"Role of derivatives market in attenuating underreaction to left-tail risk", Journal of Futures Markets (2024), 44, 484-517 (with Sumit S., Agarwalla, S. K.)
The anomalous negative relationship between left-tail risk measures and future returns has recently attracted the attention of finance researchers. We examine the role of the derivatives market in attenuating left-tail risk anomaly in India, where derivatives trade only for a subset of stocks. We find that the negative association between left-tail risk measure and future return is absent only in stocks having derivatives, indicating that derivatives trading hastens the diffusion of negative information into the stock prices. We find evidence that the information generation role of derivatives markets plays a primary role compared to investor inattention and limits to arbitrage.
"Harvesting the volatility smile in a large emerging market: A Dynamic Nelson–Siegel approach", Journal of Futures Markets (2023), 43, 1615–1644 (with Kumar, S., Agarwalla, S.K., Virmani, V.)
While there is a large literature on modeling volatility smile in options markets, most such studies are eventually focused on the forecasting performance of the model parameters and not on the applicability of the models in a trading environment. Drawing on the analogy of volatility smile like a term structure in the context of interest rates in fixed-income markets, we evaluate the performance of the Dynamic Nelson–Siegel (DNS) approach to modeling the dynamics of volatility smile in a trading environment against competing alternatives. Using model-based mispricing as our sorting criterion, and deploying a trading strategy of going long the options in the upper deciles and going short the options in the lower deciles, we show that dynamic models consistently outperform their static counterparts, with the worst dynamic model outperforming the best static model in terms of the percentage of mean returns from the trading portfolios and the Sharpe ratio. Specifically, we find that the DNS model consistently outperforms all other competing specifications on most of our selected criteria.
"Belief distortion near 52W high and low: Evidence from Indian equity options market", Journal of Futures Markets (2023), 43, 1531–1558 (with Sumit S., Agarwalla, S. K.)
We examine investors' behavioral biases and preferences in the options market near 52-week high and low (52W-H/L) using Indian options market data. We document that as the stock price approaches 52W high (low), the skewness of risk-neutral density (RND), and out-of-the-money (OTM) call volume decreases (increases), while OTM put volume increases (decreases). After crossing the 52W high (low), the skewness of RND and OTM call volume increases (decreases), while OTM put volume decreases (increases). The effects are economically large and significant. Our findings provide evidence consistent with the anchoring theory of belief distortion near 52W-H/L. There is no evidence of preference distortion, contrary to what prospect theory predicts.
"Choice of margin period of risk and netting for computing margins in central counterparty clearinghouses: a Monte Carlo investigation", Journal of Financial Market Infrastructures (2021), 10(2) (with Virmani, V.)
Given the increasing importance of central counterparty clearinghouses (CCPs) to developments in modern financial market infrastructure, in this study we provide a quantitative comparison for evaluating the impact of collecting margins in a gross versus net system with the margin period of risk (MPOR) set to between one and five days. Historically, gross and net margins have been used by different CCPs, and the two-day MPOR has been used to compensate for the leniency of the net margining system. Using a Monte Carlo experiment design, we analyze the trade-off between gross and net margins in scenarios where a large client of a clearing member defaults idiosyncratically and where defaults arise out of 'crowded trades'. We describe the conditions under which the longer MPOR does, or does not, offset the risks induced by net margins. We find that the level of client heterogeneity plays a crucial role in determining the trade-off. Our modeling framework encapsulates the complex multilevel margining system in a few parameters that CCPs and their supervisors can easily calibrate based on data privately available to them. Our simulation methodology could thus be useful for CCPs to analyze the effect of other changes to the margining system.
"Lottery and bubble stocks and the cross-section of option-implied tail risks", Journal of Futures Markets (2021), (with Agarwalla S.K., Saurav, S.)
The options smile provides forward-looking information about the risk at the center of the distribution (ATM-IV) and at the tails (Skew). We investigate the cross-sectional determinants of the options smile using indices that capture firm fundamental risks, heterogeneity in belief, lottery characteristics, and bubble characteristics. We find that at-the-money (ATM) volatility is explained mainly by historical risks and predicted future risks measured using accounting-based risk measures and firm characteristics. However, the cross-sectional variation in the skew is driven by risk premia and by buying and selling pressure, which is influenced by heterogeneity in belief and the underlying's lottery-like and bubble-like characteristics.
"Rational repricing of risk during COVID‐19: Evidence from Indian single stock options market", Journal of Futures Markets (2021), (with Agarwalla S.K., Virmani, V.)
Could the COVID-19 related market crash and subsequent rebound be ex- plained as a rational response to evolving conditions? Our results using multiple forward-looking measures of uncertainty implied from stock option prices suggest so. First, we find a gradual build-up of volatility during the month preceding the spike at the start of the pandemic. Second, while tail risk declined after government interventions, the level of uncertainty remained elevated for stocks across industries. Third, the dynamics of decline in tail risk in stocks was industry-dependent, suggesting that the market performed a fine-grained analysis of each stock's uncertainty through the pandemic.
"The impact of COVID-19 on tail risk: Evidence from Nifty index options", Economics Letters (2021), (with Agarwalla S.K., Virmani, V.)
We investigate the impact of COVID-19 using multiple forward-looking measures of uncertainty in Indian stock markets using liquid Nifty index options. The WHO declaration of COVID-19 as a pandemic coincides with a sharp rise in all measures of uncertainty considered, including option- implied volatility smiles, risk-neutral density, skewness, and kurtosis. We find that while subsequent government-imposed lockdowns and monetary easing induced a near-normalization of skewness and kurtosis, the volatility level remained elevated, demonstrating the importance of higher mo- ments in capturing uncertainty during a pandemic. Structural breaks identified using the Bai–Perron methodology closely track the dates of significant announcements or interventions
"Betting Against Beta in the Indian Market", in Mishra A.K., Arunachalam V., Mohapatra S., Olson D. (eds) The Financial Landscape of Emerging Economies (2020), (with Agarwalla S.K., Jacob J., Vasudevan E.)
Recent empirical evidence from different markets suggests that the security market line is flatter than posited by CAPM. This flatness implies that a portfolio long in low-beta assets and short in high-beta assets would earn positive returns. Frazzini and Pedersen (2014) conceptualize a BAB factor that tracks such a portfolio. We find that a similar BAB factor earns significant positive returns in India. The returns on the BAB factor dominate the returns on the size, value and momentum factors. We also find that stocks with higher volatility earn relatively lower returns. These findings indicate overweighting of riskier assets by leverage constrained investors in the Indian market.
