Derivatives – A Movie becoming Reality (Part II)

In the first part of this article,for the sake of better understanding of negative influence that derivatives had on
financial crisis,the mechanism behind thosefinancially engineered products was
explained using the analogy with an old movie called Trading places”.
Now, what was happening in the back stage of financial crisis in 2008 is quite similar to what was described there, with only a few specific differences relating to a type of derivatives traded, appetites of key market makers and regulation aspects.


Credit Default Swaps (CDS) – Derivatives Guilty as Charged

As derivatives were evolving and getting more sophisticated through time, in the last several years leading to crisis, some specific variations of basic derivatives called Credit Default Swaps(CDS) became increasingly popular on the market. Credit Default Swap is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of loan default or other credit event. In other words, CDSs are meant to serve as normal insurance contracts, with protection buyer paying upfront amounts in the form of yearly premium(CDS spread), aiming to protect himself from any potential loss on the face amount of referenced corporation’s or sovereign’s bond or loan. In case such loan default happens, protection seller is obliged to compensate losses by paying usually the face amount of CDS to protection buyer and at the same time protection seller takes possession of the defaulted loan. And the outcome investors were betting on in this case was related to wide spectrum of possible events, from potential default of specific corporation loans to the crash of large investment companies and even economies of some countries.


Greedy Market Makers – What’s in it for them?

If you go on Investopedia, you will learn that “modern CDSs were invented by J.P. Morgan bankers led by Blythe Masters and related to their Exxon $4.8 billion credit line, when J.P.Morgan actually sold the credit risk from that credit line to EBRD, in order to cut the reserves they were required to hold against Exxon’s default, which as a result immediately improved position of its balance sheet”. It is not arguable that derivatives and more specifically CDSs are important, in general, for managing a diversification of risks and hedging against a diversity of exposures. However, if we know that in 2007 the outstanding amount of CDS was $50.000 billion and that this amount was 10 times greater than the total volume of all bonds that could be insured, it becomes clear that such growth did not result only from the need to protect against default. The truth is that Wall Street market makers, who were perceived on the market as “too big to fail”, were in reality using their privileged position to bet on such financial instruments and extensively speculate on possible outcomes, using to the largest extent so called CDS “naked short selling” (selling something they did not own). Only one among many examples can be found in the case when American International Group (AIG) required a federal bailout, due to the fact that it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses of over $100 billion.


Deregulation and Lack of Transparency – Main Sources of Evil?

Commodity Exchange Act from 1936 enabled futures market to function well for more than 50 years, since it allowed regulators to monitor and police the commodities futures markets to ensure that they are free from  fraud, manipulation and excessive speculation. However, in 2000 the Commodities Futures Modernization Act (CFMA) changed the previously stable system, allowing trading without limits on speculative position on the Exempt Commercial Markets (ECM) and the CFTC regulations of Designed Commercial Markets (DCM). Removal of regulations by governments was made in order to create the illusion of a booming economy, yet the price that economy had to pay at the end was much higher than the short term benefits created by imposing new (de)regulation. In other words, since CDSs are traded on Over-The-Counter (OTC) market which, unlike the standard commodities exchanges, is known to be unregulated, they were responsible for creating a systemic risk due to the unclear web of interconnections between institutions and their markets, which at the end lowered counterparty confidence on one side and created disproportionate volatility in commodities prices on the other side, putting more pressure on the economy. Also, as already mentioned, the lack of transparency in OTC derivatives enabled dealers to make large profits from wider bid-ask spreads, since they had an informational advantage over their customers.

krizaTo conclude, the lessons learned are that the Wall Street market makers, such as Goldman Sachs, Lehman Brothers, J.P. Morgan Chase and others, have shown that they cannot be self-regulated, because once the platform for profiting on imperfect financial markets was created, the result was immediate exploitation of such an opportunity and greed without compromise as an expected behavior, which as a bottom line destabilized the global financial markets and even more,  made them vulnerable on the long run.

Derivatives – A Movie becoming Reality (Part I)

March, 2008 – Collapse of Bear Stearns….September, 2008 – Bankruptcy of Lehman Brothers…August, 2010 – The AIG Bailout Scandal…

Although such headlines are now left behind us in the past, they still remind us on events that triggered one of the worst global financial crisis the world had ever seen. We have learned from very different perspectives that derivative markets are the ones to blame as being the major cause of the crisis, however not much has been written about the underlying issues and specific reasons behind what had actually happened.

