Global And Globally Oriented Leadership
- An Indian Perspective
Basudeb Sen
Leadership Distinction
In the past decade or so, India has taken the opportunity to tread the path of economic globalization. Being in this path demands leadership of a different character and quality than the leadership required in a closed, slowing growing poor economy of the decades prior to 1991 when India rescued herself from bankruptcy by reforms for progressively freeing her citizens from the iron chains of the Government and its oppressive operating agencies and progressively opening up the economy to the world outside. Even though the reforms were/ are introduced with great resistance and reluctance, India has made substantial progress along the path of economic globalization that in turn has led to some measure of cultural and social globalization. But the extent of globalization of the Indian economy is as yet far behind many of the advanced, high-income or middle-income economies of the world. It may take few decades before India becomes a true globalized economy. We need effective leadership to steer us in our long travel through the process of globalization, before India can become an important part of the global leadership. The tasks of the leadership of a globalizing economy and the tasks of global leadership are different: the nature and quality of leadership for the different tasks are different. Global leadership may therefore have different connotations and the leadership requirement for nations that are accepted global leaders today are not the same as those for nations that are on the path of globalization, like India or China. This distinction is important from both analytical and practical point of view and is consistent with the aspirations of nations to become globally accepted leaders of the community of nations.
2. Most human beings or groups or societies aspire to be leaders, a few actually become and still fewer succeed in making a significant impact on the environment, the fields or organizations they lead and the rest of the world. That India will in a time of a few decades will be second or third largest economy of the world ignites our imagination and dreams of establishing our leadership, at least in economic and business sphere. Without trying to undermine such dreams, it is necessary to understand the situation of global leadership today and what the prospect of economic prosperity of India means in terms of the requirement for and scope of assuming global leadership.
3. At the time of Indian Independence, a vision of assuming the role of global leadership led to our initiatives of non aligned movement that might have caused a great sensation in India and that the World, at best, ignored. The initiative did bring nothing of significance to Indian economic history or the global political scenario. Maybe, trying to play the role of a leader in the global arena cost us something in terms of economic and social progress. Leadership does not come from a mere desire to lead: it emerges from the interplay of challenges in the environment and nation’s/ person’s capabilities and focused goals.
Scope of Global Leadership
4. Let us look at the current environment. Who are which nations provide global leadership today? Irrespective of whether the present leadership is successful or not, do we have a leadership role that we can effectively discharge or are expected of by the community of nations? Do we have the capabilities or strengths that would help us assume the role of global leadership in any field like Peace and Anti-terrorism, economic prosperity, military and weapons power, Science and technology, Education and Quality of Life, Environmental Protection, Sports and Culture, World Politics and Diplomacy or Business, Trade and Commerce? How do we stand in all these fields in relation to USA, European Union, China, Russia, Japan, Australia or the Arabs countries?
5. Even within business, trade and commerce, where do we excel and capable of beating international competition most because of our productivity, innovation and/ or economy in scale of operation? Is that in steel manufacturing, iron-ore mining, oil refining, shipbuilding, construction, entertainment, tourism, aviation, space travel, nuclear technology, information technology, molecular bio-technology, medical treatment, school education, management education, toy making, etc? Or, for example, in rice and wheat production is our farming productive enough. Can we impact international prices in some products because we are the dominant buyer or seller or both? The answers will determine where we need global leadership of what type. There is no need, however, to seek detailed answers to these questions and debate here. We should be fairly clear where we stand. We know in which areas we have flourished and won global recognition and to which extent. And, what our future prospects are.
6. Let us then look at the prospects for the next two/ three decades. We are projected to be the second or third largest economy in the World in terms of National Income (Gross National Product). But when we reach the size of the US economy, an average Indian will still be one-third as rich as an average American (in terms of per capita income on purchasing power parity basis). Our standards of living will still be poorer than many of the existing advanced countries. Will that be an adequate strength that would make the whole world search for India to provide global leadership? The answer to this question lies with the time: time will tell. But one can identify a few strengths may be demanded of future global leadership in any field/ activity. These would include, besides the strength of economic prosperity, considerably high trading and economic relations with countries spread over many regions, military capability, power of innovation and progress in the some of the emerging fields of science and technology, a transparent and open, democratic society with very limited role for corruption and bribery.
Emerging Nature of Global Leadership
7. In future, no nation or organization may be expected to be the supreme leader in any business or politics or technology of significance. Some groups of nations or groups of companies/ organizations or groups of individuals will be part of a global leadership coalition. That is the way the world is evolving. Unless one participates in the global activity in a substantive way and with significant stake, others are not going to accept one as part of the global leadership. Acceptability will not come from the strength of population or size of economy, but from the extent of global exposure and experience in the relevant fields/ activity. Global leadership will not attract followers. Global leadership will be recognized by their impact and influence on the future of the global economic, political or social activity of each type. Absolute large, commanding leaders will fall: in economics and business due to competition regulation and freer international trade, and in politics because of diversity of views and cultures. Those who get into the global leadership of any activity will be respected as friends rather than as formidable foes or adversaries. Global leadership in future will involve leading coalitions of networks of entities across the globe – networks that are able to enhance effectiveness, value and contribution of each entity and collaborative effort in scientific research, technological applications, economic integration and prosperity.
8. There is no need to bring in specific illustrations to elaborate on global leadership. We all know how mobile, inter-net and entertainment companies collaborate to establish and maintain their individual industry leadership positions. How credit card businesses and retailing business or airlines businesses collaborate. We know of the collaboration of research institutes and universities in the field of scientific research, or of the collaboration among different nations against money laundering, terrorism and global warming. Yet, businesses are operating under increasing competition and competitive threats.
Global leadership is now beyond competition: it is more about meaningful collaborations.
Role of Indian Leadership
9. It is this context in which India needs to view its role in global leadership. Currently, however, India is far from the stage of being part of global leaderships in most areas/ fields of significance. The only record it has is of sustained high economic growth in the last 12-15 years achieved mainly through economic liberalization from the suffocating web of State control and oppression and transition from a closed, isolated economy to an open economy. India’s trade and capital flow links with the world economy have strengthened, though yet very tiny in relation to the size of the economy. Indian businesses have just started acquiring businesses abroad. India is yet to make her impact felt on the international market for goods and services (except in the case information technology enabled services and other business process outsourcing from foreign countries). India is still not a major power in WTO negotiations and is yet to get a permanent seat on the UN Security Council. Many Indians may be engaged abroad at the frontiers of scientific and technological research, but India’s own achievement has not been significant enough to attract global attention. Indian democracy has a long way to go beyond mere elections to ensure civil liberties, responsive and performing governance, human rights and justice and to eradicate bribery, corruption, illiteracy and oppression of the women. It is difficult to envision a global leadership role for India in the near future.
10. This does not mean, however, that India does not need to build up her leadership strengths. The sustainability of India’s high economic growth performance and India’s rapid progress on the path of globalization is itself critically dependent on the development availability of sufficient mass of globally oriented managers. The new leadership that will steer us through a long period of sustained, high economic growth to a position of recognition in the global market place and the global society, would be different from the past leadership so afraid of international competition, international capital, international investors and international trade and so fond of controlling and directing the economic, social and cultural lives of Indian individuals. The new leadership in India has to first provide leadership to India before it can dream about providing leadership globally or become part of the global leadership.
11. The new leadership will make the Indian economy more open, will welcome more global exposure and exchange than less, will be prepared to deal with the situation post full convertibility of the Rupee, will not be scared off military, nuclear power and other economic collaboration agreements with different countries of the world, will not be scared of imaginary loss of sovereignty to foreigners and will not be dependent on government policies and initiatives or blessings. A coward leadership, however wise but afraid of the national/ provincial Govt. or foreign powers, cannot lead a nation to any pride of place in the world economy or the community of nations.
12. The mass and quality of globally oriented leadership among Indians need to grow. Leadership of an entity may be localized and yet globally oriented (or, of global order) depending primarily on (a) the perspective/ approach to standards and practices with which its leadership operates and (b) the scale of impact it makes or seeks to make on its chosen field of operation and other fields. The leadership that benchmarks its management practices, corporate governance and operational standards to its geographically local competitors is essentially a localized order leadership. The leadership that aims at standards and practices better than those that prevail in its local environment is a globally oriented leadership. Similarly, the leadership that has already established / seeks to establish it leading position in an extended market beyond its local environment is also at a globally oriented leadership level. It is necessary to point out at this stage that all globally oriented leadership may not be of the same global order. There is a continuum of globally oriented leadership scale along which a leadership can upgrade itself over time at varying pace. Thus, India needs more and more globally oriented leadership at higher and higher levels on the continuum of leadership of global order as India herself lifts her level of globalization over the years.
13. This new leadership is fast developing in the country. They believe in their competence are acquiring expertise and experience working along with foreigners as colleagues, partners, competitors, consultants, clients or employers within the country or abroad. Whether the Indian leaders are in small or large businesses, or whether they are in education and training or in administration and government or cultural activities or sports, whether they are operating in India or abroad, or whether they are in the private or public sector, they are all becoming progressively more globally oriented leaders than before.
Globally oriented leaders are a scarce and very valuable resource with high demand worldwide. If India does not offer them opportunities and freedom to face the challenges of India in an increasingly global sing world, foreign countries and companies will draw them. Many of the Indian private sector companies, some public sector companies and all foreign companies operating in India are incubating numerous globally oriented leaders who are Indians. Even as they take up higher positions of leadership, they all will be either locally operating, globally oriented (LOGO) leaders or globally operating, globally oriented (GOGO) leaders. Many of them are frequent travelers both within the country and across the globe.
They are constantly monitoring the international environment; tracking the India’s economic and political developments over mobiles, inter net and other devices. They are agile, vibrant, dynamic, lively, competent and full of confidence.
14. The process of globalization itself breeds globally oriented leadership. In the last decade, leaders of various levels from far more globalized nations and foreign companies have started operating in India. Many Indians with global exposure as also foreigners with similar exposure have been leading their companies global/ regional/ local businesses from their Indian offices. Even Indian companies have hired foreigners to lead their businesses in India. Indian businesses that have begun operations abroad are using India-bred employees to lead those operations from offices located in different countries. This has contributed to the fast growth in the availability of globally oriented Indian leaders for India’s local and global businesses. The owner- manager driven companies are also traveling the path of progressively higher order of global orientation. Although the demand for globally oriented Indian leaders is far in excess of the supply, international investors are eagerly searching for globally oriented Indian leaders to entrust their funds for acquiring, managing and expanding businesses in India and abroad. The impact has been so great that the leaders groomed in the earlier closed and govt. controlled regime, especially in the public sector, have been forced by competitive circumstances to become globally oriented simultaneously with their much younger colleagues. Within a period of another decade, millions of globally oriented Indian leaders, operating both in India and abroad, will start shaping businesses and impacting the global economic environment. Maybe, that is when India would be economically and politically globalized enough to be respected as a useful part of the global leadership.
15. The voyage along the path of globalization and the path of winning acceptance as an important part of the global leadership is laden with many challenges. Such challenges for India’s globally oriented leadership will involve exploitation of new opportunities and enhancing new skills. Globally oriented leadership will be attracted by the need to lift 30-crore Indians below the poverty line to minimum living standards not through subsidies, reservation and employment guarantees but through improving the pace of economic expansion. The leadership is already engaged in making technical and general education as a thriving business: but it quality needs to be enhanced considerable to meet India’s human resources needs. The challenge of the leadership in this area would most likely involve alternative systems that bypass the Government’s ineffective and expensive systems of licensing and control over education in India. The argument that in almost all countries the State (Government) leadership in education has been both desirable and essential has already been proved invalid in India. The huge scale and diversity of the task of reaching quality education and skills to support India’s aim of global leadership is beyond the capability of the institution of Government anywhere in the world. This task can only be fulfilled by private business initiatives in an open, competitive market environment. Continued reliance on govt. for support, especially for land in exchange of freedom to cater to the needs of the market demand, is already proving to be great bottleneck for India’s economic prosperity. Such public-private partnerships do not speak highly of India’s leadership. Freeing the farmers from the stranglehold of small-scale farming is yet another challenge. So is the need to break the mental barrier that retailing vegetables can be done effectively by anybody (Some politicians think we need not have to learn from Wal-Mart how vegetables have to be sold. They are right. We need to first forget the most inefficient and costly way in which vegetables are retailed by millions of small and large traders in India. The current system of retailing vegetables and fish in India is essentially a network of monopoly- oligopoly nexus and so oppressive to the consumers that they need to go at the earliest).
16. There are many other challenges along the path of globalization. Managing in different cultures across the globe and developing internal network of leaderships and people of diverse nationalities, cultures and background located in different countries demand leadership of a different type than in the past. Converting the concern over global warming into opportunities of businesses that could contribute significantly to the welfare of the global society and India is a challenge more important for India than even the most advanced countries today. If we are to be global leaders we cannot continue to depend only on the West for technologies that would contribute to reduction of global warming and dependence on the rapidly depleting mineral fuels. The same is true of emerging technologies in areas like molecular biology, genetics, disease control, nano-technology, space technology, nuclear technology, etc. If a nation cannot be a substantive partner in some of the emerging technologies, its pace of globalization would slow down and the dream of becoming part of global leadership would fade into the distant time. Two more important aspects of global environment will have to be faced: terrorism and the certainty of the instability of the financial systems. Anti-terror efforts will no longer remain the business of the governments only: businesses and civil societies will get increasing involved in dealing with terrorism. It maybe worth while using the network of globally oriented leaderships to create socially and economically meaningful products and services. Living in a continuously innovating and fast changing financial sector environment that would remain unstable and prone to repeat crises and yet thriving is going to be another challenge for global leaderships. Instead of trying to make the financial systems stable and rely on the comfort of having installed regulatory systems, the real leadership challenge would be surviving and growing despite recurring crises. Today that may be called risk management. Tomorrow this may be called art of surviving under uncertainty. How business leaders in India envision and deal with the challenges in these fields will be a test of their globally oriented leadership strength and their success. The vision of tomorrow is no longer what one wishes to become but how one deals with the unfolding environment.
@paper presented at Global Leadership Conference at Kolkata
Friday, July 31, 2009
On Intellectual Property Rights (2004)
Impact of Intellectual Property Right on Indian Industry and Financial Sector:
A Framework for Assessment @
Dr. Basudeb Sen
Creators of new ideas, knowledge and technology with actual and potential applications seek the right to prevent others from unauthorized use of their creations (inventions, innovation, research output). This Intellectual Property Right (IPR) constitutes an important foundation of the progress of civilization and economic exchange. Social and legal acceptance of the IPRs has facilitated technological progress, expansion of national and international trade/ commerce, and economic growth. Yet, such social and legal acceptance of IPRs has not come easily. The debates over the desirability of IPRs are not new. The issue of IPR is indeed a very old and settled one. However, the forces of economic progress, especially in countries that sought to benefit from expanding trade among themselves, have slowly but steadily made IPRs an essential feature of modern open economies. Debates still arise every time one or more countries try to simultaneously pursue two contradictory objectives: enjoy the benefits of international trade and deny IPRs to foreigners. The fears of the unknown and of the higher technological/ financial strength/ power of the advanced nations have also influenced such debates. This is true for India as well. Since the beginning of the last century and particularly after Independence, India has enacted various laws on IPR protection and provided for their enforcement. Notwithstanding this long period of experience, India’s IPR regime did not witness much improvement in line with international developments. In a rather closed and State-controlled economic framework, India’s real exposure to IPR issues was relatively insignificant until the early 1990s. Compelled by the natural economic forces, India started dismantling her closed, controlled economic environment and sought economic regeneration through economic liberalization and greater participation in rapidly expanding and increasingly competitive international commodity, services and capital markets. As a result, India could no longer avoid dealing with IPR issues and being impacted emerging cross-border IPR regimes. This paper is an attempt to explore various analytical approaches to facilitate objective assessment of the impact of emerging IPR regime on Indian industry and financial sector. Inputs from such objective analysis can help Indian industry plan respond effective and purposeful response to the emerging IPR environment.
An old, continuing issue
2. One approach to objective assessment is to look at the history of IPRs. More than a century ago, fourteen countries signed the first major international treaty to protect the people of one country from unauthorized use of their creations. This agreement signed as early as in 1883 is known as the Paris Convention for the Protection of Intellectual Property (covering such aspects as we now call patents, industrial designs). Soon thereafter, in 1986, some countries signed the Berne Convention for Protection of Literary and Artistic Works. This agreements helped nationals of one country to obtain protection of their rights to control and receive payments for the use, in other countries, of the creative works like novels, poems, stories, plays, songs, operas, musicals, drawings, paintings, sculptures and architectural works. In 1893, the offices of these Conventions merged to form one forum based in Berne and, after several decades of successful contribution, this gave birth to the World Intellectual Property Organization (WIPO).WIPO with about 180members signed a cooperation agreement with the World Trade Organization in 1996. This history shows that IPR is not a new and unsettled issue in economics or commerce. IPR issue is not just a product of the recent negotiations at or related to the World Trade Organization. Nor has fresh fundamental research has broken new grounds on the benefits/ advantages and costs/ disadvantages of IPRs. The recent arguments over IPR are largely over the coverage of items/ areas under IPR. There are also differences over the likely time profile of the positive economic impact of newer IPR regimes on the various types/ classes of participating countries, especially those who now intend to abandon their closed-economy characteristics and substantially increase their exposures to global trade and
commerce. The debates seeks to find solutions that would enable weaker countries intending to enjoy the benefits of international trade to better adjust to the new IPR regimes. The obvious question is whether, with the adoption of new trade-related IPR regimes, the weaker economies will face severe economic growth constraint arising from unaffordable rise in costs of imports. Or, will they suffer severe unemployment as local manufacturing units have to be prevented from continuing unauthorized use of foreign intellectual property through methods such as ‘reverse engineering’ or ‘ process differentiation’. Alternatively, will the advanced countries gain more relative to the gain of weaker economies in the bargain?
Positive Impact on Active Traders
3. The history of nations participating in cross-border IPR regimes for the past 50 to 100 years can help answer these questions and assess the nature of impact India may experience with her transition to the new policy IPR regime under WTO. Analysis of the experience of different nations actively participating in cross-border IPR regimes in the past decades can be useful in this context. Though such detailed analysis is beyond the scope of the paper, it is possible to suggest broad hypotheses on the nature of impact of IPR regimes on industries in WIPO member countries. The history of the evolution of the IPR regime over the last 120 years indicates the substantial progress of international trading partners to work out IPR regime solutions to reconcile the two opposing effects of IPR. Inventions and innovations have been encouraged through IPR protection to the creative people of the trading-partner countries. Also, the jointly agreed limited tenure/ periods of each item under IPR protection regimes ensured that the ultimate benefits of better technology, better quality products and lower cost are available to the nationals of all trading partners. The advanced nations benefited from trading among themselves. Their industrial growth and sophistication have radically improved over the period. The industries in these countries have generally benefited from continuous surge in international trade and diffusion of technological progress resulting from the continuously improving IPR regimes. Some of these countries have been able to build up innovation expertise in particular industries/ products. At the same time, they continued to rely on innovation expertise of other countries in other areas/ industries to lift the general level of their technological sophistication, productivity/ efficiency and the comfort/convenience of their people. In many areas/ industries/ sectors, several countries continue to compete in the market for generation and supply of newer intellectual properties even as old intellectual properties complete their pre-specified IPR protection tenures.
Strategy of Closed Economies
4. In contrast to the above countries, some other countries have taken little interest in ensuring cross-border IPR protection. Remaining effectively outside a cross-border IPR protection environment, these countries have sought to secure the best international prices for technology and sophisticated machinery imports through bilateral trade agreements. In the absence of growth of competitive export industries, these countries have preferred to negotiate the items of export, the prices and the quantity off-take under (largely, barter) bilateral trade agreements and had to encourage domestic industries to export by giving them special benefits and subsidies. Exporting high cost goods (at the cost of subsidies paid out of taxpayers’ money) has not helped hiding inefficiencies: the loss due to inefficient use of the country’s resources has adversely affected growth/ inflation performance. An export-led policy oriented economy may initially adopt (and benefit from) ‘reverse engineering’ methods inconsistent with cross-border IPR. Such an economy may also be successful in reaching progressively higher levels of technological competence and acquire strong enough research and innovation capability.
Strategy of Opening Up
5. At some stage, such a country may have to adopt progressively more effective and stronger IPR protection regimes to sustain its technological progress and economic growth. The stronger a country is capable of commercializing new ideas/ products/ materials/ technologies, the more interested it becomes to protect its own innovations and exploit their commercial potential across the borders. This country now seems more interested in shopping all over the world to secure the best prices (and quality/ deals) for its exports and imports. At this stage, such a country may find it attractive to implement effective IPR regimes for the protection of IPR of foreigners as well. Depending on (a) how fast such a country can improve its capability, it reaches (b) the stage when adoption of more effective IPR protection regimes becomes an attractive strategy for sustaining the technological and economic progress of that country. However, some countries that are unsure of building up adequate technological research and innovation capability, continue their reliance on bilateral (largely barter) trade agreements and on reverse engineering and adopt weak cross-border IPR regimes. Some other countries, despite their bleak technological prospects in the medium term future, do not wait for their dream of competing in the international market for generating innovations to come true; instead, they adopt a strategy of conforming to global agreements on IPR regime implementation and make the best use of the innovations of foreigners. This is another strategy for economic survival and growth.
6. The above possibilities lead to the expectation that the impact of implementing strong IPR regimes on domestic industry may vary across countries depending on the technological conditions in terms of strength or latent potential of innovation capability and prospects as well as the strategies adopted. Some suggests that Indian industry will overall experience a time profile of negative impacts or relatively lower benefit flowing from the emerging IPR protection regime. This suggestion may remain a matter of belief until one proves that all opening up strategies is are inferior to remaining closed and ignoring cross-border IPR protection regimes. Given the dramatic change over the last decade in the exploitation of latent potential of Indian research and technological capabilities, the spurt in flow of foreign direct investments, this may be difficult to prove. This is especially so because the potential of larger gains from bilateral (barter) trade agreements has considerably reduced over the past two decades and because the benefits from the bilateral free-trade agreements and free trade zones (which have seen a great spurt in recent period) cannot sustain without strong IPR regimes.
Intra-country IPR
7. Another approach to assessment of the impact of cross-border trade-related IPR regime is one of comparison of domestic trade with and without domestic (intra-country) IPR protection. In other words, a comparative study of experience of two (largely) closed economies, one with strong domestic IPR protection regimes and another without any effective domestic IPR regime may help assess the nature of impact of international trade-related IPR protection regimes on local industries. The hypothesis to be tested is that the country with strong domestic IPR regime is likely to have stronger and more efficient domestic industry. Interestingly, it may be difficult to find the instances of many open economies with strong domestic IPR remaining weak in cross-border IPR protection for long periods in history. If the existence of strong IPR regime within a country has a positive effect on domestic industry, would not strong cross-border IPR regime produce similar results on all the trading partners? A related question that needs examination is whether cross-border IPO regimes encourage research, innovations and inventions in weak, technologically backward countries. Or, whether strong IPR protection regime for foreigners helps accelerate domestic industrial research and innovations in a world of rising foreign direct investments and growing competition among multi-national companies to outsource activities based on competitive advantage calculations. Strong IPR for nationals and weak protection for foreign innovators are increasingly becoming infeasible to practice in today’s world.
Industry-specific Experience
8. Another approach to study the impact of IPR regimes is to consider the experience of specific Indian industries facing international IPO regimes. For example, consider the pharmaceutical industry’s experience. Many foreign pharma companies had withdrawn from India as state controls and weak IPR regimes hurt the economics of their operations in India. The local pharma companies fully exploited the resultant space created and expanding rapidly, though largely through reverse engineering or process differentiation methods. The deregulation and decontrol measures of the 1990s gave a further impetus to local pharma companies. They expanded their exports effectively competing with foreign companies in segments of the world market. They changed their strategies to exploit the research and development expertise they had developed during the period of fast growth. They prepared for the emerging global environment of trade-related IPR regimes. Therefore, they have been considerably successful so far in making the most out of the trade-related IPR regime obligations. The foreign pharma companies are now considering resuming operations in India now that the state controls have gone and a stronger IPR regime is likely to be under effective implementation. The hypothesis to be tested is whether the local pharma companies have indeed found a strategy to survive and grow in an environment of strong trade-related IPR regime.
9. The multi-national pharmaceutical companies are closely assessing the progressive improvement in the IPR regime in India and the withdrawal of the Indian Govt. policy of dictating the industry. Many MNCs are considering return to India to set up production facilities. Contract research outsourcing to India has already progressed. These would mean considerable increase in competition among MNC in India and introduction of new products in India. This would benefit the Indian consumers/ patients. The local industry will also benefit from competition. The ongoing of opportunity of producing patent- expiration drugs will continue to remain for the internationally competitive local drug firms. A new area of competition will be the herbal drug. The MNCs and the medicine researchers at the best laboratories in the world are vigorously studying the old texts in various languages available in different countries across the world. The search is for ideas to identify medicinal properties of plants and herbs so that modern pharmaceutical plants can produce drugs based on such plants and herbs. The local pharmaceutical industry is also giving considerable attention to this area. These are all going to have positive impact Indian industry and consumers. Both local firms and MNCs may try to get some new products based on Indian Ayurvedic/ Unani medicine patented. Not all such products will get patent easily (use of old knowledge to produce in a chemical plant a medicine more refined than the manually-made medicine of the past will not be adequate to obtain patent: even if some such medicine did get patent in one country, there will be disputes on them raised by players within the industry). It is inconceivable that products essentially equivalent to traditional Indian products like churangoli or chyavanprash, panchhon, puri, rassogolla, or roti will be acceptable for patent registration because these are not innovations and certainly not products backed by lot of R&D expenditure. Irrespective of how many herbal drugs are patented in future, the use of traditional Indian medical knowledge for improved products means that India gains (and not loses as some tend to believe). Those who can prepare ayurvedic medicines (like mixture of lime and turmeric in warm water for sprains) at home may continue to do so without any restriction: those who can not will be able to buy the products (e.g., readymade lime-turmeric paste) of the pharmaceutical companies. Clearly, pharma companies can develop brands for such products. There is always a benefit from brands competing in the market place: assurance of quality at competitive prices.
10. Similarly, researchers can study the impact of IPR protection on foreign exchange earnings of Hindi films and Indian music. The weak IPR protection enforcement has hurt domestic earnings of film and music industry. If India is not part of international trade-related IPR protection regime, this will hit their earnings further. Indian heroes, heroines, musicians and singers have potentially a large international market to protect their earnings both nationally and internationally. Should weak IPR protection regimes encourage piracy-based low quality products to constrain the long-term interest of these industries? Again, consider the case of IT and ITES industry. IPR regimes in foreign countries protect the continued growth of Indian IT and ITES industries. These cases point to the hypothesis that a number of high-growth Indian industries need strong domestic and international IPR protection regimes. These industries need researchers’ attention.
11. A more generic study would concern itself with India’s own history of IPR. As for the period till 1990, the hypotheses to be tested include whether the weak IPR regime in the relatively closed economy (a) hinder the pace of technological capability formation, (b) hurt the rates of technological progress, industrial growth, exports and (c) raise the cost of goods to the Indian consumers. Research may be able to verify whether India missed any great opportunity to spur technological innovations and industrial growth because of weaker IPR regime. Economic policies like industrial licensing and rehabilitation of sick units, rather than encouraging innovations, promote a bias against innovations. A closed economy with inadequate resources for investment tends to trap itself in to a policy that discourages innovations with potential to displace extant technology-based manufacturing and employment. Maybe looking too far into the past may not interest many researches.
12. They may be more interested in examining whether the movement towards WTO-compatible IPR regime since 1999 has any potential to enhance industrial competency and capability of India. True, India has ratified the World Trade Organization Agreement including the Trips Agreement that has come into effect in 1995. As a developing country, India enjoyed a transition period of 5 years ending January 2000 (for product patent protection to areas of technology hitherto not protected like pharmaceuticals and agricultural chemicals, the transition period of 10 years, ends in January 2005). India revised various laws to make them WTO compatible in the very recent period. These include Indian Copyright Act of 1957, Trade and Merchandise Marks Act, 1959, the Designs Act, 1911 and Patents Act, 1970 – all through amendments by Parliament in 1999 and 2000. Besides, India passed a new law, Geographical Indications of Good (Registration and Protection) Act, in 1999. How far have these measures enhanced India’s potential? The effectiveness of India’s new IPR regime would not depend merely on the establishment of laws relevant to IPR protection and the adequacy of the legal provisions but also on the quality and adequacy of administration, monitoring, enforcement and dispute settlement machinery relating to IPR laws. It may be difficult to prove that Indian IPR regime has attained the desired standards in respect of all these. Both domestic patent/ copyright holders and foreigners complain of lax enforcement of IPR protection laws. They also complain about lack of confidentiality of information submitted to obtain patents and procedural delays. An effective TRIPS regime changes the attitude of the local industry and inventors from being defensive and prone to unauthorized copying to being alert, opportunistic and aggressive. An effective IPR protection regime should lead to growth of employment of persons to monitor and study IPR protection regimes in other countries as also to enforce internationally agreed laws and rules recently adopted in India. This helps the domestic industry to become all the more pro-active in safeguarding its own IPR through monitoring and access to WTO mechanism for relief and compensation against infringement by others as also dispute settlement. There are no signs yet that all these have happened as expected. The effectiveness of Indian IPR regime is still low. A less than effective IPR regime can have negative impact on the future of local industries: future of a nation cannot be build on prolonged encouragement to unauthorized piracy and reverse engineering.
Impact on Financial Sector
13. IPR regimes influence the financial sector in two ways. First, the impact depends on its exposure to industries varyingly sensitive to Trips obligations. The risk management processes in banks and other financial services firms, including investment management for mutual funds, pension funds and insurance are now gearing up to take into account the impact of IPR regimes in different ways. In a competitive world, tracking the progress of innovations is essential for anticipating the impact of new product patents of one company on other companies. Again, the news about the likelihood of a new product patent clearance tends to move the share prices of pharmaceutical companies in the stock markets. Correspondingly, reports of likely failure to obtain a patent on a product under development with substantial investments, result in decline in stock prices. The success or failure of companies to obtain patents has also implications on their capability to service loans taken from/ debt instruments issued to banks and investment institutions. Even getting into legal disputes concerning infringement of IPR-laws has implications of both financial penalty implications and goodwill/ reputation. The lenders and shareholders of the companies have to assess these implications before and after taking exposures in companies dealing with IPR-issue sensitive products.
14. The second way in which the IPR regimes can affect the financial sector is the direct influence of the innovations, inventions and ideas for the financial sector itself. Financial services firms can consider patenting their designs, products and brands. However, as of now, it is difficult to imagine proliferation of patented intellectual property in the form of designs and products. The IPR for the financial sector itself is difficult to evolve outside the areas of brands, trademarks and copyrights. Product patents may be limited to proprietary computer software embedded models of portfolio management and securities trading. The overwhelming part of the financial sector firms’ activities are based on too simple and too widely used concepts and ideas, allowing very little scope for developing intellectual property that can be given more than a few months of natural protection from copying. Moreover, Government appointed/ controlled supervisors who tend to force standardization of industry practices and products will continue to rule the financial sector in all countries. Financial sector regulations generally inhibit company-specific product innovations. Such innovations tend to become industry-level standards at the instance of the regulators. Maybe in future situations may change. At present, more than IPR, the issue is one of freer trade in financial services. Free trade in financial services across borders may take a long time to mature. Maybe India can benefit from both import and export of financial services. The scope for specialization in the financial sector may increase, at some stage, to such a degree that helps generate large research and development expenditure induced and ‘difficult-to-copy’ service products that can be patented.
