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Issue 1, December 2009

Market Report

IFS

http://yorkinvestment.com/

UNIVERSITY OF YORK INVESTMENT AND FINANCE SOCIETY


An introduction by the editors: The Investment and Finance Society at the University of York is a new-founded society with only one year history. However, its members are ambitious young people with an interest in finance. Our main goal is to challenge and deepen their knowledge. We have In Focus presentations every other week trying to familiarise our members with the latest events in the market. Our challenge is the publication of a Market Report every term, which would contain financial articles produced by our most talented and analytical writers. Our target readers are financial institutions and our main goal is to show that there are bright young students in the University of York, who have strong interest in finance and are striving for new challenges. In this issue we have managed to cover a wide variety of topics. We have a section developed to commodities and currencies. In the Merger and Acquisition section you would find interesting information on Kraft’s “hostile bid” for Cadbury. The “hot issues” section contains articles on the Pre-Budget Report and the turmoil surrounding it as well as the discussions on the government spending over 2009. Last but not least our Market Report takes a brief but profound look at repo markets and credit derivatives.



Contents

FOREX

FOREX: Page 3: ”Still in the tunnel – an overview of the US dollar/Japanese yen rate” Akihiro Takemura Page 5 : “Sailing with the wind – oceanic currencies overview” Akihiro Takemura

Still in the tunnel – an overview of

Commodities: Page 6: “Is the crude oil bubble of 2008 inflating again?” Ivan Rangelov Page 8: “Gold, reached the Peak?” Jeongho Park M&A: Page 10: “Another British symbol about to be swallowed by globalising markets” Ivan Rangelov Hot Issues: Page 12: “Who wants to be a banker in UK? –the effect generated by new levy on bankers’ bonuses” Yu Lu Page 13: “UK government spending spree 2009” Yingwei Chen In Depth: Page 14: “Repo Markets” Aaron Ong Page 15: ”Credit derivatives” Aaron Ong Page 17: “The Black-Scholes Model: Obsolete or useful nowadays?” Dario Palumbo Other Industries: Page 19: “UK retail market: back to growth” Yingwei Chen Page 21: “The Shipping Industry after the Meltdown” Dario Palumbo

the US dollar/Japanese yen rate By Akihiro Takemura This summer saw a historical change in Japanese politics: the opposition party – the Democratic Party of Japan (DPJ) – scored a landslide victory against the Liberal Democratic Party (LDP) that virtually dominated the politics in Japan ever since World War II. The new government promised to bring major changes across to a broad spectrum of policies, for example, social security and bureaucracy. The Japanese economy has been in a long struggle since the bubble, in which real estate and stock prices rose dramatically, collapsed nearly twenty years ago. The monetary authorities in Japan have been trying to stimulate the economy in many ways such as by lowering the interest rate and quantitative easing, but clear signals of true recovery are yet to be seen, especially after the credit crisis in 2008. In economies where the export industry plays an important role, the effect of shrinking foreign market can be devastating. This was the case for Japan during the credit crisis. It was not hit hard by the excess exposure to sub-prime financial products, but rather suffered a nasty blow by the decline in global consumer demand. The Bank of Japan (BoJ) has been cooperating with the government (LDP back then) for the last few decades to prevent the strong yen, by market intervention. For example, in 2004, the

BoJ conducted 30 trillion yen (about 155 billion pounds then) of yen-selling intervention. (In Japan, the BoJ acts on behalf of the Ministry of Finance in market interventions) The cheaper yen favours the export industry, into which manufacturing giants like Toyota or Honda can be categorised. In contrast, the DPJ aims to bring the economy out of the depression by shifting the shape of the economy from export based one to domestic consumption based economy. This approach was received by the market as approval of yen appreciation. The yen carry trade is another factor, causing yen to gain strength against other currencies. The Minister of Finance, Fujii Hirohisa, was reported to be reluctant in intervening in the forex market when he was first appointed, and this further strengthened the bearish trend in USD/ JPY. The appreciation of yen has severe consequences in export sectors. The appreciation of yen against dollar by 1 yen would cause losses of about $2.5 billion and $1.2 billion for Toyota and Honda, respectively. In the electronics sector, for instance, Panasonic would suffer $2 million in sales. On the other hand, companies like Nitori, a major furniture retailer, and Seven & i holdings, a large diversified retail group, would benefit from lower cost of importing goods from overseas. The stock prices of the aforementioned companies at the Tokyo Stock Exchange have been moving very closely to the dollar-yen exchange rates in recent months. A consumer might say, “If the goods can be imported much cheaper now, surely it’s not doing much harm to us, we can




buy things cheaper.” However, if one looks at what’s hiding below the surface, he would realise that this can potentially be very damaging to the whole economy. When the net profit of a company suffers, the salaries and bonuses decrease, which in turn damage the purchasing power of consumers. The retailers would have to cut the prices further to encourage people to purchase their goods, but this will reduce the profit of manufacturers. The manufacturers then would have to lower the spending on investment and salaries. The cycle will continue, decreasing the economic activity dramatically. In short, a perfect setup for a deflationary spiral. A few weeks ago, both the government and the BoJ acknowledged that Japan was now officially in deflation. A continued down trend in USD/JPY will certainly accelerate the process. Curiously enough, there has been no explicit sign of tackling this problem neither from the government nor the BoJ. Mr. Fujii, insists that he would “respond flexibly to abnormal price movements”, and the BoJ has just conducted its new quantitative easing operation. Neither of them had a direct impact on the USD/JPY

