Discussion on finance concepts/problems for people interested in finance

[rajatb]

Originally Posted by subodh_iit

My 2 cents: Can we have this thread mainly dedicated to problems related to the work that Financial Analysts, M&A specialists and Traders encounter in their day to day work.. Because that will be more apt from career point of view.


I will contribute to the discussion when I discover enough about Black Scholes Model and Quantitative Models for Investing. Anyone who knows something about LTCM will know abt these models.

..

I have been working in this field for just under a year so if you have any questions related to the above mentioned topics just shoot.

[anupam will return]

Ok,with some help from the web, here's my $3 for a begining:

Key concepts to be discussed here:

Deferred taxes:
- what are they and why are they needed?

Sometimes it is observed that tax payers tend to delay paying their taxes. The argument goes that due to the concept of Time value of money (the present value of a certain amount "a" of money is greater than the present value of the right to receive the same amount of money at a time in the future), certain tax payers prefer to pay less tax now. This way they can invest more money now for future gains. The tax payers are in the process just delaying the tax paying process to a future date. Ofcourse, the amount of tax paid in a period still remains the same.
In such cases, we observe that there are temporary differences resulting between the book value of the assets/liabilities and their tax value. The accounting term used to describe the future tax liability or asset resulting from such temporary differences between the book value and the tax value of assets/liabilities are known as deferred taxes.

Deffered tax liabilities:

In some tax systems, companies may be able to "carry forward" losses to future years, which may be referred to as tax write-offs. In such cases, the company may have a tax asset representing the amount that future taxes payable may be reduced due to tax losses in previous years.
Expenses which are accounted for on an accrual basis (that is, when they become due and not when they are actually paid) may not be applicable to tax accounting and therefore to taxable profit. Companies may charge off duty, cess and tax dues against profits when they become due, but they would be recognised for tax computation only when actually paid.
In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that are taxable would be higher than those computed in the company's books of accounts; there is a timing difference in the recognition of the taxable profit compared to the accounting profit.
So, while the company shells out a disproportionately high tax in the current year, it would save on tax in the years when the expenses or provisions actually materialise.

Deffered tax assets:

Deferred tax assets are the deferred tax consequences attributable to deductible temporary differences and carryforwards.

Valuation allowance:
- what is it and what's the need for a valuation allowance?

having given a background on deferred taxes,Lemme explain what a "valuation allowance" is:
As per the web definition, "Funds in an account established to cover probable loan losses constitute a valuation allowance. If a savings association believes a loan is uncollectible, it sets aside in the reserve account a portion of earnings equal to the difference between unpaid principal and the market value of the loan. If the loan is charged off as worthless, the institution writes down the loan portfolio and the reserve account by equal amounts."

Going a li'l deep, incase there is felt that a deferred tax asset will not be realized in the future, companies generally adhere to a standard practise of setting aside some money refered to as a valuation allowance. In stict accounting sense, valuation allowance is nothing but another special contra account

cheers,

-Vengeance

[andy_jaan]

Hmm so nice to se these many enthus ..................par ab bhaag mat jaiyo.......bhai log

Neways my 2 paise
Valuation allownce can be taken as regulatory capital or something like economical capital, but like always purposes may seem same but denominations and originations differ in finance( more so in accounts ).................So if valuation allownce is sufficient to take care of all possible losses on loan portfolio it will be equal to bank's economic capital i.e. the funds deployed @ low or no earnings...............elsewhere the gap will be a measure of unstability carried within institution, more in case of banks and FIs. Remember.one and only....LTCM!!

Regards
Andy

[rajatb]

Originally Posted by andy_jaan

Hmm so nice to se these many enthus ..................par ab bhaag mat jaiyo.......bhai log

Neways my 2 paise
Valuation allownce can be taken as regulatory capital or something like economical capital, but like always purposes may seem same but denominations and originations differ in finance( more so in accounts ).................So if valuation allownce is sufficient to take care of all possible losses on loan portfolio it will be equal to bank's economic capital i.e. the funds deployed @ low or no earnings...............elsewhere the gap will be a measure of unstability carried within institution, more in case of banks and FIs. Remember.one and only....LTCM!!

