Prof Simply Simple – Understanding hedging

From the link: http://www.projdemo.com/tata_mf/pss/PSS_Understanding_Currency_Hedging.htm

Though the example below cites currency hedging, it is true for F&O segment as well.

There is a village known as Champak. The village is well known for the intelligence of its people. Chameli is one smart girl of the village and Chatur a smart young man, is keen to marry Chameli. However, Chameli is unwilling to commit. She sets her condition that she might consider marrying him but would confirm only after one year.

She comes up with an idea and makes an offer to Chatur.

She suggests that they draw up a contract which states that at the end of the year she might consider marrying Chatur but there would be no obligation to do so. For signing up the contract, she would pay Chatur a sum of money. As part of the contract, Chatur has to stay within bounds and not persuade her during this period.

If one sees this situation from Chameli’s perspective, it appears that she is “Hedging” herself or we may say she is “covering her risks” for a sum of money. Chatur on the other hand stands a chance of marrying Chameli after a year and the sum of money that he gets for the contract becomes the icing on the cake.

However, let us examine the scenario in the event of Chameli not marrying Chatur.

Chameli would use her option of not marrying Chatur if she happens to find a groom more eligible than Chatur. The only price that she would have to bear for this decision is the sum of money that Chatur would get on account of the contract.

So by offering this money, she covers her risks by ensuring that she enjoys the option of marrying either Chatur or somebody better. Chatur has a reasonable chance of marrying Chameli at the end of the year, but if that does not occur he at least gets to pocket the money.

Hedging of currency risk is similar to this story. Let’s say Chameli places an order to buy foreign machinery at a million dollars at the end the year. As per the contract, she will need to make the payment at the end of the year. Now let’s say the value of a million dollar is 5 cr. rupees at the time of signing the contract.

At the end of the year the value of the dollar rises by 10%. Now she would have to cough up additional Rs. 50 lacs for the machinery (Rs 5.5 cr for a million dollars due to price appreciation).

This increase in cost is not good for her business. And she looks for ways of covering such currency risk. Instead of risking what could be Rs 50 lacs, she buys a call option (you always buy a “call” option but sell a “put” option).

This option in essence gives her the option of either purchasing a million dollars for Rs 5 cr. or else allowing the option to expire. Logically, if the value of the million dollars falls below Rs 5 cr, she would allow the option to expire. But if the value of the million dollars goes up beyond Rs 5 cr, she would execute the option.

For getting the benefit of this protection, which is popularly expressed as hedging in the financial terms, she would naturally have to pay a fee or price. Let’s say this is Rs 5 lacs (This is just for the sake of illustration. The exact price of the option etc. is beyond the scope of this lesson).

So by risking Rs 5 lacs, she gets the option of purchasing a million dollars either for Rs 5 cr. or less but certainly not more. And for this she would have to pay Rs 5 lacs. If the price of a million dollars were to drop to Rs 4.95 cr. then she would also recover her fee, (Rs 5 lacs) and if the price were to drop to Rs 4.9 cr., she would end up making a profit of Rs 5 lacs. (Her total cost would then be Rs 4.9 cr for a million dollar + Rs 5 lacs as the fee = Rs 4.95 cr. which is Rs 5 lacs less than the agreed price fixed a year ago.)

Otherwise she would risk only Rs 5 lacs in the deal for which she would get a peace of mind by ensuring that the exchange rate for her does not change over the year. This is popularly known as covering the currency risk by way of hedging through the purchase of call options.

Prof Simply Simple – Understanding quantitative easing

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Another excellent article from Prof Simply Simple. The original link is here

http://www.projdemo.com/tata_mf/PSS/PSS_Quantitative.htm

The word “quantitative easing” more commonly known as “QE” made a grand entry into our lives along the media highway. We had the QE 1 and then the QE 2 by the Federal Reserve to revive the US economy.

What is this QE all about? To understand let’s look at a simple story.

Let’s say there was a prosperous village – Suskhsagar. Most of the villagers were into agriculture. Their lands were fertile and the farmers were happy. The village had good schools, shops, entertainment hubs, hospitals, municipality etc. Then one day, a pundit, who enjoyed the confidence of the villagers, visited the village. The villagers believe that the pundit was blessed with the knowledge of the future and could predict their future.

