Quant funds who bet on high-quality stocks, while at the same time shorting those stocks that are over-priced, have been under-performing the stock market (WSJ). This under-performance has come in part as a result of poor balance sheet stocks being pulled along by the momentum train of the last few months. The performance gap has even widening recently as short squeezes have pushed weak stocks higher, just as those with brighter prospects have done worse. Some feel that the under-performance of higher quality stocks may be an indication that the recent move is running out of steam, and that the market may be due for a correction. Breadth and other overbought/oversold indicators continue to flirt at times with high levels and cause concern among the bulls - but then again, they did so one month ago as well. Nonetheless, a correction, even if mild and short-term, could be in the cards as it seems an increasing number of participants have started watching and waiting for their overbought biases to be confirmed, including some of those who continue to be long in the market. Time will tell, but the next month could be interesting, and telling, as we move into October.

Given the recent "black swan" events in the market, quant funds that have relied on longer-term trading strategies have suffered (see Reuters article). As a result, many quants are now focusing on higher-frequency strategies that are executed quickly, both to get into and out of positions. No doubt that such an increase in programmed algorithmic trading is contributing to already elevated levels of market volatility. Ironically, many traditional quant funds operate more efficiently in stable market environments, causing such funds to suffer under the recent higher levels of volatility.

The change in trading duration is needed in part since many of the longer-term strategies are no longer valid given the changing market landscape, which due to company failures and shifting regulations, seems to be changing nearly everyday. Modelers using intelligent trading systems, especially supervised systems like neural networks that require extensive historical data in order to learn market patterns, are finding it a challenge to train their systems given the changing market dynamics and subsequent lack of relevant data. The tracking errors have also been significant enough to cause many funds to scale back their use of leverage, putting further pressure on quant funds that rely on borrowed money to juice returns.

While some quant funds could potentially go out of business given current losses, there is no doubt that many other quant traders are seeing this as an opportunity to create new algorithms not yet adopted by the larger quantitative trading community. I image the next great algorithms and trading strategies - which we will not hear about for a few years - are begin developed and deployed as we speak. If there is one thing many quants like more than money, it is a good challenge. The market has certainly provided the challenge, along with some unique opportunities.

Trend following managed futures funds have outperformed hedge funds this year, gaining 8.9 percent year-to-date (see WSJ article). Hedge funds have lost almost 19 percent during the same time frame. Managed futures funds often use quantitative trading algorithms to spot market trends, at which point a long or short position is quickly taken in futures or other derivatives. Managed futures underperformed between 2003 to 2007 when volatility was lower, but have since done better as volatility increased. The ability to quickly initiate an "unemotional" short selling signals has also added to recent gains. Ironically, the reduction of risk by some traders and hedge funds has resulted in less liquidity and larger price swings, both of which have allowed managed futures to outperform hedge funds who have traded in many of the same markets.

We have heard the old computer adage "garbage in - garbage out" to highlight how even a sophisticated computer program will produce nonsensical output if provided nonsensical input. The world of risk management is no different. The quants on Wall Street that are hard at work developing the next best trading and risk management systems are not perfect, but their job and measured performance becomes even more difficult when they are given bad information (see NY Times blog article).

On the surface, the goal of the risk management quants seem simply - tell me how much of the portfolio is at risk, and then tell me how much I need to sell, or how much capital I need to set aside so that I can sleep at night. In a sense, prepare me for the 100 year flood. Yet the 100 year floods seem to be occurring more often. Why is this? One possible reason is the "garbage in - garbage out" phenomenon, the problem of which is exacerbated as the markets continue to become more complex. Recent case in point, Lehman Brothers. As talk continued about a potential failure with Lehman, it became almost impossible to tell what their exposure was. Who are the counterparties? What are the default rates? What are the recovery rates? And most frightening of all, was does this new product even do? If companies cannot even understand the products they are selling, how can one expect to develop an adequate risk management system to help protect against the 100 year flood when it is not clear that water damage is even the problem, or that the strength of the levees is even important?

There is no doubt that some systems on Wall Street were provided optimistic data and assumptions, or had smoothed-out historical data in order to reduce the number of times the warning bells sounded, ultimately keeping companies from scaling back positions or redeploying capital to less profitable areas. But I suspect that there was an equal number of firms that diligently tried to provide the best information possible, but were simply in the dark. Why is this the case? There are no doubt a number of reasons, many of which are financial, but the separation between those that develop such risk management systems from those that develop products that need to be managed is not helping the situation. The information gap most likely goes both ways as the financial engineers are unaware of the workings of the risk management systems, while the risk managers are blind to the real exposures of the complex structured products that are being purchased and sold.

As more retail investors enter the markets, institutional trading continues to rise, and the securitization and engineering of products increases, both volatility and the values at risk will continue to affect markets. As new products are offered to the markets, it is essential that those who develop such products are on the same team as those who manage the risk. Risk management truly needs to be an enterprise-wide proposition, with incentives in place to reward those who properly managing risk, just as they are in place for those who engineer and sell the latest structured product. Performance on Wall Street is measured in money. If risk managers start to become rewarded in a similar manner, or if the risk management of new products begins to influence how new products are rewarded, we may then begin to find that the garbage provided to risk managers will begin to smell a little better.

David Ko, a quantum physicist who was formally with Long-Term Capital Management, has a new hedge fund out of London focused on profiting from volatile markets (see WSJ article). The fund, called Kurtosis Capital Partners is in partnership with Stephen Cain, a former global head of currency trading at Deutsche Asset Management. The global macro fund hopes to initially raise between $100 to $250 million. As quoted by Cain, "Our strategy is to buy options when we think a market is going to become volatile. The closer to the dislocation, the better. Then, at the moment of highest volatility, sell." Buy low and sell high. Sounds like a good strategy to me. Certainly not complicated on the surface, but it would be interesting to see what types of models they are coming up with to forecast volatility, especially if Ko plans to use his background in quantum physics. Something tells me it is a little more complicated than GARCH. Cain also mentions that the fund will not use leverage, but will limit risk to the option purchase price. Another good lesson, and one learned the hard way at LTCM.

Below are the weekly link summaries for the usual topics, with energy added. As usual, hopefully you find some interesting articles that you may have passed over.

Commodities and Energy

S&P launches new commodities and natural resources indices
Hedgeweek
* Standard & Poor's has launched two new indices, the S&P Global Natural Resource Index (with contributions from 60 large energy, agribusiness, metals, and mining companies), and the S&P PMI Commodities and Resources Index (similar sectors, but with 160 stocks for broader exposure). The indices can be invested in and are available for benchmarking. Often, but not always, this kind of activity begins to mark the top, or at least short-term peak, in a sector or market. Time will tell.

Why Cap-And-Trade Won't Work
Paul Cicio - Forbes
* An opinion article in Forbes about the problems with the proposed cap-and-trade legislation. Beyond the pros and cons of whether cap-and-trade will actually help reduce carbon emissions, of interest is the effect on clean energy. Low carbon alternatives, such as natural gas, should see an increase in price as companies look for ways around new mandates. Nuclear is another carbon-free option for power generation, but given its own regulatory issues, and the 10-20 year backlog for reactor domes and other critical components, it is likely that natural gas will be the only viable short-term alternative. If the legislation is passed, expect natural gas prices and electricity prices (natural gas plants currently set the marginal price) to increase.

Joy Global Mines Money From Commodities Boom
Melinda Peer - Forbes
* As usual, look for and consider the "consequence" or periphery plays when investing in sector booms. As for commodities, mining equipment makers Joy Global and Bucyrus International are doing well, very well. Downturns in these and other similar companies may give an early indication of changes in the commodity landscape. Often it is the pick equipment makers, and not those selling the gold, that make the most money during the rush.

Coal seam gas seen as Asia's next hot energy play
Reuters
* Interesting article from Reuters talking about how some countries are using coalbed methane (CBM) as an energy source to power cars and electricity plants, among with things. Methane stores in Asia are estimated at 2,100 trillion cubic feet. As LNG prices continue to rise, CBM is hoped to be a viable alternative for both developing and developed countries with large coal deposits. Storage is still a problem for some counties as they retool existing plants. Coal seam gas also has a lower heating value compare to natural gas, but is able to be blended with LPG (liquefied petroleum gas). The gas does have a low sulfur and carbon content, allowing it to burn cleaner.

Derivatives

Banks launch central clearer for derivatives
Hal Weitzman - Financial Times
* To mitigate some of the risk of privately negotiated credit derivatives, 11 of the world's biggest banks announced the creation of the first central clearer for derivatives, in particular credit derivatives. The clearer will use funds contributed by traders to guarantee against counterparty default. The clearing will be run by The Clearing Corporation, a Chicago-based institution backed by the banks.

Canada's emissions-trading market open for business
Boyd Erman - Globe and Mail
* Short article about a new emission-trading market, called the Montreal Climate Exchange, from the TSX Group. The exchange will allow companies (AKA "polluters" in the article) to buy and sell carbon credits. Look for emissions trading to continue to be a big business going forward. It will be of interest to see if these markets allow for "greener" companies to develop and survive. Since carbon credits can be traded from non-polluters to polluters, a green company could sell its carbon credits to the polluters, essentially making the polluting companies subsidize part of their business. In fact, just about any business, with or without environmental intentions, could do this. I guess it depends on how the credits are distributed, but the system may leave itself open for gaming and profit opportunities.

Climate-Bond Plan by UN Official Aims to Boost Energy Investing
Alex Morales - Bloomberg
* Why should Canada have all the fun? The United Nations is considering a new climate bond that would be sold to investors in developing countries as a way to spur investment in green projects. How would they work? Mature bonds, after they have been used to finance green projects, could be exchanged for credits that allow industrial plants to emit a certain amount of carbon gases. How are they funded and priced? The amount of money generated would depend on the level of emissions-reduction targets set in the current round of UN climate talks. I guess if you need more funds, you could raise emission targets. As with the Canadian system, the effort is noble in intentions, but has the potential to kill the goose that laid the golden egg (or provides the revenues in this case), while not really solving the problem. Hopefully safeguards will be put in place to prevent abuse. In its current form it is also not clear that overall emissions will actually be reduced. Time will tell.

US and European debt markets flash new warning signals
Ambrose Evans-Pritchard - Telegraph (London)
* The cost of insuring against default on bonds of Lehman Brothers, Merrill Lynch, and others has increased in the last few weeks, as debt markets are signaling fears that the global credit problems are still here, and could be entering another phase of write-downs. Inter-bank Libor and Euribor spreads are back to near record levels, with Lehman Brothers debt credit default swaps rising from 130 to 247 in a little over one month. Merrill Lynch debt has spiked to 196. As reported by Willem Sels, a credit analyst at Dresdner Kleinwort, ".... banks are beginning to face waves of defaults on credit card, car loans, and now corporate loans. We believe we're entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come." It is also felt that the increase in corporate bankruptcies is not yet being seen by the usual indicators, which tend to lag the market.

