Putting News-Based Profits “in the Bank”: Understanding the Financial Sector
This sector is quite broad, including everything from vast holding companies like Warren Buffet’s Berkshire Hathaway to banks to insurance companies. At a broad level, we can divide Finance into basic business models to help us cut through this complexity and identify important strategic similarities:
- Arbitrage: As you may know, arbitrage refers to profiting on price differences between asset types—buying low and selling high. We can use this concept to understand many of the core business models for the financial sector. Banks attempt to secure liquidity at a lower rate and loan it out at a higher rate. Real estate firms try to arbitrage profits. And so on. Any arbitrage-based business model is likely to be sensitive to interest rates. Higher rates are generally good for banks, for instance—a higher premium on loans means more room for profits. Rates may suppress activity for other market segments, such as real estate, where higher borrowing costs can strangle demand.
- Fee-for-Service: Other financial companies generate revenue simply by charging a fee for their service. The closing costs of a consumer loan or mortgage are great examples of this category. Some firms—like credit card companies—generate a substantial portion of revenue from both fees and arbitrage-operations.Rather than being sensitive to interest rate dynamics, we expect fee-for-service models to be more in-line with consumer and business confidence, which drive the overall volume of transactions in the economy. And the more transactions, the more fees! A
low-interest rateenvironment will drive slimmer margins for banks, but also drive more financial activity.
Financial Sector Dynamics
Let’s consider the relationship between interest rates and arbitrage a bit more closely. It’s vital to understand that firms like banks are trying to find arbitrage profits on interest rate differentials over time. These firms are acquiring shorter-term liquidity (deposits or inter-bank loans) and converting them into longer-term assets. Therefore, the profitability of the financial sector depends not just on the absolute level of interest rates, but rates at different maturity lengths.
Financial analysts call the collection of current interest rates at different maturity lengths the “yield curve.” You’ve probably heard this term discussed in the financial press; it’s widely perceived as a vital macroeconomic indicator. The greater the differential between short and long-term rates, the more profit opportunities for financial companies.
Unfortunately, we don’t have the space to conduct a lesson on the macroeconomics of the yield curve here—but that’s not really the point. The immense macroeconomic complexity of the financial sector actually renders it a great target for news-based traders. Arriving at an objective valuation of a financial firm for a buy-and-hold style portfolio requires vast feats of macroeconomic modeling—an area where big institutional investors have a huge advantage.
News-based trading helps abstract away from precise macroeconomic predictions, profiting on the momentum created by news-data as it emerges. With the ability to fully diversify into news-based short sales, this strategy helps harness the powerful profits generated by this sector without exposure to traditional buy-and-hold risk. That’s precisely why our approach performed so well during the 2007-2008 financial crisis.
If you’d like to learn more about how news-based trading offers market-beating profits with a uniquely neutral risk profile, we’re pleased to invite our readers to our totally free training seminars. There’s no hard sell, just an up-close look at our data-based trading platform and some discussion of the fundamentals of news-based trading. You can claim a spot in our next session using the button below: