AR T H A AR T H I S SU E I II
C O NT E N T S
Visit us at finomina.iimu.ac.in Editorial Team: Anusha Ganne, Aditya Raghunath, Arun Kumar Design Team: Ankur Agarwal, Deewakar Gupta, Madhavi Patil, Rajesh Kumar, Shubha Bansal Cover Design: Prateek Shukla Publishing & Distribution: Anusha Ganne, Ashvini Kumar, Prateek Shukla, Shubha Bansal Coordinator: Anusha Ganne
Contents Let's Beat The Market - *Conditions Apply
Page 1
Corporate Bond Market in India
Page 4 Insurance Industry: The driver of economic development in India
Page 6 The Dangerous DerivativesDemystified
Page 10
Risk management in crisis
Page 13 Rupee vs Dollar: 1/x or log(x)
Page 16 Money Ratnam
Page 19 The Leadership Summit “Need to Redesign”
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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AR T H A AR T H I S SU E I I I
E D I T O R I AL
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From the Editor’s Desk, inomina is proud to present yet another brand new issue of Arthaarth. Finomina, the
Finance Club of IIM Udaipur, strives towards nurturing interest and creating aware-
ness among students regarding the different domains of the financial services industry and finance profiles in other industries. Arthaarth goes a long way in helping Finomina achieve these objectives.
The current issue of Arthaarth is quite unique and very different from the previous issues. There are articles
focusing on issues ranging from the insurance sector in India to the financial markets around the world. Apart from having the privilege of being launched at the prestigious flagship event of IIM Udaipur, The Leadership Summit 2013, the issue has an impressive assortment of articles which explore the depths of finance. The theme of the issue is “Redesign”. Whether it is in redesigning the market benchmarks or redesigning the risk management process of an organization or the regulations of insurance sector, it is time for India to em-
brace redesigning for the next big leap it is meant to take. The cover story of this issue, “Let's Beat the Market *Conditions Apply” is an academician’s galore. It is an article in which an investor takes on the audacious task
of beating the Bombay Stock Exchange Sensex and comes out with flying colors, I dare say. “Corporate Bond Market in India” looks at the issues being faced by this market in India and compares it with the markets in the USA. The article on “Insurance Industry” compares the performance of this sector with that in the US and
UK. It discusses the impact of FDI in this sector and peeks into the investment function of this industry. “The Dangerous Derivatives – Demystified” takes a new look at the different types of derivatives and analyzes their
role in the 2008 credit crisis. Speaking of the financial crisis, we have another article “Risk Management in Crisis” which talks about the various steps an organization needs to take to cushion the fall in times of crisis and also how to prevent such a fall in the first place. But it looks like crisis has already engulfed India due to
the huge rupee depreciation. “Rupee vs Dollar: 1/x or log(x)” analyzes the three pronged strategy adopted by RBI to arrest this decline of Rupee.
And then we have Arthaarth’s most lovable character, Money Ratnam, once again coming out of hibernation to demystify finance in his own unique way. This time he talks about his most recently acquired wisdom about Penny Stocks.
Last but not the least we dedicate an article to The Leadership Summit 2013, the theme for which is the “The
Need to Redesign”. It talks about the importance of “Redesign” in today’s evolving world and honors the distinguished panel members who would be gracing us with their presence during the event. We wish your reading would be as pleasurable as it has been for us authoring the articles. Yours Sincerely, Anusha Ganne
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1
C O V E R ST O R Y
Let’s Beat The Market- *Conditions apply
data set? 3000 stocks with information on ticker, industry, beta, market cap, last price, P/E, annual returns for the last nine years (from 2004 to 2013), etc.
To start building the portfolio, I cannot work with 3000 stocks. Thus, the first filter I choose is market cap. I pick the top 50 stocks according to mar-
ket cap. The new set of stocks is now workable. To Image:tudogs.com
P
make some sense out of it, I calculate the annual returns for each year from 2004-05 to 2012-13.
roblem with money is that you just cannot see
To build FINTOP I need two key things for each
your savings bank account, insurance, stock mar-
stock, what is the measure of risk associated with
it sit idle. You need to invest it somewhere –
stock– what is my expected rate of return for each
kets, etc. - depending on your risk appetite. If I
each stock. In the end, every investment can be
investments why not aim for something fancy.
deviation of the annual returns as the measure of
have to invest my time and real money towards
treated as a risk-return problem. I take standard
Academicians say one cannot really earn excess
volatility – the risk. The return volatility of a stock
just by reading it. I need to test it to see it for my-
in the returns. And thus I calculate the standard
wait for a year or two to see what returns I earn.
With that knowledge, I need to the find an optimal
returns in the long run. But I am not convinced self. But I don’t have enough money to invest, and
captures a whole lot of other risks that is reflected deviation of all the 50 stocks.
So I take the shelter of an analytical mind, some
allocation of weights to the stocks to build the
and, put simply, start crunching numbers. The rest
gramming model to vary the weights of the stocks
conceptual understanding of how markets work
portfolio. What I need now is a non-linear pro-
of the story is about my quest for the holy grail of
in the portfolio and maximize the Sharpe Ratio -
I go to Bloomberg lab and pull out data of the top
risk free rate (assumed to be 8%) and the standard
investing: “Let’s beat the market!”
the ratio of portfolio return in the excess of the
3000 stocks listed on Bombay stock Exchange
deviation of the portfolio. Maximizing Sharpe Ra-
excel sheet and voila, my battle ground is ready.
takes not just returns but risk adjusted returns in-
already – FINTOP – “The Optimal Portfolio of Fi-
into a bunch of stocks from the same sector. To
(BSE) for the last 9 years. I put all that into a neat Before I build the portfolio, I have a name for it nomina”
The problem at hand is- how do I read the huge INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
tio ensures that my decision of picking stocks to account. But I don’t want to put all my money avoid that risk, I ensure that I put an upper limit (20%) on the weight any single stock can have in FINOMINA
C O V E R ST O R Y
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the portfolio.
