Risk Management, PRMIA

Identify Risks

'Identify Risks' will focus on risk identification at both the micro and the macro levels. Occasionally, it will offer solutions for managing the same. Note: The views expressed here are personal.

January 26, 2010

Reforming the money systems

Worldwide the extant money systems are bank debt fiat systems ---the money is generated by debits and credits made by commercial banks (currency notes are a relatively small portion of our money). Unrestricted creation of this fiat money can lead to uncontrollable inflation. Hence, a monetary authority is required to police the money creation by commercial banks. While this money is not linked to the not-so-useful gold, like bullion money the bank debt fiat money too is scarce. The function of the bank debt money as a “store of value” combined with the positive interest rates, encourages hoarding of this money. This scarcity adversely affects the “medium of exchange” function of money—say ten entities may not be able to exchange goods and services amongst themselves if they lack money.
Considering that India’s population may peak soon, a few decades later the dependency ratio (the ratio of number of individuals aged below 15 years or above 64 years, to the number of individual aged between 15 years and 64 years) may spike. When Bismarck instituted a retirement age of 65 years in 19th century Germany, the average life expectancy in Germany was 48 years. We have to do away with a fixed retirement age, or may be push it to say 100 years as promises of a leisurely retirement are unlikely to be kept if retirement occours too early. Also, some of our money needs to be anchored with a future need of ours. This alone can make retirement planning meaningful—what use is the conventional money if inflation renders it insufficient to buy anything a few decades later. At an interest rate of 3% p.a., 10gm of gold invested in 1 AD would now equal the weight of the earth! So, we need to accept that high interest rates are not sustainable without accompanying general inflation, unless the money is anchored in a future need that is fulfilled by increased capacity generation. The solution could be to incentivize capacity generation by offering positive interest rates, and to encourage the role of money as a medium of exchange by charging negative interest rates once the capacity is generated. The negative interest rate would also correspond to depletion in the residual life of the capacity generated. The demurrage charge on currencies (negative interest rate) implemented by Gesell was formally endorsed even by Keynes.

Continue reading "Reforming the money systems"

Posted by Aniruddha Godbole at 12:24 PM | Comments (1)

November 30, 2009

Mutual Funds in India: Lending to top-rated corporates below call money rates

In recent times, the money market in India has been flush with liquidity.
Around Rs 1 lac crores (US$ 21bn) was today's (30-Nov-09) turnover in the three segments of the money market. The weighted average interest rate was 3.25% p.a. in the overnight call money market. The call money market is uncollateralized. Besides, Rs 88K cr (US$ 19 bn) was parked with the Reserve Bank of India by banks at 3.25% p.a. under the central bank's reverse repo facility (only government securities are acceptable for this facility) for one day---interestingly the weighted average call money rate that is uncollateralized is similar to the reverse repo rate of 3.25% available for parking excess liquidity with the central bank. The total outstanding bank credit in India is Rs 28.91 lac cr (US$ 624 bn) while the outstanding aggregate deposits is Rs 41.67 lac cr (US$ 900 bn).
Interestingly, Mutual Funds (under their short-term debt schemes) are lending to top-rated corporates on an uncollateralized basis at Mibor plus either a negligible or even negative spreads. Mibor is the Mumbai Interbank Offer Rate--a polled rate for the inter-bank call money market--and today the Mibor was 3.30% (this benchmark is similar to London's Libor).

Continue reading "Mutual Funds in India: Lending to top-rated corporates below call money rates"

Posted by Aniruddha Godbole at 04:33 PM | Comments (2)

October 05, 2009

"Law of Conservation of Financial Risk"...

Does a "Law of Conservation of Financial Risk" on the lines of "Law of Conservation of Energy" exist?
What does it or what could such a "Law of Conservation of Financial Risk" mean?

Continue reading ""Law of Conservation of Financial Risk"..."

Posted by Aniruddha Godbole at 01:07 PM | Comments (9)

August 31, 2009

Riksbank's negative interest rate experiment...

Effective 8-Jul-09 Riksbank pays -0.25% on deposits!
As per the Minutes of the Executive Board’s monetary policy meeting on 1 July 2009:

Continue reading "Riksbank's negative interest rate experiment..."

Posted by Aniruddha Godbole at 08:29 AM | Comments (0)

August 01, 2009

Googling Sentiments...

Larry Summers, Economic Adviser to the US government, recently mentioned that the more normal levels of the search "economic depression" is an indication that the economic free-fall has ended.

Continue reading "Googling Sentiments..."

Posted by Aniruddha Godbole at 07:13 PM | Comments (1)

June 28, 2009

How can exotic options be used for risk management?

More than half of all exotic options are currency options. And more than 90% of exotic currency options are barrier options.
So, the question may be simplified (over-simplified?) to: what is the use of a long currency barrier options position for the purpose of risk management (we know that the seller of these options make thick margins on this business and thus the sellers of these options would certainly find these options useful!)

