Niveshak Volume II ISSUE I January 2009
Editor Biswadeep Parida Team Niveshak Amit Chowdhary Nilesh Bhaiya Sareet Misra Sarvesh Choudhury Sujal Kumar Tripurari Prasad
All Images and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management, Shillong
From Editor's DesK
of the entire team, I wish all the readers a very Happy New Year O nandbehalf hope we see the Bull running wild on the markets very soon.
The ghost of the sub-prime has not yet passed; the bear is still at large at the markets. Stock prices fight each other in defeating historic lows. Government of India has again revised estimated GDP growth projections taking it a notch below. Negative corporate quarterly results put the sensex on a slippery slope, but India Inc has more has more to worry about. This time the image of India Inc has been tarnished by the Satyam’s disgraced ex-chief Mr. B Ramalinga Raju, once hailed as the blue eyed boy of India Inc. Merger talks & bailout pleads take most of the news space. Apart from negative financial data across the globe grabbing headlines, Mr Barack Obama brings in some cheer and hope for change to viewers by taking over the Presidentship of the United States of America. In this edition we have tried not to talk about sub-prime crisis much. Since this is the first issue of this year, we would try to look at the blunders we committed in 2008 in the world of finance and try not to repeat them in future. We shall also try to take a historic look at Great Depression of 1929 and draw parallels with the current crisis. We have important lessons to learn from the failure of Bear Stearns, a sub-prime hit bank that had to shed its I-Bank glamour, swallow its pride and sell itself to JP Morgan Chase, a less glittery but huge commercial bank. One of the most complicated financial instruments-the Credit Default Swaps has also been extensively covered. We shall discuss one of the most elusive topics - the pricing of CDS by some globally accepted methods. The regime of regulated oil prices in India has always troubled oil companies and they had to often take support of oil bonds to see the light of another day. Last few years of stratospheric crude oil rates has further endangered their existence. We shall analyze if they can ever end up in green. As the catastrophe of Wall Street has hammered valuations across world stock markets to unimaginable lows, certain corporate have started to stroll between the ruins and pick stocks of rival companies at throwaway prices. To fend such a type of acquisition, India Inc has finally arisen to Differential Voting Rights. This issue carries an article on DVRs. This volatility of stock market indices has also prompted some analysts to question if these indices are representative enough of the world business outlook. May be we have an alternative in the Baltic Dry Index that is only dependent on fundamentals and not much on sentiments. Talking about Sub-prime, historically low stock prices, acquisition of shares, bankruptcy of banks, we remember that Sovereign Wealth Funds acquired major chunks of shares of wall street behemoths like Merrill Lynch, Morgan Stanley, Bear Stearns, Citigroup, UBS, London Stock Exchange among many other corporate which are regarded as America’s pride. These funds are swelling with cash and are always hungry for shares of huge western companies, but have faced severe opposition from governments of the countries where they targeted strategic acquisitions. What are these funds, how big are they, who owns them and why are they being opposed? We will try to answer. Still you found lots of sub-prime talks. Well there is no way out of it as of now. Happy Reading. - Biswadeep Parida (Editor- Niveshak)
Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsover.
ContentS
The Year That was 2008- A year of big blunders- Page 4
Fin Sight Oil companies- Page 5 Differential voting rights- Page 12
Investor’s Pick Deepak Parekh- Page 8
Cover Story Sovereign wealth funds- Page 11
Article of the month CDS Pricing- Page 15
Institutions World Bank- Page 18
Opinion Lessons from Bear Stearns- Page 20
Review Life settlement bonds- Page 23
Market Watch Baltic Index- Page 24 The Great Depression-Page 26
Finlounge FinToon- Page 17 FinQ- Page 27 © The Finance Club, Indian Institute of Management, Shillong
The year that waS
2008 An year of Big
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Higher inflation rate prompted interest rates and the cash reserve ratio to be increased. This was a time when inflation was caused by lower supplies and high oil prices. Sixth blunder was committed by The Government of India for introducing a fiscal stimulus package of Rs 30,000 crore. But there isn’t a single person who believes that it will work. But even if it works, it would take time as government expenditure will take time to be approved and tendered and it would be mid 2009 before we see any action. The credit of the seventh blunder goes to the OPEC nations. After much dithering it has decided to lower its output by a little over 4 million barrels a day to stabilize prices. They prefer a price of $75 per barrel, which seems like a distant dream as of today. But what confounds all the more is the fact that the prices are down today because of a slowdown, and by cutting output to ostensibly raise crude prices; it would actually lead to slide in prices as demand declines further. Apparently, it is unsure of what is to be done. Eighth has been the failure of the series of bailouts. So far it had been only for the distressed financial institutions but we had three auto companies in the U.S actually approaching government for a bailout. But this is truly justified on the premise that these are the firms that are involved in production and these along with reality sectors are the drivers of growth. But the problem lies in deciding the extent of the bailouts. The ninth institutional shock was the domestic suspect-ICICI. This leading Indian bank featured again as deposit holders made a beeline for the ATMs to withdraw money because of a rumour that the bank was over exposed to toxic Lehman assets. The dynamism that propelled the bank to stardom was their strong presence in the derivative segment this time and agricultural loans earlier became a liability. RBI also came to rescue and went out of the way to reassure everybody that it was all well. Lastly, a blow to the economy was dealt by the terror attacks on the Taj and Oberoi as this was the attack on the financial and commercial capital of India. The debate continues as to whether this would have long term financial implications.
Volume 2 Issue 1
By Nupur Khanna
Delhi School of Economics
January 2009
Page 4
ear 2008 will always be remembered as an year which gave a fatal blow to the reputation of investment bankers, rating agencies, economists and regulators. The fact that prediction of a crisis is nearly unpredictable is acceptable but the hard fact that so many people were consistently wrong is something that cannot be digested easily. Let us have a look at some of the biggest blunders of 2008:The first and by far the biggest blunder was the approach to financial sector bailouts. It all started with the rescue of Bear Stearns in March 2007 but the crisis resurfaces soon. When the US Treasury & Federal reserve lined up bail-out packages for failed housing twins Freddie Mac and Fannie Mac, it raised thousand eyebrows. Public money was used to fund the misadventures of these greedy financial institutions who forgot the basic due diligence and jumped into the so-called casino capitalism. Subsequently, Lehmann Brothers collapsed and Merrill Lynch was saved by the skin of the teeth, while Goldman Sachs and Morgan Stanley swallowed their pride to become old fashioned commercial banks. The government was unsure of whether or not moral hazard had to be eradicated or whether there was a larger duty to the public or the failed institutions. The second biggest blunder has been the regulation. While the investment banks and hedge funds do not have a regulator, banks do. Though Basel-II takes the credit for bringing about discipline across banks and the Fed has made it difficult to skip the rope, what remains yet to be explained is the fact that why in spite of this discipline Citibank landed in trouble. The third has been the panic response from Fed which lowered its interest rates to 0.25% at a time when the economy was going into recession. Mr Greenspan has been blmed as the biggest culprit in this respect for pursuing a policy of liberal interest rates and creating serial bubbles. It looks as if he was up to starting another bubble and time will tell which one it would be. The ECB and BoE stand fourth in the hierarchy of blunders as being central banks without an independent mind, as they have lowered their indicative rates too visa-vis the Federal Reserve. They could also not do anything to save the banking majors of the euro zone. But the billion dollar question is that whether in this scenario wasn’t Euro supposed to actually challenge the dollar and steal a lead? The situation worsened and even developing nations like India weren’t spared in spite of having a fairly regulated banking system. RBI in India fared no better.
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I N E S A P C O M NUND O C L I RU EO
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“It is said that human beings have some basic needs: Food, Shelter, Clothes, and OIL. The importance of all these in today’s life cannot be ignored at all”
Oil Industry overview It is imperative to build a perspective by understanding the industry structure and have a brief value chain analysis. The value chain follows the following sequence: • Exploration - Using technology to find new oil • Production - Bringing oil to the surface using artificial and natural methods • Transportation - Moving oil to refineries and consumers through trucks and pipelines • Refining - Converting crude oil to finished products • Marketing - Distributing and selling the products There can be a broad two-way categorization of the
Indian petroleum sector as Upstream and Downstream. The Upstream consists of the oil and gas exploration companies with players such as ONGC, OIL, RIL. However, the Downstream is divided into Refining and Marketing companies and Natural Gas distribution companies. The former has companies such as IOC, BPCL, HPCL, ONGC, RIL, CPCL, BRPL, KRL, NRL, MRPL, while the latter has company like GAIL. Moreover, the downstream sector shall be providing a demand for the upstream sector which will be the source of supply.
Oil pricing and oil company’s losses In India, oil prices are controlled by the government in a process called APM (Administered Price Mechanism). This means that periodically, based on the international prices, government would set prices for Petrol (Gasoline), Diesel (used by trucks), Kerosene (used by poor for cooking and lighting) and LPG (used for cooking by middle class) and all the oil market companies have to fix their prices as per that price. The price is set in a way that oil companies make profits on Gasoline, break even on Diesel and make losses on Kerosene and LPG, and in return get compensated by government bonds. Currently, the Government follows the principle of ‘equitable burden sharing’ – issue of oil bonds, upstream/ refinery discounts, and minimal price increase. For 2007-08, the oil companies reported a total revenue loss of Rs 70,579 crore of which Rs 35,289.50 crore is to be compensated through oil bonds. The government has already issued, oil bonds worth Rs 20,333.33 crore for April-December 2007 period. The government shares almost 46% of the burden, but there are few points worth noting as far as oil subsidies are concerned.
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he global scenario over the past few years has witnessed a phase of high growth, especially in the emerging economies such as India and China. The sustainability of this steep growth path largely depends on the ability of the nation to build sufficient infrastructure that can support and propel the growth further. A key component of this infrastructure is energy. The basic growth and competitiveness of the nation hinges on how well the country can meet its growing demand for energy. With the accelerated pace of growth that we have witnessed, the demand for energy is only rising, with crude oil being India`s key source. Over the last year, price of crude oil surpassed its own records with an all-time high of $147.27 on 12th July 2008. India, which imports nearly 80% of its oil requirements, faces the brunt of such sharp increases in term of its swelling import bills. As far as India is concerned, it continues to remain one of the least explored countries of the world, yet ranks among the top consumers of the world. The picture in the Indian market therefore, becomes highly skewed with a heavy reliance on imports.
