What if nothing is risk free?

Every discipline develops its own dogma and finance is no exception; we make assumptions about how markets are structured and investor behavior that underlie much of our theory. Those within the discipline either take these fundamental assumptions as given or are reluctant to question them. Over the last few months, I have been working on a new book titled "What if?", where I am looking at how financial theory and practice would change, if the bedrock assumptions of finance were violated or no longer true. I just finished my first installment, where I look at how investment practice and corporate finance would change if there is nothing that is guaranteed or risk free. You can get the paper by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164

In an earlier post, I examined the mechanics of how best to estimate the risk free rate when there is no default free entity. Through most of that post, I focused on emerging markets, where governments are often prone to default, but left untouched the basic presumption that developed market governments like the United States, UK and Germany are default free. But that presumption has been put to the test by the banking crisis of 2008 and the Greek default drama of 2010.

I start by looking at how the presence of a risk free investment changes the way in which we construct portfolios and make corporate finance decisions. In particular, the presence of a risk free investment allows for separation between risk preferences and portfolio composition. Thus, two investors with different degrees of risk aversion can end up holding the same portfolio of risky assets and adjust for risk, by altering the proportions of their wealth that they put into the risk free asset. In corporate finance, the presence of a risk free investment can alter investment, financing and dividend policy.

So, what makes for a risk free investment? The issuing entity has to have no default risk, which restricts us to government securities, because governments alone have the power to print currency. The catch, though, is that governments sometimes default. While the explanation for default is simple, when governments borrow in foreign currencies, it is more complex when governments borrow in their own currency. The trade off that leads to domestic currency default - the debasement of the currency that comes with printing more currency versus the pain of default - has resulted in governments defaulting on local currency borrowings. If the probability of such default exists, even if slight, government bond rates are no longer risk free.

The most common and widely used measures of government default are sovereign ratings from S&P, Moody's and Fitch. While ratings and default rates are highly correlated over time, suggesting that ratings agencies do a good job, on average, there is also evidence that ratings changes are lagging indicators. An alternative measure of sovereign default risk comes from the Credit Default Swap (CDS) market, where investors can buy or sell insurance against default by governments. CDS prices tend to update faster than sovereign ratings, but come with more volatility.


The absence of a risk free investment can have significant effects on both portfolio management and corporate finance. When investors lack a safe haven, they will  become more risk averse and charge higher prices for risk. Higher prices for risk will translate into lower prices for all risky investments; we should expect to see stock prices and corporate bond prices decline. When firms have no risk free investments, lenders to these firms will be more wary about lending to them (leading to lower debt ratios) and investors may be less inclined to allow companies to accumulate cash (since that cash will be invested in risky assets).

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Will the financial overhaul bill fix what's wrong with banks?

On Friday, congressional conference committee members announced that they had reached agreement on the final contours of the financial overhaul bill. The bill is expected to be put to a final vote in the next week and perhaps be ready to be signed into law by July 4. Knowing the speed with which Congress completes tasks, I will not hold my breath, but it is time to examine what's in the bill and whether it will accomplish its stated objective: to put financial services firms (and especially banks) on a firmer footing and to prevent another banking crisis.

The bill is almost 2000 pages long, which scares the daylights out of me, but it supposedly contains the following ingredients (I will admit that I have not read whole chunks of this bill and what I have read is mind numbingly boring):
Regulatory framework: In addition to allowing regulators to seize and break up troubled financial service firms, the bill allows regulators to recoup the costs of the bailout by making other financial service firms with more than $50 billion in assets pay a fee. In tandem, it reduces the Fed's emergency lending powers and prevents bankers from having a say in who gets to be a Fed president. The Office of Thrift Supervision will cease to exist and the Fed will retain oversight of community banks.
The Volcker Rule: The rule restricts banks from trading with their proprietary capital and from investing more than 3% of the capital in hedge or private equity funds. It also limits banks from bailing out hedge funds that they have invested their capital in.
Derivatives: Standard derivatives (on foreign currency, interest rates etc.) have to be traded on exchanges and backed up by clearing houses, with standardized capital and margin requirements. Banks can still create customized derivatives for clients, but only in restricted circumstances. Banks have to create separate entities for their swap business.
Consumer Agency: There is a new federal agency (Consumer Financial Protection Bureau) that is supposed to protect consumers from fraud/misinformation in financial service company products (including mortgages) by regulating these products and enforcing the regulations.
Investor protection/ power: The SEC can set standards for brokers who give investment advice and hold them to the same fiduciary duty requirements already governing investment advisers. Hedge funds and private equity funds have to register as investment advisers and provide information on trades.
Securitization: Banks that package assets and securitize them are required to hold 5% of the credit risk on their balance sheets.
Credit Rating firms: Allows investors to sue ratings firms for "knowing or reckless" failure in assigning ratings.