Continue reading "How can exotic options be used for risk management?"

Posted by Aniruddha Godbole at 08:50 AM | Comments (3)

May 27, 2009

Negative nominal interest rates in the US?

Professor Gregory N Mankiw wrote a very interesting article entitled "It may be time for the Fed to go negative", The New York Times,18-Apr-09. Professor Mankiw gives the following example (borrowed from a student attending one of his seminars) :

"Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit."

"Fed Study puts ideal interest rate at -5%", Financial Times, 27-Apr-09 is interesting.

And read this: "FRBSF Economic Letter 2009-17; May 22, 2009: The Fed's Monetary Policy Response to the Current Crisis"

I would like to point out a few problem areas with reference to negative nominal interest rates in the US.

Continue reading "Negative nominal interest rates in the US?"

Posted by Aniruddha Godbole at 01:27 PM | Comments (0)

April 29, 2009

Why is India's swap curve almost always below the government securities curve?

“The swap curves have often traded below the government securities curve.” (Source: Reserve Bank of India’s Report on Currency and Finance 2005-06 (section on Financial Market Integration) dated 31-May-07)

In recent times, the swap market is overwhelmingly concentrated in the Overnight Indexed Swap (OIS) linked market. The OIS benchmark is the Mumbai Interbank Offer Rate (MIBOR). And the remark about the swap curve often being traded below the government securities curve continues to be true. In fact this is the case almost always.

Why should the OIS-linked swap curve be below the government securities curve?

Continue reading "Why is India's swap curve almost always below the government securities curve?"

Posted by Aniruddha Godbole at 06:42 AM | Comments (0)

March 03, 2009

The Rating Demons: Why they are the real demons and the case for nationalizing them before any possible nationalization of the banking system

Since August 2007, Banks have been derided for their role in causing the current mess in the financial sector, which has clearly spilled over into the real economy. And to my mind, the banks thoroughly deserve it.

Regulators too have faced a lot of flak. Their mistakes are almost entirely by way of omission rather than commission. Let me elaborate. Prior to the current crisis, some Financial Stability Reports (published by various Central Banks and some supranational agencies) had pointed out some of the same lacunae that are now being 'found' post-facto. One such report, which I remember is the Bank of England's Financial Stability Report (July 2006). I have selected some of the relevant extracts and compiled a note at the end. While there seems to have been an appreciation of the systemic risks by atleast some Central Banks...very little was effectively done to manage these systemic risks a priori.

In his recent comments, the ECB President Trichet said

...The current crisis is a loud and clear call to extend regulation and oversight to all systemically important institutions – notably hedge funds and credit rating agencies – as well as all systemically important markets – in particular the OTC derivatives market...

Until recently, the hedge fund industry was the favourite "whipping boy" for most commentators and that is principally because the typical hedge fund has short horizons and high leverage.And while the hedge fund industry should be required to report their activities--for better market surveilance of their activities, I find no wrong with their buiness objectives. The key control has to be market surveilance (to ensure non-manipulation of markets) and reduction is counterparty exposure of systemically important institution to hedge funds. Banks may have replaced hedge funds as the favourite "whipping boy"---atleast temporarily. Interestingly, Rating agencies have been largely spared by most commentators. Perhaps, because the damage caused by them is not so easily quantifiable. It is my case that the Rating Demons are by far the biggest cause of concern (out of banks, regulators, hedge funds and rating agencies).

Before I try to justify my case, please consider the following two data points in relation to the US:
1. The total bailout disbursements made till 18-Feb-09 is US$ 337 bn (out of the US$ 700 bn available for disbursements). Besides, guarantees of US$ 1.98 trillion have been announced (Source: Grail Research Bailout Tracker).

2. As per Federal Deposit Insurance Corporation data, FDIC-insured Commercial Banks and Savings Institutions have paid income tax of U$ 678 bn in the period 1992 - 2007. This period roughly begins after the previous major financial sector crisis, namely the Savings & Loans crisis.
The then non FDIC-insured banks such as Goldmansachs, Merrill Lynch,...,& insurance companies such as AIG; would have paid taxes over and above this US$ 678 bn (and this has not been adjusted for inflation for considering the US$ of today).

The eventual cost of bailout will depend upon the salvage value of investments made, the guarantees that actually require the guaantor to perform, the value of rights acquired while extending guarantees,...
The Swiss government actually made a profit on its previous bailout of UBS. Whether, the eventual cost of bailout is in excess of the taxes collected from the banking system or not will only be known at a much later date. Its possible that the banking system may still be revenue positive for the exchequer, net of the eventual cost of bailout. If and when we consider complete (management control and permanent)nationalisation of the banking system we would have to ask whether the nationalised banking system would generate higher revenues for the exchequer, net of future bailouts? And to my mind this is a necessary (but not sufficient) question which needs to be answered before permanently nationalising the ownership as well as management control of the banks.

