Wednesday, October 31, 2007

Fed Policy

Fed has just cut rates by 25 basis points (both its Fed fund and discount rate). The markets appears to be flat ( atleast right now) probably because of the dissenting voice and the renewed concerns of inflation expressed by the Fed.

Well from the statement issued by Fed it looks as if they would pause (which is the right thing to do). Now if the Fed cuts more in December that would be surely out of the concern of a serious slowdown in US which would not argur well for the world economy as a whole. The effect on the emerging markets would be visible tommorrow. But my sense is that the EM's are not going to go very high from here, probably a little more and thats about it-------

Tuesday, October 30, 2007

RBI's Credit Policy

There are 3 topics I would like to discuss in my following posts:

1. The valuation crap
2. Bubble in the making continued (Final part)
3. Start with options trading

But for today let's discuss in brief the implications of RBI monetary policy. Well I believe RBI missed a trick by not reducing rates or may be it's adopting a wait and watch policy and take cues from the Fed announcement today. The differential between Indian and US interest rates is about 4% add to this the annual rupee appreciation of about 10%. So in essence the foreign investors are getting 14% of effortless returns. No doubt they are being attracted to Indian assets.

Cutting interest rates would have meant hitting 2 birds with one shot. The credit growth is slowing and this might impact growth so with cut in rates the credit growth would have taken off and the Indian assets may had become a bit sour for foreign investors. On the inflation front although the CPI is high but its not very interest sensitive unlike the WPI which looks under control and add to this the Central governments reluctance to increase the oil price. So the ingredients were right for a rate cut by RBI.

One can ofcourse sympathise with the Central Bank here because they are trying to break the problem of impossible trinity, which is that a country cannot have a fixed exchange rate, almost full capital convertibility and independent monetary policy at the same time. While the trinity cannot be broken it can always be tweaked by trying to do a little bit of all and I believe thats what our policy makers are trying to do i.e. trying to mantain not a fixed rather an exchange rate in a relatively moderate band, introducing some capital controls P-Notes, ECB curbs (though I am totally against this particular move) and hence cutting of interest rates would have been the final throw of dice. Well maybe the RBI would like to reserve this final throw for some later date. Let's hope that time never comes because if does the World Economy would be soon reaching a flashpoint all thanks to the Big Ben................

Saturday, October 27, 2007

Bubble in the making

Before moving forward let me state that although on this blog I would share my views on topics related to finance and economics but occasionally other topics may also find their way.

Now on to today's topic. Emerging markets are zooming like anything. The sensex itself makes lifetime highs every other day, this calls for great celebrations without a doubt but this is increasingly making me uncomfortable. Let's go into the genesis of this asset boom, so here is how the story begins------

In trying to do away with subprime problems in the US the federal reserves cuts its fed fund rate, this makes the world awash with liquidity. Now the first issue i just don't understand is how does cutting the interest rates help in the crisis. If I have the paper (debt) which no one wants to buy at any price it doesn't matter what the interest rates are. The problem is the Fed is trying to cure the problem with a tonic which in my opinion was the cause of this problem to start with. If it feels it can pull US economy out of the mess by doing this each time it is sadly mistaken because all it is doing is making a downturn longer and bigger both in impact and in geography.

The effects have started to reflect in front of us. Liquidity is what causes inflation and growth, related by the famous Milton Friedman equation:

PY=LV; where P is inflation, Y growth, L liquidity, V velocity of money.

However as the liquidity increases the change in inflation is much steepr that change in growth. Ofcourse if increase in liquidity doesn't increase both growth and inflation you are in much serious trouble (liquidity trap in Japan). So keeping that scenario aside the representation of liquidity and inflation and liquidity and growth can be as follows:

where A,B,z,phi,e are positive variables. *Note that the equations is just to give an idea of the relationship betweeen the variables.
So the flush of liquidty on accounts of fed rate cut is increasing asset price inflation without increrasing real growth and this is what is causing the asset price bubble. Although let me commend the move by SEBI to prevent this from happening. How successful will be this current move, well only time will tell. But one thing is for sure now whenever this bubble bursts (not very far off in my opinion) it will be very painful. The same analysts who are upgrading their targets of every other company based upon their so called VALUATION ( one of the biggest craps in the field of finance -- we shall discuss about this in greater detail in later articles) will be rubbing salt on their faces.
So what does one do in this scenario. Well 1 of the 2 things can be done and 1 thing should necessarily be done.
--Should be done: Don't invest in equity assets from an investment point of view.
--Could be done: 1. Step away and wait
2. Buy the chalice and do volatility trading or make a portfolio of 2 calls and 1 put ratio (at the money)
-- Reason behind the second suggestion: Buying 2 calls and 1 put of Nifty would entail an investment of around 30000, now the rate at which the market is moving up one would surely end up making good profits at the end of each month and whenever the day of reckoning arrives ('The Great Crash') the one single put would not only cover the loss in the 2 calls it would also add substantially to your bank balance.--------

Friday, October 26, 2007

Role of Chance in Wealth Creation

I would like to open this blog with a little philosophical but the most cardinal point to wealth creation. 'Wealth cannot be created by planning' ofcourse it can wither away without proper planning but certainly can't be created by it.

'Wealth is created by chance'. You accidently discover a goldmine, oil well, invest in a stock that turns out to be a Microsoft (don't tell me you knew it would happen - no one can because it had never happened before) and why just wealth Sir Newton discovered gravity (world knows the story). All big things happen by accident.

Hey wait before you start wondering I am not suggesting you guys to surrender to fate, what I am asking is to recognize the key ingredient to wealth creation and work towards a way to expose yourself towards it. Sir Newton discovered gravity accidently but he was working towards something and so essentially he was ready to caputre the chance.

So now the question is how does one capture chance and create wealth. Well people try it a lot - they buy lottery tickets, play in casinos. However the problem with these mediums are that they follow a highly predictable normal curve probability distribution. What they lack is 'Unpredictability' or what we call 'Volatility'. While we shall discuss this topic in detail in time to come let me end this post post by stating one of the ways to capture volatility specially in equity markets.

'Form a Chalice' and thats where the name of this blog comes from. Form a cup to caputre chance/randomness/volatility and how is a chalice formed in markets - well simple buy an 'at the money' call and put. The rest later -----------