This post is for all the finance graduates who are wondering about opportunities that are present for them in Indian IT industry. There is very less awareness about the roles for finance graduate in IT. It is common perception that only role available is that of business analyst who acts as domain expert for financial sector and plays key link between business and software engineers. This business analyst is expected to work from requirement gathering to testing. But this is just operational role from IT organization perspective. Of course then there are also roles which are present in any company irrespective of the industry like one of financial planning and budgeting etc. But other than these there are other exciting and upcoming areas which I guess should interest most of the finance guys and which are present in most of the companies which have attained certain IT maturity.I intend to just highlight this broad area in my post.
Assuming a finance graduate joins an investment bank/fund house; his success would depend on his ability to manage his portfolio of assets such that he provides higher returns to his clients. This requires skill-set that enables him to perform valuation of different available assets and which I believe is the one of the most difficult part of his job. So is there any opportunity for the such person in IT industry ? Is there anything which could be as challenging as this? And my answer is yes. In fact gravity of problem increases than in financial sector. There the aim is to do valuation of asset and manage portfolio of assets which are mostly tangible and quantifiable but in case of IT one must do valuation of services and manage portfolio of applications. This is certainly more difficult since its intangible. If asked to draw parallel with equity then imagine yourself trying to value equity offered by newly formed company in some very new industry with no existing comparables. Imagine if someone was asked to value google as company in say 1980’s. Yes now I guess one would understand the gravity of problem trying to value intangible service. So why is it required in IT to do valuation of services? Its answer is very simple: - for its existence. It is very common problem which many CFO and CEO face today. They unable to understand where does the money for IT go? And moreover what tangible benefits does IT provide to the company. If you put in more MBA terms how does IT help in increasing shareholders value? You may like stakeholder instead of shareholder then I am fine with it too!! The problem is more aggravated when IT is horizontal servicing different business units. No business units are able to determine financial gains from IT services and economic downturn like this certainly makes them prune their IT budgets. So it is required to determine value of the IT services. Now the next question is how. This is most difficult since there has not been any Damodaran born in the industry to help them. Though there are certain guidance provided by different governing body but literature and research is much sparse compared to one available with financial sector. So I think this is one of most challenging areas for finance guys with bit of IT knowledge and strong business fundamentals to look forward for in IT industry.
I hope I pointed to some new areas for most of you guys who are not well versed with this industry and an opportunity for 2010 graduates. I know it doesn’t look as sexy as working in investment bank but for someone like me who passed out in 2009 and was forced to join IT industry it looks really exciting. From the day I joined industry my aim was to leverage my finance knowledge and provide new perspective in IT and am atleast satisfied that in my 6-7 months I have been able to research and work on this area. This is how I have made my knowledge relevant to my company and “am trying to create value for shareholder/stakeholders and who knows I may be damodaran in making for this industry." :)
This post is also answer to lot of questions which my friends are trying to figure out like what am I doing in an IT company. In fact one of them was shocked to know that even after MBA Finance I have rejoined IT industry. He glanced at me with a look as if I was black sheep in finance community and must be stripped of my degree. For him it was demeaning of the esoteric financial knowledge by working in an IT company . I hope that this awareness will help me to salvage some pride in eyes of such guys.
Marketing lessons for political parties
This 13th October,2009 I performed the duty of responsible citizen of democratic India. I casted my vote for first time for Maharashtra state election after having missed it during last two occasions. Was I excited? Not sure about that but certainly wanted to feel the experience. So what did I discover? Nothing significant about elections but lot of lessons for political parties though. These are the various marketing lessons for them. I know I should not compare the business to election but still MBA cannot think anything other than that I guess. This post I would dedicate to my all marketing friends at B-school with whom I have fought relentless battles, that typical Finance Vs Marketing once.
Consumer behavior:-
I think political parties need to undertake this course for sure. They need to understand shelf space concept from HUL and P&G. Now what has it to do with elections? Let me explain. It is known fact that FMCG companies fight for the ideal shelf space in retail store to ensure that their products are sold more. Even in election the same principle applies. The person who is not sure about his vote would not go through entire list of 20-25 candidates. He tends to view the candidates from 3rd-4th to maybe say 9th-10th in the list. This set of candidates fall right under his eyesight by default. These candidates have more probability to being voted by undecided candidate. So I believe political parties must fight for the order of their candidate in the list.
