Sunday, March 30, 2008
Assume a small slow growing economy Torts from tortoise having just 3 players A B C each having 1 kg of wheat. Let’s put a monetary cost to their produce at Rs. 10/- . In such a scenario the economy would remain stagnant and the growth of the economy is going to be 0%. Now seeing this perilous scenario an angel descends on their world with the name ‘The Party Pooper Bank of Torts’ – PPBT. The bank says that it is prepared to lend Rs. 5/- to anyone for 1 year but wants Rs. 5.5/- in return. A is the entrepreneurial type of guy. He comes forward and takes the offer. Now at the end of year one the following 3 scenarios can occur:
First of all in all the 3 cases let’s convert their wheat stock to Rs. 10/- per kg unless otherwise mentioned. A toils his land and produces rice. Now he can sell his rice at any price between Rs. 0-10, let’s take 2 cutoffs of 5.5 or less and more than 5.5, in the scenario where A is able to sell his rice at more than Rs 5.5, he is able to make a profit on his venture. Let’s say A is able to sell his rice at Rs. 10 so the GDP grows at 33.33%.
Let me add that this scenario also answers one of the basic questions in economics: ‘Why do economies grow’. This economy grew because of 3 factors:
Capital (Money from PPBT)
Land (Asset which is natural resource in this case)
Labour (The effort put in by A)
Entrepreneurial spirit (As shown by A)
A would have equivalent of Rs 20/- , B would have equivalent of Rs. 10/- and C would have equivalent of Rs. 10/-. Now A can buy some of the goods from C at Rs 10 or more. If A knows that B has just Rs 10 with him then he would buy the goods at Rs lets say at 10.05, so the inflation in the economy stands at 0.5%. However in a normal scenario there is ‘information asymmetry’ in the market and so A may jack up the price to as high as Rs 14.5/- for the product of C causing inflation to shoot up to 45% !!!. So its important to understand that the culprit here is not the monetary policy but information asymmetry.
In the next scenario wherein A gets Rs 5.5 or less A makes no profit however the economy still grows at 18.33%, any surplus liquidity is absorbed and so inflation menace doesn’t raises its head. Well this looks like the perfect scenario which has no excesses, the only problem is that if this scenario continues for long it will generate 2 problems. A would loose any interest in investing in the venture and also A would have no surplus capital of his own to invest.
In the last scenario A takes the 10 rupees and jacks up the price of the product of C to Rs 20. This causes the inflation to rise at 100% and GDP growth is 0%. Later on in order to repay the loan when A tries to sell back the product whose value is supposedly Rs 20/- but only C has the capacity to buy, however there is no reason for C to buy back the product he sold a little earlier (Velocity of money comes into picture) the value of the product crashes. This might lead to cutback in supply leading to negative GDP growth.
One question that can come to mind is why on earth would A behave in such a manner. The reason can be mainly two fold:
- The inflation is very high and so he feels that he needs money just to consume
- The inflation expectation is very high and he wants to buy products today expecting a rise in prices in the future
So it’s important to understand that printing money in itself is not inflationary. Inflation happens because there exists an information asymmetry and high inflation expectation. Printing more money in such scenario could be disastrous.
In countries like Zimbabwe which is suffering from hyperinflation is clear case in this regard. The supply crunch led to inflation and higher expected inflation, to top it all the government printed more money thus creating hyperinflation and causing the nation to go in a tailspin.
I conclude this article with two points that must be amply clear while taking the decision of printing more money and thus making sure that this money results to higher growth rather than inflation:
- Information Assymetry should be minimal
- Extra money to be used in capital assets and not in consumption.
If inflation expectations are high then the money supply would go into consumption instead of creating assets and hence leading to further inflation at the cost of growth (as players would first be concerned with consuming goods to survive and then think about creating capital assets). …………………..
Thursday, March 27, 2008
So I would start with directional trade on equity prices using options the next I write on this topic...............
