Money Manager

AN IIMA, IIMB, IIMC Initiative | June 2009 THE MONEY MANAGER

eDITOR’S nOTE tHE tEAM 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 Managing Editors: of auto giants GM and Chrysler indicated that the Rajatdeep S Anand [IIMC] US economy still has some way to go before it has seen the worst of this crisis. The consensus amongst Anuja Arvind Lele [IIMC] strategists seems to be that things may worsen in short Devdutt Marathe [IIMA] term before becoming better by the end of 2009. So Piyush Soonee [IIMA] the question staring all of us in face is whether 2009 would be the beginning of a new Dawn or could Editorial Board we be heading to the something akin to the Great Depression of 1930s. Ashutosh Agarwal [IIMA] Devendra Agarwal [IIMC] The silver lining seems to be that Indian economy is Divya Devesh [IIMC] 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 Design economics especially after the upheaval in US, Majid Asadullah [IIMC] Europe and their effects on China and Japan. Abhishek Nagaraj [IIMC] The second anniversary edition of “The Money Manager” brings you insightful interviews of Prof. Coordination Committee: Partha Mohanram of Columbia University who Shishir Agarwal [IIMC] talks about the current financial crisis and how Manu Jain [IIMB] corporations should gear up for the next phase. We Ravi Shankar [IIMA] also had an opportunity to talk to Mr. K. V. Kamath, Neha Verma [IIMB] 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 Corp. Communications: in the current financial crisis, identifying successful Akshat Babbar [IIMA] hedge fund strategies for investing, new monetary policy tools, failure of TARP and climate change induced financial risks. As usual this issue is packed Logistics: with challenging puzzles, crosswords, and interesting Jay Kumar Doshi [IIMC] trivia. We hope you have a great time reading the Saurabh Mishra [IIMA] 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.

cONTENTS COVER STORY 06 An Interview with Prof. Partha Mohanram SPECIAL FEATURE 11 An Interview with K.V. Kamath EXPERT OPINION 15 Central Counterparty (CCP) - Role of Clearing Corporation of India Limited 19 An Interview with Prof. 12 Prof.Marti Subrahmanyam STUDENT ARTICLES 25 Extracting Alpha Using Behavioural Finance 30 New Monetary Policy Tools - Innovative Response to the Meltdown 36 CDS and CDS Pricing 40 Climate Change Induced Financial Risks - A Strategic Approach 60 50 Credit Default Swap Pricing: Empirical Results & Inferences 55 Effectiveness of Basel II in the current ﬁnancial crisis 60 Identifying Hedge Fund Strategies for Investing in Emerging Markets 69 MNC Delisting - Reaping the Beneﬁts in 2009 74 Failure Of Tarp And Solutions To The Banking Crisis 78 Value Investing: Past Trends and Current Opportunities in India PRIMER What do we know about the market 83 microstructure of the Indian Stock Markets? - Malay K. Dey KNOW YOUR PRODUCT 86 Barrier Options

cOVER sTORY cover story cover page An Interview with Prof. Partha Mohanram Phillip H. Geier Jr. Associate Professor of Business, Graduate School of Business, Columbia University. 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.

07 THE MONEY MANAGER | JUNE 2009 Q: We’ve seen the worldwide economic crisis continue its course” because the real effects – job losses in the auto to deepen over the last few months. How and when do sector for example, are too dramatic. So that’s something you think will it abate, and what can governments do the governments will have to do. One can of course argue to prevent the losses from piling up? about what the appropriate mechanism is – should it be a capital infusion, or a buyback of bad loans – but that is A: It’s a crisis at many levels. It’s a fundamental crisis, a simply a matter of detail. Something has to be done, and crisis of confidence, and a crisis of trust, depending on how something was done. 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 Q: What about corporations? What can they do to through bailouts, etc., banks haven’t yet started the lending survive, even thrive in this sort of environment? How process. People are just biding their time – they’re too can they prepare themselves for the next cycle? scared to do anything right now. In some sense, therefore, A: You’ve probably heard this cliché, “Cash is King”. It’s it’s almost like a self-fulfilling prophecy – it’s not going to unclear whether people mean that cash flows are more get better because nobody thinks it’s going to get better. important than net income, or that it’s critical to have cash So to some extent, the only thing that can help really is the on the balance sheet. In this case, it’s clearly the latter. This passage of time. With time, hopefully people will realize might actually go against the textbook notions of shareholder things are getting better, and that they can start stepping out value maximization – one doesn’t normally want companies again, slowly. In the immediate term, though, there is very to diversify unnecessarily and build up excess assets on their little we can really do. balance sheets that aren’t earning the required rate of return. One of the things that we can see is that some countries What the current crisis has shown is that having some sort are not as badly affected as some others. For instance, in of buffer for bad times is in everybody’s interest, including Europe, if we look at Spain, they’ve managed to do better the shareholder. Nothing good has come out of bankruptcy than England. One of the reasons for this is that they have – the shareholders are essentially wiped out. counter-cyclical capital adequacy policies. Let’s say that the Going forward, companies that haven’t built up their reserves bank has a capital adequacy ratio of 6% normally. If the need to take cost cutting seriously, and try to conserve as economy is doing really well, the adequacy ratio could be much cash as possible. They should take a complete relook raised to, say, 8%. The logic here is that (a) you want to save at their business and not build up any sacred cows – no for a rainy day, and (b) you want to prevent people from business line is not subject to clean up or closure. A good making bad, reckless choices because they believe that the analogy here is the Tata Nano. When Tata engineered good times are going to last forever. If you think of the the Nano, they essentially questioned every engineering big financial institutions, the big American and European element and asked, “Is this really required in a car?” That institutions are in big trouble. Their market capitalization was how they were able to bring their costs down. There is is down 50% or so, not 98%! One of the reasons is that of course no guarantee that they will continue to be able to they’ve borne the onerous burden of having extra capital do this going forward, but at least they have brought down adequacy requirements in good times, meaning that their the costs dramatically as of today. Similarly, corporations balance sheets are much stronger. At the same time, they should look at their businesses in totality and ask, “Do we were constrained in making lending choices, which means really need this? Can we do without it?” Hopefully this will that they have fewer bad loans on their balance sheets. lead to enough cost savings that companies can bide their So one of the things governments may want to do is to time till the economy recovers. constitute these sorts of “negative feedback” measures to help stabilize the economy. Of course, it is too late to do One of the things to keep in mind is that it’s very human to this to solve the current crisis, but it might help prevent or assume that good times will last forever, when the economy dampen the next one. is growing. The result of this is a string of bad decisions – over-investment, reckless spending, etc. We are equally A bailout of some sort is inevitable in most countries prone to assuming that bad times will last forever, essentially today. One cannot just say, “Let economic Darwinism take

08 THE MONEY MANAGER | JUNE 2009 building up “doom and gloom” scenarios. The point here is research – there’s a large body of literature and researchers, that companies should not needlessly eliminate what makes myself included, who look at fundamental valuation them great, based on a myopic view of the economy. If issues and come up with what you can call trading rules or you are an R&D-intensive company and your competitive anomalies. Given that most of these people hold doctoral advantage has always been your intellectual property, you degrees themselves, they are well placed to understand the shouldn’t start off saying “I need to cut my R&D costs”. research, and convert it into something that they can use. Sure, you need to trim and rationalize where necessary, but Research papers normally ignore issues such as trading you cannot eliminate them entirely – they are your raison costs, shorting costs and other implementation details that d’être. It is therefore a really thin line – on one hand you can make these sorts of strategies infeasible. need to cut costs, on the other, you need to preserve your Q. What advice would you have for students of business competitive edge. schools who will soon be part of the industry? Do we The other aspect companies need to learn is to pay close need to learn things differently or learn different things attention to the balance sheet. Unfortunately, in good times, to both adapt to and pre-empt future crises? How do we we are constantly worried about the income statement equip ourselves to tide over the current global meltdown? – the earnings-per-share number is the most important. Companies therefore tend to lose sight of capital efficiency A. Firstly, everybody has been fascinated by the world – Returns on Assets, for example. One of the more of Finance. I don’t say it’s categorically wrong, but you discomfiting implications of this is the prevailing practice cannot just have people dealing with trading, paper of valuing companies on an EV/EBITDA type of basis, income, investment banking and getting things together. saying essentially that one doesn’t care about Depreciation Somebody has got to be doing the real stuff as well. and Amortization, which are nothing but proxies for Hopefully, what this [the current crisis] might do is to investments in assets. This is one of the biggest fictions encourage people to do something more real and tangible. because you are then saying, “I don’t care how I use my Career in Finance would be there but people have to start assets”. thinking in terms of other alternatives as well - something entrepreneurial or something in manufacturing etc. Q: What do you think about quantitative investment Don’t just pick up skills in Finance or Accounting; pick up strategies particularly statistical arbitrage strategies of skills in economy, in industries, in manufacturing, in services. Renaissance and accounting-based strategies of firms Even if you were in Finance, you would be financing a such as Barclays Global Investors? particular industry. Just knowing fancy valuation techniques A: I wouldn’t put Barclays and Renaissance in the same or how to price a derivative would not be enough in the world league. Renaissance uses a bunch of data-mining and other we are going to live in. I always tell my students, even in good tools without really going into the reasons or fundamentals times, here at Columbia that if you are a Finance guy, do some based on which they work. Marketing Course or Operations Course etc. Increasingly, Barclays for example has always had a number of accounting having a generalist perspective would be far more important experts on their professional staff. The head of Equity than remaining stuck in one area. In my class, we spend a Research, till last year, was Charles Lee, who was a top lot of time looking at the market, things like Porter’s Five academician with affiliations to Cornell, Michigan, etc. They Forces, before going into the financial or accounting aspects. also hired Richard Sloan, who was the first to document the “accrual anomaly”. Both of these guys are now back in Q. You have studied at IIM-A and done your PhD at academia – Sloan to Berkeley and Charles to Stanford. Harvard. You have taught at Stern and are now teaching at Columbia. Can you share some thoughts on the As a whole, Quantitative Asset Management is a worthwhile IIM-A methodology of teaching, especially in Finance field. The prospects in the short-run are unclear of course. and Accounting, and contrasting that with your own What these professionals do well is to look at academic experiences at Harvard, Stern and Columbia?

09 THE MONEY MANAGER | JUNE 2009 A. There are some essential similarities and some essential going on. I argue that much of what is going on is because differences. The principle of Finance, Accounting are the people don’t do things properly. People are thinking more in same everywhere. There is some difference in the pedagogy a mechanical way; Investment bankers are more concerned where some places there is a lot of focus on theory while about their pitch books rather than worrying if the deal at others it is mostly a case method of learning. IIM-A and really makes sense or not. There is this lack of academic Harvard follow very similar ways of teaching. At IIMA, we rigour. Through research, one can also affect what people do have some classes where we start with some lecture and do. then move on to a case. Harvard has absolutely no lectures - every class is a case. Nobody is going to teach you anything Academia is - as I put it - high risk, low reward. You would - you are supposed to learn from the case. This is a slight get a fraction of what you would be paid in the corporate difference of perspective, but is mostly unimportant. 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 The main thing is about the students - and it does not academic institution, you get amazing amount of flexibility. matter where you are taught and how you are taught. [The students should] always try to take a course from Q. Areas like asset management, valuation, and the perspective of what one can learn. Things like accounting need a relook. Is it that we have gone grades etc. are pretty unimportant. You realize this only away from the basics and we need to return to those or after some years and you wonder why I was striving for that we have to find new ways of dealing within these those. It is more important to get the knowledge and areas? the understanding of what these courses are about. A. There has been a lot of over quantification of issues that Q. Not many people from the Indian B-Schools need to be done away with. People who don’t understand choose to become academicians these days. What are the industry, how a company works and don’t consider the your thought on careers in academia and industry (in mean effect are talking about the third moment and the Finance), especially in the light of the large number of fourth moment. People are getting into very complicated lay-offs, collapses and semi-scandals that have plagued analysis when they don’t understand the basics. One the financial services industry over the last year? needs to have more of an overall perspective and need to understand what the company is doing - before coming A. Hopefully the fact that no one is going to academia from up with any valuation model involved in the investment PGPs would change - this is one of the few good things decision. The problem with these valuation models is that about the downturn. People would start looking at areas people start making them based on some numbers without they would not have looked otherwise. I am the Director of paying attention to qualitative issues. the PhD program at Columbia Business School and I can tell you that the number of applications have increased this In a valuation model, it is mostly the question of the how year. Normally, we get around 60 applications - of which you calculate the terminal value. There are other methods around 40 are from China and South Korea - and we admit such as abnormal earnings or residual income methods, 2-3 students in the program. This year we have received 85 which I would encourage one to use rather than DCF. applications. Usually, we shortlist 7-8 candidates for future All valuation models are ad hoc at certain level, but the consideration. This year I could not shortlist less than 16, extent of ad-hoc-ness is ridiculous in DCF. Basically, one because these were some exceptional candidates. These are can come up with any answer in DCF. Also, the practice from across the World, some from India as well. of looking at different scenarios in DCF is just looking at numerical scenarios (changing numbers) and not looking People are looking at academia, not necessarily because there at economic scenarios. This is what needs to change. are no jobs out there. I am sure there would be sufficient opportunity available to the exceptional candidates. People Q. In India, we saw a recent discovery of an accounting see that a lot of stuff that is happening in the real world is fraud that happened at Satyam. How would / should just random and arbitrary. So, lets just understand what is

10 THE MONEY MANAGER | JUNE 2009 accounting, regulatory practices change to pre-empt you have now come to see were not so true? And you this sort of event from occurring or do you think that wish that you did not have those at that point of time. it is bound to happen and the regulations can only be And that you would not like future batches to graduate reactionary? with that notion. A. This is difficult to answer given the news is still unraveling. A. Actually, I cannot think of anything. However, a few We are not yet sure what kind of scandal we are seeing here. things I would like to mention. It is a very different world What is important is having an overall understanding of these days and the world changed after our batch. Our batch the company, the economic situation before making any was the first batch to have McKinsey come to campus. For judgments. From what I understand, Satyam used to always us, the concept of international job markets did not exist. undercut its opponents in contracts. It would always be the There was no course on derivates for they were not there in lowest bidder and yet pay the same salaries as everybody else. the Indian markets. I remember doing an IP on Futures and Yet it was as profitable as its competitors. One should ask Options, just to learn about them. With 2-3 years (1995- that how is this possible. This kind of overlooking comes 96), a whole bunch of foreign placements happened and from the lack of taking an overall perspective. in that sense, things got pretty internationalized. Also, it might be fair to say, Finance completely took over the other Changes in regulations are definitely required. For e.g. professions. In our batch, people had the choice - whether auditors would start relying more on actual due diligence they wanted to do a Finance job, or a Marketing job etc. But rather than say, just a bank statement. The regulations are now, Finance has completely dominated everything else. already in place. Satyam being a U.S. listed firm - they would be subject to the regulations under the Sarbanes Oxley I would suggest, that whatever you are doing, always choose Act. They would have to face up to these and rightly so. 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 The other issue is that there would be a lot of reaction - start. Remember, any company is going to hire you because not only for India but the entire Emerging Market space. you are a smart person and they are going to teach you Either the liquidity would just stop or the risk premium whatever is required for the job. But insights are something would go up significantly. There is a serious chance of loss that cannot be taught. There is tendency, especially among of capital. MBA students to judge different courses. This is a very bad notion to have. You would realize after many years that However, all regulations would have to be a bit of reactionary. some of the most important learning happens in these so- called soft courses. Because the thing that the hard courses Q. B-schools like Columbia have been facing issues teach you is something you can look it up in some text. with their endowments. What kinds of strategies are being looked at to make the endowments a more sustainable income source? - By Ashutosh Agarwal and Devdutt Marathe, IIM A. These Endowments had some very good years - and Ahmedabad 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

sPECIAL FEATURE cover story cover page An Interview with Mr K.V. Kamath Managing Director and CEO, ICICI Bank Limited 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.

12 THE MONEY MANAGER | JUNE 2009 Q. Under your leadership, ICICI has grown by representation of women in the sector? leaps and bounds. What in your view should the System based on the fundamental premises of bank need to do, to make its image / perception meritocracy and gender neutrality, has enabled a lot as you would ideally like to see from a bank of that of women managers in ICICI to compete with their size? male counterparts on an even footing and establish Over the years, the growth of the bank would not leadership positions based on their mettle. We are have been possible without the DNA of passion and indeed, seeing an encouraging number of women managing change ingrained in team ICICI. The market occupying board seats in financial services companies, and our competitors, though often criticized for being and strongly feel that a sense of fair-play encourages ahead of its time, have usually endorsed the strategy all to maximize their potential. of the bank through the years, in due course. We Q. What do you think can the industry and CII do would continue to fashion our moves based on our to ensure something like the Satyam incident is assessment of market realities and our appetite for not repeated? As the leader of one of the largest risk, and maintain a continuous communication with banks in the country, what do you think is the our stakeholders on the rationale for our strategies. new role of independent directors and watchdogs Q. The succession plans and the delegation of to uphold corporate governance? What can the responsibilities at top management level at ICICI, government do to incorporate stricter legislation is a model for a large number of Indian companies. that deters occurrences of further instances like What is your view about these? Satyam from happening? At ICICI, we believe in and encourage the spirit of There are regulations and detailed code of conduct enterprise of our young managers. Empowering in place for the roles, duties and responsibilities of through delegation allows managers to achieve their auditors and independent directors. The present potential within the framework of the bank’s strategy. framework, if adhered to, has sufficient checks and We follow a structured approach to identify and balances to easily prevent a fraud of such proportions. develop talent from an early stage and have, over the It is the responsibility of each participant to understand years, developed a rich talent pool that provides a ready his responsibilities and perform his role in accordance capacity of leaders to spearhead our various initiatives with the code. and opportunities that arise. The regulator and the government have shown by their It is by adopting a clear, transparent and structured response in the present case that they would indeed act approach to the process of selection and by involving promptly and effectively if any violations / aberrations significant stakeholders in the process, that we have come to light. been able to handle the process of succession planning Q. As we all know, ICICI Bank was caught up well. in the rumours sometime back and which also Q. In the financial sector, ICICI has a distinguished affected the share price. Reputation is of utmost record of women reaching top leadership positions, importance for a bank as it can have severe such as Ms Chanda Kochhar, who will succeed impact on its ability to raise capital for day-to-day you as CEO, and Ms Shikha Sharma, CEO ICICI operations. What short and long-term steps would Prudential. What can be done to promote better you recommend to a financial institution to take

13 THE MONEY MANAGER | JUNE 2009 under such situation? orient their strategies with a much greater emphasis on liquidity, risk containment and continuous cost Rumours are baseless and used by vested interests optimization, to tide through this and future crises. for their malicious ends. In the recent episode, when the confidence of our investors and depositors was Q. There have been few instances of consolidation threatened, we ensured that we kept all communication in the Indian banking system, perhaps largely due channels open at all times to restore their faith. As to strict regulatory controls. With the emergence a trustee of public deposits, we have taken utmost of a strong counterbalance in foreign & private care to communicate our true position and dispel the banking, do you believe that this is about to doubts on our reputation. The regulatory authorities change? should take firm action against the perpetrators of Any merger or acquisition has to be driven by strong such crimes, as they could jeopardize the stability of business rationale of scale, complementarily or the system. synergies. In the Indian banking space, there is no Q. As the President of CII, are you satisfied with mandate to privatize the public sector banks. Within the measures taken by the government to abate the private sector, three banks have built up meaningful the current slowdown? What would you like to see scale and any further consolidation would need to be done further? based on strategic rationale and synergies. The Central Bank and the government have through Q. With the fall in equity markets, the ULIP use of tools under monetary and fiscal policy, eased market has dried up, affecting ICICI Prudential the transition pain as the economy adjusts from a which has been losing market share in the past high demand-high-cost structure to a low demand– few months, especially to SBI Life Insurance. low cost one. The various measures have ensured What is your strategy for ICICI Prudential in the enough liquidity in the system, as also made it easier coming months? for companies to undertake business and financial The ULIP product has seen a slowdown in growth, in restructuring. line with the weakening equity market. This has affected Going forward, we would like to see a greater focus all players, including ICICI Prudential. However, ULIP, on infrastructure, both by way of increased spending as a product, continues to appeal to customers who on its committed plans as also increased flow of funds favor transparency and flexibility in their insurance to the sector through the public-private partnership purchase, and there would be a continued market for route. the same. ICICI Prudential has achieved a leadership Q. The financial system across the world is position in the private insurance space by a wide margin witnessing a huge transition. What is ICICI by investing in a robust distribution network. Going advising its clients to do, in order to brace forward, it is best positioned to leverage this strength themselves for this change? to offer diverse products in the protection, health and investment categories. Combined with its focus on cost- As a result of the challenges being faced in the optimization, ICICI Prudential is well set to continue financial sector, the real sector is facing a liquidity to be the leader in the private insurance space. ICICI and credit squeeze. This puts tremendous pressure on Prudential has, unlike some other players, not focused companies for meeting their cash flow requirements on the single premium product, preferring to position for operational and committed capital expenditure life insurance as a combination of protection and long purposes. Companies are indeed working to re-

