154) Make sense of market jargon

Understanding the technical terms that go to capture stock market action will simplify matters for the investor – and impress people around him too. Here’s a sampler.

The road to upward mobility is best travelled by ‘term-droppers.’ The more jargon you throw at colleagues, bosses, vendors, the more likely people will regard you as intelligent and well read and in-the-know.

So if you want to impress that snooty colleague in the next cubicle with a few well-chosen technical terms, make sense of all the jargon splashed across the pink papers. Here’s a primer:

India is expensive; Investors reconsider fresh investments; Valuations look attractive

Lesson 101 of Valuation comprises four words really — Buy Low, Sell High. Behind this seemingly simple line resides a very complex world. The terms ‘Low’ and ‘High’ are relative terms — which means that we need a common parameter of comparison. This is where P/E comes into the picture.

P/E ratios are typically used as a first-cut measure by investors to determine if a stock is overvalued or underpriced and whether it makes sense to invest in it. The P/E ratio or Price Earnings Multiple is calculated by dividing the price (of a share) by its earnings (EPS or earnings per share). It means that for a given level of performance by the company — EPS, the market has priced the stock at a particular level — P.

Take, for instance, a company, Xlerate, in the biotech space. Say, the company’s stock price is Rs 240 and its EPS forecast for the year is Rs 8, then the PE for Xlerate is 30. However, 30, per se means nothing; it doesn’t signify if the P/E is high or low and whether one should buy Xlerate stock.

To take that decision, one needs to compare the P/E to other stocks in a comparable category or industry. So if most other stocks in the biotech industry have P/Es of around 40, then Xlerate could be undervalued and hence its ‘valuation seems attractive.’

However, there could be two reasons why the market has priced it lower : Either the major local and global investors are unaware of the company and its performance and hence haven’t been able to value it correctly, or they think the stock purposely ought to be priced lower than competitors due to reasons such as bad management, expected slowdown in performance, inadequate ability to deal with future/competition, etc.

Similarly, if most of the other emerging market indices P/E s are at around 12 and India’s P/E is at 17, then India is considered ‘expensive.’

Inflation figures spook market

Inflation is basically a measure of prices in the country. It is measured by something called the WPI — wholesale price index, which factors in prices of basic goods and commodities in India. It is usually indicated in percentage terms. For the banking and financial system players, inflation is the centre of their universe. The reason: inflation erodes the value of money and hence the return on investment. If inflation is 4 per cent, it means that a lunch that cost Rs 100 last year will cost you Rs 104 today. Your Rs 100 should have grown by Rs 4 in one year for you to enjoy the same standard of living. Hence, for you to have a ‘real’ return on your investment of Rs 100, the interest rate should be more than 4 per cent.

Hence when inflation rises, interest rates need to rise to ensure that investors get ‘real returns.’

Liquidity is tight

This phrase is used generously by journalists across the stock, debt and commodities markets. Liquidity refers to the amount of money floating in the system and which is available to corporates, government and individuals. The Reserve Bank of India creates money in the system. It also reduces the amount of money in circulation by sucking up money from the system either by buying rupees from banks and selling them foreign currency, or by issuing government securities which banks and institutions subscribe to. The RBI is, therefore, the controller of liquidity. Liquidity can become ‘tight’ when the demand for funds far exceeds the supply. This could happen due to a variety of reasons:

Corporates are borrowing more to fund their business growth and for capital investments;

The Government of India is borrowing more to cover the gap between its expenses and income;

The value of the rupee is depreciating faster than the RBI would like and hence the RBI is ‘buying rupees’ to increase its value versus the dollar.

And the usual repercussion of tight liquidity is increasing interest rates.

Market is currently overbought

Simply put, the market being overbought means that the market has risen too much or too fast and is ‘expensive’ . Likewise, oversold means that the prices have fallen too sharply.

The terms per se are used by technical analysts who chart price movements to predict what the future price of the stock is likely to be. Usually there is a fair degree of balance between buyers and sellers in the market.

However, sometimes, there might be too much buying or too much selling. These are unnatural conditions and often an indicator that one must take the contrary action. Hence if the market is considered overbought, the technical analyst will sell, and if the market is considered oversold, she/he will buy.

There was some unwinding of long positions in the futures market....

It’s probably easier to learn two foreign languages simultaneously than decipher finance’s complexity. So baby steps on this one:

Futures market

This market refers to contracts where the buyer and seller agree to transact at a future date; the price and quantity for that future transaction is, however, fixed in the present.

Think of a futures contract as an understanding you would get into with your local raddiwallah. You promise the raddiwallah that you will give him 5 kg of newspapers every month over the next six months.

The raddiwallah, in turn, promises to pay you Rs 5 per kg. So, basically, you two will have entered into a futures contract where the price and quantity has been pre-fixed, regardless of what the price of second-hand newspapers will be in the coming months. Both parties benefit: The raddiwallah is locking in a guaranteed supply of newspapers whereas you are guaranteed you will get a good price for the next six months.

Similar transactions take place in the stocks and commodities markets. People tend to enter into futures contracts if they think the markets will be volatile in the future. By agreeing to price and quantity now, they can control their risk.

Long positions: When an investor holds a long position, it means that he actually holds the share and intends to hold it for a while because he thinks prices will go up on the share. If prices go down, then the investor loses money. Similarly, a long position in a futures contract means the person is required to buy the share at a future date. She will make money if the share price goes up at a later date.

Unwinding: This refers to the process of selling to liquidate long positions

’There was some unwinding of long positions in the futures market’ basically means that investors think the market is likely to go down in the future and hence are selling their underlying shares and offloading their long positions.

Rajiv Anand
(The author is Head – Investments, IDFC Mutual)

153) Measuring ‘skill’ and ‘earning’ returns

Should you invest in the fund that has given investors a higher return or in the fund that has a better fund manager? Here is how you approach this equation.

As an investor, this one is going to be a tough call. You want to invest Rs 10,000 today in a mutual fund. Where should you invest? Should you invest in the fund that has given investors a higher return? Or should you invest in the fund that has a better fund manager? You might ask “Does not the better performing fund have the better manager?” Well, the answer surprisingly is “No.”

To understand that, you must get to know two more “rates of return”. Let me explain them with an example.

Scene 1: Mr X, Mr Y and Mr Z are the chief investment officers (CIOs) of Fund X, Fund Y and Fund Z, respectively. Each of these funds began on January 1, 2006 with a portfolio of Rs 100 crore. A year later, the value of their portfolio fell by 50 per cent. That is, on January 1, 2007 it stood at Rs 50 crore.

This means that the performance of all three CIOs in the first year has been identical. Now suppose in the second year the portfolio appreciated by 100 per cent. That is, on January 1, 2008 it stood at Rs 100 crore. This means that the performance of all three CIOs the second year has been identical. Hence, across two years, all three of them have performed alike.

Scene 2: Let’s tweak the scene a bit. Suppose at the end of year one, when the market had fallen, investors of Fund X thought that this was the right time to invest further and poured an additional Rs 50 crore into Fund X. So, on January 1, 2007, the Fund holds the initial Rs 50 crore plus the additional Rs 50 crore, adding to Rs 100 crore.