The rot in rating agencies seems to be much more widespread. I found the evidence damning.

...e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S&P speaking frankly about a deal they were being asked to examine.

"Btw — that deal is ridiculous," one wrote. "We should not be rating it."
"We rate every deal," came the response. "It could be structured by cows and we would rate it."...

But, surely one rotten apple does not cause the whole basket to rot!

So, read this:

...The Securities and Exchange Commission in a July report found the credit-rating companies improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

An e-mail that a S&P employee wrote to a co-worker in 2006, obtained by committee investigators, said, ``Let's hope we are all wealthy and retired by the time this house of cards falters.'' ...

And for the most damning part read this:

...It amounted to a ``market-share war where criteria were relaxed,'' says former S&P Managing Director Richard Gugliada.

``I knew it was wrong at the time,'' says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. ``It was either that or skip the business. That wasn't my mandate. My mandate was to find a way. Find the way.'' ...

...Moody's could produce a lower default rate by incorporating a decade of ratings stability for structured finance into its assumptions. The average five-year loss rate on U.S. structured finance products between 1993 and 2003 was 1.9 percent, compared with 6.3 percent for corporate bonds, the company had said in September 2004. A drawback was that raters didn't have data going back to the 1920s, as they did on corporate bonds.

In a press release on the report, Moody's said ``structured- finance ratings are broadly comparable in quality to the ratings of corporate bonds.''...
...Philippe Jorion, 53, a finance professor at the University of California, Irvine, criticizes the Moody's decision to factor ratings stability into its evaluations.

``This uses the output of their model as input into their models,'' Jorion says. ``This type of model is totally out of touch with the underlying economic reality.''...

...according to an Aug. 17, 2004, e-mail obtained by Bloomberg. Managing Director Gale Scott warned of the ``threat of losing deals'' to Moody's unless the company relaxed its rating requirements.

``OK with me to revise criteria,'' replied Gugliada, then S&P's top CDO-rating executive, the e-mail exchange shows...

...Gugliada says that when the subject came up of tightening S&P's criteria, the co-director of CDO ratings, David Tesher, said: ``Don't kill the golden goose.''...

The three main rating agencies worldwide are Standard & Poors, Moody's and Fitch Ratings. S&P is a unit of McGraw-Hill Cos. Moody's is a unit of Moody's Corp. Fitch is a unit of Paris-based Fimalac SA.

McGraw-Hill Cos paid taxes of US$ 5.9 bn in the period 1998 - 2008.
Moody's Corp paid taxes of US$ 1.9 bn in the period 2004 - 2008. Fitch Ratings generated an operating profit of EUR 178mn in fiscal 2008.

Thus, even by very conservative estimates the rating agencies would have paid less than 2% of the taxes paid by the banking system. And what portion of the current financial crisis can we attribute to the rating agencies? Its not possibly to precisely quantify this...But, consider the following: even if only 10% of the current mess is attributable to the rating companies (I think 10% is an under-estimation), the rating companies are still worse than banks by atleast five times -- because the Rating Demons cause a five-fold damage (requiring bailout) corresponding to every dollar of revenue generated for the exchequer by way of taxes, in comparison to the banks' damage (requiring bailout) corresponding to every dollar of revenue generated for the exchequer by way of taxes.

While decisions regarding nationalization, should take into account a whole lot of issues...I think the above metric i.e. ratio of damage to the contribution to the exchequer(for a defined period) should not be ignored especially when it turns out to be decisively in different in comparisions.

In comparison to the banks, the Rating Demons are a much more surer case of privatizing profits and socializing losses.

If the picture in the rest of the free market economies is similar to that in the US economy, the above conjecture will substantively hold for rest of the free market economies too.

I think nationalization of the Rating Demons should logically take place prior to any serious talk about the nationalization of the banking system!

WHAT DO YOU THINK?

NOTE : The following are some of the relevant extracts taken from the Bank of England Financial Stability Report (July 2006):

The Report
discusses two extreme but plausible scenarios:
• A sharp turn in the credit cycle: There are several potential supply-side factors (for example, a marked further rise in oil and other commodity prices) which might prompt such a reassessment of creditworthiness. Were the credit cycle to turn sharply due to these forces — for example, on the scale of the early 1990s recession in the United Kingdom
— it would have implications for, in particular, the corporate and household vulnerabilities.
• A substantial further fall in asset prices: Despite recent market movements, an abrupt and widespread rise in risk premia and risk-free rates would have important implications for, in particular, the low risk premia, global imbalance, household and corporate vulnerabilities.
…could trigger additional amplification channels…
In such severe stress situations, certain structural features of
the UK and global financial systems, which have grown in importance over the past few years, could amplify market and credit risks. For example, UK and international institutions have increased their exposures to potentially illiquid instruments over recent years. Given their potential illiquidity,a rapid unwind of these positions in the event of losses would tend to depress prices by more than has been the case in the past, particularly if many investors were pursuing similar strategies in such markets. The adjustment in the prices of some risky assets during May and June illustrate these effects.
On the liabilities side of the balance sheet, UK banks’increasing dependence on wholesale funding has heightened their sensitivity to liquidity developments. Increasing linkages within the UK financial system — for example, arising from interbank and counterparty exposures between UK banks and LCFIs — would also amplify the transmission of risk at a system-wide level. All of these factors would tend to increase correlations between asset returns in a stress scenario, thereby reducing some of the diversification benefits that appeared to exist when correlations were low. Again, recent market developments perhaps illustrate such effects, albeit on a limited scale.

