Derivative Market - Financial weapons of mass destruction!!

Yesterday I made a decent 40% profit on the CALL option which I had bought a couple of days back. I started getting interest in option trading last year and followed market religiously. Index option of NIFTY has got decent volume and a volatile market like this could get fair return in the derivative side. The foray in derivative market was a good learning for me. Option market is good for those who have fair idea of economics, who do not get tempted and most important who trades in a market which follows logic.

In case of Indian derivative market, the volume is really thin as compared to equity market. The inflation reported to 42 month’s high at 7.61 on May 9th 2008, but the market did not move down for “some time”. Analysts came with opinion that the current inflation figure was expected and already accounted for. The market started falling after that and the opinion changed that the high inflation was causing the mayhem... On May 12th, the Index of industrial Production (IIP) number came, which was lowest in the last 6 years. Markets fell initially, but regained its loss in the second half with no positive trigger. Not only this, it closed surprisingly in green. Next day market fell by around 2% and the IIP number was blamed for such movement... The inflation on May 16th was reported as 7.83, the highest in last 44 months but market went up in spite of low IIP number and such high inflation. Same story gets repeated and market closes in green - about 0.50-1.0% higher than the previous day close. There are many such instances, which indicate that Indian market is rigged, does not follow logic and is well manipulated for the benefit of a few.

In such a scenario, whether derivative trading is sensible investment alternative or not is an issue to be debated. As per the report from Chicago & New York, between 80-95 % of the amateur players lose in the Futures & Option market. And these odds are worse than the worst odds at casino or at the racetrack. The large potential return in this market is attractive to many small investors who are not satisfied with getting rich slowly by investing in stocks for long term. They venture into the derivative market to get rich faster and eventually lose all their saving in a very short span of time. Options are only for certain period and get expired at the end of the period. One has invested in stock and his research suggests that price will come down soon, so he buys PUT option to hedge his losses. But price does not come down in this month. The option expires worthless and he loses all the money he had paid as the premium. To be protected continually, he has to keep buying PUT option every month which he can not afford to do. The worst thing happens when the sure thing proves to be true and the price of the stock comes down the next month. Not only he has lost his money, he has done it while being right about the stock. Instead of being rewarded he is wiped out from the market with very thin saving at hand.

Another sad part of the story is that these options are very expensive. The more volatile the market is and the more time-horizon the option has got, the higher the premium is. The Black-Scholes formula for calculating the premium of option suggests that NIFTY has got roughly 20-35% of volatility (Volatility index), which results in quite higher premium.

Options are zero-sum game, for every Rupee won in the market there is someone who lost a Rupee, and interestingly, minority does all the winning. Buying option has nothing to do with owning a share and it does not make one owner of the dividend paid by the company. One contributes to the growth of the economy of the country when he buys the share of stock even in the secondary market. But in options market, not a bit of money is put to any constructive use.

To sum up, trading in derivative is one of the riskiest investments. While stock itself is highly priced, the derivative trading could lead to major disaster. Warren Buffet referred these volatile, dangerous options as “financial weapons of mass destruction”. Small investors should be cautious of making investment in such financial instruments and should be rationale than being tempted.

Face 2 Face : INFLATION AND MONETARY MEASURES

For

Monetary measures can be effectively used to control the liquidity to regulate the demand. While supply is the core of the problem, there is not much that can be done to in-crease supply in the short term, whereas demand can be directed easily to keep the inflation in the desired range.

An increase in the price leads to price-wage inflationary spiral. A monetary squeeze can stabilize price level and hence the wage. With the lack of a well developed bond market in India, bonds issued by the central bank squeezes money significantly. Further, rise in interest rate not only makes the borrowing costly but also encourages saving and reduces consumption. The recent increase in CRR will eventually bring down the amount available with banks for lending. Moreover, any monetary measure adopted by RBI signals the market about the intention of government and thus checks the price rise. Though restricting credit-availability impacts growth, inflation needs to be curtailed for the survival of the poor.

