## Thursday, June 29, 2006

### How easy is it to manipulate a financial market?

A lot of people in India believe (a) that market manipulation is easy and (b) that it happens all the time.

An excellent blog entry by Michael Stastny offers some good reasoning on the issues. The key insight is to distinguish between the ease with which a price can be distorted by a manipulative cartel and the ease with which the cartel is able to walk away holding profits. In the past, I have called this the Abhimanyu problem' (if this literary allusion means nothing to you, that's okay). It's easy to walk into a large long position, with a huge MTM profit. It's enormously more difficult to walk out with no position and clean cash.

Market manipulation is a business, and the basic rules about entry continue to hold. If market manipulation were an easy business offering supernormal rates of return, there would be a flood of entry, and a lot of people would plunge into doing it!

The thought process about position limits needs to be illuminated by such reasoning.

### Bond trading stopped in Japan for two hours because of a computer systems glitch

Jayanth Varma and I have previously written about the systemic risk aspects of computer security [link] [link]. Today, there is story in the New York Times about a computer systems problem owing to which bond trading in Japan stopped for two hours. Add this one to the list of computer disasters that have affected finance.

### Estimation of the equity premium in India

Jayanth Varma and Samir Barua have written a mini-paper on estimation of the historical equity premium in India. They wage a brave war against difficult data problems, and come up with an estimate of 8.75 percent.

A while ago, in October 2005, I had written some notes about my views about the equity premium in India. In that note, I had argued that looking forward, one might estimate an Indian equity premium like 8%. With a short rate of roughly 5% and an equity premium like 8%, this means nominal equity index (total) returns might work out to around 13%.

An equity premium of 800 bps is huge! Just to be safe, in all our discussions about the New Pension System, much more conservative numerical values have been utilised. As an example, in my paper A sustainable and scalable approach in Indian pension reform, which is forthcoming in the LKYSPP India/China book, the three scenarios (page 28) have values of the equity premium of 3.5%, 4% and 4%.

Update: Kaushik Gala says:

Thanks for pointing to the IIM-A equity premium paper. You must be familiar with other estimates as well:
1. 5.2% by Damodaran,
2. 11% by Mehra,
3. 6% by JM Morgan Stanley,
4. 7% or 4.6%, by Haribhakti.

## Wednesday, June 21, 2006

### It was in Bill Gates' self interest to leave

Look at the intra-day time-series of the Microsoft share price superposed with the S&P 500: So it looks like the market feels it was worth giving a golden handshake to Bill Gates worth around 4% of his ownership for relinquishing control of the embattled giant. (How much is that?) I was fascinated by how slow the information processing was. I seem to remember that the announcement came out after hours on Friday? I would have thought that by monday morning, everyone would have made up their mind on how this changes things. But actually, the trading on monday seems to have gone on till evening discovering the new price. The monday evening gap, of around 4%, between MSFT and the S&P 500 was then stable on Tuesday. In the period after Tuesday, the gap rose a bit.

### Central bank transparency

There is a traditional belief that monetary authories have to be enigmatic, and that market participants have to then zealously watch the central bank to pick up crumbs of information and decipher cryptic clues. The transition from Greenspan to Bernanke, with a market that has to learn a whole new style of communication, has highlighted the poor institutional structure of US monetary policy. In a Bloomberg column a while ago, Andy Mukherjee had pointed out that the phrase "unfolding constellation of uncertainties" used by RBI had never before been seen by google. The recent RBI rate hike was a surprise to markets because there was no scheduled monetary policy meeting.

In an article Plain english versus mumbo jumbo in Business Standard today, I argue that modern monetary economics involves a powerful move towards central banks that speak in plain english and are transparent. In a well functioning monetary regime, market participants would only zealously watch the economy, not the central bank. Sound institutions involve a nuanced relationship between data releases, rules, and rate changes.

