The flagship publication of NMIMS MBA Capital Markets
September to December 2011
Whatâ€™s Inside 2 Letter from the Editor 3 Private Equity-A Pioneer for Sustainable Growth of India 11 Lying the dust off the gold 22 High Frequency Trading: The Good, Bad and Ugly 28 Commodity Price Dynamics 32 The Problems Plaguing the Real Estate Sector 37 Analysis On India â€“ Latin America Trade Barriers, Tariff and Non-Tariff Barriers, Comparison with China, Effectiveness of PTA 44 Launching REITs for India's for India's Real Estate 52 Insights into Market Efficiency 56 Investocross
People Behind this Issue Senior Editorial Team
Vaibhav Vakharia | Mridu Chadha | Pooja Joukani | Toufiq Shaikh Junior Editorial Team
Madusudanan Ramani | Ankit Johri | Harish Srigiriraju Sudeep S Mallya | Sneha Aggarwal | Siddhant Anthony Johannes (Design) Nishtha Sardana | Rachit Goyal | Ashish Aggarwal 1
Letter from the Editor 2011, the year where pessimism on account of Sovereign Debt Crisis in the Developed Countries and Policy Paralysis that mired the Indian Economy and the capital markets draws to an end. The greatest shortage in the markets is not of liquidity, funds or stocks with good valuation but of moral leadership. The India story is threatened by the governance deficit and the problems confronting the markets & the economy are more homegrown than imported from the west. Markets have been starved of news about renewal of reforms which will bring in the much needed liquidity and foreign capital required to support and drive the Indian markets. Everyone was witness to the short-lived optimism in the surging counters of retail stocks before the FDI reforms in retail was put back into abeyance. The year-end saw some not so inspiring numbers in Capital Investments and IIP numbers. Successive rate hikes by the Reserve Bank of India did not yield the desired result and had an impact on the growth of the economy. Every sector had its own share of problems which depressed the investment climate in the respective sector. Power Sector was mired with problems on account of lack of fuel availability and fuel linkages. Metals sector remained affected due to depressing demand from the developed economies. Banking and financial services sector had to face woes on account of Asset quality due to increased defaults and change in NPA recognition method. Real estate was mired with trouble due to increasing interest rates and high level of debt on balance sheet. Defensive sectors like Healthcare and FMCG outperformed the markets in 2011. The 2012 is expected to be better for the economy and capital markets. Reforms and proactive government measures would ensure certainty and flow of foreign funds. Some of the key reforms awaiting government approval are Land Acquisition Bill, Companies Act 2011 and FDI in Retail, Insurance & Pension Fund Management. In the last quarter of the year 2011, the regulator SEBI drafted and enforced the new Take-Over. The year also saw SEBI become more proactive and cracked on many offenses through the year. BSE and NSE also announced plans to launch platform for SME firms. This platform will be similar to the OTCEI launched in 1990s, which was really ahead of its time. 2012 promises to be filled with a lot of action. The year could set the platform to how the entire decade would span out. Year is expected to throw clarity on how the woes of sovereign debt of the developed world are resolved and dealt. In the domestic front, government coming out of the policy paralysis it slipped into would be a big positive for the economy and the markets. Evolving policies of SEBI and introduction of newer financial products would further lead to development Indian Capital Markets. Hope
email@example.com) about the review and feedback.
Private Equity-A Pioneer for Sustainable Growth of India Deepali Sharma , Sanchit Sawhney | FMS Delhi
Introduction & History of Private Equity The first PE fund was started way back in 1978 in USA by Kohlberg, Kravis and Roberts (KKR) which was based on the venture capital limited partnership model. The innovative PE model of western countries that was introduced to India got customized with time. The underlying logic on which the western PE model was based is theâ€? inadequate or misallocated capital resulting in underperformance of businessesâ€?. PE funds job is to search for such companies and to buy them with the purpose of providing cheap debt and institutional equity to the business and turn them around
by hiving off its unprofitable
operations so as to resell the company to public at a higher price either directly (IPO) or indirectly (trade sale).Developing countries like India differ from the developed counterparts in terms of lacking the large, mature capital markets that not only provide PE funds their target firms, but also help them to attract foreign investors. In addition regulatory barriers in India further raised concerns for easy access to capital in scale resulting in undermined western model results. Indian businesses primarily controlled by families wherein the largest shareholders runs the firms as managers made any kind of disagreement between the two entities over the use of cash flow almost negligible forcing the PE Industry to adapt to Indian landscape by targeting unlisted firms that need capital to grow and expand. KPMG Survey done in 2008 revealed the unique factor that differentiates India from other countries that is the requirement of overseas equity, corporate governance issues, lower fund size, longer holding periods, above-market risk with higher expected returns. A Glance at the PE journey in India Over the past decade PEs have adapted itself to Indian economy drawn by excellent growth opportunities in market-oriented environment in addition to increased number of entrepreneurs coming up constraint by lack of capital to expand their businesses as shown in the figure.
Figure above provides the snapshot of the performance of PE Industry in India. India has moved from the sixth position among the largest PE markets in the Asia-Pacific region (including Australia) in 2004 to the top spot by 2007 due to the macro fundamentals that suited the requirements of both PE investors and the Indian economy. PE provided businesses with new source of capital, extensive network of connections and expertise in management. In return, Indian Businesses rewarded PE with exceptional returns with number of PE deals rapidly grew and reached the record levels in 2007 and 2008.The rapid takeoff of PE industry in India came to an end in second half of 2008 with the global financial crisis unfolded after US housing bubble collapsed that led to slowdown in global economy especially US and Europe. The 2007 Crisis & Impact The impact of financial crisis started showing from the second half of 2008 when the euphoric results enjoyed by PEs in India have been mirrored by uncertainty in the financial world with the slowdown becoming more pronounced. As a result, PE in India witnessed a change majorly characterised by lower volumes and fewer exits due to the unwillingness of selling stakes at lower prices due to depressed market sentiments. However, Indiaâ€™s medium and long term potential remains intact backed by its strong domestic consumption 4
that offers superior investment opportunity. By the second half of 2009 Indian economy bounced back. Private Equity in India has not recovered from recent financial downturn. Fund raising fell by more than 70 percent in the first half of 2009 from its peak. Moreover, the credit crunch has made leveraging cost much more expensive. Thus, PE investors have to play a more diligent & critical role.
Post Crisis In 2010 Indian economy environment stabilized and price expectation become well below the peak in 2007 although comparatively high relative to developed markets, PE space regained strength in India. PE firms made 66 exits valued at US$2.1 billion in 2009 compared to 120 exits worth US$5.3 billion in 2010 according to financial research firm. Following Figure shows trends in PE investments with Deal both in terms of number & value in year 2011 signifying the rise of PE investments both in value & in number of deals from the Q4 of 2009 after the crisis.
Trends: Private Equity as a Pioneer for Sustainable growth Sustainable Growth focuses on economic growth which is a necessary and crucial condition for poverty reduction. For growth to be sustained in the long run, it should be broad-based across sectors. Issues of structural transformation for economic diversification therefore take a front stage. It should also be inclusive of the large part of the countryâ€™s labor force, where inclusiveness refers to equality of opportunity in terms of access to markets, resources and unbiased regulatory environment for businesses and individuals. Sustainability focuses on both the pace and pattern of growth.PE funds from around the globe are being lured by the enormous opportunities that are on offer in many sectors of the Indian economy. Factors that are boosting the inflow of PE funds: ď‚ˇ Sharp drop in stock market indices that have consequently resulted in a significant fall in stock offerings.
