jargon watch · 2014-07-24 · jargon watch 2 fixed income academy 3 intro to jargon watch 4 asset...

1Jargon Watch

F I X E D I N C O M E A C A D E M Y

JARGON WATCH

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3 INTRO TO JARGON WATCH4 ASSET PRICES VS. INFLATION5 BLACK SWAN7 BREAK THE BUCK8 CROSSOVER CREDITS9 EXIT FEES10 FILL OR KILL10 HAIRCUT11 HIT THE BID/LIFT THE OFFER12 LEVER UP13 LOCKED MARKET14 MAKE-WHOLE CALLS16 MARK TO MARKET17 RIDING THE CURVE18 RISK ON/RISK OFF19 TAIL RISK20 CONTRIBUTORS

CONTENTSF I X E D I N C O M E A C A D E M Y

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INTRO TO JARGONWATCH

WE SPEAK BOND, DO YOU?WE HOPE YOU ENJOY THIS RESOURCE TO HELP DEMYSTIFY COMMONLY MISUSED AND MISUNDERSTOOD FIXED INCOME RELATED TERMS. IT IS NOT AN EXHAUSTIVE LIST, BUT A COLLECTION OF WORDS AND PHRASES WE UNRAVELED FOR STUDENTS AND FOLLOWERS THIS PAST YEAR.

IT IS IMPORTANT TO KEEP IN MIND THAT MARKET PARTICIPANTS OFTEN USE PHRASES AND TERMS DIFFERENTLY DEPENDING ON A PLETHORA OF FACTORS SUCH AS THE SIDE OF THE MARKET THEY ARE ON AND/OR WHAT TYPES OF PRODUCTS ONE IS SPEAKING ABOUT. FOR EXAMPLE, CORPORATE TRADERS USE WORDS DIFFERENTLY THAN MORTGAGE TRADERS. FOR THAT REASON, NEVER HESITATE TO ASK FOR CLARIFICATION WHENEVER YOU HEAR A TERM YOU DO NOT COMPLETELY UNDERSTAND. I LOVE THE STORY INSTRUCTOR GEORGE RICHARDSON SHARED IN COURSE 02…DURING HIS FIRST YEAR ON THE TRADING DESK HE CARRIED AROUND A NOTEBOOK TO JUST WRITE DOWN THE DOZENS OF UNFAMILIAR TERMS HE WAS HEARING EVERY DAY. WE DID THE SAME THING. TRUTH IS, THEY JUST DON’T TEACH THIS STUFF IN COLLEGE. THERE IS ONLY ONE WAY TO LEARN PRACTICAL TRADING AND INVESTMENT SKILLS, BY PRACTICING.

THANKS AGAIN FOR ENTRUSTING US TO HELP YOU ACHIEVE YOUR LEARNING OBJECTIVES. WE LOOK FORWARD TO SEEING YOU IN CLASS AND, AS ALWAYS, REMIND YOU THAT IF YOU HAVE ANY QUESTIONS FOR OTHERS OR US… DON’T HESITATE TO ASK!

ALL THE BEST,SUSAN, ARJUN, DAVID AND THE FIA RESEARCH TEAM fixedincomeacademy.com

This publication provided by Fixed Income Academy (FIA) is intended for Institutional Investors and Market Participants and is informational only. FIA is neither an investment advisor nor a municipal advisor and the content provided is neither investment advice nor municipal advice. All content is general in nature, and cannot substitute for the advice of a licensed professional in any respect. The information, is deemed reliable but it is not guaranteed and is subject to change at any time. Opinions expressed by any individual contributor, whether or not affiliated with FIA, are their own and do not represent the views of FIA or any affiliated organizations.


http://fixedincomeacademy.com

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F I X E D I N C O M E A C A D E M Y F I X E D I N C O M E A C A D E M Y

ASSET PRICES VS. INFLATION

Many investors, including some of the popular commentators on CNBC, confuse asset price increases with that of inflation. “Inflation” is defined as an increase in the price of goods and services, the things that people consume. On the other hand, “Assets” are not consumables but represent stores of value or investments, like real estate or stocks. Therefore, an increase in asset prices is not inflation. Rather, the impact of the asset prices is to make people feel wealthier and thus increase confidence and propensity to spend. As such, asset prices can lead to more growth and, if goods are scarce, inflation. This, in turn, leads businesses to hire and thus reduces unemployment.

