Have we forgotten what finance is?

And finally I did wake up from the long slumber of laziness to pen down my thoughts on the recent financial turmoil which has taken the whole world by surprise. This post is a long due and in response to the request put forth by a coupla my friends who aspired to become Mostly Below Average (read MBA) and are currently contemplating whether they should quit their cushy jobs for this “holy” pursuit.

Coming to the core of the issue, the major problem with the financial architecture of the world is that finance is not playing the role which it’s supposed to. If you look back at the history why did finance as a function originate? Why were banks set up? How the concept of currency sprang up?

The world of commerce started off with the barter system of trade and then people realised that with the number of items traded increased, the complexity of valuation of items increased. To speak the computer algorithm lingo it became a function of O(n^2) (read order of n squared). As in, if you have four products A, B, C and D in the market then A has to be valued in terms B, C and D, and B in terms of A, C and D and so on. So for just 4 kinds of products there were about 12 different conversion standards (A to B and B to A are considered different). So for n products there were n(n-1) combination and as ‘n’ grew it became cumbersome for traders to trade and hence they agreed upon a common currency standard like gold where for A, B, C, D there are just 4 values in total. To again speak the computer lingo, the algorithm was optimised for the solution to be O(n).

Slowly financial institutions – banks, in this case were set up which started off as a means to protect the gold against the robbers. In no time banks realised that there is a better way of doing business by putting the gold deposited to better use by lending it to the needy. Thus originated finance. So finance can be thought of as function which enables the exchange of money from the hands of people who have some extra money to the hands of people who need money (read capital) for business which comes at a cost (read interest rates). So essentially finance is all about putting money into productive use. And these banks used to make money by the interest rate spread between borrowers and lenders. And it’s evident from the history that whenever this transfer of funds happened and the money was put into speculative use rather than productive use, there have been bank runs and financial turmoils.

And this is what we are witnessing now. The financial institutions of repute which should ideally support other businesses by providing capital (remember: putting the money into productive use) are increasingly getting into the business of money itself. Trading of money is happening more than the lending and borrowing of money. This is where the financial architecture becomes complex and difficult to fathom. The subprime crisis is an excellent case in point. Banks lent excessively to home and property buyers and in turn sold the loans off to Investment Banks. The investment banks in turn sliced and diced these loans and created bonds named as Mortgage Backed Security/Asset backed Security and sold it off to a lot of investors like hedge funds, mutual funds, pension funds. So there was essentially flow of funds from the hands of end investors like hedge funds to the hands of I-Bankers and from the hands of I-bankers to the hand of normal retail bankers. And retail bankers hand sudden liquidity (which otherwise they would have got after the payment of loans by the borrowers say after 10 years). This liquidity situation enabled retail bankers to further lend excessively. To make matters worse the MBS/CDO were insured by players like AIG and they named the fancy instrument as Credit Default Swap (CDS).

The investors in these securities were big names like Japanese Pension funds which invested for the greed of higher coupon rates (interest rate on these CDO securities). The higher interest rate was a classical case of supply demand situation. There were a lot of buyers of property and hence investment bankers kept on buying the loans from the retail banks and sold them off as CDO and investors like pension funds kept on buying these instruments.

There was one inherent but wrong assumption in this whole chain that the property prices would keep on increasing whatsoever the external conditions would be. The retail banks thought that even if the home buyer defaults on payments, the banks can seize the property and sell it off at a higher price and make for the loss of default.

But when the market interest rates went up and the borrowers could not pay the EMIs (as the loans were issued at floating rate of interest), the property market bubble had bust and there were no takers of the loans. Again the supply demand forces came into picture and these ‘mighty’ instruments called as CDO/MBS took a bath. The end investors started selling off but there were no buyers and the investment banking fraternity went bankrupt.

But again would this have happened if the investors like the very reputed hedge funds had questioned the assumption that is the money getting invested for the purpose of productive use? This is the first lesson Finance 101 would teach you and the one MBA Fin graduates and Quantitative fin PhDs from the Ivy League missed to remember!! And all these investors are financial institutions themselves and hence the question again arises: Is finance playing the role what it is supposed to? Is it the financial architecture to be blamed or the regulators?

To make things simple whenever you invest your hard earned money in any instrument or share or whatever security it may be, just try to figure out if your money is being put into productive use. If you are investing in the stock of a bicycle company, just go to the road and see how many people use bicycles of that particular company. Many times common sensical approach is far better than advanced quantitative models!!

