Crystal ball gazing..the NIFTY

Hello.. thought I might start a little column on markets in general.. its a good way to keep a tab on one's thought process and accuracy.. 

lets start with NIFTY... should visit 2850 first stop next week (Dec 1st to Dec 5th).. and test 3000 sometime in December.. a good strategy would be to buy 3000 calls....write 3200/3300 calls.. and once (if) the market gets to 3000, start selling some lower puts depending on how close you are to expiry.. 

Bernanke on Deflation

A speech by Bernanke on deflation...delivered on Nov 21, 2002, at the National Economists Club in Washington.  He talk about the possibility of deflation in the US and what the Fed can do (even after policy rates come down to zero)... its a long speech that describes defation, the causes, how the Fed can prevent it and how the Fed can cure it if it actually comes about..

Bernanke underscores how a fiat money system money system can be used to fight deflation by printing money and buying all kinds of assets and undertaking aggregate demand stimulating policy measures.. I can see gold becoming  more and more attractive (read post) read the speech here

CLSA on Gold

Interesting excerpt from a CLSA report on Gold..

CLSA

Gold : Dont Give Up Yet

End of decade target maintained at $ 2700 an ounce. The reversal of carry trade currencies - the Yen and the US Dollar is imparting near term strength to the Samurai and Greenback. The flight of the US Dollar and Jap Yen towards domestic shores should complete over the coming months.

 

This is when massive liquidity flows unleashed by Central Banks across the World will begin reflecting in weak Japanese and US currencies. While the current hoardes of Gold lie in vaults owned by Gold ETFs and many Central Banks, in future the Gold market which is presently occupied by reversals in the Value of "Bubble" Commodity currencies of Australia, New Zealand and Russia will have to contend only with Gold coming in from miners and not from the Hedge fund liquidation of Gold futures. Central Banks are likely to hold on to Gold Reserves for dear life, just as paper currencies continue to be debased.

 

CLSA continues to be asked a lot of questions about Gold in the context of the continuing correction in the oil-led commodity complex and the continuing US Dollar rally. 

 

The key point is that investors should not give up on Gold. It is natural that Gold should have participated in the recent oil-led commodity correction since most investors just assume it is only an inflation hedge. This is fundamentally wrong. Gold is a currency, and a hedge against both inflation and deflation since it is the only financial asset that is not part of the contaminated credit system.

 

This is why Gold will rally again in US dollar terms when the markets start to discount renewed Fed easing, as they have begun to do. And the more the US Dollar rallies, the more comfortable Billy Boy Ben will feel about cutting rates again. 

 

But the key point for investors to note when Gold starts to rally again is that, it will in the next bull upmove outperform dramatically oil and other economically sensitive commodities.

 

This is important since in its recent parabolic spike Oil reached an unprecedented premium valuation over Gold. Thus, Gold/Oil price collapsed from 12.4 in January 2007 to a near record low of 6.35 in June 2008 and is now 8.9.

 

This is why Gold is now set to Outperform Oil dramatically from here. It is also why Gold stocks are now very attractive since a major negative for Gold mining stock's profit margin has been rising energy costs.

 

But the key point to remember is that Gold is a currency and not just an "inflation hedge". CLSA recommends a 30 per cent allocation to Gold and Gold miners for Long Only US dollar denominated pension funds.

More evidence towards deflation...Treasuries trading at 0.04% yields

Just checked the bond yields...havent done that for over a week and I was shell-shocked... I know I've been talking about deflation, risk-aversion, etc etc...but didnt' realize that 3 month bond yields in the US were at 4 basis points, i.e. 0.04% ! 

Well I'm no bond trader and this interpretation might be incorrect since current prices are a reflection of tomorrow's reality.. Another way to look at this that bond traders may be expecting a further in inflation index (change in the values of the index gives us inflation levels) three months from now, i.e. a fall in price levels in the next three months (as opposed to measuring yoy inflation which is reported by the media). This may the correct way to look at the yields since inflation has just been reported as fallen by 1% in the US (read blog post).

The other possible story is that of extreme risk aversion.. Treasuries are considered risk-free (though CDS swaps on the Treasuries are creeping upwards). If you're petrified of holding any risky asset, then you'd hold cash..or US Government bonds.. Cash yields no nominal return. So you'd continually switch from cash to US Treasuries so long as the Treasuries do not yield a negative nominal return. The assumption here is that Treasuries are risk-free and easily convertible to cash with minimal transaction cost. This gives me an idea..maybe the 4 basis points of yield left on the bond reflects transaction costs?

