Money Manager

Climbing out of the Crisis?

Also See> K V Kamath: ICICI, the Road Ahead> Interview: Prof. P. Mohanram, Columbia Univ> Indian Stock Market: Microstructure> Behavioral Finance: Extracting Alpha> Financial Meltdown: Monetary Policy Tools

THEMONEYMANAGER

AN IIMA, IIMB, IIMC Initiative | June 2009

eDITOR’S nOTE

tHE tEAMManaging Editors:Rajatdeep S Anand [IIMC]Anuja Arvind Lele [IIMC]Devdutt Marathe [IIMA]Piyush Soonee [IIMA]

Editorial BoardAshutosh Agarwal [IIMA]Devendra Agarwal [IIMC]Divya Devesh [IIMC]

DesignMajid Asadullah [IIMC]Abhishek Nagaraj [IIMC]

Coordination Committee:Shishir Agarwal [IIMC]Manu Jain [IIMB]Ravi Shankar [IIMA]Neha Verma [IIMB]

Corp. Communications:Akshat Babbar [IIMA]

Logistics:Jay Kumar Doshi [IIMC]Saurabh Mishra [IIMA]

While 2008 was not a particularly great year for the World financial markets, by the middle of 2009 there seems to be some real hope. The surprising outcome of the Indian Elections has given an impressive boost to the Indian markets, even as the global economy seems set for a long and painful recovery. The fall of auto giants GM and Chrysler indicated that the US economy still has some way to go before it has seen the worst of this crisis. The consensus amongst strategists seems to be that things may worsen in short term before becoming better by the end of 2009. So the question staring all of us in face is whether 2009 would be the beginning of a new Dawn or could we be heading to the something akin to the Great Depression of 1930s.

The silver lining seems to be that Indian economy is on a firmer footing. We are now one of the fastest growing economies in the world. It seems India is destined to play a much greater role in world economics especially after the upheaval in US, Europe and their effects on China and Japan.

The second anniversary edition of “The Money Manager” brings you insightful interviews of Prof. Partha Mohanram of Columbia University who talks about the current financial crisis and how corporations should gear up for the next phase. We also had an opportunity to talk to Mr. K. V. Kamath, MD and CEO of ICICI bank who shared his views on his vision for the bank. We have selected articles on diverse topics such as effectiveness of Basel II in the current financial crisis, identifying successful hedge fund strategies for investing, new monetary policy tools, failure of TARP and climate change induced financial risks. As usual this issue is packed with challenging puzzles, crosswords, and interesting trivia. We hope you have a great time reading the latest issue of Money Manager.

aCKNOWLEDGEMENTS

The Money Manager team would like to thank Prof. Ashok Banerjee, and Prof Anindya Sen for their constant support.

We would also like to express our heartfelt gratitude towards Prof. Partha Mohanram, Mr. K.V.Kamath and Prof. Marti Subrahmanyam for sharing with us their views during interviews. We are grateful to Dr. Golaka C. Nath and Prof. Malay K. Dey for their thought provoking articles.

We would like to thank Ashutosh Agarwal and Devdutt Marathe, for conducting the interview with Prof. Partha Mohanram; Akshat Babbar, Ashutosh Agarwal, Saurabh Mishra and Rohit Karan for interviewing Prof. Marti Subrahmanyam; and Nishant Mathur, Samrat Lal, Dhruv Dhanda and Tarun Agarwal for the interview with Mr. K.V.Kamath. We would also like to thank Rajatdeep Anand for interviewing Prof. Golaka C. Nath.

We thank Professor Ajay Pandey, Professor Sidharth Sinha, Prof. Joshy Jacob, and Prof. Samar Datta for adjudging the articles.

We would also like to acknowledge the sponsorship team consisting of Alok Srivastava, Ananya Mittal, Anuja Arvind Lele, Rajatdeep Singh Anand, Guhan M, Gaurav Lal, Abhishek Nagaraj, Divya Devesh, Jaykumar Doshi & Vishal Agarwal.

cONTENTSCOVER STORY

An Interview with Prof. Partha Mohanram06

SPECIAL FEATUREAn Interview with K.V. Kamath11

EXPERT OPINIONCentral Counterparty (CCP) - Role of

Clearing Corporation of India Limited15An Interview with Prof.

Prof.Marti Subrahmanyam19STUDENT ARTICLES

Extracting Alpha Using Behavioural Finance25

New Monetary Policy Tools - Innovative Response to the Meltdown30

Climate Change Induced Financial Risks - A Strategic Approach

36

Credit Default Swap Pricing: Empirical Results & Inferences

40

Effectiveness of Basel II in the current financial crisis

50

Identifying Hedge Fund Strategies for Investing in Emerging Markets

55

MNC Delisting - Reaping the Benefits in 2009

60

Failure Of Tarp And Solutions To The Banking Crisis

69

Value Investing: Past Trends and Current Opportunities in India

74

PRIMERWhat do we know about the market microstructure of the Indian Stock

Markets? - Malay K. Dey

78

KNOW YOUR PRODUCTBarrier Options

83

12CDS and CDS Pricing

86

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cover storycover pagecOVER sTORY

An Interview with

Phillip H. Geier Jr. Associate Professor of Business, Graduate School of Business, Columbia University.

Prof. Partha Mohanram

Partha Mohanram’s research has been published in the leading academic journals including the Accounting Review, Journal of Accounting Research, Journal of Accounting and Economics and the Review of Accounting Studies. His research has examined the valuation of Internet stocks, the calculation of cost of capital, the use of fundamental information in the valuation of growth stocks and the manipulation of earnings to maximize executive compensation. Mohanram teaches Financial statement analysis and valuation to MBAs and executive MBAs, with an emphasis on exposing students to the potential manipulations of financial statements. He also teaches in Columbia’s executive education programs. He is currently the coordinator of doctoral program for the accounting group, and has served on the dissertation committees of several students.

THE MONEY MANAGER | JUNE 2009

Q: We’ve seen the worldwide economic crisis continue to deepen over the last few months. How and when do you think will it abate, and what can governments do to prevent the losses from piling up?

A: It’s a crisis at many levels. It’s a fundamental crisis, a crisis of confidence, and a crisis of trust, depending on how you choose to look at it. It’s going to take a lot of time to abate. Despite all the attempts to free the financial markets through bailouts, etc., banks haven’t yet started the lending process. People are just biding their time – they’re too scared to do anything right now. In some sense, therefore, it’s almost like a self-fulfilling prophecy – it’s not going to get better because nobody thinks it’s going to get better. So to some extent, the only thing that can help really is the passage of time. With time, hopefully people will realize things are getting better, and that they can start stepping out again, slowly. In the immediate term, though, there is very little we can really do.

One of the things that we can see is that some countries are not as badly affected as some others. For instance, in Europe, if we look at Spain, they’ve managed to do better than England. One of the reasons for this is that they have counter-cyclical capital adequacy policies. Let’s say that the bank has a capital adequacy ratio of 6% normally. If the economy is doing really well, the adequacy ratio could be raised to, say, 8%. The logic here is that (a) you want to save for a rainy day, and (b) you want to prevent people from making bad, reckless choices because they believe that the good times are going to last forever. If you think of the big financial institutions, the big American and European institutions are in big trouble. Their market capitalization is down 50% or so, not 98%! One of the reasons is that they’ve borne the onerous burden of having extra capital adequacy requirements in good times, meaning that their balance sheets are much stronger. At the same time, they were constrained in making lending choices, which means that they have fewer bad loans on their balance sheets. So one of the things governments may want to do is to constitute these sorts of “negative feedback” measures to help stabilize the economy. Of course, it is too late to do this to solve the current crisis, but it might help prevent or dampen the next one.

A bailout of some sort is inevitable in most countries today. One cannot just say, “Let economic Darwinism take

its course” because the real effects – job losses in the auto sector for example, are too dramatic. So that’s something the governments will have to do. One can of course argue about what the appropriate mechanism is – should it be a capital infusion, or a buyback of bad loans – but that is simply a matter of detail. Something has to be done, and something was done.

Q: What about corporations? What can they do to survive, even thrive in this sort of environment? How can they prepare themselves for the next cycle?

A: You’ve probably heard this cliché, “Cash is King”. It’s unclear whether people mean that cash flows are more important than net income, or that it’s critical to have cash on the balance sheet. In this case, it’s clearly the latter. This might actually go against the textbook notions of shareholder value maximization – one doesn’t normally want companies to diversify unnecessarily and build up excess assets on their balance sheets that aren’t earning the required rate of return. What the current crisis has shown is that having some sort of buffer for bad times is in everybody’s interest, including the shareholder. Nothing good has come out of bankruptcy – the shareholders are essentially wiped out.

Going forward, companies that haven’t built up their reserves need to take cost cutting seriously, and try to conserve as much cash as possible. They should take a complete relook at their business and not build up any sacred cows – no business line is not subject to clean up or closure. A good analogy here is the Tata Nano. When Tata engineered the Nano, they essentially questioned every engineering element and asked, “Is this really required in a car?” That was how they were able to bring their costs down. There is of course no guarantee that they will continue to be able to do this going forward, but at least they have brought down the costs dramatically as of today. Similarly, corporations should look at their businesses in totality and ask, “Do we really need this? Can we do without it?” Hopefully this will lead to enough cost savings that companies can bide their time till the economy recovers.

One of the things to keep in mind is that it’s very human to assume that good times will last forever, when the economy is growing. The result of this is a string of bad decisions – over-investment, reckless spending, etc. We are equally prone to assuming that bad times will last forever, essentially

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building up “doom and gloom” scenarios. The point here is that companies should not needlessly eliminate what makes them great, based on a myopic view of the economy. If you are an R&D-intensive company and your competitive advantage has always been your intellectual property, you shouldn’t start off saying “I need to cut my R&D costs”. Sure, you need to trim and rationalize where necessary, but you cannot eliminate them entirely – they are your raison d’être. It is therefore a really thin line – on one hand you need to cut costs, on the other, you need to preserve your competitive edge.

The other aspect companies need to learn is to pay close attention to the balance sheet. Unfortunately, in good times, we are constantly worried about the income statement – the earnings-per-share number is the most important. Companies therefore tend to lose sight of capital efficiency – Returns on Assets, for example. One of the more discomfiting implications of this is the prevailing practice of valuing companies on an EV/EBITDA type of basis, saying essentially that one doesn’t care about Depreciation and Amortization, which are nothing but proxies for investments in assets. This is one of the biggest fictions because you are then saying, “I don’t care how I use my assets”.

Q: What do you think about quantitative investment strategies particularly statistical arbitrage strategies of Renaissance and accounting-based strategies of firms such as Barclays Global Investors?

A: I wouldn’t put Barclays and Renaissance in the same league. Renaissance uses a bunch of data-mining and other tools without really going into the reasons or fundamentals based on which they work.

Barclays for example has always had a number of accounting experts on their professional staff. The head of Equity Research, till last year, was Charles Lee, who was a top academician with affiliations to Cornell, Michigan, etc. They also hired Richard Sloan, who was the first to document the “accrual anomaly”. Both of these guys are now back in academia – Sloan to Berkeley and Charles to Stanford.

As a whole, Quantitative Asset Management is a worthwhile field. The prospects in the short-run are unclear of course. What these professionals do well is to look at academic

research – there’s a large body of literature and researchers, myself included, who look at fundamental valuation issues and come up with what you can call trading rules or anomalies. Given that most of these people hold doctoral degrees themselves, they are well placed to understand the research, and convert it into something that they can use. Research papers normally ignore issues such as trading costs, shorting costs and other implementation details that can make these sorts of strategies infeasible.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre-empt future crises? How do we equip ourselves to tide over the current global meltdown? A. Firstly, everybody has been fascinated by the world of Finance. I don’t say it’s categorically wrong, but you cannot just have people dealing with trading, paper income, investment banking and getting things together. Somebody has got to be doing the real stuff as well. Hopefully, what this [the current crisis] might do is to encourage people to do something more real and tangible. Career in Finance would be there but people have to start thinking in terms of other alternatives as well - something entrepreneurial or something in manufacturing etc. Don’t just pick up skills in Finance or Accounting; pick up skills in economy, in industries, in manufacturing, in services. Even if you were in Finance, you would be financing a particular industry. Just knowing fancy valuation techniques or how to price a derivative would not be enough in the world we are going to live in. I always tell my students, even in good times, here at Columbia that if you are a Finance guy, do some Marketing Course or Operations Course etc. Increasingly, having a generalist perspective would be far more important than remaining stuck in one area. In my class, we spend a lot of time looking at the market, things like Porter’s Five Forces, before going into the financial or accounting aspects. Q. You have studied at IIM-A and done your PhD at Harvard. You have taught at Stern and are now teaching at Columbia. Can you share some thoughts on the IIM-A methodology of teaching, especially in Finance and Accounting, and contrasting that with your own experiences at Harvard, Stern and Columbia?

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A. There are some essential similarities and some essential differences. The principle of Finance, Accounting are the same everywhere. There is some difference in the pedagogy where some places there is a lot of focus on theory while at others it is mostly a case method of learning. IIM-A and Harvard follow very similar ways of teaching. At IIMA, we do have some classes where we start with some lecture and then move on to a case. Harvard has absolutely no lectures - every class is a case. Nobody is going to teach you anything - you are supposed to learn from the case. This is a slight difference of perspective, but is mostly unimportant.

The main thing is about the students - and it does not matter where you are taught and how you are taught. [The students should] always try to take a course from the perspective of what one can learn. Things like grades etc. are pretty unimportant. You realize this only after some years and you wonder why I was striving for those. It is more important to get the knowledge and the understanding of what these courses are about. Q. Not many people from the Indian B-Schools choose to become academicians these days. What are your thought on careers in academia and industry (in Finance), especially in the light of the large number of lay-offs, collapses and semi-scandals that have plagued the financial services industry over the last year?

A. Hopefully the fact that no one is going to academia from PGPs would change - this is one of the few good things about the downturn. People would start looking at areas they would not have looked otherwise. I am the Director of the PhD program at Columbia Business School and I can tell you that the number of applications have increased this year. Normally, we get around 60 applications - of which around 40 are from China and South Korea - and we admit 2-3 students in the program. This year we have received 85 applications. Usually, we shortlist 7-8 candidates for future consideration. This year I could not shortlist less than 16, because these were some exceptional candidates. These are from across the World, some from India as well.

People are looking at academia, not necessarily because there are no jobs out there. I am sure there would be sufficient opportunity available to the exceptional candidates. People see that a lot of stuff that is happening in the real world is just random and arbitrary. So, lets just understand what is

going on. I argue that much of what is going on is because people don’t do things properly. People are thinking more in a mechanical way; Investment bankers are more concerned about their pitch books rather than worrying if the deal really makes sense or not. There is this lack of academic rigour. Through research, one can also affect what people do.

Academia is - as I put it - high risk, low reward. You would get a fraction of what you would be paid in the corporate world. Your rewards are things like you are the master of your own desk on a day-to-day basis. Once you get tenure at an academic institution, you get amazing amount of flexibility. Q. Areas like asset management, valuation, and accounting need a relook. Is it that we have gone away from the basics and we need to return to those or that we have to find new ways of dealing within these areas?

A. There has been a lot of over quantification of issues that need to be done away with. People who don’t understand the industry, how a company works and don’t consider the mean effect are talking about the third moment and the fourth moment. People are getting into very complicated analysis when they don’t understand the basics. One needs to have more of an overall perspective and need to understand what the company is doing - before coming up with any valuation model involved in the investment decision. The problem with these valuation models is that people start making them based on some numbers without paying attention to qualitative issues.

In a valuation model, it is mostly the question of the how you calculate the terminal value. There are other methods such as abnormal earnings or residual income methods, which I would encourage one to use rather than DCF. All valuation models are ad hoc at certain level, but the extent of ad-hoc-ness is ridiculous in DCF. Basically, one can come up with any answer in DCF. Also, the practice of looking at different scenarios in DCF is just looking at numerical scenarios (changing numbers) and not looking at economic scenarios. This is what needs to change. Q. In India, we saw a recent discovery of an accounting fraud that happened at Satyam. How would / should

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accounting, regulatory practices change to pre-empt this sort of event from occurring or do you think that it is bound to happen and the regulations can only be reactionary?

A. This is difficult to answer given the news is still unraveling. We are not yet sure what kind of scandal we are seeing here. What is important is having an overall understanding of the company, the economic situation before making any judgments. From what I understand, Satyam used to always undercut its opponents in contracts. It would always be the lowest bidder and yet pay the same salaries as everybody else. Yet it was as profitable as its competitors. One should ask that how is this possible. This kind of overlooking comes from the lack of taking an overall perspective.

Changes in regulations are definitely required. For e.g. auditors would start relying more on actual due diligence rather than say, just a bank statement. The regulations are already in place. Satyam being a U.S. listed firm - they would be subject to the regulations under the Sarbanes Oxley Act. They would have to face up to these and rightly so. The other issue is that there would be a lot of reaction - not only for India but the entire Emerging Market space. Either the liquidity would just stop or the risk premium would go up significantly. There is a serious chance of loss of capital.

However, all regulations would have to be a bit of reactionary. Q. B-schools like Columbia have been facing issues with their endowments. What kinds of strategies are being looked at to make the endowments a more sustainable income source?

A. These Endowments had some very good years - and apparently with very low risk. It seems a little farfetched to me. These funds invested in a whole set of risky assets and made fantastic returns and they ascribed it to their ability to extract alpha, either themselves or hiring whiz-kid fund managers. Some of this alpha looks a lot like misguided beta to me. I am not directly involved with the Columbia Endowment Fund and so would not be able to comment on that. Q. When you graduated from IIMA, were there any notions that you and your classmates held widely that

you have now come to see were not so true? And you wish that you did not have those at that point of time. And that you would not like future batches to graduate with that notion.

A. Actually, I cannot think of anything. However, a few things I would like to mention. It is a very different world these days and the world changed after our batch. Our batch was the first batch to have McKinsey come to campus. For us, the concept of international job markets did not exist. There was no course on derivates for they were not there in the Indian markets. I remember doing an IP on Futures and Options, just to learn about them. With 2-3 years (1995-96), a whole bunch of foreign placements happened and in that sense, things got pretty internationalized. Also, it might be fair to say, Finance completely took over the other professions. In our batch, people had the choice - whether they wanted to do a Finance job, or a Marketing job etc. But now, Finance has completely dominated everything else.

I would suggest, that whatever you are doing, always choose insight over skills - in coursework etc. Don’t think that I would be a trader and so I need this course to get a head start. Remember, any company is going to hire you because you are a smart person and they are going to teach you whatever is required for the job. But insights are something that cannot be taught. There is tendency, especially among MBA students to judge different courses. This is a very bad notion to have. You would realize after many years that some of the most important learning happens in these so-called soft courses. Because the thing that the hard courses teach you is something you can look it up in some text.

- By Ashutosh Agarwal and Devdutt Marathe, IIM Ahmedabad

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cover storycover pagesPECIAL FEATURE

An Interview with

Managing Director and CEO,ICICI Bank Limited

Mr K.V. Kamath

K V Kamath is currently the Managing Director and CEO of ICICI Bank, the largest private bank in India.. He is also a Member of the National Council of Confederation of Indian Industry (CII). He was awarded the prestigious Padma Bhushan Award by the Indian Government in 2008. The Asian Banker Journal of Singapore had voted Mr. Kamath as the most e-savvy CEO amongst Asian banks. He was also awarded the Asian Business Leader of the Year at the Asian Business Leader Award in 2001. World HRD Congress in November 2000, voted him as the best CEO for Innovative HR practices.


Q. Under your leadership, ICICI has grown by leaps and bounds. What in your view should the bank need to do, to make its image / perception as you would ideally like to see from a bank of that size?

Over the years, the growth of the bank would not have been possible without the DNA of passion and managing change ingrained in team ICICI. The market and our competitors, though often criticized for being ahead of its time, have usually endorsed the strategy of the bank through the years, in due course. We would continue to fashion our moves based on our assessment of market realities and our appetite for risk, and maintain a continuous communication with our stakeholders on the rationale for our strategies.

Q. The succession plans and the delegation of responsibilities at top management level at ICICI, is a model for a large number of Indian companies. What is your view about these?

At ICICI, we believe in and encourage the spirit of enterprise of our young managers. Empowering through delegation allows managers to achieve their potential within the framework of the bank’s strategy. We follow a structured approach to identify and develop talent from an early stage and have, over the years, developed a rich talent pool that provides a ready capacity of leaders to spearhead our various initiatives and opportunities that arise.

It is by adopting a clear, transparent and structured approach to the process of selection and by involving significant stakeholders in the process, that we have been able to handle the process of succession planning well.

Q. In the financial sector, ICICI has a distinguished record of women reaching top leadership positions, such as Ms Chanda Kochhar, who will succeed you as CEO, and Ms Shikha Sharma, CEO ICICI Prudential. What can be done to promote better

representation of women in the sector?

System based on the fundamental premises of meritocracy and gender neutrality, has enabled a lot of women managers in ICICI to compete with their male counterparts on an even footing and establish leadership positions based on their mettle. We are indeed, seeing an encouraging number of women occupying board seats in financial services companies, and strongly feel that a sense of fair-play encourages all to maximize their potential.

Q. What do you think can the industry and CII do to ensure something like the Satyam incident is not repeated? As the leader of one of the largest banks in the country, what do you think is the new role of independent directors and watchdogs to uphold corporate governance? What can the government do to incorporate stricter legislation that deters occurrences of further instances like Satyam from happening?

There are regulations and detailed code of conduct in place for the roles, duties and responsibilities of auditors and independent directors. The present framework, if adhered to, has sufficient checks and balances to easily prevent a fraud of such proportions. It is the responsibility of each participant to understand his responsibilities and perform his role in accordance with the code.

The regulator and the government have shown by their response in the present case that they would indeed act promptly and effectively if any violations / aberrations come to light.

Q. As we all know, ICICI Bank was caught up in the rumours sometime back and which also affected the share price. Reputation is of utmost importance for a bank as it can have severe impact on its ability to raise capital for day-to-day operations. What short and long-term steps would you recommend to a financial institution to take

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under such situation?

Rumours are baseless and used by vested interests for their malicious ends. In the recent episode, when the confidence of our investors and depositors was threatened, we ensured that we kept all communication channels open at all times to restore their faith. As a trustee of public deposits, we have taken utmost care to communicate our true position and dispel the doubts on our reputation. The regulatory authorities should take firm action against the perpetrators of such crimes, as they could jeopardize the stability of the system.

Q. As the President of CII, are you satisfied with the measures taken by the government to abate the current slowdown? What would you like to see done further?

The Central Bank and the government have through use of tools under monetary and fiscal policy, eased the transition pain as the economy adjusts from a high demand-high-cost structure to a low demand–low cost one. The various measures have ensured enough liquidity in the system, as also made it easier for companies to undertake business and financial restructuring.

Going forward, we would like to see a greater focus on infrastructure, both by way of increased spending on its committed plans as also increased flow of funds to the sector through the public-private partnership route.

Q. The financial system across the world is witnessing a huge transition. What is ICICI advising its clients to do, in order to brace themselves for this change?

As a result of the challenges being faced in the financial sector, the real sector is facing a liquidity and credit squeeze. This puts tremendous pressure on companies for meeting their cash flow requirements for operational and committed capital expenditure purposes. Companies are indeed working to re-

orient their strategies with a much greater emphasis on liquidity, risk containment and continuous cost optimization, to tide through this and future crises.

Q. There have been few instances of consolidation in the Indian banking system, perhaps largely due to strict regulatory controls. With the emergence of a strong counterbalance in foreign & private banking, do you believe that this is about to change?

Any merger or acquisition has to be driven by strong business rationale of scale, complementarily or synergies. In the Indian banking space, there is no mandate to privatize the public sector banks. Within the private sector, three banks have built up meaningful scale and any further consolidation would need to be based on strategic rationale and synergies.

Q. With the fall in equity markets, the ULIP market has dried up, affecting ICICI Prudential which has been losing market share in the past few months, especially to SBI Life Insurance. What is your strategy for ICICI Prudential in the coming months?

The ULIP product has seen a slowdown in growth, in line with the weakening equity market. This has affected all players, including ICICI Prudential. However, ULIP, as a product, continues to appeal to customers who favor transparency and flexibility in their insurance purchase, and there would be a continued market for the same. ICICI Prudential has achieved a leadership position in the private insurance space by a wide margin by investing in a robust distribution network. Going forward, it is best positioned to leverage this strength to offer diverse products in the protection, health and investment categories. Combined with its focus on cost-optimization, ICICI Prudential is well set to continue to be the leader in the private insurance space. ICICI Prudential has, unlike some other players, not focused on the single premium product, preferring to position life insurance as a combination of protection and long

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term savings.

Q. With interest rates expected to remain in single digits through 2009, what are the steps ICICI Bank is planning to take to protect its net interest margins (NIM)?

The softening of interest rates would reduce the cost of our wholesale funding. Besides, with our expanded branch network of 1400 branches, and proposed addition of 580 branches in the coming year, we would be able to garner a larger share of low cost deposits by way of savings and current accounts. Together, this would mean significant lowering of funding costs, which would hold the key to protecting our margins in a low-interest rate cycle.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre-empt future crises? How do we equip ourselves to tide over the current global meltdown?

Focusing on one’s skills and strengths, and creating a value proposition for oneself based on such assessment, is a strategy that works well through both good and not-so-good times. Given the inherent fundamentals and the resilience of our economy, its only a matter of time before the economy is back on its growth trajectory. Accordingly, as always, young minds should continue to choose their careers and jobs, not based on the highest pay check on offer, but one that offers maximum value in terms of learning, growth potential and personal satisfaction.

- by Nishant Mathur, Samrat Lal, Dhruv Dhanda and Tarun Agarwal, IIM Ahmedabad

Did You Know?The Lipstick Theory:

This theory say’s that lipstick purchases are a way of measuring the economy.

During times of economic uncertainty, women load up on affordable luxuries as a substitute for more expensive items like clothing and jewellery. This phenomenon is called The Lipstick Effect. The theory was first identified in the Great Depression, when industrial production in the US halved, but sales of cosmetics rose between 1929 and 1933.

However as a theory, it was proposed by Leonard Lauder, chairman of Estée Lauder Companies. After the terrorist attacks of 2001, which affected the U.S. economy on a large scale, Lauder noted that his company was selling more lipstick than usual.

During the Second World War the German Operation Bernhard attempted to counterfeit various denominations between £5 and £50 producing 500,000 notes each month in 1943. The original plan was to parachute the money on Britain in an attempt to destabilize the British economy, but it was found more useful to use the notes to pay German agents operating throughout Europe -- although most fell into Allied hands at the end of the war, forgeries were frequently appearing for years afterward, so all denominations of banknote above £5 were subsequently removed from circulation

- Compiled by Satwik Sharma, IIM Calcutta

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cover storycover pageeXPERT oPINION

Senior Vice President, CCIL, Mumbai

Central Counterparty (CCP) – Role of Clearing Corporation of India Limited

Dr. Golaka C. Nath


CCPs occupy an important place in securities settlement systems (SSSs). A CCP interposes itself between counterparties to financial transactions, becoming the buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial stability. A CCP has the potential to reduce significantly risks to market participants by imposing more robust risk controls on all participants and, in many cases, by achieving multilateral netting of trades. It also tends to enhance the liquidity of the markets it serves, because it tends to reduce risks to participants and, in many cases, because it facilitates anonymous trading.

The Recommendations for CCPs by the CPSS-IOSCO Technical Committee are:

1. Legal riskA CCP should have a well founded, transparent and enforceable legal framework for each aspect of its activities in all relevant jurisdictions.

2. Participation requirementsA CCP should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP.

3. Measurement and management of credit exposuresThrough margin requirements, other risk control mechanisms or a combination of both, a CCP should limit its exposures to potential losses from defaults by its participants in normal market conditions so that the operations of the CCP would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control.

4. Margin requirementsIf a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions.

5. Financial resourcesA CCP should maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

6. Default proceduresA CCP’s default procedures should be clearly stated and publicly available, and they should ensure that the CCP can take timely action to contain losses and liquidity pressures and to continue meeting its obligations.

7. Custody and investment risksA CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimised.

8. Operational riskA CCP should identify sources of operational risk and minimise them through the development of appropriate systems, controls and procedures.

9. Money settlementsA CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants.

10. Physical deliveriesA CCP should clearly state its obligations with respect to physical deliveries. The risks from these obligations should be identified and managed.

11. Risks in links between CCPsCCPs that establish links either cross-border or domestically to clear trades should evaluate the potential sources of risks that can arise, and ensure that the risks are managed prudently on an ongoing basis.

12. EfficiencyWhile maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of participants.

13. GovernanceGovernance arrangements for a CCP should be clear and transparent to fulfill public interest requirements and to support the objectives of owners and participants.

14. TransparencyA CCP should provide market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using its services.

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15. Regulation and oversightA CCP should be subject to transparent and effective regulation and oversight.

Overview of CCP’s risks and risk managementRisksMany CCPs face a common set of risks that must be controlled effectively, though exact risks that a CCP must manage depend on the specific terms of its contracts with its participants. There is the risk that participants will not settle obligations either when due or at any time thereafter (counterparty credit risk) or that participants will settle obligations late (liquidity risk). If a commercial bank is used for money settlements between a CCP and its participants, failure of the bank could create credit and liquidity risks for the CCP (settlement bank risk). Other risks potentially arise from the taking of collateral (custody risk), the investment of clearing house funds or cash posted to meet margin requirements (investment risk), and deficiencies in systems and controls (operational risk). A CCP also faces the risk that the legal system will not support its rules and procedures, particularly in the event of a participant’s default (legal risk). If a CCP’s activities extend beyond its role as central counterparty, those activities may amplify some of these risks or complicate their management.

Approaches to risk managementCCPs have a range of tools that can be used to manage the risks to which they are exposed, and the tools that an individual CCP uses will depend upon the nature of its obligations. The most basic means of controlling counterparty credit and liquidity risks is to deal only with creditworthy counterparties. CCPs typically seek to reduce the likelihood of a participant’s default by establishing rigorous financial standards for participation. This is done through maintenance of minimum capital requirements, minimum acceptable rating, trading limits to control potential losses, posting of collateral to cover losses, specific liquidity requirements for participation and reporting and monitoring programmes. Margin system and stress tests to assess the adequacy and liquidity of financial resources are other techniques available to a CCP to mitigate credit and liquidity risks. Settlement risk is eliminated by using the central bank of issue, while custody risks can be limited by carefully selecting custodians and monitoring the quality of accounting and safekeeping services provided by the custodians. CCPs limit investment risk by investing in relatively liquid instruments, while legal risk is managed through

a well founded legal framework that supports each aspect of a CCP’s operations. Safeguards against operational risk include programmes to ensure adequate expertise, training and supervision of personnel as well as establishing and regularly reviewing internal control procedures.

CCIL’s role as a CCP in the Indian Fixed Income and Forex MarketCCIL was set-up on April 30, 2001 as per the recommendations of the committee constituted by Reserve Bank of India as a CCP for the clearing and settlement of trades in Government Securities, Forex and Money Markets. CCIL currently provides guaranteed settlement and is a central counter-party to every accepted trade in Government Securities, Forex (USD-INR) and CBLO (Collateralised Borrowing and Lending Obligation) segment and offers settlement on non-guaranteed basis to IRS trades in the Indian market.

The settlement operations in CCIL are based on the concept of multilateral netting and novation by a central counterparty for a transaction in the OTC as well as anonymous order driven markets. Multilateral netting involves aggregating member’s obligation to pay or receive funds arising out of every single transaction and offsetting it into a single net fund obligation. CCIL has applied the concept of novation at a central counterparty in the fixed income and the currency markets. Under novation, CCIL becomes the central counterparty to the trade by replacing the trade between the two members. In addition to substantially reducing individual member funding requirement, such netting reduces liquidity and counterparty risk from gross to net basis. By reducing the overall value of payment between its members, CCIL has enhanced the efficiency of the payment system and reduced settlement costs associated with growing volumes of market activity.

The earlier instances of ‘gridlock’ and ‘SGL bounce’ have become history after CCIL came into the settlement arena. Due to CCIL’s multilateral net settlement processes, the total counter-party exposures of all settlement participants (i.e., by the entire system) on account of the settlement risk has come down by about 93% on an average.

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Risk Management at CCILIn order to offer guaranteed settlement in the various segments and to manage all incidental associated risks, CCIL has put in place elaborate risk management processes. The risk management process has been designed to address the risk in each segment of the market where CCIL provides its settlement services. In case of securities settlement, market risk is managed through collecting margins like Initial Margin, Mark to Market Margin, Volatility Margin etc. Liquidity risk is managed through Lines of Credit from various banks to enable it to meet any shortfall arising out of a default and through the Settlement Guarantee Fund and a security borrowing arrangement. CCIL has a well designed back testing model for assessing efficiency & adequacy of the adopted method for margining process and a stress testing model to compute the potential losses.

In the forex segment, risk management is ensured through strict membership norms, exposure limits, well defined process for default handling, Lines of Credit etc. In the CBLO segment, risk management is facilitated through initial margin maintenance and pre-set borrowing limits.

CCIL’s risk processes are almost fully compliant with the recommendations of Committee on Payments and Settlement Systems of the International Organisation of Securities Commissions in respect of Risk Management for central counterparties.

- by Rajatdeep Anand, IIM Calcutta

1) There are 1000 camels, all painted gold initially. Also, there are 1000 riders who, upon reaching a camel paint it black if its gold or gold if it is black, reversing the color. The first rider goes to every camel, the second rider goes to every second camel, and the third one goes to every third (3rd, 6th 9th) camel. The process goes on similarly for all others. How many camels would be painted black once all riders are done.

2) Given a coin with probability p of landing on heads after a flip, what is the probability that the number of heads will ever equal the number of tails assuming an infinite number of flips?

3) The king has 100 young ladies in his court each with an individual dowry. No two dowries are the same. The king says you may marry the one with the highest dowry if you correctly choose her. The king says that he will parade the ladies one at a time before you and each will tell you her dowry. Only at the time a particular lady is in front of you may you select her. The question is what is the strategy that maximizes your chances to choose the lady with the largest dowry?

4) Five ants are on the corners of an equilateral pentagon with side of length 1. They each crawl directly towards the next ant, all at the same speed and traveling in the same orientation. How long will each ant travel before they all meet in the center?

5) 100 bankers are lined up in a row by an assassin. The assassin puts either red or blue hats on them. They can’t see their own hats, but they can see the hats of the people in front of them. The assassin starts with the last banker and says, “what color is your hat?” The bankers can only answer “red” or “blue.” The banker is killed if he gives the wrong answer; then the assassin moves on to the next banker. The bankers in front get to hear the answers of the bankers behind them, but not whether they live or die. They can consult and agree on a strategy before being lined up, but after being lined up and having the hats put on, they can’t communicate in any other way. What strategy should they choose to maximize the number of bankers who will be surely saved?

6) Three ants on a triangle, one at each corner. At a given moment in time, they all set off for a different corner at random. What is the probability that they don’t collide?

- Compiled by Devendra Agarwal, IIM Calcutta

Puzzles

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cover storycover pageeXPERT oPINION

An Interview with

Charles E. Merrill Professor of Finance & Economics, Stern School of Business, New York University

Prof.Marti Subrahmanyam

Prof. Marti G. Subrahmanyam is the Charles E. Merrill Professor of Finance, Economics and International Business in the Stern School of Business at New York University. He has published numerous articles and books in the areas of corporate finance, capital markets and international finance. He currently serves on the editorial boards of many academic journals and is the co-editor of the Review of Derivatives Research. He has served and continues to serve as a consultant to several corporations, industrial groups, and financial institutions around the world. Prof. Subrahmanyam serves as an advisor to international and government organizations, including the Securities and Exchange Board of India.


Q. In the current financial crisis, mostly complex Over-The-Counter derivative instruments have been blamed. What regulatory changes do you foresee in this area and how would this affect financial innovation in times ahead?

There is no doubt in my mind that the regulatory oversight of OTC derivatives is bound to grow in the years ahead. One major institutional development that is almost sure to occur is the creation of central clearinghouses for the most important derivatives such as those on credit, interest rates, and foreign exchange. Standardized derivatives products will gravitate to these markets by regulatory fiat or due to market forces. New exotic products will continue to trade over-the- counter, with clear guidelines regarding when they will move to the clearinghouses, based on size, complexity etc. This may be a reasonable compromise between the need to permit and encourage innovation, while containing the systemic risks that we have experienced in the recent financial crisis. I have laid out some of the details of the architecture in a white paper I contributed to a volume put together by the faculty at Stern, entitled “Centralized Clearing for Credit Derivatives,” in “Restoring Financial Stability: How to Repair a Failed System”

Q. It is common knowledge that governments have played a central role in the current financial rescue efforts but it appears that they themselves are not entirely untouched by this crisis anymore. For instance, if we look at the CDS premium on the US government bonds, it has swelled from 0.1% to more than 0.5% during this crisis, which is a very high premium for a AAA rated government security. Are US government bonds really as safe as they are claimed by the rating agencies?

The simple answer is no. Several developments have taken place during the current financial crisis that no one would have forecast (except possibly my colleague Nouriel Roubini, who seems to have some special powers of divination!). I would have been extremely sceptical of any one who forecast that the CDS spread on the 10-Year US Treasury bond would be greater than that of a AAA corporate like GE only a year ago. 50 bps or more for US Treasuries and much more for the Japanese Government Bonds and UK Gilts was well outside any estimate I ever heard prior to September 2008, for the 5-year swap. The spreads of Eurozone Treasury paper over the most credit worthy

German bunds are anywhere from 100 to 250 bps, up from the 20-30 bps range. Prima facie, this means that the market thinks that there is a reasonable chance of default/restructuring for these instruments over the next five years. Given the explosion in the issue of new government paper – the additional amounts planned already run into trillions - this is not an unreasonable conclusion. While no government needs to default on its nominal obligations in its own currency, it is entirely possible that political conditions will force some sort of restructuring of these instruments. Notice the substantially higher spreads for large economies such as Italy or Spain, since they have handed over the authority to print money to the ECB.

Q. This question is related to the US Dollar. As we have seen, the current account deficit of the US has touched unprecedented levels, interest rates have taken a nosedive and the economy is in a recession. Despite all these factors, and contrary to the claims by several analysts, the USD has not yet crashed. What factors, in your opinion, are supporting the USD at present and what future would you predict for it?

I generally do not make specific forecasts regarding market variables, because these forecasts are not worth very much, in my experience. I will only say that given the burgeoning deficits in the US, there is a long-term overhang on the US Treasury bonds and hence the dollar. No one can say if or when the overhang will drag the dollar down. On the other hand, there is no other market in the world, other than the German bunds to some degree, which can absorb a substantial part of global savings. Also, it is entirely possible that the productivity gains in the US economy in the next several years will outweigh this effect. Net net, I have no clue and I doubt that anyone else does as to what is going to happen to the dollar in the next few years.

Q. Many believe that the Indian derivatives market is under-developed and over-regulated, especially given the pace of development in the equities market. Is the current state of regulation justified in the Indian context? How must the regulators go about the task of development of this market and what are the pitfalls they must watch out for?I would not agree that the Indian derivatives market is “under-developed and over-regulated,” across the board. First of all, one needs to make a distinction

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between the exchange-traded and over-the-counter markets. In the case of exchange-traded markets, the most important underlying securities in India are those on individual stocks and equity indices. There is also limited trading in currency derivatives. I believe that the Indian equity derivatives market, particularly that for single stock futures contracts, is highly liquid and efficient. I also think that the regulatory oversight at the level of the exchanges, the NSE in particular, and the SEBI is strong. Indeed, I think the overall structure of this market is as good as any other in the world, that I know of. When it comes to OTC products, such as interest rate and credit derivatives, the market in India is still in its infancy. The regulators are understandably cautious, and the recent events worldwide will make them even more so. I am hopeful that regulators will understand the need for such markets to grow and not dismiss innovation in these products as too risky. As with most markets these days, the expertise in such products in the regulatory bodies is somewhat limited. We need to think of ways in which such skills can be acquired by the professionals in bodies such as SEBI, the RBI, the FMC, and the MofF. The IIMs, in particular, can play an important role in this process of training and development.

Q. One of the casualties of the financial crisis has been the ‘exotic’ derivatives market, a leading money spinner for trading desks. Most of these exotics are OTC products where the counterparty risk is borne by the investment bank. Now, given the threat to the survival of investment banks how do you foresee the revival of ‘exotic’ derivatives?

I am not sure one can say that the exotic derivatives market is dead for good, although such a prognosis today is quite understandable. Of course, market participants will continue to be reluctant to do complex deals for some time, because of the counterparty risks that have come to light, post-Lehman and especially, post-AIG. However, these market developments have a tendency to get reversed. I suspect that a few years from now this experience will become less and less of an issue and the market will be up and running as before. I should point out that even today, hedge funds, and some credit worthy corporations are doing complex deals, although cautiously and with a lot more collateral involved than before.

Q. A lot of people have criticised the concept of VaR. Nassim Nicholas Taleb calls it a ‘fraud’. What then, in your opinion, can be better

instruments of measuring risk, given the changes in the trading environment?

Nassim Taleb has grabbed the attention of the media by making controversial statements about markets, finance education and many other issues. In my opinion, he has said little that is new. Everyone in the business, both academics and practitioners, has been aware of “fat tails” and “stochastic volatility” for a long time. Saying that there are many events that fall outside the 3-sigma limits is simply a matter of saying that the commonly- made assumption of lognormality of returns is not correct, especially at the tails. No one would disagree with this simple statement. If the standard VaR calculations assume lognormality without any caveats, of course, the measurements are going to be faulty. This is no different from any other assumption in the physical, biological or social sciences. Modelling requires some simplifications of complex reality; the conclusions drawn are subject to the errors from these simplifications. Any application of the conclusions has to take these errors into account. In the absence of a clear alternative theory, one is forced to use the theory, with some degree of caution and adjustments. In practice, people make the adjustments to the simple VaR concept using scenario analysis, stochastic volatility adjustments, extreme value analysis etc. Taking a nihilistic view in these matters is neither scientific nor practically useful, although it may yield the proponent a lot of free publicity. When a model fails to fit the data, the prescription ought to be to go back to the drawing board, not stop modelling forthwith.

Q. People have been aware of model risk since the days of the LTCM crisis. Why did the banks still not make changes and repeated the same mistakes with credit derivatives?

I am not sure that the problems of LTCM or the recent financial crisis are due to the failure of models, per se. After all, some of the partners of LTCM were among the foremost financial economists of our times, including my teachers, Robert Merton and Myron Scholes. You can have the greatest model in the world, but if you put in the wrong inputs, or forget some of the key assumptions that are not quite right in practice, you are bound to make a big mistake. Also, there are several practical issues that are not quite in the model including liquidity, counter-party risk, freezing of funding etc, which were obviously ignored in both instances. History is replete with

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instances of human beings ignoring the lessons of prior experience. George Santayana said it best in his The Life of Reason: “Those who cannot remember the past are condemned to repeat it.”

Q. TARP has been one of the most discussed topics recently. The main idea behind the TARP is to buy troubled assets so that banks can start lending again. However, data shows that the lending in the top 13 beneficiaries of this program has actually gone down by more than USD 50 billion. There are two questions:

a. Isn’t TARP essentially providing subsidy to the financial institutions by buying the troubled assets at a much higher price without any provisions for nationalizing them, and thus providing nothing in return to the tax payers.

b. Why is there so much push towards increased lending given the fact that businesses and consumers are actually unlikely to borrow in these troubled times and pushing the lending agenda would only increase problems of adverse selection.

The simply answer to the first questions above is “yes.” There is no excuse for the subsidy given to the financial institutions without the US taxpayer getting much in exchange. At the end of the day, this whole bailout has been a complex political process, with the taxpayer being on the hook for essentially a blank cheque to the financial institutions. Combined with the outsized bonuses that are still being paid, the average person in the US is understandably outraged. I am sure that the situation will get corrected and the US government will end up owning substantial stakes in most of the major financial institutions in the country.

The second question, which relates to an important aspect of macroeconomics in the context of a recession, is a classical conundrum. It is important for individuals to be prudent in tough economic times and conserve their finances and spending. At the same time, if everyone does this, the situation for the whole economy is going to get worse. This is precisely why Keynes argued that only the government can get the economy out of the hole in such a situation. The massive fiscal stimulus proposed by President Obama is exactly in this direction. (It is also the reason that

Keynesians argue that public spending is more effective than a tax cut, since individuals may simply save the proceeds.) Similar packages will be implemented in all the major economies in the world, including India in the next few months.

Q. With the massive influx of rescue packages, it would be rational to assume that rising inflation would be the first side effect. What are your views on the apparent stability of the inflation rate in the US? What could be Fed’s policy reaction when the credit crisis reaches its end?

At this point, no one is worried about an up tick in inflation, provided we can get out of this gloomy economy situation, which may well last years in much of the industrialised world, with collateral damage everywhere, including India and China. Frankly, if inflation goes up by 2% per year for the next several years, that seems a small price to pay for digging ourselves out of the present deep crisis. If anything, the markets are signalling a long period of near-deflation in the US and many other countries. Perhaps that is an over-reaction, but few people see a quick end to the current deep recession. I am not sure the Fed is even thinking about when it will be able to tighten monetary policy. That is at least two to three years away, perhaps longer.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre-empt future crises? How do we equip ourselves to tide over the current global meltdown?

I think back to what my classmates and I used to discuss when we were at IIMA. Most of us had no experience whatsoever. Even summer internships for undergraduates were scarce in those days. Nor did we have much information about what was happening in industry. Today’s students are far better informed than we were. Looking back, I realize how naïve we were about what to expect in our careers.

