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THE INVESTOR VOLUME 5 ISSUE 4 April 2012 Algorithmic, high frequency and flash trading, Pg. 08 The ‘africa cup’: advantage scapering dragon or loitering elephant, pg. 19 Who won and Who lost?
Transcript
Page 1: Niveshak April 2012

THE INVESTOR VOLUME 5 ISSUE 4 April 2012

Algorithmic, high frequency and flash trading, Pg. 08

The ‘africa cup’: advantage scapering dragon or loitering elephant, pg. 19

NiveshakUnion Budget 2012-13

Who won and Who lost?

Page 2: Niveshak April 2012

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 VISSUE IV

April 2012

Faculty MentorProf. N. Sivasankaran

Editorial TeamAkanksha BehlAkhil Tandon

Chandan GuptaHarshali Damle

Kailash V. MadanNilkesh Patra

Rakesh Agarwal

Creative TeamAnuroop Bhanu

Venkata Abhiram M.

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,It is the budget season in the country and all the newspapers across the nation are

abuzz with analyses of two of the most important budgets, the Railway Budget and the Union Budget.

The Railway Budget was seen as a golden opportunity for Trinamool Congress nomi-nated Dinesh Trivedi to make a mark in Union Politics. However, with an increase in prices ranging from 2 paise to 30 paise per kilometer, across different sections of the Railways, Mr. Trivedi did his reputation no good. The budget will be remembered more for the political drama that unfolded between him and Ms. Mamta Banerjee. With strong demands to roll-back the fare hike, Mr. Trivedi had no option but to resign leaving the TMC to nominate Mr. Mukul Roy as his successor.

The Union Budget rolled out no such surprises, with Mr. Pranab Mukherjee, now a veteran at presenting budgets, presenting a satisfactory blueprint for the next finan-cial year. The crux of the budget was aimed at maintaining the delicate balance between growth (currently at 6.9%, but pegged to reach levels of 7.6%), inflation (which has seen a continued decline) and the burgeoning fiscal deficit (currently at 5.9%, but pegged to lower down to 5.1%).

For the individual investor, an increase in the income tax slab to Rs.2 lakh brings much cheer. However, the provident fund rate reduced by 125 basis points to 8.25% to offset some of the benefits. The auto industry is likely to take a hit, with an increase in prices highly likely. This is mainly due to an increase in excise duty to 12% from the cur-rent 10% levels. The retail sector saw some cheer with the FM committing to allow FDI in Multi-brand retail in the near future and also setting august as the deadline to implement Goods and Services Tax.

Overall, the budget was in line with the expectations of many and did not dish out too many surprises. The cover story this edition, features a detailed analysis of the Union Budget, what it means for a company and to the individual.

The last fiscal seems to have overcome some of the gloominess that existed in the market, with top CEO’s pocketing handsome salaries. Indra Nooyi, the Indian born CEO of PepsiCo pocketed a hefty $17 million in compensation, while the Indian born CEO of Citigroup Inc., Vikram Pandit pocketed a handsome $14.5 million.

Protest-hit Maruti Suzuki has decided to invest Rs.900 crore more at its upcoming R&D centre at Rohtak. This comes in the backdrop of a strong shift in customer focus from petrol cars to diesel ones. The Rs.900 crore investment is over and above the Rs.1700 crore investment in the plant in Gurgaon, which is set to be operational by mid-2013.

This month’s issue brings to you an insight into the Union Budget of Indian Gov-ernment 2012-2013. The article of the month explains the legal aspects of algorithmic, high frequency and flash trading. The issue also features interesting reads on the investment strategies of India and China in African continent, scenario of weather based insurance index in India and the concept of sovereign credit ratings. This month’s classroom section explains to you the concept of ‘Quantitative Easing’.

With summer placements about to begin for most of our readers, we, at Niveshak wish you all the very best in your respective internship stints.

We would also like to thank our readers for mailing their wonderful articles and appre¬ciation e-mails. It is your constant encouragement and enthusiasm that keeps us going.

Kindly send in your suggestions and feedback to [email protected] and as always, Stay Invested.

Team Niveshak

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C O N T E N T S

Niveshak Times04 The Month That Was

Article of the month 08 Algorithmic, High Frequen-cy and Flash Trading

Cover Story

11 Union Budget 2012-13- Who Won and Who Lost ?

Perspective 16 The ‘Africa Cup’: Advantage Scampering Dragon or Loitering Elephant

Finsight

19 Weather Based Crop Insur-ance in India

Fingyaan22 Sovereign Credit Ratings:An Analysis of The Ratings Downgrades in The US and Euro Zone

CLASSROOM25 Quantitative Easing

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April 2012

Threat of flying license of Kingfisher Air-lines being cancelled

Kingfisher Airlines lacks aircrafts as well as reserves for its day-to-day processes. They have not only caused inconvenience to passengers by not meeting their flight schedule but have also failed to pay salaries to their employees for over four months. This resulted in the prospects of its fly-ing license being cancelled. Also, the airline has decided to limit its overseas flights operations to avoid more losses and also return its leased aircraft. An explanation, for the same, needs to be presented to the Directorate General of Civil Aviation (DGCA) by Vijay Mallya. However, Civil Aviation Minister Ajit Singh said that as per rules the licenses of an airline cannot be cancelled as long as it has five planes and certain equity to run the business. Hence, shutting down of operations is call that Vijay Mallya would have to take.

India to continue being an importer of crude oil from IranOil Minister S Jaipal Reddy announced that India will continue to import crude oil from Iran as long as the International law is not violated de-spite financial sanctions made by the US against countries which do not cut Iranian oil purchases. The country’s purchases of crude oil, accounting for about one tenth of its total crude imports, have been hampered due to banking difficulties as most of the international banks are following the sanctions imposed by US and Europe and hence are not ready to route Indian payments for Iranian oil. As a result, the two countries are considering making payment for oil partly in In-dian rupees and the remaining through export of various commodities and services from India. The country is however, looking forward to diver-sifying its sources of crude imports to reduce the risks of dependence on any particular region. As mentioned by the Foreign Minister S.M Krishna,

India would not be directed by authorizations unless they are made obligatory by the United Nations.

US nominee to lead the World Bank – an expert in global healthOverturning a seven-decade tradition of having officials with experience in finance or diplomacy, as the president of the World Bank, President Obama nominated Jim Yong Kim, president of Dartmouth College in New Hampshire and former director of the Department of HIV/AIDS at the World Health Organization. Dr. Kim is a Korean-American known for his work in fighting disease in impoverished countries. The choice came as a surprise as Washington’s past picks for the post have had more standing in political circles. Mr. Obama also broke the practice of selecting po-litically connected indi-viduals for this post. The decision to nominate Dr. Kim was taken in part to counterweight disparage-ment from developing na-tions about the U.S. lock on the job. He has demonstrated a leadership style and charisma that would serve him well at the bank. He is nearly certain to succeed Rob-ert Zoellick as Washington has the largest single voting share at the World Bank and is likely to get the support of the bank’s second-largest vot-ing member, European nations and Japan.

Citigroup fails Fed Stress TestA stress test conducted by the Federal Reserve on 19 banks proved that Citigroup was amongst the four banks, others being Ally Financial Inc., MetLife Inc. and SunTrust Banks Inc., which failed to pass the test designed to assess the neces-sity of reserves to endure another catastrophe like the credit crisis of 2008. The test showed that these four banks had less than 5% of capital set aside under Tier 1 capital ratio, thereby fail-ing to meet the adequacy standards. This deci-sion was a disappointment to Citi, which had

The Niveshak Times

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IIM, ShillongTeam NIVESHAK

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assured to increase its dividend above a notional 1 cent a share for the first time since its near downfall during the financial crisis. The group claimed that it failed only because of its planned capital-return plan.

