BETA, the Finance Club of IIMA BETA is the most prestigious club of IIM Ahmedabad 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 Beta's regular activities are organizing placement oriented sessions, internship experience talks, interesting contests and informal discussions on current issues.

MONEY MANAGER
An IIMA, IIMB, IIMC Initiative

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OCTOBER 2008

NetWorth, the Finance Club of IIMB 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 an 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 and Investments Club of IIMC 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 abilities. The collective effort is towards gaining a comprehensive picture of the world of finance. The club organizes industry talks, workshops, stock trading and other finance based simulated events. It plays an active role during summers and final placements to help students in their preparation

Can Dalal Street be the next Wall Street?

Also inside Special Feature on financial crisis Dr. K. P. Krishnan on Unfinished Agenda in Indian Financial Markets

For feedback/querries contact Manu Jain (9916950146), Neha (9916950101)

Publication sponsored by UTI Mutual Fund

EDITORS NOTE

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Editor's Note
As I type this note, the Indian Capital Markets is witnessing the turmoil's of the Global Financial Crisis with SENSEX falling off the tenth floor. Some say that now they can see the bottom, while others argue that this is a Grand Canyon. We are beyond doubt in midst of a crisis the depth of which is still unknown. In this context it will be apt to quote Napolean Hill: "Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." It is an established fact that the genesis of crisis is not in the Indian economy itself, which is by all means fundamentally sound - or would be with a proper regulations to oil the wheels of production. This adversity in fact provides us great opportunities since our economic growth is primarily driven through domestic savings of which 28% constitutes household savings, FDI and FII put together is merely 8% of our gross savings in any one of the past several years. The focus of the world is now towards the Asian economies and India & China are going to be the next epicenters of economic activity. However at present, though the license-permit raj has been dismantled in the real economy, it is still flourishing in finance. The financial muscle of the lower half of Manhattan and London's business engine have been most important driver's of economies of US and UK. No wonder that cities like Shanghai, Dubai and Singapore are busy trying to turn themselves into the hubs of their respective regions. The recently published MIFC report is a call to arms to replicate this success story in India through turning Mumbai into an international financial center, by laying down a blueprint for how India must globalize. We have tried to bring an Indian flavor in this edition of Money Manager. While the Cover Story and the article by Dr. K. P. Krishnan (Joint Secretary, Ministry of Finance) talk about the potential of Mumbai in becoming a global financial hub; we have also received a whole range of articles on Indian economy, ranging from Reforms in Indian Pension Funds, Financial instruments to tackle inflation, Sustainability Index for BSE to Bid Ask Spread in Indian markets and Indian VIX. We have the regular stuff like the Book Review on Black Swan, note on few nontraditional financial products, puzzles, trivia and a lot more. Starting this issue we also plan to bring out a Special Feature on the latest developments in the financial markets. This issue's special feature focuses on The Global Financial Crisis. We hope you like this edition. Feel free to send your feedback to us at manuj07@iimb.ernet.in or nehav07@iimb.ernet.in. Happy reading! Neha Verma (IIMB) Editor in Chief

MONEY MANAGER
Chairman Manu Jain (IIMB) Editor - in - Chief Neha Verma (IIMB) Editorial Board Chintan Valia (IIMB) Shubham Satyarth (IIMB) Gaurav Parasrampuria (IIMB) Neha Gupta (IIMB) Coordinating Committee Manik Lather (IIMB) Sharmili Phulgirkar (IIMB) Piyush Sonee (IIMA) Ravi Shankar Saxena (IIMA) Rajatdeep Anand (IIMC) Anuja Lele (IIMC)

THE

For any feedback/querries mail to: manuj07@iimb.ernet.in or nehav07@iimb.ernet.in

THE MONEY MANAGER

FOREWORD

CONTENTS

THE MONEY MANAGER

Foreword
UTI Mutual Fund is proud to be associated with Money Manager 4.0. We at UTI Mutual Fund have always believed that some of the best ideas come up from the young brains of the country and Money Manager seeks to achieve just that. It is thus our constant endeavour to associate ourselves with these new minds for more vibrant and, perhaps, more effective ideas. Simultaneously, we believe that finance being an integral part of any career path that an individual charts out; any number of steps to popularise and explore this stream cannot exhaust its scope. For the fulfilment of this objective Money Manager provides a great platform for management students in the country to share insights with the academia and industry experts across the globe. What makes UTI Mutual Fund to associate with Money Manager 4.0 is that, it is not an academic oriented research journal but a compilation of relevant practical views from different streams of the industry. Therefore, it can be and is of use to people connected to finance in any which way, namely the students, faculty, researchers and the industry. IIM Bangalore is undoubtedly among the top business schools in India and to interact with students from here has been a two way learning process. Money Manager 4.0 seeks to capture the views of some of the best minds of the country on the pulse of the economy. These views are only then corroborated by the industry experts and prominent academicians writing for Money Manager 4.0. We are at a significant point in the history of finance. The Indian economy is burgeoning today - growing leaps and bounds. With strong fundamentals and improved efficiency, the time is ripe for the markets to move ahead. At this point in time the inevitable question thus becomes: Is Dalal Street on its way to becoming the next Wall Street? Does India have it in itself to emerge as the next power to reckon with in the capital markets? This is what Money Manager 4.0 seeks to find out. It has sought the opinions of all who matter: the who's who in the industry, those who teach and research on the theories behind each of these phenomenon and those who actually will be in there in the times to come. UTI Mutual Fund proudly presents the Bangalore chapter of Money Manager 4.0. U.K.Sinha Chairman & Managing Director UTI AMC Ltd

Contents
Message from the Dean, IIM Bangalore..... 06 Acknowledgements...... 06 Cover Story
Can Dalal Street be the Next Wall Street?.....07 Did you know.....43 3. An Introduction to Volatility Index (Vix) and Analysis of India Vix.....44 4. Inflation: The Future is in Futures.....49 5. Can BSE Sustain a Sustainability Index.....53 6. Re-Introducing G-Sec Futures In India.....58 Crossword.....63 7. The India Vix - "An Effective Financial Instrument?".......64 8. Sub-Prime Crisis - Are We Done Now? A $5.2 Trillion Question.....69 9. Understanding the movements in Crude Oil Prices......73 10. Islamic Financial Products: Road Ahead In India.....77

Special Feature
Financial Crisis.....16

Book Review
The Black Swan: The Impact of the Highly Improbable....23

Invited Article
1. Indian Financial Markets: The Unfinished Agenda.....24 Did you know.....22 2.Indian Mutual Fund Industry....28 Did you know.....30

Primer
Adoption of BASEL II Norms Are the Indian banks ready?......82

Student Articles
1.Bid-Ask Spread and its Asymmetric Nature: A Case of Indian Nifty Futures.....33 2.Pension Funds & Capital Markets -Reforms & Implications in the Indian Context......38 Puzzle Questions.....37

Know this Product

1. Target Redemption Notes (TARN).....89 2.Variance Swaps......90

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ACKNOWLEDGEMENTS

COVER STORY

THE MONEY MANAGER

Message from the Dean, IIM Bangalore

The past one month has witnessed the worst turmoil in the global financial system. What is its geographical spread and how long it will last is anybodys guess. One thing is clear. No country is immune to such turmoil; the difference is only one of degree. The effect of the global meltdown is being felt across sectors all over the world. Even the elite global business school students are worried about what this turmoil holds for them in terms of placement opportunities. Against this background of uncertainty, an effort like Money Manager is a tremendous help in assessing the magnitude of the problem. The articles written in Money Manager are well-researched and cover topics that are at the top of the mind of B-school students. With summer placements of most Bschools round the corner, I find this a very commendable effort on the part of the students of IIMA, IIMB & IIMC to apprise their peers about the latest developments in the financial world, help them allay their unknown fears and make an informed decision on the career path that lies ahead. My heartiest congratulations to Money Manager. I wish the editorial team the very best in all future initiatives, Shyamal Roy Dean, IIM Bangalore

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Acknowledgements
We would like to thank UTI Mutual Fund; sponsors of this issue of Money Manager who not only supported us with the finances but also advised us on the content part. It would have been impossible to bring out the issue without their support. Special thanks to Professor Sankarshan Basu and Professor Prakash Apte for their constant support and encouragement during all the issues of the magazine. We thank Professor Shyamal Roy and Professor Basu again for taking out their valuable time to select the best student articles. We are grateful to Dr. K. P. Krishnan and Mr. A. Balasubramanian for their insightful articles. While Dr. Krishnan speaks of the unfinished agenda in the Indian Financial Markets, Mr. BalaSubramanian writes about the success of the Indian Mutual Fund industry. A special mention to Anshul, Sourav, Amit, Rahul, and Sumeet whose contribution has been instrumental in bringing out the issue. Lastly we would like to thank all students from IIMA, IIMB, and IMC for their feedback and all those students who sent us their well researched article for this edition. These articles are truly the backbone of the magazine.

Can Dalal Street be the Next Wall Street?

Chintan Valia Manu Jain Neha Verma Shubham Satyarth Sourav Das (IIM Bangalore)

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Executive Summary
India's financial system holds one of the keys, if not the key, to the country's future growth trajectory. A growing and increasingly complex market-oriented economy, and its rising integration with global trade and finance, require deeper, more efficient and well-regulated financial markets. Financial markets in India in the period before the early 1990s were marked by administered interest rates, quantitative ceilings, statutory pre-emptions, captive market for government securities, excessive reliance on central bank financing, pegged exchange rate, and current and capital account restrictions. In recognition of the critical role of the financial markets, the initiation of the structural reforms in the early 1990s in India also encompassed a process of phased and coordinated deregulation and liberalization of financial markets. As a result of various reforms, the financial markets have transited to a regime characterized by market-determined interest and exchange rates, price-based instruments of monetary policy, current account convertibility, phased capital account liberalization and an auction-based system in the government securities market. The Indian stock markets are now amongst the best in the world in terms of modernization and the technology. It also had its shares of scams which were huge even by international standards, revealing the many gaps in our existing financial system. Fortunes were lost overnight, middle class people and retirees were the hardest hit because of the irregularities. As a result, the ambit of the Securities Exchange Board of India, the stock exchanges and regulatory financial institutions was widened. While India remained unaffected by the contagion effects of Asian crisis of 1997, it could not escape the sub-crime crisis. Today, India is some way from this ideal, and progress on reforms has been glacial at best. But this is not an intractable problem. However, the groundwork that has been laid will allow us to move rapidly towards the regulatory architecture that is appropriate for a country of India's size and aspirations. While building on past successes, it is also important to remember there are gaps keeping it away from the status of an International Financial Center. A number of problems exemplify the substantial road that still has to be travelled in achieving an adequate financial regulatory and supervisory structure in India.

What Changed?
As discussed above, the times of isolated and insulated financial markets are now history. The success of any capital market would depend upon its alignment with the global economy. The Indian economy adopted the process of liberalization in 1991 under the watchful eyes of the now Prime Minister, Dr. Manmohan Singh - a move not designed, but out of compulsion. But as the saying goes "It's the runs that matter, not how they come". This initial step has had far reaching effect in the next 17 years thus far and the capital markets are the ones most benefited out of it. However, liberalization was not the only contributing factor to the emergence of the strong Indian capital markets. Liberalization spurred the economy which is essentially the backbone of any developed financial market. However, the development of financial markets would not have been forthcoming had the liberalization not been coupled with series of market reforms. We will focus on some specific changes that we believed played a significant role in bringing Indian markets to the forefront of the global financial markets. The initial transformation of the Indian capital markets was initiated with the establishment of the Securities and Exchange Board of India (SEBI) in 1989, initially as an informal body and in 1992 as a statutory autonomous regulator with the twin objectives of protecting the interests of the investors and developing and regulating the securities markets over a period of time. The incorporation of The National Stock Exchange of India Limited in 1992 as a tax-paying company unlike the other stock exchanges in India. It put in place a country-wide stock exchange similar to The Bombay Stock Exchange Limited.

The regulatory changes in the Primary Market relating to free pricing resulted in a surge in the primary market activity broadening the base of the companies listed on the Indian bourses and thus providing ample scope for diversification. The increased transparency of the process was crucial to the success of the IPO's in the recent past. o < IPO Trend> The introduction of 'Online / Electronic trading' in 1995 through the price time priority matching through over 10,000 terminals across the country resulted in a better price discovery and improved the efficiency of the Indian markets. This infrastructure set-up is ultra-modern and has resulted in bringing down the transaction costs to a level which even the developed exchanges would find hard to match. The establishment of the National Securities Clearing Corporation of India Limited in 1995 eliminated the concept of 'counterparty risk', which resulted in increased participation and improved liquidity in the market. The establishment of depositories in 1996 eliminated the need for maintaining the securities in the physical form and thus further eased the process of settlement.

Background
It was October 19th 1987. The Dow Jones witnessed its biggest percentage fall (22.6%) on a single day. The day is known as "Black Monday". While all the major indices across the world caught the cold, India remained insulated from this global crash. "Pundits" lauded it as a victory of closed Indian financial system which made the system immune to world crises. It was 1987, and India was still very much caught up with the idea of a closed self sustaining economy! If someone talked about developing Mumbai as an International Finance Centre, the response would have been akin to what Galileo received from the Church for proclaiming the Earth to be spherical. Twenty one years hence we are in midst of another crisis. Unlike 1987, India has lost its immunity & is moving in line with the global hysteria. Rather it is an active participant. Numerous changes in the financial system have given rise to this coupling phenomenon. And talks about developing Mumbai as an International Financial Centre are no longer subjected to same mockery as it was 20 years ago. In fact

there are people who claim that the current crisis could well be the required trigger! In an article, Prof. Vaidyanathan from IIM Bangalore says - "The decline of these institutions - many more to come - is the best thing that has happened to countries such as India, which are poised to play a larger role in global financial affairs".

The introduction of Trade Guarantee Funds and Derivatives trading in 2000 further strengthened the depth of the Indian markets. The Derivatives trading enabled better price discovery and the Trade Guarantee Funds ensured sustainability of the Exchanges in bearing the brunt of the defaults. The Investor Protection Guidelines introduced around the same time provided the investors with the desired security. Adoption of more stringent accounting practices in terms of disclosure and also the board room practices have resulted in better dissemination of information and helped investors make informed decisions.

India Shining
As optimistic as this may sound, the truth is that not only we Indians, but the entire world believes that India might just be poised to make it to the big league. With the largest markets, a rampant growth in GDP and sustained optimism, it is already a preferred investment destination along with China and few other emerging economies. Through this article, we will put forward various significant changes in the Indian financial system along with the impact it had on our capital markets. Following that, we will highlight some major deficiencies that still prevail in our system. Finally we will have some recommendations for making Dalal Street the next Wall Street.

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Allowing Foreign Institutional Investors (FII) to participate in the Indian markets have resulted in improved liquidity in the markets. Opening up of the Indian markets to investors such as Mutual Funds, Pension Funds, other country funds, etc have allowed the integration of the Indian markets with the global economy / markets.

Thus, a plethora of reasons, namely, growth opportunities, partial capital account convertibility, consolidation options, rising GDP, robust equity markets, etc have resulted in India emerging as a preferred investment destination. In a survey conducted by Ernst and Young in June 2008, India was voted as the 4th most preferred investment destination in the world.

Each of these factors has contributed in taking the Indian Capital Markets to its present position. The robustness of the markets was severely tested during the markets crashes in 2004 and then again in 2006, where the Indian capital markets sustained them thanks to the financial systems in place. To its credit, not a single case of default was registered during these crashes. Yet another comforting factor is that our markets are no longer overly dependent on the whims of FIIs. Simply put, although a mass FII exodus would depress our market, it would not cause a mass hysteria. This was evident when SEBI ban on participatory notes (P-Notes) in September 2007. FIIs exited in massive numbers, but domestic mutual funds, insurance and pension funds helped prop up the market.

Advantage Mumbai
Some other factors that have contributed and will continue to contribute towards India's competitive advantages are: Democracy - Properly functioning financial markets require a constitutional basis and machinery for system governance that is stable, reliable, resilient and flexible. India has proven strength in upholding liberal values, protecting property rights and maintaining political stability Human Capital - Proficiency in English along with proven technical and quantitative knowhow give Indians the edge over their counterparts in Dubai, Shanghai and Singapore. Location - Mumbai is well located in being able to interact with all of Asia and Europe through the trading day. Apart from the Americas, transactions with most of world GDP can occur in daylight However, in spite of all these positives, the Indian capital markets are still far from reaching the volumes and trades witnessed by the likes of New York, London and Tokyo. The next section would deal with the deficiencies of the system that are slowing us down in our race to become the next Wall Street.

As a result, the ambit of the Securities Exchange Board of India, the stock exchanges and regulatory financial institutions was widened. Today, India is some way from this ideal, and progress on reforms has been glacial at best. But this is not an intractable problem. However, the groundwork that has been laid will allow us to move rapidly towards the regulatory architecture that is appropriate for a country of India's size and aspirations. While building on past successes, it is also important to remember there are deficiencies in the current regulatory system. A number of problems exemplify the substantial road that still has to be travelled in achieving an adequate financial regulatory and supervisory structure in India. We through this story try to bring out the deficiencies in the Indian market which need to be overcome for India to become a financial powerhouse.

figure is expected to grow at an exponential rate. Investment banking transactions typically involve fees of 2% to 4% of transaction value. Even a 2% revenue for the Financial Services industry will result in $360 mn of revenues going out of the country per year! The total trade has also grown immensely over the past 10 years. The trade GDP ratio in 2005 - 06 was 36.1% as against 7.5% in 1970 - 73 period. Even this 35% understates the country's globalization as the export of services is not accounted in the trade figure. The overall (two way) flow of funds stood at $657 bn for the period 2005 - 06. The financial services required in trade (say currency hedging, other asset management services, etc) are carried in the country with access to high quality, low cost financial services. Because, India doesn't have developed currency markets most of these transactions takes place in the other country (usually Europe or America). Annual fees for asset management services are typically between 1-2% of the portfolio under management with entry fees varying from 2-5%. Private banking and hedge funds involve higher annual loads and. Assuming a very conservative 1.5% revenue for the financial services (FS) industry out of this $657 bn figure; still turns out to be a massive $10 bn per year! Thus there is a huge untapped demand for the FS in India.
Attributes, Characteristics and Capabilities of an IFC (scale = 0-10; 0 = worst; 10 = best) Mumbai London New York Tokyo Singapore Frankfurt Demand Factors for IFS Domestic Demand for IFS Demand for IFS from regional clients Demand for IFS from Global clients Supply Factors for IFS Full array of international banking services for corporates and individuals Full array of international capital markets, products, and services Full array of risk mgmt services Full array of insurance services Existence of wide, deep and liquid derivatives mkt for: Equities and indexes Interest rates Currencies Commodities Services Offered Fund Raising, wholesale and capital mgmt Asset Mgmt M&A (national, regional, and global) Financial Engineering for Large Complex Projects and PPP financing 10 1 0 10 10 10 10 10 10 10 3 3 4 9 5 10 7 3

Huge domestic demand; but where's the supply

Inspite of the growing number of Indian MNCs, the increasing no of cross border M&A deals, and the rising GDP; the financial services industry have barely been able to keep pace with the huge demand created due to the India Shining story. Rarely do we see these deals being funded by Indian financial system. Tata - Corus deal (the $12 bn deal) generated financial services revenue for Singapore and London. The table below lists a few big M&A deals by India Inc. and the investment banks involved in the deal
Acquirer Tata Steel Target Co. Corus Group plc Deal Value(in mn $) Investment Banks involved 12000 ABN Amro, Credit Suisse and Deutsche Bank. Debt Financing by Standard Chartered and Citi UBS, ABN Amro, Bank of America Debt financed by Abn Amro, ICICI, and SBI Debt financing by Citigroup & ICICI UBS

What makes India click?

Having said that, there is no denying the fact that FII inflows have played a crucial part in making Indian markets what they are today. And regulations and policies directed towards supporting and encouraging these inflows have been the key contributor but not the only ones. In spite of the fact that the FII's were allowed to participate in the Indian Capital Markets since 1992, the activity levels increased only after 2004. The primary reason for this is the fact that the Indian economy started showing signs of rapid growth then. It was a period when India consistently clocked a GDP growth rate of 8% with indications of sustainability. Also, closed structure of Indian economy over last so many decades ensured that most of the sectors in the economy though being substantial in terms of revenue have remained highly unorganized leaving a lot of scope for investment and consolidation.

5 3 2 1

9 10 10 10

9 10 10 10

9 7 5 7

10 8 7 5

6 5 6 8

A tough road ahead

India's financial system holds one of the keys, if not the key, to the country's future growth trajectory. A growing and increasingly complex market-oriented economy, and its rising integration with global trade and finance, require deeper, more efficient and well-regulated financial markets. The Indian stock markets are now amongst the best in the world in terms of modernization and the technology. India remained unaffected by the contagion effects of Asian crisis of 1997 & have escaped the effects of Sub-prime crisis as well, which has plagued the developed economies. However, it has also been a decade marred with scams, which were huge even by international standards, revealing the many gaps in our existing financial system. Be it the Harshad Mehta scam in 1991, or Ketan Parekh in 2001, or the US-64 scam. Fortunes were lost overnight, middle class people and retirees were the hardest hit because of the irregularities.
Hindalco Suzlon UB Vodafone Novelis RE Power Whyte & Mackay Hutch 5982 1000 1170 1110

5 1 1 3

10 10 10 10

10 10 10 8

6 8 7 7

7 7 8 5

6 7 8 8

5 4 3 3

10 10 10 10

10 10 10 10

8 8 6 8

7 9 5 7

7 6 5 6

he total value of M&A deals in a year in the country (averaging for the last 3 years) is close to $20 bn1; and this

Source: MIFC Report

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The offshore Demand

Due to lack of liberal policies, weak institutional mechanisms, and small liquidity in the OTC derivatives (currency, OIS (Overnight Indexed Swaps), etc); investors buy these derivatives products on Indian underlyings from offshore markets like Hong Kong, Singapore, and London. There is perhaps a billion dollars a day of notional value of derivatives which are traded outside the country on Indian underlyings. These markets could wax and wane with the entire demand coming to India if Indian financial regulations got more sophisticated. More liberal policies could shift a great part of this market to India. The table below shows the offshore demand for Indian OTC derivatives
OTC Debt Derivatives OIS Swaps MIFOR Swaps Currency Fwds Market Lot (million $) 5 5 5 Spread Average Daily Volume (million $) 50 - 150 50 - 150 500 - 700

being marked to market, thus reducing the possibility of unexpected demands on bank capital. Foreign investors, who do not suffer from the same sources of risk aversion as Indian institutions, are allowed only to a very limited extent into the market (a total of $1.5 billion). Given the very limited liquidity, they are not always eager to even take up the available quota. On the issuance side major detracting factors are, the high interest rates demanded by buyers, because bonds are illiquid and because bond holders are poorly protected in bankruptcy, means that bank debt is available at much more attractive terms. Add to this the issuance and compliance costs, and issuers do not find significant reasons to run a regular issuance program. Also, until the recent credit crisis, larger corporate issuers had access to much cheaper funds in the offshore debt capital markets. Even after hedging their currency risks, the total cost of borrowing offshore is much lower than the cost of borrowing in the domestic market. This is reflected in the strong growth of External Commercial Borrowings (ECB) in recent years.
Domestic Debt Securities - Amount outstanding as on Sept 2007 (USD Billion)
World US UK Japan India China Indon esia Malay sia Singa pore

Currency futures in India launched only now on Aug 29, 2008 and currently are allowed in only INR/USD

Full Capital Account Convertibility still not there

All the dreams of Dalal street being the next Wall street will involve a paradigm shift in many of the current economic policies, the most important being making the rupee fully convertible on both current and capital accounts. It goes without saying that our conservatism in the 1997-2000 era regarding capital controls saved us from the scourge of the Asian currency crisis. The central bank's intervention to avoid these effects causes problems and affects the independent monetary policy operation. However we have to appreciate the fact growing integration of India with the world economy is pushing us towards capital account convertibility in any case. Also there are scores of models where countries have combined convertibility with independent monetary policies. In order to have higher seat in the world economic order it's imperative that we look adopt the successful models and learn lessons from the instances of failure. This will not only open the opportunity of exporting financial services for India but also send a strong signal to the international markets about our confidence in the liquidity and efficiency of our financial markets.

Bond and Derivative market - The missed synergies

One of the crucial factors behind the success of New York (hence wall street) as a financial centre is the presence of deep, highly liquid bond and derivative market. Any financial centre will generate huge demands in all currency spot and derivative markets. With the current rate of growth Indian would soon become fourth largest economy by 2012, and INR would soon emerge as the one of the six most traded currencies (i.e. USD, JPY, EUR, GBP, CNY and INR) in the world. International bond issues both sovereign and corporate will be denominated in the six currencies. If Mumbai has to compete with Wall Street then it's imperative and Mumbai attracts global issuers both in the bond market as well. This will require an arbitrage-free INR yield curve, backed by interest rate and credit default protection derivatives of every kind. It must be appreciated that the yield curve and interest rate derivatives markets and the currency spot and derivatives markets are inextricably bound together by arbitrage. At present these markets are plagued by absence of liquidity, have structural weaknesses with no price discovery mechanisms. Arbitrageurs and risk takers are key participants of these markets as they provide liquidity and ensure informational efficiency. The effect is too obvious if one looks at the basic arbitrage relationship in the currency forward market, Covered interest parity (CIP). The CIP principle requires that two alternatives for borrowing should have identical returns: (a) borrowing in USD and using funds in India with a locked-in INR/USD exchange rate for repayment in USD; versus (b) borrowing in INR over the same maturity. In India, the CIP principle is persistently violated (see figure) to a point where the CIP deviation is utilized as a predictor of future currency fluctuations. Though considerable progress has been made in equity and equity derivatives, commodity and recently with the launch of currency futures, the development of a concomitant BCD nexus has lagged.