14 THE MONEY MANAGER | JUNE 2009 term savings. Did You Know? Q. With interest rates expected to remain in single The Lipstick Theory: digits through 2009, what are the steps ICICI Bank is planning to take to protect its net interest This theory say’s that lipstick purchases are a way of margins (NIM)? measuring the economy. The softening of interest rates would reduce the cost During times of economic uncertainty, women load of our wholesale funding. Besides, with our expanded up on affordable luxuries as a substitute for more branch network of 1400 branches, and proposed expensive items like clothing and jewellery. This phenomenon is called The Lipstick Effect. The theory addition of 580 branches in the coming year, we would was first identified in the Great Depression, when be able to garner a larger share of low cost deposits industrial production in the US halved, but sales of by way of savings and current accounts. Together, cosmetics rose between 1929 and 1933. this would mean significant lowering of funding costs, However as a theory, it was proposed by Leonard which would hold the key to protecting our margins in Lauder, chairman of Estée Lauder Companies. After a low-interest rate cycle. the terrorist attacks of 2001, which affected the U.S. economy on a large scale, Lauder noted that his Q. What advice would you have for students of company was selling more lipstick than usual. business schools who will soon be part of the industry? Do we need to learn things differently During the Second World War the German Operation Bernhard attempted to counterfeit various or learn different things to both adapt to and pre- denominations between £5 and £50 producing empt future crises? How do we equip ourselves to 500,000 notes each month in 1943. The original plan tide over the current global meltdown? was to parachute the money on Britain in an attempt to destabilize the British economy, but it was found more Focusing on one’s skills and strengths, and creating a useful to use the notes to pay German agents operating value proposition for oneself based on such assessment, throughout Europe -- although most fell into Allied is a strategy that works well through both good and hands at the end of the war, forgeries were frequently not-so-good times. Given the inherent fundamentals appearing for years afterward, so all denominations of banknote above £5 were subsequently removed from and the resilience of our economy, its only a matter circulation of time before the economy is back on its growth trajectory. Accordingly, as always, young minds should - Compiled by Satwik Sharma, IIM Calcutta 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

eXPERT oPINION cover story cover page Senior Vice President, CCIL, Mumbai Dr. Golaka C. Nath Central Counterparty (CCP) – Role of Clearing Corporation of India Limited

16 THE MONEY MANAGER | JUNE 2009 CCPs occupy an important place in securities 6. Default procedures settlement systems (SSSs). A CCP interposes itself A CCP’s default procedures should be clearly stated and between counterparties to financial transactions, publicly available, and they should ensure that the CCP becoming the buyer to the seller and the seller to the can take timely action to contain losses and liquidity buyer. A well designed CCP with appropriate risk pressures and to continue meeting its obligations. management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial 7. Custody and investment risks stability. A CCP has the potential to reduce significantly A CCP should hold assets in a manner whereby risk of risks to market participants by imposing more robust loss or of delay in its access to them is minimised. risk controls on all participants and, in many cases, by achieving multilateral netting of trades. It also tends to 8. Operational risk enhance the liquidity of the markets it serves, because A CCP should identify sources of operational risk it tends to reduce risks to participants and, in many and minimise them through the development of cases, because it facilitates anonymous trading. appropriate systems, controls and procedures. The Recommendations for CCPs by the CPSS-IOSCO 9. Money settlements Technical Committee are: A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, 1. Legal risk that is, its credit and liquidity risks from the use of banks A CCP should have a well founded, transparent and to effect money settlements with its participants. enforceable legal framework for each aspect of its activities in all relevant jurisdictions. 10. Physical deliveries A CCP should clearly state its obligations with respect 2. Participation requirements to physical deliveries. The risks from these obligations A CCP should require participants to have sufficient should be identified and managed. financial resources and robust operational capacity to meet obligations arising from participation in the 11. Risks in links between CCPs CCP. CCPs that establish links either cross-border or domestically to clear trades should evaluate the potential 3. Measurement and management of credit sources of risks that can arise, and ensure that the risks exposures are managed prudently on an ongoing basis. Through margin requirements, other risk control mechanisms or a combination of both, a CCP should 12. Efficiency limit its exposures to potential losses from defaults by While maintaining safe and secure operations, CCPs its participants in normal market conditions so that the should be cost-effective in meeting the requirements operations of the CCP would not be disrupted and of participants. non-defaulting participants would not be exposed to losses that they cannot anticipate or control. 13. Governance Governance arrangements for a CCP should be clear 4. Margin requirements and transparent to fulfill public interest requirements If a CCP relies on margin requirements to limit its and to support the objectives of owners and credit exposures to participants, those requirements participants. should be sufficient to cover potential exposures in normal market conditions. 14. Transparency A CCP should provide market participants with 5. Financial resources sufficient information for them to identify and evaluate A CCP should maintain sufficient financial resources accurately the risks and costs associated with using its to withstand, at a minimum, a default by the participant services. to which it has the largest exposure in extreme but plausible market conditions.

17 THE MONEY MANAGER | JUNE 2009 15. Regulation and oversight a well founded legal framework that supports each A CCP should be subject to transparent and effective aspect of a CCP’s operations. Safeguards against regulation and oversight. operational risk include programmes to ensure adequate expertise, training and supervision of personnel as well Overview of CCP’s risks and risk management as establishing and regularly reviewing internal control Risks procedures. Many CCPs face a common set of risks that must be controlled effectively, though exact risks that a CCP CCIL’s role as a CCP in the Indian Fixed Income must manage depend on the specific terms of its and Forex Market contracts with its participants. There is the risk that CCIL was set-up on April 30, 2001 as per the participants will not settle obligations either when recommendations of the committee constituted due or at any time thereafter (counterparty credit by Reserve Bank of India as a CCP for the clearing risk) or that participants will settle obligations late and settlement of trades in Government Securities, (liquidity risk). If a commercial bank is used for money Forex and Money Markets. CCIL currently provides settlements between a CCP and its participants, failure guaranteed settlement and is a central counter-party to of the bank could create credit and liquidity risks for every accepted trade in Government Securities, Forex the CCP (settlement bank risk). Other risks potentially (USD-INR) and CBLO (Collateralised Borrowing and arise from the taking of collateral (custody risk), the Lending Obligation) segment and offers settlement investment of clearing house funds or cash posted on non-guaranteed basis to IRS trades in the Indian to meet margin requirements (investment risk), and market. deficiencies in systems and controls (operational risk). A CCP also faces the risk that the legal system will The settlement operations in CCIL are based on the not support its rules and procedures, particularly in the concept of multilateral netting and novation by a event of a participant’s default (legal risk). If a CCP’s central counterparty for a transaction in the OTC as activities extend beyond its role as central counterparty, well as anonymous order driven markets. Multilateral those activities may amplify some of these risks or netting involves aggregating member’s obligation complicate their management. to pay or receive funds arising out of every single transaction and offsetting it into a single net fund Approaches to risk management obligation. CCIL has applied the concept of novation CCPs have a range of tools that can be used to at a central counterparty in the fixed income and the manage the risks to which they are exposed, and the currency markets. Under novation, CCIL becomes the tools that an individual CCP uses will depend upon central counterparty to the trade by replacing the trade the nature of its obligations. The most basic means between the two members. In addition to substantially of controlling counterparty credit and liquidity risks reducing individual member funding requirement, is to deal only with creditworthy counterparties. CCPs such netting reduces liquidity and counterparty risk typically seek to reduce the likelihood of a participant’s from gross to net basis. By reducing the overall value default by establishing rigorous financial standards for of payment between its members, CCIL has enhanced participation. This is done through maintenance of the efficiency of the payment system and reduced minimum capital requirements, minimum acceptable settlement costs associated with growing volumes of rating, trading limits to control potential losses, market activity. posting of collateral to cover losses, specific liquidity requirements for participation and reporting and The earlier instances of ‘gridlock’ and ‘SGL bounce’ monitoring programmes. Margin system and stress have become history after CCIL came into the tests to assess the adequacy and liquidity of financial settlement arena. Due to CCIL’s multilateral net resources are other techniques available to a CCP to settlement processes, the total counter-party exposures mitigate credit and liquidity risks. Settlement risk is of all settlement participants (i.e., by the entire system) eliminated by using the central bank of issue, while on account of the settlement risk has come down by custody risks can be limited by carefully selecting about 93% on an average. 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

18 THE MONEY MANAGER | JUNE 2009 Risk Management at CCIL 2) Given a coin with probability p of landing on heads In order to offer guaranteed settlement in the various after a flip, what is the probability that the number of segments and to manage all incidental associated risks, heads will ever equal the number of tails assuming an CCIL has put in place elaborate risk management infinite number of flips? processes. The risk management process has been designed to address the risk in each segment of the 3) The king has 100 young ladies in his court each with market where CCIL provides its settlement services. an individual dowry. No two dowries are the same. The In case of securities settlement, market risk is managed king says you may marry the one with the highest dowry through collecting margins like Initial Margin, Mark to if you correctly choose her. The king says that he will Market Margin, Volatility Margin etc. Liquidity risk parade the ladies one at a time before you and each will is managed through Lines of Credit from various tell you her dowry. Only at the time a particular lady banks to enable it to meet any shortfall arising out of is in front of you may you select her. The question is a default and through the Settlement Guarantee Fund what is the strategy that maximizes your chances to and a security borrowing arrangement. CCIL has a well choose the lady with the largest dowry? designed back testing model for assessing efficiency & adequacy of the adopted method for margining 4) Five ants are on the corners of an equilateral process and a stress testing model to compute the pentagon with side of length 1. They each crawl potential losses. directly towards the next ant, all at the same speed and traveling in the same orientation. How long will each In the forex segment, risk management is ensured ant travel before they all meet in the center? through strict membership norms, exposure limits, well defined process for default handling, Lines of 5) 100 bankers are lined up in a row by an assassin. The Credit etc. In the CBLO segment, risk management is assassin puts either red or blue hats on them. They facilitated through initial margin maintenance and pre- can’t see their own hats, but they can see the hats of set borrowing limits. the people in front of them. The assassin starts with the last banker and says, “what color is your hat?” The CCIL’s risk processes are almost fully compliant with bankers can only answer “red” or “blue.” The banker the recommendations of Committee on Payments and is killed if he gives the wrong answer; then the assassin Settlement Systems of the International Organisation moves on to the next banker. The bankers in front of Securities Commissions in respect of Risk get to hear the answers of the bankers behind them, Management for central counterparties. but not whether they live or die. They can consult and agree on a strategy before being lined up, but after - by Rajatdeep Anand, IIM Calcutta being lined up and having the hats put on, they can’t communicate in any other way. What strategy should Puzzles they choose to maximize the number of bankers who will be surely saved? 1) There are 1000 camels, all painted gold initially. Also, there are 1000 riders who, upon reaching a camel paint 6) Three ants on a triangle, one at each corner. At a it black if its gold or gold if it is black, reversing the given moment in time, they all set off for a different color. The first rider goes to every camel, the second corner at random. What is the probability that they rider goes to every second camel, and the third one don’t collide? goes to every third (3rd, 6th 9th) camel. The process goes on similarly for all others. How many camels - Compiled by Devendra Agarwal, IIM Calcutta would be painted black once all riders are done.

eXPERT oPINION cover story cover page An Interview with Prof.Marti Subrahmanyam Charles E. Merrill Professor of Finance & Economics, Stern School of Business, New York University 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.

20 THE MONEY MANAGER | JUNE 2009 Q. In the current financial crisis, mostly complex German bunds are anywhere from 100 to 250 bps, up Over-The-Counter derivative instruments have from the 20-30 bps range. Prima facie, this means that been blamed. What regulatory changes do you the market thinks that there is a reasonable chance of foresee in this area and how would this affect default/restructuring for these instruments over the financial innovation in times ahead? next five years. Given the explosion in the issue of new government paper – the additional amounts planned There is no doubt in my mind that the regulatory already run into trillions - this is not an unreasonable oversight of OTC derivatives is bound to grow in the conclusion. While no government needs to default on years ahead. One major institutional development its nominal obligations in its own currency, it is entirely that is almost sure to occur is the creation of central possible that political conditions will force some sort clearinghouses for the most important derivatives such of restructuring of these instruments. Notice the as those on credit, interest rates, and foreign exchange. substantially higher spreads for large economies such Standardized derivatives products will gravitate to these as Italy or Spain, since they have handed over the markets by regulatory fiat or due to market forces. authority to print money to the ECB. New exotic products will continue to trade over-the- counter, with clear guidelines regarding when they will Q. This question is related to the US Dollar. As we move to the clearinghouses, based on size, complexity have seen, the current account deficit of the US etc. This may be a reasonable compromise between has touched unprecedented levels, interest rates the need to permit and encourage innovation, while have taken a nosedive and the economy is in a containing the systemic risks that we have experienced recession. Despite all these factors, and contrary in the recent financial crisis. I have laid out some to the claims by several analysts, the USD has not of the details of the architecture in a white paper I yet crashed. What factors, in your opinion, are contributed to a volume put together by the faculty supporting the USD at present and what future at Stern, entitled “Centralized Clearing for Credit would you predict for it? Derivatives,” in “Restoring Financial Stability: How to Repair a Failed System” I generally do not make specific forecasts regarding market variables, because these forecasts are not worth Q. It is common knowledge that governments very much, in my experience. I will only say that given have played a central role in the current financial the burgeoning deficits in the US, there is a long-term rescue efforts but it appears that they themselves overhang on the US Treasury bonds and hence the are not entirely untouched by this crisis anymore. dollar. No one can say if or when the overhang will For instance, if we look at the CDS premium on drag the dollar down. On the other hand, there is the US government bonds, it has swelled from no other market in the world, other than the German 0.1% to more than 0.5% during this crisis, which is bunds to some degree, which can absorb a substantial a very high premium for a AAA rated government part of global savings. Also, it is entirely possible that security. Are US government bonds really as safe the productivity gains in the US economy in the next as they are claimed by the rating agencies? several years will outweigh this effect. Net net, I have no clue and I doubt that anyone else does as to what is The simple answer is no. Several developments have going to happen to the dollar in the next few years. taken place during the current financial crisis that no one would have forecast (except possibly my colleague Q. Many believe that the Indian derivatives Nouriel Roubini, who seems to have some special market is under-developed and over-regulated, powers of divination!). I would have been extremely especially given the pace of development in the sceptical of any one who forecast that the CDS spread equities market. Is the current state of regulation on the 10-Year US Treasury bond would be greater justified in the Indian context? How must the than that of a AAA corporate like GE only a year ago. regulators go about the task of development of 50 bps or more for US Treasuries and much more this market and what are the pitfalls they must for the Japanese Government Bonds and UK Gilts watch out for? was well outside any estimate I ever heard prior to I would not agree that the Indian derivatives market September 2008, for the 5-year swap. The spreads of is “under-developed and over-regulated,” across the Eurozone Treasury paper over the most credit worthy board. First of all, one needs to make a distinction

21 THE MONEY MANAGER | JUNE 2009 between the exchange-traded and over-the-counter instruments of measuring risk, given the changes markets. In the case of exchange-traded markets, the in the trading environment? most important underlying securities in India are those on individual stocks and equity indices. There is also Nassim Taleb has grabbed the attention of the media limited trading in currency derivatives. I believe that by making controversial statements about markets, the Indian equity derivatives market, particularly that finance education and many other issues. In my for single stock futures contracts, is highly liquid and opinion, he has said little that is new. Everyone in the efficient. I also think that the regulatory oversight at business, both academics and practitioners, has been the level of the exchanges, the NSE in particular, and aware of “fat tails” and “stochastic volatility” for a the SEBI is strong. Indeed, I think the overall structure long time. Saying that there are many events that fall of this market is as good as any other in the world, that outside the 3-sigma limits is simply a matter of saying I know of. When it comes to OTC products, such as that the commonly- made assumption of lognormality interest rate and credit derivatives, the market in India of returns is not correct, especially at the tails. No is still in its infancy. The regulators are understandably one would disagree with this simple statement. If cautious, and the recent events worldwide will make the standard VaR calculations assume lognormality them even more so. I am hopeful that regulators without any caveats, of course, the measurements will understand the need for such markets to grow are going to be faulty. This is no different from any and not dismiss innovation in these products as too other assumption in the physical, biological or social risky. As with most markets these days, the expertise sciences. Modelling requires some simplifications of in such products in the regulatory bodies is somewhat complex reality; the conclusions drawn are subject to limited. We need to think of ways in which such skills the errors from these simplifications. Any application can be acquired by the professionals in bodies such as of the conclusions has to take these errors into SEBI, the RBI, the FMC, and the MofF. The IIMs, in account. In the absence of a clear alternative theory, particular, can play an important role in this process one is forced to use the theory, with some degree of of training and development. caution and adjustments. In practice, people make the adjustments to the simple VaR concept using Q. One of the casualties of the financial crisis scenario analysis, stochastic volatility adjustments, has been the ‘exotic’ derivatives market, a leading extreme value analysis etc. Taking a nihilistic view money spinner for trading desks. Most of these in these matters is neither scientific nor practically exotics are OTC products where the counterparty useful, although it may yield the proponent a lot of risk is borne by the investment bank. Now, given free publicity. When a model fails to fit the data, the the threat to the survival of investment banks how prescription ought to be to go back to the drawing do you foresee the revival of ‘exotic’ derivatives? board, not stop modelling forthwith. I am not sure one can say that the exotic derivatives Q. People have been aware of model risk since market is dead for good, although such a prognosis the days of the LTCM crisis. Why did the banks today is quite understandable. Of course, market still not make changes and repeated the same participants will continue to be reluctant to do complex mistakes with credit derivatives? deals for some time, because of the counterparty risks that have come to light, post-Lehman and especially, I am not sure that the problems of LTCM or the post-AIG. However, these market developments recent financial crisis are due to the failure of models, have a tendency to get reversed. I suspect that a few per se. After all, some of the partners of LTCM years from now this experience will become less and were among the foremost financial economists of less of an issue and the market will be up and running our times, including my teachers, Robert Merton and as before. I should point out that even today, hedge Myron Scholes. You can have the greatest model funds, and some credit worthy corporations are doing in the world, but if you put in the wrong inputs, or complex deals, although cautiously and with a lot forget some of the key assumptions that are not quite more collateral involved than before. right in practice, you are bound to make a big mistake. Also, there are several practical issues that are not Q. A lot of people have criticised the concept of quite in the model including liquidity, counter-party VaR. Nassim Nicholas Taleb calls it a ‘fraud’. risk, freezing of funding etc, which were obviously What then, in your opinion, can be better ignored in both instances. History is replete with

22 THE MONEY MANAGER | JUNE 2009 instances of human beings ignoring the lessons of Keynesians argue that public spending is more effective prior experience. George Santayana said it best in his than a tax cut, since individuals may simply save the The Life of Reason: “Those who cannot remember the past proceeds.) Similar packages will be implemented in all are condemned to repeat it.” the major economies in the world, including India in the next few months. Q. TARP has been one of the most discussed topics recently. The main idea behind the TARP Q. With the massive influx of rescue packages, it is to buy troubled assets so that banks can start would be rational to assume that rising inflation lending again. However, data shows that the would be the first side effect. What are your views lending in the top 13 beneficiaries of this program on the apparent stability of the inflation rate in the has actually gone down by more than USD 50 US? What could be Fed’s policy reaction when the billion. There are two questions: credit crisis reaches its end? a. Isn’t TARP essentially providing At this point, no one is worried about an up tick in subsidy to the financial institutions by inflation, provided we can get out of this gloomy buying the troubled assets at a much economy situation, which may well last years in higher price without any provisions for much of the industrialised world, with collateral nationalizing them, and thus providing damage everywhere, including India and China. nothing in return to the tax payers. Frankly, if inflation goes up by 2% per year for the b. Why is there so much push towards next several years, that seems a small price to pay for increased lending given the fact that digging ourselves out of the present deep crisis. If businesses and consumers are actually anything, the markets are signalling a long period of unlikely to borrow in these troubled near-deflation in the US and many other countries. times and pushing the lending agenda Perhaps that is an over-reaction, but few people see a would only increase problems of adverse quick end to the current deep recession. I am not sure selection. the Fed is even thinking about when it will be able to tighten monetary policy. That is at least two to three The simply answer to the first questions above is “yes.” years away, perhaps longer. There is no excuse for the subsidy given to the financial institutions without the US taxpayer getting much in Q. What advice would you have for students of exchange. At the end of the day, this whole bailout business schools who will soon be part of the has been a complex political process, with the taxpayer industry? Do we need to learn things differently being on the hook for essentially a blank cheque to or learn different things to both adapt to and pre- the financial institutions. Combined with the outsized empt future crises? How do we equip ourselves to bonuses that are still being paid, the average person in tide over the current global meltdown? the US is understandably outraged. I am sure that the situation will get corrected and the US government will I think back to what my classmates and I used to end up owning substantial stakes in most of the major discuss when we were at IIMA. Most of us had no financial institutions in the country. experience whatsoever. Even summer internships for undergraduates were scarce in those days. Nor did The second question, which relates to an important we have much information about what was happening aspect of macroeconomics in the context of a in industry. Today’s students are far better informed recession, is a classical conundrum. It is important than we were. Looking back, I realize how naïve we for individuals to be prudent in tough economic times were about what to expect in our careers. and conserve their finances and spending. At the same time, if everyone does this, the situation for the whole With the benefit of hindsight, I think the most economy is going to get worse. This is precisely why important lesson for fresh graduates is to look beyond Keynes argued that only the government can get the the first job, its rewards and opportunities, and try to economy out of the hole in such a situation. The take a longer term view. One has to look for jobs massive fiscal stimulus proposed by President Obama where there is an opportunity to learn constantly. If is exactly in this direction. (It is also the reason that there is a choice between maintaining one’s financial

