Niveshak September Issue

THE INVESTOR VOLUME 5 ISSUE 9 September 2012

the reality of real estate companies, Pg. 18

Is it the end of Dollar as world’s reserve currency?,pg. 14

Niveshak

Quantitative Easing3

How will it effect the global economy?

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 IX

September 2012

Faculty MentorProf. N. Saravanan

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,

The major reforms announced by the US Federal Reserve as well as the Indian government and their timing and manner of announcements guarantee to boost the Indian economy and market sentiments at large. The US Federal Re-serve’s third round of quantitative easing (QE3) helped to extend gains on global stocks and bonds, and strengthened the US dollar against euro and yen. A simi-lar effect was palpable in the Indian rupee which gained against US dollar. This was further influenced by the government’s decision to raise fuel prices. Indian stock market has also seen some rise because of reforms relating to foreign direct investment (FDI) and disinvestment. The benefits of FDI, especially in the case of multi-brand retail, will accrue over time but investors have to wait for the politi-cal clearance. Apart from this, 49% stake in domestic carriers by foreign airlines, 49% in power exchanges, increase of foreign equity cap to 74% in broadcasting services will buy the government some time with the rating agencies, some of who have already put India’s sovereign rating on a “negative” watch list.

The government’s effort to reduce the fuel subsidy bill has helped the Re-serve Bank of India to provide some monetary stimulus by reducing the CRR by 25 basis points and the RBI may also cut the rates in the future. These moves will be positive-both for the domestic stocks and currency. However, the ‘spill-over’ effect of these initiatives on inflation cannot be ignored, which has already increased to 7.55%. Over all of these, the major force which drives the market is the political pressure which may roll back any of its latest reforms.

This issue brings to you some more interesting and insightful reads. The cover story of this month focuses on the US Federal Reserve’s latest effort- Quan-titative Easing III. The issue also features an article on the future of Dollar as the reserve currency. The article of the month throws light on the full capital account convertibility. This issue also features other articles on the reality of real estate companies and LIBOR’s labor’s lost. The classroom section explains the concept of “CAT Bonds”.

We would like to thank our readers for their constant support through wonderful articles and appreciation. It is your endless encouragement and en-thusiasm that keeps us going. Kindly send in your suggestions and feedback to [email protected] and as always,

Stay invested.

Team Niveshak

C O N T E N T S

Niveshak Times04 The Month That Was

Article of the month 08 Full Capital Account Convertibility: A Double Edged Sword?

Cover Story

11 QE3 and its impact on emerging economies

FinGyaan 14 Is It the End of Dollar As World’s Reserve Currency?

Perspective

16 LIBOR’s Labour’s Lost

Finsight18 The Reality of Real Estate Companies

CLASSROOM21 CAT Bonds

July 2012

A fresh hope of reformsGovernment of India, in an unexpected but pleasing move, announced much awaited eco-nomic reforms on FDI in single brand & multi brand retail, civil aviation, power exchanges and broadcasting services. Though all the reforms come with certain conditions but the surge in market clearly showed the immediate need of these reforms. The foreign investors are now al-lowed 100% stake in single brand retail subject to certain conditions like ownership of the for-eign investor and 30% sourcing from local small enterprises. Commerce Minister Anand Sharma also announced that foreign investors are now allowed to invest up to 51% in multi brand re-tail and open the stores in all the states and UTs subject to approval of the respective govern-ments. The FDI in multi brand retail also comes bundled with certain conditions like 30% sourc-ing, minimum amount to be brought in by the foreign investor would be USD 100 million and at least 50 per cent of FDI should be invested in ‘back-end infrastructure’ within three years of the first tranche and outlets may be set up only in cities with a population of more than 10 lakh. Wal-Mart also announced that with the reforms in place, they expect the first store to be opened within two years.

Government also approved 49% FDI in aviation sector providing relief to the bleeding domestic air carriers. Although the mood in the industry was upbeat after the announcement, most of the foreign carriers seem to be on wait and watch mode before mak- i n g any commitments. The Government also n o -t i f i e d 4 9 %

FDI in p o w e r

exchanges and 74 per

cent foreign eq-uity cap in broad-

casting services like teleports, DTH, Multi Sys-tem Operators (MSOs).

Diesel price up by Rs. 5; LPG cylinders cut to six a yearCabinet Com-mittee on Po-litical Affairs (CCPA), headed by Prime Min-ister Manmo-han Singh, an-nounced a Rs. 5 hike in diesel prices and also restricted the supply of LPG cylinders at six do-mestic LPG (14.2 Kg) cylinders per annum. The diesel price including VAT will increase by Rs. 5.63 and any requirement of cooking gas above stipulated amount would have to be procured at market rate which is more than double of Rs 399 price--the price of subsidised 14.2 kg cylin-der. The increase in diesel prices is considered to be inevitable to control the rising subsidy bill of the government. Non-revision of diesel, kerosene and cooking gas (LPG) prices as per market rates since June last year had resulted in almost Rs 140,000 crore of oil subsidy last year and would have risen to Rs 200,000 crore in case of inaction on the part of government. The re-forms have brought a huge relief to Oil market-ing Companies suffering from huge under recov-ery as a result of non-revision of fuel prices. The move is expected to reduce the under recovery amount by Rs. 5300 crore for the remaining part of financial year.

Federal Reserve announces QE3 to aid US recoveryIn a major announcement this month, Amer-ica’s central bank announced that it will pur-chase $40bn (£25bn) of mortgage-backed bonds a month to stimulate the housing market and keep long-term interest rates low in the third round of quantitative easing. “By assuring the public that we will be prepared to take action if the economy falters, we’re hopeful that that will

The Niveshak Times


IIM, ShillongTeam NIVESHAK

NIVESHAK4T

he M

onth

Tha

t Was

increase confidence, make people more willing to invest, hire, and spend,” Chairman Ben S.

Bernanke said. The central bank also assured that it will continue its pro-gram to swap $667 billion of short-term debt with longer-term securities to lengthen the aver-age maturity of its

holdings. The move has been highly appreciated and at the same time harshly criticised by the concerned parties.

Unlimited bond buying programme gets backing of ECBIn an effort to address the distortions in bond market and control the rising borrowing cost of struggling Euro Zone countries, ECB has agreed to Mario Draghi’s strategy of unlimited bond buying. The sovereign debt to be covered un-der the plan would be restricted to the bonds of maturity up to 3 years. The plan comes with certain conditions and would be suspended in case of violation of any kind. The move is ex-pected to ensure struggling government’s ac-cess to funding to meet their requirements at low cost. IMF has also agreed to back the plan. Christine Lagarde, the IMF’s managing director, said that the fund was “ready to help” with the European Central Bank president’s plan to staunch the euro zone crisis. The programme,on the other hand, has been harshly criticized by German Bundesbank Chief Jens Weidmann, as he appeared to compare Mario Draghi’s bond buying programme with the Goethe’s classic, where the money printing solves the kingdom’s financial problems but the tale ends badly with rampant inflation.

