Why we cannot do without the foreign

exchange market
In large foreign exchange transactions, no physical exchange of currencies
takes place, Jinny tells Johnny
Markets run our daily lives. We cannot live without them. What would our lives be like if there
were no markets for, say, fruits or vegetables? Our friend Johnny agrees that markets play a role
in making our lives more comfortable. But he is not sure how different markets actually work.
One morning, he is busy thinking about one of the most complicated markets: the foreign
exchange market. He has no idea how the foreign exchange market operates and so, as usual,
he asks his trusted friend, Jinny.
Johnny: Sometimes, even the most obvious things seem so confusing. A few weeks ago, you
talked about raining dollars causing a problem of plenty for our economy. I was just wondering
why the foreign exchange market exists at all. Can’t we do without one? If there was no foreign
exchange market, there would be no problem of inflows or outflows causing rise and fall in the
exchange rate of the rupee, right?
Jinny: Wrong. Have you tried to imagine what our lives would be like if there was no foreign
exchange market? Let us first try to understand why the foreign exchange market exists. You
may be aware that each country has its own domestic currency, which serves as a medium of
exchange within its domestic market. You purchase fruits and vegetables and pay your vendor
the price in terms of the Indian rupee. But, suppose you want to purchase a shirt made in the
US. How would you pay for that? Your Indian rupees can’t be used as a medium of exchange in
the US market. The seller in the US will let you purchase only if you pay the price in terms of his
domestic currency, that is, the US dollar. So, you will now have to exchange your Indian rupees
for US dollars. You can exchange one currency for the other only if there is a foreign exchange
market. If there were no such market, all our foreign trade, travel and business would come to a
halt. Imagine what it would be like if you were to barter shiploads of your goods for shiploads of
goods from another country. This is how your foreign trade would work if there was no market
for foreign exchange.
Johnny: But, how exactly does the exchange of one currency for the other take place in a
foreign exchange market?
Jinny: Well, small transactions by individuals take place face to face. You might have seen a
foreign tourist approaching an authorized moneychanger with his domestic currency for changing
it to the domestic currency. In such small transactions, the physical exchange of one currency
with the other takes place.
However, large foreign exchange transactions by importers or exporters, or by different firms,
governments and central banks take place through banking channels. In such large transactions,
no physical exchange of currencies takes place.
Johnny: What? No physical transfer? Then how does the trading in the foreign exchange market
take place?
Jinny: There can be two types of participants in the foreign exchange market: retail and
wholesale. Retail participants are mainly individuals, importers, exporters and firms that may
require foreign exchange for their own use. Retail customers do not directly trade in the foreign
exchange market. Instead, they purchase and sell foreign exchange mainly through wholesale
participants such as commercial banks and financial institutions. Actual trading in the foreign
exchange market takes place between different wholesale participants. There are also foreign
exchange brokers and agents who act as market intermediaries.
Let us understand how the wholesale participants trade in the market: Suppose your bank is
interested in purchasing US dollars and someother foreign bank is interested in purchasing
Indian rupees. Both the banks can directly talk over the phone or through any other electronic
means for exchanging rupees with dollars.
Johnny: What will happen if the banks are not directly in touch with each other?
Jinny: In that case, they can approach foreign exchange brokers or dealers. These
intermediaries play a very important role in bringing the buyers and the sellers together. All the
participants in the foreign exchange market—such as buyers and sellers, and dealers and
brokers—keep on obtaining exchange rate quotes from each other. These foreign exchange
transactions between the wholesale participants involve huge amounts of money. It would be
very cumbersome if you were required to make physical delivery of one paper currency for
exchanging it with another paper currency. So, the transactions are completed only through
debit and credit of accounts.
That is, in case you are purchasing dollars, the foreign bank will make arrangements for getting
your account credited with the dollars. You, in turn, will ensure that the account of the foreign
bank is credited with the rupees. How many rupees are exchanged for how many dollars
depends upon the exchange rate of the two currencies.
Johnny: Exchange rate? How is that decided?
Jinny: Good question! Let it be your food for thought till we meet next week.
What:The foreign exchange market is the largest financial market in the world.
Who: The main participants in the foreign exchange market are individuals, firms, foreign
exchange brokers/dealers, commercial banks, central banks and governments.
Why: We need the foreign exchange market for carrying out transactions denominated in
different currencies.
How much: According to the Bank of International Settlements triennial survey 2007, the
average daily global turnover of the foreign exchange market is around $3.2 trillion (Rs125.76
trillion).
 

What determines the exchange rate of

one currency against another?
There are mainly three kinds of exchange rate regimes that determine how a
country manages the exchange rate of its domestic currency against another
currency, Jinny tells Johnny
Comparing the strength of two different currencies in terms of their exchange rates can be more
difficult than comparing the strength of two sumo wrestlers. What determines the exchange rate
of one currency against the other? Is it their looks? Or the size of their paper? Today, our friend
Johnny tries to understand from Jinny how the exchange rates of two different currencies work.

Johnny: Hi Jinny! Last week you didn’t tell me how the exchange rates work. I hope today you
will clarify.

Jinny: Of course! Let’s try to understand how exchange rates work. The exchange rate of a
currency tells you how much of one currency you can get for another currency.

There areԝmainly three kinds of exchange rate regimes that determine how a country manages
the exchange rate of its domestic currency against another currency. The first is the pegged or
fixed exchange rate regime in which the exchange takes place at a fixed rate. The second is the
floating exchange rate regime in which the exchange rate is determined purely by the market
forces of demand and supply. And, the third is the pegged float rate or “managed float” regime,
which is a mix of fixed and floating rate systems. Under the managed float system, the central
bank first decides the target range or band of the exchange rate and then tries to prevent the
currency from deviating too much from the target range by managing the demand and supply.

Johnny: Three types of exchange rate regimes! Tell me first how the fixed exchange rate
system works.

Jinny: In a fixed exchange rate system, the central bank or the government determines the
value at which the exchange of domestic currency against another currency will take place. This
could be done by several methods. One method that became popular as the “gold standard” uses
gold to back up the value of the currency. This method was used by many countries for fixing the
exchange rate of their currency before World War I. In this system, the central bank keeps gold
reserves for backing up its domestic currency. This means that any holder of the currency can
exchange the paper currency for a prefixed amount of gold kept with the central bank. So, if we
assume for the sake of simplicity that one Indian rupee is worth 1gm of gold and one US dollar is
worth 40gm of gold, then you can maintain a fixed exchange rate of 40 Indian rupees for one US
dollar under the gold standard.

But the gold standard can work only if you continuously maintain the value of your domestic
currency in terms of gold by keeping gold reserves. If you fail to do so, your exchange rate will
collapse. For this reason, the Bretton Woods system after World War II tried to use a modified
version of the gold standard.

Johnny: Bretton Woods system? What’s that?

Jinny: I will try and explain it in brief. Under this system, all participating countries kept US
dollars as reserves instead of gold. This system required the US to back up its dollars with
reserves of gold. The dollar was linked with gold at the rate of 35 dollars per ounce of gold. This
meant that you could exchange your reserves of 35 dollars with one ounce of gold any time from
the American central bank. So keeping reserves of US dollars was as good as keeping reserves of
gold. You fixed the exchange rate in terms of US dollars on the basis of how much dollar
reserves you were maintaining. But this system failed in the 1970s when the US was unable to
sustain the value of its currency with gold reserves. After all this, many countries prefer simply
using the currency reserves method for maintaining fixed exchange rates.

Johnny: And how does that work?

Jinny: In the currency reserve system, instead of keeping gold reserves or dollar reserves, you
simply keep the reserves of any foreign currency against which you want to fix your exchange
rate. Say, for instance, that you want to maintain an exchange rate of 40 Indian rupees for one
US dollar. Then you need to keep a reserve of one US dollar for every 40 Indian rupees so that
your reserve is sufficient to convert all your domestic currency into foreign currency at the fixed
rate. In other words, if we suppose that your total domestic currency is worth Rs4 trillion, that is,
Rs4,000 billion, then you need to maintain a reserve of $100 billion. Your central bank must
have sufficient reserves to manage the demand and supply of the two currencies.

Johnny: I was just wondering, why go to so much trouble? Can’t we simply fix the exchange
rate by a diktat?

Jinny: That’s an interesting question. But I want you to apply your own mind. If you are unable
to find the answer, you can always ask me...

What: Exchange rate determines how much of one currency can be exchanged for another
currency.

How: Exchange rate could be determined by one of the three kinds of systems—fixed, floating
and managed floating exchange rate systems.

Who: In case of floating exchange rate, demand and supply decide the exchange rate; in case of
fixed or managed float, the government or the central bank decides the rate.
How do firms determine share price
for an IPO?
The issuer companies have two options for fixing the price, they can either
fix the price themselves or they can let the investors determine it
In stock markets, numbers speak louder than words. Whether it is quarterly results of companies
or price discovery mechanisms in an initial public offering (IPO), numbers are our trusted
signposts. But numbers don’t fall from the sky. There are well-known price discovery
mechanisms in case of an IPO. Our friend Johnny thinks that one should clearly understand these
mechanisms before investing in IPOs. So let’s try to understand how the book-building price
discovery method is different from the fixed-price method.

Johnny: How is the price discovered during IPOs?

Jinny: Well, discovery of price in an IPO is both a science and an art. The issuer companies have
two options for fixing the price. They can either fix the price themselves or they can let the
investors determine it. The first method, in which the company itself fixes the price, is known as
the fixed-price method and the second, in which investors determine the price, is known as the
book-building method. It is important to keep in mind that even in the fixed-price method, the
prices are not determined randomly and the company has to disclose all the quantitative and
qualitative factors that justify the fixed price.

But the fixed-price method has one drawback. It does not take into account investor demand
into price discovery. If you want to sell a piece of gold at its intrinsic value but there is no
demand in the market, your piece of gold will not be able to fetch that price. Fixed-price issues
also face a similar problem. The issuers arrive at the fixed price after taking into consideration
the reasonable value of their company but if there is no demand in the market, the shares will
fail to generate subscription. In the opposite scenario, if the demand in the market is high, the
price fixed by the issuer may not reflect the true market value and the shares may get sold at a
low price. To overcome these kinds of problems, issuers use the book-building method. It helps
in matching the price of shares with the demand.

Johnny: How does the book-building method work?

Jinny: In the book-building method, the issuers indicate either a floor price or a price band
within which the investors can place their bids. For executing the whole process, the issuers
appoint the lead merchant banker as a book runner. The book runner appoints syndicate
members who collect bids from investors. Both retail and institutional investors can take part in
the bid. The bids received from investors are recorded in a book in electronic form. The book
runner, in consultation with the issuer company, evaluates the bids and decides the final price,
which is also known as the cut-off price. The cut-off price is the price at which the demand for
the shares meets the price. In case your bid is below the cut-off price, you will not receive any
allotment.

However, you can avoid this situation by submitting your bid without indicating any price. You
have to simply indicate in your bid that you are ready to accept the offer of shares at whatever
cut-off price the company fixes in the book-building process. This option is available only to retail
investors and most of them submit their bid at the cut-off price.

Johnny: That’s interesting, Jinny. If all investors start submitting their bid at the cut-off price,
the price discovery would become a discovery without surprise.

 
Leverage gives you extra power
Leveraging is all about putting the right force at the right position through a
lever
Who says there are no free lunches? You just need the skill of pulling the right lever at the right
time. Take the case of our friend Johnny. Whenever he invites a new friend for lunch, he ensures
that one of his old friends also comes along. The new friend enjoys the free lunch and thanks
Johnny whereas the old friend pays the bill. A day will come when this lunch table will complete a
full circle and this new friend will be paying for the lunch of some other new friend of Johnny. But
Johnny, who brings the old and new friends together, will always enjoy a free lunch. Johnny is
leveraging a free lunch out of his networking skills to his advantage. But what Johnny is doing is
pretty small compared with what others are doing with leveraged money in the financial
markets.

Johnny: Leverage? I have read this term so many times in so many articles in Mint but I really
do not know what it means.

Jinny: Well, you might have heard about using a lever to lift weight by employing minimum
force.

How does a lever work? If you have to budge a heavy stone, you simply use a long stick as a
lever through a supporting point. If your lever is positioned correctly, you can budge even a
heavy stone by using minimum force. So leveraging is all about putting the right force at the
right position through a lever. In business and finance also, leverage seeks to achieve the same
objective. It enables you to enhance your financial force by using the lever of borrowed money.
In other words, the term leverage signifies the extent to which you are able to use borrowed
money for your business. You have only Rs100 in your pocket but you are able to borrow
Rs1,000 more from others. How are you able to do that?

Well, you show your Rs100 to Peter and ask him to lend you Rs100 more. Now you have Rs200
in your pocket, which you show to Paul to borrow Rs200 more. In this manner, you just keep on
borrowing. Anyone who is able to borrow many times more than his own money is called highly
leveraged.
Johnny: But I am not able to understand whether leverage is good, bad or ugly for the financial
markets.
Jinny: Leverage gives you extra power. If you had only Rs100 in your pocket, without leverage,
you would have ended using Rs100 only. Now you have extra cash, which you can use to
increase your profit. But too much of anything is bad. Applying too much force on a stick to lift a
heavy stone can sometimes break the stick. Similarly, too much of financial leverage can also
put a company on the door of bankruptcy.

If your business is not able to generate enough profit, how are you going to pay back your
lenders? So, leverage can work in both ways. It can increase your gains many times but it can
also cause a heavy loss. Maintaining a proper balance between what you borrow and what you
own is always necessary.

Johnny: That’s true. But tell me, how does leverage work in the case of derivative instruments?
Jinny: You can use derivative instruments for getting leverage in the financial markets. Let us
try to understand this through an example. Suppose you have Rs1,000, which you want to invest
for a month in the stock market. Suppose you want to purchase the stocks of a company, which
is presently trading at a price of Rs10 per share in the spot market.

If you purchase the shares directly from the spot market, you can purchase only 100 shares. But
take a look at another strategy. Instead of purchasing the shares from the spot market, you
purchase one-month futures contracts of the same shares at the future price of, say, Rs12 per
share.

For entering into a futures contract, you are not required to pay the whole future price of the
shares. You only pay the initial margin money and marked-to-market margin on a day-to-day
basis. Initial margin is what you pay upfront and marked-to-market margin is what you pay on
the day-to-day value of your derivative contract.

If your broker is taking 10% as initial margin money, your Rs1,000 will fetch you shares worth
Rs10,000. Even at a future price of, say, Rs12 per share, which is higher than the spot price, you
would end up controlling more than 800 shares by following this strategy.

By using derivatives, you can earn a profit or suffer a loss, many times more than what you
could have earned or lost by trading with the same amount of money in the spot market. This is
how leverage through derivatives works.

Johnny: Thanks, Jinny, for telling me all this. I just remembered that I have invited some of my
friends for lunch today. So, I will leave now. Bye.

What:The use of borrowed money for enhancing return on investment in business and finance is
known as leverage. A company with more debt than equity is called highly leveraged.

Why: Leverage increases the potential for heavy profit but it also increases the potential for
heavy loss.

