Crude

Cushing, OK
* The delivery point for futures traded on NYMEX
* Rising inventories/stockpiling reflects wide gap between price of oil for delivery in next month & contracts to deliver later
* Contango is the norm in oil markets, with the price gap representing the cost of storing the oil & locking up investors' money
* Unusually large gap or super-contango may reflect current sluggish demand & expectations that demand will pick up in following months...
  + Contango 'creates financial incentive to store more barrels'
  + Investors can simply buy early contract, take physical deliver, store it, & at same time sell later contract at higher prices
* Max storage capacity in Cushing is ~42.4M barrels, but only ~80% (or ~34M barrels) is operable storage space
* BBERG: DOESCROK Index
  + DOE Cushing, OK Crude Oil Total Stocks Data
  + Updated Weds 10:30AM for previous week end Friday
  + From Energy Information Administration's Weekly Petroleum Status Report
  + Estimated, based on weekly data collected by DOE

Balance Sheet

NCOs — or loans written off as uncollectable

What is Quantitative Easing?

What is Quantitative Easing?

It's basically when a central bank can't cut interest rates anymore, because they are too low. It can also happen if a central bank decides that cutting rates won't work for some reason. To meet its liquidity objectives, the central bank instead manipulates the size of its balance sheet.

How does it normally work?

The central bank buys financial assets from financial institutions using money it creates out of thin air. This causes bank reserves in the financial system to increase, creating 'excess reserves'. The result is a huge increase of the monetary base in the economy.

It's called quantitative easing because it 'involves a change in the quantity variable (reserves and/or the monetary base) as opposed to a change in the interest rate target.'

What's the point?

It's meant to provide needed liquidity to a financial system and stimulate economic activity, though it carries inflation risk.

But... then what is 'sterilization' and how does it control things?

Sterilization is used to offset the acquisition of assets by a central bank. After the central bank buys new assets, it can 'sterilize' these assets by either getting rid of different assets or adding an equal, counterbalancing amount of liabilities. It is important to understand that 'when the acquisition of an asset is sterilized, there is no QE because the balance sheet effects are neutralized.' Thus, when sterilization is happening, quantitative easing hasn't happened yet, even though the central bank is buying financial assets from the market as a form of support.

When did QE in America start?

'The Federal Reserve shifted to quantitative easing in September 2008 when it expanded a number of liquidity programmes, including the term auction facility (TAF) and central bank FX swap lines, and ceased its sterilization efforts.”

QE started in September 2008, when sterilization ended but the central bank was still buying financial assets from financial institutions.

'Up to this point, the Fed had been sterilizing the impact of its new support facilities by liquidating Treasuries.

Liquidating Treasuries

For example, the TAF was introduced in late 2007 and was scaled up to US$150 billion by May 2008. Over that same interval, the Fed liquidated more than US$200 billion of its holdings of Treasuries in order to sterilize the TAF and other special programmes.

So, the volume of bank reserves was essentially unchanged during this period, but the mix of balance sheet items shifted.'

QE caused bank reserves to explode.

In September 2008 – as financial markets were melting down – the Fed cried uncle and gave up trying to sterilize. Excess reserves rose from a normal level of US$1.0-1.5 billion to US$270 billion in October 2008 as the liquidity support programmes continued to expand.

These reserves were created from central bank money created out of thin air. This was the 'money-printing' so many have complained about.

By the end of 2008, excess reserves reached US$800 billion and the monetary base had nearly doubled in size.

In early 2009, the Fed started to purchase large quantities of MBS and agency debt, and in March it began buying Treasuries. However, it’s important to note that the bulk of the QE took place several months before the Fed started buying mortgages and Treasuries.

Thus, it is incorrect to simply refer to the Fed’s bond purchases as QE.

The Fed’s objective was to restore liquidity to important markets, and it did.

The Fed succeeded in achieving these goals. The TAF, FX swap lines and alphabet soup of other liquidity support facilities appeared to play an important role in reining in LIBOR.

The economy was jump-started, and pressure was taken off of housing, by far cheaper mortgage rates.

Meanwhile, the LSAPs (large-scale asset purchases) helped to drive mortgage rates lower. This provided a significant amount of stimulus to the economy.

Many were worried about the effects of giant growth in money supply... but here's why it has been okay so far.