One evening, the pundit called an urgent meeting for the villagers to tell them about their future. This kind of meeting had been a regular feature in the village and most people attended it because the pundit’s prediction often was accurate.

So while he addressed the villagers, the pundit dropped a bombshell. He told the villagers that the future appeared very dark. He expected that the villagers would soon lose their jobs and source of livelihood. Their incomes would vanish. Therefore, time had come for them to store all that they had so that they could overcome the bad times.

The petrified villagers acted upon his instruction without any further delay. They began to save their money like there was no tomorrow. The villagers were in a state of shock. It appeared like the smiles had been erased from their faces. People stopped spending money and just focused on saving.

They were in no mood to visit the entertainment hub. Nobody visited the market to buy anything. Markets wore a deserted look. Even people stopped visiting the hospital except for emergencies. The fear of losing their jobs and source of income was sucking out every aspect of happiness from their lives. The demand for all goods and services nosedived. The producers of goods felt the pain and reduced prices to get some hold of their lives. But the demand simply did not lift up. Clearly, negative sentiments had come to enshroud the entire village that led to a standstill of economic activity.

One day, a government official passed through the village and wondered to himself how Sukhsagar village turned into Dukhsagar village. He talked to the village elders to understand. After listening to them, he made an attempt to dissuade their fears by informing them that there was no imminent danger of bad times befalling on them. But the villagers continued to embrace fear. After all they had more faith in the Pundit than the government official. The official had realized that the villagers themselves were making things bad. Seeing that his advice was falling on deaf ears, he invited another learned person to address the villagers. But all his efforts were in vain.

Soon the villagers started suffering. Although they had money stocked up in their houses, it meant little. The producers of goods and services due to the demand slump had either closed shop or left the village. So now there was even a shortage of goods. This meant that even though there was no demand, the prices had stopped falling. So while everyone had money in their homes, there was no economic activity. Without economic activity the markets had dried up just like a car would get stalled without petrol. How does it make a difference to the car if there is petrol in the pump but not in the engine? Just as the engine of the car running dry and coming to a standstill, so did the markets in the village in the absence of money that did not reach the markets even though there was plenty in the homes of the villagers.

There was only pain and misery left in the village. Although there was no external threat to their jobs but the peculiar behavior of the villagers to save money and stop buying goods and services was turning out to be the cause of job losses. So in a sense, the behavior of the villagers was making their nightmare come alive.

The government official was afraid that the villagers would destroy themselves if they continued on this path. So he thought of an idea to release the village from this grip of negativity. He made an unprecedented announcement to jolt the villagers into action.

The key parts of his announcement were:-
 

1) Money would be made available to everybody at 0% interest
   
2) As much money that would be needed would be provided
   
3) The villagers could pay off their debts over time
   
4) The government would buy off all the debt that others owed them
 
   
This announcement was manna from heaven for the villagers.

The assurance of easy money made them realize that it was futile to hoard money in their homes. The announcement encouraged them to buy goods and services from the market. This led to an increase in the demand for goods and services. Soon, the producers of other goods and services who had fled from the village started to return in large numbers. The entertainment hub also sprung into action.

The economic engine sputtered into action just as a car engine would when supply of fuel resumes.

The sentiments of the villagers took a U turn from negativity to positivity and Dukhsagar once again turned into Sukhsagar.

This process of releasing money into the hands of people to revive sentiment and getting people to actively participate in economic activity is what is popularly known as, “Quantitative Easing”. Quantitative easing literally means easing (or increasing) the supply of money in the economy. This is done by printing additional currency.

The cheap money released becomes an incentive for the people to consume and invest. While consumption increases, the demand for goods and services infuses life to the production process, investment provides the credit to build manufacturing capacity for goods and services so that the rise in demand does not lead to high inflation. Thus changing sentiments is a self fulfilling prophecy that helps the economy to gain momentum and sustains itself. The moment sentiments change, people are inclined to hoard less and inject more money into the economy. The infused money acts as the lubricant for the economy to chug along smoothly.

Insourcing – the new buzzword

Since the 1990s, we have heard a lot about outsourcing and its effects on certain economies like India and China. Money has actually moved from the developed economies to the yet developing ones, even as companies look for more avenues to cut costs. But the party had to end, and President Obama is leaving no stone unturned to fulfill his election promise: of bringing jobs back to the US. And this has given rise to a new trend of getting jobs back to the company.

