By Edward Leone Jr. DMD MBA RFC
Contact Information:
Dentistry www.leonedmddentalcare.com
Financial Planning leonee@vzw.blackberry.net
The interactivity and exchange of information through this blog is growing. As a result of comments I made about the slow down in GDP over the second quarter of 2010, several readers shared their difficulties in maintaining employment and business viability along with strategies they are using to mitigate these negative experiences. These strategies include retraining for other career opportunities and severe scale down in business structure to survive in the short-term. It is apparent that many more are hurting, but not talking about it. Congress has left Washington to go home for a while. Perhaps we are safe for the next few weeks and can reassess our possibilities in surviving what has become a very long period of economic slowness.
Much has been made of the contribution that derivatives have made to the collapse in financial operations globally. How many of use really understand derivatives and what it is that they do? Kristina Zucchi has written a great article on investopedia.com called Derivatives 101. The content will be helpful to any and all who are interested in the subject of derivatives. Derivatives and futures contracts have been used in the agriculture industry to help stabilize prices and profit margins for many years. “Derivatives are types of investments where the investor does not own the underlying asset, but makes a bet on the direction of the price movement of the underlying asset via an agreement with another party. There are many different types of derivative instruments, including options, swaps, futures and forward contracts.” There are three main reasons why investors might use derivatives:
1. Hedging—-a strategy used to insure against the risk of an asset’s price changes.
2. Increase Leverage–Since the investor who owns a derivative or option does not own the underlying asset but the right to buy that asset at a given price within a given time period, one can magnify the gain when the price of the underlying asset goes up and, of course, can experience magnified loses when the price of the underlying asset goes down depending on the type of option “put or call” owned and the position of the investor “long (buyer) or short (seller). This leverage aspect is a part of the speculators advantage when speculation of future price structure is a part of the strategy.
3. Speculation on Future Prices
Derivatives can be traded in two ways:
1. Over the Counter—-the source of much of the controversy of the role of derivatives traded in this fashion and the potential lack of transparency which goes along with this trading forum. Many trades are private and not regulated in any form.
2. Trading on an Exchange–derivatives are standard contracts handled by an intermediary. Content and structure are openly available and know to investors.
Options–the right to buy or sell an asset and take advantage of price movements without owning the asset. Positions:
1. Long Call–the right to by an asset in the future at a fixed price (exercise price) up to some point (expiration date) for a premium. The advantage comes if the market price rises to a level that exceeds the exercise price and the option premium. This condition (in the money) yields a profit.
2. Long Put–the right to sell and asset in the future at a fixed price up to some point in the future. The advantage comes if the market price falls bellow the exercise price and the premium paid.
3. Short Call–selling to another party the right to buy an asset at a fixed price up to a point in the future. The advantage comes here if the market price of the asset declines bellow the exercise price since the option will not be exercised by the buyer and the premium represents the profit to the seller. If the market price goes the other way such that the rise is more than the exercise price and the premium, loses can be significant to the seller of the call.
4. Short Put–selling the right to another to sell an asset at a fixed price up to a point in the future. The seller wins if the asset’s market price goes above the exercise price since the put will not be exercised and the premium paid to the seller of the put is the profit. If things go the other way, loses can be significant.
The math necessary to analyze these strategies is complex, but a necessary exercise to improve the odds of achieving a successful out-come.
Swaps–the exchange of cash flows or other variables associated with investments.
Interest Rate Swaps–exchanging of fixed rate assets for variable rate.
Currency Swaps–exchange of payments or investments from one currency to another.
Commodity Swaps–based on pricing of underlying commodities
The winning strategy here depends on the prospect of a win-win for the parties engaged. It does not alway work out that way, particularly if the asset involved in the swap fails to perform in the market place or the information available on the asset is faulty (such as a credit rating).
Futures Contracts–used to hedge risk of price changes in commodities at a future time. The contract holder has the right to buy or sell an asset in the future for a fixed price.
We us these concepts ourselves in our everyday commerce without realizing it. Options on the purchase of a home, buying grocery items when discounted with the expectation that the price will go up in the future and selling receivables of your business at a discount to an investor are examples.
Another subject I committed to discuss this month is the Social Security System.
Few people know of the following facts:
1. The Social security System is now 75 years old.
2. The system is bigger than the economies of most countries. Through 2007 $13 trillion has been collected and $10.6 trillion paid out.
3. It’s not just a retirement program. Disability benefits and survivors’ benefits are also a part of the program.
4. You pay 6.2% of your income into the system. This amount is matched by your employer yielding a 12.4% contribution up to $106,800 of income for this year.
5. Cost of living increases are not a mandatory feature.
6. Retiree benefits vary with the time of filing and married couples have several design options.
7. Your social security number tells where it was issued by the first 3 digits.
8. Paper benefit checks are just about gone. Direct deposit is the method of benefit transfer.
9. The trust fund has a projected deficit and will not meet total benefit obligations after 2037.
As a financial planner, the Social Security benefit an individual will gain upon retirement is an important ingredient in retirement planning for clients. Use a financial planner to help you explore this potential in concert with your retirement income needs and other available assets. What is needed to fix the system? We are hearing much about raising the retirement age, means testing benefits, changing the COLA calculation rules, setting up personal accounts and raising payroll taxes. I have no idea what will be contained in the ultimate solution. I can say that the longer we wait to address this issue, the more difficult the fixes will be to implement and accept.
Many investors have been shifting equity investment strategies to developing economies across the globe accepting higher risk with the expectation of higher returns from these growing economies. China is very high-profile in the news with its 10% plus growth in GDP and its gain in stature as a global economy. Putting aside social and civil rights conditions in China, economic growth in that country has imposed significant hardships on the population. The relocation of agriculture workers to the city to gain a better standard of living much as occurred in this country in the late 19th century and early to middle 20th century during the industrial revolution is stressing the country’s ability to feed the population. Pressure on urban housing demands is causing inflation which low salary workers cannot manage and working conditions are less than desirable. The educated are having a difficult time finding work because the key demand is for low skill assembly workers and not those with innovative and entrepreneurial talents. Other broader issues include financial mismanagement which with the central government planning is causing massive bank bail outs, corruption in regional government entities costing the Chinese economy $700 billion a year and severe water and air pollution (we were able to see the air pollution issue during the telecasts of the olympic games). The lack of consistent contract law is also a problem which Warren Buffet’s BH is learning about as a result of its significant investment in China’s auto industry. The question is “With all of these challenges, can China keep up this aggressive rate of growth?” Only time will tell, but caution and good research are essential before investment into the Chinese economy is considered.
Look for comments on India’s economy in future blogs.
If you are a Colorado resident, you have just in the past day or two received you blue book. I will review it and have some discussion from an economic prospective in the November blog before the election.
For the Record:
DJIA 10,788.05
NASDQ 2,368.62
S&P 500 1,141.20
Suggested Reading: “The Power of Living Your Values
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