...What actions are needed?
A range of actions might usefully be taken by both the private and official sectors to insure against these risks...
A third priority area is liquidity risk management, in particular liquidity risks arising in markets for new and complex instruments. More work is needed on appropriate liquidity standards for firms and liquidity stress tests, both domestically and
internationally...

Trading revenues and Value-at-Risk...These institutions experienced a 50% increase in trading revenues in 2005, but this was accompanied by only a relatively small increase in their VaR(Chart B). This could mean that firms are diversifying their portfolios more efficiently. But it may also support the widely held view that VaR is an imperfect measure of risk in the trading book...

Collateralised debt obligations and risk...Systemic stability also relies on investors knowing what risks they are bearing. The very complexity of these instruments makes it difficult for investors to determine precisely how exposed they are to particular risk factors. The potential losses, and hence the market values, of CDO tranches are dependent on default correlations within the existing portfolio, which are difficult to calibrate. Modelling difficulties can also lead to errors in hedging, so traders can find themselves with residual exposures that they thought they had hedged. In such situations, they may wish to reduce the residual exposure if credit losses rise. But with the liquidity of CDO markets still developing, especially for some of the more complex instruments, a shortage of secondary market liquidity could potentially amplify price movements in the event of a shock...

Posted by Aniruddha Godbole at 04:27 PM | Comments (1)

February 06, 2009

What ails India's Corporate Bond Market and a solution

The new issuance of bonds and debentures by non-Government Public Limited companies in India was at Rs 1,309 crores (US$ 270mn approx) in the whole of 2007-08. This same class of companies made an equity issuance of Rs 56,848 crores (US$ 11.7 bn) over the same period(Source Reserve Bank of India Annual Report 2008).

In the US, the largest concentration of corporate issuers is of those rated as 'A' followed by those rated 'BBB'. In India, the corporate bond market is largely concentrated in the 'AAA' issuers.

In the eurozone the outstanding floating rate long term bonds as a percentage of the total outstanding bonds issued by MFIs(Monetary financial institutions i.e. financial institutions forming the money-issuing sector of the euro area. They include the ECB, the NCBs of the euro area countries, and credit institutions and money market funds located in the euro area. MFIs is 'the biggest private sector
issuer category in the euro area') has been growing from 1999 to 2006.The outstanding floating rate long term bonds were around 40% of all outstanding long term bonds issued by MFIs while the corresponding number for fixed rate bonds was around 55% (Source: ECB's Euro Bonds and Derivatives Markets June 2007). In general, credit spreads are larger for fixed rate loans rather than floating rate loans.

In India there is no transparent+traded benchmark for floating rate borrowings.

In the context of refinancing fixed interest rate housing loans of banks the National Housing Bank gives itself the right "... to revise the rates on outstanding loans on completion of 3 years...". And banks pass on this risk of revision in fixed interest rate for housing loans to retail borrowers every three years.

In effect, fixed rate loans are floating rate loans with a three year reset. And that too without transparency in which the way the interest rate is reset.

The benchmark used for the existing sovereign bonds is the average of the last three(for some bonds its six) 364 Day TBill Auction implied cut-off yield rounded to two decimal places. These bonds have a half yearly coupon.This is a transparent benchmark as its based on a fortnightly aution(The calendar for TBill issuances released by the Reserve Bank of India indicates the fortnighlty schedule for 182 Day TBills).

The Reserve Bank of India has already proclaimed an intention to move to the average of last three 182 Day TBill Auction implied cut-off yields as it tenor corresponds better with a half yearly coupon(for the exisiting sovereign bonds the reset of the coupon is either half yearly or yearly, thought the coupon is half yearly).

In its Master Circular-Interest Rates & Advances dated 1st July 2008 The Reserve Bank of India informs and instructs banks that

'...In order to ensure
transparency, banks should use only external or market-based rupee benchmark interest rates for pricing of their floating rate loan products. The methodology of computing the floating rates should be objective, transparent and mutually acceptable to counter parties. Banks should not offer floating rate loans linked to their own internal benchmarks or any other derived rate based on the underlying. This methodology should be adopted for all new loans. In the case of existing loans of longer / fixed tenure, banks should reset the floating rates according to the above method at the time of review or renewal of loan accounts, after obtaining the consent of the concerned borrower/s."

