Up up and away

Ok, up up, down, up, down down down, up up and away.

I’ve been away furiously recruiting staff and working on QIS2 while completing a house move, so not much blogging recently. Should pick up again shortly.

The other news is of course Spanish bond yields, which were heading for the stratosphere before the latest “solutions” were proposed. This had, for me anyway, an unexpectedly long-lived impact towards depressing Spanish bond yields.

That story is over and bond yields are back up testing the highs from a week or two.  Nothing is properly fixed, so default and exit are still too likely to encourage investors to buy bonds at below these yield levels.

Lose a Million

The Make a Million competition, as I’ve mentioned before, is an awful idea. It doesn’t promote investing or even “normal” trading, but rather massive, speculative risk-taking trading because the prize for performing well is nothing and the prize for performing best is significant.

I’m continually disappointed that Moneyweb continues to partner with this distraction.

As I’ve done in the past, I’ve analysed very quickly some of the results of the most recent competition. As background to that, the basic rules are:

  1. Put up R20,000 of your own money
  2. Trade over three months in currencies, commodities single stock futures and some index trackers.
  3. Whoever has the most at the end wins a million rand
  4. Everyone keeps what is left of their initial “investment”

So let’s be clear, there are no long-term investment learnings here.

The winner did return 165.5% over 3 months, which is not an impressive performance even though it might look like it.  The point is, given the volatility of the investment universe available for the competition and the encouragement towards rampant risk-taking, it’s entirely pedestrian performance.  It’s very likely an individual’s performance will be good given the wide range of possible outcomes.

Let’s look at some other statistics

Average performance -18.4%
Annualised average performance -73.4%
Proportion making a profit 26%
Total amount won -R1 020 762
Standard Deviation of performance 48.0%
Annualised standard deviation 96%

These are not performance statistics of which to be proud. They are similar to the losses incurred in prior competitions.

So in short, the competition cost the entrants in total just over a million rand. Losing a million rand is a great way to Make a Million.

What is best practice for matching annuities in Greece in 2012?

Best practice for matching non-profit annuities in most countries, certainly from a risk perspective, is still to cash flow match (or at the very least, match key durations) using government bonds.

The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

Greek default?

So European politicians have more or less agreed a deal which may, more or less, push some of their problems to one side for a period. Yes, I’m not madly optimistic about this as a cure-all.  This is not the end of the Euro problems.

Part of the deal is a “50% loss for private investors”. Which is part true and part nonsense but will be an effective Greek default when enacted / agreed. (I don’t care how “voluntary” it may be, it’s a default and almost all definitions of default include restructuring of debt in any way that isn’t what was originally promised.)

Why is it only partly true? Well it’s not necessarily a “loss” for private investors. The probability of default on Greek bonds has been just about 100% for a while now. This probability of default is derived from market prices for Greek bonds and market spreads on Greek Credit Default Swaps (CDS) and an assumed Loss Given Default or Recovery Rate for investors when the bonds do default. Actual Recovery Rates vary widely, but often analysts plug in the average Recovery Rate over most of this century on unsecured debt which is around 40%.

So if market prices for Greek bonds assumed 100% default probability and a 40% recovery, then a 50% recovery doesn’t sound so bad. The potential downside is that Greece may still (need to) default on these written-down bonds at some point in the next two decades.

So the real question is what will the new probability of default be? Then we will know whether investors “took a loss” and perhaps gain the market’s view on how successful the deal really will be.

Golden Stories

Gold has had a fantastic run, getting to within sight of $2,000 recently. Many see this as a clear indication of hyper inflationary pressures arising out of loose monetary policy. The informed recognise that you can’t have hyperinflation if all sensible measures of actual prices other than a particular, volatile commodity are showing very low inflation.

Some stories about gold today and recently:

Now I don’t spend much time on gold as an investment, but these stories are certainly interesting.

I’ll leave you with one thought (for the OMG! Inflation! of my readers).  If the gold price is a measure of “real prices” in the economy, but prices of actual goods and services are more or less unchanged in dollar terms, this means the price of these items in gold terms has plummeted massively. Do you really think that a scenario where all prices are half of what they were two years ago is workable? What should have to wages? What needs to happen to wages? What will likely actually happen to wages? Does any part of this scenario seem like a Good Thing?

Surveys, papers and books on the ERP

Some interesting papers on the ERP:

Market Risk Premium used in 56 countries in 2011: a survey with 6,014 answers

The Equity Premium in 150 Textbooks

Equity Premium: Historical, Expected, Required and Implied

  • This work provides a fairly in-depth analysis of the differences between the various definitions of ERP and a comprehensive survey of major sources for estimates of these. In general, the estimates of the Expected ERP over T-bonds (rather than short-dated T-bills) are in line with the range I use of 3% to 5% with several showing values to the lower end of this range.
The debate certainly isn’t over, but these papers and the referenced papers, research and textbooks are a good starting place to get up to speed.