23 THE MONEY MANAGER | JUNE 2009 capital and human capital, I think the balance should Turning to why many students today do not go swing in the direction of human capital early on in through the academic route, I think there are several one’s career. The second lesson is to stay away from explanations. The first is that there are manifold excessive specialization. While one has to acquire economic opportunities in industry today, although depth in some area, staying in a narrow field, however they have dimmed somewhat in the last few months. remunerative it may be, becomes less interesting as time The second is the lack of academic role models even goes on. One must try to obtain a broader perspective in the elite academic institutions in India, such as the as you advance in your career. Many who chose to go IITs and IIMs. Very few students want to become into jobs in the financial services industry, particularly like their teachers, which is rather sad. The last is that in Wall Street, made the mistake of concentrating in a many students simply do not know what a rich and narrow area. When the industry imploded, their skill satisfying career one can have as an academic. I often set proved to be too narrow and finding another job wish I could communicate my own enthusiasm to the became difficult. The third lesson in this increasing youngsters in these institutions. Without intending to global world is to develop inter-cultural skills – for sound smug, I am thrilled to be a professor and prefer example, language skills - that can come in handy my job to anything else I have seen. as one moves to a different geographical or cultural setting. Many of my own classmates did not develop The main reason I chose to become an academic this agility and could not adapt to the changing was to pursue a career where I could study and think circumstances even within India, not to speak about independently. After I became a professor, I realized moving to another country seeking more challenging that I enjoyed teaching. Almost four decades later and rewarding opportunities. Last, but not least, one these reasons are still valid. It is a great privilege to should maintain a balance between family and career. be a professor, with the tremendous freedom and This seems to be an obvious point, but it is surprising independence one enjoys. I have also been lucky to be how many people are so busy with their jobs that their able to combine this with involvement in the world of children grow up and leave home before they realize practice as a consultant and board member. I have had it. great flexibility in managing my time, for professional and family reasons. I feel really privileged to have Q. How did you choose to become an academician? the best job in the world. At my age, many think, “I Not many people from the Indian B-Schools do could have... or I should have.” I am lucky to be one the same these days. What advice would you have of those who can say, “I did what I wanted to do and for them? am thrilled to have had the opportunity to do it.” I graduated from IIMA four decades ago. It was a - by Akshat Babbar, Ashutosh Agarwal, Saurabh very different world. In my second year at IIMA, I Mishra and Rohit Karan, IIM Ahmedabad 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.

THE MONEY MANAGER | JUNE 2009 sTUDENT aRTICLES cover story cover page 1st Prize Extracting Alpha Using Behavioural Finance Akhil Dokania, Nitin Agrawal, Prabhudutta Kar IIM Bangalore 2nd Prize New Monetary Policy Tools - Innovative Policy Response to Financial Meltdown Ajay Jain, Atishay Jain, Sourav Dutta IIM Bangalore

25 THE MONEY MANAGER | JUNE 2009 Extracting alpha using Behavioral Finance Akhil Dokania, Nitin Agrawal, Prabhudutta Kar. [IIM Bangalore] Executive Summary Literature Survey – Behavioral Economics Economics is all about allocating resources, trade-off and Behavioral economics attempts to explain how and why making choices. Thus decision-making is central to every emotions and cognitive errors influence decision makers economic theory. All economic theories assume a very and create anomalies such as bubbles and crashes. To be able unrealistic model of human behavior. The assumptions to exploit such anomalies, we first gain an understanding of made on the human behavior are that individuals have the common factors which affect decision-making: unlimited will power, unlimited rationality and unlimited 1. Overconfidence: Most of us think that we are safe selfishness. Behavioral Finance deals with understanding drivers or are above average performers, which can’t be true, and explaining how certain cognitive errors or biases and it’s certain that all of us can’t be above average. This influence investors in their decision-making process. overconfidence may lead to excessive leveraging, trading and portfolio concentration. In this study, we applied principles from the behavioural finance literature to shed light on the merits of including 2. Information Overload: It has been found that inputs from behavioral economics in business decision experienced analysts are unaware of the extent to which making, This study identifies situations which warrants use their judgments are determined by a few dominant factors, of behavioral factors and suggesting rational & irrational rather than by the systematic integration of all available input variables to be considered for decision making. information. We start by understanding the principles of behavioral 3. Herd-like Behavior: It has been found that people economics and identifying factors affecting effective have tendency to conform to the crowd because they do not want to be an outcast. decision making followed by an explanation of already proven anomalies in financial markets. We went on to 4. Loss Aversion: This means people feel pain of loss test these hypotheses on Indian markets and devised twice as much as they derive pleasure from an equal gain. an innovative trading strategy to exploit the cognitive This manifests itself into refusal by traders to sell their stocks in loss. biases to extract alpha (superior returns) from the financial markets. The results are highly encouraging 5. Commitment: Once we make a choice, we will and prove the fact that markets are indeed irrational. 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.

26 THE MONEY MANAGER | JUNE 2009 6. Anchoring: This has most direct implications in the to the NPV of future cash flows. Dividends and other financial markets. fundamentals simply do not move around enough to justify a. Anchoring on purchase price - As aptly described by observed volatility in stock prices. Warren Buffett “When I bought something at X and it went 2. Long-term reversals - There is definite trend of up to X and 1/8th, I sometimes stopped buying, perhaps long-term reversal of returns in financial markets. If one hoping it would come back down. That thumb-sucking, the compares the performance of two groups of companies: reluctance to pay a little more, cost us a lot.” extreme loser companies (companies with several years of b. Anchoring on historical price - Refusal to buy a stock poor news) and extreme winners (companies with several today because it was cheaper last year or has a high price per successive years of good news), then the extreme losers share. tend to earn on average extremely high subsequent returns. c. Anchoring on historical perceptions - Buying/selling based on pre-conceived notions such as triple-A company 3. Short-term trends (momentum) - Empirical studies is always better, etc. provide evidence of short-term trends or momentum in stock market prices. 7. Misunderstanding Randomness: People often relate windfall gains with their good decision-making and confuse 4. Size premium - Historically, stocks issued by small unexpected losses with their bad decisions. However, it companies have earned higher returns than the ones issued might be the case that the decision was actually correct just by large companies. that it was momentary loss. 5. Predictive power of price-scaled ratios - There has 8. Vividness Bias: People tend to underestimate low been evidence that portfolios of companies with low B/M probability events when they haven’t happened recently, and ratio have earned lower returns than those with high ratios. overestimate them when they have. In addition, stocks with extremely high E/P ratio are known to earn larger risk-adjusted returns than the ones with low 9. Failing to act: In markets, where the dynamism is at E/P ratio. the root, failure to buy/sell can be devastating. It arises from status quo bias, regret aversion, choice paralysis and 6. Predictive power of corporate events and news - It information overload among others. is often the case that stock prices overreact to corporate announcements or events. Having understood the principles of behavioral economics, let us now look into the manifestation of such biases in real Some of the reasons for existence of these anomalies world in terms of financial anomalies. are: 1. Limited arbitrage- Opportunities for arbitrage Financial anomalies in security prices nullification in real-world securities markets are often Empirical studies of the changes of stock prices have severely limited. unearthed several phenomena that can hardly be 2. Investor beliefs – There can often be numerous explained using rational models and efficient market personal beliefs of the investor which guide the way he hypothesis. These facts, often termed as anomalies often invests in the market: bring to light the fact that some stocks systematically 3. Investor preferences – Most of the models are based earn higher average returns than others, although the on the hypothesis that investors evaluate gambles based risk profile of such stocks would be similar. Some of on the Expected Utility framework. However empirical the most widely accepted anomalies that have been studies have shown that investors time and again violate the proven are: expected utility framework: 1. Excessive Volatility of prices relative to fundamentals  Loss aversion – Individuals often show greater - Stock market prices are often far more volatile than could sensitivity to losses than to gains. be justified by rational models that equate prices as equal  Regret Aversion – People often try to minimize

27 THE MONEY MANAGER | JUNE 2009 the trauma of having to take the responsibility of a poor companies over a 10-year period. Correlations with investment decision. different lags have also been provided. A graph has also  Mental accounting – Investors frame situations and been provided which depicts the same information. problems in a way that is more desirable to them It can be seen that the correlation levels are very low Are Indian Markets rational? and hence it can be inferred that markets are not just Having studied the different types of anomalies, we based on fundamental information and lots of other Table 1 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 test the extent of rationality in the Indian markets. information need to be considered. Since stock prices are nothing but present value of Testing anomalies in the Indian scenario expected future cash ﬂows, hence we believe that stock Having inferred that Indian markets are not the most prices should have high correlation with earnings. It rational we tried to test the most common anomalies can be contested that there is an inherent lag between that have been observed in the western stock markets, in when actually the earnings happen and when they are the Indian scenario. Mentioned below are some of the incorporated in stock prices. Hence we computed hypothesis tests we carried out with data from the Indian correlation between earnings and stock prices of 305 stock market: companies over 10 year periods. To account for lags, 1. Size premium Hypothesis we computed correlation with lags of 0, .5 yr, 1 yr, It has been observed that returns from smaller companies 1.5yr, 2 yr, 2.5 yr and 3 yrs. give higher returns as compared to larger companies. Result: The table below (Table 1) shows the correlation Data: 5 years (2003-2008) data of 361 companies from BSE levels between earnings and stock price of the 305 500. We deﬁned companies as small, mid and large based

28 THE MONEY MANAGER | JUNE 2009 Figure 1: Variation in Correlation with time on average market capitalization: their returns. To be more specific stocks with low book Small - <250 crore to market ratio were supposed to provide lower returns as Mid - 250-1000 crore compared to stocks with high book to market ratio. Large - >1000 crore Data: 5 years (2003-2008) data of 361 companies from BSE Returns = 0.2log(P2008/P2003) 500. Results are as shown in Table 1. Results are shown in Table 2. Inference: We see that there is a clear trend of small Inference: As we can see there is no distinct trend that companies giving a distinctively high return as compared relates the returns of a firm with its book value to market to large companies. However the distinction in terms of value ratio. Hence we cannot conclusively state if there returns is much more blurred between mid size companies exists any anomaly in the Indian stock market. and Large companies 3. Long term trend reversals 2. Predictive power of price scaled ratios Empirical studies abroad have identified a definite trend of Some of the empirical studies abroad have found a distinctive long-term reversal of returns in financial markets. If one relation between the book to market ratio of stocks and compares the performance of two groups of companies: Table 2 Size No of companies Average of Return Large 204 6.4% Mid 134 6.2% Small 23 13.4% Table 3 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%

29 THE MONEY MANAGER | JUNE 2009 extreme loser companies and extreme winners, then the to point towards the fact that markets are hardly driven extreme losers (winners) tend to earn on average extremely by fundamental data because there is a low correlation high (relatively poor) subsequent returns. between prices and earnings. It further delved deep into the application of behavioral economics in finance and tried Data: 10 years (1998-2008) data of 305 companies from to identify the anomalies in security prices and the possible BSE 500 explanations that behavioral finance provides for these Returns = (P2 – P1/P1) anomalies. The later part of the paper dealt with trying to Methodology: We implemented a trading strategy to test test the different established anomalies on Indian stock if there was a trend of long-term reversals. We performed market data. Analysis indicated that some of the biases the testing assuming we were in 2003. We computed returns working in western markets also exist in Indian markets over the last 5 years in 2003 (1998-2003) and sorted the and they can be systematically analyzed and used to make companies based on the returns. Then we went neutral superior returns than the market. (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 Quotations was that their returns might have been affected by some major event (merger, foreign expansion etc) and hence they When asked what the stock market will do, J.P Morgan are not suitable to be studied for applications of behavioral (1837-1913) (banker, financier, businessman) replied: finance. Then we went short on the 90th to 70th percentile that “It will fluctuate.” is companies that had been providing very high returns and hence were expected to provide low returns in the future. “Don’t try to buy at the bottom and sell at the top. It We went long on the 30th to 10th percentile companies that can’t be done except by liars.” Bernard Baruch (1870-1965) financier & economist are companies that were providing very low returns and hence were expected to give high subsequent returns. We “With an evening coat and a white tie, anybody, even a left the middle 40% as they could not be categorized as stock broker, can gain a reputation for being civilized.” extreme winners or losers in the period of 1998-2003. We Oscar Wilde (1854-1900) Poet & playwright back tested our strategy in the period of 2003-2008. -- compiled by Shishir Kumar Agarwal, IIM Calcutta 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

30 THE MONEY MANAGER | JUNE 2009 New Monetary Policy Tools Innovative Policy Response to Financial Meltdown Ajay Jain, Atishay Jain, Sourav Dutta [IIM Bangalore] Executive Summary: used by the Fed. The financial crisis which began in 2007 resulted in The Financial Crisis a severe liquidity crisis that prompted a substantial The subprime mortgage crisis is an unprecedented injection of capital into financial markets by the United crisis that threatens the stability of the world financial States Federal Reserve. markets and the economy of the US. The real trigger The Fed tried using conventional policy tools like the for the turmoil came on Thursday, 9 August 2007, when open market operations and discount window without the large French bank BNP Paribas announced that it significant improvements. As a remedy, the Fed would close three of its funds that held assets backed introduced three new policy instruments: the Term by US subprime mortgage debt. As a consequence of Auction Facility (TAF), the Term Securities Lending this, overnight interest rates in Europe shot up. Since Facility (TSLF), and the Primary Dealer Credit Facility then, the money markets have experienced a rather (PDCF). All these actions distribute liquidity to the unusual financial crisis, with most risk measures, such segments of the financial markets facing shortages. as the LIBOR-OIS spread which is considered to be a TAF especially generated a lot of interest among the measure of interbank funding pressure, substantially primary dealers, and was a key monetary tool used by widened and made highly volatile. the Fed to lower the extent of the crisis. The two effects of TAF—meeting banks’ immediate funding demands Failure of Conventional Tools and reassuring potential lenders of their future access In response to the rapidly deteriorating financial to funds—both worked in the direction of reducing conditions, central banks around the world initially liquidity risks of banks, increasing transaction volumes resorted to the conventional monetary policy toolbox. and values, and reducing market interest rates. The tools used by Federal Reserve to inject liquidity These new tools are flexible in terms of the durations into the market could not adequately address the of the loans, the size of the loans, the safety of the unusual financial market distress this time. collateral and availability. Hence, they have the potential Open Market Operations are the most powerful and to become a part of the permanent monetary tools

31 THE MONEY MANAGER | JUNE 2009 frequently used among all tools used by the Federal The New Tools Reserve, however, during the current financial turmoil, Term Auction Facility (TAF) a heightened reluctance of banks to lend to each The TAF is a credit facility that allows depository other in the inter-bank money market interrupted this institutions (e.g. commercial banks) to borrow from process and led to a credit crunch. the Fed for 28 days against a wide variety of collateral. The second tool used by the Federal Reserve to Though this policy can potentially lead to an increase infuse liquidity is the discount window. In response to in bank reserves and ultimately also the monetary base, the soaring strains in the money market, the Federal the Fed conducts open market operations (OMOs) to Reserve narrowed the discount rate premium, from counteract unwanted increases (or decreases) in the 100 basis points to 25 basis points. The terms of loans monetary base by selling Treasury securities to exactly through discount window were also extended to ninety offset this increase. days. These measures were taken to encourage banks’ The Federal Reserve uses TAF to auction set amounts borrowing through the discount window. However, of collateral-backed short-term loans to depository their effects had been modest, due to the so-called institutions, which are judged by their local reserve “stigma” problem: during a financial crisis, the banks banks to be in sound financial condition. Participants may be reluctant to borrow from the discount window, bid through the reserve banks, with a bid that has its worrying that such actions would be interpreted by minimum set at an overnight indexed swap rate relating the market as a sign of their financial weakness, which to the maturity of the loans. The financial institutions would reduce their ability to borrow from the market. Figure 1: Rise in 3-month Libor-OIS Spread 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 While well-established mechanisms existed for the interest rate is determined in the marketplace. injecting reserves into a country’s financial system, Term Securities Lending Facility (TSLF) officials had no way to guarantee that the reserves will reach the banks that need them. As it became apparent The TSLF permits primary dealers to borrow Treasury that conventional tools were not effective enough securities against other securities as collateral for 28 in addressing unusual financial distress, the Federal days. The range of securities, which can be used as Reserve introduced new facilities to provide liquidity collateral, is wider than for the TAF. The TSLF is a to the market. “bond-for- bond” form of lending and it affects only the composition of the Fed’s assets without increasing total reserves.

32 THE MONEY MANAGER | JUNE 2009 In exchange for the collateral, the primary dealers bond” form of lending. To prevent PDCF operations receive a basket of Treasury general collateral, which from increasing the monetary base, the Fed offsets the includes Treasury bills, notes, bonds and inﬂation- increase with a sale of Treasury securities as in the case indexed securities from the Fed’s system open market of TAF. With the PDCF the Federal Reserve has in account, extending the range of acceptable collateral effect opened the discount window to primary dealers. beyond Treasuries. This facility allows the Fed to offer liquidity assistance directly to certain major investment banks that were The main advantage of TSLF is that it doesn’t involve previously ineligible. The new Credit Facility increases the any cash since a direct injection of cash can affect the scope of ﬁrms in transitory distress that may be supported federal funds rate and also have a downbeat impact through Fed liquidity injections. on the value of the dollar. TSLF also serves as an alternative to the direct purchases of the mortgaged By October ‘08 end, Fed carried $301 billion of TAF investors, which goes against the aim of the Federal on balance with a further $600 billion auction fund Reserve to avoid directly affecting security prices. 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 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 Figure 3: Composition of Fed’s Assets 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- Acceptance of TAF over others

33 THE MONEY MANAGER | JUNE 2009 Table 1: Comparison of various policy tools Though all the three tools introduced by Fed had an From 17th December, 2007 to 21st April, 2008, the Fed impact of easing the liquidity, TAF by far was the most completed ten auctions in the facility. The amount of active and successful tool. Instead of calling for banks term loans auctioned was $20 billion in each of the to come to the Fed to request a discount window loan, first two auctions, $30 billion in the next four auctions, under the TAF the Fed auctions a predetermined and $50 billion in the last four auctions. There was amount of funds amongst the participants. Second, high demand for funds at the auctions. The number instead of paying the primary credit rate, depository of banks bidding for the term loans in the TAF varied institutions that borrowed under the TAF paid the between 52 and 93 and the bid/cover ratio (i.e., the ‘stop-out rate’—the lowest bid rate that exhausts total amount bid as a ratio of funds auctioned) ranged the funds being auctioned. It generated interest in between 1.25 and 3.08. depository institutions as there was no stigma, similar to the one associated with discount window, attached Reasons for Efficacy of TAF with 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 Figure 4: TAF Auction Amount Results inter-bank interest rates. Under the prevailing disrupted

34 THE MONEY MANAGER | JUNE 2009 market conditions, the effectiveness of the TAF and Figure 6: Variation of Deposit Rates other liquidity facilities depended on whether they can with TAF announcement 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 In confirmation with the expectations, the empirical investors asked for less compensation for a given unit results suggest that TAF had strong effects in relieving of risk and the risk price declined in the presence of the liquidity concerns in the inter-bank money market. the TAF. Finally, with this additional funding source One indication of the scramble for liquidity, shown readily available, that too at a rate generally less than in the chart, was a sharp increase in the interest rates the primary credit rate, there was less demand for banks offered by banks on one-month bank certificates of to excessively hoard liquidity purely out of individual deposit relative to the Federal Reserve’s federal funds precautionary concerns. 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 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 7: Variation in LIBOR-OIS Spread with TAF auctions

35 THE MONEY MANAGER | JUNE 2009 In the LIBOR-OIS spread, a cumulative reduction of References more than 50 basis points can be associated with the - DeCecio, Riccardo and Gascon, Charles S: New TAF announcements and its operations. It was found Monetary Policy Tools that that the TAF had, on average, reduced the 1-month - Wheelock, David C: Another Window – The Libor-OIS spread by at least 31 basis points, and the Term Auction Facility 3-month Libor-OIS spread by at least 44 basis points. - Board of Governors of the Federal Reserve The reduction is economically important because it System press release, December 12, 2007:- is approximately 90 percent of the average level of www.federalreserve.gov/newsevents/press/ the LIBOR-OIS spread in the recent period of credit monetary/20071212a.htm crunch. However, TSLF and PDCF were found to have had less noticeable effects so far in allaying financial strains - www.online.wsj.com/public/us in the Libor market. This is thus consistent with the - www.dallasfed.org observations of the market of a weaker interest from - www.bloomberg.com 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.

