Wednesday, 29 May 2013


Long-Term Performance Incentives for Executives
Long-term Performance Incentives Reward Executives for achieving superior long-run performance that provides above average returns to shareholders. 
Long-term incentives encourage executives to take risks with firm assets leading to shareholder gains that they might otherwise avoid.
       Example: Investing in a risky project that leads to a radical innovation that changes the rules of competition. 

Types of Long-term Performance Incentives (Source: R. Bernstein, 1998: Foundation for Enterprise Development)
       Founders’ equity
       Restricted stock tied to Executive tenure - golden handcuff
       Stock options given as a Recruiting Bonus
Performance-based LT Incentives for Executives
            Vested Stock Bonus - An award of stock given to executives to reward specific performance.
       Outright Award
       Taxable to employee based on full market value at the time of the grant
       Deductible to employer at same time and same amount
            Restricted Stock Bonus - an award of stock that has further restrictions that must be satisfied before the stock can be owned. 
       Requires that the executive must stay with the company during a vesting schedule or meet some specific performance goals.
       Taxable to employee when restrictions are removed
       Deductible to employer at same time and same amount   
            Stock Option Plans - gives the executive the right to purchase company stock in the future at a price that is fixed at the date of the grant.
       Value of options not reported on accounting records
       Options given to executives dilute value of stock owned by other shareholders
       “Strike price” of stock options are set at time of grant and may be set at market price of stock on day of grant, or some other price of the stock. 
       Stock options are given a period when they can be exercised which in most cases is around 10 years. 
Types of Stock Option Plans
            Incentive Stock Option (ISO)
       Limits on number, length, price and who may participate
       Non-taxable to executive until stock is sold and then taxed at capital gains rate of taxes.
       No corporate tax deduction
            Non-Qualified Stock Options (NSO)
       Flexible to apply compared to ISO
       Taxable to employee at exercise date
        Taxed as ordinary income if sold when options exercised; taxed as capital gains if held for more than 12 months.
       Corporate tax deduction at exercise date
        Most high technology firms use non-qualified stock options for flexibility and tax reasons.

Stock Appreciation Rights (SARs) and Phantom Stock - cash based plans that simulate stock perf.
       long-term incentive without issuing stock; less complex from legal perspective
       does not dilute voting control
       avoids admin. & regulatory complexities, more flexible designs
       no real ownership provided to executive
       company must book value of outstanding SARs or phantom stock as compensation expense periodically

            Stock Appreciation Rights (SARs)
       SARs mirror stock options - receives cash difference between strike price and market value of stock
       No investment on part of executive required
       Gives executive “feel” of ownership  without giving up control to executive

            Phantom Stock
       Phantom stock mirrors stock bonuses
       Executive receives units of value in firm, tied to value of stock appreciation
       Results in a cash distribution
Problems with Stock Option Plans:
1.  Windfall effects - between 1995-1997 there was a 100% increase in stock indexes resulting in huge gains for below average performers.
2. Fixed price options are problematic - poorly related to strategic performance goals
3. Downside on options is minimal
           Improving the Relationship between Stock Options and Performance (Source: A. Rappaport, 1999)
Proposed Solutions
1.  Premium priced stock options
       price must exceed a premium above market on day options are granted, such as 25% or 50% above market price: used by Monsanto, Colgate-Palmolive
2.  Indexing:
       tie options to an index of competitors or market index such as S & P 500
       “in the money” when index is exceeded
       discount value of options when index is not reached
       more indexed options needed than fixed to encourage execs to bear greater risk

Tuesday, 28 May 2013


       Investment banks help companies and governments and their agencies to raise money by issuing and selling securities in the primary market. They assist public and private corporations in raising funds in the capital markets (both equity and debt), as well as in providing strategic advisory services for mergers, acquisitions and other types of financial transactions.