jective is to simulate the returns of FINTOP for the
This exercise leaves me with an expected rate of
next one year and see if the returns can be more
return of the portfolio that just does not seem right
– simply because it’s too much. I check everything again and again, the calculation is alright. Then my attention goes to data for 2008-09 and 20092010. The return for a lot of stocks is just too
much. I realize that the recovery from impact of the financial crisis of 2008 may have caused high returns for a lot of stocks. Assuming that we are not seeing another financial crisis in the next one year, I intend to remove the effect of such an event. To do that, I remove the returns of year 2008 to year 2010 from all my calculations. I run the whole exercise again, only now, without the data for 2008-10. What I am left with is a set of six stocks from five industries (Fig. 1) that, today,
has an expected rate of return of 24.42% and
than that of the SENSEX. So I start simulating the cumulative return for the next 252 days (number of trading days in a year) for both – FINTOP and the SENSEX. I make use of
the theory that daily stock returns follow a normal distribution. A random number between 0 and 1 for the probability of daily return, the daily expected return (expected annual return divided by 252) and the daily standard deviation (annual standard deviation divided by square root of 252)
are three things I need to estimate the daily return of the portfolio. I do this for the next 252 days to
arrive at the annual return available on the 252nd day. I then simulate this return for 1000 trial paths. Average of these 1000 trials is the return that FINTOP can earn in the next one year.
standard deviation of 33.28%. (Fig.2) But how do I prove that in the next one year, FINTOP will earn more than what the SENSEX will earn? I turn back to a simulation (Monte Carlo). The obFINOMINA
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3
The same exercise is done for the SENSEX (along
Firstly, my expectations of the future return
lation, in the next one year, FINTOP can earn an
historical data. Secondly, my assumption is
with the simulation). As it turns out after simuannual return of 27.64% and SENSEX can earn an annual return of 26.05% (Fig. 3).
In other words, I can beat the market! But, what are the caveats here? It’s not the first time that someone has claimed to do such a thing. Fund managers in the past have done it occasionally, if not on a sustained basis.
Are my claims too tall to stand the test of time? Am I reveling at the idea of beating the market and missing something important?
The answer is both yes and no. Yes, because I have not seen the future. No because it may so
just happen. The reasoning that has gone into building the portfolio is not flawed. But there are assumptions that one must not ignore.
of the stocks are been derived from their that the fundamentals of a company are al-
ready embedded in its price and returns, and that the same will be the case in the future. Thirdly, I have assumed that the daily
returns of the portfolio will follow a normal distribution. And fourthly, but not limited to, that the simulation results of the returns for
FINTOP and the SENSEX brings the same level of error, if any, to both the portfolios. The results are fascinating, not because I potentially stand to gain more than what the market may earn, but because the whole
exercise teaches me a thing or two about investing. Last few weeks well spent! Vivek Pandey, PGP 2, IIM Udaipur
“I've come loaded with statistics, for I've noticed that a man can't prove anything without statistics. No man can.” - Mark Twain
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T
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Corporate Bond Market in India he importance of a well-developed corporate
bond market for any country’s financial system
has been well researched and stated in a number of
publications. Though corporate bond markets are the chief source of funds in many developed countries, the trend is yet to catch on in India. India’s to-
there is a strong case for the bond market in India to grow.
Source of Borrowing
Average (% of Highest (% of total Lowest (% of total total borrowings borrowings) borrowings) as of March 2012)
Bank Borrowings
38.27
95 (Adani)
1.78(BPCL)
Foreign Currency Borrowings
29.66
88.4 (BPCL)
0 (5 companies)
debt outstanding as of quarter ended June 2013 is
Bonds and Debentures
17.51
62.6(Power Grid Corporation of India Ltd.)
0 (4 companies)
BSE market capitalization and 25% of the current
Others
14.56
43 (Tata Motors)
0.02 (NTPC)
tal government securities outstanding as of July 8, 2013 is Rs. 32,27,961.20 crore and total corporate
Rs.13,56,481.44 crore. This figure is nearly 20% of bank credit. Other than this comparison, one more
parameter is the ratio of corporate debt to country’s
GDP. For India, this figure is as low as 2-3%, whereas for USA, the figure is as high as 59%. These fig-
ures tell us the inadequacy of the corporate bond markets in India. Since the common debt equity ratio
is 2:1, the size of the bond market should correspondingly be twice that of the equity market. Rely-
ing solely on banks loans for the purpose of debt is-
n’t the best option, as in case of crisis similar to what happened in 2008, the whole banking system might
Source: Table compiled from CMIE database
The secondary market for bonds is not well developed in India. As can be seen from the graph below,
the fraction of corporate bonds trading in the mar-
ket was mere one-sixth of the gilts traded in 20112012. Although the figure has increased to almost
triple, within a span of four years, there is still a long way to go. An inactive secondary market reduces the attractiveness of any marketable instrument as it
leads to rather large bid-ask spreads and hence
fail and thus lead to the collapse of the entire economy. This calls for a need to develop the corporate bond market.
Comparing the borrowings of the asset wise largest 19 publicly listed companies of India (as shown in the table below), we see that borrowings from banks
are more than double that of the amount borrowed from bonds and debentures. It is even lower than
borrowings in foreign currency. The cost of raising
money through bonds is much cheaper than money raised from banks, and when borrowings are done in foreign currency, there is a huge risk of currency
devaluation as has happened in India recently. So FINOMINA
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price discovery is inefficient. Once a good secondary
NBFCs issued lesser number of bonds due to the eco-
trades as in the current equity markets, it will become
ments of bonds have continued steadily at 19% and
market is developed by ensuring transparency in easier for the corporates to raise money through this route.
nomic slowdown. On the contrary, private place38% over the last two years.
Developments are taking place in India with respect
In a survey conducted by Barclays close to 83% of
to the bond market. Before 2005, the bonds were
tions in the Indian bond sector are the biggest obsta-
In 2005, government bonds started trading on Nego-
on the investments by foreign players and the ab-
works like an exchange and thus provides the ease of
which acts as a dampener.
separate platform for bond trading in May 2013,
foreign investors said that registration and regula-
traded in India through over the counter deals only.
cles in investing. India also places quantitative limits
tiated Dealing System Order Matching (NDS-OM). It
sence of an insolvency code is another parameter
use to the bond holders. NSE has recently opened a
which will provide direct access to investors for trading. Also, the percentage of bonds issued through
public issues has increased to 7.3% in 2011-12, from a meager 0.86% in 2008-09. Looking at the four
modes of resource mobilization- IPO, FPO, bonds, rights issues; the percentage of bonds have increased to 73.5% in 2011-12, from 9.2% in 2008-09.
