IIM Shillong Niveshak Nov 11

THE INVESTOR VOLUME 4 ISSUE 11 November 2011

currency manipulation debate Pg. 20

Indian Housing finance market pg. 16

Niveshak

Green Finance

What after Kyoto Protocol ?

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

F R O M E D I T O R ’ S D E S K

NiveshakVolume IV

ISSUE XINovember 2011

Faculty MentorProf. N. Sivasankaran

EditorRajat Sethia

Sub-EditorsAlok AgrawalDeep Mehta

Jayant KejriwalMrityunjay Choudhary

Sawan SingamsettyShashank Jain

Tejas Vijay Pradhan

New TeamAkanksha BehlAkhil Tandon

Chandan GuptaHarshali Damle

Kailash V. MadanNilkesh Patra

Rakesh Agarwal

Creative TeamAnuroop Bhanu

Venkata Abhiram M.Vishal Goel

Vivek Priyadarshi

All images, design and artwork are copyright of

IIM Shillong Finance Club

©Finance ClubIndian Institute of Management

Shillong

www.iims-niveshak.com

THE TEAM

Dear Niveshaks,

The past month like the previous ones since a long time witnessed growing uncertainty in the Euro zone on the possible measures to prevent an economic meltdown. New ECB president Mario Draghi, in his very first public appearance at the European Banking Congress in Frankfurt, displayed stridency of views and called for immediate action from European politicians to implement the decisions taken in earlier summits. The troubled nations of Greece and Italy now have new Prime Ministers, Lucas Papademos and Mario Monti respectively, in the hope of enforcing better reforms to tide over the crisis. A sense of dismay prevailed in the EU when Mr. Papademos refused to give a written pledge to implement austerity measures prior to release of next instalment package from the EU, saying his words were enough. In neighbouring Italy, the political uncertainty raised their 10-year bond yield to as high as 7.48 %. However, Mr. Monti’s slew of policy priori-ties on labour and pension reforms helped in raising the confidence of investors and lowering the bond yields to manageable levels. Meanwhile in US, the super committee’s progress on measures to reduce the US deficit by at least $1.2 trillion over the next 10 years would be reviewed on 23rd November. It is widely believed that in case the committee falls short of expectations, the financial markets could be headed for another nosedive. These conditions do not augur well for US, which is still trying to emerge from the after effects of the 2008 recession.

There was no respite for the Indian sub-continent as well. High interest rate and unbridled inflation have led to yet another disappointing IIP number for the month of September, which has slumped to a two year low of 1.9 % against 6.1 % in the corresponding month a year ago. The weak number is mainly due to slow-down in capital intensive manufacturing and mining sectors indicating that though the series of rate hikes have not been able to rein in inflation, it has an ad-verse effect on growth. Global research firm, Macqquarie, has gone to the extent of lowering the next fiscal year (FY2012-13) GDP projection for India to 6.9% citing lack of political reforms by the government as the major reason while maintain-ing this year growth marginally higher at 7.4 %. The series of rate hikes by the RBI to control the rampant rise in inflation is expected to show some effect from December onwards. In case that happens, RBI governor has indicated that further tightening in terms of interest rate hikes might not be needed.

This issue brings to you some more interesting and insightful reads. The cover story this month focuses on Green Finance especially carbon credits and its relevance in the current scenario. The issue also features an article on the Housing Finance Market in India and the road ahead for it. Another article in this issue focusses on High Frequency Trading used by large banks for proprietary trading. The Classroom this month explains the process of Factoring.

We, the Editorial Team of Niveshak, are pleased to introduce to you our new team, which has been selected to carry on the legacy of Niveshak. They are: Akanksha, Akhil, Anuroop, Chandan, Harshali, Kailash, Nilkesh, Rakesh and Venkata. Please join us in welcoming them to Team Niveshak. We are confident that the new team will not only meet but will surpass your expectations in this and the coming editions. Keep supporting them the way you have been supporting us.

Stay Invested.

Rajat Sethia(Editor - Niveshak)

C O N T E N T S

Niveshak Times04 The Month That Was

Article of the month 08 A new framework for proactive monitoring &management of risks

Cover Story

11 Green Finance

Fingyaan 16 Indian housing finance market

Perspective

20 Currency manipulation debate US v/s China : Who will win?

Finsight22 High frequency trading demystified

CLASSROOM25 Factoring

He speaketh 14 Mr. Sanjib Bezbaroa

November 2011

Twin deficit – a major concern for India

Higher fiscal deficit and trade deficit referred to as twin deficit is raising macro-economic concerns for India. The trade deficit is moving in line with the fiscal deficit. The fiscal deficit target is going to be abandoned as the slowing economy is making it very difficult for the government to meet the rev-enue targets due to the 2.5% drop in indirect tax collections in October. The finance ministry , while presenting the mid-year economic review in the winter session of the parliament, is going to review the fiscal deficit and revise it from 4.6% of GDP to a value slightly lower than the psychological mark of 5% . Another problem is the current account deficit which is giving more challenges to the ministry. In October, India’s exports fell to a 12-month low of $19.9 billion pushing the trade deficit to a four year high of $19.6 billion. Now, this deficit has increased to 3% of the GDP from 2.6% in 2010-11.

Kingfisher crisis

Kingfisher Airlines is in its biggest crisis ever as it was fighting a battle to save some of its aircrafts from angry lenders who wanted to take them back due to non-payment of the lease rentals. The airline has defaulted on payments because of the worsening situation of rising fuel costs and intense price war in the domestic market. Because of severe cash shortage to pay for even fuel supplies, the airline continued to cancel flights recently disrupting travel plans of hundreds of passengers.

Super Committee for America’s deficit

It’s now the turn of United States’ politicians who can actually hack away America’s swollen deficit. A jointly selected committee, a group of six democrats and six republicans drawn equally from the House of Representatives and the Senate, is supposed to come up with a plan to reduce the deficit by $1.2 trillion to $1.5 trillion over the next ten years. This plan only needs a simple majority in the Senate. But if the plan fails to get through, more cuts will automatically be imposed. This $1.5 trillion is not

enough compared to $12 trillion predicted deficit over the next decade. So another deal of reducing the deficit by $3 trillion to $4 trillion will be good to convince in-vestors that America’s long-term problem is being tackled. But for this to hap-pen, certain entitlements such as Social Security, Medicare should be put on the table. Another im-portant parameter is tax. Without increasing tax, it would be very difficult to meet the target of deficit reduction.

FDI reforms in India

While Mr. Vijay Mallya led Kingfisher is fighting the cash crunch problem, the government is preparing some reforms which include foreign direct invest-ment by foreign airlines. The government is prepar-ing a cabinet note to allow 26% foreign direct invest-ment by foreign airlines in the aviation sector. This will provide much needed financial help to the loss making carriers like Kingfisher and Air-India. Some other sectors are also going to have foreign direct investment. The finance ministry has approved to allow 51% FDI in multi brand retail, which will wel-come giants like Walmart and Tesco to India. There was also a reform in the pension sector, where the government allowed 26% FDI. This would allow the foreign portfolio managers to manage over $12 bil-lion of the employee pension money.

Monti takes over as Italy’s PM

Silvio Berlusconi, a prime minister notorious for his buffoonery and flamboyant lifestyle, has given way to a sober, monogamous economist Mario Monti. Mario Monti was sworn in as Italy’s prime minister following Silvio Berlusconi’s resignation.