This Rs 100 crore doubles in the second year to touch Rs 200 crore. In essence, a total investment of Rs 150 crore has grown to Rs 200 crore, generating a positive IRR.

Now turn to Fund Y. Suppose at the end of year one, the investors of Fund Y decided to adopt a wait-and-watch attitude. Hence they decided to keep off the market. So on January 1, 2007, the fund holds the initial Rs 50 crore only. This doubles in value in the second year to touch Rs 100 crore. In essence, across two years, a total investment of Rs 100 crore has stagnated at Rs 100 crore, giving a zero IRR

Finally, let’s look at Fund Z. Suppose at the end of year one, the investors of Fund Z felt that it was time to partially exit the market and hence withdrew Rs 25 crore. So on January 1, 2007, the fund, whose value had, like others, depleted to Rs 50 crore, paid Rs 25 crore and has Rs 25 crore only for investment. This Rs 25 crore doubles in value in the second year to touch Rs 50 crore. In essence, a total investment of Rs 75 crore has fallen to Rs 50 crore, generating a negative IRR.

The bottom line is that Fund X has given the best return, Fund Y the second best return and Fund Z the least return. This, however, does not mean that CIO Mr X is more skilled than CIO Mr Y and that CIO Mr Y is more skilled than CIO Mr Z. Remember the performance of the three CIOs is identical because in the first year their value went down by 50 per cent and in the second year it rose by 100 per cent.

Yet their IRRs are different.. This had to do with the intervening inflows and outflows of cash. Additional money came to Fund X at the right time and additional money went out of Fund Z at the wrong time, affecting the overall return. The moral: Fund returns are a function of fund manager’s skills and the time when investors pour money. This brings us to a crucial point. That we must make a distinction between the skills of the manager and the returns earned. The return relevant to measure skill is called time-weighted rate of return. In this case we ignore the intervening inflows and outflows of cash.

We merely look at how Re 1 has progressed over a period of time. In the case of each of the three funds, Re 1 invested in time zero became Re 0.50 in time 1 and ended as Re 1 at end of second year, leading to nil overall return.

The return relevant to measuring returns earned is called rupee-weighted rate of return. It considers the intervening inflows and outflows of cash and is the same as IRR. This in our example was highest in the case of X, second highest in the case of Y and least in the case of Z.

V. Pattabhi Ram
(The author is a Chennai-based chartered accountant.)

152) Mildly bearish? Here’s a low-risk low-return option strategy

Essentially a low-risk and low-return strategy, bear call spreads can be used when you have a mildly bearish outlook.

Volatile markets are an option trader’s delight, provided the right strategy is used.

If you are moderately bearish on a stock or the index but do not have the stomach to directly short the stock or index, worry not – use the bear call spread instead.

Essentially a low-risk and low-return strategy, bear call spreads can be used when you have a mildly bearish outlook.

How to set the strategy?

This strategy involves selling at-the-money call options and buying out-of-money call options.

That is, to set a bear call spread you will need to sell call options at a strike price that is the same as the spot price and buy calls at strikes higher than the spot.

But since at-the-money calls will be priced higher than out-of-the money calls, this spread will entail an initial inflow of money to you.

Sample this: Say you are mildly bearish on Nifty (last closed at 4136).

You think that the Nifty will trade lower the next week, though not significantly lower from the current levels.

While you expect the Nifty to be volatile, you definitely do not expect it to trend significantly above the current market levels.

Given such an outlook, you can consider buying Nifty 4100 put (trading at Rs 197) or selling the 4100 call (trading at Rs 172).

But while buying the put will require you to shell out a significant chunk of money, selling calls can expose you to unlimited losses and margin money issues.

So, if you do not have the appetite for the risk involved, but nevertheless want to play the downtrend in the market, consider a bear call spread.

In this case, you can set the spread by selling 4100 Nifty calls (trading at Rs 172) and buying 4200 Nifty calls (trading at Rs 127).

It will result in an initial credit inflow of Rs 45 per share (Rs 172-Rs 127).

But note that both the legs of this strategy should be executed at the same time. This will help you benefit from a lower cost of setting the spread as the premium inflow from selling the options, to an extent, will compensate for the premium to be paid for buying the other option.

Risk-return trade off

Depending on how the spot price of the underlying moves, your strategy will deliver range-bound returns. Let us study the return probabilities.

Maximum profit potential: When the spot closes below the strike price of the ‘in the money’ call that was sold (in this case, 4100), you stand to make the maximum profits.

And that is limited to the initial net premium that you pocketed while setting the spread (Rs 45 per share).

Maximum loss potential: This situation arises should the spot Nifty close above the strike price of the ‘out of money’ calls that were bought (4200).

The maximum loss however would be limited to the difference in the strike prices of the options (4200-4100 = 100) that were transacted minus the initial premium inflow (Rs 45).

In the example considered, your maximum loss would be limited to Rs 55 per share (100-45).

The breakeven point for the strategy would lie between the two strikes and can be arrived at as follows: Lower Strike price (4100) + Net credit (45), that is 4145.

So, the bear call spread not only limits your maximum profit potential, it also caps the maximum loss - low on risk and return strategy. In this example considered, while your maximum profit would be limited to Rs 45 per share, the maximum loss would be only Rs 55.

This risk-return payoff however can be changed by transacting in options with different strike prices.

That is, the strike prices of the options involved can be tweaked at price points that you feel will limit your overall risk, without significantly lowering your premium collections.

When to exit?

Since the maximum profit potential is limited, it is advisable to exit the position when the underlying trends below the strike price of the sold options.

Alternately, if the underlying fails to move lower as expected, mark your exit depending on the maximum loss you are willing to take.

Srividhya Sivakumar

151) Regret Aversion and how to avoid it

Financial markets have come a long way since Eugene Fama propounded the Efficient Market Hypothesis. Psychologists and neuroscientists now study how our thought processes affect asset price movements. Studies have shown that asset price does not move on real earnings or other fundamental factors of a company but on our perception of such factors. And perception manifests in our behaviour. Behavioural finance is, hence, an essential part of the portfolio management process. It studies market anomalies and investor biases.

This article discusses one such bias - the Regret Aversion Bias. It shows how such bias leads to sub-optimal returns and what investors can do to moderate the bias.

Regret Aversion Bias

We sometimes avoid taking any decision because we feel that our action will prove sub-optimal on hindsight. That is regret aversion.

Take an astute investor who believes that BOC India will break out if it closes above Rs 162-163 levels. The investor buys 500 shares at Rs 161.75 in anticipation of a breakout. And sure enough, the stock breaks out four days later and hits the 20 per cent circuit breaker. If, on the other hand, the stock had moved down, the investor would have stopped the position based on some pre-determined risk management rule.

Now, consider a normal investor. This investor is confused about buying the stock in a wobbly market. She decides to wait for a trend confirmation. After four days, the stock breaks out. But the investor is unable to buy the stock as it hits the upper circuit. There is a strong feeling of regret- of not buying the stock.

But what if this normal investor had taken exposure and the stock instead declined sharply? There will be a feeling of regret - of having bought the stock.

The normal investor knows before the fact that she will experience this feeling of regret. She will, hence, make some sub-optimal choices now to avert regret ex-post.