36 THE MONEY MANAGER | JUNE 2009 CDS and Credit Crisis What Went Wrong, What Lies Ahead? Saurabh Mishra [IIM Ahmedabad] Credit Default Swap (CDS) market has shown What is CDS? extraordinary growth in past few years (Exhibit-1). As the name indicates, CDS provides protection The total notional amount outstanding at the end of against the credit event1 (like credit default) in a year 2007 on all CDS contracts was approximately $ particular company or sovereign entity. There are 62.2 trillion (ISDA Market Survey: Notional amount two counterparties involved in this transaction. The outstanding, semiannual data, all surveyed contract, counterparty that wants protection against credit event 1987-present, 2008). 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 Exhibit 1: CDS Notional Amount like credit rating of the reference entity2, seniority of Outstanding Historically bond etc. A pictorial depiction of physically settled CDS contract is shown in Exhibit-2 (Draft Guidelines Though this growth is a great story of ﬁnancial for Introduction of Credit Derivatives in India, 2003). innovations that fuelled the growth of Wall Street, Another type of settlement, known as cash settlement it is also an example of regulatory issues with such in which protection seller provides the remaining face derivatives. Following is an analysis of the issues that value of the bond after recovery by the protection CDS contracts have created in the current credit crisis buyer. So there is actually no physical transaction of and how they can be tackled for a smooth functioning underlying security and only cash changes hands. of this market.

37 THE MONEY MANAGER | JUNE 2009 section, it can be said that CDS acts as an insurance Exhibit 2: Physical Settlement of CDS 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 Apart from the obvious use as a hedging instrument the market. Since the CDS market is unregulated, it against the debts, CDS can be used in many other ways. is not possible to know accurately the exposure of CDS can be simply used as a speculative instrument on various financial institutions in this market. Also this the financial health of the company. If the investor market is illiquid because of specific nature and terms believes that the financial health of the company is of every contract that can vary from one to another. improving or deteriorating, then he can buy or sell CDS So we can see that the CDS market faces almost similar accordingly to make money by speculation. CDS can risks that other OTC derivative contracts face, but the also be used for arbitrage. The relationship between problem is manifold in comparison to other derivatives the stock price of the company and CDS premium on because of the sheer size of the market. the bonds of the company is expected to be negatively Current Credit Crisis and CDS correlated. The logic is that as the financial health of the firm improves the stock prices should go up and the The size of the CDS market (more than $ 60 trillion) is CDS spread (premium) should tighten. If the investor significantly more than the underlying debt and bond finds a mismatch in the two, he can take position in the market3. So it can be inferred that the most of the CDS CDS and equity accordingly to exploit this situation. contracts are actually speculative bets only and are not This strategy is known as Capital Structure Arbitrage actual protection on the underlying. As mentioned (Credit Default Swap, 2008). Before going forward, earlier, that being an unregulated market, exposure one thing should be noted that though CDS looks of various companies is not known in this market. like insurance, there are many differences in both Combining the above two facts, it can be inferred that the products. CDS can be used as a mere speculative a large event in the credit market can actually have vast instrument only. For buying CDS, it is not necessary impact on the CDS market, and then eventually on the that the protection buyer owns the underlying which economy as a whole. is not the case in insurance. Similarly there are not One such big credit event was the Lehman’s bankruptcy. enough regulations to check the credit worthiness of The size of Lehman’s debts was $ 613 billion making protection seller so that he is able to pay in case of it the largest bankruptcy filing ever (An Update on the default, which is again in stark contrast with insurance. Lehman Bankruptcy, By the Numbers, 2008). As far as The regulatory aspect has been discussed further. CDS market was concerned, this event had two faces. The first was related to protection that Lehman sold. It Risk Associated With CDS Contracts was feared that these protections would no longer exist. Taking the discussion forward from the previous One of the examples was of Washington Mutual that

38 THE MONEY MANAGER | JUNE 2009 bought corporate bonds in 2005 and took protection impact it will have on the pricing on the CDS contracts from Lehman through CDS contracts. Other side was protecting those structured credit products and the about the firms that wrote CDS on Lehman’s bonds kind of systemic risk it can create in the market. and debts. The final auction of Lehman’s debt was Insurance and re-insurance companies like AIG and at $8.625. It means that the protection seller would Swiss Reinsurance Company are the initial casualties have to give remaining $ 91.375 on these debts in only (Lehman Brothers: A Primer on Credit Default CDS. Since the size of the Lehman’s debt was so large Swaps, 2008). that there was possibility that the protection seller So by seeing the risks associated with CDS market in companies may themselves go bankrupt in protecting the current situation and the size of this market, it the Lehman’s bonds. So if a firm is heavily involved in can be fairly assumed that any crisis in this market can the CDS market then it creates a problem of “too big create issues bigger than what we have from subprime to fail” for the government. Infact one of the reasons crisis. for the bailout of AIG was the role of AIG in the CDS market (Lehman Brothers: A Primer on Credit How to Fix the CDS Market? Default Swaps, 2008). It has a massive unhedged CDS There are many lessons that can be learned from the portfolio of more than $ 600 billion and most of the current crisis. Following are the few ways through which losses have come from this portfolio only (Why Wasn’t reforms can be done in the CDS market (Testimony AIG Hedged?, 2008). Concerning Credit Default Swaps, 2008). Another worrying fact about the CDS is the nature of trade itself. The contract can be traded or swapped CENTRAL COUNTER PARTY (CCP) FOR multiple times and it can happen from both the ends, CDS: One of the major improvements can be made i.e. protection seller and protection buyer. Because the in the direction of establishing a single counterparty market is not regulated, it is actually not checked if for the CDS. This would reduce the counterparty risk the new buyer of the contract has enough resources in such transactions in future. This would make sure to pay in case of credit event. This in itself makes that the counterparties would not be exposed to each the pricing of the contract difficult. The problem other’s risk in future as is the case in current bilateral becomes even more severe because banks are one of CDS contracts. This CCP can act as both protection the biggest players in the market and they are already seller and protection buyer and thus would actually under pressure from the other derivatives like CDOs net out the risks. This would also help in minimizing and synthetic CDOs (CDO^n). the impact of failure of a big market participant Another worry right now is the linkage between (like Lehman or AIG). This would also ensure timely CDO and CDS market. In recent years, CDS market settlement of trades and in keeping track of market expanded into structured credit products like CDOs participants to avoid market manipulations. and synthetic CDOs. One of the major reasons for MORE OVERSIGHT TO SEC IN OTC current credit crisis is the wrong assessment of the DERIVATIVE MARKETS: risks associated with the structured credit products like SEC should be allowed to monitor OTC derivative CDOs and thus the incorrect pricing of these assets. markets that would make sure that timely action is Since the structured credit products are already quite taken before the crisis actually comes. Under the complex instruments which were not priced correctly, current laws, SEC is prohibited to interfere in the OTC so it is just a matter of imagination to see the kind of

39 THE MONEY MANAGER | JUNE 2009 swap market. Credit Default Swap. (2008, Nov 27). Retrieved Nov 27, 2008, from Wikipedia: http://en.wikipedia.org/wiki/ REPORTING OF CDS TRANSACTIONS Credit_default_swap TO SEC: Due to lack of any central clearing house it has become very difficult to quickly trace the past Credit Default Swaps: The Next Crisis? (2008, Mar 17). CDS transactions. A mandatory rule to report CDS Retrieved Nov 25, 2008, from TIME: http://www.time. transactions to SEC would ensure a close watch over com/time/business/article/0,8599,1723152,00.html these transactions and would provide alternative to Draft Guidelines for Introduction of Credit Derivatives voluntarily reporting to Deriv/SERV4. in India. (2003, Mar 26). Retrieved Nov 25, 2008, from EXCHANGE FOR CDS TRADING: As Reserve Bank of India: http://www.rbi.org.in/scripts/ NotificationUser.aspx?Mode=0&Id=1097 mentioned earlier, CCP can actually set up an exchange for CDS trades. This would ensure better ISDA Credit Event Definitions. (n.d.). Retrieved Nov 25, market transparency in terms of prices, volumes, open 2008, from Credit Derivatives WWebsite: http://www. interests etc. This would make sure that CDSs are credit-deriv.com/isdadefinitions.htm standardized and thus it would reduce the liquidity risk (2008). ISDA Market Survey: Notional amount outstanding, in the market. semiannual data, all surveyed contract, 1987-present. Conclusion International Swaps and Derivatives Association. CDS market serves the purpose of pricing the risk http://www.isda.org/statistics/pdf/ISDA-Market- associated with reference entities. Such type of Survey-historical-data.pdf contract is very important to develop the credit market. Lehman Brothers: A Primer on Credit Default Swaps. (2008, The recent rapid unregulated expansion of the CDS Oct). Retrieved Nov 25, 2008, from Credit Writedowns: market has created systemic risk for the economy in http://www.creditwritedowns.com/2008/10/lehman- general. The current idea of 2-party contract exposes brothers-primer-on-credit.html each party to the creditworthiness of the other party Testimony Concerning Credit Default Swaps. (2008, and non-standard format of the trades make the Nov 20). Retrieved Nov 25, 2008, from US Securities market very illiquid. Also, “too big to fail” syndrome and Exchange Commission: http://www.sec.gov/news/ of various firms has created fundamental problems for testimony/2008/ts112008ers.htm this market. Seeing the importance of the market and Why Wasn’t AIG Hedged? (2008, Sep 28). Retrieved the challenges associated with it, reforms are required Nov 25, 2008, from Forbes: http://www.forbes. in this market. As suggested earlier, exchange based com/2008/09/28/croesus-aig-credit-biz-cx_rl_ trading, establishing a single Central Counter Party 0928croesus.html 1 (Footnotes) (CCP), better monitoring and regulation of existing There are usually six type of credit event specified in the ISDA CDS trades are few ways to ensure the safety of this master agreement on which CDS can be written. They are market and to reduce the risks that poses to economy Bankruptcy, Failure to Pay, Obligation Acceleration, Obligation Default, Restructuring and Repudiation/Moratorium (ISDA in general. 2 Credit Event Definitions). The borrower (or other entity) whose credit event trigger the Bibliography 3 payout from protection seller To give a perspective, size of US mortgage market is $ 7.1 trillion; An Update on the Lehman Bankruptcy, By the Numbers. US treasury market is $ 4.4 trillion. Even the size of US equity (2008, Oct 17). Retrieved Nov 25, 2008, from The Wall market is approximately $ 20 trillion (Credit Default Swaps: The 4 Next Crisis?, 2008). Street Journal: http://blogs.wsj.com/deals/2008/10/17/ A subsidiary of DTCC that provides automated matching and an-update-on-the-lehman-bankruptcy-by-the-numbers/ confirmation for over-the-counter trades.

40 THE MONEY MANAGER | JUNE 2009 Climate Change Induced Financial Risks A Strategic Approach Pramod Kumar Yadav, Kuppa Vijay Krishna, Vikas Bathla [IIM Ahmedabad] Executive Summary on local and global level. It refers to a statistically Climate change has recently emerged as an unintended significant variation in either the mean state of the global negative externality problem derived from a relentless climate (which includes temperature, precipitation and pursuit of economic development. There is no sphere of wind patterns) or in their variability over an extended the competitive market place that will remain unaffected by period that ranges from decades to centuries. Climate change. Literature review suggests that the financial Climate change poses a major risk to the global and banking sector will be severely affect by the different economy. The impact of climate change on global allocations of climate-induced risks. economy has been assessed by using various top down At the outset, we analyzed the various financial risks that models to estimate damage functions that relate GDP arise due to climate change. Next, we examined the impact losses to variations in temperature. According to the of climate change on the business value chain of a firm Stern report, which is globally touted as a cornerstone using a generic financial-strategic framework. We then for future climate change economic studies, mean moved onto mapping climate risk onto the financial sector. In the next section we analyzed the impact of climate risk yearly GDP loss due to climate change is between 5 on the Basel II accord and proposed an approach to model and 20 % of global GDP. However, consistency among climate risk using Bayes Theorem and further incorporated the results of such international modeling exercises that risk into the asset (credit and market risk) portfolio of is yet to be established as different studies subsumes a bank. Developing climate change risk as a time dependent different treatments of climate induced market, non function has further substantiated this. market, and catastrophic risks This paper will help firms make their financial decisions in In this article, we will examine the impact of climate more advanced and informed manner in the light of future change on the financial sector, which forms a significant uncertainties associated with climate change. part of any economy- competitive or regulated. We Introduction will first systematically categorize the various kinds of financial risks that arise due to climate change. Then Climate change has emerged as the strongest negative we will investigate the role of such climate induced global externality that demands collective actions risks in altering the value and properties of asset

41 THE MONEY MANAGER | JUNE 2009 portfolios held by banks. Finally, we attempt to model have a great interest in ensuring the long-term security climate risk by using posterior probabilities and suggest and profitability of their investments. Mainstream methodologies for doing this. investment houses are developing sophisticated means of assessing companies’ strategic response to Climate Climate Change induced Financial Risks Risk. The size and influence of socially responsible Climate change induces risks to business sector either investment funds is growing. Thus even banks will through a direct carbon cost or through an increase look towards hedging instruments or suitable debt in the cost of factor of production. Such risks cannot portfolio allocations. or only inadequately be classified in common risk All business sectors are at risk, though the type and categories. The extent to which a company is exposed extent of risk varies. Those industries, which interface to Climate Risk and the strategy it employs to mitigate directly with the environment, are more likely to be the risk will depend on that company’s business model, affected such as Agriculture, Tourism, Energy and Real balance sheet, operations, and future plans. Some of Estate sectors. But within a sector, the risk exposure the major climate induced financial risks faced by would be different for different firms and this would public and private companies are show below: 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 1. Climate Change induced Financial Risks Figure 2. Climate Change and Business Value Among the above risks, maximum impact will be on a firm’s ability to raise capital. Climate Risk is an Climate risk mapping on the financial sector increasingly relevant consideration in the choice and Climate change is bound to increase costs for the maintenance of investments. Companies that have financial sector in future. The financial industry failed to address Climate Risk can be expected to face needs to prepare itself for the adverse effects that increased difficulty raising capital. A firm in the power climate change may have on its businesses and sector or real estate sector will find it harder to finance on its customers. Banks play an important role in its debt in the light of adverse affects of climate change climate-related financing and investment, credit risk which can completely alter the competitive landscape. management, and the development of new climate Banks and financial institutions on the other hand risk hedging products. They also need to be aware

42 THE MONEY MANAGER | JUNE 2009 that climate change could result in a compounding of Climate change can be treated as a risk management risk across the entire business spectrum, diluting some problem, especially for governments and corporations, of the benefits of diversification. Price volatility in given that climatic changes have a reasonably low to carbon markets (e.g. CO2, coal, oil) and climate-related medium probability of occurrence and a very high commodities (e.g. agriculture crops, water) leads to probability of impact. This goes hand-in-hand with uncertainty in financial projections. The opportunity in the growing realization that such low probability this environment for the financial services industry is weather events can have a lasting effect on issues such that they can significantly help mitigate the economic as investment decisions, productivity and political risks and enter the low-carbon economy by providing stability. The difficulty in mapping climate risk on a appropriate products and services. Some of the current financial portfolio is amplified as financial sector financial products are shown in the figure below. modeling is deeply rooted in historic data, which do not account for climatic impacts. We can only say that Financial service providers need to review and optimize depending on the climate exposure of the portfolio, their own carbon risk management and develop tools the conditional value at risk (CVaR) will grow due to before catering to client needs to assess their internal climate change as confidence interval surrounding processes and policies on which they can adapt and climate change predictions is likely to increase. The base their investment and lending decisions to meet following figure gives an idea about the impact of the challenges their clients face by safeguarding their climate change on expected losses and capital needs: own viability first. 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

43 THE MONEY MANAGER | JUNE 2009 Figure 4. Impact of Climate Change on Probability Loss lead to decreased margins. On top of this, the related Distribution operational risks for the bank’s clients, for example, The challenge they face is to not only include climate suboptimal carbon risk management can result in risks in their risk management but - if applicable - also financial sanctions, which also impair the client’s have to adjust applied methods for the quantification liquidity and therefore the bank’s competitiveness and of risk. creditworthiness. Credit Risk: This risk is related to policies and regulations Market Risk: The main components of this risk are that create new liabilities or transfer existing ones and volatile carbon certificate prices and volatile commodity therefore affect business directly. They affect the credit prices (e.g. coal, gas, oil). These price and volumetric ratings of GHG intensive borrowers and create direct risks lead to decreased corporate planning reliability costs of compliance on related sectors and indirect - both for banks and their clients. Banks must have costs on all consumers of energy and electricity. the expertise to monitor and understand the impact This has implications for banks in their role as loan of emissions trading or any future climate regulatory providers, equity investors, and project financiers. changes on clients’ business. The more frequent the occurrence of extreme weather events such as flooding Operational Risk: Operation risk arises from and storms, the higher the direct climate change related inappropriate risk identification, assessment, and risk of physical damage to corporate assets and real allocation processes inside the bank. For e.g. a bank’s estate. internal failures in the due diligence for investments or loans that are highly sensitive to climate change The existence of these risks mean banks need to Figure 4

44 THE MONEY MANAGER | JUNE 2009 Figure 5. Risk Measurement Approches under Basel II develop carbon risk management tools for their loan Climate Risk and Basel II: A New Modeling and investment due diligence. Some of these can be: Paradigm • To integrate an environment sustainability Climate risk assessment and aggregation with other criteria into the bank’s overall assessment of prevailing risks faced by banks is conducted through investment risk and opportunity the prism of BASEL-II principles in the absence of any other international risk norms for banking sector. • To develop new metrics to demonstrate the The essential principle of Basel II is the three-pillars- “carbon intensity” of their client portfolios concept (minimum capital requirement, supervisory and to restrict its lending and underwriting review process and market discipline), which aims at a practices for industrial projects that are likely comprehensive evaluation of risk-related capitalization to have an adverse environmental impact of banking institutions. Currently, BASEL-II proposed • To incorporate a set of emission trading banking book structure which includes minimum capital related questions in its credit rating process requirement in the form of market risk charges, credit and conduct thorough investment research risk charges, and operation risk charges is sufﬁcient to • To calculate the ﬁnancial cost of greenhouse incorporate climate risk. There are no instructions or gas emissions while reviewing loans, such as techniques of how these risks can be measured. Based the risk of a company losing business to a on our previous qualitative assessment of risks, we competitor with lower emissions have distributed climate risk across market, credit, and

