Niveshak

THE INVESTOR VOLUME 4 ISSUE 11

November 2011

Green Finance

What after Kyoto Protocol ?

currency manipulation debate Pg. 20

Indian Housing finance market pg. 16

FROM EDITORS DESK

Dear Niveshaks,

Niveshak Volume IV ISSUE XI November 2011

Faculty Mentor Prof. N. Sivasankaran

Editor Rajat Sethia

THE TEAM

Sub-Editors Alok Agrawal Deep Mehta Jayant Kejriwal Mrityunjay Choudhary Sawan Singamsetty Shashank Jain Tejas Vijay Pradhan New Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M. Vishal Goel Vivek Priyadarshi

The past month like the previous ones since a long time witnessed growing uncertainty in the Euro zone on the possible measures to prevent an economic meltdown. New ECB president Mario Draghi, in his very first public appearance at the European Banking Congress in Frankfurt, displayed stridency of views and called for immediate action from European politicians to implement the decisions taken in earlier summits. The troubled nations of Greece and Italy now have new Prime Ministers, Lucas Papademos and Mario Monti respectively, in the hope of enforcing better reforms to tide over the crisis. A sense of dismay prevailed in the EU when Mr. Papademos refused to give a written pledge to implement austerity measures prior to release of next instalment package from the EU, saying his words were enough. In neighbouring Italy, the political uncertainty raised their 10-year bond yield to as high as 7.48 %. However, Mr. Montis slew of policy priorities on labour and pension reforms helped in raising the confidence of investors and lowering the bond yields to manageable levels. Meanwhile in US, the super committees progress on measures to reduce the US deficit by at least $1.2 trillion over the next 10 years would be reviewed on 23rd November. It is widely believed that in case the committee falls short of expectations, the financial markets could be headed for another nosedive. These conditions do not augur well for US, which is still trying to emerge from the after effects of the 2008 recession. There was no respite for the Indian sub-continent as well. High interest rate and unbridled inflation have led to yet another disappointing IIP number for the month of September, which has slumped to a two year low of 1.9 % against 6.1 % in the corresponding month a year ago. The weak number is mainly due to slow-down in capital intensive manufacturing and mining sectors indicating that though the series of rate hikes have not been able to rein in inflation, it has an adverse effect on growth. Global research firm, Macqquarie, has gone to the extent of lowering the next fiscal year (FY2012-13) GDP projection for India to 6.9% citing lack of political reforms by the government as the major reason while maintaining this year growth marginally higher at 7.4 %. The series of rate hikes by the RBI to control the rampant rise in inflation is expected to show some effect from December onwards. In case that happens, RBI governor has indicated that further tightening in terms of interest rate hikes might not be needed. This issue brings to you some more interesting and insightful reads. The cover story this month focuses on Green Finance especially carbon credits and its relevance in the current scenario. The issue also features an article on the Housing Finance Market in India and the road ahead for it. Another article in this issue focusses on High Frequency Trading used by large banks for proprietary trading. The Classroom this month explains the process of Factoring. We, the Editorial Team of Niveshak, are pleased to introduce to you our new team, which has been selected to carry on the legacy of Niveshak. They are: Akanksha, Akhil, Anuroop, Chandan, Harshali, Kailash, Nilkesh, Rakesh and Venkata. Please join us in welcoming them to Team Niveshak. We are confident that the new team will not only meet but will surpass your expectations in this and the coming editions. Keep supporting them the way you have been supporting us. Stay Invested. Rajat Sethia (Editor - Niveshak)

All images, design and artwork are copyright of IIM Shillong Finance Club Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS
Niveshak Times

Cover Story

04 The Month That Was

Article of the month
proactive monitoring & management of risks

08 A new framework for

He speaketh

14 Mr. Sanjib Bezbaroa

11 Green Finance

Fingyaan
16 Indian housing finance
market

22 High frequency trading

demystified

Finsight

Perspective
20 Currency manipulation 25 Factoring
debate US v/s China : Who will win?

CLASSROOM

NIVESHAK

www.iims-niveshak.com

The Month That Was

The Niveshak Times

Team NIVESHAK

IIM, Shillong

Twin deficit a major concern for India Higher fiscal deficit and trade deficit referred to as twin deficit is raising macro-economic concerns for India. The trade deficit is moving in line with the fiscal deficit. The fiscal deficit target is going to be abandoned as the slowing economy is making it very difficult for the government to meet the revenue targets due to the 2.5% drop in indirect tax collections in October. The finance ministry , while presenting the mid-year economic review in the winter session of the parliament, is going to review the fiscal deficit and revise it from 4.6% of GDP to a value slightly lower than the psychological mark of 5% . Another problem is the current account deficit which is giving more challenges to the ministry. In October, Indias exports fell to a 12-month low of $19.9 billion pushing the trade deficit to a four year high of $19.6 billion. Now, this deficit has increased to 3% of the GDP from 2.6% in 2010-11. Kingfisher crisis Kingfisher Airlines is in its biggest crisis ever as it was fighting a battle to save some of its aircrafts from angry lenders who wanted to take them back due to non-payment of the lease rentals. The airline has defaulted on payments because of the worsening situation of rising fuel costs and intense price war in the domestic market. Because of severe cash shortage to pay for even fuel supplies, the airline continued to cancel flights recently disrupting travel plans of hundreds of passengers. Super Committee for Americas deficit Its now the turn of United States politicians who can actually hack away Americas swollen deficit. A jointly selected committee, a group of six democrats and six republicans drawn equally from the House of Representatives and the Senate, is supposed to come up with a plan to reduce the deficit by $1.2 trillion to $1.5 trillion over the next ten years. This plan only needs a simple majority in the Senate. But if the plan fails to get through, more cuts will automatically be imposed. This $1.5 trillion is not

enough compared to $12 trillion predicted deficit over the next decade. So another deal of reducing the deficit by $3 trillion to $4 trillion will be good to convince investors that Americas long-term problem is being tackled. But for this to happen, certain entitlements such as Social Security, Medicare should be put on the table. Another important parameter is tax. Without increasing tax, it would be very difficult to meet the target of deficit reduction. FDI reforms in India While Mr. Vijay Mallya led Kingfisher is fighting the cash crunch problem, the government is preparing some reforms which include foreign direct investment by foreign airlines. The government is preparing a cabinet note to allow 26% foreign direct investment by foreign airlines in the aviation sector. This will provide much needed financial help to the loss making carriers like Kingfisher and Air-India. Some other sectors are also going to have foreign direct investment. The finance ministry has approved to allow 51% FDI in multi brand retail, which will welcome giants like Walmart and Tesco to India. There was also a reform in the pension sector, where the government allowed 26% FDI. This would allow the foreign portfolio managers to manage over $12 billion of the employee pension money. Monti takes over as Italys PM Silvio Berlusconi, a prime minister notorious for his buffoonery and flamboyant lifestyle, has given way to a sober, monogamous economist Mario Monti. Mario Monti was sworn in as Italys prime minister following Silvio Berlusconis resignation. Monti brings credentials from a decade as a European commissioner that his technocrat government will need while facing a financial crisis threatening to spin out of control. Montis cabinet, which is devoid of any political flavor, consists of experts such as bankers, ambassadors and bureaucrats. Mr.