Mahindra Satyam to merge with Tech MahindraTech Mahindra and Mahindra Satyam have decid-ed to merge into a combined entity which would run under the aegis of C.P Gurnani, current Chief

executive of-ficer of Ma-hindra Saty-am. The $2.4 billion entity is all set to

become a major player in the competitive Indian software industry. The Board of Directors of the two companies fixed the swap ratio for the merg-er at 17 shares of Mahindra Satyam for every 2 shares of Tech Mahindra. The combined entity is India’s sixth largest IT service provider, with a market value of over $3billion and revenues in excess of $2.4billion. The roots of the merger can be dated back to 2009, when Tech Mahindra acquired the scam-struck Satyam computers, the then fourth largest IT service provider of India. The news was well accepted by the bourses, as the shares of both the companies closed at a 5% high on the day of announcement.

Norms for gold loan NBFCs revisedCiting concerns over the heavy borrowing and sale of bonds by Gold finance NBFCs, the reserve bank of India has tightened rules for lending against gold by finance companies, saying the rapid growth in such loans in the past few years had increased risks to the banking system and retail investors. The NBFC’s having atleast 50% of their assets in gold have been directed to main-tain a 12% Tier 1 capital from April 2014. In addi-tion to this, the companies have been instructed not to lend more than 60% of the value of their gold jewelry. Of late, these NBFCs have borrowed in huge numbers from the banks and the public. Since these companies use Gold as collateral, it makes the entire system vulnerable to gold price movements. The central bank fears that a fall in

the price of gold, might lead to a collapse of the entire system. RBI has also banned companies from lending against bullion, primary gold and gold coins, leaving just jewelry.

BRIC nations eye multilateral develop-ment bankIn wake of the faltering glob-al economy, the BRIC na-tions of Bra-zil, Russia, In-dia and China are consider-ing creation of a multilateral development bank which would facilitate financing of projects in these countries as well as abroad. As per the statements doing rounds in the public domain, Brazil seems to be enthusiastic about the prospects of the deal. The leaders from the respective countries are sched-uled to meet in India soon, where they are ex-pected to sign a memorandum of understanding for the same.

SBI to be more customer focussedIn another effort to become more customer friendly, State Bank of India announced that it will permit loan borrowers to switch to a lower interest rate. The decision is likely to affect a major chunk of its 17 lakh loan borrowers, and a gain of approximately Rs 6000 a month on a 20 year mortgage of Rs 50,00,000 can be ascer-tained. Recently, the bank also waived off pre-payment penalty on loans. In another valiant ef-fort SBI has cut its processing fee, and the fee now stands at 10.75% for home loans up to Rs 30 lakh, 11% for loans between Rs 30 lakh and Rs 75 lakh, and 11.25% for upward of Rs 75 lakh. The bank is setting strong standards in the highly competitive banking industry, which will be dif-ficult for others to ape.

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MARKET CAP (IN RS. CR)BSE Mkt. Cap 60,81,408Index Full Mkt. Cap 28,61,366Index Free Float Mkt. Cap 14,35,450

CURRENCY RATESINR / 1 USD 50.92INR / 1 Euro 67.85INR / 100 Jap. YEN 61.52INR / 1 Pound Sterling 81.21

POLICY RATESBank Rate 9.50%Repo rate 8.50%Reverse Repo rate 7.50%

Market Snapshotwww.iims-niveshak.com

RESERVE RATIOSCRR 4.75%SLR 24%

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

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

Source: www.bseindia.com

Source: www.bseindia.com13th March to 28th March 2012

Data as on 28th March 2012

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CURRENCY MOVEMENTS

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arket Snapshot

BSEIndex Open Close % ChangeSensex 17,772 17,122 -3.66%

MIDCAP 6,375 6,191 -2.89%Smallcap 6,787 6,451 -4.95%AUTO 10,030 9,844 -1.85%BANKEX          12,260 11,476 -6.39%CD 6,751 6,283 -6.93%CG 10,341 9,995 -3.35%FMCG 4,151 4,473 7.76%Healthcare 6,455 6,446 -0.14%IT 6,151 6,021 -2.11%METAL 11,629 11,017 -5.26%OIL&GAS 8,383 7,850 -6.36%POWER 2,234 2,057 -7.92%PSU 7,656 7,138 -6.77%REALTY 1,839 1,726 -6.14%TECK 3,611 3,528 -2.30%

www.iims-niveshak.com

Market Snapshot

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Trading has been traditionally carried out in the stock exchanges, where traders negotiate on the bid-ask prices and make profit on the dif-ference in spread or by using price differences of the same security in different exchanges (ar-bitrage). In the last decade, with competition becoming much intensive, traders began using fast computer systems to execute trades close to the speed of light. These computer systems used High frequency algorithms to take advan-tage of miniscule spreads for ephemeral peri-ods, which is impossible to be performed by human traders. High Frequency Trading systems use algorithms which track miniscule changes in prices, ephemeral price arbitrages and execute trades with extremely low latency. With emer-gence of advanced technology new methods like co-location, flash trading and dark pools be-gan to be used in the markets. High frequency trading systems can be simply viewed as a large group of market makers providing liquidity in the markets. But there are also shades of grey associated as some investors feels that these systems make money from the pockets of other investors by bypassing trades and acting as ar-tificial pseudo- middlemen. This negative senti-ment has been accentuated by events like the

Flash Crash of May 6, 2010.

This article attempts to analyse the different forms of HFT systems and their regulatory ambit with respect to the SEC and SEBI and whether the fears of some investors about unfair advan-tage to certain favoured traders using HFT sys-tems is indeed true.

Co-locationCo-location is a practice where exchanges build data centres and rent out racks of computing space to HFT traders for a fee and thus allow traders to position their computers as close as possible to the exchange’s servers to cut down a few microseconds off trading times. Co-loca-tion has become a controversial issue in recent times with a lot of question raised about its fair-ness and even legality in terms of offering equal opportunity for all market participants. If a bro-ker hits the enter key faster than a HFT firm, then the broker should get the stock and not the HFT firm that paid co-location rent to place its server closer to the exchange. But currently with co-location that is not the case. Here, the issue is a market structure which threatens to thwart competition. Regulators including the US Securities and Exchange Commission and SEBI are concerned that whether this practice holds

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IIM CalCuttaCharan Kumar U

High Frequency Trading systems use algorithms which track miniscule changes in prices, ephem-eral price arbitrages and execute trades with extremely low latency. With emergence of ad-vanced technology, new methods like co-location, flash trading and dark pools began to be used

in the markets.

Algorithmic, High Frequency and Flash Trading

Are they anti-competitive? What is the regulatory view point?

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everyone on an equal footing.

The SEA (1934) requires that the “terms of co-location services must not be unfairly discrimi-natory, and the fees must be equitably allocated and reasonable” Exchanges must obtain approv-al of the SEC for offering co-location services to their customers. By approving the co-location services of NASDAQ, however, the SEC seemed to imply that this practice, by itself, is not ‘unfairly discriminatory’.

With respect to India, NSE has already entered into contracts with 60 members for the co-loca-tion facility. The members can place their trad-ing servers close to that of the exchange for Rs. 22.5 lakhs. The available space is offered on a first-come-first served policy. The broker with the trading server next to the exchange engine has his price feed updated every 3 to 4 mil-liseconds as compared to a broker at a remote place whose feed gets updated once in 30 to 40 milliseconds. In an attempt to not leave aside anyone, NSE has developed a computer cloud model where in the IT infrastructure is shared with small brokers who cannot afford the high-end servers used for HFT. This would mean not differentiating anyone with their capacity to in-vest. But is this enough? Does SEBI feel that it offers an equal ground for every market partici-pant? This remains the much debated question.

