Tuesday, 23 August 2011

The Leverage Cliff: Watch Your Step

Good article from : The Leverage Cliff: Watch Your Step

Due to positive experiences, many people grow comfortable with hedge fund managers and the leverage they use, even without fully understanding the dangers leverage can pose when times get tough. Understanding horizon leverage and risk tolerance can help the investor avoid financial ruin when the perfect storm hits.
Horizon Leverage and the Positive Return Dilemma
Many smart people managing sophisticated funds have run clients into financial ruin. Why? Because money managers are not properly accounting for horizon leverage. Investors who don't have money to lose must not over-wager with these managers, hoping the perfect storm won't hit; it's better is to plan that it will, and adjust your risk parameters accordingly. (For more tips, check out 8 Ways To Survive A Market Downturn.)
Let's Play a GameFor instance, imagine you were to place a bet where the odds of you winning are great, but the consequence of losing is bankruptcy. To a person who understands positive expected return - defined loosely as the product of the probability of a positive outcome times the expected reward is greater than the product of the probability of a negative outcome times the expected loss - this seems like a good bet.
Now suppose you start with a bet of $10 and win! This game seems good, so you play again and again until you are now going double or nothing on several million dollars. While the odds of winning haven't changed, the disastrous consequences of losing have. Beware! You are going up a leverage cliff, and you are about fall off. After about twenty years into the game, the perfect storm hits and you are broke and despondent.
Financial Ruin Using Sound StrategiesA money manager who is myopically focused on positive expected return plays the game over and over again, leveraging up bets. The leverage investment strategy may be sound, but risk tolerance of constituent investors is not being factored in. It is a mathematically certainty that eventually you will lose the bet, and you'd better hope you are not betting all of your money when it happens.
This is a problem for many investors, since money managers often don't feel your risk tolerance like you do. Money managers only focus on expected return and get lost in it, not accounting for the horizon leverage. They are being well compensated for generating high returns, but do not suffer as much if the perfect storm hits, which eventually it will, since all of their money is likely not in the fund. (For more, read Use A Money Manager Or Go It Alone?)
Bankruptcy or No BankruptcyIf money managers did feel your risk tolerance, things would be much different. This can be readily witnessed on the game show Deal or No Deal, where the player guesses on which briefcase holds a million dollars, and is then made offers to stop playing before going through all the cases. The offer is rarely a good move based on an expected return standpoint, suggesting that you should keep climbing up the cliff and never take the "deal." However, some people do. Do they crunch numbers as they progress? No. Rather they go off their gut instincts.
Breaking this down a little further, they are starting to envision themselves with the money offered, understanding that they have a very real possibility of losing it. They then think about things like the time it would take them to earn the wagered amount, the time it would take them to replace the wagered amount if lost, and savings goals relative to their ages.
One step further, I would almost guarantee you that if Warren Buffet played the game, he would never make a deal due to it being negative expected return and his risk tolerance is way beyond a million dollars. (For more, read Personalizing Risk Tolerance.)
Real World Application
Better investing seems to lie in the willingness to make good bets, where the expected return is positive, but only wagering in an amount you can certainly afford to lose. In the first example, $10 was definitely an amount most people could afford to lose; however, one million dollars is generally not. Thus, the risk tolerance needs to be coupled with expected return. This way, the investor can be prepared for the perfect storm while still making good investment decisions, just to a lesser degree.

Rule of ThumbA good rule for many might be to wager no more than would affect your earnings power the next year. Simply put, preserve principal, taking risk only to the extent of not making money for the year, but not permanently losing your principal either. If you are near retirement and need your investments to live off of, your risk capacity would be even lighter, suggesting ultra-conservative, non-leveraged investments.
ConclusionUnderstanding horizon leverage and risk tolerance can help the investor avoid financial ruin and the associated feelings when the perfect storm hits. Hired money managers can be useful in building wealth, by understanding what they are investing in and how much leverage they are using. Try to match your risk tolerance to your underlying investment strategy in order to mitigate the likelihood of financial ruin when you are several years down the road and your ability to play the investment game is hindered. Lastly, understand that the perfect storm will eventually happen; just be able to handle it - not by trying to miss the storm through luck, but by having the ability to weather it. (For more on risk tolerance, read Determining Risk And The Risk Pyramid and Risk Tolerance Only Tells Half The Story.)

