http://mukul.org/ - This blog is no longer being updated. The last post was in 2008. Please visit www.riskprep.com - en-us Nucleus CMS v3.32 © Weblog http://backend.userland.com/rss http://mukul.org//nucleus/nucleus2.gif http://mukul.org/ http://mukul.org/index.php?itemid=32 here. Or if you have time, here. Perhaps there are positive returns to be had in a bet on these. But as John Paulson was quoted in the WSJ , “you can’t short houses”. But maybe we can short some of the companies that build and sell these houses.

The Indian equity markets have enjoyed a tremendous bull run over the past few years. In 2007 the Indian markets were up 47%. Real estate was up even more on a frenzy that makes New York and London decidedly tame. Seeing the time to cash in, multiple ‘mega-issues’ or IPOs from real estate developers came out in 2007. Exorbitantly priced to begin with, they did not disappoint their investors. These IPO stocks outperformed the index (the one that was up by 47%!) by a handsome margin. We look at how some of the larger public offerings have done since they were listed. Terrific!



Which brings us to the point of this post. How sustainable are half a million dollar apartments in a country with an average wage of about $1000 (a year). Sure there are rich people in poor countries. Maybe enough to keep things going merrily forever. But maybe not.

Most people do believe that this is a bubble that is bound to burst. Perhaps it is only a question of when, and not if. But as said Keynes – the market can stay irrational for longer than you can stay solvent. There is no shortage of alpha seekers (and of academics & economists ridiculed on television) that were hurt calling a false top to the real estate market in the US. The same can happen anywhere, but given the fizz going out of the global markets, the Indian bubble may probably be short lived too.

Sourcing alpha
One bet may be to short some or a diversified portfolio of these real estate companies. The Indian markets have already seen a correction in 2008, and that may or may not continue. These stocks do contain significant beta, so to guard against the risk of the general market going up, perhaps a market neutral short position in some of these companies may be desirable. As is the nature of the game, many of these companies have not been listed for too long, so betas that I calculated in the table below are probably unreliable but perhaps not a bad starting point for making an estimate for the future.

Here are some tickers (on nseindia.com, or add .ns after the ticker for Yahoo Finance) with some data. All information is approximate, US dollar conversions have been done using a single rate of Indian Rupees 40 = USD 1. Notice the volatility in the stocks, they go up and down fast for sure. Also look at their fantastic profit margins. Who cares about EBITDA when net income to revenue ratios are straight out of wonderland!



Profiting from the strategy
For investors in the US, it is not easy to gain non-systematic exposure to a particular company or sector in India. There are a few funds such as IFN, IIF, INP and more recently EPI from Wisdom Tree that provide broad based exposure to the Indian market, but nothing that would specifically target a particular stock or a sector.

However, there are a number of Indian stocks that are listed either on the NASDAQ or the NYSE as ADRs. Many of them are also included in the broader Indian S&P Nifty-50 market index (referred to above). These include the following:

List of Indian stocks listed in the US that are also a part of the S&P Nifty-50 market index:
Dr Reddy's Labs - RDY
HDFC Bank - HDB
ICICI Bank - IBN
Infosys - INFY
Satyam - SAY
Satyam Technologies - SIFY
Sterlite - SLT
Tata Communications - TCL
Tata Motors - TTM
Wipro Ltd - WIT

The list above covers industry, banking, communications and technology, but does not include any exposure to the real estate sector - except probably with the exception of HDB and IBN that have mortgage lending operations in India.

This opens up an interesting possibility - consider building a synthetic portfolio where one goes short on the entire market using IFN, IIF or INP; and simultaneously going long on a portfolio of individual stocks listed above in a way that the net exposure is only to real estate or related stocks. Unfortunately, real estate stocks currently comprise only about 4% of the Indian stock market capitalization, and as of the date of this post only Unitech is part of the Nifty-50. That makes this strategy a bit tricky to achieve but in the coming days as DLF and other Indian companies get included in the Nifty-50, it would be possible to create a portfolio that is strongly correlated (positively or negatively) to the Indian real estate sector.

