (II)
Interest expense (IE)
Interest income less interest expense equals
net interest income (NII)
Loan-loss provisions (PL)
represent management's estimate of
potential lost revenue from bad loans
Noninterest income (OI)
Noninterest expense (OE)
noninterest expense usually exceeds
noninterest income such that the difference
is labeled the bank's burden
Securities gains or losses (SG)
Taxes
77

Noninterest income
has increased significantly and consists of
fees & other revenues for services
Fiduciary activities
Deposit service charges
Trading revenue, venture cap., securitize inc.
Investment banking, advisory inc.
Insurance commissions & fees
Net servicing fees
Loan & lease net gains (losses)
Other net gains (losses)
Other noninterest income
78

INCOME
Return to the Bank
ROA = NI / TA
EXPENSES
Rate
Composition (mix)
Volume
Interest
Overhead
Prov. for LL
Taxes
Fees and Serv Charge
Trust
Other
Rate
Composition (mix)
Volume
Interest
Non Interest
Salaries and Benefits
Occupancy
Other
Bank Performance Model
Returns to
Shareholders
ROE = NI / TE
Degree of Leverage
EM =1 / (TE / TA)
79

Fundamental risks
Credit risk
Liquidity risk
Market risk
Operational risk
Capital or solvency risk
Legal risk
Reputational risk
80

Interest rate risk
the variability in a bank's net interest income
and market value of equity due to changes in the
level of market interest rates

Example: $10,000 Car loan
4 year fixed-rate car loan at 8.5%
1 year CD at 4.5%
Spread 4.0%
But for How long?
Funding GAP
GAP = $RSA - $RSL,
where $RSA = $ amount of assets expected to reprice in
a give period of time.
In this example:
GAP1yr = $0 - $10,000 = - $10,000
This is a negative GAP.
81

Capital risk
closely tied to asset quality and a bank's overall risk profile
The more risk taken, the greater is the amount of
capital required.
Appropriate risk measures include all the risk
measures discussed earlier as well as ratios
measuring the ratio of:
Tier 1 capital and total risk based capital to
risk weighted assets
Equity capital to total assets
Dividend payout, and growth rate
82

CAMELS (I)
Capital Adequacy
Measures banks ability to maintain capital
commensurate with the banks risk
Asset Quality
Reflects the amount of credit risk with the loan
and investment portfolios
Management Quality
Reflects managements ability to identify,
measure, monitor, and control risks
83

CAMELS (continued)
Earnings
Reflects the quantity, trend, and quality of
earnings
Liquidity
Reflects the sources of liquidity and funds
management practices
Sensitivity to market risk
Reflects the degree to which changes in
market prices and rates adversely affect
earnings and capital
84

Customer Profitability 8020 Rule
-10
0
10
20
30
40
50
60
70
80
P
e
r
c
e
n
t

o
f

T
o
t
a
l

P
r
o
f
i
t
s
High Value
Customers
Value
Customers
Average
Customers
Low Value
Customers
High
Maintance
Customers
Who are they, what do they need?
How do you move them up?
Move up or move
out
85

The Mathematics of Interest
Rates
Future Value & Present Value: Single Payment
Terms
Present Value = PV
value today of a single future cash flow.
Future Value = FV
The amount to which a single cash flow
or series of cash flows will grow over a
given period of time when compounded
at a given interest rate.

86

Rates
Future Value: Single Payment
FV = PV(1 + i)n
FV = $1,000(1+.05)1 = $1,050

0 1
$1,000 $1,050
PV FV
5%
87

Rates
Present Value
Suppose you need $10,000 in one year. If
you can earn 7% annually, how much do you
need to invest today?
Present Value = 10,000/(1.07)1 = 9,345.79
0 1
$9,345.79 $10,000
PV FV
7%
88

Rates
Future Value: Multiple Payments
0 1 2 3
4,000 4,000 4,000 7,000
8%
4,320.00
4,665.60
8,817.98
21,803.58
FV =
89

Rates
Compounding Frequency
Suppose you can earn 1% per month on $100
invested today.
How much are you effectively earning?
i* = (1 + .12/12)12 1
i* = (1.01)12 1 = .1268 = 12.68%
90

The Effect of Compounding on Future Value and Present Value
Continuous compounding is based on Eulers e such that

limit
m =
1 +
1
m
|
\

|
.
|
i n
= e
i
, where e = 2.71828. Thus, FVn = PVe
in
, and

PV =
FVn
e
i n
.
A. What is the future value after 1 year of $1,000 invested at an 8% annual
nominal rate?

Compounding Number of Compounding Future Effective
Interval Intervals in 1 Year (m) Value (FV1)* Interest Rate*
Year 1 $1,080.00 8.00%
Semiannual 2 1,081.60 8.16
Quarter 4 1,082.43 8.24
Month 12 1,083.00 8.30
Day 365 1,083.28 8.33
Continuous

1,083.29 8.33

B. What is the present value of $1,000 received at the end of 1 year with compounding at 8%?
Compounding Number of Compounding Present Effective
Interval Intervals in 1 Year (m) Value (PV)* Interest Rate*
Year 1 $925.93 8.00%
Semiannual 2 924.56 8.16
Quarter 4 923.85 8.24
Month 12 923.36 8.30
Day 365 923.12 8.33
Continuous

923.12 8.33

91

The Relationship Between Interest Rates
and Option-Free Bond Prices
Bond Prices
A bonds price is the present value of the
future coupon payments (CPN) plus the
present value of the face (par) value (FV)

n
n
r
FV CPN
r
CPN
r
CPN
r
CPN
) (
. . .
) ( ) ( ) (
Pric e
+
+
+ +
+
+
+
+
+
=
1 1 1 1
3
3
2
2
1
1
n
n
t
t
t
i
FV
i
CPN
) ( ) (
Price
+
+
+
=

=
1 1
1
92

Bond Prices and Interest Rates are Inversely
Related
Consider a bond which pays semi-annual
interest payments of $470 with a maturity of 3
years.
If the market rate of interest is 9.4%, the
price of the bond is:

000 10
047 1
000 10
047 1
470
6
6
1
, $
) . (
,
) . (
Pric e = + =

= t
t
93

Bond Prices and Interest Rates are Inversely
Related
If the market rates of interest decreases to
8.8%, the price of the bond rises to:

24 155 10
044 1
000 10
044 1
470
6
6
1
. , $
) . (
,
) . (
Pric e = + =

= t
t
94

Relationship between price and interest rate on a 3-year,
$10,000 bond that pays $270 in semiannual interest
10,155.24