exchange rates. According to Reuters, on the 27th Nov the BoJ checked the exchange rates with commercial banks, hinting at the possibility of intervention, which stopped after 2004. This time the answer from the BoJ was “nothing”, but it was enough to drive the exchange rates up to around 86 yen per dollar from the record low in the last 14 years of 84.82. However, it should be noted that only when the warnings are followed by actions, are they going to be effective. The Nikkei index is crawling out of recession slowly compared to the DowJones or the FTSE, and even worse, many analysts see this recovery as being very fragile. If the government and the BoJ continue to be undecided, the market will undoubtedly challenge their tolerance levels again. The blank round is already fired. Now it will be interesting to see whether the next one will be a live bullet, otherwise the blank might have been an early Christmas cracker for them Figure 1: Daily close price chart of USD/ JPY. Source: MetaTrader 4, © 2001-2009 MetaQuotes Software Corp.

Sailing with the wind – oceanic currencies overview By Akihiro Takemura As the Fed’s interest rate is at a record low level, traders are shifting their US-dollar based positions into higheryielding currencies based ones. The two major oceanic currencies, namely the Australian (AUD) and New Zealand (NZD) dollars have been the rising stars in the global currency market in recent months, both of them have almost recovered from the massive loss of their values against the US dollar during the financial crisis in 2008 (Figure 1). Australia In the global recession, in which the GDP’s of major economies were suffering, the Australian economy also suffered a minor contraction compared to, say, the US (-6.3% in Q4/2008). There are several factors contributing to the recent performance of the Australian economy in a difficult climate. The banking system was still strong when the economy started to struggle, and the real-estate and mortgage markets were not in a bubble. Also, being a major commodity exporter, trading relationships with emerging economies like China and India helped to stabilise the economy much quicker. China’s commodity demand remained strong during the global recession, and it is expected that the demand will increase as the Chinese economy continues to grow. Strong demand for commodities encourages growth in related sectors in Australia. Mining companies are



investing in production capacity and related infrastructures, and the public sector is also helping to grow the industry. Improvement in company profits will have positive influences on its share price and payments the employees receive, and this would induce other multiplier effects, contributing to the recovery of Australia’s economy. The Reserve Bank of Australia (RBA) has been praised for its quick actions taken against the financial crisis in 2008. The interest rate cuts were especially aggressive - from 7.25% in August 2008 to 3.00% in April 2009. Despite the vigorous initial action, out of industrialised nations, the RBA was the first to raise the interest rate. The RBA interest rate as of Dec. 16, 2009 is 3.75%, which is considerably more attractive compared to 0.25% of the US, 0.5% of the UK, 1.00% of the ECB and 0.10% of Japan. This has been one of the factors forcing the investors into commodity currencies such as AUD and NZD. New Zealand The wingman of the Aussie dollar in the high-flying currency market since March has been the Kiwi dollar. New Zealand, unlike its neighbour, had actually plunged into recession in the second half of 2008, but it is slowly recovering. Foreign investment has been playing an important role in the New Zealand’s economy, which was hit hard by the financial crisis as the foreign investors withdrew their capital. As the fear of further financial meltdown subsided, foreign investment is once again returning to New Zealand, and started to revive the economy. Strengthening




recovery has increased global oil demand, which has been falling for eighteen months. If we add the growing middle class’ demand for automobiles in emerging economies such as China and India a higher demand in 2010 is almost inevitable. IEA forecasts 2009’s oil demand to reach an average of 84.8m b/ d, and that in 2010 there would be a rise in demand with around 1.4m b/d.



agricultural commodities are also backing up the economy. Although the interest rate at the Reserve Bank of New Zealand (RBNZ) is at a record low of 2.50%, it is certainly advantageous over other major currencies.

Figure 2: Daily close price chart of AUD/USD and NZD/USD. Source: MetaTrader 4, © 2001-2009 MetaQuotes Software Corp.

Is sky the limit? As many analysts expect the RBNZ to start raising the interest rate and the RBA to continue raising the rate through Q1 of 2010, both currencies seem to remain bullish against the US dollar. On the other hand, it is equally expected that the FRB is going to raise its rate from the near-zero level sometime in 2010. When other major central banks start to follow the RBA’s decision to raise their interest rates, the high-yielding advantage of the two oceanic currencies will start to fade away. It might be a good idea to look over the horizon for any potential storms.

Is the crude oil bubble of 2008 inflating again?

Commodities

By Ivan Rangelov

traders. The highest price the crude oil has ever seen catapulted world economy straight into what some analysts call the worst recession after 1929. This led to a constant decline in crude’s price with almost a fifth until the beginning of 2009. Since then the black gold enjoys a steady rally and has more than doubled its price. Some analysts consider this phenomenon not strongly supported by fundamentals and claim it as the reinflating of another bubble. Is this statement correct or has the crude oil discovered its real price between $70 and $80 pb? Considering fundamentals

The crude oil market is volatile and sensitive to external changes, but at the same time its importance is crucial for industries and economies in general. The price of $150 pb from July 2008 still echoes in the minds of investors and haunts the dreams of industrialists and

Despite the steady growth in markets’ activity the industry is still struggling to recover after the recession. On the other hand the figures shown in the US monthly employment report add to the expectations of future recovery in industrial sphere which would probably raise the demand for crude oil over the next year. According to the International Energy Agency (IEA) Asia’s quicker

