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

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

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

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

Outsourcing Finance & Accounting(4)

Article Of The Month
Lessons Learnt: Derivative Disasters (7)

Cover Story
Recovery or Recession???(10)

Markets in Financial Instruments Directive (15)

The Godzilla that ransacked Wall Street (18)

Market or Policy Failure? (21)


© The Finance Club, Indian Institute of Management, Shillong

...Finance and Accounting

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

F inance and Accounting Outsourcing (FAO) is a IT technology. A good team aims for continuous devel-
sub-contract with a consultant for developing opment of processes so as to construct an efficient and
Finance and Accounting (F&A) activities in a company. In secure delivery model.
recent times, businesses have been outsourcing financial Classification of FAO solutions
activities at strategic level to enhance their performance Nature Activities Standardized/ Implementa-
and efficiency. Like any other form of outsourcing, FAO Specialized tion
has the following advantages:- Complexity
1) Helps company free its precious resources in non- Financial Budgeting and Fore- Standardized Medium
core activities to focus on innovation in business and sat- Planning casting
isfy the customers. Routine back-end tasks like General Financial Management Report- Standardized Medium
Accounting and operational support tasks, that are diffi- Reporting ing, Allocation, Activ-
ity Based Costing, Tax
cult to control, can be shifted to other destinations. Cor- Compliances
porate Strategy can be re-designed to have radical trans-
General Account Payable/ Re- Standardized Low
formation on a global scale. Accounting ceivable, Contract and
2) Acquire state-of-art facilities with superior tech- Order Management,
nology. Best industry practices can be achieved at lower Vendor Manage-
ment, Reconciliation,
cost. An automated Accounting Control System can be General Ledger, Fixed
developed at any offshore location to reap labor arbi- Assets, Payroll and
trage. It has been observed that the development cost is benefits
about 70% of the consultation charges of a certified Ac- Shared Maintenance and Standardized Low
countant under ordinary circumstances. Operations are Services Training
independent of location. In addition there is no cost for Financial Financial Analysis, Customized High
hardware and software. The reduction of cost increases Support Project Appraisal,
Creating Dashboard,
savings. work-flow solutions,
3) Electronic transaction and data-processing saves Treasury and cash
time and is more accurate and reliable. Superior quality Management
and control reduces the budgeting cycle. Moreover, the Financial Improvement of Customized High
incidence of error is much lower. Improved adherence to Advisory financial transparency,
centralization of func-
accounting norms facilitates decision support systems. tions, Risk Evaluation
Requirements for building a FAO solution
The business in every organization is unique. More- Risk Associated with FAO
over, the complexity in implementation of F&A functions
• Loss of ownership of finance functions and reli-
are not the same. This requires customization of F&A ap-
ance on external agency
plication. A FAO Consultant builds the F&A model using
standardized processes, modern technologies and apply • Short-term conflict in organization regarding
best practices. During this phase, constructive communi- roles. Also the in-house training facility in accounts func-
cation and collaboration are needed between the client tion gets weakened
and the FAO consultant to deliver the most appropriate • Confidentiality of vital information like project
solution. Significant economy of scale can be achieved in allocation data, cost – sheet, investment and estimates
this process. The FAO consulting team essentially consists are at stakes
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Niveshak Volume 2 Issue 5 June 2009

Fig: The Delivery Model for FAO Services
General Predictions for the Industry to mitigate risk and chose the right FAO vendor.
• According to Vengroff Williams & Associates Many pharmaceutical and Retail companies have
(VWA), FAO improves business conditions during reces- implemented FAO services to focus more on their custom-
sion. The industry will still grow at healthy pace. ers. FAO consultants are having many clients in countries
• IDC Research had predicted that in the year 2011, like UK and Australia where the management believes
the market size of FAO will be double of what it was in that FAO is the answer during rising prices and recession.
2007. The estimated size of annual contract value was Most of the FAO vendors are based in South-East
USD 2.2 billion in 2007. Asia, Eastern Europe, and Mexico. These places have great
• FAO Research, Inc. reports that 2008 showed the advantage in terms of availability of talent pool at lower
maximum annual growth of FAO contracts. rates.
• The business advisory firm EquaTerra, found out FAO Services – Indian Scenario
that in 2008-09, 63% of the outsourcing participants were India still holds global advantage in terms of English
the organizations in UK. proficiency. The technical and financial teams are equally
Key Developments in FAO competent. During the recent times, the growth rate of
The Industry is still in its developing stage. A major revenues from FAO services in India have dropped to 17%
chunk of the FAO business has been due to transactional from 21%, as estimated by NASSCOM. This has been partly
accounting. These tasks include General Ledger, Accounts due to the economic recession. The infrastructure has
Payable/Receivable Management and Annual/Quarterly been a bottle-neck in the process as it has failed to devel-
Close. The solutions are generally simpler to implement op uniformly to support financial data mining. Develop-
(using simple arithmetic functions) at little cost. There ment has been restricted only to major cities like Hyder-
has been limited development of high-end cash and trea- abad, Bangalore, Gurgaon, Noida and Kolkata. There are
sury management services. possible expansion options in states like Madhya Pradesh
and Kerala. Policies need to be implemented by both the
The stress is more on Project Management to pro-
Central as well as the State Government in India for ho-
vide better services and build relationship at competitive
listic development beyond major cities to smaller towns.

By Agnimitra Kar
cost. Complexities in implementation have reduced with
experience. Many US companies have gone for FAO ser-
vices to have their systems Sarbanes Oxley (SOX) compli-
ant. The recent recession has made it imperative to instill IIM Kozhikode
fair accounting practices. Extra efforts needs to be put in
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© The Finance Club, Indian Institute of Management, Shillong
In the newS