Increase in interest rates that are making borrowings dearer, and tough Reserve Bank of India norms. Not surprisingly, most PE funds’ inflow into India has been in sectors that generally have a relatively long gestation period. According to IndusView, the real estate and infrastructure sectors accounted for 50 per cent of the total PE inflows in 2009.Still Private Equity has been successful in India, the main reason being dire need of their service much more than their money. Companies in India have different reasons for wanting private capital depending on the type of company and what stage it is at, i.e. growing, seeking acquisitions, family owned, or a large corporate. For an example, first generation business builders look for private capital because they gain a considerable credibility and governance by having private equity representative on board. This in turn will help them while bidding for international contracts or attracting good talent. The Indian Scenario-Inducing Sustainability Aid the budding Entrepreneurs & act as partners than just fund providers:-In India where the situation is characterised by family-owned companies, 8000 companies listed on the stock exchanges, abundantly available capital, and yet a relative lack of liquidity in the market means that private equity companies will need to position themselves as partners than just fund providers if they are to become the preferred source of investment capital. These companies expect private equity firms to be able to add value, as required, in strategic, operational and human capital matters in addition to their financial contribution. Labour Diligence:-Another issue addressed by private equity firms is due diligence. Much of the time spent on “demand diligence” is mostly irrelevant as companies already know there is enough demand and important question is whether the management can actually deliver or not. And to find out the answer they need to spend time on the shop floor for what can be called “labour diligence”. Most of the family-owned businesses have boards consisted almost exclusively of family members and friends. Private equity firms recognise the importance of finding outside directors who can provide the knowledge, environmental local expertise and experience necessary to help steer a company through its next stage of growth or towards a public offering. For many companies, the board meeting is purely about compliance and the real debate and decision-making happens outside the meeting. Adjusting to a more rigorous style of board meeting can be extremely difficult for such companies. Private equity firms often play a strong 7
influencing role in helping companies attract talent, commissioning search activity, and helping promoters to interview and assess talent & leadership. Infrastructure/Real Estate & SEZ’z:-The Planning Commission estimates that India needs an additional $500bn over the next ﬁve years itself to ﬁnance infrastructure. Under the growing power and effect of global capitalists over third world nations like India, where the state has become an easy tool to facilitate these activities - huge investment for both industrial and non-industrial purpose from national and foreign investors are allowed. Land acquisitions are one aspect that draws a lot of controversial aspects related with question of national interest versus community interest. One of the decisive factors of fast growth of corporate sector is the impact of economic policies of liberalisation that have undergone a sea change in the two decades, starting from 1991. The underlying theory is to have a minimal reliability on state and more on market forces. PE has contributed by investing in such sectors & making them economically feasible in the interest of the nation .PE plays a key role critical growth driving sectors of the economy, As per Deloitte Report the various sector wise requirements from PE are as follows:
Road Ahead : The Securities & Exchange Board of India (SEBI) proposed new takeover rules that will make acquisitions by Indian companies easy and scrap the non-compete fee. The minimum holding requirement to trigger an offer to minority holders has been increased to 25% from 15% for a company. Once that level is reached, the acquirer must offer to buy 26% up from 20% now.
Implications-This move by the SEBI is in the right direction as it will lead to more participation from PE players both in terms of value and size of the deals and will also give the opportunity
to increase their stakes in existing portfolio companies. This draft, if implemented, will also ease the difficulties faced by the listed companies due to 15% barrier for open offer. In Japan, the trigger for an open offer is 33.3 per cent, while in Hong Kong it is 30 per cent and in Singapore it is 29.99 per cent. In all three, the trigger requires an acquirer to make an offer for the entire company. The Achuthan Committee on Takeover Regulations had recommended that an open offer ought to be for all the shares (100 per cent) of the target company to ensure equality of opportunity and fair treatment of all shareholders no matter if they are big and small. On SEBI abolishing non-compete fees, companies would split the total pricing consideration (deal size) into a non-compete fee portion too so that the acquirer spent less on the total transaction cost. The fact is very often people with a considerable stake in a company signify some extra value for the acquirer ,that person could be a technology innovator, a progressive leader and/or manager with in depth understanding of the business and the environment, etc. A control premium/non-compete fee is often recognition of this reality. With non-compete fees abolished, what is likely to happen is that promoters may look to issue different classes of shares a practice that is legal in India, but almost never followed â€“ to ensure a premium. The reduction of open offer size from 100 per cent to 26 per cent and scrapping of non-compete fees is a welcome balancing act. Conclusion Private Equity provides a unique edge so as to result in sustainable development of India. As per Deloitte survey various parameters that make PE a reliable companion for funding are shown:
Others Private equity
To conclude the discussion, PE investments are not only a source of funds but also play the bigger role of the partner in taking the Indiaâ€™s companies to next level in terms of good governance, building capable executive teams, improving organisational capability, enhancing evaluations, creating liquidity and global competence. Private equity is developing into a major player in the Indian economy and there is a growing perception 9
among Indian companies that private equity firms can add value on several fronts. With more and more companies setting up local offices and teams which work at the ground level, this industry will continue to be successful in the years to come.
References: Bain report on Private Equity 2010 Bain report on Private Equity 2011
Deepali Sharma is a 2nd year MBA student at FMS, Delhi. She has completed her BE from NSIT, Delhi University and can be reached at firstname.lastname@example.org
Sanchit Sawhney is a 2nd year MBA student at FMS, Delhi. He has completed her B.Com from SRCC, Delhi University and can be reached at email@example.com
LYING THE DUST OFF THE GOLD Kunal Jain & Rachit Goyal | NMIMS Gold is considered a very precious commodity across the globe and its importance in terms of value and liquidity has gained immense pace in recent periods. In the current global environment, gold is being considered the safest investment option on account of uncertain macroeconomic environments in Europe and United States of America. Gold has a unique sentiment for Indian investors, apart from the usual belief across world. In India, Gold holds a sacred meaning for Hindu’s in particular; who believe that Hindu goddess Lakshmi came from an egg of gold and consider it auspicious to buy gold and believe it’s a good sign, as it brings luck. Gold is considered as a sign of security and prosperity in India. Gold Demand by Country in 2010 India
Europe and Russia
Turkey North America
India is the biggest consumer of gold in the world. The recent statistics of India’s gold imports accounting for more than 30% of global imports for 2011 is a testimony to this fact. In 2010, India accounted for 32% demand of the total gold demand in the world. The year on year volume growth for India was 38% compared to global average of 7%. With India emerging as a strong economy and strong fundamentals suggest that the average Indian income is bound
to rise in future, the future prospects for gold are good. Based on the World Gold Council estimates India owns approx 18,000 tonnes of above ground gold, which is 11% to the total global share.
Ironically, although India is the biggest consumer of gold, it is a price taker and not a price setter. This is due to inadequate supply of gold from within the country. Over the past decade total Indian gold consumption has increased at an average rate of 13%, outnumbering the inflation of 8%, real GDP of 6% and population of 12%. Indian demographics suggest that more than half the population is below 25 years and with economy bound to grow at approx 8% for next few years, the demand for gold will only improve.
With Indiaâ€™s gold import for the current year already rising to 553 tonnes in the first half of 2011, there are increasing chances of it reaching the estimated 1000 tonnes a year by WGC. Imports have already risen 34.9 percent in 2011, along with a 72% jump in 2010 to 959
tonnes. The Centre for Monitoring Indian Economy (CMIE) has estimated that India’s gold consumption of gold will surge 50% to 1200 tonne a year by 2020-21. Demands for Gold In India, categories of demand are less distinct than what is observed worldwide. In other markets the demand for gold is well differentiated into various sections like jewellery markets, investments, Exchange traded funds (ETF’s) and Technology. Indian investors tend to associate the investment psychology to almost all sections and hence to make a clear distinction is to defeat the entire mindset of investor. The two most famous sources of investment for an average Indian is bank deposits and purchasing gold. Gold assumes importance because of the liquidity and value preservation. With gold assuming cultural and religious importance in the Indian atmosphere, the demand for gold can be explained in many ways. The graph below depicts that India traditionally has a jewellery dominated market. India historically has been a market where gold is purchased and sold for several reasons like buying gold on auspicious occasions like Akshay Trithiya and in marriages where gold is considered as ‘Streedhan’.
People do purchase gold coins and bars for investment
purposes, but these are limited in numbers as compared to jewellery.
1. JEWELLERY MARKETS Gold assumes a significance importance in marriages in India. The cultural tradition of purchasing gold in marriages and passing on some wealth with daughters is a long followed ritual. Apart from marriages, gold is being purchased by any household women for different 13
reasons. Indians have been using gold for jewellery for adornment since several decades. Incidentally gold is the most widely used metal for bridal ornaments. Gold even forms a part of gifts on many auspicious occasions like â€˜Diwaliâ€™. Men are observed to be using gold bracelets, pedants and chains, while it holds utmost significance for women. Every woman will be having at least some kind of jewellery. Nowadays we have seen that jewelers offer schemes whereby one can purchase gold at certain installments. With demands for jewelry only going to continue as time passes, the jewelry markets will continue to rise. 2. INVESTMENT DEMANDS In India, gold is considered as one of the most liquid and safest form of investment apart from bank deposits. It has been observed that majority of Indian households have invested in gold in one form or the other. With the economy expected to grow at 8-8.5% annually for next five years, the average income and savings rate will also tend to increase and so will the demand for gold. Nowadays, investors are also looking at gold to diversify their portfolio to manage risk; the demand for investment is only going to increase. In fact in recent years, the ratio of investment is increasing steadily as compared to other sections. A correlation analysis of the key financial assets with the gold price is shown below. We can see that gold is not correlated significantly to any asset and hence provides with a good diversification option for an investor. The net retail investment consists of purchases for gold coins and bars. There is growing demand for gold on account of diversification and increasing gold investment opportunities in markets. A study of the returns on gold investment against different financial assets in rupees is calculated as shown below. The below table reflects the fact gold investment has proved to earn much better return on investment than other selected assets over the same period. Table : 5-year correlations of weekly returns in INR (data ending 24 June 2011) Gold
Gold Lon Fix (INR/oz)
DJ UBS INR 3- JPM
Lon Fix GS Oil Comdty
S&P GS Oil Index
INR 3-month deposit
JPM GBI India
Source: Barclays Capital, World Gold Council; calculations based on total return indices in INR unless not applicable.
