Hans in China!

I will be a visiting professor at Zhejiang University in Hangzhou, China until the end of September and I will therefore (probably) not be able to write anything on my blog until early October. Instead I will try to enjoy the fine teas of the slopes of Hangzhou hills. And before I go I will of course reread about my (only true) hero's adventures in the east......

Sell European Bank Stocks?

I have investigated around 30 EU banks for a research paper that I will come back to on this blog after it is published (soon I hope). The paper deals with something completely different than algorithmic trading but a side-result of the paper is that I found that over the last nine months the average European bank’s total asset value (financed with around 90% debt) actually fell substantially more than its stock value! This is rather odd in a highly leveraged firm such as a bank and not something I have really observed before (2004-2010). The trader in me (of course) reacted to this!! One driver behind an increased stock price in the light of a fall in the value of assets is of course that the volatility of the assets perhaps have increased. Remember, equity in a firm is like a call-option on the firm’s assets and an increase in the volatility of the underlying leads to an increase in the option price (ceteris paribus). I have not observed such an increase in the asset volatility over the last year, though.

On average, the asset value fell 12% and the stock value fell 8%. Now, how did I estimate the asset value? That is the crucial point here and if I screwed up here then my trading signal is completely useless. The problem is that the asset value is not observable and that is what makes the suggested trade interesting as well as risky. I have not had time to look deeper into the balance sheets and quarterly reports of several EU banks and it is also possible that some kind of outlier drives the result so my advice therefore has to be taken with a dose of skepticism. In any case, I believe that either the asset value will recover or the stock price will fall for the typical bank in Europe over the next couple of months. And if you already, as me, are sceptical about the health of the european banks you could try to focus on asset values when chosing bank stock to trade.

Anyway, my n-month verdict for the EU banking sector is underperform!

Hans in The Journal of Fixed Income

There is currently a lot of discussion about whether OTC derivatives should be traded through clearing houses or not. Among the various OTC derivatives markets that are discussed, the credit default swap market takes center stage. This is a fairly young market, it has figured extensively in the media due to the crisis and it is not as massively huge as for instance the interest rate swap market. This makes this market an interesting test case. I have written frequently about this development here in this blog (see for instance Is the current turmoil a boon for exchange traded credit derivatives? from back in 2007).

In this context I would like to highlight my article that was recently published in The Journal of Fixed Income: Byström, H., (2010), Margin Setting in Credit Derivatives Clearing Houses, The Journal of Fixed Income 19 (4) Spring 2010, pp. 37-43.

In this article I try to stress how extreme the movements in the credit derivatives market have become and how multi-sigma credit spread changes have become the name of the day. This renders traditional methods of calculating margin requirements in clearing houses inadequate and as an alternative I suggest extreme value theory.

Now, it just remains to be seen whether my suggestions will be acknowledged or not!