The lurking global Inflationary trend

Fridays have become nightmares for the current UPA government. No points for guessing why. The weekly inflation numbers in India are out every Friday. The last thing the government would have wanted was a double digit inflation rate. The number last week was a whopping 11.05%. Though the sudden spike is largely due to the base effect, the fear of outcome of this inflationary trend can't be allayed.

The seemingly obvious reasons for inflation like food shortage, dollar depreciation and the skyrocketing crude oil prices have been discussed in enough detail by various columnists and bloggers. So I don't want to delve upon these reasons. I somehow feel that the cause of the current global inflationary trend is a lil more fundamental and profound.

One thing that we have been noticing for the past coupla decades is that emerging nations like China and India are not allowing their currencies to be completely market determined. In fact China as we all know keeps its currency artificially very much low against the dollar. This can be easily noticed by observing the huge difference between GDP at market price and GDP at PPP of these nations. The reason is not difficult to guess. This is one good way to boost export led growth and hence increase employment opportunity within your own country. Apart from the currency front, governments take many other measures like creation of Export Promotion Zones (currently known as SEZ in India), resorting to deficit spending etc.

You might artificially create watersheds to store water, but in accordance to the fundamental principle of Physics water seeks its own level. When water is bound by creating water sheds, it develops a potential energy and if the energy is strong enough to break the watershed, then the potential energy is converted into kinetic energy and water seeks its own level, by breaking the barrier. This principle is very much valid in all sciences and economics is no exception.

The same thing is happening in the world economy. The emerging countries like China have artificially created watershed by means of artificially keeping its currency low for quite a long time. What it does in the long run is that it increases the domestic prices (akin to potential energy) leading to what I call as embedded inflation, where inflation gets embedded into the economy. You might ask if inflation is bound to occur, why this is this suddenly showing up now? Well, the looming current financial crisis, food shortage and crude fears are just the triggers. When water blocked by watershed is disturbed by some physical phenomenon like a mild tremor, it is highly likely that water may break the barrier and that’s what is happening now. But we don’t know how intensive the current tremors (read trigger) are.

If you ask me is this artificial depreciation wrong, I would not say so. We create watersheds to preserve water and also save villages. Similarly such monetary measures have definitely boosted the growth of these emerging countries and that's what we have been witnessing for the past decade. But there are no free lunches. The exuberant growth has come at a cost of an embedded inflation which is showing up big time now. The ideal monetary policy is to balance growth and inflation. One might think, forget monetary policy and all the sauce, let market determine every thing; let free market prevail. But we are not living in Utopia where everyone is equally wealthy and capable. About a quarter in India do not enjoy one full meal a day. Inflation less inclusive growth is what governments should aim at. The outcome need not always be optimal (Remember Pareto Sub-optimality!)

So what’s the solution? I would say that in the short term, allow the domestic currency to appreciate to cool the prices. Might be a 25 basis point interest rate hike is on the cards and it is acceptable. The Fed might keep the rate unchanged leading only to an increase in the interest rate spread between the US and India. This might lead to more dollars flowing in and RBI should not resort to buying dollars through MSS. Allow the domestic currency to appreciate. This would automatically cool the inflation (Imports become cheaper and supply within the nation increases)

Let market determine the exchange rate and in the long run once we attain a little more depth and breadth in our financial markets, full Capital Account Convertibility should be the panacea. This is a part of the cycle. The emerging world has come a full circle. Countries like China should not anymore resort to artificial depreciation of the local currencies for the sake of export led growth. I would like to reiterate here that there are no free lunches whatsoever be the context.

PS: It has been 3 years, 3 eventful years since I started blogging. It was on the same day back in 2005 when I had started this blogging journey. Looking back it gives me a feeling of great ecstasy that I have survived. I have learnt a lot in this journey, got a lot of new friends who have appreciated bold and really crazy thoughts of mine. Though I have been not very regular in this journey I have tried to make sure that I don’t present clichéd content in my blog. I sincerely and heartily thank all my readers and wish for greater support in my forthcoming blogging journey.

Making money - 'The advertising way', Will it last long?

Internet is amazing! Web 2.0 rocks! I can get anything and everything I want in the internet for free. How do you get a host of services like free e-mails, free music and information to the extent of every Sodium atom that goes into the making of common salt? Well, the answer is a no-brainer. It’s because of advertisements, the overtly ambitious companies which pump-prime a huge sum of money for its marketing spends.