With the benefit of hindsight, I think the most important lesson for fresh graduates is to look beyond the first job, its rewards and opportunities, and try to take a longer term view. One has to look for jobs where there is an opportunity to learn constantly. If there is a choice between maintaining one’s financial

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http://www.quotationspage.com/quote/2042.html

http://www.quotationspage.com/quote/2042.html


capital and human capital, I think the balance should swing in the direction of human capital early on in one’s career. The second lesson is to stay away from excessive specialization. While one has to acquire depth in some area, staying in a narrow field, however remunerative it may be, becomes less interesting as time goes on. One must try to obtain a broader perspective as you advance in your career. Many who chose to go into jobs in the financial services industry, particularly in Wall Street, made the mistake of concentrating in a narrow area. When the industry imploded, their skill set proved to be too narrow and finding another job became difficult. The third lesson in this increasing global world is to develop inter-cultural skills – for example, language skills - that can come in handy as one moves to a different geographical or cultural setting. Many of my own classmates did not develop this agility and could not adapt to the changing circumstances even within India, not to speak about moving to another country seeking more challenging and rewarding opportunities. Last, but not least, one should maintain a balance between family and career. This seems to be an obvious point, but it is surprising how many people are so busy with their jobs that their children grow up and leave home before they realize it.

Q. How did you choose to become an academician? Not many people from the Indian B-Schools do the same these days. What advice would you have for them?

I graduated from IIMA four decades ago. It was a very different world. In my second year at IIMA, I applied to the leading PhD programs in the US and was accepted by almost all of them. I decided to defer my admission to gain some experience in industry. Opportunities for graduates of what was even then the most prestigious business school in the country were far fewer than today. I was lucky enough to get one of the plum jobs available then – I became the first IIM graduate to be selected for the Tata Administrative Service. Tatas treated me very well but I quickly realized that I would be far happier as an academic rather than an executive. My bosses at Tatas, including some of the directors of Tata Sons tried to dissuade me, but my mind was made up. Tatas were very generous with me and kept me on leave for almost four years even though I told them I did not intend to return! They also insisted on giving me a Tata scholarship, even though I already had a fellowship from MIT, where I went to for my PhD.

Turning to why many students today do not go through the academic route, I think there are several explanations. The first is that there are manifold economic opportunities in industry today, although they have dimmed somewhat in the last few months. The second is the lack of academic role models even in the elite academic institutions in India, such as the IITs and IIMs. Very few students want to become like their teachers, which is rather sad. The last is that many students simply do not know what a rich and satisfying career one can have as an academic. I often wish I could communicate my own enthusiasm to the youngsters in these institutions. Without intending to sound smug, I am thrilled to be a professor and prefer my job to anything else I have seen.

The main reason I chose to become an academic was to pursue a career where I could study and think independently. After I became a professor, I realized that I enjoyed teaching. Almost four decades later these reasons are still valid. It is a great privilege to be a professor, with the tremendous freedom and independence one enjoys. I have also been lucky to be able to combine this with involvement in the world of practice as a consultant and board member. I have had great flexibility in managing my time, for professional and family reasons. I feel really privileged to have the best job in the world. At my age, many think, “I could have... or I should have.” I am lucky to be one of those who can say, “I did what I wanted to do and am thrilled to have had the opportunity to do it.”

- by Akshat Babbar, Ashutosh Agarwal, Saurabh Mishra and Rohit Karan, IIM Ahmedabad

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cover storycover pagesTUDENT aRTICLES

Extracting Alpha Using Behavioural Finance1st Prize

Akhil Dokania, Nitin Agrawal, Prabhudutta Kar IIM Bangalore

New Monetary Policy Tools - Innovative Policy Response to Financial Meltdown

2nd Prize

Ajay Jain, Atishay Jain, Sourav DuttaIIM Bangalore


Executive Summary

Economics is all about allocating resources, trade-off and making choices. Thus decision-making is central to every economic theory. All economic theories assume a very unrealistic model of human behavior. The assumptions made on the human behavior are that individuals have unlimited will power, unlimited rationality and unlimited selfishness. Behavioral Finance deals with understanding and explaining how certain cognitive errors or biases influence investors in their decision-making process.

In this study, we applied principles from the behavioural finance literature to shed light on the merits of including inputs from behavioral economics in business decision making, This study identifies situations which warrants use of behavioral factors and suggesting rational & irrational input variables to be considered for decision making.

We start by understanding the principles of behavioral economics and identifying factors affecting effective decision making followed by an explanation of already proven anomalies in financial markets. We went on to test these hypotheses on Indian markets and devised an innovative trading strategy to exploit the cognitive biases to extract alpha (superior returns) from the financial markets. The results are highly encouraging and prove the fact that markets are indeed irrational.

Literature Survey – Behavioral Economics

Behavioral economics attempts to explain how and why emotions and cognitive errors influence decision makers and create anomalies such as bubbles and crashes. To be able to exploit such anomalies, we first gain an understanding of the common factors which affect decision-making:

1. Overconfidence: Most of us think that we are safe drivers or are above average performers, which can’t be true, and it’s certain that all of us can’t be above average. This overconfidence may lead to excessive leveraging, trading and portfolio concentration.

2. Information Overload: It has been found that experienced analysts are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information.

3. Herd-like Behavior: It has been found that people have tendency to conform to the crowd because they do not want to be an outcast.

4. Loss Aversion: This means people feel pain of loss twice as much as they derive pleasure from an equal gain. This manifests itself into refusal by traders to sell their stocks in loss.

5. Commitment: Once we make a choice, we will encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision.

Extracting alpha using Behavioral Finance

Akhil Dokania, Nitin Agrawal, Prabhudutta Kar.[IIM Bangalore]

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6. Anchoring: This has most direct implications in the financial markets.a. Anchoring on purchase price - As aptly described by Warren Buffett “When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. That thumb-sucking, the reluctance to pay a little more, cost us a lot.”b. Anchoring on historical price - Refusal to buy a stock today because it was cheaper last year or has a high price per share.c. Anchoring on historical perceptions - Buying/selling based on pre-conceived notions such as triple-A company is always better, etc.

7. Misunderstanding Randomness: People often relate windfall gains with their good decision-making and confuse unexpected losses with their bad decisions. However, it might be the case that the decision was actually correct just that it was momentary loss.

8. Vividness Bias: People tend to underestimate low probability events when they haven’t happened recently, and overestimate them when they have.

9. Failing to act: In markets, where the dynamism is at the root, failure to buy/sell can be devastating. It arises from status quo bias, regret aversion, choice paralysis and information overload among others.

Having understood the principles of behavioral economics, let us now look into the manifestation of such biases in real world in terms of financial anomalies.

Financial anomalies in security prices

Empirical studies of the changes of stock prices have unearthed several phenomena that can hardly be explained using rational models and efficient market hypothesis. These facts, often termed as anomalies often bring to light the fact that some stocks systematically earn higher average returns than others, although the risk profile of such stocks would be similar. Some of the most widely accepted anomalies that have been proven are:

1. Excessive Volatility of prices relative to fundamentals - Stock market prices are often far more volatile than could be justified by rational models that equate prices as equal

to the NPV of future cash flows. Dividends and other fundamentals simply do not move around enough to justify observed volatility in stock prices.

2. Long-term reversals - There is definite trend of long-term reversal of returns in financial markets. If one compares the performance of two groups of companies: extreme loser companies (companies with several years of poor news) and extreme winners (companies with several successive years of good news), then the extreme losers tend to earn on average extremely high subsequent returns.

3. Short-term trends (momentum) - Empirical studies provide evidence of short-term trends or momentum in stock market prices.

4. Size premium - Historically, stocks issued by small companies have earned higher returns than the ones issued by large companies.

5. Predictive power of price-scaled ratios - There has been evidence that portfolios of companies with low B/M ratio have earned lower returns than those with high ratios. In addition, stocks with extremely high E/P ratio are known to earn larger risk-adjusted returns than the ones with low E/P ratio.

6. Predictive power of corporate events and news - It is often the case that stock prices overreact to corporate announcements or events.

Some of the reasons for existence of these anomalies are:1. Limited arbitrage- Opportunities for arbitrage nullification in real-world securities markets are often severely limited.

2. Investor beliefs – There can often be numerous personal beliefs of the investor which guide the way he invests in the market:

3. Investor preferences – Most of the models are based on the hypothesis that investors evaluate gambles based on the Expected Utility framework. However empirical studies have shown that investors time and again violate the expected utility framework:

Loss aversion – Individuals often show greater sensitivity to losses than to gains. Regret Aversion – People often try to minimize

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the trauma of having to take the responsibility of a poor investment decision. Mental accounting – Investors frame situations and problems in a way that is more desirable to them

Are Indian Markets rational?

Having studied the different types of anomalies, we

test the extent of rationality in the Indian markets. Since stock prices are nothing but present value of expected future cash flows, hence we believe that stock prices should have high correlation with earnings. It can be contested that there is an inherent lag between when actually the earnings happen and when they are incorporated in stock prices. Hence we computed correlation between earnings and stock prices of 305 companies over 10 year periods. To account for lags, we computed correlation with lags of 0, .5 yr, 1 yr, 1.5yr, 2 yr, 2.5 yr and 3 yrs.

Result: The table below (Table 1) shows the correlation levels between earnings and stock price of the 305

companies over a 10-year period. Correlations with different lags have also been provided. A graph has also been provided which depicts the same information. It can be seen that the correlation levels are very low and hence it can be inferred that markets are not just based on fundamental information and lots of other

information need to be considered.

Testing anomalies in the Indian scenario

Having inferred that Indian markets are not the most rational we tried to test the most common anomalies that have been observed in the western stock markets, in the Indian scenario. Mentioned below are some of the hypothesis tests we carried out with data from the Indian stock market:

1. Size premium HypothesisIt has been observed that returns from smaller companies give higher returns as compared to larger companies.

Data: 5 years (2003-2008) data of 361 companies from BSE 500. We defined companies as small, mid and large based

0 Lag 0.5y Lag 1y Lag 1.5y Lag 2y Lag 2.5y Lag 3y Lag

apr_99-98 0.1001 -0.0445 0.0106 -0.0445 -0.0704 -0.0457 0.0863

oct_99-98 0.0137 0.0221 -0.0023 -0.0194 -0.0131 0.0156 0.0180

apr_00-99 0.0297 0.0004 -0.0107 0.0004 -0.0028 -0.0087 -0.0085

oct_00-99 0.0388 -0.0280 -0.0468 0.0089 0.0187 -0.0631 -0.0018

apr_01-00 0.0074 0.0082 0.0258 0.0082 -0.0220 0.0052 0.0115

oct_01-00 -0.0121 0.0059 -0.0138 -0.0168 -0.0084 -0.0161 -0.0208

apr_02-01 -0.0296 -0.0236 0.0066 -0.0236 -0.0097 -0.0064 -0.0574

oct_02-01 0.0021 -0.0131 -0.0045 -0.0001 -0.0042 -0.0170 -0.0224

apr_03-02 0.0238 -0.0074 0.0015 -0.0074 -0.0193 -0.0324 0.0282

oct_03-02 0.0213 0.0121 -0.0183 -0.0264 0.0102 -0.0152 -0.0107

apr_04-03 -0.0001 0.0077 0.0235 0.0077 0.0008 -0.0008 0.0065

oct_04-03 0.0197 0.0341 0.0109 0.0080 0.0035 -0.0327 -0.0235

apr_05-04 0.0292 -0.0021 0.0029 -0.0021 -0.0043 -0.0066 -0.0058

oct_05-04 0.0207 0.0620 0.0109 -0.0248 -0.0072 0.0047 -0.0148

apr_06-05 0.0027 0.0090 0.0019 0.0090 0.0014 -0.0129

oct_06-05 -0.0052 -0.0018 0.0083 0.0050 -0.0115

apr_07-06 0.0923 -0.1566 -0.0662 -0.1566

oct_07-06 0.1928 -0.0251 -0.2220

apr_08-07 0.0216 -0.0218

oct_08-07 0.0978

Table 1

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on average market capitalization:Small - <250 croreMid - 250-1000 croreLarge - >1000 croreReturns = 0.2log(P2008/P2003)

Results are as shown in Table 1.Inference: We see that there is a clear trend of small companies giving a distinctively high return as compared to large companies. However the distinction in terms of returns is much more blurred between mid size companies and Large companies

2. Predictive power of price scaled ratiosSome of the empirical studies abroad have found a distinctive relation between the book to market ratio of stocks and

their returns. To be more specific stocks with low book to market ratio were supposed to provide lower returns as compared to stocks with high book to market ratio.

Data: 5 years (2003-2008) data of 361 companies from BSE 500.

Results are shown in Table 2.Inference: As we can see there is no distinct trend that relates the returns of a firm with its book value to market value ratio. Hence we cannot conclusively state if there exists any anomaly in the Indian stock market.

3. Long term trend reversalsEmpirical studies abroad have identified a definite trend of long-term reversal of returns in financial markets. If one compares the performance of two groups of companies:

Size No of companies Average of ReturnLarge 204 6.4%Mid 134 6.2%Small 23 13.4%

B/M Buckets No of companies Average of Return<0.25 80 8.9%0.25-.5 105 7.4%0.5-0.75 77 5.6%0.75-1.0 37 7.1%>1.0 62 4.0%

Table 2

Table 3

Figure 1: Variation in Correlation with time

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extreme loser companies and extreme winners, then the extreme losers (winners) tend to earn on average extremely high (relatively poor) subsequent returns.

Data: 10 years (1998-2008) data of 305 companies from BSE 500Returns = (P2 – P1/P1)

Methodology: We implemented a trading strategy to test if there was a trend of long-term reversals. We performed the testing assuming we were in 2003. We computed returns over the last 5 years in 2003 (1998-2003) and sorted the companies based on the returns. Then we went neutral (neither long neither short) on the top 10%ile (extreme winners) and the bottom 10%ile (extreme losers). The major reason behind excluding these companies from the analysis was that their returns might have been affected by some major event (merger, foreign expansion etc) and hence they are not suitable to be studied for applications of behavioral finance. Then we went short on the 90th to 70th percentile that is companies that had been providing very high returns and hence were expected to provide low returns in the future. We went long on the 30th to 10th percentile companies that are companies that were providing very low returns and hence were expected to give high subsequent returns. We left the middle 40% as they could not be categorized as extreme winners or losers in the period of 1998-2003. We back tested our strategy in the period of 2003-2008.

Inference: We found that this strategy gives a whooping return of over 900% over 5-year period. This may be the first step to prove the point that markets indeed witness long-term reversal. Thus, we can exploit this human tendency, which makes the regression to the mean a recurring phenomenon.

Conclusion

This paper identifies the concepts of behavioral economics and the different biases that decision subconsciously suffers from. Having identified the common mistakes that decision makers often make and the traps they fall into, the papers identified things that need to be done for the decision to be most logical and rational.

Additionally, it tests the rationality of Indian stock market by computing correlations between stock prices and earnings of different companies listed in BSE 500. The findings tend

to point towards the fact that markets are hardly driven by fundamental data because there is a low correlation between prices and earnings. It further delved deep into the application of behavioral economics in finance and tried to identify the anomalies in security prices and the possible explanations that behavioral finance provides for these anomalies. The later part of the paper dealt with trying to test the different established anomalies on Indian stock market data. Analysis indicated that some of the biases working in western markets also exist in Indian markets and they can be systematically analyzed and used to make superior returns than the market.

When asked what the stock market will do, J.P Morgan (1837-1913) (banker, financier, businessman) replied: “It will fluctuate.”

“Don’t try to buy at the bottom and sell at the top. It can’t be done except by liars.” Bernard Baruch (1870-1965) financier & economist

“With an evening coat and a white tie, anybody, even a stock broker, can gain a reputation for being civilized.” Oscar Wilde (1854-1900) Poet & playwright

-- compiled by Shishir Kumar Agarwal, IIM Calcutta

Quotations

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New Monetary Policy Tools

Ajay Jain, Atishay Jain, Sourav Dutta[IIM Bangalore]

Innovative Policy Response to Financial Meltdown

Executive Summary:

The financial crisis which began in 2007 resulted in a severe liquidity crisis that prompted a substantial injection of capital into financial markets by the United States Federal Reserve.

The Fed tried using conventional policy tools like the open market operations and discount window without significant improvements. As a remedy, the Fed introduced three new policy instruments: the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). All these actions distribute liquidity to the segments of the financial markets facing shortages. TAF especially generated a lot of interest among the primary dealers, and was a key monetary tool used by the Fed to lower the extent of the crisis. The two effects of TAF—meeting banks’ immediate funding demands and reassuring potential lenders of their future access to funds—both worked in the direction of reducing liquidity risks of banks, increasing transaction volumes and values, and reducing market interest rates.

These new tools are flexible in terms of the durations of the loans, the size of the loans, the safety of the collateral and availability. Hence, they have the potential to become a part of the permanent monetary tools

used by the Fed.

The Financial Crisis

The subprime mortgage crisis is an unprecedented crisis that threatens the stability of the world financial markets and the economy of the US. The real trigger for the turmoil came on Thursday, 9 August 2007, when the large French bank BNP Paribas announced that it would close three of its funds that held assets backed by US subprime mortgage debt. As a consequence of this, overnight interest rates in Europe shot up. Since then, the money markets have experienced a rather unusual financial crisis, with most risk measures, such as the LIBOR-OIS spread which is considered to be a measure of interbank funding pressure, substantially widened and made highly volatile.

Failure of Conventional Tools

In response to the rapidly deteriorating financial conditions, central banks around the world initially resorted to the conventional monetary policy toolbox. The tools used by Federal Reserve to inject liquidity into the market could not adequately address the unusual financial market distress this time.

Open Market Operations are the most powerful and

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frequently used among all tools used by the Federal Reserve, however, during the current financial turmoil, a heightened reluctance of banks to lend to each other in the inter-bank money market interrupted this process and led to a credit crunch.

The second tool used by the Federal Reserve to infuse liquidity is the discount window. In response to the soaring strains in the money market, the Federal Reserve narrowed the discount rate premium, from 100 basis points to 25 basis points. The terms of loans through discount window were also extended to ninety days. These measures were taken to encourage banks’ borrowing through the discount window. However, their effects had been modest, due to the so-called “stigma” problem: during a financial crisis, the banks may be reluctant to borrow from the discount window, worrying that such actions would be interpreted by the market as a sign of their financial weakness, which would reduce their ability to borrow from the market.

Figure 1: Rise in 3-month Libor-OIS Spread

While well-established mechanisms existed for injecting reserves into a country’s financial system, officials had no way to guarantee that the reserves will reach the banks that need them. As it became apparent that conventional tools were not effective enough in addressing unusual financial distress, the Federal Reserve introduced new facilities to provide liquidity to the market.

The New Tools

Term Auction Facility (TAF)

The TAF is a credit facility that allows depository institutions (e.g. commercial banks) to borrow from the Fed for 28 days against a wide variety of collateral. Though this policy can potentially lead to an increase in bank reserves and ultimately also the monetary base, the Fed conducts open market operations (OMOs) to counteract unwanted increases (or decreases) in the monetary base by selling Treasury securities to exactly offset this increase.

The Federal Reserve uses TAF to auction set amounts of collateral-backed short-term loans to depository institutions, which are judged by their local reserve banks to be in sound financial condition. Participants bid through the reserve banks, with a bid that has its minimum set at an overnight indexed swap rate relating to the maturity of the loans. The financial institutions are allowed by these auctions to borrow funds at a rate below the discount rate. The TAF offers an anonymous source of term funds without the stigma attached to discount window borrowing.

The TAF represents an improvement with respect to repurchase agreements in their capacity to provide liquidity. First, the range of collateral it accepts is widened from General Collateral to discount window collateral. Second, by providing funds for a longer term, it eliminates the need to roll over the loans every day or every week. And third, unlike discount window loans, the money goes to the institutions that value it most as the interest rate is determined in the marketplace.

Term Securities Lending Facility (TSLF)

The TSLF permits primary dealers to borrow Treasury securities against other securities as collateral for 28 days. The range of securities, which can be used as collateral, is wider than for the TAF. The TSLF is a “bond-for- bond” form of lending and it affects only the composition of the Fed’s assets without increasing total reserves.

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In exchange for the collateral, the primary dealers receive a basket of Treasury general collateral, which includes Treasury bills, notes, bonds and inflation-indexed securities from the Fed’s system open market account, extending the range of acceptable collateral beyond Treasuries.

The main advantage of TSLF is that it doesn’t involve any cash since a direct injection of cash can affect the federal funds rate and also have a downbeat impact on the value of the dollar. TSLF also serves as an alternative to the direct purchases of the mortgaged investors, which goes against the aim of the Federal Reserve to avoid directly affecting security prices.

Figure 2: The TSLF lending program and intended effects on credit markets

The Open Market Trading desk operates the term securities lending facility. It holds auctions on a weekly basis in which dealers submit competitive bids for the basket of securities in increments of $10 million. The primary dealers may borrow up to 20% of the announced amount at the discretion of the Federal Reserve.

Primary Dealer Credit Facility - PDCF

The PDCF is an overnight loan facility that provides funding for up to 120 days to primary dealers in exchange for collateral at the same interest rate as the discount window does. The PDCF accepts a broader range of securities than the TSLF and is a “cash-for-

bond” form of lending. To prevent PDCF operations from increasing the monetary base, the Fed offsets the increase with a sale of Treasury securities as in the case of TAF. With the PDCF the Federal Reserve has in effect opened the discount window to primary dealers. This facility allows the Fed to offer liquidity assistance directly to certain major investment banks that were previously ineligible. The new Credit Facility increases the

scope of firms in transitory distress that may be supported through Fed liquidity injections.

By October ‘08 end, Fed carried $301 billion of TAF on balance with a further $600 billion auction fund scheduled for November and December, $169 billion of PDCF and $200 billion of TSLF on balance. Table 1 compares the main features of these three new liquidity facilities with those of the regular open market operations and the discount window.

Figure 3: Composition of Fed’s Assets

Acceptance of TAF over others

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Though all the three tools introduced by Fed had an impact of easing the liquidity, TAF by far was the most active and successful tool. Instead of calling for banks to come to the Fed to request a discount window loan, under the TAF the Fed auctions a predetermined amount of funds amongst the participants. Second, instead of paying the primary credit rate, depository institutions that borrowed under the TAF paid the ‘stop-out rate’—the lowest bid rate that exhausts the funds being auctioned. It generated interest in depository institutions as there was no stigma, similar to the one associated with discount window, attached with TAF.

Figure 4: TAF Auction Amount Results

From 17th December, 2007 to 21st April, 2008, the Fed completed ten auctions in the facility. The amount of term loans auctioned was $20 billion in each of the first two auctions, $30 billion in the next four auctions, and $50 billion in the last four auctions. There was high demand for funds at the auctions. The number of banks bidding for the term loans in the TAF varied between 52 and 93 and the bid/cover ratio (i.e., the total amount bid as a ratio of funds auctioned) ranged between 1.25 and 3.08.

Reasons for Efficacy of TAF

During a financial turmoil, banks become increasingly reluctant to lend to each other for two reasons. First, counterparty or default risk increases as the uncertainty around the financial conditions of the counterparty rises. Second, banks tend to build up precautionary liquidity as uncertainty about the market value of their own assets mounts. Furthermore, fund managers could also demand additional liquidity readily available to cover potential redemptions. Heightened counterparty risk and extra liquidity demand led to an increased unwillingness to lend and contributed to the jumps in inter-bank interest rates. Under the prevailing disrupted

Table 1: Comparison of various policy tools

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market conditions, the effectiveness of the TAF and other liquidity facilities depended on whether they can resolve the misallocation of liquidity in the market.