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Oil bonds as the preferred form of subsidy is twofold. First, and most importantly, in a system of cashbased government budgeting like ours, the transfer of oil bonds can be kept off the budget. It does not affect the fiscal and revenue deficits of the central government at the time of transfer, thus proving to be of great advantage especially when fiscal responsibility laws mandate specified targets for such deficits. Secondly, the cash impact of the bonds, in the form of interest payments to the holders and final repayment, is postponed and attenuated over time. From the viewpoint of the OMCs, of course, these features of oil bonds are huge negatives. For operational expenses, interest earnings is something that only cumulates, while attempt to sell bonds for cash results in huge discounts, if tradable. Petro bonds have different economic implications as compared to issuing of transparent cash subsidies from government to OMCs. In case of cash subsidies, governments revenue deficit would get widened, borrowings increase, thus leading to high interest rates and “crowding out” of private investment. While in the former case, OMCs take a hit on their profits culminating to reduction in public savings. The switch to a transparent cash subsidy from government to OMCs can and should be accomplished swiftly. Though the deficit targets of the fiscal responsibility law is breached by wide margins. But in the present environment the official deficit numbers simply hide huge repressed deficits without being able to mitigate their adverse economic consequences.
Strategies for long-term viability With output prices tightly monitored and input prices highly fluctuating, it seems tougher for oil companies to stay profitable year-on-year in India. However, the following strategies/steps can guard these companies against crude price escalation: Energy Derivatives: Starting with an example, jet fuel consumption represents up to 23% of all costs of an airline company. If an airline seeks to protect itself from rises in the jet fuel price in the future, it would purchases a swap or a call option from an institution prepared to make prices in these instruments. Any subsequent rise in the jet price for the period would be protected now. A cash settlement at the expiry of the contract will fund the financial loss incurred by any rise in the physical jet fuel. Energy Derivatives can provide low cost energy alternatives and popularizing emission trading can go a long way in providing sustainable and effective energy solutions to a fast developing and energy starved economy like India. India’s energy needs are likely to increase six times over the next 20 years and there is an urgent need for energy derivatives, renewable and nuclear energy as
Niveshak
well as a mitigating process. Moreover, a recent CII report proposed the way forward for the structured development of energy markets in India. It indicated how market players can use derivatives as effective tools for risk management. The report notes various developments taking place in India towards the advancement of energy markets in general and energy derivatives market in particular. Branded oil: Price of premium brands being controlled by the oil companies, the firms are in a way forcing its purchase by consumers. By adopting pick-and-chose policy, oil companies do not give same stock to all its dealers. With exhaustion of normal fuel, it’s the premium brands that are sold. Petrol and diesel are 4/litre and 2.25/ litre respectively more costly than normal. Moreover, the government must also seriously consider colorizing diesel and selling it at two different rates. The types of fuel are classified by the type of use, amount of sulfur emissions and tax category. Colored diesel can be sold at a subsidized rate to keep the inflation under check, whereas the colorless diesel and premium diesel can be sold at Rs. 60 (or more) per liter. Also, the pricing of Diesel at lower rate makes sense, because Diesel is much more efficient (40% more power compared to Petrol) and it emits just 69% as much greenhouse gases as petrol for every kilometer of ride. Considering the increasing awareness for environment friendly products among Indian consumers, the introduction of branded fuels will help the oil companies in making up for their losses. Oil subsidy removal: Taking a longer four-year perspective, when the price of the crude was up 230% ($135/barrel, up from $51/ barrel in January 2007), Indian petrol was up only 35%, diesel 46%, and kerosene not at all! This was so because government provides massive implicit subsidies to consumers of almost Rs 200,000 crore. Subsiding oil consumers, most of which are middle class or rich, does not make sense in a poor country. The Arjun Sengupta Committee found that most people live on less than Rs 20/day. But the implicit petrol subsidy for many car-owners exceeds Rs 100/day. This offends both justice and economic sense. As said by many politicians that subsidies protect poor from inflation, in reality, it only protects car owners. If high fuel price push up transport costs and hence, overall prices a bit, so will the deficit financing used to subsidize oil. Demand for oil is kept at a very high level and can only be checked if prices are allowed to be increased. Oil subsidy is also a subsidy for street pollution
Volume 2 Issue 1
January 2009
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Oil bonds and its problems
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Way ahead Crude oil is one of the most necessary commodities worldwide. Even the slightest fluctuation in crude oil prices can have both direct and indirect influence on the economy of many countries. The volatility of crude oil prices has driven many companies away. Crude oil prices act like any other product cost with more variation taking place during shortage and excess
supply. It has been observed that $10 decrease in the crude oil price means decrease in the economic growth of the OPEC countries by 0.5%. Thus, the rise in prices has a major influence on the economic condition of developing countries. However, considering the above measures would not only guard the oil companies against crude price escalation, it would also help them to stay afloat in times of uncertainty. Thus, oil companies in the green would no more remain a distant dream, but become a concrete reality for times to come
By Kunal Kha itan
MDI Gurgaon
FinQ December’08 Issue Answers 1. Luca Pacioli, double-entry accounting system 2. John Clifton Bogle, known as Father of Index Fund investing. He created the first S&P 500 Index fund). 3. Commissioning of Monte dei Paschi si, First trading bank in the world. 4. The Charging Bull statue. Sculptor Arturo Di Modica sues Wal-mart for selling replicas of the Charging Bull. 5. Marshall Plan (European Reconstruc tion Plan). 6. Paul Volcker and Alan Grenspan. 7. Stephen Ross X = Arbitrage Pricing Theory Y = Binomial Options Pricing Model 8. The Almighty Dollar. 9. Peter Lynch 10. Tulip Mania, First Speculative(credit) Bubble
© The Finance Club, Indian Institute of Management, Shillong
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and congestion, and reduces the incentive to switch from private to public transport. It is like subsidizing India’s own emissions. In India and many other developing countries, rising oil prices are not passed on to consumers. Thus, oil demand is not checked commensurate with the price change. Hence, it takes much longer to restore the supply-demand balance. The quicker fuel prices are raised, the faster people will adjust. This will not only improve the state in which PSU and private oil companies are, it will also take care of pollution, congestion and various emission requirement. No further reduction in prices: While the decline in global crude oil prices had helped state-run Indian Oil, Bharat Petroleum and Hindustan Petroleum trim their losses on sale of petrol, diesel, domestic LPG and kerosene, the appreciation in value of the Rupee against the US dollar had wiped away some of the gains. They are currently losing about Rs 280 crore per day on sale of petrol, diesel, domestic LPG and kerosene as government has not allowed them to align retail prices with cost of production. Domestic prices of petrol and diesel are pegged to a global oil price of $ 61/barrel. If the world price falls below this, consumers will demand a cut in domestic prices. But having subsidized petroleum products by over Rs 100,000 crore after oil skyrocketed in 2007, the government should now recoup part of that to build a reserve. One option is to revive the Oil Pool Account (OPA), which in the 1980s and 1990s smoothened fluctuations in product prices. They got cash from the Oil Pool Account (OPA), when price control imposed losses on oil marketing companies. OPA had generated a big surplus when the government had not slash the price of petroleum products in 1986, it was then when the oil stood at $ 16/barrel, down from $ 32/barrel in the early 1980s. This cushioned government finances, and provided a reserve for darker days ahead--oil prices shot up again in 1991. With oil heading south, government should seize the opportunity to build up a reserve fund –through a revived OPA. In these dire circumstances, the fall in global oil prices is a boon. With global prices of petrol and diesel falling below Indian controlled prices, the oil marketing companies would have a small windfall gain instead of huge losses.
Investor’s picK
eepak Parekh is the Chairman of HDFC, the country’s leading housing finance company. A pioneer in mortgage finance, he has enabled scores of Indian middle class people owning their houses or apartments through affordable loans. Parekh graduated from Mumbai’s Sydenham College in 1965. He qualified as a chartered accountant in England and worked with Ernst & Young, Precision Fasteners, ANZ Grindlays and Chase Manhattan in New York and Mumbai. He joined HDFC in 1978. Though HDFC was founded in 1977 by his uncle H.T. Parekh, it was Deepak Parekh’s vision and entrepreneurial acumen that enabled the company to create a niche in housing finance and emerge as the market leader. He was promoted as its Managing Director in 1985 and appointed its Chairman in 1993. From a single-product company that focused on the Indian middle class to develop the mortgage market, the HDFC family today offers a buffet of every possible financial product. Parekh’s vision for HDFC is to make it the GE Capital of India. His focus has always been to maintain a steady growth rate and not on market share. He still sees the opportunity in housing loans in India where it is just 3.9% of GDP. In countries like Malaysia it is 31% and in US it is as high as 50% of GDP. He feels bankers should be prudent in credit assessments, in loan-to-value ratios, and in installment-to-income ratios. Mr Deepak Parekh currently serves as the Chairman (since 1993) and Chief Executive Officer of Housing Development Finance Corporation Limited (‘HDFC’). Mr. Parekh is also a director on the board of several Indian public companies such as Siemens Ltd., HDFC Chubb General Insurance Co. Ltd., HDFC Standard Life Insurance Co. Ltd. , HDFC Asset Management Co. Ltd, WNS Holdings India Ltd, Housing Development Finance Corporation Ltd, Castrol India Ltd., GlaxoSmithKline Pharmaceuticals Ltd., Infrastructure Development Finance Co. Ltd, Hindustan Lever Ltd., Hindustan Oil Exploration Corporation Ltd., Mahindra & Mahinda Ltd., The Indian Hotels Co. Ltd. and Burroughs Wellcome (India) Ltd .He is also a non-executive, independent Director of SingTel. Banking is in Parekh’s genes. His grandfather was the first employee of Central Bank Of India. His father spent 40 years in the same bank and retired as deputy managing director. Deepak Parekh is also the Non-Executive Chairman of Infrastructure Development Finance Company Ltd (IDFC), a Government of India enterprise for infrastructure projects in 1997.