### The enforcement process at SEBI

The debate on retail quotas for IPOs appears to be continuing, while in the meantime, the SEBI "IPO Scam" order has been having a rough time in the courts and the SAT. An editorial in Business Standard yesterday looks beyond the specifics of this order, and has suggestions for improving SEBI's processes:

• The infamous "ex parte order", which is supposed to only be applied in a grave emergency, is being misused; each SEBI chairman should have only one go at doing this in his three years.
• The first step of an enforcement action should be a well-drafted show-cause notice sent - in private - to the accused. This should come up to UK/US standards of drafting quality.
• The release of this show cause notice to the public constitutes libel, for it is a mere accusation.
• The next step should be a quasi-judicial hearing, in private within SEBI, where the investigators argue as the "prosecution", and a dedicated "bench" of two board members listen to the defence, and award a penalty. There should be a full separation between this "bench" within SEBI and the board member(s) who handle investigations. This will reduce the mistakes caused by prosecutorial zeal.
• It is better to take on one entity at a time, with "five pages of top quality order", instead of writing one jumbo order about 24 entities. It is better to not have policy mistakes like the retail IPO quota, for that sets up an insuperable task of enforcement when millions of households are given an incentive to break the law.

I am, personally, an optimist on how SEBI is faring and where SEBI is going. I think that SEBI is on the right track on the core issue of : rule of law. SEBI has full clarity through SC(R)A and the SEBI Act on what it does. Both these acts are philosophically sound, and have been amended repeatedly so as to solve problems. Regulated entities regularly challenge SEBI at the level of the letter of the law, and SAT has proved to be a successful specialised court hearing financial cases. So while it looks messy, I think the basic framework "rule of the law in the public eye" is in place, and there are self-correcting forces - such as the public failure on the "IPO Scam" order - which will keep pushing SEBI in the right direction. It's messy, like democracy, but that's about okay in my book.

If all of finance operated in such a fashion - with repeated legal challenges to the regulator, and a rule of law - then many of the problems of Indian finance would be solved.

## Wednesday, June 14, 2006

### Trying to understand what happened on the stock market in May

I saw some fascinating data, from CMIE, on the behaviour of foreign investors in the recent days of enhanced market volatility. There are small difficulties in measurement in this data - it includes options notional values, which aren't that clearly interpreted. But options trading is small so it doesn't contaminate the results that much.

The data shows the net purchase by all foreign investors on the equity derivatives market, and on the equity spot market, both measured in rupees crore. I also show the official closing price of the Nifty spot, and of the May Nifty futures, in the table. A useful piece of background is that the last date in the table (25 May) was expiration date for the May contracts.

 Buy on F&O Buy on spot Nifty May Nifty May 10 -156 322 3754 3745 May 11 -852 -1199 3701 3693 May 12 -1124 18 3650 3633 May 15 -1084 -728 3503 3462 May 16 537 -533 3523 3520 May 17 390 -423 3635 3641 May 18 430 -810 3389 3364 May 19 1877 -1361 3247 3224 May 22 1914 -929 3081 3021 May 23 1266 -1243 3199 3191 May 24 883 -1935 3116 3087 May 25 1017 -1632 3178 3180

As an example, if I may read out the last row in the table to you, on 25th May, FIIs purchased Rs.1,017 crore of equity derivatives in notional value, and sold Rs.1,632 crore on the equity spot market. The official Nifty close was 3177.7, and the May futures nicely converged to the spot with an expiration-date closing price of 3180.15.

The story that I think this data tells is like this.

• I know, it seems like a long time ago, on 10 May, Nifty closed at 3754.25. On the three following days, foreigners appear to have been successful speculators, selling on both the spot and the derivatives market. Nifty dropped to 3502.95. By 15 May, a big negative basis (-1.17%) had opened up.
• So from this point onwards, foreign investors were steadily buying on the derivatives while selling on the spot market. This sounds to me like reverse cash and carry arbitrage.
• Particularly, from 19th to 25th, local speculators were selling the Nifty futures, while the FIIs were doing the work of buying on the futures and selling on the spot. The basis showed up values as large as -2% on 22nd may, when FII purchase on the derivatives peaked. I find it reassuring for my story that on the days with the largest FII purchases on derivatives (19-25), the basis was at it's biggest negative values (-0.7, -2, -0.3 and -0.9). Of course, this "basis" is computed by comparing the official closing price on the futures and the official closing price on the spot, so it surely misses out the intra-day story.

