About Structured Products...

What are structured products?

Structured products are an investment instrument formed with a combination of a multiple financial instruments with one or more derivatives.

So in order to understand structured product we need to understand what derivatives are.

Derivatives like the name suggest, derive their value from the underlying asset. So an equity derivative will derive its value partly from one or more of the underlying equities it represents. So some of the examples of derivatives are as follows. So derivatives can derive their value from an asset like stocks, bonds, real estate (commercial & residential), mortgages, loans and commodities. Derivatives can also be based on an index like any of the stock indices, interest rates, or currency exchange rates. Investors and institutions use derivatives to mitigate risk (hedging) of economic loss arising from fluctuations in the underlying asset value. So investors will use these derivatives either to increase profit or protect against loss. Some of the commonly used derivatives are options, futures and swaps. Generally the price the derivative is less than that of the actual asset which makes it and ideal instrument for speculation. So investors can take advantage of asset’s price fluctuations using less amount of money on the board. In a nutshell structured product can be called hybrid securities which can be used to hedge and speculate

Here are how some of the widely talked about derivatives.

Options:
Options derive their value form the underlying stocks/ index or asset. An options gives the option owner a right (but not an obligation) to buy or sell the asset at strike price and before a specified expiry. A buy option is called Call option while a sell option is called a Put option. If option is not exercised before its expiry date then its value dies down to zero. In the coming days I will devote and entire post just for these options.

Swaps
As reflected by its name, swaps are contracts which exchange cash flows on or before a specified future date. So swaps can have an underlying asset in the form of currencies/ exchange rages, interest rates. Swaps are important as the parties selling and buying these swaps does not exchange the asset’s principal amount but profit can be derived from the asset’s price fluctuations.

Futures/ Forwards:
Futures and Forwards are contracts to either buy or sell an underlying asset on or before the future date. Unlike forwards, futures are created by the exchange on which the futures are sold.

Now coming back to the structured products

So structured products are an investment instrument based on derivatives. These are contracts issued by an investment bank promise to pay a specific payments in specified circumstances described in the contract. So the investment bank in this case will replace the usual periodic interest/ final principal payment to an investor with a non traditional payment offered to an investor based on the performance of the underlying asset. This non traditional pay off may be based on the contingency that the underlying asset returns a specified return as per the contract. Structured products are popular with investors because they can be customized for exposure in various asset classes which may not be otherwise available to the investors.

So to go into a bit more detail, a structured product will a note part and a derivative part with it. The note pays the investor an interest at a specific time interval and the derivative as discussed previously can be based on stock, bond, index etc. There is also a level of principal protection i.e. risk (full, partial or no principal protection) which brings along with it returns (less than, equal to, multiple of the underlying assets return)

One type of structured product is principal-protected notes (PPN). These are considered one of the safest structured products. So because this investment protects the principal, the investor buying such a note gives up the dividend yield. So normally the initial investment is invested in federally insured CDs and the rest is invested in securities which track the market indexes. So the principal get shielded and investors benefit as markets rise/ rebound.


Other example of a structured product is reverse convertible notes which are linked to a stock or a basket of stocks. These notes offer some % of downside protection but also have a cap on the upside. So if the stock doubles i.e. goes up 100%, the note may only return about 15% while if the stock tanks, these structured products offer a buffer. These are the most risky structured products. But these were the very instruments which burned investors in the current recession. Investors got burned as the underlying asset tanked and as per the contract, the investors received the tainted shares instead of getting their money back. When the stocks below a certain value (below the buffer) also known as the knock-in level, the investors will be given the lower value shares instead of the principal. So the investors now becomes an unwilling owner of those low valued stocks.

For Pros only!

Risk, return, acronyms associated with structured products can be very confusing for any naive investor. There are good reasons why a lot of investors are apprehensive about putting there money in structured products: loss of dividends, low trading volume, taxing inefficiencies and complex fee, cost and returns disclosure. Investors putting their money into structured products require a broad understanding of the actual assets, their derivatives, rate of return, risks and fees.

Did you buy low and sell high?