By establishing TAF to provide funding to financial institutions in need, the Federal Reserve sought to relieve the financial strains through several channels. The first and most direct channel was to serve as an additional funding source for banks in immediate need of liquidity, thereby lowering the short-term borrowing costs. Second, because TAF reduced pressure on banks to liquidate their assets, it brought down their funding costs induced by deteriorations in money market conditions. Third, with strengthened confidence the investors asked for less compensation for a given unit of risk and the risk price declined in the presence of the TAF. Finally, with this additional funding source readily available, that too at a rate generally less than the primary credit rate, there was less demand for banks to excessively hoard liquidity purely out of individual precautionary concerns.

Figure 5: TAF Auction Rates Results

The two effects of TAF—meeting banks’ immediate funding demands and reassuring potential lenders of their future access to funds—both worked in the direction of reducing liquidity risks of banks, increasing transaction volumes and values, and reducing market interest rates.

Figure 6: Variation of Deposit Rates with TAF announcement

In confirmation with the expectations, the empirical results suggest that TAF had strong effects in relieving the liquidity concerns in the inter-bank money market. One indication of the scramble for liquidity, shown in the chart, was a sharp increase in the interest rates offered by banks on one-month bank certificates of deposit relative to the Federal Reserve’s federal funds rate target. Market interest rates generally fell after the December 12 announcement, suggesting that market participants viewed the coordinated central bank action as likely to ease money market pressures, especially during the year-end period when the demand for liquidity typically is high.

Figure 7: Variation in LIBOR-OIS Spread with TAF auctions

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In the LIBOR-OIS spread, a cumulative reduction of more than 50 basis points can be associated with the TAF announcements and its operations. It was found that that the TAF had, on average, reduced the 1-month Libor-OIS spread by at least 31 basis points, and the 3-month Libor-OIS spread by at least 44 basis points. The reduction is economically important because it is approximately 90 percent of the average level of the LIBOR-OIS spread in the recent period of credit crunch. However, TSLF and PDCF were found to have had less noticeable effects so far in allaying financial strains in the Libor market. This is thus consistent with the observations of the market of a weaker interest from primary dealers in participating in the TSLF auctions than banks have shown in tapping the TAF.

Conclusion

Future relevance of the Tools

The facilities the Fed created during the crisis enhance the Fed’s lender-of-last-resort function, and extend the reach of its liquidity provision. They bridge the gap between OMO and discount window lending, in the sense that they are available to a large number of financial institutions and can be secured by a much larger array of collateral, as in the case of discount window loans but the initiative rests with the Fed, just like OMO.

However, certain modifications might be required in these policies depending on the scenario. They are flexible in terms of the durations of the loans, the size of the loans, the safety of the collateral and availability. The duration of available lending could be increased beyond the current window. The size of the lending could be increased for the TAF and the TSFL since there is no technical limit on lending via the PDCF. Using non-investment grade securities as collateral, availability could also be enhanced. Some programs reach primary dealers (TAF and PDCF) and others reach only depository institutions (discount window and TSFL). It is possible that some of these programs could be opened up to both sets in the future.

References- DeCecio, Riccardo and Gascon, Charles S: New Monetary Policy Tools

- Wheelock, David C: Another Window – The Term Auction Facility

- Board of Governors of the Federal Reserve System press release, December 12, 2007:-www.federalreserve.gov/newsevents/press/monetary/20071212a.htm

- www.online.wsj.com/public/us

- www.dallasfed.org

- www.bloomberg.com

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Credit Default Swap (CDS) market has shown extraordinary growth in past few years (Exhibit-1). The total notional amount outstanding at the end of year 2007 on all CDS contracts was approximately $ 62.2 trillion (ISDA Market Survey: Notional amount outstanding, semiannual data, all surveyed contract, 1987-present, 2008).

Exhibit 1: CDS Notional Amount Outstanding Historically

Though this growth is a great story of financial innovations that fuelled the growth of Wall Street, it is also an example of regulatory issues with such derivatives. Following is an analysis of the issues that CDS contracts have created in the current credit crisis and how they can be tackled for a smooth functioning of this market.

What is CDS?

As the name indicates, CDS provides protection against the credit event1 (like credit default) in a particular company or sovereign entity. There are two counterparties involved in this transaction. The counterparty that wants protection against credit event is called protection buyer and the counterparty selling protection is called protection seller. This protection is usually bought or sold on bonds or debts (or instruments that promises to pay a stream of cash flows in future) of corporate or government. In case of any credit event, the protection seller has a liability to buy the bond or debt for its face value. In order to get this protection, protection buyer pays a periodic premium to the protection seller as decided in the agreement. This premium obviously depends on many factors like credit rating of the reference entity2, seniority of bond etc. A pictorial depiction of physically settled CDS contract is shown in Exhibit-2 (Draft Guidelines for Introduction of Credit Derivatives in India, 2003). Another type of settlement, known as cash settlement in which protection seller provides the remaining face value of the bond after recovery by the protection buyer. So there is actually no physical transaction of underlying security and only cash changes hands.

CDS and Credit Crisis

Saurabh Mishra[IIM Ahmedabad]

What Went Wrong, What Lies Ahead?

36


Exhibit 2: Physical Settlement of CDS

Apart from the obvious use as a hedging instrument against the debts, CDS can be used in many other ways. CDS can be simply used as a speculative instrument on the financial health of the company. If the investor believes that the financial health of the company is improving or deteriorating, then he can buy or sell CDS accordingly to make money by speculation. CDS can also be used for arbitrage. The relationship between the stock price of the company and CDS premium on the bonds of the company is expected to be negatively correlated. The logic is that as the financial health of the firm improves the stock prices should go up and the CDS spread (premium) should tighten. If the investor finds a mismatch in the two, he can take position in the CDS and equity accordingly to exploit this situation. This strategy is known as Capital Structure Arbitrage (Credit Default Swap, 2008). Before going forward, one thing should be noted that though CDS looks like insurance, there are many differences in both the products. CDS can be used as a mere speculative instrument only. For buying CDS, it is not necessary that the protection buyer owns the underlying which is not the case in insurance. Similarly there are not enough regulations to check the credit worthiness of protection seller so that he is able to pay in case of default, which is again in stark contrast with insurance. The regulatory aspect has been discussed further.

Risk Associated With CDS Contracts

Taking the discussion forward from the previous

section, it can be said that CDS acts as an insurance against the defaults on debts and bonds by corporate and sovereign, and being a derivative, it is different from insurance. Since derivatives derive their values from the underlying on which contract has been written, and there is no intrinsic worth attached to them.

Being a complicated derivative instrument, there are many problems attached with CDS. First, this market is an over-the-counter market and is not well monitored and regulated. In the past few years, it has seen unprecedented growth and a need is felt to standardize the market. Since the CDS market is unregulated, it is not possible to know accurately the exposure of various financial institutions in this market. Also this market is illiquid because of specific nature and terms of every contract that can vary from one to another. So we can see that the CDS market faces almost similar risks that other OTC derivative contracts face, but the problem is manifold in comparison to other derivatives because of the sheer size of the market.

Current Credit Crisis and CDS

The size of the CDS market (more than $ 60 trillion) is significantly more than the underlying debt and bond market3. So it can be inferred that the most of the CDS contracts are actually speculative bets only and are not actual protection on the underlying. As mentioned earlier, that being an unregulated market, exposure of various companies is not known in this market. Combining the above two facts, it can be inferred that a large event in the credit market can actually have vast impact on the CDS market, and then eventually on the economy as a whole.

One such big credit event was the Lehman’s bankruptcy. The size of Lehman’s debts was $ 613 billion making it the largest bankruptcy filing ever (An Update on the Lehman Bankruptcy, By the Numbers, 2008). As far as CDS market was concerned, this event had two faces. The first was related to protection that Lehman sold. It was feared that these protections would no longer exist. One of the examples was of Washington Mutual that

37


bought corporate bonds in 2005 and took protection from Lehman through CDS contracts. Other side was about the firms that wrote CDS on Lehman’s bonds and debts. The final auction of Lehman’s debt was at $8.625. It means that the protection seller would have to give remaining $ 91.375 on these debts in CDS. Since the size of the Lehman’s debt was so large that there was possibility that the protection seller companies may themselves go bankrupt in protecting the Lehman’s bonds. So if a firm is heavily involved in the CDS market then it creates a problem of “too big to fail” for the government. Infact one of the reasons for the bailout of AIG was the role of AIG in the CDS market (Lehman Brothers: A Primer on Credit Default Swaps, 2008). It has a massive unhedged CDS portfolio of more than $ 600 billion and most of the losses have come from this portfolio only (Why Wasn’t AIG Hedged?, 2008).

Another worrying fact about the CDS is the nature of trade itself. The contract can be traded or swapped multiple times and it can happen from both the ends, i.e. protection seller and protection buyer. Because the market is not regulated, it is actually not checked if the new buyer of the contract has enough resources to pay in case of credit event. This in itself makes the pricing of the contract difficult. The problem becomes even more severe because banks are one of the biggest players in the market and they are already under pressure from the other derivatives like CDOs and synthetic CDOs (CDO^n).

Another worry right now is the linkage between CDO and CDS market. In recent years, CDS market expanded into structured credit products like CDOs and synthetic CDOs. One of the major reasons for current credit crisis is the wrong assessment of the risks associated with the structured credit products like CDOs and thus the incorrect pricing of these assets. Since the structured credit products are already quite complex instruments which were not priced correctly, so it is just a matter of imagination to see the kind of

impact it will have on the pricing on the CDS contracts protecting those structured credit products and the kind of systemic risk it can create in the market. Insurance and re-insurance companies like AIG and Swiss Reinsurance Company are the initial casualties only (Lehman Brothers: A Primer on Credit Default Swaps, 2008).

So by seeing the risks associated with CDS market in the current situation and the size of this market, it can be fairly assumed that any crisis in this market can create issues bigger than what we have from subprime crisis.

How to Fix the CDS Market?

There are many lessons that can be learned from the current crisis. Following are the few ways through which reforms can be done in the CDS market (Testimony Concerning Credit Default Swaps, 2008).

CENTRAL COUNTER PARTY (CCP) FOR CDS: One of the major improvements can be made in the direction of establishing a single counterparty for the CDS. This would reduce the counterparty risk in such transactions in future. This would make sure that the counterparties would not be exposed to each other’s risk in future as is the case in current bilateral CDS contracts. This CCP can act as both protection seller and protection buyer and thus would actually net out the risks. This would also help in minimizing the impact of failure of a big market participant (like Lehman or AIG). This would also ensure timely settlement of trades and in keeping track of market participants to avoid market manipulations.

MORE OVERSIGHT TO SEC IN OTC DERIVATIVE MARKETS:

SEC should be allowed to monitor OTC derivative markets that would make sure that timely action is taken before the crisis actually comes. Under the current laws, SEC is prohibited to interfere in the OTC

38


swap market.

REPORTING OF CDS TRANSACTIONS TO SEC: Due to lack of any central clearing house it has become very difficult to quickly trace the past CDS transactions. A mandatory rule to report CDS transactions to SEC would ensure a close watch over these transactions and would provide alternative to voluntarily reporting to Deriv/SERV4.

EXCHANGE FOR CDS TRADING: As mentioned earlier, CCP can actually set up an exchange for CDS trades. This would ensure better market transparency in terms of prices, volumes, open interests etc. This would make sure that CDSs are standardized and thus it would reduce the liquidity risk in the market.

Conclusion

CDS market serves the purpose of pricing the risk associated with reference entities. Such type of contract is very important to develop the credit market. The recent rapid unregulated expansion of the CDS market has created systemic risk for the economy in general. The current idea of 2-party contract exposes each party to the creditworthiness of the other party and non-standard format of the trades make the market very illiquid. Also, “too big to fail” syndrome of various firms has created fundamental problems for this market. Seeing the importance of the market and the challenges associated with it, reforms are required in this market. As suggested earlier, exchange based trading, establishing a single Central Counter Party (CCP), better monitoring and regulation of existing CDS trades are few ways to ensure the safety of this market and to reduce the risks that poses to economy in general.

Bibliography

An Update on the Lehman Bankruptcy, By the Numbers. (2008, Oct 17). Retrieved Nov 25, 2008, from The Wall Street Journal: http://blogs.wsj.com/deals/2008/10/17/an-update-on-the-lehman-bankruptcy-by-the-numbers/

Credit Default Swap. (2008, Nov 27). Retrieved Nov 27, 2008, from Wikipedia: http://en.wikipedia.org/wiki/Credit_default_swap

Credit Default Swaps: The Next Crisis? (2008, Mar 17). Retrieved Nov 25, 2008, from TIME: http://www.time.com/time/business/article/0,8599,1723152,00.html

Draft Guidelines for Introduction of Credit Derivatives in India. (2003, Mar 26). Retrieved Nov 25, 2008, from Reserve Bank of India: http://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=1097

ISDA Credit Event Definitions. (n.d.). Retrieved Nov 25, 2008, from Credit Derivatives WWebsite: http://www.credit-deriv.com/isdadefinitions.htm

(2008). ISDA Market Survey: Notional amount outstanding, semiannual data, all surveyed contract, 1987-present. International Swaps and Derivatives Association.

http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdfLehman Brothers: A Primer on Credit Default Swaps. (2008, Oct). Retrieved Nov 25, 2008, from Credit Writedowns: http://www.creditwritedowns.com/2008/10/lehman-brothers-primer-on-credit.html

Testimony Concerning Credit Default Swaps. (2008, Nov 20). Retrieved Nov 25, 2008, from US Securities and Exchange Commission: http://www.sec.gov/news/testimony/2008/ts112008ers.htm

Why Wasn’t AIG Hedged? (2008, Sep 28). Retrieved Nov 25, 2008, from Forbes: http://www.forbes.com/2008/09/28/croesus-aig-credit-biz-cx_rl_0928croesus.html(Footnotes)1 There are usually six type of credit event specified in the ISDA master agreement on which CDS can be written. They are Bankruptcy, Failure to Pay, Obligation Acceleration, Obligation Default, Restructuring and Repudiation/Moratorium (ISDA Credit Event Definitions).2 The borrower (or other entity) whose credit event trigger the payout from protection seller3 To give a perspective, size of US mortgage market is $ 7.1 trillion; US treasury market is $ 4.4 trillion. Even the size of US equity market is approximately $ 20 trillion (Credit Default Swaps: The Next Crisis?, 2008).4 A subsidiary of DTCC that provides automated matching and confirmation for over-the-counter trades.

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Executive Summary

Climate change has recently emerged as an unintended global negative externality problem derived from a relentless pursuit of economic development. There is no sphere of the competitive market place that will remain unaffected by Climate change. Literature review suggests that the financial and banking sector will be severely affect by the different allocations of climate-induced risks.

At the outset, we analyzed the various financial risks that arise due to climate change. Next, we examined the impact of climate change on the business value chain of a firm using a generic financial-strategic framework. We then moved onto mapping climate risk onto the financial sector. In the next section we analyzed the impact of climate risk on the Basel II accord and proposed an approach to model climate risk using Bayes Theorem and further incorporated that risk into the asset (credit and market risk) portfolio of a bank. Developing climate change risk as a time dependent function has further substantiated this.

This paper will help firms make their financial decisions in more advanced and informed manner in the light of future uncertainties associated with climate change.

Introduction

Climate change has emerged as the strongest negative global externality that demands collective actions

Climate Change Induced Financial Risks

Pramod Kumar Yadav, Kuppa Vijay Krishna, Vikas Bathla[IIM Ahmedabad]

A Strategic Approach

on local and global level. It refers to a statistically significant variation in either the mean state of the climate (which includes temperature, precipitation and wind patterns) or in their variability over an extended period that ranges from decades to centuries.

Climate change poses a major risk to the global economy. The impact of climate change on global economy has been assessed by using various top down models to estimate damage functions that relate GDP losses to variations in temperature. According to the Stern report, which is globally touted as a cornerstone for future climate change economic studies, mean yearly GDP loss due to climate change is between 5 and 20 % of global GDP. However, consistency among the results of such international modeling exercises is yet to be established as different studies subsumes different treatments of climate induced market, non market, and catastrophic risks

In this article, we will examine the impact of climate change on the financial sector, which forms a significant part of any economy- competitive or regulated. We will first systematically categorize the various kinds of financial risks that arise due to climate change. Then we will investigate the role of such climate induced risks in altering the value and properties of asset

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portfolios held by banks. Finally, we attempt to model climate risk by using posterior probabilities and suggest methodologies for doing this.

Climate Change induced Financial Risks

Climate change induces risks to business sector either through a direct carbon cost or through an increase in the cost of factor of production. Such risks cannot or only inadequately be classified in common risk categories. The extent to which a company is exposed to Climate Risk and the strategy it employs to mitigate the risk will depend on that company’s business model, balance sheet, operations, and future plans. Some of the major climate induced financial risks faced by public and private companies are show below:

Figure 1. Climate Change induced Financial Risks

Among the above risks, maximum impact will be on a firm’s ability to raise capital. Climate Risk is an increasingly relevant consideration in the choice and maintenance of investments. Companies that have failed to address Climate Risk can be expected to face increased difficulty raising capital. A firm in the power sector or real estate sector will find it harder to finance its debt in the light of adverse affects of climate change which can completely alter the competitive landscape. Banks and financial institutions on the other hand

have a great interest in ensuring the long-term security and profitability of their investments. Mainstream investment houses are developing sophisticated means of assessing companies’ strategic response to Climate Risk. The size and influence of socially responsible investment funds is growing. Thus even banks will look towards hedging instruments or suitable debt portfolio allocations.

All business sectors are at risk, though the type and extent of risk varies. Those industries, which interface directly with the environment, are more likely to be affected such as Agriculture, Tourism, Energy and Real Estate sectors. But within a sector, the risk exposure would be different for different firms and this would depend on their financial and strategic value chain. For e.g. oil industries will face greater risks than alternate energy industries and coastal rural settlements will be at a greater danger than urban infrastructure.

Figure 2. Climate Change and Business Value

Climate risk mapping on the financial sector

Climate change is bound to increase costs for the financial sector in future. The financial industry needs to prepare itself for the adverse effects that climate change may have on its businesses and on its customers. Banks play an important role in climate-related financing and investment, credit risk management, and the development of new climate risk hedging products. They also need to be aware

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that climate change could result in a compounding of risk across the entire business spectrum, diluting some of the benefits of diversification. Price volatility in carbon markets (e.g. CO2, coal, oil) and climate-related commodities (e.g. agriculture crops, water) leads to uncertainty in financial projections. The opportunity in this environment for the financial services industry is that they can significantly help mitigate the economic risks and enter the low-carbon economy by providing appropriate products and services. Some of the current financial products are shown in the figure below.

Financial service providers need to review and optimize their own carbon risk management and develop tools before catering to client needs to assess their internal processes and policies on which they can adapt and base their investment and lending decisions to meet the challenges their clients face by safeguarding their own viability first.

Climate change can be treated as a risk management problem, especially for governments and corporations, given that climatic changes have a reasonably low to medium probability of occurrence and a very high probability of impact. This goes hand-in-hand with the growing realization that such low probability weather events can have a lasting effect on issues such as investment decisions, productivity and political stability. The difficulty in mapping climate risk on a financial portfolio is amplified as financial sector modeling is deeply rooted in historic data, which do not account for climatic impacts. We can only say that depending on the climate exposure of the portfolio, the conditional value at risk (CVaR) will grow due to climate change as confidence interval surrounding climate change predictions is likely to increase. The following figure gives an idea about the impact of climate change on expected losses and capital needs:

Climate and Weather Disaster: Risk Hedging Instrument

Catastrophe bonds are subject to default if a defined catastrophe occurs during the life of the bond but are attractive to investors because of their correspondingly high yields Contingent surplus notes are essentially “put” rights that allow the notes’ owners to issue debt to pre-specified buyers in the event of a catastrophic event Exchange-traded catastrophe options allow purchasers to demand payment under an option contract if the index of property claims service options traded on the Chicago Board of Trade surpasses a pre-specified level Catastrophe equity puts are a type of option that permits the insurer to sell equity shares on demand after a major disaster Catastrophe swaps are derivatives that use capital market players as counterparties. An insurance portfolio with potential payment liability is swapped for a security and its associated cash flow payment obligations Weather derivatives are contracts that provide payouts in the event of a

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Figure 4. Impact of Climate Change on Probability Loss Distribution

The challenge they face is to not only include climate risks in their risk management but - if applicable - also have to adjust applied methods for the quantification of risk.

Credit Risk: This risk is related to policies and regulations that create new liabilities or transfer existing ones and therefore affect business directly. They affect the credit ratings of GHG intensive borrowers and create direct costs of compliance on related sectors and indirect costs on all consumers of energy and electricity. This has implications for banks in their role as loan providers, equity investors, and project financiers.

Operational Risk: Operation risk arises from inappropriate risk identification, assessment, and allocation processes inside the bank. For e.g. a bank’s internal failures in the due diligence for investments or loans that are highly sensitive to climate change

lead to decreased margins. On top of this, the related operational risks for the bank’s clients, for example, suboptimal carbon risk management can result in financial sanctions, which also impair the client’s liquidity and therefore the bank’s competitiveness and creditworthiness.

Market Risk: The main components of this risk are volatile carbon certificate prices and volatile commodity prices (e.g. coal, gas, oil). These price and volumetric risks lead to decreased corporate planning reliability - both for banks and their clients. Banks must have the expertise to monitor and understand the impact of emissions trading or any future climate regulatory changes on clients’ business. The more frequent the occurrence of extreme weather events such as flooding and storms, the higher the direct climate change related risk of physical damage to corporate assets and real estate.

The existence of these risks mean banks need to

Figure 4

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develop carbon risk management tools for their loan and investment due diligence. Some of these can be:

• To integrate an environment sustainability criteria into the bank’s overall assessment of investment risk and opportunity

• To develop new metrics to demonstrate the “carbon intensity” of their client portfolios and to restrict its lending and underwriting practices for industrial projects that are likely to have an adverse environmental impact

• To incorporate a set of emission trading related questions in its credit rating process and conduct thorough investment research

• To calculate the financial cost of greenhouse gas emissions while reviewing loans, such as the risk of a company losing business to a competitor with lower emissions

Climate Risk and Basel II: A New Modeling Paradigm

Climate risk assessment and aggregation with other prevailing risks faced by banks is conducted through the prism of BASEL-II principles in the absence of any other international risk norms for banking sector. The essential principle of Basel II is the three-pillars-concept (minimum capital requirement, supervisory review process and market discipline), which aims at a comprehensive evaluation of risk-related capitalization of banking institutions. Currently, BASEL-II proposed banking book structure which includes minimum capital requirement in the form of market risk charges, credit risk charges, and operation risk charges is sufficient to incorporate climate risk. There are no instructions or techniques of how these risks can be measured. Based on our previous qualitative assessment of risks, we have distributed climate risk across market, credit, and

Figure 5. Risk Measurement Approches under Basel II

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operational risks under BASEL-II accord. All that can be said is that risk adjusted capital requirements will increase from earlier levels. Rigorous quantification will be necessary to establish the exact levels.

Portfolio Analysis

Any bank or credit institution will have a portfolio of asset allocations. The credit loss of the portfolio or an asset of the portfolio is calculated as in Equation I.