As a result of the way asset price increases can lead to more growth, the Fed likes to increase asset prices as long as there is an excess of unused capacity and labor. On the other hand, the Fed does not want to use monetary policy to promote asset price increases when resources are near full utilization because the latter would cause inflation.

The most common way of increasing asset prices is through low interest rates, which then drive money towards riskier assets. As we can see by the preceding, consumers who are asset-heavy, by owning real estate or stocks, gain to benefit and become richer. Similarly, people entrenched in stable jobs or companies in strong positions benefit from rising asset valuations while enjoying the benefits of low interest rates.

Asset Prices and Inflation are not technically jargon, but we included because David has pointed out that there is a great deal of misunderstanding about the differences between the two in general media. Thanks, David, for the head’s up!

Jargon Watch


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A “Black Swan”, popularized in its eponymous book by Nicholas Taleb, refers to an unknown event, one that can have catastrophic consequences. Especially because we have not planned for such an outcome, our defenses are laid bare to this type of an event. As explained by Taleb in his book, a “Black Swan” typifies something that has not been seen. As Taleb expands, for some time mankind assumed that all swans were white because that was the only color of swan ever seen. Finally, a “Black Swan” was discovered and conse¬quently rendered obsolete our assumptions on a swan’s color.

A “Black Swan” does not necessarily mean a negative event by itself; indeed, seeing a “Black Swan” for the first time does not blind an observer who until then was accustomed to seeing only white swans. Instead, the negativity around “Black Swans” highlights the chinks in our defense planning and the speculation into the ensuing size of the failure from any such breaches. We, as a society, pride ourselves on our planning and in capturing all pieces of the puzzle that could go awry. And in recent years, the increased confidence around our planning aided by infrastructure (like high speed computing, low financing rates etc.) has sparked a “levering” up of bets around such planning, whether they be in finance or electric¬ity management. And thus, discomfort arises when visualizing the concept of a “rare” event that can bring down this levered house, causing catastrophic losses potentially.

The concept of a “Black Swan” has especially been highlighted with financial portfolios and decision-making processes that try to take all “risks” (like interest rate, currency, prepayments, defaults etc.) into account, but cannot of course plan around a “Black Swan” or “unseen” risk or catastrophe (like 9-11 or a sharp earthquake in Manhattan). The “Black Swan” is further accentuated in finance because finance is a fast-moving market where human emotions like “greed” and “fear” are volatile and can change the momentum quickly. For instance, a sharp earthquake in Manhattan, very rare and unforeseen, does not necessarily have to do a lot of harm: computers are omnipresent, data is backed up multiple times, and electronic trails prevail so that business can be conducted, albeit slower, at alternate locations until the real damage is assessed and restorative steps taken. But what happens is that such a rare event shakes public confidence, raising the deepest “what if”, “what has”, “what could be” questions. Investors start selling most securities, and rushing into safety (cash or Treasuries). And the panic builds on itself multiple times until most “babies are thrown out with the bathwater”.

BLACK SWAN

-continued to pg. 6

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Similarly, the very reveal of a chink in the armor (from a “Black Swan”) of a supposedly finely-tuned instrument like a CMO held by a variety of institutions can be enough to cause a run on the bank; the scale of that “run on the bank” not befitting the size of the chink and potential injury. And frequently, that “run on the bank” extends to the broader market in stocks and bonds, far beyond the potential losses to that individual CMO and its holders. Indeed, the “black swan” exposes fully blown fears of the worst outcomes because we had supposedly planned a valuable resource (portfolios or assets) around all possible outcomes; the plans that now lay shattered for their lack of universal coverage.

Finally, to dovetail with our topic on “fat tails” in finance, a “Black Swan” would be the creator of a fat tail on the negative side, creating extraordinary losses not seen in a normal distribution.

BLACK SWAN

-continued from pg. 5

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Break the buck is typically heard when talking about money funds. Although it rarely happens, it is something all money fund investment managers seek to avoid and an issue the SEC is extremely concerned about. We are currently awaiting word from the SEC regarding regulatory changes in an attempt to avoid a repeat of events seen in 2008 when a large fund did break the buck and paid investors less than $1 per dollar invested..