I nflation has turned negative 1.61% for the first from overseas and from private investments has fallen.
time in thirty years but the prices of food items The fact is that the inflation measured in terms of the
like fruit and vegetables, cereals and oil are still higher CPI is still hovering at higher levels clearly signaling high
than last year. The wholesale price index shrunk to 232.7 demand levels.
points for the week ended June 6 from 236.5 in the same Back in 1978, when inflation rate entered nega-
week a year ago. tive territory, the first non-Congress government led by
The decline in the rate of price rise to sub-zero lev- the Janata Party was in its second year. Between April
els is, in fact, just a statistical phenomenon owing to the and December 1978, the inflation rate was -0.6%. Prices
high base effect, considering that WPI inflation during of fruits and vegetables had fallen (-8.2%), as had cot-
the same period a year ago was at a high of 11.66 per cent ton (-13.5%) and oilseeds (-14.6%). Among manufactured
on account of high commodity and crude oil prices. products, sugar and gur prices fell dramatically by
Interestingly, the inflation rate measured 23% and edible oil prices by 11%. This decline in
in terms of the Consumer Price Index (CPI) prices was attributed to a good harvest in 1977-
is still high despite the WPI inflation fall- 78, and cheaper inputs to agriculture.
ing to sub-zero levels. The inflation rate With inflation already in the red,
in terms of the CPI softened from its banks have shown intentions of re-
peak of 10.5% in January 2009 but ducing the interest rates. Bank-
still hovers above 8%. Prices of ers are divided over whether a
most essential food items are negative inflation rate will
still showing double digit prompt the RBI to cut its
rise and prices of daily use benchmark policy rates or
items such as rice, potatoes, not. However, some banks
onions, sugar, salt and tea have have announced that they
registered a substantial surge on a won’t wait for a signal from RBI
year-on-year basis. before they start cutting lending and
Deflation, an indicator of falling pric- deposit rates. Industry seems to concur
es, would normally signal economic contrac- on a rate cut of 100 basis points. This may
tion. Hence, instead of rejoicing that each rupee further bring in some cheer to the market.
of their income will now be worth more than a

By Sarvesh Chowdhury
year ago, consumers may start worrying about the
loss of jobs and incomes. Falling prices also mean bad
news for borrowers. The real rate of interest is the
nominal rate less than the rate of inflation, and de- IIM Shillong
flation means a real rate of interest that is higher
than the nominal rate. Hence, each rupee that you use to
repay a loan would be worth more than the rupee you
But this time deflation is expected to have a posi-
tive impact on growth, because the reason for the fall in
prices is different. Manufacturers will benefit with input
prices coming down at a faster pace than a fall in the
prices of finished goods. The domestic consumption de-
mand remains strong, even at a time when the demand
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Niveshak Volume 2 Issue 5 June 2009
Article of the montH

...and Lessons Learnt
D erivatives are often referred to as financial in-
struments of mass destruction. After all the bad
publicity of derivative losses and companies going bank-
CEO – I don’t understand all this. Sorry Mr. X. You
are fired for misappropriation of funds.
Irrespective of the inherent risks, derivatives have
rupt a negative perception has been formed that perhaps been historically used by traders to speculate and gamble
make derivatives untouchable for some of us. But is it in pursuit of windfall gains. Traders in lure of big money
not equivalent to thinking that nuclear energy is bad be- take positions which are out of their authority and con-
cause nuclear bombs in Japan had caused unimaginable trol. The money at stake is sometimes so huge that a
destruction or saying that Chernobyl tragedy occurred derivative decision gone wrong wipes out the complete
due to harmful effects of nuclear radiations? Derivatives company and spoils the hard reputation earned by the
undoubtedly are risky but the recent events occurred be- firms in seconds. There are numerous instances of huge
cause of the greed, over optimism of financial institutions losses from derivatives trading but there are few cases
and lack of precautions. We all know that counter to the in the derivatives history which stand out. Let’s look at
perceived notion of derivatives being risky; they are ide- some of the biggest derivatives disasters and learning we
ally used for hedging and acts as insurance against future can gain from them.
uncertainty. Barings Bank
Ideally it would not be prudent to expect profits One of the biggest and the most infamous deriva-
and losses from derivatives. Derivatives as instruments tive disaster was the Barings Bank collapse.
were not created keeping profit and losses in mind. They French Foreign Minister, Duc
are used as a risk transfer techniques and can be viewed

de Richelieu in 1818 had said:

as insurance which any one of us can sell in the “There are six great powers

economy. The investor here by invest- in Europe: England, France,

ing in derivatives tries to Prussia, Austria, Russia and

merely protect himself Baring Brothers.” It took

against the unexpected one man – Nick Leeson,
changes in the prices whose equity derivative
of the underlying com- fiasco brought about the
modity. But still we see a fall of one of this 242
loss in derivatives to a fi- year old bank.

nancial decision gone hor-
Nick Leeson was
ribly wrong and attribute supposed to be exploiting the inter
the gain in derivatives to the
exchange arbitrage by trading Nikkie 225 fu-
efficiency of firm. A conver-
tures simultaneously on SIMEX (Singapore International
sation below can explain this
Monetary Exchange) and OSE (Osaka Stock exchange). He
situation correctly –
was also authorized to trade option and futures for other
CEO – Mr. X. This year we have lost USD 10 mil- clients in Barings. This scope of operations did not in-
lion in currency forwards. How do you explain that? volve much risk. But instead of simple arbitrations Lee-
Mr. X – Sir it is because of the fall in our currency son started taking substantial unauthorized risk and kept
rate that we have lost this money his positions open. He also ventured into short strad-
CEO – But how do I explain this to our shareholder dling which significantly increased the risk. Once Leeson
who are asking for justification on investing in deriva- started incurring losses it was a spiral effect and he took
tives even further long positions to offset the previous loss-
Mr. X – But derivatives are never supposed to be for es. Unfortunately Japanese market collapsed because of
earning profits they are just instruments for hedging risk. the earthquake in 23rd January 1995 resulting in loss of
You would not have said this if we would have instead around USD 1.4 billion for Barings Bank.
earned USD 10 million through derivatives. What was surprising is that Leeson was able to hide
all this from the management. Leeson before working
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© The Finance Club, Indian Institute of Management, Shillong
Article of the montH

