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Archive for April 2008

Futures

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One of the financial terms that really puzzled me when I heard it was “derivatives”, which till then was to me only a mathematical concept. Naturally,derivatives would be the next in line for my writeups on finance. Derivatives, by definition are instruments(fancy word for “object”) that derive their value (and price) from an underlying commodity. This post will look at futures contracts which are just one kind of derivatives traded today. As I find a lot of finance rather hand-wavy, I shall stick to my hypothetical situation method.

Futures

Futures are agreements between two parties in which one takes up the obligation to buy a certain commodity(something tangible like gold/oil or intangible like a stock or bond) at a certain price on a certain date in the future. The price is fixed by the two parties depending on their outlook towards the value of the commodity in the future.

For instance, suppose we have a rice farmer and a grain dealer. The farmer produces 100 units of rice, which he sells either in the market or to anyone who offers a better price. Let us also assume for illustration purposes, that the current price of rice in the market is $3/unit and the farmer will be ready to sell in say, 2 weeks time.

So the farmer sits down one day to forecast the price of his grain and decides that in two weeks time, the price would decrease to $2.50/unit. Concurrently, the dealer does his own forecasting and thanks to being privy to some additional information predicts that the price of the grain will go up to $3.5/unit. The dealer also realises that if he waits till harvest time the farmer will not sell at a lower price and the dealer will lose his informational advantage.

To ensure a profit, the dealer approaches the farmer and proposes to buy all 100 units of his produce at $3/unit two weeks from today. The dealer also offers to pay the farmer $10 upfront for the right to buy the rice at $3/unit irrespective of the existing market price. To ensure that no one chickens out on the day of reckoning, the pair sign a contract making it obligatory for the dealer to buy from the farmer at $3/unit and the farmer to sell to the dealer at $3/unit. This is a pretty rough example of a futures contract with a price of $10. It is a derivative as it “derives” its value from the value of the underlying commodity(rice).

Getting back to the two people scenario, we can see that if the farmer was right and the price does settle at $2.5/unit, then through this deal, the farmer has ensured a profit of $60 ($50 on the sale + $10 for the future) while the dealer makes a loss of $60. On the other hand if the dealer is right and the price settles at $3.5, then the dealer makes a profit of $40 ($50 on the sale minus $10 for the future) with the farmer losing $40 ($50 from the crop sale minus the $10 he earned). For prices settling anywhere else, its easy enough to figure out the profit and loss made by either party.

Long and short of it…

This example also illustrates the two strategies prevalent in the futures trading market. Let us, for this section look at the two parties as merely holders of the future contract. The farmer is the original holder of the future (thanks to owning the underlying asset) and the dealer is the buyer. In this scenario we have two strategies, the first when the price is forecasted to fall(farmer’s perspective) and the second when the price is forecasted to rise(dealer’s perspective). When a person sells futures anticipating a fall in commodity price, it is called a “short” futures position, while buying futures anticipating an increase in the asset price is called a “long” futures position.

Futures are also based on the more intangible commodities like shares, wherein traders take long or short positions depending on whether they think the share price will increase or decrease. Futures deriving their value from shares (known as “equity futures”) are more complex in the sense that there is no waiting period as there was for the rice in the example and demand and supply for futures is heavily dependent on what information traders have regarding the company and their share price forecasts.

Futures can therefore be used to make money in both a rising and a falling market by taking a long or short position respectively. Theoretically, one should also be able to minimise the risk by simultaneously buying and selling futures with the same underlying asset, ensuring an income irrespective of the market. There is quite a lot more to futures, but I will leave that to those more interested to read about from the references I have listed. As always, any corrections/additions from those more knowledgeable than me in this regard are welcome…

References:

1) http://www.liffe.com/liffeinvestor/introduction/how/index.htm
2) http://en.wikipedia.org/wiki/Futures_contract

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Written by clueso

April 29, 2008 at 11:23 pm

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Bonding with Stocks.

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In the first blog of what will hopefully be a long series, I will explain the differences between stocks and bonds. I found it a lot easier to understand the concept with a hypothetical situation and will therefore use the same here.

The Hypothetical Scenario

Assume that there is a company worth $1000 which is owned completely by one person. Also assume that business has been good lately and the owner wishes to expand his business(buy a new shop or set up a new factory etc) and has calculated that he needs an additional $100 to do so. He also foresees that the investment of $100 may potentially increase the size of his business by an additional $500 over the next 5 years, so that finally he will be in charge of a $1500 business. The owner also does not have the $100 cash to finance the project himself and so has to get someone else involved. To compare returns on investment from the investor’s point of view, I shall assume that money put in a bank earns an interest rate of 5% p.a.

The problem arises when this person cannot pay the $100 expansion bill himself and needs someone else to loan/give him the money. Some options are by taking a loan from a bank or by borrowing from family, but these methods have their limitations. The other avenues are to issue (a fancy term for “sell”) stocks and/or bonds.

