VOLUME II: ISSUE VIII

OCTOBER 2012

INDUSTRY ANALYSIS:
By Teddy Xiong

Retail, Amazon and E-Commerce

In analyzing todays retail and consumer industry, by far the most dominant trend is the shift towards e-commerce and away from traditional brick-and-mortar stores. Past retailing giants including Borders, Blockbuster, and Circuit City have all filed for bankruptcy, attributing their losses to a lack of consumer spending combined with the general economic impacts of the recession. Nevertheless, the increasing role of e-commerce in consumerism today is an undeniable factor in their ultimate demise. At the forefront of this trend is the ever-growing dominance of Amazon. Cost Structure E-commerce businesses naturally have cost structure advantages that enable them to offer discounted prices to consumers. Traditional brick-and-mortar storefronts must account for store employee wages, rental fees, and utilities in their expenses. With virtual storefronts and thus lower overhead costs, Amazon has been able to greatly cut its costs relative to a traditional retailer, passing these savings on to the end consumer. Traditional brick-and-mortar stores must also account for storage costs and optimize their sales per selling square foot. This is especially true with high-ticket items such as home appliances and home electronics that have lower turnover; companies must maintain higher markups on their goods, with the higher profit margins compensating for lower turnover rates. With more centralized storage warehouses and fulfillment centers, Amazon can funnel disparate demands into fewer supply stocks to decrease shelving times and increase turnover in its goods sold. Finally, Amazon has now begun circumventing distributors, directly negotiating with the original manufacturer and publishers and further decreasing its costs. With all of these cost structure advantages, e-commerce businesses generate greater positive cash flow and can offer better discounts for consumers whilst maintaining high margins. Pricing Vulnerabilities Lower prices naturally accommodate the end consumer, and

Amazon has steadily cut into its competitors market share through its price competition. According to a recent consumer study, as many as 45% of customers will walk out of physical stores and complete their purchases online for savings as low as 2.5%. If you double these discounts to 5%, 60% of customers will purchase the product online. And at discounts of 20%, only 13% of customers would complete the purchase in store. This troublesome showrooming phenomenon has long plagued appliance and home electronics retailers, as these companies turn into little more than walk-in trial centers for end-user online purchases. Compound this with occasional free shipping and no taxes and the savings quickly reach the threshold where its simply a better deal online. Not surprisingly, companies like Best Buy and Radioshack have struggled greatly in recent years, and office supply stores like Office Max and Staples are also particularly susceptible to the cheaper prices available on Amazon. Convenience Finally, most consumers appreciate the simplicity and convenience of online shopping. Price comparisons are more easily done online than in stores. Online shopping also enables customers to leave their own comments and testimonials, enabling future buyers to evaluate the quality of an item even without the ability to phys