Table : Performance on various assets in INR (data ending 30 Jun 2011) Gold
DJ UBS INR
Lon Fix Comdty
3y CAGR 5y CAGR
Source: Barclays Capital, World Gold Council; calculations based on total return indices in INR unless not applicable.
With inflationary pressures, the individual’s purchasing power is going to reduce in real value. The expected values for inflation remaining high in near future and hence gold would stand as a good protection for Indian investors against rising inflation. Also, with the monetary policy followed by the Reserve Bank of India, the interest rates are rising. But a closer look at the real rates show that the effective return on investments are almost zero or even negative due to rising inflation. All these reasons led to the rising demand for gold as investments in the recent times. Exchange Traded Funds (ETF’s): Gold ETF is mutual fund schemes that invest in standard gold bullion. ETF are gold investments on paper and provide high exposure to physical gold. In Feb 2007, SEBI launched India’s first Gold ETF. These ETF’s can be traded on stock exchanges just as we can buy and sell stocks. In India, gold ETF are supposed to have at least 90% exposure to pure gold. Although the current market for ETF, it is growing steadily and with the advent of new financial products the demand will only surge higher. The advantage with ETF is that one can purchase even a small amount of gold on exchange. Gold ETFs, which have become hugely popular among investors, have gained over 32% so far in 2011 (till August 24). Gold ETF have consistently given more than 20% returns since 2007. India Post Gold Coins: India post, the country’s national postal service in association with the Reliance Money and World Gold Council sells gold coins in the denomination of 0.5g, 1g, 5g and 8g of 24 carat over 466 post offices across the country. These post office coins are sold at discounted prices as compared to normal banks and are growing in demand due to the lower cost. The coins are 99.9% pure and internationally certified. 3. Industrial Demand Gold is used for industrial purposes electronic manufacturing items, microchips and other products. Apart from these gold is used in sari-making for gold threads used in decorating the sari. Gold is also used to some extent in artificial dental tooth and plated metals or jewellery. 16
As gold prices go higher people tend to substitute them with other products. The demand for such markets has always been low on account of price sensitivity.
SUPPLY India has a very low refining capacity and depends mostly on the supply of scrap and gold dores from overseas mines. Dores are semi-pure alloy of gold and silver made usually at mining sites and then transported to a refinery for further purification. The major imports for gold bars and coins to India are from South Africa, Switzerland and Australia. Due to the inflexible import structure, miners face difficulty in importing dores of gold. Duty on finished gold is Rs300 per 10 gram, while it is Rs140 per 10 gram for dore. In addition, dore has to bear an excise duty of Rs200 per 10 gram against which a refiner gets countervailing duty benefit. According to the Finance Bill of 2011, dore with up to 80% gold content can be imported through nominated agencies, but under strict conditions and a complex tax structure. The problem here is twofold; one it is very difficult to find dores with up to 80% purity since internationally dores are available for at least 90% purity on most occasions and secondly customs department undertakes test to verify the purity content before delivering to refineries and this exercise usually takes approx three weeks for clearing the consignment. As a result, government should allow free imports with no limits on purity of dores to strengthen the supply for mining. Even in international markets there are no conditions on limits for purity of dores. There needs to be a direct link between imports and consumption and government should look at the import structure.
Gold refineries currently are facing shortage of supply for many reasons like rising prices of gold, import duty structure and hallmarking of jewellery causing reduction in supply of reused gold. The domestic refineries operational capacity has declined to 20-25% on account of the non-availability of adequate used gold. As per the WGC, reused gold had declined from 25 tonnes in last quarter of 2010 to 10 tonnes in first quarter of 2011. In 2010, these refineries were operating at 35-40% of capacity. With gold prices rising globally, the amount of reused gold is reducing as people are keeping gold for investment. Total recycled gold supply plunged to 89 tonnes in 2010 as compared to 122 tonnes in 2009. Rather than selling old ornament to jewelers in order to meet financial obligations, people are pledging them with non-banking financial institutions like Manappuram Finance and redeeming it later by paying back the dues. Hutti Gold Mines Limited (HGML) HGML is the only producer of gold for India, apart from gold produced as a by-product by Hindalco from its copper mining sites. This state-owned company is the first member of India in the WGC and has two units in Karnataka, Hutti and Chitradurga. HGML has recently registered a phenomenal growth of around 45% in gold production by producing 689 kg of gold in first quarter of 2011 as compared to 474 kg produced in first quarter of 2010. This 18
growth has been attributed to the Sag and Mills construction which has helped improve the efficiencies for refining. With an estimated annual 2500 kg of gold the firm is growing but will need to refine more than current 4g of gold per tonne of ore. HGML needs to get the nod from government for its joint venture with foreign players to further improve on its operating capacity. HGML has been planning to enter into joint ventures with gold firms abroad to commence mining in Davangere, Chitradurga, Tumkur, Shimoga, Gulbarga, and Dharwad districts where gold minerals have been found. Deccan Gold Mining Limited (DGML) Deccan Gold mining, the first private gold-exploration sector firm has plans to setup a gold processing plant in Karnataka. DGML engages in exploration, development and production of gold in India and has explored prospects in the states of Andhra Pradesh, Karnataka, Kerala and Rajasthan. The firm hopes to build a 2000 tonne-a-day plant and investing up to Rs 225 crores. Deccan is now waiting for final clearances from central and state personnel to kick off with the plant and expects is to be operational within 24 months from approval. Deccan is currently facing tough times as the state government recommendation of reserving 16000 hectares in Hutti Belt for state owned HGML. Recent Happenings on Supply Side Bharat Gold Mines Limited a PSU was Indiaâ€™s glory in gold mining until it was closed in 2001 due to reducing deposits and increasing costs. BGML was to operate primarily in Kolar Gold Mines and has produced over 800 tonnes of gold over 121 years and is regarded as the second deepest mine ever in the world. With gold prices soaring and growing more than fivefold than what it was in 2001, BGML firm wants to reopen and has been applying for permission from the governments. Kolar mines still have reserves which could yield 10 tonnes for next 15 years. But the government is delaying the revival plan and causing hindrance in increasing the production of gold in India since the first application for reopening came in 2006. A recent discovery of gold in Goa was reported by Goan professor Dr Nandakumar Kamat. Mineb reported in January "A very large tonnage of secondary gold deposits reportedly lies just 60 meters below the ground, spread over 40,000 hectares". On account of this discovery 19
in early January this year, many firms have applied for permission from the ministry of mines to study the exploration for gold in Goa.
Geo Mysore India may be granted an approval from the Andhra Pradesh government for gold mining in Jonnagiri area. The firm has already obtained the necessary approvals from Central government in 2008. Geo Mysore proposes to invest 220 crores for setting up 1000 tonne-aday capacity. On similar lines, Ramgad Minerals and Mining Pvt Ltd (RMMPL), is waiting for the nod from government to setup its gold mining plant in Gadang District in Karnataka. According to Jaydeep Biswas, Chief Executive Officer of Astra Mining, Australian based Astra Mining Ltd may acquire one of the 12 gold mines in Karnataka and filed for 18 preliminary licenses.
The World Gold Council had earlier stated that mere 38,000 tonnes of recoverable reserves were left for excavation which is equivalent to nine years of global demand. This implies a tight supply pressure globally and even if a new months is discovered it will take at least 10 years to start producing raw gold on account of several issues like prior exploration survey, environment clearances and other mining issues.
GOLD Foreign Reserves
India had borrowed foreign reserves worth Rs 31,490 crores to purchase 200 tonnes of gold when International Monetary Fund decided to sell of 403 tonnes of gold. Today, this transaction has resulted into a profit of about 50% only within 2 years, due to the soaring gold prices. If Reserve Bank of India does plan to sell these gold today than it would certainly help the balance of payment for India. This amount will not only help India in reducing the interest burden from external borrowing but also relief some pressure of a high fiscal deficit in 2011. One can argue that the foreign reserves will lower but selling gold will only result in change in foreign reserves from gold to FCA (foreign currency assets). But a longer view would suffice that RBI should hold on to the reserves due to the huge demand supply pressure and uncertain global macroeconomic environment. With inflation causing a huge concern, gold seem to even more stress on this fact. Conclusion Once a leading producer of gold a century ago, it now produces only around 4 tonnes annually. India needs a more liberal policy for a deeper and more efficient gold mining market. China is a prime example; it has contributed significantly to world demand and has even beaten South Africa in 2008 as the leading producer of gold. India is only spending less than 10 crore in exploration as compared to Australia which is spending nearly Rs 2,640 crores. The biggest hindrance in Indiaâ€™s gold mining growth is the number of approvals from around 20 departments and duration for the same ranges from at least 3-4 years. This is the
biggest concern for any foreign player and hence Indiaâ€™s needs to come up with a liberal policy.