Bonds Insuring Next Hurricane Hugo Beat Subprime
Erik Holm - Bloomberg
* As hurricane season begins, investors are clamoring once again for catastrophe bonds, the market of which as tripled over the past three years to more than $13 billion. Some of these bonds yield near 15%, with the average around 11% - assuming that we don't get another Rita, Katrina, or Hugo. One attraction to the bonds is their lack of correlation with the stock and bond markets. The key here is weather or natural disasters, and not credit. Given the problems with mortgages and subprime, hurricanes and earthquakes seem like a safer alternative for some - but it is still possible to lose your entire cat bond investment if the big one does occur. What I find interesting is how the whole market is somewhat circular. Cat bonds are often offered by insurance companies as a form of reinsurance to protect themselves if a catastrophe does occur and they are forced to pay out. Who buys the bonds? We do, through pension funds, hedge funds, and less so through individual investments. We are essentially taking out insurance with the insurance companies to protect against an event happening, and then buying bonds against the event actually happening. On the other hand, insurance companies are selling us the insurance to protect us in case the event does happen, betting themselves that it won't, and then selling us bonds to protect themselves in case it does. Confused? Ah, you have to love the markets. Who are the big reinsurance companies? Swiss Re, Munich Re, and General Re (Warren Buffett's Berkshire Hathaway's reinsurance company).

Hedge Funds

Hedgeweek Comment: Going with the flow
Hedgeweek
* There was been a lot of talk about hedge funds looking for investment in Asia, but not as much action as the talk (although some investments). It appears that now some funds are entering Asia, and not just for opportunity (which they can take advantage of stationed nearly anywhere). Instead, funds are opening in Asia to take advantage of liquidity and capital that is not as available in the west, as in the past.

Prime Brokerage Will Make $11B in ’08: Study
Christopher Glynn - HedgeFundfont>.net
* Prime brokerages are expected to receive $11 billion in hedge fund money in 2008, a 15% increase over the 2008 value. Goldman Sachs, Morgan Stanley, and JP Morgan, who own the majority of prime brokerage market share, are expected to be the biggest beneficiaries.

Private Equity

Morgan Stanley, Citigroupfont> Bankers Leave as LBOsfont> Slow
Pierre Pauldenfont> and Jonathan Keehnerfont> - Bloombergfont>
* Top bankers are leaving larger firms, such as Morgan Stanley and Citigroupfont>, as the LBOfont> market grinds to a near-halt, compared to recent years. Many banks are still trying to clear out old loans that they are unable to get off their books. Banks have traditionally made money twice, once on the deal, and once when they sell the debt to others. Many banks are now being forced to hang on to the bad debt that in the past they were able to push off on other investors. Some of this debt is now selling for less than 70 cents on the dollar, making it difficult unload without taking a huge loss.

FT REPORT - CORPORATE FINANCE 2008: Public life after private equity
Chris Hughes - Financial Times
* Interesting case study of one company, now public after it was floated on the stock market by a private equity group, is now having difficult dealing with current high energy and raw material cost after taking on previous private equity debt. Companies with high leverage can do well in boom times, but suffer more in downturns given that their fixed cost per unit begin to rise rapidly as sales decrease. The effect on the bottom line is intensified as variable cost increase, as they have for many companies highly dependent on raw materials and energy. We often hear about the slowdown and problems with private equity investors, but often forget about the companies that are now dealing with the debt issues directly.

An unlikely financier
Janet Morrisseyfont> - Investment News
* Yes, you too can start you own private equity firm. Interesting story of Malonfont> Wilkusfont>, a college dropout that started his own private equity firm, American Capital Strategies, with a focus on middle-market companies. So far the fund has delivered annual compound returns of 18%, including an average dividend yield of nearly 10%. Not bad, although last year the firm was down 22% with other financial stocks.

Quantitative Finance, Financial Engineering, and Trading

Prospectors join Canada's electronic gold rush
Melanie Wold - Financial News
* Not a specific trading strategy article, but does highlight to impact of the recent commodity boom on trading, at least in Canada. Given the rise and interest in trading in the commodity-rich country, investors are taking an increased interest in the Canadian markets. As such, market technology vendors and investors are increasing, providing numerous alternative trading systems, platforms, and trade crossing networks, causing Canadian regulators to implement institutional trade matching, settlement framework, and best practice guidelines. This looks very similar to the buildup of ECNsfont> and exchanges in the late 1990s during the U.S. technology dot-com boom. Hopefully it does not end the same way for the Canadian market.

China rebukes west’s lack of regulation
Jamil Anderlinint> - Financial Times
* Interesting perspective from Liaont> Min, the head of the China Banking Regulatory Commission, about how western governments must strengthen oversight of their financial markets. There argument is that by giving the market too much leeway, problems such as the subpriment> crisis were allowed to develop. It is believed that tight regulation has made it nearly impossible for exotic financial instruments to be developed in China. Of interest from the regulator is worries regarding the increased flow of money into their market, as a result of investors abandoning the dollar and U.S. markets (argued as being due to our regulation-lacking induced problems). This shift in funds is causing a potential asset bubble and rising inflation in the Chinese market. As a result, China is considering advocating new international laws and regulations for providing timely and accurate information during crisis. Even so, as international economies develop and mature, and the flow of money into the "new" economies slows down, I would not be surprised to see their use of derivatives increase (in order to internally reallocate capital), regardless of current perspectives.

Three ETF-of-ETFsnt> are launched
David Hoffman - Investment News
* Admit it. You knew it was going to happen. It was just a matter of time. Invescont> PowerSharesnt> Capital Management has launched three new ETFsnt> that invest in ...... what you say ..... other ETFsnt>. While providing investment advisers more choice, especially those that are not investment strategists, many advisers are not happy. Why, the ETFsnt> of ETFsnt> (ETFsnt> squared anyone - you heard it here first, I think) reduce the fees that advisers receive for recommending and selling products to investor. Why get one fee when you can get three by selling three different ETFsnt>. Even worse, some investors may realize that they don't even need an adviser, and can just invest in a diversified exchange traded pool of diversified asset classes. Then again, some investors probably will not know what that means, so the advisers job is probably safe. Now, if we only had derivatives on ETF-squares. Ah, Wall Street can dream.

Below are the weekly link summaries for the usual groups: commodities, derivatives, hedge funds, private equity, quantitative finance and financial engineering, and trading. As usual, hopefully you find some articles that you may have passed over, but might be interested in reading. Enjoy the long holiday weekend.

Commodities

Oil's tense trading scene may sway a move to Dubai
Myra Saefong - MarketWatch.com
* The Dubai Gold and Commodities Exchange will begin trading crude-oil futures on Tuesday. This planned commodity trade is turning out to be a timely move given the talk from Congress and elsewhere about the regulation of speculators in the commodity markets. As with many actions in Congress, there are unintended consequences. The movement of trading off-shore may be one such consequence. Without really affecting the overall problem, the move may just end up taking the control of the issue out of our hands - to the extent it can even be controlled. Liquidity and volume are low in comparison, but in a few years the Dubai exchange could see an increase in volume as traders look for a friendly environment.

Derivatives

Citigroup Says Swaps Mania in Muniland Is Finished: Joe Mysak
Joe Mysak - Bloomberg
* Sales of synthetic fixed-rate munis, used to help the municipal market hedge their bond issue interest rate risk, are being scaled back, in part due to counterparty risk, but mainly due to inexperience. Many local municipalities are realizing that they don't have the experience and knowledge to understand the risk involved, the money to hire professionals, or the ability to know if the professionals (if hired) are taking advantage of them. As a result, they are eliminating one type of risk, but are in some instances now leaving themselves without a hedged position.

World Watches EU's Carbon Trading Scheme
Leigh Phillips - BusinessWeek
* Another article about the law of unintended consequences. This time with carbon trading. When Europe first implemented carbon trading, the scheme resulted in windfall profits for energy companies, drops in the price for carbon credits (due to over-allocation), and a disincentive for the industry to increase expenditures on clean energy infrastructure and efficiency measures. The result were higher consumer prices, higher energy company profits, and higher carbon emissions. Hopefully the EU experiment will provide lessons. They are currently taking measures to correct mistakes.

Derivatives Market Grows to $596 Trillion on Hedging
Abigail Moses - Bloomberg
* Data shows that derivatives on debt, currencies, commodities, stocks, and interest rates has increased 44% compared to last year, to $596 trillion. Amazing numbers indeed. CDS protection doubled during this time to $58 trillion of debt. Interest rate derivatives were up 35%, foreign exchange derivatives were up 40%, equity derivatives were up 14%, and commodity derivatives were up 26.5%.

OTC platform to offer iron ore access
Javier Blas - FT.com
* Both Credit Suisse and Deutsche Bank are teaming together to create an off-exchange over-the-counter (OTC) market to trade iron ore swaps. The swaps will have initial maturities out to December 2009 and be cash settled on a monthly basis against an iron ore index published by the Metal Bulletin. Iron ore was one of the largest commodities without a market, and given the rising demand and prices for steel, it makes sense that a new hedging (and speculation) contract would be offered.

Hedge Funds

Global Hedge Funds Rose in April as Worldwide Stocks Gained
Tomoko Yamazaki - Bloomberg
* Overview of global hedge fund performance. Of interest is how hedge funds worldwide were up in April as global stock markets recovered. In particular, managers of long-short equity fund were the best performers.

Age is key to hedge funds
Anuj Gangahar - FT.com
* A recent study finds that hedge funds that are less than two years old produced higher returns on average than older funds (11.7% per year to 10.2% per year), but that older funds tended to have returns that were more steady. In a sense, as managers get older, return is given up for risk management. It was not mentioned in the article, but this may results from the manager having so much of their wealth in the fund the he or she starts to get a little more conservative.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
David Evans - Bloomberg
* Interesting article on the problems with trading in swaps in the current market. This is a longer article, but well worth the read. In part, it discusses how given that the swap markets are basically unregulated, counterparty risk is not only present, but it is difficult to quantify. But this is not stopping the swap market, which has doubled every year since 2000, and is currently larger in dollar value than the entire NYSE. As of now, 40% of credit default swap protection sold worldwide is on companies or securities that are rated below investment grade. Estimates have hedge funds selling about 31% of all CDS protection, yet many have not been asked to post adequate collateral to back up their positions, and no set regulations are in place. Many hedge funds do not have the necessary funds in place if a problem does develops.

Ex-Amaranth Trader Hunter Helps Deliver 17% Gain for Peak Ridge
Saijel Kishan - Bloomberg
* Well, if you are wondering why anyone would hire Brian Hunter, the hedge fund trader that helped bring down Amaranth Advisors in 2006, this is why: His new fund returned 17% last month using a similar strategy as that employed at Amaranth. The fund is using option spreading strategies on natural gas prices, nearly the same strategy to that was used at Amaranth. The quote of the day comes from energy analyst Kent Bayzaitoglu: "To have lost that amount of money and get back into the market with a similar-type trade takes a lot of confidence, if not arrogance."

Private Equity

Mideast Private Equity Looks to India
Saikat Das - BusinessWeek
* Middle East sovereign wealth funds are beginning to focus on the country of India as a result of believing that the country’s long-term growth prospects are good and that the country is decoupled from the United States. Areas of interest include real estate, health care, retail, and education. The number of private equity deals in India for the first four months of year were 156 ($4.94 billion) compared with 136 deals ($3.42 billion) over the same four months in 2007.