Sub-optimal choices

Some sub-optimal choices due to regret aversion bias are:

Investors choose less risky investments such as term deposits or fixed maturity bond funds. This leads to sub-optimal returns because such investments run high inflation risk - the risk that returns will not be enough to counter the rise in price levels.

Investors do not sell their profitable positions due to the fear that they might forgo the upside potential. Often, riding winners without a trading plan is risky because the stock could reverse direction and wipe out all the unrealised gains.

Regret aversion forces investors to herd. The rationale is that the market cannot be wrong. Besides, if the investment does turn wrong, the investor can at least console herself stating she was not the only one who got it wrong!

At the extreme, investors suffering from regret aversion shy away from a market that has declined sharply. Their fear is that the regret will be higher if the market goes down further. In the process, they sometimes fail to seize the opportunity to buy stocks at a bargain.

Finally, investors prefer to invest in large caps and mature companies. The reason is that smaller high-growth companies are riskier. While high risk may eventually lead to higher return, it also means higher regret.

Moderating Bias

The core-satellite approach to portfolio management can help investors moderate some aspects of regret aversion bias. Here is how.

The core portfolio carries exposure to index funds or large-cap stocks. The satellite portfolio invests in active funds, arbitrage funds and high-growth stocks.

Now, consider the investor’s desire to herd and/or take exposure only in mature well-known companies. The urge to take exposure to such companies will be satisfied through the core portfolio. The opportunity to chase higher returns and to herd on momentum stocks will be provided through the satellite portfolio.

The same portfolio structure will also help moderate the aversion for bargain-buys on market downturns. Investors can add large-caps to their core portfolio after a market decline. The fact that the core portfolio is long-term holding will help moderate regret aversion. For the same reason, investors should avoid bargain-buys in their satellite portfolio.

The only way to avoid the sub-optimal decision to hold profitable positions for too long is to have a pre-determined trading plan. The trading plan could, for instance, allow for selling half the holding at the initial price objective (target price). The other half could be allowed to run with adequate risk management rules. This approach, called the incremental sale rule, helps the investor take profits, yet allow for upside gains.

Conclusion

It is important to identify behavioural biases and assess their impact on the portfolio management process. Regret aversion is just one such bias. Investors would do well to take the help of their investment advisors to moderate such biases.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

150) Monetary policy overload in combating inflation

Excessive monetary measures are best avoided in an uncertain world environment, where financial flows and political instability can alter the macroeconomic climate in a matter of months. Such policy moves take effect after a lag of at least six months, by which time the economy might require stimulation rather than restraint, says A. SRINIVAS.

All of a sudden, a dream has turned into a nightmare. In less than two years, a situation of high growth and subdued inflation has changed to one of high inflation and definite indications of a slowdown.

Hit by high commodity prices and rising credit costs, industry is showing signs of slowdown. The food price rise might be lower than core inflation rate of 10 per cent, but given the high prices right through 2007-08, even an increase of close to 7 pe r cent is cause for concern. The objective should be to restore the ideal combination of low inflation and high growth in double-quick time.

Inflation experience

What’s wrong with inflation, if it is accompanied by high growth? India’s recent experience shows that inflation hurts the poor the most. The rate of poverty reduction between 1993-94 and 1999-2000 was marginal, prompting many to call the 1990s the lost decade in terms of poverty alleviation. In contrast, 1999-2000 to 2004-05 saw the poverty ratio drop from 33 per cent to 28 per cent.

One big difference between the two periods was the rate of inflation. With the bulk of India’s workforce in the unorganised sector, high inflation is bound to erode income and savings. If the economy-managers are serious about broadening the demand base and tapping micro-savings through an expanded bank and insurance network, inflation can upset their plans. However, the issue at hand is to arrest inflation without sacrificing growth and employment generation.

Different character

The current bout of double-digit inflation is different in character from what the country experienced last fiscal. Last year’s spurt was driven by food articles, with an appreciating rupee holding back core inflation. Foreign institutional funds have become net sellers since the start of 2008; this, alongside high oil and commodity prices worldwide, contributed to a slide in the rupee this year.

Oil prices were about $70 a barrel at this time last year, almost half the present level. The growth of hedge fund activity in all commodities in the aftermath of the sub-prime crisis had not reached current proportions. In short, the role of global forces in today’s inflation is more pronounced than in 2007-08.

The RBI has been responding to inflation with the same prescription of CRR and repo rate hikes for about a year, even as the circumstances have changed. While money supply and non-food credit continue to grow at an impressive clip, the fact of the matter is cost-push inflation poses a bigger threat than demand-pull inflation. By contributing to higher costs in a bid to curb money supply, the RBI may well be leading the country into a stagflation trap — a combination of unemployment and rising prices.

The theoretically inclined would call this a failure of monetarism: focusing on money supply to the exclusion of other factors and paying the price for it. Why didn’t policymakers foresee the changes in world financial patterns in the wake of the sub-prime crisis and identify rising costs as the bigger threat? Renowned economist John Kenneth Galbraith was always sceptical of the ability of central bankers to come up with the right remedy at the right time.

Monetary instruments

The Reserve Bank of India should not have used blunt monetary instruments over recent months to combat inflation. Interest rates were hardening anyway, thanks to a liquidity crunch. This has come about because financial flows have ebbed, as risks to business have increased in a situation of high input costs.

A 50 basis point hike in the repo rate — the rate at which banks borrow from the RBI — will force banks to hike their prime lending rates, especially when the market is no longer an attractive place to borrow. Similarly, the 50 basis point CRR hike will impound Rs 19,000 crore from the banking system, accentuating the liquidity crunch. In trying to reduce money supply growth from the current level of 22 per cent, as against the targeted 15-17 per cent, the RBI might have exacerbated conditions for cost-push inflation. If the global economy were to witness a slowdown, high costs could hit exports and nullify the benefits of the currently depreciating rupee.

Those who feel that higher rates of interest will attract capital flows, with the appreciating rupee taking care of the spiralling costs of crude imports, are mistaken. This has not happened in the recent past when the RBI resorted to rate hikes to tame inflation. A $3-billion cap on FII flows into debt effectively rules out significant interest rate arbitrage.

Excessive monetary measures are best avoided in an uncertain world environment, where financial flows and political instability can alter the macroeconomic climate in a matter of months. Such policy moves take effect after a lag of at least six months, by which time the economy might require stimulation rather than restraint.

Repeated CRR hikes have had no impact on the growth of non-food credit and money supply. This is perhaps because inflationary expectations, thanks to heated commodity markets all over the world, are forcing people to buy today what they might have put off for tomorrow. Unless the world outlook on inflation changes, the current pattern of expectations will remain, nullifying rate hikes.

There are indications that, buoyed by an expected 8.7 per cent increase in global wheat output in 2008, food prices will cool off. India might have a good year on the farm front. But how crude prices will go is anyone’s guess. If the US opts for a sudden strike in Iran, the prospects of which are not exactly remote, it could disrupt crude supplies in the short run and yet provide a stimulus to the world economy, as military operations often do.

Rein-in speculators

Since all this is in the realm of crystal-ball gazing, the best way to tackle inflationary expectations is to take on speculators and hoarders within the country. Instead of focusing on money supply control per se, the RBI should investigate into the uses to which bank credit is being put. It showed the way nearly two years ago by tightening provisional norms for real-estate lending, instead of hiking rates across the board.