·        Investment banks also act as intermediaries in trading for clients. Investment banks differ from commercial banks, which take deposits and make commercial and retail loans.
In recent years, however, the lines between the two types of structures have blurred, especially as commercial banks have offered more investment banking services.
·        Investment banks may also differ from brokerages, which in general assist in the purchase and sale of stocks, bonds, and mutual funds. However some firms operate as both brokerages and investment banks; this includes some of the best known financial services firms in the world.
·        In the strictest definition, investment banking is the raising of funds, both in debt and equity, and the division handling this in an investment bank is often called the "Investment Banking Division" (IBD).
·        However, only a few small firms provide only this service. Almost all investment banks are heavily involved in providing additional financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.
·        More commonly used today to characterize what was traditionally termed "investment banking" is "sell side." This is trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e. underwriting, research, etc.).
·        The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing public who consume the products and services of the sell-side in order to maximize their return on investment. Many firms have both buy and sell side components.
Organizational Structure of an Investment Bank
·        The primary function of an investment bank is buying and selling products both on behalf of the bank's clients and also for the bank itself. Banks undertake risk through proprietary trading, done by a special set of traders who do not interface with clients and through Principal Risk,
·        Risk undertaken by a trader after he or she buys or sells a product to a client and does not hedge his or her total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet.

·        An investment bank is split into the so-called Front Office, Middle Office and Back Office.
·        Investment Banking is the traditional aspect of investment banks which involves helping customers raise funds in the Capital Markets and advising on mergers and acquisitions. Investment bankers prepare idea pitches that they bring to meetings with their clients, with the expectation that their effort will be rewarded with a mandate when the client is ready to undertake a transaction.
·        Once mandated, an investment bank is responsible for preparing all materials necessary for the transaction as well as the execution of the deal, which may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.
Other terms for the Investment Banking Division include Mergers & Acquisitions (M&A) and Corporate Finance (often pronounced).

·        INVESTMENT MANAGEMENT The professional management of various securities (shares, bonds etc) and other assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes, mutual funds) .

·        SALES AND TRADINGis often the most profitable area of an investment bank responsible for the majority of revenue of most investment banks.
·        In the process of market making, traders will buy and sell financial products with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, who can price and execute trades, or structure new products that fit a specific need.

·        RESEARCH is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. In recent years the relationship between investment banking and research has become highly regulated, reducing its importance to the investment bank.

·        STRUCTURING has been a relatively recent division as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities.
·        Risk Management involves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent 'bad' trades having a detrimental effect to a desk overall.
·        Another key Middle Office role is to ensure that the above mentioned economic risks are captured accurately (as per agreement of commercial terms with the counterparty) correctly (as per standardized booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution).
·        In recent years the risk of errors has become known as "operational risk" and the assurance Middle Offices provide now include measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation.
·        BACK OFFICE
·        OPERATIONS involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While it provides the greatest job security of the divisions within an investment bank, it is a critical part of the bank that involves managing the financial information of the bank and ensures efficient capital markets through the financial reporting function. The staff in these areas are often highly qualified and need to understand in depth the deals and transactions that occur across all the divisions of the bank.

·        TECHNOLOGY Every major investment bank has considerable amounts of in-house software, created by the Technology team, who are also responsible for Computer and Telecommunications-based support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading platforms. These platforms can serve as auto-executed hedging to complex model driven algorithms.
Recent Evolution of the Business
·        Investment banking is one of the most global industries and is hence continuously challenged to respond to new developments and innovation in the global financial markets. Throughout the history of investment banking, many have theorized that all investment banking products and services would be commoditized.
·        New products with higher margins are constantly invented and manufactured by bankers in hopes of winning over clients and developing trading know-how in new markets.
·        However, since these can usually not be patented or copyrighted, they are very often copied quickly by competing banks, pushing down trading margins.
·        For example, trading bonds and equities for customers is not a commodity business, but structuring and trading derivatives is highly profitable. Each OTC contract has to be uniquely structured and could involve complex pay-off and risk profiles.
·        Listed option contracts are traded through major exchanges, such as the CBOE, and are almost as commoditized as general equity securities.
Possible Conflicts of Interest
·        Potential conflicts of interest may arise between different parts of a bank, creating the potential for financial movements that could be market manipulation. Authorities that regulate investment banking require that banks impose a Chinese wall which prohibits communication between investment banking on one side and research and equities on the other.
·        Many investment banks also own retail brokerages. Also during the 1990s, some retail brokerages sold consumers securities which did not meet their stated risk profile.
·        This behavior may have led to investment banking business or even sales of surplus shares during a public offering to keep public perception of the stock favorable.
·        Since investment banks engage heavily in trading for their own account, there is always the temptation or possibility that they might engage in some form of front running.