Niveshak
Volume 2 Issue 1
By Amit Chow dhary
IIM Shillong
January 2009
Page 8
Deepak Parekh
He has also been a member of various Committees set up by the Government of India. He was appointed Chairman of the high level expert committee, formed to recommend measures for strengthening the Unit Scheme – 1964. The Reserve Bank of India appointed him Chairman of the Advisory Group for Securities Market Regulation, which was tasked to compare the level of adherence to international standards in India with that in other countries. He was also Chairman of the Expert Committee constituted by the Ministry of Power to look into the reform efforts in the power sector. In recognition of his services to the nation, the Govt of India has conferred him with the prestigious Padma Bhushan. Mr.Parekh also has won several awards including Businessman of the Year 1996 by Business India and the JRD Tata Corporate Leadership Award by All India Management Association (AIMA). He was the first recipient of the Qimpro Platinum Award for Quality for his contributions to the services sector and the youngest recipient of the prestigious Corporate Award for Life Time Achievement by the Economic Times. He is often dubbed as the unofficial crisis manager for the government. . In 1999, the government bailed UTI with a Rs 3,300-crore package when US-64, its flagship scheme, ran into trouble. Parekh chalked out this important rescue plan for the then Unit Trust of India. He served as an invaluable problem-solver with creative and credible inputs on the final decision on the Telecom Regulatory Authority of India. To stabilize the fraud-devastated Satyam Computer, the government nominated Deepak Parekh to the Satyam’s new board. He has been awarded the responsible task to appoint the Chairman and other board members of Satyam and get Satyam back on track. He feels the importance of corporate governance in industry and stresses on inculcating a process that facilitates board evaluation. To him a board evaluation is not a one-size-fits-all proposition, but needs to be customized and tuned into the culture of the organization. He says that the key objective of a board evaluation is to check if the board is on track and seek opportunities for change, which would enable the board to be more productive. His genius will now face an acid test when he sits down to assemble the disgraced IT firm Satyam from the ruins. Can he put Satyam, the not so long ago blue eyed Indian IT giant that is plunging deeper into darkness with every passing day, back on the Investors’ top pick list? Can he pull another miracle? The whole world is closely watching your steps Mr. Parekh.
FinSighT
Differential Voting Rights
What is a DVR Share? A differential voting right share exercises either more or less voting power than a normal share. Two types of Differential Voting Right (DVR) shares can be issued: • Those that carry more voting power than an ordinary share: In this the person having the share will be exercising more voting power than an ordinary share. For example, in case of a DVR in which one share carries a voting right of equal to 3, a shareholder with 100 shares will be entitled to 300 votes. • Those that carry less power than an ordinary share: In this the person having the share will be exercising less voting power than an ordinary share. For example, in case of a DVR in which one share carries a voting right of equal to 1/4th, a shareholder with 100 shares will be entitled to 25 votes. In the presence of DVRs, in order to make a distinction, a company generally classifies either the DVRs or the ordinary shares as Class A shares and the other as Class B shares. Invariably, the class of shares with lower voting rights are compensated by offering of a higher dividend than the shares with higher voting rights.
Companies Act As per the Companies Act, any company can issue a DVR provided:
• The company should have been profitable for three years and should have had a no default record in filing annual accounts and returns • The company should have not defaulted in meeting investors’ grievances • the shares with differential voting rights shall not exceed 25% of the total share capital issued
Benefits of issuing a DVR A DVR has certain advantages, both to the company and the investors. The company on its part is able to ensure minimum dilution of voting stake for the owners of the company when issuing a DVR instead of a normal share. This is pretty helpful for a company which needs to raise further capital to pursue its expansion plans, while resisting any hostile takeovers. For example, the promoters of Gujarat NRE Coke are looking at a rights issue with DVR to ward off any takeover threat from companies seeking to secure coking coal assets. The management of the company has that the high demand for coke has resulted in companies looking for takeover candidates in the sector. The company expects DVRs to be a long term shield against a possible takeover bid. The DVR will increase the promoters voting rights in the company to 51 per cent, though their actual equity will remain at 41 per cent. In terms of small investors concerned primarily with their return on shares, DVRs offer a higher return in terms of higher dividend than the normal shares. Most of the small investors as it is, are least bothered about their voting rights. Why was there no such provision earlier? A popular theory put in this regard is that only after the liberalisation, advent of foreign investors and dynamism displayed in the shareholding pattern, has there been felt a need to bring in the DVRs. The government was always wary of hostile takeovers. It used its influence in company boardrooms – through institutions like LIC, IDBI, ICICI and other government backed funding- to always vote with the promoters and block any attempts of a hostile takeover. The government did this to protect their loans and investments in the company. Result was the helplessness of ordinary shareholders in decided the fate of their investments and killing of any share activism. But as the FIIs begin to own more and more shares, their voting rights can command considerable power and hence, the need for DVRs. The companies will also now look to start issuing DVRs for firstly, the emergence of shareholders’ activism and secondly, for the now very real threats of hostile takeovers.
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he corporate India is finally waking up to the opportunity presented to it nearly eight years ago by the Companies Act. As a result of the inclusion of The Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2001, it became possible for Indian companies to issue shares with differential voting rights. Though such shares are a common feature in many of the international markets, it is only this revision, which makes it possible for Indian companies to issue DVRs. Tata Motors became the first major company to issue a share with Differential Voting Rights (DVR) with its offering open on September 29, 2008.
FinSighT Tata Motors and DVR issue The management of Tata Motors already hold a minority stake in the company. The company is looking at significant capital expenditure as a result of its acquisition of Jaguar and Land Rover. These two factors may combine to make it an ideal takeover target, The DVRs are probably being issued to prevent that possibility. Other companies looking at a DVR issue Apart from Gujarat NRE Coke, cited earlier, the other company looking at issuing DVR is Pantaloon Retail. It has already approved a proposal to give shareholders one bonus share for every ten held. The bonus share will be a DVR. The new shares will get 5 percent more dividend and would be entitled to one vote for every 10 held. Some of the international companies to have dabbled with DVRs include Berkshire Hathaway, Google and News Corp.
Pricing of DVRs At present, only one set of guidelines are provided for the issue of shares, be it ordinary or differential. So any company issuing a DVR has two alternatives at its disposal: • Seek clarification from SEBI before issuance of such shares and waste precious time in the process • Issue shares according to the current guidelines and leave tackle any issues as they come up Hence, the situation presents a case for issuance of clarifications on SEBI’s part. Sonal Sachdev, in his article “Price of a vote”, an interesting formula to price a vote has been illustrated. Price of a vote = the probability of influencing a decision multiplied by the value this can create minus the status quo value. In other words, it is the additional value that can be created through the exercise of influence in a company’s decision-making process multiplied by the probability of being able to influence a decision. Thumb rule seems to be- a premium of 5-10% for a voting right.
stake, if meant to garner greater control over a company, could create an acquisition premium for higher voting rights shares. In most other cases, the evident inability of non-strategic/non-institutional investors to exercise influence on company managements will render these rights near worthless
And the negatives... Issues with the guidelines: The laws stipulate that only the companies who have made profits in the three preceding financial years will be allowed to issue shares with differential voting rights. Companies defaulting on either interest or redemption debenture are also barred from issuance of such shares. This precludes many financially weak companies and new ventures looking for expansion and most vulnerable to a hostile takeover, unable to issue DVRs. There is also an absurd clause which enables only those companies which a=have not defaulted in meeting investors’ grievances to issue DVRs. Practically, it is almost impossible for any company to remain totally complain free from petty grievances of the investor like non receipt of dividends or improper transfer of share certificates. Issues with the concept: There are various purposes which are achieved by linking of economic interests to voting power. Firstly, it acts as an incentive for shareholders to properly exercise their voting rights. This enables shareholder activism and acts as a check on the managers of a company. Secondly, the right of economic owners to choose their own directors provides a basis by which the legitimacy of managerial authority is established. The small investors have not been particularly enthusiastic of the shares with lower voting rights offered to them, compensating in form of higher dividends. It is speculated that perhaps the investors do not want to miss out on their voting rights just because of a few percentage points of dividends thrown at them. They are also mindful of the large capital gains to be had for shares with higher voting rights in case of takeover battles.
By Karan Parmanandka & Rajat Brar XLRI Jamshedpur
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Volume 2 Issue 1
January 2009
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But there are caveats to applying this benchmark. A prospective acquisition target could well see its shares with full voting rights trade at a premium to those with lesser voting rights. A compulsory open offer for a 20%
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SOVEREIGN WEALTH FUNDS Are we heading towards communism? reserve currencies such as the dollar, euro and yen. Such investment management entities may be set up as official investment companies, state pension funds, or sovereign oil funds, among others.
Major SWFs The amount of money in these SWF is substantial. Estimates suggest there are about 25 to 30 active SWFs with assets under management in the range of $3.5 trillion. Sovereign wealth funds pumped in huge investments in several Wall Street financial firms including Citigroup, Morgan Stanley, UBS and Merrill Lynch etc when these firms needed a cash infusion due to losses resulting from the subprime mortgage crisis. Chinese SWF, CIC infused USD 5 bn into Morgan Stanley in exchange for securities that would be convertible to 9.9% of its shares in 2010. Although they shot into stardom by investing in liquidity starved wall-street giants, SWFs are not something new. Kuwait created the Kuwait Investment Authority (KIA) in 1953. The UAE, Oman, Singapore and Brunei also created investment agencies to recycle their reserves holdings in the 1970s and 1980s. Norway and Malaysia did so in the 1990s. Russia followed suit more recently by creating a Stabilisation Fund in 2003, as did some other countries like Chile and Veneuzuela. Oil-producing countries (OPEC and Russia) have constituted over half of SWF funds (that is, commodity-based funds) in terms of assets under management as well as numbers. The UAE’s Abu Dhabi Investment Authority Fund (ADIA), which was established in 1976, is the world’s largest SWF currently, with $625 billion under management.