Why not: Too much leverage can cause financial instability or even bankruptcy if the business is
not able to generate enough profit.
Everyone has heard of simple interest,
but what is open interest?
A rising open interest number indicates that the present trend is likely to
continue
Stock markets are known for their random progress. Sometimes they move up, sometimes they
move down and sometimes they even move sideways. But intelligent investors always keep
looking for different cues to overcome the randomness. The futures and options market provides
many indicators about market expectations. One such handy indicator is the open interest
number in the futures and options market. But for our friend Johnny, the term open interest, far
from being an indicator, is a source of confusion. The problem is that he does not even know
what the term “open interest” means. Today, as usual, he is taking the help of Jinny.
Johnny: I have heard about simple interest, compound interest and even penal interest. But
what is this open interest?
Jinny: Open interest has nothing to do with the types of interest rates you have heard about.
People generally get confused between trading volume and open interest in the futures and
options market. Open interest simply means all the outstanding futures or options contracts that
have not yet been exercised or squared off, expired or fulfilled by delivery. Each transaction will
be a part of trading volume but may not lead to increase or decrease of open interest.

Johnny: What? How so?

Jinny: Okay, let’s try to understand how it is so. Suppose you are buying a single call option
from me. Your buying a single call stock option will result in a single contract of call option in
which you acquire the right to purchase and I get obliged to sell the underlying stock. This
transaction will create one trading volume and one open interest in the market. Both your right
and my obligation form part of the same transaction and hence, a single call option contract
would lead to single open interest in the market. You and I may square off our respective
positions by entering into opposite contracts with someone else. For instance, you may square
off your position by selling a call option and I may square off by purchasing a call option with a
third party. These transactions will lead to an increase in trading volume. But will it change the
position of the open interest in the market? No, because our squaring off with the third party
merely brings someone else into our shoes. No separate rights and obligations are created. New
parties will assume our existing rights and obligations under the contract. So the open interest of
the market would continue to be the same. However, the number of options left open in the
market would rise in case one new buyer enters into a derivative contract with one new seller. In
that case, new rights and obligations come into existence.

Johnny: Then what leads to a fall in the open interest number?

Jinny: The number of options left open would fall in case you settle your derivative contract
either by cash or physical delivery at the expiry date. In either case, the derivative contract
comes to an end leading to a decrease in open interest. Further, options contracts automatically
come to an end at the expiry date if the party purchasing the option fails to exercise its right.
There can be a fall in open interest before the expiry date in case parties square off by entering
into an opposite contract with each other. If I had earlier sold you an option contract, I can
square off by purchasing an option contract from you. Entering into opposite contracts will
extinguish our mutual rights and obligations.

Johnny: Future trends? How can open interest tell us about that?

Jinny: Well, you can use the rise or fall in the open interest number as an indicator of the future
expectations of the market. A rising open interest number indicates that the present trend is
likely to continue. If the open interest number is stagnant, then it means that the market is in a
wait-and-watch mode. If it starts declining, then the market is clearly in a trend reversal mood.
In a rising market, continuous decline of open interest indicates an expectation of downward
movement. Similarly, in a falling market, the decline of open interest indicates that the market
expects an upward trend. But all said and done, trends in the futures and options market are all
future expectations only, and like the performance of the Indian cricket team, expectations may
go wrong anytime.

Johnny: Yes, Jinny, there is always a possibility of getting fooled by randomness.

What:Open interest means all the outstanding futures or options contracts that have not yet
been exercised or squared off, expired or fulfilled by delivery.

How: The number of open interest in the market rises in case one new buyer enters into a
derivative contract with one new seller.

When: If the number of open interest is rising, it indicates that the present market trend is likely
to continue. If the number of open interest is declining, the market is likely to be in a trend
reversal mood
What causes credit crunch in financial
markets?
Credit crunch is a situation in which the wheel of lending gets jammed
leading to a sudden decline in lending, that is, credit
Ladies and gentlemen! Welcome to the Real Simple Best News of the Year award ceremony. We
are assembled here to assess people and events in the financial world that kept us engaged for
the whole year. And now, this year’s award for the Best Financial Evangelist goes to Mervyn
King, governor of the Bank of England, for raising the flag of moral hazard just before a bank
run. The Most Sensational News award goes to “credit crunch” for creating a fire after the storm.
And the award for the Best Firefighter of financial market goes to...

Jinny: Wake up Johnny! In which world are you lost?

Johnny: Ah! You spoiled my dream. I was the chief guest at the best news of the year awards.
“Credit crunch” won the award for the most sensational financial news. They were just going to
announce the award for the best firefighter of the financial market.
Jinny: I’m sorry! But you can go back to sleep and finish the dream. What’s the problem?
Johnny: The problem is now yours. You have to pay a penalty for spoiling my dream at the
wrong time. Before I go to sleep again, you will have to tell me about a few basic things. First
tell me, what exactly is “credit crunch”?

Jinny: As you may be aware, our credit market runs on two wheels. One wheel is borrowing and
the other is lending. Credit crunch is a situation in which the wheel of lending gets jammed
leading to a sudden decline in lending, that is, credit. This situation will automatically jam the
other wheel. So if there is a credit crunch, borrowers are not able to find lenders. And even if
they find them, the credit is available at unusually high interest rates. “Credit crunch” could
happen due to many reasons, including an increased perception of risk on the part of lenders,
imposition of credit controls or a sharp restriction in money supply. Increase in risk perception
causes the worst kind of credit crunch. When the lenders are not sure about the creditworthiness
of borrowers, there is an increase in the risk perception. This makes lenders nervous and they
stop lending. When one of your wheels is in a rut, you can’t expect the other wheel to keep on
moving. As a result, the flow of credit comes to a grinding halt.

Johnny: What causes lenders to doubt the creditworthiness of borrowers?

Jinny: Lenders doubt the creditworthiness of borrowers when they are not sure about getting
their money back. The memory of recent defaults adds fuel to suspicion, and lenders become
reluctant to lend. You may think that the lenders can
demand high interest rates for taking a risk and part with their cash. The problem, however, is
that it is difficult to set a price for risk when you are uncertain about the likely loss. This is how
the defaults of “subprime mortgages” in the US started a fear of the werewolf in the financial
markets this year. Lenders were not sure when their borrowers would turn into werewolves.
Small depositors started lining up outside their banks. Even banks started fearing each other,
which led to the worst kind of credit crunch seen in the inter-bank markets. This kind of fear and
uncertainty is a perfect recipe for credit crunch.
Johnny: Tell me, what can happen if credit crunch persists for long?

Jinny: A credit crunch affects not only borrowers and lenders but also our financial markets and
the economy. With the onset of credit crunch, interest rates shoot up. But even high rates may
fail to bring lenders to the market. High interest rates put a brake on new investments and
consumer demands, which may ultimately slow economic growth. New deals are scrapped due to
lack of credit. Leveraged borrowers take the heaviest blow. Lenders may start demanding their
money back. Even sound borrowers may default due to sudden demand for repayment. This can
surely set the financial markets on fire.

Johnny: If there is a fire, there must be a firefighter around. Tell me, who takes care of a fire of
this kind?

Jinny: That’s an interesting question. There is indeed a firefighter, known around the world as a
“lender of last resort”. But I will tell you about him some other time. Meanwhile, you can make
your plans for New Year’s party.

What:Non-availability of credit to the borrowers at a reasonable cost is known as credit crunch.

Why: Doubts about the creditworthiness of borrowers, imposition of capital controls and lack of
liquidity are some of the reasons that may cause credit crunch.

Whom: Credit crunch can affect the whole economy by slowing new investments and consumer
demands.
What are the predominant risks in
currency carry trade?
Currency carry trade has two major risks: the interest rate risk and the
exchange rate risk
Financial markets are like oceans. When the tide is low, you enjoy the flow. But when the tide is
rough, sailing gets tough. Few know this better than carry traders. Their lives start on one tide
and end on another. In between the rise and fall of tides, numerous questions arise. How does
carry trade work? What are the risks? These questions leave our friend Johnny clueless. But
there is no need to worry when Jinny is around.

Jinny: Hi Johnny! Nice to see you. But why are you playing ping-pong today?

Johnny: Jinny, I was thinking of doing the great ping-pong ball experiment for the financial
markets. Even big ships sometimes can’t survive the rough tide, but a simple ping-pong ball can
float long distances without any problem. Can’t we have something like a ping-pong ball for the
financial markets that can keep on floating come what may?

Jinny: Sounds interesting. What is making you so thoughtful today?

Johnny: I was just wondering what inspires carry traders to take risks when they know they
may sink if the tide turns.

Jinny: Well, it is very tempting to jump in the waters when you see easy money flowing around.

In financial markets, carry trade is like fishing for the flowing money. Its working looks so simple
that you could say, “Wow! I can do it too.” But how? The answer is pretty straightforward; you
borrow at a low rate and invest that money in a high-yielding investment. Is that all? Yes, that’s
it.

I will give you an example of a simple carry trade. If the short-term interest rate is less and
long-term interest rate is high, you borrow money for the short term and lend the same for the
long term. But there is one problem. You would be required to repay your short term borrowing
much before you receive repayment from your long term borrower. What would you do? You
again borrow for the short term and repay your earlier loan. In this manner you keep your boat
sailing. But the problem is that any rise in short term interest rates can sink your boat.If you are
ready, we can now move on to a more advanced version of carry trade, popularly known as the
currency carry trade, that takes place in the foreign exchange markets.

Johnny: Sure, go ahead.

Jinny: Currency carry trade works on the basis of interest rate differentials of two currencies.
Many factors decide what would be the interest rates for a debt denominated in a particular
currency. Similarly, many factors decide what would be the exchange rate of one currency
against another. For doing carry trade, you borrow the currency which is available at a lower
interest rate and convert the same into the currency which is available at a higher interest rate.
By doing so, you can invest your money in the debt instruments of the currency carrying a
higher interest rate. In this manner, you pay less interest on your loan and get high interest on
your investments. This is how currency carry trade works. Currency carry trade is a type of
interest rate arbitrage. If you are borrowing Japanese yen to purchase some other currency,
then it is called “yen carry trade”. But remember, unlike risk-free profits in other arbitrage
opportunities, currency carry trades face many risks.

Johnny: Really? What are the risks?

Jinny: There are two predominant risks. The first is interest rate risk and the second is exchange
rate risk.

If the interest rate of the currency that you have borrowed increases, then the gap between the
interest rate of the currency that you borrowed and the currency that you have invested will get
narrowed. This will reduce your profit margin.

Similarly, the exchange rate of the two currencies also plays a major role. If the currency you
have borrowed appreciates, your debt liability increases, and if it depreciates, your debt liability
decreases. So you make a profit when your borrowed currency depreciates and you suffer a loss
when the borrowed currency appreciates.

Johnny: This puzzle of appreciation and depreciation is a bit confusing. Please explain this with
an example.

Jinny: Okay, let’s put it this way. Suppose you borrow Rs5,000 and get this amount converted
into $100 at the rate of Rs50 for a dollar. Suppose, after two years you have to repay your debt,
for which you will require to convert your dollars into rupees. During these two years, suppose
the rupee has appreciated and the exchange rate has become Rs25 to the dollar. At this rate,
you would require $200 to purchase Rs5,000. But suppose the rupee depreciates and the
exchange rate has become Rs100 for a dollar. Then you would require only $50 to purchase
Rs5,000. I think the arithmetic of profit and loss is now clear to you.

Johnny: Yes Jinny. I now also understand what makes a ping-pong ball safer than carry trades.

IN A NUTSHELL:

What:Borrowing one currency at low interest rate for purchasing another currency paying high
interest rate is called currency carry trade.

How: Traders earn profit by taking advantage of difference in interest rates of the two
currencies.

Why: Any adverse movement of interest rates or exchange rates may bring about unwinding of
currency carry trades.
How do companies raise money
through initial public offerings?
A public company must have a minimum of seven owners but there is no
restriction on the maximum number
Can you imagine our movie theatres without any movies or our newspapers without any news?
What would it be like to go to a theatre just to eat popcorn and to purchase a newspaper only to
wrap up old shoes? Sounds ridiculous? Now try to imagine the existence of our stock markets
without initial public offerings (IPOs). Can our stock markets exist without them? Sounds a bit
confusing. Maybe our friends Jinny and Johnny can enlighten us about the role IPOs play in the
stock markets.

Johnny: Santa Claus, Santa Claus where have you been? I’ve waited one whole year to get a
trash bin!
Jinny: What happened Johnny? Why are you talking to yourself?
Johnny: I am complaining to Santa Claus for bringing a trash bin as this year’s Christmas gift. It
seems he is running short of money. We may very well see him coming out with an IPO. What do
you say?

Jinny: But what makes you think that anybody running short of money can come out with an
IPO? You really need to know a few basic things about IPOs.

Johnny: I’d be happy if you would explain them to me.

Jinny: You might have heard that there are two types of companies: public and private. Ever
wondered what’s the difference between the two? Well, a private company is formed by a small
group of individuals for carrying out their business. The ownership of a private company remains
confined to this group of individuals. Every owner of the company owns shares, which represent
his percentage of ownership of the firm. As per law, a private company can have a minimum of
two and a maximum of 50 owners. A public company must have a minimum of seven owners but
there is no restriction on the maximum number. These owners contribute the capital of the
company by purchasing its shares and take home whatever is their profit or loss. But, a company
may require more money than its owners bring in as capital. If you have 50 owners and each of
them contributes by purchasing 1,000 shares of Rs100 each, then you will have a capital of Rs50
lakh. But suppose tomorrow you need more money to expand your business. What options do
you have?
You can ask the owners to bring in more capital but beyond a limit, even that may not be
possible. You can also approach a bank or a financial institution for a loan. This can work to a
certain extent but taking a loan makes you liable to pay interest irrespective of what you earn.
Beyond a point, even taking a loan may not work. After all this, you may consider offering
ownership of your company to the public at large. But a private company can’t have more
owners than what has been prescribed by law. The option of offering ownership to the public is
only available to another class of company, which we call public companies. This entire process
of raising money by offering subscription of shares of the company for the first time to the public
is what we call initial public offerings or IPOs in short.
Johnny: I see! It seems an IPO enables a company to get its shares listed on the stock
exchange where further trading takes place. Right?

Jinny: That’s right. Now let’s move further. This IPO can be done either by making a fresh issue
of shares or by offering for sale the already existing shares or by a combination of both. Fresh
issue of shares helps in expanding the capital whereas the sale of already existing shares enables
the existing owner to dilute his shareholding. Once the company is listed after IPO, a follow-on
public offering can also be made by the company to raise more money from the market. The
company can also raise money by coming out with a rights issue. In a rights issue, new shares
are offered to the existing shareholders as on the record date in a particular ratio to the number
of shares already held. For instance, a ratio of one share for every five shares held will entitle a
shareholder having 10 shares to acquire two new shares. This method enables a company to
raise more money without diluting the stake of the existing shareholders.

Johnny: So, IPOs provide an easy way of raising money to all public companies.

Jinny: No. This alternative is available only to those companies that satisfy the eligibility criteria
laid down by the market regulator, in our case, the Securities and Exchange Board of India.

The eligibility norms ensure that only companies meeting the desired level of standing are able
to tap the market through IPOs. So the invitation is strictly on merit.

Johnny: Thanks Jinny. I will ask about the eligibility norms later. I think Santa is back. So, let’s
celebrate. Merry Christmas!

What:Initial public offerings (IPOs) enable public companies to raise money through public
subscription for the first time.

Where: After IPOs, companies get listed at stock exchanges where subsequent trading of shares
takes place.