as a trader in BSS (Barings Securities Singapore) was in- the losses on an existing position. The traders should re-
volved in the back office activities. Later when he started straint themselves from doubling down but rather look
trading as head trader of BSS he was also the head of BSS towards moving out of the existing position in case of
operations. He was therefore easily able to misrepresent losses. Chasing the losses can further compound prob-
and forge the accounts information. Instead of mounting lems. There should be good corporate governance and
losses, profits were showed to the management which risk management in place which was absent in case of
got him huge money as bonuses. Management of Bar- CAO. Speculative trading started without being properly
ings was clueless about derivatives business and could encapsulated in risk management policies. There must be
not see anything fishy in the windfall gains that Leeson well defined rules in the financial management activities
was showing. to create accountability. Proper valuation of the open po-
Learning from Barings episode sitions is also important as improper valuation leads to
Barings disaster happened predominantly because erroneous financial statements.
of improper control and supervision. Audits were not Sumitomo Corporation
conducted properly and trader himself was involved in Sumitomo Corporation lost around USD 2.5 billion
presenting the financials to the management. Improper in the copper derivatives. This is a classic case of – ‘Run-
assessment of risk on the part of Leeson which can be ning on the top of tiger not knowing how to get off
attributed to over optimism or over confidence was a without being eaten.’ Yasuno Hamanaka the head trader
major reason for the fraud. Had management kept proper of Sumitomo Corporation manipulated the world cop-
control and supervision the damage control would have per prices through his operations on the LME (London
been possible. Metal Exchange) copper futures market over the period
China Aviation Oil of 1991-95. This artificial increase in copper price resulted
CAO was one of the 25 companies in China to enter in increased profits for Sumitomo Corporation from sell-
into overseas energy market. These companies were al- ing copper. Whenever any hedge fund or speculator who
lowed to trade in futures to hedge the risks due to vola- was aware of manipulation tried to take short position,
tile spot markets. In the company prospectus company Hamanaka invested more money into his positions thus
had mentioned to its shareholders that if company’s trad- sustaining the high price.
ing losses exceed USD 5 million, the open positions of During late 1995 due to increased copper produc-
the company would be closed unless an exception was tion facilities particularly in China copper prices started
authorized from CEO Chen Jiulin. declining. That was ominous for Sumitomo as they had
The company was bearish on the future prices of long positions in the futures market. Hamanaka failed
the oil and started speculating on the oil price in the year to get rid his positions. Later when LME started investi-
2003 and by March 2004 the short derivative position re- gating on the alleged manipulation of copper prices Ha-
sulted in USD 5.8 million in losses for CAO. Instead of clos- manaka was taken off from his position of head trader.
ing the positions CAO kept increasing the size of trades This brought the short traders and hedge funds into the
in the hope of offsetting the losses already incurred. Later act causing the Copper prices to fall further on LME. In
Chen Jiulin also bought futures contract betting the oil September 1996 Sumitomo Corporation the figure of USD
prices to continue to rise. However when he had to de- 2.6 billion as the loss on derivatives trading which was
liver on his futures contract, oil prices dropped and again about 10% of Sumitomo’s annual sales.
he incurred huge losses. As the losses kept mounting, This disaster was the result of successful manipu-
CAO wasn’t left with enough money to meet the margin lation of the copper prices due to lack of transparency
calls of the counter parties. In November 2004, CAO an- in the reporting positions of large clients at LME. CFTC
nounced that it had lost USD 550 million through trading (Commodities Futures Trading Commission) which regu-
in crude oil swaps, futures and options. lated US futures market required regular reporting from
This case also presented the case poor corporate gov- the large client on all US exchanges which was not the
ernance. One month before making the derivative losses case with SIB (Securities and Investments Board) which
public CAO’s parent company China Aviation Oil Holding oversees regulation of all London Financial markets. Fi-
Company (CAOHC) sold USD 108 million CAO stocks to nancial Services Act under which the financial markets
investors. This money was used to meet the margin call of Britain are governed also failed to provide any explicit
requirements. Chen was charged with 15 counts including provisions in case of price manipulation. Thus it was dif-
fraud and failure to disclose the losses. ficult for the regulators to identify the potential manipu-
lating position.
Learning from CAO scandal
Learning from Sumitomo fiasco
The derivative mishap was not due to inherent dan-
gers of instruments but due to ill conceived and poor- Regulators must now be more aware and proactive
ly defined strategies. There were number of rollovers than ever before as the possibilities to manipulate the
of loss generating positions whereby options on bigger markets have become more practical with the advent
of complex and high leveraged instruments like deriva-
volumes were sold to generate sufficient cash to settle
tives. Prevention here is always better than prosecution.
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Niveshak Volume 2 Issue 5 June 2009
Article of the montH

Companies should also restrain themselves from vesting portion of funds asset to avoid risk. One single mistake led
too much power on a single employee and follow a job to the fall of Amaranth. Sound risks management should
rotation policy. By entering into fictitious trades and ma- be in place to tackle the unforeseen events. Appropriate
nipulating accounts, Hamanaka successfully misled the hedging strategy is crucial as there is a thin line between
management to believe that he was making huge prof- a good trading decision and speculation. Leveraging be-
its. Sound operational and monitoring system need to be yond the firms values is a huge risk which should never
in place to keep track of activities of traders. Successful be taken particularly if investing in unpredictable instru-
traders might require more, not less, scrutiny. ments like derivatives. And lastly each trader is worth
Amaranth Advisors the last trade. Often it is seen that traders once reaching
the height of glory are given too much of freedom which
This was the largest hedge fund collapse in history
ultimately leads to the fall of the firm as in this case.
when Amaranth Advisors lost USD 6 billion in natural gas
futures. Large part of Amaranth Advisors was in energy There are a lot more derivative disasters which we
trading and the hedge fund was performing well provid- can review and they all present more or less same learn-
ing consistent return to its investors. Energy desk used to ing. But one thing that comes out quite clearly is the
contribute around 30% of the annual returns and energy importance of self regulation. Often the traders and firms
trading was initially quite conservative in nature. are lured by greed in search of huge gains. Human greed
is perennial therefore traders will be lured of big money
After Brain Hunter joined the fund he took large
and risks will be taken. But a proper control system and
speculative positions by using natural gas futures in the
regulation can prevent such mishaps which rob investors
year 2005. It worked as natural gas supplies were disrupt-
of their hard earned money and causes downfall of firms.
ed due to hurricanes like Rita and Katrina and natural gas
Time and again lessons are not learnt and mistakes are
prices went through the roof. This earned Amaranth USD
repeated as in the case of Societe Generale scam which
1 billion profits and Hunter was labeled as star trader.
was a replay of Barings Bank episode.
Hoping for the repeat performance Hunter again went
long on the natural gas contracts leveraging their posi- Nevertheless derivative instruments give lot of op-
tion 8:1. Hunter had put 50% of the USD 9 billion hedge tions, flexibility to the businesses. A decision gone right
fund at stake on natural gas. But that year US did not or gone wrong can turn the fortunes of the firms and
experience any major storm and on the back of increased sometimes the industry. Traders have to be on their toes
supplier the natural gas prices plummeted. This gave a and each second counts. Opportunities are unlimited; the
body blow to the hedge fund and the firm shed USD 6 returns are high and a lot is at stake. But all this come
billion in losses. with a warning – “Handle with Care”.

By Atul Gupta
Learning from Amaranth debacle
While venturing in instruments and positions with
high risk the firms should go for position sizing. Position SIBM Pune
of Amaranth in natural gas should have been a small pro-

Rising food prices in times of negative inflation

By D i lpr eet S. Gandhi &Saurav Bagchi
IIM Shillong
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© The Finance Club, Indian Institute of Management, Shillong
Cover storY

Of Rosy Projections...

... And Reality
...Is the Recovery for real?

