Wednesday, September 21, 2011

Hedge funds. What are they? [Note to self]

Here is another post inspired by the book "Ascent of Money" written by Niall Ferguson. You will probably get better information on hedge funds and hedging from Wikipedia, but here is my take on the subject and what I saw as important in Ferguson's presentation of the matter.

Hedging and hedge funds have their roots in agriculture. For a farmer there are two things that affect his income: first one is the amount of crop and second one is price of the crop. The amount of crop depends on the weather and there is not much you can do about it. The price the farmer gets paid depends on the market price. The farmer pretty much knows what his expenses will be when sows his seeds. What he does not know is how much he will be paid at harvest. The farmer could protect himself against price fluctuations by making a deal with, for example, bakery that it will by all of his wheat with certain price. At harvest the market price may be lower than the price the farmer and agreed upon, in this case the farmer wins. It also could be that the market price is higher than agreed in which case the bakery wins, because it gets it wheat at a cheaper price than if it would by the same amount of raw material with market prices.

The first standardised future contracts that were traded in after markets were created in Chicago. The Chicago Produce Exchange was the first permanent place for trading futures.

Since this type of elimination of risk requires a speculator as a counter part trading in futures has been viewed as nothing more than a casino. Partly because of that only 1970s trading of interest and currency futures was permitted. In 1982 the future contracts were allowed to stock trade.


Since all futures contracts are derived from the value of the property the contract is based on all futures contracts are so called derivatives. Here are some derivatives that Ferguson presents in his books. There is a good list of derivatives on Wikipedia.

Options are form of derivative financial instrument closely related to futures contracts. There basically are two types of options selling and buying options. The option grants the owner of the contract the option (not an obligation) to buy/sell a certain amount of goods at a price agreed in the contract.

Swaps are a form of derivative where two parties basically bet on, for example, the development of interest rates. Someone who receives income from loan where interest is fixed can swap the interest rate to floating rate. 

Credit default swap is a contract where the buyer of the CDS makes a payment to the seller and receives a pay off if a instrument goes default.

There are also weather derivatives which enable you to insure against natural catastrophes and extreme weather patterns. In 2006 the nominal value of weather derivative was 46 billion dollars.

Nowadays most of the derivatives are no longer standardized but tailor made and sold in so called over the counter (OTC) trade outside the stock exchanges. Banks are the usual seller of OTC derivatives and majority are temporarily arranged between two parties.

The problem with derivatives and future contracts is that it has divided world into those that have money to protect themselves to those that don't. It usually takes a seven-figure-sum of money to protect against unexpected fluctuations in interest rates or in commodity prices etc.

Tuesday, September 20, 2011

Facts About Financial Crisis Of 2008 [Note to self]

I recently listened to an interesting radio programme where Heikki Koskenkylä explained some facts that contributed to the financial crisis of 2008. The radio programme was a series produced by YLE and you find link to the programme here.

Here are some interesting points that I picked up from the programme:

  1. Community Reinvestment Act = CRA Banks are obligated to issue loans to the area from which they receive deposits. Initially created to support housing industry and expand house ownership. 
  2. Sub-prime loans where only 15% of the total number of mortgages in U.S. Only about 20% were left unattended, and the amount of bad debt was not that large.
  3. Sub-prime loans where bundled together with other loans (student loans, car loans, credit cards) and sold to investors. On paper the profit from these bonds where higher than from normal mortgage loans.
  4. The problem was that "bad" and "good" loans where mixed together and rating agencies gave these bonds AAA-rating. There was wide belief that housing market could not collapse and these mortgage and loan bundles were built on safe ground.
  5. Already in 2007 there were couple of instances where banks where affected by the sub prime crisis (1 English bank winter of 2007, couple more in the summer.)
  6. On 7th of September 2008 Fannie Mae and Freddie Mac were put under the control of federal government.
  7. In Europe many thought that it would be the hedge funds that would start crumbling, not the institutions that issue mortgages. 
  8. Basic problem in the U.S. was that people with know in come where allowed to purchase houses. Europe had it problems too. In Spain (circa 07/08) there were unsold apartments as much as in Germany and France combined. But unlike in U.S. in Spain no "bad" credit was given.
  9. Week after the take over of Freddie and Fannie Bank of America purchased Merrill Lynch
  10. On 15th of September  Lehman Brothers declared it was entering company reorganisation procedures (Chapter 11).
  11. On 17th of September Federal Government issued a emergency credit of 85 billion dollars to American International Group and as collateral the government got 79,9% of stock and withheld a veto to all significant decisions in the company. AIG had large investment in credit default swaps (check next post for explanation) which led to it's down fall. The insurance part of AIG's business was healthy but it had issued credit risk insurance (hedging credit risks) amounting to hundreds of millions of dollars. The company failed totally in evaluating the risk and the price to be paid for these insurance were very low during the economic up turn.
  12. The complexity of the system was a partial contributor to the crisis. It was very hard to comprehend the risks and due to how deeply the whole system is interconnected it was difficult to determine who would take the losses.

    Monday, September 19, 2011

    Kit, Kit, Kit(once again): Camelbak Cloudwalker reservoir backbag

    Camelbak Cloudwalker
    Since I started geocaching I've been hiking and biking a lot more than before. When you are on the move for three hours or more a single half a litre bottle does not get you far. You just need to have more drinking water with you. Secondly my old backbag was a bit too big for short hikes and bike rides. Luckily I spotted a used (in this case used 3-4 times) Camelbak Cloudwalker at an on-line auction and managed to purchase it at very good price.

    I've used the backbag almost daily and used the water reservoir couple of times on short hikes and I must say that I am very pleased. It is just amazing what a difference having enough to drink makes on your stamina. I could quite easily walk for three hours and when I got to home I wasn't that tired. Hydration is important! But now to the properties of Cloudwalker.

    The backbag is designed so that it does not make your whole back sweat after half an hour. Somehow the design is better ventilated and the bag is narrow so it does not cover all of your back. I also like the 10l of carrying space. It fits quite easily the equipment I need for geocaching (flashlight, multitool, camera etc.). Last weekend I had my jacket and some food in the backbag and it all fit quite well inside. Pocket in front of the bag hold easily your wallet, phone, gps or what ever you need to take with you to the trail. The front compartment has two pocket with zippers so your stuff won't be flailing around.

    Pocket for the water reservoir.
    The drink reservoir itself fits quite nicely to the pocket in the backbag and there is loop inside the pocket that holds the reservoir in place. Having the reservoir in place does not affect the carrying comfort in anyway. The bag still feels comfy. If you are a runner this is not the bag for you, the water inside the reservoir does start slosh the moment you start running. The reservoir holds 2 litres of water and if you are not drinking all the time it should be enough also for longer workouts. After you come home you most likely want to dry the reservoir. The operation calls for little creativity. I use the drinking tube to hold the reservoir open by making a loop out of the tube and sticking it inside the bag. The tube itself is a bit harder to dry. Mine has been in the cupboard for a week and it still contains some moisture. I guess I need to remove the nozzle next time.

    Nozzle and valve
    The drinking nozzle is really ingenuous. When you squeeze the tip of the nozzle with your lips it opens up and you can take your sip of water. The seam is really tight when closed and no water will run out. There is also a valve in the nozzle (the yellow bit in the picture) that turns and closes the pipe if you want to be extra sure that no water gets out. The valve comes useful, for example, when you want to keep the drinking  tube inside the bag.

    Over all Cloudwalker very good backbag for me. I am pretty sure it will serve me for a long time on my geocaching adventures, hikes and bike rides.