How: Companies can raise further money after listing through follow-on public offerings and
rights issue.
What is purchasing power parity?
PPP theory assumes that identical goods and services must have the same
price in different markets when measured in a common currency
If a falling apple can teach Newton the law of gravity, the pricing of burgers can surely teach
Johnny the law of purchasing power parity (PPP). But, the problem is that the foreign exchange
market—the real testing ground for the law of PPP—is subject to many exceptions. So, unlike the
law of gravity working on a falling apple, you may observe the law of “reverse gravity” working
in the foreign exchange market. This is what makes the law stranger than the exceptions. It
would be interesting to see what the law of PPP talks about.

Jinny: Hi Johnny! What are you doing next Sunday? If you are free, can we go shopping?

Johnny: Shopping? No way. I will not go shopping till I find out why our markets are so
inefficient.

Jinny: What makes you think that our markets are inefficient?

Johnny: You may be aware about the principle of “one price”. It says that the same goods
should trade at the same price in different markets. But, that’s hardly the case. You may not
even find the same vegetables at the same price two blocks apart. What, then, to talk about
goods selling in different countries.

Jinny: You should understand that the theory of one price could work only if we ignored local
taxes and the cost of carrying goods from one market to another. Since ignoring taxes and
carrying costs is only possible in theory, the law of one price also works only in theory. Anyway,
this theory forms the basis for another interesting theory known as purchasing power parity
(PPP). I hope you are aware of it.

Johnny: I would be happy if you would tell me about it.

Jinny: A Swedish economist, Gustav Cassel, developed the theory of PPP. This theory works on
the assumption that our markets work on the law of one price. So, it assumes that identical
goods and services must have the same price in different markets when measured in a common
currency. If goods are not trading at the same price in two different currencies, then it means
that the purchasing power of the two currencies is different. You can very well use the price of
the same goods in different currencies compare their purchasing power. If a McDonald’s Big Mac
burger is selling at $1 in the US, and at Rs20 in India, then it means that one dollar is worth 20
rupees in terms of purchasing power.

On the basis of the difference in the price of burgers, we can arrive at the PPP of different
currencies. In fact, The Economist uses the price of the McDonald's Big Mac burger in different
countries to arrive at its “Big Mac Index”, which gives the exchange rate of different currencies in
terms of PPP.

Johnny: But people can’t live on burgers alone. What about other goods and services?

Jinny: I was coming to that. To arrive at a realistic PPP of one currency against another, you
need to carefully select a comparable basket of goods and services consumed in different
countries.
Getting a haircut in India may be cheaper than in the US. So you can truly assess the purchasing
power of the Indian rupee against the US dollar only when you compare a wider variety of goods
and services. But, the goods and services that you compare must be of the same quality. You
can’t compare a haircut in a deluxe salon in the US with a haircut by a roadside barber’s shop in
India.

In fact, choosing a comparable basket of goods and services is the most challenging task in
arriving at the PPP of different currencies.

Once you have a basket of comparable goods and services in hand, you need to just compare
the difference in prices in terms of different currencies to arrive at the value of PPP.

Johnny: I was wondering why there is a disparity in the value of currencies in terms of PPP and
the value of currencies in terms of their market exchange rate...

Jinny: Theoretically speaking, the value of currencies in terms of their market exchange rate
should converge with their value in terms of PPP, in the long run. But that may not happen due
to many reasons. For instance, some countries follow a fixed exchange rate system, which keeps
the exchange rate at a fixed level. Some follow the managed float system, in which the central
bank constantly tries to keep the exchange rate within a band. Even in countries where the free
float system prevails, the market exchange rate may not converge with the PPP rate owing to
many reasons.

As you know, the law of one price hardly works in many instances, making the calculation of the
true value of PPP difficult. Our basic assumption, that the difference in price is due to the
difference in purchasing power, may itself be only partially true. Who knows, pizzas may be
selling at a higher price in India due to the higher digestive power of Indians. So, you may see
lots of exceptions.

Johnny: Yeah. That’s what we call the law of reverse gravity in action.

What: Determination of the exchange rate of two currencies on the basis of their purchasing
power parity (PPP).

Who: Swedish economist Gustav Cassel developed the theory of PPP.

How: This theory compares the price of the same goods and services in different currencies to
calculate the PPP exchange rate of the currencies.
What is net asset value all about?
The present value of your assets depends upon the present market value of
the stocks in which your scheme has invested
Like many other things in life, the stock market works on the principle of survival of the fittest.
But our friend Johnny intends to discover a formula that could ensure the survival of the
dumbest. Last week, Jinny had told him how mutual funds provide professional management of
funds at an affordable cost. Even the dumbest guy can use the expertise of mutual funds to his
advantage. But before that, he needs to understand some of the technical terms most commonly
used in the market.
Johnny: Last week you really made me think that I could also ride the tide of the stock market
by making investments through mutual funds. But some of the technical terms are beyond my
understanding. For instance, what does the term “net asset value” or the NAV of a scheme
denote?
Jinny: If you ask an expert, he would simply say that the NAV of a scheme denotes the market
value of the assets of the scheme after subtracting all its liabilities. You may wonder what that
means. But before you ask about anything else, the expert will hasten to add that you can
calculate NAV per unit of your scheme by dividing the NAV of the scheme by the number of units
outstanding on the valuation date.

Johnny: With such an explanation, I will start having mental indigestion! Could you explain this
with an example?

Jinny: Very well then, let’s try to understand the concept of NAV by taking an example. Suppose
any scheme of a mutual fund initially offers 10 units at a face value of Rs10 each. The total
corpus mobilized under the scheme would thus be Rs100. Out of this Rs100, suppose Rs10 each
is invested in 10 different stocks. The value of the investment of your scheme in 10 different
stocks is what we know as the assets of your scheme. The present value of your assets depends
upon the present market value of the stocks in which your scheme has invested. Some of the
stocks may trade at a value higher than the purchase price, leading to a rise in your assets,
whereas some of the stocks may trade at a lower value, leading to a loss.

To arrive at the total market value of the assets of the scheme, you multiply the current market
price of a particular stock with the number of units of that stock in the portfolio. The sum total of
the market value of different stock portfolios, along with any dividend or income received, will
give you the total market value of your assets under a particular scheme. For arriving at the
NAV, you deduct the management fees and other expenses from the total market value of your
assets. This is how you arrive at the NAV of a particular scheme.

Johnny: What do you mean by “management fees” and “other expenses”?

Jinny: Mutual funds employ professional fund managers to look after your investments. Lots of
people, whom you will probably never meet, work day and night to make your investment grow.
All these people expect a reward for doing your job, which you pay in terms of management
fees. Further, mutual funds—like any other business enterprise—incur expenditures in the form
of telephone bills, rent for the office, and so on. Who will bear these expenses? Mutual funds are
running their shop for your benefit. So, apart from management fees, the mutual funds also
charge other expenses to you. The management fees and other expenses are deducted from the
value of your assets. Further, the funds can also levy an entry fee when you purchase a scheme
or an exit fee when you redeem your investment. The entry fee, in technical terms, is known as
front-end load and the exit fee is known as back-end load.

Johnny: Now what is this front-end load and back-end load all about?

Jinny: Front-end load is charged at the time of entry to pay the brokerage fee to the agent who
“advised” you to choose that particular mutual fund. Investors think they should not be the ones
to pay the piper. But, mutual funds take the money out of investors’ pockets in the name of
front-end load to pay the bill. Some funds ask you to pay the brokerage at the time you leave
their scheme, which is known as back-end load. The sooner you leave, the higher you pay.
Charging an entry or exit fee discourages non-serious investors. But, many funds do not charge
any front- or back-end load. So you should examine all the costs and benefits involved before
making any investment.

Johnny: That’s true, Jinny. One should not get blindly led by the piper.
Demat accounts: making physical
shares disappear
In dematerialization, physical shares are converted into securities in
electronic form, and the value of your holding is credited into your demat
account, just like physical money is converted into a deposit in a bank
account
Opening a demat account could be as simple as buying a doormat for your house. But to
some,opening a demat account may seem like crossing a big hurdle. Many questions crop up in
their minds. Our friend Johnny also has some doubts. Let’s see how Jinny answers him.

Johnny: I used to like the smell of physical share certificates. But it has become difficult to spot
them now. I wonder where they have disappeared. Is it the outcome of some sort of magic spell?

Jinny: Nothing to wonder about, actually. All your physical shares have got dematerialized. But
this is not a magic scene out of a Harry Potter sequel. Dematerialization of shares has a different
connotation from dematerialization of a witch.

In dematerialization of shares, your physical shares are converted into an equivalent number of
securities in electronic form, and the value of your holding is credited into your demat account. It
is just like a bank—taking your physical money as a deposit and crediting the value of the same
in your passbook. You remain the beneficial owner of your shares in demat account for all
practical purposes. But your depository becomes the registered owner.

Johnny: Registered owner? Beneficial owner? Depository? There are many questions in my mind
but, right now, I will ask only one. Tell me, how does the concept of registered owner and
beneficial owner actually work?

Jinny: You should not be confused about the concept of a registered owner and a beneficial
owner. Its working is fairly simple.

If you want to avail of the services of a depository, you have to open an account with a
depository, through a depository participant (DP). Before you get confused between depository
and DP, I want to tell you that a depository is someone who acts like a record-keeper of your
shares.

First, it converts all your physical shares into electronic form and credits the value of these in
your demat account. Then, it maintains a record of all incoming and outgoing shares of your
account in the electronic form.

However, you do not directly interact with a depository. All your interactions take place through
DPs, who act as an agent or branch of a depository. After opening the account, you have to
surrender your physical share certificates through your DP to the issuer company, which will
cancel the physical share certificates and enter the name of the depository as a registered owner
in its record. The depository, on its part, will enter your name as a beneficial owner in its record.
All the rights and liabilities of a shareholder, such as voting rights, dividends and so on, remain
with the beneficial owner.
Entering the depository’s name as a registered owner in the books of the company makes record
keeping easy. Suppose you sell your shares of Reliance Industries Ltd to me. For effecting the
transfer, your depository will simply substitute my name in your place as the beneficial owner of
the shares. There is no need to make any change in the records of the company, where the
depository will continue to be the registered owner.

Johnny: Holding a physical share certificate has its own benefit. In moments of loneliness, you
can hold it, touch it, or even smell it. What are the benefits of holding shares in demat form?

Jinny: Well, too much handling can tear your securities, making their transfer difficult. Holding
securities in demat form eliminates many of the risks, such as bad delivery, fake securities and
so on, that are associated with physical shares. Demat shares can be transferred immediately
without any stamp duty, with less paperwork and at a lower cost. You can trade on the electronic
platform of the stock exchanges and settle your trade through your demat account electronically.
You can also easily pledge your demat shares to take loans from banks. What more do you
want?

However, you are free to keep your shares in physical form. There is no legal compulsion to
convert your shares to demat form. In fact, you have the option to request for reconverting your
demat shares into physical shares. The choice is always yours.

Johnny: I think you have counted enough benefits. Now tell me, how can I open a demat
account?

Jinny: You can approach any of the DPs for opening an account. You have to submit proof of
identity and proof of address. Production of a permanent account number card has also been
made mandatory from 1 April 2006. After completing all the formalities, the DP allots you a
Beneficiary Owner Identification Number.

The schedule of charges for operating the account is provided at the time of opening the account
itself. The Securities and Exchange Board of India has rationalized the cost structure for
dematerialization by removing account-opening charges, transaction charges for credit of
securities and custody charges.

Before opening the account, you should find out about the charges levied by different DPs by
examining the comparative charts available at depositories’ websites. It takes only a few simple
steps to get a demat account.

Johnny: A small step for you is a huge jump for Johnny.

What: Dematerialization means conversion of physical sharesinto electronic form.

Who: Depositories act as the registered owner of the demat shares; however, beneficial
ownership remains with theactual owner.

Why: Keeping shares in demat form has many advantages such as easy transferability, less
paperwork and lower costs.

With whom: Demat accounts can be opened with any Depository Participant, who acts as an
agent of the depositories.
What makes interest rates the masters
of the universe?
Money is one of the most important factors that enable you to acquire not
only the basic necessities, but also exotic luxuries
Whether you like it or not, interest rates play an important role in our lives. Just like rivers in the
ancient world, interest rates in modern times determine the flow of trade and commerce. They
also affect major events of our life, such as when we plan to purchase a car or house, or decide
to go abroad to study. Our friend Johnny wonders what makes interest rates so powerful. To
know the answer, he needs to understand how interest rates really work. Maybe Jinny will help
him find the answers today.
Johnny: Hi, Jinny. Finding someone taking interest in others’ interest is really a tough job these
days. I am lucky that you are always around.
Jinny: Well, you can stop trying to flatter me, and come straight to the point.

Johnny: I was just wondering who the master of the universe is these days. Is it George or
Gordon or Vladimir?

Jinny: If you ask me, I would say interest rates are the masters of the universe these days. The
have the power to shake the lives of not only bond traders, but also tomb raiders. They can put
George down or make Gordon frown—such is their power. If you are interested, I can tell you in
detail how interest rates really work.

Johnny: I am always interested. You can go ahead without asking.

Jinny: Let’s start with the basics. Money is one of the most important factors that enable you to
acquire not only the basic necessities, but also exotic luxuries. You can buy vegetables or a
penthouse or even a new company depending upon how much money there is in your pocket.
But this money in your pocket need not necessarily be yours. The modern world runs on
borrowed money. But where does this borrowed money come from? Well, there are many people
who are interested in buying neither vegetables nor penthouses at present. They want to save
money for the future. At this point, someone like me appears and requests them to lend me their
surplus money, so that I can put it to some use. I promise to return the money after some time,
which sounds credible. But then the lender may ask what benefits he will get by lending the
money. I promise to pay a “rent” for lending me the money. I say, tomorrow, I will return more
money than what I am borrowing from you today. This “rent” for borrowing or lending money is
what we know as interest rates in financial terms.

Johnny: But, I fail to understand how such a simple thing as interest rates can rule the world.

Jinny: You can divide the world into two broad categories: borrowers and lenders. Those who
are neither borrowers nor lenders must still be living in a primitive age. There could be different
kinds of borrowers—right from a small farmer looking for microcredit to a business tycoon
looking for money for his mega project. Even governments borrow to meet their deficit.
Similarly, lenders could also be of different shapes and sizes, right from a housewife saving
money from her monthly expenses to a high net worth individual owning his private jet.
Interest rates affect both borrowers and lenders. Borrowers want lower interest rates, whereas
lenders want higher interest rates. What rates ultimately prevail is decided by a host of factors.

Johnny: What factors ultimately decide interest rates?

Jinny: There are many interwoven factors that influence interest rates. In the first place,
interest rates—like the price of any other commodity —are affected by demand and supply. If the
demand for borrowing money is more than the supply, the interest rates will rise. But there are
many factors that influence demand and supply themselves. For instance, short-term interest
rates, which may act as a benchmark for long-term interest rates, are set by the central bank.
While setting the short-term interest rates, the central bank takes note of many factors, such as
the outlook on inflation and growth. In case inflation is rising, the central bank hikes the short-
term interest rates to control money supply. Inflation or rise in prices erodes the purchasing
power of a currency. So, if you can purchase a dozen eggs today for Rs100, you may be able to
purchase only half-a-dozen after five years due to the rise in prices. So, anybody lending Rs100
today, would expect a return of, at least, Rs200 in the next five years to offset the fall in the
purchasing power of currency.

However, demand and supply are not the only factors affecting long-term interest rates. A lender
is also likely to take note of the risk in lending his capital for a longer period. As a general rule,
the higher the risk, the higher the interest rate.

Johnny: Well, Jinny, you have tried to explain everything in a few words, which could very well
be a subject matter of a long discussion. I have a few questions regarding the role of the central
bank in the whole process. I’ll bother you with that later.

