Blue Economy – Sagarmala Financial Engineering: Yet Another Dig. Skeletal Sketch of an Upcoming Talk in Somnath, Gujarat.

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Authorized Share Capital in the case of Sagarmala happens to be INR 1000 crore, and is the number of stock units Sagarmala Development Company Limited (SDCL) has issued in its articles of incorporation. This ASC is open, in that share capital isn’t fully used, and there is ample room for future issuance of additional stock in order to raise capital quickly as and when a demand arises. SDCL can increase the authorized capital at anytime with shareholders’ approval and paying an additional fee to the RoC, Registrar of Companies. 

Capital Budgeting: Business determines and evaluates potential large expenditures/investments. Capital Budgeting is generally a long-term venture, and is a process that SDCL would use (and uses) to identify hat capital projects would create the biggest returns compared with the funds invested in the project. The system of ranking helps establish a potential return in the future, such that the SDCL management can choose where to invest first and most. Let us simply call it the first and most principle of budgeting. Blue Economy that instantiates itself via Sagarmala in India has options to choose from as regards its Capital Budgeting, viz. 

  1. Throughput analysis – This defines the main motives behind a project, where all the costs are operating costs, and the main emphasis is on maximizing profits in passing through a bottleneck. The best example for Sagarmala speculatively thought out is the marking of Western Shipping Corridor for container traffic and posing a livelihood threat to traditional fishermen. Throughput is an alternative to the traditional cost accounting, but is neither accounting, not costing, since it is focused on cash flows. It does not allocate fixed costs to products and services sold or provided and treats direct labour as a fixed expense. Decisions made are based on three critical monetary variables: throughput, investment or inventory and operating expenses. Mathematically, this is defined as revenue minus totally variable expenses, the cost of raw materials or services incurred to produce the products sold or services delivred. T = R – TVE. 
  2. Net Present Value (NPV) – this s the value of all future cash flows, either positive or negative over the entire life of an investment discounted to the present. NPV forms a part of an intrinsic valuation, and is employed for valuing business, investment security, capital project, new venture, cost reduction and almost anything involving cash flows. 

NPV = z1/(1 + r) + z2/(1 + r)2 – X

      , where z1 is the cash flow in time 1, z2 is the cash flow in time 2, r is the discount       range, and X is the purchase price, or initial investment. NPV takes into account the timing of each cash flow that can result in a large impact on the present value of an investment. It is always better to have cash inflows sooner and cash outflows later. this is one spect where SDCL might encounter a bottleneck and thereby take recourse to throughput analysis. Importantly, NPV deliberates on revolving funds.  

  1. Internal Rate of Return (IRR) – this is an interest rate at which NPV from all cash flows become zero. IRR qualifies attractiveness of an investment, whereby if IRR of a new project exceeds company’s required rate of return, then investment in that project is desirable, else project stands in need of a rejection. IRR escapes derivation analytically, and must be noted via mathematical trial and error. Interestingly, business spreadsheets are automated to perform these calculations. Mathematically, IRR is:

0 = P0 + P1/(1 + IRR) + P2/(1 + IRR)2 + …. + Pn/(1 + IRR)n

, where P0, P1,…, Pn are cash flows in periods of time 1, 2, …, n. 

 With a likelihood of venture capital and private equity expected in Sagarmala accompanied with multiple cash investments over the life-cycle of the project, IRR could come in handy for an IPO. 

     4. Discounted Cash Flow – this calculates the present value of an investment’s future            cash flows in order to arrive at  current fair value estimate for an investment. Mathematically, 

DCF =  CF1/(1 + r) + CF2/(1 + r)2 + CF3/(1 + r)3 + … + CFn/(1 + r)n

, where CFn are cash flows in respective n periods, and r is discount rate of return. 

DCF accounts for the fact that money received today can be invested today, while money we have to wait for cannot. DCF accounts for the time value of money and provides an estimate of what e should spend today to have an investment worth a certain amount of money at a specific point in the future. 

       5. Payback period – mathematically, this is defined as: 

Payback Period = Investment required/Annual Project Cash flow

This occurs the year plus a number of months before the cash flow turns positive. Though seemingly important, payback period does not consider the time value of investment/money, and is quite inept at handling projects with uneven cash flows. 

As a recap (and here, here, here)

Sagarmala is a 3-tier SPV structure

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Private Players/PPPs OR EPCs/Turnkey – the latter are used for projects with high social impact or low IRR. 

Expenses incurred for project development will be treated as part of equity contribution by SDCL, or, in case SDCL does not have any equity, or expenses incurred are more than the stake of SDCL, SPV will defray SDCL. Divestment possibilities cannot be ruled out in order to recoup capital for future projects. 

“The Scam” – Debashis Basu and Sucheta Dalal – Was it the Beginning of the End?

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“India is a turnaround scrip in the world market.”

“Either you kill, or you get killed” 

— Harshad Mehta

“Though normally quite reasonable and courteous, there was one breed of brokers he truly detested. to him and other kids in the money markets, brokers were meant to be treated like loyal dogs.”

— Broker

The first two claims by Harshad Mehta could be said to form the central theme of the book, The Scam, while the third statement is testimony to the fact of how compartmentalization within the camaraderie proved efficacious to the broker-trader nexus getting nixed, albeit briefly. The authors Debasish Basu and Sucheta Dalal have put a rigorous investigation into unraveling the complexity of what in popular culture has come to be known as the first big securities scam in India in the early 90s. That was only the beginning, for securities scams, banking frauds and financial crimes have since become a recurrent feature, thanks to increasing mathematization and financialization of market practices, stark mismatches on regulatory scales of The Reserve Bank of India (RBI), Public Sector Banks and foreign banks, and stock-market-oriented economization. The last in particular has severed the myth that stock markets are speculative and had no truck with the banking system, by capitalizing and furthering the only link between the two, and that being banks providing loans against shares subject to high margins.  

The scam which took the country by storm in 1992 had a central figure in Harshad Mehta, though the book does a most amazing archaeology into unearthing other equally, if not more important figures that formed a collusive network of deceit and bilk. The almost spider-like weave, not anywhere near in comparison to a similar network that emanated from London and spread out from Tokyo and billed as the largest financial scandal of manipulating LIBOR, thanks to Thomas Hayes by the turn of the century, nevertheless magnified the crevices existing within the banking system and bridging it with the once-closed secretive and closed bond market. So, what exactly was the scam and why did it rock India’s economic boat, especially when the country was opening up to liberal policies and amalgamating itself with globalization? 