Each of the assets (or industry sectors) in the portfolio will be affected by climate change risk in their own way. In the case of climate sensitive sectors such as transport, energy, real estate and water utility, each or all among probability of default, potential credit exposure and recovery factor will be adversely affected. These in turn will have a negative impact on their debt payback capacities, which will eventually diminish the bank’s cash flow. This will further be exacerbated by the climate change induced co-movement among the risk factors of the sectors leading to a high correlation of risks that will drastically change the riskiness of the overall portfolio. Thus it is very important to appropriately quantify climate risk to have an exact idea of the credit status of the portfolio.

Market risk of the bank portfolio is essentially comprised of risks to their currency and commodity assets. Basel II proposes use of stress testing and back-testing in assessing the market risk of a bank’s portfolio. Mapping of climate change risks on market risks cannot be adequately conducted as both, stress testing and back testing are backward looking approaches.

Integrating Climate Risks in Bank Portfolio

We propose to model climate risk in the banking sector by assuming that a rational agent observes new information disseminating in the market and updates his assessment of the risks using conditional probabilities. However, prior probability assessment and likelihood function determination always run the risk of statistically insignificant and biased outcomes in the presence of sparse or limited data distributed over a very long period of time. The knowledge of climate change and its impact is acknowledged as a recent phenomenon and hence, as mentioned before, there is insufficient historical data on which to base the likelihood function.

Therefore we formulate climate risk as a recursive process involving learning in which a risk-averse rational agent will absorb new information and learn from previous climatic impacts. The new information will be in the form of stochastic processes, particularly climatic physical impacts, policy and regulation regime shifts, and change in key market variables. The main problem with such a learning based risk assessment process is the rate of real information flow and technological know-how.

Let us say at time t=o, the information available regarding climate risk is x and the probability of the adverse climatic impact is p. At t= t, a new set of information y appears. After the new information, the decision maker updates his prior probability distribution to arrive at posterior probability distribution f (p/y, x). The posterior probability can be obtained by using Bayes theorem in following manner:

Equation I

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This can be further simplified as,

The expected probability of occurring in the future will be found as:

This formulation assumes that the expectation of a rational agent changes as the new information start penetrating the market. Decision-maker changes the prior probability distributions, often with bias, as the time passes by. Therefore, it can be said that prior probability of climate risk was zero earlier as such risk was not contemplated.

The priori distribution that is used above is a hypothetical model based on the limited historical data that is available till date. From the present e.g. t=0, we contemplate the future risk in time t=t. However we scientifically cannot specify what the future risk would be in time t=t as shown in figure 6. Moreover, the trajectory of climate risk evolution would also drift over the duration as the exact path of risk transfer cannot be specified. However, with time, as more data points are generated, our priori distribution will keep changing and hence its robustness increases and eventually it will near a real world approximation.

Currently, the risk for any portfolio of a bank (the expected values of the statistical properties of exposures together with portfolio specific risk measures such as moments of distribution, VaR etc) is represented by distributions, which to an extent are known or can be simulated using available data. The above climate risk model can easily be extrapolated calculate the effect of climate change on the asset portfolio allocation of a bank or other credit institutions. Any bank will have an existing Monte Carlo simulation model with a given probability distribution to determine its asset portfolio allocation. Now to incorporate climate change risk

Figure 6. Evolution of Climate Change Risk as a Function of Time

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into the model we would need to apply Bayes theorem assuming a priori distribution as shown above to generate a conditional probability of climate risk. Then we would need to superimpose this distribution onto the portfolio probability distribution to arrive at a comprehensive portfolio distribution that has climate risk included in it.

Conclusion

The concepts of uncertainty and ambiguity, but not risk, have been used extensively in the field of assessing the economic impacts of climate change. This paper identifies and assesses whole spectrum of climate risks on variety of sectors with a focus on financial and banking sector. Having argued that climate induced risks are inevitable in medium to long term future, it maps climate risks on capital requirement proposed by BASEL-II and further presents a methodology to map climate change risks on portfolio value of a bank.

EXHIBIT 1

Financial Risks of Climate Change

Some of the major climate induced risks faced by public and private companies are:

• Physical Risk: This corresponds to physical disruptions such as loss of life, limb or other assets due to calamities caused by climate changes.

• Policy Risk: Governments at national and global levels are starting to introduce policies to tackle the causes and combat the effects of greenhouse gas emissions (GHG). These policy and regulatory changes will modify company share prices, both positively and negatively. The impact of various climate regulatory schemes on emissions and ensuing compliance costs can be direct such as a carbon tax or emissions trading scheme or indirect through increased fossil energy prices. Thus a company’s current and future financial liabilities can be reduced by acting on its current emissions and energy consumption.

• Insurance Risk: A firm might need to pay extremely high insurance premiums if the chances of it being affected by climate change are significant. This is particularly severe for real estate firms and firms functional in agriculture and commodities.

• Reputational Risk: Companies which are perceived to undermine steps to address climate change or who have projects or practices which contribute to climate change run the risk of damaging their image. Reputational Risk can impede a company’ ability to compete in the marketplace, as consumers and future employees seek alternative choices.

• Litigation: Litigation costs resulting from ‘climate litigation’ and associated reputational risks need also to be considered.

• Competitive Risk: Companies that fail to address Climate Risk may be placing themselves at a competitive disadvantage. Action can lead to a direct gain over competitors, for example through “first mover” advantage; and indirect gains, for example by improving a company's negotiating position when a government proposes to introduce regulation, or simply through an improved or "greener" reputation.

• Shareholder: Loss in competitive advantage resulting from a loss of economic opportunities has a direct affect on the bottom line of a firm. This in turn results in shareholder risk arising from activism and disruption of affairs.

• Capital: Climate Risk is an increasingly relevant consideration in the choice and maintenance of investments. Companies that have failed to address Climate Risk can be expected to face increased difficulty raising capital. A firm in the power sector or real estate sector will find it harder to finance its debt in the light of adverse affects of climate change which can completely alter the competitive landscape. Banks and financial institutions on the other hand have a great interest in ensuring the long-term security and profitability of their

47


investments. Mainstream investment houses are developing sophisticated means of assessing companies’ strategic response to Climate Risk. The size and influence of socially responsible investment funds is growing. Thus even banks will look towards hedging instruments or suitable debt portfolio allocations

EXHIBIT 2

Currently available financial instruments

Growing sensitivity of financial and insurance markets towards climate induced chaotic and severe events is evident with the increasing popularity of catastrophe bonds, carbon trading instruments, and weather derivatives. A critical review of such instruments is following.

Emissions Trading: The international emissions trading market offers new opportunities for banks and their clients. Emissions’ trading is also an interesting option for project financiers, since the IRR of emission reduction projects can be enhanced through the project-based mechanisms

Catastrophe Bonds: Catastrophe bonds are financial instruments that help disperse catastrophic weather risk. Issuance of such bonds has risen sharply following various hurricanes in US in the last decade. There is a considerable demand for products like catastrophe bonds; exchange-traded catastrophe options; catastrophe equity puts; and catastrophe swaps.

Weather Derivatives: Weather risk is primarily a volume risk rather than a price risk. To mitigate against weather risks financial instruments based on weather related index such as the Heating Degree Days (HDDs), Cooling Degree Days (CDDs) for temperature risks. Initially restricted to energy firms of the west, today major financial institutions and other industries including agriculture, insurance, tourism and retail are also entering this market. A brief summary of climate risk hedging instruments is given in the following

figure.

Micro Finance: Installation of solar power plants is an innovative business solution that can be funded by micro financing agencies.

References

• Arnold, M.; Kreimer, A., 2000 "World Bank's role in reducing impacts of disasters." Natural Hazards Review 1(1): 37-42

• Benson, C. and E.J. Clay. 2002. “Disasters, Vulnerability and the Global Economy.” ProVention

• Consortium, Draft Papers presented at the December 2002 conference, "The Future of Disaster Risk: Building Safer Cities.”

• Covello, V.T./ Merkhofer, M.W.,1993 Risk Assessment Methods: Approaches for Assessing Health and Environmental Risks. New York: Plenum Press

• Citigroup. Climate Consequences – Investment Implications of a Changing Climate. Citigroup-Study, 2007

• Credit and Basis Risk Arising From Hedging Weather-Related Risk with Weather Derivatives, Patrick Brockett and Linda Golden, McCombs School of Business, University of Texas at Austin, Jul 2008

• Enhancing Security, Reducing Vulnerabilities: Climate Change and Financial Innovation,

Jacob Park, Assistant Professor, Business and Public Policy, Green Mountain College (USA)

Presented at Human Security and Climate Change: An International Workshop, Oslo, June 2005

• Financial Risks of Climate Change, Association of British Insurers, Summary Report, 2005

• International Energy Agency / OECD. Climate Policy Uncertainty and Investment Risk. Paris.

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2007

• Investing in Climate Change: An Asset Management Perspective, Deutsche Bank, Oct 2007

• IPCC. The IPCC 4th Assessment Report on Climate Change 2007: The Physical Science Basis. Summary for Policymakers. Geneva2007

• Greenpeace International, http://www.greenpeace.

org/international/campaigns/climate-change

• Marsh. Climate Change: Business Risks and Solutions. Climate Change. V (2). 2006

• Mills, E. 2003a. "The Insurance and Risk Management Industries: New Players in the Delivery of Energy-Efficient Products and Services.” Energy Policy, 31:1257-1272., http://eetd.lbl.gov/emills/PUBS/Insurance_Case_Studies.html

• Musiela, M. and Rutkowski, M. 1998: Martingale Methods in Financial Modelling. New York,N.Y.: Springer-Verlag.

• Nordhaus, William, D and Joseph Boyer, 2000, Warming the World: Economic Models of Global Warming (Cambridge, Massachusetts: MIT Press).

• Smit, B., O. Pilifosova, I. Burton, B. Challenger, S. Huq , R.J.T. Klein, G. Yohe, N. Adger, T. Downing, E. Harvey, S. Kane, M. Parry, M. Skinner, J. Smith, J. Wandel, A. Patwardhan, and J.-F. Soussana. 2001. “Adaptation to Climate Change in the Context of Sustainable Development and Equity.” Chapter 18 in Climate Change 2001: Impacts, Vulnerability, and Adaptation. Intergovernmental Panel on Climate Change, United Nations and World Meteorological Organization, Geneva. Working Group 2.

• Stern, N. The Economics of Climate Change. The Stern Review. Cambridge 2007

• Tol, Richard S.J., 2002, “Estimates of the Damage Costs of Climate Change. Part 1: Benchmark Estimates,” Environmental and Resource Economics, Vol. 21 (January), pp. 47–73.

• Urrutia,Jorge1986.,The capital asset pricing model and the determination of fair underwriting returns for the property-A liability insurance industry, The Geneva papers on risk and insurance, vol. 11,No.38 (January 1986).

Value at Risk: Climate Change and the Future of Governance, April 2002, CERES Sustainable Governance Project Report prepared by Innovest Strategic Value Advisors, Inc.

A1) 31 (all perfect squares up to 1000)

A2)2*min(p,1-p)

A3) You should let 37 ladies go by and select the first one with a dowry greater than the maximum of the first 37 dowries.

A4) 1/(1-cos(72)) = 1+5-1/2

A5) If the number of red hats that the last banker can see were even, he would say “red”. If they add up to an odd number, he would say “blue”.

A6) 0.25

Puzzle Answers

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http://www.greenpeace.org/international/campaigns/climate-change

http://www.greenpeace.org/international/campaigns/climate-change

http://eetd.lbl.gov/emills/PUBS/Insurance_Case_Studies.html




Executive Summary

Credit Default Swaps (CDS) are one of the most widely traded credit derivative contracts in the financial world. It is estimated that the total amount of outstanding CDS are in the range of 55-60 trillion dollars, indicating the popularity of these instruments. Given their widespread use and the unregulated and non transparent nature of CDS transactions, the pricing of CDS assumes particular significance. While several models have been proposed for the same, performance of these models has been inconclusive. In this paper we implement and analyze the performance of two of the most basic models, namely the Merton Model and the EJO model both in the developed as well as developing markets. The results and inferences from the same are subsequently presented. The authors believe that the current economic crisis and the role of CDS in the same makes the analysis presented in the paper all the more germane.

1. Credit Default Swaps: The concept

A credit default swap (CDS) is a credit derivative contract between two counterparties, structured such that the buyer has to make periodic payments to the seller and in return obtains the right to a payoff if there is a default or credit event with respect to a reference entity. The market size for Credit Default Swaps began to grow rapidly from 2003 and by late 2007 it was

approximately ten times as large as it had been four years earlier.

However the rapid growth of the CDS market has not been without its critics. Several analysts have pointed out that the CDS market lacks regulation and the deals are far from transparent and often fuel speculation. There have even been claims that the CDS markets exacerbated the 2008 global financial crisis by hastening the fall of companies such as Lehman Brothers and AIG.

2. CDS Pricing: Approaches and Models

Given the huge market for CDS, it is but natural that substantial amount of research has been conducted on their pricing.

The price, or spread, of a CDS is the annual amount that the buyer of the protection must pay the protection seller over the length of the contract.

There exist two fundamental approaches to CDS pricing:

(a) Structural Approach

(b) Reduced Form Approach

2.1 Structural Approach to CDS Pricing

The structural approach links the prices of credit risky instruments directly to the economic determinants of

Credit Default Swap Pricing

Anshul Gupta,Radhika A R[IIM Bangalore]

Empirical Results and Inferences

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financial distress and loss given default. These models imply that the main determinants of the likelihood and severity of default are financial leverage, volatility and the risk free term structure. Popular implementation of the Structural models today include Moody’s KMV model. However it is often difficult to implement such models as it is difficult to get reliable estimates of the asset volatility and risk free term structures. Most of the structural models in place today are derived from the work done by Black & Scholes (1973) and Merton (1974). The Merton model, the foundation of all subsequent structural models, is described next.

2.1.1 The Merton Model

The Merton model works on the principle that a firm’s equity can be viewed as a call option on the firm’s assets. Thus the probability of a firm defaulting on its obligations can be found by determining the probability of the exercise of this option. The model assumes that a company has a certain amount of zero-coupon debt that will become due at a future time T. The company defaults if the value of its assets is less than the promised debt repayment at time T. The equity of the company is a European call option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The model can be used to estimate either the risk-neutral probability that the company will default or the credit spread on the debt.

The mathematical implementation of the Merton model involves determining a firm’s asset value and asset volatility using the easily observable equity value and the debt profile of the firm. Detailed mathematical description of the model can be found in Merton (1974) and Hull, Nelken & White (2004).

2.2 Reduced Form Approach to CDS Pricing

These models exogenously postulate the dynamics of default probabilities and use market data to obtain the parameters needed to value credit-sensitive claims (Ericsson, Jacobs and Oviedo (2004)). While these models have been shown to be versatile in practical

applications, they don’t touch upon the theoretical determinants of the prices of defaultable securities. Another approach within the reduced form approach focuses on estimating the default probabilities and the loss given default using statistical functions and pricing the CDS based on the results.

Thus it is seen that while the Structural models are theoretically sound, they are difficult to implement while the Reduced form models, though easy to implement lack theoretical rigor. Therefore as a combination of the Structural and Reduced Form Approach, some researchers actually use the structural approach to identify the theoretical determinants of corporate bond credit spreads. These variables are then used as explanatory variables in regressions for changes in corporate credit spreads, rather than inputs to a particular structural model. Important work in this area was carried out by Collin-Dufresne, Goldstein, and Martin (2001), Campbell and Taksler (2003) and Cremers, Driessen, Maenhout, and Weinbaum (2004). Ericsson, Jacobs and Oviedo (2004) suggested an extension of these approaches in which they regressed the Credit Spread with the firm’s leverage, volatility and the risk free interest rate. This model is implemented in this paper and results on companies both in the developed and the developing world are described.

3. Implementation Approach

The main considerations while choosing the various parameters for implementation are described below:

(a) Comparing performance of Structural and Reduced Form Models: In order to evaluate the performance of both the approaches, one structural model (Merton Model) and one reduced form model (EJO Model) was implemented.

(b) Covering companies across different sectors: The companies on which the models were tested were chosen from a wide range of sectors so that any sectoral biases would not affect the evaluation of the performance of the models.

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(c) Covering companies from different countries: In order to test the performance of the models for firms from both the developing and developed worlds, firms from US, UK and India were chosen. This enabled us to draw relevant conclusions regarding the applicability of the models in emerging markets like India as well.

(d) Covering companies with different leverage: Since the ultimate aim of the pricing models is to predict whether a company is likely to default on its obligations or not, we chose companies with leverages varying from low to high so as to test the performance of the models for companies having different balance sheet debt structures.

(e) Period of testing: The performance of the models was tested for the last two months of 2007. The most recent data points were deliberately not taken to test the models as given the current financial conditions, measuring the performance for current data would not have given an accurate picture of the utility of these models.

Overall six companies were chosen for testing the models and a summary of these companies is presented in Table 1.

4. Data Sources

The data required for the implementation of the two models is listed below:

(a) Merton’s Model: Equity Price of the firm, Equity Volatility of the firm, Debt Structure of the firm, Risk free interest rate in the country of operation.

(b) EJO Model: Equity Price, Book Value of Debt and Market Value of Equity, Risk free interest rate in the country of operation.

All data required was sourced from Bloomberg. To obtain a good balance between capturing recent events and preventing disruption due to spurious information, a 60-day period for volatility was used. Since the Merton model requires the firm’s debt to be modeled as a zero coupon bond, weighted average of the debt and its maturity was used to do so. The risk free interest rate was then taken to be the rate for government bills with maturity closest to the maturity of the zero coupon bond. Microsoft Excel was used for implementing the model.

CDS spreads for a 5 year CDS on each firm were also obtained from Bloomberg. The mean value of the CDS was assumed to be the average of the bid and ask for the purpose of comparison with the value predicted by the two models.

5. Results and Discussions

The results for the six companies for both the Merton as well as the EJO model are summarized in this section.

5.1 Merton Model

Company Country Sector Debt LevelsReliance India Ltd. India Petrochemicals ModerateState Bank of India India Banking Moderate - HighGeneral Motors USA Automobile ModerateVodafone UK Telecom Low-ModerateGlaxo Smithkline UK Healthcare Very LowJohnson and Johnson USA Healthcare Very Low

Table 1 : Companies chosen for testing

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Overall the Merton model was found to work reasonably well for companies with medium to high leverage and the predicted values were found to follow the trends depicted by the actual values. However the Merton model was observed to consistently under predict the actual spread. This could be because of the very basic nature of the model and the simplicity of the underlying assumptions. The results obtained are consistent with the past research which showed that structural models under predict credit spreads and display low accuracy (Arora, Bohn, Zhu, 2005).

The results obtained by the Merton model for the four companies with moderate-high leverage are summarized below. Sample outputs obtained can be seen in the annexure.

Table 2: Result obtained by the Merton model

Company Extent of Under predictionRIL 19%SBI 32%Vodafone 71%GM 14%

However the flaws of the Merton model are accentuated when tested on companies with very low leverage namely Johnson & Johnson and Glaxo Smithkline (GSK). Because the Merton model essentially models the equity as a call option on the firm’s assets and given the fact that if the debt of a firm is very low, the probability of exercising this option is very low, the Merton model gave extremely low CDS spreads for such companies. Thus it was found that the Merton model is not suitable for firms with very low leverage.

5.2 The Ericsson, Jacobs and Oviedo Model

The Reduced Form model – the Ericsson, Jacobs and Oviedo (EJO) model which regresses the CDS spreads against the firm leverage, equity volatility and the interest rates was also used to estimate the CDS spreads. The results obtained by the EJO model are summarized below (the +/- indicate the positive/negative correlation between the CDS spread and the explanatory variable):

Table 3: Results obtained by the EJO model

Company R2 (%) Vol. Leverage Int.RateRIL 90.30 + + -SBI 70.97 + + -GM 52.15 + + +Vodafone 76.38 + + -GSK 79.40 + + -MKS 83.89 - + +

As predicted by past research, the EJO model gave superior performance when compared to the Merton model with high R2’s for most companies. All the three explanatory variables were found to be significant for all companies. The EJO model was also found to be better suited for firms with low leverage as shown by its good performance for GSK and MKS.

The credit spread was found to be positively correlated with the equity volatility and firm leverage and negatively correlated with the interest rates. Thus the effect of these market driven variables is economically important as well as intuitively plausible. These results are also consistent with previous research in these areas (Ericsson, 2004).

6. Inferences and future work

The results indicate that while the Merton model is theoretically sound, due to the simplifying assumptions built into the model, its performance on real life companies and data is not satisfactory. Although it does give encouraging results for companies with medium-high leverage, overall it is found to under predict the CDS spreads by a substantial amount.

In contrast the EJO model gives good results in estimating the CDS spread as described in the previous sub-section. This could be due to the fact that it uses market driven parameters to estimate the CDS spread. The EJO model also performs relatively better than the Merton model for companies with low leverage. Further for emerging economies with low market depth and inefficient price discoveries, the EJO model may be better suited.

Future work would involve testing the Advanced

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Merton Model proposed by Hull and White (2004). Non-linear models wherein the CDS spreads are regressed with non-linear functional forms can also be tested. One such possible model was suggested by Collin-Dufresne, Goldstein, and Martin (2001).

7. Conclusion

The paper presents the results obtained by the testing of the Merton Model and the EJO Model for estimating CDS spreads for a diverse set of companies.

The EJO model is found to deliver better and more consistent results for the selected firms whereas the Merton model is found to consistently under predict the CDS spreads by a substantial amount. It was also found that the Merton model (and most structural models) fails for firms with very low amount of debt on their balance sheets.

The paper also postulates that the reduced form models would be more suitable for implementation in firms in the developing markets because of the lack of market depth and firm specific information in such economies.

8. Select References

1. Hull, J., 1999, Options, Futures and Other Derivatives, Prentice Hall Publications, Fourth Edition.

2. Hull, J., and White, A., Valuing Credit Default Swaps: No Counterparty Default Risk, Working Paper- University of Toronto

3. Jan Ericsson, Kris Jacobs, and Rodolfo A. Oviedo ,The Determinants of Credit Default Swap Premia, Faculty of Management, McGill University∗

4. Merton, R., 1974, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, 29, 449-70.

5. Hull, J., and White, A., 2004, Merton’s Model, Credit Risk, and Volatility Skews.

6. Karol Frielink, 2008, Credit Default Swaps and Insurance Issues, Spigthoff Attorneys and Tax Advisors Newsletter

7. Geske, R., 1977, The Valuation of Corporate Liabilities as Compound Options, Journal of Financial and Quantitative Analysis, 541-552.

8. Jarrow, R., 2001, Default Parameter Estimation Using Market Prices, Financial Analysts Journal, 57, 75-92.

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Effectiveness of Basel II in the financial crisis

Sumit Bhalotia, Hemant Dujari [XIMB, IIM Ahmedabad]

This paper attempts to analyze the role played by Basel II norms in the current financial crisis. Since Basel II norms have not been implemented uniformly throughout the world and have been mainly adopted by European countries and not by US banks its role is not very clear. But still there are certain inefficiencies in the Basel II norms that need to be taken care of else they will add to the financial instability. Basel II does not address all the regulatory issues that figure in the lessons learned from current market events. In particular, it is not a liquidity standard, though it recognizes that banks’ capital positions can affect their ability to obtain liquidity, especially in a crisis. It requires banks to evaluate the adequacy of their capital in the context of both their liquidity profile and the liquidity of the markets in which they operate. But it is widely agreed that more work needs to be done on developing guidance for liquidity provision. The current turmoil has provided an opportunity to examine the robustness of the Basel II securitization framework, which is now being done by the Basel committee. .

