Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 24 Jan 2007

Voting rights of hedged equity

US SEC Commissioner Paul Atkins in his talk at the Corporate Directors forum this week raised the issue of "empty voting" by those who have used derivatives to hedge the economic risk of their shareholding.

First of all, it is unfortunate that Atkins raised this issue in the context of the debate about giving shareholders more rights in the election in the directors. If “empty voting” is a problem at all, then it is a problem for all shareholder resolutions and not just the election of directors. By raising the issue in this context, Atkins sends an unfortunate and inappropriate signal to the investors about the SEC’s approach to the problem.

Second, the potential for the separation of voting rights and economic rights existed even without derivatives. Supervoting shares is one way in which separation occurs. For example, in the case of Google, each of the Class B shares held by the founders has ten times the voting rights of the Class A shares held by others. Google management controls a majority of the voting rights with a much smaller economic interest in the company.

Tracking shares are another way in which separation happens. Holders of tracking shares in a division of a company own the entire economic interest in the division, but the board has no obligation to them as opposed to their obligations to the company as a whole. This means that holders of the tracking stock own a division without controlling it and the holders of the regular stock control the division without owning it.

When all these mechanisms have been in existence for decades, it is strange that the SEC finds only the use of derivatives troubling. The nice thing about derivatives is that they are traded in an open market where everybody is welcome to play the game. You do not have to be the founder of a company to unbundle a share into economic rights and voting rights using total return swaps or other means. In an efficient market, the economic interests and the voting rights will both be valued in the market and anybody can buy or sell voting rights at this market price. Once everybody realizes that this can be done, both sides in any proxy battle or takeover struggle will use this method. It is then a level playing field.

Posted at 16:51 on Wed, 24 Jan 2007     View/Post Comments (0)     permanent link

Thu, 11 Jan 2007

Risk Management at Exchanges

I gave a seminar this week at ICRIER (Indian Council for Research on International Economic Relations) where I argued that it is today computationally feasible to implement a risk management system for derivative exchanges that is (a) based on Expected Shortfall, (b) incorporates fat tailed distributions and (c) computes portfolio risk across multiple underlyings (securities or commodities) using non linear dependence models (copulas).

Risk measures like Value at Risk, SPAN and Risk Metrics have their intellectual roots in the early 1990s or earlier when the notion of coherent risk measures had not been developed and risk modelling had not yet embraced fat tailed distributions with non linear dependence structures. For example, current global best practice in handling exposure to multiple underlyings (“inter commodity spreads”) in exchange risk management can only be characterized as crude and ad hoc. Their continued popularity owes much to the inadequacies of correlation based dependency modelling. Similarly, the SPAN framework uses too few scenarios to meet the highly desirable “relevance axiom” for risk measures though computational advances allow us to come very close to fulfilling this axiom.

In India, the regulatory framework for risk management at Indian exchanges is still supposed to be based on the 99% value at risk mandated by the L C Gupta Committee a decade ago. In practice, however, Indian exchanges and their regulators have adopted several features of a fat tailed expected shortfall approach. Risk management practice has thus outgrown the regulatorily mandated value at risk to which it still pays lip service. The time has come to formally discard value at risk from the regulatory lexicon and adopt a more modern vocabulary. This would provide an opportunity to spur new research on improving exchange risk management systems.

My presentation made specific proposals for a modern risk management system and indicated directions for further research. The slides of this presentation are available here.

Posted at 14:13 on Thu, 11 Jan 2007     View/Post Comments (2)     permanent link

Tue, 02 Jan 2007

Alphabet Soup is not Innovation

Gillian Tett, the capital markets editor of the Financial Times writes (“Let us pass on the alphabet soup, SVP”, Financial Times, December 29, 2006) that bankers trained in science and mathematics are creating innovative debt instruments but giving them unimaginative names with unwieldy acronyms – the alphabet soup.

He talks about “the broader acceleration of the global financial innovation cycle” and says “banks are responding by inventing products at such a furious pace, they barely have time to think up names.” By contrast, he argues that “A couple of decades ago, when new financial products hit the markets, banks gave them names. A host of new words crept into the investment bible over the years, such as options, swaps or puts”.

I am unable to agree with this view. Much of the alphabet soup today does not represent really new products. Rather it consists of simple adaptations to the credit market of ideas and instruments well known in equity and other markets. Compared to true innovations like cash settled index futures, the credit market innovations that we are seeing are minor modifications and adaptations of well known dynamic portfolio strategies.

For decades, credit has been the preserve of the banking system. Today, as credit breaks out of that prison and moves into the hands of people accustomed to the joys and pleasures of vibrant financial markets, we are seeing a lot of changes. Even the simple idea of trading a portfolio of credits rather than a single credit appears revolutionary though this is what equity traders have been doing for decades now. However, all this is catch up and not innovation.

Posted at 12:22 on Tue, 02 Jan 2007     View/Post Comments (2)     permanent link