Wikipedia defines insourcing as a situation where a company ceases to contract a business function and begins to perform it internally. This isn’t onshoring, where jobs are brought back to the country, not necessarily in house.

Why is this trend emerging? And what does it mean for the future?
Cio.com’s list includes poor service quality, failure to meet business objectives and the desire for companies to have greater control over the IT function. The causes in manufacturing sectors include political interference, law compliance and reduction of transportation costs. Yet a whitehouse blog page reveals how this is strongly politically motivated.

What does it mean for India which has emerged as a service destination and is now witnessing revenue reduction owing to reduced dependence by the West? Unless India develops its R&D capabilities and its people power, things will only be tougher. The unstable scam laden political climate is only making things worse. We are importing more and more yet exporting less. Unless there is a big move by the industry or the government, things will be tough for India.

Sources:
http://m.whitehouse.gov/blog/2012/01/11/everything-you-need-know-about-insourcing

http://www.cio.com/article/665686/Goodbye_Outsourcing_Hello_Insourcing_A_Trend_Rises

http://en.m.wikipedia.org/wiki/Insourcing

(Just for the record: I did the full research and composed the post on my blackberry bold 9780, great browser, great wordpress app)

Prof Simply simple – What Do Share Prices of Companies Reflect?

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From: http://www.projdemo.com/tata_mf/Intellect/whatdoshare.htm

There is a difference between the price of a share and its intrinsic value. This is because while the share price represents a company’s valuation, it is dependent on several macro – economic factors as well. So it is not just the performance of the company that matters. Also when the profitability and outlook of profitability comes down, the price can follows suit because “price of the share of a company” is a function of profitability expectation of that company. Below are the various parameters that have a bearing on share prices.

1) Inflation: When inflation is high, people have less money to buy goods. Hence the demand for goods and services comes down. This reduces profitability of companies which in turn brings down the price of shares. Also when inflation is high, the input costs for companies soar and many times companies do not pass this increase on to consumers. At such times, the company takes a hit by way of margin squeeze which brings down both profitability and share price.
   
2) Interest Rates: When interest rates go up, companies are directly impacted as their interest costs increases. This may bring down profits and the outlook of future profits if the high interest rates are expected to sustain. When profit outlook comes down, the share prices too tend to move down.
   
3) Currency Devaluation: When currency gets devalued or expectations of devaluation sets in, the interest of foreign investors could start to decrease. For example, if an international investor invests $100 when the value of the rupee was Rs 50 (this means the person bought Rs 5000 from the $100). Subsequently if the value of the rupee decreases to Rs 55 to a dollar, then one can only recover about $90 from the Rs 500) which one purchased. Thus the returns are adversely impacted in a depreciating currency scenario. Hence during such times, foreign investors are hesitant to invest and cause foreigners to sell off Indian shares, converting the proceeds into dollars and fleeing Indian markets. This sale of shares initiated by them would bring share prices down.
   
4) Government Spending: A government that borrows in excess and overspends reduces the money available in the system. Private companies either have to make do with limited finance which hampers its growth plans or it has to borrow at higher interest rates which brings down its profit growth outlook and hence its market capitalization (price). This phenomenon is what is popularly termed in finance as “crowding out” of private investments. Also one must understand that overspending on part of the government can lead to inflation if the supply of goods and material is inadequate. Inflation itself has an adverse impact on share prices as explained in the section on “inflation”.
   
5) Fiscal Deficit and Current Account Deficit: When the government spends more than it earns (imports more than it exports), it either borrows at higher prices which raises interest rates in the economy or it has to print notes to meet the deficit. In the case of printing currency without equal economic activity, the value of money goes down or in other words “inflation” kicks in. Thus higher interest rates, inflation and devalued currency impact cost of input and demand of goods and services unfavorably. This impacts company profitability and brings down share prices.
   
There are several macro – economic factors that influence share prices. Secondly, these factors are inter-related and these factors play a vital role in creating negative or positive sentiments among investors as the case may be. So even if a company is performing steadily and having reasonable operational profits, the macro – economic outlook plays a significant role in determining its share price.
   
