Science_and_Money

Derivatives in Mutual Funds

In the semiannual report for the Janus Worldwide Fund (JAWWX), the fund manager made special note of the fund’s investment in derivatives.  While I knew that mutual funds are allowed to invest in derivatives, I had not thought to investigate which mutual funds use them, how they use them, and how (or whether) they assess the impact of the derivatives on the risk level of the mutual fund.

Derivatives

When you buy stock, you’re purchasing a slice of a company — you are actually buying something for your money.  Derivatives are a bet.  They can wager that a company’s stock price will go up or down (options), or that a foreign currency will go up or down (currency options), or they can be more exotic (credit default swaps).  They are a contract for a specified length of time, during which, if the terms of the contact are met, one party owes the other some money.  After the contact expires, the contact has no value.

Derivatives are not all bad

Like a gun, there are good and bad uses for derivatives.

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Fire!

Honk! Honk! Honk! …………..  Honk! Honk! Honk! …………..

There’s no mistaking it.  It’s the fire alarm. 

Honk! Honk! Honk! …………..  Honk! Honk! Honk! …………..

I’m in a hotel in Portland, Oregon.  I’m on the third floor.  What do I do? 

Fire in the Hotel

On a recent business trip, my sleep was interrupted by a blaring fire alarm.  I managed to get my bearings, get dressed, and get down the stairs. 

There was no smoke outside my door, so I assumed it was a flase alarm.  Then I saw several families tumbling out of the building coughing and holding wet towels over their mouths.  They collapsed on the grass, and I overheard them describing their ordeal.  When they opened the doors of their rooms, they could barely see the other side of the hallway. 

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The Persistence of Memory

Office photocopiers and multifunction devices (that scan, print, fax, and copy) have a hard drive embedded in them.  As you feed documents in, it stores the images on the hard drive.  It then prints the images from the disk.

When a photocopier is replaced, the used one can be resold.  The used copier still has the hard drive with all the document images intact.  The hard drive can be removed and the images retrieved.

Think of all the sensitive information that gets copied:  employment records, medical records, tax returns, and financial account information.   It’s all stored and available to those who would desire to retrieve it.

CBS News recently purchased four used copiers, removed the hard drives, and recovered documents about sex offenders, financial statements, and documents with Social Security numbers.

It’s not a new story.  Computerworld interviewed the president of Sharp Document Solutions in 2007, where he expressed concern about identity theft through copiers and intelligent printers.

A better way

It’s a great opportunity for a manufacturer of copier machines to redesign the device so that it uses random-access memory (RAM) instead of a hard drive.  Data stored in RAM is lost when power is removed.  RAM is the main memory in computers and is <$100 for 1GB, which would seem to be plenty for the typical office copier.  The copier maker could charge a premium for a RAM-based data-safe copier.  (Are you listening Sharp? Xerox? Ricoh?).

Other storage devices

Hard drives are difficult to fully erase.  The “delete” function in Windows, merely moves a file to the “Recycle” bin.  “Emptying” the Recycle bin merely deletes the file name from the directory list.  The file can still be recovered with a DOS-level function.  Fully wiping a drive requires writing to every itty bitty bit on the drive.

Hard drives are one form of information storage, but there are others.

Flash memory — like the kind found in “memory sticks” — is now embedded in virtually everything you plug into the wall or has batteries: cameras, cell phones, MP3 players, voice recorders, pagers, game boxes — just to name a few.  I’m convinced that one day even my toaster will have an IP address.  iPhones now have banking and financial apps for mobile transactions.  It’s safe to bet that the transactions are secure, but what about the data stored on the device.  When the device gets recycled, can that information be cleared?  Do people bother to delete it? Does “deleting” a file really make it unreadable?

CD’s and DVD’s are a common way to back up computer hard drives.  Do you know where your back up disks are?  I’ve moved a few times over the years, and I’m sure I’ve lost some along the way.  I’ve probably also lost some 3 1/2″ disks (and even some 5 1/4′s — but that tells you how old I am).

Information protection will become more important as we move further into the information age.  We need to consider the “cradle-to-grave” of our digital bits.  We need to be careful how we create, distribute, store, and ultimately destroy our digital records.

Tip o’ the green shade to Bill Winterberg at FP Pad, who brought the issue to my attention.

Image credit: jzawodn of Flickr.

Carnivals: This post was included in this week’s Carnival of Personal Finance hosted at PopEconomics.

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Sexy CD's: Who Needs 'Em?

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I was reading an article enticingly entitled “Boost Your Returns” in the latest issue of SmartMoney magazine.  My eyes skimmed down to a section on certificates of deposit.  I like CD’s.  They’re FDIC insured and provide a small but certain return.

CD’s as derivatives

But, whoa, not these CD’s.  The SmartMoney article is about CD’s that are indexed to various assets.  One highlighted CD is pegged to the value of BRIC currencies.  If the value of the foreign currencies rise, I receive an interest rate that is a portion of this growth.  If the currencies fall, relative to the dollar, then I receive no interest, but I do get the principal back at the end of the term.   Huh?  Why would I want to do this?  What does the average person know about the Brazilian real, Russian ruble, Indian rupee, or Chinese renminbi?  And by average, of course, I mean me. Read the rest of this entry »

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"…Where all of the children are above average"

report_cardThe concept of risk underlies much of finance.  We expect that riskier investments will have higher returns.  The riskiness of a corporate bond is one of the main determinants of its price.  But measuring — truly quantifying — risk is hard to do.

Sure, companies like Moody and Fitch assign companies risk letter grades akin to schoolgrades.  But, in college, my sister used to bake brownies for her teaching assistant to get better grades.  And if brownies can give one a boost, just imagine what you can get for the millions of dollars paid by the companies being rated to the companies doing the ratings.  It’s not hard to see (in hindsight) why we’re in the mess we are today.

Enter Freerisk.org.  A couple of slide-rule wielding financial guys who want to throw open the data and crowdsource a better solution.

While I applaud their intentions, isn’t asymmetric data the root problem?  Only the guys inside the company know the true financial picture.  The data reported in the SEC filings are the most optimistic view (within GAAP) of the true situation.  If the data is skewed, how can the result be straight?

I am intrigued by the creation of a large public financial dataset.  Could one use it to investigate things other than risk?  Expected market returns?  Geopolitical stability?  The flow of illicit funds?  If you’re interested, there a Google group forming –get in on the ground floor.

Tip ‘o the green shade to Wired Magazine (June 2009, p. 28) and to Garrison Keillor’s Lake Wobegon for the title phrase.

Photo credit:  Flickr

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