Long-term Perspective
15. The impact of IPR regimes on domestic industry needs assessment in the light of longer-term direction of the international economic exchange. Adam Smith’s ideas ushered in the era of maximizing economic gains through free trade in all areas other than those areas where non-economic considerations (like defense) are more important to the society. He showed the irrationality of the ‘mercantilism’ objective of maximizing trade surplus through State regulation of imports. David Ricardo enunciated the ‘comparative advantage’ foundation of mutually beneficial exchange among countries with varying natural endowments and competencies in production of goods by different countries. The progress of free trade was continuous since then despite John Stuart Mill’s infant industry argument and the lack of perfect, perfect competition and presence of externalities. The movement towards free trade also hindered by closed economies and communist blocks for quite sometime. Yet, the GATT progressed over time since 1948 through negotiations and better understanding as well as the recognition of societal concerns over the impact of free trade on infant industries, relatively poor and technologically backward countries. As technology, knowledge and goodwill/reputation became progressively more important to civilization than the product itself, IPR became the key issue in further progress of technology, product development and free trade. Extent of protection and enforcement of IPR varied widely over the countries as intellectual property became more important in trade. All this led to tension in international economic relations. New internationally agreed rules for intellectual property rights became necessary for order and predictability in the conduct of international trade (including more systematic resolution of trade disputes).
16. The emerging international IPR regime seeks to contribute to open, fair, predictable and undistorted competition environment free trade with minimum barriers. At the same time, it seeks to provide adequate safeguards for minimizing the duration of IPR protection and access to protected technologies in case of societal urgency in respect of public health and spread of technology. Clearly, the new era has a great potential in altering the industrial structure of different economies. In the past, technologically advanced nations exited the low technology manufacturing areas to less developed countries. This trend will gather further momentum with business process outsourcing by enterprises in richer
countries. The rapid expansion of market demand in China, India, Brazil and Russia will alter the scope of division of labor and specialization. All this together with the changing proportions of knowledge-based workers in the workforce will imply potential for changes in the comparative cost advantages of different countries. The actual impact on Indian industries will of course depend on how India turns the emerging WTO and IPR protection regime to her advantage.
-------------------------------------------------------------------------------------@Abstract of this paper was presented by the contributor at the Seminar on Intellectual Property Rights & Related Issues organized by Department of Business Administration and Department of Commerce, University of Kalyani, West Bengal on Sept. 3, 2004
A Framework for Assessment @
Dr. Basudeb Sen
Creators of new ideas, knowledge and technology with actual and potential applications seek the right to prevent others from unauthorized use of their creations (inventions, innovation, research output). This Intellectual Property Right (IPR) constitutes an important foundation of the progress of civilization and economic exchange. Social and legal acceptance of the IPRs has facilitated technological progress, expansion of national and international trade/ commerce, and economic growth. Yet, such social and legal acceptance of IPRs has not come easily. The debates over the desirability of IPRs are not new. The issue of IPR is indeed a very old and settled one. However, the forces of economic progress, especially in countries that sought to benefit from expanding trade among themselves, have slowly but steadily made IPRs an essential feature of modern open economies. Debates still arise every time one or more countries try to simultaneously pursue two contradictory objectives: enjoy the benefits of international trade and deny IPRs to foreigners. The fears of the unknown and of the higher technological/ financial strength/ power of the advanced nations have also influenced such debates. This is true for India as well. Since the beginning of the last century and particularly after Independence, India has enacted various laws on IPR protection and provided for their enforcement. Notwithstanding this long period of experience, India’s IPR regime did not witness much improvement in line with international developments. In a rather closed and State-controlled economic framework, India’s real exposure to IPR issues was relatively insignificant until the early 1990s. Compelled by the natural economic forces, India started dismantling her closed, controlled economic environment and sought economic regeneration through economic liberalization and greater participation in rapidly expanding and increasingly competitive international commodity, services and capital markets. As a result, India could no longer avoid dealing with IPR issues and being impacted emerging cross-border IPR regimes. This paper is an attempt to explore various analytical approaches to facilitate objective assessment of the impact of emerging IPR regime on Indian industry and financial sector. Inputs from such objective analysis can help Indian industry plan respond effective and purposeful response to the emerging IPR environment.
An old, continuing issue
2. One approach to objective assessment is to look at the history of IPRs. More than a century ago, fourteen countries signed the first major international treaty to protect the people of one country from unauthorized use of their creations. This agreement signed as early as in 1883 is known as the Paris Convention for the Protection of Intellectual Property (covering such aspects as we now call patents, industrial designs). Soon thereafter, in 1986, some countries signed the Berne Convention for Protection of Literary and Artistic Works. This agreements helped nationals of one country to obtain protection of their rights to control and receive payments for the use, in other countries, of the creative works like novels, poems, stories, plays, songs, operas, musicals, drawings, paintings, sculptures and architectural works. In 1893, the offices of these Conventions merged to form one forum based in Berne and, after several decades of successful contribution, this gave birth to the World Intellectual Property Organization (WIPO).WIPO with about 180members signed a cooperation agreement with the World Trade Organization in 1996. This history shows that IPR is not a new and unsettled issue in economics or commerce. IPR issue is not just a product of the recent negotiations at or related to the World Trade Organization. Nor has fresh fundamental research has broken new grounds on the benefits/ advantages and costs/ disadvantages of IPRs. The recent arguments over IPR are largely over the coverage of items/ areas under IPR. There are also differences over the likely time profile of the positive economic impact of newer IPR regimes on the various types/ classes of participating countries, especially those who now intend to abandon their closed-economy characteristics and substantially increase their exposures to global trade and
commerce. The debates seeks to find solutions that would enable weaker countries intending to enjoy the benefits of international trade to better adjust to the new IPR regimes. The obvious question is whether, with the adoption of new trade-related IPR regimes, the weaker economies will face severe economic growth constraint arising from unaffordable rise in costs of imports. Or, will they suffer severe unemployment as local manufacturing units have to be prevented from continuing unauthorized use of foreign intellectual property through methods such as ‘reverse engineering’ or ‘ process differentiation’. Alternatively, will the advanced countries gain more relative to the gain of weaker economies in the bargain?
Positive Impact on Active Traders
3. The history of nations participating in cross-border IPR regimes for the past 50 to 100 years can help answer these questions and assess the nature of impact India may experience with her transition to the new policy IPR regime under WTO. Analysis of the experience of different nations actively participating in cross-border IPR regimes in the past decades can be useful in this context. Though such detailed analysis is beyond the scope of the paper, it is possible to suggest broad hypotheses on the nature of impact of IPR regimes on industries in WIPO member countries. The history of the evolution of the IPR regime over the last 120 years indicates the substantial progress of international trading partners to work out IPR regime solutions to reconcile the two opposing effects of IPR. Inventions and innovations have been encouraged through IPR protection to the creative people of the trading-partner countries. Also, the jointly agreed limited tenure/ periods of each item under IPR protection regimes ensured that the ultimate benefits of better technology, better quality products and lower cost are available to the nationals of all trading partners. The advanced nations benefited from trading among themselves. Their industrial growth and sophistication have radically improved over the period. The industries in these countries have generally benefited from continuous surge in international trade and diffusion of technological progress resulting from the continuously improving IPR regimes. Some of these countries have been able to build up innovation expertise in particular industries/ products. At the same time, they continued to rely on innovation expertise of other countries in other areas/ industries to lift the general level of their technological sophistication, productivity/ efficiency and the comfort/convenience of their people. In many areas/ industries/ sectors, several countries continue to compete in the market for generation and supply of newer intellectual properties even as old intellectual properties complete their pre-specified IPR protection tenures.
Strategy of Closed Economies
4. In contrast to the above countries, some other countries have taken little interest in ensuring cross-border IPR protection. Remaining effectively outside a cross-border IPR protection environment, these countries have sought to secure the best international prices for technology and sophisticated machinery imports through bilateral trade agreements. In the absence of growth of competitive export industries, these countries have preferred to negotiate the items of export, the prices and the quantity off-take under (largely, barter) bilateral trade agreements and had to encourage domestic industries to export by giving them special benefits and subsidies. Exporting high cost goods (at the cost of subsidies paid out of taxpayers’ money) has not helped hiding inefficiencies: the loss due to inefficient use of the country’s resources has adversely affected growth/ inflation performance. An export-led policy oriented economy may initially adopt (and benefit from) ‘reverse engineering’ methods inconsistent with cross-border IPR. Such an economy may also be successful in reaching progressively higher levels of technological competence and acquire strong enough research and innovation capability.
Strategy of Opening Up
5. At some stage, such a country may have to adopt progressively more effective and stronger IPR protection regimes to sustain its technological progress and economic growth. The stronger a country is capable of commercializing new ideas/ products/ materials/ technologies, the more interested it becomes to protect its own innovations and exploit their commercial potential across the borders. This country now seems more interested in shopping all over the world to secure the best prices (and quality/ deals) for its exports and imports. At this stage, such a country may find it attractive to implement effective IPR regimes for the protection of IPR of foreigners as well. Depending on (a) how fast such a country can improve its capability, it reaches (b) the stage when adoption of more effective IPR protection regimes becomes an attractive strategy for sustaining the technological and economic progress of that country. However, some countries that are unsure of building up adequate technological research and innovation capability, continue their reliance on bilateral (largely barter) trade agreements and on reverse engineering and adopt weak cross-border IPR regimes. Some other countries, despite their bleak technological prospects in the medium term future, do not wait for their dream of competing in the international market for generating innovations to come true; instead, they adopt a strategy of conforming to global agreements on IPR regime implementation and make the best use of the innovations of foreigners. This is another strategy for economic survival and growth.
6. The above possibilities lead to the expectation that the impact of implementing strong IPR regimes on domestic industry may vary across countries depending on the technological conditions in terms of strength or latent potential of innovation capability and prospects as well as the strategies adopted. Some suggests that Indian industry will overall experience a time profile of negative impacts or relatively lower benefit flowing from the emerging IPR protection regime. This suggestion may remain a matter of belief until one proves that all opening up strategies is are inferior to remaining closed and ignoring cross-border IPR protection regimes. Given the dramatic change over the last decade in the exploitation of latent potential of Indian research and technological capabilities, the spurt in flow of foreign direct investments, this may be difficult to prove. This is especially so because the potential of larger gains from bilateral (barter) trade agreements has considerably reduced over the past two decades and because the benefits from the bilateral free-trade agreements and free trade zones (which have seen a great spurt in recent period) cannot sustain without strong IPR regimes.
Intra-country IPR
7. Another approach to assessment of the impact of cross-border trade-related IPR regime is one of comparison of domestic trade with and without domestic (intra-country) IPR protection. In other words, a comparative study of experience of two (largely) closed economies, one with strong domestic IPR protection regimes and another without any effective domestic IPR regime may help assess the nature of impact of international trade-related IPR protection regimes on local industries. The hypothesis to be tested is that the country with strong domestic IPR regime is likely to have stronger and more efficient domestic industry. Interestingly, it may be difficult to find the instances of many open economies with strong domestic IPR remaining weak in cross-border IPR protection for long periods in history. If the existence of strong IPR regime within a country has a positive effect on domestic industry, would not strong cross-border IPR regime produce similar results on all the trading partners? A related question that needs examination is whether cross-border IPO regimes encourage research, innovations and inventions in weak, technologically backward countries. Or, whether strong IPR protection regime for foreigners helps accelerate domestic industrial research and innovations in a world of rising foreign direct investments and growing competition among multi-national companies to outsource activities based on competitive advantage calculations. Strong IPR for nationals and weak protection for foreign innovators are increasingly becoming infeasible to practice in today’s world.
Industry-specific Experience
8. Another approach to study the impact of IPR regimes is to consider the experience of specific Indian industries facing international IPO regimes. For example, consider the pharmaceutical industry’s experience. Many foreign pharma companies had withdrawn from India as state controls and weak IPR regimes hurt the economics of their operations in India. The local pharma companies fully exploited the resultant space created and expanding rapidly, though largely through reverse engineering or process differentiation methods. The deregulation and decontrol measures of the 1990s gave a further impetus to local pharma companies. They expanded their exports effectively competing with foreign companies in segments of the world market. They changed their strategies to exploit the research and development expertise they had developed during the period of fast growth. They prepared for the emerging global environment of trade-related IPR regimes. Therefore, they have been considerably successful so far in making the most out of the trade-related IPR regime obligations. The foreign pharma companies are now considering resuming operations in India now that the state controls have gone and a stronger IPR regime is likely to be under effective implementation. The hypothesis to be tested is whether the local pharma companies have indeed found a strategy to survive and grow in an environment of strong trade-related IPR regime.
9. The multi-national pharmaceutical companies are closely assessing the progressive improvement in the IPR regime in India and the withdrawal of the Indian Govt. policy of dictating the industry. Many MNCs are considering return to India to set up production facilities. Contract research outsourcing to India has already progressed. These would mean considerable increase in competition among MNC in India and introduction of new products in India. This would benefit the Indian consumers/ patients. The local industry will also benefit from competition. The ongoing of opportunity of producing patent- expiration drugs will continue to remain for the internationally competitive local drug firms. A new area of competition will be the herbal drug. The MNCs and the medicine researchers at the best laboratories in the world are vigorously studying the old texts in various languages available in different countries across the world. The search is for ideas to identify medicinal properties of plants and herbs so that modern pharmaceutical plants can produce drugs based on such plants and herbs. The local pharmaceutical industry is also giving considerable attention to this area. These are all going to have positive impact Indian industry and consumers. Both local firms and MNCs may try to get some new products based on Indian Ayurvedic/ Unani medicine patented. Not all such products will get patent easily (use of old knowledge to produce in a chemical plant a medicine more refined than the manually-made medicine of the past will not be adequate to obtain patent: even if some such medicine did get patent in one country, there will be disputes on them raised by players within the industry). It is inconceivable that products essentially equivalent to traditional Indian products like churangoli or chyavanprash, panchhon, puri, rassogolla, or roti will be acceptable for patent registration because these are not innovations and certainly not products backed by lot of R&D expenditure. Irrespective of how many herbal drugs are patented in future, the use of traditional Indian medical knowledge for improved products means that India gains (and not loses as some tend to believe). Those who can prepare ayurvedic medicines (like mixture of lime and turmeric in warm water for sprains) at home may continue to do so without any restriction: those who can not will be able to buy the products (e.g., readymade lime-turmeric paste) of the pharmaceutical companies. Clearly, pharma companies can develop brands for such products. There is always a benefit from brands competing in the market place: assurance of quality at competitive prices.
10. Similarly, researchers can study the impact of IPR protection on foreign exchange earnings of Hindi films and Indian music. The weak IPR protection enforcement has hurt domestic earnings of film and music industry. If India is not part of international trade-related IPR protection regime, this will hit their earnings further. Indian heroes, heroines, musicians and singers have potentially a large international market to protect their earnings both nationally and internationally. Should weak IPR protection regimes encourage piracy-based low quality products to constrain the long-term interest of these industries? Again, consider the case of IT and ITES industry. IPR regimes in foreign countries protect the continued growth of Indian IT and ITES industries. These cases point to the hypothesis that a number of high-growth Indian industries need strong domestic and international IPR protection regimes. These industries need researchers’ attention.
11. A more generic study would concern itself with India’s own history of IPR. As for the period till 1990, the hypotheses to be tested include whether the weak IPR regime in the relatively closed economy (a) hinder the pace of technological capability formation, (b) hurt the rates of technological progress, industrial growth, exports and (c) raise the cost of goods to the Indian consumers. Research may be able to verify whether India missed any great opportunity to spur technological innovations and industrial growth because of weaker IPR regime. Economic policies like industrial licensing and rehabilitation of sick units, rather than encouraging innovations, promote a bias against innovations. A closed economy with inadequate resources for investment tends to trap itself in to a policy that discourages innovations with potential to displace extant technology-based manufacturing and employment. Maybe looking too far into the past may not interest many researches.