Basel II and the current Financial Crisis Bank regulators across the globe are implementing what is known as Basel II—an international standard

for the amount of capital that banks need to put aside to deal with current and potential financial and operational risks. Basel II norms are based o three pillars. The first pillar refers to the set of rules that deal with minimum capital requirements to be held against key risks namely credit risk, market risk and operational risk. Pillar two refers to the supervisory review process in identifying and assessing all the risks banks face which even goes beyond the risks mentioned in pillar 1 such as credit concentration risk etc. In essence, Pillar 2 provides a strong push for strengthening both risk management and bank supervision systems. Pillar three refers to market discipline that seeks to supplement the supervisory effort by building a strong partnership with other market participants. It requires banks to disclose sufficient information on their Pillar 1 risks to enable other stakeholders to monitor bank conditions. Analysis of current financial crisis reveals that one of the major reasons was creation of very complex risk exposures not fully understood and assessed by both investors and the banks’ own risk management systems. Poor risk assessment and risk management of market and funding liquidity, concentration and reputational risks, insufficient regard for off balance sheet risks and the interaction of tail risks under stress. This was exaggerated by poor performance of the credit

Executive Summary

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rating agencies in evaluating the risks of structured credit and various incentive distortions in relation to the regulatory capital treatment of securitization, the opacity of information disclosures, and the structure of compensation schemes in the banking industry. The current crisis has highlighted the importance of sound and thorough assessment of quality of underlying assets as without it any regulatory regime will quickly become ineffective. Basel II requires banks to set aside more capital against complex structured products and off balance sheet vehicles, two of the main sources of stress in recent financial crisis. Presently European companies are in the process of implementing Basel II norms whereas US banks have still not started the implementation. Since Basel II norms were finalized in the year 2007 and it takes around a year to completely adopt Basel II norms the role of Basel II in the current financial is not clear. But there are certain concerns over the role played by Basel II norms during a financial crisis, which are discussed in subsequent sections.

Pro Cyclicality Effect of Basel II Though Basel II tightly links capital requirements to the risks associated but according to experts it suffers from cyclical nature of the business and adds to the boom and bust cycle. The rules are too lax on capital requirements during the “good times” and too tough during the “hard times,” exacerbating boom-bust cycles in the process. When an economy is growing, even badly managed banks with inadequate capital levels and provisioning can expand their level of operations and business because the downside probability is very low during economic booms. But when economy takes a turn to the worse, badly managed banks have to immediately respond and change their lending policies so as to avoid going under. For example as shown in the diagram below the probability of default is clearly low during the boom period leading to low capital requirements and hence high lending amount available in the market. So the Basel II norm

adds to the boom by even more lending amount. Figure 3: Pro Cyclicality effect

Again during the depression period the effect is opposite. As shown in the diagram below during depression credit becomes riskier having high probability of default. This leads to increased capital requirements level to act as a cushion for the high expected losses. So banks cut on the lending amount to reduce its balance sheet’s size. They may also have more difficulty increasing capital and issuing subordinated debt because of the heightened uncertainty. The combination of higher capital requirements (because of increased risk) and the difficulty of raising new capital could lead institutions to reduce credit to firms and households, which would aggravate the recession or hinder economic recovery

Figure 4: Pro cyclicality effect

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Likely Effects of Basel II Adoption in the Current Scenario BASEL II norms are expected to have far reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks’ risk management systems, supervisory review process and market discipline.

The new norms bring to fore not only the issues of bank wide risk measurement but also of active risk management. This will help in better pricing of the loans in alignment with their actual risks. The beneficiary will be the customer with high creditworthiness and ratings as they will be able to get cheaper loans.

Basel II norms require vast amount of historical data and advanced techniques and software for calculation of risk measures. This will translate into huge demand for IT, BPO and outsourcing services. According to estimates, cost of implementation of the new norms may range from $10 million to $150 million depending on the size of the ban.A flip side is that the knowledge acquired by the big banks due to the implementation of complex norms would act as an entry barrier to any new competition entering into the market, as international markets provide incentive to sovereigns and banks that have implemented Basel II. Small and medium sized banks will find it difficult to finance high implementation costs of the norms. If national supervisors make the norms compulsory to implement, these banks might have no other option but to merge with other bank. Therefore, consolidation in banking industry with increased mergers and acquisitions is expected.

Higher risk sensitivity of the norms provides no incentive to lend to borrowers with declining credit quality. During economic downturns, corporate profits and ratings tend to decline. This can lead to banks pulling the plugs on lending to corporate with falling credit ratings, at a time when these companies will be in desperate need of credit. The opposite is expected during economic booms, when corporate credit worthiness improves and banks will be more than willing to lend to corporate.

With better risk measurement practices in place the capital

allocation for loans to quality borrowers are going to decrease. Banks can use this capital for other purposes to increase profits. But the population of rated corporate is small in India and most of them would have to be assigned a risk weight of 100 per cent. The benefit of lower risk weight of 20 per cent and 50 per cent would, therefore, be available only for loans to a few corporate. The cover required for bad loans will increase exponentially with deteriorating credit quality, which can lead to an increase in capital requirement.

Weaknesses Prevalent in Basel II Making it Ineffective for Financial Crisis Basel II relies heavily on a number of key elements, which, to many eyes, appear weakened in light of the credit and liquidity crisis

Basel II promotes the use of internal quantitative modeling techniques by banks in calculating their regulatory capital. Some commentators have expressed worries over the opacity of these more complex models, and the fact that the use of internal models by banks could potentially lead to conflicts of interest.

The new capital adequacy rules depend heavily on the use of credit agency ratings. Given the culpability being ascribed by many to the rating agencies in the structured credit market turmoil, one has to decide whether to give these agencies a quasi-regulatory role in relation to capital adequacy.

Despite improvements over Basel I, the new rules still focus very much on credit origination, as opposed to new credit derivative instruments and structured products.

The IMF has recently stated that the pro-cyclical nature of Basel II capital requirements, which require banks to hold additional capital against greater anticipated losses as the economic cycle turns downward, could exacerbate an economic recession by forcing banks to restrict their provision of credit in a downturn scenario.

The credit and liquidity crunch was partly the result of a widespread lack of information, which exacerbated the initial US subprime problems. Whilst enhanced disclosure is one of the three pillars of Basel II, it is recognized as

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likely to be the weakest in terms of both prescription and enforcement. Basel II disclosure is required to assess an individual bank’s capital adequacy. But that is not enough: a strong bank capital base, while essential to avoid the collapse of any major financial institution, was not sufficient to prevent the systemic effects of the subprime crisis.

Basel II and the Reaction of the Indian banking System In the wake of the turmoil in global financial markets, the FSF (Financial stability forum of BIS) brought out a report in April 2008 identifying the underlying causes and weaknesses in the international financial markets. The report dealt with strengthening prudential oversight of capital, liquidity and risk management, enhancing transparency and valuation, changing the role and uses of credit ratings, strengthening the authorities’ responsiveness to risk and implementing robust arrangements for dealing with stress in the financial system.

The Reserve Bank had put in place regulatory guidelines covering many of these aspects, while in regard to others, actions are being initiated. In many cases, actions have to be considered as work in progress. In any case, the guidelines are aligned with global best practices while tailoring them to meet country specific requirements at the current stage of institutional developments. The proposals made by the FSF and status in regard to each in India are narrated below:

(i) Capital requirements: Specific proposals will be issued to raise Basel II capital requirements for certain complex structured credit products; Introduce additional capital charges for default and event risk in the trading books of banks and securities firms Strengthen the capital treatment of liquidity facilities to off balance sheets conduits. Changes will be implemented over time to avoid

exacerbating short-term stress. (ii) Liquidity: Supervisory guidance will be issued for the supervision and management of liquidity risks.(iii) Oversight of risk management: Guidance for supervisory reviews under Basel II will be developed that will Strengthen oversight of banks' identification and management of firm wide risks; Strengthen oversight of banks' stress testing practices for risk management and capital planning purposes; Require banks to soundly manage and report off balance sheet exposures; Supervisors will use Basel II to ensure banks' risk management, capital buffers and estimates of potential credit losses are appropriately forward looking.

(iv) Over the counter derivatives: Authorities will encourage market participants to act promptly to ensure that the settlement, legal and operational infrastructure for over the counter derivatives is sound.

The roadmap for the implementation of Basel II in India has been designed to suit the country specific conditions. All other commercial banks (except Local Area Banks and RRBs) are encouraged to migrate to Basel II in alignment with them not later than March 31, 2009. The process of implementation is being monitored on an ongoing basis for calibration and fine-tuning. The minimum capital to risk weighted asset ratio (CRAR) in India is placed at 9 per cent, one percentage point above the Basel II requirement. Further, regular monitoring of banks’ exposure to sensitive sectors and their liquidity position is also undertaken.

Conclusion

Countries should adopt Basel II framework based on their national circumstances. Also there should be complete implementation of Basel II and not selective or partial implementation as different parts complement each other. Incomplete implementation can even lead to eventual harm rather than financial

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stability. Basel II norms have to be modified taking into account the recent happenings and addressing the weakness discussed earlier. Also the norms have to take care of the cyclical nature of the business and not add to the already prevalent boom or the bust cycle. Though the role played by Basel II is not very clear in the current crisis but it definitely needs to be fine tuned in order to address future financial crisis and maintain financial stability.

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ReferencesJohn C. Hull, The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned? Atif Mian and Amir Sufi The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis. RBI Guidelines in the wake of credit crisis. (www.rbi.org.in) Bank for International Settlements – Website : www.bis.org

Across

2.) Jordan’s Furniture is the subsidiary of which famous American company?(18)8). Which is the third Latin American country to adopt the US dollar as its currency. (2,8)10.) What is the largest non-US company listed on the NASDAQ in terms of market capitalization?(8)12.) Which company used the trademark slogan “World’s most experienced airline” in the early 1970s?(5)15.)Whose autobiography is called ‘Dreams of my fa-ther’?(5)17.) Which company filed a lawsuit in 2008 against Face-book, forcing it to remove its hit game Scrabulous?(5)18.) Which was the first foreign company to open a fac-tory in the United States?10)19.) Fischer _____ and Myron ______ write a path break-ing article in the Journal of Political Economy in 1973. What are their last names?(5,7)

Down

1. )SEC filed a civil suit against which billionaire owner of the Dallas Mavericks for insider trading in Nov 2008. (4,5)2. )What is the Index of about 50 stocks that are traded on the São Paulo Stock Exchange?(7)3.) ________ Street is London’s equivalent of Wall Street. (11)4.) This business magnate started her catering busi-ness in 1976. (6,7)5.) A Universal Product Code was scanned for the first time in 1974. What was the first product to be sold with this code?(8)6.) A Stock that drops suddenly and sharply in price, usually because of lower-than-expected earnings or other bad news.(4,6,5)7.)What is the study and collection of stocks and bonds called? (11)9. )The largest college student loan company.(6,3)11.) A bond with a par value of less than $1,000.(4,4)13.) The merger of Delta Airlines with which airlines created the largest US carrier in 2008.(9)14.)Who launched his business career at the age of 14 by forming his own company, Traf-O-Data, with friends?(4,5)16.)Which century old Japanese firm manufactured playing cards before it made its mark in the world of

CROSSWORD- by Divya Devesh, IIM Calcutta

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Hedge Fund Strategies

Prateek Mathur,Pinky Singh,[FMS, Delhi]

Identifying Successful Hedge Fund Strategies for Investing

in Emerging Markets

Executive SummaryHedge Funds (HF) are privately organized, loosely regulated private investment vehicles. The total assets managed under HF increased by 24.4% to an estimated $2.68 trillion in the first three quarters 2007. Globally in past, the funds through the strategy ‘Convertible Arbitrage’ topped followed by Distressed Debt Funds, which are the next best return-generators. The various types of hedge funds strategies used by investors across the globe are:

The recommendations given discuss the hottest destination in emerging markets and the suitable strategies both globally and in Indian context. Among the emerging markets, particularly the BRIC countries (especially Russia), are most lucrative as they have some of the best opportunities for investors.

Most hedge fund managers and portfolio managers look for a certain type of equity or industry research for their fund. Hedge funds currently use and are

Table 1: Hedge Fund strategies

STRATEGY DEFINITION

Market Neutral 50% short, 50% longConvertible Arbitrage Long convertible security, Short underlying equityGlobal Macro Focus on global macroeconomic changesGrowth Look for growth potential in earnings and revenuesValue Invest based on assets, cash flow, book valueSector Focus on particular economic or industry sectorDistressed Securities Invest in companies undergoing reorganization or in bankruptcyEmerging Markets Invest in emerging foreign market equity and debtOpportunistic Trading oriented, takes advantage of market trends and eventsLeverage Bonds Employ leverage to invest in fixed income instrumentsShort Only Take short positions only

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in constant need of high end unbiased qualitative and quantitative research to identify and evaluate opportunities in the global markets. This paper explores the various strategic and research options available to Hedge funds investing in emerging markets and concludes with certain recommendations that would help Hedge funds succeed in emerging markets. What are Hedge Funds?Hedge Funds (HF) are privately organized, loosely regulated private investment vehicles that are generally open-ended, and are available to a limited number of investors. They are generally structured as Limited Liability Partnerships (LLP). Trends and DevelopmentsThe total assets managed by HF increased by 24.4% to an estimated $2.68 trillion in the first three quarters 20071. New allocations increased total asset levels by an estimated $339 billion, but asset reductions from liquidations outpaced the increase from new fund launches in Q2 and Q3 of 20082. Total assets outside USA increased 28.5% through the first three quarters of 2007, compared to a 12.5% increase in US. Impact of Hedge Funds on The Market

A typical HF involves aggressive participation, strategies and positions in the market. Most strategies move around short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.

HF can provide benefits to financial markets by contributing to market Efficiency, Liquidity, Price determination, and Financial Market Integration. Many HF advisors take speculative trading positions on behalf of their managed HF based extensive research about the true value or future value of a security. They also use short term trading strategies to exploit perceived pricings of securities. Thus, new combinations in the risk-return space can be achieved with HF, thereby increasing the completeness of financial markets. Strategies Though there are not set classifications, we have broadly categorized the strategies according to the similar characteristics that they seem to exhibit. Each fund has its own strategy that it uses to try and earn a high return on investment for its investors. Each

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of these strategies varies in the types of returns they generate and in their expected volatility.

1. Directional StrategiesHF managers following directional strategies put bets on the general direction of the markets going up and down and profiting from such movements.

1(a) Dedicated Short Bias (Short Selling) [Volatility: Very High]Short selling funds short all of the investments in their portfolio. These funds often come into favour when people feel the market is about to approach a bearish cycle. However, since short selling a stock exposes the investor to an unlimited amount of risk, these funds are often seen as very risky.

1(b) Long/Short Equity Hedge [Volatility: High]‘Long undervalued securities and short overvalued securities’- It attempts to factor out market and sectoral factors, leaving only the inefficiencies of stock selection and their identification thereof, as a source of portfolio return. Some approaches balance the dollar amount long against the dollar amount short, while others attempt to balance the estimated volatility of the longs and the shorts.

1(c) Emerging Markets [Volatility: Very High]Emerging market funds invest in stocks or bonds of emerging markets. These are considered very volatile because emerging markets typically have higher inflation and volatile economic conditions. Not all emerging markets allow short selling so hedging is usually not available.

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1(d) Global Macro [Volatility: High]Macroeconomic funds aim to profit from changes in global economies. They are typically involved in stocks, bonds, commodities, and currencies. These funds usually use derivatives to increase the impact of market movements.1(e) Managed Futures [Volatility: High]

These are funds that invest on a long and/or short basis almost exclusively in exchange traded commodity derivatives and/or financial derivatives (futures, options and warrants). Broadly speaking, managed futures are an investment for the purpose of speculating in futures and options markets.

2. Event Driven StrategiesEvent driven strategies are long-biased strategies that focus on specific corporate transactions that are likely to produce a reasonably well-defined increase in the value of a security within a reasonably well-defined time horizon.

2(a) Distressed/ High Yield Securities [Volatility: Moderate]These funds buy equity or debt in companies that are facing bankruptcy. These fund managers usually think that the general public doesn’t understand troubled companies very well so they seek to profit from deeply discounted securities.

2(b) Risk (Merger) Arbitrage [Volatility: Moderate]The risk arbitrage investor focused on equity-related opportunities created by mergers and acquisitions, tender offers and related situations. Risk arbitrageurs are typically long in the stock of the company being acquired and short in the stock of the acquirer. By shorting the stock of the acquirer, the manager hedges out market risk, and isolates his/her exposure to the outcome of the announced deal.

2 (c) Regulations D (Reg. D) [Volatility: Moderate]This sub-set refers to investments in micro and small capitalization public companies that are raising money in private capital markets. Investments usually take the form of a convertible security with an exercise price that floats or is subject to a look-back provision that insulates the investor from a decline in the price of the underlying stock.

3. Market Neutral StrategiesIt is the only strategy that primarily focuses on linking specific positions in a ‘hedged’ fashion. These positions seek returns independent of market movements while extracting returns from mispriced securities, market sectors, or groups of securities. These strategies attempt to limit market or systematic risk while taking advantage of inefficiencies between asset classes or securities. Essentially, the manager buys undervalued securities and shorts overvalued securities, hoping that the long positions outperform the short positions or vice versa.

3(a) Convertible Arbitrage [Volatility: Low]‘Long convertible bonds and short the underlying common stock’.This approach recommends buying a convertible bond (or other type of convertible instrument such as preferred stock) and then shorts an appropriate amount of the same company’s stock to make it a hedged transaction.

3(b) Fixed Income Arbitrage [Volatility: Low]HF with a focus on income usually focuses on high-yield stocks or bonds. They also might purchase fixed income derivatives that enhance their profit from the appreciation and interest income.

3(c) Equity Market Neutral [Volatility: Low]Market neutral funds attempt to remove the market risk from their portfolios by being both long and short in a given sector. A market neutral fund may pick two

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similar stocks and purchase the one it feels is better and short the stock that is weaker, hoping that the stock it likes more outperforms the other stock.

4. Fund of Hedge Fund (FOHF)Rather than investing in individual securities, a Fund of Funds invests in other HF. Any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds. Investors are allocating assets to Fund of Funds products mainly for diversification amongst the different managers’ styles, while keeping an eye on risk exposure.

5. Other Strategies5(a) Aggressive Growth [Volatility: High]Aggressive growth HF typically takes an aggressive approach to investing by buying stocks with high P/E multiples and shorting stocks that are likely to miss their earnings estimates. They’re usually biased towards investing in companies in the technology and biotechnology sectors.

5(b) Opportunistic [Volatility: Depends]These types of HF often vary their investment strategies

to whatever conditions they feel are profitable at the time. Past Performance of StrategiesIn order to compare returns over a longer term, the ranking were allotted based on Sharpe Ratio3. The ranking by risk-adjusted returns shows that the convertible arbitrage funds turn up tops with an annualized return of 6.7% and a volatility of just 2.2%. Distressed debt funds are the next best return-generators with an annualized return of 9.4% and a volatility of 5.3%. This is owing to the concentrated and isolated evaluative model followed by these strategies. In recent past, combination of strategies has witnessed maximum funds asset, followed by Long/Short Equity Hedge Strategy4.

Emerging MarketEmerging markets, particularly the BRIC countries, are most lucrative as they have some of the best opportunities for investors. These countries have benefited from the global spike in commodities, but there are now potential risks to future returns from threats such as the global fallout from the sub-prime meltdown and the possibility of a US recession. The securities markets showed less reaction to threats of a

Investment Strategy% Share (No.)

2005 YTD Return

Annualized Return

Sharpe Ratio

Rank

Convertible Arbitrage 3.0 % 3.72 6.67 2.63 1Others 0.4 % 8.54 9.7 1.73 2Distressed/High Yield Securities

1.3 % 8.72 9.41 1.61 3

Multi-Strategy 68.0 % 7.25 7.81 1.51 4Commodity Trading Advisor (CTA)

2.0 % 1.35 9.99 1.43 5

Global Macro 1.4 % 4.04 7.45 1.4 6Event Driven 0.9 % 5.30 7.6 1.39 7Long/Short Equity Hedge 19.0 % 10.64 6.7 1.11 8Fixed Income Arbitrage 2.0 % 4.69 5.48 0.98 9Relative Value 2.0 % 5.91 5.16 0.85 10

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slowdown in the US.Research options for Hedge Funds Investing in Emerging MarketsOne of the main issues which still remain for HF managers investing in emerging markets is to penetrate the perception and find reality which is often difficult given the fact that on-the ground and fundamental unbiased research is still an evolving culture and business here.

Most HF currently use and are in constant need of high end unbiased qualitative and quantitative research to identify and evaluate opportunities in the global markets. Many of these opportunities are now being found emerging markets; however, there are few quality research options for HF investing in these regions. Hedge Funds account for approximately 70% of equity-based commissions and demand value for their research spend.

The big macro trend is that in the past, research was provided centrally and now today everyone has to do more and more research on their own. That puts a tremendous strain on the hedge fund community and it makes the screening processes harder.

In addition to hiring their own researchers, some hedge funds use analysts from outsourcing firms that assign analysts to do research for specific clients.

An important factor is that hedge funds need to understand their own research process very well. Very young funds should spend time to figure out their own research process before deciding what they are comfortable outsourcing.

One major attraction of outsourcing research is less human resources management, which is a lot if one takes the turnover of junior analysts into consideration. Outsourcing is also a cheaper alternative to expending the fund’s research department. Indian ScenarioA lot of activity has also been seen in the Indian market with respect to HF in the recent past. With money making opportunities becoming rare in US and EU, HF the world over has been seen aggressively pumping money in India.

India-focused HF delivered a yearly return of 53% as on July 2007 while the Sensex returns were 44%. The current assets of HF investing in India are to the tune of approximately $14 billion. In just 2 years the

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assets have multiplied 5 fold from $2.8 billion to $ 14 billion5.

India is the largest market for single stock futures in the world and has a well-developed derivatives market in index futures and options. This gives the HF the hedging possibilities not available in other emerging markets. The high degree of liquidity offered by the Indian markets is suitable to HF style of investing.

RecommendationsTarget DestinationAmong the emerging market (BRIC nations), Russia would be the hottest HF destination. As Russia has substantially lagged the rest of the emerging market world in 2007 based on investor fears about the state of the Russian government would look like after Putin is gone.

Future Scope of Hedge Fund StrategiesIn future, the strategies that are expected to do well are the Convertible Arbitrage, CTA and Global Macro funds. As shown in the graph below, these are low on asset size but high on risk-adjusted returns, suggesting that there could be a lot of potential in these strategies. This would of course be subject to the investors’ perception of investment avenues and constraints. The emerging markets is the riskiest of strategies with above average annual returns

Strategy For IndiaGlobally, most Hedge Funds follow a strategy of long/short equity. In India, a common opinion is that HF might bring in too much volatility in the market. So, a strategy like Convertible Arbitrage may be more suitable. It fetches an average rate of return with a low level of risk. Similarly, Global Macro is a useful strategy option for India6.

