31) Demystifying Sensex

The BSE SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media.

The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology.

Due to is wide acceptance amongst the Indian investors; SENSEX is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the SENSEX has over the years become one of the most prominent brands in the country.

Q.1 What is SENSEX? The SENSEX, short form of the BSE-Sensitive Index, is a "Market Capitalization-Weighted" index of 30 stocks representing a sample of large, well-established and financially sound companies. It is the oldest index in India and has acquired a unique place in the collective consciousness of investors. The index is widely used to measure the performance of the Indian stock markets. SENSEX is considered to be the pulse of the Indian stock markets as it represents the underlying universe of listed stocks at The Stock Exchange, Mumbai. Further, as the oldest index of the Indian Stock market, it provides time series data over a fairly long period of time (since 1978-79).

Q.2 What are the objectives of SENSEX? The SENSEX is the benchmark index of the Indian Capital Markets with wide acceptance among individual investors, institutional investors, foreign investors and fund managers. The objectives of the index are:

To measure market movements Given its long history and its wide acceptance, no other index matches the SENSEX in reflecting market movements and sentiments. SENSEX is widely used to describe the mood in the Indian Stock markets.

Benchmark for funds performance The inclusion of blue chip companies and the wide and balanced industry representation in the SENSEX makes it the ideal benchmark for fund managers to compare the performance of their funds.

For index based derivative products Institutional investors, money managers and small investors all refer to the SENSEX for their specific purposes The SENSEX is in effect the proxy for the Indian stock markets. The country's first derivative product i.e. Index-Futures was launched on SENSEX.

Q.3 What are the criteria for selection and review of scrips for the SENSEX? A. Quantitative Criteria:

1. Market Capitalization:The scrip should figure in the top 100 companies listed by market capitalization. Also market capitalization of each scrip should be more than 0.5 % of the total market capitalization of the Index i.e. the minimum weight should be 0.5 %. Since the SENSEX is a market capitalization weighted index, this is one of the primary criteria for scrip selection. (Market Capitalization would be averaged for last six months)

2. Liquidity:(i) Trading Frequency: The scrip should have been traded on each and every trading day for the last one year. Exceptions can be made for extreme reasons like scrip suspension etc. (ii) Number of Trades: Number of Trades: The scrip should be among the top 150 companies listed by average number of trades per day for the last one year. (iii) Value of Shares Traded: Value of Shares Traded: The scrip should be among the top 150 companies listed by average value of shares traded per day for the last one year.

3. Continuity: Whenever the composition of the index is changed, the continuity of historical series of index values is re-established by correlating the value of the revised index to the old index (index before revision). The back calculation over the last one-year period is carried out and correlation of the revised index to the old index should not be less than 0.98. This ensures that the historical continuity of the index is maintained.

4. Industry Representation: Scrip selection would take into account a balanced representation of the listed companies in the universe of BSE. The index companies should be leaders in their industry group.

5. Listed History: The scrip should have a listing history of at least one year on BSE.

B. Qualitative Criteria:

Track Record: In the opinion of the Index Committee, the company should have an acceptable track record.

Q.4 What is the beta of SENSEX scrips?

Beta measures the sensitivity of a scrip movement relative to movement in the benchmark index i.e. SENSEX. A Beta of one means that for every change of 1% in index, the scrip moves by 1%. Statistically Beta is defined as: Covariance (SENSEX, Stock )/ Variance(SENSEX)Note: Covariance and variance are calculated from the Daily Returns data of the SENSEX and SENSEX scrips.

Q.5 How is SENSEX calculated?

SENSEX is calculated using a "Market Capitalization-Weighted" methodology. As per this methodology, the level of index at any point of time reflects the total market value of 30 component stocks relative to a base period. (The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company). An index of a set of a combined variables (such as price and number of shares) is commonly referred as a 'Composite Index' by statisticians. A single indexed number is used to represent the results of this calculation in order to make the value easier to work with and track over time. It is much easier to graph a chart based on indexed values than one based on actual values.

The base period of SENSEX is 1978-79. The actual total market value of the stocks in the Index during the base period has been set equal to an indexed value of 100. This is often indicated by the notation 1978-79=100. The formula used to calculate the Index is fairly straightforward. However, the calculation of the adjustments to the Index (commonly called Index maintenance) is more complex.

The calculation of SENSEX involves dividing the total market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index maintenance adjustments. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time.

Q.6 How is the closing Index calculated?

The closing SENSEX is computed taking the weighted average of all the trades on SENSEX constituents in the last 15 minutes of trading session. If a SENSEX constituent has not traded in the last 15 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value.

Q.7 How is the routine maintenance of SENSEX carried out?

One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that additional issue of capital and other corporate announcements like bonus etc. do not destroy the value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Index Cell of the Exchange does the day-to-day maintenance of the index within the broad index policy framework set by the Index Committee. The Index Cell takes special care to ensure that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between high turnover in Index scrips and its representative character. The Index Committee of the Exchange has experts from different field of finance related to the capital markets. They include Academicians, Fund-managers from leading Mutual Funds, Finance - Journalists, Market Participants, Independent Governing Board members, and Exchange administration.

Q.8 How are adjustments for Bonus, Rights and newly issued Capital carried out in SENSEX?

The arithmetic calculation involved in calculating SENSEX is simple, but problem arises when one of the component stocks pays a bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value. The Index Cell of the Exchange periodically adjusts the base value to take care of such corporate announcements. Adjustments for Rights Issues: When a company, included in the compilation of the index, issues right shares, the market capitalisation of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market Capitalisation (see ' Base Market Capitalisation Adjustment' below). Adjustments for Bonus Issue: When a company, included in the compilation of the index, issues bonus shares, the market capitalisation of that company does not undergo any change.

Therefore, there is no change in the Base Market Capitalisation, only the 'number of shares' in the formula is updated. Other Issues: Base Market Capitalisation Adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc. Base Market Capitalisation Adjustment: The formula for adjusting the Base Market Capitalisation is as follows: New Base Market Capitalisation = Old Base Market Capitalisation X (New Market Capitalisation/Old Market Capitalisation) To illustrate, suppose a company issues right shares which increases the market capitalisation of the shares of that company by say, Rs.100 crores. The existing Base Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the aggregate market capitalisation of all the shares included in the index before the right issue is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be: Rs.2501.24 crores = 2450 X (4781+100)/4781 This figure of 2501.24 will be used as the Base Market Capitalisation for calculating the index number from then onwards till the next base change becomes necessary.

Q.9 With what frequency is SENSEX calculation done?

During market hours, prices of the index scrips, at which trades are executed, are automatically used by the trading computer to calculate the SENSEX every 15 seconds and continuously updated on all trading workstations connected to the BSE trading computer in real time.

30) Chasing index returns

A growth economy is likely to benefit a large number of companies than the narrow basket the Sensex represents. So, restricting your investments to the index alone may mean missing several promising opportunities.

You see the index values rising daily to new highs. Yet the return on the stocks you hold in your portfolio looks relatively modest. This is despite following every rule in the investment handbook, be it doing your homework, diversifying your portfolio, or buying into undervalued stocks. If so, do not fret!

