AN IIMA, IIMB, IIMC Initiative | June 2009
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
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.
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.
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
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.
06 An Interview with Prof. Partha
11 An Interview with K.V. Kamath
15 Central Counterparty (CCP) - Role of
Clearing Corporation of India Limited
19 An Interview with Prof.
25 Extracting Alpha Using Behavioural
30 New Monetary Policy Tools -
Innovative Response to the Meltdown
36 CDS and CDS Pricing
40 Climate Change Induced Financial
Risks - A Strategic Approach
50 Credit Default Swap Pricing: Empirical
Results & Inferences
55 Effectiveness of Basel II in the current
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
78 Value Investing: Past Trends and
Current Opportunities in India
What do we know about the market
83 microstructure of the Indian Stock
Markets? - Malay K. Dey
KNOW YOUR PRODUCT
86 Barrier Options
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
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
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
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
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
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
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
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
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
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.
An Interview with
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
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
Extracting Alpha Using Behavioural Finance
Akhil Dokania, Nitin Agrawal, Prabhudutta Kar
New Monetary Policy Tools -
Innovative Policy Response to Financial Meltdown
Ajay Jain, Atishay Jain, Sourav Dutta
25 THE MONEY MANAGER | JUNE 2009
Extracting alpha using Behavioral Finance
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
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
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
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)
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:
Size No of companies Average of Return
Large 204 6.4%
Mid 134 6.2%
Small 23 13.4%
B/M Buckets No of companies Average of Return
<0.25 80 8.9%
0.25-.5 105 7.4%
0.5-0.75 77 5.6%
0.75-1.0 37 7.1%
>1.0 62 4.0%
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
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
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