Fee-based income holds the key for Banking system

ImageIn the era of quantitative easing and significant market competition, maintaining profitability through interest-based income is becoming very tough for banks. In the last two decades, interest margins have come under tremendous pressure. In modern times, banks prefer non-interest income i.e. fee based income to drive profitability and return on capital.

The 2008 financial crisis was a big blow for banks, especially for those depending broadly on interest-based income. As the global economic recovery still looks fragile, banks are finding it hard to do loan- and mortgage-based business i.e. interest-based business. The ultra-low central bank interest rate regime was supposed to spur economic activity, as it (theoretically) supports more lending activity, but many banks are hesitant in lending due to potential bad loan losses and slow demand for loans. It would be worth to mention the ultra-low interest rate regime has also dampened savings account activities in banks.

Most of the fee-based incomes (advisory and management fees) are fairly risk-free, as these services don’t involve significant capital investment.

In recent times, banks have reported handsome revenues from fee-based income; thanks to the spur in M&A activities and private equity deals (mainly in US). Since we are living in a globalized society, there are no boundaries for banks and they can reach out to any corner of the world, thus making many potential M&A and private equity activities lucrative.

It would be pertinent to mention that fee-based driven income cushions banks against market competition. In coming days, implementation of new banking rules and regulations are going to take a paradigm shift (Dodd Frank rule, Basel III). This might curb the freedom of leverage banks take on their reserves and provisions, which in turn will leave banks with limited capital or liquidity to do the traditional business of loans and advances –further constraining interest-based income.

Fee-based income is more volatile than interest-based income, but a range of services like wealth management, transaction banking, treasury, and investment banking are covered under fee-based income. The wide spectrum of fee-based service provides room for banks to shuffle service strategies.

In the prevailing economic situation, banks would look for more fee-based income, but they won’t be able to ignore interest-based income completely. They have to build up modus operandi for various possible economic situations. For example, they will have to understand, what would be good for business if the Fed will increase the short-term interest rate or possible ‘tapering’ in coming months? How to benefit from the global corporate houses’ quest for M&A?

RBI’s never ending dilemma

ImageIt seems the Reserve Bank of India (RBI) is having very hard times these days. No wonder if they complain the current bond yield and rupee fall is all because of the U.S. Fed and Bank of Japan (BoJ). Meanwhile, RBI has got entangled in the current account deficit and inflation problem, adding more headache to it is – the fall of Indian currency against the U.S. dollar. The fall in Indian Rupee has forced FIIs to dump the G-sec (Indian Bonds), and they had dumped bonds at record level during last few trading sessions. For the FIIs there is no point to hold their investment in the Indian bond market as the U.S. 10-year bonds are looking much more attractive. Plus the weakening of Indian rupee will hurt further investments (read article from Economic Times). The yield differential of U.S. 10-yr bond with Indian debt is at one year low.  According to the bond spread calculator of Bloomberg, the spread between US 10-yr bond and Indian 10-yr bond is around 504 basis point or 5 percent, it was at 7 percent, last year . It is very pertinent to mention that not only G-sec even yield for corporate bonds have also fallen in the market. Many fear the banks (PSU and private) might play the spoil sports and sell bonds in the market to book profits.

The Indian currency  is down almost 10 percent since first week of May, now hovering around 59 against the dollar. Today, traders reported RBI sold dollars in the market to curb the fall of rupee but previously done acts by RBI suggests it has failed to curb the fall of rupee due to structural economic problem. Meanwhile, chief economic advisor, Raghuram Rajan believes the rupee’s fall is a temporary phenomenon. Many economists think more liquidity in the market will ease the pressure from rupee.  In the coming weeks macro economic data will decide if the RBI is willing to cut the rates in July. RBI might give its  stance regarding the comfort zone with rupee in the currency economic circumstances on its June 17 monthly meeting.

Delta Hedging (Tutorial version)

A trader in option market always looks for delta hedging for his/her portfolio. A delta hedging gives an opportunity to the trader to keep his/her trading position neutral from market movement.

What is Delta?
Delta is the ratio which measures change in price of the derivative with respect to the change in price of underlying asset  . So, if delta (∆) for an option is 0.5 then it implies for every one dollar change in the price for the underlying asset (whether it is an increase or decrease), there will be a change of 50 cents to the option price.

Characteristics of Delta

For a call option, delta moves between 0 and +1 while, for a put option it fluctuates between -1 and 0. Delta will be close to zero if the option (call or put) is ‘out of the money‘. When the call option is ‘in the money‘, delta will tick close to +1 while, for put option, it will be close to -1. Options, ‘at the money‘ will have delta around +0.50 for call, and -0.50 for put.

The mechanism behind delta

A trader tries to hedge his/her portfolio by establishing delta long or delta short position in accordance with the underlying assets. For example, a trader takes a call option of $10 which gives right to buy 100 shares of Apple Inc (trading at $ 430) with a delta at 0.70 (i.e. in the money). Suppose if the market price of shares are now at $450 then what will be the option price? Since, delta is 0.70 an increase in underlying price of $20 ($450-$430) will increase the call option price by 0.70*20= $1.40. So, the new call option price will be $10+$1.4=$11.4.

Thus, an increase of $20 in the Apple Inc share will increase the call option price to $1.40 or call option price for share of Apple Inc trading at $450 will be $11.40.

Delta Neutral Hedging

The objective of Delta Neutral Hedging is to remove price risk regardless of how the stock moves. According to the trading jargon, an option contract with 0.50 delta is referred as “50 deltas”. So, 100 deltas are related to 100 shares thus each share will have delta value equals to 1. To sum up, if you are long on 100 deltas then increase of $1 in stock price will give a gain of $100 and if it fall $1 then you will end up having loss of $100. If a position is long on 50 deltas then increase in price of stock for $1 will fetch you $50 and in case of decrease in stock price, a loss of $50.

So, if a trader buys 100 shares of a stocks to get his/her portfolio a delta neutral position, he/she has to buy 2 put contracts; at the money with a delta value of -50 per contract.

Thus, 100(delta value of 100 shares)- 100( 2 put contacts* 50 deltas)= 0 delta.

For example, if a trader held 100 shares of Apple Inc for $400 per share on 14 March 2013. On 14 May, when Apple Inc was trading at $430, the trader performed a delta neutral hedge against possible price change while being able to make profit. The trader bought 2 ‘contracts of July31 put’ to get the delta neutral hedge on his/her position.
100 (delta of 100 shares) – 100 (delta of 2 contracts of at the money put options of 50 deltas) = 0 delta

Now what will happen is if the stock moves up by $1, trader will make  $100 with shares, but loses $50 with each put, so $100 lost in the puts; overall no gain or loss in his position.  Although ideally it would not happen as the put option price would change with the change is stock price and since the position is long (i.e. long straddle) the trader will end up with some profits. So, if Apple rallies from $430 put option will expire being worthless and the trader will gain from increase in the price of stock by keeping his position alive in the market and the put option loss will be offset by the profits he/she would make.
There are many permutations and combinations among call and put option to get a delta neutral hedging. We will have more on the topic later.  Keep reading and learning.