Before understanding the negative impact of derivatives as triggers of the financial crisis, it is important to first understand the mechanism behind those financially engineered products. Unlike equity and debt, derivatives as financial instruments “derive” value from the performance of their underlying assets, such as commodities, stocks, insurance, indexes etc. Key basic derivatives are nowadays known as futures, forwards, options and swaps and their operating models are quite similar to each other.


Trading Places

There are plenty of popular movies dealing with the subject topic, however an old movie that take us back to
1983called Trading Places”, with Eddie Murphy as a main actor, perhaps in a best way describes how derivative markets function. The movie is about two powerful and respected investors, Duke brothers, who put a $1 bet that they could change  lives of two different people, an educated executive director Winthorpe who was successfully running trading operations at their company and a small criminal Valentine accused for money robbery, who have been offered with an opportunity to become a top tier trader in Duke&Duke company.

The story about destroying the career of a successful trader and making of new trader out of nothing just for the sake of a bet, subsequent revenge against the powerful shareholders as a result of rage of two betrayed men, the use of insider information and excessive speculations on the commodities exchange using orange juice futures contracts, for the purpose of powerful investors becoming even more powerful, is not much different from Wall Street and financial markets’ reality even nowadays. In general, derivatives are providing the platform for investors to bet on certain outcomes, either for the sake of hedging against potential risks or speculating aiming to earn higher profits. In derivatives trading there are two sides or two basic positions of a trade, short and long position. Short position is betting that the prices will drop down,  entering into derivative contract and committing to sell underlying security/commodity at price defined at current moment, earning the price difference if the price goes down as anticipated, and conversely long position is putting bets that prices will go up on the market, entering into derivative contract with obligation to buy certain security/commodity at current price that is lower than future expected price, again earning the price difference as its profit.

tumblr_inline_nghvj8c4B01qz65iuIn the subject movie the betting outcome was related to future crop of fresh oranges, since the price of orange juice
will be quite dependent on the crop size following equation: bigger crop=lower price, smaller crop=higher price. Greedy Duke brothers, not much different than today’s Wall Street market makers, were trying to “corner the market”, in other words to take the advantage of an insider information on the future crop, aiming to get the sufficient control over the supply of orange juice, thus being able to set the price for it. So what happened in a movie is as follows: based on a forgery crop report the Duke brothers were provided with from Valentine and Winthorpe who prepared a revenge plan against them, stating the orange crop will be quite low and meaning the prices would go up on the market, the brothers decided to start buying on the commodities trading floor as many orange juice futures contracts as they could, at the price traded at that time. In parallel with that, other traders followed their lead, heavily inflated the price, which in general is known as perception based trading.
This would have mean that once the prices would go up, the Duke brothers would use the rights from their futures contract, giving them an option to buy specified quantities of orange juice at the price of trading in the moment of entering the contract, that is lower than the new inflated price, thus profiting on a price difference. In reality, they would have had two available options for settlement and closing of their open positions from the futures contract, either to aim for physical settlement which would mean physically buying of orange juice from the commodities exchange at the price they entered into contract and then selling subject commodity at the current higher market price, or they might alternatively want to close their position by simply virtually entering into opposite contract position, in this case short position, meaning they would be virtually selling the same commodity at the new higher price on the market and thus closing previously open long position, again profiting from the difference between the initial lower and current higher market price.

On the other side, since Valentine and Winthorpe were actually the ones to have real insider information, in this case due to the fact that they came into possession of a real crop report showing that the orange crop would be average, suggesting normal market prices, they mis(used) the opportunity with already inflated prices due to large blocks buying from the Duke brothers and entered into short position of orange juice futures contract, which guaranteed them that they could sell the subject commodities at this inflated market prices. At the very moment when actual crop report was revealed in the public, showing that the orange crop would be average, the price of orange juice futures plummeted and Valentine and Winthorpe immediately used this opportunity to buy back their futures at the lower price, earning a large profit out of it. What the two of them did is known on derivative markets as short selling or “naked” short selling, where the investors are selling commodities or securities they currently do not own and subsequently repurchasing subject commodities (covering positions). What happened with the Duke brothers is that they failed to meet a “margin call” and practically went bankruptcy, suffering total loss of $394 million on the respective transaction. Margin call is part of the “mark-to-market” process related to the way that regulated derivative markets, such as futures commodities exchange, are functioning. Futures are marked-to-market on a daily basis, in a way that the current price is compared to the previous day’s price and the profit or loss on the day of a position (both short and long) is then paid to or debited from the holder by the futures exchange. This is all made possible due to the fact that the exchange is the central counter party (CCP) to all contracts where the number of long contracts equals the number of short contracts traded.

