## Sunday, March 30, 2008

### Decoding the relation between Money Supply, Inflation and Growth

The cutting of interest rates by the Fed has raised the inflation and inflation expectation of people. This has prevented other Central Banks particularly that of the Euro zone, Bank of England and the RBI to resist in cutting of interest rates. While I have given my views on this topic in the previous article, over here I am going to discuss one fundamental dilemma in economics that of money supply on Inflation and growth. Are they truly antagonistic and if not in what scenario.

Assume a small slow growing economy Torts from tortoise having just 3 players A B C each having 1 kg of wheat. Let’s put a monetary cost to their produce at Rs. 10/- . In such a scenario the economy would remain stagnant and the growth of the economy is going to be 0%. Now seeing this perilous scenario an angel descends on their world with the name ‘The Party Pooper Bank of Torts’ – PPBT. The bank says that it is prepared to lend Rs. 5/- to anyone for 1 year but wants Rs. 5.5/- in return. A is the entrepreneurial type of guy. He comes forward and takes the offer. Now at the end of year one the following 3 scenarios can occur:

First of all in all the 3 cases let’s convert their wheat stock to Rs. 10/- per kg unless otherwise mentioned. A toils his land and produces rice. Now he can sell his rice at any price between Rs. 0-10, let’s take 2 cutoffs of 5.5 or less and more than 5.5, in the scenario where A is able to sell his rice at more than Rs 5.5, he is able to make a profit on his venture. Let’s say A is able to sell his rice at Rs. 10 so the GDP grows at 33.33%.

Let me add that this scenario also answers one of the basic questions in economics: ‘Why do economies grow’. This economy grew because of 3 factors:

Capital (Money from PPBT)
Land (Asset which is natural resource in this case)
Labour (The effort put in by A)
Entrepreneurial spirit (As shown by A)

A would have equivalent of Rs 20/- , B would have equivalent of Rs. 10/- and C would have equivalent of Rs. 10/-. Now A can buy some of the goods from C at Rs 10 or more. If A knows that B has just Rs 10 with him then he would buy the goods at Rs lets say at 10.05, so the inflation in the economy stands at 0.5%. However in a normal scenario there is ‘information asymmetry’ in the market and so A may jack up the price to as high as Rs 14.5/- for the product of C causing inflation to shoot up to 45% !!!. So its important to understand that the culprit here is not the monetary policy but information asymmetry.

In the next scenario wherein A gets Rs 5.5 or less A makes no profit however the economy still grows at 18.33%, any surplus liquidity is absorbed and so inflation menace doesn’t raises its head. Well this looks like the perfect scenario which has no excesses, the only problem is that if this scenario continues for long it will generate 2 problems. A would loose any interest in investing in the venture and also A would have no surplus capital of his own to invest.
In the last scenario A takes the 10 rupees and jacks up the price of the product of C to Rs 20. This causes the inflation to rise at 100% and GDP growth is 0%. Later on in order to repay the loan when A tries to sell back the product whose value is supposedly Rs 20/- but only C has the capacity to buy, however there is no reason for C to buy back the product he sold a little earlier (Velocity of money comes into picture) the value of the product crashes. This might lead to cutback in supply leading to negative GDP growth.

One question that can come to mind is why on earth would A behave in such a manner. The reason can be mainly two fold:

- The inflation is very high and so he feels that he needs money just to consume
- The inflation expectation is very high and he wants to buy products today expecting a rise in prices in the future

So it’s important to understand that printing money in itself is not inflationary. Inflation happens because there exists an information asymmetry and high inflation expectation. Printing more money in such scenario could be disastrous.

In countries like Zimbabwe which is suffering from hyperinflation is clear case in this regard. The supply crunch led to inflation and higher expected inflation, to top it all the government printed more money thus creating hyperinflation and causing the nation to go in a tailspin.

I conclude this article with two points that must be amply clear while taking the decision of printing more money and thus making sure that this money results to higher growth rather than inflation:

- Information Assymetry should be minimal
- Extra money to be used in capital assets and not in consumption.

If inflation expectations are high then the money supply would go into consumption instead of creating assets and hence leading to further inflation at the cost of growth (as players would first be concerned with consuming goods to survive and then think about creating capital assets). …………………..

