THE SEARCH FOR INDEPENDENT INSURANCE LINKED SECURITIES
HISTORY OF BITCOIN: THE RISE AND FALL
INTERVIEW: MEET JOHANNA LARSSON
THE MINTS - HOPE OF THE EMERGING MARKETS
THE EVOLUTION OF THE FINANCIAL MARKETS
ELECTRONIC TRADING AND MARKET FRAGMENTATION
INTEREST RATE PARITY AND MONETARY INTEGRATION
EDITOR-IN-CHIEF Peter Touma ART DIRECTOR Rui-Xin “Xinga” Li
INTERVIEW WITH JONAS OLSSON
CONTRIBUTORS Fredrik Giertz Lukas Magnusson Oskar Luo Peter Touma Richard Ruthberg Sofia Gavefalk Steven Zhao Victoria Drewsen
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DISCLAIMER Opinions published in Capital Magazine do not necessarily represent the opinions of the editorial staff or KTHFS PRINTING HOUSE Wikströms tryckeri AB
his year marks the 20th anniversary of the KTH Finance Society. In 1994 the Stock Society (Akties채llskapet) was founded at KTH and in 2003 the society went through a rebranding to become KTH Finance Society. The KTH Finance Society exists on behalf of you holding this paper, our member. It is therefore the great pleasure of the KTH Finance Society to, after a brief pause, bring you the fifth edition of Capital Magazine. In this issue we are delighted to present an interview with Claes-Henrik Julander, CEO of Pan Capital. We had the opportunity to sit with ClaesHenrik and discuss the ever-evolving financial markets. Many of us might have heard about the phenomenon High Frequency Trading, which has been depicted a lot in media. Contrary to mainstream beliefs, Claes-Henrik shares another point of view in the area, read more about this on page 12. The world of Finance is a multifaceted sphere; in this issue we have tried to cover some of those areas. On page 4 you can read about so called catastrophe bonds which gives investors an ample opportunity to diversify their portfolio based on independence rather than low correlation. If you like this magazine I can greatly recommend you becoming involved in the next issues. The continuing success of this magazine depends on the people working with it. With this I would like to end by thanking everyone that has been involved in shaping this issue and a special thanks to all the writers. You all have made this issue possible.
Peter Touma Editor-in-chief
THE SEARCH FOR INDEPENDENT INSURANCE LINKED SECURITIES
In a simplified view, a typical investor wants to maximize the investment return and the risk manager wants to minimize the risk, something that initially could be seen as an antithesis. In times where risk management becomes an increasingly important element of the capital market, it is important that risk management principles are allowed to influence investment decisions. An important risk management concept that is well incorporated into asset management is diversification, the theory of spreading the risks. The father of modern portfolio theory, Harry Markowitz, once said, “Diversification is the only free lunch in finance”.
he search for diversification starts with an investigation of dependence and correlation. Using some appropriate measure, say a measure of risk, applied to two (groups) of assets A and B, diversification is obtained if the measure value of A and B combined is lower than or the equal to the measure values of A and B measured separately and added. In the simple case of using variance as this measure, diversification is obtained if the correlation of A and B is lower than or equal to zero. The problem is that negative dependence will not just decrease the risk, it will also increase the likelihood that one asset moves down when another moves up which in turn will affect the return of the portfolio. In the case of perfect negative dependence of two assets, also known as co-monotonicity, the net outcome may even be zero, producing a rather uninteresting investment portfolio. Furthermore, it may in some cases be easier to distinguish independence than to assess the specific dependence structure of a non-independent association. In the light of this, investors may search for investments being independent with respect to other assets. Is it possible to find assets with perfect independence from typical investments, such as common stocks or corporate bonds? Typically the answer would be no, but there are several asset types that are nearly independent from a typical capital market portfolio. In this article, one such investment will be discussed: insurance linked securities, abbreviated ILS. An ILS contract works as a means of reinsurance for the insurance industry. Insurance companies may face large risks that they have to recognize and actively manage. An insurance company may control or decrease their risks by selling the risk to someone else. Through the ILS, the capital market may assume some of the risk in exchange for a return. Typically, ILS’s are applied to risks relating to natural catastrophes because of their potentially severe effect on insurance companies. There exists several different types of ILS’s and a common example is the catastrophe bond. The name catastrophe bond originates from the main type risk that these contracts relate to, the occurrence and severity of natural catastrophes such as cyclones or earthquakes. The term bond originates from the simple
fact that these contracts resemble the structure of a typical coupon-bearing bond. There is a principal amount paid at maturity and coupon payments throughout the contract term. Similar to a typical corporate bond, there is a risk of the investor losing the invested capital, which in the case of the corporate bond relates to the financial status of the underlying company. In the case of catastrophe bonds, the risk relates to the occurrence and severity of pre-defined natural catastrophes. There are several different examples of so-called perils, e.g. earthquakes or cyclones, and related geographic exposure areas that typical contracts are designed to cover. Some examples of combinations are Florida Hurricanes, Californian Earthquakes or Japanese Earthquakes. However, there are several more exotic contract risks such as extreme influenza outbreaks or European windstorms. The immediate question concerning the topic is the following: is it not cynical to speculate in the occurrence of natural catastrophes? The short answer is no. With the help of reinsurance, it is possible to decrease the risk of failure of insurance companies and in turn making sure that the insured receive their rightful insurance claims. Thus, this speculation could in some sense be seen as something benefitting the general public. The next question is: why would an investor be interested in these instruments? This question have many different answers, but one of the most important reasons is their low dependence, or even independence, with respect to other types of investments. When inspecting past occurrences of natural catastrophes, it is possible to see that the capital market is generally not as affected by natural catastrophes as one could initially think. Perfect independence cannot in general be guaranteed, where the Japanese Tohoku Earthquake is an example. Several stock market indices were, though possibly only momentarily, affected by this catastrophe. In spite of this example, the general capital market is mostly unaffected by the occurrence natural catastrophes.