As Basu and Dalal say, simply put, the first traces of the scam were observed when the State Bank of India (SBI), Main Branch, Mumbai discovered that it was short by Rs. 574 crore in securities. In other words, the antiquated manually written books kept at the Office of Public Debt at the RBI showed that Rs. 1170.95 crore of an 11.5% of central government loan of 2010 maturity was standing against SBI’s name on the 29th February 1992 figure of Rs. 1744.95 crore in SBI’s books, a clear gap of Rs. 574 crore, with the discrepancy apparently held in Securities General Ledger (SGL). Of the Rs. 574 crore missing, Rs. 500 crore were transferred to Harshad Mehta’s account. Now, an SGL contains the details to support the general ledger control account. For instance, the subsidiary ledger for accounts receivable contains all the information on each of the credit sales to customers, each customer’s remittance, return of merchandise, discounts and so on. Now, SGLs were a prime culprit when it came to conceiving the illegalities that followed. SGLs were issued as substitutes for actual securities by a cleverly worked out machination. Bank Receipts (BRs) were invoked as replacement for SGLs, which on the one hand confirmed that the bank had sold the securities at the rates mentioned therein, while on the other prevented the SGLs from bouncing. BRs is a shrewd plot line whereby the bank could put a deal through, even if their Public Debt Office (PDO) was in the negative. Why was this circumvention clever was precisely because had the transactions taken place through SGLs, they would have simply bounced, and BRs acted as a convenient run-around, and also because BRs were unsupported by securities. In order to derive the most from BRs, a Ready Forward Deal (RFD) was introduced that prevented the securities from moving back and forth in actuality. Sucheta Dalal had already exposed the use of this instrument by Harshad Mehta way back in 1992 while writing for the Times of India. The RFD was essentially a secured short-term (generally 15 day) loan from open bank to another, where the banks would lend against Government securities. The borrowing bank sells the securities to the lending bank and buys them back at the end of the period of the loan, typically at a slightly higher price. Harshad Mehta roped in two relatively obscure and unknown little banks in Bank of Karad and Mumbai Mercantile Cooperative Bank (MMCB) to issue fake BRs, or BRs not backed by Government securities. It were these fake BRs that were eventually exchanged with other banks that paid Mehta unbeknownst of the fact that they were in fact dealing with fake BRs. 

By a cunning turn of reason, and not to rest till such payments were made to reflect on the stock market, Harshad Mehta began to artificially enhance share prices by going on a buying spree. To maximize profits on such investments, the broker, now the darling of the stock market and referred to as the Big Bull decided to sell off the shares and in the process retiring the BRs. Little did anyone know then, that the day shares were sold, the market would crash, and crash it did. Mehta’s maneuvers lent a feel-good factor to the stock market until the scam erupted, and when it did erupt, many banks were swindled to a massive loss of Rs. 4000 crore, for they held on to BRs that had no value attached to them. The one that took the most stinging loss was the State Bank of India and it was payback time. The mechanism by which the money was paid back cannot be understood unless one gets to the root of an RBI subsidiary, National Housing Bank (NHB). When the State Bank of India directed Harshad Mehta to produce either the securities or return the money, Mehta approached the NHB seeking help, for the thaw between the broker and RBI’s subsidiary had grown over the years, the discovery of which had appalled officials at the Reserve Bank. This only lends credibility to the broker-banker collusion, the likes of which only got murkier as the scam was getting unravelled. NHB did come to rescue Harshad Mehta by issuing a cheque in favor of ANZ Grindlays Bank. The deal again proved to be one-handed as NHB did not get securities in return from Harshad Mehta, and eventually the cheque found its way into Mehta’s ANZ account, which helped clear the dues due to the SBI. The most pertinent question here was why did RBI’s subsidiary act so collusively? This could only make sense, once one is in the clear that Harshad Mehta delivered considerable profits to the NHB by way of ready forward deals (RFDs). If this has been the flow chart of payment routes to SBI, the authors of The Scam point out to how the SBI once again debited Harshad Mehta’s account, which had by then exhausted its balance. This was done by releasing a massive overdraft of Rs. 707 crore, which is essentially an extension of a credit by a lending institution when the account gets exhausted. Then the incredulous happened! This overdraft was released against no security!, and the deal was acquiesced to since there was a widespread belief within the director-fold of the SBI that most of what was paid to the NHB would have come back to SBI subsidies from where SBI had got its money in the first place. 

The Scam is neatly divided into two books comprising 23 chapters, with the first part delineating the rise of Harshad Mehta as a broker superstar, The Big Bull. He is not the only character to be pilloried as the nexus meshed all the way from Mumbai (then Bombay) to Kolkata (then Calcutta) to Bengaluru (then Bangalore) to Delhi and Chennai (then Madras) with a host of jobbers, market makers, brokers and traders who were embezzling funds off the banks, colluded by the banks on overheating the stock market in a country that was only officially trying to jettison the tag of Nehruvian socialism. But, it wasn’t merely individuated, but the range of complicitous relations also grabbed governmental and private institutions and firms. Be it the Standard Chartered, or the Citibank, or monetizing the not-even in possession of assets bought; forward selling the transaction to make it appear cash-neutral; or lending money to the corporate sector as clean credit implying banks taking risks on the borrowers unapproved by the banks because it did not fall under the mainline corporate lending, rules and regulations of the RBI were flouted and breached with increasing alacrity and in clear violations of guidelines. But credit is definitely due to S Venkitaraman, the Governor of the RBI, who in his two-year at the helm of affairs exposed the scam, but was meted out a disturbing treatment at the hands of some of members of the Joint Parliamentary Committee. Harshad Mehta had grown increasingly confident of his means and mechanisms to siphon-off money using inter-bank transactions, and when he was finally apprehended, he was charged with 72 criminal offenses and more than 600 civil action suits were filed against him leading to his arrest by the CBI in the November of 1992. Banished from the stock market, he did make a comeback as a market guru before the Bombay High Court convicted him to prison. But, the seamster that he was projected to be, he wouldn’t rest without creating chaos and commotion, and one such bomb was dropped by him claiming to have paid the Congress Prime minister PV Narsimha Rao a hefty sum to knock him off the scandal. Harshad Mehta passed away from a cardiac arrest while in prison in Thane, but his legacy continued within the folds he had inspired and spread far and wide. 

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Ketan Parekh forms a substantial character of Book 2 of The Scam. Often referred to as Midas in privy for his ability to turn whatever he touched into gold on Dalal Street by his financial trickery, he decided to take the unfinished project of Harshad Mehta to fruition. Known for his timid demeanor, Parekh from a brokers family and with his training as a Chartered Accountant, he was able to devise a trading ring that helped him rig stock prices keeping his vested interests at the forefront. He was a bull on the wild run, whose match was found in a bear cartel that hammered prices of K-10 stocks precipitating payment crisis. K-10 stocks were colloquially named for these driven in sets of 10, and the promotion of these was done through creating bellwethers and seeking support fro Foreign Institutional Investors (FIIs). India was already seven years old into the LPG regime, but still sailing the rough seas of economic transitioning into smooth sailing. This wasn’t the most conducive of timing to appropriate profits, but a prodigy that he was, his ingenuity lay in instrumentalizing the jacking up of shares prices to translate it into the much needed liquidity. this way, he was able to keep FIIs and promoters satisfied and multiply money on his own end. This, in financial jargon goes by the name circular trading, but his brilliance was epitomized by his timing of dumping devalued shares with institutions like the Life Insurance Corporation of India (LIC) and Unit Trust of India (UTI). But, what differentiated him from Harshad Mehta was his staying off public money or expropriating public institutions. such was his prowess that share markets would tend to catch cold when he sneezed and his modus operandi was invest into small companies through private placements, manipulate the markets to rig shares and sell them to devalue the same. But lady luck wouldn’t continue to shine on him as with the turn of the century, Parekh, who had invested heavily into information stocks was hit large by the collapse of the dotcom bubble. Add to that when NDA government headed by Atal Bihari Vajpayee presented the Union Budget in 2001, the Bombay Stock Exchange (BSE) Sensex crashed prompting the Government to dig deep into such a market reaction. SEBI’s (Securities and Exchange Board of India) investigation revealed the rogue nature of Ketan Parekh as a trader, who was charged with shaking the very foundations of Indian financial markets. Ketan Parekh has been banned from trading until 2017, but SEBI isn’t too comfortable with the fact that his proteges are carrying forward the master’s legacy. Though such allegations are yet to be put to rest. 