Monti brings credentials from a decade as a Euro-pean commissioner that his technocrat government will need while facing a financial crisis threaten-ing to spin out of control. Monti’s cabinet, which is devoid of any political flavor, consists of experts such as bankers, ambassadors and bureaucrats. Mr.

The Niveshak Times


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Monti reserved the finance portfolio for himself and said that he intends to serve a full term, until 2013. The new government, which was sworn in before President Giorgio Napolitano, will be tasked with passing a strict austerity program aimed at restoring investor confidence that Italy will not go bankrupt and require an international bailout.

Greece banking on Papademos for reforms

In another striking develop-ment, former Vice President of European Central Bank, Lucas Papademos, has been selected as the new prime minister of the debt ravaged Greece. His 48-member cabi-net includes MPs from the conservative New Democracy

party, the populist far-right Laos party and outgo-ing socialist government, which caved in under the pressure of handling Greece’s worst economic crisis.

The immediate task at hand is to focus on securing a 130 billion euro aid package agreed to by euro-zone leaders at a summit last month. Acceptance of the bailout had been thrown into doubt after the outgoing Prime Minister, George Papandreou, said he would put it up to a public referendum. With elections due in February, the new government has approximately 100 days to implement painful re-forms that will ram home the message that even in its near-bankrupt state the country is intent on remaining in the eurozone.

IIP slumps to 1.9% in September

As per the latest data released by ICRA, the Index of Industrial Production (IIP) slumped to 1.9 per cent in September, relative to the 6.1% growth recorded in September 2010, marking the slowest pace of IIP growth in the last two years. The General Index for September has been recorded at 163.2, which is just 1.9 percentage point higher than the figure observed during the similar period last year.

In terms of sectors, mining reported a sharp de-cline, dropping 5.6 per cent after posting growth of 4.3 per cent a year ago. Manufacturing grew by 2.1 per cent, while electricity recorded encouraging figures of 9 per cent from a year ago. In terms of use-based classification, capital goods production disappointed as it fell by a whopping 6.8 per cent.

The growth in the consumer non-durables segment also declined by 1.3 per cent. Moreover, growth in consumer durables halved to 8.7 percent from 14.2 per cent a year ago. Consumer goods output also grew by a slower 3.5 per cent from 9.7 a year ago.

The cumulative growth for the six months ending September 2011-12 is also significantly low, as a growth of only 5.0% has been recorded over the cor-responding period of the previous year, as against 8.2 per cent in the same period last year. A slowing economy is squeezing center’s finances and ques-tions are being raised over the government’s ability to restrict the fiscal deficit for the fiscal ending in March 2012 at the budgeted level of 4.6% of gross domestic product.

Rupee surpasses 52 against dollar

On Tuesday, November 22nd, Indian rupee wit-nessed an all-time low of 52.73 intraday against the US dollar on account of a persistent demand for the American currency from banks and importers. Later in the day, it settled at 52.36/37.

The domestic currency had tumbled by 81 paise to close at a nearly 33-month low of Rs 52.15/16 per dollar on the previous day in the backdrop of an eight-session losing streak in the stock market and a deepening euro-debt crisis.

The US dollar has been surging against major cur-rencies as investors shun higher yielding risky as-sets over fears that the ongoing European debt cri-sis may spill over into the global economy.

The Indian currency is also hit by broad selloff in risky assets as global investors shun emerging mar-ket equities and currencies amid mounting fears that European leaders won’t be able to effectively tackle the Eurozone debt crisis

In addition to this, the declining local shares also failed to provide any support to the do-mestic currency.

The falling rupee can have catastrophic effects on the already declining Indian industries, as it would make imports more expensive. Oil imports will take a hit, thereby exert-ing more pressure on the deficit estimates of the government.

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© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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MARKET CAP (IN RS. CR)BSE Mkt. Cap 55,81,144Index Full Mkt. Cap 26,43,222Index Free Float Mkt. Cap 12,99,442

CURRENCY RATESINR / 1 USD 52.25INR / 1 Euro 69.82INR / 100 Jap. YEN 67.75INR / 1 Pound Sterling 81.23

POLICY RATESBank Rate 6%Repo rate 8.50%Reverse Repo rate 7.50%

Market Snapshotwww.iims-niveshak.com

RESERVE RATIOSCRR 6%SLR 24%

LENDING / DEPOSIT RATESBase rate 10%-10.75%Savings Bank rate 4.00%Deposit rate 8.5% - 9.25%

Source: www.bseindia.com www.nseindia.com

Source: www.bseindia.com

Source: www.bseindia.com 29th October to 24th Novemberber 2011

Data as on 24th November 2011

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BSEIndex Open Close % changeSensex 17,805 15,858 -10.93%

MIDCAP 6,275 5,591 -10.89%Smallcap 6,960 5,989 -13.95%AUTO 9,571 8,187 -14.46%BANKEX 11,372 9,743 -14.33%CD 6,633 5,745 -13.39%CG 11,036 9,289 -15.83%FMCG 4,153 3,928 -5.41%Healthcare 6,171 5,953 -3.53%IT 5,830 5,517 -5.37%METAL 12,143 10,040 -17.32%OIL&GAS 9,179 8,030 -12.52%POWER 2,217 1,887 -14.88%PSU 7,616 6,652 -12.66%REALTY 1,923 1,558 -18.98%TECk 3,522 3,340 -5.17%


Market Snapshot

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IntroductionThe financial downturn of 2007-08 highlighted the limits of traditional risk management systems. Traditional risk measurement tools, such as val-ue-at-risk and stress testing failed to grasp risk patterns promptly. Moreover they lagged behind in regard to recognizing signals of future crises. Based on historical data, these traditional back-ward looking tools respond slowly to change, preventing financial institutions from reacting in a timely manner and from taking the necessary actions to minimize risk exposure.

To overcome such limitations, a team of two quantitative risk analysts in the Risk Integra-tion & Counterparty Risk unit at Banco Popolare

Group- Nicola Andreis and Paolo Zamboni, has sketched a new framework for monitoring and managing risks based on an Early Warning Sys-tem (EWS) that supports and supplements the traditional methods like VaR and stress testing. They have described EWS as a set of economic and financial variables that are able to foresee unexpected losses that have not yet been de-tected by the traditional risk management sys-tems. The process consists of monitoring a set of macroeconomic and financial indicators that are able to foresee the dynamics of risk. When specific thresholds are exceeded by these indica-tors, scenarios are defined and applied in order to evaluate risks.

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A New Framework for Proactive Monitoring &

Management of Risks

EWS as a set of economic and financial variables are able to foresee unexpected losses that have not yet been detected by the traditional risk management systems


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EWS can be thoroughly understood with an ex-ample of Gold Backed Lending Business by NB-FCs/Banks in India. In this business, NBFCs/Banks lend to retail customers against pledging of gold. They face a major risk due to change in value of gold as high competition forces them to lend more against per unit of gold. This type of assessment provides the impetus for preven-tive actions which should give a firm more time to obtain sufficient capital and liquid resources, limiting the potential negative effects of any fu-ture crisis.

EWS An EWS should not replace the traditional sys-tems used by the risk management department of financial institutions, but should form a part of an integrated framework that includes several steps from monitoring of macroeconomic and fi-nancial variables to the definition of actions for mitigation purposes.