 
   
 

Prof Simply simple – Depreciation of the rupee

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From: http://www.projdemo.com/tata_mf/Intellect/understanding_depreciation.htm

Every country exports and imports for its survival. As long as this equation of imports versus exports is balanced, it is good for the nation but when imports become more than exports, the value of the currency starts declining. It means that the country needs more from other countries while it has little to offer to them. Indian goods are bought with Indian rupees. Hence if the demand for Indian goods falls, consequently the demand for Indian rupee also falls.

India has dual challenges. While the demand for Indian goods seems to be waning, due to export slippage, India continues to import crude (petrol/diesel) and other imports vital for the economy at high international commodity prices and an inelastic demand for gold and silver. Therefore the demand for the dollars continues to be high. This situation puts further pressure on the Indian rupee widening the current account deficit.

What is the immediate fallout of the rupee depreciation:-

1) The price of petrol has gone up substantially. Also the price of diesel and LPG could spike. When the price of fuel goes up, the cost of transportation goes up and when the cost of transportation goes up, the cost of goods goes up and thus inflation goes up. As we have a current account deficit, rupee depreciation has an inflationary impact.
   
2) Companies which are dependent on raw material imports or have imported components could see profitability and market capitalization take a beating. This is because its profitability may get hit by higher input costs.
   
3) Foreign travel is set to get costlier. One would have to keep more rupees on hand to purchase dollars to fund foreign travel.
4) Studying in foreign universities may get costly. This is the same in the case of foreign travel; more rupees would be needed to fund foreign education.
   
5) Several electronic goods which depend on imports and royalty payouts may get more expensive.
   
6) NRIs and exporters would be happy and can be expected to remit more dollars as they would get a higher price. Companies like IT software, Pharma and BPO would gain from the dollars that they earn by providing goods and service abroad.
   
As seen above, devaluation of the rupee is inflationary in nature, as we are net importers. There is a need by the Government to devise policies and tools to stem the fall of the rupee. In this context it is important to examine the tools (short term and long term) that may be available:-
   
1) Government can buy Indian Rupees from the foreign exchange market by selling its dollars. This would however reduce the foreign exchange reserves which are needed to fund our imports. Hence this is not a sustainable solution.
   
2) Government can mandate banks to increase their Cash Reserve Ratio and Statutory Liquidity Ratio which means banks would have to deposit more rupees with the Reserve Bank. Alternately the central banks can issue bonds for the public. By these measures the central bank would reduce the liquidity in the system and try and make the rupee dearer. However, these measures have the effect of increasing interest rates which hurts profitability of companies and thus adversely affecting economic growth. When economic growth gets limited, the production of goods and services too gets unfavorably impacted giving rise to inflation.
   
3) The Government can ask companies who have dollar accounts to bring in the dollars back into the country and convert them into rupee accounts. This would increase demand for the rupee which in turn would stem the slide of the rupee.
   
4) The Government can make it easier for companies to borrow in dollars from abroad. Companies would get more rupees for every dollar borrowed. This would help them finance their working capital requirements. If the rupee regains its strength over a period of time, the borrower could have to return lesser rupees. However, if the rupee further slides then business would be at a disadvantage. Hence businesses would take this route based on their outlook of the rupee.
   
5) The Government can attract NRI dollar deposits by offering attractive interest rates
   
6) Government can reschedule / delay in paying off its dollar debts with the hope that the rupee would regain strength subsequently.Thus at a later day lesser rupees would have to be coughed up to repay the debts.
   
7) The Government can increase the limit of FII investment in debt papers. This would certainly bring hot money seeking quick gains. Some flow of hot money would be useful.
   
8) Government can liberalize foreign investments in insurance, aviation and retail, infrastructure sector, agro-based businesses as well as may reduce subsidy from various sectors. This would be one of the better moves as it would bring in serious long term money from abroad.
   
9) The Government could frame policies to restrict the import of gold by raising custom duty and thereby making investment in gold less attractive.
   
10) The Government could action some long standing economic reforms to induce both domestic and international investments. This would help in increasing production and productivity of the economy. Higher production along with productivity would help in increasing supply of goods and services and thereby reduce inflation. This would be a better and sustainable method for tackling both the rupee crisis as well as inflation. Economic reforms would bring in “Foreign Direct Investment”. Economic growth can improve investor confidence and this ultimately bringing back a higher trajectory of GDP growth.
   