The legacy of Harshad Mehta and Ketan Parekh continue to haunt financial markets in the country to date, and were only signatures of what was to follow in the form of plaguing banking crisis, public sector banks are faced with. As Basu and Dalal write, “in money markets the first signs of rot began to appear in the mid-1980s. After more than a decade of so-called social banking, banks found themselves groaning under a load of investments they were forced to make to maintain the Statutory Liquidity Ratio. The investments were in low-interest bearing loans issued by the central and state governments that financed the government’s ever-increasing appetite for cash. Banks intended to hold these low-interest government bonds till maturity. But each time a new set of loans came with a slightly higher interest rate called the coupon rate, the market price of older securities fell, and thereafter banks began to book losses, which eroded their profitability,” the situation is a lot more grim today. RBI’s autonomy has come under increased threat, and the question that requires the most incision is to find a resolution to what one Citibank executive said, “RBI guidelines are just that, guidelines. Not the law of the land.” 

The Scam, as much as a personal element of deceit faced during the tumultuous times, is a brisk read, with some minor hurdles in the form of technicalities that intersperse the volume and tend to disrupt the plot lines. Such technical details are in the realm of share markets and unless negotiated well with either a prior knowledge, or hyperlinking tends to derail the speed, but in no should be considered as a book not worth looking at. As a matter of fact, the third edition with its fifth reprint is testimony to the fact that the book’s market is alive and ever-growing. One only wonders at the end of it as to where have all such journalists disappeared from this country. That Debashis Basu and Sucheta Dalal, partners in real life are indeed partners in crime if they aim at exposing financial crimes of such magnitudes for the multitude in this country who would otherwise be bereft of such understandings had it not been for them. 

Bear Stearns. Note Quote.

Like many of its competitors, Bear Stearns saw the rise of the hedge fund industry during the 1990s and began managing its own funds with outside investor capital under the name Bear Stearns Asset Management (BSAM). Unlike its competitors, Bear hired all of its fund managers internally, with each manager specializing in a particular security or asset class. Objections by some Bear executives, such as co-president Alan Schwartz, that such concentration of risk could raise volatility were ignored, and the impressive returns posted by internal funds such as Ralph Cioffi’s High-Grade Structured Credit Strategies Fund quieted any concerns.

Cioffi’s fund was invested in sophisticated credit derivatives backed by mortgage securities. When the housing bubble burst, he redoubled his bets, raising a new Enhanced Leverage High-Grade Structured Credit Strategies Fund that would use 100 leverage (as compared to the 35 leverage employed by the original fund). The market continued to turn disastrously against the fund, which was soon stuck with billions of dollars worth of illiquid, unprofitable mortgages. In an attempt to salvage the situation and cut his losses, Cioffi launched a vehicle named Everquest Financial and sold its shares to the public. But when journalists at the Wall Street Journal revealed that Everquest’s primary assets were the “toxic waste” of money-losing mortgage securities, Bear had no choice but to cancel the public offering. With spectacular losses mounting daily, investors attempted to withdraw their remaining holdings. In order to free up cash for such redemptions, the fund had to liquidate assets at a loss, selling that only put additional downward pressure on its already underwater positions. Lenders to the fund began making margin calls and threatening to seize its $1.2 billion in collateral.

In a less turbulent market it might have worked, but the subprime crisis had spent weeks on the front page of financial newspapers around the globe, and every bank on Wall Street was desperate to reduce its own exposure. Insulted and furious that Bear had refused to inject any of its own capital to save the funds, Steve Black, J.P. Morgan Chase head of investment banking, called Schwartz and said, “We’re defaulting you.”

The default and subsequent seizure of $400 million in collateral by Merrill Lynch proved highly damaging to Bear Stearns’s reputation across Wall Street. In a desperate attempt to save face under the scrutiny of the SEC, James Cayne made the unprecedented move of using $1.6 billion of Bear’s own capital to prop up the hedge funds. By late July 2007 even Bear’s continued support could no longer prop up Cioffi’s two beleaguered funds, which paid back just $300 million of the credit its parent had extended. With their holdings virtually worthless, the funds had no choice but to file for bankruptcy protection.

On November 14, just two weeks after the Journal story questioning Cayne’s commitment and leadership, Bear Stearns reported that it would write down $1.2 billion in mortgage- related losses. (The figure would later grow to $1.9 billion.) CFO Molinaro suggested that the worst had passed, and to outsiders, at least, the firm appeared to have narrowly escaped disaster.

Behind the scenes, however, Bear management had already begun searching for a white knight, hiring Gary Parr at Lazard to examine its options for a cash injection. Privately, Schwartz and Parr spoke with Kohlberg Kravis Roberts & Co. founder Henry Kravis, who had first learned the leveraged buyout market while a partner at Bear Stearns in the 1960s. Kravis sought entry into the profitable brokerage business at depressed prices, while Bear sought an injection of more than $2 billion in equity capital (for a reported 20% of the company) and the calming effect that a strong, respected personality like Kravis would have upon shareholders. Ultimately the deal fell apart, largely due to management’s fear that KKR’s significant equity stake and the presence of Kravis on the board would alienate the firm’s other private equity clientele, who often competed with KKR for deals. Throughout the fall Bear continued to search for potential acquirers. With the market watching intently to see if Bear shored up its financing, Cayne managed to close only a $1 billion cross-investment with CITIC, the state-owned investment company of the People’s Republic of China.

Bear’s $0.89 profit per share in the first quarter of 2008 did little to quiet the growing whispers of its financial instability. It seemed that every day another major investment bank reported mortgage-related losses, and for whatever reason Bear’s name kept cropping up in discussions of the by-then infamous subprime crisis. Exacerbating Bear’s public relations problem, the SEC had launched an investigation into the collapse of the two BSAM hedge funds, and rumors of massive losses at three major hedge funds further rattled an already uneasy market. Nonetheless, Bear executives felt that the storm had passed, reasoning that its almost $21 billion in cash reserves had convinced the market of its long-term viability.

Instead, on Monday, March 10, 2008, Moody’s downgraded 163 tranches of mortgage- backed bonds issued by Bear across fifteen transactions. The credit rating agency had drawn sharp criticism for its role in the subprime meltdown from analysts who felt the company had overestimated the creditworthiness of mortgage-backed securities and failed to alert the market of the danger as the housing market turned. As a result, Moody’s was in the process of downgrading nearly all of its ratings, but as the afternoon wore on, Bear’s stock price seemed to be reacting far more negatively than those of competitor firms.