We see dozens of Web 2.0 companies mushrooming every day. Ask them how they’re gonna make money. You’d not be surprised if everyone responds as advertising. Are these models sufficiently succulent to yield juice for another decade? Well, my prognosis on the future of such businesses is not rosy.

Let’s briefly look at how this digital advertising business evolved. Advertisers are by and large extremely smart. They grab opportunities; rather create opportunities where they find a remotest chance of doing so. When they found internet to be an emerging media used by a lot of people about a decade or so ago, they started the party. Though the initial few years were not great, their prognosis came true. With the advent of Google Ad-Sense, Ad-Words etc, digital advertising reached its pinnacle. We are talking about the generic ads here.

In the last couple of years or so, there has been a lot of emphasis on ‘Web Analytics’ and the marketers want to target the right segment(Google the following to know more - ‘Adzilla’ , ‘NebuAd’). For instance, if you log in to google and search a lot on the car you want to buy, you’ll be shown much of Car ads. This has been termed as ‘behavioural targeting’ and this is evolving big time. Evolving in the sense, the level of customisation of such specific ads is zooming up.

But hold on, how many of us still click the ads on google or any website that we visit? From my personal experience I have realised that, my mind is trained to ignore the ads when I surf the pages and this is the case with a lot of my friends. So even if someone runs a behavioural targeting algorithm and places an ad of a car in front of me, when I’m on the look out for buying a new car, will I notice and benefit from the ad or rather the other way around, will the company benefit from showing the ad to me? My basic question is whether these marketers are connecting effectively to the changing mindsets of customers. Are they effectively tracking the psychological changes the customers are going through at a rapid pace?

This leads to the most fundamental discussion of what advertising is all about. Well, a lot of us tend to lose the sight of the bigger picture when we hear the word advertising. We tend to think of ads ONLY as those creative banners or posters or the flash clips we see around us. Advertising Science fundamentally is a tool of communication and good advertisers are those who can effectively communicate what values their products can add to their targeted customers. Advertisers need not draw the attention of the public by banner ads or flash ads of their product alone, but they can resort to any innovative technique. History shows that advertising techniques have evolved faster than the human psychological changes. Has the time come to think of completely crazy and wacky ways of communicating to the public? My answer is a big yes.

This leads to another fundamental question. What will be the revenue model for the e-businesses in the near future, assuming that the current wave of advertising would lose sheen? One of my friends Sumit strongly believes that you would be paying for each and everything you do on the internet in the near future. Well, I do believe in that to a certain extent, but more importantly I feel that you’d also be payed for every thing you contribute to the web. I have a crazy feeling that you’d even be paid for every useful post you make on a community like orkut or may be on a blog. So the net effect would be that you get richer by spending time on the web. But who would pay you for all this? Advertisers? Well, the answer may be yes, if advertisers come up with some crazy ways of web-advertising (read: communicating values) and I strongly believe in the prowess of Advertisers!

This would lead to a lot of money transaction on the web. Even the conventional concepts of money and finance behind these transactions might change. Crazy, isn’t it? There would be a huge business opportunity not only for these wild gaga marketers, but also for the finance guys since web transaction finance would get really big.

PS: If you are a PE investor or a PE manager aspirant who happened to stumble across this post, think twice before putting your money in the so called evolving ‘web analytics’ companies (for short term, it’s really brilliant though). For whatever change the advertising would undergo, it’s certain that web based transaction finance would be the next big thing and think of putting the big bucks in such ventures.

The INR 2.5 Sugarcane Juice and Consumer Spending

This afternoon when I was walking by JP Road, Andheri (west) I saw a crowded shop. My curiosity led me to that place which I saw was a sugarcane juice shop where it was written in bold all across the shop - “Full Glass Rs. 2.5” I happily drank a glass of sugarcane juice. While I was walking back to my college, I had an interesting thought. I remember drinking a glass of sugarcane juice for 5 bucks 16 years ago. My memories went back to those balmy days in Delhi when I used to go to a nearby park, play cricket and gulp a glass of sugarcane juice in a shop near the park.

Suddenly I asked myself when inflation averaged more than 5% for the past decade or so, the price of sugarcane juice should have increased from Rs 5 in the year 1992 to somewhere close to Rs 10 ( in the shops of same kind of course!). But I remember drinking sugarcane juice for 5 bucks for a long time and now it’s 2.5 bucks! What is causing this anomalous reduction in price?