S&P lowers India’s 2012 GDP growth fore-cast to 5.5 per centDeficient monsoon and poor investors’ senti-ment has resulted in S&P lowering India’s GDP growth forecast to 5.5% for 2012-2013. Last month Crisil also lowered the GDP growth fore-cast from 6.5% to 5.5% and Nomura, in June,

lowered its forecast to 5.8%. “Although Asia Pa-cific has recorded strong GDP growth relative to other global economies, we have observed a continued change in the region’s economic barometer,” said S&P ratings in a statement. “Additionally, the more cautious investor senti-ment globally has seen potential investors be-come more critical of India’s policy and infra-structure shortcomings. The latter was recently highlighted by the power outage in early August that affected 20 of India’s 28 states,” the credit rating agency added. However, Prime Minister’s Economic Advisory Council differed from S&P in their growth forecasts. The country’s growth rate is expected to pick up in the second half of this fiscal and reach 6.7 per cent for entire 2012-13, said Prime Minister’s Economic Advisory Coun-cil Chairman C Rangarajan. The agency has also lowered the GDP forecasts for number of Asian economies including China, Japan, Korea, Singa-pore and Taiwan recently. The move has further put country’s investment grade rating at risk.

RBI cuts CRR by 0.25% to unlock Rs. 17,000 croreRBI in its mid quarter monetary policy review cuts CRR by 25 basis points to 4.50% to inject Rs. 17,000 crore worth liquidity in the system. The CRR cut will be effective from September 22, 2012. CRR has been cut by 150 basis points so far in 2012 by the central bank in order to fuel growth of the economy. RBI left repo and reverse repo rate unchanged at 8% and 7% re-spectively. “Since the first quarter review, while growth risks have increased, inflation risks re-main…….In the current situation, persistent in-flationary pressures alongside risks emerging from twin deficits — current account deficit and fiscal deficit — constrain a stronger response of monetary policy to growth risks,” RBI said. The central Bank also appreciated Government for actions to spur economic growth and contain fiscal deficit.

The Niveshak Times

www.iims-niveshak.com 5NIVESHAKT

he Month T

hat Was

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

September 2012

6C

over

Sto

ryNIVESHAK6

Art

icle

of t

he M

onth

MARKET CAP (IN RS. CR)BSE Mkt. Cap 65,05,150Index Full Mkt. Cap 30,87,121Index Free Float Mkt. Cap 15,86,541

CURRENCY RATESINR / 1 USD 53.53INR / 1 Euro 69.03INR / 100 Jap. YEN 68.86INR / 1 Pound Sterling 86.82

POLICY RATESBank Rate 9.00%Repo rate 8.00%Reverse Repo rate 7.00%

Market Snapshotwww.iims-niveshak.com

RESERVE RATIOSCRR 4.50%SLR 23%

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.com31st August to 25th September 2012

Data as on 25th September 2012

Mar

ket S

naps

hot

CURRENCY MOVEMENTS

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

7C

over Story

NIVESHAK 7A

rticle of the Month

7C

over Story

NIVESHAK 7M

arket Snapshot

BSEIndex Open Close % ChangeSensex 17558.00 18694.00 6.47%

MIDCAP 5996.00 6483.00 8.12%Smallcap 6387.00 6903.00 8.08%AUTO 9338.00 10275.00 10.03%BANKEX 11550.00 13105.00 13.46%CD 6259.00 6732.00 7.56%CG 9519.00 10895.00 14.46%FMCG 5408.00 5314.00 -1.74%Healthcare 7468.00 7379.00 -1.19%IT 5752.00 5974.00 3.86%METAL 9778.00 10563.00 8.03%OIL&GAS 8298.00 8709.00 4.95%

POWER 1892.00 2033.00 7.45%PSU 6973.00 7426.00 6.50%REALTY 1518.00 1841.00 21.28%TECK 3253.00 3441.00 5.78%


Market Snapshot

% CHANGE

September 2012

8C

over

Sto

ryNIVESHAK8

Art

icle

of t

he M

onth

8C

over

Sto

ry

In the 15th August edition of the Business Stan-dard, Sajjid Chinoy, an economist at J. P. Morgan postulated the idea that the rupee’s slide against the dollar has underpinned a meaningful improve-ment of the trade deficit by a possible J-curve ef-fect where Indian exports have become more com-petitive in the world market and certain imports have been significantly substituted. Against such a tide-turning backdrop, we explore whether it really makes sense to open up India’s capital account for free two-way investment. CAC convertibility has been an age-old question in India’s economic story ever since the freeing of the capital account (ba-sically enabling citizens to exchange currency at market rates) revived the economy from the brink of insolvency in 1991.

The capital account is composed of four constitu-ents- FDI, Portfolio investment, Debt investment (bank A/C loans, short term capital flows) and the Reserve account. Capital account convertibility (CAC) denotes the extent to which local assets can be converted into foreign capital assets at market determined rates of exchange. A fully convertible rupee on the capital account implies a free flow of assets to and from the country at the market determined currency exchange rate, independent of the amount being transacted. The advantages of CAC are evident- businesses would be able to

borrow at interest rates much lower than those offered locally, the ease of access to fast moving capital which would help improve the efficiency of local operations and firms would also be able to expand their operations abroad to tap into the overseas markets. Additionally, there would now be minimal transaction costs involved in dealing with securities denominated in a foreign currency. The investments made by overseas corporations in India would spur domestic growth and would indi-rectly lead to a higher national income. On the flip-side, the consolidation of foreign firms in the In-dian market space may affect sustainable internal growth. Also, Indian transnational companies may choose to invest abroad and cut down on domestic investments. On the other hand, even these dis-advantages are relatively minor compared to those described later in this article.

Reviewing the current scenario for CAC, the RBI has laid certain guidelines-

i. The CAC would be aimed at benefitting those for-eign firms which plan to invest more than $500,000

ii. Investments should be in semi-liquid assets (such as long term bonds) or liquid assets tied to static ones

iii. Foreign institutional investors (FIIs) cannot use CAC to manipulate exchange rates

8A

rtic

le o

f the

Mon

thNIVESHAK

IIM CalCuttaTanay Deshpande

Full Capital Account Convertibility:

A double edged sword?

