Finally done with two assignments

Okay, I finally finished my Financial Risk Management assignment after working on it for so long - it was fun though as we were working on real data and were analyzing the current crisis in terms of risk management. We looked at a 5 day period in October when there were more than 5% gains and losses on the FTSE 100. Also tried to predict the VaR and Expected shortfall for some days in November. The assignment helped give me a better picture of how the theory works in practice.

Also, finished one of my special topics assignment. Left Energy Markets and studying for Financial Markets exams...I guess I must be getting old because I don't really feel the kind of panic I used to get when exams are near. Either that, or I'm just exhausted with all these assignments. Anyway, will be glad that it will all be over soon.

The Warren Buffett Way, part deux

The more I read the book and keep up with the current financial news, the more impressed I am with Warren Buffett. In the current banking turmoil, Wells Fargo has done better than expected as it is not as burdened by the subprime mortgage paper pitfall. Recently Coca-Cola registered a profitable third quarter as compared to its rival PepsiCo. Coke and WF are some of the companies Buffett has a stake in.


These two companies were also featured in the book. These two companies illustrates some of Warren Buffett's strategies which I really admire:


1. Know the companies very well; its assets and core business, its record of consistency, and favourable long term prospects - so do your research
2. Place importance on trustworthy, honest, rational, independent thinking, and exellent managers.
3. Value of the companies - whether buying at under the value or a fair price, you need to know the intrinsic value of the companies. This is where Williams' model come into practice.

And recently, he was quoted as saying, "Be fearful when others are greedy, and be greedy when others are fearful" and advising people to buy stocks now. The editorial in the Financial Times (dated 21/10/08) said that it is not so easy for investors to follow as they are not sure when is the lowest.

However, if you were to follow the book, Buffett does not just buy indiscriminately but buys undervalued companies at bargain prices. Even if the prices were to go lower, it will not matter as much as he believes that these undervalued companies will sooner or later realise their actual values. Also, since he invests mostly long term, the subsequent returns over the long term will not be much different.

Of course, the editorial comment had a point, which is why I especially liked Bloomberg's advice following Buffett's. He mentioned that for small investors, best to invest in mutual funds and do it over certain period of time. For example, say do it monthly over a period of six months. Your investment would most likely have an averaging effect.

The Warren Buffett Way (second edition)

This book is one of the five "optional" books that we've to read (and testable) for Financial Markets. I've just read the first four chapters and I'm already impressed! His strategy makes sense. If I may summarise the first four chapters:

Buffett's investment strategy is shaped by four men: Graham, Fisher, Williams, and Munger. From them, he synthesized the following - a need for margin of safety, control of his emotions and therefore use market fluctuations to his advantage, have as complete understanding and knowledge of the company as possible, investing in companies with above average potential and capable management, a good model for the intrinsic value of the business, and paying a fair price for quality companies.

Based on these, his strategy puts forward the following criteria:
1. Simple, undertandable business
2. Consistent earning power and possess good economics
3. Little debt as possible
4. Trustworthy managers/management team

And of course, the fundamental idea behind his strategy is basically that he is the owner of the business whether he buys a business or buy stocks in the business. Long term commitments instead of short term holding.

As I was reading, I recalled how my father lost a lot of his savings when he was playing the stock markets in the 80s. Part of the fault lies in the little understanding of the companies and dangerous strategy to make money from any arbitrage opportunities. I'm also wondering how I could apply to my own investment strategy. Given that my investments are mostly in mutual funds, it's definitely not easy to know who the managers of these funds are and my knowledge is limited to the prospectus and annual reports given out. Well, I've got more chapters to go. So, perhaps the answer will come along the way.

The Credit Crunch

First, it was the subprime market that fell, then it was investment banks failing, now it has spread to many major banks all over the world...leading to (possibly) the Bankruptcy of a sovereign country - Iceland. Next, they say, will be the economic downturns and recessions. In a global economy where credit and debt are the underlying forces moving it, this is definitely a recipe for disaster as the banks are hoarding their capital and interbank loan rates skyrockets. In the cycle of credit and debt, the economy is basically fueled by consumer spending - the more you spend, the more you need to borrow and therefore the more "profit" is made from the credit. This unchecked spending/lending has led to the credit crunch where even large banks are defaulting on their own debts. From a book I'm reading, it highlight two very important deficiencies of the present system:


1. A debt-based system needs an effective lender of last resort and right now, it's been proven that we don't have one. The banks are looking to the Governments to bail them out but as Iceland proved, even sovereign countries may go bankrupt.


2. A debt-based system need debt restructuring and workout mechanism which as can be seen currently, even the US is grappling with this issue.


Right now, there is talk of needing a new model or better regulation. However, without changing the fundamental and here, I mean, the debt-based system itself, I seriously don't think the economy can sustain itself in the long run even if we get out of this crisis unscathed.


An economy that can sustain itself, I believe, has to be founded on justice and equitability. Justice in such that the gap between the poor and the rich do not widen but instead will close. What constitute a just economy? Well, based on what I've read:
1. equality in opportunities for all and in utilizing the natural resources (no hoarding of resources by a few or due to "national" interest)
2. just exchange and distribution of goods (was thinking of how in the zero-sum "game" economy I wrote in my blog earlier, this just/equitable exchange is unlikely to occur.)

Definitely, a debt-based system where the poor gets poorer as they get further into debt fail this test of being a just system. With the kind of economy founded on justice, there has to be a regulatory body (global) to ensure justice is served. Perhaps, our leaders are brave enough and will take this opportunity to change the current system...not that I'd hold my breath on it.

Model Risk - Illiquidity

Being Sunday and a brilliant day to boot, I decided to go to Holyrood Park. Climbed the first hill (well, midway) and because it was almost 1 pm, decided to have lunch and enjoy the sun there. With a view over the park, most of Edinburgh and the sea (well I think it is the sea), I finished lunch and started to enjoy my book on quantitative risk management. Amidst VaR and loss functions, the chapter I was reading discussed the importance of model risk in risk management. One of these is actually the ability (or inability) to capture the illiquidity of the situation. It gave the example of LTCM but I was thinking of the current situation of the bailout and the challenges the Fed face in pricing the bad assets when the market's liquidity is almost nil. The book gave a few references of works done to include this liquidity/illiquidity as a risk factor. Managed to get two of the papers and hopefully read them soon. Very interesting, indeed.

Islamic Finance Part 2 - credit/debt-driven economy

Merrill Lynch, Lehman, AIG, HBOS? What's next? This article is a good read on one of the underlying factors causing the failures of these organizations. The main problem with the credit crunch is that it is driven by debt, debt-securities and derivatives/instruments. That is exactly the problem that perplexes me the most.

In my life, the one rule to do with finance that I follow is a wisdom that my father passed down very early to all his children, i.e. "Live your life free from debt." It is such that I dread using the credit card and makes sure that I can pay my bills on time - never borrow on credit. I know of several of my friends who live by this maxim too. One of them even bought her car in cash!

As I grew up, I realize that the wisdom was an actual wisdom that Islam promotes for its financial sector. Coupled with its prohibition on interest rates/usury, Muslims are discouraged to spend with what they do not have. That means, in financial terms, the practice of borrowing from the bank to buy equities/other financial instruments are frowned at. This is because of the interest rates of the bank for one and second, you do not have the underlying asset to pay off the debt in the case that the prices of these instruments fall, as we see it doing right now.

Of course, this does not extend to things like financing your business or car/home loans. The way Islamic finance deal with these matters is through either a shared-partnership schemes in the case of the business or in which they retain ownership until such a time you have fully paid the price of the car/home. Of course, this is from what little I've read. The actual process is slightly more complicated but basically the foundation is not debt-driven. Allah knows best...

Islamic Finance

Read this interesting article: Al-Suwailem, S. (2000) Towards an objective measure of Gharar in Exchange. Islamic Economic Studies. Vol 7, No. 1&2, pp. 61-102.


His paper is very interesting as he defined Gharar, not as uncertainty and risk as in the traditional sense, but a zero-sum game (that is, in order for one to win, the other must lose). He argued quite well using Islamic and non-Islamic sources that one important Islamic principle, the eating of others' money for nothing, is reflected strongly by the zero-sum exchange.

He then suggests a measure of Gharar based on the Shariah: Y(d) = sum_w(p_iy_i) - sum_w'(p_iy_i) where Y(d) represents the net cooperation value for a given player from exchange d. The probability of state i = p_i , y_i = payoff of state i. w = set of states for win-win while w' = set of states for win-lose or lose-lose. So a negative value indicates a zero-sum exchange which is undesirable.

What I find interesting is really his arguments which gives me some insights into Islamic finance. With the argument of zero-sum exchange, I see why gambling is illegal, not so much as the uncertainty and game of chance, but that it is an extreme form of a zero-sum exchange where there is definitely no possibility of a win-win situation. In order for one to win, others have to lose.

That is in contrast with the lucky draws that we always organize in Singapore. I've always wondered why lucky draws are deemed to be legal Islamically. Now I understand. In gambling, the players have to set their bets - which means there will be negative payoffs (a set of winners and losers)...in the lucky draw, the players do not contribute anything, so there is no losers, only winners (payoffs are always positive). Using the Gharar measure, w' will be an empty set and the net cooperation value should not be negative.

That helps set the tone for the financial organizations for more cooperative contracts rather than competing ones. Will write more on this later.

Understanding investment theories

Okay, I've been reading this book entitled "Investments" by Sharpe, Alexander, and Bailey. I'm also starting to read on "Derivative Securities" by Jarrow and Turnbull. Really, mind boggling...I thought I am quite savvy about investments, but little did I know.


Anyway, read about all types of instruments used for investments like call/put options, short selling, etc. So buy = long and sell = short. While I understand the dynamics of short selling, it doesn't make much sense to me. How is it possible to sell something that you don't own?

Another concept is the interest rates and present values. Seems like today's money is worth more than tomorrow's money. That means that not only does our wealth decreases with time, but to make up for it, we would need to use more and more resources to maintain the same level of wealth...hmm, given we have finite resources, is that why we're having all these crisis of food shortage, poverty, and so on? No wonder, we are called the consumer society.


I do understand that the argument that if you invest now, your money will grow...but that is not the same as "today's money is worth more than tomorrow's." Because of inflation and other factors, our purchasing power decreases even as we invest the money. A return of $100 in 5 years for every $100 we invest now (nominal return) may not have the same purchasing power if we had obtained that return today.


So, something is seriously wrong with our economy if my intepretations of what I'm reading are correct.