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overeign Wealth Funds are state owned investment funds derived from a country’s foreign exchange reserves, which are set aside for investment purposes that will benefit the country’s economy and citizens. The funding for a Sovereign Wealth Fund (SWF) comes from from central bank reserves that accumulate as a result of budget and trade surpluses, and even from revenue generated from the exports of natural resources. The traditional investment vehicles for sovereign wealth in the form of foreign currency reserves have been the debt instruments such as government bonds from the industrialized nations. The low returns on these investments have prompted nations with excess foreign reserves to invest in equities to achieve a higher return. Some countries have created SWF to diversify their revenue streams. For example, United Arab Emirates (UAE) relies on its oil exports for its wealth; therefore, it devotes a portion of its reserves in an SWF that invests in other types of assets that can act as a shield against oil-related risk. Some other SWFs are simply state savings which are invested by various entities for the purposes of investment return, and which may not have significant role in fiscal management. The accumulated funds may have their origin in, or may represent foreign currency deposits, gold, SDRs and IMF reserve positions held by central banks and monetary authorities, along with other national assets such as pension investments, oil funds, or other industrial and financial holdings. These are assets of the sovereign nations which are typically held in domestic and different
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How big is the money they hold? Sovereign wealth funds, currently holding $ 3-3.5 trn, have bigger assets than hedge funds and private equity companies combined, but are still small compared with the estimated $75 trillion assets held by institutional investors, that is, pension funds, mutual funds and insurance companies. The size of U.S. GDP is $12 trillion, the total value of traded securities (debt and equity) denominated in U.S. dollars is estimated to be more than $50 trillion, and the global value of traded securities is about $165 trillion(before sub-prime). In that context, $3 trillion is significant but not huge. But when we compare it to the size of some emerging markets, this seems a huge sum. The total value of traded securities in Africa, the Middle East, and emerging Europe combined is about $4 trillion; this is also roughly the size of these markets in all of Latin America. And total assets under management by private hedge funds—a broad category of private investment funds that seek high returns and, as a consequence, often take on considerable risks—are estimated to be around $2 trillion. So, perhaps not surprisingly, a debate about the potential risks and opportunities of sovereign wealth funds, similar to the ongoing debate about
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Is Communism knocking at the door ? The Sub Prime crisis has brought the world to its knees. Blue chip companies have felt the pinch of liquidity crunch in their balance sheets, even in working capital accounts. This has forced them to move out with their hats in hands for money. Guess who has got the money. While corporate houses approach Banks for money, the most formidable names of high street finance were pleading before Sovereign Wealth funds to help them fight bankruptcy. Thus, SWFs pick up huge stakes in western banking legends Citigroup, Merrill Lynch, Morgan Stanley, UBS, Barclays etc. Since then sovereign funds have poured over $60 billion into US and European banks, and no doubt there will be more. They have also bought substantial stakes in private equity companies such as Carlyle and Blackstone. Sovereign wealth funds have purchased an estimated $85 billion of US equities since the beginning of 2007, as well as taking big stakes in both the London Stock Exchange and Sweden’s OMX exchange. But then this was not enough. The world plunged deeper into darkness. The catastrophe of wall-street hammered valuations across the world into unimaginable lows. This is the time when Asset managers (Institutional Investors, Hedge Funds, Pension Funds, Mutual Funds, Insurance companies etc) would have loved to stroll through the ruins picking up many gems at throwaway prices. But they could not. Liquidity had vanished from the markets. Ultimately corporate houses and Financial Institutions pleaded for Bailout packages before their respective governments(United States & Governments of Euro-zone). They did respond after several high voltage debates and votings in their assemblies & congress. The extent & nature of these bailouts have been extensively covered in our earlier issues. US Dept. of Treasury rolled out billions of dollars of lifelines to corporate but not without picking up stakes in those companies. AIG, to mention, had to deliver 79% of its stake to US Govt for an $ 85 bn rescue. This would mean that the managers of the once world’s largest insurer AIG would need the approval of US government bureaucrats before any decision. Similarly, Bank of America, Bear Stearns, JP Morgan Chase, General Motors, Ford, Chrysler have received huge bailouts. The total size of assets under management for SWFs is expected to touch $ 10 tn by 2010 & $ 15 tn by 2015. With such high amount of cash they can have seats on the boards of some of the world’s most admired companies and influence their decisions. Imagine hard-nosed bureaucrats & filthy politicians representing Governments of India/China/Middle eastern oil economies on the boards of General Motors, Wal-Mart, Coca-Cola, GE or Exxon Mobil. Does this give you goosebumps? hedge funds, is now developing.
Major Concerns surrounding SWFs Growth of Sovereign Wealth Funds is catching the
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Among the better known non-commodity-based SWFs in Asia are Singapore’s Government Investment Corporation (GIC) and Temasek Holdings. In fact, Singapore is the only country which has two separate agencies among the top ten SWFs. Since some of the sources of funding for the agencies also include pension contributions from Singapore residents, these entities are really a combination of SWFs and Sovereign Provident Funds (SPFs). The China Investment Corporation (CIC) which is said to be motivated by Singapore’s GIC in both concept and design, began operations in 2007. The Chinese government transferred $200 billion of its $1,300 billion of its reserves to the agency to kick-start operations, making it the world’s fifth largest SWF. CIC’s first major investment was a $3 billion investment in the US-based private equity group, the Blackstone Group. The largest SWFs with assets over $100 billion are designated the Super Seven funds: Abu Dhabi Investment Authority (ADIA); The Government Pension Fund of Norway; Government of Singapore Investment Corporation ($330 billion); Kuwait Investment Authority; China Investment Corporation; Singapore’s Temasek Holdings; and the Stabilization fund of Russian Federation.
Cover Stor Y course, there are always some national security limitations on what foreigners can own. In the past, sovereign wealth funds were mainly ‘passive’ investors, quietly buying shares in big corporations and property without getting involved in management. However, as sovereign wealth funds are investing more, there are fears among western leaders that they will become more active, demanding seats on boards of directors. Certain strategic assets are guarded by local governments and politicians. Can one expect them simply to stand by passively while another government tries to acquire these assets? Even when private companies have done so, they have had to jump over several hurdles. Others have had to simply live with situations where their contracts were not upheld: Hugo Chavez’s abrupt cancellation of Exxon Mobil’s contracts is a case in point. Many politicians in the U.S. were up in arms when Dubai Ports World, a Dubai-owned company tried to buy an American port-operating company which operated 6 major US ports. The target, they claimed, was a strategic asset and should not be controlled by a foreign country. Imagine the furor if the target were a company such as Exxon Mobil or Chevron when today wars (Iraq war) are being said to be fought for oil.
SWFs are here to stay SWFs are based on current account surpluses and will become less important only if the countries with huge surpluses pass through a stage of prolonged current account deficits. Major countries have committed to reducing their current account imbalances, and this would limit the growth of sovereign funds. But the world economy evolves continuously in ways that make it hard to be sure current account imbalances will shrink. For example, global growth may accelerate or decelerate, and this is likely to affect commodity prices. If commodity prices remain high, commodity exporters will have large surpluses for the foreseeable future. Similarly, If commodity prices fall, the surpluses of Asian countries that export manufactures may increase. There’s no apparent reason to see the continued existence of these funds as destabilizing or worrying. In fact, the IMF has strongly encouraged exporters of nonrenewable resources to build up exactly such funds in preparation for turbulent times. On September 2-3, 2008, at a summit in Chile, the International Working Group of Sovereign Wealth Funds, consisting of the world’s main SWFs, agreed to a voluntary code of conduct first drafted by IMF. They are also considering a standing committee to represent them in international policy debates. The 24 principles in the draft will be made public after being presented to the IMF governing council on October 11, 2008. To put it in black & white, sovereign wealth funds are big time state-owned players of the 21st century. Hedge funds, I-Banks & General Partners(the other name for Private Equity Funds), while becoming more prominent in this century, are in some sense a carryovers from the end of the 19th century, when large pools of private
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attention of every developed capitalist country. There are various reasons responsible for it. Some are worried that as this asset pool continues to expand in size and importance, so does its potential impact on various asset markets. One of the major worries of some countries is that foreign investment by SWFs raises national security concerns because the purpose of the investment might be to secure control of strategically-important industries for political rather than financial gain. These concerns have led the EU to reconsider whether to allow its members to use “golden shares” to block certain foreign acquisitions. In the U.S., these concerns are addressed by the Exon-Florio Amendment to the Omnibus Trade and Competitiveness Act of 1988. The failure of Wall Street Investment banks and many highly leveraged Hedge Funds have taught us the hard way that in today’s fast-paced financial markets, the impact of a particular pool of money on financial stability depends not only on assets under management but also on the potential leverage used in investment strategies. Many hedge funds and private equity funds are reported to use leverage ratios of 10:1 or much higher. That means they borrow 10 times or more their own capital for particular transactions. Hedge funds almost certainly improve the allocation of capital around the world, but recent developments indicate that they also pose a danger to the global financial system. The consensus so far is that while hedge funds deserve considerably greater scrutiny, there are advantages for the allocation of global capital flows if this sector continues to have a relatively light direct regulatory burden. Their inadequate transparency is a concern for investors and regulators. For example, size and source of funds, investment goals, internal checks and balances, disclosure of relationships and holdings in private equity funds. They are not bound by any agency like the Central Bank or the Securities Market regulatory body to make any mandatory disclosures or follow certain best practices in their strategies and investments. It’s thought that SWFs have traditionally pursued buy-and-hold strategies, with no short positions and perhaps no borrowing or direct lending of any kind. They probably have long horizons and like other long-term investors, have an appetite for bottom fishing. This likely exerts a stabilizing influence on the world’s financial system. But there is also anecdotal evidence that some sovereign funds have placed investments with other leveraged funds. At least one central bank is reported to have had investments with Long-Term Capital Management when that ill fated hedge fund went bankrupt in 1998. Another central bank has invested recently with a major private equity fund. The Norwegian sovereign wealth fund reports that it has shifted somewhat from bonds to equities. They have started placing their bets on riskier assets but before that they should have realized that this is people’s money. The real danger is that sovereign wealth funds may encourage capital account protectionism through which countries pick and choose who can invest in what. Of
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Should India start its SWF? As India’s forex reserves swell to record levels making India the fifth largest holder of reserves in the world, so do their costs. India’s reserves have been propelled into the $ 260-300 billion range as of end October 2007, forming nearly 30% of our GDP. The surge in reserves causes a mismatch between the opportunity costs of holding the reserves with macro-economic adjustment costs incurred when they fall short. A major share of our reserves is invested in US Fed securities. The interest rates in both US and the euro zone have yielded negative real rates of return of between 2% and 3% in the last 5 years. At this negative real yield on investments in US government securities, India’s loss on its foreign reserves holdings lies between $6 billion and $9 billion per annum at current reserves level. This is the high cost paid by the country for maintaining excessive liquidity, besides the opportunity costs foregone by not investing in longer maturing, higher yielding bonds and equities. This savings glut of oil and emerging economies has been largely channeled to the US, cheaply financing its large current account imbalance. The US current account deficit is estimated to absorb about 75% of the global external surpluses. Increasing liquidity of the oil and newly industrialized economies are being funneled into financial instruments issued by advanced countries yielding negative real rates of return. It may be time for India to reconsider its exchange management practices and increase its risk-taking appetite. Why & How much of liquidity(Forex) do we need ? There are several globally accepted norms & calculations estimate the optimal level of foreign reserves holdings providing adequate liquidity for current account transactions such as imports and debt servicing. One such rule predicts that reserves should be enough to cover three months of imports. The current level of foreign reserves holdings in India covers 12-15 months of imports, making current foreign reserves holdings overvalued by four-five times.
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One of the most famed rules, the Greenspan-Guidotti rule suggests that the reserves should be enough to cover the short-term debt, that is, the average reserves holdings during a year should be roughly equal to shortterm debt payable. Currently, India’s Forex reserves are nearly 6-7 times of its short term debt payable. Another quick back of the envelope calculation suggests that average reserves to GDP ratio is 30% in India as compared to 10% on average in advanced countries. Any measurement would clearly indicate that we are holding too much cash and losing opportunity cost. By means of any of the above benchmarks, India should ideally possess not more than USD 80 bn. So why should we not move away from the regime of negative rates of return on our hard earned forex by creating and efficiently managing a SWF. The balance of available foreign reserves holdings ought to be gainfully deployed in foreign assets which maximize returns. Some argue that the problem in India is the sustainability of reserves given they are driven by capital account surpluses rather than the current account. Thus there may be a need to maintain reserves in relatively more liquid and lower-yielding assets. There are more prickly issues surrounding the creation and operation of SWFs in India, including the degree of independence of the agency and its investment managers from the RBI and finance ministry (that is, governance), organizational structure, investment objectives and policies (like, commercial versus strategic; diversified portfolio or concentrated bets), and the degree of transparency in the agency’s holdings and policies. Some Economists say that such a proposal is at best risky and, at worst, misguided. There are lots of reasons and views against India creating an SWF, but none of them satisfying enough. These issues are admittedly much harder to resolve in a democratic and open society like India, but that is no reason to shy away from debating the issue seriously. India should at least actively participate in the ongoing, though nascent international dialogue of establishing a code of behavioral guidelines for the creation, management and operation of SWFs under the leadership of the International Monetary Fund. Moreover it would be foolish to constrain the foreign capital held domestically from exploring higher returns in high yielding equities, corporate bonds and commodities markets abroad when we permit foreign capital, which earns high returns in the domestic equity and commodity markets. After all we deserve much higher rates of return on our Foreign Exchange Reserves. But before jumping into the fray, we should make sure that the fund in managed by highly qualified professionals and is separated from politicians & bureaucrats
Volume 2 Issue 1
By Bisw adeep Parida
IIM Shillong
January 2009
Page 11
capital moved around the world with unregulated ease and contributed to a long global boom and rapid increase in industrial productivity around the world. What happens when the 21st-century state meets the 19th-century private sector? What happens when huge western corporate are brought to their knees be the Sub-Prime demon and they reach SWF, hat-in-hand? How much money can they roll out in the name of bailouts to save corporate once they took pride of? How long can governments keep the huge funds of SWFs at bay in the name of protecting strategic sectors from foreign hands? The outcome remains to be seen.
Article of the montH
CREDIT DEFAULT credit default swap (CDS) is a credit derivative contract between two counterparties, structured such that the buyer has to make periodic payments to the seller and in return obtains the right to a payoff if there is a default or credit event with respect to a reference entity. The market size for Credit Default Swaps began to grow rapidly from 2003 and by late 2007 it was approximately ten times as large as it had been four years earlier. However the rapid growth of the CDS market has not been without its critics. Several analysts have pointed out that the CDS market lacks regulation and the deals are far from transparent and often fuel speculation. There have even been claims that the CDS markets exacerbated the 2008 global financial crisis by hastening the fall of companies such as Lehman Brothers and AIG.
CDS Pricing: Approaches and Models Given the huge market for CDS, it is but natural that substantial amount of research has been conducted on their pricing. The price, or spread, of a CDS is the annual amount that the buyer of the protection must pay the protection seller over the length of the contract. There exist two fundamental approaches to CDS pricing: (a) Structural Approach (b) Reduced Form Approach
Structural Approach to CDS Pricing The structural approach links the prices of credit risky instruments directly to the economic determinants of financial distress and loss given default. These models imply that the main determinants of the likelihood and severity of default are financial leverage, volatility and the risk free term structure. Popular implementation of the Structural models today include Moody’s KMV model. However it is often difficult to implement such models as it is difficult to get reliable estimates of the asset volatility and risk free term structures. Most of the structural models in place today are derived from the work done by Black & Scholes (1973) and Merton (1974).
The Merton Model The Merton model works on the principle that a firm’s equity can be viewed as a call option on the firm’s assets. Thus the probability of a firm defaulting on its obligations can be found by determining the probability
of the exercise of this option. The model assumes that a company has a certain amount of zero-coupon debt that will become due at a future time T. The company defaults if the value of its assets is less than the promised debt repayment at time T. The equity of the company is a European call option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The model can be used to estimate either the risk-neutral probability that the company will default or the credit spread on the debt. The mathematical implementation of the Merton model involves determining a firm’s asset value and asset volatility using the easily observable equity value and the debt profile of the firm. Detailed mathematical description of the model can be found in Merton (1974) and Hull, Nelken & White (2004).
Reduced Form Approach to CDS Pricing These models exogenously postulate the dynamics of default probabilities and use market data to obtain the parameters needed to value credit-sensitive claims (Ericsson, Jacobs and Oviedo (2004)). While these models have been shown to be versatile in practical applications, they don’t touch upon the theoretical determinants of the prices of defaultable securities. Another approach within the reduced form approach focuses on estimating the default probabilities and the loss given default using statistical functions and pricing the CDS based on the results. Thus it is seen that while the Structural models are theoretically sound, they are difficult to implement while the Reduced form models, though easy to implement lack theoretical rigor. Therefore as a combination of the Structural and Reduced Form Approach, some researchers actually use the structural approach to identify the theoretical determinants of corporate bond credit spreads. These variables are then used as explanatory variables in regressions for changes in corporate credit spreads, rather than inputs to a particular structural model. Important work in this area was carried out by Collin-Dufresne, Goldstein, and Martin (2001), Campbell and Taksler (2003) and Cremers, Driessen, Maenhout, and Weinbaum (2004). Ericsson, Jacobs and Oviedo (2004) suggested an extension of these approaches in which they regressed the Credit Spread with the firm’s leverage, volatility and the risk free interest rate. This model is implemented in this paper and results on companies both in the developed and the developing world are described.
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Credit Default Swaps: The concept
Article of the montH
The main considerations while choosing the various parameters for implementation are described below: (a) Comparing performance of Structural and Reduced Form Models: In order to evaluate the performance of both the approaches, one structural model (Merton Model) and one reduced form model (EJO Model) was implemented. (b) Covering companies across different sectors: The companies on which the models were tested were chosen from a wide range of sectors so that any sectoral biases would not affect the evaluation of the performance of the models. (c) Covering companies from different countries: In order to test the performance of the models for firms from both the developing and developed worlds, firms from US, UK and India were chosen. This would ensure relevant conclusions regarding the applicability of the models in emerging markets like India as well. (d) Covering companies with different leverage: Since the ultimate aim of the pricing models is to predict whether a company is likely to default on its obligations or not, companies with leverages varying from low to high so as to test the performance of the models for companies having different balance sheet debt structures were chosen. (e) Period of testing: The performance of the models was tested for the last two months of 2007. The most recent data points were deliberately not taken to test the models as given the current financial conditions, measuring the performance for current data would not have given an accurate picture of the utility of these models. Overall six companies were chosen for testing the models and a summary of these companies is presented below: Company
Country
Sector
Debt Levels
Reliance India Limited
India
Petrochemicals
Moderate
State Bank of India
India
Banking
Moderate High
General Mo- USA tors
Automobile
Moderate
Vodafone
UK
Telecom
Low-Moderate
Glaxo Smithkline
UK
Healthcare
Very Low
Johnson and USA Johnson
Healthcare
Very Low
Data Sources The data required for the implementation of the two models is listed below: (a) Merton’s Model: Equity Price of the firm, Equity
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Volatility of the firm, Debt Structure of the firm, Risk free interest rate in the country of operation. (b) EJO Model: Equity Price, Book Value of Debt and Market Value of Equity, Risk free interest rate in the country of operation. All data required was sourced from Bloomberg. To obtain a good balance between capturing recent events and preventing disruption due to spurious information, a 60 day period for volatility was used. Since the Merton model requires the firm’s debt to be modeled as a zero coupon bond, weighted average of the debt and its maturity was used to do so. The risk free interest rate was then taken to be the rate for government bills with maturity closest to the maturity of the zero coupon bond. Microsoft Excel was used for implementing the model. CDS spreads for a 5 year CDS on each firm were also obtained from Bloomberg. The mean value of the CDS was assumed to be the average of the bid and ask for the purpose of comparison with the value predicted by the two models.
Findings The results for the six companies for both the Merton as well as the EJO model are summarized in this section. Merton Model Overall the Merton model was found to work reasonably well for companies with medium to high leverage and the predicted values were found to follow the trends depicted by the actual values. However the Merton model was observed to consistently under predict the actual spread. This could be because of the very basic nature of the model and the simplicity of the underlying assumptions. The results obtained are consistent with the past research which showed that structural models under predict credit spreads and display low accuracy (Arora, Bohn, Zhu, 2005). The results obtained by the Merton model for the four companies with moderate-high leverage are summarized below. Sample outputs obtained can be seen in the annexure. Company
Extent of Underprediction
RIL
19%
SBI
32%
Vodafone
71%
GM
14%
However the flaws of the Merton model are accentuated when tested on companies with very low leverage namely Johnson & Johnson and Glaxo Smithkline (GSK). Because the Merton model essentially models the equity as a call option on the firm’s assets and given the fact that if the debt of a firm is very low, the probability of exercising this option is very low, the Merton model gave extremely low CDS spreads for such companies. Thus it was found that the Merton model is not suitable for
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Implementation Approach
Article of the montH firms with very low leverage. The Ericsson, Jacobs and Oviedo Model The Reduced Form model – the Ericsson, Jacobs and Oviedo (EJO) model which regresses the CDS spreads against the firm leverage, equity volatility and the interest rates was also used to estimate the CDS spreads. The results obtained by the EJO model are summarized below (the +/- indicate the positive/negative correlation between the CDS spread and the explanatory variable): Company R2
Volatility
Leverage
Interest Rate
RIL
90.30%
+
+
-
SBI
70.97%
+
+
-
GM
52.15%
+
+
+
Vodafone 76.38%
+
+
-
GSK
79.40%
+
+
-
MKS
83.89%
-
+
+
As predicted by past research, the EJO model gave superior performance when compared to the Merton model with high R2’s for most companies. All the three explanatory variables were found to be significant for all companies. The EJO model was also found to be better
suited for firms with low leverage as shown by its good performance for GSK and MKS. The credit spread was found to be positively correlated with the equity volatility and firm leverage and negatively correlated with the interest rates. Thus the effect of these market driven variables is economically important as well as intuitively plausible. These results are also consistent with previous research in these areas (Ericsson, 2004). The results indicate that while the Merton model is theoretically sound, due to the simplifying assumptions built into the model, its performance on real life companies and data is not satisfactory. Although it does give encouraging results for companies with mediumhigh leverage, overall it is found to under predict the CDS spreads by a substantial amount. In contrast the EJO model gives good results in estimating the CDS spread as described in the previous sub-section. This could be due to the fact that it uses market driven parameters to estimate the CDS spread. The EJO model also performs relatively better than the Merton model for companies with low leverage. Further for emerging economies with low market depth and inefficient price discoveries, the EJO model may be better suited.