Capital account convertibility (CAC) denotes the extent to which local assets can be converted into foreign capital assets at market determined rates of exchange


9C

over Story

NIVESHAK 9A

rticle of the Month

9C

over Story

9A

rticle of the Month


9

iv. National banks are to provide collateral for capi-tal flows headed in or out of India

v. Furthermore, the RBI has deemed it necessary that India must have a sound banking system, a low fiscal deficit, tight regulatory surveillance on lending export competitiveness and sufficient im-port price elasticity before implementing full CAC

However, in reality, a formal CAC would make little difference to retail Indian investors. Though Indian citizens cannot directly invest in foreign equities, they can still do so via the route of internation-al mutual funds. Also since 2002, India’s foreign exchange policy allowed domestic companies to enter into mergers and acquisitions abroad with-out any case by case permission from the govt. Currently, direct investment by an Indian compa-ny can be upto 400% of Net Worth and portfolio investment upto 50%; besides mutual funds can invest upto $7b overseas. Some firms such (e.g.- Tata Motors) have also been listed on exchanges abroad such as the NYSE. Besides, In fact, in most emerging economies, the concept of partial CAC is implicit, without making it a formal arrangement of economic and fiscal policy.

Now, we head to the next level of the argument- CAC has been shown in the past to have a deeper effect on short-term FII capital flows rather than long-term FDIs. FDIs are much less liquid and have a more permanent impact on the real economy than FIIs, which are mostly directed towards port-folio & debt investment. The great dangers of FIIs lie in their short-term “hot money” speculative capital flows which can rapidly head in or drive out of an economy. This kind of large scale volatil-ity can lead to sudden shocks in a nation’s finan-cial system. The best examples of these kinds of capital shocks were manifested in the East Asian crisis of 1997, and more recently in the Argentine crisis of 2001.

In 1997, the East Asian Tigers were booming with a spectacular growth of 8-12% GDP. Their currencies were pegged to the dollar and interest rates were low since banks could borrow cheap and lend dear (in the form of US govt. bonds). As interest rates started increasing with growth and other avenues of investment such as Asian equity markets started opening up with CAC, investors from the US & rest

of the developed world started piling their capital into the Tiger countries. In the span of 1992-1997, external debt for this region had become nearly 40% of the GDP. Net private capital flows into the 5 nations had shot up by 150% to $97b, out of which short-term private inflow represented 80% of the net capital inflow. This tremendous deluge of cash had made the financial markets of the Asian Ti-gers extremely liquid while asset markets were being driven into bubbles of unprecedented size. Large CADs (current account deficits) piled up and the economy of these nations became so coupled with the external world that even a minor currency fluctuation could now pose serious systemic risks. And then, the tide turned. A hike in U.S. interest rates to curb inflation and a wave of speculation regarding the plausibility that the Asian economies could not meet their deficit targets any longer drove investors away in a sudden frenzy. And soon enough, the prophecy that the East Asian nations might default on their debt became self-fulfilling. Speculators aggressively charged in by shorting the Asian currencies and by the end of 1997, these 5 nations had a net outflow of private capital worth $112b, which amounted to a complete turnaround of $109b in 2 quarters from July to December 1997. The result was massacre. Malaysia’s overnight lending rate skyrocketed to 40% due to a liquid-ity crunch. The Kuala Lumpur Stock Exchange fell by 50% and the Ringgit simultaneously devalued by 50%. The Rupiah depreciated 86% against the USD leading to a market capitalization of 75% be-ing wiped out from the stock exchanges as the contagion spread to the real economy. Meanwhile in Thailand, the stock markets collapsed by 75%.

In another continent four years later, even when the Argentine govt. had followed IMF procedures to the hilt for opening up its economy- to the extent that even public sector corporations were foreign owned, paying hardly any tax to the government and currency flowed freely in and out of the coun-try. The result was again disaster- debt expanded to 50% of GDP, yields spiraled upwards of 60% and the Argentine economy faced negative GDP growth for 3 consecutive years. Finally better sense pre-vailed when Nestor Kirchner rose to presidency on

NIVESHAK 9A

rticle of the Month

CAC has been shown in the past to have a deeper effect on short-term FII capital flows rather than long-

term FDIs

September 2012

10C

over

Sto

ryNIVESHAK10

Art

icle

of t

he M

onth

10C

over

Sto

ry10

25th May 2003 and applied Keynesian economics to devalue the peso, attract FDI, rely on import substitution and start building a war chest of forex reserves to cover debt restructuring.

All these instances regarding the hazards of CAC serve to illustrate the Impossible Trinity of public finance. An economy cannot simultaneously con-trol both, domestic liquidity as well as the curren-cy exchange rate, if the currency is capital account convertible.

In the first case, if the rupee is CAC and the govt. holds down the USD/INR exchange rate, this will attract a massive influx of foreign capital which will put an upward pressure on the exchange rate. To counter this, the govt. can participate in open market operations which will mop up the foreign currency by selling bonds. Yet, this is a circle, and the sale of bonds will drive yields upwards, which can only attract more capital. Plus, the govt. incurs a slight loss as it sells the bonds for a coupon rate that needs to be marginally higher than the rate at which it will buy foreign assets to impedi-ment rupee appreciation. Yet it is known that such sterilization is only a temporary defense against speculative pressures on currency appreciation. The second flaw of sterilization is that the money that the central bank prints to absorb the foreign currency denominated liquidity will eventually find its way back in the nation’s economy through ex-ports. This can soon give rise to runaway inflation.

In the second case, if the rupee is CAC and the govt. allows the rupee to appreciate, this will make imports cheaper, preceding an imbalance of payments and as a consequence, rampant infla-tion. To counter this, the lending rates (such as the repo & the BPLR) will have to be increased by the RBI & commercial lending institutions and this will in turn drive the currency upwards even faster. Again, the cycle is unsustainable and the trinity of financial aims cannot be simultaneously achieved.

Instead, if we take a third case where the rupee begins to depreciate even as it becomes CAC, the scenario is even more hazardous. If the govt. tries to restrict the fall of the rupee in a capital convert-ible open market, speculators will swarm around the economy, heavily shorting INR, just as in the case of the East Asian crisis of 1997. This will cause the govt. to hold up the rupee by buying foreign currencies and assets and such open market op-erations at an unreasonable value of the USD/INR will finally end up depleting the forex reserves in India’s treasury. Again, this will be a terrible waste of taxpayers’ money. Likewise, if the govt. allows the rupee to slide, at least initially, the balance of

Art

icle

of t

he M

onth

NIVESHAK

trade will get skewed against India’s favor. This will cause a capital flight, deflation and a slowdown of the economy as the very reasons for which CAC was introduced would get eliminated. Foreign cor-porations would enter and consolidate the Indian domestic market and Indian businesses would never be able to compete with an undervalued currency. This scenario is very different from that of a closed economy such as China where currency devaluation would actually be welcome, which is also pointed out by the J-curve effect.