On the other hand, the foreign investors are pulling their money out of Indian bonds as a result of decreasing yields on Indian bonds and increasing yields A look at the graph above will show that Indian cor-
on US bonds. FIIs sold Rs.11,300 crores worth Indian
raising funds as the cost is lower compared to the
the highest sell off witnessed ever since the FIIs were
porates prefer the private route of placement for
bonds over a period of 10 days in May 2013. This is
public issue route. In a private placement, the issue is
allowed to invest in fixed income securities in 1988.
an scenario, this route is not suggested as investor
treasuries increased by 56 basis point (35% increase
allow for trading in the secondary market which is a
an government bonds has reduced from 8.3% in June
cipline on the issuer. Although publicly issued bonds
ing forex risk being 6.5%, it doesn’t make sense for
limited to a maximum of 49 persons but in the Indi-
It was in May, 2013 itself when the yields on US
information is low. Private placement also does not
from 1.6% to 2.15%). Also the yield on 10 year Indi-
must for efficient price discovery and imposing dis-
2012 to 7.15% in June 2013. With the cost of hedg-
clocked a growth rate of above 270% in each of the
FIIs to invest in India anymore.
years 2010-11 and 2011-12, they experienced a
sudden slump in 2012-13 due to decrease in de-
Rahul Agrawal & Ratika Mittal, PGP 2, IIM Udaipur
mand for loans and lower coupon rates being offered on bonds as compared to previous years. Also, the INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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Insurance Industry
The driver of economic development in INDIA
T
he insurance sector in India has been growing
rapidly, this is reflected in the increasing per-
centage share of its assets to India’s GDP. Yet the scenario in India has a long way to go before standing up to the global market.
The insurance sector plays a major role in the eco-
nomic and human development of a country. It provides the necessary funds for building the infrastructure of the country and also significant
contributions from insurance and pension funds are going towards funding private equities.
The Evolution The first insurance company in India was the Oriental Life Insurance Company which was setup in 1818 in Calcutta. Due to nationalization of life in-
surance sector in 1956, LIC enjoyed monopoly till the time industry was re-opened for private players
in late 90s.General insurance (non-life insurance) finds its roots in the industrial revolution in west.
The first General insurance company in India is the Triton Insurance Company Ltd which was established by the British in 1850 in Calcutta. It was na-
tionalized later in 1973. During this time, 107 insurers grouped together to form four companies, namely National Insurance Company Ltd. at Kolkata, the New India Assurance Company Ltd. at Mumbai,
the Oriental Insurance Company Ltd at New Delhi and the United India Insurance Company Ltd at Chennai.
An autonomous body, IRDA (Insurance Regulatory and Development Authority) was formed in 1999 to regulate the insurance sector. Its main aim was to
increase customer satisfaction and lower the premiums paid by them by promoting competition in the industry and also to ensure the financial security of the industry.
IRDA opened up the market for private players in
August 2000 simultaneously allowing foreign investment of up to 26%. In 2013, there are 27 general
insurance companies in India and 24 life insurance companies. FINOMINA
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FDI in Insurance The limit of foreign direct investment in the insur-
more number of lives than the prescribed 20 lakh lives in the social sector.
ance sector has not been changed from 26% till
date. There has been a bill pending with the upper house of parliament to increase this limit to 49%.
The penetration of insurance (percentage of insurance premium to GDP) and insurance density
(ratio of total premium to population) in India are very poor compared to many of the other countries
in the world. There is a huge untapped market in rural India which needs to be addressed. But in or-
der for the existing insurance players to expand into these remote areas of India, they would need
large capital investments initially. A raise in the FDI limit would ensure capital inflows which would encourage the companies to increase their scale of
operations, due to which the insurance premium would also fall, since the premium is a direct re-
sultant from the law of large numbers. Also more capital would imply more efficiency and more in-
novation in the form of new products which would better suit India’s needs. It would also ensure a better distribution network.
Insurance Inclusion In recent times, financial inclusion has become a
buzz word. Though, up until now, importance has been given majorly to only banking inclusion. But
increasingly, efforts are being made to towards
inclusion of all the people of India in insurance also. IRDA has imposed obligations on the insurance companies to attain certain targets in terms of
number of policies underwritten and total premium income generated in the rural and social sec-
tors. As part of the obligations for 2011-12, LIC
has more than the prescribed 25% of the total policies coming from the rural sector and covered
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
The reason for the slow growth of the insurance sector in India stems from its inability to expand in
the rural and semi-urban areas. The inability of the
people to understand and comprehend the role and importance of insurance coupled with the extensive
used of jargon and legal nature of the documents makes it very difficult to know the benefits of an
insurance policy. Insurance inclusion can be increased by raising awareness about the need and
utility of various insurance products. The companies need to focus on innovation not only in terms of developing products with simpler choices but also in
the delivery methods being employed. A very beneficial product would be the no-frills insurance in both life and general categories. The insurance com-
panies are already on the verge of launching a nofrills health insurance policy which would be at a much lower premium.
Bancassurance is an efficient route of insurance disbursal which needs to be utilized to its full potential as more and more banks are going to be setup in the
rural areas in the near future. There is also a pro-
posal put to IRDA to allow banks to act as insurance brokers and allow cross-selling of micro-insurance
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products. This would further increase the penetra-
tion by leveraging the current expansion being undertaken by the banking sector.
Investments of Insurance Companies Insurance companies play a major role in the Indian economy. In the financial year 2011-12, the
total investments held by the insurance sector in the Indian economy is Rs. 16 lakh Crores. 80%
share of these investments belong to the public
sector, though investments from the private sector
insurers have been growing at a fast pace. Also, life insurers contribute 94% of the total investments.
The investments of LIC alone are to the tune of Rs. 12.7 lakh Crores.
