arthaarth issue iii

INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR FINOMINA

Editorial Team: Anusha Ganne, Aditya Raghunath, Arun Kumar

Design Team: Ankur Agarwal, Deewakar Gupta, Madhavi Patil, Rajesh Kumar, Shubha Bansal

Cover Design: Prateek Shukla

Publishing & Distribution: Anusha Ganne, Ashvini Kumar, Prateek Shukla, Shubha Bansal

Coordinator: Anusha Ganne

Contents

Let's Beat The Market - *Conditions Apply Page 1 Corporate Bond Market in India

Page 4 Insurance Industry: The driver of economic development in India Page 6

The Dangerous Derivatives- Demystified Page 10

Risk management in crisis Page 13 Rupee vs Dollar: 1/x or log(x) Page 16

Money Ratnam Page 19 The Leadership Summit

“Need to Redesign”

Visit us at finomina.iimu.ac.in

ARTHAARTH ISSUE I I I CONTENTS

From the Editor’s Desk,

F inomina is proud to present yet another brand new issue of Arthaarth. Finomina, the Finance Club of IIM Udaipur, strives towards nurturing interest and creating aware-

ness among students regarding the different domains of the financial services industry and finance profiles in other industries. Arthaarth goes a long way in helping Finomina achieve these objectives.

The current issue of Arthaarth is quite unique and very different from the previous issues. There are articles focusing on issues ranging from the insurance sector in India to the financial markets around the world. Apart from having the privilege of being launched at the prestigious flagship event of IIM Udaipur, The Leadership Summit 2013, the issue has an impressive assortment of articles which explore the depths of finance.

The theme of the issue is “Redesign”. Whether it is in redesigning the market benchmarks or redesigning the risk management process of an organization or the regulations of insurance sector, it is time for India to em-brace redesigning for the next big leap it is meant to take. The cover story of this issue, “Let's Beat the Market - *Conditions Apply” is an academician’s galore. It is an article in which an investor takes on the audacious task of beating the Bombay Stock Exchange Sensex and comes out with flying colors, I dare say. “Corporate Bond Market in India” looks at the issues being faced by this market in India and compares it with the markets in the USA. The article on “Insurance Industry” compares the performance of this sector with that in the US and UK. It discusses the impact of FDI in this sector and peeks into the investment function of this industry. “The Dangerous Derivatives – Demystified” takes a new look at the different types of derivatives and analyzes their role in the 2008 credit crisis. Speaking of the financial crisis, we have another article “Risk Management in Crisis” which talks about the various steps an organization needs to take to cushion the fall in times of crisis and also how to prevent such a fall in the first place. But it looks like crisis has already engulfed India due to the huge rupee depreciation. “Rupee vs Dollar: 1/x or log(x)” analyzes the three pronged strategy adopted by RBI to arrest this decline of Rupee.

And then we have Arthaarth’s most lovable character, Money Ratnam, once again coming out of hibernation to demystify finance in his own unique way. This time he talks about his most recently acquired wisdom about Penny Stocks.

Last but not the least we dedicate an article to The Leadership Summit 2013, the theme for which is the “The Need to Redesign”. It talks about the importance of “Redesign” in today’s evolving world and honors the distin-guished panel members who would be gracing us with their presence during the event.

We wish your reading would be as pleasurable as it has been for us authoring the articles. Yours Sincerely,

Anusha Ganne

ARTHAARTH ISSUE I I I EDITORIAL

FINOMINA INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR

Let’s Beat The Market- *Conditions apply data set? 3000 stocks with information on ticker, industry, beta, market cap, last price, P/E, annual returns for the last nine years (from 2004 to 2013), etc. To start building the portfolio, I cannot work with 3000 stocks. Thus, the first filter I choose is mar-ket cap. I pick the top 50 stocks according to mar-ket cap. The new set of stocks is now workable. To make some sense out of it, I calculate the annual returns for each year from 2004-05 to 2012-13. To build FINTOP I need two key things for each stock– what is my expected rate of return for each stock, what is the measure of risk associated with each stock. In the end, every investment can be treated as a risk-return problem. I take standard deviation of the annual returns as the measure of volatility – the risk. The return volatility of a stock captures a whole lot of other risks that is reflected in the returns. And thus I calculate the standard deviation of all the 50 stocks. With that knowledge, I need to the find an optimal allocation of weights to the stocks to build the portfolio. What I need now is a non-linear pro-gramming model to vary the weights of the stocks in the portfolio and maximize the Sharpe Ratio - the ratio of portfolio return in the excess of the risk free rate (assumed to be 8%) and the standard deviation of the portfolio. Maximizing Sharpe Ra-tio ensures that my decision of picking stocks takes not just returns but risk adjusted returns in-to account. But I don’t want to put all my money into a bunch of stocks from the same sector. To avoid that risk, I ensure that I put an upper limit (20%) on the weight any single stock can have in

P roblem with money is that you just cannot see it sit idle. You need to invest it somewhere –

your savings bank account, insurance, stock mar-kets, etc. - depending on your risk appetite. If I have to invest my time and real money towards investments why not aim for something fancy. Academicians say one cannot really earn excess returns in the long run. But I am not convinced just by reading it. I need to test it to see it for my-self. But I don’t have enough money to invest, and wait for a year or two to see what returns I earn. So I take the shelter of an analytical mind, some conceptual understanding of how markets work and, put simply, start crunching numbers. The rest of the story is about my quest for the holy grail of investing: “Let’s beat the market!” I go to Bloomberg lab and pull out data of the top 3000 stocks listed on Bombay stock Exchange (BSE) for the last 9 years. I put all that into a neat excel sheet and voila, my battle ground is ready. Before I build the portfolio, I have a name for it already – FINTOP – “The Optimal Portfolio of Fi-nomina” The problem at hand is- how do I read the huge

Image:tudogs.com


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ARTHAARTH ISSUE I I I COVER STORY


the portfolio. This exercise leaves me with an expected rate of return of the portfolio that just does not seem right – simply because it’s too much. I check everything again and again, the calculation is alright. Then my attention goes to data for 2008-09 and 2009-2010. The return for a lot of stocks is just too much. I realize that the recovery from impact of the financial crisis of 2008 may have caused high re-turns for a lot of stocks. Assuming that we are not seeing another financial crisis in the next one year, I intend to remove the effect of such an event. To do that, I remove the returns of year 2008 to year 2010 from all my calculations. I run the whole exercise again, only now, without the data for 2008-10. What I am left with is a set of six stocks from five industries (Fig. 1) that, today, has an expected rate of return of 24.42% and standard deviation of 33.28%. (Fig.2) But how do I prove that in the next one year, FIN-TOP will earn more than what the SENSEX will earn? I turn back to a simulation (Monte Carlo). The ob-

jective is to simulate the returns of FINTOP for the next one year and see if the returns can be more than that of the SENSEX. So I start simulating the cumulative return for the next 252 days (number of trading days in a year) for both – FINTOP and the SENSEX. I make use of the theory that daily stock returns follow a normal distribution. A random number between 0 and 1 for the probability of daily return, the daily ex-pected return (expected annual return divided by 252) and the daily standard deviation (annual standard deviation divided by square root of 252) are three things I need to estimate the daily return of the portfolio. I do this for the next 252 days to arrive at the annual return available on the 252nd day. I then simulate this return for 1000 trial paths. Average of these 1000 trials is the return that FINTOP can earn in the next one year.


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The same exercise is done for the SENSEX (along with the simulation). As it turns out after simu-lation, in the next one year, FINTOP can earn an annual return of 27.64% and SENSEX can earn an annual return of 26.05% (Fig. 3). In other words, I can beat the market! But, what are the caveats here? It’s not the first time that someone has claimed to do such a thing. Fund managers in the past have done it occasionally, if not on a sustained basis. Are my claims too tall to stand the test of time? Am I reveling at the idea of beating the market and missing something important? The answer is both yes and no. Yes, because I have not seen the future. No because it may so just happen. The reasoning that has gone into building the portfolio is not flawed. But there are assumptions that one must not ignore.

Firstly, my expectations of the future return of the stocks are been derived from their historical data. Secondly, my assumption is that the fundamentals of a company are al-ready embedded in its price and returns, and that the same will be the case in the fu-ture. Thirdly, I have assumed that the daily returns of the portfolio will follow a normal distribution. And fourthly, but not limited to, that the simulation results of the returns for FINTOP and the SENSEX brings the same level of error, if any, to both the portfolios. The results are fascinating, not because I potentially stand to gain more than what the market may earn, but because the whole exercise teaches me a thing or two about investing. Last few weeks well spent! Vivek Pandey, PGP 2, IIM Udaipur



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“I've come loaded with statistics, for I've noticed that a man can't prove any-

thing without statistics. No man can.” - Mark Twain

Corporate Bond Market in India there is a strong case for the bond market in India to grow.

The secondary market for bonds is not well devel-oped in India. As can be seen from the graph below, the fraction of corporate bonds trading in the mar-ket was mere one-sixth of the gilts traded in 2011-2012. Although the figure has increased to almost triple, within a span of four years, there is still a long way to go. An inactive secondary market reduces the attractiveness of any marketable instrument as it leads to rather large bid-ask spreads and hence

T he importance of a well-developed corporate bond market for any country’s financial system

has been well researched and stated in a number of publications. Though corporate bond markets are the chief source of funds in many developed coun-tries, the trend is yet to catch on in India. India’s to-tal government securities outstanding as of July 8, 2013 is Rs. 32,27,961.20 crore and total corporate debt outstanding as of quarter ended June 2013 is Rs.13,56,481.44 crore. This figure is nearly 20% of BSE market capitalization and 25% of the current bank credit. Other than this comparison, one more parameter is the ratio of corporate debt to country’s GDP. For India, this figure is as low as 2-3%, where-as for USA, the figure is as high as 59%. These fig-ures tell us the inadequacy of the corporate bond markets in India. Since the common debt equity ratio is 2:1, the size of the bond market should corre-spondingly be twice that of the equity market. Rely-ing solely on banks loans for the purpose of debt is-n’t the best option, as in case of crisis similar to what happened in 2008, the whole banking system might fail and thus lead to the collapse of the entire econo-my. This calls for a need to develop the corporate bond market. Comparing the borrowings of the asset wise largest 19 publicly listed companies of India (as shown in the table below), we see that borrowings from banks are more than double that of the amount borrowed from bonds and debentures. It is even lower than borrowings in foreign currency. The cost of raising money through bonds is much cheaper than money raised from banks, and when borrowings are done in foreign currency, there is a huge risk of currency devaluation as has happened in India recently. So

Source of

Borrowing

Average (% of total borrowings

as of March 2012)

Highest (% of total borrowings)

Lowest (% of total borrowings)

Bank Borrowings 38.27 95 (Adani) 1.78(BPCL)

Foreign Currency Borrowings

29.66 88.4 (BPCL) 0 (5 companies)

Bonds and Deben-tures

17.51 62.6(Power Grid Corporation of

India Ltd.) 0 (4 companies)

Others 14.56 43 (Tata Motors) 0.02 (NTPC)

Source: Table compiled from CMIE database


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ARTHAARTH ISSUE I I I

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BOND MARKET

price discovery is inefficient. Once a good secondary market is developed by ensuring transparency in trades as in the current equity markets, it will become easier for the corporates to raise money through this route. In a survey conducted by Barclays close to 83% of foreign investors said that registration and regula-tions in the Indian bond sector are the biggest obsta-cles in investing. India also places quantitative limits on the investments by foreign players and the ab-sence of an insolvency code is another parameter which acts as a dampener.

A look at the graph above will show that Indian cor-porates prefer the private route of placement for raising funds as the cost is lower compared to the public issue route. In a private placement, the issue is limited to a maximum of 49 persons but in the Indi-an scenario, this route is not suggested as investor information is low. Private placement also does not allow for trading in the secondary market which is a must for efficient price discovery and imposing dis-cipline on the issuer. Although publicly issued bonds clocked a growth rate of above 270% in each of the years 2010-11 and 2011-12, they experienced a sudden slump in 2012-13 due to decrease in de-mand for loans and lower coupon rates being offered on bonds as compared to previous years. Also, the

NBFCs issued lesser number of bonds due to the eco-nomic slowdown. On the contrary, private place-ments of bonds have continued steadily at 19% and 38% over the last two years. Developments are taking place in India with respect to the bond market. Before 2005, the bonds were traded in India through over the counter deals only. In 2005, government bonds started trading on Nego-tiated Dealing System Order Matching (NDS-OM). It works like an exchange and thus provides the ease of use to the bond holders. NSE has recently opened a separate platform for bond trading in May 2013, which will provide direct access to investors for trading. Also, the percentage of bonds issued through public issues has increased to 7.3% in 2011-12, from a meager 0.86% in 2008-09. Looking at the four modes of resource mobilization- IPO, FPO, bonds, rights issues; the percentage of bonds have increased to 73.5% in 2011-12, from 9.2% in 2008-09. On the other hand, the foreign investors are pulling their money out of Indian bonds as a result of de-creasing yields on Indian bonds and increasing yields on US bonds. FIIs sold Rs.11,300 crores worth Indian bonds over a period of 10 days in May 2013. This is the highest sell off witnessed ever since the FIIs were allowed to invest in fixed income securities in 1988. It was in May, 2013 itself when the yields on US treasuries increased by 56 basis point (35% increase from 1.6% to 2.15%). Also the yield on 10 year Indi-an government bonds has reduced from 8.3% in June 2012 to 7.15% in June 2013. With the cost of hedg-ing forex risk being 6.5%, it doesn’t make sense for FIIs to invest in India anymore. Rahul Agrawal & Ratika Mittal, PGP 2, IIM Udaipur


ARTHAARTH ISSUE I I I BOND MARKET

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Insurance Industry

The driver of economic development in INDIA

The Evolution The first insurance company in India was the Orien-tal Life Insurance Company which was setup in 1818 in Calcutta. Due to nationalization of life in-surance sector in 1956, LIC enjoyed monopoly till the time industry was re-opened for private players in late 90s.General insurance (non-life insurance) finds its roots in the industrial revolution in west. The first General insurance company in India is the Triton Insurance Company Ltd which was estab-lished by the British in 1850 in Calcutta. It was na-tionalized later in 1973. During this time, 107 in-surers grouped together to form four companies, namely National Insurance Company Ltd. at Kolkata, the New India Assurance Company Ltd. at Mumbai, the Oriental Insurance Company Ltd at New Delhi and the United India Insurance Company Ltd at Chennai.

An autonomous body, IRDA (Insurance Regulatory and Development Authority) was formed in 1999 to regulate the insurance sector. Its main aim was to increase customer satisfaction and lower the premi-ums paid by them by promoting competition in the industry and also to ensure the financial security of the industry.

IRDA opened up the market for private players in August 2000 simultaneously allowing foreign in-vestment of up to 26%. In 2013, there are 27 general insurance companies in India and 24 life insurance companies.

T he insurance sector in India has been growing rapidly, this is reflected in the increasing per-

centage share of its assets to India’s GDP. Yet the scenario in India has a long way to go before standing up to the global market.

The insurance sector plays a major role in the eco-nomic and human development of a country. It provides the necessary funds for building the in-frastructure of the country and also significant contributions from insurance and pension funds are going towards funding private equities.


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INSURANCE



more number of lives than the prescribed 20 lakh lives in the social sector.

The reason for the slow growth of the insurance sector in India stems from its inability to expand in the rural and semi-urban areas. The inability of the people to understand and comprehend the role and importance of insurance coupled with the extensive used of jargon and legal nature of the documents makes it very difficult to know the benefits of an insurance policy. Insurance inclusion can be in-creased by raising awareness about the need and utility of various insurance products. The companies need to focus on innovation not only in terms of de-veloping products with simpler choices but also in the delivery methods being employed. A very bene-ficial product would be the no-frills insurance in both life and general categories. The insurance com-panies are already on the verge of launching a no-frills health insurance policy which would be at a much lower premium.

Bancassurance is an efficient route of insurance dis-bursal which needs to be utilized to its full potential as more and more banks are going to be setup in the rural areas in the near future. There is also a pro-posal put to IRDA to allow banks to act as insurance brokers and allow cross-selling of micro-insurance

FDI in Insurance The limit of foreign direct investment in the insur-ance sector has not been changed from 26% till date. There has been a bill pending with the upper house of parliament to increase this limit to 49%. The penetration of insurance (percentage of insur-ance premium to GDP) and insurance density (ratio of total premium to population) in India are very poor compared to many of the other countries in the world. There is a huge untapped market in rural India which needs to be addressed. But in or-der for the existing insurance players to expand into these remote areas of India, they would need large capital investments initially. A raise in the FDI limit would ensure capital inflows which would encourage the companies to increase their scale of operations, due to which the insurance premium would also fall, since the premium is a direct re-sultant from the law of large numbers. Also more capital would imply more efficiency and more in-novation in the form of new products which would better suit India’s needs. It would also ensure a bet-ter distribution network.

Insurance Inclusion In recent times, financial inclusion has become a buzz word. Though, up until now, importance has been given majorly to only banking inclusion. But increasingly, efforts are being made to towards inclusion of all the people of India in insurance also. IRDA has imposed obligations on the insur-ance companies to attain certain targets in terms of number of policies underwritten and total premi-um income generated in the rural and social sec-tors. As part of the obligations for 2011-12, LIC has more than the prescribed 25% of the total poli-cies coming from the rural sector and covered

ARTHAARTH ISSUE I I I INSURANCE

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Recently, IRDA has been relaxing its regulations on these equity investments. In early 2013, it has in-creased the limit of investing in one company from 10% to 15%. It has also encouraged the insurance companies to invest in infrastructure funds by rais-ing the limits on these investments. This would also reduce the cost of capital. But as compared to the global counterparts, there is still a substantial im-provement possible in the regulatory policies and the practices followed in the Indian Insurance in-dustry. There is a huge potential for insurance companies to contribute to the stock and bond mar-kets in India.

products. This would further increase the penetra-tion by leveraging the current expansion being undertaken by the banking sector.

Investments of Insurance Companies

Insurance companies play a major role in the Indi-an economy. In the financial year 2011-12, the total investments held by the insurance sector in the Indian economy is Rs. 16 lakh Crores. 80% share of these investments belong to the public sector, though investments from the private sector insurers have been growing at a fast pace. Also, life insurers contribute 94% of the total investments. The investments of LIC alone are to the tune of Rs. 12.7 lakh Crores.

The investment function in Indian Insurance com-panies is heavily regulated as the first and fore-most obligation of insurance companies is to pay all the claims on policies; hence they need to be liquid enough at all times. For life insurers, the re-quired solvency ratio is 1.5. They also need to aim for maximum return and minimal risk.

IRDA has strict exposure limits to investments in one company and one sector. Traditionally, the in-vestments were made mostly into Government bonds for low risk factors but slowly, investments are being shifted into corporate bonds and equity markets. Whereas, in most of the developed mar-kets, insurance investments are allocated to equity markets in higher proportions. In UK, the share of equity investments is around 40% and that in US is 45%. In 2012, almost 40% of the investments made by the life insurers in India are in Govern-ment Securities (See Figure).


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INSURANCE



LIC has raised its stake in the Oil and Gas industry as this sector has become more attractive with the deregulation of diesel and petrol prices.

This is expected to reduce the under-recoveries of the oil companies. The holdings in IT sector has also been raising consistently as IT stocks like TCS have always been the favorites of stocks markets, offering decent returns. The increase in stake in the Ambani Group has been due to RIL which was expected to make a windfall gain out of KG D6 basin. Another factor in favor of RIL is the monopolistic power of RIL in petroleum products markets. The stake in Mahindra group declined since 2012 has been a sluggish time for auto sector and M&M motors, the significant arm of Mahindra has seen falling sales with their acquisition of Sangyong which is yet to turn profitable. LIC has decreased its holdings in the automobile industry since the auto sector as a whole contracted in the latter half of 2012 forcing inves-tors to withdraw.

Anusha Ganne & Khushboo Goyal , PGP 2, IIM Udaipur

Currently, investment decisions being taken are very conservative in nature, but if asset allocations follow a similar strategy as that of global insurance industry, then equity and corporate bond markets would have an inflow of large amounts of stable funds. This could bring in the required liquidity to these markets and help reduce their volatility.

LIC Investment Portfolio

LIC is the largest institutional investor in India with Rs. 12.7 lakh crores as its investment corpus as on March 31, 2012. But only 20% of this is in equity. The investments made by this institution traces many major changes which have happened over the past 3 years. There have been significant changes in LIC’s effec-tive ownership in several organizations across in-dustries. The figure below shows the value of LIC’s stake in the group companies termed as the LIC's effective ownership.

ARTHAARTH ISSUE I I I INSURANCE

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D erivatives are instruments which generate value from its underlying asset, asset here

can be anything ranging from stocks to commodi-ties to even currencies. They are generally used as a hedging tool to mitigate risk. There are primarily two types of derivatives namely exchange traded and over the counter (OTC) derivatives. Exchange traded derivatives are ones in which an exchange acts as an intermediary thereby reducing the coun-ter party risk, the exchange here acts as a guaran-tor. OTC derivatives on the other hand are custom made derivatives which are directly transacted be-tween two parties; the counter party risk is very high in these kinds of derivatives. We would be focusing more on the Exchange Traded Derivatives for the purpose of our study

Exchange Traded Derivative

Futures and Options are some of the standard ex-change traded derivatives. A derivative is an instrument to transfer risk from one party to another, now you might wonder why a person would be willing to accept risk. This is how the market functions, not all people have the same risk appetite, and market in general will have three kinds of people: Risk Averse, Risk Neutral and Risk Loving. The Risk Averse person will transfer his risk to the risk loving person and in exchange the risk loving person charges a premium for it. There is also a possibility of two risk averse people coming in to futures contract where both want to limit their downside risk i.e. consider a Wheat-Farmer and a Wholesaler, They enter into a futures contract in which the farmer agrees to sell a speci

fied quantity of wheat on a future date at the price agreed today. At that future date the price may go up, in that case farmer will lose or may go down in which the wholesaler will lose. But the other way is also possible, so to mitigate the downside risk both give up their upside gain potential and enter into a futures contract. If derivatives were so simple and good then why did they lead to the 2008 crisis? Derivatives we have discussed so far are very simple, straight forward were both the buyer and seller of the derivative were aware of the underlying asset. But consider the cases of derivatives over deriva-tives; it will be difficult for all traders to understand the risk of the underlying asset. To make it more simple let’s look into a jargon called CDO’s.

CDOs and their role in the 2008 crisis:

CDOs or Collateralized Debt Obligations are class of derivatives in which the underlying asset is the pay-ment from Debt (Both principal and Interest) i.e. think of a bank disbursing loans, soon its loan book


The Dangerous Derivatives - Demystified


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DERIVATIVES

soars to point where the bank reaches its reserve threshold. Beyond this point a bank cannot lend un-til there is liquidity infusion into the bank either in the form of capital or deposits. But doing both of these is tough. Instead there is a simple method, until there is liquidity infusion into the bank either in the form of capital or deposits. But doing both of these is tough. Instead there is a simple method. As-sume the loan book of the bank is 100cr, now the bank discounts this loan book and sells it to a third part at 98cr. The 2cr is the premium the bank is willing to pay to get the cash immediately; the same 2cr is the premium the third party charges for ac-cepting the default risk by banks debtors. Now with this 98cr, the liquidity position of the bank improves and it again issue new loans. But the new 98cr came at a higher cost compared to the earlier 100cr, so the interest charged for this round of loan disburse-ment will be greater. All the while we have assumed demand for money to be inelastic.

Meanwhile the third party, who bought these loans, creates a market instrument (Derivative) and trades the same in the market. These instruments are noth-ing but CDO’s. Things sound fine then what went wrong is your question?

All these loans were asset backed, and the asset in most cases was homes. As the real estate was soaring more and more people borrowed, speculating that asset prices would go up. But by the start of 2008, asset prices started declining. As the value of the as-set dropped below the value of the outstanding loan, people started defaulting. As more and more people defaulted, the contagion spread and asset prices fell further. But still you would wondering why this im-pacted the global economy.

`The CDO’s which were issued over these assets started to default on payments, the holders of these CDO’s were banks of several countries. As the banks defaulted, the central banks of those coun-tries had to bail them out; this converted the CDO’s crisis to a sovereign debt crisis engulfing the entire world.

2008 crisis mitigation measures saw central banks bailing out banks and large institutions, but the markets haven’t still regained the same flow simi-lar to pre 2008. This is more of the suppression in speculative trading in market as people have be-come wary of investing in markets.

How can Such a Problem be Avoided?

The Commodity Exchange Act (CEA) of 1936 passed by the U.S government mandated that all futures contracts, which were the first form of de-rivatives that came into existence, be traded on a regulated exchange providing full transparency to the counterparties regarding future prices. Some of the conditions imposed by CEA on futures trading were : (1) Price realization based on market de-mand (2) Intermediary regulation (3) Disclosure of the parties involved in the transaction (4) Custom-er protection rules (5) Supervision of self-regulated exchanges by a federal regulator (6) Barriers prohibiting market manipulation, exces-sive speculation and fraud. In the 1980s, a new variant of derivatives called “swaps” came into existence, which is basically an exchange of cash flows between two parties on the basis of differential in interest rates, currency ex-change rates or any underlying principal base.


ARTHAARTH ISSUE I I I DERIVATIVES

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Within these, an interest rate swap is one in which one of the parties in the transaction agrees to ex-change a floating rate interest obligation on an ex-isting loan for a fixed rate obligation with a swaps dealer or a counterparty to whom the swap has been assigned by the dealer, with an expectation that the fixed rate will be lesser than the floating rate. An assumed amount is incorporated into the swap which in most cases reflects the outstanding loan value on which a floating rate is being paid to the lender. The fixed interest rate payment is by the swaps dealer to the borrower. So here comes the catch; there is a “swap” of commitments in such a transaction between the buyer and the seller, based on floating and fixed interest rates. This is in con-trast to that of a conventional futures contract which involves transactions based on a single rate/price. CEA excluded swaps from its exchange trading re-quirements due to its inherent nature of being non-standardized and dependent on counterparty credit assessment. The Commission however later validated its stand by stating that swap agreements were still under its exchange trading requirements as they were fixed and not subject to negotiation.

The International Swaps and Derivatives Association (ISDA) had created a Master Agreement and a relat-ed document laying down rules for the execution of a swap. Consequentially, this led to OTC derivatives getting standardized and by 1998 they had grown at an alarming rate, with the notional value of out-standing contracts in these instruments crossing $28.733 trillion, at a growth of 154.2% since 1994. And in Oct 2008, this same value had climbed up to a whopping $600 trillion, within which credit de-fault swaps (CDS) were expected to be worth $35-

65 trillion. While it has been estimated that general ly 3% of the notional amount in a swap is the risk associated with it, a CDS’ insurance like quality im-plies that in the case of default, the entire amount is at risk. Adding up the lower value of outstanding CDS ($35 trillion) and this 3% of the remaining no-tional amount ($565 trillion), the net value at risk was $52 trillion, which was almost at par with the world’s GDP in 2008!

The same instruments were used to mask the im-pending disaster that was to come in 2008 – the sub-prime crisis. Securitized subprime mortgage loans were converted to simple mortgage backed securities (MBS) which were embedded within complex CDOs. This distracted investors from the underlying risky loans and individuals likely to default, by reframing the risk in the form of these instruments. False assur-ances by credit rating agencies mislead the investors by high of evaluations of these CDOs. More im-portantly, the CDS were framed as insurance on CDOs, which only provided false protection to these investments.

The above article is only a peek into how innovations in financial instruments were manipulated, and made opaque by hiding them from firms’ balance sheets, even with regulations passed by centralized bodies, to cause the world’s most impactful financial disaster. There is a highly impending need for better, foolproof regulations – not just in the U.S, but all capital markets at a global level; and only such preemptive measures can save us from another dis-aster, but this time, a fateful one! Aditya Raghunath & Arun Kumar, PGP 2, IIM Udaipur



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DERIVATIVES

Risk Management in Crises Types of Risk There are basically three types of risks that organi-zations have to deal with. Preventable Risks (Known-Knowns): These are the risks which arise due to internal factors. They are controllable by nature. Some examples of such risks are risks from machine breakdowns or risks due to unethical practices. Organizations do not benefit strategically by taking these risks and thus should try to reduce or eliminate the occurrence of these risks. These risks can be managed by having an ef-fective control and monitoring mechanism and by instilling a culture which makes employees aware about these risks and their effects. This can be done through having a clear and well communicated mission statement and by having clear cut values, beliefs, systems and procedures which assist the em-ployees in doing the right thing. Strategy Risks (Known-Unknowns): These are the risks which the organizations take with the aim to generate superior strategic returns. Rule based con-trol model is not effective to manage these risks. An example for these types of risks is bank credit risks. To deal with these types of risks, the organization needs a risk management system. This system is aimed at minimizing the probability of occurrence for these risks. Also, the risk management system helps organizations to prepare themselves to contain or manage these strategy risks in the event of their occurrence by allocating resources to mitigate the effect of these risks. External Risks (Unknown-Unknowns): These risks materialize due to happenings outside the organiza-tion. They are beyond the control of the organization and cannot be completely eliminated or managed.

