The daily financial statements

The Manager should have access to continuously updated statements of income, cash flow, and a balance sheet. The most important statement is that of the cash flow. The manager should be able to know, at each and every stage, what his real cash situation is - as opposed to the theoretical cash situation which includes accounts payable and account receivable in the form of expenses and income.

These pro forma financial statements should include all the future flows of money - whether invoiced or not. This way, the Manager will be able to type a future date into his computer and get the financial reports and statements relating to that date.

In other words, the Manager will not be able to see only a present situation of his company, but its future situation, fully analysed and fully updated.

This is the most important part of the decision support system.

It enables the Manager to instantly analyse dozens of important aspects of the functioning of his company. It allows him to compare the behaviour of these parameters to historical data and to simulate the future functioning of his company under different scenarios.

It also allows him to compare the performance of his company to the performance of his competitors, other firms in his branch and to the overall performance of the industry that he is operating in.

The Manager can review these financial and production ratios. Where there is a strong deviation from historical patterns, or where the ratios warn about problems in the future – management intervention may be required.

Instead of sifting through mountains of documents, the Manager will only have to look at four computer screens in the morning, spot the alerts, read the explanations offered by the software, check what is happening and better prepare himself for the future.

1. 
   SUE measure - deviation of actual profits from expected profits;
   
2. 
   ROE - the return on the adjusted equity capital;
   
3. 
   Debt to equity ratios;
   
4. 
   ROA - the return on the assets;
   
5. 
   The financial average;
   
6. 
   ROS - the profit margin on the sales;
   
7. 
   ATO - asset turnover, how efficiently assets are used;
   
8. 
   Tax burden and interest burden ratios;
   
9. 
   Compounded leverage;
   
10. 
    Sales to fixed assets ratios;
    
11. 
    Inventory turnover ratios;
    
12. 
    Days receivable and days payable;
    
13. 
    Current ratio, quick ratio, interest coverage ratio and other liquidity and coverage ratios;
    
14. 
    Valuation price ratios;
    and many others.
    

A decision system has great impact on the profits of the company. It forces the management to rationalize the depreciation, inventory and inflation policies. It warns the management against impending crises and problems in the company. It specially helps in following areas:

1. 
   The management knows exactly how much credit it could take, for how long (for which maturities) and in which interest rate. It has been proven that without proper feedback, managers tend to take too much credit and burden the cash flow of their companies.
   

2. 
   A decision system allows for careful financial planning and tax planning. Profits go up, non cash outlays are controlled, tax liabilities are minimized and cash flows are maintained positive throughout.
   

3. 
   As a result of all the above effects the value of the company grows and its shares appreciate.
   

4. 
   The decision system is an integral part of financial management in the West. It is completely compatible with western accounting methods and derives all the data that it needs from information extant in the company.
   

Decision Support Systems cost as little as 20,000 USD (all included: software, hardware, and training). They are one of the best investments that a firm can make.

No country was exempt, all suffered collapsing or near-collapsing banking systems. India had to nationalize the fourteen biggest banks - and, later on, tens of private, smaller ones - in 1969.

This was done to avert a major financial catastrophe. No one can enumerate all the banking crises in England. As late as 1991 it had a 10 billion USD collapse (the BCCI bank).

In 1973-4, during the "secondary banking crisis", the government had to launch operation "Lifeboat" to save 60 banks. They failed because the Bank of England deregulated the credit markets and freed it to competition.

As we review this scorched earth of ruined banks, six patterns emerge concerning the compensation offered by the state to the adversely affected clients.

The USA established a Federal Deposit Insurance Corporation (FDIC) as early as 1933.

Every depositor in every American bank is insured and the participation of the banks in the FDIC is obligatory. The FDIC covers deposits of up to 100,000 USD per person per bank.

The savings and loans associations (SLAs) were insured in a separate agency, the FSLIC.

When a wave of bankruptcies engulfed the SLAs in 1985-7, the FSLIC went bust and was unable to meet the demands of the panicky depositors.

The USA reorganized the whole system but it also decided to compensate the depositors and savers in the SLAs. To do that, it initially injected - using budget contingency funds - 10.8 billion USD. Then, a special agency was set up (the RTC). This agency established RefCorp, a corporation whose sole purpose was to issue bonds to the public and sell them in the various stock exchanges throughout the USA. The proceeds of the of the sale were used to beef up the failing SLAs and to make their balance sheets much healthier.

