Finance Terminology

A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities. The so-called lower risk of securitised instruments attracts a greater number of investors seeking to benefit in the process of taking many individual assets and repackaging them as Collateralized debt obligation.

Confusion between on and off balance sheet

Traditionally, banks lend to borrowers under tight lending standards, keep loans on their balance sheets and retain credit risk -- the risk that borrowers will default (be unable to repay interest and principal as specified in the loan contract). In contrast, securitization enables banks to remove loans from balance sheets and transfer the credit risk associated with those loans. Therefore, two types of items are of interest: on-balance sheet and off-balance sheet. The former is represented by traditional loans, since banks indicate loans on the asset side of their balance sheets. However, securitized are represented off the balance sheet, because securitization involves selling the loans to a third party (the loan originator and the borrower being the first two parties). Banks disclose details of securitized assets only in notes to their financial statements. 

The Banking Example

A bank may have substantial sums in off-balance sheet accounts, and the distinction between these accounts may not seem obvious. For example, when a bank has a customer who deposits $1 million in a regular bank deposit account, the bank has a $1 million liability. If the customer chooses to transfer the deposit to a money market mutual fund account sponsored by the same bank, the $1 million would not be a liability of the bank, but an amount held in trust for the client (formally as shares or units in a form of collective fund). If the funds are used to purchase stock, the stock is similarly not owned by the bank, and do not appear as an asset or liability of the bank. If the client subsequently sells the stock and deposits the proceeds in a regular bank account, these would now again appear as a liability of the bank.

As an example UBS has CHF 60,316 Million Undrawn irrevocable credit facilities off its balance sheet in 2008 (USD 60.37 Billion.)

Citibank has USD $960 Billion in off-balance sheet assets in 2010, which amounts to 6% of the GDP of the United States.

Arbitrage Trading

“Arbitrage” trading is simply the trading of securities when the opportunity exists during the trading day to take advantage of differences in value between the markets the trades are made within. Arbitrage trading takes place all day long on most days that the markets are active.

Arbitrage traders will buy and sell the same or closely related securities at the same time. They take advantage of the price or value differences in two separate markets such as the NYSE and the CME futures. In perfect securities markets there would never be any arbitrage traders or trades. Since the securities markets are not perfect when news or other information moves a security or index they can and often do become unequal in price temporally. If the markets were perfect all identical securities would trade at the same value or price on each market they were traded on.

One of the most popular Arbitrage trading opportunities is played with the S&P futures and the S&P 500 stocks. During most trading days these two will develop disparity in the pricing between the two of them. This happens when the price of the stocks which are mostly traded on the NYSE and NASDAQ markets either get ahead or behind the S&P Futures which are traded in the CME market.

Let’s say the stocks get ahead of the futures in price. Arbitrage traders will sell the stock and buy the futures. They end up with the same or closely related investment but have just made money by taking the difference in the prices from the two separate markets.

Another example of arbitrage trading. Lets say there is a Company that releases good news in a press release. The stock starts to trade higher on the NASDAQ, and there are call options available for the stock on the AMEX which has not had any or little action or volume. If you jump on the options before they catch up with the climbing stocks price you can often make money by selling the stock and buying the options at the same time. Remember the price disparities that offer the opportunities will not last long, seconds is the norm.

Stock Dilution

What is dilution? 

Dilution occurs when a company issues out more shares to the public, at less than the market value of the company. So lets say that if stock XYZ is trading at $100/share, any other shares that enter the market which the company receives cash of less than $100/share will have a dilutive effect on the company's stock. So, if XYZ issues out stock options priced at $10/share to their employees, whenever those options get exercised, there will be a net dilution to the company of roughly $90/share.

Why do companies dilute their shares? 
The two primary answers involve employee stock options, and buyouts/mergers involving stock swaps.
In the case of a stock swap/merger, the larger company issues out shares in exchange for the smaller company's shares. In most cases, the company that is being bought out has a book value far less than what it is being bought out for - the dilution is the market value of the stock issued minus the book value of the acquired company. The rest is entered as "Goodwill" in the balance sheet of a company.
Everybody knows about employee stock options: They are issued to employees at some price (usually less than the market value of the company) so that employees have an incentive to work harder in order to get the company's stock price up. Both sides win - the company and the employee. Not only that, but with current accounting methods, the issuance of stock options are not considered a cost to the company. In theory, the company could just forgo any cash salaries and issue stock options. This way, the company can report higher profits, as they do not have to deduct the cash salaries to their employees.
Who really pays for the employees then when a company decides to issue stock options? The existing shareholders do when they have their ownership in the company reduced. I am not implying that stock options are bad - when a company can increase its profitability at a rate greater than the dilution, then generally speaking the dilution is acceptable by the shareholders. However, when options are issued rapidly beyond prudence, the shareholders suffer badly.