What: Interest rates are the cost of money paid by the borrower to the lender.

Why: Interest rates are paid to the lender to compensate for the loss of opportunity and risk of
default.

How: Interest rates are determined by a host of factors like demand and supply of money,
inflation and risk premium, among others.
If you find the market puzzling, try the
mutual fund route
The main advantage is that you do not have to worry about the day-to-day
management of your investment
Real Simple | Shailaja and Manoj K. Singh
Our friend Johnny thinks that the rise in the Sensex this year has been the outcome of interest
shown by some invisible aliens from Mars. What else could explain the doubt expressed by some
regarding the source of money sloshing around the globe? Johnny has no complaints against the
aliens, but he regrets not having joined the party sooner. Johnny missed the tide because he has
neither the time nor the expertise to invest. Then what’s the solution? Let’s see what our friends
are chatting about today:

Johnny: Hi Jinny! What a wonderful rise the stock market saw this year. I really regret not
having entered the market at the right time. But what else could I have done? After a day’s job
in the office, I hardly get any time to think about the stock market.

Jinny: I don’t know what makes you think aliens are behind the rise of our stock market. But
you could have joined the party by using the expertise of mutual funds.

Johnny: Mutual funds? But how can they help me?

Jinny: Look, to invest in the stock market, you need to first understand how the market works.
You also need to understand the fundamentals of the firm in which you want to invest. As if
that’s not enough, you are also required to keep track of different economic indicators that can
shake the market. All of this requires time. But even after putting in so much effort, you may
end up picking a wrong stock at the wrong time. To end all this trouble, you have the option of
investing through a mutual fund, which pools the savings of a number of investors for investing
in the stock market. The main advantage of investing through mutual funds is that you do not
have to worry about the day-to-day management of your investment. Mutual funds offer you
different schemes that have well-defined investment objectives. Mutual funds use the expertise
of professional fund managers for investing your money in different kinds of securities such as
money market instruments, shares, debentures, and so on, depending on the objectives of the
schemes.

Johnny: Different schemes, different objectives, how will I knowԝwhichԝone suits me best?

Jinny: Theԝchoiceԝof schemes depends upon many factors, including your age, financial position
and your risk appetite and return expectations. On the basis of their structure, mutual fund
schemes can be of three types: open-ended, closed-ended and schemes of a third type, which
carry the features of both the open- and closed-ended schemes. Open-ended schemes do not
have any prefixed maturity date. You can walk in or out of the scheme any time at the net asset
value (NAV) of your investment. In contrast, closed-ended schemes have a prefixed maturity
period. You can directly invest in the scheme at the time of initial launch of the issue.
Subsequently, the units of the scheme are listed on the stock exchange, where you can buy or
sell at the market price, which could be different from the NAV of your units. The schemes of the
third type are traded on the stock exchange and, at the same time, they may also offer you an
option of redemption at predetermined intervals at NAV-related prices.

Johnny: But what about the investment objectives?

Jinny: Mutualԝfundԝschemes cater to many objectives. First, there are growth-oriented schemes,
the primary objective of which is to invest in equities so that your investment grows with the
rising stock market. Second, there are income-oriented schemes, the primary aim of which is to
provide you a steady source of income at regular intervals. These schemes mainly invest in
fixed-income securities such as bonds and debentures. Third,ԝthereԝare schemes that try to
balance both the growth and the income objectives by investing in both shares and fixed-income
securities in different proportions, which could vary from scheme to scheme. Fourth, there are
money markets and liquid schemes that invest in short-term instruments such as treasury bills,
certificates of deposit, commercial paper and inter-bank call money. The main objective of these
is to offer high liquidity and security to investors. Fifth, there are tax-saving schemes such as
equity-linked savings schemes and pension schemes, the main objective of which is to provide
tax saving to investors. In this manner, you could have as many schemes as the number of
objectives.

Johnny: Yeah! Multiple schemes take care of multiple needs. But what about the multiple jargon
that crops up? Can you explain what net asset value means?

Jinny: I can surely explain, but for that you will have to wait till next week.

IN SHORT:

What:Mutual funds pool the savings of retail investors to collectively invest them in the stock
market.

Why: Mutual funds are popular because they provide professional management of funds at an
affordable cost.

How: Mutual funds make use of professional fund managers to make investments in different
securities such as shares, debentures, money market instruments and other securities.
Arbitrage favours those who can wait
and watch
Arbitrage takes place if the price of the same asset is different in two or
more markets. You buy the asset from one market at a lower price and
simultaneously sell it at a higher price in another market
Trying to keep arbitrageurs out of financial markets is like trying to keep compulsive chain-
smokers out of public toilets. Putting a sign saying “No smoking” or even a fire alarm or a guard
round the clock is not enough. Compulsive smokers manage to slip into public toilets the
moment there is an opportunity. Similarly, arbitrageurs also make inroads in the market to cash
in on every minute opportunity of arbitrage. Our friend Johnny wonders how this whole business
of arbitrage works. Let’s see what answers Jinny provides:

Johnny: Hi Jinny, I see you are in a great hurry today. Are you also looking for some
opportunity?

Jinny: Opportunity? You can’t look for an opportunity in a hurry. You need to have patience to
wait for the right thing to happen at the right moment. But anyway, what is this prelude all
about?

Johnny: Well, Jinny, a couple of weeks ago, I read an article in Mint that talked about arbitrage
opportunity in the financial market. I do not understand how this whole business of arbitrage
actually works. Do you have any idea?

Jinny: Sure. Arbitrage is the favourite way of earning a risk-free profit. But arbitrage prefers
those who can patiently wait and watch. Theoretically speaking, arbitrage takes place if the price
of the same product or asset is different in two or more markets. You purchase the product or
asset from one market at a lower price and simultaneously sell the same at a higher price in
another market. In this manner, you earn a risk-free profit by indulging in what we call
arbitrage. The people who indulge in arbitrage are called arbitrageurs. This kind of arbitrage can
take place in any market in respect of any commodity or product; however, the financial markets
are one of the most preferred places for arbitrageurs. This is so because all the financial markets
today are interconnected through electronic means and you can simultaneously execute trades in
different markets to take advantage of even a small price difference.

In financial markets, most of the financial instruments such as stocks, bonds, currencies or
derivatives, or even variables such as interest rates, are subject to arbitrage.

You may hear about arbitrage of different kinds such as currency arbitrage, interest rates
arbitrage, or even labour arbitrage, regulatory arbitrage, cash and carry arbitrage etc.

Johnny: It seems even a dumb person such as me can earn a money by simply doing arbitrage.
What do you say?

Jinny: Well, looking for an arbitrage opportunity requires the eyesight of an eagle and the
quickness of a leopard. Nowadays, arbitrageurs use sophisticated computer programs for
locating every microscopic discrepancy in price. Once the opportunity is located, you quickly
need to jump on it before others do.

Arbitrage opportunities in financial markets, or any other market, evaporate very quickly
because they carry the seed of their own destruction. The moment arbitrageurs start to cash in
on the differences in the price of two markets, the prices of both the markets start to converge.
The price of the asset in the market where it is priced low starts rising due to the buying activity
of the arbitrageurs. Similarly, the price of the asset in the market where it is priced high starts
falling due to the selling activity of the arbitrageurs. Finally, the prices of both the markets
converge at a price that is called the arbitrage equilibrium price.

So arbitrageurs play an important role in filling the gap between the demand and supply. How
quickly this happens depends upon how efficient your markets are.

But, so far, I have told you about arbitrage that takes place if the same asset does not trade at
the same price in different markets at the present time. However, arbitrage can also take place if
there is divergence between the present price and the future price of any asset.

Johnny: How does that kind of exotic arbitrage work?

Jinny: There is nothing exotic about it. Suppose the future price of an asset is higher than its
present price, you simply buy that asset now at a lower price and simultaneously sell the same in
the futures market at a higher price. But this kind of arbitrage can work only if the purchase
price of the asset at present, after adding the carrying cost, is less than the future price.
Carrying cost includes cost of money in terms of interest and cost of preservation and storage,
depending on the type of asset. This type of arbitrage, in technical terms, is known as “cash and
carry arbitrage”.

There is an opposite version of this arbitrage also, which is known as “reverse cash and carry
arbitrage”, in which you simply sell the asset at a higher price now and simultaneously purchase
the same at a lower price from the futures market. In this manner, you can take advantage of
the difference between the spot and future prices.

Johnny: Thank you Jinny, for giving me the opportunity to arbitrage my doubts with your
wisdom.

What:Buying an asset or product at a lesser price in one market and simultaneously selling the
same at a higher price in another market is called arbitrage.

How: Arbitrageurs use sophisticated computer analysis to detect even minute differences in
prices of the same asset in different markets.

Why: Arbitrageurs are important because they fill the gap between the demand and supply,
leading to arbitrage equilibrium price.
‘Impossible trinity’ is all about
problems of choice
Of the three options of a fixed exchange rate, free capital movement, and an
independent monetary policy, one can choose only two at a time,
Economists like to juggle even the simplest economic issues. That’s why it is difficult to find an
economist who does not talk in terms of “on the one hand...” and “...on the other”. Interestingly,
there are certain economic ‘trilemmas’ that can’t be resolved even with two hands. One such
‘trilemma’—the impossible trinity—says it is impossible to hold three things with two hands.
Economists Robert Mundell and Marcus Fleming developed this hypothesis through what is now
known as the Mundell-Fleming model. Today, our friends Jinny and Johnny are discussing what
kind of challenge the term impossible trinity talks about.

Johnny: Recently, I heard one economist talk about how the theory of the impossible trinity
poses a challenge for policymakers. What is so serious about impossible trinity?

Jinny: Well, the term impossible trinity talks about the problem of choice among three options at
the same time. The three options are: a fixed exchange rate, free capital movement, and an
independent monetary policy. The wisdom of impossible trinity says of these, you can choose
any two at a time, at best. Suppose you want to follow a fixed exchange rate regime: You can
either choose free capital movement or an independent monetary policy. Suppose you want to
maintain free capital movement: You will have to compromise on the independence of your
monetary policy. Similarly, if you want to preserve the independence of your monetary policy
and maintain free capital movement, you can’t keep a fixed exchange rate system at the same
time. No matter what permutations and combinations you try, choosing any of the two options
would rule out the third option.

Johnny: I think you should further elaborate on this hypothesis by giving an example.

Jinny: Suppose you decide to keep fixed exchange rate and free capital movement at the same
time. Free capital movement requires you not to put any restrictions on the outflows or inflows of
capital.

Any volatility in the inflows or outflows will put pressure on your fixed exchange rates. In such a
situation, your central bank will have to intervene in the forex market to keep the foreign
exchange rate at the target. In case there is any imbalance between the demand and supply of
the domestic currency against the foreign currency, there will be pressure on the exchange rate
to deviate from the target. Suppose the inflow of the foreign currency is high. Then your
domestic currency may appreciate due to increase in demand.

In such a situation, your central bank will be required to come out with a solution. One solution
could be to absorb the excess inflow by purchasing the foreign currency from the market. The
other could be to lower the domestic interest rates so that any inflow due to a difference in the
foreign and domestic interest rates is curtailed. Intervention by the central bank in the market
helps in keeping the exchange rate of the domestic currency within the target. But at the same
time, it may jeopardize the success of the monetary policy of your central bank.
Johnny: But how is the success of the monetary policy compromised?

Jinny: The monetary policy of your central bank is based on many key assumptions. One of the
most basic assumptions behind the policy is the desirable growth of money supply in the
economy. For achieving the desired level of money supply, there are many instruments at the
disposal of your central bank.

One such instrument is interest rates. In case the central bank is not able to keep the money
supply within the desired range, it may miss the other targets set in the monetary policy.

Johnny: But, how can this assumption go wrong if the central bank itself controls the levers of
money supply?

Jinny: Frequent intervention by the central bank, either for buying or selling in the forex market,
makes it difficult to keep the money supply within the target range. For buying the foreign
currency, the central bank has to pay in terms of domestic currency. This means that the cash
which was lying with the central bank will come into the market and lead to an increase in
money supply. In case the central bank is selling the foreign exchange, then it would lead to a
decrease in money supply. In both cases, it would be difficult for the central bank to keep the
money supply within the desirable range.

Further, the use of interest rates as a tool for controlling the inflow or outflow of foreign
exchange makes one of the key instruments of monetary policy a slave of exchange rate
management. This is how your monetary policy loses its independence and the prophecy of
impossible trinity comes true.

Johnny: This means that it is really difficult to choose if you have too many options. But I will
definitely choose to ask you if ever I have a doubt.
Derivatives are based on future value
of underlying instruments
Derivatives derive their value from some other underlying financial
instruments, such as stocks, bonds, or assets and are used for hedging risk
Different people have described derivatives differently. Warren Buffett, for one, described them
as financial weapons of mass destruction. Martin Mayer has called them instruments that shift
the risk to the dumbest guy in the room.

Our friend Jinny thinks that derivatives are like a double-edged sword. You can use the sword to
protect yourself but, if you are not careful, you may end up hurting yourself. Let us try to
understand how derivative instruments work by joining our friends Jinny and Johnny in their
chat:

Johnny: Recently, I heard about one guy selling “flat tyre options” that give you an option of
exchanging your flat tyre for a perfectly good one. I don’t know how these derivative products
actually work. Do you have any idea?

Jinny: Well, I don’t know what “flat tyre options” you are talking about, but I can definitely tell
you how financial derivative products such as futures and options work if you are really
interested.

Johnny: Interested? Why not? Maybe I can design my own derivative product if only I can
understand how derivatives work.

Jinny: Literally speaking, derivative means something that has been derived from something
else. For instance, butter is derived from milk. So, butter is a derivative product of milk.
Similarly, derivatives are financial instruments that derive their value from some other
underlying financial instruments, such as stocks, bonds, or assets—including loans, currencies
and commodities or even abstract variables such as changes in the weather or interest rates.

Derivatives are based on the future value of the underlying financial instruments or assets or
variables. For this reason, derivative instruments are used for hedging risk.

Overԝtheԝcounter derivatives are tailor-made to suit the requirements of the parties involved

Suppose you want to purchase an asset after a month but you are not sure what its price will be
then. To hedge the price uncertainties, you purchase a derivative instrument that promises to
sell you that asset after one month at a price that is fixed today. This is how derivative
instruments help you hedge the price risk.

Johnny: But, I have heard that derivatives themselves are of several kinds. How do different
kinds of derivatives operate?

Jinny: We can put derivatives into different classes on the basis of different criteria.

On the basis of their trading mechanism, we can put derivatives into two categories: derivatives
traded over the counter (OTC) and derivatives traded on the floor of a stock exchange.
Further, on the basis of the underlying instrument or asset, the derivatives can again be
classified into different types.

For instance, in an equity derivative, the underlying instruments are equity instruments. In a
forex derivative, they are foreign currencies and in a commodity derivative, they could be
different commodities. In this manner, you could have as many kinds of derivative instruments
as their underlying assets or instruments.

Johnny: How are derivatives traded over the counter different from derivatives traded on the
floors of stock exchanges?

Jinny: OTC derivatives are privately negotiated between parties. They are tailor-made to suit the
requirements of the parties involved.

One common example of OTC derivatives is a forward contract. In a forward contract, two
parties sit together and decide the contract size, maturity and price.

Derivatives traded on the floor of a stock exchange are like ready-made clothes of universal size.
The contract size, maturity, lot size are standardized in the case of exchange-traded derivatives.
The settlement of all such derivatives takes place through the stock exchange and hence, the
default risk is less.

Exchange-traded derivatives are again of two types: futures and options. There is a third kind of
derivative, which we call swaps, that can be traded both privately as well as on the stock
exchanges.

Johnny: Ah! futures, options and swaps! I have heard so much about them. But the more I
hear, the more I get confused.

Jinny: As I said, futures are standardized contracts that are traded on a stock exchange. The
contracts relate to buying or selling the underlying assets or instruments at a specified price at a
future, or final settlement, date. The parties have to pay margin money for entering into a
futures contract.

On the settlement date, the parties have to settle their obligation either by physical delivery or
by cash. In case of physical delivery, actual delivery of the asset or instrument takes place. In
the case parties are not interested in taking actual delivery, they can settle their obligation by
payment of cash on the basis of the difference between the contracted price and the actual price
of the asset on the settlement date. The parties can also offset their positions before the
settlement date by entering into an opposite contract.

Suppose, on 1 September, I enter into a futures contract to buy an asset at the future price of
Rs100, and the settlement date is 30 September. Suppose, by 20 September, the future price
rises to Rs105 and I want to offset my position. How will I do that? I will simply enter into an
opposite contract to sell the asset at the prevailing future price. My gain or loss depends upon
the rise or fall of the future price of the asset between the two dates.
Derivatives: passing the risk to the
dumbest guy in the room?
The purchaser of an option can always compel the seller to fulfil his
obligation, whereas the purchaser himself is totally free of any obligation
The wisdom of the wise says that derivatives are financial weapons of mass destruction, which
pass the risk to the dumbest guy in the room. Undeterred by such warnings, our friend Johnny is
interested in designing derivative products of his own. But, there is a problem—Johnny has no
idea of how derivatives work. Last week, Jinny explained to him how futures contracts help in
hedging price uncertainties. Their discussion is still not over. Let’s join in their ongoing discussion
on derivatives:

Johnny: Jinny, tell me about options before I start getting confused.

Jinny: Options, as the term suggests, are a special kind of derivative instrument in which a
purchaser has the option, but not the obligation, of buying or selling the underlying asset or
instrument at a predetermined price, which is also called the strike price. Options are of two
types: put options and call options. Put options give you the right, but no obligation to sell.
Likewise, call options give you the right, but no obligation to purchase. You can also classify
options on the basis of their underlying assets or instruments. For instance, if the underlying of
an option contract is a stock index such as the Sensex or NSE Nifty, then it is called an index
option, and if the underlying asset is individual equity shares, then it is called a stock option. All
these options, with simple straightforward features such as right to put or call at a strike price,
are also called “plain vanilla” options. You could also have options of a more “exotic” kind with
tailor-made features that are mostly traded privately over the counter (OTC). For instance, in
one type of option called a “chooser option”, or “preference option”, the purchaser is provided an
opportunity to choose whether the option is for put or call during the period of the option. In
fact, there are so many exotic options that even a lengthy book may not be able to fully describe
them.
Johnny: So much about options of different flavours. What about European and American
options? Do we have options for different geographical boundaries, too?
Jinny: Well, European or American options have nothing to do with geographical boundaries.
Their main difference lies in the time frame during which the option has to be exercised. A
European option can be exercised only at the expiry date or the settlement date, whereas an
American option can be exercised at any time before the expiry date. Much can happen between
the day you purchase the option and the day you exercise it. So, American options give you
better flexibility in exercising your rights.

Johnny: That’s great! Options give you the right but no obligation. No risk, all gains. Tell me,
how is this possible?

Jinny: This is possible because somebody else is there to take your risk. But, nothing comes for
free. The purchaser of the option has to pay the seller a premium to acquire the right to buy or
sell the underlying instrument or asset at the strike price. The seller of the option undertakes the
corresponding obligation to sell or buy. The purchaser of an option can always compel the seller
to fulfil his obligation, whereas the purchaser himself is totally free of any obligation. At the
settlement date, the purchaser can either exercise his option, or let it simply expire. He is not
going to lose anything more than the premium, which he has already paid to the seller of
options. You might have noticed that the purchaser of an option pays a fixed price but enjoys the
possibility of unlimited gains, whereas the seller receives fixed profit but runs the risk of
unlimited loss.

Johnny: What? The situation seems really complicated.

Jinny: OK! Let’s try to understand how this works by taking an example. Suppose, I purchase a
call option for a stock from you to be exercised at the strike price of Rs100. I pay you Rs10 as a
premium for purchasing the option. Now, take a look at our respective positions. At the
settlement date, I have a right to purchase the underlying stock at the price of Rs100 from you.
I can exercise that right or simply let it expire. By common sense, I will exercise my right only if
the price of the stock on the settlement date remains higher than the strike price. If the market
price is Rs150 on the settlement date, I can purchase the same stock from you for Rs100 by
exercising my option. The higher the price, the more my profit. In case the price of the stock
falls below the strike price at the settlement date, I simply let the option expire. In that case, my
loss is limited to the Rs10 paid as premium. Now, let’s consider your position. In your case, the
more the prices rise, the more loss you suffer. But, in case of a fall in price, your profit is limited
to whatever premium you have received. This is what makes you feel like the dumbest guy in
the room.

Johnny: Thanks, Jinny, for enlightening me. But, I have many more questions about derivatives.
We’ll talk about it some other time.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and
Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to
both of them at realsimple@livemint.com

What: Options are derivative instruments that provide the right, but not obligation, to buy or
sell the underlying at the strike price.

Who: The purchaser of the option acquires the right, but no obligation. The seller of the option
(option writer) undertakes the obligation.

When: American options can be exercised on any date before the expiry date whereas European
options can be exercised only on the expiry date.

How: Plain vanilla options are traded on the floor of stock exchanges while exotic options are
tailor-made by private negotiation.
How do private equity funds raise
money for mammoth buyouts?
PE funds, true to their name, like to do their business privately. This is not
because they have some sinister design, but mainly because private
businesses provide them better flexibility
Admirers call private equity (PE) funds “the new kings of capitalism”, whereas those who hate
them call them “barbarians at the gate”. Our friend Johnny is not sure why PE funds arouse so
much interest. Are they really kings? Or are they some sort of mischief-makers working behind
closed doors? As usual, Johnny has no answers. He starts a discussion with Jinny to find out.

Johnny: Hi Jinny! I hope I am not disturbing you, but I wanted to ask you something. I want to
know what kinds of businesses PE funds are into. Of late, I am seeing a lot many regulators
taking interest in their private affairs.

Jinny: Regulators are always busy sniffing around something or the other. That is part of their
job. But I will tell you a few basic things about PE funds. PE funds, true to their name, like to do
their business privately. This is not because they have some sinister design, but mainly because
private businesses provide them better flexibility. PE funds, as a part of their strategy, invest in
unlisted companies. In case the company is already listed, they get the company delisted after
the acquisition.

There are many advantages of investing in an unlisted company. First, an unlisted company is
not required to make many disclosures. For instance, an unlisted company is not required to
publish its quarterly results. It is also not subject to any listing rules. So, you do not have to
worry about a regulator poking his nose in to see how many independent directors you have on
board.

Further, the value of investment in an unlisted company is not subject to day-to-day fluctuations
in the stock market. The value of investment depends on the long-term performance of the
company. So, PE funds can conveniently focus on long-term goals. For these reasons, PE funds
opt to invest in unlisted companies. They not only bring in capital, but also management and
technical inputs for improving the performance of the company.

Johnny: Well, there seems to be nothing wrong in what PE funds have been doing. But, tell me,
how are they able to raise funds for mammoth buyouts of companies?

Jinny: PE funds do not raise funds publicly like mutual funds. Their entire investment corpus is
collected privately, and is used for making investments in unlisted companies. Other than their
own funds, PE funds are also famous for using the technique of leveraged buyouts (LBOs) for
making big-ticket acquisitions.

LBO is a complicated term for something very simple. I will give one example to explain it.
Suppose I want to purchase a company having assets worth Rs100 crore by paying a price of
Rs125 crore. In a leveraged buyout, I mortgage the assets of the company with some financier
or bank and take a loan of Rs100 crore. In this way, I have to spend only Rs25 crore from my
pocket for purchasing the company and the rest of the cost is taken care of by the loan. The
repayment of the loan and interest is taken care of by the cash flows generated from the
business. This whole technique of acquisition through loans is called LBOs in business jargon.

This kind of leveraged funding has become very famous—not only among PE funds, but also
among acquirers of different colours and sizes.

Johnny: I have a silly question in mind. Why would anyone pay Rs125 crore if the assets of the
company are worth Rs100 crore only?

Jinny: The price at which you purchase a company depends not only on the value of its lands
and buildings, but also on many other factors. There are many intangible things, such as the
value of the goodwill enjoyed by the company in the market, the future earning prospects of the
company, and so on.

You should not be surprised if somebody buys a company at a price that seems higher than the
price of its bricksand mortar.

Johnny: Thank god I don’t have to think about intangibles while purchasing my rations,
otherwise I would never be able to arrive at the correct price! Anyway, tell me, what do PE funds
finally do with the companies they acquire?

Jinny: Well, PE funds try to turn the fortunes of the company around by providing better
management and technical inputs. They are famous—or should I say infamous?— for stripping
costs and streamlining operations through hard decisions such as retrenchment of the workforce.
Once the company is successful, they float the shares to other investors, mostly through initial
public offerings (IPOs). In this manner, they earn handsome returns on their investments.

Johnny: Wait a minute, you have never talked about IPOs before. What’s that?

Jinny: Well, it’s now time for me to actually attend to my private business. We will talk about
IPOs some other time.
The similarity between the call money
market and a pizza
The money market is a market where transactions relating to short-term
borrowing and lending of money take place
Whenever our friends Jinny and Johnny come back late from their office, they order pizza for
dinner. Today is one such day. After having ordered pizza on phone, they are waiting eagerly for
the delivery boy to ring the doorbell. Jinny is getting restless. But Johnny knows how to engage
a restless soul in meaningful discussion. Let’s see how he starts the discussion today:

Johnny: I recently heard someone say that all markets are in some
way interconnected. How could this be possible? For instance, what could be the link between
the call money market and the fish market? Do you have any idea?

Jinny: Well, the common link between the two is fairly obvious. Both the call money market and
the fish market are affected by liquidity. However, one is affected by the liquidity in the market
(money supply) and the other is affected by the liquidity in our ponds and lakes (water supply).
But jokes apart, I think you want to know about the call money market, right? Hmm! Nice way of
starting a discussion. But, before I jump to the call money market, it would be better to give you
an idea about the money market in general. The money market is a market where transactions
relating to short-term borrowing and lending of money take place. These short-term transactions
are generally done by buying and selling debt instruments maturing within a year. So, you can
also say that the money market deals with short-term financial assets that are close substitutes
of money.

The money market has different segments. The call money market is one of its segments. This
market deals with overnight borrowing and lending among the banks. If the borrowing and
lending is for more than one day but extending up to 14 days, the same is called the notice
money market. Interestingly, call or notice money markets have no physical presence. So, they
cannot have an address like your fish market. Orders in the call money market can be placed
just like orders for pizzas over the phone.

Johnny: Sounds interesting, but I was just wondering why banks have to borrow from the call
money market when the whole day they are busy taking money from their depositors.

Jinny: Well, the need to borrow money from the call money market arises due to short-term
mismatches of funds. As a part of their operations, banks borrow money from their depositors
and lend money to their borrowers. In this process, banks’ assets and liabilities get locked into
different maturities brackets. Some deposits are repayable instantly on demand. However, the
banks cannot instantly take the money back from their borrowers. Banks keep some cash ready
for meeting any demand from their depositors but sometimes, the demand could be higher than
the cash in hand. Further, banks may also urgently require funds for meeting their statutory
requirements of cash reserve ratio and statutory liquidity ratio.

During the course of the day, after taking care of all their needs, some banks may have surplus
cash in hand and some may have a deficit. The bank having a deficit will call up the bank having
a surplus to borrow money overnight or for any period extending up to 14 days. The borrowing
bank has to pay interest on the borrowed money. You might have observed that call money
interest rates undergo changes on a day-to-day basis. That’s because of changes in demand and
supply.

Johnny: So, the call money market really helps banks in managing short-term deficit or surplus
of money. But tell me, why has the central bank prescribed prudential limits?

Jinny: Well yes, the central bank has prescribed prudential limits for banks on borrowing and
lending in the call money market. Lending of scheduled commercial banks, on a fortnightly
average basis, should not exceed 25% of their capital fund.

However, banks are allowed to lend a maximum of 50% of their capital fund on any single day,
during a fortnight. Similarly, borrowings by scheduled commercial banks should not exceed
100% of their capital fund or 2% of aggregate deposits, whichever is higher. However, banks are
allowed to borrow a maximum of 125% of their capital fund on any day, during a fortnight.
Transactions in the call money market are not secured by any collateral. Prudential limits on
borrowing and lending have been prescribed to ensure that the risk of default remains within the
limit.

Johnny: But tell me, why can banks not borrow the money from other non-banking financial
institutions such as insurance companies?

Jinny: Earlier, non-banking financial institutions were allowed to lend in the money market but
now, except for primary dealers, all other non-bank participants have been phased out. The
simple logic behind a pure inter-bank call money market is that it allows the central bank more
flexibility in managing liquidity and short-term interest rates in the banking system. In case you
have any more questions in mind, save them for some other time, because the pizza man has
rung the doorbell!

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and
Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to
both of them at realsimple@livemint.com

What: The call money market deals with overnight borrowing and lending. Notice money market
deals with borrowing and lending repayable within a fortnight.

Who: Banks and primary dealers participate in the call money market.

Why: The call money market helps banks to manage short-term deficit or surplus of money.

How: Transactions in the call money market can be executed over the phone or by any other
means of communication.
Laundry service: Keeping money,
bank accounts clean
Dirty money, if kept at one place, starts stinking, like dirty socks
D.B.C. Demellow is a dirty fellow. He knows how to take anyone for a ride. One fine morning, he
appeared at the doorstep of a small bank in a sleepy corner of our town. He wanted to open an
account. The branch manager, in his hurry to tap a money-loaded customer, forgot to ask the
many questions that any prudent banker should ask. The result was disastrous. The money
deposited that day subsequently disappeared to a remote corner of the globe for some nefarious
design. Demellow was successful in using banking channels to transmit his dirty money for a
wicked plan. People like Demellow can strike once again anywhere, any time. How to stop them
is a challenge. Let’s see what solution our friends Jinny and Johnny have:
Johnny: Earlier, we used to hear about celebrities washing their dirty linen in public but
nowadays, we hear about people like Demellow washing their dirty money through banks. What
is this all about?

Jinny: Well, dirty money, if kept at one place, starts stinking, like dirty socks. Such a stink may
invite the sniffing nose of law enforcement agencies. Banks can be used as an easy conduit for
flushing out dirty money from one place to another. This enables people like Demellow to carry
out one transaction after another with the hope that a series of transactions will conceal the real
source of money. Cash is put in one bank and transferred from one account to another to make
the trail difficult to trace or follow.

Afterwards, the same cash is invested in some business activity to make it appear like a part of
some legitimate business. The main purpose of such investments is to conceal the real source of
money through mix and match. Just like a magician who puts a rat in his hat and pulls out a cat.
The dirty money slowly begins to look clean and white. This kind of eyewash, in the parlance of
law enforcement agencies, is called money laundering.

Johnny: Money laundering? I never thought that some people specialize in it. But first tell me,
what is dirty money?

Jinny: Dirty money comes out of dirty sources like smuggling, drug trafficking, illegal arms trade
and a host of other sinful activities.

In fact, India’s Prevention of Money Laundering Act, 2002, gives a long list of all such activities.
However, the riskiest kind of dirty money comes out of unknown sources. For instance, it is very
difficult to establish the trail of money used to finance terrorist activities. Terrorist money could
come out of any of the above sources or it could even come out of donations for waging war. A
few months ago, Mint had reported on one militant outfit extorting money in equated monthly
instalments from people. Unless our banks are cautious, all this money may be put in our
banking channels. We really need to arm ourselves for preventing the misuse of our financial
system for such purposes.

Johnny: Yeah, sure! We should not allow money launderers to use our financial system as a
washing machine. But what steps can we take?
Jinny: KYC norms are one such step, which all financial institutions around the world are
following. In our country, the Reserve Bank of India has given all banks guidelines on KYC
norms. KYC, as you may be aware, stands for Know Your Customer. The basic philosophy behind
these norms is that a bank should be careful while starting a relationship with a new customer. It
should also be careful in monitoring suspicious transactions in respect of all its customers.

Johnny: Thanks for clarifying what KYC stands for. I used to think that banks use it as a Kick-
out Your Customer policy if they are not satisfied with their monthly average balance. Anyway,
tell me, what kind of precautions do banks have to take under the KYC norms?

Jinny: Banks have to be careful in many respects. First of all, while opening a new account, they
need to be sure about the identity of their customer. This can be done through several sources.
A documentary proof of identity, such as a PAN card, voter I-Card, passport, etc, is one such
source. Introduction through an existing customer of the bank could be another source. Taking a
photograph of the customer at the time of opening the account ensures the physical identity of
the customer. Further, banks are also required to obtain address proof from the customer. For
this purpose, banks request for copies of telephone bills, lease deeds, and so on. However,
bankers should not merely rely blindly on all the documents submitted by a new customer. They
should cross-check the authenticity of information through independent sources. Small steps,
such as sending a welcome letter to the customer at the given address, can reveal a fake
address if the letter is returned undelivered. Once the account is operational, the bank should be
careful about any suspicious transaction. In short, all these efforts require cooperation between
the customers and the bank.

Johnny: Yes, of course! This is a small price you pay if you want to keep people like Demellow
away.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and
Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to
both of them at realsimple@livemint.com

What: Know Your Customer (KYC) norms work as an antidote to money laundering.

Who: Banks and financial institutions need to follow KYC norms while starting business with a
new client.

Why: Prevention of money laundering helps in checking the use of banking channels for
transmitting money for illegal purposes.

How: Banks should verify the identity of their new customers through different sources. They
should also carefully monitor all suspicious transactions.
How are central banks around the
world fighting inflation?
It is important that the central bank must have full control over important
monetary policy instruments
One fine morning, Johnny reached office dressed like a hunter, totally unmindful of the curious
glances he was attracting. He was also carrying a handgun. Jinny was also surprised to see him
dressed up like a hunter. Could this be one of his numerous gimmicks? Or was he dressed like a
hunter for some purpose? Jinny decided to ask Johnny himself.

Jinny: Hi, partner. Why are you geared up like this today? Found some drama company on your
way to office? Or have you finally decided to shoot your boss today?

Johnny: Why will I shoot my boss? May God give him a long life! But I am definitely on a
mission. A mission called SIN. Have you heard about it?

Jinny: SIN? Don’t tell me that you are on a mission to shoot all sinners one by one.

Johnny: Well, my mission SIN stands for Shoot Inflation Now. Central banks around the world
are known for doing that only. Why are you surprised if I’m trying to do this in my own way?

Jinny: Fantastic! The catchphrase Whip Inflation Now (WIN) was a roaring success in the 1970s
and now you have come up with an idea of straightaway shooting inflation. But are you sure you
can shoot it with a handgun?

Johnny: Well, I’m not sure, but tell me, how do central banks around the world do inflation
targeting?

Jinny: Definitely not with a handgun. We’ll talk about the ways and means later, But first you
should know what inflation targeting is all about. Some central banks follow a focused agenda of
controlling inflation at a certain point. It makes an explicit commitment to meet a publicly
announced inflation target. The bank has to hit the target, come what may. There is no room for
error. Some countries follow a single-point target, while others follow a more flexible approach of
controlling inflation within a range. The institutional arrangements for fixing the target, and also
for dealing with deviations from the target, differ from country to country. In some countries, if
the central bank misses the target, the chairman or governor has to publicly explain why it is so.
Inflation targeting has been adopted by a number of central banks, including those in New
Zealand, Australia and the UK. Since inflation targeting requires rigorous discipline, there must
be certain prerequisites, too.

Johnny: Prerequisites? I think the only prerequisite is that the central bank of that country must
be armed with a loaded gun.

Jinny: The loaded gun is not a prerequisite. But it is important that the central bank must have
full control over important monetary policy instruments such as short-term interest rates, that
must be fully market determined. In the absence of effective instruments, you will end up
holding a gun without cartridges.
Further, the central bank should have full autonomy in the conduct of the monetary policy. For
better transparency and accountability, it would be desirable that the central bank is not involved
with the debt management of the government. The single focus should be monetary
management, without being constrained in any manner. Further, inflation targeting may turn out
to be elusive if the economy is vulnerable to supply-side shocks. Monetary weapons of the
central bank can’t control any price rise due to shortages of supply of goods and services.

Johnny: But what kind of monetary policy strategy do we follow in India? I hear the central
bank in our country provides some sort of range for inflation.

Jinny: The Reserve Bank of India (RBI) does not practise inflation targeting. However, it does
focus on a desirable range of inflation. You may have noticed that in the last annual policy
statement, RBI talked about keeping inflation close to 5% during 2007-08. However, over the
medium-term, the range of inflation indicated by RBI has been between 4% and 4.5%.
Controlling inflation is always given top priority, but it is not the only priority. RBI follows a
multiple goals approach, like the US. Apart from the inflation range, RBI also indicates a range
for the growth of the gross domestic product (GDP). The projected GDP growth for 2007-08 is
around 8.5%. Further, ensuring financial stability is also one of the assigned objectives of our
monetary policy. Sometimes, we have to trade off one for the sake of the other. The central
bank has to exercise its judgement in choosing different policy goals. For instance, acceleration
of growth may require commensurate liquidity in the market.

In that case, increase of money supply by the central bank may cause you to miss the inflation
target. If the central bank tightens the screws for controlling inflation, then you may miss out on
your growth target. So, in a multiple goals approach, you have to do a tightrope walk. You can’t
just start shooting inflation like a sharpshooter.

Johnny: But just watch your prey “inflation” closely and take proactive action to keep it under
control.

What: Inflation targeting as main objective of monetary policy.

Who: Manyԝcentralԝbanks,ԝlikeԝthose of New Zealand, Australia, and the UK, practise inflation
targeting.

How: By keeping inflation at a pre-announced target. In case the central bank misses the target,
it has to publicly explain why it is so.

Why: Low inflation helps in keeping the economy stable.

Inflation targeting is a challenging
business for central banks
If inflation is able to rear its head before you can use your instruments, you
are out of the game
Jinny is surprised to see Johnny come to office dressed like a hunter. But unmindful of the raised
eyebrows, Johnny proclaims that he is on a mission called SIN: Shoot Inflation Now. He wants to
kill inflation like a professional shooter. Johnny feels that many central banks in the world are
busy shooting inflation in the name of inflation targeting. So why can’t he also do the same in his
own way with his handgun? Jinny tries to convince him that inflation can’t be shot with a
handgun. Jinny further explains the implications of inflation targeting approach and its important
prerequisites. She adds that India’s central bank follows a multiple targets approach in its
monetary policy, which requires sound exercise of judgement by the central bank. Here is the
concluding portion of their chat on inflation targeting:

Johnny: Tell me, what kinds of skills do central banks need to have to successfully target
inflation?

Jinny: Well, inflation targeting requires skills better than a sharpshooter. First of all, you need to
choose a time horizon within which you seek to achieve the desired rate of inflation. Your time
horizon depends upon many factors. One of them is the difference between the desired rate of
inflation and the actual rate. Then you need to predict in advance what the rate of inflation is
likely to be in future. Since all your instruments of monetary policy show the desired results with
a time lag, you have to use your weapon in advance. You have to fire your shot even before
seeing the enemy. If inflation is able to rear its head before you can use your instruments, you
are out of the game. However, if you fire your shot on a false alarm, then you may
unintentionally hurt some other target. Too many missed shots may take the sheen out of the
growth in your gross domestic production or may lead to a high unemployment rate. Further,
keeping inflation under control is an ongoing process. You have to wage a permanent war. The
moment you blink, inflation makes a comeback. This is one of the most basic challenges
associated with targeting inflation.

Johnny: No doubt inflation targeting is a challenging business. But I have my own methods of
fighting it. Guess what? If the prices of vegetables are getting high, I will ask people to grow
vegetables in their backyard. If the prices of petrol and diesel are touching the sky, I will ask
people to use their bicycles. So asking people to stop all unnecessary consumption will be my
style of shooting inflation. But leave my methods of fighting inflation aside and tell me, what are
the benefits that inspire central banks to explicitly target inflation?

Jinny: There are many benefits. First, aiming for explicit inflation targets makes monetary policy
more transparent. Having a single goal makes it easier for people to judge the performance of
the central bank. You can know for sure how far the central bank has been successful in
achieving its objective. The central bank can also conveniently focus on a single target instead of
chasing multiple targets. Second, explicit inflation targets help in containing inflationary
expectations. Today, inflationary expectations are treated as a bigger enemy than inflation itself.
If you tame inflationary expectations, half of your battle is already won. In planning for the
future, all of us are influenced by our expectations about the rise in prices in the future. Explicit
inflation targets make you feel safe. Will you not be comfortable if you know that your guard is
keeping a loaded gun ready for your enemy? Likewise, inflation targeting acts as a great
assurance to the market and helps in planning for the future.

Johnny: If inflation targeting helps so much, then why don’t all central banks practice it?

Jinny: Many central banks do not follow inflation targeting due to several reasons. For one,
many central banks prefer the flexibility afforded by the multiple targets approach. You can
change your policy stance as per your desired goal. Inflation targeting approach ties your hands.
It seriously restricts your judgement in evaluating different policy goals. It simply puts you in the
league of “inflation nutters”. You always have to keep your finger ready on the trigger. Second, it
is felt that the approach of inflation targeting requires you to place overbearing reliance on
inflation forecasts. All your actions are strictly determined by your forecast of what is going to
happen tomorrow. In case your forecast goes wrong, then your entire plan may backfire. And
lastly, many central banks have been able to achieve the goal of low inflation even without
adopting inflation targeting approach. So what’s the point in becoming a proclaimed trigger-
happy sharpshooter? You simply keep doing your job like a silent killer.

Johnny: What a style of doing the job! By the way, I just realized that we have also to get down
to our own jobs, otherwise we may soon see our boss targeting us.
Insight into the bond family
Bonds are of different kinds, but all of them are all debt instruments and pay
interest
My name is Bond. Junk Bond. I am one among several of my other kith and kin. You might have
heard about some of my other family members like relief bonds, government bonds and euro
bonds who enjoy a very respectable name. My name may sound notorious but I belong to the
same bond family. If you are interested in knowing more about my bond family, then you should
join Jinny and Johnny in their chat:

Johnny: I heard someone say that gentlemen prefer bonds. I thought that he was referring to
James Bond, but he started taking different names that I have not even heard of, such as
convertible bonds, strip bonds, junk bonds and many others of the same family. How come this
bond family has become a favourite choice of gentlemen?

Jinny: Well, gentlemen prefer bonds because gentlemen always like to get confused. In case
you also want to confuse anybody, start talking to him about bonds, which come in so many
varieties. Bonds are of different kinds, but all of them have essentially one common
characteristic that makes all of them part of a family—they are all debt instruments. Like any
other debt instrument, all of them pay interest. In financial terms, the payment of regular
interest is also called “coupon” payments and the rate at which the interest is paid is called the
“coupon rate”. A bond of Rs100 face value having a 10% coupon rate per annum will fetch you a
payment of Rs10 every year as interest. However, the manner in which this interest is paid may
be different for different kinds of bonds. For instance, in a zero coupon bond, there is no regular
payment of interest. You purchase the bond at a discounted value and, later on, redeem the
same at its face value. The difference between the discounted value and the face value
represents your interest earning. Similarly, in case of inflation-linked bonds, the rate of interest
to be paid is decided by some benchmark index and hence your earnings may go up or down
depending upon the index. The risk-return profile of different bonds differs. Government bonds
are less risky but their return is also low. Junk bonds are more risky, but their return is high.

Johnny: So far so good. But I have heard bond traders talk about “current yield”. What’s that?

Jinny: The coupon rate of a bond gives you the interest earned as a percentage of its face value,
whereas current yield gives you the interest earned as a percentage of its current market price.
A bond may trade in the market at a price different from its face value. A bond having Rs100 of
face value may trade at a premium price of Rs105 or at a discount price of Rs95 depending on
the current interest rates. Suppose you purchase a Rs100 bond, earning Rs10 of interest per
annum at a market price of Rs105. Then you can calculate the yield by taking out the percentage
of interest earned at the current market price. Since the earning will remain constant during the
rest of the tenure of your bond, any rise in the market price will lower the yield. Similarly, any
fall in the market price will increase your yield. Confused?

Johnny: I have many questions in mind. First of all, what makes a bond trade at a premium or
discount to its face value? And what role does the change in interest rates play in the change of
market price of bonds?
Jinny: Changes in interest rates play a very vital role. Bond prices and interest rates always
move in reverse directions. If one rises, the other falls. As I have already said, all bonds pay you
interest, which is also known as the coupon rate. A coupon rate of 10% per annum on a bond of
face value Rs100 will fetch you an interest of Rs10 every year. You will continue earning Rs10
during the entire tenure of your bond. But suppose current interest rates fall tomorrow to 2%.
Then what will happen? It will surely not affect the earning on your bond, which will continue to
fetch you the same return. However, any new bond will fetch a coupon rate of 2% per annum
only. So a new bond of Rs100 will fetch only Rs2 as return in a year. This scenario will push up
the market price of your existing bond to a level where the current yield from your bond is
aligned with the current interest rates. Likewise, any rise in the interest rates pushes down the
price of bonds carrying lower coupon rates. Since your old bonds carry lower coupon rate than
the prevailing interest rate, you sell your bonds at a discount to the face value.

Johnny: Enough, Jinny! I have started getting confused. Let the bond traders worry about bond
prices. Lets talk about something different.

Jinny: I will spare you for now. But there are many interesting things about bonds, which I will
like to share with a gentleman like you some other time.
What’s this cross-breed called
stagflation?
The 1970s saw the emergence of a new disease in the world economy. Some
ingenious mind named it stagflation -- a cross-breed of stagnation and
inflation
The 1970s saw the emergence of a new disease in the world economy. Some ingenious mind
named it stagflation—a cross-breed of stagnation and inflation.

Today, the world economy is once again debating the possible comeback of this scourge. Is
stagflation around the corner? We may not yet know the answer for sure.

But our friends, Jinny and Johnny, are busy today in putting this disease under their microscope.

Johnny: I received an email today from a friend, asking what stagflation is all about. My guess
is that it is some kind of coded message, which you send to your partner: STAy with your Girl
Friend at the same LocATION. What do you say?

Jinny: You should not be joking about a serious disease. Stagflation is a deadly combination of
two evils, stagnation and inflation. It is just like a patient suffering from constipation and high
blood pressure at the same time. Both problems are equally bad. Most commonly, we hear about
high growth rates and high inflation. But stagflation proves this old wisdom wrong.

You have high inflation, declining growth and consequently, high unemployment all existing
together. What would you do?

Johnny: I am neither a doctor nor an economist. I would simply pray.

Jinny: Well, handling stagflation no doubt poses a serious challenge. Stagflation leaves you fit
for neither laughing nor crying. You are not sure which problem to tackle first, stagnation or
inflation. It is just like your doctor not able to decide which of your diseases he should treat first,
constipation or high blood pressure. If you start whipping inflation too hard, it may have a two-
fold effect. On the one hand, it may cool off some of the heat of inflation, but on the other hand,
it may also lead to further slowdown of the economy. Your growth rate is already in a bind. Any
tightening of monetary screws for controlling inflation may push the stagnation from bad to
worse. Imagine what will happen if, due to monetary tightening, the growth rate comes down
further without any corresponding fall in inflation. You would be caught in a stagflation trap. It is
just like your doctor asking you to change your food habit to cure your high blood pressure. But
the same, instead of curing blood pressure, results in further constipation. You may think that
you should take care of the problem of stagnation first. But even if you decide to tackle the
problem of stagnation first, you may end up in further trouble. Anything done for stimulating
growth may further stoke the fire of inflation. Now you realize that you are caught between the
devil and the deep blue sea.

Johnny: My God! Now tell me, what causes stagflation?

Jinny: There are more than half-a-dozen economic theories that explain the causes of
stagflation. I am not going to confuse you further by talking in terms of an economist or a
pathologist. Let’s take a simple approach. There could be many reasons. It is believed that the
stagflation of the 1970s, most prominently seen in the US economy, was the outcome of price
shocks of inputs like crude oil. If your economy is structurally weak, then even a minor external
shock is likely to jolt your nuts and bolts. Some of your uncompetitive industries will have to
shut shop because they can’t sustain production due to rising input costs. Those who manage to
survive will be able to produce lesser number of goods at a higher price. The net result is a
decline in production and rise in unemployment and prices. Some economists are of the view
that excessive government regulation causes structural weaknesses resulting in the failure of the
overall market to allocate goods and services efficiently. If the growth is hampered due to
structural weaknesses, any attempt by the central bank for spurring growth by increasing money
supply can lead to a counter-effect of rising prices.

Johnny: But what is the remedy for stagflation?

Jinny: There is no ready-made remedy for stagflation. It depends on what situation you are in.
However, traditional remedies suggest the use of structural reforms and a sustained tightening
of monetary screws at the same time. Tightening of money supply will further slow down the
growth in the short run. But you try to counterbalance the same by removing the structural
bottlenecks of your economy so that the full potential of growth is achieved. You gear your
economy to face the external shocks more comfortably. All these remedies sound fantastic. But
only the actual testing time will tell whether they are going to work or not.

Johnny: That’s true, Jinny. Only the actual test will tell whether the suggested remedies are
successful. But I think one should not stop eating merely due to fear of constipation or high
blood pressure.

What: Condition of high inflation, high unemployment and declining growth, also known as
stagflation.

Why: Stagflation is caused due to many reasons like abrupt rise in the cost of production due to
external shocks, structurally weak domestic economy, et cetera.

How: Dealing with stagflation requires simultaneous handling of both inflation and stagnation.

Whom: Rising prices and high unemployment directly affect the people at the bottom of the
pyramid.
When it’s raining dollars, how can we
deal with the problem of plenty?
The problem is that management of dollar inflows imposes cost
Last week, our friend Johnny came across a forecast that talked about dollars raining down.
Johnny is confused about the implications of continuous deluge of forex inflows. He is happy that
we can at least boast of abundance. But he is not sure why some people call it a problem of
plenty.

As usual, he started a discussion with Jinny to clear his doubts.

Jinny, first of all, told him about different sources through which dollars are pouring in the
country. Continuing their talk, they are now discussing why management of excess inflow poses
a challenge for policymakers.

Jinny: Excess inflow of dollars, like excess rainfall during the monsoon, can pose a problem of
plenty if you don’t know how to put them into the right channels. Your domestic currency may
start appreciating under the pressure of heavy inflows, which may hurt your exports.

Some people feel that just like monsoon rains, which we store in dams, dollar inflows can be
saved in the form of reserves for future use. You may be aware that in 1991, India had a forex
reserve of only $5.8 billion (Rs23,780 crore), which was not sufficient to cover imports of more
than three weeks.

Now our forex reserves have crossed the figure of $210 billion. But nobody can predict what
level of forex reserves wouldԝbeԝmore than necessary.

Some experts feel that things can go wrong any time. As you have seen, investments by foreign
institutional investors (FIIs) in the stock markets constitute a substantial part of the total foreign
exchange inflows. Net FII inflows each year have been around $9-10 billion in recent times. The
level of our reserves should be sufficient to meet any worst-case scenario arising out of a sudden
capital flight.

Johnny: True. Then we should keep on building the reserves. What’s the problem?

Jinny: The problem is that management of dollar inflows imposes cost. The country’s central
bank has to keep intervening in the market for purchasing dollars. Experts have a special name
for such frequent intervention by the central bank in the forex market: “dirty float system of
exchange rate management”.

Frequent intervention by the Reserve Bank of India (RBI) prevents the domestic currency from
appreciating. This no doubt to some extent can boost exports. But frequent dirty floats come
with a cost.

First, the foreign currency assets purchased by RBI may earn lower interest than the domestic
currency assets. This is because forex reserves are kept in the form of securities of foreign
governments, deposits with other central banks and deposits with foreign banks, all of which are
safe modes of investment, but typically earn lower interest.
Second, for purchasing dollars, RBI has to sell the domestic currency. Selling of domestic
currency increases money supply in the economy, which in turn causes inflation. For controlling
money supply, RBI has to carry out sterilization, which again imposes cost.

Johnny: You talked about dirty float first, now sterilization. Is the sterilization required to kill the
germs coming out of the dirt?

Jinny: Not the germs exactly. Simply put, sterilization is done by selling securities in the market,
which allows the central bank to absorb the liquidity. However, there are two problems. First,
selling of securities entails cost in terms of interest paid to the purchasers. Second, the stock of
securities available with the central bank, at one point or the other, is likely to get exhausted.

To overcome the second problem, in India, RBI started the Market Stabilization Scheme from 1
April 2004, in which securities are issued specially for carrying out sterilization.

Johnny: Well, sterilization solves just one problem. You said our forex earns less interest when
deployed in the securities of another countries. Why can’t we put our forex to more productive
use in some alternative avenues?

Jinny: There has been no dearth of suggestions about this. Some experts suggest that we
should create investment vehicles on the lines of Temasek Holdings and Government of
Singapore Investment Corp. for investing our forex in riskier assets for generating good returns.

But the point is, what is the purpose of creating forex reserves? Do we create reserves for
generating profits through investments or do we create reserves for bailing us out in case of
need? We need to look at all the pros and cons before taking any decision. This year’s Union
Budget proposed to create subsidiaries of the Infrastructure Finance Co. for borrowing foreign
currencies from RBI to invest in domestic infrastructure projects. We have yet to see how this
proposal works out.

Johnny: Well Jinny, I think the debate for managing the forex can go on and on. Let’s not forget
that it is better to get soaked in the rain than to sit idle and scratch our heads. I think the rising
forex will one day teach us the art of eatingԝour cake and saving it, too.
Why do companies reward employees
with sweat equity?
Esops are not like the monthly salary. They are more like dangling carrots to
make employees stay with the company
Our friend Johnny is disturbed. He is disturbed because strange terms—Esops, sweat equity—
keep echoing in his head, and he is not able to understand their meaning. As usual, the only
hope for Johnny is to talk with Jinny and clear his doubts.

Johnny: Hi Jinny! I hope today too you will clear all my doubts.

Jinny: Why do you want to clear your doubts? Don’t you know doubts and dandruff are signs of
a fertile head? Did you notice that bald people have no dandruff?

Johnny: But bald people can have doubts. Anyway, I never intended to start a discussion on
dandruff. I hope you will not mind if I ask you about Esops or sweat equity shares. Can you
provide me some insight on these terms?

Jinny: Providing insights on Esops or sweat equity shares may not be as interesting as starting a
discussion on dandruff. But I will do my best. Let’s start with the basics. As you may be aware,
the term Esops stands for employee stock option plans. Many people think that the term Esops
sounds like the name of a bug. So they use sweat equity as another respectable name for Esops.
However, some experts may draw a finer line of distinction between the two terms. Let’s not get
into that to keep our discussion simple. Many firms allot sweat equity shares to their employees
as a reward for sweating on their jobs. But please don’t think that you can also earn sweat
equity shares by literally sweating in your office. The funda is fairly simple. Suppose I contribute
money for starting a firm and you contribute your expertise and labour. Both money and
expertise are equally important for the success of the firm. Keeping your value-addition in mind,
I may give you an option to acquire the shares of the company. This allotment can be either free
of cost or at a concession depending on how much I want to reward you.

Johnny: It means that sweating in the office really pays. But I used to think that sweating only
gives you a salary that you carry home at the end of the month. Why do companies reward
employees with sweat equity shares in addition to whatever salary they are already getting for
doing their job?

Jinny: Esops are not like the monthly salary. They are more like dangling carrots to make
employees stay with the company. Esops give you an option to acquire the shares that can only
be exercised after a fixed period. As per Securities and Exchange Board of India (Sebi)
guidelines, there shall be a minimum period of one year between the grant of options and
vesting of options. Vesting of an option entitles you to actually apply for the shares offered. In
case of resignation or termination of the employee, all options not vested lapse and the
employee can claim no benefit.

This ensures that you continue to work for the betterment of the company. Sebi guidelines
further provide that the company shall have the freedom to specify the lock-in period for the
shares issued pursuant to exercise of option. So even after acquisition, the shares may continue
to have a lock-in period so that you can’t immediately sell them in the market.

Johnny: Oh I see! Esops are like golden chains, which the companies use to hook their best
performing employees. But tell me, how can you ensure that Esops are not misused to the
detriment of the equity shareholders of the company?

Jinny: There are numerous checks to ensure that Esops are not misused. In the first place,
Esops can be issued only with the approval of the shareholders through a special resolution in a
general meeting. Second, all terms and conditions on which Esops are issued are determined by
the compensation committee of the board of directors, which has a majority of independent
directors. Further, an employee who is a promoter or belongs to the promoter group shall not be
eligible to participate in Esops. A director who either by himself or through his relative or through
any body corporate directly or indirectly holds more than 10% of equity shares in the company is
also not eligible to participate in Esops.

These safeguards ensure that people having control over the company do not misuse Esops for
acquiring shares at a dirt-cheap price.

Johnny: So many checks and balances. I think you have given me enough idea to start having a
new doubt. This shows that I have a fertile head. Anyway, I just hope that Esops will continue to
prosper for the benefit of those employees who sweat day and night for their companies.
The long road to convertibility
Building flyovers overnight will not help if your roads continue to have
potholes. Our financial system still has many potholes that we need to take
care of
Last week Jinny and Johnny were engrossed in a discussion about capital account convertibility.
Jinny is of the view that regulating the flow of capital is like regulating the flow of traffic on the
road. Too many procedural “red lights” can act as a hindrance to capital movement. However,
you can’t fully dispense with all the red lights. Moving towards fuller capital account convertibility
is like building flyovers for capital movement with appropriate check posts. Here’s the concluding
portion of the chat between Jinny and Johnny on convertibility.

Johnny: But why are we moving in phases? Can’t we build flyovers for capital movement at one
go?

Jinny: Building flyovers overnight will not help if your roads continue to have potholes. Our
financial system still has many potholes that we need to take care of. The first committee on
capital account convertibility (1997) had set out many signposts such as gross fiscal deficit to be
3.5% of gross domestic product (GDP), inflation rate to be within the 3-5% range, gross non-
performing assets (NPAs) to be 5% of total advances, cash reserve ratio (CRR) to be 3% for
moving towards capital account convertibility over a three-year period ending March 2000.
Except for NPAs, we have missed the targets in many respects. Fiscal deficit is still above the
target. Inflation has been above the indicated range. CRR is also on the rise. But it’s not as if we
have not made any progress since the first committee submitted its report. In fact, there has
been liberalization in capital account transactions step by step so that the market could adjust to
the changes without any difficulty.

Johnny: What kind of signposts has the second committee on convertibility placed for achieving
the targets?

Jinny: Well, the second committee in its report has set out a broad framework for sequencing
and timing of further capital account liberalization. The government’s fiscal health no doubt
continues to be a cause of concern. The committee has emphasized that there should be more
transparency in disclosing the actual liabilities of both the Union and state governments. It is felt
that there are many liabilities like small savings and unfunded pension liabilities that are not
reflected in the figures of fiscal deficit.

The committee talks about a new indicator—public sector borrowing requirements—that will
more accurately reflect the dependence of the government on market borrowings. The
committee recommends that a revenue surplus of 1% of GDP be created by 2010-11 for meeting
the Union government’s repayment obligations. A good fiscal condition, of course, remains the
first precondition for achieving fuller capital account convertibility.

Johnny: You mean to say that the fiscal health of the government remains one of the roadblocks
to capital account convertibility?

Jinny: Yes, but there are many other roadblocks. For instance, the committee is concerned
about the health of the banking system. It has been observed that at present the banking sector
is fragmented by the presence of different categories of banks. Different categories of banks
have different strengths and weaknesses. A weak bank in the chain can make the entire system
vulnerable. The committee favours consolidation in the banking sector. The emphasis is on
creating strong and professionally managed banks, not just large banks.

Johnny: Well, it would be great if we achieve all the targets by 2011. But what practical
difference will fuller convertibility make in our lives?

Jinny: Fuller capital account convertibility will provide resident individuals, like you and me,
freedom of choice. Just a year ago, a resident individual was permitted to remit only $25,000 per
calendar year for any permissible current or capital account transaction or a combination of both.
This limit was raised to $50,000 in December 2006. The Reserve Bank of India has further raised
it to $100,000. If the recommendations of the committee on fuller capital account convertibility
are followed, then this limit will be further enhanced to $200,000 by 2011. Don’t you think that it
will make a lot of difference?

Johnny: Freedom to remit $200,000 in a year? I don’t know whether I would be able to earn
that much money even in the next 10 years. Anyway, Jinny, I hope that by the time the capital
account “flyover” is ready, people like me who now ride on bullock carts have at least a bicycle
to ride.
How no-frills accounts spread the
banking habit
No identity or address proof to open an account, nil or very low minimum
balance requirements are some ways banks are reaching out to the masses
No-frills. The term conjures up images of a host of things. You can have a no-frills airline or a
no-frills supermarket. If this is not enough, you can have a no-frills date with your partner. In
such a date, each partner foots his or her part of the bill. Our friends Jinny and Johnny have no
intention of going on a no-frills date. However, at present they are busy discussing the salient
features of no-frills accounts offered by different banks.

Johnny: Recently I heard about one private sector bank offering ‘aazadi’ (independence) to its
customers. Another public sector bank is extending its helping hand like a true ‘mitra’ (friend).
Another bank is throwing open its doors for barefoot customer through its ‘Janatha’ savings bank
accounts. I hope banks are not resorting to marketing gimmicks like some of our mobile phone
companies.

