NIVESHAK

THE INVESTOR VOLUME 2 ISSUE 5 June 2009

 Niveshak From Editor's DesK
Volume II
ISSUE 5
June 2009
F rustrated with bad financial news for about three quarters, most of the part time
& wannabe investor of our street had lost track of the Sensex. But somewhere
between spring and summer, quietly and unmourned, bad news vacated its dominating posi-
Faculty Mentor tion on the street and allowed a glimmer of hope on the world of hazy finance. Some say
that this glimmer of hope is just a feel good factor, too tentative to measure, a faith without
Prof. S. S. Sarkar
validation or just a flash in the pan. But to the rescue of optimists, comes none other than
BRICs specialist Goldman Sachs which again predicts that India would be soon jump into
the 8% growth zone.
Editor The Congress led UPA government came back to power with a clear mandate and
Biswadeep Parida without the shackles of the Left. Prior to that the Indian share market indices had seem-
ingly bottomed out and the Sensex was moving out of sub-10,000 levels to nearly 12,000
mark. If you do not want to believe in the hyper volatile share bazaar, you would surely
Team Niveshak believe in increasing sales figures of automobiles, steel & cement. The slight improvement
in the Industrial Index of Production also brought in some cheer to investors and citizens
Amit Choudhary like never before. Some pessimists believe that this meagre improvement is just a play of
Nilesh Bhaiya numbers and there has been no real recovery yet. A handful of Index figures were blamed to
Sareet Mishra have been calculated on a lower base that prevailed for most of the times last year. To make
Sarvesh Chowdhury this statement clear, we can consider the Inflation figures. Even though food prices have
Sujal Kumar skyrocketed, Inflation figures fell down to sub-zero levels after thirty one years. That may
seem paradoxical. These die hard pessimists also say that the markets may have been buoyed
Tripurari Prasad up by manipulated figures and a correction is inevitable within a month. But they forget
that within a month we have the Budget coming up in which the old warhorse, Mr.Pranab
Mukherjee will not leave any stone unturned to justify the faith that the Aam Aadmi has
showered on them.
We also have our share of pessimists in our editorial board who try to dig out the
reality from the speculation. May be they are desperate to throw a word of caution. Our
Cover story for the month carries a detailed analysis of a host of Indian and Global fac -
tors to justify that this glimmer of hope is probably not the first light of the sun. There is
a short article on what issues must Mr. Mukherjee touch upon in his budget (and further)
to make this recovery for real and get India back the tag of the fastest growing economy of
the world. The issue of Negative Inflation, as described above, as well as the bankruptcy of
one of America’s iconic brands-General Motors have been briefly discussed.
We have also covered articles on MiFID, Outsourcing of Finance & Accounting
functions and The Godzilla that ransacked the Wall Street. In this edition, we have tried to
derive some key learnings from some of the greatest Derivative disasters of all times. As we
hopefully move out of the sub-prime crisis, we will try to answer if the present (or hopefully
past) financial turmoil was a market or a policy failure.
All the evidences of economic recovery may be only anecdotal evidences. A few more
dots will appear soon. We will happily join them to create the picture of the desperately
awaited perpetual BULL. Enough of Optimism. Now get us some real good market news.
Make the Street happy for real reasons.

-biswadeep Parida
All Images and artwork
(Editor- Niveshak)
are copyright of IIM Shil-
long Finance Club

©Finance Club
Indian Institute
of Management, Shillong
http://www.iims-niveshak.com
Disclaimer: The views presented are the opinion/work of the individual
author and The Finance Club of IIM Shillong bears no responsibility whatsoever.
 ContentS

In The News
Inflation Turns Deflation (6)
Budget 2009 (14)
GM Goes Bust (20)

FinSight
Outsourcing Finance & Accounting(4)

Article Of The Month

Lessons Learnt: Derivative Disasters (7)

Cover Story
Recovery or Recession???(10)

FinGyaan
Markets in Financial Instruments Directive (15)

FinTrax
The Godzilla that ransacked Wall Street (18)

Opinion
Market or Policy Failure? (21)

FinLounge
FinToon(9)
FinQ(23)

© The Finance Club, Indian Institute of Management, Shillong

 FinSighT

Outsourcing...
...Finance and Accounting

Purpose of F&A Outsourcing of experts in the fields of Finance and Accounting and

F inance and Accounting Outsourcing (FAO) is a IT technology. A good team aims for continuous devel-
sub-contract with a consultant for developing opment of processes so as to construct an efficient and
Finance and Accounting (F&A) activities in a company. In secure delivery model.
recent times, businesses have been outsourcing financial Classification of FAO solutions
activities at strategic level to enhance their performance Nature Activities Standardized/ Implementa-
and efficiency. Like any other form of outsourcing, FAO Specialized tion
has the following advantages:- Complexity
1) Helps company free its precious resources in non- Financial Budgeting and Fore- Standardized Medium
core activities to focus on innovation in business and sat- Planning casting
isfy the customers. Routine back-end tasks like General Financial Management Report- Standardized Medium
Accounting and operational support tasks, that are diffi- Reporting ing, Allocation, Activ-
ity Based Costing, Tax
cult to control, can be shifted to other destinations. Cor- Compliances
porate Strategy can be re-designed to have radical trans-
General Account Payable/ Re- Standardized Low
formation on a global scale. Accounting ceivable, Contract and
2) Acquire state-of-art facilities with superior tech- Order Management,
nology. Best industry practices can be achieved at lower Vendor Manage-
ment, Reconciliation,
cost. An automated Accounting Control System can be General Ledger, Fixed
developed at any offshore location to reap labor arbi- Assets, Payroll and
trage. It has been observed that the development cost is benefits
about 70% of the consultation charges of a certified Ac- Shared Maintenance and Standardized Low
countant under ordinary circumstances. Operations are Services Training
independent of location. In addition there is no cost for Financial Financial Analysis, Customized High
hardware and software. The reduction of cost increases Support Project Appraisal,
Creating Dashboard,
savings. work-flow solutions,
3) Electronic transaction and data-processing saves Treasury and cash
time and is more accurate and reliable. Superior quality Management
and control reduces the budgeting cycle. Moreover, the Financial Improvement of Customized High
incidence of error is much lower. Improved adherence to Advisory financial transparency,
centralization of func-
accounting norms facilitates decision support systems. tions, Risk Evaluation
Requirements for building a FAO solution
The business in every organization is unique. More- Risk Associated with FAO
over, the complexity in implementation of F&A functions
• Loss of ownership of finance functions and reli-
are not the same. This requires customization of F&A ap-
ance on external agency
plication. A FAO Consultant builds the F&A model using
standardized processes, modern technologies and apply • Short-term conflict in organization regarding
best practices. During this phase, constructive communi- roles. Also the in-house training facility in accounts func-
cation and collaboration are needed between the client tion gets weakened
and the FAO consultant to deliver the most appropriate • Confidentiality of vital information like project
solution. Significant economy of scale can be achieved in allocation data, cost – sheet, investment and estimates
this process. The FAO consulting team essentially consists are at stakes
Page 4