"Blockchain in Finance", Vikalpa, 44.1 (2019) 1-11
Blockchain – the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies – provides a potentially attractive alternative way to organize modern finance. Currently, the financial system depends on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide securities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large investment institutions. Until a decade ago, it was commonly assumed that the financial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluctantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increasingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.
However, even a decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encountered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications – mainstream payment and settlement, securities issuance, clearing and settlement, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or whether they will be disrupted by the new technology remains to be seen.
Blockchain is still an evolving and therefore immature technology; it is hard to predict how successful it would be outside its only proven use domain of cryptocurrencies. History teaches us that radically new technologies take many decades to realize their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential.
"Informed trading around earnings announcements - Spot, futures, or options?", Journal of Futures Markets, 39.5 (2019) 579-589 (with Sonali Jain, Sobhesh Kumar Agarwalla and Ajay Pandey)
Recent literature reports higher single stock options (SSO) volume before earnings announcements (EA). There are no studies that explore single stock futures (SSF) in this context because of illiquid SSF markets in developed countries. Similar to SSO, SSF provide embedded leverage and facilitate short selling although at a lower cost, but do not provide downside‐risk protection. India's liquid SSO and SSF provide a unique setting to study the preference of informed traders. We observe an increase in both SSO and SSF volume before EA. Further, SSF dominate SSO possibly due to SSO becoming expensive before EA and higher information leakage in India.
"Indian equity options: Smile, risk premiums, and efficiency", Journal of Futures Markets, 39.2 (2019), 150-163 (with Sonali Jain and Sobhesh Kumar Agarwalla)
We study the pricing of equity options in India which is one of the world's largest options markets. Our findings are supportive of market efficiency: A parsimonious smile-adjusted Black model fits option prices well, and the implied volatility (IV) has incremental predictive power for future volatility. However, the risk premium embedded in IV for Single Stock Options appears to be higher than in other markets. The study suggests that even a very liquid market with substantial participation of global institutional investors can have structural features that lead to systematic departures from the behavior of a fully rational market while being 'microefficient'.
"Bitcoin and Blockchain", Global Business Press Expert Insights, 2018
The blockchain is a decentralized system that offers an alternative to conventional systems centered around highly trusted, systemically important institutions. Bitcoin is the best known application of the blockchain; however, blockchain is also used for many other things, and in the decades to come, these applications may overshadow Bitcoin. The blockchain is an evolving and improving technology, which is another way of saying that it is an immature technology. Noncurrency uses of blockchain are in their infancy, and radically new technologies take many decades to realize their full potential. Thus, it is perfectly possible that blockchain would prove revolutionary in the years to come. What is certain is that businesses should be looking at this technology, and understanding it, because its underlying ideas are powerful and likely to be influential
"Structured Products for Corporate Risk Management", Global Business Press Expert Insights, 2018 (with Vineet Virmani)
Risk management in modern nonfinancial corporations uses a wide range of derivative and hedging instruments that go well beyond simple forward contracts and options. Popularly known as structured products, such complex derivatives manufactured by financial institutions can often be both difficult to understand and hard to assess and value. Despite their benefits in providing tailor-made solutions to risk-management problems,they often come with hidden traps that have been the bane of many unwary risk managers and chief financial officers. What then explains the popularity of such products with corporate treasuries worldwide? What gaps and needs are satisfied by such products which cannot be met by simple contracts? What is the incentive of financial institutions to promote such products? Drawing on real-world examples from the world of business, this article sheds light on these issues and also talks about precautions that companies need to take to ensure that use of structured products for risk manage- ment does not end up creating new risks.
"Size, Value, and Momentum in Indian Equities", Vikalpa, 42(4), October-December 2017, 211–219 (with Sobhesh Kumar Agarwalla and Joshy Jacob)
The results presented here indicate that factor investing using value and momentum is a viable investment strategy in India, but size does not perform well. This remains true, even if short positions are excluded, and only value and momentum tilts to the market portfolio are considered. Institutional investors and other large investors may be able to implement these tilts quite easily. However, it is harder for retail investors to adopt this style of investing. There may be a scope for making factor-based investing accessible to retail investors through mutual funds (or even exchange traded funds) that make these factors available at low cost.
"Finance in a World of Negative Rates", Global Business Press Expert Insights, 2016 (with Vineet Virmani)
Many European countries and Japan have introduced negative interest rates, and the Swiss franc denominated bonds of many US companies now trade at negative yields. Why do central banks push interest rates negative and what are the costs and benefits of doing so? How much more negative can rates go or have we reached the limit in some countries? How does a bank remain profitable when you have to pay your borrowers to take money from you? How do investors allocate their portfolios in an environment where the government bond is offering not a risk free return, but a guaranteed loss? What happens to the equity risk premium in such a world? How do companies manage working capital in a situation where you want to pay your suppliers instantly and want your customers to delay their payments to you? What happens to standard present value formulas in a negative rates world? Does the present value of perpetuities actually become negative? These are a few of the disturbing questions that arise when negative interest rates upend our traditional assump- tions about how the financial system works. Our piece addresses these questions in a nontechnical style and provide a lucid guide to managers trying to make sense of this brave new world.
"Computational Finance Using QuantLib-Python", Computing in Science & Engineering, 18.2 (2016): 78-88 (with Vineet Virmani) [Full Text - PDF (Accepted Paper Version) ]
Given the complexity of over-the-counter derivatives and structured products, almost all of derivatives pricing today is based on numerical methods. While large financial institutions typically have their own team of developers who maintain state-of-the-art financial libraries, till a few years ago none of that sophistication was available for use in teaching and research. For the last decade, there is now a reliable C++ open-source library available called QuantLib. This note introduces QuantLib for pricing derivatives and documents our experience using its Python extension, QuantLib-Python, in our course on Computational Finance at the Indian Institute of Management Ahmedabad. The fact that it is also available in Python has allowed us to harness the power of C++ with the ease of IPython notebooks in the classroom as well as for student’s projects.
"Financial Literacy among Working Young in Urban India", World Development, Volume 67, March 2015, Pages 101–109 (with S. K. Agarwalla, S. K. Barua and J. Jacob) [Full Text - PDF (Working Paper Version) ]
The working young in urban India exhibit inferior financial knowledge, inferior financial attitude, and superior financial behavior compared to their counterparts elsewhere. While both men and women require intervention to enhance their financial knowledge, focused intervention is needed to improve the financial attitude of men and the financial behavior of women. Living in a joint family impacts financial literacy negatively and consultative decision-making in families impacts it positively. The influence of these key aspects of Indian family life indicates the need to involve family members in financial literacy programs to improve financial decision making of families.
