- 1. AN IIMA, IIMB, IIMC Initiative | June 2009 THE MONEY
MANAGER
2. eDITORS nOTE tHE tEAM While 2008 was not a particularly great
year for the World nancial 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. SoPiyush Soonee [IIMA] the
question staring all of us in face is whether 2009 would be the
beginning of a new Dawn or could Editorial Board we be heading to
the something akin to the Great Depression of 1930s.Ashutosh
Agarwal [IIMA] Devendra Agarwal [IIMC] The silver lining seems to
be that Indian economy isDivya Devesh [IIMC] on a rmer 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 worldDesign
economics especially after the upheaval in US,Majid Asadullah
[IIMC] Europe and their effects on China and Japan.Abhishek Nagaraj
[IIMC] The second anniversary edition of The Money Manager brings
you insightful interviews of Prof. Coordination Committee: Partha
Mohanram of Columbia University whoShishir Agarwal [IIMC] talks
about the current nancial crisis and how Manu Jain [IIMB]
corporations should gear up for the next phase. WeRavi 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 nancial crisis, identifying successfulAkshat Babbar [IIMA]
hedge fund strategies for investing, new monetary policy tools,
failure of TARP and climate change induced nancial 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. 3. aCKNOWLEDGEMENTSThe Money Manager team
would like to thank Prof. AshokBanerjee, and Prof Anindya Sen for
their constant support. We would also like to express our heartfelt
gratitude towardsProf. Partha Mohanram, Mr. K.V.Kamath and Prof.
MartiSubrahmanyam for sharing with us their views during
interviews.We are grateful to Dr. Golaka C. Nath and Prof. Malay K.
Deyfor 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 RohitKaran for interviewing Prof. Marti Subrahmanyam;
and NishantMathur, Samrat Lal, Dhruv Dhanda and Tarun Agarwal for
theinterview with Mr. K.V.Kamath. We would also like to
thankRajatdeep Anand for interviewing Prof. Golaka C. Nath. We
thank Professor Ajay Pandey, Professor Sidharth Sinha,Prof. Joshy
Jacob, and Prof. Samar Datta for adjudging thearticles. We would
also like to acknowledge the sponsorship teamconsisting of Alok
Srivastava, Ananya Mittal, Anuja ArvindLele, Rajatdeep Singh Anand,
Guhan M, Gaurav Lal, AbhishekNagaraj, Divya Devesh, Jaykumar Doshi
& Vishal Agarwal. 4. cONTENTSCOVER STORY 06 An Interview with
Prof. Partha MohanramSPECIAL FEATURE 11 An Interview with K.V.
KamathEXPERT OPINION 15Central Counterparty (CCP) - Role ofClearing
Corporation of India Limited19 An Interview with Prof. 12
Prof.Marti SubrahmanyamSTUDENT ARTICLES 25 Extracting Alpha Using
Behavioural Finance30New Monetary Policy Tools - Innovative
Response to the Meltdown36CDS and CDS Pricing40 Climate Change
Induced Financial Risks - A Strategic Approach60 50 Credit Default
Swap Pricing: Empirical Results & Inferences55 Effectiveness of
Basel II in the current nancial crisis60 Identifying Hedge Fund
Strategies forInvesting in Emerging Markets69 MNC Delisting -
Reaping the Benets in 2009 74 Failure Of Tarp And Solutions To
TheBanking Crisis78 Value Investing: Past Trends andCurrent
Opportunities in India PRIMER What do we know about the market
83microstructure of the Indian StockMarkets? - Malay K. Dey KNOW
YOUR PRODUCT 86 Barrier Options 5. cOVER sTORY cover story cover
page An Interview with Prof. Partha Mohanram Phillip H. Geier Jr.
Associate Professor of Business, Graduate School of Business,
Columbia University. Partha Mohanrams research has been published
in the leading academicjournals 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 ofcost of capital,
the use of fundamental information in the valuation of growthstocks
and the manipulation of earnings to maximize executive
compensation.Mohanram teaches Financial statement analysis and
valuation to MBAs andexecutive MBAs, with an emphasis on exposing
students to the potentialmanipulations of nancial statements. He
also teaches in Columbias executiveeducation programs. He is
currently the coordinator of doctoral program forthe accounting
group, and has served on the dissertation committees of
severalstudents. 6. 07 THE MONEY MANAGER | JUNE 2009Q: Weve seen
the worldwide economic crisis continueits 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 thats
something you think will it abate, and what can governments dothe
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: Its a crisis at many levels. Its a fundamental crisis, a
simply a matter of detail. Something has to be done, and crisis of
condence, and a crisis of trust, depending on how something was
done. you choose to look at it. Its going to take a lot of time to
abate. Despite all the attempts to free the nancial marketsQ: What
about corporations? What can they do to through bailouts, etc.,
banks havent yet started the lending survive, even thrive in this
sort of environment? How process. People are just biding their time
theyre toocan they prepare themselves for the next cycle? scared to
do anything right now. In some sense, therefore, A: Youve probably
heard this clich, Cash is King. Its its almost like a self-fullling
prophecy its not going to unclear whether people mean that cash ows
are more get better because nobody thinks its going to get better.
important than net income, or that its critical to have cash So to
some extent, the only thing that can help really is the on the
balance sheet. In this case, its 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
doesnt 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
arent earning the required rate of return. One of the things that
we can see is that some countriesWhat the current crisis has shown
is that having some sort are not as badly affected as some others.
For instance, inof buffer for bad times is in everybodys interest,
including Europe, if we look at Spain, theyve 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. Lets say that the Going forward, companies that
havent 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
nancial 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 theyve 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 its very
human to this to solve the current crisis, but it might help
prevent orassume 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 7. 08 THE
MONEY MANAGER | JUNE 2009building up doom and gloom scenarios. The
point here is research theres 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 shouldnt 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 dtre. It is therefore a
really thin line on one hand youcan make these sorts of strategies
infeasible. need to cut costs, on the other, you need to preserve
your Q. What advice would you have for students of business
competitive edge. schools who will soon be part of the industry? Do
we The other aspect companies need to learn is to pay closeneed 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 statementequip 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 efciency A.
Firstly, everybody has been fascinated by the world Returns on
Assets, for example. One of the more of Finance. I dont say its
categorically wrong, but you discomting 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 doesnt 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 ctions
encourage people to do something more real and tangible. because
you are then saying, I dont 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 Dont 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 rms Even if you were
in Finance, you would be nancing a such as Barclays Global
Investors? particular industry. Just knowing fancy valuation
techniques A: I wouldnt put Barclays and Renaissance in the sameor
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 accountinghaving 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 toplot of time looking at the market, things like
Porters Five academician with afliations to Cornell, Michigan, etc.
TheyForces, before going into the nancial or accounting aspects.
also hired Richard Sloan, who was the rst 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 eld. 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? 8. 09 THE MONEY MANAGER
| JUNE 2009A. There are some essential similarities and some
essentialgoing on. I argue that much of what is going on is because
differences. The principle of Finance, Accounting are thepeople
dont do things properly. People are thinking more in same
everywhere. There is some difference in the pedagogya mechanical
way; Investment bankers are more concerned where some places there
is a lot of focus on theory whileabout their pitch books rather
than worrying if the deal at others it is mostly a case method of
learning. IIM-A andreally makes sense or not. There is this lack of
academic Harvard follow very similar ways of teaching. At IIMA,
werigour. Through research, one can also affect what people do have
some classes where we start with some lecture anddo. 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 slightget 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 yourown 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 exibility. 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 onlyaway 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 nd 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 quantication of issues that Q. Not many people from the
Indian B-Schools need to be done away with. People who dont
understand choose to become academicians these days. What are the
industry, how a company works and dont 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
plaguedanalysis when they dont understand the basics. One the
nancial services industry over the last year? needs to have more of
an overall perspective and need tounderstand what the company is
doing - before coming A. Hopefully the fact that no one is going to
academia fromup 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 areaspeople 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
admitsuch 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 futureAll 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 arecan 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 atnumerical scenarios
(changing numbers) and not looking People are looking at academia,
not necessarily because thereat economic scenarios. This is what
needs to change. are no jobs out there. I am sure there would be
sufcient opportunity available to the exceptional candidates.
PeopleQ. In India, we saw a recent discovery of an accounting see
that a lot of stuff that is happening in the real world isfraud
that happened at Satyam. How would / should just random and
arbitrary. So, lets just understand what is 9. 10 THE MONEY MANAGER
| JUNE 2009accounting, regulatory practices change to pre-emptyou
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 beAnd that you would not like future batches
to graduate reactionary? with that notion.A. This is difcult 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 ofthese days and the world changed after our batch.
Our batch the company, the economic situation before making anywas
the rst 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 theThere 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 protable 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 comes96), a
whole bunch of foreign placements happened and from the lack of
taking an overall perspective.in that sense, things got pretty
internationalized. Also, itmight be fair to say, Finance completely
took over the other Changes in regulations are denitely required.
For e.g.professions. In our batch, people had the choice - whether
auditors would start relying more on actual due diligencethey
wanted to do a Finance job, or a Marketing job etc. But rather than
say, just a bank statement. The regulations arenow, Finance has
completely dominated everything else. already in place. Satyam
being a U.S. listed rm - 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. Dont think
that Iwould 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 signicantly. There is a serious
chance of lossthat cannot be taught. There is tendency, especially
among of capital.MBA students to judge different courses. This is a
very badnotion 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 issuesteach 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 10. sPECIAL
FEATURE cover story cover page An Interview with Mr K.V. Kamath
Managing Director and CEO, ICICI Bank Limited K V Kamath is
currently the Managing Director and CEO of ICICI Bank, thelargest
private bank in India.. He is also a Member of the National Council
ofConfederation of Indian Industry (CII). He was awarded the
prestigious PadmaBhushan Award by the Indian Government in 2008.
The Asian Banker Journalof Singapore had voted Mr. Kamath as the
most e-savvy CEO amongst Asianbanks. He was also awarded the Asian
Business Leader of the Year at the AsianBusiness Leader Award in
2001. World HRD Congress in November 2000,voted him as the best CEO
for Innovative HR practices. 11. 12 THE MONEY MANAGER | JUNE 2009Q.
Under your leadership, ICICI has grown byrepresentation of women in
the sector? leaps and bounds. What in your view should theSystem
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 thatof 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 notleadership 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 nancial services
companies, and our competitors, though often criticized for
beingand 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. Empoweringin 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 banks strategy.framework, if adhered
to, has sufcient 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 initiativeswith 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 signicant stakeholders
in the process, that we havecome to light. been able to handle the
process of succession planning Q. As we all know, ICICI Bank was
caught up well. in the rumours sometime back and which also Q. In
the nancial sector, ICICI has a distinguishedaffected 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 betteryou recommend to a
nancial institution to take 12. 13 THE MONEY MANAGER | JUNE
2009under such situation?orient their strategies with a much
greater emphasison liquidity, risk containment and continuous cost
Rumours are baseless and used by vested interestsoptimization, to
tide through this and future crises. for their malicious ends. In
the recent episode, when the condence of our investors and
depositors wasQ. There have been few instances of consolidation
threatened, we ensured that we kept all communicationin the Indian
banking system, perhaps largely due channels open at all times to
restore their faith. Asto 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 rm action against the perpetrators ofAny merger
or acquisition has to be driven by strong such crimes, as they
could jeopardize the stability ofbusiness rationale of scale,
complementarily or the system.synergies. In the Indian banking
space, there is no Q. As the President of CII, are you satised
withmandate to privatize the public sector banks. Within the
measures taken by the government to abatethe 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 scal policy,
easedmarket has dried up, affecting ICICI Prudential the transition
pain as the economy adjusts from awhich 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 ensuredWhat 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
nancialThe ULIP product has seen a slowdown in growth, in
restructuring.line with the weakening equity market. This has
affected Going forward, we would like to see a greater focusall
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 ow of fundsfavor transparency and exibility 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 nancial
system across the world is position in the private insurance space
by a wide margin witnessing a huge transition. What is ICICIby
investing in a robust distribution network. Going advising its
clients to do, in order to braceforward, it is best positioned to
leverage this strength themselves for this change?to offer diverse
products in the protection, health andinvestment categories.
Combined with its focus on cost- As a result of the challenges
being faced in theoptimization, ICICI Prudential is well set to
continue nancial sector, the real sector is facing a liquidityto be
the leader in the private insurance space. ICICI and credit
squeeze. This puts tremendous pressure onPrudential has, unlike
some other players, not focused companies for meeting their cash ow
requirementson the single premium product, preferring to position
for operational and committed capital expenditurelife insurance as
a combination of protection and long purposes. Companies are indeed
working to re- 13. 14 THE MONEY MANAGER | JUNE 2009term savings.Did
You Know? Q. With interest rates expected to remain in single The
Lipstick Theory: digits through 2009, what are the steps ICICI Bank
is planning to take to protect its net interestThis theory says
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 expandedup 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 rst identied 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 signicant 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 Este
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
differentlyDuring 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 to500,000 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
ones skills and strengths, and creating auseful 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 fundamentalsappearing for years afterward, so
all denominations of banknote above 5 were subsequently removed
from and the resilience of our economy, its only a
mattercirculation 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 14. eXPERT oPINION cover story
cover page Senior Vice President, CCIL, MumbaiDr. Golaka C. Nath
Central Counterparty (CCP) Role of Clearing Corporation of India
Limited 15. 16 THE MONEY MANAGER | JUNE 2009CCPs occupy an
important place in securities 6. Default procedures settlement
systems (SSSs). A CCP interposes itself A CCPs default procedures
should be clearly stated and between counterparties to nancial
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 nancial 7.
Custody and investment risks stability. A CCP has the potential to
reduce signicantlyA 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, becauseA CCP should identify
sources of operational risk it tends to reduce risks to
participants and, in manyand 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 arrangementsthat eliminate or
strictly limit its settlement bank risks, 1. Legal riskthat is, its
credit and liquidity risks from the use of banks A CCP should have
a well founded, transparent andto effect money settlements with its
participants. enforceable legal framework for each aspect of its
activities in all relevant jurisdictions.10. Physical deliveriesA
CCP should clearly state its obligations with respect 2.
Participation requirementsto physical deliveries. The risks from
these obligations A CCP should require participants to have
sufcientshould be identied and managed. nancial resources and
robust operational capacity to meet obligations arising from
participation in the11. Risks in links between CCPs CCP. CCPs that
establish links either cross-border ordomestically to clear trades
should evaluate the potential 3. Measurement and management of
creditsources of risks that can arise, and ensure that the risks
exposuresare managed prudently on an ongoing basis. Through margin
requirements, other risk control mechanisms or a combination of
both, a CCP should12. Efciency 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. GovernanceGovernance
arrangements for a CCP should be clear 4. Margin requirements and
transparent to fulll public interest requirements If a CCP relies
on margin requirements to limit itsand to support the objectives of
owners and credit exposures to participants, those requirements
participants. should be sufcient to cover potential exposures in
normal market conditions.14. TransparencyA CCP should provide
market participants with 5. Financial resources sufcient
information for them to identify and evaluate A CCP should maintain
sufcient nancial 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. 16. 17 THE MONEY MANAGER |
JUNE 200915. Regulation and oversight a well founded legal
framework that supports each A CCP should be subject to transparent
and effective aspect of a CCPs operations. Safeguards against
regulation and oversight.operational risk include programmes to
ensure adequateexpertise, training and supervision of personnel as
well Overview of CCPs risks and risk managementas establishing and
regularly reviewing internal control Risksprocedures. Many CCPs
face a common set of risks that must be controlled effectively,
though exact risks that a CCPCCILs role as a CCP in the Indian
Fixed Income must manage depend on the specic terms of its and
Forex Market contracts with its participants. There is the risk
thatCCIL 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 lateand 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, failureguaranteed
settlement and is a central counter-party to of the bank could
create credit and liquidity risks forevery 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), theLending
Obligation) segment and offers settlement investment of clearing
house funds or cash postedon non-guaranteed basis to IRS trades in
the Indian to meet margin requirements (investment risk), and
market. deciencies 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 theconcept of multilateral netting and
novation by a event of a participants default (legal risk). If a
CCPscentral 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 ornetting involves aggregating members
obligation complicate their management. to pay or receive funds
arising out of every singletransaction and offsetting it into a
single net fund Approaches to risk managementobligation. CCIL has
applied the concept of novation CCPs have a range of tools that can
be used to at a central counterparty in the xed income and the
manage the risks to which they are exposed, and thecurrency
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
meansbetween 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
participants from gross to net basis. By reducing the overall value
default by establishing rigorous nancial standards forof payment
between its members, CCIL has enhanced participation. This is done
through maintenance of the efciency 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, specic liquidity requirements for participation and
reporting and The earlier instances of gridlock and SGL bounce
monitoring programmes. Margin system and stresshave become history
after CCIL came into the tests to assess the adequacy and liquidity
of nancial settlement arena. Due to CCILs 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 isof 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 selectingabout 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 17. 18 THE MONEY MANAGER | JUNE
2009Risk Management at CCIL 2) Given a coin with probability p of
landing on heads In order to offer guaranteed settlement in the
variousafter a ip, 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 innite number of ips? 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 managedking 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
riskparade 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 efciency
& adequacy of the adopted method for margining4) 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 ensuredant travel before they
all meet in the center? through strict membership norms, exposure
limits, well dened process for default handling, Lines of5) 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- cant 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 CCILs risk processes are almost fully compliant with
bankers can only answer red or blue. The banker the recommendations
of Committee on Payments andis killed if he gives the wrong answer;
then the assassin Settlement Systems of the International
Organisationmoves on to the next banker. The bankers in front of
Securities Commissions in respect of Riskget 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
Calcuttabeing lined up and having the hats put on, they cant
communicate in any other way. What strategy shouldPuzzlesthey
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 paint6) Three ants on a
triangle, one at each corner. At a it black if its gold or gold if
it is black, reversing thegiven moment in time, they all set off
for a different color. The rst 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 dont 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. 18.
eXPERT oPINION cover story cover page An Interview withProf.Marti
Subrahmanyam Charles E. Merrill Professor of Finance &
Economics, Stern School of Business, New York University Prof.
Marti G. Subrahmanyam is the Charles E. Merrill Professor of
Finance,Economics and International Business in the Stern School of
Business at NewYork University. He has published numerous articles
and books in the areasof corporate nance, capital markets and
international nance. He currentlyserves on the editorial boards of
many academic journals and is the co-editor ofthe Review of
Derivatives Research. He has served and continues to serve as
aconsultant to several corporations, industrial groups, and nancial
institutionsaround the world. Prof. Subrahmanyam serves as an
advisor to internationaland government organizations, including the
Securities and Exchange Board ofIndia. 19. 20 THE MONEY MANAGER |
JUNE 2009Q. In the current nancial crisis, mostly complex German
bunds are anywhere from 100 to 250 bps, up Over-The-Counter
derivative instruments havefrom 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 affectdefault/restructuring for these
instruments over the nancial innovation in times ahead? next ve
years. Given the explosion in the issue of new government paper the
additional amounts planned There is no doubt in my mind that the
regulatoryalready run into trillions - this is not an unreasonable
oversight of OTC derivatives is bound to grow in theconclusion.
While no government needs to default on years ahead. One major
institutional developmentits 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 suchof
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 at 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 decit of the US etc. This may be a reasonable compromise
betweenhas touched unprecedented levels, interest rates the need to
permit and encourage innovation, whilehave taken a nosedive and the
economy is in a containing the systemic risks that we have
experiencedrecession. Despite all these factors, and contrary in
the recent nancial 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 specic forecasts regarding
market variables, because these forecasts are not worth Q. It is
common knowledge that governmentsvery much, in my experience. I
will only say that given have played a central role in the current
nancialthe burgeoning decits in the US, there is a long-term rescue
efforts but it appears that they themselvesoverhang 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 ondrag the dollar down.
On the other hand, there is the US government bonds, it has swelled
fromno 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
governmentpart of global savings. Also, it is entirely possible
that security. Are US government bonds really as safethe
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
havegoing to happen to the dollar in the next few years. taken
place during the current nancial 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 greaterjustied 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 morethis market and what are the
pitfalls they must for the Japanese Government Bonds and UK
Giltswatch 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 20. 21 THE MONEY MANAGER | JUNE 2009between 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 thatby
making controversial statements about markets, the Indian equity
derivatives market, particularly thatnance 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
efcient. I also think that the regulatory oversight atbusiness,
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 structurelong time. Saying that there are many events that
fall of this market is as good as any other in the world,
thatoutside the 3-sigma limits is simply a matter of saying I know
of. When it comes to OTC products, such asthat the commonly- made
assumption of lognormality interest rate and credit derivatives,
the market in Indiaof 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 makethe standard VaR
calculations assume lognormality them even more so. I am hopeful
that regulatorswithout any caveats, of course, the measurements
will understand the need for such markets to groware going to be
faulty. This is no different from any and not dismiss innovation in
these products as tooother assumption in the physical, biological
or social risky. As with most markets these days, the
expertisesciences. Modelling requires some simplications of in such
products in the regulatory bodies is somewhatcomplex reality; the
conclusions drawn are subject to limited. We need to think of ways
in which such skills the errors from these simplications. 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 makethe adjustments to the simple VaR concept using Q. One
of the casualties of the nancial crisisscenario analysis,
stochastic volatility adjustments, has been the exotic derivatives
market, a leadingextreme value analysis etc. Taking a nihilistic
view money spinner for trading desks. Most of these in these
matters is neither scientic nor practically exotics are OTC
products where the counterpartyuseful, 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 t 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 derivativesQ. 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 nancial
crisis are due to the failure of models, have a tendency to get
reversed. I suspect that a fewper se. After all, some of the
partners of LTCM years from now this experience will become less
andwere among the foremost nancial 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 lotforget 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
ofquite 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
betterignored in both instances. History is replete with 21. 22 THE
MONEY MANAGER | JUNE 2009instances of human beings ignoring the
lessons of Keynesians argue that public spending is more effective
prior experience. George Santayana said it best in histhan 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 TARPQ. With the massive inux of rescue packages, it
is to buy troubled assets so that banks can start would be rational
to assume that rising ination lending again. However, data shows
that the would be the rst side effect. What are your views lending
in the top 13 beneciaries of this programon the apparent stability
of the ination rate in the has actually gone down by more than USD
50US? What could be Feds policy reaction when the billion. There
are two questions: credit crisis reaches its end? a. Isnt TARP
essentially providingAt this point, no one is worried about an up
tick in subsidy to the nancial institutions by ination, provided we
can get out of this gloomy buying the troubled assets at a
mucheconomy situation, which may well last years in higher price
without any provisions for much of the industrialised world, with
collateral nationalizing them, and thus providingdamage everywhere,
including India and China. nothing in return to the tax
payers.Frankly, if ination goes up by 2% per year for theb. 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 troublednear-deation in the
US and many other countries. times and pushing the lending
agendaPerhaps 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 rst questions above is yes.
years away, perhaps longer. There is no excuse for the subsidy
given to the nancial institutions without the US taxpayer getting
much inQ. 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 nancial institutions. Combined
with the outsized empt future crises? How do we equip ourselves to
bonuses that are still being paid, the average person intide 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 nancial 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 importantwe have much information about what was
happening aspect of macroeconomics in the context of ain industry.
Todays students are far better informed recession, is a classical
conundrum. It is importantthan we were. Looking back, I realize how
nave we for individuals to be prudent in tough economic times were
about what to expect in our careers. and conserve their nances and
spending. At the same time, if everyone does this, the situation
for the wholeWith the benet of hindsight, I think the most economy
is going to get worse. This is precisely whyimportant lesson for
fresh graduates is to look beyond Keynes argued that only the
government can get thethe rst job, its rewards and opportunities,
and try to economy out of the hole in such a situation. Thetake a
longer term view. One has to look for jobs massive scal stimulus
proposed by President Obamawhere 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 ones nancial 22. 23 THE
MONEY MANAGER | JUNE 2009capital 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 ones career. The second lesson is
to stay away fromexplanations. The rst is that there are manifold
excessive specialization. While one has to acquireeconomic
opportunities in industry today, although depth in some area,
staying in a narrow eld, however they have dimmed somewhat in the
last few months. remunerative it may be, becomes less interesting
as timeThe 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 nancial services industry, particularly
like their teachers, which is rather sad. The last is that in Wall
Street, made the mistake of concentrating in amany students simply
do not know what a rich and narrow area. When the industry
imploded, their skillsatisfying career one can have as an academic.
I often set proved to be too narrow and nding another jobwish I
could communicate my own enthusiasm to the became difcult. The
third lesson in this increasingyoungsters in these institutions.
Without intending to global world is to develop inter-cultural
skills forsound 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 developThe
main reason I chose to become an academic this agility and could
not adapt to the changingwas 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 challengingthat 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 theirable 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 exibility 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 docould 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, IMishra 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 rst 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. 23. THE MONEY
MANAGER | JUNE 2009 sTUDENT aRTICLES cover story cover page 1st
Prize Extracting Alpha Using Behavioural FinanceAkhil Dokania,
Nitin Agrawal, Prabhudutta KarIIM Bangalore 2nd Prize New Monetary
Policy Tools - Innovative Policy Response to Financial MeltdownAjay
Jain, Atishay Jain, Sourav DuttaIIM Bangalore 24. 25 THE MONEY
MANAGER | JUNE 2009 Extracting alpha using Behavioral FinanceAkhil
Dokania,Nitin Agrawal,Prabhudutta Kar.[IIM Bangalore] Executive
Summary Literature Survey Behavioral EconomicsEconomics 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
inuence 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 rst 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 unlimited1. Overcondence: Most of us think that we are safe
selshness. Behavioral Finance deals with understandingdrivers or
are above average performers, which cant be true, and explaining
how certain cognitive errors or biasesand its certain that all of
us cant be above average. This inuence investors in their
decision-making process. overcondence may lead to excessive
leveraging, tradingand portfolio concentration. In this study, we
applied principles from the behavioural nance literature to shed
light on the merits of including 2. Information Overload: It has
been found that inputs from behavioral economics in business
decisionexperienced analysts are unaware of the extent to which
making, This study identies 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 effectivehave tendency to conform to the crowd because
they donot want to be an outcast. decision making followed by an
explanation of already proven anomalies in nancial markets. We went
on to4. Loss Aversion: This means people feel pain of loss test
these hypotheses on Indian markets and devisedtwice as much as they
derive pleasure from an equal gain. an innovative trading strategy
to exploit the cognitiveThis manifests itself into refusal by
traders to sell theirstocks in loss. biases to extract alpha
(superior returns) from the nancial 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 behaveconsistently with that commitment.
Those pressureswill cause us to respond in ways that justify our
earlierdecision. 25. 26 THE MONEY MANAGER | JUNE 20096. Anchoring:
This has most direct implications in the to the NPV of future cash
ows. Dividends and other nancial 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 denite trend of up to X and 1/8th, I sometimes
stopped buying, perhaps long-term reversal of returns in nancial
markets. If one hoping it would come back down. That thumb-sucking,
thecompares 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 stockpoor 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 company3. Short-term trends
(momentum) - Empirical studies is always better, etc. provide
evidence of short-term trends or momentum instock 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, itcompanies have earned higher returns than
the ones issued might be the case that the decision was actually
correct justby large companies. that it was momentary loss.5.
Predictive power of price-scaled ratios - There has 8. Vividness
Bias: People tend to underestimate lowbeen evidence that portfolios
of companies with low B/M probability events when they havent
happened recently, andratio have earned lower returns than those
with high ratios. overestimate them when they have.In addition,
stocks with extremely high E/P ratio are knownto earn larger
risk-adjusted returns than the ones with low 9. Failing to act: In
markets, where the dynamism is atE/P ratio. the root, failure to
buy/sell can be devastating. It arises from status quo bias, regret
aversion, choice paralysis and6. Predictive power of corporate
events and news - It information overload among others. is often
the case that stock prices overreact to corporateannouncements or
events. Having understood the principles of behavioral economics,
let us now look into the manifestation of such biases in realSome
of the reasons for existence of these anomalies world in terms of
nancial anomalies.are:1. Limited arbitrage- Opportunities for
arbitrage Financial anomalies in security prices nullication in
real-world securities markets are often Empirical studies of the
changes of stock prices haveseverely limited.unearthed several
phenomena that can hardly be 2. Investor beliefs There can often be
numerous explained using rational models and efcient marketpersonal
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 systematically3. Investor
preferences Most of the models are based earn higher average
returns than others, although theon the hypothesis that investors
evaluate gambles based risk prole of such stocks would be similar.
Some of on the Expected Utility framework. However empirical the
most widely accepted anomalies that have beenstudies 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 justied by rational models that equate
prices as equal Regret Aversion People often try to minimize 26. 27
THE MONEY MANAGER | JUNE 2009the 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 themIt can be seen that
the correlation levels are very low Are Indian Markets rational?and
hence it can be inferred that markets are not just Having studied
the different types of anomalies, we based on fundamental
information and lots of other Table 10 Lag 0.5y Lag 1y Lag 1.5y
Lag2y Lag2.5y Lag 3y Lag apr_99-98 0.1001-0.04450.0106 -0.0445
-0.0704 -0.04570.0863 oct_99-98 0.01370.0221 -0.0023-0.0194 -0.0131
0.0156 0.0180 apr_00-99 0.02970.0004 -0.01070.0004-0.0028
-0.0087-0.0085 oct_00-99
0.0388-0.0280-0.04680.00890.0187-0.0631-0.0018 apr_01-00
0.00740.0082 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
-0.02360.0066 -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
0.0238-0.00740.0015 -0.0074 -0.0193 -0.03240.0282 oct_03-02
0.02130.0121 -0.0183-0.0264 0.0102-0.0152-0.0107 apr_04-03 -0.0001
0.0077 0.0235 0.00770.0008-0.00080.0065 oct_04-03 0.01970.0341
0.0109 0.00800.0035-0.0327-0.0235 apr_05-04 0.0292-0.00210.0029
-0.0021 -0.0043 -0.0066-0.0058 oct_05-04 0.02070.0620 0.0109