Regards
Andy

I think you are mixing two concepts ,although I am very weak in accounts the explanation given by Anupam is correct .Valuation Allowance is an accounting concept designed to make sure companies do not inflate their assets and hence boost their Equity value by unnecessarily showing tax assets or accounts recievables which have a low probability of realization.

On the other hand economic capital is a regulatory requirement designed to protect investors ,the amount of it is determined statistically by by charting an expected loss curve and then having sufficient capital to cover unexpected losses given certain assumptions.

Economic capital is closely linker to Var ( Value -at-Risk) .VaR is a risk measure that gives you the maximum possible loss at a specified probability and a given time horizon .Economic capital is then set equal to that loss so that under the given assumptions the Bank or Financial Institutions remain solvent even after taking on that maximum loss.

The LCTM example is also not correct as it was a Hedge Fund under no regulatory obligation to maintain Economic capital .Hedge Funds do implement their internal VaR based measures but that is mostly for their own desired levels of risk and not because of any regulatory requirements.

[andy_jaan]

Originally Posted by rajatb

I think you are mixing two concepts ,although I am very weak in accounts the explanation given by Anupam is correct .Valuation Allowance is an accounting concept designed to make sure companies do not inflate their assets and hence boost their Equity value by unnecessarily showing tax assets or accounts recievables which have a low probability of realization.

Originally Posted by rajatb

On the other hand economic capital is a regulatory requirement designed to protect investors ,the amount of it is determined statistically by by charting an expected loss curve and then having sufficient capital to cover unexpected losses given certain assumptions.

Economic capital is closely linker to Var ( Value -at-Risk) .VaR is a risk measure that gives you the maximum possible loss at a specified probability and a given time horizon .Economic capital is then set equal to that loss so that under the given assumptions the Bank or Financial Institutions remain solvent even after taking on that maximum loss.

The LCTM example is also not correct as it was a Hedge Fund under no regulatory obligation to maintain Economic capital .Hedge Funds do implement their internal VaR based measures but that is mostly for their own desired levels of risk and not because of any regulatory requirements.

Hmm well without sounding too rigid I'll like to enforce that FIs and in particualar banks are supposed to keep only so called provisions and even those are also not regulatory capital as RC includes investments/own funds also.
So as far as provisions are concerned they may be further classified into categories (including valuation allowance) but otherwise generally its not a practice to disclose that for public. Refer link below:

ICICI Bank Online 

Thats why I was emphasising on economic capital measurment and then comparing the current provisions with EC required in order to asess solvency of FI.
In LTCM eg. actually I tend to refer the undermined calculation of EC and then assuming their provisions to be sufficient to cover it.
Regards
Andy

P.S. I again stress that there's no final in finance and like always many different actions/measures are often taken by some (few) basic objectives....................so inspite of so called valuation allowance being technically different from RC they tend to cover expected losses completely and also unexpected losses upto some extend.

[subodh_iit]

As far as LTCM is concerned, it was a hedge fund and used trading in Derivatives and Bonds with high leverage to give the investors astronomical returns by betting on narrowing of spreads (the so called opportunities according to Black-Scholes Model).

Now I do not think its example is exactly linked with Valuation Allowance other than in a very loose sense.

LTCM's modus operandi was it used to draw loans of 30X where X = capital it had. Means the leverage was 30 times. At the start of 1998 it had ~$5 billion in capital and ~$140 billion assets. Then when it started losing its capital, it rather than decreasing the assets let the leverage increase to an astonishing 100. When it was taken over by the consortium of Wall Street Banks, it had leveraged its capital well over 100.

Besides, LTCM did not give loans unless equity and bond investments can be called loans. And it was not a FI either. However Merriwether (LTCM CEO) always kept the NY Fed in confidence with its falling capital.

[rajatb]

Originally Posted by subodh_iit

As far as LTCM is concerned, it was a hedge fund and used trading in Derivatives and Bonds with high leverage to give the investors astronomical returns by betting on narrowing of spreads (the so called opportunities according to Black-Scholes Model).

Now I do not think its example is exactly linked with Valuation Allowance other than in a very loose sense.