## Thursday, March 27, 2008

The beauty of options trading is the whole array of trades that are made possible by options with varying risk profiles. One more thing I would like to add here is that unless specified I would be refering to equity options. Ofcourse after sometime I would be moving towards options on other asset classes as well. Using options one can get into the directional trades on equity prices, perform volatility trades, trade on skewness and kurtosis. I would be covering each of these class of trades, this would including various trading strategies and arbitrage trades for some. Each trade would include the risk and returns possible. Right now derivatives products are limited in Indian equity markets and those that are available have limited volumes specially in stock puts. However unless you are a very big player the lack of volumes should not bother you. However new products are being introduced now in our markets. This include long term options and the volatility index to come very soon, so things are going to specially become quite interesting.

So I would start with directional trade on equity prices using options the next I write on this topic...............

## Wednesday, March 26, 2008

### The China Story

I know its a story told to death... But whatever articles I have read have either been in complete awe of the Chinese growth story or have been completely cynical... From now on I have decided to write something on this article and the options trading article. Ofcourse I would try to fill up in between with some ideas that strike me from time to time. I may be travelling to Zurich next week so not sure how frequently I would be able to write next week. Anyways before I start this China story from my next article I should tell you what my position is...............

I beleive China is a disaster waiting to happen. I sincerely hope it doesn't happen because an economically vibrant China is good for the entire world as I also believe that the global boom that we are seeing this decade is mainly due to China. However the way they are progressing is similar to over leverage trading. You are the king on every day till the day of reckoning. So in just one day you loose all what you made your entire life. The West is ofcourse crazy for China especially the American fund managers.... Now what can I say for them, people who loose billions of dollars ( for record some of the topmost I-Banks and the famous commercial bank supposedly composed of best talent have lost more than what they have made in a decade)......To be fair even I am awed by Chinese growth but I can't loose the sight of the structural deficiencies in its growth and system making it a disaster waiting to happen. I would try to analyse various aspects of Chinese growth to put the puzzle together..........

## Tuesday, March 25, 2008

In continuation with the earlier article written on March 19, 2008...........
Call option and Put option are also known as option to buy and option to sell respectivelly from a buyers perspective at a certain predesignated price called the 'Strike Price'.
Now let's intutively try to understand what factors would influence the price of the options. So basically how much is the just price that A should charge B. Well ofcourse market forces can determine the price and ultimately that is what govern options prices in reality (no fourmlas!!!) but in this case our market is limited to just two people so the market forces may not work prudently. So let's think about the variables governing the option price.
- The first factor that straightaway comes to mind is the goal difference on which the option is bought. For eg. if the B buys from A a call option on the victory of Italy by two goals or more the option value would be lesser when compared to the scenario wherein B buys from A a call option on the victory of Italy by any number of goals as chances of the first scenario happening is lesser than the second.
-The second factor is time. Let's consider two scenarios wherein in the first scenario the bet is made at the start of the match and in the other scenario the bet is made in the injury time of the second half (both teams stuck at 0-0). Obviously the chances of B winning the bet is far less in scenario B as compared to scenario A and hence the value of option is greater for first scenario vis as vis second.
So to sum it up this option can be valued on the basis of goal difference (distance from the current price in generic form) and time before expiry. These two are predictable components. What makes the option trading fun is the third and most critical component 'chance' or in mathematical form probability. Though the underlying distribution of this probablity is unknown (don't assume normal and ruin the real fun of options!!!). The probability is governed by the distance, time and to a very limited extent past track record. However let me add that it is this notorious unpredicatable probability component that can make or break fortunes in option trading...............

## Monday, March 24, 2008

### The New Economic Growth

Since the end of World War 2, thw world has seen a structural change in economic growth. This structural change has accelerated since the dawn of 21st century. Till about 1900 the trend grwoth per capita has been 1% or less. Moreover only a small portion of the planet participated in the then new economic order. However I would say that since the World War 2 that world did change dramatically (atleast in terms of economic growth). I would say that 3 main factors are responsible for this dramatic change in growth:
1. Technological progress contributing to very high productivity
2. Larger part of the planet participating in economic growth (earlier Japan, now India & China)
3. Better understanding of how economy works leading to improved management of economies
Now you must be wondering why am I writing this article. This is because I just now read a book, 'Bull' by Maggie Mahar. It spoke about for how long the Dow stuck to levels of 1000 and how dramatically it has broken levels of 10000 in so little time indicating as though it is some sort of very big bubble. Well bubbles will be formed in the financial markets, this is their nature as prices sometimes get ahead of themselves. However the reason why Dow got stuck to levels of 1000 for so long and now has broken those levels can easily be explained by the 3 factors explained earlier. The growth dramatically increasing in large parts of the world leading to much higher corporate profits specially to global companies, dramatic changes in productivity again contributing to higher profits and the Central bank and government intervention at right moments preventing system from complete collapse (ofcourse will this last factor always playout is a question mark). So I would like to say that the world has changed in the last 50 years and this is reflected in the stocks, ofcourse the markets can collapse back in case we undo much of the good our previous generation has done, let's hope it doesn't happen and I am positive that if the growth in India and China continue one would see not just newer market levels, but much higher standard of living across the world and newer economic theories shall come into the fore trying to explain this phenomena.