"Indian Financial Market Development and Regulation: What Worked and Why?", in Masahiro Kawai and Eswar Prasad (ed), , Asian Perspectives on Financial Sector Reforms and Regulation, Brookings Institution Press, 2011
Technology, competition and regulatory reform have been the key drivers of market development in India over the last two decades. The success stories are characterized by regulatory reform that unleashed competition and actively pushed rapid adoption of new technology.
The reforms have led to a modest improvement in creditor and shareholder rights, but this change has been too small to have made a major difference to the development of the markets.
The Indian experience makes me sceptical of a reliance on private ordering as a means of achieving efficient market structures speedily without direct intervention by regulators and government in market development. In particular, I find only a limited direct contribution from foreign investors and participants in market development.
Many of the Indian reforms were driven by an attempt to conform to global best practices, while several reforms have responded to crises in the broader economy or in a particular market. Finally, I discuss some of the lessons from the Indian experience for the development and regulation of financial markets and highlight some of the regulatory challenges that lie ahead.
"Finance Teaching and Research after the Global Financial Crisis", Vikalpa, October-December 2011 [Full Text - PDF (Working Paper Version) ]
Finance has come in for a great deal of criticism after the global financial crisis of 2007 and 2008. Clearly there were serious problems with finance as it was practiced in the years before the crisis. To the extent that this was only a gap between theory and practice, there is a need for finance practice to go back to its theoretical roots. But there is a need to re-examine finance theory itself.
The paper begins with an analysis of what the crisis taught us about preferences, probabilities and prices, and then goes on to discuss the implications for the models that are used in modern finance.
The paper concludes that the finance curriculum in a typical MBA programme has not kept pace with the developments in finance theories in the last decade or more. While a lot needs to change in finance teaching, finance theory also needs to change though to a lesser extent. Many ideas that are well understood within certain subfields in finance need to be better assimilated into mainstream models. For example, many concepts in market microstructure must become part of the core toolkit of finance. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. Above all, finance needs more sophisticated mathematical models and statistical tools.
"Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges", in Robert W. Kolb (ed.), , Lessons from the Financial Crisis: Causes, Consequences and Our Economic Future, Kolb Series in Finance, New Jersey: John Wiley, 2010, 317-323
The global financial crisis has shown that the quality of risk management models does matter. Three important lessons have emerged from this experience:
"Indian Financial Sector and the Global Financial Crisis", Vikalpa, July-September 2009, 34(3), 25-34
Though the Indian financial sector had very limited exposure to the toxic assets at the heart of the global financial crisis, it suffered a severe liquidity crisis after the Lehman bankruptcy. This liquidity crisis could have been averted with timely injection of liquidity into the system by the Reserve Bank of India. Apart from the liquidity crisis, India also had to deal with the collapse of global trade finance; deflation of an asset market bubble; demand contraction for exports; and corporate losses on currency derivatives. Looking ahead, the paper argues that the crisis is a wake-up call for the Indian banks and financial system for better managing their liquidity and credit risks, re-examining the international expansion policies of banks, and reviewing risk management models and stress test methodologies. Rejecting the widely held notion that financial innovation caused the global crisis, the author offers examples from bond markets and securitization to establish the necessity of continuing with the financial reforms. While India has high growth potential, growth is not inevitable. Only the right economic and financial policies and a favourable global environment can make rapid growth a sustainable phenomenon.
"Satyam Fraud: The Regulatory Response", in “The Satyam Story: Many Questions and A Few Answers”, , Vikalpa, January-March 2009, 34(1), 75-77
A major fraud is an opportunity to push through important reforms which would otherwise be resisted by powerful vested interests. In my view, this opportunity was missed in India. The initial regulatory response to the Satyam fraud was swift and appropriate, but this momentum was lost very quickly. Those who hoped for comprehensive and decisive reforms have been disappointed – at least so far.
"Corporation and its Shareholders: What Should B-Schools Teach? (Colloqium)", Vikalpa, 31(2), April-June 2006, 120-121
What should be the stance of B Schools regarding teaching of shareholder value maximization, ethics, and social responsibility? Each individual faculty must perforce grapple with these dilemmas, but I believe that the B School itself cannot and should not have a stance on these issues at all. It is the very essence of a vibrant academic institution that it provides an environment for a healthy debate between opposing view points. When it ceases to do that and imposes a particular orthodoxy on its faculty and its students, it becomes nothing more than an indoctrination camp bereft of any moral legitimacy.
The struggle between shareholder and stakeholder views of governance is no different from similar struggles between classical statistics and Bayesian statistics, between Keynesian economics and monetary economics, between the efficient market theories and behavioural finance and so on. In all of these struggles, the B School cannot afford to impose a choice. It must instead allow individual faculty members to articulate their positions forcefully and unapologetically. Each student must then make his or her own choices knowing fully well the arguments that have been marshalled for and against each position.
Therefore, I believe that the relevant question is how an individual B School professor should deal with these dilemmas. I believe we must emphasize the shareholder perspective very strongly and remind the students that this is not a morally neutral position at all. On the contrary, it is simply a corollary of the near universal moral imperative that we find in almost all civilizations and cultures - “Thou shalt not steal”.
"Selected Issues in the Regulation of Firms and Capital Markets", in Priya Basu (ed), , India’s Financial Sector: Recent Reforms, Future Challenges, Macmillan, New Delhi, 2005.
The collapse of equity prices in 2000 exposed a number of frauds and scandals both in India and in the developed capital markets. This naturally leads to the question about the role of the regulator and how much can be legitimately expected from a regulator in terms of prevention, investigation and punishment of corporate frauds. The answer is that prevention and detection of frauds must rely heavily on market discipline, while the regulator’s job is to ensure a speedy trial and effective punishment. Market discipline can be effective if hostile take overs are possible, short selling is permitted, private securities litigation is allowed and private sector watchdogs like rating agencies, auditors and investment bankers face intense competition.
"Development Financial Institutions and the Development of Financial Markets", in S. Morris (ed.), , India Infrastructure Report 2004: Ensuring Value for Money, Oxford University Press, New Delhi.
Over 300 development financial institutions (DFIs) were established worldwide during the twenty five years after World War II when fixed exchange rates and repressed financial markets prevailed in most developing countries. Since then there has been a wave of financial liberalization that has brought financial markets to centre stage. In India, financial markets were liberalized from the mid 1980s onward.