A ccording to the classical finance theory, in per-fect capital markets, a firm has no incentive to

use risk management techniques like hedging, in-surance, diversifications etc. According to the Miller Modigliani propositions these actions do not add any shareholder value, which is the main aim of a firm. Moreover, these actions can be taken by the share-holders themselves at the same cost. Thus any firm is risk neutral and has no incentive to manage risk. Its aim is to maximize shareholders’ value. In, practi-cality however, the assumptions of the classical fi-nance theory like no transaction costs, no bankrupt-cy costs, equal borrowing costs for firms and share-holders, information symmetry etc don’t hold. Thus, in order to identify, access and prioritize the risks that the organization is exposed to, and to coordi-nate and economically apply manpower and re-sources to minimize, monitor and control the likeli-hood and impact of the events where organizations are exposed to these risks, organizations need to have a risk management system.


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shifts and natural disasters. The organizations fo-cus on identifying these risks and prepare them-selves for their mitigation in the event of occur-rence. This can be done by applying proactive tools like scenario planning and war gaming.

Risk management in the times of normalcy Even in bull markets, companies take measures to manage their risks in relation to their returns, these include: a) identification of the risks that the compa-ny faces. But it is also true that all the risks systems to capture data in order to identify risks, empirical approach to risk management, including risk man-agement into critical decision making process and adopting governance structure to ensure better risk management. associated cannot be appropriated cor-rectly hence Chief Risk Officers try to incorporate as a whole best business practices in the system; b) once

risks are underwritten it is essential to communicate the same to the top management; c) the risk taken in any particular instrument must conform to the overall risk taking strategy of the firm; d) finally, the risk asso-ciated with the company must be effectively communi-cated to the external shareholders, so as to ensure valu-ation is as close to reality. Key dimensions to the com-pany level risk management system are adequate

Case: Allianz Approach to Risk Management Allianz through its pro-activeness in risk management was able to take into account the Euro crisis since 2009. Even in a bullish market, Allianz has certain measures to keep itself in good stead. The first is Top Risk Assessment, under which there is a cross func-tional team to identify the risks the company faces. Second is Emerging Risk Assessment, in which scenario planning is undertaken to devise steps to avert differ-ent situational risks. Lastly, they have developed Risk Controlled Self-assessment which helped them in rec-ognising and managing reputational and operational risks.

When things go down, how to go about risk management

The usual practices of risk management might not be sufficient to mitigate the effects of the downturn; hence special efforts are required by the risk manage-ment team to mitigate the risks, which are discussed in above two steps it should be kept in mind that building consensus regarding the direction of economy or com-pany is important but excessive discussions regarding exact figures can lead to counter-productive results. It must be ensured that management action is prompt post impact analysis and the scenarios envisioned need to be refreshed only in case there is a change in the underlying assumptions.

Case: BP Oil Crisis In 2007, when Tony Hayward became the new Chief Executive Officer of BP, safety was on his priority list. He incorporated several rules in this direction to the extent that the employees couldn’t text while driving and had to use lids on coffee cups while walking. Hay-ward was still the CEO when the Deepwater Horizon rig exploded in the Gulf of Mexico, causing one of the worst manmade disasters in the history. In spite of all the money they invested in Risk Management activi-ties, risk management in BP became more of a compli-ance issue and they were not able to identify, properly evaluate and communicate the risks they faced. They handled the Preventable risks well but accepted the high strategic risk of drilling several miles below the Gulf’s surface because of the high value of the oil and gas they hoped to extract.



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RISK MANAGEMENT

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It is common practice in the times of bull to forecast taking into account the mean values prevailing, which does not necessarily hold true in depressed circumstances and one must look to give more im-portance to tail values as most of the times these are the ones that seem to be present. When the chips of the market are down one must be extremely careful regarding the level of risk that the company exposes itself to. Small time risks are fine but too much exposure can be devastating. Lastly, for the ‘too big to fail’ firms, governments in-evitably come to their rescue in the times of down-turn, hence in order to make companies mindful of the levels of risks they are exposed to, it is proposed that there must be a premium charged from these companies for the riskiness attached to these firms.

Conclusion As seen in the prior sections of the article, risk man-agement as a practice needs to be incorporated into day-today working of businesses. In the times of nor-malcy, the firms going over the top are expected to achieve far greater growth rates but in case of a downturn, the same firms will be the worst hit. Good risk management practices will ensure manageable growth rates during bullish markets and bearable de-scent in the times of crises. Pranav Gupta & Prateek Shukla, PGP 2, IIM Udaipur

Bias in effective decision making Anchor Bias: People tend to anchor their estimates based heavily on readily available proofs and evi-dences even if they are aware about the known dan-ger of making extrapolations from recent history to a future which is highly uncertain. Overestimation Bias: People tend to overestimate their capability to influence things that are actually heavily dependent on chance. There is a normal ten-dency to be overconfident about the accuracy of forecasts and assessments and give far less im-portance to the negative outcomes that can happen.

Lessons from 2008 crisis The events leading to the 2008 crisis clearly demon-strate the kind of behavior that can be lead the com-panies to high growth figures during bullish mar-kets and when there is a downturn, the losses are intolerable. The companies became so enamored with the successes during bullish markets that all the risks associated with subprime mortgages and CDOs were completely ignored as if there is no end to this day. The management fell in the trap of what shareholders will say if equal benefits are not reaped out of the growing bubble. Also scenario planning was given a backseat which is exemplified by failure of risks models, which were built on volatility fig-ures of 2004-2006, in 2007 when the volatility started to spike. Regulators also failed to set their foot right and were unable to control the excessive risk taking.

“Experience taught me a few things. One is to listen to your gut, no matter how good something

sounds on paper. The second is that you're generally better off sticking with what you know. And the

third is that sometimes your best investments are the ones you don't make.” Donald Trump


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Rupee vs Dollar: 1/x or log(x)

Marginal Standing Facility

MSF is a facility where banks can borrow up-to 1% of their Net Demand and Time Liabilities (to accom-modate for the asset liability mismatch). The MSF was recalibrated from ‘Repo plus 200’ to ‘Repo plus 300’ basis points which effectively resulted in MSF of 10.25%. This is a whole 1% increase over the pre-vious rate. The bank rate which is pegged to MSF also became 10.25%, but none of the banks have in-creased their interest rates to customers. The reason being that, the amount borrowed through MSF was not significant. Controlling the Liquidity Adjustment Facility (LAF) The total funds allocated for banks to borrow through LAF facility was limited to Rs. 75,000crores; each bank had to submit a bid for the money it needed and each bank has to ensure that it had re-quired SLR (Bonds) to furnish as collateral. This came into effect from 17th July, the amount of bor-rowings through this route was Rs.92,000crores and Rs.2,21,800crores on July 15th and 16th respectively. From 17th only a maximum of Rs.75,000crores was disbursed.