By Anshul G upta & Radhika AR
IIM Bangalore
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FIN TOON
InstitutionS
RLD Bank Restructuring
n the last edition we talked about the need for restructuring of International Monetary Organization for its failure to play its role as a regulator and supervisor in the current financial crisis. One more International organization which has been criticized for taking up the lead role in the current financial crisis is World Bank. The financial crisis has not only crippled the financial sector, but also seriously affected real economy with its spillovers. The international financial crisis has resulted from three failures: • Regulatory and supervisory failure in major developed countries • A failure in risk management in private financial institutions • A failure in market discipline mechanism The World Bank and IMF were created in 1944 to rebuild the world economy after World War II, concentrating on efforts to reconstruct war-torn Europe and to manage the old exchange rate system, where currency values were tied to the price of gold. The IMF was intended to concentrate on core issues of monetary, fiscal and exchange rate policy, while the World Bank’s “core mandate” was to reduce poverty and help countries build a framework to guarantee growth and development. In general, World Bank loans pay for development and social sector projects, although it also provided massive “adjustment loans” to richer countries at the peak of the crisis. The IMF provides broad balance of payments support to countries which meet tough economic conditions, and members can use this money as they see fit. But their tasks have changed considerably since those early days, and each institution now lends tens of billions of dollars each year to member states. The entire international economic architecture established after World War II - the World Bank, the International Monetary Fund and now the World Trade Organization - is buckling under the weight of globalization, trade disputes and the ambitions of rising economic powers in Asia and elsewhere. They have failed to play a significant role in the current financial crisis. Like IMF some question the relevance of the World Bank in the current context of the world economy. The World Bank’s cumulative lending to China, for example, is $40 billion for 274 projects. But China is now an export superpower, sitting on reserves worth more than $1 trillion - so wealthy that it recently announced its own
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$210 billion program of loans and credits to Africa. Some question whether the World Bank should be lending to China at all. The world economy has changed dramatically since September 2008. What began as a downturn in the US housing sector is now a global crisis, spreading to both rich and poor economies. Many believe that this may go down in history as the worst crisis since the Great Depression of the 1930s. Developing countries—at first sheltered from the worst elements of the turmoil—are now much more vulnerable, with dwindling capital flows, huge withdrawals of capital leading to losses in equity markets, and skyrocketing interest rates. GDP growth in developing countries—only recently expected to increase by 6.4 percent in 2009—is now likely to be only 4.5 percent, according to economists at the World Bank. And rich countries are now expected to contract by 0.1 percent next year. As per World Bank Group President Robert B. Zoellick “The global financial crisis, coming so soon after the food and fuel crises, is likely to hurt the poor most in developing countries” The World Bank Group’s response to this crisis includes increased lending for crisis-hit developing countries—likely to nearly triple from US$13.5 billion last year to more than US$35 billion this year— as well as accelerated grants and virtually interest-free long-term loans to the world’s 78 poorest countries, 39 of which are in Africa. Besides extending help to cash-strapped governments, the Group is boosting support to the private sector through four initiatives by the International Finance Corporation (IFC), and providing much-needed liquidity in developing country banking markets through the Multilateral Investment Guarantee Agency (MIGA). So World Bank is promoting the social safety net programs—particularly those that are well-designed—are a smart investment both for today and the future. These programs are affordable; For example Mexico’s successful Oportunidades and Brazil’s Bolsa Familia cost just about 0.4 percent of GDP. The current financial turmoil has highlighted the need for a “new multilateralism” to replace outdated structures. The financial turmoil of this year is a “wakeup call,” for the multilateral institutions. The world needed to look beyond resolving the current crisis to the underlying role of multilateral institutions.
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THE W
InstitutionS
brutally exposed in recent months. Opinion is now hardening around the case for a new global architecture to enforce rules that ensure lessons are learnt and that the actions which have brought free markets to the brink of collapse are never repeated. Resolution of financial crises requires a complex mix of macroeconomic and financial sector policies. One important element in the resolution of such crises is the restructuring and resolution of World Bank, with considerable experience gained in this area in the past decade. World Bank should capitalize on its complementarity with private-sector banks and allow middle-income countries to graduate to private-sector lending. The Bank now has to adapt to a world in which; private capital flows to developing countries are at an all time high; the private sector is the dominant engine of growth in developing countries; environmental issues were creating new demands; and; the Bank’s own resources were becoming increasingly stretched as a consequence of cuts in its administrative budget. World Bank along with IMF and the World Trade Organization now need to take the lead role in helping the world economy tide over the current crisis and also prevent such systemic crisis in the future. Although the financial crisis highlights the systemic failure of the institutions, using the current financial crisis to revert to state-led, rather than market-led solutions to economic growth might not be the best way out: While intervention is going to be necessary and inevitable, it may, as before, store up considerable problems for future growth and prosperity. World Bank should play its due role as the world’s largest multilateral development financial institute to help developing countries to fend off external impacts and maintain financial stability and economic growth.
By Manjunath M
© The Finance Club, Indian Institute of Management, Shillong
IIM Shillong
Page 11
We now need a new multilateral network for a new global economy. There is also reform required in the International Monetary Fund and the World Trade Organization (WTO).The IMF’s early warning system for the global economy should be strengthened, “focused on crisis prevention and not just crisis resolution.”. The economic multilateralism must be redefined beyond a traditional focus on finance and trade. Today, energy, climate change, and stabilizing fragile and post-conflict states are economic issues. But a system that was designed 64 years ago has, not surprisingly, has proved to be ill equipped to deal with the fiendishly complex practices of 21st-century banking that led to the current worldwide crisis. Neither the IMF, the World Bank nor any other institution has the power to police the global financial system in a way that might have prevented the excessive risk-taking which led to the sub-prime mortgage crisis and, in turn, the credit crunch. Hindering the World Bank in both its tasks is its governance. The existing board structure of the World Bank is one which minimises risks to the institution, at the cost of its borrowers. A full-time resident board, nominally representing all countries who are members of the bank, oversees the application of detailed rules and procedures which constrain the staff and senior management. The board also monitors a plethora of internal auditing and quality controls, the work of an independent evaluation group, and the work of the judicial style inspection panel. The result limits any risk-taking by the bank. Or better said, distributes risks to those least able to bear them. The costs of minimizing risks are borne mostly by borrowers (who face slower and more costly loans) and by the world’s most at-risk and vulnerable populations whose hopes of assistance in a crisis or conflict are postponed while the bank’s board ensures that rules and procedures are followed. The result is a bank which is too slow, too riskaverse, and too unresponsive to its needy members to be as effective as it can and should be. To deliver public goods, the World Bank needs a board which enunciates the collective purpose of members. This means a board which engages and reflects political leadership at the highest level. The governments sitting on the board need to make decisions which give the institution political cover. Those governments themselves should sometimes collectively shoulder risks, permitting the bank to act rapidly in uncharted terrain, and to act with other international institutions without fearing for damage to its own procedures and rules. The failures of modern global capitalism have been
OpinioN
Lessons Learnt from Bear STearns The Great Bear Fall
Niveshak
Volume 2 Issue 1
January 2009
Page 22
he Bear Stearns Companies Inc was one of the largest global investment banks and securities trading and brokerage firms, prior to its sale to JP Morgan in 2008. History Founded as an equity trading house in 1923, it survived the Great Depression of 1929, growing from strength to strength in terms of assets, profitability and reputation over the twentieth century. Business Areas Capital markets (equities, fixed income, investment banking), wealth management and global clearing services. In 2007, Bear was recognized as the “Most Admired” securities firm in Forbes’ “America’s most admired companies” survey.
The timeline below summarizes the failure Exogenous Causes • Bust of the US housing market bubble – This was the immediate trigger. Plunging house prices caused values of CDOs to plummet. • Lax government regulations on lending – Freddie and Fannie mandated to issue loans to the subprime market regardless of bad credit history, which were bundled into mortgage-backed securities and sold worldwide. Other banks followed suit. • Low interest rates – Capital abundance in the US due to international inflows, low interest rates and demand for higher yields incentivized banks to pursue predatory lending. When interest rates started rising, defaults began to occur. • Crisis Of Confidence & The Pygmalion Effect – Rumours that Bear Stearns is facing liquidity issues started spreading quickly. Actions taken upon rumours actually caused the speculative events. • Put Option debate – Put options with very low exercise prices of $5, $10 and $15, typically not traded, were opened for trading though Bear’s stock was trading at $70 which may have helped funds in taking short positions. • Pre-planned by hedge funds? – Financial firms such as Goldman Sachs reduced their exposure to Bear Stearns by exiting CDS with Bear Stearns as the counterparty. The volume of novation contracts where hedge funds transferred their exposure to Bear Stearns to other parties was 20 times the normal volume.
OpinioN Endogenous Causes
2) Inherent Organization Culture : • Cowboy culture- A very interesting fact about Bear Stearns is that it has been predominantly governed by men since 1923, and even in 2008, the board of directors consisted of only men. The aggressive isolated nature of Bear Stearns stood out amongst all the investment banks leading to a macho risk taking incentivized culture. • Corporate Governance Culture - The standard governance practices recommend not more than 2 insiders in a 12 member board. In the case of Bear Stearns, the number was 3.Thus accountability and sound decisionmaking could have been severely compromised. Moreover, the executive committee, which made strategy decisions, consisted only of insiders. Thus the insider problem in Bear Stearns was heavily pronounced, with lack of a regular outside opinion. 3) Short term Debacles : • Lack of leadership focus during crisis - The sailor of the ship is the CEO, who in this case was James Cayne. A common problem associated with many CEOs is denial and pseudo listening. In Cayne’s case however, the issue was not of denial but of absenteeism. He was on a golf vacation when the two hedge funds collapsed, and on a bridge holiday, in mid March, when the sale to JPM took place.