10,000.00

9,847.73
8.8 9.4 10.0
Interest Rate %
$s
A = +$155.24
A = -$152.27
Bond Prices Change
Asymmetrically to
Rising and Falling
Rates
For a given absolute change
in interest rates, the
percentage increase in a
bonds price will exceed the
percentage decrease.
This asymmetric price
relationship is due to the
convex shape of the curve--
plotting the price interest
rate relationship.
95

Duration and Price Volatility
Duration as an Elasticity Measure
Duration versus Maturity
What is the effective maturity of both?
The effective maturity of the first security
is: (1,000/1,000) x 1 = 20 years
The effective maturity, second security:
[(900/1,000) x 1]+[(100/1,000) x 20] =
2.9 years
Duration is similar, however, it uses a
weighted average of the present values of
the cash flows
96

Duration and Price Volatility
Measuring Duration
Example
What is the duration of a bond with a
$1,000 face value, 10% coupon, 3 years to
maturity and a 12% YTM?

years 2.73 =
951.96
2,597.6

(1.12)
1000
+
(1.12)
100
(1.12)
3 1,000
+
(1.12)
3 100
+
(1.12)
2 100
+
(1.12)
1 100
D
3
1 = t
3 t
3 3 2

1
=

=
97

Summary of money market yield
quotations and calculations
Simple Interest i
s
:

Discount Rate i
dr
:

Money Mkt 360-day rate, i
360

Bond equivalent 365 day rate, i
365
or i
be
:

Effective ann. interest rate,

Definitions
Pf = final value
Po = initial value
h=# of days in holding
period
Discount Yield quotes:
Treasury bills
Repurchase agreements
Commercial paper
Bankers acceptances
Interest-bearing, Single
Payment:
Money market funds
o
o f
s
p
p p
i

=
(

=
h
360
p
p p
i
f
o f
dr
(

=
h
360
p
p p
i
o
o f
360
(

=
h
365
p
p p
i
o
o f
be
1
365/h
i
1 i
365/ h
*
+ =
98 Investment Management and International Financial Markets, ASE, 2013

Interest Rate Risk: GAP & Earnings
Sensitivity
When a banks assets and liabilities do not
reprice at the same time, the result is a change
in net interest income.
The change in value of assets and the change
in value of liabilities will also differ, causing a
change in value of stockholders equity
Interest Rate Risk
The potential loss from unexpected changes
in interest rates which can significantly alter a
banks profitability and market value of equity.

99

Factors Affecting Net Interest Income

Consider the following balance sheet:
Assets Yield Liabilities Cost
Rate sensitive 500 $ 8.0% 600 $ 4.0%
Fixed rate 350 $ 11.0% 220 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 500 - 600 = -100
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NIM = 41.3 / 850 = 4.86%
NII = 78.5 - 37.2 = 41.3
Expected Balance Sheet for Hypothetical Bank
100

What if: 1% increase in short-term rates
Assets Yield Liabilities Cost
Rate sensitive 500 $ 9.0% 600 $ 5.0%
Fixed rate 350 $ 11.0% 220 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 500 - 600 = -100
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NIM = 40.3 / 850 = 4.74%
NII = 83.5 - 43.2 = 40.3
Expected Balance Sheet for Hypothetical Bank
With a negative GAP, more liabilities
than assets reprice higher; hence NII
and NIM fall
101

Adjust the Effective Rate Sensitivity of a
Banks Assets and Liabilities
Objective Approaches
Reduce asset
sensitivity
Buy longer-term securities.
Lengthen the maturities of loans.
Move from floating-rate loans to term loans.
Increase asset
sensitivity
Buy short-term securities.
Shorten loan maturities.
Make more loans on a floating-rate basis.
Reduce liability
sensitivity
Pay premiums to attract longer-term deposit
instruments.
Issue long-term subordinated debt.
Increase liability
sensitivity
Pay premiums to attract short-term deposit
instruments.
Borrow more via non-core purchased liabilities.
102

Reinvestment Rate Risk and Price
Risk
An immunized security or portfolio is one
in which the gain from the higher
reinvestment rate is just offset by the
capital loss.
For an individual security, immunization
occurs when an investors holding period
equals the duration of the security.
103

Using Derivatives to Manage
Interest Rate Risk

Derivatives Used to Manage IR Risk
Financial Futures Contracts
Forward Rate Agreements
Interest Rate Swaps
Options on Interest Rates
Interest Rate Caps
Interest Rate Floors

104

Speculation versus Hedging
Speculating
You believe interest rates will fall, so you buy Eurodollar
futures
If rates fall, the price of the underlying Eurodollar
rises, and thus the futures contract value rises to
profit
If rates rise, the price of the Eurodollar futures
contract falls in value, resulting in a loss

Hedging
A bank anticipates needing to borrow $1,000,000 in 60
days. The bank is concerned that rates will rise in the
next 60 days
A possible strategy would be to short Eurodollar
futures.
If interest rates rise (fall), the short futures
position will increase (decrease) in value;
(partially) offset the increase (decrease) in
borrowing costs

105

Liquidity versus Profitability
There is a short-run trade-off between liquidity
and profitability
The more liquid a bank is, the lower are its
return on equity and return on assets, all other
things equal
In a banks loan portfolio, the highest
yielding loans are typically the least liquid
The most liquid loans are typically
government-guaranteed loans
106

The Relationship Between Liquidity,
Credit, and Interest Rate Risk
Liquidity risk for a poorly managed bank closely
follows credit and interest rate risk
Banks that experience large deposit outflows
can often trace the source to either credit
problems or earnings declines from interest
rate gambles that backfired
Potential liquidity needs must reflect estimates
of new loan demand and potential deposit
losses
107

The Basel Agreement
Risk-Based Elements of the Plan
Classify assets into one of four risk
categories
Classify off-balance sheet commitments into
the appropriate risk categories
Multiply the dollar amount of assets in each
risk category by the appropriate risk weight
This equals risk-weighted assets
Multiply risk-weighted assets by the
minimum capital percentages, currently 4%
for Tier 1 capital and 8% for total capital
108

109

Basel III Introduction
Lots of regulatory reform
Lots of interested parties

Main issues
Quality of capital
Excessive leverage
Capital buffers, maintained
Calibration and risk coverage
Insufficient liquidity
110

