AN IIMA, IIMB, IIMC Initiative | June 2009

THE Also See

> K V Kamath: ICICI, the Road Ahead

MONEY > Interview: Prof. P. Mohanram, Columbia Univ

> Indian Stock Market: Microstructure

MANAGER > Behavioral Finance: Extracting Alpha

> Financial Meltdown: Monetary Policy Tools

Climbing out of
the Crisis?
eDITOR’S nOTE
tHE tEAM
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 Managing Editors:
of auto giants GM and Chrysler indicated that the Rajatdeep S Anand [IIMC]
US economy still has some way to go before it has
seen the worst of this crisis. The consensus amongst
Anuja Arvind Lele [IIMC]
strategists seems to be that things may worsen in short Devdutt Marathe [IIMA]
term before becoming better by the end of 2009. So Piyush Soonee [IIMA]
the question staring all of us in face is whether 2009
would be the beginning of a new Dawn or could
Editorial Board
we be heading to the something akin to the Great
Depression of 1930s. Ashutosh Agarwal [IIMA]
Devendra Agarwal [IIMC]
The silver lining seems to be that Indian economy is Divya Devesh [IIMC]
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 Design
economics especially after the upheaval in US, Majid Asadullah [IIMC]
Europe and their effects on China and Japan. Abhishek Nagaraj [IIMC]
The second anniversary edition of “The Money
Manager” brings you insightful interviews of Prof.
Coordination Committee:
Partha Mohanram of Columbia University who Shishir Agarwal [IIMC]
talks about the current financial crisis and how Manu Jain [IIMB]
corporations should gear up for the next phase. We Ravi Shankar [IIMA]
also had an opportunity to talk to Mr. K. V. Kamath,
Neha Verma [IIMB]
MD and CEO of ICICI bank who shared his views
on his vision for the bank. We have selected articles
on diverse topics such as effectiveness of Basel II Corp. Communications:
in the current financial crisis, identifying successful Akshat Babbar [IIMA]
hedge fund strategies for investing, new monetary
policy tools, failure of TARP and climate change
induced financial risks. As usual this issue is packed Logistics:
with challenging puzzles, crosswords, and interesting Jay Kumar Doshi [IIMC]
trivia. We hope you have a great time reading the Saurabh Mishra [IIMA]
latest issue of Money Manager.
aCKNOWLEDGEMENTS
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.
 cONTENTS
COVER STORY
06 An Interview with Prof. Partha
Mohanram
SPECIAL FEATURE
11 An Interview with K.V. Kamath

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

19 An Interview with Prof.

12
Prof.Marti Subrahmanyam
STUDENT ARTICLES
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

60
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
PRIMER
What do we know about the market
83 microstructure of the Indian Stock
Markets? - Malay K. Dey
KNOW YOUR PRODUCT
86 Barrier Options
cOVER story
cover sTORY
cover page

An Interview with
Prof. Partha Mohanram
Phillip H. Geier Jr. Associate Professor of Business,
Graduate School of Business, Columbia University.

Partha 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.
07 THE MONEY MANAGER | JUNE 2009

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
08 THE MONEY MANAGER | JUNE 2009
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?
09 THE MONEY MANAGER | JUNE 2009
A. 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.
The main thing is about the students - and it does not
matter where you are taught and how you are taught.
[The students should] always try to take a course from
the perspective of what one can learn. Things like
grades etc. are pretty unimportant. You realize this only
after some years and you wonder why I was striving for
those. It is more important to get the knowledge and
the understanding of what these courses are about.
Q. Not many people from the Indian B-Schools
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?
A. Hopefully the fact that no one is going to academia from
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
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
academic institution, you get amazing amount of flexibility.
Q. Areas like asset management, valuation, and
accounting need a relook. Is it that we have gone
away from the basics and we need to return to those or
that we have to find new ways of dealing within these
areas?
A. There has been a lot of over quantification of issues that
need to be done away with. People who don’t understand
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
up with any valuation model involved in the investment
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
10 THE MONEY MANAGER | JUNE 2009
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.
Q. When you graduated from IIMA, were there any
notions that you and your classmates held widely 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.
- By Ashutosh Agarwal and Devdutt Marathe, IIM
Ahmedabad
sPECIALstory
cover FEATURE
cover page

An Interview with
Mr K.V. Kamath
Managing Director and CEO,
ICICI Bank Limited

K V Kamath is currently the Managing Director and CEO of ICICI Bank, 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.
12 THE MONEY MANAGER | JUNE 2009
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
13 THE MONEY MANAGER | JUNE 2009
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 system across the world is
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
14 THE MONEY MANAGER | JUNE 2009
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?
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
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Senior Vice President, CCIL, Mumbai

Dr. Golaka C. Nath

Central Counterparty (CCP) – Role of Clearing
Corporation of India Limited
16 THE MONEY MANAGER | JUNE 2009
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
exposures
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.
17 THE MONEY MANAGER | JUNE 2009
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.
18 THE MONEY MANAGER | JUNE 2009
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
Puzzles
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
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An Interview with

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

Prof. Marti G. Subrahmanyam is the Charles E. Merrill Professor of Finance,

Economics and International Business in the Stern School of Business at 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.
20 THE MONEY MANAGER | JUNE 2009
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
21 THE MONEY MANAGER | JUNE 2009
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
22 THE MONEY MANAGER | JUNE 2009
instances of human beings ignoring the lessons of
prior experience. George Santayana said it best in his
The Life of Reason: “Those who cannot remember the past
are condemned to repeat it.”
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
23 THE MONEY MANAGER | JUNE 2009
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
THE MONEY MANAGER | JUNE 2009

sTUDENT
cover aRTICLES
story
cover page

1st Prize
Extracting Alpha Using Behavioural Finance
Akhil Dokania, Nitin Agrawal, Prabhudutta Kar
IIM Bangalore

2nd Prize
New Monetary Policy Tools -
Innovative Policy Response to Financial Meltdown
Ajay Jain, Atishay Jain, Sourav Dutta
IIM Bangalore
25 THE MONEY MANAGER | JUNE 2009
Extracting alpha using Behavioral Finance
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.
26 THE MONEY MANAGER | JUNE 2009
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
share.
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. Investor beliefs – There can often be numerous
personal beliefs of the investor which guide the way he
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:
 Loss aversion – Individuals often show greater
sensitivity to losses than to gains.
 Regret Aversion – People often try to minimize
27 THE MONEY MANAGER | JUNE 2009

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
apr_99-98 0.1001 -0.0445 0.0106 -0.0445 -0.0704 -0.0457 0.0863
oct_99-98 0.0137 0.0221 -0.0023 -0.0194 -0.0131 0.0156 0.0180
apr_00-99 0.0297 0.0004 -0.0107 0.0004 -0.0028 -0.0087 -0.0085
oct_00-99 0.0388 -0.0280 -0.0468 0.0089 0.0187 -0.0631 -0.0018
apr_01-00 0.0074 0.0082 0.0258 0.0082 -0.0220 0.0052 0.0115
oct_01-00 -0.0121 0.0059 -0.0138 -0.0168 -0.0084 -0.0161 -0.0208
apr_02-01 -0.0296 -0.0236 0.0066 -0.0236 -0.0097 -0.0064 -0.0574
oct_02-01 0.0021 -0.0131 -0.0045 -0.0001 -0.0042 -0.0170 -0.0224
apr_03-02 0.0238 -0.0074 0.0015 -0.0074 -0.0193 -0.0324 0.0282
oct_03-02 0.0213 0.0121 -0.0183 -0.0264 0.0102 -0.0152 -0.0107
apr_04-03 -0.0001 0.0077 0.0235 0.0077 0.0008 -0.0008 0.0065
oct_04-03 0.0197 0.0341 0.0109 0.0080 0.0035 -0.0327 -0.0235
apr_05-04 0.0292 -0.0021 0.0029 -0.0021 -0.0043 -0.0066 -0.0058
oct_05-04 0.0207 0.0620 0.0109 -0.0248 -0.0072 0.0047 -0.0148
apr_06-05 0.0027 0.0090 0.0019 0.0090 0.0014 -0.0129
oct_06-05 -0.0052 -0.0018 0.0083 0.0050 -0.0115
apr_07-06 0.0923 -0.1566 -0.0662 -0.1566
oct_07-06 0.1928 -0.0251 -0.2220
apr_08-07 0.0216 -0.0218
oct_08-07 0.0978

test the extent of rationality in the Indian markets. information need to be considered.
Since stock prices are nothing but present value of Testing anomalies in the Indian scenario
expected future cash flows, hence we believe that stock
Having inferred that Indian markets are not the most
prices should have high correlation with earnings. It
rational we tried to test the most common anomalies
can be contested that there is an inherent lag between
that have been observed in the western stock markets, in
when actually the earnings happen and when they are the Indian scenario. Mentioned below are some of the
incorporated in stock prices. Hence we computed hypothesis tests we carried out with data from the Indian
correlation between earnings and stock prices of 305 stock market:
companies over 10 year periods. To account for lags,
1. Size premium Hypothesis
we computed correlation with lags of 0, .5 yr, 1 yr, It has been observed that returns from smaller companies
1.5yr, 2 yr, 2.5 yr and 3 yrs. give higher returns as compared to larger companies.
Result: The table below (Table 1) shows the correlation Data: 5 years (2003-2008) data of 361 companies from BSE
levels between earnings and stock price of the 305 500. We defined companies as small, mid and large based
28 THE MONEY MANAGER | JUNE 2009

Figure 1: Variation in Correlation with time

on average market capitalization: their returns. To be more specific stocks with low book
Small - <250 crore to market ratio were supposed to provide lower returns as
Mid - 250-1000 crore compared to stocks with high book to market ratio.
Large - >1000 crore
Data: 5 years (2003-2008) data of 361 companies from BSE
Returns = 0.2log(P2008/P2003)
500.
Results are as shown in Table 1.
Results are shown in Table 2.
Inference: We see that there is a clear trend of small
Inference: As we can see there is no distinct trend that
companies giving a distinctively high return as compared
relates the returns of a firm with its book value to market
to large companies. However the distinction in terms of
value ratio. Hence we cannot conclusively state if there
returns is much more blurred between mid size companies
exists any anomaly in the Indian stock market.
and Large companies
3. Long term trend reversals
2. Predictive power of price scaled ratios
Empirical studies abroad have identified a definite trend of
Some of the empirical studies abroad have found a distinctive
long-term reversal of returns in financial markets. If one
relation between the book to market ratio of stocks and
compares the performance of two groups of companies:

Table 2
Size No of companies Average of Return
Large 204 6.4%
Mid 134 6.2%
Small 23 13.4%