## Sunday, March 23, 2008

### The valuation conundrum and stock market dynamics 2

Continuing with this topic let me add the third variable which we termed as X. The condition was that no exchange was allowed. Well let's just allow such an exhange between gold and bread. Let's say that in this economy there are 10 people, 10 loaves of bread and 10 gold coins. What happens now. As one can see bread is the most precious commodity for people right now, so we would observe that the value of gold would come down dramatically and people would become vary of taking gold as a medium of exchange.
So doesn't this happen in markets. The liquidity dries up, the marignal utility of players shift from investment demand to consumption demand and the there is collapse in valuation of investment related products (the more illiquid the product the faster its fall) leading to a friction in asset markets as various players would tend to resist from accepting such securities as collaterals. This is how basically a market functions, the valuations etc are secondary, however important specially for an investor.
You don't have to go into complex calculations while buying a stock, remember you the real return from the stock comes out of random events, this is what make fortunes. The only research that you have to do is how is the company (because chances of positive random events striking a good company are far greater), don't try to buy stocks that you think are cheap in valuation terms (simply because chances are you would not be able to find very many stocks of this type and even if you do find them the returns would be very limited as they are predictable). However it's important that you also don't buy very expensive stocks. To decide if a stock is expensive or not decide upon your payback period (the period within which you want your investment back) this can depend upon the company, sector, its period of existence etc. Once you decide that take the expected growth rate of the company and see if the investment break evens in the expected time by adding profits of the company for the forward years.
For example lets say a company grows at 20% yoy, adding the various expected earnings for next 7 years would give you a PE multiple of 16.5 [((1+g)^8-1)/g], g is growth rate. Now let's say the current PE multiple is around 16.5 as well. Now you can decide wheter to invest in the stock or not the payback period, the linear growth rate assumed (20%) and component of unpredictibility.
Just remember one thing investing in markets is also like a business (the only difference being that you generally have a negligible or no control) and like in any business getting your investment back is critical, the same holds true in the markets. Ofcourse I am not saying that if calculations say that this stock cannot payback your investment in next 7 years don't invest in it, as you can see there is the assumed component of growth which can vary dramatically due to random events like the comapny entering a new line of business or geography, expanding its capacity much more than expected, getting a very big order etc., all I am saying is that if let's say the PE of the stock is 20 and your calculations gave you 16.5 and you decide to invest in this stock, you are investing on the positive bias of randomness which generally would be the case for most investors. So basically while investing you must know what are you betting on and how much are you paying for the stock's predictibility and how much for the stocks unpredictibility component............

## Friday, March 21, 2008

### Why we need communists

When I started writing this blog the idea was to put forward philosophical ideas (creative and fresh) in the area of economics & finance (mainly) but sometimes even other areas of social sciences like politics and to touch some aspects of my favourite area, physics. Apart from this I wanted to share my views on current issues that would come up from time to time. Some of my friends after reading the last couple of articles have said that I am getting too much into explaining valuations, options which really one can find anywhere and I am really loosing out on the objective for which I really started writing. Well i believe that that they are partly correct and wrong. I want to address through this blog to readers who are interested in ideas and philosophy as well as to people who want to know about trading and investment from scratch in a language by which they can easily connect. Hence I have decided that for every technical article I would follow it up by a philosophical article wherein I would place ideas and arguments.