As mentioned earlier, the monetarist view is that QE represents an important event because the expansion of the monetary base is likely to be accompanied by growth in the money supply. However, this was not really the case in the US. While the base doubled, growth in narrow money experienced only a modest acceleration, as the money multiplier plummeted. This reflected the fact that the excess reserves created by the Fed were parked in cash.

Banks have been paid interest on their reserves to prevent inflation.

The Fed has been paying interest on banks' reserves in order to incentivize them not too lend everything out, and thus in an attempt to prevent huge excess bank reserves from translating into inflationary forces. This interest is likely higher than the market-rate which would banks would get if such a program didn't exist. It's meant to put a floor under short-term rates (i.e. rates can't fall below Fed's interest rates on the reserves.)

This entire process could prove itself to have been extremely smart.

If the Fed can now engineer a successful exit from QE, any inflation consequences and market distortions should largely evaporate.

It all depends on whether the Fed can restore normalcy to its balance sheet successfully.

The Fed plans to use multiple methods in order to reduce the size of its balance sheet and remove excess reserves from the banking system. For our purposes here, the exact methods need only be briefly referenced: 'The Fed plans to use term deposits, reverse RPs and asset sales to unwind QE. The asset sale option has generated a lot of interest recently and appears to have gained unanimous acceptance among Fed officials.

But the sequencing still appears to be reverse RPs and term deposits first, followed by asset sales later on.

It'll be a tricky balancing act for the U.S. going forward...

The trick will be whether the Fed can use the aforementioned methods to drain at least one trillion dollars of excess reserves from the banking system, as a completion of the QE process, in a balancing act between unsettling the financial system and high U.S. inflation.

'We are... concerned that the Fed may not be able to hike the fed funds rate when the time comes, unless it is willing to drain away a size able portion of the excess reserve position.

...

Bernanke is saying that the Fed will try to engineer a gradual exit from QE, but could be forced into a more rapid exit. It should be obvious that the process of draining US$1 trillion or more of excess reserves in a short period of time is fraught with potential market risks.

A rapid exit, in a bid to prevent emerging inflation, could cause a substantial shock to the financial system, as it would be a very sudden form of monetary tightening.

It's perilous, and now Europe is beginning a similar journey, just as the U.S. is exiting.

Last week, the ECB announced that it would start to intervene in euro area bond markets and buy public and private debt under a new Securities Market Programme (SMP)

...

The ECB’s recent decision to purchase debt securities in order to ease market ‘dysfunction’ has certainly had the desired impact on bond yields, but it has also left many questions unanswered. Do the bond purchases represent QE or a move towards QE?'

Filings

13F - SEC form filed by institutional investment mangers (see section 13(f) of Securities and Exchange Act of 1934)... all institutional investment managers managing over $100MM on the last trading day of any month of the calendar year must disclose their holdings on a quarterly basis

Interest Rate Movements

Interest-rate movements are based on the simple concept of supply & demand. If the demand for credit (loans) increases, so do interest rates. When the economy is expanding there is a higher demand for credit so rates move higher, whereas when the economy is slowing the demand for credit decreases and so do interest rates.

US Exchange/Trading Platforms Market Share as of 12/26/2009

Platform Market Share

Nasdaq 36.6%

NYSE 26.8

Direct Edge 12.7

BATS 10.0

Dark Pools 9.5

ISE 2.2

Other 2.2

OECD's CLI

OECD - Organisation for Economic Co-operation and Development

CLI - Composite Leading Indicator

* Designed to provide early signals of turning points between expansions & slowdowns of economic activity.

* OECD compiles CLIs for 29 member countries, 6 non-member economies, & 7 country groupings.

* The CLI comprises a set of component series selected from a wide range of key short-term economic indicators to ensure that the indicators will still be suitable when change in economic structures occur in the future.

* A common way to exploit CLI data is to take their YoY growth rate

* Releases are monthly, on the Friday of the first full week of the month, & refer to activity two months earlier (i.e. Jan's release reports leading indicators for Nov)

* The US has its own set of domestic leading economic indicators by the Conference Board, a business research group in NY (i.e. the Index of Leading Economic Indictaors)

Closing Auctions

The official cutoff time for submitting MarketOnClose (MOC) and LimitOnClose (LOC) orders to the NASDAQ closing auction is 3:50pm ET. For the NYSE and NYSE Amex closing auctions, the official cutoff time is 3:45pm ET. For the NYSE Arca closing auction, the official cutoff time is 3:59pm ET. With the exception of orders that are submitted to offset published imbalances, all MOC and LOC orders must be submitted before each market center’s official cutoff time.