45 THE MONEY MANAGER | JUNE 2009 operational risks under BASEL-II accord. All that can Integrating Climate Risks in Bank Portfolio be said is that risk adjusted capital requirements will We propose to model climate risk in the banking increase from earlier levels. Rigorous quantification sector by assuming that a rational agent observes will be necessary to establish the exact levels. new information disseminating in the market and Portfolio Analysis updates his assessment of the risks using conditional probabilities. However, prior probability assessment Any bank or credit institution will have a portfolio of and likelihood function determination always run the asset allocations. The credit loss of the portfolio or an risk of statistically insignificant and biased outcomes asset of the portfolio is calculated as in Equation I. in the presence of sparse or limited data distributed Each of the assets (or industry sectors) in the portfolio over a very long period of time. The knowledge of will be affected by climate change risk in their own climate change and its impact is acknowledged as a way. In the case of climate sensitive sectors such as recent phenomenon and hence, as mentioned before, transport, energy, real estate and water utility, each there is insufficient historical data on which to base the or all among probability of default, potential credit likelihood function. exposure and recovery factor will be adversely affected. Therefore we formulate climate risk as a recursive These in turn will have a negative impact on their debt process involving learning in which a risk-averse payback capacities, which will eventually diminish the rational agent will absorb new information and learn bank’s cash flow. This will further be exacerbated by from previous climatic impacts. The new information the climate change induced co-movement among the will be in the form of stochastic processes, particularly risk factors of the sectors leading to a high correlation climatic physical impacts, policy and regulation regime of risks that will drastically change the riskiness of shifts, and change in key market variables. The main the overall portfolio. Thus it is very important to problem with such a learning based risk assessment appropriately quantify climate risk to have an exact process is the rate of real information flow and idea of the credit status of the portfolio. technological know-how. Market risk of the bank portfolio is essentially Let us say at time t=o, the information available comprised of risks to their currency and commodity regarding climate risk is x and the probability of the assets. Basel II proposes use of stress testing and adverse climatic impact is p. At t= t, a new set of back-testing in assessing the market risk of a bank’s information y appears. After the new information, the portfolio. Mapping of climate change risks on decision maker updates his prior probability distribution market risks cannot be adequately conducted as both, to arrive at posterior probability distribution f (p/y, stress testing and back testing are backward looking x). The posterior probability can be obtained by using approaches. Bayes theorem in following manner: Equation I

46 THE MONEY MANAGER | JUNE 2009 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, This can be further simplified as, 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 The expected probability of occurring in the future eventually it will near a real world approximation. will be found as: 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 This formulation assumes that the expectation of a simulated using available data. The above climate risk rational agent changes as the new information start model can easily be extrapolated calculate the effect penetrating the market. Decision-maker changes the of climate change on the asset portfolio allocation of prior probability distributions, often with bias, as the a bank or other credit institutions. Any bank will have time passes by. Therefore, it can be said that prior an existing Monte Carlo simulation model with a given probability of climate risk was zero earlier as such risk probability distribution to determine its asset portfolio was not contemplated. allocation. Now to incorporate climate change risk Figure 6. Evolution of Climate Change Risk as a Function of Time

47 THE MONEY MANAGER | JUNE 2009 into the model we would need to apply Bayes theorem • Insurance Risk: A firm might need to pay extremely assuming a priori distribution as shown above to high insurance premiums if the chances of it being generate a conditional probability of climate risk. affected by climate change are significant. This is Then we would need to superimpose this distribution particularly severe for real estate firms and firms onto the portfolio probability distribution to arrive at a functional in agriculture and commodities. comprehensive portfolio distribution that has climate • Reputational Risk: Companies which are perceived risk included in it. to undermine steps to address climate change or Conclusion who have projects or practices which contribute to climate change run the risk of damaging their The concepts of uncertainty and ambiguity, but not image. Reputational Risk can impede a company’ risk, have been used extensively in the field of assessing ability to compete in the marketplace, as consumers the economic impacts of climate change. This paper and future employees seek alternative choices. identifies and assesses whole spectrum of climate risks on variety of sectors with a focus on financial and • Litigation: Litigation costs resulting from ‘climate banking sector. Having argued that climate induced litigation’ and associated reputational risks need risks are inevitable in medium to long term future, it also to be considered. maps climate risks on capital requirement proposed by • Competitive Risk: Companies that fail to address BASEL-II and further presents a methodology to map Climate Risk may be placing themselves at a climate change risks on portfolio value of a bank. competitive disadvantage. Action can lead to a EXHIBIT 1 direct gain over competitors, for example through “first mover” advantage; and indirect gains, for Financial Risks of Climate Change example by improving a company's negotiating Some of the major climate induced risks faced by position when a government proposes to introduce public and private companies are: regulation, or simply through an improved or "greener" reputation. • Physical Risk: This corresponds to physical disruptions such as loss of life, limb or other assets • Shareholder: Loss in competitive advantage due to calamities caused by climate changes. resulting from a loss of economic opportunities has a direct affect on the bottom line of a firm. • Policy Risk: Governments at national and global This in turn results in shareholder risk arising from levels are starting to introduce policies to tackle activism and disruption of affairs. the causes and combat the effects of greenhouse gas emissions (GHG). These policy and regulatory • Capital: Climate Risk is an increasingly relevant changes will modify company share prices, both consideration in the choice and maintenance of positively and negatively. The impact of various investments. Companies that have failed to address climate regulatory schemes on emissions and Climate Risk can be expected to face increased ensuing compliance costs can be direct such as a difficulty raising capital. A firm in the power sector carbon tax or emissions trading scheme or indirect or real estate sector will find it harder to finance through increased fossil energy prices. Thus a its debt in the light of adverse affects of climate company’s current and future financial liabilities change which can completely alter the competitive can be reduced by acting on its current emissions landscape. Banks and financial institutions on and energy consumption. the other hand have a great interest in ensuring the long-term security and profitability of their

48 THE MONEY MANAGER | JUNE 2009 investments. Mainstream investment houses are figure. developing sophisticated means of assessing Micro Finance: Installation of solar power plants is companies’ strategic response to Climate Risk. an innovative business solution that can be funded by The size and influence of socially responsible micro financing agencies. investment funds is growing. Thus even banks will References look towards hedging instruments or suitable debt portfolio allocations • Arnold, M.; Kreimer, A., 2000 "World Bank's role in reducing impacts of disasters." Natural Hazards EXHIBIT 2 Review 1(1): 37-42 Currently available financial instruments • Benson, C. and E.J. Clay. 2002. “Disasters, Growing sensitivity of financial and insurance markets Vulnerability and the Global Economy.” towards climate induced chaotic and severe events is ProVention evident with the increasing popularity of catastrophe • Consortium, Draft Papers presented at the bonds, carbon trading instruments, and weather December 2002 conference, "The Future of derivatives. A critical review of such instruments is Disaster Risk: Building Safer Cities.” following. • Covello, V.T./ Merkhofer, M.W.,1993 Risk Emissions Trading: The international emissions Assessment Methods: Approaches for Assessing trading market offers new opportunities for banks and Health and Environmental Risks. New York: their clients. Emissions’ trading is also an interesting Plenum Press option for project financiers, since the IRR of emission reduction projects can be enhanced through the • Citigroup. Climate Consequences – Investment project-based mechanisms Implications of a Changing Climate. Citigroup- Study, 2007 Catastrophe Bonds: Catastrophe bonds are financial instruments that help disperse catastrophic weather • Credit and Basis Risk Arising From Hedging risk. Issuance of such bonds has risen sharply following Weather-Related Risk with Weather Derivatives, various hurricanes in US in the last decade. There is Patrick Brockett and Linda Golden, McCombs a considerable demand for products like catastrophe School of Business, University of Texas at Austin, bonds; exchange-traded catastrophe options; Jul 2008 catastrophe equity puts; and catastrophe swaps. • Enhancing Security, Reducing Vulnerabilities: Weather Derivatives: Weather risk is primarily a volume Climate Change and Financial Innovation, risk rather than a price risk. To mitigate against weather Jacob Park, Assistant Professor, Business and Public risks financial instruments based on weather related Policy, Green Mountain College (USA) index such as the Heating Degree Days (HDDs), Presented at Human Security and Climate Change: An Cooling Degree Days (CDDs) for temperature risks. International Workshop, Oslo, June 2005 Initially restricted to energy firms of the west, today major financial institutions and other industries • Financial Risks of Climate Change, Association of including agriculture, insurance, tourism and retail are British Insurers, Summary Report, 2005 also entering this market. A brief summary of climate • International Energy Agency / OECD. Climate risk hedging instruments is given in the following Policy Uncertainty and Investment Risk. Paris.

49 THE MONEY MANAGER | JUNE 2009 2007 • Urrutia,Jorge1986.,The capital asset pricing model • Investing in Climate Change: An Asset Management and the determination of fair underwriting returns Perspective, Deutsche Bank, Oct 2007 for the property-A liability insurance industry, The Geneva papers on risk and insurance, vol. 11,No.38 • IPCC. The IPCC 4th Assessment Report on (January 1986). Climate Change 2007: The Physical Science Basis. Value at Risk: Climate Change and the Future Summary for Policymakers. Geneva2007 of Governance, April 2002, CERES Sustainable • Greenpeace International, http://www.greenpeace. Governance Project Report prepared by Innovest Strategic Value Advisors, Inc. 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 Puzzle Answers Delivery of Energy-Efficient Products and Services.” Energy Policy, 31:1257-1272., http:// A1) 31 (all perfect squares up to 1000) eetd.lbl.gov/emills/PUBS/Insurance_Case_ A2)2*min(p,1-p) Studies.html A3) You should let 37 ladies go by and select the first • Musiela, M. and Rutkowski, M. 1998: Martingale one with a dowry greater than the maximum of the Methods in Financial Modelling. New York,N.Y.: first 37 dowries. Springer-Verlag. A4) 1/(1-cos(72)) = 1+5-1/2 • Nordhaus, William, D and Joseph Boyer, 2000, Warming the World: Economic Models of Global A5) If the number of red hats that the last banker can Warming (Cambridge, Massachusetts: MIT Press). see were even, he would say “red”. If they add up to an odd number, he would say “blue”. • Smit, B., O. Pilifosova, I. Burton, B. Challenger, S. Huq , R.J.T. Klein, G. Yohe, N. Adger, T. Downing, A6) 0.25 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.

50 THE MONEY MANAGER | JUNE 2009 Credit Default Swap Pricing Empirical Results and Inferences Anshul Gupta, Radhika A R [IIM Bangalore] Executive Summary approximately ten times as large as it had been four years earlier. Credit Default Swaps (CDS) are one of the most widely traded credit derivative contracts in the financial world. However the rapid growth of the CDS market has not It is estimated that the total amount of outstanding been without its critics. Several analysts have pointed CDS are in the range of 55-60 trillion dollars, out that the CDS market lacks regulation and the deals indicating the popularity of these instruments. Given are far from transparent and often fuel speculation. their widespread use and the unregulated and non There have even been claims that the CDS markets transparent nature of CDS transactions, the pricing exacerbated the 2008 global financial crisis by hastening of CDS assumes particular significance. While several the fall of companies such as Lehman Brothers and models have been proposed for the same, performance AIG. of these models has been inconclusive. In this paper 2. CDS Pricing: Approaches and Models we implement and analyze the performance of two of the most basic models, namely the Merton Model Given the huge market for CDS, it is but natural that and the EJO model both in the developed as well as substantial amount of research has been conducted on developing markets. The results and inferences from their pricing. the same are subsequently presented. The authors The price, or spread, of a CDS is the annual amount believe that the current economic crisis and the role of that the buyer of the protection must pay the protection CDS in the same makes the analysis presented in the seller over the length of the contract. paper all the more germane. There exist two fundamental approaches to CDS 1. Credit Default Swaps: The concept pricing: A credit default swap (CDS) is a credit derivative (a) Structural Approach contract between two counterparties, structured such (b) Reduced Form Approach that the buyer has to make periodic payments to the seller and in return obtains the right to a payoff if there 2.1 Structural Approach to CDS Pricing is a default or credit event with respect to a reference The structural approach links the prices of credit risky entity. The market size for Credit Default Swaps began instruments directly to the economic determinants of to grow rapidly from 2003 and by late 2007 it was

51 THE MONEY MANAGER | JUNE 2009 financial distress and loss given default. These models applications, they don’t touch upon the theoretical imply that the main determinants of the likelihood and determinants of the prices of defaultable securities. severity of default are financial leverage, volatility and Another approach within the reduced form approach the risk free term structure. Popular implementation focuses on estimating the default probabilities and the of the Structural models today include Moody’s KMV loss given default using statistical functions and pricing model. However it is often difficult to implement such the CDS based on the results. models as it is difficult to get reliable estimates of the Thus it is seen that while the Structural models are asset volatility and risk free term structures. Most of theoretically sound, they are difficult to implement the structural models in place today are derived from while the Reduced form models, though easy to the work done by Black & Scholes (1973) and Merton implement lack theoretical rigor. Therefore as a (1974). The Merton model, the foundation of all combination of the Structural and Reduced Form subsequent structural models, is described next. Approach, some researchers actually use the structural 2.1.1 The Merton Model approach to identify the theoretical determinants of corporate bond credit spreads. These variables are The Merton model works on the principle that a firm’s then used as explanatory variables in regressions for equity can be viewed as a call option on the firm’s changes in corporate credit spreads, rather than inputs assets. Thus the probability of a firm defaulting on its to a particular structural model. Important work in this obligations can be found by determining the probability area was carried out by Collin-Dufresne, Goldstein, of the exercise of this option. The model assumes and Martin (2001), Campbell and Taksler (2003) and that a company has a certain amount of zero-coupon Cremers, Driessen, Maenhout, and Weinbaum (2004). debt that will become due at a future time T. The Ericsson, Jacobs and Oviedo (2004) suggested an company defaults if the value of its assets is less than extension of these approaches in which they regressed the promised debt repayment at time T. The equity of the Credit Spread with the firm’s leverage, volatility and the company is a European call option on the assets of the risk free interest rate. This model is implemented the company with maturity T and a strike price equal in this paper and results on companies both in the to the face value of the debt. The model can be used developed and the developing world are described. to estimate either the risk-neutral probability that the company will default or the credit spread on the debt. 3. Implementation Approach The mathematical implementation of the Merton The main considerations while choosing the various model involves determining a firm’s asset value and parameters for implementation are described below: asset volatility using the easily observable equity value (a) Comparing performance of Structural and and the debt profile of the firm. Detailed mathematical Reduced Form Models: In order to evaluate description of the model can be found in Merton the performance of both the approaches, one (1974) and Hull, Nelken & White (2004). structural model (Merton Model) and one reduced 2.2 Reduced Form Approach to CDS Pricing form model (EJO Model) was implemented. These models exogenously postulate the dynamics (b) Covering companies across different sectors: of default probabilities and use market data to obtain The companies on which the models were tested the parameters needed to value credit-sensitive claims were chosen from a wide range of sectors so that (Ericsson, Jacobs and Oviedo (2004)). While these any sectoral biases would not affect the evaluation models have been shown to be versatile in practical of the performance of the models.

52 THE MONEY MANAGER | JUNE 2009 (c) Covering companies from different countries: (a) Merton’s Model: Equity Price of the firm, Equity In order to test the performance of the models Volatility of the firm, Debt Structure of the firm, for firms from both the developing and developed Risk free interest rate in the country of operation. worlds, firms from US, UK and India were chosen. (b) EJO Model: Equity Price, Book Value of Debt This enabled us to draw relevant conclusions and Market Value of Equity, Risk free interest rate regarding the applicability of the models in in the country of operation. emerging markets like India as well. All data required was sourced from Bloomberg. To (d) Covering companies with different leverage: obtain a good balance between capturing recent events Since the ultimate aim of the pricing models is to and preventing disruption due to spurious information, predict whether a company is likely to default on a 60-day period for volatility was used. Since the Merton its obligations or not, we chose companies with model requires the firm’s debt to be modeled as a zero leverages varying from low to high so as to test the coupon bond, weighted average of the debt and its performance of the models for companies having maturity was used to do so. The risk free interest rate different balance sheet debt structures. was then taken to be the rate for government bills with (e) Period of testing: The performance of the models maturity closest to the maturity of the zero coupon was tested for the last two months of 2007. The bond. Microsoft Excel was used for implementing the most recent data points were deliberately not taken model. to test the models as given the current financial CDS spreads for a 5 year CDS on each firm were also conditions, measuring the performance for current obtained from Bloomberg. The mean value of the CDS data would not have given an accurate picture of was assumed to be the average of the bid and ask for the utility of these models. the purpose of comparison with the value predicted by Overall six companies were chosen for testing the the two models. models and a summary of these companies is presented 5. Results and Discussions in Table 1. The results for the six companies for both the Merton 4. Data Sources as well as the EJO model are summarized in this The data required for the implementation of the two section. models is listed below: 5.1 Merton Model Table 1 : Companies chosen for testing Company Country Sector Debt Levels Reliance India Ltd. India Petrochemicals Moderate State Bank of India India Banking Moderate - High General Motors USA Automobile Moderate Vodafone UK Telecom Low-Moderate Glaxo Smithkline UK Healthcare Very Low Johnson and Johnson USA Healthcare Very Low

53 THE MONEY MANAGER | JUNE 2009 Overall the Merton model was found to work Table 3: Results obtained by the EJO model reasonably well for companies with medium to high Company R2 (%) Vol. Leverage Int.Rate leverage and the predicted values were found to follow RIL 90.30 + + - the trends depicted by the actual values. However the SBI 70.97 + + - Merton model was observed to consistently under GM 52.15 + + + Vodafone 76.38 + + - predict the actual spread. This could be because of the GSK 79.40 + + - very basic nature of the model and the simplicity of MKS 83.89 - + + the underlying assumptions. The results obtained are As predicted by past research, the EJO model gave consistent with the past research which showed that superior performance when compared to the Merton structural models under predict credit spreads and model with high R2’s for most companies. All the three display low accuracy (Arora, Bohn, Zhu, 2005). explanatory variables were found to be significant for The results obtained by the Merton model for the all companies. The EJO model was also found to be four companies with moderate-high leverage are better suited for firms with low leverage as shown by summarized below. Sample outputs obtained can be its good performance for GSK and MKS. seen in the annexure. The credit spread was found to be positively correlated Table 2: Result obtained by the Merton model with the equity volatility and firm leverage and negatively correlated with the interest rates. Thus the Company Extent of Under prediction effect of these market driven variables is economically RIL 19% SBI 32% important as well as intuitively plausible. These results Vodafone 71% are also consistent with previous research in these areas GM 14% (Ericsson, 2004). However the flaws of the Merton model are accentuated 6. Inferences and future work when tested on companies with very low leverage namely Johnson & Johnson and Glaxo Smithkline The results indicate that while the Merton model is (GSK). Because the Merton model essentially models theoretically sound, due to the simplifying assumptions the equity as a call option on the firm’s assets and built into the model, its performance on real life given the fact that if the debt of a firm is very low, the companies and data is not satisfactory. Although it does probability of exercising this option is very low, the give encouraging results for companies with medium- Merton model gave extremely low CDS spreads for high leverage, overall it is found to under predict the such companies. Thus it was found that the Merton CDS spreads by a substantial amount. model is not suitable for firms with very low leverage. In contrast the EJO model gives good results in estimating the CDS spread as described in the previous 5.2 The Ericsson, Jacobs and Oviedo Model sub-section. This could be due to the fact that it uses The Reduced Form model – the Ericsson, Jacobs market driven parameters to estimate the CDS spread. and Oviedo (EJO) model which regresses the CDS The EJO model also performs relatively better than spreads against the firm leverage, equity volatility and the Merton model for companies with low leverage. the interest rates was also used to estimate the CDS Further for emerging economies with low market spreads. The results obtained by the EJO model are depth and inefficient price discoveries, the EJO model summarized below (the +/- indicate the positive/ may be better suited. negative correlation between the CDS spread and the Future work would involve testing the Advanced explanatory variable):

54 THE MONEY MANAGER | JUNE 2009 Merton Model proposed by Hull and White (2004). 6. Karol Frielink, 2008, Credit Default Swaps and Non-linear models wherein the CDS spreads are Insurance Issues, Spigthoff Attorneys and Tax regressed with non-linear functional forms can also Advisors Newsletter be tested. One such possible model was suggested by 7. Geske, R., 1977, The Valuation of Corporate Collin-Dufresne, Goldstein, and Martin (2001). Liabilities as Compound Options, Journal of Financial and Quantitative Analysis, 541-552. 7. Conclusion 8. Jarrow, R., 2001, Default Parameter Estimation The paper presents the results obtained by the testing Using Market Prices, Financial Analysts Journal, of the Merton Model and the EJO Model for estimating 57, 75-92. 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.