Wall Street’s drive toward ever more sophisticated communications devices had created an interconnected network of traders and bankers across the world. On most days, Internet chat and mobile e-mail devices relayed gossip about compensation, major employee departures, and even sports betting lines. On the morning of March 10, however, they were carrying one message to the exclusion of all others: Bear was having liquidity problems. At noon, CNBC took the story public on Power Lunch. As Bear’s stock price fell more than 10 percent to $63, Ace Greenberg frantically placed calls to various executives, demanding that someone publicly deny any such problems. When contacted himself, Greenberg told a CNBC correspondent that the rumors were “totally ridiculous,” angering CFO Molinaro, who felt that denying the rumor would only legitimize it and trigger further panic selling, making prophecies of Bear’s illiquidity self-fulfilling. Just two hours later, however, Bear appeared to have dodged a bullet. News of New York governor Eliot Spitzer’s involvement in a high-class prostitution ring wiped any financial rumors off the front page, leading Bear executives to believe the worst was once again behind them.

Instead, the rumors exploded anew the next day, as many interpreted the Federal Reserve’s announcement of a new $200 billion lending program to help financial institutions through the credit crisis as aimed specifically toward Bear Stearns. The stock dipped as low as $55.42 before closing at $62.97. Meanwhile, Bear executives faced a new crisis in the form of an explosion of novation requests, in which a party to a risky contract tries to eliminate its risky position by selling it to a third party. Credit Suisse, Deutsche Bank, and Goldman Sachs all reported a deluge of novation requests from firms trying to reduce their exposure to Bear’s credit risk. The speed and force of this explosion of novation requests meant that before Bear could act, both Goldman Sachs and Credit Suisse issued e-mails to their traders holding up any requests relating to Bear Stearns pending approval by their credit departments. Once again, the electronically linked gossip network of trading desks around the world dealt a blow to investor confidence in Bear’s stability, as a false rumor circulated that Credit Suisse’s memo had forbidden its traders from engaging in any trades with Bear. The decrease in confidence in Bear’s liquidity could be quantified by the rise in the cost of credit default swaps on Bear’s debt. The price of such an instrument – which effectively acts as five years of insurance against a default on $10 million of Bear’s debt – spiked to more than $626,000 from less than $100,000 in October, indicating heavy betting by some firms that Bear would be unable to pay its liabilities.

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Internally, Bear debated whether to address the rumors publicly, ultimately deciding to arrange a Wednesday morning interview of Schwartz by CNBC correspondent David Faber. Not wanting to encourage rumors with a hasty departure, Schwartz did the interview live from Bear’s annual media conference in Palm Beach. Chosen because of his perceived friendliness to Bear, Faber nonetheless opened the interview with a devastating question that claimed direct knowledge of a trader whose credit department had temporarily held up a trade with Bear. Later during the interview Faber admitted that the trade had finally gone through, but he had called into question Bear’s fundamental capacity to operate as a trading firm. One veteran trader later commented,

You knew right at that moment that Bear Stearns was dead, right at the moment he asked that question. Once you raise that idea, that the firm can’t follow through on a trade, it’s over. Faber killed him. He just killed him.

Despite sentiment at Bear that Schwartz had finally put the company’s best foot forward and refuted rumors of its illiquidity, hedge funds began pulling their accounts in earnest, bringing Bear’s reserves down to $15 billion. Additionally, repo lenders – whose overnight loans to investment banks must be renewed daily – began informing Bear that they would not renew the next morning, forcing the firm to find new sources of credit. Schwartz phoned Parr at Lazard, Molinaro reviewed Bear’s plans for an emergency sale in the event of a crisis, and one of the firm’s attorneys called the president of the Federal Reserve to explain Bear’s situation and implore him to accelerate the newly announced program that would allow investment banks to use mortgage securities as collateral for emergency loans from the Fed’s discount window, normally reserved for commercial banks.

The trickle of withdrawals that had begun earlier in the week turned into an unstoppable torrent of cash flowing out the door on Thursday. Meanwhile, Bear’s stock continued its sustained nosedive, falling nearly 15% to an intraday low of $50.48 before rallying to close down 1.5%. At lunch, Schwartz assured a crowded meeting of Bear executives that the whirlwind rumors were simply market noise, only to find himself interrupted by Michael Minikes, senior managing director,

Do you have any idea what is going on? Our cash is flying out the door! Our clients are leaving us!

Hedge fund clients jumped ship in droves. Renaissance Technologies withdrew approximately $5 billion in trading accounts, and D. E. Shaw followed suit with an equal amount. That evening, Bear executives assembled in a sixth-floor conference room to survey the carnage. In less than a week, the firm had burned through all but $5.9 billion of its $18.3 billion in reserves, and was still on the hook for $2.4 billion in short-term debt to Citigroup. With a panicked market making more withdrawals the next day almost certain, Schwartz accepted the inevitable need for additional financing and had Parr revisit merger discussions with J.P. Morgan Chase CEO James Dimon that had stalled in the fall. Flabbergasted at the idea that an agreement could be reached that night, Dimon nonetheless agreed to send a team of bankers over to analyze Bear’s books.

Parr’s call interrupted Dimon’s 52nd birthday celebration at a Greek restaurant just a few blocks away from Bear headquarters, where a phalanx of attorneys had begun preparing emergency bankruptcy filings and documents necessary for a variety of cash-injecting transactions. Facing almost certain insolvency in the next 24 hours, Schwartz hastily called an emergency board meeting late that night, with most board members dialing in remotely. Bear’s nearly four hundred subsidiaries would make a bankruptcy filing impossibly complicated, so Schwartz continued to cling to the hope for an emergency cash infusion to get Bear through Friday. As J.P. Morgan’s bankers pored over Bear’s positions, they balked at the firm’s precarious position and the continued size of its mortgage holdings, insisting that the Fed get involved in a bailout they considered far too risky to take on alone.

Its role as a counterparty in trillions of dollars’ worth of derivatives contracts bore an eerie similarity to LTCM, and the Fed once again saw the potential for financial Armageddon if Bear were allowed to collapse of its own accord. An emergency liquidation of the firm’s assets would have put strong downward pressure on global securities prices, exacerbating an already chaotic market environment. Facing a hard deadline of credit markets’ open on Friday morning, the Fed and J.P. Morgan wrangled back and forth on how to save Bear. Working around the clock, they finally reached an agreement wherein J.P. Morgan would access the Fed’s discount window and in turn offer Bear a $30 billion credit line that, as dictated by a last-minute insertion by J.P. Morgan general counsel Steven Cutler, would be good for 28 days. As the press release went public, Bear executives cheered; Bear would have almost a month to seek alternative financing.

Where Bear had seen a lifeline, however, the market saw instead a last desperate gasp for help. Incredulous Bear executives could only watch in horror as the firm’s capital continued to fly out of its coffers. On Friday morning Bear burned through the last of its reserves in a matter of hours. A midday conference call in which Schwartz confidently assured investors that the credit line would allow Bear to continue “business as usual” did little to stop the bleeding, and its stock lost almost half of its already depressed value, closing at $30 per share.

All day Friday, Parr set about desperately trying to save his client, searching every corner of the financial world for potential investors or buyers of all or part of Bear. Given the severity of the situation, he could rule out nothing, from a sale of the lucrative prime brokerage operations to a merger or sale of the entire company. Ideally, he hoped to find what he termed a “validating investor,” a respected Wall Street name to join the board, adding immediate credibility and perhaps quieting the now deafening rumors of Bear’s imminent demise. Sadly, only a few such personalities with the reputation and war chest necessary to play the role of savior existed, and most of them had already passed on Bear.