12. They may be more interested in examining whether the movement towards WTO-compatible IPR regime since 1999 has any potential to enhance industrial competency and capability of India. True, India has ratified the World Trade Organization Agreement including the Trips Agreement that has come into effect in 1995. As a developing country, India enjoyed a transition period of 5 years ending January 2000 (for product patent protection to areas of technology hitherto not protected like pharmaceuticals and agricultural chemicals, the transition period of 10 years, ends in January 2005). India revised various laws to make them WTO compatible in the very recent period. These include Indian Copyright Act of 1957, Trade and Merchandise Marks Act, 1959, the Designs Act, 1911 and Patents Act, 1970 – all through amendments by Parliament in 1999 and 2000. Besides, India passed a new law, Geographical Indications of Good (Registration and Protection) Act, in 1999. How far have these measures enhanced India’s potential? The effectiveness of India’s new IPR regime would not depend merely on the establishment of laws relevant to IPR protection and the adequacy of the legal provisions but also on the quality and adequacy of administration, monitoring, enforcement and dispute settlement machinery relating to IPR laws. It may be difficult to prove that Indian IPR regime has attained the desired standards in respect of all these. Both domestic patent/ copyright holders and foreigners complain of lax enforcement of IPR protection laws. They also complain about lack of confidentiality of information submitted to obtain patents and procedural delays. An effective TRIPS regime changes the attitude of the local industry and inventors from being defensive and prone to unauthorized copying to being alert, opportunistic and aggressive. An effective IPR protection regime should lead to growth of employment of persons to monitor and study IPR protection regimes in other countries as also to enforce internationally agreed laws and rules recently adopted in India. This helps the domestic industry to become all the more pro-active in safeguarding its own IPR through monitoring and access to WTO mechanism for relief and compensation against infringement by others as also dispute settlement. There are no signs yet that all these have happened as expected. The effectiveness of Indian IPR regime is still low. A less than effective IPR regime can have negative impact on the future of local industries: future of a nation cannot be build on prolonged encouragement to unauthorized piracy and reverse engineering.
Impact on Financial Sector
13. IPR regimes influence the financial sector in two ways. First, the impact depends on its exposure to industries varyingly sensitive to Trips obligations. The risk management processes in banks and other financial services firms, including investment management for mutual funds, pension funds and insurance are now gearing up to take into account the impact of IPR regimes in different ways. In a competitive world, tracking the progress of innovations is essential for anticipating the impact of new product patents of one company on other companies. Again, the news about the likelihood of a new product patent clearance tends to move the share prices of pharmaceutical companies in the stock markets. Correspondingly, reports of likely failure to obtain a patent on a product under development with substantial investments, result in decline in stock prices. The success or failure of companies to obtain patents has also implications on their capability to service loans taken from/ debt instruments issued to banks and investment institutions. Even getting into legal disputes concerning infringement of IPR-laws has implications of both financial penalty implications and goodwill/ reputation. The lenders and shareholders of the companies have to assess these implications before and after taking exposures in companies dealing with IPR-issue sensitive products.
14. The second way in which the IPR regimes can affect the financial sector is the direct influence of the innovations, inventions and ideas for the financial sector itself. Financial services firms can consider patenting their designs, products and brands. However, as of now, it is difficult to imagine proliferation of patented intellectual property in the form of designs and products. The IPR for the financial sector itself is difficult to evolve outside the areas of brands, trademarks and copyrights. Product patents may be limited to proprietary computer software embedded models of portfolio management and securities trading. The overwhelming part of the financial sector firms’ activities are based on too simple and too widely used concepts and ideas, allowing very little scope for developing intellectual property that can be given more than a few months of natural protection from copying. Moreover, Government appointed/ controlled supervisors who tend to force standardization of industry practices and products will continue to rule the financial sector in all countries. Financial sector regulations generally inhibit company-specific product innovations. Such innovations tend to become industry-level standards at the instance of the regulators. Maybe in future situations may change. At present, more than IPR, the issue is one of freer trade in financial services. Free trade in financial services across borders may take a long time to mature. Maybe India can benefit from both import and export of financial services. The scope for specialization in the financial sector may increase, at some stage, to such a degree that helps generate large research and development expenditure induced and ‘difficult-to-copy’ service products that can be patented.
Long-term Perspective
15. The impact of IPR regimes on domestic industry needs assessment in the light of longer-term direction of the international economic exchange. Adam Smith’s ideas ushered in the era of maximizing economic gains through free trade in all areas other than those areas where non-economic considerations (like defense) are more important to the society. He showed the irrationality of the ‘mercantilism’ objective of maximizing trade surplus through State regulation of imports. David Ricardo enunciated the ‘comparative advantage’ foundation of mutually beneficial exchange among countries with varying natural endowments and competencies in production of goods by different countries. The progress of free trade was continuous since then despite John Stuart Mill’s infant industry argument and the lack of perfect, perfect competition and presence of externalities. The movement towards free trade also hindered by closed economies and communist blocks for quite sometime. Yet, the GATT progressed over time since 1948 through negotiations and better understanding as well as the recognition of societal concerns over the impact of free trade on infant industries, relatively poor and technologically backward countries. As technology, knowledge and goodwill/reputation became progressively more important to civilization than the product itself, IPR became the key issue in further progress of technology, product development and free trade. Extent of protection and enforcement of IPR varied widely over the countries as intellectual property became more important in trade. All this led to tension in international economic relations. New internationally agreed rules for intellectual property rights became necessary for order and predictability in the conduct of international trade (including more systematic resolution of trade disputes).
16. The emerging international IPR regime seeks to contribute to open, fair, predictable and undistorted competition environment free trade with minimum barriers. At the same time, it seeks to provide adequate safeguards for minimizing the duration of IPR protection and access to protected technologies in case of societal urgency in respect of public health and spread of technology. Clearly, the new era has a great potential in altering the industrial structure of different economies. In the past, technologically advanced nations exited the low technology manufacturing areas to less developed countries. This trend will gather further momentum with business process outsourcing by enterprises in richer
countries. The rapid expansion of market demand in China, India, Brazil and Russia will alter the scope of division of labor and specialization. All this together with the changing proportions of knowledge-based workers in the workforce will imply potential for changes in the comparative cost advantages of different countries. The actual impact on Indian industries will of course depend on how India turns the emerging WTO and IPR protection regime to her advantage.
-------------------------------------------------------------------------------------@Abstract of this paper was presented by the contributor at the Seminar on Intellectual Property Rights & Related Issues organized by Department of Business Administration and Department of Commerce, University of Kalyani, West Bengal on Sept. 3, 2004
Security Analysis & Portfolio Management Course Outline (2003)
A course on Security Analysis & Portfolio Management ( 30-35 hours)
1. What is a Security? Examples. Traditional and new. Equity, Debt, Hybrid,
Units of pools. Securisation and Pass through certificates. Future/Forward
Contracts. Options.
Why securities? The purpose they serve. Acknowledgement of financial
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2. Why analyse securities? What do we want to find? Objectives.
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Advisors to purchasers. Different classes of purchasers and sellers.
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The theory of relationships. The Content of Analysis. The tools of Analysis.
3. What is Portfolio? Why portfolio? Natural availability to Diversification for risk
containment.
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4. Time value of Money. Discounting and compounding. Time intervals.
Present Value. Net Present Value. Internal Rate of Return.
Perpetuity. Annuity. Yield. Yield to Maturity. Current Yield.
t. t
Related Mathematics: P (1+r) = A. PV (1+r) = TV
t
PV = TV / (1+r) > Numeric. 100 = 110/1.10
t
PV (Si) = Sum (t= 1…n) of Dt /(1+r)
t-1. t. t-1
or, Sum D(1+g) / (1+r) = Sum [ {D / (1+r)} * {(1+r)/(1+g)} ]
= D / (r-g)
t. t
Sum D/(1+r) = (D/r) * { 1 – 1 / (1+r) } = D/ r as n tends to infinity.
PV (Si) = PV (D1) + PV (D2) + PV (D3) + PV ( S3) Numeric ex.
t.
PV = b * Sum E / (1+r) + (b * E)/(r-g) = b * E/r
P / E = m. From PV = (b * E) / (r-g). m = b/r or b/ (r-g)
Value of a Firm: Fair Market Value : FMV
= PV of the stream of future after tax free cash flows to debt & equity holders.
= EBIT (1-t) + Depreciation – Investment
FMV firm = FMV of equity = FMV of debt.
Value of share = FMV equity / no. of outstanding shares.
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Stock. Issuer. Company? Finance? Listing> Corporate Governance and other
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Share Valuation :Financial Projections. Earnings estimates
with probabilities. Sensitivity analysis.
8. Market Psychology based Approach to Security Analysis. & Market portfolio analysis: why in addition to fundamental analysis? Short-term fluctuations in stock prices. Deviations from fundamental /intrinsic value. Time series of prices, every minute or hourly or daily or monthly (opening, closing, high, low, average) and so on. Study for discerning patterns. Interpretation of patterns. Anticipation of future movements based on past patterns. Development of trading rules and judgement. Trading based on such knowledge not identified by others. Profit/gains through trading based on such trading. Called technical analysis. Technical analysts or chartists.
Dow Theory. Dow Jones Co. Most stocks generally move up and down together with the market. Market Indices DJIA, DJTA. Study of impact of information on prices. Identification of Trend: Primary Trend – Tides, Secondary Trend (Waves), Minor /Tertiary Trends (ripples).
Primary 3 moves up: first accumulation by knowledgeable, then buying based on good earnings report corroborating knowledgeable traders anticipation, and finally entry of late comer masses influenced by spread of information. Prices rise high beating expert anticipation of fundamental value, knowledgeable exits, leading to 3 moves down. First as knowledgeable exit in hurry, then as earnings report show fundamentals cannot justify prevailing high market valuations, and as the information spreads panic selling.
Identification of trend reversal indicators for each trend, e.g. whether index crosses high of the previous secondary reversal. Identification of start of bullish/ bearish phase. Notion of Resistance / Reaction and Support levels.
Use of appropriate data on market indicators. Breadth of market and volume of transactions: rising index with rising volumes – unsatisfied demand- strong bull market, falling index with rising volumes- bearish, panic selling; rising index with falling volumes – end of bullish period; falling index and falling volumes – listless bearish phase.
Advance-decline ratio as indicator: no. of Scripps rising to no. of Scripps falling – how widespread is the rally or decline. Interpreting trend in AD ratio along with trend in volumes.
Support levels and Resistance levels marked on charts. Gaps between Resistance and support levels.
Concept of Channel, narrowing Wedge and widening gaps. Break out of boundaries. Direction reversal.
Other concepts. Triangle, Flag and series of flags, Head & Shoulders, Inverted H&S, Opening & Closing prices - Gaps between them,
Opening, closing, high & low and Candle stick.
Use of Moving average Lines: 5/10/30/90/180/365 DMA’s. Arithmetic and Exponential Moving Averages.
Concept of ROC (rate of change in prices).
Filter Rules as mechanical Trading strategies – x % filter: down x % from top requires exit.
Concept of Non-linear, stochastic dynamic price generating models.
Trading based Approach to Investing. Advice on Trading. Strict following of Objectives and Rules, stop-loss and no Greed and Fear psychosis.
9. Utility Theory & Portfolio of securities
Utility against Wealth curve. Shape of curve. Definition of Risk Aversion
First derivative positive, second derivative negative: alternative exposition –
Fait game: 50: 50 chance of A: 200 and B: 0 return against C: 100 investment.
Expected value of A and B is 100 equal to certainty 100 and yet risk averse investor prefers C.
Indifference curves.
Solution at tangency with efficiency frontier.
Portfolio of Securities.
Weights. Weighted return. Weighted mean. Weighted risk.
Concept of Mean-Variance framework.
Expected Return concept. Probabilities as weights, Expected Value as Mean Return
Portfolio risk. Portfolio variance equals Sum of weighted Co-variances: two-security case and extension to n securities case.
Risk diversification as the number of securities increases to 30?
Efficiency Frontier on Risk-Return Space. Draw graph
Concept of Risk-averse Investor
Example of A 150 or 50 with equal probability and not-A choice.
Concept of Utility function and indifference Curves.
Maximise Z as risk adjusted return of portfolio
Choose portfolio p such that Z= (rp – rm)/Sdp is max p {wi, Si}
First derivatives with respect to weights to equal zero. N equations to solve
Introduction of Risk-free security and Risk-free return.
Market portfolio.
Systematic risk and specific risk.
Capital Asset Pricing Theory (CAPM).
Capital Market Line.
[R(p) –R(f)] / [ R(m) – R(f)] = SD. (p) / SD. (m). Draw graph
Capital market equilibrium; market portfolio in equilibrium for all.
Security Market Line.
[ R(i) – R(f) ] / [ R(m) – R(f) ] = beta of i. draw graph
Bi = cov. (i, m) / var. (m) = Corelation. (I, m ) * Sdi / Sdm
= Measure of systematic risk for security I
10 assumptions of CAPM: No transaction costs, infinitely divisible security,
No capital gain or income tax, perfect competition and all price-takers,
Decision within mean-variance framework by all, unlimited short-sale allowed,
Unlimited borrowing and lending at risk free rate allowed, identical expectations by all, homogenous investment period, all securities/assets are marketable (tradable).
Relaxation of assumptions one at a time and model valilidity. Simultaneous relaxation of two or more assumptions and validity of CAPM.
Empirical tests on CAPM validity.
CAPM as one type of Single Index Model: R (I) = a (I) + B (I) r (m)
General Multi-index Models: R (I) = A (I) + B (i1) I (1) + B (i2) I (2) +…B (L) I (L) + e (I)
Where E (ei)=0 E (eiej)= 0, E (ei) (Ij) = 0
These can also be expressed in terms of differences between indexes.
Are factors. B (I) s are factor loading.
Use of statistical techniques, principal component analysis. Factor Analysis.
Standard Statistical packages available to determine / estimate As and Bs.
Alternatively, to pre-specify the indexes and do standard empirical testing.
Firm level & sector data: beta, dividend per share, bond beta, size market cap, sector dummy.
Macro-economic factor model: differences in expected and actual inflation, short-term & long-term govt. bond yields, etc.
Alternative sets of portfolios as Factors: Small stock and large stock, high and low beta, G-sec and corporate bonds, etc.
Multi- index Models for Bond Valuation.
10. Bond Portfolios:
Concept of bonds.
Tradable bonds.
Coupon.
Marurity.
Yield to maturity. Yield to call/put
Interest Rate Risk: Reinvestment Risk and Valuation Risk
Inverse relationship. Examples.
Concept of Duration
Pure discount bond. Any bond can be reduced a series of pure discount bonds.
Weighted Average duration.
Pb = C/ (1+r)^ T
DP/P = -T * D(1+r)/(1+r)
So, coupon bond P = Sum 0ver 1 to T Ct/ ( 1 + r ) ^t
DP= - {……………………………………+ Ct/(1+r)^T}
DP/P = Sum weighted present values of each coupon and return flow with -t as weights. Divided by the present value of cash flows without weights = - D * d (1+r)
Concept of Convexity
Taylor Series Expansion – f(r+h) = f ( r) + f’ ( r ). H/ 1+ f” (r). H^2/2*1 + ---------
[P (r + h) – P (r)]/ P (r) = - Sum t * Ct/ (1+r)^t D (1+r) + Sum t. (t+1) Ct/(1+r)^t d (1+r)^2/ (1+r)^2
= - D * d (1+r) + C * d^2(1+r)
Why concept of convexity required:
Interest Volatility and Bond Portfolio Immunization - Exact Matching of assets and liabilities cash flows
Barbell Strategy: Match average duration.
Focussed Strategy: match around liability cash flow duration
Rebalancing of Portfolio. Hedging with swaps. Floating to fixed or higher to lower rating bonds. Costs of hedging.
Index Bond Portfolio Investing. Choice of rating, and maturity mix.
Single Index Vs Multi Index Bond Models
11. Concept of Market Efficiency
Weak form all historical information data get promptly reflected in future prices
Semi-strong Form: all publicly available information gets quickly reflected in future prices.
Strong Form: all publicly available and insider information get quickly reflected in future prices.
The speed with which information gets reflected/ incorporated/ discounted in the market price of stocks better it is: this implies on an average no one will be able to benefit extra from information compared with others.
Results from empirical testing of these concepts of market efficiency.
12. Treatment of Taxes:
Tax adjusted returns.
Different tax regimes: ordinary investors, traders, tax exempt categories (mutual funds?).
Treatment of Interest income on bonds, G-sec, tax-exempt instruments.
Treatment of dividend income, Capital gains tax- short-term and long-term,
Distributions on winding up.
Permissible deduction. Cost of financing investments.
Shares acquired at different points of time, bonus shares, and rights shares & rights renunciation.
Convertible debentures,
Effect of company mergers and issue of new shares. Indexsation.
Carry forward of capital losses.
For Traders: Sales + closing stock- purchases- opening stock
Stock Valuation of FIFO or Average basis?