The investment function in Indian Insurance companies is heavily regulated as the first and fore-
most obligation of insurance companies is to pay all the claims on policies; hence they need to be
liquid enough at all times. For life insurers, the required solvency ratio is 1.5. They also need to aim for maximum return and minimal risk.
IRDA has strict exposure limits to investments in
one company and one sector. Traditionally, the investments were made mostly into Government
bonds for low risk factors but slowly, investments are being shifted into corporate bonds and equity
markets. Whereas, in most of the developed mar-
kets, insurance investments are allocated to equity markets in higher proportions. In UK, the share of equity investments is around 40% and that in US
is 45%. In 2012, almost 40% of the investments made by the life insurers in India are in Government Securities (See Figure).
FINOMINA
Recently, IRDA has been relaxing its regulations on these equity investments. In early 2013, it has in-
creased the limit of investing in one company from
10% to 15%. It has also encouraged the insurance companies to invest in infrastructure funds by raising the limits on these investments. This would also reduce the cost of capital. But as compared to the
global counterparts, there is still a substantial im-
provement possible in the regulatory policies and
the practices followed in the Indian Insurance industry. There is a huge potential for insurance
companies to contribute to the stock and bond markets in India.
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Currently, investment decisions being taken are
LIC has raised its stake in the Oil and Gas industry
follow a similar strategy as that of global insurance
deregulation of diesel and petrol prices.
very conservative in nature, but if asset allocations industry, then equity and corporate bond markets
would have an inflow of large amounts of stable funds. This could bring in the required liquidity to these markets and help reduce their volatility.
LIC Investment Portfolio LIC is the largest institutional investor in India with Rs. 12.7 lakh crores as its investment corpus as on March 31, 2012. But only 20% of this is in
equity. The investments made by this institution traces many major changes which have happened over the past 3 years.
There have been significant changes in LIC’s effec-
tive ownership in several organizations across in-
dustries. The figure below shows the value of LIC’s stake in the group companies termed as the LIC's effective ownership.
as this sector has become more attractive with the This is expected to reduce the under-recoveries of the oil companies. The holdings in IT sector has also been raising consistently as IT stocks like TCS have
always been the favorites of stocks markets, offering decent returns. The increase in stake in the Ambani
Group has been due to RIL which was expected to
make a windfall gain out of KG D6 basin. Another factor in favor of RIL is the monopolistic power of
RIL in petroleum products markets. The stake in Mahindra group declined since 2012 has been a sluggish time for auto sector and M&M motors, the
significant arm of Mahindra has seen falling sales with their acquisition of Sangyong which is yet to
turn profitable. LIC has decreased its holdings in the automobile industry since the auto sector as a whole contracted in the latter half of 2012 forcing investors to withdraw. Anusha Ganne & Khushboo Goyal , PGP 2, IIM Udaipur
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The Dangerous Derivatives - Demystified
D
erivatives are instruments which generate
value from its underlying asset, asset here
can be anything ranging from stocks to commodi-
ties to even currencies. They are generally used as a hedging tool to mitigate risk. There are primarily two types of derivatives namely exchange traded
and over the counter (OTC) derivatives. Exchange traded derivatives are ones in which an exchange
acts as an intermediary thereby reducing the counter party risk, the exchange here acts as a guaran-
tor. OTC derivatives on the other hand are custom made derivatives which are directly transacted be-
tween two parties; the counter party risk is very high in these kinds of derivatives. We would be
fied quantity of wheat on a future date at the price
for the purpose of our study
up, in that case farmer will lose or may go down in
focusing more on the Exchange Traded Derivatives Exchange Traded Derivative Futures and Options are some of the standard exchange traded derivatives.
A derivative is an instrument to transfer risk from one party to another, now you might wonder why
a person would be willing to accept risk. This is how the market functions, not all people have the
same risk appetite, and market in general will have three kinds of people: Risk Averse, Risk Neutral and Risk Loving. The Risk Averse person will transfer
his risk to the risk loving person and in exchange
the risk loving person charges a premium for it. There is also a possibility of two risk averse people
agreed today. At that future date the price may go
which the wholesaler will lose. But the other way is
also possible, so to mitigate the downside risk both give up their upside gain potential and enter into a
futures contract. If derivatives were so simple and good then why did they lead to the 2008 crisis?
Derivatives we have discussed so far are very simple, straight forward were both the buyer and seller of
the derivative were aware of the underlying asset. But consider the cases of derivatives over deriva-
tives; it will be difficult for all traders to understand the risk of the underlying asset. To make it more simple let’s look into a jargon called CDO’s. CDOs and their role in the 2008 crisis:
coming in to futures contract where both want to
CDOs or Collateralized Debt Obligations are class of
Farmer and a Wholesaler, They enter into a futures
ment from Debt (Both principal and Interest) i.e.
limit their downside risk i.e. consider a Wheatcontract in which the farmer agrees to sell a speci FINOMINA
derivatives in which the underlying asset is the paythink of a bank disbursing loans, soon its loan book INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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11
soars to point where the bank reaches its reserve threshold. Beyond this point a bank cannot lend until there is liquidity infusion into the bank either in
the form of capital or deposits. But doing both of these is tough. Instead there is a simple method,
until there is liquidity infusion into the bank either in the form of capital or deposits. But doing both of
these is tough. Instead there is a simple method. Assume the loan book of the bank is 100cr, now the bank discounts this loan book and sells it to a third part at 98cr. The 2cr is the premium the bank is
willing to pay to get the cash immediately; the same
2cr is the premium the third party charges for accepting the default risk by banks debtors. Now with
`The CDO’s which were issued over these assets
started to default on payments, the holders of these CDO’s were banks of several countries. As the
banks defaulted, the central banks of those countries had to bail them out; this converted the CDO’s
crisis to a sovereign debt crisis engulfing the entire world. 2008 crisis mitigation measures saw central banks
bailing out banks and large institutions, but the markets haven’t still regained the same flow simi-
lar to pre 2008. This is more of the suppression in speculative trading in market as people have become wary of investing in markets.
this 98cr, the liquidity position of the bank improves
How can Such a Problem be Avoided?
at a higher cost compared to the earlier 100cr, so
The Commodity Exchange Act
and it again issue new loans. But the new 98cr came
(CEA) of 1936
the interest charged for this round of loan disburse-
passed by the U.S government mandated that all
demand for money to be inelastic.
rivatives that came into existence, be traded on a
ment will be greater. All the while we have assumed Meanwhile the third party, who bought these loans,
creates a market instrument (Derivative) and trades the same in the market. These instruments are noth-
ing but CDO’s. Things sound fine then what went wrong is your question?