Taking Stock…

The “stock” mechanism involves sale of part of the company to people who are interested in investing their money. The stockholders then become “members” of the company and have a right to vote on and decide the course of action for a company in some ways at least. So now for the mathematics…

Suppose the owner decides that he will issue 10 shares worth $10 each (giving a total of $100) to interested investors and in return they will gain 1% of his company for every share purchased. The amount of money the owner and the investors hold in the company, before and after the stock issue is summarised in the table below

Owner Investor(s)
Before issue $1000 $0
After Issue $900 $100
After 5 Years $1350 $150
ROI 6.19% 8.45%

In this transaction therefore, the owner initially accepts the loss of 10% of his company in favour of raising the cash for expansion which has the potential to increase his worth to $1350, giving him a return of 6.19%. The investors on the other hand, have seen their wealth increase from $100 to $150 dollars in 5 years, giving them a return of 8.45% which beats the returns they would get if they put their money in the bank(5%). The net result? Everyone is happy.

It is important to note that we may not always have a fairy tale ending as considered here. Its quite likely that the value of the company actually decreases, in which case everyone loses, but the owner is not really responsible for refunding the investors their money. The investors may exercise their afore-mentioned right to vote and change the policies of the company or even the person in charge, but they will still lose money. The investors therefore have to do their homework well and assess their risk accurately before investing.

The name is Bond…

Bonds are a slightly different mechanism in that the owner of the enterprise does not sell a part of his company but instead sells part of the debt he will incur to finance the new project he has in mind. Investors therefore do not really “own” part of the company and cannot exert any special influence on its functioning. Bonds also guarantee to pay out a certain return on investment and are thus a less risky investment. The mathematics of issuing bonds for the same company would be as follows…

The owner decides to issue 10 bonds at a price of $10 each to investors. He also promises to pay 6% of the original capital (no compounding) every year for the next 5 years after which the bond matures and the investors will get their original investment. The owner thus gets his $100 from the sale of the bonds. At the end of 5 years, the owner would have spent a total of $130($6 in interest for 5 years + return of original capital) to honour his side of the bond agreement. This leaves him with a net worth of $1370 and he retains full control of his company, which he can now operate in an unhindered fashion and keep all the future profits for himself. The investors as well, have earned a higher return on their money compared to banking it and are happy.

When compared to stocks, it is easy to see that the investors money is relatively safe when they invest in bonds. The bond issuer is responsible for returning the money as well as the interest and they generally do not break their word. The flip side of this safety is that the investors see smaller returns for their investment as compared to the stocks case. From what I have read, bonds are generally issued by governments while most companies will prefer using stocks to raise money.

Conclusion

This is a highly simplified explanation of stocks and bonds which is intended merely to illustrate the mechanisms of these two investment methods. I cannot include any more complexity because it would draw focus away from the main topic and frankly, I haven’t understood everything myself :). Comments/corrections from anyone who is more knowledgeable than me are therefore welcome.

Written by clueso

April 24, 2008 at 10:04 pm

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Show me the money!!!

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We always get interested in the industry which is most prevalent in our surroundings. In India, it was IT and the quest to learn more and more about it seemed to be the holy grail. Since I have come to the UK, it has been finance and theres even more coverage to the issue thanks to the credit crunch which has grabbed most of the western financial-services dependent economies.

In addition to retaining a healthy interest in the techy side of life, I am quite interested in finance and business and thought I should learn a bit more about it. I have also concluded that a good way of understanding anything is to read about it and then paraphrase it and therefore I decided that I will blog about some of the financial knowledge I gain from my random (and sometimes directed) searches. Most of this knowledge is already on the net, but I will not give any links as the whole point is that I explain things in my words. I will also try to use mathematics as much as possible to illustrate the advantage/disadvantage and the mechanisms involved. Being a finance novice, I would appreciate any inputs from more knowledgeable people than me.

Now let me write the first article!

Written by clueso

April 23, 2008 at 11:56 pm

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A dog’s life…

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I came across this article on BBC regarding a new fad of hiring out dogs for days/weekends whatever just to make yourself feel good.

This kind of stuff really makes me cringe as it highlights the current pleasure-without-responsibilities and use-and-throw culture that is so pervasive nowadays. Any true dog lover will vouch for the fact that the joy of having a pet dog is in the whole journey from puppy-hood to adult-hood and not just for a couple of walks on the weekend. They will also vouch that though we may not think of them in that light, dogs have unique personalities and sometimes do not take well to being shunted from one person to another.

I also believe that a true dog lover will have the courage suppress their desires and not keep a dog if their schedule does not allow it or to change their schedule to make sufficient room for a dog if they decide to keep one. To me, anyone who uses this service is for sure not worthy of being called a dog lover.