Hence, the only rational way to approach CAC is to impose a measure of capital control. Capital control essentially uses one of three routes- prohibition, transaction taxes or govt. clearance for capital flux. Control is, in effect, the antithesis of full CAC. As is demonstrated by all the instances above, only an equilibrium combination of both can propel an economy towards stable growth. Methods to slowly implement CAC would be to first introduce domestic liberalization reforms before opening the external market. Many Indian businesses are shift-ing abroad simply because of the lack of operating efficiency in India compounded by policy paraly-sis, red tape and corruption. Opening up to CAC in such a situation where the rupee is naturally slip-ping against the dollar can cause immediate capi-tal flight and a sudden stop of domestic growth as Indian businesses themselves move out.

However, in the end, the Indian economy must finally open up slowly to the world of interna-tional finance. A reduction in FDI inflow & outflow has gone hand in hand with a slowdown of GDP growth, a sharp decline of the rupee and increas-ing fiscal deficit. Foreign entrants can certainly make the market more competitive and efficient. Hence, the only way to go about CAC is with warily with prudence, opening up only those sectors of the economy which need the reforms and by en-couraging long term FDI as opposed to short-term capital flow. Long term debt contracts can also be encouraged and India needs to hold a war-chest of forex reserves with a credit-worthy and sound baking system before implementing CAC.

Perhaps then, the route chosen by the RBI may prove to be the wisest. Probably, it might be better to wait, watch and learn for when the Indian econ-


11C

over Story

NIVESHAK 11A

rticle of the Month

11NIVESHAK 11


11NIVESHAK 11

growth. The Central Bank, in such a situation, may fall back on its last resort to bring the economy on the path of growth. It would do this by perform-ing quantitative easing. QE requires purchasing of a pre-determined amount of bonds or other assets like long-term Treasuries or mortgage-backed securi-ties from commercial banks and other institutions. This artificially injects money into the system. As the Central Bank purchases bonds, its demand increas-es. With an increase in demand, the yield on bonds falls, thereby making it less attractive for the banks to invest in them. The investment proposals of busi-ness houses now appears more productive to them, and they readily extend credit. With the multiplier in operation, this gives a huge impetus to growth, and pulls the economy 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.

Impact of QE1 and QE2

As per a recent research, QE has certainly been mar-ginally effective in boosting the economic growth, but it has not been as effective as it was first pro-jected.

The US Federal Reserve formally announced the em-ployment of QE during the financial crisis in March 2009. It expanded the assets on its balance sheet from $800 billion to $2.93 trillion at the beginning of 2012 through a successive round of QE. These are popularly known as QE 1 and 2. The motive behind the policy was to boost the economy by shooting up credit and liquidity into the balance sheets of finan-cial institutions and corporations thereby making an effort to reduce the credit crunch and the liquidity

Cover Story

teaM NIveshak

Rakesh Agarwal & Akanksha Behl

Meaning of quantitative easing – the Cen-tral Bank’s last resort

The monetary authority of any country can control the supply of money in the economy thereby affect-ing the interest rates prevailing in the economy. This is done for the purpose of promoting growth and stability in the economy. The monetary policy can be both expansionary and contractionary in nature with the aim of inviting businesses to expand or with the aim of curbing inflation. Mostly the Central Bank increases or decreases the money supply by buy-ing or selling government securities or other securi-ties from the market. Quantitative easing (QE) is an alternative monetary policy used by central banks to stimulate the national economy when traditional monetary policy becomes ineffective. QE 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.

How and when does quantitative easing take place

Quantitative Easing is used when the economy is in a deflationary mode and the interest rates reduc-tion doesn’t curb deflation. Also, there is no further possibility of decline in the interest rates and the economy is still struggling. This situation is known as ‘Liquidity Trap’. The banks are reluctant to lend funds to businesses as they fear they will default. They prefer investing in government treasury which is safe and also provides a healthy return. Due to this, business houses are deprived of funds which further results in a deceleration in investment ac-tivities and thereby leads to a further decline in

on emerging economies

QE3 and its impact

September 2012

12C

over

Sto

ryNIVESHAK12

Art

icle

of t

he M

onth

Cov

er S

tory

effect in nominal terms. However, the dollar has been weakened due to employment of QE. Fed hasn’t been successful in reducing unemployment and it still pre-vails at a whopping 9%. Fed has also not been able to create a maintainable economic retrieval. The private sector still remains weak and can’t make up for the reduction in fiscal spending in the short term to keep the economy recuperating out of the stagnation at a sharp pace.

Quantitative Easing 3

The third round of ‘quantitative easing’ by the Fed comes only days after the European Central Bank com-mitted to a fresh programme that allows it to execute potentially unlimited sovereign bond-buying, a widely-expected bid to save the region’s currency. The prelim-inary idea behind another round of quantitative easing by the Fed is to boost ‘aggregate demand’ by putting more money in the customer’s pocket.

In its third round of QE, the Fed plans to buy $40 billion in mortgage-backed securities (MBS) every month for an indefinite period till the economy improves and un-employment reduces to an acceptable level. By buying mortgage-backed securities, it plans to lower interest rates for homeowners and other long-term buyers.

trap caused as an aftershock of the downfall of the investment bank Lehman Brothers and the downturn that followed. The Fed did so by increasing the mon-etary supply through expanding the liabilities on its balance sheet and using the new credit to buy assets such as bonds, bank loans and mortgage backed se-curities, which had become illiquid in the wake of the catastrophe. It was hoped that the increased credit li-quidity would make financial institutions more willing to lend money to other institutions and businesses, lowering interbank lending rates and thereby provide economic stimulus without causing excess inflation.

In November 2010, Fed announced the second round of quantitative easing, also known as QE2. It bought another $600 billion in long term treasuries over a pe-riod of 8 months.

As per IMF, “QE 1 and 2 have improved market confi-dence and reduced systematic risks in financial sys-tems during the credit crunch in 2008 to 2009 in the G7 countries, which includes US and Britain.”

Moreover, it has been observed that through QE, Fed has been able to maintain low interest rate on treasur-ies despite a massive increase of 30% in public debt. Also, it has stirred stock prices and created a wealth

Fig 1: Effects of quantitative easing Fig 2: FED balance sheet - S&P 500

Fig 3: Civil employment-population ratio


13C

over Story

NIVESHAK 13A

rticle of the Month

13C

over Story

NIVESHAK 13A

rticle of the Month

13C

over StoryNIVESHAK 13

including faster payment of export tax rebates and boosting loans to exporters by cutting interest rates in June and July and injecting cash into money mar-kets to ease credit conditions to support an economy that notched a sixth straight quarter of slower annual growth, at 7.6 per cent, in the April-June period.