Story continued on page 4, Industry Analysis

RISEOFTHE MACHINES Guilherme Baiardi

Page 2

ESBEXPLAINED Matt Parmett

Pages 3

TRADE OF THE MONTH KevinGoldfarb

Pages 4

OFFBEATINTERNSHIP Tony Murphy

Page 5

INSIDE THIS ISSUE

WHARTON UNDERGRADUATE FINANCE CLUB

OCTOBER 2012

RISE OF THE MACHINES

By Guilherme Baiardi
Stock prices are volatile, but we accept the unpredictability, even going as far as to embrace it. We can make directional trades, attempting to predict the direction of a particular stocks expected return, but risk is always a factor. This is why the events that took place during the trading hours of July 19th are so mystifying. For a significant portion of the trading day, the stocks of CocaCola (KO), IBM (IBM), Apple (AAPL), and McDonalds (MCD) followed a very particular pattern: they went up for half an hour, then down for another 30 minutes, eight times, from 10 a.m to 2 p.m. Conspiracy theories abound as to the source of the atypical stock movement, but the probable culprits are not that different from the machines you are using to read this now. According to Marko Kolanovic, an analyst at J.P. Morgan (and a finance P.h.D), computer algorithms specially designed to hedge gamma exposure on expiring options were the root cause of this movement. Gamma refers to the second derivative of the options price with respect to the price of the underlying security (the stocks in this case). It tells you how much the delta (change in option price with respect to a change in the price of a stock) changes relative to a change in the stock price. Too technical? Think about it like this: the delta measures how much the option price changes for a $1 dollar movement in the price of the stock, lets say, KO. If the delta is 0.5, that means the options price will increase by 50 cents for every dollar movement of KO. To hedge exposure to this sensitivity, traders usually buy and sell the underlying security in specific proportions so as to create a delta hedge. This protects the portfolio from the price movements of the underlying securitye.g. if the option loses value, the underlying stock gains value. When you add gamma, the proportions of the underlying security that are going to be bought and sold are changing, so you have to be constantly rebalancing your option portfolio. The final consequence of this continuous buying/selling of the shares should go completely unnoticed on a regular trading day, but this was no regular trading day. This was the day before the July expiration date for options. Coke, Apple, IBM, and McDonalds options would all expire the following day. To make things even more interesting, guess which stocks had some the greatest values in expiring options positions? KO, APPL, IBM and MCD. This is where the machines most likely tripped up. In order to completely hedge their delta exposure, the algorithms repeatedly bought and sold the underlying stocks, but did so in disproportionate amounts, probably influenced by the impending expiration date. The algorithm also failed to account for whatever influence its own trading would have on the stock price. Mix this frantic buying/selling in response to very small changes in stock prices with a liquidity starved market, and the result is the mystifying (yet absolutely meaningless) pattern of stock prices seen on July 19th. To the disappointment of some, this wasnt the result of black magic or a government conspiracy, it was just another example of rogue trading algorithms drowning the human aspect of trading. Enough has been said of the algorithms and how high frequency, automated trading is changing the market landscape. I, for one, believe that as technical as markets can be, they are an important reflection of the interests and thought processes of the humans behind it. They are ultimately representative of human behavior. If we are giving that up, if we are allowing machines to do the thinking, then it says a lot about us and where we are going.

IBM (IBM)

Coca-Cola (KO)

McDonalds (MCD)

Apple (AAPL)

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OCTOBER 2012

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NOT JUST ANOTHER ACRONYM:

The EuropeanStability Mechanism (ESM) Explaine
Over the past five years, bailout has become a politically and economically charged term. In light of the recent European debt crisis, the term has evolved to represent the loan packages given to irresponsible governments in order to lead them away from the brink of bankruptcy. Recently, member states of the Eurozone have pushed to formally institutionalize the international bailout system as the European Stability Mechanism (ESM). Will the ESM be an institutional backstop for irresponsible politicians and governments, lending money in times of need to protect against the negative consequences of financial distress? Or will the ESM be an arbiter of sound economic policy and corrective austerity measures, using its financial resources as collateral? To better understand the purpose and workings of the ESM, we must examine its origins, structure, and operational abilities. Background: The European Debt Crisis, the EFSF, and the EFSM The European debt crisis is deeply rooted in the structure of the Euro as a common currency. The Eurozone is a monetary union which integrates wealthy, strong economies and the PIIGS nations -- with high unemployment and low growth -- into one unified system. The root of the crisis is the moral hazard created by a unified European monetary system: poorer countries are motivated to borrow at high levels because they know Germany, France, and the Netherlands will have to share the burden of default. Those countries, including Greece, Ireland, Spain, and Portugal, have built levels of debt that they cannot easily repay without receiving bailouts and implementing severe domestic austerity measures. The debt crisis is driven by investors fears of the effects of sovereign default on European banks, which could be forced to take losses on their large amounts of sovereign debt holdings. The debt crisis came to a head in 2009, when the downgrade of several states sovereign debt prompted investors and politicians to react to the rapidly increasing levels of European government debt. In May 2010, concerns about a possible Greek default led to a bailout of Greece by the European Commission, European Central Bank (ECB), and International Monetary Fund (IMF) a triumvirate known as the Troika. Subsequently, a temporary European rescue fund called the European Financial Stability Facility (EFSF) was created by the European Union to lend money to troubled states, recapitalize European banks, and purchase distressed sovereign debt. The EFSF raised capital by issuing bonds on the global market, and is authorized to borrow up to 440 billion. Additionally, the European Commission (an executive body of the European Union) supervises the European Financial Stability Mechanism (EFSM), which is authorized to raise and lend up to 60 billion. The EFSF and EFSM, however, are temporary international bailout systems. They were created in 2010 to provide financial assistance to troubled states during the debt crisis and are set to expire in June of 2013. The need for longer-term financial stability in the
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By Matt Parmett