1.5 - 2 basis points 10 - 15 basis points 0.5 - 2 ps

An Almost Nonexistent Corporate Bond Market:

The state of India's corporate bond market has been the subject of much discussion and analysis but little progress over the last ten years. This is in contrast to the strong growth witnessed in the equity markets as well as the government securities market. The corporate bond market remains practically non-existent. Most of the large issuers are quasi-government, including banks, public sector oil companies, or government sponsored financial institutions. Of the rest, a few known names dominate. There is very little high yield issuance, and spreads between sovereign debt, AAA debt and high yield debt are high in comparison to other markets. Very few papers trade on a regular basis. Trading in most papers dries up after the first few days of issuance, during which the larger players "retail" the bonds they have picked up to smaller pension funds and cooperative banks. Most trading is between financial institutions. The reasons for the near-absence of a corporate bond market can be divided into constraints on both demand and issuance side. On the demand side, pension funds, who invest heavily in corporate debt outside India, are constrained by their prudential norms and conservative investment policies. Mutual Funds, and to a lesser extent insurance companies, are buyers of higher yield debt, but do not create enough demand for the market to grow. Banks tend to prefer loans to bonds, because loans can be carried on the books without

Domestic Debt Securities a) Government b) Govtsecurities as a % of total Domestic Debt securities c) Functional Institutions d) Corporate Issues

55,389 26,200 47%

23,899 1,354 6,480 27% 901 67%

8,706 7,034 81%

435 396 91%

1,528 1,042 68%

89 80 90%

155 66 43%

90 64 71%

Regulatory Gaps
1) Rule based Regulation: High standards of regulation and governance are the prerequisite for the establishment of any financial regime. If Dalal Street aspires to be the next financial powerhouse then its imperative that it too establishes a robust governance regimes which not only weeds unviable institutions and structures but also promotes financial innovation. India's strategy for financial regulation deploys rules based regulation - the same strategy used in continental Europe. This prescriptive rule based approach approach avoids legal ambiguity through precise codification. But, it also causes excessive regulatory micro-management leading to a counter-productive interaction between the regulator and the regulated. The regulated respond to the needs and opportunities in the market place while attempting to comply only with the letter of the law. Rule based approach also inhibits innovation.

23,053 6,135

14,499 2,918

429 23

969 703

29 8

400 86

4 5

31 57

19 6

Source: BIS Quarterly Review, March 2008

Slow pace of Innovation:

The pace of innovation is very slow. Products that have been well established in the financial markets worldwide & subsequently are proposed to be introduced in India take several years to get regulatory approval. The following examples illustrate the long delay from serious proposal by a potential innovator to actual successful launch: Index futures were proposed in early/mid 1990s and launched in 2000 Gold Exchange Traded Funds were proposed in 2002 and launched in 2007 Interest rate futures were proposed in 2003 (and there was also an abortive launch of an unviable variant) but have yet to be permitted in a viable form

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Every new idea on products, services, markets or even new ways of doing business requires going to the regulator requesting a modification of rules. This tends to eliminate the temporary profits obtained by innovative firms who obtain an edge over their competitors by coming up with new ideas, which (in turn) tends to reduce investments into research and development. 2) Flaws in Regulatory Structure: Some areas of the financial sector have multiple regulators, while others that could pose systemic risks have none. Both situations, of unclear responsibility, and of no responsibility, are dangerous. Some examples of regulatory overlap include: Overlap between SEBI and MCA in the regulation of issuer companies Overlap between SEBI and RBI in the regulation of foreign institutional investors as well as in exchange traded currency and interest rate products Overlap between RBI and state governments in the regulation of cooperative banks Some examples of regulatory gaps include: Absence of any mechanism for regulatory review of corporate accounting statements for compliance with disclosure requirements. The growing number of credit co-operative societies and MFIs involved in deposit taking or gathering, with little oversight Absence of supervision of cross-market activities 3) Wrong regulatory incentive structure: The quality of regulatory output is influenced by the overall environment in which the regulator operates, the consequent incentives they face, and the performance standards they are held to. In fact, the perceived inadequacies in the quality of regulatory output may have more to do with incentives and environment than with fundamental deficiencies in the quality of talent that regulators attract. Also, regulatory incentive structures lead to excessive caution, which can be augmented by the paucity of skills among the regulator's operational staff relative those of the regulated. Such caution could actually exacerbate risks

world markets started in the U.S. sub-prime sector, in part because of excessive financial exuberance, despite its proximity and exposure the United States financial system has been so far capable of weathering the losses surprisingly very well. It can be attributed partly to the openness to & variety of investors in U.S. financial markets. U.S. banks could recapitalize quickly by tapping into sovereign wealth funds elsewhere. Even while banks are hamstrung by overloaded balance sheets, hedge funds and private equity players are entering the markets for illiquid assets and establishing a bottom. Two-pronged structure for Derivatives Market. With the growing importance of risk management, the growing size of exposures by financial and nonfinancial firms, and the growing sophistication of financial firms, India is likely to witness the explosive growth of derivatives positions. In order to control the associated systemic risks, a twopronged strategy should be followed. First, standardized products should be encouraged to migrate to exchanges. Second, clearing corporations such as NSCC and CCIL must be encouraged to offer risk management services for the OTC market. If these two strategies are applied fully, systemic risk will then be limited to the small class of OTC derivatives positions which are not understood by the clearing corporations. Though India has three major and several smaller modern commodity futures exchanges with billions of dollars of transactions on a daily basis, small farmers are not able to benefit from these. This is because the key functions - quantity aggregation and price assessment are currently played by traditional commodity brokers, who often collude to make lower payments to small farmers. To ensure that they do not exploit farmers, apart from wide dissemination of price information, which is happening already, farmers need the ability to sell to a processor right from the village (as is currently happening with ITC e-Choupals) if they find the price attractive. Alternately, farmers bringing their produce to a mandi, but not finding the price attractive, should be able to sell to another distant mandi. This is being enabled by the new generation of "spot" exchanges like NCDEX Spot Exchange Ltd (NSEL) and SAFAL National Exchange (SNX) but requires a network of reliable warehousing and assaying agents. It is important to support these legitimate functions and let banks finance them, so as to encourage the emergence of this commodity marketing eco-system. Effective co-operation among regulatory authorities. There is no perfect regulatory system. The problems with Northern Rock in the United Kingdom are being attributed

to the fact that the United Kingdom had moved to a single supervisor, the Financial Services Authority (FSA), with the monetary authority having no supervisory powers. At the same time, the Bear Stearns debacle in the United States is being attributed to the absence of a single supervisor. What is essential is effective cooperation between all the concerned authorities, which transcends the specifics of organizational architecture. India is at a turning point in its financial sector. There are many successes-the rapidity of settlement at the NSE or the developments in derivatives market and the increasing level of interest shown by foreign institutions. There is justifiable reason to take pride in this. However, there is an opportunity here to gain a unique edge & scale up to become internationally competitive. We actually need a paradigm shift in financial sector. The shift in paradigm, if implemented, could usher in a revolution in the financial sector almost as dramatic as the revolution that hit the real economy in the early 1990s, whose fruits we are now reaping There has been an enormous amount of attention paid to issues like capital account convertibility, bank privatization, and priority sector norms. While they are extremely important, there are many other areas where reforms are less controversial, but perhaps as important. With the right reforms, the financial sector can be an enormous source of job creation and is fundamental to the development of other sectors. The implications for inclusion, growth, and political stability would be enormously beneficial for the economy. Without reforms, however, the financial sector could become an increasing source of risk, as the mismatches between the capacity and needs of the real economy and the capabilities of the financial sector will widen. Not only would the lost opportunities be large, but with not insignificant probability, the consequences could be devastating for the economy. Right now, however it is a difficult time to propose financial sector reforms in India. The meltdown of the US financial sector seems to be proof to some that markets and competition do not work. The right lesson for India from the debacle is that markets and institutions do succumb occasionally to excesses, which is why regulators have to be vigilant, and constantly finding the right balance between attenuating risk-taking & inhibiting growth. At the same time, well-functioning competitive markets can reduce vulnerabilities-the U.S. equity, government debt, and corporate debt markets, despite being close to the epicenter of the crisis, have remained far more resilient than markets in far away countries. We see with the current developments that vulnerabilities are also building up in India.

Underdeveloped markets and strict regulations on participation are no guarantee that risks are contained, in fact they may have created additional sources of risk, a forewarning of which has already come from the steep decline in the Stock Market and substantial losses incurred by corporations on currency bets. Yet the primary lesson of the Global financial crisis is not that foreign capital or financial markets are destabilizing, but that poor governance, poor risk management, asset liability mismatches, inadequate disclosure, and excessive related party transactions make an economic system prone to crisis. Financial sector reform can reduce these vulnerabilities substantially. As on the timing of these reforms, Prof. Vaidyanathan comments "The existing institutions have failed and the existing market mantra has been exposed in the most compromising position wherein the market and government are caught in the act. Unless we internalize the fundamental truth that the decline of the West is a pre-requisite for the emergence of India as a global power, we are not going anywhere. To do that, we need to be pro-active and not supplicant. To build a new architecture, India should take the lead. Unfortunately, we have the US lobby, Chinese lobby, Pakistan lobby and all sorts of lobbies in the Capital, but no India lobby yet. Until we do, we cannot but be mouthing inanities and discussing inconsequential things.

Recommendations
Deep markets with varied participants can absorb overall risk better. While indeed the risk that has infected

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August 2008 marked the end of an era, the end of investment banks, the reigning of capitalism, and the increasingly getting louder voices of a post American world. Almost everywhere, governments are stepping in to rescue the banking system. Even America and Britain, the pioneers of free enterprise and privatization are being forced to accept the part ownership by the state of the financial system.

The financial services industry is one of the greatest revenue generators of the US economy. Its share of total American corporate profits rose from 10% in the early 1980s to 40% at its peak last year. But the industry had probably grown too big, and probably at the expense of some lax regulatory measures too. The credit boom not only inflated asset prices, it also inflated finance itself. The signs of break-down were first noticed in June 2007 when two Bear Stearns hedge funds ran into trouble after a downgrade. The firm had to pay billions to assume the hedge funds' mortgage-backed securities holdings. Shortly, the contagion spread as banks worldwide took hefty write-offs including the likes of Citi, Lehman, Merill Lynch & UBS. After that it was carnage - the seizure of Fannie Mae and Freddie Mac by their regulator, the record-breaking bankruptcy of Lehman Brothers, Merrill Lynch's shotgun marriage to Bank of America, and most shocking of all, the government takeover of a desperately illiquid American International Group (AIG).

The end of an era

SPECIAL FEATURE

Financial Crisis
Gaurav Parasrampuria, Manu Jain, Neha Gupta, and Neha Verma (IIM Bangalore)

Figure 1 How did it start? : From Innovation to collapse

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Thus, ten short days saw the nationalisation, failure or rescue of what was once the world's biggest insurer, with assets of $1 trillion, two of the world's biggest investment banks, with combined assets of another $1.5 trillion, and two giants of America's mortgage markets, with assets of $1.8 trillion. Big regional lenders have fallen too - regulators have seized Seattle-based Washington Mutual, the country's largest savings and loan institution. WaMu had more than $300

billion in assets. The previous largest failure, Continental Illinois, had $40 billion-worth when it toppled in 1984. Wall Street has asked for a massive bail-out-some $1.6 trillion so far, but most believe that this is just a down payment.

The Lehman Debacle

federal funds rate as high as 6%. That week, no investmentgrade bonds were issued, for the first time (holidays aside) since 1981. Several Washington-based experts have argued Lehman did not endear itself to the authorities by walking away from earlier rescue proposals because it felt the prices on offer were too low. A few critics claim, that Lehman CEO Dick Fuld, could not accept that Lehman had to do unpalatable things, and failed to react timely.

March 16: Bear Stearns Cos. bought by JPMorgan Chase & Co. In a deal orchestrated by & backed by the Fed following a sharp decline in shares due to collapse in confidence in the company Sept. 7: Government Seizes Fannie Mae, Freddie Mac; putting the liability of more than $5 trillion of mortgages onto the backs of U.S. taxpayers Sept. 11: Lehman Brothers Says it's Actively Looking to be Sold; Shares of the investment bank plunge 45% as traders feared it was having a difficult time finding a suitor Sept. 14: Bank of America Says it Will Buy Merrill Lynch for $29 a Share Sept. 15: Lehman Brothers Files for Bankruptcy: This is the largest bankruptcy filing in the history of the United States, at $639 billion

bankruptcy, picks up the failed firm's North American investment banking and trading operations for $250 million Sept. 19: Bush Administration Announces Bailout Plan to Confront Crisis

AIG
The story of AIG bailout is another colossal story. At its peak, the insurance firm was the world's largest with a market value of $239 billion. At one stage, its investment banking unit contributed over a quarter of profits - mostly by writing credit-default swaps with a giant notional exposure of $441 billion as of June 2008. Of this, $58 billion is exposed to subprime securities which have already generated huge mark-to-market losses. But, the real horror story is the $307 billion of contracts written on instruments owned by banks in America and Europe and designed to guarantee the banks' asset quality!

Sept. 21: Goldman Sachs, Morgan Stanley to Become Bank Holding Companies Sept. 23: Bernanke and Paulson Testify on Capital Hill on Bailout; The Fed Chairman says, "If financial conditions fail to improve for a protracted period, the implications for the broader economy could be quite adverse." Sept. 24-27 Bush Works With Legislators on Bailout Plan

Lehman Brothers a 148 year old Wall Street Institution, was left with large holdings after the sub-prime crisis curtailed investor appetite for the fixed income products. Its share prices slumped this year after large writedowns on the banks troubled mortgage portfolios. The beleaguered bank was in August holding talks with Private Equity funds and strategic bidders to sell all or part of its asset management arm, to replenish its bleeding balance sheet. On September, Lehman shares fell by 45%, sparked by a report that Korea Development Bank decided to pull out of talks to take 50% stake in Lehman Brothers. What followed was a death trail and the fate of this Wall Street veteran was decided over the following weekend. Lehman went bust with $613 billion of debt, of which $160 billion was unsecured bonds held by an array of investors around the world, including European pension funds and individuals in Asia who had taken comfort in Lehman's high credit rating. The price of this paper quickly collapsed to 15 cents on the dollar or less, destroying overnight twice as much value as Lehman's shareholders had seen evaporate over several months. These losses set off a spiral in money markets. Investors yanked $400 billion from money-market funds, a supposedly super-safe source of funding, when several money-market funds that held Lehman debt reported negative returns, sparking a flight of cash to the safety of Treasury bills that briefly pushed their yields close to zero. On September 18th companies could no longer issue commercial paper. Banks, anticipating huge demands from companies seeking funds, began hoarding cash, sending the

What Future beckons

In its latest calculations the IMF reckons that worldwide losses on debt originated in America (primarily related to mortgages) will reach $1.4 trillion, up by almost half from its previous estimate of $945 billion in April. The IMF's "base case" is that American and European banks will shed some $10 trillion of assets, equivalent to 14.5% of their stock of bank credit in 2009. In America overall credit growth will slow to below 1%, down from a post-war annual average of 9%. That alone could drag Western economies' growth rates down by 1.5 percentage points. Without government action along the lines of America's $700 billion plan, the IMF reckons credit could shrink by 7.3% in America, 6.3% in Britain and 4.5% in the rest of Europe.

Sept. 26: Washington Mutual Becomes Largest Thrift Failure With $307 Billion in Assets Sept. 29: Citigroup Acquires Wachovia's Banking Operations

Sept.16: Government Announces $85 Billion Emergency Loan to Rescue AIG Sept. 17: Barclays Makes Deal With Lehman to Buy North American Banking Division; The British bank, which had passed on buying Lehman before it filed for

March 08
Debacle of bear stearns

Dec 08*

Sept 08
Fall of lehman

Figure 2: The death trail...

Figure 3: Fall of the Mighty

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As of date, the day this magazine goes to print, of the five independent investment banks open for business at the start of the year, only Goldman Sachs and Morgan Stanley remain.

The culprit?
The rating agencies for the subprime, the regulators and politicians for lax regulations, and investment bankers for their greed - no one has been spared in the blame game. It is not that markets have been unregulated. But the intellectual tide of the past 30 years, have resulted in regulator not being able to keep pace with the financial innovations.

Alan Greenspan, the chairman of the Fed from 1987 to 2006, was in the vanguard of this view. In his book, "The Age of Turbulence" (2007), he welcomed the growth of CDSs, arguing: "Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment." Securitisation, which has been at the centre of the current crisis, is another child of the 1970s. It involves bundling loans into packages that are then sold to outside investors. The first big market was for American mortgages. When homeowners pay their monthly payments, these are collected by the servicing agent and passed through to investors as interest payments on their bonds. Again, this business was encouraged by the authorities as a means of spreading risk. Everybody appeared to win. Banks earned fees for originating loans without the burden of holding them on their balancesheets (which would have restricted their ability to lend to others). Investors got assets that yielded more than government bonds and represented claims on a diversified group of borrowers. No wonder securitisation grew so fast. Securitisation eventually gave rise to collateralised debt obligations, sophisticated instruments that bundled together packages of different bonds and then sliced them into tranches according to investors' appetite for risk. The opacity of these products has caused no end of trouble in the past 18 months. The authorities did make a more fundamental attempt to regulate the banks with the Basel accord. The first version of this, in 1988, established minimum capital standards. Banks have always been a weak link in the financial system because of the mismatch between their long term assets and short term liabilities. The Basel accord was designed to deal with a different problem: that big borrowers might default. It required banks to set aside capital against such contingencies. Because this is expensive, banks looked for ways around the rules by shifting assets off their balancesheets. Securitisation was one method. The structured investment vehicles that held many subprime-mortgage assets were another. And a third was to cut the risk of borrowers defaulting, using CDSs with insurers like American International Group. When the markets collapsed, these assets threatened to come back onto the balance-sheets, a prime cause of today's problems. Bankers and traders were always one step ahead of the regulators. That is a lesson the latter will have to learn next time.

Role of Leaders

crore to Unitech Ltd, for its mixed-use development project in Mumbai. Lehman had also signed a MoU with Ashok Piramal's real estate company-to fund the its projects to the tune of Rs 576 crore. Another major real estate organisation whose valuations are affected by this meltdown is DLF Assets in which it had invested $200 million.

The crisis management

The world's governments are shocked and dismayed by their inability to stop the increasingly grave financial crisis. Nothing they have attempted has gotten lending flowing normally. Profitable companies are cut off from borrowing. Confidence is at is an all-time low. Through Oct. 7 the U.S. stock market had its worst five-day performance since 1932 on fears of a severe economic downtur. The central banks are pumping money but the question is how the money should be spent. Buying out equity stake in banks will put undue govt control on them. Extending credit lines to banks (the Swedish way of coming out of the crisis in 1990s) will require a much larger package than the current proposed 700 billion USD relief package. The best solution is to protect the assets. The federal government has put some 7% of GDP on the line, a vast amount of money but well below the 16% of GDP that the average systemic banking crisis (see box on some of the world crisis) ultimately costs the public purse. Just how America's proposed Troubled Asset Relief Programme (TARP) will work is still unclear. The Treasury plans to buy huge amounts of distressed debt using a reverse auction process, where banks offer to sell at a price and the government buys from the lowest price upwards. The complexities of thousands of different mortgage-backed assets will make this hard. If direct bank recapitalization is still needed, the Treasury can do that too. Treasury's attempt to buy out distressed debt (which in a way signals to other buyers that quality of assets is not that bad) rather than buying into the equity of banks is laudable, and above all, the main point is that America is prepared to act, and act decisively.

The financial innovation

Economic theory suggests that financial innovation must lead to failures. And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms. The roots of the innovation could be traced back to the end of Bretton Woods era - resulting in capital account convertibility. Today's complex derivatives are direct descendants of the early currency trades. Forwards, Options, Swaps all helped companies to change their risk exposure dep ending on their view of the asset prices and where rates would go. The final stage emerged only in the past decade. A credit-default swap (CDS) allows investors to separate the risk of interest-rate movements from the risk that a borrower will not repay. For a premium, one party to a CDS can insure against default. From almost nothing just a few years ago, CDSs grew at an explosive rate until recently.

Henry M. Paulson Jr., left; Ben S. Bernanke, center; and Timothy F. Geithner, of the New York Federal Reserve

Politic ians encouraged banks to make riskier loans through series of measures, starting with the Community Reinvestment Act of 1977, which required banks to meet the credit needs of the "entire community". In practice, it meant more lending to poor people. Fannie Mae and Freddie Mac, the two government-sponsored giants of the mortgage market, were encouraged to guarantee a wider range of loans in the 1990s. The share of Americans who owned their homes rose steadily. But more buyers meant higher prices, making loans even less affordable to the poor and requiring even slacker lending standards. The seeds of the subprime crisis were sown, and the new techniques of securitisation allowed banks to make these loans and then offload them quickly.

Impact in India
With nearly half of their revenues coming from banking and financial services segments, India's top software exporters are closely monitoring the financial crisis spreading across markets. The IT giants which had all these investment banks as their clients are TCS, Wipro, Satyam and Infosys Technologies. The government is worried the ongoing crisis would have an adverse impact on Indian banks. Lehman Brothers and Merrill Lynch had invested substantially in the stocks of Indian banks. The banks, in turn, have invested in derivatives, which might have exposure to these investment bankers. ICICI bank is the worst hit as of now. The country's largest private bank ICICI Bank is expected to lose approximately $80 million (Rs 375 cr), invested in Lehman's bonds through the bank's UK subsidiary. The meltdown is also expected to hit Axis bank but the impact is not clear yet. Lehman Brothers Real Estate Partners had given Rs 740

Source: ISDA

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GLOBAL ACTION

The Black Swan: The Impact of the Highly Improbable

Amit Mantri
(IIM Bangalore)

Figure4: Future Implications: Planned Bailouts

While world over the financial markets have been in doldrums for the better part of 2008 with investors losing a major share of their wealth there was one set of investors guided by a completely different way of working who stood vindicated. Investors advised by The Black Swan author Nassim Taleb have gained 50 percent or more this year as his strategies for navigating big swings in share prices paid off . The Black Swan is Nassim Nicholas Taleb's follow-up to his immensely popular Fooled By Randomness (chosen by Fortune as one of "The Smartest Books of All Time"). While Fooled talks about the fallibility of human knowledge, The Black Swan is all about randomness and uncertainty. The book deals with the "highly improbable" and its impact. It says that these events, dubbed Black Swans are much more common than we would like to believe. The black swan refers to high impact, rare events which are hard to predict and beyond imagination also known as "fat tails". The WTC attacks and the rise of the internet are examples of black swans. "Lucky fools do not know that they may be lucky fools." The book often has a lighthearted take on how people react to black swans. Success according to Taleb is more often an outcome of completely random events than due to reasons retrospectively attributed for the success. The book delves deeply into human behavior and how we are often blind to black swans calling it "our blindness with respect to randomness". Taleb also goes on to debunk Modern Portfolio Theory and explains the collapse of Long Term Capital Management using his black swan theory taking a swipe at a few Nobel laureates who were involved in it. Taleb considers

most of history to be silent and hence questions the use of past information to analyze the cause of events. A follower of Popperian philosophy, Taleb uses the ideals of Mediocristan and Extremistan as the core of the book. Mediocristan is the land where all events fit beneath the bell curve while Extremistan is the land where extreme events are all but too common. While in Mediocristan, a single observation does not have a significant impact on the sum of the observation; in Extremistan, a single observation can very well overshadow all the other observations. Taleb goes on to explain how most of the real world lies in Extremistan and not in the popularly believed Mediocristan. The financial markets are in Extremistan something which many people will agree in the current circumstances. Unlike normal practices Taleb advises using a "barbell" strategy wherein most of your money is in low yielding and low risk Treasury bills and a small portion is allocated to exploit the occurrence of a black swan, like deep out-of-the-money put or call options. This strategy provides for average returns in normal times but assumes significance when a black swan event occurs. It is widely expected that the events of the last few months will increase the followers of the Black Swan theory making Taleb's ideas and insights relevant once again.

What future holds?

It seems implausible that the investment bank will make a comeback, given the speed with which it has unravelled. Yet, 75 years after the legal separation of commercial and investment banking, America has made a full return to the one-stop-shop model practised by John Pierpont Morgan. Power may shift in two other directions: abroad and, to a lesser extent, to boutique investment banks. MUFG will be joined by others. After a brief wrangle in the bankruptcy courts, Britain's Barclays has taken over Lehman's American operations and quickly put its logo on the fallen firm's headquarters. "Global financial power is becoming more diffuse," says Andrew Schwedel of Bain & Company, a consultancy. Merger boutiques, such as Lazard and Greenhill, will emphasise their stability to pick up business. Their shares have done relatively well this year. Emerging economies also offer a sense of optimism in the current global crisis, and this crisis could well see transition to a new Post American World. It would not be one clear

superpower this time but the rise of the collective rest (BRIC, turkey, South Africa, and a whole host of others). Although these economies are not as "decoupled" from the rich world's travails as they once seemed - their stock markets have plunged and many currencies have fallen sharply, but domestic demand in much of the emerging world is not collapsing (it's slowing down a bit). The IMF expects emerging economies, led by China, to grow by 6.9% in 2008 and 6.1% in 2009. That will cushion the world economy but may not save it from recession. While we believe that some rebalancing is needed, particularly in financial regulation, where innovation outpaced a sclerotic supervisory regime, it would be a mistake to blame today's mess only, or even mainly, on modern finance and "free-market fundamentalism". Amid the crisis of 2008, it is easy to forget that liberalisation had good consequences as well: by making it easier for households and businesses to get credit, deregulation contributed to economic growth. Deregulation may not have been the main cause of the rise in living standards over the last 30 years, but it helped more than it harmed. Will the new, regulated world be as benign?

1. http://www.bloomberg.com/apps/news?pid=20601103&sid=aDVgqxiT9RSg&refer=us

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A sound financial system is indispensable for any economy to sustain a high and stable rate of growth. The financial system and financial infrastructure that are in existence at a given point in time are an outcome of a continuous process of interactive exchange and a series of actions and reactions between regulators, regulated institutions, financial markets, and the consumers of financial services and products. Thus, a financial system obtaining at a particular instant is a function of the thought process of the regulators; their attempt to achieve balance between innovation and risk and that of the investors and consumers of their felt-needs. With changes in these variables, the financial system of an economy shapes itself, adapting to changes in circumstances, innovations and to competition. The evolution of Indian financial markets and the regulatory system has also been along a similar path. Financial service providers like banking institutions, insurance companies, securities market intermediaries and stock exchanges and their regulatory agencies are in place. In the early stage of its evolution, the country's financial regulatory system has been nurtured; given a direction and purpose and the necessary strength in a gradual way as warranted by the circumstances and contingencies. The role of regulators, in the process, has evolved over time from that of an instrument for planned development in the initial stage to that of a custodian of modern, complex and robust financial sector at present. Over this period, a variety of financial sector reform measures have been undertaken in India with many important successes. An important feature of these reforms has been the intent of the authorities to align the regulatory framework with international best practices keeping in view the developmental needs of the country and domestic factors. To list a few reforms and their achievements, in the securities markets we now have fully automated trading on all stock exchanges; a wide range of products- equities, government bonds, corporate bonds, futures and options on equity index and individual stocks; corporatized and de-mutualized stock exchanges ; modern risk management systems at these exchanges; a fiercely competitive mutual funds industry with an array of products to suit differing risk profiles of investors and a well articulated and relatively less cumbersome investment regime for foreign investors. In the banking sector, achievements have included deregulated interest rates diversified ownership and consolidation; foreign direct investment in the private sector banks up to 74 per cent.

The insurance sector has also been progressively opened up to domestic and foreign competition. In addition, the NBFC sector regulation and supervision has been strengthened considerably. In a growing and increasingly complex market-oriented economy such as India's , with increasing integration with global trade and finance, our financial system would be an important element in the country's future growth trajectory. Further steps are required to make the financial markets deeper, more efficient and well-regulated. In this direction, two important Government Committees, the High Powered Expert Committee on Making Mumbai an International Financial Centre (HPEC on MIFC) and High Level Committee on Financial Sector Reforms (CFSR) have charted out the road ahead for India's financial system to prepare it for the challenges of the future. Despite differences in their scope and terms of reference , the two reports have a common underlying theme of reference, viz. to recommend next generation of financial sector reforms for India. The mandate of HPEC on MIFC was to look ahead and prepare for the emergent role of Mumbai as a regional/international financial centre by reviewing the existing legal, regulatory, taxation and accounting framework related to financial services in India and recommend an enabling framework to facilitate such a transformation of Mumbai. The CFSR has on the other hand, focused on financial sector reforms with a view to : (i) include more Indians in the growth process; (ii) foster growth itself and (iii) improve financial stability and thus protect the economy from any kind of turbulence that has affected emerging markets in the past and is affecting industrial countries today. The two reports emphasize that recognizing the deep linkages among different reforms, including broader reforms to monetary and fiscal policies, are essential to achieve real progress. The reports outline the key elements of a financial system that India will need in its quest for higher growth over the next few years. Drawing from these reports, I place here some broad areas on which our financial sector regulators need to focus on and act upon in the near future.

I T
Dr. K. P. Krishnan1
Dr. K.P. Krishnan currently holds the position of Joint Secretary (Capital Markets), Ministry of Finance, Government of India. Prior to this Dr. Krishnan has served as Managing Director, Karnataka Urban Infrastructure Development and Finance Corporation, Bangalore and Secretary, Urban Development and Secretary, Finance Department, Government of Karnataka. He has also worked as Advisor to the Executive Director, World Bank in Washington DC. Dr. Krishnan belongs to the Indian Administrative Service, Karnataka Cadre, 1983 batch. He received Ph.D. (Eco) from IIM Bangalore and M.A. (Eco) from University of Mysore. He has carried out extensive research in the area of financial sector including role of financial intermediaries in financing sub national governments and targeting financial education campaigns to vulnerable groups and has presented his work in national and international seminars/conferences.

enhanced efficiency and productivity through competition

1. The author is at present Joint Secretary (Capital Markets Division) Department of Economic Affairs, Ministry of Finance, Government of India. These are his personal views and not the views of his present employer GOI. Nor are these necessarily the views of his teachers in IIM Bangalore where the author was a student from 1999-2002!

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Financial inclusion
A robust financial system is not hugely relevant if most people in the country don't have access to it. Financial inclusion is a key priority for India, especially rural India. This means providing not just basic banking, but also a variety of other financial instruments. One example would be instruments to insure against adverse events such as low crop yields due to bad weather. Even regards credit, nearly three-quarters of Indian farm households have no access to formal sources of credit, leaving the rural poor especially vulnerable to moneylenders. Most of the loans taken by those in the bottom quarter of the income distribution are from informal lenders at an interest rate above 36% a year, nearly two times above the mandated lending rate for banks. At present, all banks must lend to "priority" sectors such as agriculture. They are also subject to interest rate ceilings on small loans, which restrict rather than improve access to institutional finance. Banks have no incentive to expand lending if the price of small loans is fixed by fiat. The solution is not more government intervention but more competition between formal and informal financial institutions and fewer restrictions on the former. What is required is a set of deeply intertwined reforms which level the playing field between banks and non-bank financial institutions by easing the requirement of banks financing priority sectors. But making these changes while the government continues to have huge financing needs, and without a more uniform and nimble regulatory regime, could be dangerous. Broader macroeconomic reforms could reinforce individual financial sector measures. For instance, allowing foreign investors to participate more freely in corporate and government debt markets could increase liquidity in those markets, provide financing for infrastructure investment and reduce public debt financing through banks.

Traded Fund for Gold again took four years to become a reality; interest-rate derivatives though launched in 2003 have not taken off mainly due to constraints on the participation of banks in this market. These experiences highlight the adverse environment that financial innovation is currently witnessing in the country. This should not continue if we wish to project ourselves as the next International financial centre of the world.

Framework for institutional investments

Various segments of the financial markets can develop and thrive only when participation in them is not artificially constrained. The most successful parts of Indian finance at present are those in which non-institutional participants have taken a lead and engaged in speculative price discovery. This large mass of retail participation in financial markets in a unique edge that India has when compared with other international financial markets. However, considering that we are striving to project Mumbai as an International financial centre, the capabilities and strength of institutional investors need to be harnessed. This class of investors brings with them sophisticated analytical tools in quantitative trading systems, pools of capital and help link Indian finance with the rest of the world. Thus, the strategy should be to remove the constraints on the institutional sector to allow them to reap the benefits of financial market innovations and in turn assist these markets with depth and liquidity. The regulators should move gradually to a "prudent man" principle where the institutional investor is allowed to exercise judgment based on what a prudent man might deem to be appropriate investments.

There is therefore little incentive to innovate to remain competitive. This is not unlike firms in the real economy before 1992. For a shift into a high-innovation regime, both carrot and stick are required. The stick would be the introduction of competition: entry barriers in domestic finance and protectionism need to be removed. The carrot would be the significantly reduced cost of innovation that would result from a different regulatory attitude and approach. In addition, a shift from a domestic-focused financial sector to an international financial service-focused financial sector would induce the associated carrot of enormously larger market size.

Did you know?

Origin of $ - Many suggestions have been made about the origin of the dollar symbol $, one of the commonest being that it derives from the figure 8, representing the Spanish 'piece of eight'. However, it actually derives from a handwritten 'ps', an abbreviation for 'peso' in old Spanish-American books. The $ symbol first occurs in the 1770s, in manuscript documents of EnglishAmericans who had business dealing with SpanishAmericans, and it starts to appear in print after 1800. The name 'dollar', however, derives from the Dutch or Low German word daler (in German taler or thaler) originally Joachimstaler, referring to a coin from the silver

Regulatory regime to support the above

With the dream of an innovating and competitive financial sector; on the one hand seeking to include the rural economy in the main stream and on the other aiming to engage institutional participation in a proactive manner; we need a seamless regulatory regime which is not plagued with the problem of artificial segmentation and boundaries between the domains of the regulators. A series of measures need to be taken to achieve market integration and convergence and thus enable economies of scale and scope and greater competition. This would, inter-alia, require redrafting of legal foundations for organized financial trading, so as to unify all organized financial trading under one regulator, create wholesale asset management businesses and shift away from regulation by "entity" to regulation by "domain". It is time for the regulators to introspect on the over-prescriptive regulatory framework that obtains in the country at present; whether it is acting as a hurdle in adapting to the fast innovating area of financial markets? ; is there merit in moving towards a flexible approach to regulation which can be achieved by shifting the regulatory regime from rule-based to principles-based? If so, can we aim for a new law may be called Financial Markets Modernization Act embracing 'Principles Based Regulation"? This calls for an extensive and serious debate among the regulators, economists, academicians and market players. This debate needs to be initiated now when the HPEC on MIFC and CFSR have listed out a reform agenda on the above lines.

Competition
Lack of sufficient competition in parts of the financial services industry, pervasiveness of public ownership and over compartmentalization of sub-sectors have resulted in suboptimal performance by existing market players. Competition needs to be across larger, more capable players rather than among a plethora of small weak, undercapitalized players that cannot capture economies of scale or make the kinds of investments in people, training, technology and research into product development that supports innovation. The Indian financial sector needs a wave of consolidation -through acquisitions and mergers, among private and publicly owned institutions - for its financial firms to be strong enough to compete as aggressively with each other, and with foreign firms, in Indian and global markets as they should. A license to operate in a certain area of Indian finance is, all too often, a safe sinecure with stable profits and a near-zero probability of death.

Innovation
History shows that financial innovation has been a critical and continuing part of the economic landscape over the past few centuries. Innovative changes in financial institutions, regulatory structures and practices, and financial instruments have occurred from time to time, over a long period. Financial markets have continued to produce a multitude of new products; including many new forms of derivatives, alternative risk transfer products, exchange traded funds, and variants of tax-deductible equity. We, in India, have adopted some of these products with success. However, it is poignant to note that such innovations have appeared ground in the country after years of additional toil and wait. Stock index futures took five years to be offered to the investors, from the time they were conceived; Exchange-

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Mutual Funds: The way ahead

Indian Mutual Fund industry has grown significantly in past 10 years to over Rs5lakh crore now. The growth in the industry has been much higher compared to traditional investment options like bank deposits, NSC, PPF etc. Though equity investing is inherently a higher risk investment, equity as an asset class has outperformed various other asset classes over a longer period of time frame. Also they are treated as comparatively better hedge with regard to inflation. Note: Some illustrations on MF industry growth & Inflation Growth in AUM

Strong GDP growth Hectic industrial activity Accelerated investment in infrastructure especially Road and Power

Favorable demographic changes, leading to higher level of consumption Strong credit growth High business confidence Apart from the above factors, demand for Indian equity has been outstripping supply of equity in the form of IPO. Foreign Funds have pumped in more than US$ 30 billion in past few years. Close to Rs.1, 60,000 crores is being managed by local mutual funds investing in equity market. Money has been chasing equity assets, thus, in the process, valuation also get stretched in some sense. In a rising market, factors such as Mergers, De-merger, and Sum of parts valuation play a role in determining the valuation of the company. This some time leads to a scenario where one cannot buy a company on the basis of traditional valuation parameters like P/E, P/BV etc; however, the stock price could be justified on the basis of sum parts of valuation or unlocking of value. Diversified companies, as a result of this phenomenon, have outperformed the market with significant margin. Indian companies increased their focus on M&A activities to become part of global giants. Indian companies began to buy out companies overseas or overseas companies were acquiring them. Obviously, such transactions would happen at very high valuation due to the premium paid for getting the controlling stake, brand value and immediate platform to operate (thus reducing the lead time to grow). However, from stock market perspective, these types of transactions provide a new way to price the companies, thus, moving up the PE or other such parameters that would justify the price movements. This kind of change in the overall valuation metrics posed big challenge to Money Manager in terms of identifying companies that not only offer true long term value but it also offers the potential of unlocking of value over a period of time. However, the scenario has completely changed in today's scenario wherein Investment Manager have to worry about the potential impact of the global slowdown and other risk arising out of exposure to currency, rising operating cost and rising interest rate. To top it all, there has been a general aversion towards lending to corporate, thus, pushing up the corporate spread and Credit Default Swap rate.

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Mr. A. Balasubramanian
CIO, Birla Sunlife AMC

Mutual Funds have been offering products of different kinds to meet varied investment requirement of an investor. The investment strategy of the money manager is driven by the underlying objective of the scheme. The investment product offerings have been changing with times on the basis of emerging opportunities at every point. Mutual Funds offering from plain vanilla products have graduated to offering products that suits the current investment opportunities / theme. Thematic funds generally have got a specific mandate such as investing only in companies that benefits out of consumption, investing in companies that benefit out of infrastructure investment opportunities, investing only in companies that benefit out of commodity boom and so on so forth. While investing the underlying investment principle from a money manager perspectives remains broadly in line with the overall economic outlook and individuals corporate earnings. In today's context, macro variables have undergone a major change impacting the global investment sentiment. At the same time, Indian market has generated phenomenal return in the last 10 years, despite going through different phases. This was possible purely on the back of substantial change in the underlying fundamentals of India Inc. Our market, so far, has been driven by strong fundamentals such as Robust corporate earnings

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Chart on credit spread (5 yr Gsec vs 5 yr corporate bond)

With the change in the financial market in US, the pressure on Regulator has gone up significantly to bring in the necessary stability to the financial market including Banks and Mutual funds etc. It is imperative to understand the Indian market in the context of global happenings in the financial market. They may be narrated as follows: Indian Financial Market is far more stronger than any of the peer countries purely on the back of tight regulation Indian Banks have to maintain higher Statutory Reserve in the form of SLR (25%) and CRR (9%). These kind of tight regulatory norms are hardly prevailing anywhere in the world. However, most of the countries do have Capital Adequacy Requirement to expand their business. Indian Banks were discouraged to do blind lending towards real estate sector. This in essence saved Indian banking system in generating sub-prime assets in its book. Indian corporates have not gone extreme in terms of increasing their debt except few companies who have forayed into global expansion. ROE and ROCE for Indian corporate continue to remain one of the best in the worl.

Subsidy and Farm loan subsidy. On the Fixed Income market, there has been a shift towards quality in terms of managing the credit side of the portfolio. In this kind of market, safety is very important which can be achieved by focusing more on underlying quality of the investment rather than focusing on return by taking extra credit. While this is challenging period of Money Managers, it is also equally important to know that Mutual Funds fixed income funds are run with far more prudence when comes to the question of taking interest rate risk as well as credit risk. Most of the Mutual Funds fixed income schemes, especially, the one focus on short-term interest rate curve are rated P1+ or its equivalent. This is nothing but reflection of the underlying credit quality of the portfolio. However, what remains a challenging is managing liquidity when overall Banking system liquidity is under severe pressure due to outflow of dollar as well as Government borrowing. To sum up, it is a challenging time for Indian Mutual Fund industry and financial market in general. However, given the robust regulatory environment and prudent way of managing funds, one might see the relative impact being lesser than the global market. At the same time, financial market is linked to each other due to the global portfolio, therefore, there is no way one can stay from the noise that is being made in the global market. For retail investor SIP (systematic investment plan) are considered best option to participate in the markets. Also starting early in the cycle helps in creating wealth over a long period of time. As is well said - It is not the timing but the time in the market, which determine the final returns to an investor.

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However, inflation, high commodity prices (mainly oil) has been hurting the fortune of our market. At the same time, overall fiscal situation has undergone such a major shift since the time Government funded farm loan. Since then, three "F" factor has been hurting the sentiment as well as underlying dynamics of the economy. They are Fuel, Food

Did you know?

China was the first country to use paper money. Ancient paper money can be traced back to the Pai-Lu P'i-pi (white deer-skin money) of Han Dynasty (140 BC) and the Fei-Chien (flying money) of Tang Dynasty (618 AD). However, the Ming Dynasty notes are the earliest surviving paper money of which the 1 Kuan is the most common. Issued between 1368 and 1399, the note measures 222mm x 340mm. The world's highest denomination note is the Hungarian 100 Million B-Pengo, issued in 1946. That's 100,000,000,000,000,000,000 Pengo. It was worth about U.S. $0.20 in 1946

WINNERS 1. Priyanka Singh & Brajesh Kumar 2. Anshul Gupta*, Kapil Bawiskar 3. Vaibhav Shintre 4. Saurabh Sood 5. Abhijit Parashar Nidhish Jain

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1.1 Quote driven and order driven Market

There are broadly two types of stock markets which exist: quote driven and order driven. They can be further categorized into call market or continuous markets. Quote driven market consists of a dealer or a specialist who are given the task of providing liquidity by the exchange. Anybody who wants to trade has to trade with the dealer and is called quote driven market as dealers quote the prices as they will buy and sell the share. On the other hand, there is no dealer or third party in case of order driven market. In an order driven market, the liquidity is provided by limit orders. A limit order is an instrument to trade at the best price available, if it is no worse than the limit price specified by the trader. Limit buy order specifies the maximum price that the trader is willing to pay for the share whereas the limit sell order is the minimum price that a trader can take for a share. The open or outstanding limit orders provide liquidity to the market. Whenever two sides match, trade happens. More often trade happens by the incoming market order which specifies to trade at whatever best price currently available. As long as there are limit orders available on both side of the market, market order will always execute and take away the liquidity. Though market orders always fill, they do so sometimes at inferior prices i.e. they pay for immediacy. Most of the world stock exchanges are quote driven including NASDAQ, LSE etc and fewer are order driven markets. Some of the order driven markets are Australian Stock Exchange, and the Tokyo Stock Exchange, etc. The Indian stock and commodity markets are continuous order driven markets. Very few markets are purely order driven markets. NYSE has evolved over the years into a market that successfully combines variety of different trading strategies. In Germany, the Deutsche Borse has developed a new electronic trading system, Xetra, which includes a continuous, order-driven component and three calls a day (at the opening, intraday, and at the close). In addition, market makers (Betreuers) set bid and ask quotes on request for the purpose of providing additional liquidity to the market.

Bid-Ask Spread and its Asymmetric Nature: A Case of Indian Nifty Futures

there. Handa and Schwartz (1996) argue that because of better information available and anonymity of trading in an order driven market (since order book is visible to traders while trading), order driven market are expected to perform better for reasonably good traded share.

1.3 Objective
As mentioned above, bid ask spread is a major variable component of the transaction costs. Hence, it is important to find out the bid-ask spread of a market to talk about the quality of the market. Order driven markets are supposed to have lesser bid-ask spread for a well traded stock. Hence, in this study we have taken nifty index futures to calculate the bid-ask spread and compare it with S&P 500 Index futures (quote driven) and Deutsche mark futures (hybrid). We also compare the bid-ask spread between futures with different maturity. We expect to see higher bid-ask spread for far away futures because of lower participation. Further, we do time series analysis of the bid-ask spread and expect to see lower spread with time. Lastly, we compare the trading costs in the bear market and bull market.

Priyanka Singh & Brajesh Kumar

(FPM, IIM Ahmedabad)

2. Data and its basic properties

Daily closing price data on S&P CNX Nifty index and its futures contracts, published by NSE India, for the period from 1st January 2004 to 8th August 2008 has been analyzed in this study. All three futures contracts trading at a given point of time are analyzed and compared. As we are interested in understanding the time series behavior of NIFTY futures and its property in bull and bear phase, we divided the data yearly and also according to bull and bear phase. We are able to identify two bear phase from 1st January 2004 to 29th November 2008 and 1st January 2008 to 8th august 2008. Figure 1 (a) to 1 (d) depicts time series plot of all three Nifty futures prices at different phase.

Executive Summary
This study examines the properties of the bid-ask spread. Bid-ask spread is the most important part of the trading costs incurred in a stock exchange and often signal the quality of the market. Times series behavior, asymmetric nature i.e. different spread in bull and bear phase and benchmarking with other international stock exchanges of the trading costs have been taken here. It is found that bid-ask spread has not shown any consistent upward or downward trend in the Nifty futures. This can be attributed to the different types of phases that Indian market has gone through. As expected we have obtained higher spread for bear phase than bull phase. This asymmetric nature of the bid-ask spread can be attributed to the asymmetric nature of volatility. We find that Nifty futures has lower trading costs than the S & P 500 and higher than Deutche Borse futures. This supports the argument that order driven markets are more effective for well traded stocks than quote driven markets. Results seem to suggest that the hybrid structure is the best for the stock exchange.

1.2 Bid-Ask Spread

Bid-ask spread is the amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. Literature has suggested three probable reasons for bid-ask spread: inventory holding costs; order processing costs; and adverse selection costs. However, all these models where developed for quote driven market where dealer needs compensation for holding a portfolio which may not be an optimal one. In an order driven market , the inventory holding costs does not exist because there is no dealer but a new risk or costs which comes in such a market is the risk of execution. Limit orders stand a risk of execution because they don't know when their order will be executed or they may not execute at all. Hence, they need compensation for that. Adverse selection costs is the risk of trading against a well informed trader and order processing costs include the fees, time, computer costs etc. However the latter is expected to less in an order driven market as costs related to the exchange seat, floor space rent charge a dealer faces is not

1. Introduction
The purpose of this study is to provide an extensive time series analysis of trading costs for the NSE stock futures market. It is important to understand the transaction costs as it closely affects the trading strategies of the investors as well the cost of capital of the firm. One of the important proxies for transaction costs in the capital markets is the 'bid ask spread'. The objective of this article is to analyze the time series behavior of the bid-ask spread, comparison of the costs with other stocks exchanges with a different market structure and the behavior of the trading costs in the bull and the bear phase. We expect to see a decrease in the trading costs with time as market stabilizes and matures. As will be discussed later in the paper, we expect to have lower bid-ask spread in the Indian stock exchange which is an order driven market as compared to other quote driven markets. A high

bid-ask spread is expected in the bear markets as compared to the bull market. Bear market has more volatility as compared to the bull market. This property is also referred as the asymmetric property of the volatility. This implies that due to leverage effect, the volatility is higher in downfall as compared to the upward phase. Foster and Viswanathan (1990) predict wider spreads when volatility is more. The volume also drops due to people being more cautious while trading. Admati and Pfleiderer (1988) show that spread will narrow when volume is high and vice versa. Due to panic factor i.e. investors wanting to exit the market as soon as possible to square off their losses, these investors will end up paying for the immediacy costs in the market. Due to all these factors combined, we expect to observe a higher spread in the bear market than bull market. Ness et al. (2005) found that the bid-ask spread decreased over time at NASDAQ and also found that the bear phase has higher bidask spread than the bull market.

1. Adverse selection costs and order processing costs are common in both the markets. 2. Figures for S & P 500 Index futures and Deutsche Stock Index to be taken from the paper: Wang, G., Yau, J. and Baptiste, T., (1997) "Trading Volume and Transaction Costs in Futures Markets", Journal of Futures Markets, Vol. 17, Issue No. 7. 3. The near month futures are named as Future 1, next to near month futures as Future 2 and Future 3 subsequently.

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Table 1 (c) Bull period (year 2005)

Future Mean Max Min SD Skewness Kurtosis 2261.949 2842.8 1881.85 264.4364 0.555813 -0.87647 1 Future 2254.614 2838.3 1877.95 263.0407 0.577599 -0.83928 2 Future 3 2250.171 2825.8 1874.1 260.7142 0.590225 -0.82635 R_Future 1(%) 0.126023882 3.539676135 -4.940560428 1.268011039 -0.501739485 1.296060108 R_Future 2 0.124765013 3.519372714 -4.703087792 1.259137059 -0.487028419 1.131550888 R_Future 3 0.124155068 3.58812469 -4.544928213 1.240197407 -0.382207925 0.989266637

Figure 1(a): Over all period

Figure 1(b): Bear period-1st January 2004 to 29th November 2004

Mean Max Min SD Skewness Kurtosis

Table 1 (d) Bull period (year 2006)

Future 1 3345.765 4018.65 2618.25 354.5533 0.16369 -1.07764 Future 2 3336.442 4024.9 2594.8 362.3949 0.172667 -1.07904 Future 3 3329.335654 4029.15 2585.05 367.7453231 0.182595553 -1.0793220 R_Future 1 0.143983821 6.235194441 -7.924087795 1.867027007 -0.580808323 2.694447631 R_Future 0.145783308 6.186615441 -7.964434863 1.90716347 -0.595905092 2.768588011 2 R_Future 3 0.14666212 5.97430458 -8.12928233 1.89736397 -0.73924962 3.14605912

Table 1 (e) Bull period (year 2007)

Figure 1(c): Bull period- 1st January 2005 to period to 31st Dec 2007 Figure 1(d): 2nd Bear period- 1st January 2008 to 8th August 2008
Future 1 Mean Max Min SD R_Future 2 0.077727 9.761755 -16.5649 1.905464 -0.90975 7.588097 R_Future 3 0.077739 9.532382 -16.7265 1.898372 -0.97648 8.019639 Mean Max Min SD Future 1 4870.662 6288.25 3803.35 566.546 0.5926 0.48867 Skewness Kurtosis 4561.141 6189.05 3548.75 733.7839 0.88967 -0.57568 Future 2 4553.377 6177.25 3551.85 730.8964 0.902609 -0.56012 Future 3 4548.302 6162.9 3553.45 727.378 0.910184 -0.55255 R_Future 1 0.18577779 5.89442924 -5.351399 1.80966983 -0.3087117 1.35035352 R_Future 2 0.184591149 5.933409247 -5.339627897 1.810275686 -0.29126916 1.32863038 R_Future 3 0.183867858 5.891769686 -5.402923629 1.805920259 -0.29334134 1.317114335

We also calculated the basic statistics of the all futures as presented in Table 1 below:

Table 1 (a) Over all period

Future 1 Mean Max Min SD Skewness Kurtosis 3231.643 6288.25 1337.35 1279.793 0.432544 0.88277 Future 2 3224.547 6284.6 1334.1 1279.024 0.433901 -0.88236 Future 3 3220.027 6272.35 1333.3 1277.62 0.434545 -0.88583 R_Future 1 0.077781433 9.593197634 -16.2580617 1.898902941 -0.91453445 7.320236049

Table 1 (f) Bear period (year 2008)

Future 2 4863 6284.6 3786.2 569.3441 0.582628 0.48747 Future 3 4857.725 6272.35 3788.1 568.6122 0.580593 0.473641 R_Future 1 -0.201317167 7.40394703 -9.753153234 2.598339049 -0.216895873 1.18185731 R_Future 2 -0.20077 7.305234 -9.60567 2.589191 -0.17376 1.176346 R_Future 3 -0.19922 7.402144 -9.96155 2.576239 -0.1998 1.337373

Table 1 (b) Bear period (year 2004)

Future 1 Mean Max Min SD Skewness Kurtosis 1752.111 2087.2 1337.35 164.9433 -0.13227 -0.91674 Future 2 1748.428 2086.55 1334.1 169.4837 -0.16932 -0.93713 Future 3 1747.374 2084.8 1333.3 170.7916 -0.1813 -0.94313 R_Future 1 0.033502761 9.593197634 -16.25806168 2.017423656 -2.188467365 19.8562864 R_Future 2 0.033556752 9.761755114 -16.56490977 2.021554735 -2.236292905 20.9628362 R_Future 3 0.03309 9.532382 -16.7265 2.025781 -2.33223 21.51118

Skewness Kurtosis

As expected average return in the bear market is negative as compared to positive return in the bull period, however, very small in magnitude (.1% to .2% daily). It is important to note that average yearly volatility of all futures is around 30%. However, in the bear phase (year 2004) has higher volatility (approx 30%) than near bull phase (2005) volatility (approx 20%). Similarly recent bear phase (year 2008) also has higher volatility than year 2006 or 2007 (approx 40% in bear phase than 30% in bull phase). This asymmetric nature of volatility is well documented and known as leverage effect. It can be modeled as the exponential general autoregressive conditional heteroskedastic (EGARCH). This asymmetric nature of volatility may affect volume of the trading and aggregately may affect transaction cost, which is the main concern of the article.

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3. Estimation of bid-ask spread: a simplified approach

In absence of quote prices, bid ask spread is estimated using the trade prices. Bid-ask spread can be explained through basic Microstructure model as described below:

The slope coefficient estimates the half spread S/2. So do this we need price and "direction" data on a sequence of trades t= 1,.,T

3.1 Basic Microstructure model

Consider the following model of transaction prices. Let, pt is the transaction price, mt is midpoint of bid and ask quotes, S is the average bid-ask spread then pt can be written as pt = mt + (S/2)Qt and mt = mt-1 + et where, Qt is the trade direction indicator, takes value "+1" if trade is buyer initiated and "-1" if trade is seller initiated, and et is the new public information arriving between trades Typically, mt is not observed. Taking the differences

3.2 A simplified model: Roll's estimator

Roll's estimator is a good approximation for daily prices, as daily prices have negligible autocorrelation in trade direction indicator. This assumption may not be true for data at high frequency level.

As discussed in the first section, we found higher bid-ask spread in bear market (year 2008) than bull market (Year 2006 & 2007). In the bear phase volatility is higher than the bull phase which accompanied with panic factor and immediacy costs may give rise to higher bid-ask spread. In two consecutive bull market (from year 2006 to year 2007) we found significant decrease in the spread in all three futures, which may be attributed to maturity and stabilization of the NIFTY futures market. It is interesting to note that in bull market all futures have approx equal transaction cost, however, in bear market Future 1 has higher transaction cost than Future 2 and further decreases to Future 3. This can be attributed to the fact that when bear happens investors first close down the near month futures leading higher volatility and immediacy. Table 3 also compares the bid-ask spread of NIFTY futures with other index futures.

driven market is more effective than the quote driven market. Also, the results suggest that a hybrid structure like that followed by the German stock exchange may be superior to both the order driven as well as the quote driven market.

4. Conclusions
The study examines the properties of the bid-ask spread, one of the most important parts of the trading costs at any stock exchange. The time series behavior of the bid-ask spread, its asymmetric nature and benchmarking with other exchanges have been taken up here. We observe that over the years, the bid-ask spread has not decreased contrary to what is expected from any market due to maturity with time. The bidask spread has first increased (2004-06), decreased (2006-07) and then again increased (2007-08). This can be due to coming of bull and bear phase. We find that second bear market has much higher transaction costs compared to the bull period. This is expected because of the heightened volatile behavior in the market recently and its asymmetric behavior. Lastly we find that Indian market has lower transaction costs than the US and more than German stock market. This supports the argument of order driven market being more effective than the quote driven market. The results suggest that the hybrid markets are most efficient.

Table 3: Bid-Ask Spread Values (%)

Index S & P 500 Futures Deutche Borse Futures Nifty Index Futures Bid-Ask Spread 0.152895591 0.000242381 0.517308 Currency Dollar Euro Rupee

3.3 Empirical results of bid-ask spread

We have estimated the bid-ask spread (all period together and yearly) for all three NIFTY futures. Results are presented in Table 2 and Figure 2.

It can be seen that the trading costs for the Nifty futures is lesser than S & P 500 futures but more than the Deutche Borse futures. This supports the argument that the order

Table 2: Rolls estimates of bid-ask spread (%)

Year 2004 Future 1 Future 2 Future 3 0.436416 0.223132 0.25189
5

Year 2005 --_

Year 2006 0.819445 0.852046 0.858949

Year 2007 0.627598 0.566836 0.594574

Year 2008 1.185026 1.027191 0.886365

All 0.517308 0.501611 0.463169

Puzzles Questions
1. A businessman devises a business plan for buying and selling coconuts. He calculates that by buying coconuts for $5 a dozen and selling them for $3 a dozen, that in less than a year he will be a millionaire. His business plan and calculations are accurate. How is this possible?

2. Your friend is dying and he can be saved by a pill. You have 100 such pills but one of them is poisonous. The poisonous pill has slightly different weight than the good ones. You have a beam balance. What is the minimum number of times you need to use the balance in order to save your friend? 3. What's the probability of random three points on a circle falling into the shorter arc? 4. At a restaurant downtown, Mr. Red, Mr. Blue, and Mr. White meet for lunch. Under their coats they are wearing either a red, blue, or white shirt.Mr. Blue says, "Hey, did you notice we are all wearing different colored shirts from our names?" The man wearing the white shirt says, "Wow, Mr. Blue, that's right!" Can you tell who is wearing what color shirt? 5. A census taker approaches a house and asks the woman who answers the door "How many children do you have, and what are their ages?"Woman: "I have three children, the product of their ages is 36, the sum of their ages are equal to the address of the house next door."The census taker walks next door, comes back and says "I need more information."The woman replies "I have to go, my oldest child is sleeping upstairs."Census taker: "Thank you, I now have everything I need." What are the ages of each of the three children?

Figure 3: Bid-ask Spread of NIFTY futures

4.We found positive covariance (Pt and Pt-1) for all three futures, hence Roll's estimate can not be applied to estimate bid-ask spread 5. Roll's estimator is downward biased and the actual values are expected to be slightly more. Hence, we observe in the year 2004, costs lesser than 0.005 Rs.

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Pension Funds & Capital Markets -Reforms & Implications in the Indian Context

1. Indian Pension Sector: An Introduction

India does not have a comprehensive old age security scheme as of now. There are some mandatory scheme for employees of state and central governments but these leave the vast majority of the workforce uncovered. The Employee Provident Fund Organization ( EPFO) which holds a monopoly over the pension business, guarantees a rate of just 8.5% to the policyholders which is even less the current prevailing inflation rate of 11-12%. Therefore the awardment of fund management rights to private players represents a welcome step as it will not only result in better returns for the policyhodlers but also signals the intent of the givernment to push thorugh the pension reforms as soon as possible.

(d) Inefficiency of the EPFO: Not only has the EPFO been shown up as a consistently poor performer in terms of returns offered; its service record is so poor that it is still not able to deliver a unique customer ID that subscribers can use all their life. It is hoped that reforms will lead to greater efficiency and accountability from the EPFO as well.

3. History of Proposed Reforms

The first comprehensive study of the Indian pension sector was undertaken by the Invest India Economic Foundation (IIEF) and was named OASIS (Old Age Social and Income Security). The OASIS was a seminal report and examined the shortcomings of existing pension provisions in India and proposed important changes and improvements to these schemes. Thus it can be seen as the start of the pension reform initiative in India. Taking note of the recommendations of the OASIS report and all the factors listed in the previous section, the Indian government launched on January 1, 2004 a New Pension System (NPS). The move shifted all new central government employees to a defined contribution plan from the current noncontributory defined benefit scheme, shifting the risk of retirement financing from the government to individuals. The NPS was also supposed to be thrown open on a voluntary basis to all non-government workers including those in the unorganized private sector. In 2005, the government sent the Pension Fund Regulatory and Development Authority (PFRDA) Bill to Parliament, to allow new pension fund managers, both public sector as well as private, to compete with the EPFO, with the PFRDA acting as an impartial regulator. The Bill has been languishing in the parliament since then because the Left parties argued that private fund managers were not to be trusted. However the recent awarding of EPFO fund management rights to private players have raised hopes that the PFRDA Bill will soon become a law and that the entire scope of NPS will be implemented soon.

Anshul Gupta*, Kapil Bawiskar

(PGP2, IIM Bangalore)

2. The Need for Pension Sector Reforms

The need for reforms in the Pension Funds management has been felt for quite some time now. Indeed in a survey conducted by Allainz Pension Reform, India was chosen as the country which needed pension reforms the most . Mentioned below are some of the reasons which have made reforms inevitable:

Executive Summary
A robust and efficient pension system is one of the pillars of the financial and social setup of any country. The pension system along with the capital markets and the insurance sector perform much of the crucial task of financial intermediation. Indeed the effective evolution of pension management could very well turn out to be the factor which decides whether the Indian financial system can effectively challenge the dominance of the western systems in the years to come. In India, the Employees Provident Fund Organization (EPFO) holds monopoly rights over the pension business. However the performance of the EPFO has come under severe criticism because of poor performance in both financial as well as operational aspects. Till recently, the State Bank of India (SBI) was in sole charge of managing the Rs. 250,000 crore corpus of the EPFO. However in July 2008 along with SBI, three private players, ICICI, HSBC and Reliance Capital were also chosen as fund managers for these funds . The changed political alignments in the center and the above development have raised fresh hopes of speedy reforms in the pension sector,. This paper analyzes the need for reforms, the proposed reforms and finally the impact these reforms are expected to have on the Indian Capital Markets.

(a) Increasing pension liabilities of both the central and state government: It has been estimated that the central government alone pays a whopping Rs. 100,000 crore as pension to retired employess which constitute just 1% of India's total population . This number makes up almost 1% of the Indian GDP and is projected to rise even faster if reforms are not undertaken. The total implicit pension debt in India stands at Rs. 20 lakh5 crore thus emphasizing the gravity of the situation. (b) Lack of comprehensive coverage by the existing schemes: It is estimated that only 15-20 million of India's 400 million strong workforce have a retirement savings plan . However the demand for such schemes is much more with a survey showing that atleast 80 million more people are willing to contribute to a retirement fund. Thus to ensure that the pension schemes are made available to one and all urgent reforms are needed. (c) Low returns on the funds invested: The government servants have to make do with only 8.5% returns which is very low when compared to other similar schemes. It has been widely accepted that giving the investors and pension managers more flexibility in investing the funds can lead to much better returns for the policy holders.

*Corresponding Author: anshulgu07@iimb.ernet.in 1. http://uk.reuters.com/article/breakingFundsNews/idUKDEL14192220080729 2. http://www.silobreaker.com/View360.aspx?Item=11_670208 3. http://timesofindia.indiatimes.com/Pension_reforms_bill_likely_in_Monsoon_Session__/articleshow/3329392.cms 4. http://www.thehindubusinessline.com/2007/11/15/stories/2007111550680600.htm 5. http://www.rediff.com/money/2006/jan/05pension.htm 6. http://www.business-standard.com/india/storypage.php?autono=329593 7. http://pensionreform.org/articles/india.html 8. http://www.wharton.universia.net/index.cfm?fa=viewfeature&language=english&id=937

4. The Pfrda Bill: Features and Comparisons

This section lists out the main features of the Pension Fund Regulatory and Development Authority (PFRDA) and the New Pension Scheme (NPS).

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The Indian pension sector reforms are largely inspired by the highly acclaimed Chilean model . In fact so successful is the Chilean model that several other countries are also modeling their reforms on the Chile experience . Therefore comparisons are made with Chile wherever possible. Some of the features of the NPS and the Pension Fund Regulatory and Development Authority (PFRDA) Bill (and comparisons with international models) are mentioned below: a. The employee contribution rate is 10 percent which will be matched by an equal government contribution. This is very much within the international norms. b. The targeted terminal replacement rate i.e. monthly payment to be done at the end of employment is 50 percent of the final salary. This is also in line with the standards recommended by the World Bank. c. Expected management costs of 0.5 percent of assets (Ministry of Finance, 2005) are comparable to those in other emerging markets. d. Participants are offered a variety of investment options with varying risk appetite. They are free to chose and later switch between various funds and schemes. e. The pension system account can be kept common across jobs changes. f. Employees can voluntarily contribute over and above the mandated investments. g. Voluntary participation over and above the mandated contribution rate is available to those participants that want additional coverage, providing a so-called third pillar. Thus the NPS aims at being at par with some of the best pension schemes in existence today.

5.1 More Options for the Investors

The NPS envisages providing the investors with several schemes each provide a different combination of risk and return, with the investor having the choice of opting for the best suited scheme. Since the investor can choose across various combination of investment portfolio, the replacement rate would differ. Table-1 indicates the fact that all the options except the 100% government securities investment are able to generate more than replacement rate of more than 50% of last wage.

5.2 Increased Financial Depth

India's pension sector is very small relative to advanced Asian economies and other emerging countries. Figure-2 indicates that demand for retirement services would increase in the years to come. This can be attributed to rising income.

5.3 Diversification of the Investor Base

Majority of the Indian financial sector is still involved in deposit and loan services. With Pension sector reforms & introduction of new institutional investors, there could be an increase in the relative importance of equity and corporate bond markets vis--vis bank deposits. Thus we visualize a diversified investor base in capital market. A diversified investor base is critical for the development of the local corporate bond market as it helps ensure a stable demand for fixed-income securities. Broadening and deepening of the corporate bond market in turn would help enhance the supply of long-term funds. For example, After the pension reforms in Chile, the average maturity of bond issue increased from 10-15 years in the first half of the 1990s to 10-20 years more recently. In Mexico in the last five years, the diversification of the investor base has been critical for the development of the corporate bond market, with institutional investors buying, holding, and trading the bulk of corporate bonds. Notably, pension funds held more than one third of all outstanding bonds as of end-2004. Pension fund asset growth should also be an important factor in triggering the re-pricing of the stock market via reductions in liquidity and risk premiums and reduced cost of capital. Recent analysis by HSBC (2006) points to a strong correlation between price earning ratios and various measures of the importance of institutional savings in Asia.

Thus the NPS gives the investor a choice between investing in the Stock Markets which offer higher returns but at the same time are more uncertain and between government securities which yield lower but assured returns as shown in the table below.

Pension assets in India currently amount to only 5 percent of GDP which is much below other developing nations like Hong Kong, Singapore, or Chile as seen in the table below

5.4 Diversification of Asset

AllocationThe proportion of Indian pension funds allocated to equity is significantly lower than in most other economies. However, young and growing populations in India and other Southeast Asian countries (Figure 5) suggest that there would be more aggressive asset allocation in future. For example, in Korea, the National Pension Fund increased its stock allocation from 12% to 16.4%by 2007.

5. Implication of Pension Reforms for the Financial Sector

Given the huge amount of funds involved in the pension segment, any reform in this sector is bound to have an effect on the entire financial sector. Listed below are some of the major implications:

Several studies have shown that there a positive impact of institutional investment-including pension funds on market capitalization using panel regressions, controlling for other determinants of stock and bond market capitalization. This is true for both mature and emerging markets. Granger causality tests confirm that where causality exists, it runs predominantly from contractual savings to market capitalization. Thus institutional investor like Pension funds entering into Indian market would increase the market capitalization. In fact according to a report prepared by KPMG, the pension reforms are expected to increase the market size to 95 billion dollars by 2025

9. http://www.in.kpmg.com/pressreleases/pdf/PR_100407.pdf

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Std. dev (In percent)

There can be altogether new instruments like high yield bonds, mortgage-backed securities, and foreign exchange and interest rate derivatives which can be spurred by Pension Funds. Indian Pension reforms include relaxing limits on investments in corporate bonds and allowing investments based on the company rating rather than the category of issuers. Thus any good credit rated bond is a candidate for investment for Indian Pension Funds.

180 Equity Market Volatility vs. Pension Fund Assets 160 140 120 100 80 60 40 20 0 0 20 40 60 80 100 120 140
In percent of GDP

8. References
Non-OECD

1. International Monetary Fund working paper on "Financial Market Implication of India's Pension Reforms", by Hlne K. Poirson, April 2007 2. International Monetary Fund working paper on "Pension Reforms in India", by Robert Gillingham and Daniel Kanda, September 2001

6.Empirical Evidences
We will now look at empirical evidences of implications of Pension Fund investments on capital markets. This section is based on three broad themes as follows: Pension fund savings have a strong positive co-relation with financial market development. Pension fund savings are inversely related to market volatility. Pension fund savings are inversely related to risk adjusted returns in equity market

Non-OECD Full Sample

3. India's Pension reform: A case study in complex institutional change, by Surendra Dave, Chairman, CMIE, January 2006 4. Indian Pension reform: A sustainable and scalable approach, by Ajay Shah, December 2005 5. Pension Reforms in India: Myth, Reality, and Policy Choices, Dr. Ramesh Gupta, IIMA 6. Pension Reforms and Financial Markets: Encouraging Household savings for Retirement, by Anita Talukdar, IMF Conference on International Pension Reforms, June 2007 7. Footnotes references.

Source: Bllomberg; and OECD.

Figure 5: Equity market volatility vs. Pension fund assets (in % of GDP) graph

6.3 Risk Adjusted Returns

We can also see a negative co-relation between risk adjusted returns and pension fund investment empirically proved in following graph.
2.5 Risk Adjusted Return vs. Pension Fund Assets

These three hypotheses were empirically verified in a paper by International Monetary Fund. We will describe the essence of the analysis here.

6.1 Financial Market Development

A graph of Market Capitalization vs. Pension fund assets shows a strong positive relation as can be seen below. Pension funds contribute to the development of both the government bond and equity market.

2.0

1.5

1.0
Full Sample

0.5
Non-OECD Non-OECD

0.0 0 20 40 60 80 100 120 140

Figure 6: Risk Adjusted Return vs. Pension fund assets (in % of GDP) graph

Did you know?

1. Reserve Primary Fund (a money market Mutual Fund) Fund lowered its share price below $1 due to exposure to Lehman debt? 2. Wall Street gets its name from a defensive wall that was put up to protect New Amsterdam (now New York) from native tribes, New England colonists and Britain. 3. Bank of New York was the first company to be listed on the New York Stock Exchange 4. The Dow Jones Industrial Average is an average of 30 stocks. When it started there were only 12 stocks. General Electric is the only company of the original 12 still in the index. 5. Antwerp, Belgium is the world's first stock exchange established in 1460 under the rule of Phillip the Good facilitating trading in financial securities - primarily bonds

7. Conclusion
Given the fact that pension sector reforms are now a question of when and not if, this paper offers a very pertinent analysis of the effects the reforms will have on the Indian financial sector. The paper concludes that the Pension fund reforms would definitely have a positive impact on the Indian capital market. These positive impacts include improved financial depth, diversified investor base, diversified asset allocation and improved regulatory framework and transparency. To conclude it can be safely said that Pension Sector Reforms will play a very central role if the Dalal Street aims to be the next Wall Street anytime soon.

Figure 4: Market capitalization vs. Pension fund assets graph plotted in % of GDP

6.2 Market Volatility

Since Pension funds are long term investors and also are little conservative, they are highly unlikely to take the money out of the market. This would cause reduced market volatility. This inverse relationship between Pension fund investment and market volatility is empirically tested in the following graph

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3 rd Prize

An Introduction to Volatility Index (Vix) and Analysis of India Vix

VIX is such a measure as it does not constrain volatility to be constant. VIX pools the information from options across strike prices and extracts the full information conveyed by the skew to reconstitute expected volatility. Also, mean reverting nature within a short range, makes it easy to spot highs and lows for VIX which makes it more popular.

Also, the nature of symmetry in the above mentioned relationship is critical as well. There are various factors which imply that the relationship mentioned above should be asymmetric. i.e. VIX hitting its top(bottom) might be more informative for identifying SPX hitting its bottom (top). Some of these factors are As SPX hits its bottom, the panic sets in and panic buying of puts takes place. This drives the implied volatility higher and thus volatility reflected by VIX is expected to hit its top levels. The effect of the volatility smile might hint at symmetric relationship. However, in practice, volatility smirk is observed predominantly. When we combine this fact with behavioral issues such as slow confidence building and quick setting in of panic, it should ideally result in asymmetric relationship. Hence, there are seemingly contradictory conclusions from purely theoretical point of view. However, empirical observations have proven that the relationship is indeed asymmetric. Increase in VIX with decline in SPX is stronger as compared to decrease in VIX with increase in SPX. i.e. negative stock index returns yield bigger proportional changes in implied volatility measures than do positive returns. The significant correlation between changes in VIX and the underlying index also hints at potential use of changes in VIX as a leading indicator of the changes in the underlying index. Although public availability of information about these changes and liquid markets suggest no such sustainable predictability, it needs to be confirmed using actual data. Also, though predicting absolute values might not be possible and induce large errors, VIX can be used to predict the direction of the SPX going forward.

Calculation Methodology
The methodology used for calculation of VIX is basically modeled on the methodology of replicating a variance swap. Here the replication is done using At-The-Money (ATM) and Out-The-Money (OTM) options on underlying index- SPX across the strikes. Options with near month and next month expiry are taken into consideration. The complete methodology can be summarized as follows VIX as square root of annualized forward price of 30 Days variance of the Index returns Replicating the variance using a portfolio of options deltahedged with stock index futures The contribution of a single option is proportional to price of the option and inversely proportional to the square of the option's strike price

Vaibhav Shintre
(PGP2, IIM Ahmedabad)

Executive Summary
Following huge popularity of Volatility Index(VIX) among market participants in US markets, NSE has introduced India VIX in April 2008. The following article covers the preliminary introduction to VIX as a concept, its calculation methodology and the rationale behind the same. It also analyses the performance of India VIX and probes for the reasons behind it. Based on these possible reasons, some modifications in the calculation methodology of India VIX are suggested which rest mainly on empirical observations while also conforming to theoretical assumptions. While derivatives on India VIX are not introduced yet, we look at VIX futures and options briefly in the last section of the article, to get basic idea of their uses

Forward pricing for the two nearest-term expiration as forward price of the strip of the options

Rolling over to next and far months with 8 days left to expiry - to minimize expiration effects in prices Interpolation of variances of both months to get the final variance with a constant maturity of 30 days

Acknowledgement
The central idea of the following article is a part of work done by the author at Equity Derivatives Trading Desk (Hong Kong), Citigroup Global Markets Asia Ltd. The author gratefully acknowledges the guidance and help provided by the desk.

calculation model-free, VIX has become very popular among the market participants and is considered not only to be the market's expectation of the volatility in the SPX over the next month, but also to reflect investor sentiment and risk aversion.

VIX =

Interpretation and use of VIX

The relationship between the changes in VIX and the underlying index in short and mid-term is of great interest for any trader to assess if the increase (decline) in underlying SPX actually results in decrease (increase) in VIX level. As mentioned, the methodology used for calculating VIX is model-free and relies on the prices of ATM and OTM options. Though these prices should reflect the index level changes, it might not do so precisely every time. However, statistical tests using real data proves this assumed reflection of index level changes on VIX.

Why VIX? What is a Volatility Index?

In simple terms, Volatility Index is a measure of market's expectation of volatility over the near term. VIX was first introduced by CBOE in 1993 and later on revised in 2003. It is aimed at serving as an indicator of the measure of volatility in the market as reflected through implied volatilities embedded in the near and far month options on the underlying index. Thus, VIX is derived from the bid/ask quotes of options on the S&P 500 index(SPX). Especially after its revision to make its

Conceptually, implied volatilities obtained from the option prices (using Black-Scholes model which assumes constant volatility) should be good reflection of the market volatility. However, the skew of stock index implied volatilities signals that the Black-Scholes model mis-specifies the underlying return, and that random volatility matters a great deal. This suggests using a more consistent and robust measure of expected volatility, one which will not depend on the strike and will be model-independent.

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India VIX
Following the popularity of VIX in US markets and development of derivatives markets in India, NSE has introduced its own volatility index based on NSE NIFTY index options in April-2008. It uses the same methodology as VIX described above. The only difference is in the underlying index which is NIFTY 50 for IndiaVIX. Unlike CBOE, NSE has not yet introduced any derivatives on IndiaVIX and as of now, and it is just used as an indicator reported daily by NSE. However, IndiaVIX has not been able to gain popularity among market participants in comparison of VIX. While lack of awareness and non-availability of derivatives based on IndiaVIX are some of the reasons for it, IndiaVIX itself has run into problems due to adaptability issues concerning Indian derivatives market. Following figure show behavior of these indices for last 11 months. (starting from 01-Nov-2007)

While the range experienced by IndiaVIX is much larger in comparison to VIX, we can also observe that the reaction to the changes in overall market sentiments as reflected in NIFTY index options generally overshoots and hence the volatility of IndiaVIX is very high. Even more important issue is lack of any apparent relationship between the changes in NIFTY and changes in IndiaVIX. The figure shown below compares the scatter plots for daily returns of VIX and SPX against the same for IndiaVIX and NIFTY along with the regression equation.

While negative relationship is evident in case of VIX, it is apparent that no such trend exists in case of IndiaVIX. In addition to IndiaVIX not falling in line with expected behavior of a volatility index, (theoretically as well as based on experience of VIX) it has also faced criticism for not being able to reflect the market sentiment as perceived by the market participants.

acceptance among the market participants. Volume filters need to be introduced in order to remove the strikes for two categories. To prevent mispriced quotes with no volume from affecting the calculated IndiaVIX, identification and removal of quotes where the spread is disproportionate and volume is very low is necessary. As mentioned before, this is observed specifically in **50 strike options NIFTY options. Removing all such strikes is not desirable as near ATM options do not exhibit such tendency significantly. Instead, we can use rule based filters which rely on combination of volumes and bid-ask spread. However, replication of variance swap assumes continuous strikes, which is not possible in real world in first place. Using above filters makes the strikes used for replication even more discreet. This can be dealt with by interpolation for strikes within the available strikes range and extrapolating beyond this range. However, extrapolating is not really desired as it is not only more error-prone, but also the weight for strikes beyond the range is anyway very less to make any significant difference. Hence, interpolation of option prices between the available strike range is recommended which will make these strikes used in calculation less discreet. It is also recommended that a nonparametric method such as cubic spline is used for this purpose as it ensures that no accuracy is lost on available data points because they are used as knot points during interpolation. Further, it is recommended that rolling period should be reduced from the current 8 days period. The rationale behind reducing the rolling period is the extreme lack of liquidity in far month options till 3-4 days before near month expiry date. This modified method described above has been backtested for one month and the results seem to be encouraging. Following figure shows the performance of modified IndiaVIX for this test period.

Possible issues with India VIX

Based on the analysis of the methodology of calculating IndiaVIX, its underlying assumptions and checking their validity in Indian markets, we can trace some of the possible reasons for above issues. The replication of variance swap as a portfolio of options assumes continuous strikes. Especially in Indian markets, lack of liquidity across the strikes is evident. As the volume for trades happening at deep OTM options and specifically at **50 strikes (i.e. strikes in denomination of 50s) is very low, when considered at par with the heavily traded strikes, lead to misrepresentation. The case is worse with next month options as the liquidity problem spreads to majority range of strikes for better part of calculation there. Above issue combined with often observed, mispriced quotes which can be observed from the bid-ask spreads (with very little volume), aggravates the problem. Rolling period of 8 days is probably too large for Indian market due to little activity in the far month options

Recommended Modifications
Based on above analysis and empirical observations, following changes in methodology are recommended which can help in making IndiaVIX more representative of market volatility without compromising theoretical ground it stands on and intuitive explanation it relies upon for gaining

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Derivatives based on Volatility Index

The VIX formula isolates expected volatility from other factors affecting option prices, such as changes in underlying price, interest rates, dividends and time to expiration. VIX derivatives offer a way for investors to buy and sell volatility simply and directly, without having to deal with the other risk factors that would otherwise have an impact on the value of an SPX derivative position. They may also provide an effective way to hedge equity returns, to diversify portfolios, and to implied against realized volatility spread. While NSE has not introduced derivatives with underlying as India VIX yet, CBOE has introduced VIX derivatives (futures and options) long back. These derivatives are explained in brief here.

Conclusion
While introduction of India VIX is a step in the right direction, above analysis shows the need and ways of modifications in the calculation methodology to make it more applicable and relevant to Indian markets. Also, introducing derivatives based on India VIX such as futures and options is desirable going forward as it will provide opportunity for the market participants to have a pure play on volatility. However, this requires that India VIX itself gains more acceptance and becomes popular among the market participants. This mandates that India VIX becomes more stable and reflective of the market sentiments which can be achieved by suitable modifications in the methodology.

Inflation: The Future is in Futures

References
Demeterfi, K., E. Derman, M. Kamal J. Zhou, 1999, "More than You Ever Wanted to Know about Volatility Swaps," March 1999, Goldman Sachs Quantitative Strategies Research Notes. Moran, Matthew T., "Review of the VIX Index and VIX Futures.", Journal of Indexes, October/November 2004. pp. 16 - 19. www.cboe.com/micro/vix/introduction.aspx India VIX computation methodology accessible at http://nseindia.com/content/vix/vix_comp_meth.pdf

Saurabh Sood
(IInd Year, MBA, VGSOM, IIT Kharagpur)

VIX futures
VIX futures (VX) are standard futures contracts that cash settle to a Special Opening Quotation (SOQ) of VIX. VIX futures are therefore contracts on forward 30-day implied volatilities and the price of a VIX futures contract is to VIX what a thirtyday forward interest rate is to a thirty-day spot interest rate. Also, it should be noted that there is no cost-of-carry relationship between the price of VIX futures and VIX. This is because there is no "carry" arbitrage between VIX futures and VIX unlike between a stock index futures and the underlying index. As VIX is a volatility forecast, and not an asset; we cannot create a position equivalent to one in VIX futures by buying VIX and holding the position to the futures expiration date while financing the transaction.

EXECUTIVE SUMMARY
The sudden and tremendous increase in the global and domestic inflation has spelt doom for the Indian markets and investors. The ever-increasing integration of the Indian markets with the global markets has posed an unprecedented increase in inflation-risk. To prevent wealth-corrosion from increasing inflation a mature, sophisticated, and advanced market should present its investors access to inflation-hedging financial instruments. The recent launch of currency futures trading has opened the doors for the introduction of inflation index based futures. Such inflation futures are already prevalent in advanced global markets on U.S. and Europe and have become an important tool in every investor's arsenal. The Indian market participants have become experienced in trading in index and stock linked futures. Inflation futures with the WPI Inflation Index as the underlying are need of the day if India is to be counted amongst the developed financial markets. Not only would such an instrument provide an effective hedge against inflation but it would also provide a reliable indicator of the market's inflation expectations and help the central bank chalk out its monetary policy. With an efficient contract design, market making services, regulatory mechanisms and an increased investor knowledge about such an instrument, the introduction of inflation index based futures would definitely pave the way for the further progress of the Indian stock markets onto a global stage.

VIX Options
The underlying for VIX options is the expected (or forward) value of VIX at expiration. This forward value is estimated using the price quotations of SPX options that will be used to calculate the exercise settlement value for VIX on the expiration date. For example, VIX options expiring in August 2008 will be based on SPX options expiring 30 days later - i.e.; September 2008 SPX series. VIX option prices reflect the forward value of VIX, which is typically not as volatile as spot VIX. For instance, if spot VIX experienced a big up move, depending on the value of forward VIX, call prices might not rise at all, or could even fall. As time passes, the options used to calculate spot VIX gradually converge with the options used to estimate forward VIX. Finally, at expiration, the SPX options used to calculate VIX are the same as those used to calculate the exercise settlement value for VIX options.

The Devil is in Inflation

Mirroring inflation trends in many advanced as well as emerging economies, inflation in India has also risen significantly over the last two quarters. In India, inflation based on the wholesale price index (WPI) increased upto 12.83% year-on-year, reflecting the impact of higher international crude oil prices as well as continued increase in the prices of iron and steel, basic heavy inorganic chemicals,

machinery and machinery tools, oilseeds/edible oils/oil cakes and raw cotton on account of strong demand and international commodity price pressures. Equity markets in most of the emerging markets also declined due to signs of economic slowdown, sharp rise in inflation rate, high international crude oil prices and concerns over stagflation in the US. The domestic equity prices also witnessed huge corrections during the first two quarters of 2008-09 in line with trends in major international equity markets.

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The primary purpose of inflation futures is the transfer of inflation risk. For example, real estate companies may want to shed some of their natural exposure to inflation risk, while pension funds may want to cover their natural liabilities to this risk. In their simplest form, inflation derivatives provide an efficient way to transfer inflation risk. Inflation products attract a diverse group of investors such as banks, pension funds, mutual funds, insurance companies and hedge funds.

One of the most common derivatives is Inflation futures, and these inflation derivatives require buyers to provide only a small premium to initiate the trade.

India: The need for Inflation Futures

Certainly the hedging function is central to any proposed contract market, regardless of variety. The absence of any directly tradable financial instrument which provides an effective hedging mechanism against inflation poses a grave risk to any investor. Also an important variable upon which the Reserve Bank of India grounds its policy decisions is inflationary expectations on the part of economic agents. Inflation derivatives will provide undoubtedly a close to perfect estimator of such expectations, in addition to revealing useful information as to the inflation risk premium and real interest rates. A second argument in favour of the development of inflation derivatives markets is the high degree of expertise achieved by present traders, as evidenced by the development of the exchange traded derivatives markets in India. An investor expecting an inflation rate higher than the one implicit in the price pegged by the Central Bank will buy the contract. The equilibrium prices of the futures contracts will reflect the relevant information about the market expectations of inflation and the required inflation risk premia. This information will always be more accurate than the one conveyed by nominal bond and indexed bond prices. It will also be easier to extract from market prices, a very desirable property. For example, if the inflation risk premium is nil, the futures price yields directly the market expectation of inflation. A move towards introducing inflation-linked securities was attempted in the previous decade when the RBI introduced inflation-linked bonds, but the market did not respond favourably for liquidity reasons. However, the current situation is very different and favours the development of an exchange traded inflation futures market on the footsteps of currency and (likely to be soon introduced) interest-rate futures markets. All market participants now master the subtleties of derivatives in general and of futures in particular. A company, whose inputs are inflation-indexed (e.g. wages and salaries of its workers are tied to an inflation index), may find a contract on inflation useful. If the company cannot pass the input price increases on to its customers through retail prices, its earnings may suffer. A long position in inflation futures may help to solve this problem. Some experts have suggested that commodity futures markets might be naturally complemented by an Inflationfutures market. The idea received support from many economists, since such market would allow hedging inflation risk directly, rather than through indirect inflation hedges

used before (e.g. real estate, stocks, metals, etc.). Existence of inflation futures price would also permit converting nominal amounts into real ones (e.g. in debt contracts). For the arguments in favour of an inflation-futures market the following benefits need to be considered: Effective hedge: There existed other strategies to hedge against inflation risk, but an exchange-facilitated market will allow hedging of risks directly. Contract Design: The volume of the CPI futures contract should not be too large for the average potential user. Experienced investors and traders: Market participants have gained experience with indexed financial instruments.

The Beginning of Inflation Futures

The CME (Chicago Mercantile Exchange) started trading futures on the US CPI inflation index on 8 February 2004. The main advantage of CPI futures over zero-coupon inflatioN swaps is the mitigated counterparty risk. The CPI futures traded on the CME are designed to resemble the Eurodollar futures contract. These CME CPI Futures contracts are based on the quarterly changes in the Consumer Price Index, U.S. city average for all urban consumers, all items, not seasonally adjusted (CPI-U). The final settlement value of the June 2008 contract for instance, is computed using the annualized percentage change from the CPI-U for February 2008 (released in March 2008) to CPI-U for May 2008 (released in June 2008). As the CPI-U statistic is released monthly by the Bureau of Labour Statistics, U.S. Department of Labour, one expects CPI Futures to be priced using market expectations of inflation. Although there are several measures of inflation expectations, a measure based on futures contracts written on the inflation index is relatively new and potentially useful. The contracts are based on the CPI for all urban consumers, all items (not seasonally adjusted). Similar to federal funds futures contracts, they have a pricing structure of 100 minus the contracted inflation rate-the three-month change in the CPI ending in the month prior to the expiration of the contract. The prices of CPI futures capture market participants' expectation of future inflation and the associated risk premium. If investors believe that the realized inflation rate will be lower than implied by the futures price, they will buy CPI futures and thus drive up the price until a new consensus is reached. One potential use of the inflation futures contracts, therefore, is to gauge the future inflation rate relative to the current rate. The prices of CPI futures capture market expectations of future inflation and the associated risk premium. Assuming that the latter is negligible, another potential use of the CPI In recent years the market for inflation-linked exchangetraded derivative securities has experienced considerable growth on the Wall Street. From almost being non-existent in early 2004, it has grown multiple times mainly in response to the increased demands for effective and efficient inflationhedging instruments. futures contracts is to gauge the future inflation rate relative to the current rate. Many investors (in the countries where these instruments are available) prefer inflation protection from exchange-traded derivatives because unlike inflationindexed bonds, these instruments do not require substantial amounts of capital.

These developments make an effective and efficient hedge against inflation highly indispensable if India is to develop as a world-class financial market. With the introduction of exchange-traded currency futures the time is ripe for taking the next steps in developing the Indian financial market as a mature platform for all financial intermediaries. Allowing trading in Interest-rate and Inflation futures is the inevitable solution. The Indian financial markets have an impressive history in derivatives markets, with many notable successes. The most conspicuous evidence on such performance is available from the organized futures exchanges. World-wide the number of financial instruments actively traded in futures markets has increased dramatically in the last quarter century. Globally, the most actively traded futures markets today include interest rate, currency and stock index markets, most of which were established in the past quarter century. The major reasons for the success of such instruments, in addition to the numerous other factors, include hedging demand and contract novelty that impact a contract design's eventual success

Criteria for Contract Market Success

One of the most important criterion for defining market success is the achievement of sustained, significant levels of trading activity. This activity is typically measured by the trading volume and open interest statistics reported by regulated futures exchanges. Another alternative is to judge the success of a contract market from society's point of view rather than the exchange's, functions of commodity futures markets, each of which promotes an increase in society's welfare. First, futures markets are useful to handlers of a commodity, providing means of hedging inventories and forward marketing. Second, futures markets provide publicly observable prices for a commodity that are established in an open, competitive environment. In the absence of a futures market and such publicly observable prices, smaller firms in an industry can be at an informational disadvantage with regards to current market conditions. Also, since the RBI and the Government of India plan to release monthly inflation data on the 15th of every month starting from November 2008, the pricing and trading of inflation futures will become a highly profitable and easily quantifiable activity. The inflation futures may be designed on the basis of the existing 1-month, 2-month and 3-months series contracts or the market regulators and exchanges may follow the contract design trends followed in international markets.

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These developed markets have inflation futures contracts designed to be traded on quarterly inflation data. A longer duration provides a more effective hedge against inflation in such markets.

buyers or sellers, at the expense of significant participation on the part the opposite side. In the case of cash-settled contracts, the choice of the underlying value is important. It must be chosen in such a way that hedgers do not face an excessive amount of basis risk.

Key Characteristics of Successful Contracts

For the inflation futures contracts to be successful in India the following conditions must be satisfied: Existence of a precisely defined underlying value Provision of mechanisms that ensure contract enforceability and acceptable counterparty risk, Provision of market making services, Existence of an impetus for trade, and Attraction of hedging activity. The conventional wisdom is that new contracts that allow for hedging of previously unhedgable risks are popular. The first three conditions constitute integrated financial services that the SEBI, RBI and the Finance Ministry must provide before trading can begin in earnest, while the last three conditions are necessary for a market to thrive once trading has commenced. Contract design is important for all contracts. For physically settled contracts, it is important that the delivery provisions correspond to dominant industry practice (Gray 1965 ; Williams 2001). This includes factors such as lot size, delivery locations, delivery timing, grade of the asset, and the price differentials associated with deviations from the standardized terms. Poor design can result in a contract that favours either

Conclusion
In view of the poor ability of both broad macroeconomic aggregates and financial asset prices or interest rates to forecast inflation, the relevance of the WPI based Inflation futures as the appropriate measure of the inflation, and the potential immense success of such an instrument for inflation-risk hedging, exchange-traded inflation futures must be created based on the WPI. Since inflation is a crucial variable that impacts each and every economic and market participant's decisions such a market would also be welfare improving: It would help provide a direct instrument to hedge the ever-increasing inflation risk. Also it would provide a realistic preview to the inflationary expectations and future inflation. Finally, once the futures market is fully developed, an option market on such derivatives can be launched.

Can BSE Sustain a Sustainability Index

Abhijit Parashar, Nidhish Jain
(PGP1, IIM Bangalore)

Gaurav Parashar
(Sr. Undergraduate, CSE, IIT Bombay)

Executive Summary
Sustainability Index is an index which provides an opportunity to investors to invest in sustainable companies. The report proposes a model BSE Sustainability Index (BSE SIN) in line with Dow Jones Sustainability Index. The mode index incorporates companies, in BSE, based on their score in different parameters. The main criteria for selection are the company's economic, social and environmental performance. To test the effectiveness of this model, a simulation Sustainability Index is composed. The average returns and volatility of this index is compared with that of BSE over a period of a year from April 2006 to April 2007. The results show that BSE SIN's performance is comparable to that of BSE throughout the year. With formal launch of such an index and increase in investments on sustainable practices, BSE SIN will provide an excellent opportunity for investors to invest in sustainable companies. It will also promote environmental friendly and sustainable business practices from companies which will help in sustainable growth of the country.

Introduction

Puzzle Answers
1. He started out as a billionaire!! 2. 1 - Your objective is to find out a good pill and not to isolate the poisonous pill!! 3. 0.75 - Fix one point. Now the other 2 points will lie on the shorter arc w.r.t the 1st point by probability of 0.25. This will be the case with all the 3 points. Hence 0.75. 4. Mr. White is wearing blue, Mr Blue is wearing red, and Mr Red is wearing white 5. 2.2.9

Over the past decades, the calls for virtually all organizations to become better stewards of our natural resources, embrace environment-friendly practices, adopt fair trade policies, and implement "sustainable business practices" have continuously shifted from a small but vocal number of advocates to broad majorities of consumers and governments worldwide. Today, issues such as climate change, energy consumption, labor practices, food safety, pollution, and waste management are strong factors in the impression that companies make on its consumers, investors, regulators, watchdogs, and other stakeholders. From an investment perspective, the world's financial markets are showing greater interest in the heightened role that sustainability and, more broadly, corporate social

responsibility are playing. Today, investing in sustainability is not merely a "feel-good" measure set, but a savvy strategy that can deliver above-average returns. The concept of a Triple Bottom Line expands the traditional financial framework to encompass rigorous reporting on the organization's performance on sustainability issues such as the carbon footprint, hiring practices, and dozens of other metrics.

Throughout the world, sustainability indexes are being planned. In fact the Dow Jones sustainability indexes, were the first ones, and have delivered superior returns from the inception.Unfortunately, the Dow Jones World Index does not have even a single Indian company as a component. In the current article, we conceptualize a BSE sustainability index (BSE SIN), devise the methodology for such an index and run a simulation, comparing the returns with that of the Sensex.

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(b) Proposed Criteria and Indicator System 2. Sustainability vis--vis Investing

Sustainable Investing is an approach which will create a longterm shareholder value by exploiting opportunities arising from and managing risks derived from economic, environmental and social developments. It combines the best of both worlds: the market's potential for sustainability products and services and at the same time successfully reducing and avoiding sustainability costs and risks. A growing number of investors perceive sustainability as a catalyst for enlightened and disciplined management, and, thus, a crucial and differentiating success factor. As a result, investors are increasingly diversifying their portfolios by investing in companies that set industry-wide sustainability best practices. The proposed Sustainability Index will cover a dozen of industry groups and sectors. Because of increased investor appetite for socially-conscious investments and corporate social and environmental responsibility, in future the index can be effectively used by private wealth managers as a Amongst all Asian nations, India is one of the active countries in the field of corporate responsibility. A number of leading companies are also actively managing their environmental impacts and some major Indian companies producing detailed sustainability reports and exercising leadership within the broader Indian business community evidence this. The Confederation of Indian Industry has adopted Social Principles and embraced the CSR concept.

Group Heading

Criteria
Operation and Maintenance Costs Compliance

Weightage
8

Notes
Includes the amount spent on the proper operation and maintenance of the organization Depending upon the compliance to various regulations like Environmental Regulations, Sales Tax Act etc. Includes the details of financial ratings, economic excellence awards and recognitions conferred in the past few year Does the organization maintain and demonstrate transparency internally and externally on financial and economic Health and safety threats in the organization; injury rate, fatality rate and workday lost in the past few years. Major accidents/disasters at any operating unit in the past few years Processes, mission and vision adopted by the organization to address its social issues Social risks in the organization; mention incidents such as strikes, unrest, protests, and lockouts in the past few years Policies, practices and procedures to impart training and awareness to its employees Efforts and initiatives to influence the suppliers and vendors to become environmentally responsible Environmental regulations applicable to the organization; environmental disputes if any in the past few years. Mission, policies and values that the organization has adopted; environmental Consistency to international agreements such as Kyoto Protocol, Basel Convention, Stockholm Convention etc Environmental awards and recognitions conferred to the organization during the past 5 years

Economic Aspects

3. Proposed Methodology
The BSE SIN will contain the top 10 %( by market cap) of the companies listed in BSE that have incorporated sustainable practices in their business models. The methodology is based on the application of criteria to assess the opportunities and risks deriving from economic, environmental and social dimensions for each of the eligible companies in the BSE.
Awards, Recognition and Certifications 6

Transparency and Reporting

(a) Short listing the Companies

The companies will initially go through a screening process to qualify for the BSE SIN. The screening process will be based on three parameters namely, economic, social and environmental. Each of these three parameters will have certain criteria with specific weights attached to each criterion. To determine the ratings for each criterion a questionnaire will be sent to each of the companies and the rating will be decided partly on the basis of the responses and documentation sent back by the companies, and partly on surveys done by NGOs and CII on corporate sustainability.

Occupational Health and Safety

Disaster Management Social Aspects Policy Management System Social Risk Managemen

8 7

Training

Graph 1: Performance of DJSI World since inception benchmark, with billions of assets under management pegged to it. This index will provide an incentive to company management to invest further in sustainable business practices. The sustainable index can also be used by the companies to educate their investors of the environmental friendly practices followed by the company's management.

Greening of Supply Chain Compliance

10

Corporate Sustainability Index

Environmental Aspects Policy and Management International Agreements 6

Criteria: General and Industry specific Sources of information: Questionaires, Company Documents. CSR ratings

Awards, Recognition and Certifications

Figure 2: Corporate Sustainability Assessment: The steps

Table 1: Proposed Criteria and weights

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(c) Index Methodology

(i) Each company's total score is calculated based on the weights and the ratings. (ii) After this each company will be placed in a sector based on its primary revenue source. (iii) The companies will then be ranked in their respective sectors on the basis of the sustainability score. (iv) Only those sectors will be considered for BSE SIN for which the score of the highest ranked company is at least one tenth of the minimum desired sustainability score. (v) In a particular sector only those companies will be selected which have a score of at least one third of the highest score in that particular sector. (vi) The target free float of BSE SIN will be 15% of BSE. If the free float exceeds this limit then there will be a proportional decrease from the different sectors. Once the composition of BSE SIN is determined the calculation of this index will be done in the same way as BSE SENSEX and will be based on free float method. There will be a yearly review of the companies in BSE SIN and those companies found not conforming to the criteria of the sustainability index will be dropped

screening process, due to in availability of data , and no responses to any questionnaires sent out to the companies listed. The main aim of the screening process was to determine companies which are following sustainable business practices. For screening purposes we have made use of the first ever 'Karmayog CSR ratings of top 500 Indian companies'. These ratings are very comprehensive and rate the companies on various parameters under social, environmental and economic categories. As per our screening process, we have identified 44 companies to constitute the BSE SIN (BSE Sustainability Index). Further in determining the BSE SIN companies having businesses in Alcohol, Gambling, Tobacco, Armaments and Firearms were excluded. The assumptions made while determining the index values are: (i) The effects of stock split and rights issue are not considered. Graph 2: Comparison of Sensex and BSE SIN (ii) The closing price of every stock is used for calculating index. For calculating the BSE SIN we have used the Free Float Market Capitalization Method. The quarter yearly trading prices of each of the 44 companies and the value of non promoter holdings were taken to determine the market capitalization. The weights to calculate the index were decided on the basis of the free float market capitalization. After deciding on the market capitalization and the respective weights the BSE SIN was calculated to have a comparison with BSE Sensex. This was repeated for all the four quarters for the year 2006-2007. The volatility of BSE is observed to be approximately 0.13 and that of BSE SIN to be 0.155.In the current simulation, the BSE SIN outperforms the Sensex marginally in a period of an year, but demonstrates greater volatility. With a concretely established sustainability evaluation and greater investor interest, the BSE SIN is expected to perform much better. The detailed Index caculations are available on request.

4. Simulation Methodology
In this section, we compare the returns (for all the quarters of FY 2006-2007) of the BSE 30 index with a group of 44 companies which we have identified as per a slightly modified (a) Simulation Results

5. Recommendations
The current simulation analysis is merely demonstrative, and much cannot be read into the returns offered. It is largely constrained for the want of responses from companies to the questionaires, and available CSR ratings. However, it conceptualises the BSE SIN, in its proposed shape. A BSE SIN would go a long way in promoting sustainable practices in the country and rewarding those already following sustainable practices. It will also provide an alternative investment platform for the investors looking to park their money in such Indian companies and leading global financial firms looking to launch financial products based on the index.Any such measure will spur more private investments in sustainable growth of the country. Hence, BSE should look forward to making it a ground reality very soon.

The results from the simulation have been summarized in the following table
Index value as on April 3,2006 Index value as on July 3,2006 Index value as on Oct 2,2006 Index value as on Jan 1,2007 Index value as on Apr 2,2007

Index

Volatility

BSE SIN SENSEX BSE SIN (scaled by a factor of 20)

578 11564 11553

498 10695 9954

579 12454 11578

674 13787 13476

625 12455 12497

0.00775 0.13 0.155

Table 2: Sensex and BSE SIN Index values

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Re-Introducing G-Sec Futures In India

History
The first semblance of an interest rate futures contract to be listed on an exchange was in 1975 when the Chicago Board of Trade (CBOT) introduced GNMA-CDR futures tracking mortgage related interest rates . But, the first bond futures contract happened to be listed in 1977 when the futures were written on the 30-year U.S. Treasury bond. This was followed by futures contracts on 10-Year Treasury Note, 5-Year Treasury Note and 2-Year Treasury Note listed on the CBOT. Taking a cue from this, other exchanges throughout the world started listing futures on government securities and money market instruments to manage interest rate risk. The first bond futures contract outside USA was the British Government 10-year Gilt started in 1982 at London International Financial Futures and Option Exchange (LIFFE).

participants enforcing settlement and margin payments. This enables the ease of trading in them and enhanced liquidity of the same. Another very important feature is that most of the Exhibit 1

Top 10 Bond Futures, Volumes 2007

Sl. No 1 2 3 4 Contact 10y Note, CBOT Euro-Bund, Eurex Euro-Schatz, Eurex Euro-Bobl, Eurex 5Y Note, CBOT 30Y Bond, CBOT 2Y Note, CBOT 3Y Bond, ASX Long Gilt, LIFFE JGB, TSE Vol. (no. contracts) 349,229,371 338,319,416 181,101,310 170,909,055 166,207,391 107,630,211 68,610,392 33,585,015 27,367,489 16,196,071 Ch% 36.65 5.76 9.55 2.15 33.1 14.8 80.71 8.28 24.35 25

Aditya Gupta
(PGP2, IIM Bangalore)

Statistics
The Eurodollar futures traded at the Chicago Mercantile Exchange (CME) of the CME Group traded with maximum volumes amongst interest rate derivative contracts in 2007 trading 621.57 million contracts with a growth of around 23.78% from the previous year. While the most voluminous bond futures contract in 2007 was the 10-Year Treasury Note Futures traded on the CBOT with volume of 349.23 million contracts with a growth of 36.65% from the previous year.

5 6 7 8 9 10

Executive Summary
Government securities (G-Secs) futures are one of the most voluminous exchange traded products in the world. They are nearly more than 30 year old and are very liquid in developed markets. Interest rate futures as a whole make up one-fifth of the world's exchange traded derivatives. They are very liquid products with high level of transparency involved and are used for hedging, arbitraging, speculation and duration management. The G-sec futures introduced in India in 2003 failed as it had a cash-settlement on a curve less understood by common traders and banks were not allowed to hold trading positions in the product. The current working group of RBI recommends introduction of futures physically settled and recommends additional measures needed to make them successful and useful to all market participants. There lies an opportunity for Banks in India as they will be able to speculate and hedge more through another fixed income product. A primary dealer and a bank having higher access to both cash and the futures market could lead to an advantage in trading such as basis trading and providing access products. But there are issues like patchy liquidity in the local bond market which would create hurdles for the development of the same.

1. Introduction
Bond futures are derivative contractual agreements between two parties to buy or sell bonds at a future date. The invoice value of the transaction is already set on the date the agreement is reached. It is different from a forward contract as they are traded on an exchange. As the contract expiration date approaches, the underlying bond moves from its original price causing the futures price to change. As a result of this, the counterparty either on the buy side (referred as 'long')

and the sell side (referred as 'short') would either expect a loss or a gain at expiry. This being an exchange traded product, the exchange behaves as counterparty to both the short and the long. To guarantee there is no default in the transaction, the exchange marks to market each day's loss of the party foreseeing a loss. The exchange standardizes these futures contracts to drive more liquidity into these products. Also being a derivative, the bond futures have a risk attached to it. Futures theoretically have potentially unlimited risk.

The top bond futures contracts worldwide by volumes are listed in Exhibit 1. Clearly, we see that the CBOT-based US Treasury futures are the most traded. The Eurex-based futures on German-based or Swiss-based Bonds follow the US futures closely on trading volumes. But the growth in volume in the US-Based Bond futures is phenomenally higher than their German counterparts. The other bond futures well-traded are for the British (Gilt) and Japanese government securities (JGB). We would see in the Fixed Income market that the government debt bonds are more popular than the corporate-based bonds due to the higher risk of default associated with the corporate. The early futures on bonds were listed in the developed fixed income markets and they are still one of the most popular. Statistics show that interest rate exchange traded derivates are 17.14% of the global exchange-traded derivatives. Also a very interest fact is the trading in exchange derivatives in Asia Pacific Region has surpassed the European region in the year 2007. But the North America region still has the largest number of exchange traded derivatives having 41% share with the highest growth rate ever of around 33%.

Source: Futures Industry Magazine, Mar-Apr '08

contracts are not settled at expiry - either they get rolled over or they get closed out - hence it is not important to take positions in the underlying as such. Therefore they are able to short sell as well as take long positions bigger than they could take in the physical market. Mostly futures contracts are run parallel with different underlying type. That is 10-year deliverable underlying along with either 30-year or 5-year. Also, futures of next few expiry dates are traded simultaneously. This enables rolling of contracts into next period easy. Another important aspect of bond futures is that it is literally impossible to deliver an exact 10 year, 5 year or a specific time maturity bond as they are issued or auctioned at different times. Therefore the futures contracts are either cash settled or have a delivery grade for physical settlement. Or, in some cases a bond may be assigned to be deliverable against a contract, but that rarely happens, the reason for which will be explained later.

Features
Being exchange traded, the contracts regulate all

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Uses
Bond futures provide an excellent hedging instrument for a
fixed income portfolio. They also add or subtract duration to the underlying portfolio. In developed markets, where the Futures volumes have exceeded the cash market - futures lead the cash market and thus they are indicators to the fixed income portfolio managers. Bonds have a unique property of having a yield level based on their availability and outstanding in the market. Therefore a bond portfolio might not follow the benchmark yield. This makes it difficult to balance the portfolios. Futures can be used for the same. Speculation can be easily done by the futures market as it is highly liquid and is less anomalous then individual bonds. Arbitraging between the various spreads can be used to make money, thereby making the futures markets efficient.

By the end of 2003 trading in the product ceased to exist. Later in 2004, the SEBI in consultation with RBI tried to introduce a basked of bonds, which were highly liquid, to be used as an underlying. But this was never implemented and the product never revived. This led to the formation of the working group to re-introduce interest rate futures

Whereas cash-settlement reduces chances of squeeze, they make the futures market decoupled from the debt market bringing about more speculation. But being used in more developed markets, the physically-settled mechanism is proposed . The deliverable grade has to be specified by the exchanges, but the best basket seems to be in the range where the time to maturity is 7.5 years to 15 years. Also it should be good if the trading hours matched those of the bond market to remove any wildcard options. One major restriction which the group recommends is that the total outstanding stock of the bond shouldn't be less than Rs. 20,000 Crores to be eligible to be part of the basket. For obvious reasons, this is meant to avoid hoarding of the deliverable.

Primary Dealing and Futures

The pronounced advantage which a bank, which is also a primary dealer (PD), could be the immense access to the cash and futures market at the same time. The cash market operates in bigger lots whereas the futures would come in smaller notional face values. The PDs could hold the appropriate Government Securities, which would be in demand for the futures contracts.

Major Recommendations and Observations

Trading Positions Allowed The banks would be allowed to take trading positions in the interest rate futures which are slated to be introduced. Taking a cue from historical failure, this is a correct step towards the success of the product. Accounting Standards Currently in Interest Rate Swaps, there is separate treatment for different financial entities. There are periodic intervals where the markings to market have to be made and Profit and Loss to be calculated. Similar treatment is advised for the futures. Currently there is a detailed hedge effectiveness method suggested for futures products. To be fair, the group recommended a clear accounting treatment for futures, and it being symmetrical to the treatment of swaps and other derivatives. Short-Selling and Liquidity and Efficiency of Repo Market Presently short selling is allowed for five days in the cash market. Group recommends short selling intervals coterminus with the futures contracts. This has to be added with increasing liquidity in Repo market by removing certain existing restrictions . Micro Structure to be left to exchanges RBI would be making policy-level decisions, whereas the procedures relating to trade execution and settlement has to be best left to the respective exchanges.

Access Products
The futures market would also be accessed by various high net worth individuals (HNIs) and smaller corporate houses. They would not be able to access the OTC market to hedge interest rate risks because of higher amounts involved there. Futures entail use of margin accounts which have much smaller investment than actually investing in the cash market. There would be certain investors who would want financing for the margin amounts. Banks could provide ways to provide this access to the debt market. They could maintain one margin account and undertake trading for their clients. This would become one of the mediums for earning service charge from such flows. Also certain derived products on this margin amount can be made. Margins have to be marked to market each day requiring regular exchange of cash. Instead of making clients trade through the banks, they could act as pure financers for the same. Derived products such as options on futures losses could be used to fulfill margin requirements of retail investors. These would be essentially OTC derivatives structures designed for investors accessing futures markets.

Follow up
The success of the interest rate futures would lead to introduction of options on futures and transmitting the products to the corporate bond market.

2. Introduction in India: RBI Report

On February 22, 2008, the Working Group on Interest Rate Futures came out with a report suggesting introduction of bond futures in India in a physically settled manner. The history of interest rate futures dates back to 2003 when they were introduced for the first time in India. Ab initio the products were a failure.

3. Opportunities in India
Proprietary Trading - Speculation & Hedging
The futures would bring about another medium to speculate in the interest rates in India for the banks to trade proprietary. Futures, an exchange listed product, would be a transparent and easily observable market for interest rates. Futures are not equivalent to just being a product imitating the forwards or swap legs, but they are in a way embedding options in them too. Customer flows come in Interest Rate Swap or the Cash-Bond markets, but the speculation in those products could often prove to be risky. Also, currently the portfolios having interest rate products would not be effectively hedged. The market currently uses swaps or caps to try and hedge the portfolios. Futures are a much effective and a cheaper way to do so. Hedging was explained in Chapter 5. We know that the Statutory Liquidity Ratio- the amount of deposits banks have to hold in Government securities, bring about huge risks to the bank portfolios. For the longer term periods, we do not have any liquid products which can speculate those interest rates. We know the 10 year rates through the Government Securities and try to benchmark them hence getting a measure of how the term structure is. The problem right now is that only few bonds have sufficient liquidity. Futures enable the contract to have a basket of underlying hence averaging out the liquid as well as illiquid bonds.

Failure of products in 2003

After the existence of Interest Rate Swaps and Forward Rate Agreements from 1999, the RBI decided to introduce futures in 2002. First of all let us understand how the bond futures were structured. Initially 10-year bond futures were introduced based on a notional zero-coupon yield. Also, the method of settlement suggested was cash as this would remove any possibility of squeeze due to a low outstanding stock of a particular bond. Along with it a notional 6% coupon and 91-day Treasury bill futures were also introduced. While Primary Dealers were being allowed to take trading positions, banks were barred. The reasons attributed to the instant failure were: The daily marking to market was based on the basis of Zero Coupon Yield Curve (ZCYC), which was different than the underlying yields, leading to a basis risk. This nonobservable nature of the ZCYC reduced the understanding of settlement amounts. Initial active participation was curtailed due to banks being barred from taking trading positions.

4. Issues in India
Patchy Liquidity
The very important condition in India is the patchy liquidity of Indian G-Secs. They show trading in some securities in different time periods. One reason for major liquidity is the major holding of banks due to the Statutory Liquidity Requirement. If we consider the 10 year note futures contract, which might be deliverable in June 2008,considering the deliverable grade as 7.5 years to 15 years, a patchy basket is observed, as seen in Exhibit 2.

Structure
The Group presently recommends introducing 10-year bond futures with a notional coupon underlying, which has to be physically settled from a basket of bonds. Here two views arise - a battle between the cash-settled and physical settlement system.
References 1.The current penalties imposed against SGL bouncing should be replaced with a more transparent system. 2. Not by a group member - Ms. Susan Thomas

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This is a very wide range for a 10-year futures contract. This has led to considerably big basket. The major liquidity lies in the two bonds - 7.49% and the 7.99% coupons. They have traded more than 1000 crores in volumes everyday for the last one year. Four other bonds have traded for more than 100 crores daily. The bond which might turn out to be the CTD could be the 12.30% coupon bond - because it has the highest coupon among lesser duration bonds, if the current 10 year yield is less than 8% - the assumed notional coupon. Now, this bond wasn't traded enough for the last year. Hence, this contract would be a sure shot profit for banks or funds holding the 12.30. The other bond which could then become the CTD is 11.60% coupon. This again did not trade last year. Hence, apparently there is a huge possibility of squeeze in such a scenario. If we remove such bonds having a very small amount of outstanding, most of the bonds would be removed from the eligible basket. Then bonds like the 7.49% and 7.99% would mostly comprise the liquid basket. The RBI has therefore indeed recommended that condition like Rs. 20,000 crore outstanding be imposed. But if it happens so that a huge outstanding bond still is not trading at all - and then it becomes the CTD for a contract, it would lead to failure of the futures contract. Also, such a thing could worsen the risk management feature of a futures contract. The holders of such contracts could run into a certain risk of an illiquid CTD and hence high cost of managing risk.

would add to the set of clients the banks could serve in terms of dealing with the futures contracts. They include pension funds and the pension schemes prevalent in India.

CROSS WORD

Liquidity of imaginative 10 year futures basket

Bond 5.59% 2016 12.30% 2016 8.07% 2017 7.49% 2017 (con) 7.99% 2017 7.46% 2017 6.25% 2018 (conv) 8.24% GS 2018 10.45% 2018 5.69% 2018 (Conv) 12.60% 2018 5.64% 2019 6.05% 2019 (con) 10.03% 2019 6.35% 2020 (con) 10.70% 2020 11.60% 2020 7.94% 2021 10.25% 2021 8.20% 2022 8.35% 2022 8.08% 2022 5.87% 2022 (conv) 8.13% 2022 6.30% 2023 6.17% 2023 (conv) Liquidity (Avg.Daily Vol.for 12 months) (Rs. Million) 30.00 2662.50 12215.83 19594.73 23.38 57.33 Hot run 103.13 4.78 25.87 19.02 48.64 3578.27 2557.45 175.00 4623.58 328.81 57.27 33.16
9. This requirement for banks is fixed at 255 10. Market risk is measured by 11. Coined by Goldman Sachs, this term signifies the 4 rapidly growing economies 8. 7. A fraudulent brokerage firm that uses aggressive telephone sales tactics to sell securities that the brokerage owns and wants to get rid of. The securities they sell are typically poor investment opportunities, and almost always penny stocks. An illegal stock trading practice where an investor simultaneously buys and sells shares in a company through two different brokers. .... Trading Across 3. A type of forex account that allows the trader to enter positions that are one-tenth the size of the standard lot of 100,000 units Down 1. 2. Headd, UBS , India The currency is made up of 100 cents and is often presented with the symbol R. it's name comes from the word "Witwatersrand" which means "white waters ridge". q ratio (= mkt value/ asset value) was given by "king of Wall Street", 2007, Wall Street Journal Index estabilished on April Fool's DAy Traders who work with high volumes andsmall profits

Further imbalance of Liquidity

We can easily see that the liquidity in G-Secs is very varied. When the 10-year futures contract comes into the market, not covering other time period, it could lead to liquidity of bonds in the basket having a little less than 7.5 year of maturity or more than 15 years of maturity to shift towards this active basket. Although the liquidity in the spot market is bound to increase due to the futures market, it could drastically cause some bonds to suddenly lose their liquidity. This is an apparent risk which banks run, as they considerably hold the G-Secs.

4. 5. 6. 9.

13. The first life insurance company in india was strted here 14. Oracle of Obama (surname) 15. Established in 1930, it is the oldest international financial organization, and was created to administer the transaction of monies according to the Treaty of Versailles 17. Futures introduced for the first time in india in 2003

Addressing longer maturities

The introduction of 30-year bond futures contract could only serve institutions desiring long maturities. They are investors wanting to hedge their long term durations (of more than 15 years). So the current introduction restricted to 10-year futures may not interest all institutions. Although, we do not see a near future requirement of such durations, we would need the 30-year bond futures. Also, such longer maturities

source: www.ccilindia.com

12. Futures trading started for the first time on this exchange 16. The model which gives the "impossible trinity" 18. A division of the U.S. Fixed Income Clearing Corporation (FICC). Established in 1986 to provide clearing and settlement of U.S. government securities, it handles both new issues and resales of government securities.

References a. 'CBOT U.S. Treasury Futures and Options - Reference Guide', CBOT 2006 b. 'Volume Surges Again', Futures Industry Magazine, Mar-Apr 2008 issue

19. A standard numbering system developed to identify bank accounts from around the world. It was originally developed by banks in Europe to simplify transactions involving bank accounts from other countries

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The India Vix - "An Effective Financial Instrument?"

VIX as a hedging instrument

Correlation Study
The most notable feature of the VIX that has been highlighted umpteen number of times is its negative correlation with the price index. This presents immense potential to use the volatility asset class as offered by the VIX as an effective hedging instrument. The correlation of Indian VIX with the NIFTY index is shown in the following table for various periods. The VIX is appropriate as a hedging tool due to its strong negative correlation to the NIFTY. Duration Correlation -0.68 -0.74 -0.76 -0.88 -0.32 Figure 4: Monthly returns of the VIX and NIFTY Index

Figure 3: Daily returns of the VIX and NIFTY Index

Arup Halder, Chandra Prakash Tiwari

(PGP2, IIM Bangalore)

1 week 1 month 2 months 3 months 6 months

Index Returns Study

The analysis was further extended to analyze the average return of the NIFTY index and VIX index. The analysis is based on the return type (positive or negative) and the magnitude of the return.

Table 1: Correlation between NIFTY and VIX index for various durations

Executive Summary
Introduced in 1993, the VIX index measures the implied volatility in the market using the price levels of the index options. The attractiveness of the VIX stems from the fact that it is negatively correlated with the underlying index, and that it creates a new asset class which bases itself on non directional volatility views. The need for such an asset class which derives itself more on the movement and not on the direction has been made particularly important in light of the high volatility in the markets, coupled with the increasing frequency of financial crises. VIX was introduced in India, on April 2008, and is based on the CBOE methodology. This article tries to highlight the features of VIX that make it an effective financial instrument. The work presented in this article tries to demonstrate the hedging and the forecasting potential that exists when one utilizes the VIX. Furthermore, one trading strategy is demonstrated which uses the India VIX to make trading calls for the underlying NIFTY index.

The correlation is very high in short term (1 week to 3 months), however in long term the negative correlation goes down as the VIX is a range bound index while the stock index may go significantly up or down in long term. The following graph depicts the inverse movement relation between the VIX and the underlying price index.

Negative return:
The return of VIX index was observed on the days at which the NIFTY index has given negative returns. The analysis was done for the days with less than -1%, -2%, -3% and -4% returns. The period chosen for the analysis of the data was November 1, 2007 to July 31, 2008. It was observed that the number of days on which NIFTY has given less than -1% return is 59 and the average return on these days is -2.64%. Out of these 59 days, the VIX index gave positive returns on 50 days. The average return on VIX index for these 59 days (when the NIFTY index was up 1%) was 3.75%. This shows that VIX offsets the negative returns of the underlying index. The similar exercise was carried out for the days at which NIFTY gave returns of -2%, -3% and -4% respectively and the results are shown in Table 3. It can be seen that as the average return on NIFTY decreases, the return on VIX index increases. Return <-1% <-2% <-3% <-4% No of days 59 33 19 11 Ret - NIFTY -2.64 -3.60 -4.42 -5.14 Ret - VIX 3.75 6.20 8.04 12.26

Introduction
The Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by stock index option prices. Since its introduction in 1993 by CBOE, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility. It has quickly become the benchmark for stock market volatility. The VIX index is also known as fear and greed index in the market. VIX is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility. During periods of financial stress, which are often

accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. In India, VIX was launched in April, 2008 by National stock exchange (NSE). The VIX index of India is based on the Nifty 50 Index Option prices. The methodology of calculating the VIX index is same as that for CBOE VIX index. The current focus on the VIX is due to its inherent property of negative correlation with the underlying price index, and its usefulness for predicting the direction of the price index.

Figure 2: NIFTY and VIX movement from November, 2007 to July, 2008 A further analysis of the daily returns of the index and VIX was done and the correlation between the two was observed. The correlation of daily returns of NIFTY and VIX varies from -0.4 to -0.8 depending upon the period in which the analysis is being done. The correlation is obvious, but magnitude is not a certainty. This analysis was further extended to find out the monthly returns of the index and VIX

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Return >1% >2% >3% >4%

No of days 52 25 12 8

Ret - NIFTY 2.48 3.55 4.83 5.45

Ret - VIX -2.27 -3.32 0.21 -0.09

VIX as a trading instrument

Apart from its effectiveness as a hedging strategy, the VIX can also be used as a tool to predict short term movements of the underlying price index and make appropriate trading calls. We attempt to derive a strategy which utilizes some quantitative indicators and generate buy/sell signals on the price index.

Trading Window: 10 days Threshold Value Average Strategy Return "Long only" Index Return Trading Signals

40 60 80 100 120

1.99% 2.25% 2.84% 3.30% 3.38%

-1.38% -1.38% -1.38% -1.38% -1.38%

46.33% 41.21% 33.90% 24.86% 17.51%

The below graphs show us the working of this strategy, the strategy tends to capture the positive returns with long trading signals and the negative returns with short trading signals. The plot is shown for the 30 day and the 60 day trading window.

Table 3. Average Daily Returns of NIFTY and VIX index The negative NIFTY returns and corresponding VIX returns are shown in Figure 5.

Spearman Rank Correlation Coefficient Based Trading Strategy

The Spearman rank correlation coefficient describes the strength of a link between two sets of data. It is a measure of the strength of the associations between two variables, and it provides a measure of how closely two sets of rankings agree with each other. The correlation is not measured on the actual observed data, but on the ranks of the data within the series. In other words, the series 546, 500, 654, 300 would become 3, 2, 4, 1 before the correlation coefficient were calculated. This can provide a better indicator that a relationship exists between two variables, particularly when the relationship is non-linear. The above ranking methodology is applied to the VIX and the NIFTY index, and the difference of the ranks is taken to identify the points when there is significant difference or convergence between the two sets, this difference in rank score give us the appropriate trading call.

Trading Window: 20 days Threshold Value Average Strategy Return "Long only" Index Return Trading Signals

40 60 80 100 120

0.21% 1.46% 1.38% 2.68% 4.47%

-8.79% -8.79% -8.79% -8.79% -8.79%

46.33% 41.21% 33.90% 24.86% 17.51%

Figure 9 : 30 day return split

Trading Window: 30 days Threshold Value Average Strategy Return "Long only" Index Return Trading Signals

40 60 80 100 120

7.60% 8.09% 9.15% 9.96% 10.53%

-5.68% -5.68% -5.68% -5.68% -5.68%

46.50% 42.68% 35.67% 26.11% 19.11% Figure 10: 60 day return split

Figure 5: Average Daily Returns of NIFTY and VIX index for negative NIFTY returns

Positive returns:
The result for the positive NIFTY returns is shown in Figure 6. It can be seen that the VIX is a good hedge when the returns are not very high on a particular day. However, if the NIFTY returns are very high on a particular day, VIX has also given positive return or only slightly negative return. Figure 8: Spearman Rank Difference and NIFTY plot Our trading strategy was to generate a sell signal whenever the rank difference was rising from the previous value and was above a given threshold value, and to generate a buy signal whenever the present rank different was below a threshold given value. The basic idea behind the strategy is the rank difference predicts whether the underlying index will go up or down, and based on this prediction a long or short signal is generated. Figure 6: Average Daily Returns of NIFTY and VIX index for negative NIFTY returns Thus we observe that the VIX is a very good but a biased hedging instrument. On most of the days, correlation of the returns is negative, however, when the markets move up significantly, VIX may show positive correlation with the market. In a way, this hedge is better than the other market neutral hedging schemes as VIX will limit the downside but wouldn't offset the gains if the markets move up significantly.

Trading Window: 60 days Threshold Value Average Strategy Return "Long only" Index Return Trading Signals

From the above, we see the effectiveness of the strategy to capture the positive and negative turns in the market, and appropriately go long and short on the index. Further modifications to this trading strategy may be in the form of using the above in conjunction with delta one (index following) strategies, various forms are listed below: Pure Delta One: In case of no trading signal, invest in market. However if there is a trading signal is generated then follow that signal. Accelerated Delta One: In case of no trading signal, invest in market. However if a buy signal is generated, double the exposure on the underlying index to accelerate the returns (going by the signal that the index is going to rise).

40 60 80 100 120

6.42% 6.79% 7.26% 10.49% 12.77%

-11.54% -11.54% -11.54% -11.54% -11.54%

45.67% 43.31% 35.67% 26.77% 21.26%

Results
The following table captures the average trading return that we made; we calculate this figure for various threshold values (used for generating the trading calls). We compare this trading return for the average return for a "long only" on the index for the same trading window. We also give the number of trading signals generated as a percentage of the data points. The results are shown for various trading window lengths.

from our back testing results, we observe that the trading call based strategy outscores the "Long only" Index strategy in all the trading window/threshold value combinations when compared to an average return value. The general observation that the VIX is more meaningful for longer term volatility indications (more than a month) are strengthened further in this case, wherein the out performance of our rank based strategy is more when the trading window is increased (from a week to a 60 day period). There are certain trade-offs involved in this strategy, the most important of them being the number of trading calls generated, as we increase the threshold we tend to increase the average return, however the number of trading calls decrease significantly which again tends to depress the overall return. Thus, it is necessary to strike a balance between a high threshold value and the number of trading calls.

Volatility Trading
VIX options are an excellent tool for traders who want to take a position on expected implied volatility. Just like traditional stock options, they can be traded during normal stock market hours through a securities broker. The features of volatility trading are that they are non directional in nature, and that the view taken by a trader is that whether the underlying asset will be more volatile in the future or not. The traditional way to implement such a view without incurring directional risks would be to use non-vanilla options like straddles, strangles or through variance swaps. However, with the introduction of VIX derivatives, such views can be simply implemented, with the advantage of having a standardized implied volatility calculation. Furthermore, such index based VIX derivatives, would enable implementation of complex strategies like volatility arbitrage.

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Concluding Remarks
Modeling of financial markets volatility is one of the most significant issues of recent times. Accurate quantification and forecast of volatility are of immense importance in risk management. The current credit crisis has further emphasized the importance of accurate modeling and forecasting of volatility. In Indian context, the introduction of VIX has helped the traders gauge market sentiments and many traders are already using VIX values for the trading calls. The introduction of trading in VIX index will enable active management of risks that are un-hedgeable nowadays it. The regulator will allow the trading in index as well when the market participants will become comfortable with the index. We believe that the developed instruments like VIX will significantly contribute to the development of the emerging markets like India in the course of time. The authors would like to sincerely thank Professor Sankarshan Basu whose guidance and direction was integral to the research findings.

Sub-Prime Crisis - Are We Done Now? A $5.2 Trillion Question

Ashish Kumar
(SPJIMR, Mumbai)

Executive Summary
The global financial markets have been rocked subsequently by two major crisis - the ubiquitous sub-prime crisis in the US and the commodity boom that followed it which saw crude oil jump to as high as $147 a barrel. While commodity prices may have started tapering off, the aftermath of sub prime seems still not done. The present crisis lurks around the two US housing secondary market giants - Fannie Mae and Freddie Mac - who seem to be facing trouble with regard to mortgage write downs, derivative losses and lack of liquidity. The current situation with the duo puts the whole US housing finance industry in a vicious circle. And it seems the Fed and Treasury will have to come together for a bailout just like in the Bear Stearns case. The article discusses the secondary housing market in US and the recent trouble surrounding the two 'agencies' in supporting the feeble housing market. The ironical theme that comes out of the analysis is that the idea that 'the business of the government is not to do business' is turned topsy turvy in the greatest champion of laissez faire -US

Sub-prime crisis - are we done now? A $5.2 trillion question

Everything seemed to be sailing smooth for the world economy at large before August 2007 last year when the tremors of the sub-prime crisis shook the roots of the US financial market exposing its vulnerability. All major US financial institutions have been forced to write down billions of dollars of assets to reflect the falling value of the Mortgage Backed Securities (MBS) due to falling home prices. Till date more than $500 bn of asset write downs have taken place significantly eroding the capital base of the financial institutions thereby necessitating the need to shore up capital. It is here that the Sovereign Wealth Funds (SWF) has infused equity into these financial institutions. These SWFs

from China & Middle East are going to play a very significant role in reviving the world financial markets in the US. One can foresee the inevitability of dominance of the Middle East countries spreading to financial markets as well. As if the sub prime was not enough to shake up the whole system, the commodity boom began to overshadow the sub prime crisis. Crude oil prices shot up to $147/barrel and most other commodity prices including steel, food crops, etc were on a free run.

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Notwithstanding the growing demand from emerging economies like India and China and disruption in supply from some oil exporting countries like Nigeria, speculation was rife on the role of the financial traders of US to have speculated the oil prices in the futures market (to make up for losses on sub-prime). The secondary effect of increase in oil prices seems to now result in demand destruction. There is general slowdown in the global economy with US and Europe turning bad and the realization of the fact the China and India might not be enough to offset a probable contraction in the developed countries. Despite Russia's assault on Georgia and possibility of Hurricane Gustav halting refineries in US, crude oil have fallen significantly off its earlier peaks to about $105/barrel.

Role of Freddie Mac and Fannie Mae

Both Fannie and Freddie are giants in the US secondary mortgage market. They function in two primary ways: 1) They would buy the loans from these originators, repackage them as MBS which is backed by the mortgage and sell it to other investors like hedge funds. They in turn would guarantee the payment of the loans in the event the borrower defaults. In exchange, they receive guarantee payments from investors. 2) They would themselves buy the MBS issued by other banks. They thus retain ownership of the mortgage loans issued by originators.

How they made money?

Given the fact that the two giants were Government Sponsored Enterprises, it was reason enough for lenders to believe the US government would not allow them to collapse. Although officially the debt issued by them is not backed by US government, yet no one believed it. As such it was easy for them to borrow money at the rating of AAA. By raising money at much lower cost, they earned a larger spread by investing the money in mortgages. As the Economist suggests, had they been hedge funds, this strategy would have been called 'carry trade'.

Given the gearing in the businesses, things only need to go slightly wrong for there to be a big problem. Freddie lost $3.5 billion in 2007; Fannie reported a $2.2 billion loss in the first quarter 2008, having lost $2.05 billion last year. Each had credit-related write-downs of between $5 billion and $6 billion last year. On a fair-value basis, which assumes that all assets and liabilities are realized immediately, Freddie had negative net worth of $5.2 billion at the end of the first quarter 2008. (refer the income statement below)

Pain points
One thing is very clear. The entire sub prime crisis had busted the 'illusion' amongst investors that the US housing prices could never come down. In fact, the way the housing finance industry in the US was organized (backed by the secondary market), it only lent credence to the above illusion. But with rising interest rates and sub prime borrowers defaulting, the entire system collapsed like a pack of cards. The real issue with both Freddie Mac and Fannie Mae seems to be their high leverage and low liquidity. As discussed earlier their GSE status enabled them to raise a lot of cheap debt. With a combined core equity capital of around $84 billion (only), they support mortgage debt and guarantees worth $5.2 trillion - leverage stands at more than 60 times!!! According to the research group, CreditSights, the two of them were counter parties in derivatives transaction worth $2.3 trillion related to their hedging activities. The hedging activities have been mainly on account of reinvestment risk i.e. if the borrowers paid back early and interest rates were to fall, there was this risk of reinvesting at lower returns. Initially, the duo guaranteed mortgages which were of the highest quality. However in the late 1990s they started buying the MBS issued by some other banks as well which were not of high quality. As a result, they started venturing into subprime assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007 it had $267 billion. Fannie's outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. It is true that compared to some larger US banks, the write downs for the duo has not been quite as large (see below). But the leverage is so high, that it necessitates the shoring up of capital base even with smaller write downs. In essence, the equity cushion is so small, that the leverage magnifies the whole problem.

Features
While commodity boom seems to be reeling under its own weight and prices of most commodities having started to decline, the question left unanswered is if we are done with the sub-prime crisis. In this run up to commodity boom, attention seems to have shifted away from the after effects of the financial disaster. But the pains from sub-prime crisis are definitely not done. The answer to this $5.2 trillion probably has to be answered by Henry Paulson. The latest buzz in the financial markets seem to be the troubling times faced by the two US Government Sponsored Enterprises in the 'secondary mortgage markets' viz Fannie Mae and Freddie Mac. We explore below the secondary mortgage market in US, the role of these two housing giants, their financial problems and its possible effect on the health of financial markets and possible solutions mooted by the US government and Federal Reserve in protecting the two of them from possible collapse. The most common form of MBSs are those guaranteed by the two housing-related GSEs. They are also known as 'agencies' and hence the market for loan guaranteed by them is also called 'agency market'. The following figure shows the increasing importance of agency guarantee for mortgage funding:

Evolution of mortgage funding

Secondary Mortgage Market

The secondary mortgage market is a secondary market for the 'originators' of mortgage (housing) loans to sell their loans to third parties so as to free up their capital. Say a bank X (originator) has granted a housing loan to a customer. Now bank X can fund the housing loan by itself through out the tenor of the loan or it can sell this loan to another investor. The latter option represents the secondary market in mortgage loans. Clearly, it can be seen that the secondary market for mortgages helps the originators of loans to not only free up their money tied in loans but also makes its possible for them to further lend money for more loans. As such the secondary market provides the much needed liquidity for the flourishing of the mortgage market which in turn helps to drive the house prices.

Source: FFA, a paper written by Andreas Lehnert The importance of the two companies to the housing market can be gauged from the fact that they either guarantee or own nearly half of US mortgages outstanding - a whopping $5.2 trillion. The fact they are GSEs further lends credibility to their ability to guarantee housing loans and which in turn helps to support the entire housing market. The importance of such secondary market institutions in US mortgage industry cannot be more overemphasized.

Source: Figures from official website of Fannie Mae and Freddie Mac

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The only way there can be some stability in the market is that they continue their activities. For them to continue activities, they will need to raise more capital. With falling stock prices (see above), it seems impossible that they would be able to raise equity from the capital markets. However, though surprising, Freddie Mac was able to raise short term finance on July 14th of about $3 bn, thereby offering some comfort on the liquidity side. However, that in no way helps to bring down the leverage.

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What more they are faced with write downs at a time when the US housing industry needs them the most. With the two secondary housing market giants in trouble, it seems that the US housing finance industry is caught in a vicious circle. Consider this. For the US housing market to stabilize, there has to be financing available in these difficult times of credit crunch. Other investors seem to have shunned the mortgage backed securities completely with the inventories of houses rising and home prices falling. Now, if because of erosion of capital and subsequent capital adequacy issues, both Fannie Mae and Freddie Mac were to stop guaranteeing the mortgages, no bank would be willing to lend money for mortgages. The two remain the only place where lenders can sell mortgages. If this source of liquidity also dries up, it will further exacerbate the housing prices which mean more write downs and greater liquidity drying up thereby completing the vicious circle. The problem of liquidity relates to the two companies debt maturing. As of mid August, the two companies have $223 bn of loans to be repaid. The following figures show the reaction of stock market to the two giant's stock and the erosion of market capitalization of the two giants.

Understanding the movements in Crude Oil Prices

US Treasury and Federal Reserve in action

Both US Treasury and Federal Reserve have been quick to identify the lurking problem with the two biggies because of their leverage and possible liquidity crunch. One option before the authorities seems to be 'nationalization' of the two entities which would mean that shareholders get nothing and the US government essentially backing $5.2 trillion of loans and guarantees of the duo. Former Federal Reserve chairman Alan Greenspan is in favour of nationalization, recapitalization and splitting up of the two giants to be sold to private players. However, this will only increase the already high fiscal burden of the US government. Although these mortgages are backed by a collateral - the house itself - what good is the collateral when it itself is falling in value. The other option being explored is the US government injecting equity into the two entities in the form of preferred shares to shore up the equity capital of the two. This option would also be fair to the tax payers as well.

Mehul Agrawal, Shubham Singal

(IIM Calcutta)

Introduction Closing Thoughts

For now, US Treasury secretary, Henry Paulson, fearing the worst has already claimed from the US Congress the authority to inject funds to the two entities apparently to calm the markets. Whatever be the future course of action, it is very evident that the US authorities can ill afford to let the two housing giants collapse for that would mean the unthinkable in the US housing market. Logically then, they will not collapse! (Indeed the US government has decided to invest in the duo's senior preferred shares as reported in the newspapers on September 8, 2008).

The rally in the commodity markets in the past few years has brought a lot of attention towards it. Even with the equity markets going for a drop, the commodity markets have been going strong over the past year. This has further strengthened the belief that speculators are present and dominating the commodity markets. The commodity where such changes have been the most visible is definitely Crude Oil. We have seen crude oil prices going from 18$ a barrel in 2002 to 120$ a barrel in 2008. Moreover the prices have been extremely volatile during this period. A similar trend is visible in almost

all the commodities including metals, energy and now agriculture. In this article we try to examine two issues with respect to the commodity market movements. We discuss the role of speculators and also the physical participation by financial players. Both these issues are extremely pertinent to the current discussion present in India which is whether commodity futures markets should be allowed or not. The following two charts show the trend of crude oil prices over these years and help us compare how the prices have suddenly boomed in the last 5-6 years.

References:
1) The Economist (July 17, 2008) 2) The Wall Street Journal (September 2, 2008) 3) An article published on US secondary housing market by Andreas Lehnert.

Source: The Economist, 17th July, 2008

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The chief reasons behind these trend movements & volatility in crude oil prices are Increasing demand from emerging countries Supply constraints Devaluation of Dollar Increase in Oil Reserves
1. Increasing Demand from emerging countries- Increasing demand from non-OECD countries like China & India whereas global oil production has stagnated. This increase in demand is a result of the economic growth, population growth and improvement in the standards of living of people across nations. 2. Supply Constraints- Limited supply of oil from Non-OPEC sources and also failure to increase capacity any further by OPEC have both resulted in a supply stagnation for crude oil. 3. Devaluation of Dollar - The US$ has been declining since 2002 - first against the OECD countries and then against the developing nations too. Since the world prices of Oil is denominated in US$, its depreciation is effectively raising prices of the same. 4. Oil Reserves - Increase in National Oil Strategic Reserves due to instability in Middle East and also such reserves are not reported due to security reasons 5. Geopolitical Tensions - There has also been an increase in the geopolitical tensions across the globe. Militant Attack & Strikes in Nigeria and also continuous tension in Iraq are putting an upward pressure on prices. Iran's nuclear ambitions and hostilities in Turkey are also contributing to the same problem 6. Participation by Financial Institutions - Increased participation by financial bodies due to poor performance of equity markets has resulted in increased activity in commodity space over the past few years. 7. Natural Calamities - Natural events are also responsible for the volatility in oil prices. For eg. Hurricane in US in the oil producing areas. 8. Speculation - Interplay of Speculative forces resulting in a mismatch between demand and supply. out of the factors listed above, two factors deserve a bit more attention in the current market scenario - Participation by financial institutions and Speculation in the Oil market. Let us look at the role of these two factors in a broader way.

Increase in Geo-political tensions Participation by Financial Institutions Natural Calamities Speculation

He tried to show with this example that it is the growing demand from emerging countries and not speculation which is driving up prices of commodities like oil. However a flaw in this argument is that iron-ore prices are dependent upon mining costs and shipping costs, both of which are linked to fuel prices. As a result it is the hike in fuel prices which is indirectly resulting in increase in these costs thereby causing a rise in iron-ore prices too. Also earnings in bulk ship freights are often index linked as the prices are determined daily looking at the futures prices. This again means that if futures prices are going up, they would be strongly reflected in the spot prices for such commodities as well. So we see the existence of speculators in the market in three forms. The first form is where the speculators perform the service of a messenger by delivering the news that the rise in demand in future will raise the prices. This is helpful as the right price signal helps to prevent a future mismatch between demand and supply, because otherwise the price would have risen even more due to shortfall in supply. The second form is where the speculators perform the role of stabilizers in cases where prices are peaking out. Speculators begin to short sell in anticipation in such cases which again helps in reduction of volatility and a smoother transition of prices. The third form is where speculators carry on the bandwagon behavior by simply extrapolating past trends. These selfconfirming expectations often result into a bubble as prices are raised above the equilibrium level. Perhaps this is the form which is destabilizing in nature and harmful for the economy. However, there seems to exist little proof that the current run in prices is being caused as a result of this behavior of the speculators. [3]

Participation by Financial Institutions

One of the main arguments in favor of futures market is that financial participants are able to participate only in the paper market. The participation in physical market of commodities requires large storage & operational facilities and hence the financial participants are unable to take part in it. Thus the financial participants are not able to do any physical hoarding and can only perform virtual hoarding which should not affect the price of commodities.

Role of Speculation in Price Volatility

Perhaps we would now like to stress a bit more upon Speculation in Oil market and its impact on price volatility. There has been a lot of discussion on the possible role of speculators in the recent run-up of prices across commodity sectors. We have seen various economists debating the issue concerning involvement of speculators in this price rise. Michael Masters in his article [1] has held the "Index Speculators" responsible for the price hike stating their participation in commodity futures as the factor which has driven the demand up along with the spot prices. These set of people carry the belief that buying futures contract is equivalent to burning the commodity (eg. oil). Masters has defined "Index Speculators" as a different class compared to Traditional Speculators. According to him Index speculators never sell and are involved in buying futures contract and rolling positions forward through calendar spread. Therefore they cause virtual hoarding of oil and thereby consume liquidity from the oil market. In fact the increase in demand from Index speculators is nearly equivalent to the increase in demand of China. [1] On the other hand, economists like Paul Krugman are totally against the idea of holding speculators responsible for all this. They believe that each long futures contract is balanced by another short futures contract which effectively neutralizes the demand-supply equation. Therefore it cannot lead to increase in virtual demand only as there is always a counter creation of virtual supply as well. Rather they help in stabilizing the prices and smoothing the price change through the increased demand today. So the logic that buying a futures contract by a speculator leads to increase in prices today is not correct. However they indirectly might raise prices by encouraging the producers to hoard supply instead of selling it off today. [2] Krugman also took up the example of Iron-Ore, which is a commodity not traded on any global exchange and yet has a price increase similar to oil over the past year.

Commodity Indices against Equity Markets The pictures above depict the performance of GSCI (Goldman Sachs Commodity Index) in comparison with the S&P 500 in 1990 when Iraq invaded Kuwait and in 1987 during the stock market crash. The visible trend is how the commodity markets performed well while the equity markets faltered. [4] A similar situation is represented in the graph below comparing GSCI with the S&P 500 during 2007-08. As we can see the commodity markets have again fared much better in comparison to the equity markets [5]. Arguments like above have increased the participation of financial institutions manifold in the commodity markets. A simple statistic is that pension funds held around $10 billion investment in commodities in 2000 and today they hold well over $250 billion. The hedge funds are not far behind and although much of the data is not available about them still it is known that 5% of hedge fund business is from the energy commodity market with about $60 billion in assets [6].

Messenger Stabilizer Destabilizer

Role of Speculators

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Islamic Financial Products: Road Ahead In India

Sneh Jain, Aarti Nihalani

The result of such widespread investment in the commodity markets has led to financial institutions also becoming physical players in these markets. The leaders in the financial markets, investment banks like Morgan Stanley, Goldman Sachs, UBS, JP Morgan, & Lehman Brothers have started trading commodities in physical form as well. Thus the concept of virtual hoarding no longer applies to the commodity markets. The investment banks have given statements regarding their physical trading activities on their websites which have been included in the exhibits. Morgan Stanley is one of the leading banks in the business of commodities. The bank has an increased presence in the physical market having more than 50 vessels for storing and transporting crude oil. It has also started providing crude oil to INEOS refining and marketing their refined products globally [7][8]. JP Morgan also has developed large physical capacity in the field of energy and offer power supply and risk management services to large clients in North America. J.P. Morgan is also an active participant in liquid physical and financial power markets in Germany, France & UK. They also claim expertise in moving electricity across most European countries through their sophisticated operations platform [9]. Morgan Stanley has already acquired 4 power plants increasing its presence in the physical markets of energy [8]. UBS commodity services page actually states its objective as 'Bringing the physical and financial markets together' [10]. They claim to offer better service to their customers by having more physical presence and providing better risk management and competitive prices. The full text is available in the exhibits. Even Barclays is aiming a foray into the physical oil market according to the Forbes magazine [7]. hike. A lot of other factors have been left unattended and they are the ones responsible for majority of the price increase. It is therefore very unlikely that this will turn out to be a bubble which bursts and brings down the prices to the old levels of 50-60$.

(PGP2, IIM Ahmedabad)

References:
1. Testimony of Michael W. Masters before the Committee on Homeland Security and Governmental Affairs, United States Senate 2. Fuels on the Hill, Article by Paul Krugman, New York Times, June 25th, 2008. 3.http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/20 08/07/25/commodity-prices-again-are-speculators-to-blame/ 4.http://www.pimco.com/LeftNav/Bond+Basics/2006/Commod ities+Basics.htm 5. http://finance.google.com 6.http://www.iht.com/articles/2006/04/30/business/web.0430oi l.php?page=3 7.http://www.forbes.com/reuters/feeds/reuters/2008/08/ 05/2008-08-05T124540Z_01_SP185585_RTRIDST_0_MORGAN STANLEY-OIL.html 8. Morgan Stanley Publication, Commodity Capabilities, March 2008 9.http://www.jpmorgan.com/pages/jpmorgan/investbk/solutio ns/commodities/energy 10.http://www.ubs.com/1/e/canada/about/commodities/comm group.html#markets Islamic finance is emerging in many parts of the world as an alternative financing concept to the conventional orthodoxy of paying interest on borrowings and deposits. The growing preference for Shariah compliant financial instruments is all the more meaningful with the spread of the industry into newer markets. Islamic banking has grown faster than conventional banking in the past decade, and is set to expand even more rapidly, making the industry one of the most dynamic in international finance. Competition is thus heating up amongst the world's financial centers to attract Islamic issuers and investors. With a Muslim population of about 160 million and a blazing economy, India is emerging as a natural choice for Islamic investors. This paper aims at understanding the fundamental tenets of Islamic finance, tracking its growth at the global level and analyzing its potential in India.

The Core Principles

An investing approach based on "Shariah" or Islamic law, Islamic finance essentially abides by five core rules: The ban on interest (riba): No financial transaction should be based on the payment or receipt of interest. Profit from the trading of debts is seen to be unethical. Instead, the investor and investee should share in the risks and profits generated from a venture, asset or project. The ban on uncertainty (gharar): Uncertainty in the terms of a financial contract is considered unlawful, but not risk per se. Consequently, speculation (maysir) is forbidden and financial derivatives are unacceptable under Shariahcompliant finance.

The ban on unlawful (haram) assets: No financial transaction should be directed towards economic sectors considered unlawful as per the Shariah, such as arms dealing, tobacco, or gambling industries, as well as all enterprises for which financial leverage (indebtedness) would be deemed excessive (including conventional banks). The profit-and-loss sharing (PLS) obligation: Parties to a financial contract should share in the risks and rewards derived from such financing or investment transaction. The asset-backing obligation: Any financial transaction should be based on a tangible underlying asset

Conclusion
Given these factors, crude oil prices can be expected to be volatile for a longer period of time. Also we need to get out of the notion that speculation is the only reason behind this price

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Islamic Financial Products

Islamic financial services are carried out by Islamic banks and conventional banks, through so-called Islamic windows. Islamic finance currently mostly offers basic products and services but is developing quickly, with some forays into project finance and securitization. Some of the prominent products available currently are: Sukuk: Shariah-compliant financial instruments that can be compared to conventional notes. Of the many categories of sukuk, the most common in the market are "ijara" sukuk, which are backed by leases and often guaranteed by sovereign or regional governments. Takaful: Shariah-compliant system of insurance based on the principle of mutual support. Mudaraba: form of contract in which one party brings capital and the other (the mudarib) personal effort. A mudaraba is typically conducted between an Islamic financial institution as mudarib and investment account holders as providers of funds.

Islamic banks in the Gulf have focused on the retail segment, as individual customers are more sensitive to religious arguments than corporate clients. Shariah-compliant investment banks are also emerging, mainly in the Gulf Cooperation Council (GCC) countries. These banks have no retail customers and refinance themselves chiefly through the interbank market or by issuing sukuk. Retail banking services and issuance of sukuk, have been and will continue to be frontrunners in the global Islamic finance boom. Moreover, given that most GCC currencies will continue to be pegged to the US dollar in 2008, and due to inflationary pressures and the need to create a benchmark against which to value corporate sukuk, a number of GCC governments might be considering issuing sukuk. Islamic real estate investment trusts (IREITs), both in Asia-Pacific and the GCC, are expected to reach new record issuance in 2008. In terms of Shariah-compliant insurance, the Takaful industry is expected to grow by about 13% per annum until 2015.

There is acute awareness of Islamic financial products, plus India's Muslim community has a high savings track record of more than INR40 billion (US$932.18 million) a year. The external supply such as the investment opportunities in other Muslim countries is limited. Moreover, restrictions imposed on money flows from Muslim states in developed countries have led investors seeking to invest in Shariah compliant funds to look for opportunities in emerging economies like India. India, as an Islamic financial center, has a number of competitive advantages compared with its emerging-market counterparts. Among those are: Large size and international reach; Deep, efficient markets, where investors can switch from one asset class to another (including in and out of sukuk); Liquidity in the secondary market; Legal framework, which protects foreign investments; and Tremendous human resources and expertise (including research, analysis and structuring)

shows that the number of companies complying with Shariah principles has steadily grown from merely 95 in March 2002 to 257 in December 2007.

Current Scenario:
In spite of the bright potential, the number of organizations offering Islamic finance in India is still small, primarily due to current regulatory constraints. As of now, the RBI does not have separate Islamic banking rules. Islamic financial institutions facilitate investments in companies which operate in areas that do not violate key Islamic tenets. As Islamic banking is limited to only a handful of companies, the total Islamic banking deposits is estimated at US$17.31 million (INR750 million) compared to US$0.755 trillion (INR32.7 trillion) total deposits in the banking system. Currently, the two leading players are Parsoli Corporation and Idafa Investments. The past 18 months have seen rising interest in Islamic products, particularly in asset management. While SBI Mutual Fund has already introduced a Shariah compliant offshore Resurgent India Opportunities Fund, UTI Mutual Fund has an offshore Shariah compliant fund and plans to start a domestic counterpart. Tata Asset Management has a Shariah compliant mutual fund and Taurus Asset Management is expected to introduce an Islamic fund in association with Parsoli.

Expansion of Islamic Finance

The demand for Shariah-compliant investments and loans began to take off in the early 1990s. This fresh interest was sparked by a new geopolitical backdrop in the Gulf and abundant liquidity flows from the recycling of oil dollars in the region's economies. Today, demand rather than supply is driving the development of Islamic products. Moody's reports state that the Islamic finance market has grown by approximately 15% in each of the past three years. Islamic finance is estimated to be worth around USD700 billion globally. By 2007, outstanding global sukuk volumes had reached USD97.3 billion.

Shariah compliant stocks in India: To gauge the scope of Islamic investment opportunities in the Indian stock markets, it is imperative to examine stocks which conform to the norms stipulated by the Shariah principles. A detailed study was conducted by Dr Shariq Nisar, an eminent personality in Islamic finance in India. NSE: Of the 1,331 companies listed on the NSE, 405 companies are qualified on Shariah parameters. The market capitalization of the qualifying stocks was 61% of the total market capitalization of the NSE. Surprisingly, the growth in market capitalization of Shariah compliant stocks was found to be more impressive than the growth of non-Shariah compliant stocks. Moreover, even though the number of Shariah compliant stocks was limited, the share of market capitalization of these Shariah compliant stocks never went below 50% of the total market capitalization. The current share of Shariah compliant market capitalization in India is higher than that of most of the Muslim countries such as Malaysia, Pakistan and Bahrain. BSE: Research of Shariah compliant stocks on the BSE 500 Index

India - An Islamic Finance Centre

Today, India is one of the fastest growing economies and an exciting investment destination. The world's economic center of gravity is gradually shifting from the established economies to the emerging economies including India. The share of the US in the world's GDP is expected to fall (from 21% to 18%) and that of India to rise (from 6% to 11%) by 2025. The transformation into a tripolar economy will be completed by 2035, with the Indian economy only a little smaller than the US economy but larger than that of Western Europe. The scope for Islamic investments in India has widened mainly due to two reasons: internal demand and the external supply. The internal demand is due to the huge Muslim population in the country which is at 150-160 million (India is the second largest Muslim populated country in the world).

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Challenges:
Islamic financial service providers in India face challenges, some relating to their own capabilities and some to the market as a whole. Overcoming these challenges must be a priority for those aiming to capitalize on the opportunities in this sector. External challenges to be overcome are: Islamic retail products have traditionally been expensive. Consumers lack knowledge about products that are Shariah compliant. There is a shortage of liquidity in some products. Internal challenges to be overcome are: These products are inherently complex, raising concerns about risk management. Rigid yet unclear rules: while institutions have no latitude in implementing the strictures of their religious advisors, the advice itself is not necessarily consistent between advisors. Shariah compliance itself remains a thorny issue subject to individual interpretation. Islamic financial institutions will also face additional regulatory challenges, not only around Basel II but also the capital requirements mandated by the Financial Services Board of thecountry.

Early lead in worldwide trends

India is well placed to gain an early lead into developing trends in Islamic finance. For example: Many new IREITs are expected to have assets in Asian jurisdictions, such as China or India, where the real estate markets are booming and where IREITs are not yet in existence. Also, the takaful industry is set to witness a phase of rapid growth worldwide.

The industry has already spread its wings beyond the Muslim world and is attracting investors looking to broaden their horizons. But the real journey has just begun. All economic and demographic indicators place India at the pole position of the Islamic finance race. However, a concerted effort by the government, industry, experts and investors would be required to avoid any speed breakers and ensure a smooth ride for all the stakeholders.

Howladar K. and Hassoune A., "Islamic Finance: Glossary of Usual Terms and Core Principles", Moody's Global Credit Research, June 2008. Retrieved July 12, 2008 from www.moodys.com Nisar S., "Islamic Investments Opportunities in India". Retrieved July 16, 2008 from http://www.financeinislam.com/article/7/1/543 Ramachander S., "Islamic finance: What it is, and how it works", The Hindu Business Line, December 3, 2007. Retrieved July 12, 2008 from http://www.thehindubusinessline.com/manager/2007/12/03/s tories/2007120350351000.htm "Islamic Finance Matures And Expands", Standard and Poor's research, November 14, 2006.Retrieved July 14, 2008 from www.ratingsdirect.com "India: Boom Time Ahead For Islamic Finance", Islamic Finance news, Volume5 Issue26, July 4, 2008. Retrieved July 13, 2008 from http://www.islamicfinancenews.com/ "Islamic Finance: From Niche to Mainstream", Accenture industry report. Retrieved July 15, 2008 from http://www.accenture.com/Global/Research_and_Insights/By _Industry/Financial_Services/Banking/IslamicMainstream. htm

Sensitization of financial institutions to Shariah

Due to existing norms about minimum capital requirement and minimum number of deposits, the viability of establishment of an Islamic bank is uncertain. Hence a number of alternatives can be proposed to attract Islamic investors to conventional banks. In order to make deposits in current account fully compatible with Shariah, we suggest that deposits mobilized from Muslims in current accounts by a bank should be utilized in making interest-free loans preferably to Muslims and the government. As regards the mobilization of savings for investment on PLS basis, a number of opportunities are available outside the banking sector. Existing public and private mutual funds may also be encouraged to adopt Islamic financial practices.

References:
Ahmed N., "Islamic finance in India: a prospective", Newstrack India report, 28 April 2008. Retrieved July 15, 2008 from http://www.newstrackindia.com/newsdetails/3283 Badshah T., "Scope of Islamic Investments in India", Islamic Finance news, Volume5 Issue26, July 4, 2008. Retrieved July 13, 2008 from http://www.islamicfinancenews.com/ Basu I., "Islamic investors turn to India", Asia Times - South Asia bulletin, June15, 2007. Retrieved July 15, 2008 from http://www.atimes.com/atimes/South_Asia/IF15Df02.html Haq A., "Islamic Finance in India". Retrieved July 14, 2008 from http://www.iosworld.org/islamic_finance_in_india.htm Hassoune A. and Willis K., "Credit FAQ: An Introduction To Islamic Finance", Standard and Poor's research, November 14, 2006. Retrieved July 14, 2008 from www.ratingsdirect.com Hassoune A. and Volland E., "World's Islamic Finance Industry To Get A Boost From U.K.'s Development As A Major Marketplace", Standard and Poor's research, March 21, 2007. Retrieved July 14, 2008 from www.ratingsdirect.com Hassoune A. and Damak M., "Chief Drivers Behind Islamic Finance's Global Expansion", Standard and Poor's research, April 23, 2007. Retrieved July 14, 2008 from www.ratingsdirect.com Hijazi F. and Gribot-Carroz D., "2007 Review and 2008 Outlook: Islamic Finance: Sukuk Take Centre Stage, Other Shariah-Compliant Products Gain Popularity as Demand Increases", Moody's Global Credit Research, February 25, 2008. Retrieved July 12, 2008 from www.moodys.com Hijazi F. and Dr el-Nakla J., "Islamic finance market shows no sign of slowing, with sukuk enjoying phenomenal growth", Moody's Global Credit Research, February 26, 2008. Retrieved July 12, 2008 from www.moodys.com

Role of the Government:

The government can play an important role in promoting the growth of Islamic finance in India. Sovereign sukuks are gaining increasing popularity world over. Suggestions can be made to thegovernment for financing their different projects through Islamic modes under its recent PPP policy. Various government projects can be financed through Musharaka, Murabaha, Ijarah modes in a win-win situation. Crop loan to farmers and purchase of farm products at minimum support price (MSP) can also be made through Salam.

The Way Ahead:

The Islamic finance industry is at a nascent stage in India and there is tremendous scope for proactive intervention and conscious policy decisions that would work towards developing India as a hub for the industry.

Regulatory framework:
To encourage Islamic financial systems, involvement of Islamic finance experts, investors, fund managers, banks, farmers, industrialists and specialized projectfinancing institutions seems to be inevitable. Wide discussions among allthe prospective parties with respect to efficient fund deployment to exploit all the opportunities should be held before submitting a concrete proposal to the government for establishment and development of Islamic financial system.

Innovation
All over the world, product diversification through innovation is critical to rival product offerings at conventional banks. On the deposit side, profit-sharing investment accounts (PSIAs) can be designed to offer depositors the right to share in Islamic banks' profits (and losses), which appear an attractive alternative for customers compared to fixed-rate conventional deposits, at a time when Islamic banks are more profitable than ever. As far as asset management is concerned, Islamic financial institutions must replicate in a Shariah-compliant manner a number of money market, equity, real estate, private equity and infrastructure funds with comparable risk-return characteristics.

Conclusion:
Islamic finance is a great success story in the making. Emerging modestly from a small town of Egypt, less than four decades ago, Islamic finance has reached critical mass.

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Adoption of BASEL II Norms

Are the Indian banks ready?
Parv Bansal, Sharmili Phulgirkar
(PGP II, IIM Bangalore) parvb07@iimb.ernet.in, phulgirkars07@iimb.ernet.in

Second Pillar (Supervisory Review) Only capital adequacy requirements don't protect the banks from all risks, in addition they need to employ better risk management practices so as to minimise the risks. Pillar II ensures qualitative supervision by regulators of internal risk control of banks and capital assessment. Third Pillar (Market Discipline) This pillar introduces new public disclosure requirements to ensure market discipline. The potential audiences are the stakeholders in the bank like supervisors, bank's customers, rating agencies, depositors and investors. Market discipline has two important components:

Impact on Spread of Bank Bonds In the Standardized approach of calculating risk weighted assets under the Basel II norms, though the AAA to AA bonds continue to be risk weighted at 20% , the risk weights of the AA- to BBB rated bonds has been increased to 50%. Moreover since bank bonds have historically low default there may arise situations under the advanced IRB approach where subordinated bank debt will be risk weighted at less than 100% Impact On Abcp Conduits In the context of ABCP, only eligible liquidity facility transactions are exempt . The market for securities arbitrage conduits will suffer as the requirement of funding for investment grade assets to qualify as eligible liquidity facility offsets the advantage of less regulatory capital achieved by a low CCF The prohibitive regulatory capital associated with liquidity facilities will see an increase in issuances of extendible note structures which limit use of the third party liquidity along with commercial Papers issued by Structured Investment Vehicles (SIVs) based on the concept of pure market value advance rates and cash flow analyses along with alternative structures as total return swaps Impact on Securitization Markets Basel II norms give banks an incentive of lower capital requirement to hold a portfolio of rated securitized assets rather than holding unrated assets mainly for the middle rated tranches. It is advantageous for banks under Basel II to hold securitized assets rather than keeping an equivalent unsecuritized pool of assets on the balance sheet with an exception to the CDOs and prudence concept gives an incentive to hold a pool of assets compared to the unrated assets

EXECUTIVE SUMMARY
The much delayed migration to Basel II norms is finally happening consequent to the recent credit crisis that hit the world financial markets over a year ago. The aftermath effects continue to mount in size by the day and have seen the fall of some of the most trusted names on the Wall Street. The solution for this as suggested by the academicians and policy makers is implementation of Basel II norms. The Basel II framework is based on a three-pillar structure: minimum capital requirements (Pillar I), the supervisory review process (Pillar II), and market discipline (Pillar III) which are supposed to reduce the possibility of occurrences of credit crisis. This paper divides the impact of implementing Basel II norms on Indian Banks, ABCP conduits and securitization markets. When it comes to banks, with the implementation of Basel II, primary beneficiaries of lower capital requirement will be banks with highly rated loans and securities in their portfolio and Domestic focused banks using Internal Risk Based (IRB) approach. Those who would be hit adversely are banks exposed to large interbank loans to non-OECD banks, high non-OECD/non-investment grade sovereign exposure etc. With such a divided impact, the paper goes on to conclude that despite Basel II being a significant improvement on Basel I, it is not a cure all. It seems a bit too early for Indian Banks to make that transition to Basel II norms purely because of the reason that there is not enough equity capital cushion to accommodate the enhanced capital charges. Though banks will be able to raise the required capital but it will be sometime before this materializes and in the short term banks will face capital crunch.

failed bank are left high and dry (and might even be subject to bank runs of their own), and there is carnage on the stock markets. All this helps to explain why banks are subjected to special regulations. Until recently, these regulations were known as Basel I, drawn up by the Bank of the International Settlements in 1988 and implemented in 1992. Basel I, however, had an unexpected consequence: its weights did not match the market assessment of the risks faced by banks. Thus, banks indulged in what came to be known as "regulatory arbitrage". Owing to this and several other deficiencies, a new system of regulation came into existence. Basel II is the second of the Basel Accords , which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is an international initiative that requires financial services companies to have a more risk sensitive framework for the assessment of regulatory capital. In other words, it tries to protect against systemic failure, of the sort we are witnessing today. The Basel II framework is based on a three-pillar structure: minimum capital requirements (Pillar I), the supervisory review process (Pillar II), and market discipline (Pillar III).

Market signaling in form of change in bank's share prices or change in bank's borrowing rates Responsiveness of the bank or the supervisor to market signals

IMPACT OF BASEL II
Impact on Banks' Capital Bases Subsequent to the recent credit crunch, it is expected that various national regulators would continue to mandate banks to maintain higher capital than the minimum requirement calculated as per Basel II norms. In this competitive market, investor expectations, peer pressure and favorable credit rating requirements will also influence the capital requirements to remain on the higher side. Primarily the beneficiaries of the lower capital requirement will be banks with highly rated loans and securities in their portfolio, scientific risk management and credit risk mitigation techniques, strong retail and mortgage lending portfolios and Domestic focused banks using Internal Risk Based (IRB) approach Similarly, prima facie, the entities who will be hit adversely with a higher capital charge will banks exposed to large interbank loans to non-OECD banks, high non-OECD/noninvestment grade sovereign exposure, corporate exposures with above average PDs and LGDs and assets with longer maturities, exposures to considerable non-investment grade securitization tranches rated BB+/ BB- which carry standardized risk weights of 350% To evaluate the quantitative effects of Basel II provisions on the capital levels of banks the Basel Supervision Committee conducted the global fifth quantitative impact study (QIS5). The results have been summarized in the table- I

A Description Of The Three Pillars

First Pillar (Minimum Capital Charges) Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the "one size fits all" approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardised Approach, Internal Ratings Based Approach, and Securitisation Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks. or realization of assets.

1. http://en.wikipedia.org/wiki/Basel_2 2. Basel II and Banks, Key aspects and likely market impact' Income Research, 20-Sep-05 3 Results of fifth Quantitative Impact Study', Basel Committee on Banking Supervision, 16-Jun-06 4. 'What effects will Basel II have on the Global ABCP market?' Standard & Poor's research, 11-Oct-04 Nomura Fixed

Introduction
It is widely accepted that the smooth functioning imperative for a healthy economy. The failure of like Lehman Brothers, Inc. is always a harbinger depositors lose their money, other banks which of banks is a big bank of misery lent to the

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BASEL II IN THE INDIAN CONTEXT

Reserve Bank of India - The Regulator The Reserve Bank of India (RBI) has asked banks to move in the direction of implementing the Basel II norms and plans to adopt a consultative approach rather than a directive one. The RBI has set up a steering committee to suggest migration methodology to Basel II. Based on recommendations of the Steering Committee, in February 2005, RBI has proposed the "Draft Guidelines for Implementing New Capital Adequacy Framework" covering the capital adequacy guidelines of the Basel II accord. RBI expects banks to adopt the Standardized Approach for the measurement of Credit Risk and the Basic Indicator Approach for the assessment of Operational Risk. RBI has also specified that the migration to Basel II will be effective March 31, 2007 and has suggested that banks should adopt the new capital adequacy guidelines and parallel run effective April 1, 2006. Impact on Credit Risk Measurement Basel II gives a free hand to national regulators (in India's case, the RBI) to specify different risk weights for retail exposures, in case they think that to be more appropriate. To facilitate a move towards Basel II, the RBI has come out with an indicative mapping of domestic corporate long term loans and bond credit ratings against corporate ratings by international agencies. However, given the investments into higher rated corporate bonds and debentures portfolio, the risk weighted corporate assets measured using the standardized approach may get marginally lower risk weights as compared with the 100% risk weights assigned under Basel I. For retail exposures-which banks in India are increasing focusing on for asset growth-RBI has proposed a lower 75% risk weights (in line with the Basel II norms) against the currently applicable risk weights of 125% and 100% for personal/credit card loans, and other retail loans respectively. Given mortgage loan portfolio collateralized on residential property and the current credit guidelines of majority of banks giving housing loans with 20% margins, we estimate that the risk weight applicable would be 100%. The banks can drive maximum benefit from these proposed short-term credit risk weights, RBI's draft capital adequacy guidelines also provides for lower risk weights for short term exposures, if these are rated on the ICRA's short term rating scale.

Impact Due to Operational Risk Basel II has indicated three methodologies for measuring operational risk: Basic Indicator Approach; Standardized Approach; and Advanced Measurement Approach (AMA). The RBI has clarified that banks in India would follow the Basic Indicator Approach. The Basic Indicator approach specifies that banks should hold capital charge for operational risk equal to the average of the 15% of annual positive gross income over the past three years, excluding any year when the gross income was negative. In ICRA's estimates, Indian banks would need additional capital to the extent of Rs. 120 billion to meet the capital charge requirement for operational risk under Basel II. This would grow 15-20% annually over the next three years, which implies that the banks would need to raise Rs. 180-200 billion over the medium term. Provision of capital for Operational Risk could lead to tier - I regulatory capital adequacy declining to below 6%. However, as the preceding table shows, some banks would be comfortable, like Corporation Bank, State Bank of India, Canara Bank, Punjab National Bank, Bank of Baroda etc. Further, many of the public sector banks besides private sector banks have announced plans to raise equity capital in the current financial year, which would boost their tier I capital.

In a recent guideline, the Reserve Bank of India has required banks to develop an Internal Capital Adequacy Assessment Process to address risks not captured under the first pillar (minimum capital requirement). While banks are integrating these into their risk management systems, the internal capital planning process appears to throw up the CAR threshold by about 200bp to 300bp higher than the regulatory minimum ratio of 9%. Additionally, Indian banks have also been working on internal risk models in preparation of the Internal Risk Based approach for credit risk, although it may take a few years before these are ready for validation.

Exhibits
Change in Minimum Required Capital under Basel II compared to Basel I requirement, in per cent Source: http://www.bis.org/bcbs/qis/qis5sup.pdf G10 - Includes, the 13 Basel Committee Members CEBS - 30 members of Committee of European Banking Supervisors Non G10 - Includes all other non G10 countries not included in CEBS Group 1 - Internationally active, diversified banks with tier-I capital > 3 billion Group 2 - All banks not included in Group 1

Conclusion
This paper has studied the principal tenets of Basel II, the expected impact on various aspects. Basel II is a significant improvement on Basel I, without question. However, if one were to say that Basel II is a panacea for all systemic maladies, it would be with the greatest hesitation. In context of Indian Banks, after being postponed by a year to allow greater preparation, the standardized approach on credit risk and the basic indicator approach for operational risk were implemented on 31 March 2008 by Indian banks having international operations. It seems a bit too early for them to make that transition to Basel II norms purely because of the reason that there is not enough equity capital cushion to accommodate the enhanced capital charges. Though banks will be able to raise the required capital but it will be sometime before this materializes and in the short term banks will face capital crunch.

References
1. "A proposal for how to avoid the next crash " Financial Times Jan 31 2008 2. "Basel Backlash" Risk Magazine. Winter 2008 3. "Basel II and Banks, Key aspects and likely market impact", Nomura Fixed Income Research, 20-Sep-05 4. "Basel II: Bottom-Line Impact on Securitization Markets", Fitch Ratings Special Report, Sept. 2005

Current Scenario
While most of the Indian banks that migrated to Basel II in FY08 reported a reduction in their total capital adequacy ratios (CARs) on account of a capital charge on operational risk (65-75bp), a few banks actually reported capital relief on account of higher exposures to better rated corporates or savings on the regulatory retail portfolio (including the small business segment). However, following the imposition of an additional charge for the unrated corporate portfolio that became applicable on 1 April 2008, the sustainability of the capital relief remains to be seen, since the additional capital charge on account of the higher risk weight for unrated corporate loan portfolio could be up to 30-40bp Basel II regulations may influence the proportion and direction of bank lending making attractive to give out loans to the small business segment that qualify as regulatory retail, given their higher lending margins and lower risk weights; Also, the increase in risk weight for residential mortgage loans where the loan to value (LTV) exceeds 75% could dissuade aggressive lending policies by some banks.

Standardized Approach

Foundation IRB Approach

Advanced IRB Approach

Most Likely Approach

G10 Group 1

1.7 -1.3

-1.3 -12.3

-7.1 -26.7

-6.8 -11.3

G10 Group 2 CEBS Group 1

0.9

-3.2

-8.3

-7.7

CEBS Group 2

-3.0 1.8

-16.6 -16.2

-26.6 -29.0

15.4 -20.7

Non G10 Group 1

Non G10 Group 2

38.2

11.4

-1.0

19.5

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5. "Bothersome Basel" The Economist, Apr 15th 2004 6. Danielsson, Embrechts, Goodhart, Keating, Muennich, Renault, Shin. An Academic Response to Basel II. FMG Special Paper No.130 7. Goldman Sachs - June 2008 Report 8. http://en.wikipedia.org/wiki/Basel_2 9. http://www.basel-ii-risk.com/Basel-II/index.htm 10.http://www.thehindubusinessline.com/iw/2005/02/13/ stories/2005021300351300.htm 11. "One Basel leads to another" The Economist May 18 2006 12. Research Paper-Basel II Norms, Nomura Research Channel 13. Results of fifth Quantitative Impact Study, Basel Committee on Banking Supervision, 16-Jun-06

CROSS WORD SOLUTION

14. The Black Swan, by Nassim Nicholas Taleb 15. "Turmoil reveals the inadequacy of Basel II" Financial Times February 27 2006 16. "Weak Basel II might not be enough to calm credit fears" Financial Times Dec 18 2007 17. "What effects will Basel II have on the Global ABCP market?" Standard & Poor's research, 11-Oct-04 18. "Will Basel II Help Prevent Crises or Worsen Them?" IMF Publication 2008 19. http://www.banknetindia.com/banking/80319.htm 20. Basel II Accord: Impact on Indian Banks, ICRA Rating Feature, March 2005

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KNOW THIS PRODUCT

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Target Redemption Notes (TARN)

Shubham Satyarth, Chintan Valia
(PGP2 IIM Bangalore)

Interest Rate Exotics

KNOW THIS PRODUCT

Interest rate derivatives are by far the largest derivatives market in the world. Some popular instruments include Interest Rate Swaps, Interest Rate Options, Caps and Floors. However, with increasing complexity of customer needs along with increasing sophistication and efficiency of the derivatives market have led to the development of whole new market for interest rate exotics. We will talk about one such exotic product - Target Redemption Notes (TARN).

are received by the TARN holder. The interest rate fluctuation leads to uncertainty in the coupon payments received on the coupon dates, and also results in uncertainty in the redemption date (knock-out). The uncertainty regarding the termination date is governed by a path dependent variable, which is the accumulated coupon sum. The TARN value thus depends on the two stochastic state variables, namely, the interest rate and the path dependent variable of running coupon sum. TARN: Example

Target Redemption Notes (TARN)

This refers to any financial product whose life is conditional to the fact that the sum of the paid coupons is below a target level. When the target level is crossed, the deal gets cancelled. A TARN could also specify a target floor level. This would mean that if at maturity the target floor level is not reached, we pay a last coupon to reach the target floor level. The last coupon will be the difference of target floor level and sum of previously paid coupons. Coupon payments for a TARN can be structured in any possible way. It can be coupons on the difference between the swap rates or any other reference rates. The main idea is that as soon as the sum of paid coupons increases the specified target level, the deal stands cancelled. A case for TARN Suppose you are receiving a reverse floater coupon. In a steep increasing yield curve environment, these reverse floater coupons may be worth very little for long maturities. Investors may therefore want to exit the structure whenever they are worthless. Simultaneously, they may have some target level for the sum of all received coupons. Reverse floater TARN provides an elegant solution to this problem. It is worth noting that these notes were very attractive to the Asian retail investors in the early 2000's when the interest rates were at a low level. However, pricing of TARN is an issue. The value is given by the sum of present values of the par and coupon payments and this sum depends on the times at which the payments 7.5% USD Target Redemption Index Linked Deposit (issued by Bank of East Asia, 2004). The key selling point was that buyers could enjoy potentially higher returns with Index Linked Deposit. 100% principal protection plus 7.5% guaranteed coupon return over a maximum of 5-year investment period. 1st year annual coupon is guaranteed at 6.5%, payable semi-annually. The remaining coupon rate of 1% will be based on the LIBOR movement. The inverse floater formula is max{7% 2 6-month LIBOR (in arrears), 0} However, the total coupon received will not shoot beyond the target rate of 7.5%. If the coupon payment accrued during the deposit period is less than the target rate, then the remaining amount will be paid at maturity.

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KNOW THIS PRODUCT

Manik Lather, Shubham Satyarth

(PGP2, IIM Bangalore)
One thing that the world of capital markets teaches you very quickly is that there are number of exotic ways to make money or lose it as a matter of fact! Ever wondered if there was a way to make fortunes out of these rapidly tumbling stock markets apart from the usual short selling? Can one make money without having any directional view on the markets? Volatility trading provides a solution to all the above problems. In the most conventional forms, one can trade volatility by buying an option contract and then delta hedging the position. However, there are much better and purer ways of trading volatility and the most popular amongst them is an instrument called Variance Swaps. However, it should be noted that traders and market makers always judge a product based on their ease of replication. Volatility swaps cannot be replicated with a static hedge. In other words a hedge against volatility swap needs have to be continuously changed to maintain a perfect hedge. Only variance -the squared volatility- can be replicated with a static hedge. The same argument applies for trading volatility by buying an option and delta hedging the position. One needs to continuously change the hedge to remain perfectly delta neutral. Moreover, in case of a delta hedged option position, it is possible to incur a loss even if the realized volatility turns out to be higher than the implied volatility (for a long volatility position). This happens due to path dependency of the P&L of delta hedged option position. This will never be the case with variance swaps. We have not discussed the mathematical details of replication and path dependency in this article. For more details, the following paper can be referred - "Just What You Need To Know About Variance Swaps" - Quantitative Research and Development, JP Morgan.

Variance Swaps

Implied Vs Realized Volatility...

Technically volatility is defined as the standard deviation of log returns. The Black-Scholes model uses a number of inputs to price an option. However, the only speculative component is the estimate of the future volatility. Thus, price of an option implies an estimate of future volatility. The implied volatility of an option contract is the volatility implied by the market price of the option based on a particular option pricing model. Realized volatility is what is actually realized over the life of an option. There is money to be made by betting on the magnitude of realized volatility with respect to the implied volatility. Variance swaps are by far the most sophisticated way of taking on such bets.

Convexity
Another feature that makes variance swaps attractive is the convexity of the payoff. The figure below shows how the payoff varies with different realized volatility.

What is Variance Swaps?

A variance swap is a forward contract on annualized variance, the square of the realized volatility. Its payoff at expiration is equal to s where s is the square of realized volatility and K is the variance strike. Thus a long position on variance swaps benefits if the realized volatility turns out to be higher than the strike over the life of the contract. The strike is generally the implied volatility of at-the-money option with same maturity with slight adjustment for the skew and convexity. An important feature of variance swap is that we use square of volatility rather than the volatility itself. Another product with similar structure that uses volatility directly is called Volatility Swap. On the surface it might appear that volatility swaps are simpler and better way of trading volatility. Due to the convex nature of the payoff, an investor who is long a variance swap (i.e. receiving realized variance and paying strike at maturity) will benefit from boosted gains and discounted losses. In other words, the upside increases at a faster rate as compared to the downside.

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