Kunal Jain is a 1st year MBA student at NMIMS, Mumbai. He has completed his graduation in Information Technology from SPCE, Mumbai University and can be reached at firstname.lastname@example.org
Rachit Goyal has done B- Tech in computer science from Amity University. He is pursing MBA in Capital Markets from NMIMS and you can contact him email@example.com
HIGH FREQUENCY TRADING: THE GOOD, BAD AND UGLY Prashant Rishi | IIM L
It was in late 2000, when the NYSE decided to quote prices of stocks in decimals of a dollar, as opposed to a fixed list of fractions. The event (called decimalization) sowed the seeds of what is today popularly known as High Frequency Trading or HFT. Stated simply, HFT is trading in stocks by computers, with minimal human assistance. Carried out by super computers of major investment banks & hedge funds, high frequency trades range in time from less than a second to a few hours. Today, it is estimated that majority (~60%) of all equity trading in NYSE is done by trading algorithms. Although predominantly into equity, HFT firms have started moving into other asset classes, like derivatives, FX and fixed income instruments.
Figure 1: Asset classes traded by HFT firms
The obvious advantage that computers offer in trading assets is speed of processing information and executing trades. Add to it other advantages like low cost, high execution consistency & anonymity and you begin to understand why High Frequency Trading is so popular among all trading desks.
Figure 2: Why funds prefer High Frequency Trading Generally, trading algorithms are built on complex mathematics and statistical modeling. They are designed by Quants (as Math PhDs are known in Wall Street lingo). The hedge funds, who own these algorithms, protect them with as much zeal as Google protects its proprietary search algorithm or Coke protects its secret soft-drink ingredient. Most algorithms typically employ â€œflatâ€? strategy, i.e. trading positions are closed within the same day. Profit with one such milliseconds-long trade is sometimes only a few pennies, but it is the massive trade volume that drives the total daily profits, which are in several thousands of dollars. Players & Strategies In the US equity markets, some of the highest volume high-frequency traders include proprietary trading desks of firms like Goldman Sachs, Knight Capital Group, Getco LLC & Citadel LLC.
Figure 3: Players in HFT space (US Equities) There are 4 basic strategies employed by almost every HFT firm: Market Making Traditional market making involves placing limit orders to buy & sell in order to earn the bidask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market makers provide additional liquidity to the market by being counterparty to incoming market orders, they get rebates from exchanges for quotes that lead to execution. So, if an HFT’s bid (buy order) of $15 for XYZ shares is matched, it might immediately post an offer (sell order) for the same price, hoping to capture two rebates while breaking even on the spread. Building up such market making strategies typically involves precise modelling of the target market structure & trading volumes using stochastic control techniques. Ticker Tape Trading To appreciate ticker tape trading, it is essential to understand the concept of “co-location”. Co-location is a system where in a stock exchange allows large hedge funds and i-banks to place their computers near its own data terminals, in exchange for rental income. Proximity to the stock exchange’s data centre ensures that any market movement (read the ticker tape) is detected by these computers before general public. Pre-designed algorithms can thus detect any trend in the prices, and carry out their own trades seconds before the general public even knows about the prices, and reacts to them. To realize the importance of a few seconds 25
in computing terms, consider the case of Lotus Capital Management LP of New York. Earlier this year, it realized that a competitor was beating it to a trade it had programmed by exactly 3 microseconds, day after day. The loss meant Lotus was forfeiting about $1,000 in daily revenue on that particular trading strategy. Subsequently, that trading strategy was discarded since firm did not have the infrastructure to speed up the execution by 3 microseconds. Event Arbitrage Event Arbitrage is very similar to Ticker Tape Trading, except that the item of interest here is the news feed. Most HFT traders employ a class of algorithms to deal with each possible kind of corporate event (including earnings reports, earnings outlook, mergers and acquisitions, and analyst rating changes), and convert news into positive or negative trading signals. An example would be a very simple algorithm that would read words like “profit”, “confidence”, “beats expectations”, “good quarter” from a Reuters news flash, and would start buying the stock before general public have a chance to even finish reading the news. The trick is to be the one who makes the move first: to be the one whom has the fastest news feed, the fastest information extraction algorithms and the fastest execution. Statistical Arbitrage Statistical Arbitrage strategies aim to make money by exploiting statistical mispricing of securities, like deviations in interest rate parity in forex markets. Carried out over prices of over hundreds of securities at a time, it is possible to detect such mispricing using extensive data mining & complex mathematical techniques. The arbitrage strategies hinge on the possibility that assets would obey their historical statistical relationships with each other in long run. The Dark Side of HFT There is another side of the story. High Frequency Trading is in the midst of a raging debate. Consider ticker tape trading as described above. A person who is privy to market prices before other players is called an insider trader, but if it is only a question of few seconds, the boundaries of law start to blur. Any firm with enough cash to buy high-tech infrastructure & pay rents to a stock exchange can enjoy the free lunch of being few seconds ahead of the market. HFT is, thus, accused by its critics to be a legal form of insider trading. Now, consider market making. HFTs are in no obligation to provide liquidity to the markets. They do so to serve their own profit purpose (bid-ask spreads and rebates from exchanges). However, during periods of high volatility, these market making algorithms stop immediately, leading to an almost instantaneous erosion of liquidity. A perfect example of this phenomenon was Dow Jones Flash Crash on May 6, 2010, when DJIA plunged 900 points 26
(9%) in 5 minutes, only to recover within next 10 minutes. A July, 2011 report by the IOSCO concluded that "the usage of HFT technology was also clearly a contributing factor in the flash crash event of May 6, 2010." Since then, many mutual funds have moved significant portions of their money out of US equity markets, and are considering other asset classes. They say that the US stock markets have been reduced to computerized gambling houses where algorithms devise microsecond-length trading strategies. All long-term valuation of business fundamentals seems to have lost its meaning. And it’s not just equity. In February 2010, a trading algorithm owned by Infinium Capital Management ran amok and caused worldwide surge in oil prices by USD 1. The company currently faces civil charges for causing a global mayhem. Of course, advocates of HFT (read hedge funds and investment banks) are quick to dismiss this criticism. They point that they provide the much-needed liquidity to the market, and hence improve efficiency of the markets. While regulators are vying to bring High Frequency Trading into the ambit of rules, there is undoubtedly a powerful lobby opposing this.
Figure 4: The Dow Jones Flash Crash of 2006 SEC recently passed a legislation banning the use of naked sponsored access, which allowed firms to trade directly on an exchange using a broker’s infrastructure without pretrade risk controls. Similarly, IIROC, Canada’s financial regulator, has proposed new tariffs 27
that would charge trading desks per message, rather than per executed trade. If these costs are passed down by trading venues to their members, it would have a marked impact on the execution fees paid by HFTs. What now remains to be seen is will these regulations prove effective in tightening the actions of HFT firms, or will the exodus of long-term investors from the US equity markets continue unabated.
Bibliography Chlistalla, M. (2011). High-frequency trading. Frankfurt: Deutsche Bank Research. Crosthwait, A. (2011, January 7). HFT expected to grow despite new regulation. Retrieved August 2, 2011, from Trade News: http://www.thetradenews.com/tradingexecution/regulation/5576
Firm faces civil charges for U.S. oil trading mayhem. (2010, September 23). Retrieved August 12, 2011, from Thomson Reuters: http://hft.thomsonreuters.com/2010/09/23/exclusive-firm-faces-civil-charges-for-u-s-oiltrading-mayhem
Flash Crash 2010. (n.d.). Retrieved August 12, 2011, from Wikipedia: http://en.wikipedia.org/wiki/2010_Flash_Crash Skoko, D. (2010, July 7). Colocation and Liquidity Provisioning: An Uneven Playing Field. Retrieved August 7, 2011, from Advanced Trading: http://www.advancedtrading.com/exchanges/225702636 The Grahamian. (2011, June 13). Retrieved August 10, 2011, from The Grahamian: http://thegrahamian.blogspot.com/2011/06/event-arbitrage.html
Prashant Rishi is a 2nd year PGDM - Finance student of IIM Lucknow. He has completed his graduation in electronics and communications engineering from Manipal University. He can be reached at firstname.lastname@example.org or on phone number 7897180796.