-0.0248 -0.0072 0.0047 -0.0148 apr_06-05 0.00270.0090 0.0019
0.00900.0014-0.0129 oct_06-05 -0.0052 -0.00180.0083 0.0050-0.0115
apr_07-06 0.0923-0.1566-0.0662-0.1566 oct_07-06
0.1928-0.0251-0.2220 apr_08-07 0.0216-0.0218 oct_08-07 0.0978 test
the extent of rationality in the Indian markets. information need
to be considered. Since stock prices are nothing but present value
of Testing anomalies in the Indian scenario expected future cash
ows, 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 305stock 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 dened companies
as small, mid and large based 27. 28 THE MONEY MANAGER | JUNE 2009
Figure 1: Variation in Correlation with time on average market
capitalization:their returns. To be more specic stocks with low
book Small - 1000 croreData: 5 years (2003-2008) data of 361
companies from BSE Returns = 0.2log(P2008/P2003)500. Results are as
shown in Table 1.Results are shown in Table 2. Inference: We see
that there is a clear trend of smallInference: As we can see there
is no distinct trend that companies giving a distinctively high
return as comparedrelates the returns of a rm with its book value
to market to large companies. However the distinction in terms
ofvalue ratio. Hence we cannot conclusively state if there returns
is much more blurred between mid size companiesexists any anomaly
in the Indian stock market. and Large companies3. Long term trend
reversals 2. Predictive power of price scaled ratiosEmpirical
studies abroad have identied a denite trend of Some of the
empirical studies abroad have found a distinctivelong-term reversal
of returns in nancial markets. If one relation between the book to
market ratio of stocks andcompares the performance of two groups of
companies: Table 2 Size No of companies Average of Return Large204
6.4% Mid134 6.2% Small2313.4%Table 3 B/M Buckets No of
companiesAverage of Return1.062 4.0% 28. 29 THE MONEY MANAGER |
JUNE 2009extreme loser companies and extreme winners, then theto
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 theapplication of behavioral economics in nance and tried
Data: 10 years (1998-2008) data of 305 companies fromto identify
the anomalies in security prices and the possible BSE
500explanations that behavioral nance 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 performedmarket data. Analysis
indicated that some of the biases the testing assuming we were in
2003. We computed returnsworking 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
analysisQuotations 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, nancier, businessman) replied: nance. Then we went short
on the 90th to 70th percentile that It will uctuate. is companies
that had been providing very high returns and hence were expected
to provide low returns in the future.Dont try to buy at the bottom
and sell at the top. It We went long on the 30th to 10th percentile
companies thatcant be done except by liars.Bernard Baruch
(1870-1965) nancier & economist are companies that were
providing very low returns and hence were expected to give high
subsequent returns. WeWith an evening coat and a white tie,
anybody, even a left the middle 40% as they could not be
categorized asstock 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
rst step to prove the point that markets indeed witness long-term
reversal. Thus, we can exploit this human tendency, which makes the
regression to the mean a recurring phenomenon. Conclusion This
paper identies the concepts of behavioral economics and the
different biases that decision subconsciously suffers from. Having
identied the common mistakes that decision makers often make and
the traps they fall into, the papers identied 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 ndings tend 29. 30
THE MONEY MANAGER | JUNE 2009 New Monetary Policy Tools Innovative
Policy Responseto Financial Meltdown Ajay Jain, Atishay Jain,Sourav
Dutta[IIM Bangalore]Executive Summary:used by the Fed.The nancial
crisis which began in 2007 resulted in The Financial Crisis a
severe liquidity crisis that prompted a substantial The subprime
mortgage crisis is an unprecedented injection of capital into
nancial markets by the United crisis that threatens the stability
of the world nancial States Federal Reserve. markets and the
economy of the US. The real trigger The Fed tried using
conventional policy tools like thefor the turmoil came on Thursday,
9 August 2007, when open market operations and discount window
withoutthe large French bank BNP Paribas announced that it
signicant improvements. As a remedy, the Fed would close three of
its funds that held assets backed introduced three new policy
instruments: the Term by US subprime mortgage debt. As a
consequence of Auction Facility (TAF), the Term Securities Lending
this, overnight interest rates in Europe shot up. Since Facility
(TSLF), and the Primary Dealer Credit Facility then, the money
markets have experienced a rather (PDCF). All these actions
distribute liquidity to the unusual nancial crisis, with most risk
measures, such segments of the nancial markets facing shortages.as
the LIBOR-OIS spread which is considered to be a TAF especially
generated a lot of interest among themeasure of interbank funding
pressure, substantially primary dealers, and was a key monetary
tool used bywidened and made highly volatile. the Fed to lower the
extent of the crisis. The two effects of TAFmeeting banks immediate
funding demands Failure of Conventional Tools and reassuring
potential lenders of their future access In response to the rapidly
deteriorating nancial to fundsboth worked in the direction of
reducing conditions, central banks around the world initially
liquidity risks of banks, increasing transaction volumesresorted to
the conventional monetary policy toolbox. and values, and reducing
market interest rates. The tools used by Federal Reserve to inject
liquidity These new tools are exible in terms of the durations into
the market could not adequately address the of the loans, the size
of the loans, the safety of theunusual nancial market distress this
time. collateral and availability. Hence, they have the potential
Open Market Operations are the most powerful and to become a part
of the permanent monetary tools 30. 31 THE MONEY MANAGER | JUNE
2009frequently used among all tools used by the Federal The New
Tools Reserve, however, during the current nancial turmoil,Term
Auction Facility (TAF) a heightened reluctance of banks to lend to
each The TAF is a credit facility that allows depository other in
the inter-bank money market interrupted this institutions (e.g.
commercial banks) to borrow from process and led to a credit
crunch. the Fed for 28 days against a wide variety of collateral.