Flash OrdersFlashing is the process of disclosing specific or-ders/ quotes to only a special class of inves-tors for a fee. It helps the exchange concerned to convert the unmatched trades into matched ones by providing an incentive (commission) to traders willing to take additional risk by execut-ing such trades. It creates a scenario where both the flash participants and the flashing exchange are mutually benefitted.

Anti-competition vs Efficiency of markets - Flash Traders defend this practise by citing the gen-eral principles of competition applying to all in-dustries where advantage due to technological advancement or inn patents is legal and valid. While this competition among the Flash traders can be deemed fair, the practise of paying a fee

to obtain information which can make the dif-ference between competitors miles apart does not seem to be fair. This practise creates a two-tiered market and even multi-tiered market de-pending on the resources of the traders. This is exactly the reason why SEC proposed to ban Flash Trading in 2009 stating the following rea-sons:

• SEC states that flash trading could destroy fair competition and efficiency if flash trad-ing were to expand to greater trading vol-ume11.

• SEC states that banning flash orders could lead market participants to display more of their trading interest, thus providing addi-tional price transparency.

Under Regulation NMS, a registered exchange or an ATS is prohibited from “imposing unfairly dis-criminatory terms that would prevent or inhibit any person from obtaining efficient access” to the trading centre’s displayed quotations at the best prices. An exchange will violate this rule if it charges access fee more than the limit set by the Regulation NMS. But the issue in Flash Trad-ing is about the very practise of charging access fee to view data.

Presently, flash orders are permitted as an ex-ception to Rule 602 of Regulation NMS under the Securities Act of 1934. However, the proposed ban has still not taken effect as lot of HFT lob-byists and industry executives are emphasising the fact that how flash orders benefit retail in-vestors by lowering costs and even if a ban is initiated, it should not be a blanket ban and should exclude a few markets like the equity market.

From a legal viewpoint, Flash trading & HFT are primarily not used with the intention to defraud investors. The mechanism of HFTs like quote stuffing might create mispricing in course of action, but such instances have been rare. But such misrepresentation is in violation of sec 12 A (a), SEBI Act 1992.

Flash traders are disclosed quotes milliseconds before others see them and they disclose their

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Flash trading allows a section of traders to view proprietary data feed and execute trades, but it does not create artificial rise or fall in prices of securities. Also the intent is to affect a trade for the trader himself rather than to induce purchase or sale by another trader. Though flashing involves dissemination of information, there is no evidence of artificial rise or fall of prices of

securities.

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executions only after trades are completed. The position of SEBI regarding this practise is un-clear.

Defenders of Flash trading argue that there is no clear definition of ‘fairness’ in trading – “fair-ness-based arguments are difficult to employ in support of compelling disclosure of private in-formation by large liquidity traders, particularly as regards transaction information and future transactions4”. They also cite references from section 9 a(3), SEA Act (1934) implying an am-biguous position on Flash Trading -

“circulation or dissemination in the ordinary course of business of information to the effect that the price of any such security will or is likely to rise or fall because of market opera-tions of any 1 or more persons conducted for the purpose of raising or depressing the price of such security”

Flash trading allows a section of traders to view proprietary data feed and execute trades, but it does not create artificial rise or fall in prices of securities. Also the intent is to effect a trade for the trader himself rather than to induce pur-chase or sale by another trader. Though Flash-ing involves dissemination of information, there is no evidence of artificial rise or fall of prices of securities.

The market regulators need to evaluate the trad-eoffs and take a hard line here as the stakes are too high, especially after the flash crash of May 6 2010 which erased $862 billion in value from the markets.

Fat FingerTrade/ Freak TradeFreak trade arises in a situation when a large volume order on a specific stock/derivative is wrongly entered on some other stock/derivative by the trader’s mistake. The Indian flash crash on June 1, 2010, similar to the US flash crash on May 6, 2010, is attributed to a freak trade order entered by a trader causing a quick sell off in the market. The alleged cause for the crash is a freak order entered by an unidentified trader for 500,000 Reliance shares at Rs. 840 instead of putting the same for ICICI Bank stock that

was trading at Rs. 846. Immediately, Reliance shares came crashing down from Rs. 1028.60 to Rs. 840.55, a fall of 18% in a moment. Because of the high weight of Reliance in the Sensex, the index also fell by 442 points, a fall of 3%, with-in a minute. According to Bloomberg data, this caused a panic in the market and about 2.12 lakh Reliance shares exchanged hands within a minute. This unusually high number was almost 40% of the traded volume of the Reliance scrip the previous day. All in a minute!

Soon after this incident, SEBI is working on framing a policy for the stock exchanges to go through a stress test so as to better prepare them in facing flash-crash like situations in the future. Issues like across-the-board panic sale due to a steep fall in some stock (either due to a freak trade or due to stock-related bad news such as scams) and crashes due to large market orders interacting with a thin order book are keeping the regulator on its toes.

Dark PoolsDark pools, in simple terms, are trading plat-forms / exchanges that match buy and sell or-ders of large institutional investors with huge blocks of securities, in the process bypassing the central exchanges and carrying out off-mar-ket deals in a completely anonymous manner. There are no stock quotes published all the time like in public exchanges. An electronic system is used for order-matching, prices fixed between the counterparties and transactions completed. Dark pools raise the issue of equality of oppor-tunity for all market participants. Dark pools can turn disadvantageous to the retail investors in the market as they are totally left out from the system and can’t participate in these trades.

To better understand why investors participate in a dark pool, let us consider an institutional investor like a large pension fund wanting to sell a huge block of a particular stock, say GE, in the market. Suppose the pension fund manager goes to a public exchange like NYSE with the big chunk of GE shares, every move of his is being closely watched by the market since these in-stitutional investors act as the bellwether in the

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SEBI started working on framing a policy for the stock exchanges to go through a stress test so as to better prepare them in facing flash-crash like situations in the future. Issues like across-the-board panic sale due to a steep fall in some stock (either due to a freak trade or due to stock-related bad news such as scams) and crashes due to large market orders interacting with a thin

order book are keeping the regulator on its toes.

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market. Since all the bid and offer are shown publicly in NYSE, due to the weight of the mul-tiple blocks sold and the technical pressure, the last block of GE share sold by the pension fund might be much lower than the first block. Dark pools, in contrast, guarantee ab-solute anonymity. It cuts away the opportunity of market reacting before the transaction is made as no disclosure is to be manda-torily made to the public by the dark pool and any dis-closure made is only done post-trade.

Stub QuotesA stub quote is an offer to buy or sell a security at a price that is far away from the prevailing market price, say a bid at 1 cent and an offer at $100,000, that if executed could lead to freak movements in the price of the security and unnecessary market panic. Stub quotes, cited to be the main villain of the May 2010 flash crash in the US, is a tool that market mak-ers use to meet their obli-gation of maintaining two-way quotes continually in the market but in actuality are unwilling to provide li-quidity. For example, if an investor has put in a “sell at market price order” and a stub quote of bid 1 cent is the only order in the market, the stock falls from its current market price to 1 cent in no time. The same happened with a few stocks during the flash crash. There were no safeguards in the US markets to pre-vent this until recently. The SEC, with effect from

Dec 6, 2010, realized this and imposed a ban on stub quotes. Apart from this, the SEC has also initiated a circuit breaker pilot program. Under this, trading would be stopped if certain equity

prices moved more than 10% in 5 minutes.

From a legal viewpoint, section 9. 2(A) of the SEA Act (1934) prohibits any trade practice with intent to create price manipula-tion or deceive the mar-kets by creating a sce-nario of artificial pricing. By using HFT systems to perform ‘quote stuffing’, which is making random non-executable orders to glean market inter-est in an order, the HFTs might be in violation of the above regulation. But since the probability of a crash due to stub quotes is very low until now and the traders try to outsmart law by using a loophole in the same sec-tion 9.2(a) by saying that there was no “malicious intent” while using the practice of quote stuffing.

Naked / Unfiltered / Sponsored AccessNaked or unfiltered ac-cess is a practice that al-lows HFT traders of vari-ous firms to send orders directly (and anonymous-ly) to stock exchanges us-ing a sponsoring broker’s

ID. Exchanges might not get to know the identity of the firms using naked access as the only way to know the same is the computer identifica-tion code. Naked access allows a reckless HFT trader to put in thousands of erroneous trade

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Stub quotes, cited to be the main villain of the May 2010 flash crash in the US, is a tool that market makers use to meet their obligation of maintaining two-way quotes continually in the

market but in actuality are unwilling to provide liquidity.

The issue of a trade-off that exists between promoting efficiency & competition among ex-changes and the conse-quent impartiality shown towards normal investors has to be highlighted. The whole issue of whether to effect an outright ban on HFT, Flash trading or not has been hanging in balance for about 3 years now mainly because of the trade-off described above. Numerous litiga-tions about the proposed ban, especially in the US, have failed chiefly due to the argument of traders about the consequent cost of banning algorith-mic trading outweighing the benefits to smaller market participants. This makes it difficult for law-makers to pass conclusive judgements on the issue making it a matter of con-tention and debate that’s going on even as this ar-

ticle is being written.

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within the two minute period it might take to correct a market glitch. In November 2010, SEC approved a rule to curb the practice of naked access and prevent brokers from handing over their IDs to trading firms. According to Mary Schapiro, SEC chairman, “Unfiltered access is similar to giving your car keys to a friend who doesn’t have a licence and letting him drive un-accompanied. This proposal would require that if a broker-dealer is going to loan his keys, he must not only remain in the car, but he must also maintain control of it so that the person driving observes the rules before the car is ever put into drive.” HFT firms, though, have raised objections citing that addition of identifiers and pre-trade risk management practices will slow down their trading speeds.

On a concluding note, the issue of a trade-off that exists between promoting efficiency & com-petition among exchanges and and the conse-quent impartiality shown towards normal inves-tors has to be highlighted. The whole issue of whether to effect an outright ban on HFT, Flash trading or not has been hanging on a balance for about 3 years now mainly because of the trade-off described above. Numerous litigations about the proposed ban, especially in the US, have failed chiefly due to the argument of trad-ers about the consequent cost of banning al-gorithmic trading outweighing the benefits to smaller market participants. This makes it dif-ficult for lawmakers to pass conclusive judge-ments on the issue making it a matter of con-tention and debate that’s going on even as this article is being written.

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FIN-Q SolutionsMarch 2012

1. SEBI, U. K. Sinha

2. Nakahara Prize, Jap-anese Economic Association

3. Bank for Internation-al Settlements

4. Help-Wanted Index – HWI

5. Corporate Dossier

6. Commissioner vs. Mary Archer W. Morris Trust, Reverse Morris Trust

7. Buon Ma Thuot Coffee Exchange Center, Vietnam

8. Walt Disney

9. National Rural Em-ployment Guarantee Act, 2005

10. Seagull Leafin

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•Agriculturegrowthprojectedat2.5%in2011-12

•Industrialgrowthpeggedat4-5%inFY12

•Inflationarypressuresfadebytheyearendasfood prices fall

•WPIfoodinflationslumpsfrom20.2%inFeb’10to 1.6% in Jan 12

•Fiscal consolidation could spur Savings andCapital formation

Impact on Common ManThe Union Budget could not meet the expec-tations of common men because of rising in-flation. They had an expectation that this time they will get some major benefits from taxation. They got some benefits from this budget but those cannot be categorized as major. There are changes in the tax slabs. Tax exemption limit is increased from 1.8lacs to 2lacs and the 20% tax slab is now from 5lacs to 10lacs. There will be no implementation of Direct Tax Code this year. Because government did not have enough time as there were issues related to Anna Hazare, Food security bill and lot more. There is a new deduction called “preventive health checkup” included under Section 80D, where a person can include health checkup cost up to 5,000. Now

Cover Story

teaM NIveshak

Harshali Damle & Nilkesh Patra

This year’s Union Budget came amidst tons of expectations not only from our countrymen but also the entire global community. This ar-ticle provides an analysis of the budget and the major take-aways for the common man. At the start, the finance minister stated five objectives of which focus on demand driven growth, ex-panding private sector investment and address-ing supply side bottlenecks were considered to be high priority. The focus of this Budget was clearly on infrastructure and fiscal consolida-tion.

Economic Survey SummaryThe Union budget was preceded by the Econom-ic Survey tabled by finance minister, Mr. Pranab Mukherjee. This document is useful for policy-makers, economists, policy analysts, business practitioners, government agencies, students, researchers, the media, and all those interested in the development in the Indian economy. The major highlights of the survey are:

•IndianEconomyestimatedtogrowby6.9%in2011-12

•FY13 and FY14 growth estimates pegged at7.6% and 8.6% respectively

Union BUdget 2012-13

Who won and who lost ?

..

The Union Budget could not meet the expectations of common men

because of rising inflation.

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infrastructure bonds apart from 80C, which was introduced two years back, is not extended this

year. So, there is no tax ex-emption on these bonds.

Impact on Industry

The Union Budget 2012 was not that severe on the indus-try, which is contrary to the expectation of people, be-cause currently the focus of the government should be to increase revenue and de-crease expenses to achieve the target of lower fiscal deficit. Total planned outlay in the agriculture sector has been increased by 18% from Rs171bn in FY12 to Rs202bn in FY13. Agriculture estimated to grow at 2.5% in FY12. Amend-ments are introduced to the FRBM Act as part of Finance Bill 2012, the medium-term expenditure framework to lay down a three-year rolling tar-get for expenditure indicators. Endeavour to limit central subsidies under 2% of GDP in FY13; to be further brought down to 1.75% of GDP over next 3 years.

This budget has tried to sim-plify the process of IPOs by re-ducing their expenditure and helping companies to reach more retail investors. There is a proposal to make it man-datory for companies to is-sue IPOs of Rs100mn and that should be in electronic form through countrywide broker network of stock exchanges.

The corporate tax rate remains the same. The charge of Mini-mum Alternate Tax (MAT) has

been extended to all persons other than compa-

people don’t have to pay tax on saving bank inter-est income up to 10,000.

Another new tax deduction is introduced for equity in-vestments, which is called as “Rajiv Gandhi Equity Sav-ing Scheme”. In this scheme an investor can claim 50% of his investments in direct equity up to the maximum investment limit of 50,000. But the investment has to be locked for 3 years. This scheme is only available to people with taxable income below 10lacs. STT transac-tion tax has to be paid by the investors, whenever they make equity transac-tions. This tax was previ-ously 0.125%, but now it is reduced to 0.1%.

There are some announce-ments, which can make negative impact on public. The interest rate on EPF is now reduced from 9.5% to 8.25% and this will be ap-plicable from next year. As the service tax is increased from 10% to 12%, people have to pay more on the bill amount like telephone & internet bills, hotel & res-taurant bills, flight charges and several other services. The manufacturers pay a tax called excise duty on any kind of goods produc-tion. The excise duty is in-creased from 10% to 12%, which means that manufac-turers have to pay more tax now and they will put ad-ditional burden on consum-ers by making the goods costly. The benefit of tax saving up to 20,000 on

The Union Budget 2012 was not that severe on the industry, which is contrary to the expectation of people, because currently the focus of the government should be to increase revenue and decrease

expenses to achieve the target of less fiscal deficit.