Development of EWS The first step consists of defining the phenom-enon to be monitored. Here, for the Gold Backed Lending example, the phenomenon is the “Pe-riod of turbulence for the Gold Backed Lending Industry, after the beginning of a crisis”. The fo-cus of this phenomenon is on the financial crisis associated with lending backed by gold. The tur-bulence can also occur in a general upward cycle of the economy.

The second step in EWS development aims to identify macroeconomic and financial indica-

tors that are potentially able to anticipate the stated phenomenon. Potential Indicators for gold backed lending can be the current gold price, its volatility, performance of equity market, crude oil price, interest rate, exchange rate, inflation, probability of default and loss (given default). Using econometric models of regression, inten-sity of each variable on the occurrence of this phenomenon should be identified. A map is then plotted between probability of default due to each indicator and occurrence of threshold alert by that indicator. For example, if probability of default due to indicator “Inflation” is 0.5 and oc-currence of this event has the probability of 0.4, a map can be plotted. This map is required for simulation and gauging the risk due to threshold alert of each indicator.

The last step in the development of EWS is the setting of alert thresholds, which should be mon-itored every day. When the early warning indi-cator exceeds threshold values, there is a high probability that a crisis or future stress situa-tion is approaching, and relevant management actions and interventions can be taken. The limi-tation of using threshold values is connected to the unavailability of historical data for predicting financial crises. For Gold Backed Lending, thresh-old alert limit is ` 25000 for gold price. So, if this value falls below the limit (day 6, as shown in Fig. 1), threshold alert will get activated. Now, the Risk Management Team should perform Sce-nario Analysis to evaluate potential risk by varia-tion of the indicator. After the potential risk is

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calculated, proactive risk management measures can be taken.

The method of signals consists of drawing a tem-poral graph of the crisis periods on the basis of recognized indications. This allows a financial institution to identify an indicator and to fix a threshold, beyond which it is assumed that the indicator signals a state of crisis.

Risk AssessmentThe assessment of the effects on lending is very similar to the stress testing analysis used to quantify the impact of certain extreme but plau-sible scenarios and to measure the ability of a bank to cope with such risks. A way to quantify the impact of a scenario on an intermediary’s risks is via simulation. Under this approach, after having defined the connection between financial and economic variables with risk exposure, a large number of scenarios are generated in order to get a distribution of potential loss.

Proactive Risk ManagementProactive management of potential risks is un-dertaken according to the possible development of the crisis and intensity of an indicator. The use of the proposed EWS will particularly impact the following stages of the day-to-day risk man-agement: evaluation of risk exposure and daily reporting, active management of risk, and con-tingency plans.

For example, the emergence of an alert in NBFC/Banks arising from an EWS, although not yet real, could induce: (1) the finance department to se-lect and define the features of sources of funding due to change in interest rate and (2) the cred-it department to require preventive actions to amend the guidelines for lending policies due to threshold alerts generated by an indicator, such as price of gold.

As a proactive measure, Banks/NBFC can take fol-lowing actions depending upon the intensity of

risks. It takes advantage of the ability of the top management to overcome crisis situations.

1.ALM and hedging actions related to Gold.

2.Ad hoc financing and detailed reporting of loan outstanding.

3.Business contingency plan.

4.Capital contingency plan.

This model can be applied across various indus-tries, especially financial institutions. The expla-nation of Gold backed Lending using EWS model will help replicate the same model across other industry domains.

Parting Thoughts by Nicola Andreis and Paolo ZamboniThe EWS can become the “activating” source for specific and more frequent stress tests that fa-cilitate a better understanding of the potential effects of the growing risk dynamics. This can have a direct impact on management reporting, government operating risk, strategic activities (e.g., asset and liability management), capital management processes and the management of different states of a crisis. Given the pioneering nature of early warning development and the lack of best practices in this area, financial insti-tutions considering EWS implementation should lean towards a gradual rollout. Careful and criti-cal testing, experimental application, internal discussions and sharing are important compo-nents of any successful EWS deployment.

The development of Early Warning Systems will be fostered only by firms committed to (1) strong and courageous investment in mental and pro-fessional energy and resources; (2) an open-ness to new areas of research and testing; and (3) the activation of intense, more direct chan-nels of dialogue between research, business and controls units inside the bank.

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Figure 1 : Threshold Alert due to Indicator


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by United States, which is one of the major emitter of carbon in the world.

Carbon Credits- CERs and carbon markets

Kyoto Protocol plans to deal with the problem of carbon emissions by commercializing them and creating a whole new carbon asset market for the investors. Kyoto Protocol has provisions for three schemes through which trading can be done in car-bon assets. These are:

1.Emissions Trading Scheme

2.Clean Development Scheme

3.Joint Implementation scheme

The major chunk of carbon credit market comes from Clean Development Scheme (CDS). With 84% share in volume and 91% share in value in primary market approximately, Clean Development Mecha-nism provides developed countries an opportunity to meet their Kyoto commitments by buying car-bon credits, known as Certified Emission Reduc-tions (CERs) from other nations. Clean Development Mechanism is beneficial to both developing and de-veloped countries. For developed countries, it is a cost effective way to meet their Kyoto commitments as development of sustainable projects is relatively costlier prospect than buying carbon credits from developing countries. On the other hand, develop-ing countries gain in terms of foreign investment they attract from carbon credit trading.

Carbon Markets: Status Quo

As US has not ratified the Kyoto Protocol, the Euro-pean Union has emerged as a major buyer of car-

Cover Story

TeaM NIveshak

Chandan Gupta & Harshali Damle

Introduction

“If Kyoto dies in Durban, it will be a death knell for the climate fight”, Tony Blair. With the 17th Confer-ence of the Parties scheduled to be held from 28th November, 2011 to 9th December, 2011 at Durban, Kyoto Protocol has emerged as the most debatable topic in the political spheres.

With the expiration of the first round of Kyoto Com-mitments at the end of 2012, the rift between the developed and developing countries is on the rise. Amidst all this, Durban has become the center-stage of international negotiations, which is expected to provide an effective platform to reach a decision which would lay a strong foundation for the holistic and sustainable development of the planet.

Kyoto Protocol- Background

Kyoto Protocol is an international agreement of United Nations Framework Convention on Climate Change (UNFCC) which deals with the issue of carbon emissions, signed by 193 parties, which includes 192 nations and 1 regional economic in-tegration organization. Kyoto Protocol, through its legal framework, binds 37 of the most developed countries and 15 states of the European Union to reduce their carbon emissions as per certain stan-dards below the 1990 level within a stipulated time period of 2008-2012. For all the parties put together, the protocol sets a carbon emission target of 5.2% below that of the 1990 level. One of the major de-terrents in the implementation of Kyoto protocol as the only international legal legislation with respect to carbon emissions is that it has not been ratified

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Emission Trading System will continue during 2013-2020 and the demand for carbon credits will continue to increase in at least the countries which have re-gional commitments and systems for carbon emis-sions.

The struggle for ‘Carbon’ Power

Carbon credits, because of the Kyoto Protocol legal obligations, have proved to be a blessing in disguise for developing countries. With about 58.04% of con-tribution in carbon credit market, China has emerged as a leader in supplying carbon credits. India, which is a home to two commodity exchanges which trade in carbon credits, follows China at rank second in carbon trading. According to a CRISIL research study, the number of carbon credits issued for emission re-duction projects in India is set to reach 246 million by December 2012 from 72 million in November 2009. The figures clearly demonstrates the kind of presence emerging economies have in carbon credit market.