55 THE MONEY MANAGER | JUNE 2009 Effectiveness of Basel II in the financial crisis Sumit Bhalotia, Hemant Dujari [XIMB, IIM Ahmedabad] Executive Summary for the amount of capital that banks need to put This paper attempts to analyze the role played by aside to deal with current and potential financial and Basel II norms in the current financial crisis. Since operational risks. Basel II norms are based o three Basel II norms have not been implemented uniformly pillars. The first pillar refers to the set of rules that deal throughout the world and have been mainly adopted with minimum capital requirements to be held against by European countries and not by US banks its role is key risks namely credit risk, market risk and operational not very clear. But still there are certain inefficiencies risk. Pillar two refers to the supervisory review process in the Basel II norms that need to be taken care of in identifying and assessing all the risks banks face else they will add to the financial instability. Basel II which even goes beyond the risks mentioned in pillar 1 does not address all the regulatory issues that figure such as credit concentration risk etc. In essence, Pillar in the lessons learned from current market events. 2 provides a strong push for strengthening both risk In particular, it is not a liquidity standard, though it management and bank supervision systems. Pillar three recognizes that banks’ capital positions can affect their refers to market discipline that seeks to supplement ability to obtain liquidity, especially in a crisis. It requires the supervisory effort by building a strong partnership banks to evaluate the adequacy of their capital in the with other market participants. It requires banks to context of both their liquidity profile and the liquidity disclose sufficient information on their Pillar 1 risks to of the markets in which they operate. But it is widely enable other stakeholders to monitor bank conditions. agreed that more work needs to be done on developing Analysis of current financial crisis reveals that one of guidance for liquidity provision. The current turmoil the major reasons was creation of very complex risk has provided an opportunity to examine the robustness exposures not fully understood and assessed by both of the Basel II securitization framework, which is now investors and the banks’ own risk management systems. being done by the Basel committee. Poor risk assessment and risk management of market . and funding liquidity, concentration and reputational Basel II and the current Financial Crisis risks, insufficient regard for off balance sheet risks Bank regulators across the globe are implementing and the interaction of tail risks under stress. This what is known as Basel II—an international standard was exaggerated by poor performance of the credit

56 THE MONEY MANAGER | JUNE 2009 rating agencies in evaluating the risks of structured adds to the boom by even more lending amount. credit and various incentive distortions in relation to Figure 3: Pro Cyclicality effect 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 Again during the depression period the effect is opposite. the year 2007 and it takes around a year to completely As shown in the diagram below during depression credit adopt Basel II norms the role of Basel II in the current becomes riskier having high probability of default. financial is not clear. But there are certain concerns over This leads to increased capital requirements level to the role played by Basel II norms during a financial act as a cushion for the high expected losses. So banks crisis, which are discussed in subsequent sections. cut on the lending amount to reduce its balance sheet’s size. They may also have more difficulty increasing Pro Cyclicality Effect of Basel II capital and issuing subordinated debt because of the Though Basel II tightly links capital requirements to heightened uncertainty. The combination of higher the risks associated but according to experts it suffers capital requirements (because of increased risk) and the from cyclical nature of the business and adds to the difficulty of raising new capital could lead institutions boom and bust cycle. The rules are too lax on capital to reduce credit to firms and households, which would requirements during the “good times” and too tough aggravate the recession or hinder economic recovery during the “hard times,” exacerbating boom-bust cycles Figure 4: Pro cyclicality effect 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

57 THE MONEY MANAGER | JUNE 2009 Likely Effects of Basel II Adoption in the Current allocation for loans to quality borrowers are going to Scenario decrease. Banks can use this capital for other purposes to BASEL II norms are expected to have far reaching increase profits. But the population of rated corporate is consequences on the health of financial sectors worldwide small in India and most of them would have to be assigned because of the increased emphasis on banks’ risk a risk weight of 100 per cent. The benefit of lower risk management systems, supervisory review process and weight of 20 per cent and 50 per cent would, therefore, market discipline. be available only for loans to a few corporate. The cover required for bad loans will increase exponentially with The new norms bring to fore not only the issues of bank deteriorating credit quality, which can lead to an increase in wide risk measurement but also of active risk management. capital requirement. This will help in better pricing of the loans in alignment with their actual risks. The beneficiary will be the customer Weaknesses Prevalent in Basel II Making it with high creditworthiness and ratings as they will be able Ineffective for Financial Crisis to get cheaper loans. Basel II relies heavily on a number of key elements, which, to many eyes, appear weakened in light of the credit and Basel II norms require vast amount of historical data and liquidity crisis advanced techniques and software for calculation of risk measures. This will translate into huge demand for IT, BPO Basel II promotes the use of internal quantitative modeling and outsourcing services. According to estimates, cost of techniques by banks in calculating their regulatory capital. implementation of the new norms may range from $10 Some commentators have expressed worries over the million to $150 million depending on the size of the ban opacity of these more complex models, and the fact that . the use of internal models by banks could potentially lead A flip side is that the knowledge acquired by the big banks to conflicts of interest. due to the implementation of complex norms would act as an entry barrier to any new competition entering into The new capital adequacy rules depend heavily on the use of the market, as international markets provide incentive to credit agency ratings. Given the culpability being ascribed by sovereigns and banks that have implemented Basel II. Small many to the rating agencies in the structured credit market and medium sized banks will find it difficult to finance high turmoil, one has to decide whether to give these agencies a implementation costs of the norms. If national supervisors quasi-regulatory role in relation to capital adequacy. make the norms compulsory to implement, these banks might have no other option but to merge with other bank. Despite improvements over Basel I, the new rules still focus Therefore, consolidation in banking industry with increased very much on credit origination, as opposed to new credit mergers and acquisitions is expected. derivative instruments and structured products. Higher risk sensitivity of the norms provides no incentive The IMF has recently stated that the pro-cyclical nature to lend to borrowers with declining credit quality. During of Basel II capital requirements, which require banks to economic downturns, corporate profits and ratings tend to hold additional capital against greater anticipated losses decline. This can lead to banks pulling the plugs on lending as the economic cycle turns downward, could exacerbate to corporate with falling credit ratings, at a time when these an economic recession by forcing banks to restrict their companies will be in desperate need of credit. The opposite provision of credit in a downturn scenario. is expected during economic booms, when corporate credit worthiness improves and banks will be more than willing to The credit and liquidity crunch was partly the result of a lend to corporate. widespread lack of information, which exacerbated the initial US subprime problems. Whilst enhanced disclosure With better risk measurement practices in place the capital is one of the three pillars of Basel II, it is recognized as

58 THE MONEY MANAGER | JUNE 2009 likely to be the weakest in terms of both prescription and exacerbating short-term stress. enforcement. Basel II disclosure is required to assess an (ii) Liquidity: Supervisory guidance will be issued for individual bank’s capital adequacy. But that is not enough: a the supervision and management of liquidity risks. strong bank capital base, while essential to avoid the collapse (iii) Oversight of risk management: of any major financial institution, was not sufficient to Guidance for supervisory reviews under Basel II will prevent the systemic effects of the subprime crisis. be developed that will Strengthen oversight of banks' identification and Basel II and the Reaction of the Indian banking management of firm wide risks; System Strengthen oversight of banks' stress testing practices for risk management and capital planning purposes; In the wake of the turmoil in global financial Require banks to soundly manage and report off markets, the FSF (Financial stability forum of balance sheet exposures; BIS) brought out a report in April 2008 identifying Supervisors will use Basel II to ensure banks' risk the underlying causes and weaknesses in the management, capital buffers and estimates of potential international financial markets. The report dealt with credit losses are appropriately forward looking. strengthening prudential oversight of capital, liquidity and risk management, enhancing transparency and (iv) Over the counter derivatives: Authorities will valuation, changing the role and uses of credit encourage market participants to act promptly to ensure ratings, strengthening the authorities’ responsiveness that the settlement, legal and operational infrastructure to risk and implementing robust arrangements for over the counter derivatives is sound. for dealing with stress in the financial system. The roadmap for the implementation of Basel II in The Reserve Bank had put in place regulatory guidelines India has been designed to suit the country specific covering many of these aspects, while in regard to conditions. All other commercial banks (except Local others, actions are being initiated. In many cases, Area Banks and RRBs) are encouraged to migrate to actions have to be considered as work in progress. In Basel II in alignment with them not later than March any case, the guidelines are aligned with global best 31, 2009. The process of implementation is being practices while tailoring them to meet country specific monitored on an ongoing basis for calibration and fine- requirements at the current stage of institutional tuning. The minimum capital to risk weighted asset ratio developments. The proposals made by the FSF and (CRAR) in India is placed at 9 per cent, one percentage status in regard to each in India are narrated below: point above the Basel II requirement. Further, regular monitoring of banks’ exposure to sensitive sectors and (i) Capital requirements: Specific proposals will be their liquidity position is also undertaken. issued to raise Basel II capital requirements for certain Conclusion complex structured credit products; Introduce additional capital charges for default and Countries should adopt Basel II framework based event risk in the trading books of banks and securities on their national circumstances. Also there should firms be complete implementation of Basel II and not Strengthen the capital treatment of liquidity facilities selective or partial implementation as different parts to off balance sheets conduits. complement each other. Incomplete implementation Changes will be implemented over time to avoid can even lead to eventual harm rather than financial

59 THE MONEY MANAGER | JUNE 2009 stability. Basel II norms have to be modified taking References into account the recent happenings and addressing John C. Hull, The Credit Crunch of 2007: What Went the weakness discussed earlier. Also the norms have to Wrong? Why? What Lessons Can Be Learned? take care of the cyclical nature of the business and not Atif Mian and Amir Sufi The Consequences of add to the already prevalent boom or the bust cycle. Mortgage Credit Expansion: Evidence from the U.S. Though the role played by Basel II is not very clear in Mortgage Default Crisis. the current crisis but it definitely needs to be fine tuned RBI Guidelines in the wake of credit crisis. (www.rbi. in order to address future financial crisis and maintain org.in) financial stability. Bank for International Settlements – Website : www. bis.org 1 2 3 CROSSWORD 4 5 6 7 8 9 10 - by Divya Devesh, IIM Calcutta 11 12 13 14 15 16 Down 1. )SEC filed a civil suit against which billionaire owner of the Dallas Mavericks for insider trading in 17 18 Nov 2008. (4,5) 2. )What is the Index of about 50 stocks that are 19 traded on the São Paulo Stock Exchange?(7) Across 3.) ________ Street is London’s equivalent of Wall Street. (11) 2.) Jordan’s Furniture is the subsidiary of which famous 4.) This business magnate started her catering busi- American company?(18) ness in 1976. (6,7) 8). Which is the third Latin American country to adopt the 5.) A Universal Product Code was scanned for the US dollar as its currency. (2,8) first time in 1974. What was the first product to be 10.) What is the largest non-US company listed on the sold with this code?(8) NASDAQ in terms of market capitalization?(8) 6.) A Stock that drops suddenly and sharply in price, 12.) Which company used the trademark slogan “World’s usually because of lower-than-expected earnings or most experienced airline” in the early 1970s?(5) other bad news.(4,6,5) 15.)Whose autobiography is called ‘Dreams of my fa- 7.)What is the study and collection of stocks and ther’?(5) bonds called? (11) 17.) Which company filed a lawsuit in 2008 against Face- 9. )The largest college student loan company.(6,3) book, forcing it to remove its hit game Scrabulous?(5) 11.) A bond with a par value of less than $1,000.(4,4) 18.) Which was the first foreign company to open a fac- 13.) The merger of Delta Airlines with which airlines tory in the United States?10) created the largest US carrier in 2008.(9) 19.) Fischer _____ and Myron ______ write a path break- 14.)Who launched his business career at the age of ing article in the Journal of Political Economy in 1973. 14 by forming his own company, Traf-O-Data, with What are their last names?(5,7) friends?(4,5) 16.)Which century old Japanese firm manufactured playing cards before it made its mark in the world of

60 THE MONEY MANAGER | JUNE 2009 Hedge Fund Strategies Identifying Successful Hedge Fund Strategies for Investing in Emerging Markets Prateek Mathur, Pinky Singh, [FMS, Delhi] Executive Summary The recommendations given discuss the hottest Hedge Funds (HF) are privately organized, loosely destination in emerging markets and the suitable regulated private investment vehicles. The total assets strategies both globally and in Indian context. Among managed under HF increased by 24.4% to an estimated the emerging markets, particularly the BRIC countries $2.68 trillion in the first three quarters 2007. (especially Russia), are most lucrative as they have some Globally in past, the funds through the strategy of the best opportunities for investors. ‘Convertible Arbitrage’ topped followed by Distressed Debt Funds, which are the next best return-generators. Most hedge fund managers and portfolio managers The various types of hedge funds strategies used by look for a certain type of equity or industry research investors across the globe are: for their fund. Hedge funds currently use and are Table 1: Hedge Fund strategies STRATEGY DEFINITION Market Neutral 50% short, 50% long Convertible Arbitrage Long convertible security, Short underlying equity Global Macro Focus on global macroeconomic changes Growth Look for growth potential in earnings and revenues Value Invest based on assets, cash flow, book value Sector Focus on particular economic or industry sector Distressed Securities Invest in companies undergoing reorganization or in bankruptcy Emerging Markets Invest in emerging foreign market equity and debt Opportunistic Trading oriented, takes advantage of market trends and events Leverage Bonds Employ leverage to invest in fixed income instruments Short Only Take short positions only

61 THE MONEY MANAGER | JUNE 2009 in constant need of high end unbiased qualitative A typical HF involves aggressive participation, strategies and quantitative research to identify and evaluate and positions in the market. Most strategies move opportunities in the global markets. This paper explores around short selling, trading in derivative instruments the various strategic and research options available like options and using leverage (borrowing) to enhance to Hedge funds investing in emerging markets and the risk/reward profile of their bets. concludes with certain recommendations that would help Hedge funds succeed in emerging markets. HF can provide benefits to financial markets by What are Hedge Funds? contributing to market Efficiency, Liquidity, Price Hedge Funds (HF) are privately organized, loosely determination, and Financial Market Integration. Many regulated private investment vehicles that are generally HF advisors take speculative trading positions on behalf open-ended, and are available to a limited number of of their managed HF based extensive research about investors. They are generally structured as Limited the true value or future value of a security. They also Liability Partnerships (LLP). use short term trading strategies to exploit perceived Trends and Developments pricings of securities. Thus, new combinations in the The total assets managed by HF increased by 24.4% risk-return space can be achieved with HF, thereby to an estimated $2.68 trillion in the first three quarters increasing the completeness of financial markets. 20071. New allocations increased total asset levels by an estimated $339 billion, but asset reductions from Strategies liquidations outpaced the increase from new fund Though there are not set classifications, we have launches in Q2 and Q3 of 20082. Total assets outside broadly categorized the strategies according to the USA increased 28.5% through the first three quarters similar characteristics that they seem to exhibit. Each of 2007, compared to a 12.5% increase in US. fund has its own strategy that it uses to try and earn Impact of Hedge Funds on The Market a high return on investment for its investors. Each

62 THE MONEY MANAGER | JUNE 2009 of these strategies varies in the types of returns they 1(b) Long/Short Equity Hedge [Volatility: High] generate and in their expected volatility. ‘Long undervalued securities and short overvalued securities’- It attempts to factor out market and 1. Directional Strategies sectoral factors, leaving only the inefficiencies of stock HF managers following directional strategies put bets selection and their identification thereof, as a source on the general direction of the markets going up and of portfolio return. Some approaches balance the down and profiting from such movements. dollar amount long against the dollar amount short, while others attempt to balance the estimated volatility 1(a) Dedicated Short Bias (Short Selling) [Volatility: of the longs and the shorts. Very High] Short selling funds short all of the investments in their 1(c) Emerging Markets [Volatility: Very High] portfolio. These funds often come into favour when Emerging market funds invest in stocks or bonds of people feel the market is about to approach a bearish emerging markets. These are considered very volatile cycle. However, since short selling a stock exposes the because emerging markets typically have higher investor to an unlimited amount of risk, these funds inflation and volatile economic conditions. Not all are often seen as very risky. emerging markets allow short selling so hedging is usually not available.

63 THE MONEY MANAGER | JUNE 2009 2 (c) Regulations D (Reg. D) [Volatility: Moderate] 1(d) Global Macro [Volatility: High] This sub-set refers to investments in micro and small Macroeconomic funds aim to profit from changes capitalization public companies that are raising money in global economies. They are typically involved in in private capital markets. Investments usually take the stocks, bonds, commodities, and currencies. These form of a convertible security with an exercise price funds usually use derivatives to increase the impact of that floats or is subject to a look-back provision that market movements. insulates the investor from a decline in the price of the 1(e) Managed Futures [Volatility: High] underlying stock. These are funds that invest on a long and/or short 3. Market Neutral Strategies basis almost exclusively in exchange traded commodity It is the only strategy that primarily focuses on linking derivatives and/or financial derivatives (futures, options specific positions in a ‘hedged’ fashion. These positions and warrants). Broadly speaking, managed futures are seek returns independent of market movements while an investment for the purpose of speculating in futures extracting returns from mispriced securities, market and options markets. sectors, or groups of securities. These strategies attempt to limit market or systematic risk while taking 2. Event Driven Strategies advantage of inefficiencies between asset classes or Event driven strategies are long-biased strategies that securities. Essentially, the manager buys undervalued focus on specific corporate transactions that are likely securities and shorts overvalued securities, hoping that to produce a reasonably well-defined increase in the the long positions outperform the short positions or value of a security within a reasonably well-defined vice versa. time horizon. 3(a) Convertible Arbitrage [Volatility: Low] 2(a) Distressed/ High Yield Securities [Volatility: ‘Long convertible bonds and short the underlying Moderate] common stock’. These funds buy equity or debt in companies that are This approach recommends buying a convertible facing bankruptcy. These fund managers usually think bond (or other type of convertible instrument such that the general public doesn’t understand troubled as preferred stock) and then shorts an appropriate companies very well so they seek to profit from deeply amount of the same company’s stock to make it a discounted securities. hedged transaction. 2(b) Risk (Merger) Arbitrage [Volatility: Moderate] 3(b) Fixed Income Arbitrage [Volatility: Low] The risk arbitrage investor focused on equity-related HF with a focus on income usually focuses on high- opportunities created by mergers and acquisitions, yield stocks or bonds. They also might purchase fixed tender offers and related situations. Risk arbitrageurs income derivatives that enhance their profit from the are typically long in the stock of the company being appreciation and interest income. acquired and short in the stock of the acquirer. By shorting the stock of the acquirer, the manager hedges 3(c) Equity Market Neutral [Volatility: Low] out market risk, and isolates his/her exposure to the Market neutral funds attempt to remove the market outcome of the announced deal. risk from their portfolios by being both long and short in a given sector. A market neutral fund may pick two

64 THE MONEY MANAGER | JUNE 2009 similar stocks and purchase the one it feels is better and to whatever conditions they feel are profitable at the short the stock that is weaker, hoping that the stock it time. likes more outperforms the other stock. Past Performance of Strategies In order to compare returns over a longer term, 4. Fund of Hedge Fund (FOHF) the ranking were allotted based on Sharpe Ratio3. Rather than investing in individual securities, a Fund The ranking by risk-adjusted returns shows that the of Funds invests in other HF. Any fund that pools convertible arbitrage funds turn up tops with an capital together, while utilizing two or more sub annualized return of 6.7% and a volatility of just managers to invest money in equity, commodities, or 2.2%. Distressed debt funds are the next best return- currencies, is considered a Fund of Funds. Investors generators with an annualized return of 9.4% and a are allocating assets to Fund of Funds products mainly volatility of 5.3%. This is owing to the concentrated and for diversification amongst the different managers’ isolated evaluative model followed by these strategies. styles, while keeping an eye on risk exposure. In recent past, combination of strategies has witnessed maximum funds asset, followed by Long/Short Equity 5. Other Strategies Hedge Strategy4. 5(a) Aggressive Growth [Volatility: High] Aggressive growth HF typically takes an aggressive Emerging Market approach to investing by buying stocks with high Emerging markets, particularly the BRIC countries, P/E multiples and shorting stocks that are likely to are most lucrative as they have some of the best miss their earnings estimates. They’re usually biased opportunities for investors. These countries have towards investing in companies in the technology and benefited from the global spike in commodities, but biotechnology sectors. there are now potential risks to future returns from threats such as the global fallout from the sub-prime 5(b) Opportunistic [Volatility: Depends] meltdown and the possibility of a US recession. The These types of HF often vary their investment strategies securities markets showed less reaction to threats of a % Share 2005 YTD Annualized Sharpe Investment Strategy Rank (No.) Return Return Ratio Convertible Arbitrage 3.0 % 3.72 6.67 2.63 1 Others 0.4 % 8.54 9.7 1.73 2 Distressed/High Yield 1.3 % 8.72 9.41 1.61 3 Securities Multi-Strategy 68.0 % 7.25 7.81 1.51 4 Commodity Trading Advisor 2.0 % 1.35 9.99 1.43 5 (CTA) Global Macro 1.4 % 4.04 7.45 1.4 6 Event Driven 0.9 % 5.30 7.6 1.39 7 Long/Short Equity Hedge 19.0 % 10.64 6.7 1.11 8 Fixed Income Arbitrage 2.0 % 4.69 5.48 0.98 9 Relative Value 2.0 % 5.91 5.16 0.85 10