The budget can be considered to be a con-servative one with no big-ticket announce-ments. The budget is high on credibility compared to previous years. The numbers have been computed on realistic expecta-tions and projections and deviations at year-end would be minimal unlike the situation in the current year. Realis-ing that development of infrastructure is cru-cial for the projected high future growth, a slew of measures have been taken to channel funds from public and foreign sources to this sector. Also, from the general public point of view some positives coming from the bud-get were introduction of Rajiv Gandhi Equity Scheme and hike in personal tax exemption limit that will give them much needed higher

disposable income

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Measures to curb inflation

Increase in Agricultural Spending by 18%

Reduction in Subsidies - Neutral

Final Verdict- Neutral

Market ReactionThe flat markets showed what the investors thought of the Budget. Markets were expecting some comment on issues such as foreign direct investment in retail and aviation sector, but these were not touched upon. Another mildly positive step was the reduction in securities transaction tax (STT) for cash delivery-based transactions by 20% to 0.1%. Bond markets reacted negatively to the increased borrowing program that was an-nounced. The Bond yields signaled thumbs down from the bond markets. The actual response and implementations of the proposals will have an ef-fect on the market in the coming days. Also the investors are eying the RBI for acting on interest rates in April.

ConclusionThe budget presented a realistic assessment of the current political and economic situation. Tar-geting fiscal deficit at 5.1% and 4.5% of GDP for the next two years, along with subsidy at 2% of GDP, are reassuring for optimists. However, there is a need for a balancing act in the midst of high fiscal deficit. There is a need to adopt strict measures to ensure the implementation of the proposals and plans to reach the planned fiscal deficit for the coming year.

nies claiming profit linked deductions. The defini-tion of income deemed to arise in India has been widened with retrospective effect from April 1, 1962. This is significant considering the Supreme Court judgment in the Vodafone Case. Dividend from foreign subsidiary is permitted at a lower tax rate of 15% against the full tax rate to be per-mitted for a further one year i.e. up to March 31, 2013. In the multi-tier corporate structure, there is a proposal to remove the falling effect of Dividend Distribution Tax. This benefit was currently avail-able only in a two tier corporate structure. The weighted deduction of 200% is available for invest-ment in research and development in an in-house facility, which will be available for a further five years beyond March 31, 2012. There is a raise in the turnover limit from Rs6mn to Rs10mn for SMEs for compulsory tax audit. Weighted deduction at the rate of 150% on expenditure incurred on skill development in manufacturing sector would be available as per prescribed guidelines. Peak Cus-toms Duty rate is kept unchanged at 10%. Howev-er, relief is provided for specific sector, especially those under stress. Full exemption is provided for coal mining project imports, reduction for mineral prospecting machineries, aircrafts & equipment imported for third-party maintenance, repair & overhaul. Relief is proposed to steel (import duty on flat products hiked to 7.5%). However, custom duty on Gold has been doubled (to 4% for stan-dard gold, 10% for non-standard gold and 2% for gold ore and concentrate) to check the trend of rise in gold imports.

Major TakeawaysRise in Excise Duty and Service Tax

No change in Corporate Taxation

Implementation of GST

Lack of major Direct Tax changes w.r.t deductions and slabs

Increase in Infrastructure spending

The budget presented a realistic assessment of the current political

and economic situation.

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ness with Africa while the Indians have adopted the ‘soft’ version.INDIA: The ongoing relationship between Africa and the competing Asian duo has evolved over time and is currently dominated by competing interests in trade, investment, economic cooperation and the quest for influence. Trade between Africa and China has grown from $20 billion in 2001 to $122.3 billion in the first three quarters of 2011 while over the same period India’s engagement with Africa has ris-en from $8.5 billion to $49.1 billion with a target to

The last one-and-a-half decade has seen China and India, the world’s most populous and economi-cally fastest growing countries emerge as Africa’s most important economic partners. It all started in the last decade of the twentieth century, when first China and later India, after breaking off from the socio-economic shackles of centuries of colo-nialism started on a path of modernization and economic development and lately results started to pay off in the form of sustained economic and military growth. This ever-burgeoning growth has led both the countries to look further for resources to fuel their robust march onto the status of glob-al superpower. And Africa, lagging behind under the constrained economic aid of the West was the ideal ground to launch their initiatives. Though both China and India are South Asian behemoths and have a cultural heritage dating back to the ancient yore, their paths to investment in Africa couldn’t have been any more different. China, the manufacturing hub of the new economic order has centered on a no-political-strings attached policy of pouring money into the African continent and its foray has been led by the State-owned companies fully supported by the deep pockets of the Chinese government. On the other end of the spectrum, India has been a cautious player, less risk-seeking in its investment strategy and the Indian contingent has been led by the private sector and only recently has the Indian govern-ment entered the fray. The timelines in figures 1 & 2 highlight the difference in attitudes and actions taken by the respective governments to shore up their countries’ stocks in the continent. CHINA: While China has had clear-cut objectives in mind vis-à-vis its African sojourn, India has approached on a multi-pronged plan which is versatile enough to accommodate humanitarian aid but not ro-bust enough to successfully face-off and thwart the relentless Chinese highlight. In summary, the Chinese have gone the ‘hard’ way of doing busi-

The ‘Africa Cup’ :

Fig. 1: Roadmap for China’s African involvement: Focus on Oil & Mining, Construction, Agriculture and Capital Equipment

Fig. 2: Roadmap for India’s African involvement: Focus on Agri-culture, Power, Pharmaceutical, Information & Telecommunica-

tion sectors, Small & Medium scale Enterprises

Advantage Scampering Dragon or Loitering Elephant

IIM RohtakMohit Mathur & Soumya Sarthak Mishra

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reach $75 billion by 2015. China has outmaneu-vered not only India but also erstwhile largest business partners of Africa viz. Europe and USA.The figure 3 depicts the African nations where the Indians and the Chinese have made their presence felt with a plethora of wide-ranging in-vestments. What is interesting to note in the figure is that while the Chi-nese have reached out to the most interior and reclu-sive regions of the ‘Dark Continent’, the same can’t be said of the Indian modus operandi. Speaking of the macro-economic ramifications, the mind-boggling rate of expansion of China-Africa and India-Africa trade has brought the Western and East-ern interests and economic clout to a face off and the consequent dynamics are bound to affect the development of African countries and their international rela-tions and place in the new pecking order.In the current scenario, the Chinese economic bandwagon is viewed to be cantering away and out of reach of its Indian counterpart. The Chi-nese government, in its African Policy Paper, is-sued in January 2006, declared its commitment to a new and strategic long-term partnership with Africa based on the five principles of: 1. Peaceful co-existence2. Respect for African countries’ independent choice of development path3. Mutual benefit and reciprocity 4. Interaction based on equality 5. Consultation and co-operation in global af-fairs

This proclaimed humanistic approach coupled with the massive amount of economic capi-tal being poured in by the Chinese has helped them rake up massive investment projects in

every nook and cranny of Africa as highlighted in the following fig 4.