If someone has any ideas or suggestions on how this strategy could be refined to target the desired exposure, do send me your comments.
]]> General http://mukul.org/index.php?itemid=32 Fri, 22 Feb 2008 22:15:12 -0600 http://mukul.org/index.php?itemid=31 The Sharpe Ratio and the Information Ratio are indicators of risk adjusted returns. Both are ratios of mean returns to standard deviations of some flavor, but different from each other.

The Sharpe Ratio:
The Sharpe Ratio reflects the ratio of all excess returns over the risk free rate to the total risk (or standard deviation) of the return stream. In other words, we strip out the risk free rate from the earned returns, and divide that by the total standard deviation of the returns.

The Information Ratio:
The Information Ratio, on the other hand, is the ratio of the alpha component of total returns to the standard deviation of these excess alpha returns. The alpha component is the return that is attributable to the manager’s skill (or luck ;-), and is the residual after taking out the risk free return and the beta components from the total returns. Also note the difference in the denominator – while the Sharpe ratio considers the standard deviation of the total returns, the information ratio considers the variability of only the alpha component of the return (which also forms the numerator).

Conceptually, think of this like this: if total returns can be considered the sum of the risk free rate, the beta (ie the compensation for taking on systematic risk, or market risk), and the alpha, then the Sharpe ratio looks to express the ‘excess’ returns over the risk free return (ie, beta plus alpha) per unit of total risk undertaken. That is intuitive because the risk free rate, by definition, has no risk anyway and all risk arises from the beta and alpha components.

The information ratio only looks to compute the return per unit of risk undertaken for the alpha component. This is important because alpha is always in a very risky category – its mean for the market as a whole is zero (in practice slightly less than zero because of transaction and other costs) and therefore it is easy to lose money on alpha that will bite into the beta returns.

Here is a graphic that explains the whole reasoning:
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Interpreting the information ratio, or why is the information ratio important?

The information ratio is very useful to understand how risky is dabbling with the alpha in question. If we were to assume that alpha returns will be normally distributed, then the information ratio allows us to model the alpha as being a distribution with mean = IR and standard deviation = 1. This is intuitive because IR = (mean alpha return/standard deviation of alpha returns). A ratio of say, 0.4 can be interpreted to imply a normal distribution with mean equal to 0.4 and a standard deviation of one. From this point, everything is easy because we can now estimate the probability of losing money, or the probability of meeting a benchmark.



Note that just simply putting the formula =normsdist(-IR) gives us the probability of losing money in one year.

We can extend the analysis to multiple years – for example, consider a manager with an alpha of say, 3%, and standard deviation of say 10% (IR = 0.3). The probability of him losing money over a one year period is 38%. Now think of a three year horizon. The mean returns over a three year period will be 9%, and the standard deviation will be (3^1/2)*10%, or 17.3%, and therefore a possibility of losing money over a three year period to be about 30%.


]]> General http://mukul.org/index.php?itemid=31 Wed, 6 Feb 2008 08:59:00 -0600 http://mukul.org/index.php?itemid=29 Foreign exchange reserves and the balance of payments

The balance of payments is an account of all of a country’s transactions with the rest of the world. On one side of the account are money flows out of the country (debits), and on the other are the receipts (credits). The interesting thing is that the balance of payments is, by definition, balanced. However, this balance is struck in a mere accounting sense as debits must equal credits.

Taking a very simple view of world trade, a country would export and earn foreign exchange with which it can buy goods from abroad. Let us assume a simple scenario where a country’s demand for imports is more than its exports. In such a case, the country’s ability to import would be limited by the foreign exchange it has earned from its exports, or from what is called the ‘current account’ – unless it chooses, as countries often do, to finance their deficit by borrowings, i.e. from the ‘capital account’. To the extent that the deficit is not financed by the capital account, it will experience a reduction in its foreign currency ‘cash balance’, i.e. a fall in its forex reserves. In the same way, forex reserves will increase if the exports are more than the imports. Forex reserves however cannot increase (or decrease) forever. Over a period of time, a sustained excess of imports over exports (or the other way round) will move the exchange rates in a way as to bring the two in balance by affecting demand and supply. But we digress – back to the balance of payments.