We see a lot of products whose prices come down because the products are associated with some technology and it is common wisdom that enhancements in technology can reduce the costs and hence the prices. But the sugarcane juice vendor doesn’t seem to be blessed with any technology and he uses the same old machine driven by an electric motor. In fact the real estate prices have escalated greatly and that too running a shop in a place like Andheri West should in fact increase the overheads and hence the price. But we are seeing the reverse.

There are two reasons I can think off. The first is that the transportation and logistics has improved big time as compared to a decade ago. This means cost of sugarcane supplied to a shop does not increase much from that a decade ago. The second and most important reason is that there is an increase in consumer spending across all strata of Indian society. This leads to a lot of people drinking sugarcane juice as compared to a decade ago and hence the number of glasses of sugarcane juice sold per day increases which considerably reduce the overhead costs (land, electricity etc) per glass of sugarcane juice. Hence increase in consumption is one of the most important factors that have reduced the price of many items.

Increase in consumption spurs the GDP growth which leads to better economies of scale. This leads to reduction in price. But this price reduction can’t happen on a continuous basis. Let us analyse why. We saw in the sugarcane juice case that the costs could be minimised by increasing the efficiency of the game. The shops have increased the number of glasses it could sell per day. It can sell more as people buy more. But it can’t produce more than its capacity. To technically put across, all these years the sugarcane shop has been moving towards achieving a higher ‘utilisation rate’ or ‘utilisation capacity’ or in other words increasing its efficiency to cut costs. Prices will fall till utilisation of resources is maximised.

World’s top notch Management Guru CK Prahalad believes that for achieving sustainable growth, corporations should look at ‘Inclusive Business Models’ (co-creation!). The fact of the matter is that, as explained above increase in consumption should lead to increase in GDP which should again lead to increase in prosperity and consumption in a merry go around way, but the bottomline is that for this cycle to be sustainable the consumption should be ‘Inclusive Consumption’. By ‘Inclusive Consumption’ I mean the whole India including those at the bottom of the pyramid earning and spending more. A recent McKinsey report suggests that India will be the 5th largest consumer market by 2025. All these signal very interesting times to come!

In pursuit of 'Rationality' ( A 'Probabilistic' Explanation)

"All the World's a stage and we all are actors" said William Shakespeare. When I read this poem way back in my 9th grade, my understanding of this was totally different as against my current interpretation. Most of us are not true to ourselves. We are not truely rational though we proclaim so. Why is it so?

A child is born with certain numerical abilities. Even before mathematics is formally taught to a child, it can count the number of toys it has with it. It can add the number of toffees it has even before the mother teaches 'addition'. The logical explanation for this characteristic is that the child has genetically inherited such a trait. Man has been playing around with mathematics for tens of thousands of years and hence he is genetically strong.

I have always loved mathematics till now and so have many of my friends. But I have observed one peculiar behavior. Most of my friends including me are pretty strong in Algebra, Geometry, Numbers but most of us are dreaded by the chapter 'Probability'. Most people I have observed are not very comfortable with 'Probability' and 'Combinatorics(Permutation and Combination)'. What can be the reason for this? The most common answer I get from people is that 'Probability' is tough. But why is it tough?

It is an intrigiung fact that though Geometry, Algebra, Numbers had been in use for thousands of years, 'Probability' is one branch of science which was popularised only post 15th century when some gamblers wanted to estimate their return from the game of chance. Probability is relatively the new kid on the block of science. So the element of 'Probability' is not strong in our genes. And it would still take hundreds of years before genetically, the mankind is comfortable with probability. But what is the implication ?

'Rationality' is strongly related to 'Probability theory'. One way of looking at rationality might be choosing the right path from a given set of alternatives. Such a choice can be termed as rational decision making. Decision theory was popularised by the 18th century mathematician Thomas Bayes (of Bayes' Theorem fame). 'Decision Theory' applications are indispensable tools for the rational decision making by managers(My MBA friends would agree with me on this fact). But we don't use decision theory beyond our professional life. Do we draw a decision tree for our day to day decisions? A lot of our decisions are taken not from our minds but from our hearts. We are not perfectly rational simply because we are not genetically coded so. Nevertheless we are in pursuit of rationality.

It will be a really interesting proposition when more and more of rationality creeps into the society. It'll be a whole new world. Marketers can't allure customers by 'Buy 1 get 1 free'! Investment Bankers and other traders would no longer successfully underwrite European Options! Insurance industry would rewrite its business equations (FYI Insurance Rationale is very much based on Bayesian Probability theory)! And students would say 'Probability' is a piece of cake!!