National Role for Investment Banks
·        Investment banks are social institutions. They are custodians and trustees of the public’s money and promoting national interests—strengthening the sovereignty of our state technological up-gradation and reduction of asset distributional inequities—must be explicit objectives of their business strategy.
·        These objectives will not be unintentionally, automatically achieved by profit maximization. A strategy has to be crafted which deliberately synthesizes financial viability and profitability concerns with the concern for safeguarding national sovereignty and promoting national development.


Decision Making Under Uncertainty

Risk and Uncertainty
§  Knight (1921):
Risk: applies to events for which objective probabilities can be assigned.
Uncertainty : applies to events for which objective probabilities cannot be assigned, or for which it would not make sense to assign them.
  • Keynes (1936):
A game of chance is Risky because, although the outcome of any one trial is unknown in advance, repetition of the game a large number of times enables observed relative frequencies to be interpreted sensibly as objective probabilities.

  • Uncertain events are those that cannot be repeated in any controlled way, thus rendering the calculation of relative frequencies difficult, if not impossible.
  • Insurance markets aside, most financial markets involve uncertainty rather than risk, in the sense that relative frequencies are not readily available to estimate probabilities.
  • Most applications in finance permit the estimation of probabilities from past data or other info.
  • Financial analysis is located somewhere a long the spectrum between two polar extremes, one allows for calculating frequencies while the other doesn’t.
  • The Stat-preference Approach (SPA)
v   Modelling Uncertainty
  •  The SPA comprises three basic ingredients:
  1. State of the world, denoted by set S = {s1, s2, ..s}. It describes some contingency that could occur.
  2.  Actions, describe all relevant aspects of the decision that are made before the state of the world is revealed. They describe choice of assets.
  3.  Consequences, express the outcomes of an action corresponding to each state of the world. They are represented by a list, each element of which is the total value of the portfolio in the  corresponding state.
  • If (c) denotes a consequence and (a) denotes an action,  then the three components of the theory are related by a function of (sk) and (a) such that
c = f(sk, a).  Function f(.,.) maps states and actions into the space of consequences.
  • In portfolio selection, the function links the amount of each asset held (the action) to each asset’s payoff in every state, and hence to the consequence (terminal wealth).
  • In the state-preference model, each individual has a utility function the value of which serves to rank all the possible consequences.
u = U(f(s1, a), f(s2, a), …, f(s, a))
  • The function U(.,.,.,.) differs across individuals.
  • The individual’s decision problem is to maximize utility, u , by choosing a feasible action which is a portfolio that satisfies the individual’s wealth constraint, and other constraints.
  • At date (0), today, investors have to make decisions not knowing which of the six states will occur at date (2).
  • At date (1), it becomes known that one of the events has occurred.
  • Finally at date (2) the state is revealed.
  • For simplicity, it is assumed that investors make decisions with respect to  a single future date.
  • The payoff on the (n) assets in the (ℓ) possible state can be arranged in a payoff array.
  • Rows correspond to states and columns to assets.
  • vkj is the payoff to a unit of asset j if state k occurs
§  Let pj denote the price of asset (j) observed today. Then the rate of return on asset (j) in the state (k) is defined by:
  rkj = (vkj - pj) / p= (vkj / pj) -1

  • The gross rate of return on asset j, Rkj, is:
  Rkj ≡ (1+rkj)  = vkj / pj

  • Risk-free asset has the same payoff in each state, is denoted with subscript (0), with payoff (v0) in every state and rate of return:
        r0 = (v0/p0) - 1  