A crucial plank behind the success of these Asian nations is the role played by the state in guid-

ing the m a r k e t and the s t a t e ’ s w i l l i n g -ness to intervene and ex-periment with het-e r o d o x po l i c i e s to re-vive the economy, compete in global markets and re-d u c e p o v e r t y in the p r o c e s s of mov-ing in a free-mar-

ket direction. The hallmark of Indian entry into Africa has been heavy investment in infrastruc-ture, education, research and development complemented with versatile policies designed to enhance the competitiveness of local produc-ers through technological retooling and workers’ retraining. Opposed to this, the Chinese have relied on bringing in their cheap, indigenous Chinese labor and this has created disquiet amongst the local populace. The deepening competition and the policies of China have led India to cast the former as a ‘fair-weather’ friend while presenting itself as an ‘all-weather’ friend of Africa. Chinese investment has been more aggressive, with the Chinese state-owned enterprises enjoying both political and financial support to undercut other competitors in general and Indian in particular. On the other hand, India’s relations with Africa include rela-tively modest but highly valued aid, economic cooperation and technical assistance programs. Energy security is writ large in the strategic in-terests of both China and India as they continue to expand in Africa. China’s two-pronged strat-

Fig. 3: Chinese vs Indian investments in Africa

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egy of engaging the major Afri-can oil produc-ers (Nigeria, An-gola and Sudan) by offering them integrated pack-ages of aid and low interest/in-terest free loans and simultane-ously targeting the less visible African oil pro-ducers (Gabon, Equatorial Guin-ea) has helped it score high on the success lad-der over India in gaining ac-cess to Africa’s oil. The Chi-nese state-run oil companies China National Petroleum Corporation, Sinopec, China Gas, Chinese National Overseas Oil Cor-poration et al have outmaneuvered their Indian counterpart Oil and Natural Gas Corporation time and again. However, despite these setbacks, In-dia has continued to look for niches where it can maximize its comparative advantage and slowly but steadily converting its toehold in Af-rica to a firm foothold. Indicators Present

(2010)Projected

(2050)

CHINA INDIA CHINA INDIA

GDP $ 4667bn. $ 1256bn. $ 70710bn. $ 37668bn.

GDP per capita

$ 3,463 $ 817 $ 49,650 $ 20,836

Population 1.347 bn. 1.21 bn. 1.303 bn. 1.656 bn.

% Popula-tion in

15 - 45 age group

47 41 28 46

Table 1: Present and projected strategic developmental indica-tors for China and India

From an African perspective, the emergence of China and India as important development part-ners will be able to address the prevalent critical infrastructure gap cheaply, less bureaucratically and in a shorter timeframe. The Asian giants’ engagement with Africa is growing by leaps and bounds, which simultaneously presents both opportunities and challenges for the Afri-

can continent and critical interven-tions by the Afri-can governments in order to negoti-ate with the Asian superpowers is the need of the hour. The question that now faces Africa is whether there exists a coherent African strategy for harnessing the potential devel-opment spin-offs that could accrue from increased investments, trade and aid from the belligerents and if one does not ex-ist, what should be

done to create one. A look at the crucial socio-economic indicators shows China being way ahead of India on all fronts and it is not predicted to change by the forecasts of 2050 but a closer look reveals the demographic advantage will swing decisively in India’s favor. Further, India may, in the medium to long term, gain considerable comparative advantage over China due to its closer proximity to Africa, its historical ties, the sharing of English as a com-mon language, the special niches to promote its friendship and its excellent educational and training opportunities and democratic systems. However, all this will depend on a tectonic shift in India’s foreign policy, bureaucracy and the capacity to adapt its ‘low-cost high efficiency business model’ to the African ground realities and the corresponding response of the African countries.

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Fig. 4: Quantum of Chinese FDI in Africa

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ble growth and upliftment

In this article we will focus on Agriculture Insurance product innovations, analysing the product design, implementation insights, benefit analysis and the open issues. We will focus on the products offered by two major private players in this area: ICICI Lom-bard & IFFCO Tokio.

Agriculture Insurance in India

Agriculture insurance addresses goal no. 2 identi-fied above. Crop yields are variable which leads to variability of income for farmers. The goal is to re-duce this variability through insurance products and thereby promote a steady income.

There have been innovations in the recent past and both government and private sector products are in the offering. Based on the insurance basis used, these products can be classified into two broad cat-egories: Weather Based and Yield Based.

This article focusses on weather based products and innovations.

Weather Based Insurance – Overview

To a farmer, weather represents a risk. 89 % of the households surveyed as part of a study by Cole et al. in 2009 reported rainfall variation as the most im-portant risk faced by them. In principle, we should be able to manage this risk. Weather uncertainties faced by a farmer have hardly any correlation with stock exchange movements. This means the risk should be largely diversifiable.

There have been significant developments in the arena of weather based crop insurance products as visible from the data for 2004-11.

1. Total Sum Insured crossed USD 3 billion in 2010-11, a 200% increase over the previous year

2. A rapid volume growth in past 7 years with total number of farmers insured reaching close to 1 Crore

Finsight

XlRI, JaMshedpuRPrashant Kulbhushan Sahni & Shivendra Sharma

In recent years, there has been a growing interest in use of finance as a means of promoting devel-opment and economic growth. Within this context, terms like inclusive finance, rural finance and mi-crofinance refer to the use of the innovative tools of finance which promote a more even distribution of income and poverty alleviation via inclusive growth.

But what does finance really mean for the rural citi-zens?

We have identified three aspects: Savings, Credit & Insurance. These tools are a hygiene factor for the urban; hence we may, at times, underestimate their importance. But in absence of a formal access to these, the lower income group has to face:

1. The vicious circle of high cost local debt

2. Severing of treatable medical emergencies

3. High impact of income variability and uncertainty

4. Exhausting of current resources leading to con-strained future opportunities

In fact a World Bank 2006 study indicated that rural people do borrow, but in absence of a formal system they rely on alternatives which are either very high in terms of cost or negatively impact their long term well-being. Specifically for insurance products, the study indicated that rural demand far exceeds the supply.

The primary benefits that the financial system can extend to the rural and the lower income groups are:

1. Capital provision for rural entrepreneurs - and promotion of income generation through credit

2. Reducing the impact of income variability - through affordable credit and agriculture insurance

3. Improving healthcare - through tools like commu-nity health insurance and healthcare financing

4. Enabling a steady living standard promoting sta-

WEATHER BASED CROP INSURANCE IN INDIA

Table 1: Weather and Crop insurance differences

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3. Claims as a percentage of premiums have been as high as 76%

(a) High liquidity requirement for Insurers

(b) A market for reinsurers

4. Low value of premium per farmer served com-bined with difficulty in reaching out to rural custom-ers

(a) Need to minimize administrative and transaction costs

(b) Issue of financial viability

(c) Need for channel partners – NGOs, commercial partners – which can reach out to customer at low cost

(d) Space for technology innovations to reduce transaction costs

Delivery Mechanism

We saw in the overview section that there is a place for re-insurers in this arena given the high liquid-ity requirement of the weather insurance products. We also realized the need for channel partners and technology innovations to reduce transaction and administration costs.

But the product design principles discussed above also imply that:

1. The design of the contract depends upon actuarial estimates of weather parameters

2. The pay-out depends on the actual values of these parameters

3. These parameters , cumulative rainfall in our case, vary locally

These implications create the role of a delivery part-ner that can help reduce the transaction costs and act as an interface between local customers and the insurance provider. The above insights can help us understand the rationale behind general delivery structure and implementation innovations utilized. The general delivery model is given in fig 1.

Distribution channels have been the key in the scale-up of these projects. The private insurance provid-ers have joined with partners such as companies involved in contract farming or agricultural input

supply in order to take advantage of their existing links with farmers.

1. IFCCO-Tokio, for example, sells the bulk of its poli-cies through the extensive cooperative network of its parent company, IFFCO Fertilizers

2. ICICI Lombard has worked with ITC, taking advan-tage of ITC’s Internet kiosks

3. ICICI Lombard is also working with contract farm-ing operations such as that of PepsiCo for potatoes

Apart from NGOs and microfinance institutions, spe-cialized technology and delivery partners are also emerging which will help in reaching out to the cus-tomers and also lowering the transaction and ad-ministration costs.

1. ICICI Lombard – BASIX set up is an example in this area

2. FINO has emerged as a specialized transaction provider for banking services

Contract Implementation Statistics

Analysis

It can be seen from statistics in tables 2 and 3 that IFFCO Tokio contracts were designed to cater more to cases of extreme rainfall shortage.