Table 3

B/M Buckets No of companies Average of Return

<0.25 80 8.9%
0.25-.5 105 7.4%
0.5-0.75 77 5.6%
0.75-1.0 37 7.1%
>1.0 62 4.0%
29 THE MONEY MANAGER | JUNE 2009

extreme loser companies and extreme winners, then the to point towards the fact that markets are hardly driven
extreme losers (winners) tend to earn on average extremely by fundamental data because there is a low correlation
high (relatively poor) subsequent returns. between prices and earnings. It further delved deep into the
application of behavioral economics in finance and tried
Data: 10 years (1998-2008) data of 305 companies from
to identify the anomalies in security prices and the possible
BSE 500
explanations that behavioral finance provides for these
Returns = (P2 – P1/P1)
anomalies. The later part of the paper dealt with trying to
Methodology: We implemented a trading strategy to test test the different established anomalies on Indian stock
if there was a trend of long-term reversals. We performed market data. Analysis indicated that some of the biases
the testing assuming we were in 2003. We computed returns working in western markets also exist in Indian markets
over the last 5 years in 2003 (1998-2003) and sorted the and they can be systematically analyzed and used to make
companies based on the returns. Then we went neutral superior returns than the market.
(neither long neither short) on the top 10%ile (extreme
winners) and the bottom 10%ile (extreme losers). The major
reason behind excluding these companies from the analysis Quotations
was that their returns might have been affected by some
major event (merger, foreign expansion etc) and hence they When asked what the stock market will do, J.P Morgan
are not suitable to be studied for applications of behavioral (1837-1913) (banker, financier, businessman) replied:
finance. Then we went short on the 90th to 70th percentile that “It will fluctuate.”
is companies that had been providing very high returns and
hence were expected to provide low returns in the future. “Don’t try to buy at the bottom and sell at the top. It
We went long on the 30th to 10th percentile companies that
can’t be done except by liars.”
Bernard Baruch (1870-1965) financier & economist
are companies that were providing very low returns and
hence were expected to give high subsequent returns. We “With an evening coat and a white tie, anybody, even a
left the middle 40% as they could not be categorized as stock broker, can gain a reputation for being civilized.”
extreme winners or losers in the period of 1998-2003. We Oscar Wilde (1854-1900) Poet & playwright
back tested our strategy in the period of 2003-2008.
-- compiled by Shishir Kumar Agarwal, IIM Calcutta
Inference: We found that this strategy gives a whooping
return of over 900% over 5-year period. This may be the
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.

Conclusion
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
30 THE MONEY MANAGER | JUNE 2009
New Monetary Policy Tools
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
Innovative Policy Response
to Financial Meltdown
Ajay Jain, Atishay Jain,
Sourav Dutta
[IIM Bangalore]
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
31 THE MONEY MANAGER | JUNE 2009
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
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.
32 THE MONEY MANAGER | JUNE 2009

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.
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.

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 Figure 3: Composition of Fed’s Assets
exchange for collateral at the same interest rate as the
discount window does. The PDCF accepts a broader
range of securities than the TSLF and is a “cash-for- Acceptance of TAF over others
33 THE MONEY MANAGER | JUNE 2009
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.
Figure 4: TAF Auction Amount Results
From 17th December, 2007 to 21st 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
34 THE MONEY MANAGER | JUNE 2009

market conditions, the effectiveness of the TAF and Figure 6: Variation of Deposit Rates
other liquidity facilities depended on whether they can with TAF announcement
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
In confirmation with the expectations, the empirical
investors asked for less compensation for a given unit
results suggest that TAF had strong effects in relieving
of risk and the risk price declined in the presence of
the liquidity concerns in the inter-bank money market.
the TAF. Finally, with this additional funding source
One indication of the scramble for liquidity, shown
readily available, that too at a rate generally less than
in the chart, was a sharp increase in the interest rates
the primary credit rate, there was less demand for banks
offered by banks on one-month bank certificates of
to excessively hoard liquidity purely out of individual
deposit relative to the Federal Reserve’s federal funds
precautionary concerns.
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.

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 7: Variation in LIBOR-OIS

Spread with TAF auctions
35 THE MONEY MANAGER | JUNE 2009

In the LIBOR-OIS spread, a cumulative reduction of References

more than 50 basis points can be associated with the - DeCecio, Riccardo and Gascon, Charles S: New
TAF announcements and its operations. It was found Monetary Policy Tools
that that the TAF had, on average, reduced the 1-month - Wheelock, David C: Another Window – The
Libor-OIS spread by at least 31 basis points, and the Term Auction Facility
3-month Libor-OIS spread by at least 44 basis points.
- Board of Governors of the Federal Reserve
The reduction is economically important because it
System press release, December 12, 2007:-
is approximately 90 percent of the average level of
www.federalreserve.gov/newsevents/press/
the LIBOR-OIS spread in the recent period of credit
monetary/20071212a.htm
crunch. However, TSLF and PDCF were found to have had
less noticeable effects so far in allaying financial strains - www.online.wsj.com/public/us
in the Libor market. This is thus consistent with the - www.dallasfed.org
observations of the market of a weaker interest from
- www.bloomberg.com
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.
36 THE MONEY MANAGER | JUNE 2009
CDS and Credit Crisis
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).
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 Went Wrong,
What Lies Ahead?
Saurabh Mishra
[IIM Ahmedabad]
What is CDS?
As the name indicates, CDS provides protection
against the credit event1 (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 entity2, 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.
37 THE MONEY MANAGER | JUNE 2009
Exhibit 2: Physical Settlement of CDS
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
market3. 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
38 THE MONEY MANAGER | JUNE 2009
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).
CENTRAL COUNTER PARTY (CCP) FOR
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.
MORE OVERSIGHT TO SEC IN OTC
DERIVATIVE MARKETS:
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
39 THE MONEY MANAGER | JUNE 2009
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/SERV4.
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.
Conclusion
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.
Bibliography
An Update on the Lehman Bankruptcy, By the Numbers.
(2008, Oct 17). Retrieved Nov 25, 2008, from The Wall
Street Journal: http://blogs.wsj.com/deals/2008/10/17/
an-update-on-the-lehman-bankruptcy-by-the-numbers/
Credit Default Swap. (2008, Nov 27). Retrieved Nov 27,
2008, from Wikipedia: http://en.wikipedia.org/wiki/
Credit_default_swap
Credit Default Swaps: The Next Crisis? (2008, Mar 17).
Retrieved Nov 25, 2008, from TIME: http://www.time.
com/time/business/article/0,8599,1723152,00.html
Draft Guidelines for Introduction of Credit Derivatives
in India. (2003, Mar 26). Retrieved Nov 25, 2008, from
Reserve Bank of India: http://www.rbi.org.in/scripts/
NotificationUser.aspx?Mode=0&Id=1097
ISDA Credit Event Definitions. (n.d.). Retrieved Nov 25,
2008, from Credit Derivatives WWebsite: http://www.
credit-deriv.com/isdadefinitions.htm
(2008). ISDA Market Survey: Notional amount outstanding,
semiannual data, all surveyed contract, 1987-present.
International Swaps and Derivatives Association.
http://www.isda.org/statistics/pdf/ISDA-Market-
Survey-historical-data.pdf
Lehman Brothers: A Primer on Credit Default Swaps. (2008,
Oct). Retrieved Nov 25, 2008, from Credit Writedowns:
http://www.creditwritedowns.com/2008/10/lehman-
brothers-primer-on-credit.html
Testimony Concerning Credit Default Swaps. (2008,
Nov 20). Retrieved Nov 25, 2008, from US Securities
and Exchange Commission: http://www.sec.gov/news/
testimony/2008/ts112008ers.htm
Why Wasn’t AIG Hedged? (2008, Sep 28). Retrieved
Nov 25, 2008, from Forbes: http://www.forbes.
com/2008/09/28/croesus-aig-credit-biz-cx_rl_
0928croesus.html
(Footnotes)
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.
40 THE MONEY MANAGER | JUNE 2009
Climate Change Induced Financial Risks
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.
Introduction
Climate change has emerged as the strongest negative
global externality that demands collective actions
A Strategic Approach
Pramod Kumar Yadav,
Kuppa Vijay Krishna,
Vikas Bathla
[IIM Ahmedabad]
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
41 THE MONEY MANAGER | JUNE 2009
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:
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.
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
42 THE MONEY MANAGER | JUNE 2009

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. CO2, 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

43 THE MONEY MANAGER | JUNE 2009
Figure 4. Impact of Climate Change on Probability Loss
Distribution
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.
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
Figure 4
lead to decreased margins. On top of this, the related
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.
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
44 THE MONEY MANAGER | JUNE 2009
Figure 5. Risk Measurement Approches under Basel II
develop carbon risk management tools for their loan
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
• 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
• To incorporate a set of emission trading
related questions in its credit rating process
and conduct thorough investment research
• 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
Climate Risk and Basel II: A New Modeling
Paradigm
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.
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
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
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
45 THE MONEY MANAGER | JUNE 2009

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
46 THE MONEY MANAGER | JUNE 2009
This can be further simplified as,
The expected probability of occurring in the future
will be found as:
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.
Figure 6. Evolution of Climate Change Risk as a Function of Time
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
47 THE MONEY MANAGER | JUNE 2009
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
comprehensive portfolio distribution that has climate
risk included in it.
Conclusion
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
on variety of sectors with a focus on financial and
banking sector. Having argued that climate induced
risks are inevitable in medium to long term future, it
maps climate risks on capital requirement proposed by
BASEL-II and further presents a methodology to map
climate change risks on portfolio value of a bank.
EXHIBIT 1
Financial Risks of Climate Change
Some of the major climate induced risks faced by
public and private companies are:
• 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.
• 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
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.
• Litigation: Litigation costs resulting from ‘climate
litigation’ and associated reputational risks need
also to be considered.
• Competitive Risk: Companies that fail to address
Climate Risk may be placing themselves at a
competitive disadvantage. Action can lead to a
direct gain over competitors, for example through
“first mover” advantage; and indirect gains, for
example by improving a company's negotiating
position when a government proposes to introduce
regulation, or simply through an improved or
"greener" reputation.
• 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
48 THE MONEY MANAGER | JUNE 2009
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
EXHIBIT 2
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
figure.
Micro Finance: Installation of solar power plants is
an innovative business solution that can be funded by
micro financing agencies.
References
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in reducing impacts of disasters." Natural Hazards
Review 1(1): 37-42
• Benson, C. and E.J. Clay. 2002. “Disasters,
Vulnerability and the Global Economy.”
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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.
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2007 • Urrutia,Jorge1986.,The capital asset pricing model

• Investing in Climate Change: An Asset Management
Perspective, Deutsche Bank, Oct 2007
• IPCC. The IPCC 4th Assessment Report on
Climate Change 2007: The Physical Science Basis.
Summary for Policymakers. Geneva2007
• Greenpeace International, http://www.greenpeace.
org/international/campaigns/climate-change
and the determination of fair underwriting returns
for the property-A liability insurance industry, The
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. 2003a. "The Insurance and Risk

Management Industries: New Players in the Puzzle Answers
Delivery of Energy-Efficient Products and
Services.” Energy Policy, 31:1257-1272., http:// A1) 31 (all perfect squares up to 1000)
eetd.lbl.gov/emills/PUBS/Insurance_Case_
A2)2*min(p,1-p)
Studies.html
A3) You should let 37 ladies go by and select the first
• Musiela, M. and Rutkowski, M. 1998: Martingale
one with a dowry greater than the maximum of the
Methods in Financial Modelling. New York,N.Y.: first 37 dowries.
Springer-Verlag.
A4) 1/(1-cos(72)) = 1+5-1/2
• Nordhaus, William, D and Joseph Boyer, 2000,
Warming the World: Economic Models of Global A5) If the number of red hats that the last banker can
Warming (Cambridge, Massachusetts: MIT Press). 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, A6) 0.25
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.