The depreciation of the rupee has an immediate impact on India in many ways, as discussed above. It is important to understand the macro-economic situation and the ways and means by which the Government can battle the challenges and try to steady the economy.

Prof Simply simple- Understanding S&P’s criteria for Sovereign Ratings

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Copied from: http://www.projdemo.com/tata_mf/pss/pss.htm

The current crisis in Europe has brought into the spotlight sovereign creditworthiness and highlighted the ongoing task of credit ratings agencies in assessing this issue. Sovereign government bonds are issued globally and it is imperative that investors have globally recognized and consistent benchmarks to guide their investment decisions. There are 3 major credit rating agencies known as Moody’s, Standard and Poor’s(S&P) and Fitch. They account for 90% of the market. The focus will be on Standard & Poor’s to explain their criteria on sovereign ratings.

The list of the criteria is as follows:-

1) Institutional Effectiveness and Political Risks: If the judiciary, the executive and the legislature along with scores of other institutions such as CAG, Election Commission, Police, and Defense etc. are robust. Political risk is a reflection of government stability that indicates whether the government is enjoying reasonable confidence in both the Houses of Parliament and whether it is expected to last its complete term.
   
2) Economic Structure and Growth Prospects: This looks at economic growth and future potential. It may also analyze the debt to GDP ratio and several other financial ratios to arrive at the health of the economy.
   
3) External Liquidity and Internal Investment Position: The focal point is whether FIIs are considering India as a good destination for investment, whether FDI money is coming in and whether the domestic investment scenario is good.
   
4) Fiscal Performance and Flexibility: This focuses on if the fiscal deficit is under control, whether budgetary management is professional, and if the aid being offered by the government has any basis or not.
   
5) Monetary Flexibility: If the RBI is robust in its performance, if it regulates money supply according to the need, whether inflation is being kept under check, and what the expectations are going forward.
   
   
Source: Understanding Ratings: Standard & Poor’s Rating Services http://img.en25.com/Web/StandardPoorsRatings/Sov_Default_2011.pdf

Retrospective amendment

Sometime back I had heard the phrase “No one is above the law”. While this sounded just then, the reality is that the law enforcers are the first ones who bend laws to suit themselves.
The current spate between the government and vodafone over capital gains taxes is a case of lawmakers twisting the law to boost their egos.

The story goes like this:
Hutchinson Whampoa decided to leave India in 2007 and passed the baton of telecom licences to Vodafone. Retrospectively, It has turned out to be the best thing to do since the government is now destroying the industry. Now by law, someone needs to pay the capital gains tax on the transaction, had the gain been made by a company of Indian origin. But it wasn’t, since Vodafone plc is British and Hutchinson Wampoa from Hong Kong.

But this didn’t deter the IT sleuths from going after the transaction. But they had no jurisdiction in Hong Kong, hence couldn’t send the tax bill. So the scapegoat was the entity that wanted to do business in India, and a controversy was started.

5 years on, the Supreme court passed the judgment that the income tax department couldn’t ask for anything from vodafone since there was no such law in 2007. Red faced over the high profile loss, the finance minister jumped into action to undo what supreme court had ruled. And the concept of retrospective amendment was born. This allows the government to tax any deal dating as back as 1962.

This is the kind of circus going on in the highest echelons of the Indian government. Allowing retrospective amendments at will is akin to opening a can of worms. Consider these cases:

1.Raise income tax rates of people to double, effective 1991. So anyone who hasn’t paid double income tax since 1991 has violated the law and has to pay a fine as well.
2. Add luxury tax of 200% on all hotels with effect from 2000. So hotels who haven’t paid 200% tax since then will face penalty.

Somewhere I had heard that we live in a free and fair society, that doesn’t hold true any more.