13. Asset Allocation & Stock Picking
Strategic assets allocation among equity, bonds, money market instruments. Implication on portfolio beta and duration.
Asset allocation based on target beta and duration.
Target return based asset allocation.
Tactical Asset allocation and Portfolio revision.
Type of Investors and Investment behaviour:
A. No market timing skills and No stock picking skills: simply a diversified portfolio, passive management, -- some bonds and index funds or low beta stocks--- target low beta.
B. No market timing skills but with stock picking skills: 60%-90% in diversified portfolio and rest up to 405 in undervalued stocks, generally a concentrated portfolio with constant target beta.
C. No stock picking skills but with market timing skills: have a diversified portfolio but actively manage beta to gain from market timing.
D. Both market timing and Stock-picking skills: Concentrated and not very diversified portfolio. Active and aggressive management with fluctuating beta with a long-term target beta.
14. Portfolio Management Performance Evaluation:
Self-evaluation, comparative evaluation – across time, across portfolio managers, against benchmarks.
Need for portfolio view: individual buy/sell/hold decisions do not matter, portfolio matters.
Period and frequency of evaluation. - Short periods may be misleading, average over cycles of boom and bust. – Return performance over 1m, 3m, 6m, 1yr, 2 yr., 3yr, 5 yr.,
Risk adjusted return performance criteria:
Taylor measure = risk premium over risk free return / beta
Sharpe measure = risk premium over risk free / total variability i.e. standard deviation
Jenson Measure = excess over expected return,
where expected return = Rf + beta (Rm – Rf).
Fama Decomposition:
Portfolio actual return =
Risk free return
Rf
+ Premium on systematic risk beta
( Rm-Rf)
+ Return due to imperfect diversification
{(Std dev of p/ STD dev m) – p’s beta} ( Rm- Rf)
+ Net gain due to superior selectivity
[(Rp – Rf) – (std dev of p / std dev of market) ( Rm - Rf)}
Example: R f= 12 %*
T = (Rp – Rm)/ beta = (70.6% - 12%) / 1.121 = 52.3
Market earned = ( 41.2 – 12.0)/ 1.0 = 29.4
Sharpe ratio = (70.6 –12.0)/ 41.31 = 1.418 where std.dev.of p = 41.31
As against required of : (Rm – Rf /std dev. of m = (41.4 –12) / 19.44 + 1.512
Showing that performance is not as good as desired
Systematic Risk return = 1.121 ( 41.4-12) = 32.95*
Imperfect diversification: ( 41.31/19.44) ( 41.4 – 12 ) - 32.95 = 29.52*
Jenson measure = 70.6 { 12.0 + 1.121 ( 41.4 – 12)} = 58.6 – 44.75 = 13.65
So, Fama decomposition = 12.0 + 32.95 + 29.52 – 3.27
Explanation of performance: Inadequate return due to inadequate / improper diversification and poor selection of scrips.
Concept of Value at Risk.
Derivatives
Financial Contracts. Involving time between investors private or exchange traded.
Forwards, Futures, Options
Swaps, Warrants
Example of Thale ( Aristotle 2500 yrs ago). Knowledge of weather. Crop farmers, crop crushers, oil output.
As forward contract to buy use of crushers
As call option for right to use
Strike price or exercise price. Market price. Underwriter/option writer
Right to buy or right to sell.
Example. Sp , Mp, and Premium : profit, loss
Call/ put graph for purchaser and for seller (writer)
Graphs for combinations:
Straddle 1 put + 1 Call
Strip 2 puts + 1 call
Strap 1 put + 2 calls
Naked call Vs: covered call
Short selling of share Vs derivatives: short sell, sell now at given price and deliver in future at that price… borrowing share at margin.
Long buy of share: buy now takes delivery later.
European vs. American Call
In the money and Out of the money options.
Options on Stocks, bonds, Gilts, currency, indexex, commodity futures, and financial futures.
Summary Chart: Put Call
Buy Right to sell , pay premium Right to Buy, pay premium
Max. Loss = premium cost Max Loss = premium cost
Sell Obligation to buy, collect premium Obligation to sell , collect premium
Max. Loss = SP- MP – premium
Max. Loss = MP- SP- Premium, unlimited
Is delivery necessary for options? Useless. - Contracts bought back much before expiration date.
Fair Value of Option = Intrinsic Value + Time Value
Time Value = Time to expiration & volatility of stocks,
Intrinsic Value of Put: SP – MP >= 0, Call: MP – SP >= 0
Value of American call >= Value of European Call
Value of longer call >= Value of Shorter duration call
Value of higher strike price call <= Value of lower strike price call
Use of derivatives for Hedging. Hedging by portfolio managers
Reducing risk means reducing return or loss of opportunity to make higher gains.
Valuation Models: Binomial Model
Black Scholes Model
Interest rate derivatives. Housing loans.
Fixed to floating interest rates.
Indian history. Mind sets. Forward trading repeatedly band. Emergence of Badla. Liberalisation in 1991.
Derivatives introduced only in 2001.
References:
1.Modern Portfolio Theory and Investment Analysis by Edwin J. Elton & Martin J. Gruber, John Wiley
2. Portfolio Management, Samir K Barua, V Raghunathan & J R Verma, Tata Mcgra-Hill Publishing, New Delhi
3. Thoughts on Markets, Securities, Contracts & Portfolio Management, Basudeb Sen , Yet to be written
Questions for Examination.
1.Contrast Fundamental Analysis and Market psychology based
Analysis Approaches to securities valuation. Why do academics
generally dislike Technical Analysis and yet practitioners use
Technical Analysis? How do the Chartists interpret
Moving Averages?
OR
1.Briefly explain the contributions of Bachelior (1950) and
Elliot (1938) to Technical Analysis.What is Dow Jones Theory?
What does Head and Shoulders formation signify
in Technical Analysis?
2.Who laid the foundations of Modern Portfolio theory in 1951
and what was his contribution? Define Risk Averse Investor
in terms of the shape of his utility function. Will a risk averse
investor invest Rupee one in a project which is expected to
generate total benefit of Rupees Two or NIL (zero) with
equal probability of 0.5?
3.State the three forms of Efficient Market Hypothesis.
Distinguish between Security Market line and Capital Market
line. Given the variance and covariance of returns from various
securities in a portfolio, derive the formula for portfolio return
variance. Why is the exercise of an American Option unlikely
before the expiration date.
OR
3..What are the plausible interpretations of the following:
Triangle, (b) rising price of a share along with increasing
volume of trade and (c) declining Advance-Decline ratio
along with rising market index. What do the terms Theta,
Delta and Vega mean in the context of options pricing?
Contrast between European and American Options and their values.
4..Given that the investor’s objective is to maximize the Excess
portfolio return over the risk free return, derive the simultaneous
equations that will determine the weights of different securities in
the optimum portfolio. Assuming that all the investors choose the
market portfolio in equilibrium to prove that the following
relation holds: r(i) = r(m) + beta times { r(m) – r(f).}.
5..What are two major risks associated with investing in corporate
bonds? How are the concepts of Duration and Convexity relevant
to interest rate Risk Management? Derive the formula for Duration
and Convexity from the relation between the price of a bond
and the cash flows.
6..Distinguish between Single Index Models and Multiple Index
Models with suitable examples. What is Arbitrage pricing theory?
State the assumptions underlying the Capital Asset Pricing theory.
What happens if these assumptions are relaxed?
OR
6..What are the different ways of immunizing a bond portfolio?
How should the investor who has both market timing and
stock picking skills design and manage his portfolio compared
with an investor who has no such skills.
7.State the formula for Black Scholes model and explain the
factors that determine the value of an option? Explain the
terms in the money and out of the money in the context of a
call option on a stock. What is a straddle and when does an
investor adopt a straddle strategy?
8..Critically evaluate the growth of Indian mutual fund industry
during 1992-2002.Why is the Indian financial asset market not a
fully competitive and efficient one as yet? In what manner can a
mutual fund use derivatives for the benefit of its investors?
9.What prudential safeguards are taken to prevent misuse of the
facility of short selling? What does a Collar mean? Explain how
a Swap helps manage risk giving suitable example. Explain the
concepts of Put option, call option and buying and selling options
with their implications on risk and return
10.(a) Compute cost of equity and value of a share with the
following data:
r (m) = 0.1, r (f) = 0.06 , beta = 1.2 , effective tax rate=0.2,
present value of future free cash flows = Rs.42000 ,
future value of debt = Rs.12000 , debt-equity ratio = 2:1
and number of outstanding shares = 1000.
(b) The current price of a share of company XYZ is Rs.100.
The company is expected to give annual dividend of Rs.5 per
share in the next three years. At the end of the third year the
market price of a share is expected to be Rs.132. Will an
investor looking for a minimum return of 10% invest in
this share for three years?
© Compute the fund performance measures suggested by
Treynor, Sharpe and Jenson on the basis of following
information on the market (m) and portfolio (p):
r (p) =70.6%, r (f) =12%, r (m) = 41.4%, beta = 1.121,
standard deviation of market returns = 19.44 and
standard deviation of portfolio returns = 41.31.
(In answering question 10 (a), ,(b) and (c), you may
make other suitable assumptions, if necessary):
1. What is a Security? Examples. Traditional and new. Equity, Debt, Hybrid,
Units of pools. Securisation and Pass through certificates. Future/Forward
Contracts. Options.
Why securities? The purpose they serve. Acknowledgement of financial
Claims. Legal implications. Enforcement of contracts.
Need for contracts.
Savings investment. Lending Borrowing. Risk sharing. Future contracts..
Trading in contracts. Liquidity. Market . Nature of Markets.
Price determination.
Infrastructure Intermediaries. Institutional infrastructure. Technological Infrastrucure,
Knowledge and Skills Infrastructure. Regulatory Infrastructure.
Systems Risk Minimisation.
2. Why analyse securities? What do we want to find? Objectives.
Issuer of Securities, purchaser and sellers. Rating agencies.
Advisors to purchasers. Different classes of purchasers and sellers.
What does analysis involve? What factors/ parameters? What relationships?
The theory of relationships. The Content of Analysis. The tools of Analysis.
3. What is Portfolio? Why portfolio? Natural availability to Diversification for risk
containment.
Problem of uncertainty. Problem of risk. Definition of Risk.
Measurement of risk.
Relationship between Risk and return. Criteria of risk-adjusted return.
Management of Risk. Sharing, transfer and pricing of risk.
Risk immunization. Risk Insurance
Investment Portfolio Management. Investment. Divestment. Objectives of Design,
Construction, Holding and changing/ re-balancing /churning Portfolio.
Objective.
Return. Increase in Value through Dividend, Interest, benefits,
Gains on selling at higher price.
Return in excess of costs. Return in excess of opportunity cost.
Cash outflow and inflows spread over time.
Problem of aggregation. Time value of cash flows.
Predictability of future cash flows.
What does management of Portfolio mean? Activities related to
Portfolio Management.
Relationship between Security Analysis and Portfolio Management.
4. Time value of Money. Discounting and compounding. Time intervals.
Present Value. Net Present Value. Internal Rate of Return.
Perpetuity. Annuity. Yield. Yield to Maturity. Current Yield.
t. t
Related Mathematics: P (1+r) = A. PV (1+r) = TV
t
PV = TV / (1+r) > Numeric. 100 = 110/1.10
t
PV (Si) = Sum (t= 1…n) of Dt /(1+r)
t-1. t. t-1
or, Sum D(1+g) / (1+r) = Sum [ {D / (1+r)} * {(1+r)/(1+g)} ]
= D / (r-g)
t. t
Sum D/(1+r) = (D/r) * { 1 – 1 / (1+r) } = D/ r as n tends to infinity.
PV (Si) = PV (D1) + PV (D2) + PV (D3) + PV ( S3) Numeric ex.
t.
PV = b * Sum E / (1+r) + (b * E)/(r-g) = b * E/r
P / E = m. From PV = (b * E) / (r-g). m = b/r or b/ (r-g)
Value of a Firm: Fair Market Value : FMV
= PV of the stream of future after tax free cash flows to debt & equity holders.
= EBIT (1-t) + Depreciation – Investment
FMV firm = FMV of equity = FMV of debt.
Value of share = FMV equity / no. of outstanding shares.
5. Efficiency and Safety of Markets.
Design of Markets and Market Practices.
Markets & Market Infrastructure. Stock Exchanges.
Stock. Issuer. Company? Finance? Listing> Corporate Governance and other
Standards. Listing? Listing Rules.
Primary Market. Issue fresh. IPO. Additional Issue. Rights Issue. Bonus Issue.
Book building. Gilt Auctions. Intermediaries. Investment Bankers. Registrar.
Secondary Market . Trading . Buying and Selling of securities. Intermediaries.
Brokers. Trading Rules, Procedures and Practices.
Order-driven and Quote-driven Systems.
Trading Ring. Open Cry system. Electronic Exchanges. Screen-based Trading.
Dematerialisation of Securities. Paper-less system. Depositories.
Settlement Systems. Clearing House and Banks.
Rules concerning record date, book closure. Partly paid share. Multiple listing.
Kerb trading. Trading of small co shares/ unlisted paper. .
Rules relating to Insider Trading. Rules relating to Takeover.
Rules relating to Accounting. Audit and Information disclosures.
Speculation. Greed & Fear. Margin Trading. Short selling. Various requirements.
Spot Market vs : Futures Market.
6. Regulatory Infrastructure.
Design of Regulation, regulators, regulatory powers,
regulatory zeal. Costs of regulation. Risk of regulation. Enforcement of regulation.
Efficiency of Regulation. Regulation knowledge and information intelligence..
7.Fundamental Value of a Security. Present Value of Future Earnings.
Fundamental Analysis.
Cashflows of the Future. Predicting Cashflows. Earnings and Debt servicing.
Capability. Reliability of estimates. Relevance of the analysis of the past.
Importance of what is likely to happen rather than what has happened already.I Issuer Evaluation - operating, financial and management efficiency & reputation: past & reliability of future
Economy/Industry/Input market / Technology prospect Evaluation
Instrument Market Evaluation
Continuous assessment =monitoring
Entry & Exit timing - continuos review with reference to impact on risk, return and capital adequacy
Analysis of the Firm
Management. Corporate Governance
Human Resources
Intangible Assets. Brand, Reputation
Non-business Assets. Property . Investments.
Business Segment Analysis.
Balance Sheet & Profit/Loss Account strength & Weaknesses.
Net Worth. Book Value. Asset-Liability Match
Liquidity. Working capital management,
Leverage. Debt policy.
Turnover Growth trends, Market share, marketing and
distribution strengths,.
Profitability Ratios. Capacity utilization. Break-even Analysis.
Division-wise Analysis.
Cost of Capital. Return on Capital Employed. Economic Value Added.
Inter-firm cost & productivity comparison
Long-term agreements for sales, purchases, investments,
Contingent Liabilities. Derivatives Exposures.
Dividend record and Pay-out policy..
Accounts & accounts Information. Notes to Accounts. Auditors’ Report.
Systems & Procedures. Internal Monitoring & Controls. Risk Management.
Safety Systems.
Sensitivity to Industry Environment
Industry cycle. Product life cycle and Innovation.
Consumption Trends. Exports and Imports. International Trade. WTO.
Demand- Supply Trends and Gaps. Price trends.
Market Structure. Entry Barriers.
Input Supply Market Analysis.
Sensitivity to General Economic Environment
Economic Expansion and Growth Rates. GNP, GDP, IIP,
Sector composition & trends. Agriculture, Services. Infrastructure & Utilities.
Savings Investment. Productivity trends.
WPI, inflation rate, monetary and fiscal trends and policies.
Balance of Payments. Exchange rate. Forex Market trends.
International economic Relations. Impact of World economy.
Technological Advances.
Political and Bureaucratic Environment.
SWOT Analysis & Business Strategy.
Corporate Mussion, Plans and Targets. Capital Expenditure
programs and Financing policy,
Share Valuation :Financial Projections. Earnings estimates
with probabilities. Sensitivity analysis.
8. Market Psychology based Approach to Security Analysis. & Market portfolio analysis: why in addition to fundamental analysis? Short-term fluctuations in stock prices. Deviations from fundamental /intrinsic value. Time series of prices, every minute or hourly or daily or monthly (opening, closing, high, low, average) and so on. Study for discerning patterns. Interpretation of patterns. Anticipation of future movements based on past patterns. Development of trading rules and judgement. Trading based on such knowledge not identified by others. Profit/gains through trading based on such trading. Called technical analysis. Technical analysts or chartists.