• 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
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50 THE MONEY MANAGER | JUNE 2009
Credit Default Swap Pricing
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
Empirical Results and
Inferences
Anshul Gupta,
Radhika A R
[IIM Bangalore]
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
51 THE MONEY MANAGER | JUNE 2009
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.
52 THE MONEY MANAGER | JUNE 2009
(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:
Table 1 : Companies chosen for testing
Company Country
Reliance India Ltd. India
State Bank of India India
General Motors USA
Vodafone UK
Glaxo Smithkline UK
Johnson and Johnson USA
(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
Sector Debt Levels
Petrochemicals Moderate
Banking Moderate - High
Automobile Moderate
Telecom Low-Moderate
Healthcare Very Low
Healthcare Very Low
53 THE MONEY MANAGER | JUNE 2009

Overall the Merton model was found to work Table 3: Results obtained by the EJO model
reasonably well for companies with medium to high Company R2 (%) Vol. Leverage Int.Rate
leverage and the predicted values were found to follow RIL 90.30 + + -
the trends depicted by the actual values. However the SBI 70.97 + + -
Merton model was observed to consistently under GM 52.15 + + +
Vodafone 76.38 + + -
predict the actual spread. This could be because of the GSK 79.40 + + -
very basic nature of the model and the simplicity of MKS 83.89 - + +
the underlying assumptions. The results obtained are As predicted by past research, the EJO model gave
consistent with the past research which showed that superior performance when compared to the Merton
structural models under predict credit spreads and model with high R2’s for most companies. All the three
display low accuracy (Arora, Bohn, Zhu, 2005). explanatory variables were found to be significant for
The results obtained by the Merton model for the all companies. The EJO model was also found to be
four companies with moderate-high leverage are better suited for firms with low leverage as shown by
summarized below. Sample outputs obtained can be its good performance for GSK and MKS.
seen in the annexure. The credit spread was found to be positively correlated
Table 2: Result obtained by the Merton model with the equity volatility and firm leverage and
negatively correlated with the interest rates. Thus the
Company Extent of Under prediction
effect of these market driven variables is economically
RIL 19%
SBI 32% important as well as intuitively plausible. These results
Vodafone 71% are also consistent with previous research in these areas
GM 14% (Ericsson, 2004).
However the flaws of the Merton model are accentuated
6. Inferences and future work
when tested on companies with very low leverage
namely Johnson & Johnson and Glaxo Smithkline The results indicate that while the Merton model is
(GSK). Because the Merton model essentially models theoretically sound, due to the simplifying assumptions
the equity as a call option on the firm’s assets and built into the model, its performance on real life
given the fact that if the debt of a firm is very low, the companies and data is not satisfactory. Although it does
probability of exercising this option is very low, the give encouraging results for companies with medium-
Merton model gave extremely low CDS spreads for high leverage, overall it is found to under predict the
such companies. Thus it was found that the Merton CDS spreads by a substantial amount.
model is not suitable for firms with very low leverage. In contrast the EJO model gives good results in
estimating the CDS spread as described in the previous
5.2 The Ericsson, Jacobs and Oviedo Model
sub-section. This could be due to the fact that it uses
The Reduced Form model – the Ericsson, Jacobs market driven parameters to estimate the CDS spread.
and Oviedo (EJO) model which regresses the CDS The EJO model also performs relatively better than
spreads against the firm leverage, equity volatility and the Merton model for companies with low leverage.
the interest rates was also used to estimate the CDS Further for emerging economies with low market
spreads. The results obtained by the EJO model are depth and inefficient price discoveries, the EJO model
summarized below (the +/- indicate the positive/ may be better suited.
negative correlation between the CDS spread and the
Future work would involve testing the Advanced
explanatory variable):
54 THE MONEY MANAGER | JUNE 2009

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

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, J., 1999, Options, Futures and Other

Derivatives, Prentice Hall Publications, Fourth
Edition.

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.
55 THE MONEY MANAGER | JUNE 2009
Effectiveness of Basel II in the financial crisis
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.
. and funding liquidity, concentration and reputational
Basel II and the current Financial Crisis
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
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 adds to the boom by even more lending amount.
credit and various incentive distortions in relation to Figure 3: Pro Cyclicality effect
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 Again during the depression period the effect is opposite.
the year 2007 and it takes around a year to completely As shown in the diagram below during depression credit
adopt Basel II norms the role of Basel II in the current becomes riskier having high probability of default.
financial is not clear. But there are certain concerns over This leads to increased capital requirements level to
the role played by Basel II norms during a financial act as a cushion for the high expected losses. So banks
crisis, which are discussed in subsequent sections. cut on the lending amount to reduce its balance sheet’s
size. They may also have more difficulty increasing
Pro Cyclicality Effect of Basel II capital and issuing subordinated debt because of the
Though Basel II tightly links capital requirements to heightened uncertainty. The combination of higher
the risks associated but according to experts it suffers capital requirements (because of increased risk) and the
from cyclical nature of the business and adds to the difficulty of raising new capital could lead institutions
boom and bust cycle. The rules are too lax on capital to reduce credit to firms and households, which would
requirements during the “good times” and too tough aggravate the recession or hinder economic recovery
during the “hard times,” exacerbating boom-bust cycles
Figure 4: Pro cyclicality effect
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
57 THE MONEY MANAGER | JUNE 2009
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
. the use of internal models by banks could potentially lead
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
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
58 THE MONEY MANAGER | JUNE 2009

likely to be the weakest in terms of both prescription and exacerbating short-term stress.
enforcement. Basel II disclosure is required to assess an (ii) Liquidity: Supervisory guidance will be issued for
individual bank’s capital adequacy. But that is not enough: a the supervision and management of liquidity risks.
strong bank capital base, while essential to avoid the collapse (iii) Oversight of risk management:
of any major financial institution, was not sufficient to
Guidance for supervisory reviews under Basel II will
prevent the systemic effects of the subprime crisis.
be developed that will
Strengthen oversight of banks' identification and
Basel II and the Reaction of the Indian banking
management of firm wide risks;
System
Strengthen oversight of banks' stress testing practices
for risk management and capital planning purposes;
In the wake of the turmoil in global financial
Require banks to soundly manage and report off
markets, the FSF (Financial stability forum of
balance sheet exposures;
BIS) brought out a report in April 2008 identifying
Supervisors will use Basel II to ensure banks' risk
the underlying causes and weaknesses in the
management, capital buffers and estimates of potential
international financial markets. The report dealt with
credit losses are appropriately forward looking.
strengthening prudential oversight of capital, liquidity
and risk management, enhancing transparency and
(iv) Over the counter derivatives: Authorities will
valuation, changing the role and uses of credit
encourage market participants to act promptly to ensure
ratings, strengthening the authorities’ responsiveness
that the settlement, legal and operational infrastructure
to risk and implementing robust arrangements
for over the counter derivatives is sound.
for dealing with stress in the financial system.

The roadmap for the implementation of Basel II in

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
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.
Conclusion
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
 59 THE MONEY MANAGER | JUNE 2009

stability. Basel II norms have to be modified taking References

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.
org.in)
Bank for International Settlements – Website : www.
bis.org

2 3

CROSSWORD
4 5 6
7 8 9 10

- by Divya Devesh, IIM Calcutta

11

12 13

14

15 16
Down

1. )SEC filed a civil suit against which billionaire

owner of the Dallas Mavericks for insider trading in
17 18
Nov 2008. (4,5)
2. )What is the Index of about 50 stocks that are
19
traded on the São Paulo Stock Exchange?(7)
Across 3.) ________ Street is London’s equivalent of Wall
Street. (11)
2.) Jordan’s Furniture is the subsidiary of which famous 4.) This business magnate started her catering busi-
American company?(18) ness in 1976. (6,7)
8). Which is the third Latin American country to adopt the 5.) A Universal Product Code was scanned for the
US dollar as its currency. (2,8) first time in 1974. What was the first product to be
10.) What is the largest non-US company listed on the sold with this code?(8)
NASDAQ in terms of market capitalization?(8) 6.) A Stock that drops suddenly and sharply in price,
12.) Which company used the trademark slogan “World’s usually because of lower-than-expected earnings or
most experienced airline” in the early 1970s?(5) other bad news.(4,6,5)
15.)Whose autobiography is called ‘Dreams of my fa- 7.)What is the study and collection of stocks and
ther’?(5) bonds called? (11)
17.) Which company filed a lawsuit in 2008 against Face- 9. )The largest college student loan company.(6,3)
book, forcing it to remove its hit game Scrabulous?(5) 11.) A bond with a par value of less than $1,000.(4,4)
18.) Which was the first foreign company to open a fac- 13.) The merger of Delta Airlines with which airlines
tory in the United States?10) created the largest US carrier in 2008.(9)
19.) Fischer _____ and Myron ______ write a path break- 14.)Who launched his business career at the age of
ing article in the Journal of Political Economy in 1973. 14 by forming his own company, Traf-O-Data, with
What are their last names?(5,7) friends?(4,5)
16.)Which century old Japanese firm manufactured
playing cards before it made its mark in the world of
60 THE MONEY MANAGER | JUNE 2009

Hedge Fund Strategies

Identifying Successful Hedge

Fund Strategies for Investing
in Emerging Markets

Prateek Mathur,
Pinky Singh,
[FMS, Delhi]

Executive Summary The recommendations given discuss the hottest

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:
Table 1: Hedge Fund strategies
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

STRATEGY DEFINITION
Market Neutral 50% short, 50% long
Convertible Arbitrage Long convertible security, Short underlying equity
Global Macro Focus on global macroeconomic changes
Growth Look for growth potential in earnings and revenues
Value Invest based on assets, cash flow, book value
Sector 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
Opportunistic 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
61 THE MONEY MANAGER | JUNE 2009
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
20071. 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 20082. 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 leverage (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
62 THE MONEY MANAGER | JUNE 2009
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.
63 THE MONEY MANAGER | JUNE 2009
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]
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.
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.
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.
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.
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
64 THE MONEY MANAGER | JUNE 2009