Structure of the reform proposals
111

Basel capital ratios as at 2019
112

Potential Impact of Basel III Requirements
Operating Policies Effect on Capital
Requirements
Changing the Capital Mix
Internal versus External capital
Change Asset Composition
Hold fewer high-risk category assets
Pricing Policies
Raise rates on higher-risk loans
Shrinking the Bank
Fewer assets requires less capital
113

Discount rate and the investment
risk of a LT investment portfolio

A pension that has to pay 10,000 in 50 years which
discounts that obligation at 4 % will show that obligation in
todays money at 1,400; the use of 7 % rate reduces that to
only 340 today, but 10,000 remains
IFRS: discount rate should be determined by reference to
market yields on high quality corporate bonds with similar
durations to those of benefit obligations
Where a deep market of highly quality corporate bonds do not
exist (CEE) pension companies are required to account for
the yield on government bonds when selecting discount rate

114

The nature of options on financial futures
An option
an agreement between two parties in which one gives
the other the right, but not the obligation, to buy or sell a
specific asset at a set price for a specified period of time.
The buyer of an option
pays a premium for the opportunity to decide whether
to effect the transaction (exercise the option) when it is
beneficial.
The option seller (option writer)
receives the initial option premium and is obligated to
effect the transaction if and when the buyer exercises
the option.
115

Two types of options
1. Call option
the buyer of the call has the right to buy the
underlying asset at a specific strike price for a
set period of time.
the seller of the call option is obligated to deliver the
underlying asset to the buyer when the buyer
exercises the option.
2. Put option
the buyer has the right to sell the underlying
asset at a specific strike price for a set period
of time.
the seller of a put option is obligated to buy the
underlying asset when the put option buyer
exercises the option.
116

Profit or loss in a futures position
Value of the Asset --------->
Profit
Futures
Price
97.52 97.52
A. Futures Positions
Loss
1. Buy June 2013 Eurodollar Futures at 97.52.
0
Profit
Futures
Price
Loss
2. Sell June 2013 Eurodollar Futures at 97.52.
0
117

Profit or loss in an options position
Profit
Futures
Price
Futures
Price
97.68
97.50 97.75
98.68
B. Call Options on Futures
Loss
1. Buy a June 2013 Eurodollar Futures Call
Option at 97.50.
0
2 0.18
Profit
Loss
2. Sell a Sept. 2013 Eurodollar Futures Call
Option at 97.75.
0
0.93
Profit
Futures
Price
Futures
Price
97.17
97.25
97.25
C. Put Options on Futures
Loss
1. Buy a June 2013 Eurodollar Futures Put
Option at 97.25.
0
2 0.08
Profit
Loss
2. Sell a Sept. 2013 Eurodollar Futures Put
Option at 97.25.
0
0.56
96.69
118

Profit and loss potential on futures, options on
futures positions, and basic interest rate swaps

Generate Profits if Futures Rates Rise
Transaction Potential Profit Potential Loss
Sell financial futures Unlimited Unlimited
Sell call options on futures Limited to call premium Unlimited
Buy put options on futures Unlimited Limited to put premium
Generate Profits if Futures Rates Fall
Buy financial futures Unlimited Unlimited
Buy call options on futures Unlimited Limited to call premium
Sell put options on futures Limited to put premium Unlimited
Generate Profits if Floating Rates Rise: Basic I nterest Rate Swap
Pay fixed rate, receive floating rate Unlimited Unlimited
Generate Profits if Floating Rates Fall. Basic I nterest Rate Swaps
Pay floating rate, receive fixed rate Unlimited Unlimited
NOTE: Profits and losses are limited when futures rates equal 0 % and 100%
119

Consumer Credit
Discount Rate Method
Example:
Consider a 1-year loan with a single $3,000
payment at maturity.
The borrower receives only $2,640, or the total
loan minus 12% discount rate interest.
The effective annual percentage rate, or APR,
equals 13.64%
Interest charge = 0.12 ($3,000) = $360

13.64% i
) i + (1
$3,000
= $2,640 ) (i Rate Percentage Annual
n
n
=
120

Consumer Credit
Simple Interest

Interest is paid on only the principal sum
Example:
$3,000 loan at 12% simple interest per
year produces $360 in interest, or a 12
percent effective rate interest (is): =
$3,000(0.12)(1)= $360
12% i
) i + (1
$3,360
= $3,000
s
s
=
121

Consumer Credit
Simple Interest

Repayment Schedule
End of Month Monthly
Payment
Interest
Portion
Principal Outstanding
Principal
Balance
January $266.55 $30.00 $236.55 $2,763.45
February 266.55 27.63 238.92 2,524.53
March 266.55 25.25 241.30 2,283.23
April 266.55 22.83 243.72 2,039.51
May 266.55 20.40 246.15 1,793.36
June 266.55 17.93 248.62 1,544.74
July 266.55 15.45 251.10 1,293.64
August 266.55 12.94 253.61 1,040.03
September 266.55 10.40 256.15 783.88
October 266.55 7.84 258.71 525.17
November 266.55 5.25 261.30 263.87
December 266.51 2.64 263.87 0.00
Total $3,198.56 $198.56 $3,000.00

Effective interest rate: Monthly rate = 1%
Annual precentage rate = 12%

12
1 = i
t
(1. 01)
1
$3, 000 = pa yme nt Monthl y
122

Managing the Investment Portfolio

Banks concentrate their asset management on:
Managing investment securities is typically a
secondary role, especially at smaller banks

Historically, small banks have purchased
securities and held them to maturity

When banks purchase securities, they must
indicate the underlying objective for accounting
purposes:
Held-to-Maturity
Trading
Available-for-Sale
123

Dealer Operations and the
Securities Trading Account
Held to Maturity
Securities purchased with the intent and
ability to hold to final maturity
Carried at historical (amortized) cost on
the balance sheet
Unrealized gains and losses have no
impact on the income statement
124

Trading:
Securities purchased with the intent to
sell them in the near term
Carried at market value on the balance
sheet with unrealized gains and losses
included in income

125

Available for Sale:
Securities that are not classified as
either held-to-maturity securities or
trading securities
Carried at market value on the balance
sheet with unrealized gains and losses
included as a component of
stockholders equity
126
126

Objectives of the Investment Portfolio
Accounting for Investment Securities
Assume IRs increase and bond prices fall:
Held-to-Maturity Securities
There is no impact on either the balance sheet or income
statement
Trading Securities
The decline in value is reported as a loss on the income
statement
Available-for-Sale Securities
The decline in value reduces the value of bank capital
127

