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AN IIMA, IIMB, IIMC Initiative | June 2009




Also See > K V Kamath: ICICI, the Road Ahead > Interview: Prof. P. Mohanram, Columbia Univ > Indian Stock Market: Microstructure > Behavioral Finance: Extracting Alpha > Financial Meltdown: Monetary Policy Tools

Climbing out of the Crisis?


While 2008 was not a particularly great year for the World financial markets, by the middle of 2009 there seems to be some real hope. The surprising outcome of the Indian Elections has given an impressive boost to the Indian markets, even as the global economy seems set for a long and painful recovery. The fall of auto giants GM and Chrysler indicated that the US economy still has some way to go before it has seen the worst of this crisis. The consensus amongst strategists seems to be that things may worsen in short term before becoming better by the end of 2009. So the question staring all of us in face is whether 2009 would be the beginning of a new Dawn or could we be heading to the something akin to the Great Depression of 1930s.

The silver lining seems to be that Indian economy is on a firmer footing. We are now one of the fastest growing economies in the world. It seems India is destined to play a much greater role in world economics especially after the upheaval in US, Europe and their effects on China and Japan.

The second anniversary edition of “The Money Manager” brings you insightful interviews of Prof. Partha Mohanram of Columbia University who talks about the current financial crisis and how corporations should gear up for the next phase. We also had an opportunity to talk to Mr. K. V. Kamath, 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 in the current financial crisis, identifying successful hedge fund strategies for investing, new monetary policy tools, failure of TARP and climate change induced financial risks. As usual this issue is packed with challenging puzzles, crosswords, and interesting trivia. We hope you have a great time reading the latest issue of Money Manager.


Managing Editors:

Rajatdeep S Anand [IIMC]

Anuja Arvind Lele [IIMC] Devdutt Marathe [IIMA] Piyush Soonee [IIMA]

Editorial Board

Ashutosh Agarwal [IIMA] Devendra Agarwal [IIMC] Divya Devesh [IIMC]


Majid Asadullah [IIMC] Abhishek Nagaraj [IIMC]

Coordination Committee:

Shishir Agarwal [IIMC] Manu Jain [IIMB] Ravi Shankar [IIMA] Neha Verma [IIMB]

Corp. Communications:

Akshat Babbar [IIMA]


Jay Kumar Doshi [IIMC]

Saurabh Mishra [IIMA]


The Money Manager team would like to thank Prof. Ashok Banerjee, and Prof Anindya Sen for their constant support.

We would also like to express our heartfelt gratitude towards Prof. Partha Mohanram, Mr. K.V.Kamath and Prof. Marti Subrahmanyam for sharing with us their views during interviews. We are grateful to Dr. Golaka C. Nath and Prof. Malay K. Dey for their thought provoking articles.

We would like to thank Ashutosh Agarwal and Devdutt Marathe, for conducting the interview with Prof. Partha Mohanram; Akshat Babbar, Ashutosh Agarwal, Saurabh Mishra and Rohit Karan for interviewing Prof. Marti Subrahmanyam; and Nishant Mathur, Samrat Lal, Dhruv Dhanda and Tarun Agarwal for the interview with Mr. K.V.Kamath. We would also like to thank Rajatdeep Anand for interviewing Prof. Golaka C. Nath.

We thank Professor Ajay Pandey, Professor Sidharth Sinha, Prof. Joshy Jacob, and Prof. Samar Datta for adjudging the articles.

We would also like to acknowledge the sponsorship team consisting of Alok Srivastava, Ananya Mittal, Anuja Arvind Lele, Rajatdeep Singh Anand, Guhan M, Gaurav Lal, Abhishek Nagaraj, Divya Devesh, Jaykumar Doshi & Vishal Agarwal.



  • 06 An Interview with Prof. Partha Mohanram


  • 11 An Interview with K.V. Kamath


  • 15 Central Counterparty (CCP) - Role of Clearing Corporation of India Limited

  • 19 An Interview with Prof. Prof.Marti Subrahmanyam


  • 25 Extracting Alpha Using Behavioural Finance

  • 30 New Monetary Policy Tools - Innovative Response to the Meltdown

  • 36 CDS and CDS Pricing

  • 40 Climate Change Induced Financial Risks - A Strategic Approach

  • 50 Credit Default Swap Pricing: Empirical Results & Inferences

  • 55 Effectiveness of Basel II in the current financial crisis

  • 60 Identifying Hedge Fund Strategies for Investing in Emerging Markets

  • 69 MNC Delisting - Reaping the Benefits in 2009

  • 74 Failure Of Tarp And Solutions To The Banking Crisis

    • 78 Value Investing: Past Trends and Current Opportunities in India

c ONTENTS COVER STORY 06 An Interview with Prof. Partha Mohanram SPECIAL FEATURE 11 An Interview
c ONTENTS COVER STORY 06 An Interview with Prof. Partha Mohanram SPECIAL FEATURE 11 An Interview


  • 83 What do we know about the market microstructure of the Indian Stock Markets? - Malay K. Dey KNOW YOUR PRODUCT

  • 86 Barrier Options

c ONTENTS COVER STORY 06 An Interview with Prof. Partha Mohanram SPECIAL FEATURE 11 An Interview
c ONTENTS COVER STORY 06 An Interview with Prof. Partha Mohanram SPECIAL FEATURE 11 An Interview


cover story cover page

c OVER s TORY cover story cover page An Interview with Prof. Partha Mohanram Phillip H.

An Interview with

Prof. Partha Mohanram

c OVER s TORY cover story cover page An Interview with Prof. Partha Mohanram Phillip H.

Phillip H. Geier Jr. Associate Professor of Business, Graduate School of Business, Columbia University.

Partha Mohanram’s research has been published in the leading academic journals including the Accounting Review, Journal of Accounting Research, Journal of Accounting and Economics and the Review of Accounting Studies. His research has examined the valuation of Internet stocks, the calculation of cost of capital, the use of fundamental information in the valuation of growth stocks and the manipulation of earnings to maximize executive compensation. Mohanram teaches Financial statement analysis and valuation to MBAs and executive MBAs, with an emphasis on exposing students to the potential manipulations of financial statements. He also teaches in Columbia’s executive education programs. He is currently the coordinator of doctoral program for the accounting group, and has served on the dissertation committees of several students.




Q: We’ve seen the worldwide economic crisis continue to deepen over the last few months. How and when do you think will it abate, and what can governments do to prevent the losses from piling up?

A: It’s a crisis at many levels. It’s a fundamental crisis, a crisis of confidence, and a crisis of trust, depending on how you choose to look at it. It’s going to take a lot of time to abate. Despite all the attempts to free the financial markets through bailouts, etc., banks haven’t yet started the lending process. People are just biding their time – they’re too scared to do anything right now. In some sense, therefore, it’s almost like a self-fulfilling prophecy – it’s not going to get better because nobody thinks it’s going to get better. So to some extent, the only thing that can help really is the passage of time. With time, hopefully people will realize things are getting better, and that they can start stepping out again, slowly. In the immediate term, though, there is very little we can really do.

One of the things that we can see is that some countries are not as badly affected as some others. For instance, in Europe, if we look at Spain, they’ve managed to do better than England. One of the reasons for this is that they have counter-cyclical capital adequacy policies. Let’s say that the bank has a capital adequacy ratio of 6% normally. If the economy is doing really well, the adequacy ratio could be raised to, say, 8%. The logic here is that (a) you want to save for a rainy day, and (b) you want to prevent people from making bad, reckless choices because they believe that the good times are going to last forever. If you think of the big financial institutions, the big American and European institutions are in big trouble. Their market capitalization is down 50% or so, not 98%! One of the reasons is that they’ve borne the onerous burden of having extra capital adequacy requirements in good times, meaning that their balance sheets are much stronger. At the same time, they were constrained in making lending choices, which means that they have fewer bad loans on their balance sheets. So one of the things governments may want to do is to constitute these sorts of “negative feedback” measures to help stabilize the economy. Of course, it is too late to do this to solve the current crisis, but it might help prevent or dampen the next one.

A bailout of some sort is inevitable in most countries today. One cannot just say, “Let economic Darwinism take

its course” because the real effects – job losses in the auto sector for example, are too dramatic. So that’s something the governments will have to do. One can of course argue about what the appropriate mechanism is – should it be a capital infusion, or a buyback of bad loans – but that is simply a matter of detail. Something has to be done, and something was done.

Q: What about corporations? What can they do to survive, even thrive in this sort of environment? How can they prepare themselves for the next cycle?

A: You’ve probably heard this cliché, “Cash is King”. It’s unclear whether people mean that cash flows are more important than net income, or that it’s critical to have cash on the balance sheet. In this case, it’s clearly the latter. This might actually go against the textbook notions of shareholder value maximization – one doesn’t normally want companies to diversify unnecessarily and build up excess assets on their balance sheets that aren’t earning the required rate of return. What the current crisis has shown is that having some sort of buffer for bad times is in everybody’s interest, including the shareholder. Nothing good has come out of bankruptcy – the shareholders are essentially wiped out.

Going forward, companies that haven’t built up their reserves need to take cost cutting seriously, and try to conserve as much cash as possible. They should take a complete relook at their business and not build up any sacred cows – no business line is not subject to clean up or closure. A good analogy here is the Tata Nano. When Tata engineered the Nano, they essentially questioned every engineering element and asked, “Is this really required in a car?” That was how they were able to bring their costs down. There is of course no guarantee that they will continue to be able to do this going forward, but at least they have brought down the costs dramatically as of today. Similarly, corporations should look at their businesses in totality and ask, “Do we really need this? Can we do without it?” Hopefully this will lead to enough cost savings that companies can bide their time till the economy recovers.

One of the things to keep in mind is that it’s very human to assume that good times will last forever, when the economy is growing. The result of this is a string of bad decisions – over-investment, reckless spending, etc. We are equally prone to assuming that bad times will last forever, essentially




building up “doom and gloom” scenarios. The point here is that companies should not needlessly eliminate what makes them great, based on a myopic view of the economy. If you are an R&D-intensive company and your competitive advantage has always been your intellectual property, you shouldn’t start off saying “I need to cut my R&D costs”. Sure, you need to trim and rationalize where necessary, but you cannot eliminate them entirely – they are your raison d’être. It is therefore a really thin line – on one hand you need to cut costs, on the other, you need to preserve your competitive edge.

The other aspect companies need to learn is to pay close attention to the balance sheet. Unfortunately, in good times, we are constantly worried about the income statement – the earnings-per-share number is the most important. Companies therefore tend to lose sight of capital efficiency – Returns on Assets, for example. One of the more discomfiting implications of this is the prevailing practice of valuing companies on an EV/EBITDA type of basis, saying essentially that one doesn’t care about Depreciation and Amortization, which are nothing but proxies for investments in assets. This is one of the biggest fictions because you are then saying, “I don’t care how I use my assets”.

Q: What do you think about quantitative investment strategies particularly statistical arbitrage strategies of Renaissance and accounting-based strategies of firms such as Barclays Global Investors?

A: I wouldn’t put Barclays and Renaissance in the same league. Renaissance uses a bunch of data-mining and other tools without really going into the reasons or fundamentals based on which they work.

Barclays for example has always had a number of accounting experts on their professional staff. The head of Equity Research, till last year, was Charles Lee, who was a top academician with affiliations to Cornell, Michigan, etc. They also hired Richard Sloan, who was the first to document the “accrual anomaly”. Both of these guys are now back in academia – Sloan to Berkeley and Charles to Stanford.

As a whole, Quantitative Asset Management is a worthwhile field. The prospects in the short-run are unclear of course. What these professionals do well is to look at academic

research – there’s a large body of literature and researchers, myself included, who look at fundamental valuation issues and come up with what you can call trading rules or anomalies. Given that most of these people hold doctoral degrees themselves, they are well placed to understand the research, and convert it into something that they can use. Research papers normally ignore issues such as trading costs, shorting costs and other implementation details that can make these sorts of strategies infeasible.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre-empt future crises? How do we equip ourselves to tide over the current global meltdown?

A. Firstly, everybody has been fascinated by the world of Finance. I don’t say it’s categorically wrong, but you cannot just have people dealing with trading, paper income, investment banking and getting things together. Somebody has got to be doing the real stuff as well. Hopefully, what this [the current crisis] might do is to encourage people to do something more real and tangible. Career in Finance would be there but people have to start thinking in terms of other alternatives as well - something entrepreneurial or something in manufacturing etc. Don’t just pick up skills in Finance or Accounting; pick up skills in economy, in industries, in manufacturing, in services. Even if you were in Finance, you would be financing a particular industry. Just knowing fancy valuation techniques or how to price a derivative would not be enough in the world we are going to live in. I always tell my students, even in good times, here at Columbia that if you are a Finance guy, do some Marketing Course or Operations Course etc. Increasingly, having a generalist perspective would be far more important than remaining stuck in one area. In my class, we spend a lot of time looking at the market, things like Porter’s Five Forces, before going into the financial or accounting aspects.

Q. You have studied at IIM-A and done your PhD at Harvard. You have taught at Stern and are now teaching at Columbia. Can you share some thoughts on the IIM-A methodology of teaching, especially in Finance and Accounting, and contrasting that with your own experiences at Harvard, Stern and Columbia?





There are some essential similarities and some essential

differences. The principle of Finance, Accounting are the same everywhere. There is some difference in the pedagogy where some places there is a lot of focus on theory while at others it is mostly a case method of learning. IIM-A and Harvard follow very similar ways of teaching. At IIMA, we do have some classes where we start with some lecture and then move on to a case. Harvard has absolutely no lectures - every class is a case. Nobody is going to teach you anything - you are supposed to learn from the case. This is a slight difference of perspective, but is mostly unimportant.

going on. I argue that much of what is going on is because people don’t do things properly. People are thinking more in a mechanical way; Investment bankers are more concerned about their pitch books rather than worrying if the deal really makes sense or not. There is this lack of academic rigour. Through research, one can also affect what people do.

Academia is - as I put it - high risk, low reward. You would get a fraction of what you would be paid in the corporate world. Your rewards are things like you are the master of your own desk on a day-to-day basis. Once you get tenure at an

The main

thing is

about the students -



does not

academic institution, you get amazing amount of flexibility.

matter where you are taught and how you are taught.


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 grades etc. are pretty unimportant. You realize this only

accounting need a relook. Is it that we have gone away from the basics and we need to return to those or

after some years and you wonder why I was striving for

that we have to find new ways of dealing within these



is more

important to get the knowledge and


the understanding of



courses are



Not many people from the Indian B-Schools

A. There has been a lot of over quantification of issues that need to be done away with. People who don’t understand

choose to become academicians these days. What are your thought on careers in academia and industry (in Finance), especially in the light of the large number of lay-offs, collapses and semi-scandals that have plagued the financial services industry over the last year?

the industry, how a company works and don’t consider the mean effect are talking about the third moment and the fourth moment. People are getting into very complicated analysis when they don’t understand the basics. One needs to have more of an overall perspective and need to understand what the company is doing - before coming


Hopefully the fact that no one is going to academia from

up with any valuation model involved in the investment

PGPs would change - this is one of the few good things

about the downturn. People would start looking at areas they would not have looked otherwise. I am the Director of the PhD program at Columbia Business School and I can tell you that the number of applications have increased this year. Normally, we get around 60 applications - of which around 40 are from China and South Korea - and we admit 2-3 students in the program. This year we have received 85 applications. Usually, we shortlist 7-8 candidates for future consideration. This year I could not shortlist less than 16, because these were some exceptional candidates. These are from across the World, some from India as well.

People are looking at academia, not necessarily because there are no jobs out there. I am sure there would be sufficient opportunity available to the exceptional candidates. People see that a lot of stuff that is happening in the real world is just random and arbitrary. So, lets just understand what is

decision. The problem with these valuation models is that people start making them based on some numbers without paying attention to qualitative issues.

In a valuation model, it is mostly the question of the how you calculate the terminal value. There are other methods such as abnormal earnings or residual income methods, which I would encourage one to use rather than DCF. All valuation models are ad hoc at certain level, but the extent of ad-hoc-ness is ridiculous in DCF. Basically, one can come up with any answer in DCF. Also, the practice of looking at different scenarios in DCF is just looking at numerical scenarios (changing numbers) and not looking at economic scenarios. This is what needs to change.

Q. In India, we saw a recent discovery of an accounting fraud that happened at Satyam. How would / should




accounting, regulatory practices change to pre-empt this sort of event from occurring or do you think that it is bound to happen and the regulations can only be reactionary?

  • A. This is difficult to answer given the news is still unraveling.

We are not yet sure what kind of scandal we are seeing here.

What is important is having an overall understanding of the company, the economic situation before making any judgments. From what I understand, Satyam used to always undercut its opponents in contracts. It would always be the lowest bidder and yet pay the same salaries as everybody else. Yet it was as profitable as its competitors. One should ask that how is this possible. This kind of overlooking comes from the lack of taking an overall perspective.

Changes in regulations are definitely required. For e.g. auditors would start relying more on actual due diligence rather than say, just a bank statement. The regulations are already in place. Satyam being a U.S. listed firm - they would be subject to the regulations under the Sarbanes Oxley Act. They would have to face up to these and rightly so.

The other issue is that there would be a lot of reaction - not only for India but the entire Emerging Market space. Either the liquidity would just stop or the risk premium would go up significantly. There is a serious chance of loss of capital.