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 Ratio3.
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 Strategy4.
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

% Share 2005 YTD Annualized Sharpe

Investment Strategy Rank
(No.) Return Return Ratio
Convertible Arbitrage 3.0 % 3.72 6.67 2.63 1
Others 0.4 % 8.54 9.7 1.73 2
Distressed/High Yield
1.3 % 8.72 9.41 1.61 3
Securities
Multi-Strategy 68.0 % 7.25 7.81 1.51 4
Commodity Trading Advisor
2.0 % 1.35 9.99 1.43 5
(CTA)
Global Macro 1.4 % 4.04 7.45 1.4 6
Event Driven 0.9 % 5.30 7.6 1.39 7
Long/Short Equity Hedge 19.0 % 10.64 6.7 1.11 8
Fixed Income Arbitrage 2.0 % 4.69 5.48 0.98 9
Relative Value 2.0 % 5.91 5.16 0.85 10
65 THE MONEY MANAGER | JUNE 2009
slowdown in the US.
Research options for Hedge Funds Investing in
Emerging Markets
One of the main issues which still remain for HF
managers investing in emerging markets is to penetrate
the perception and find reality which is often difficult
given the fact that on-the ground and fundamental
unbiased research is still an evolving culture and
business here.
Most HF currently use and are in constant need of
high end unbiased qualitative and quantitative research
to identify and evaluate opportunities in the global
markets. Many of these opportunities are now being
found emerging markets; however, there are few
quality research options for HF investing in these
regions. Hedge Funds account for approximately 70%
of equity-based commissions and demand value for
their research spend.
The big macro trend is that in the past, research was
provided centrally and now today everyone has to do
more and more research on their own. That puts a
tremendous strain on the hedge fund community and
it makes the screening processes harder.
In addition to hiring their own researchers, some hedge
funds use analysts from outsourcing firms that assign
analysts to do research for specific clients.
An important factor is that hedge funds need to
understand their own research process very well. Very
young funds should spend time to figure out their
own research process before deciding what they are
comfortable outsourcing.
One major attraction of outsourcing research is less
human resources management, which is a lot if one
takes the turnover of junior analysts into consideration.
Outsourcing is also a cheaper alternative to expending
the fund’s research department.
Indian Scenario
A lot of activity has also been seen in the Indian market
with respect to HF in the recent past. With money
making opportunities becoming rare in US and EU,
HF the world over has been seen aggressively pumping
money in India.
India-focused HF delivered a yearly return of 53%
as on July 2007 while the Sensex returns were 44%.
The current assets of HF investing in India are to the
tune of approximately $14 billion. In just 2 years the
66 THE MONEY MANAGER | JUNE 2009
assets have multiplied 5 fold from $2.8 billion to $ 14
billion5.
India is the largest market for single stock futures in
the world and has a well-developed derivatives market
in index futures and options. This gives the HF the
hedging possibilities not available in other emerging
markets. The high degree of liquidity offered by the
Indian markets is suitable to HF style of investing.
Recommendations
Target Destination
Among the emerging market (BRIC nations), Russia
would be the hottest HF destination. As Russia has
substantially lagged the rest of the emerging market
world in 2007 based on investor fears about the state
of the Russian government would look like after Putin
is gone.
Future Scope of Hedge Fund Strategies
In future, the strategies that are expected to do well
are the Convertible Arbitrage, CTA and Global Macro
funds. As shown in the graph below, these are low on
asset size but high on risk-adjusted returns, suggesting
that there could be a lot of potential in these strategies.
This would of course be subject to the investors’
perception of investment avenues and constraints.
The emerging markets is the riskiest of strategies with
above average annual returns
Strategy For India
Globally, most Hedge Funds follow a strategy of
long/short equity. In India, a common opinion is that
HF might bring in too much volatility in the market.
So, a strategy like Convertible Arbitrage may be more
suitable. It fetches an average rate of return with a low
level of risk. Similarly, Global Macro is a useful strategy
option for India6.
References
1. Garbaravicius Tomas & Dierick Frank, “HF and
their implications for financial stability”.
2. Atiyah, S. and A. Walters (2004), “HF – An
Overview”, Butterworths Journal of International
Banking and Financial Law, May, pp. 173-77.
3. Standard & Poor’s, “HF for retail investors”.
4. http://www.atimes.com/atimes/Asian_Economy/
EC27Dk01.html
5. Statement of the Financial Economists Roundtable
on HF, November 3,2005
6. IBM Consulting Services, “Fund Managers: the
challenge of HF”
Dries Darius, Aytac Ilhan, John Mulvey, Koray D.
Simsek, Ronnie Sircar; “Trend-following HF and
Multi-period Asset Allocation”, Dec 2001.
(Footnotes)
1
Excluding double counting of assets in funds of funds
2
‘2008 HF Asset Flows & Trends Report’, By Peter H. Laurelli,
CFA, Head of HF Industry Research, HedgeFund.net
3
Sharpe Ratio: A measure of the mean return per unit of risk in an
investment asset or a trading strategy
4
http://www.eurekahedge.com/news/06_FOF2006_Key_trends.
asp
5
HF Net- Tracks the HF flows across the world
6
Centre for International Securities and Derivatives Markets
(CISDM)
67 THE MONEY MANAGER | JUNE 2009
Additional Figures and Tables
Research Budget (Fund) Spending Options
Building in-house research capabilities
Leveraging alternative research tools
Engaging Expert Networks
Buying Selective Independent Research
While not every firm has the budget and the scale to
undertake such an effort, those that can are doing so
and keeping idea generation inside the firm.
By doing this, these firms are fully bifurcating the
research decision from the execution decision,
maximizing quality control while minimizing costs.
A new type of tool vendor has emerged over the
past few years, one that is designed to aggregate,
parse and analyze information from a wide range
of disparate sources, with an eye towards mitigating
the signal/noise problem that plagues the research
analyst, portfolio manager and trader.
This helps institutional investors cast a wide
information net without having the devoting the
internal resources necessary to staff such an effort.
Rather than relying on research analysts to do general
legwork, which is then broadly disseminated across
hundreds or thousands of clients, an increasing
number of institutional investors are using targeted
expert networks to mine for the data they really
need. And their findings aren’t published and widely
distributed.
This, like the alternative research tools, is a vehicle
for maximizing return on human capital and making
the analyst’s job more efficient.
There are certain boutique research shops that are
very good at what they do, so good that arrays of
investors are willing to pay for their work.
They suffer from the “diminishing value of
information” conundrum: as the company becomes
more successful, the value of its research declines,
as its insights are more widely known, causing the
information’s value to decay rapidly.
68 THE MONEY MANAGER | JUNE 2009

Advantages in Emerging Markets

Disadvantages in Emerging Markets

List of hedge Funds in India

Avatar Investment Naissance ( Jaipur) India fund

Management Fair Value Atlantis India Opportunities fund

India Deep Value Fund Vasistha South Asian Fund Ltd.

