Stress Testing

Stress testing and capital planning are increasingly linked too many risk management processes that require coordination across risk, treasury, and financial planning and analysis functions.

A successful stress testing program demands flawless integration and execution of numerous tasks, including program governance, process and results validation, documentation, data quality management, economic scenario development, expected loss modeling, forecasting, and reporting. 

Establishing an integrated approach to the use of stress testing results require infrastructure, analytics, data, clear governance, and active participation of all stakeholders across divisions, business units and geographies.

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Stress testing involves running computer simulations to identify hidden vulnerabilities in institutions and investment portfolios to evaluate how well they might weather adverse events and market conditions.

However, a robust risk management framework demands the implementation of scenario simulation where the distribution is extremely skewed towards the tails (tail events); a the situation that happens in very rare cases. Such shocks could be caused by various macro-economic or idiosyncratic events, which can consequently spread widely to previously thought of as uncorrelated choices of assets (Systematic or else Undiversified risk). 

 Vivid examples of historical crises that resulted in large losses of invested capital within a certain period (varying from a few days to a few months) include the Black Monday of 1987, the Gulf War of 1990, the Asian Crisis of 1997, the Russia Devaluation of 1998 and the Financial Crisis of 2008.

Although a large portion of such losses was often due to excessive leverage and over-concentration of positions, one wonders if an an investor should use such extreme divergences from normality to stress test their seemingly well-diversified multi-asset portfolios.

Admittedly, we should not rely on the the assumption that history repeats itself since background conditions and driving factors often differ vastly between distant periods of economic and market activity. However, to assess and verify that adequate capital is preserved to cover any unexpected losses, investors could attempt to estimate the impact on the portfolio performance that the re-occurrence of such damaging historical events could have.

In this way, stress testing would give us an idea of how stretched the loss-tolerance levels of a risk management the strategy would turn out to be during a crisis of historical precedence.

To conduct such an analysis, one would need to select a the historical crisis of relevance (a subjective choice) and apply changes to the risk factors driving the price of various asset classes (e.g. equities, bonds, credit, commodities, foreign exchange) accordingly, to assess their impact on the current portfolio if an identical market condition occurs. Such market shocks might be global or local in nature; consequently, geographical disparities in valuation changes would need to be identified and incorporated.

The date ranges one could use for such stress testing, could largely match the length of the a referenced historical event, with the return change being the cumulative return over the entire testing period.

This requires the risk management system to give as much flexibility on stress testing modeling as needed since every portfolio or strategy will not be subject to the same risk factors. It should at least contain quantitative information about extreme market movements during historical crises, the application of which, to the current portfolio would have to be straightforward. 

It would also be advantageous to provide the functionality for custom stress modeling based on a combination of lessons taken from several past crises such as significant price movements, correlation dislocations, etc. 

The latter will give the manager the confidence required for estimating the portfolio performance on extreme market conditions with scenarios tailor-made for its unique nature.

Once the adverse scenario simulation has been chosen, regardless of it being based on historical events or custom (hypothetical) market conditions, it can be applied to the current portfolio for a detailed risk evaluation analysis. Methods such as Stressed VaR that is perceived to be common market practice will provide sufficient information, whilst the ability to decompose the risk exposure into its core sources will provide a more detailed view of the concentration risk the portfolio may face. 

Moreover, the ability to implement portfolio tail the analysis will enhance the manager’s confidence in regards to the capital adequacy to cover significant losses even in the most detrimental conditions.

Economic Development

Economic development, the process whereby simple, low-income national economies are transformed into modern industrial economies. Although the term is sometimes used as a synonym for economic growth, generally it is employed to describe a change in a country’s economy involving qualitative as well as quantitative improvements. 

The theory of economic development—how primitive and poor economies can evolve into sophisticated and relatively prosperous ones—is of critical importance to underdeveloped countries, and it is usually in this context that the issues of economic development are discussed.

Economic growth in an economy is demonstrated by an outward shift in its Production Possibility Curve (PPC). Another way to define growth is the increase in a country’s total output or Gross Domestic Product (GDP). It is the increase in a country’s production.