This approach not only spares the rest of the economy, but is right in principle because it punishes only those responsible for distortions. With elections in the air, intermediaries close to political parties may be making a quick buck. As in 1995, the last time when inflation was in double digits , general elections are a year away. So, inflation may not be as global a phenomenon as the Government might have us believe.

The importance of specific controls cannot be overemphasised at a time when the exercise of restraint in fiscal policy seems an unlikely prospect. Tackling both inflation and growth calls for a different approach — of calibrated fiscal and monetary moves, rather than pendulum swings between accommodation and restraint.

A. SRINIVAS

149) Is crude price logic not just crude logic?

Even as crude oil prices have risen 40 per cent since January, the rupee has depreciated by almost 10 per cent against the dollar. The fuel price hike could have been deferred and inflation reined in had the RBI not been buying dollars from the market and instead released from its reserves the oil firms’ requirement of the greenback, argues S. GURUMURTHY.

“Ninety-four per cent of the weekly jump is on account of the fuel prices” — this is how the Finance Minister, Mr P. Chidambaram, has attempted an instant explanation for the demon of rising inflation. Many analysts, under pressure from the media for a quick response, have also found it easy to name the fuel price rise as the culprit. On a closer look at the facts, the fuel cost logic seems more like the instant reactions to Budgets without reading the fine-print that conceals the truth.

For a beleaguered government shocked by the huge jump in inflation numbers the fuel logic seems to have come handy as an easy escape. The Opposition parties have fared no better. They have, as usual, blamed the government without saying what it could have done.

In this game of escape and blame, the ordinary people are totally confused. Feeling the pinch of the real inflation in the market, and seeing the difference between actual inflation and the sarkari index, they wonder whether the figure, fixed at just 11.05 per cent, is true at all! Thus the national debate on inflation is more a game between those blaming and those escaping the blame, leaving the truth and the people as casualties.

The issue for debate is not what is causing the high rise in inflation but whether the government could have moderated its cause and contained its rise. But the shocking rise in global crude prices seems to have convinced the government that it is ridiculous to even think of seeking answers elsewhere for the unprecedented inflation.

Even if it were a ridiculous venture it seems worthwhile to ask, and attempt to answer, the question of whether inflation could have been moderated or contained by the government, rather than helplessly accept the crude price logic as final. Look at the background to the June the 7 figure of 11.05 per cent inflation.

INVERSE RELATION

After dilly-dallying for months and citing the global crude prices of over $128 per barrel, the government raised the petrol prices by Rs 5 and diesel prices by Rs 2 a litre in June 2008. What seems to have escaped the attention of many is something as obvious as the apple that Newton saw falling and others did not.

And that is, even as global crude was on a mad rise of 30-40 per cent between January and May this year, in the same period the rupee too depreciated against the dollar from Rs 39.20 to Rs 43.00 — almost 10 per cent. More, in just seven weeks from April 2, 2008, the rupee depreciated from Rs 39.95 to Rs 43.00 to a dollar — that is, by about 8 per cent.

Many seem to have missed the effect of this inverse relation between the rupee value and the crude cost. One per cent fall in rupee value in terms of dollars increases the cost the local fuel prices by 80 paise per litre. That is, the 10 per cent fall in the rupee value means a rise in oil prices by Rs 8 per litre; and the 8 per cent fall means a rise of Rs 6.40 per litre of petrol, in both cases without accounting for global crude rates.

It means this: the rise of Rs 5 for petrol and Rs 2 for diesel effected by the government in June 2008 does not offset the full effect of the fall in the rupee value on local fuel cost. It does not contribute a single paisa to the higher global crude prices.

Now, imagine that the rupee has not fallen in terms of the dollar. The rise in petrol/diesel prices made in June 2008 could have been deferred, at least for now, as taming inflation is undoubtedly the Government’s top priority. Even in respect of imported petro-products not subject to administered prices, the fall in rupee value has increased their cost to the domestic market.

It is evident that if the rupee had not depreciated, the petrol/diesel prices, which have triggered the high inflation, could have been deferred.

The next question now is: Could the government or the RBI have prevented the fall in rupee value from Rs 39.20 to a dollar in January 2008 to Rs 43 to a dollar in May 2008, where it stands even today? The answer is: Yes.

Undoubtedly the RBI and the Government could have prevented the fall in the rupee value at this critical time, and at least for the time being. When global crude is in a mad state, to allow the rupee to fall against the dollar would have the effect of adding the fall rupee value to the crude price in terms of rupees.

In fact, the Government and the RBI ought to maintain the rupee value. But a look at the exchange management by the RBI in 2007-08 reveals that the Government and the RBI were doing the very opposite, namely they had worked to ensure that the rupee fell in value and the dollar rose.

RBI’s dollar purchases

The greatest damage occurred in exchange management during the 12 months ending March 2008. In this 12-month period, the RBI bought dollars in the spot market for $78.2 billion.

To compound it and make it worse, in the six months from October 2007 to March 2008, shockingly, the RBI began buying dollars in the forward market too — taking positions of $4.99 billion (October), $7.55 billion (November), $8.2 billion (December), $16.6 billion (January), $18.2 billion (February) and $14.74 billion (March) to strengthen the dollar and weaken the rupee.

Thus, during the year 2007-08 the RBI bought and took forward position in dollars for a shocking amount of $94 billion for the year, at an average of $8 billion per month.

Ironically, the dollar purchase by the RBI for the entire year 2005-06 was just about that figure — $8.1 billion! Again, for the whole year 2006-07, the net total dollar purchase by the RBI was $26.82 billion, less than 30 per cent of the dollar acquisition in 2007-08. Had the RBI not supported the dollar and not suppressed the rupee as intensely as it has done, the rupee, which was around Rs 39-40 per dollar in 2007-08, would have risen to a band of Rs 35-37 per dollar.

This would have meant a huge cut in fuel prices in India. In fact, only because the rupee was less than Rs 40 to a dollar for most part of the year 2007-08 did the oil firms in India survive, their crude cost less by at least Rs 40,000 crore.

The RBI exchange management policy to keep the rupee around 40 to a dollar not only kept the rupee undervalued, but also caused the sudden appreciation of the dollar in April and May 2008 to Rs 43. Why did the dollar appreciate in April and May 2008? A look at the Reuters and MSN news reports on forex dealings in India from March to May 2008 brings out the fact that huge purchases of dollars by oil firms in India to pay for highly priced crude resulted in huge demand for dollars in April-May 2008 and that caused the dollar to appreciate, and the rupee to fall.

But could the RBI have prevented this? Yes. It could have released from its huge foreign currency holdings of over $300 billion — more than a third of which it had built during the 12 months ending March 2008 — a few billion dollars to the oil firms to bring down the demand for dollars in the spot and futures markets.

But this is precisely what the RBI and the Government did not do. Instead, even in April and May, the RBI kept buying dollars and increased its forex currency holdings from $299 billion at end-March 2008 to $305 billion at end-May 2008 — a rise of $5 billion.