COMMODITY PRICE DYNAMICS Pallav Kumar & Ashish Agrawal | NMIMS Mumbai In spite of the consistent attempts being made for stabilizing the commodities market, it still remains to be the most volatile one. Several steps are being taken in order to overcome the volatility. In the agricultural commodities for example, commodity buffer stock scheme has been used, the idea behind this is to store a part of the production in the years when there is good harvest, thus increasing the price from what it would have been and sell the stored goods in the years when there is less production, thus reducing the price from what it would have been. While the neo classical commodity market models (which promotes efficient markets hypothesis) believe the rational speculators to be a key element in the price stability in the commodities market, the speculators are proving themselves to be a major cause of price instability. As per the chartists and fundamental approach, the interaction between heterogeneous agents, chartists and fundamentalists, may cause a skewed movement of asset prices. As per simulations, whenever the govt. imposes a minimum price to support the producers, the volatility decreases, however the average price of the commodities declines too. Likewise, when the government imposes a maximum price to support the consumers, the volatility decreases; but the average price which consumers pay, increases. This puzzling outcome is because of the dynamic lock in effect. When the price of the commodities has crossed a critical upper limit the bull market turns into a bearish one. When the govt. intervenes to inhibit this shift it puts a cap on the price of the commodity. As a result, the average price becomes higher than what it would have been without the cap. Moreover, since the price is fluctuating at a high level, it reaches the price cap repeatedly so that the buffer stock is likely to finish rather quickly. Alternating between a lower and an upper price boundary can be seen as one of the ways to counter this problem. The price volatility thus gets decreased but the market still remains distorted. This process of changing the level of price limiters and on-off switching however leads to severe bubbles, crashes or volatility clusters. Hence commodity markets are extremely volatile and regularly display severe bubbles and crashes. Such price dynamics may, of course, be triggered by demand and supply shocks. As per the cobweb model, complicated price movements can be attributed to nonlinearities. However, apart from this there exists an additional source of market instability. As most of the 29
commodities are traded at stock exchanges, speculators can also prove to be the deciding factor in commodity markets. Surprisingly, this aspect has received only little attention so far. In a market basically three types of agents interact i.e. the consumers, the producers and the speculators. Speculators are considered to be the heterogeneous one since they are used to both technical and fundamental trading strategies, and, at the inception of each trading period, they choose one of the two strategies as their own trading strategy for that given trading period. Their behaviour can be regarded to be rational since they decide between these two strategies depending upon the market. We are assuming that the price adjustment on the commodity markets may be given by a loglinear price function.
Hence, the log of price S at time t + 1 is St+1 = St + a (Dt + WtC Dt + WtF Dt ) Here ‘a’ corresponds to the positive scaling coefficient in order to calibrate the price adjustment speed; Dt corresponds to the excess demand of the real economy, the technical and the fundamentalist analysts respectively at time t. The weight of the chartists at time t is given as WtC, whereas the weight of the fundamentalists is given as WtF To illustrate the demand and supply decisions for the real economy we are introducing a reduced form assuming that the supply schedules of both the consumers and the producers are log-linear. The excess of demand for the real economy can be expressed as Dt = m (F − St), Here ‘m’ refers to the slopes of the supply and demand curves and F corresponds to the longrun equilibrium price (also called the fundamental price). When the value of the price is equal to the value of the long-run equilibrium price F, the excess demand of the real economy turns out to be zero. We can then assume that the economic structure is quite stable and there are no or very few permanent demand and supply shocks. As a result, the value of F remains constant over time. In the absence of speculators, WtC = WtF = 0,
In this case law of motion of the commodity’s log price has a unique fixed point at St =F, Such a state is obviously efficient. Speculators are familiar with both technical and fundamental analysis. Now, to model the excess demand generated by chartists or the technical analyst we formulate: Dt = b (St - F) Where ‘b’ is a positive reaction coefficient and F is the long-run equilibrium price (also called the fundamental price). The technical analysts believe typically in bear and bull markets. As long as the price is above the fundamental value, chartists regard the market to be bullish. Since a further price increase is expected, chartists believe in buying the commodity. However, if the price drops below the fundamental value then the chartists tend to lose faith in the stock. In a bear market, chartists sell the commodity. Since changes in excess demand are positively correlated with changes in price, it is in a broader sense consistent with positive feedback trading.
Fundamental analysts believe that prices tend to revert back to their fundamental value. If the price is above its equilibrium value, lower prices are expected and fundamental analysts tend to sell the commodity. In the same way if the price is below its equilibrium value, higher prices are expected and fundamental analysts tend to buy the commodity. The excess of demand generated by fundamental analysts can be given as Dt = c(F − St). Here c is the reaction coefficient.
The Speculators tend to exploit interchangeably the bull and the bear market situations. However, when the price deviates more from its fundamental value, speculators perceive more risk for the bull or bear market to collapse. As a result, an increasing number of speculators tend to go for fundamental trading. The market share of speculators who tend to apply technical analysis may thus be given a t =1/ 1+d (F−St) 2.
The higher the switching parameter d is greater than 0, faster the speculators tend to switch to fundamental analysis. The weight of fundamentalists is
WtF = 1 âˆ’ WtC
Although producers and consumers are the two primary participating agents in the commodity markets, there are also other participants, such as speculators, who may have a definite effect on the degree of price variability and on the success of any commodity price stabilization scheme. Thus we can say that the chartists are a source of market instability. Also weak reaction of the speculators (either the fundamentalists or the chartists) can push the market to be either a bull or a bear market and strong reaction of the speculators causes market prices to fluctuate irregularly between bull and bear markets.
Ashish Agrawal is a 1st year MBA student at NMIMS, Mumbai. He has completed his B.Tech in Electrical Engineering from NIT Allahabad. After graduating, he served as an Asst. Manager, Marketing with Crompton Greaves & Bajaj Electricals for a period of 2 years. He can be reached at email@example.com
Pallav Kumar is a 1st year MBA student at NMIMS, Mumbai. He has completed his BE in Computer Science & Engineering from MIT Manipal. After graduating, he served as a Business Analyst with TCS for a period of 2 years. He can be reached firstname.lastname@example.org
THE PROBLEMS PLAGUING THE REAL ESTATE SECTOR Madusudanan Ramani & Pavan Nayak | NMIMS Mumbai Real estate or immovable property is a legal term (in some jurisdictions) that encompasses land along with anything permanently affixed to the land, such as buildings. However, in technical terms, real estate refers to the land and fixtures themselves and real property are used primarily in over real estate. In the last decade, the real sector has been largely driven increasing working population, increasing urbanization, rising income levels and easy availability of funds. The sector has a high multiplier effects on the economy in general and a few sectors like Cement, Paints and Steel. It had attracted more than
$ 10 billion of Foreign Direct Investment (FDI) since the
year 2000. The sector has grown from a largely fragmented/unorganized market to semiconcentrated market with growth of large listed firms in the last decade. Problems in Plenty From a sector once promising astronomical returns with an element of high risk is facing a huge liquidity crisis on account of increasing interest rates and commodity prices. The sector was carrying huge debt pile of about $ 24.6 billion in July this year as against $ 3.8 billion in September 2005. With increasing interest rates, the sector faces twin challenges of reducing demand and increased interest expenses, which is squeezing the profits of the participants. The factors that were driving the sector such as increasing disposable income and availability of funds are de-accelerating the growth in the sector in the recent times. Figure depicts the city-wise movements of Residex in the period 2008-2011
Residex is an index of housing prices across major cities of the country, published by National Housing Bank (NHB). Prices in most of the cities are either fallen or the growth has moderated in the two quarters. The sector is highly interest sensitive as it affects both the supply side and the demand side. The high interest rate reduces the consumerâ€™s ability to avail of a higher denomination of credit. Unlike in the developed countries, the turnaround time for projects in India is high and companies hold on to their land holding for considerably higher period of time to profit from land appreciation during that period. Since most of this purchase of land holding is done using borrowed funds, any increase in interest rate reduces the profitability of the firm. The cost of material such as Cement and Steel also has a considerable negative impact on the profitability of the sector. The sector is also plagued with the rising wage cost. The supply of labour from states such as Bihar and Uttar Pradesh has come down significantly in the last one year, due to increase in wage rates in these respective states. This has pushed the cost of labour for the real estate due to short supply. The proposed Land Acquisition Act could further add to the woes of the real estate sector in India. Once in force, the act is expected to increase the cost of acquisition of land by real estate participants. Other than the cost, the process of acquisition would become difficult on issues of Rehabilitation & Resettlement (R&R) programs. Increase in cost of land would
affect the participants operating in the low cost housing space as this segment is the most price sensitive. But the passing of this Bill, could give competitive edge to real estate participants who own with large land banks already. Financing of the Deals The problems faced by the sector intensified by the inability of the dilute equity due to poor stock market conditions and reluctance on the part of Private Equity (PE) investors. The Private Equity investment into this sector have reduced sharply from the levels seen in 200708, but quarterly averages show the investments have started to show some uptrend. Weak governance, financial mismanagement, lack of transparency, execution capabilities, market absorption, over valuation of the project and rampant malpractices are the main reasons that inhibit flow of PE investments in the sector. The sector is expected to receive PE investments into the sector once the regulator in place and issues of corporate governance ease. Chart depicts the PE investments (in $ millions) in Real Estate Sector in India during the period Q1, 2006 to Q1, 2011.
