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Niveshak From Editor's DesK

Volume II
ISSUE I
January 2009
O nandbehalf of the entire team, I wish all the readers a very Happy New Year
hope we see the Bull running wild on the markets very soon.
The ghost of the sub-prime has not yet passed; the bear is still at large at the
Editor markets. Stock prices fight each other in defeating historic lows. Government of India
Biswadeep Parida has again revised estimated GDP growth projections taking it a notch below. Nega-
tive corporate quarterly results put the sensex on a slippery slope, but India Inc has
Team Niveshak more has more to worry about. This time the image of India Inc has been tarnished by
the Satyam’s disgraced ex-chief Mr. B Ramalinga Raju, once hailed as the blue eyed
Amit Chowdhary boy of India Inc. Merger talks & bailout pleads take most of the news space. Apart
Nilesh Bhaiya from negative financial data across the globe grabbing headlines, Mr Barack Obama
Sareet Misra brings in some cheer and hope for change to viewers by taking over the Presidentship
Sarvesh Choudhury of the United States of America.
Sujal Kumar In this edition we have tried not to talk about sub-prime crisis much. Since this
Tripurari Prasad is the first issue of this year, we would try to look at the blunders we committed in
2008 in the world of finance and try not to repeat them in future. We shall also try to
take a historic look at Great Depression of 1929 and draw parallels with the current
crisis. We have important lessons to learn from the failure of Bear Stearns, a sub-prime
hit bank that had to shed its I-Bank glamour, swallow its pride and sell itself to JP
Morgan Chase, a less glittery but huge commercial bank. One of the most complicated
financial instruments-the Credit Default Swaps has also been extensively covered.
We shall discuss one of the most elusive topics - the pricing of CDS by some globally
accepted methods.
The regime of regulated oil prices in India has always troubled oil companies
and they had to often take support of oil bonds to see the light of another day. Last
few years of stratospheric crude oil rates has further endangered their existence. We
shall analyze if they can ever end up in green. As the catastrophe of Wall Street has
hammered valuations across world stock markets to unimaginable lows, certain cor-
porate have started to stroll between the ruins and pick stocks of rival companies at
throwaway prices. To fend such a type of acquisition, India Inc has finally arisen to
Differential Voting Rights. This issue carries an article on DVRs. This volatility of
stock market indices has also prompted some analysts to question if these indices are
representative enough of the world business outlook. May be we have an alternative
in the Baltic Dry Index that is only dependent on fundamentals and not much on
sentiments.
Talking about Sub-prime, historically low stock prices, acquisition of shares,
bankruptcy of banks, we remember that Sovereign Wealth Funds acquired major
chunks of shares of wall street behemoths like Merrill Lynch, Morgan Stanley, Bear
Stearns, Citigroup, UBS, London Stock Exchange among many other corporate which
are regarded as America’s pride. These funds are swelling with cash and are always
hungry for shares of huge western companies, but have faced severe opposition from
governments of the countries where they targeted strategic acquisitions. What are
these funds, how big are they, who owns them and why are they being opposed? We
will try to answer.
Still you found lots of sub-prime talks. Well there is no way out of it as of
All Images and artwork now.
are copyright of IIM Happy Reading.
Shillong Finance Club

- Biswadeep Parida
©Finance Club (Editor- Niveshak)
Indian Institute
of Management, Shillong

Disclaimer: The views presented are the opinion/work of the individual
author and The Finance Club of IIM Shillong bears no responsibility whatsover.
ContentS

The Year That was
2008- A year of big blunders- Page 4

Fin Sight
Oil companies- Page 5
Differential voting rights- Page 12

Investor’s Pick
Deepak Parekh- Page 8
Cover Story
Sovereign wealth funds- Page 11

Article of the month
CDS Pricing- Page 15

Institutions
World Bank- Page 18

Opinion
Lessons from Bear Stearns- Page 20

Review
Life settlement bonds- Page 23

Market Watch
Baltic Index- Page 24

The Great Depression-Page 26

Finlounge
FinToon- Page 17
FinQ- Page 27

© The Finance Club, Indian Institute of Management, Shillong
The year that waS

2008
An year of Big
ear 2008 will always be remembered as an Higher inflation rate prompted interest rates
year which gave a fatal blow to the reputa- and the cash reserve ratio to be increased. This
tion of investment bankers, rating agencies, was a time when inflation was caused by lower supplies
economists and regulators. The fact that prediction of a and high oil prices.
crisis is nearly unpredictable is acceptable but the hard Sixth blunder was committed by The Government
fact that so many people were consistently wrong is of India for introducing a fiscal stimulus package of Rs
something that cannot be digested easily. Let us have a 30,000 crore. But there isn’t a single person who believes
look at some of the biggest blunders of 2008:- that it will work.
The first and by far the biggest blunder was the ap- But even if it works, it would take time as govern-
proach to financial sector bailouts. It all started with the ment expenditure will take time to be approved and ten-
rescue of Bear Stearns in March 2007 but the crisis resur- dered and it would be mid 2009 before we see any ac-
faces soon. When the US Treasury & Federal reserve lined tion.
up bail-out packages for failed housing twins Freddie Mac The credit of the seventh blunder goes to the OPEC
and Fannie Mac, it raised thousand eyebrows. Public mon- nations. After much dithering it has decided to lower its
ey was used to fund the misadventures of these greedy output by a little over 4 million barrels a day to stabilize
financial institutions who forgot the basic due diligence prices. They prefer a price of $75 per barrel, which seems
and jumped into the so-called casino capitalism. Subse- like a distant dream as of today. But what confounds all
quently, Lehmann Brothers collapsed and Merrill Lynch the more is the fact that the prices are down today be-
was saved by the skin of the teeth, while Goldman Sachs cause of a slowdown, and by cutting output to ostensibly
and Morgan Stanley swallowed their pride to become old raise crude prices; it would actually lead to slide in prices
fashioned commercial banks. The government was un- as demand declines further. Apparently, it is unsure of
sure of whether or not moral hazard had to be eradicated what is to be done.
or whether there was a larger duty to the public or the Eighth has been the failure of the series of bailouts.
failed institutions. So far it had been only for the distressed financial in-
The second biggest blunder has been the regulation. stitutions but we had three auto companies in the U.S
While the investment banks and hedge funds do not have actually approaching government for a bailout. But this
a regulator, banks do. Though Basel-II takes the credit for is truly justified on the premise that these are the firms
bringing about discipline across banks and the Fed has that are involved in production and these along with re-
made it difficult to skip the rope, what remains yet to be ality sectors are the drivers of growth. But the problem
explained is the fact that why in spite of this discipline lies in deciding the extent of the bailouts.
Citibank landed in trouble. The ninth institutional shock was the domestic
The third has been the panic response from Fed suspect-ICICI. This leading Indian bank featured again as
which lowered its interest rates to 0.25% at a time when deposit holders made a beeline for the ATMs to withdraw
the economy was going into recession. Mr Greenspan has money because of a rumour that the bank was over ex-
been blmed as the biggest culprit in this respect for pur- posed to toxic Lehman assets. The dynamism that pro-
suing a policy of liberal interest rates and creating se- pelled the bank to stardom was their strong presence in
rial bubbles. It looks as if he was up to starting another the derivative segment this time and agricultural loans
bubble and time will tell which one it would be. earlier became a liability. RBI also came to rescue and
The ECB and BoE stand fourth in the hierarchy of went out of the way to reassure everybody that it was
blunders as being central banks without an independent all well.
mind, as they have lowered their indicative rates too vis- Lastly, a blow to the economy was dealt by the ter-
a-vis the Federal Reserve. They could also not do any- ror attacks on the Taj and Oberoi as this was the attack
thing to save the banking majors of the euro zone. But on the financial and commercial capital of India. The de-
the billion dollar question is that whether in this scenario bate continues as to whether this would have long term
wasn’t Euro supposed to actually challenge the dollar and financial implications.

By Nupur Khanna
steal a lead?
The situation worsened and even developing na-
tions like India weren’t spared in spite of having a fairly
regulated banking system. RBI in India fared no better. Delhi School of Economics
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Niveshak Volume 2 Issue 1 January 2009
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C O M P ANIES C O NUND
IL
EO RU M
TH

“It is said that human beings have some basic needs: Food, Shelter, Clothes,
and OIL. The importance of all these in today’s life cannot be ignored at all”

he global scenario over the past few years Indian petroleum sector as Upstream and Downstream.
has witnessed a phase of high growth, es- The Upstream consists of the oil and gas exploration
pecially in the emerging economies such as companies with players such as ONGC, OIL, RIL. How-
India and China. The sustainability of this steep growth ever, the Downstream is divided into Refining and Mar-
path largely depends on the ability of the nation to build keting companies and Natural Gas distribution compa-
sufficient infrastructure that can support and propel the nies. The former has companies such as IOC, BPCL, HPCL,
growth further. A key component of this infrastructure is ONGC, RIL, CPCL, BRPL, KRL, NRL, MRPL, while the latter
energy. The basic growth and competitiveness of the na- has company like GAIL. Moreover, the downstream sec-
tion hinges on how well the country can meet its growing tor shall be providing a demand for the upstream sector
demand for energy. With the accelerated pace of growth which will be the source of supply.
that we have witnessed, the demand for energy is only
rising, with crude oil being India`s key source. Oil pricing and oil company’s losses
Over the last year, price of crude oil surpassed its
In India, oil prices are controlled by the government
own records with an all-time high of $147.27 on 12th July
in a process called APM (Administered Price Mechanism).
2008. India, which imports nearly 80% of its oil require-
This means that periodically, based on the international
ments, faces the brunt of such sharp increases in term of
prices, government would set prices for Petrol (Gasoline),
its swelling import bills. As far as India is concerned, it
Diesel (used by trucks), Kerosene (used by poor for cook-
continues to remain one of the least explored countries
ing and lighting) and LPG (used for cooking by middle
of the world, yet ranks among the top consumers of the
class) and all the oil market companies have to fix their
world. The picture in the Indian market therefore, be-
prices as per that price. The price is set in a way that oil
comes highly skewed with a heavy reliance on imports.
companies make profits on Gasoline, break even on Die-
sel and make losses on Kerosene and LPG, and in return
Oil Industry overview get compensated by government bonds.
It is imperative to build a perspective by understand- Currently, the Government follows the principle of
ing the industry structure and have a brief value chain ‘equitable burden sharing’ – issue of oil bonds, upstream/
analysis. The value chain follows the following sequence: refinery discounts, and minimal price increase.
• Exploration - Using technology to find new oil For 2007-08, the oil companies reported a total rev-
• Production - Bringing oil to the surface using enue loss of Rs 70,579 crore of which Rs 35,289.50 crore is
to be compensated through oil bonds. The government
artificial and natural methods
has already issued, oil bonds worth Rs 20,333.33 crore for
• Transportation - Moving oil to refineries and April-December 2007 period.
consumers through trucks and pipelines The government shares almost 46% of the burden,
• Refining - Converting crude oil to finished but there are few points worth noting as far as oil subsi-
products dies are concerned.
• Marketing - Distributing and selling the products
There can be a broad two-way categorization of the
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© The Finance Club, Indian Institute of Management, Shillong
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Oil bonds and its problems well as a mitigating process.
Oil bonds as the preferred form of subsidy is two- Moreover, a recent
fold. First, and most importantly, in a system of cash- CII report proposed the
based government budgeting like ours, the transfer of oil way forward for the
bonds can be kept off the budget. It does not affect the structured devel-
fiscal and revenue deficits of the central government at opment of en-
the time of transfer, thus proving to be of great advan- ergy markets in India.
tage especially when fiscal responsibility laws mandate It indicated how market players
specified targets for such deficits. can use derivatives as effective tools for risk man-
Secondly, the cash impact of the bonds, in the form agement. The report notes various developments taking
of interest payments to the holders and final repayment, place in India towards the advancement of energy mar-
is postponed and attenuated over time. From the view- kets in general and energy derivatives market in particu-
point of the OMCs, of course, these features of oil bonds lar.
are huge negatives. Branded oil:
For operational expenses, interest earnings is some- Price of premium brands being controlled by the oil
thing that only cumulates, while attempt to sell bonds companies, the firms are in a way forcing its purchase by
for cash results in huge discounts, if tradable. consumers. By adopting pick-and-chose policy, oil com-
Petro bonds have different economic implications panies do not give same stock to all its dealers. With
as compared to issuing of transparent cash subsidies exhaustion of normal fuel, it’s the premium brands
from government to OMCs. In case of cash subsidies, that are sold. Petrol and diesel are 4/litre and 2.25/
governments revenue deficit would get widened, litre respectively more costly than normal.
borrowings increase, thus leading to high interest Moreover, the government must also seriously
rates and “crowding out” of private investment. consider colorizing diesel and selling it at two dif-
While in the former case, OMCs take a hit on their ferent rates. The types of fuel are classified by the
profits culminating to reduction in public savings. type of use, amount of sulfur emissions and tax category.
The switch to a transparent cash subsidy from gov- Colored diesel can be sold at a subsidized rate to keep
ernment to OMCs can and should be accomplished swift- the inflation under check, whereas the colorless diesel
ly. Though the deficit targets of the fiscal responsibility and premium diesel can be sold at Rs. 60 (or more) per
law is breached by wide margins. But in the present en- liter. Also, the pricing of Diesel at lower rate makes sense,
vironment the official deficit numbers simply hide huge because Diesel is much more efficient (40% more power
repressed deficits without being able to mitigate their compared to Petrol) and it emits just 69% as much green-
adverse economic consequences. house gases as petrol for every kilometer of ride.
Considering the increasing awareness for environ-
Strategies for long-term viability ment friendly products among Indian consumers, the in-
troduction of branded fuels will help the oil companies
With output prices tightly monitored and input
in making up for their losses.
prices highly fluctuating, it seems tougher for oil com-
panies to stay profitable year-on-year in India. However, Oil subsidy removal:
the following strategies/steps can guard these companies Taking a longer four-year perspective, when the
against crude price escalation: price of the crude was up 230% ($135/barrel, up from $51/
Energy Derivatives: barrel in January 2007), Indian petrol was up only 35%,
diesel 46%, and kerosene not at all!
Starting with an example, jet fuel consumption rep-
resents up to 23% of all costs of an airline company. If This was so because government provides massive
an airline seeks to protect itself from rises in the jet fuel implicit subsidies to consumers of almost Rs 200,000
price in the future, it would purchases a swap or a call crore. Subsiding oil consumers, most of which are middle
option from an institution prepared to make prices in class or rich, does not make sense in a poor country. The
these instruments. Any subsequent rise in the jet price Arjun Sengupta Committee found that most people live
for the period would be protected now. A cash settlement on less than Rs 20/day. But the implicit petrol subsidy for
at the expiry of the contract will fund the financial loss many car-owners exceeds Rs 100/day. This offends both
incurred by any rise in the physical jet fuel. justice and economic sense.
Energy Derivatives can provide low cost energy al- As said by many politicians that subsidies protect
ternatives and popularizing emission trading can go a poor from inflation, in reality, it only protects car own-
long way in providing sustainable and effective energy so- ers. If high fuel price push up transport costs and hence,
lutions to a fast developing and energy starved economy overall prices a bit, so will the deficit financing used to
like India. India’s energy needs are likely to increase six subsidize oil. Demand for oil is kept at a very high level
times over the next 20 years and there is an urgent need and can only be checked if prices are allowed to be in-
for energy derivatives, renewable and nuclear energy as creased. Oil subsidy is also a subsidy for street pollution
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and congestion, and reduces the incentive to switch from supply. It has been observed that $10 decrease in the
private to public transport. It is like subsidizing India’s crude oil price means decrease in the economic growth
own emissions. of the OPEC countries by 0.5%. Thus, the rise in prices has
In India and many other developing countries, ris- a major influence on the economic condition of develop-
ing oil prices are not passed on to consumers. Thus, oil ing countries. However, considering the above measures
demand is not checked commensurate with the price would not only guard the oil companies against crude
change. Hence, it takes much longer to restore the sup- price escalation, it would also help them to stay afloat
ply-demand balance. The quicker fuel prices are raised, in times of uncertainty. Thus, oil companies in the green
the faster people will adjust. This will not only improve would no more remain a distant dream, but become a
the state in which PSU and private oil companies are, it concrete reality for times to come
will also take care of pollution, congestion and various

By Kunal Kha itan
emission requirement.
No further reduction in prices:
While the decline in global crude oil prices had MDI Gurgaon
helped state-run Indian Oil, Bharat Petroleum and Hindu-
stan Petroleum trim their losses on sale of petrol, diesel,
domestic LPG and kerosene, the appreciation in value of
the Rupee against the US dollar had wiped away some of
the gains. They are currently losing about Rs 280 crore
per day on sale of petrol, diesel, domestic LPG and kero-
sene as government has not allowed them to align retail
prices with cost of production.
Domestic prices of petrol and diesel are pegged to
a global oil price of $ 61/barrel. If the world price falls
below this, consumers will demand a cut in domestic
prices. But having subsidized petroleum products by over
Rs 100,000 crore after oil skyrocketed in 2007, the govern-
ment should now recoup part of that to build a reserve. FinQ December’08 Issue Answers
One option is to revive the Oil Pool Account (OPA),
which in the 1980s and 1990s smoothened fluctuations in 1. Luca Pacioli, double-entry accounting
product prices. They got cash from the Oil Pool Account system
(OPA), when price control imposed losses on oil market- 2. John Clifton Bogle, known as Father of
ing companies.
Index Fund investing. He created the first
OPA had generated a big surplus when the govern-
ment had not slash the price of petroleum products in
S&P 500 Index fund).
1986, it was then when the oil stood at $ 16/barrel, down 3. Commissioning of Monte dei Paschi si,
from $ 32/barrel in the early 1980s. This cushioned gov- First trading bank in the world.
ernment finances, and provided a reserve for darker days 4. The Charging Bull statue. Sculptor
ahead--oil prices shot up again in 1991. With oil heading Arturo Di Modica sues Wal-mart for selling
south, government should seize the opportunity to build
up a reserve fund –through a revived OPA.
replicas of the Charging Bull.
5. Marshall Plan (European Reconstruc
In these dire circumstances, the fall in global oil
prices is a boon. With global prices of petrol and diesel tion Plan).
falling below Indian controlled prices, the oil marketing 6. Paul Volcker and Alan Grenspan.
companies would have a small windfall gain instead of 7. Stephen Ross
huge losses. X = Arbitrage Pricing Theory
Y = Binomial Options Pricing Model
Way ahead
8. The Almighty Dollar.
Crude oil is one of the most necessary commodi- 9. Peter Lynch
ties worldwide. Even the slightest fluctuation in crude oil 10. Tulip Mania, First Speculative(credit)
prices can have both direct and indirect influence on the
economy of many countries. The volatility of crude oil
Bubble
prices has driven many companies away.
Crude oil prices act like any other product cost with
more variation taking place during shortage and excess
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© The Finance Club, Indian Institute of Management, Shillong
Investor’s picK

He has also been a member of various Committees
set up by the Government of India. He was appointed

Deepak Chairman of the high level expert committee, formed to
recommend measures for strengthening the Unit Scheme
– 1964. The Reserve Bank of India appointed him Chair-
man of the Advisory Group for Securities Market Regula-

Parekh tion, which was tasked to compare the level of adherence
to international standards in India with that in other
countries. He was also Chairman of the Expert Commit-
tee constituted by the Ministry of Power to look into the
eepak Parekh is the Chairman of HDFC, the
country’s leading housing finance company. reform efforts in the power sector.
A pioneer in mortgage finance, he has en- In recognition of his services to the nation, the Govt
abled scores of Indian middle class people owning their of India has conferred him with the prestigious Padma
houses or apartments through affordable loans. Parekh Bhushan. Mr.Parekh also has won several awards includ-
graduated from Mumbai’s Sydenham College in 1965. ing Businessman of the Year 1996 by Business India and
He qualified as a chartered accountant in England and the JRD Tata Corporate Leadership Award by All India
worked with Ernst & Young, Precision Fasteners, ANZ Management Association (AIMA). He was the first recipi-
Grindlays and Chase Manhattan in New York and Mum- ent of the Qimpro Platinum Award for Quality for his
bai. He joined HDFC in 1978. Though HDFC was founded contributions to the services sector and the youngest re-
in 1977 by his uncle H.T. Parekh, it was Deepak Parekh’s cipient of the prestigious Corporate Award for Life Time
vision and entrepreneurial acumen that enabled the com- Achievement by the Economic Times.
pany to create a niche in housing finance and emerge He is often dubbed as the unofficial crisis manager
as the market leader. He was promoted as its Managing for the government. . In 1999, the government bailed UTI
Director in 1985 and appointed its Chairman in 1993. From with a Rs 3,300-crore package when US-64, its flagship
a single-product company that focused on the Indian scheme, ran into trouble. Parekh chalked out this im-
middle class to develop the mortgage market, the HDFC portant rescue plan for the then Unit Trust of India. He
family today offers a buffet of every possible financial served as an invaluable problem-solver with creative and
product. credible inputs on the final decision on the Telecom Reg-
Parekh’s vision for HDFC is to make it the GE Capital ulatory Authority of India. To stabilize the fraud-devastat-
of India. His focus has always been to maintain a steady ed Satyam Computer, the government nominated Deepak
growth rate and not on market share. He still sees the Parekh to the Satyam’s new board. He has been awarded
opportunity in housing loans in India where it is just 3.9% the responsible task to appoint the Chairman and other
of GDP. In countries like Malaysia it is 31% and in US it is board members of Satyam and get Satyam back on track.
as high as 50% of GDP. He feels bankers should be pru- He feels the importance of corporate governance in in-
dent in credit assessments, in loan-to-value ratios, and in dustry and stresses on inculcating a process that facili-
installment-to-income ratios. tates board evaluation. To him a board evaluation is not
Mr Deepak Parekh currently serves as the Chair- a one-size-fits-all proposition, but needs to be customized
man (since 1993) and Chief Executive Officer of Housing and tuned into the culture of the organization. He says
Development Finance Corporation Limited (‘HDFC’). Mr. that the key objective of a board evaluation is to check if
Parekh is also a director on the board of several Indian the board is on track and seek opportunities for change,
public companies such as Siemens Ltd., HDFC Chubb Gen- which would enable the board to be more productive.
eral Insurance Co. Ltd., HDFC Standard Life Insurance Co. His genius will now face an acid test when he sits
Ltd. , HDFC Asset Management Co. Ltd, WNS Holdings down to assemble the disgraced IT firm Satyam from the
India Ltd, Housing Development Finance Corporation Ltd, ruins. Can he put Satyam, the not so long ago blue eyed
Castrol India Ltd., GlaxoSmithKline Pharmaceuticals Ltd., Indian IT giant that is plunging deeper into darkness with
Infrastructure Development Finance Co. Ltd, Hindustan every passing day, back on the Investors’ top pick list?
Lever Ltd., Hindustan Oil Exploration Corporation Ltd., Can he pull another miracle? The whole world is closely
Mahindra & Mahinda Ltd., The Indian Hotels Co. Ltd. and watching your steps Mr. Parekh.
Burroughs Wellcome (India) Ltd .He is also a non-execu-
tive, independent Director of SingTel.

By Amit Chow dhary
Banking is in Parekh’s genes. His grandfather was
the first employee of Central Bank Of India. His father
spent 40 years in the same bank and retired as deputy IIM Shillong
managing director. Deepak Parekh is also the Non-Exec-
utive Chairman of Infrastructure Development Finance
Company Ltd (IDFC), a Government of India enterprise
for infrastructure projects in 1997.
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Differential Voting Rights • The company should have been profitable for
he corporate India is finally waking up to
the opportunity presented to it nearly eight three years and should have had a no default record in
years ago by the Companies Act. As a result filing annual accounts and returns
of the inclusion of The Companies (Issue of Share Capi- • The company should have not defaulted in meet-
tal with Differential Voting Rights) Rules, 2001, it became ing investors’ grievances
possible for Indian companies to issue shares with differ- • the shares with differential voting rights shall
ential voting rights. Though such shares are a common not exceed 25% of the total share capital issued
feature in many of the international markets, it is only
this revision, which makes it possible for Indian compa- Benefits of issuing a DVR
nies to issue DVRs. Tata Motors became the first major A DVR has certain advantages, both to the company
company to issue a share with Differential Voting Rights and the investors. The company on its part is able to
(DVR) with its offering open on September 29, 2008. ensure minimum dilution of voting stake for the owners
of the company when issuing a DVR instead of a normal
What is a DVR Share? share. This is pretty helpful for a company which needs to
A differential voting right share exercises either more raise further capital to pursue its expansion plans, while
or less voting power than a normal share. Two types of resisting any hostile takeovers. For example, the promot-
Differential Voting Right (DVR) shares can be issued: ers of Gujarat NRE Coke are looking at a rights issue with
• Those that carry more voting power than an or- DVR to ward off any takeover threat from companies
dinary share: In this the person having the share will be seeking to secure coking coal assets. The management
exercising more voting power than an ordinary share. For of the company has that the high demand for coke has
example, in case of a DVR in which one share carries a resulted in companies looking for takeover candidates in
voting right of equal to 3, a shareholder with 100 shares the sector. The company expects DVRs to be a long term
will be entitled to 300 votes. shield against a possible takeover bid. The DVR will in-
• Those that carry less power than an ordinary crease the promoters voting rights in the company to 51
share: In this the person having the share will be exercis- per cent, though their actual equity will remain at 41 per
ing less voting power than an ordinary share. For exam- cent.
ple, in case of a DVR in which one share carries a voting In terms of small investors concerned primarily
right of equal to 1/4th, a shareholder with 100 shares will with their return on shares, DVRs offer a higher return in
be entitled to 25 votes. terms of higher dividend than the normal shares. Most of
In the presence of DVRs, in order to make a distinc- the small investors as it is, are least bothered about their
tion, a company generally classifies either the DVRs or the voting rights.
ordinary shares as Class A shares and the other as Class Why was there no such provision earlier?
B shares. Invariably, the class of shares with lower voting A popular theory put in this regard is that only after
rights are compensated by offering of a higher dividend the liberalisation, advent of foreign investors and dyna-
than the shares with higher voting rights. mism displayed in the shareholding pattern, has there
Companies Act been felt a need to bring in the DVRs. The government
As per the Companies Act, any company can issue a was always wary of hostile takeovers. It used its influ-
DVR provided: ence in company boardrooms – through institutions like
LIC, IDBI, ICICI and other government backed funding- to
always vote with the promoters and block any attempts
of a hostile takeover. The government did this to protect
their loans and investments in the company. Result was
the helplessness of ordinary shareholders in decided the
fate of their investments and killing of any share activ-
ism. But as the FIIs begin to own more and more shares,
their voting rights can command considerable power and
hence, the need for DVRs.
The companies will also now look to start issuing
DVRs for firstly, the emergence of shareholders’ activism
and secondly, for the now very real threats of hostile
takeovers.
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Tata Motors and DVR issue stake, if meant to garner greater control over a company,
The management of Tata Motors already hold a mi- could create an acquisition premium for higher voting
nority stake in the company. The company is looking at rights shares. In most other cases, the evident inability
significant capital expenditure as a result of its acquisi- of non-strategic/non-institutional investors to exercise
tion of Jaguar and Land Rover. These two factors may influence on company managements will render these
combine to make it an ideal takeover target, The DVRs rights near worthless
are probably being issued to prevent that possibility. And the negatives...
Other companies looking at a DVR issue Issues with the guidelines: The laws stipulate that
Apart from Gujarat NRE Coke, cited earlier, the oth- only the companies who have made profits in the three
er company looking at issuing DVR is Pantaloon Retail. It preceding financial years will be allowed to issue shares
has already approved a proposal to give shareholders one with differential voting rights. Companies defaulting on
bonus share for every ten held. The bonus share will be a either interest or redemption debenture are also barred
DVR. The new shares will get 5 percent more dividend and from issuance of such shares. This precludes many finan-
would be entitled to one vote for every 10 held. Some of cially weak companies and new ventures looking for ex-
the international companies to have dabbled with DVRs pansion and most vulnerable to a hostile takeover, un-
include Berkshire Hathaway, Google and News Corp. able to issue DVRs.
There is also an absurd clause which enables only
Pricing of DVRs
those companies which a=have not defaulted in meet-
At present, only one set of guidelines are provided
ing investors’ grievances to issue DVRs. Practically, it is
for the issue of shares, be it ordinary or differential. So
almost impossible for any company to remain totally
any company issuing a DVR has two alternatives at its
complain free from petty grievances of the investor like
disposal:
non receipt of dividends or improper transfer of share
• Seek clarification from SEBI before issuance of certificates.
such shares and waste precious time in the process
Issues with the concept: There are various purpos-
• Issue shares according to the current guidelines es which are achieved by linking of economic interests to
and leave tackle any issues as they come up voting power. Firstly, it acts as an incentive for sharehold-
Hence, the situation presents a case for issuance of ers to properly exercise their voting rights. This enables
clarifications on SEBI’s part. shareholder activism and acts as a check on the manag-
Sonal Sachdev, in his article “Price of a vote”, an ers of a company. Secondly, the right of economic owners
interesting formula to price a vote has been illustrated. to choose their own directors provides a basis by which
Price of a vote = the probability of influencing a decision the legitimacy of managerial authority is established.
multiplied by the value this can create minus the sta- The small investors have not been particularly
tus quo value. In other words, it is the additional value enthusiastic of the shares with lower voting rights of-
that can be created through the exercise of influence in fered to them, compensating in form of higher dividends.
a company’s decision-making process multiplied by the It is speculated that perhaps the investors do not want
probability of being able to influence a decision. Thumb to miss out on their voting rights just because of a few
rule seems to be- a premium of 5-10% for a voting right. percentage points of dividends thrown at them. They are
also mindful of the large capital gains to be had for shares
with higher voting rights in case of takeover battles.

By Karan Parmanandka & Rajat Brar
XLRI Jamshedpur

But there are caveats to applying this benchmark.
A prospective acquisition target could well see its shares
with full voting rights trade at a premium to those with
lesser voting rights. A compulsory open offer for a 20%
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v

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SOVEREIGN WEALTH FUNDS
Are we heading towards communism?
overeign Wealth Funds are state owned in- reserve currencies such as the dollar, euro and yen. Such
vestment funds derived from a country’s investment management entities may be set up as official
foreign exchange reserves, which are set investment companies, state pension funds, or sovereign
aside for investment purposes that will benefit the coun- oil funds, among others.
try’s economy and citizens. The funding for a Sovereign
Wealth Fund (SWF) comes from from central bank re- Major SWFs
serves that accumulate as a result of budget and trade The amount of money in these SWF is substantial.
surpluses, and even from revenue generated from the ex- Estimates suggest there are about 25 to 30 active SWFs
ports of natural resources. with assets under management in the range of $3.5 tril-
The traditional investment vehicles for sovereign lion. Sovereign wealth funds pumped in huge investments
wealth in the form of foreign currency reserves have in several Wall Street financial firms including Citigroup,
been the debt instruments such as government bonds Morgan Stanley, UBS and Merrill Lynch etc when these
from the industrialized nations. The low returns on these firms needed a cash infusion due to losses resulting from
investments have prompted nations with excess foreign the subprime mortgage crisis. Chinese SWF, CIC infused
reserves to invest in equities to achieve a higher return. USD 5 bn into Morgan Stanley in exchange for securities
Some countries have created SWF to diversify their rev- that would be convertible to 9.9% of its shares in 2010.
enue streams. For example, United Arab Emirates (UAE) Although they shot into stardom by investing in liquidity
relies on its oil exports for its wealth; therefore, it devotes starved wall-street giants, SWFs are not something new.
a portion of its reserves in an SWF that invests in other Kuwait created the Kuwait Investment Authority (KIA)
types of assets that can act as a shield against oil-related in 1953. The UAE, Oman, Singapore and Brunei also cre-
risk. Some other SWFs are simply state savings which are ated investment agencies to recycle their reserves hold-
invested by various entities for the purposes of invest- ings in the 1970s and 1980s. Norway and Malaysia did
ment return, and which may not have significant role in so in the 1990s. Russia followed suit more recently by
fiscal management. creating a Stabilisation Fund in 2003, as did some other
The accumulated funds may have their origin in, or countries like Chile and Veneuzuela. Oil-producing coun-
may represent foreign currency deposits, gold, SDRs and tries (OPEC and Russia) have constituted over half of SWF
IMF reserve positions held by central banks and mon- funds (that is, commodity-based funds) in terms of as-
etary authorities, along with other national assets such sets under management as well as numbers. The UAE’s
as pension investments, oil funds, or other industrial and Abu Dhabi Investment Authority Fund (ADIA), which was
financial holdings. These are assets of the sovereign na- established in 1976, is the world’s largest SWF currently,
tions which are typically held in domestic and different with $625 billion under management.
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Among the better known non-commodity-based Is Communism knocking at
SWFs in Asia are Singapore’s Government Investment
Corporation (GIC) and Temasek Holdings. In fact, Singa-
the door ?
pore is the only country which has two separate agencies The Sub Prime crisis has brought the world to its
among the top ten SWFs. Since some of the sources of knees. Blue chip companies have felt the pinch of liquid-
funding for the agencies also include pension contribu- ity crunch in their balance sheets, even in working capital
tions from Singapore residents, these entities are really accounts. This has forced them to move out with their
a combination of SWFs and Sovereign Provident Funds hats in hands for money. Guess who has got the money.
(SPFs). The China Investment Corporation (CIC) which is While corporate houses approach Banks for money, the
said to be motivated by Singapore’s GIC in both concept most formidable names of high street finance were plead-
and design, began operations in 2007. The Chinese gov- ing before Sovereign Wealth funds to help them fight
ernment transferred $200 billion of its $1,300 billion of its bankruptcy. Thus, SWFs pick up huge stakes in western
reserves to the agency to kick-start operations, making it banking legends Citigroup, Merrill Lynch, Morgan Stanley,
the world’s fifth largest SWF. CIC’s first major investment UBS, Barclays etc.
was a $3 billion investment in the US-based private equity Since then sovereign funds have poured over $60
group, the Blackstone Group. billion into US and European banks, and no doubt there
The largest SWFs with assets over $100 billion are will be more. They have also bought substantial stakes in
designated the Super Seven funds: Abu Dhabi Investment private equity companies such as Carlyle and Blackstone.
Authority (ADIA); The Government Pension Fund of Nor- Sovereign wealth funds have purchased an estimated $85
way; Government of Singapore Investment Corporation billion of US equities since the beginning of 2007, as well
($330 billion); Kuwait Investment Authority; China Invest- as taking big stakes in both the London Stock Exchange
ment Corporation; Singapore’s Temasek Holdings; and and Sweden’s OMX exchange.
the Stabilization fund of Russian Federation. But then this was not enough. The world plunged
deeper into darkness. The catastrophe of wall-street ham-
How big is the money they hold? mered valuations across the world into unimaginable
Sovereign wealth funds, currently holding $ 3-3.5 lows. This is the time when Asset managers (Institutional
trn, have bigger assets than hedge funds and private eq- Investors, Hedge Funds, Pension Funds, Mutual Funds,
uity companies combined, but are still small compared Insurance companies etc) would have loved to stroll
with the estimated $75 trillion assets held by institutional through the ruins picking up many gems at throwaway
investors, that is, pension funds, mutual funds and insur- prices. But they could not. Liquidity had vanished from
ance companies. the markets. Ultimately corporate houses and Financial
Institutions pleaded for Bailout packages before their re-
The size of U.S. GDP is $12 trillion, the total val-
spective governments(United States & Governments of
ue of traded securities (debt and equity) denominated
Euro-zone). They did respond after several high voltage
in U.S. dollars is estimated to be more than $50 trillion,
debates and votings in their assemblies & congress. The
and the global value of traded securities is about $165
extent & nature of these bailouts have been extensively
trillion(before sub-prime). In that context, $3 trillion is
covered in our earlier issues. US Dept. of Treasury rolled
significant but not huge. But when we compare it to the
out billions of dollars of lifelines to corporate but not
size of some emerging markets, this seems a huge sum.
without picking up stakes in those companies. AIG, to
The total value of traded securities in Africa, the Middle
mention, had to deliver 79% of its stake to US Govt for
East, and emerging Europe combined is about $4 trillion;
an $ 85 bn rescue. This would mean that the managers
this is also roughly the size
of the once world’s largest insurer AIG would need the
of these markets in all of
approval of US government bureaucrats before any deci-
Latin America. And total
sion. Similarly, Bank of America, Bear Stearns, JP Morgan
assets under management
Chase, General Motors, Ford, Chrysler have received huge
by private hedge funds—a
bailouts.
broad category of private
investment funds that The total size of assets under management for SWFs
seek high returns and, is expected to touch $ 10 tn by 2010 & $ 15 tn by 2015. With
as a consequence, often such high amount of cash they can have seats on the
take on considerable boards of some of the world’s most admired companies
risks—are estimated and influence their decisions. Imagine hard-nosed bureau-
to be around $2 tril- crats & filthy politicians representing Governments of In-
lion. So, perhaps dia/China/Middle eastern oil economies on the boards of
not surprisingly, a General Motors, Wal-Mart, Coca-Cola, GE or Exxon Mobil.
debate about the Does this give you goosebumps?
potential risks and hedge funds, is now developing.
opportunities of
sovereign wealth funds,
Major Concerns surrounding SWFs
similar to the ongoing debate about Growth of Sovereign Wealth Funds is catching the
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Niveshak Volume 2 Issue 1 January 2009
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attention of every developed capitalist country. There are course, there are always some national security limita-
various reasons responsible for it. Some are worried that tions on what foreigners can own. In the past, sovereign
as this asset pool continues to expand in size and im- wealth funds were mainly ‘passive’ investors, quietly
portance, so does its potential impact on various asset buying shares in big corporations and property without
markets. One of the major worries of some countries is getting involved in management. However, as sovereign
that foreign investment by SWFs raises national security wealth funds are investing more, there are fears among
concerns because the purpose of the investment might western leaders that they will become more active, de-
be to secure control of strategically-important industries manding seats on boards of directors.
for political rather than financial gain. These concerns Certain strategic assets are guarded by local gov-
have led the EU to reconsider whether to allow its mem- ernments and politicians. Can one expect them simply
bers to use “golden shares” to block certain foreign ac- to stand by passively while another government tries to
quisitions. In the U.S., these concerns are addressed by acquire these assets? Even when private companies have
the Exon-Florio Amendment to the Omnibus Trade and done so, they have had to jump over several hurdles. Oth-
Competitiveness Act of 1988. ers have had to simply live with situations where their
The failure of Wall Street Investment banks and contracts were not upheld: Hugo Chavez’s abrupt cancel-
many highly leveraged Hedge Funds have taught us the lation of Exxon Mobil’s contracts is a case in point. Many
hard way that in today’s fast-paced financial markets, the politicians in the U.S. were up in arms when Dubai Ports
impact of a particular pool of money on financial stabil- World, a Dubai-owned company tried to buy an Ameri-
ity depends not only on assets under management but can port-operating company which operated 6 major US
also on the potential leverage used in investment strate- ports. The target, they claimed, was a strategic asset and
gies. Many hedge funds and private equity funds are re- should not be controlled by a foreign country. Imagine
ported to use leverage ratios of 10:1 or much higher. That the furor if the target were a company such as Exxon
means they borrow 10 times or more their own capital Mobil or Chevron when today wars (Iraq war) are being
for particular transactions. Hedge funds almost certainly said to be fought for oil.
improve the allocation of capital around the world, but
recent developments indicate that they also pose a dan- SWFs are here to stay
ger to the global financial system. The consensus so far SWFs are based on current account surpluses and
is that while hedge funds deserve considerably greater will become less important only if the countries with
scrutiny, there are advantages for the allocation of global huge surpluses pass through a stage of prolonged cur-
capital flows if this sector continues to have a relatively rent account deficits. Major countries have committed
light direct regulatory burden. to reducing their current account imbalances, and this
Their inadequate transparency is a concern for in- would limit the growth of sovereign funds. But the world
vestors and regulators. For example, size and source of economy evolves continuously in ways that make it hard
funds, investment goals, internal checks and balances, to be sure current account imbalances will shrink. For
disclosure of relationships and holdings in private equity example, global growth may accelerate or decelerate, and
funds. They are not bound by any agency like the Central this is likely to affect commodity prices. If commodity
Bank or the Securities Market regulatory body to make prices remain high, commodity exporters will have large
any mandatory disclosures or follow certain best prac- surpluses for the foreseeable future. Similarly, If com-
tices in their strategies and investments. modity prices fall, the surpluses of Asian countries that
It’s thought that SWFs have traditionally pursued export manufactures may increase.
buy-and-hold strategies, with no short positions and per- There’s no apparent reason to see the continued
haps no borrowing or direct lending of any kind. They existence of these funds as destabilizing or worrying. In
probably have long horizons and like other long-term in- fact, the IMF has strongly encouraged exporters of non-
vestors, have an appetite for bottom fishing. This likely renewable resources to build up exactly such funds in
exerts a stabilizing influence on the world’s financial sys- preparation for turbulent times. On September 2-3, 2008,
tem. But there is also anecdotal evidence that some sov- at a summit in Chile, the International Working Group of
ereign funds have placed investments with other lever- Sovereign Wealth Funds, consisting of the world’s main
aged funds. At least one central bank is reported to have SWFs, agreed to a voluntary code of conduct first drafted
had investments with Long-Term Capital Management by IMF. They are also considering a standing committee
when that ill fated hedge fund went bankrupt in 1998. to represent them in international policy debates. The
Another central bank has invested recently with a ma- 24 principles in the draft will be made public after being
jor private equity fund. The Norwegian sovereign wealth presented to the IMF governing council on October 11,
fund reports that it has shifted somewhat from bonds to 2008.
equities. They have started placing their bets on riskier To put it in black & white, sovereign wealth funds
assets but before that they should have realized that this are big time state-owned players of the 21st century.
is people’s money. Hedge funds, I-Banks & General Partners(the other name
The real danger is that sovereign wealth funds may for Private Equity Funds), while becoming more promi-
encourage capital account protectionism through which nent in this century, are in some sense a carryovers from
countries pick and choose who can invest in what. Of the end of the 19th century, when large pools of private
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© The Finance Club, Indian Institute of Management, Shillong
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capital moved around the world with unregulated ease One of the most famed rules, the Greenspan-Guidot-
and contributed to a long global boom and rapid increase ti rule suggests that the reserves should be enough to
in industrial productivity around the world. What hap- cover the short-term debt, that is, the average reserves
pens when the 21st-century state meets the 19th-century holdings during a year should be roughly equal to short-
private sector? What happens when huge western corpo- term debt payable. Currently, India’s Forex reserves are
rate are brought to their knees be the Sub-Prime demon nearly 6-7 times of its short term debt payable. Another
and they reach SWF, hat-in-hand? How much money can quick back of the envelope calculation suggests that aver-
they roll out in the name of bailouts to save corporate age reserves to GDP ratio is 30% in India as compared to
once they took pride of? How long can governments keep 10% on average in advanced countries. Any measurement
the huge funds of SWFs at bay in the name of protect- would clearly indicate that we are holding too much
ing strategic sectors from foreign hands? The outcome cash and losing opportunity cost. By means of any of the
remains to be seen. above benchmarks, India should ideally possess not more
than USD 80 bn.
Should India start its SWF? So why should we not move away from the regime
As India’s forex reserves swell to record levels mak- of negative rates of return on our hard earned forex by
ing India the fifth largest holder of reserves in the world, creating and efficiently managing a SWF. The balance of
so do their costs. India’s reserves have been propelled into available foreign reserves holdings ought to be gainfully
the $ 260-300 billion range as of end October 2007, form- deployed in foreign assets which maximize returns. Some
ing nearly 30% of our GDP. The surge in reserves causes a argue that the problem in India is the sustainability of
mismatch between the opportunity costs of holding the reserves given they are driven by capital account sur-
reserves with macro-economic adjustment costs incurred pluses rather than the current account. Thus there may
when they fall short. be a need to maintain reserves in relatively more liquid
A major share of our reserves is invested in US Fed and lower-yielding assets. There are more prickly issues
securities. The interest rates in both US and the euro zone surrounding the creation and operation of SWFs in In-
have yielded negative real rates of return of between 2% dia, including the degree of independence of the agency
and 3% in the last 5 years. At this nega- and its investment managers from the RBI and fi-
tive real yield on investments in US nance ministry (that is, governance), organizational
government securities, India’s loss on structure, investment objectives and policies (like,
its foreign reserves holdings lies be- commercial versus strategic; diversified portfolio or
tween $6 billion and $9 billion per an- concentrated bets), and the degree of transparency
num at current reserves level. This is in the agency’s holdings and
the high cost paid by the country for policies. Some Economists say
maintaining excessive liquidity, besides that such a proposal is at best
the opportunity costs foregone by not risky and, at worst, misguided.
investing in longer maturing, higher There are lots of reasons and
yielding bonds and equities. views against India creating
This savings glut of oil and an SWF, but none of them sat-
emerging economies has been largely isfying enough.
channeled to the US, cheaply financ- These issues are admittedly much harder to
ing its large current account imbalance. The US current resolve in a democratic and open society like India, but
account deficit is estimated to absorb about 75% of the that is no reason to shy away from debating the issue
global external surpluses. Increasing liquidity of the oil seriously. India should at least actively participate in the
and newly industrialized economies are being funneled ongoing, though nascent international dialogue of estab-
into financial instruments issued by advanced countries lishing a code of behavioral guidelines for the creation,
yielding negative real rates of return. It may be time for management and operation of SWFs under the leadership
India to reconsider its exchange management practices of the International Monetary Fund. Moreover it would
and increase its risk-taking appetite. be foolish to constrain the foreign capital held domesti-
cally from exploring higher returns in high yielding equi-
Why & How much of liquidity(Forex) do we need ? ties, corporate bonds and commodities markets abroad
when we permit foreign capital, which earns high re-
There are several globally accepted norms & cal-
turns in the domestic equity and commodity markets.
culations estimate the optimal level of foreign reserves
After all we deserve much higher rates of return on our
holdings providing adequate liquidity for current account
Foreign Exchange Reserves. But before jumping into the
transactions such as imports and debt servicing. One
fray, we should make sure that the fund in managed by
such rule predicts that reserves should be enough to cov-
highly qualified professionals and is separated from poli-
er three months of imports. The current level of foreign
ticians & bureaucrats

By Bisw adeep Parida
reserves holdings in India covers 12-15 months of imports,
making current foreign reserves holdings overvalued by
four-five times.
IIM Shillong
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Niveshak Volume 2 Issue 1 January 2009
Article of the montH

CREDIT DEFAULT
Credit Default Swaps: The concept of the exercise of this option. The model assumes that
a company has a certain amount of zero-coupon debt
credit default swap (CDS) is a credit deriva-
that will become due at a future time T. The company
tive contract between two counterparties,
defaults if the value of its assets is less than the promised
structured such that the buyer has to make
debt repayment at time T. The equity of the company is a
periodic payments to the seller and in return obtains the
European call option on the assets of the company with
right to a payoff if there is a default or credit event with
maturity T and a strike price equal to the face value of
respect to a reference entity. The market size for Credit
the debt. The model can be used to estimate either the
Default Swaps began to grow rapidly from 2003 and by
risk-neutral probability that the company will default or
late 2007 it was approximately ten times as large as it had
the credit spread on the debt.
been four years earlier.
The mathematical implementation of the Merton
However the rapid growth of the CDS market has
model involves determining a firm’s asset value and asset
not been without its critics. Several analysts have pointed
volatility using the easily observable equity value and the
out that the CDS market lacks regulation and the deals
debt profile of the firm. Detailed mathematical descrip-
are far from transparent and often fuel speculation. There
tion of the model can be found in Merton (1974) and Hull,
have even been claims that the CDS markets exacerbated
Nelken & White (2004).
the 2008 global financial crisis by hastening the fall of
companies such as Lehman Brothers and AIG. Reduced Form Approach to CDS Pricing
CDS Pricing: Approaches and Models These models exogenously postulate the dynamics
of default probabilities and use market data to obtain
Given the huge market for CDS, it is but natural that
the parameters needed to value credit-sensitive claims
substantial amount of research has been conducted on
(Ericsson, Jacobs and Oviedo (2004)). While these models
their pricing.
have been shown to be versatile in practical applications,
The price, or spread, of a CDS is the annual amount they don’t touch upon the theoretical determinants of
that the buyer of the protection must pay the protection the prices of defaultable securities. Another approach
seller over the length of the contract. within the reduced form approach focuses on estimating
There exist two fundamental approaches to CDS the default probabilities and the loss given default using
pricing: statistical functions and pricing the CDS based on the
(a) Structural Approach results.
(b) Reduced Form Approach Thus it is seen that while the Structural models are
Structural Approach to CDS Pricing theoretically sound, they are difficult to implement while
the Reduced form models, though easy to implement
The structural approach links the prices of credit lack theoretical rigor. Therefore as a combination of the
risky instruments directly to the economic determinants Structural and Reduced Form Approach, some researchers
of financial distress and loss given default. These models actually use the structural approach to identify the theo-
imply that the main determinants of the likelihood and retical determinants of corporate bond credit spreads.
severity of default are financial leverage, volatility and These variables are then used as explanatory variables in
the risk free term structure. Popular implementation of regressions for changes in corporate credit spreads, rath-
the Structural models today include Moody’s KMV model. er than inputs to a particular structural model. Impor-
However it is often difficult to implement such models as tant work in this area was carried out by Collin-Dufresne,
it is difficult to get reliable estimates of the asset volatil- Goldstein, and Martin (2001), Campbell and Taksler (2003)
ity and risk free term structures. Most of the structural and Cremers, Driessen, Maenhout, and Weinbaum (2004).
models in place today are derived from the work done by Ericsson, Jacobs and Oviedo (2004) suggested an exten-
Black & Scholes (1973) and Merton (1974). sion of these approaches in which they regressed the
Credit Spread with the firm’s leverage, volatility and the
The Merton Model risk free interest rate. This model is implemented in this
The Merton model works on the principle that a paper and results on companies both in the developed
firm’s equity can be viewed as a call option on the firm’s and the developing world are described.
assets. Thus the probability of a firm defaulting on its
obligations can be found by determining the probability
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Article of the montH

Implementation Approach Volatility of the firm, Debt Structure of the firm, Risk free
The main considerations while choosing the various interest rate in the country of operation.
parameters for implementation are described below: (b) EJO Model: Equity Price, Book Value of Debt
(a) Comparing performance of Structural and Re- and Market Value of Equity, Risk free interest rate in the
duced Form Models: In order to evaluate the performance country of operation.
of both the approaches, one structural model (Merton All data required was sourced from Bloomberg. To
Model) and one reduced form model (EJO Model) was obtain a good balance between capturing recent events
implemented. and preventing disruption due to spurious information,
(b) Covering companies across different sectors: a 60 day period for volatility was used. Since the Merton
The companies on which the models were tested were model requires the firm’s debt to be modeled as a zero
chosen from a wide range of sectors so that any sectoral coupon bond, weighted average of the debt and its ma-
biases would not affect the evaluation of the performance turity was used to do so. The risk free interest rate was
of the models. then taken to be the rate for government bills with ma-
turity closest to the maturity of the zero coupon bond.
(c) Covering companies from different countries:
Microsoft Excel was used for implementing the model.
In order to test the performance of the models for firms
from both the developing and developed worlds, firms CDS spreads for a 5 year CDS on each firm were also
from US, UK and India were chosen. This would ensure obtained from Bloomberg. The mean value of the CDS
relevant conclusions regarding the applicability of the was assumed to be the average of the bid and ask for the
models in emerging markets like India as well. purpose of comparison with the value predicted by the
two models.
(d) Covering companies with different leverage:
Since the ultimate aim of the pricing models is to pre- Findings
dict whether a company is likely to default on its obliga-
tions or not, companies with leverages varying from low The results for the six companies for both the Mer-
to high so as to test the performance of the models for ton as well as the EJO model are summarized in this sec-
companies having different balance sheet debt structures tion.
were chosen. Merton Model
(e) Period of testing: The performance of the mod- Overall the Merton model was found to work rea-
els was tested for the last two months of 2007. The most sonably well for companies with medium to high lever-
recent data points were deliberately not taken to test the age and the predicted values were found to follow the
models as given the current financial conditions, mea- trends depicted by the actual values. However the Mer-
suring the performance for current data would not have ton model was observed to consistently under predict
given an accurate picture of the utility of these models. the actual spread. This could be because of the very basic
Overall six companies were chosen for testing the nature of the model and the simplicity of the underlying
models and a summary of these companies is presented assumptions. The results obtained are consistent with
below: the past research which showed that structural models
under predict credit spreads and display low accuracy
Company Country Sector Debt Levels (Arora, Bohn, Zhu, 2005).
Reliance In- India Petrochemi- Moderate The results obtained by the Merton model for the
dia Limited cals four companies with moderate-high leverage are sum-
marized below. Sample outputs obtained can be seen in
the annexure.
State Bank India Banking Moderate -
of India High Company Extent of Underprediction
General Mo- USA Automobile Moderate RIL 19%
tors SBI 32%
Vodafone UK Telecom Low-Moder- Vodafone 71%
ate GM 14%
Glaxo UK Healthcare Very Low
Smithkline However the flaws of the Merton model are accen-
Johnson and USA Healthcare Very Low tuated when tested on companies with very low leverage
Johnson namely Johnson & Johnson and Glaxo Smithkline (GSK).
Because the Merton model essentially models the equity
Data Sources as a call option on the firm’s assets and given the fact
The data required for the implementation of the that if the debt of a firm is very low, the probability of
two models is listed below: exercising this option is very low, the Merton model gave
extremely low CDS spreads for such companies. Thus
(a) Merton’s Model: Equity Price of the firm, Equity
it was found that the Merton model is not suitable for
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Niveshak Volume 2 Issue 1 January 2009
Article of the montH

firms with very low leverage. suited for firms with low leverage as shown by its good
performance for GSK and MKS.
The Ericsson, Jacobs and Oviedo Model The credit spread was found to be positively cor-
The Reduced Form model – the Ericsson, Jacobs related with the equity volatility and firm leverage and
and Oviedo (EJO) model which regresses the CDS spreads negatively correlated with the interest rates. Thus the
against the firm leverage, equity volatility and the inter- effect of these market driven variables is economically
est rates was also used to estimate the CDS spreads. The important as well as intuitively plausible. These results
results obtained by the EJO model are summarized below are also consistent with previous research in these areas
(the +/- indicate the positive/negative correlation between (Ericsson, 2004).
the CDS spread and the explanatory variable): The results indicate that while the Merton model
is theoretically sound, due to the simplifying assump-
Company R2 Volatility Leverage Interest tions built into the model, its performance on real life
Rate companies and data is not satisfactory. Although it does
RIL 90.30% + + - give encouraging results for companies with medium-
SBI 70.97% + + - high leverage, overall it is found to under predict the
CDS spreads by a substantial amount. In contrast the EJO
GM 52.15% + + + model gives good results in estimating the CDS spread
Vodafone 76.38% + + - as described in the previous sub-section. This could be
GSK 79.40% + + - due to the fact that it uses market driven parameters to
estimate the CDS spread. The EJO model also performs
MKS 83.89% - + + relatively better than the Merton model for companies
with low leverage. Further for emerging economies with
As predicted by past research, the EJO model gave low market depth and inefficient price discoveries, the
superior performance when compared to the Merton EJO model may be better suited.
model with high R2’s for most companies. All the three
By Anshul G upta & Radhika AR
explanatory variables were found to be significant for all
companies. The EJO model was also found to be better
IIM Bangalore

FIN TOON

Page 11

© The Finance Club, Indian Institute of Management, Shillong
InstitutionS

THE W RLD Bank
Restructuring
n the last edition we talked about the need
$210 billion program of loans and credits to Africa. Some
for restructuring of International Monetary
question whether the World Bank should be lending to
Organization for its failure to play its role as
China at all.
a regulator and supervisor in the current financial crisis.
The world economy has changed dramatically since
One more International organization which has been crit-
September 2008. What began as a downturn in the US
icized for taking up the lead role in the current financial
housing sector is now a global crisis, spreading to both
crisis is World Bank.
rich and poor economies. Many believe that this may go
The financial crisis has not only crippled the finan-
down in history as the worst crisis since the Great De-
cial sector, but also seriously affected real economy with
pression of the 1930s. Developing countries—at first shel-
its spillovers. The international financial crisis has result-
tered from the worst elements of the turmoil—are now
ed from three failures:
much more vulnerable, with dwindling capital flows,
• Regulatory and supervisory failure in major de-
huge withdrawals of capital leading to losses in equity
veloped countries
markets, and skyrocketing interest rates.
• A failure in risk management in private financial
GDP growth in developing countries—only recently
institutions
expected to increase by 6.4 percent in 2009—is now likely
• A failure in market discipline mechanism to be only 4.5 percent, according to economists at the
The World Bank and IMF were created in 1944 to World Bank. And rich countries are now expected to con-
rebuild the world economy after World War II, concen- tract by 0.1 percent next year.
trating on efforts to reconstruct war-torn Europe and to As per World Bank Group President Robert B.
manage the old exchange rate system, where currency Zoellick “The global financial crisis, coming so soon after
values were tied to the price of gold. The IMF was in- the food and fuel crises, is likely to hurt the poor most in
tended to concentrate on core issues of monetary, fiscal developing countries” The World Bank Group’s response
and exchange rate policy, while the World Bank’s “core to this crisis includes increased lending for crisis-hit de-
mandate” was to reduce poverty and help countries build veloping countries—likely to nearly triple from US$13.5
a framework to guarantee growth and development. In billion last year to more than US$35 billion this year—
general, World Bank loans pay for development and social as well as accelerated grants and virtually interest-free
sector projects, although it also provided massive “adjust- long-term loans to the world’s 78 poorest countries, 39 of
ment loans” to richer countries at the peak of the crisis. which are in Africa.
The IMF provides broad balance of payments support to
Besides extending help to cash-strapped govern-
countries which meet tough economic conditions, and
ments, the Group is boosting support to the private sec-
members can use this money as they see fit. But their
tor through four initiatives by the International Finance
tasks have changed considerably since those early days,
Corporation (IFC), and providing much-needed liquidity
and each institution now lends tens of billions of dollars
in developing country banking markets through the Mul-
each year to member states.
tilateral Investment Guarantee Agency (MIGA).
The entire international economic architecture es-
So World Bank is promoting the social safety net
tablished after World War II - the World Bank, the In-
programs—particularly those that are well-designed—are
ternational Monetary Fund and now the World Trade
a smart investment both for today and the future. These
Organization - is buckling under the weight of globaliza-
programs are affordable; For example Mexico’s successful
tion, trade disputes and the ambitions of rising economic
Oportunidades and Brazil’s Bolsa Familia cost just about
powers in Asia and elsewhere. They have failed to play a
0.4 percent of GDP.
significant role in the current financial crisis.
The current financial turmoil has highlighted the
Like IMF some question the relevance of the World
need for a “new multilateralism” to replace outdated
Bank in the current context of the world economy. The
structures. The financial turmoil of this year is a “wake-
World Bank’s cumulative lending to China, for example,
up call,” for the multilateral institutions. The world need-
is $40 billion for 274 projects. But China is now an ex-
ed to look beyond resolving the current crisis to the un-
port superpower, sitting on reserves worth more than $1
derlying role of multilateral institutions.
trillion - so wealthy that it recently announced its own
Page 11

Niveshak Volume 2 Issue 1 January 2009
InstitutionS

We now need a new multilateral network for a brutally exposed in recent months. Opinion is now hard-
new global economy. There is also reform required in ening around the case for a new global architecture to
the International Monetary Fund and the World Trade enforce rules that ensure lessons are learnt and that the
Organization (WTO).The IMF’s early warning system for actions which have brought free markets to the brink of
the global economy should be strengthened, “focused on collapse are never repeated.
crisis prevention and not just crisis resolution.”. The eco- Resolution of financial crises requires a complex
nomic multilateralism must be redefined beyond a tradi- mix of macroeconomic and financial sector policies. One
tional focus on finance and trade. Today, energy, climate important element in the resolution of such crises is the
change, and stabilizing fragile and post-conflict states are restructuring and resolution of World Bank, with con-
economic issues. siderable experience gained in this area in the past de-
But a system that was designed 64 years ago has, cade. World Bank should capitalize on its complementar-
not surprisingly, has proved to be ill equipped to deal ity with private-sector banks and allow middle-income
with the fiendishly complex practices of 21st-century countries to graduate to private-sector lending. The Bank
banking that led to the current worldwide crisis. Neither now has to adapt to a world in which; private capital
the IMF, the World Bank nor any other institution has the flows to developing countries are at an all time high; the
power to police the global financial system in a way that private sector is the dominant engine of growth in devel-
might have prevented the excessive risk-taking which led oping countries; environmental issues were creating new
to the sub-prime mortgage crisis and, in turn, the credit demands; and; the Bank’s own resources were becoming
crunch. increasingly stretched as a consequence of cuts in its ad-
Hindering the World Bank in both its tasks is its ministrative budget. World Bank along with IMF and the
governance. The existing board structure of the World World Trade Organization now need to take the lead role
Bank is one which minimises risks to the institution, in helping the world economy tide over the current crisis
at the cost of its borrowers. A full-time resident board, and also prevent such systemic crisis in the future.
nominally representing all countries who are members Although the financial crisis highlights the system-
of the bank, oversees the application of detailed rules and ic failure of the institutions, using the current financial
procedures which constrain the staff and senior manage- crisis to revert to state-led, rather than market-led solu-
ment. tions to economic growth might not be the best way out:
The board also monitors a plethora of internal au- While intervention is going to be necessary and inevita-
diting and quality controls, the work of an independent ble, it may, as before, store up considerable problems for
evaluation group, and the work of the judicial style in- future growth and prosperity. World Bank should play its
spection panel. The result limits any risk-taking by the due role as the world’s largest multilateral development
bank. Or better said, distributes risks to those least able financial institute to help developing countries to fend
to bear them. off external impacts and maintain financial stability and
The costs of minimizing risks are borne mostly by economic growth.
borrowers (who face slower and more costly loans) and

By Manjunath M
by the world’s most at-risk and vulnerable populations
whose hopes of assistance in a crisis or conflict are post-
poned while the bank’s board ensures that rules and pro- IIM Shillong
cedures are followed.
The result is a bank which is too slow, too risk-
averse, and too unresponsive to its needy members to be
as effective as it can and should be.
To deliver public goods, the World Bank needs a
board which enunciates the collective purpose of mem-
bers. This means a board which engages and reflects po-
litical leadership at the highest level. The governments
sitting on the board need to make decisions which give
the institution political cover. Those governments them-
selves should sometimes collectively shoulder risks, per-
mitting the bank to act rapidly in uncharted terrain, and
to act with other international institutions without fear-
ing for damage to its own procedures and rules.
The failures of modern global capitalism have been
Page 11

© The Finance Club, Indian Institute of Management, Shillong
OpinioN

Lessons Learnt from
Bear STearns
The Great Bear Fall
The timeline below summarizes the failure
Exogenous Causes
• Bust of the US housing market bubble – This was
the immediate trigger. Plunging house prices caused val-
ues of CDOs to plummet.
• Lax government regulations on lending – Freddie
and Fannie mandated to issue loans to the subprime mar-
ket regardless of bad credit history, which were bundled
into mortgage-backed securities and sold worldwide.
Other banks followed suit.
• Low interest rates – Capital abundance in the
US due to international inflows, low interest rates and
demand for higher yields incentivized banks to pursue
predatory lending. When interest rates started rising, de-
faults began to occur.
• Crisis Of Confidence & The Pygmalion Effect – Ru-
he Bear Stearns Companies Inc was one of
mours that Bear Stearns is facing liquidity issues started
the largest global investment banks and se-
spreading quickly. Actions taken upon rumours actually
curities trading and brokerage firms, prior
caused the speculative events.
to its sale to JP Morgan in 2008.
• Put Option debate – Put options with very low
History
exercise prices of $5, $10 and $15, typically not traded,
Founded as an equity trading house in 1923, it sur- were opened for trading though Bear’s stock was trading
vived the Great Depression of 1929, growing from strength at $70 which may have helped funds in taking short posi-
to strength in terms of assets, profitability and reputation tions.
over the twentieth century.
• Pre-planned by hedge funds? – Financial firms
Business Areas such as Goldman Sachs reduced their exposure to Bear
Capital markets (equities, fixed income, investment Stearns by exiting CDS with Bear Stearns as the coun-
banking), wealth management and global clearing servic- terparty. The volume of novation contracts where hedge
es. In 2007, Bear was recognized as the “Most Admired” funds transferred their exposure to Bear Stearns to other
securities firm in Forbes’ “America’s most admired com- parties was 20 times the normal volume.
panies” survey.
Page 22

Niveshak Volume 2 Issue 1 January 2009
OpinioN

Endogenous Causes
• Managing Stakeholders and Rumour Control -
1) Long term policies :
During a crisis of confidence among the investors and
• Aggressive highly leveraged investment strategies creditors, there were very few assurances from its side,
- Followed by Bear Stearns who wanted to maximize re- possibly because of its arrogant nature and denial mode
turns. However the importance of prudence to manage in accepting the problem. Increasing rumours of liquidity
risk was forgotten. The firm, with leverage ratios as high crunch and no action from the firm caused even strong
as 35:1, faced huge investor redemption and liquidity is- stakeholders like Goldman Sachs to stop trading, thus
sues, when the CDO assets became worthless. putting the final nail into the coffin.
• Greed and Principal Agent Relationship – Perhaps • Managing Employee Confidence - Media reports
the biggest perpetrators of this crisis have been the man- suggested that part of the stock fall was related to heavy
agers, the agents of the firm, whose greed led them to selling by its own employees in March. Bear Stearns failed
acquire highly risky subprime assets with their commis- to sustain the employee confidence itself, let alone inves-
sions dependent on their profits. A decision to link execu- tors and other stakeholders.
tive pay to return on equity is one of the main reasons
• Loss of integrity, Hedge Fund Crisis, 2007 - Two
why managers increased leverage indefinitely, without
of Bear’s top employees had been charged with releasing
caring about the risks involved.
misleading information to investors in its hedge funds,
• Risk Management System – Bear Stearns was which failed in 2007 regarding the amount of returns.
among the most aggressive risk takers of the top invest- When Bear Stearns again faced such a situation in March
ment banks. The firm never took a formal approach to its 2008, investors were less willing to accept assurances of
risk oversight responsibilities until March 22, 2007 when stability, hence leading to the domino effect of redemp-
the board approved the charter for a finance and risk tion
committee.
• Non-diversified portfolio – Bear Stearns, being the Decision making analysis
highest underwriter of mortgage bonds, had 70 % of its
• Silence
investments in fixed income instruments, which were the
most hit during the subprime crisis. Interestingly, Bear “Not taking a decision is also a decision”
Stearns followed a policy of a single instrument non di- - Anonymous
versified fund which compounded this problem further Bear Stearns’ silence throughout the situation
and in fact led to collapse of two of its mortgage funds. was a major factor in its downfall. Bear Stearns suffered
losses quarter after quarter beginning with its first ever
quarterly loss in its 85 year history, incurred staff layoffs
2) Inherent Organization Culture :
and a CEO switch-off. This wave of bad news started fuel-
• Cowboy culture- A very interesting fact about ling and strengthening rumours that the company was
Bear Stearns is that it has been predominantly governed facing liquidity issues and stakeholders began question-
by men since 1923, and even in 2008, the board of directors ing the ability of the firm to do business. The CEO was
consisted of only men. The aggressive isolated nature of silent throughout this span as events were allowed to
Bear Stearns stood out amongst all the investment banks unfold. It was extremely late when Bear Stearns issued
leading to a macho risk taking incentivized culture. an official statement that “There is absolutely no truth
• Corporate Governance Culture - The standard to the rumours of liquidity problems that circulated in
governance practices recommend not more than 2 insid- the market”. In a business where reputation and assur-
ers in a 12 member board. In the case of Bear Stearns, the ances are essential, Bear had lost both. This loss could
number was 3.Thus accountability and sound decision- have been pre-empted by increasing transparency to the
making could have been severely compromised. More- stakeholders regarding the current position, detail out
over, the executive committee, which made strategy deci- the exact nature of the problems present and unfolding
sions, consisted only of insiders. Thus the insider problem future strategies and course of action being adopted by
in Bear Stearns was heavily pronounced, with lack of a the firm to increase profitability could have gone a long
regular outside opinion. way in reassuring investors.
• Late Equity Raise – Henry Kravis, from KKR was
3) Short term Debacles : interested in buying a 20% stake in Bear Stearns. It was
• Lack of leadership focus during crisis - The sailor a chance for Bear Stearns to raise more than $2 billion in
of the ship is the CEO, who in this case was James Cayne. capital and gain approval from all stakeholders by putting
A common problem associated with many CEOs is denial a reputed investor like Kravis on the board of directors.
and pseudo listening. In Cayne’s case however, the issue This could have helped dismiss rumours about the firm
was not of denial but of absenteeism. He was on a golf apart from strengthening the cash position. However the
vacation when the two hedge funds collapsed, and on a talks fell apart citing that the deal might upset Bear’s PE
bridge holiday, in mid March, when the sale to JPM took clientele. In the next few weeks Bear received an offer
place. from JC Flowers regarding the purchase of a 20% stake.
Page 22

© The Finance Club, Indian Institute of Management, Shillong
OpinioN

However the Bear executives felt in the meeting that
Flowers was just gauging their desperation and told him • Financial Ethics and Risk Management
that they were not interested. After quite some time, a
a) Accountability in a principal agent relationship - Gold-
deal with Citic worth $ 1 billion was announced. This did
man CEO and top executives will be given $1 annual bo-
not immediately lead to cash inflows but was contingent
nus in 2008. This is in line with creating a more owner-
on regulatory approval. Other fund raising mechanisms
ship driven environment, where bonuses are linked to
including mergers were tried but efforts were fruitless.
the trading practices followed.
• Carlyle Capital Corporation (CCC) Collapse – Bear
Stearns had advanced $1.6 billion to CCC. When CCC went
b) Stronger risk management systems - The failure showed
bust, Bear was forced to take mortgage backed securities
lack of clarity in the company in understanding the real
in lieu of some of its cash. This fuelled rumours that Bear
worth of the CDO assets. Even the standard pitfalls of risk
was running out of money and its own lenders began to
management systems like incorrect correlation between
call in their loans. None of these rumours was addressed
risks, failure to communicate risks, failure to track risks
by management. This decision of not declaring their ex-
and denying blatant risks have come out in the open dur-
posure to hedge funds resulted in Bear having to make
ing this crisis. Firms like Goldman have been following a
bigger and bigger margin payments on loans and trading
policy of regular risk review every half hour in order to
positions. Regular sources of funding became unviable
keep the risk management shored up.
forcing the firm to look out for other sources. Bear ulti-
mately had to fall back on the Fed.
• Executives sell stock in the middle of the crisis • Accountability of the firm in eyes of the external share-
- Bear Stearns executives including Cayne and Schwatrz holders
sold Bear stock worth more than $20 million in Decem- a)Regular communication with the investors and credi-
ber, although they remain big shareholders in the belea- tors - When speculations started milling around regard-
guered broker. This directly acted as a signal to the other ing Lehman, traders at the firm were issued with a list of
shareholders about the executives’ lack of confidence in “talking points” last week, advising them on the details
the ability of the firm to withstand the crisis. of the firm’s liquidity position to increase transparency
to the firm’s clients. If anyone really did pull their busi-
Alternative Strategies to a JP Morgan Takeover ness, senior executives would make it a high priority to
call the client and try and reassure him to get the busi-
• Emergency Rights Issue and raise new funds –
ness back. Lehman had learnt from the communication
Would have had to do so at a heavy discount because
failures of Bear Stearns.
of increased perceived risk. Existing shareholders maybe
b) Role of CEO and top leadership -An absentee leader and
averse to putting good money after “bad”.
the lack of pro-active decisions at various points between
• Finding Long term funding or a white knight –
June 2007 and March 2008, ultimately killed Bear Stearns.
Belief that Bear had huge exposures to troubled hedge
An immediate effect could be seen in the form of active
funds was a deterrent for rivals to pick up a stake or for
CEO communication in the media about the liquidity po-
institutions to lend money.
sition of firms, a movement out of the denial mode and
• Continued support from the Fed – This would have an acceptance about the impending recession.
given Bear time to restructure itself and shrink its bal-
ance sheet to manageable levels.
• Break-up of the bank – This was not a viable option

By Ravi Subramani an & Rohan Chaudhury
because Bear was not diversified. The bulk of its business
was from Fixed Income and mortgages which Wall Street
was unwilling to touch. Neither its investment banking IIM Ahmedabad
business nor its equity underwriting business was big
enough to be sold separately.

Lessons

The subprime crisis continues and analysts fear that
the worst might not be yet over. Learnings from this cri-
sis range from regulatory provisions to strategic planning.
We have summarized the key learning from the point of
view of a firm as Corporate Social Responsibility.
Rather than going with a narrow view of CSR, we define
it as building a healthy relationship, one of trust, between
company and other stakeholders. This includes the fol-
lowing dimensions.
Page 22

Niveshak Volume 2 Issue 1 January 2009
RevieW

Life Settlement Bonds
ife settlement fund benefits the policyholders, who are typically asset rich but cash poor. By selling off
their policies, these insured can now have the opportunity to release capital for a stated need, an option
not available to them before Life Settlements. The creation of a secondary market for policies also means
that policyholders may now obtain higher values for their life policies, instead of merely surrendering their policies
for much lower surrender cash values.

Life Settlement transaction always begins with policyholders who do not need their policies anymore. They
would call their agent/adviser to arrange for policy surrender or sale to a third party. The problem occurs when it
start with the agent/adviser proactively encouraging their clients to surrender or sell their policies. In its early years,
the industry witnessed this problem known as Stranger Originated Life Insurance (STOLI), which has hurt to the in-
dustry in some ways.

STOLI is the initiation of a life insurance policy for the
benefit of a person who, at the time of the creation of the policy,
has no insurable interest in the in- sured. Investors, working
through life insurance agents, induce seniors to provide their
names for a fraudulent purchase of a life insurance policy. The
seniors immediately agree to cede control over the policy
to the investors. Seniors engaging in a STOLI scheme typically
receive some financial inducement at the beginning of the
transaction. Financial inducements may also be paid as some
portion of the proceeds, when the pol- icy is sold. The indispen-
sible element in STOLI is a contract be- tween the senior and the
investor where the senior gives up to the investor full or par-
tial control of the policy at the time of policy issue. Investors
profit by collecting the death benefit after the senior dies or by
selling the policy to unwary investors in the Life Settlement
Market.

To put a control over these practices, there was an establishment of life insurance settlement association (LISA)
in USA. It comprises of over 170 member companies in North America, Europe and Australia and Its diversity provides
a broad and authoritative voice. LISA is a valuable source of information for the consumer, member companies, policy
makers and all interested parties and is regarded as the most comprehensive source in the life settlement industry.

Life Settlements Funds are being seen as a “safe harbour” by prudent and savvy investors. The Life Settlements
Wholesale Fund, in particular, is highly regulated and well structured to ensure continuous growth in value to unit
holders on a continuous basis regardless of the volatility of financial markets. Life Settlements funds are non-corre-
lated to shares, property, cash or fixed assets. As such, fund performance is not affected by fluctuating stocks and
bonds, raising interest rates, skyrocketing oil prices, global economic instability or terrorism. Yield is determined by
time, and not market forces.

For investors who are looking to enjoy consistent net returns of 8% to 12% p.a., while seeking to further diversify
their core portfolio allocations, Life Settlements Funds, especially the Life Settlements Wholesale Fund, do worth a
second look.

By Seema Sharma
IIM Shillong
Page 22

© The Finance Club, Indian Institute of Management, Shillong
Market WatcH

Forget Dow Jones
and Sensex
FoLlow Baltic Index

ost of the indicators that the market relies it would cost to book various cargoes of raw materials
on to forecast the future are worthless in on various routes—150,000 tons of iron ore going from
this type of environment. The truth is data Australia to China or 150,000 tons of coal from South Af-
coming out of the traditional economic indicators isn’t rica to Japan. Brokers are also asked to consider variables
current. By the time it’s being reported, the information such as the type and speed of the ship and the length of
is already weeks or even months old. the voyage. Based on the answers, a number is arrived at
One of the lesser-known fundamentals underpin- which represents the shipping costs. The Baltic Dry index
ning the global economy is the Baltic Dry Index, a bench- represents the true price at which shipping is done and
mark that measures dry-bulk shipping rates. So forget has no speculative content. People don’t book containers
unemployment, Inflation, Consumer confidence, Personal unless they have cargo to move.
Incomes and you can even ignore the ever-popular gross
domestic product (GDP).
Baltic Dry Index (BDI) which is also known as Dry
Index is a number issued daily by the London-based Baltic
Exchange, which gives an assessment of the price of mov-
ing major raw materials by sea. The index measures the
demand for shipping capacity versus the supply of dry
bulk carriers; and indirectly measures global supply and
demand for the commodities. It is an accurate barometer
of the volume of global trade.
The Baltic Dry Index is also a compelling indicator
because it is a simple, real-time indicator that is difficult
to manipulate. Some economic indicators—like unem-
ployment rates, inflation indexes and oil prices—can be • BDI was at 11793 on 21st May 2008
difficult to interpret because they can be manipulated • Last October, BDI was at 815. (Decline of 93%)
or influenced by governments, speculators and other key This clearly means that back of the shipping indus-
players. The Baltic Dry Index, on the other hand, is diffi- try had been broken. Does this mean - the world trade
cult to manipulate because it is driven by clear forces of has come to a halt. The answer is YES.
supply and demand.
What caused the crash?
The supply that affects the Baltic Dry Index is the
supply of ships available to move materials around the There are two problems:
globe. It is difficult to manipulate or distort this supply • Producers are stuck with huge inventories. Post
because it takes years to build a new ship that could be the collapse of commodity prices, no one is in hurry to
put into service to increase supply, and it would cost far build inventories. Also, with production cuts and factory
too much to leave ships empty in an attempt to decrease shut downs, existing inventories have become a huge is-
supply. The demand that affects the Baltic Dry Index is the sue.
demand of commodity buyers who need the raw goods • Credit Crisis: No one wants to lend in current
for production. It is difficult to manipulate or distort de- market environment. As a result, Letters of credit are not
mand because it is calculated solely by those who have getting issued. They are required to load cargoes for de-
placed orders to have raw goods shipped. parture at ports. One analyst described it pretty well - “If
I can’t get credit to get iron ore shipped to me today, then
How does it work? I’m not buying iron ore -- and “demand” has dropped”
As discussed earlier the value for the index is deter- This is unprecedented and unusual situation and
mined by the London-based Baltic Exchange, which trac- may not last long. The improvement in credit market will
es its origins back to 1744. Every working day, the Baltic help the ships moving again. Movements in the Baltic In-
Exchange asks brokers around the world on how much
Page 22

Niveshak Volume 2 Issue 1 January 2009
Market WatcH

dex tend to precede movements in global stock markets. meted in the past several months, as the U.S. financial
(Remember BDI is termed a leading economic indicator crisis has snowballed into a global economic downturn
because it predicts future economic activity.) and the consumption of raw materials has ground to a
halt. For example, China is the world’s biggest consumer
Interpreting the Baltic Dry Index of steel, but it has cut its consumption as infrastructure
The Baltic Dry Index typically increases in value as projects have slowed in response to slumping economic
demand for commodities and raw goods increases and growth. The same situation has played out with a host of
decreases in value as demand for commodities and raw other raw goods - and as demand for materials slows, so
goods decreases. Here’s what it typically means when the too does the earnings growth of a dry bulk shipper.
Baltic Dry Index turns around and starts moving UP:
- Global economies are starting to, or continuing In light of the above, it doesn’t take a market ma-
to, grow ven to predict what direction the index’s been heading
- Companies are starting to, or continuing to, growlately - practically straight down. Here’s the thing. The
Baltic Dry Index started plummeting in early June, before
- Stock prices should start to, or continue to,
the global equity markets went into a tailspin, proving
increase in value
its predictive abilities. Besides there are other reasons to
- Commodity prices should start to, or continue favor the Baltic Dry Index over other leading indicators,
to, increase in value including :
- The value of commodity currencies should start • No room for Speculation
to, or continue to, increase in value • Not subject to Revisions
• An inability to be manipulated
Here’s what it typically means when the Baltic Dry • Real-time, daily updates
Index turns around and starts moving DOWN:
- Global economies are starting to, or continuing So if you’re looking for a clear indication of a mar-
to, contract ket bottom, forget about any other leading indicator or
- Companies are starting to, or contin uing to, popular convention. Just look for the Baltic Dry Index to
contract start trending noticeably higher.
- Stock prices should start to, or continue to,

By Manish Lalw ani
decrease in value
- Commodity prices should start to, or continue to,
decrease in value
- The value of commodity currencies should start IMNU, Ahmedabad
to, or continue to, decrease in value.

The Baltic Dry Index (BDI) tracks rates in the 22 main
shipping routes for these key inputs. The BDI has plum-

Page 22

© The Finance Club, Indian Institute of Management, Shillong
Great depressioN

The Great Depression through
Historical
or almost one year now, the media is full of
news, editorials and discussions on the cur-
rent financial crisis. The good old Econom-
ics textbooks, which were kept in dusty racks for quite
some time, are being dusted and read by all in order to market crashed, hurting business confidence and con-
reinforce the basics. But it is not the first time that such sumer sentiment. The real output of the US dropped by
a financial crisis is wrecking havoc, the great depression nearly 30% and unemployment rate touched to 25%.
of 1929 is one of the largest in recent history. Many econ- Many central banks, investors and speculators start-
omists have given their opinions on the Great Depres- ed converting their currency to gold which resulted in
sion, but the work done by two great economists -Milton the depletion of Fed’s gold reserve. The speculative at-
Friedman and Anna J. Schwartz helped the world to un- tacks on the dollar had created panic in the banking sys-
derstand the Great Depression in a better way. The book tem and many depositors had started to withdraw their
authored by Milton Friedman and Anna J. Schwartz, ‘A deposits from banks. Fed ignored this plight of the bank-
Monetary History of the United States, 1867-1960’, gives a ing system and this resulted in the failure of thousands
vivid description about the reasons behind the Great De- of banks.
pression. “The Great Depression, like most other periods In 1933, Franklin D. Roosevelt became the President
of severe unemployment, was produced by government of US. He declared the ‘bank holiday’ and relaxed the
mismanagement rather than by any inherent instability gold standards. The economy started to stabilize when
of the private economy”, says Milton Friedman. Roosevelt became the President and recovery arrived
To understand the reasons of the great depres- only on the advent of the World War II.
sion we need to understand the world scenario which It is true that history has lessons for all. The les-
existed during 1900-1940s. Since 1870, the Gold Standard sons for the central banks all over the world were: The
was highly successful until the beginning of World War central banks should not ignore any panic in the banking
I (WWI). The leadership of Bank of England had provided system of the country because it may lead to the collapse
very sophisticated management of the international sys- of the whole financial system of the country (and might
tem, with cooperation from other major central banks. impact the whole world); and Central banks should use
But the Gold Standard was suspended during the World appropriate monetary tools to monitor and control the
War I because every country needed more financial flex- banking system. The Great Depression brought in many
ibility to finance their war efforts. regulatory changes; formation of Security Exchange Com-
The end of the WWI saw enormous economic de- mission (SEC) and the introduction of deposit insurance
struction in the world. Great Britain was economically are just two examples.
and financially depleted and hence the leadership of the After nearly seventy eight years, when history had
international system shifted from the Bank of England started repeating itself (this time not because of specu-
to the Federal Reserve. But due to the lack of experience lation but because of high leverage, securitization and
and the decentralized structure of the Federal Reserve, its highly complex financial products), the central banks re-
leadership was ineffective in managing the international acted wisely and did not repeat the past mistakes. Now,
system. The acceptability of the Gold Standard was also it’s the beginning of a new history left for many econo-
reduced because of the change in the economic views mists to derive new theories and economic models.
and political balance of power in the world. Ironically,
reduced political and ideological support for the Gold

By Akash Joshi
Standard made it more difficult for the central banks to
maintain the gold values of their currencies. As a result,
when some countries started the reconstitution of the KJ Somaiya, Mumbai
Gold Standard in 1920, it proved to be unstable and gave
rise to currency speculation.
In order to curb the money supply which was flow-
ing to speculators through bank credit, the Fed started
tightening of the monetary policy in 1928. The US econo-
my, which had slowed down because of the world war,
was further adversely affected due to the tightened mon-
etary policies. As a result, in October 1928 the US stock
Page 22

Niveshak Volume 2 Issue 1 January 2009
FinLoungE

FinQ
1. Identify the images & Connect..

2. The story goes that X and Y were set to take corporate finance class for business students despite the fact that they
had no prior experience in the subject. When found the material inconsistent so they sat down together to figure it
out and as a result of this an article was published in the American Economic Review and what has later been known
as the Z. X was awarded the 1985 Nobel Prize in Economics. While Y was awarded the 1990 Nobel Prize in Economics,
along with two other counterparts, for their work in the theory of financial economics, Identify X, Y and Z

3. Identify and Connect the
Pictures

4 A sitter. Identify this new
CEO of an Internet major.

5. Identify the individual logos
and connect the companies.

6. To hide his losses he used one of the bank’s error account numbered-88888 to do unauthorized Speculative trading.
He put a short straddled in stock exchanges hoping Japanese Stock market would not move significantly. However
Kobe earthquake hit 1 day’s later sending Asian market to tailspin. The whole episode led to collapse of one of the
oldest bank. In 1999 a film was made based on his autobiography. Identify the person
7.Which Indian financial Institution has Dog in its Logo?
8. Identify the coat of arms of a one of the
oldest Banking family, the basis of whose
fortunes were laid during the early 1800’s.
The story of their family has been featured
in a number of films.

9. What is the phenomenon in some stock market called when stock returns in October are lower than other month?
Note that the major stock market crashes in history like in 1929, 1987 and recently in 2008 roughly occurred in Oc-
tober. The name came from the following quotation from a book “October. This is one of the peculiarly dangerous
months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December,
August, and February.” Identify the book also.
10. Ending with an easy one, Name world’s first credit card?
All Enteries should be mailed at niveshak.iims@gmail.com by 10th February 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

Thank You :)
We would like to thank all the 30-odd contributors who sent articles for the

January issue. we look forward for your continued support.

ARTICLE OF THE MONTH
The article of the month for January 2009 goes to Mr. Anshul Gupta and Miss
Radhika A.R of IIM Bangalore. They receive a cash prize of Rs.1000/-.
CONGRATULATIONS!!

Fin-Q Winner for december issue
Mr. Puneet Aggarwal of XLRI Jamshedpur. He 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 15 February 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.

SUBSCRIBE!! By Akash Joshi
KJSOM, Mumbai
Get YOUR OWN COPY DELIVERED TO INBOX
Drop a mail at niveshak.iims@gmail.com

Thanks
Team Niveshak
Page 22

Niveshak Volume 2 Issue 1 January 2009
COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com
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Finance Club
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Shillong- 793014