Had the RBI stopped buying dollars in April and May 2008, and released from its dollar stocks the requirements of the oil firms’ dollars, the rupee would not have depreciated, and the rise of domestic petrol/diesel prices could have been deferred for better times. Undoubtedly this would have directly moderated the inflation. So, Mr Chidambaram, is not the crude price logic just crude logic?

S. GURUMURTHY.

(The author, a corporate adviser, can be reached at guru@gurumurthy.net)

148) Where are you Roger Bootle?

Roger Bootle’s Death of Inflation was a best seller in the mid-90s. His argument about the reality of zero inflation eras was both provocative and persuasive. It was a Goldilocks background at that point in time — witness to economic expansion and at the same time, low interest rates. He claimed that inflation is dead for good and in fact the danger was of central bankers causing deflation.

Now, nearly two-third of the world population is reeling under inflation. There is double-digit inflation in many countries. Even in the Euro zone, the inflation level is at a 16-year high. This burst of inflation reminds us of Mark Twain’s famous words ‘The reports of my death are greatly exaggerated’.

Those were the days when the fashionable distinction between ‘headline’ and ‘core’ inflation gained popular currency. A theory even goes that what ever central bankers could not control was not ‘core’ for the common man and, therefore, kept out of the measure. .

It looked as though it was gay abandon so far as monetary discipline is concerned, particularly in the US and much of developed world. What ensued was a regime of low interest rates and the gasoline (monetary looseness) was sprayed in abundance all over the place. There was a rush of institutional finance and funds of all names and kinds to commodities. Everything was an asset class, if not an alternate ass(et) class. The gap between measured (official) inflation and inflation suffered by the housewife went on widening. It was not just price elevation, but fear elevation as well bordering on schizophrenic.

Given the pace of globalisation, it is fast download. Indulgent monetary policies have blurred the distinction between growth and bubble. Market fashions on relationship between values and wealth are undergoing rapid changes.

Manpower shortage

There is this conventional debate as to whether inflation is caused by demand factors or supply factors. In the new economy, knowledge is the capital and there is huge shortage of this capital leading to high wage spiral. The shortage of not merely top talent, but even middle management level, is itself exacerbating shortages in the real economy. There is not one industry and not one country that do not complain of shortage of manpower. This is accentuating demand-supply gap in other sectors. Can this supply shortage lend itself for treatment by conventional monetary policy? Do we have new age monetary policy to tackle the burgeoning demand for manpower?

In another era, inflation expectations led to wage increase demands. But in the new economy, inflation or no inflation, the wage inflation feeds forward — not feeds back — into the real economy.

Swollen by dollars, many countries imagined that they can buy their shortage through imports. Given the herd instinct there are stampedes.

The US probably is the only country that majorly prints its way not merely fiscal deficit but also trade deficit. Dollar, dollar everywhere, commodity prices anywhere, anywhere. This limits efficacy of domestic monetary policies. Earn dollars or perish was the theme that was played to the hilt by emerging economies and ably dollar printed by the US. This is an idea that is past due date. It is said that achieving growth is about technical competence and ushering in progress is about vision thing backed up and not bent by political will.

Insulation from inflation

How can governments insulate populations from inflation? In China, which has reserve ratios of over 17 per cent (more than double of ours), the interest rate on deposits is about 1.5 per cent and loan rates are about 5-6 per cent? Can the Chinese puzzle do an Indian rope trick?

They appear to have unique monetary transmission mechanism. Governments in many developing countries are anesthetising people by blocking pass through. This state of denial can make future crisis costly. The elevated prices convey message. How do we cushion the impact of sudden surges and at the same time avoid anaesthetising?

Everyone wants the price of what he/she owns or produces to go up but whatever he/she consumes to go down. What else explains riots/protests for lower food prices on one hand and suicides and riots by farmers for higher prices on the other? Do we have right economics/politics to balance this contradiction so that fear and greed do not overwhelm us? Do we need folk wisdom?

Are we hitting the limits to growth-Rome roundtable version or otherwise? Can we really say that, when over 400 million people are still suffering from poverty? The growth models we are adopting and at times imitating, at least in some sectors, could only worsen the problem. The increase in airport miles (location of new airports), increase in food miles (organised retail) , increase in office miles, increase in sleep mile etc. would only serve to make us more oil dependent.

Can this be addressed by monetary policy? The reduction in these miles would require a change in our fundamental behaviour and way of living & working. Simple living has become complex and complexity has become the norm. This complexity has been fed on energy. We are embracing energy guzzling life and work style. Mass transportation needs acceleration.

Carbon neutral — not just reduction — and even water neutral by some beverage companies — are not mere catch phrases but are central sustainable development strategies. Some reports indicate that if sustainability model is neglected, two-thirdof the global population would face water shortage in not too distant future. Half the world population is anesthetised by fuel subsidies. There is no place to hide from high energy and food prices except green. Let us start counting green jobs. Why not start from diapers? A few countries like Iceland are striving for carbon neutrality, and not just reduction. We cannot achieve real and sustainable progress without giving up oil addiction and move towards environment neutrality.

Before I could finish reading Stephen Leeb’s The Coming Economic Collapse: How You Can thrive When Oil Costs $200 a Barrel, comes the warning by Gazprom of $250.

IMF’s clarification on inflation: even if the inflation is not going to deepen, it would be protracted. If it was hard enough, read Greenspan.

To be fair to Roger Bootle, his discussion was about perpetual inflation.

To be precise, by zero inflation he meant alternate periods of low inflation and deflation. Moral of the story — the challenge of inflation, like many other challenges, would never be solved in a lasting manner.

Let us hope that inflation would be reined in. But hope is not policy.

B. Sambamurthy

(The author is the Chairman and Managing Director of Corporation Bank)

147) Three lessons in computing returns

With so many rates — simple interest, compound interest, holding period, arithmetic mean, geometric mean, IRR — floating around, it is important for the investor to know what each stands for, how to compute them, where they are useful and when they are misleading.

You invest Rs 10,000 today in X Ltd, and it grows to Rs 20,000 in five years. Yes, the investment has doubled in five years; yes, the five-year return is 100 per cent; but what is its annual return? Is it 20 per cent per annum? You invest Rs 10,000 today in Y Ltd, and it grows to Rs 40,000 in ten years’ time. Yes, the investment has quadrupled in 10 years; yes the ten-year return is 300 per cent; but what is its annual return? Is it 30 per cent per annum?

When an investment in X Ltd doubles in five years, it would, if reinvested at the same rate, double again in the next five years. Hence Rs 10,000 invested in X Ltd will become Rs 40,000 in 10 years. Therefore, both, the investment in X Ltd and that in Y Ltd, give identical returns whereas we had earlier thought that the first gave 20 per cent and the second, 30 per cent.

Go back to the school formula on compound interest to get the right rate. Using Rs 10,000 as principal, Rs 20,000 as amount, and five as years, we get the rate as 14 per cent in the case of X Ltd. Using Rs 10,000 as principal, Rs 40,000 as amount, and 10 as years, we get 14 per cent in Y Ltd, as well.

This 14 per cent is the compound return, and is the only relevant return when you analyse an investment. The 20 per cent and the 30 per cent are called simple return. They are misleading and should not form part of an analysis. The 100 per cent and the 300 per cent are referred to as holding period return. They too are misleading because they grow with time.