It is important to note that nothing explicit was promised to the depositors. The government made vague and late statements about its willingness to support the ailing institutions. This was enough to calm the panic and to re-establish trust between the depositors and the SLAs.

RefCorp bonds were not backed by a federal guarantee. Still, the fact that RefCorp was a federal entity, associated with the administration was enough to give it a federal credit rating.

People believed in the sincerity of the commitment of the government and in the long term repayment prospects of the bonds. They bought 300 billion worth and the money was immediately injected to heal the bankrupt institutions. Using long term debt - which was not even part of its obligations - the government was able to stabilize the financial system and to fully compensate depositors for their money.

A similar approach was adopted by Israel to cope with its 1983 banking crisis. The whole banking system collapsed as a result of a failure of a pyramid scheme involving the banks' shares. The government was faced with civil unrest and decided to compensate those who bought the shares in the stock exchange.

At first, the banks were nationalized and trading in their shares in the stock exchange was suspended to prevent panic selling. The government, having become the owner of the banks, declared a share buyback scheme. Owners of bank shares were permitted to sell them to the government in three specific dates over a period of 9 years (originally, the share buyback scheme was for a period of 6 years with two exit dates but it was prolonged). The price at which the government agreed to buy the shares back from the public was the price on the last day that the shares were traded prior to the collapse (5/10/83) and it was linked to the exchange rate of the Shekel-USD. The government used funds allocated within the national budget to buy the shares back. This means that it used taxpayers money to financially save a select group of shareholders. But there was no public outcry: so many people were involved in these pyramid schemes for so long that all the citizens stood to benefit from this generous handout. When the last shares were bought in 1992 the total damage became evident: no less than 6 billion USD (minus what the government could get when it were to sell the banks that it owned).

1994 was arguably the worst year for banks in South America since 1982. Banks collapsed all over that region.

It started with Venezuela in January 1994. One of the major banks there, Banco Latino, failed, dragging with it 7 others. The Government decided to fully compensate all the depositors and savers in these banks. It has created a special fund to which revenues from the sale of oil were transferred. Obviously, this money was taken away from the budget and was compensated for by extra taxation. The whole economy was horribly effected: inflation shot up uncontrollably, a credit crunch ensued and business bankruptcies proliferated. Venezuela entered one of the worst economic periods in its history with rampant unemployment and a virtual state of economic depression. It cost the country 12 billion USD to extract its banking system from the throes of imminent evaporation - an amount equal to 22% of its annual GDP.

And this was nothing compared to the Brazilian predicament. Brazil is divided to geographically huge states, each with its own development bank. These banks are really commercial banks. They have hundreds of branches spread across the states, they take deposits and make loans to business firms and to individuals. But their main debtors are the administrations of the states. When Banespa, the Sao Paolo state development bank collapsed, it was owed 19 billion USD by the state government, not to mention other bad loans. This bank had 1,500 branches and millions of depositors. It would have been political suicide to just let it die away. In December 1994, the Central Bank took over the day to day management of the bank and installed its own people in it. The bank was later completely nationalized. Moreover, the other state development banks began to wobble, together with a sizeable chunk of the private banking sector - 27 banks in total. This was really ominous and the government came up with a creative solution: instead of saving the banks - it saved the big clients of the banks. Sao Paolo received 66 billion USD in federal credits which assisted it in re-financing and in re-scheduling its debts, especially its debts towards Banespa. The bank was saved, the state was saved, the federal budget was 66 billions poorer - and this was only the beginning. In certain cases, the loan (asset) portfolios were so bad and unrecoverable that the government had to inject money to the bank itself - because there were no more clients to inject money to. Banco do Brazil received 7.8 billion USD on condition that it writes off loans from its books. Another 13.6 billion USD were given to private banks. The government also cajoled banks into merging or into finding foreign partners. The depositors were completely compensated but only a few of the 27 saved banks are of any interest to foreign investors. After all, a bank without assets is hardly a bank at all.