So here we go for today. We need communists. If there is one class of people I have hated in my life they are communists, however inspite of this in a very strange way I believe we need them. You must be wondering whats the reason for this dichotomy. Well look around (in this world I mean) you would find that most of the countries that have adopted a single religion and don't have appreciation for people of other religion have become totalitarion nations, fundamentalists and fanatics in their way of thinking. I believe that by driving the communists out of this country we would become 'Eco Communalists'. Listening to ideas that the are poles apart from our way of thinking broadens our outlook and gives us a sense of appreciation towards others. Also I believe that no idea is completely right or completely wrong either. So that's why I beleive that no matter how much we despise communists we still need them. Why would like to end this article by this line that I thought of describing the stark contrast between Capitalism and Communism.

'Communism begins with an order that leads to chaos
Capitalism begins with chaos that leads to order'
However remember with the ideas of Karl Marx there would have been no labour standards, perhaps even no environmental standards, no corporate social responsiblity and without these the whole notion of capitalism would have collapsed at its infancy. So preserving communism is essential for the longeivity of free markets themselves.

## Thursday, March 20, 2008

### The valuation conundrum and stock market dynamics

These days as market takes a nosdive suddenly I see a lot of people talking about value, valuations and multiple of sub 14 times etc. and term this as irrational fall. The same arguments of value were also given when the BSE sensex was at 21000+ with a minor difference wherein we talked about valuations and embeded vauations and then tried to justify the rise as a rational rise. I to be honest never understood this kind of thinking and branding stocks in some closet of multiple. Sure valuations are important but the most important thing in any market are three variables liquidity and let's rename the other two variables as X and Y, stock market is no different.

Let's have an economy in which there is one supplier of gold and copper and these are the only two tangible products produced in this economy and the rest of the population has lots of money with them (also let me add exchange of commodities is not allowed: I will explain later how this condition comes to play even in real life for now this condition is our variable X), due to this the copper sells for rupees x and gold sells for rupees 100x. However one fine day all the money is gone. Then it's irrelevant to talk that gold is more valuable than copper they both attract negligible value as there is no liquidity.

Let's slightly tweak this example, so now we replace copper with bread. Whats more valuable after 7 days of hunger 'gold or bread'. So another factor that is extremely important in markets is 'marginal utility': The satisfaction a person recieves from one addtional unit of the good. This is our variable X.

If I have lot's of money in my pocket I would buy 'luxury brands', essentially the same quality of cloth from an expensive showroom with some fuzzy symbol on it. The same happens to stocks, in periods of high liquidity various popular names skyrocket.

Now when a person becomes cash strapped he becomes economical in his spending. The same happens in market he buys businesses that have real cash flows, he starts thinking about PE multiples. So really if one thinks about it, its liquidity that determines the performance of the stocks by controlling the marginal utility the players. I shall continue this article next time by explaining more about the variable X and hence completing the market dynamics.......

## Wednesday, March 19, 2008

From this post I introduce you all to the magical world of 'options'. I would try to limit the use of mathematics because frankly to be a successful options trader intutive understanding of options is what is needed rather than complex pricing formulas.

So what's essentially an option, well an option is essentially a bet. Let's say two people A & B while watching a football match of Italy vs France enter into a bet that if Italy beats France A pays B 1000 rupees else B pays A 1000 rupees. This if I translate it into options would actually constitue into an options trading strategy which I would address sometime later. For now to explain the most basic structure of option let's just extend our example a little bit----------

A fine evening in India in a B school campus to students (A & B) were worried about the derivatives exam tommorrow. To relieve the stress they start watching a friendly match between Italy and France. The match was turning out to be a big dissapointment 30 minutes gone and still no goals!! To heat things up they enter into a bet. A tells B that he pays him 500 rupees upfront. Now if France beats Italy he should forget his money and go back to his books, however if Italy beats france then A would pay B an amount equivalent to 250*(goal difference by which Italy beats France). This is what we know as a 'call option on the victory of Italy'.

B buys from A a call option on the victory of Italy. The payment he gives to A upfront is called the premium (the price of this option). A is known as the option writer, his maximum profit would be 500 rupees in the scenario where France beats Italy. However his loss potential is infinite and will start loosing if Italy beats France by a margin of more than 2 goals.

The same option can be termed as a 'put option on the defeat of France'. So basically the call and put options are the same thing, its just a function of your position.

In trading buying call is part of the bullish strategy --- You are bullish on Italy. While buying put is part of the bearish strategy --- You are bearish on France.

The rest of the article I would continue later..........