How do ILS’s compare in terms or risk and return to other types of investments? First, it should be noted that a significant risk might be linked to holding a single ILS, such as a catastrophe bond. However, since different types of catastrophe risks are independent, such as earthquake and cyclone risks, it is possible to build portfolios having good characteristics and an extremely low probability of losing all invested capital. For more information, see (Giertz, 2014). To compare the risk and return of a typical ILS portfolio, the Eurekahedge ILS Advisers Insurance Linked Securities Fund Index is compared to the S&P 500 stock market index in Figure 1 With the comparison shown in Figure 1, it is clear that the ILS index was not heavily affected by the 2008 financial crisis. It should be noted that this statement is not entirely true. The reason is the effect of credit risk pertaining to the riskfree investment of the contract reinsurance capital. As an example, prior to the financial crisis there existed contracts having Lehman Brothers as their swap counterparty in hope to create a risk-free investment. Consequently, such contracts were affected heavily by the 2008 financial crisis. Returning to the analysis, the immediate conclusion is that, over the considered investment horizon, the ILS index receives a higher total return than the S&P 500 with seemingly less risk. A simple calculation of the underlying data show that the ILS index has an annualized volatility of 4.5% whereas the S&P 500 index has an annualized volatility of 9.5%. The annualized return of the ILS index is 7.1% and 4.9% for the S&P 500 Index giving rise to return volatility ratio of 1.6 for the ILS index and 0.5 for the S&P 500. These simple calculations directly show another potential benefit of ILS investments - a good risk return ratio. We now return to the opening statement concerning risk and return and the antithesis this creates for an investor and the risk manager. The idea is that independent investments should to some extent be favorable for them both. The combination of the excellent risk return characteristics of ILS’s and their low dependence, or even independence, with respect to the general capital market, makes it possible to conclude that ILS’s should in theory make both the risk manager and the portfolio manager content. Thus, ILS investments may serve as an important addition to a wide range of investment portfolios. Reference: Giertz, F. (2014). Analysis and Optimization of a Portfolio of Catastrophe Bonds. Master’s Thesis in Mathematical statistics at The Royal Institute of Technology, Stockholm Sweden. Writer Fredrik Giertz
Figure 1 - Total Return indices comparison of the Eurekahedge ILS Advisers Insurance Linked Securities Fund Index compared and the S&P 500 index.
Photo Vo Minh Thong
ARTICLE | THE SEARCH FOR INDEPENDENT INSURANCE LINKED SECURITIES
HISTORY OF BITCOIN: THE RISE AND FALL 6
In 2009, an anonymous group or person going by the pseudonym “Satoshi Nakamoto” released the cryptocurrency Bitcoin to the Internet. Unbeknownst to them, they would be the creators of a massive craze which would begin nearly 4 years after Bitcoin’s inception. Success stories of men and women having bought bitcoins for a few dollars and suddenly becoming multimillionaires years later, turned up everywhere across the globe. Nowadays people know about the Bitcoin phenomenon, however, do they genuinely understand what the concept of Bitcoin is?
illegal drugs had generated more than $1.2 billion in terms of Bitcoin value. The criminal market could have been a catalyst for the boom but others believe that it is simply because of the simplicity and accessibility of Bitcoins. Another reason for its growth could be because of the popularity and fame Bitcoin gained by users marketing them via websites such as Twitter, Facebook and Reddit. Speculating and theorizing can be done all day, however, one thing is for certain and that is the fact that one Bitcoin currently is valued at $570.
itcoin is a peer to peer open source payment system which Some experts have started comparing BTC to gold, some even uses the same encryption verification method as in military saying that it could replace gold as the standard commodity. and government operations. One could wonder why you would This is questionable though as bitcoins lately have been one of choose to make it open source; the idea is that the more eyes the most volatile currencies in the world. The reason for this watching the safer it would be. Nevertheless, it is the system extreme volatility has many factors behind it. However, the which Bitcoin has chosen and history tells us that it is working most notable events that have caused this uncertainty about moderately. It should also be noted that Bitcoin has one of the Bitcoin must be the recent Chinese shutdown and bankruptcy lowest payment processing fees and is the filing of Mt. Gox, a Bitcoin exchange. simplest of all payment systems. According to most people, the main use of Bitcoin is for During a period of time, starting at the peak of Buying a fast micro-transactions. Buying a coffee for a Bitcoin’s value, China has been eviscerating the coffee for a few dollars becomes much easier when you hopes and dreams of Bitcoin believers systematically. few dollars can easily scan a QR code, saving you those By completely banning the deposition of Bitcoin for precious seconds for your next project. becomes much the national currency, they made it worthless for most Chinese citizens. Then, when regulators also easier when How does it work? The whole Bitcoin system forbade the firms that acted as middlemen from is built on “The Block Chain”, which is the you can easily working with the exchanges, the massive decline in public record for Bitcoin transactions. BTC exchange rate made sense. scan a QR Every block in this chain is a record which code” contains and confirms waiting transactions. Then, in February this year, as the BTC value started The encryptions are there to provide a high to stabilize; the Bitcoin exchange based in Tokyo, level of security. Transactions are usually going through several Mt. Gox, began to have issues with their customers. Growing blocks of confirmation to exponentially decrease the risk of a delays in cash withdrawals ending in a complete halt, blaming reversed transaction. The amount of confirmations required are it on technical difficulties, made their clients increasingly based on the amount of money currently being transacted. concerned. Three days after, the exchange shut down all trading; the news hit everyone hard as Tokyo’s main Bitcoin exchange During each transaction, Bitcoin miners come into play and had filed for bankruptcy protection. They had lost over 850,000 do their bidding. Mining is the process of using your computer bitcoins allegedly to hackers - a devastating blow to the whole to do computations for the network and further increasing ecosystem and like a broken promise, damaging the trust of security while confirming transactions. There are rewards for many. After trying to stabilize for a few days to no avail, the doing this service; a transaction fee can be collected along with exchange rate plummeted down in its lowest to a mere $350. newly created bitcoins. This is the only way for new bitcoins to Today, BTC has gone back up slightly but there is no telling as come into the system. The amount of bitcoins can never exceed to when the next crash will come. Most of the investors who 21 million as the total increases by a geometric series. By doing stood by the entrance at the start of the Bitcoin revolution have this, the BTC (Bitcoin currency) value will increase over time left. since no new bitcoins will be mined; a controlled environment with finite supply. The algorithm was chosen because it Comparing the Bitcoin phenomenon with the well-known resembles the rate at which gold is mined. “tulip mania” which occurred in the early 1600s in Netherlands draws some striking parallels. The bulbs of tulips, virtually The reason as to why Bitcoin gained so much value is generally worth nothing had become so valuable that at its peak, could be unknown. Nevertheless, as the dice began to roll, investors were sold for more than ten times the annual income of a craftsman. already standing at the entrance waiting eagerly to come into The crash that inevitably came was as sudden as the rise; the this new Bitcoin universe. The anonymity of each transaction “tulip mania” can be used to describe many economic bubbles has made it quite popular within the criminal world and most but with the recent trends, Bitcoin seems to be the perfect tulip famous incident must be the shutdown of the anonymous bulb of our generation. market place “Silk Road” by the FBI in early October 2013. During the raid authorities seized over $3.6 million worth of Writer Photo Bitcoin and the charges against the website said the sales of Oskar Luo Antana, Flickr