These are highly aggregated numbers summing up the behaviour of over 1000 distinct entities., and it's always dangerous to anthropomorphise across aggregation. So one should not interpret this as "the behaviour of all FIIs" - instead it is the behaviour of the aggregate FIIs, and I'm sure there is huge heterogeneity within that class of investors.

The other remarkable thing in this data is how small these values are. The equity market (NSE + BSE, spot + derivatives) typically does over Rs.45,000 crore of turnover a day. The values for FII turnover seen here are all small, much smaller than what you might think if you read the newspapers shouting about FII exit (here's an example) leading to a drop of Indian equities.

The numbers in this table sum up to: A sale of Rs.10,456 crore of equities on the spot market, coupled with a purchase of Rs.5,100 crore on the derivatives market. Once again, the average per-day net buy/sell is small change compared with the size of the equity market. And, this reasoning and evidence suggests that a full picture of what FIIs are doing on both spot and derivatives is important to understanding what is going on.

In an ideal world, near-infinite arbitrage capital should be in play through sophisticated IT systems, so that the fair value of the index futures is circumscribed between a very tight "no-arbitrage band" at all times. In India, there are two big problems holding this back. First, SEBI and NSE have banned the IT systems - they insist that arbitrage be done in a labour intensive way. Second, the big institutional investors who are the natural players in this fixed income game - banks, pension funds, insurance companies - are prohibited from doing it.

India is doing some pioneering stuff by world standards in overcoming this problem by selling arbitrage funds to retail customers through mutual funds. I disagree slightly with the sales pitch that some of these funds make - they should clearly say it's a fixed income investment, but they don't always say that. For the rest, it's a great way to make progress delivering risk/return profiles to customers that existing institutional investors are unable to, and helping the country achieve "near-infinite capital in play for arbitrage".

FIIs have found a niche in derivatives arbitrage, with a comparative advantage owing to their regulators being better than ours. They have near-infinite capital and could thus do a great job in bringing about market efficiency on the derivatives. What holds them back is (a) the ban on IT systems, and (b) limits on FII ownership of individual stocks.

## Monday, June 12, 2006

### Pessimisation, n.: Doing the worst you can, given the constraints

Bibek Debroy says that the word optimisation' ("doing the best you can, given the constraints") is related to the word optimism'. He read the scary Arjun Sengupta report and feels it warrants great pessimism. He wants to coin a word pessimisation' for "doing the worst you can, given the constraints".

It does look like a gloomy time. P. Chidambaram defended Arjun Singh saying:

"Amongst all the instruments available to us for affirmative action the one that has proved most effective is reservation. Experience tells us that ... reservation has helped many, many, many members of the OBCs to rise in the southern States. I am totally convinced about that."

There are signs of movement towards job quotas in the private sector. And for comic relief, the CITU has complained to the ILO that India is trying to improve inflation measurement.

I wonder if teachers will respond to a reduction in the quality of student intake by grade inflation, or will weak students simply fail exams? Or will the government legislate to ensure that there are quotas for the number of students who graduate?

## Sunday, June 11, 2006

### Talk by Raghu on monetary policy & asset prices

Raghuram Rajan has done a wonderful talk linking up agency problems in fund management with monetary policy. I have sketched a quick summary of his argument here. But the talk (~ 3000 words) is wonderful and well worth reading.

The literature has long emphasised the difficulties of the principal-agent problem between fund managers and their customers. Index funds only cost 1 bps to manage; so the only justification for almost all of fees & expenses is alpha. But there are only five sources of alpha:

• To be a Warren Buffet and identify undervalued assets.
• To create value out of activism - whether a hostile takeover of a poorly managed/governed company, or private equity investment.
• Financial engineering - innovate with creating new kinds of cashflow-streams.
• Liquidity provision.
• Sell deep out of the money puts, to generate an appearance of a steady stream of income. For many years, this will look nice, and then occasionally things will blow up. Raghu calls this "tail risk seeking" behaviour.