Professional fund managers may well share your angst. Apparently, following the rules did not pay off in the last year. Not if you measure yourself to the performance of the benchmark indices. Many equity fund managers struggled to beat the Sensex and the Nifty last year. In fact, holding a few stocks that make up the key weights in the index may have delivered far better results last year than holding a portfolio of many stocks. Chasing index returns

One reason why your portfolio could have struggled to match the Sensex or the Nifty is the highly selective nature of the recent rally. The Sensex has gained 38 per cent in 2007. Yet only about 10 stocks within this basket have generated returns greater than the index; clear evidence that gains were driven by just a few stocks.

Only a handful of stocks — Reliance Energy, Reliance, L&T, chief among them — have led the gains of the Sensex. Not only are these stocks among the top performers over the past year but they also have a significant weight in the index, contributing to the rise in the overall index levels. Even if you held mid or small-cap stocks, your portfolio wouldn’t have performed unless you held the handful of stocks that did well.

Testing the waters

If the recent stock price rally is all about the India story, why is it that only a handful of stocks have notched up much of the returns? Well, that is because foreign investors testing the waters in India tend to automatically migrate to the most visible names of India Inc. As a result, a huge body of inflows has been directed towards the index stocks by foreign investors who wish to buy the India theme. While some of the more seasoned FIIs invest deeper in mid-cap and small-cap stocks, investors unfamiliar with the Indian markets might choose to stick to the familiar names because they offer higher liquidity and more predictable returns. Tracking breadth

Ever wondered what reports on the markets refer to when they say the “breadth of the market was weak”? What this means is that although the Sensex and other indices closed the day with gains, not all stocks participated in the rally. The reason why going by the performance of the index can be deceiving is because of the way indices are constructed.

Indices are meant to capture the essence of the entire market activity. Yet Indian indices don’t always do so, because of the manner in which they are constructed. To be included in the Sensex or Nifty, stocks need to meet market capitalisation and liquidity criteria.

While the indices attempt to provide a wide industry representation, the strict criteria have invariably led to a concentration of holdings within a particular sector. For instance, the Sensex has a heavy weightage (about 40 per cent) in finance and oil and gas sectors.

Because of this concentrated index construction, companies from sectors in take-off mode, such as media, retail, brokerages, logistics and construction, barely make an appearance in the Sensex or Nifty. The Sensex covers only 30 stocks after all, out of more than 7,000 listed companies.Index changes

If you are chasing index returns, keeping an eye on its changing composition is also necessary. The frequent changes in composition in the indices over the past year have made a big difference to how the Sensex or Nifty fared. For instance, over the past year, the likes of Unitech, NTPC, Reliance Petroleum and Reliance Communication have been included in the Nifty, while stocks such as Jet Airways and Tata Tea, which had a tendency to lag, were shown the exit.

The Nifty, after a long period of trailing the Sensex, has finally caught up with the latter over the past year through these changes. The BSE, for its part, has introduced DLF into the Sensex, recognising the emergence of real-estate development as a significant sector.

Interestingly, keeping track of these changes might help you spot ideas that you can incorporate into your own portfolio. The mere announcement of the inclusion of a stock into either of these indices often sparks off buying in that particular stock. For instance, Unitech rose almost 30 per cent in the month running up to its inclusion in the Nifty.Does index investing pay?

If the indices are so hard to beat, should one just stick to investing in the basket of index stocks? Index funds and exchange traded funds allow you to replicate the bellwether indices with little effort. But you probably shouldn’t get too carried away by what has happened over the past year or two, as this might only be a temporary phenomenon.

Diversified equity funds in India have traditionally delivered significantly superior returns by investing in stocks outside the indices.

Moreover, prudent investing practices, such as limiting their exposure to sectors and stocks, has helped them contain declines better than the indices during sudden market meltdowns.

A growth economy is likely to benefit a far greater number of companies than the narrow basket the Sensex represents. So, restricting your investments to the index alone may not only result in a concentrated portfolio but may also mean missing several promising opportunities. This is especially true if you are building a portfolio for a five-ten year period.

29) Locking in gains using OPTIONS — Strategies to hedge equity risk

Dabbling in derivatives can be very risky. However, when used for hedging, the same instruments help reduce the risk an investor bears when stock prices fall. Investors of all descriptions, with the help of options, can hedge their equity investments and protect them from potential declines in stock prices.

While investments made with a short-term horizon are, by nature, more susceptible to market vagaries, long-term investments too cannot remain unscathed when markets turn extremely volatile.
How can derivatives be used to hedge equity risk? When should a hedge be created? How can idle long-term stock holdings be used to lock in gains? Here are a few strategies that apply in different situations: Insurance against downside

Consider this. Markets are at an all time high. Your portfolio value too has appreciated considerably. If you are worried that the stock prices will fall in the near future or that volatility in the broad markets can wipe out some of your gains, portfolio-hedging can come in handy.

This can be implemented by buying index put options, which gain in value with every fall in the markets. But how may puts do you need to buy to protect your portfolio?

Say, you hold 1,000 shares of Bharti Airtel, 300 shares of Infosys, 500 shares of Reliance Industries and 700 shares of Hindustan Unilever. In order to completely hedge the portfolio, you need to arrive at the total beta value of your holdings. To begin with, get the beta of individual stocks against the index (available in NSE monthly newsletters).

Now, multiply individual beta value of stocks to the current value of investment in that stock. Then, divide the sum of all these numbers with the total value of your investment (current) to arrive at the overall beta of your portfolio.

Typically, ‘Beta’ captures the extent to which the value of your portfolio will change with every movement in the index; higher the beta, higher the correlation with the index.

To calculate the number of puts you need to buy, multiply the current value of your investment with portfolio beta and then divide that by the Nifty value (arrived at by multiplying Nifty spot by its lot size). Say the Nifty spot value is at 5200.

Now, if you want to hedge your portfolio against any drop of more than 10 per cent, you should buy puts with 4680-spot price.

Possible outcomes: Now if the market falls below 4680, the index puts will turn ‘in-the-money’, and gains made through the options will make up for the notional loss in portfolio value.

On the contrary, if the market does not correct, as you had feared, then the puts will expire worthless. However, in such a scenario, the premium paid for securing the puts would be a one-time pay out and would be the cost of insuring your portfolio.

Note that brokerage commissions and other charges have not been included. Investors, however, will have to include such charges to arrive at optimum spreads.
Preserving your wealth

Hedging can also be used when you hold a large chunk of a specific company’s shares, either earned as ESOPs or accumulated over the years. In such a scenario, your cost of investment might be significantly lower than the current value of your holdings.

However, if your financial goal involves selling these shares in near future, you could be better off creating a hedge, to lock in a certain minimum level of gains. There are different ways to hedge your portfolio and profit from these idle holdings of a single stock.

If the stock you hold is being traded in the derivatives segment, buying stock puts can create a good hedge.
Again, the spot price of the option will depend on the minimum sale price you intend to secure for your shares (or the percentage of loss that you can tolerate).

Alternatively, if you are confident on the stock prospects (for the period of the contract) but are concerned that broad market volatility could weigh on the stock performance, buying Nifty puts can be considered.
Depending on the stock beta and the hedge required, you can arrive at the number of Nifty puts that should be bought. This way, you can minimise the influence of Nifty on your stock performance.