That brings us to the first moral of computing return. Simple return is wrong; holding period return is misleading; go by compound rate of return only.

Arithmetic mean and Compound Return

Suppose you want to make an estimate of future rate of return of a stock. One way of doing so, in the absence of the crystal ball, is to look at the past rate of return as an indicator of the future. Here’s how the return is computed in this case.

Consider a stock, A Ltd, whose return during each of the last five years has been 10 per cent, 20 per cent, 15 per cent, minus 30 per cent and 20 per cent per annum. Hence its simple average, also known as Arithmetic Mean, is 7 per cent per annum. Consider another stock, B Ltd, whose return during the last five years has been 10 per cent, 15 per cent, 20 per cent, 10 per cent and minus 20 per cent. Its simple average return too is 7 per cent per annum. So should we say that they are identical performers? Surprisingly, the answer is ‘No’. Here’s why.

If the stock price of A Ltd began at Rs 100, it would have grown to Rs 110, Rs 132, Rs 151.8, Rs 106.26 and Rs 127.51 at the end of each of the five years. Rs 100 growing to Rs 127.51 is a compounded rate (CARG) of 4.98 per cent using the compound interest rate formula. Similarly Y Ltd, which began at Rs 100 at the beginning of the first year, would have sequentially grown to Rs 110, Rs 126.5, Rs 151.8, Rs 166.98 and Rs 133.54 at the end of each of the five years. Rs 100 growing to Rs 133.58 is a compounded rate of 5.96 per cent.

Clearly, Rs 100 growing to Rs 127.51 is not the same as Rs 100 growing to Rs 133.58. Yet CARG, also called geometric mean, suggests exactly that. We already know that the 7 per cent return called Arithmetic Mean is incorrect. So what should we consider? While the geometric mean is considered the right measure of return, the arithmetic mean is used for purposes of projecting the expected return on a stock. The logic runs thus: The geometric mean is relevant only to the investor who buys, goes to sleep for five years and wakes up five years later — long term investors. As most investors are not of that kind, the arithmetic mean is relevant. For instance, in the case of Stock A, an investor has the opportunity to make 10 per cent, 20 per cent, 15 per cent, -30 per cent and 20 per cent. Hence the expected return is 7 per cent.

That brings us to the second moral of return. In making an estimate of future return, arithmetic mean, rather than the more sophisticated geometric mean, is adopted.

Internal rate of return

Actually, computing returns is not complicated, especially if you use spreadsheets. Once you have laid out the cash flow, you can calculate the compounded rate of return using a tool called internal rate of return (IRR) in the spreadsheet. Let’s take an example.

Bought 100 shares in January 2004 Rs 150

Dividend per share in each year end Rs 12, Rs 15, Rs 10 and Rs 8 per share

Rights offer 1:2 in December 05 at Rs 100

Bonus 1:1 in December 06

Market price 2007 end Rs 125

The cash flows appear as under during the period from January 2004 to December 2007 (Table)

The IRR works out to 27 per cent.

There is, however, a major catch here. Without getting into the details, let me tell you that the above computation assumes that the in-between cash flows that you received, namely the dividends, are also reinvested at 27 per cent. If those cash flows are actually reinvested at a lower rate, the IRR is overstated. That brings us to the third moral of return. Return is always the IRR. But you have to use it with care, especially when it is high. That’s because the computation assumes reinvestment at IRR.

With so many rates — simple interest, compound interest, holding period, arithmetic mean, geometric mean, IRR — floating around, it is important to know what each stands for, how to compute them, where they are useful and when they are misleading.

V. Pattabhi Ram
(The author is a Chennai-based chartered acccontant.)

146) Fixed maturity plans: Minimising equity risk at the horizon

Asset management firms’ offer fixed maturity plans within the fixed income space. One of the participants in a workshop that we conducted recently raised an interesting question: Why not have such plans in the equity space as well?

This article discusses the need for equity exposure within a fixed maturity plan and the difficulty in structuring such plans. The problem arises because equity, unlike fixed-income securities, does not have finite life. This non-finite life exposes the portfolio to market risk at the horizon (when the investor wants to encash his investment). Portfolio managers have to apply sophisticated models to manage this risk.

Horizon-matching liability structures

Suppose an investor wants Rs 25 lakh five years hence to fund her child’s education. She can construct a typical portfolio with stocks and bonds. Such a portfolio, if not custom-tailored to meet the investment objectives, will be exposed to market risk at the horizon. This is because the portfolio has to be liquidated five years hence at the market price prevailing then. And if asset prices are down at the horizon, the portfolio may be unable to meet the education cost.

Fixed maturity plans help in this regard. Suppose the investor has lump-sum amount that she wants to invest now to meet this liability structure. She can invest in a five-year fixed-maturity bond fund. The bond fund will only invest in five-year bonds. At the end of five years, the fund will redeem the bonds with issuer-companies and deliver the proceeds to the investors. As the fund is not required to liquidate the portfolio at the market price, it is not exposed to market risk. This helps the portfolio meet the liability structure.

But what if the investor does not have lump-sum amount to invest now? She may invest a smaller sum now and hope to earn higher returns through the five-year period. Or she may invest some amount every year to achieve her investment objective. Typically, the investor will choose to do both.

Fixed maturity plans: Equity exposure?

Investors typically prefer equity exposure because of the higher returns. But investing in equity exposes the portfolio to market risk. This is because equity, unlike fixed income securities, does not have finite life and, hence, cannot be typically redeemed with issuer-companies. That is why asset management firms do not provide equity exposure within the fixed maturity plans.

The question is: Can portfolio managers minimise market risk so as to provide such exposure? One alternative would be to apply asset allocation strategies. This refers to cutting equity exposure and moving into bonds so as to change the portfolio composition.

This process can begin six months before the horizon date. It will help portfolio managers capture profits in the equity portfolio. The flip side is the high cost of cash drag- the cost of earning lower returns because of moving out of equity and losing further upside gains till the horizon date. The portfolio may also suffer impact cost from selling shares. Asset management firms can, however, apply algorithmic trading to optimize trade size and market timing.

Another alternative would be to delta-hedge the equity portfolio with short-term options. This way, the portfolio will participate in upside gains while the put options will protect the downside risk. The hedge cost is the put premium. Astute managers will prefer using a ‘fence’ to reduce the hedge cost. A fence refers to buying a put and selling a higher strike call to minimize the hedge cost.

The objective of this article is not to provide alternatives to reducing market risk at the horizon. Rather, it is to show that such solutions do exist.

What next?

Imagine then a scenario where the asset management firms offer, say, a five-year fixed maturity plan that has three variants- a conservative plan, a balanced plan and an aggressive plan. A conservative plan would have only bond exposure. The balanced plan will have 50 per cent in bonds and 50 per cent in equity while an aggressive plan will have 60-75 per cent equity exposure.

Portfolio managers can also offer Constant Proportion asset allocation strategy that shifts between stocks and bonds depending on the stock price movements. Aggressive portfolio managers can offer tactical asset allocation strategy to take advantage of their view on the bond and stock markets.

It is more advantageous to the investor if asset management firms offer equity exposure within a fixed maturity fund rather than have a fixed maturity equity fund. The reason is that the portfolio manager will take responsibility for the asset allocation process.