Total Return Swaps

A TRS is a financial contract which transfers both the credit risk and market risk of an underlying asset. (It can be categorized as a type of credit derivative).

The protection seller (i.e. the investor) pays the fixed rate (i.e. LIBOR + 40 bps) to receive the return (& risk) of the underlying asset.

The protection buyer (i.e. the broker/dealer) receives the fixed rate & pays the return of the underlying asset (as well as transfers the risk of the underlying asset) to the seller.

Essentially, the protection buyer has "bought protection" by swapping the risky underlying for a fixed rate.

An advantage of a TRS is that one party (i.e. the seller) can derive the economic benefit of owning an asset without actually carrying the asset on its balance sheet while the other party, who does carry the asset on its balance sheet, is protected from loss in the asset's value.

(It is not unlike the scenario where the dealer gives the investor a loan to purchase assets, that are held with the dealer as collateral.)

Hedge funds may use TRS's to obtain leverage on the reference assets (i.e. they can post a smaller amount of collateral upfront than the size of the reference asset.)

The cost of the derivative is determined by the cost to the dealer (i.e. the buyer) of carrying the underlying position (which is made up of the financing charge for acquiring the underlying index position in the cash market, compensation for counterparty risk, dealer profit, & any adjustment for tax related expenses).

So if the cost to the investor (i.e. the seller) is "LIBOR - 40" bps to get long the return of the S&P 500...

We can view it as... The investor is borrowing money at the cost of LIBOR to buy underlying stocks. However, the actual cost is 40 bps less. This "made" 40 bps can be considered "out-performance" offered by the broker/dealer. Perhaps the broker/dealer is able to offer this out-performance due to its actual way of implementing the return (i.e. futures that roll cheap, lending stock inventory, etc.)

Alpha Transport/Portable Alpha

"Portable alpha" refers to separating the active manager’s excess return from the base market return and transporting the alpha to some other market index.

For example, to accomplish this using futures, the investor allocates a pool of capital across three strategies: The majority of the assets are invested with the active manager, a small portion is used to purchase the "other market" index futures, and index futures are sold to eliminate the market return (beta) from the active manager’s total return. The investor is then left with the active manager’s alpha plus passive exposure to the "other market" returns.

Another example for an active bond investment...

Invest in an actively managed fixed income portfolio & keep the exposure to both the fixed income beta and the manager’s alpha. Then use the fixed income portfolio as collateral for a portfolio of futures or swaps that provide equity exposure.

Note that the beta exposure, say through a third-party overlay manager buying futures or executing swaps, may require only a small portion of cash/collateral (for margin). This may allow for a greater portion of the funds to be committed to generating alpha.

Quadruple Witching

A day on which contracts for stock index futures, stock index options, stock options and single stock futures (SSF) all expire.

(Single stock futures are not at all a significant source of volume)


(Stock index futures and index future options expire on the open)
(Stock options and single stock futures expire on the close)

(Index options are cash settled.)
(ETFs and single stock options are physical)

Overnight Indexed Swap (OIS)

An Overnight Indexed Swap (OIS) (an interest-rate derivative) is a fixed/floating interest rate swap with the floating leg computed using a published overnight rate index, typically considered less risky than the corresponding interbank rate (LIBOR), in the case of the USD, the Fed Funds Effective Rate.

Two parties agree to exchange at maturity the difference between interest accrued at the fixed rate & interest accrued at the compounded floating rate on the agreed notional amount of the swap.

Net payment is made two business days after maturities

The basis convention is Annual ACT/360 (or Actual/360)

(Interest = Principal x CouponRate x Factor)

(Factor = (Actual days between the start and end dates inclusive)/360) (i.e. Assumes 360 day year)

swap receiver... receives fixed rate payments (and makes floating rate payments)

swap payer... receives floating rate payments (and makes fixed rate payments)

An OIS acts as a perfect hedge for a cash instrument...