Covered calls

This strategy involves selling ‘out-of-money’ call options in a stock, while simultaneously holding an equivalent position in the underlying.

Covered call can be written when you are bullish on the underlying stock over the long term but feel that the stock price will trade in a tight range over the lifetime of the contract.

Remember that writing a call gives the buyer the right, and not the obligation, to buy shares from you at the specified price, on or before the stipulated time period. Say, you hold 1,000 shares of Infosys. You are bullish on the long-term prospects of the company but feel that given the rupee appreciation and sub-prime concerns the stock might trade sideways for the next one month.

Depending on what you foresee as the upper trading range of the stock (say, it is Rs 2,200), you can consider selling calls at that spot price. However, note that you stand the risk of not finding takers for your calls if they are sold with unrealistically high spot prices.

Possible outcomes: If the stock trades flat, the option will expire worthless and you get to keep the premium. Similarly, even if the stock price falls, the options expire worthless.

In both these scenarios, you get to pocket the premium, which will help you outperform the stock returns in the cash market.

However, if the stock price were to rise beyond the spot price, you will have to part with your shares since the options will be exercised. In this case, your upside is capped at Rs 2,200, plus the premium you received.

Writing covered calls helps investors sitting on idle long-term holdings generate additional gains linked to these shares, provided you can forecast a trading range. This apart, it also secures the downside risk for the stock to an extent.

Moreover, since it requires writing calls only against an equivalent equity holding, it is also not very risky.
Nevertheless, investors stand the risk of parting with their stocks if the stock price were to move above the upper limit of the trading range. In such a case they also stand to lose out on any upside potential in the stock in the cash market.

Using a “protective collar”

Alternatively, you can also use ‘Protective Collar’, a strategy that will provide short-term downside protection to your stock holdings. Interestingly, this strategy, unlike the previous two, can be created at little or no cost at all.
Creating a collar requires you to buy puts on the stocks at lower spot prices and sell calls of the stock for the same month, but for a higher spot price.

Say, you hold 100 shares of ABC shares trading at Rs 1,900. Your cost of purchase for the stock was significantly lower, at Rs 200. So, on a per share basis, you are sitting on a profit of Rs 1,700.

Therefore, when you buy ABC put options with a strike price of 1,800, which trades at, say, Rs 35 per lot, you will lock in gains of Rs 1,665 per share (1,700-35). Remember that you will have to shell out Rs 3,500 for securing this position (35*100, the lot size).

This will now limit your downside risk.

The second part of the strategy is to sell call options (that is, write calls) on the stock at a higher spot price. Assume you sell ABC call option with a strike of 2100 at Rs 44 per lot.

This position will earn you an initial sum of Rs 4,400. In this way, you net in a total of Rs 900 for creating the collar (Rs 4,400-3,500). The position now caps the maximum downside risk at about 5 per cent and upside potential (for the contract period) at 11 per cent.

Note that different spreads can be chosen, depending on the investors’ stock price outlook and risk tolerance.
Possible outcomes: If the stock price falls much below the strike price of the put option, gains from the long put position will offset the notional loss in portfolio value. The calls, however, will expire worthless. In addition to this, investors also get to pocket the gains that were made to create the collar.

If the stock price rises beyond the strike price of the call options, it will result in a loss. This loss will be offset by the rise in value of the stock holding. The put option will expire worthless. However, investors stand the risk of their calls being exercised, in which case they could be forced to part with their stock holdings.

If the stock price trades in a range between the put strike price of Rs 1,800 and the call strike price of Rs 2,100, both the options expire worthless. In this case, you gain only the money made from setting up the option spread.

28) Right move on PNs

As we become a destination for global investors, we need to check not only the quantum of capital inflows but their quality as well. Any outside infusion of capital into an economy could create a bubble if not used constructively.

Globally, October has never been an easy month for equity markets. In 1987 and 1997 the markets tanked in October and again threaten to this year. In the last 100 years beginning 1907, only in 1947 did the markets move up in October.As for the Indian markets, though October has never really been a ‘deadly’ month, this yearit may turn out to be one.

Till some years back, it took around a year for the Sensex to climb 1000 points. The time-span for such a climb has shrunk rather quickly to one season and even to a month. And in the first half of October we saw the Sensex climb from 18K to 19K in just four days. But then came the October effect, as circuit breakers were applied on October 16.

The power of money was at play. The Money Momentum Mania (3Ms) was the cause for the indices scaling to such heights. While the various players in the stock market were celebrating, the monetary authorities and the Government were turning apprehensive. The deluge of money, described by some as “funny money”, prompted the regulators to act, by issuing a notification to regulate the issue of Participatory Notes (PN).What’s PN?

A Participatory Note is an Offshore Derivative Instrument (ODI) . The invention of this product was necessitated as many fund managers did not want to register with SEBI (Securities and Exchange Board of India) as foreign institutional investors (FII), but still wanted to play the stock market.

The mechanism is simple. Contact a foreign broking house registered also as an institutional investor in India and ask it to buy shares in the local market, and issue a synthetic share by way of a PN.

There are about 1,000 FIIs registered with SEBI. Of these, only about 34 are both stock brokers and institutional investors. These are the ones that buy Indian stocks for their own clients as well as on behalf of those who do not wish to be registered in India, mainly hedge funds, that is.

These 34 brokers have issued offshore derivatives to the tune of about $100 billion, or almost 10 per cent of the country’s GDP. Now we get a very clear picture of how we have developed a completely new market that is outside the purview of Indian regulators.

The whole purpose of SEBI’s draft notification is to bring these unknown, unregistered investors into its fold. And this has created much hue and cry and nervousness in the market.

When it started, PN made up only a small portion of the total ownership by foreigners, but this has now reached alarmingly high levels. Until March 2004, it was just 20 per cent of the total FII participation.

By August 2007 it was over 50 per cent and by October it is likely to touch 60 per cent, amounting to around $100 billion.

In the six weeks from September, the RBI has had to grapple with the problem of buying the huge influx of dollars on account of PN purchases..

The case against PN is not only quantitative but also qualitative — that is, quality of investors participating in the Indian market.

Look at how local investors are regulated. In addition to the KYC (know your clients) requirement, they have to be registered with brokers giving details of proof of address, PAN, and so on. Why this step-motherly treatment to Indian investors and red carpet welcome for institutional investors who don’t even want to be registered and yet participate in the Indian market?

Welcome step

The step taken by SEBI is in the right direction. As we become a destination for global investors, we need to not only check the quantum of capital inflows but their quality as well.

Any outside infusion of capital into an economy could create a bubble if not used constructively. We have to avoid the kind of situation that led to the 1997 East Asian financial crisis which affected almost the entire Asian region.

If not for the breaks applied by the policymakers, the Indian stock market could well have headed into a crisis.
While there is no denying the fact that India needs huge amounts of investments for growth, the same should be orderly and, more importantly, on a sustained basis.

The huge amounts of capital currently flowing into the stock market are basically hot money pumped in by hedge funds. These funds do not want to be regulated, and this has become a global problem. India is one of the few countries that is addressing this problem openly and boldly.

To safeguard our capital market against financial crises, it is essential that these funds are not only registered but also monitored. One should not forget the stock market crisis of 2001, when there was a deluge of money coming from OBCs (Overseas Bodies Corporates). PN money is no different.

