Capital Market Efficiency

Introduction


The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory, and has had an impact on much of the literature in the subject since the 1960’s when it was first proposed and on our understanding about potential gains from active portfolio management. Markets are efficient when prices of securities assimilate and reflect information about them. While markets have been generally found to be efficient, the number of departures seen in recent years has kept this topic open to debate.
 
Market Efficiency


The extent to which the financial markets digest relevant information into the prices is an important issue. If the prices fully reflect all relevant information instantaneously, then market prices could be reliably used for various economic decisions. For instance, a firm can assess the potential impact of increased dividends by measuring the price impact created by the dividend increase. Similarly, a firm can assess the value of a new investment taken up by ascertaining the impact on its market price on the announcement of the investment decision. Policymakers can also judge the impact of various macroeconomic policy changes by assessing the market value impact. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. The early evidence suggests a high degree of efficiency of the market in capturing the price relevant information. Formally, the level of efficiency of a market is characterized as belonging to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strongform efficiency.
 
Weak-form Market Efficiency



The weak-form efficiency or random walk would be displayed by a market when the consecutive price changes (returns) are uncorrelated. This implies that any past pattern of price changes are unlikely to repeat by itself in the market. Hence, technical analysis that uses past price or volume trends do not to help achieve superior returns in the market. The weak-form efficiency of a market can be examined by studying the serial correlations in a return time series. Absence of serial correlation indicates a weak-form efficient market.
 
Semi-strong Market Efficiency


The semi-strong form efficiency implies that all the publicly available information gets reflected in the prices instantaneously. Hence, in such markets the impact of positive (negative) 38 information about the stock would lead to an instantaneous increase (decrease) in the prices. Semi-strong form efficiency would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. The hypothesis suggests that only information that is not publicly available can benefit investorsseeking to earn abnormal returns on investments. All other information is accounted for in the stocks price and regardless of the amount of fundamental and technical analysis one performs, above normal returns will not be had. The semi-strong form efficiency can be tested with event-studies. A typical event study would involve assessment of the abnormal returns around a significant information event such as buyback announcement, stock splits, bonus etc. Here, a time period close to the selected event including the event date would be used to examine the abnormal returns. If the market is semi-strong form efficient, the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium pricing model (such as CAPM,which has been discussed later in the book).

Introduction to Banking

Banks have played a critical role in the economic development of some developed countries such as Japan and Germany and most of the emerging economies including India. Banks today are important not just from the point of view of economic growth, but also financial stability. In emerging economies, banks are special for three important reasons. First, they take a leading role in developing other financial intermediaries and markets. Second, due to the absence of well-developed equity and bond markets, the corporate sector depends heavily on banks to meet its financing needs. Finally, in emerging markets such as India, banks cater to the needs of a vast number of savers from the household sector, who prefer assured income and liquidity and safety of funds, because of their inadequate capacity to manage financial risks. Forms of banking have changed over the years and evolved with the needs of the economy. The transformation of the banking system has been brought about by deregulation, technological innovation and globalization. While banks have been expanding into areas which were traditionally out of bounds for them, non-bank intermediaries have begun to perform many of the functions of banks. Banks thus compete not only among themselves, but also with nonbank financial intermediaries, and over the years, this competition has only grown in intensity. Globally, this has forced the banks to introduce innovative products, seek newer sources of income and diversify into non-traditional activities. This module provides some basic insights into the policies and practices currently followed in the Indian banking system. The first two chapters provide an introduction to commercial banking in India and its structure. Bank deposits are dealt with in detail in Chapter 3, lending and investments in Chapter 4 & Chapter 5 respectively. Chapter 6 deals with other basic banking activities of commercial banks, while Chapters 7 and 8 explain the relationship between a bank and its customers and the trends in modern banking respectively.

1.1 Definition of banks

In India, the definition of the business of banking has been given in the Banking Regulation Act, (BR Act), 1949. According to Section 5(c) of the BR Act, 'a banking company is a company which transacts the business of banking in India.' Further, Section 5(b) of the BR Act defines banking as, 'accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable, by cheque, draft, order or otherwise.' This definition points to the three primary activities of a commercial bank which distinguish it from the other financial institutions. These are: (i) maintaining deposit accounts including current accounts, (ii) issue and pay cheques, and (iii) collect cheques for the bank's customers.