With the first round of Kyoto protocol coming to an end in 2012, deliberations for second round of com-mitments has already begun. However countries like Russia, Japan and United States along with some other developed countries are not ready to sign the second round of commitments unless the develop-ing countries like China also accept the obligations for reduction in emissions. As per the US Energy Ad-ministration Report 2009, China has surpassed United States in carbon emissions and India has emerged as third largest carbon emitter surpassing Russia. How-ever, at the same time if we look at the per capita emissions, US is still the leader with 18 tonnes per person, while on an average a Chinese emits only 6 tonnes and an Indian only 1.38 tonnes.

One of the reasons for this conflict is that the Unit-ed States is not very comfortable with the growing

bon credits. Thus, the Carbon Credit Market is heavily dependent on the economic conditions of European Union and that is the major reason why Euro Debt cri-sis has severely impacted the carbon credit market.

The crisis has adversely affected the demand of car-bon credits, which mainly depends upon the indus-trial activity in the buyer country and the industry in Europe at present is at an all-time low. Figure 1 shows fluctuations in Industrial Output in European Union during September 2010-September 2011. Industrial output in the region has come down by 1.3% in Sep-tember 2011 as compared to August 2011. Industry in Europe, because of these fluctuations and ill effects of exposure to Greece debt, has reduced its demand for carbon credits, which has led to approximately 41% fall in value of carbon credits in 2010. Also, the record issuance of CERs in the current year has led to oversupply in the carbon credit market which in turn has negatively affected the price of CERs. As per Re-uters, ”A record 254 million CERs have been awarded this year so far, well above the 132 million awarded in the whole of 2010 and 123 million in 2009”. Fig-ure 2 shows the price and volume of CERs traded at European Energy Exchange during 2009-2012. The fluctuations in price and volume traded clearly dem-onstrate the volatility in carbon market. The price of U.N. carbon credits hit a new record low of 7.13 euros ($9.77) per tonne in November 2011, before recover-ing slightly to 7.28 euros and as predicted by analysts at UBS EU carbon prices could crash to as low as 3 euros as European Union grapples with debt crisis and oversupply in the market.

However in spite of falling prices, the numbers of firms applying for registration under Clean Develop-ment Scheme in emerging economies like India and China is on an increase. This is because of the ex-pectations that even in absence of Kyoto Protocol, EU

Figure 1 : Production indices of EU 27 for total industry excluding construction seasonally adjusted


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thus any chance of adoption of second round of Kyoto Protocol by the member nations at present seems to be very low.

China’s Chief Climate Change official Xie Zhenhua, who played a pivotal role in Copenhagen round discussions, made a call to emerging economies to bring forward their own plans to demonstrate their willingness to curb the growth of carbon emissions. This action has fueled speculations that the develop-ing countries may come out with novel frameworks which might be significantly different from the ones suggested by the developed countries. There may be some emission standards under the same but it is highly unlikely that the framework will put develop-ing nations under any obligation to cut the carbon emission rates. The failure of the nations to come to any agreement in Durban, apart from other conse-quences, will also have an adverse impact on carbon trading as the prices in carbon market are mainly driven by Kyoto Protocol, and in absence of any such legal binding the future of carbon trading looks bleak.

Conclusion

There is an increasing need to recognize that the core agenda of the COP is a conscious effort to reduce carbon emissions as a part of the shared global vi-sion of sustainable environment. There is a need to rise above the self-seeking political interests and look at the broader picture of sustainable development of the planet as a whole. The world expects the 17th COP to lay a strong foundation for the same.

global footprint of China. Also considering the current status of its economy, the United States is not will-ing to come under any obligation to cut the carbon emissions till the same obligations are also imposed on China, which has posed a serious challenge to its economy.

The European Union, on the other hand, saves a lot of money by purchasing carbon credits from devel-oping countries because of low developmental cost in these countries. If the developing countries come under obligation, the Carbon Credits available for sale will be less in number and that too at a higher price. Thus, European Union does not want the developing countries to be under any such obligations.

All this suggests how defining obligations for develop-ing nations has become a contentious issue. Howev-er, some standards should surely be set for emerging economies like India, China & Brazil and we should not wait for them to reach an alarming stage where many of today’s developed countries are in terms of global warming because of unsustainable practices of their industries.

17th COP Durban, Nov 2011

With the failure of the countries to reach any con-sensus at previous Conference of Parties (COPs) at Cancun and Copenhagen and the current rift between developed and developing countries, it is quite pos-sible that this rupture may once again come in the way of a global and sustainable solution to the prob-lem of carbon emissions at 17th COP, Durban. And

Figure 2 : Price and volume of CERs traded at European Energy Exchange during 2009-2012

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Mr. Sanjib Bez-baroa, Head,

Corporate Envi-ronment Health

and Safety, ITC in a candid discus-sion with Team Niveshak talks

about the future of Kyoto protocol and how ITCs’ ap-proach to carbon emissions is not

restricted only to carbon credits but stretches even to the National Ac-tion Plan on Cli-mate Change.

Niveshak: From greeN hotels to WiNd projects, itc has doNe it all. What are the greeN aveNues that itc is lookiNg For iN the Near Future?

Mr. BezBaroa: Solar energy is something which we are working on, and we ex-pect it to be a significant contributor in our green investment portfolio for the years to come. The actual financial and technical aspects of the same are still under consideration.

Niveshak: does itc carry out a cost beNeFit aNalysis beFore makiNg a ‘greeN iNvestmeNt’? iF so, theN What is the cri-terioN that the compaNy coNsiders?

Mr. BezBaroa: Any new project to be un-dertaken is addressed on its potential financial, social and environmental im-pact. This forms the basic acceptance criteria. However, not always does the company make decisions based on Internal Rate of Return. The company also has to consider the long term goals, perspectives and the social im-pact of the decisions on a case to case basis, depending upon on its strategic importance.

Niveshak: hoW is itc vieWiNg reNeW-able eNergy certiFicates (rec) - the NeW iNitiative by the iNdiaN goverNmeNt? are there aNy NeW projects uNder the rec iNitiative?

Mr. BezBaroa: We are actively seeing how it will work for ITC. Right now all we can say is that the same is under the as-sessment of the Carbon Committee for future plan of action.

Niveshak: do you thiNk that carboN credits are really serviNg the purpose oF eNviroNmeNtal protectioN For Which they Were iNitiated? or has their scope beiNg restricted to that oF a FiNaNcial iNstru-meNt?

Mr. BezBaroa: The energy related projects which involve renewables are definitely serving the purpose of environmental protection. However there are certain Clean Development Mechanism projects, mainly related to ChloroFlouro Carbons (CFCs), which have been misused by people, thereby portraying a negative image of the overall system. However, in my view, barring few such projects, it has contributed positively to the cause

Mr. Sanjib Bezbaroa heaD, CorporaTe eNvIroNMeNT healTh aND safeTy, ITC lTD.

