Chapter 17: Topical issues in financial management

Chapter learning Objectives

Upon completion of this chapter you will be able to:

• describe and discuss the significance to the firm, of the latest developments in the world financial markets with reference to the removal of barriers to the free movement of capital and the international regulations on money laundering
• identify the latest emerging derivative products, explain the risks of derivative trading, and describe how tools such as value at risk, scenario analysis and stress testing can help a firm to manage the process
• identify the latest developments in the macroeconomic environment (regarding international trade and finance) - such as the credit crunch and dark pool trading systems - and explain the impact on a firm.

1 Introduction to topical issues

Note on further reading

The Advanced Financial Management examiner has stated that he wantsthe paper to be a contemporary, "Masters Level" paper. Therefore it isvery important to read widely around the subject to develop an awarenessof emerging, topical issues and techniques.

The starting point for further reading is the Student Accountantmagazine, and the ACCA website, where the examiner and other expertsregularly post articles on key topical financial management topics.

However, you should also subscribe to a quality newspaper, and usethe internet to develop a broader awareness of topical issues.

Introduction to this chapter

This chapter introduces a few of the main topical issues infinancial management at the moment, such as the "credit crunch", darkpool trading systems, financial engineering and internationalregulations on money laundering.

2 Regulation of world financial markets

The free movement of goods, services and capital across nationalbarriers has long been considered a key factor in establishing stableand independent world economies.

However, removing barriers to the free movement of capital, alsoincreases the opportunities for international money laundering andterrorist financing.

Money launderingis a process in which assets obtained or generated by criminal activityare moved or concealed to obscure their link with the crime.

The International Monetary Fund (IMF)

Ever since the second world war, organisations such as theinternational monetary fund (IMF) have been working to establish amultilateral framework for trade and finance. The free movement ofgoods, services and capital has been seen as a vitally important part ofthe increasing economic and financial stability and independence of theworld’s economies.

The IMF is an international organisation of 184 member countries.It was established, amongst other things, to promote internationalmonetary cooperation, exchange stability, and orderly exchangearrangements and to foster economic growth and high levels ofemployment.

However, terrorist activities are sometimes funded from theproceeds of illegal activities, and perpetrators must find ways tolaunder the funds in order to use them without drawing the attention ofauthorities.

The international community has made the fight against moneylaundering and terrorist financing a priority. Among the goals of thiseffort are:

• protecting the integrity of the international financial system
• cutting off the resources available to terrorists
• making it harder for criminals to profit from their crimes.

The IMF is especially concerned about the possible consequences ofmoney laundering on its members’ economies, which could include risksto the soundness and stability of financial institutions and financialsystems and increased volatility of international capital flows.

International efforts to combat such activities have resulted in:

• the establishment of an international task force on money laundering
• the issue of specific recommendations to be adopted by nation states
• the enactment of legislation by many countries on matters covering:
  • the criminal justice system and law enforcement
  • the financial system and its regulation
  • international co-operation.

The international financial action task force (FATF)

In order to combat activities such as money laundering andterrorist financing the international financial action task force onmoney laundering (FATF) was established to determine what measuresshould be taken by the international community.

FATF is a 33-member organisation established by the G-7 summit inParis in 1989 with primary responsibility for developing a worldwidestandard for anti-money laundering and combating the financing ofterrorism. It works in close cooperation with other key internationalorganisations, including the IMF, the World Bank, the United Nations,and FATF-style regional bodies (FSRBs), most of which participate in itsmeetings as observers.

Within a year, FATF had issued forty recommendations to provide acomprehensive plan of action needed to fight against money laundering.These were supplemented by another nine recommendations specificallyfocused on the financing of terrorism in the wake of the events of 9/11.They have been recognised, endorsed, or adopted by many internationalbodies and though not a binding international convention, many countriesin the world have made a political commitment to combat moneylaundering by implementing them.

In the UK, the third money laundering directive was adopted inOctober 2005. It represents Europe’s response to the global standardsproduced by the financial action task force (FATF) in 2003. The UKgovernment has to implement the directive into UK law by December 2007.It lays down in detail the roles and responsibilities of individuals andfirms in the drive to combat money laundering and terrorist financing.