However, all regulations would have to be a bit of reactionary.

  • Q. B-schools like Columbia have been facing issues

with their endowments. What kinds of strategies are being looked at to make the endowments a more sustainable income source?

  • A. These Endowments had some very good years - and

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.

you have now come to see were not so true? And you wish that you did not have those at that point of time. And that you would not like future batches to graduate with that notion.

A. Actually, I cannot think of anything. However, a few things I would like to mention. It is a very different world these days and the world changed after our batch. Our batch was the first batch to have McKinsey come to campus. For us, the concept of international job markets did not exist. There was no course on derivates for they were not there in the Indian markets. I remember doing an IP on Futures and Options, just to learn about them. With 2-3 years (1995- 96), a whole bunch of foreign placements happened and in that sense, things got pretty internationalized. Also, it might be fair to say, Finance completely took over the other professions. In our batch, people had the choice - whether they wanted to do a Finance job, or a Marketing job etc. But now, Finance has completely dominated everything else.

I would suggest, that whatever you are doing, always choose insight over skills - in coursework etc. Don’t think that I would be a trader and so I need this course to get a head start. Remember, any company is going to hire you because you are a smart person and they are going to teach you whatever is required for the job. But insights are something that cannot be taught. There is tendency, especially among MBA students to judge different courses. This is a very bad notion to have. You would realize after many years that some of the most important learning happens in these so- called soft courses. Because the thing that the hard courses teach you is something you can look it up in some text.










  • Q. When you graduated from IIMA, were there any

notions that you and your classmates held widely that


cover story cover page

s PECIAL F EATURE cover story cover page An Interview with Mr K.V. Kamath Managing Director

An Interview with

Mr K.V. Kamath

s PECIAL F EATURE cover story cover page An Interview with Mr K.V. Kamath Managing Director

Managing Director and CEO, ICICI Bank Limited

K V Kamath is currently the Managing Director and CEO of ICICI Bank, the

largest private bank in India

He is also a Member of the National Council of

.. Confederation of Indian Industry (CII). He was awarded the prestigious Padma Bhushan Award by the Indian Government in 2008. The Asian Banker Journal of Singapore had voted Mr. Kamath as the most e-savvy CEO amongst Asian banks. He was also awarded the Asian Business Leader of the Year at the Asian Business Leader Award in 2001. World HRD Congress in November 2000, voted him as the best CEO for Innovative HR practices.



  • Q. Under your leadership, ICICI has grown by

leaps and bounds. What in your view should the bank need to do, to make its image / perception as you would ideally like to see from a bank of that size?

Over the years, the growth of the bank would not have been possible without the DNA of passion and managing change ingrained in team ICICI. The market and our competitors, though often criticized for being ahead of its time, have usually endorsed the strategy of the bank through the years, in due course. We would continue to fashion our moves based on our assessment of market realities and our appetite for risk, and maintain a continuous communication with our stakeholders on the rationale for our strategies.

  • Q. The succession plans and the delegation of

responsibilities at top management level at ICICI, is a model for a large number of Indian companies. What is your view about these?

At ICICI, we believe in and encourage the spirit of enterprise of our young managers. Empowering through delegation allows managers to achieve their potential within the framework of the bank’s strategy. We follow a structured approach to identify and develop talent from an early stage and have, over the years, developed a rich talent pool that provides a ready capacity of leaders to spearhead our various initiatives and opportunities that arise.

It is by adopting a clear, transparent and structured approach to the process of selection and by involving significant stakeholders in the process, that we have been able to handle the process of succession planning well.

  • Q. In the financial sector, ICICI has a distinguished

record of women reaching top leadership positions, such as Ms Chanda Kochhar, who will succeed you as CEO, and Ms Shikha Sharma, CEO ICICI Prudential. What can be done to promote better

representation of women in the sector?

System based on the fundamental premises of meritocracy and gender neutrality, has enabled a lot of women managers in ICICI to compete with their male counterparts on an even footing and establish leadership positions based on their mettle. We are indeed, seeing an encouraging number of women occupying board seats in financial services companies, and strongly feel that a sense of fair-play encourages all to maximize their potential.

Q. What do you think can the industry and CII do to ensure something like the Satyam incident is not repeated? As the leader of one of the largest banks in the country, what do you think is the new role of independent directors and watchdogs to uphold corporate governance? What can the government do to incorporate stricter legislation that deters occurrences of further instances like Satyam from happening?

There are regulations and detailed code of conduct in place for the roles, duties and responsibilities of auditors and independent directors. The present framework, if adhered to, has sufficient checks and balances to easily prevent a fraud of such proportions. It is the responsibility of each participant to understand his responsibilities and perform his role in accordance with the code.

The regulator and the government have shown by their response in the present case that they would indeed act promptly and effectively if any violations / aberrations come to light.

Q. As we all know, ICICI Bank was caught up in the rumours sometime back and which also affected the share price. Reputation is of utmost importance for a bank as it can have severe impact on its ability to raise capital for day-to-day operations. What short and long-term steps would you recommend to a financial institution to take




under such situation?

Rumours are baseless and used by vested interests for their malicious ends. In the recent episode, when the confidence of our investors and depositors was threatened, we ensured that we kept all communication channels open at all times to restore their faith. As a trustee of public deposits, we have taken utmost care to communicate our true position and dispel the doubts on our reputation. The regulatory authorities should take firm action against the perpetrators of such crimes, as they could jeopardize the stability of the system.

Q. As the President of CII, are you satisfied with the measures taken by the government to abate the current slowdown? What would you like to see done further?

The Central Bank and the government have through use of tools under monetary and fiscal policy, eased the transition pain as the economy adjusts from a high demand-high-cost structure to a low demand– low cost one. The various measures have ensured enough liquidity in the system, as also made it easier for companies to undertake business and financial restructuring.

Going forward, we would like to see a greater focus on infrastructure, both by way of increased spending on its committed plans as also increased flow of funds to the sector through the public-private partnership route.

Q. The financial






witnessing a huge transition. What is ICICI advising its clients to do, in order to brace themselves for this change?

As a result of the challenges being faced in the financial sector, the real sector is facing a liquidity and credit squeeze. This puts tremendous pressure on companies for meeting their cash flow requirements for operational and committed capital expenditure purposes. Companies are indeed working to re-

orient their strategies with a much greater emphasis on liquidity, risk containment and continuous cost optimization, to tide through this and future crises.

Q. There have been few instances of consolidation in the Indian banking system, perhaps largely due to strict regulatory controls. With the emergence of a strong counterbalance in foreign & private banking, do you believe that this is about to change?

Any merger or acquisition has to be driven by strong business rationale of scale, complementarily or synergies. In the Indian banking space, there is no mandate to privatize the public sector banks. Within the private sector, three banks have built up meaningful scale and any further consolidation would need to be based on strategic rationale and synergies.

Q. With the fall in equity markets, the ULIP market has dried up, affecting ICICI Prudential which has been losing market share in the past few months, especially to SBI Life Insurance. What is your strategy for ICICI Prudential in the coming months?

The ULIP product has seen a slowdown in growth, in line with the weakening equity market. This has affected all players, including ICICI Prudential. However, ULIP, as a product, continues to appeal to customers who favor transparency and flexibility in their insurance purchase, and there would be a continued market for the same. ICICI Prudential has achieved a leadership position in the private insurance space by a wide margin by investing in a robust distribution network. Going forward, it is best positioned to leverage this strength to offer diverse products in the protection, health and investment categories. Combined with its focus on cost- optimization, ICICI Prudential is well set to continue to be the leader in the private insurance space. ICICI Prudential has, unlike some other players, not focused on the single premium product, preferring to position life insurance as a combination of protection and long




term savings.

Q. With interest rates expected to remain in single digits through 2009, what are the steps ICICI Bank is planning to take to protect its net interest margins (NIM)?

The softening of interest rates would reduce the cost of our wholesale funding. Besides, with our expanded branch network of 1400 branches, and proposed addition of 580 branches in the coming year, we would be able to garner a larger share of low cost deposits by way of savings and current accounts. Together, this would mean significant lowering of funding costs, which would hold the key to protecting our margins in a low-interest rate cycle.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre- empt future crises? How do we equip ourselves to tide over the current global meltdown?

Focusing on one’s skills and strengths, and creating a value proposition for oneself based on such assessment, is a strategy that works well through both good and not-so-good times. Given the inherent fundamentals and the resilience of our economy, its only a matter of time before the economy is back on its growth trajectory. Accordingly, as always, young minds should 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

Did You Know?

14 THE MONEY MANAGER | JUNE 2009 term savings. Q. With interest rates expected to remain

The Lipstick Theory:

This theory say’s that lipstick purchases are a way of measuring the economy.

During times of economic uncertainty, women load up on affordable luxuries as a substitute for more expensive items like clothing and jewellery. This phenomenon is called The Lipstick Effect. The theory was first identified in the Great Depression, when industrial production in the US halved, but sales of cosmetics rose between 1929 and 1933.

However as a theory, it was proposed by Leonard Lauder, chairman of Estée Lauder Companies. After the terrorist attacks of 2001, which affected the U.S. economy on a large scale, Lauder noted that his company was selling more lipstick than usual.

During the Second World War the German Operation Bernhard attempted to counterfeit various denominations between £5 and £50 producing 500,000 notes each month in 1943. The original plan was to parachute the money on Britain in an attempt to destabilize the British economy, but it was found more useful to use the notes to pay German agents operating throughout Europe -- although most fell into Allied hands at the end of the war, forgeries were frequently appearing for years afterward, so all denominations of banknote above £5 were subsequently removed from circulation

- Compiled by Satwik Sharma, IIM Calcutta


cover story cover page

e XPERT o PINION cover story cover page Senior Vice President, CCIL, Mumbai Dr. Golaka C.

Senior Vice President, CCIL, Mumbai

Dr. Golaka C. Nath

e XPERT o PINION cover story cover page Senior Vice President, CCIL, Mumbai Dr. Golaka C.

Central Counterparty (CCP) – Role of Clearing Corporation of India Limited




CCPs occupy an important place in securities settlement systems (SSSs). A CCP interposes itself between counterparties to financial transactions, becoming the buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial stability. A CCP has the potential to reduce significantly risks to market participants by imposing more robust risk controls on all participants and, in many cases, by achieving multilateral netting of trades. It also tends to enhance the liquidity of the markets it serves, because it tends to reduce risks to participants and, in many cases, because it facilitates anonymous trading.

The Recommendations for CCPs by the CPSS-IOSCO Technical Committee are:

  • 1. Legal risk

A CCP should have a well founded, transparent and

enforceable legal framework for each aspect of its activities in all relevant jurisdictions.

  • 2. Participation requirements

A CCP should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP.

  • 3. Measurement and management of credit


Through margin requirements, other risk control mechanisms or a combination of both, a CCP should limit its exposures to potential losses from defaults by its participants in normal market conditions so that the operations of the CCP would not be disrupted and non-defaulting participants would not be exposed to

losses that they cannot anticipate or control.

  • 4. Margin requirements

If a CCP relies on margin requirements to limit its

credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions.

  • 5. Financial resources

A CCP should maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

  • 6. Default procedures

A CCP’s default procedures should be clearly stated and publicly available, and they should ensure that the CCP can take timely action to contain losses and liquidity pressures and to continue meeting its obligations.

  • 7. Custody and investment risks

A CCP should hold assets in a manner whereby risk of

loss or of delay in its access to them is minimised.

  • 8. Operational risk

A CCP should identify sources of operational risk and minimise them through the development of appropriate systems, controls and procedures.

  • 9. Money settlements

A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants.

  • 10. Physical deliveries

A CCP should clearly state its obligations with respect

to physical deliveries. The risks from these obligations should be identified and managed.

  • 11. Risks in links between CCPs

CCPs that establish links either cross-border or domestically to clear trades should evaluate the potential sources of risks that can arise, and ensure that the risks are managed prudently on an ongoing basis.

  • 12. Efficiency

While maintaining safe and secure operations, CCPs

should be cost-effective in meeting the requirements of participants.

  • 13. Governance

Governance arrangements for a CCP should be clear and transparent to fulfill public interest requirements and to support the objectives of owners and participants.

  • 14. Transparency

A CCP should provide market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using its services.




15. Regulation and oversight

A CCP should be subject to transparent and effective regulation and oversight.

Overview of CCP’s risks and risk management Risks

Many CCPs face a common set of risks that must be controlled effectively, though exact risks that a CCP must manage depend on the specific terms of its contracts with its participants. There is the risk that participants will not settle obligations either when due or at any time thereafter (counterparty credit risk) or that participants will settle obligations late (liquidity risk). If a commercial bank is used for money settlements between a CCP and its participants, failure of the bank could create credit and liquidity risks for the CCP (settlement bank risk). Other risks potentially arise from the taking of collateral (custody risk), the investment of clearing house funds or cash posted to meet margin requirements (investment risk), and deficiencies in systems and controls (operational risk). A CCP also faces the risk that the legal system will not support its rules and procedures, particularly in the event of a participant’s default (legal risk). If a CCP’s activities extend beyond its role as central counterparty, those activities may amplify some of these risks or complicate their management.

Approaches to risk management

CCPs have a range of tools that can be used to

manage the risks to which they are exposed, and the tools that an individual CCP uses will depend upon the nature of its obligations. The most basic means of controlling counterparty credit and liquidity risks is to deal only with creditworthy counterparties. CCPs typically seek to reduce the likelihood of a participant’s default by establishing rigorous financial standards for participation. This is done through maintenance of minimum capital requirements, minimum acceptable rating, trading limits to control potential losses, posting of collateral to cover losses, specific liquidity requirements for participation and reporting and monitoring programmes. Margin system and stress tests to assess the adequacy and liquidity of financial resources are other techniques available to a CCP to mitigate credit and liquidity risks. Settlement risk is eliminated by using the central bank of issue, while custody risks can be limited by carefully selecting 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

a well founded legal framework that supports each aspect of a CCP’s operations. Safeguards against operational risk include programmes to ensure adequate expertise, training and supervision of personnel as well as establishing and regularly reviewing internal control procedures.

CCIL’s role as a CCP in the Indian Fixed Income and Forex Market

CCIL was set-up on April 30, 2001 as per the recommendations of the committee constituted by Reserve Bank of India as a CCP for the clearing and settlement of trades in Government Securities, Forex and Money Markets. CCIL currently provides guaranteed settlement and is a central counter-party to every accepted trade in Government Securities, Forex (USD-INR) and CBLO (Collateralised Borrowing and Lending Obligation) segment and offers settlement on non-guaranteed basis to IRS trades in the Indian market.

The settlement operations in CCIL are based on the concept of multilateral netting and novation by a central counterparty for a transaction in the OTC as well as anonymous order driven markets. Multilateral netting involves aggregating member’s obligation to pay or receive funds arising out of every single transaction and offsetting it into a single net fund obligation. CCIL has applied the concept of novation at a central counterparty in the fixed income and the currency markets. Under novation, CCIL becomes the central counterparty to the trade by replacing the trade between the two members. In addition to substantially reducing individual member funding requirement, such netting reduces liquidity and counterparty risk from gross to net basis. By reducing the overall value of payment between its members, CCIL has enhanced the efficiency of the payment system and reduced settlement costs associated with growing volumes of market activity.

The earlier instances of ‘gridlock’ and ‘SGL bounce’ have become history after CCIL came into the settlement arena. Due to CCIL’s multilateral net settlement processes, the total counter-party exposures of all settlement participants (i.e., by the entire system) on account of the settlement risk has come down by about 93% on an average.




Risk Management at CCIL

In order to offer guaranteed settlement in the various segments and to manage all incidental associated risks, CCIL has put in place elaborate risk management processes. The risk management process has been designed to address the risk in each segment of the market where CCIL provides its settlement services. In case of securities settlement, market risk is managed through collecting margins like Initial Margin, Mark to Market Margin, Volatility Margin etc. Liquidity risk is managed through Lines of Credit from various banks to enable it to meet any shortfall arising out of a default and through the Settlement Guarantee Fund and a security borrowing arrangement. CCIL has a well designed back testing model for assessing efficiency & adequacy of the adopted method for margining process and a stress testing model to compute the potential losses.

In the forex segment, risk management is ensured through strict membership norms, exposure limits, well defined process for default handling, Lines of Credit etc. In the CBLO segment, risk management is facilitated through initial margin maintenance and pre- set borrowing limits.

CCIL’s risk processes are almost fully compliant with the recommendations of Committee on Payments and Settlement Systems of the International Organisation of Securities Commissions in respect of Risk Management for central counterparties.

- by Rajatdeep Anand, IIM Calcutta

18 THE MONEY MANAGER | JUNE 2009 Risk Management at CCIL In order to offer guaranteed

1) There are 1000 camels, all painted gold initially. Also, there are 1000 riders who, upon reaching a camel paint

it black if its gold or gold if

it is black, reversing the

color. The first rider goes to every camel, the second

rider goes to every second camel, and the third one goes to every third (3rd, 6th 9th) camel. The process goes on similarly for all others. How many camels would be painted black once all riders are done.

2) Given a coin with probability p of landing on heads after a flip, what is the probability that the number of heads will ever equal the number of tails assuming an infinite number of flips?