Mr. Sanjib Bezbaroa heads the Corporate Environment Health & Safety department at ITC Ltd. and leads the sustainability initiatives on the product and services front, including supply chain, be-sides being responsible for Sustainability Reporting of the organization. He is an Electrical Engineer with over 20 years’ experience in power plant engineering and commissioning, covering both genera-tion as well as transmission & distribution systems. He did his PGDM in Environment Manage-ment from Imperial College, London. He is also a Chartered Engineer and a Bureau of Energy Efficiency Certified Energy Auditor. Mr Bezbaroa has been working with ITC from last 11 years and is currently positioned at their Kolkata office. He has earlier worked with TCS as well.

Branding might be one of the major reasons, but if a company uses sustainability only as brand building exercise, it doesn’t cut much ice for very long.


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for assessment of their sustainability initiatives. Branding might be one of the major reasons, but if a company uses sustainability only as brand building exercise, it doesn’t cut much ice for very long.

Niveshak: are there aNy shortFalls iN regulatioNs relatiNg to sustaiNability? What are your commeNts oN iNcreasiNg legislatioNs to make sustaiNability more viable? do you have aNy suggestioNs iN this regard?

Mr. BezBaroa: I do not think there are any major short-falls in regulations related to sustainability. Howev-er, there are issues in implementation of the same. There is a lack of incentive as well as low recogni-tion for even the genuine sustainability initiatives. Usually, the financial markets also don’t pick up the ‘sustainability signals’ as the projects involved are long-term in nature, and benefits accrued are also recognised over a long period of time. Hence, I be-lieve there is a need to ensure proper recognition of efforts in this regard.

Also, as a suggestion, there is a need for a proper grading system relevant to the sustainability in the Indian context which should be based on perfor-mance parameters defined by the government.

Niveshak: What Will be your suggestioNs For the ‘Fu-ture maNagers’ to eNsure that they aligN themselves With the idea oF sustaiNability?

Mr. BezBaroa: The suggestion sounds simple but is difficult to implement. There is a need to think be-yond financial performance. There are many busi-ness elements which are not measurable in mon-etary terms. Many environment depletion costs are not considered in financials. We need to be open to such aspects. We need to work in line with the na-tional objectives and priorities. This attitude is lack-ing in the current educational system as well as the organisations. There is a need to make a conscious effort in this regard. Together, we need to find a way out for a sustainable future.

of environment protection.

Niveshak: hoW do you see the Future oF carboN cred-its post 2012, that is, aFter the deadliNe oF the First rouNd oF kyoto protocol?

Mr. BezBaroa: That is a difficult question to answer. Fundamentally, we believe and accept the fact that carbon will have a price, whether in the form of taxation or market based opportunities. We prepare ourselves to grab maximum out of these opportuni-ties, as and when they appear. Not to forget that our approach to energy is not just restricted to Clean Development Mechanism, it is more fundamen-tally aligned with National Action Plan on Climate Change. We need to reduce our specific energy con-sumption. Our next goal is to increase our portfolio of renewables. We try to ensure maximum environ-mental good and if the same is realisable in form of tangible monetary benefits, we try to make use of it. But our strategy is incidental to the whole plan of sustainability.

Niveshak: there is a geNeral perceptioN that sustaiN-ability For corporates is merely a ‘braNd buildiNg’ ex-ercise. What are your vieWs oN the same?

Mr. BezBaroa: When we see Sustainability from the business perspective, it has 5 value propositions:

One is Top-line growth, when you use it to ensure higher sales. Second is Bottom-line performance which includes improving efficiency in use of re-sources, Energy & material conservation, etc. Third part will be the Branding opportunity, as it helps improve the brand visibility. Say for example what we at ITC have done in our hotels business. The fourth aspect is it helps in managing risk. Sustain-ability is a process of getting and being receptive to the information from all your stakeholders and that too from all dimensions, and working on that information, which helps in risk management. The fifth will be that it contributes towards Employees motivation, as it is comparatively easier to identify with an organisation which is conscious towards the environment.

Every business must consider all these 5 aspects

heaD, CorporaTe eNvIroNMeNT healTh aND safeTy, ITC lTD.

There is a lack of incentive as well as low recognition for even the genuine sustainability initiatives.

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Figure 1: Mortgage to GDP ratio 2007 (Source: European Mortgage Federation & Asian Development Bank)

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to urban areas.Also, India has the following features, which fur-ther signify the need of ease of access to housing finance for the masses.1. Rapid population growth2. Increasing disposable income 3. Very high population density4. Lack of supporting financial products5. Low competition6. Regulation & Exchange RiskHowever there is a huge demand-supply discon-nect (as shown in Fig 1). We see that though a huge demand for housing finance exists in India, the mortgage/GDP ratio, which is a key indicator of Housing finance penetration, is one of the lowest in the world. This naturally is a great opportunity waiting to be tapped.Government Initiatives:Housing finance problems as outlined above began to surface as early as in the 1970s (See Fig 2). The Indian Government has taken various initiatives over time to address these problems.Competition in Housing Finance Sector in IndiaThe following are providers of housing finance in India, in one form or another:1. Commercial Banks: They are the largest mobiliser of savings and also in respect of coverage. Their role has traditionally been limited to providing the working capital needs of business, industry and

A lot has been written about India’s growing strength as an emerging nation. The Indian econ-omy has been growing and some of the factors which highlight the same are:1. GDP growth rate averaging over 8% from 2003-20102. Rapid urbanization, rising middle class3. Increasing political stability with re-election of last government4. Forex reserves over $250bn5. Service sector contributing 60% of GDPImportance of Housing in Indian Scenario1. 2nd Largest employment generated in this sec-tor (after agriculture)2. Fosters development of ancillary industries via strong vertical linkages (forward & backward)3. US $110 bn market size The problem The major problem plaguing the Indian housing industry is the consistent demand-supply mis-match. The shortage was 23.3 million units in 1981, 22.90million in 1991, ~20 mn in 2001 and so on. Although a clear downward trend is visible, the fact is that the rate of closure of this gap has been decreasing over time. The recent figures in this respect are worse. Moreover the growth rate in urban areas is clearly above that in rural areas signifying the urban-ization phase India is currently undergoing with more and more people migrating from the rural

FINANCE MARKET


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commerce and hence, they have not been very active participants in the housing finance mar-ket. Another reason for the same is that they are funded by short-term resources which can-not be profitably employed in long term lending.2. Cooperative Banks: They deploy funds from a common pool of resources to provide for the various needs of its members. In the Indian scenario, a lot of reluctance has been noticed by these cooperative banks to provide loans for housing finance. One of the major reasons for this is the high risk and illiquidity in giving housing loans from common corpus.3. Regional Rural Banks: Again, they have not been very active in housing finance sector be-cause of the large amounts and low creditwor-thiness involved leading to illiquidity and losses.4. Agricultural and Rural Development Banks: The major function of these banks is not the provision of housing finance. Consequently, there is low threat from these too.5. Housing Finance Companies: These are com-panies with principal objective of lending for housing finance. However, there are only about 20 companies accounting for greater than 90% of total housing loans provided.6. Cooperative housing finance societies: These are specialized institutions established and sub-sidized by NHB to cater to the housing needs of the masses. These institutions do not have ad-equate technical expertise to be able to design right product for the right target. However, state

subsidy is major factor in their favour.Thus, the housing finance market competition in India can be summarized as follows:

Current Housing Credit Products In general, most of the banks provide slightly modified schemes of the same basic version of housing finance products to all kinds of custom-ers. Herein the basic version of Standardized fixed rate mortgage is described.