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NIVESHAK

The Niveshak Times

Monti reserved the finance portfolio for himself and said that he intends to serve a full term, until 2013. The new government, which was sworn in before President Giorgio Napolitano, will be tasked with passing a strict austerity program aimed at restoring investor confidence that Italy will not go bankrupt and require an international bailout. Greece banking on Papademos for reforms In another striking development, former Vice President of European Central Bank, Lucas Papademos, has been selected as the new prime minister of the debt ravaged Greece. His 48-member cabinet includes MPs from the conservative New Democracy party, the populist far-right Laos party and outgoing socialist government, which caved in under the pressure of handling Greeces worst economic crisis. The immediate task at hand is to focus on securing a 130 billion euro aid package agreed to by eurozone leaders at a summit last month. Acceptance of the bailout had been thrown into doubt after the outgoing Prime Minister, George Papandreou, said he would put it up to a public referendum. With elections due in February, the new government has approximately 100 days to implement painful reforms that will ram home the message that even in its near-bankrupt state the country is intent on remaining in the eurozone. IIP slumps to 1.9% in September As per the latest data released by ICRA, the Index of Industrial Production (IIP) slumped to 1.9 per cent in September, relative to the 6.1% growth recorded in September 2010, marking the slowest pace of IIP growth in the last two years. The General Index for September has been recorded at 163.2, which is just 1.9 percentage point higher than the figure observed during the similar period last year. In terms of sectors, mining reported a sharp decline, dropping 5.6 per cent after posting growth of 4.3 per cent a year ago. Manufacturing grew by 2.1 per cent, while electricity recorded encouraging figures of 9 per cent from a year ago. In terms of use-based classification, capital goods production disappointed as it fell by a whopping 6.8 per cent. The growth in the consumer non-durables segment also declined by 1.3 per cent. Moreover, growth in consumer durables halved to 8.7 percent from 14.2 per cent a year ago. Consumer goods output also grew by a slower 3.5 per cent from 9.7 a year ago. The cumulative growth for the six months ending September 2011-12 is also significantly low, as a growth of only 5.0% has been recorded over the corresponding period of the previous year, as against 8.2 per cent in the same period last year. A slowing economy is squeezing centers finances and questions are being raised over the governments ability to restrict the fiscal deficit for the fiscal ending in March 2012 at the budgeted level of 4.6% of gross domestic product. Rupee surpasses 52 against dollar On Tuesday, November 22nd, Indian rupee witnessed an all-time low of 52.73 intraday against the US dollar on account of a persistent demand for the American currency from banks and importers. Later in the day, it settled at 52.36/37. The domestic currency had tumbled by 81 paise to close at a nearly 33-month low of Rs 52.15/16 per dollar on the previous day in the backdrop of an eight-session losing streak in the stock market and a deepening euro-debt crisis. The US dollar has been surging against major currencies as investors shun higher yielding risky assets over fears that the ongoing European debt crisis may spill over into the global economy. The Indian currency is also hit by broad selloff in risky assets as global investors shun emerging market equities and currencies amid mounting fears that European leaders wont be able to effectively tackle the Eurozone debt crisis In addition to this, the declining local shares also failed to provide any support to the domestic currency. The falling rupee can have catastrophic effects on the already declining Indian industries, as it would make imports more expensive. Oil imports will take a hit, thereby exerting more pressure on the deficit estimates of the government.

The Month That Was

FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Market Snapshot Cover Story

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR)

BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap 55,81,144 26,43,222 12,99,442

LENDING / DEPOSIT RATES

Base rate Savings Bank rate Deposit rate 10%-10.75% 4.00% 8.5% - 9.25%

Source: www.bseindia.com

CURRENCY RATES
INR/1USD INR/1Euro INR/100Jap.YEN INR/1PoundSterling 52.25 69.82 67.75 81.23

RESERVE RATIOS
CRR SLR 6% 24%

POLICY RATES
Bank Rate Repo rate Reverse Repo rate 6% 8.50% 7.50%

Source: www.bseindia.com 29th October to 24th Novemberber 2011 Data as on 24th November 2011

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Market Snapshot
BSE
Index Sensex MIDCAP Smallcap AUTO BANKEX CD CG FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY TECk Open Close % change 17,805 15,858 -10.93% 6,275 6,960 9,571 11,372 6,633 11,036 4,153 6,171 5,830 12,143 9,179 2,217 7,616 1,923 3,522 5,591 5,989 8,187 9,743 5,745 9,289 3,928 5,953 5,517 10,040 8,030 1,887 6,652 1,558 3,340 -10.89% -13.95% -14.46% -14.33% -13.39% -15.83% -5.41% -3.53% -5.37% -17.32% -12.52% -14.88% -12.66% -18.98% -5.17%

Market Snapshot Cover Story

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Article of the Month Cover Story

A New Framework for Proactive Monitoring & Management of Risks

Amit Bhansali

IMI, New DelhI

Introduction The financial downturn of 2007-08 highlighted the limits of traditional risk management systems. Traditional risk measurement tools, such as value-at-risk and stress testing failed to grasp risk patterns promptly. Moreover they lagged behind in regard to recognizing signals of future crises. Based on historical data, these traditional backward looking tools respond slowly to change, preventing financial institutions from reacting in a timely manner and from taking the necessary actions to minimize risk exposure. To overcome such limitations, a team of two quantitative risk analysts in the Risk Integration & Counterparty Risk unit at Banco Popolare

Group- Nicola Andreis and Paolo Zamboni, has sketched a new framework for monitoring and managing risks based on an Early Warning System (EWS) that supports and supplements the traditional methods like VaR and stress testing. They have described EWS as a set of economic and financial variables that are able to foresee unexpected losses that have not yet been detected by the traditional risk management systems. The process consists of monitoring a set of macroeconomic and financial indicators that are able to foresee the dynamics of risk. When specific thresholds are exceeded by these indicators, scenarios are defined and applied in order to evaluate risks.