V olatility in exchange rates have been a cause of concern, with US signaling an end to

quantitative easing, the fears are becoming even more relevant. Apart from correcting the trade balances, a couple measures in the internal finan-cial markets will also help set rupee straight. When we are talking about internal financial mar-kets the significant ones are the Call Money mar-ket, Repo Market and the Government Securities Market. In last couple of weeks were action packed with the Rupee reaching 60 and gaining back to settle at Rs.59. The driver behind these changes was none other than our Monetary Regulator. Let’s see what happened. RBI opted for a three dimensional attack to arrest rupee depreciation 1. Recalibration of Marginal Standing Facility

Rate (MSF) 2. Controlling the Liquidity Adjustment Facility

(LAF) 3. Open Market sale of Government of India Se-

curities

Markets (2013) 12th July 15th July 16th July 17th July 18th July 19th July 23rd July 25th July

Call Money 7.02 7.21 8.53 7.99 7.43 6.96 7.14 8.27

CBLO 6.47 7.18 4.67 7.55 6.11 6.28 6.93 7.40

Market Repo 7.08 7.18 8.71 7.97 7.29 - 7.13 7.75

Overnight Segment 6.58 7.18 6.02 7.68 6.48 6.52 6.98 7.54

INR vs USD 60.05 59.9 59.32 59.32 59.65 59.4 59.72 59.10


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ANALYSIS


* all rates in %, Overnight Segment Rate is weighted average of Call Money + CBLO + Market Repo adjusted for the borrowings through each route


longest can extended up-to 30years. So based on this, there are primarily two Yields, the short term yield and the long term yield. Now, if I increase the yields on the long term bond and make it more attractive, people who have in-vested in short term bonds will pull out their money and put it in long term bonds. This results in excess availability of short term bonds, due to which the price of short term bonds fall thereby increasing the yield. Moreover, withdrawal of lenders from short term market creates a liquidity crunch in short term markets. Think of the same in a larger scale. RBI last week announced the issue of Government Bonds worth Rs.12000crore with maturity period ranging from 5 to 17years. These were long term bonds and Rs.12000crore was a significant amount, with rates attractive as compared to existing long term yields. People, who were till now not interested in Long term Bonds, who felt that this marginal increase in yield was worth the risk taking would pull out mon-ey from the short term markets and try to put it in long term markets. As you can see from Exhibit 1 & 2, between 12th July and 18th July, the short term yield shot up from 7.25% to 8.75%. In the same period the yield in long term market moved from slightly less than 8% to more than 8%. Ideally the long term rates should have fallen if there is excess availability of funds, but RBI had a floor yield rate on the new bonds be-ing issued which made sure that long term interest rates also stayed up. The issue of Rs.12000crore was oversubscribed by 2times with the bid amount reaching Rs.24300crores. A significant portion of this money was raised by selling short term securities. At the end of the bidding process (i.e. close of 18th July),

But this spike on 16th July seems to be caused by more of a speculative reaction, expecting rates to go up, because during the preceding week the borrowings through this route never crossed Rs.75,000crores. If we notice in the table on previous page, we find that the surplus borrowings through Repo on 16th resulted in a surplus funds with Banks, Also the interest rate on repo borrowing shot up. But banks couldn’t apply the excess money anywhere else and CBLO markets had too many lenders with too little borrowers. The CBLO rates crashed. The over-night borrowing rate is the weighted average of call money, CBLO and Market Repo, it shows vola-tility despite all these efforts. Going by this trend RBI came up with another change on 23rd July reducing the borrowings through LAF facility to 0.5% of Net Time and De-mand Liabilities. This would cut down the 75000 by nearly half. This has led to spike in borrowing through call money and CBLO markets. Accompanying this change was the increase in the average CRR on a daily basis from 70% to 99%, thereby further reducing the liquidity in the sys-tem. All these put an upward pressure on the inter-est rates in the market. Open Market Sale of Government Securities

Open Market sale is where the RBI either issues government securities to absorb the excess liquidity or redeems the outstanding government bonds to increase liquidity. As you would have read in your Micro-Economics, you can control the price of the goods by controlling the demand-supply equation. RBI too has done the same thing with Money being the Good here. Government bonds will be of various maturity pe-riod, the shortest ones being the 91 day T-Bills and

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term market, the excess funds created a demand for bonds leading to an increase in the prices of the bonds, which lead to decrease in yield. Net-Net, yields went up compared to last month levels and the slide in rupee was also arrested with FII’s staying put. The government of India also backed up these steps with policy initiative, announcing FDI reforms in 12 sectors thereby enabling flow of foreign capital which will help in appreciation of rupee.

RBI accepted bids worth only Rs. 2500crores, that too in the bonds with maturity period greater than 12years. All those people, whose bids were not ac-cepted, had no other option but to invest again in short term securities. Between 18th July and 19th July, the short term yield fell by .25% and the long term yield had risen by 0.5%. The reason the long term yield reaching 8.5% is that, the bids which were accepted had a cut-off yield of 8.54%. So long term yield held steady at 8.54%. On the short

Date & Action Intended Result Actual Result

15th July, RBI announces in-crease in MSF rates, Cap on LAF borrowings

Reduction in Exchange Vola-tility

Limited or No Impact

18th July, RBI opens Bonds is-sue worth Rs.12000crore

Absorb excess liquidity from short term markets

Successful, short term yield went up

23rd July, RBI reduced LAF borrowing limits further

Reduce Liquidity in the system Successful, Borrowing rates in overnight markets went up

23rd July, RBI increases Aver-age CRR on a daily basis

Reduce liquidity in the system Successful, Borrowing rates in overnight markets went up

The peculiar thing to note here, which you may not come across once again in your life is the yield on short term and long term bonds are almost the

same on 19th July (Denoted by a green line in the fig), with medium term bonds offering lower yields. Overall if we consider all the three together, the impact of OMO was more pronounced in the first week than the rest two. In the second week we saw how LAF and CRR requirements impacted the mon-ey supply in the system. But these are short term measures which will not prevent rupee slide in the longer term if we don’t back this up with good fis-cal policies. That is the reason behind government urgently pushing FDI reforms in 12sectors last week. Let’s hope that the best happens.