Economic stimulus measures such as QE3 lower the value of the U.S. dollar and other fiat currencies. From that, investors flee paper assets for commodities such as oil, grains and precious metals. Thus, commodity prices like that of oil, food and precious metals go up, since “hot money” floods into them. Investors seeking protection from inflation, invest in gold; driving gold prices further. As a result, India which is the fourth largest importer of oil and largest importer of gold will face adverse effect on its trade balance deteriorating the already rickety financial condition (current account deficit) of the country. There is high probability that inflation which has remained persistently high may re-gain momentum on the upside bringing all the work put in by RBI to naught. In face of the adverse eco-nomic scenario, India was forced to adopt the path of economic reforms like reducing subsidy on diesel and LPG, increasing FDI limits in aviation, retail and broadcasting to revive the economy in spite of severe political backlash.

Meanwhile, Brazil, Russia, and other emerging econo-mies are experiencing a similar situation. Weakness in advanced economies has reduced room for export-led growth and delayed structural reforms which are needed to boost private-sector development and pro-ductivity growth. This has dented investor confidence. So the recent slowdown of growth in emerging markets is not just cyclical, owing to weak growth or outright recession in advanced economies; it is also structural.

What is needed in reality, are structural reforms that can not only spur the economy but also reduce per-sistently high unemployment in a sustainable manner for time to come.

However during the earlier quantitative easing pro-grams by Fed, inflation in emerging economies soared on an average, particularly in China and India, while job growth in US hardly showed any signs of recovery. Thus, precedence certainly lay to rest any hope that the third quantitative easing would be any different and actually achieve its said purpose.

However, this time around the Fed has targeted hous-ing finance in order to prop up the faltering labour market and has pledged the ultra-low rates regime (between 0 and 0.25 per cent) to continue till mid-2015. This is an ambitious response by the Fed and certainly a step in the right direction as it differs from the first and second QE programmes; however it re-mains to be seen if the plan would be successful.

Few concerns that have been raised repeatedly but never addressed include the risk of inflation and price rises in future and rationale for continuing the policy of low interest rates that hurt savers.

Following in the footsteps of the Fed, Bank of Japan also announced easing of monetary policy to support an economy feeling the pinch from a strong yen, wid-ening fallout from Europe’s debt crisis and the more recent tension with its major trading partner China. BoJ has increased its asset buying and loan programme, currently its key monetary easing tool, by 10 trillion yen to 80 trillion yen, with the increase earmarked for purchases of government bonds and treasury discount bills.

All this monetary easing is certainly going to glut the global market with liquidity and fuel more speculation if proper checks and balances are not put in place.

Impact of QE3 on emerging economies

With QE3, dollar will once again flood the global mar-ket and invariably find its way into the emerging econ-omies that provide huge potential for growth. This will lead to pressure on export-oriented economy like Chi-na that will certainly experience currency appreciation. To counter, China in-turn unveiled a series of its own measures last week to help stabilise export growth,

Fig 4: Inflation in major emerging economies

September 2012

14 NIVESHAKC

over

Sto

ry14

Art

icle

of t

he M

onth

14 NIVESHAKC

over

Sto

ry14

Art

icle

of t

he M

onth

14 NIVESHAKC

over

Sto

ry14

Art

icle

of t

he M

onth

14 NIVESHAKC

over

Sto

ry14

FinG

yan

tlements in Yuan and thus freeing themselves from undertaking the foreign exchange transactions. Al-lowing Chinese banks, for their part, to do interna-tional transactions in Yuan will allow them to grab a bigger slice of the global financial pie.Also, the status of dollar being safe haven is now lost mainly due to the financial crisis and the fed-eral debt approaching 75% of US GDP.Reasons for decline of US Dollar as Reserve currency:From Fig 1, it is evident that the share of US Dollar as the world’s reserve currency is facing a gradual fall and has come down from 75 % in the late 90’s to around 58% in the last quarter of 2011.

As shown in Fig. 2, the same duration saw growth of the Euro as an emerging reserve currency.

Also, the last few years have seen an increasing use of Yuan in settling Chinese trade. Fig. 3 shows an increasing use of Yuan in settling Chinese trade from the Q1 of 2010 to Q4.

So based on these figures and statistics, we can enumerate some of the reasons for the decline of Dollar as Reserve currency:

1. Dumping of Dollar as the reserve currency in bi-lateral trade by China, Japan and BRICS nations.

2. Chinese and the Russians have been using their respective currencies for trade.

3. China and UAE have decided to ditch US Dollar and to use their own currencies in oil transactions.4. Despite sanctions against Iran by the Western

What is Reserve Currency?A currency which is held in considerable quan-tities by different governments as part of their foreign exchange reserves. It is also used for the products traded in global markets such as oil, gold etc. Reserve currency is also called as ‘An-chor Currency’.US Dollar as Reserve Currency:Traditionally, US Dollar has been regarded as the reserve currency and for more than 50 years it has been the currency of choice used by various nations of the world to facilitate trade involving commodities such as petroleum, manufactured products and gold. This stature has had tremen-dous benefits for the U.S. financial system and the consumers, and it has given the U.S. govern-ment tremendous power and influence all over the world. Today, more than 60 percent of all for-eign currency reserves in the world are in U.S. dollars. The Dollar became so dominant because of the following reasons:

• The ease of availability of derivative instruments to hedge dollar exchange-rate risk and this makes the dollar the most convenient currency for cor-porations, central banks and governments alike.

• Dollar is world’s safe haven and during the time of crisis investors instinctively returns to it.

• Dollar gained heavily from the dearth of alterna-tives. Threats faced by US Dollar:There has been a growth of viable alternatives: Euro and Chinese Yuan. With the changing times, market has evolved significantly and today, there is scope for more than one international currency to function simultaneously.

Recently there have been precedents where ma-jor oil producing nations have glided away from using dollar and this constitutes a major threat to petrodollar. Apart from this there have been reports from International FI’s like UN and IMF, is-suing the need to move away from the US Dollar and towards a new world reserve currency.