Parties must also understand the simple concepts like person tends to favor the product whose advertisement he sees just at time of buying. It is very important marketing concepts and that is why one finds lot of advertisement by companies in shopping malls. So what should political do? They are not allowed to put posters in 100 mts or so near election center but they can cover entire area before that with their advertisements, billboards etc. I didn’t find it at all.
STP :-
I know our political parties have been very good at this. They have segmented people based on religion and have accordingly targeted them. But is this only segmentation possible? These segments were identified by British or maybe even before that. I think there is further scope to even segment each of the segments to yield better results. In fact past experience also confirms that. The success of Rahul Gandhi targeting youth in last Lok Sabha election, the success of BJP targeting middle and upper class in previous elections. In fact present demographic clearly indicates the age group 20-40 can clearly win election for any party. I believe marketers can really help in this pursuit.
Branding:-
Let us compare our election with American Presidential election and you would clearly note the difference in this aspect. Obama’s slogan “We can” and his brand was very strong which made Americans vote for him. Did we notice anything like that in this election? Certainly not. Parties still persisted with old icons and old slogans. They didn’t even package old stuff in new wrapper. At some places ‘gas’ really works.
Analytics :-
This has become integral part of marketing and political should fast catch up with this. There is some level of win-loss analysis being done but analytics would help to solve most of their problems. No efforts are being made in this direction.
I know this post would not go in national interest and I am not sure whether these suggestions are ethical to be implemented. Further they would not have any bearing if citizen has firm belief on particular candidate. But I believe there are good numbers of people who go to vote without being strongly aligned to any party and this suggestion can certainly influence them. I have identified need of marketers in political parties and it’s up to these marketing graduates who are searching for job to create demand for them in this altogether new industry.
This post is one more evidences about the way management studies have shaped my thinking. I could not have gained these insights without the help of the marketing courses undertaken by me during my course of study. The fact is that I am also shocked that pro-Finance guy like me also can write so much gas.
Consumer behavior:-
I think political parties need to undertake this course for sure. They need to understand shelf space concept from HUL and P&G. Now what has it to do with elections? Let me explain. It is known fact that FMCG companies fight for the ideal shelf space in retail store to ensure that their products are sold more. Even in election the same principle applies. The person who is not sure about his vote would not go through entire list of 20-25 candidates. He tends to view the candidates from 3rd-4th to maybe say 9th-10th in the list. This set of candidates fall right under his eyesight by default. These candidates have more probability to being voted by undecided candidate. So I believe political parties must fight for the order of their candidate in the list.
Parties must also understand the simple concepts like person tends to favor the product whose advertisement he sees just at time of buying. It is very important marketing concepts and that is why one finds lot of advertisement by companies in shopping malls. So what should political do? They are not allowed to put posters in 100 mts or so near election center but they can cover entire area before that with their advertisements, billboards etc. I didn’t find it at all.
STP :-
I know our political parties have been very good at this. They have segmented people based on religion and have accordingly targeted them. But is this only segmentation possible? These segments were identified by British or maybe even before that. I think there is further scope to even segment each of the segments to yield better results. In fact past experience also confirms that. The success of Rahul Gandhi targeting youth in last Lok Sabha election, the success of BJP targeting middle and upper class in previous elections. In fact present demographic clearly indicates the age group 20-40 can clearly win election for any party. I believe marketers can really help in this pursuit.
Branding:-
Let us compare our election with American Presidential election and you would clearly note the difference in this aspect. Obama’s slogan “We can” and his brand was very strong which made Americans vote for him. Did we notice anything like that in this election? Certainly not. Parties still persisted with old icons and old slogans. They didn’t even package old stuff in new wrapper. At some places ‘gas’ really works.
Analytics :-
This has become integral part of marketing and political should fast catch up with this. There is some level of win-loss analysis being done but analytics would help to solve most of their problems. No efforts are being made in this direction.
I know this post would not go in national interest and I am not sure whether these suggestions are ethical to be implemented. Further they would not have any bearing if citizen has firm belief on particular candidate. But I believe there are good numbers of people who go to vote without being strongly aligned to any party and this suggestion can certainly influence them. I have identified need of marketers in political parties and it’s up to these marketing graduates who are searching for job to create demand for them in this altogether new industry.