  • Suppose there is an asset that has a positive payoff of one unit of wealth in a particular state, k, and zero in every other state.
  • This asset could play the role of an insurance policy; the purchase of which allows the investor to offset any adverse consequences in state k, only.
  • Assume that one such asset exists for every state.
  • Investors can insure against the adverse consequences of every possible contingency.
  • Conditional on the occurrence of any state, investors could be certain of obtaining a known payoff, the cost of which is the asset’s price (or insurance premium). 
  • The presence of such an asset for every state is sufficient for the existence of a complete set of asset markets.
  • Otherwise, asset markets are said to be incomplete
  • Completeness is an idealization, and useful as a benchmark against which more realistic circumstances can be evaluated
Decision making under uncertainty
  • Denote terminal wealth as Wk, the investor’s utility function is defined over the consequences,
 Wk , k = 1, 2, ..., ℓ:
u = U(W1 ,W2 , ..., W)
Wk ≡ f(sk, a)
U(.) is similar to standard consumer theory, but  in the presence of uncertainty, the investor must make a decision before the state is revealed. So, he must weigh up the consequences across all the conceivable states.
The wealth constraint states that the investor’s outlay on assets equals initial wealth:
  p1x1 + p2x2 + …+ pnxn = A 
Where (A) is the initial wealth and (xj)s denote the number of units of each asset in the portfolio, so that (pjxj)  is the amount of wealth devoted to asset j= 1, 2, …n.
The portfolio is linked to terminal wealth via the payoffs of each asset in each state of the world:
  Wk = vk1 x1 + vk2 x2 + …+ vkn xn    (k = 1, 2, ..., ℓ)
§  which is the sum of the payoff of each state multiplied by the chosen amount of the asset.
  • The result is a portfolio decision in which the amount of each asset held depends on asset prices, initial wealth and preferences.
  • The analysis can be extended to cover a multiperiod horizon, generalizing the single period decision problem described so far.
  • In this case, preferences (and utility) depend on the levels of wealth in all states and all dates.
  • The wealth constraint must be modified to reflect the opportunities for the investor to transfer wealth from one period to the next.
The Expected Utility Hypothesis (EUH)
 Assumptions of the EUH
  • Probability is completely absent from the analysis in the state preference model.
  • The EUH approach permits a role for probability (by assigning probabilities to states of the world) to yield more definite implications.
  • By attaching prob. to each state, the EUH enables a distinction to be drawn between the decision maker’s beliefs (expressed by probabilities) about which state will occur and preferences about how the decision maker orders the consequences of different actions
  • The implications of the EUH emerge by imposing a number of assumptions:
1.      Irrelevance of common consequences. The decision maker orders the actions independently of the common consequences for states not in the event.
2.      Preferences are independent of beliefs. Preferences over consequences for the given state  are independent of the state in which they occur.
Decision maker cares only about the consequence not the label (e.g. k) of the state in which it is received.
3.      Beliefs are independent of consequences. The decision maker’s degree of belief about whether a state will occur is independent of the consequences in the state.
  • Together, the three assumptions imply that:
§  The decision maker acts as if a probability is assigned to each state.
§  There exists a function that is dependent only on the outcomes.
§  The decision maker orders the actions according to the expected value of the utility function.
  • Formally, the EUH implies that:
u = U(W1 ,W2 , ..., W)
= π1 u(W1) + π2 u(W2) + …+ πu(W)
where πk is the probability that the investor assigns to state sk.
  • The u(.) is the same for all states, although the value of its arguments, wk, generally differs across states.
  • But probabilities and u(.) are allowed to differ across investors.
  •  Assume u/ (W) > 0, meaning that investors prefer more wealth to less. 
  • The EUH is written as stating that actions are ordered according to E[u(W)], where E[.] denotes the operation of summing over the product of probabilities and utilities.
  • The EUH asserts that actions are chosen to maximize expected utility:
o   E[u(W)] ≡ π1 u(W1) + π2 u(W2) + …+ πu(W)
 Portfolio Selection In The EUH
  • The portfolio selection problem can be stated as: choose the portfolio of assets to maximize expected utility subject to the wealth constraint.
  • This is the static problem: it does not address the issues of (a) revising decisions overtime, or (b) the possibility that the investor wishes to consume some wealth before the terminal date.
  • The analysis is expressed in terms of rates of return and proportions of initial wealth invested in assets. Thus, terminal wealth is: W = (1+rP) A
The Fundamental Valuation Relationship
  • Every portfolio that maximizes expected utility must satisfy a condition called the fundamental valuation relationship (FVR).
  • The FVR is the set of first order conditions for maximizing expected utility, one for each asset.
  • Its general form is: E[(1+rj)H]=1   j=1,2, …, n
  • H is a random variable that varies across states.
  • If the investor devotes one additional unit of wealth to asset j.
  • The payoff is (1+rj) and the increment to expected utility is E[(1+rj) u/ (W)].
  • It means: weight the utility increment in each state by the state’s probability and sum over the states.
  • At a maximum of expected utility it is necessary that the expected utility increment is the same, say λ, for each asset, so that
E[(1+rj) u/ (W)] = λ             j=1,2, …, n
  • If this equation does not hold, then expected utility can be increased by shifting wealth from those assets with low values of E[(1+rj) u/ (W)] to those with high values.
  •  Only when equality holds for every asset can expected utility be at a maximum.     
  •  λ is the increment to expected utility resulting from a small increase in initial wealth(i.e. E[u/ (W)]).
  • At a maximum of expected utility, the expected marginal utility of wealth must equal the increment to expected utility from a small change in the holding of any asset; otherwise, expected utility is not at a maximum.
  • The FVR in the present of a risk –free asset is: E[(rj – r0) H] = 0             j=1,2, …, n
  • The FVR provides a set of necessary conditions for a maximum.
  • The 2nd order conditions, together with the FVR, provide necessary and sufficient conditions that a solution of the FVR constitutes a maximum of expected utility.
  • The 2nd order conditions amount to the requirement that u//(W) < 0; that is, that the investor is risk-averse.
Risk Neutrality
  • The case of risk neutrality (u//(W)=0) implies that the marginal utility of wealth is independent of wealth – say u/(W) = c,  a positive constant.
  • This means that:
E[(rj – r0) u/ (W)] = 0
c E[(rj – r0)] = 0
E[rj ] = r0                            j=1,2, …, n