Real estate companies have not been able to raise funds from the stock market due to poor valuations. The performance of the all the real estate companies have not been equally bad. Some companies like Godrej Properties have been able to give outperform the Sensex due to their nature of operations.
Stock prices of participants who have low levels of debt and have not financed land acquisition using debt have outperformed the rest of the participants. Some of the participants have entered other business such as like insurance, mobile and hospitality trying to build a leverage using the existing real estate business. This diversification has affected the profitability and some of the participants have been exiting such investments of theirs.
Regulator in Pipeline Government proposes to set up a regulator for the sector mired with issues of transparency. This would provide welcome relief to the potential buyers from the unfair practices followed by the developers and this would increase buying in the long term. The Real Estate (Regulation and Development) Bill 2011 is expected to be tabled in the parliament in the winter session, after getting approved by the cabinet. The regulator would be responsible for â€“ 1. Protect the potential buyers from the Fly-By-Operators.
2. Certifying the registration of projects or land that are 4,000 sq. metres or more in size 3. Ensure property developers comply with registration norms such as clear land titles, and prevent diversion of customer advances for a specific project to another one. 4. At least 70% of the money collected from buyers from time to time will be put in a separate escrow account within 15 days of its realization and will be used only for the construction of the particular project. 5. Developers will not be able to sell or book any apartment without prior registration of the project with the authority Investment Opportunities The real estate sector in India is expected to grow in the longer run on account of strong growth of Indian Economy. The participants have to fine-tune the operations to make them more efficient. They could reduce the turnaround time for the projects and reduce the requirement of funds. They could improve their corporate governance projects and attract funding from Private Equity Investors. The sector expected to grow in years to come is expected to be valued at $ 180 billion by 2020 and investors can take positions in real estate firms with lower level of debt.
Madusudanan Ramani is a student of MBA (Capital Markets, Class of 2013), NMIMS. He completed his under-graduation (B.B.A) from Vivekananda College, University of Madras in the year 2008. After graduating, He served as a Financial Analyst with Frost & Sullivan for a period of three years. He can be reached at Madusudanan.email@example.com.
Pavan Nayak is a student of MBA (Capital Markets, Class of 2013), NMIMS. He completed his under-graduation (B.E) from R.V College of Engineering in the year 2010. After graduating, he served as a Software Engineer with Huawei Technologies for a period of one year. He can be reached at firstname.lastname@example.org.
ANALYSIS ON INDIA – LATIN AMERICA TRADE BARRIERS, TARIFF AND NON-TARIFF BARRIERS, COMPARISON WITH CHINA, EFFECTIVENESS OF PTA Debasmita Panja & Swapneela Biswas | IIM B
1. SUMMARY India and Latin America have opportunities of development in each other’s’ territories. Latin America which is valued for textiles, cosmetics, cars and pharmaceuticals and India which is known for its specialization in IT, realized that they could successfully utilize their resources by collaboration to improve the economic conditions in both the regions. India signed Preferential Trade Agreement (PTA) with MERCOSUR to improve bilateral trade relations. However, the trade between India and Latin American countries (LAC) is much less as compared to trade between LAC and China. We have analysed tariff and non-tariff barriers vis-à-vis China to study the underlying reasons. 2. Tariff Barriers We have taken Argentina and Brazil for investigation as establishing trade relations with these two countries will open up entry route into other countries because the countries are very well connected through road transport. The following table has tariff analysis based on the top 5 imports to India over the period of 2005-2009.1 Top 5
imports to India MINERAL
IRON AND STEEL
Source: Ministry of Commerce: http://commerce.nic.in/eidb/default.asp and
Arab Emirate s
Not a top export of
of good for
from Brazil in
Brazil in 2009
Not a top
3 best export from
Brazil in 2009
Brazil 5.67 *
tariff for India Where
2 best export
Not a top export of
8th best export from
Not a top
Not a top export of
of good for
tariff for India Where
* indicates existence of Preferential Agreement Observations:
27, Mineral Fuels: It is one of the top imports of India. This is the top export good of Brazil in 2009 but the trade is not much with India, even though Brazil has less tariff (6.25%) than the other top import partners (9.29% for Iran) of India. One of the reasons can be Brazil has even lesser tariff with other countries like USA (0.82%) or Uruguay (0.92%). But there are countries like Chile (6%) and Peru (5%) as well who are top export destinations for Brazil instead of having similar tariff rate as with India. The reason can be less distance and well transport facilities with these countries as Mineral Fuels are heavy commodities and transporting this good to a longer distance becomes a major non-tariff trade barrier. But then there is China which is a top export partner of Brazil. Brazil has 6% tariff rate for China which is almost same as 6.25% with India and distance wise also the two countries are almost similar. Still, the trade with India is not picking up. This good has been considered in the preferential agreement between India and Brazil but the effectiveness of that poses a big question. But on the other hand, this is one of the highest bilaterally traded goods of Brazil and India. Thus it can be inferred that though there is bilateral trade in this good, the overall trade in all the goods is itself very less between Brazil and India and also the trade in this particular good is very small as compared to trade with other countries. This good is of potential strategic importance and should be considered while making future policies. Same observation follows for Argentina as well. This is the second best export good from Argentina in 2009, but still the trade with India is not much.
Same pattern can be observed for 72, Iron and steel as well
71, Precious or semiprecious stone is included in the offer list in the preferential agreement but it is of no interest to Brazil or Argentina as they do not export this commodity much.
3. Other Trade Barriers Thus the general observation from analyzing the tariff structures between India and Latin America and comparing that with other countries in the world is that India has high tariff rates not only with Latin America but with other countries as well. This is imposing a barrier to trade with India. However there are several goods like mineral fuels, iron and steel etc. for which tariff rates imposed by India on Latin America are low, yet trade flows in this category from Latin America to India are not gaining momentum. This implies that there must be some reason other than tariff rates which is imposing problems in trade flows. Another observation is that in these categories of goods, tariff rates with China though similar; trade with China is 40
far exceeding trade with India from Latin America. So the next part of our analysis tries to answer these questions by focusing on the following:
Whether distance between India and Latin America is acting as a trade barrier?
If distance is a factor, then why trade between Latin America and China is huge despite the fact that China and India are at similar distances from Latin America?
Distance as a Non-Tariff Barrier: Geographical distances have impeded trade between India and Latin America. There is no direct shipping service from India to Latin America. Goods have to be shipped to Europe or Singapore which increases freight costs and shipping times. For example, in the case of Brazil, shipping a product from Santos directly to Mumbai would take an estimated 27 days and 15 hours. Shipping via Singapore would take approximately 36 days and 18 hours – almost nine days longer.2 Transport costs between India and Latin America seems to act as a significant trade barrier between the regions. Heavy commodities are difficult to trade between such long distances. Due to the long voyage period, perishable gods also cannot be traded. Comparison with China: Some of the initiatives that China has taken to increase trade with the region are:
China is planning to build a rail link through Colombia to trade with Latin America3
China is rivalling with World Bank and Inter-American Development Bank as a major lender to Latin America
China is opening up its embassies throughout Latin America
China is opening Confucian centres to expand Chinese culture
China is sending high-level trade delegations and encouraging ordinary Chinese to visit Machu Picchu, Rio, and other tourism hot spots.4
4. Trade Initiatives: PTA with Mercosur5 MERCOSUR is a conglomeration of four countries - Brazil, Argentina, Paraguay and Uruguay formed in 1991. PTA was signed between India and Latin America on January 25, 2004. India-MERCOSUR PTA came into effect from 1st June, 2009.
4.1 Effectiveness Of PTA: Since the PTA is very recent, there has not been any significant effect on trade between the regions. However it is observed that more than half the products covered under MERCOSUR’s
offer list come under the category - Organic Chemicals. This is India’s one of the top exports to Latin America. With this inclusion, trade with India was supposed to improve in this category. Most of the subcategories of organic chemicals have a Common External Tariff of 2% to which India has been granted a 10% concession. Probably this being not very significant, it has not impacted the export trends of organic chemicals from India to LAC. We have identified top exports of each of the four countries of MERCOSUR to India.