1. Hence IFFCO Tokio contracts have lower premium due to lower expected actuarial pay-out.

2. ICICI contracts were offered in two different cate-gories of premiums – Low & High. Combined with the three phased system, they present greater flexibility.

3. ICICI contracts have greater pay-out possibilities hence greater premium.

Most Importantly: How will the farmer understand these contract differences and make an appropriate choice?

This is an open issue that we have listed down in the issues section.

A study that statistically analysed the rainfall insur-ance pay-outs indicated that even the ICICI policy:

1. Was expected to make actual pay-outs in only 11% of the cases

2. 95th percentile of the pay-out occurred at around Rs 200

Fig. 1: General delivery model

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3. Only in 1% of the cases the maximum pay-out was made

Though the actual benefits accrued cannot be as-sessed with great accuracy, but we may still see that an ideal policy design would require extensive fo-cussed analysis and critiquing, and we are still far from the target.

Open Issues

There are many open issues but here we focus on the ones most relevant to weather based insurance. The biggest of all is the ‘Basis Risk’.

1. Basis Risk – Index insurance is vulnerable to basis risk. Simply put, basis risk is when insurance pay-outs do not match actual losses – either there are losses but no pay-out, or a pay-out is triggered even though there are no losses. Obviously, if either of the basis risk situations occurs too frequently, the insurance scheme will not be viable, and may even damage livelihoods.

2. Literacy – Financial and even general literacy of the rural customer is an ever persisting problem while providing financial products and insurance is no ex-ception. In many cases, the rural customer does not understand paying for a product which does not pay a guaranteed return.

Recent innovations in this area offer insurance cou-pled with credit or other similar products or con-tracts to overcome this problem to some extent.

3. Reliable and Extensive weather data – The current growth of weather station network in India is largely haphazard and devoid of a coordinated approach and integrated planning.

(a) In order to attain the objective of an integrated data system for India, Public-Private Partnerships (PPP) and integrated planning at the National level should be taken up.

(b) These centralized efforts have to be followed up by decentralized implementation in identified loca-tions across the country.

4. As the distance of the rainfall recording station from the farms increases, the chance of getting a

meaningful insurance cover decreases.

5. Premiums for private contracts were not subsi-dized and were therefore higher than for NAIS con-tracts (6–14% of the sum insured versus 2–3.5%)

In 2007, a few state governments began subsidizing index insurance products offered by private insur-ance companies, paying 40–50% of the premium.

Possibilities & Improvements

Based on the discussion above, and related re-search, we have compiled a list of areas where in-novation may be focussed going forward. These are given below:

1. Build partnerships with several insurance com-panies to overcome the underwriting limitations in-curred by reliance on a single company

2. Intensification of investment (both private and public) in the network of weather stations through-out the country, particularly in rural areas

3. Improve product design for better correlation be-tween indices and crop losses

4. Ensure products remain simple enough to be un-derstood by farmers and other stakeholders

5. Financial literacy training for stakeholders

6. Exploring innovations such as money-back in case of no pay out

7. Insurance product combination offered could in-clude both an early payment (based on a weather index) and a final payment (based on an area yield index).

This will help to avoid the problem of the insurance claim payment made to a policyholder not always reflecting the true loss incurred by that policyholder.

Table 2: ICICI Policies – Gujarat 2006

Table 3: IFFCO Tokio Poilicies – Gujarat 2007. Rs. payout as a function of rainfall deficit from normal rain

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Credit ratings reflect the financial health of an economy. Major credit ratings agencies like S&P, Moody’s and Fitch periodically come out with such ratings based on the performance and financial environment in different economies. Though the ratings are only indicative, it cov-ers exhaustively a host of factors and hence any downgrade leads to financial implica-tions across the globe and hence the threat of a domino effect looms large.

negative outlook in April 2011, and had said that it might lower the rating unless the government approves a $4 trillion deficit cut in the next ten years.

Even though there was dodgy analysis in-volved in the downgrade, which resulted in artificial inflation of the US debt by 8% by 2021, there were some solid reasons behind the credit downgrade.

• Mounting Public Debt

In contrast to other AAA rated countries like Germany & Britain who have actively taken steps to stabilise and lower their debt to GDP ratio, America’s debt has been rising unsustainably as a share of its GDP. There have also been criticisms that plan to slash government expen-diture by $2.4 trillion over the next ten years, which accompanied by the debt ceiling rise, are just not acceptable.

2011 may very well be remembered as the year of sovereign credit downgrades. Apart from the historic credit downgrade of the United States from AAA to AA+ by Standard & Poor’s (S&P), there was a slew of other high profile credit down-grades. The credit rating agency, Moody’s downgraded Italian & Spanish govern-ment bonds by two & three notches re-spectively. Thirteen days into 2012, S&P downgraded the credit rating of nine Eurozone sovereigns, including that of France from AAA to AA+. All throughout, Greece’s sovereign credit rating took a beating and is currently rated as junk status.

So what triggered these credit ratings and what are their implications?

United States Credit Downgrade

On 5th August 2011, S&P downgraded the credit rating of the United States gov-ernment from AAA (Prime Grade) to AA+ (High grade). The downgrade took place three days after the US congress raised the debt ceiling by $2.1 trillion from $14.3 trillion. However, the downgrade was not unexpected. S&P had put US debt on a

MdI, GuRGaoNPragati Sangal & Raghav Pandey

Fig. 1: Soverign credit rating : Feb, 2012

Fig. 2: U.S. GDP Growth rate in % change

Sovereign Credit Ratings:An Analysis of the ratings

downgrades in the US and Euro Zone

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yaan• Slowdown in Recovery

The global and US economic recovery has dragged on for the past 2 years at a slow pace. Given the backdrop of the Eurozone Crisis, several economists have lowered the estimated growth rate of the US GDP from 3% to 2%. Fiscal tightening & the Eurozone crisis have been a drain on the growth. The unem-ployment statistics are still grim, though they have improved over the last 6 months.

• Lack of Political Will

There have also been concerns about the lack of political will to take the necessary steps to curb the mounting fiscal deficit. American policymaking and political institutions have weakened at a time of on-going fiscal and economic challenges. It is unclear if the US government will end the Bush era tax cuts or tackle entitlements. This anaemic policy making and brinksmanship was the cause behind the US debt crisis which resulted in the increase in the debt ceiling. S&P has said that the US is likely to face a further rating downgrade if the government contin-ues to extend the Bush tax cuts for the wealthiest Americans.

Implications

Following the downgrade, US Treasury bond yields actually fell. Thanks to the combination of America’s status as a safe haven and the on-going crisis in the Eurozone, the US dollar’s special place as the world’s reserve currency reinforced this movement. However, on an average, lower credit rating has led to higher bond yields and this may very well be the case with the US, over a long period of time.

Fig. 4: U.S. Govt Bond 10 year - Implied Yield

Gold prices also shot up, following the downgrade, as investors fled equity and other risky assets and looked for safe picks. However, since then, spot gold prices have somewhat moderated.

However, there are deeper implications for this his-toric downgrade. It is the latest and the biggest blow

that the US economy has taken from the huge ramp up in housing and other debt that lead to the finan-cial crisis. As the US population ages, healthcare & other social welfare costs are expected to rise fur-ther. In the long run, the US government may find that it will have to offer higher interest rates to find takers for its bonds. This is going to exasperate the growth problem in America, as corporations and the government find it harder to take loans and expand.

European Credit Downgrades

The Eurozone crisis resulted in financial instability in the continent owing to large government debt in Greece and other countries. In January 2012, S&P downgraded nine European Nations including France, Austria, Malta, Slovenia, the Slovak Republic, Spain, Italy, Portugal and Cyprus. However, Belgium, Fin-land, Ireland, Luxembourg, The Netherlands and Ger-many were exempted from any downgrading which indicates relative confidence in their economies. With the current trend, UK and Germany, currently enjoying the top notch status in the ratings also face a threat of a similar downgrade, as the outlook has been changed to watch and negative status.