US TREASURY BONDS RATES

Maturity	Yield	Yesterday	Last Week	Last Month
3 Month	0.04	0.06	0.12	1.01
6 Month	0.63	0.73	0.71	1.49
2 Year	1.12	1.13	1.15	1.70
3 Year	1.36	1.43	1.58	1.34
5 Year	2.08	2.19	2.35	2.78
10 Year	3.36	3.53	3.64	3.83
30 Year	3.96	4.12	4.17	4.25

Source: Yahoo Finance

Deflation Update: US reports record drop in consumer prices..

The US reported a record drop of 1% in consumer prices this week (after reporting a record drop in producer prices just yesterday).. read the Bloomberg story here..read another interesting Bloomberg story here.

Fortunately the drop was led by drop in energy prices which fell by 8.6%.. core prices fell as wel (excerpt from Bloomberg)l:

The drop in core prices reflected declines in the cost of clothing, automobiles, air fares and hotel rates. New-vehicle prices fell 0.5 percent and clothing costs dropped 1 percent. The price of airfares plunged 4.8 percent, the most since June 1999....The cost of all services, excluding fuel, was unchanged, the first time it hadn't increased since 1982.

Warren Buffet sells puts on equity indices !!

Warren Buffet sold puts on equity indices according to a Bloomberg article:

Under the agreements, Berkshire will pay as much as $37 billion if, on specific dates beginning in 2019, the market indexes are below the point where they were when he made the agreements. By Sept. 30, Omaha, Nebraska-based Berkshire had written down the contracts by $6.73 billion as the S&P declined for a fourth straight quarter.

This bet has caused the CDS on Berkshire, Warren Buffet's holding company, to more than double from 140 to 388 basis points.. this maybe, however, maybe a result of counterparties hedging their bets against default risk which might rise if the contracts pay-off..

Buyers of the credit-default swap protection on Berkshire may include the companies that stand to gain if Buffett loses on the stock bets, said Matthews. They may be hedging their gains against Berkshire by entering into separate agreements to ensure they recover some funds if Berkshire is unable to pay, he said.

Can't figure the markets out? Go market neutral !!

If you're one of the guys out there who's having a miserable time trying to get the market direction, try pair-trades.. they involve going long and short two securities simultaneously to keep market exposure at zero. The idea is that one security will outperform the other (and you'll ex-ante figure out which one) and you'll make money without taking on market risk..

A lot of prop desks use these strategies with time horizones varying from 1 day to months.. In India, Edelweiss has a good pair-trading desk..so does Kotak.. If you're a client with these firms, they share their trade suggestions with you... 

On the more adventurous side (and more gratifying as well).. you can build your very own model !! Either how, for now..you can track these trades..

Long Axis Bank Short HDFC

Long Axis Bank Short HDFC Bank

Long KotakBank Short Power Finance Corporation

Long Bank of Baroda Short Union Bank

China now the world's largest non-US holder of treasuries

China is now the world's largest holder of treasuries (read the Bloomeberg story). What an interesting set-up...the world's largest emerging economy saving and financing the deficit of the world's largest developed country... I think of the sequence this way:

1. Poor man in China produces a good
2. Rich man in America buys the good
3. However, the rich guy in America realizes that he doesnt' have the money to buy the good
4. The poor man in China takes money from the rich American guy and lends it back to him to be able to buy more Chinese goods
5. The American guy keeps borrowing money from the Chinese to buy Chinese goods
6. Both guys are happy...
7. But...the American guy is getting more and more indebted to the Chinese guy.. the Chinese guy ends up owning more and more of American assets..
8. Motivation: the American guy wants to buy more stuff and he doesnt care about saving since the government can issue more debt; the Chinese guy is poor and he must hoard assets/savings to protect himself from future crisis
9. What makes this possible? The status of the dollar as the world's reserve currency

Deflation update: US and UK witness sharp drop in price levels

Just a follow-up on what I said in the 'Weekly Watch' section..deflation continues to remain a concern in price levels in the economy (not just asset price deflation which has already been happening for quite some time across all asset class save gilts)..  Inflation data for both the US and the UK this week recorded historic drops..with the most on record drop in the US at -2.8% (read story) and the largest drop in 10 years for the UK (read story).