Establishing Investment Policy Guidelines
Each banks asset and liability or risk management
committee is responsible for policy guidelines
These guidelines define the parameters within
which investment decisions help meet overall
return and risk objectives
Because securities are impersonal loans that are
easily bought and sold, they can be used at the
margin to help achieve a banks liquidity, credit
risk, earnings sensitivity or duration gap targets
128

Establishing Investment Policy Guidelines
Investment guidelines identify specific goals and
constraints regarding:
Return Objective
Composition of Investments
Liquidity Considerations
Credit Risk Considerations
Interest Rate Risk Considerations
Total Return Versus Current Income

129

Interest Rates and the Business Cycle
Expansion
Increasing Consumer Spending
Inventory Accumulation
Rising Loan Demand
CBs Begins to Slow Money Growth
Peak
Monetary Restraint
High Loan Demand
Little Liquidity
130

Interest Rates and the Business Cycle
Contraction
Falling Consumer Spending
Inventory Contraction
Falling Loan Demand
CB Accelerates Money Growth
Trough
Monetary Policy Eases
Limited Loan Demand
Excess Liquidity

131

Passive Strategies Over the Business Cycle
A problem arises because banks normally
have excess liquidity during contractionary
periods when loan demand is declining and
the CB starts to pump reserves into the
banking system

Interest rates are thus relatively low

See previous sections on non conventional,
quantitative easing policies of current phase
of economic crisis

132

Active Strategies Over the Business Cycle
Expanding portfolio and lengthening maturities at
the top of business cycle, when interest and loan
demand are high
Note that the yield curve generally inverts
when rates are at peak prior to a recession
Alternatively, at the bottom of the business cycle
when interest rates and loan demand are low, a
bank contracts the portfolio, shorten maturities
133

Comparative Yields on Taxable
versus Tax-Exempt Securities
Example
Let:
Rm = 5.75%
Rt = 7.50%
Marginal Tax Rate = 16%

An investor would be indifferent between these two investment
alternatives if marginal tax rate were 23.33%
23. 33%
7. 50%
5. 75%
1 t
*
= =
134

Risk-adjusted returns on loans
When deciding what rate to charge, loan officers
attempt to forecast default losses over the life of the
loan.
Credit risk, in turn, can be divided into expected losses
and unexpected losses.
Expected losses might be reasonably based on
mean historical loss rates.
In contrast, unexpected losses should be measured
by computing the deviation of realized losses from
the historical mean.
135

Floating-rate loans transfer interest rate
risk from the bank to the borrower
Given equivalent rates, most borrowers prefer fixed-
rate loans in which the bank assumes all IR risk.
Banks frequently offer two types of inducements to
encourage floating-rate pricing:
Floating rates are initially set below fixed rates for
borrowers with a choice
A bank may establish an interest rate cap on
floating-rate loans to limit the possible increase in
periodic payments
136

EVA concept: overview
Direct calculation Indirect calculation
Result
Cost of capital
EVA =
+

Result Cost of capital EVA
RoE
Cost of
capital rate
EVA
Equity

X
+
=

Cost of
capital rate
Equity

Return
137

-100
-50
0
50
100
150
200
0 500 1,000 1,500
Cumulative EVA in Mio.
Client distribution according to value creation Cumulative EVA-contribution
425
765
85
5%
Strong
value
creators
255
15%
Value
creators
45%
Neutral
25%
Need for
action
170
10%
Strong need
for action
#
clients
#
clients
Focus for individual client
measures due to
negative EVA
contribution and RWA
consumption
Example Clients with strong need for action represent 10% of clients, 19% of
revenues, 39% of Assets and contribute 130% of negative EVA
-130%
of EVA
Focus on individual client measures to be
identified based on EVA contribution
138

Target return and cost of capital
ROE
Equity
capital
Cost of capital rate
EVA

X
Target ROE defined for each business area/subsidiary
Definition of target ROE takes structural
profitability of each business area/subsidiary into
account

Cost of capital rate as benchmark for minimum return
expectations of owners/investors
Consistent application for all business
areas/subsidiaries
Capital definition takes respective risk into
account

Calculation of capital
139

EVA-chart
2
10
25
10
Standard risk
costs
Operative
Result
Gross revenue
contribution
8
5
Admin costs Cost of Capital Pre-tax EVA
To be calculated for relevant subportfolio (e.g. client groups, branches, products)
Value contribution
140

Portfolio segmentation
along value creation
RWA
( M)
Avg. Client per value creation segment
900
300
500
+
13%
600
15%
++
8%
0
23%
-
1.400
36%
--
--
22.0
-
8.0
30.0
++ 0
6.0
+
2.0
Avg.
RWA
( M)
Strong value creators: EVA >150; Value creators: 150>EVA>10; Neutral: 10>EVA>-10; Need for Action: -10>EVA>-150; Strong Need for Action: EVA<-150;
# Clients 20 80 170 170
Gross Revenue
(in M )
EVA
(in M )
27
14
13
4
6
1
6
1
16
-7
115
Avg. Gross
Revenue (in
M )
Avg. EVA
(in M)
1.3
0.65
0.16
0.05
0.03
0.00
0.7
-0.5
0.12
-0.06
Value contribution by individual client
141

The Course

The MACRO CONTEXT





Decision making:
Psi-factors
vs.
Rational logic
143

Some Behavioral Traits and Patterns of Investors;
more pronounced during economic/market pressure
Illusion of control
Conservationism
Mistaken Causality
Extrapolation
Mental Accounting
Risk Compensation
Framing
House Money Effect
Selective Memory
Protection of Blame
Rationalization
Denial
Herd Instinct
Extremism
Ambiguity Aversion
Heuristics
Anchoring

Heroics
Overconfidence
Overweighting Recent
Stereotyping
Narrow Framing
Disposition Effect
Hindsight Bias
Regret
Idealization
Avoidance
Loss Aversion
Optimism
Representativeness
Categorization
Pain of regret
Pain of loss
Three is a trend
144

Emotional Finance: Loving, Hating, or Knowing
(ad. source: CFA Magazine, May/June 2008, S. Trammell, D. Tuckett, R. Taffler)
In the
K n o w
H a t i n g
L o v i n g
Paranoid
schizoid
Depressive
Aware of either good or bad, moody
Ambivalent Hate and Love situations
Prone to crushing reversals in trust or
confidence (from unconscious anxiety)
Stock market exuberance, speculative
what had been thought impossible
might be attained after all, omnipotence
After burst: panic, manic, blame others, guilt
hunt, pain of loss, humiliation

