Bank of Canada – Wait and see

As widely anticipated, the Bank of Canada has held the short term interest rate to be steady at 1%. The official statement has the following salient paragraphs:

The global economic recovery is proceeding largely as expected, although risks have increased. As anticipated, private domestic demand in the United States is picking up slowly, while growth in emerging-market economies has begun to ease to a more sustainable, but still robust, pace. In Europe, recent data have been consistent with a modest recovery. At the same time, there is an increased risk that sovereign debt concerns in several countries could trigger renewed strains in global financial markets.

The recovery in Canada is proceeding at a moderate pace, although economic activity in the second half of 2010 appears slightly weaker than the Bank projected in its October Monetary Policy Report. In the third quarter, household spending was stronger than the Bank had anticipated and growth in business investment was robust. However, net exports were weaker than projected and continued to exert a significant drag on growth. This underlines a previously-identified risk that a combination of disappointing productivity performance and persistent strength in the Canadian dollar could dampen the expected recovery of net exports.

The translation to this is simply: “We’re waiting and watching”. The other note is that the elevated value of the Canadian currency, while great for all of us consumers that purchase imported goods, is damaging the economic prospects of exporting companies.

Bank of Canada – Interest Rates

One event coming this week is the December 7 scheduled announcement of the Bank of Canada overnight target rate. It is currently 1% and it is widely expected that it will remain at 1% given the impact of economic news (i.e. growth is moderating from the economic crisis, and that the high Canadian dollar is impairing growth).

Some are even criticizing the decision to raise rates from 0.25% to 1%, but it is important to note that a short term bank rate of 0.25% introduces more risk to the financial system than a slightly higher rate – although banks are trying their hardest to find credit-worthy entities to loan money to (since money is still very cheap at 1%), there is less of an impulse to doing so than at a 0.25% rate.

You will still get the usual yield-chasing as people continually try to earn a return on their capital. The consideration to ensure the return of capital continues to be secondary.

Price of crude

It is an important benchmark to see that the price of crude oil is at an all-time high, at least in nominal US dollar terms, since the economic crisis:

Every day when I look around me, I see people in their automobiles, and I see trucks on the road, and airplanes flying in the sky. While the sample of one is statistically insignificant, when you start to think about world-wide demand for concentrated portable energy (which is what crude oil represents), coupled with the increasingly high costs to mine supply, leads one to suspect that hedging their energy consumption in the form of owning energy assets would be a prudent portfolio decision.

This isn’t new – I have been discussing this for the past couple years. I believe in crude much more than gold in terms of hedging your purchasing power.

Large-cap oil sand companies like Suncor (TSX: SU) and Cenovus (TSX: CVE) are highly correlated to the price of crude oil. They also have significant bitumen reserves which become increasingly valuable as the price of crude rises. Due to the nature of the financial structure of these companies, they are not going to double overnight, but they will retain their value as long as you believe in the stability of the Canadian and Alberta governments.

Companies with oil assets outside “safe” jurisdictions (e.g. Venezuela) involve much more risk, hence you will find them cheaper.

There are also some other smaller cap companies in the oil sands space that are worthy of consideration, and they contain a bit more financial leverage which would result in potentially larger gains.

Sucked in by volatility

It looks like the volatility trading crowd (at least if you were long) took a hit over the past week – things had looked like they were stirring up with the Irish debt issue, but it had abated over the week.

First, a chart of the S&P 500 volatility index (VIX):

Secondly, a chart of a high-volume Volatility ETF (NYSE: VXX):

Traders that were long for the week have taken over a 10% haircut. In fact, the ETF closed at a record low from its inception back in early 2009. The “spot” volatility index was down about 22% from the beginning of the week. How much lower can volatility go?

I have no positions in any of this, but do watch carefully – for example, when index implied volatility is low, it is usually a horrible time to engage in strategies like selling puts or calls. Conversely if you have any bullish projections to the future of the market, it is usually a good time to purchase calls since their pricing will be lessened by the overall volatility projection. What causes this is that there is some mean-regression baked into the quantitative models that option traders use.

Principles of valuing options – Delta

A concept that is important to people that are considering the purchase of stock options (I will strictly deal with “call” options for the purposes of this discussion) is the concept of delta.

Delta is the change in price of the option over the change in price of the underlying. For those that are calculus-minded, it is the instantaneous change, given that all other variables are constant (parameters such as strike price, time to expiry, implied volatility, etc.)

As an example, if you owned an option contract (100 shares) to buy stock XYZ at $50/share, and if XYZ was trading at $50, with an implied volatility of 50%, expiring on the 3rd week of Friday January 2011, would have a delta of 0.537, according to the Black-Scholes Model. This effectively means that the current price you have exposure to the equivalent of 53.7 common shares at the current price and time. This increases as the stock price increases – a $55 share price translates into a delta of 0.729, and a $45 share price results in a delta of 0.318.

Intuitively, this makes sense – as your option goes deeper “into the money”, you start to have more real equity in the underlying stock.