GROUP WORK PROJECT # 1 M5 MScFE 560: FINANCIAL MARKETS

GROUP NUMBER: 44000

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ANURAG RAJESH AGRAWAL INDIA [email protected]

LUO FAN CHINA [email protected]

DANISH RIZWAN PAKISTAN [email protected]

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GROUP WORK PROJECT # 1 M5 MScFE 560: FINANCIAL MARKETS
Group Number: 44000
Income Stocks

Investors, being part owners of a company are entitled to the profits of the company proportionate to
their stake. A company, upon making a profit may choose to either invest it back into the business, repay
any outstanding debt or disburse the profits amongst its shareholders or a combination of these. These
disbursed profits are called dividends. Income stocks are those where the company regularly pays
dividends almost every year.

Naturally, most of the income stocks are large profitable companies. These businesses generate healthy
profits and are no longer in the growth phase. Hence, they are left with a large sum of cash which is then
paid back as dividends.

Let us consider the Dow Jones US Dividend 100 Index to look at the historical performance of income
stocks. The average price return for the last 10 years has been 6.64% with the average total return
(including dividends) being 10.27%.

The standard deviation of the last 10 years is 14.44%. However, the same for S&P 500 is 14.93%. This
implies that the volatility of income stocks is just slightly lower than the overall market.

This portfolio has a skewness of around 0.449 meaning that negative returns are a little more probable
than positive ones.

The portfolio has a kurtosis of -2.83 meaning the tails are significantly fatter than normal distribution.

Looking at the skewness and kurtosis we can conclude that large price drops are far more likely as
compared to a normal distribution.

Just like any other stock, income stocks can be sold short if an investor wishes so. Following are the steps
to be followed to short sell stocks:

● Borrow the stocks from someone who owns them (typically the broker)
● Sell the stocks in the market
● Pay the borrowing cost to the lender
● Buy back the stocks from the market
● Return the stocks to the original owner

There is no credit risk in this portfolio as equities do not have a credit risk.

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Group Number: 44000
Sovereign and Corporate Bonds’ Portfolio Summary

Both sovereign Bonds and corporate bonds normally display distinct performance statistics compared to
stocks and cryptocurrencies, as they tend to be less volatile. The real bond market always trades and
displays in rates (yield to maturity) rather than exact tradable price. We use Bloomberg Bond Indexes to
display the basic statistics of bond assets. We use Bloomberg US Treasury 1-3 Year Total Return Index
Value to represent the sovereign bonds, and use Bloomberg US Corporate 1-3 Yr Index to represent the
corporate bonds.

In recent 5 years, the annualized return for US Sovereign bonds and Corporate Bonds are 1.20% and
1.97% respectively (daily average returns are 0.0048% and 0.0078% respectively). The annualized
volatility for both bonds are 1.71% and 1.94% respectively. In terms of the skewness, sovereign bond
daily returns show 0.83 skewness, showing the probability of extreme losses is relatively small. Yet
corporate bonds’ skewness is -0.8, their probability of extreme loss shall not be ignored. In terms of the
kurtosis, sovereign bonds’ kurtosis is 9.86, while that of corporate bonds is 15.2. This difference shows
that bonds’ return tend to be more concentrated around the mean value than that in normal
distribution.

Apart from the return statistics, the bond portfolio has two characteristics that are essential in
comparison with stocks and cryptocurrencies. First of all, bonds can be sold short, both sovereign and
corporate bonds can be sold short. To go through the mechanism, if we want to sell a bond short, we
shall first create a margin account with collateral prepared for the shorting. We then borrow the bonds
from bondholders with specific collateral and margin clauses, and then sell the borrowed bonds in the
market. Before we purchase equivalent amounts of bonds back, if the bonds pay coupons, we shall
deliver the coupons to the bond lenders. In the end, we shall buy back the same amount of bonds to
bond lenders and close the shorting deal over. Apart from the simple bond shorting, we can also use
derivatives to short bonds, for example, we can use future/forward contracts, or use option contracts to
do the hedge, with similar effect as shorting the bonds.

Secondly, bonds display credit risk. In the case of sovereign bonds, the credit risk inherited in the
national credit risk. In practice, we consider the US treasury bonds to have zero credit risks. However, the
sovereign bonds issued by developing countries may show certain country-level credit risks to
international investors, as countries may go bankrupt as we have witnessed in 2011 and in earlier
history. To clearly illustrate the credit risk, credit risk is the risk that the bond issuer may not be able to
pay back the capital or the bearing interest to a bondholder, normally it is associated with the default
risk. In the case of corporate bonds, the credit risk can be hardly mitigated. The corporation that issued
bonds may encounter management difficulty or liquidity shock, hence the company may fail to pay the
interest or the bond capitals. In this case, investors may give the bond issuer a grace period for it to get
sufficient financing, or the bond issuer may file bankruptcy to the government.