Aware of both good and bad in every
investment, capital relocation
Realistic, appreciative, mature
See people and things as they are
Reality checks, mixed feelings
Experience consequences of others
imperfection plus enjoying the
pleasure of good attributes
Investor emotional oscillations
145

Individual asset allocation/location based on risk profiling,
market situation, job security, net worth, perceived social status, MT/LT
financial goals, economic prospects, taxation, personal circumstances,
liquidity constraints, etc; limited on Romanian market
146

Improve bevioral decison making biases

Be Curious, Receptive not defensive, closed, resistant, overconfident,
need to be right all the time. When open, thinking quality improves,
creativity arises. Start asking I wonder if...
Use Candor not Conceal; rather than say: I am right, youre wrong, say:
here is how I see it. Candor creates feedback rich environment
Account not Conceal; we simplistically divide info as:
- Accurate and right or
-Inacccurate and wrong (no furhter thinking necessarily); no blame
game (finding who screwed it up and hang him)
Get 360 feeback; Constructive, The Can Do Attitude: I have an opinion
on this topic, but I would like to know others view
Keep track (journals of good and bad decisons/post mortems); monitor
past decisions w/ accurate post mortems (what/how cost performance);
keep track of thinking significant decisions since our memories are poor

147

The Greed and Fear Index (VIX)
Investors can be motivated by Ms. Fear and Mr. Greed. So more often than
not, investors turn bullish when they think a stock is headed higher and
bearish when they fear that all is lost; during these extremes in sentiment
they often lose their shirts
Conventional financial theory suggests that markets behave rationally; not
accounting for the emotional aspect of the trade often leads to the wrong
entry and exit points. It's hard to survive in the market constantly
getting one or both of them wrong
Successful traders often rely on the VIX indicator; is the current market
sentiment excessively bullish or bearish?.
VIX is a contrarian indicator, do markets have reached an extreme position -
a quasi-sure sign that the markets are about to stage a reversal
If the wide majority believes that one bet is such a sure thing, they pile on.
But by the time that happens, the market is usually ready to turn the other
way. Of course, "the crowd" hardly ever gets its right
It's counter-intuitive, especially in volatile markets as of todays

148

What is the VIX Indicator?
CBOE Volatility Index (Chicago Options: ^VIX) to gauge stock market
volatility. Using short-term near-the-money call and put options, the index
measures the implied volatility of S&P 500 index options over the next 30
day period, basically a derivative of a derivative
A level below 20 is considered to be bearish, investors have become
complacent. a reading of greater than 30, a high level of investor fear is
implied, which is bullish from a contrarian point of view;
If "the crowd" is feeling bullish probably its time to think about getting
bearish; then, wait for peaks in the VIX above 30 and let the VIX start to
decline, before placing buy orders
As the volatility declines, stocks in general will rise. When the VIX is
high, logic says it's time to buy
When volatility is high and rising, that means the crowd is scared. And when
the crowd is scared, they sell, and stock prices fall
149

Bad time even for best guys
VIX, July 28, 2010: 24.25
Obsolete GS and W. Buffett (BofA)?
Selling insurance against market
volatility (variance swaps)
speculate on volatility magnitude
(vs. index), but lost money lately
by shorting volatility
There are two consenting
adults to every trade
WB sold puts at top of market
a bet on rising market in the LT
(2018-2028), got the premium up
front (free to invest), ST pain for
LT gain
Premium of written contracts
(collected at inception, with no
counterparty risk) chasing
opportunities in a bear market

150

Tough
Harder
Longer
Smaller
Difficult
Unusual
Complex
Uncertain
Challenging
Complicated

151

Emancipated gen Y consumer
Gen Y has 10 special characteristics:
Continually connected: android, iphone, sms, chat, facebook
Speak their own language: cool, yeah
Sceptical of authority: who says?
Influenced by peers: clubbing, fashion, motors, bikes
Seek recognition and fame: personal image, LI, FB,TW
Enjoy absurdity and odd humour: simpsons
Embrace a variety of subcultures: hip hop, techo, parades
Skin text and information quickly: pictures, youtube
Easily bored: movies not books, places not locations
Expressive and digitally creative: twitter, facebook walls

Source: Forrester Research Center + own
152

i, android
Forgiving of mistakes, something the seniors fear when
dealing with computers
Unlike the PC, it doesnt require prior knowledge
Trying new things like that is a good mental exercise
Seniors these days time, money and curiosity
Give sense of community, acceptance, cool
Its hot and its cool
I-economy, Icloud
153

Contemporary Banking Business
Models
Appendix

Threats and opportunities
Key chalanges
Banking Sector: strengthening capital ratios to satisfy regulators VS. increase
lending to businesses to stimulate economic growth
Regulatory reform agenda is having the desired effect - driving a fundamental
overhaul in the way banks do business
Maximize opportunities
New Customer Priorities
Banks - more selective where to invest scarce capital and resources, to provide
a cost efficient, high quality customer proposition in areas with the best growth
potential
Banks able to deliver an effective multi-channel marketing and sales capability
to an increasingly technology-savvy customer base will be well-positioned to
profit from the brighter times to come.
155
Overview

A new agenda
Key challenges
New best practices to consumer behavior scenario planning have been
developed to help financial institutions identify the most promising strategy
for segmenting and then owning the consumer - will enable delegates to
engage with the customer rapidly and effectively, even in this challenging and
difficult times.
New Values
New Customer Priorities
Develop new customers and new risk approaches
Explore new markets for investment and development
Green offers linked to cars and household equipment
Meet the needs of different segments
Expand the range of services linked to credit and provide a wider range of
insurance offers
Online consumer credit and financial services distribution
Mobile consumer finance, e-commerce and cards.

