Leverage - Flathead Lake, in Montana

Leverage denotes any technique aiming at increasing the size of assets under control, either directly (i.e., buying more assets) or indirectly (buying financial assets that ensure a partial participation in the underlying asset’s price development), without increasing the initial amount of the capital invested.

In other words, leverage is any financial mechanism used to increase the potential return per unit of amount invested, by magnifying the risk exposure at the same time.

Leverage comes in three main forms. Traditionally, leverage is understood as the use of borrowed funds to increase the size of assets under control. Beyond traditional leverage, economic leverage is also widely used. Economic leverage denotes the inclusion of assets with internal leverage in the portfolio (instrument leverage).

Since these assets are notionally funded, it is possible to control a larger amount of the underlying position with a small initial investment / margin. Beyond these, using a third form of leverage, which is referred to as “construction leverage,” is also observable.

This term refers to the practice of combining certain long and short positions of assets with preferably high correlation, thus eliminating market risk (at least in part). By using this methodology, fund managers are targeting idiosyncratic risk with a relatively small initial investment.

Measuring the degree of leverage is not an easy task. As for the traditional form of leverage, it measures the ratio between interest bearing debt and equity within the balance sheet.

The effect of paying fixed debt costs will magnify the volatility of the (after-tax) earnings per unit of capital invested—this is also known as leverage effect. Certainly, the use of borrowed funds is, as a rule, efficient if the gains are higher than the fixed costs of borrowing.

As for economic and construction leverage, the degree of leverage characterizes the ratio between the size off(or investment in) the initial position and the total value of the underlying controlled through this position.

The leverage effect denotes in this case that, when investing in such assets, changes in the market value of the underlying position might lead to disproportional changes in the value of the derivative position.

Note that leverage generates return distributions with inherent non-normality. This is so since by using leverage the underlying return distribution will be capped and part of this risk is transferred to other market participants (debt holders, option writers, etc.), thus creating an option-like characteristic in every case.

Leveraged Buyouts

Leveraged Buyouts - Moose walks, Denali National Park, Alaska
Leveraged Buyouts

A leveraged buyout (LBO), also known as a highly leveraged transaction (HLT), is a financial transaction where a firm’s assets are acquired using a high level of debt. This results in a very high leverage for the firm after the transaction.

Using a sample of 76 management buyout (MBO) transactions— a special case of an LBO undertaken by a firm’s management—Kaplan (1989) reports that the book value of debt to equity ratio increased from 21% before the buyout to 86% after the transaction.

LBOs along with venture capital investments are the two primary investment vehicles for private equity funds. Using a sample of 746 private equity funds that are largely liquidated, Kaplan and Schoar (2005) report that about 41% of the private equity capital was invested in these funds. The mean size of an LBO fund in their sample is about U.S. $416 million.

To compare the performance of the LBO funds, the authors discount the cashflows for these funds with the return on S&P 500 index. Net of fees and on equal-weighted basis, the median LBO fund underperformed S&P 500 by a factor of 0.80 while the fund at the 75th percentile outperformed the index by a factor of 1.13.

On value-weighted basis, where value is proxied by the amount of capital committed to the fund, the respective performance numbers are 0.83 and 1.03. They also find evidence of persistent performance.

Given LBO specialists such as KKR closely monitor a portfolio of firms after these transactions, LBOs should be thought of as a new form of organization similar in structure to that of a diversified conglomerate, according to Jensen (1989).

Kaplan (1991), however, argues that LBOs are neither permanent nor short-lived organization form. this conclusion is based on his observation that the median firm in a sample of 183 large LBO transactions between 1979 and 1986 remained private for 6.8 years after the transaction.

But why do LBOs exist? theoretically, in a Modigliani–Miller (1958) ideal world where taxes, transaction cost, and agency problems do not exist, capital structure is irrelevant and LBOs do not add any value. In reality, however, the tax shield of debt is valuable to a firm’s equity holders.

Hence, LBOs are expected to increase firm value. A counterargument is presented in Miller (1977) where an investor holds both debt and equity, and any benefit from the tax deduction for the equity gets completely offset by the tax paid on the interest income from the debt.