Therefore, managing liquidity would continue to take priority to push inflation back to around 5.5 percent this fiscal year.

- Kumar Saurav

AGAINST

Although Inflation is a monetary phenomenon and hence monetary policy is most logical tool to correct it; there are various limitations on the effective working of the quantitative measures of credit control adopted by the Central banks which weaken the monetary policy. Moderate monetary measures are relatively ineffective in controlling inflation and drastic monetary measures are not good because they turn economy into a tailspin. More-over, very often monetary policy is so mildly applied that it hardly has any impact on inflation.

In a developing economy like India, there is always an in-creasing need for credit to fuel the growth. However, there is a need to contract credit to curb inflation. Therefore, this conflict leads to dampening of growth if Central Bank resorts to credit control to check inflation.

Also in modern economies, securities, bonds etc. which are known as near money; represent tangible wealth. As they are highly liquid and are very close to being money, they increase the general liquidity of the economy. Therefore, it is not so simple to control the rate of spending merely by controlling the quantity of money.

Thus, there is no immediate; and direct relationship between money supply and the price level.

- Jaspreet Singh Arora

Courtesy - FY Newsletter

Credit Derivatives- Part I

"The news hit stocks and knocked jittery credit markets hard, with the widely watched iTraxx Crossover index breaking above 600 basis points for the first time, a reflection of soaring debt-insurance cost" - Reuters
"Credit risk measure the change in the credit quality that have the potential for creating losses resulting in stress in systemtically important financial institutions". Derivative is a risk shifting agreement, the value of which is derived from the underlying asset. The underlying asset can be anything you value, which could be physical commodity, an interest rate, a company's stock, a stock index, a currency, or virtually any other tradable instrument.
The reason we go about analyzing this is because of the credit concerns now extend beyond the subprime crisis. One way this is becoming increasingly evident is through the pressure on the balance sheets of financial institutions. What began as deterioration in credit quality altered the market liquidity and this altered various credit products valuation as people added more risk component in the short term. The credit worthiness of customers and the lending rates of the financial institutions are under distress. The question is what is the way forward?
Although the economic condition is adding to the distress, most of it is mitigated by the efforts of the central bank to instigate spending. There should be other ways of improving this situation.
This situation is not just for European or American markets, but it extends to markets like India, where we witnessed some adverse fallout since the starting of this year, a spillover effect.
This has lead to tighter economic and monetary policies which could curtail economic activity further. Falling equity prices will exacerbate the reduced consumer spending. And finally, capital spending could be reduced as the cost of capital increases.

What is interesting is the way the emerging markets are responding to these global cues. High inflation which is as high as 7% in India for example will have to go down as the global economy shrinks. What about the equity inflows in India? According to the recent study on equity inflows in emerging markets by Bank of New York goes against conventional wisdom. It find little to no net effect of inflows on equity prices. But definitely there is a significant relation between the inflows and the equity prices in India at least in the short term.

In the subsequent article we will see how credit is managed and what are various credit derivative products that are available.

Common Currency in South Asia

Introduction

The issue of consolidating the South Asian economies, and have stronger economic relations in the region, is not new. However, the idea of having a common currency in South Asia was encouraged after a successful launch of EURO by European Union in 2002. The talks for a common currency in South Asia began in 2004, when then Prime Minister of India Mr. Atal Bihari Vajpayee went to Pakistan for SAARC summit. It was termed by economies as a visionary initiative which would bring businesses in South Asia closer to each other, kick-starting closer economic ties. This was followed up by the commitment towards economic integration through free trade agreement in the Twelfth SAARC Summit, Islamabad. However, not many empirical studies have taken place to suggest the framework for launching a common currency for South Asia.

Many industry stalwarts and economists have put forth the prospective benefits and problems of having a common currency. The aim of this article is to summarize these benefits and problems and to have an introspection of each of these factors in order to have an understanding of the issue.