Did you buy low and sell high?

If you ask me this question or for that matter any other investor, they would say that all I try to do is buy low and sell high. It’s was necessary for some folks to sell securities at whatever rate they can get coz it was an emergency but blog is for all the other folks who sold their securities out of fear.

Looking back at 2007 highs

Buy Low and Sell High has not always what we do. Especially during the 2007’s earnings season when companies were reporting out of the roof positive earning surprises and at the same time you must have overheard folks discussing their stock market paper profits at lunch, gym and during other water cooler conversations. Such conversation was dreadful especially if you had not invested money other than your 410K into the stocks or mutual funds. I bet you went online to check your bank balance and also had a chat with your honey about that money which needs to be moved to the brokerage account. Yes, we have all done that some point in time. We did it due to the human tendency of fear of being left on the sidelines while people board the train. Looking at the stock market after a few months or years (if you were long on those positions), your investment doesn’t look that rosy does it? The reason for the super rally in the stock market was surely an “irrational exuberance” or super optimism but the recession/ depression we are in right now may well be coined as irrational pessimism. We as humans will do any certain act only to avoid pain or gain pleasure. So most of us buy stocks at high prices or during a rally coz we don’t want to be left behind when others/market makes progress. On similar lines we sell stock when newspapers, TV channels and other media are portraying super pessimism about the stock market. This is when we decide enough is enough and we refuse can’t take any more potential losses. We just went through a naïve investor’s mindset of buying high and selling low even when we know that the right thing to do is buy low and sell high.

Have you adjusted your 401k contributions lately?

I know some many people who changed their 401k allocations from high in stocks to low in stocks during Nov 2008 to April 2009 window. Guys..let me remind you that stocks market is cyclic with the only difference in each of the recession and the following rise being the cycle time. If stocks in your 401k fall by a huge percentage and you end up changing the allocation to something less risky then necessarily you have booked those losses and delayed the recovery of your 401k by several years (read my DCA blog) I can say this confidently because risk and return go hand in hand. There is no way in the world that you can recover the paper loses you took in your riskier allocation and come back up in green using the allocation which is less risky than the one you were previous in. Moreover if you changed your allocation at or close to the bottom of the stock market means that you took the biggest possible loses and having done that you have surrendered to the fact that your 401k’s recovery won’t be at a dramatic rate as its decline. My heart goes out to the older folks close to retirement who lost tremendous amount of money in their retirement account. I am confident that recovery is imminent, but chances that these older folks would be able to make full use of the recovery are slim. I hope some of these folks would have changed there allocations to bonds or other fixed income sources when market was at the peak.

What did I do?

I will admit that I was devastated by more than 50 % loses on some of my holdings and took loses last year as I Sold Low the securities I had bought High previously. But I invested (speculated) the same money back in some of the securities which had lost about 80 to 90% of their value as compared to their 52 week high. That is surely risky because their prices were beat up for a reason but you have to realize that these are the very securities which will and have bounced back up from their 52 week lows. So I moved my money to more risky positions with an anticipation of recovery. I take pride in the fact that I am back in green (marginally) after considerable amount of effort, research and gut checking. I am confident that it’s going to be a huge upside form here on forward.

The logic is simple here…even JT (Justin Timberlake) knows it … “That's okay baby 'cause in time you will find...What goes around, goes around Comes all the way back around”

Here is a link to an interesting article on similar lines at…

http://www.filife.com/stories/investors-lament-buy-high-sell-low

Common Stock Preferred Stock Arbitrage

Hey Folks. Happy Friday! After reading today’s blog you guys are going to do some homework for sure. Brain food is here!

What is Stock Arbitrage?

Stock Arbitrage started as a means of cashing in on the difference between the prices of same stock listed on different exchanges. So an investor wanting to take advantage of this discrepancies, buys stock from an exchange where it is at a lower value and hopes that the stock price will eventually catch up to the higher stock price in the other exchange. This is arbitrage trade and such a discrepancy in the prices of same security is short lived and only the most active traders will be able to take advantage of such an arbitrage trade.