156
Consumer credit (card)

Reinforcing the global financial system
Redefining key structural banking parameters for 2013 and beyond
What changes are needed to the EU regulatory regime?
Improving risk management, promoting transparency and reinforcing
international cooperation
Disclosure and transparency to better protect investments
When the going gets tough, the tough gets going
Consumer credit and mortgage lending: a paradise lost?
Dont blame (only) regulators and subprime lenders
Welcome to a new world
Who is fit?
157
2013, trends

Regulation, responsible lending
Best business models
Customer relationships, management and responsibility: a shift in knowledge,
culture and language in banks and supervisory authorities
Examining the legacy of irresponsible lending and borrowing practices
New data and information transparency: cross-border data sharing vs. privacy
Profitable growth in the new environment
Best organisational
structure
Addressing the new environment (liquidity-capital Basel III)
Expanding the business model selectively
Leveraging the group retail banking presence
Developing partnerships with banks
Ensuring customer satisfaction and operational efficiency
158
New trends in financial world

Economic role of consumer credit
environment
Cost & risk management
Continuously update of the regulatory environment eg: IFRS Implementation, Basel III
Peer-to-peer credit and micro-credit: challenges and opportunities for consumer finance
players
Best practices in cost management and collection procedures
Review risk measurement and management tools within the new context
Rethink risk management: an international perspective on change and evolution -
housing and tackling the inventory supply jam and cost of capital
Re-examine risk and underwriting decisions
Carving out growth in a turbulent market: where to next?
Global growth vs risks and impact for the West on the BRIC economies
Matching innovation to change
re-shaping the consumer credit offer
Linking new lending propositions and risk appetite to macroeconomic challenges
Matching responsible lending and innovation
Different business models
Customer centricity and market forces
New proactive risk management
159
The new normal landscape

Consumer credit and retail banking
good reasons to get married?
Consumer credit and retail banking are a good fit:
Scarcity of liquidity: easier to find funding when there is a retail bank in the
background
Customers: cross-selling can be very effective
It is not the only way:
The new light bank concept: specific mix of retail banking and consumer
credit
Need to develop independent funding without having to rely completely on
retail banking
Cash loans
improvement by smart pricing

Standard approach: one rate for all
Pricing as a function of risk: increasing profitability, attracts good customers
with competitive credit terms, increasing the average check
Customer refusal and difficulties with the regulator
Next steps: pricing using LTV model sophisticated products: event-based
products, variable interest rate, last payment amnesty, be quick to pay
160
Best business models

Sustainable growth through rigorous touch point
management
Responsible lending: between buzz and future
Rigorous brand management
Focusing on the consumer journey
Operationalizing strategies

Improve efficiency and effectiveness in consumer finance workout
Why workout needs to be strategically redesigned
The make or buy dilemma in workout
Towards a customer-centric approach
The advantages of a champion: challenger approach
Key social and economic elements of consumer credit
Evolution of drivers business model
Characteristics of new value propositions
161
Delivering value through values

Interactive channels
a way of significantly leveraging credit performance
Create new proposition via effective use of interactive channels
Reach and acquire non-customers through alternative channels
Promote through online and mobile via targeted credit offers
Expand total revenues on loan applications: managing an efficient funnel
New opportunities: mobility, social networks and locations-based services
Collections from a strategic
perspective
The new hierarchy of collections during and after the crisis
The target operating model of a collections unit: lessons learned
Importance of credit bureau in collections: experience-based insights
Some selected successful collection strategies
162
Using digital approach

use of data analytics across the
credit cycle
maximize business performance
Using acquisition models for profitable product sales
Use of statistical tools for retention and anti-attrition
Use of scores for designing and implementing risk based collection strategies
The implementation of information-based strategies for recoveries

Underwriting: solutions for healthy newly booked
volumes
Risk methodology: risk maturity evaluation, credit capacity, Default Type
Investigation (DTI)
Centralization and segmentation
Score card management
System support and process automation and reporting
Collateral management and risk-based pricing
X-sell activities
163
Updated methodologies and models

Individual level:
Survive
vs.
Succeed
164

Psychology of markets
Greatest risk is no risk at all. Investment management into post
recessionary, high volatility low growth environment is difficult:

-Can an informed investor make money systematically by exploitation of
behavioral, cognitive and psychological inefficiencies of the market?

-Financial behavior analysis relaxes the fundamental analysis requirement for
convergence of price and value. The difference between the two is seldom
systematic, so probably it can be exploited by a rational and disciplined investor

-Managing in bear market is the skill. Bear correlations can easily destroy the
hard earned return

-Risk aversion vs. loss aversion; by making a loss you can still make money

Propensity to borrow, spend, save or invest under change from
crisis; a major rebalance of wealth and social benefits commensurate
with productivity and economic value added; most likely, some of us
have lived better than economically sustainable

165

Investment managers often feel beset by forces
beyond their control: yet, if they probe the matter home,
may find that the fault lies not in their stars, but in themselves*

Expenses sustained by the Diversified Portfolio
60.000
70.000
80.000
90.000
100.000
110.000
120.000
60000 55.000 50.000 45.000 40.000 35.000 30.000 25.000
G
a
i
n
:

G
r
o
w
i
n
g

s
u
s
t
a
i
n
a
b
l
e

e
x
p
e
n
s
e
s

Risk: Decrease in sustainable expense rate
100% Equity

70% Equity + 30 %
Bonds/Deposits/TBills

20% Equity + 80 % Debt

100 % Debt, Deposits

*CFA Magazine, May/June 2008
166

Strategic Financial Decision Making Process

Investment decions
making process, steps
Outcomes of IDM process
phases
Common behavioral
phases
Investment philosophy Clear philosopy and statement
of competitive edge
Risk or return?
Overconfidence
Data and info collection
and interpretation
Process
Resources
Consistency, updates
Confirmation
Hot is cool, new, in vogue
Research and analyis Inputs into process
Opportunities Coverage
Evaluation, individual risk return
Value added knowledge
Efficient, real time communique
Anchoring
Recent events
Overoptimism
Assets selection Relative valuatio
Systemic vs. specific risk
Selection rationale
Short vs. longer time
Framing
Overconfidence
Cognitie dissionance
Risk aversion
Asset allocation into
Portfolio
Sector, industries, classes
Risk parameters are real time
monitoring
Regret aversion
Conservatims
Compartimentalization
Feedback and Reflection Post mortems on both winners
and lossers
Journal tracking, Captains log
(Star Trek)
Disciplined Self control
Hindsight
Cognitive Dissonance
167

Financial decisions are influenced by
psychological factors

Valuation is not related to past performance, correlation
between past and future performance is low. Past high
performers (high betas) are most exposed to downturns

Past success attributed to professional skill can be a matter of
luck rather than knack. If this apparent non rationality is
recurrent, it can be associated with predictable cognitive
errors. Can a rational investor make, or lose less, on these?

In a world of uncertainty, good decisions can lead to bad
outcomes and vice versa. Risk management is not equal with
diversification.
Risk means that more things can happen than will happen

Market advice for a fee is a paradox.
Anybody who really knew, just wouldnt share. In three years, she could
be very rich. Why pass the word on?