Establishing an Investment Plan

Establishing Goals and Realistic Expectations


Determining your fi nancial goals is the fi rst step to successful investing. You may have immediate goals, such as making a down payment on a home, paying for a wedding, or creating an emergency fund. You may also have long-term goals, like paying for college or retirement. Establishing goals will help assess how much money you need to invest, how much your investments must earn, and when you will need the money. The next step is to make a realistic investment plan designed to meet your goals. Setting realistic expectations about your investments and about market performance is an important part of your investment plan. Securities don’t always rise in value, and when they fall, the downturns can sometimes be lengthy. A well-conceived, diversifi ed personal investment plan can help you weather these downturns, and give you a measure of comfort when market volatility occurs.

Remember, also, that your plan should paint a broad picture of your personal fi nancial situation now and
 where you want it to be in the future. In addition to goals, your plan should refl ect your time horizon, financial situation, and personal feelings about risk. Establish your goals and create an investment plan now—the sooner you begin investing, the longer your money has to work for you.

Goals and Time Horizon

Generally, your goals will dictate how much time you have to invest. For example, if you are 35 years old and investing for retirement at age 65, then you have a time horizon of 30 years before you plan to begin withdrawing money. Identifying your time horizon is important because it infl uences how you invest your assets. Typically, a shorter time frame necessitates conservative investments, while a longer period allows you to handle more risk.

Risk/Reward Tradeof f

All mutual funds involve investment risk, including the possible loss of principal. Making an informed decision to assume some risk also creates the opportunity for greater potential reward. This fundamental principle of investing is known as the risk/reward tradeoff. When forming a plan, examine your personal attitude toward investment risk. Is stability more important than higher returns, or can you tolerate short-term losses for potential long-term gains?Remember, investments that increase in value in a short period can just as quickly decrease in value. But if you’ve considered the risk/reward tradeoff, you know that investment volatility is a characteristic of a successful long-term plan.

Three Common Investment Goals

Goal No. 1: Retirement

Most individuals buy mutual funds for long-term goals, especially retirement. It is estimated that retirees will need 70 to 80 percent of their fi nal, pre-tax income to maintain a comfortable lifestyle in retirement. If you plan to retire at age 65, retirement savings should last for at least 18.5 years, since the average life expectancy for a 65-year-old is 83.5, and continues to rise. Ideally, individuals use a combination of sources to fund retirement, such as Social Security benefi ts, employer-sponsored retirement plans-like 401(k) plans—and personal savings, including Individual Retirement Accounts (IRAs).

Goal No. 2: Education

Many parents and grandparents use mutual funds to invest for children’s college educations. Your time horizon is an essential consideration when investing for education: if you start when the child is born, you
 have 18 years to invest. However, if a child or grandchild is in your future, the time horizon can be lengthened by investing now.

Goal No. 3: Emergency Reserves and Other Short-Term Goals

Emergency reserves are assets you may need unexpectedly on short notice. Many investors use money market funds for their reserves. Money market funds alone, or in combination with short-term bond funds, can also be appropriate investments for other short-term goals.

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Forwards, Futures, Options, and Swaps

I begin with a description of the simplest types of derivatives: forwards, futures, options and swaps. To illustrate a forward contract, consider the following example (unless otherwise stated, all prices are in rupees per gram). Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery price) three months from now (the delivery date) from gold mining concern Goldseller. This is an example of a forward contract. No money changes hands between Goldbuyer and Goldseller at the time the forward contract is created. Rather, Goldbuyer’s payoff depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then Goldbuyer gains Rs. 10 on his forward position (i.e. the difference between the spot and forward prices) by taking delivery of the gold at Rs. 600.


A futures contract is similar to a forward contract, with some exceptions. Futures contracts are traded on exchange markets, whereas forward contracts typically trade on OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-to-market), whereas forwards are settled only at expiration.

Returning to the example above, suppose that Goldbuyer believes that there is some chance for the spot price to fall below Rs. 600, so that he loses on his forward position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs. 600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold at the strike price on the expiration date.15 Then, if the spot price indeed declines, he could choose not to exercise the option, and his loss would be limited to the purchase price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot gold price is very likely to decline, and attempt to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike price on the expiration date.

Swaps are derivatives involving exchange of cash flows over time, typically between two parties. One party makes a payment to the other depending upon whether a price is above or below a reference price specified in the swap contract.

Derivatives - India

1. Rise of Derivatives


The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates.

The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.

Price fluctuations make it hard for businesses to estimate their future production costs and revenues.2 Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term.

2. Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures, options and swaps.

Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.3

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’s long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge, market frictions and regulatory impediments have led to low levels of capital employedin arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).