On similar lines, an investor can take advantage of difference in stock price of Preferred Stock and Common stock. Such a trade has many advantages over the earlier arbitrage trade I have described

Let me introduce to Common Stock and Preferred Stock before we jump into this arbitrage.

A company issues common and preferred stock. Dividends for common stocks vary based on the company’s financial health and performance whereas generally all the preferred shares have a fixed dividend payment. Unlike to preferred stock, common stock has voting rights. In case of bankruptcy, preferred stocks holders are paid after common stock holders, bondholders and creditors.

Now getting back to the Common-Preferred Stock Arbitrage trade and its advantages.

Preferred stock generally trades at a lower volume than common stock. Although the same news generally applies to preferred and common stock, common stock tends to be very volatile and trades in greater volume. Take a look at the stock’s Beta (volatility compared to S&P 500) to know the difference between the volatility of preferred and common stock.

It is the common stock price which fluctuates quite a bit with positive or negative news. So in normal circumstances, the movement in the stock value of the preferred shares lags behind the movement observed in common shares. This lag in a few cases is not in seconds, minutes but also can be days or even weeks. So using this finite lag an investor who doesn’t keep a pulse on the market will get a chance to identify this discrepancy easily.

Any news about the company does apply to both preferred and common stock. So this brings us to another major advantage. An investor can predict the movement of preferred stock because it always follows the common stock which instantaneously tracks investor sentiment based on current news. Having said that, an investor must be really careful not to place such an arbitrage trade close to earnings, court ruling, board elections or any other news expected by that investor. Always remember that it is not the news but the way the market perceives the news that moves stock price. Such a trade placed by a vigilant investor will ensure that the common stock maintains the direction of its movement which the investor was tracking till the trade has been placed.

I am sure what the discussion above will open you eyes to a whole new area of investment strategy. Hold on now…before you place a bunch of money in preferred stock which lags commons stock be sure to try this strategy out with small or no money by tracking such shares.

Case Study 1

The above column is focused on an arbitrage where we are assuming that the price of preferred stock will converge with the price of common stock.

But in the following case study, investors are betting that there is too large of a spread between the common and preferred stock. The article suggests not only to buy preferred stock but to sell common stock as the author believes that the stock prices will converge some where in between the current spread.

http://www.bloomberg.com/apps/news?pid=20601086&sid=aAdZKSyBdqjs

Case Study 2

All the above strategies I have mentioned are good for a healthy company. But in case you want to analyze how certain news about a distressed company can lead to different arbitrage trade, please read the following article.

http://www.marketwatch.com/story/investors-buy-citi-preferred-sell-common

Until then…its Suaz signing off…

How can you benefit from Ford’s public offering?

Ford Motor Company announced that it will offer 300 million common shares in public offering on market close Tuesday 12 May 2009.

This blog focuses on how an investor can benefit from this news.

How is the stock offering beneficial to current Ford’s common share holders?

We know that these 300 million common shares will raise anywhere from $ 1.2 billion to $2 billion for Ford but will dilute current share holder’s equity as these new 300 million shares will be available as common stock but there is a silver lining to this offering. Ford is most likely to use the proceeds of this sale to shore up cash reserves as it distances itself from bankruptcy. This not only will make company’s balance sheet stronger but will also aid distancing Ford from other US auto manufacturers like GM and Chrysler. This move will also boost investor confidence that Ford will surely see the it through this automotive depression. So the current Ford Motor Co. shareholders should realize that this stock offering is beneficial for them and will bring in delayed gratification them.

Some Significant Improvements at Ford

UAW Concessions:
Unlike GM and Chrysler, Ford has been successful in working out new terms with UAW. These concessions included reduced labor costs by $ 500 million annually and making half the contributions to health care trust for UAW workers by stock instead of cash. The later does carry a risk of diluting company’s stock value even further but these are considered be lifesaving concessions gained by Ford.