LTCM's modus operandi was it used to draw loans of 30X where X = capital it had. Means the leverage was 30 times. At the start of 1998 it had ~$5 billion in capital and ~$140 billion assets. Then when it started losing its capital, it rather than decreasing the assets let the leverage increase to an astonishing 100. When it was taken over by the consortium of Wall Street Banks, it had leveraged its capital well over 100.

Besides, LTCM did not give loans unless equity and bond investments can be called loans. And it was not a FI either. However Merriwether (LTCM CEO) always kept the NY Fed in confidence with its falling capital.

True the LTCM crew believed in the sanctity of their models .They were betting for the spreads to narrow in the Bonds market in tune with market fundamentals ,the more the spreads widened the more leverage they undertook believing it to be a fantastic opportunity to make astronomical profits .But with the Russian default in 1998 market fundamentals went for a toss and the spreads kept widening killing off LTCM with the margin payments they had too make.The market did revert to its fundamentals in the long term proving the LTCM models to be correct but by then it was too late....

As a wise man once said:

The markets can remain insane far longer than you can remain. solvent


The NY Fed was informed quite late about the troubles at LTCM ,they then organized a consitorium of Investment Banks to bail out LTCM and save the Financial markets from collapse.

[andy_jaan]

Originally Posted by rajatb

True the LTCM crew believed in the sanctity of their models .They were betting for the spreads to narrow in the Bonds market in tune with market fundamentals ,the more the spreads widened the more leverage they undertook believing it to be a fantastic opportunity to make astronomical profits .But with the Russian default in 1998 market fundamentals went for a toss and the spreads kept widening killing off LTCM with the margin payments they had too make.The market did revert to its fundamentals in the long term proving the LTCM models to be correct but by then it was too late....

As a wise man once said:

The markets can remain insane far longer than you can remain. solvent


The NY Fed was informed quite late about the troubles at LTCM ,they then organized a consitorium of Investment Banks to bail out LTCM and save the Financial markets from collapse.

So here is the catch, the margin payments and possible losses were calculated on assumtions far away from distress scenarios and that made LTCM's ability to sustain adversity too little, particularly at the time of Russian Default and so called "Flight to Quality".
Thats why keeping capital aside to sustain losses and remain solvent for durations longer then expected revertion period of markets is important.
Of course this exercise is noway related directly to Valuation Allowance but when insted of Bond we consider Loan portfolio.............a similar objective is acheived through valuation allowance........which I still think is more a term used for corporates and not Bank's, which are more familiar with various provisions, and measuring Economic Capital.
By the way mine effort even at begining was just to add whatever has been posted prior and hence I don't see myself contradicting anywhen anywhere till now.

Regards
Andy

[crazyphoton]

Originally Posted by subodh_iit

Then when it started losing its capital, it rather than decreasing the assets let the leverage increase to an astonishing 100.

However Merriwether (LTCM CEO) always kept the NY Fed in confidence with its falling capital.

(a) wot do u mean by "rather than decreasing the assets, it let the leverage increase"?? when your assets decrease on the balance sheet(in LCTM's case, the value of the portfolio of its investments), liabilities also have to decrease by the same amount. Now liabilities are comprised of debt and equity. you can't reduce the debt component (until u pay it back), and hence any reduction in assets has to result in corresponding decrease in equity. now if debt has remained constant, and equity decreased, obviously the leverage is going to increase. LCTM did not do anything wrong here as u seem to be accusing it for, it is just a natural outcome of accounting.

btw, for information, JM never disclosed his problems to fed chief until the very last days of the fund.

[crazyphoton]

Originally Posted by andy_jaan

So here is the catch,

the catch was simply that black sholes model assumed volatility (uncertainty in measuring price) of an asset under consideration as constant. this assumption was critical for all the further calculations in the differential equation. now volatility is constant under normal circumstances and stock returns do follow log normal distribution, but under distress conditions, volatility of assets increases dramatically (by as much as 2-3 points per day during august and september 199 signifying the nervousness of the market.

JM and his colleagues did not account for the change in volatility in their trades.
just for instance, JM had reported that the probability of the fund losing $35 mill in any single day was a 10 sigma event. This indeed was true given the constant volatility assumption. But with russia's default and volatility going for a toss, the fund lost as much as 500 mill per day on some trading days.!