EWS as a set of economic and financial variables are able to foresee unexpected losses that have not yet been detected by the traditional risk management systems

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Article of the Month Article of the Month Cover Story

EWS can be thoroughly understood with an example of Gold Backed Lending Business by NBFCs/Banks in India. In this business, NBFCs/ Banks lend to retail customers against pledging of gold. They face a major risk due to change in value of gold as high competition forces them to lend more against per unit of gold. This type of assessment provides the impetus for preventive actions which should give a firm more time to obtain sufficient capital and liquid resources, limiting the potential negative effects of any future crisis. EWS An EWS should not replace the traditional systems used by the risk management department of financial institutions, but should form a part of an integrated framework that includes several steps from monitoring of macroeconomic and financial variables to the definition of actions for mitigation purposes. Development of EWS The first step consists of defining the phenomenon to be monitored. Here, for the Gold Backed Lending example, the phenomenon is the Period of turbulence for the Gold Backed Lending Industry, after the beginning of a crisis. The focus of this phenomenon is on the financial crisis associated with lending backed by gold. The turbulence can also occur in a general upward cycle of the economy. The second step in EWS development aims to identify macroeconomic and financial indica-

tors that are potentially able to anticipate the stated phenomenon. Potential Indicators for gold backed lending can be the current gold price, its volatility, performance of equity market, crude oil price, interest rate, exchange rate, inflation, probability of default and loss (given default). Using econometric models of regression, intensity of each variable on the occurrence of this phenomenon should be identified. A map is then plotted between probability of default due to each indicator and occurrence of threshold alert by that indicator. For example, if probability of default due to indicator Inflation is 0.5 and occurrence of this event has the probability of 0.4, a map can be plotted. This map is required for simulation and gauging the risk due to threshold alert of each indicator. The last step in the development of EWS is the setting of alert thresholds, which should be monitored every day. When the early warning indicator exceeds threshold values, there is a high probability that a crisis or future stress situation is approaching, and relevant management actions and interventions can be taken. The limitation of using threshold values is connected to the unavailability of historical data for predicting financial crises. For Gold Backed Lending, threshold alert limit is ` 25000 for gold price. So, if this value falls below the limit (day 6, as shown in Fig. 1), threshold alert will get activated. Now, the Risk Management Team should perform Scenario Analysis to evaluate potential risk by variation of the indicator. After the potential risk is

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Article of the Month Cover Story

Figure 1 : Threshold Alert due to Indicator

calculated, proactive risk management measures can be taken. The method of signals consists of drawing a temporal graph of the crisis periods on the basis of recognized indications. This allows a financial institution to identify an indicator and to fix a threshold, beyond which it is assumed that the indicator signals a state of crisis. Risk Assessment The assessment of the effects on lending is very similar to the stress testing analysis used to quantify the impact of certain extreme but plausible scenarios and to measure the ability of a bank to cope with such risks. A way to quantify the impact of a scenario on an intermediarys risks is via simulation. Under this approach, after having defined the connection between financial and economic variables with risk exposure, a large number of scenarios are generated in order to get a distribution of potential loss. Proactive Risk Management Proactive management of potential risks is undertaken according to the possible development of the crisis and intensity of an indicator. The use of the proposed EWS will particularly impact the following stages of the day-to-day risk management: evaluation of risk exposure and daily reporting, active management of risk, and contingency plans. For example, the emergence of an alert in NBFC/ Banks arising from an EWS, although not yet real, could induce: (1) the finance department to select and define the features of sources of funding due to change in interest rate and (2) the credit department to require preventive actions to amend the guidelines for lending policies due to threshold alerts generated by an indicator, such as price of gold. As a proactive measure, Banks/NBFC can take following actions depending upon the intensity of

risks. It takes advantage of the ability of the top management to overcome crisis situations. 1.ALM and hedging actions related to Gold. 2.Ad hoc financing and detailed reporting of loan outstanding. 3.Business contingency plan. 4.Capital contingency plan. This model can be applied across various industries, especially financial institutions. The explanation of Gold backed Lending using EWS model will help replicate the same model across other industry domains. Parting Thoughts by Nicola Andreis and Paolo Zamboni The EWS can become the activating source for specific and more frequent stress tests that facilitate a better understanding of the potential effects of the growing risk dynamics. This can have a direct impact on management reporting, government operating risk, strategic activities (e.g., asset and liability management), capital management processes and the management of different states of a crisis. Given the pioneering nature of early warning development and the lack of best practices in this area, financial institutions considering EWS implementation should lean towards a gradual rollout. Careful and critical testing, experimental application, internal discussions and sharing are important components of any successful EWS deployment. The development of Early Warning Systems will be fostered only by firms committed to (1) strong and courageous investment in mental and professional energy and resources; (2) an openness to new areas of research and testing; and (3) the activation of intense, more direct channels of dialogue between research, business and controls units inside the bank.

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Cover Story Article of the Month Cover Story

GREEN FINANCE

Chandan Gupta & Harshali Damle

TeaM NIveshak

Introduction If Kyoto dies in Durban, it will be a death knell for the climate fight, Tony Blair. With the 17th Conference of the Parties scheduled to be held from 28th November, 2011 to 9th December, 2011 at Durban, Kyoto Protocol has emerged as the most debatable topic in the political spheres. With the expiration of the first round of Kyoto Commitments at the end of 2012, the rift between the developed and developing countries is on the rise. Amidst all this, Durban has become the center-stage of international negotiations, which is expected to provide an effective platform to reach a decision which would lay a strong foundation for the holistic and sustainable development of the planet. Kyoto Protocol- Background Kyoto Protocol is an international agreement of United Nations Framework Convention on Climate Change (UNFCC) which deals with the issue of carbon emissions, signed by 193 parties, which includes 192 nations and 1 regional economic integration organization. Kyoto Protocol, through its legal framework, binds 37 of the most developed countries and 15 states of the European Union to reduce their carbon emissions as per certain standards below the 1990 level within a stipulated time period of 2008-2012. For all the parties put together, the protocol sets a carbon emission target of 5.2% below that of the 1990 level. One of the major deterrents in the implementation of Kyoto protocol as the only international legal legislation with respect to carbon emissions is that it has not been ratified

by United States, which is one of the major emitter of carbon in the world. Carbon Credits- CERs and carbon markets Kyoto Protocol plans to deal with the problem of carbon emissions by commercializing them and creating a whole new carbon asset market for the investors. Kyoto Protocol has provisions for three schemes through which trading can be done in carbon assets. These are: 1.Emissions Trading Scheme 2.Clean Development Scheme 3.Joint Implementation scheme The major chunk of carbon credit market comes from Clean Development Scheme (CDS). With 84% share in volume and 91% share in value in primary market approximately, Clean Development Mechanism provides developed countries an opportunity to meet their Kyoto commitments by buying carbon credits, known as Certified Emission Reductions (CERs) from other nations. Clean Development Mechanism is beneficial to both developing and developed countries. For developed countries, it is a cost effective way to meet their Kyoto commitments as development of sustainable projects is relatively costlier prospect than buying carbon credits from developing countries. On the other hand, developing countries gain in terms of foreign investment they attract from carbon credit trading. Carbon Markets: Status Quo As US has not ratified the Kyoto Protocol, the European Union has emerged as a major buyer of car-

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Article of the Month Cover Story Cover Story