However when we look at the offers list of India in the PTA, it does not feature most of MERCOSUR’s key exports. Only raw hides and skins, nuclear reactors, boilers and machinery, and electrical, electronic equipment are covered in the list. Trade competitiveness between India and Argentina for electrical and electronic equipment has increased in 2009, which can have some bearing on the inclusion of this item in the offers list of India in the PTA. But items like minerals, iron and steel are showing decreasing trends in competitiveness for export from Argentina to India. Yet they have no presence in the offers list of India. These are potential grounds for improvement for bilateral trade. India has high competitiveness in organic chemicals. Tariff concessions on a number of
lines in this category have been given in MERCOSUR’s offer list. This gives advantage to India’s exports in this category to Latin American countries. India has got concessions on pharmaceutical products. However the lines which have been covered in this category represent only 5% of India’s export value in pharmaceuticals to MERCOSUR. Thus the effect of this inclusion might not be very significant.
Source: Ministry of Commerce: http://commerce.nic.in/trade/international_ta_indmer.asp
Considering the exports of India to MERCOSUR, the key complementary products are petroleum and machinery. These categories appear in MERCOSUR’s offer list. Thus this can have a positive impact on trade.
For the exports of MERCOSUR to India, petroleum oil is a complementary product. But this product does not appear in India’s offer list. Trade could have increased positively if concessions are provided to MERCOSUR in this line of items.
There is huge trade potential between India and LAC bilateral trade as the economies are almost similar. Moreover, LAC can be a potential bypass to enter into US market. Hence, India should identify goods of strategic importance and future negotiations.
MERCOSUR countries are rich in agricultural land, labor and efficient technology. Commodities like soybeans, corn, wheat, cereals, rice are produced in huge quantities in these countries. India should consider investing in agriculture in these countries for cheap and large volume sourcing.
Distance is a major non-tariff barrier for trade between India and LAC, but China has overcome this factor and the trade is increasing with China. India can follow China’s footsteps in taking many strategic initiatives like building shipping link, investing in LAC countries using its huge cash surplus and offering extremely favourable tariff rates. Building shipping link requires huge investment, but since distance will always be a factor against trade, this investment is highly required.
The goods included in the offer list of the preferential agreement between India and MERCOSUR are not in accordance with the needs of the two countries. There are many goods included which are not of importance to the offered country and many goods of strategic importance and requiring tariff concession are not included. These issues should be resolved in future for an effective preferential agreement.
India can invest in service industries in MERCOSUR countries specially in IT i.e. India can outsource its IT operations for US clients to MERCOSUR countries which will help to procure low cost labour and also to overcome language and cultural barriers for US clients.
India imports mining goods like minerals and ores in huge volume from the world. MERCOSUR countries are rich in these commodities. India can invest in mining in these countries for cheap souring.
Debasmita Panja is a 2nd year MBA student at IIM Bangalore. She has completed her graduation in Computer Science Engineering and can be reached at email@example.com
Swapneela Biswas is a 2nd year MBA student at IIM Bangalore. She has completed her graduation in Information Technology Engineering and can be reached at firstname.lastname@example.org
LAUNCHING REITS FOR INDIA’S REAL ESTATE Sujit Khanna | NMIMS Mumbai ABSTRACT The Indian government has realized that India’s real estate is a key component of economic growth and is on the verge of second boom. However, there are many issues with India’s real estate sector structure especially in financing. This article attempts to outline the working and basic structure of Real Estate Investment Trusts or REITs and how they can institutionalize India’s real estate sector, provide quicker financing to real estate projects and give investors an alternate source of investment by acting as best inflation hedge around. Finally, the article discusses the basic underlying problem with launching REITs in India and suggests alternative solutions.
WHAT IS AN REIT? An REIT (Real Estate Investment Trust), first introduced in the US in 1962, is a corporate structure which invests its assets in real estate holdings. One gets its share of earnings or losses from the REIT’s portfolio of real estate holdings. REITs distribute the profits earned through generation of rental income (more than 90% of annual income) to their investors in the form of dividends. This investment is comparatively more liquid as compared to traditional physical holding of real estate. However, the downside is that one has no control over the buying/selling/holding or managing it. The reason REITs are liquid is that they can be traded on major exchanges, making it easier to buy and sell REIT assets/shares than to buy and sell real estate properties in physical market. The typical structure of an REIT is shown below in Exhibit 1.
NEED FOR REITS IN INDIA:Indiaâ€™s real estate sector is highly unorganised. In fact, the construction sector did not even have an industry status till a few years ago, which it badly needed to get easier access to funds from banks and financial institutions. This resulted into inflow of a lot of black money into the sector. Moreover, before 2005, government did not allow FDI into the sector. Even now, FDI allowed is only in construction development, partially blocking out the sector from financial markets. Development of new town and cities is on the anvil and India, because of its ever-growing population, requires them drastically. These new developments are in need for huge amount of investment and technical expertise, which cannot be achieved under present structure as most of the work is done in an unorganised manner. Indian government has realised that real estate sectorâ€™s growth is key component of economic growth and any factors inhibiting its growth will have a negative impact on the economy. Introduction of REITs will help India
overcome this problem in a big way by institutionalizing the real estate sector and will also provide foreign investors with ample of opportunities to invest.
REITS IN INDIA AS INVESTMENT OPPORTUNITIES Real estate sector has provided the best return on investments in recent years and, with ever increasing real estate projects all across India, this trend will continue at least for a few years and REITs will act as a special vehicle for investment in the sector. REITs will provide
investors with an alternative investment class and an access to ownership in a large high value Real Estate project at a low ticket size. Exhibit 2 shows the investment opportunity in Indiaâ€™s real estate sector. Exhibit 2
Exhibit 3 shows that India provides a considerably good opportunity for REITs.
Inflation hedge Along with liquidity REITs also provide the best inflation hedge, far better than that offered gold stocks. EXHIBIT 4
As shown in Exhibit 4, the two assets providing the most dependable inflation protection since January 1978 have been commodities and equity REITs. Commodities led by exceeding the inflation 70.4%times during high inflation six month periods, while equity REITs followed close behind at 65.8%. Stocks and TIPS (Treasury Inflation Protection Securities) provided somewhat weaker inflation protection, with stock returns exceeding inflation 60.8%times and TIPS exceeding 53.8% times. The weakest inflation protector has been gold, with returns beating inflation during only 43.2% of high inflation six month period. Exhibit 5 shows the returns when inflation is high. Best returns have come from commodities with gold coming second and REITs third. However during periods of low inflation commodities and gold have typically provided returns close to zero percent but listed equity REITs have historically provided strong returns when inflation is high also when inflation is low as shown in graph below. Exhibit 5
Another characteristic that made REITs popular in United States of America is the tax
benefits offered to companies incorporating REITs, provided they follow the set rules and regulations.
Issues with launching REITs in India and its recommended solutions Launch of REITs in India has been delayed because SEBI (Securities and Exchange Board of India) feels that Indian property markets lack depth and liquidity required for proper functioning of REITs. Other problems that exists with launching of REITs in India are1. Institutional grade spaceâ€“For the purpose of comparison these Real estate properties are grouped into three classes Class A, Class B, and Class C with class A being the best class of real estate. These classes represent a subjective quality rating of buildings which indicates the competitive ability of each building to attract tenants and a combination of factors like rent, building amenities, location and market perception. Except for office space some of which can be classified as grade A, organised real estate space market for other property types like health care, retail storage, apartments and specialties do not exist in the form of income producing properties. 2. Valuation models-Currently there are no valuation models for audit and sales purposes, no requirements to be an evaluator and lack of specialized personnel in this domain. 3. Weak legal structure â€“ Non uniform state taxes, title issues with land and stamp duty on every sale and purchase which can effect IRR that is Internal Rate of Return(the discount rate at which sum of your cash flows equals the initial cash investment) of REITs. 4. Lack of trained employee base- REITs require asset and portfolio management expertise along with development and leasing expertise whereas in India there is no Real Estate education at corporate or university level and is not looked as a career option. 50
The absence of any one of the above elements could lead to an inefficient REIT market and trigger a collapse in the entire system, rather than a failed attempt it would be wise to build up each element over time before initiating REITs in India. But a quicker and better alternative would be to look for offshore listing of Indian real estate assets in destinations like Singapore Stock exchange SGX. The typical structure of an overseas REIT is as shown below.
However one must also consider the risks involved with overseas listing, a few of them are1. Currency risk â€“ Sudden changes in the exchange rates can drastically change the price of the asset. 2. Legislative risk-Sudden changes in the regulatory and taxation frameworks. 3. Lack of BT or business trust between the participating companies. But recent developments of a health care business trust of Indian assets being listed on SGX suggests that companies are unfazed by the risks involved and are willing to employ unconventional financial instruments like REITs for better financing of their projects.
