Saturday, September 12, 2009

An interesting hypothesis about a career in finance

As I have experienced some practicalities of the market in the past , have had a formal knowledge of finance , seen few people who succeed and few who have failed in the field of finance , I wanted to hypothesize the ‘could be’ reasons for being successful in finance

I would attribute the success in finance to only three factors..
1. Knowledge of economics
2. Risk taking ability
3. Understanding people

Knowledge of Economics: The mother of finance..The field of economics has been existing even before the existence of money …A thorough understanding of this subject is necessary to master finance(Be it trading , be it corporate finance or Structuring of products in a IBank , Assessing the credit risk in a bank loan portfolio)..

Just look back , if there was some rationale while designing all the ‘structured finance products’ like CDO’s , would there have been a financial crisis..Is it the greed of some of the wreckless bankers to blame or should we pity the ignorance of those bankers who were not able to understand the basics of economics and thought the prices of house will always go up(Or where they believing fools theory will work always…)

It is like a Value at Risk for options …The so called traders earn lakhs every year only to lose crores on a particular point of time , finally ending up with less than risk free rate of return..The most rational(who understand economics) always expect little more than the risk free rate(to compensate for the risk that they take) and earn them consistently..

Risk taking ability :

This is one another important aspect to be successful in the field of finance..How much of a risk can you bear in your belly??

I was the first guru to my friend ‘Manikandan’ to do trading during the third year of my UG at CEG..I was pretty comfortable with most of the technical terminologies , was able to predict the market movement etc…At a time when I was trading with 5000 , mani pulled out a 1.5 lakh rupee loan from the bank and started trading(that was a real surprise for everybody)…After a year ROE for both of us was around 20% …Obviously the difference showed up in the magnitude of profits…(not to mention that his taxes last year was in lakhs!!)

Both were rational..Both understood the market…The only difference which separated us was the risk taking ability..It could have gone either ways for him..But it was that calculated risk taking which made him succesful..

Buffet bought stocks which were shunned by investors ..There were stocks like GEICO which dropped to the point of near bankruptcy and almost every investor sold it off...but Warren Buffet invested billions in that stock during that time believing in that stock..That is risk taking ability...

When i mentioned the example of my friend , I don’t mean to say that you have to leverage through loans every time…When you believe in something, when you think that you are not investing the essential money for a risky proposition(essential money – money that might be needed to fund your college fees , or to pay your house loan etc), then go invest that money without any second thoughts…

Understanding people

Be it structuring of a product and selling it to a client or giving a loan to a client under CCC category or managing the wealth for your client , ‘understanding people’ becomes a key asset..
When I was reading credit risk measurement topic , there are a lot of complex things done to finally arrive at the probability of default and the expected loss out of the default…This is done through models..If i give a model(KMV , Merton..what else??) to the most knowledgable finance guy(with a formal education) and let me compare his predictions with my friends father who has been in the loan disbursement section for about 15 years (no formal education in finance)…I can bet 9/10 times my friends father can judge the credit quality of the person with just five minutes of interaction with him…The complex models are just tools to substantiate our beliefs..They are not the ‘panacea’..

PS: The above are the three factors for being successful in finance according to my hypothesis..In case if you wish to differ from me you are welcome to do so…

PS: For Gods sake dont interpret this as a propoganda against formal education in finance....I'm a die hard fan of academic finance and still consider studying finance in a great campus like IIML being my life time achievement!!

Friday, September 4, 2009

Swap - A concept to remember

Couple of weeks back we went to ‘Kaminey’...Not a very exciting movie, I would say, except for couple of facts..One – Priyanka Chopra, who is becoming more beautiful with every passing day …Second – I got an example to explain the concept of ‘Swap’ in financial market...

Two parties in the financial market enter into a swap agreement when they feel the agreement can bring in mutual benefit to each other (which would not have existed individually)…

Example: Shahid Kapoor vs Shahid Kapoor..

Group of Mafias would be searching for Shahid Kapoor 1 in the movie (elder of the twins) and the police would be searching for Shahid Kapoor 2..Now each of the Shahid kapoor will get caught in the hands of the wrong party (ie SK1 in the hands of police and SK2 in the hands of mafia)…Now assume if both the parties (police and mafia) had to take the trouble of getting the other person, it’s going to cost them huge resources , time , money….

But once they get to know the whereabouts of the Shahid Kapoors they enter into a private agreement (Rule no 1: Swap is a private agreement as opposed to futures or options) , to exchange the Shahid Kapoors..

Very easy right…This is all what Swap is about…

Example 1 in financial market: ICICI wants to raise Euros to serve its High net worth client(say maruthi …because maruthi has some parts manufactured from Britan and hence has a liability in Euros)..And a bank in Europe say Bank of England wants Indian currency to serve its client (say an FDI who wants to invest in India and hence needs rupees)..

If ICICI wants to borrow Euro the cost would be somewhere around 5% and if BOE wants to borrow Indian Rupee it would cost them around 10-11 %(approximate figures)..But if ICICI wants to raise money in India it is just the cost of deposit for them which would be like 7-8%(or even in debt markets around 9%) and for BOE it would be around 3% in their own backyard for raising Euros..

So both of them enter into a private deal..You raise money in your country and I’ll do it in my country and we’ll swap it amongst ourselves..ICICI will be able to get euros from BOE at say 4%(a net saving of 1%) and BOE will be able to get it at 9% from ICICI(around a percent of savings)..Both of them will mostly enter into a deal such that the mutual gain for each of them are equal(but not a necessary condition..depends upon the bargaining power)…

Example 2:Another case could be when one bank within the same country is trying to raise fixed rate loans because of its balance sheet structure(I don’t want to confuse you by introducing the technical terminologies) and another bank wants to raise floating rate loans . But they are able to give loans in the other way(floating and fixed respectively) ..Now they enter into a swap deal so that it benefits both of them…First bank gets the fixed loans and second bank gets the floating loans

So simple right….All finance concepts are very simple…It would be denefitly a concept which we would have unconsciously used in some time in our life..Just that they are embedded into complex names: P

PS:If you are further interested abt swaps just go through existing literature on ‘valuing swaps’…I promise you that it’ll not take more than fifteen minutes to understand how is a swap valued..It is interesting as well!!