Figure 1 : Production indices of EU 27 for total industry excluding construction seasonally adjusted

bon credits. Thus, the Carbon Credit Market is heavily dependent on the economic conditions of European Union and that is the major reason why Euro Debt crisis has severely impacted the carbon credit market. The crisis has adversely affected the demand of carbon credits, which mainly depends upon the industrial activity in the buyer country and the industry in Europe at present is at an all-time low. Figure 1 shows fluctuations in Industrial Output in European Union during September 2010-September 2011. Industrial output in the region has come down by 1.3% in September 2011 as compared to August 2011. Industry in Europe, because of these fluctuations and ill effects of exposure to Greece debt, has reduced its demand for carbon credits, which has led to approximately 41% fall in value of carbon credits in 2010. Also, the record issuance of CERs in the current year has led to oversupply in the carbon credit market which in turn has negatively affected the price of CERs. As per Reuters, A record 254 million CERs have been awarded this year so far, well above the 132 million awarded in the whole of 2010 and 123 million in 2009. Figure 2 shows the price and volume of CERs traded at European Energy Exchange during 2009-2012. The fluctuations in price and volume traded clearly demonstrate the volatility in carbon market. The price of U.N. carbon credits hit a new record low of 7.13 euros ($9.77) per tonne in November 2011, before recovering slightly to 7.28 euros and as predicted by analysts at UBS EU carbon prices could crash to as low as 3 euros as European Union grapples with debt crisis and oversupply in the market. However in spite of falling prices, the numbers of firms applying for registration under Clean Development Scheme in emerging economies like India and China is on an increase. This is because of the expectations that even in absence of Kyoto Protocol, EU

Emission Trading System will continue during 20132020 and the demand for carbon credits will continue to increase in at least the countries which have regional commitments and systems for carbon emissions. The struggle for Carbon Power Carbon credits, because of the Kyoto Protocol legal obligations, have proved to be a blessing in disguise for developing countries. With about 58.04% of contribution in carbon credit market, China has emerged as a leader in supplying carbon credits. India, which is a home to two commodity exchanges which trade in carbon credits, follows China at rank second in carbon trading. According to a CRISIL research study, the number of carbon credits issued for emission reduction projects in India is set to reach 246 million by December 2012 from 72 million in November 2009. The figures clearly demonstrates the kind of presence emerging economies have in carbon credit market. With the first round of Kyoto protocol coming to an end in 2012, deliberations for second round of commitments has already begun. However countries like Russia, Japan and United States along with some other developed countries are not ready to sign the second round of commitments unless the developing countries like China also accept the obligations for reduction in emissions. As per the US Energy Administration Report 2009, China has surpassed United States in carbon emissions and India has emerged as third largest carbon emitter surpassing Russia. However, at the same time if we look at the per capita emissions, US is still the leader with 18 tonnes per person, while on an average a Chinese emits only 6 tonnes and an Indian only 1.38 tonnes. One of the reasons for this conflict is that the United States is not very comfortable with the growing

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Article of the Month Cover Story Cover Story

Figure 2 : Price and volume of CERs traded at European Energy Exchange during 2009-2012
global footprint of China. Also considering the current status of its economy, the United States is not willing to come under any obligation to cut the carbon emissions till the same obligations are also imposed on China, which has posed a serious challenge to its economy. The European Union, on the other hand, saves a lot of money by purchasing carbon credits from developing countries because of low developmental cost in these countries. If the developing countries come under obligation, the Carbon Credits available for sale will be less in number and that too at a higher price. Thus, European Union does not want the developing countries to be under any such obligations. All this suggests how defining obligations for developing nations has become a contentious issue. However, some standards should surely be set for emerging economies like India, China & Brazil and we should not wait for them to reach an alarming stage where many of todays developed countries are in terms of global warming because of unsustainable practices of their industries. 17th COP Durban, Nov 2011 With the failure of the countries to reach any consensus at previous Conference of Parties (COPs) at Cancun and Copenhagen and the current rift between developed and developing countries, it is quite possible that this rupture may once again come in the way of a global and sustainable solution to the problem of carbon emissions at 17th COP, Durban. And thus any chance of adoption of second round of Kyoto Protocol by the member nations at present seems to be very low. Chinas Chief Climate Change official Xie Zhenhua, who played a pivotal role in Copenhagen round discussions, made a call to emerging economies to bring forward their own plans to demonstrate their willingness to curb the growth of carbon emissions. This action has fueled speculations that the developing countries may come out with novel frameworks which might be significantly different from the ones suggested by the developed countries. There may be some emission standards under the same but it is highly unlikely that the framework will put developing nations under any obligation to cut the carbon emission rates. The failure of the nations to come to any agreement in Durban, apart from other consequences, will also have an adverse impact on carbon trading as the prices in carbon market are mainly driven by Kyoto Protocol, and in absence of any such legal binding the future of carbon trading looks bleak. Conclusion There is an increasing need to recognize that the core agenda of the COP is a conscious effort to reduce carbon emissions as a part of the shared global vision of sustainable environment. There is a need to rise above the self-seeking political interests and look at the broader picture of sustainable development of the planet as a whole. The world expects the 17th COP to lay a strong foundation for the same.

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He Speaketh

Mr. Sanjib Bezbaroa

heaD, CorporaTe eNvIroNMeNT healTh aND safeTy, ITC lTD.

Mr. Sanjib Bezbaroa heads the Corporate Environment Health & Safety department at ITC Ltd. and leads the sustainability initiatives on the product and services front, including supply chain, besides being responsible for Sustainability Reporting of the organization. He is an Electrical Engineer with over 20 years experience in power plant engineering and commissioning, covering both generation as well as transmission & distribution systems. He did his PGDM in Environment Management from Imperial College, London. He is also a Chartered Engineer and a Bureau of Energy Efficiency Certified Energy Auditor. Mr Bezbaroa has been working with ITC from last 11 years and is currently positioned at their Kolkata office. He has earlier worked with TCS as well.
Niveshak: From greeN projects, itc has doNe
For iN the Near Future? hotels to it all.

Mr. Sanjib Bezbaroa, Head, Corporate Environment Health and Safety, ITC in a candid discussion with Team Niveshak talks about the future of Kyoto protocol and how ITCs approach to carbon emissions is not restricted only to carbon credits but stretches even to the National Action Plan on Climate Change.

WiNd What are

the greeN aveNues that

itc

is lookiNg

Mr. BezBaroa: Solar energy is something which we are working on, and we expect it to be a significant contributor in our green investment portfolio for the years to come. The actual financial and technical aspects of the same are still under consideration.
Niveshak: does itc cost beNeFit aNalysis beFore makiNg a greeN iNvestmeNt? iF so, theN What is the criterioN that the compaNy coNsiders?
carry out a

Niveshak: hoW is itc vieWiNg reNeWable eNergy certiFicates (rec) - the NeW iNitiative by the iNdiaN goverNmeNt? are there aNy NeW projects uNder the rec iNitiative?

Mr. BezBaroa: We are actively seeing how it will work for ITC. Right now all we can say is that the same is under the assessment of the Carbon Committee for future plan of action.
Niveshak: do you thiNk that carboN credits are really serviNg the purpose oF
eNviroNmeNtal protectioN For Which they Were iNitiated? meNt?

or

has their scope beiNg

restricted to that oF a FiNaNcial iNstru-

Mr. BezBaroa: Any new project to be undertaken is addressed on its potential financial, social and environmental impact. This forms the basic acceptance criteria. However, not always does the company make decisions based on Internal Rate of Return. The company also has to consider the long term goals, perspectives and the social impact of the decisions on a case to case basis, depending upon on its strategic importance.