  • The equation involves no choice variable of the individual, it either holds or it does not.
  • If it doesn’t hold, the investor can borrow at r0 and invest an unbounded amount in any asset for which E[rj]> r0;
and short sell an unbounded amount of any asset for which E[rj]< 0, the proceeds being invested at the risk-free rate, r0.
  • This implies that no solution to the maximization problem unless E[rj ]=r0  holds; (i.e. the expected return on every asset equals the rate of return on the risk-free asset).
  • In such an equilibrium, risk neutral investors are indifferent about which asset to hold.
  • It may seem that a world of uncertainty with risk neutral investors would look rather like a world of certainty (asset payoffs not differ across states).
  • But, E[rj ]=r0  involves an expectation.
  • Exactly one state will be realized, and almost surely the actual excess return for asset j will be negative or positive (not zero).
  • The expectation may be equal to r0 but the actual outcome, when the state is revealed, may will differ. In this case risk is present (future is unknown) even if investors choose to ignore it.
The Mean-Variance Model
The Mean-variance approach to decision making
  • The EUH remains a general rule for decision making unless a specific form is assumed for the von Neumann-Morgenstern utility function.
  • One form is that u(.) is quadratic in wealth. Expected utility can be written as a function of the expected value (mean) and the variance (or standard deviation) of terminal wealth.
  • Hence the name “mean-variance analysis” for a framework that greatly facilitates the construction of optimal portfolios.
  • Denote the expected value of terminal wealth by E[W] and its variance by
var[W] ≡ E[(W – E[W])2].
  • If  u(.) is quadratic, the expected value of u(W) is a function of E[W] and var[W]:
E[u(W)] = F(E[W], var[W])
 The FVR in the Mean-variance model
The FVR can be written as:
μj – r 0 = μP – r 0           j= 1, 2, …, n    (4.15)
σjP / σP       σP             
  • Where (σjP) denotes the covariance between the rate of return on asset j and the rate of return on the portfolio as a whole.
  • The ratio (σjP / σP) equals the increment to risk (as expressed by σP) associated with an incremental change to the proportion of asset j in the portfolio.
  • Thus, the FVR states that each asset’s expected rate of return in excess of the risk-free rate, μj–r0, per unit of its contribution to overall risk, σjP / σP, is the same for all assets – a necessary condition for a mean-variance optimum.
  • Investor’s preferences (attitudes to risk) do not appear in expression (4.15).
  • The equalities depend only on beliefs (expressed in terms of means, variances and covariances of assets’ rates of return).
  • This implies that there is a role of preferences separate from the role of beliefs.
  • For a mean-variance investor, portfolio selection is an outcome of a two-stage process:
  • . Choose a portfolio that satisfies the FVR conditions, (4.15). This portfolio takes a very special form, consisting of only two special assets, which are themselves portfolios of assets.
o   . If a risk-free asset is available, one of the two special assets can be chosen to comprise just the risk-free asset alone.
o   . Investor preferences are not relevant in constructing the special assets; their composition depends only on means, variances and covariances that can be estimated from observed data.

  • According to investor preferences, choose the optimal portfolio that optimizes these preferences (i.e. that reaches the highest feasible indifference curve).

  • The practical importance of this approach is that it is often reasonable to assume that the first stage is the same for all investors who have the same information, while investors can be allowed to possess their own, unique preferences (expressing attitudes to risk) in the second stage.