One of the results of this activity is to create a wide definition of the offence to include:

• possessing, dealing with, or concealing the proceeds of a crime
• attempting or conspiring to commit such an offence
• failing to inform the national financial intelligence unit (FIU) of knowledge or suspicion of such an offence.

Details on framework introduced by task force

Money laundering regulations and the financial system

The regulatory framework recommended by the taskforce andimplemented in countries throughout the world, place significantresponsibilities on accountants and other professional advisors.

The rules are designed to ensure:

• all customers are properly identified as legitimate and no anonymous accounts are permitted
• any suspect financial activities are immediately reported to the appropriate authorities
• records of all due diligence investigations and financial transactions are kept for the proscribed number of years
• adequate and appropriate policies and procedures are established to forestall and prevent operations related to money laundering or terrorist financing including staff training
• sanctions for non-compliance are in place.

The laws implemented by most countries have had a significant impact on professional accountants who are obliged to:

• undertake customer due diligence (CDD) procedures before acting for a client
• keep records of transactions undertaken and of the verification procedures carried out on clients
• report suspicions to the relevant financial intelligence unit (FIU) e.g. the national criminal intelligence service (NCIS) in the UK.

Professional accountants are not in breach of their professionalduty of confidence if, in good faith, they report any knowledge orsuspicions of money laundering to the appropriate authorities.

Penalties for non-compliance can be imposed by the regulator (suchas the financial services authority in the UK) on any firm orindividual. In addition, the ACCA may take its own disciplinary actionagainst its members. It is therefore essential for all accountants to:

• monitor developments in legislation
• stay abreast of the requirements
• implement all recommended protocols.

3 Financial engineering and emerging derivative products

Derivatives are financial instruments that have no intrinsic value, butderive their value from something else, such as equity securities,fixed-income securities, foreign currencies, or commodities.

They fall into three main categories:

• Options.
• Forwards.
• Swaps.

Some simple derivatives were covered earlier in this text.

However, there is a vast and diverse range of potential underlyingassets and payoff alternatives, and consequently a huge range ofderivatives contracts available to be traded in the market, beyond thebasic varieties of derivatives covered in this paper.

Derivatives and risk

Derivatives can be used to hedge risk or to speculate. Mostderivatives are sold as a way to hedge the risk of a portfolio. However,even as a hedging tool, as derivatives become more complex, so theybecome more difficult to measure, manage, and understand.

Use of complex derivatives requires:

• a firm understanding of the trade-off of risks and rewards
• a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities, covering matters such as:
  • the role of senior management
  • valuation and market risk management
  • credit risk measurement and management
  • operating systems and controls
  • accounting and disclosure of risk-management positions.

Financial engineering and the management of derivative risk

Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their overall position.

Financial engineeringrefers to the development of pricing methodologies and hedgingtechniques that underpin the use of financial derivative products.Black, Scholes and Merton were the first financial engineers when theyused mathematics to model the price of a plain (vanilla) option.

Financial engineering techniques can also be used to measure and therefore manage the risk of a portfolio of derivatives.

Examples of financial engineering techniques are Value at Risk (VaR), scenario analysis and stress testing.

Details of financial engineering techniques

Value at risk

The concept of value at risk (VaR) was covered in detail earlier in this text.

VaR measures the maximum expected loss for a given portfolio, undernormal market conditions, attributable to changes in the market priceof financial instruments:

• for a given time horizon
• for a given confidence interval.

Scenario analysis

In addition to understanding the expected maximum loss under normalmarket conditions, a portfolio manager must also understand theimplications for the portfolio of abnormal market conditions.

Using the Monte Carlo simulation method, particular marketconditions and the effects of hypothetical events can be simulated todetermine their effect on the value of the portfolio.

For each iteration:

• the scenario of random market moves is generated based on a model of the particular conditions under analysis
• the portfolio is then revalued assuming the simulated scenario occurred as before.

After a large number of iterations have been performed, a distribution is computed. This may be a distribution of:

• the potential range of values of the portfolio under these specific conditions, or
• the potential range of profits or losses on the portfolio under these conditions.

Stress testing

Stress testing is a simplified version of scenario analysis. Itassesses the impact of a specific set of circumstances on a portfolio:

• Particular high risk events are identified.
• The value of the portfolio is calculated assuming the occurrence of this specific set of possible risk factors.
• The size of the potential loss is calculated.