ARTICLE | HISTORY OF BITCOIN: THE RISE AND FALL
MEET JOHANNA LARSSON
Johanna Larsson is one of the many students that have graduated from KTH this summer. Unlike most of her fellow classmates, Johanna will move to London to work at Goldman Sachs, the investment bank where she also conducted a summer internship. We sat down with Johanna to discuss her experiences from doing a summer internship at an investment bank and what she recommends students interested in a career in the finance industry.
ursuing a career in the finance industry was not an obvious alternative for Johanna when she started studying Industrial Engineering and Management. Her ambition was instead to major in Energy Systems. “I was all set to become an environmentalist but I noticed that most of my friends wanted to study Financial Mathematics. So at the last minute, I had a change of heart and decided to join them.” It was a decision which she now says she does not regret, as Johanna quickly discovered that she found the courses she took in her specialisation very interesting. Becoming more interested in the area, she took the opportunity to get involved in the KTH Finance Society. “I started to become involved in the KTH Finance Society by participating in many of their events such as Finance Day, but it was not until I participated in the London Banking Week that I realised that I wanted to work in banking.” London Banking Week is a weeklong trip organised every year by the KTH Finance Society. It gives 25 KTH students the opportunity to meet with international investment banks and prominent financial institutions. Johanna is clear to emphasize the benefit she had from networking during the trip. “During London Banking Week, there were a lot of opportunities to network. It is also a great opportunity to get to know the people working at the firms. I spent time trying to see if these were people I would like to work with.”
Back in Sweden, Johanna followed up with the people “We got to meet with many people from the bank which she had met in London and started applying for helped me discover which desk would be the most summer internships. “I spent a lot of time preparing my suitable for me if I was to start working there. I perceived applications. Later on when I got to interview with a few that the organisation was flat in the sense that I felt I banks I made sure I took time to prepare as much as I could easily approach people of different seniority and all could. A good way to prepare for interviews is to search on were keen to help.” At any type of firm, the internship is the web for interview questions and answer them in full. an important tool for the firm - and also for the intern - to This enabled me to be specific when describing different find their fit within the firm. scenarios for my interviewer.” She also suggests that one reads publications “I think that when you start your internship, such as the Financial Times and the you are expected to get to know the people If you have Economist in order to keep up to speed you are working with. I spent a lot of time an interest in with the financial markets. Spending talking to people at the desk, as well as finance – start to setting up meetings with people from other time discussing financial news with friends was something Johanna made get involved. KTH desks. By being proactive, you have the sure to do in order to prepare for her chance to show and discover what you are Finance Society interviews. “It is also good to prepare interested in.” was a great way yourself for some brainteasers and for me to discover After 10 weeks, Johanna returned to math questions. They might ask you more about the something during your interview to Stockholm to start the autumn semester simply test your skillset and also how at KTH. She also got to know that she had industry” you handle a bit of pressure on the spot. been offered a place for a full-time job at Don’t worry if you don’t know the exact the bank. With this, Johanna sums up the correct answers, as long as you give it a try. If you prepare central things in her experiences with the internship. a bit for these types of questions in advance, you will feel more comfortable during the interviews.” “If you have an interest in finance – start to get involved. KTH Finance Society was a great way for me to discover Understandably, most people are nervous for their more about the industry. Also, make sure you network interviews, as it is the opportunity to show a firm why and get to know the people that work at the firm you are one is a suitable hire. Apart from preparation, Johanna applying for. This gives you a hint of where you might points out that it is important to be sociable and positive actually enjoy working. When it’s time for applying; during the interview. “Showing that you have a passion preparation is of utmost importance. Make sure you is of great importance. It does not have to be related to prepare your applications well and then also for your finance at all, it can be sports, music or whatever, but an interviews. While at the internship, be proactive, positive, evidence of passion indicates that you have strong drive, demonstrate a good attitude and a willing to learn and which is appreciated. By preparation you will be able discover more about the work you are doing. I believe to concretely speak about situations that display your that just being a social and positive person takes you a passion. Another important aspect during interviews is long way.” to always be friendly and humble. If you feel that your interviewer is sceptic or points out something you did It is clear that a great deal of Johanna’s decision making is wrong, don’t ever be let down but keep a smile and listen based on the people she gets involved with – something to their feedback.” that we truly believe will continue to serve her well in the future. After receiving offers from several banks, Johanna made the choice to join the summer internship programme Writer at Goldman Sachs. Johanna did her internship in the Victoria Drewsen and Peter Touma Securities Division, where she got to meet people from all over the world. “One of the best things about the Photo internship was the people I got to meet. Starting the Peter Touma internship was much like starting at KTH again, we became a tight-knit group and I made friends from all over the world whom I still have contact with today.” Apart from the social aspects she thoroughly enjoyed working at the bank. She describes the programme as very structured and well organised and she got to meet a lot of people from different areas of the division.