Mr. BezBaroa: The energy related projects which involve renewables are definitely serving the purpose of environmental protection. However there are certain Clean Development Mechanism projects, mainly related to ChloroFlouro Carbons (CFCs), which have been misused by people, thereby portraying a negative image of the overall system. However, in my view, barring few such projects, it has contributed positively to the cause

Branding might be one of the major reasons, but if a company uses sustainability only as brand building exercise, it doesnt cut much ice for very long.

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ArticleSpeaketh He of the Month Cover Story

of environment protection.

for assessment of their sustainability initiatives. Branding might be one of the major reasons, but if a Niveshak: hoW do you see the Future oF carboN cred- company uses sustainability only as brand building its post 2012, that is, aFter the deadliNe oF the First exercise, it doesnt cut much ice for very long. rouNd oF kyoto protocol? Niveshak: are there aNy shortFalls iN regulatioNs Mr. BezBaroa: That is a difficult question to answer. relatiNg to sustaiNability? What are your commeNts Fundamentally, we believe and accept the fact that oN iNcreasiNg legislatioNs to make sustaiNability more carbon will have a price, whether in the form of viable? do you have aNy suggestioNs iN this regard? taxation or market based opportunities. We prepare ourselves to grab maximum out of these opportuni- Mr. BezBaroa: I do not think there are any major shortties, as and when they appear. Not to forget that our falls in regulations related to sustainability. Howevapproach to energy is not just restricted to Clean er, there are issues in implementation of the same. Development Mechanism, it is more fundamen- There is a lack of incentive as well as low recognitally aligned with National Action Plan on Climate tion for even the genuine sustainability initiatives. Change. We need to reduce our specific energy con- Usually, the financial markets also dont pick up the sumption. Our next goal is to increase our portfolio sustainability signals as the projects involved are of renewables. We try to ensure maximum environ- long-term in nature, and benefits accrued are also mental good and if the same is realisable in form of recognised over a long period of time. Hence, I betangible monetary benefits, we try to make use of lieve there is a need to ensure proper recognition of it. But our strategy is incidental to the whole plan efforts in this regard. of sustainability. Also, as a suggestion, there is a need for a proper Niveshak: there is a geNeral perceptioN that sustaiN- grading system relevant to the sustainability in the ability For corporates is merely a braNd buildiNg ex- Indian context which should be based on perforercise. What are your vieWs oN the same? mance parameters defined by the government. Mr. BezBaroa: When we see Sustainability from the Niveshak: What Will be your suggestioNs For the Fubusiness perspective, it has 5 value propositions: ture maNagers to eNsure that they aligN themselves With the idea oF sustaiNability? One is Top-line growth, when you use it to ensure higher sales. Second is Bottom-line performance Mr. BezBaroa: The suggestion sounds simple but is which includes improving efficiency in use of re- difficult to implement. There is a need to think besources, Energy & material conservation, etc. Third yond financial performance. There are many busipart will be the Branding opportunity, as it helps ness elements which are not measurable in monimprove the brand visibility. Say for example what etary terms. Many environment depletion costs are we at ITC have done in our hotels business. The not considered in financials. We need to be open to fourth aspect is it helps in managing risk. Sustain- such aspects. We need to work in line with the naability is a process of getting and being receptive tional objectives and priorities. This attitude is lackto the information from all your stakeholders and ing in the current educational system as well as the that too from all dimensions, and working on that organisations. There is a need to make a conscious information, which helps in risk management. The effort in this regard. Together, we need to find a way fifth will be that it contributes towards Employees out for a sustainable future. motivation, as it is comparatively easier to identify with an organisation which is conscious towards the environment. Every business must consider all these 5 aspects

There is a lack of incentive as well as low recognition for even the genuine sustainability initiatives.

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Article of the Month FinGyaan Cover Story

FINANCE MARKET
Ankit Goel

IIM BaNgalore

A lot has been written about Indias growing strength as an emerging nation. The Indian economy has been growing and some of the factors which highlight the same are: 1. GDP growth rate averaging over 8% from 20032010 2. Rapid urbanization, rising middle class 3. Increasing political stability with re-election of last government 4. Forex reserves over $250bn 5. Service sector contributing 60% of GDP Importance of Housing in Indian Scenario 1. 2nd Largest employment generated in this sector (after agriculture) 2. Fosters development of ancillary industries via strong vertical linkages (forward & backward) 3. US $110 bn market size The problem The major problem plaguing the Indian housing industry is the consistent demand-supply mismatch. The shortage was 23.3 million units in 1981, 22.90million in 1991, ~20 mn in 2001 and so on. Although a clear downward trend is visible, the fact is that the rate of closure of this gap has been decreasing over time. The recent figures in this respect are worse. Moreover the growth rate in urban areas is clearly above that in rural areas signifying the urbanization phase India is currently undergoing with more and more people migrating from the rural

to urban areas. Also, India has the following features, which further signify the need of ease of access to housing finance for the masses. 1. Rapid population growth 2. Increasing disposable income 3. Very high population density 4. Lack of supporting financial products 5. Low competition 6. Regulation & Exchange Risk However there is a huge demand-supply disconnect (as shown in Fig 1). We see that though a huge demand for housing finance exists in India, the mortgage/GDP ratio, which is a key indicator of Housing finance penetration, is one of the lowest in the world. This naturally is a great opportunity waiting to be tapped. Government Initiatives: Housing finance problems as outlined above began to surface as early as in the 1970s (See Fig 2). The Indian Government has taken various initiatives over time to address these problems. Competition in Housing Finance Sector in India The following are providers of housing finance in India, in one form or another: 1. Commercial Banks: They are the largest mobiliser of savings and also in respect of coverage. Their role has traditionally been limited to providing the working capital needs of business, industry and

Figure 1: Mortgage to GDP ratio 2007 (Source: European Mortgage Federation & Asian Development Bank)

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Figure 2: Evolution of Housing Finance Industry (Government Intervention)

commerce and hence, they have not been very active participants in the housing finance market. Another reason for the same is that they are funded by short-term resources which cannot be profitably employed in long term lending. 2. Cooperative Banks: They deploy funds from a common pool of resources to provide for the various needs of its members. In the Indian scenario, a lot of reluctance has been noticed by these cooperative banks to provide loans for housing finance. One of the major reasons for this is the high risk and illiquidity in giving housing loans from common corpus. 3. Regional Rural Banks: Again, they have not been very active in housing finance sector because of the large amounts and low creditworthiness involved leading to illiquidity and losses. 4. Agricultural and Rural Development Banks: The major function of these banks is not the provision of housing finance. Consequently, there is low threat from these too. 5. Housing Finance Companies: These are companies with principal objective of lending for housing finance. However, there are only about 20 companies accounting for greater than 90% of total housing loans provided. 6. Cooperative housing finance societies: These are specialized institutions established and subsidized by NHB to cater to the housing needs of the masses. These institutions do not have adequate technical expertise to be able to design right product for the right target. However, state

subsidy is major factor in their favour. Thus, the housing finance market competition in India can be summarized as follows: Organisations providing
Commercial Banks Cooperative Banks Regional Rural Banks Agricultural and Rural Developmant Banks Housing Finance Companies Cooperative housing finance societies