Financial liberalization means a redefinition of the DFIs’ mission and nature of operations. During the era of financial repression, the developmental role of these institutions consisted in mobilizing large amounts of capital and deploying them in direct funding of industrial enterprises. In an era of financial deregulation, the developmental role is very different - development of markets and market institutions, innovation of new products and securities and using relatively small amounts of capital to intermediate and support much larger capital flows through the markets. Thus there is a role for a DFI in an era of financial deregulation, but it is a very different role from its past role. Not all DFIs would cope with these traumatic changes in mission and emerge as free market DFIs. Some may not survive at all and some may cease to be DFIs.
The free market DFIs whether newly created or created by the transformation of older DFIs must confront a number of difficult questions about management and governance. Old performance measures like loan disbursements, profits and contribution to priority sectors are meaningless and irrelevant. New measures are needed that measure the developmental role that they have played.
"Equity Options in India: An Empirical Examination", in Susan Thomas (ed), , Derivative Markets in India 2003, Tata McGraw Hill, New Delhi, 2003.
This paper examines the relationship between index futures and index options prices in India. By using futures prices, we eliminate the effect of short sale restrictions in the cash market that impede arbitrage between the cash and derivative markets. We estimate the implied (risk neutral) probability distribution of the underlying index using the Breeden-Litzenberger formula on the basis of estimated implied volatility smiles. The implied probability distribution is more highly peaked and has (with one exception) thinner tails than the normal distribution or the historical distribution. The market appears to be underestimating the probability of market movements in either direction, and thereby underpricing volatility severely. At the same time, we see some overpricing of deep-in-the-money calls and some inconclusive evidence of violation of put-call-parity. We also show that the observed prices are rather close to the average of the intrinsic value of the option and its Black-Scholes value (disregarding the smile). This is another indication of volatility underpricing.
"Putting ‘Private Finance’ back into the Private Finance Initiative", in S. Morris (ed.), , India Infrastructure Report 2003: Public Expenditure Allocation and Accountability, Oxford University Press, New Delhi. [Full Text - PDF ]
This paper discusses the importance of private finance in making PFI (Private Finance Initiative) and PPP (Public Private Partnerships) projects successful. This question assumes greater relevance in the context of recent developments that have raised questions about whether PFI projects involve genuine private finance at all. Some recent PFI projects have invited comparisons with Enron’s off balance sheet financing.
This paper argues that while Enronic accounting is indeed to be found in some PFI projects, the proper response to this should be an improvement in governmental accounting.
The paper argues that private management produces benefits only when accompanied by private finance for three key reasons:
In all of these financial markets play a critical role:
Well functioning financial markets are thus critical for successful PFI.
The paper argues that we must put private finance back into the Private Finance Initiative so that we can use private sector management effectively to provide better public services at lower cost.
"Governance, Supervision and Market Discipline: Lessons from Enron", Journal of the Indian School of Political Economy, October-December 2002, 14(4), 559-632. [Full Text - PDF ]
This paper studies and documents the accounting scandals and corporate frauds that came to light during 2001 and 2002 at Enron and other companies in the United States and elsewhere. It then describes the failure of governance and supervision as well as the failure of market discipline that took place and goes on to analyse the lessons that can be drawn from these episodes.
The principal conclusion of this paper is that while the Enron and related scandals represent a massive regulatory failure, such failures are inherent in the regulatory process. Regulators are poor at detecting fraud, and therefore we must strengthen market discipline. This in turn calls for four important measures: encouraging hostile take-overs, allowing free short selling, permitting and facilitating class action lawsuits, and promoting competition in the securities industry.
The second important lesson is that the world must learn from the US to prosecute and punish wrong doers swiftly after they are caught.
Finally, changes in regulation and supervision could facilitate the process of market discipline. Measures proposed here include: drastic reform of the system for regulatory review of corporate accounting filings, vast improvements in accounting standards and a movement towards detailed real time disclosures going far beyond the traditional accounting statements.
"Private Finance to Private Entrepreneurship", in S. Morris (ed.), , India Infrastructure Report 2002: Governance Issues for Commercialization, Oxford University Press, New Delhi. [Full Text - PDF ]
For the last few years, there has been much discussion and agonising about how to attract private finance to infrastructure. This paper argues that we have so far tried to attract private finance without welcoming private entrepreneurship. The government while attempting to withdraw from the financing of infrastructure has sought to retain its decision-making role in the selection, design and operation of infrastructure projects. This means that even today capital markets have not been assigned much of a role in allocating capital in the infrastructure sector. There has not been much room for entrepreneurs willing to take large risks in anticipation of large rewards. The net effect is that while there have been sporadic successes in attracting private finance to infrastructure projects, there has been little success in transferring the risks of these projects to the private sector. As long as the government continues to assume the principal risks of the projects, the only effect of the so-called private finance is to convert what would have been an immediate borrowing requirement of the government into an off balance sheet liability. Thus this form of private finance neither contributes to fiscal stabilisation nor promotes allocative efficiency. In fact, when the government’s attempts to promote private finance in infrastructure are ill designed or market distorting, the net result might well be negative both for fiscal stabilisation and allocative efficiency. On the other hand, private entrepreneurship in infrastructure could give large benefits in terms of fiscal consolidation and allocative efficiency. To achieve this result, the government needs to:
There would remain a class of infrastructure projects that the government may consider of strategic importance but which entrepreneurs do not find profitable to implement. These would require direct government support in the form of an outright subsidy (a negative licence fee established through competitive auction) or some form of credit enhancement. But these should be the exception rather than the rule.
"Regulatory Dilemmas in Infrastructure Financing", in S. Morris (ed.), , India Infrastructure Report 2001: Issues in Regulation and Market Structure, Oxford University Press, New Delhi. [Full Text - PDF ]
It is now well understood that private capital will have to build a large part of the infrastructure that we need in India over the coming years. However, the private sector can play this role only if it has access to domestic or international sources of financing for both equity and debt. In emerging markets, financing large infrastructure projects can become difficult since financial institutions and markets are not sufficiently well developed. Promoters of infrastructure projects then turn to the government to help them by either:
This paper discusses the conditions under which governments should consider either of these two approaches to promoting privately financed infrastructure. It concludes that while both these approaches have potential uses, they are quite often simply "soft" alternatives to painful but essential reforms in the regulation of the infrastructure sectors themselves.
The paper is fairly sanguine about the possibility of private financing of infrastructure in India. There is definitely no need for the state to step in with direct or indirect support on such a scale that the private project effectively becomes a privately managed but publicly funded project. Government intervention, where necessary, should take the form of limited subsidy and credit enhancement. There is little cause for relaxation of financial sector regulations to deal with the alleged peculiarities of infrastructure.