3) The king has 100 young ladies in his court each with an individual dowry. No two dowries are the same. The king says you may marry the one with the highest dowry if you correctly choose her. The king says that he will parade the ladies one at a time before you and each will tell you her dowry. Only at the time a particular lady is in front of you may you select her. The question is what is the strategy that maximizes your chances to choose the lady with the largest dowry?

4) Five ants are on the corners of an equilateral pentagon with side of length 1. They each crawl directly towards the next ant, all at the same speed and traveling in the same orientation. How long will each ant travel before they all meet in the center?

5) 100 bankers are lined up in a row by an assassin. The assassin puts either red or blue hats on them. They can’t see their own hats, but they can see the hats of the people in front of them. The assassin starts with the last banker and says, “what color is your hat?” The bankers can only answer “red” or “blue.” The banker is killed if he gives the wrong answer; then the assassin moves on to the next banker. The bankers in front get to hear the answers of the bankers behind them, but not whether they live or die. They can consult and agree on a strategy before being lined up, but after being lined up and having the hats put on, they can’t communicate in any other way. What strategy should they choose to maximize the number of bankers who will be surely saved?

6) Three ants on a triangle, one at each corner. At a given moment in time, they all set off for a different corner at random. What is the probability that they don’t collide?

- Compiled by Devendra Agarwal, IIM Calcutta


cover story cover page

e XPERT o PINION cover story cover page An Interview with Prof.Marti Subrahmanyam Charles E. Merrill

An Interview with

Prof.Marti Subrahmanyam

e XPERT o PINION cover story cover page An Interview with Prof.Marti Subrahmanyam Charles E. Merrill

Charles E. Merrill Professor of Finance & Economics, Stern School of Business, New York University

Prof. Marti G. Subrahmanyam is the Charles E. Merrill Professor of Finance, Economics and International Business in the Stern School of Business at New York University. He has published numerous articles and books in the areas of corporate finance, capital markets and international finance. He currently serves on the editorial boards of many academic journals and is the co-editor of the Review of Derivatives Research. He has served and continues to serve as a consultant to several corporations, industrial groups, and financial institutions around the world. Prof. Subrahmanyam serves as an advisor to international and government organizations, including the Securities and Exchange Board of India.




Q. In the current financial crisis, mostly complex Over-The-Counter derivative instruments have been blamed. What regulatory changes do you foresee in this area and how would this affect financial innovation in times ahead?

There is no doubt in my mind that the regulatory oversight of OTC derivatives is bound to grow in the years ahead. One major institutional development that is almost sure to occur is the creation of central clearinghouses for the most important derivatives such as those on credit, interest rates, and foreign exchange. Standardized derivatives products will gravitate to these markets by regulatory fiat or due to market forces. New exotic products will continue to trade over-the- counter, with clear guidelines regarding when they will move to the clearinghouses, based on size, complexity etc. This may be a reasonable compromise between the need to permit and encourage innovation, while containing the systemic risks that we have experienced in the recent financial crisis. I have laid out some of the details of the architecture in a white paper I contributed to a volume put together by the faculty at Stern, entitled “Centralized Clearing for Credit Derivatives,” in “Restoring Financial Stability: How to Repair a Failed System”

Q. It is common knowledge that governments have played a central role in the current financial rescue efforts but it appears that they themselves are not entirely untouched by this crisis anymore. For instance, if we look at the CDS premium on the US government bonds, it has swelled from 0.1% to more than 0.5% during this crisis, which is a very high premium for a AAA rated government security. Are US government bonds really as safe as they are claimed by the rating agencies?

The simple answer is no. Several developments have taken place during the current financial crisis that no one would have forecast (except possibly my colleague Nouriel Roubini, who seems to have some special powers of divination!). I would have been extremely sceptical of any one who forecast that the CDS spread on the 10-Year US Treasury bond would be greater than that of a AAA corporate like GE only a year ago. 50 bps or more for US Treasuries and much more for the Japanese Government Bonds and UK Gilts was well outside any estimate I ever heard prior to September 2008, for the 5-year swap. The spreads of Eurozone Treasury paper over the most credit worthy

German bunds are anywhere from 100 to 250 bps, up from the 20-30 bps range. Prima facie, this means that the market thinks that there is a reasonable chance of default/restructuring for these instruments over the next five years. Given the explosion in the issue of new government paper – the additional amounts planned already run into trillions - this is not an unreasonable conclusion. While no government needs to default on its nominal obligations in its own currency, it is entirely possible that political conditions will force some sort of restructuring of these instruments. Notice the substantially higher spreads for large economies such as Italy or Spain, since they have handed over the authority to print money to the ECB.

Q. This question is related to the US Dollar. As we have seen, the current account deficit of the US has touched unprecedented levels, interest rates have taken a nosedive and the economy is in a recession. Despite all these factors, and contrary to the claims by several analysts, the USD has not yet crashed. What factors, in your opinion, are supporting the USD at present and what future would you predict for it?

  • I generally do not make specific forecasts regarding

market variables, because these forecasts are not worth very much, in my experience. I will only say that given

the burgeoning deficits in the US, there is a long-term overhang on the US Treasury bonds and hence the

dollar. No one can say if or when the overhang will

drag the dollar down.

On the other hand, there is

no other market in the world, other than the German bunds to some degree, which can absorb a substantial part of global savings. Also, it is entirely possible that the productivity gains in the US economy in the next several years will outweigh this effect. Net net, I have no clue and I doubt that anyone else does as to what is going to happen to the dollar in the next few years.

Q. Many believe that the Indian derivatives market is under-developed and over-regulated, especially given the pace of development in the equities market. Is the current state of regulation justified in the Indian context? How must the regulators go about the task of development of

this market and what are the pitfalls they must watch out for?

  • I would not agree that the Indian derivatives market

is “under-developed and over-regulated,” across the board. First of all, one needs to make a distinction




between the exchange-traded and over-the-counter markets. In the case of exchange-traded markets, the most important underlying securities in India are those on individual stocks and equity indices. There is also limited trading in currency derivatives. I believe that the Indian equity derivatives market, particularly that for single stock futures contracts, is highly liquid and efficient. I also think that the regulatory oversight at the level of the exchanges, the NSE in particular, and the SEBI is strong. Indeed, I think the overall structure

of this market is as good as any other in the world, that

  • I know of. When it comes to OTC products, such as

interest rate and credit derivatives, the market in India is still in its infancy. The regulators are understandably cautious, and the recent events worldwide will make them even more so. I am hopeful that regulators will understand the need for such markets to grow and not dismiss innovation in these products as too risky. As with most markets these days, the expertise in such products in the regulatory bodies is somewhat limited. We need to think of ways in which such skills can be acquired by the professionals in bodies such as SEBI, the RBI, the FMC, and the MofF. The IIMs, in particular, can play an important role in this process of training and development.

Q. One of the casualties of the financial crisis has been the ‘exotic’ derivatives market, a leading money spinner for trading desks. Most of these exotics are OTC products where the counterparty risk is borne by the investment bank. Now, given the threat to the survival of investment banks how do you foresee the revival of ‘exotic’ derivatives?

  • I am not sure one can say that the exotic derivatives

market is dead for good, although such a prognosis today is quite understandable. Of course, market participants will continue to be reluctant to do complex deals for some time, because of the counterparty risks that have come to light, post-Lehman and especially, post-AIG. However, these market developments have a tendency to get reversed. I suspect that a few years from now this experience will become less and less of an issue and the market will be up and running as before. I should point out that even today, hedge funds, and some credit worthy corporations are doing complex deals, although cautiously and with a lot more collateral involved than before.

Q. A lot of people have criticised the concept of VaR. Nassim Nicholas Taleb calls it a ‘fraud’. What then, in your opinion, can be better

instruments of measuring risk, given the changes in the trading environment?

Nassim Taleb has grabbed the attention of the media by making controversial statements about markets, finance education and many other issues. In my opinion, he has said little that is new. Everyone in the business, both academics and practitioners, has been aware of “fat tails” and “stochastic volatility” for a long time. Saying that there are many events that fall outside the 3-sigma limits is simply a matter of saying that the commonly- made assumption of lognormality of returns is not correct, especially at the tails. No one would disagree with this simple statement. If the standard VaR calculations assume lognormality without any caveats, of course, the measurements are going to be faulty. This is no different from any other assumption in the physical, biological or social sciences. Modelling requires some simplifications of complex reality; the conclusions drawn are subject to the errors from these simplifications. Any application of the conclusions has to take these errors into account. In the absence of a clear alternative theory, one is forced to use the theory, with some degree of caution and adjustments. In practice, people make the adjustments to the simple VaR concept using scenario analysis, stochastic volatility adjustments, extreme value analysis etc. Taking a nihilistic view in these matters is neither scientific nor practically useful, although it may yield the proponent a lot of free publicity. When a model fails to fit the data, the prescription ought to be to go back to the drawing board, not stop modelling forthwith.

Q. People have been aware of model risk since the days of the LTCM crisis. Why did the banks still not make changes and repeated the same mistakes with credit derivatives?

I am not sure that the problems of LTCM or the recent financial crisis are due to the failure of models, per se. After all, some of the partners of LTCM were among the foremost financial economists of our times, including my teachers, Robert Merton and Myron Scholes. You can have the greatest model in the world, but if you put in the wrong inputs, or forget some of the key assumptions that are not quite right in practice, you are bound to make a big mistake. Also, there are several practical issues that are not quite in the model including liquidity, counter-party risk, freezing of funding etc, which were obviously ignored in both instances. History is replete with




instances of human beings ignoring the lessons of prior experience. George Santayana said it best in his

Q. TARP has been one of the most discussed topics recently. The main idea behind the TARP is to buy troubled assets so that banks can start lending again. However, data shows that the lending in the top 13 beneficiaries of this program has actually gone down by more than USD 50 billion. There are two questions:

a. Isn’t TARP essentially providing subsidy to the financial institutions by buying the troubled assets at a much higher price without any provisions for nationalizing them, and thus providing nothing in return to the tax payers. b. Why is there so much push towards increased lending given the fact that businesses and consumers are actually unlikely to borrow in these troubled times and pushing the lending agenda would only increase problems of adverse selection.

The simply answer to the first questions above is “yes.” There is no excuse for the subsidy given to the financial institutions without the US taxpayer getting much in exchange. At the end of the day, this whole bailout has been a complex political process, with the taxpayer being on the hook for essentially a blank cheque to the financial institutions. Combined with the outsized bonuses that are still being paid, the average person in the US is understandably outraged. I am sure that the situation will get corrected and the US government will end up owning substantial stakes in most of the major financial institutions in the country.

The second question, which relates to an important aspect of macroeconomics in the context of a recession, is a classical conundrum. It is important for individuals to be prudent in tough economic times and conserve their finances and spending. At the same time, if everyone does this, the situation for the whole economy is going to get worse. This is precisely why Keynes argued that only the government can get the economy out of the hole in such a situation. The massive fiscal stimulus proposed by President Obama is exactly in this direction. (It is also the reason that

Keynesians argue that public spending is more effective than a tax cut, since individuals may simply save the proceeds.) Similar packages will be implemented in all the major economies in the world, including India in the next few months.

Q. With the massive influx of rescue packages, it would be rational to assume that rising inflation would be the first side effect. What are your views on the apparent stability of the inflation rate in the US? What could be Fed’s policy reaction when the credit crisis reaches its end?

At this point, no one is worried about an up tick in inflation, provided we can get out of this gloomy economy situation, which may well last years in much of the industrialised world, with collateral damage everywhere, including India and China. Frankly, if inflation goes up by 2% per year for the next several years, that seems a small price to pay for digging ourselves out of the present deep crisis. If anything, the markets are signalling a long period of near-deflation in the US and many other countries. Perhaps that is an over-reaction, but few people see a quick end to the current deep recession. I am not sure the Fed is even thinking about when it will be able to tighten monetary policy. That is at least two to three years away, perhaps longer.

Q. What advice would you have for students of business schools who will soon be part of the industry? Do we need to learn things differently or learn different things to both adapt to and pre- empt future crises? How do we equip ourselves to tide over the current global meltdown?

I think back to what my classmates and I used to discuss when we were at IIMA. Most of us had no experience whatsoever. Even summer internships for undergraduates were scarce in those days. Nor did we have much information about what was happening in industry. Today’s students are far better informed than we were. Looking back, I realize how naïve we were about what to expect in our careers.

With the benefit of hindsight, I think the most important lesson for fresh graduates is to look beyond the first job, its rewards and opportunities, and try to take a longer term view. One has to look for jobs where there is an opportunity to learn constantly. If there is a choice between maintaining one’s financial




capital and human capital, I think the balance should swing in the direction of human capital early on in one’s career. The second lesson is to stay away from excessive specialization. While one has to acquire depth in some area, staying in a narrow field, however remunerative it may be, becomes less interesting as time goes on. One must try to obtain a broader perspective as you advance in your career. Many who chose to go into jobs in the financial services industry, particularly in Wall Street, made the mistake of concentrating in a narrow area. When the industry imploded, their skill set proved to be too narrow and finding another job became difficult. The third lesson in this increasing global world is to develop inter-cultural skills – for example, language skills - that can come in handy as one moves to a different geographical or cultural setting. Many of my own classmates did not develop this agility and could not adapt to the changing circumstances even within India, not to speak about moving to another country seeking more challenging and rewarding opportunities. Last, but not least, one should maintain a balance between family and career. This seems to be an obvious point, but it is surprising how many people are so busy with their jobs that their children grow up and leave home before they realize it.

Q. How did you choose to become an academician? Not many people from the Indian B-Schools do the same these days. What advice would you have for them?

I graduated from IIMA four decades ago. It was a very different world. In my second year at IIMA, I applied to the leading PhD programs in the US and was accepted by almost all of them. I decided to defer my admission to gain some experience in industry. Opportunities for graduates of what was even then the most prestigious business school in the country were far fewer than today. I was lucky enough to get one of the plum jobs available then – I became the first IIM graduate to be selected for the Tata Administrative Service. Tatas treated me very well but I quickly realized that I would be far happier as an academic rather than an executive. My bosses at Tatas, including some of the directors of Tata Sons tried to dissuade me, but my mind was made up. Tatas were very generous with me and kept me on leave for almost four years even though I told them I did not intend to return! They also insisted on giving me a Tata scholarship, even though I already had a fellowship from MIT, where I went to for my PhD.

Turning to why many students today do not go through the academic route, I think there are several explanations. The first is that there are manifold economic opportunities in industry today, although they have dimmed somewhat in the last few months. The second is the lack of academic role models even in the elite academic institutions in India, such as the IITs and IIMs. Very few students want to become like their teachers, which is rather sad. The last is that many students simply do not know what a rich and satisfying career one can have as an academic. I often wish I could communicate my own enthusiasm to the youngsters in these institutions. Without intending to sound smug, I am thrilled to be a professor and prefer my job to anything else I have seen.

The main reason I chose to become an academic was to pursue a career where I could study and think independently. After I became a professor, I realized that I enjoyed teaching. Almost four decades later these reasons are still valid. It is a great privilege to be a professor, with the tremendous freedom and independence one enjoys. I have also been lucky to be able to combine this with involvement in the world of practice as a consultant and board member. I have had great flexibility in managing my time, for professional and family reasons. I feel really privileged to have

the best job in the world. At my age, many think, “I

could have

or I should have.” I am lucky to be one

... of those who can say, “I did what I wanted to do and

am thrilled to have had the opportunity to do it.”

- by Akshat Babbar, Ashutosh Agarwal, Saurabh Mishra and Rohit Karan, IIM Ahmedabad





cover story cover page

THE MONEY MANAGER | JUNE 2009 s TUDENT a RTICLES cover story cover page 1st Prize

1st Prize

1st Prize

Extracting Alpha Using Behavioural Finance

Akhil Dokania, Nitin Agrawal, Prabhudutta Kar IIM Bangalore


2nd Prize

2nd Prize

New Monetary Policy Tools - Innovative Policy Response to Financial Meltdown

Ajay Jain, Atishay Jain, Sourav Dutta IIM Bangalore




Extracting alpha using Behavioral Finance

25 THE MONEY MANAGER | JUNE 2009 Extracting alpha using Behavioral Finance
25 THE MONEY MANAGER | JUNE 2009 Extracting alpha using Behavioral Finance Executive Summary Economics is

Executive Summary

Economics is all about allocating resources, trade-off and making choices. Thus decision-making is central to every economic theory. All economic theories assume a very unrealistic model of human behavior. The assumptions made on the human behavior are that individuals have unlimited will power, unlimited rationality and unlimited selfishness. Behavioral Finance deals with understanding and explaining how certain cognitive errors or biases influence investors in their decision-making process.

In this study, we applied principles from the behavioural finance literature to shed light on the merits of including inputs from behavioral economics in business decision making, This study identifies situations which warrants use of behavioral factors and suggesting rational & irrational input variables to be considered for decision making.

We start by understanding the principles of behavioral economics and identifying factors affecting effective decision making followed by an explanation of already proven anomalies in financial markets. We went on to test these hypotheses on Indian markets and devised an innovative trading strategy to exploit the cognitive biases to extract alpha (superior returns) from the financial markets. The results are highly encouraging and prove the fact that markets are indeed irrational.

Akhil Dokania, Nitin Agrawal, Prabhudutta Kar.