Jinny: Well, banks rarely resort to marketing gimmicks. The products that you are talking
about—‘aazadi’ and ‘mitra’—are some of the no-frills accounts offered by banks to their
customers. I hope you are familiar with the concept of no-frills account.

Johnny: No-frills account? I have come across no-frills airlines but had no chance to encounter a
bank account without any frills. What is this all about?

Jinny: Let me first give you a brief background of the whole concept. No-frills account is one of
the key methods of ensuring financial inclusion for the masses living at the bottom of the
pyramid. You may be aware that despite all progress made by our banking sector during the last
five-six decades, there are a large number of people who have never even gone inside a bank.
They have no permanent address, no proof of identity, and no fat salary to carry home at the
end of the month. They toil all day and squirrel away their meagre savings at home. These
people need the services of a bank as much as we do. The concept of no-frills accounts tries to
bring banking to the doorstep of the poor masses.

Johnny: How did this idea of financial inclusion really make inroads in the collective psyche of
banks? As far as I know, banks have been busy chasing only well-heeled customers.

Jinny: Well, in our country the Reserve Bank of India (RBI) gave the first push to this idea in its
annual policy statement of 2005-06. Subsequently, through various circulars, RBI advised banks
to implement the same.

The present state of affairs will testify that the banks are now taking more interest in opening
no-frills accounts because they smell a very good business opportunity. Spreading the banking
habit among the masses ultimately brings manifold benefits to the banks themselves.

Johnny: Sounds interesting! But tell me, how does it actually work?
Jinny: The working of a no-frills account is fairly simple. First of all, you do not require an
address proof or identity proof for opening a no-frills account. You only require an introduction
from someone who is a regular account holder with the bank.

Second, for maintaining a no-frills account, you require nil balance or a very low minimum
balance. So there is no need to arrange for a hefty amount as a minimum deposit, as is the case
usually.

However, there are certain restrictions. The total credit at any point of time in your account
should not exceed Rs50,000. Further, the total of all credits in your account during any financial
year should not exceed Rs1 lakh.

Johnny: But what benefits do no-frills account holders enjoy by maintaining an account? The
last time when I travelled on a no-frills airline, I had to literally jostle for my seat. I hope one
doesn’t have to repeat the same exercise while operating a no-frills account with a bank.

Jinny: Well, apart from earning interest on their deposits, the other services offered to such
account holders differ from bank to bank. Banks are free to design their product on their own.
However, they are required to provide wide publicity of their schemes in a transparent manner.

As I said, services offered vary from bank to bank. For instance, some banks provide a
chequebook facility with a no-frills account, while some don’t provide any chequebook facility.

Some banks restrict the number of transactions you can carry out across the counter during a
year whereas some banks don’t impose any such restrictions.

So ultimately, the facility that you enjoy depends upon the bank with which you maintain your
account.

But in any case, no-frills account holders don’t have to jostle for just entering into the bank. You
are treated like any other customer of the bank.

Johnny: No wonder banks are treating no-frills account holders with respect. After all, there is a
good scope of making handsome profit on large number of small accounts. In fact, it appears to
be a win-win proposition for both the banks and the customers.

What: No-frills or basic banking accounts offered by banks.

Who: No-frills accounts intend to bring people at the bottom of the pyramid within the banking
system. As per one estimate, 41% of our population is unbanked.

How: Theԝaccountsԝcanԝbeԝopened with zero or a very small balance and with fewer formalities.

How much: Total credit in the account at any time should not exceed Rs50,000. The total of all
credits during a year should not exceed Rs1 lakh.
What does the forex forecast on
raining dollars really mean?
In India, dollars are coming like the monsoon deluge. Initially, the inflow
was like a drizzle—soothing the starving nerves of the country that had seen
scarcity
Johnny was engrossed in reading the forecast of the day, which said that it might rain today. He
was amused because what he was reading was not a weather forecast talking about the Mumbai
rains, but a forexforecast talking about raining dollars.

In India, dollars are coming like the monsoon deluge. Initially, the inflow was like a drizzle—
soothing the starving nerves of the country that had seen scarcity. Soon, the drizzle turned into
a downpour and we started filling our buckets with a cheer. Now that all our buckets are full, the
downpour has turned into a deluge. Our forex reserves have already crossed $210 billion (Rs8.6
trillion). What to do now?

Johnny has no idea how the inflow of dollars has changed our life. But the forecast that he read
today forced him to think. Soon, he got an opportunity to discuss this with his trusted partner
Jinny:

Johnny: The forecast of today has really left me clueless. How could dollars rain? I have never
seen dollars hanging on the clouds. Some say that we may catch a cold if we continue to get
further soaked in the dollarsԝdownpour.ԝI don’t know what this talk is all about.

Jinny: Well, I think you have missed the point. Don’t get confused by the comparison of forex
inflows with the rainfall. Dollars don’t fall from the clouds. However, like the rains, their inflows
sometimes may cause a problem of plenty.

I think I should tell you briefly about how inflows of forex take place in our country. But first of
all you should know that the forex reserves of our country, apart from foreign currency, also
include gold, special drawing rights (SDRs) and reserve tranche position. But here we would be
discussing only inflows of foreign currency.

There are many sources through which a country can earn forex. Take, for instance, the most
common source—exports of goods. We make clothes in Mumbai and send these to London.

In this manner, we earn dollars. However, we have to also import goods that we require for
ourselves, say the crude oil for which we may have to pay dollars.

The difference between the payment and receipts determines whether we are earning or losing
dollars. Historically speaking, our imports have been more than exports and so we have been net
losers of dollars on our trade account.

In 2005-06, we had a deficit of about $51 billion on our trade account (imports minus exports).

Johnny: If our forex is slipping because our imports are bigger than exports, then how are the
piles of dollars accumulating?
Jinny: Well, export and import of goods is one part of the story. The other part is that we have
been receiving net foreign exchange on account of invisibles. Please don’t get confused by the
nomenclature invisibles. Simply put, invisible receipts are constituted of all our exports of
services, incomes form our investment abroad, remittances from Indians working abroad, and
official transfers received by the government.

Out of these, export of services and receipt of remittances have really been our shining stars. In
2005-06, the net earning on account of export of services has been $23 billion and the
remittance receipt has been around $24 billion.

But, due to a negative net balance on account of investment income, the total invisible receipts
have been around $42 billion. Not enough to completely wipe out the deficit on account of
imports and exports, but covering a substantial portion of it.

Johnny: But we are still running a deficit…

Jinny: Don’t be impatient. You have still not seen the full picture. There are three more stars to
come. These are foreign investments—both direct as well as portfolio, non-residents deposits,
and external commercial borrowings. Foreign direct investments (FDIs), simply put, are long-
term investment by foreign entities in Indian companies or projects in which the foreign entities
are interested in taking part in management.

Foreign portfolio investments (FPIs) are investments made through stock exchanges, in which
investors are not interested in exercising management control.

Both FDIs and FPIs (which are also commonly known as FIIs inflow) have been onthe rise. In
2005-06, the total net foreign investment has been around $17 billion.

Net commercial borrowings and net non-residents depo-sits have been around $2.7 billion each.

On the whole, in 2005-06, the net capital account inflow has been around $24 billion, more than
enough not only for completely wiping out our total forex deficit, but also for creating an overall
surplus.

Johnny: Now I understand how the dollars are falling on our roof. But why do some people call
it a problem of plenty? In my view, we should be happy that from the days of scarcity we have
moved to days of abundance. I don’t know what’s the problem.
What are participatory notes all about?
Participatory notes are instruments used for making investments in the stock
markets. However, they aren’t used within the country
Participatory notes have acquired unparalleled mystique as a market instrument. Their popularity
may soon inspire some ingenious film-maker to make a blockbuster. The era of some policeman
chasing a gold smuggler in a Bollywood movie is gone. Now, we may instead see our beloved
Shah Rukh Khan, in a pinstriped suit, investigating terrorist money being funnelled through
participatory notes.

Participatory notes have all the elements it takes to become popular. They invite rapt attention
of not only the laymen, but also experts around the world. There is no consensus on their use or
misuse. In a short span of less than two years in our country, two expert committees reached
two radically different conclusions about their fate. While one committee recommended giving
them a lease of life, another recommended ending their life sooner than later.

Today, Jinny is in a mood to unravel some of the mysteries surrounding participatory notes with
her buddy Johnny. Let’s see what they are up to:

Jinny: PN… PN tricky star…. I just wonder what you are….

Johnny: Hey, what’s that? New rhyme?

Jinny: No. But it can be a song in a new movie… say ‘Dirty PNs’… starring Shah Rukh, along with
a high-voltage team of two expert committees.

Johnny: ‘Dirty PNs’? … What’s that?... Some virus?

Jinny: PNs are participatory notes. I hope you have heard about this term.

Johnny: Aha! Participatory notes. Who hasn’t heard about them? But, I wouldn’t mind if you
provided some more insight on participatory notes and how Shah Rukh dealt with the wise men
of two expert committees.

Jinny: Let me first introduce you to participatory notes. Participatory notes are instruments used
for making investments in the stock markets. However, they are not used within the country.
They are used outside our country for making investments in shares listed in our country. That’s
why they are also called offshore derivative instruments.

Like any other derivative instruments, their value is determined on the basis of the underlying
asset. In the case of participatory notes, the underlying assets are shares listed on the stock
exchanges.

In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use
these instruments for facilitating the participation of their overseas clients, who are not
interested in participating directly in the Indian stock market. According to one estimate,
participatory notes constitute more than 25% of the cumulative net investments in equities by
FIIs.

Johnny: But why are the clients who use participatory notes not interested in participating
directly in the market?
Jinny: Several reasons can be cited. The first and foremost reason is convenience. Any entity
investing in participatory notes is not required to register with Sebi (Securities and Exchange
Board of India), whereas all FIIs have to compulsorily get registered. Trading through
participatory notes is easy because participatory notes are like contract notes transferable by
endorsement and delivery. Secondly, some of the entities route their investment through
participatory notes to take advantage of the tax laws of certain preferred countries. Thirdly,
participatory notes are popular because they provide a high degree of anonymity, which enables
large hedge funds to carry out their operations without disclosing their identity.

Johnny: Hedge funds… tax benefits… contract notes… so many complex things. We will talk
about them some other time. Tell me what difficulty does anonymous buying and selling pose for
the market?

Jinny: It is felt that anonymity can be misused for routing dirty money in the economy. That is
why regulators around the world are putting strict disclosure requirements on participants. In
India, FII regulations mandate that participatory notes are issued only to a regulated entity and
the FII has to ensure that no downstream issuance to any unregulated entity takes place. It is
also felt that anonymous traders have a very short-term horizon and most of the money flowing
through the participatory notes is hot money chasing some quick returns in the Indian market.
Any adverse movements of the capital can destabilize the market.

Johnny: If participatory notes are susceptible to misuse, then why have they not been banned?

Jinny: There is resistance because, ultimately, it is money, stupid! Investment through

participatory notes contributes to better participation of FIIs in the Indian market. Investment by
FIIs amounts to around 12% of the spot or cash market volumes. Except for 1998-99, the net
FII inflow into the Indian stock market has always been positive. Net FII inflow crossed the
magic figure of $10 billion (Rs43,000 crore) in 2004-05. The same can be contrasted with 1992-
93, when the net FII inflow was only $4 million. High inflows lead to better market capitalization.
Nobody is sure what effect the banning of participatory notes will have on the sentiments of FIIs.
The whole market may go into a tailspin and that will be our own doing.

Johnny: I get it now Jinny. But enough of this already. Time to check out the real Shah Rukh on
Kaun Banega Crorepati.
When do central banks assume the
role of lenders of last resort?
Banks work on the assumption that at any given point of time, only a
fraction of depositors would turn up to take their money back
Great ideas don’t have time to look at a watch. So, they are sometimes ahead of their time.

The whole concept of “lender of last resort” originated at a time when many central banks were
not even born. Many had ridiculed the concept at that time. But today the words of Walter
Bagehot in his seminal work, Lombard Street, asking the central banks to lend “quickly, freely
and readily” at penal interest rates sound like a home-made remedy. However, many still feel
that such a role poses a “moral hazard”. Our friend Johnny is confused. He is trying to figure
what role “the lender of last resort” plays.
The central bank assumes the role of lender in the larger interest of the financial market

Johnny: Last week you had told me that central banks play the role of lender of last resort. Tell
me, under what circumstances do central banks assume such a role?

Jinny: There is no prize for guessing. Central banks assume this role only as a matter of last
resort. Let’s try to understand what brings commercial banks at the doors of the lender of last
resort. You may be aware that as a part of their business, banks accept money from their
depositors. They keep a fraction of their deposits as reserves with the central bank and lend the
remaining to their borrowers.

Banks work on the assumption that at any given point of time, only a fraction of depositors
would turn up to take their money back. In normal times, the cash coming in as deposits every
day and the reserves with the central bank are more than enough to take care of day-to-day
repayments.

However, the bank may face a problem if a large number of depositors start asking for
repayments at the same time.

In such a situation, the demand may exceed the cash in hand and the cash kept as reserves with
the central bank. As you know, the rest of the money is lying with the bank’s borrowers. But the
bank can’t go to its borrowers and ask for its money back. That’s because all loans given by your
bank are repayable on maturity.

Borrowers are more comfortable than banks in the sense they can’t be forced to make
repayment overnight. The loans given by your bank lie invested in plant, machinery and other
goods that can’t be wound up overnight. In case borrowers are forced to make a repayment
overnight, they will in all probability go bankrupt. So, your bank tries to explore another option.
Johnny: What could that be?
Jinny: Your bank borrows money from other banks for the short term. But this option can work
only if other banks have confidence in your bank. In case other banks think your bank is on fire,
they many decline to lend even a single penny. Nobody likes to jump into a fire.

Johnny: That’s true.

Jinny: At this stage, when all other doors are shut, the central bank assumes the role of lender
of last resort. This is a purely discretionary role of the central bank and banks can’t ask for help
as a matter of right. The central bank carries out this role in the larger interest of the financial
market. Even sound and safe banks can sometimes experience difficulties in repayment due to
immediate shortage of ready cash.

If your bank is unable to return the money of even a single depositor, there can be panic in the
market. Panic begets more panic, and the queue of depositors outside your bank will get even
longer. So, the shortage of cash, if not tackled immediately, can ultimately lead to the collapse
of even a healthy bank. Liquidity problem of one bank may become liquidity problem of another
bank. A simultaneous run on two or three banks is a sure-shot recipe for financial doom. So, it is
necessary that the central bank assumes the role of lender of last resort by lending money to
banks in trouble.

Johnny: I see. This means that the lender of last resort protects the larger interest of the
financial market. But why do people talk about the “moral hazard” in such a role?

Jinny: It is very difficult to distinguish between a solvent bank and an insolvent bank facing
shortage of money. Many times, banks face such problems when they are internally sick. If you
have put your house on fire by recklessly lighting a firecracker, you have no moral right to ask
for a fire tender. It is another matter if your house caught fire due to an accident not of your
making. Using this logic, the proponents of moral hazard argue that central banks should not
come to the rescue of insolvent banks. A broke bank must be left alone to face its day of
reckoning. But despite all arguments, the central bank has to exercise its own judgement. Fire in
one house, whether caused by pure recklessness or an accident, may well engulf the entire
neighbourhood.

Johnny: Yeah, Jinny I agree. The central bank must be careful in exercising its judgement,
otherwise financial markets may turn into “Bombard Street”.