The first is truly hard. The 2nd and 3rd are feasible but highly competitive. That leaves the fourth and the fifth that are an ideal field of play for ordinary fund managers. A great deal of "active fund management" is really about earning alpha as a fee for giving out liquidity services or giving out tail risk insurance. (This argument is generic, and holds whether r_f is high or low).

Even if you are a smart fund manager, your customers can be stupid. Customers seem to do stupid things, taking assets-under-management (AUM) away from poorly performing managers and giving them to managers who have recently produced high returns. They thus generate wrong incentives for managers, and send AUM towards managers who exhibit these kinds of behaviours.

How does this situation link up to interest rates? Suppose interest rates are low. A finance company that has put out an assured return product promising (say) 6% returns is hard-pressed to produce 6% returns when r_f is low. It gets pushed into high risk assets. Similarly, the 2+20 hedge-fund compensation structure delivers higher absolute compensation when r_f is high. When r_f drops, the manager has an incentive to take bigger risks (or go into illiquid assets) to hang on to old levels of compensation. This is particularly the case when the compensation for the manager starts after a hurdle rate' of an absolute level of returns is attained. When r_f is lower, expected returns on all assets are lower, and the hurdle rate is harder to reach.

In an ideal world, shifts towards high risk and low liquidity assets by some speculators should be compensated by other rational investors - e.g. a person trading with his own money who does not get into the issues of principal-agent problems of fund managers. But in a world where the bulk of liquid wealth of the planet is managed by external fund managers, institutional investors are large compared with rational speculators. Aberrations in their behaviour can then generate systematic distortions in asset prices.

Raghu's conjecture is that when r_f is low, agency problems generate incentives for institutional investors to go into illiquid assets, high risk assets, and returns from tail risk. The size of these investors is big enough that on the scale of the world economy, it looks like there is "heightened risk tolerance" - e.g. the very low values of the VIX when Greenspan had low interest rates. These flows are reversed when r_f becomes higher. Raghu cites Kashiwase & Kodres who find relationships between the VIX and emerging market spreads also.

In addition to traditional notions of monetary transmission, such effects constitute an additional channel through which monetary policy impacts upon the economy (though disentangling the channels of influence will be hard). This could have many implications for our understanding of how monetary policy works, and how optimal monetary policy should be crafted.

From an emerging markets perspective, this could be particularly important, because emerging markets offer risky and illiquid assets. I think it further undermines the case for a pegged exchange rate in India, for autonomous monetary policy would be a precious thing to have when faced with capital flows and trade flows which are strongly correlated with the world business cycle, and a local fiscal policy that can't stabilise. The only thing that can stabilise is local monetary policy, but there is a need for greater autonomy of local monetary policy.

## Wednesday, June 07, 2006

### Entry barriers in higher education

There has been a great deal of discussion about the efforts by the UPA at extending quotas for a bigger slice of the population in universities. I have an article in Business Standard today titled Don't play Arjun Singh's game where I make an analogy with industrial licensing.

My analogy is wrist watches made by HMT. The government made fairly-good watches at HMT. The quantity was pitiful, and they were in short supply. The government would neither move up to top quality nor would they let you start a factory to make watches. The only saving grace in that situation was that there was no SC/ST or OBC quota for watches.

The same is going on with higher education. The government makes a few seats of fairly-good (though not top quality) education at some IITs. The quantity is pitiful and the seats are in short supply. The State will neither move up to top quality, nor produce adequate quantity, nor will they let entry take place.

Once industrial licensing was abolished, entry took place; the quality of watches went up; the shortages went away. In similar fashion, I think the single most important problem with Indian higher education is the entry barriers, where the State essentially prohibits anyone from starting universities. I am aware of efforts by top names like Stanford at setting up operations in India, but these have run afoul of the existing rules.