[IIM Bangalore]

Literature Survey – Behavioral Economics

Behavioral economics attempts to explain how and why emotions and cognitive errors influence decision makers and create anomalies such as bubbles and crashes. To be able to exploit such anomalies, we first gain an understanding of the common factors which affect decision-making:

  • 1. Overconfidence: Most of us think that we are safe

drivers or are above average performers, which can’t be true, and it’s certain that all of us can’t be above average. This overconfidence may lead to excessive leveraging, trading and portfolio concentration.

  • 2. Information Overload: It has been found that

experienced analysts are unaware of the extent to which

their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information.

  • 3. Herd-like Behavior: It has been found that people

have tendency to conform to the crowd because they do

not want to be an outcast.

  • 4. Loss Aversion: This means people feel pain of loss

twice as much as they derive pleasure from an equal gain.

This manifests itself into refusal by traders to sell their stocks in loss.

  • 5. Commitment: Once we make a choice, we will

encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision.



  • 6. Anchoring: This has most direct implications in the

financial markets.

  • a. Anchoring on purchase price - As aptly described by

Warren Buffett “When I bought something at X and it went

up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. That thumb-sucking, the reluctance to pay a little more, cost us a lot.”

  • b. Anchoring on historical price - Refusal to buy a stock

today because it was cheaper last year or has a high price per


  • c. Anchoring on historical perceptions - Buying/selling

based on pre-conceived notions such as triple-A company

is always better, etc.

  • 7. Misunderstanding Randomness: People often relate

windfall gains with their good decision-making and confuse unexpected losses with their bad decisions. However, it might be the case that the decision was actually correct just that it was momentary loss.

  • 8. Vividness Bias: People tend to underestimate low

probability events when they haven’t happened recently, and

overestimate them when they have.

  • 9. Failing to act: In markets, where the dynamism is at

the root, failure to buy/sell can be devastating. It arises

from status quo bias, regret aversion, choice paralysis and information overload among others.

Having understood the principles of behavioral economics, let us now look into the manifestation of such biases in real world in terms of financial anomalies.

Financial anomalies in security prices

Empirical studies of the changes of stock prices have unearthed several phenomena that can hardly be explained using rational models and efficient market hypothesis. These facts, often termed as anomalies often bring to light the fact that some stocks systematically earn higher average returns than others, although the risk profile of such stocks would be similar. Some of the most widely accepted anomalies that have been proven are:

  • 1. Excessive Volatility of prices relative to fundamentals

- Stock market prices are often far more volatile than could

be justified by rational models that equate prices as equal

to the NPV of future cash flows. Dividends and other fundamentals simply do not move around enough to justify observed volatility in stock prices.

  • 2. Long-term reversals - There is definite trend of

long-term reversal of returns in financial markets. If one compares the performance of two groups of companies:

extreme loser companies (companies with several years of poor news) and extreme winners (companies with several successive years of good news), then the extreme losers tend to earn on average extremely high subsequent returns.

  • 3. Short-term trends (momentum) - Empirical studies

provide evidence of short-term trends or momentum in

stock market prices.

  • 4. Size premium - Historically, stocks issued by small

companies have earned higher returns than the ones issued

by large companies.

  • 5. Predictive power of price-scaled ratios - There has

been evidence that portfolios of companies with low B/M ratio have earned lower returns than those with high ratios. In addition, stocks with extremely high E/P ratio are known to earn larger risk-adjusted returns than the ones with low E/P ratio.

  • 6. Predictive power of corporate events and news - It

is often the case that stock prices overreact to corporate

announcements or events.

Some of the reasons for existence of these anomalies are:

  • 1. Limited arbitrage- Opportunities for arbitrage

nullification in real-world securities markets are often

severely limited.

  • 2. – personal beliefs of the investor which guide the way he

Investor beliefs

There can often be numerous

invests in the market:

  • 3. Investor preferences – Most of the models are based

on the hypothesis that investors evaluate gambles based on the Expected Utility framework. However empirical studies have shown that investors time and again violate the expected utility framework:







sensitivity to losses than to gains.

  • Regret Aversion – People often try to minimize




the trauma of having to take the responsibility of a poor investment decision.

  • Mental accounting – Investors frame situations and

problems in a way that is more desirable to them

Are Indian Markets rational?

Having studied the different types of anomalies, we

companies over a 10-year period. Correlations with different lags have also been provided. A graph has also been provided which depicts the same information. It can be seen that the correlation levels are very low and hence it can be inferred that markets are not just based on fundamental information and lots of other

Table 1


0 Lag

0.5y Lag

1y Lag

1.5y Lag

2y Lag

2.5y Lag

3y Lag


















































































































































test the extent of rationality in the Indian markets. Since stock prices are nothing but present value of expected future cash flows, hence we believe that stock prices should have high correlation with earnings. It can be contested that there is an inherent lag between when actually the earnings happen and when they are incorporated in stock prices. Hence we computed correlation between earnings and stock prices of 305 companies over 10 year periods. To account for lags, we computed correlation with lags of 0, .5 yr, 1 yr, 1.5yr, 2 yr, 2.5 yr and 3 yrs.

Result: The table below (Table 1) shows the correlation levels between earnings and stock price of the 305

information need to be considered.

Testing anomalies in the Indian scenario

Having inferred that Indian markets are not the most rational we tried to test the most common anomalies that have been observed in the western stock markets, in the Indian scenario. Mentioned below are some of the hypothesis tests we carried out with data from the Indian stock market:

  • 1. Size premium Hypothesis

It has been observed that returns from smaller companies

give higher returns as compared to larger companies.

Data: 5 years (2003-2008) data of 361 companies from BSE 500. We defined companies as small, mid and large based


Figure 1: Variation in Correlation with time

on average market capitalization:

Small - <250 crore Mid - 250-1000 crore Large - >1000 crore Returns = 0.2log(P 2008 /P 2003 )

Results are as shown in Table 1. Inference: We see that there is a clear trend of small companies giving a distinctively high return as compared to large companies. However the distinction in terms of returns is much more blurred between mid size companies and Large companies

  • 2. Predictive power of price scaled ratios

Some of the empirical studies abroad have found a distinctive

relation between the book to market ratio of stocks and

their returns. To be more specific stocks with low book to market ratio were supposed to provide lower returns as compared to stocks with high book to market ratio.

Data: 5 years (2003-2008) data of 361 companies from BSE


Results are shown in Table 2.

Inference: As we can see there is no distinct trend that relates the returns of a firm with its book value to market value ratio. Hence we cannot conclusively state if there exists any anomaly in the Indian stock market.

  • 3. Long term trend reversals

Empirical studies abroad have identified a definite trend of

long-term reversal of returns in financial markets. If one compares the performance of two groups of companies:

Table 2


No of companies


Average of Return












Table 3

B/M Buckets

No of companies


Average of Return

























extreme loser companies and extreme winners, then the extreme losers (winners) tend to earn on average extremely high (relatively poor) subsequent returns.

Data: 10 years (1998-2008) data of 305 companies from BSE 500 Returns = (P 2 – P 1 /P 1 )

Methodology: We implemented a trading strategy to test if there was a trend of long-term reversals. We performed the testing assuming we were in 2003. We computed returns over the last 5 years in 2003 (1998-2003) and sorted the companies based on the returns. Then we went neutral (neither long neither short) on the top 10%ile (extreme winners) and the bottom 10%ile (extreme losers). The major reason behind excluding these companies from the analysis was that their returns might have been affected by some major event (merger, foreign expansion etc) and hence they are not suitable to be studied for applications of behavioral finance. Then we went short on the 90 th to 70 th percentile that is companies that had been providing very high returns and hence were expected to provide low returns in the future. We went long on the 30 th to 10 th percentile companies that are companies that were providing very low returns and hence were expected to give high subsequent returns. We left the middle 40% as they could not be categorized as extreme winners or losers in the period of 1998-2003. We back tested our strategy in the period of 2003-2008.

Inference: We found that this strategy gives a whooping return of over 900% over 5-year period. This may be the first step to prove the point that markets indeed witness long-term reversal. Thus, we can exploit this human tendency, which makes the regression to the mean a recurring phenomenon.

to point towards the fact that markets are hardly driven by fundamental data because there is a low correlation between prices and earnings. It further delved deep into the application of behavioral economics in finance and tried to identify the anomalies in security prices and the possible explanations that behavioral finance provides for these anomalies. The later part of the paper dealt with trying to test the different established anomalies on Indian stock market data. Analysis indicated that some of the biases working in western markets also exist in Indian markets and they can be systematically analyzed and used to make superior returns than the market.

29 THE MONEY MANAGER | JUNE 2009 extreme loser companies and extreme winners, then the extreme


29 THE MONEY MANAGER | JUNE 2009 extreme loser companies and extreme winners, then the extreme

When asked what the stock market will do, J.P Morgan (1837-1913) (banker, financier, businessman) replied:

“It will fluctuate.”

“Don’t try to buy at the bottom and sell at the top. It can’t be done except by liars.” Bernard Baruch (1870-1965) financier & economist

“With an evening coat and a white tie, anybody, even a stock broker, can gain a reputation for being civilized.” Oscar Wilde (1854-1900) Poet & playwright

-- compiled by Shishir Kumar Agarwal, IIM Calcutta


This paper identifies the concepts of behavioral economics and the different biases that decision subconsciously suffers from. Having identified the common mistakes that decision makers often make and the traps they fall into, the papers identified things that need to be done for the decision to be most logical and rational.

Additionally, it tests the rationality of Indian stock market by computing correlations between stock prices and earnings of different companies listed in BSE 500. The findings tend




New Monetary Policy Tools

30 THE MONEY MANAGER | JUNE 2009 New Monetary Policy Tools
30 THE MONEY MANAGER | JUNE 2009 New Monetary Policy Tools Innovative Policy Response to Financial

Innovative Policy Response to Financial Meltdown

Ajay Jain, Atishay Jain, Sourav Dutta

[IIM Bangalore]

Executive Summary:

The financial crisis which began in 2007 resulted in a severe liquidity crisis that prompted a substantial injection of capital into financial markets by the United States Federal Reserve.

The Fed tried using conventional policy tools like the open market operations and discount window without significant improvements. As a remedy, the Fed introduced three new policy instruments: the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). All these actions distribute liquidity to the segments of the financial markets facing shortages. TAF especially generated a lot of interest among the primary dealers, and was a key monetary tool used by the Fed to lower the extent of the crisis. The two effects of TAF—meeting banks’ immediate funding demands and reassuring potential lenders of their future access to funds—both worked in the direction of reducing liquidity risks of banks, increasing transaction volumes and values, and reducing market interest rates.

These new tools are flexible in terms of the durations of the loans, the size of the loans, the safety of the collateral and availability. Hence, they have the potential to become a part of the permanent monetary tools

used by the Fed.

The Financial Crisis

The subprime mortgage crisis is an unprecedented crisis that threatens the stability of the world financial markets and the economy of the US. The real trigger for the turmoil came on Thursday, 9 August 2007, when the large French bank BNP Paribas announced that it would close three of its funds that held assets backed by US subprime mortgage debt. As a consequence of this, overnight interest rates in Europe shot up. Since then, the money markets have experienced a rather unusual financial crisis, with most risk measures, such as the LIBOR-OIS spread which is considered to be a measure of interbank funding pressure, substantially widened and made highly volatile.

Failure of Conventional Tools

In response to the rapidly deteriorating financial conditions, central banks around the world initially resorted to the conventional monetary policy toolbox. The tools used by Federal Reserve to inject liquidity into the market could not adequately address the unusual financial market distress this time.

Open Market Operations are the most powerful and




frequently used among all tools used by the Federal Reserve, however, during the current financial turmoil, a heightened reluctance of banks to lend to each other in the inter-bank money market interrupted this process and led to a credit crunch.

The second tool used by the Federal Reserve to infuse liquidity is the discount window. In response to the soaring strains in the money market, the Federal Reserve narrowed the discount rate premium, from 100 basis points to 25 basis points. The terms of loans through discount window were also extended to ninety days. These measures were taken to encourage banks’ borrowing through the discount window. However, their effects had been modest, due to the so-called “stigma” problem: during a financial crisis, the banks may be reluctant to borrow from the discount window, worrying that such actions would be interpreted by the market as a sign of their financial weakness, which would reduce their ability to borrow from the market.

Figure 1: Rise in 3-month Libor-OIS Spread

31 THE MONEY MANAGER | JUNE 2009 frequently used among all tools used by the Federal

While well-established mechanisms existed for injecting reserves into a country’s financial system, officials had no way to guarantee that the reserves will reach the banks that need them. As it became apparent that conventional tools were not effective enough in addressing unusual financial distress, the Federal Reserve introduced new facilities to provide liquidity to the market.

The New Tools Term Auction Facility (TAF)

The TAF is a credit facility that allows depository institutions (e.g. commercial banks) to borrow from the Fed for 28 days against a wide variety of collateral. Though this policy can potentially lead to an increase in bank reserves and ultimately also the monetary base, the Fed conducts open market operations (OMOs) to counteract unwanted increases (or decreases) in the monetary base by selling Treasury securities to exactly offset this increase.

The Federal Reserve uses TAF to auction set amounts of collateral-backed short-term loans to depository institutions, which are judged by their local reserve banks to be in sound financial condition. Participants bid through the reserve banks, with a bid that has its minimum set at an overnight indexed swap rate relating to the maturity of the loans. The financial institutions 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 the interest rate is determined in the marketplace.

Term Securities Lending Facility (TSLF)

The TSLF permits primary dealers to borrow Treasury securities against other securities as collateral for 28 days. The range of securities, which can be used as collateral, is wider than for the TAF. The TSLF is a “bond-for- bond” form of lending and it affects only the composition of the Fed’s assets without increasing total reserves.




In exchange for the collateral, the primary dealers receive a basket of Treasury general collateral, which includes Treasury bills, notes, bonds and inflation- indexed securities from the Fed’s system open market account, extending the range of acceptable collateral beyond Treasuries.

The main advantage of TSLF is that it doesn’t involve any cash since a direct injection of cash can affect the federal funds rate and also have a downbeat impact on the value of the dollar. TSLF also serves as an alternative to the direct purchases of the mortgaged investors, which goes against the aim of the Federal Reserve to avoid directly affecting security prices.

32 THE MONEY MANAGER | JUNE 2009 In exchange for the collateral, the primary dealers receive

Figure 2: The TSLF lending program and intended effects on credit markets

The Open Market Trading desk operates the term securities lending facility. It holds auctions on a weekly basis in which dealers submit competitive bids for the basket of securities in increments of $10 million. The primary dealers may borrow up to 20% of the announced amount at the discretion of the Federal Reserve.

Primary Dealer Credit Facility - PDCF

The PDCF is an overnight loan facility that provides funding for up to 120 days to primary dealers in 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-

bond” form of lending. To prevent PDCF operations from increasing the monetary base, the Fed offsets the increase with a sale of Treasury securities as in the case of TAF. With the PDCF the Federal Reserve has in effect opened the discount window to primary dealers. This facility allows the Fed to offer liquidity assistance directly to certain major investment banks that were

previously ineligible. The new Credit Facility increases the scope of firms in transitory distress that may be supported

through Fed liquidity injections.

By October ‘08 end, Fed carried $301 billion of TAF on balance with a further $600 billion auction fund scheduled for November and December, $169 billion of PDCF and $200 billion of TSLF on balance. Table 1 compares the main features of these three new liquidity facilities with those of the regular open market operations and the discount window.

32 THE MONEY MANAGER | JUNE 2009 In exchange for the collateral, the primary dealers receive

Figure 3: Composition of Fed’s Assets

Acceptance of TAF over others


Table 1: Comparison of various policy tools

Though all the three tools introduced by Fed had an impact of easing the liquidity, TAF by far was the most active and successful tool. Instead of calling for banks to come to the Fed to request a discount window loan, under the TAF the Fed auctions a predetermined amount of funds amongst the participants. Second, instead of paying the primary credit rate, depository institutions that borrowed under the TAF paid the ‘stop-out rate’—the lowest bid rate that exhausts the funds being auctioned. It generated interest in depository institutions as there was no stigma, similar to the one associated with discount window, attached with TAF.

THE MONEY MANAGER | JUNE 2009 33 Table 1: Comparison of various policy tools Though all

Figure 4: TAF Auction Amount Results

From 17 th December, 2007 to 21 st April, 2008, the Fed completed ten auctions in the facility. The amount of term loans auctioned was $20 billion in each of the first two auctions, $30 billion in the next four auctions, and $50 billion in the last four auctions. There was high demand for funds at the auctions. The number of banks bidding for the term loans in the TAF varied between 52 and 93 and the bid/cover ratio (i.e., the total amount bid as a ratio of funds auctioned) ranged between 1.25 and 3.08.

Reasons for Efficacy of TAF

During a financial turmoil, banks become increasingly reluctant to lend to each other for two reasons. First, counterparty or default risk increases as the uncertainty around the financial conditions of the counterparty rises. Second, banks tend to build up precautionary liquidity as uncertainty about the market value of their own assets mounts. Furthermore, fund managers could also demand additional liquidity readily available to cover potential redemptions. Heightened counterparty risk and extra liquidity demand led to an increased unwillingness to lend and contributed to the jumps in inter-bank interest rates. Under the prevailing disrupted




market conditions, the effectiveness of the TAF and other liquidity facilities depended on whether they can resolve the misallocation of liquidity in the market.