Wednesday, March 26, 2008
I beleive China is a disaster waiting to happen. I sincerely hope it doesn't happen because an economically vibrant China is good for the entire world as I also believe that the global boom that we are seeing this decade is mainly due to China. However the way they are progressing is similar to over leverage trading. You are the king on every day till the day of reckoning. So in just one day you loose all what you made your entire life. The West is ofcourse crazy for China especially the American fund managers.... Now what can I say for them, people who loose billions of dollars ( for record some of the topmost I-Banks and the famous commercial bank supposedly composed of best talent have lost more than what they have made in a decade)......To be fair even I am awed by Chinese growth but I can't loose the sight of the structural deficiencies in its growth and system making it a disaster waiting to happen. I would try to analyse various aspects of Chinese growth to put the puzzle together..........
Tuesday, March 25, 2008
Monday, March 24, 2008
Sunday, March 23, 2008
Friday, March 21, 2008
So here we go for today. We need communists. If there is one class of people I have hated in my life they are communists, however inspite of this in a very strange way I believe we need them. You must be wondering whats the reason for this dichotomy. Well look around (in this world I mean) you would find that most of the countries that have adopted a single religion and don't have appreciation for people of other religion have become totalitarion nations, fundamentalists and fanatics in their way of thinking. I believe that by driving the communists out of this country we would become 'Eco Communalists'. Listening to ideas that the are poles apart from our way of thinking broadens our outlook and gives us a sense of appreciation towards others. Also I believe that no idea is completely right or completely wrong either. So that's why I beleive that no matter how much we despise communists we still need them. Why would like to end this article by this line that I thought of describing the stark contrast between Capitalism and Communism.
Thursday, March 20, 2008
Let's have an economy in which there is one supplier of gold and copper and these are the only two tangible products produced in this economy and the rest of the population has lots of money with them (also let me add exchange of commodities is not allowed: I will explain later how this condition comes to play even in real life for now this condition is our variable X), due to this the copper sells for rupees x and gold sells for rupees 100x. However one fine day all the money is gone. Then it's irrelevant to talk that gold is more valuable than copper they both attract negligible value as there is no liquidity.
Let's slightly tweak this example, so now we replace copper with bread. Whats more valuable after 7 days of hunger 'gold or bread'. So another factor that is extremely important in markets is 'marginal utility': The satisfaction a person recieves from one addtional unit of the good. This is our variable X.
If I have lot's of money in my pocket I would buy 'luxury brands', essentially the same quality of cloth from an expensive showroom with some fuzzy symbol on it. The same happens to stocks, in periods of high liquidity various popular names skyrocket.
Now when a person becomes cash strapped he becomes economical in his spending. The same happens in market he buys businesses that have real cash flows, he starts thinking about PE multiples. So really if one thinks about it, its liquidity that determines the performance of the stocks by controlling the marginal utility the players. I shall continue this article next time by explaining more about the variable X and hence completing the market dynamics.......
Wednesday, March 19, 2008
So what's essentially an option, well an option is essentially a bet. Let's say two people A & B while watching a football match of Italy vs France enter into a bet that if Italy beats France A pays B 1000 rupees else B pays A 1000 rupees. This if I translate it into options would actually constitue into an options trading strategy which I would address sometime later. For now to explain the most basic structure of option let's just extend our example a little bit----------
A fine evening in India in a B school campus to students (A & B) were worried about the derivatives exam tommorrow. To relieve the stress they start watching a friendly match between Italy and France. The match was turning out to be a big dissapointment 30 minutes gone and still no goals!! To heat things up they enter into a bet. A tells B that he pays him 500 rupees upfront. Now if France beats Italy he should forget his money and go back to his books, however if Italy beats france then A would pay B an amount equivalent to 250*(goal difference by which Italy beats France). This is what we know as a 'call option on the victory of Italy'.
B buys from A a call option on the victory of Italy. The payment he gives to A upfront is called the premium (the price of this option). A is known as the option writer, his maximum profit would be 500 rupees in the scenario where France beats Italy. However his loss potential is infinite and will start loosing if Italy beats France by a margin of more than 2 goals.
The same option can be termed as a 'put option on the defeat of France'. So basically the call and put options are the same thing, its just a function of your position.