An example: Amazon

I will be looking at Amazon between July 31, 1997 and July 31, 1999. Amazon split 2:1 and 3:1 between those time periods, and I have accounted for this. I have obtained this information by looking at previous SEC filings which you can access by clicking on the two dates above.
Over this time period, what happens to somebody's ownership of the company? Lets assume that you owned 25% of Amazon on July 31, 1997. What would happen to your ownership stake in the company after two years? Also, lets just pretend that Amazon actually made $200 million a year for the trailing 12 months behind those dates, and issued it out directly to their shareholders in a dividend. This is the chart of data we get:
Date SharesOutstanding SharesOwned Ownership DividendPerShare NetDividend 
07/31/1997 143,152,212 35,788,053 25.0% $1.40 $50,000,000

07/31/1999 168,602,175 35,788,053 21.2% $1.19 $42,452,659

The result of having an extra 25,449,963 shares of Amazon has reduced your net ownership in the company by 3.8%. However, in relative terms, that turns out to be a 15.2% dilution of your previous ownership. That 15.2% turns out to cut your dividend by 15.2%. So we can learn from this that shareholders ultimately pay for dilution. In order for our hypothetical owner to continue getting his original dividend, Amazon has to make 17.9% more income in 1999 than it did in 1997.

Question: What? You just said that the shares are diluted by 15.2%, but why do you need 17.9% more income to make up for it? Don't you just need 15.2% more income? Think of this: If you buy a stock and it sinks 50%, what gain from that point does the stock need in order to break even? 

Not 50%, but 100%. The math with dilution is similar. For those mathematically inclined, if a stock is diluted by a factor of x (lets say 0.152 = 15.2%), then the profit increase has to be ((1/(1-x))-1)% in order to break even with the dilution. If a stock is diluted 50%, you need to make a 100% profit increase in order to break even with the dilution.

A question which should be asked is: So what? That investment in Amazon has appreciated nearly 21 times during those two years even though the shares have been diluted. The answer is psychological: Amazon is perceived as making even more profits in the future in the past two years, and therefore its stock price has risen in greater proportion than the dilution. The problem is nobody actually thinks that when they put down $1,000,000 in Amazon stock today (which will buy 0.00315% of the company assuming a $31.7 billion capitalization) that they will continue to own 0.00315% of the company in five years when it will allegedly become profitable. The fact is that they won't. Assuming that Amazon keeps up a 5% dilution rate for the next 5 years, that person's investment will shrink down to around 0.00246% of the company. Even if Amazon turns out to be incredibly profitable in the future, wouldn't you want to be owning the same slice you paid for it today, rather then the smaller one you will have tomorrow? Whether this has been implicitly priced in the stock is a philosophical debate.
Shareholders pay for dilution. Shareholders have to trust management that when they give up 20% of their ownership in the company, that management will be able to deliver more than 25% of a return on their investment.

Interest Rate

CRR Rate :Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.

Reverse Repo rate :Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system. Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.

Repo Rate : Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
Statutory Liquidity Ratio :SLR (Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit.

Leverage Ratio
1. The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

2. Companies with high fixed costs, after reaching the breakeven point, see a greater increase in operating revenue when output is increased compared to companies with high variable costs. The reason for this is that the costs have already been incurred, so every sale after the breakeven transfers to the operating income. On the other hand, a high variable cost company sees little increase in operating income with additional output, because costs continue to be imputed into the outputs. The degree of operating leverage is the ratio used to calculate this mix and its effects on operating income

Sovereign Debt Default

You've heard it before: someone runs into credit card or mortgage payment problems and needs to work out a payment plan to avoid going bankrupt. What does an entire country do when it runs into a similar debt problem? For a number of emerging economies issuing sovereign debt is the only way to raise funds, but things can go sour quickly. How do countries deal with their debt while striving to grow?