In BIS' Developing Corporate Bond Markets in Asia the then General Manager of BIS asked

"...if the US market has a government bond benchmark yield curve that helps in the pricing of corporate debt, does that mean your market should have the same kind of yield curve? Let’s bear in mind that even the euro zone’s corporate bond market, which is about $7 trillion in size and which functions efficiently, relies for its benchmark yield curve not on a government curve, but on the euribor or euro-swaps curves."

V.K. Sharma & Chandan Sinha both from the Reserve Bank of India, but in their personal capacities say "...The government securities market is well developed, so that it can provide the benchmark yield curve for bond pricing."

A soverign benchmark like the TBill yield allows us to clinically separate the spread over the benchmark, as we can attribute this spread to the credit risk of the corporate issuing the bond. But, swap market trading volumes often dwarf sovereign bond trading volumes. This in general makes the swap curve more observable(from traded prices). Thus, by having a swap market which trades on a sovereign benchmark we can get the best of both world's: the benchmark sovereign rate for floating rate bonds that would also likely be easily observable when the swap market trades on this bechmark. So in a way India could attempt to get the better aspects of both the American and the European corporate bond markets.

We try to convert the only transparent benchmark for sovereign bonds i.e. TBill benchmark into a tradeable benchmark in the swap market(this will require interest by banks/FIs/other traders and hedgers). Simultaneously, we try to have all floating rate loans to be linked to the same benchmark(this may be enforced by regulations). This will build a virtuous cycle as it will allow banks which want to lend at a fixed rate(floating rate) to convert it into floating rate(fixed rate) by using the swap market. (Currently, only the Overnight Index Linked Swap(OIS)is liquid in India's Interest Rate Swap Market). This will create a conducive environment for issuances by non-AAA corporates. This will take a lot of stress on the demand for bank credit by corporates.The availability of a floating rate corporate bond market and swap market, will together allow pricing for the fixed rate corporate bond market to become much simpler.

The above, in my humble opinion is the key to growing a liquid corporate bond market that is able to meet corporate India's debt financing needs.

Posted by Aniruddha Godbole at 08:08 AM | Comments (0)

January 26, 2009

Should public resources be auctioned? On which parameter?

Background: In India sale/access to natural resources like oil & natural gas, spectrum(in the telecom sector) has often been auctioned. At times, auctions have also been combined with revenue sharing agreements i.e. the private entity which wins the right to access the particular natural resource also has to share a portion of its revenues.

These auctions often cause controversies.

Unitech sold its 60 per cent stake in the telecom venture to Telenor, for Rs 4,470 crore. Swan Telecom sold 45 per cent stake to the UAE-based Etisalat for Rs 4,100 crore ($900 million). This was Rs 2,450 crore more than what its promoters paid to acquire the licences in February. Unitech also had acquired licences for 22 circles by paying Rs 1,650 crore to the Government. The valuations received by these Indian companies are unprecedented as neither of them has a single subscriber nor any infrastructure........

The debate in the Indian media seems to be biased in favour of getting the highest possible price for every publicly owned natural resource.

I would like to argue otherwise.

To my mind, the Government should be trying to get for its citizens goods & services at the lowest possible sustainable prices. Thus, selections of private managers should be carried out by defining an auction on the correct financial parameter. Let me elaborate.

Scenario: A billionaire offers to allow you to deploy a very large amount of his funds—a sufficiently large amount which could influence prices in pockets of the financial market.
Question: would you expect the billionaire to pay you a part of the returns you may earn on deploying these funds? Or, would you be happy to do it for free, if you have already manage a significant amount of money and you hope that your existing funds will be able gain substantially from your enormously increased influence in the financial markets? Or would you be willing to pay the billionaire for allowing you to acquire this new influence in the financial markets?

As on 31st March 2007, the Employees’ Provident Fund Organisation(EPFO) had investments of Rs 1,69,939 crores (US$ 34bn approx.) under Employees’ Provident Fund; Rs80,766 crores (US$ 16bn approx.) under Employees Pension Fund( Securities & Public Account); and another Rs5,533 crores (approx. US$ 1bn) under Employees’ Deposit Linked Insurance Fund( Securities & Public Account).

