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