To be continued…


Road to successful strategy execution in companies

The great Sir Winston Churchill once said: “However beautiful the strategy, you should occasionally look at the results “. This old wisdom undoubtedly shifted from the battlefields in World War II and found its way to dynamic and competitive markets of today. Most recent research from the Fortune magazine revealed quite discouraging results that only 10% of companies who have effectively formulated their strategies, succeed in effectively executing them.
Regardless the strategic framework the company might consider using for management of its strategy, such as a Balanced scorecard, Office of Strategy Management or some internally developed framework, it is instrumental to ensure success in both strategy origination and strategy deployment.



Strategy origination 

It is here where all the beauty is born. Starting from their mission, vision and values, and based on thorough strategic analysis derived from both external and internal environment, at this stage companies craft their strategy map, consisting of different strategic themes that are stretched across four major layers in the strategy map, namely: financial, customer, internal processes and development layer. Each strategic theme outlines key value drivers that are crucial for strategy execution, along with KPIs associated with respective value drivers, which measure a success in realisation of the strategy. If we take, for example, ultimate customer loyalty as a strategic theme, then the company might consider to set key value drivers defined for each of the four layers, such as revenue growth in the financial layer, increasing customer spending and upgrading existing customers in the customer layer, implementing Loyalty Management System (LMS) in the internal processes layer and organising appropriate LMS training for company’s employees in the development layer.


Strategy deployment

Unlike the standard planning & budgeting process, where only financial figures are regularly tracked against the plan and where strategic and business plans often end up in the desks of CEOs and CFOs until the next year’s planning & budgeting cycle, driver based planning & budgeting process calls for continuous progress tracking of realisation among all relevant strategic value drivers, as well as of the action plans and initiatives, coming from each of them. Strategy deployment consists of three key steps.


Step 1: Cascading driver based action plans and initiatives throughout the organisation

Depending on the organizational design and maturity of it’s business and supporting functions, different companies
will use different approaches in cascading action plans and initiatives.
For example, a company operating with several divisions with mature business and supporting functions, will want to have one strategy map for each division, with segments on the strategy map that outline value drivers for specific departments of the respective
division. In that case, next step would mean creating sound action plans, initiatives and projects for each of the departments, with clearly defined responsibilities, accountabilities and deadlines for execution of each of the action plans/initiatives/projects. In parallel with translating value drivers into action plans and initiatives, it is also necessary to set a blend of smartly defined KPIs to be tracked on all relevant organisation levels. In that way, the company ensures that both business planning and business reporting are inevitably focused on strategy.


Step 2: Ensuring strong interlock between business and support functions

Each strategy map shows a clear cause and effect relationship between the business and support function actions. In
other words, a strategy map of a business division that in the internal processes layer points out an immediate need to improve a lead time of ordering process will on the other side mean that IT, as a supporting function, should develop appropriate applications aimed towards solving this issue. From that moment this business requirement becomes one of the targets for enabling functions, such as IT function, which will also have its internal strategy map consisted of similar targets and KPIs to be realised, in order to enable smooth strategy execution. That is called the interlock between business and support functions and it seeks for an efficient coordination within the company.


Step 3: Linking personal goal – setting process with the strategy execution

Finally, once key value drivers from strategy maps have been successfully cascaded in the form of departmental
action plans and initiatives, with proper interlock defined between business and support functions, in the last step the company will need to ensure that the driver based plans and budgets are also being translated into personal targets for its employees and that the strategy has been clearly communicated to them. This will ensure that people are focused on their contribution to strategy execution, provided that proper incentive schemes are triggered in order to motivate the staff in striving towards great performance, because remember that no matter how beautiful the strategy, it could never be as powerful as people who execute it.