The telecom industry is in danger

http://economictimes.indiatimes.com/news/news-by-industry/telecom/telcos-including-airtel-idea-and-vodafone-say-trais-proposals-inconsistent-tariff-may-double/articleshow/12983379.cms

I have always believed that the so called notional loss that Raja was tainted with was nothing but an eyewash to get him out of the picture. I must congratulate the UPA government for making him a scapegoat. This way of recovering the losses only means that an industry is in danger.
First a number of players are invited resulting in tariff war and poorer service. But at least it connected the common man. Now the newer players are being driven out.
Then the government is wants more ‘hafta’ over 2G. 3G is already a disaster due to high spectrum pricing, plus inter circle roaming pacts are also illegal. So one isnt expected to be mobile and have 3G services.
Only Reliance has 4G licences, along with airtel for a few circles.
The government has no interest in the development of this industry, as long as their pockets are being filled.
Shame!

Whats wrong with infosys?

“In an open letter to the company’s CEO & MD S D Shibulal, brokerage firm, CLSA Asia Pacific Markets, voiced the collective dismay of 100 institutional investors seeking to know the company’s plans to correct the loss of revenues and earnings before interest and tax.

 Infosys, which announced its fourth-quarter numbers earlier this week, missed its March 2012 guidance by 1.9-2.2 per cent. More importantly, its guidance of 8-10 per cent growth in FY13 shocked the Street, as it was lower than industry body Nasscom’s estimate of 11-13 per cent”

(http://www.equitybulls.com/admin/news2006/news_det.asp?id=103313)

The investors are disappointed, the employees are agitated. Yet this remains a cash rich company ($4 billion as per the CFO) with a market cap of $26.5 bn with a respectable image. But what went wrong with the early player of the sunshine industry?

In this environment, Infosys doesn’t want to be a commodity player. Yet their premium offerings seem to be taking a beating.

But the reality remains that Infosys has large been an epitome of commodity business, with low growth. Ask an employee or a manager and the truth will be evident.

If the focus on pricing and the fact that most of the work done isn’t premium, where does Infosys head to? The company seriously requires a change of strategy. Like Cognizant and HCL, there is a need to cut prices, provide innovative solutions and look for acquisitions to unlock value.

An exodus of talent will only increase costs of service. However with low utilization levels, this may not affect the company much. In fact, the decision to indefinitely delay increments may have been a deliberate move to reduce lateral staff. And of course, it is possible to service commodity offerings with newer staff. However, any move in this direction will only tarnish the image NRN and Nilekani had worked so hard to build.

To an outsider, this is akin to anarchy in a giant after the founders have relinquished their management responsibilities.

http://www.business-standard.com/india/news/open-houseceo-disenchanting-infy-staff/472201/

http://www.business-standard.com/india/news/investors-show-%5Crare-frustration%5Cinfosys/472139/

http://timesofindia.indiatimes.com/Infosys-After-increment-freeze-steep-cut-in-variable-pay/articleshow/12789774.cms

http://m.economictimes.com/PDAET/articleshow/msid-12686188,curpg-3.cms

Immigration rules in UK

I cant help but be amused at the sentiments people have with the new rule. The times of India featured an article today, flaring sentiments from far and sundry. More than the news, the comments made me sit back and think.

The issue here: Automatic immigration into UK of non EU temporary visa holders is stopped.
The expressed cause: UK needs to protect the interests of its citizens.

Then why only non EU countries?
Because of some sort of free trade agreement between EU countries that is supposed to allow movement of people. So UK is not obligated to allow people from non EU countries to work.
Then why not stop immigration altogether?
Some good people do enter UK, and the Cameron government cannot do away with such talent. So the government is devising policies that would filter out the ones they dont need (and they are right in doing so).

Why do people want to enter UK?
For skilled workers: better opportunities and lifestyle
For unskilled workers: same.

The sentiments that can be seen in the comments:

– The people who are out want to enter for reasons mentioned above.
– The people who are already in the circle want to keep others out. The foreigners have  a tendency to work on low wages and disrupt the economy and culture of the country. Where is the free market economics? For people who are ethnically non British, constant inflow of labour would only mean difficulty in maintaining their identity.

But the fact is:

The ones who could enter UK earlier were lucky.
The ones who want to enter want to try their luck.

This goes on everywhere.

The is a constant debacle between the haves and the have nots. A mutual hatred can be seen everywhere. We can see it in Maharashtra, in the eastern borders of India, in US, Australia or even UK. There is no end to it, nor a solution in place, unless there are ample opportunities for everyone.