Figure 2: Evolution of Housing Finance

Industry (Government Intervention)

Organisations providing ThreatCommercial Banks Medium

Cooperative Banks Low

Regional Rural Banks Low

Agricultural and Rural Developmant Banks Low

Housing Finance Companies HIgh

Cooperative housing finance societies HIgh

Standard fixed rate mortgageFixed ROI (consistently falling over time since 20 yrs)

Maximum period 25 years

Repayment limited to retirement age (60/65 yrs)

Equated Monthly Installment Method/ Graduated Installments

Interest Tax passed on to the borrower, Process-ing Fee (0.5% - 1%) and Administration Fee (1%)

Max. Loan to value ratio : 80% at origination

Avg. Loan to value ratio : 70% at origination

Average age : 37 yearsTable 1: Standard fixed rate mortgage

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We can see from table 2, as to how the basic structure described in table 1 is used in Indian Context by various housing finance institutions. Also, there is not much difference between the terms offered to salaried (table 2) and self-employed people (table 3). While the basic re-quirements, by and large remained the same, self-employed people were asked for greater se-curity requirements when compared to salaried individuals.Refinancing options There are several sources from where these housing finance institutions fund their products. Apart from Internal Funding / Ploughing back of profits which is basically interest income and

principal repayments redeployed in these busi-nesses that are used for extending further credit to its clients, securitization is also used. Secu-ritization is a very common process to refinance the loans, but it basically means transfer or sale of loan assets and hence somewhat different from refinancing in the traditional sense.Some of the other options of funding are as fol-lows:1. Bank Deposits (including interbank participa-tion certificates)2. Insurance Premiums3. Contribution from members

4. Central & State Government funding (includ-

Table 2: Terms for Salaried People

Terms for Salaried PeopleLender Interest Rate Max loan amount Processing fee Tenure Pre Closure Details

(in %) (% of property value)

(% of loan amount)

(Years) Allowed after (Months)

Charges (% of outstanding amt)

HDFC 9.25% - 10.25% 80% 0.5% - Rs 11300 20 36 2% - NIL

Citibank 9.25% - 9.75% 75% - 80% 0.50% 25 6 2%

Axis Bank 9.25% - 10% 80% 0.50% - 1% 25 1 NIL

Kotak Mahindra Bank

10.75% 75% - 80% 0.50% 20 6 2%

Reliance Con-sumer Finance

10% - 10.5% 80% 0.75% 20 6 2% - 5%

Deutsche Bank 9.75% 75% - 80% 0.50% 20 6 2%

Standard Char-tered Bank

9.75% 75% - 80% 0.5% - 1.5% 20 6 2%

ING Vysya 9.75% - 10% 80% Rs 5000 - 0.5% 20 6 2%

India Bulls 9.25% 80% 0.50% 20 6 2%

Deutsche Post Bank

9.25% - 10% 80% Rs 6000 - 8000 20 1 2%

Tata Capital 9.25% - 10% 80% 0.5% - 0.75% 20 6 2%

Table 3: Terms for Self Employed People

Terms for Self Employed PeopleLender Interest Rate Max loan amount Processing fee Tenure Pre Closure Details

(in %) (% of property value)

(% of loan amount)

(Years) Allowed after (Months)

Charges (% of outstanding amt)

HDFC 9.25% - 10.25% 80% 0.5% - Rs 11300 20 36 2% - NIL

Citibank 10.00% 75% 0.50% 25 6 2%

Axis Bank 9.25% - 10% 80% 0.50% - 1% 25 1 NIL

Kotak Mahindra Bank

10.75% 75% - 80% 0.50% 20 6 2%

Reliance Con-sumer Finance

10% - 10.5% 80% 0.75% 20 6 2% - 5%

Deutsche Bank 9.75% 75% - 80% 0.50% 20 6 2%

Standard Char-tered Bank

9.75% 75% - 80% 0.5% - 1.5% 20 6 2%

ING Vysya 9.75% - 10% 80% Rs 5000 - 0.5% 20 6 2%

India Bulls 9.25% 80% 0.50% 20 6 2%

Deutsche Post Bank

9.25% - 10.25% 80% Rs 6000 - 10000 20 1 2%

Tata Capital 9.25% - 10.25% 80% 0.5% - 0.75% 20 6 2%

Bajaj 10.50% 80% 1% 20 6 2%


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ing NHB refinancing) and International fundingArranging in increasing order of duration (from left to right – bank deposits being the shortest and insurance premium, the longest) for which these refinancing options are available gives the above figure

Conclusion:From the above analysis, an Industry wide Analy-sis Map of the Indian Housing Finance Market fol-lows:SWOT

Strengths 1. 2nd Largest employment generated in this sec-tor (after agriculture)2. Fosters development of ancillary industries via strong vertical linkages (forward & backward)3. US $110 bn market size Weaknesses 1. Infrastructure Issues

2. Government’s Participation & Regulation3. Fragmented industry with power concentra-tion in hands of few playersOpportunities

1. Consistent demand-supply mismatch2. Urbanization phase of India3. Low Mortgage to GDP ratio4. Government Support5. Refinancing SupportThreats

1. Threat from Housing Finance Companies and Cooperative Housing Finance Societies2. Non-availability of wide range of long term refinancing options3. Capability Constraints4. Internal Policy ChallengesClearly, we can understand that Indian housing finance market is in its nascent stage of devel-opment. Since this is a newly formed market for a hitherto unaddressed product, there will be a huge first mover advantage. The drawbacks stem only from the event of unfavorable policy changes or uneven competition from State. Both the drawbacks are relatively unlikely to occur judging on the basis of Government’s current policy trends.Hence, we can conclude that the Housing Fi-nance market in India is very attractive and forms a good case for investment.

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The United States of America is contemplating to take a tough stance against the currency valua-tion issues in China by passing the China Yuan Bill in order to press Beijing to revalue its currency. The bill has been approved by the Senate and is currently placed in the House of Representatives where its fate would be decided. This might culmi-nate into a trade war between the two economic superpowers amidst the on-going global economic turmoil spanning from America’s tepid economy to Europe’s sovereign debt crisis.

Chinese economy is driven by exports to all the major economies of the world. The availability of cheap labour and technology has made it the ex-port hub for many companies. However, it is wide-ly believed that to maintain its export competitive-ness China has kept its currency artificially low.

Sen. Charles Schumer, a Democrat from New York and one of the co-sponsors of the bill, believes that the artificially undervalued Renminbi is the prime reason for the growing US trade deficit. He argues that this is hurting American manufactur-ers and slowing the U.S. economic recovery. With another recession looming large, there is growing concern that the currency manipulation by China is hurting exporters from US as they have to com-pete with cheaply priced goods and services.

The Chinese have however, responded to increas-ing global pressure by letting their currency ap-preciate at a steady rate. However, at the slight-est hint of uncertainty in the global environment, they revert back to tight regulation of the currency as can be seen from USD/CNY historical exchange rate. Both economic and political factors influence the way the Renminbi is managed since the Chi-

nese ended formal peg against the US dollar in July 2005. In spite of slow and steady appreciation of approximately 30% against the US dollar, as long as the appreciation is kept slow, Chinese export-ers are likely to enjoy a competitive advantage on price.