65 THE MONEY MANAGER | JUNE 2009 slowdown in the US. In addition to hiring their own researchers, some hedge Research options for Hedge Funds Investing in funds use analysts from outsourcing firms that assign Emerging Markets analysts to do research for specific clients. One of the main issues which still remain for HF managers investing in emerging markets is to penetrate An important factor is that hedge funds need to the perception and find reality which is often difficult understand their own research process very well. Very given the fact that on-the ground and fundamental young funds should spend time to figure out their unbiased research is still an evolving culture and own research process before deciding what they are business here. comfortable outsourcing. Most HF currently use and are in constant need of One major attraction of outsourcing research is less high end unbiased qualitative and quantitative research human resources management, which is a lot if one to identify and evaluate opportunities in the global takes the turnover of junior analysts into consideration. markets. Many of these opportunities are now being Outsourcing is also a cheaper alternative to expending found emerging markets; however, there are few the fund’s research department. quality research options for HF investing in these regions. Hedge Funds account for approximately 70% Indian Scenario of equity-based commissions and demand value for A lot of activity has also been seen in the Indian market their research spend. with respect to HF in the recent past. With money making opportunities becoming rare in US and EU, The big macro trend is that in the past, research was HF the world over has been seen aggressively pumping provided centrally and now today everyone has to do money in India. more and more research on their own. That puts a tremendous strain on the hedge fund community and India-focused HF delivered a yearly return of 53% it makes the screening processes harder. 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

66 THE MONEY MANAGER | JUNE 2009 assets have multiplied 5 fold from $2.8 billion to $ 14 References billion5. 1. Garbaravicius Tomas & Dierick Frank, “HF and their implications for ﬁnancial stability”. India is the largest market for single stock futures in 2. Atiyah, S. and A. Walters (2004), “HF – An the world and has a well-developed derivatives market Overview”, Butterworths Journal of International in index futures and options. This gives the HF the Banking and Financial Law, May, pp. 173-77. hedging possibilities not available in other emerging 3. Standard & Poor’s, “HF for retail investors”. markets. The high degree of liquidity offered by the 4. http://www.atimes.com/atimes/Asian_Economy/ Indian markets is suitable to HF style of investing. EC27Dk01.html 5. Statement of the Financial Economists Roundtable Recommendations on HF, November 3,2005 Target Destination 6. IBM Consulting Services, “Fund Managers: the Among the emerging market (BRIC nations), Russia challenge of HF” would be the hottest HF destination. As Russia has Dries Darius, Aytac Ilhan, John Mulvey, Koray D. Simsek, Ronnie Sircar; “Trend-following HF and substantially lagged the rest of the emerging market Multi-period Asset Allocation”, Dec 2001. world in 2007 based on investor fears about the state of the Russian government would look like after Putin (Footnotes) 1 Excluding double counting of assets in funds of funds is gone. 2 ‘2008 HF Asset Flows & Trends Report’, By Peter H. Laurelli, CFA, Head of HF Industry Research, HedgeFund.net 3 Sharpe Ratio: A measure of the mean return per unit of risk in an Future Scope of Hedge Fund Strategies investment asset or a trading strategy In future, the strategies that are expected to do well 4 http://www.eurekahedge.com/news/06_FOF2006_Key_trends. asp are the Convertible Arbitrage, CTA and Global Macro 5 HF Net- Tracks the HF ﬂows across the world funds. As shown in the graph below, these are low on 6 Centre for International Securities and Derivatives Markets (CISDM) 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 India Globally, 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.

67 THE MONEY MANAGER | JUNE 2009 Additional Figures and Tables Research Budget (Fund) Spending Options 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.

68 THE MONEY MANAGER | JUNE 2009 Advantages in Emerging Markets Disadvantages in Emerging Markets List of hedge Funds in India 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)

69 THE MONEY MANAGER | JUNE 2009 MNC Delisting - Reaping the Benefits in 2009 Swati Aggarwal, Neha Gupta [IIM Bangalore] Abstract just entered a bear phase that was to last till 2003. The The Indian Stock market crash of 2001 was Ketan Parekh Scam had unfolded and bank call rates accompanied by large scale delisting of MNC’s as they were at an all time high. It was during this phase that a took advantage of the abnormally low stock prices to large number of major MNCs that had been listed on buy back shares and pack off from the Indian Bourses. the BSE/NSE decided to take advantage of the free fall At that time the movement was much criticized by in the stock prices to buy-back their shares, converting observers and many blamed the lax SEBI rules for the their Indian subsidiaries into unlisted, wholly owned same. The authors of this paper however believe that private limited companies. in the context of the current financial meltdown the This trend started with small and mid-sized MNCs delisting may have proved to be a blessing in disguise but soon caught on with bigger names too jumping for India leading to greater decoupling of Indian on the bandwagon. In 1999 there were six buyback equity markets from that of the US then would have offers; the next year the number rose to eight, finally otherwise been the case. The reason being that these peaking in the financial year 2001-02 to twenty. Some MNCs are more affected by global downturns since of the major names exiting the Indian bourses were their business interests are spread across the globe, Reckitt Benckiser, Cadbury, Philips, Carrier Aircon, especially the US. To test this hypothesis separate Otis Elevator and Industrial Oxygen. regressions were run between the Indian and the US Reasons for the Exit stock markets and between an MNC stock index of This move was prompted by a number of reasons: still listed shares and the US stock market. The later • Indian regulatory framework: The regulatory displayed a higher correlation lending support to the environment became favourable to such buy hypothesis that without the delistings, in the presence backs. In the early 1970’s, many of these of a greater number of listed MNCs the Indian stock multinationals had been forced by the Indian market would have responded far more to the US stock Government to take their companies public market developments. under the tenets of the Foreign Exchange Introduction Regulation Act. This brought down their stake The year was 2001 and the Indian stock markets had in Indian subsidiaries from complete ownership

70 THE MONEY MANAGER | JUNE 2009 to around 40 percent. However after the launch Concerns expressed of the economic liberalization program in It was at that time believed that such a mass exodus 1991, government regulations governing MNCs of MNCs did not bode very well for the Indian became more lax in an effort to attract more FDI. markets and stockholders. While there were some who Foreign companies were first allowed to increase were optimistic enough to suggest that such a move their stake to 51 and, later, to 74 percent followed suggested that the MNCs were preparing to take the later by removal of all caps in some sectors. The Indian Markets more seriously and hence were adopting requirements on buy-back imposed by SEBI also a more aggressive stance, most were not convinced. became less tedious (For instance, an amendment Even the FICCI had expressed its concerns.1 to the Companies Act, effected in the last quarter The biggest fear that was expressed was the fact of 2001, enabled companies to go ahead with that this meant that now a significant portion their buyback proposals with just board instead of of the economic activity in the country would become shareholder approval.) The MNCs were also aided more opaque. It would have also meant that in the by the Indian Finance Ministry's decision to raise absence of domestic players enjoying similar credibility from 5 to 10 percent, the annual limit on shares to replace them, the Indian capital markets, still young that the major shareholders could buy in their would become shallow. Concerns were also expressed companies without making a formal offer. The for the dying regional exchanges as volumes traded fell abolition of Section 43A of the Companies Act, to minimum. Finally anger was also expressed on the which imposed onerous disclosure requirements behalf of small stockholders who were bought out on large private companies as `deemed public cheap when the markets were low. companies' further served the purpose. A Blessing in Disguise? • The MNCs’ defence: The MNC’s cited a number The authors of this paper believe that the exodus of of reasons for their decision. These included major MNCs in the period 2001-2002 has turned out the fact that given the then existing poor market to be a blessing in disguise in the turbulent times of conditions, they had no alternate means to invest today. These companies, prominent on the US Stock these funds more productively; their share price exchanges and with significant business interests in the did not reflect their true value as also the desire worst affected markets of US and Western Europe, to avoid the spurts of scams and allegations of have suffered heavily in the ongoing crisis. These manipulation that seemed to plague the Indian stocks, if listed today, could have rendered significant markets. volatility to the Indian stock markets exposing them • The critics: Independent observers pointed to a further to the risks from the US markets. Their delisting number of other advantages that these companies has in fact contributed to the decoupling of the Indian would gain by this move. Multiple listings in economy. various countries tend to be cumbersome. Hypothesis: Also fully controlling their Indian subsidiaries The question that first strikes in the above explanation makes proprietary technology transfers easier is – would MNCs listed on the Indian stock exchange for the MNCs. Many dubious motives were really import volatility from the West? It is this forwarded too, like the fact that post-delisting hypothesis that the authors have attempted to test, and conversion of their subsidiaries into local the basis being the MNCs listed on the National Stock branches, these companies would be able to Exchange today. These companies’ stock prices, we escape public scrutiny and accountability. believe, have a higher degree of correlation with the US

71 THE MONEY MANAGER | JUNE 2009 Equity Market than the overall Indian Stock Market. 500 is a broad-based benchmark of the Indian In an attempt to ﬁnd the same, a regression was run capital market, representing about 84.24% of between the MNC stocks and the US Stock Market total market capitalisation and about 78% of Index on one hand and the Indian and the American the total turnover on the NSE as on March 31, stock markets on the other. 2008. Methodology: In both cases the guiding philosophy was the For this purpose, the following indices were chosen: fact that in order to understand the extent of • The NYSE Composite Index was taken as the correlation it is imperative to take a broad measure representative of US stock market activity. This of the stock market, a measure that would help is a stock market index covering all common establish clearly the relationship between the stock listed on the New York Stock Exchange, companies and the market. including American Depositary Receipts, Real • For the MNCs, an MNC index was constructed Estate Investment Trusts, tracking stocks, and by taking a simple average of 10 prominent foreign listings MNCs2 on the National Stock Exchange. The • For the Indian Stock Market, the representative selection criteria for the same include a trading index taken was the S&P CNX 500. The CNX frequency of atleast 90% in the last 6 months Fig 1. Scatter Plot for adjusted NYSE composite v/s S&P CNX 500 Regression Statistics Multiple R 0.913273 R Square 0.834068 Adjusted R-Square 0.833407 Standard Error 355.3616 Observations 253

72 THE MONEY MANAGER | JUNE 2009 Fig 2. Scatter plot for adjusted NYSE composite v/s MNC index Regression Statistics Multiple R 0.949816 R Square 0.90215 Adjusted R Square 0.901761 Standard Error 353.7057 Observations 253 and a market capitalization and turnover rank markets are more closely related with the US stock in the universe of less than 500. market. However owing to their small number in a Data for all the indices was collected for the period pool of 500 CNX they were, fortunately, not able to January 1, 2008 to January 23, 2009, the period of the significantly destabilize the Indian markets. The same financial meltdown. could not have been said, however, had the turn of Results: events not been what it was in the period 2001-02. The following results were derived: Most of the over 40 MNCs which exited then have • There was a significant correlation observed major operations in the West and have seen major between CNX 500 and NYSE Composite turbulences in their stock prices, as has the US Market. Index with a R2 of 0.83407. (See Figure1) The story, as can be seen from the results of the model, • There was a higher correlation between the would not have been very different here. Moreover, MNC index constructed and the NYSE given the fact that some of these companies were a Composite Index. The scatter plot of the two part of the then Sensex30, the extent of volatility can showed a significant positive linear relationship. only be imagined. An economy that has been able to The regression model run on the same gave an decouple (though to what extent is in itself a highly R2 value of .90215 ( See Figure 2.) disputed fact) and shield itself from the tumultuous Inference: movement of the West, would perhaps not have been Thus in line with expectations it was observed that able to do so. the stock prices of the 10 MNCs listed on the Indian Conclusion:

73 THE MONEY MANAGER | JUNE 2009 The paper began with a brief description of the MNC References: exit from the Indian stock market that occurred at the http://finance.yahoo.com beginning of this century along with the fears that http://www.nseindia.com were expressed about the same. The authors then went http://www.capitaline.com on to propose that despite such pessimism that was http://www.atimes.com/ind-pak/DF05Df04.html associated with the move, retrospectively it may have http://www.thehindubusinessline.com/ had in fact contributed to the decoupling of the Indian iw/2002/03/17/stories/2002031700430600.htm stock markets from that of the United States and thus http://www.atimes.com/atimes/South_Asia/ may have insulated us somewhat from the effects of the EF25Df03.html financial meltdown. This was based on the hypothesis http://www.indiadaily.com/editorial/14853.asp that MNCs with business interests in several parts of http://www.icmrindia.org/casestudies/catalogue/ Finance/FINC006.htm the world including the worst affected countries have been affected more by the crisis and hence their stock 1 (Footnotes) prices have taken a greater beating too. To test this According to Amit Mitra FICCI’s secretary general, “FICCI is concerned about recent trends of foreign companies getting hypothesis, the correlation of the stock prices of still delisted and acquiring 100 percent equity.” MNCs delist in India listed MNCs to the US stock market during the current on revelation fears Indrajit Basu Asia Times Online June 25 2003 2 http://www.atimes.com/atimes/South_Asia/EF25Df03.html stock market flip-flop was compared to the correlation The ten companies included in the MNC index include ABB, between the Indian and US stock markets. As was ACC, Britannia, Colgate, CRISIL, Cummins, Gillette, GSK, HUL expected, the correlation in the first case was higher, and Macmillan 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 Quotes making it more volatile in the current times. Perhaps, there is a silver lining in every cloud… “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

74 THE MONEY MANAGER | JUNE 2009 Failure of TARP & Solutions to the Banking Crisis Arjun Ravi Kannan [IIM Bangalore] Executive Summary Introduction The banking crisis in the US shows no signs of abating. The worst ﬁnancial crisis since the great depression has The Treasury Asset Relief Program (TARP), which was wrecked havoc on the global economy and seemingly envisaged, as a means to stabilize the system has not paralyzed policy makers as well. What started out as succeeded in its endeavor to restart lending. By lurching defaults in one segment of the ﬁnancial markets has from one solution to the next, and by bailing out bank since consumed and imperiled the very foundations of after bank, the program has lost its credibility both with the modern capitalist economy. Hence, a solution to the the markets and the public. TARP has created perverse banking crisis is de rigueur for any hopes of a sustained incentives to existing shareholders and managers recovery in the medium term. At the heart of much of without attracting private capital. An alternative bold these attempts have been the US Federal Reserve and solution to the crisis would be nationalization of the the Treasury Department. In addition to several lending banking system. In one stroke we remove uncertainty programs and an alphabetical soup of acronyms that and can go about the task of restructuring the entire act as sources of liquidity, the US Treasury has been sector. Lending can also be restarted and the real using the Troubled Assets Relief Program, commonly economy stabilized from a vicious cycle. The pros and known as TARP, to tide over this crisis. While it may cons of this measure are debated and the arguments be premature to condemn this program as a complete of both sides are presented. Finally, nationalization is failure, it is clear that it is not working towards the recommended as a possible permanent solution to the intended consequence and is becoming increasingly crisis. 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

75 THE MONEY MANAGER | JUNE 2009 risks of a systematic failure are examined. valuations by the banks with the securities. This led to a shift in strategies from outright asset TARP and its various strategies purchases to capital infusions in the form of preferred TARP allows the Treasury Dept. to extend a line of shares to the government. Those firms, which did sell credit of up to $ 700 billion to various institutions in assets to the government, would have to issue equity the form of guarantees, capital infusions, asset swaps warrants (if company is unlisted then senior debt) so and any other mechanism so as to ease the credit and that taxpayers can benefit from the potential upside. liquidity crunch. The original intention of TARP was The problem with this approach as is now being seen to purchase “troubled assets”, including mortgage is that the whole process is opaque. There is no clear backed securities, collateralized debt obligations and benchmark to decide who gets to use the funds. For other illiquid securities, so that banks could rid their example, even the financing arms of the US automakers balance sheet of these uncertain assets. The hope was are getting a share of the funds. Further, there is no that once the markets recovered and these securities incentive to lend, given the leverage of many of these actually had a functioning market, the value of these institutions. As far as they are concerned, this is a way assets could be better realized than dumping them in of padding their balance sheet to protect against future troubled times. While past losses/write downs were losses. A more effective way to ensure this would have not allowed to be funded, any fresh troubled assets or been to take common equity stakes. At the same time, existing assets still in the portfolio of companies could existing shareholders are affected by such a move, and be swapped. The rationale was that once the balance the whole program creates nil to negative incentives sheet of these companies was clean, private capital for private capital to enter. would enter and recapitalize the institutions. This would then encourage banks to restart the lending The current situation and the way forward process to banks, corporations and consumers to once A realistic assessment of the current situation presents more jumpstart a credit-driven economy. a scary picture. The entire banking system in the US (and UK) is technically insolvent. If the total credit However, the problems with the above approach were losses (expected to be around USD 3-4 trillion) apparent. The fact that the banks could not really value are recognized, the number would exceed the total these securities (the percentage of level 3 assets which capitalization of the entire US banking system (closer are essentially “marked to model” is very high) at to USD 2.5 trillion). It is often argued, and rightly so, market prices should have warned authorities that the that in such stages of a downturn, mark to market original proposal was not implementable. There are a insolvency does tend to happen. However, what these few issues here. One, if the government pays too low a arguments miss out is that in this particular crisis, many price for the security the banks would refuse to sell the of these losses are very real, and the current value of assets as it would increase their losses and potentially securities (as present on the banks’ balance sheet) is bankrupt them. Second, if the government pays too likely to present an inflated picture. Take an example high a price, then taxpayers are being taken for a ride of a mortgage like the adjustable rate mortgage (or at the expense of the same people who got us into this even Alt-A loans) that was worth a million dollars. The mess. Finally, there is always a fundamental problem of house is probably worth half that value and the loss of information asymmetry, where the bank clearly knows $ 500000 is very real. It is unlikely to be recovered since more about the asset than the government can ever the structure of the loan, the shape of the housing find out. This would thus be a recipe for inflated asset market which is still above historical averages and the

76 THE MONEY MANAGER | JUNE 2009 type of people who got these loans (liar loans) suggest holders, must be forced to take a haircut, as there is no very little upside even in the long run and will likely rationale for the taxpayer to fund bondholders. Sixth, default. This alone is likely to result in future loses close managers may be incentivized to lend according to to a trillion dollars. Hence the argument that holding long-term profitability. Seventh, the bad assets are now assets for a long time would improve the situation does moved to an RTC like bank where debt is paid down not hold water. and the assets are gradually sold to private investors. Finally, when the books are sufficiently cleaned up and So what is the alternative? It is clear that no amount markets stabilize the banks can once more be available of quantitative easing (QE) or zero interest rate for public ownership. policy (ZERP) from the Federal Reserve over any length of time will help too much. Nor will a fiscal What are the advantages of nationalization? The most stimulus, however bold, be able to act as anything but a obvious advantage is that uncertainty in the markets is temporary bandage. The alternative, which is probably removed once and for all. Rather than lurching from gaining traction, is the concept of a “bad” bank or an one bailout to another, and markets worrying about “aggregator” bank to bundle all the bad securities, as creeping nationalization, a bold solution like this would was done with the Resolution Trust Corporation (RTC) signal a bottom. Another advantage is that banks can back during the savings and loan crisis. However, the begin to lend again. The problem with equity stakes way it is being suggested will not make a difference without control was that managers and shareholders, because of two reasons: the problem of valuation of worried about their future would rather use the money assets, and the fact that government will be a major to pay their salaries and repair their balance sheet, shareholder but without taking control. The answer: resulting in a hobbling bank that does not take risk. nationalization. At the same time moral hazard is vastly reduced when exiting managers are punished for reckless lending Nationalization: Benefits and Problems and hence future excessive risk taking is minimized. Nationalization seems to suggest that we are abandoning The greatest advantage though is that the problem of the principles of markets. However, if done in an valuing assets is no more a necessity. Since both the orderly fashion, we can bring the banking system back “good” bank and “bad” bank are under government to reasonable health and restore confidence. control, the asset valuation does not matter, as it These are the steps that should be followed in merely involves transfer of assets from one part to nationalization. First, a quick review of every major another part of the same owner. This could be done at and mid level bank must be made to determine the historical cost or zero value or any other value as there extent of their exposure to these assets. Second, the is essentially no difference. The “bad” bank collects ones that are otherwise healthy must be saved, while all the cash flows associated with the assets and if no the ones that are irredeemable must be allowed to fail. market develops, then it holds the assets to maturity. Third, the fundamentally healthy but impaired banks The “good” bank can be privatized when conditions (those which don’t need capital can exist as it is) should improve. The cost of nationalization has been shown be placed under a conservatorship (like Freddie and to have a lesser final fiscal cost than this stage wise Fannie). Fourth, their entire equity must be wiped out, bleeding. As an example of its actual implementation, managements fired, and no golden parachutes must be we need not look further than Sweden, which in 1993 given. This takes care of one form of moral hazard. did the same thing. The overall cost to the government Fifth, debt holders, other than senior most debt was minimal. Finally, the reason debt holders have to