Money funds are mutual funds strictly governed by SEC’s rule 2a7 and used as cash equivelents by many investors. Therefore, they need to be highly liquid to meet demand for daily redemptions. For this reason, fund managers strive to maintain $1 NAV (net asset value). The challenge is that the investments owned by the fund, even the very short ones, fluctuate in price. Currently money funds have some wiggle room, meaning they can continue to pay $1 back to investors as long as the overall market value of the fund does not move outside of a narrow band.

For years regulators and market participants have been debating whether or not the NAVs of money funds should be required to float. Should the SEC determine that money fund NAVs will need to float to account for the market value fluctuations, an investor could invest, for example, $100,000 but get back more or less than $100,000 upon redemption. This makes it challenging for investors to use the funds as cash equivelents, which will drastically change the way the funds are used.

BREAK THE BUCK


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The terms high-yield and junk technically mean the same thing but have different connotations. High-yield sounds positive while junk carries a note of caution.

Technically speaking, bonds that are “investment grade” need to be rated at least at 6Bs (i.e. a minimum of BBB- by Moody’s and Baa3 by S&P). If they do not satisfy these criteria, they are considered crossover or high yield. A 5B rating (BBB/Baa on one side and BB/Ba on the other) is the prevailing definition for a “cross-over” and a 4B rating and below (BB/Ba and below from either of the agencies) is considered “high yield”. As we can see, a 5B is the gray area between 6Bs and higher (investment grade) crossover to 4Bs and below (high yield). This gray area also distorts the way investors flip the coin in deciding whether 5Bs should be housed in investment grade portfolios or in high yield books.

CROSSOVER CREDITS

To access Moody’s Rating Definitions and Scales:https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004

To access S&P’s Rating Definitions and Scales:http://www.standardandpoors.com/ratings/definitions-and-faqs/en/us

https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004



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This is a topical topic set amidst declining liquidity in secondary bond markets; that in turn, has been caused by implementation of regulations that inhibit the risk-taking by secondary broker dealers. As asset managers have grown larger and larger, attention has turned to them and the fact that they are now becoming “too big to fail”, like the larger banks in the dealer side. The larger size of asset managers set in the context of declining liquidity sets the stage for a “run on the bank”; or in this case, a “run on the fund”. To prevent this, the Fed is loosely pondering levying exit fees on bond funds in order to avoid a run on the $10 trillion corporate bond market (source: Federal Reserve and Bloomberg – DOUTCORP Index <GO>).

Normally, bond investors (like bank depositors) should be able to withdraw their money from funds. However, many of the securities could be longer-term and/or harder to sell when there is a crisis. Adding to this quandary, federal watchdogs have handcuffed broker-dealers in providing liquidity, citing proprietary positioning that do not serve their investors. “So much activity in open-end corporate bond and loan funds is a little bit bank like,” Jeremy Stein, a Fed governor from 2012-2014 was quoted in the Financial Times mid 2014. “It may be the essence of shadow banking is … giving people a liquid claim on illiquid assets.”

Exit fees would be meant to prevent investors from withdrawing funds, postponing their claims and making them illiquid. This would of course, reduce the appeal of debt funds among investors and possibly usher them into funds of other asset classes that provide better liquidity. On the asset managers’ side, this reduces the chance of a scenario where they have to fire-sell their securities. As expected, larger asset managers would welcome this type of rule.

A great way to get to the source of what you hear in the news is to bookmark the SEC’s Proposed Rules page:http://www.sec.gov/rules/proposed.shtml

There you can find the actual press releases and actions regarding the regulations you are most interested in tracking.

EXIT FEES

http://www.sec.gov/rules/proposed.shtml

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It is not unusual for a broker-dealer to offer to “work” an order on a customer’s behalf. For example, let’s say you own a security that you would like to sell. While the broker-dealer may not want to purchase your bond for their inventory, they have other accounts that may want to purchase the bond from you at a suitable price. So you agree to give the broker-dealer a “reasonable” period of time, anywhere from an hour to a day (or more), to find another party to purchase the bond from you at an agreed-upon price or spread; and the broker-dealer has now gone to work for you.

Keep in mind that reasonable” is based on multiple factors such as the type, size and complexity of the security. An exotic Latin American loan security could easily take a week or two of work, whereas a domestic investment-grade would merit no more than an hour.