• Managing Stakeholders and Rumour Control During a crisis of confidence among the investors and creditors, there were very few assurances from its side, possibly because of its arrogant nature and denial mode in accepting the problem. Increasing rumours of liquidity crunch and no action from the firm caused even strong stakeholders like Goldman Sachs to stop trading, thus putting the final nail into the coffin. • Managing Employee Confidence - Media reports suggested that part of the stock fall was related to heavy selling by its own employees in March. Bear Stearns failed to sustain the employee confidence itself, let alone investors and other stakeholders. • Loss of integrity, Hedge Fund Crisis, 2007 - Two of Bear’s top employees had been charged with releasing misleading information to investors in its hedge funds, which failed in 2007 regarding the amount of returns. When Bear Stearns again faced such a situation in March 2008, investors were less willing to accept assurances of stability, hence leading to the domino effect of redemption
Decision making analysis • Silence “Not taking a decision is also a decision” - Anonymous Bear Stearns’ silence throughout the situation was a major factor in its downfall. Bear Stearns suffered losses quarter after quarter beginning with its first ever quarterly loss in its 85 year history, incurred staff layoffs and a CEO switch-off. This wave of bad news started fuelling and strengthening rumours that the company was facing liquidity issues and stakeholders began questioning the ability of the firm to do business. The CEO was silent throughout this span as events were allowed to unfold. It was extremely late when Bear Stearns issued an official statement that “There is absolutely no truth to the rumours of liquidity problems that circulated in the market”. In a business where reputation and assurances are essential, Bear had lost both. This loss could have been pre-empted by increasing transparency to the stakeholders regarding the current position, detail out the exact nature of the problems present and unfolding future strategies and course of action being adopted by the firm to increase profitability could have gone a long way in reassuring investors. • Late Equity Raise – Henry Kravis, from KKR was interested in buying a 20% stake in Bear Stearns. It was a chance for Bear Stearns to raise more than $2 billion in capital and gain approval from all stakeholders by putting a reputed investor like Kravis on the board of directors. This could have helped dismiss rumours about the firm apart from strengthening the cash position. However the talks fell apart citing that the deal might upset Bear’s PE clientele. In the next few weeks Bear received an offer from JC Flowers regarding the purchase of a 20% stake.
© The Finance Club, Indian Institute of Management, Shillong
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1) Long term policies : • Aggressive highly leveraged investment strategies - Followed by Bear Stearns who wanted to maximize returns. However the importance of prudence to manage risk was forgotten. The firm, with leverage ratios as high as 35:1, faced huge investor redemption and liquidity issues, when the CDO assets became worthless. • Greed and Principal Agent Relationship – Perhaps the biggest perpetrators of this crisis have been the managers, the agents of the firm, whose greed led them to acquire highly risky subprime assets with their commissions dependent on their profits. A decision to link executive pay to return on equity is one of the main reasons why managers increased leverage indefinitely, without caring about the risks involved. • Risk Management System – Bear Stearns was among the most aggressive risk takers of the top investment banks. The firm never took a formal approach to its risk oversight responsibilities until March 22, 2007 when the board approved the charter for a finance and risk committee. • Non-diversified portfolio – Bear Stearns, being the highest underwriter of mortgage bonds, had 70 % of its investments in fixed income instruments, which were the most hit during the subprime crisis. Interestingly, Bear Stearns followed a policy of a single instrument non diversified fund which compounded this problem further and in fact led to collapse of two of its mortgage funds.
OpinioN However the Bear executives felt in the meeting that Flowers was just gauging their desperation and told him that they were not interested. After quite some time, a deal with Citic worth $ 1 billion was announced. This did not immediately lead to cash inflows but was contingent on regulatory approval. Other fund raising mechanisms including mergers were tried but efforts were fruitless. • Carlyle Capital Corporation (CCC) Collapse – Bear Stearns had advanced $1.6 billion to CCC. When CCC went bust, Bear was forced to take mortgage backed securities in lieu of some of its cash. This fuelled rumours that Bear was running out of money and its own lenders began to call in their loans. None of these rumours was addressed by management. This decision of not declaring their exposure to hedge funds resulted in Bear having to make bigger and bigger margin payments on loans and trading positions. Regular sources of funding became unviable forcing the firm to look out for other sources. Bear ultimately had to fall back on the Fed. • Executives sell stock in the middle of the crisis - Bear Stearns executives including Cayne and Schwatrz sold Bear stock worth more than $20 million in December, although they remain big shareholders in the beleaguered broker. This directly acted as a signal to the other shareholders about the executives’ lack of confidence in the ability of the firm to withstand the crisis.
Alternative Strategies to a JP Morgan Takeover • Emergency Rights Issue and raise new funds – Would have had to do so at a heavy discount because of increased perceived risk. Existing shareholders maybe averse to putting good money after “bad”. • Finding Long term funding or a white knight – Belief that Bear had huge exposures to troubled hedge funds was a deterrent for rivals to pick up a stake or for institutions to lend money. • Continued support from the Fed – This would have given Bear time to restructure itself and shrink its balance sheet to manageable levels. • Break-up of the bank – This was not a viable option because Bear was not diversified. The bulk of its business was from Fixed Income and mortgages which Wall Street was unwilling to touch. Neither its investment banking business nor its equity underwriting business was big enough to be sold separately.
• Financial Ethics and Risk Management a) Accountability in a principal agent relationship - Goldman CEO and top executives will be given $1 annual bonus in 2008. This is in line with creating a more ownership driven environment, where bonuses are linked to the trading practices followed. b) Stronger risk management systems - The failure showed lack of clarity in the company in understanding the real worth of the CDO assets. Even the standard pitfalls of risk management systems like incorrect correlation between risks, failure to communicate risks, failure to track risks and denying blatant risks have come out in the open during this crisis. Firms like Goldman have been following a policy of regular risk review every half hour in order to keep the risk management shored up. • Accountability of the firm in eyes of the external shareholders a)Regular communication with the investors and creditors - When speculations started milling around regarding Lehman, traders at the firm were issued with a list of “talking points” last week, advising them on the details of the firm’s liquidity position to increase transparency to the firm’s clients. If anyone really did pull their business, senior executives would make it a high priority to call the client and try and reassure him to get the business back. Lehman had learnt from the communication failures of Bear Stearns. b) Role of CEO and top leadership -An absentee leader and the lack of pro-active decisions at various points between June 2007 and March 2008, ultimately killed Bear Stearns. An immediate effect could be seen in the form of active CEO communication in the media about the liquidity position of firms, a movement out of the denial mode and an acceptance about the impending recession.
By Ravi Subramani an & Rohan Chaudhury IIM Ahmedabad
Lessons
Niveshak
Volume 2 Issue 1
January 2009
Page 22
The subprime crisis continues and analysts fear that the worst might not be yet over. Learnings from this crisis range from regulatory provisions to strategic planning. We have summarized the key learning from the point of view of a firm as Corporate Social Responsibility. Rather than going with a narrow view of CSR, we define it as building a healthy relationship, one of trust, between company and other stakeholders. This includes the following dimensions.
RevieW
Life Settlement Bonds ife settlement fund benefits the policyholders, who are typically asset rich but cash poor. By selling off their policies, these insured can now have the opportunity to release capital for a stated need, an option not available to them before Life Settlements. The creation of a secondary market for policies also means that policyholders may now obtain higher values for their life policies, instead of merely surrendering their policies for much lower surrender cash values. Life Settlement transaction always begins with policyholders who do not need their policies anymore. They would call their agent/adviser to arrange for policy surrender or sale to a third party. The problem occurs when it start with the agent/adviser proactively encouraging their clients to surrender or sell their policies. In its early years, the industry witnessed this problem known as Stranger Originated Life Insurance (STOLI), which has hurt to the industry in some ways. STOLI is the initiation of a life benefit of a person who, at the time of has no insurable interest in the inthrough life insurance agents, induce names for a fraudulent purchase of a seniors immediately agree to cede to the investors. Seniors engaging in receive some financial inducement transaction. Financial inducements portion of the proceeds, when the polsible element in STOLI is a contract beinvestor where the senior gives up to tial control of the policy at the time profit by collecting the death benefit selling the policy to unwary investors Market.
insurance policy for the the creation of the policy, sured. Investors, working seniors to provide their life insurance policy. The control over the policy a STOLI scheme typically at the beginning of the may also be paid as some icy is sold. The indispentween the senior and the the investor full or parof policy issue. Investors after the senior dies or by in the Life Settlement
To put a control over these practices, there was an establishment of life insurance settlement association (LISA) in USA. It comprises of over 170 member companies in North America, Europe and Australia and Its diversity provides a broad and authoritative voice. LISA is a valuable source of information for the consumer, member companies, policy makers and all interested parties and is regarded as the most comprehensive source in the life settlement industry. Life Settlements Funds are being seen as a “safe harbour” by prudent and savvy investors. The Life Settlements Wholesale Fund, in particular, is highly regulated and well structured to ensure continuous growth in value to unit holders on a continuous basis regardless of the volatility of financial markets. Life Settlements funds are non-correlated to shares, property, cash or fixed assets. As such, fund performance is not affected by fluctuating stocks and bonds, raising interest rates, skyrocketing oil prices, global economic instability or terrorism. Yield is determined by time, and not market forces. For investors who are looking to enjoy consistent net returns of 8% to 12% p.a., while seeking to further diversify their core portfolio allocations, Life Settlements Funds, especially the Life Settlements Wholesale Fund, do worth a second look.
By Seema Sharma
© The Finance Club, Indian Institute of Management, Shillong
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IIM Shillong
Market WatcH
Forget Dow Jones and Sensex FoLlow Baltic Index it would cost to book various cargoes of raw materials on various routes—150,000 tons of iron ore going from Australia to China or 150,000 tons of coal from South Africa to Japan. Brokers are also asked to consider variables such as the type and speed of the ship and the length of the voyage. Based on the answers, a number is arrived at which represents the shipping costs. The Baltic Dry index represents the true price at which shipping is done and has no speculative content. People don’t book containers unless they have cargo to move.