Eurozone has prompted membernations to suggest the creation of a permanent ESM to lend to EU states in times of trouble. The European Stability Mechanism: Creation and Operation Because the European Union is founded upon international treaties, major changes in legislation and policies of the European Union typically require the drafting and ratification of new treaties. Accordingly, all 17 Eurozone members must ratify the Treaty Establishing the European Stability Mechanism. Germany was the last to ratify it; on September 12, 2012, its Constitutional Court ruled that German membership in the ESM is constitutional. The ESM is expected to become operational at the end of 2012. The ESM will operate similarly to the EFSF and EFSM. The ESM will be an intergovernmental organization located in Luxembourg, and a partnership between participating states not subject to central EU control. The maximum lending capacity of the ESM will be 500 billion, and the ESM will be able to raise 700 billion (80 billion in paid-in capital and 620 in committed callable capital). The ESM will take preferred creditor status on loans made to troubled nations, with the exception of loans made to the Spanish banking sector for recapitalization. Consequently, governments that borrow money from the ESM agree to pay the ESM before other creditors. Additional powers of the ESM include intervention in the debt and secondary bond markets. The procedure by which troubled states request funds from the ESM is robust. First, a state makes a formal request for funds to the Chairperson of the ESM. Next, the European Commission and the European Central Bank review the potential risk to European financial stability, the sustainability of the countrys public debt, and the countrys financing needs. Based on the findings of the EC and the ECB, the ESM makes a funding proposal, which is voted on by the ESM Board of Governors. The ESM then creates a Financial Assistance Facility Agreement, which acts as a term sheet for the financial package agreed upon by the Board of Governors. Finally, after ensuring that the package complies with policy, the ESM makes funds available to the troubled state. The entire application and review process is expected to take about four weeks. Looking Ahead The ESM is a bold endeavor that institutionalizes international rescue loans in an attempt to maintain long-term fiscal stability in the Eurozone. The organization will reduce the amount of damage caused by irresponsible management of government debt in poorer Eurozone states, but that reduction will also require billions of euros from the richer Euro economies, such as Germany. Europhiles hope that the ESM will promote greater cooperation and economic health in the Eurozone, but Euroskeptics fear that an established rescue system may encourage more reckless borrowing and hurt the larger, more responsible European economies in the long-run.

WHARTON UNDERGRADUATE FINANCE CLUB

OCTOBER 2012
one additional reason that is integral: Yes, Switzerland has been the safe haven of Europe. Its strong budget and low taxes mean that it is a great place to keep money and its currency the Swiss Franc is a great currency to buy. Norway, however, can one-up the Swiss: massive oil reserves. Norway has a booming oil-based economy, but also has the some of the highest HDI and Gini indices, meaning there is very little political risk. To put it bluntly, Norway is the opposite of the rest of Europe: they like their government, they are flush with cash, and they have a huge export economy. As I have shown, this trade will be profitable on both ends. The Euro is doomed to get weaker, and the Krone is to get stronger. To make it better, under this trade, Krone deposits also earn a 0.3% interest premium.
This article was written on October 16, 2012, when EUR/NOK traded at 7.3929 NOK/EUR. Disclosure: I may or may not take a position in this trade in the near future. All data is sourced from Bloomberg or Yahoo! Finance.

TRADE OF THE MONTH:

Sell EUR/NOK (Norwegian Krone)
By KevinGoldfarb
There are very few things in life that are inevitable. Many people believe them to be solely death and taxes. However, there is actually a third: European Sovereign Debt troubles. This trade provides the proper exposure and return to make that inevitability much more profitable than the other two. Why Should I Short the Eurozone? Of the many reasons to be pessimistic about the Euros short- to medium-term viability, I am going to focus on its credibility. During late July, European Central Bank (ECB) President Mario Draghi uttered the words we will do whatever it takes to preserve the euro. These comments may not seem out of the ordinary for a European intergovernmentalist, but they came right on the back of Spanish 10year bond yields soaring above 7.5% and the Euro dropping to record lows against most other currencies ($1.20/, for example). As you have read in Matt Parmetts article, this spike in yields is due to ludicrously high levels of sovereign debt in the periphery countries (Spain, Portugal, Italy, Greece, and previously Ireland). This issue was caused, in part, by unrealistically low borrowing rates and unrealistically high expectations for growth and Eurozone membership benefits. Once the sovereign debt yields started spiking, Central Bankers and the European Council responded with plan after plan to bail out the member states with newly minted Euros. There were two problems with this plan: it deflated the value of the Euro, and the bailout funds imposed restrictions on receiving countries. Although these restrictions, austerity measures, and tax hikes were massively unpopular, they were deemed necessary to attain any resemblance of a balanced budget. Unfortunately these plans did not work, and bond yields maintained their levels. Getting back to credibility, a new plan was devised in Europe: instead of bailing out nations without pre-conditions, use the threat of it to maintain unrealistically high market expectation. This is why Draghis whatever it takes comment sent the Euro soaring over 200 pips (1/100th of a cent) in a matter of minutes. The markets will scrutinize every press release to get any sort of insight into the market. The issue with this comment, however, is that Europeans dont have the stomach to collect billions of euros worth of debt, nor do the Germans care to be further dragged into this slow moving train wreck. In short, there is no bite to the Europeans bark. Their economy will continue to get worse, and the Euro will continue to have less and less value. Norway? Yes, Norway. For three main reasons, the Krone is a great currency to buy. First of all, its in Europe but not part of the European Union, which means the country is not susceptible to any debt collectivization. Next, Norway has the second highest government budget surplus in the world and the second highest GDP/per capita. While it is a very wealthy country with very wealthy people, there is