Niveshak Volume 2 Issue 5 June 2009


Fig: The Delivery Model for FAO Services
General Predictions for the Industry
• According to Vengroff Williams & Associates
(VWA), FAO improves business conditions during reces-
sion. The industry will still grow at healthy pace.
• IDC Research had predicted that in the year 2011,
the market size of FAO will be double of what it was in
2007. The estimated size of annual contract value was
USD 2.2 billion in 2007.
• FAO Research, Inc. reports that 2008 showed the
maximum annual growth of FAO contracts.
• The business advisory firm EquaTerra, found out
that in 2008-09, 63% of the outsourcing participants were
the organizations in UK.
Key Developments in FAO
The Industry is still in its developing stage. A major
chunk of the FAO business has been due to transactional
accounting. These tasks include General Ledger, Accounts
Payable/Receivable Management and Annual/Quarterly
Close. The solutions are generally simpler to implement
(using simple arithmetic functions) at little cost. There
has been limited development of high-end cash and trea-
sury management services.
The stress is more on Project Management to pro-
vide better services and build relationship at competitive
cost. Complexities in implementation have reduced with
experience. Many US companies have gone for FAO ser-
vices to have their systems Sarbanes Oxley (SOX) compli-
ant. The recent recession has made it imperative to instill
fair accounting practices. Extra efforts needs to be put in
© The Finance Club, Indian Institute of Management, Shillong
FinSighT
to mitigate risk and chose the right FAO vendor.
Many pharmaceutical and Retail companies have
implemented FAO services to focus more on their custom-
ers. FAO consultants are having many clients in countries
like UK and Australia where the management believes
that FAO is the answer during rising prices and recession.
Most of the FAO vendors are based in South-East
Asia, Eastern Europe, and Mexico. These places have great
advantage in terms of availability of talent pool at lower
rates.
FAO Services – Indian Scenario
India still holds global advantage in terms of English
proficiency. The technical and financial teams are equally
competent. During the recent times, the growth rate of
revenues from FAO services in India have dropped to 17%
from 21%, as estimated by NASSCOM. This has been partly
due to the economic recession. The infrastructure has
been a bottle-neck in the process as it has failed to devel-
op uniformly to support financial data mining. Develop-
ment has been restricted only to major cities like Hyder-
abad, Bangalore, Gurgaon, Noida and Kolkata. There are
possible expansion options in states like Madhya Pradesh
and Kerala. Policies need to be implemented by both the
Central as well as the State Government in India for ho-
listic development beyond major cities to smaller towns.
By Agnimitra Kar
IIM Kozhikode
Page 5

Inflation
I nflation has turned negative 1.61% for the first
time in thirty years but the prices of food items
like fruit and vegetables, cereals and oil are still higher
than last year. The wholesale price index shrunk to 232.7
points for the week ended June 6 from 236.5 in the same
week a year ago.
The decline in the rate of price rise to sub-zero lev-
els is, in fact, just a statistical phenomenon owing to the
high base effect, considering that WPI inflation during
the same period a year ago was at a high of 11.66 per cent
on account of high commodity and crude oil prices.
Interestingly, the inflation rate measured
in terms of the Consumer Price Index (CPI)
is still high despite the WPI inflation fall-
ing to sub-zero levels. The inflation rate
in terms of the CPI softened from its
peak of 10.5% in January 2009 but
still hovers above 8%. Prices of
most essential food items are
still showing double digit
rise and prices of daily use
items such as rice, potatoes,
onions, sugar, salt and tea have
registered a substantial surge on a
year-on-year basis.
Deflation, an indicator of falling pric-
es, would normally signal economic contrac-
tion. Hence, instead of rejoicing that each rupee
of their income will now be worth more than a
year ago, consumers may start worrying about the
loss of jobs and incomes. Falling prices also mean bad
news for borrowers. The real rate of interest is the
nominal rate less than the rate of inflation, and de-
flation means a real rate of interest that is higher
than the nominal rate. Hence, each rupee that you use to
repay a loan would be worth more than the rupee you
borrowed.
But this time deflation is expected to have a posi-
tive impact on growth, because the reason for the fall in
prices is different. Manufacturers will benefit with input
prices coming down at a faster pace than a fall in the
prices of finished goods. The domestic consumption de-
mand remains strong, even at a time when the demand
Niveshak Volume 2 Issue 5 June 2009
In the newS
turns
RED
from overseas and from private investments has fallen.
The fact is that the inflation measured in terms of the
CPI is still hovering at higher levels clearly signaling high
demand levels.
Back in 1978, when inflation rate entered nega-
tive territory, the first non-Congress government led by
the Janata Party was in its second year. Between April
and December 1978, the inflation rate was -0.6%. Prices
of fruits and vegetables had fallen (-8.2%), as had cot-
ton (-13.5%) and oilseeds (-14.6%). Among manufactured
products, sugar and gur prices fell dramatically by
23% and edible oil prices by 11%. This decline in
prices was attributed to a good harvest in 1977-
78, and cheaper inputs to agriculture.
With inflation already in the red,
banks have shown intentions of re-
ducing the interest rates. Bank-
ers are divided over whether a
negative inflation rate will
prompt the RBI to cut its
benchmark policy rates or
not. However, some banks
have announced that they
won’t wait for a signal from RBI
before they start cutting lending and
deposit rates. Industry seems to concur
on a rate cut of 100 basis points. This may
further bring in some cheer to the market.
By Sarvesh Chowdhury
IIM Shillong
Page 6

D erivatives are often referred to as financial in-
struments of mass destruction. After all the bad
publicity of derivative losses and companies going bank-
rupt a negative perception has been formed that perhaps
make derivatives untouchable for some of us. But is it
not equivalent to thinking that nuclear energy is bad be-
cause nuclear bombs in Japan had caused unimaginable
destruction or saying that Chernobyl tragedy occurred
due to harmful effects of nuclear radiations? Derivatives
undoubtedly are risky but the recent events occurred be-
cause of the greed, over optimism of financial institutions
and lack of precautions. We all know that counter to the
perceived notion of derivatives being risky; they are ide-
ally used for hedging and acts as insurance against future
uncertainty.
Ideally it would not be prudent to expect profits
and losses from derivatives. Derivatives as instruments
were not created keeping profit and losses in mind. They
are used as a risk transfer techniques and can be viewed
E
L
as insurance which any one of us can sell in the
D
economy. The investor here by invest-
N
ing in derivatives tries to
A
merely protect himself
H ITH CAR E
against the unexpected
changes in the prices
of the underlying com-
modity. But still we see a
loss in derivatives to a fi-
W
nancial decision gone hor-
ribly wrong and attribute
the gain in derivatives to the
efficiency of firm. A conver-
sation below can explain this
situation correctly –
CEO – Mr. X. This year we have lost USD 10 mil-
lion in currency forwards. How do you explain that?
Mr. X – Sir it is because of the fall in our currency
rate that we have lost this money
CEO – But how do I explain this to our shareholder
who are asking for justification on investing in deriva-
tives
Mr. X – But derivatives are never supposed to be for
earning profits they are just instruments for hedging risk.
You would not have said this if we would have instead
earned USD 10 million through derivatives.
© The Finance Club, Indian Institute of Management, Shillong
Article of the montH
...and Lessons Learnt
CEO – I don’t understand all this. Sorry Mr. X. You
are fired for misappropriation of funds.
Irrespective of the inherent risks, derivatives have
been historically used by traders to speculate and gamble
in pursuit of windfall gains. Traders in lure of big money
take positions which are out of their authority and con-
trol. The money at stake is sometimes so huge that a
derivative decision gone wrong wipes out the complete
company and spoils the hard reputation earned by the
firms in seconds. There are numerous instances of huge
losses from derivatives trading but there are few cases
in the derivatives history which stand out. Let’s look at
some of the biggest derivatives disasters and learning we
can gain from them.
Barings Bank
One of the biggest and the most infamous deriva-
tive disaster was the Barings Bank collapse.
French Foreign Minister, Duc
de Richelieu in 1818 had said:
“There are six great powers
in Europe: England, France,
Prussia, Austria, Russia and
Baring Brothers.” It took
one man – Nick Leeson,
whose equity derivative
fiasco brought about the
fall of one of this 242
year old bank.
Nick Leeson was
supposed to be exploiting the inter
exchange arbitrage by trading Nikkie 225 fu-
tures simultaneously on SIMEX (Singapore International
Monetary Exchange) and OSE (Osaka Stock exchange). He
was also authorized to trade option and futures for other
clients in Barings. This scope of operations did not in-
volve much risk. But instead of simple arbitrations Lee-
son started taking substantial unauthorized risk and kept
his positions open. He also ventured into short strad-
dling which significantly increased the risk. Once Leeson
started incurring losses it was a spiral effect and he took
even further long positions to offset the previous loss-
es. Unfortunately Japanese market collapsed because of
the earthquake in 23rd January 1995 resulting in loss of
around USD 1.4 billion for Barings Bank.
What was surprising is that Leeson was able to hide
all this from the management. Leeson before working
Page 7