• BDI was at 11793 on 21st May 2008 • Last October, BDI was at 815. (Decline of 93%) This clearly means that back of the shipping industry had been broken. Does this mean - the world trade has come to a halt. The answer is YES.
What caused the crash?
There are two problems: • Producers are stuck with huge inventories. Post the collapse of commodity prices, no one is in hurry to build inventories. Also, with production cuts and factory shut downs, existing inventories have become a huge issue. • Credit Crisis: No one wants to lend in current market environment. As a result, Letters of credit are not getting issued. They are required to load cargoes for departure at ports. One analyst described it pretty well - “If I can’t get credit to get iron ore shipped to me today, then How does it work? I’m not buying iron ore -- and “demand” has dropped” As discussed earlier the value for the index is deterThis is unprecedented and unusual situation and mined by the London-based Baltic Exchange, which trac- may not last long. The improvement in credit market will es its origins back to 1744. Every working day, the Baltic help the ships moving again. Movements in the Baltic InExchange asks brokers around the world on how much
Niveshak
Volume 2 Issue 1
January 2009
Page 22
ost of the indicators that the market relies on to forecast the future are worthless in this type of environment. The truth is data coming out of the traditional economic indicators isn’t current. By the time it’s being reported, the information is already weeks or even months old. One of the lesser-known fundamentals underpinning the global economy is the Baltic Dry Index, a benchmark that measures dry-bulk shipping rates. So forget unemployment, Inflation, Consumer confidence, Personal Incomes and you can even ignore the ever-popular gross domestic product (GDP). Baltic Dry Index (BDI) which is also known as Dry Index is a number issued daily by the London-based Baltic Exchange, which gives an assessment of the price of moving major raw materials by sea. The index measures the demand for shipping capacity versus the supply of dry bulk carriers; and indirectly measures global supply and demand for the commodities. It is an accurate barometer of the volume of global trade. The Baltic Dry Index is also a compelling indicator because it is a simple, real-time indicator that is difficult to manipulate. Some economic indicators—like unemployment rates, inflation indexes and oil prices—can be difficult to interpret because they can be manipulated or influenced by governments, speculators and other key players. The Baltic Dry Index, on the other hand, is difficult to manipulate because it is driven by clear forces of supply and demand. The supply that affects the Baltic Dry Index is the supply of ships available to move materials around the globe. It is difficult to manipulate or distort this supply because it takes years to build a new ship that could be put into service to increase supply, and it would cost far too much to leave ships empty in an attempt to decrease supply. The demand that affects the Baltic Dry Index is the demand of commodity buyers who need the raw goods for production. It is difficult to manipulate or distort demand because it is calculated solely by those who have placed orders to have raw goods shipped.
Market WatcH dex tend to precede movements in global stock markets. meted in the past several months, as the U.S. financial (Remember BDI is termed a leading economic indicator crisis has snowballed into a global economic downturn and the consumption of raw materials has ground to a because it predicts future economic activity.) halt. For example, China is the world’s biggest consumer Interpreting the Baltic Dry Index of steel, but it has cut its consumption as infrastructure The Baltic Dry Index typically increases in value as projects have slowed in response to slumping economic demand for commodities and raw goods increases and growth. The same situation has played out with a host of decreases in value as demand for commodities and raw other raw goods - and as demand for materials slows, so goods decreases. Here’s what it typically means when the too does the earnings growth of a dry bulk shipper. Baltic Dry Index turns around and starts moving UP: - Global economies are starting to, or continuing to, grow - Companies are starting to, or continuing to, grow - Stock prices should start to, or continue to, increase in value - Commodity prices should start to, or continue to, increase in value - The value of commodity currencies should start to, or continue to, increase in value
In light of the above, it doesn’t take a market maven to predict what direction the index’s been heading lately - practically straight down. Here’s the thing. The Baltic Dry Index started plummeting in early June, before the global equity markets went into a tailspin, proving its predictive abilities. Besides there are other reasons to favor the Baltic Dry Index over other leading indicators, including : • No room for Speculation • Not subject to Revisions • An inability to be manipulated Here’s what it typically means when the Baltic Dry • Real-time, daily updates Index turns around and starts moving DOWN: - Global economies are starting to, or continuing So if you’re looking for a clear indication of a marto, contract ket bottom, forget about any other leading indicator or - Companies are starting to, or contin uing to, popular convention. Just look for the Baltic Dry Index to contract start trending noticeably higher. - Stock prices should start to, or continue to, decrease in value - Commodity prices should start to, or continue to, By Manish Lalw ani decrease in value IMNU, Ahmedabad - The value of commodity currencies should start to, or continue to, decrease in value.
© The Finance Club, Indian Institute of Management, Shillong
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The Baltic Dry Index (BDI) tracks rates in the 22 main shipping routes for these key inputs. The BDI has plum-
Great depressioN
The Great Depression through Historical
Niveshak
market crashed, hurting business confidence and consumer sentiment. The real output of the US dropped by nearly 30% and unemployment rate touched to 25%. Many central banks, investors and speculators started converting their currency to gold which resulted in the depletion of Fed’s gold reserve. The speculative attacks on the dollar had created panic in the banking system and many depositors had started to withdraw their deposits from banks. Fed ignored this plight of the banking system and this resulted in the failure of thousands of banks. In 1933, Franklin D. Roosevelt became the President of US. He declared the ‘bank holiday’ and relaxed the gold standards. The economy started to stabilize when Roosevelt became the President and recovery arrived only on the advent of the World War II. It is true that history has lessons for all. The lessons for the central banks all over the world were: The central banks should not ignore any panic in the banking system of the country because it may lead to the collapse of the whole financial system of the country (and might impact the whole world); and Central banks should use appropriate monetary tools to monitor and control the banking system. The Great Depression brought in many regulatory changes; formation of Security Exchange Commission (SEC) and the introduction of deposit insurance are just two examples. After nearly seventy eight years, when history had started repeating itself (this time not because of speculation but because of high leverage, securitization and highly complex financial products), the central banks reacted wisely and did not repeat the past mistakes. Now, it’s the beginning of a new history left for many economists to derive new theories and economic models.
Volume 2 Issue 1
By Akash Joshi
KJ Somaiya, Mumbai
January 2009
Page 22
or almost one year now, the media is full of news, editorials and discussions on the current financial crisis. The good old Economics textbooks, which were kept in dusty racks for quite some time, are being dusted and read by all in order to reinforce the basics. But it is not the first time that such a financial crisis is wrecking havoc, the great depression of 1929 is one of the largest in recent history. Many economists have given their opinions on the Great Depression, but the work done by two great economists -Milton Friedman and Anna J. Schwartz helped the world to understand the Great Depression in a better way. The book authored by Milton Friedman and Anna J. Schwartz, ‘A Monetary History of the United States, 1867-1960’, gives a vivid description about the reasons behind the Great Depression. “The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy”, says Milton Friedman. To understand the reasons of the great depression we need to understand the world scenario which existed during 1900-1940s. Since 1870, the Gold Standard was highly successful until the beginning of World War I (WWI). The leadership of Bank of England had provided very sophisticated management of the international system, with cooperation from other major central banks. But the Gold Standard was suspended during the World War I because every country needed more financial flexibility to finance their war efforts. The end of the WWI saw enormous economic destruction in the world. Great Britain was economically and financially depleted and hence the leadership of the international system shifted from the Bank of England to the Federal Reserve. But due to the lack of experience and the decentralized structure of the Federal Reserve, its leadership was ineffective in managing the international system. The acceptability of the Gold Standard was also reduced because of the change in the economic views and political balance of power in the world. Ironically, reduced political and ideological support for the Gold Standard made it more difficult for the central banks to maintain the gold values of their currencies. As a result, when some countries started the reconstitution of the Gold Standard in 1920, it proved to be unstable and gave rise to currency speculation. In order to curb the money supply which was flowing to speculators through bank credit, the Fed started tightening of the monetary policy in 1928. The US economy, which had slowed down because of the world war, was further adversely affected due to the tightened monetary policies. As a result, in October 1928 the US stock
FinLoungE
FinQ 1. Identify the images & Connect..
2. The story goes that X and Y were set to take corporate finance class for business students despite the fact that they had no prior experience in the subject. When found the material inconsistent so they sat down together to figure it out and as a result of this an article was published in the American Economic Review and what has later been known as the Z. X was awarded the 1985 Nobel Prize in Economics. While Y was awarded the 1990 Nobel Prize in Economics, along with two other counterparts, for their work in the theory of financial economics, Identify X, Y and Z 3. Identify and Connect the Pictures
4 A sitter. Identify this new CEO of an Internet major.
5. Identify the individual logos and connect the companies.
6. To hide his losses he used one of the bank’s error account numbered-88888 to do unauthorized Speculative trading. He put a short straddled in stock exchanges hoping Japanese Stock market would not move significantly. However Kobe earthquake hit 1 day’s later sending Asian market to tailspin. The whole episode led to collapse of one of the oldest bank. In 1999 a film was made based on his autobiography. Identify the person 7.Which Indian financial Institution has Dog in its Logo? 8. Identify the coat of arms of a one of the oldest Banking family, the basis of whose fortunes were laid during the early 1800’s. The story of their family has been featured in a number of films. 9. What is the phenomenon in some stock market called when stock returns in October are lower than other month? Note that the major stock market crashes in history like in 1929, 1987 and recently in 2008 roughly occurred in October. The name came from the following quotation from a book “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” Identify the book also. 10. Ending with an easy one, Name world’s first credit card?
© The Finance Club, Indian Institute of Management, Shillong
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All Enteries should be mailed at
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Team NiveshaK
Thank You :)
We would like to thank all the 30-odd contributors who sent articles for the January issue. we look forward for your continued support.
ARTICLE OF THE MONTH
The article of the month for January 2009 goes to Mr. Anshul Gupta and Miss Radhika A.R of IIM Bangalore. They receive a cash prize of Rs.1000/-. CONGRATULATIONS!!
Fin-Q Winner for december issue
Mr. Puneet Aggarwal of XLRI Jamshedpur. He receives a cash prize of Rs.500/-. CONGRATULATIONS!!
All Are INVITED!!
The team Niveshak invites article from B Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month.” and would be awarded cash prize of Rs.1000/Please send your articles before 15 February 2009 to
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Niveshak
Volume 2 Issue 1
January 2009
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