By establishing TAF to provide funding to financial institutions in need, the Federal Reserve sought to relieve the financial strains through several channels. The first and most direct channel was to serve as an additional funding source for banks in immediate need of liquidity, thereby lowering the short-term borrowing costs. Second, because TAF reduced pressure on banks to liquidate their assets, it brought down their funding costs induced by deteriorations in money market conditions. Third, with strengthened confidence the investors asked for less compensation for a given unit of risk and the risk price declined in the presence of the TAF. Finally, with this additional funding source readily available, that too at a rate generally less than the primary credit rate, there was less demand for banks to excessively hoard liquidity purely out of individual precautionary concerns.

34 THE MONEY MANAGER | JUNE 2009 market conditions, the effectiveness of the TAF and other

Figure 5: TAF Auction Rates Results

The two effects of TAF—meeting banks’ immediate funding demands and reassuring potential lenders of their future access to funds—both worked in the direction of reducing liquidity risks of banks, increasing transaction volumes and values, and reducing market interest rates.

Figure 6: Variation of Deposit Rates with TAF announcement

34 THE MONEY MANAGER | JUNE 2009 market conditions, the effectiveness of the TAF and other

In confirmation with the expectations, the empirical results suggest that TAF had strong effects in relieving the liquidity concerns in the inter-bank money market. One indication of the scramble for liquidity, shown in the chart, was a sharp increase in the interest rates offered by banks on one-month bank certificates of deposit relative to the Federal Reserve’s federal funds rate target. Market interest rates generally fell after the December 12 announcement, suggesting that market participants viewed the coordinated central bank action as likely to ease money market pressures, especially during the year-end period when the demand for liquidity typically is high.

34 THE MONEY MANAGER | JUNE 2009 market conditions, the effectiveness of the TAF and other

Figure 7: Variation in LIBOR-OIS Spread with TAF auctions




In the LIBOR-OIS spread, a cumulative reduction of more than 50 basis points can be associated with the TAF announcements and its operations. It was found that that the TAF had, on average, reduced the 1-month Libor-OIS spread by at least 31 basis points, and the 3-month Libor-OIS spread by at least 44 basis points. The reduction is economically important because it is approximately 90 percent of the average level of the LIBOR-OIS spread in the recent period of credit crunch. However, TSLF and PDCF were found to have had less noticeable effects so far in allaying financial strains in the Libor market. This is thus consistent with the observations of the market of a weaker interest from primary dealers in participating in the TSLF auctions than banks have shown in tapping the TAF.

Conclusion Future relevance of the Tools

The facilities the Fed created during the crisis enhance the Fed’s lender-of-last-resort function, and extend the reach of its liquidity provision. They bridge the gap between OMO and discount window lending, in the sense that they are available to a large number of financial institutions and can be secured by a much larger array of collateral, as in the case of discount window loans but the initiative rests with the Fed, just like OMO.

However, certain modifications might be required in these policies depending on the scenario. They are flexible in terms of the durations of the loans, the size of the loans, the safety of the collateral and availability. The duration of available lending could be increased beyond the current window. The size of the lending could be increased for the TAF and the TSFL since there is no technical limit on lending via the PDCF. Using non-investment grade securities as collateral, availability could also be enhanced. Some programs reach primary dealers (TAF and PDCF) and others reach only depository institutions (discount window and TSFL). It is possible that some of these programs could be opened up to both sets in the future.


  • - DeCecio, Riccardo and Gascon, Charles S: New

Monetary Policy Tools

  • - Wheelock, David C: Another Window – The Term Auction Facility

  • - Board of Governors of the Federal Reserve System press release, December 12, 2007:-


  • -

  • -

  • -




CDS and Credit Crisis

36 THE MONEY MANAGER | JUNE 2009 CDS and Credit Crisis
36 THE MONEY MANAGER | JUNE 2009 CDS and Credit Crisis What Went Wrong, What Lies

What Went Wrong, What Lies Ahead?

Saurabh Mishra

[IIM Ahmedabad]

Credit Default Swap (CDS) market has shown extraordinary growth in past few years (Exhibit-1). The total notional amount outstanding at the end of year 2007 on all CDS contracts was approximately $ 62.2 trillion (ISDA Market Survey: Notional amount outstanding, semiannual data, all surveyed contract, 1987-present, 2008).

36 THE MONEY MANAGER | JUNE 2009 CDS and Credit Crisis What Went Wrong, What Lies

Exhibit 1: CDS Notional Amount Outstanding Historically

Though this growth is a great story of financial innovations that fuelled the growth of Wall Street, it is also an example of regulatory issues with such derivatives. Following is an analysis of the issues that CDS contracts have created in the current credit crisis and how they can be tackled for a smooth functioning of this market.

What is CDS?

As the name indicates, CDS provides protection against the credit event 1 (like credit default) in a particular company or sovereign entity. There are two counterparties involved in this transaction. The counterparty that wants protection against credit event is called protection buyer and the counterparty selling protection is called protection seller. This protection is usually bought or sold on bonds or debts (or instruments that promises to pay a stream of cash flows in future) of corporate or government. In case of any credit event, the protection seller has a liability to buy the bond or debt for its face value. In order to get this protection, protection buyer pays a periodic premium to the protection seller as decided in the agreement. This premium obviously depends on many factors like credit rating of the reference entity 2 , seniority of bond etc. A pictorial depiction of physically settled CDS contract is shown in Exhibit-2 (Draft Guidelines for Introduction of Credit Derivatives in India, 2003). Another type of settlement, known as cash settlement in which protection seller provides the remaining face value of the bond after recovery by the protection buyer. So there is actually no physical transaction of underlying security and only cash changes hands.




Exhibit 2: Physical Settlement of CDS

37 THE MONEY MANAGER | JUNE 2009 Exhibit 2: Physical Settlement of CDS Apart from the

Apart from the obvious use as a hedging instrument against the debts, CDS can be used in many other ways. CDS can be simply used as a speculative instrument on the financial health of the company. If the investor believes that the financial health of the company is improving or deteriorating, then he can buy or sell CDS accordingly to make money by speculation. CDS can also be used for arbitrage. The relationship between the stock price of the company and CDS premium on the bonds of the company is expected to be negatively correlated. The logic is that as the financial health of the firm improves the stock prices should go up and the CDS spread (premium) should tighten. If the investor finds a mismatch in the two, he can take position in the CDS and equity accordingly to exploit this situation. This strategy is known as Capital Structure Arbitrage (Credit Default Swap, 2008). Before going forward, one thing should be noted that though CDS looks like insurance, there are many differences in both the products. CDS can be used as a mere speculative instrument only. For buying CDS, it is not necessary that the protection buyer owns the underlying which is not the case in insurance. Similarly there are not enough regulations to check the credit worthiness of protection seller so that he is able to pay in case of default, which is again in stark contrast with insurance. The regulatory aspect has been discussed further.

Risk Associated With CDS Contracts

Taking the discussion forward from the previous

section, it can be said that CDS acts as an insurance against the defaults on debts and bonds by corporate and sovereign, and being a derivative, it is different from insurance. Since derivatives derive their values from the underlying on which contract has been written, and there is no intrinsic worth attached to them.

Being a complicated derivative instrument, there are many problems attached with CDS. First, this market is an over-the-counter market and is not well monitored and regulated. In the past few years, it has seen unprecedented growth and a need is felt to standardize the market. Since the CDS market is unregulated, it is not possible to know accurately the exposure of various financial institutions in this market. Also this market is illiquid because of specific nature and terms of every contract that can vary from one to another. So we can see that the CDS market faces almost similar risks that other OTC derivative contracts face, but the problem is manifold in comparison to other derivatives because of the sheer size of the market.

Current Credit Crisis and CDS

The size of the CDS market (more than $ 60 trillion) is significantly more than the underlying debt and bond market 3 . So it can be inferred that the most of the CDS contracts are actually speculative bets only and are not actual protection on the underlying. As mentioned earlier, that being an unregulated market, exposure of various companies is not known in this market. Combining the above two facts, it can be inferred that a large event in the credit market can actually have vast impact on the CDS market, and then eventually on the economy as a whole.

One such big credit event was the Lehman’s bankruptcy. The size of Lehman’s debts was $ 613 billion making it the largest bankruptcy filing ever (An Update on the Lehman Bankruptcy, By the Numbers, 2008). As far as CDS market was concerned, this event had two faces. The first was related to protection that Lehman sold. It was feared that these protections would no longer exist. One of the examples was of Washington Mutual that




bought corporate bonds in 2005 and took protection from Lehman through CDS contracts. Other side was about the firms that wrote CDS on Lehman’s bonds and debts. The final auction of Lehman’s debt was at $8.625. It means that the protection seller would have to give remaining $ 91.375 on these debts in CDS. Since the size of the Lehman’s debt was so large that there was possibility that the protection seller companies may themselves go bankrupt in protecting the Lehman’s bonds. So if a firm is heavily involved in the CDS market then it creates a problem of “too big to fail” for the government. Infact one of the reasons for the bailout of AIG was the role of AIG in the CDS market (Lehman Brothers: A Primer on Credit Default Swaps, 2008). It has a massive unhedged CDS portfolio of more than $ 600 billion and most of the losses have come from this portfolio only (Why Wasn’t AIG Hedged?, 2008).

Another worrying fact about the CDS is the nature of trade itself. The contract can be traded or swapped multiple times and it can happen from both the ends, i.e. protection seller and protection buyer. Because the market is not regulated, it is actually not checked if the new buyer of the contract has enough resources to pay in case of credit event. This in itself makes the pricing of the contract difficult. The problem becomes even more severe because banks are one of the biggest players in the market and they are already under pressure from the other derivatives like CDOs and synthetic CDOs (CDO^n).

Another worry right now is the linkage between CDO and CDS market. In recent years, CDS market expanded into structured credit products like CDOs and synthetic CDOs. One of the major reasons for current credit crisis is the wrong assessment of the risks associated with the structured credit products like CDOs and thus the incorrect pricing of these assets. Since the structured credit products are already quite complex instruments which were not priced correctly, so it is just a matter of imagination to see the kind of

impact it will have on the pricing on the CDS contracts protecting those structured credit products and the kind of systemic risk it can create in the market. Insurance and re-insurance companies like AIG and Swiss Reinsurance Company are the initial casualties only (Lehman Brothers: A Primer on Credit Default Swaps, 2008).

So by seeing the risks associated with CDS market in the current situation and the size of this market, it can be fairly assumed that any crisis in this market can create issues bigger than what we have from subprime crisis.

How to Fix the CDS Market?

There are many lessons that can be learned from the current crisis. Following are the few ways through which reforms can be done in the CDS market (Testimony Concerning Credit Default Swaps, 2008).


CDS: One of the major improvements can be made in the direction of establishing a single counterparty for the CDS. This would reduce the counterparty risk in such transactions in future. This would make sure that the counterparties would not be exposed to each other’s risk in future as is the case in current bilateral CDS contracts. This CCP can act as both protection seller and protection buyer and thus would actually net out the risks. This would also help in minimizing the impact of failure of a big market participant (like Lehman or AIG). This would also ensure timely settlement of trades and in keeping track of market participants to avoid market manipulations.








SEC should be allowed to monitor OTC derivative markets that would make sure that timely action is taken before the crisis actually comes. Under the current laws, SEC is prohibited to interfere in the OTC




swap market.

REPORTING OF CDS TRANSACTIONS TO SEC: Due to lack of any central clearing house it has become very difficult to quickly trace the past CDS transactions. A mandatory rule to report CDS transactions to SEC would ensure a close watch over these transactions and would provide alternative to voluntarily reporting to Deriv/SERV 4 .

EXCHANGE FOR CDS TRADING: As mentioned earlier, CCP can actually set up an exchange for CDS trades. This would ensure better market transparency in terms of prices, volumes, open interests etc. This would make sure that CDSs are standardized and thus it would reduce the liquidity risk in the market.


CDS market serves the purpose of pricing the risk associated with reference entities. Such type of contract is very important to develop the credit market. The recent rapid unregulated expansion of the CDS market has created systemic risk for the economy in general. The current idea of 2-party contract exposes each party to the creditworthiness of the other party and non-standard format of the trades make the market very illiquid. Also, “too big to fail” syndrome of various firms has created fundamental problems for this market. Seeing the importance of the market and the challenges associated with it, reforms are required in this market. As suggested earlier, exchange based trading, establishing a single Central Counter Party (CCP), better monitoring and regulation of existing CDS trades are few ways to ensure the safety of this market and to reduce the risks that poses to economy in general.


An Update on the Lehman Bankruptcy, By the Numbers. (2008, Oct 17). Retrieved Nov 25, 2008, from The Wall Street Journal: an-update-on-the-lehman-bankruptcy-by-the-numbers/

Credit Default Swap. (2008, Nov 27). Retrieved Nov 27, 2008, from Wikipedia: Credit_default_swap

Credit Default Swaps: The Next Crisis? (2008, Mar 17). Retrieved Nov 25, 2008, from TIME: http://www.time.


Draft Guidelines for Introduction of Credit Derivatives in India. (2003, Mar 26). Retrieved Nov 25, 2008, from Reserve Bank of India:


ISDA Credit Event Definitions. (n.d.). Retrieved Nov 25, 2008, from Credit Derivatives WWebsite: http://www.

(2008). ISDA Market Survey: Notional amount outstanding, semiannual data, all surveyed contract, 1987-present. International Swaps and Derivatives Association.


Lehman Brothers: A Primer on Credit Default Swaps. (2008, Oct). Retrieved Nov 25, 2008, from Credit Writedowns:


Testimony Concerning Credit Default Swaps. (2008, Nov 20). Retrieved Nov 25, 2008, from US Securities and Exchange Commission:


Why Wasn’t AIG Hedged? (2008, Sep 28). Retrieved Nov 25, 2008, from Forbes: http://www.forbes.




  • 1 There are usually six type of credit event specified in the ISDA master agreement on which CDS can be written. They are Bankruptcy, Failure to Pay, Obligation Acceleration, Obligation Default, Restructuring and Repudiation/Moratorium (ISDA Credit Event Definitions).

  • 2 The borrower (or other entity) whose credit event trigger the payout from protection seller

  • 3 To give a perspective, size of US mortgage market is $ 7.1 trillion; US treasury market is $ 4.4 trillion. Even the size of US equity market is approximately $ 20 trillion (Credit Default Swaps: The Next Crisis?, 2008).

  • 4 A subsidiary of DTCC that provides automated matching and confirmation for over-the-counter trades.




Climate Change Induced Financial Risks

40 THE MONEY MANAGER | JUNE 2009 Climate Change Induced Financial Risks
40 THE MONEY MANAGER | JUNE 2009 Climate Change Induced Financial Risks A Strategic Approach Pramod

A Strategic Approach

Pramod Kumar Yadav, Kuppa Vijay Krishna, Vikas Bathla

[IIM Ahmedabad]

Executive Summary

Climate change has recently emerged as an unintended global negative externality problem derived from a relentless pursuit of economic development. There is no sphere of the competitive market place that will remain unaffected by Climate change. Literature review suggests that the financial and banking sector will be severely affect by the different allocations of climate-induced risks.

At the outset, we analyzed the various financial risks that arise due to climate change. Next, we examined the impact of climate change on the business value chain of a firm using a generic financial-strategic framework. We then moved onto mapping climate risk onto the financial sector. In the next section we analyzed the impact of climate risk on the Basel II accord and proposed an approach to model climate risk using Bayes Theorem and further incorporated that risk into the asset (credit and market risk) portfolio of a bank. Developing climate change risk as a time dependent function has further substantiated this.

This paper will help firms make their financial decisions in more advanced and informed manner in the light of future uncertainties associated with climate change.


Climate change has emerged as the strongest negative global externality that demands collective actions

on local and global level. It refers to a statistically significant variation in either the mean state of the climate (which includes temperature, precipitation and wind patterns) or in their variability over an extended period that ranges from decades to centuries.

Climate change poses a major risk to the global economy. The impact of climate change on global economy has been assessed by using various top down models to estimate damage functions that relate GDP losses to variations in temperature. According to the Stern report, which is globally touted as a cornerstone for future climate change economic studies, mean yearly GDP loss due to climate change is between 5 and 20 % of global GDP. However, consistency among the results of such international modeling exercises is yet to be established as different studies subsumes different treatments of climate induced market, non market, and catastrophic risks

In this article, we will examine the impact of climate change on the financial sector, which forms a significant part of any economy- competitive or regulated. We will first systematically categorize the various kinds of financial risks that arise due to climate change. Then we will investigate the role of such climate induced risks in altering the value and properties of asset




portfolios held by banks. Finally, we attempt to model climate risk by using posterior probabilities and suggest methodologies for doing this.