INTERVIEW | JOHANNA LARSSON
THE MINTS – HOPE OF THE EMERGING MARKETS In 2001, the economist Jim O’Neill coined the acronym slowing growth and an emerging housing bubble and Brazil has “BRIC” which refers to the countries Brazil, Russia, India taken a more nationalist approach which in the end may hurt the and China. The acronym quickly became a symbol for economy. These countries are after all developing and there is still that the global economic development was shifting a huge amount of investment going in to these countries. As an from the G7 countries to the developing example, at the time of writing, the index tracking economies. Today, many of the BRIC exchange-traded fund “MSCI BRIC ETF”, which countries stand before a number of In 2014 it was provides investors with the opportunity to track hurdles in their on-going economic the BRIC index, holds assets of about 400MUSD. clear that Mexico maturity which has drawn the spotlight surpassed Japan This article will focus on where investors might to another set of countries on the rise, namely the MINTs. turn to when the clouds pile up over the BRIC in becoming countries. Mexico, Indonesia, Nigeria and Turkey the number two he BRICs were long considered to be the were as of 2011 started collectively being referred biggest exporter to as the MINTs receiving the same focus today rescuers to the World economy, with the western world seeing a stagnation of their as the BRICs did about a decade ago. What will of cars to the economic development. However, as the BRIC follow is short analysis of the opportunities in USA” economies have started to develop, a number of each of the countries. these countries are facing difficulties in keeping their momentum. Well known is that Russia along with India are Mexico grappling with tense political situations, China is experiencing With the highest GDP per capita of all of the MINT countries
some argue that Mexico’s economy is the most developed economy in the collective. It is reported that Mexico was a contender to be a part of the BRIC countries but was opted out due to that it was considered more developed than the rest of the BRIC countries. Manufacturing is one area that has bloomed in the country. With its proximity to the USA, Mexico is an optimal alternative for big corporations looking to insource manufacturing from mainly Asian countries such as China. In the decade following up to 2012 the country saw a 6.8 % gain in exports as share of GDP. One area of manufacturing that has been on the rise is the automotive industry. In 2014 it was clear that Mexico surpassed Japan in becoming the number two biggest exporter of cars to the USA. The country is also seeing a rise of a big middle class that, along with the improving infrastructure, is set to boost a big domestic consumer demand. Indonesia Southeast Asia’s biggest economy has experienced some economic turbulence the last year with a spike in inflation and a widened current account deficit. The central bank, Bank Indonesia, took steps to dampen consumer demand in response to the inflation by raising interest rates. The Asian Development Bank forecasts a GDP growth of 5.7 % in this coming year followed by a 6 % growth in 2015 as inflation cools off. A property that gives the fourth most populous country in the world an edge is the richness of natural resources in the country. The country has become a commodities powerhouse with abundance of resources in for example cocoa and rubber. But there is one metal that the country is currently empowering – nickel. As demand cools in China most metals have seen a slump in prices, but due to an Indonesian export ban of nickel ore the price of the key ingredient to steel has seen a big rise in price. The country sees the opening of 9 nickel-processing plants that will enable it to instead of exporting nickel ore, starting to export the refined metal for a big mark-up. Indonesia will thus most likely become an even more dominant player in the important commodities market. Nigeria Of all the MINT countries, Nigeria has the lowest GDP per capita. Still, this is after the country revised their use of base year. Now the country uses 2010 as their base year instead of 1990 which revised GDP up by 89 % and made the economy the biggest in all of Africa. Along with Indonesia, Nigeria is experiencing a great rise in service and communication sectors. The country has great wealth coming from its large oil sector but the African Development Bank (ABD) lifts other sectors that may further grow the country’s economy such as agriculture, IT and trade services.