At a fundamental level, most problems in infrastructure financing arise due to weaknesses in the sectoral regulatory structure. For example, the near-bankruptcy of the state electricity boards is the key problem in the power sector. It would be a tragedy if we tried to deal with these deep-seated regulatory problems by creating harmful distortions in the financial sector.
"Modelling Credit Risk in Indian Bond Markets", ICFAI Journal of Applied Finance, 6(3), July 2000, 53-67 [Full Text - PDF ]
Government bonds are subject only to interest rate risk. However, corporate bonds are subject to credit risk in addition to interest rate risk. Credit risk subsumes the risk of default as well as the risk of an adverse rating change. Considerable work has been done in the US and other countries on credit rating migrations. However, there is little work done in India in this regard. In this paper therefore, we analyse credit rating migrations in Indian corporate bond market to bring about greater understanding of its credit risk.
"Rupee-Dollar Option Pricing and Risk Measurement: Jump Processes, Changing Volatility and Kurtosis Shifts", Journal of Foreign Exchange and International Finance, 13 (1), April-June 1999, 11-33 [Full Text - PDF ]
Exchange rate movements in the Indian rupee (and many other emerging market currencies) are characterised by long periods of placidity punctuated by abrupt and sharp changes. Many, but by no means all, of these sharp changes are currency depreciations. This paper shows that econometric models of changing volatility like Generalised AutoRegressive Conditional Heteroscedasticity (GARCH) with non normal residuals which perform quite well in other financial markets fail quite miserably in the case of the INR-USD process because they do not allow for such jumps in the exchange rate. The empirical results very convincingly demonstrate the need to model the exchange rate process as a mixed jump-diffusion (or normal mixture) process. Equally importantly, the empirical results provide strong evidence that the jump probabilities are not constant over time. From a statistical point of view, changes in the jump probabilities induce large shifts in the kurtosis of the process. The failure of GARCH processes arises because they allow for changes in volatility but not for changes in kurtosis. The time varying mixture models are able to accommodate regime shifts by allowing both volatility and kurtosis (not to mention skewness) to change. This also shows that the periods of calm in the exchange rate are extremely deceptive; in these periods, the variance of rate changes is quite low, but the kurtosis is so high (in the triple digit range) that the probability of large rate changes is non trivial. The empirical results also show that the Black-Scholes-Garman-Kohlhagen model for valuation of currency options is quite inappropriate for valuing rupee-dollar options and that the Merton jump-diffusion model is the model of choice for this purpose.
"Asian Crisis and Finance Theory", Vikalpa, 23(4), October-December 1998, 23-34 [Full Text - PDF ]
The Asian crisis did not involve generalized financial panic. Stock markets behaved rationally and the crash in exchange rates is explained by the presence of credit risk. The crisis highlights the need for better risk management at the national level focusing less on the size of the external debt and more on its currency and maturity composition. There should be more freedom in capital outflows and less reliance on the banking system. IMF assistance to crisis stricken countries should be in the form of a currency swap which addresses the root cause of the crisis and subjects the IMF itself to financial discipline.
"Indian Financial Sector Reforms: A Corporate Perspective", Vikalpa, 23(1), January-March 1998, 27-38. [Full Text - PDF ]
Until the early nineties, corporate finance managers in India were given very little freedom in the choice of key financial policies as the government regulated the pricing of debt and equity instruments and directed the flow of credit. Financial sector reform over the last six years has exposed managers to complex financial choices amidst increased volatility of interest rates and exchange rates, and made them accountable to an increasingly competitive financial marketplace. Nevertheless, the slow pace of financial liberalization gave Indian corporates the luxury of learning slowly and adapting gradually. Gradualism has also meant that there is a large unfinished agenda of financial sector reforms. Indian companies should now prepare themselves for the further changes that lie ahead. The East Asian crisis is a warning for the Indian corporate sector to pursue more prudent and sustainable financial policies.
"Corporate Governance in India: Disciplining the Dominant Shareholder", IIMB Management Review,, 9(4), 5-18. October-November 1997. [Full Text - PDF ]
The nascent debate on corporate governance in India has tended to draw heavily on the large Anglo-American literature on the subject. This paper argues however that the corporate governance problems in India are very different. The governance issue in the US or the UK is essentially that of disciplining the management who have ceased to be effectively accountable to the owners. The problem in the Indian corporate sector (be it the public sector, the multinationals or the Indian private sector) is that of disciplining the dominant shareholder and protecting the minority shareholders. Clearly, the problem of corporate governance abuses by the dominant shareholder can be solved only by forces outside the company itself. The paper discusses the role of two such forces - the regulator and the capital market. Regulators face a difficult dilemma in that correction of governance abuses perpetrated by a dominant shareholder would often imply a micro-management of routine business decisions which lie beyond the regulators’ mandate or competence. The capital market on the other hand lacks the coercive power of the regulator, but it has the ability to make business judgements. The paper discusses the increasing power of the capital market to discipline the dominant shareholder by denying him access to the capital market. The newly unleashed forces of deregulation, disintermediation, institutionalization, globalization and tax reforms are making the minority shareholder more powerful and are forcing the companies to adopt healthier governance practices. These trends are expected to become even stronger in future. Regulators can facilitate the process by measures such as: enhancing the scope, frequency, quality and reliability of information disclosures; promoting an efficient market for corporate control; restructuring or privatizing the large public sector institutional investors; and reforming bankruptcy and related laws. In short, the key to better corporate governance in India today lies in a more efficient and vibrant capital market. Of course, things could change in future if Indian corporate structures also approach the Anglo-American pattern of near complete separation of management and ownership
"Indian Money Market: Market Structure, Covered Parity and Term Structure", ICFAI Journal of Applied Finance, 3(2), July 1997, 1-10 [Full Text - PDF ]
In the context of the relatively recent deregulation of interest rates in India, this paper analyses the structure and inter- relationships of money market interest rates and studies the extent to which covered interest parity holds in India. The paper shows that there was a major structural break in September 1995 when in the wake of turmoil in the foreign exchange markets, covered interest arbitrage came into play in a big way for the first time. Even after September 1995, the forward premia continue to violate covered parity in systematic ways. These violations are shown to be related partly to the distortions in the foreign exchange market as measured by the premium in the unofficial foreign exchange market. Partly, however, covered parity violations also reflect distortions in the money market rates and in the formation of expectations. Though the money market is free from interest rate ceilings, structural barriers and institutional factors continue to create distortions in the market. Apart from the overnight inter-bank (call market) rate, the other interest rates in the money market are sticky and appear to be set in customer markets rather than auction markets. A well defined yield curve does not therefore exist in the Indian money market
"A Comparative Analysis of Response of International Capital Markets to Political Upheaval", Global Business and Finance Review, Spring 1997, 51-60 (with S. K. Barua and M. R. Gujarathi)
One explanation for the apparent excessive volatility of stock prices, not justified by fundamentals, could be that prices sometimes react in anticipation of shocks which do not actually materialize. The most dramatic examples of such shocks are fleeting political upheavals such as the abortive coup of August 1991 in the Soviet Union. Our analysis of the responses of several stock markets to this coup suggests that price fluctuations induced by fleeting political events can partially explain the excessive volatility of stock markets. Our finding of major differences in adjustment processes between different stock markets has implications for international capital market integration.