Debt Holder Agreements:

Ford also negotiated its survival with the debt holders by which Ford reduced its debt by $9.5 billion and lowered annual interest payment by more than $ 500 million annually. Lower loss in Q1 of 2009: Yes, these days loss in US automotive sector is a reason to celebrate especially if it was lower than previous quarter. For the 1st quarter of 2009 Ford posted a loss of 60 cents a share which was lower than that expected by analysts.

Win Win for Investors:

Is there a way where you can directly benefit from Ford’s stock offering without being negatively affected by equity dilution?

Yes, look to invest in Ford’s biggest suppliers. As mentioned above, lower loss in the most recent quarter along with concessions obtained from UAW and debt holders are essential for Ford’s survival. In addition to that, Ford now with its stronger balance sheet and new strategy will be able to steal customers from GM and Chrysler. Improved sales of Ford vehicles will be reflected in the future revenues of its biggest suppliers. Investing in these suppliers will ensure great returns without share holder dilution. While doing so an investor has to ensure that particular supplier’s dependence on GM or Chrysler is at a minimum.

Dollar Cost Averaging (DCA) really works during economic depressions or recessions?

For our fellow bloggers who don't know what dollar cost averaging is, please see what sister wiki has to say about it. (http://en.wikipedia.org/wiki/Dollar_cost_averaging)

Well if you ask me that question, I think dollar cost averaging does work in an economic depression or recession. I am writing this when Dow Jones Industrial Average (DJIA) is at 8,574.65 vs. its March lows of 6,469.95.

Now the reason I like dollar cost averaging is because I don't have a crystal ball to tell me when the market is going to bottom out or when the prices of any specific security are at its lowest. We may have some lucky chaps in the audience who may have caught the bottom for a couple of stocks but chances of that happening are really slim to none in every stock you invest in and moreover I think it's pure luck and not reproducible.

So my suggestion is to look for companies which have absolutely no chance of getting bankrupt. I have learned the hard way never to say "no" so I will rephrase it as... single out companies which have the least chance of insolvency and which have enough cash on hand. Look at book value /share and free cash/share ratios before starting dollar cost averaging.

Who should invest using DCA strategy?

DCA strategy becomes very beneficial for people who are time and/ or knowledge poor. This strategy can work wonders for busy professionals who don't necessary have the time required during normal market hours to trade. DCA is a great tool for people to are less knowledgeable about stock market strategies which can be very confusing.

What kind of money should I invest?

I would like to think that the money which you won't be needing for another say 2 years should be invested using DCA. The amount of money you invest during each time period may be insignificant but when pooled together for your specific investment timeframe should be significant enough amount.

Apart from money what is needed to invest using DCA?

Investor using DCA needs discipline. Discipline is I decide and do!
I believe the biggest deterrent to DCA not working as expected is lack of discipline from an investor. I do understand that it takes some heart to put money in a company's stock while the price is moving down...but fellows that is the exact reason why we are interested in DCA. So as the stock value falls, fixed amount of money which you put in at every interval is going to bring in more units/shares.

Which companies should you invested in using DCA?

Again...it only applies to companies which are not going bankrupt...hint hint...look for companies which government has promised to be too big to fail :) I didn't say that...Pres Obama did...so do you think he will keep his promise...I hope. There are also a ton of other companies which are diversified enough not to fail even if its few divisions are underperforming.


Other Advantages of DCA

Deciding to conduct a DCA on a certain stock pressurizes the investors to put that amount of money away every period. So this pressure over an extended duration creates delayed gratification.


Other strategies: I call it DCA++

Invest same amount of money each time the stock falls a predetermined amount or percentage. So as the value of the stock falls, you will be able to buy more units/ share of the same company. This combined with traditional dollar cost averaging helps to buy stocks close to the bottom and leads to a better average price. So you will essentially have two triggers to invest the 1st being the DCA time period and other is the price of stock falling a predetermined amount. Be sure to use both these triggers and not just one.
I hope you had fun reading this DCA blog. Similar to any other investment strategy, I am sure DCA and my self coined DCA++ will have many critics but let me tell you this one of the simplest secret of wealth building.

Well...adios… until next time. Happy Investing!