The cautionary approach of the regulators may be resented by some, but for long term sustainable growth of our capital market, such an approach is imperative.

27) Fundamentals or technicals?

In today's complex trading environment, market players need both kinds of analysis to understand price movement better.

Fundamental and technical analysis are tools available to market participants to understand price movements. Of course, there is always a debate on what drives the market — fundamentals or technicals.

In fact, there are a host of factors such as demand-supply, production-consumption, exports-imports, inventory, weather, government policies, taxes, exchange rate, freight and so on, as well as changes therein. Besides, there are external impacts such as of inflation, interest rates, economic growth and geopolitics.

We also know that markets move based not only on current fundamentals but also changes in future. The price movement of a particular commodity reflects the view of the majority of players in that market.

This view can, however, alter dramatically. For instance, a sudden change in government policy or emergence of a weather concern can instantaneously alter the price perception. In view of these uncertainties, traders and investors need tools that can indicate to them the likely direction of the market.

The big picture

What does a fundamental approach mean? Very simply, one looks at a set of data, including production, consumption, trade and stocks, and then decides whether the market is in deficit or surplus or balanced.

It is simple economics and common sense that if the market is in deficit (demand greater than supply), prices will rise, and if the market is in surplus (supplies exceed demand), prices willfall.
Take any commodity. Opening stock plus production plus imports would give total supplies. Consumption plus exports would be disappearance; and then there is closing stock. An analysis of production, consumption, trade and stock data would give a fairly good insight into the surplus/deficit situation and, thereby, the direction of prices.

This, of course, is one of the simplest ways of looking at a commodity from a fundamental perspective. In real life, a fundamental approach to price forecasting is complex. Estimation of demand or production is not easy. Production could be cyclical or demand could be stagnant or spiking. Income or price elasticity may come into play in demand estimation.
In case of production, besides weather, factors such as cost of inputs and quality of output are relevant. Initially, fundamentals ruled, with supply and demand controlling the underlying price mechanism.

Even today, fundamental analysis is important. The overall demand and supply numbers do move the market.

Yet, the market has become difficult to trade from a strictly fundamental perspective. Market dynamics today are much more complex than fundamental analysis would suggest. Non-fundamental factors too have become important.

Each futures market is different, yet, fundamental reports follow largely the same pattern. The fundamental approach to agricultural commodities would be different from, say, non-agricultural commodities, because of the differing nature of factors — in terms of their magnitude, direction and periodicity.

Tracking patterns

As commodity markets matured and technology became acceptable, technicals have gained dominance vis-à-vis market analysis. Commodity markets attempt to achieve price discovery and go beyond. They explore the potential of the unknown. This is where technical analysis comes in.

It is strongly believed that there is a pattern to life's every movement. This is true of the market too. It is axiomatic to technical analysts that there is a pattern in market movements.
These analysts study the pattern of historical price changes and predict future movements.Technical analysis is as much an art as a science. No single programme is 100 per cent accurate all the time.

The perception of each analyst and interpretation of a given set of data may vary and therefore conclusions may differ. Yet, technical analysis is known to give confidence to traders in making their decisions. Institutional investors and large traders use trends and moving averages, while intermediate traders use swings (one/three-week trends). Short-term traders watch daily or intra-day charts.

In sum, it is not about choosing fundamentals or technicals, but needing both. Good traders follow both in their trading approach. Trading success depends on how well a trader reads and understands price signals.

26) Arriving at the ‘sum insured’

Everybody who owns property or runs a business has, at some point, felt the need to know how to arrive at the correct ‘sum insured’ for a property. This is an oft repeated question at most seminars and meetings.

If you insure property for less than its actual value, the dreaded ‘under-insurance’ factor comes into play and the Average Clause (that reimburses you for only a part of the claim) may be applied when a claim is made.

Here is a simple version of this calculation for those who buy insurance.
What is part of sum insured?

It is essential to note that the cost of land is not a part of sum insured in a fire policy.
Nor, generally, is the plinth and foundation. Therefore, the sum insured would essentially be the built-up value of the super-structure. Plinth and foundation, can, however, be part of sum insured for a policy that covers earthquake risk.

The value of the building should ideally include the following:
Floors and walls,

False roofs and ceiling,.

Value of embedded items in walls/roofs, that is, Pipes, electric and telephone wiring and similar fixtures.

The following inputs can be used to arrive at the value of building:

Original cost: It is relevant only for the first year of insurance and obviously not for subsequent years.

Book value: The book value has no relevance to insurable value except, of course, in the first year of insurance.

Market Value: The guiding principle is determining the amount at which a building of the same age and condition can be bought or sold.

The steps to be taken for arriving at market value are:

Determine the present cost of a similar building.

Deduct, of course, cost of land, plinth and foundation.

Adjust for depreciation due to age and usage.

Reinstatement Value: It is, in effect, the value of similar new property without taking into account the depreciation. This reinstatement value clause enables building owners to avoid financial strain on their own resources in the even t of a loss.

For arriving at the cost of construction of buildings, CPWD rates are the best guides. The National Buildings Organisation publishes escalation indices every year, which should be used for arriving at insurable value. The final step would be to adjust for depreciation from the estimated current replacement cost (see table).

We now make a comparison of the four methods discussed above:
Assuming it is a 30-year-old building, its original cost in 1975, the year of construction, is Rs 10,00,000, The following parameters have been taken into account for arriving at the above figure:

The Book Value has been calculated at 10 per cent depreciation per year on diminishing value basis.

The Reinstatement Value has been calculated after applying average 10 per cent escalation per year.

The Market Value is calculated by applying 2 per cent depreciation on straight line basis on Reinstatement Value.

By following this methodology, it would become clear that the market value or the reinstatement value, as the case may be, can be correctly fixed and under-insurance avoided.
While insuring property for less than the actual value would invite a proportionate reduction in claim amount due to the condition of Average in Fire Policies, insuring for more than the actual value doesn’t give any advantage to the insured.

In the event of a claim, the principle of indemnity will result in only actual losses being covered. It also results in wastage in extra premium paid on higher sum insured.

25) Ways to gild your portfolio

Stocks and real estate make up the lion’s share of your portfolio and you are worried about both stock and property prices melting down at the same time. If that’s your worry, gold may be an ideal addition to your portfolio, as it seldom loses value when other assets do. That, simply put, is the most compelling argument for investing in gold.

Having offered single-digit returns over the past ten years, gold cannot replace equities or real estate in your portfolio to meet your long-term growth targets. Nor does gold, with its long somnolent phases and sudden price spurts, come anywhere near debt in offering stable returns.

Gold’s merit as an investment lies simply in the fact that it tends to perform well when other markets and assets are in the throes of crisis. The recent surge in gold prices to a near 30-year high was also sparked by fears of a crisis — a weakening US economy and whether this would result in a marked depreciation of the dollar.

Having said this, global factors such the health of the US economy, the gyrations in the dollar and the actions by central banks in Japan and China have an increasing impact on stock, bond, currency and property markets worldwide, and India is no exception.

Given the difficulty of predicting these variables, investors need to hold a portion of their portfolio in a “safe haven” asset that does not move in tandem with their other investments. Gold fits the bill quite well, given its historically low correlation with most conventional investments such as stocks, bonds and currencies. What are the options?