All these loans were asset backed, and the asset in most cases was homes. As the real estate was soaring
more and more people borrowed, speculating that asset prices would go up. But by the start of 2008, asset prices started declining. As the value of the as-
set dropped below the value of the outstanding loan, people started defaulting. As more and more people defaulted, the contagion spread and asset prices fell further. But still you would wondering why this impacted the global economy.
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
futures contracts, which were the first form of de-
regulated exchange providing full transparency to the counterparties regarding future prices. Some of the conditions imposed by CEA on futures trading were : (1) Price realization based on market de-
mand (2) Intermediary regulation (3) Disclosure of the parties involved in the transaction (4) Custom-
er protection rules (5) Supervision of selfregulated exchanges by a federal regulator (6)
Barriers prohibiting market manipulation, excessive speculation and fraud.
In the 1980s, a new variant of derivatives called “swaps” came into existence, which is basically an
exchange of cash flows between two parties on the basis of differential in interest rates, currency exchange rates or any underlying principal base.
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Within these, an interest rate swap is one in which
65 trillion. While it has been estimated that general
change a floating rate interest obligation on an ex-
associated with it, a CDS’ insurance like quality im-
dealer or a counterparty to whom the swap has been
at risk. Adding up the lower value of outstanding
one of the parties in the transaction agrees to existing loan for a fixed rate obligation with a swaps assigned by the dealer, with an expectation that the
ly 3% of the notional amount in a swap is the risk plies that in the case of default, the entire amount is
CDS ($35 trillion) and this 3% of the remaining no-
fixed rate will be lesser than the floating rate. An
tional amount ($565 trillion), the net value at risk
which in most cases reflects the outstanding loan
world’s GDP in 2008!
assumed amount is incorporated into the swap value on which a floating rate is being paid to the
lender. The fixed interest rate payment is by the swaps dealer to the borrower. So here comes the catch; there is a “swap” of commitments in such a
transaction between the buyer and the seller, based on floating and fixed interest rates. This is in con-
trast to that of a conventional futures contract which involves transactions based on a single rate/price.
CEA excluded swaps from its exchange trading re-
quirements due to its inherent nature of being nonstandardized and dependent on counterparty credit
assessment. The Commission however later validated
its stand by stating that swap agreements were still
under its exchange trading requirements as they were fixed and not subject to negotiation.
The International Swaps and Derivatives Association (ISDA) had created a Master Agreement and a related document laying down rules for the execution of a swap. Consequentially, this led to OTC derivatives getting standardized and by 1998 they had grown at
an alarming rate, with the notional value of out-
standing contracts in these instruments crossing $28.733 trillion, at a growth of 154.2% since 1994. And in Oct 2008, this same value had climbed up to
a whopping $600 trillion, within which credit default swaps (CDS) were expected to be worth $35-
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was $52 trillion, which was almost at par with the The same instruments were used to mask the impending disaster that was to come in 2008 – the subprime crisis. Securitized subprime mortgage loans were converted to simple mortgage backed securities
(MBS) which were embedded within complex CDOs. This distracted investors from the underlying risky
loans and individuals likely to default, by reframing
the risk in the form of these instruments. False assurances by credit rating agencies mislead the investors
by high of evaluations of these CDOs. More importantly, the CDS were framed as insurance on
CDOs, which only provided false protection to these investments. The above article is only a peek into how innovations in financial instruments were manipulated, and made opaque by hiding them from firms’ balance
sheets, even with regulations passed by centralized bodies, to cause the world’s most impactful financial disaster. There is a highly impending need for better,
foolproof regulations – not just in the U.S, but all capital markets at a global level; and only such preemptive measures can save us from another disaster, but this time, a fateful one!
Aditya Raghunath & Arun Kumar, PGP 2, IIM Udaipur
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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R I SK M A N A GE M E NT
Risk Management in Crises Types of Risk
There are basically three types of risks that organizations have to deal with.
Preventable Risks (Known-Knowns): These are the risks which arise due to internal factors. They are
controllable by nature. Some examples of such risks are risks from machine breakdowns or risks due to
unethical practices. Organizations do not benefit strategically by taking these risks and thus should
try to reduce or eliminate the occurrence of these risks. These risks can be managed by having an ef-
fective control and monitoring mechanism and by
A
instilling a culture which makes employees aware ccording to the classical finance theory, in perfect capital markets, a firm has no incentive to
use risk management techniques like hedging, in-
surance, diversifications etc. According to the Miller Modigliani propositions these actions do not add any
about these risks and their effects. This can be done through having a clear and well communicated
mission statement and by having clear cut values,
beliefs, systems and procedures which assist the employees in doing the right thing.
shareholder value, which is the main aim of a firm.
Strategy Risks (Known-Unknowns): These are the
holders themselves at the same cost. Thus any firm is
generate superior strategic returns. Rule based con-
aim is to maximize shareholders’ value. In, practi-
example for these types of risks is bank credit risks.
nance theory like no transaction costs, no bankrupt-
needs a risk management system. This system is
holders, information symmetry etc don’t hold. Thus,
for these risks. Also, the risk management system
Moreover, these actions can be taken by the share-
risks which the organizations take with the aim to
risk neutral and has no incentive to manage risk. Its
trol model is not effective to manage these risks. An
cality however, the assumptions of the classical fi-
To deal with these types of risks, the organization
cy costs, equal borrowing costs for firms and share-
aimed at minimizing the probability of occurrence
in order to identify, access and prioritize the risks
helps organizations to prepare themselves to contain
nate and economically apply manpower and re-
occurrence by allocating resources to mitigate the
hood and impact of the events where organizations
External Risks (Unknown-Unknowns): These risks
have a risk management system.
tion. They are beyond the control of the organization
that the organization is exposed to, and to coordi-
or manage these strategy risks in the event of their
sources to minimize, monitor and control the likeli-
effect of these risks.
are exposed to these risks, organizations need to
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
materialize due to happenings outside the organiza-
and cannot be completely eliminated or managed.