The reviews are already coming in. On the one hand, there are some who believe that this reform is too little, too late and that it will do nothing to prevent the next crisis. These critics feel that Congress should have returned Glass-Steagall to the books and broken up big banks. At the other extreme, there are some who believe that the heavy hand of regulation will destroy the competitiveness of US banks, by making them less profitable and valuable, and move the derivatives and swaps businesses to offshore locales. Strange though it may seem, I think that both sides are right on some issues and wrong on others.

Focusing just on the bank-related portion of the bill, there are three questions that I would like to address:
1. Will this bill prevent financial service firms from becoming "too big to fail"?
I don't see how this bill will reduce the likelihood that banks will become "too big to fail". While the bill doles out some punishment to larger banks - the fees on banks with more than $ 50 billion in assets and the exemption of smaller banks from some of the regulations - there is nothing in the bill that will prevent banks from becoming larger. In fact, given that a ton of regulation is going to emerge from this bill, I will predict that the largest banks will have a competitive advantage when it comes to playing the "rules" game and get even larger. I will also predict that the requirement that banks carve out the swap business and other risky businesses will make them more complex and less transparent. From a valuation standpoint, I am not looking forward to valuing either JP Morgan or Bank of America in a couple of years.

2. Will it reduce "bad" risk taking at banks?
The focus of this bill is clearly directed at trying to prevent "bad risk taking" by banks, where "bad risks" are defined as very large risks, which if they pay off, deliver large profits to the bank, but if they fail, become systemic risk that taxpayers are called upon to cover. The separation of the swap businesses at banks, the restrictions on derivatives and the limits on investing proprietary capital in hedge funds seem to be directed at this bad risk taking. On all counts, the lawmakers are reflecting the conventional wisdom of both academics and practitioners on the roots of the 2008 banking crisis and the legislation is written to prevent a re-occurrence. Having watched investment banks operate for 30 years, I believe that they will find new and never-before-seen ways of taking large risks. I will predict that the next crisis will look nothing like the last one, and that this legislation will not only do little to prevent it but will actually contribute to it (by driving risks underground and away from the regulatory eye). Until we deal with the compensation structures at these institutions, where decision makers profit from upside risk and are relatively unaffected by downside risk, we are designed to repeat our mistakes over and over again: "Groundhog Day" in financial markets.


3. Will it make banks less profitable?
Interesting question. At first sight, the answer seems to be yes, since there are restrictions on banks investing in hedge funds and limitations on their derivatives and swaps businesses. On a pure return on equity basis, these are some of the highest return businesses for banks but they are also the highest risk businesses. As an investor in banks, I have always looked at these businesses with a jaundiced eye: they earned high returns but I am unconvinced that they earned high excess returns (over and above the risk-adjusted cost of equity). My prediction is that, if this legislation is passed and put into effect, the returns on equity at banks will decrease, as they return to safer businesses, but their excess returns may very well increase, as the regulations scare away new entrants. Bottom line: Banks may become less profitable (if you define it in terms of return on equity) but in the process become more valuable.

Like all legislation, this one is written with the best of intentions. I hope it succeeds but I don't think it will.

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Valuation Approaches...

I have always believed that valuation is simple at its core and that we choose to make it complex. Furthermore, the determinants of value have not changed through the ages; all that has changed are the estimation practices. One of my pet peeves relating to valuation is when an entity (usually a consultant, academic or an appraiser) takes a standard valuation equation, does some algebra, moves terms around and then claims to have discovered a new and "better" valuation model.

Each consulting firm has its own proprietary value measure, with a fancy name and acronym (Economic value added (EVA), Cash Flow Return on Investment (CFROI), Cash Return on Capital Invested (CROCI) etc.) that it markets to its clients as the magic bullet for value creation. To make themselves indispensable, consultants usually add computational twists that require their presence. To get a sense of how these measures are marketed, you can check out books on each (usually written by the measure's developers):
CFROI
EVA
CROCI
All of these models share two themes. First, they relate the value of a business to excess returns (returns earned over and above the cost of capital or equity). Second, each claims to be easier to use, more intuitive and better than the other models out there.