"The Stochastic Dynamics of the Short Term Interest Rate in India", Indian Journal of Applied Economics, 6(1), January-March 1997, 47-58 [Full Text - PDF ]
The stochastic dynamics of interest rates is a crucial element in modern term structure theories and in the pricing of the various interest rate options which are embedded in bond issues today. International studies show that no model of these dynamics is valid world-wide.
This paper studies the dynamics of the short term interest rate in India (the call market rate) and shows that it follows a mean reverting dynamics with a volatility which is independent of the level of interest rates (conforming to the model proposed by Brennan and Schwartz, 1979). This finding has important implications for the theory of the term structure of interest rates. In particular the Cox-Ingersoll-Ross theory of the term structure is strongly rejected in India.
The normal rate of interest to which the short term rate mean- reverts is itself shown to be changing over time. The Kalman filtering methodology shows that the normal rate too follows a mean reverting process with a much slower speed of adjustment.
A companion paper translates these findings into a methodology for pricing interest rate options in India and presents applications of the proposed methodology.
"Bond Valuation and the Pricing of Interest Rate Options in India", ICFAI Journal of Applied Finance,, 2(2), July 1996, 161-176 [Full Text - PDF ]
In recent years, Indian corporates and institutions have issued a large number of exotic bonds with a variety of embedded interest rate options. Pricing the embedded interest rate options is a pre-requisite for valuing these bonds. The pricing of interest rate options is quite complex and depends crucially on the dynamics of interest rates. International studies show that no model of these dynamics is valid world-wide. Drawing on the author’s earlier study of Indian interest rate dynamics, this paper expounds a practical methodology for pricing interest rate options in India and valuing bonds with embedded interest rate options. The Black-Derman-Toy model (Black et al., 1994) is shown to be the most attractive tool for valuing interest rate options in India.
A real-life application of the proposed approach shows its practical usability in valuing complex instruments with multiple embedded options. This also serves to show that embedded options in bonds can make a big difference to their valuation.
"High Frequency Manipulation at Futures Expiry: The Case of Cash Settled Indian Single Stock Futures", IIMA Working Paper No. 2014-02-01, February 2014 (with S. K. Agarwalla and J. Jacob) [Full Text - PDF ]
Futures markets are known to be vulnerable to manipulation, and despite the presence of a variety of mechanisms to prevent such manipulation, instances of market manipulation have been found in some of the largest and most liquid futures markets worldwide. In 2013, the Securities and Exchange Board of India identified a case of alleged manipulation (in September 2012) of the settlement price of cash settled single stock futures based on high frequency circular trading. As is well known, it is easy for any well-endowed manipulator to manipulate the price; the real challenge for the manipulator is to make the manipulation profitable. The use of high frequency circular trading of the form alleged in the SEBI order makes many forms of manipulation profitable, and makes futures market manipulation a much bigger problem than previously thought.
As argued by Pirrong (2004), it is more practical to detect and punish manipulation than to try and prevent it. We develop an econometric technique that uses high frequency data and which can be integrated with the automated surveillance system to identify suspected cases of high frequency manipulation at futures expiry. We then use these techniques to identify a few suspected cases of manipulation. Needless to say, human judgement needs to be applied to decide which, if any, of these cases need to be taken up for investigation (and, after that, possible prosecution). This judgement is beyond the scope of our paper, and we refrain from making any judgement on whether any of the identified cases constitutes actual market manipulation.
"Four factor model in Indian equities market", IIMA Working Paper No. 2013-09-05, September 2013 (with S. K. Agarwalla and J. Jacob) [Full Text - PDF ]
We compute the Fama-French and momentum factor returns for the Indian equity market for the 1993-2012 period using data from CMIE Prowess. We differ from the previous studies in several significant ways. First, we cover a greater number of firms relative to the existing studies. Second, we exclude illiquid firms to ensure that the portfolios are investible. Third, we have classified firms into small and big using more appropriate cut-off considering the distribution of firm size. Fourth, as there are several instances of vanishing of public companies in India, we have computed the returns with a correction for survival bias. During the period, the average annual return of the momentum factor was 21.2%; the average annual return on the value portfolio (HML or VMG) was 6%; that of the size factor (SMB) was -0.8%; and the average annual excess return on the market factor (Rm-Rf) was 3.5%. The daily and monthly time series of the four factor returns and the returns of the underlying portfolios are available at http://www.iima.ac.in/~iffm/Indian-Fama-French-Momentum/.
"Time Resolution of the St. Petersburg Paradox: A Rebuttal", IIMA Working Paper No. 2013-05-09, May 2013 [Full Text - PDF ]
Peters (2011) claims to provide a resolution of the three century old St Petersburg paradox by using time averages and thereby avoiding the use of utility theory completely. Peters also claims to have found an error in Menger (1934, 1967) who established the vulnerability of any unbounded utility function to the St Petersburg paradox. This paper argues that both these claims in Peters (2011) are incorrect. The time average argument can be circumvented by using a single random number (between zero and one) to represent the entire infinite sequence of coin tosses, or alternatively by applying a time reversal to the coin tossing. Menger’s proof can be reinstated by comparing the utility of playing the Super St Petersburg game to the utility of an arbitrarily large sure payoff.
"When index dissemination goes wrong: How fast can traders add and multiply?", IIMA Working Paper No. 2010-08-04, August 2010 [Full Text - PDF ]
This paper studies an episode of dissemination of wrong stock index values in real time due to a software bug in the Indian Nifty index futures market on the morning of January 18, 2006.
The episode provides an opportunity to test various models of cognitive biases and bounded rationality highlighted in behavioural finance. The paper provides strong evidence against cognitive biases like “anchoring and adjustment” (Tversky and Kahneman, 1974) that one might expect under such situations. The futures market tracked the true Nifty index which it could not see while completely ignoring the wrong Nifty index that it could see.