Possible action

If America does impose trade sanctions on Chinese exports, China could use various weapons at their disposal in retaliation. The Chinese who are the major buyers of American bonds could stop buying American government bonds or worst they could sell American government bonds. If the situation boils down to that then interest rates in America would surely go through the roof and the value of the US Dollar would go for a free-fall. But such a scenario would not be helpful for anybody and might lead to a trade war similar to the one in

TeaM NIveshak

Rakesh Agarwal

Figure 1: Log real value of CNY (blue, left axis), 2005=0; up is appreciation of the Chinese currency, and monthly trade balance, in billion USD (red, right axis), and trailing 12 month moving average Chinese trade balance (purple)


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the 1930s that led to the Great Depression. How-ever, America does not seem to have the gumption to label China a currency manipulator because of the growing importance of the later in the global scenario. China is the largest holder of US dollars as foreign reserves and thus wields considerable influence on US policy decisions.

Alternative view

On the other side of the coin, it can also be con-tended that the Renminbi is over-valued if that credit problem in the Chinese system is taken into consideration. China’s credit is rising at an average rate of 30% which is approximately three times faster than its economic growth. Thus if we take into account the amount of Renminbi that would have to be floated by the Chinese bank regula-tors to re-float the system, we would find the cur-rency to be over-valued. This is partially due to the fact that the real estate market is perceived to be the only safe investment opportunity in China driving up the real estate prices and hence, credit

off-takes. In the likely event of a bubble burst, bad loans will increase with more intensity than before having dire implications on the Chinese financial system.

Future Outlook

The consensus is that neither the US nor China would take any action to significantly affect the status quo. On part of the US, the debate on the

China Yuan Bill is largely symbolic to keep the vot-er (read manufacturer and labour unions) happy ahead of the next elections. On the other side, the Chinese markets remain fundamentally strong due to its growing middle class, which continues to drive growth – especially for consumer prod-ucts. In addition, the Chinese equities and balance sheets are incomparably stronger than their West-ern counterparts that gives investors considerable confidence and margin of safety. These factors combine to give China the platform to aim for ex-pansion at a time the when West must continue to look at its own monetary policies to avoid an-other global crisis and simulate growth. This would result in China and Asian markets grabbing the major share of global economic growth for years to come.

Benefits of free float for China

China as an ascending economic power is flex-ing its muscle to demonstrate its growing might. However, since it shares a symbiotic relationship with the US, there is need for both sides to reach to a compromise. All would not be lost for China in the event it lets the Renminbi be valued more transparently. In case China eases control over its currency valuation, it stands to gain the ad-vantages of Renminbi being a global currency. An international currency would benefit the country by lowering trade settlement costs and increasing financial influence commensurate with its grow-ing economic and political stature on the interna-tional stage. Also a revaluation would help China in slowing down its overheating economy. On the down side, China, used to a stable currency for decades, would face increased risks by its decision to internationalise the Renminbi. Such risks would include higher vulnerability to external shocks be-cause funds can flow more freely in and out of the country. However, the benefits of integration with the global economy far outweigh the risks.

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High Frequency Trading refers to the use of su-per-computers to trade in stocks with minimal human intervention. Generally used by high volume traders, HFT gives the traders unpar-alleled advantage over the general public. Crit-ics are increasingly voic-ing their concerns on the use of HFT and demand-ing regulatory control to protect the public.

anonymity and you begin to under-stand why High Frequency Trading is so popular among all trading desks.

Generally, trading algorithms are built on complex mathematics and statisti-cal modeling. They are designed by Quants (as Math PhDs are known in Wall Street lingo). The hedge funds, who own these algorithms, protect them with as much zeal as Google pro-tects its proprietary search algorithm or Coke protects its secret soft-drink ingredient. Most algorithms typically employ “flat” strategy, i.e. trading po-sitions are closed within the same day. Profit with one such milliseconds-long trade is sometimes only a few pennies, but it is the massive trade volume that drives the total daily profits, which are in several thousands of dollars.

Players & Strategies

In the US equity markets, some of the highest volume high-frequency traders include proprietary trading desks of firms like Goldman Sachs, Knight Capi-tal Group, Getco LLC & Citadel LLC.

There are 4 basic strategies employed by almost every HFT firm:

Market Making

Traditional market making involves placing limit orders to buy & sell in or-der to earn the bid-ask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market

It was in late 2000, when the NYSE decided to quote prices of stocks in decimals of a dollar, as op-posed to a fixed list of fractions. The event (called decimalization) sowed the seeds of what is today popularly known as High Frequency Trading or HFT. Stated simply, HFT is trading in stocks by computers, with minimal human assistance. Carried out by su-per computers of major investment banks & hedge funds, high frequency trades range in time from less than a second to a few hours. Today, it is estimated that majority (~60%) of all equity trading in NYSE is done by trading algorithms. Although pre-dominantly into equity, HFT firms have started moving into other asset classes, like derivatives, FX and fixed income instruments.

The advantage that computers offer in trading assets is speed of process-ing information and executing trades. Add to it other advantages like low cost, high execution consistency &

High FREQUENCY TRADING

DEMYSTIFIED

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Prashant Rishi

Asset classes traded by HFT Proprietary shops

Stocks 83%

Futures 67%

Options 58%

Bonds 36%

FX 26%


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makers provide additional liquidity to the market by being counterparty to incoming market orders, they get rebates from exchanges for quotes that lead to execution. So, if an HFT’s bid (buy order) of $15 for XYZ shares is matched, it might im-mediately post an offer (sell order) for the same price, hoping to capture two rebates while break-ing even on the spread. Building up such market making strategies typically involves precise mod-eling of the target market structure & trading vol-umes using stochastic control techniques.

Ticker Tape Trading

To appreciate ticker tape trading, it is essential to understand the concept of “co-location”. Co-loca-tion is a system wherein a stock exchange allows large hedge funds and i-banks to place their com-puters near its own data terminals, in exchange for rental income. Proximity to the stock exchange’s data centre ensures that any market movement (read the ticker tape) is detected by these com-puters before general public. Pre-designed algo-rithms can thus detect any trend in the prices, and carry out their own trades seconds before the general public even knows about the prices, and reacts to them. To realize the importance of a few seconds in computing terms, consider the case of Lotus Capital Management LP of New York. Earlier this year, it realized that a competitor was beat-ing it to a trade it had programmed by exactly 3 microseconds, day after day. The loss meant Lotus was forfeiting about $1,000 in daily revenue on that particular trading strategy. Subsequently, that trading strategy was discarded since firm did not have the infrastructure to speed up the execution by 3 microseconds.

Event Arbitrage

Event Arbitrage is very similar to Ticker Tape Trad-

ing, except that the item of interest here is the news feed. Most HFT traders employ a class of algorithms to deal with each possible kind of cor-porate event (including earnings reports, earnings outlook, mergers and acquisitions, and analyst rating changes), and convert news into positive or negative trading signals. An example would be a very simple algorithm that would read words like “profit”, “confidence”, “beats expectations”, “good quarter” from a Reuters news flash, and would start buying the stock before general public have a chance to even finish reading the news. The trick is to be the one who makes the move first: to be the one who has the fastest news feed, the fastest information extraction algorithms and the fastest execution.

