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.

Calculating returns is not simple

This is in response to an article published by Sivaram Velauthapillai who was citing a Globe and Mail article on the art of calculating returns.

The calculation and interpretation of “return on investment” is not as easy as one might think. The two most important and basic formulas in calculating return I will illustrate. They do not factor in the removal or addition of cash in an account.

The simple method of calculating the return, in very non-technical terminology, the following:

(simple return) = [(value today) – (value invested)] / (value invested)

To convert this into a percentage return, multiply by 100 and append a “%” to it.

You can see by this formula that if the “value today” is less than the “value invested”, you will have a negative return.

This formula should be in the arsenal of everybody investing. If you cannot calculate it on your own, there is really no point in investing in the markets at all since you will have no idea how to measure your own performance. Online sites have tools to measure performance, but without understanding the underlying formulas, the numbers will be meaningless.

The next parameter to get thrown into the equation is “return over time” – for example, making a simple return of 40% over one year is different than making a simple return of 40% over four years. Most people take 40% and divide by 4 and say they made “10% per year”, which is an incorrect calculation since it ignores the effects of compounding.

If you make 10% a year, your actual return would be 1.1^4-1 = 46.4%, not 40%.

To factor in compounding when calculating an annual return, you must engage in some mathematical finagling, which is a test of how much you remembered in high school math:

(annual compounded return) = exp[ln[1+(simple return)] / (time in years)]-1

For those not mathematically oriented, exp[…] and ln[…] refer to the exponential function.

When plugging in a 40% simple return over 4 years, you end up with an annual compounded return of 8.78% a year, which is the correct answer – verify by doing (1.0878^4)-1 = 40%.

The calculations become more complicated when you try to measure them for cash, time, and simple return. This will wait for a future post.