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R I SK M A N A GE M E NT
14
Page
shifts and natural disasters. The organizations fo-
risks are underwritten it is essential to communicate
selves for their mitigation in the event of occur-
any particular instrument must conform to the overall
cus on identifying these risks and prepare them-
rence. This can be done by applying proactive tools like scenario planning and war gaming. Case: BP Oil Crisis In 2007, when Tony Hayward became the new Chief Executive Officer of BP, safety was on his priority list. He incorporated several rules in this direction to the
extent that the employees couldn’t text while driving and had to use lids on coffee cups while walking. Hay-
ward was still the CEO when the Deepwater Horizon
rig exploded in the Gulf of Mexico, causing one of the worst manmade disasters in the history. In spite of all
the money they invested in Risk Management activities, risk management in BP became more of a compli-
ance issue and they were not able to identify, properly
evaluate and communicate the risks they faced. They handled the Preventable risks well but accepted the
high strategic risk of drilling several miles below the Gulf’s surface because of the high value of the oil and gas they hoped to extract.
Risk management in the times of normalcy Even in bull markets, companies take measures to manage their risks in relation to their returns, these
include: a) identification of the risks that the company faces. But it is also true that all the risks systems to capture data in order to identify risks, empirical
approach to risk management, including risk management into critical decision making process and
adopting governance structure to ensure better risk
management. associated cannot be appropriated correctly hence Chief Risk Officers try to incorporate as a whole best business practices in the system; b) once
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the same to the top management; c) the risk taken in
risk taking strategy of the firm; d) finally, the risk asso-
ciated with the company must be effectively communicated to the external shareholders, so as to ensure valu-
ation is as close to reality. Key dimensions to the company level risk management system are adequate
Case: Allianz Approach to Risk Management Allianz through its pro-activeness in risk management was able to take into account the Euro crisis since 2009. Even in a bullish market, Allianz has certain measures to keep itself in good stead. The first is Top
Risk Assessment, under which there is a cross functional team to identify the risks the company faces. Second is Emerging Risk Assessment, in which scenario
planning is undertaken to devise steps to avert different situational risks. Lastly, they have developed Risk Controlled Self-assessment which helped them in recognising and managing reputational and operational risks.
When things go down, how to go about risk management
The usual practices of risk management might not be sufficient to mitigate the effects of the downturn;
hence special efforts are required by the risk manage-
ment team to mitigate the risks, which are discussed in
above two steps it should be kept in mind that building consensus regarding the direction of economy or company is important but excessive discussions regarding
exact figures can lead to counter-productive results. It must be ensured that management action is prompt
post impact analysis and the scenarios envisioned need to be refreshed only in case there is a change in the underlying assumptions.
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
AR T H A AR T H I S SU E I II Page
R I SK M A N A GE M E NT
15
It is common practice in the times of bull to forecast
taking into account the mean values prevailing, which does not necessarily hold true in depressed circumstances and one must look to give more im-
portance to tail values as most of the times these are the ones that seem to be present.
When the chips of the market are down one must be
extremely careful regarding the level of risk that the company exposes itself to. Small time risks are fine but too much exposure can be devastating.
Lastly, for the ‘too big to fail’ firms, governments in-
evitably come to their rescue in the times of downturn, hence in order to make companies mindful of
Page
Lessons from 2008 crisis The events leading to the 2008 crisis clearly demonstrate the kind of behavior that can be lead the com-
panies to high growth figures during bullish markets and when there is a downturn, the losses are
intolerable. The companies became so enamored with the successes during bullish markets that all the risks associated with subprime mortgages and CDOs were completely ignored as if there is no end
to this day. The management fell in the trap of what
shareholders will say if equal benefits are not reaped out of the growing bubble. Also scenario planning
was given a backseat which is exemplified by failure
the levels of risks they are exposed to, it is proposed
of risks models, which were built on volatility fig-
companies for the riskiness attached to these firms.
started to spike. Regulators also failed to set their
that there must be a premium charged from these
Bias in effective decision making
ures of 2004-2006, in 2007 when the volatility foot right and were unable to control the excessive risk taking.
Anchor Bias: People tend to anchor their estimates based heavily on readily available proofs and evi-
dences even if they are aware about the known dan-
ger of making extrapolations from recent history to a future which is highly uncertain.
Overestimation Bias: People tend to overestimate their capability to influence things that are actually heavily dependent on chance. There is a normal ten-
dency to be overconfident about the accuracy of forecasts and assessments and give far less importance to the negative outcomes that can happen.
Conclusion As seen in the prior sections of the article, risk management as a practice needs to be incorporated into
day-today working of businesses. In the times of normalcy, the firms going over the top are expected to achieve far greater growth rates but in case of a
downturn, the same firms will be the worst hit. Good
risk management practices will ensure manageable growth rates during bullish markets and bearable descent in the times of crises.
Pranav Gupta & Prateek Shukla, PGP 2, IIM Udaipur
“Experience taught me a few things. One is to listen to your gut, no matter how good something
sounds on paper. The second is that you're generally better off sticking with what you know. And the third is that sometimes your best investments are the ones you don't make.” Donald Trump
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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Rupee vs Dollar: 1/x or log(x)
V
olatility in exchange rates have been a cause
of concern, with US signaling an end to
quantitative easing, the fears are becoming even
more relevant. Apart from correcting the trade
balances, a couple measures in the internal finan-
cial markets will also help set rupee straight. When we are talking about internal financial markets the significant ones are the Call Money mar-
ket, Repo Market and the Government Securities Market.
In last couple of weeks were action packed with
the Rupee reaching 60 and gaining back to settle at Rs.59. The driver behind these changes was none other than our Monetary Regulator. Let’s see what happened.