However, the paper demonstrates that market efficiency failed in more subtle ways. There is evidence of a partial breakdown of price discovery in the futures markets and a weakening of the bonds linking futures and cash markets.
This evidence is consistent with the centrality of “market devices” as argued in “actor network theory” in economic sociology (Muniesa, Millo and Callon, 2007 and Preda, 2006). Well functioning markets today depend critically on a whole set of information and communication technologies. Any failures in these material, socio-technical aspects of markets can make markets quite fragile even if behavioural biases are largely absent.
"Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges", IIMA Working Paper No. 2009-02-06, February 2009 [Full Text - PDF ]
During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many banks were pushed to the brink and beyond. An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. This is an important lesson. The global financial crisis has also taught us that in risk management, robustness is more important than sophistication and that it is dangerous to use models that are over calibrated to short time series of market prices. The paper applies these lessons to the important exchange traded derivatives in India and recommends major changes to the current margining systems to improve their robustness. It also discusses directions in which global best practices in exchange risk management could be improved to take advantage of recent advances in computing power and finance theory. The paper argues that risk management should evolve towards explicit models based on coherent risk measures (like expected shortfall), fat tailed distributions and non linear dependence structures (copulas).
"A First Cut Estimate of the Equity Risk Premium in India", IIMA Working Paper No. 2006-06-04, June 2006 (with S. K. Barua) [Full Text - PDF ]
We estimate the equity risk premium in India using data for the last 25 years. We address the shortcomings of existing indices by constructing our own total return index for the 1980s and early 1990s. We use our estimates of the extent of financial repression during this period to construct a series of the risk free rate in India going back to the early 1980s. We find that the equity risk premium is about 8.75% on a geometric mean basis and about 12.50% on an arithmetic mean basis. There is no significant difference between the pre reform and post reform period: the premium has declined marginally on a geometric mean basis and has risen slightly on an arithmetic mean basis. The reason for this divergence between the sub period behaviour of the two means is the increase in the annualized standard deviation of stock market returns from less than 20% in the pre reform period to about 25% in the post reform period. The higher standard deviation depresses the geometric mean in the post reform period.
"Towards a Unified Market for Trading Gilts in India", IIMA Working Paper No. 2004-11-05, November 2004 [Full Text - PDF ]
A Working Group of the Reserve Bank of India (RBI) under the chairmanship of Dr. R. H. Patil has recommended that Indian government securities should be traded in two separate and segregated markets. Banks and primary dealers are to trade on an anonymous electronic screen based order matching trading system - a monopoly exchange based on the Negotiated Dealing System (NDS) owned by the RBI. Households, pension and provident funds and most other investors are proposed to be relegated to a separate segregated market driven by compulsory market making. The Patil Report also recommends that the RBI should indulge in systematic market manipulation in the NDS to reduce the borrowing cost of the government.
This paper argues for a reconsideration of most elements of this design. Government securities are a unique asset class to which all Indians should have non discriminatory access. Segregated markets are unacceptable. Nor are monopolies desirable since intense competition is the principal mechanism for fostering innovation and investor protection.
Market manipulation is unacceptable in any financial market even if this manipulation is performed by the state itself. Moreover market manipulation to reduce interest rates would reintroduce financial repression through the back door and would reverse the principal success of the financial sector reforms initiated in 1991.
The paper proposes an alternative design for the government securities market and also a new regulatory architecture. Unified markets, non discriminatory access to all classes of investors, intense competition and investor protection are the key elements of the proposed design.
"The Indian Financial Sector After a Decade of Reforms", ViewPoint 3, Centre for Civil Society, New Delhi, April 2002. [Full Text - PDF ]
After a decade of reforms, many of the deep seated problems in the financial sector remain. The state has not relinquished its grip on the financial sector. Except in isolated pockets, competition has not been unleashed in the financial sector on a scale sufficient to produce visible benefits in terms of efficiency, innovation and customer service.
There is this a large unfinished agenda of financial sector reforms. In the banking sector, the unfinished reforms include:
In the capital market, the important measures that are needed include the following:
In the field of fixed income and foreign exchange markets, the following issues are important:
Finally, real sector reforms (for example in the field of bankruptcy law) are very important.
The dynamism of the reform process that was lost in the mid-1990s needs to be recaptured to satisfy the aspirations of the Indian people for a vibrant modern economy with a strong and efficient financial sector.
"Mispricing of Volatility in the Indian Index Options Market", IIMA Working Paper No. 2002-04-01, April 2002 [Full Text - PDF ]
This paper examines the relationship between index futures and index options prices in India. By using futures prices, we eliminate the effect of short sale restrictions in the cash market that impede arbitrage between the cash and derivative markets. We estimate the implied (risk neutral) probability distribution of the underlying index using the Breeden-Litzenberger formula on the basis of estimated implied volatility smiles. The implied probability distribution is more highly peaked and has (with one exception) thinner tails than the normal distribution or the historical distribution. The market appears to be underestimating the probability of market movements in either direction, and thereby underpricing volatility severely. At the same time, we see some overpricing of deep-in-the-money calls and some inconclusive evidence of violation of put-call-parity. We also show that the observed prices are rather close to the average of the intrinsic value of the option and its Black-Scholes value (disregarding the smile). This is another indication of volatility underpricing.
"Regulatory Implications of Monopolies in the Securities Industry", IIMA Working Paper, 2001-09-05, September 2001 [Full Text - PDF ]
Since the mid-1990s, investors and regulators have benefited from a high degree of competition in the Indian securities industry. Even more than all the policy changes that have taken place, it is technology and competition that have transformed the Indian capital market in the last 7-8 years. This paper shows that there is now considerable evidence that critical elements of the Indian securities industry are becoming significantly less competitive than in the past. Reduced competition would remove the single most important driver of capital market modernisation in this country and would create several serious regulatory problems. The paper argues that rather than applying the traditional solution of “regulated monopolies”, regulators need to adopt strong measures to stimulate competition. The regulator must also ruthlessly discard those elements of the regulatory regime that are anti-competitive in nature.
