Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma

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Mon, 24 Apr 2006

I am off for six weeks

I am on vacation for about six weeks till early June. I will not be posting on my blog during this period.

Posted at 18:46 on Mon, 24 Apr 2006     View/Post Comments (0)     permanent link

Thu, 13 Apr 2006

Have risk premiums declined?

The IMF’s Global Financial Stability Report, April 2006 has a discussion about risk premiums (Box 1.2) which states

There is a widely held view that investors’ appetite for risk has increased over the past few years, leading to higher prices for risky assets and narrower spreads on credit and other risky products. ... However, the analysis here suggests that investors’ overall attitude toward risk appears not to have changed appreciably

Basically, the IMF says that that while the credit risk premium seems to have declined, there is little change in the equity risk premium. Therefore, on balance, the IMF seems to say there is no evidence of under pricing of risk.

This conclusion is problematic for several reasons. First the evidence on falling risk premium is not based only on a declining credit spread. The term structure spread also has a large risk premium component and this component appears to have declined sharply. Similarly, there is surely some evidence that currency risk premiums have declined. Some observers are even talking of the end of ‘original sin’. So even if we accept the claim regarding stable equity premium, I would think that the score is 3-1 in favour of a decline in premium rather than the 1-1 draw that the IMF seems to portray.

But even the claim regarding the equity risk premium has to be taken with more than a pinch of salt. First, equity risk premiums declined sharply in the late 1990s and even an unchanged premium is still quite low by longer historical standards. Second, the estimate of risk premium is based on the earnings yield without any adjustment for growth. Most discussions on over pricing of equity today emphasize the apparent disconnect between the high growth expectation embedded in current valuation and the low long term interest rate. Thus any discussion of equity risk premium that treats the earnings yield as the return on equity simply misses the point.

Posted at 15:26 on Thu, 13 Apr 2006     View/Post Comments (0)     permanent link

Wed, 05 Apr 2006

Foreign investment in rupee debt

Ajay Shah has written an interesting piece about what is wrong with India’s policy on foreign debt. His most important point is that India restricts foreign investment in rupee debt while being much more liberal about Indian companies borrowing in foreign currency internationally. I agree with Ajay Shah that this is truly absurd but it is fully explained by the political economy of the situation. The corporate sector usually gets what it wants through intensive lobbying. This happened in East Asia before the crisis and it is happening in India now.

We should work towards getting rid of ‘original sin’ and replacing foreign currency debt with rupee debt. There are though two caveats. First if foreign investors are allowed to hedge currency risk, then the true national exposure may still be that of foreign currency debt if it is an Indian entity that stands on the other side of the hedge. In fact, the effective position of the nation can be that of short term foreign currency debt. This problem is not insurmountable but some thought needs to be given to it.

Second, as Martin Wolf points out, many countries have been able to overcome ‘original sin’ and borrow in their own currencies “once they have persuaded their own citizens to lend to them”. We need a proper government debt market instead of the captive market that we have now.

Posted at 13:55 on Wed, 05 Apr 2006     View/Post Comments (0)     permanent link

Tue, 04 Apr 2006

Australian Insider Trading Case against Citigroup

There has been a lot of discussion in the press and in the blogs about an insider trading case launched by the Australian Securities and Investments Commission (ASIC) against Citigroup Global Markets Australia Pty Ltd. ASIC’s press release provides some details and has published the full text of ASIC’s Statement of Claim

The facts are that while Citi’s investment bankers were advising a potential acquirer, its proprietary trading desk was buying the target’s stock. When the investment bankers came to know about this, they informally communicated to the traders that they should not be buying. The traders then stopped buying and in fact sold some shares. Since the shares rose sharply when the bid was announced, the traders would have made more money if they had continued buying or held on to what they had already bought.

Much of the comments that I have read are sceptical about whether ASIC has any case at all. Several authors have pointed out that Citi did not profit from its selling and that the client actually gained. But after reading the statutes that ASIC cites, it appears to me that ASIC has framed its claim very well.

These statutory provisions seem to imply that in the absence of adequate Chinese Walls any trading in the securities concerned becomes insider trading regardless of whether Citi benefited from such trading or whether anybody suffered due to it.

Some commentators have suggested that modern financial conglomerates would find it impossible to function in such a situation. I think this is totally wrong. Conglomerates can still function freely provided they ensure that they have strong Chinese Walls and adequate mechanisms for managing conflicts of interest. If ASIC has its facts right, Citi’s systems were simply inadequate.

Posted at 14:39 on Tue, 04 Apr 2006     View/Post Comments (0)     permanent link

Sat, 01 Apr 2006

London and New York

Peter Weinberg, a former CEO of Goldman Sachs International has a piece in the Financial Times (“How London can close gap on Wall Street”, Financial Times, March 30, 2006) arguing why London could catch up with New York as the world’s leading financial centre. He believes that two factors give London a chance today:

  1. The huge amount of Arab money that goes to or through London because of political reasons.
  2. The preference for new issuers to list outside the United States due to Sarbanes-Oxley and other reasons.

Weinberg also suggests that an acquisition of the London Stock Exchange by a US exchange could facilitate this process.

We know that the United Kingdom has historically paid a big price for the success of London in the form of subordinating its domestic economic policies to the needs of the City. The United States has clearly shown that it is unwilling to do so. This would mean that even if London does gain, this will be a pyrrhic victory that does little good to the United Kingdom. See my post last year on whether financial centres are worthwhile.

Weinberg does however make an important point that New York’s dominance of global finance cannot be taken for granted. Those of us who had loosely interpreted Kindleberger as implying that a global centre is more or less secure in the absence of war or other serious upheaval should probably think again.

Posted at 15:08 on Sat, 01 Apr 2006     View/Post Comments (0)     permanent link