At the end of the “working period”, you have the option of giving the firm additional time or you can tell them to “fill or kill”, meaning complete the transaction or stop working on it. “Fill or kill” is essentially to stop dawdling on the broker-dealer side so that the transaction is completed or frees up the security to be marketed somewhere else (or with another dealer).

FILL OR KILL

Haircuts most often refer to margin. For example, a 1% “haircut” would allow one to borrow $99 by pledging $100 worth of bonds as collateral. Higher haircuts denote a higher perceived risk in the transaction. In the repo world, lenders decide the percentage depend¬ing on the risk of the collateral for the loan, term of the transaction and credit worthiness of the counterparty to the transaction. 2% haircuts are quite common for high grade and less volatile assets with investment grade counterparties.

We also use the term “haircut” when discussing whether or not bondholders are going to receive all of their money back from bond issues in distress. For example, in Detroit’s bank¬ruptcy proceedings, investors wait to see how the judge was going to treat owners of general obligation bonds versus pensioners. The question is how much of a “haircut” will each party have to take? In this way, haircut means receiving back less money that one originally anticipated.

So, for example, if the judge ruled that both sides were going to share the pain equally and get back 50 cents on the dollar, you might hear someone say that everyone is getting a 50% haircut.

HAIRCUT

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When an owner of a bond contacts, either by phone or electronic trading platform, one or more broker dealer with the intention of selling a bond, the bond owner needs to receive a bid (or price) indication from a potential buyer of the bond.

When the owner of the paper opts to sell at the price (bid) he or she was given, the owner is “hitting the bid”. So you’ll often hear sales people ask, “do you want to hit the bid?” or “Can I tell the trader you will hit the bid?” I suppose, the notation started with associating this with “hitting” a target, in this case “hitting” a bid.

Similarly, when buying a bond, an offer indication from a dealer is “lifted”. When you buy the paper at the “offer” level, you are “lifting inventory” at the agreed-upon level, perhaps harking back to an agricultural time when grain from a dealer from lifted onto the owner’s cart to signify possession.

As with all bond lingo, various trading desks often use terms differently, but generally speaking that is what they are talking about.

HIT THE BID/LIFT THE OFFER

Always remember the FIA motto: If you do not completely understand something,

Don’t be afraid to ask!

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In finance, leverage signifies control of a larger amount of capital using a smaller amount of money. This may also be known in equity circles as “buying using margin” or buying using marginal funds. For quants and accountants, the best measure of leverage is the “debt to equity” ratio. That is, leveraging is increasing one’s ratio of debt to assets and deleveraging means reducing that ratio. Using leverage increases one’s potential for return (as with homeowners who put little down on homes), but also increases the risk. The global debate revolves around determining the appropriate amount of leverage to grow and sustain our interconnected economy.

Let’s take a very simple example, because it can get complex quickly when talking about capital ratios and regulatory requirements.

• I have $1000; • I buy a bond for $1000 and earn 3% (Zero Leverage); • I use the bond I own as collateral to borrow $990 and pay 1% for the money

borrowed; • I take the $990 and buy another bond and earn an additional 2% (3% for the new

bond less the 1% borrowing cost. Now I am leveraged 1 time, or 100%); • So my portfolio (in this case, one bond) can earn either 3% with zero leverage or 5%

with 100% (or 1x) leverage. Hey, that’s an extra $20 bucks in my pocket every year!

However, there are dozens of factors that need to be taken into consideration and we did not address the risk that must be taken in order to achieve the higher returns. This illustra¬tion gets a little mind boggling when we talk about our financial institutions being leveraged 30 times, as many of them were at the peak of the crisis. And, yes, that is 3000%. And, in case you are wondering, leverage is back on the move again, even amongst retail investors (margin debt is back to 2007 levels).

When market participants say “lever up” they are typically referring to making a conscious decision to increase the leverage in their portfolio with the goal of increasing their potential rate of return.

LEVER UP

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A “locked” market is trader parlance where there is no difference between a “bid” and an “offer”. Most securities trade at a spread, which is the difference between a “bid” and an “offer”, to enable a market-maker to earn the difference for engaging in the transaction. Naturally then, “bids” are lower than “offers” – in terms of price – to enable a dealer or market maker to buy a security at the “bid” price and sell it immediately at the “offer” price. The more liquid the market, it follows that the difference between the “bid” and the “offer” would shrink to reflect the lower risk of “carrying” a security past the market-maker’s bid, and before it is almost instantaneously sold. Therefore, it is common to see shrinking spreads between “bids” and “offers” in Treasury securities, large cap equities and the like. Similarly, larger spreads are found in riskier, less-liquid securities like high yield, distressed etc.