The most vicious of all banking affairs in this part of the world occurred in Paraguay a year later. The Treasure of the Central Bank, no less, was found using the Central Bank funds to run a lucrative money lending operation. He lent 3 million of the bank's funds before he was caught. Needless to sat that he pocketed the interest payments. In April 1995, the Governor of the Central Bank there decided that things were getting too hot for him and he fled the country altogether. The public was in panic. No one knew what happened to the reserves of the commercial banks which were deposited with the Central Banks. Banks with no reserves are very shaky and dangerous institutions. So, depositors and savers queued in front of the banks to draw their money. It was a matter of a very short time before the banks became insolvent and closed down their operations, albeit "temporarily". Four banks and 16 savings houses collapsed that year and four more banks - the next. The bank supervision discovered mountains and oceans of black money on which the banks paid high rates of interest. The legal "white" money - a much smaller amount altogether - bore a lower rate of interest.

The government adopted a politically brave decision: it would compensate only those depositors which deposited money on which they paid taxes ("legal money"). Even so, the damage was great (in Paraguayan terms): 450 million USD. Those depositors who received excess interest payments on their undeclared funds - lost both their funds and the interest accruing thereon. Moreover, the government forced the owners of the banks to increase the equity capital. The system was saved, though the basic malaise was not cured and the banking system is still obscure, secretive, nepotistic and highly dangerous.

A course very similar to that chosen by Macedonia was adopted by the government of Japan.

In 1990, the Tokyo Stock Exchange began its long 50% decline. People lost trillions of USD.

As a result, they had no money to continue to pay the outlandish prices which were demanded by sellers of real estate property. So, real estate prices went down by as much as 80% in the Tokyo area - and by a bit less elsewhere in Japan. Real estate property served as the main security on huge portfolios of loans which were provided by banks through Junsen, financing corporations set up especially to provide mortgage collateralised loans.

The logical - and inevitable - result was the collapse of seven important Junsen, followed by a chain reaction of banks ceasing to function.

The Japanese government set up a special agency, the HLAC, which "cleaned" the books of the banks by taking over the non-performing loans. This move was very similar to what the Macedonian government did with the Ägencija za Sanacija na Bankiti" - clean off the balance sheets of the banks, make them healthier and then supervise them heavily. No one knows how much the government of Japan has doled out to save the banks (actually, the depositors money). Rumours have it that about 1.8 billion were invested in the rescue operation of 1 junsen, the Nichiei Junsen.

Different countries bring different cultures and different solutions to the same problems.

Yet, there is one thing common to all: depositors are usually almost fully compensated using state money on and off budget. Some countries spread the payments over longer periods of time - other do not even dare raise the possibility and they take over the liabilities (and the assets) of the failing banking system. Some sell bonds to raise the money - other us taxpayers money. But they all succumb to the ultimate political imperative: survival.

Derivatives, Pricing of

The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1997, to Professor Robert C. Merton, Harvard University, and to Professor Myron S. Scholes, Stanford University, jointly. The prize was awarded for a new method to determine the value of derivatives.

This sounds like a trifle achievement - but it is not. It touches upon the very heart of the science of Economics: the concept of Risk. Risk reflects the effect on the value of an asset where there is an option to change it (the value) in the future.

We could be talking about a physical assets or a non-tangible asset, such as a contract between two parties. An asset is also an investment, an insurance policy, a bank guarantee and any other form of contingent liability, corporate or not.

Scholes himself said that his formula is good for any situation involving a contract whose value depends on the (uncertain) future value of an asset.

The discipline of risk management is relatively old. As early as 200 years ago households and firms were able to defray their risk and to maintain a level of risk acceptable to them by redistributing risks towards other agents who were willing and able to assume them. In the financial markets this is done by using derivative securities options, futures and others. Futures and forwards hedge against future (potential - all risks are potentials) risks. These are contracts which promise a future delivery of a certain item at a certain price no later than a given date. Firms can thus sell their future production (agricultural produce, minerals) in advance at the futures market specific to their goods. The risk of future price movements is re-allocated, this way, from the producer or manufacturer to the buyer of the contract. Options are designed to hedge against one-sided risks; they represent the right, but not the obligation, to buy or sell something at a pre-determined price in the future. An importer that has to make a large payment in a foreign currency can suffer large losses due to a future depreciation of his domestic currency. He can avoid these losses by buying call options for the foreign currency on the market for foreign currency options (and, obviously, pay the correct price for them).

Fischer Black, Robert Merton and Myron Scholes developed a method of correctly pricing derivatives. Their work in the early 1970s proposed a solution to a crucial problem in financing theory: what is the best (=correctly or minimally priced) way of dealing with financial risk. It was this solution which brought about the rapid growth of markets for derivatives in the last two decades. Fischer Black died in August 1995, in his early fifties. Had he lived longer, he most definitely would have shared the Nobel Prize.

Black, Merton and Scholes can be applied to a number of economic contracts and decisions which can be construed as options. Any investment may provide opportunities (options) to expand into new markets in the future. Their methodology can be used to value things as diverse as investments, insurance policies and guarantees.

One of the earliest efforts to determine the value of stock options was made by Louis Bachelier in his Ph.D. thesis at the Sorbonne in 1900. His formula was based on unrealistic assumptions such as a zero interest rate and negative share prices.

Still, scholars like Case Sprenkle, James Boness and Paul Samuelson used his formula. They introduced several now universally accepted assumptions: that stock prices are normally distributed (which guarantees that share prices are positive), a non-zero (negative or positive) interest rate, the risk aversion of investors, the existence of a risk premium (on top of the risk-free interest rate). In 1964, Boness came up with a formula which was very similar to the Black-Scholes formula. Yet, it still incorporated compensation for the risk associated with a stock through an unknown interest rate.

Prior to 1973, people discounted (capitalized) the expected value of a stock option at expiration. They used arbitrary risk premiums in the discounting process. The risk premium represented the volatility of the underlying stock.

In other words, it represented the chances to find the price of the stock within a given range of prices on expiration. It did not represent the investors' risk aversion, something which is impossible to observe in reality.

The Black and Scholes Formula

The revolution brought about by Merton, Black and Scholes was recognizing that it is not necessary to use any risk premium when valuing an option because it is already included in the price of the stock. In 1973 Fischer Black and Myron S. Scholes published the famous option pricing Black and Scholes formula. Merton extended it in 1973.

The idea was simple: a formula for option valuation should determine exactly how the value of the option depends on the current share price (professionally called the "delta" of the option). A delta of 1 means that a $1 increase or decrease in the price of the share is translated to a $1 identical movement in the price of the option.

An investor that holds the share and wants to protect himself against the changes in its price can eliminate the risk by selling (writing) options as the number of shares he owns. If the share price increases, the investor will make a profit on the shares which will be identical to the losses on the options. The seller of an option incurs losses when the share price goes up, because he has to pay money to the people who bought it or give to them the shares at a price that is lower than the market price - the strike price of the option. The reverse is true for decreases in the share price. Yet, the money received by the investor from the buyers of the options that he sold is invested. Altogether, the investor should receive a yield equivalent to the yield on risk free investments (for instance, treasury bills).

Changes in the share price and drawing nearer to the maturity (expiration) date of the option changes the delta of the option. The investor has to change the portfolio of his investments (shares, sold options and the money received from the option buyers) to account for this changing delta.

This is the first unrealistic assumption of Black, Merton and Scholes: that the investor can trade continuously without any transaction costs (though others amended the formula later).

According to their formula, the value of a call option is given by the difference between the expected share price and the expected cost if the option is exercised. The value of the option is higher, the higher the current share price, the higher the volatility of the share price (as measured by its standard deviation), the higher the risk-free interest rate, the longer the time to maturity, the lower the strike price, and the higher the probability that the option will be exercised.

All the parameters in the equation are observable except the volatility , which has to be estimated from market data. If the price of the call option is known, the formula can be used to solve for the market's estimate of the share volatility.

Merton contributed to this revolutionary thinking by saying that to evaluate stock options, the market does not need to be in equilibrium. It is sufficient that no arbitrage opportunities will arise (namely, that the market will price the share and the option correctly). So, Merton was not afraid to include a fluctuating (stochastic) interest rate in HIS treatment of the Black and Scholes formula.

His much more flexible approach also fitted more complex types of options (known as synthetic options - created by buying or selling two unrelated securities).

The Nobel laureates succeeded to solve a problem more than 70 years old.

But their contribution had both theoretical and practical importance. It assisted in solving many economic problems, to price derivatives and to valuation in other areas. Their method has been used to determine the value of currency options, interest rate options, options on futures, and so on.

Today, we no longer use the original formula. The interest rate in modern theories is stochastic, the volatility of the share price varies stochastically over time, prices develop in jumps, transaction costs are taken into account and prices can be controlled (e.g. currencies are restricted to move inside bands in many countries).