A lot of this threat emanates from China, world’s 3rd largest economy. Seventy thousand Chinese companies are now doing their cross-border set-

Is it the end of Dollar as world’s reserve currency?

lal bahadur shastrI INstItute of MaNageMeNtShubham Singh

Fig 1: Dollar Value Share of foreign exchange reserves in %


15C

over Story

NIVESHAK 15A

rticle of the Month

15C

over Story

NIVESHAK 15FinG

yan

world, the trade with Iran continues to be im-portant aspect of many nations. Indian and Ira-nian deal of payment in Gold for the oil transac-tion is one such example of that.5. Increased stress from international institu-tions like IMF and UN pitching in for the emer-gence of a new world currency.6. China is the largest importer of oil from the Saudi Arabia, importing 1.39 million barrels of oil every day. Also there has been consider-able Chinese investment in Saudi Arabia for the development of oil refineries. Hence, there is a possibility that this growing partnership will take deal away from petrodollar.Impact on US EconomyAs the world moves away from the US dollar, there will no longer be an automatic jump in the value of US Dollar and this will have an adverse impact on the other major economies during the time of volatility surges.With Dollar, Yuan and Euro being used as Re-serve currency, no single currency will rise as strongly as the Dollar did. The impact would be severely faced by the US companies who until now had the convenience of using their currency to pay their workers, im-porting parts and components, or selling their products to foreign customers. As of now they don’t have to incur the cost of changing foreign-currency earnings into dollars or bear losses due to changes in the exchange rate but this will all change in the brave new world that is coming. American companies will have to cope with some of the same exchange-rate risks and exposures as their foreign competitors.Conversely, life will become easy for European and Chinese companies and this will lend them competitive advantages.Another important aspect for US economy would

be its failure to finance it budget deficits so cheaply in the event of decline in the demand for the US dollar. Also U.S. will not be able to maintain such large trade and current-account deficits, as financing them will be very expen-sive. Reducing the current-account deficit will trig-ger increased exports which will make US goods more competitive in the global markets. This would mean that dollar will have to fall in the Forex markets thereby helping US exporters.ConclusionWith the changing financial situations and evolv-ing markets, Dollar is no doubt facing a serious threat in being the reserve currency of the world. However, favourably for US, recent turmoil seen in the European markets might have slowed its decline. Still, the major threat comes from Yuan. With its stature as an emerging power and with its new deals in the oil exporting countries, China will soon play a stronger role in world economy and the coming times might see Yuan emerging as an alternative reserve currency.

Fig 2: Euro Value Share of foreign exchange reserves in %

Fig 3: Increasing use of Yuan for trade settlement

September 2012

16C

over

Sto

ryNIVESHAK16

Art

icle

of t

he M

onth

Pers

pect

ive

In 1598, William Shakespeare scripted the rib-tickling comedy “Love’s Labour’s Lost”. The world has seen an unprecedented paradigm shift by then. But, now, the history seems to re-peat itself. This time around, Barclays comes up with an ad nauseam thriller, “LIBOR’s Labour’s Lost”.PreludeDuring the late 1984 and early 1985, the finan-cial world felt an inalienable need to provide a standardized rate to facilitate the ever increas-ing usage of new financial instruments such as interest rate swaps, foreign currency options, and forward rate agreements, that’s when LI-BOR, or the London Interbank Offered Rate, was born. Countries that rely on the LIBOR for a ref-erence rate include the likes of United States, Canada, Switzerland and the U.K. LIBOR is the average interest rate estimated by leading banks in London. The Banks charge this rate for lending credit to other banks in the Lon-don Interbank Market. For instance, a multi-na-tional corporation (MNC) with a very good credit rating may be able to borrow money for one year at LIBOR plus four to five points. LIBOR is calculated and published by Thomson Reuters on behalf of the British Banker’s Association (BBA) after 11:00 AM (usually around 11:45 AM) each day (London time) on a daily basis wherein they survey interbank interest rate quotes by 16 large banks. The submitted rates are, then, ranked and the mean is calculated using only the two middle quartiles of the ranking. So, if 16 rates are submitted, the middle 8 rates are used to calculate the mean. The calculated mean becomes the London Inter-bank Offered Rate for that particular currency, maturity, and fixing date. The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market. It is published for various currencies and for maturi-ties ranging from overnight to one year.

BBA follows a typical, believed by many as im-maculate, method for calculating the sacrosanct LIBOR for the day. LIBOR plays a much crucial role by not only providing information about the cost of borrowing in different currencies but it also actually influences it. LIBOR, the lingua franca of

the banks helps them in figuring out what they should charge for not just home loans, but car loans, commercial loans, credit cards. Plot (LIBOR… Lie More?)So far the LIBOR’s journey was a dream run. Right from its inception, it has enjoyed fame and acceptance in a world where change is the only constant. But, all was not rosy as it ap-peared. As every flick has its protagonist, this story had the Wall Street Journal (WSJ) as its saviour. In 2008, WSJ released a controversial study suggesting that some banks might have understated borrowing costs they reported for LIBOR during the 2008 credit crunch that may have misled others about the financial position of these banks. To obliterate gloomy economic scenario, banks showed lower than actual interest rates. The lower interest rates therefore resulted in lower LIBOR and thus heaved up the confidence and increased lending. As LIBOR is the average of the interest quotes by different banks, so rigging of LIBOR would have involved many banks. Why was the rate rigged in the first place? A close examination into the issue transpired that Barclays was itself facing rising interest rates; had it provided the same rates to BBA, it would have created an unhealthy picture on the bank’s financial stability and liquidity issues it was fac-ing would have surfaced. So, in order to protect its own interest Barclays resented on reporting (read rigging) lower rates so as to present a merrier outlook to the outer world. The rigging happened between 2005 and 2009, as often as daily.Creating a bang in the already turbulent banking world- thanks to Euro crisis, the WSJ report on rigging was welcomed with raised eyebrows and harsh criticisms. A fast-paced turns of events ranging from staunch investigations into the conversations of Barclays’ CEO Bob Diamond and the Deputy Governor of Bank of England to the Barclays’ public admittance of the rig-ging, the world witnessed abdication of three stalwarts of Barclays from the throne. Barclays Bank was fined a total of £290 million (US$450 million) for attempting to manipulate the daily settings of LIBOR.

NMIMs, MuMbaI

Anuj Narula & Prakash Nishtala

LIBOR’S LABOUR’S LOST


17C

over Story

NIVESHAK 17A

rticle of the Month

17C

over Story

NIVESHAK 17Perspective

What’s the big deal?Upshots on proletarian: If LIBOR is very high that means one needs to dish out more to avail the credit. If it’s maneuvered towards a lower rate, it implies that your interest earnings on savings account would be subdued. Hence, in either ways, a manipulation would lead to common man’s loss.As it is used as a benchmark for deciding various rates across numerous banks including central banks or even EURIBOR, so at a macroeconomic scale, it has the potential to create many ripples in financial assets worth $500 trillion.Mumbai Inter-Bank Offered Rate (MIBOR) - The Younger BrotherIn India, as the financial markets started devel-oping, the need for a reference rate in the debt market was felt. The National Stock Exchange (NSE) on 15 June 1998, developed the Mumbai Inter-Bank Offered Rate, referred to as MIBOR, on the lines of LIBOR.