Indian Stock Market at a glance this just a flash in the pan or is just the beginning of the

S tock market is considered to be the place to get greatest Bull Run ever? Few factors which can be consid-
the best return within the given time span as ered to understand the present situation and access
compared to other available options. But we know that the future trends of market are as follows:
stock market is the place of “High Risk and High Return”.
It also follows the law of nature what we call as law of Domestic Factors
uncertainty. The journey of Sensex (Index for Bombay India’s industrial production (IIP):
Stock Exchange) from 1990 to 2009 ascertain the volatility India’s industrial production rose unexpectedly for
and uncertainty associated with stock market. the first time in three months, suggesting interest-rate
As one can see it took nearly 2 years for Sensex to cuts and government stimulus measures are helping re-
reach 20,000 from 10,000 but it tumbled to 8,000 from suscitate demand in Asia’s third biggest economy. Output
20,000 in a span of 10 months. Hence it is very impor- at factories, utilities and mines advanced 1.4% from a year
tant to consider various factors which lead to bullish and earlier after a revised 0.75% drop in March, the statistics
bearish trend of stock market. To name a few market agency said in New Delhi few days back. Economists ex-
reacts to news like fundamental macroeconomic vari- pected a contraction of 0.1%. Asia’s largest economies are
ables, monetary policy decisions, industry fundamentals, showing signs of recovering from the global recession as
monsoon forecast, FII inflow, GDP, inflation, net export the region’s governments start to implement nearly $950
figures, Budget expectation, Election results etc. But the billion (Rs45.03 trillion) of stimulus measures. Though the
fact of matter is the volatility of stock market indicators demand for industrial sector’s consumer goods appears
goes beyond any reasonable explanations. to remain weak, April’s industrial production data points
tentatively to a stabilization of the industrial sector. In
Indian Stock Market Post Sub-Prime Crisis coming months, industrial production is likely to con-
With the ghost of sub-prime crisis and global melt- tinue to show signs of improvement. Already, the recent
down hovering around during the end of 2008, the stock rise in commodity prices has led to increased production
market went into a bearish mode. The poor third quarter in mines, while recovering domestic demand has led to
results of Indian corporate industry along with the Sa- electrical production recovering. These trends will likely
tyam fiasco pulled the SENSEX to further low. The trend continue in coming months. But the point to ponder is
continued in the first two month of 2009 and bear was that this increment has come mainly due to Government
smiling in the DALAL Street and the risk aversion was at fiscal measures as export continue to collapse. The gov-
large among the investors. From March 9th, 2009 the bull ernment cannot keep on providing stimulus after stimu-
started pricking its horn. The market started recovering lus forever at the expense of taxpayer’s money. But nev-
and the upward trend continued with the great political ertheless the IIP number suggests that there is a positive
circus of India, The General Election of 2009 around the turnaround in the real economy which was downturn
corner. With the results of general election out on May due to global slowdown.
16th 2009 and stable government in the center, market
Rate cuts
saw two upper circuits in a matter of two hour of trad-
ing when market opened on May 18th 2009. Yes as our The Reserve Bank of India cut its repurchase rate
editor mentioned in the last edition of Niveshak that’s by 4.25 percentage points to 4.75% from 20 October 2008
called a Bull Run. Now the few questions which arise to 21 April 2009. It also lowered the reverse repurchase
from all these facts are is this Bull Run sustainable in the rate to 3.25% to reduce the cost of lending and stimulate
long run? How much correction is expected in the com- domestic demand.
ing months? What factors are leading to this Bull Run? Is The Sensex has risen 26% since the 16 May re-elec-
tion of Singh’s Congress party-led United Progressive Al-
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Niveshak Volume 2 Issue 5 June 2009
Cover storY

liance, on optimism that higher government spending closed for two hours. The market reopened at 11.55 a.m.
will boost company profits. The $1.2 trillion economy sta- Within a matter of seconds, the Sensex marched ahead by
bilized in the three months to March, maintaining the 2,110.79 points and the Nifty went up by 651.50 points. As
5.8% pace of expansion recorded in the preceding three both the indices had hit the third and final level of circuit
months. The central bank expects the economy to grow — 1,950 points (20%) for the Sensex and 600 points (20%)
6% in the fiscal year that started 1 April, the slowest pace for the Nifty — the equity and equity derivatives markets
of expansion since 2003. Annual growth averaged 8.5% in were closed for the rest of the day. The Sensex closed
the previous five years. 17.34% above its previous close, while the Nifty reported
Production rebounded in April as manufacturing, a gain of 17.74%.
accounting for about 80% of the total output, grew 0.7% These mouth-watering gains were simply notional
from a year earlier after a decline of 1.6% in the previous or paper profit as the market closed with thin volumes.
month. Mining climbed 3.8% and electricity rose 7.1%, ac- The combined cash and future and options volumes on
celerating from March. the two exchanges stood at around Rs 3103 crore. This is
Election Results against a trading volume of around Rs 70000 crore on Fri-
18 May 2009 will be remembered as a historic day day, 15 May 2009. On the BSE, only 847 stocks witnessed
for the Indian capital markets. The Bombay Stock Ex- trading out of around 2,500 stocks that were traded on
change (BSE) and the National Stock Exchange (NSE) hit 15 May 2009. Similarly, on the NSE, only 207 stocks wit-
the upper circuit within seconds after opening on the nessed trading compared with 1,300 on the same day.
unexpected electoral win of the United Progressive Al- FII
liance (UPA) government and the better-than-expected Indian stocks have continued to rally on a view of
performance of the Congress party, which has ensured ample global liquidity and a return of risk appetite. This
a stable government without any pressure tactics from will help India Inc help raise funds for expansion which
allies, particularly Left. in turn will boost corporate profits. India Inc has already
The stage for the unprecedented market rally was raised almost Rs 5,000 crore from three qualified institu-
set on Saturday, 16 May 2009, when the results of the tional placements (QIPs) so far in 2009 and announced
election for the 15th Lok Sabha were declared. The Con- plans to raise another Rs 20,000 crore. Foreign funds are
gress-led United Progressive Alliance (UPA) emerged vic- aggressively buying Indian stocks. FII inflow in June 2009
torious and stronger. A formation of stable government totaled Rs 4,718.80 crore (till 9 June 2009). FII inflow in
in New Delhi is certainly a big positive for the markets. calendar year 2009 totaled Rs 25,192.30 crore (till 9 June
Moreover, investors were expecting the markets to open 2009). Moreover Foreign institutional investors (FIIs)
with a bang on Monday. Indeed, the markets surprised have pumped in Rs 20,117 crore (US$ 4.3 billion) into the
everyone and created history. Indian equity markets in the month of May 2009 alone—
Within a few seconds after stock markets opened the highest in 19 months.
on 18 May 2009, the Sensex went up by 1,789.88 points. International Factors
Similarly, the Nifty jumped by 531.65 points. As both the TED Spread
indices hit the market-wide circuit filter by crossing 1,450 If we try to look at some of the macroeconomic
points (15%) for the Sensex and 450 point (15%) for the indicators to get an insight on the present economic con-
Nifty, the equity and equity derivatives markets were dition of the world, we will find that the TED spread,
Page 11

© The Finance Club, Indian Institute of Management, Shillong
Cover storY

which is the price difference between three-month fu- But this run is direct effect of Chinese buying as
tures contracts for U.S. Treasuries and three-month con- Chinese are hastily stocking up on cheap commodities.
tracts for Eurodollars having identical expiration months, As China has already bought in excess of actual domestic
which usually averages approximately 50 basis points, but demand - and thus this run is not sustainable. Already,
during the Lehman Brothers crisis it soared to 450 basis 90 freighters carrying iron ore are lying idle off Chinese
points. With the Federal Reserve’s balance sheet actions ports, because of a lack of storage facilities. As the pace of
to flood the credit markets with funds, the Ted spread this stockpiling starts to slow, the BDI will fall.
has nearly returned to its historical range, suggesting Oil Prices
that normal functioning is returning Prices of OIL have increased to $68 a barrel from
$30s we saw earlier in the year, which indicates that the
world economy is not yet about to fall into a great de-
pression. A number of factors can be attributed to this
rally oil prices such as weakening dollar, fears of infla-
tion, increased investor risk appetite and the appearance
of ‘green shoots’. While many investors are arguing that
oil’s rally is a good sign for the global economy and eq-
uity markets, we can just hope that it doesn’t revert to
the detrimental $150. According to some analysts though
credit crunch was the triggering point of the present cri-
sis but it was soaring oil prices which had pushed the
world towards recession. It is also being argued that fall
Fig: TED Spread of the oil prices has now helped the economy back to its
This clearly shows that the default risk is now be- feet.
ing considered to be decreasing and risk appetite of the If we watch the movement of oil prices closely we
investors has increased and they are moving out of their would find that While the price of oil has risen from
safe investments. The economy which was seeing a li- the $30s to $68, oil stocks have not really rallied much.
quidity crisis just a few months back is now flooded with Such a dramatic out performance of oil vis-à-vis oil stocks
huge amount of liquidity because of the low interest indicates that oil is probably factoring in a speculative
rate that is prevailing in most of the countries. This large element, and not just health of the economy as widely
availability of liquidity coupled with the increased risk perceived. Also oil inventories in developed countries
appetite of investors has led to heavy infusion of FII’s in are one of their highest levels ever. The rising Chinese
the stock market of emerging economies like India, China demand may have more to do with the Chinese govern-
and Brazil. ment stockpiling oil than an increase in energy consump-
Baltic Dry Index tion. All this points out that though oil prices are raising
Another indicator which can be used as a global but fundaments of oil still remain weak.
economic indicator is Baltic Dry Index (BDI). It is a ship- Conclusion
ping and trade index created by the London-based Baltic At US$ 1.04 trillion, India’s market capitalization (m-
Exchange that measures changes in the cost to transport cap) has emerged as the ninth largest in the world. The
raw materials such as metals, grains and fossil fuels by speculation of bottoming out of recession and remote
sea. Changes in the Baltic Dry Index can give investors in- chance of V-shape recovery might be true. But as the age
sight into global supply and demand trends. This change old fact says; as a smart investor we should go by funda-
is often considered a leading indicator of future economic mentals of the company, be patient and think long term.
growth (if the index is rising) or contraction (index is fall- Corrections are bound to happen, but when and exactly
ing) because the goods shipped are raw, pre-production by how much are nearly impossible to predict. The year
material, which is typically an area with very low levels started with dampened spirit and dented optimism, but
of speculation. If we look the Baltic dry index in the past as Warren Buffet suggested for this phase of market “Let
one year, we can clearly see a sharp contraction of index us become wiser and lead a happy, healthy, prosperous
from 7500 in September to its lowest level in Nov-Dec. and peaceful life”. By saying this he meant we should
Before the gauge rose to 4,291 points on June 3rd 2009 in rely on our financial wisdom and apply our basic knowl-
a run of 23 straight gains as China imported iron ore. edge and common sense rather than relying on financial
experts to find a way out, as one should not forget the
present condition are more or less outcome of the finan-
cial experts in Wall Street. Thus in world of share market
“Follow your heart with an intelligent brain”.

By Sareet Mishra &Sujal Kumar
IIM Shillong

Fig: Baltic Dry Index
Page 11

Niveshak Volume 2 Issue 5 June 2009
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In the newS

B u dg e t 2 0 09
...Looking Ahead

W ith great power, comes great responsibility.
These words of wisdom inspired Peter Parker
to fight the evils in the Hollywood flick Spiderman. In the
ernment is at a good position to push its reforms agenda
and disinvestment. This would unlock huge value from
PSUs, at the same time provide huge funds to fight fiscal
last general election, the UPA government was voted back deficit.
to power with a clear mandate to fight the evils that have • Increase FDI limits across all sectors. This will
threatened India- terrorism, corruption, poverty to name boost markets to a good extent
a few. But what we are more concerned about anything • Give stimulus to export oriented sectors and spe-
else in this magazine is- how will the Finance Minister cial economic zones to increase competitiveness, rein-
revive the financial system that dealt a body blow from state and create jobs, and boost competition.
the US Sub-Prime crisis. This time around they are blessed
• Enough is Enough: Its high time government
enough by having a clear majority without the pesky left
gives priority to control fiscal and revenue deficits.
that always hindered its reforms agenda.
• Ensure more and easy loans, and single window
As the news of the election results was flashed the
clearance to SMEs.
market was flooded with all sorts of positive data as if
they were just waiting for the results. Stock markets • Weed out non-merit subsidy, it rots the whole
defeated western counterparts, Industrial Index of Pro- system.
duction jumped and the Central Statistical Organization • Focus on Education and health care.
came with forward looking statement and reports about • Tax cuts can bring some cheer to corporate but
the Indian Economy. Corporate financial results suddenly may widen fiscal deficit.
went into green zone. FII inflows also had jumped. Be- • Although Strict Financial regulations have helped
lieve me, the new UPA government had nothing to do India avert crisis several times, Its time to deregulate the
with this so called recovery. system and get foreign players in a bigger way. But a
Their actual task starts with the Union Budget which word of caution needs to be exercised.
is scheduled to be rolled out on 6th of July. Historically, • Improvise on NREGA and create alternate av-
Budgets have led to downfall in markets a few days after enues to provide sustainable employment to the rural
announcement on most of the occasions. But the one in poor. This is important as India fought this recession ow-
1992 boosted the markets by 34% in a month. The Finance ing to huge consumption in rural India.
Minister is expected to pull some sort of a similar miracle With a sound government, a well structured budget
with a reform-oriented Budget that will incorporate tax and proper financial mechanism, India can get back to
cuts, fiscal consolidation, a divestment programme and the above 8% growth rate and be counted among the
infrastructure spending to justify the faith of the people fastest growing economies of the world. All eyes are on
in their government. Let us have a look at what steps and the Union Budget. Mr. Pranab Mukherjee, whole of India
reforms can they push to guarantee an early recovery is at your mercy now. Perform or get the blame of letting
from this crisis and ensure sustainable growth. India Perish.
• Ramp up spending in Infrastructure. This creates
jobs, public goods, a conducive environment for doing

By Biswadeep Parida
business and a handsome return on Investment.
• First, Interest rates can be cut and banks be di-
rected to pass this cut to consumers. This will help in
IIM Shillong
increasing consumption and spending. It must also im-
prove liquidity in the system to enhance industry.
• With a clear majority and no Left forces, the gov-
Page 11

Niveshak Volume 2 Issue 5 June 2009

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

Best execution Established exchanges have seen their positions
MIFID requires that firms take all reasonable steps challenged and the most significant change to the trad-
to obtain the best possible result in the execution of an ing landscape has been the impact of new MTF platforms.
order for a client. The best possible result is not limited to These new entrants have had the effect of moving trad-
execution price but also includes cost, speed, likelihood ing away from regulated markets, as well as of attracting
of execution and likelihood of settlement and any other new liquidity from the OTC space. MTFs have steadily in-
factors deemed relevant. creased their market share of trading in all markets. This
growth has occurred in parallel with the launch of new
Systematic Internalizer
MTF platforms. A key reason for this is that new trad-
Systematic Internalizer is a firm that executes orders ing platforms offer more opportunities for pan-European
from its clients against its own book or against orders trading because of the range of shares offered by the ven-
from other clients. MIFID treats Systematic Internalizer ues and their very competitive fees.
as mini-exchanges, hence, for example, they are subject
However, it is important to note that while the
to pre-trade and post-trade transparency requirements.
market share of regulated markets has decreased since
MIFID: The Impact on trading venues the implementation of MIFID, the majority of trading
The introduction of MIFID has significantly remains on the incumbent regulated markets
changed the secondary markets landscape rather than new entrants and OTC. There is
across Europe. In principle, a trade limited competition between regulated
can now be executed in all national markets due to the fact that regu-
markets either on an organized lated markets generally offer trad-
market (a regulated market or ing in shares admitted to trading
MTF), or by an investment firm on their own regulated mar-
either acting as an SI or ex- ket rather than pan-European
ecuting trades OTC. In prac- trading of shares admitted to
tice, the venue used to exe- trading on other regulated
cute a trade will depend on markets in the EU, although
where the share is admitted some regulated markets op-
to trading and a number of erate MTFs that offer pan-
other factors such as liquid- European share trading and
ity, certainty of execution, in this way compete with
and costs. regulated markets (e.g., all
When considering the German regulated markets
impact of MIFID, it is impor- traditionally operate MTFs
tant to bear in mind other driv- where also a lot of shares listed
ers that have had an impact on the on markets in other countries can
trading services market. The market be traded.
has faced unprecedented volatility over Market share of OTC trading has
the past 12 months and dealt with defaults continually fluctuated since the implemen-
of major counterparties. tation of MIFID with a slight upward trend.
Page 11

Niveshak Volume 2 Issue 5 June 2009

One of the main developments has been a signifi- interests underpinning the concerns expressed, it is im-
cant decrease in hit sizes, coupled with an increase in the portant to be and remain aware of the challenges raised
number of trades. This is likely to be due to a combina- by the still recent introduction of the MIFID framework
tion of different factors, including an increase in the level governing competition in equity trading so that action
of algorithmic trading, market fragmentation and market can be taken or recommendations made to address issues
volatility, rather than simply the implementation of MI- identified. A review of how trading functionality is devel-
FID. Whilst it had started before MIFID, the decline in hit oping across the whole market could be a useful start
sizes has been more pronounced since MIFID came into of further consideration of the still blurring distinction
force. It is not clear that this decline was caused solely between broker activities and the operation of a trading
by MIFID. platform. The significance reached by some MTFs may
MIFID: The Future lead to reconsideration of some potential differences in
regulatory requirements for MTFs and regulated markets.
Finally, MIFID aimed to develop competition and
greater efficiency of equity trading while maintaining in-

By Amit Agarwal
vestor protection. This greater competition is raising con-
cerns among trading platforms, by regulated markets vis-
a-vis MTFs, and by regulated markets and MTFs vis-a-vis
investment firms OTC activities. Beyond the commercial XLRI Jamshedpur
Page 11

© The Finance Club, Indian Institute of Management, Shillong

The Godzilla
that ransacked Wall St
How Finance Became the Rampaging monster of our age
T he past 18 months saw a monster of epic pro-
portions out of no Hollywood movie ever made,
come and ransack some of the biggest financial centers in
However, this assumption has been negated by peo-
ple ranging from Joseph Stilgitz to George Soros; as well
as the consistent boom-bust cycles that battered many
the world- New York, London, Tokyo. In its wake, it left 31 industries (IT) and countries (East Asian Crisis). George
collapsed banks in the USA alone (2007-January 31, Source: Soros summarizes that the underlying assumption of fi-
FDIC Failed Bank List), and trillions of dollars washed nancial markets that the aggregate knowledge of all indi-
away. What potent diet did this monster grow on? viduals discounts the future to reflect the “true price” is
Over the past few decades, finance has become a essentially flawed.
cornerstone of the global economy- it contributed nearly Reflexivity- Soros contends that participants think-
35% of corporate profits in USA until 2007, and the tril- ing and ideas shape reality in an unending process so that
lions of dollars of cash flows kept companies running on both become codependent in an endless feedback loop.
easy credit, people buying products on cheap rates, and For example a company’s falling stock makes financing
the economy chugging along relatively smoothly. How- difficult. This leads to even more pressure on the stock
ever, finance was built on the foundations of economic price, hence reinforcing actions and events.
thinking- based on certain assumptions assumed to be Hence in certain cases, the participants’ bias can
infallible. These assumptions are rounded off in what is change the fundamentals which are supposed to deter-
known as the “Efficient Market Hypothesis” which as- mine market prices.
sumes people to be rational, information to be freely The Grossman-Stiglitz Paradox takes the idea fur-
available, nil transaction costs-- an ideal world far re- ther by contending that efficient markets assume prices
moved from the imperfections of day-to-day markets. The are right and it takes energy to discover information. If
Efficient market hypothesis assumed investors to filter both statements are true, then no one will search for any
all information on an asset and based on that, derive a information that has a bearing on the price, since it is
fair value. This fair value will lead to an efficient flow of already captured.
capital. Hence, finance was believed to be a key lever in The underlying foundation of many of these theo-
ensuring open and efficient markets. ries is “asymmetric information”. A seller often knows
Page 11

Niveshak Volume 2 Issue 5 June 2009

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

© The Finance Club, Indian Institute of Management, Shillong
In the newS

Down it Goes....
T he financial crisis in US has till now witnessed
the collapse of banking, investment and tech-
nology firms. But now this was the term of manufactur-
of directors and management team with a track record
in American manufacturing. They, and not the US govern-
ment, will call the shots and make the decisions about
ing sector. On 1st June 2009, US car giant General Motors, how to turn this company around.
having 100 years of strong legacy and presence in 140 GM was against the filing of bankruptcy protection
countries, filed for Chapter 11 bankruptcy. This was the considering two facts:
2nd consecutive collapse of auto giants in US since Chrys- • Fear of sales loss
ler filed for bankruptcy a month earlier.
• Fear that some form of their $170 billion debt will
Till March 6,2009 GM tried some restructuring not be wiped clean in a bankruptcy
plans until it was clear that it has to seek bankruptcy
Of course the company tried to improve its opera-
production. General Motors, which once held an iron clad
tions and reduce its liabilities via out-of-court settlement.
50% plus market share for the domestic car market has
An out of court process demonstrates the Company’s abil-
finally succumbed to the extraordinary pressure put on
ity to re-pay the U.S. Department of Treasury loans and
its balance sheet by unsustainable pension and health
to structure a viable business with a positive net present
care promises, benefits, and wages given to the unions
value, credibility with consumers and a competitive op-
over the years. Unable to compete with Japanese imports
erating and capital structure, while minimizing the risk
that had none of these expenses, the free market dealt a
that further financial reorganization will be required. GM
crushing blow to the giant over the course of the past
also felt that there was no assurance that the company
three decades. Reacting to this, DOW fell to the 12-years
will be able to exit out of the bankruptcy quickly. Lehm-
low on March 6,2009. One of the biggest names in the
an Brothers filed for Chapter 11 in September last year but
Dow Jones was about to become a penny stock trading at
is still stuck due to a dispute between Lehman’s Ameri-
$1.45 (with finally trading at 75 cents on 30th May, 2009).
can and British units over the distribution of assets. GM
The proposed plan consists of the deal with the is over 3 times bigger than Lehman and present in double
United Auto Workers which will allow GM to forgo a $10 the number of countries. The out-of-the court process
billion payment to a union healthcare fund in return for would have the best balance of rightsizing the company’s
a 17.5% stake in the new GM. Bondholders are also to be liability with preserving the value of enterprise. But the
given 10% of the new firm for debts totaling $27 billion. need of an unprecedented amount of debtor-in-posses-
The governments of America and Canada, will have 72.5% sion financing was needed which was not available with
of the new firm. traditional sources of funding. GM had no other option
Some of its global operations, for example, most of to accept government support by filing chapter 11 bank-
those in Asia, are run via independent companies that ruptcy. The hope now lies on how fast GM emerges out
continue to be solvent and in good financial shape. of the bankruptcy which will bring cheers to the manu-
US government is also acting as a reluctant share- facturing sector in the world scenario with Indian firm
holder as it doesn’t want to see a successive collapse of like Mahindra & Mahindra seeing opportunity in becom-
more manufacturing firms. The government has already ing a component supplier or a service supplier to GM, of
expressed its intention of selling out their shares as soon course post bankruptcy
as possible after GM emerges from bankruptcy. But it will
be difficult for America’s government to recouping the

By Amit Chowdhary
$50 billion so far sunk into GM.
But the government has expressed commitment to
the firm by saying that GM will be run by a private board IIM Shillong
Page 22

Niveshak Volume 2 Issue 5 June 2009

Is It A Failure of Market???
...Or That Of Policy???

Joseph Stiglitz: An Interview the proponents of the free market theory say. Market

J oseph E. Stiglitz was awarded with a Nobel prize failures are said to occur when the competitive equilib-
in economics for his pioneering research on mar- rium fails to achieve ‘Pareto efficiency’. Pareto efficiency
kets with asymmetric information, and his work helped is the state where one person can be made better off only
explain the circumstances in which markets would work by making the other person worse off. Thus the outcome
better with selective government intervention. In a re- achieved is far from the ‘preferred’ outcome. The pre-
cent interview with the mint, he commented that the ferred outcome is on the basis of Pareto efficiency and on
measures necessary to get out of the present economic distributional equity considerations. A perfectly competi-
turmoil are not yet been taken; and that Obama assuming tive market is Pareto efficient.
presidency and implementing policy measures is awaited. Reasons For Market Failure
He turns to India and says that the growth story lies con- The reasons for market failures are:
siderably in the hands of the government. There is a large 1. Externalities: The classical definition of externali-
need for the provision of public goods, especially in the ties is that there are some non monetary effects (costs or
infrastructure space which requires massive government benefits) which are not taken into account in the deci-
expenditure and in turn a revisit of the tax structure. sion making process (Baumol).
Competitive Equilibrium & Efficiency 2. Public Goods: Goods are said to be rival when a
Most of the economic theory is based on the free unit of a good consumed by one person cannot also be
market system. In the context of competitive markets, consumed by another person. They are said to be exclud-
there is a balance between the demand and supply of able when a person who does not pay for a good can be
the different goods and services in the economy. Further, excluded from its consumption. When it comes to provi-
the competitive equilibrium is also an efficient one (Pa- sion of public goods, markets usually fail due to the
reto efficiency) and this is known as the ‘First Fundamen- above two element
tal Theorem of Welfare Economics’. This is based on the 3. Imperfect Competition and Natural Monopolies:
existence of perfect information about prices. Not only While in a competitive equilibrium, a producer equated
will competitive markets lead to an efficient outcome, price to the marginal cost, in an imperfect competition,
but any efficient outcome that one might desire can be the producer equates marginal revenue to marginal cost,
attained through the operation of competitive markets. and price is greater than the marginal cost.
This is known as the ‘Second Fundamental Theorem of
4. Information asymmetries: It refers to the fact
Welfare Economics’. Thus, if one efficient outcome is not
that the buyer and the seller of the commodity may have
desirable due to, say, inequities involved in it, there is
different amounts of information about that commod-
another competitive equilibrium which can be attained.
ity’s attributes.
Hence the government does not have much of a role. The
only acceptable role that can be seen arises from the Sec- 5. Equity Considerations: The fact that the economy
ond Fundamental Theorem and that is of redistribution is Pareto efficient says nothing about the income distri-
to resolve inequalities. bution. Markets may result in an unequal distribution
of income leaving some individuals with very high and
Market Failure
some with very low amount of resources.
Most of the production in Industrialized economies
6. Merit Goods: Even in a Pareto efficient economy,
is out of private production. The drive for profit on the
part of the entrepreneur and the competition prevailing the individual might not act in his own best interests.
leads to high degree of efficiency and also gave spur to Individuals may smoke even thought they know it is bad
innovation. for them. This is known as the paternalism as against lib-
ertarianism which requires governments not to interfere
However, the market does not work as perfectly as in deciding the preferences of the public.
Page 22

© The Finance Club, Indian Institute of Management, Shillong

Government Intervention As The on subprime mortgages. The causes of the bubble were
Approach To Market Failure the extremely low interest rates maintained by the Fed,
and these were kept low despite the inflation pressures
Most economists have attributed the present finan-
(there was too much money chasing too few goods). It
cial turmoil to inadequate government regulation. And
was expected that the Fed would bail out troubles finan-
this story is not just of today, when the Enron scandal
cial firms (“Greenspan Push”). Further, there was govern-
eroded confidence in America’s financial markets and ac-
ment support to the Freddie Mac and Fannie Mae, the
counting firms, there was a demand for stronger regula-
two huge corporations which backed more than half of
tion to restore confidence.
the mortgages outstanding in the US. There was also po-
So how can government intervention overcome litical pressure on banks to lend in the name of ‘afford-
market failure? Some of the forms it can take are: able housing’. Thus, when markets fail (as in did in the
• Regulation great depression of the 1930s), government is not always
• Taxes & Subsidies the best answer; in fact it might to more harm than good.
• Environment Regulations The Market Element:
• Provision of public goods Does this however mean that the banks and finan-
• Monopolies cial institutions were not to be blamed? Worldwide, peo-
Government Failure ple attribute the turmoil to the failure of capitalism and
the advent of globalization. Martin Wolf, chief econom-
We say that market failures occur when the com-
ics commentator at the Financial Times, announced the
petitive system is unable to deliver a Pareto Efficient
death of the dream of global free-market capitalism in
outcome, similarly a non market failure or government
March 2008; Economist Robert Shiller advocated robust
failure occurs when the state fails to achieve the Pareto
government intervention to tackle the financial crises.
efficient outcome.
A series of major bail outs was seen (including the
It is usually difficult to measure the goods provid-
U.S. government’s decision to nationalize Fannie Mae and
ed by non market institutions. For instance, how do you
Freddie Mac). In October, the British Chancellor of the
measure the impact of the environmental regulations
Exchequer referred to Keynes as he announced plans for
imposed, or the students taught under the government
substantial fiscal stimulus to head off the worst effects
education system, or the benefits provided by the state
of recession, in accordance with Keynesian economic
health service because the evidence of output quality
thought. Similar policies have been announced in other
is missing Further, In a non-market setup, it is usually
European countries, by the U.S., and by China.
one or very few agents that provide the good or service.
The absence of competition not only adds to difficulty in Market And Non Market Failure In The
evaluating the quality of the product, but adds to inef- Financial Services Sector
ficiencies as well. How do we discuss the concept of market and non
Reasons For Government Failure: market failures when it comes to the financial services
1. Internalities and private goals sector? The most common problem that arises is of in-
formation asymmetry. As a result of which, this industry
2. Redundant and Rising Costs
is highly regulated. In India the regulatory authority is
3. Derived externalities SEBI, RBI and the Stock Exchanges. Banks are not allowed
4. Distributional Inequities to engage in insider trading. In many investment banks,
5. Agency Problems there is a ‘Chinese wall’ between the research depart-
6. Information Asymmetry ment and the corporate finance/M&A/equities and debt
trading departments, so that the output of research ana-
The Present Financial Turmoil: lysts is not affected by the deals under execution in the
Market Or Policy Failure? company. When the Enron scandal burst, the regulators
The Great Depression of 1930’ was a major con- enforced the Sarbanes Oxley Act for adequate disclosure.
sequence of market failure, which paved the way for The ‘Basel norms’ is also a step of intense government
Keynesian economics emphasizing the role of the govern- intervention to overcome market failures.
ment. He advocated interventionist government policy,
One of the concerns about the sub-prime mortgage
by which the government uses tolls of fiscal and mon-
crisis is that it would have been less severe had legis-
etary policy to mitigate the adverse effects of recessions,
lation or regulations to restrict predatory lending been
depressions and booms. The East Asian Crisis was largely
adopted. At the time, some argued that the loose lend-
due to faulty government policies of maintaining fixed
ing standards would enable more individuals to become
and overvalued exchange rates and controls on capital
homeowners. But it should have been clear that giving
flows. Now when we are seeing another major global
a loan to someone beyond their capacity to pay was not
recession, which is to blame - The Market mechanism or

By Abhinav Chugh & Nidhi Kai cker
the government institutions?
The Government Element:
The present turmoil all began with the bursting
of the US Housing bubble and the high default rates FMS, Delhi
Page 22

Niveshak Volume 2 Issue 5 June 2009

How Well You know Wall-Street

1. What was the first listed company on the
New York Stock Exchange?

2. What is the highest priced share on the
New York Stock Exchange?

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

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

5. When did the New York Stock Exchange
first introduce the stock ticker?

6. Oldest commodities exchanges in the US?

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

8. When did the Dow Jones Industrial Average first close
over 10,000?

9. What was the original name of the American Stock
Exchange and why?

10. The first official mutual fund of Wall Street?

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

© The Finance Club, Indian Institute of Management, Shillong
Team niveshaK

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

Fin-Q Winner for Last issue
Ms. Shakshi Gupta of IIM Shillong. She receives a cash prize of Rs.500/-

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

Please send your articles before 10th July 2009 to Do
mention your name, institute name and batch with your article.
Format: Font:- Times New Roman, Size:- 12, Length <= 5 Pages in word doc/docx.
Please DO NOT send PDF files and Kindly stick to the format.
Number of authors 2 at max.

Drop a mail at

Team Niveshak
Page 22

Niveshak Volume 2 Issue 5 June 2009
Finance Club
Indian Institute of Management, Shillong
Mayurbhanj Complex,Nongthymmai
Shillong- 793014