Since crude oil is traded in US dollars the price relation between the Greenback and the crude has proven to be inversely proportional. The monetary policies which the US Government has undertaken led to a serious decrease in dollar’s value. Since the beginning of the year the buck has dropped around 20 cents towards the euro and the pound. Weakening dollar stimulates the demand for oil. Possibility of a bubble Prerequisites for the emergence of a new bubble are almost at hand. There is an expectation for future demand which combined with a weak dollar might attract some speculators. Such a threat seems to be inconsistent at the moment considering the Dubai Debt Crisis from the end of November and the inability of the crude to hold a price above $80 pb. Apparently the black gold has found a safe refuge in $70-$80 marks. This would probably hold true until the OPEC’s meeting in Luanda, Angola in December. The oil cartel will be reviewing its production policy and this would undoubtedly have some reflection on the market. If there was a bubble…




Many economists consider the emergence of a new crude oil bubble to have devastating consequences on the economy. A surge in oil prices would slow the pace of recovery in the industry. This would possibly lead to a doubledip recovery and would perpetuate the recession. According to Nouriel Roubini, an economist famous for his early prediction of the US housing bust and global oil shock, “If oil goes to $100 today, it will have the same effect on the global economy as what $147 oil had last year.”

the price reached its peak. It is important to investigate why the price has gone up so sharply over the last year and also look at why the price decreased so significantly. There is some evidence to indicate that the price has been artificially pushed up and then pulled down. Why did the price go up? Generally, commodities are very popular when the stock market falls or the dollar weakens. However, this is not the only reason why the price has gone up. 1. Financial crisis

Has ‘Gold’ reached its Peak yet? By Jeongho Park The price of gold has constantly rising in recent years. Especially since November 2008, the price has surged dramatically, from $704.90 an ounce and hit a record high, $1,227.50 an ounce, on 3rd of December 2009. However, the price has dropped very sharply by approximately 9 per cent since



Due to the world financial crisis, people have invested money into commodities rather than paper-based stocks or currencies. This uncertain economic situation makes commodities more valuable and attractive. 2. Inflation Concerns of inflation might be considered another reason. Comparatively, commodities, especially gold, seem

more valuable and safer to investors. As it is tangible, rare and physical, the value of the gold will never plummet like currencies. 3. Weak dollar

10 metric tonnes of gold from the IMF to restructure its financial resources. According to ‘GoldAlert’, BRIC countries –more specifically China, India, and Russia – have increased their gold reserves in 2009.

Also low interest rate made people less attracted to dollars. Since the dollar fell, the dollar has been transferred to commodities. It became more expensive to buy gold in dollars.

5. Speculation

4. Central Banks

Then why did it fall?

The central banks boosted the gold price as well. They are diversifying foreign exchange reserves which attracted other investors to gold. The Reserve Bank of India (RBI) purchased 200 metric tonnes of gold from the IMF in a very short time between 19th and 30th October and the Central bank of Sri Lanka bought

1. Economic improvement

Speculation is another reason of the price rise. As the price of gold rose, investors were foreseeing a further increase.

4th December 2009, the chairman of the US Federal Reserve, Ben Bernanke, announced that the US unemployment rate had fallen by 0.2% in November. 2. Strong dollar




Improvement of unemployment rate shows that US economy is recovering from the recession which strengthened the dollar. Therefore, gold price has sharply fallen. 3. Strategy According to Mark Robinson, Dubaibased bullion analyst, the Central Bank of China is purchasing gold but wants at the price below $1,000 an ounce, trying to get the lowest price. This may be the reason why they claim gold is experiencing a bubble growth. View There are two different views of future gold price. On one hand, many bullion analysts have predicted the price of gold would surge to $1,300 in 2010 and to $1,500 in the next few years. For example, Chief Executive Officer Richard O’Brien, Newmont Mining Corp., says bullion may rise to $1,350 an ounce next year and reach as high as $1,500 within two years. Investment bank, Goldman Sachs also predicted that the gold price could surge to $1,350 an ounce. According to UBS AG gold may reach $1,300 an ounce next year. On the other hand, Marc Robinson, a bullion analyst says, “The most realistic gold price is $800 per ounce.” Marc Faber Limited says gold still has the potential to go under the $1,000 mark, even as low as $800 - $900, suggesting that the current gold price is on a bubble.

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In the short run, due to the price of dollar increase and slight economic recovery, the price of gold might fall significantly. However, as other analysts or firms anticipated, in the long-run, price might increase up to $1,300 or more to $1,500. Due to the uncertainty of the financial crisis, a further decrease of the dollar might have serious consequences on the gold price. It is still too early to say if the world economy is recovering.

M&A Another British symbol about to be swallowed by globalising markets By Ivan Rangelov The globalized nature of markets and the powerful multinational companies are gradually taking on a British identity. The symbol of British car manufacturing Rolls Royce was purchased by BMW, some of the most recognised football clubs are owned by non- British companies or individuals and now another hallmark of Great Britain is about to be internationalised. The well known flavour of most Britons’ childhood (Cadbury) might acquire a more international taste, more specifically American.