India Capital Fund (Healthcare Sector) Karma Capital Management LLC

Monsoon Capital Equity Value Fund Kotak WM India Fund Limited (Long/Short)
69 THE MONEY MANAGER | JUNE 2009
MNC Delisting - Reaping the Benefits in 2009
Abstract
The Indian Stock market crash of 2001 was
accompanied by large scale delisting of MNC’s as they
took advantage of the abnormally low stock prices to
buy back shares and pack off from the Indian Bourses.
At that time the movement was much criticized by
observers and many blamed the lax SEBI rules for the
same. The authors of this paper however believe that
in the context of the current financial meltdown the
delisting may have proved to be a blessing in disguise
for India leading to greater decoupling of Indian
equity markets from that of the US then would have
otherwise been the case. The reason being that these
MNCs are more affected by global downturns since
their business interests are spread across the globe,
especially the US. To test this hypothesis separate
regressions were run between the Indian and the US
stock markets and between an MNC stock index of
still listed shares and the US stock market. The later
displayed a higher correlation lending support to the
hypothesis that without the delistings, in the presence
of a greater number of listed MNCs the Indian stock
market would have responded far more to the US stock
market developments.
Introduction
The year was 2001 and the Indian stock markets had
Swati Aggarwal,
Neha Gupta
[IIM Bangalore]
just entered a bear phase that was to last till 2003. The
Ketan Parekh Scam had unfolded and bank call rates
were at an all time high. It was during this phase that a
large number of major MNCs that had been listed on
the BSE/NSE decided to take advantage of the free fall
in the stock prices to buy-back their shares, converting
their Indian subsidiaries into unlisted, wholly owned
private limited companies.
This trend started with small and mid-sized MNCs
but soon caught on with bigger names too jumping
on the bandwagon. In 1999 there were six buyback
offers; the next year the number rose to eight, finally
peaking in the financial year 2001-02 to twenty. Some
of the major names exiting the Indian bourses were
Reckitt Benckiser, Cadbury, Philips, Carrier Aircon,
Otis Elevator and Industrial Oxygen.
Reasons for the Exit
This move was prompted by a number of reasons:
• Indian regulatory framework: The regulatory
environment became favourable to such buy
backs. In the early 1970’s, many of these
multinationals had been forced by the Indian
Government to take their companies public
under the tenets of the Foreign Exchange
Regulation Act. This brought down their stake
in Indian subsidiaries from complete ownership
70 THE MONEY MANAGER | JUNE 2009
to around 40 percent. However after the launch
of the economic liberalization program in
1991, government regulations governing MNCs
became more lax in an effort to attract more FDI.
Foreign companies were first allowed to increase
their stake to 51 and, later, to 74 percent followed
later by removal of all caps in some sectors. The
requirements on buy-back imposed by SEBI also
became less tedious (For instance, an amendment
to the Companies Act, effected in the last quarter
of 2001, enabled companies to go ahead with
their buyback proposals with just board instead of
shareholder approval.) The MNCs were also aided
by the Indian Finance Ministry's decision to raise
from 5 to 10 percent, the annual limit on shares
that the major shareholders could buy in their
companies without making a formal offer. The
abolition of Section 43A of the Companies Act,
which imposed onerous disclosure requirements
on large private companies as `deemed public
companies' further served the purpose.
• The MNCs’ defence: The MNC’s cited a number
of reasons for their decision. These included
the fact that given the then existing poor market
conditions, they had no alternate means to invest
these funds more productively; their share price
did not reflect their true value as also the desire
to avoid the spurts of scams and allegations of
manipulation that seemed to plague the Indian
markets.
• The critics: Independent observers pointed to a
number of other advantages that these companies
would gain by this move. Multiple listings in
various countries tend to be cumbersome.
Also fully controlling their Indian subsidiaries
makes proprietary technology transfers easier
for the MNCs. Many dubious motives were
forwarded too, like the fact that post-delisting
and conversion of their subsidiaries into local
branches, these companies would be able to
escape public scrutiny and accountability.
Concerns expressed
It was at that time believed that such a mass exodus
of MNCs did not bode very well for the Indian
markets and stockholders. While there were some who
were optimistic enough to suggest that such a move
suggested that the MNCs were preparing to take the
Indian Markets more seriously and hence were adopting
a more aggressive stance, most were not convinced.
Even the FICCI had expressed its concerns.1
The biggest fear that was expressed was the fact
that this meant that now a significant portion
of the economic activity in the country would become
more opaque. It would have also meant that in the
absence of domestic players enjoying similar credibility
to replace them, the Indian capital markets, still young
would become shallow. Concerns were also expressed
for the dying regional exchanges as volumes traded fell
to minimum. Finally anger was also expressed on the
behalf of small stockholders who were bought out
cheap when the markets were low.
A Blessing in Disguise?
The authors of this paper believe that the exodus of
major MNCs in the period 2001-2002 has turned out
to be a blessing in disguise in the turbulent times of
today. These companies, prominent on the US Stock
exchanges and with significant business interests in the
worst affected markets of US and Western Europe,
have suffered heavily in the ongoing crisis. These
stocks, if listed today, could have rendered significant
volatility to the Indian stock markets exposing them
further to the risks from the US markets. Their delisting
has in fact contributed to the decoupling of the Indian
economy.
Hypothesis:
The question that first strikes in the above explanation
is – would MNCs listed on the Indian stock exchange
really import volatility from the West? It is this
hypothesis that the authors have attempted to test,
the basis being the MNCs listed on the National Stock
Exchange today. These companies’ stock prices, we
believe, have a higher degree of correlation with the US
71 THE MONEY MANAGER | JUNE 2009
Equity Market than the overall Indian Stock Market.
In an attempt to find the same, a regression was run
between the MNC stocks and the US Stock Market
Index on one hand and the Indian and the American
stock markets on the other.
Methodology:
For this purpose, the following indices were chosen:
• The NYSE Composite Index was taken as the
representative of US stock market activity. This
is a stock market index covering all common
stock listed on the New York Stock Exchange,
including American Depositary Receipts, Real
Estate Investment Trusts, tracking stocks, and
foreign listings
• For the Indian Stock Market, the representative
index taken was the S&P CNX 500. The CNX
Fig 1. Scatter Plot for adjusted NYSE composite v/s S&P CNX 500
Regression Statistics
Multiple R
R Square
Adjusted R-Square
Standard Error
Observations
500 is a broad-based benchmark of the Indian
capital market, representing about 84.24% of
total market capitalisation and about 78% of
the total turnover on the NSE as on March 31,
2008.
In both cases the guiding philosophy was the
fact that in order to understand the extent of
correlation it is imperative to take a broad measure
of the stock market, a measure that would help
establish clearly the relationship between the
companies and the market.
• For the MNCs, an MNC index was constructed
by taking a simple average of 10 prominent
MNCs2 on the National Stock Exchange. The
selection criteria for the same include a trading
frequency of atleast 90% in the last 6 months
0.913273
0.834068
0.833407
355.3616
253
72 THE MONEY MANAGER | JUNE 2009
Fig 2. Scatter plot for adjusted NYSE composite v/s MNC index
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
and a market capitalization and turnover rank
in the universe of less than 500.
Data for all the indices was collected for the period
January 1, 2008 to January 23, 2009, the period of the
financial meltdown.
Results:
The following results were derived:
• There was a significant correlation observed
between CNX 500 and NYSE Composite
Index with a R2 of 0.83407. (See Figure1)
• There was a higher correlation between the
MNC index constructed and the NYSE
Composite Index. The scatter plot of the two
showed a significant positive linear relationship.
The regression model run on the same gave an
R2 value of .90215 ( See Figure 2.)
Inference:
Thus in line with expectations it was observed that
the stock prices of the 10 MNCs listed on the Indian
0.949816
0.90215
0.901761
353.7057
253
markets are more closely related with the US stock
market. However owing to their small number in a
pool of 500 CNX they were, fortunately, not able to
significantly destabilize the Indian markets. The same
could not have been said, however, had the turn of
events not been what it was in the period 2001-02.
Most of the over 40 MNCs which exited then have
major operations in the West and have seen major
turbulences in their stock prices, as has the US Market.
The story, as can be seen from the results of the model,
would not have been very different here. Moreover,
given the fact that some of these companies were a
part of the then Sensex30, the extent of volatility can
only be imagined. An economy that has been able to
decouple (though to what extent is in itself a highly
disputed fact) and shield itself from the tumultuous
movement of the West, would perhaps not have been
able to do so.
Conclusion:
73 THE MONEY MANAGER | JUNE 2009
The paper began with a brief description of the MNC
exit from the Indian stock market that occurred at the
beginning of this century along with the fears that
were expressed about the same. The authors then went
on to propose that despite such pessimism that was
associated with the move, retrospectively it may have
had in fact contributed to the decoupling of the Indian
stock markets from that of the United States and thus
may have insulated us somewhat from the effects of the
financial meltdown. This was based on the hypothesis
that MNCs with business interests in several parts of
the world including the worst affected countries have
been affected more by the crisis and hence their stock
prices have taken a greater beating too. To test this
hypothesis, the correlation of the stock prices of still
listed MNCs to the US stock market during the current
stock market flip-flop was compared to the correlation
between the Indian and US stock markets. As was
expected, the correlation in the first case was higher,
thus validating the idea that had more MNC stocks
been listed on the Indian Stock market, its correlation
with the US stock market would have been greater
making it more volatile in the current times. Perhaps,
there is a silver lining in every cloud…
References:
http://finance.yahoo.com
http://www.nseindia.com
http://www.capitaline.com
http://www.atimes.com/ind-pak/DF05Df04.html
http://www.thehindubusinessline.com/
iw/2002/03/17/stories/2002031700430600.htm
http://www.atimes.com/atimes/South_Asia/
EF25Df03.html
http://www.indiadaily.com/editorial/14853.asp
http://www.icmrindia.org/casestudies/catalogue/
Finance/FINC006.htm
(Footnotes)
1
According to Amit Mitra FICCI’s secretary general, “FICCI is
concerned about recent trends of foreign companies getting
delisted and acquiring 100 percent equity.” MNCs delist in India
on revelation fears Indrajit Basu Asia Times Online June 25 2003
http://www.atimes.com/atimes/South_Asia/EF25Df03.html
2
The ten companies included in the MNC index include ABB,
ACC, Britannia, Colgate, CRISIL, Cummins, Gillette, GSK, HUL
and Macmillan
Quotes
“Diversification is a hedge for ignorance” -
William O’Neil.
“Don’t bottom fish” -
Peter Lynch.
“Don’t try to buy at the bottom or sell at the top” -
Bernard Baruch
“The worst trader you’ll ever meet is your ego.” -
Charles B Schaap
“If it’s not in the chart, its only in your mind.”
Charles B Schaap
- compiled by Shishir Kumar Agarwal, IIM
Calcutta
74 THE MONEY MANAGER | JUNE 2009
Failure of TARP & Solutions to the Banking Crisis
Executive Summary
The banking crisis in the US shows no signs of abating.
The Treasury Asset Relief Program (TARP), which was
envisaged, as a means to stabilize the system has not
succeeded in its endeavor to restart lending. By lurching
from one solution to the next, and by bailing out bank
after bank, the program has lost its credibility both with
the markets and the public. TARP has created perverse
incentives to existing shareholders and managers
without attracting private capital. An alternative bold
solution to the crisis would be nationalization of the
banking system. In one stroke we remove uncertainty
and can go about the task of restructuring the entire
sector. Lending can also be restarted and the real
economy stabilized from a vicious cycle. The pros and
cons of this measure are debated and the arguments
of both sides are presented. Finally, nationalization is
recommended as a possible permanent solution to the
crisis.
Arjun Ravi Kannan
[IIM Bangalore]
Introduction
The worst financial crisis since the great depression has
wrecked havoc on the global economy and seemingly
paralyzed policy makers as well. What started out as
defaults in one segment of the financial markets has
since consumed and imperiled the very foundations of
the modern capitalist economy. Hence, a solution to the
banking crisis is de rigueur for any hopes of a sustained
recovery in the medium term. At the heart of much of
these attempts have been the US Federal Reserve and
the Treasury Department. In addition to several lending
programs and an alphabetical soup of acronyms that
act as sources of liquidity, the US Treasury has been
using the Troubled Assets Relief Program, commonly
known as TARP, to tide over this crisis. While it may
be premature to condemn this program as a complete
failure, it is clear that it is not working towards the
intended consequence and is becoming increasingly
unpalatable to the taxpayer by the day. In what follows,
the reasons for the continuing poor performance of
the program, why a new program might be needed,
and possible innovative strategies to combat rising
75 THE MONEY MANAGER | JUNE 2009
risks of a systematic failure are examined.
TARP and its various strategies
TARP allows the Treasury Dept. to extend a line of
credit of up to $ 700 billion to various institutions in
the form of guarantees, capital infusions, asset swaps
and any other mechanism so as to ease the credit and
liquidity crunch. The original intention of TARP was
to purchase “troubled assets”, including mortgage
backed securities, collateralized debt obligations and
other illiquid securities, so that banks could rid their
balance sheet of these uncertain assets. The hope was
that once the markets recovered and these securities
actually had a functioning market, the value of these
assets could be better realized than dumping them in
troubled times. While past losses/write downs were
not allowed to be funded, any fresh troubled assets or
existing assets still in the portfolio of companies could
be swapped. The rationale was that once the balance
sheet of these companies was clean, private capital
would enter and recapitalize the institutions. This
would then encourage banks to restart the lending
process to banks, corporations and consumers to once
more jumpstart a credit-driven economy.
However, the problems with the above approach were
apparent. The fact that the banks could not really value
these securities (the percentage of level 3 assets which
are essentially “marked to model” is very high) at
market prices should have warned authorities that the
original proposal was not implementable. There are a
few issues here. One, if the government pays too low a
price for the security the banks would refuse to sell the
assets as it would increase their losses and potentially
bankrupt them. Second, if the government pays too
high a price, then taxpayers are being taken for a ride
at the expense of the same people who got us into this
mess. Finally, there is always a fundamental problem of
information asymmetry, where the bank clearly knows
more about the asset than the government can ever
find out. This would thus be a recipe for inflated asset
valuations by the banks with the securities.
This led to a shift in strategies from outright asset
purchases to capital infusions in the form of preferred
shares to the government. Those firms, which did sell
assets to the government, would have to issue equity
warrants (if company is unlisted then senior debt) so
that taxpayers can benefit from the potential upside.
The problem with this approach as is now being seen
is that the whole process is opaque. There is no clear
benchmark to decide who gets to use the funds. For
example, even the financing arms of the US automakers
are getting a share of the funds. Further, there is no
incentive to lend, given the leverage of many of these
institutions. As far as they are concerned, this is a way
of padding their balance sheet to protect against future
losses. A more effective way to ensure this would have
been to take common equity stakes. At the same time,
existing shareholders are affected by such a move, and
the whole program creates nil to negative incentives
for private capital to enter.
The current situation and the way forward
A realistic assessment of the current situation presents
a scary picture. The entire banking system in the US
(and UK) is technically insolvent. If the total credit
losses (expected to be around USD 3-4 trillion)
are recognized, the number would exceed the total
capitalization of the entire US banking system (closer
to USD 2.5 trillion). It is often argued, and rightly so,
that in such stages of a downturn, mark to market
insolvency does tend to happen. However, what these
arguments miss out is that in this particular crisis, many
of these losses are very real, and the current value of
securities (as present on the banks’ balance sheet) is
likely to present an inflated picture. Take an example
of a mortgage like the adjustable rate mortgage (or
even Alt-A loans) that was worth a million dollars. The
house is probably worth half that value and the loss of
$ 500000 is very real. It is unlikely to be recovered since
the structure of the loan, the shape of the housing
market which is still above historical averages and the
76 THE MONEY MANAGER | JUNE 2009
type of people who got these loans (liar loans) suggest
very little upside even in the long run and will likely
default. This alone is likely to result in future loses close
to a trillion dollars. Hence the argument that holding
assets for a long time would improve the situation does
not hold water.
So what is the alternative? It is clear that no amount
of quantitative easing (QE) or zero interest rate
policy (ZERP) from the Federal Reserve over any
length of time will help too much. Nor will a fiscal
stimulus, however bold, be able to act as anything but a
temporary bandage. The alternative, which is probably
gaining traction, is the concept of a “bad” bank or an
“aggregator” bank to bundle all the bad securities, as
was done with the Resolution Trust Corporation (RTC)
back during the savings and loan crisis. However, the
way it is being suggested will not make a difference
because of two reasons: the problem of valuation of
assets, and the fact that government will be a major
shareholder but without taking control. The answer:
nationalization.
Nationalization: Benefits and Problems
Nationalization seems to suggest that we are abandoning
the principles of markets. However, if done in an
orderly fashion, we can bring the banking system back
to reasonable health and restore confidence.
These are the steps that should be followed in
nationalization. First, a quick review of every major
and mid level bank must be made to determine the
extent of their exposure to these assets. Second, the
ones that are otherwise healthy must be saved, while
the ones that are irredeemable must be allowed to fail.
Third, the fundamentally healthy but impaired banks
(those which don’t need capital can exist as it is) should
be placed under a conservatorship (like Freddie and
Fannie). Fourth, their entire equity must be wiped out,
managements fired, and no golden parachutes must be
given. This takes care of one form of moral hazard.
Fifth, debt holders, other than senior most debt
holders, must be forced to take a haircut, as there is no
rationale for the taxpayer to fund bondholders. Sixth,
managers may be incentivized to lend according to
long-term profitability. Seventh, the bad assets are now
moved to an RTC like bank where debt is paid down
and the assets are gradually sold to private investors.
Finally, when the books are sufficiently cleaned up and
markets stabilize the banks can once more be available
for public ownership.
What are the advantages of nationalization? The most
obvious advantage is that uncertainty in the markets is
removed once and for all. Rather than lurching from
one bailout to another, and markets worrying about
creeping nationalization, a bold solution like this would
signal a bottom. Another advantage is that banks can
begin to lend again. The problem with equity stakes
without control was that managers and shareholders,
worried about their future would rather use the money
to pay their salaries and repair their balance sheet,
resulting in a hobbling bank that does not take risk.
At the same time moral hazard is vastly reduced when
exiting managers are punished for reckless lending
and hence future excessive risk taking is minimized.
The greatest advantage though is that the problem of
valuing assets is no more a necessity. Since both the
“good” bank and “bad” bank are under government
control, the asset valuation does not matter, as it
merely involves transfer of assets from one part to
another part of the same owner. This could be done at
historical cost or zero value or any other value as there
is essentially no difference. The “bad” bank collects
all the cash flows associated with the assets and if no
market develops, then it holds the assets to maturity.
The “good” bank can be privatized when conditions
improve. The cost of nationalization has been shown
to have a lesser final fiscal cost than this stage wise
bleeding. As an example of its actual implementation,
we need not look further than Sweden, which in 1993
did the same thing. The overall cost to the government
was minimal. Finally, the reason debt holders have to
77 THE MONEY MANAGER | JUNE 2009
pay a price is because there is no reason for risky debt
investors to be rewarded while stockholders suffer.
The taxpayer should not subsidize them (senior debt
holders may need to be accommodated for fear of
greater contagion while junior debt holders’ rationale
for investing itself is that they sought more risk and
hence were paid a higher rate).
The arguments against nationalization exist. The major
reason is the mistrust that government cannot run
efficient operations and would be prone to political
pressures. Appointing commercially oriented managers
can reduce this problem. Further, it can be argued that
state control may become permanent. Finally, a very
credible argument exists to make a distinction between
the Nordic experience in the 1990’s and the US. The
US banking system is much larger than the Swedish
system and both the costs and time required are higher
and chances of a successful withdrawal at a later stage
by the government are likely to be lower. The linkages
in global finance may also cause issues on valuation
of assets unlike in the 1990’s when most of the assets
in Sweden were regionally owned. However, none of
these reasons are sufficient to continue with status
CROSSWORD
SOLUTIONS
quo. The costs are too high, and a bold initiative is a
must. Nationalization and nimble restructuring is the
quickest and cleanest end to the mess we are in right
now.
Conclusion
The banking crisis has been dragging on for a long time
with no apparent end in sight. The TARP, which was
introduced to ameliorate the problems in the system,
has not made an appreciable impact. With the real
economy in serious danger of significant long-term
damage, bold solutions are required to dig us out of
this morass. Nationalization is the best among the bad
alternatives available at the moment. By eliminating
uncertainty, moral hazard, and questions on valuation
of assets, it can go a long way in finding the bottom in
this crisis. Critics, who fear socialism, should take a leap
of faith, and give a chance for a complete overhaul of
the banking system. With firm regulatory structures in
place, a more healthy banking system can be built and
a quick withdrawal by the government can be achieved.
In summary, to save capitalism, the state must step in
and do the job.
78 THE MONEY MANAGER | JUNE 2009
Value Investing
Executive Summary
Value investing is an investment philosophy given
by Benjamin Graham and David Dodd in the 1920s.
Value investing focuses on investing in stocks, which
are under-valued i.e., are trading below their intrinsic
values. It aims to capitalize on the inefficiencies in the
market, in terms of the disparity between the value
and price of a stock. A bearish market is usually an
excellent opportunity to invest in value stocks. This is
so because in a bearish scenario, like the current, the
investors are extremely pessimistic about the entire
stock market. This results in some stocks being heavily
under-valued. This article analyses the performance of
such value-based picks compared to the average market
performance, in the previous bull phase. For this
purpose, five value based stock portfolios were formed
based upon different value themes at prices prevailing
at the end of the dot-com bust. The performance
of these portfolios was compared with that of the
Nifty and was found to be superior to that of the
market, in general. Thus, value investing was shown
to be an investing approach providing super-normal
returns. Lastly, value stocks in the current market were
identified. These are expected to give super-normal
results in the future.
Past Trends and Current
Opportunities in India
Deepak Gupta,
Nikhil Maheshwari,
Rohit Chawla
[MDI, Gurgaon]
What is Value Investing
Value investing is an investment paradigm that is based
on the ideas of Benjamin Graham & David Dodd. The
ideas of this theory developed with Graham and Dodd’s
teachings at Columbia Business School, USA, in late 1920’s.
Graham presented the ideas in his books; Security Analysis
and The Intelligent Investor. The theory is based on the
philosophy of investing in securities, which trade at a deep
discount to their intrinsic value. Warren Buffet is the most
famous follower of the principles of value investing in the
modern world. The core principles of value investing are
the following:
• A stock, or any other security for that matter,
has an intrinsic value, and this underlying value
does not depend upon the market price.
• The market, at times, assigns prices to certain
stocks which may be unjustifiably low or high.
• An intelligent investor buys when the market
price is unjustifiably low and sells when it is
unjustifiably high. This is best captured by
Buffet’s philosophy of being “Greedy when
others are fearful and fearful when others are
greedy”.
• Investors should be prepared for long-term
investments in a stock. Value investing is
not concerned with and cannot predict the
short-term movements of the market or of
79 THE MONEY MANAGER | JUNE 2009
a stock. However, a stock which is genuinely
underpriced will yield significant results in the
long run.
Value investing as an investment method, is focused
on the curtailment of risk in investments. Value
investors focus on how not to lose money, rather than
how to make huge amounts of money. In this respect,
Benjamin Graham talked about introducing a ‘Margin
of Safety’ in the analysis to minimize the downside
risk. This just means that you buy at a big enough discount
to allow some room for error in your estimation of value.
However, this does not imply that value investments are
low-risk, low-return ventures. In fact, value investors
believe that low risk investments actually result in high
returns. This is well demonstrated by the success of
value investors like Warren Buffet. In this article, we
will test this statement by evaluating the performance
of some value stocks in the Indian market during the
previous stock-market boom.
Value Investing in Current Scenario
The current slowdown has brought about an
interesting scenario for stock markets around the
world. The stock market is under a strong hold of the
bears and investors are wary of putting their money
into stocks. The financial sector crisis in the US has
seen stocks around the world tumble to levels, which
were unthinkable less than a couple of years ago. Most
people would thus argue that the best strategy to play
the stock market right now is to stay away from it.
Value investors, however, differ from this view. The
value investing philosophy suggests that the current
condition provides an excellent opportunity to pick
up shares at very cheap prices. Talking in Graham’s
language, this could be one of the times when the
market is unjustifiably pessimistic on a large number
of stocks. This however, does not imply that we should
start picking up each and every stock just because it is
trading at way below its bull-run highs. What this does
suggest is that in every bear run, although there are
stocks which fall due to genuine falls in their values,
there are many which decline simply because of the
widespread pessimism among investors. Obviously,
the intrinsic value of the company does not swing with
the mood of the investors. A large number of stocks
consequently end up taking a huge beating without any
rational reason and hence trading at huge discounts to
their intrinsic value. Thus, every bearish phase brings
about some excellent opportunities for the value
investor to capitalize upon. In the later part of this
article, we will evaluate the performance of some such
opportunities provided at the end of the dot-com bust,
over the subsequent boom in the Indian stock markets.
We will also evaluate and present some stocks, which
are good value buys in the current bear market and
should yield excellent returns in the long run.
Value Investment Themes
The major challenge in value investing is to determine
the intrinsic value of the company and hence of its
shares, relative to the prevalent market price. Value
investing works on various ratios and themes to
determine if a stock is under-valued. Some of these
ratios are the price-to-earnings ratio (P/E), price-
to-book value (P/B) etc. We have demonstrated the
principles of value investing with the use of the
following themes:
Cash Bargains: A cash bargain arises when the
market value of a company goes below the
amount of cash and other liquid assets in its
possession, net of all current liabilities and
debt. In effect, the market is not giving any
valuation to the fixed assets, to the inventories,
and to the receivables.
Debt capacity bargains: The value of a debt free
company has to be substantially more than the
amount of debt it can comfortably service.
Thus, a company is highly under-valued if its
market capitalisation is less than its debt-raising
capacity. It’s a principle which was first laid out
by Ben Graham in Security Analysis.
Price-to-earnings ratio (P/E ratio): This is the
ratio of the company’s market capitalisation
80 THE MONEY MANAGER | JUNE 2009
and the net profit. According to Benjamin
Graham’s principles, the earnings yield of a
value pick should be very high, or equivalently,
its P/E ratio should be very low. Graham said
that a stock with an earnings yield of twice the
yield on AAA bonds is a safe value bet.
• Price-to-book value ratio (P/B ratio): The
P/B ratio is a ratio of the market capitalisation
of a company and its book value. Theoretically,
a P/B of less than 1 shows that the market has
valued a company below the book value of its
assets, adjusted for all liabilities. However, in
accordance with the margin of safety concept,
value investment requires the P/B ratio to be
much lower.
• Dividend yield: The dividend yield is a ratio of
the dividend paid by a company to its market
capitalisation. To an investor, it signifies the
annualised return (in terms of dividend) he can
achieve by investing at the current market price,
assuming that the dividend remains constant
over the years. A high dividend yield shows
that a stock is under-valued. Graham has used
this parameter extensively in The Intelligent
Investor.
Performance Evaluation of Value Investing
Approach
In this section, we have made an attempt to evaluate the
performance of the value investing approach over the
previous bull phase in the stock markets and compare
it with the market’s performance in general. Using this
comparison, we aim to test if the results yielded by
the value investing approach are truly superior to other
approaches. This evaluation consisted of the following
steps:
• Audited financial results of the companies
comprising S&P 500 was obtained from CMIE
database Prowess for the year ending March
2003 (beginning of the Bull Run) and March
2008.
• Various Price ratios and price data for the
similar periods was also obtained.
• Stocks worth purchasing in 2003 were identified
using various value investing criteria. These
criteria are:
• Cash Bargain: Stocks were identified
as value stocks, based upon the cash bargain
theme if their cash + market value of their
investments was more than their market
capitalization and outsider’s liabilities. All
the stocks that satisfied the criteria were
selected.
• Debt Capacity Bargain: The debt-
raising capacity is estimated using the PBIT
figure in the company’s last annual result. We
have estimated that a company can comfortably
raise loans which would keep its interest cover
ratio above 5. This has been used to estimate
the amount any company can safely pay as
an annual interest expense. The interest rate
has been taken to be at 14 per cent for the
calculation of the debt raised which will result
in the interest expense calculated above. Both
these assumptions are pretty conservative
according to the actual conditions faced by
Indian companies to raise debt from the market
and thus allow for a margin of safety.
• P/E ratio: We have considered a stock
with P/E ratio of below 2 to be a value
stock. This translates to an earnings yield
of 50%, which is much higher than that
available on bonds.
• P/B ratio: All stocks with P/B of less
than 0.3 were selected.
• Dividend Yield: All stocks with
dividend yield of 9% or more were
selected.
• Based on each of the above value investment
81 THE MONEY MANAGER | JUNE 2009