Dow Theory. Dow Jones Co. Most stocks generally move up and down together with the market. Market Indices DJIA, DJTA. Study of impact of information on prices. Identification of Trend: Primary Trend – Tides, Secondary Trend (Waves), Minor /Tertiary Trends (ripples).
Primary 3 moves up: first accumulation by knowledgeable, then buying based on good earnings report corroborating knowledgeable traders anticipation, and finally entry of late comer masses influenced by spread of information. Prices rise high beating expert anticipation of fundamental value, knowledgeable exits, leading to 3 moves down. First as knowledgeable exit in hurry, then as earnings report show fundamentals cannot justify prevailing high market valuations, and as the information spreads panic selling.
Identification of trend reversal indicators for each trend, e.g. whether index crosses high of the previous secondary reversal. Identification of start of bullish/ bearish phase. Notion of Resistance / Reaction and Support levels.
Use of appropriate data on market indicators. Breadth of market and volume of transactions: rising index with rising volumes – unsatisfied demand- strong bull market, falling index with rising volumes- bearish, panic selling; rising index with falling volumes – end of bullish period; falling index and falling volumes – listless bearish phase.
Advance-decline ratio as indicator: no. of Scripps rising to no. of Scripps falling – how widespread is the rally or decline. Interpreting trend in AD ratio along with trend in volumes.
Support levels and Resistance levels marked on charts. Gaps between Resistance and support levels.
Concept of Channel, narrowing Wedge and widening gaps. Break out of boundaries. Direction reversal.
Other concepts. Triangle, Flag and series of flags, Head & Shoulders, Inverted H&S, Opening & Closing prices - Gaps between them,
Opening, closing, high & low and Candle stick.
Use of Moving average Lines: 5/10/30/90/180/365 DMA’s. Arithmetic and Exponential Moving Averages.
Concept of ROC (rate of change in prices).
Filter Rules as mechanical Trading strategies – x % filter: down x % from top requires exit.
Concept of Non-linear, stochastic dynamic price generating models.
Trading based Approach to Investing. Advice on Trading. Strict following of Objectives and Rules, stop-loss and no Greed and Fear psychosis.
9. Utility Theory & Portfolio of securities
Utility against Wealth curve. Shape of curve. Definition of Risk Aversion
First derivative positive, second derivative negative: alternative exposition –
Fait game: 50: 50 chance of A: 200 and B: 0 return against C: 100 investment.
Expected value of A and B is 100 equal to certainty 100 and yet risk averse investor prefers C.
Indifference curves.
Solution at tangency with efficiency frontier.
Portfolio of Securities.
Weights. Weighted return. Weighted mean. Weighted risk.
Concept of Mean-Variance framework.
Expected Return concept. Probabilities as weights, Expected Value as Mean Return
Portfolio risk. Portfolio variance equals Sum of weighted Co-variances: two-security case and extension to n securities case.
Risk diversification as the number of securities increases to 30?
Efficiency Frontier on Risk-Return Space. Draw graph
Concept of Risk-averse Investor
Example of A 150 or 50 with equal probability and not-A choice.
Concept of Utility function and indifference Curves.
Maximise Z as risk adjusted return of portfolio
Choose portfolio p such that Z= (rp – rm)/Sdp is max p {wi, Si}
First derivatives with respect to weights to equal zero. N equations to solve
Introduction of Risk-free security and Risk-free return.
Market portfolio.
Systematic risk and specific risk.
Capital Asset Pricing Theory (CAPM).
Capital Market Line.
[R(p) –R(f)] / [ R(m) – R(f)] = SD. (p) / SD. (m). Draw graph
Capital market equilibrium; market portfolio in equilibrium for all.
Security Market Line.
[ R(i) – R(f) ] / [ R(m) – R(f) ] = beta of i. draw graph
Bi = cov. (i, m) / var. (m) = Corelation. (I, m ) * Sdi / Sdm
= Measure of systematic risk for security I
10 assumptions of CAPM: No transaction costs, infinitely divisible security,
No capital gain or income tax, perfect competition and all price-takers,
Decision within mean-variance framework by all, unlimited short-sale allowed,
Unlimited borrowing and lending at risk free rate allowed, identical expectations by all, homogenous investment period, all securities/assets are marketable (tradable).
Relaxation of assumptions one at a time and model valilidity. Simultaneous relaxation of two or more assumptions and validity of CAPM.
Empirical tests on CAPM validity.
CAPM as one type of Single Index Model: R (I) = a (I) + B (I) r (m)
General Multi-index Models: R (I) = A (I) + B (i1) I (1) + B (i2) I (2) +…B (L) I (L) + e (I)
Where E (ei)=0 E (eiej)= 0, E (ei) (Ij) = 0
These can also be expressed in terms of differences between indexes.
Are factors. B (I) s are factor loading.
Use of statistical techniques, principal component analysis. Factor Analysis.
Standard Statistical packages available to determine / estimate As and Bs.
Alternatively, to pre-specify the indexes and do standard empirical testing.
Firm level & sector data: beta, dividend per share, bond beta, size market cap, sector dummy.
Macro-economic factor model: differences in expected and actual inflation, short-term & long-term govt. bond yields, etc.
Alternative sets of portfolios as Factors: Small stock and large stock, high and low beta, G-sec and corporate bonds, etc.
Multi- index Models for Bond Valuation.
10. Bond Portfolios:
Concept of bonds.
Tradable bonds.
Coupon.
Marurity.
Yield to maturity. Yield to call/put
Interest Rate Risk: Reinvestment Risk and Valuation Risk
Inverse relationship. Examples.
Concept of Duration
Pure discount bond. Any bond can be reduced a series of pure discount bonds.
Weighted Average duration.
Pb = C/ (1+r)^ T
DP/P = -T * D(1+r)/(1+r)
So, coupon bond P = Sum 0ver 1 to T Ct/ ( 1 + r ) ^t
DP= - {……………………………………+ Ct/(1+r)^T}
DP/P = Sum weighted present values of each coupon and return flow with -t as weights. Divided by the present value of cash flows without weights = - D * d (1+r)
Concept of Convexity
Taylor Series Expansion – f(r+h) = f ( r) + f’ ( r ). H/ 1+ f” (r). H^2/2*1 + ---------
[P (r + h) – P (r)]/ P (r) = - Sum t * Ct/ (1+r)^t D (1+r) + Sum t. (t+1) Ct/(1+r)^t d (1+r)^2/ (1+r)^2
= - D * d (1+r) + C * d^2(1+r)
Why concept of convexity required:
Interest Volatility and Bond Portfolio Immunization - Exact Matching of assets and liabilities cash flows
Barbell Strategy: Match average duration.
Focussed Strategy: match around liability cash flow duration
Rebalancing of Portfolio. Hedging with swaps. Floating to fixed or higher to lower rating bonds. Costs of hedging.
Index Bond Portfolio Investing. Choice of rating, and maturity mix.
Single Index Vs Multi Index Bond Models
11. Concept of Market Efficiency
Weak form all historical information data get promptly reflected in future prices
Semi-strong Form: all publicly available information gets quickly reflected in future prices.
Strong Form: all publicly available and insider information get quickly reflected in future prices.
The speed with which information gets reflected/ incorporated/ discounted in the market price of stocks better it is: this implies on an average no one will be able to benefit extra from information compared with others.
Results from empirical testing of these concepts of market efficiency.
12. Treatment of Taxes:
Tax adjusted returns.
Different tax regimes: ordinary investors, traders, tax exempt categories (mutual funds?).
Treatment of Interest income on bonds, G-sec, tax-exempt instruments.
Treatment of dividend income, Capital gains tax- short-term and long-term,
Distributions on winding up.
Permissible deduction. Cost of financing investments.
Shares acquired at different points of time, bonus shares, and rights shares & rights renunciation.
Convertible debentures,
Effect of company mergers and issue of new shares. Indexsation.
Carry forward of capital losses.
For Traders: Sales + closing stock- purchases- opening stock
Stock Valuation of FIFO or Average basis?
13. Asset Allocation & Stock Picking
Strategic assets allocation among equity, bonds, money market instruments. Implication on portfolio beta and duration.
Asset allocation based on target beta and duration.
Target return based asset allocation.
Tactical Asset allocation and Portfolio revision.
Type of Investors and Investment behaviour:
A. No market timing skills and No stock picking skills: simply a diversified portfolio, passive management, -- some bonds and index funds or low beta stocks--- target low beta.
B. No market timing skills but with stock picking skills: 60%-90% in diversified portfolio and rest up to 405 in undervalued stocks, generally a concentrated portfolio with constant target beta.
C. No stock picking skills but with market timing skills: have a diversified portfolio but actively manage beta to gain from market timing.
D. Both market timing and Stock-picking skills: Concentrated and not very diversified portfolio. Active and aggressive management with fluctuating beta with a long-term target beta.
14. Portfolio Management Performance Evaluation:
Self-evaluation, comparative evaluation – across time, across portfolio managers, against benchmarks.
Need for portfolio view: individual buy/sell/hold decisions do not matter, portfolio matters.
Period and frequency of evaluation. - Short periods may be misleading, average over cycles of boom and bust. – Return performance over 1m, 3m, 6m, 1yr, 2 yr., 3yr, 5 yr.,
Risk adjusted return performance criteria:
Taylor measure = risk premium over risk free return / beta
Sharpe measure = risk premium over risk free / total variability i.e. standard deviation
Jenson Measure = excess over expected return,
where expected return = Rf + beta (Rm – Rf).
Fama Decomposition:
Portfolio actual return =
Risk free return
Rf
+ Premium on systematic risk beta
( Rm-Rf)
+ Return due to imperfect diversification
{(Std dev of p/ STD dev m) – p’s beta} ( Rm- Rf)
+ Net gain due to superior selectivity
[(Rp – Rf) – (std dev of p / std dev of market) ( Rm - Rf)}
Example: R f= 12 %*
T = (Rp – Rm)/ beta = (70.6% - 12%) / 1.121 = 52.3
Market earned = ( 41.2 – 12.0)/ 1.0 = 29.4
Sharpe ratio = (70.6 –12.0)/ 41.31 = 1.418 where std.dev.of p = 41.31
As against required of : (Rm – Rf /std dev. of m = (41.4 –12) / 19.44 + 1.512
Showing that performance is not as good as desired
Systematic Risk return = 1.121 ( 41.4-12) = 32.95*
Imperfect diversification: ( 41.31/19.44) ( 41.4 – 12 ) - 32.95 = 29.52*
Jenson measure = 70.6 { 12.0 + 1.121 ( 41.4 – 12)} = 58.6 – 44.75 = 13.65
So, Fama decomposition = 12.0 + 32.95 + 29.52 – 3.27
Explanation of performance: Inadequate return due to inadequate / improper diversification and poor selection of scrips.
Concept of Value at Risk.
Derivatives
Financial Contracts. Involving time between investors private or exchange traded.
Forwards, Futures, Options
Swaps, Warrants
Example of Thale ( Aristotle 2500 yrs ago). Knowledge of weather. Crop farmers, crop crushers, oil output.
As forward contract to buy use of crushers
As call option for right to use
Strike price or exercise price. Market price. Underwriter/option writer
Right to buy or right to sell.
Example. Sp , Mp, and Premium : profit, loss
Call/ put graph for purchaser and for seller (writer)
Graphs for combinations:
Straddle 1 put + 1 Call
Strip 2 puts + 1 call
Strap 1 put + 2 calls
Naked call Vs: covered call
Short selling of share Vs derivatives: short sell, sell now at given price and deliver in future at that price… borrowing share at margin.
Long buy of share: buy now takes delivery later.
European vs. American Call
In the money and Out of the money options.
Options on Stocks, bonds, Gilts, currency, indexex, commodity futures, and financial futures.
Summary Chart: Put Call
Buy Right to sell , pay premium Right to Buy, pay premium
Max. Loss = premium cost Max Loss = premium cost
Sell Obligation to buy, collect premium Obligation to sell , collect premium
Max. Loss = SP- MP – premium
Max. Loss = MP- SP- Premium, unlimited
Is delivery necessary for options? Useless. - Contracts bought back much before expiration date.
Fair Value of Option = Intrinsic Value + Time Value
Time Value = Time to expiration & volatility of stocks,
Intrinsic Value of Put: SP – MP >= 0, Call: MP – SP >= 0
Value of American call >= Value of European Call
Value of longer call >= Value of Shorter duration call
Value of higher strike price call <= Value of lower strike price call
Use of derivatives for Hedging. Hedging by portfolio managers
Reducing risk means reducing return or loss of opportunity to make higher gains.
Valuation Models: Binomial Model
Black Scholes Model
Interest rate derivatives. Housing loans.
Fixed to floating interest rates.
Indian history. Mind sets. Forward trading repeatedly band. Emergence of Badla. Liberalisation in 1991.
Derivatives introduced only in 2001.
References:
1.Modern Portfolio Theory and Investment Analysis by Edwin J. Elton & Martin J. Gruber, John Wiley
2. Portfolio Management, Samir K Barua, V Raghunathan & J R Verma, Tata Mcgra-Hill Publishing, New Delhi
3. Thoughts on Markets, Securities, Contracts & Portfolio Management, Basudeb Sen , Yet to be written
Questions for Examination.
1.Contrast Fundamental Analysis and Market psychology based
Analysis Approaches to securities valuation. Why do academics
generally dislike Technical Analysis and yet practitioners use
Technical Analysis? How do the Chartists interpret
Moving Averages?
OR
1.Briefly explain the contributions of Bachelior (1950) and
Elliot (1938) to Technical Analysis.What is Dow Jones Theory?
What does Head and Shoulders formation signify
in Technical Analysis?
2.Who laid the foundations of Modern Portfolio theory in 1951
and what was his contribution? Define Risk Averse Investor
in terms of the shape of his utility function. Will a risk averse
investor invest Rupee one in a project which is expected to
generate total benefit of Rupees Two or NIL (zero) with
equal probability of 0.5?
3.State the three forms of Efficient Market Hypothesis.
Distinguish between Security Market line and Capital Market
line. Given the variance and covariance of returns from various
securities in a portfolio, derive the formula for portfolio return
variance. Why is the exercise of an American Option unlikely
before the expiration date.
OR
3..What are the plausible interpretations of the following:
Triangle, (b) rising price of a share along with increasing
volume of trade and (c) declining Advance-Decline ratio
along with rising market index. What do the terms Theta,
Delta and Vega mean in the context of options pricing?
Contrast between European and American Options and their values.
4..Given that the investor’s objective is to maximize the Excess
portfolio return over the risk free return, derive the simultaneous
equations that will determine the weights of different securities in
the optimum portfolio. Assuming that all the investors choose the
market portfolio in equilibrium to prove that the following
relation holds: r(i) = r(m) + beta times { r(m) – r(f).}.
5..What are two major risks associated with investing in corporate
bonds? How are the concepts of Duration and Convexity relevant
to interest rate Risk Management? Derive the formula for Duration
and Convexity from the relation between the price of a bond
and the cash flows.
6..Distinguish between Single Index Models and Multiple Index
Models with suitable examples. What is Arbitrage pricing theory?
State the assumptions underlying the Capital Asset Pricing theory.
What happens if these assumptions are relaxed?
OR
6..What are the different ways of immunizing a bond portfolio?
How should the investor who has both market timing and
stock picking skills design and manage his portfolio compared
with an investor who has no such skills.
7.State the formula for Black Scholes model and explain the
factors that determine the value of an option? Explain the
terms in the money and out of the money in the context of a
call option on a stock. What is a straddle and when does an
investor adopt a straddle strategy?
8..Critically evaluate the growth of Indian mutual fund industry
during 1992-2002.Why is the Indian financial asset market not a
fully competitive and efficient one as yet? In what manner can a
mutual fund use derivatives for the benefit of its investors?