3. Exchange-Traded and Over-the-Counter Derivative Instruments

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.5

4. Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the world’s largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.

In the equity markets, a system of trading called “badla” involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and

Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.


The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991.7 The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.
 
Source:  Asani Sarkar

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Inflation Update - January 2011

WPI inflation for Jan 11 at 8.23% (yoy) was above consensus expectations of around 8.1%. The WPI inflation for the month of Dec 10 was at 8.43% (yoy). For the current month, rise in manufactured products inflation has turned out to be much stronger than the expectations and also the trend seen so far. The inflation for Nov 10 was revised higher to 8.08% from the provisional estimate of 7.48%. The revision was sharply upwards under food articles and the non-food manufactured products. Since the time of introduction of new index, the revisions have been upwards and sharper every next month. The quantum of upward revision on the y-o-y headline inflation has widened from 0.3% in Aug 10 to 0.6% in Nov 10. Apart from higher provisional numbers, such sharper upward revisions pose a greater threat to the outlook on monetary policy.The m-o-m rise in headline WPI was clocked at 1.25%, which is substantially higher than 0.70% mom growth observed previous month. The m-o-m rise is also the sharpest since April 2010. Hence, the current slide in annual inflation numbers, from 8.43% (Dec 10, yoy) to 8.23% (Jan 11, yoy) is purely a factor of a high statistical base. The Primary Articles index too has seen a sharp jump in index by 2.4% (mom), which again is the sharpest since April 2010. The weekly readings in Jan 11 had seen considerable upside on food prices tracking seasonal disturbances on the supply side. But, the last week of Jan 11 saw considerable softening in the prices of food articles, marking improvement in the supply conditions. The food prices, thus, are expected to soften further, giving downward thrust to the inflation readings. However, before one gets comfortable with softening of food prices, it is also interesting to note that the current month’s rise in non-food articles at 3.7% (mom) is much higher than the rise in food articles at 2.03% (mom). Therefore, along with food prices, the developments on non-food articles would also need to be watched avidly. The Fuel index has risen by 0.8% (m-o-m) in Jan 11, a slowdown from increase of 1.0% seen previous month. The upside on index is primarily on account of a substantial rise in prices of petrol (4.6%, mom) and aviation turbine fuel (5.39%, mom). The oil companies had announced a petrol price hike of Rs 2.50 a litre on 15 January 2011 seeingconsiderable upside on global crude oil prices. The spot prices of crude are currently seen hovering in the range of USD 85-90 a barrel. The crude prices have not hardened much since the sharp upside seen in November. As a result, the domestic oil companies have gone ahead on record to state that they do not foresee another round of petrol price hike in the near term. Moreover, the government too remains reluctant in revising the prices of diesel upwards, despite oil companies facing huge losses on a daily basis. In light of above factors, we see stability on domestic fuel prices arresting upward movements on the Fuel index.But in current context, it is the rise in manufactured products inflation, which is of greater concerns as it tends to be sticky in nature. The manufactured products index has presently risen by 0.8% (mom) in Jan 11, which is double the 0.4% (mom) increase seen previous month. The current upside on manufactured products index is also the fastest since April 10. Even the RBI's preferred indicator, the non-food manufactured products index, has moved up by 0.7% (mom), sharply up from an average uptick of 0.2% seen over the past few months. This sudden and considerable increase in manufactured products inflation is also reflected in the prices data of PMI manufacturing index. The PMI data releases for months of December 2010 and January 2011 have seen the input & output prices indices move up at a very sharp pace. The manufacturers had previuosly felt the stress, in terms of rising input costs and slow recovery in demand. However, with a significant rise in demand side pressures coupled with current high capacity utilization levels, the manufacturers are now in a position to set the output prices upwards. Such increase in the pricing power with manufacturers is alarming, especially in a scenario where the input costs are primarily on the upside. Therefore over the next couple of months, despite visible softening in food prices and possibility of stable fuel prices domestically, we continue to see considerable pressure on headline inflation coming from the manufactured products.
In light of above developments, we do not see the fiscal year end inflation reading matching the RBI's projection of 7%. Even going by conservative estimates, we see the fiscal year end inflation reading crossing 8% levels. Taking these possibilities into consideration, we see the RBI hiking rates by 25bps at its mid-quarter review scheduled in March 2011. However, if the developments on the inflation front turn out to be much worse, expectations may rise for the RBI to adopt a more aggressive stance.


Source: IDBI Gilts