On average from 2007 to 2012, Nigeria has had the biggest GDP growth of all the MINT countries. It is also estimated that the GDP will grow by 7.2 % this year, which will further attract investors to the country. The ABD highlights some risks to the Nigerian economic outlook, the primary one being the inclusiveness in the economy. The wealth from oil has not trickled down to the society and to change this, the Nigerian government has focused their work and a large part of their budget on mass job creation and making the growth more inclusive. A threat to this development is hence a slowdown in the oil sector that worries some sceptics. However, the country shows great prominence in non-oil sectors as well. The country saw a sectorial growth of over 30 % in telecommunication just from 2012. After extensive liberalisation of the sector, it comes as no surprise that the mobile sector has experienced triple-digit growth in the country, attracting a great number of foreign corporations. Turkey The last country in the collective is Turkey, which is seen as one of the more developed economies, along with Mexico. One of the country’s great strengths, relative the other MINT countries, is its economic diversification. The country’s stronghold is its agricultural sectors but several other strong sectors include consumer electronics, automotive and textile. Turkey has also gone ahead with extensive privatization programs that have led to increasing numbers of middle-class entrepreneurs. After an economic downturn in 2001, Turkey turned to the IMF for help. This led the country to redefine its fiscal policy and it came out experiencing strong growth up until 2008. In later times political tension in the country has been a risk factor for foreign investors. In 2013, an outbreak of protests against the country’s Prime Minister Recep T. Erdogan erupted mainly on the streets of Istanbul. With no solution in sight many feared that the unstable political situation would affect the economy, which it did. The Turkish lira had a minor free fall that led to emergency meetings by the central bank followed by hiked interest rates. With its attempts to approach a membership of the European Union, the country could experience greater growth granted a membership. As an example almost three quarters of their textile exports are to EU members. As such, a membership would indeed boost its economic growth. Next Big Thing As the BRICs cool off, investors looking to chase higher yields will most definitely look to MINTs as the next big thing. Writer Peter Touma Illustration Xinga Li
ARTICLE | THE MINTS
THE EVOLUTION OF THE FINANCIAL MARKETS
PAN CAPITAL CEO CLAES-HENRIK JULANDER “High Frequency Trading “ (HFT) is a topic that is often depicted in media but still remains rather mystical. We had the opportunity to sit down with Claes-Henrik Julander, CEO of Pan Capital - a successful Swedish trading firm specialising in algorithmic execution. Claes-Henrik shares his knowledge in the area through the journey he has had with Pan Capital, a firm that can be regarded as a pioneer in the area.
resh off with a degree in Finance from Stockholm University, Claes-Henrik began his career at Swedbank where he worked as a Quantitative analyst focusing on option strategies. Admitting that he lacked some of the quantitative skills his other, mostly physicist colleagues possessed, he acknowledges his former boss for his steep learning curve. The options desk at Swedbank was at the time the biggest option trader in the Nordic region and Claes-Henrik describes how he was forced to grasp new and complex topics in order to match some of his colleagues. A few years later on, Claes-Henrik and five other colleagues from Swedbank felt the urge to try out new ideas and strategies they did not get to act on in the big organisation. In 1996 the group of six left what ClaesHenrik describes as a really stimulating job. “I had a great time at Swedbank but trying out new things at large banks tend to be rather sluggish.” The group first deployed the trading firm with the help from Swedish businessman Mats Qviberg. By coincidence, they later got in contact with another businessman, Erik Penser under whom they formed Pan Capital in 1998. “High frequency trading was unheard of in 1998. The natural thing was that people were acting like ‘Market Makers’ who sat in front of a screen and moved the spreads by hand for a handful of shares. We realised that his process had to be able to be automatized instead of having people starring blindly at computer screens.” The group decided to take on this daunting task with a hope that instead of having traders acting like ‘Market Makers’ only tracking a few shares, an automated system could do it with many more shares. At the time if you needed a driver, someone had to come and deliver it
on a diskette and with no one in the group having any experience of computer programming, things started out tough. “It is when you have to solve a problem with that big lump in your throat that you learn the most.” The group persevered and were throughout the process self-taught. Claes-Henrik credits his perseverance from his time at the National Defence College, which he describes as the best education he has ever received. Building on their success from their base in Stockholm, Pan Capital decided in 2002 to open an office in Chicago, USA; the office later moved to Fort Lauderdale, Florida. The usual message displayed by the media is that HFT firms want to be as close to the exchanges as possible and with Florida being some 1800 kilometres from New York City, Claes-Henrik says that proximity has not been of utmost importance for the firm. “We would invest in stocks we actually believed in and executing those orders in a smart way.” The Evolving Financial Markets Pan Capital has seen a tremendous success throughout its years of operations. Being active since 1998 the company has endured two financial crises, digitalisation and decimalisation of the exchanges and the cascade of regulations. Having experienced all of this, Claes-Henrik paints a different picture of the HFT environment usually depicted by the media. “Most people who speak out about HFT really do not know what they are talking about.” He argues that due to the automatization of the financial markets, money has been transferred from the big banks and financial institutions back to the end investor which are the pension funds, individual investors etc. “It is the biggest paradigm shift in finance to date. As the competition among HFT firms grew bigger, profitability from the trading business imploded and the spreads between the bid and the ask price grew even thinner.” There are a number of factors that brought about this revolution but Claes-Henrik points out the role of the Internet and the access to information. “Back in 1998, it was very hard to analyse market conditions. It was important for the banks to deliver analysis to their customers and they rightfully got paid
INTERVIEW | CLAES-HENRIK JULANDER
for it because obtaining the analysis was expensive for the bank. Nowadays, analysis costs nothing and it is the investor who makes the final decision. In a way, the analyst has played out its role because there are so many of them and information is now available freely to everyone.” Another part of the cash outflow from the banks has been the diminishing cost to execute trades. “The customer should not have to pay the trader more than one basis point1 for the execution.” About a decade ago, the customer could have to pay at least 15 basis points for simple executions with the possibility to exceed well over 60 basis points. Today the customer will pay around 2-4 basis points in Bill McNabb who is the CEO The exchanges fees. of Vanguard, one of the world’s release information largest mutual funds, estimates to the public at the that transaction costs has declined same time, anyone by over 50 basis points in 10-12 years, a decline that he accredits can get a hold of HFT firms for. Claes-Henrik still the information points out that the trader plays a huge role for clients that want to at the time it is execute very large trades. “The released” trader should get paid to help their customer find buyers or sellers.”