Climate Change induced Financial Risks

Climate change induces risks to business sector either through a direct carbon cost or through an increase in the cost of factor of production. Such risks cannot or only inadequately be classified in common risk categories. The extent to which a company is exposed to Climate Risk and the strategy it employs to mitigate the risk will depend on that company’s business model, balance sheet, operations, and future plans. Some of the major climate induced financial risks faced by public and private companies are show below:

41 THE MONEY MANAGER | JUNE 2009 portfolios held by banks. Finally, we attempt to model

Figure 1. Climate Change induced Financial Risks

Among the above risks, maximum impact will be on a firm’s ability to raise capital. Climate Risk is an increasingly relevant consideration in the choice and maintenance of investments. Companies that have failed to address Climate Risk can be expected to face increased difficulty raising capital. A firm in the power sector or real estate sector will find it harder to finance its debt in the light of adverse affects of climate change which can completely alter the competitive landscape. Banks and financial institutions on the other hand

have a great interest in ensuring the long-term security and profitability of their investments. Mainstream investment houses are developing sophisticated means of assessing companies’ strategic response to Climate Risk. The size and influence of socially responsible investment funds is growing. Thus even banks will look towards hedging instruments or suitable debt portfolio allocations.

All business sectors are at risk, though the type and extent of risk varies. Those industries, which interface directly with the environment, are more likely to be affected such as Agriculture, Tourism, Energy and Real Estate sectors. But within a sector, the risk exposure would be different for different firms and this would depend on their financial and strategic value chain. For e.g. oil industries will face greater risks than alternate energy industries and coastal rural settlements will be at a greater danger than urban infrastructure.

41 THE MONEY MANAGER | JUNE 2009 portfolios held by banks. Finally, we attempt to model

Figure 2. Climate Change and Business Value

Climate risk mapping on the financial sector

Climate change is bound to increase costs for the financial sector in future. The financial industry needs to prepare itself for the adverse effects that climate change may have on its businesses and on its customers. Banks play an important role in climate-related financing and investment, credit risk management, and the development of new climate risk hedging products. They also need to be aware




that climate change could result in a compounding of risk across the entire business spectrum, diluting some of the benefits of diversification. Price volatility in carbon markets (e.g. CO 2 , coal, oil) and climate-related commodities (e.g. agriculture crops, water) leads to uncertainty in financial projections. The opportunity in this environment for the financial services industry is that they can significantly help mitigate the economic risks and enter the low-carbon economy by providing appropriate products and services. Some of the current financial products are shown in the figure below.

Financial service providers need to review and optimize their own carbon risk management and develop tools before catering to client needs to assess their internal processes and policies on which they can adapt and base their investment and lending decisions to meet the challenges their clients face by safeguarding their own viability first.

Climate change can be treated as a risk management problem, especially for governments and corporations, given that climatic changes have a reasonably low to medium probability of occurrence and a very high probability of impact. This goes hand-in-hand with the growing realization that such low probability weather events can have a lasting effect on issues such as investment decisions, productivity and political stability. The difficulty in mapping climate risk on a financial portfolio is amplified as financial sector modeling is deeply rooted in historic data, which do not account for climatic impacts. We can only say that depending on the climate exposure of the portfolio, the conditional value at risk (CVaR) will grow due to climate change as confidence interval surrounding climate change predictions is likely to increase. The following figure gives an idea about the impact of climate change on expected losses and capital needs:

Climate and Weather Disaster: Risk Hedging Instrument

Catastrophe bonds are subject to default if a defined catastrophe occurs during the life of the bond but are attractive to investors because of their correspondingly high yields

Contingent surplus notes are essentially “put” rights that allow the notes’ owners to issue debt to pre-specified buyers in the event of a catastrophic event

Exchange-traded catastrophe options allow purchasers to demand payment under an option contract if the index of property claims service options traded on the Chicago Board of Trade surpasses a pre-specified level

Catastrophe equity puts are a type of option that permits the insurer to sell equity shares on demand after a major disaster

Catastrophe swaps are derivatives that use capital market players as counterparties. An insurance portfolio with potential payment liability is swapped for a security and its associated cash flow payment obligations

Weather derivatives are contracts that provide payouts in the event of a













lead to decreased margins. On top of this, the related



The challenge they face is to not only include climate risks in their risk management but - if applicable - also have to adjust applied methods for the quantification of risk.

operational risks for the bank’s clients, for example, suboptimal carbon risk management can result in financial sanctions, which also impair the client’s liquidity and therefore the bank’s competitiveness and creditworthiness.

Credit Risk: This risk is related to policies and regulations that create new liabilities or transfer existing ones and therefore affect business directly. They affect the credit ratings of GHG intensive borrowers and create direct costs of compliance on related sectors and indirect costs on all consumers of energy and electricity. This has implications for banks in their role as loan providers, equity investors, and project financiers.

Operational Risk: Operation risk arises from inappropriate risk identification, assessment, and allocation processes inside the bank. For e.g. a bank’s internal failures in the due diligence for investments or loans that are highly sensitive to climate change

Market Risk: The main components of this risk are volatile carbon certificate prices and volatile commodity prices (e.g. coal, gas, oil). These price and volumetric risks lead to decreased corporate planning reliability - both for banks and their clients. Banks must have the expertise to monitor and understand the impact of emissions trading or any future climate regulatory changes on clients’ business. The more frequent the occurrence of extreme weather events such as flooding and storms, the higher the direct climate change related risk of physical damage to corporate assets and real estate.

The existence of these risks mean banks need to

43 THE MONEY MANAGER | JUNE 2009 Figure 4. Impact of Climate Change on Probability Loss

Figure 4


Figure 5. Risk Measurement Approches under Basel II

develop carbon risk management tools for their loan


Risk and

Basel II: A New Modeling

and investment due diligence. Some of these can be:


To integrate an environment sustainability criteria into the bank’s overall assessment of investment risk and opportunity

Climate risk assessment and aggregation with other prevailing risks faced by banks is conducted through the prism of BASEL-II principles in the absence of any other international risk norms for banking sector.

To develop new metrics to demonstrate the “carbon intensity” of their client portfolios and to restrict its lending and underwriting practices for industrial projects that are likely to have an adverse environmental impact

The essential principle of Basel II is the three-pillars- concept (minimum capital requirement, supervisory review process and market discipline), which aims at a comprehensive evaluation of risk-related capitalization of banking institutions. Currently, BASEL-II proposed

To incorporate a set of emission trading related questions in its credit rating process and conduct thorough investment research

banking book structure which includes minimum capital requirement in the form of market risk charges, credit risk charges, and operation risk charges is sufficient to

To calculate the financial cost of greenhouse gas emissions while reviewing loans, such as the risk of a company losing business to a competitor with lower emissions

incorporate climate risk. There are no instructions or techniques of how these risks can be measured. Based on our previous qualitative assessment of risks, we have distributed climate risk across market, credit, and




operational risks under BASEL-II accord. All that can be said is that risk adjusted capital requirements will increase from earlier levels. Rigorous quantification will be necessary to establish the exact levels.

Portfolio Analysis

Any bank or credit institution will have a portfolio of asset allocations. The credit loss of the portfolio or an asset of the portfolio is calculated as in Equation I.

Each of the assets (or industry sectors) in the portfolio will be affected by climate change risk in their own way. In the case of climate sensitive sectors such as transport, energy, real estate and water utility, each or all among probability of default, potential credit exposure and recovery factor will be adversely affected. These in turn will have a negative impact on their debt payback capacities, which will eventually diminish the bank’s cash flow. This will further be exacerbated by the climate change induced co-movement among the risk factors of the sectors leading to a high correlation of risks that will drastically change the riskiness of the overall portfolio. Thus it is very important to appropriately quantify climate risk to have an exact idea of the credit status of the portfolio.

Market risk of the bank portfolio is essentially comprised of risks to their currency and commodity assets. Basel II proposes use of stress testing and back-testing in assessing the market risk of a bank’s portfolio. Mapping of climate change risks on market risks cannot be adequately conducted as both, stress testing and back testing are backward looking approaches.

Integrating Climate Risks in Bank Portfolio

We propose to model climate risk in the banking sector by assuming that a rational agent observes new information disseminating in the market and updates his assessment of the risks using conditional probabilities. However, prior probability assessment and likelihood function determination always run the risk of statistically insignificant and biased outcomes in the presence of sparse or limited data distributed over a very long period of time. The knowledge of climate change and its impact is acknowledged as a recent phenomenon and hence, as mentioned before, there is insufficient historical data on which to base the likelihood function.

Therefore we formulate climate risk as a recursive process involving learning in which a risk-averse rational agent will absorb new information and learn from previous climatic impacts. The new information will be in the form of stochastic processes, particularly climatic physical impacts, policy and regulation regime shifts, and change in key market variables. The main problem with such a learning based risk assessment process is the rate of real information flow and technological know-how.

Let us say at time t=o, the information available regarding climate risk is x and the probability of the adverse climatic impact is p. At t= t, a new set of information y appears. After the new information, the decision maker updates his prior probability distribution to arrive at posterior probability distribution f (p/y, x). The posterior probability can be obtained by using Bayes theorem in following manner:

Equation I

45 THE MONEY MANAGER | JUNE 2009 operational risks under BASEL-II accord. All that can be



46 THE MONEY MANAGER | JUNE 2009 This can be further simplified as, The expected probability

This can be further simplified as,

46 THE MONEY MANAGER | JUNE 2009 This can be further simplified as, The expected probability

The expected probability of occurring in the future will be found as:

46 THE MONEY MANAGER | JUNE 2009 This can be further simplified as, The expected probability

This formulation assumes that the expectation of a rational agent changes as the new information start penetrating the market. Decision-maker changes the prior probability distributions, often with bias, as the time passes by. Therefore, it can be said that prior probability of climate risk was zero earlier as such risk was not contemplated.

The priori distribution that is used above is a hypothetical model based on the limited historical data that is available till date. From the present e.g. t=0, we contemplate the future risk in time t=t. However we scientifically cannot specify what the future risk would be in time t=t as shown in figure 6. Moreover, the trajectory of climate risk evolution would also drift over the duration as the exact path of risk transfer cannot be specified. However, with time, as more data points are generated, our priori distribution will keep changing and hence its robustness increases and eventually it will near a real world approximation.

Currently, the risk for any portfolio of a bank (the expected values of the statistical properties of exposures together with portfolio specific risk measures such as moments of distribution, VaR etc) is represented by distributions, which to an extent are known or can be simulated using available data. The above climate risk model can easily be extrapolated calculate the effect of climate change on the asset portfolio allocation of a bank or other credit institutions. Any bank will have an existing Monte Carlo simulation model with a given probability distribution to determine its asset portfolio allocation. Now to incorporate climate change risk

46 THE MONEY MANAGER | JUNE 2009 This can be further simplified as, The expected probability

Figure 6. Evolution of Climate Change Risk as a Function of Time




into the model we would need to apply Bayes theorem assuming a priori distribution as shown above to generate a conditional probability of climate risk. Then we would need to superimpose this distribution onto the portfolio probability distribution to arrive at a

Insurance Risk: A firm might need to pay extremely high insurance premiums if the chances of it being affected by climate change are significant. This is particularly severe for real estate firms and firms functional in agriculture and commodities.

Reputational Risk: Companies which are perceived

comprehensive portfolio distribution that has climate risk included in it.


The concepts of uncertainty and ambiguity, but not risk, have been used extensively in the field of assessing the economic impacts of climate change. This paper identifies and assesses whole spectrum of climate risks


to undermine steps to address climate change or who have projects or practices which contribute to climate change run the risk of damaging their image. Reputational Risk can impede a company’ ability to compete in the marketplace, as consumers and future employees seek alternative choices.

on variety of sectors with a focus on financial and banking sector. Having argued that climate induced

Litigation: Litigation costs resulting from ‘climate litigation’ and associated reputational risks need also to be considered.

risks are inevitable in medium to long term future, it maps climate risks on capital requirement proposed by

Competitive Risk: Companies that fail to address

BASEL-II and further presents a methodology to map climate change risks on portfolio value of a bank.

Climate Risk may be placing themselves at a competitive disadvantage. Action can lead to a direct gain over competitors, for example through

Financial Risks of Climate Change


“first mover” advantage; and indirect gains, for example by improving a company's negotiating

Some of the major climate induced risks faced by public and private companies are:


position when a government proposes to introduce regulation, or simply through an improved or

"greener" reputation.

Physical Risk: This corresponds to physical disruptions such as loss of life, limb or other assets due to calamities caused by climate changes.

Policy Risk: Governments at national and global levels are starting to introduce policies to tackle the causes and combat the effects of greenhouse gas emissions (GHG). These policy and regulatory changes will modify company share prices, both positively and negatively. The impact of various climate regulatory schemes on emissions and ensuing compliance costs can be direct such as a carbon tax or emissions trading scheme or indirect through increased fossil energy prices. Thus a company’s current and future financial liabilities can be reduced by acting on its current emissions and energy consumption.

Shareholder: Loss in competitive advantage resulting from a loss of economic opportunities has a direct affect on the bottom line of a firm. This in turn results in shareholder risk arising from activism and disruption of affairs.

Capital: Climate Risk is an increasingly relevant consideration in the choice and maintenance of investments. Companies that have failed to address Climate Risk can be expected to face increased difficulty raising capital. A firm in the power sector or real estate sector will find it harder to finance its debt in the light of adverse affects of climate change which can completely alter the competitive landscape. Banks and financial institutions on the other hand have a great interest in ensuring the long-term security and profitability of their




investments. Mainstream investment houses are developing sophisticated means of assessing companies’ strategic response to Climate Risk. The size and influence of socially responsible investment funds is growing. Thus even banks will look towards hedging instruments or suitable debt portfolio allocations


Currently available financial instruments

Growing sensitivity of financial and insurance markets towards climate induced chaotic and severe events is evident with the increasing popularity of catastrophe bonds, carbon trading instruments, and weather derivatives. A critical review of such instruments is following.

Emissions Trading: The international emissions trading market offers new opportunities for banks and their clients. Emissions’ trading is also an interesting option for project financiers, since the IRR of emission reduction projects can be enhanced through the project-based mechanisms

Catastrophe Bonds: Catastrophe bonds are financial instruments that help disperse catastrophic weather risk. Issuance of such bonds has risen sharply following various hurricanes in US in the last decade. There is a considerable demand for products like catastrophe bonds; exchange-traded catastrophe options; catastrophe equity puts; and catastrophe swaps.

Weather Derivatives: Weather risk is primarily a volume risk rather than a price risk. To mitigate against weather risks financial instruments based on weather related index such as the Heating Degree Days (HDDs), Cooling Degree Days (CDDs) for temperature risks. Initially restricted to energy firms of the west, today major financial institutions and other industries including agriculture, insurance, tourism and retail are also entering this market. A brief summary of climate risk hedging instruments is given in the following


Micro Finance: Installation of solar power plants is an innovative business solution that can be funded by micro financing agencies.


Arnold, M.; Kreimer, A., 2000 "World Bank's role in reducing impacts of disasters." Natural Hazards Review 1(1): 37-42






2002. “Disasters,








Consortium, Draft Papers presented at the December 2002 conference, "The Future of Disaster Risk: Building Safer Cities.”

Covello, V.T./ Merkhofer, M.W.,1993 Risk Assessment Methods: Approaches for Assessing Health and Environmental Risks. New York:

Plenum Press


Citigroup. Climate Consequences – Investment Implications of a Changing Climate. Citigroup- Study, 2007

Credit and Basis Risk Arising From Hedging Weather-Related Risk with Weather Derivatives, Patrick Brockett and Linda Golden, McCombs School of Business, University of Texas at Austin, Jul 2008

Enhancing Security, Reducing Vulnerabilities:

Climate Change and Financial Innovation,

Jacob Park, Assistant Professor, Business and Public Policy, Green Mountain College (USA)

Presented at Human Security and Climate Change: An International Workshop, Oslo, June 2005

Financial Risks of Climate Change, Association of British Insurers, Summary Report, 2005

• International Energy Agency / OECD. Climate Policy Uncertainty and Investment Risk. Paris.





Urrutia,Jorge1986.,The capital asset pricing model

Investing in Climate Change: An Asset Management Perspective, Deutsche Bank, Oct 2007

and the determination of fair underwriting returns for the property-A liability insurance industry, The

IPCC. The IPCC 4th Assessment Report on Climate Change 2007: The Physical Science Basis. Summary for Policymakers. Geneva2007

Greenpeace International, http://www.greenpeace.

Geneva papers on risk and insurance, vol. 11,No.38 (January 1986).

Value at Risk: Climate Change and the Future of Governance, April 2002, CERES Sustainable Governance Project Report prepared by Innovest


Strategic Value Advisors, Inc.

Marsh. Climate Change: Business Risks and Solutions. Climate Change. V (2). 2006

Mills, E.






• Mills, E. 2003a. "The Insurance and Risk

Management Industries: New Players in



Delivery of

Energy-Efficient Products and


Services.” Energy Policy, 31:1257-1272., http://

A1) 31 (all perfect squares up to 1000)



Musiela, M. and Rutkowski, M. 1998: Martingale Methods in Financial Modelling. New York,N.Y.:

A3) You should let 37 ladies go by and select the first one with a dowry greater than the maximum of the first 37 dowries.



A4) 1/(1-cos(72)) = 1+5-1/2

Nordhaus, William, D and Joseph Boyer, 2000, Warming the World: Economic Models of Global Warming (Cambridge, Massachusetts: MIT Press).

A5) If the number of red hats that the last banker can see were even, he would say “red”. If they add up to an odd number, he would say “blue”.