The ultimate shrinkage of spreads to zero is reflected in a “locked” market, where the “bid” and “offer” level is identical. “Locked” markets, by their very definition, are temporary because there is always a “spread”-- or cost to make a market-- regardless of whether the “spread” reflects risk or pays for fixed costs (like rent or electricity) or variable costs like tickets or electronic trails. A “spread” needs to exist purely to compensate market-makers for these costs, and to earn a profit. Also, more interestingly, “locked” markets can happen anywhere, in liquid markets like AA paper and even in riskier, illiquid sectors like EM or high yield.

The question then becomes: why would a market-maker offer a “locked” market? The answer is: to right-size his inventory, or position to a desired level. For example, dealer A is too long on some bank paper – say the 2s of 2015 issued by “Best Farmers Bank” – and wishes to downsize that position by half. Let’s say the “Best Farmer’s” trade at 100-100.25 in price (bid-offer). Dealer A would “lock” himself at the bid side (100) or even slightly lower, like 99.99. At this price--say 100--he is willing to buy more “Best Farmer’s” or sell. He is now the cheapest “offer” on the security, and he should naturally be engaged to sell this paper, bringing his inventory naturally down to his desired level. But alternately, he may be engaged to buy more of this paper (not his desired direction); but even in this case, he should be able to unload this new paper back at 100 since other dealers are bidding similarly in the market.

In a reverse of the above, let’s say Dealer B is short these “Best Farmer’s” and is nervous about his short and wants to cover his position. He would “lock” himself at the “offer” side (100.25) and thus become the “best” bid for the paper, thereby covering his short. So then, this begs the question: why can’t dealers just improve their bids or offers since that should get them the same result, given the superior levels? Well, we now address the final appeal of “locked” markets – advertising! When a “locked” market is broadcast, participants stop to notice the “locked” market. It is rare, and an opportunity to trade at the best levels (depending on the counter position), and it signals whether the dealer is long or short that security. In short, a lot of information travels through a “lock” and a lot more eyeballs are observing the “lock” than they are observing regular markets. This market attention and higher probable execution is the main reason why a dealer “locks” himself.

LOCKED MARKET

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MAKE WHOLE CALLSA “make whole” call (MWC) is an extraordinary call that “makes an investor whole”. As with any call, this allows an issuer to prepay the remaining portion of the debt issue. However, using a formula, the issuer has to make an additional payment that can be quite significant, thus making such a call quite rare. So, why do they exist? Primarily so the issuer has a “fire exit” if they want to get out of their obligations. This expensive fire exit could be needed if there is an M&A situation with the issuer for example or any other extraordinary circumstance.

Basically, all the issuer is telling the bondholder is “yes, I have this weapon of last resort. But if I use it, you will be richly compensated and some”. Therein lays the difference between a MWC and a regular call.

We first began to see “Make-Whole” calls in the mid 90’s and they have become quite common. Today, the majority of corporates and taxable munis include MWC provisions. MWCs are used on both “bullets”, issues that are considered non-callable, and traditional callable bonds. So since you can buy a non-callable bond with a make whole call feature, it’s easy to see how it can get a little confusing.

-continued to pg. 15

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MAKE WHOLE CALLS

Bonds with MWC provisions are not classified as “callable” because they are structured so if they are called, the bondholder will most likely be paid a higher than market price for the bonds. For that reason, bonds are typically only called if there is an extraordinary event, as mentioned above.

Let us work through an example. The issuer promises to pay the bondholder the greater of:

A) Par Value, or

B) a price that corresponds to the yield of a specified treasury plus a predetermined spread.

Last year, for example, IBM issued a bond with a MWC provision of Treasuries + 10 basis points. (IBM 1.25% 2/8/2018) At pricing the issue came at Treasuries + 47 basis points. Bondholders felt protected because if IBM opted to buy back the bonds they would have to pay at least par or a higher price than the bonds would be trading at in the open market. Keep in mind that multiple factors influence price moves. What could occur is that the spread on IBM tightens dramatically to +5, making it financially beneficial for the issuer to call the bond at +10, which would equate to a lower than market price for the bondholder.