The second tool used by the Federal Reserve toThough this policy
can potentially lead to an increase infuse liquidity is the
discount window. In response to in bank reserves and ultimately
also the monetary base, the soaring strains in the money market,
the Federalthe Fed conducts open market operations (OMOs) to
Reserve narrowed the discount rate premium, fromcounteract unwanted
increases (or decreases) in the 100 basis points to 25 basis
points. The terms of loans monetary base by selling Treasury
securities to exactly through discount window were also extended to
ninetyoffset this increase. days. These measures were taken to
encourage banks The Federal Reserve uses TAF to auction set amounts
borrowing through the discount window. However, of
collateral-backed short-term loans to depository their effects had
been modest, due to the so-called institutions, which are judged by
their local reserve stigma problem: during a nancial crisis, the
banks banks to be in sound nancial condition. Participants may be
reluctant to borrow from the discount window, bid through the
reserve banks, with a bid that has its worrying that such actions
would be interpreted by minimum set at an overnight indexed swap
rate relating the market as a sign of their nancial weakness, which
to the maturity of the loans. The nancial institutions would reduce
their ability to borrow from the market.Figure 1: Rise in 3-month
Libor-OIS Spread are allowed by these auctions to borrow funds at a
rate below the discount rate. The TAF offers an anonymous source of
term funds without the stigma attached to discount window
borrowing.The TAF represents an improvement with respect to
repurchase agreements in their capacity to provide liquidity.
First, the range of collateral it accepts is widened from General
Collateral to discount window collateral. Second, by providing
funds for a longer term, it eliminates the need to roll over the
loans every day or every week. And third, unlike discount window
loans, the money goes to the institutions that value it most as
While well-established mechanisms existed for the interest rate is
determined in the marketplace. injecting reserves into a countrys
nancial system, Term Securities Lending Facility (TSLF) ofcials had
no way to guarantee that the reserves will reach the banks that
need them. As it became apparent The TSLF permits primary dealers
to borrow Treasury that conventional tools were not effective
enough securities against other securities as collateral for 28 in
addressing unusual nancial distress, the Federaldays. The range of
securities, which can be used as Reserve introduced new facilities
to provide liquiditycollateral, is wider than for the TAF. The TSLF
is a to the market.bond-for- bond form of lending and it affects
only the composition of the Feds assets without increasing total
reserves. 31. 32 THE MONEY MANAGER | JUNE 2009In exchange for the
collateral, the primary dealersbond form of lending. To prevent
PDCF operations receive a basket of Treasury general collateral,
which from increasing the monetary base, the Fed offsets the
includes Treasury bills, notes, bonds and ination-increase with a
sale of Treasury securities as in the case indexed securities from
the Feds system open market of TAF. With the PDCF the Federal
Reserve has in account, extending the range of acceptable
collateraleffect opened the discount window to primary dealers.
beyond Treasuries. This facility allows the Fed to offer liquidity
assistancedirectly to certain major investment banks that were The
main advantage of TSLF is that it doesnt involvepreviously
ineligible. The new Credit Facility increases the any cash since a
direct injection of cash can affect thescope of rms in transitory
distress that may be supported federal funds rate and also have a
downbeat impactthrough Fed liquidity injections. on the value of
the dollar. TSLF also serves as an alternative to the direct
purchases of the mortgaged By October 08 end, Fed carried $301
billion of TAF investors, which goes against the aim of the Federal
on balance with a further $600 billion auction fund Reserve to
avoid directly affecting security prices. scheduled for November
and December, $169 billionof PDCF and $200 billion of TSLF on
balance. Table1 compares the main features of these three
newliquidity facilities with those of the regular open
marketoperations and the discount window. Figure 2: The TSLF
lending program and intendedeffects on credit marketsThe Open
Market Trading desk operates the term securities lending facility.
It holds auctions on a weekly basis in which dealers submit
competitive bids for the basket of securities in increments of $10
million. The primary dealers may borrow up to 20% of the announced
amount at the discretion of the Federal Reserve. Primary Dealer
Credit Facility - PDCFThe PDCF is an overnight loan facility that
provides funding for up to 120 days to primary dealers in Figure 3:
Composition of Feds Assets exchange for collateral at the same
interest rate as the discount window does. The PDCF accepts a
broader range of securities than the TSLF and is a
cash-for-Acceptance of TAF over others 32. 33 THE MONEY MANAGER |
JUNE 2009 Table 1: Comparison of various policy tools Though all
the three tools introduced by Fed had anFrom 17th December, 2007 to
21st April, 2008, the Fed impact of easing the liquidity, TAF by
far was the mostcompleted ten auctions in the facility. The amount
of active and successful tool. Instead of calling for banks term
loans auctioned was $20 billion in each of the to come to the Fed
to request a discount window loan,rst two auctions, $30 billion in
the next four auctions, under the TAF the Fed auctions a
predetermined and $50 billion in the last four auctions. There was
amount of funds amongst the participants. Second,high demand for
funds at the auctions. The number instead of paying the primary
credit rate, depositoryof banks bidding for the term loans in the
TAF varied institutions that borrowed under the TAF paid thebetween
52 and 93 and the bid/cover ratio (i.e., the stop-out ratethe
lowest bid rate t