Industry Analysis, story continued from page 1

ically inspect it. Direct shipping leaves all of the logistics to the companies, furthering relieving the burdens of the consumer, and companies have become increasingly efficient with their shipping times. For example, Amazon Prime offers two-day delivery on a wide variety of goods for an annual subscription, often making it easier to buy convenience goods as well as larger consumer durables. Now, Amazon is gearing towards the pinnacle achievement of Internet retailers - same day delivery. It has recently given up its fight against sales tax laws in certain states in order to legally set up warehouses near the largest metropolitan areas in the US. This enables immediate shipping for consumers, and further emphasizes the obsolescence of physical retailers. Finally, many types of content are now easier to purchase and consume digitally, including books, music, and video media. Not surprisingly, revenues for traditional brick-and-mortar stores in such industries have drastically declined, leading to the bankruptcy of Borders and Blockbusters respectively. The Future of Retail E-commerce will continue to shape the landscape of consumer and retail companies, and traditional business models must adapt to avoid the fate of past companies who have failed to reposition themselves. The cost structure advantages are simply too powerful to ignore, and companies must understand the price and convenience sensitivities of their consumers. Many companies already have their own online sales sections, but many are far behind the logistical advantages, buying power, and brand recognition of Amazon. New challengers in e-commerce must understand how to best monetize their consumer bases and retain their business. Meanwhile, current brick-and-mortar companies selling goods that are easily substitutable by online sales look very vulnerable, and have very attractive short prospects in the market.
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OCTOBER 2012

WHARTON UNDERGRADUATE FINANCE CLUB

OFFBEAT INTERNSHIP:
By Tony Murphy
To most Penn students, an internship in finance means a summer analyst position at an investment bank in New York. However, this summer, I decided to break the mold, and I realized there is much more to finance than just Wall Street. In a broad sense, finance concerns the raising of funds to meet the various cash flow needs of an organization. Its scope ranges from initial public offerings for large firms like Facebook to equity raises for individual projects. I worked in the latter capacity, as a financial analyst for Barzilay Development, a real estate development firm in Philadelphia. Barzilay Development specializes in the redevelopment of historic structures. Its portfolio consists of hotels and apartment buildings throughout the Northeast. I worked on two projects during my internship, the conversion of a church into 40 apartments and the reconstruction of an historic skyscraper into a 100 room boutique hotel. My job was to perform pro forma analysis for the properties, which is a form of cash flow analysis that determines a projects value by projecting future income streams. For example, to de-

The Finance Of Real Estate Development

termine the value of the hotel, I had to analyze the hospitality market of its location (in this case, Philadelphia) to estimate the appropriate revenue per room. I also had to design a multi-tier waterfall model to optimize the distribution of cash flows to the developer and equity investors. The finance principles I practiced are applicable to many investments, whether it be to value the acquisition of a property or company. So why did I choose to work at Barzilay Development? For one, it was my sophomore summer, and I figured that it was a great opportunity for me to do something offbeat that I may not have the freedom to do later. Also, Barzilay is a small firm, and while smaller companies may not have the same brand cache as larger ones, I was given a lot more responsibility than I may have been given at a firm with more employees. Finally, both the projects I worked on were in Philadelphia, so I enjoyed giving back to my hometown city and taking part in its revival. Not to mention, I will have VIP access to the roof deck bar of the hotel once it is completed.

Adaptive reuse of the historic Hale Building into a 100-room branded boutique hotel with restaurant and roof deck tenant (below: photos from past, present and future, respectively)

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