A country’s economic development is usually indicated by an increase in citizens’ quality of life. ‘Quality of life’ is often measured using the Human Development Index, which is an economic model that considers intrinsic personal factors not considered in economic growth, such as literacy rates, life expectancy and poverty rates.

As economist Amartya Sen points out, "economic growth is one aspect of the process of economic development".

Economic development goals

The development of a country has been associated with different concepts but generally encompasses economic growth through higher productivity, political systems that represent as accurately as possible the preferences of its citizens, the extension of rights to all social groups and the opportunities to get them and the proper functionality of institutions and organizations that are able to attend more technically and logistically complex tasks (i.e. raise taxes and deliver public services). 

These processes describe the State's capabilities to manage its economy, polity, society and public administration. 

With this in mind, economic development is typically associated with improvements in a variety of areas or indicators (such as literacy rates, life expectancy, and poverty rates), that may be causes of economic development rather than consequences of specific economic development programs.

 For example, health and education improvements have been closely related to economic growth, but the causality with economic development may not be obvious. In any case, it is important to not expect that particular economic development programs be able to fix many problems at once as that would be establishing unsurmountable goals for them that are highly unlikely they can achieve. Any development policy should set limited goals and a gradual approach to avoid falling victim to something Prittchet, Woolcock and Andrews call ‘premature load bearing’

Many times the economic development goals of specific countries cannot be reached because they lack the State's capabilities to do so. For example, if a nation has little capacity to carry out basic functions like security and policing or core service delivery it is unlikely that a program that wants to foster a free-trade zone (special economic zones) or distribute vaccinations to vulnerable populations can accomplish their goals. 

This has been something overlooked by multiple international organizations, aid programs and even participating governments who attempt to carry out ‘best practices’ from other places in a carbon-copy manner with little success. This isomorphic mimicry –adopting organizational forms that have been successful elsewhere but that only hide institutional dysfunction without solving it on the home country –can contribute to getting countries stuck in ‘capability traps’ where the country does not advance in its development goals. 

An example of this can be seen through some of the criticisms of foreign aid and its success rate at helping countries develop.

Beyond the incentive compatibility problems that can happen to foreign aid donations –that foreign aid granting countries continue to give it to countries with little results of economic growth but with corrupt leaders that are aligned with the granting countries’ geopolitical interests and agenda–there are problems of fiscal fragility associated to receiving an important amount of government revenues through foreign aid.

 Governments that can raise a significant amount of revenue from this source are less accountable to their citizens (they are more autonomous) as they have less pressure to legitimately use those resources. 

Just as it has been documented for countries with an abundant supply of natural resources such as oil, countries whose government budget consists largely of foreign aid donations and not regular taxes are less likely to have incentives to develop effective public institutions. This in turn can undermine the country's efforts to develop.

Mergers and Acquisitions

Differentiating the two terms, Mergers is the combination of two companies to form one, while Acquisitions is one company taken over by the other. M&A is one of the major aspects of the corporate finance world. The reasoning behind M&A generally given is that two separate companies together create more value compared to being on an individual stand. With the objective of wealth maximization, companies keep evaluating different opportunities through the route of merger or acquisition.

Mergers & Acquisitions can take place:

• by purchasing assets

• by purchasing common shares

• by exchange of shares for assets

• by exchanging shares for shares

Reasons for Mergers and Acquisitions:

• Financial synergy for lower cost of capital

• Improving company’s performance and accelerate growth

• Economies of scale

• Diversification for higher growth products or markets

• To increase market share and positioning giving broader market access

• Strategic realignment and technological change

• Tax considerations

• Undervalued target

• Diversification of risk

4 Types of Mergers and Acquisitions

Companies will merge together and acquire each other for a variety of reasons. Here are four of the main ways companies join forces:

Horizontal Merger / Acquisition

Two companies come together with similar products / services. By merging they are expanding their range but are not essentially doing anything new. In 2002 Hewlett Packard took over Compaq Computers for $24.2 billion. The aim was to create the dominant personal computer supplier by combining the PC products of both companies.