The year of the vulture
Allan Sloan and Katie Benner - Fortune
* Article on private equity, discussing how those that will profit are most likely to be the firms that profit from other's misfortunes. In particular, firms are "double cropping," or in other words, making a second profit from the buyouts already done by offering capital to the institutions that financed the original deals and now need help. In a sense, they are buying their own debt back from the banks at reduced cost, given that the banks were unable to unload it after the credit crunch, not only eliminating the extra commissions and fees, but also now exposing themselves to credit risk. Ah, the old golden rule - those with the gold make the rules, and in this case, profit from the misfortunes in the market. Those with capital truly can buy when things look the worst, and not just pray on others, but also help them out of difficult positions.

Quantitative Finance and Financial Engineering

Quantitative funds aim to retool models
Mark Copley and Ben Wright - WSJ
* Interesting article on how quant funds suffered as the credit crisis unfolded, causing many of their models to breakdown. One aspect that has the quant managers worried is how many of the quant strategies that are being used seemed to be affected in the same way at the same time for certain market conditions, suggesting that the models were using the same techniques - a kind of quantitative herd mentality. It is believed that one of the problems is that they tend to use the same type of academic research, and be trained by the same set of researchers. Many are now trying to considering non-traditional public information (at least non-traditional for quants), such as short interest, quality of R&D, and insider buying.

Quant to Double Assets This Year After Beating Hedge Fund Peers
Netty Ismail - Bloomberg
* The rise of the quants from the ashes. Well, not exactly, but the QAM Asian Equities fund, a small Singapore-based quant hedge fund is doing well by betting against stock index futures. The QAM global fund rose 44.5%, while the Asian portfolio gained 66.2% in 2007. Not bad in the current market, especially for a fund not concentrated totally in energy. The fund has only $150 million in total assets under management, but is growing at 30% per year. The fund manager has a Masters in computer engineering, among other graduate degrees.

Trading

The Most Promising ETF's? Russia and Coal
Dash of Insight Blog
* A discussion of various ETFs, with an emphasis on an ETF from Russia and a Coal EFT. A sector ETF report is also provided by Dash of Insight. Of interest, not surprisingly, are that energy and international EFTs continue to rise to the top of the list.

Straddle Strangle Swaps
Condor Options Blog
* A nice overview of the straddle strangle swap, which is a specific type of double diagonal that involves selling a front month straddle and buying a back month strangle. Too much detail (see the article) without reprinting everything in the article, but the position has a number of positive attributes. In particular, it has a larger width (more profit opportunity) and positive vega, but only half the theta of a swap (for the example given). It can also be entered for a credit rather than a debit. Nonetheless, it does require more commissions.

Below are the weekly link summaries for the usual groups: commodities, derivatives, hedge funds, private equity, quantitative finance and financial engineering, and trading. Hopefully you find some articles that you may have passed over, but might be interested in reading. Have a good week.

Commodities

Limited trading gains dampen corporate wheat purchases
Harish Damodaran - Business Line
* There is a cutback in demand for wheat from India this year as many companies got burned when the price of wheat did not keep rising, and sold off quickly. Many corporations in India that use wheat have large stockpiles left over from the previous year.

Soaring freight costs add to price of basics
Javier Blas - Financial Times
* Freight cost for basic commodities are rising as the Blatic Dry Index rose to an all-time high, increasing inflationary pressures on countries importing natural resources, in particular India and China. One of the main reasons is a surge in demand for iron ore in China, but consumption is high for nearly all commodities. Analysts are finding that there are not enough new vessels entering the market to match the increases in demand. Port delays are also rising across the globe, adding another element to drive shipping prices higher.

European Coal Rises to Record on Limited Supply, Power Demand
Alistair Holloway - Bloomberg
* Interesting article on how coal for delivery in Europe has rose to record levels as global supplies become limited. Demand from India and elsewhere is increasing as these countries need coal for new coal-fired power stations being built across the globe. Of particular interest is the quote: "We are in a long-term pattern because the world is building a massive amount of coal-fired generation. Current supply is definitely running under global demand.'' The need for coal is also strong in the European Union, where the 27 nations in the union use coal for about 30% of their power. Given that a lot of the coal comes from the U.S. and elsewhere, hauling costs are currently accounting for as much as half the price of delivered coal.

Bears begin to separate the wheat prices from the corn
Javier Blas - Financial Times
* A discussion of how wheat and corn prices, which have at times risen together, have been diverging in price as corn continues to increase in price, while wheat prices decrease. Analysts expect them to begin tracking each other at some point. The key is to determine whether it will be wheat going back up, or corn correcting and selling off. Given that there have been record harvests of wheat in the Northern hemisphere, wheat is expected to continue to fall in price. Nonetheless, the amount of corn in the ground, on a percentage basis, is still below average levels, suggesting that prices will not selling off.

Derivatives

Libor Alternatives Used for Liffe Futures Contracts
Nandini Sukumar - Bloomberg
* Problems with Libor are causing some to look for alternatives. As it turns out, the NYSE Euronext's Liffe derivatives market will begin trading contracts on alternatives to the Libor. The Liffe's contracts include futures based on the euro overnight interbank average, a borrowing rate calculated by the European Central Bank, along with contracts on the sterling overnight interbank average, calculated by the Wholesale Markets Brokers' Association. ICAP Plc is also planning a U.S. alternative to Libor called the New York Funding Rate, based on an anonymous daily survey of at least 24 banks.

Futures suspension fails to trim commodity prices
The Economic Times
* The government of India has suspended futures trading in soy oil, chick peas, potatoes and rubber for at least four months. Last year India banned futures trading in rice and wheat, each in an effort to reduce inflation. Critics feel the ban will simply make the problem worse by shutting down the market-pricing mechanisms, essentially encouraging traders into the country's unregulated black market, further reducing tax receipts and causing even more unpredictability in prices.