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Group Number: 44000
Cryptocurrencies comparison with “Income Stocks” and “Sovereign and corporate bonds”

Cryptocurrencies are relatively new financial assets as compared to income stocks or Sovereign and
corporate bonds. Cryptocurrencies are digital currencies which are encrypted and secured using
cryptography algorithms. Bitcoin was the first cryptocurrency released in 2009 and the first
cryptocurrency exchange named Bitcoin Market soon came into being in 2010. Some studies show that
cryptocurrencies have been used as an alternative way to carry out transactions. Baur et al. (2018)1 show
that the largest cryptocurrency —Bitcoin— is not related to traditional asset classes, such as stocks or
bonds, thus indicating the possibility of diversification.

Cryptocurrencies show higher returns and volatility compared to income stocks and Sovereign and
corporate bonds, which are relatively stable portfolios. Analyzing data from Yahoo Finance for Bitcoin
(BTC) for over the last 5 years (07 November 2018 to 05 November 2023), we see a daily average return
of 0.16% with a standard deviation of 4%. This much standard deviation shows a significantly high
volatility in returns. Analyzing further, the returns show a low (and slightly left) skewness of -0.38
meaning the returns are overall symmetrical. The kurtosis value of 9.4 shows a high kurtosis where the
return has a very high peak around the average value. When we analyze the same data for annualized
returns, we see the true picture of cryptocurrency behavior. Annual average return is 106% (meaning
you double your investment on average over the year), but also with high standard deviation of 195%,
reiterating the volatility of cryptocurrencies. Further, the returns show a high right skewness of 1.86 and
a high kurtosis value of 3.84 where the returns have a very high peak around the mean value of 106%.
Fig A compares the Daily vs Annual returns of Bitcoin.

Normally shorting is associated with stocks but cryptocurrencies can also be shorted, even more so since
cryptocurrencies are volatile and thus more suitable for short selling. When short-selling a stock or
normal financial asset, the investor believes the price of the asset is expected to drop hence he borrows
the asset, sells it at high price and when price drops, the asset is bought back from the market and
returned. For cryptocurrencies, the model is similar with a slight difference. Instead of borrowing actual
units of cryptocurrency, the investors use future contracts and other crypto-related derivatives. Shorting
can be a useful hedging strategy to consider minimizing the loss in one’s portfolio.

The credit risks associated with Sovereign and corporate bonds do not apply to directly cryptocurrencies.
Still there are credit risks similar to that of stocks and other standard financial assets associated with the
investment firms involved in trade of cryptocurrencies and assets. Also there are other risks like ability
(or lack of) to convert cryptocurrency into fiat currency and the technological and cybersecurity risks
associated with a decentralized digital currency make cryptocurrencies a unique asset.

Generally cryptocurrencies can be considered more similar to income stocks in terms of returns,
volatility, trading mechanisms and risks as compared to Sovereign and corporate bonds.

1
Baur, Dirk G., Kihoon Hong, and Adrian D. Lee. 2018. Bitcoin: Medium of exchange or speculative
assets? Journal of International Financial Markets, Institutions and Money 54: 177–89.

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Group Number: 44000
Interview Transcript

Journalist: What was the primary reason for FTX collapse?

Non-tech: FTX was leveraging customer assets, specifically, customers’ personal cryptocurrency deposits.
According to Allison from CoinDesk (2022), the sibling corporation of FTX, Alameda Research, held
around $5 billion in FTT which is the token currency of FTX, not fiat currency. Hence its solvency is
questionable under this highly concentrated portfolio. Meanwhile, it has been revealed that a massive
amount of funding of Alameda was from FTX’s customer deposits. When CoinDesk released the report,
followed by the argument between Binance and FTX. The value of FTT significantly declines, resulting in
a large number of FTX market participants withdrawing money from their accounts. However, the FTT
market is not liquid compared to other major cryptocurrencies. Massive withdrawals triggered liquidity
shocks to FTX, and left Alameda with significant losses. FTX crashed on Nov.12, 2022, exactly 10 days
after CoinDesk’s report.

Journalist: Tech RM, would you like to add to Non-Tech RM’s points?

Tech: The primary reason for FTX collapse was misappropriation of funds deposited by their customers
wherein these funds were lent to Alameda Research, a trading firm also founded by Sam Bankman-Fried.
Most of Alameda’s assets were in FTT, a token created by FTX itself.