"Value at Risk Models in the Indian Stock Market", IIMA Working Paper, 99-07-05, July 1999 [Full Text - PDF ]
This paper provides empirical tests of different risk management models in the Value at Risk (VaR) framework in the Indian stock market. It is found that the GARCH-GED (Generalised Auto-Regressive Conditional Heteroscedasticity with Generalised Error Distribution residuals) performs exceedingly well at all common risk levels (ranging from 0.25% to 10%). The EWMA (Exponentially Weighted Moving Average) model used in J. P. Morgan’ RiskMetrics® methodology does well at the 10% and 5% risk levels but breaks down at the 1% and lower risk levels. The paper then suggests a way of salvaging the EWMA model by using a larger number of standard deviations to set the VaR limit. For example, the paper suggests using 3 standard deviations for a 1% VaR while the normal distribution indicates 2.58 standard deviations and the GED indicates 2.85 standard deviations. With this modification the EWMA model is shown to work quite well. Given its greater simplicity and ease of interpretation, it may be more convenient in practice to use this model than the more accurate GARCH-GED specification. The paper also provides evidence suggesting that it may be possible to improve the performance of the VaR models by taking into account the price movements in foreign stock markets.
"Comparison of Indian Accounting Standards with International Practices", paper presented at the International Accounting Standards Conference, Association of Chartered Certified Accountants and the Indian Institute of Management, Ahmedabad, July 16-17, 1999, (with V. Raghunathan)
Paper presented at the International Accounting Standards Conference, Association of Chartered Certified Accountants and the Indian Institute of Management, Ahmedabad, July 16-17, 1999, (with V. Raghunathan).
To succeed in a globalised economy, Indian companies must perforce adopt the best practices from around the world in every aspect of their management. The voluntary move towards international accounting standards in the Indian corporate sector is part of this process.
Today, the Indian investor has seen the difference between Indian accounting standards and international standards. We therefore find a palpable sense of dissatisfaction with Indian accounting standards among Indian retail and institutional investors. Where possible, they will push Indian companies towards voluntary acceptance of international standards. However many companies will be able to resist this pressure and carry on with their current ways.
It then becomes the regulators’ task to take a hard look at Indian accounting standards and attempt to bring them on par with global best practices. One simple route that some countries have taken is to adopt international accounting standards in toto. There is a great deal of merit in following this route, but perhaps many in this country will find this loss of “accounting sovereignty” too radical.
In this paper, therefore, we focus on key changes that must be made in our standards to reduce the gap with global best practices. While examining the differences between Indian accounting standards and international accounting standards, we have asked three basic questions:
Our analysis identified several fundamental deficiencies in Indian accounting standards which have allowed Indian companies to conceal or misrepresent accounting information. We have then prioritised these into two lists:
Some of the above issues have been pointed out by some recent Committees (Malegam Committee and Bhave Committee) but we believe that regulators must deal with them more decisively than they have done so far. The paper reviews the recommendations of the Malegam and Bhave committees.
"The Debt Market and Corporate Financing Decisions", Paper presented at the Ninth State Level Conference, Karnataka State Chartered Accountants Association, Bangalore, February 1997
In 1996, while the primary market for equity virtually evaporated, the primary debt market came to centre stage with a string of successful mega-issues. The question naturally arises whether this was an aberration or whether the debt market is really coming of age in India. In answering this question, this paper begins with an analysis of the behaviour of the Indian retail investor in the first half of the nineties, evaluates the developments of 1996 in this context and highlights the weaknesses and deficiencies in this market today. It argues that these deficiencies are gradually being removed and that in the next few years, we are likely to see the emergence of a vibrant debt market.
Thus, borrowing in the debt market would soon become an important financing option for Indian companies. Yet it is important to realize that debt brings with it hidden costs and risks and is by no means a soft financing option. Reliance on the debt route demands a high degree of skill in evaluating these risks and managing them. Moreover, to borrow in a cost effective manner, companies must also pay great deal of attention to the design of innovative debt instruments that meet investor needs better. In short, borrowing in the bond market is a highly challenging and exciting task.
"Financial Sector Reforms: The Unfinished Agenda", Paper presented at the Seminar on Economic Reforms: The Next Step at Rajiv Gandhi Institute for Contemporary Studies, New Delhi, October 2-4, 1996
The reform process was initiated in 1991 in the midst of two grave crises in the financial sector - a balance of payments crisis and a threat of insolvency in the banking system. At the same time, several deep seated problems like financial repression, governmental pre-emption of banking resources, excessive structural regulation, and poor prudential regulation also demanded attention. This paper evaluates the successes of the reforms in addressing each of these problems.
The paper argues that the difficult and important tasks of restoring financial solvency of the financial system and ending the regime of financial repression have been substantially completed. The balance of payments position has also become much healthier though we are still some distance away from capital account convertibility. These are the major and lasting achievements of the last five years of reform. At the same time, the reformers have succeeded in avoiding the financial crises that have overwhelmed hasty liberalizers in other countries. The paper then discusses the factors that caused the slackening of financial sector reforms after the first couple of years. As a result of this slowing down of reforms, we are today left with a large unfinished agenda of financial reforms. Even in areas where reforms have progressed substantially, it is necessary to preserve the gains already made and carry the process forward to its logical culmination. But the most important and urgent task that remains to be done is that of dismantling the structural and micro regulations that have accumulated in the financial system over several decades of a command economy.
Above all, an essential precondition for the success of the entire financial reforms programme is the maintenance of macroeconomic stability. The large fiscal deficit is, therefore, the single biggest threat to the long term success of the financial reforms.
"Indian Interest Rate Dynamics and the Pricing of Options", UTI-IIMB Centre for Capital market Education and Research, Working Paper 1/96, Indian Institute of Management, Bangalore, May 1996
The continuing flood of bond issues in India with embedded options has made pricing of these options an urgent necessity. The pricing of interest rate options is quite complex and depends crucially on the dynamics of interest rates. International studies show that no model of these dynamics is valid world-wide.
This paper studies the dynamics of the short term interest rate in India (the call market rate) and shows that it follows a mean reverting dynamics with a volatility which is independent of the level of interest rates (conforming to the model proposed by Brennan-Schwartz, 1979). The normal rate of interest to which the short term rate mean-reverts is itself shown to be changing over time. The Kalman filtering methodology shows that the normal rate too follows a mean reverting process with a much slower speed of adjustment.
These dynamics are used to estimate the term-structure of volatility in India. It is seen that the resulting volatilities are high by international standards but are quite close to the Japanese experience.
Given the above conclusions regarding the dynamics of interest rates and taking into account the constraints of data availability in India, the Black-Derman-Toy model (Black et al., 1994) emerges as an attractive tool for valuing interest rate options and embedded options in India.
A real-life application of the proposed approach shows its practical usability in valuing complex instruments with multiple embedded options. This also serves to show that embedded options in bonds can make a big difference to their valuation and that issue advertisements that do not fully disclose some of these options can be grossly misleading.