As per a Press Trust of India report dated 29th July, The Central Board of Trustees (of the Employees Provident Fund Organisation) have decided to allow three private sector firms and one public sector firm to manage provident fund of employees. The lowest bidder quoted an asset management fee of 0.0063%. Another private sector firm quoted 0.0075%, while the public sector firm(which is also the existing manager for the EPFO funds) and a third private sector firm quoted 0.01% each.(Note: Two bidders, both from the private sector, who bid zero were actually disqualified. However, the disqualification was a technical legality)

An expert estimate of the average cost to company of a fund manager for managing a large fund is of the order of Rs 2.5 crores(US$ 0.5mn approx.). Thus, for the three private firms the cost of the fund manager could be of the order of Rs 7.5 crores (US$ 1.5mn approx.). Considering the infrastructure costs as well as the costs of other key employees, these firms may barely be able to recover their cost. Why? Because the total asset management fee earned by the three private firms in managing the EPFO fund would total to around Rs 10 crores (US$ 2mn approx.)! Maybe, the three private sector firms are quoting these rates out of some new Corporate Social Responsibility(CSR) initiative! Maybe the private players will not deploy their best talent. Or may be the will keep the staff for the fund really small. Maybe they will use the same staff which manages other funds, and which manages the EPFO funds as if it were part of their secondary or tertiary work stack! Or maybe the asset management fee would be renegotiated (revised upwards) at a later date!

Why bother as long as the returns on the EPFO funds managed by the private firms are close to the average returns on the rest of their(private firms’) funds! In fact, all we should do is monitor the EPFO fund performance.
I believe the auction conducted by EPFO was conducted on the wrong parameter. The auction should not have been conducted on asset management fees. Rather, the technical bids evaluation process should have shortlisted those private firms which have a track record which satisfies the EPFO. Then, the asset management fees(in %) should have been negotiated with the shortlisted firms to arrive at a single number. Last and most importantly, the financial bids should have been on the basis of a multiple of the average future returns earned by that entity in all its other(existing and future) assets under management. As an example consider that ABC, PQR and XYZ are among the shortlisted firms. Then, they should submit their multiples. Say, ABC promises a minimum return of 1.05 times that of the average future return in its other funds. The bids by PQR and XYZ could be multiples of 0.90 and 0.95 respectively. Then, the most favourable bid is that of ABC, followed by the one made by XYZ.
What if the promised return is not earned? The difference should be credited to the EPFO fund managed by the private firm, from the private firm’s own pocket. And as a risk mitigating factor the EPFO should take good collateral as a security against the private player not fulfilling its promise.
If the private players cannot promise even something close to its own performance for its other assets under management, we can be sure that EPFO is being shortchanged!

WHAT DO YOU THINK? WHAT MIGHT BE A BETTER SOLUTION?

Posted by Aniruddha Godbole at 11:27 AM | Comments (1)

December 10, 2008

Derivatives in Public Finance | Oil prices in India

The following analysis and the suggested solution is largely specific to the Indian context. However, parts of the following may be relevant to crude oil producing countries and/or to those countries which do not have a market based oil pricing mechanism for retail customers.

Is the government subsidizing petroleum products? The contribution of the oil industry to the central and state exchequers in 2005 was Rs 573 billions and Rs 432 billions respectively. These figures exclude corporate taxes and dividends(and dividend taxes paid by State owned or partly State owned oil companies). These figures are available in the Report of the Committee on Pricing and Taxation of Petroleum Products, February 2006. Let us consider a modest 10% increase p.a. (compounded) for four years. The combined contribution to the government exchequer would then be Rs 1.47 trillions for 2009. However, this figure is an underestimation since the upstream oil companies in among the State owned/partly State owned(ONGC,OIL) sell indigenous crude oil at market prices. As per US’ Energy Information Administration the average global cost of finding(exploration) and lifting of crude oil was US$ 23.19 per barrel in 2006. India's Ministry of Petroleum & Natural Gas gives the budgeted expenditure on exploration and production by public sector oil companies(‘Basic Statistics’ document at the Ministry’s website) for the year 2009. Even if we conservatively assume that the entire cost of exploration and production by all public sector oil companies (except GAIL and ONGC Videsh) is for crude oil, the cost of indigenous crude oil would not exceed US$ 23 per barrel in 2009. At US$ 123 per barrel( the average of India’ international crude oil basket in Q1 of 2008-09 was US$ 118.1) these public sector companies would make a gross profit of Rs 1 trillion approximately. Thus, the a very conservative estimate would be that the government would make Rs 2.47 trillions approximately. This exceeds the gross under-recovery that the Oil Marketing Companies(OMCs) are expected to make. The Ministry of Petroleum & Natural Gas expects the OMCs to have gross under-recoveries of Rs 2.45 trillions if the international price were to stay at US$ 123 per barrel. Since the oil pool deficit(surplus?) mechanism is not subsidizing the consumer on a net basis when oil prices are at record levels, we can only infer what might be the case at lower prices of crude oil such as prevailent today(sub US$ 50 per barrel).
The Planning Commission’s Integrated Energy Policy(August, 2006) suggests market(trade parity) based prices be used. It notes that :

‘…the prevailing pricing and taxation policies and the market structure provide significant protection to the private refineries.’

An alternative solution may be considered.

Even if its becomes administratively feasible to update product prices on a fortnightly or monthly basis, we must bear in mind that poor people in our country are not in a position to face this volatility (risk) in prices, since to bear financial risk one needs financial capital ---and by definition poor people have negligible or no capital. There exist forward markets overseas, wherein crude oil and petroleum product prices are available (Platts prices are benchmark prices for crude and petroleum products, and are widely used). The government while preparing its annual budget for the next financial year can use the forward Platts prices and the corresponding INR/US$ exchange rate in the forward market to calculate the crude oil and petroleum product prices which may be frozen in INR terms by way of forward contracts(or swap). If these fixed prices (for crude oil and each of the petroleum products) are higher than what the government feels appropriate for the end-consumer then lower fixed prices could be put in place. The difference between the prices would be made good by the government to the oil companies by reimbursement (or oil bonds) in a gradual manner throughout the year. The prices would be fixed for the whole year. In fact it would only be prudent for the oil companies to actually enter into these forward contracts so that they do not suffer from adverse movement of prices in international markets. However, this would be best left to the managements of the individual oil companies. Of course, oil companies would be free to sell at prices lower than the fixed prices, if they wish to do so for competitive reasons.
The above system would be transparent, would allow stability in retail prices through the year, would introduce market based pricing which in turn could promote healthy competition between oil companies. Moreover, such a system would allow de-politicisation of petroleum product prices.
Besides, the Ministry of Finance will be able to forecast revenues better. A level playing field will now be available to public sector oil companies. Stable retail prices of petroleum products would help in anchoring general inflationary expectations.

Posted by Aniruddha Godbole at 10:11 AM | Comments (0)

November 20, 2008

Quick fixes won't work in the real economy: Implicit Dollarisation and its impact on national incomes and global trade in volatile times

Most of the invoicing of international trade is done in USD (Pl note technically the invoicing currency maybe be distinct from the currency in which the payment is made).

Last year the global trade was USD 13.6 trillion approximately.

And Global GDP in the same period was USD 54.3 trillion.

With an increasing Global trade/Gloabal GDP ratio, pricing of tradeable goods and services is increasingly happening in US$ implicitly if not explicitly. The moment the domestic pricing (in a country whose currency is not the USD) moves away from US$ price in the international market, there is likely to be an arbitrage in that tradeable good/service.

For example, if I can buy copper(of a certain grade) for say USD 2,500 per tonne while the internatonal price of the same grade of copper is USD 3,500 per tonne; I could make some riskless profit if the difference is higher than the transaction costs(freight,etc).

What does this mean for price risk managment in corporates outside the US?

How does such a corporate entity manage its implicit currency risk(say in the above example, a liquid OTC contract for copper in the domestic currency is not available, neither is there a liquid copper futures contract in the domestic currency) for its purchases and sales in the domestic market.

I think the solution is simple if the correlation of US$ equivalent prices and US$ price in international market is very high.

Often significant correlation exists,but it is a lot less than perfect.

This low appreciation and a lack of management(where posssible) of implicit currency risks is going to increasingly hamper prospects of global trade in the future.Already we know from media reports that the World Bank expects a contraction in global trade :

In closed-door talks, leaders also discussed ways for nations to boost government spending to counter a global slowdown that could lead trade to contract next year for the first time since 1982, said World Bank President Robert Zoellick.

While the adverse impact on trade would be partly because of credit crunch( only US$ 25 bn as per an arguably over-optimistic(my words) market estimate mentioned by WTO )the problem might infact be much larger because of lower churning of trade credit and super-high volatility in the currency market (the good i.e. non-toxic linear derivatives called a forward contract can only postpone the problem of volatility, and the good non-toxic derivative called a plain vanilla option is extremely expensive).

PROBLEM STATEMENT : Implicit dollarisation, or implicit euroisation or any other implict foreign currency--isation is almost inevitable for other countries considering the long term trend of growth in international trade. The accompanying implicit currency risk is also a reality which will only grow in the long term.
OBSERVATION: Until volatility in currency market subsides, not only international trade, but also national incomes will suffer from low growth/contraction.And unfortunately, it might not be possible to accelerate stabilisation(reduction in volatility) in the currency markets since acceleration to an unknown level would cause the volatility to spike! Quick fix solutions could be counter-productive even if they were available

WHAT DO YOU THINK?

Posted by Aniruddha Godbole at 02:14 PM | Comments (2)

October 31, 2008

Quantos ....do they improve price discovery?

The Singapore Exchange(SGX) has a US$ denominated Nifty futures contract in Singapore. BSE's Dollex-30 is currently 'under review' by US' Commodity Futures Trading Commission and on getting a 'no action letter issued ' it may be introduced in America.

Would the introduction of overseas exchange traded derivatives based on Indian equity drive price discovery of Indian indices overseas? I shall attempt to answer this question. Please consider the following thought experiment:

Gold futures for current month's expiry are being traded at US$ 800 per ounce in London. Now, suppose a commodity exchange in India introduces an INR denominated contract which settles at the same numerical value and on the same date as the contract in London. However, the contract in Mumbai is necessarily cash settled. Thus, this contract in Mumbai is also being quoted at say INR 800 per ounce(I have just defined a QUANTO).

If on expiry date the London contract settles for US$ 840 per ounce then the contract in Mumbai will also settle at INR 840 per ounce.

Thus, for a trader in London for whom the base currency is US$, the gain/loss would be 5% in his currency.

Similarly, for a trader in Mumbai for whom the base currency is INR, the gain/loss would be 5% in his currency.

By using the contract in Mumbai, the trader in Mumbai can have a pure play on the movement of Gold prices without taking INR/US$ exchange rate risk.

Those of us who buy gold in India, will readily notice that this new contract in Mumbai is an artificial construct, as gold prices in jewelry stores in India are based upon the price of gold in US$ per ounce converted into INR per gram, to which an additional margin is added by the jeweler. The fact that INR denominated gold cannot currently exist in the spot market, only reinforces the assessment that INR denominated gold futures contract is an artificial construct.

Although we have an artificial construct, there is no risk-free arbitrage possible between the markets in London and Mumbai. Thus, there is no direct linkage between the two(the linkage may be called weak at best). Even if the turnover of this contract in Mumbai was many times that of the turnover in London, Mumbai would still be a price taker and London the price maker. Unless, traders in London were (irrationally) influenced by the traders in Mumbai.

A risk-free arbitrage would have been possible when the futures price in Mumbai and London are different, only if the INR/US$ exchange rate were fixed—which is clearly not the case.

On the other hand if a US$ denominated INR settled gold futures contract is introduced in Mumbai, then there would be a linkage between the market in Mumbai and London. This link would be created by arbitrageurs who would ensure that prices in the two markets are identical (but for transaction costs). Then, the market with larger volumes can reasonably expect to influence the price in the lower volume market. And if Mumbai were to one day have larger trading volumes than London, then it could influence the prices of gold (in US$) in London.

Similarly, the US$ denominated Nifty futures contract is an artificial construct since the Nifty is denominated in INR.

Considering that there is no real linkage between the SGX's US$ Nifty futures contract and the Nifty contract on the NSE, if the traders in Mumbai collectively believe that they should be taking the price of Nifty from Singapore--it shall be a damaging self-fulfilling prophecy for the Indian derivatives market!

In conclusion, we can say that we the SGX should perpetually be a price taker as long as its Nifty contract is not INR denominated, even if in future its turnover is many times the turnover at the NSE. Rationally, we can also say that the SGX is likely to become a price maker if its Nifty contract is INR denominated, and if its turnover is much larger than the turnover at the NSE---then India have truly exported the most important function of an exchange, namely price discovery.

Note-1: SGX has JPY denominated Nikkei futures contract since 1986 and a US$ denominated Nikkei futures contract was introduced two decades later. All Nikkei options on SGX are JPY denominated.USD denominated Nikkei futures are being traded in the US for decades.
Note-2: Dollex-30 is the BSE Sensex-30 adjusted for the change in INR/US$ exchange rate(in real time). US$ denominated Dollex-30 futures contract is equivalent to INR denominated BSE Sensex-30 futures contract.

Continue reading "Quantos ....do they improve price discovery?"

Posted by Aniruddha Godbole at 02:42 PM | Comments (0)

October 30, 2008

About Aniruddha Godbole

I am working as an adviser in a risk management advisory firm, A.V.Rajwade & Co., in Mumbai,India since August 2006.

I advise corporate and bank treasuries on managing their currency and interest rate risks. I have the ability to identify, assess and manage risks in accordance with the risk appetite of the entity bearing the risk. I am also involved in applied research on various aspects of financial markets.

I hold a Post-Graduate Diploma in Banking and Finance from National Institute of Bank Management (established by the Reserve Bank of India) and have worked for an year as Manager-Treasury in Indian Bank after completion of my Post-Graduate Diploma.

Posted by Aniruddha Godbole at 09:57 AM | Comments (1)

• Contact Me
• About Me

Categories

Archives

• January 2010
• November 2009
• October 2009
• August 2009
• June 2009
• May 2009
• April 2009
• March 2009
• February 2009
• January 2009
• December 2008
• November 2008
• October 2008

Recent Entries

• Reforming the money systems
• Mutual Funds in India: Lending to top-rated corporates below call money rates
• "Law of Conservation of Financial Risk"...
• Riksbank's negative interest rate experiment...
• Googling Sentiments...
• How can exotic options be used for risk management?
• Negative nominal interest rates in the US?
• Why is India's swap curve almost always below the government securities curve?
• The Rating Demons: Why they are the real demons and the case for nationalizing them before any possible nationalization of the banking system
• What ails India's Corporate Bond Market and a solution

Syndicate this site (XML)