Nonetheless, Schwartz left Bear headquarters on Friday evening relieved that the firm had lived to see the weekend and secured 28 days of breathing room. During the ride home to Greenwich, an unexpected phone call from New York Federal Reserve President Timothy Geithner and Treasury Secretary Henry Paulson shattered that illusion. Paulson told a stunned Schwartz that the Fed’s line of credit would expire Sunday night, giving Bear 48 hours to find a buyer or file for bankruptcy. The demise of the 28-day clause remains a mystery; the speed necessary early Friday morning and the inclusion of the clause by J.P. Morgan’s general counsel suggest that Bear executives had misinterpreted it, although others believe that Paulson and Geithner had soured both on Bear’s prospects and on market perception of an emergency loan from the Fed as Friday wore on. Either way, the Fed had made up its mind, and a Saturday morning appeal from Schwartz failed to sway Geithner.

All day Saturday prospective buyers streamed through Bear’s headquarters to pick through the rubble as Parr attempted to orchestrate Bear’s last-minute salvation. Chaos reigned, with representatives from every major bank on Wall Street, J. C. Flowers, KKR, and countless others poring over Bear’s positions in an effort to determine the value of Bear’s massive illiquid holdings and how the Fed would help in financing. Some prospective buyers wanted just a piece of the dying bank, others the whole firm, with still others proposing more complicated multiple-step transactions that would slice Bear to ribbons. One by one, they dropped out, until J. C. Flowers made an offer for 90% of Bear for a total of up to $2.6 billion, but the offer was contingent on the private equity firm raising $20 billion from a bank consortium, and $20 billion in risky credit was unlikely to appear overnight.

That left J.P. Morgan. Apparently the only bank willing to come to the rescue, J.P. Morgan had sent no fewer than 300 bankers representing 16 different product groups to Bear headquarters to value the firm. The sticking point, as with all the bidders, was Bear’s mortgage holdings. Even after a massive write-down, it was impossible to assign a value to such illiquid (and publicly maligned) securities with any degree of accuracy. Having forced the default of the BSAM hedge funds that started this mess less than a year earlier.

On its final 10Q in March, Bear listed $399 billion in assets and $387 billion in liabilities, leaving just $12 billion in equity for a 32 leverage multiple. Bear initially estimated that this included $120 billion of “risk-weighted” assets, those that might be subject to subsequent write-downs. As J.P. Morgan’s bankers worked around the clock trying to get to the bottom of Bear’s balance sheet, they came to estimate the figure at nearly $220 billion. That pessimistic outlook, combined with Sunday morning’s New York Times article reiterating Bear’s recent troubles, dulled J.P. Morgan’s appetite for jumping onto what appeared to be a sinking ship. Later, one J.P. Morgan banker shuddered, recalling the article. “That article certainly had an impact on my thinking. Just the reputational aspects of it, getting into bed with these people.”

On Saturday morning J.P. Morgan backed out and Dimon told a shell-shocked Schwartz to pursue any other option available to him. The problem was, no such alternative existed. Knowing this, and the possibility that the liquidation of Bear could throw the world’s financial markets into chaos, Fed representatives immediately phoned Dimon. As it had in the LTCM case a decade ago, the Fed relied heavily on suasion, or “jawboning,” the longtime practice of attempting to influence market participants by appeals to reason rather than a declaration by fiat. For hours, J.P. Morgan’s and the Fed’s highest-ranking officials played a game of high-stakes poker, with each side bluffing and Bear’s future hanging in the balance. The Fed wanted to avoid unprecedented government participation in the bailout of a private investment firm, while J.P. Morgan wanted to avoid taking on any of the “toxic waste” in Bear’s mortgage holdings. “They kept saying, ‘We’re not going to do it,’ and we kept saying, ‘We really think you should do it,’” recalled one Fed official. “This went on for hours . . . They kept saying, ‘We can’t do this on our own.’” With the hours ticking away until Monday’s Australian markets would open at 6:00 p.m. New York time, both sides had to compromise.

On Sunday afternoon, Schwartz stepped out of a 1:00 emergency meeting of Bear’s board of directors to take the call from Dimon. The offer would come somewhere in the range of $4 to 5 per share. Hearing the news from Schwartz, the Bear board erupted with rage. Dialing in from the bridge tournament in Detroit, Cayne exploded, ranting furiously that the firm should file for bankruptcy protection under Chapter 11 rather than accept such a humiliating offer, which would reduce his 5.66 million shares – once worth nearly $1 billion – to less than $30 million in value. In reality, however, bankruptcy was impossible. As Parr explained, changes to the federal bankruptcy code in 2005 meant that a Chapter 11 filing would be tantamount to Bear falling on its sword, because regulators would have to seize Bear’s accounts, immediately ceasing the firm’s operations and forcing its liquidation. There would be no reorganization.

Even as Cayne raged against the $4 offer, the Fed’s concern over the appearance of a $30 billion loan to a failing investment bank while American homeowners faced foreclosures compelled Treasury Secretary Paulson to pour salt in Bear’s wounds. Officially, the Fed had remained hands-off in the LTCM bailout, relying on its powers of suasion to convince other banks to step up in the name of market stability. Just 10 years later, they could find no takers. The speed of Bear’s collapse, the impossibility of conducting true due diligence in such a compressed time frame, and the incalculable risk of taking on Bear’s toxic mortgage holdings scared off every buyer and forced the Fed from an advisory role into a principal role in the bailout. Worried that a price deemed at all generous to Bear might subsequently encourage moral hazard – increased risky behavior by investment banks secure in the knowledge that in a worst-case scenario, disaster would be averted by a federal bailout – Paulson determined that the transaction, while rescuing the firm, also had to be punitive to Bear shareholders. He called Dimon, who reiterated the contemplated offer range.

“That sounds high tome,” Paulson told the J.P. Morgan chief. “I think this should be done at a very low price.” It was moments later that Braunstein called Parr. “The number’s $2.” Under Delaware law, executives must act on behalf of both shareholders and creditors when a company enters the “zone of insolvency,” and Schwartz knew that Bear had rocketed through that zone over the past few days. Faced with bankruptcy or J.P. Morgan, Bear had no choice but to accept the embarrassingly low offer that represented a 97% discount off its $32 close on Friday evening. Schwartz convinced the weary Bear board that $2 would be “better than nothing,” and by 6:30 p.m., the deal was unanimously approved.

After 85 years in the market, Bear Stearns ceased to exist.

Delta Hedging.

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The principal investors in most convertible securities are hedge funds that engage in convertible arbitrage strategies. These investors typically purchase the convertible and simultaneously sell short a certain number of the issuer’s common shares that underlie the convertible. The number of shares they sell short as a percent of the shares underlying the convertible is approximately equal to the risk-neutral probability at that point in time (as determined by a convertible pricing model that uses binomial option pricing as its foundation) that the investor will eventually convert the security into common shares. This probability is then applied to the number of common shares the convertible security could convert into to determine the number of shares the hedge fund investor should sell short (the “hedge ratio”).