as a trader in BSS (Barings Securities Singapore) was in-
volved in the back office activities. Later when he started
trading as head trader of BSS he was also the head of BSS
operations. He was therefore easily able to misrepresent
and forge the accounts information. Instead of mounting
losses, profits were showed to the management which
got him huge money as bonuses. Management of Bar-
ings was clueless about derivatives business and could
not see anything fishy in the windfall gains that Leeson
was showing.
Learning from Barings episode
Barings disaster happened predominantly because
of improper control and supervision. Audits were not
conducted properly and trader himself was involved in
presenting the financials to the management. Improper
assessment of risk on the part of Leeson which can be
attributed to over optimism or over confidence was a
major reason for the fraud. Had management kept proper
control and supervision the damage control would have
been possible.
China Aviation Oil
CAO was one of the 25 companies in China to enter
into overseas energy market. These companies were al-
lowed to trade in futures to hedge the risks due to vola-
tile spot markets. In the company prospectus company
had mentioned to its shareholders that if company’s trad-
ing losses exceed USD 5 million, the open positions of
the company would be closed unless an exception was
authorized from CEO Chen Jiulin.
The company was bearish on the future prices of
the oil and started speculating on the oil price in the year
2003 and by March 2004 the short derivative position re-
sulted in USD 5.8 million in losses for CAO. Instead of clos-
ing the positions CAO kept increasing the size of trades
in the hope of offsetting the losses already incurred. Later
Chen Jiulin also bought futures contract betting the oil
prices to continue to rise. However when he had to de-
liver on his futures contract, oil prices dropped and again
he incurred huge losses. As the losses kept mounting,
CAO wasn’t left with enough money to meet the margin
calls of the counter parties. In November 2004, CAO an-
nounced that it had lost USD 550 million through trading
in crude oil swaps, futures and options.
This case also presented the case poor corporate gov-
ernance. One month before making the derivative losses
public CAO’s parent company China Aviation Oil Holding
Company (CAOHC) sold USD 108 million CAO stocks to
investors. This money was used to meet the margin call
requirements. Chen was charged with 15 counts including
fraud and failure to disclose the losses.
Learning from CAO scandal
The derivative mishap was not due to inherent dan-
gers of instruments but due to ill conceived and poor-
ly defined strategies. There were number of rollovers
of loss generating positions whereby options on bigger
volumes were sold to generate sufficient cash to settle
Niveshak Volume 2 Issue 5 June 2009
Article of the montH
the losses on an existing position. The traders should re-
straint themselves from doubling down but rather look
towards moving out of the existing position in case of
losses. Chasing the losses can further compound prob-
lems. There should be good corporate governance and
risk management in place which was absent in case of
CAO. Speculative trading started without being properly
encapsulated in risk management policies. There must be
well defined rules in the financial management activities
to create accountability. Proper valuation of the open po-
sitions is also important as improper valuation leads to
erroneous financial statements.
Sumitomo Corporation
Sumitomo Corporation lost around USD 2.5 billion
in the copper derivatives. This is a classic case of – ‘Run-
ning on the top of tiger not knowing how to get off
without being eaten.’ Yasuno Hamanaka the head trader
of Sumitomo Corporation manipulated the world cop-
per prices through his operations on the LME (London
Metal Exchange) copper futures market over the period
of 1991-95. This artificial increase in copper price resulted
in increased profits for Sumitomo Corporation from sell-
ing copper. Whenever any hedge fund or speculator who
was aware of manipulation tried to take short position,
Hamanaka invested more money into his positions thus
sustaining the high price.
During late 1995 due to increased copper produc-
tion facilities particularly in China copper prices started
declining. That was ominous for Sumitomo as they had
long positions in the futures market. Hamanaka failed
to get rid his positions. Later when LME started investi-
gating on the alleged manipulation of copper prices Ha-
manaka was taken off from his position of head trader.
This brought the short traders and hedge funds into the
act causing the Copper prices to fall further on LME. In
September 1996 Sumitomo Corporation the figure of USD
2.6 billion as the loss on derivatives trading which was
about 10% of Sumitomo’s annual sales.
This disaster was the result of successful manipu-
lation of the copper prices due to lack of transparency
in the reporting positions of large clients at LME. CFTC
(Commodities Futures Trading Commission) which regu-
lated US futures market required regular reporting from
the large client on all US exchanges which was not the
case with SIB (Securities and Investments Board) which
oversees regulation of all London Financial markets. Fi-
nancial Services Act under which the financial markets
of Britain are governed also failed to provide any explicit
provisions in case of price manipulation. Thus it was dif-
ficult for the regulators to identify the potential manipu-
lating position.
Learning from Sumitomo fiasco
Regulators must now be more aware and proactive
than ever before as the possibilities to manipulate the
markets have become more practical with the advent
of complex and high leveraged instruments like deriva-
tives. Prevention here is always better than prosecution.
Page 8

Companies should also restrain themselves from vesting
too much power on a single employee and follow a job
rotation policy. By entering into fictitious trades and ma-
nipulating accounts, Hamanaka successfully misled the
management to believe that he was making huge prof-
its. Sound operational and monitoring system need to be
in place to keep track of activities of traders. Successful
traders might require more, not less, scrutiny.
Amaranth Advisors
This was the largest hedge fund collapse in history
when Amaranth Advisors lost USD 6 billion in natural gas
futures. Large part of Amaranth Advisors was in energy
trading and the hedge fund was performing well provid-
ing consistent return to its investors. Energy desk used to
contribute around 30% of the annual returns and energy
trading was initially quite conservative in nature.
After Brain Hunter joined the fund he took large
speculative positions by using natural gas futures in the
year 2005. It worked as natural gas supplies were disrupt-
ed due to hurricanes like Rita and Katrina and natural gas
prices went through the roof. This earned Amaranth USD
1 billion profits and Hunter was labeled as star trader.
Hoping for the repeat performance Hunter again went
long on the natural gas contracts leveraging their posi-
tion 8:1. Hunter had put 50% of the USD 9 billion hedge
fund at stake on natural gas. But that year US did not
experience any major storm and on the back of increased
supplier the natural gas prices plummeted. This gave a
body blow to the hedge fund and the firm shed USD 6
billion in losses.
Learning from Amaranth debacle
While venturing in instruments and positions with
high risk the firms should go for position sizing. Position
of Amaranth in natural gas should have been a small pro-
FIN TOON
Rising food prices in times of negative inflation
By D i lpr eet S. Gandhi &Saurav Bagchi
© The Finance Club, Indian Institute of Management, Shillong
Article of the montH
portion of funds asset to avoid risk. One single mistake led
to the fall of Amaranth. Sound risks management should
be in place to tackle the unforeseen events. Appropriate
hedging strategy is crucial as there is a thin line between
a good trading decision and speculation. Leveraging be-
yond the firms values is a huge risk which should never
be taken particularly if investing in unpredictable instru-
ments like derivatives. And lastly each trader is worth
the last trade. Often it is seen that traders once reaching
the height of glory are given too much of freedom which
ultimately leads to the fall of the firm as in this case.
There are a lot more derivative disasters which we
can review and they all present more or less same learn-
ing. But one thing that comes out quite clearly is the
importance of self regulation. Often the traders and firms
are lured by greed in search of huge gains. Human greed
is perennial therefore traders will be lured of big money
and risks will be taken. But a proper control system and
regulation can prevent such mishaps which rob investors
of their hard earned money and causes downfall of firms.
Time and again lessons are not learnt and mistakes are
repeated as in the case of Societe Generale scam which
was a replay of Barings Bank episode.
Nevertheless derivative instruments give lot of op-
tions, flexibility to the businesses. A decision gone right
or gone wrong can turn the fortunes of the firms and
sometimes the industry. Traders have to be on their toes
and each second counts. Opportunities are unlimited; the
returns are high and a lot is at stake. But all this come
with a warning – “Handle with Care”.
By Atul Gupta
SIBM Pune
IIM Shillong
Page 9