This post is one more evidences about the way management studies have shaped my thinking. I could not have gained these insights without the help of the marketing courses undertaken by me during my course of study. The fact is that I am also shocked that pro-Finance guy like me also can write so much gas.
Is the Crisis finally over???
One more blog post on crises trying to answer same question which every newspaper writes about or every economy guru debates or discusses on various channels on television. So it’s obvious for you guys to believe that this blog would be nothing but copy pasted material from different sources on web. What else can fresh management graduate do other than, the very skill acquired (CTRL-C & CTRL –V) and now being groomed by corporate world? I believe it would have been same if it had no impact on my career but like other 2009 graduates my career has been one of biggest casualty of the crisis and so I do have fair amount of opinion at least on this topic. But at same time I can obviously not resist temptation of copying so like Mba assignments sources would be quoted.
‘Big Banks cannot fail’- It is believed by lot of people the part of the financial crisis was due to this assumption. But the crisis has proved this assumption to be wrong. It has also proved that if such banks fail it could lead to system failure. So what has action has been taken? No banks are allowed to act as investment banker like before on Wall Street. So did it have any impact? Have we ensured that we don’t create such huge banks whose greed can affect entire world? I have attached image below and it’s up to you to see and come to your own conclusion
.
We have ended up with bigger and fewer banks. Some would say that it was survival of fittest and the better players have survived and it’s good for everyone. But it concerns me even more. Just imagine impact of these even more larger banks failing in future years. Any lack of prudence and responsibility by these banks can lead to even bigger crisis and I doubt world would be able tackle the same.
Liquidity game – Let’s go back to history and understand the lessons from previous crises. The end of Great Depression had seen lot of tough policy changes, socio-economic changes etc. but do we see such drastic changes today? I really doubt. It was dotcom burst at start of 2000-2001 which had created huge recession scare. So how was that avoided? By increasing liquidity in markets, pushing federal rates close to 0%. But did it achieve its purpose? Yes and No. In short term it avoided recession but in long term it led to this housing bubble. So what have we done this time? Nothing different the same policy has been followed by all the central banks across the world. The interest rates brought to lowest level, huge borrowing was allowed for banks and bad loans were restructured for longer duration to ease liquidity pressure and avoid bankruptcy. I believe there was no other option to stop the “run on the banks”. So if I use same deduction reasoning then would I be wrong to believe that the recovery is nothing but temporary bubble or perception due to excessive liquidity in the markets?
US-China duopoly - Isn’t this crisis an indication that correction is required here? In any markets, fundamental theory believes that asset attains its true value then for how long do we have to wait for correction for US economy which has huge fiscal deficit and China which has huge surplus. Both of them have avoided this correction for too long I believe. China is throwing its huge surplus in its local markets to fuel consumerism and get rid of this huge surplus. But this can lead to nothing but one more local bubble. Won’t we have to face similar financial crisis when this correction occurs? Everyone believes world economic order is set to change but it’s time we are trying to buy with this temporary recovery. Maybe to be ready to handle the bigger crisis better!! I still haven’t considered the demographic factors like ageing population and its distribution across the world. It looks scary. Just go through recent Mckinsey report which indicated the year when China’s population would be aged and their conclusions.
I do believe this crisis hasn’t changed the world much. Our inertia to avoid changes and inclination for short term gains or maybe our short sightedness has led to same state as we were before the crisis. When markets plummeted people believed it was correction and now again we are reaching sky crappers so was that correction not correct? No one in the world is isolated in this globalised economy so there can be no India story without considering these macroeconomic factors. So guys pour in your comments on this pessimistic blog of mine. I would be more than happy to be proved wrong though.
‘Big Banks cannot fail’- It is believed by lot of people the part of the financial crisis was due to this assumption. But the crisis has proved this assumption to be wrong. It has also proved that if such banks fail it could lead to system failure. So what has action has been taken? No banks are allowed to act as investment banker like before on Wall Street. So did it have any impact? Have we ensured that we don’t create such huge banks whose greed can affect entire world? I have attached image below and it’s up to you to see and come to your own conclusion
.