168

Effective net return decreases with increased
portfolio turnover. Efficient market takes time
169

Who we are up against to
(75% of an exceptional strategy is still a bad strategy)
By fear of losing opportunity, investors do not keep temper, act
impulsively, extrapolate short-term trend into a long-term investment
attraction. Risk profile changes, investors appear to be able to bear
more risk that would be otherwise reasonable, advisable and rational

Investors overestimate their individual abilities in terms of luck,
education, intellect and aptitude to process, disseminate and
understand Mrs. Market; she fools most of us, most of time

The market price is resisted by a multitude of educated, determined,
intelligent, psychologically tough individuals that act for single scope
to maintain the fun and privilege, to survive as market player

Job security is the most important argument and constraint that
prevails in the decision mind of investment managers

We have met the enemy and he is us. Pogo, Cartoon Character

170

- Succesful active management recognize the gap between theory and
practice; invest in unpopular sectors, do not see trend as friend; do not
rebalance aggresively in response to emotional impulses, clouded logic,
make changes for the sake of change and fooled by illusion of action

- Investment managers change styles in a period of dissapointment to fix
a present perfect underperformance just before results style rebounds.
Relentless chasing of short term performance reflects human nature of
competitiveness and need for constant action, but rarely benefits results

- Succesful investors are disciplined. They make disciplined changes
even when they are performing well; they endure dissapointment
patiently. Disciplined investment process adds value, by providing an
objective basis for confidence in an uncomforatable investment action

There is no better practice than a good theory.
In the investment management, when one has
too much company, success is improbable

171

Investor financial behavior
Although there is a low correlation between professional abilities
and investment success, investors have high confidence that
somehow, someday they will succeed in beating the markets

Beating the index by outsmart moves, ahead of competition, finding
undervalued/overvalued securities and implementing the buying and
selling decision at right time is difficult, if not impossible, in the long run

Investors put too much weight into most recent financial experiences
and ignore a longer term, larger perspective. Other players decisions as
discretional and non-rational; our decision are logical and rational, and
in conformity with all existing information

The fusion b/w classical analysis and behavioral evaluation should help
investors to a larger, more informed perspective of the market

What your competitors do is equally important with what you do
172

Teams, rather than individuals are more likely to provide a
feasible strategy-based on feedback for correcting biasess

Information gathering and processing Decision Making, tactical, strategical
I
n
d
i
v
i
d
u
a
l

-Use most recent reference point
-Anchor to facts and trends
-Self screeing and confirmation only of the
data to fit our theory
-Benefit of hindsight by rewriting history
(aha!, then looks obvious now)
-Ambiguity aversion, stay in the know, avoid
chaos and new
-Representativenes by conecting dots
-Need to confirm belief that we are right
-Ingnore, underweight discomfirmations
-Vigorous denial of our biases
-Loss aversion rather than risk aversion
-Overconfidence, overate in own skills,
knowledge, luck
-Fear of regret managed by rationalization of
decisions so as to avoid negative feelings
and comforting ourselfs
-Belonginess, acceptance, herd instinct
-Avoid Metacognitive Dissonance, try to keep
internal harmony
-Stories and colors creating subjectively
biased presentations
-Creating patterns; three is a line
C
o
l
l
e
c
t
i
v
e
-Confirmation by selectively filter data to fit ex
ante theory
-Anchoring to previous creed, beliefs, rules of
engament
-Illusion of control

-Avoiding dissonance lead to groupthink
-Framing by creating bias, nudges in the way
data si preseted
-Self attribution of success (is mine), others
attribution of failure (bad luck)
173

Contrarian decisions that resulted in negative results
are penalized more severely that are rewarded
those with positive results
Investors are indifferent to opportunities at incipient phase of a bull; they
start to be interested when upside trend is obvious; from now on, the
buying spree makes a clear trend. Is it the same on the downward

Nobody wants to be just a spectator of the game; everybody wants a
piece of action - a non-rational herd instinct. Rational however, it
should be clear that the upward trend need not to continue indefinitely

To compound the problem, the objects of investor affection is
represented by those stocks that performed dearly lately and are
obvious most exposed to the eventual correction

174

Contrarian investing; Behavioral Finance supports the
idea that the so-called rational is anything but

Fundamentals of market prices: correlation b/w investor experience
and expectations and momentum. Slow changes in market sentiment
are emotionally contagious, insinuate hesitantly but strongly in a trend

Insatisfaction of a negative result, after a contrarian decision, weights
significantly higher than eventual satisfaction from a contrarian
decision, so investors find it difficult to assume au contraire decisons

If investor deviates from a conservative diversified portfolio she
becomes vulnerable to the pain of regret if things go badly because it
is easy to imagine having done the appropriate action (fully
diversify or reduce equity exposure)

Strategic asset allocation is a disciplined rebalancing: disciplined sale,
reduced exposure to outperformers and increased exposure to
underperformers, ie, selling high and buying low

When it comes to the long term, we mostly regret inaction. In the
short term, we regret action

175

Decisions are heavily informed by emotions;
institutional investing can help avoid misallocations
or bad timing
Major difficulty of investing is that we are all our worst enemies: buy
high and sell low, do worst possible thing at worst possible time

Feasibility of an investment decision is critical. People do what is
feasible/doable not what is theoretically sound and attractive

Critical is not what investors ought to do to get optimal results but
what they can do, what is feasible for them to do

A good investing advice is not theoretically ideal by psychologically
practical. Investors need something to do; i.e., impulse urge for the
illusion of control

Why we push the elevator button several times after we have
pushed it first - we think we can make it arrive more quickly
176

Mr. Big
177

Does active money management add
investment value systematically?
In evolutionary terms, we are more adaptive to learn from negative
than from positive surprises, since at the most biological level, a
negative surprise is more powerful than a positive one; better
err on positive than be surprised by negative

The speculative public is incorrigible. In financial terms it cannot
count beyond 3. - B. Graham

Investors should kept the margin of safety at all times and should
not focus exclusively on how much money can be made but on how
much money can be lost, because even the best investors are
wrong 45% of all time. (B. Graham, The Intelligent Investor,
updated by Jason Zweig)

We are most certain that we are right just when we are are most
likely to be wrong
178

The riskiest moment is when you're right. That's when you're in the
most trouble, because you tend to overstay the good decisions.
So, in many ways, it's better not to be so right. That's what
diversification is for. It's an explicit recognition of ignorance
(Peter Bernstein).