Empirically, Kaplan (1989) provides evidence that value of the tax shield in a sample of MBOs between 1979 and 1985 ranged from 21 to 143% of the premium paid to pre-buyout shareholders.

A second source of value in an LBO may come from the reduced agency problem of the free cashflow. Free cashflow is the cash flow in excess of what is required to finance all the positive NPV project opportunities for a firm.

Jensen and Meckling (1976) suggest that agency problem arises when a firm’s manager is not a 100% owner of the equity, he/she has incentives to invest in negative NPV projects, including consumption of excessive perks. This happens because the manager accrues 100% of the benefit from such wasteful expenditures but bears less than 100% of the cost.

Jensen (1986) argues that LBOs can mitigate the agency problem of free cashflow. Increasing a firm’s leverage increases managerial equity ownership. This assumes that the manager does not sell his/her equity interest at the LBO.

This provides the manager with powerful incentives to improve the operating performance of the firm and reduce investments in negative NPV projects.

In addition, with the interest payment of debt hanging over the manager’s head as a sword and close monitoring by the buyout specialist, he/she becomes disciplined and does not have the opportunity to waste resources.

A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efi ciently and hence may be willing to pay a premium.

Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.

A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efficiently and hence may be willing to pay a premium.

Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.

Critiques of LBOs may argue that such transactions transfer wealth from a firm’s employees to its equity holders. Improved operating performance may come from the reduced wages and benefits of the employees who have little equity ownership and hence stand to gain little from such transactions.

Based on empirical evidence, Kaplan (1989) concludes that the gain from the buyouts comes from better alignment of managerial incentive to those of the shareholders and from the reduced agency cost rather than wealth transfer from the employees.

Another critique against LBOs may be that such transactions transfer wealth from pre-LBO debt holders to equity holders. Increasing leverage also increases the probability of a bankruptcy.

As the new debt used to finance an LBO is often senior to the preexisting debt, original bondholders are likely to recover less in case of a bankruptcy.

Thus the original bondholders bear most of the increased cost of financial distress brought on by the LBO but almost none of its gains such as the benefit of the tax shield or the reduced agency cost.

LBOs may also create an asset substitution problem where a firm has to forego positive NPV projects because it is unable to finance those projects due to a high level of debt.

The evidence is mixed on whether a firm’s cost of financial distress increases after an LBO. Andrade and Kaplan (1998) examine 31 LBOs that became financially distressed subsequent to the transaction.

They provide evidence that although some firms are forced to reduce capital expenditure and a few engage in asset fire sale, these firms still had superior operating performance than the median firm in the industry.

In addition, they argue that the leveraged transaction generated a positive, albeit small, value even after subtracting the cost of financial distress. They did not find any evidence of asset substitution in their sample.

In contrast to these results, Zingales (1998) finds that highly leveraged firms have lower ability to make capital investments. Using data from trucking industry he finds that this was particularly pronounced in firms that were eventually forced to exit the industry.

Following a buyout, a firm may also face predatory threat from its deeper pocket competitors that do not have a high level of debt or interest payment. In the same study, Zingales analyzes the effect of high leverage on a firm’s ability to react to and survive competitive pressures in the product market following deregulation.

The author found that transportation firms with high leverage were forced to charge lower prices during the price war. In the end, the more efficient firms with superior operating performance were forced to exit partly due to high leverage, leaving the playing field for their inefficient, underleveraged, and deep pocket competitors.

Licensed Warehouse

Licensed Warehouse - British Columbia, Canada
Licensed Warehouse

A licensed warehouse is a warehouse approved by an exchange from which a commodity may be delivered under a futures contract. A regular warehouse must satisfy exchange requirements for financing, facilities, capacity, and location and has been approved as acceptable for delivery of commodities against futures contracts.

Indeed, exchange-traded commodities, such as energy commodities, are traded in specific lots of specific quality for specific delivery and usually also trade in forward, futures, and options contracts.