RBI opted for a three dimensional attack to arrest rupee depreciation 1. Recalibration Rate (MSF)
of Marginal Standing Facility
2. Controlling the Liquidity Adjustment Facility (LAF)
3. Open Market sale of Government of India Securities
Marginal Standing Facility MSF is a facility where banks can borrow up-to 1% of their Net Demand and Time Liabilities (to accommodate for the asset liability mismatch). The MSF
was recalibrated from ‘Repo plus 200’ to ‘Repo plus 300’ basis points which effectively resulted in MSF of 10.25%. This is a whole 1% increase over the pre-
vious rate. The bank rate which is pegged to MSF also became 10.25%, but none of the banks have in-
creased their interest rates to customers. The reason being that, the amount borrowed through MSF was not significant.
Controlling the Liquidity Adjustment Facility (LAF) The total funds allocated for banks to borrow
through LAF facility was limited to Rs. 75,000crores; each bank had to submit a bid for the money it needed and each bank has to ensure that it had re-
quired SLR (Bonds) to furnish as collateral. This
came into effect from 17th July, the amount of borrowings through this route was Rs.92,000crores and
Rs.2,21,800crores on July 15th and 16th respectively. From 17th only a maximum of Rs.75,000crores was disbursed.
Markets (2013)
12th July
15th July
16th July
17th July
18th July
19th July
23rd July
25th July
Call Money
7.02
7.21
8.53
7.99
7.43
6.96
7.14
8.27
CBLO
6.47
7.18
4.67
7.55
6.11
6.28
6.93
7.40
Market Repo
7.08
7.18
8.71
7.97
7.29
-
7.13
7.75
Overnight Segment
6.58
7.18
6.02
7.68
6.48
6.52
6.98
7.54
INR vs USD
60.05
59.9
59.32
59.32
59.65
59.4
59.72
59.10
* all rates in %, Overnight Segment Rate is weighted average of Call Money + CBLO + Market Repo adjusted for the borrowings through each route FINOMINA
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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A N AL Y SI S
17
But this spike on 16th July seems to be caused by
longest can extended up-to 30years. So based on
go up, because during the preceding week the
yield and the long term yield.
Rs.75,000crores.
and make it more attractive, people who have in-
more of a speculative reaction, expecting rates to
borrowings through this route never crossed If we notice in the table on previous page, we find
that the surplus borrowings through Repo on 16th resulted in a surplus funds with Banks, Also the interest rate on repo borrowing shot up. But banks
couldn’t apply the excess money anywhere else
this, there are primarily two Yields, the short term Now, if I increase the yields on the long term bond
vested in short term bonds will pull out their money and put it in long term bonds. This results in excess availability of short term bonds, due to which the
price of short term bonds fall thereby increasing the
yield. Moreover, withdrawal of lenders from short
and CBLO markets had too many lenders with too
term market creates a liquidity crunch in short term
night borrowing rate is the weighted average of
Think of the same in a larger scale. RBI last week
little borrowers. The CBLO rates crashed. The over-
markets.
call money, CBLO and Market Repo, it shows vola-
announced the issue of Government Bonds worth
Going by this trend RBI came up with another
to 17years. These were long term bonds and
tility despite all these efforts. change on 23
rd
July reducing the borrowings
Rs.12000crore with maturity period ranging from 5
Rs.12000crore was a significant amount, with rates
through LAF facility to 0.5% of Net Time and De-
attractive as compared to existing long term yields.
by nearly half. This has led to spike in borrowing
term Bonds, who felt that this marginal increase in
mand Liabilities. This would cut down the 75000
People, who were till now not interested in Long
through call money and CBLO markets.
yield was worth the risk taking would pull out mon-
average CRR on a daily basis from 70% to 99%,
long term markets.
Accompanying this change was the increase in the thereby further reducing the liquidity in the sys-
ey from the short term markets and try to put it in As you can see from Exhibit 1 & 2, between 12th July
tem. All these put an upward pressure on the inter-
and 18th July, the short term yield shot up from
Open Market Sale of Government Securities
term market moved from slightly less than 8% to
est rates in the market.
Open Market sale is where the RBI either issues government securities to absorb the excess liquidity or redeems the outstanding government bonds to increase liquidity. As you would have read in your
Micro-Economics, you can control the price of the goods by controlling the demand-supply equation. RBI too has done the same thing with Money being the Good here.
Government bonds will be of various maturity period, the shortest ones being the 91 day T-Bills and INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
7.25% to 8.75%. In the same period the yield in long
more than 8%. Ideally the long term rates should have fallen if there is excess availability of funds, but RBI had a floor yield rate on the new bonds be-
ing issued which made sure that long term interest rates also stayed up.
The issue of Rs.12000crore was oversubscribed by 2times
with
the
bid
amount
reaching
Rs.24300crores. A significant portion of this money was raised by selling short term securities. At the end of the bidding process (i.e. close of 18th July),
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Page
RBI accepted bids worth only Rs. 2500crores, that
term market, the excess funds created a demand for
12years. All those people, whose bids were not ac-
bonds, which lead to decrease in yield. Net-Net,
short term securities. Between 18th July and 19th
the slide in rupee was also arrested with FII’s staying
term yield had risen by 0.5%. The reason the long
The government of India also backed up these steps
were accepted had a cut-off yield of 8.54%. So
sectors thereby enabling flow of foreign capital
too in the bonds with maturity period greater than
bonds leading to an increase in the prices of the
cepted, had no other option but to invest again in
yields went up compared to last month levels and
July, the short term yield fell by .25% and the long
put.
term yield reaching 8.5% is that, the bids which
with policy initiative, announcing FDI reforms in 12
long term yield held steady at 8.54%. On the short
which will help in appreciation of rupee.