Smit, B., O. Pilifosova, I. Burton, B. Challenger, S. Huq , R.J.T. Klein, G. Yohe, N. Adger, T. Downing, E. Harvey, S. Kane, M. Parry, M. Skinner, J. Smith, J. Wandel, A. Patwardhan, and J.-F. Soussana. 2001. “Adaptation to Climate Change in the Context of Sustainable Development and Equity.” Chapter 18 in Climate Change 2001: Impacts, Vulnerability, and Adaptation. Intergovernmental Panel on Climate Change, United Nations and World Meteorological Organization, Geneva. Working Group 2.

A6) 0.25

Stern, N. The Economics of Climate Change. The Stern Review. Cambridge 2007

Tol, Richard S.J., 2002, “Estimates of the Damage Costs of Climate Change. Part 1: Benchmark Estimates,” Environmental and Resource Economics, Vol. 21 (January), pp. 47–73.




Credit Default Swap Pricing

50 THE MONEY MANAGER | JUNE 2009 Credit Default Swap Pricing
50 THE MONEY MANAGER | JUNE 2009 Credit Default Swap Pricing Empirical Results and Inferences Anshul

Empirical Results and Inferences

Anshul Gupta, Radhika A R

[IIM Bangalore]

Executive Summary

Credit Default Swaps (CDS) are one of the most widely traded credit derivative contracts in the financial world. It is estimated that the total amount of outstanding CDS are in the range of 55-60 trillion dollars, indicating the popularity of these instruments. Given their widespread use and the unregulated and non transparent nature of CDS transactions, the pricing of CDS assumes particular significance. While several models have been proposed for the same, performance of these models has been inconclusive. In this paper we implement and analyze the performance of two of the most basic models, namely the Merton Model and the EJO model both in the developed as well as developing markets. The results and inferences from the same are subsequently presented. The authors believe that the current economic crisis and the role of CDS in the same makes the analysis presented in the paper all the more germane.

  • 1. Credit Default Swaps: The concept

A credit default swap (CDS) is a credit derivative contract between two counterparties, structured such that the buyer has to make periodic payments to the seller and in return obtains the right to a payoff if there is a default or credit event with respect to a reference entity. The market size for Credit Default Swaps began to grow rapidly from 2003 and by late 2007 it was

approximately ten times as large as it had been four years earlier.

However the rapid growth of the CDS market has not been without its critics. Several analysts have pointed out that the CDS market lacks regulation and the deals are far from transparent and often fuel speculation. There have even been claims that the CDS markets exacerbated the 2008 global financial crisis by hastening the fall of companies such as Lehman Brothers and AIG.

  • 2. CDS Pricing: Approaches and Models

Given the huge market for CDS, it is but natural that substantial amount of research has been conducted on their pricing.

The price, or spread, of a CDS is the annual amount that the buyer of the protection must pay the protection seller over the length of the contract.

There exist two fundamental approaches to CDS pricing:

  • (a) Structural Approach

  • (b) Reduced Form Approach

2.1 Structural Approach to CDS Pricing

The structural approach links the prices of credit risky instruments directly to the economic determinants of




financial distress and loss given default. These models imply that the main determinants of the likelihood and severity of default are financial leverage, volatility and the risk free term structure. Popular implementation of the Structural models today include Moody’s KMV model. However it is often difficult to implement such models as it is difficult to get reliable estimates of the asset volatility and risk free term structures. Most of the structural models in place today are derived from the work done by Black & Scholes (1973) and Merton (1974). The Merton model, the foundation of all subsequent structural models, is described next.

  • 2.1.1 The Merton Model

The Merton model works on the principle that a firm’s equity can be viewed as a call option on the firm’s assets. Thus the probability of a firm defaulting on its obligations can be found by determining the probability of the exercise of this option. The model assumes that a company has a certain amount of zero-coupon debt that will become due at a future time T. The company defaults if the value of its assets is less than the promised debt repayment at time T. The equity of the company is a European call option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The model can be used to estimate either the risk-neutral probability that the company will default or the credit spread on the debt.

The mathematical implementation of the Merton model involves determining a firm’s asset value and asset volatility using the easily observable equity value and the debt profile of the firm. Detailed mathematical description of the model can be found in Merton (1974) and Hull, Nelken & White (2004).

2.2 Reduced Form Approach to CDS Pricing

These models exogenously postulate the dynamics of default probabilities and use market data to obtain the parameters needed to value credit-sensitive claims (Ericsson, Jacobs and Oviedo (2004)). While these models have been shown to be versatile in practical

applications, they don’t touch upon the theoretical determinants of the prices of defaultable securities. Another approach within the reduced form approach focuses on estimating the default probabilities and the loss given default using statistical functions and pricing the CDS based on the results.

Thus it is seen that while the Structural models are theoretically sound, they are difficult to implement while the Reduced form models, though easy to implement lack theoretical rigor. Therefore as a combination of the Structural and Reduced Form Approach, some researchers actually use the structural approach to identify the theoretical determinants of corporate bond credit spreads. These variables are then used as explanatory variables in regressions for changes in corporate credit spreads, rather than inputs to a particular structural model. Important work in this area was carried out by Collin-Dufresne, Goldstein, and Martin (2001), Campbell and Taksler (2003) and Cremers, Driessen, Maenhout, and Weinbaum (2004). Ericsson, Jacobs and Oviedo (2004) suggested an extension of these approaches in which they regressed the Credit Spread with the firm’s leverage, volatility and the risk free interest rate. This model is implemented in this paper and results on companies both in the developed and the developing world are described.

  • 3. Implementation Approach

The main considerations while choosing the various parameters for implementation are described below:

(a) Comparing performance of Structural and

Reduced Form Models: In order to evaluate the performance of both the approaches, one structural model (Merton Model) and one reduced form model (EJO Model) was implemented.

(b) Covering companies across different sectors:

The companies on which the models were tested were chosen from a wide range of sectors so that

any sectoral biases would not affect the evaluation of the performance of the models.



  • (c) Covering companies from different countries: In order to test the performance of the models for firms from both the developing and developed worlds, firms from US, UK and India were chosen. This enabled us to draw relevant conclusions regarding the applicability of the models in emerging markets like India as well.

  • (d) Covering companies with different leverage: Since the ultimate aim of the pricing models is to predict whether a company is likely to default on its obligations or not, we chose companies with leverages varying from low to high so as to test the performance of the models for companies having different balance sheet debt structures.

  • (e) Period of testing: The performance of the models was tested for the last two months of 2007. The most recent data points were deliberately not taken to test the models as given the current financial conditions, measuring the performance for current data would not have given an accurate picture of the utility of these models.

Overall six companies were chosen for testing the models and a summary of these companies is presented in Table 1.

  • 4. Data Sources

The data required for the implementation of the two models is listed below:

(a) Merton’s Model: Equity Price of the firm, Equity Volatility of the firm, Debt Structure of the firm, Risk free interest rate in the country of operation.

(b) EJO Model: Equity Price, Book Value of Debt and Market Value of Equity, Risk free interest rate in the country of operation.

All data required was sourced from Bloomberg. To obtain a good balance between capturing recent events and preventing disruption due to spurious information, a 60-day period for volatility was used. Since the Merton model requires the firm’s debt to be modeled as a zero coupon bond, weighted average of the debt and its maturity was used to do so. The risk free interest rate was then taken to be the rate for government bills with maturity closest to the maturity of the zero coupon bond. Microsoft Excel was used for implementing the model.

CDS spreads for a 5 year CDS on each firm were also obtained from Bloomberg. The mean value of the CDS was assumed to be the average of the bid and ask for the purpose of comparison with the value predicted by the two models.

  • 5. Results and Discussions

The results for the six companies for both the Merton as well as the EJO model are summarized in this section.

5.1 Merton Model

Table 1 : Companies chosen for testing




Debt Levels

Company Reliance India Ltd.




State Bank of India




General Motors



Moderate - High Moderate





Glaxo Smithkline



Very Low

Johnson and Johnson



Very Low




Overall the Merton model was found to work reasonably well for companies with medium to high leverage and the predicted values were found to follow the trends depicted by the actual values. However the Merton model was observed to consistently under predict the actual spread. This could be because of the very basic nature of the model and the simplicity of the underlying assumptions. The results obtained are consistent with the past research which showed that structural models under predict credit spreads and display low accuracy (Arora, Bohn, Zhu, 2005).

The results obtained by the Merton model for the four companies with moderate-high leverage are summarized below. Sample outputs obtained can be seen in the annexure.

Table 2: Result obtained by the Merton model


Extent of Under prediction









However the flaws of the Merton model are accentuated when tested on companies with very low leverage namely Johnson & Johnson and Glaxo Smithkline (GSK). Because the Merton model essentially models the equity as a call option on the firm’s assets and given the fact that if the debt of a firm is very low, the probability of exercising this option is very low, the Merton model gave extremely low CDS spreads for such companies. Thus it was found that the Merton model is not suitable for firms with very low leverage.

5.2 The Ericsson, Jacobs and Oviedo Model

The Reduced Form model – the Ericsson, Jacobs and Oviedo (EJO) model which regresses the CDS spreads against the firm leverage, equity volatility and the interest rates was also used to estimate the CDS spreads. The results obtained by the EJO model are summarized below (the +/- indicate the positive/ negative correlation between the CDS spread and the explanatory variable):

Table 3: Results obtained by the EJO model


R 2 (%)





  • 90.30 +





  • 70.97 +





  • 52.15 +





  • 76.38 +





  • 79.40 +





  • 83.89 +




As predicted by past research, the EJO model gave superior performance when compared to the Merton model with high R 2 ’s for most companies. All the three explanatory variables were found to be significant for all companies. The EJO model was also found to be better suited for firms with low leverage as shown by its good performance for GSK and MKS.

The credit spread was found to be positively correlated with the equity volatility and firm leverage and negatively correlated with the interest rates. Thus the effect of these market driven variables is economically important as well as intuitively plausible. These results are also consistent with previous research in these areas (Ericsson, 2004).

  • 6. Inferences and future work

The results indicate that while the Merton model is theoretically sound, due to the simplifying assumptions built into the model, its performance on real life companies and data is not satisfactory. Although it does give encouraging results for companies with medium- high leverage, overall it is found to under predict the CDS spreads by a substantial amount.

In contrast the EJO model gives good results in estimating the CDS spread as described in the previous sub-section. This could be due to the fact that it uses market driven parameters to estimate the CDS spread. The EJO model also performs relatively better than the Merton model for companies with low leverage. Further for emerging economies with low market depth and inefficient price discoveries, the EJO model may be better suited.

Future work would involve testing the Advanced




Merton Model proposed by Hull and White (2004). Non-linear models wherein the CDS spreads are regressed with non-linear functional forms can also be tested. One such possible model was suggested by Collin-Dufresne, Goldstein, and Martin (2001).

  • 7. Conclusion

The paper presents the results obtained by the testing of the Merton Model and the EJO Model for estimating CDS spreads for a diverse set of companies.

The EJO model is found to deliver better and more consistent results for the selected firms whereas the Merton model is found to consistently under predict the CDS spreads by a substantial amount. It was also found that the Merton model (and most structural models) fails for firms with very low amount of debt on their balance sheets.

The paper also postulates that the reduced form models would be more suitable for implementation in firms in the developing markets because of the lack of market depth and firm specific information in such economies.

  • 8. Select References

  • 1. Hull,







Derivatives, Prentice Hall Publications, Fourth


  • 2. Hull, J., and White, A., Valuing Credit Default Swaps: No Counterparty Default Risk, Working Paper- University of Toronto

  • 3. Jan Ericsson, Kris Jacobs, and Rodolfo A. Oviedo ,The Determinants of Credit Default Swap Premia, Faculty of Management, McGill University

  • 4. Merton, R., 1974, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, 29, 449-70.

  • 5. Hull, J., and White, A., 2004, Merton’s Model, Credit Risk, and Volatility Skews.

  • 6. Karol Frielink, 2008, Credit Default Swaps and Insurance Issues, Spigthoff Advisors Newsletter

Attorneys and Tax

  • 7. Geske, R., 1977, The Valuation of Corporate Liabilities as Compound Options, Journal of Financial and Quantitative Analysis, 541-552.

  • 8. Jarrow, R., 2001, Default Parameter Estimation Using Market Prices, Financial Analysts Journal, 57, 75-92.




Effectiveness of Basel II in the financial crisis

55 THE MONEY MANAGER | JUNE 2009 Effectiveness of Basel II in the financial crisis
55 THE MONEY MANAGER | JUNE 2009 Effectiveness of Basel II in the financial crisis Executive

Executive Summary

This paper attempts to analyze the role played by Basel II norms in the current financial crisis. Since Basel II norms have not been implemented uniformly throughout the world and have been mainly adopted by European countries and not by US banks its role is not very clear. But still there are certain inefficiencies in the Basel II norms that need to be taken care of else they will add to the financial instability. Basel II does not address all the regulatory issues that figure in the lessons learned from current market events. In particular, it is not a liquidity standard, though it recognizes that banks’ capital positions can affect their ability to obtain liquidity, especially in a crisis. It requires banks to evaluate the adequacy of their capital in the context of both their liquidity profile and the liquidity of the markets in which they operate. But it is widely agreed that more work needs to be done on developing guidance for liquidity provision. The current turmoil has provided an opportunity to examine the robustness of the Basel II securitization framework, which is now being done by the Basel committee.









Bank regulators across the globe are implementing what is known as Basel II—an international standard

Sumit Bhalotia, Hemant Dujari

[XIMB, IIM Ahmedabad]

for the amount of capital that banks need to put aside to deal with current and potential financial and operational risks. Basel II norms are based o three pillars. The first pillar refers to the set of rules that deal with minimum capital requirements to be held against key risks namely credit risk, market risk and operational risk. Pillar two refers to the supervisory review process in identifying and assessing all the risks banks face which even goes beyond the risks mentioned in pillar 1 such as credit concentration risk etc. In essence, Pillar 2 provides a strong push for strengthening both risk management and bank supervision systems. Pillar three refers to market discipline that seeks to supplement the supervisory effort by building a strong partnership with other market participants. It requires banks to disclose sufficient information on their Pillar 1 risks to enable other stakeholders to monitor bank conditions. Analysis of current financial crisis reveals that one of the major reasons was creation of very complex risk exposures not fully understood and assessed by both investors and the banks’ own risk management systems. Poor risk assessment and risk management of market and funding liquidity, concentration and reputational risks, insufficient regard for off balance sheet risks and the interaction of tail risks under stress. This was exaggerated by poor performance of the credit


56 THE MONEY MANAGER | JUNE 2009 rating agencies in evaluating the risks of structured credit


56 THE MONEY MANAGER | JUNE 2009 rating agencies in evaluating the risks of structured credit

rating agencies in evaluating the risks of structured credit and various incentive distortions in relation to the regulatory capital treatment of securitization, the opacity of information disclosures, and the structure of compensation schemes in the banking industry. The current crisis has highlighted the importance of sound and thorough assessment of quality of underlying assets as without it any regulatory regime will quickly become ineffective. Basel II requires banks to set aside more capital against complex structured products and off balance sheet vehicles, two of the main sources of stress in recent financial crisis. Presently European companies are in the process of implementing Basel II norms whereas US banks have still not started the implementation. Since Basel II norms were finalized in the year 2007 and it takes around a year to completely adopt Basel II norms the role of Basel II in the current financial is not clear. But there are certain concerns over the role played by Basel II norms during a financial crisis, which are discussed in subsequent sections.

Pro Cyclicality Effect of Basel II

Though Basel II tightly links capital requirements to the risks associated but according to experts it suffers from cyclical nature of the business and adds to the boom and bust cycle. The rules are too lax on capital requirements during the “good times” and too tough during the “hard times,” exacerbating boom-bust cycles in the process. When an economy is growing, even badly managed banks with inadequate capital levels and provisioning can expand their level of operations and business because the downside probability is very low during economic booms. But when economy takes a turn to the worse, badly managed banks have to immediately respond and change their lending policies so as to avoid going under. For example as shown in the diagram below the probability of default is clearly low during the boom period leading to low capital requirements and hence high lending amount available in the market. So the Basel II norm





by even more

lending amount.

Figure 3: Pro Cyclicality effect

56 THE MONEY MANAGER | JUNE 2009 rating agencies in evaluating the risks of structured credit

Again during the depression period the effect is opposite. As shown in the diagram below during depression credit becomes riskier having high probability of default. This leads to increased capital requirements level to act as a cushion for the high expected losses. So banks cut on the lending amount to reduce its balance sheet’s size. They may also have more difficulty increasing capital and issuing subordinated debt because of the heightened uncertainty. The combination of higher capital requirements (because of increased risk) and the difficulty of raising new capital could lead institutions to reduce credit to firms and households, which would aggravate the recession or hinder economic recovery

Figure 4: Pro cyclicality effect

56 THE MONEY MANAGER | JUNE 2009 rating agencies in evaluating the risks of structured credit




Likely Effects of Basel II Adoption in the Current Scenario

BASEL II norms are expected to have far reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks’ risk management systems, supervisory review process and market discipline.

The new norms bring to fore not only the issues of bank wide risk measurement but also of active risk management. This will help in better pricing of the loans in alignment with their actual risks. The beneficiary will be the customer with high creditworthiness and ratings as they will be able to get cheaper loans.