Cash can be lent daily (i.e. in a daily accruing interest bearing account) for daily interest receipts. In contrast, the swap receiver effectively makes daily interest payments. If the daily rates 'line up,' the cash inflow can be matched with the cash outflow, the the OIS receiver has hedged the daily rate change uncertainty with a fixed rate.

OIS rates (or, in particular, the difference or 'spread' between OIS rates & LIBOR) are an important measure of risk & liquidity in the money market, considered by many to be a strong indicator for the relative stress in money markets. A higher spread is typically interpreted as an indication of decreased willingness to lend by major banks, while lower spread indicates higher liquidity in the market. The spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions & general availability of funds for lending purposes

Net Foreign Security Purchases (TIC)

Summarizes the flow of stocks, bonds, and money market funds to and from the United States (i.e. capital flow into US denomiated assets). The headline figure is the difference in value between American purchases of foreign securities and foreign purchases of American securities, expressed in millions of dollars. The Treasury International Capital or TIC statement is a major component of the American capital account and gives valuable insight into foreign demand for American investments and dollar.

A positive figure indicates that more capital is entering the US than leaving as sales of American securities to foreigners exceed American purchases of foreign securities. Positive figures suggest that American security markets are competitive with those of other countries.

Foreign security purchases are especially important in the case of a trade deficit, as a positive figure can offset the depreciating effect (on the USD) of a trade shortfall. A negative or declining TICS figure reflects a declining capital flow picture. Outflows are indicative of weaker demand for US assets which puts downward pressure on the value of the dollar.

TIC data breaks down investors into governments and private investors. Usually, a strong government holding of dollar denominated assets signals growing dollar optimism as it shows that governments are confident in the stability of the U.S. dollar. Most importantly seems to be the purchases of Asian central banks such as that of Japan and China. Waning demand by these two behemoth US Treasury holders could be bearish for the US dollar. As for absolute amount of foreign purchases, the market generally likes to see purchases be much stronger than the funding needs of that same month's trade deficit. If it is not, it signals that there is not enough dollars coming in to match dollar going out of the country. As a side note, purchases by Caribbean central banks are generally seen to be less consistent since most hedge funds are incorporated in the Caribbean. Hedge funds generally have a much shorter attention span than other investors.

Release Schedule: 9:00 AM (EST); monthly, in the second month following the reporting month

Revisions Schedule: Data are subject to revisions for 24 months following release

Source of Report: U.S. Treasury

Web Address: http://www.treasury.gov

Address of Release: http://www.treasury.gov/tic/ticsec2.html

What is Debt Monetization? How does it work?

1. Suppose the government runs a deficit... E.g. let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.

2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.

3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).

4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.

5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that). (In other words, the Treasury just ends up owing money to the Fed.)

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.

2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).

3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed

Monetization vs Sterilization

Sterilization is usually discussed in the context of currency intervention, but it’s functionally the same when a central bank wants to drain cash from the system.

It’s the process of selling longer-dated assets in exchange for zero-maturity money. This locks money up for a time, effectively removing it from current circulation. Usually, this would be done by selling off some of the Treasuries on the Fed’s own books for cash. The Fed will take the cash it receives and sit on it.

If the Fed doesn’t own enough treasuries, it might not be able to do this in large enough scale on its own. Now, the Treasury could just issue more treasuries and sell them to the Fed.

But the new ability to pay arbitrary interest rates to banks on their deposits is quite similar and can be used for sterilization. The banks deposit their cash with the Fed, which locks it up, taking it out of circulation.

The big difference is maturity: these deposits are generally just overnight, while a Treasury has a much longer term, up to 30 years, but with whatever maturity the government wants. Perhaps the Fed could start offering CD’s, essentially, to remove even this distinction...

The Federal Funds Rate

The Fed maintains the federal funds rate - the interest rate at which US banks make overnight loans to each other - at (or close to) the Fed's chose target by injecting (the rate falls) and extracting (the rate rises) liquidity from the banking system. The Fed does this through repurchase agreements (repos) or by manipulating the stock of Treasuries on its balance sheet.

However, when the Fed wants to keep the federal funds rate unchanged but add liquidity by other means (perhaps by auctioning off funds), the Fed sterilizes the effects of the new liquidity on the monetary base by performing an offsetting open market operation - an overnight repo or selling Treasuries outright.

Leaving money in the banking system as excess reserves increases the supply of federal funds & reduces the federal funds rates (below the Fed's target). The increased money supply is inflationary-too much money chasing the same number of goods & services.

Understanding The Yield Curve

What is it?

The graph you get when you plot the rates for 1-month T-Bills to 30-year T-Bonds.

When people think about interest rate changes, they generally are discussing a parallel change in interest rates, where rates change by the same amount across the yield curve.

When yield curve changes are discussed from a bearish or bullish standpoint...

Rising rates are considered bearish.

Falling rates are considered bullish.

Non-parallel shifts are generally discussed as yield curve twists.

The shape of the yield curve is simply the difference in yield between two maturities. The "rule of thumb" is to look at the 2-year to 10-year Treasury curve slope. If the 10-year rate less the 2-year rate is positive, the yield curve is normal, or positively sloped. If it were negative, it is called an inverted yield curve. If the difference is relatively small, it's considered flat.

Non-parallel shifts

Steepeners... when the difference between the long end & the short end increases

Bull steepener... short interest rates are falling faster than long rates

Bear steepener... long rates are rising faster than short rates.

Flatteners... when the difference between the long & short end decreases

Bull flattener... long interest rates are falling faster than short rates

Bear flattener... short rates rise faster than long rates

Measuring Performance

IC, information coefficient - A correlation value that measures the relatinoship between a variable's predicted & actual values, used for evaluating forecasting skill.

In our active quant strategies, an IR of .10 in considered excellent. An IR of .05 would be considered good.

IR, information ratio - A measure of the risk-adjusted return of a financial security (or asset or portfolio), defined as expected active return divided by tracking error. Top-quartile investment managers typically achieve information ratios of about one-half.

tracking error - the standard deviation of the active return

Why we use log returns

Log Returns

If $100 grows to $120, what is the single period return?

Discretely... +20% because 120/100-1 = 20%

Continuously... log return is given by LN(P1/P0) or ~18.2%. (If the asset paid dividends, they are included in the numerator).

Period log returns are typically used in quantitative finance

Benefits of log return

* Time additive: Note that the two-period log return is identical to the sum of the each period’s log return. To get the n-period log return, we can simply add the consecutive single period log returns. Conversely, notice the simple return is not time additive.

* Mathematically convenient: logs and exponents are easier to manipulate with calculus. Theoretical models tend to assume, unrealistically but conveniently, continuously compounded rates of return. For example, if LogReturn = LN(P1/P0), then EXP[LogReturn] = P1/P0. If f(y) = EXP[LogReturn] then the first derivative, f’(y) is quite wonderfully also EXP[LogReturn]. In short, d/dx EXP[x] = EXP[x].

* Approximately good: for short periods (e.g., daily), the log return approximates the discrete return anyway

Drawbacks of log return

* Not "linear" in portfolio return: We would like to be able to say that portfolio return is a weighted sum of components (assets). However, we cannot say this under log returns: the log return is not linearly additive across portfolio components. But, the discrete return is linearly additive.

* Unrealistic: Markets tend to quote discrete returns

Trade Finance Definitions

Export Credit Agencies (ECAs)

Are private or quasi-governmental institutions that act as intermediaries between national governments & exporters to issue export financing, in the form of credits (financial support) or credit insurance and guarantees (pure cover) or both, much like normal banking activities

letter of credit

* Document issued which usually provides an irrevocable payment undertaking; can be source of payment for a transaction (i.e. redeeming the letter of credit will pay an exporter)

* Parties involved:

+ beneficiary - who is to receive the money

+ issuing bank - of whom the applicant is a client

+ advising bank - of whom the beneficiary is a client

* bill of landing (BOL or B/L) - document issued by carrier to shipper acknowledging that specified goods have been received on board as cargo for conveyance toa named place for delivery to the consignee

factoring

* Financial transaction where by business sells its accounts receivables to a third party (called a factor) at a discount in exchange for immediate money w/which to finance continued business

* Firm based operation (i.e. firm sells all its receivables); vs. forfaiting, which is a transaction based operation

* Parties involved:

+ seller of receivables

+ debtor

+ factor

Bonds and Inflation

Inflation breakeven rate refers to the difference between the nominal yield on a conventional bond and the real yield on an inflation-indexed bond of the same maturity. It has been used extensively as a tool to obtain the expected inflation.