Misc stuff on the US

I found a couple of interesting posts on CalculatedRisk...

1. Personal bankruptcies are on the rise in the US (read NY Times). It looks like households are in much worse shape entering this recession than compared to the 2001 bust. Bankruptcies in California and Nevada were up between 70% to 80% in October 2008. For details read this post.
2. Slowing exports and Residential investments
   Accordingly to CalculatedRisk (read the post), the US non-petrol current account deficit widened in September.. export growth is expected to remain slow due to a strong dollar. Data for October is expected to be worse.
   The second point made is that contributions of exports and residential investments to GDP are countercyclical...the export growth is tapering off but the ability of residential investments to support the GDP seems limited given the high inventory building up.

Rating agencies relaxed rating standards in greed for profit

A brilliant article on the role of rating agencies in helping create the sub-prime bubble by laxi rating standards, not update models, hiding model error and other dirty practices....read "When Junk was Gold" by Sam Jones of FT.

Weekly Watch: Nov 16, 2008

Hello..stuff to watch out for this week:

1. G20 meeting
   I do not expect any significant fiscal plan to emerge from the G20's meeting this weekend. All countries are already trying their best to keep their economies from slipping into recession and any fiscal/monetary plans announced should not be considered the result of the G20. The event is largely political
2. General Motors Bailout
   US Congress and the current Bush administration will work on bailing out General Motors (GM). While the consequences of GM failing will be severe both politically and economically for the US, it remains to be seen how a comprehensive bailout plan can be worked out with Republican opposition.  The most likely outcome is a stop-gap measure to keep the automakers alive till Obama takes office in Jan.
3. US Inflation data
   US inflation data, to be released this week, is expected to be negative. While the data in itself is not too important, if followed by subsequent negative core-inflation data points it will point to contracting consumer spending and corporate investment in the future.
4. Details of Paulson's new plan for consumers (high market impact)
   This is important for the market trader. If Paulson announces a credible plan to address the problem of diminishing consumer credit, markets and commodities, which are in highly oversold territory, may give a sharp upward move.
5. Possible rate cut in India 
   India reported 9% yoy inflation this Thursday - the first single digit number in many months (read about how india calculated inflation). This gives the RBI room to further cut interest rates to stimulate growth in a slowing economy..
6. India's GDP number to come towards Nov end
   I don't have the exact dates with me right now.. but India's quarterly GDP growth number is expected towards the end of November. The PM's forecast has been between 7% - 7.5% I'd take the forecast pretty seriously since its from the Prime Minister.. my estimate is around 7.4%; the bad GDP numbers should start coming out around next quarter.. read an interesting article on the Indian GDP on Ajay Shah's blog

Economists expect negative CPI in the US for October

We're certainly living in dynamic, unpredictable times.. just a couple of months back the world was worried about inflation (Mr Trichet especially).. and now delfation !!

Falling commodity prices may cause the consumer price index to fall for the first time in 60 years according to forecasts. Bond prices in the US imply a fall in consumer prices of about 2.5% over the next year (read my earlier blog post on the consequences of deflation). Unless monetary authorities can restart the free flow of credit in the banking system and come up with credible fiscal stimulus packages that support consumers and consumption, the deflationary spiral looks increasingly probable. 

The silver lining for now is that the expected drop in consumer prices is due to the collapse of energy and commodity prices; prices ex food and energy are forecast to rise 0.2%. 

Read the Bloomberg article..

Nov. 16 (Bloomberg) -- The cost of living in the U.S. probably fell in October by the most in almost sixty years, while manufacturing and homebuilding sank deeper into a recession, economists said before reports this week.

Consumer prices probably dropped 0.8 percent last month, the most since 1949, according to the median estimate in a Bloomberg News survey. Builders broke ground on the fewest houses in at least a half century and factory output weakened further, other reports may show.......

A report from the Labor Department on Nov. 18 may foreshadow the drop in retail costs. Wholesale prices fell 1.8 percent last month, the most since records began in 1947, according to economists surveyed....

India's slowdown recognized officially...

BRE (Reuters)
* PM - India growth rate will slow to 7.0-7.5 pct in current financial year from close to 9 pct

This number's on the optimistic side compared to consensus expectations.
Sent from BlackBerry® on Airtel

Deflation in the developed world

I was discussing deflation with a friend a couple of days back and was planning a blog post on it.. lucky for me that The Economist ran a story containing most of what I wanted to say (and some more).. read the story here..