Threat
Medium Low Low Low HIgh HIgh

Current Housing Credit Products In general, most of the banks provide slightly modified schemes of the same basic version of housing finance products to all kinds of customers. Herein the basic version of Standardized fixed rate mortgage is described. Standard fixed rate mortgage
Fixed ROI (consistently falling over time since 20 yrs)

Maximum period 25 years Repayment limited to retirement age (60/65 yrs) Equated Monthly Installment Method/ Graduated Installments Interest Tax passed on to the borrower, Processing Fee (0.5% - 1%) and Administration Fee (1%) Max. Loan to value ratio : 80% at origination Avg. Loan to value ratio : 70% at origination Average age : 37 years
Table 1: Standard fixed rate mortgage

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Terms for Salaried People

Lender Interest Rate (in %) HDFC Citibank Axis Bank Kotak Mahindra Bank Reliance Consumer Finance Deutsche Bank Standard Chartered Bank ING Vysya India Bulls Deutsche Post Bank Tata Capital 9.25% - 10.25% 9.25% - 9.75% 9.25% - 10% 10.75% 10% - 10.5% 9.75% 9.75% 9.75% - 10% 9.25% 9.25% - 10% 9.25% - 10% Max loan amount (% of property value) 80% 75% - 80% 80% 75% - 80% 80% 75% - 80% 75% - 80% 80% 80% 80% 80% Processing fee (% of loan amount) 0.5% - Rs 11300 0.50% 0.50% - 1% 0.50% 0.75% 0.50% 0.5% - 1.5% Rs 5000 - 0.5% 0.50% Rs 6000 - 8000 0.5% - 0.75% Tenure (Years) 20 25 25 20 20 20 20 20 20 20 20 Pre Closure Details Allowed after (Months) 36 6 1 6 6 6 6 6 6 1 6 Charges (% of outstanding amt) 2% - NIL 2% NIL 2% 2% - 5% 2% 2% 2% 2% 2% 2%

Table 2: Terms for Salaried People

We can see from table 2, as to how the basic structure described in table 1 is used in Indian Context by various housing finance institutions. Also, there is not much difference between the terms offered to salaried (table 2) and selfemployed people (table 3). While the basic requirements, by and large remained the same, self-employed people were asked for greater security requirements when compared to salaried individuals. Refinancing options There are several sources from where these housing finance institutions fund their products. Apart from Internal Funding / Ploughing back of profits which is basically interest income and

principal repayments redeployed in these businesses that are used for extending further credit to its clients, securitization is also used. Securitization is a very common process to refinance the loans, but it basically means transfer or sale of loan assets and hence somewhat different from refinancing in the traditional sense. Some of the other options of funding are as follows: 1. Bank Deposits (including interbank participation certificates) 2. Insurance Premiums 3. Contribution from members 4. Central & State Government funding (includ-

Terms for Self Employed People

Lender Interest Rate (in %) HDFC Citibank Axis Bank Kotak Mahindra Bank Reliance Consumer Finance Deutsche Bank Standard Chartered Bank ING Vysya India Bulls Deutsche Post Bank Tata Capital Bajaj 9.25% - 10.25% 10.00% 9.25% - 10% 10.75% 10% - 10.5% 9.75% 9.75% 9.75% - 10% 9.25% 9.25% - 10.25% 9.25% - 10.25% 10.50% Max loan amount (% of property value) 80% 75% 80% 75% - 80% 80% 75% - 80% 75% - 80% 80% 80% 80% 80% 80% Processing fee (% of loan amount) 0.5% - Rs 11300 0.50% 0.50% - 1% 0.50% 0.75% 0.50% 0.5% - 1.5% Rs 5000 - 0.5% 0.50% Rs 6000 - 10000 0.5% - 0.75% 1% Tenure (Years) 20 25 25 20 20 20 20 20 20 20 20 20 Pre Closure Details Allowed after (Months) 36 6 1 6 6 6 6 6 6 1 6 6 Charges (% of outstanding amt) 2% - NIL 2% NIL 2% 2% - 5% 2% 2% 2% 2% 2% 2% 2%

Table 3: Terms for Self Employed People

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ing NHB refinancing) and International funding Arranging in increasing order of duration (from left to right bank deposits being the shortest and insurance premium, the longest) for which these refinancing options are available gives the above figure

Conclusion: From the above analysis, an Industry wide Analysis Map of the Indian Housing Finance Market follows: SWOT Strengths 1. 2nd Largest employment generated in this sector (after agriculture) 2. Fosters development of ancillary industries via strong vertical linkages (forward & backward) 3. US $110 bn market size Weaknesses 1. Infrastructure Issues

2. Governments Participation & Regulation 3. Fragmented industry with power concentration in hands of few players Opportunities 1. Consistent demand-supply mismatch 2. Urbanization phase of India 3. Low Mortgage to GDP ratio 4. Government Support 5. Refinancing Support Threats 1. Threat from Housing Finance Companies and Cooperative Housing Finance Societies 2. Non-availability of wide range of long term refinancing options 3. Capability Constraints 4. Internal Policy Challenges Clearly, we can understand that Indian housing finance market is in its nascent stage of development. Since this is a newly formed market for a hitherto unaddressed product, there will be a huge first mover advantage. The drawbacks stem only from the event of unfavorable policy changes or uneven competition from State. Both the drawbacks are relatively unlikely to occur judging on the basis of Governments current policy trends. Hence, we can conclude that the Housing Finance market in India is very attractive and forms a good case for investment.

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Article of the Month Perspective Cover Story

Rakesh Agarwal

TeaM NIveshak
The whole story The United States of America is contemplating to take a tough stance against the currency valuation issues in China by passing the China Yuan Bill in order to press Beijing to revalue its currency. The bill has been approved by the Senate and is currently placed in the House of Representatives where its fate would be decided. This might culminate into a trade war between the two economic superpowers amidst the on-going global economic turmoil spanning from Americas tepid economy to Europes sovereign debt crisis. Chinese economy is driven by exports to all the major economies of the world. The availability of cheap labour and technology has made it the export hub for many companies. However, it is widely believed that to maintain its export competitiveness China has kept its currency artificially low. Sen. Charles Schumer, a Democrat from New York and one of the co-sponsors of the bill, believes that the artificially undervalued Renminbi is the prime reason for the growing US trade deficit. He argues that this is hurting American manufacturers and slowing the U.S. economic recovery. With another recession looming large, there is growing concern that the currency manipulation by China is hurting exporters from US as they have to compete with cheaply priced goods and services. The Chinese have however, responded to increasing global pressure by letting their currency appreciate at a steady rate. However, at the slightest hint of uncertainty in the global environment, they revert back to tight regulation of the currency as can be seen from USD/CNY historical exchange rate. Both economic and political factors influence the way the Renminbi is managed since the Chinese ended formal peg against the US dollar in July 2005. In spite of slow and steady appreciation of approximately 30% against the US dollar, as long as the appreciation is kept slow, Chinese exporters are likely to enjoy a competitive advantage on price.