These rates are calculated by a combination of two methods—polling and bootstrapping. In the polling method, like in the case of LIBOR, the data is collected from the panel of 30 banks which has a mix of public sector banks, private sector banks, foreign banks and primary deal-ers.

How safe is MIBOR?As MIBOR shares a similar DNA as that of its elder brother LIBOR, it might also have a little room to get manipulated.

But, MIBOR has its own merits over LIBOR which makes it a bit safer. Firstly, instead of omitting 2 highest and 2 lowest rates as is done in case of LIBOR, NSE uses a statistical technique called bootstrapping to separate the outliers and de-termine the mean rate. It is expected to help against any attempt by the market participants to come together and influence rates. Secondly, though in a less extent, the very fact of Indi-an banking system being largely dominated by public sector banks makes one to believe that MIBOR could not be affected by private players to satiate their own interests.

Learning from LIBOR scandalPrior to the exposure of scandal, proponents of LIBOR were too confident about its piousness. Promoters of MIBOR such as Reserve Bank of India (RBI) should act proactively to tighten the possible loose links and to cover the undiscov-ered loopholes.

The case in point is the possible switching over of MIBOR calculation to actual dealt rates on a trading platform. As India has online, screen-based trading of money market instruments such as call money, unlike voice-based markets in many countries, it makes sense to move to a transparent, actual screen based traded rate system which could capture actual MIBOR lev-els. EpilogueAs the Shakespeare’s classic had not only the King of Navarre involved in the promiscuity, he had an unflinching support from his three noble companions as well, on a similar line, even in this story Barclays is not forlorn, they reported-ly, have support from many other players (refer to Exhibit 1) of the game. The immediate action in the current context should be to identify the hidden miscreants and subject them to serious punishments. What we require today from regulators is not merely whipping fines on the perpetrators rath-er a system should evolve wherein there is no scope for manipulation at all. The world is now hopeful that one day, prefer-ably sooner than later, the system should get clear of all the malpractices and the market par-ticipants can again reinforce their faith in LIBOR.The time must come sooner when we could say, “LIBOR’s LABOUR’s WON!”

Fig 1: Benchmark Interest rate Libor calculationSource: chasvoice.blogspot.com

September 2012

18C

over

Sto

ryNIVESHAK18

Art

icle

of t

he M

onth

18 NIVESHAKC

over

Sto

ry18

Fins

ight

This article is a synopsis of the performance of the real estate sector in India during the last de-cade. It begins with the transformation of the sector from being family run businesses to hav-ing a professional struc-ture. During the financial crisis in the US, the real estate stocks had fallen drastically but more than four years down the line, they haven’t been able to recover. There has been a massive erosion of wealth for the inves-tors. The article tries to highlight the reason be-hind the fall and what can be done to improve the sector.

pects along with large land banks as the reasons for high issue prices. Fig-ure 1 shows the comparison of the book values vis-a-vis the issue prices. The companies justified it as their discounted value of future earnings. All the companies issued a very little percentage of their share capital as part of the IPO.The IPOs were over-subscribed up to 3 times in many cases. In retrospect, the causes for such enthusiasm can be attributed to the following events:• Government allowing FDI of up to 100% in the sector.• Repealing of the Urban Land Ceiling Act in certain parts of the country. • Positive outlook about India’s eco-nomic growth.The Tumble Begins:After reaching astronomical heights, the share prices saw their first fall in the beginning of 2008, when news about the fall of banks in the US start-ed coming. As the real face of the cri-sis evolved, stock markets all over the world tumbled and prices fell sharply. The BSE Realty Index fell from a high of 13848.09 in January 2008 to its close of 1227.13 by the end of the year.

Family run businesses are going on to become some of the largest cor-porations of India, dividing the gains among all its stakeholders. Sounds like India “shining” right?That’s precisely what the real estate companies promised investors while coming out with the IPOs. That was during the years 2006 and 2007 in the midst of the real estate boom. Those who had missed the IT bandwagon did not want to lose another chance at what seemed to be the next big thing. The talk of the town was Roopa Purushothaman’s report on the future of India’s economy.The two most important facets of a growing economy are power and in-frastructure. According to the census of 2001, 27.82% of the population lived in Urban India, where the land mass was just 2.34%. Tier II and Tier III cities were being developed to sup-port this ballooning population. The real estate companies started creat-ing large land banks in these areas to fuel their growth. A number of real estate companies came out with IPOs to cash in on this boom. Their red herring prospectus mentioned double digit growth pros-

taPMI, MaNIPal

Avirup Chatterjee

The RealiTy of RealesTaTe Companies

Fig 1: Book value Vs Issue price


19C

over Story

NIVESHAK 19A

rticle of the Month

19C

over Story

NIVESHAK 19Finsight

By mid 2009, the markets had substantially improved but a look at the realty index would make one feel as if the storm was yet to pass. It has now been more five years that most of the real estate companies came out with their IPOs, but none of them have even recovered their ini-tial listing price.The rumble behind the tumbleIt is a surprise today as to why the markets back then did not recognize the signs showing the prices being inflated. The most important reasons for their failure can be summarised as follows:• Sales figures inflated by sales to subsidiaries/holding companies: Example: DLF Ltd’s top line increased by 224.81%, from Rs 1,242 crores in March 2006 to Rs 4,034.1 crores in March 2007. Of this Rs 2,207.1 crores came from sale of assets to DAL, one of its pro-moter group companies. Incidentally, their IPO came out in July 2007. It puts a question mark on the policies adopted by them. Was it done to show robust growth just before the IPO? The debate is left to the readers. • Grossly overvalued:The companies were valued on the basis of NAV (Net Asset Value) models. The expected earn-ings from the future projects were discounted to arrive at the NAV per equity share. This formed the basis for deciding the issue price. The oth-er comparisons used were the peer group P/E ratios. Everyone was following the script. The companies listed at that time were trading on P/E ratios as high as 174.4. Comparing this and arriving at an issue price on the basis of that was gross overvaluation. • Rating Agencies:The companies were given “strong buy” or “buy” recommendations by most of the rating agencies. It is hardly a secret that the rating agencies have their own interests, which more

often than not come directly in the way of un-biased analysis.The result is out there for all to see. Figure 4 shows the issue price and the present prices of some of the major real estate players in India, making it clear that a lot of wealth has been eroded from the markets.Solving the JumbleReal Estate sector in India is the second largest employment generator, next only to agriculture. The real estate sector contributes to about 5.3 % of India’s GDP. Despite its size, the sector is grossly unregulated. Involvement of black mon-ey, Ponzi companies cheating customers and the like are regular headlines now. The govern-ment as well as the real estate companies need to join hands to form regulations that ensure growth as well as the safety of stakeholders in this sector.