Note that stress testing does not assign probabilities to the likelihood of these events occurring. It is used to:

• understand the weak spots is in a portfolio
• reconfigure a portfolio to reduce risk to a manageable level, or
• help a portfolio manager act decisively if the worst-case scenario should unexpectedly unfold.

This kind of stress testing prevents portfolio managers from havingto react at speed in a moving market, a situation that can exacerbatethe losses. In a complex derivatives portfolio, stress-testing thatreveals excessively risky exposures either to movements in theunderlying cash rate or shifts in volatility or interest rates (orcombinations of these factors) is said to identify ‘risk holes.’These are particular combinations of circumstances that would make theportfolio very difficult to manage and the profitability of theportfolio too volatile for the company’s risk appetite.

Test your understanding 1

Distinguish between:

• Value at risk.
• Scenario analysis.
• Stress testing.

4 The global credit crunch and toxic assets

Over the last few months, since the “Credit Crunch” began, thephrase “toxic assets” has been used by the international media todescribe the range of financial products traded by banks and otherfinancial institutions in order to earn income and lay off risk.

To understand the problem of toxic assets it is first necessary tounderstand how banks have traditionally moved to lay off risk through aprocess of securitisation using “Collateralised Debt Obligations”(CDOs).

Securitisation through CDOs

When banks lend money to borrowers (for mortgages, car loans etc),they invariably try to lay off their risk by a process ofsecuritisation. This involves selling the asset from the bank’sbalance sheet to a company called a “Special Purpose Vehicle” (SPV).This sale generates cash for the bank in the short term which can thenbe lent again, in an expanding cycle of credit formation.

CDOs are “packages” of many securitised loans which are puttogether by an SPV and sold to investors. The investors decide whatlevel of risk they are prepared to tolerate and invest in an appropriategrade of CDO accordingly. The CDOs are then traded between investors(usually banks).

The Credit Crunch

During the last few months, it has become apparent that the bankshad pursued borrowers so aggressively that many of the loans sold toSPVs in the securitisation process were likely not to be repaid (socalled “sub-prime” loans). This in turn means that it has becomevery difficult to trace which CDOs represent loans which are sound, andwhich are likely to be defaulted. Even some CDOs which were sold as AAAgrade investments have been found to be unexpectedly risky.

Consequently, suspicion has grown in the financial markets thatsome bank balance sheets are carrying large amounts of CDOs which arenot worth what they appear to be.

This has meant that inter-bank lending has reduced dramatically, asbanks view each other with suspicion. These CDOs are known as toxicassets. 

The main problem is the uncertainty about which loans (and CDOs)are sound and which aren’t. In practice, until time passes and some ofthe loans are repaid, it will be impossible to tell which banks’balance sheets are most badly affected.

The impact on business in general

As a consequence of the credit crunch, the banks have been morereluctant to lend and have set more stringent lending criteria. This hasmeant that many businesses have struggled to refinance their debts.

It is hoped that the financial stimulus packages introduced bygovernments in early 2009 will encourage banks to lend, and will have apositive impact on businesses in general.

Illustration 1: Securitisation

Smithson Bank has made a number of loans to customers with acurrent value of $500 million. The loans have an average term tomaturity of four years. The loans generate a steady income to the bankof 9.5% per annum. The company will use 95% of the loan’s pool ascollateral for a collateralised loan obligation structured as follows:

• 70% of the collateral value to support a tranche of A-rated floating rate loan notes offering investors LIBOR plus 100 basis points.
• 20% of the collateral value to support a tranche of B-rated fixed rate loan notes offering investors 9.5%
• 10% of the collateral value to support a tranche of subordinated certificates (unrated).

In order to minimise interest rate risk, the company has decided toenter into a fixed for variable rate swap on the A-rated floating ratenotes exchanging LIBOR for 8.5%.

Service charges of $1million per annum will be charged for administering the income receivable from the loans.

Required:

Calculate the expected returns of the investments in each of the three tranches described above.

Solution

In order to estimate the returns an annual cash account should becreated showing the cash flow receivable from the pool of assets and thecash payments against the various liabilities created by thesecuritisation process. In this securitisation a degree of leverage hasbeen introduced by the swap giving a return of 12.4% to the holders ofthe subordinated loans but carrying a high degree of risk.