Text-book economics tells us that deflation has the opposite effect of inflation.. deflation favours lenders rather than borrowers which...

1. Increases the real burden of fiscal debt on the government. Since debt is largely denominated in nominal terms, the tax on nominal income (which is the source of debt-servicing) has to be raised higher to service the debt. 
   One argument against is that the government can simply print money to service debt. This is not the case in the Western world where the printing press is independent from the debt issuing agency. However, more thought needs to go into this aspect of deflation..
2. Indebted consumers suffer as interest payments increase as a portion of their dimishing nominal income. This will almost certainly lead to contraction in consumption, aversion to debt and other ugly effects which will hurt the GDP.. 
3. The same sad story holds true for corporate investments.. 

The net effect of all this is what many would charmingly call a "vicious deflationary spiral" that kills the economy, growth and standards of living...

The sad reality is that text-book economics seems to be coming to life.. according to the above article in The Economics, bond markets expect consumer prices in America to fall by as much as 2½% over the next year.

The Price of Volatility !!

I recall my first attempt at running an delta-hedged options portfolio very clearly. It all started with my fascination of trying to devise quant trading strategies based on financial theory I'd read at various points.. I'd tried 2-3 strategies earlier with considerable success so I was pretty confident that this would work out as well... 

Couldn't have choosed a worse time to try the strategy - using the October 2008 contacts (the period before volatility levels went off the charts) on the NIFTY (one of the most volatile equity indices around).. The NIFTY was at around 4000 levels.. Option implied vols were up from around 30% levels to around 50%...almost at historic highs... it was just the opportunity I was waiting for. I sold an at-the-money straddle that gave me a profit band of around 10% around the strike price. 

Little did I know what lay in store for me.. and I guess this was the best way to learn.. the market collapsed.. went down 10% to 3600 in the next week.. and I sold another straddle at a lower strike to widen my profit band (read as dig a deeper grave).. I was delta hedging my portfolio perfectly.. but the losses were huge.  Couldnt figure it out too well except that implied volatility had gone up to around 80%..  

Anyway, the markets' returned to a level where I was previously making profit.  I was shocked to see that one week later (when theoretically the profit should've been higher), I was still losing money.. and a lot of it.. the only difference from a week earlier was that volatility had risen to levels of 90-100%. 

I cut all positions immediately and booked my losses (booking losses quick was another hard learned lesson from earlier experiments).. and god knows I was lucky...the markets collapsed another 50% from the levels I had booked my losses.. had I not cut my positions, I would've been seriously hit.. 

I guess I paid a very small price to understand what volatility was....and now I know why they call VIX the 'fear index' - the part of insurance cost that cannot be explained by models (and thus considered irrational) is the reflection of higher than normal uncertainty or 'fear'..

Europe Economy Falls Into First Recession in 15 Years

Read the article on The Economist.

From Bloomberg:

"Gross domestic product in the 15 euro nations shrank 0.2 percent from the previous three months, when it also contracted 0.2 percent, the European Union's Luxembourg-based statistics office said today. The two quarters of contraction -- the result of this year's surges in the cost of credit, the euro and oil prices -- mark the first recession since the single currency was introduced almost a decade ago....."

Read the story here

Citi downgrades India growth estimates

Citi lowered India's growth estimates in their report dated 14th Nov, 2008:

"We thus further lower our FY09 and FY10 GDP estimates from 7.2% and 6.6% to 6.8% and 5.5%. This factors an additional 200bps reduction in interest rates."

Citi executives, Pandit, buy Citi shares at $9..

Vikram Pandit and other executives from Citi purchased 1.3 million equity shares in the company on 13th Nov, 2008, as Citi made a new low at around $9 levels (read the Bloomberg story). The stock is how down almost 83% from its high of $55. 

New wave of CDOs at risk of default [Financial Times]

New wave of CDOs at risk of default 

By Paul J Davies 

Published: November 13 2008 23:55 | Last updated: November 13 2008 23:55

Synthetic CDOs, the risky and complex debt products that are based on pools of corporate credit derivatives, are under increasing pressure after suffering a wave of default-related losses on top of general credit market deterioration.

Synthetic collateralised debt obligations based on exposure to corporate bonds through the derivatives market have already seen $24bn of losses from the recent defaults of Lehman Brothers and other financial institutions, according to analysts at JPMorgan.