The warehouse must verify that the products delivered in their walls are conforming to the contract specifications. Furthermore, only 2% of the transacted commodity futures contracts give way to delivery.

Investors, generally, close their contracts before expiration so that they do not have to take delivery of enormous quantities of commodities for which they have no storing space and no need. Therefore, as the delivery date nears, most investors close out their positions by undertaking an equal and opposite trade.

A warehouse operator cannot issue a warehouse receipt unless that person holds a warehouse license issued by an accredited organism. All delivery of commodities must be inspected and graded to comply with the exchange specifications, stored at a licensed warehouse, and fully insured against loss from fire, windstorm, and explosion.

Life of Contract

Life of Contract - Granite Hot Springs in Jackson Hole, Wyoming
Life of Contract

Unlike stocks, futures contracts have limited lives. The life of contract refers to the period of those limited lives. It is typically used as an adjective, as in “life-of-contract high” or “life-of-contract low,” meaning the highest price or lowest price at which the contract traded since it was listed.

For example, the June 2008 live cattle futures contract was listed for trading on January 2, 2007 and its last day of trading (or maturity date or expiry date or expiration date—all terms for the same thing) was June 30, 2008. The life of contract for June 2008 live cattle futures refers to the 18-month period of time between those two dates.

If on July 1, 2008 an analyst said the life-of-contract high was $105.50, it would refer to the highest price during the 18-month period. But if someone mentions a life-of-contract high or low while the contract is still trading, then it means for the period from contract listing only up until that date.

Depending on the underlying asset, there are significant differences in the lives of contracts. For example, each Japanese yen contract is listed for 18 months, while each S&P 500 contract is listed for 24 months. At the other extreme are contracts such as eurodollars and crude oil.

Eurodollars typically has a 10-year life of contract while crude oil can be as much as 8 years. These differences are driven by differences in the demand for trading in the specific contracts.

For example, in the case of eurodollars, because swap dealers are entering into OTC swap contracts with institutions that go out for 10 years and since they need to often hedge the risk associated with these contracts, they need instruments that go out for a similar period of time.

In the case of stock indexes, on the other hand, even if an individual needs protection or exposure for a longer period of time the historical tendency is to take advantage of good liquidity in the nearby months and if, by the time the front month contract expires, the trader still needs exposure or protection, then the trader engages in what is referred to as a roll.

A roll involves moving one’s position to a more distant month by of setting the position in the nearby month and simultaneously establishing a new position in the more distant month.

the context in which life of contract is typically used is when referring to price statistics, like high and low. Traders are interested in the high and low prices during the previous trading day, possibly during the previous week or month, and certainly during the life of contract.

In addition, when one is analyzing futures data for different purposes, especially when one is engaging in technical analysis, a decision must be made about whether to look at the life of contract data, which is of course limited to the length of the life of that contract, or continuous (or continuation) data.

Continuous data is created by splicing together the prices for the nearby contracts during their last few months of life, but stopping usually a few weeks before the contracts expire. Stringing nearby prices together allows you to analyze many years of prices.

Naked Options

Naked Options - Magic Swordwoman
Naked Options

A naked option is an option that is written by the option seller with no underlying asset position in the portfolio to cover its risk exposure. This means that the option seller is purely speculating on the option, assuming a very risky position. Hence, naked options are also called uncovered options, as the seller has no underlying position to cover it.

As the underlying asset starts rising call options follow the move. And, as the underlying asset has no theoretical limit to stop, the liability associated with the short call option position has no theoretical limit too. Therefore, a seller of a call option that has no underlying asset protecting the position has no theoretical loss limit.

The same effect happens for put options, considering deep market falls. When shorting naked puts, investors assume a potential downside risk without any position to sustain the losses. As the market starts falling, the put option position starts incurring losses.

Selling naked options is a very risky strategy that can be assumed in the options’ market. Sometimes it is difficult to stop losses on naked positions, especially when the series where the seller has a position is far from-the-money (deep in-the-money or deep out-of-the-money).