77 THE MONEY MANAGER | JUNE 2009 pay a price is because there is no reason for risky debt quo. The costs are too high, and a bold initiative is a investors to be rewarded while stockholders suffer. must. Nationalization and nimble restructuring is the The taxpayer should not subsidize them (senior debt quickest and cleanest end to the mess we are in right holders may need to be accommodated for fear of now. greater contagion while junior debt holders’ rationale for investing itself is that they sought more risk and Conclusion hence were paid a higher rate). The banking crisis has been dragging on for a long time with no apparent end in sight. The TARP, which was The arguments against nationalization exist. The major introduced to ameliorate the problems in the system, reason is the mistrust that government cannot run has not made an appreciable impact. With the real efficient operations and would be prone to political economy in serious danger of significant long-term pressures. Appointing commercially oriented managers damage, bold solutions are required to dig us out of can reduce this problem. Further, it can be argued that this morass. Nationalization is the best among the bad state control may become permanent. Finally, a very alternatives available at the moment. By eliminating credible argument exists to make a distinction between uncertainty, moral hazard, and questions on valuation the Nordic experience in the 1990’s and the US. The of assets, it can go a long way in finding the bottom in US banking system is much larger than the Swedish this crisis. Critics, who fear socialism, should take a leap system and both the costs and time required are higher of faith, and give a chance for a complete overhaul of and chances of a successful withdrawal at a later stage the banking system. With firm regulatory structures in by the government are likely to be lower. The linkages place, a more healthy banking system can be built and in global finance may also cause issues on valuation a quick withdrawal by the government can be achieved. of assets unlike in the 1990’s when most of the assets In summary, to save capitalism, the state must step in in Sweden were regionally owned. However, none of and do the job. these reasons are sufficient to continue with status CROSSWORD SOLUTIONS

78 THE MONEY MANAGER | JUNE 2009 Value Investing Past Trends and Current Opportunities in India Deepak Gupta, Nikhil Maheshwari, Rohit Chawla [MDI, Gurgaon] Executive Summary What is Value Investing Value investing is an investment philosophy given Value investing is an investment paradigm that is based by Benjamin Graham and David Dodd in the 1920s. on the ideas of Benjamin Graham & David Dodd. The ideas of this theory developed with Graham and Dodd’s Value investing focuses on investing in stocks, which teachings at Columbia Business School, USA, in late 1920’s. are under-valued i.e., are trading below their intrinsic Graham presented the ideas in his books; Security Analysis values. It aims to capitalize on the inefficiencies in the and The Intelligent Investor. The theory is based on the market, in terms of the disparity between the value philosophy of investing in securities, which trade at a deep and price of a stock. A bearish market is usually an discount to their intrinsic value. Warren Buffet is the most excellent opportunity to invest in value stocks. This is famous follower of the principles of value investing in the so because in a bearish scenario, like the current, the modern world. The core principles of value investing are investors are extremely pessimistic about the entire the following: stock market. This results in some stocks being heavily • A stock, or any other security for that matter, under-valued. This article analyses the performance of has an intrinsic value, and this underlying value such value-based picks compared to the average market does not depend upon the market price. performance, in the previous bull phase. For this • The market, at times, assigns prices to certain purpose, five value based stock portfolios were formed stocks which may be unjustifiably low or high. based upon different value themes at prices prevailing • An intelligent investor buys when the market at the end of the dot-com bust. The performance price is unjustifiably low and sells when it is of these portfolios was compared with that of the unjustifiably high. This is best captured by Nifty and was found to be superior to that of the Buffet’s philosophy of being “Greedy when market, in general. Thus, value investing was shown others are fearful and fearful when others are to be an investing approach providing super-normal greedy”. returns. Lastly, value stocks in the current market were • Investors should be prepared for long-term identified. These are expected to give super-normal investments in a stock. Value investing is results in the future. not concerned with and cannot predict the short-term movements of the market or of

79 THE MONEY MANAGER | JUNE 2009 a stock. However, a stock which is genuinely widespread pessimism among investors. Obviously, underpriced will yield significant results in the the intrinsic value of the company does not swing with long run. the mood of the investors. A large number of stocks Value investing as an investment method, is focused consequently end up taking a huge beating without any on the curtailment of risk in investments. Value rational reason and hence trading at huge discounts to investors focus on how not to lose money, rather than their intrinsic value. Thus, every bearish phase brings how to make huge amounts of money. In this respect, about some excellent opportunities for the value Benjamin Graham talked about introducing a ‘Margin investor to capitalize upon. In the later part of this of Safety’ in the analysis to minimize the downside article, we will evaluate the performance of some such risk. This just means that you buy at a big enough discount opportunities provided at the end of the dot-com bust, to allow some room for error in your estimation of value. over the subsequent boom in the Indian stock markets. However, this does not imply that value investments are We will also evaluate and present some stocks, which low-risk, low-return ventures. In fact, value investors are good value buys in the current bear market and believe that low risk investments actually result in high should yield excellent returns in the long run. returns. This is well demonstrated by the success of Value Investment Themes value investors like Warren Buffet. In this article, we The major challenge in value investing is to determine will test this statement by evaluating the performance the intrinsic value of the company and hence of its of some value stocks in the Indian market during the shares, relative to the prevalent market price. Value previous stock-market boom. investing works on various ratios and themes to Value Investing in Current Scenario determine if a stock is under-valued. Some of these The current slowdown has brought about an ratios are the price-to-earnings ratio (P/E), price- interesting scenario for stock markets around the to-book value (P/B) etc. We have demonstrated the world. The stock market is under a strong hold of the principles of value investing with the use of the bears and investors are wary of putting their money following themes: into stocks. The financial sector crisis in the US has Cash Bargains: A cash bargain arises when the seen stocks around the world tumble to levels, which market value of a company goes below the were unthinkable less than a couple of years ago. Most amount of cash and other liquid assets in its people would thus argue that the best strategy to play possession, net of all current liabilities and the stock market right now is to stay away from it. debt. In effect, the market is not giving any Value investors, however, differ from this view. The valuation to the fixed assets, to the inventories, value investing philosophy suggests that the current and to the receivables. condition provides an excellent opportunity to pick up shares at very cheap prices. Talking in Graham’s Debt capacity bargains: The value of a debt free language, this could be one of the times when the company has to be substantially more than the market is unjustifiably pessimistic on a large number amount of debt it can comfortably service. of stocks. This however, does not imply that we should Thus, a company is highly under-valued if its start picking up each and every stock just because it is market capitalisation is less than its debt-raising trading at way below its bull-run highs. What this does capacity. It’s a principle which was first laid out suggest is that in every bear run, although there are by Ben Graham in Security Analysis. stocks which fall due to genuine falls in their values, there are many which decline simply because of the Price-to-earnings ratio (P/E ratio): This is the ratio of the company’s market capitalisation

80 THE MONEY MANAGER | JUNE 2009 and the net profit. According to Benjamin 2003 (beginning of the Bull Run) and March Graham’s principles, the earnings yield of a 2008. value pick should be very high, or equivalently, • Various Price ratios and price data for the its P/E ratio should be very low. Graham said similar periods was also obtained. that a stock with an earnings yield of twice the • Stocks worth purchasing in 2003 were identified yield on AAA bonds is a safe value bet. using various value investing criteria. These criteria are: • Price-to-book value ratio (P/B ratio): The • Cash Bargain: Stocks were identified P/B ratio is a ratio of the market capitalisation as value stocks, based upon the cash bargain of a company and its book value. Theoretically, theme if their cash + market value of their a P/B of less than 1 shows that the market has investments was more than their market valued a company below the book value of its capitalization and outsider’s liabilities. All assets, adjusted for all liabilities. However, in the stocks that satisfied the criteria were accordance with the margin of safety concept, selected. value investment requires the P/B ratio to be • Debt Capacity Bargain: The debt- much lower. raising capacity is estimated using the PBIT figure in the company’s last annual result. We have estimated that a company can comfortably • Dividend yield: The dividend yield is a ratio of raise loans which would keep its interest cover the dividend paid by a company to its market ratio above 5. This has been used to estimate capitalisation. To an investor, it signifies the the amount any company can safely pay as annualised return (in terms of dividend) he can an annual interest expense. The interest rate achieve by investing at the current market price, has been taken to be at 14 per cent for the assuming that the dividend remains constant calculation of the debt raised which will result over the years. A high dividend yield shows in the interest expense calculated above. Both that a stock is under-valued. Graham has used these assumptions are pretty conservative this parameter extensively in The Intelligent according to the actual conditions faced by Investor. Indian companies to raise debt from the market and thus allow for a margin of safety. Performance Evaluation of Value Investing Approach • P/E ratio: We have considered a stock In this section, we have made an attempt to evaluate the with P/E ratio of below 2 to be a value performance of the value investing approach over the stock. This translates to an earnings yield previous bull phase in the stock markets and compare of 50%, which is much higher than that it with the market’s performance in general. Using this available on bonds. comparison, we aim to test if the results yielded by • P/B ratio: All stocks with P/B of less the value investing approach are truly superior to other than 0.3 were selected. approaches. This evaluation consisted of the following • Dividend Yield: All stocks with steps: dividend yield of 9% or more were • Audited financial results of the companies selected. comprising S&P 500 was obtained from CMIE • Based on each of the above value investment database Prowess for the year ending March

81 THE MONEY MANAGER | JUNE 2009 themes, we have come up with portfolios of investing portfolios. Walchandnagar Industries, which stocks that were highly undervalued in March was a part of 2 portfolios shot up from Rs. 2.73 to Rs. 2003. We have evaluated the returns obtained 863.20 over the same period. The returns obtained by on each of these portfolios and compared it the different portfolios and the returns of the Nifty with the average performance of the market or are tabulated below. the index itself. All stocks in a portfolio were given equal weights. As can be seen from Table 1, supernormal returns can • The return was calculated for each of these be obtained by following the value investing approach. portfolios for the period starting from 31st Nifty provided an annualized yield of 39.25%, from March 2003 to 1st of January 2008. Mar 2003 to Jan 2008, which is less than half of the • For the same period, the return of the Nifty minimum return provided by any of the portfolios was calculated and was compared with the (Debt capacity portfolio provided 86.95%). Therefore, portfolios’ return. it is observed that the returns obtained upon value Results and Conclusion investment are much higher than those offered by the The value stocks thus identiﬁed were observed to market in general. generate returns which were much superior to those Since we have established that the value investing generated by the stock markets in general. Some of themes discussed in this article can help generate these stocks produced absolutely staggering results. superior returns, we have identiﬁed some value stocks For example, Videocon Industries that traded at a based on these themes in the current market. We thus P/E of 0.14 and P/B of 0.01 in March 2003 moved present below stocks that are expected to produce from Rs. 12.80 in March 2003 to Rs. 811.50 (as on 1st excellent returns in the future, based on each of the Jan 2008). This stock was a part of 3 of the 5 value value themes. Dividend P/E P/B Cash Debt Index Return Yield Portfolio Portfolio Bargain Capacity (Nifty) Average Return (in %) 4976.55 10713.82 19932.96 14600.87 2283.65 523.65 Average Return 49.77 107.14 199.33 146.01 22.84 5.24 Annualized Return 2.18 2.55 2.88 2.71 1.87 1.39 Annualized Return 118.47 154.68 188.35 170.94 86.95 39.25 (in%) Table 1 : Comparative returns of the portfolios and the Nifty

82 THE MONEY MANAGER | JUNE 2009 Table 2 : Value stocks at current valuations based on different themes 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

THE MONEY MANAGER | JUNE 2009 pRIMER cover story cover page What do we know about the market microstructure of the Indian Stock Markets? An Article by Prof. Malay K. Dey Associate Professor of Finance, William Patterson University, New Jersey 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.

84 THE MONEY MANAGER | JUNE 2009 Not much! A keyword search on ssrn.com on “India report that for 1998-99, while BSE and NSE account and stock markets” returned 179 papers, albeit mostly for 71 percent, the top five- NSE, BSE, Calcutta, Delhi, unpublished working papers. Almost all of those and Ahmedbad account for more than 95 percent of academic/semi-academic papers posted on ssrn.com turnover for the entire Indian stock market. While related to the Indian stock markets investigate market there is an ongoing debate on the role and continued efficiency and corporate governance issues. When I survival of regional exchanges, since 2000 there has searched on ssrn.com for research papers on Indian been a consolidation initiative that has resulted in a stock market with a qualifier like “microstructure” memorandum of understanding for the sharing of a or “intra day” the search returns between three trading platform and the demutualization of regional and six papers, a few of those papers being simply exchanges.2 Currently the number of stocks listed opinion pieces or commentaries. A similar search in various stock exchanges in India adds up to more on ABI-Inform, Econlit, and JSTOR all of which than 10,000 although many stocks are cross-listed in index published papers only returned 2/3 entries. multiple stock exchanges. These 10,000 stocks are These searches confirm that in fact, we know very spread over more than 100 sectors including banking, little or nothing about the market microstructure retail, consumer durables, electronics, business services, – the organization and regulatory structure, the inner software, and consulting. workings of the markets, how those markets perform, and the governance of those markets. NSE, the leading Second, two of the above exchanges, NSE and BSE stock exchange in India in terms of trading volume have composite indexes, which track the performance supports a project based funding scheme for research of the respective market. BSE is a free-float market on Indian stock market and compiles a working paper capitalization (since 2004) index that started in 1989 series based on the completed research projects funded and was initially composed of 100 stocks from the five under that scheme (www.nseindia.com). However, major stock exchanges, Ahmedabad, Bombay, Calcutta, I have not seen many academic papers citing those Delhi, and Madras. Since 1996, BSE-100 consists of sources. only BSE listed stocks. NSE introduced a market value weighted NSE 100 index with a base date of Jan Before I go any further, let me first compile some 1, 2003 and base value of INR 1000. stylized facts about the Indian Stock markets. Third, I cannot find any published paper using intra First, India has a long history of organized stock day price and/or trading volume data from the Indian exchanges since its first exchange opened in the western stock markets. Hence I conclude that no convincing city of Bombay, now renamed Mumbai, in 1857. research exists on the traders’ behavior and market Since then and mostly since Indian independence in microstructure effects on price formation in the 1947, multiple stock exchanges opened and operated Indian stock markets. Similarly although there is a throughout India.1 At the beginning of the financial street perception of some liquid and illiquid stocks, market reform in early 1990s there were more than 20 no empirical evidence exists on either liquidity or cost regional stock exchanges in India although there was a of liquidity of stocks traded on the exchanges. While huge concentration of trading activities in only a few eyeball statistics may confirm some very liquid and of those. Indeed at the beginning of 1990s, the top five illiquid stocks, often such simple statistics like trading exchanges in terms of trading volume, Ahmedabad, frequency and volume turn out to be misleading. Bombay, Calcutta, Delhi, and Madras account for more than 75 percent of trading volume for the entire Indian The statistical properties of intra day returns, bid stock market. The financial market reform in India ask spread, trading volume, and liquidity might be that started in early 1990s prompted major structural different in one exchange from another. While ex ante changes in the exchanges including the opening of there may be some obvious differences among the NSE, the wholly electronic market place for securities, exchanges in terms of their organization and structure, and the consolidation of several exchanges. Since the price formation processes may be also different the introduction of NSE, the first fully automated due to locations and heterogeneity among traders trading system in India almost all trading activities are and listed stocks in each exchange. Further, based on concentrated at NSE with BSE being a distant second the evidence provided by Aggarwal (2002) that stock in terms of trading volume. Bhole and Pattanaik (2002) exchange ownership and governance structure has an

85 THE MONEY MANAGER | JUNE 2009 impact on the liquidity of stock exchanges, it might be Bibliography worthwhile to investigate how much of the success of NSE is due to its joint stock corporation rather than Aggarwal, Reena, 2002, Demutualization and regulation brokers’ association (mutual corporation) status. of stock exchanges, Journal of Applied Corporate Finance, 15. One of the primary reasons why empirical research on Alexander Gordon and Mark Peterson, 1999, Short Indian stock markets is severely lacking has to do with selling on the NYSE and the effect of uptick rules, the availability and access to data. NSE and BSE, the Journal of Financial Intermediation, January-April. leading exchanges can facilitate empirical research by Bhole, L. M. and Shreeya Pattanaik, 2002, The state providing easy access to transaction level data similar to of Indian stock market under liberalization, Finance TAQ (NYSE) to finance researchers across the globe. India, 16, 159-80. NYSE’s TAQ data has been instrumental in fueling Christie, William, and Paul Schultz, 1994, Why do the interest in empirical microstructure research with NASDAQ market makers avoid odd-eighth quotes? respect to US stock markets. There is another more Journal of Finance, 49, 1813-40. fundamental reason for the lack of empirical research Lee, Charles, Mark Ready, and Paul Seguin, 1994, in microstructure of securities markets – it’s the lack Volume, volatility and NYSE trading halts, Journal of of appreciation of the role of economic analysis and Finance, 49, 183-214 3 empirical evidence on securities market regulation. In USA there is a realization that both regulation and its (Endnotes) enforcement are costly, and regulation without proper 1 For a compact history of the Indian stock exchanges enforcement is vacuous, and thus there is a great urge and some of the institutional features of the Indian to weigh the costs and benefits of regulation. For stock market, please refer to Bhole and Pattanaik example, after the stock market crash in 1987, NYSE (2002). instituted trading halt and suspension rules. Several 2 Please refer to the following financial press coverage. studies have now reported on the relative effectiveness 1) SMEs would benefit from revitalized regional of the trading suspension rules on market performance bourses by V. Balasubramanian, The Economic Times, and crashes (Lee et al, 1994). Similarly, in the aftermath September 30, 2008. 2) Indian Stock Exchanges – stage of SEC downtick rules, researchers have studied and set for a dramatic change by Dr. Uday Lal Pati posted documented the effect of uptick rules on short interest on investorideas.com on Februray 28, 2007. and volatility in the market (Alexander and Peterson, 3 I am grateful for the research assistance provided by 1999) and decimalization came into force after Christie XueFan Cai, an MBA student at the Cotsakos School and Schultz (1994) provided evidence of collusion of Business, William Paterson University in New Jersey among NASDAQ market makers avoiding odd-eighth while I was preparing the manuscript 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.

86 THE MONEY MANAGER | JUNE 2009 Know Your Product - Barrier options By Gaurav Lal, IIM Calcutta Barrier options are path-dependent options build on Knock in option vanilla call and vanilla put options with a condition These are just the reverse of Knock out options in that they are initiated or exterminated depending on the sense that they get activated only if a predefined the underlying asset hitting a certain barrier. These barrier is reached at least once during the course of barriers can be in any shape or size and there can be their time. multiple barriers. Barrier options may have a built-in rebate that is paid as compensation when the barrier is Example: not reached. Some basic variants of barrier options are A Barrier call with initial value S(0) = 100, Strike K = discussed below. 110, a Knock in level of B = 130 and a running time of T = 2 years has following disbursement profile: Payoff functions of a barrier option  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- Knock Out option call, like the example above and its counterpart would These are call or put options which purge if a certain be a Down-and-in-call which kicks in, if the Barrier, predefined barrier above or below the initial price is which is lower than the initial price, is breached. reached. Digital Barrier option Example: A Barrier call with initial value S(0) = 100, Strike K = 90, a running time of T = 2 years and A digital option is an option that pays out a fixed Knock out level B = 120 has following disbursement amount if the option at maturity is in-the-money profile: (ITM). Build upon a digital option, a digital barrier option is one that includes a barrier which, if reached  If the conclusion price S(2) is below the Strike K during the life, affects the existence of the option. The nothing is disbursed barriers may be placed either above the strike or below,  If the S(t) hits the Knock out level B = 120 meaning that prior to expiry, an active digital can be sometime during the course of T, nothing is knocked out or an inactive digital can be knocked in. disbursed independent of the conclusion price Because the use of barriers decreases the probability  If the conclusion price S(2) (lets say S(2) = 115) that the digital will pay off, the gearing factor will be lies over the Strike K = 90 but never reached higher than a regular digital. 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.

IIM Calcutta Financial Research and Trading Lab “ 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 Features Live 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

BETA, The Finance Club of IIM Ahmedabad BETA 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 Bangalore With the growing importance of finance and the plethora of 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 Calcutta Finance & 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. AN IIMA, IIMB, IIMC Initiative | June 2009 THE MONEY MANAGER

Money Manager

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