With analysts, the search for a better valuation approach usually takes the form of concocting new multiples or modifying existing ones. Consider the PEG ratio, a favored tool of analysts following high tech (and growth) companies. The PEG ratio is obtained by dividing the PE ratio by the expected growth rate in earnings per share, and companies that trade at low PEG ratios are considered cheap. It is viewed as a less time-intensive and assumption-free substitute for intrinsic valuation.

As analysts and consultants push their favored approaches to the forefront, it is no surprise that most of us feel overwhelmed by the choices that we face. Which of these dozens of approaches will yield the right value? How do I pick? At the risk of being simplistic, let me offer a solution. Pick the approach that you feel most comfortable with and use it correctly. The value you obtain will be identical to the value you would have obtained using any alternate approach. I have an extended survey paper that I wrote on valuation approaches (and their history) in 2005 that can be downloaded online, if you are interested:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1625010
Valuation is not rocket science. Valuing companies may not be easy but the challenges we face are not in valuation theory but in estimation practice. Put another way, we know exactly how to value companies. What we do not have a handle on is how best to estimate growth, risk and cash flows. So, let's stop concocting new models and theories and start thinking more seriously about how best to estimate cash flows for a cyclical firm, risk for a regulated company and growth for young start-up firm. The second edition of one of my books, The Dark Side of Valuation, is dedicated to this concept. You may not like or agree with some of the solutions that I have to estimation challenges, but I hope it will start you thinking about how best to deal with these challenges.

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What is "fair value"?

What is the fair value of an asset? Sounds like a simple question but the question has taken on a life of its own, given recent changes in both accounting and legal standards. In both contexts, the rule makers contend that their objective is to ensure that assets are recorded at fair value and have created rules to ensure that this happens.

Let us start with accounting. The push towards fair value accounting has now become an article of faith for accounting standards boards. In the United States, FAS 157 (the very fact that we are at rule number 157 tells you something about how accountants think - the more rules the better) provides a synopsis of what the accounting definition of fair value. I have expressed my skepticism about fair value accounting before on this blog and made my case for why this is not only a good idea. 

In legal circles, the hypocrisy about fair value is even greater. Appraisers are supposedly unbiased and fair in their estimates in value, no matter who they work for or which side of the legal divide pays them. The Internal Revenue Service has made this requirement explicit in its guidelines for appraisers. All of the valuation appraiser organizations - The National Association of Certified Valuation Analysts (NACVA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA)- argue that their members provide fair, unbiased estimates of the values of businesses.

I have a simple definition (and test) of fair value. If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either  a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.

Let's be honest. Asking "biased" appraisers to estimate fair value is a hopeless task; the bias comes from the way appraisers get compensated/ paid.  Either change the way that we hire/pay appraisers or accept that each side's appraisers are going to come up with valuations that reflect which side of the divide they are coming from.

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Parent versus Consolidated financial statements

My last post on valuing the Tata companies, all of which have significant holdings in other companies, has raised a natural follow up question. When valuing a company, is it better to use stand-alone parent company financial statements or should we use consolidated financial statements?  More generally, which of these two should you focus on as an investor/manager/regulator?

Accounting Background
The question of whether to use parent-company or consolidated statements becomes an issue only when a company has cross holdings in other companies. To illustrate the difference, consider a simple example, where company A owns 60% of company B. Company A can report its financial results in a parent company statement or in a consolidated statement.
a. If it chooses to report the financial results in a parent company statement, the operating income statement will center on just company A's operating results. The revenues and operating income will reflect only company A's operations. However, there will be a line item on the income statement, below the operating income line, which will include 60% of the net income of company B.
On the balance sheet, only the operating assets and liabilities of company A will be recorded. However, there will be a line item on the asset side of the balance sheet that reflects the accountant's estimate of the value of the 60% of company B; the rules on how to estimate this value and how often it has to be updated can vary from country to country.
b. If the financial results are in a consolidated statement, the operations of company A and B will be combined. As a result, the revenues, operating income and other operating numbers (depreciation, cost of goods sold) will reflect the sum of those numbers for companies A and B. In a similar vein, the assets and liabilities on the balance sheet will reflect the combined values of companies A &B, notwithstanding the fact that company A owns only 60% of company B. The accounting adjustment for the 40% of company B's equity that does not belong to company A takes the form of minority interest, shown on the liability side of the consolidated balance sheet. Again, the rules on how to estimate this value and how often it gets updated varies across countries.

A final note on consolidation. Consolidated statements exclude intra company transactions. Thus, if company A sells $ 100 million in products to company B, the parent company financials will show revenues of $100 million for company A and costs of $ 100 million for company B, but the consolidated statements will net them out and show nothing.

Why would a company choose to use one versus the other?
It is not always a choice. In the United States, companies are required to consolidate financial statements, if they own a controlling stake of a subsidiary (defined as >50% of the outstanding equity). They do not have to consolidate minority holdings in companies. In general, US companies are required to report only consolidated statements and do not have to provide parent company financials, but these consolidated statements represent a mix of consolidation (for majority stakes) and parent company rules (for minority stakes).

The rules for consolidation are similar in international accounting standards. In much of Europe and in many emerging markets, companies will report both parent company and consolidated statements in the same annual report, with wildly different results. What does add to the confusion is that the rules on consolidation still vary across markets.

All of the Tata companies that I valued had both parent company and consolidated financial statements in their annual reports. Tata Steel, for instance, had a parent company statement, where its holding of equity in Corus Steel was shown as an asset on the balance sheet and a consolidated statement, which reflected the combined revenues and operating results of the companies, with a minority interest item reflecting the portion of Corus Steel that is not owned by Tata Steel.

Valuation fundamentals
 In theory, you can value a company using either parent company or consolidated statements, with the following key differences:
a. Parent company financials: If you value a firm, using parent company financials, you are using the operating income and cash flows (cap ex, depreciation, working capital) of just the parent company. Consequently, discounting the cash flows at the cost of capital yields a value for just the parent company. To value the equity in this company, you will have to subtract out net debt in the parent company and add the value of equity in cross holdings, using either the book value of these holdings as a base or through an intrinsic value of the subsidiaries.
b. Consolidated financials: If you value a firm, using consolidated financials, you have valued the parent firm and its consolidated subsidiaries together, since your earnings and cash flows reflect the combined earnings and cash flows of the companies. To get to the value of equity in the company, you will have to subtract out the net debt of the combined companies and the estimated value of the portion of the equity in the subsidiary that does not belong to the parent company. Again, this estimate can be based upon the book value of minority interest or on the intrinsic value of the subsidaries.

Which set of statements for valuation?
If I had access to full information on both the parent and the subsidiaries, I would value a company based upon its parent company financials and then value every one of its subsidiaries, using their individual financial statements. I have two reasons for this bias:
1. This would give me the maximum flexibility in terms of valuation inputs - the cash flows, growth and risk can be very different across parent companies and subsidiaries. The final value of equity in the company would then be the summation of the values of equity holdings in the parent company and all subsidiaries.
2. It allows me to avoid the two items in consolidated financial statements that give me headaches - goodwill (and whatever accountants choose to do with that cursed item) and minority interests (where I have trust an accountant to estimate the value of a holding)


In practice, though, this ideal is not easy to reach. In many cases, there will be incomplete or no financial statements available for subsidiaries. In this case, it becomes a choice between two imperfect estimates of value, the book value of the holdings in subsidiaries in parent company statements or the minority interests in consolidated statements.  The more homogeneity there is between the parent company (same business, same growth and profitability trends), the greater the argument for using consolidated financial statements, valuing the combined company and subtracting out the estimated value of the minority interests in the subsidiary. As

In the case of Tata Steel, for instance, I chose to value Tata Steel as a stand alone company in 2009 and added the book value of the Corus holding to arrive at the value of equity in Tata Steel overall. I could have valued the company using consolidated statements and subtracted out the value of minority interests. The choice ultimately was driven by the fact that Tata's Steel's consolidated statements were still in a state of flux in 2008-09, two years after the acquisition of Corus. As Corus is integrated in Tata Steel, the consolidated statements should become more informative. In fact, the 2009-10 consolidated statement looks far more settled and I may try to value the company based upon these numbers now.


More generally, which statements should you use to assess a company?
While the answer I have given is valuation focused, there are many constituent groups that use financial statements. Bankers and ratings agencies look at them, so that they can assess default risk. Portfolio managers and investors use the numbers from financial statements to compute ratios and multiples (PE, EV/EBITDA..) Since the rating is for a company, with its cross holdings, and the multiple is for the equity in the consolidated company, there is an argument to be made that we should be looking a consolidated statements. However. this makes sense if and only if the parent company has holdings in subsidiaries with very similar fundamentals - risk, growth and cash flows. If not, it would make more sense to judge the parent company and its subsidiaries separately and to make comparisons to different peer groups.

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Cash and Cross holdings

I am sorry about the long break between posts but I was on the road for much of the last two weeks and grading exams prior to that. I started my road trip with sessions in Slovenia and Croatia and continued on to India to make a presentation to the Tata Group, one of India's premier family groups, with a long history of operating in every aspect of Indian business. As part of the preparation, I did value a Slovenian pharmaceutical company (Krka), a Croatian tobacco company (Adris Grupa) and four Tata companies (Tata Chemicals, Tata Steel, Tata Motors and Tata Consulting Services). The presentations and the spreadsheets containing the valuations are online and can be accessed by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/country.htm

Without belaboring the details, there were two key issues that came up when valuing Adris Grupa and the Tata Companies.

1. Cash holdings: Adris Grupa, as a tobacco company with significant operating cash flows, has accumulated a very large cash balance; it amounts to 20% or greater of the overall value of the firm. Adris is clearly not the only company that accumulates cash and it is not a phenomenon just restricted to emerging markets. Technology companies in the United States, such as Apple and Microsoft, have also been avid cash accumulators. While the conventional valuation practice with cash has been to add the cash balance to the value of operating assets, thus adopting the common sense rule that a dollar in cash has to be worth a dollar, there is substantial evidence that markets do not always treat cash as a neutral asset. In particular, markets seem to view companies that generate poor returns on their operating assets (less than the cost of capital) and accumulate cash with disfavor, while being much more sanguine about companies with good investment track records and substantial cash. Apple, for instance, is clearly not being penalized (and may be even be rewarded) for its large cash balance; after the most recent decade, investors trust the company to find good uses for the cash. In the Adris valuation, one of the concerns I raised was that the company's return on capital has lagged its cost of capital.It is therefore possible that the market may be discounting the cash holdings; a Croatian kuna in cash may be valued at less than a kuna.


2. Cross holdings: The Tata companies that I valued, with the exception of Tata Consulting Services, shared a common feature. A third to half the value that I estimated for each company came from  holdings in other Tata companies. In effect, investing in any Tata company is a joint investment in that company and a portfolio of 25-30 other Tata companies. While one reason for this cross holding structure is corporate control - it allows the family to preserve its control of the group companies - there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.

The Indian equity markets today are different. While Indian companies have their own share of scandals and investment advice/ equity research can be tainted, the market is wider (thousands of publicly traded companies) and much deeper (more investors both from Indian and from outside). The cross holdings at family group companies can now become a valuation problem for two reasons:

1. To value one company, you have to value dozens:  Consider a firm with holdings in 25 other companies. Even if we could access information on these companies (because they are public), a thorough analysis of the firm would require a valuation of 26 companies. (Using the book value of these holdings, which are not marked to market, will yield skewed estimates. Using the market values of these holdings risks feeding any market mistakes into your valuation).
2. Some cross holdings cannot be valued: With many family group companies, some of the companies in the group are privately owned and never go public. As a consequence, there is little or no information that can be used to value companies. We have no choice but to use book value.

If you carry these concerns through to their logical conclusion, it is possible that investors either unconsciously (by using book value) or consciously (by discounting the market value of the cross holdings) will reduce the values of family group companies below what they would have been worth as independent companies. In effect, the sum of the parts will be greater than the whole. I have a paper on valuing cash and cross holdings that explores the technical details of this discount:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485

In my next post, I hope to examine the link between corporate governance and the phenomenon of cash and cross holdings.

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"We are not in Kansas anymore"

It looks like that they have found the culprit for the 1000-point intraday swing on the Dow 30 on May 6. It turns out that rather than the hedge funds that were initially suspected, it was a Kansas-based money management firm, Waddell & Reed Financial, that traded 75000 e-mini S&P 500 contracts between 2.32 and 2.51 pm on May 6. That amounted to 9% of the trading volume on e-mini contracts during that period and all of the trading was executed by one trader at the firm. Incidentally, the CME report that uncovered this news also found that neither the trader nor the firm were acting imprudently or were at fault. This news item may still leave you a little bemused. How does one trader at a small money management firm cause a drop in market value of billions? And how can they not be at fault if they caused a market collapse? So, here is my attempt at providing an explanation.

What are e-mini contracts?
E-mini contracts are future contracts on the S&P 500. The "mini" in the name refers to the fact that each contract is $50 times the level of the index. (If the S&P 500 is at 1200, each contract is for a notional value of $60,000) E-mini contracts were introduced in the late 1990s by the Chicago Mercantile Exchange to provide a "smaller size" alternative to the long-standing S&P 500 futures contracts which were set to $500 times the level of the index; they have since been dropped to $250 times the level of the index.

How do investors use these contracts?
As with all futures contracts, there are speculators and hedgers in the e-mini market. The speculators buy or sell the e-mini to try to profit from overall market movements. Thus, a bullish (bearish) investor will buy (sell) e-mini contracts and make money if they are right on market direction. (If you buy 100 contracts and the S&P 500 moves up 80 points, you will make 100* 80 * 50 = $400,000; the 50 refers the fact that the futures contract is $50 times the index) The hedgers use the index to protect existing portfolio positions. Thus, a portfolio manager who wants to either protect profits already made or one who desires a floor on his or her losses will sell e-mini futures. (A portfolio manager who has $ 1 billion in equities can sell enough futures contracts to ensure that the value of the position does not drop below $ 900 million. Generally speaking, the more insurance you want, the more futures contracts you will have to sell. In more technical terms, you are creating a synthetic put on your portfolio, using options, and the number of futures contracts you will need to sell can be extracted using an option pricing model)

In many ways, the hedging position with futures is a lot more volatile than the speculative position, simply because the degree of selling is tailored to what the index does. As the index falls, the selling will often accelerate. partly because the point at which different portfolio managers hedge can vary. Thus, some portfolio managers may begin their hedging when the market drops 3%, others at 5% and still others at 10%.


How can futures affect the level of the index?
With financial futures, there is a third player that we have not mentioned in the section above, the arbitrageurs. Arbitrageurs have neither a market view nor do they have a portfolio to hedge. Instead, they are looking to make riskless profits, To prevent these profits, the futures price and the spot price are linked together in a rigid relationship:
Futures Price = Spot price (1 + riskfree rate - dividend yield)
To see why, assume that the S& P 500 is at 1000 right now, that the riskfree rate is 5% and that the dividend yield is 2%. Assume also that the one-year futures price on the index is 1045. Here is the arbitrage:
1. Borrow 1000 at the riskless rate and buy the index today at its spot price of 1000.
2. Sell the one-year futures contract at 1045.
3. During the next year collect dividends on the stocks in the index (2% of 1000 = 20). At the end of the year, deliver the stocks in the index in fulfillment of the futures contract and collect 1045. Pay the interest at the riskfree rate on the initial borrowing of 1000 (from step 1) and pocket the difference:
Profit = 1045 - 1000*.05 +20 = 15
To prevent this profit from occurring, the futures price has to be 1030. There are points at which you can quibble - being able to borrow at the riskfree rate and knowing the dividends for the next year - but they are minor ones, especially for the larger institutional players. The overall dividend yield on the S&P 500 index is very predictable and you can borrow at close to the riskfree rate, especially if you can back the borrowing up with marketable securities (as is the case here).

This futures-spot relationship creates the link. If one (spot or futures price) moves, the other has to follow. Thus, if there is an imbalance in the futures market, the futures price will change and the spot will follow. On May 6, here is how the script unfolded. The sell order placed by the trader at Waddell and Read was large enough to cause the e-mini futures price to drop significantly and the spot market had to follow. The fact that the trade was entirely driven by liquidity or hedging concerns (and not by information) resulted in a swift correction of both the spot and futures markets, with both reversing the losses by 3.30 pm.

What should be done about this?
I think that the May 6 collapse was an aberration. In what sense? The trade by the W&R trader occurred at a point in the day when the market was already skittish - it was down 250 points as worries about Greek default were rampant. When traders get antsy, they look for clues in trading by others. In other words, they assume that large trades, especially anonymous ones, must be coming from more informed traders (such as the Greek central banker) and they follow the trade.

While there is always the potential for this type of panic with or without futures markets, the existence of futures contracts has made it easier to create this type of panic. To the regulatory-minded, the solution seems simple. Ban futures trading or add more restrictions to the trading.  I disagree with the sentiment and think more harm than good will come out of it. As an investor who uses futures contracts very rarely and only to hedge, I still benefit from the liquidity created by these markets and bear little or no cost, simply because I choose not to trade frequently. In fact, as an intrinsic-value driven, long term investor, selling panics such as these can actually be opportunities to take positions in companies that I have always wanted to buy. For short term traders, though, futures markets may increase intraday volatility and thus their perception of risk in equities. I cannot speak for them but they are short term traders by choice!!

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