Kraft’s hostile offer to Cadbury The American food and beverage producer Kraft Food has started a campaign towards acquisition of the strongest British confectioner Cadbury in the late August. The initial offer consisted of 300p in cash and 0.2589 Kraft shares for each Cadbury share. This approximates to 745p per share. The board rejected the offer in September 7 claiming it is “derisory” and undervalues the future growth prospects of the company. According to the board a price of around 800p per share seemed reasonable. As a result since the beginning of September the shares of Cadbury skyrocketed from between 550-600p to 750-800p. Kraft on the other hand did not fold but made another bid on December 4 for £10.1 billion. The offer still holds the same figures: 300p in cash and 0.2589 Kraft shares for each Cadbury share, which evaluates to around 717p per share. Kraft relies on the absence of counter bidders and is trying to take the most of its time. Kraft’s attempts are facing a strong opposition. The prospect of acquisition is seen by British as serious threat to Cadbury’s employees. A possible wave of shortening the staff and closing of factories is highly expectable. Lord Mandelson, the Business Secretary, announced that if Kraft’s plans are associated with “making a fast buck” out of Cadbury, this would be strongly opposed by the local people and the government.

Britain and 26% of the candy market. This makes it the biggest producer in the British confectionery market. On the other hand Cadbury is performing extremely well in developing markets such as India where it holds around 70% of the chocolate market. Cadbury is performing more than satisfactory on the international scene and surprisingly in the quite well in the biggest and most competitive market for confectionery- the USA. In case Kraft succeeded in its attempt of acquisition, it would strengthen its confectionery portfolio and would gain access to the extensive British market and emerging markets. In the meantime occasional information for counter bidding incentives are circulating the press. The American chocolate maker Hershey, which sells Cadbury’s products under license in the USA, is said to have interest in future merger with Cadbury. Rumours have it that Hershey might team up with Italian chocolate producer Michele Ferrero to launch a joint offer for Cadbury. The position of Nestle is still not quite clear although there are some speculations that the Swiss company might overtake a counterbid. There is no doubt that Cadbury’s markets and portfolio of products are quite tempting and draw an extreme amount of interest from investors and companies.

Why is Cadbury attractive? According to Cadbury’s estimates, it holds 42% of the chocolate market in

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Hot issues Who wants to be a banker in UK? –the effect generated by new levy on bankers’ bonuses By Yu Lu Alistair Darling, the Chancellor of the treasury, delivered his Pre-Budget Report(PBR) on Wednesday 9 December. In order to reform financial services, one of the most important announcements was made in PBR. It stated that a temporary bank payroll tax of 50 per cent will apply to discretionary bonuses above £ 25,000 awarded from 9 December 2009 to 5 April 2010. As a result, if bonuses are paid under the new rules, the total tax cost would be 103.8 per cent of the amount of the bonuses received in excess of £25,000. Details are given below: Bonus paid: Tax levied: BPT* Employee Tax and NICs Employer NICs Total

100% 50% 41% 12.8% 103.8%

* Bankers Payroll Tax There are several key features of the BPT, which are worth mentioning. Firstly, the tax is levied on banks rather than the employees. As the Government stated, the aim is to force banks to develop sustainable long-term remuneration policies and build up their loss-absorbing capital. And second, the BPT currently only applies to the payments made to employees

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by bank or building societies. But the precise coverage of the BPT is very likely to become larger and larger. Additionally, there are further detailed anti-avoidance provisions. It is sure that the supertax applies to loans made from 9 Dec. 2009 to 5 Apr. 2010 where one of the purposes of the loan is the reduction or elimination of BPT or any other tax or national insurance contribution. Last but not least, the period of the BPT is from 9/12/2009 to 5/04/2010, although the Government might consider extending the period of the charge. In fact, Alistair Darling gambled that tax rises, including bonus raid, would be more acceptable so as to lay the foundation for a come-from-behind victory in general election next year. The cut of the deficit will be shared between taxes and spending, in which tax rise accounts for 27%. The Treasury forecasts that the move would raise £550m and would affect 20,000 bankers. On the other hand, it is because of the corporate governance and regulatory reforms. The Chancellor said that he did not wish to impose a windfall tax on the Banks but rather to give them a choice between building their capital or paying bonuses but being ruling by the newly announced levy.

a level of international playing field in financial regulation and taxation. Otherwise the UK’s 2nd position in the global banking industry will be replaced by the emerging markets.

UK government spending spree 2009 By Yingwei Chen In the latest pre-budget report Chancellor Alistair Darling announced the borrowing forecast was revised to £177.6 bn from the previous £175 this fiscal year, with deficit and nation debt peaking at 7% and nearly 60% of national output (see the graphs below), respectively, the highest for more than 30 years. This results in an outcry and concern of Government’s ability to handle its substantially increased deficit. Why and where has the money gone? Since the credit crunch worsened, Government thought it necessary to intervene in the banking sector, and increased its ‘active role’ in the financial market, such

as bail-out of the failing banks (we are familiar with these names: Northern Rock, Bradford and Bingley, Royal Bank of Scotland, Lloyds TSB, etc), printing money in the form of quantitative easing, etc. The fiscal deficit was nearly 7.7 billion pounds on the national account in October, a big contrast to some £ 2 billion in surplus a year ago. A lot of us might say, most countries are doing the same as Britain during the recession. Moreover, IMF also indicates the importance of fiscal stimulus measures to maintain durable growth. However, Shadow Chancellor of the Conservative Party points out that Britain is still the only advanced economy remaining in recession. HM Treasury’s 2009 UK economic forecast is 4.5% down. With interest rate remaining at near-zero level, the Monetary Policy Committee launched its quantitative easing as a means in hope to inject £ 200 billion of credit into the financial market. Lloyds Bank and RBS are the highlights in the government’s bailout. Although both tightly controlled by taxpayers,