## Tuesday, March 18, 2008

### The Fed finally does what's needed

Atlast the Fed took the right bit of action. Expressing concern about inflation while not getting carried away by the market demand of a full monty cut. Also I believe the most critical action and in my opinion the correct action was the deftness it showed on the Bear Sterns issue, Fantastic!!! and adding onto this action is the fact that the Fed has opened its lending doors to Brokerage houses. This is what is really needed, the liquidity needs to go where it is needed and just blind rate cuts were never going to help. This action should have been taken long ago. Anyways as is true for everyone of us, it takes real adversity to tkae drastic actions.

However I still feel the Fed and more importantly the US government has to do more. I ultimately has to buy this mess (The mortgage backed securities). Hey I know the arguments against it and stop talking about moral hazzard, tax payers money and saving the rich. Let me give you a simple example----

You are driving on a Highway athigh speed and suddenly see some moron coming from a wrong direction. What would you do, sure that guy is an idiot and you feel like hitting him hard (Road Rage !!!) but would you do that, ofcourse not because it will hurt you aswell, so you just crib about it and give him way to get out. The same principle can be applied to the Fed and later on possibly the US govenment bailout. As for the tax payers money, well there would not be much left if this thing goes for long.

What required after these bailout packages and clearing the system is change in laws, increased vigilance. Like in our Higway example, had there been more vigilance the car would not have been allowed to enter the wrong way on the highway. The companies entering into any kind of derivatives transaction have to commit wafer thin margins. That has to change or if not change atleast it has to be made mandatory for the companies to report there equity against the derivatives position they are taking and the worst case scenario loss on equity (Not the Var crap, no more 95 percent confidence of this loss that loss etc. Keep these things limited to the MBA classes), The worst case scenario loss simple. No more fancy statistics just report how much maximum you can loose based upon there derivatives trade and then its upto the shareholders to decide whether to invest in such companies or not..........

## Saturday, March 15, 2008

Well It has been a long time since I last wrote on this blog. Since my last blog lot of events have happened. The raging bull market has suddenly seem to become inverted. The same analysts (One of the most dumb & useless post in market) who not long back were tomtoying the great Indian bull story and taking this index into 30000 in next two months are now talking of four figures on sensex. Ofcourse this is market and anything can happen but my point is that no one no matter how succesful he or she has been in this market is better or worse than any guy on the street in predicting the future, if it sounds surprising just believe it.

Well this fall in the index has made my job slightly easier, as I wrote in my last post about explaining the market bubble; well I don't have to do it now so basically saved of some gruelling work in preparing excel sheets.

Now what I think about the months ahead well even I am looking forward for the drama to unfold but one thing is clear and since I started writing this blog I have been shouting this--- Sack the Fed Committee. Look what has happened now and these morons still have the tenacity to say that the inflation expectations of the people are intact. Well in that case either these people are completely stupid, are in a state of self denial, or bigtime liars. Well all is still not lost and the situation can still be salvaged in my opinion by going for one of the three ways:

1. The Fed must stop cutting rates. I know the markets across the globe would tumble for a couple of days but they would recover. More importantly the bubble in commodity markets would burst. I am sure that as you have the seen some hostoric rises in oil and bullion prices similarly you would also see the biggest ever fall recorded to date in these prices. But I doubt the Fed would have the teeth for this. Ideally in my opinion this is the best option.

2. The EU and BOE must cut rates. Today the most preferred trade is go short on dollar and long on oil or gold. With ECB and BOE cutting rates the expectation of dollar weaking would reduce and this trade would fall apart. Ofcourse with more excess liquidity there is a likelihood of bubble reforming in Emerging markets and again in commodities. However as a temprory measure this option can be utilised. I must also add the position the ECB chairman is taking is too textbookish. Economics is not Physics. Everyone knows what Fed cutting interest rates would do to the dollar. So this commodity inflation will not aggravate because of ECB or BOE rate cuts as this inflation id because of a hedge against weak dollar. The key in economics is to be creative and not do things which are written in textbooks as everyone is well aware so such scenarios and hence these things get discounted in markets.

3. A coordinated effort by main Central Banks of the world US, UK, Europe and Japan is needed to strenghten the dollar. This would break the back of speculators in the forex and commodity markets.

Out of the 3 options discussed the third one seems to be the most likely, I hope its excersised soon enough before its too late. We are living in uncertain ( well life is always uncertain) and interesting times. Hope this time would write soon and let's see how things pan out.........