Ultimately:

Deficit/Surplus of the current account + Deficit/Surplus of the capital account = Net change in foreign exchange reserves

Transactions inside the balance of payments can be classified in two broad categories: transactions on the capital account, and those on the current account.

The current account: The current account is a record of all transactions relating to trade in goods and services, net interest and dividend payments and any transfers in the form of foreign aid. Therefore, the three component of the current account are:

1. The trade balance: This is the difference between the exports and imports of goods and services. The excess of exports over imports is called the trade surplus, and likewise if the imports exceed exports, there is a trade deficit. Often, a distinction is made between goods and services by calling them visible and invisible trade. The trade balance is the most significant element of the current account. Often, a ‘worsening balance of payments’ refers to an increase in the trade deficit.

2. Net foreign income: Income is earned by residents on assets held abroad and likewise foreigners earn income on the domestic assets. Net foreign income is the difference of the two and includes interest and dividends.

3. Unilateral transfers: include transfers such as foreign aid which are made without consideration.

The capital account: The capital account is a record of all financing transactions. These represent flow of money for investment and international loans. It is different from the current account in that it does not include settlements for current transactions. To illustrate with an example, while the purchase of a machinery would feature in the current account, its financing with an international loan would be an entry in the capital account. Investments by foreigners in a domestic stock market, raising of capital by domestic companies in markets abroad, foreign direct investments in domestic industry are all inflows on the capital account. Likewise, extinguishment of debt by settlement, investments in foreign financial assets (eg, in the US treasuries) represent an outflow on the capital account.

Long and short term capital flows
One characteristic of the capital account is the nature of the capital flow, i.e. whether it is short term or long term in nature. ‘Hot money’, or investments in local debt or equity markets to exploit differences in interest rate or stock market expectations, are short term capital flows that can reverse quickly. On the other hand, long term loans or investment in equity that cannot be easily monetized and taken out of a country are examples of long term or ‘stable’ capital flows. The difference is crucial because short term capital flows can cause significant market disruptions & economic hardship as they did in the late nineties in the South Asian crisis.

Debt and non-debt creating inflows
It is also possible to consider the capital account transactions as being debt creating or not. Investment in equity, whether in the secondary market or direct investment in the equity of an Indian venture, are not debt creating. On the other hand, external commercial borrowings and external debt assistance both create a debt liability.

The current account and the capital account are complementary to each other. The net total of the two decides the net increase or decrease in the country’s forex reserves. A deficit in the current account is not necessarily a negative indicator, so long as the deficit is used to augment productive capacity. This can take the form of investments in infrastructure that make economic expansion possible and increase the capacity of the country to export in the future. At the same time, a surplus in the current account does not necessarily imply prosperity, for instance Russia had a large current account surplus in the nineties from its export of commodities and arms, which was offset by large scale capital flight and therefore a deficit on the capital account. China currently has a surplus on both the capital and current accounts and so we see their foreign exchange reserves go up each month.


The composition of the ‘balance’ of payments can therefore be summarised as follows:

balance of payments

About exchange controls:
Countries impose different levels of controls on exchange flows, for example, a number of developing countries have opened their current accounts but not their capital accounts. What that means is that people are free to trade with foreigners and settle bills that arise from such trades, but need central bank or other regulatory approval before investing or borrowing from abroad. Both India and China, for example, have controls on the capital account while the current account is largely open. The United States and most developed countries have no restrictions on either.
]]> General http://mukul.org/index.php?itemid=29 Fri, 28 Dec 2007 10:12:21 -0600 http://mukul.org/index.php?itemid=28
Controls are not only expensive to put in place and operate, they create further downstream costs such as increased audit hours and a decline in process throughputs. This article discusses some ideas on automating controls and reducing costs.