As a result, this new BPT arouses the fury among bankers in UK. Some of them even warn of shift to Switzerland and US. On the contrary, the bonus super tax is widely supported in continental Europe. France and Germany intend to apply the similar legislation. However, the BPT will have a substantial effect on the financial services in UK. This move could make the affected institutions uncompetitive. It is important to maintain

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nationalisation has not led to saving of more employment positions, thousands of jobs have been lost this year. What’s the government’s plan for the future? The pre-budget report also outlines taxation plan for the next year, with VAT adjusted back to 17.5%, a super-tax imposed on the bonuses of bankers in the city, maintaining a relatively low tax rate for small and medium businesses and no tax for households’ sales to National Grid. Government has also been criticised for its increasing debt but the Chancellor still defends for the necessity of continued borrowing. There is some good news for the government: unemployment rate has apparently slowed down in October, this can be explained as the blessing of Government’s labour policy, by securing more jobs across the country, jobseeker’s claimant in November fell by 6300. Office for National Statistics says vacancies in the third quarter this year rose by 432,000. Although it is hard to see whether Government policies work, Q3 GDP contracted only by 0.3%, which is a slight improvement in comparison to the previous prediction of 0.4%. According to the data*, expenditure on pension, education and NHS has also risen steadily since 2007. However, since UK economy is badly hit by the global economic crisis there are many uncertainties whether the government could reduce the debt in the next few years. Net debt for 2014/2015 is forecast to be 78% of

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the GDP. Even though David Cameron, the leader of the Conservatives, promises to cut borrowing significantly if they win the next general election, I think it would be a very difficult decision to make. The main purpose to increase government budget is to improve the economy and provide better service for the people. In the face of the borrowing spree in 2009, is Keynesianism already dominant on the policymaker’s mind? Without economic growth, government debt will not improve as a tax raise is not favoured in such economic conditions. Notes 1. *From ukpublicspending.co.uk.

ownership. All repos are driven by the need to lend or borrow cash or a specific security. The US Federal Reserve began transacting repos in 1918 in the form of bankers’ acceptance (BA).It was further stimulated by the Glass-Steagall Act 1933 which bans investment banks from taking customers’ deposits. So for the investment banks to source funding, they turned to repos as they are able to use their portfolios as collateral for borrowing for their investments. As a result of numerous bank defaults during the Wall Street Crash of 1929, lending was spurred by sellers for the repo market i.e. the deposit rich commercial banks. Repos in the Finance Industry

In-depth Repo Markets By Aaron Ong Introduction and History The term repos is an abbreviation for the sale and repurchase agreement. The first transaction that occurs is the purchase or sale of a security- in most cases a government bond-for instant delivery .The second transaction will be the reversal of the first at some future point. The original owner of the security still has economic rights of the asset, which entitles him/her the income and capital gains or losses. Repos have the characteristic of double security because collateral will be relied upon when a counterparty defaults. This has a slightly different meaning in this usage, as this asset undergoes a change of

Repos are used by numerous finance agencies among them, hedge funds. Hedge funds can use their portfolio as collateral to bring in more cash which they can use to invest in new securities. This process can be repeated until it is not possible to further borrow. However if the bond market crashes, margin calls will be made on each repo along the chain forcing hedge funds to sell the assets that were invested in, in this case bonds, to realise the collateral. Swap dealers are exposed to falls in longterm interest rates. Any fall in long term interest rates by the time, he/she does another swap the other way around will result in a loss. To hedge against this risk, the dealer can sell a government bond than borrow it against the cash received from the sale of a reverse repo. Finally, central banks use repos as part

of managing liquidity in the economy. Viewed from the commercial banks perspective, in order to boost liquidity central banks would do reverse repos while the banking system does the repo. In the US these reverse repos are called matched sales purchases (MSPs). Non Traditional Repos Floating rate repos which are common in the French market allows borrowers access to floating-rate funds, which then can be hedged by the dealer using interest rate swaps. However, this repos have a longer term maturity date than fixed rate repos allowing dealers to have secure funding for a longer period of time. In addition, dealers can take spreads between repo rates and LIBOR. This has probably started the financial engineering of repos which would become increasingly sophisticated in the coming future.

Credit Derivatives By Aaron Ong Introduction Over the past decade there has been a rapid rise in the innovation of credit derivatives that has progressed beyond vanilla derivatives to assets that reference complex financial assets, securitised and other structured finance products. In this article, we will explore credit default swaps. Credit Default Swaps Credit Default Swaps, both vanilla and credit index forms are the most common

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type of credit derivatives. The protection seller provides credit protection to the protection buyer for a fee for certain debt instruments (called reference obligations) of a third party (called the reference entity). Hence, there is a transfer of credit risk, the subject of the credit default swap, to the protection seller but not the underlying asset itself. When the reference party goes bankrupt or fails to make principal and interest payments, the protection seller is obligated to make a payment to the protection buyer. The amount of the payment will depend on how the settlement was structured. For physically settled credit default swaps, the protection seller will be obligated to purchase the reference obligations, or other eligible substitute debt instruments of the reference entity to the full face value of the protection buyer. For cash-settled credit default swaps, the protection seller has the obligation to pay a fixed proportion of the face value of the reference obligations or the reference to the fall in the value of the reference obligations. Time until default using Copula Based Model for Credit Risk in Multiname Credit Default Swaps Time Until Default Modelling using survival time principle as used in life assurance calculations. Denoting T0 random variable for time until default having continous density function f0(t), we have the distribution function:

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And the exposure function S(t) denotes the probability that the CDS will survive t years and this can be written as the Hazard rate function as

Where τ is the time horizon and for which yields and the time-until-default follows an exponential distribution with parameter . With the assumption of constancy, the estimation of the one-year default probability is:

Beyond the Vanilla Credit Default Swaps Asset backed securities (ABS) underwent an exponential growth over the last decade which paved the way for credit default swaps that reference asset backed securities. Asset backed securities are securities of financial assets that are securitised which are backed by long term debt, lease or current assets against assets excluding property and mortgage backed securities. These CDS that reference the ABSs’ are most commonly in the form of debt securities issued in cash securitisations. These debt securities are then used to fund the acquisition of diversified pools of income-generating assets where the cash flows that are generated are then utilised to make the principal and interest

payments on the aforementioned debt securities. Since the assets are isolated in an orphan entity, this allows the originator of the assets to transfer the credit risk and all other risks of the assets to the orphan entity, allowing the originator to remove these assets from its balance sheet and for banks, release the risk capital held against those assets. These assets removed are mostly mortgage loans, credit card receivables, auto loans and corporate loans. In addition to transferring credit risks, these debt securities are used to produce transfers of credit risk in relation to funded CDSs, or other debt securities that have incorporated other CDSs. Although the credit derivatives market is seeing maturity especially as a result of the innovation of the past decade, it remains to be seen whether the sophisticated nature of them will be altered after the credit crunch of 2007/2008.

The Black-Scholes Model turned that guessing game into a mathematical science which helped develop the options market into the lucrative industry it is today. Options traders compare the prevailing option price in the exchange against the theoretical value derived by the Black-Scholes Model in order to determine if a particular option contract is over or under valued, hence assisting them in their options trading decision. The Black-Scholes Model was originally created for the pricing and hedging European Call and Put options as the American Options market. The objective of the model is to evaluate the price of an European option call at time t with expiration in T, with an agreed-upon price of K, written on a security or other financial asset, usually a stock, of value S in a market where there are also some other activities without risk as bonds, which have a free-risk interest rate of r. The price can be obtained by the following formula,

The Black-Scholes Model: Obsolete or useful nowadays? By Dario Palumbo The Black-Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options. Prior to the development of the BlackScholes Model, there was no standard options pricing method and nobody can put a fair price to charge for options.

Where: N(•) is the cumulative distribution function of the standard normal distribution. T - t is the time to maturity. σ is the standard deviation of the annualized continuously compounded rate of return on the stock or, better, the volatility in the log-returns of the

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underlying. When this module has been first formulated its creators defined its existence on some simplifying assumptions on the market. There are exact six assumptions of the BlackScholes Model: 1. Stock pays no dividends 2. Option can only be exercised upon expiration 3. Market direction cannot be predicted, hence “Random Walk” 4. No commissions are charged in the transaction 5. Interest rates remain constant 6. Stock returns are normally distributed, thus volatility is constant over time Those axioms are considered the main problem of this formula because they reduce the application in a too restrictive and unreal context creating doubts on its utility in real markets. Now some of those problems can be solved as for the case of the dividends. In this case the formula can be adjusted including the simplifying assumption that dividends are paid continuously, and that the dividend amount is proportional to the level of the stock. The dividend payment paid over the time period [t, t + dt] is then modeled as for some constant q (the dividend yield). Under this formulation the arbitragefree price implied by the Black–Scholes model can be shown to be

where now

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is the modified forward price that occurs in the terms d1 and d2:

There also exists a more accurate version which assumes that the options on instruments pay discrete proportional dividends becoming closer to reality. There are different critiques on this model nowadays, mainly because of the assumptions that the risk-free interest rate and the stock’s volatility are constant. In reality this is obviously wrong as risk free rate and volatility fluctuates according to market conditions. With Black-Scholes, volatility is golden. Consider two companies, Boring Story Inc. and Wild Child Corp., which both happen to trade for $25 a share. Now, consider a $30 call option on these stocks. For these options to become “in the money,” the stocks would need to increase by $5 before the option expires. From an investor’s perspective, the option on Wild Child - which swings wildly in the market - would naturally be more valuable than the option on Boring Story, which historically has changed very little day to day. But in the case of the formula the values for the volatility are constant so that an analysts can only estimate a stock’s volatility instead of directly observing it, as they can for the other inputs, and this means that the price won’t include the possibility that

the volatility will increase increasing the value of the option. On the other side higher interest rates increase the value of a call option, raising the value of a stock option. The interest rates affect options prices because of the importance of the time value of money in options. Consider a person buying options for 100 shares of ManyPenny Inc. with a target price of $20. The investor may pay only a small amount for the option but may set aside $2,000 to cover the eventual cost of exercising the option and buying the 100 shares of stock. When interest rates rise, the options buyer can earn more interest on that $2,000 reserve. As a result, when interest rates are higher, buyers of call options are generally willing to pay more for an option. So, as interest rates vary over time this volatility may make a significant contribution to the real price, especially of long-dated options. This means that if the formula is applied to extended time periods, it can produce absurd results. In the end as you can see, the validity of many of these assumptions used by the Black-Scholes Model is questionable or invalid, resulting in theoretical values

which are not always accurate. Hence, theoretical values derived from the Black-Scholes Model are only useful as a guide for relative comparison and are not an exact indication to the over or under priced nature of a stock option Of course nowadays there are more sophisticated methods of estimating the options price The most widely used alternative, the binomial method, is more flexible than Black-Scholes because it uses a lattice framework. This enables the model to take into account many more assumptions. In any case this model is still one of the most widely used mainly for a conventional wisdom but it can, if used properly, be used to give us satisfactory results.