The payment of $5.9m to the subordinated loan holders represents an effective return of

5.9m / ($500m × 95% × 10%) = 12.4%

(W1) A class total $500m × 95% ×70% = $332.5m

(W2) B class $500m × 95% ×20% = $95m

Student Accountant article

The examiner's January 2009 article in Student Accountant magazine provides further details on toxic assets.

5 Developments in the macroeconomic environment

Part of your responsibility as a member of the ACCA is to keepyourself up-to-date with developments that will impact the advice yougive and the decisions you take as an accountant.

Developments in the macroeconomic environment, may be global or national, but are likely to be the result of:

• political factors
• legal factors
• economic factors.

Test your understanding 2

Suggest specific areas, under each of the threeheadings above, which financial accountants should monitor in order tokeep abreast of potentially significant developments affecting thecompany.

As you pursue your studies, ensure that you keep up to date witheconomic developments both nationally and internationally and considerhow the changes would impact specific firms and decisions.

Many of the topics covered in this paper are of particularrelevance in assessing the effect of such factors on a firm, bothinternally and externally.

Test your understanding 3

For each of the factors listed below consider how they might impact the financial decisions made by a firm.

• Increases in the capital allowances given on investment.
• Reduction in planned government spending.
• Significant strengthening of the home currency.

6 Dark pool trading systems

Definition

Dark pool trading relates to the trading volume in listed stockscreated by institutional orders that are unavailable to the public. Thebulk of dark pool trading is represented by block trades facilitatedaway from the central exchanges.

It is also referred to as the "upstairs market", or "dark liquidity", or just "dark pool."

The dark pool gets its name because details of these trades areconcealed from the public, clouding the transactions like murky water.Some traders that use a strategy based on liquidity feel that dark pooltrading should be publicised, in order to make trading more "fair" forall parties involved. Indeed, some stock exchanges have prohibited darkpool trading.

The problem with dark pool trading

If an institutional investor looking to make a large block order(thousands or millions of shares) makes a trade on the open market,investors across the globe will see a spike in volume.

This might prompt a change in the price of the security, which inturn could increase the cost of purchasing the block of shares. Whenthousands of shares are involved, even a small change in share price cantranslate into a lot of money. If only the buyer and seller are awareof the transaction, both can skip over market forces and get a pricethat's better suited to them both.

The rise in popularity of dark pool trading raises questions forboth investors and regulators. With a significant proportion of tradesoccurring without the knowledge of the everyday investor, informationasymmetry becomes an issue of greater importance.

7 Chapter summary

Test your understanding answers

Test your understanding 1

Value at risk measures the maximum expected loss for a givenportfolio, under normal market conditions, attributable to changes inthe market price of financial instruments.

Scenario analysis, using Monte Carlo simulation techniques, gives aprobability distribution of the potential range of values of aportfolio under a particular set of abnormal market conditions.

Stress testing values a portfolio under a given set of high-risk assumptions.

Test your understanding 2

• Political factors:
  • taxation policy
  • government spending policies
  • regional and national economic groupings
  • foreign trade regulations
  • price controls
  • government stability.
• Legal factors:
  • monopolies legislation
  • corporate governance regulations
  • international harmonisation of accounting standards
  • national implementation of international regulations such as those on money laundering
  • national regulation of companies such as the Companies Acts in the UK.
• Economic factors:
  • business cycles
  • interest rates
  • inflation rates
  • exchange rates.

Test your understanding 3

Increases in the capital allowances given on investment:

• The acceleration of capital allowances may improve the present value of the returns on some projects such that they become worth taking on.
• The increases may however reduce the tax payable such that the tax shield on debt is lost and the advantages of gearing are lost alongside.

Reduction in planned government spending:

• May result in lower wage settlements & higher unemployment.
• This could mean a reduction in labour costs but also in ready income and therefore consumer spending on luxury items.
• Would impact on cashflow and revenue forecasts.
• Need for accurate market research and sensitivity analysis on the estimates.

Significant strengthening of the home currency:

• If long-term would affect competitive position overseas – potential problems for exporters as goods become more expensive.
• In the short-term may impact on contract settlements if risk not previously hedged.
• May lead to changes in borrowing plans if balance sheet hedge deemed appropriate to offset translation exposure.
• Could impact the value of derivatives portfolios.

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags: