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Tuesday, May 23, 2006

Two years of the UPA

The UPA has finished two years, and things look gloomy (Shankar Acharya). The achievements of the UPA include:

  • Quotas in schools; threats of reservation in the private labour market
  • Mandal-style conflicts all over again (politics)
  • The fundamental threat to public finance posed by SEZs
  • The 6th pay commission
  • The Arjun Sengupta report (Gautam Bhardwaj, Susan Thomas, Sunil Jain).
  • The stalled PFRDA Bill

Global factors are part, though not all, of the story. A global `emerging-markets-factor' appears to have taken a beating. India and South Korea are more liquid, when compared with other emerging markets, so these two countries are likely to both do well when times are good and do badly when times are bad. The second thing that seems to have changed is global risk expectations. The VIX is back up to 18%, after slumbering for months at around 12%. I don't fully understand what a higher implied volatility on the S&P 500 does to global general equilibrium.

Ila Patnaik argues that while there are serious problems in the world, the current gloom on Indian stock prices is substantially derived from domestic problems, and less from global factors. Business Standard has two excellent editorials, one ruminating about what has happened to the UPA, and another interpreting recent movements in the stock market.

As with May 2004, a lot is made of margin calls generating positive autocorrelations. The story told is: market goes down, then margin calls hit, and market goes down further. This is plain wrong because derivatives trading is a zero sum game. For each person bleeding a marked-to-market loss promising himself he will never trade again, there is another with a marked-to-market profit. who feels he is a hero who made the right call. In fact, May 2006 was a bit easier on the risk management systems as compared with May 2004, for two reasons. First, the biggest move we have seen in this episode was smaller. Second, margins went up over a period of a few days in response to a slow escalation of volatility. In contrast, in May 2004, margins went up more suddenly.


  1. nice blog with good information !!

    Best Wishes !!!

  2. There has been excellent historical data that shows the very strong inverse relationship between the VIX and underlying S&P level i.e. pick ups in volatility have always taken place whenever there has been a downward correction..No wonder, fund managers in the US take positions in the VIX to hedge against falling index levels. Unfortunatley fund managers in India do not have recourse to such an instrument..

    I also read a couple of papers in Risk magazine last year which pointed out to two broad things:

    1)Falling leverages (debt-equity ratios) have made balance sheets of corporates in Asia far healthier than they were during the time of the Asian crisis..This was one of the drivers for low volatility in the Asian stock markets. Though volatility levels were not as low in the Indian markets, the trend of stronger balance sheets of Indian companies did have an effect (as all of them benefitted from low interest rates to pay off their legacy, high cost debts).

    2) Asian companies have also delivered significantly higher levels of returns (RoE)..However they have also acquired higher levels of operational leverage (instead of financial leverage)..Which basically means that either companies have started acquiring higher fixed cost bases (ex:investments in new plants etc.) or are not sufficiently far off from the break even point..This operational risk could mean that companies in Asia are much more dependent on exports to the US, Europe etc..Obviously any slowdown in the US would lead to falling RoEs and probably higher volatilities.. Again this may not apply all that much to India given that our exports are not as high as the other Asian economies (as a % of GDP)

    Even though some analysts have been pointing out that India does not depend all that much on US demand, the effect could be offset by our currency peg and rising interest rates...Leading to a slowdown in the massive investment projects that were being announced all of last year...

  3. The relationship between volatility and expected index returns is attempted to be captured by the `arch-in-mean' or `garch-in-mean' models. I don't know what they say for Indian index data.

    I also think that the low leverage of Indian companies is quite astonishing. It throws up an opportunity for growth in EPS by adding leverage. See this recent paper by Susan Thomas which talks about India's evolution into a stock market dominated financial system.


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