In trading buying call is part of the bullish strategy --- You are bullish on Italy. While buying put is part of the bearish strategy --- You are bearish on France.
The rest of the article I would continue later..........
Tuesday, March 18, 2008
However I still feel the Fed and more importantly the US government has to do more. I ultimately has to buy this mess (The mortgage backed securities). Hey I know the arguments against it and stop talking about moral hazzard, tax payers money and saving the rich. Let me give you a simple example----
You are driving on a Highway athigh speed and suddenly see some moron coming from a wrong direction. What would you do, sure that guy is an idiot and you feel like hitting him hard (Road Rage !!!) but would you do that, ofcourse not because it will hurt you aswell, so you just crib about it and give him way to get out. The same principle can be applied to the Fed and later on possibly the US govenment bailout. As for the tax payers money, well there would not be much left if this thing goes for long.
What required after these bailout packages and clearing the system is change in laws, increased vigilance. Like in our Higway example, had there been more vigilance the car would not have been allowed to enter the wrong way on the highway. The companies entering into any kind of derivatives transaction have to commit wafer thin margins. That has to change or if not change atleast it has to be made mandatory for the companies to report there equity against the derivatives position they are taking and the worst case scenario loss on equity (Not the Var crap, no more 95 percent confidence of this loss that loss etc. Keep these things limited to the MBA classes), The worst case scenario loss simple. No more fancy statistics just report how much maximum you can loose based upon there derivatives trade and then its upto the shareholders to decide whether to invest in such companies or not..........
Saturday, March 15, 2008
Well It has been a long time since I last wrote on this blog. Since my last blog lot of events have happened. The raging bull market has suddenly seem to become inverted. The same analysts (One of the most dumb & useless post in market) who not long back were tomtoying the great Indian bull story and taking this index into 30000 in next two months are now talking of four figures on sensex. Ofcourse this is market and anything can happen but my point is that no one no matter how succesful he or she has been in this market is better or worse than any guy on the street in predicting the future, if it sounds surprising just believe it.
Well this fall in the index has made my job slightly easier, as I wrote in my last post about explaining the market bubble; well I don't have to do it now so basically saved of some gruelling work in preparing excel sheets.
Now what I think about the months ahead well even I am looking forward for the drama to unfold but one thing is clear and since I started writing this blog I have been shouting this--- Sack the Fed Committee. Look what has happened now and these morons still have the tenacity to say that the inflation expectations of the people are intact. Well in that case either these people are completely stupid, are in a state of self denial, or bigtime liars. Well all is still not lost and the situation can still be salvaged in my opinion by going for one of the three ways:
1. The Fed must stop cutting rates. I know the markets across the globe would tumble for a couple of days but they would recover. More importantly the bubble in commodity markets would burst. I am sure that as you have the seen some hostoric rises in oil and bullion prices similarly you would also see the biggest ever fall recorded to date in these prices. But I doubt the Fed would have the teeth for this. Ideally in my opinion this is the best option.
2. The EU and BOE must cut rates. Today the most preferred trade is go short on dollar and long on oil or gold. With ECB and BOE cutting rates the expectation of dollar weaking would reduce and this trade would fall apart. Ofcourse with more excess liquidity there is a likelihood of bubble reforming in Emerging markets and again in commodities. However as a temprory measure this option can be utilised. I must also add the position the ECB chairman is taking is too textbookish. Economics is not Physics. Everyone knows what Fed cutting interest rates would do to the dollar. So this commodity inflation will not aggravate because of ECB or BOE rate cuts as this inflation id because of a hedge against weak dollar. The key in economics is to be creative and not do things which are written in textbooks as everyone is well aware so such scenarios and hence these things get discounted in markets.
3. A coordinated effort by main Central Banks of the world US, UK, Europe and Japan is needed to strenghten the dollar. This would break the back of speculators in the forex and commodity markets.
Out of the 3 options discussed the third one seems to be the most likely, I hope its excersised soon enough before its too late. We are living in uncertain ( well life is always uncertain) and interesting times. Hope this time would write soon and let's see how things pan out.........