Media has also accused HFT firms for the, at times, increasing volatility on the stock market, a view that ClaesHenrik does not share. “During the crisis of 2008, the financial institutions saw their systems break down due to the amount of volume and the volatile movements in the market. Firms that engage in algorithmic trading do not benefit from high volatility, they want the market to be stable and predictable with spreads held in a narrow range.” Accusations to the industry have also included market manipulation. Some would argue that HFT firms, granted their superior technology, rig the markets. “The exchanges release information to the public at the same time, anyone can get a hold of the information at the time it is released.” He also states that the motives of HFT firms and individual firms often diverge; an individual investor, in most cases looks for good long-term investments that are not bothered by the technology or strategies conducted by HFT firms. Claes-Henrik is careful to point out that if there is any wrongdoing in the business, such as firms benefiting from insider information, they should be rightfully prosecuted. One of the greatest benefits from this evolution according to him is that there is an increasing accountability on banks. “The high comparability among banks services has made the environment truly competitive. Nowadays, you have to deliver good services in order to attract clients. This has resulted in common good due to increasing efficiency.”
CLAES-HENRIK JULANDER | INTERVIEW
KTH Students as Colleagues Claes-Henrik is very clear to emphasize the importance of the people he has worked with and he proudly declares that the majority of Pan Capital’s employees have been graduates from KTH. A curious person by nature, Claes-Henrik finds it stimulating working with people who possesses different skill-sets than himself. “The finance industry has been full of economists, it has worked well with the variation we have had.” He also shares an example from when they hired a KTH graduate who had an outstanding track record in computer science as well as being the winner of numerous programming challenges. “We described a problem to this employee that he said was fairly simple and he had great confidence that he could solve it in a matter of hours. Three weeks later and no optimal solution had been found.” With this, Claes-Henrik emphasizes that theory, very seldom, aligns with practice but having a curious mind takes you a long way in solving very complex tasks. Recommendations for the Future When asked what he would recommend students interested in this area, he explains that there is no clear-cut answer. “This is a truly exciting area to work in and nowadays you do not have to be ashamed to say that you work in the finance industry.” Having been both in a large organisation like Swedbank and a smaller firm such as Pan Capital he states that there are advantages to both environments. “If you want to have a career in finance and make a name for yourself you should start at a big bank. If you want to have more influence and at the same time have fun, you are better off at a smaller firm.” 1
basis point = One hundredth of a per cent = 0.01%
Interview & writers Peter Touma and Christian Strömbäck Photo Xinga Li
ELECTRONIC TRADING AND MARKET FRAGMENTATION 16
Computers have been used in the trading environment even as early as the 70s. In the beginning they were used as advanced calculators or organisers. In the mid 80s institutions began to connect their computers, eliminating the human middleman. This has had a major impact on the development of financial markets ever since. During the last decade there has been a development explosion mostly fuelled by new technology and the introduction of new regulations. Today we see a fragmented landscape where before there was only one venue for any given security while now there are at least twenty worth mentioning. This fragmentation in turn gave rise to the need for much more advanced market data services, order routers and low latency cross-market arbitrage.
ow traders lean heavily on technology and hence the success of a given trade relies to a great extent on the technology employed by the trader. It is no longer enough to get your market data from one trading venue, as many trades will happen on other venues. Furthermore, where and how to send the order is far from trivial. You need smart order routers capable of slicing your order into many child-orders and routing them all over the world based on hundreds of different parameters and all in a few microseconds.
In dark pools there is no public order book and orders are instead entered blindly in hope of executionâ€?
Trading takes place on several different types of trading systems where the most important ones are exchanges, MTFs and dark pools. The difference between an exchange and a MTF is mostly regulatory while dark pools function in a different way. On exchanges and MTFs, generally referred to as lit markets, there is for each security a publicly disseminated order book. However in dark pools there is no public order book and orders are instead entered blindly in hope of execution.
The main reason dark pools have become so popular is information leakage. Each order entered by an investor signals other traders. An analogy is that you are tipping your hand in poker. In a well-designed dark pool, information about the order will not leak in time for other traders to act upon it thus nullifying the hand tipping. The fragmented market landscape together with the need to defend against other traders trying to act against your order flow has created a large need for so called Smart Order Routers (SOR). A SOR is a low touch system that executes your order in the best possible manner. It consists of several functions but fundamentally it collects market data from many trading venues and creates a consolidated market view. It then acts on the consolidated market view sending out orders to the different venues following predefined and optimised execution strategies. A simple execution cycle can look like this:
1. A parent order is received from a client. 2. Entering a dark execution phase, searching for liquidity in dark pools. Some of the volume may be executed. 3. The remaining volume is moved over into a lit phase. First establishing if and where matching liquidity is present. Executing the remainder of the order against available liquidity in best possible manner. 4. Entering a passive phase if the order is not filled and is then posted on a suitable exchange. Tracing back through this basic example we see several concepts; dark phase, dark pools, searching for liquidity, lit phase, and passive phase. It is beyond the scope of this article to explain all these concepts in detail but most exist in order to hide intent by disguising activity. A lot of optimisation goes into making sure other participants are unable to act against your orders. A successful SOR consists of many details being optimised but generally they are either to decrease latency or adhering to market microstructure. Sometime it can be tedious, hard or even impossible to perform a satisfying analysis. Nonetheless it is vitally important to never cut corners, never guess nor assume. Building successful trading systems is a process of stacking solutions to specific problems on top of each other resulting in an end-to-end platform. However the system will never be stronger than its weakest link and thus attention to detail is of paramount interest. For example it will not matter if you have the fastest and most efficient business logic if you are slow at decoding market data. Not all details are created equal though, it is far more important to colocate than to optimise a function call so it fits into the CPU cache. In the first case we can shave milliseconds while in the latter we will shave nanoseconds. However, those nanoseconds quickly add up. Building low latency trading systems is a tough business as the fastest system will win on average and quickly eliminate others but it is also rewarding, creating the trading version of Formula 1 cars. Everything is specialised and tuned to a point where the last gram on the camshaft counts. You get the chance to work on a broad range of highly specialised issues, ranging from CPU cache optimisation to network topologies to order entry types. It is a line of work I can strongly recommend if these things interest you. I would like to thank my colleagues at Pantor for their assistance in writing this article. Writer Lukas Magnusson Photo Creativity103, Flickr
ARTICLE | THE MINTS
INTEREST RATE PARITY AND MONETARY INTEGRATION
In the light of the elections to the EU parliament, discussions have focused on Swedish involvement in the EU. This article gives a preview of the thesis “Interest Rate Parity and Monetary Integration: A Cointegration Analysis of Sweden and the EMU” written by Richard Ruthberg and Steven Zhao. The article will try to answer if Sweden would benefit from entering the EMU from a monetary integration point of view.
or countries within the European Economic and Monetary Union (EMU), monetary integration is a key determinant for the success of membership. Being a wide concept, monetary integration includes capital market substitutability, monetary policy integration as well as exchange rate stability. As an initiative to maintain monetary integration between the EMU and Euroaccessing countries, the Exchange Rate Mechanism (ERM) has been a tool of the European Union (EU) to reduce fluctuations in exchange- and interest rates against those countries that will potentially adopt the Euro. Sweden, as a member of the EU, has not yet adopted the Euro but have been close to enter the ERM as the economy is closely related to those within the EMU. This study will take a closer look at some underlying factors that could potentially speak for a re-evaluation of the adoption of the Euro in Sweden. Specifically, the thesis will aim to answer two separate but related questions: 1) “Does the covered- and uncovered interest parity condition hold between Sweden and the EMU?” and 2) “Is there evidence of monetary integration between the two regions that could motivate a Swedish entry into the EMU?”. The former question is better off answered using quantitative techniques whereas the latter benefits from a thorough qualitative analysis of earlier studies on monetary integration combined in a discussion with results on interest rate parity. Benefits of joining the EMU Because there are conceivable benefits to Sweden in a potential EMU entry, among them reduced transaction costs and increased trade, there is great motivation for re-evaluating membership as it can potentially increase Swedish competitiveness. Furthermore, the level of monetary integration is not only a topic of discussion in entering a monetary union, but a broader measure of frictions in capital markets that in itself gives insight into the level of trade. Since trade between countries becomes increasingly more important for country-specific competitiveness, studies on this topic is not only important for policymakers but also for decision makers in businesses. In modeling monetary relationships, the main threat is market volatility and uncertainty which both vary in time and makes any model derivation a complex task. Nevertheless, the importance of such modeling is crucial to policymakers as it provides groundwork for policy as well as guidance for central banks in determining interest rates. Interest rate parity The covered- and uncovered interest parity (CIP, UIP) conditions are both well-studied concepts in macroeconomics and relate the interest rate differential to the exchange rate change between two countries. Specifically, CIP states that the interest rate differential should equal the percentage difference between the forward- and current spot exchange rate. UIP, on the other
hand, is a pure expectation based relationship that states that the interest rate differential between two countries equals the expected percentage change in the spot exchange rate. The two conditions are both of great importance as they give insight into market imperfections and how risk premiums materialize. Monetary integration Furthermore, deviations from UIP and evidence of a foreign exchange risk premium are both commonly used in the literature as determinants of capital market substitutability. Since capital market substitutability is a measure of monetary integration, UIP can be used as a point of discussion for monetary union as one condition to enter is that financial assets are substitutes between economies. The potential entry of Sweden into the EMU can, therefore, be evaluated using UIP where the ideal environment would suggest its existence. In addition, CIP is often used to determine the efficiency of financial markets and capital market mobility as it is based on the assumption of no arbitrage in the forward exchange rate market. The two conditions are thus of great importance in the assessment of financial markets as well as in discussions on policy with respect to topics such as potential EMU entry and determination of interest rates. Empirical evidence Both conditions have been studied extensively with mixed results. UIP is usually rejected whereas CIP has proven to hold more frequently. The main reason for the rejection of UIP is, as literature suggests, due to the existence of a time-varying risk premium. Furthermore, most studies regard the conditions in isolation and only focus on either of the two relationships, a surprising trait of past studies since the rejection or acceptance of one condition enforces constraints on the other with respect to underlying assumptions. This is where the authors follow a slightly different road than the majority of previous studies in the sense that both relationships will be studied, as well as their interdependence, with the specific view of the Swedish entry into the EMU and a contrasting feature relating pre- and postcrisis conditions. Mainly due to the need for assessing both relationships in a discussion on monetary integration between Sweden and the EMU, the conditions will be studied extensively by looking at interest rate differentials in the interbank markets and corresponding exchange rate changes using forward- and spot exchange rates on horizons less than one year. Additionally, the separate link between the two, the forward rate unbiasedness hypothesis (FRUH), is used to tie the two relationships together and to provide a deeper discussion on a potential Swedish EMU entry. Interested readers are advised to consult the original thesis for more in-depth results and discussions as well as to gain a deeper understanding of the topic and the quantitative methods used to answer the research questions of the thesis. Writer Steven Zhao and Richard Ruthberg Photo Fdecomite, Flickr
ARTICLE | INTEREST RATE PARTY AND MONETARY INTEGRATION
FROM KTH TO CORPORATE FINANCE The financial sector encompasses a wide variety of job opportunities. For the unacquainted it may seem as an endless world of activities and ever so often engineers follow the slightly conventional path. Engineers usually take on jobs within the financial markets as traders, or employees at FinTech firms and other more canonical jobs for engineers wanting to begin a career within finance.