The unstable economic and political environment in the Eurozone has led to a spate of ratings down-grades in the last year. The credit rating agencies have highlighted the following concerns:

• Tightening Credit Conditions

It is essential to ensure that easy credit is not avail-able across the European countries that are already debt laden. With already soaring debt to GDP levels in various nations, easy access to credit facility must be tightened. Downgrading of credit ratings ensures that the interest rates for borrowing for these na-tions increase. On the other hand, expensive bor-rowing raises the risk of these nations to default, thus making the European Central Bank all the more responsible for a possible bail out option to ensure the consolidation of Euro. The fig 6 shows the mag-nitude of debts raised by European nations and ex-plains why tightening of credit is essential.

• Disagreements among European policy makers

Euro zone members failed to tackle the immediate crisis at hand and were unable to define measures

Fig. 3: U.S. Debt to GDP in % of GDP

Fig. 5: Spot gold price in USD

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to ensure greater economic, financial, and fiscal con-vergence in the longer term. European Central Bank’s hesitancy to go for bail out, citing its objective is to control inflation alone led to increasing the extent of troubles. The establishment of European Financial Stability Facility and European Stability Mechanism, the two funds meant to put an end to the debt crisis gave hope of revival, but majority of the burden lies unfairly on Germany and France. Also, the amount decided for bailout has been increasing, which now stands at £1.3 trillion making the bailouts excruciat-ingly painful. The recent default concerns with Italy and Spain could have been fatal for France which had the highest exposure to the debt. However, £780 billion were pledged by European leaders to protect safeguard against contagion. The ouster of govern-ments in Ireland, Portugal, Greece, Italy, Spain, Fin-land and Romania has also indicated an unstable political environment.

• Higher risk premiums

It was continuously being observed that a number of Eurozone sovereigns including some which were rated ‘AAA’ actually were riskier investments than as reflected in the ratings. This can be attributed to the phenomenon known as financial contagion which is the transmission of financial crisis across financial markets for direct or indirect economies. Greece with the highest debt to GDP ratio, owes a large share to France and Germany, the two biggest economies of the Eurozone. But even France and Germany have more than 80% government debt to GDP ratios, which constrains their ability to bail out the PIIGS nations. Apart from Greece, Italy is anoth-er threat to the stability of Europe as it owes large amounts to defaulting nations.

• Low Confidence in Economy

Reports have indicated that quarterly growth in the euro zone has fallen to its lowest rate in the last two years. This has led to raising the risk of economic recession in the coming financial year. The main

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reason for this is the high rates of unemployment. In addition, various austerity measures are leading to wage cuts and increased tax burden on individu-als which is leading to sluggish economic growth in various countries.

Implications

The immediate implications of the downgrading of the European credit ratings will come in the form of an increase in borrowing costs of the nations affect-ed. This also leads to the instability of the European currency owing to a loss in confidence in the Euro-pean economy. A credit rating downgrade is viewed as a negative sign in markets, thus, a few commer-cial banks may replace French bonds with bonds of Germany to hold only the highest-rated govern-ment securities. It also would lead to widening of the dividing line between France and Germany, with France being now considered less investment wor-thy than its competitive neighbour. A global financial domino effect is the biggest concern behind the Eu-rope downgrades at this point of time.

Fig. 6: Public Debt and Debt to GDP 2010

Fig. 7: European youth unemployment

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Sir, yesterday while having dinner, I heard three of my seniors discussing the term quantitative easing. I tried to get in-volved in the discussion, but it all went over my head. Can you explain me what

exactly is quantitative easing?

Hmmmm… It’s good that you are keeping your ears and eyes open 24*7. Anyways listen. Quantitative easing is one of the monetary tools used by the central banks to augment the money supply in the

economy. Usually, the central bank uses the indirect way of moderating economic activity, i.e. by varying the interest rates. However, in the case of quantita-tive easing, it influences the market in a direct way by buying government and corporate bonds directly from the banks. The intention is to ‘ease’ pressure off the market by pumping in more ‘quantity’ of money.

All right sir. But when does the cen-tral bank do so?

Quantitative easing is used when economy is in a deflationary mode. Banks are reluctant to lend funds to businesses as they fear a default. They find it better to invest in government treasury, which is

safe and also provides a healthy return. This deprives business houses of funds, which results in a decelera-tion in investment activities, and gradually leads to a further fall in growth.

But central banks can also influence money supply by changing the interest rates. What is the need of quantitative eas-ing?

The central banks generally use quan-titative easing when reducing the interest rates does not give them the desired suc-cess in curbing deflation. Quantitative eas-ing might be termed as the central bank’s

last resort to bring the economy back on the path of growth.

Sir, why are central banks so wor-ried when economy is experiencing de-flation? Isn’t a fall in price good for the people, as it will help them in buying more?

No, not really. When people expect falling prices, they become less willing to spend, and in particular less willing to borrow. In such a scenario, just sitting on cash becomes productive for the inves-

tors, as the effective purchasing power of rupee held is on the rise. Business houses to shy away from borrowing, as the loan will have to be repaid in rupees which are worth more than the rupees they borrowed.

Also, when the prices are falling, people tend to postpone their demand for goods in anticipation of a further reduction in price. As more and more consumers think on these lines, the entire economy is engulfed in a slowdown.

Oh! I always used to think that lower prices are good. Anyways sir, how does the Central Bank go about execut-ing Quantitative easing?

The central banks buy corporate and government bonds from commercial banks. In return, it just credits the com-mercial bank’s account with an equivalent amount, and thus artificially injects mon-

ey into the system. This has a two-way effect on the economy.

Firstly, by buying the bonds held by banks, it pumps in money, which improves the bank’s lending capacity.

Secondly, as the central bank purchases bonds, it’s demand increases. With an increase in demand, the yield on bonds falls, thereby making it less at-tractive for the banks to invest in them. The invest-ment proposals of business houses now appears more productive to them, and they readily extend credit to them. With the multiplier in operation, this gives a huge impetus to growth, and pulls the econ-omy out of that deflationary spiral.

However, if too much money is created, it might lead to rampant inflation, which is again detrimental for the economy.

CLASSROOMFinFunda

of the Month

QUANTITATIVE EASING

NIVESHAK 25C

lassroomIIM Shillong Akhil tandon

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F I N - Q1. What are we referring to?

2. Name the type of auction in which the price on an item is lowered until it gets a bid.

3. This currency was called ‘Royal’ before adoption of the current name. Name the currency.

4. Identify this famous national landmark building.

5. Among all the currencies with distinctive identities, what is the unique feature of the pound sterling?

6. The first budget of independent India was presented by ________________.

7. This defense strategy (coined by Bruce Wasserstein) prevented hostile takeover of Martin Marietta by Bendix Corporation in 1982. Identify the term.

8. What term became popular after the newspaper report of Watergate Scandal in the year 1973?

9. The annual shareholder meeting for which organization is held in the Qwest Cen-ter in Omaha.

10. Which word connected to stock exchange has its origin from Latin for ‘money bag’?

All entries should be mailed at [email protected] by 20th April, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

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Article of the MonthPrize - INR 1000/-Charan Kumar U

IIM Calcutta

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

Article>_<Institute Name>_<Author’s name/Group’s name> by 20 April 2012. » Article must be sent in Microsoft Word Document (doc/docx), Font: Times New

Roman, Font Size: 12, Line spacing: 1.5 » Please ensure that the entire document has a wordcount between 1200 - 1500 » The cover page of the article should only contain the Title of the Article, the Au-

thor’s Name and the Institute’s Name » Mention your e-mail id/ blog if you want the readers to contact you for further

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