We have ended up with bigger and fewer banks. Some would say that it was survival of fittest and the better players have survived and it’s good for everyone. But it concerns me even more. Just imagine impact of these even more larger banks failing in future years. Any lack of prudence and responsibility by these banks can lead to even bigger crisis and I doubt world would be able tackle the same.
Liquidity game – Let’s go back to history and understand the lessons from previous crises. The end of Great Depression had seen lot of tough policy changes, socio-economic changes etc. but do we see such drastic changes today? I really doubt. It was dotcom burst at start of 2000-2001 which had created huge recession scare. So how was that avoided? By increasing liquidity in markets, pushing federal rates close to 0%. But did it achieve its purpose? Yes and No. In short term it avoided recession but in long term it led to this housing bubble. So what have we done this time? Nothing different the same policy has been followed by all the central banks across the world. The interest rates brought to lowest level, huge borrowing was allowed for banks and bad loans were restructured for longer duration to ease liquidity pressure and avoid bankruptcy. I believe there was no other option to stop the “run on the banks”. So if I use same deduction reasoning then would I be wrong to believe that the recovery is nothing but temporary bubble or perception due to excessive liquidity in the markets?
US-China duopoly - Isn’t this crisis an indication that correction is required here? In any markets, fundamental theory believes that asset attains its true value then for how long do we have to wait for correction for US economy which has huge fiscal deficit and China which has huge surplus. Both of them have avoided this correction for too long I believe. China is throwing its huge surplus in its local markets to fuel consumerism and get rid of this huge surplus. But this can lead to nothing but one more local bubble. Won’t we have to face similar financial crisis when this correction occurs? Everyone believes world economic order is set to change but it’s time we are trying to buy with this temporary recovery. Maybe to be ready to handle the bigger crisis better!! I still haven’t considered the demographic factors like ageing population and its distribution across the world. It looks scary. Just go through recent Mckinsey report which indicated the year when China’s population would be aged and their conclusions.
I do believe this crisis hasn’t changed the world much. Our inertia to avoid changes and inclination for short term gains or maybe our short sightedness has led to same state as we were before the crisis. When markets plummeted people believed it was correction and now again we are reaching sky crappers so was that correction not correct? No one in the world is isolated in this globalised economy so there can be no India story without considering these macroeconomic factors. So guys pour in your comments on this pessimistic blog of mine. I would be more than happy to be proved wrong though.
Experiential Learning
This post is going to be quite uninteresting because it is about mundane stuff which all of us experience everyday but still make mistakes. It is especially key learning of fresh MBA entering the corporate world. Even though I had previous work experience and knew this very well but still a stint in academic changes the mindset. These are my 3 most important learning in first two months of work:-
1)Expectation Management :-
MBA coming out of from B school working 20 hrs a day, learning a merger and acquisition case study, developing pricing strategy for new product, understanding the impact of globalization, doing industry analysis using Porter framework as part of assignments that too in a day, one can imagine his expectation from the corporate world. He considers himself fully ready equipped with all sort of management ammunition to attack the “bottom of the pyramid” and "creating value for the shareholder". He is waiting for companies to embrace him and ask him to turnaround their company. Don’t get bewildered, this is practically most of the MBA’s expectation to work as management consultant/investment manager/brand manager etc. And please don’t ask about salary and of course there is certainly location preference (after all he is “MBA”).
But wait what he finds in real world? He is not doing the expected work but is simply googling data or making some report for some senior to make presentation and no one is asking his inputs for the company’s future strategy. And what happen to salary it’s not even 50% of what he was suppose to get. Location? ? Are you joking to ask such question in globalized world? Wait didn’t mention most important point he would have landed in wrong industry all together
So you can understand his state of mind. So what should one do? Someone told don’t worry till you are in “right bus” but here there seems to be no vehicle altogether.
Relax this is fact of life and most of people would have experienced the same. It’s called Murphy’s Law. I had read somewhere “career planning = career limiting” and most of us make this mistake. We make ourself too inflexible since we have planned career well from manager to CEO in some record time of 5-6 yrs. We have fixation to profile, industry to such an extent that even if we get better opportunity in other areas we turn blind eye to it. So my only learning is plan career with caveat its never going to be way you intended. Then you may ask y plan career? Simple answer to this is that everyone of us either make gymn schedule or study schedule or take new year resolution sometime or the other knowing fully that we have always failed to follow it but that doesn’t stop us from making them. Same is true with career planning.