Referencesreit.com FDI in real estate and REITs for Indian assets â€“PWC report http://realism.in/resources/white_papers_and_downloads/Is_India_Ready_for_REITS.pdf http://www.accommodationtimes.com/research/student-projects/launching-of-reits-in-india/ http://yamanote.hubpages.com/hub/Internal-Rate-of-Return-for-Dummies http://www.boma.org/Resources/classifications/Pages/default.aspx http://prajnacapital.blogspot.com/2010/08/real-estate-investment-trusts-reits-in.html
Sujit Khanna is a student of MBA (Capital Markets, Class of 2013), NMIMS. He completed his under-graduation (B.E) from Watumull Institute of Electronics Engineering and Computer Technology in 2011. He can be reached at Sujitkhanna@gmail.com
INSIGHTS INTO MARKET EFFICIENCY Harish Srigiriraju | NMIMS Mumbai "I'd be a bum on the street with a tin cup if the markets were always efficient." â€“ Warren Buffet Efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that, at any given time, prices fully reflect all available information on a particular stock and/or market. This implies that the stocks always trade at their fair price or intrinsic value. Now if this were true, does it make sense investing in stocks?
If this hypothesis is true, generating excess returns would not be possible. All investors will perceive a stock in the same fashion, as it is assumed that all investors are fully aware of all the information on that stock. There would be no need of performing valuation of companies or identifying undervalued stocks. It would have not been possible for Warren Buffett to beat the market over several years.
Now it is clear that the markets are not always efficient, but in few instances they are. It is generally accepted by value investors that markets are efficient in the long run. So the next question to ask is, how long is long enough? Value Investors look for undervalued stocks in view that they will reach their true value at some point in time. This may vary from stock to stock. A particular stock may reach its value within one year while the other may take ten years. Now the time frame is important as our return depends on this ultimately. So how to identify stocks which will reach its potential quickly? A stock whose information is available to greater set of people will have better chances of reaching its fair value quickly. Consider two stocks RIL and KCP(Assumption here is that they are undervalued) . RIL is a stock which will be followed by a large number when compared to KCP. Now if RIL is undervalued, there will
be many who will invest in it, which will lead to price appreciation. For KCP, there will be few who track this and hence may take more time to reach the fair value. Definitely there will be exceptions to this. So for the value investors out there, it should be a learning that just investing in undervalued stocks will not suffice.
It can be conveniently assumed that more people follow Large Cap compared to Small Cap. If a stock makes its way in the Sensex 30 or Nifty 50, then all the more attention will be given to it due to the index funds coming into picture. So, if an investor is able to identify stocks in them, then it can be called a safe bet. Probably this is one of the reasons why Warren Buffet prefers to invest in Large Cap companies.
So how can we measure market efficiency for a market, say in India? Is it possible to quantify it? One way to do it would be calculate the fair value of each and every stock in the Indian market. Then measure the deviation with respect to the CMP. Also as mentioned earlier the stocks would then need to be classified on basis of flow of Information. Efficiency for each category would have to be calculated separately. Even if we were to achieve this, the biggest criticism would be, how will you arrive at a fair value of a company? Is it not a perception and hence will vary? There is no standard method to calculate the fair value of a stock. In most of the research, shortcuts are used to avoid hard work. So I can do something similar here. What can be done is, to take only few stocks in Sensex. Calculate their fair value in 2000 based on the cash flows from 2000-2005. Here we use 2 stage DCF model as it is the best tool available for valuation. An alternative can be using Market Multiples, but it wouldnâ€™t make sense as the whole idea is to measure inefficiency and in Market Multiples, you assume markets to be efficient.
Based on the fair values obtained, the deviation can be calculated with respect to the prices in 2000. Similar methodology can be done for 2006. The resultant deviation now can be used as a measure to compare efficiency in 2000 and 20006. This can be used in the current scenario also. However the fair value would need to be calculated on the growth estimates 54
from 2011 and this may not be accurate. Thus we can land up with a relative measure to compare efficiencies of different markets or different time periods.
This study will be based on the inference that the CMP is the fair value of a stock as per EMH. However, the EMH was mainly focused on the flow of information and not on valuations. To study this, the market needs to be observed for flow of information in various instances like,
Mergers and Acquisition
Yearly or Quarterly results
Macro Economic changes
Changes in capital structures
Unit root test, Co-integration Test, variance ratio tests, autocorrelation test and few other tests are generally used to test the EMH. For a week form, a study is carried out whether the CMP are a reflection of the previous prices. For a semi strong, a study is done to measure the speed at which a particular piece of information affects the stock price. For a strong form, a study can be done to check if any mutual funds, investment funds or individual investors have generated above average returns over the years. Is a study required for a strong form? Can we straight away say that, the markets do not have a strong form of efficiency because there are people like Warren Buffet and Rakesh Jhunjunwala? Can we say that, there is no strong form as there are scams like in case of Satyam where investors did not have the
accurate information? The answer to these is â€œyesâ€?. There is only weak and semi strong form. This will again depend on the information flow, media, investors and ultimately the rationality of investors.
So why is it taught in many places that the markets are efficient? EMH should be taught no doubt, but it should be also taught as to why this theory fails many a times and that it holds true in the long term. Flow of information is something which each one should learn, as there will be opportunities to make money. In the previous edition of Investocraft, if you have read the article Takeover Arbitrage, we have seen how there is an arbitrage opportunity due to lack of information equally among all investors. "Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards. It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn't do any good to think."-Warren Buffet. The point Warren Buffett is making is true. Phew! At least the competition is reduced if you know what Buffett and I mean.
Harish Srigiriraju is a 1st Year MBA Capital Markets student of NMIMS-SBM. He can be reached at email@example.com
SOLUTION to INVESTOCROSS
CENTRE FOR MBA CAPITAL MARKET NMIMS
The center for Capital Market studies in NMIMS is an outcome of the synergistic relationship between The Stock Exchange Education and Research Services (a public trust established by the Bombay Stock Exchange) and SVKM's NMIMS since March 2005. With the advent of global capital flows, information and technology, there was an acute need for trained professionals to man important positions in all spheres of capital market activity which include stock exchanges, commodity exchanges, regulatory bodies, policy-making bodies, market intermediaries, asset management companies, corporate bodies, etc., to name a few. With this objective in mind, a long-duration program called the MBA (Capital Markets) was custom-designed by the two collaborators. MBA (Capital Markets) is a two year full time programme offered by NMIMS University to cater to the needs of requisite intellectual capital to the fast-growing financial world with a keen focus on capital markets. The program is unique because it aptly integrates conceptual knowledge, contemporary inputs, technology, information and skill development. The programme is a blend of traditional core finance subjects along with capital market related subjects such as Asset Valuation, Treasury and Investment Banking, Asset Management, Equity Research, Industry Research, Private Equity. Its most striking feature is the Trading Room facility. In fact it is the first Program in India with such an advanced facility incorporating Bloomberg and Reuters. It is also the first Program in India to have been visited
International Financial Centers like Singapore and Hong Kong which was proposed and supported by BSE. The design and development of the curriculum for the MBA (Capital Markets) was approved by the Academic Council and the Board of Management of the Deemed University. It focuses on all major Financial Markets: Equity, Fixed Income, Forex, Commodity and Derivatives. NMIMS has played the role of a worthy torchbearer in initiating such a welldesigned specialized course, which is essential as the economy begins to mature. The programme intends to create capital market experts having managerial expertise; and has been well received and appreciated by the industry.
Investocraft is an in-house publication of the Investocraft Editorial team, MBA capital Markets, NMIMSMumbai and features articles and analysis by the academia. The primary aim of this magazine is todevelop a long term interest and considerable following in the capital markets. The Investocraft Event at NMIMS Mumbai is a unique student initiative that collaborates with both the corporateworld and the academia to provide a platform for students to present their views on contemporary issues in the economy pertinent to capital markets. The committee organizes a diverse portfolio of activities throughoutthe year, industry interaction for the students.Some of the more popular activities include the Investocraft annual meet. The event, organized by the class of MBA Capital Markets, attempts to capture the pulse of the Indian bourses through exciting and impactful discussions that occur every year.Since inception, the event has witnessed overwhelming response from our erudite Industry Stalwarts and is the largest student driven initiative in India with nearly 600 participants comprising Management Students, Brokers, Analysts and Investors.
Investocraft Editorial Team www.investocraft.com
INVESTOCRAFT | quarterly 2011 MBA CAPITAL MARKETS NMIMS SBM
Published on May 26, 2012