We might as well have husband/wives, babies, toddler, teenagers, parents and grandparents for hire services to that we can fit our “families” around our “busy lives”

thoroughly disgusting….

Written by clueso

April 22, 2008 at 10:50 pm

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Drugs legalisation.

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I first came across the concept of legalising drugs when I read Ben Elton’s “High Society”, a work of fiction set in modern Britain, where drugs are illegal (or at least not completely legal) but a huge section of society consumes them anyway. Though the idea was revolutionary, I felt kinda queasy at the thought of legalised drugs and could not really stomach it.

I was again made to think about it after I saw a BBC program on cannabis use in Britain and the potential effect of legalising it etc etc. At the moment, cannabis is classified as a Class C drug, which means that people dealing or even possessing the drug could land up being jailed for quite a while(Home office drug classification). But despite this, there seems to be a burgeoning cannabis growing industry in Britain and the police seem to have their hands busy trying to bust all operations of the kind. The disturbing thing is that the cannabis on sale on the streets seems to be a more potent strain than what was available earlier, with higher chances of causing schizophrenia, depression and all the other cannabis associated malaises. The MOST disturbing thing however, is that people are really not aware what they are buying, so even buying from the same drug dealer on two separate occasions could mean that one gets completely different stuff.

Cut to the part of the programme was when the presenter travelled to Holland, where cannabis is freely available for consumption and though it is still an illegal drug, the authorities “tolerate” it for the greater good. The removal of this fear of the police has made buying cannabis in the Dutch cafes something like buying a cup of coffee. The person in charge will tell you how strong a particular strain is, how to smoke it and even some of the science behind how it gives the high that it does. Regular smokers have their favourite strains, depending on the intensity of the high they give and they are pretty much guaranteed that if they ask for a particular type, they will get exactly that. With so much information available, people can make a more reasonable choice about how great a risk they wish to take with their health.

That program made me rethink my original stance on legalisation. Maybe it wasn’t so bad a thing after all. It makes more information available about the risks involved, it drives away the criminal element in the drugs trade and when properly taxed, it may actually contribute handsomely to the government coffers. Money which can then be used to fund anti-addiction programmes maybe. A second reservation I had stemmed from the fact that alcohol is pretty legal in the UK, but the country has its fair share of alcohol driven problems, especially on weekends when people drink like there is no tomorrow and then spill out onto the streets at the same time, sometimes causing violence and destruction. The program in question however, pointed out that while alcohol causes the person to be more confident and aggressive, cannabis consumption causes them to become paranoid, and the stronger strains made them downright scared of pretty much everything. I have also heard(not verified) that drugs like marijuana also give a more mellow high (think of the hippies going “peace brother” 🙂 ), so maybe having some stoned people out on the streets instead of the drunk ones is not too bad an idea. They may die of fright when a cat jumps out of the bushes, but at least they won’t kill anyone else.

I certainly cannot make a strong case for legalisation or not based on an half an hour TV programme, so I will refrain from doing so. Personally I think as long as people don’t cause any problems to others, they should be allowed to consume what they want but no free healthcare should be provided (as is unfortunately done in the UK) to those who make such debilitating lifestyle choices. This programme just got me thinking about the idea and maybe it should be given more attention instead of being treated as a taboo and swept under the carpet.

Written by clueso

April 14, 2008 at 11:31 pm

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The “Memory cannot be read” error

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Often I have come across computing problems for which I have not found direct solutions on the net, but havs still solved somehow or the other. The bad part is that I have not published the solution anywhere on the net/forums, which means that the solution is pretty much lost to anyone else who faces the problem. Since I have recently become more of a “give and take” person, I thought I should post any new important snippets of information I find on my blog for others to find and use. Since I got this idea after I solved the problem, I do not remember the EXACT error message, but I think its enough to understand what is going on. Also, the intention was to have a separate page for the computing info, but that seems to put up some hurdles and may be a while.

So here goes my first one…

Problem: during bootup, we get an error with something to the effect “Rundll32.exe – Instruction at 0xaaaaa tried to reference memory 0xgggg which cannot be read.” The memory location changes everytime, so thats not something that can be reported. After this, none of the executables used to run, which means that the PC is pretty much useless, except for moving the mouse cursor around and using explorer. Funnily, when I tried to run Task Manager, two instances of Task Manager started up, with one hogging around 98% of the cpu. In this busy state, executables ran (or crawled) along, though its definitely not a long term solution.

Solution: This problem was solved when we learnt of a tool called the System File Checker(SFC) which basically checks integrity of all windows system executables and DLLs and replaces any which it thinks are problematic. This tool is included with win XP so there is no need to go around downloading anything. A good tutorial is available at here. Running this tool seemed to get rid of my problems.

I dont know what exactly the issue was with my pc, but SFC was something new I learnt today. Hope someone else benefits too!!!

Written by clueso

April 13, 2008 at 11:06 pm

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