The Real Estate Bill, already drafted, could not be presented in the Parliament because of the reservations of some states. Getting a legisla-tion passed on this is very important. After the sector was opened to FDI, there has been a sub-

Fig 2: The IPO’s as a % of post issue capitalFig 3: BSE realty

September 2012

20C

over

Sto

ryNIVESHAK20

Art

icle

of t

he M

onth

NIVESHAK

stantial inflow of investment into the country. At the same time, these investors need assurances that the sector is transparent. “In 2011, the RBI introduced strict and ponderous rules for bank lending to the real estate sector and this has made it even more expensive and cumbersome for banks to extend loans to real estate devel-opers. Compared to developed economies, India still does not allow Real Estate Investment Trusts (REITs) and Real Estate Mutual Funds (REMFs)”.

Over the centuries, most wars have been fought over land disputes. Today we see protests hap-pening across the country over land acquisition. The real estate developers should keep in mind that they are building homes for people on the land of others. They have a social obligation to see that the affected people get adequate reha-bilitation. It is high time that an independent regulator is set up to look after the functioning of the real estate companies. The regulator may consider setting up a public portal for monitor-ing real time projects. The financial dealings in various projects need to be made transparent to prevent the inflow of black money into this sector. This will not only help buyers make an informed choice but also will give confidence to equity investors about the governance of the companies.

20C

over

Sto

ry20

Fins

ight

Fig 4: Issue price and the present prices of some of the major real estate players in India

FIN-Q SolutionsJuly 2012

1. Dundee Mutual Fund

2. Vatican’s Coin has the phrase printed on it

3. ANCON

4. Asset Stripping

5. Klaus Schwab

6. Starwood Capital Group Global, LLC

7. Iceberg Order - Place orders in small lots

8. Samit Ghosh

9. Robert Diamond, Barclays

10. Spain


21C

over Story

NIVESHAK 21A

rticle of the Month


21C

over Story

NIVESHAK 21A

rticle of the Month


21C

over Story

Sir, I was reading about a recent earthquake and came across a term called CAT bonds. Could you please explain what CAT bonds are?

Well, CAT bonds are short for Catas-trophe Bonds. It is a high yield debt instru-ment, which is usually insurance linked and meant to raise money in case of a catas-

trophe such as an earthquake. Usually Insurance or reinsurance companies issue these bonds to various investors. This helps them transfer a part of their risks to the investors. Insurance companies can further in-vest this money generated through the issue of these bonds.

They were created in the mid-1990’s after the Northridge earthquake and Hurricane Andrew. In case of such a major catastrophe, insurance companies would incur damages which cannot be covered by the premiums and returns from investments using the pre-miums. In order to alleviate such risks, CAT bonds have been designed.

Oh I see. But how are they different from Regular bonds?

Good question. An insurance com-pany issues CAT bonds through an invest-ment bank, which are subsequently sold to investors. Unlike regular bonds where the

principal is guaranteed to be returned at the end of the tenure, there is a special condition called as Trigger condition which determines if the investor stands to gain or lose at the end of the tenure of the bond. For example, if no catastrophe occurs during the tenure of the bond, the insurance company will pay a coupon to the investors and return the principal at the end of the tenure. However, if a catastrophe does occur, then the investors will have to forego their principal and the

insurance company would use this money to pay their claim-holders.

But won’t such bonds be very risky as the investor stands to lose everything in case the catastrophe occurs?

Yes, that is a very valid observation. CAT bonds are often rated based on its probability of default due to a qualifying catastrophe, resulting in a loss of princi-

pal. Catastrophe models are used to determine the rating. Most CAT bonds are generally given a rating of BB or B by credit rating agencies which are below the investment grade limit of BBB-.

Agencies such as Standard & Poor’s and Moody’s are responsible for the credit rating of CAT bonds.

Given their riskiness, why would somebody invest in such bonds?

These bonds often offer a higher re-turn than other instruments in the market. CAT bonds usually offer a coupon of LI-BOR (London Interbank offered rate) plus a

spread which can be as high as 20% in some cases.

Investors choose to invest in CAT bonds be-cause their return is largely uncorrelated with eco-nomic conditions and the return of investments in other fixed income or equities. So CAT bonds help investors diversify their risk.

I haven’t heard a lot about these bonds in the Indian media. Are they available in India?

No. These bonds aren’t available in India yet. They are largely issued in the developed world.

India is exposed to windstorms, floods, earthquakes and other perils and hence the use of CAT bonds to mitigate natural disaster risks seems to be likely in the near future.

CLASSROOMFinFunda

of the Month

CAT Bonds

NIVESHAK 21C

lassroomIIM Shillong G. S. N. Aditya

September 2012

2222

F I N - Q1. A momentum based strategy, this type of trading involves focusing only on the

short term outlook of the market. It is an advanced trading strategy.

2. A typical insurance policy devised specifically for sheep owners and allied busi-nesses who are indulged in the logistics of wool business.

3. X is an index used to assess the economic well being of the economy. It is cal-culated by aggregating the inflation rate and unemployment rate of the economy over a given period. A higher value of the index implies deteriorating economic climate.

4. Who is the first Indian woman to become the CEO of a foreign bank?

5. Identify. (Hint: Think basics of accounting)

6. The Tirupati Branch of Bank of Baroda has a unique offering in addition to its usual portfolio.

7. If Bullish and bearish are 2 ends of a continuum, what lies in the middle?

8. Who are the first two women to appear on the U.S. $1 coin?

9. Connect:

10. ______ options has features of both American and European auctions. The op-tion can be exercised only on predetermined dates, typically every month.

All entries should be mailed at [email protected] by 10th October, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

Article of the MonthPrize - INR 1000/-Tanay Deshpande

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 10th October 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

discussion » Also certain entries which could not make the cut to the Niveshak will get figured

on our Blog in the ‘Specials’ section

SUBSCRIBE!!Get your OWN COPY delivered to inbox

Drop a mail at [email protected]

ThanksTeam Niveshakwww.iims-niveshak.com

23


FIN - QPrize - INR 500/-

Neeraj GuptaXIME, Bangalore

COMMENTS/FEEDBACK MAIL TO [email protected]://iims-niveshak.comALL RIGHTS RESERVED

Finance ClubIndian Institute of Management, Shillong

Mayurbhanj Complex,NongthymmaiShillong- 793014

Date post:	23-Mar-2016
Category:	Documents
Upload:	niveshak-finance-club-iim-shillong
View:	217 times
Download:	1 times

Niveshak September Issue

Documents