Swaption Volatility Rises Amid Risk of Higher Revision in Libor
Liz Capo McCormick - Bloomberg
* The volatility on options for U.S. interest rate swaps increased as investors became worried that the benchmark for borrowing costs may be adjusted higher, causing an increase in hedges against changes in rates. Swaption volatility tracks options on interest rate swaps with maturities of 1 to 10 years. The increase in volatility is due in part to the current issue with the Libor rate, increasing the number of people interested in using swaptions to hedge interest rate risk. The swap spread has contracted about 27 basis points since it reached 112.56 basis points on March 7, the biggest contraction since November 1988, reflecting an improvement in the opinion of the interest rate market as to where the U.S. economy is going. Interestingly, the spreads have contracted also in part as fixed-rate corporate bond issuance increased, given that there has been more corporations using bond issuance to raise capital. Much of this fixed rate paper gets swapped back to Libor. The increase in fixed-to-floating swapping has caused tightening of the swap spread.

China to Develop Currency Derivatives This Year, Official Says
Li Yanping and Judy Chen - Bloomberg
* China has announced that it will continue with its plan to develop existing currency derivatives this year. The derivative products are being produced to help exporters and importers within China hedge their currency risks. The yuan, foreign exchange swaps, and forwards are already being traded.

Hedge Funds

A Commodity Hedge Fund in Every Pot
Paul Kedrosky - Seekingalpha.com
* Click on the link to the article to see the growth rate of commodity hedge funds. It will not continue forever (as humorously mentioned by the author), but does show the recent growth in such funds. Not sure if this is a sign of a top or not.

Gas Deposit Lures Hedge Funds
Eric Baum - WSJ
* A discussion of how hedge funds are betting on the three companies, Chesapeake Energy, Petrohawk Energy, and Goodrich Petroleum, buying land and drilling for natural gas in parts of Arkansas, eastern Texas, and northwest Louisiana. Some funds are placing bets on all three companies as each scrambles for land and mineral rights, while others are placing their bets (and investment dollars) on the two smaller companies, and not the larger Chesapeake, assuming the smaller companies will be able to get more bang for their buck if the estimated reserves come anywhere close to being realized.

Private Equity

Clawback Rule Takes a Bite
Peter Lattman - Deal Journal, WSJ
* Interesting article about clawbacks. In short, a clawback is an investor protection that prevents a company from performance fees and forces them to refund already booked performance fees to investors when unrealized investments fall in price below the stated minimum return. The firm can recover fees if the firm earns positive profits on future deals, essentially digging itself out of a hole by clawing back, causing the clawback accural to disappear.

Fears of private equity talent vacuum
Martin Arnold and Lina Saigol - Financial Times
* A discussion of how some of the largest banks in the world are getting rid of their private equity groups, which is causing some concern that there will not be the proper expertise available regarding financing on leveraged buy-outs when the market eventually corrects. While financing LBOs for private equity is very profitable for banks, many feel that it will be a number of years before a profitable level returns, therefore they are timing staff in the meantime.

ICICI Seeks $3 Billion for India Private Equity, Property Funds
Sumit Sharma - Bloomberg
* ICICI Bank, which is the second biggest lender in India, plans to raise up to $3 billion for two private equity funds as it competes with U.S. firms. ICICI joins Blackstone in seeking opportunity in India. Private equity fund investments in India were seven times more than that investment in China in Q1 of this year.

Why U.S. Highways Are Falling Into Private Equity Hands
Heidi N. Moore - Deal Journal, WSJ
* An article about private equity bidding for transportation assets, including KKR's recent bid for assets in Pennslyania. If you don't like toll roads - too bad. You are likely to see more of them in your future.

Quantitative Finance and Financial Engineering

Amaranth Founder Maounis to Start New Multistrategy Hedge Fund
Katherine Burton - Bloomberg
* Nicholas Maounis, whose hedge fund Amaranth Advisors collapsed after a $6.6 billion loss in 2006, is developing a new fund. The fund, called Verition (Latin for truth), will initially utilize three strategies: quantitative (uses computer models to pick trades), bonds and loans, and special situations (focusing on convertible bonds issued by companies going through corporate events). Maybe the talk I have been hearing about the death of my beloved quantitative funds is true. Just kidding. Really.

Trading

Is A Low VIX A Short Trigger?
Quantifiable Edges
* Interesting analysis of using the VIX as a short trigger. From the blog Quantifiable Edges: "Over the last 10 years, owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. Let me repeat that. Owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. To illustrate I ran a study: Short the VIX on a cross of the lower 10% envelope of the 10-day moving average. Cover when it moved back above this envelope. From 5/98 until now there were 87 such trades. The average lasted just over 3 days. The S&P actually GAINED 91.09 points in the 272 days that this was in effect. That is an average of about 0.33 points per day. In the other 2,379 days the market only managed to gain 184.22 points – about 0.08 points per day. In other words, the market actually performed over 4 times BETTER when the VIX was stretched more than 10% below its 10-day moving average. Also, when this VIX-stretch was active the S&P made nearly 1/3 of its total gains in only 9% of the time." Interesting indeed. This follows a comment by Adam Warner at the Daily Options Report blog stating that: “Also, oversold VIX does not provide as good an indicator as overbought. Outright fear tends to lead to big turns, outright disinterest can just linger.”