Date & Action 15th July, RBI announces in-
Intended Result
Actual Result
Reduction in Exchange Vola-
Limited or No Impact
18th July, RBI opens Bonds is-
Absorb excess liquidity from
Successful, short term yield
23rd July, RBI reduced LAF
Reduce Liquidity in the system
Successful, Borrowing rates in
23rd July, RBI increases Aver-
Reduce liquidity in the system
Successful, Borrowing rates in
crease in MSF rates, Cap on
tility
LAF borrowings sue worth Rs.12000crore borrowing limits further age CRR on a daily basis
short term markets
went up
overnight markets went up overnight markets went up
The peculiar thing to note here, which you may
same on 19th July (Denoted by a green line in the
on short term and long term bonds are almost the
Overall if we consider all the three together, the
not come across once again in your life is the yield
fig), with medium term bonds offering lower yields.
impact of OMO was more pronounced in the first week than the rest two. In the second week we saw how LAF and CRR requirements impacted the mon-
ey supply in the system. But these are short term
measures which will not prevent rupee slide in the longer term if we don’t back this up with good fis-
cal policies. That is the reason behind government urgently pushing FDI reforms in 12sectors last week. Let’s hope that the best happens.
Arun Kumar P & Vivek Batra, PGP 2, IIM Udaipur FINOMINA
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19
M O NE Y R AT N AM
Can Pennies become Millions?
fter a delightful morning walk, Money Ratnam shivered in the morning cold as he sat on a park
bench waiting for his friend. Money Ratnam was ex-
cited, he wanted to talk about his latest investment.
Taking the advice of his financial planner, he had invested a substantial amount in Infosys and the stock had also moved upwards as the company’s quarter numbers exceeded market expectations. Soon his friend arrived and after the usual pleasantries, Money Ratnam was quick to change the topic. He
boasted about his investment and the following up-
ward movement in the stock. He felt like a million bucks. His friend though had a smirk on his face. He
explained that had he been smart, he could have prob-
ably bought 3000 shares of XYZ Company for every share of Infosys. XYZ’s share costs less than a rupee
and he could have bought thousands of those. Also, being already dirt cheap, there was no chance of them
decreasing in value any more. Money Ratnam was rattled. He felt his thunder was stolen.
rently trading under Rs. 10, 90 stocks had had a fall of over 50%, some falling by as much as 97% and only 5
stocks gave positive returns. Whereas several Indian blue chips like Reliance, Infosys and HUL had given returns of 25%, 35% and 42% respectively. Such blue chip
companies not only have better governance but also provide better capital preservation. The cheaper stocks
Money Ratnam went home and looked up for low val-
are usually very illiquid; it is tough to find a buyer. And
tifold returns over a period of time. Even a small price
the markets, making it difficult to gauge their current
Also many of such stocks were trading at lifetime lows.
also very easy to manipulate the price of these stocks.
before. Now, all that he hoped for was a small increase
stocks aggressively and the price increases rapidly. Oth-
some return. Infosys now seemed a big mistake!
them. At high prices the stocks are dumped in the mar-
ue stocks. He found that some penny stocks gave mul-
very little information on these companies is available in
movement of Re.0.01 made a price change of over 1%.
performance and forecast their future performance. It is
This caught Money Ratnam’s attention like nothing
Sometimes, people with not so good intentions buy such
of around 10 paisa in the stock price to give a hand-
er investors get attracted to such stocks and invest in
The next day, Money Ratnam met his financial plan-
ner and told him everything about his new found passion for penny stocks. Contrary to his expectations, the
ket and the last holders of the stock suffer huge losses. Dividends, generally given on stocks, are also not given out by penny stocks.
financial planner was concerned. So, he started by ex-
The financial planner kept on going, but Money Ratnam
down to Re.0 and that a low price didn’t mean it could
lieved that the fee he was paying to the financial plan-
one year, he had found out that of the 150 stocks cur-
Kamaljeet Saini & Naimish Shah, PGP 1, IIM Udaipur
plaining to him that any company’s stock price can go
wasn’t listening anymore. He was convinced and re-
not go down further. In a recent analysis for the past
ner was worth it.
INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR
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AR T H A AR T H I S SU E I I I
RE-DESIGN
R
The Need to Re-Design ural consumerism, Information and Communications Technology (ICT), Supply circles - change is galore in the world today. There was a time when GE’s story of change with changing CEO caught everyone’s eyes. Now the case is different.
Change is expected and anticipated. Challenges are thought of as pathways to redesign. It has become the second nature of organizations. No part of the organization is alien to it. Be it human resource policy, marketing strategy, consumer base, IT infrastructure, supply chain, structure of an organization, leaders have redesigned it all. Looking at the importance this term now has in the business environment; Indian Institute of Management Udaipur will be presenting the second edition of its annual flagship event, “The Leadership Summit 2013” on the 3rd August, with umbrella theme of Need to Re-Design. The event is aimed to serve as a platform for leaders from different walks of life, to share their opinions and views on select themes, through engaging panel discussions. The inaugural edition of the event, which was hosted at the resplendent Durbar hall of the City Palace of Udaipur on 4th August, 2012, saw speakers like Mr. Pradeep Kashyap – CEO, MART and President – Rural Marketing Association of India, Mr. Debashish Poddar – CEO, Bombay Dyeing grace the stage, amongst other luminaries. Last year, the panelists deliberated on the umbrella theme “Ideation and Execution in a business cycle”, touching on the importance of nurturing innovation and achieving execution excellence. An important link between innovation and execution excellence is change. Innovation can be incorporated to achieve execution excellence only if the existing systems are changed or tweaked. Reflecting this line of thought the umbrella theme for “The Leadership Summit 2013” is the "Need to Redesign”. The event will involve panel discussions covering a wide range of issues like the shift in focal point from urban to rural, the pressing need to redesign the supply chain and the changing roles and styles of leadership. Shri Ashok Chawla, Chairman, Competition Commission of India, will be the key note speaker this year. The event will witness stalwarts from the industry like Mr. TCA Ranganathan, CMD, EXIM Bank; Mr. Sandip Sen, CEO, Aegis Global; Mr. Hardeep Singh, Senior V.P. Bharti Walmart; Mr. Sudhir Kumar Shetty, Group COO, UAE Exchange Centre; Mr. Rajkumar Jha, National Creative Director, Ogilvy Action; Mr Piyush Srivastava, Anchor, Zee Business; Mr. Ashish Bhatia, COO, Rajasthan Circle, Sistema Shyam Teleservices; Mr. Murali Parna, COO, Sagar Ratna Restaurants. Udaipur based companies -Vedanta Hindustan Zinc and Rajasthan State Mines and Minerals and Union Bank of India have extended their wholehearted support in making this event a success.
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