themes, we have come up with portfolios of
stocks that were highly undervalued in March
2003. We have evaluated the returns obtained
on each of these portfolios and compared it
with the average performance of the market or
the index itself. All stocks in a portfolio were
given equal weights.
• The return was calculated for each of these
portfolios for the period starting from 31st
March 2003 to 1st of January 2008.
• For the same period, the return of the Nifty
was calculated and was compared with the
portfolios’ return.
Results and Conclusion
The value stocks thus identified were observed to
generate returns which were much superior to those
generated by the stock markets in general. Some of
these stocks produced absolutely staggering results.
For example, Videocon Industries that traded at a
P/E of 0.14 and P/B of 0.01 in March 2003 moved
from Rs. 12.80 in March 2003 to Rs. 811.50 (as on 1st
Jan 2008). This stock was a part of 3 of the 5 value
investing portfolios. Walchandnagar Industries, which
was a part of 2 portfolios shot up from Rs. 2.73 to Rs.
863.20 over the same period. The returns obtained by
the different portfolios and the returns of the Nifty
are tabulated below.
As can be seen from Table 1, supernormal returns can
be obtained by following the value investing approach.
Nifty provided an annualized yield of 39.25%, from
Mar 2003 to Jan 2008, which is less than half of the
minimum return provided by any of the portfolios
(Debt capacity portfolio provided 86.95%). Therefore,
it is observed that the returns obtained upon value
investment are much higher than those offered by the
market in general.
Since we have established that the value investing
themes discussed in this article can help generate
superior returns, we have identified some value stocks
based on these themes in the current market. We thus
present below stocks that are expected to produce
excellent returns in the future, based on each of the
value themes.

Dividend P/E P/B Cash Debt Index

Return
Yield Portfolio Portfolio Bargain Capacity (Nifty)
Average Return (in %) 4976.55 10713.82 19932.96 14600.87 2283.65 523.65
Average Return 49.77 107.14 199.33 146.01 22.84 5.24
Annualized Return 2.18 2.55 2.88 2.71 1.87 1.39
Annualized Return
118.47 154.68 188.35 170.94 86.95 39.25
(in%)

Table 1 : Comparative returns of the portfolios and the Nifty

82 THE MONEY MANAGER | JUNE 2009

Table 2 : Value stocks at current valuations based on different themes

Theme Stocks to look out for

Cash Bargain Reliance Infrastructure , Hindalco Industries , Aditya Birla Nuvo ,Bajaj Holdings
&Invst. , Tata Investment Corp. , Jai Corp, Jindal South West Holdings, PTC
India, Shaw Wallace& Co., Patni Computer Systems, Cairn India, Subex, JM
Financial, Hinduja Ventures, Aftek, Mascon Global, Hexaware Technologies,
Kolte Patil Developers, BSEL Infrastructure Realty, IL&FS Investmart, Pheonix
Mills, Mahindra Lifespace Developers, Country Club (India), Balaji Telefilms,
Sasken Communication Technologies, Tanla Solutions, GSS America Infotech
Debt Capacity Bargain JM Financial, LIC Housing Finance, DCM Shriram Consolidated, Alok
Industries, Orbit Corporation, JK Lakshmi Cement, India Glycols, SREI
Infrastructure Finance, Vakrangee Softwares
P/E Ratio Aftek, Amtek India, Vakrangee Softwares, Prajay Engineers Syndicate, Lok
Housing & Constructions, JM Financial, Prithvi Information Solutions, IVR
Prime Urban Developers, JK Lakshmi Cement, Orbit Corporation, Kolte
Patil Developers, JK Cement, Marg, Sujana Towers, Chennai Petroleum
Corp., Kesoram Industries, Mysore Cements, Country Club (India), India
Glycols, Bharati Shipyard, Alok Industries, HDIL, Gujarat State Fertilizers &
Chemicals Ltd, KLG Systel, Ruchi Soya Inds, Orient Paper & Inds, Gujarat
Fluorochemicals, Nava Bharat Ventures, Kei Industries, Ajmera Realty & Infra
India, Unity Infraprojects
P/B Ratio Aftek, Prajay Engineers Syndicate, Country Club (India), Subex, Prithvi
Information Solutions, Amtek India, Mascon Global, Vakrangee Softwares, Alok
Industries, Bajaj Auto Finance, IVR Prime Urban Developers, Lok Housing
& Constructions, Arvind Ltd, Megasoft, Mukund Ltd, Ansal Properties &
Infrastructure, Gitanjali Gems, BSEL Infrastructure Realty, Sujana Towers,
Kolte Patil Developers, Sasken Communication Technologies, Bharati Shipyard,
JSL Ltd, Kei Industries, Ganesh Housing Corp., JK Lakshmi Cement, Marg,
Ruchi Soya Inds
Dividend Yield Indiabulls Securities, Monsanto India, Chennai Petroleum Corp., Prajay
Engineers Syndicate, SRF Ltd, Indiabulls Real Estate, JK Cement, IVR Prime
Urban Developers, Varun Shipping Co, NIIT Technologies, Bongaigaon
Refinery & Petrochemicals, Tata Motors, Ganesh Housing Corp., Graphite
India, Finolex Industries, Ashok Leyland, HCL Infosystems, Deccan Chronicle
Holdings, Indiabulls Financial Services, Kalyani Steels, Sasken Communication
Technologies, Orbit Corporation
THE MONEY MANAGER | JUNE 2009

pRIMERstory
cover
cover page
What do we know about the market microstructure
of the Indian Stock Markets?