These series are usually very illiquid and it is sometimes difficult to close out an open positions. In these circumstances, it is advised to “close” the position using a different exercise price, creating a spread position instead.

National Futures Association

Regulatory relationship
Regulatory relationship

The Commodity Futures Trading Commission (CFTC) was created in conjunction with the Commodity Exchange Act of 1974 to regulate the U.S. futures markets (see Fung and Hsieh, 1999, for an evolutionary history of the legal environment of hedge funds).

The CFTC is an independent federal regulatory authority with the legal responsibility to ensure that futures trading serves a valuable economic purpose, to guarantee the integrity of the market and the clearing process, and to protect the interests of futures market participants from market manipulation, misuse, and fraud. The CFTC is represented at the largest futures exchanges: Washington, DC (its headquarters); New York; Chicago; and Kansas City.

The futures industry attempts to regulate itself through an industrywide selfregulatory organization called the National Futures Association (NFA), which was formed in 1982 to establish and enforce standards of professional conduct. This organization works in conjunction with the CFTC to protect the interests of futures traders as well as those of the industry.

Every company or individual who carries out futures or options trading with the public is required to register with the CFTC and become a member of the NFA. Th e NFA’s objective is to offer new regulatory programs and services making sure of futures industry integrity and to help its members in attaining their regulatory responsibilities.

In order to ensure regular trading activity, the NFA conducts background checks on applicants, conducts exams and tests, ensures compliance regulations are met, and can impose sanctions on members if necessary.

The NFA’s activities are overseen by the CFTC, on whose behalf the registration process is performed. NFA members fall into four categories:
  1. commodity trading advisors (CTAs),
  2. commodity pool operators (CPOs),
  3. futures commission merchants (FCMs), and
  4. introducing brokers (IB).
FCMs who are members of an exchange are subject not only to CFTC and NFA regulations, but also to the regulations of the exchanges and clearing organizations they belong to. Therefore, the exchange and clearing corporation personnel are under the CFTC supervision and are accountable for scrutinizing the business conduct and assuming financial responsibility for their member firms, floor brokers, and traders.

Violating exchange rules can have serious consequences resulting in heavy fines, suspension, revocation of trading privileges, and even the loss of exchange or clearing corporation membership. Even though the different regulatory organizations in the futures industry have their own particular areas of authority, jointly they form a regulatory partnership that watches over all industry members.

Once CPOs or CTAs have registered with the CFTC and the NFA, they are subject to several disclosure obligations (see Anson, 2006, for a survey). If a registered entity violates the rules, the NFA has the authority to take disciplinary action, which can range from issuing a warning for small rule violations to ofi cial complaints if rule violations merit prosecution.

Penalties consist of censure, reprimand, expulsion, suspension, ban from future association with any NFA member, and fines up to $250,000 per violation. The NFA also has the authority to reject, suspend, restrict, or place conditions on any firm’s or individual’s registration.

National Futures Association
National Futures Association

Natural Gas

Natural gas is a gaseous fossil fuel. It is mainly used for heating in households and industrial processes, in power generation, and increasingly as raw material for chemical processes (e.g., fertilizer production).

Transportation is either via pipelines or via liquefied natural gas (LNG) ships. Consequently, the delivery of natural gas is defined via hubs, where one or more pipelines or LNG terminals are connected to, for example, Henry-hub in the United States.

Demand for gas is mainly driven by weather, demographics, economic growth, and fuel competition. Additional price influence is given by storage and exports while the supply is mainly determined by pipeline capacity, storage, gas drilling rates, and weather events like hurricanes, technical issues, and imports. Natural gas consumption in the power sector is expected to grow in Europe as the shift from coal to gas is one of the many possibilities to reduce CO2 emissions.

Gas is traded on exchanges, for example, NYMEX or ICE. Contract size at the NYMEX is 10 million British thermal Units (btu) with a tick size of 0.001 USD per 10 million btu leading to a tick size of 10 USD per contract. The daily price limit is 3 USD per 10 million btu. Deliveries start at the first calendar day of the delivery month and end at the last calendar day of the month.

Natural Gas
Natural Gas