Vertical Merger / Acquisition

Two companies join forces in the same industry but they are at different points on the supply chain. They become more vertically integrated by improving logistics, consolidating staff and perhaps reducing time to market for products. A clothing retailer who buys a clothing manufacturing company would be an example of a vertical merger.

Conglomerate Merger / Acquisition

Two companies in different industries join forces or one takes over the other in order to broaden their range of services and products. This approach can help reduce costs by combining back office activities as well as reduce risk by operating in a range of industries.

Concentric Merger / Acquisition

In some cases, two companies will share customers but provide different services. An example would be Sony who manufacture DVD players but who also bought the Columbia Pictures movie studio in 1989. Sony were now able to produce films to be able to be played on their DVD players. Indeed, this was a key part of the strategy to introduce Sony Blu-Ray DVD players.

Technical analysis

Technical analysis

Technical analysis is a means of examining and predicting price movements in the financial markets, by using historical price charts and market statistics. It is based on the idea that if a trader can identify previous market patterns, they can form a fairly accurate prediction of future price trajectories.

It is one of the two major schools of market analysis, the other being fundamental analysis. Whereas fundamental analysis focuses on an asset’s ‘true value’, with the meaning of external factors and intrinsic value both considered, technical analysis is based purely on the price charts of an asset. It is solely the identification of patterns on a chart that is used to predict future movements.

Technicians using charts search for an archetypal price chart patterns, such as the well-known head and shoulders  or double top/bottom reversal patterns, study technical indicators, moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns.

Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down the volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the moving average, relative strength index, and MACD. Other avenues of study include correlations between changes in Options (implied volatility) and put/call ratios with a price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc.

Technical analysis analyzes price, volume, psychology, money flow, and other market information, whereas fundamental the analysis looks at the facts of the company, market, currency or commodity. Most large brokerage, trading group, or financial institutions will typically have both a technical analysis and fundamental analysis team.

A core principle of technical analysis is that a market's price reflects all relevant information impacting that market. A technical analyst, therefore, looks at the history of a security or commodity's trading pattern rather than external drivers such as economic, fundamental and news events. It is believed that price action tends to repeat itself due to the collective, patterned behavior of investors. Hence technical analysis focuses on identifiable price trends and conditions.

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart. Recognition of these patterns can allow the technician to select trades that have a higher probability of success.

Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment.

John Murphy states that the principal sources of information available to technicians are price, volume and open interest. Other data, such as indicators and sentiment analysis, are considered secondary.

However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is John Bollinger, who coined the term rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis. Another such approach, fusion analysis, overlays fundamental analysis with technical, in an attempt to improve portfolio manager performance.

Types of charts

·         Candlestick chart – Of Japanese origin and similar to OHLC, candlesticks widen and fill the the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.

·         Line chart – Connects the closing price values with line segments. You can also choose to draw the line chart using open, high or low price.

·         Open-high-low-close chart – OHLC charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually, a tick to the left for the open price and a tick to the right for the closing price.

·         Point and figure chart – a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.

Pros and cons of technical analysis

Pros of technical analysis

Being able to identify the signals for price trends in a market is a key component of any trading strategy. All traders need to work out a methodology for locating the best entry and exit points in a market, and using technical analysis tools is a a very popular way of doing so.

In fact, technical analysis tools are so commonly used, that many believe they have created self-fulfilling trading rules: As more and more traders use the same indicators to find support and resistance levels, there will be more buyers and sellers congregated around the same price points, and the patterns will inevitably be repeated.

Cons of technical analysis

There will always be an element of market behavior that is unpredictable. There is no definitive guarantee that any form of analysis – technical or fundamental – will be 100% accurate. Although historical price patterns give us an insight into an asset’s likely price trajectory, that is no promise of success.

Traders should use a range of indicators and analysis tools to get the highest level of assurance possible, and have a risk management strategy in place to protect against adverse movements