An Article by

Prof. Malay K. Dey

Associate Professor of Finance, William Patterson
University, New Jersey

Malay K. Dey is currently an Associate Professor of Finance at the Cotsakos

School of Business, William Paterson University in New Jersey. He has also been
a Visiting Faculty at the Indian Institute of Management Calcutta (Summer
2006 and Winter 2008). Professor Dey received his Ph.D. (Finance) degree
from the University of Massachusetts Amherst in 2001. His primary research
interests are market microstructure, international financial markets, and financial
econometrics with a secondary interest in financial technology.
84 THE MONEY MANAGER | JUNE 2009
Not much! A keyword search on ssrn.com on “India
and stock markets” returned 179 papers, albeit mostly
unpublished working papers. Almost all of those
academic/semi-academic papers posted on ssrn.com
related to the Indian stock markets investigate market
efficiency and corporate governance issues. When I
searched on ssrn.com for research papers on Indian
stock market with a qualifier like “microstructure”
or “intra day” the search returns between three
and six papers, a few of those papers being simply
opinion pieces or commentaries. A similar search
on ABI-Inform, Econlit, and JSTOR all of which
index published papers only returned 2/3 entries.
These searches confirm that in fact, we know very
little or nothing about the market microstructure
– the organization and regulatory structure, the inner
workings of the markets, how those markets perform,
and the governance of those markets. NSE, the leading
stock exchange in India in terms of trading volume
supports a project based funding scheme for research
on Indian stock market and compiles a working paper
series based on the completed research projects funded
under that scheme (www.nseindia.com). However,
I have not seen many academic papers citing those
sources.
Before I go any further, let me first compile some
stylized facts about the Indian Stock markets.
First, India has a long history of organized stock
exchanges since its first exchange opened in the western
city of Bombay, now renamed Mumbai, in 1857.
Since then and mostly since Indian independence in
1947, multiple stock exchanges opened and operated
throughout India.1 At the beginning of the financial
market reform in early 1990s there were more than 20
regional stock exchanges in India although there was a
huge concentration of trading activities in only a few
of those. Indeed at the beginning of 1990s, the top five
exchanges in terms of trading volume, Ahmedabad,
Bombay, Calcutta, Delhi, and Madras account for more
than 75 percent of trading volume for the entire Indian
stock market. The financial market reform in India
that started in early 1990s prompted major structural
changes in the exchanges including the opening of
NSE, the wholly electronic market place for securities,
and the consolidation of several exchanges. Since
the introduction of NSE, the first fully automated
trading system in India almost all trading activities are
concentrated at NSE with BSE being a distant second
in terms of trading volume. Bhole and Pattanaik (2002)
report that for 1998-99, while BSE and NSE account
for 71 percent, the top five- NSE, BSE, Calcutta, Delhi,
and Ahmedbad account for more than 95 percent of
turnover for the entire Indian stock market. While
there is an ongoing debate on the role and continued
survival of regional exchanges, since 2000 there has
been a consolidation initiative that has resulted in a
memorandum of understanding for the sharing of a
trading platform and the demutualization of regional
exchanges.2 Currently the number of stocks listed
in various stock exchanges in India adds up to more
than 10,000 although many stocks are cross-listed in
multiple stock exchanges. These 10,000 stocks are
spread over more than 100 sectors including banking,
retail, consumer durables, electronics, business services,
software, and consulting.
Second, two of the above exchanges, NSE and BSE
have composite indexes, which track the performance
of the respective market. BSE is a free-float market
capitalization (since 2004) index that started in 1989
and was initially composed of 100 stocks from the five
major stock exchanges, Ahmedabad, Bombay, Calcutta,
Delhi, and Madras. Since 1996, BSE-100 consists of
only BSE listed stocks. NSE introduced a market
value weighted NSE 100 index with a base date of Jan
1, 2003 and base value of INR 1000.
Third, I cannot find any published paper using intra
day price and/or trading volume data from the Indian
stock markets. Hence I conclude that no convincing
research exists on the traders’ behavior and market
microstructure effects on price formation in the
Indian stock markets. Similarly although there is a
street perception of some liquid and illiquid stocks,
no empirical evidence exists on either liquidity or cost
of liquidity of stocks traded on the exchanges. While
eyeball statistics may confirm some very liquid and
illiquid stocks, often such simple statistics like trading
frequency and volume turn out to be misleading.
The statistical properties of intra day returns, bid
ask spread, trading volume, and liquidity might be
different in one exchange from another. While ex ante
there may be some obvious differences among the
exchanges in terms of their organization and structure,
the price formation processes may be also different
due to locations and heterogeneity among traders
and listed stocks in each exchange. Further, based on
the evidence provided by Aggarwal (2002) that stock
exchange ownership and governance structure has an
85 THE MONEY MANAGER | JUNE 2009
impact on the liquidity of stock exchanges, it might be
worthwhile to investigate how much of the success of
NSE is due to its joint stock corporation rather than
brokers’ association (mutual corporation) status.
One of the primary reasons why empirical research on
Indian stock markets is severely lacking has to do with
the availability and access to data. NSE and BSE, the
leading exchanges can facilitate empirical research by
providing easy access to transaction level data similar to
TAQ (NYSE) to finance researchers across the globe.
NYSE’s TAQ data has been instrumental in fueling
the interest in empirical microstructure research with
respect to US stock markets. There is another more
fundamental reason for the lack of empirical research
in microstructure of securities markets – it’s the lack
of appreciation of the role of economic analysis and
empirical evidence on securities market regulation. In
USA there is a realization that both regulation and its
enforcement are costly, and regulation without proper
enforcement is vacuous, and thus there is a great urge
to weigh the costs and benefits of regulation. For
example, after the stock market crash in 1987, NYSE
instituted trading halt and suspension rules. Several
studies have now reported on the relative effectiveness
of the trading suspension rules on market performance
and crashes (Lee et al, 1994). Similarly, in the aftermath
of SEC downtick rules, researchers have studied and
documented the effect of uptick rules on short interest
and volatility in the market (Alexander and Peterson,
1999) and decimalization came into force after Christie
and Schultz (1994) provided evidence of collusion
among NASDAQ market makers avoiding odd-eighth
ticks. Financial market regulators in the USA weigh
such evidence produced by academic research to
determine the effectiveness of existing and proposed
regulations. In India, as SEBI becomes more reliant
on empirical evidence (a good first step in the process
would be to create a research cell powered with highly
skilled financial economists and econometricians,
transactions level data for all securities market
transactions, and analytical tools) as a powerful input
to its policy making process, we’ll see more empirical
research on securities markets along the way.
Bibliography
Aggarwal, Reena, 2002, Demutualization and regulation
of stock exchanges, Journal of Applied Corporate
Finance, 15.
Alexander Gordon and Mark Peterson, 1999, Short
selling on the NYSE and the effect of uptick rules,
Journal of Financial Intermediation, January-April.
Bhole, L. M. and Shreeya Pattanaik, 2002, The state
of Indian stock market under liberalization, Finance
India, 16, 159-80.
Christie, William, and Paul Schultz, 1994, Why do
NASDAQ market makers avoid odd-eighth quotes?
Journal of Finance, 49, 1813-40.
Lee, Charles, Mark Ready, and Paul Seguin, 1994,
Volume, volatility and NYSE trading halts, Journal of
Finance, 49, 183-214 3
(Endnotes)
1
For a compact history of the Indian stock exchanges
and some of the institutional features of the Indian
stock market, please refer to Bhole and Pattanaik
(2002).
2
Please refer to the following financial press coverage.
1) SMEs would benefit from revitalized regional
bourses by V. Balasubramanian, The Economic Times,
September 30, 2008. 2) Indian Stock Exchanges – stage
set for a dramatic change by Dr. Uday Lal Pati posted
on investorideas.com on Februray 28, 2007.
3
I am grateful for the research assistance provided by
XueFan Cai, an MBA student at the Cotsakos School
of Business, William Paterson University in New Jersey
while I was preparing the manuscript
86 THE MONEY MANAGER | JUNE 2009
Know Your Product - Barrier options
By Gaurav Lal, IIM Calcutta
Barrier options are path-dependent options build on
vanilla call and vanilla put options with a condition
that they are initiated or exterminated depending on
the underlying asset hitting a certain barrier. These
barriers can be in any shape or size and there can be
multiple barriers. Barrier options may have a built-in
rebate that is paid as compensation when the barrier is
not reached. Some basic variants of barrier options are
discussed below.
Payoff functions of a barrier option
. B lies above the initial price then it is called Up-and-in-
Knock Out option
These are call or put options which purge if a certain
predefined barrier above or below the initial price is
reached.
Example: A Barrier call with initial value S(0) = 100,
Strike K = 90, a running time of T = 2 years and
Knock out level B = 120 has following disbursement
profile:
 If the conclusion price S(2) is below the Strike K
nothing is disbursed
 If the S(t) hits the Knock out level B = 120
sometime during the course of T, nothing is
disbursed independent of the conclusion price
 If the conclusion price S(2) (lets say S(2) = 115)
lies over the Strike K = 90 but never reached
the Knock out level B then the difference of the
closing price S(2) and the Strike is disbursed (here
for example 115-90 = 25)
When the barrier B lies above the initial price then it
is called Up-and-out-call, like the example above. The
counterpart for this would be a Down-and-out-call which
expires, if the Barrier, which is lower than the initial
price, is fallen below.
Knock in option
These are just the reverse of Knock out options in
the sense that they get activated only if a predefined
barrier is reached at least once during the course of
their time.
Example:
A Barrier call with initial value S(0) = 100, Strike K =
110, a Knock in level of B = 130 and a running time
of T = 2 years has following disbursement profile:
 If the conclusion price S(2) is below the Strike K =
110 nothing is disbursed
 If the S(t) never hits the Knock out level B =
130 during the course of T, nothing is disbursed
independent of the conclusion price
 If the conclusion price S(2) (lets say S(2) = 123)
lies over the Strike K = 110 and hits the mark B =
130 at least once during the course of time then the
difference of the closing price S(2) and the Strike
is disbursed (here for example 123-110 = 13)
Similar to the Knock out options case, when the barrier
call, like the example above and its counterpart would
be a Down-and-in-call which kicks in, if the Barrier,
which is lower than the initial price, is breached.
Digital Barrier option
A digital option is an option that pays out a fixed
amount if the option at maturity is in-the-money
(ITM). Build upon a digital option, a digital barrier
option is one that includes a barrier which, if reached
during the life, affects the existence of the option. The
barriers may be placed either above the strike or below,
meaning that prior to expiry, an active digital can be
knocked out or an inactive digital can be knocked in.
Because the use of barriers decreases the probability
that the digital will pay off, the gearing factor will be
higher than a regular digital.
 IIM Calcutta
Financial Research and Trading Lab
“ We aim to give cutting edge tools to understand
financial markets and to enable exciting research
possibilities in the field of finance.
Prof. Ashok Banerjee, IIM Calcutta

Features
Live access to data from 5 different financial markets :
NSE Cash, NSE F&O, MCX, BSE Cash and NCDEX.
Exact replica of real broker terminals
‘Trading Strategies’ a fully lab-based course introduced inaddition to course on
Investment Analysis and Portfolio Management
Bloomberg terminal along with simulation software
 BETA, The Finance Club of IIM Ahmedabad
BETA is the most prestigious club of IIM Ahmedabad and
has been an integral part of IIMA culture since decades.

Beta aims to generate and promote interest in finance

among IIMA students. However, its activities are not
limited to IIMA alone. It has organized several national
level case contests, trading games and workshops in the
past. It has also been associated with distinguished
people from academia and industry. Some of Betas’s
regular activities are organizing placement oriented
sessions, internships experience talks, contests and
informal discussions on current issues.

NetWorth, The Finance Club of IIM Bangalore

With the growing importance of finance and the plethora
of activities that financial institutions have become
a part of knowing about ‘Finance’ becomes not only
important but also imperative. Networth’s activities
are used to bring out the very best and disseminate
the gyaan the movers and shakers in this field have to
offer. So be it a Private Equity talk, a session to know if
you have the skill sets for an I-Banking job or analysis of
mergers and acquisitions from experts we have it all.If
you love finance and are an avid follower then this club
is the place to be.

Finance & Investments Club of IIM Calcutta

Finance & Investments Club of IIM Calcutta, popularly
known as the Finclub is a student driven initiative that
collaborates with both the corporate and academia from
the financial sector to provide a platform for students
to improve their quantitative and analytical thinking
abilities. The club also manages and maintains the IIM
Calcutta Finance Laboratory in collaboration with the
Department of Finance and Control.

The club organizes industry talks, workshops, stock

trading and other finance based simulated events.

AN IIMA, IIMB, IIMC Initiative | June 2009

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MONEY
MANAGER