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Money with an Intrinsic Value

admin — Wed, 29 Apr 2009 21:43:35 +0000

For most of human histor y societies have functioned without money. The development of tokens to represent value is a relatively modern development and for thousands of years those tokens were deemed to have an intrinsic value. It is only in the last 500 years or so that money has been represented by tokens with a legal status but no intrinsic value. At ﬁrst such notes were issued backed by real physical assets (gold) but today that linkage has been completely broken. The most commonly used mediums for money in historic times were gold and silver. Other more exotic currencies, to our way of thinking at least, have included salt and cowr y seashells. Gold in par ticular has always had a fascination because of its unique physical qualities. Gold does not tarnish as silver does or rust as iron does. It can be beaten into extremely thin leaf.
It has attractive, decorative qualities and is used widely in jewelr y. It is of a uniform standard – gold from Egypt cannot be distinguished from gold extracted from the New World. This is not the case with organic products such as coffee or saffron. At the time of writing the price of saffron was around $400 an ounce, in line with that of gold, but prices var y depending on quality and source. Gold also has a scarcity value. It is not a common element and is difﬁcult to extract from the ground. It is a ver y dense element and requires little storage space.
When gold is used as a medium of exchange it provides a way in which different products and ser vices can be given equivalent values in terms of a given weight of gold. To illustrate this point we use a highly stylized example taken from Dreamworld.
Dreamworld is a wonderful place where cream and chocolate are not fattening and air planes leave on time. When necessar y in Dreamworld we can assume no transaction costs, no taxes, no bid–offer spread, we can borrow or lend what we choose at the risk-free rate whenever we want, companies pay dividends only when required, there is no counter par ty risk and we don’t need to worr y about capital allocation issues! Dreamworld has a ver y convenient location and is populated largely by ﬁnance academics. One group can use the power of its simplifying assumptions to formulate fundamental theories. The second group woks on how to modify these theories to take the chosen assumptions into account.
In this example we will ignore the costs of capital investments, taxes and transaction costs, the impact of skill levels on labor costs and so on. We will take only human labor into account. Suppose it takes 10 days of human labor to produce one ounce of gold, ﬁve days to make a table, 20 days to build a car t and one day to clean a house. For the markets to be in equilibrium the table should be sold at half an ounce of gold, the car t for two ounces and the cleaner should get one-tenth of an ounce for his daily efforts.
In periods of high inﬂation or uncer tainty over the future value of paper money many people turn to gold as a way to preser ve value. A paper currency may lose all of its value in the event of a regime change or a militar y defeat. Gold hidden in a hole in the garden provides a way to preser ve value. It is a generally accepted axiom (although not always borne out by facts) that the price of gold rises in terms of political and economic uncer tainty. There are, however, signiﬁcant problems with using tokens that have an intrinsic value as money:
Transaction costs. Gold is completely negotiable and there is no foolproof way to establish ownership. Gold ornaments or coins can be melted down and recast as standard bars. Its density makes it difﬁcult to move large amounts easily and this also makes it vulnerable to loss. The physical deliver y of gold involves risks arising from natural disasters such as a ship sinking in a storm or human inter vention in the form of theft. Gold has to be kept in a secure location and shipments require tight security. Transport has been both slow and difﬁcult for most of human histor y. All of these factors push up transaction costs.
Costs to the economy. Gold’s intrinsic value comes from demand for its use in jewelry, in specialist applications such as the decoration of churches and temples and, in modern times, in the electronic and space industries. Gold extraction requires signiﬁcant capital investment and labor and is the source of damaging environmental pollution. Using gold as a medium for money ties up capital and human resources that could be used in a more productive manner. King Midas learnt the hard way that gold cannot satisfy human hungers.
The world’s central banks all have vaults where they store their gold reser ves. Between them they hold thousands of tons of gold. The US gold reserve is held at Fort Knox, one of the world’s most secure facilities, where it is jealously guarded. At least squirrels use their hoards to help them sur vive the winter. There is something delightfully ironic about a system where one group of people expend huge effor t to extract a metal from one hole in the ground which is then sold to another group of people who, at huge expense, put it in their own hole in the ground.
Supply and demand. Our simple example showing the equivalence of values in gold based on labor inputs looked only at the supply side. Suppose that demand for car ts exceeded that which could be produced. In this situation car t builders might be able to sell each cart they made at 21/2 ounces of gold. This would attract people making tables or digging for gold to switch to making car ts and would result in a reduction in the supply of gold and tables, pushing up the price of tables relative to car ts and lowering the price of car ts in terms of gold. This would continue until equilibrium between the markets was re-established.
When the Spanish discovered huge quantities of gold in the New World, much of it already extracted and reﬁned, they thought they had made their for tunes – and many of the early conquistadors did. But the huge inﬂux of gold had a much wider impact. With the supply of gold (money) expanding rapidly the price of real goods and ser vices in terms of gold rose. In modern times this would be seen as a period of high inﬂation. There was no change in the real output of the Spanish economy but a transfer of wealth took place from those who had held gold as a store of value and those on ﬁxed incomes to people who had invested in real assets.
Debasement. A gold or silver coinage can be debased in one of three ways. Ver y pure gold is ver y soft and is usually mixed with a base metal, such as silver, to make a harder alloy. A carat, or karat, is a measure of the propor tion of precious metal in an alloy. Twenty-four-carat gold is pure gold while 18-carat gold is 18/24 or three-quar ter gold. The authority to mint coins in medieval times usually rested with the monarchy.
A king could make his gold go fur ther by increasing the level of silver contained in newly minted coins. In some instances the coinage in circulation would be recalled, melted down and reissued in a debased form. For obvious reasons people preferred to hold onto older coins with the same nominal face value but a higher gold content. People tried to pay for goods and ser vices with coins that had the lower gold content. This is the basis for what is known as Gresham’s law, “Bad money drives out good money”, after Sir Thomas Gresham the master of the royal mint in the reign of Elizabeth I. In modern times the US dollar has become the preferred currency in many developing and transitional economies. This reﬂects greater conﬁdence in the US dollar retaining its value and being conver tible than in the local currency.
A second method was to shave metal off the edges of the coins. To tr y to prevent such practices coins were produced with serrated edges. Most countries continue to produce coins milled in this manner but the serrated edges are now only useful in slot and vending machines. The last method was to take a lower value base metal, such as lead, and to produce counterfeit gold-plated coins.