Deals worth $103bn have been left in what the analysts call a “binary” position and could see a quick descent into losses if more defaults materialise, the analysts said. Between $32bn and $56bn of these mezzanine, or middle ranking, tranche deals are at risk of high capital losses with the next default.

JPMorgan estimates there are about $757bn outstanding of synthetic CDO tranches based solely on corporate debt derivatives, many of which were created and sold during a boom in issuance through 2006-07. 

Synthetic corporate CDOs were instrumental in driving down spreads, or risk premiums, on credit default swaps during the height of the credit bubble, because the banks that created these products hedged them by selling contracts for protection against default on hundreds of individual companies referenced in the CDOs.

The main concern for credit markets is that a flight by investors away from CDOs would lead to a reversal of this process, whereby banks would be forced to buy back huge volumes of protection and so push spreads dramatically wider from their already elevated levels.

The JPMorgan analysts expect the rate at which investors look to unwind their trades will remain slow and gradual for now, in part because there are no market value triggers to cause a run for the door.

“Having said that, the size of this market remains significant and investors experience of the first capital losses could be a turning point in their decisions around holding these trades,” said Yasmine Saltuk of JPMorgan. 

At the moment, market value losses exceed credit losses by most estimates. Analysts at Citigroup put market value losses on an estimated $584bn of outstanding synthetic CDOs at $67bn by November 10. This is a recovery from the $81bn loss position on October 24 when CDS spreads were around their widest.

The private nature of the CDO industry makes estimating even just the size of the market difficult, hence the difference between the Citi and JPMorgan estimates. 

Ms Saltuk and her team estimate market value losses on about $436bn of remaining mezzanine tranches to be in the region of 30-40 per cent, or up to $174.4bn.

Michael Hampden-Turner of Citi is more sanguine about the pace of unwinds, saying that investment grade defaults in the near future are not likely to be as numerous as during the recent weeks of extreme financial crisis. “The pace of [CDO] unwinds and restructuring has increased, but it still remains low and orderly given the overall size of the market,” he said.

Germany Officially Slips into recession [Bloomberg]

More bad economic data..Germany has officially slipped into a recession (read the bloomberg story).

The only upside for the German people is that they do not have mountains of debt like their counterparts in the UK and America. Few people have mortgages, there is no housing crash like in the UK or Spain and household debt is nothing like that in other European countries... read here.

According to Recession Watch, 

1. US Treasury Secretary Hank Paulson more or less admits that his $700 billion bailout plan is not delivering results. He now has a Plan B.

2. China says that its industrial production is growing at its slowest rate in seven years.

3. The mood in Japan is glum, with companies expected to announce bad results.

4. The World Bank says global trade will shrink in 2009, the first time in 27 years. Lead indicator: The Baltic Dry Freight Index is down 90 percent.

5. The Bank of England forecasts a deep 18-month recession in the UK. 

CII suggests stabilisation fund

CII, in its recent meeting, suggested a stabilisation fund with a minimum corpus of $20bn. Read the news story.

While the nature of CIIs fund is not totally clear, the aim is similar to the stock stabilisation fund suggestion earlier on this blog. 

Head and Shoulders..!

The market's been through a lot these days.. the head & shoulders pattern (both upright and inverted) has been appearing on charts a lot recently.. I'm posting an example of one of the longer-term examples which I personally didn't believe would pan out.. if you're unfamiliar with the pattern, there's a short note available here. On the NIFTY, the pattern executed perfectly.. the rule is that the fall/rise would be equal to the distance between the head and the neckline..

It doesn't work everytime.. and one should never take a trade just on the basis of this pattern..but it is one of the more powerful chart patterns and is almost never ignored by a trader (which perhaps is a case of self-fulfilling which results in the pattern itself..) From my experience, I'd say it works 40-60% of the time...

Weekly Watch

Latest set of issues people are talking about this week:

1. Fed's balance sheet
   The Fed's balance sheet has almost doubled in the last one year beacuse of interventions in the money markets and acceptance of a wide range of collateral against which it has been lending. Treasuries as a percentage of the Fed's balance sheet have declined sharply.. while concerns about the Fed's balance sheet have been there along, they've hit the headlines this week when Bloomberg sued the Fed.
2. Downgrading of Emerging Market ratings by Fitch
   Fitch has recently downgraded 4 CEE economies. There are concerns that more economies may be on the line... Downgrading increases the cost of sovereign debt and in some cases may cause a balance of payments crisis if there are no takers for rolling-over of short-term debt. There should be more sovereign defaults/IMF bailouts in the coming months.. lookout for action in this space.
3. Revision of mortgage terms
   US lenders get rational and have started revising terms of loans made earlier.. JP Morgan did it last week.. Citi's at it now.. Read the bloomberg story
4. China's stimulus package
   China's stimulus package this week whipsawed a lot of commodity traders this week.. on announcement of the package commodities rallied around the world..only to fall back to lower levels after the rally...crude even breached $60 on Monday..