As an example, assume a company’s share price is $10 at the time of its convertible issuance. A hedge fund purchases a portion of the convertible, which gives the right to convert into 100 common shares of the issuer. If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the issuer’s stock on the same date as the convertible purchase. During the life span of the convertible, the hedge fund investor may sell more shares short or buy shares, based on the changing hedge ratio. To illustrate, if one month after purchasing the convertible (and establishing a 65-share short position) the issuer’s share price decreases to $9, the hedge ratio may drop from 65 to 60%. To align the hedge ratio with the shares sold short as a percent of shares the investor has the right to convert the security into, the hedge fund investor will need to buy five shares in the open market from other shareholders and deliver those shares to the parties who had lent the shares originally. “Covering” five shares of their short position leaves the hedge fund with a new short position of 60 shares. If the issuer’s share price two months after issuance increases to $11, the hedge ratio may increase to 70%. In this case, the hedge fund investor may want to be short 70 shares. The investor achieves this position by borrowing 10 more shares and selling them short, which increases the short position from 60 to 70 shares. This process of buying low and selling high continues until the convertible either converts or matures.

The end result is that the hedge fund investor is generating trading profits throughout the life of the convertible by buying stock to reduce the short position when the issuer’s share price drops, and borrowing and selling shares short when the issuer’s share price increases. This dynamic trading process is called “delta hedging,” which is a well-known and consistently practiced strategy by hedge funds. Since hedge funds typically purchase between 60% and 80% of most convertible securities in the public markets, a significant amount of trading in the issuer’s stock takes place throughout the life of a convertible security. The purpose of all this trading in the convertible issuer’s common stock is to hedge share price risk embedded in the convertible and create trading profits that offset the opportunity cost of purchasing a convertible that has a coupon that is substantially lower than a straight bond from the same issuer with the same maturity.

In order for hedge funds to invest in convertible securities, there needs to be a substantial amount of the issuer’s common shares available for hedge funds to borrow, and adequate liquidity in the issuer’s stock for hedge funds to buy and sell shares in relation to their delta hedging activity. If there are insufficient shares available to be borrowed or inadequate trading volume in the issuer’s stock, a prospective issuer is generally discouraged from issuing a convertible security in the public markets, or is required to issue a smaller convertible, because hedge funds may not be able to participate. Alternatively, an issuer could attempt to privately place a convertible with a single non-hedge fund investor. However, it may be impossible to find such an investor, and even if found, the required pricing for the convertible is likely to be disadvantageous for the issuer.

When a new convertible security is priced in the public capital markets, it is generally the case that the terms of the security imply a theoretical value of between 102% and 105% of face value, based on a convertible pricing model. The convertible is usually sold at a price of 100% to investors, and is therefore underpriced compared to its theoretical value. This practice provides an incentive for hedge funds to purchase the security, knowing that, by delta hedging their investment, they should be able to extract trading profits at least equal to the difference between the theoretical value and “par” (100%). For a public market convertible with atypical characteristics (e.g., an oversized issuance relative to market capitalization, an issuer with limited stock trading volume, or an issuer with limited stock borrow availability), hedge fund investors normally require an even higher theoretical value (relative to par) as an inducement to invest.

Convertible pricing models incorporate binomial trees to determine the theoretical value of convertible securities. These models consider the following factors that influence the theoretical value: current common stock price; anticipated volatility of the common stock return during the life of the convertible security; risk-free interest rate; the company’s stock borrow cost and common stock dividend yield; the company’s credit risk; maturity of the convertible security; and the convertible security’s coupon or dividend rate and payment frequency, conversion premium, and length of call protection.

Credit Bubbles. Thought of the Day 90.0

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At the macro-economic level of the gross statistics of money and loan supply to the economy, the reserve banking system creates a complex interplay between money, debt, supply and demand for goods, and the general price level. Rather than being constant, as implied by theoretical descriptions, money and loan supplies are constantly changing at a rate dependent on the average loan period, and a complex of details buried in the implementation and regulation of any given banking system.

Since the majority of loans are made for years at a time, the results of these interactions play out over a long enough time scale that gross monetary features of regulatory failure, such as continuous asset price inflation, have come to be regarded as normal, e.g. ”House prices always go up”. The price level however is not only dependent on purely monetary factors, but also on the supply and demand for goods and services, including financial assets such as shares, which requires that estimates of the real price level versus production be used. As a simplification, if constant demand for goods and services is assumed as shown in the table below, then there are two possible causes of price inflation, either the money supply available to purchase the good in question has increased, or the supply of the good has been reduced. Critically, the former is simply a mathematical effect, whilst the latter is a useful signal, providing economic information on relative supply and demand levels that can be used locally by consumers and producers to adapt their behaviour. Purely arbitrary changes in both the money and the loan supply that are induced by the mechanical operation of the banking system fail to provide any economic benefit, and by distorting the actual supply and demand signal can be actively harmful.

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Credit bubbles are often explained as a phenomena of irrational demand, and crowd behaviour. However, this explanation ignores the question of why they aren’t throttled by limits on the loan supply? An alternate explanation which can be offered is that their root cause is periodic failures in the regulation of the loan and money supply within the commercial banking system. The introduction of widespread securitized lending allows a rapid increase in the total amount of lending available from the banking system and an accompanying if somewhat smaller growth in the money supply. Channeled predominantly into property lending, the increased availability of money from lending sources, acted to increase house prices creating rational speculation on their increase, and over time a sizeable disruption in the market pricing mechanisms for all goods and services purchased through loans. Monetary statistics of this effect such as the Consumer Price Index (CPI) for example, are however at least partially masked by production deflation from the sizeable productivity increases over decades. Absent any limit on the total amount of credit being supplied, the only practical limit on borrowing is the availability of borrowers and their ability to sustain the capital and interest repayments demanded for their loans.

Owing to the asymmetric nature of long term debt flows there is a tendency for money to become concentrated in the lending centres, which then causes liquidity problems for the rest of the economy. Eventually repayment problems surface, especially if the practice of further borrowing to repay existing loans is allowed, since the underlying mathematical process is exponential. As general insolvency as well as a consequent debt deflation occurs, the money and loan supply contracts as the banking system removes loan capacity from the economy either from loan repayment, or as a result of bank failure. This leads to a domino effect as businesses that have become dependent on continuously rolling over debt fail and trigger further defaults. Monetary expansion and further lending is also constrained by the absence of qualified borrowers, and by the general unwillingness to either lend or borrow that results from the ensuing economic collapse. Further complications, as described by Ben Bernanke and Harold James, can occur when interactions between currencies are considered, in particular in conjunction with gold-based capital regulation, because of the difficulties in establishing the correct ratio of gold for each individual currency and maintaining it, in a system where lending and the associated money supply are continually fluctuating and gold is also being used at a national level for international debt repayments.

The debt to money imbalance created by the widespread, and global, sale of Asset Backed securities may be unique to this particular crisis. Although asset backed security issuance dropped considerably in 2008, as the resale markets were temporarily frozen, current stated policy in several countries, including the USA and the United Kingdom, is to encourage further securitization to assist the recovery of the banking sector. Unfortunately this appears to be succeeding.