Of Rosy Projections...
... And Reality
...Is the Recovery for real?
Indian Stock Market at a glance
S tock market is considered to be the place to get
the best return within the given time span as
compared to other available options. But we know that
stock market is the place of “High Risk and High Return”.
It also follows the law of nature what we call as law of
uncertainty. The journey of Sensex (Index for Bombay
Stock Exchange) from 1990 to 2009 ascertain the volatility
and uncertainty associated with stock market.
As one can see it took nearly 2 years for Sensex to
reach 20,000 from 10,000 but it tumbled to 8,000 from
20,000 in a span of 10 months. Hence it is very impor-
tant to consider various factors which lead to bullish and
bearish trend of stock market. To name a few market
reacts to news like fundamental macroeconomic vari-
ables, monetary policy decisions, industry fundamentals,
monsoon forecast, FII inflow, GDP, inflation, net export
figures, Budget expectation, Election results etc. But the
fact of matter is the volatility of stock market indicators
goes beyond any reasonable explanations.
Indian Stock Market Post Sub-Prime Crisis
With the ghost of sub-prime crisis and global melt-
down hovering around during the end of 2008, the stock
market went into a bearish mode. The poor third quarter
results of Indian corporate industry along with the Sa-
tyam fiasco pulled the SENSEX to further low. The trend
continued in the first two month of 2009 and bear was
smiling in the DALAL Street and the risk aversion was at
large among the investors. From March 9th, 2009 the bull
started pricking its horn. The market started recovering
and the upward trend continued with the great political
circus of India, The General Election of 2009 around the
corner. With the results of general election out on May
16th 2009 and stable government in the center, market
saw two upper circuits in a matter of two hour of trad-
ing when market opened on May 18th 2009. Yes as our
editor mentioned in the last edition of Niveshak that’s
called a Bull Run. Now the few questions which arise
from all these facts are is this Bull Run sustainable in the
long run? How much correction is expected in the com-
ing months? What factors are leading to this Bull Run? Is
Niveshak Volume 2 Issue 5 June 2009
Cover storY
this just a flash in the pan or is just the beginning of the
greatest Bull Run ever? Few factors which can be consid-
ered to understand the present situation and access
the future trends of market are as follows:
Domestic Factors
India’s industrial production (IIP):
India’s industrial production rose unexpectedly for
the first time in three months, suggesting interest-rate
cuts and government stimulus measures are helping re-
suscitate demand in Asia’s third biggest economy. Output
at factories, utilities and mines advanced 1.4% from a year
earlier after a revised 0.75% drop in March, the statistics
agency said in New Delhi few days back. Economists ex-
pected a contraction of 0.1%. Asia’s largest economies are
showing signs of recovering from the global recession as
the region’s governments start to implement nearly $950
billion (Rs45.03 trillion) of stimulus measures. Though the
demand for industrial sector’s consumer goods appears
to remain weak, April’s industrial production data points
tentatively to a stabilization of the industrial sector. In
coming months, industrial production is likely to con-
tinue to show signs of improvement. Already, the recent
rise in commodity prices has led to increased production
in mines, while recovering domestic demand has led to
electrical production recovering. These trends will likely
continue in coming months. But the point to ponder is
that this increment has come mainly due to Government
fiscal measures as export continue to collapse. The gov-
ernment cannot keep on providing stimulus after stimu-
lus forever at the expense of taxpayer’s money. But nev-
ertheless the IIP number suggests that there is a positive
turnaround in the real economy which was downturn
due to global slowdown.
Rate cuts
The Reserve Bank of India cut its repurchase rate
by 4.25 percentage points to 4.75% from 20 October 2008
to 21 April 2009. It also lowered the reverse repurchase
rate to 3.25% to reduce the cost of lending and stimulate
domestic demand.
The Sensex has risen 26% since the 16 May re-elec-
tion of Singh’s Congress party-led United Progressive Al-
Page 11

liance, on optimism that higher government spending
will boost company profits. The $1.2 trillion economy sta-
bilized in the three months to March, maintaining the
5.8% pace of expansion recorded in the preceding three
months. The central bank expects the economy to grow
6% in the fiscal year that started 1 April, the slowest pace
of expansion since 2003. Annual growth averaged 8.5% in
the previous five years.
Production rebounded in April as manufacturing,
accounting for about 80% of the total output, grew 0.7%
from a year earlier after a decline of 1.6% in the previous
month. Mining climbed 3.8% and electricity rose 7.1%, ac-
celerating from March.
Election Results
18 May 2009 will be remembered as a historic day
for the Indian capital markets. The Bombay Stock Ex-
change (BSE) and the National Stock Exchange (NSE) hit
the upper circuit within seconds after opening on the
unexpected electoral win of the United Progressive Al-
liance (UPA) government and the better-than-expected
performance of the Congress party, which has ensured
a stable government without any pressure tactics from
allies, particularly Left.
The stage for the unprecedented market rally was
set on Saturday, 16 May 2009, when the results of the
election for the 15th Lok Sabha were declared. The Con-
gress-led United Progressive Alliance (UPA) emerged vic-
torious and stronger. A formation of stable government
in New Delhi is certainly a big positive for the markets.
Moreover, investors were expecting the markets to open
with a bang on Monday. Indeed, the markets surprised
everyone and created history.
Within a few seconds after stock markets opened
on 18 May 2009, the Sensex went up by 1,789.88 points.
Similarly, the Nifty jumped by 531.65 points. As both the
indices hit the market-wide circuit filter by crossing 1,450
points (15%) for the Sensex and 450 point (15%) for the
Nifty, the equity and equity derivatives markets were
© The Finance Club, Indian Institute of Management, Shillong
Cover storY
closed for two hours. The market reopened at 11.55 a.m.
Within a matter of seconds, the Sensex marched ahead by
2,110.79 points and the Nifty went up by 651.50 points. As
both the indices had hit the third and final level of circuit
— 1,950 points (20%) for the Sensex and 600 points (20%)
for the Nifty — the equity and equity derivatives markets
were closed for the rest of the day. The Sensex closed
17.34% above its previous close, while the Nifty reported
a gain of 17.74%.
These mouth-watering gains were simply notional
or paper profit as the market closed with thin volumes.
The combined cash and future and options volumes on
the two exchanges stood at around Rs 3103 crore. This is
against a trading volume of around Rs 70000 crore on Fri-
day, 15 May 2009. On the BSE, only 847 stocks witnessed
trading out of around 2,500 stocks that were traded on
15 May 2009. Similarly, on the NSE, only 207 stocks wit-
nessed trading compared with 1,300 on the same day.
FII
Indian stocks have continued to rally on a view of
ample global liquidity and a return of risk appetite. This
will help India Inc help raise funds for expansion which
in turn will boost corporate profits. India Inc has already
raised almost Rs 5,000 crore from three qualified institu-
tional placements (QIPs) so far in 2009 and announced
plans to raise another Rs 20,000 crore. Foreign funds are
aggressively buying Indian stocks. FII inflow in June 2009
totaled Rs 4,718.80 crore (till 9 June 2009). FII inflow in
calendar year 2009 totaled Rs 25,192.30 crore (till 9 June
2009). Moreover Foreign institutional investors (FIIs)
have pumped in Rs 20,117 crore (US$ 4.3 billion) into the
Indian equity markets in the month of May 2009 alone—
the highest in 19 months.
International Factors
TED Spread
If we try to look at some of the macroeconomic
indicators to get an insight on the present economic con-
dition of the world, we will find that the TED spread,
Page 11

which is the price difference between three-month fu-
tures contracts for U.S. Treasuries and three-month con-
tracts for Eurodollars having identical expiration months,
which usually averages approximately 50 basis points, but
during the Lehman Brothers crisis it soared to 450 basis
points. With the Federal Reserve’s balance sheet actions
to flood the credit markets with funds, the Ted spread
has nearly returned to its historical range, suggesting
that normal functioning is returning
Fig: TED Spread
This clearly shows that the default risk is now be-
ing considered to be decreasing and risk appetite of the
investors has increased and they are moving out of their
safe investments. The economy which was seeing a li-
quidity crisis just a few months back is now flooded with
huge amount of liquidity because of the low interest
rate that is prevailing in most of the countries. This large
availability of liquidity coupled with the increased risk
appetite of investors has led to heavy infusion of FII’s in
the stock market of emerging economies like India, China
and Brazil.
Baltic Dry Index
Another indicator which can be used as a global
economic indicator is Baltic Dry Index (BDI). It is a ship-
ping and trade index created by the London-based Baltic
Exchange that measures changes in the cost to transport
raw materials such as metals, grains and fossil fuels by
sea. Changes in the Baltic Dry Index can give investors in-
sight into global supply and demand trends. This change
is often considered a leading indicator of future economic
growth (if the index is rising) or contraction (index is fall-
ing) because the goods shipped are raw, pre-production
material, which is typically an area with very low levels
of speculation. If we look the Baltic dry index in the past
one year, we can clearly see a sharp contraction of index
from 7500 in September to its lowest level in Nov-Dec.
Before the gauge rose to 4,291 points on June 3rd 2009 in
a run of 23 straight gains as China imported iron ore.
Fig: Baltic Dry Index
Niveshak Volume 2 Issue 5 June 2009
Cover storY
But this run is direct effect of Chinese buying as
Chinese are hastily stocking up on cheap commodities.
As China has already bought in excess of actual domestic
demand - and thus this run is not sustainable. Already,
90 freighters carrying iron ore are lying idle off Chinese
ports, because of a lack of storage facilities. As the pace of
this stockpiling starts to slow, the BDI will fall.
Oil Prices
Prices of OIL have increased to $68 a barrel from
$30s we saw earlier in the year, which indicates that the
world economy is not yet about to fall into a great de-
pression. A number of factors can be attributed to this
rally oil prices such as weakening dollar, fears of infla-
tion, increased investor risk appetite and the appearance
of ‘green shoots’. While many investors are arguing that
oil’s rally is a good sign for the global economy and eq-
uity markets, we can just hope that it doesn’t revert to
the detrimental $150. According to some analysts though
credit crunch was the triggering point of the present cri-
sis but it was soaring oil prices which had pushed the
world towards recession. It is also being argued that fall
of the oil prices has now helped the economy back to its
feet.
If we watch the movement of oil prices closely we
would find that While the price of oil has risen from
the $30s to $68, oil stocks have not really rallied much.
Such a dramatic out performance of oil vis-à-vis oil stocks
indicates that oil is probably factoring in a speculative
element, and not just health of the economy as widely
perceived. Also oil inventories in developed countries
are one of their highest levels ever. The rising Chinese
demand may have more to do with the Chinese govern-
ment stockpiling oil than an increase in energy consump-
tion. All this points out that though oil prices are raising
but fundaments of oil still remain weak.
Conclusion
At US$ 1.04 trillion, India’s market capitalization (m-
cap) has emerged as the ninth largest in the world. The
speculation of bottoming out of recession and remote
chance of V-shape recovery might be true. But as the age
old fact says; as a smart investor we should go by funda-
mentals of the company, be patient and think long term.
Corrections are bound to happen, but when and exactly
by how much are nearly impossible to predict. The year
started with dampened spirit and dented optimism, but
as Warren Buffet suggested for this phase of market “Let
us become wiser and lead a happy, healthy, prosperous
and peaceful life”. By saying this he meant we should
rely on our financial wisdom and apply our basic knowl-
edge and common sense rather than relying on financial
experts to find a way out, as one should not forget the
present condition are more or less outcome of the finan-
cial experts in Wall Street. Thus in world of share market
“Follow your heart with an intelligent brain”.
By Sareet Mishra &Sujal Kumar
IIM Shillong
Page 11
 Team Niveshak
presents
Niveshak Blog
Just Key in
www.iims-niveshak.com

Enter the whole new world of finance!!!!

Catch up with new discussions apart from magazine

Share your views.

A Wholesome discussion board
Subscription made easy!!
Just fill the form and get Niveshak
delivered every month in your inbox

Find latest issue here

And a lot more Previous issues too :)

Explore..the..Possibilities!!!

B u dg e t 2 0 09
W ith great power, comes great responsibility.
These words of wisdom inspired Peter Parker
to fight the evils in the Hollywood flick Spiderman. In the
last general election, the UPA government was voted back
to power with a clear mandate to fight the evils that have
threatened India- terrorism, corruption, poverty to name
a few. But what we are more concerned about anything
else in this magazine is- how will the Finance Minister
revive the financial system that dealt a body blow from
the US Sub-Prime crisis. This time around they are blessed
enough by having a clear majority without the pesky left
that always hindered its reforms agenda.
As the news of the election results was flashed the
market was flooded with all sorts of positive data as if
they were just waiting for the results. Stock markets
defeated western counterparts, Industrial Index of Pro-
duction jumped and the Central Statistical Organization
came with forward looking statement and reports about
the Indian Economy. Corporate financial results suddenly
went into green zone. FII inflows also had jumped. Be-
lieve me, the new UPA government had nothing to do
with this so called recovery.
Their actual task starts with the Union Budget which
is scheduled to be rolled out on 6th of July. Historically,
Budgets have led to downfall in markets a few days after
announcement on most of the occasions. But the one in
1992 boosted the markets by 34% in a month. The Finance
Minister is expected to pull some sort of a similar miracle
with a reform-oriented Budget that will incorporate tax
cuts, fiscal consolidation, a divestment programme and
infrastructure spending to justify the faith of the people
in their government. Let us have a look at what steps and
reforms can they push to guarantee an early recovery
from this crisis and ensure sustainable growth.
• Ramp up spending in Infrastructure. This creates
jobs, public goods, a conducive environment for doing
business and a handsome return on Investment.
• First, Interest rates can be cut and banks be di-
rected to pass this cut to consumers. This will help in
increasing consumption and spending. It must also im-
prove liquidity in the system to enhance industry.
• With a clear majority and no Left forces, the gov-
Niveshak Volume 2 Issue 5 June 2009
In the newS
...Looking Ahead
ernment is at a good position to push its reforms agenda
and disinvestment. This would unlock huge value from
PSUs, at the same time provide huge funds to fight fiscal
deficit.
• Increase FDI limits across all sectors. This will
boost markets to a good extent
• Give stimulus to export oriented sectors and spe-
cial economic zones to increase competitiveness, rein-
state and create jobs, and boost competition.
• Enough is Enough: Its high time government
gives priority to control fiscal and revenue deficits.
• Ensure more and easy loans, and single window
clearance to SMEs.
• Weed out non-merit subsidy, it rots the whole
system.
• Focus on Education and health care.
• Tax cuts can bring some cheer to corporate but
may widen fiscal deficit.
• Although Strict Financial regulations have helped
India avert crisis several times, Its time to deregulate the
system and get foreign players in a bigger way. But a
word of caution needs to be exercised.
• Improvise on NREGA and create alternate av-
enues to provide sustainable employment to the rural
poor. This is important as India fought this recession ow-
ing to huge consumption in rural India.
With a sound government, a well structured budget
and proper financial mechanism, India can get back to
the above 8% growth rate and be counted among the
fastest growing economies of the world. All eyes are on
the Union Budget. Mr. Pranab Mukherjee, whole of India
is at your mercy now. Perform or get the blame of letting
India Perish.
By Biswadeep Parida
IIM Shillong
Page 11
 FingyaaN

Markets in Financial
Instruments Directive
& its Impact on European Equity Markets
M IFID, which was adopted in 2004 by the Eu-
ropean Commission, apply in the entire Eu-
ropean Union and the additional countries that make up
These services are regulated by the member state in their
“home state” (whereas currently under ISD, a service is
regulated by the member state in which the service takes
the European Economic Area. It replaced the Investment place).
Services Directive (the ‘ISD’) which established what is Client categorization
known as the passport regime under which a financial MIFID requires firms to categorize clients as “eli-
services firm in one European country can do business in gible counterparties”, professional clients or retail clients
another, either cross-border from its home jurisdiction or (these have increasing levels of protection). Clear pro-
through branches. cedures must be in place to categorize clients and as-
Some of the key changes implemented by MIFID are sess their suitability for each type of investment product.
that it: That said, the appropriateness of any
• Eliminated the ‘concen- investment advice or suggested
tration rules’ under which financial transaction must
each EEA nation could still be verified before be-
require trading in na- ing given.
tional securities on a Client order handling
national platform.
MIFID has
This opened up
requirements re-
the market for
lating to the in-
new trading ven-
formation that
ues, including
needs to be cap-
possible multina-
tured while ac-
tional platforms.
cepting client
• I n t r o - orders, ensuring
duced new rules that a firm is act-
on client classifi- ing in a client’s
cation. best interests and
• H a r m o - as to how orders
nized the con- from different cli-
duct of business ents may be ag-
rules applicable gregated.
to financial ser-
Pre-trade transpar-
vices firms
ency
Since the pri-
MIFID requires
mary purpose of MI-
that operators of con-
FID was to harmonize
tinuous order-matching
the law of the European ju-
systems must make aggre-
risdictions regulating financial
gated order information on “liquid
service providers, the rules in the
shares” available at the five best price
various jurisdictions under MIFID have
levels on the buy and sell side; for quote-driven markets,
been similar
the best bids and offers of market makers must be made
MIFID: The Characteristics available.
Authorization, regulation & passporting
Post-trade transparency
Firms covered by MIFID needs to be authorized and
MIFID requires firms to publish the price, volume
regulated in their “home state” (broadly, the country in
and time of all trades in listed shares, even if executed
which they have their registered office). Once a firm has
outside of a regulated market, unless certain require-
been authorized, it can use the MIFID passport to pro-
ments are met to allow for deferred publication.
vide services to customers in other EU member states.
Page 11

© The Finance Club, Indian Institute of Management, Shillong


Best execution
MIFID requires that firms take all reasonable steps
to obtain the best possible result in the execution of an
order for a client. The best possible result is not limited to
execution price but also includes cost, speed, likelihood
of execution and likelihood of settlement and any other
factors deemed relevant.
Systematic Internalizer
Systematic Internalizer is a firm that executes orders
from its clients against its own book or against orders
from other clients. MIFID treats Systematic Internalizer
as mini-exchanges, hence, for example, they are subject
to pre-trade and post-trade transparency requirements.
MIFID: The Impact on trading venues
The introduction of MIFID has significantly
changed the secondary markets landscape
across Europe. In principle, a trade
can now be executed in all national
markets either on an organized
market (a regulated market or
MTF), or by an investment firm
either acting as an SI or ex-
ecuting trades OTC. In prac-
tice, the venue used to exe-
cute a trade will depend on
where the share is admitted
to trading and a number of
other factors such as liquid-
ity, certainty of execution,
and costs.
When considering the
impact of MIFID, it is impor-
tant to bear in mind other driv-
ers that have had an impact on the
trading services market. The market
has faced unprecedented volatility over
the past 12 months and dealt with defaults
of major counterparties.
Niveshak Volume 2 Issue 5 June 2009
FingyaaN
Established exchanges have seen their positions
challenged and the most significant change to the trad-
ing landscape has been the impact of new MTF platforms.
These new entrants have had the effect of moving trad-
ing away from regulated markets, as well as of attracting
new liquidity from the OTC space. MTFs have steadily in-
creased their market share of trading in all markets. This
growth has occurred in parallel with the launch of new
MTF platforms. A key reason for this is that new trad-
ing platforms offer more opportunities for pan-European
trading because of the range of shares offered by the ven-
ues and their very competitive fees.
However, it is important to note that while the
market share of regulated markets has decreased since
the implementation of MIFID, the majority of trading
remains on the incumbent regulated markets
rather than new entrants and OTC. There is
limited competition between regulated
markets due to the fact that regu-
lated markets generally offer trad-
ing in shares admitted to trading
on their own regulated mar-
ket rather than pan-European
trading of shares admitted to
trading on other regulated
markets in the EU, although
some regulated markets op-
erate MTFs that offer pan-
European share trading and
in this way compete with
regulated markets (e.g., all
German regulated markets
traditionally operate MTFs
where also a lot of shares listed
on markets in other countries can
be traded.
Market share of OTC trading has
continually fluctuated since the implemen-
tation of MIFID with a slight upward trend.
Page 11

One of the main developments has been a signifi-
cant decrease in hit sizes, coupled with an increase in the
number of trades. This is likely to be due to a combina-
tion of different factors, including an increase in the level
of algorithmic trading, market fragmentation and market
volatility, rather than simply the implementation of MI-
FID. Whilst it had started before MIFID, the decline in hit
sizes has been more pronounced since MIFID came into
force. It is not clear that this decline was caused solely
by MIFID.
MIFID: The Future
Finally, MIFID aimed to develop competition and
greater efficiency of equity trading while maintaining in-
vestor protection. This greater competition is raising con-
cerns among trading platforms, by regulated markets vis-
a-vis MTFs, and by regulated markets and MTFs vis-a-vis
investment firms OTC activities. Beyond the commercial
© The Finance Club, Indian Institute of Management, Shillong
FingyaaN
interests underpinning the concerns expressed, it is im-
portant to be and remain aware of the challenges raised
by the still recent introduction of the MIFID framework
governing competition in equity trading so that action
can be taken or recommendations made to address issues
identified. A review of how trading functionality is devel-
oping across the whole market could be a useful start
of further consideration of the still blurring distinction
between broker activities and the operation of a trading
platform. The significance reached by some MTFs may
lead to reconsideration of some potential differences in
regulatory requirements for MTFs and regulated markets.
By Amit Agarwal
XLRI Jamshedpur
Page 11

The Godzilla
that ransacked Wall St
How Finance Became the Rampaging monster of our age
T he past 18 months saw a monster of epic pro-
portions out of no Hollywood movie ever made,
come and ransack some of the biggest financial centers in
the world- New York, London, Tokyo. In its wake, it left 31
collapsed banks in the USA alone (2007-January 31, Source:
FDIC Failed Bank List), and trillions of dollars washed
away. What potent diet did this monster grow on?
Over the past few decades, finance has become a
cornerstone of the global economy- it contributed nearly
35% of corporate profits in USA until 2007, and the tril-
lions of dollars of cash flows kept companies running on
easy credit, people buying products on cheap rates, and
the economy chugging along relatively smoothly. How-
ever, finance was built on the foundations of economic
thinking- based on certain assumptions assumed to be
infallible. These assumptions are rounded off in what is
known as the “Efficient Market Hypothesis” which as-
sumes people to be rational, information to be freely
available, nil transaction costs-- an ideal world far re-
moved from the imperfections of day-to-day markets. The
Efficient market hypothesis assumed investors to filter
all information on an asset and based on that, derive a
fair value. This fair value will lead to an efficient flow of
capital. Hence, finance was believed to be a key lever in
ensuring open and efficient markets.
Niveshak Volume 2 Issue 5 June 2009
FinTraX
However, this assumption has been negated by peo-
ple ranging from Joseph Stilgitz to George Soros; as well
as the consistent boom-bust cycles that battered many
industries (IT) and countries (East Asian Crisis). George
Soros summarizes that the underlying assumption of fi-
nancial markets that the aggregate knowledge of all indi-
viduals discounts the future to reflect the “true price” is
essentially flawed.
Reflexivity- Soros contends that participants think-
ing and ideas shape reality in an unending process so that
both become codependent in an endless feedback loop.
For example a company’s falling stock makes financing
difficult. This leads to even more pressure on the stock
price, hence reinforcing actions and events.
Hence in certain cases, the participants’ bias can
change the fundamentals which are supposed to deter-
mine market prices.
The Grossman-Stiglitz Paradox takes the idea fur-
ther by contending that efficient markets assume prices
are right and it takes energy to discover information. If
both statements are true, then no one will search for any
information that has a bearing on the price, since it is
already captured.
The underlying foundation of many of these theo-
ries is “asymmetric information”. A seller often knows
Page 11
 FinTraX

more about the good than the buyer. This lopsidedness an active role in developing their economies- by creating
can lead to adverse selection which can prevent markets physical and institutional infrastructure, including cor-
from existing due to the quality uncertainty. Only when porate governance and law, and help their markets ma-
better-informed market agents ‘signal’ information to ture slowly. The markets will not work well in all areas,
other agents does price discovery occur. Hence people and externalities will ensure that less beneficial research
might turn to dealers to buy a car rather than from a takes place, and more pollution occurs. If countries in Af-
private seller. rica, South America and Asia want to achieve sustainable
In simpler words, in any principal-agent relation- long-term development, they cannot rely on speculative
ship, many times the agents knows more than the prin- foreign capital, but have to instead attract stable long-
cipal, and they use this information for maximizing their term FDI. This will require work on many fronts, includ-
own wealth. The simplest example is insider trading. ing creating infrastructure, strengthening education, cre-
ating jobs and promoting savings. This is the long-term
This asymmetry means that prices are not correct.
lesson out of the financial crisis.
Hence, capital is incorrectly allocated, which leads to
market distortions and failures. It can also incentivize fi- The present crisis presents new challenges for
nancial agents to become even greedier and misappropri- both the developed and the developing world- econo-
ate information. All this indeed did happen, and 2008 was mists and policy-makers are clueless about the kind of
a bleak year for Finance. responses needed; but in the end, the market will prevail
and cleanse itself. Older, inefficient companies should be
Momentum investing- for example, moving along
made to die while new companies emerge. In the end,
with the flow and investing in IT stocks which then
the whims of supply and demand brought down an un-
boom and more people invest and so on; has increased
sustainable sector that had grown too big and unwieldy.
incentives for fund managers to patronize the practice
This game will continue forever. New regulations will
and derive gains from it, through commissions and man-
emerge from this crisis too; and entrepreneurs engaging
agement fees. Otherwise, the volatility in stocks will be
in creative destruction will devise new ways to circum-
low enough to not require active investment strategies.
vent those regulations and create something new and in-
Some critics advocate monitoring fund managers for use
novative. It might lead to another crisis in the future, but
of momentum, and set limits on turnover to encourage
the flight to equity premium will always take off.
fair value investing.
After all the mess, Wall St. still doled out $18 bil-
Pranav Arvind Dhingra
lion worth of bonuses in 2008, almost as much as 2004;
but considerably lesser than 2007. The recently passed
$787 billion stimulus bill of the USA contains provisions
NMIMS Mumbai
to limit bonuses for executives at institutions receiving
government funds to a third of their salaries. And the
bonuses could be paid only in stock irredeemable until
the government was paid back in full. The problem is that
the caps apply not just to senior executives but also to
traders, investment bankers, fund managers and others FinQ May’09 Issue Answers
compensated largely through performance-based com-
missions. This has elicited warnings of a mass-outflow of
talent from Finance and stifling innovation. 1. Montek Singh Aluwalia
The best solution to the compensation problem is to 2. Goldman Sachs
use market discipline, be transparent and heed the inves- 3. The Netherlands
tor interest (e.g. shareholder “say on pay”). However, this 4. Fiat Money
requires time to wait out the disaster and gradually limit
the role of the government.
5. Greater Fool Theory also called
‘Castle-in-the-Air Theory’
The Future
An interview with Richard Foster in the McKinsey 6. It is a phenomenon where rising
Quarterly puts it best when he says that this period is incomes push individuals into higher
another example of creative destruction at work; which tax brackets, leaving them worse off
will create a new generation of leaders. A new set of peo- with lower real disposable incomes.
ple will challenge incumbents and new companies will
emerge from the rubble; like Microsoft in the 80’s and 7. Eurobond
Google in the 90’s. 8. ITC Classic Finance
What is important is that the policies of Govern- 9. Bank of India in London
ments around the world do not turn too protectionist and 10. DaimlerChrysler
stifle the invisible hand of the market. The market might
be imperfect but it has ensured tremendous returns and
wealth distribution around the world. It instead signals
governments, especially in developing countries to take
Page 11

© The Finance Club, Indian Institute of Management, Shillong


T he financial crisis in US has till now witnessed
the collapse of banking, investment and tech-
nology firms. But now this was the term of manufactur-
ing sector. On 1st June 2009, US car giant General Motors,
having 100 years of strong legacy and presence in 140
countries, filed for Chapter 11 bankruptcy. This was the
2nd consecutive collapse of auto giants in US since Chrys-
ler filed for bankruptcy a month earlier.
Till March 6,2009 GM tried some restructuring
plans until it was clear that it has to seek bankruptcy
production. General Motors, which once held an iron clad
50% plus market share for the domestic car market has
finally succumbed to the extraordinary pressure put on
its balance sheet by unsustainable pension and health
care promises, benefits, and wages given to the unions
over the years. Unable to compete with Japanese imports
that had none of these expenses, the free market dealt a
crushing blow to the giant over the course of the past
three decades. Reacting to this, DOW fell to the 12-years
low on March 6,2009. One of the biggest names in the
Dow Jones was about to become a penny stock trading at
$1.45 (with finally trading at 75 cents on 30th May, 2009).
The proposed plan consists of the deal with the
United Auto Workers which will allow GM to forgo a $10
billion payment to a union healthcare fund in return for
a 17.5% stake in the new GM. Bondholders are also to be
given 10% of the new firm for debts totaling $27 billion.
The governments of America and Canada, will have 72.5%
of the new firm.
Some of its global operations, for example, most of
those in Asia, are run via independent companies that
continue to be solvent and in good financial shape.
US government is also acting as a reluctant share-
holder as it doesn’t want to see a successive collapse of
more manufacturing firms. The government has already
expressed its intention of selling out their shares as soon
as possible after GM emerges from bankruptcy. But it will
be difficult for America’s government to recouping the
$50 billion so far sunk into GM.
But the government has expressed commitment to
the firm by saying that GM will be run by a private board
Niveshak Volume 2 Issue 5 June 2009
In the newS
Down it Goes....
of directors and management team with a track record
in American manufacturing. They, and not the US govern-
ment, will call the shots and make the decisions about
how to turn this company around.
GM was against the filing of bankruptcy protection
considering two facts:
• Fear of sales loss
• Fear that some form of their $170 billion debt will
not be wiped clean in a bankruptcy
Of course the company tried to improve its opera-
tions and reduce its liabilities via out-of-court settlement.
An out of court process demonstrates the Company’s abil-
ity to re-pay the U.S. Department of Treasury loans and
to structure a viable business with a positive net present
value, credibility with consumers and a competitive op-
erating and capital structure, while minimizing the risk
that further financial reorganization will be required. GM
also felt that there was no assurance that the company
will be able to exit out of the bankruptcy quickly. Lehm-
an Brothers filed for Chapter 11 in September last year but
is still stuck due to a dispute between Lehman’s Ameri-
can and British units over the distribution of assets. GM
is over 3 times bigger than Lehman and present in double
the number of countries. The out-of-the court process
would have the best balance of rightsizing the company’s
liability with preserving the value of enterprise. But the
need of an unprecedented amount of debtor-in-posses-
sion financing was needed which was not available with
traditional sources of funding. GM had no other option
to accept government support by filing chapter 11 bank-
ruptcy. The hope now lies on how fast GM emerges out
of the bankruptcy which will bring cheers to the manu-
facturing sector in the world scenario with Indian firm
like Mahindra & Mahindra seeing opportunity in becom-
ing a component supplier or a service supplier to GM, of
course post bankruptcy
By Amit Chowdhary
IIM Shillong
Page 22

Is It A Failure of Market???
Joseph Stiglitz: An Interview
J oseph E. Stiglitz was awarded with a Nobel prize
in economics for his pioneering research on mar-
kets with asymmetric information, and his work helped
explain the circumstances in which markets would work
better with selective government intervention. In a re-
cent interview with the mint, he commented that the
measures necessary to get out of the present economic
turmoil are not yet been taken; and that Obama assuming
presidency and implementing policy measures is awaited.
He turns to India and says that the growth story lies con-
siderably in the hands of the government. There is a large
need for the provision of public goods, especially in the
infrastructure space which requires massive government
expenditure and in turn a revisit of the tax structure.
Competitive Equilibrium & Efficiency
Most of the economic theory is based on the free
market system. In the context of competitive markets,
there is a balance between the demand and supply of
the different goods and services in the economy. Further,
the competitive equilibrium is also an efficient one (Pa-
reto efficiency) and this is known as the ‘First Fundamen-
tal Theorem of Welfare Economics’. This is based on the
existence of perfect information about prices. Not only
will competitive markets lead to an efficient outcome,
but any efficient outcome that one might desire can be
attained through the operation of competitive markets.
This is known as the ‘Second Fundamental Theorem of
Welfare Economics’. Thus, if one efficient outcome is not
desirable due to, say, inequities involved in it, there is
another competitive equilibrium which can be attained.
Hence the government does not have much of a role. The
only acceptable role that can be seen arises from the Sec-
ond Fundamental Theorem and that is of redistribution
to resolve inequalities.
Market Failure
Most of the production in Industrialized economies
is out of private production. The drive for profit on the
part of the entrepreneur and the competition prevailing
leads to high degree of efficiency and also gave spur to
innovation.
However, the market does not work as perfectly as
© The Finance Club, Indian Institute of Management, Shillong
OpinioN
...Or That Of Policy???
the proponents of the free market theory say. Market
failures are said to occur when the competitive equilib-
rium fails to achieve ‘Pareto efficiency’. Pareto efficiency
is the state where one person can be made better off only
by making the other person worse off. Thus the outcome
achieved is far from the ‘preferred’ outcome. The pre-
ferred outcome is on the basis of Pareto efficiency and on
distributional equity considerations. A perfectly competi-
tive market is Pareto efficient.
Reasons For Market Failure
The reasons for market failures are:
1. Externalities: The classical definition of externali-
ties is that there are some non monetary effects (costs or
benefits) which are not taken into account in the deci-
sion making process (Baumol).
2. Public Goods: Goods are said to be rival when a
unit of a good consumed by one person cannot also be
consumed by another person. They are said to be exclud-
able when a person who does not pay for a good can be
excluded from its consumption. When it comes to provi-
sion of public goods, markets usually fail due to the
above two element
3. Imperfect Competition and Natural Monopolies:
While in a competitive equilibrium, a producer equated
price to the marginal cost, in an imperfect competition,
the producer equates marginal revenue to marginal cost,
and price is greater than the marginal cost.
4. Information asymmetries: It refers to the fact
that the buyer and the seller of the commodity may have
different amounts of information about that commod-
ity’s attributes.
5. Equity Considerations: The fact that the economy
is Pareto efficient says nothing about the income distri-
bution. Markets may result in an unequal distribution
of income leaving some individuals with very high and
some with very low amount of resources.
6. Merit Goods: Even in a Pareto efficient economy,
the individual might not act in his own best interests.
Individuals may smoke even thought they know it is bad
for them. This is known as the paternalism as against lib-
ertarianism which requires governments not to interfere
in deciding the preferences of the public.
Page 22