Bear Stearns's collapose linked to stock manipulation by naked shorting [Bloomberg]

Very interesting article on alleged manipulationg of Bear Stearns stock and forcing it into bankruptcy.. read it on Bloomberg.

Story of Lehman's end [Bloomberg]

Bloomberg ran a story on Lehaman's bankruptcy.. throws light on the entire sequence of events and people involved in Lehman's failure..  a definite read !

Lipstick Index of financial crisis [Financial Times]

hello...something curious i came across on the FT website.. the lip-stick index of financial crisis !!

Limited Liability Parternship to come to India !

India may introduce the Limited Liability Partnership (LLP) in 2009. LLPs function exactly like partnerships except that the liability of the partners in an LLP is limited to the contribution of the partner. A discussion on the LLP bill can be found here and the actual bill can be found on the Ministry of Company Affairs' Wesite.

What I find very interseting is the implications the LLP bill will have for the portfolio management/hedge fund industry. Currently, portfolio managers in India are regulated by SEBI and face numerous restrictions/regulations on their strategies and operations. Some regulations are resonable and protect the investors while some are completely bizzare (take for example the regulation touting a ban on pooled accounts).

The question is - will SEBI object outright to the use of LLPs as a vehicle to pool and channel private investments? If not, then the LLP opens a whole new world of opportunities for HNI  investors and hedge fund managers interested in leverage, shorting the market, convertible arbitrage, long-short strategiesand other unconventional investment strategies. 

Presently, the only way an investor can gain access to strategies other than buy-and-hold are through research analysts at brokerage houses. However, there is an obvious conflict of interst present there which is removed in the case of an asset manager who's revenue depends on client profits (and not on portfolio churning).

LLPs will allow asset managers to start offering sophisticated portfolio strategies to individuals/corportates/institutions who desire them while limiting liability from losses and from SEBIs interference. This will benefit the investment profession as well as investors. 

SEBI's role should be similar to the Financial Services Authority, UK, or the Securities Exchange Commission (SEC), USA, which prohibit hedge funds from marketing their services to the general public.  SEBI spread awareness to investors of the risks and that hedge funds running as LLPs are not restricted in their investment practices by SEBI. Invetors who want to take the additional risk should be allowed to take it.

*********

an after-thought---

Since the proposed LLP strucuture allows for foreign partners, theoretically a NRI/foreign investor can take a partnership stake in the LLP investment vehicle. This direct route may allow the foreign investor to side-step the numerous SEBI guidelines. It will be interseting to watch how this aspect of the LLP will play out..

Bubbles - a simple depiction

I came across this very simple depiction of an asset bubble in a (closed) economy.. should be an interesting read..

Once there was a little island country. The 'land' of this country was the tiny island itself.

The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country.
A owned the land.
B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.
* The net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and togethe with his own 1 dollar, he bought the land from B for 2 dollars.
*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since
he owed B 2 dollars, his net asset is 1 dollar.

* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars.

A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by, borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net
asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt
of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.
* The net asset of the country = 6 dollars; even though, the country has
only one piece of land and 2 Dollars in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C's mind.

'Hey, what if the land price stop going up, how could B repay my loan. There
is only 2 dollars in circulation, and, I think after all the land that B
owns is worth at most only 1 dollar, and no more.'

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars
is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net
asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.

(10) So, who has stolen the 3 dollars from the country ? Of course, before
the bubble burst B thought his land was worth 4 dollars. Actually, right
before the collapse, the net asset of the country was 6 dollars on paper.
B's net asset is still 2 dollars, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2
dollars bad debt to B, but in return he acquired the land which is worth 1
dollar now.

* A owns the 2 coins, his net asset is 2 dollars.
* B is bankrupt, his net asset is 0 dollar. ( he lost everything )
* C got no choice but end up with a land worth only 1 dollar
* The net asset of the country = 3 dollars.

--- End of story ---- 

There is however a redistribution of wealth.

A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting -

(1) When a bubble is building up, the debt of individuals to one another in
a country is also building up.

(2) This story of the island is a closed system whereby there is no other
country and hence no foreign debt. The worth of the asset can only be
calculated using the island's own currency. Hence, there is no net loss.

(3) An over-damped system is assumed when the bubble burst, meaning the
land's value did not go down to below 1 dollar.

(4) When the bubble burst, the fellow with cash is the winner. The fellows
having the land or extending loan to others are the losers. The asset could
shrink or in worst case, they go bankrupt.

(5) If there is another citizen D either holding a dollar or another piece
of land but refrains from taking part in the game, he will neither win nor
lose. But he will see the value of his money or land go up and down like a
see saw.

(6) When the bubble was in the growing phase, everybody made money.

(7) If you are smart and know that you are living in a growing bubble, it is
worthwhile to borrow money (like A) and take part in the game. But you must
know when you should change everything back to cash.

(8) As in the case of land, the above phenomenon applies to stocks as well.

(9) The actual worth of land or stocks depend largely on psychology

Convertible Arbitrage: an example - Tata Steel

Here's an idea for people looking for arbitrage opportunities in the Indian markets.. The pre-tax exptected returns are approximately 15-20% (annualized) compared to 10.5% pre-tax in a bank deposit.

Background

The idea's a variant of convertible arbitrage where we can exploit the difference between equity shares (EQ) and convertible stock (CCPS)  of Tata Steel (details of converion can be found here). Briefly, under the terms of conversion, 6 CCPS shares will automatically convert to 1 ordinary EQ share on 1st Sept 2009. 

CCPS paid Rs. 12 (Rs. 2 per CCPS * 6) dividend while the ordinary stock paid a dividend of Rs. 16. Dividends on both the equity stock and CCPS have been paid for 2008 and if one assumes the same dividend for 2009 (though dividend on the EQ share may be cut given the financial pressure on the company), it accounts for a discount of Rs. 0.66 per CCPS. If one discounts the cash flow, the figure is even lower.

Opportunity

The EQ share has been trading at a premium of between 5% to 15% to the CCPS. For the month of October, it averaged at 11.5% (12.5% annualized). 

To lock in this arbitrage profit, one should buy the CCPS in the cash market and short the futures in the derivative markets (since the stock borrowing is not feasbile in the Indian markets) and keep rolling the short positions on the futures till Sept 2009. In Sept 2009, on receipt of the EQ shares in lieu of the CCPS, the position is reversed to realize the profit.

As a matter of fact, since stock futures trade at a premium to the underlying EQ share, one will gain an additional 10-12% over the 11 month period under normal market conditions. Therefore the returns can be as high as 20% to 25% for the 11 month period untill Sept 2009.

Risks

Since we cannot practically short the EQ shares and have to reply on the futures, we run the risk of losing money on the trade if the stock futures trade at a discount to the underlying common stock (EQ) through the 11 month period (known as backwardation). This is possible in the Indian markets since futures are cash settled.

FIIs Short-Selling in India

For information on short-selling in India, you can refer to SEBI's discussion paper and read an interview on Moneycontrol.

Short-selling in India was always possible (and actively engaged in by all types of investors - from FIIs to the individual small investor) via the futures market. Allowing shorting will increase the overall liquidity available to parties wanting to short a stock - liquidity will now be the sum of cash and futures volume as opposed to just cash futures volume. Further, for the stock where the futures are not active, it will be possible to short the cash market.

Now, the reasons why the FIIs shorted by borrowing stocks instead of the futures markets are:

1) They borrow and short stocks for which futures do not exist (e.g. Educomp)

2) It was much cheaper for them to short by borrowing as opposed to shorting the futures because of the cost involved. The cost of borrowing stocks, according to reliable industry sources, is approximately 4% annualized. The margin requirements on stock futures vary from 25-50% of the contract value depending on individual stock volatility. 

3) In India, for both stock and index futures, liquidity exists only for the future contract expiring at the next earliest expiry (near month futures). The liquidity in longer-term future contracts (extending from 2 to 3 months ) is very low. 

In any case, the impact on the Indian markets of FII short selling in the cash market is over-rated since the overall volume is low compared to the traded volumes and one shouldnt read too much into it from a trading perspective.