9.What prudential safeguards are taken to prevent misuse of the
facility of short selling? What does a Collar mean? Explain how
a Swap helps manage risk giving suitable example. Explain the
concepts of Put option, call option and buying and selling options
with their implications on risk and return
10.(a) Compute cost of equity and value of a share with the
following data:
r (m) = 0.1, r (f) = 0.06 , beta = 1.2 , effective tax rate=0.2,
present value of future free cash flows = Rs.42000 ,
future value of debt = Rs.12000 , debt-equity ratio = 2:1
and number of outstanding shares = 1000.
(b) The current price of a share of company XYZ is Rs.100.
The company is expected to give annual dividend of Rs.5 per
share in the next three years. At the end of the third year the
market price of a share is expected to be Rs.132. Will an
investor looking for a minimum return of 10% invest in
this share for three years?
© Compute the fund performance measures suggested by
Treynor, Sharpe and Jenson on the basis of following
information on the market (m) and portfolio (p):
r (p) =70.6%, r (f) =12%, r (m) = 41.4%, beta = 1.121,
standard deviation of market returns = 19.44 and
standard deviation of portfolio returns = 41.31.
(In answering question 10 (a), ,(b) and (c), you may
make other suitable assumptions, if necessary):
Indian Economiy 1999-2000
SUSTAINING GROWTH ACCELERATION
Basudeb Sen *
The economic scenario for 1999-2000 painted in July (ET-17.7.99) seems to be coming true : the end-October RBI assessment broadly confirms this. With four months to go, the scenario for the year looks as follows : GDP growth close to 6.5%, industrial growth of over 7%, services sector growth close to 8.5% and average inflation rate for the year below 5% (though end-March point-to-point rate may touch 6%). Balance of payments will remain under control, current account deficit at comfortable level and exchange rate below Rs 44.50.
Economic Scenario
99-00
(July) 99-00
(Oct) 99-00
(Dec) 00-01
(Dec)
GDPGrowth (%) >6% 6 - 6.5 6.5 6.6-7.2
Industrial Growth (%) 7.0 7.0 >7.0 7.0-8.0
Services Growth (%) 9.0 - 8.5 8.5-9.0
Inflation (%) <5.0 <5.0 <5.0 5.0-6.0
Exchange Rate (Rs/$) 43-45 - <44 <44.5
2. Our July hypotheses on market dynamics continues to hold : (a) demand is growing though at a slow rate for many sectors, (b) capacity utilisation is improving while excess capacity situation still remains and therefore
(c) upward pressure on prices is not yet strong especially in view of domestic and import competition. Corporate profits will grow though at a slower rate than growth in sales value. Interest costs have declined (sharply for highly
rated companies with lower dependence on high cost borrowings and greater efficiency in working capital). However, many companies in the midst of large grass-root project implementation are yet to benefit from lower interest rates. Most banks are likely to report better profits.
3. Can the growth acceleration witnessed this year sustain in the next year? Yes, a GDP growth of 7% is possible in 2000-01. Industry may record a growth of 7.5% to 8.0% and services sector 8.5% to 9.0%. Agriculture may grow by about 3% in 2000-01. The growth drivers in 2000-01 will include higher crop output in the Eastern and North Eastern Region, competition-induced modernization investment and associated productivity gains in industry, revival of demand for clothing and housing, wealth effect on purchase of consumer durables, additional construction demand in Orissa and border areas as also surge in entertainment industry, tourism, financial services (demat, mutual funds, financial re-engineering/consultancy, securities placement and trading), IT, telecom and internet related services. Growth of many of these economic activities will require relatively low Bank/FI credit, while some others will avoid high cost debt. Strong growth in OECD and SE Asian countries and lower import duties should help export growth. Agricultural exports will rise. Software export growth will sustain. However, sharp rise in industrial capacity investments may not take off till September 2000.
4. Price situation may not be as favourable with a point-to-point inflation rate of about 6% in April 2000. As subsidies are reduced and ‘administered’ prices and user charges freed/raised, inflation rate will tend to rise as capacity utilisation levels will have increased substantially by August-September 2000. Strong price-dampening factors will include domestic competition (except those like textile and paper where consolidation and closure of uneconomic units may lead to some price rise), lower input duties, greater access to imports and control on M3 growth. Net effect of all these may mean an average inflation rate of 6% in 2000-01.
5. The imbalance in the savings investment-loanable funds market may become too severe to avert further decline in interest rate : banks may not find adequate opportunities for low-risk lending at interest rates above 12% while strong growth of 10% - 10.5% fixed deposit continues. With more buoyant government revenues (as growth acceleration continues) and sharp rise in PSU divestment, Government may be able to borrow at much lower rates in 2000-01. Even State Governments may seek to reduce their cost of borrowings on bonds/small savings. As a result, G-Sec may not remain so attractive avenue for deploying high-cost deposits and the resistance to reduce deposit/lending rates may weaken. Falling interest rates can be both growth-inducing and inflation abating. At lower interest rates, capacity investment may pick up. Especially, long-gestation infrastructure projects require low cost debt funds to be viable if the infrastructure services tariffs are to remain low. Also, capacity locked-up in companies unable to continue because of high-interest burden may get released as lenders begin restructuring debts at lower interest rates. Moreover, enhanced commercial attractiveness of capacity-creating investment may lead to higher growth of import. This may help arrest upward pressure on the Rupee consequent on stronger FDI and FII inflows expected next year.
6. While market dynamics suggest sustainability of growth momentum with some rise in inflation, economic policy can stand in the way or strengthen the positive market dynamics. There are constraints on freedom of economic agents (including PSUs) in responding to varying market conditions. To remove such constraints, economic agents may be prohibited from referring their commercial decisions to any State agency/official for consultation or approval. Rather, the State may facilitate and encourage individual and corporate initiative. The economy will also benefit from speedy implementation of reforms agenda already announced and the first set of mega road/bridge projects, as also from re-allocation of government spending away from subsidising income-earning citizens to strengthen infrastructure for health and primary education. Thus, the scenario of 7% GDP growth, less than 6% inflation rate and higher investment rate in 2000-01 reflects realistic macro-economic objectives. The Economic Survey and the Budget in February will indicate to what extent the advantageous market dynamics and efficiency gains from further liberalisation of individual enterprise are sought to be leveraged to achieve these objectives.
______________________________________________________________
* Executive Director, Unit Trust of India. Views expressed here are his own.
Basudeb Sen *
The economic scenario for 1999-2000 painted in July (ET-17.7.99) seems to be coming true : the end-October RBI assessment broadly confirms this. With four months to go, the scenario for the year looks as follows : GDP growth close to 6.5%, industrial growth of over 7%, services sector growth close to 8.5% and average inflation rate for the year below 5% (though end-March point-to-point rate may touch 6%). Balance of payments will remain under control, current account deficit at comfortable level and exchange rate below Rs 44.50.
Economic Scenario
99-00
(July) 99-00
(Oct) 99-00
(Dec) 00-01
(Dec)
GDPGrowth (%) >6% 6 - 6.5 6.5 6.6-7.2
Industrial Growth (%) 7.0 7.0 >7.0 7.0-8.0
Services Growth (%) 9.0 - 8.5 8.5-9.0
Inflation (%) <5.0 <5.0 <5.0 5.0-6.0
Exchange Rate (Rs/$) 43-45 - <44 <44.5
2. Our July hypotheses on market dynamics continues to hold : (a) demand is growing though at a slow rate for many sectors, (b) capacity utilisation is improving while excess capacity situation still remains and therefore
(c) upward pressure on prices is not yet strong especially in view of domestic and import competition. Corporate profits will grow though at a slower rate than growth in sales value. Interest costs have declined (sharply for highly
rated companies with lower dependence on high cost borrowings and greater efficiency in working capital). However, many companies in the midst of large grass-root project implementation are yet to benefit from lower interest rates. Most banks are likely to report better profits.
3. Can the growth acceleration witnessed this year sustain in the next year? Yes, a GDP growth of 7% is possible in 2000-01. Industry may record a growth of 7.5% to 8.0% and services sector 8.5% to 9.0%. Agriculture may grow by about 3% in 2000-01. The growth drivers in 2000-01 will include higher crop output in the Eastern and North Eastern Region, competition-induced modernization investment and associated productivity gains in industry, revival of demand for clothing and housing, wealth effect on purchase of consumer durables, additional construction demand in Orissa and border areas as also surge in entertainment industry, tourism, financial services (demat, mutual funds, financial re-engineering/consultancy, securities placement and trading), IT, telecom and internet related services. Growth of many of these economic activities will require relatively low Bank/FI credit, while some others will avoid high cost debt. Strong growth in OECD and SE Asian countries and lower import duties should help export growth. Agricultural exports will rise. Software export growth will sustain. However, sharp rise in industrial capacity investments may not take off till September 2000.
4. Price situation may not be as favourable with a point-to-point inflation rate of about 6% in April 2000. As subsidies are reduced and ‘administered’ prices and user charges freed/raised, inflation rate will tend to rise as capacity utilisation levels will have increased substantially by August-September 2000. Strong price-dampening factors will include domestic competition (except those like textile and paper where consolidation and closure of uneconomic units may lead to some price rise), lower input duties, greater access to imports and control on M3 growth. Net effect of all these may mean an average inflation rate of 6% in 2000-01.
5. The imbalance in the savings investment-loanable funds market may become too severe to avert further decline in interest rate : banks may not find adequate opportunities for low-risk lending at interest rates above 12% while strong growth of 10% - 10.5% fixed deposit continues. With more buoyant government revenues (as growth acceleration continues) and sharp rise in PSU divestment, Government may be able to borrow at much lower rates in 2000-01. Even State Governments may seek to reduce their cost of borrowings on bonds/small savings. As a result, G-Sec may not remain so attractive avenue for deploying high-cost deposits and the resistance to reduce deposit/lending rates may weaken. Falling interest rates can be both growth-inducing and inflation abating. At lower interest rates, capacity investment may pick up. Especially, long-gestation infrastructure projects require low cost debt funds to be viable if the infrastructure services tariffs are to remain low. Also, capacity locked-up in companies unable to continue because of high-interest burden may get released as lenders begin restructuring debts at lower interest rates. Moreover, enhanced commercial attractiveness of capacity-creating investment may lead to higher growth of import. This may help arrest upward pressure on the Rupee consequent on stronger FDI and FII inflows expected next year.
6. While market dynamics suggest sustainability of growth momentum with some rise in inflation, economic policy can stand in the way or strengthen the positive market dynamics. There are constraints on freedom of economic agents (including PSUs) in responding to varying market conditions. To remove such constraints, economic agents may be prohibited from referring their commercial decisions to any State agency/official for consultation or approval. Rather, the State may facilitate and encourage individual and corporate initiative. The economy will also benefit from speedy implementation of reforms agenda already announced and the first set of mega road/bridge projects, as also from re-allocation of government spending away from subsidising income-earning citizens to strengthen infrastructure for health and primary education. Thus, the scenario of 7% GDP growth, less than 6% inflation rate and higher investment rate in 2000-01 reflects realistic macro-economic objectives. The Economic Survey and the Budget in February will indicate to what extent the advantageous market dynamics and efficiency gains from further liberalisation of individual enterprise are sought to be leveraged to achieve these objectives.
______________________________________________________________
* Executive Director, Unit Trust of India. Views expressed here are his own.
Six Lectures on Portfolio Management- Synopsis (2003)
Refresher Course (November 2003) at Dept. of Economics, Jadavpur University 700032
Synopsis of Six Lectures by Dr. Basudeb Sen on Portfolio Risk Management & Mutual Funds
The theory and practice of modern portfolio management reflects the high quality research efforts of a large number of economists, specially mathematical and financial economists and econometricians, during the last five decades. This area of economics however owes it origin to the contribution on general equilibrium of multiple markets by Walrus (1874) and the contribution on interest theory in a finite period sequence economy by Fisher(1930). The formal incorporation of the economic reality of uncertainty / risk in the Walrusian and Fisherian frameworks was the challenge taken up by economists like Hicks (1939), Markowitz (1952), Arrow (1953), Modiglani & Miller (1958), Tobin (1958), Sharpe (1964), Linter (1965), Stiltz (1969, 1974) and Black & Scholes (1973).
Financial Markets
An understanding of the nature and complexity of financial markets facilitates better appreciation of theory and practice of portfolio risk management and mutual fund markets. Financial markets essentially deal with contracts involving time / future. The agents who buy and sell contracts are of various types and transact on the basis of their preferences and needs of transferring /redistributing their incomes among current and future periods of time and their views about what is likely to happen in the future. In all markets, self-interest and opportunism also influence transactions of economic agents. Efficient financial markets therefore require a reliable medium of exchange, mechanism of market-making and trading, monitoring and enforcement of contracts for exchange and an effective, speedy dispute settlement systems. Financial markets constitute a giant machine of inter-temporal transfers to solve a civilized society’s problem of matching/coordinating consumption and production over different periods of time. Usually, the financial markets deal in financial securities of various types like Equity, Debt, Hybrid, Units of pools, Pass through certificates, future/ forward contracts and options. Trading in securities leads to price determination. Analysis of securities is important part of portfolio management.
Portfolio: Return & Risk
A portfolio of securities may be defined in terms of weights of each security in the universe in terms of the money value of the respective security relative to the money value of all securities in that portfolio. Therefore, each portfolio has a weighted average return and weighted portfolio return. Portfolio management is concerned with managing and risk of portfolio of securities. This demands understanding the concepts of return, risk and diversification, their measurement and their interrelation. The issues that need to be explored are criteria of risk-adjusted return; sharing, transfer and pricing of risk as also risk immunization and risk insurance. Given specified objectives, management of portfolio risk is carried out through construction, holding and changing/ re-balancing /churning of portfolio.
The usual framework for portfolio management is the mean-variance framework; Mean return is the expected value (as defined in terms of probability theory). The volatility or variance of the return measures the risk. Each portfolio has an expected (mean) return and a variance or risk and is represented by a point in the risk-return space. On this space one can order the portfolios in terms of the preference of the economic agent holding or intending to hold and manage portfolios. This is similar to consumer indifference curve family. Again, risk is assumed to vary with return in a positive relationship. The choice is to be made only among those portfolios lying on the efficiency frontier in the risk-return space. The general theory of portfolio choice is therefore one of choosing that portfolio on the efficiency frontier that maximizes the utility of wealth represented by portfolio of securities. For consistency of solution, it is assumed that the economic agents are risk-averse investors (which is true in most cases), where risk-aversion is reflected in the negative sign of the second derivative of the utility function with respect to wealth.
Capital Asset Pricing Model (CAPM)
CAPM is the most popular model of capital market equilibrium and one of the cornerstones of modern portfolio risk management theory. Assumptions of CAPM include: no transaction costs, infinitely divisible security, no capital gain or income tax, perfect competition with all as price-takers, decision-making in mean-variance framework by all, unlimited short-sale, unlimited borrowing and lending at risk-free rate, identical expectations by all, homogenous investment period, all securities/assets are marketable (tradable). Empirical test of CAPM indicates the validity of the model even if one assumption is relaxed at a time, but there are problems if two or more assumptions are relaxed simultaneously. The mean-variance framework of portfolio risk management theory is the result of the contributions of Markowitz, Sharpe and Linter. CAPM relies on the concept of beta which measures the volatility of a security’s (or, portfolio’s) return relative to the volatility of the market return and the concept of risk-free return security. If beta of a security is or a portfolio is unity, the security / portfolio is expected to yield the same return as the market. The investor is supposed to choose the portfolio with the highest risk-adjusted return (or return per unit of risk or mean return per unit of standard deviation of returns). This Markowitz approach establishes that systematic risk cannot be diversified away but diversification up to a certain point can reduce risk depending on the covariance of returns of different securities in the portfolios. CAPM has a great influence in the way value of the firm and hence the value of equity in a company is estimated. Fair Market Value is defined as the present value of the stream of future after-tax free cash flows to debt and equity holders where these cash flows equal EBIT (1-t) + Depreciation – Investment; EBIT being earnings before interest and tax and t the tax rate.
Concept of Market Efficiency
As in all other areas of economics of markets, the concept of market efficiency in terms of the speed at which all information gets reflected in the prices is very important to financial markets and CAPM. Three levels of market efficiency are empirically tested: weak form, semi-strong form and strong form. The speed with which information gets reflected/ incorporated/ discounted in the market price of stocks better it is: this implies on an average no one will be able to benefit extra from information compared with others.