This is how I have reconciled myself :).
2)People Management:-
Recollect your OB lectures when everyone was sleeping wondering why one has course such as this in their program. However after an MBA, in just few months one would realize that Kotler’s and Damodaran is of not much of use nor the Peffer’s ,Prahlads and Ghemavat. You don’t need to read “Talent is never enough” by John Maxwell since you experience it. You can see very talented MBA from best of Bschool reporting to someone who is hardly graduate and this fresh from B school starts complaining about company not being able to give its employee due worth. These examples help him to reinforce his belief that company has not given right profile/money. But the fact is intellectual capability is not of much importance if person cannot drive the behavior in organization. Best of strategies are of no use if they cannot be implemented. Sales manager who cannot motivate his team to achieve their target is of no use even if he has fool proof strategy. The same is true with all the other functions of business. Everyone has a supervisor and the other fact is everyone finds his/her supervisor as biggest fool on the Earth. Moreover this is true for fresh MBA who was taught “Managing with Power” and was never taught how to work without power. It’s very important to pursue ones viewpoint rather than reconciling to the belief that the other person is fool. It requires lot of courage, persuasion power, negotiation skill and understanding of OB to get one’s work done without “power”.
3)Don’t miss forest for trees:-
Completely frustrated MBA in wrong place under fool considers his work very trivial. He fails most of the time how this trivial work of his fits in bigger picture of the organization. This may be because he is too dejected that he doesn’t even want to put an effort to visualize the big picture. This is big trap and if one falls in it then it can act as a “tipping point” after which there would be steep descent in his career. So ensure you have big picture in mind and work towards it with hope that it would be rewarded and you would get better opportunities in future.
This has been my experiential learning till now. Some of the things I have experienced and some are my opinions/belief and its quite difficult for me to separate one from other.
Quite big and boring post and it’s in my interest to stop gyaan before I loose subscribers to my blogs.
1)Expectation Management :-
MBA coming out of from B school working 20 hrs a day, learning a merger and acquisition case study, developing pricing strategy for new product, understanding the impact of globalization, doing industry analysis using Porter framework as part of assignments that too in a day, one can imagine his expectation from the corporate world. He considers himself fully ready equipped with all sort of management ammunition to attack the “bottom of the pyramid” and "creating value for the shareholder". He is waiting for companies to embrace him and ask him to turnaround their company. Don’t get bewildered, this is practically most of the MBA’s expectation to work as management consultant/investment manager/brand manager etc. And please don’t ask about salary and of course there is certainly location preference (after all he is “MBA”).
But wait what he finds in real world? He is not doing the expected work but is simply googling data or making some report for some senior to make presentation and no one is asking his inputs for the company’s future strategy. And what happen to salary it’s not even 50% of what he was suppose to get. Location? ? Are you joking to ask such question in globalized world? Wait didn’t mention most important point he would have landed in wrong industry all together
So you can understand his state of mind. So what should one do? Someone told don’t worry till you are in “right bus” but here there seems to be no vehicle altogether.
Relax this is fact of life and most of people would have experienced the same. It’s called Murphy’s Law. I had read somewhere “career planning = career limiting” and most of us make this mistake. We make ourself too inflexible since we have planned career well from manager to CEO in some record time of 5-6 yrs. We have fixation to profile, industry to such an extent that even if we get better opportunity in other areas we turn blind eye to it. So my only learning is plan career with caveat its never going to be way you intended. Then you may ask y plan career? Simple answer to this is that everyone of us either make gymn schedule or study schedule or take new year resolution sometime or the other knowing fully that we have always failed to follow it but that doesn’t stop us from making them. Same is true with career planning.
This is how I have reconciled myself :).