Most countries – from those developing their economies to the world's richest nations – issue debt in order to finance their growth. This is similar to how a business will take out a loan to finance a new project, or how a family might take out a loan to buy a home. The big difference is size; sovereign debt loans will likely cover billions of dollars while personal or business loans can at time be fairly small.

Sovereign Debt
Sovereign debt is a promise by a government to pay those who lend it money. It is the value of bonds issued by that country's government. The big difference between government debt and sovereign debt is that government debt is issued in the domestic currency, while sovereign debt is issued in a foreign currency. The loan is guaranteed by the country of issue.

Before buying a government's sovereign debt, investors determine the risk of the investment. The debt of some countries, such as the United States, is generally considered risk free, while the debt of emerging or developing countries carries greater risk. Investors have to consider the government's stability, how the government plans to repay the debt, and the possibility of the country going into default. In some ways, this risk analysis is similar to that performed with corporate debt, though with sovereign debt investors can sometimes be left significantly more exposed. Because the economic and political risks for sovereign debt outweigh debt from developed countries, the debt is often be given a rating below the safe AAA and AA status, and may be considered below investment grade.

Debt Issued in Foreign Currencies
Investors prefer investments in currencies they know and trust, such as the U.S. dollar and pound sterling. This is why the governments of developed economies are able to issue bonds denominated in their own currencies. The currencies of developing countries tend to have a shorter track record and might not be as stable, meaning that there will be far less demand for debt denominated in their currencies.

Risk and Reputation
Developing countries can be at a disadvantage when it comes to borrowing funds. Like investors with poor credit, developing countries must pay higher interest rates and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Most countries, however, don't run into repayment problems. Problems can arise when inexperienced governments overvalue the projects to be funded by the debt, overestimate the revenue that will be generated by economic growth, structure their debt in such a way as to make payment only feasible in the best of economic circumstances, or if exchange rates make payment in the denominated currency too difficult.

What makes a country issuing sovereign debt want to pay back its loans in the first place? After all, if it can get investors to pour money into its economy, aren't they taking on the risk? Emerging economies want to repay the debt because it creates a solid reputation that investors can use when evaluating future investment opportunities. Just as teenagers have to build solid credit in order to establish creditworthiness, countries issuing sovereign debt want to repay their debt so that investors can see that they are able to pay off any subsequent loans.

The Impact of DefaultingDefaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavorable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country's population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country.

The Causes of Debt Default
Essentially, default will occur when a country's debt obligations surpass its capacity to pay. There are several circumstances in which this can happen:

• During a currency crisis
  The domestic currency loses its convertibility due to rapid changes in the exchange rate. It becomes too expensive to convert the domestic currency to the currency in which the debt is issued.
• Changing economic climateIf the country relies heavily on exports, especially in commodities, a significant reduction in foreign demand can shrink GDP and make repayment costly. If a country issues short-term sovereign debt, it is more vulnerable to fluctuations in market sentiment.
• Domestic politicsDefault risk is often associated with unstable government structure. A new party that seizes power may be reluctant to satisfy the debt obligations accumulated by the previous leaders.

Debt Default Throughout History
There have been several prominent cases in which emerging economies got in over their heads when it came to their debt.

• North Korea (1987)Post-war North Korea required massive investment in order to jump start economic development. In 1980 it defaulted on most of its newly-restructured foreign debt, and owed nearly $3 billion by 1987. Industrial mismanagement and significant military spending led to a decline in GNP and ability to repay outstanding loans.
• Russia (1998)A large portion of Russian exports came from the sale of commodities, leaving it susceptible to price fluctuations. Russia's default sent a negative sentiment throughout international markets as many became shocked that an international power can default. This catastrophic event resulted in the well documented collapse of long-term capital management.
• Argentina (2002)Argentina's economy experienced hyperinflation after it began to grow in the early 1980s, but managed to keep things on an even keel by pegging its currency to the U.S. dollar. A recession in the late 1990s pushed the government to default on its debt in 2002, with foreign investors subsequently ceasing to put more money into the Argentine economy.

Investing in Debt
Global capital markets have become increasingly integrated in recent decades, allowing emerging economies access to a more diverse pool of investors using different debt instruments. This gives emerging economies more flexibility, but also adds uncertainty since debt is spread over so many parties. Each party can have a different goal and tolerance for risk, which makes deciding the best course of action in the face of default a complicated task.