For Indian investors seeking to “gild” their portfolio, buying jewellery is no longer the only viable option. Here are alternative avenues to invest in gold, and the pros and cons of each option:
Gold Exchange Traded Funds: Gold ETFs are mutual funds that hold physical gold in their custody and then issue units to investors to represent the value of those gold holdings. Investors can buy or sell ETF units through the stock exchange much like shares, if they have a brokerage and a demat account.

In the Indian context, each Gold ETF unit usually represents one gram of gold. A Gold ETF allows you to hold gold in paper form and passively track returns on gold. Usually, NAV movements reflect changes in gold prices in the international market (London).

ETFs allow you to make very small purchases (starting from 1 gm) and phase them out over a period of several months/years to take advantage of price swings. They are cost-effective, given that pricing is transparent and you can buy and sell units at prices (net of brokerage) that are linked directly to international gold prices. No making or transaction charges are involved.

There is also no carrying cost as the investment is lodged in demat form. You are sure of your investment returns mimicking gold price returns in dollar terms. Liquidity is high as the units can be sold through the markets at any time of your choice. The investment is exempt from wealth tax and long-term capital gains tax (if held for one year). The disadvantage of ETFs is that, as passive investment vehicles, it is up to the investor to time buys and sells well, to take advantage of gold price movements.

Gold bars from banks: Private sector banks, prominent jewellers as well as brokerage firms vend hallmarked gold bars/coins of guaranteed purity and fineness. This is a good avenue for investors to buy and own physical gold, without the purity-related risks associated with buying jewellery.

The key disadvantages in investing in physical gold are the relatively higher costs and the carrying costs involved in storing and securing physical gold.

Most vendors charge a mark-up over the prevailing gold prices towards making charges when they vend gold in bar/coin form (the mark up may range anywhere between 7 and 15 per cent). Moreover, liquidity may be of a lower order than that offered by ETFs, as most banks/brokerages do not have facilities to buy back gold bars, once sold. Jewellers however, may offer this facility.

Overseas investments: With Indian investors now allowed to remit up to $100,000 in a year, private banks and large brokerages do enable and advise their high-net-worth clients on investments in stocks and other securities listed in overseas markets. Some of the investment options that could be available are large gold ETFs such as Streetracks Goldshares, iShares Gold Trust and other ETFs that track gold mining and precious metal stocks.
For domestic investors looking to take exposures to gold-related stocks overseas, the DSPML World Gold Fund (see accompanying interview) is also an option to consider. This open-ended mutual fund managed by DSPML Mutual Fund channels your investments into the Merrill Lynch-managed World Gold Fund, which is an international fund investing in stocks of gold mining companies.

Commodity exchanges: Investors who have a trading account for commodities can also acquire futures contracts in gold through commodity exchanges such as the NCDEX and NMCE. These exchanges usually specify minimum lot sizes (usually 1 kg), in which contracts can be acquired. The price at which you transact will be the price for the contract quoted on that day in the exchange, which is usually linked to domestic gold prices.

Those seeking to buy physical gold through this route can buy the near month contract (the contract for the closest future month) and take delivery of gold in the specified month. Costs involved in taking this route would be the margin requirements specified by the exchange, brokerage charges payable to the broker, charges payable to the warehouse towards weighing and storage of gold as well as stamp duty, sales tax or VAT payable on gold in that particular State.

24) Contrarian investing

If you decide to adopt a contrarian approach to investing, you need to have a lot of conviction in your ideas.

If there is a rebel in you, you just might make a good contrarian investor. Contrarians go against the market crowd in their investment decisions. They buy stocks or sectors that have been neglected or have lost favour with the markets and sell those that are highly fancied. If they are proved right and the market, which represents the thinking of the majority, is proved wrong, the returns can be multi-fold.

Conventional market theories suggest that the market is largely right in assimilating information. Momentum investing means staying on the right side of the market — you ride the wave so long as everyone is buying and jump off when things start souring. This herd mentality is what typically drives the market. But short-termism and sentiment often create exaggerated reactions in the market. There might be too much pessimism about a stock’s prospects or too much optimism surrounding a sector’s outlook.

Contrarians view these swings in asset values as aberrations or as a temporary mis-pricing. They buy or sell depending upon their alternate view on the stock and wait for the rest of the market to catch on.
For instance, following Tata Steel’s announcement of a highly leveraged acquisition of the UK-based Corus last October, the stock languished, falling 20 per cent from its October 2006 peak to Rs 400 levels in March 2007. A contrarian investor would have viewed that low as a good entry point believing that the downside from that level was limited. He would have been right. The stock has doubled since then. Concerns were seen as overdone and with steel prices looking up, the market leader could not be left behind.

Similarly, cement stocks took a beating earlier this year, on the back of Government’s efforts to rein in prices so as to contain inflation. However, contrary to the belief at the time, the ruling did not significantly affect performance of cement companies. It would have taken a good contrarian investor to zoom in on cement stocks during that time.

What would be a contrarian view now? Maybe buying IT stocks on the belief that the rupee concerns have been overdone or buying auto stocks on the expectation that an interest rate cut by the RBI would stimulate demand once again, with low valuations providing a good cushion to downside. Being Contrarian

But being contrarian is not easy. A contrarian investor’s research, understanding of the industry or company and information would have to be superior to what is normally required for investing in the stock market. You can rarely rely on good, old-fashioned luck. Secondly, you need to be patient with your investment, as it might take a while for your stock or sector to come back in market’s favour.

Timing your investments in these contrarian picks can be a huge challenge. Getting into a sector or stock much before the turnaround might involve significant opportunity costs. You need to pick up such stocks at a time when they are still out of favour but the trigger for a revival in investor interest is near. At the same time, you need to see the trigger much before everybody else does. The window of opportunity to latch on to these picks, therefore, is small.

If you decide to adopt a contrarian approach to investing, rest assured, it won’t be easy. You need to have a lot of conviction in your ideas if you wish to go against the tide. After all, if you were wrong, the whole market would say, “I told you so”. The market is not right all the time, but it is often right. In knowing when it is wrong, lies the challenge.

23) The brick and mortar of realty stocks

A look at some aspects investors ought to take into account so as to stay on safe ground



Is there a substitute to owning multiple properties across the country? This question should especially appeal to young investors who cannot afford to buy even a single piece of real estate, forget several across the country. If you are one of those young investors, don’t lose heart, there actually is a substitute– shares of real estate companies!Realty through equities

For the astute investor community looking at real-estate as an investment opportunity, land and property are not the only options. With lower investment and lesser ordeal you can still hope to receive reasonable returns if you invest in real-estate stocks. Of course, the risk of “no guaranteed return and loss of capital”, typically associated with equity investing, remains.

Unlike a couple of years ago when few quality real-estate companies were listed on the bourses, a good number of realty players chose to shed their ‘family business’ avatar and go the corporate way by listing their stocks on the exchanges. This is reflected by the spate of realty IPOs that were floated over the last one year opening up more opportunities for investors.

Having taken the realty stock route to investing in real-estate, one must, however, act with caution in making an investment decision based on news surrounding these companies. Here’s a look at a few factors that may, on the face of it, appear to have a positive impact on the performance of a real-estate play but could well turn out to be deceptive if not taken with a pinch of salt. Banking just on land?