It is easy to think, “That’s never going to happen!” or “It is so rare, why worry about it?” In this post financial crisis world we think it makes sense to consider the risk, however small. Understanding the mechanics of MWCs will help investors identify and prepare for events that may increase the current level of risk to their portfolios.


Jargon evolves and is everywhere. If you need help unraveling, ask a

friend, the person you are speaking to or let us know and we will address in future articles and publications.

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A term becomes even more confusing when diverse groups of people assign different meaning to it. The phrase Mark-to-Market falls into this category and even those in the biz for decades find it difficult to follow what people really mean when talking about the pricing of financial assets.

Before the summer of 2007, when liquidity disappeared for anything even remotely structured or asset backed, mark-to-market meant placing a value on a fixed income asset equal to what the owner could sell it for. So portfolio managers would price portfolios by either a) verifying where the bonds, or very similar bonds, last traded; or b) polling a few trading desks to ask where they would buy the bonds and using the average received from several potential buyers. We are using the term “bond” broadly to include all debt instruments from overnight commercial paper to lower rated tranches of CDO debt.

When trading stopped and the bids across the street became “zero”, bondholders needed new ways to value portfolios, unless we were prepared to suffer the far-reaching consequences. So we started to talk about fair market value versus mark-to-market value and terms like “mark-to-myth” became popular among skeptics.

In 2009, after much debate, FASB issued statement 157-4 providing additional guidance about fair value measurements titled Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. We do not claim to be experts in FASB’s pronouncements, but it seems to us that the process for determining “fair” value continues to be open for interpretation.

Since FASB issued a statement and this isn’t a topic that we hear about as much in the news today, why do we bring it up? Because we still often hear investors use the term “mark-to-market” to refer to “fair” value versus “market” value and we think it is important to pay attention to how the phrase is being used and by whom. A bond trader, for example, has a very different mindset than an accountant and thinks through the process of assigning value differently. Bond traders and accountants also have very different reasons for “marking” bonds.

Creating a global standard for appropriately valuing portfolios is a major concern and something financial regulators are attempting to solve. Perhaps we would have a better chance of resolving the debate if we do not lose sight of the true meaning of the terminology used to frame the problems we are attempting to address.

MARK TO MARKET


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Rolling and riding the curve are referring to the same thing. It has to do with making efficient use of your money by investing it at the optimal place on the yield curve. The optimal place on the curve is also referred to as the bend. Think of the bend as the point in the yield curve beyond which the incremental increases in yield for the extension in maturity diminishes. Beyond the bend, the curve flattens out.

Rolling, riding, bending, flattening. That’s still a lot of jargon so let’s look at a chart to simplify. The bend is where we marked the “X” because after that point there is little pickup in yield for purchasing longer maturities. You can see that the curve is flat after the “X”, which is why traders say the curve flattens.

You can also see that the curve is pretty steep right now in the front end. To take advantage of the “steepness” a popular strategy would be to buy at the steepest part of the curve allowable per your investment guidelines (i.e. the 5 year), then sell the investment in 2 years after it “rolls down” and becomes a 3 year to reinvest the proceeds again out the curve. Of course, we are assuming that the curve is still sufficiently steep in addition to other factors, but generally speaking, this strategy is known as rolling down the yield curve.

The phrase “riding the curve” most often refers to positioning your purchase on the steepest portion of the yield curve; the steeper the curve the better. The idea is that you lock into a fixed coupon but ski down into lower rates, making your fixed coupon more and more valuable. The steeper the curve, the more this appreciation and the more that this appreciation counters the natural decay in the bond i.e. you are getting lesser coupons as you progress to maturity.

RIDING THE CURVE


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Risk On and Risk Off are terms used by commentators to describe the overall sense of the market. If “risk is on” you’ll see stock prices rise, credit spreads tighten and treasury prices fall (aka yields rise). The opposite is true when “risk is off”.

Investors are people and people tend to be an emotional bunch so “risk on” typically means that people are happy and less fearful so willing to add more risk to their portfolios. Since we also lean towards disliking uncertainty, those are the times when we will take “risk off” the table and move money into safer assets, which have traditionally been U.S. Treasuries, Cash, and Gold.