Other Industries UK retail market: back to growth By Yingwei Chen British retail industry has suffered a great deal of loss of sales since last year. Those crucial factors that influence

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spending such as prices of products and consumers’ income and rate of debt have had negative influences on consumption . Have things become too expensive to afford? Since October of 2008, Consumer Price Index (CPI) dropped significantly from over 5% to only 1% in the same period in 2009, household expenditure also dropped 3.2% , according to the latest report released by Office of National Statistics(ONS). However, the fall of CPI was a result entailed by the slide of the whole economy. UK GDP in Q3 has lost 5.1% compared to 12 months ago. A weak economy does not encourage spending as consumers now are worried about jobs, mortgages, pensions, etc, so that a lot of people in the country decide to cut back in case should they suffer any financial difficulties. What happened to the high street shops? Retailer Marks and Spencer ‘s adjusted

profits of this year fell by 400%, down to £604.4m, with both clothing and food falling by over 5%. Retailers were badly hit by the gloom of the economic crisis which spread from the banking sector. Unemployment rate climbed from less than 6% to nearly 8% between July 2008 and Sept 2009, even people with jobs were concerned about their employment. Figures from British retail consortium and KPMG say that retail sales values rose by 1.8% since last November whereas sales decreased by 2.6%, which was caused by the loss of confidence as financial market worsened. Is it getting worse? However, adjusted volume of sales in October 2009 is over 3.4 % higher than a year ago, with food sector and nonfood contributing by 1.6% and 3.5%, respectively. Textile (eg. Clothing) is the biggest contributor to the rise, 10% up during this period. This can be explained as goods and services became more affordable as prices fell(especially food and clothing products) since last year.

Moreover, in October inflation was 0.4% up from 1.1% in September. Data from ONS indicates that the UK retail market is now improving. September was a turning point of UK’s prices, which began to rise since 7month fall. Relatively cheaper goods and services is the main reason retail market improves. Internet shopping sees its rise in sales. It increased from just 3.2% to nearly 4 % between August and October. Consumers’ shopping method and lifestyle have changed a lot as technology improves. Online shopping is not only a more convenient way but also a platform where you can find the best price for you. Ecommerce will become a potential threat to high street shopping in the next few years. Let’s take a look at UK’s economic output: Q3 production is 5% down from last year, though at its slower pace of decline. Since consumption is one of the most important elements in real GDP, the rise in people’s spending has greatly contributed to the economy. Pessimism vs Optimistism Still, Britain is the only G8 country which remains in recession, even though data of the market showing that Britain is slowly coming out of the gloom. Government spending forecast has been adjusted to £177.5 bn in 2009 from Chancellor Alistair Darling’s prebudget report. However, recovery in retail market can be deemed as a step of walking out of recession. Stephen Robertson, director-general of British

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Retail Consortium, thinks that ‘consumer confidence is fragile and has taken a turn for the worse’. Notes 1. RPI: Retail Price Index, it is a preferred measure of change in prices of a series of goods and services by the UK government. 2. RPIXL: retail price index with mortgage interest payment excluded. 3. CPI: Consumer Price Index, a measure of average prices of goods and services purchased by housedholds. A very common method of measuring inflation. 4. In the second diagram: Growths refer to the growth compared to the previous quarter and that compared to the previous year.

The Shipping Industry after the Meltdown By Dario Palumbo During boom times, shipping was expanding so fast that a slump seemed impossible. But the impossible happened, the Baltic Dry Index (BDI) fell below 1,000 for the first time in six years and now the shipping industry, along with related exchange traded fund, are searching for a firm direction. Baltic Dry is a number issued daily by the London-based Baltic Exchange, which traces its roots to the Virginia and Baltic coffeehouse in London’s financial district in 1744. Every working day, the Baltic canvasses brokers around the world and asks how much it would cost to book various cargoes of raw materials on various routes—150,000 tons of iron ore going from Australia

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to China or 150,000 tons of coal from South Africa to Taiwan. Brokers are also asked to consider variables such as the type and speed of the ship and the length of the voyage. Because it provides ”an assessment of the price of moving the major raw materials by sea”, it provides both a rare window into the highly opaque and diffuse shipping market and an accurate barometer of the volume of global trade. In the past the real force behind the BDI’s rise was China. To put it in extremely simplistic terms, China was importing enormous amounts of raw materials and exporting manufactured goods, and that was drawing ships into the Pacific. The Baltic index changed this trend a year ago. The index has dropped 89 percent last year, driving down the combined market capitalization of the 12-company Bloomberg Dry Ships Index, led by Athens-based Diana Shipping Inc., to $5.5 billion from $32 billion a year ago. Under those conditions Shipowners, reducing the prices in order to boost the demand, have taken steps to reduce costs in, for instance, trimming vessel speeds to save on fuel costs. The average capesize is sailing at 8.54 knots, down from 10.33 knots in July 2008. Now a day’s

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Capesizes are attracting rates of $7,340 a day, close to daily operating expenses of about $6,000. “You are getting very, very close to the cost of just crewing and running a ship,” Richard Haines, a senior director at London-based shipbroker Simpson, Spence & Young Ltd., said in an interview recently. “It can’t go much lower than this without owners deciding they don’t want their ships employed.” One of the consequences is the formation of the ghost fleet anchor in the north east of Singapore that includes vessels of different shipowners from all around the world. A couple of years ago those ships would have been steaming back and forth, going at full speed. But now around 12 per cent of the world’s container ships standing idle. But this situation doesn’t seem to be reaching to an end. Last year Zodiac Maritime Agencies Ltd., the shipping line managed by Israel’s billionaire Ofer, said that it may idle 20 capesize ships, which typically haul coal and iron ore. That’s about 5 percent of the fleet operating in the spot market. Some experts believe the ratio of container ships sitting idle could rise to 25 per cent within two years in an extraordinary downturn which shipping giant Maersk has called a ‘crisis

of historic dimensions’. Recently the company reported its first half-year loss in its 105-year history.

when order is placed and delayed in three or four stages of payment, closed with a 50 to 60 per cent paid on delivery.

One of the main consequences of this situation, according to Fearnley Fonds ASA, an investment bank specialized in shipping, energy and oil services, is related to the possibility for a significant number of commodity shippers to fail within two years. Britannia Bulk Holdings Inc. has “severe” financial difficulties and a “very high risk” of being in default on a $170 million loan, the London-based commodities shipping line said in a statement distributed by Market Wire a couple of months ago. Industrial Carriers Inc., a Ukrainian operator of about 55 vessels, filed for bankruptcy last year.

With contracts signed, down-payments made and work under way, stopping work on a new ship is the economic equivalent of trying to change direction in an ocean liner travelling at full speed towards an iceberg. Thus the labour of today’s Korean shipbuilders merely represents the completion of contracts ordered in the fat years of 2006 and 2007. Those ships will now sail out into a global economy that no longer wants them. Maersk announced a couple of months ago that it was renegotiating terms and prices with Asian shipyards for 39 ordered tankers and gas carriers. It is easy to see that at this point some ship owners won’t be able to pay their final instalments when the vessels are completed. So for now the shipyards are continuing to work, but the problems will start to emerge next year and certainly in 2011, because that is when the current orders will have been delivered. There have hardly been any new orders in the past year. In 2011, the shipyards will simply run out of ships to build.

The problem here is that we can’t see the bottom yet because there are still several new evolution of which we can’t keep track of especially when it comes to the orders of the new ships. The biggest number has been ordered three years during the boom of production in the Asian markets, especially in North Korea. A decade ago, South Korean President Kim Dae-jung issued a decree to his industrial captains: he wished to make his nation the market leader in shipbuilding. Thus, by 2004, Kim Daejung’s presidential vision was realised. His country’s low-cost yards were winning 40 per cent of world orders, with Japan second with 24 per cent and China way behind on 14 per cent. But shipbuilding is a horrendously hard market to plan. There is a three-year lag between the placing of an order and the delivery of a ship in addition to the form of payment that takes a ten per cent down

Fortunately in recent times it is possible to see some signs of recovery. Business for bulk carriers has picked up slightly in recent months, largely because of China’s rediscovered appetite for raw materials such as iron ore, and the BDI has start rising again. But this is just a small part of international trade, and for now the prospects for the shipping market remain bleak. Finally, Baltic Dry isn’t a Latvian deodorant or an Estonian cocktail.

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About the Investment & Finance Society at the University of York A letter by the co-founder of IFS Aaron Ong The Investment and Finance Society was set up on December 2008. The society was established to fill a gap in promotion of investment and finance related interests among students as well as providing a gateway for recruiters to reach out to students. We were founded with these aims: • To provide education and training on the various investment instruments and effective techniques of utilising them. • To provide exposure to the various Alternative Investment strategies available. • To promote inter-university investment societies links through joint events. • To invite guest speakers from investment banks, hedge funds and private equity firms in order to give insight in to the industry to University of York students. • To provide personal financial management training. • To be the first stop for recruiters when it comes recruitment events. • To set up a student fund towards building up investment experience of members. Since the society’s founding, it has been a focal point for high calibre and finance focused students. We believe that this market reports publication will showcase the varied interest and potential of our members Aaron Ong 2008/2009 President of the IFS

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Structure of the society(2010): President: Arek Wylegalski Vice-president: Lee Jian Yang Secretary: Aaron Ong Treasurer:Alex Hristea Social Officer:Ngare Muhindi Events Officers:Joe Briggs, Marcin Kopczynski Publicity Officers:Angela Valeva,Matt Ovenden Student Fund Manager: Dario Palumbo Student Fund Manager: Tomi Lupsakko Editor of the Market Report: Yingwei Chen Editor of the Market Report: Ivan Rangelov Editor of the Market Report: Frank Williams Operational Officers:Chris Selby,Aulia Beg Analysts for the Market Report: Akihiro Takemura Jeongho Park Yu Lu Patricia Nguyenova Contacts: University of York Investment and Finance Society IFS University of York York, YO10 5DD http://yorkinvestment.com/


IFS Market Report Issue I