2)People Management:-
Recollect your OB lectures when everyone was sleeping wondering why one has course such as this in their program. However after an MBA, in just few months one would realize that Kotler’s and Damodaran is of not much of use nor the Peffer’s ,Prahlads and Ghemavat. You don’t need to read “Talent is never enough” by John Maxwell since you experience it. You can see very talented MBA from best of Bschool reporting to someone who is hardly graduate and this fresh from B school starts complaining about company not being able to give its employee due worth. These examples help him to reinforce his belief that company has not given right profile/money. But the fact is intellectual capability is not of much importance if person cannot drive the behavior in organization. Best of strategies are of no use if they cannot be implemented. Sales manager who cannot motivate his team to achieve their target is of no use even if he has fool proof strategy. The same is true with all the other functions of business. Everyone has a supervisor and the other fact is everyone finds his/her supervisor as biggest fool on the Earth. Moreover this is true for fresh MBA who was taught “Managing with Power” and was never taught how to work without power. It’s very important to pursue ones viewpoint rather than reconciling to the belief that the other person is fool. It requires lot of courage, persuasion power, negotiation skill and understanding of OB to get one’s work done without “power”.
3)Don’t miss forest for trees:-
Completely frustrated MBA in wrong place under fool considers his work very trivial. He fails most of the time how this trivial work of his fits in bigger picture of the organization. This may be because he is too dejected that he doesn’t even want to put an effort to visualize the big picture. This is big trap and if one falls in it then it can act as a “tipping point” after which there would be steep descent in his career. So ensure you have big picture in mind and work towards it with hope that it would be rewarded and you would get better opportunities in future.
This has been my experiential learning till now. Some of the things I have experienced and some are my opinions/belief and its quite difficult for me to separate one from other.
Quite big and boring post and it’s in my interest to stop gyaan before I loose subscribers to my blogs.
Value based pricing ??????
I am just wondering how many theories backed by case study which you one learns in B-school have no relevance in real world. Or is it that I have not understood them properly so finding it difficult to relate to problems in corporate world or is it due to my inexperience. I sincerely wish that second reason should turn out to be true.
Value based pricing was one the most abused word in all my marketing lectures. Every professor would provide “gyaan” that customer is willing to pay upon the perceived value of the product/service and not based on the cost aspect. It is duty of the marketer to create this value perception. They told us it is difficult for company to move from cost based pricing to value based pricing. The examples of Pepsi, FMCG products etc were standard. So it became mantra for us that wherever we work we must ensure that gradually we adopt value based pricing by educating the customer. But in real life situation is totally different. Consider for example entire outsourcing industry which came to existence due to cost factor. Now Indian players as outsourcing center played cost card to their advantage and gain competitive edge over other MNC. As Indian players matured the cost of employees in India increased manifold though nothing compared to US and Europe still. Further the new cost centers like China, Brazil, and Philippines etc emerged. Also most of the MNC established there delivery center in India and such places and have removed cost as differentiator. In this given industry landscape, there is no doubt that service providers would enjoy benefit if they go for value based pricing. But how can one make transition to such pricing strategy when you are never sure whether other player would adopt such strategy or not. It could be serious loss of business if industry as whole does not adopt it. Further how do you educate customer when entire industry came to existence because of the cost arbitrage. What about the competition arising from other parts of the world? So here the service provider can only succeed if it is adopted industry wide. But that is very difficult to achieve in fragmented market where there are large number of players. So this is one more theory learnt in B-school which I have found it difficult to implement due to real world constraints. In fact I was wondering in this era of globalization where buyers are well educated and connected across the globe how difficult is to sustain value based pricing for players in other industry too?
So my marketing friends pour your views, counter arguments on this supported by as much “gas” as possible.
Value based pricing was one the most abused word in all my marketing lectures. Every professor would provide “gyaan” that customer is willing to pay upon the perceived value of the product/service and not based on the cost aspect. It is duty of the marketer to create this value perception. They told us it is difficult for company to move from cost based pricing to value based pricing. The examples of Pepsi, FMCG products etc were standard. So it became mantra for us that wherever we work we must ensure that gradually we adopt value based pricing by educating the customer. But in real life situation is totally different. Consider for example entire outsourcing industry which came to existence due to cost factor. Now Indian players as outsourcing center played cost card to their advantage and gain competitive edge over other MNC. As Indian players matured the cost of employees in India increased manifold though nothing compared to US and Europe still. Further the new cost centers like China, Brazil, and Philippines etc emerged. Also most of the MNC established there delivery center in India and such places and have removed cost as differentiator. In this given industry landscape, there is no doubt that service providers would enjoy benefit if they go for value based pricing. But how can one make transition to such pricing strategy when you are never sure whether other player would adopt such strategy or not. It could be serious loss of business if industry as whole does not adopt it. Further how do you educate customer when entire industry came to existence because of the cost arbitrage. What about the competition arising from other parts of the world? So here the service provider can only succeed if it is adopted industry wide. But that is very difficult to achieve in fragmented market where there are large number of players. So this is one more theory learnt in B-school which I have found it difficult to implement due to real world constraints. In fact I was wondering in this era of globalization where buyers are well educated and connected across the globe how difficult is to sustain value based pricing for players in other industry too?