Economic Structure of South Asian Nations

In order to have economic integration, the potential member nations should have a similar level of economic development. This includes comparable average literacy level, similar work force productivity and working standards, in order to ensure that the flow of manpower across borders is minimal. If this is not the case, it would lead to an increase in the social and fiscal strains on the immigrant country.

In case of South Asian countries, the level of development of individual economies is more or less the same, with countries like India and China leading the way towards becoming developed economies. However, there are a few countries like Bangladesh which still have a long way to go. Looking at the structure of production, it comes out that the level of contribution of the Industrial sector is reasonably similar across the South Asian countries. The Industrial sector constitutes approximately a fourth of the GDP in all the countries. However, the contribution of agriculture varies across countries.

Although this intra-regional disparity is not much, it still makes the case of South Asia different from that of Europe, where the level of development of countries is even more similar. However, few studies claim that the similarity of economic structure may make the countries vulnerable to similar shocks, which could require a similar policy response. This strengthens the case for a common currency on the grounds of similar shocks.

Feasibility of having Common Currency in South Asia

Apart from the point being mentioned regarding the economies being at similar stages of development, there are two other points which strengthen the case for launching a common currency. Most South Asians already use currency called “Rupee”. Sri Lanka, Pakistan, India and Nepal have currency called Rupee. Bhutan has both Indian Rupee and Ngultrum as legal tender. Maldives’ currency is Rufiya. So it should be easy to have a popular consensus for a unified currency. Second point is that under British rule we all had a common currency which extended to Middle East and to South East Asia. Now, Globalization and freer trade is taking South Asia back to its economic history.

But on the other hand, we need to put an emphasis on the fact that Europe emerged as a common currency economic zone after more than half a century following the end of hostilities in 1945 (End of World War-II). It took fifty years of political, economic and social negotiations for it to become a Union. In the given context, if the situation is compared for South Asia, the efforts for consolidation have only been started recently. This presents a pessimistic picture which weakens the prospect of launching a common currency.

Prospective Benefits

The common currency regime, when achieved, will confer substantial benefits to the region. It will remove the uncertainty about exchange rates and reduced transaction cost will result in providing a big boost to trade and investment in the region. Also, there would be better prospects of synchronization of inflation, interest rates and GDP growth by having a centralized control on money creation. This will contribute to accelerated growth and poverty reduction.
Also, from a business perspective, it will lead to reduction in transaction costs as they increasingly trade with each other. It will provide a bigger market for foreigners to invest in and a bigger market for savings will result in lower interest rates for all borrowers, which is beneficial for businesses everywhere.

Looking at it from another angle, this economic cooperation can prove helpful to bridge political differences among a few countries in the region, especially India and Pakistan.

Issues and Problems

One fundamental problem of having common currency is that individual countries do not have their own currency and monetary policy is agreed on regional level with agreement on national component of currency and money creation. Therefore, the system requires surrender of monetary sovereignty and of seigniorage associated with currency creation and monetary expansion.

Conclusion: The way ahead

The objective of common currency can be achieved only in an incremental manner. The Governors of Central Bank of each country should convene to develop a roadmap for currency union. The process has to begin with the initial step to introduce a parallel currency and utilize that instrument to promote regional cooperation in trade and investment. Parallel currency does not require surrender of sovereignty and individual countries retain control on their currencies and monetary policies. In addition, there is a currency created jointly, according to weightage of different currencies in the basket and assigned a value, and allocated among member countries. This common currency can be created for South Asia and will be fully convertible into any international currency. It will be used as a unit of transactions on account of trade and investment in South Asia and will be legal tender for cross-country transactions in the region. Also, South Asian countries can create a pool of forex reserves to meet emergency Balance of Payments needs as well as development needs in the region. Then, each of the Central Banks should eventually merge all their operations relating to the issue of currency, foreign exchange and interest rates. Finally, mutual trust and confidence has to be built in the parallel currency among all partners in the region, so that it becomes integrated in the economic system of the region, in order to ensure its conversion to common currency, over time.