A nuclear weapon going off in your city centre

On 13 December 2001, there was a terrorist attack on the Indian Parliament. In the following days, there was a dramatic escalation of tension, complete with nuclear sabre-rattling.

I was in North Block at the time. I could not help think that my GPS coordinates were on the shortlist of any plan for nuclear attack against India. Vaporisation is not that bad, once you get to think about it, but one does think about it.

I tried to look at the fledgling Nifty options market, to see whether there was something one could read in the implied volatility. Then I started thinking that nuclear war is a unique problem on the options market. There are really two kinds of players in this situation. The first is a person in Bombay/Delhi who expects to be vaporised in the event of nuclear war. For him, it's efficient to sell protection, getting cash for free while he's around with no cash outgo if things go wrong (thanks to vaporisation). This should generate a lot of supply of protection and generate apparently low implied vols. Then there are investors at a safe distance -- e.g. foreign investors -- who might like to buy options as protection. But they'd have to worry about whether NSCC would remain aloft across the nuclear war; though they would expect that the Indian government would ensure that NSCC would not default at a time like this. So if nuclear war was a serious threat, options would be cheap but foreign buyers would be skittish about credit risk.

It was interesting, thinking of the tree of states of nature and option payoffs, some of them labelled `vaporisation', asking how to back out the probability of nuclear war from this information. Some of these thoughts came back to me today, when I saw this talk by Irwin Redlener. His big idea is that during the cold war, civil defence countermeasures against nuclear war were irrelevant, since nuclear war between superpowers would torch the sky and there would be no life on earth after that. But the genuine nuclear threats that we face today, such as a few Indian cities being targets, are qualitatively different. Civil defence countermeasures can help greatly reduce the toll, and there is something to live for because these small scale nuclear explosions do not imply the end of life on earth. He argues that modest efforts to prepare for this scenario could save a half million lives in the scenario of a modest 10 MT nuclear weapon targeted at a major city centre.

Hedging using derivatives

There is a fascinating article in The Economist about how the world of derivatives has shaped up through the crisis.

I often encounter misconceptions about hedging. The one line that summarises the issue is this: The job of a hedging strategy is to combat extraneous economic exposure. Let me focus on currency exposure as an example, though the basic idea works in all aspects of hedging. A good currency hedge is one which neutralises the effect of currency fluctuations on the NPV of profit.

I have seen four major mistakes in the way people think about hedging:

1. Hedging seen as a way of eliminating currency risk in the translation of direct import/export proceeds. This is wrong because it's an incomplete picture of what happens to the profits of a company when the currency moves. A lot of finance practitioners are confused on this subject, particularly in India where RBI rules have had mistakes on these things for decades. (While RBI staff made mistakes, that was no reason for currency hedging consultants and such like to also make the same mistakes).
2. Hedging seen as a profit centre. This is wrong because the job of hedging is to eliminate exposure of the NPV of profit, not to make money. Suppose a company embarks on a currency hedging program. Half the time (ex-post) the hedge will appear to have made money and half the time (ex-post) the hedge will appear to have lost money. For a company which has very big currency exposure, ex-post, half the time there will be massive cash losses on the currency hedge. If top managers, directors or regulators do not understand this correctly, it's easy to jump into complaints about `massive losses on derivatives trading'. This emphasises the importance of seeing a hedging strategy and the economic exposure in an encompassing way. A person who closes out one element of an overall hedging strategy because that's generated a lot of cash outflow in recent days is, well, wrong.
3. Hedging away the core sources of profit. A refinery is a bet on the `crack spread', the gap between the price of crude oil and the price of petroleum products. The shareholder and owners of a refinery are inexorably speculators on the crack spread. If you don't believe that this spread will do well, don't build a refinery. For a refinery, this is core business risk, this is the source of profit. It is not an extraneous economic exposure. To try to hedge away this exposure is not correct.
4. Insecurities about imperfect hedges. Every now and then, a bright person complains that a proposed hedge has a substantial basis risk. The only perfect hedge is found in a Japanese garden. All realworld hedges are imperfect. The useful question is: Is an imperfect hedge better than no hedging?

The Economist article points out that with the upsurge in volatility, demand for derivatives has gone up, not down. Once most large firms of the world start doing balance-sheet scale hedging, derivatives positions will be much larger than they are today. The world needs bigger, not smaller, derivatives markets. We stumbled on our way to that world, and now have to figure out once again how we are going to get there.

In the world of OTC derivatives, firms face credit risk owing to contracts with banks and banks face credit risk owing to contracts with firms. In the good old days, these risks were mostly ignored, and OTC derivatives looked more attractive than exchange-traded derivatives (where posting collateral is unavoidable). Now, both sides are getting wary about what this involves. Banks have started charging higher prices for bearing this risk (either though a bigger price or through collateral requirement), and banks have started refusing to have exposures against certain firms. Both these phenomena should enlarge the footprint of exchange traded derivatives. All this flows logically but it was interesting seeing descriptions in the article about things actually shaping up this way.