US Slowdown and its impact on the Indian IT industry

Recently there has been talks of a slowdown in the US economy. Business Gurus opine that it will affect the Indian IT industry because the majority of the Indian IT revenues come from the US. I would beg to differ. I feel that all this is noise created by the media. And the stock markets react to it adversely.

In an event of US Slowdown, some economists argue that companies would get into the cost cutting mode and reduce their IT budgets and hence outsourcing revenues will reduce. But there is another way of looking at this. A lot of companies would feel that developing in-house IT capabilities would be a high cost proposition and hence outsource more. These companies will temporarily stop its in-house IT plans and outsource more to low cost destinations like India. Hence I would argue that US Slowdown would relatively benefit India.

The bottomline is that it is for the time to tell what would happen in the future!

What is common between CAT and capital markets?

I’m writing this article exactly a year after my CAT 06 results had come and when a lot of my friends are eagerly awaiting their CAT 07 results. When you are attempting the “all elusive” CAT for the first time, then the day of result is one which you can never forget. My memories are fresh even after a long gap of 365 days. I was eagerly awaiting my ‘Verbal Ability’ scores because my scores varied with each and every ‘Answer Key’ published by various coaching institutes. I still remember my various scores. My scores as per PT, CL, TIME and IMS keys were 31, 26, 16 and 16 respectively. Finally I got a shocker of my life when I got 6.25 in the ’IIM’s (Decider) Key’ (0.25 was ‘grace!!’ score since they had eliminated a question since 2 options were not printed for a question)

Let me delve a bit upon the capital markets at this juncture. I was thinking about investing in the markets and was analysing certain options. I was thinking about the returns of the mutual funds and that of the equity markets themselves. For those who don’t know much about mutual funds let me explain a lil on that. Mutual funds, in short are those funds (funds of ‘aam’ junta) which the “smart” fund managers invest in the equities (most common instrument) in the capital markets. There are funds like the ‘blue chip’ funds where the fund managers invest only in the blue chip stocks of the BSE sensex (India’s popular stock market index). When I was looking at the return on these mutual funds, I was in for a surprise. What I observed was the mutual funds on most occasions gave lesser returns than that of the markets themselves. Then I convinced myself thinking about fundas like diversifying the portfolio and risk mitigation in mutual funds and stuff like that. Generally mutual funds invest in debt and equity instruments and hence the returns are lower. But the funds that I observed invested only in the ‘sensex’ blue chip stocks and still gave lesser returns than the market’s return indicated by the sensex. Why is this happening? This is scenario not only in India but across the globe. Then I realised that markets as a whole comprising millions of traders are better of than the fund managers. It was a hard fact even for me to digest, but again this is the reality and power of markets. Collective wisdom is far superior to an individual’s intelligence. For those who want to research more into this you can google on topics like ‘behavioural explanation for stock market fluctuations’ and stuffs like that. In fact behavioural finance itself is a wonderful research area.

Coming back to the CAT stuff, what IIMs should have done when there was so much of an ambiguity in the answer keys? I bet even if all the IIM profs are separately asked to come up with the keys, there would have been at least 10 versions of the key. What IIMs should have ideally done is to evaluate all the answer paper on the basis of all these 10 versions of the keys and then look at the distribution of scores across the 10 keys and should have finally selected that key which gave a better 90 percentile cut off score. It was very sad to know that the 90%le cut off was around 20 last year. And doing this in definitely not a laborious process since all the answer sheets are initially fed into the system and the responses of the candidates are digitised. It takes time to feed these answer sheets into the system’s scanner and evaluating doesn’t take any time. It takes hardly a few hours to evaluate once the responses of the candidates are scanned and digitised. The logic behind this is very simple. Collective wisdom is always better than that of an individual’s intelligence the same funda of the mutual funds and markets. This is applicable to cases as that of CAT 06 English paper where different experts came up with different answers and all the CAT 06 takers would agree to me with the fact that the answers were very subjective and not objective. In fact there are a lot of statistical distributions which can be used to analyse these 10 keys. For simplicity I’m not getting into those nitty-gritties, but a simple way would be to choose that version of the key where the score corresponding to the 90%le mark is the highest. I had been thinking about this for a year, but I thought about the correlation between this aspect and the mutual funds – markets paradox and this CAT stuff helped me getting more clarity on that paradox.

For those God level profs in the IIMs who teach statistics and those mighty fin profs who are an adept at behavioural finance, please put in your thoughts in solving a real time problem like this where careers of thousands of serious aspirants are at stake! All the very best to CAT 07 takers who are eagerly awaiting their results!