Basel II norms require vast amount of historical data and advanced techniques and software for calculation of risk measures. This will translate into huge demand for IT, BPO and outsourcing services. According to estimates, cost of implementation of the new norms may range from $10 million to $150 million depending on the size of the ban . A flip side is that the knowledge acquired by the big banks due to the implementation of complex norms would act as an entry barrier to any new competition entering into the market, as international markets provide incentive to sovereigns and banks that have implemented Basel II. Small and medium sized banks will find it difficult to finance high implementation costs of the norms. If national supervisors make the norms compulsory to implement, these banks might have no other option but to merge with other bank. Therefore, consolidation in banking industry with increased mergers and acquisitions is expected.

Higher risk sensitivity of the norms provides no incentive to lend to borrowers with declining credit quality. During economic downturns, corporate profits and ratings tend to decline. This can lead to banks pulling the plugs on lending to corporate with falling credit ratings, at a time when these companies will be in desperate need of credit. The opposite is expected during economic booms, when corporate credit worthiness improves and banks will be more than willing to lend to corporate.

With better risk measurement practices in place the capital

allocation for loans to quality borrowers are going to decrease. Banks can use this capital for other purposes to increase profits. But the population of rated corporate is small in India and most of them would have to be assigned a risk weight of 100 per cent. The benefit of lower risk weight of 20 per cent and 50 per cent would, therefore, be available only for loans to a few corporate. The cover required for bad loans will increase exponentially with deteriorating credit quality, which can lead to an increase in capital requirement.

Weaknesses Prevalent in Basel II Making it Ineffective for Financial Crisis

Basel II relies heavily on a number of key elements, which,

to many eyes, appear weakened in light of the credit and liquidity crisis

Basel II promotes the use of internal quantitative modeling techniques by banks in calculating their regulatory capital. Some commentators have expressed worries over the opacity of these more complex models, and the fact that the use of internal models by banks could potentially lead to conflicts of interest.

The new capital adequacy rules depend heavily on the use of credit agency ratings. Given the culpability being ascribed by many to the rating agencies in the structured credit market turmoil, one has to decide whether to give these agencies a quasi-regulatory role in relation to capital adequacy.

Despite improvements over Basel I, the new rules still focus very much on credit origination, as opposed to new credit derivative instruments and structured products.

The IMF has recently stated that the pro-cyclical nature of Basel II capital requirements, which require banks to hold additional capital against greater anticipated losses as the economic cycle turns downward, could exacerbate an economic recession by forcing banks to restrict their provision of credit in a downturn scenario.

The credit and liquidity crunch was partly the result of a widespread lack of information, which exacerbated the initial US subprime problems. Whilst enhanced disclosure is one of the three pillars of Basel II, it is recognized as




likely to be the weakest in terms of both prescription and enforcement. Basel II disclosure is required to assess an individual bank’s capital adequacy. But that is not enough: a strong bank capital base, while essential to avoid the collapse of any major financial institution, was not sufficient to prevent the systemic effects of the subprime crisis.

Basel II and the Reaction of the Indian banking System

In the wake of the turmoil in global financial markets, the FSF (Financial stability forum of BIS) brought out a report in April 2008 identifying the underlying causes and weaknesses in the international financial markets. The report dealt with strengthening prudential oversight of capital, liquidity and risk management, enhancing transparency and valuation, changing the role and uses of credit ratings, strengthening the authorities’ responsiveness to risk and implementing robust arrangements for dealing with stress in the financial system.

The Reserve Bank had put in place regulatory guidelines covering many of these aspects, while in regard to others, actions are being initiated. In many cases, actions have to be considered as work in progress. In any case, the guidelines are aligned with global best practices while tailoring them to meet country specific requirements at the current stage of institutional developments. The proposals made by the FSF and status in regard to each in India are narrated below:

(i) Capital requirements: Specific proposals will be issued to raise Basel II capital requirements for certain complex structured credit products; Introduce additional capital charges for default and event risk in the trading books of banks and securities firms Strengthen the capital treatment of liquidity facilities to off balance sheets conduits. Changes will be implemented over time to avoid

exacerbating short-term stress. (ii) Liquidity: Supervisory guidance will be issued for the supervision and management of liquidity risks. (iii) Oversight of risk management:

Guidance for supervisory reviews under Basel II will be developed that will Strengthen oversight of banks' identification and management of firm wide risks; Strengthen oversight of banks' stress testing practices for risk management and capital planning purposes; Require banks to soundly manage and report off balance sheet exposures; Supervisors will use Basel II to ensure banks' risk management, capital buffers and estimates of potential credit losses are appropriately forward looking.

(iv) Over the counter derivatives: Authorities will encourage market participants to act promptly to ensure that the settlement, legal and operational infrastructure for over the counter derivatives is sound.

The roadmap for the implementation of Basel II in India has been designed to suit the country specific conditions. All other commercial banks (except Local Area Banks and RRBs) are encouraged to migrate to Basel II in alignment with them not later than March 31, 2009. The process of implementation is being monitored on an ongoing basis for calibration and fine- tuning. The minimum capital to risk weighted asset ratio (CRAR) in India is placed at 9 per cent, one percentage point above the Basel II requirement. Further, regular monitoring of banks’ exposure to sensitive sectors and their liquidity position is also undertaken.


Countries should adopt Basel II framework based on their national circumstances. Also there should be complete implementation of Basel II and not selective or partial implementation as different parts complement each other. Incomplete implementation can even lead to eventual harm rather than financial




stability. Basel II norms have to be modified taking into account the recent happenings and addressing the weakness discussed earlier. Also the norms have to take care of the cyclical nature of the business and not add to the already prevalent boom or the bust cycle. Though the role played by Basel II is not very clear in the current crisis but it definitely needs to be fine tuned in order to address future financial crisis and maintain financial stability.


John C. Hull, The Credit Crunch of 2007: What Went

Wrong? Why? What Lessons Can Be Learned? Atif Mian and Amir Sufi The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis. RBI Guidelines in the wake of credit crisis. (www.rbi. Bank for International Settlements – Website : www.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

2.) Jordan’s Furniture is the subsidiary of which famous American company?(18)

8). Which is the third Latin American country to adopt the

US dollar

as its currency. (2,8)

10.) What is the largest non-US company listed on the NASDAQ in terms of market capitalization?(8) 12.) Which company used the trademark slogan “World’s most experienced airline” in the early 1970s?(5) 15.)Whose autobiography is called ‘Dreams of my fa-


17.) Which company filed a lawsuit in 2008 against Face- book, forcing it to remove its hit game Scrabulous?(5)

18.) Which was the first foreign company to open a fac- tory in the United States?10)

19.) Fischer

and Myron

write a path break-

______ ing article in the Journal of Political Economy in 1973.


What are their last names?(5,7)


- by Divya Devesh, IIM Calcutta



)SEC filed a civil suit against which billionaire

owner of the Dallas Mavericks for insider trading in

Nov 2008. (4,5)


)What is the Index of about 50 stocks that are

traded on the São Paulo Stock Exchange?(7)


Street is London’s equivalent of Wall

5.) A Universal Product Code was scanned for the first time in 1974. What was the first product to be sold with this code?(8) 6.) A Stock that drops suddenly and sharply in price, usually because of lower-than-expected earnings or other bad news.(4,6,5) 7.)What is the study and collection of stocks and bonds called? (11)


)The largest college student loan company.(6,3)

11.) A bond with a par value of less than $1,000.(4,4) 13.) The merger of Delta Airlines with which airlines created the largest US carrier in 2008.(9) 14.)Who launched his business career at the age of 14 by forming his own company, Traf-O-Data, with


16.)Which century old Japanese firm manufactured playing cards before it made its mark in the world of




Hedge Fund Strategies

60 THE MONEY MANAGER | JUNE 2009 Hedge Fund Strategies
60 THE MONEY MANAGER | JUNE 2009 Hedge Fund Strategies Identifying Successful Hedge Fund Strategies for

Identifying Successful Hedge Fund Strategies for Investing in Emerging Markets

Prateek Mathur, Pinky Singh,

[FMS, Delhi]

Executive Summary

Hedge Funds (HF) are privately organized, loosely regulated private investment vehicles. The total assets managed under HF increased by 24.4% to an estimated $2.68 trillion in the first three quarters 2007. Globally in past, the funds through the strategy ‘Convertible Arbitrage’ topped followed by Distressed Debt Funds, which are the next best return-generators. The various types of hedge funds strategies used by investors across the globe are:

The recommendations given discuss the hottest destination in emerging markets and the suitable strategies both globally and in Indian context. Among the emerging markets, particularly the BRIC countries (especially Russia), are most lucrative as they have some of the best opportunities for investors.

Most hedge fund managers and portfolio managers look for a certain type of equity or industry research for their fund. Hedge funds currently use and are

Table 1: Hedge Fund strategies



Market Neutral

50% short, 50% long

Convertible Arbitrage

Long convertible security, Short underlying equity

Global Macro

Focus on global macroeconomic changes


Look for growth potential in earnings and revenues


Invest based on assets, cash flow, book value


Focus on particular economic or industry sector

Distressed Securities

Invest in companies undergoing reorganization or in bankruptcy

Emerging Markets

Invest in emerging foreign market equity and debt


Trading oriented, takes advantage of market trends and events

Leverage Bonds

Employ leverage to invest in fixed income instruments

Short Only

Take short positions only




in constant need of high end unbiased qualitative and quantitative research to identify and evaluate opportunities in the global markets. This paper explores the various strategic and research options available

to Hedge funds investing in emerging markets and concludes with certain recommendations that would help Hedge funds succeed in emerging markets.

What are Hedge Funds?

Hedge Funds (HF) are privately organized, loosely

regulated private investment vehicles that are generally open-ended, and are available to a limited number of investors. They are generally structured as Limited Liability Partnerships (LLP).

Trends and Developments

The total assets managed by HF increased by 24.4% to an estimated $2.68 trillion in the first three quarters 2007 1 . New allocations increased total asset levels by an estimated $339 billion, but asset reductions from

liquidations outpaced the increase from new fund launches in Q2 and Q3 of 2008 2 . Total assets outside USA increased 28.5% through the first three quarters of 2007, compared to a 12.5% increase in US.

Impact of Hedge Funds on The Market

A typical HF involves aggressive participation, strategies and positions in the market. Most strategies move around short selling, trading in derivative instruments like options and using leverag e (borrowing) to enhance the risk/reward profile of their bets.

HF can provide benefits to financial markets by contributing to market Efficiency, Liquidity, Price determination, and Financial Market Integration. Many HF advisors take speculative trading positions on behalf of their managed HF based extensive research about the true value or future value of a security. They also use short term trading strategies to exploit perceived pricings of securities. Thus, new combinations in the risk-return space can be achieved with HF, thereby increasing the completeness of financial markets.


Though there are not set classifications, we have broadly categorized the strategies according to the similar characteristics that they seem to exhibit. Each fund has its own strategy that it uses to try and earn a high return on investment for its investors. Each

61 THE MONEY MANAGER | JUNE 2009 in constant need of high end unbiased qualitative andshort selling , trading in derivative instruments like options and using leverag e (borrowing) to enhance the risk/reward profile of their bets. HF can provide benefits to financial markets by contributing to market Efficiency, Liquidity, Price determination, and Financial Market Integration. Many HF advisors take speculative trading positions on behalf of their managed HF based extensive research about the true value or future value of a security. They also use short term trading strategies to exploit perceived pricings of securities. Thus, new combinations in the risk-return space can be achieved with HF, thereby increasing the completeness of financial markets. Strategies Though there are not set classifications, we have broadly categorized the strategies according to the similar characteristics that they seem to exhibit. Each fund has its own strategy that it uses to try and earn a high return on investment for its investors. Each " id="pdf-obj-60-51" src="pdf-obj-60-51.jpg">

of these strategies varies in the types of returns they generate and in their expected volatility.

  • 1. Directional Strategies

HF managers following directional strategies put bets on the general direction of the markets going up and down and profiting from such movements.

1(a) Dedicated Short Bias (Short Selling) [Volatility:

Very High] Short selling funds short all of the investments in their portfolio. These funds often come into favour when people feel the market is about to approach a bearish cycle. However, since short selling a stock exposes the investor to an unlimited amount of risk, these funds are often seen as very risky.

1(b) Long/Short Equity Hedge [Volatility: High] ‘Long undervalued securities and short overvalued securities’- It attempts to factor out market and sectoral factors, leaving only the inefficiencies of stock selection and their identification thereof, as a source of portfolio return. Some approaches balance the dollar amount long against the dollar amount short, while others attempt to balance the estimated volatility of the longs and the shorts.

1(c) Emerging Markets [Volatility: Very High] Emerging market funds invest in stocks or bonds of emerging markets. These are considered very volatile because emerging markets typically have higher inflation and volatile economic conditions. Not all emerging markets allow short selling so hedging is usually not available.




1(d) Global Macro [Volatility: High] Macroeconomic funds aim to profit from changes in global economies. They are typically involved in stocks, bonds, commodities, and currencies. These funds usually use derivatives to increase the impact of market movements. 1(e) Managed Futures [Volatility: High]

2 (c) Regulations D (Reg. D) [Volatility: Moderate] This sub-set refers to investments in micro and small capitalization public companies that are raising money in private capital markets. Investments usually take the form of a convertible security with an exercise price that floats or is subject to a look-back provision that insulates the investor from a decline in the price of the underlying stock.

These are funds that invest on a long and/or short basis almost exclusively in exchange traded commodity derivatives and/or financial derivatives (futures, options and warrants). Broadly speaking, managed futures are an investment for the purpose of speculating in futures and options markets.

  • 2. Event Driven Strategies

Event driven strategies are long-biased strategies that focus on specific corporate transactions that are likely to produce a reasonably well-defined increase in the value of a security within a reasonably well-defined time horizon.

2(a) Distressed/ High Yield Securities [Volatility:

Moderate] These funds buy equity or debt in companies that are facing bankruptcy. These fund managers usually think that the general public doesn’t understand troubled companies very well so they seek to profit from deeply discounted securities.

  • 3. Market Neutral Strategies

It is the only strategy that primarily focuses on linking

specific positions in a ‘hedged’ fashion. These positions seek returns independent of market movements while extracting returns from mispriced securities, market sectors, or groups of securities. These strategies attempt to limit market or systematic risk while taking advantage of inefficiencies between asset classes or securities. Essentially, the manager buys undervalued securities and shorts overvalued securities, hoping that the long positions outperform the short positions or vice versa.

3(a) Convertible Arbitrage [Volatility: Low] ‘Long convertible bonds and short the underlying common stock’. This approach recommends buying a convertible bond (or other type of convertible instrument such as preferred stock) and then shorts an appropriate amount of the same company’s stock to make it a hedged transaction.

2(b) Risk (Merger) Arbitrage [Volatility: Moderate] The risk arbitrage investor focused on equity-related opportunities created by mergers and acquisitions, tender offers and related situations. Risk arbitrageurs are typically long in the stock of the company being acquired and short in the stock of the acquirer. By shorting the stock of the acquirer, the manager hedges out market risk, and isolates his/her exposure to the outcome of the announced deal.

3(b) Fixed Income Arbitrage [Volatility: Low] HF with a focus on income usually focuses on high- yield stocks or bonds. They also might purchase fixed income derivatives that enhance their profit from the appreciation and interest income.

3(c) Equity Market Neutral [Volatility: Low] Market neutral funds attempt to remove the market risk from their portfolios by being both long and short in a given sector. A market neutral fund may pick two




similar stocks and purchase the one it feels is better and short the stock that is weaker, hoping that the stock it likes more outperforms the other stock.

  • 4. Fund of Hedge Fund (FOHF)

Rather than investing in individual securities, a Fund of Funds invests in other HF. Any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds. Investors are allocating assets to Fund of Funds products mainly for diversification amongst the different managers’ styles, while keeping an eye on risk exposure.

  • 5. Other Strategies

5(a) Aggressive Growth [Volatility: High] Aggressive growth HF typically takes an aggressive approach to investing by buying stocks with high P/E multiples and shorting stocks that are likely to miss their earnings estimates. They’re usually biased towards investing in companies in the technology and biotechnology sectors.

5(b) Opportunistic [Volatility: Depends] These types of HF often vary their investment strategies

to whatever conditions they feel are profitable at the time.

Past Performance of Strategies

In order to compare returns over a longer term,

the ranking were allotted based on Sharpe Ratio 3 . The ranking by risk-adjusted returns shows that the convertible arbitrage funds turn up tops with an

annualized return of

6.7% and a volatility of just

2.2%. Distressed debt funds are the next best return- generators with an annualized return of 9.4% and a volatility of 5.3%. This is owing to the concentrated and isolated evaluative model followed by these strategies. In recent past, combination of strategies has witnessed maximum funds asset, followed by Long/Short Equity Hedge Strategy 4 .

Emerging Market

Emerging markets, particularly the BRIC countries, are most lucrative as they have some of the best opportunities for investors. These countries have benefited from the global spike in commodities, but there are now potential risks to future returns from threats such as the global fallout from the sub-prime meltdown and the possibility of a US recession. The securities markets showed less reaction to threats of a

Investment Strategy

% Share

2005 YTD








Convertible Arbitrage

  • 3.0 %

  • 3.72 2.63




  • 0.4 %

  • 8.54 1.73




Others Distressed/High Yield

  • 1.3 %

  • 8.72 1.61








  • 7.25 1.51




Commodity Trading Advisor

  • 2.0 %

  • 1.35 1.43




(CTA) Global Macro

  • 1.4 %