Neuroscience of investing helps explain one puzzle after another:
why we chronically buy high and sell low, why predictable growth
stocks sell at such high prices, why its so hard to understand our
own tolerance for risk until we lose money,

Why we keep buying IPOs and hot shares despite all the evidence
that we shouldnt, why stocks that miss earnings forecasts by a
penny can lose billions on dollars of market value in seconds
(Steven Zweig).
One way to succeed in this market is to act on the advice you
give to others; rational managers and irrational investors
179

The Course

The MACRO CONTEXT




Large results of Small Decisions

How do two French fries weigh 20 kilos?
20 kilos over 10 years = gaining ~ of 2 kilos per year
20 kilos divided by 10 years equals 2 kilos per year
2 kilos divided by 12 months equals 166 grams per month
This is cca. 1/200th of a kilo per day (5 grams/day)
One kilo of stored fat represents 7000 calories
Per day, extra callories to store 5 grams of fat: 35
To gain 20 kilos in 10 years = extra 35 calories every day
35 calories = 3 regular French fries
Little things count.

181

182
Opportunities multiply as they are seized (Sun Tze)
CFA Institute Research Challenge Seek opportunities
Gathers together
university students

investment industry professionals

publicly traded companies

corporate sponsors

The CFA Institute Research Challenge offers students the unique opportunity to
learn from leading industry experts and compete with peers from the worlds top
finance programs. This annual educational initiative promotes best practices in
research among the next generation of analysts through hands-on mentoring and
intensive training in company analysis and presentation skills.
How it works Local CFA societies work in conjunction with participating local universities to
assemble teams of 35 business and finance students. Each team works directly
with a mentor to research and prepare a research report.
Challenge
components:
Analysis of a Public Company
Mentoring by an Experienced Professional
Writing a Research Report
Research Presentation to Panel of Industry Experts and Leaders
Advancement to the Regional and Global Finals

Virtual Presence, a must to stay tuned
183

http://adrianmitroi.blogspot.com/
PsiFinance.ro: Insights into the Mind of Ms. Market

https://twitter.com/#!/AdiMitroi

http://www.facebook.com/adrian.tudor.mitroi

http://www.linkedin.com/pub/adrian-mitroi

184
184

CFA Institute Code of Ethics
Honesty is the best policy
Professional
integrity
Act with integrity, competence, diligence, respect, and in an ethical
manner with the public, clients, prospective clients, employers,
employees, colleagues in the investment profession, and other
participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients
above their own personal interests.
Use reasonable care and exercise independent professional judgment
when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other
professional activities.

Professional Conduct

Continuous Education is a must must
Professional
competence
Practice and encourage others to practice in a professional and ethical
manner that will reflect credit on themselves and the profession
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve their professional competence and strive to maintain
and improve the competence of other investment professionals
185

Emotional Phases; case study: PIIGS
Phase 2 Phase 4 Phase 5
Emotions and
guts
do matter
Individuals make
mistakes
Pain is a strong
evolutionary trick that
quads us against
dangers
Individual learn, adapt
(heuristic) but make a
lot of mistake in the
process
Residual risk aversion
Overconfidence
Survival of
the able
planner

Behavioral biases
create bubble and
bust phases that are
hard to predict
Contrarian strategy
needs steadfastness

Even best strategies
wax and wane over
time
If the market is
efficient, what is the
use of stock picking
ability?
A 95% perfect strategy
is a non performing
strategy
Do the right thing only
after had exhausted
every other alternative
Markets are
not always
rational
Both markets and
investors evolve and
adapt
Frame dependence
Mental accounting

Financial education is
a necessity; manage
assets and liabilities
Think long term
Make sacrifices
Can do attitude
Greed makes crises
unavoidable; humans
are kind, generous,
Econs are
unscrupulous, have a
limited span of interest
and attention
Confidence
Risk is rewarded, in
general, by higher
return, but not
necessarily
Risk is seriously
punished during crises,
rational or not
Finance is cyclical
Economic creativity
is key to human
development
Standard of living
transfer to Asia
Inertia is a very
powerful force
Most of the decisions
we make in our lives is
based on our level of
confidence
Phase 3
Survival is all that
matters
Pain is temporary,
quitting is permanent
Regret aversion
Pace of change is
faster than ever
Representativeness
Love your portfolio
Wikieconomy
Twittereconomy

Save more tomorrow
People do not react
well to bans or
mandates; they react
best at nudging

Phase 1

Individuals always act
in their own best
interest, economic
Success and
prosperity are strong
anesthetics

Biological rigor prevails
History is written by
winners
Right decision feels,
right, investor sentiment

Unstable balance
between fear and
greed
People have
noneconomic reasons
and irrational
behaviors
Achievement begets
success
Success begets
confidence
Confidence begets
opportunities
Individuals act
feasibly, and always
try to satisfice
People consumed to
much and invested
too little
Competition imposes
continuous
adaptation
Adaptation, flexibility,
innovation and
compromise are key
to survival
Overall
1
3
2
4
186

The Black Eyrar
Global insolvency of
current benefits;
need to transfer/lower
standard of living

A pension that has to pay
10,000 in 50 years (@4 %)
in todays money, 1,400; use
of 7 % reduces that to 340
today, but 10,000 remains
IFRS: discount rate should
reference to market yields on
high quality corporate bonds
with similar durations to those
of benefit obligations
Where a deep market of
corporate bonds do not exist
(CEE), pension companies
discount at yield on TBs
Yield curve bet vs.
credit quality bet
Portfolio managers time level
of interest rates relative to
cycle, adjust maturities:
time interest rate peaks,
counter-cyclical strategy: the
changes in loan demand and
the yield curves shape
at top of cycle, expanding
portfolio, when interest rates
and loan demand are high
lengthening maturities
yield curve generally inverts
when rates are at peak prior
to recession
at bottom rates and loan
demand are low, bank
contracts,shortens maturities

Mrs. Market infinite energy
to prove us wrong

Solvability and liquidity are
not interchangeable
Cannot transform liquidly into
solvability except by sale at
loss
(S =L - Current Loss)
An investor/debtor (The Real
Estate Inc.) cant get rich by
buying an overvalued asset
except by miracle or luck; luck
is non recurrent
Deficit of competitiveness
and Black Eyrar:

187

Skunked by Financial Repression
188

Q & A

adrian.mitroi@gmail.com
Status?
189

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Investment Management and

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