Warrants: A High-Return Investment Tool

Copy from : http://www.investopedia.com/articles/04/021704.asp#axzz1VrPjuq8B

A warrant is like an option. It gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. It is unlike an option in that a warrant is issued by a company, whereas an option is an instrument of the stock exchange. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of by an investor holding the shares.

Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, provided the underlying value of the security actually does increase over time. (Warrants are just one type of equity derivative. Find out about the others in 5 Equity Derivatives And How They Work.)

Types of Warrants
There are two different types of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.

Characteristics of a Warrant Warrant certificates have stated particulars regarding the investment tool they represent. All warrants have a specified expiry date, the last day the rights of a warrant can be executed. Warrants are classified by their exercise style: an American warrant, for instance, can be exercised anytime before or on the stated expiry date, and a European warrant, on the other hand, can be carried out only on the day of expiration.

The underlying instrument the warrant represents is also stated on warrant certificates. A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency.

The exercise or strike price is the amount that must be paid in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument.

The conversion ratio is the number of warrants needed in order to buy (or sell) one investment unit. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that the holder needs three warrants in order to purchase one share. Usually, if the conversion ratio is high, the price of the share will be low, and vice versa.

In the case of an index warrant, an index multiplier would be stated instead. This figure would be used to determine the amount payable to the holder upon the exercise date.

Investing in Warrants Warrants are transferable, quoted certificates, and they tend to be more attractive for medium-term to long-term investment schemes. Tending to be high-risk, high-return investment tools that remain largely unexploited in investment strategies, warrants are also an attractive option for speculators and hedgers. Transparency is high and warrants offer a viable option for private investors as well. This is because the cost of a warrant is commonly low, and the initial investment needed to command a large amount of equity is actually quite small.

Let us look at an example that illustrates one of the potential benefits of warrants. Say that XYZ shares are currently priced on the market for $1.50 per share. In order to purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to buy a warrant (representing one share) that was going for $0.50 per warrant, he or she would be in possession of 3,000 shares using the same $1,500.

Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.

Let us look at another example to illustrate these points. Say that share XYZ gains $0.30 per share from $1.50, to close at $1.80. The percentage gain would be 20%. However, with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would be 60%.

In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: $1.50 / $0.50 = 3. The "3" is the gearing factor - essentially the amount of financial leverage the warrant offers. The higher the number, the larger the potential for capital gains (or losses).

Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low. (Leverage can be a good thing, up to a point. Learn more in The Leverage Cliff: Watch Your Step.)

Like any other type of investment, warrants also have their drawbacks and risks. As mentioned above, the leverage and gearing warrants offer can be high. But these can also work to the disadvantage of the investor. If we reverse the outcome of the example from above and realize a drop in absolute price by $0.30, the percentage loss for the share price would be 20%, while the loss on the warrant would be 60% - obvious when you consider the factor of three used to leverage, but a different matter when it bites a hole in your portfolio.

Another disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value.

Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.

A Bittersweet Stock Jump
One notable instance in which warrants made a big difference to the company and investors took place in the early 1980s when the Chrysler Corporation received governmentally guaranteed loans totaling approximately $1.2 billion. Chrysler used warrants - 14.4 million of them - to "sweeten" the deal for the government and solidify the loans.

Because these loans would keep the auto giant from bankruptcy, management showed little hesitation issuing what they thought was a purely superficial bonus that would never be cashed in. At the time of issuance Chrysler stock was hovering around $5, so issuing warrants with an exercise price of $13 did not seem like a bad idea. However, the warrants ended up costing Chrysler approximately $311 million, as their stock shot up to nearly $30. For the federal government, this "cherry on top" turned quite profitable, but for Chrysler it was an expensive afterthought.

The Bottom LineWarrants can offer a smart addition to an investor's portfolio, but warrant investors need to be attentive to market movements due to their risky nature. This largely unused investment alternative, however, can offer the small investor the opportunity for diversity without having to compete with the elephants. (What's true for warrants is true for options, learn more in our Options Basics Tutorial.)