A Monetary Drain due to Excess Liquidity. Why is the RBI Playing Along

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And so we thought demonetization was not a success. Let me begin with the Socratic irony to assume that it was indeed a success, albeit not in arresting black money for sure. Yes, the tax net has widened and the cruelty of smashing down the informal sector to smithereens to be replaceable with a formal economy, more in the manner of sucking the former into the latter has been achieved. As far as terror funding is concerned, it is anybody’s guess and so let them be with their imaginations. What none can deny is the surge in deposits and liquidity in the wake of demonetization. But, what one has been consciously, or through an ideological-driven standpoint denying is the fact that demonetization clubbed with the governmental red carpet for foreign direct investment has been an utter failure to attract money into the country. And the reason attributed for the same has been a dip in the economy as a result of the idiosyncratic decision of November 8 added with the conjuring acts of mathematics and statistics in tweaking base years to let go off the reality behind a depleting GDP and project the country as the fastest growing emerging economy in the world. The irony I started off with is defeated here, for none of the claims that the government propaganda machine churns out on the assembly line are in fact anywhere near the truth. But, thats what a propaganda is supposed to doing, else why even call it that, or even call for a successful governance and so on and on (sorry for the Žižekian interjections here).

Assuming the irony still has traces and isn’t vanquished, it is time to move on and look into the effects of what calls for a financial reality-check. Abruptly going vertically through the tiers here, it is recently been talked about in the corridors of financial power that the Reserve Bank of India (RBI) is all set to drain close to 1.5 lakh crore in excess liquidity from the financial system as surging foreign investments forces the central bank to absorb the dollar inflows and sell rupees to cap gains in the local currency. This is really interesting, for the narrative or the discourse is again symptomatic of what the government wants us to believe, and so believe we shall, or shall we? After this brief stopover, chugging off again…Foreign investments into debt and shares have reached a net $31 billion this year, compared with $2.7 billion in sales last year, due to factors including India’s low inflation and improving economic growth. This is not merely a leap, but a leap of faith, in this case numerically. Yes, India is suffering from low inflation, but it ain’t deflation, but rather disinflation. There is a method to this maddening reason, if one needs to counter what gets prime time economic news in the media or passes on as Chinese Whispers amongst activists hell-bent on proving the futility of the governmental narrative. There is nothing wrong in the procedure as long as this hell-bent-ness is cooked in proper proportions of reason. But, why call it disinflation and not deflation? A sharp drop in inflation below the Reserve Bank of India’s (RBI’s) 4% target has been driven by only two items – pulses and vegetables. the consumer price index (CPI), excluding pulses and vegetables, rose at the rate of 3.8% in July, much higher than the official headline figure of 2.4% inflation for the month. The re-calculated CPI is based on adjusted weights after excluding pulses and vegetables from the basket of goods and services. The two farm items – pulses and vegetables – have a combined weight of only 8.4% in the consumer price index (CPI) basket. However, they have wielded disproportionate influence over the headline inflation number for more than a year now owing to the sharp volatility in their prices. So, how does it all add up? Prices of pulses and vegetables have fallen significantly this year owing to increased supply amid a normal monsoon last year, as noted by the Economic Survey. The high prices of pulses in the year before and the government’s promises of more effective procurement may have encouraged farmers to produce more last year, resulting in a glut. Demonetisation may have added to farmers’ woes by turning farm markets into buyers’ markets. Thus, there does not seem to be any imminent threat of deflation in India. A more apt characterization of the recent trends in prices may be ‘disinflation’ (a fall in the inflation rate) rather than deflation (falling prices) given that overall inflation, excluding pulses and vegetables, is close to the RBI target of 4%. On the topicality of improving economic growth in the country, this is the bone of contention either weakening or otherwise depending on how the marrow is key up.

Moving on…The strong inflows have sent the rupee up nearly 7 per cent against the dollar and forced the RBI to buy more than $10 billion in spot market and $10 billion in forwards this year – which has meant an equivalent infusion in rupees. Those rupee sales have added liquidity into a financial system already flush with cash after a ban on higher-denomination currency in November sparked a surge in bank deposits. Average daily liquidity has risen to around Rs 3 lakh crore, well above the RBI’s goal of around Rs 1 lakh crore, according to traders. That will force the RBI to step up debt sales to remove liquidity and avoid any inflationary impact. Traders estimate the RBI will need to drain Rs 1 lakh crore to Rs 1.4 lakh crore ($15.7 billion to $22 billion) after taking into account factors such as festival-related consumer spending that naturally reduce cash in the system. How the RBI drains the cash will thus become an impact factor for bond traders, who have benefitted from a rally in debt markets. The RBI has already drained about Rs 1 lakh crore via one-year bills under a special market stabilisation scheme (MSS), as well as Rs 30,000 crore in longer debt through open market sales. MSS (Market Stabilisation Scheme) securities are issued with the objective of providing the RBI with a stock of securities with which it can intervene in the market for managing liquidity. These securities are issued not to meet the government’s expenditure. The MSS scheme was launched in April 2004 to strengthen the RBI’s ability to conduct exchange rate and monetary management. The bills/bonds issued under MSS have all the attributes of the existing treasury bills and dated securities. These securities will be issued by way of auctions to be conducted by the RBI. The timing of issuance, amount and tenure of such securities will be decided by the RBI. The securities issued under the MSS scheme are matched by an equivalent cash balance held by the government with the RBI. As a result, their issuance will have a negligible impact on the fiscal deficit of the government. It is hoped that the procedure would continue, noting staggered sales in bills, combined with daily reverse repo operations and some long-end sales, would be easily absorbable in markets. The most disruptive fashion would be stepping up open market sales, which tend to focus on longer-ended debt. That may send yields higher and blunt the impact of the central bank’s 25 basis point rate cut in August. The RBI does not provide a timetable of its special debt sales for the year. and if the RBI drains the cash largely through MSS bonds then markets wont get too much impacted. This brings us to close in proving the success story of demonetization as a false beacon, in that with a surge in liquidity, the impact on the market would be negligible if MSS are resorted to culminating in establishing the fact that demonetization clubbed with red-carpeted FDI has had absolutely no nexus in the influx of dollars and thus any propaganda of this resulting as a success story of demonetization is to be seen as purely rhetoric. QED.

Stocks and Fundamentalists’ Behavior

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Let us consider a simple stock market with the following characteristics. A large amount of stock is traded. In the market, there are three typical groups of traders with different strategies: fundamentalists, chartists, and noise traders. Traders can invest either in money or in stock. Since the model is designed to describe stock price movements over short periods, such as one day, the dividend from stock and the interest rate for the risk-free asset will be omitted for simplicity. Traders are myopic and bent on maximizing utility. Their utility depends on the price change they expect, and on their excess demand for stock rather than simply their demand. Their excess demand is derived from utility maximization.