Pension Funds `Diversify' Into Commodity Bubble: Caroline Baum
Commentary by Caroline Baum - Bloomberg
* Interesting second half of the article regarding the way pension funds and others are getting around the position limits for speculators. As mention in the article, the CFTC - Commodity Futures Trading Commission, has historically reported the futures positions of hedgers (called commercials, and engaged in the cash market) and speculators (called non-commercials, not engaged in selling the commodity) in its Commitment of Traders report. Speculators, pension funds in this example, can use total return index swaps to get around current positions limits. From the article: "Let's say a pension fund, like the California Public Employees Retirement System, wants to increase its exposure to commodities. Calpers, a speculator according to the CFTC, does a total-return swap with Goldman Sachs Group Inc., a hedger. Goldman promises to pay Calpers the total return on the Goldman Sachs Commodity Index and hedges the swap by buying futures contracts. Calpers's speculative bet on commodities gets recorded as Goldman's hedging in the COT report. In so doing, investors circumvent the position limits on non-commercials." Beyond the regulator issues, the practice causes problems with the reporting of the Commitment of Traders number. Research shows that the swap index positions account for over 41% of the total market capitalization, much more than the positions held by both non-index hedgers and regular speculators.

There are just a few links and summaries this week. Sorry for the short list. More promised next week. I spent additional time with students last week (it was finals week), and traveling to see Mom this weekend. Happy Mother's Day! It's summertime, and the living is easy ......

Commodities

Are Commodity Funds a Long-Term Bet?
Daisy Maxey - WSJ
* Discussion of commodity-focused mutual funds, and whether the above-average gains for these funds can continue. In general, yes. Returns have been high, but demand remains strong for raw materials, which makes it likely these funds will continue to do well in the long-term, even if there are short-term corrections.

Commodities: Bubble or Not?
David Enke - SeekingAlpha.com
* Sorry for the blatant self-promotion, but if you enjoyed my recent commodity bubble discussion post (here and at seekingalpha.com), or did not enjoy it and/or felt I was way off-base, then you might want to check out the comments at the seekingalpha site. It has generated a lot of additional discussion, some of which is worth reading - pro and con.

Derivatives

Credit-Default Swaps: Weapons of Mass Speculation
Jonathan R. Laing - Barron's
* Barron's discusses the Credit Default Swap (CDS) market. A short primer on what a CDS is, followed more extensively about how they are being used for speculation. The article includes the typical mention of how hedge funds are making a killing, but then talks more about how regulators and on-air personalities may have contributed to the movement of CDS prices every time they discuss whether the monolines would be downgraded. Again, not a detailed article on the CDS market in general, and the purpose it serves, but interesting in how it is being used to profit from rumors and speculation, as with other markets.

Hedge Funds

GLG star's exit could cost $4bn
James Quinn - Telegraph UK
* Another article about what happens to investors that try to leave a hedge fund once the fund manager departs. Redemptions fees get increased or waived, based on your loyalty.

Private Equity

Wharton Private Equity Review: Harnessing the Winds of Change
Wharton - University of Pennsylvania
* The spring review discusses changes in the private equity arena. In particular, there is discussion of how since the credit markets have shut down, it is more difficult to obtain the lifeblood of private equity - cheap money. As such, PE funds are looking for other opportunities. Many are finding that they are needing to hook-up with strategic buyers and corporations, or consider going back to a previous mainstay - distressed investing. Some funds are also considering more international opportunities, some of which may be driven by changes in the tax code, or anticipated changes in the tax code. There is also a nice round-table discussion of the challenges with starting a new private equity firm.

Quantitative Finance and Financial Engineering

A Trader's Perspective on 130/30 Funds
Christopher Holt - SeekingAlpha.com
* Interesting article of 130/30 investment funds from the perspective of a trader. What is the conclusion? Despite the academic discussion of the pros and cons and general rationale for the strategy, a 130/30 strategy is nothing more than a simple short-selling strategy. In fact, there is nothing magical about the 130/30 fund. The amount of short-selling and subsequent leverage could be quiet different, given different circumstances. The article goes on to give some general 1X0/X0 mechanics as a starting point for those interested in developing their own long-short strategy, as well as what is and is not practical - such as whether the short funds can be properly and fully redeployed.

Trading

Boom in 'Dark Pool' Trading Networks Is Causing Headaches on Wall Street
Scott Patterson and Aaron Lucchetti - WSJ
* Article on the "dark pools of liquidity" that are multiplying by the second. The dark pools are simply secretive electronic trading networks that match buyers and sellers anonymously, allowing them to distribute big blocks without displaying their intentions, or moving price. The problem is that there are probably too many, and they are getting more notice. Nonetheless, hedge funds and others that need to move big blocks are using then extensively. Of interest is how securities firms and their clients are expected to increase their use to about 20% of their stock orders by 2010. This is certainly worth considering for those considering technical analysis. A further problem is that users of the dark pools obviously know about extreme buying and selling pressure that is about to affect the stock, in a sense having quasi-insider information. Depending on the size, they can shop around to get the best bid or ask. Of course, this has gotten the SEC's attention. The traditional exchanges and OTCs, on the other hand, such as NYSE and Nasdaq, are looking to get a piece of the action.

Commodities

"Copper Caper: Thieves Nab Art To Sell for Scrap"
Sarah McBride - WSJ
* Thieves are stealing sculptures that are cast in bronze, of which copper is a main ingredient. Manhole cover, pipes, and wiring are also missing as copper prices approach $4 a pound.

"Corn Ethanol Loses More Support"
Siobhan Hughes, Ian Talley, and Anjali Cordeiro - WSJ
* Members of Congress and Governors asking that ethanol requirements that were recently mandated be scaled back. Good luck in an election year, but it is a start.