Journalist: It seems that the primary reason for FTX collapse is due to FTX’s misbehavior. Has the
cryptocurrency market enacted regulation to avoid similar issues?.

Non-tech: In Japan, a similar regulation exists where crypto-exchanges have to register themselves with
the Financial Services Agency and comply with Anti-Money Laundering and Countering the Finance
terrorism regulations. And in the USA, a framework has been announced which gives more authority to
the Security and Exchange commission and Commodity and Futures Trading Commission to regulate
cryptocurrency trading and exchanges.

Journalist: From outsiders’ point of view, it seems that the cryptocurrency market is different from the
traditional asset regime. Is regulation difficult to be formulated in the cryptocurrency market? How
different is the market compared to stock and bond markets?

Non-Tech: Cryptocurrencies key characteristics include anonymity and decentralization, due to which
some would argue that cryptocurrencies should not be regulated. When formulating a regulation, a
balance is required to protect investors from fraud while maintaining and encouraging technological
development in the digital currency space.

Journalist: From your perspective, what regulation shall be imposed? Could you please give me a specific
outline of the regulation itself

Non-Tech: In context of the FTX collapse, we can see a need to maintain an arm length space between
the exchanges and the wallets/assets where customers maintain their currency. One company could be

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Group Number: 44000
licensed to store cryptocurrency on investors behalf and a separate company should be allowed to trade.
Same company should not be allowed to do both.

Tech: Well, I believe that the practice of depositing the money with the exchange is inherently flawed.
We do not see this happening in the traditional financial markets. Hence, I propose that client funds
should be stored with a separate regulated custodian. This shall apply to all exchanges globally which
facilitate trading in cryptocurrencies. This is necessitated by the simple reason that exchanges also
participate in trading on their own as well as other exchanges. The absence of a separate entity which
keeps an eye on reserve funds can easily lead to malpractice just as in the case of FTX.

Journalist: How will this prevent the primary reason for FTX collapse?

Non-Tech: With such regulation, a check and balance is maintained when funds are traded on
exchanges. Similar regulations in conventional financial markets have proven to be successful historically.
I am referring to the US stock market crash of 1929 after which the congress passed the Glass-Steagall
Act, which separated investment banking and the high-risk activities of Wall Street, from commercial
banking. Such regulation will disaggregate functions like exchange trading, broker-dealer, custodial
functions into separate entities which would result in mitigation of conflict of interest. Such regulation
will also allow an audit and accountability of the assets and liabilities of exchanges and ensure them to
comply with the thresholds for maintaining liquidity.

Journalist: In addition to the following question, How will this regulation restrict unauthorized access to
customer funds?
Non-tech: Separation of exchange and crypto funds will help maintain controls and checks on gateways
and channels used for accessing the funds. In case of FTX collapse, unfair and direct access was being
given to Alameda to access the exchange and make transactions which not just allowed unfair trading
advantage but also unchecked funds usage.

Journalist: As you have mentioned, decentralization is the fundamental philosophy in cryptocurrency’s

Tech: Yes, the decentralized nature of cryptocurrencies is a roadblock for this regulation. To counter this,
an International Securities and Exchange Board for Crypto Currencies can be created. Just like we have
the International Monetary Fund which monitors the monetary system of its member countries, the
international SEC can act as a custodian of assets for all crypto trading in the member countries.

Journalist: It seems the regulation would largely benefit the ecosystem of cryptocurrency trading. From
your professional perspective, what would be the downside risks of this regulation, and how will this
regulation reshape the market ecosystem?
Tech: A major potential downside to such regulation would be the delay and lag in digital transactions
that take place at exchanges. Arbitrage trading is one of the popular financial activities in the
cryptocurrency ecosystem and timing and speed of execution play a very important role in such

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GROUP WORK PROJECT # 1 M5 MScFE 560: FINANCIAL MARKETS
Group Number: 44000
transactions. Delays arising from separation of exchange and fund storage can result in loss or missed
opportunity in arbitrage trading.

Journalist: Since you mentioned that the occurrence of the FTX crisis was due to misbehavior by the
company promoter, how effective do you think ethics training can be in preventing such crises in the
future?

Non-tech: A code of ethics and relevant training can play a major role in mitigating and discouraging
fraudulent behavior and activities. Such training will not just raise awareness within the organization but
also encourage stakeholders to call out any potentially fraudulent activities in a timely manner.

Citation

Allison, Ian. “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s
Balance Sheet.” CoinDesk Latest Headlines RSS, CoinDesk, 16 Aug. 2023,
www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-tr
ading-titan-alamedas-balance-sheet/.