Investors purchasing sovereign debt have to be firm yet flexible. If they push too hard on repayment, they might accelerate the economy's collapse; if they don't press hard enough, they might send a signal to other debtor nations that lenders will cave under pressure. If restructuring is required, the goal of the restructure should be to preserve the asset value held by the creditor while helping the issuing country return to economic viability.

• Incentives to repay
  Countries with unsustainable levels of debt should be given the option of approaching creditors to discuss repayment options without being taken to task. This creates transparency and gives a clear signal that the country wants to continue loan payments.
• Providing restructuring alternativesBefore moving to debt restructuring, indebted nations should examine their economic policies to see what sorts of adjustments can be made to allow them to resume loan payments. This can be difficult, if the government is headstrong, since being told what to do can push them over the edge.
• Lending prudentlyWhile investors might be on the lookout for diversification into a new country, that doesn't mean that flooding cash into international securities will always have a positive result. Transparency and corruption are important factors to examine before pouring money into expensive endeavors.
• Debt forgivenessDue to the moral hazard associated with letting debtor countries off the hook, creditors consider wiping a country's debt clean to be the absolute last thing that they want. However, countries saddled with debt, especially if that debt is owed to an organization such as the World Bank, can seek to have their debt forgiven if it will create economic and political stability. A failed state can have a negative effect on surrounding countries.

Conclusion
The existence of international financial markets makes funding economic growth a possibility for emerging economies, but it can also make debt repayment troublesome by making collective agreements between creditors more complex. With no strict mechanism in place to make the resolution of problems streamlined, it is important for both the sovereign debt issuer and investors to come to a mutual understanding – that everyone is better off coming to an agreement instead of letting the debt go into default.

Government bonds are usually referred to as risk-free bonds, because the government can raise taxes to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare. As an example, in the US, Treasury securities are denominated in US dollars. In this instance, the term "risk-free" means free of credit risk. However, other risks still exist, such as currency risk for foreign investors (for example non-US investors of US Treasury securities would have received lower returns in 2004 because the value of the US dollar declined against most other currencies). Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation outturn is higher than expected. Many governments issue inflation-indexed bonds, which should protect investors against inflation risk.

Sensitivity Analysis

A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price.

Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s). 

Sensitivity analysis allows decision makers to analyze the sensitivity of each program’s criteria input to the ranking of the programs. The sensitivity analysis can be performed on all programs or only those at a specific gate.

The system looks at a specific program and calculates the necessary criteria change to the inputs to move that program up or down one slot in the ranked list. The change is calculated for each criterion independently.

Changes on some criteria will not have enough impact to change the program rank, while changes to others will. Some changes could result in the program moving more than one slot because of the relationships among the criteria weights, criteria inputs, and the range of criteria input values.

The programs are marked before calculating the sensitivity. Sensitivity analysis can be used to test the impact of moving a program either up, down, or both up and down in rank. The results are displayed by criteria for each program. You can select a criterion to change and re-calculate a new ranked program list with that change.

A new approach for sensitivity analysis that enabled the decision makers to test the program rankings and re-evaluate their assessment of the programs. 

The one thing we know with absolute certainty is that the strategic financial plan is wrong. Various externalities will find a way to interrupt any long-range plan. It is therefore important to know what is the most impactful. Where must management devote its attention and endure sleepless nights? Through sensitivity analysis, one assumption at a time is adjusted and the results are summarized in Table

Credit default swap and Credit derivative

Credit default swap is the most basic form of credit derivative trade. It is constructed to transfer the credit risk of an asset without transferring ownership of that asset.
A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference entity." A contract can reference a single credit, or multiple credits.
Credit derivatives are instruments that allow one party to transfer an asset's credit risk to another party without transferring ownership of the underlying assets.
Credit derivative structures such as credit default swaps, total return swaps and credit-linked notes, have become hugely popular both for managing credit risk and outright speculation.
A credit derivative is a financial instrument that allows participants to decouple credit risk from an asset (for example, a loan, bond or swap) and to place it with another party.
Credit derivatives can be structured to create a range of credit strategies for investors. For example, by combining a credit derivative with a risky bond, a credit derivative can be used to:
create a risk-free position in the assetspeculate on credit events such as the likelihood of a bond credit rating downgradeinsure against the default of emerging market sovereign debtCredit derivatives are similar to interest rate and currency derivatives in that they enable an investor to speculate on a market move without actually purchasing the underlying asset.