If the government has political goals, these can be achieved without distorting production. E.g. the government is free to buy watches - from a competitive and efficient watch industry - and gift one to each SC/ST. Similarly, political goals like obtaining OBC votes for the UPA can be achieved by setting up a voucher program for them on-budget, where OBC voters gain access to top quality education produced by top quality campuses in India. We are doing something singularly wrong by allowing political goals to distort higher education itself.

When we look at the funding stream of top US universities, this is made up of roughly 40% tuition fees, 30% endowment fund and 30% research contracts (a lot of which come from the government). In India, the cost of production of higher education is lower since it's labour intensive. Students are willing to pay high tuition fees. Some research contracts from the private sector are feasible. If research contracts given out by the defence, atomic energy and space establishments are done on a competitive and meritocratic basis - for these agencies care for results and not for the ownership structure of the university - then new universities could plan on these also. In my mind, in such an environment, it is now possible to start top quality universities in India without grants from the State. The two key elements of public policy which need to be sorted out are (a) Entry barriers and (b) Shifting research contracts by defence, atomic energy and space into a meritocratic framework.

## Tuesday, June 06, 2006

### Interplay between capital flows and the domestic financial system

Ila Patnaik and I recently did a paper on the broad subject of capital flows. It's a background paper' for a World Bank project, and catering to the needs of the project has meant that it's a bit diffused. Ila wrote about this in Financial Express today.

The paper does three new things. First, it does a new classification of India's debt position, and finds that things are quite different from what we have traditionally thought. Second, it sniffs at daily data on FII inflows to look for lead/lag relationships with Nifty. Third, it does a preliminary examination of firm level data on the determinants of FII ownership. There are a few other interesting components of the paper, if you are interested in the broad subject of international economics and finance.

## Saturday, June 03, 2006

### McKinsey Global Institute reports on Indian and Chinese financial systems

There's been a lot of talk about the twin McKinsey Global Institute reports on the Chinese and Indian financial systems (original URL). Their suggested priorities on India are:

• Lift most priority lending requirements, asset allocation restrictions, and guaranteed deposit schemes.
• Reduce state ownership and increase competition in banking.
• Lift restrictions on foreign ownership of banks.
• Spur development of the corporate bond market.
• Strengthen contract enforcement and bankruptcy procedures.
• Deregulate the insurance industry.
• Ensure New Pension System implementation without diluting the principles.
• Continue reforms of mutual fund industry.
• Introduce gold deposit scheme.
• Spur faster development of payments system.
• Separate the regulatory and central bank functions of RBI.
• Lift remaining capital account controls.

### Lessons from recent market volatility for the margin system

Margins are good faith deposits posted by market participants. While margins are normally defined by a rule book, recently there were two purely ad-hoc changes to margin required by SEBI. SEBI did an ad-hoc increase in one component of margins on 8 April, before the present bout of market volatility began. SEBI then did another ad-hoc decrease in margins on 25 May, while this bout of volatility was still underway. It is important to think carefully about the merits of such discretionary changes.

What should the correct margin be? The correct margin on a position is the size of the loss on this position that will be "rarely" exceeded. Jayanth Varma's Risk Management Group focused on a margin system which requires the sum of Value at Risk (VaR) at a 99% level, and the ETL or "Expected Tail Loss" which is E(r | r < VaR)), under certain simplifying assumptions. Intuitively, there is one component of the margin which is the VaR, which takes care of a loss on most days, and then on a few days, the loss is bigger than the VaR, but the ETL takes care of the average loss on those days.

VaR estimation is done adaptively in these schemes. Financial volatility is reasonably predictable: volatile days tend to be followed by volatile days, and vice versa. An adaptive system of margins involves charging low margins for the normal sleepy days, and driving up margins when higher volatility shows up.

So margins are raised after volatile days and vice versa. When market volatility goes up, participants are forced to put up more capital to support positions. I think this is an unhappy but essential feature of a sensible margin system. The alternative is to charge high margins all the time - which wastes capital. As long as margin changes are purely rule driven, market participants have correct expectations about what margins will be charged, under what circumstances.

Interestingly enough, the events of May 2006 were easier to handle, for the risk containment system, as compared with May 2004. Look at Nifty returns in both months:

Date20042006
4 1.48 0.39
5 0.93 0.43
6 1.26
7 -1.56
8 0.79
9 0.74
10 -1.98 0.90
11 -4.02 -1.43
12 0.68 -1.39
13 0.37
14 -8.19
15 -4.11
16 0.58
17 -13.05 3.12
18 7.97 -7.01
19 4.16 -4.28
20 -1.54
21 1.05
22 -5.23
23 3.76
24 3.07 -2.65
25 -0.13 1.98
26 -0.49 1.00
27 -0.78
28 -5.02
29 0.16
30 -0.92
31 -1.68 -3.65

In 2004, the first hint of higher vol was the drop of 4.02% on 11th, which drove up margins a bit. Then, out of the blue, came the 8.19% drop on 14th (which drove up margins further). This was good preparation for 17th, which was a huge change. In contrast, in 2006, the 15th was the first big move, of 4.11%, which drove up margins. After that, margins were higher, and there was no real challenge from large price movements.

There are many myths about margins. One view is that increasing margins "cools the market" and pushes down prices. Conversely, it is felt that reducing margins tends to help "prop up the market". However, higher margins hurt both buyers and sellers equally! There is no simple relationship which asserts that higher margins yield lower stock prices, and vice versa.

The more subtle relationship is one where higher margins make it difficult to hold positions, thus reducing market liquidity. Indirectly, one could get a liquidity premium story whereby higher margins drive down liquidity and thus drive down prices. The biggest challenge at a time of market stress is liquidity: what we need most is that participants do not panic and retreat from trading. From a public policy perspective, increasing margins and thus reducing market liquidity - at a time when liquidity is needed most - doesn't seem like a bright idea.

Some believe that the system of margins induces a spiral of selling where a person is forced to make good his losses, and simultaneously submit bigger deposits, and thus collapses into distress selling. This view is inconsistent with the fact that derivatives trading is a zero sum game. For each speculator who has lost money, there is an equal and opposite speculator who has made money. While half the participants feel pain, the other half are feasting in huge profits. Just think of the joy of those who were short Nifty in the hours when Nifty dropped - they made huge profits. At the level of the country, these effects cancel out.

There are no permanent longs and there are no permanent shorts. The people who happened to be short at the right time got a lot of cash, and it is perfectly feasible for them to flip around the next instant and become buyers, if their speculative view changes.

Margin systems in India are imperfect. There is certainly more work to be done on improving the system of margins. The areas for work lie in:

• Better handling of liquidity risk,
• Shifting away from the simplifications of SPAN and RiskMetrics, and
• Shifting towards portfolio margining.

However, the basic logic of the margin system is sound, and there is little doubt in my mind that the system is strong enough to deliver soundness in the face of the time-series of Nifty returns. As evidence, note that these very systems were fine in coping with the more-daunting events of May 2004 - at which time no discretionary or ad-hoc margin changes were in the play. By international standards, we hold too much collateral. If there is a flaw in the system of margins, it lies in charging too-high margins in coping with model risk. Addressing the above three problems will help in reducing model risk and thus the extent of over-margining.

In this setting, I am unimpressed by SEBI's discretionary margin-changing decisions. Margins were raised, which hurt market liquidity, at a time when liquidity was needed most. Margins were reduced at a time when market volatility had not yet subsided. Now that SEBI has embarked on discretionary margin changes - which was not done earlier - SEBI's margin-changes are now an additional source of uncertainty for the market.

Regulators in mature market economies do not engage in discretionary margin changes. The job of the regulator is to think about the rules of the margin system. If there are problems with the rule-book, SEBI should get involved in changing the rule-book. But the job of SEBI is not to step in and make ad-hoc, discretionary changes.

In Latin America, employees of central banks and financial regulators are known to trade on currency and equity markets in order to profit from inside knowledge about government actions. Before any such accusations develop in India, it is better to emphasise a purely rules based system.