Statistical Arbitrage

Statistical Arbitrage strategies aim to make money by exploiting statistical mispricing of securities, like deviations in interest rate parity in forex mar-kets. Carried out over prices of over hundreds of securities at a time, it is possible to detect such mispricing using extensive data mining & complex mathematical techniques. The arbitrage strategies hinge on the possibility that assets would obey their historical statistical relationships with each other in long run.

The Dark Side of HFT

There is another side of the story. High Frequency Trading is in the midst of a raging debate. Consider ticker tape trading as described above. A person who is privy to market prices before other players is called an insider trader, but if it is only a ques-tion of few seconds, the boundaries of law start to blur. Any firm with enough cash to buy high-tech infrastructure & pay rents to a stock exchange can enjoy the free lunch of being few seconds ahead

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of the market. HFT is, thus, accused by its critics to be a legal form of insider trading.

Now, consider market making. HFTs are in no ob-ligation to provide liquidity to the markets. They do so to serve their own profit purpose (bid-ask spreads and rebates from exchanges). However, during periods of high volatility, these market making algorithms stop immediately, leading to an almost instantaneous erosion of liquidity. A perfect example of this phenomenon was Dow Jones Flash Crash on May 6, 2010, when DJIA plunged 900 points (9%) in 5 minutes, only to re-cover within next 10 minutes. A July, 2011 report by the IOSCO concluded that “the usage of HFT technology was also clearly a contributing factor in the flash crash event of May 6, 2010.” Since then, many mutual funds have moved significant portions of their money out of US equity markets, and are considering other asset classes. They say that the US stock markets have been reduced to computerized gambling houses where algorithms devise microsecond-length trading strategies. All long-term valuation of business fundamentals seems to have lost its meaning.

And it’s not just equity. In February 2010, a trad-ing algorithm owned by Infinium Capital Manage-ment ran amok and caused worldwide surge in oil prices by USD 1. The company currently faces civil charges for causing a global mayhem.

Advocates of HFT (read hedge funds and invest-ment banks) are quick to dismiss this criticism. They point that they provide the much-needed liquidity to the market, and hence improve effi-ciency of the markets. While regulators are vying to bring High Frequency Trading into the ambit of rules, there is undoubtedly a powerful lobby op-posing this.

SEC recently passed a legislation banning the use of naked sponsored access, which allowed firms to trade directly on an exchange using a broker’s infrastructure without pre-trade risk controls. Sim-ilarly, IIROC, Canada’s financial regulator, has pro-posed new tariffs that would charge trading desks per message, rather than per executed trade. If these costs are passed down by trading venues to their members, it would have a marked impact on the execution fees paid by HFTs. What now re-mains to be seen is will these regulations prove effective in tightening the actions of HFT firms, or will the exodus of long-term investors from the US equity markets continue unabated.

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Sir, I recently read about The Regula-tion of Factor Bill (Assignment of Receiv-ables), 2011. It would be helpful if you could explain what factoring is.

Sure. Factoring is one of the oldest methods of financing by way of selling the accounts receivable of a firm. There are cer-tain financial institutions called factors which

provide this type of financing. The invoice approved by the buyer is sent to the factor. The factor in turn makes the payment to the company (seller).

What does the factor gain?

The invoice payment is done on a discount which usually ranges from 0.35 to 4 per cent of the value of the invoice. Also the entire amount is not paid by the factor. Usually it makes a payment of 75 to 80%

keeping the remaining amount as reserve. The reserve amount is paid back when the buyer actually pays the amount. Thus the factor earns commission for factor-ing.

Does this imply that through factor-ing, all the sales made by a company are like cash sales? What are the advantages of factoring to the company?

As the factor pays the amount of sales to the company, it is equivalent to having all cash sales. Also the risk of collection of re-ceivable and bad debts may be transferred

to the financial institution acting as the factor based on terms agreed upon. Other advantages of going for factoring is that it frees up large amounts of funds locked up as accounts receivables and this can be used to purchase more inventory and fund other short term projects that can accelerate growth. Factoring also re-lieves a company from the burden of maintaining re-ceivable accounts, conducting credit assessments for customers and handling collection of receivables. The working capital management of the company becomes

efficient and hence, reduces the cost which in turn improves the possibility of better profits.

This seems great. So the companies can transfer all its accounts receivables to the factor and be risk free right?

This is not the case always. Com-panies must take judicious decision when going for factoring mode of financing. If the debtor is credit worthy and has paid all the debts in time, the company will

lose money in terms of factoring fees. There must be a trade-off between the present value of the earn-ings a firm gains from sales and the cost of utilis-ing factoring as a means for financing. For example, businesses which result in slower repayment can be factored so that the company is not affected by cash deficit for other needs.

If factoring is utilised for sundry debtors alone, why financial institu-tions provide this type of financing?

Factoring can be used in place of bank loans for small and medium enter-prises. Though factoring costs are higher than bank rates, small companies which cannot obtain bank loans easily can re-

sort to this mode of financing. Also factoring finan-cial institutions look for the credit worthiness of the buyers and not the companies resorting to factoring. This proves to be an advantage for SMEs. Factoring is utilised by firms which cannot borrow money from other sources.

So what is the “Regulation of Fac-tor Bill” about?

The bill provides regulations for factoring business by RBI. All financial institutions providing factoring services should get approval from RBI before en-tering into this business. Also the mecha-

nism of assignment of receivables to the factor and payment of consideration by the factor will be regu-lated. This will also enable the factors to obtain legal remedy and claim their rights on the invoices fac-tored by them in a more efficient manner.

This clears a lot of questions that I had. Thank you sir for explaining factor-ing.

CLASSROOMFinFunda

of the Month

FactoringIIM Shillong

Pradeeba K S

NIVESHAK 25C

lassroom

November 2011

2626

F I N - Q

1. _______ came out with the largest IPO when it was listed simultaneously on both the Hong Kong and Shanghai Stock Exchange. It recently opened its first branch in India.

2. An account that is used to store short-term funds or securities until a perma-nent decision is made about their allocation.

3. Which financial term is derived from the Latin term “voster” meaning “yours”?

4. CAMEL is an effective system of rating by the banks. The model insists five main criteria and based on these the financial health is evaluated on a scale of highest to lowest, 1 to 5. In the acronym, A stands for ‘asset quality’, M stands for ‘manage-ment’ and L for ‘liability’, then what do C and E stand for?

5. What do you call a situation in which the firm’s actual bank balance is greater than the balance shown in the firm’s book?

6. __________ is not linked to any physical reserves and is solely based on faith. The government has declared it to be a legal tender, but it risks becoming worthless due to hyperinflation.

7. X is a provision in an underwriting agreement that gives the underwriter the option to ‘over allot’ the initial offer made to the public by the issuer. Usually done in order to stabilize the price of a share post the issue, it helps in reducing the occur-rence of spikes in the price of the share. Identify X.

8. X is a payment mechanism devised to facilitate inter-bank transfer of funds. The acronym of X is also found in Casinos. What is X?

9. Name the tennis tournament sponsored by the stock exchange, which was once chaired by the person who has now been sentenced 150 years prison for his al-leged involvement in a Ponzi scheme.

10. Whose portrait featured on the first set of currency notes issued by Reserve bank of India?

All entries should be mailed at [email protected] by 7th December, 2011 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

Article of the MonthPrize - INR 1000/-

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W I N N E R S

A N N O U N C E M E N T SALL ARE INVITED

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

Instructions » Please email your article with the file name and the subject as <Title of the

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