Government Intervention As The
Approach To Market Failure
Most economists have attributed the present finan-
cial turmoil to inadequate government regulation. And
this story is not just of today, when the Enron scandal
eroded confidence in America’s financial markets and ac-
counting firms, there was a demand for stronger regula-
tion to restore confidence.
So how can government intervention overcome
market failure? Some of the forms it can take are:
• Regulation
• Taxes & Subsidies
• Environment Regulations
• Provision of public goods
• Monopolies
Government Failure
We say that market failures occur when the com-
petitive system is unable to deliver a Pareto Efficient
outcome, similarly a non market failure or government
failure occurs when the state fails to achieve the Pareto
efficient outcome.
It is usually difficult to measure the goods provid-
ed by non market institutions. For instance, how do you
measure the impact of the environmental regulations
imposed, or the students taught under the government
education system, or the benefits provided by the state
health service because the evidence of output quality
is missing Further, In a non-market setup, it is usually
one or very few agents that provide the good or service.
The absence of competition not only adds to difficulty in
evaluating the quality of the product, but adds to inef-
ficiencies as well.
Reasons For Government Failure:
1. Internalities and private goals
2. Redundant and Rising Costs
3. Derived externalities
4. Distributional Inequities
5. Agency Problems
6. Information Asymmetry
The Present Financial Turmoil:
Market Or Policy Failure?
The Great Depression of 1930’ was a major con-
sequence of market failure, which paved the way for
Keynesian economics emphasizing the role of the govern-
ment. He advocated interventionist government policy,
by which the government uses tolls of fiscal and mon-
etary policy to mitigate the adverse effects of recessions,
depressions and booms. The East Asian Crisis was largely
due to faulty government policies of maintaining fixed
and overvalued exchange rates and controls on capital
flows. Now when we are seeing another major global
recession, which is to blame - The Market mechanism or
the government institutions?
The Government Element:
The present turmoil all began with the bursting
of the US Housing bubble and the high default rates
Niveshak Volume 2 Issue 5 June 2009
OpinioN
on subprime mortgages. The causes of the bubble were
the extremely low interest rates maintained by the Fed,
and these were kept low despite the inflation pressures
(there was too much money chasing too few goods). It
was expected that the Fed would bail out troubles finan-
cial firms (“Greenspan Push”). Further, there was govern-
ment support to the Freddie Mac and Fannie Mae, the
two huge corporations which backed more than half of
the mortgages outstanding in the US. There was also po-
litical pressure on banks to lend in the name of ‘afford-
able housing’. Thus, when markets fail (as in did in the
great depression of the 1930s), government is not always
the best answer; in fact it might to more harm than good.
The Market Element:
Does this however mean that the banks and finan-
cial institutions were not to be blamed? Worldwide, peo-
ple attribute the turmoil to the failure of capitalism and
the advent of globalization. Martin Wolf, chief econom-
ics commentator at the Financial Times, announced the
death of the dream of global free-market capitalism in
March 2008; Economist Robert Shiller advocated robust
government intervention to tackle the financial crises.
A series of major bail outs was seen (including the
U.S. government’s decision to nationalize Fannie Mae and
Freddie Mac). In October, the British Chancellor of the
Exchequer referred to Keynes as he announced plans for
substantial fiscal stimulus to head off the worst effects
of recession, in accordance with Keynesian economic
thought. Similar policies have been announced in other
European countries, by the U.S., and by China.
Market And Non Market Failure In The
Financial Services Sector
How do we discuss the concept of market and non
market failures when it comes to the financial services
sector? The most common problem that arises is of in-
formation asymmetry. As a result of which, this industry
is highly regulated. In India the regulatory authority is
SEBI, RBI and the Stock Exchanges. Banks are not allowed
to engage in insider trading. In many investment banks,
there is a ‘Chinese wall’ between the research depart-
ment and the corporate finance/M&A/equities and debt
trading departments, so that the output of research ana-
lysts is not affected by the deals under execution in the
company. When the Enron scandal burst, the regulators
enforced the Sarbanes Oxley Act for adequate disclosure.
The ‘Basel norms’ is also a step of intense government
intervention to overcome market failures.
One of the concerns about the sub-prime mortgage
crisis is that it would have been less severe had legis-
lation or regulations to restrict predatory lending been
adopted. At the time, some argued that the loose lend-
ing standards would enable more individuals to become
homeowners. But it should have been clear that giving
a loan to someone beyond their capacity to pay was not
acceptable.
By Abhinav Chugh & Nidhi Kai cker
FMS, Delhi
Page 22
 FinloungE

FinQ
How Well You know Wall-Street

1. What was the first listed company on the

New York Stock Exchange?

2. What is the highest priced share on the

New York Stock Exchange?

3. What were the first publicly traded securities in the U.S.?

4. When was the first stock exchange created in the US?

5. When did the New York Stock Exchange

first introduce the stock ticker?

6. Oldest commodities exchanges in the US?

7. What has been the longest-listed company on the NYSE?

8. When did the Dow Jones Industrial Average first close

over 10,000?

9. What was the original name of the American Stock

Exchange and why?

10. The first official mutual fund of Wall Street?

All Entries should be mailed at niveshak.iims@gmail.com by 10th July 2009 23:59 hours
One lucky winner will receive cash prize of Rs 500/-
Page 22

© The Finance Club, Indian Institute of Management, Shillong

 Team niveshaK

ARTICLE OF THE MONTH

The article of the month for May 2009 goes to Mr. Atul Gupta of SIBM Pune. He
receive a cash prize of Rs.1000/-
CONGRATULATIONS!!

Fin-Q Winner for Last issue

Ms. Shakshi Gupta of IIM Shillong. She receives a cash prize of Rs.500/-
CONGRATULATIONS!!

All Are INVITED!!

The team Niveshak invites article from B Schools all across India. We are
looking for original articles related to finance & economics. Students can
also contribute puzzles and jokes related to finance & economics. Refer-
ences should be cited wherever necessary. The best article will be featured
as the “Article of the Month” and would be awarded cash prize of Rs.1000/-

Please send your articles before 10th July 2009 to niveshak.iims@gmail.com. Do

mention your name, institute name and batch with your article.
Format: Font:- Times New Roman, Size:- 12, Length <= 5 Pages in word doc/docx.
Please DO NOT send PDF files and Kindly stick to the format.
Number of authors 2 at max.

SUBSCRIBE!!
Get YOUR OWN COPY DELIVERED TO INBOX
Drop a mail at niveshak.iims@gmail.com

Thanks
Team Niveshak
http://www.iims-niveshak.com
Page 22

Niveshak Volume 2 Issue 5 June 2009

COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com
http://www.iims-niveshak.com
ALL RIGHTS RESERVED
Finance Club
Indian Institute of Management, Shillong
Mayurbhanj Complex,Nongthymmai
Shillong- 793014