If the breakevens are rolling over... one possible explanation is that, while the real yield holds steady, yields on conventional bonds are falling (i.e. conventional bonds are being bid higher) (hence the difference between the two yields is also falling). Funds could be flowing into bonds because deflation is considered more of a threat than inflation.

REITs - Capitalization Rate

cap rate = NOI/Cost (or Value)

* Measures rate of return

* Direct capitalization... income generating property is often valued according to projected cap rates used as investment criteria... i.e. asset price = cash flow / cap rate

* NOI takes net income and backs out adjustments made for depreciation, interest expense, profit tax, & reserves for repairs

+ Because depreciation doesn't directly affect cash generated by asset.

+ But more careful & realistic definition... est annual maintenance expenses or capital expenditures will be included in non-interest expenses

* NOI, and thus cap rate, is a capital structure-neutral valuation measure

* Lower cap rates for properties indicate less risk associated w/investment (& and thus lower rate of return demanded for investment)

* Factors considered when assessing risk include... creditworthiness of tenants, terms of lease, quality & location of property & general volatility of market

* ERV (Estimated Rental Value)... states valuer's opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation

* reversionary... diff between the "in-place" (or "passing") rent and the ERV (Estimated Rental Value)

* "rack rented"... if the passing rent payable on property is equivalent to its ERV

Gold Hedging II

The argument goes that hedging causes gold price to decline because it increases supply when borrowed gold is sold into the spot market.

De-hedging (i.e. closing out a hedgebook), on the other hand, is thought to strengthen the gold price because it either decreases supply, when the mining companies deliver production to repay gold loans instead of selling it, or because the mining companies pay their loans off w/gold purchased from the market

Treasury Auctions

primary dealers - large securities dealers/financial institutions that are active in buying & selling US government securities & have established business relationships with the NY Fed

* The US Government auctions Treasury bills & notes to finance the public debt.

* Most are bought by primary dealers; A small amount are bought by individual investors (who buy them directly from the Treasury Dept @ auction)

* Currently... bills in three- & six-month maturities; notes in two-, five-, and ten-year maturities;

* Occasionally, Treasury auctions cash management bills (CMBs) (w/maturities that are set on an issue-by-issue basis) to meet short-term financial needs

Bidding

* Bids are accepted up to 30 days in advance of the auction, & may be submitted electronically through the Treasury Automated Auction Processing System (TAAPS) and by mail. All bids are confidential & kept sealed until auction date.

* Two types of bids may be submitted...

(1) Non-competitive tenders... generally submitted by small investors & individuals... guaranteed to receive securities... amount of securities that may be sold to single non-competitive bidder is limited to $1MM per auction for bills & $5MM for coupon issues

(2) Competitive bids... usually submitted by primary dealers for own accounts, or on behalf of customers... bids are submitted in terms of yield or discount rate... to ensure that 2ndary market for Treasury securities remains competitive, bidders are restricted to receiving no more than 35% of total amount of securities available to public

* Three categories of bidders; Dealers + Directs + Indirects = 100%

(1) Dealers submit bidding for their own house accounts & are required to make bids

(2) Directs are non-primary dealer submitters. They may make bids for their own books or on behalf of clients. Some direct bidders may make bids to look to eventually become primary dealers.

(3) Indirects are customers placing competitive bids through a primary dealer, and are largely foreign and international monetary authorities placing bids through the NY Federal Reserve Bank

Determining the winning bids

* The non-competitive tenders (which automatically receive securities) are subtracted from the total offering to determine amount awarded to competitive bidders

* The Treasury works down the list off competitive bidders, accepting highest bid prices until all securities have been awarded... all lower competitive bids are rejected

* Single-price auction... successful competitive bidders & noncompetitive bidders buy securities at price that equals the highest accepted yield or highest accepted discount rate (i.e. lowest bid)

* Total amount of bids received & total accepted are made available to the public.