RISK ON/RISK OFF


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When you hear people talk about “tail risk”, they are referring to unforeseen or improbable risk. In a “normal” environment, as assumed in a bell shaped curve, the returns at the ends of the curve, both positive and negative, will only occur a small percentage of the time. Since investors view a low or negative return as something to be avoided, the realization of a low or negative return is commonly classified as risk.

In addition to being improbable, “tail risk” is usually catastrophic. Two examples are the oil accident in the gulf in 2010 and the effect to the nuclear reactors caused by the tsunami after the earthquake in Japan in 2011. Such events increase the percentage of occurrences at the ends of the curve, also called a “fat tail”. Financial market participants dislike uncertainty, the essence of an unforeseen event, so investors and traders often “sell first, ask questions later” and are more concerned about “fat tails” on the negative side of the return curve. But keep in mind that any event can produce good or bad results from a financial point of view; depending on the side of the trade you are on.

TAIL RISK


20Jargon Watch

As Founder and CEO of Fixed Income Academy, Susan leads a senior team of expert instructors to develop and deliver world-class curriculum for Fixed Income Academy’s Bond School. Susan began her financial career 25 years ago in broker operations and advanced to become a senior account executive and regional sales manager, the majority of the time with Merrill Lynch’s Institutional Advisory Division. She has worked with high profile institutional accounts, state and local governments, financial institutions and family offices while managing a senior team of advisors. In 2008, Susan left the sell side to work as a consultant and focus her efforts on investor education. Her broad experience in the fixed income markets, relationship management, and team building; along with her passion for investor education; allows her to bring unique perspective to a variety of projects.

Susan Munson, CFP®, CFIP©Founder & CEO

CONTRIBUTORSJargon Watch is a series of articles written and edited by Susan Munson and Arjun Kondamani.

Special thanks goes to FIA’s Chief Economist, David Horner, for his guidance and contribution as well as our research team for their ongoing support.

Arjun Kondamani is a seasoned executive with 15 years of experience who has added value across various corporate credit sectors in roles ranging from bulge bracket trader, research, portfolio management, electronic trading, and risk management. Experience with a wide variety of clients across domestic fixed income, Emerging markets and Europe has allowed Arj to develop insight into macro forces and how they are impacting global markets.

In addition to his industry experience, Arj has also taught part-time at NYU.

Arj holds the CFA charter and has also a Masters in Business and a Masters in Electrical Engineering, both from the University of Southern California.

Arjun Kondamani, CFA Senior Market Strategist

-continued to pg. 21


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David Horner, Ph.D.Chief Economic Advisor

As Chief Economist of Fixed Income Academy, David Horner guides the economic research and provides weekly economic and market commentary relevant to Fixed Income Market Professionals and Investors.

David Horner is an independent economist and financial strategist, and directs a small private hedge fund. He provides macro-economic advice and trading strategies to high net worth individuals and institutional clients. He has more than 30 years of experience on Wall Street and in government.

In 2002, David left Merrill Lynch as a First Vice President and Senior Economist where he advised the firm’s trading desk and institutional clients on probable economic developments, interpreted key economic data and related economic factors to potential interest rate and spread moves. He wrote market and economics sections of the group’s Credit Market Memo, contributed to the weekly Fixed Income Strategy publication, issued “analysis briefs” on Bloomberg. He appeared frequently as a guest host

Susan Munson

Susan earned and maintains her Certified Financial Planner designation and when affiliated with FINRA regulated firms held her Principal/Supervisory and Investment Advisor Representative licenses. She is registered as an Investment Advisor Representative to provide advisory services to a select group of clients. Prior to her career in the financial industry, Susan attended community college to study business and marketing while owning and operating a small manufacturing company.

CONTRIBUTORS


and analyst on CNBC, CNN, CBC, CTV, Bloomberg, TV Tokyo and other business programs.

Prior to joining Merrill Lynch, David worked in various government capacities, as Chief Economist and Research Director for the Commodity Futures Trading Commission; as head of the economic group for the Food and Nutrition Service; and, following his return from the Peace Corps, as an assistant to the director of Head Start for the Office of Economic Opportunity. He also taught at Wayne State University, served as a senior economist and consultant to Mathematica, Inc. in Princeton, NJ as well as to the Canadian Government, specifically on tax issues related to work incentives. David earned his Ph.D. in economic theory and econometrics at the University of Wisconsin and his B.A. in Mathematics at the University of Akron.


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