Functions and Roles of Money

admin — Wed, 29 Apr 2009 16:41:32 +0000

Money is a commodity that we tend to take for granted. Most of us think of money as cash, but cash is just a small por tion of broad money. Most ﬁnancial transactions are conducted using checks, electronic transfer of funds or credit cards. Economists have a number of different deﬁnitions of money. We do not need to deﬁne these here par ticularly as deﬁnitions vary from country to countr y and this is ver y much moving into the realm of macroeconomics. It is, however, worth reviewing the three fundamental functions that money performs.
Accounting basis. Money provides a means of accounting for the value of real goods. It allows, for example, one to compare the cost of a cup of coffee with the price of a telephone call.
Store of value. Money represents a form of savings, whether it is in the form of a bank deposit or cash. It provides a means of making purchases of real goods and ser vices in the future. It is not a good store of value in an inﬂationary environment, however.
Means of exchange. Money provides a means of exchange for real goods and ser vices. In the absence of money transactions between two par ties would have to be done on a barter basis. Bar ter is a ver y inefﬁcient means of effecting transactions. Money reduces transaction costs and makes the real economy more efﬁcient.
The ﬁrst subjects to examine are how money is created and the role of banks in that process. In most countries the central bank controls how much money is created. The creation of money has always reminded me of a magician’s sleight of hand. While your intellect tells you one thing no matter how many times you see the trick it is still impossible to work out how it is done. The ancient street hustle of the “three cup” trick is a good example. In the case of money the con is contained in the word conﬁdence.

ACCURACY OF CORPORATE LOSSES

admin — Sun, 26 Apr 2009 11:17:29 +0000

Risk management is a hugely information-hungry process. Keeping an up-to-date record of banking or fund winners and losers is a data-intensive exercise. Completeness and the accuracy of the data are the bedrock for corporate scrutiny. Banks can be strange animals when it comes to releasing data; they may not even be fully aware of their own proﬁtability. The new Basel II regulations will try to enforce mandatory reporting of proﬁts and losses in detail. This is where the Basel II regulations come in to encourage more banking transparency. Losses are bad news, and sometimes nothing is worse than the embarrassment of a public loss or reputational damage.
A failure or degradation in these operations tends to make existing customers and counter-parties defect, resulting in an economic loss to the ﬁrm. Reputational effects are particularly important for larger more well-known retail banks in competitive markets whose customers can easily transact elsewhere.
Knowing how much you have lost, and why, is a sign that you are making progress in retailing. Knowing how to stop or reduce your losses is an indication of business success. These are known as “risk triggers”, while in auditing they are called “red ﬂags”.
Adapting this sort of analysis would be useful in banking and fund management. Furthermore, on the larger corporate scale, banks under the stiffer Basel II operational risk measures will rarely wish to confess to the central banking authorities that they are “banks at risk”. Certainly, banks rated as more risky will be forced to pay higher operational costs in terms of a capital adequacy ratio of reserves held in the central bank under new Basel II rules. We can adapt one feature, the recording of losses, from the Basel II banking regulations and adapt it for the retail industry. This forms the ﬁrst one-line building-block approach of our Basel II Loss Database for dealing with operational risk in the ﬁnance industry. This is a simple prototype approach towards identifying areas for monitoring, i.e. being risk proactive against solely reactive. It can identify business areas for improvement, certainly when you data-mine by business lines and deeper detail. This is a potentially rich area for business intelligence development.

Financial Innovation and Derivatives

admin — Fri, 24 Apr 2009 11:01:51 +0000

The investment diversity desired by households is far greater than most businesses have a desire to satisfy. Most firms find it simpler to issue “plain vanilla” securities, leaving exotic variants to others who specialize in financial markets. This, of course, creates a profit opportunity for innovative security design and repackaging that investment bankers are only too happy to fill.
Consider the astonishing changes in the mortgage markets since 1970, when mortgage pass-through securities were first introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae). These pass-throughs aggregate individual home mortgages into relatively homogenous pools. Each pool acts as backing for a GNMA pass-through security. GNMAsecurity holders receive the principal and interest payments made on the underlying mortgage pool. For example, the pool might total $100 million of 10 percent, 30-year conventional mortgages. The purchaser of the pool receives all monthly interest and principal payments made on the pool. The banks that originated the mortgages continue to service them but no longer own the mortgage investments; these have been passed through to the GNMAsecurity holders.
Pass-through securities were a tremendous innovation in mortgage markets. The securitization of mortgages meant that mortgages could be traded just like other securities in national financial markets. Availability of funds no longer depended on local credit conditions; with mortgage pass-throughs trading in national markets, mortgage funds could flow from any region to wherever demand was greatest.
The next round of innovation came when it became apparent that investors might be interested in mortgage-backed securities with different effective times to maturity. Thus was born the collateralized mortgage obligation, or CMO. The CMO meets the demand for mortgage-backed securities with a range of maturities by dividing the overall pool into a series of classes called tranches. The so-called fast-pay tranche receives all the principal payments made on the entire mortgage pool until the total investment of the investors in the tranche is repaid. In the meantime, investors in the other tranches receive only interest on their investment. In this way, the fast-pay tranche is retired first and is the shortest-term mortgage-backed security. The next tranche then receives all of the principal payments until it is retired, and so on, until the slow-pay tranche, the longest-term class, finally receives payback of principal after all other tranches have been retired.
Although these securities are relatively complex, the message here is that security demand elicited a market response. The waves of product development in the last two decades are responses to perceived profit opportunities created by as-yet unsatisfied demands for securities with particular risk, return, tax, and timing attributes. As the investment banking industry becomes ever more sophisticated, security creation and customization become more routine. Most new securities are created by dismantling and rebundling more basic securities. For example, the CMO is a dismantling of a simpler mortgage-backed security into component tranches. AWall Street joke asks how many investment bankers it takes to sell a lightbulb. The answer is 100—one to break the bulb and 99 to sell off the individual fragments.
This discussion leads to the notion of primitive versus derivative securities. A primitive security offers returns based only on the status of the issuer. For example, bonds make stipulated interest payments depending only on the solvency of the issuing firm. Dividends paid to stockholders depend as well on the board of directors’assessment of the firm’s financial position. In contrast, derivative securities yield returns that depend on additional factors pertaining to the prices of other assets. For example, the payoff to stock options depends on the price of the underlying stock. In our mortgage examples, the derivative mortgage backed securities offer payouts that depend on the original mortgages, which are the primitive securities. Much of the innovation in security design may be viewed as the continual creation of new types of derivative securities from the available set of primitive securities. Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks. However, derivatives also can be used to take highly speculative positions. Moreover, when complex derivatives are misunderstood, firms that believe they are hedging might in fact be increasing their exposure to various sources of risk.
While occasional large losses attract considerable attention, they are in fact the exception to the more common use of derivatives as risk-management tools. Derivatives will continue to play an important role in portfolio management and the financial system. We will return to this topic later in the text. For the time being, however, we direct you to the primer on derivatives in the nearby box.

The treasurer’s role

admin — Thu, 16 Apr 2009 11:55:43 +0000

Traditionally, the role of the treasurer and of the middle ofﬁce was the in-house policeofﬁcer. The role of position keeping ﬁtted in this domain. The treasurer may reduce losses according to how effective these risk management structures prove.
Thus, the treasurer acts as the paymaster and policeman of the modern corporation. This is a job function that is extended outside the traditional realm of accountancy. Where front ofﬁce and back ofﬁce controls have been exposed as being weak – the treasurer or the chief risk ofﬁcer (CRO) must beef up risk management. The treasurer and the CRO are two different people, working in autonomous departments. The treasurer and the middle ofﬁce are given their risk management role on these lines:
1. Risk analysis to evaluate risk scope and business objectives, determining potential sources of danger or risk.
2. Design the risk template, outlining the event, likelihood of the event occurring and the damage from the event. This forms a risk-event matrix or risk register.
3. Deﬁne the risk involved, the people and departments assigned to it, and how to solve likely problems.

INVESTMENT MANAGERIAL CONTROL

admin — Mon, 13 Apr 2009 11:55:36 +0000

A successful ﬁnancial dealing environment requires uniﬁcation of the various species of investors.
1. Managers require a high level of people interaction skills, of which risk management is only one.
2. Successful trading needs an instant eye for distinguishing a good buy from a dud.
3. Recent entrants of the risk managers, including the quants and geeks, who are familiar with the relative probabilities of the ﬁnancial risk. CAPM, Monte Carlo or VaR are just a few portfolio dishes on their menu.
So, the market is requires at least three types of investor types – few companies have the desired balance of these types.