* The high, low, & weighted averages of the price, discount rate, and equivalent bond yield of the accepted competitive bids are released to the public

* The weighted average price & yield from the successful competitive bids are applied to the non-competitive tenders

Treasury auctions tail

* In bond market jargon the tail is the distance from the level at which bonds were trading on a when issued basis immediately prior to the auction, to where the Treasury was able to complete the sale. A long tail represents a lack of interest from clients and dealers who would normally underwrite the security.

* It's the spread in price between the lowest competitive bid accepted by the U.S. Treasury for bills, bonds, and notes and the average bid by all those offering to buy such Treasury securities.

Gold Hedging I

Producer

* The producer has future gold production to deliver... enters into a contract to sell gold in the future at a fixed price.

* Why? Price protection; take advantage of $45/oz higher forward premiums to spot (E.g. $300 + ($80 - $35) = $345, where $80 is the interest rate earned & $35 is the lease rate payment)

* What is the interest rate earned? The producer must earn interest on the spot value of the gold sold in the future. Otherwise the producer would simply sell the gold now, and earn interest on the cash received now.

* What is the lease rate? The producer is paying for not delivering the gold now, because there is

* The MAJOR risks a producer has to hedging...

+ How low cost are their mines? (cost of production)

+ How well diversified & certain is their production? (certainty of having gold)

+ How good is their credit? (defining terms of contracts -- including margining on termination rights); (must avoid margin calls, early terminations rights (& thus possibly forced early delivery))

* Other risks include...

+ Counterparty risk... E.g. bullion bank declares bankruptcy, trustee defaults on gold purchase from the producer b/c spot is lower than the contract and the contract is thus a liability)

+ Opportunity cost

* Quality assets & strong credit mean...

+ Multi-year terms (up to 10-15 yrs) (= flexibility for producer)

+ No margin, & no early termination rights

+ Better pricing on long-term contracts

+ Higher forward prices based on l.t. vs. s.t. interest rates

Bullion Bank

* Plays an intermediary role in creating the gold lending & gold hedging markets. They take on the borrowing of gold, the spot positions, the deposit risk etc.

* Makes the 'vig' and does not have market exposure.

* But takes on producer's credit risk (i.e. the producer must deliver gold to bullion bank in the future). If the gold is not delivered, they may have to pay more than the amount set in the futures contract with the producer to purchase the gold they owe the Central Bank from the market.

* Sells the borrowed gold to the spot market & deposits cash received with its own funding desk, thus there is no credit risk between the two counterparties (as they are the same entity)

Central Bank

* Lends gold & receives interest payments for lending to the Bullion Bank.

* Takes on Bullion Bank credit risk (i.e. must receive gold back from Bullion Bank). That is why Central Banks deal with "AA" rated Bullion Banks and not with Producers directly.

* From 1989 thru 2002, the 3-month lease rate (the rate earned for lending the gold) was under 2%, 86% of the time

An Example Of The Whole Picture...

The producer sells its future production of gold to the bullion bank for $345. (This represents the spot rate of $300 plus interest received of $80, less lease payment of $35)

The bullion bank makes a spot sale of gold for $300. But it has no gold in its inventory until it receives future delivery from the producer.

So the bullion bank borrows gold from the central bank, makes a lease payment (of $31, less than the $35 paid by the producer) to the central bank for borrowing the gold, & delivers the borrowed gold to the spot buyer in exchange for $300 cash.

The bullion bank in return deposits the $300 cash to earn interest (of $83, more than the $80 paid t the producer) until the future contract w/the producer expires, at which point it pays the producer $345 for the gold, which is delivered to the central bank... all open positions collapse.

MTM

* Mark-to-market is the replacement value of the hedge positions at a particular point in time.

* Gold price moves up => Impact on MTM is negative; Same hedge/future sale to the bullion bank would now lock in a higher price

* US rates move down => Impact on MTM is positive; Hedge would return lower price

* Lease rates move up => Impact on MTM is positive; Hedge would return lower price

* MTM creates credit exposure to counterparties. MTM thresholds can be used to mitigate credit exposure through margining, or early termination

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spot-deferred contract - A forward contract that gives the seller the option to roll the contract forward rather than make delivery on a specific date. Often used by gold producers to hedge gold price exposures. Also called Undated Forward

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The forward price is based on i) the then spot price ii) the interest rate differential between borrowing gold & the USD deposit