Let Ytf be the amount of money that a fundamentalist holds at a time t and Xtf be the number of shares purchased by a fundamentalist at time t. Let pt be the price per share at time t. The fundamentalist’s budget constrain is given by

Ytf + ptXtf = Yt-1f + ptXt-1f —– (1)

or equivalently

ytf + ptxtf = 0 —– (2)

where

ytf = Ytf – Yt-1f

denotes the fundamentalist’s excess demand for money, and

xtf = Xtf – Xt-1f

his excess demand for stock. Suppose that the fundamentalist’s preferences are represented by the utility function,

u = α(ytf + pt+1fxtf + βxtf – (1 + βxtf) log (1 + βxtf) —– (3)

where pt+1f denotes the fundamentalist’s expectation in period t about the price in the following period t + 1. The parameters α and β are assumed to be positive. Inserting (2) into (3) the fundamentalist’s utility maximization problem becomes:

maxxtf  u =  α(pt+1– pt)xtf  βxtf – (1 + βxtf) log (1 + βxtf) —– (4)

The utility function u satisfies the standard properties: u′ (|xtf|) > 0, u′′(|xtf|) < 0 ∀ |xf|t ≤ |xf*|, where |xf*| denotes the absolute value of xf producing a maximum utility. Thus, the utility function is strictly concave. It depends on the price change expected by fundamentalists (pt+1– pt) as well as fundamentalist’s excess demand for stock xtf. The first part α(pt+1– pt)xtf implies that a rise in the expected price change increases his utility. The remaining part expresses his attitude toward risk. Even if the expected price change is positive, he does not want to invest his total wealth in the stock, and vice versa. In this sense, fundamentalists are risk averse. β is the parameter that sets the lower limitation on excess demand. All excess demand for stock derived from the utility maximization is limited to -1/β. When the expected price change (pt+1– pt) is positive, the maximum value of the utility function is also positive. This means that fundamentalists try to buy stock. By analogy, when the expected price change (pt+1– pt) is negative, the maximum value of the utility function is negative, which means that they try to sell. The utility maximization problem (4) is solved for the fundamentalist’s excess demand,

xtf = 1/β(exp(α(pt+1– pt)/β) – 1) —– (5)

Excess demand increases as the expected price change (pt+1– pt) increases. It should be noticed that the optimal value of excess supply is limited to -1/β, while the optimal value of excess demand is not restricted. Since there is little loss of generality in fixing the parameter β at unity, below, we will assume β to be constant and equal to 1. Then let us think of the fundamentalist’s expectation formation. We assume that he form his price expectation according to a simple adaptive scheme:

pt+1f = p+ ν(p* – pt) —– (6)

We see from Equation (6) that fundamentalists believe that the price moves towards the fundamental price p* by factor ν. To sum up fundamentalists’ behavior: if the price pt is below their expected price, they will try to buy stock, because they consider the stock to be undervalued. On the contrary, if the price is above the expected value, they will try to sell, because they consider the stock to be overvalued.

Debt versus Equity Financing. Why the Difference matters?

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There is a lot of confusion between debt and equity financing, though there is a clear line of demarcation as such. Whats even more sorry as a state of affair is these jargons being used pretty platitudinously, and this post tries to recover from any such usage now bordering on the colloquial, especially on the activists’s side of the camp.

What is Debt Financing?

Debt financing is a means of raising funds to generate working capital that is used to pay for projects or endeavors that the issuer of the debt wishes to undertake. The issuer may choose to issue bonds, promissory notes or other debt instruments as a means of financing the debt associated with the project. In return for purchasing the notes or bonds, the investor is provided with some type of return above and beyond the original amount of purchase.

Debt financing is very different from equity financing. With equity financing, revenue is generated by issuing shares of stock at a public offering. The shares remain active from the point of issue and will continue to generate returns for investors as long as the shares are held. By contrast, debt financing involves the use of debt instruments that are anticipated to be repaid in full within a given time frame.

With debt financing, the investor anticipates earning a return in the form of interest for a specified period of time. At the end of the life of a bond or note, the investor receives the full face value of the bond, including any interest that may have accrued. In some cases, bonds or notes may be structured to allow for periodic interest payments to investors throughout the life of the debt instrument.

For the issuer of the bonds or notes, debt financing is a great way to raise needed capital in a short period of time. Since it does not involve the issuing of shares of stock, there is a clear start and end date in mind for the debt. It is possible to project the amount of interest that will be repaid during the life of the bond and thus have a good idea of how to meet those obligations without causing undue hardship. Selling bonds is a common way of funding special projects, and is utilized by municipalities as well as many corporations.

Investors also benefit from debt financing. Since the bonds and notes are often set up with either a fixed rate of interest or a variable rate with a guarantee of a minimum interest rate, it is possible to project the return on the investment over the life of the bond. There is relatively little risk with this type of debt financing, so the investor does not have to be concerned about losing money on the deal. While the return may be somewhat modest, it is reliable. The low risk factor makes entering into a debt financing strategy very attractive for conservative investors.

What is Equity Financing?

Also known as share capital, equity financing is the strategy of generating funds for company projects by selling a limited amount of stock to investors. The financing may involve issuing shares of common stock or preferred stock. In addition, the shares may be sold to commercial or individual investors, depending on the type of shares involved and the governmental regulations that apply in the nation where the issuer is located. Both large and small business owners make use of this strategy when undertaking new company projects.

Equity financing is a means of raising the capital needed for some sort of company activity, such as the purchase of new equipment or the expansion of company locations or manufacturing facilities. The choice of which means of financing to use will often depend on the purpose that the business is pursuing, as well as the company’s current credit rating. With the strategy of equity financing, the expectation is that the project funded with the sale of the stock will eventually begin to turn a profit. At that point, the business not only is able to provide dividends to the shareholders who purchased the stock, but also realize profits that help to increase the financial stability of the company overall. In addition, there is no outstanding debt owed to a bank or other lending institution. The end result is that the company successfully funds the project without going into debt, and without the need to divert existing resources as a means of financing the project during its infancy.

While equity financing is an option that is often ideal for funding new projects, there are situations where looking into debt financing is in the best interests of the company. Should the project be anticipated to yield a return in a very short period of time, the company may find that obtaining loans at competitive interest rates is a better choice. This is especially true if this option makes it possible to launch the project sooner rather than later, and take advantage of favorable market conditions that increase the projected profits significantly. The choice between equity financing and debt financing may also involve considering different outcomes for the project. By considering how the company would be affected if the project fails, as well as considering the fortunes of the company if the project is successful, it is often easier to determine which financing alternative will serve the interests of the business over the long-term.

In summation, equity financing is the technique for raising capital organization stock to speculators whereas debt financing is the technique of raising capital by borrowing. Equity financing is offered forms like gained capital or revenue while debt financing is available in form of loan. Equity financing involves high risk as compare to debt financing. Equity holders have security but debt holders don’t have. In equity financing, entrepreneurs don’t need to channel benefits into credit reimbursement while in debt financing, entrepreneurs’ have to channel profit into repayment of loans.

Rejoinder to COMMODITY TRADING FIRMS: MORE DARKER AND SINISTER THAN CORPORATIONS

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Commodity Trading Firms (CTFs) are listed on stock markets, meaning registrations are not issues at all. They are trading entities and come out with listing in what is called a split listing, i.e. across stock exchanges to accrue better value and worth, at least they set the rules when they launch their IPOs. As to how they are different from IFIs, the idea is where do they invest and how do they invest? They are private firms to begin with and have no truck with contingency reserve funds that tie the IFIs with government and/or transnational governments. Even in the absence of any contingency reserve agreements, governments put money, rather channel money in MDBs/BDBs. This differentiates them from CTF (commodity trading firms). The investment from CTF moves thusly: investment through convertible loans tied up with rights (ownership/control), especially in places fraught with uncertain civil life versus the military regimes, markets drying up and no-takers for risks. These CTF move in there and set up shop and demand rights be transferred to them through a more than required majority of release of new shares. The deal gets struck.