Why selling a business often ends in disputes

One of the most common universal truths that the only 1articlescertain thing is uncertainty nowadays is severely shaking the global M&A market.
Once dominant “sellers’ market”, where most of the bargaining power in M&A transactions was on the side of a seller, no longer exists. After the downturn, the number of deals has dropped significantly. Regardless of the approach the seller decides to use for valuing his business, during the crisis it became even more evident that the value of a business is only what someone is willing to pay for it.

Quite opposite to sellers, buyers are now exercising much greater power than before and are a lot more cautious when deciding whether to buy or to wait, what to buy, how much to pay and what protection to insist upon should things not turn out as expected. In light of this, if the transaction does not meet the initial expectations, the buyers may seek recovery from the sellers for under-performing new investments.


In practice, transaction disputes can take a variety of forms, but the most common ones are arguments over completion accounts and earn-out mechanism. The basis of such disputes lies in a contract known as a Sale and Purchase Agreement (SPA), used both by sellers and buyers in order to safeguard their interests and maximize a value of a deal.


Completion accounts

Disputes may occur during the completion accounts process that results in preparing the financial statements as at the completion date, which are used as basis for price adjustments defined by the SPA. This means that at the completion date of transaction (which is the date of transfer of the control of the business from the seller to the buyer), a preliminary purchase price is paid to the seller. The final purchase price is subsequently determined through a completion accounts process which is a mechanism to adjust the purchase price, if the net assets or working capital are not at the level expected at the completion date.

Consider for instance a typical working capital price adjustment mechanism. A business is purchased for a headline price of € 50 million with a working capital requirement of € 5 million. This means that at the completion date, the purchase price will be adjusted (increased or decreased) by the difference between € 5 million and the actual amount of the working capital at this date.

The lack of definition for certain accounting terms combined with their vague application in the SPA, along with the risk of manipulation of completion accounts, often cause transaction related disputes, which in most of the cases end up in seeking professional advice from an independent experts.


Earn-out mechanisms

refer to the deferred payment of an additional conditional purchase price component agreed by the parties in the SPA. The parties often find it convenient to agree on a deferred payment of a supplement to the purchase price, which depends on future performance or events occurring after the completion date. In addition, earn-out mechanisms often foresee a continuing involvement of the seller after closing, which can make the transition and integration easier and safer by using his expertise and contacts.

An earn-out agreement signed in 2011 may, for example, stipulate that the sellers of a business will receive in 2014 a payment equal to 25% of the adjusted net profits from 2012 and 2013, if the profits for these two years exceed a specific target figure.

In spite of their benefits, earn-out mechanisms are also notorious for causing disputes. The buyers (or the management) can easily manipulate the performance of an acquired business. There may be a real incentive for them not to achieve the set net profit target.

Also, the buyers may for instance reduce the profitability through transfer pricing arrangements with related parties, aiming to benefit from paying fewer amounts as a supplement to the purchase price.

Which steps sellers or buyers need to follow in order to protect their interest?


Carefully draft and review the SPA

The SPA is the final outcome of the negotiation. Once it is signed, it cannot be easily
modified. Ambiguity over accounting terms may have a major impact on the deal value.
That is why it is critical to carefully determine targets (such as working capital and net debt), since the price adjustments will be calculated as the difference between the targets and the actual figures. It is also extremely important that the methodology set out in the SPA for preparation of the completion accounts is clear and unambiguous, removing subjectivity to the greatest degree possible. A clearly worded and appropriately defined completion accounts mechanism should provide protection to both the seller and the buyer.


Supervise the completion period

The completion period is the period from the signing of the SPA until the completion date. The seller has already sold the target but retains control of the business until the completion date. The seller may agree to some restrictions on the conduct of the business during this period in respect to activities that could strip value from the business. Examples include payments of dividends, non-arm’s length purchases or sales transactions with other entities of the seller’s group. For buyers, it may be prudent to make provisions in the SPA allowing for the monitoring and reviewing of accounting books and records during the completion period to assess whether the operations of the business are consistent with the provisions of the SPA and past commercial practice.


Finally, both sellers and buyers could also reach out towards alternative pricing mechanisms, such as a locked box mechanism, which has become quite popular in recent years and which could reduce a part of uncertainty since the equity price is calculated based on a defined historical balance sheet date agreed by the parties, and such price does not change. Minimizing some of the risks associated with post-transaction negotiations often terminate in disputes.