References 1. Garbaravicius Tomas & Dierick Frank, “HF and their implications for financial stability”.2. Atiyah, S. and A. Walters (2004), “HF – An Overview”, Butterworths Journal of International Banking and Financial Law, May, pp. 173-77.3. Standard & Poor’s, “HF for retail investors”.4. http://www.atimes.com/atimes/Asian_Economy/EC27Dk01.html5. Statement of the Financial Economists Roundtable on HF, November 3,20056. IBM Consulting Services, “Fund Managers: the challenge of HF”Dries Darius, Aytac Ilhan, John Mulvey, Koray D. Simsek, Ronnie Sircar; “Trend-following HF and Multi-period Asset Allocation”, Dec 2001.

(Footnotes)1 Excluding double counting of assets in funds of funds2 ‘2008 HF Asset Flows & Trends Report’, By Peter H. Laurelli, CFA, Head of HF Industry Research, HedgeFund.net3 Sharpe Ratio: A measure of the mean return per unit of risk in an investment asset or a trading strategy4 http://www.eurekahedge.com/news/06_FOF2006_Key_trends.asp5 HF Net- Tracks the HF flows across the world6 Centre for International Securities and Derivatives Markets (CISDM)

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Building in-house research capabilities While not every firm has the budget and the scale to undertake such an effort, those that can are doing so and keeping idea generation inside the firm. By doing this, these firms are fully bifurcating the research decision from the execution decision, maximizing quality control while minimizing costs.

Leveraging alternative research tools A new type of tool vendor has emerged over the past few years, one that is designed to aggregate, parse and analyze information from a wide range of disparate sources, with an eye towards mitigating the signal/noise problem that plagues the research analyst, portfolio manager and trader. This helps institutional investors cast a wide information net without having the devoting the internal resources necessary to staff such an effort.

Engaging Expert Networks Rather than relying on research analysts to do general legwork, which is then broadly disseminated across hundreds or thousands of clients, an increasing number of institutional investors are using targeted expert networks to mine for the data they really need. And their findings aren’t published and widely distributed. This, like the alternative research tools, is a vehicle for maximizing return on human capital and making the analyst’s job more efficient.

Buying Selective Independent Research There are certain boutique research shops that are very good at what they do, so good that arrays of investors are willing to pay for their work. They suffer from the “diminishing value of information” conundrum: as the company becomes more successful, the value of its research declines, as its insights are more widely known, causing the information’s value to decay rapidly.

Research Budget (Fund) Spending Options

Additional Figures and Tables

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Advantages in Emerging Markets

Disadvantages in Emerging Markets

Avatar Investment Naissance ( Jaipur) India fund

Management Fair Value Atlantis India Opportunities fund

India Deep Value Fund Vasistha South Asian Fund Ltd.

India Capital Fund (Healthcare Sector) Karma Capital Management LLC

Monsoon Capital Equity Value Fund Kotak WM India Fund Limited (Long/Short)

List of hedge Funds in India

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MNC Delisting - Reaping the Benefits in 2009

Swati Aggarwal, Neha Gupta[IIM Bangalore]

AbstractThe Indian Stock market crash of 2001 was accompanied by large scale delisting of MNC’s as they took advantage of the abnormally low stock prices to buy back shares and pack off from the Indian Bourses. At that time the movement was much criticized by observers and many blamed the lax SEBI rules for the same. The authors of this paper however believe that in the context of the current financial meltdown the delisting may have proved to be a blessing in disguise for India leading to greater decoupling of Indian equity markets from that of the US then would have otherwise been the case. The reason being that these MNCs are more affected by global downturns since their business interests are spread across the globe, especially the US. To test this hypothesis separate regressions were run between the Indian and the US stock markets and between an MNC stock index of still listed shares and the US stock market. The later displayed a higher correlation lending support to the hypothesis that without the delistings, in the presence of a greater number of listed MNCs the Indian stock market would have responded far more to the US stock market developments.IntroductionThe year was 2001 and the Indian stock markets had

just entered a bear phase that was to last till 2003. The Ketan Parekh Scam had unfolded and bank call rates were at an all time high. It was during this phase that a large number of major MNCs that had been listed on the BSE/NSE decided to take advantage of the free fall in the stock prices to buy-back their shares, converting their Indian subsidiaries into unlisted, wholly owned private limited companies.This trend started with small and mid-sized MNCs but soon caught on with bigger names too jumping on the bandwagon. In 1999 there were six buyback offers; the next year the number rose to eight, finally peaking in the financial year 2001-02 to twenty. Some of the major names exiting the Indian bourses were Reckitt Benckiser, Cadbury, Philips, Carrier Aircon, Otis Elevator and Industrial Oxygen.Reasons for the ExitThis move was prompted by a number of reasons:

• Indian regulatory framework: The regulatory environment became favourable to such buy backs. In the early 1970’s, many of these multinationals had been forced by the Indian Government to take their companies public under the tenets of the Foreign Exchange Regulation Act. This brought down their stake in Indian subsidiaries from complete ownership

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to around 40 percent. However after the launch of the economic liberalization program in 1991, government regulations governing MNCs became more lax in an effort to attract more FDI. Foreign companies were first allowed to increase their stake to 51 and, later, to 74 percent followed later by removal of all caps in some sectors. The requirements on buy-back imposed by SEBI also became less tedious (For instance, an amendment to the Companies Act, effected in the last quarter of 2001, enabled companies to go ahead with their buyback proposals with just board instead of shareholder approval.) The MNCs were also aided by the Indian Finance Ministry's decision to raise from 5 to 10 percent, the annual limit on shares that the major shareholders could buy in their companies without making a formal offer. The abolition of Section 43A of the Companies Act, which imposed onerous disclosure requirements on large private companies as `deemed public companies' further served the purpose.

• The MNCs’ defence: The MNC’s cited a number of reasons for their decision. These included the fact that given the then existing poor market conditions, they had no alternate means to invest these funds more productively; their share price did not reflect their true value as also the desire to avoid the spurts of scams and allegations of manipulation that seemed to plague the Indian markets.

• The critics: Independent observers pointed to a number of other advantages that these companies would gain by this move. Multiple listings in various countries tend to be cumbersome. Also fully controlling their Indian subsidiaries makes proprietary technology transfers easier for the MNCs. Many dubious motives were forwarded too, like the fact that post-delisting and conversion of their subsidiaries into local branches, these companies would be able to escape public scrutiny and accountability.

Concerns expressedIt was at that time believed that such a mass exodus of MNCs did not bode very well for the Indian markets and stockholders. While there were some who were optimistic enough to suggest that such a move suggested that the MNCs were preparing to take the Indian Markets more seriously and hence were adopting a more aggressive stance, most were not convinced. Even the FICCI had expressed its concerns.1

The biggest fear that was expressed was the fact that this meant that now a significant portion of the economic activity in the country would become more opaque. It would have also meant that in the absence of domestic players enjoying similar credibility to replace them, the Indian capital markets, still young would become shallow. Concerns were also expressed for the dying regional exchanges as volumes traded fell to minimum. Finally anger was also expressed on the behalf of small stockholders who were bought out cheap when the markets were low.A Blessing in Disguise?The authors of this paper believe that the exodus of major MNCs in the period 2001-2002 has turned out to be a blessing in disguise in the turbulent times of today. These companies, prominent on the US Stock exchanges and with significant business interests in the worst affected markets of US and Western Europe, have suffered heavily in the ongoing crisis. These stocks, if listed today, could have rendered significant volatility to the Indian stock markets exposing them further to the risks from the US markets. Their delisting has in fact contributed to the decoupling of the Indian economy. Hypothesis:The question that first strikes in the above explanation is – would MNCs listed on the Indian stock exchange really import volatility from the West? It is this hypothesis that the authors have attempted to test, the basis being the MNCs listed on the National Stock Exchange today. These companies’ stock prices, we believe, have a higher degree of correlation with the US

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Equity Market than the overall Indian Stock Market. In an attempt to find the same, a regression was run between the MNC stocks and the US Stock Market Index on one hand and the Indian and the American stock markets on the other.Methodology: For this purpose, the following indices were chosen:

• The NYSE Composite Index was taken as the representative of US stock market activity. This is a stock market index covering all common stock listed on the New York Stock Exchange, including American Depositary Receipts, Real Estate Investment Trusts, tracking stocks, and foreign listings

• For the Indian Stock Market, the representative index taken was the S&P CNX 500. The CNX

500 is a broad-based benchmark of the Indian capital market, representing about 84.24% of total market capitalisation and about 78% of the total turnover on the NSE as on March 31, 2008.

In both cases the guiding philosophy was the fact that in order to understand the extent of correlation it is imperative to take a broad measure of the stock market, a measure that would help establish clearly the relationship between the companies and the market. • For the MNCs, an MNC index was constructed

by taking a simple average of 10 prominent MNCs2 on the National Stock Exchange. The selection criteria for the same include a trading frequency of atleast 90% in the last 6 months

Regression Statistics Multiple R 0.913273R Square 0.834068Adjusted R-Square 0.833407Standard Error 355.3616Observations 253

Fig 1. Scatter Plot for adjusted NYSE composite v/s S&P CNX 500

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and a market capitalization and turnover rank in the universe of less than 500.

Data for all the indices was collected for the period January 1, 2008 to January 23, 2009, the period of the financial meltdown.Results:The following results were derived:

• There was a significant correlation observed between CNX 500 and NYSE Composite Index with a R2 of 0.83407. (See Figure1)

• There was a higher correlation between the MNC index constructed and the NYSE Composite Index. The scatter plot of the two showed a significant positive linear relationship. The regression model run on the same gave an R2 value of .90215 ( See Figure 2.)

Inference:Thus in line with expectations it was observed that the stock prices of the 10 MNCs listed on the Indian

markets are more closely related with the US stock market. However owing to their small number in a pool of 500 CNX they were, fortunately, not able to significantly destabilize the Indian markets. The same could not have been said, however, had the turn of events not been what it was in the period 2001-02. Most of the over 40 MNCs which exited then have major operations in the West and have seen major turbulences in their stock prices, as has the US Market. The story, as can be seen from the results of the model, would not have been very different here. Moreover, given the fact that some of these companies were a part of the then Sensex30, the extent of volatility can only be imagined. An economy that has been able to decouple (though to what extent is in itself a highly disputed fact) and shield itself from the tumultuous movement of the West, would perhaps not have been able to do so. Conclusion:

Regression Statistics Multiple R 0.949816R Square 0.90215Adjusted R Square 0.901761Standard Error 353.7057Observations 253

Fig 2. Scatter plot for adjusted NYSE composite v/s MNC index

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The paper began with a brief description of the MNC exit from the Indian stock market that occurred at the beginning of this century along with the fears that were expressed about the same. The authors then went on to propose that despite such pessimism that was associated with the move, retrospectively it may have had in fact contributed to the decoupling of the Indian stock markets from that of the United States and thus may have insulated us somewhat from the effects of the financial meltdown. This was based on the hypothesis that MNCs with business interests in several parts of the world including the worst affected countries have been affected more by the crisis and hence their stock prices have taken a greater beating too. To test this hypothesis, the correlation of the stock prices of still listed MNCs to the US stock market during the current stock market flip-flop was compared to the correlation between the Indian and US stock markets. As was expected, the correlation in the first case was higher, thus validating the idea that had more MNC stocks been listed on the Indian Stock market, its correlation with the US stock market would have been greater making it more volatile in the current times. Perhaps, there is a silver lining in every cloud…

References: http://finance.yahoo.comhttp://www.nseindia.comhttp://www.capitaline.comhttp://www.atimes.com/ind-pak/DF05Df04.htmlhttp://www.thehindubusinessline.com/

iw/2002/03/17/stories/2002031700430600.htmhttp://www.atimes.com/atimes/South_Asia/

EF25Df03.htmlhttp://www.indiadaily.com/editorial/14853.asphttp://www.icmrindia.org/casestudies/catalogue/Finance/FINC006.htm

(Footnotes)1 According to Amit Mitra FICCI’s secretary general, “FICCI is concerned about recent trends of foreign companies getting delisted and acquiring 100 percent equity.” MNCs delist in India on revelation fears Indrajit Basu Asia Times Online June 25 2003 http://www.atimes.com/atimes/South_Asia/EF25Df03.html2 The ten companies included in the MNC index include ABB, ACC, Britannia, Colgate, CRISIL, Cummins, Gillette, GSK, HUL and Macmillan

“Diversification is a hedge for ignorance” - William O’Neil.

“Don’t bottom fish” - Peter Lynch.

“Don’t try to buy at the bottom or sell at the top” - Bernard Baruch

“The worst trader you’ll ever meet is your ego.” - Charles B Schaap

“If it’s not in the chart, its only in your mind.” Charles B Schaap

- compiled by Shishir Kumar Agarwal, IIM Calcutta

Quotes

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Failure of TARP & Solutions to the Banking Crisis

Arjun Ravi Kannan[IIM Bangalore]

Executive SummaryThe banking crisis in the US shows no signs of abating. The Treasury Asset Relief Program (TARP), which was envisaged, as a means to stabilize the system has not succeeded in its endeavor to restart lending. By lurching from one solution to the next, and by bailing out bank after bank, the program has lost its credibility both with the markets and the public. TARP has created perverse incentives to existing shareholders and managers without attracting private capital. An alternative bold solution to the crisis would be nationalization of the banking system. In one stroke we remove uncertainty and can go about the task of restructuring the entire sector. Lending can also be restarted and the real economy stabilized from a vicious cycle. The pros and cons of this measure are debated and the arguments of both sides are presented. Finally, nationalization is recommended as a possible permanent solution to the crisis.

IntroductionThe worst financial crisis since the great depression has wrecked havoc on the global economy and seemingly paralyzed policy makers as well. What started out as defaults in one segment of the financial markets has since consumed and imperiled the very foundations of the modern capitalist economy. Hence, a solution to the banking crisis is de rigueur for any hopes of a sustained recovery in the medium term. At the heart of much of these attempts have been the US Federal Reserve and the Treasury Department. In addition to several lending programs and an alphabetical soup of acronyms that act as sources of liquidity, the US Treasury has been using the Troubled Assets Relief Program, commonly known as TARP, to tide over this crisis. While it may be premature to condemn this program as a complete failure, it is clear that it is not working towards the intended consequence and is becoming increasingly unpalatable to the taxpayer by the day. In what follows, the reasons for the continuing poor performance of the program, why a new program might be needed, and possible innovative strategies to combat rising

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risks of a systematic failure are examined.

TARP and its various strategiesTARP allows the Treasury Dept. to extend a line of credit of up to $ 700 billion to various institutions in the form of guarantees, capital infusions, asset swaps and any other mechanism so as to ease the credit and liquidity crunch. The original intention of TARP was to purchase “troubled assets”, including mortgage backed securities, collateralized debt obligations and other illiquid securities, so that banks could rid their balance sheet of these uncertain assets. The hope was that once the markets recovered and these securities actually had a functioning market, the value of these assets could be better realized than dumping them in troubled times. While past losses/write downs were not allowed to be funded, any fresh troubled assets or existing assets still in the portfolio of companies could be swapped. The rationale was that once the balance sheet of these companies was clean, private capital would enter and recapitalize the institutions. This would then encourage banks to restart the lending process to banks, corporations and consumers to once more jumpstart a credit-driven economy.

However, the problems with the above approach were apparent. The fact that the banks could not really value these securities (the percentage of level 3 assets which are essentially “marked to model” is very high) at market prices should have warned authorities that the original proposal was not implementable. There are a few issues here. One, if the government pays too low a price for the security the banks would refuse to sell the assets as it would increase their losses and potentially bankrupt them. Second, if the government pays too high a price, then taxpayers are being taken for a ride at the expense of the same people who got us into this mess. Finally, there is always a fundamental problem of information asymmetry, where the bank clearly knows more about the asset than the government can ever find out. This would thus be a recipe for inflated asset

valuations by the banks with the securities. This led to a shift in strategies from outright asset purchases to capital infusions in the form of preferred shares to the government. Those firms, which did sell assets to the government, would have to issue equity warrants (if company is unlisted then senior debt) so that taxpayers can benefit from the potential upside. The problem with this approach as is now being seen is that the whole process is opaque. There is no clear benchmark to decide who gets to use the funds. For example, even the financing arms of the US automakers are getting a share of the funds. Further, there is no incentive to lend, given the leverage of many of these institutions. As far as they are concerned, this is a way of padding their balance sheet to protect against future losses. A more effective way to ensure this would have been to take common equity stakes. At the same time, existing shareholders are affected by such a move, and the whole program creates nil to negative incentives for private capital to enter.

The current situation and the way forwardA realistic assessment of the current situation presents a scary picture. The entire banking system in the US (and UK) is technically insolvent. If the total credit losses (expected to be around USD 3-4 trillion) are recognized, the number would exceed the total capitalization of the entire US banking system (closer to USD 2.5 trillion). It is often argued, and rightly so, that in such stages of a downturn, mark to market insolvency does tend to happen. However, what these arguments miss out is that in this particular crisis, many of these losses are very real, and the current value of securities (as present on the banks’ balance sheet) is likely to present an inflated picture. Take an example of a mortgage like the adjustable rate mortgage (or even Alt-A loans) that was worth a million dollars. The house is probably worth half that value and the loss of $ 500000 is very real. It is unlikely to be recovered since the structure of the loan, the shape of the housing market which is still above historical averages and the

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type of people who got these loans (liar loans) suggest very little upside even in the long run and will likely default. This alone is likely to result in future loses close to a trillion dollars. Hence the argument that holding assets for a long time would improve the situation does not hold water.

So what is the alternative? It is clear that no amount of quantitative easing (QE) or zero interest rate policy (ZERP) from the Federal Reserve over any length of time will help too much. Nor will a fiscal stimulus, however bold, be able to act as anything but a temporary bandage. The alternative, which is probably gaining traction, is the concept of a “bad” bank or an “aggregator” bank to bundle all the bad securities, as was done with the Resolution Trust Corporation (RTC) back during the savings and loan crisis. However, the way it is being suggested will not make a difference because of two reasons: the problem of valuation of assets, and the fact that government will be a major shareholder but without taking control. The answer: nationalization.

Nationalization: Benefits and ProblemsNationalization seems to suggest that we are abandoning the principles of markets. However, if done in an orderly fashion, we can bring the banking system back to reasonable health and restore confidence. These are the steps that should be followed in nationalization. First, a quick review of every major and mid level bank must be made to determine the extent of their exposure to these assets. Second, the ones that are otherwise healthy must be saved, while the ones that are irredeemable must be allowed to fail. Third, the fundamentally healthy but impaired banks (those which don’t need capital can exist as it is) should be placed under a conservatorship (like Freddie and Fannie). Fourth, their entire equity must be wiped out, managements fired, and no golden parachutes must be given. This takes care of one form of moral hazard. Fifth, debt holders, other than senior most debt

holders, must be forced to take a haircut, as there is no rationale for the taxpayer to fund bondholders. Sixth, managers may be incentivized to lend according to long-term profitability. Seventh, the bad assets are now moved to an RTC like bank where debt is paid down and the assets are gradually sold to private investors. Finally, when the books are sufficiently cleaned up and markets stabilize the banks can once more be available for public ownership.

What are the advantages of nationalization? The most obvious advantage is that uncertainty in the markets is removed once and for all. Rather than lurching from one bailout to another, and markets worrying about creeping nationalization, a bold solution like this would signal a bottom. Another advantage is that banks can begin to lend again. The problem with equity stakes without control was that managers and shareholders, worried about their future would rather use the money to pay their salaries and repair their balance sheet, resulting in a hobbling bank that does not take risk. At the same time moral hazard is vastly reduced when exiting managers are punished for reckless lending and hence future excessive risk taking is minimized. The greatest advantage though is that the problem of valuing assets is no more a necessity. Since both the “good” bank and “bad” bank are under government control, the asset valuation does not matter, as it merely involves transfer of assets from one part to another part of the same owner. This could be done at historical cost or zero value or any other value as there is essentially no difference. The “bad” bank collects all the cash flows associated with the assets and if no market develops, then it holds the assets to maturity. The “good” bank can be privatized when conditions improve. The cost of nationalization has been shown to have a lesser final fiscal cost than this stage wise bleeding. As an example of its actual implementation, we need not look further than Sweden, which in 1993 did the same thing. The overall cost to the government was minimal. Finally, the reason debt holders have to

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pay a price is because there is no reason for risky debt investors to be rewarded while stockholders suffer. The taxpayer should not subsidize them (senior debt holders may need to be accommodated for fear of greater contagion while junior debt holders’ rationale for investing itself is that they sought more risk and hence were paid a higher rate).

The arguments against nationalization exist. The major reason is the mistrust that government cannot run efficient operations and would be prone to political pressures. Appointing commercially oriented managers can reduce this problem. Further, it can be argued that state control may become permanent. Finally, a very credible argument exists to make a distinction between the Nordic experience in the 1990’s and the US. The US banking system is much larger than the Swedish system and both the costs and time required are higher and chances of a successful withdrawal at a later stage by the government are likely to be lower. The linkages in global finance may also cause issues on valuation of assets unlike in the 1990’s when most of the assets in Sweden were regionally owned. However, none of these reasons are sufficient to continue with status

quo. The costs are too high, and a bold initiative is a must. Nationalization and nimble restructuring is the quickest and cleanest end to the mess we are in right now.

ConclusionThe banking crisis has been dragging on for a long time with no apparent end in sight. The TARP, which was introduced to ameliorate the problems in the system, has not made an appreciable impact. With the real economy in serious danger of significant long-term damage, bold solutions are required to dig us out of this morass. Nationalization is the best among the bad alternatives available at the moment. By eliminating uncertainty, moral hazard, and questions on valuation of assets, it can go a long way in finding the bottom in this crisis. Critics, who fear socialism, should take a leap of faith, and give a chance for a complete overhaul of the banking system. With firm regulatory structures in place, a more healthy banking system can be built and a quick withdrawal by the government can be achieved. In summary, to save capitalism, the state must step in and do the job.

CROSSWORDSOLUTIONS

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Value Investing

Deepak Gupta, Nikhil Maheshwari, Rohit Chawla[MDI, Gurgaon]

Past Trends and Current Opportunities in India

Executive SummaryValue investing is an investment philosophy given by Benjamin Graham and David Dodd in the 1920s. Value investing focuses on investing in stocks, which are under-valued i.e., are trading below their intrinsic values. It aims to capitalize on the inefficiencies in the market, in terms of the disparity between the value and price of a stock. A bearish market is usually an excellent opportunity to invest in value stocks. This is so because in a bearish scenario, like the current, the investors are extremely pessimistic about the entire stock market. This results in some stocks being heavily under-valued. This article analyses the performance of such value-based picks compared to the average market performance, in the previous bull phase. For this purpose, five value based stock portfolios were formed based upon different value themes at prices prevailing at the end of the dot-com bust. The performance of these portfolios was compared with that of the Nifty and was found to be superior to that of the market, in general. Thus, value investing was shown to be an investing approach providing super-normal returns. Lastly, value stocks in the current market were identified. These are expected to give super-normal results in the future.