With disclosure norms improving by the day, most realty companies have been revealing their “land bank” data, which refers to the land owned by the company or for which it owns development rights. The higher the land bank, the better the earnings visibility, is the general perception. No doubt, locking on to low cost or prime land essentially means assured inputs to feed the company’s projects. However, the location of these properties, the plans that the company has for such land and the gestation periods for the projects may be the key to actually unlocking value for the company rather than the presence of these land banks alone.

Holding land with no clear plans for it is probably akin to buying shoes without knowing your size and later trying to fit your feet into it! Big plans in a location where there is very little potential for demand (especially in case of commercial or retail space) should also be viewed with caution. Similarly, land earmarked for long gestation and experimental projects such as special economic zones (such as Mahindra Gesco’s Mahindra City) can be factored into the earnings expectations only if the company has proven execution skills.

On another note, land bank across various States, although a good diversification move, need not necessarily be superior to regional concentration, especially if the company has a strong brand recognition in that region.Pseudo plays

All the above is for companies who are in the business of real-estate. There are companies that are not in real-estate but excite investor sentiment with the property that they own. The likes of Century Textiles or Raymond have seen many a rally backed by the property that they held. Non-realty companies holding property gain on two counts. One, the cash flow from selling such property in a boom may well be deployed into expanding their core business. Two, such property may be used to develop the company’s own unit or office or develop and lease such property. Markets try to factor in the impending cash flows from such activities. However, valuing land of such companies may be justified only when the company has serious plans on the land development front and not merely because it holds an otherwise illiquid asset such as land.

Further, if you are serious about investing in a real-estate theme and not looking to make a few quick bucks, then you may be better off avoiding such pseudo realty plays. Additionally, unlike a few years ago, when one had to be content with such proxy plays, there is no dearth of pure realty companies in the listed space now. Track the record

Are the companies you choose to invest just fledglings hoping to make it big or have a reasonable track record of execution? While the newer ones may do well, you would be better off sticking to companies that have been able to demonstrate reasonable executions skills, overcoming various constraints, starting from buying land to developing and selling the property. Track record, combined with the quality of management, needs to be given substantial weight in your decision making.Taking stock

Many analysts value land bank by calculating the present value of future cash flows (revenues less costs) arising from developing the property and selling or leasing it. This, again, is possible only if there are concrete plans for developing the land, and the location and demand scenario in the area is known.
For a lay man these may be too many factors to keep track of. Instead, you can consider sticking to the good old metrics such as price earnings ratio, operating and net profit margins and return on capital employed across peers.

Profit per square foot (instead of price per square foot) may also be used to compare regional peers in similar business segments.

As the working capital requirement is also high, one needs to look at the options available to the company to ensure regular cash flows.

For instance, some companies prefer to sell properties rather than lease them out to ensure sufficient capital availability for their other projects. Other established players create a lease portfolio that could generate regular cash flows.

The above are just a few slippery aspects that you may have to view with discretion. If these aspects appear too cumbersome, then you may have to wait for less unwieldy vehicles such as real-estate investment trusts/mutual funds that are set to soon hit our shores.

22) Understanding Inflation & its impact

Understanding the rise and fall in prices of goods and how they are linked to one’s standard of living.

Inflation — an increase in the level of consumer prices or a decline in the purchasing power of money caused by an increased availability of currency and credit chasing too few goods — seems to pop up quite often in today’s debates and everyday conversation.

Stripped to its essentials, inflation would indicate a rise in prices as captured by an index consisting of several goods that have weights attached to them. If a particular good has a significantly higher weightage, a change in the price of that good would cause a significant change in the index and thus inflation. If the inflation for a particular week is, say, 5 per cent, it means the index is 5 per cent higher than it was in the same week last year. What’s the WPI?

The WPI or the Wholesale Price Index is used to measure the change in the average price level of goods traded in the wholesale market. In India, the index consists of 435 items divided into three broad categories: Primary Articles (food, minerals) that have a weight of 22.02 per cent; Fuel, Power, Light and Lubricants that have a weight of 14.23 per cent; and Manufactured Products, which make up the balance of 63.75 per cent. WPI as an indicator

However, there are a number of problems associated with using the WPI as an indicator of inflation. Economists point out that nearly 100 of the 435 items in the WPI have ceased to be important from a consumption point of view. A commodity such as coarse grain, which goes into the making of livestock feed, is taken into account when calculating inflation, although it may not figure among articles of daily consumption. The WPI doesn’t include prices of the services sector that makes up nearly 60 per cent of the economy today. Over the years, education costs, doctor fees, rentals , and so on, have gone up dramatically, accounting for a significant proportion of the common man’s expenses; but these aren’t captured in official inflation data. What is more, the weightages assigned to various items in the WPI have not been updated as often as they should be. Food items, which make up almost 60 per cent of the consumption basket of the common man, are given only a 22 per cent weightage in the WPI. The last WPI series of commodities was constituted in 1993-94; this underlines the need for a more contemporary barometer to calculate inflation in today’s world. Consumers should also be aware that there is a lag in reporting CPI numbers; the latest figure available today is for May 2007, whereas WPI figures are available on a weekly basis, with a time lag of only two weeks.

Why worry about inflation?

But why should investors worry about inflation? While incomes have been rising for India’s estimated 300 million middle class, fuelling demand for consumer goods, from cars to mobile phones, some 25 per cent of India’s 1.1 billion people continue to live on less than one dollar a day. Everyone realises that inflation makes things more expensive. You have to pay more for the same goods and services. So, if your income doesn’t increase at the same rate as inflation, your standard of living will decline. In other words, inflation reduces your purchasing power.

However, it is a mistaken notion that inflation affects all products or consumers equally. It could double the value of some things (such as the recent fuel prices), while keeping the value of other things unchanged.

So whom does inflation hurt the most? Obviously those whose incomes haven’t grown and they have to pay more for the things they buy. Pensioners who depend on fixed interest receipts are a typical example. But there is more to the impact of inflation on the common man.

Theoretically, rising inflation favours borrowers over lenders because borrowers, if they borrowed at fixed rates, will have to repay the same amount, despite the lower purchasing power of money. However, most large borrowings nowadays are pegged to floating interest rates (rates that move in tandem with market interest rates). With the central bank trying to curb inflation through interest rate hikes, higher inflation numbers have been accompanied by higher interest rates. If your loans are on floating rates, rising inflation could mean that your loan obligations also bloat in tandem.

21) Derivatives not for retail investors

Derivatives markets are basically for hedgers such as manufacturers, millers, exporters, importers, traders and cash-rich speculators, and not for retail investors.

It is a matter of concern that retail investors have entered the derivatives market in a big way. The National Stock Exchange (NSE) data indicate that retail investors have been the largest participants in the last four to five years, accounting for as much as 60 per cent of all derivatives activities.

Brokerage houses, with a view to boosting their income, are now on the trail to spreading awareness of derivatives in tier-II and tier-III cities.

The attractiveness of derivatives markets lies in the lower capital requirements as against the cash market, and chances of gains being in multiples compared to the cash market. This is particularly so in options, where the initial outgo is a small fraction of the contract value.