his article aims to widen the scope by meeting an engineer working in corporate finance. I met Jonas Olsson, Corporate Advisor at Swedbank’s Corporate Finance division and former student at the Royal Institute of Technology (KTH), to find out what it is like working within Corporate Finance as a engineer and get tips of how to break into finance. Jonas started working at Swedbank’s Corporate Finance division in 2009 – in the stringent aftermaths of the 2008 financial crisis. He is today, after several projects ranging from IPOs to helping large companies with capital raising, Corporate Advisor at the firm, which is one of the Nordic and Baltic region’s largest investment banks. Jonas briefly describes how his tasks at Corporate Finance have changed from day one. “In the beginning I worked with potential buyers and sellers of companies, or firms that sought financing through for instance an IPO – in short everything that has to do with selling companies privately or on the stock exchange. Today I work as an analyst, looking at companies that reach out to the bank in search for financing and evaluate the companies’ profile and repayment ability. The financial analysis reminds a little of what I did before, but now I work with Swedbank’s own balance sheet, something that implies a lot of risk analysis.” With great interests in Mathematics and enjoying
working with ambitious and motivated peers, he started studying at KTH in 2004. When studying the program of Industrial Management & Engineering, he received more and more acquaintance with economics. The more he studied the more he became interested. In his fifth semester he applied to a Master’s program at Stockholm School of Economics (SSE), where he later studied simultaneously with his studies at KTH. He applied with merits from KTH and grades from the Bachelor within economics he had obtained meanwhile from Stockholm University. A difference between engineering and economics students, he discovered when starting at SSE, was that even though the SSE students were very clever, he found that KTH students had a much higher level of mathematical skills and problem solving abilities. “I believe you have a different way of thinking, studying at KTH”, he says. After having enrolled a Master’s Degree within International Economics and Corporate Finance at SSE, he discovered how much his two degrees went hand in hand. He could combine his mathematical skills with the live cases he encountered in Corporate Finance courses and became much more effective in his studies. In hindsight, would you have done the same regarding the choices for your education? “I think about that at times - if I could turn back time, I’d still choose KTH as you learn how to structure problems and questions. The way of thinking, which you learn at KTH, is something you can use in all different kinds of sectors – being it, working in a bank or elsewhere. The ability of breaking down problems into its core components – that’s what I have with me from my time at KTH and working in an investment bank. “ Do we need more engineers generally within the financial sector? “Absolutely. It’s very good mixing people. I learn a lot from people coming from a pure economics background. There is a lot of numbers, and breaking down problems and understanding things in detail, which generally engineers are good at. You shouldn’t be afraid as an engineer to take on the possibilities within Corporate Finance or explore other areas. You have what it takes for most of the sectors – being analytical and able to solve problems. It doesn’t require a business degree; the most important aspect is having an interest in finance.” Jonas tips on how to break into finance #1 Reflect upon your studies ☑☑ The most important is when studying is that you reflect upon what you study. Several people study and prepare for exams but the important thing is to really understand what you study. And understanding has also to do with interest. If you’re interested in a subject it is more likely that you
will understand it better and that will probably lead you to understand how you want to begin your career path. Reflect a lot upon what you actually learn and study and read what you are interested in. #2 Take advantage of your non-economic background ☑☑ Jonas points out that you are definitely not excluded from the financial sector if you have studied a noneconomic degree in for instance bio engineering our chemistry. ☑☑ What is important is that you have a general interest and understanding within the area, say the stock market. You can’t work 60-70 hours a week, which you often do the first years, with something you don’t find fun. #3 Seek relevant part-time jobs (don’t be afraid) ☑☑ Apply for a job you can have outside your studies. It stands out on your CV. I have taken part in several recruitment processes. Nearly everyone writes in their personal letter that they’re social, etc. For me it’s crucial to meet the person. First thing, I look at the CV – what education does this person have, has he or she done anything relevant during his or her studies. This can include involvement in student organizations such as the KTH Finance Society. Even better is if the person in question has had any relevant summer job or part time jobs from studies. ☑☑ Getting an early taste of how it is to work within finance is a good way of discovering areas which you are interested in and not. It doesn’t have to be any advanced job. A good beginning is seeking among the insurance firms or within retail banking. ☑☑ When applying for extra jobs, don’t be frightened by the often-ambitious requirements stated in the advertisement. Apply! Nobody qualifies for everything. You’ll never get an insight if you are too afraid to apply. ☑☑ The first job is off course the hardest one to get, but once have you’ve worked half a year/a year you’ll have good references for the next one. #4 Reading ☑☑ Dagens Industri gives a good overview. Their website is accessible and free. ☑☑ Great forums are wallstreetoasis.com – provides members for instance valuation tasks, and excel tasks. Analystforum. com is an another handy online forum. Writer Sofia Gavefalk Photo Sofia Gavefalk
ARTICLE | SOFIA GAVEFALK