Figure 1: Log real value of CNY (blue, left axis), 2005=0; up is appreciation of the Chinese currency, and monthly trade balance, in billion USD (red, right axis), and trailing 12 month moving average Chinese trade balance (purple)

Possible action If America does impose trade sanctions on Chinese exports, China could use various weapons at their disposal in retaliation. The Chinese who are the major buyers of American bonds could stop buying American government bonds or worst they could sell American government bonds. If the situation boils down to that then interest rates in America would surely go through the roof and the value of the US Dollar would go for a free-fall. But such a scenario would not be helpful for anybody and might lead to a trade war similar to the one in

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the 1930s that led to the Great Depression. However, America does not seem to have the gumption to label China a currency manipulator because of the growing importance of the later in the global scenario. China is the largest holder of US dollars as foreign reserves and thus wields considerable influence on US policy decisions. Alternative view On the other side of the coin, it can also be contended that the Renminbi is over-valued if that credit problem in the Chinese system is taken into consideration. Chinas credit is rising at an average rate of 30% which is approximately three times faster than its economic growth. Thus if we take into account the amount of Renminbi that would have to be floated by the Chinese bank regulators to re-float the system, we would find the currency to be over-valued. This is partially due to the fact that the real estate market is perceived to be the only safe investment opportunity in China driving up the real estate prices and hence, credit

off-takes. In the likely event of a bubble burst, bad loans will increase with more intensity than before having dire implications on the Chinese financial system. Future Outlook The consensus is that neither the US nor China would take any action to significantly affect the status quo. On part of the US, the debate on the

China Yuan Bill is largely symbolic to keep the voter (read manufacturer and labour unions) happy ahead of the next elections. On the other side, the Chinese markets remain fundamentally strong due to its growing middle class, which continues to drive growth especially for consumer products. In addition, the Chinese equities and balance sheets are incomparably stronger than their Western counterparts that gives investors considerable confidence and margin of safety. These factors combine to give China the platform to aim for expansion at a time the when West must continue to look at its own monetary policies to avoid another global crisis and simulate growth. This would result in China and Asian markets grabbing the major share of global economic growth for years to come. Benefits of free float for China China as an ascending economic power is flexing its muscle to demonstrate its growing might. However, since it shares a symbiotic relationship with the US, there is need for both sides to reach to a compromise. All would not be lost for China in the event it lets the Renminbi be valued more transparently. In case China eases control over its currency valuation, it stands to gain the advantages of Renminbi being a global currency. An international currency would benefit the country by lowering trade settlement costs and increasing financial influence commensurate with its growing economic and political stature on the international stage. Also a revaluation would help China in slowing down its overheating economy. On the down side, China, used to a stable currency for decades, would face increased risks by its decision to internationalise the Renminbi. Such risks would include higher vulnerability to external shocks because funds can flow more freely in and out of the country. However, the benefits of integration with the global economy far outweigh the risks.

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Article of the Month Cover Story Finsight

High FREQUENCY TRADING DEMYSTIFIED

Prashant Rishi

IIM luCkNow
It was in late 2000, when the NYSE decided to quote prices of stocks in decimals of a dollar, as opposed to a fixed list of fractions. The event (called decimalization) sowed the seeds of what is today popularly known as High Frequency Trading or HFT. Stated simply, HFT is trading in stocks by computers, with minimal human assistance. Carried out by super computers of major investment banks & hedge funds, high frequency trades range in time from less than a second to a few hours. Today, it is estimated that majority (~60%) of all equity trading in NYSE is done by trading algorithms. Although predominantly into equity, HFT firms have started moving into other asset classes, like derivatives, FX and fixed income instruments. anonymity and you begin to understand why High Frequency Trading is so popular among all trading desks. Generally, trading algorithms are built on complex mathematics and statistical modeling. They are designed by Quants (as Math PhDs are known in Wall Street lingo). The hedge funds, who own these algorithms, protect them with as much zeal as Google protects its proprietary search algorithm or Coke protects its secret soft-drink ingredient. Most algorithms typically employ flat strategy, i.e. trading positions are closed within the same day. Profit with one such milliseconds-long trade is sometimes only a few pennies, but it is the massive trade volume that drives the total daily profits, which are in several thousands of dollars. Players & Strategies In the US equity markets, some of the highest volume high-frequency traders include proprietary trading desks of firms like Goldman Sachs, Knight Capital Group, Getco LLC & Citadel LLC. There are 4 basic strategies employed by almost every HFT firm: Market Making Traditional market making involves placing limit orders to buy & sell in order to earn the bid-ask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market

High Frequency Trading refers to the use of super-computers to trade in stocks with minimal human intervention. Generally used by high volume traders, HFT gives the traders unparalleled advantage over the general public. Critics are increasingly voicing their concerns on the use of HFT and demanding regulatory control to protect the public.

Asset classes traded by HFT Proprietary shops

Stocks Futures Options Bonds FX 83% 67% 58% 36% 26%

The advantage that computers offer in trading assets is speed of processing information and executing trades. Add to it other advantages like low cost, high execution consistency &

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Article of the Month Cover Story Cover Story Finsight

makers provide additional liquidity to the market by being counterparty to incoming market orders, they get rebates from exchanges for quotes that lead to execution. So, if an HFTs bid (buy order) of $15 for XYZ shares is matched, it might immediately post an offer (sell order) for the same price, hoping to capture two rebates while breaking even on the spread. Building up such market making strategies typically involves precise modeling of the target market structure & trading volumes using stochastic control techniques. Ticker Tape Trading To appreciate ticker tape trading, it is essential to understand the concept of co-location. Co-location is a system wherein a stock exchange allows large hedge funds and i-banks to place their computers near its own data terminals, in exchange for rental income. Proximity to the stock exchanges data centre ensures that any market movement (read the ticker tape) is detected by these computers before general public. Pre-designed algorithms can thus detect any trend in the prices, and carry out their own trades seconds before the general public even knows about the prices, and reacts to them. To realize the importance of a few seconds in computing terms, consider the case of Lotus Capital Management LP of New York. Earlier this year, it realized that a competitor was beating it to a trade it had programmed by exactly 3 microseconds, day after day. The loss meant Lotus was forfeiting about $1,000 in daily revenue on that particular trading strategy. Subsequently, that trading strategy was discarded since firm did not have the infrastructure to speed up the execution by 3 microseconds. Event Arbitrage Event Arbitrage is very similar to Ticker Tape Trad-

ing, except that the item of interest here is the news feed. Most HFT traders employ a class of algorithms to deal with each possible kind of corporate event (including earnings reports, earnings outlook, mergers and acquisitions, and analyst rating changes), and convert news into positive or negative trading signals. An example would be a very simple algorithm that would read words like profit, confidence, beats expectations, good quarter from a Reuters news flash, and would start buying the stock before general public have a chance to even finish reading the news. The trick is to be the one who makes the move first: to be the one who has the fastest news feed, the fastest information extraction algorithms and the fastest execution. Statistical Arbitrage Statistical Arbitrage strategies aim to make money by exploiting statistical mispricing of securities, like deviations in interest rate parity in forex markets. Carried out over prices of over hundreds of securities at a time, it is possible to detect such mispricing using extensive data mining & complex mathematical techniques. The arbitrage strategies hinge on the possibility that assets would obey their historical statistical relationships with each other in long run. The Dark Side of HFT There is another side of the story. High Frequency Trading is in the midst of a raging debate. Consider ticker tape trading as described above. A person who is privy to market prices before other players is called an insider trader, but if it is only a question of few seconds, the boundaries of law start to blur. Any firm with enough cash to buy high-tech infrastructure & pay rents to a stock exchange can enjoy the free lunch of being few seconds ahead