Such products can help investors’ optimally horizon-match their liability structure. An investor wanting to buy a house, fund her child’s education or buy a round-trip ticket on a European cruise can then use fixed maturity plans with appropriate asset allocation strategy.

B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)

145) Play the market volatility with a long straddle

Traders looking to play the volatility in the markets can consider using a long straddle on Nifty 4350 July series. This option spread can be set by buying Nifty 4350 July put and call options, which are trading at Rs 170 and Rs 165 respectively. This means that for an initial outgo of Rs 335 per share (or Rs 16,750 per lot), you can set yourself a long straddle on Nifty July series.

While this straddle can be set using even the June month series, we have suggested the July month spread since it will enjoy a higher time value of money, an aspect very important when options are purchased. The June series may not enjoy as much time value since it is nearing expiry, since time value of money tends to become zero when options approach their expiry.

Why a long straddle?

With the inflation soaring to new highs and uncertainty on the political front beginning to creep up, next week which incidentally also happens to be the settlement week of the current month derivative series may see a lot of volatility. And since long straddles are best put to use when you expect the markets to remain volatile or make a decisive move in some direction, this strategy can be considered by traders.

While the creation of quite a few short positions in the July series suggests that Nifty may continue to flirt with newer lows, there is also the possibility of a temporary relief rally in the market, propped by short covering. This fairly strong likelihood of a movement in either or even both the directions, also strengthens the case for using a long straddle in the current market. Remember you do not need to have any directional view on the market to use long straddles.

Risk-return payoff

The maximum risk in this strategy is limited to money used to set this option spread. That means, at the most you stand the risk of losing Rs 335 per share if the market fails to move as expected.

The upside potential is theoretically unlimited. But note that this spread will turn in-the-money only if the Nifty breaches its breakeven points.

The breakeven points can be arrived at as follows:

Upper breakeven (4685) = Strike price (4350) + premium outflow (335)

Lower breakeven (4015) = Strike price (4350) - premium outflow (335)

This essentially means that your straddle will be in-the-money (become profitable) only when the index moves either above 4685 (upper breakeven point) or falls below 4015 (lower breakeven point).

Between these two points, the position will suffer a range of losses with the maximum loss (limited to the premium outflow) at the strike price.

But note that you can minimise the cost of setting up this strategy by timing the purchase of options well. That is, you can time your call purchase when the markets are in the downtrend and buy the put when the Nifty rises. So, if the markets open lower on Monday, buy the calls which will become cheaper and buy puts on any subsequent short covering in the market.

But do not wait too long to buy both the options as you can miss out on profit-booking opportunities in the interim period.

In a similar manner, you can also time your exit strategy.

When to exit?

While the maximum loss in this strategy is limited to Rs 335 per share, note that you need not wait for that long to close the position.

Depending on your risk appetite and the maximum loss you are willing to take, you can exit the position if the Nifty fails to make the expected movement.

Srividhya Sivakumar

144) Where have all the bulls gone?

FIIs are not very keen on the Indian growth story right now. A look at factors souring the success story.

FIIs, the most important class of investors in Indian markets, are now having second thoughts about their India investments. This may come as a surprise since just last year the FIIs were all in praise of the India growth story and had gone on a buying spree across sectors and stocks. Quite a turnaround in outlook, you may think! But what drove this sudden change? Why are there no takers for stocks that were so sought after last year? A look at factors that could be weighing heavily on these big investors’ minds.

Growth story: losing steam
The Indian growth story appears to be losing steam and quite fast at that, if we consider the corporate earnings number.

The much-talked about Indian corporate earnings juggernaut has given away many clues that suggest an impending slowdown. While companies still continue to scale growth, it is the conspicuous slowdown in growth momentum that appears to have caught a good deal of attention.

After all, why remain invested in companies that may grow slowly over the next couple of years, when FIIs have access to companies across countries and sectors that promise higher returns?

But the slackening growth in corporate earnings is not the only reason. There is also the macro economic aspect behind the now prominent bearish outlook for India markets.

For one, it is the lower estimates of future GDP growth. Most leading multinational brokerage houses of high repute have downgraded the growth estimates of India’s GDP. How does this affect the markets? Apart from reiterating the consensus view of a slowdown in Indian economy, it also means that we may not see as much money getting pumped into the markets. FIIs appear to find investing in developed countries such as the US, which may be on the uptrend when compared to India, a more promising proposition. Agreed, India may still put up a healthy 8 per cent absolute growth in GDP, but remember that this is likely to taper, whereas developed countries could have just about begun their recovery. While it can be argued that the pessimism about Indian markets may have gone beyond levels of sanity, there is no denying that there is some element of truth in it. Not only has the IIP growth moderated in the last few quarters but there has also been an increase in the number of sectors that have witnessed negative growth in 2007-08 as compared with 2006-07. No wonder that some of the very names that were once cherished admirers of the India story have now “downgraded” the Indian market.
Overseas fund managers have pulled out over $3.03 billion out of Indian equities in the first three months of this year. And this is the first time foreign investors have been net sellers on a quarterly basis since the data was first compiled in 2000.

Soaring inflation
Most of the emerging markets are presently grappling with inflationary pressures. Thanks to the much-popularised ‘Chindia’ factor, prices of commodities worldwide have risen to new highs.

High commodity prices, in turn, threaten to pull down India’s growth potential. While India may be self-sufficient in food grains and commodities such as steel and aluminium, it bears attention that we are heavily dependent on imported copper, coking coal and edible oils. And with the demand for these commodities continuing to rise in emerging countries, high inflationary trends could well be here to stay.

This means that not only will Indian companies be forced to tackle high input costs but they may also suffer lower offtake in domestic demand.

Crude realities
The price of crude oil, which was hovering around the $70-mark last year, is now scaling new highs. Analysts are increasingly upping their target for this commodity, the last estimate being as high as $200!

High crude prices are a double whammy for countries such as India that depend heavily on the oil producing nations for its energy needs. And why is that so?

High crude prices would lead to higher import bills and that will subsequently widen the country’s fiscal deficit. And since oil continues to remain subsidised in our country despite the recent hike in domestic prices, any further rise in global crude oil price may only worsen the country’s economic health.

Besides, at a time when the Indian economy is already grappling with a slowdown, high import burden may only spell more trouble.

Yes, the government can abate the impact of higher oil price to some extent, by increasing the domestic fuel prices again, but then with General Elections round the corner, this appears quite unlikely. Moreover, any further increase in domestic oil price may only add to the country’s already soaring inflation. A catch-22 situation!

After suffering huge losses in the US sub-prime rout and global credit market crisis, foreign institutional investors cannot be blamed for their current lower appetite for risk.

Global risk aversion
And since investing in India appears laden with risks over the near term, incremental investments from FIIs may take time to happen. Indian markets’ valuations have corrected steeply in the last couple of months but it has been so for other emerging markets as well. Some analysts still feel that India continues to be at a premium!

Have the FIIs vanished from our markets for ever? Very unlikely, given that the economy still continues to grow. FIIs will once again pump money into India when its growth rate starts to accelerate relative to other economies.
Use this time to build a portfolio of all those dream stocks that, just a year ago, were beyond reach. After all, it is not every other day that such stocks are up for grabs.