The daily turnover in derivatives trading in securities is, on an average, about three to four times of the cash market — about Rs 50,000 crore as against about Rs 15,000 crore in the cash market. Added to this is the daily turnover in commodity futures markets of over Rs 15,000 crore.Derivatives markets a must

In a market economy, subject to fluctuations in prices, quite often sharp ones, derivatives are a must.
Derivatives markets are basically a mechanism for price discovery and transfer of risks arising out of fluctuations in prices from the various functionaries in the spot markets.

These markets are basically for hedgers such as manufacturers, millers, exporters, importers, and traders, enabling them to hedge their spot operations and thereby protect themselves from adverse movement in prices.
Cash-rich speculators are also a must for these markets, for without them markets cannot function as it is they who lend necessary liquidity to the market. A market without speculative forces will be a disjointed, illiquid market with sharp fluctuations in prices. It is the speculators, with varying perceptions about the bullish and bearish trends in the market, who emerge as buyers and sellers at every bulge in prices, thus helping reduce market volatility. Necessary checks and balances, including the strict margin system, and limits on trading and exposure take care of the safety of the operations.

With all the checks and balances, fluctuations in prices can occasionally be violent. For example, in three trading sessions on May 13, 14 and 17, 2004, the Sensex fell sharply by 21.71 per cent from 5399.47 to 4227.50. Futures prices of the Sensex also fell correspondingly. Similar sharp declines in prices have been occurring quite often in the last year, mainly induced by the massive sales by foreign institutional investors.

In such circumstances, a retail investor with limited funds would not be able to finance such sudden losses in futures contracts.

Not only would his outstanding positions be closed by his broker, but he would also be compelled to honour his commitments which would force him to dispose of his other assets and he may also have to borrow. Such things happen almost everyday, ruining the lives of such investors.

The story is entirely different in case of investment in the cash market. The investor can hold on to his investment, if the prices fall sharply, and wait for it to recover.

While this can be done in equities, a retail investor will not be able to do so in the futures markets as all the transactions are settled financially, since there is no provision for physical settlement of transactions. Moreover, he has to finance the mark-to-market margin instantly.Commodity futures

So far as commodity futures are concerned, although there are provisions for physical deliveries through warehouse receipts, the cost of a unit of trading is quite prohibitive for a retail investor to take delivery. Moreover, with various tenderable varieties with grading, the retail investor may just not be able to comprehend the complexities involved in all these matters.

It also needs to be noted that volatility in commodity prices is much more than in equity prices, as supply of commodities varies constantly from season to season, depending largely upon production which is subject to the vagaries of monsoon.

This is apart from various other factors such as government policies relating to imports, exports, buffer stock operations, technical position of the market, etc. In the case of equities, the supply is constant, except whenever there is a bonus issue, rights issue, warrants, and shares arising out of exercise of stock option plans. Retail investors and options market

Retail investors should desist from entering the options market without any underlying securities with them.
History of the options market indicates that over 95 per cent of call and put options go unexercised, benefiting the seller of options.

If a retail investor with holdings of shares is uncertain of the movement of prices, but wants to take advantage of a rise or fall in prices against his underlying securities, he can sell his holdings in the futures market and also buy a call in the options market.

In case of a fall in prices, his loss in the cash market is offset by his gain in the futures market. If, however, prices rise, he can exercise his call option and take advantages of the rise in prices.
His loss will only be the premium he has to pay for the purchase of the call options and transaction costs. All these are, however, too baffling for an ordinary investor to comprehend.

Mr B. C. Khatau, Chairman of the Forward Markets Commission, regulating the commodity markets, has recently warned retail investors to stay away from the commodity futures markets without a proper study of the markets.

Even with a study of the markets, it is rather doubtful whether a retail investor can really comprehend the complexities of the derivatives markets, particularly of the options market.

Moreover a retail investor, involved as he is in his daily chores of attending to his domestic and office duties, would not be able to keep a track of the minute-to-minute developments taking place in the markets, particularly so with the progressive integration of the Indian markets with the global markets. In short, retail investors are advised to desist from the persuasion by stock-brokers and investment advisers suggesting they should venture into the derivatives markets.

Instead, they should concentrate on investing their hard-earned savings in the cash market of equity shares of fundamentally sound companies, units of established mutual funds, fixed deposits with banks, post-office deposits, etc. (The author is former Executive Director of Bombay Stock Exchange.)

20) Rupee appreciation upsets export arithmetic

Rising costs and an appreciating local currency can apply pressure on both the cost and revenue sides and render export trade quite uneconomic

Imagine a Tirupur garments exporter competing with a Chinese company for American market share. This is a classic example of an Indian exporter running economic exposure on his business. The exporter has a basic transaction exposure against the US dollar. But he also runs an equally or even more significant economic exposure against the Chinese yuan. If the yuan does not appreciate or rises less than the rupee’s gains against the dollar, the Indian exporter faces a serious threat to his share in the US market as there is an effective Chinese price cut in such a scenario. Any attempt to match the effective lower Chinese prices actually compounds the problem for the Indian exporter as his final rupee realisations are under greater pressure then.

The Chinese example has been cited here to just highlight the issue of economic exposure which Indian exporters face in today’s extremely competitive global trading environment. Indian exporters are obviously facing competition from a number of other countries also in all their main export markets. It is not surprising, therefore, to see that while exports grow double-digit in dollar terms, the growth in rupee terms is severely constrained by the complex and inter-connected risks in global merchandise trade. For the first five months in FY-08, for instance, while growth in dollar terms is 18 per cent, that in rupee terms is just 5 per cent.

At one level, these developments possibly just show the limits of export-led growth and activity in a country such as India. Indeed, with exports constituting only around 12-13 per cent of GDP, one may wonder how critical is the export-led model for India. The domestic market is huge and the level of consumption/investment demand is high enough for the country to run, even if only modest now, trade deficits.

It is quite different in the case of China where exports are a national industry (as a matter of deliberate policy) and account for more than a third of total national income and domestic consumption (though now opening up) is still largely suppressed. This structural difference between India and China is also reflected in the fact that while Chinese FX reserves are basically export surpluses, Indian FX reserves are basically capital account surpluses. At another (micro) level, the export statistics also show that in a complex and competitive global trade environment, Indian exporters are possibly not yet tuned into the need for proactive (and sometimes pre-emptive) financial risk management.

Hedging economic exposure may possibly call for more advanced financial instruments (such as currency options on the currencies of competing countries for instance) and their active use. But it is one of the quirks of the global trade/markets system that while a country such as China seeks to enjoy all the benefits of open, free consuming markets of the world (specifically the US), it picks and chooses which part of the global trade/market rules it will comply with. For instance, it heavily manages its yuan currency and also, as a corollary, does not allow internationalisation of the currency. (Most other Asian currencies except Japan also fall in this bracket. Japan has traditionally intervened heavily in its currency but the yen is one of the key international currencies also. Also to be noted is that Japan has not intervened in the yen since March 2004.)