Arun Kumar P & Vivek Batra, PGP 2, IIM Udaipur


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ANALYSIS


Can Pennies become Millions? A fter a delightful morning walk, Money Ratnam

shivered in the morning cold as he sat on a park bench waiting for his friend. Money Ratnam was ex-cited, he wanted to talk about his latest investment. Taking the advice of his financial planner, he had in-vested a substantial amount in Infosys and the stock had also moved upwards as the company’s quarter numbers exceeded market expectations. Soon his friend arrived and after the usual pleasant-ries, Money Ratnam was quick to change the topic. He boasted about his investment and the following up-ward movement in the stock. He felt like a million bucks. His friend though had a smirk on his face. He explained that had he been smart, he could have prob-ably bought 3000 shares of XYZ Company for every share of Infosys. XYZ’s share costs less than a rupee and he could have bought thousands of those. Also, being already dirt cheap, there was no chance of them decreasing in value any more. Money Ratnam was rat-tled. He felt his thunder was stolen. Money Ratnam went home and looked up for low val-ue stocks. He found that some penny stocks gave mul-tifold returns over a period of time. Even a small price movement of Re.0.01 made a price change of over 1%. Also many of such stocks were trading at lifetime lows. This caught Money Ratnam’s attention like nothing before. Now, all that he hoped for was a small increase of around 10 paisa in the stock price to give a hand-some return. Infosys now seemed a big mistake! The next day, Money Ratnam met his financial plan-ner and told him everything about his new found pas-sion for penny stocks. Contrary to his expectations, the financial planner was concerned. So, he started by ex-plaining to him that any company’s stock price can go down to Re.0 and that a low price didn’t mean it could not go down further. In a recent analysis for the past one year, he had found out that of the 150 stocks cur-

rently trading under Rs. 10, 90 stocks had had a fall of over 50%, some falling by as much as 97% and only 5 stocks gave positive returns. Whereas several Indian blue chips like Reliance, Infosys and HUL had given re-turns of 25%, 35% and 42% respectively. Such blue chip companies not only have better governance but also provide better capital preservation. The cheaper stocks are usually very illiquid; it is tough to find a buyer. And very little information on these companies is available in the markets, making it difficult to gauge their current performance and forecast their future performance. It is also very easy to manipulate the price of these stocks. Sometimes, people with not so good intentions buy such stocks aggressively and the price increases rapidly. Oth-er investors get attracted to such stocks and invest in them. At high prices the stocks are dumped in the mar-ket and the last holders of the stock suffer huge losses. Dividends, generally given on stocks, are also not given out by penny stocks. The financial planner kept on going, but Money Ratnam wasn’t listening anymore. He was convinced and re-lieved that the fee he was paying to the financial plan-ner was worth it. Kamaljeet Saini & Naimish Shah, PGP 1, IIM Udaipur


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The Need to Re-Design

R ural consumerism, Information and Communications Technology (ICT), Supply circles - change is galore in the world today. There was a time when GE’s story of change with changing CEO caught everyone’s eyes. Now the case is different.

Change is expected and anticipated. Challenges are thought of as pathways to redesign. It has become the second nature of or-ganizations. No part of the organization is alien to it. Be it human resource policy, marketing strategy, consumer base, IT infra-structure, supply chain, structure of an organization, leaders have redesigned it all.

Looking at the importance this term now has in the business environment; Indian Institute of Management Udaipur will be pre-senting the second edition of its annual flagship event, “The Leadership Summit 2013” on the 3rd August, with umbrella theme of Need to Re-Design. The event is aimed to serve as a platform for leaders from different walks of life, to share their opinions and views on select themes, through engaging panel discussions.

The inaugural edition of the event, which was hosted at the resplendent Durbar hall of the City Palace of Udaipur on 4th August, 2012, saw speakers like Mr. Pradeep Kashyap – CEO, MART and President – Rural Marketing Association of India, Mr. Debash-ish Poddar – CEO, Bombay Dyeing grace the stage, amongst other luminaries.

Last year, the panelists deliberated on the umbrella theme “Ideation and Execution in a business cycle”, touching on the im-portance of nurturing innovation and achieving execution excellence.

An important link between innovation and execution excellence is change. Innovation can be incorporated to achieve execution excellence only if the existing systems are changed or tweaked. Reflecting this line of thought the umbrella theme for “The Lead-ership Summit 2013” is the "Need to Redesign”. The event will involve panel discussions covering a wide range of issues like the shift in focal point from urban to rural, the pressing need to redesign the supply chain and the changing roles and styles of lead-ership.

Shri Ashok Chawla, Chairman, Competition Commission of India, will be the key note speaker this year. The event will witness stalwarts from the industry like Mr. TCA Ranganathan, CMD, EXIM Bank; Mr. Sandip Sen, CEO, Aegis Global; Mr. Hardeep Singh, Senior V.P. Bharti Walmart; Mr. Sudhir Kumar Shetty, Group COO, UAE Exchange Centre; Mr. Rajkumar Jha, National Creative Director, Ogilvy Action; Mr Piyush Srivastava, Anchor, Zee Business; Mr. Ashish Bhatia, COO, Rajasthan Circle, Sistema Shyam Teleservices; Mr. Murali Parna, COO, Sagar Ratna Restaurants. Udaipur based companies -Vedanta Hindustan Zinc and Rajasthan State Mines and Minerals and Union Bank of India have extended their wholehearted support in making this event a success.

ARTHAARTH ISSUE I I I RE-DESIGN


arthaarth issue iii

Documents

india page

crisis page

arthaarth issue

logx page

financial crisis

insurance industry

engulfed india

money ratnam page