Portfolio of bonds
The portfolio management approach has given scientific basis of the age-old wisdom of diversification of risk: ‘not to put all eggs in the same basket’. Portfolios may consist of same or different classes of financial assets. Different classes of assets have special characteristics of their own. There are special features of portfolio management depending on the nature of financial asset class represented in the portfolio. A portfolio of equity shares can be compared with the portfolio of all shares traded in the stock market. Similarly, a portfolio of bonds may be compared with the portfolio of all bonds traded in the market. However, bonds are different than equity shares in terms of the nature of their future stream of cash flows. The value of a bond changes inversely with the changes in the interest rates. But, the cash flows are subject to reinvestment rate risk if the interest rate changes; though the relationship is positive between reinvestment rate and interest rate. The bond portfolios are therefore often managed in a manner to cancel out the above two opposite effects of a change in interest rate. This gives rise to the concept of duration of bonds and convexity property. To immunize bond portfolio values from interest rate volatility, strategies like exact matching of assets and liabilities cash flows, duration matching, etc are adopted.
Portfolio Hedging
Portfolio managers may hedge risk in different ways. One of the way to hedge risk is to invest in / buy /sell derivatives. There are various kinds of equity and credit derivatives. However hedging has a cost because the risk is transferred. Reducing risk means reducing return or loss of opportunity to make higher gains. One type of derivative is option which gives right to the buyer of an option a right to exercise the right (not an obligation) to buy / sell a security at a price specified at the time of contract within a specified future point/ period of time. Options as rights have values. Fisher Black’s valuation model for stock warrants involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The Myron Scholes joined Black to work out an accurate option-pricing model by making considerable improvement of a model developed earlier by A. James Boness in a Ph.D. dissertation. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.
Portfolio Performance Evaluation
The performance of investment portfolios is assessed in terms of the risk-return framework. Performance evaluation is done across time, across different but comparable portfolios and against benchmarks. Standard risk-adjusted return performance criteria include the
Taylor measure (risk premium earned over risk free return / beta), Sharpe measure (risk premium over risk free / total variability i.e. standard deviation), and Jenson measure ( return in excess of expected return where expected return is linked to beta. Analysis of portfolio performance is made through Fama decomposition of actual return into risk free return, premium on systematic risk, return due to imperfect diversification, and net gain due to superior selectivity.
Mutual Funds
Mutual funds mobilises the savings of the different classes of economic agents in different pools to invest in portfolio of financial assets / securities of different classes. Thus, they represent common investment vehicles in which investors can participate with the benefit of professional portfolio investment managers by paying a fee for such service. The common investment vehicles with their portfolio of financial assets are owned by the investors in proportion of their contributions (number of units) but fund/ asset management companies in accordance with the relevant regulations manage the portfolios. On behalf of the investors (unit-holders), Trustees supervise and deal with the asset management companies and the performance of the funds. In the case of an individual investor managing his/her own portfolio, his/her own preference, objective, analysis, views and experience guide the investor. In the case of mutual funds, the objectives of different mutual funds are published / disclosed up-front and cannot be change without unit-holders’ approval by majority. The unit-holders depend on the views and analysis as well as actual performance of the managers based on regular disclosures by the managers. There are various types of mutual funds (in India called mutual fund schemes) like aggressive growth equity funds, value equity funds, index funds, sector equity funds, balanced funds, equity income funds, bond funds, liquid funds, debt-income funds, money market funds. These different types of funds by their names try to convey their objectives and style of portfolio management. The funds are generally open-ended (i.e., investors can enter and exit the fund at any point of time at net asset value of the funds). The performance of different funds is tracked by different publications. The standard portfolio performance evaluation criteria are applied to asset the performance of funds.
The origin of Indian Mutual Funds may be traced back to 1964 when Unit Scheme 1964, a mutual fund type (open-end, net asset value (NAV)- based) investment vehicle, was introduced by Unit Trust of India (UTI). Over the years, UTI introduced a variety of other vehicles like Unit Linked Insurance Plan, Children Gift & Growth Fund. In the initial decades of operation, UTI invested only a small percentage of funds in equity shares. By the early 1980s, UTI started offering Monthly Income Schemes (MIPs) offering assured returns. These MIP-investment portfolios contained more than 90% debt papers. UTI introduced the first fully equity-oriented scheme, Mastershare. However, it was a closed-end scheme (even though it was referred to as a Mutual Fund). Meanwhile, US-64 had become popular because of its consistent dividend record, perception of absolute safety leading to steady inflow of investors’ subscription with very low percentage of repurchases/exit by investors as also tax concessions to investors in UTI schemes. US-64 soon became attractive to companies both as long-term investment as well as for parking of short-term funds for better liquidity management. At present there are more than 30 mutual fund (MFs) players with widely varying sizes in terms of the value of assets managed. The number of MFs increased from 9 in 1992 to 34 in 2002. The number of schemes managed by the MFs increased from 100 in 1992 to over 400 in 2002.There is a great variety of schemes (and options) for investors to choose from. More than 50% of the asset management companies have foreign equity participation. Open-end schemes (the true mutual fund schemes) account for 75% of the total number of schemes and about 70% of the total assets managed. The regulatory framework has improved since 1993 in phases and currently reflects the best standards of transparency, investor-friendliness and use of modern technology. There is now a greater awareness among the investors about the concept and nature of mutual funds and they recognise that MF investing is associated with varying levels of risk and not an assured return, absolutely safe proposition. The market value of assets managed has increased more than two-fold during the last decade. However, the share of mutual fund units in household financial savings continue to remain low (average of 7% during the four year period to 1992-93, average of about 5% during the six year period to 1994-95 and average of less than 2.5% during the seven-year period to 2000-01).
Synopsis of Six Lectures by Dr. Basudeb Sen on Portfolio Risk Management & Mutual Funds
The theory and practice of modern portfolio management reflects the high quality research efforts of a large number of economists, specially mathematical and financial economists and econometricians, during the last five decades. This area of economics however owes it origin to the contribution on general equilibrium of multiple markets by Walrus (1874) and the contribution on interest theory in a finite period sequence economy by Fisher(1930). The formal incorporation of the economic reality of uncertainty / risk in the Walrusian and Fisherian frameworks was the challenge taken up by economists like Hicks (1939), Markowitz (1952), Arrow (1953), Modiglani & Miller (1958), Tobin (1958), Sharpe (1964), Linter (1965), Stiltz (1969, 1974) and Black & Scholes (1973).
Financial Markets
An understanding of the nature and complexity of financial markets facilitates better appreciation of theory and practice of portfolio risk management and mutual fund markets. Financial markets essentially deal with contracts involving time / future. The agents who buy and sell contracts are of various types and transact on the basis of their preferences and needs of transferring /redistributing their incomes among current and future periods of time and their views about what is likely to happen in the future. In all markets, self-interest and opportunism also influence transactions of economic agents. Efficient financial markets therefore require a reliable medium of exchange, mechanism of market-making and trading, monitoring and enforcement of contracts for exchange and an effective, speedy dispute settlement systems. Financial markets constitute a giant machine of inter-temporal transfers to solve a civilized society’s problem of matching/coordinating consumption and production over different periods of time. Usually, the financial markets deal in financial securities of various types like Equity, Debt, Hybrid, Units of pools, Pass through certificates, future/ forward contracts and options. Trading in securities leads to price determination. Analysis of securities is important part of portfolio management.
Portfolio: Return & Risk
A portfolio of securities may be defined in terms of weights of each security in the universe in terms of the money value of the respective security relative to the money value of all securities in that portfolio. Therefore, each portfolio has a weighted average return and weighted portfolio return. Portfolio management is concerned with managing and risk of portfolio of securities. This demands understanding the concepts of return, risk and diversification, their measurement and their interrelation. The issues that need to be explored are criteria of risk-adjusted return; sharing, transfer and pricing of risk as also risk immunization and risk insurance. Given specified objectives, management of portfolio risk is carried out through construction, holding and changing/ re-balancing /churning of portfolio.
The usual framework for portfolio management is the mean-variance framework; Mean return is the expected value (as defined in terms of probability theory). The volatility or variance of the return measures the risk. Each portfolio has an expected (mean) return and a variance or risk and is represented by a point in the risk-return space. On this space one can order the portfolios in terms of the preference of the economic agent holding or intending to hold and manage portfolios. This is similar to consumer indifference curve family. Again, risk is assumed to vary with return in a positive relationship. The choice is to be made only among those portfolios lying on the efficiency frontier in the risk-return space. The general theory of portfolio choice is therefore one of choosing that portfolio on the efficiency frontier that maximizes the utility of wealth represented by portfolio of securities. For consistency of solution, it is assumed that the economic agents are risk-averse investors (which is true in most cases), where risk-aversion is reflected in the negative sign of the second derivative of the utility function with respect to wealth.
Capital Asset Pricing Model (CAPM)
CAPM is the most popular model of capital market equilibrium and one of the cornerstones of modern portfolio risk management theory. Assumptions of CAPM include: no transaction costs, infinitely divisible security, no capital gain or income tax, perfect competition with all as price-takers, decision-making in mean-variance framework by all, unlimited short-sale, unlimited borrowing and lending at risk-free rate, identical expectations by all, homogenous investment period, all securities/assets are marketable (tradable). Empirical test of CAPM indicates the validity of the model even if one assumption is relaxed at a time, but there are problems if two or more assumptions are relaxed simultaneously. The mean-variance framework of portfolio risk management theory is the result of the contributions of Markowitz, Sharpe and Linter. CAPM relies on the concept of beta which measures the volatility of a security’s (or, portfolio’s) return relative to the volatility of the market return and the concept of risk-free return security. If beta of a security is or a portfolio is unity, the security / portfolio is expected to yield the same return as the market. The investor is supposed to choose the portfolio with the highest risk-adjusted return (or return per unit of risk or mean return per unit of standard deviation of returns). This Markowitz approach establishes that systematic risk cannot be diversified away but diversification up to a certain point can reduce risk depending on the covariance of returns of different securities in the portfolios. CAPM has a great influence in the way value of the firm and hence the value of equity in a company is estimated. Fair Market Value is defined as the present value of the stream of future after-tax free cash flows to debt and equity holders where these cash flows equal EBIT (1-t) + Depreciation – Investment; EBIT being earnings before interest and tax and t the tax rate.
Concept of Market Efficiency
As in all other areas of economics of markets, the concept of market efficiency in terms of the speed at which all information gets reflected in the prices is very important to financial markets and CAPM. Three levels of market efficiency are empirically tested: weak form, semi-strong form and strong form. The speed with which information gets reflected/ incorporated/ discounted in the market price of stocks better it is: this implies on an average no one will be able to benefit extra from information compared with others.
Portfolio of bonds
The portfolio management approach has given scientific basis of the age-old wisdom of diversification of risk: ‘not to put all eggs in the same basket’. Portfolios may consist of same or different classes of financial assets. Different classes of assets have special characteristics of their own. There are special features of portfolio management depending on the nature of financial asset class represented in the portfolio. A portfolio of equity shares can be compared with the portfolio of all shares traded in the stock market. Similarly, a portfolio of bonds may be compared with the portfolio of all bonds traded in the market. However, bonds are different than equity shares in terms of the nature of their future stream of cash flows. The value of a bond changes inversely with the changes in the interest rates. But, the cash flows are subject to reinvestment rate risk if the interest rate changes; though the relationship is positive between reinvestment rate and interest rate. The bond portfolios are therefore often managed in a manner to cancel out the above two opposite effects of a change in interest rate. This gives rise to the concept of duration of bonds and convexity property. To immunize bond portfolio values from interest rate volatility, strategies like exact matching of assets and liabilities cash flows, duration matching, etc are adopted.
Portfolio Hedging
Portfolio managers may hedge risk in different ways. One of the way to hedge risk is to invest in / buy /sell derivatives. There are various kinds of equity and credit derivatives. However hedging has a cost because the risk is transferred. Reducing risk means reducing return or loss of opportunity to make higher gains. One type of derivative is option which gives right to the buyer of an option a right to exercise the right (not an obligation) to buy / sell a security at a price specified at the time of contract within a specified future point/ period of time. Options as rights have values. Fisher Black’s valuation model for stock warrants involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The Myron Scholes joined Black to work out an accurate option-pricing model by making considerable improvement of a model developed earlier by A. James Boness in a Ph.D. dissertation. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.
Portfolio Performance Evaluation
The performance of investment portfolios is assessed in terms of the risk-return framework. Performance evaluation is done across time, across different but comparable portfolios and against benchmarks. Standard risk-adjusted return performance criteria include the
Taylor measure (risk premium earned over risk free return / beta), Sharpe measure (risk premium over risk free / total variability i.e. standard deviation), and Jenson measure ( return in excess of expected return where expected return is linked to beta. Analysis of portfolio performance is made through Fama decomposition of actual return into risk free return, premium on systematic risk, return due to imperfect diversification, and net gain due to superior selectivity.
Mutual Funds
Mutual funds mobilises the savings of the different classes of economic agents in different pools to invest in portfolio of financial assets / securities of different classes. Thus, they represent common investment vehicles in which investors can participate with the benefit of professional portfolio investment managers by paying a fee for such service. The common investment vehicles with their portfolio of financial assets are owned by the investors in proportion of their contributions (number of units) but fund/ asset management companies in accordance with the relevant regulations manage the portfolios. On behalf of the investors (unit-holders), Trustees supervise and deal with the asset management companies and the performance of the funds. In the case of an individual investor managing his/her own portfolio, his/her own preference, objective, analysis, views and experience guide the investor. In the case of mutual funds, the objectives of different mutual funds are published / disclosed up-front and cannot be change without unit-holders’ approval by majority. The unit-holders depend on the views and analysis as well as actual performance of the managers based on regular disclosures by the managers. There are various types of mutual funds (in India called mutual fund schemes) like aggressive growth equity funds, value equity funds, index funds, sector equity funds, balanced funds, equity income funds, bond funds, liquid funds, debt-income funds, money market funds. These different types of funds by their names try to convey their objectives and style of portfolio management. The funds are generally open-ended (i.e., investors can enter and exit the fund at any point of time at net asset value of the funds). The performance of different funds is tracked by different publications. The standard portfolio performance evaluation criteria are applied to asset the performance of funds.
The origin of Indian Mutual Funds may be traced back to 1964 when Unit Scheme 1964, a mutual fund type (open-end, net asset value (NAV)- based) investment vehicle, was introduced by Unit Trust of India (UTI). Over the years, UTI introduced a variety of other vehicles like Unit Linked Insurance Plan, Children Gift & Growth Fund. In the initial decades of operation, UTI invested only a small percentage of funds in equity shares. By the early 1980s, UTI started offering Monthly Income Schemes (MIPs) offering assured returns. These MIP-investment portfolios contained more than 90% debt papers. UTI introduced the first fully equity-oriented scheme, Mastershare. However, it was a closed-end scheme (even though it was referred to as a Mutual Fund). Meanwhile, US-64 had become popular because of its consistent dividend record, perception of absolute safety leading to steady inflow of investors’ subscription with very low percentage of repurchases/exit by investors as also tax concessions to investors in UTI schemes. US-64 soon became attractive to companies both as long-term investment as well as for parking of short-term funds for better liquidity management. At present there are more than 30 mutual fund (MFs) players with widely varying sizes in terms of the value of assets managed. The number of MFs increased from 9 in 1992 to 34 in 2002. The number of schemes managed by the MFs increased from 100 in 1992 to over 400 in 2002.There is a great variety of schemes (and options) for investors to choose from. More than 50% of the asset management companies have foreign equity participation. Open-end schemes (the true mutual fund schemes) account for 75% of the total number of schemes and about 70% of the total assets managed. The regulatory framework has improved since 1993 in phases and currently reflects the best standards of transparency, investor-friendliness and use of modern technology. There is now a greater awareness among the investors about the concept and nature of mutual funds and they recognise that MF investing is associated with varying levels of risk and not an assured return, absolutely safe proposition. The market value of assets managed has increased more than two-fold during the last decade. However, the share of mutual fund units in household financial savings continue to remain low (average of 7% during the four year period to 1992-93, average of about 5% during the six year period to 1994-95 and average of less than 2.5% during the seven-year period to 2000-01).
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