Therefore, hedging economic exposures actively is still some way off. Indian exporters, though, can well and truly hedge transaction exposures with the available instruments in the local markets. The underlying math relating to the export sector — on export costing and pricing for instance — only seems to make that imperative. The underlying math on exports

An analysis of the math (see Table) is necessary to throw light on the underlying economics of the export trade at the individual exporter level. If not anything else, it may at least point to how important active hedging is for Indian exporters in the current and emerging environment.
Consider an Indian company which exports only to the US market. (This is quite a realistic scenario in Tirupur, for instance, where there are a number of mid-size exporters who sell almost entirely in dollars/ to the US market). The Economics

Equation 5 also brings out clearly how rising costs and an appreciating local currency can apply pressure on both the cost and revenue sides and render the export trade quite uneconomic.
For example, assuming per unit cost of production is Rs 100, an exchange rate of Rs 45 to the dollar and a price elasticity of 2, one can see that the unit dollar price for the exporter will be 100/45 (1-0.5) = 4.5.

Now, if production costs rise and the local currency also appreciates (as has happened in the case of Indian exports), without any change in the price elasticity (elasticities are quite sticky in the short/medium term and also unlikely to change in the case of low value added items), the exporter will be literally priced out by his competitors who have not experienced such cost side pressures/local currency appreciation. Assuming that unit costs rise to Rs 120 and the rupee appreciates to 40 against the dollar, one can see that the equilibrium dollar price for the exporter should rise to at least $6 per unit. How many mid-size Indian exporters have the pricing power to increase negotiated and agreed upon prices?

Compare the above workings with that for a Chinese exporter who has not experienced such cost side pressures and also, importantly, benefits from a relatively much more stable currency. The Chinese yuan, for instance, has been allowed to rise around 9 per cent against the dollar in the two years since July 2005 — from 8.28 to 7.51 now — but the Indian currency is up 10 per cent in just the last 7 months.

It is obvious that the Chinese exporter will have a significant price advantage which can be extremely useful in increasing market share — particularly in low value-added items.
Equation 5 tells in a very concise manner how critical it is for the exporter to protect the (initial) exchange rate based on which his export pricing has been worked out. Such protection is achieved only through active and systematic hedging.

19) Demystifying Derivatives

The following Thursday everyone trooped into the conference room to take their respective places. Goatee walked over to the white board and switched on the LCD projector.

“Good afternoon everyone! We are here to continue our discussion of derivatives and hedging strategies.”

“Morning Ganguly,” said the MD. “Welcome back after your paternity leave. I must say that you have delayed having a child for a considerable period after marriage.”

“I guess they kept evading the issue,” said Goatee, not able to resist the pun. Everyone burst into laughter including Ganguly who turned beetroot red.Call versus put

“Before you begin I have a question” said Balaji. “Last time you mentioned that call options give a right to the buyer and impose an obligation on the seller, whereas put options give a right to the seller and impose an obligation on the buyer. My question is why cannot both parties be given a right?”

“If I said that I must correct myself. Both call and put options give the right to the option buyer and impose an obligation on the option seller. The difference between calls and puts is that in the case of calls the buyer of the option has the right to buy the underlying asset whereas in the case of puts he has the right to sell the underlying asset.”

“As for your question, let us look at it this way. Assume that after a call option contract is entered into, the price of the asset goes up. The buyer of the option would like to acquire the asset at the price stipulated in the contract. However, given a choice, the seller of the option would rather sell the asset in the spot market at a higher price rather than deliver it to the buyer at the contract price. Thus if both parties were to be given rights, no transaction would ever take place. Consequently both parties can have obligations imposed on them like in the case of forward and futures contracts, or else one party can be given a right and an obligation can be imposed on the counterparty, which is what happens in the case of option.”Gyan on arbitrage

“Sorry to digress” said the MD. “But this has been eating my head. In the case of forward and futures contracts, how is the price determined for the transaction that is scheduled to take place at a future date?”

“It is done by ruling out arbitrage,” said Goatee.

“What is arbitrage?” asked Balaji.

“Arbitrage, as an American would say, is the presence of a free lunch,” said Goatee.

“I wouldn’t say that you can totally rule out a free lunch,” said Balaji. “Some public sector companies provide free lunches.”

“The public sector lives in a world of its own. My professor in college used to say that in India if something is not rational then it has to be national.”

Ganguly, Wilma and the MD burst out laughing. Balaji looked more confused.
“Let me explain Balaji,” said Goatee. “Suppose you had Rs 10,000 with you. You can invest in RBI Relief bonds which yield 8 per cent return. There is no risk of non-payment because the Central Government is the only institution vested with the power to print money. Now assume that instead you choose to invest the money in Reliance debentures. Would you accept an 8 per cent rate of return?”

“No!” said Balaji.

“Naturally, because there is a risk of non-payment in this case. Now suppose somebody offered you an opportunity to borrow at a rate of 6 per cent. What would people do.? Everyone would borrow at 6 per cent and invest in the Relief bonds to earn an assured profit of 2 per cent. Such a state of affairs obviously cannot exist. This is what is meant by arbitrage.”

“Sometimes we find that the price of a share is different on the BSE and NSE. Can we buy in one exchange and sell in the other to make arbitrage profits?” asked Curd Rice.

“You can if you have a stockpile of securities as well as cash. The reason is that both the exchanges have a T+2 settlement cycle. Consequently you cannot wait to take delivery at one exchange before delivering at the other.”

“What is T+2 settlement?” asked Balaji.

“It means that if you transact on a particular day, then delivery of shares to the buyer and payment of cash to the seller will take place two business days later.”

“Is arbitrage really feasible?” asked the MD.Bid-ask spreads

“In practice it is unlikely that people like us can make much money. You need a large pool of funds at your disposal. Besides people like us have to incur transactions costs such as commission and bid-ask spreads. Brokerage houses have an advantage. They do not have to pay commissions to themselves.”

“What are bid-ask spreads?” asked Balaji.

“The price at which a dealer will buy an asset from you is called the bid, whereas the price at which he will sell to you is called the ask. Obviously the dealer will make a profit by setting the ask higher than the bid. The difference between the two is called the spread.”

“You went to Singapore recently Balaji?” asked Ganguly.
Balaji nodded.

“When you landed at the airport you may have noticed that the foreign exchange dealer would have quoted a buying as well as a selling rate for each currency, like 40.50-41.60 for the US dollar. The buying rate is the bid while the selling rate is the ask.”Futures, forward prices

“Ok, before we digress any further let me clarify how futures and forward prices are determined so as to preclude arbitrage,” said Goatee.

“Assume that the spot price of an asset is S, and the price of a forward contract to sell the asset after one year is F. Assume that money can be borrowed at r per cent per annum. If F is greater than S(1+r), then a person can borrow and buy the asset and go short in a forward contract. One year later he will deliver at F. He has to repay S + rS, which represents principal plus interest to the guy he borrowed from. Overall he stands to make an arbitrage profit of F – S(1+r). This is called Cash and Carry arbitrage.

“On the other hand, if F is less than S(1+r) he can short sell the asset and go long in a forward contract to realise an arbitrage profit. This is called Reverse Cash and Carry Arbitrage. To rule out both forms of arbitrage we require that F = S(1+r).”

“What is a short sale?” asked Balaji.

“I am afraid that you must wait for next week,” said the MD. “We are once again running out of time. I do not want to discourage any questions since all of us are benefiting immensely from this discussion. So let us meet on Monday to take this forward.”