This article was published by ISACA (isaca.org) in their "Control" journal, Vol 2, 2007, and the copyrights to this piece already belong to ISACA.Here it is - as published, in PDF format


Automating Controls.]]> General http://mukul.org/index.php?itemid=28 Fri, 6 Oct 2006 14:28:17 -0500 http://mukul.org/index.php?itemid=25
This paper looks at the math and provides an Excel based model to understand the calculations for price-based anti-dilution provisions. While the math is easy, the real purpose of doing this exercise is to allow an understanding of how different variables affect the future shareholding pattern after a down-round, particularly the founder's holding after a down-round, as that significantly affects motivation and incentives, and also how losses in value get shared between the entrepreneurs and the VCs. Down-rounds, or subsequent investments at prices lower than that paid by earlier investors, often trigger in price-based anti-dilution provisions that are intended to protect the prior round investors from a dilution in their percentage of ownership or value in the venture.

Here is the item in The mechanics of down-rounds.

And here is the Excel file: Excel model for down-rounds article]]> General http://mukul.org/index.php?itemid=25 Sat, 24 Jun 2006 19:31:31 -0500 http://mukul.org/index.php?itemid=24 Corporations perform economic activities that create value for their stakeholders, which in nearly all market driven economies mean its shareholders. The main job of the management of any firm is to enhancing shareholder value by increasing the value of the enterprise. Managing projects well is the only way for management to generate and capture value for its shareholders.

Classical finance theory tells us that the value of the firm is nothing but the discounted cash flows expected over the life of the business.

MEASURING VALUE
The value of the firm comprises two elements: the value of its “steady state” business, and the present value of future opportunities to grow the business or run it more efficiently. The steady state business represents business as usual, i.e. the current set of operations that support a steady cash stream that is growing at the rate that mature businesses do (often close to the rate of growth of nominal GDP). This is the part of the business that is the ‘cash cow’, and purely from a financial perspective is really an annuity that can be discounted to the present using an appropriate discount rate reflecting the riskiness of the cash flows. For example, for a company selling hair dryers, the cash flows from its core business that are predictable and continuing in nature will be a part of the steady state cash flows.

The present value of growth opportunities represents the expected cash flows the company will generate in the future from new initiatives. These are nothing but the changes to value that the market perceives will happen as the management seizes the opportunities available to it. Good project management capabilities help management extract value from such initiatives.

Components of value?

VALUE VERSUS GROWTH
A portion of a firm’s value is always the discounted value of its steady state cash flows, and the rest reflects the present value of growth opportunities. The mix between the two elements differs between companies, and this relative proportion of value contributed by the two elements defines whether the company is considered a ‘value’ or a ‘growth’ company. Early stage companies usually have low or no value from the ‘steady state’, while mature businesses have little value from growth opportunities. In fact, these two components of value are recognized by investors who distinguish between growth and value stocks – value stocks are stocks of companies that have a relatively lower proportion of their firm value accruing from present value of growth opportunities, while growth stocks are those where most of the value is attributable to growth opportunities.

New value from projects

HOW PROJECTS CREATE VALUE
Value from new initiatives or projects create value in two ways: by enhancing current operations by increasing productivity, improved resource utilization, plugging cash leakages from waste; and by opening up newer sources of revenue, e.g. the launch of new products.

WHY WELL MANAGED PROJECTS INCREASE MARKET CAPITALIZATION?
According to the efficient markets theory all known information about a company is priced into its stock valuation. This includes the market’s valuation of all future growth opportunities. Since all news, regardless of whether it relates to current steady state or new cash generating opportunities, gets included in the firm valuation immediately, the only means for management to create additional value is by continuing to identifying new opportunities that add to shareholder value over and above what is already known. In other words, all value from the current state of operations and the market’s current assessment of management’s execution capabilities for future opportunities is already included in the share price. New positive expectations about the business that increase capitalization and firm value are created by doing things above and beyond business as usual, i.e. by executing new positive net present value projects. This can be done in two ways:
• Identifying new opportunities to enhance operational efficiency and extend the value of its existing franchise
• Putting in place strong project management capabilities to be able to execute on growth opportunities

This is where the value additive aspects of projects come in. All day to day stuff, or business as usual, is already covered by operations. The way to create additional value is to identify opportunities and execute on them using projects. Projects may relate to any opportunity, and could include initiatives as diverse as launching a new marketing plan, or a new product, or a cost reduction initiative.