"Turmoil leads to new index for US munis"
The Economist
* Discussion of how the Fed cuts are doing little to reduce borrowing costs but are contributing to the soaring commodity prices. On the plus side, due to the falling dollar, when you exclude oil, the U.S. current-account deficit has fallen to an eight-year low of 2.4% of GDP. How has the Fed contributed (per the article): 1.) With lower rates, the Fed encouraged speculation in commodities since inventory cost were reduced, 2.) Lower rates fostered a weaker dollar, increasing the price of dollar-denominated commodities.

"Grain Companies' Profits Soar As Global Food Crisis Mounts"
David Kesmodel, Lauren Etter, and Aaron O. Patrick - WSJ
* The food and agriculture story is not new, but what is interesting is how not only are the food producers feeling the pinch, but some farmers themselves are also starting to get squeezed as they are paying more money for seeds, fertilizer and farm gear. Like the gold rush, it is not always the commodity sellers or the miners, but those selling the pick axes that can still realize profits as commodity prices go higher. Companies such as Monsanto, Potash, Agrium, and Mosaic, etc., are still doing well - although the stocks may react a little differently given their huge run-ups. Is there too much speculation? Of interest: "Total index-fund investment in corn, soybeans, wheat, cattle and hogs has increased to more than $47 billion, up from about $10 billion in 2006..." Money is certainly flowing, and demand is still strong. It will be interesting to see how the stocks hold up.

"Commodities jump, but losses raise concerns of downturn"
Stevenson Jacobs - The Associated Press
Increased talk about the potential downturn in commodities. Of interest in the article: "... investors are funneling money out of gold exchange-traded funds, or ETFs, which sell shares backed by gold bullion. The biggest gold ETF in the U.S., streetTRACKS Gold Shares, has shed 83 tons of gold since March, roughly half the amount it acquired during the metal's run-up beginning late last year." Pretty amazing. Gold speculation truly does usually end in tears. Large funds appear to be running towards the exits. Even with increased demand, gold may still suffer loses as speculators get out. On the other hand, demand in food commodities will continue and will help to reverse any recent corrections. People need to eat (and fill up our cars with ethanol - at least until mandates are reduced). Recent corrections in the food commodities may allow these assets to build a base, filter out some speculation, and provide a little more clarity as to direction.

"Prospecting for Junior's Gold"
Matt Whittaker - Barrons
* Junior miners (no, not young miners, but small mining companies) are becoming attractive, not only because of the flexibility they have in downturns/correction, but because they are takeover targets as the majors look for ways to increase market share and juice profits. Of course, with higher potential return comes higher potential risk, including political risk and an inability to absorb high production cost as efficiently.

Derivatives

"Turmoil leads to new index for US munis"
Saskia Scholtes - Financial Times
* A new index of derivative products are being developed to protect against defaults in ....... hold your breath ....... the munis. Pretty unbelievable how times have changed. Of course, the problems with the monolines did not help the situation.

"There's triple A and there's triple A"
Alphaville - Financial Times
* Interesting article showing the effects of both Loss Given Default (LGD) and Probability of Default (PD) or Default Rate (DR). Looking at both, the level of loss is more dire for AAA rated debt, forcing triple A debt to be broken into various junior and senior levels (tranches). Another example of the problems and considerations necessary when considering either mark-to-market or mark-to-model accounting. BTW, read the article comments - highlights how confusing everything is.

Hedge Funds

"Hedge Funds Muck In Down On The Farm"
James Mackintosh and Kate Burgess - Financial Times
* Many hedge funds are beginning to invest in, and outright buy, farms. The move is being made in an effort to take advantage of rising commodity prices, which most feel are here to stay, at least for a while. A few funds also feel that buying farms and having a window into their operations and will give their traders an edge for having information that comes straight from the horse's mouth, figuratively speaking (but not far off). Are farm ETFs next?

"A New Face of Hedge Funds Isn't Shy"
Gregory Zuckerman and Jenny Strasburg - WSJ
* Profile of David Einhorn, the 39-year old manager of Greenlight Capital. Kind of seems more like a 9-to-5 job.

"New funds cut fees to counter old losses"
Alphaville - Financial Times
* Somewhat related to the previous article, hedge funds managers are now waiving fees until they again reach the high water mark. This is unusual only in that it is counter to a recent trend of just closing shop and starting over again. Maybe the legal issues are making some managers nervous.

"Hedge Fund Fees Shrink as U.S. Pensions Make Direct Investments"
Katherine Burton - Bloomberg
* Hedge fund investors, in particular pensions who have been nervous about investing directly in single hedge fund, are moving away from funds-of-funds. The move essentially allows the pension funds to remove the extra layer of fees. Given that funds-of-funds have mixed results, this may be a smart move.

Quantitative Finance and Financial Engineering

"The new fact of 130/30?"
AllAboutAlpha.com blog
* 130/30 funds not just about quants, but also being used or considered by fundamentally-managed trading-based funds.

"Cudgle Over the Quants"
Megan Barnett - Portfolio.com
* Quants and others are being sued as they leave one hedge fund to work at or start another. When big money is involved ......

Trading

"A New Wave of Vilifying Short Sellers"
Jenny Anderson - NY Times
* As with many bear markets or market downturns, Congress and others start pointing fingers at the shorts. Of interest in the article is the statement: "On the New York Stock Exchange, short selling is running near record levels. Just over 4 percent of all the shares on the Big Board were sold short as of March. That figure, however, excludes many rapid trades made every day. Market makers, for example, often go short to ensure customers’ orders are filled quickly. And most hedge funds take short positions to offset their other bets in the markets. So, in all, short selling probably accounts for a quarter or more of all trading." Yes, and some days selling totals more than buying. Maybe we should get rid of that too. Of course, hedging and market maker activities (at least the legal ones) are not usually what people are worrying about. The problem is the pump-and-dumpers, but as Jim Chanos said: "Show me the evidence."