Srividhya Sivakumar

143) Profiting from open interest

Call it wishful thinking, but how would it have been if you had known a day before that a particular company’s shares would go up the following day? Obviously great. But, sadly such premonitions are unheard of, at least in the world of stocks. Nonetheless, there are some stock market indicators that can, if not point at the exact direction the stock might move in, indicate that there could be something brewing in it. Open interest is one such indicator. Studying trends in open interest can help you spot stocks that are witnessing a notable build up in trading interest and hence may see a sudden spurt in price.

But, to best appreciate the implications of open interest, sample this. On June 10, a day before Ranbaxy made the big announcement, it added over 3.7 crore shares in open interest! This means, so many new contracts had been created in Ranbaxy just a day before the promoters’ announced a stake sale. On retrospection, we know that this addition in open interest was quite significant. What is open interest?

Open interest simply put is the total number of open contracts on a security, including the number of future contracts or options contracts that have not been exercised, expired or fulfilled by delivery. So, any significant increase or decrease in open interest can be safely assumed as an indicator of changing market sentiment on the underlying stock. But what exactly makes this indicator click? It is the fact that stock markets are not efficient all the time.

That is to say, that all material information of a company or its stock is not available to all the market participants all the time. This discrepancy was displayed in the example of Ranbaxy, in which case some of the market participants had somehow got a whiff of the upcoming news-break a day in advance. How to read open interest?
Changes in open interest can be considered as a good indicator of the flow of money into the derivatives market.

However, on a standalone basis, they do not give away sufficient clues on the direction of the likely move in the underlying. So, to circumvent this limitation, changes in open interest should be read along with the change in price of the underlying. Increasing open interest and rising prices

If the open interest has risen in tandem with the underlying price in the markets, it can be safely construed as a bullish signal.

Note that addition of open interest signals the entry of new money into that particular stock or index. And since the price of the underlying has also risen, it can be assumed that the new money has been used to create fresh long positions. Increasing open interest but falling prices

This is a bearish signal. The addition in open interest on the back of falling prices suggests that the new money which is entering that particular stock or index derivatives has been used to create fresh shorts. Decreasing open interest but rising prices

Interpreting such diverse trends can be quite tricky. When despite a decrease in open interest, the underlying continues to move up, understand that there can be more to it than what might meet the eye.

To begin with, the fall in open interest signals that market participants are squaring off or closing their existing positions.

But since there is also a rise in price, understand that it is a precursor to reversal in price trends. That is, the up move in the stock price or the index may only be temporary. This means that prices may soon begin to fall since the hitherto rise in price may have been due to squaring up of short positions. Decreasing open interest and falling prices

This again signals a trend reversal. Decrease in open interest at a time when even the prices are falling can be attributed to the forced closing of long positions by traders. This means, the fall in the stock of the index could have bottomed out and an uptrend may be in the offing.

Nonetheless, note that none of these interpretations are sacrosanct per say.

Making trading decisions solely based on such interpretations therefore may not always pay off.

Srividhya Sivakumar

142) Employing asset allocation strategies for optimal gains

Asset allocation is an integral part of the portfolio management process.

In a plain-vanilla portfolio, this strategy refers to allocating assets between stocks and bonds. In a somewhat complex portfolio, the strategy includes alternative asset classes such as commodities and art.

Empirical evidence suggests that asset allocation substantially contributes to portfolio returns.

Given the importance of the process, this article discusses two simple, yet powerful asset allocation strategies that professional money managers employ. Individual investors can replicate both these strategies with help from their investment advisors.

One is the constant mix strategy and the other, the constant proportion strategy. The former outperforms during market reversals while the latter does well in trending markets.

Asset allocation
In a seminal paper published in 1992, William Sharpe showed that the asset allocation process could explain nearly 90 per cent of the variability in returns for a mutual fund. It is no different for individual portfolios.

This does not mean that security selection is not important. If one were to explain portfolio returns in terms of excess returns (alpha) and market returns (beta), the security selection process generates alpha while the asset allocation process generates beta.

Suffice it to know here that it is important for investors to pre-determine their portfolio composition between stocks and bonds (or term deposits).

Constant Mix Strategy
This strategy maintains constant equity exposure as a percentage of the total assets. Suppose the investor has Rs 10 lakh and decides to have 60 per cent equity exposure. The initial portfolio will, hence, have Rs 6 lakh in equity and Rs 4 lakh in bonds.

What if the equity portfolio thereafter declines 10 per cent? It would be worth Rs 5.4 lakh, 57 per cent of the total assets of Rs 9.4 lakh.

To have an equity exposure of 60 per cent, the investor would have to buy shares worth Rs 24,000 and sell equivalent value of bonds.

Next, consider what happens if the equity portfolio moves up 10 per cent to Rs 6.6 lakh.

The total portfolio would be worth Rs 10.6 lakh. The portfolio would have to be rebalanced, as 60 per cent of Rs 10.6 lakh is Rs 6.36 lakh. The investor would, therefore, have to sell Rs 24,000 worth shares and invest in bonds.

The Constant Mix strategy plays on the behavioural psychology of investors.

The reason is that it engages in value-buying by increasing equity exposure when stock prices decline. The strategy also helps investors take profits quickly, as it cuts exposure when stock prices move up.

Constant Proportion Strategy
This asset allocation strategy requires the investor to define a floor and a multiplier. Portfolio Management Services firms in India use similar process to manage their capital guaranteed products.

Suppose an investor has Rs 10 lakh which she wants to allocate between stocks and bonds. Assume a floor of Rs 8 lakh and a multiplier of 2. The difference between the total assets and the floor is called the “cushion”. The equity exposure is a multiple of the cushion.

In the above example, the cushion is Rs 2 lakh. With a multiplier of 2, the initial equity exposure will be Rs 4 lakh. The balance Rs 6 lakh will be typically invested in bonds or term deposits.

Suppose the equity portfolio declines 10 per cent. The total portfolio would be worth Rs 9.6 lakh and the equity exposure permissible is Rs 3.2 lakh [2 (Rs 9.6 lakh- 8 lakh)]. This means that the investor would have to rebalance the portfolio - sell Rs 40,000 worth of equity and invest in bonds.

What if the equity portfolio moves up 10 per cent? The total portfolio would be worth Rs 10.4 lakh. The cushion would be Rs 2.4 lakh, which allows an equity exposure of Rs 4.8 lakh. So, the investor would have to sell Rs 80,000 worth bonds and invest in equity.

Conclusion
The Constant Mix strategy buys more equity when prices go down and sells as prices go up. This continual buy-and-sell strategy helps investors take advantage of reversals within a range-bound market. The strategy underperforms when the market is trending up or down, for the same reason that it does well on reversals.

The Constant Proportion strategy loads more equity into the portfolio when the market moves up and reduces exposure when the market moves down. It is precisely for this reason that the strategy outperforms in a trending market-higher equity exposure will generate more returns when the market is up and lower exposure minimise losses when the market is down.

What about rebalancing the portfolio when stock prices drift? That is a trade-off between the rebalancing cost and the drift from the pre-determined portfolio composition. Investors may wish to rebalance their portfolio at least once every year.

B.Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)