SUMMARY
If value is to be generated and retained within the organization, projects must be executed successfully. Poor execution of projects would mean management losing credibility in the eyes of the investors, implying a lower valuation on otherwise profitable ideas as investors do not perceive the management to be capable of good execution.

In addition to directly increasing value by positive value resulting from projects, strong project management capabilities reduce project risks so that the expected value from a project becomes less variable or volatile, contributing to reducing the overall risk of the firm’s earnings, further adding to value.



References: Brealey Myers, Principles of Corporate Finance

]]> General http://mukul.org/index.php?itemid=24 Mon, 3 Apr 2006 02:59:31 -0500 http://mukul.org/index.php?itemid=23 Here it is - as published, in PDF format


Living with Risk.]]> General http://mukul.org/index.php?itemid=23 Sun, 2 Apr 2006 15:32:13 -0500 http://mukul.org/index.php?itemid=22 Optimizing Internal Controls to test using Excel based modeling techniques

]]> General http://mukul.org/index.php?itemid=22 Thu, 29 Dec 2005 10:53:06 -0600 http://mukul.org/index.php?itemid=8
This article appeared in print in March 2005 in the 'Control' journal.MAKING CHOICES – POST MERGER SYSTEMS INTEGRATION

By Mukul Pareek

Integrating systems of two companies after a merger or an acquisition can be a formidable task – in fact, if not done right, many of the synergies factored into the merger valuations may never be realized. Poorly integrated systems could mean deserting customers, lack of a focused corporate brand identity for the new merged entity, and spiraling costs. Timely integration of systems and processes is necessary for the merged entity to derive the economies of scale, and the elimination of duplicate functions for the synergies to be achieved.


"Over the years, every firm acquires an agglomeration of boxes and code as unique as a fingerprint. Then firms merge, and someone has to try to stitch several of these unique datacentres together. This is the sort of thing that Charles de Felipe did at J.P. Morgan, a huge global bank, where he was one of the chief technical people for 26 years until he quit in July. During his career there Mr de Felipe went through nine mergers, which amalgamated once-famous names such as Chemical, Horizon, Manufacturers Hanover, Chase, H&Q, Jardine Fleming, J.P. Morgan and, most recently, BankOne into a single bank. “Every four years or so the entire landscape changes,” says Mr de Felipe. “On day one you merge the books; on day two you do the regulatory paperwork, and on day three you start talking about the systems.” The first two, he says, are child's play compared with the third."

- The Economist, A survey of information technology, October 30th 2004


The complete article is in PDF format and can be downloaded here

]]> General http://mukul.org/index.php?itemid=8 Mon, 28 Mar 2005 10:09:00 -0600 http://mukul.org/index.php?itemid=9
This custom Excel based formula calculates option values for a European option with no dividends. What I like about this (other than the fact that I wrote it myself) is that it calculates everything in one go.
Excel based Black Scholes calculation - array formula

Well, why talk about it - here is what a sample calculation with my formula looks like.


With one single formula, you get the call value, the put value, and all the greeks, plus a mathematical proof of the put-call parity in one go.

You can download the spreadsheet from this link. The spreadsheet is unprotected, so you can look at the code and change it.

Using the function
1. The formula BS takes the format '=BS(stock price, option exercise price, volatility, time to expiry, risk free rate)'
2. Enter the values for p, x, v, t and r anywhere in your spreadsheet.
3. Enter the formula '=BS(p,x,v,t,r)', referring the correct cells for the values of p, x, v, t and r respectively.
4. Click on the cell where you entered the formula above, then press shift and select 12 rows by 4 columns, press F2, and then Ctrl+Shift+Enter together.
5. That's it!

This formula uses an annually compounded exchange rate, and not a continuously compounded rate.

If you only know the continuously compounded rate, you will have to derive the annual rate and use that instead of the continously compounded rate. It's easy to do that: to convert a continously compounded rate to an annually compounded rate, use the Excel formula "=EXP(r)-1" where r is the continuously compounded rate.

(It is equally easy to convert from a given annual rate to continuous rate - just use the Excel function "=LN(1+annual rate)")

]]> General http://mukul.org/index.php?itemid=9 Thu, 3 Mar 2005 10:10:00 -0600