What is Value InvestingValue investing is an investment paradigm that is based on the ideas of Benjamin Graham & David Dodd. The ideas of this theory developed with Graham and Dodd’s teachings at Columbia Business School, USA, in late 1920’s. Graham presented the ideas in his books; Security Analysis and The Intelligent Investor. The theory is based on the philosophy of investing in securities, which trade at a deep discount to their intrinsic value. Warren Buffet is the most famous follower of the principles of value investing in the modern world. The core principles of value investing are the following:

• A stock, or any other security for that matter, has an intrinsic value, and this underlying value does not depend upon the market price.

• The market, at times, assigns prices to certain stocks which may be unjustifiably low or high.

• An intelligent investor buys when the market price is unjustifiably low and sells when it is unjustifiably high. This is best captured by Buffet’s philosophy of being “Greedy when others are fearful and fearful when others are greedy”.

• Investors should be prepared for long-term investments in a stock. Value investing is not concerned with and cannot predict the short-term movements of the market or of

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a stock. However, a stock which is genuinely underpriced will yield significant results in the long run.

Value investing as an investment method, is focused on the curtailment of risk in investments. Value investors focus on how not to lose money, rather than how to make huge amounts of money. In this respect, Benjamin Graham talked about introducing a ‘Margin of Safety’ in the analysis to minimize the downside risk. This just means that you buy at a big enough discount

to allow some room for error in your estimation of value. However, this does not imply that value investments are low-risk, low-return ventures. In fact, value investors believe that low risk investments actually result in high returns. This is well demonstrated by the success of value investors like Warren Buffet. In this article, we will test this statement by evaluating the performance of some value stocks in the Indian market during the previous stock-market boom. Value Investing in Current ScenarioThe current slowdown has brought about an interesting scenario for stock markets around the world. The stock market is under a strong hold of the bears and investors are wary of putting their money into stocks. The financial sector crisis in the US has seen stocks around the world tumble to levels, which were unthinkable less than a couple of years ago. Most people would thus argue that the best strategy to play the stock market right now is to stay away from it. Value investors, however, differ from this view. The value investing philosophy suggests that the current condition provides an excellent opportunity to pick up shares at very cheap prices. Talking in Graham’s language, this could be one of the times when the market is unjustifiably pessimistic on a large number of stocks. This however, does not imply that we should start picking up each and every stock just because it is trading at way below its bull-run highs. What this does suggest is that in every bear run, although there are stocks which fall due to genuine falls in their values, there are many which decline simply because of the

widespread pessimism among investors. Obviously, the intrinsic value of the company does not swing with the mood of the investors. A large number of stocks consequently end up taking a huge beating without any rational reason and hence trading at huge discounts to their intrinsic value. Thus, every bearish phase brings about some excellent opportunities for the value investor to capitalize upon. In the later part of this article, we will evaluate the performance of some such opportunities provided at the end of the dot-com bust, over the subsequent boom in the Indian stock markets. We will also evaluate and present some stocks, which are good value buys in the current bear market and should yield excellent returns in the long run.Value Investment ThemesThe major challenge in value investing is to determine the intrinsic value of the company and hence of its shares, relative to the prevalent market price. Value investing works on various ratios and themes to determine if a stock is under-valued. Some of these ratios are the price-to-earnings ratio (P/E), price-to-book value (P/B) etc. We have demonstrated the principles of value investing with the use of the following themes:

Cash Bargains: A cash bargain arises when the market value of a company goes below the amount of cash and other liquid assets in its possession, net of all current liabilities and debt. In effect, the market is not giving any valuation to the fixed assets, to the inventories, and to the receivables.

Debt capacity bargains: The value of a debt free company has to be substantially more than the amount of debt it can comfortably service. Thus, a company is highly under-valued if its market capitalisation is less than its debt-raising capacity. It’s a principle which was first laid out by Ben Graham in Security Analysis.

Price-to-earnings ratio (P/E ratio): This is the ratio of the company’s market capitalisation

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and the net profit. According to Benjamin Graham’s principles, the earnings yield of a value pick should be very high, or equivalently, its P/E ratio should be very low. Graham said that a stock with an earnings yield of twice the yield on AAA bonds is a safe value bet.

• Price-to-book value ratio (P/B ratio): The P/B ratio is a ratio of the market capitalisation of a company and its book value. Theoretically, a P/B of less than 1 shows that the market has valued a company below the book value of its assets, adjusted for all liabilities. However, in accordance with the margin of safety concept, value investment requires the P/B ratio to be much lower.

• Dividend yield: The dividend yield is a ratio of the dividend paid by a company to its market capitalisation. To an investor, it signifies the annualised return (in terms of dividend) he can achieve by investing at the current market price, assuming that the dividend remains constant over the years. A high dividend yield shows that a stock is under-valued. Graham has used this parameter extensively in The Intelligent Investor.

Performance Evaluation of Value Investing ApproachIn this section, we have made an attempt to evaluate the performance of the value investing approach over the previous bull phase in the stock markets and compare it with the market’s performance in general. Using this comparison, we aim to test if the results yielded by the value investing approach are truly superior to other approaches. This evaluation consisted of the following steps:

• Audited financial results of the companies comprising S&P 500 was obtained from CMIE database Prowess for the year ending March

2003 (beginning of the Bull Run) and March 2008.

• Various Price ratios and price data for the similar periods was also obtained.

• Stocks worth purchasing in 2003 were identified using various value investing criteria. These criteria are:

• Cash Bargain: Stocks were identified as value stocks, based upon the cash bargain theme if their cash + market value of their investments was more than their market capitalization and outsider’s liabilities. All the stocks that satisfied the criteria were selected.• Debt Capacity Bargain: The debt-raising capacity is estimated using the PBIT figure in the company’s last annual result. We have estimated that a company can comfortably raise loans which would keep its interest cover ratio above 5. This has been used to estimate the amount any company can safely pay as an annual interest expense. The interest rate has been taken to be at 14 per cent for the calculation of the debt raised which will result in the interest expense calculated above. Both these assumptions are pretty conservative according to the actual conditions faced by Indian companies to raise debt from the market and thus allow for a margin of safety.

• P/E ratio: We have considered a stock with P/E ratio of below 2 to be a value stock. This translates to an earnings yield of 50%, which is much higher than that available on bonds.• P/B ratio: All stocks with P/B of less than 0.3 were selected.

• Dividend Yield: All stocks with dividend yield of 9% or more were selected.

• Based on each of the above value investment

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themes, we have come up with portfolios of stocks that were highly undervalued in March 2003. We have evaluated the returns obtained on each of these portfolios and compared it with the average performance of the market or the index itself. All stocks in a portfolio were given equal weights.• The return was calculated for each of these portfolios for the period starting from 31st March 2003 to 1st of January 2008.• For the same period, the return of the Nifty was calculated and was compared with the portfolios’ return.

Results and ConclusionThe value stocks thus identified were observed to generate returns which were much superior to those generated by the stock markets in general. Some of these stocks produced absolutely staggering results. For example, Videocon Industries that traded at a P/E of 0.14 and P/B of 0.01 in March 2003 moved from Rs. 12.80 in March 2003 to Rs. 811.50 (as on 1st Jan 2008). This stock was a part of 3 of the 5 value

investing portfolios. Walchandnagar Industries, which was a part of 2 portfolios shot up from Rs. 2.73 to Rs. 863.20 over the same period. The returns obtained by the different portfolios and the returns of the Nifty are tabulated below.

As can be seen from Table 1, supernormal returns can be obtained by following the value investing approach. Nifty provided an annualized yield of 39.25%, from Mar 2003 to Jan 2008, which is less than half of the minimum return provided by any of the portfolios (Debt capacity portfolio provided 86.95%). Therefore, it is observed that the returns obtained upon value investment are much higher than those offered by the market in general.Since we have established that the value investing themes discussed in this article can help generate superior returns, we have identified some value stocks based on these themes in the current market. We thus present below stocks that are expected to produce excellent returns in the future, based on each of the value themes.

ReturnDividend Yield

P/E Portfolio

P/B Portfolio

Cash Bargain

Debt Capacity

Index (Nifty)

Average Return (in %) 4976.55 10713.82 19932.96 14600.87 2283.65 523.65Average Return 49.77 107.14 199.33 146.01 22.84 5.24Annualized Return 2.18 2.55 2.88 2.71 1.87 1.39Annualized Return (in%)

118.47 154.68 188.35 170.94 86.95 39.25

Table 1 : Comparative returns of the portfolios and the Nifty

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Theme Stocks to look out for

Cash Bargain Reliance Infrastructure , Hindalco Industries , Aditya Birla Nuvo ,Bajaj Holdings &Invst. , Tata Investment Corp. , Jai Corp, Jindal South West Holdings, PTC India, Shaw Wallace& Co., Patni Computer Systems, Cairn India, Subex, JM Financial, Hinduja Ventures, Aftek, Mascon Global, Hexaware Technologies, Kolte Patil Developers, BSEL Infrastructure Realty, IL&FS Investmart, Pheonix Mills, Mahindra Lifespace Developers, Country Club (India), Balaji Telefilms, Sasken Communication Technologies, Tanla Solutions, GSS America Infotech

Debt Capacity Bargain JM Financial, LIC Housing Finance, DCM Shriram Consolidated, Alok Industries, Orbit Corporation, JK Lakshmi Cement, India Glycols, SREI Infrastructure Finance, Vakrangee Softwares

P/E Ratio Aftek, Amtek India, Vakrangee Softwares, Prajay Engineers Syndicate, Lok Housing & Constructions, JM Financial, Prithvi Information Solutions, IVR Prime Urban Developers, JK Lakshmi Cement, Orbit Corporation, Kolte Patil Developers, JK Cement, Marg, Sujana Towers, Chennai Petroleum Corp., Kesoram Industries, Mysore Cements, Country Club (India), India Glycols, Bharati Shipyard, Alok Industries, HDIL, Gujarat State Fertilizers & Chemicals Ltd, KLG Systel, Ruchi Soya Inds, Orient Paper & Inds, Gujarat Fluorochemicals, Nava Bharat Ventures, Kei Industries, Ajmera Realty & Infra India, Unity Infraprojects

P/B Ratio Aftek, Prajay Engineers Syndicate, Country Club (India), Subex, Prithvi Information Solutions, Amtek India, Mascon Global, Vakrangee Softwares, Alok Industries, Bajaj Auto Finance, IVR Prime Urban Developers, Lok Housing & Constructions, Arvind Ltd, Megasoft, Mukund Ltd, Ansal Properties & Infrastructure, Gitanjali Gems, BSEL Infrastructure Realty, Sujana Towers, Kolte Patil Developers, Sasken Communication Technologies, Bharati Shipyard, JSL Ltd, Kei Industries, Ganesh Housing Corp., JK Lakshmi Cement, Marg, Ruchi Soya Inds

Dividend Yield Indiabulls Securities, Monsanto India, Chennai Petroleum Corp., Prajay Engineers Syndicate, SRF Ltd, Indiabulls Real Estate, JK Cement, IVR Prime Urban Developers, Varun Shipping Co, NIIT Technologies, Bongaigaon Refinery & Petrochemicals, Tata Motors, Ganesh Housing Corp., Graphite India, Finolex Industries, Ashok Leyland, HCL Infosystems, Deccan Chronicle Holdings, Indiabulls Financial Services, Kalyani Steels, Sasken Communication Technologies, Orbit Corporation

Table 2 : Value stocks at current valuations based on different themes

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cover storycover pagepRIMER

An Article by

Associate Professor of Finance, William Patterson University, New Jersey

Prof. Malay K. Dey

Malay K. Dey is currently an Associate Professor of Finance at the Cotsakos School of Business, William Paterson University in New Jersey. He has also been a Visiting Faculty at the Indian Institute of Management Calcutta (Summer 2006 and Winter 2008). Professor Dey received his Ph.D. (Finance) degree from the University of Massachusetts Amherst in 2001. His primary research interests are market microstructure, international financial markets, and financial econometrics with a secondary interest in financial technology.

What do we know about the market microstructure of the Indian Stock Markets?


Not much! A keyword search on ssrn.com on “India and stock markets” returned 179 papers, albeit mostly unpublished working papers. Almost all of those academic/semi-academic papers posted on ssrn.com related to the Indian stock markets investigate market efficiency and corporate governance issues. When I searched on ssrn.com for research papers on Indian stock market with a qualifier like “microstructure” or “intra day” the search returns between three and six papers, a few of those papers being simply opinion pieces or commentaries. A similar search on ABI-Inform, Econlit, and JSTOR all of which index published papers only returned 2/3 entries. These searches confirm that in fact, we know very little or nothing about the market microstructure – the organization and regulatory structure, the inner workings of the markets, how those markets perform, and the governance of those markets. NSE, the leading stock exchange in India in terms of trading volume supports a project based funding scheme for research on Indian stock market and compiles a working paper series based on the completed research projects funded under that scheme (www.nseindia.com). However, I have not seen many academic papers citing those sources.

Before I go any further, let me first compile some stylized facts about the Indian Stock markets.

First, India has a long history of organized stock exchanges since its first exchange opened in the western city of Bombay, now renamed Mumbai, in 1857. Since then and mostly since Indian independence in 1947, multiple stock exchanges opened and operated throughout India.1 At the beginning of the financial market reform in early 1990s there were more than 20 regional stock exchanges in India although there was a huge concentration of trading activities in only a few of those. Indeed at the beginning of 1990s, the top five exchanges in terms of trading volume, Ahmedabad, Bombay, Calcutta, Delhi, and Madras account for more than 75 percent of trading volume for the entire Indian stock market. The financial market reform in India that started in early 1990s prompted major structural changes in the exchanges including the opening of NSE, the wholly electronic market place for securities, and the consolidation of several exchanges. Since the introduction of NSE, the first fully automated trading system in India almost all trading activities are concentrated at NSE with BSE being a distant second in terms of trading volume. Bhole and Pattanaik (2002)

report that for 1998-99, while BSE and NSE account for 71 percent, the top five- NSE, BSE, Calcutta, Delhi, and Ahmedbad account for more than 95 percent of turnover for the entire Indian stock market. While there is an ongoing debate on the role and continued survival of regional exchanges, since 2000 there has been a consolidation initiative that has resulted in a memorandum of understanding for the sharing of a trading platform and the demutualization of regional exchanges.2 Currently the number of stocks listed in various stock exchanges in India adds up to more than 10,000 although many stocks are cross-listed in multiple stock exchanges. These 10,000 stocks are spread over more than 100 sectors including banking, retail, consumer durables, electronics, business services, software, and consulting.

Second, two of the above exchanges, NSE and BSE have composite indexes, which track the performance of the respective market. BSE is a free-float market capitalization (since 2004) index that started in 1989 and was initially composed of 100 stocks from the five major stock exchanges, Ahmedabad, Bombay, Calcutta, Delhi, and Madras. Since 1996, BSE-100 consists of only BSE listed stocks. NSE introduced a market value weighted NSE 100 index with a base date of Jan 1, 2003 and base value of INR 1000.

Third, I cannot find any published paper using intra day price and/or trading volume data from the Indian stock markets. Hence I conclude that no convincing research exists on the traders’ behavior and market microstructure effects on price formation in the Indian stock markets. Similarly although there is a street perception of some liquid and illiquid stocks, no empirical evidence exists on either liquidity or cost of liquidity of stocks traded on the exchanges. While eyeball statistics may confirm some very liquid and illiquid stocks, often such simple statistics like trading frequency and volume turn out to be misleading.

The statistical properties of intra day returns, bid ask spread, trading volume, and liquidity might be different in one exchange from another. While ex ante there may be some obvious differences among the exchanges in terms of their organization and structure, the price formation processes may be also different due to locations and heterogeneity among traders and listed stocks in each exchange. Further, based on the evidence provided by Aggarwal (2002) that stock exchange ownership and governance structure has an

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impact on the liquidity of stock exchanges, it might be worthwhile to investigate how much of the success of NSE is due to its joint stock corporation rather than brokers’ association (mutual corporation) status.

One of the primary reasons why empirical research on Indian stock markets is severely lacking has to do with the availability and access to data. NSE and BSE, the leading exchanges can facilitate empirical research by providing easy access to transaction level data similar to TAQ (NYSE) to finance researchers across the globe. NYSE’s TAQ data has been instrumental in fueling the interest in empirical microstructure research with respect to US stock markets. There is another more fundamental reason for the lack of empirical research in microstructure of securities markets – it’s the lack of appreciation of the role of economic analysis and empirical evidence on securities market regulation. In USA there is a realization that both regulation and its enforcement are costly, and regulation without proper enforcement is vacuous, and thus there is a great urge to weigh the costs and benefits of regulation. For example, after the stock market crash in 1987, NYSE instituted trading halt and suspension rules. Several studies have now reported on the relative effectiveness of the trading suspension rules on market performance and crashes (Lee et al, 1994). Similarly, in the aftermath of SEC downtick rules, researchers have studied and documented the effect of uptick rules on short interest and volatility in the market (Alexander and Peterson, 1999) and decimalization came into force after Christie and Schultz (1994) provided evidence of collusion among NASDAQ market makers avoiding odd-eighth ticks. Financial market regulators in the USA weigh such evidence produced by academic research to determine the effectiveness of existing and proposed regulations. In India, as SEBI becomes more reliant on empirical evidence (a good first step in the process would be to create a research cell powered with highly skilled financial economists and econometricians, transactions level data for all securities market transactions, and analytical tools) as a powerful input to its policy making process, we’ll see more empirical research on securities markets along the way.

Bibliography

Aggarwal, Reena, 2002, Demutualization and regulation of stock exchanges, Journal of Applied Corporate Finance, 15. Alexander Gordon and Mark Peterson, 1999, Short selling on the NYSE and the effect of uptick rules, Journal of Financial Intermediation, January-April.Bhole, L. M. and Shreeya Pattanaik, 2002, The state of Indian stock market under liberalization, Finance India, 16, 159-80. Christie, William, and Paul Schultz, 1994, Why do NASDAQ market makers avoid odd-eighth quotes? Journal of Finance, 49, 1813-40.Lee, Charles, Mark Ready, and Paul Seguin, 1994, Volume, volatility and NYSE trading halts, Journal of Finance, 49, 183-214 3

(Endnotes)1 For a compact history of the Indian stock exchanges and some of the institutional features of the Indian stock market, please refer to Bhole and Pattanaik (2002). 2 Please refer to the following financial press coverage. 1) SMEs would benefit from revitalized regional bourses by V. Balasubramanian, The Economic Times, September 30, 2008. 2) Indian Stock Exchanges – stage set for a dramatic change by Dr. Uday Lal Pati posted on investorideas.com on Februray 28, 2007.3 I am grateful for the research assistance provided by XueFan Cai, an MBA student at the Cotsakos School of Business, William Paterson University in New Jersey while I was preparing the manuscript

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Barrier options are path-dependent options build on vanilla call and vanilla put options with a condition that they are initiated or exterminated depending on the underlying asset hitting a certain barrier. These barriers can be in any shape or size and there can be multiple barriers. Barrier options may have a built-in rebate that is paid as compensation when the barrier is not reached. Some basic variants of barrier options are discussed below.

Payoff functions of a barrier option

.Knock Out optionThese are call or put options which purge if a certain predefined barrier above or below the initial price is reached.

Example: A Barrier call with initial value S(0) = 100, Strike K = 90, a running time of T = 2 years and Knock out level B = 120 has following disbursement profile:

If the conclusion price S(2) is below the Strike K nothing is disbursed

If the S(t) hits the Knock out level B = 120 sometime during the course of T, nothing is disbursed independent of the conclusion price

If the conclusion price S(2) (lets say S(2) = 115) lies over the Strike K = 90 but never reached the Knock out level B then the difference of the closing price S(2) and the Strike is disbursed (here for example 115-90 = 25)

When the barrier B lies above the initial price then it is called Up-and-out-call, like the example above. The counterpart for this would be a Down-and-out-call which expires, if the Barrier, which is lower than the initial price, is fallen below.

Knock in optionThese are just the reverse of Knock out options in the sense that they get activated only if a predefined barrier is reached at least once during the course of their time.

Example: A Barrier call with initial value S(0) = 100, Strike K = 110, a Knock in level of B = 130 and a running time of T = 2 years has following disbursement profile: If the conclusion price S(2) is below the Strike K =

110 nothing is disbursed If the S(t) never hits the Knock out level B =

130 during the course of T, nothing is disbursed independent of the conclusion price

If the conclusion price S(2) (lets say S(2) = 123) lies over the Strike K = 110 and hits the mark B = 130 at least once during the course of time then the difference of the closing price S(2) and the Strike is disbursed (here for example 123-110 = 13)

Similar to the Knock out options case, when the barrier B lies above the initial price then it is called Up-and-in-call, like the example above and its counterpart would be a Down-and-in-call which kicks in, if the Barrier, which is lower than the initial price, is breached.

Digital Barrier option

A digital option is an option that pays out a fixed amount if the option at maturity is in-the-money (ITM). Build upon a digital option, a digital barrier option is one that includes a barrier which, if reached during the life, affects the existence of the option. The barriers may be placed either above the strike or below, meaning that prior to expiry, an active digital can be knocked out or an inactive digital can be knocked in. Because the use of barriers decreases the probability that the digital will pay off, the gearing factor will be higher than a regular digital.

Know Your Product - Barrier options By Gaurav Lal, IIM Calcutta

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IIM Calcutta Financial Research and Trading Lab

FeaturesLive access to data from 5 different financial markets : NSE Cash, NSE F&O, MCX, BSE Cash and NCDEX.Exact replica of real broker terminals‘Trading Strategies’ a fully lab-based course introduced inaddition to course on Investment Analysis and Portfolio Management Bloomberg terminal along with simulation software

We aim to give cutting edge tools to understand financial markets and to enable exciting research possibilities in the field of finance.Prof. Ashok Banerjee, IIM Calcutta

“

BETA, The Finance Club of IIM AhmedabadBETA is the most prestigious club of IIM Ahmedabad and has been an integral part of IIMA culture since decades.

Beta aims to generate and promote interest in finance among IIMA students. However, its activities are not limited to IIMA alone. It has organized several national level case contests, trading games and workshops in the past. It has also been associated with distinguished people from academia and industry. Some of Betas’s regular activities are organizing placement oriented sessions, internships experience talks, contests and informal discussions on current issues.

NetWorth, The Finance Club of IIM BangaloreWith the growing importance of finance and the plethoraof activities that financial institutions have become a part of knowing about ‘Finance’ becomes not only important but also imperative. Networth’s activities are used to bring out the very best and disseminate the gyaan the movers and shakers in this field have to offer. So be it a Private Equity talk, a session to know if you have the skill sets for an I-Banking job or analysis of mergers and acquisitions from experts we have it all.If you love finance and are an avid follower then this club is the place to be.

Finance & Investments Club of IIM CalcuttaFinance & Investments Club of IIM Calcutta, popularly known as the Finclub is a student driven initiative that collaborates with both the corporate and academia from the financial sector to provide a platform for students to improve their quantitative and analytical thinking abilities. The club also manages and maintains the IIM Calcutta Finance Laboratory in collaboration with the Department of Finance and Control.

The club organizes industry talks, workshops, stock trading and other finance based simulated events.

THEMONEYMANAGER

AN IIMA, IIMB, IIMC Initiative | June 2009

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