Diamonds and MIFC

Pallavi Aiyar has an article in Business Standard on Indian entrepreneuers and the Antwerp diamond trade. You might like to also see this. She ends the piece on an MIFC theme saying:

Many within Antwerp's Indian community share this prognosis. "In Israel, Muslims are not welcome, in Dubai, Westerners don't always have an easy time, in Hong Kong, it's primarily the Chinese, and in Mumbai, it's Indians," says Mihir Shah of Jayam NV. "India is simply not so open for foreigners to come and work and this is something essential to the diamond business."

Its lack of multiculturalism is not the only obstacle to the success of Mumbai's bid to replace Antwerp. It is also plagued by lax security, sluggish bureaucracy, lengthy red tape, in addition to lacking the infrastructure, physical and financial, to support the international diamond trade. The Bharat Diamond Bourse project, intended as a one-stop shop and dedicated custom house for the trade, has taken almost two decades to complete. Value added tax has to be paid - only to be returned, although only after the government has held on to it for a while. "In Mumbai, you still have to pay octroi, and it isn't possible to import or export goods on consignment," complains Jayam's Shah.

Antwerp's Gujarati traders are quick to voice their appreciation of a slew of helpful policies the Indian government has implemented in recent years, including the removal of duties on the import of polished diamonds. But when asked about Mumbai's prospects as a leading hub in the business, they smile uncomfortably and shake their heads.

While on the subject of Bombay, see Aakar Patel on how Bombay happened, and on Surat.

Wages in banking

Early in the financial crisis, Raghuram Rajan put compensation issues into the centre of thinking about what has gone wrong. In recent weeks, in India, this dimension has come to life. P. Vaidyanathan Iyer had a story in Indian Express saying that RBI had blocked the compensation packages of the CEOs of three private banks: ING Vysya Bank, Axis Bank and Development Credit Bank. Something similar might be taking place with HDFC Bank also.

See Anita Bhoir in Mint on CEO compensation of private banks in India. In the case of Axis Bank, the compensation of the outgoing CEO (P. J. Nayak) in 2007-08 was Rs. 1.5 crore. This is a firm with a market value of Rs.25,000 crore today, which reported a net profit of Rs.1041 crore in that year. I would also reckon that of all Indian banks, Axis Bank is a cut apart in terms of the corporate governance culture, and the say that the outside board members have in the affairs of the firm.

I have an article in Financial Express today, where I say that concerns about ownership, governance and compensation are important components of the regulatory process in finance. But what is needed is a sophisticated analysis of the incentives that these three elements (in combination) induce. This requires a subtle understanding of economics and incentives. An approach of merely blocking high wages is one of giving in to the populist politics of envy. Conversely, improving compensation structures of PSUs requires not just shifting to a higher level of wages under an old-style wage formula, but a full rethink of the incentive implications of a wage formula.

See Alex Edmans and Xavier Gabaix on voxEU on designing the right mechanism for executive compensation, and we get a flavour of the kind of subtlety that RBI needs to bring into this. And, read Martin Wolf on the deeper problems of banking.

Also see: statement by Timothy Geithner on compensation on 10 June, a debate between Gary Becker and Richard Posner, and a blog post by Jayanth Varma.

Addressing shortages of human capital in India

High end skills in India are in short supply in most areas, whether we think about university professors or financial regulators. One element of addressing these shortages is to recruit globally. I just saw the following news:

Adam Posen has been appointed an External Member of the Bank of England's Monetary Policy Committee (MPC) for a three-year term beginning September 1. The MPC, akin to the Federal Reserve Board of Governors in the United States, is the Bank of England's interest-rate setting body. Dr. Posen, a US citizen, was selected for the position through an open competitive process for external appointments, ahead of 49 other applicants from the United Kingdom and around the world.

Interesting readings

1. Sunil Jain in Business Standard on building highways.
2. Gautam Bhardwaj in Business Standard on the New Pension System. Also see him in Economic Times on related issues.
3. Gautam Chikermane has an important piece in Hindustan Times on financial sector reforms in the area of insurance. Also see Monika Halan on this in Mint.
4. Ila Patnaik in Financial Express on the Goods and Services Tax.
5. The first action in financial sector reforms that's come from RBI in 2009.
6. Read Yashwant Sinha and Pratap Bhanu Mehta on the BJP's predicament.
7. Nishith Desai in Business Standard, worrying about how India is going about tax policy and tax administration.
8. Mahesh Vyas uses the CMIE Capex database to talk about what is going wrong with SEZs, in Business Standard. BS followed up with an edit on this subject.
9. Ila Patnaik in Financial Express on the revival of capital inflows into India.
10. Watch this video of a talk by Larry Summers.

The Internet changes everything: Economist in India edition

A few days ago I wrote a blog post about fears of inflation in the US and the UK in the wake of unconventional monetary policy and unusual fiscal policy. This got widely noticed thanks to links from RGE Monitor and Economists View. Today I ran a google search for the exact title and it shows 1,120 links to it (and google hasn't yet noticed Economists View). This shows a much bigger distribution of this content than the 3,200 odd people subscribing to this feed. Before the Internet, it was much harder for an economist in India to be part of the contemporary global discourse in this fashion.