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of the market. HFT is, thus, accused by its critics to be a legal form of insider trading. Now, consider market making. HFTs are in no obligation to provide liquidity to the markets. They do so to serve their own profit purpose (bid-ask spreads and rebates from exchanges). However, during periods of high volatility, these market making algorithms stop immediately, leading to an almost instantaneous erosion of liquidity. A perfect example of this phenomenon was Dow Jones Flash Crash on May 6, 2010, when DJIA plunged 900 points (9%) in 5 minutes, only to recover within next 10 minutes. A July, 2011 report by the IOSCO concluded that the usage of HFT technology was also clearly a contributing factor in the flash crash event of May 6, 2010. Since then, many mutual funds have moved significant portions of their money out of US equity markets, and are considering other asset classes. They say that the US stock markets have been reduced to computerized gambling houses where algorithms devise microsecond-length trading strategies. All long-term valuation of business fundamentals seems to have lost its meaning. And its not just equity. In February 2010, a trading algorithm owned by Infinium Capital Management ran amok and caused worldwide surge in oil prices by USD 1. The company currently faces civil charges for causing a global mayhem. Advocates of HFT (read hedge funds and investment banks) are quick to dismiss this criticism. They point that they provide the much-needed liquidity to the market, and hence improve efficiency of the markets. While regulators are vying to bring High Frequency Trading into the ambit of rules, there is undoubtedly a powerful lobby opposing this.

SEC recently passed a legislation banning the use of naked sponsored access, which allowed firms to trade directly on an exchange using a brokers infrastructure without pre-trade risk controls. Similarly, IIROC, Canadas financial regulator, has proposed new tariffs that would charge trading desks per message, rather than per executed trade. If these costs are passed down by trading venues to their members, it would have a marked impact on the execution fees paid by HFTs. What now remains to be seen is will these regulations prove effective in tightening the actions of HFT firms, or will the exodus of long-term investors from the US equity markets continue unabated.

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CLASSROOM FinFunda of the Month

Factoring
Pradeeba K S
IIM Shillong
efficient and hence, reduces the cost which in turn improves the possibility of better profits. This seems great. So the companies can transfer all its accounts receivables to the factor and be risk free right? This is not the case always. Companies must take judicious decision when going for factoring mode of financing. If the debtor is credit worthy and has paid all the debts in time, the company will lose money in terms of factoring fees. There must be a trade-off between the present value of the earnings a firm gains from sales and the cost of utilising factoring as a means for financing. For example, businesses which result in slower repayment can be factored so that the company is not affected by cash deficit for other needs. If factoring is utilised for sundry debtors alone, why financial institutions provide this type of financing? Factoring can be used in place of bank loans for small and medium enterprises. Though factoring costs are higher than bank rates, small companies which cannot obtain bank loans easily can resort to this mode of financing. Also factoring financial institutions look for the credit worthiness of the buyers and not the companies resorting to factoring. This proves to be an advantage for SMEs. Factoring is utilised by firms which cannot borrow money from other sources. So what is the Regulation of Factor Bill about? The bill provides regulations for factoring business by RBI. All financial institutions providing factoring services should get approval from RBI before entering into this business. Also the mechanism of assignment of receivables to the factor and payment of consideration by the factor will be regulated. This will also enable the factors to obtain legal remedy and claim their rights on the invoices factored by them in a more efficient manner. This clears a lot of questions that I had. Thank you sir for explaining factoring.

Article of the Month Classroom Cover Story Cover Story

Sir, I recently read about The Regulation of Factor Bill (Assignment of Receivables), 2011. It would be helpful if you could explain what factoring is. Sure. Factoring is one of the oldest methods of financing by way of selling the accounts receivable of a firm. There are certain financial institutions called factors which provide this type of financing. The invoice approved by the buyer is sent to the factor. The factor in turn makes the payment to the company (seller). What does the factor gain? The invoice payment is done on a discount which usually ranges from 0.35 to 4 per cent of the value of the invoice. Also the entire amount is not paid by the factor. Usually it makes a payment of 75 to 80% keeping the remaining amount as reserve. The reserve amount is paid back when the buyer actually pays the amount. Thus the factor earns commission for factoring. Does this imply that through factoring, all the sales made by a company are like cash sales? What are the advantages of factoring to the company? As the factor pays the amount of sales to the company, it is equivalent to having all cash sales. Also the risk of collection of receivable and bad debts may be transferred to the financial institution acting as the factor based on terms agreed upon. Other advantages of going for factoring is that it frees up large amounts of funds locked up as accounts receivables and this can be used to purchase more inventory and fund other short term projects that can accelerate growth. Factoring also relieves a company from the burden of maintaining receivable accounts, conducting credit assessments for customers and handling collection of receivables. The working capital management of the company becomes

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FIN-Q
1. _______ came out with the largest IPO when it was listed simultaneously on both the Hong Kong and Shanghai Stock Exchange. It recently opened its first branch in India. 2. An account that is used to store short-term funds or securities until a permanent decision is made about their allocation. 3. Which financial term is derived from the Latin term voster meaning yours? 4. CAMEL is an effective system of rating by the banks. The model insists five main criteria and based on these the financial health is evaluated on a scale of highest to lowest, 1 to 5. In the acronym, A stands for asset quality, M stands for management and L for liability, then what do C and E stand for? 5. What do you call a situation in which the firms actual bank balance is greater than the balance shown in the firms book? 6. __________ is not linked to any physical reserves and is solely based on faith. The government has declared it to be a legal tender, but it risks becoming worthless due to hyperinflation. 7. X is a provision in an underwriting agreement that gives the underwriter the option to over allot the initial offer made to the public by the issuer. Usually done in order to stabilize the price of a share post the issue, it helps in reducing the occurrence of spikes in the price of the share. Identify X. 8. X is a payment mechanism devised to facilitate inter-bank transfer of funds. The acronym of X is also found in Casinos. What is X? 9. Name the tennis tournament sponsored by the stock exchange, which was once chaired by the person who has now been sentenced 150 years prison for his alleged involvement in a Ponzi scheme. 10. Whose portrait featured on the first set of currency notes issued by Reserve bank of India?

All entries should be mailed at niveshak.iims@gmail.com by 7th December, 2011 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

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WINNERS
Prize - INR 1000/-

Article of the Month

Amit Bhansali
IMI, NEW DELHI

Prize - INR 500/-

FIN - Q

Ankit Gupta
SIBM, PUNE

ANNOUNCEMENTS
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