So my marketing friends pour your views, counter arguments on this supported by as much “gas” as possible.
Derivatives in IT decision making
Doesn’t topic look strange? Yes I am referring to using derivatives in selecting IT solution. I haven’t got crazy working in IT industry after MBA finance but the fact is it relates. I read an amazing article from an analyst of Forrestor who had proposed this concept and I have highest respect for his knowledge and conceptual clarity of both the worlds – IT and Finance. So the credit for this post goes to him. I am trying in this post to explain my understanding of the report in simple words for benefit of non-IT guys.
Let me start with simple question – what does a business looks for from its IT? I know it may mean different to different businesses but in very crude terms we can say that IT must at very basic level facilitate the business to grow and thereby achieve its objective. Now the question for CIO is when business looks forward to IT for some solution to business problems he needs to select best from variety of alternatives available. This is very subjective since it has to take into consideration variety of constraints like budget, available skill set and future business outlook. But do all the necessary factors are factored in while making such decision? How is the cost-benefit done for each option? More often than not CIO would determine cost of implementation and the value of direct benefits from it and then select one which gives maximum value for given cost which should be within the budget. But is this the best way to take such decision? I will give simple example. Given business problem say introducing online shopping can be solved by solution A and solution B. Cost of solution A is say Rs 1 lakh while of solution B say 1.2 lakh which provides same functionality but with flexibility to add auction feature within a year. Now given above method of decision making CIO would select solution A since there is no way to factor the value of limited (time bounded) flexibility that solution B offers. So here if CIO is able to find the value of flexibility then he can make better decision. Then how to find its value?
The answer to this problem is call option from finance industry. This case is similar to concept of the call option which gives the buyer of the option a right to buy the underlying at strike price before expiry date of the option. Here also solution B offers CIO a right to implement auction functionality at certain determined cost within a year. The call options have value for the right they provide and similarly this flexibility should also have value. Call options price is found using Black Scholes option pricing formula:-
c= s*f(d1) –xe-rt f(d2)
d1={log(s/x) + (r + v2 /2)t}/v*sqrt(t)
d2 = d1 – v*sqrt(t)
where ,
s= price of underlying
x= strike price
r= risk free rate of interest
t= time duration for expiration of option
v = volatility for stock
f= standard normal cumulative distribution function.
We can use same formula to find value of the flexibility to make more informed decision since the concept is same. In our case
c= value of the flexibility provided
s= return on implementation of auction feature
x = cost of implementation of auction feature
t = 1 year here i.e. time available to avail the flexibility
v= volatility of industry can be used to predict volatility of business and hence technology usage.
So using this above option we can find value of this flexibility and that value can be deducted from option B to make it comparable with option A. This would enable better decision making for CIO than obvious methods that are used today. Further it provides him an opportunity to deliberate on future features that might be required and may facilitate him to provide more objective explanation to CFO for budgetary approval of flexible IT solution that may help business in longer term.
I know you may question lot of assumption like that of volatility and usage of normal distribution and most important the assumption made by Black-Scholes in pricing model etc. But this post is meant to bring to your knowledge entire new dimension of using the financial knowledge in IT decision making. We can always debate out the viewpoint and criticize the shortcoming of any model but at same time I think we should appreciate the new perspective.
Let me start with simple question – what does a business looks for from its IT? I know it may mean different to different businesses but in very crude terms we can say that IT must at very basic level facilitate the business to grow and thereby achieve its objective. Now the question for CIO is when business looks forward to IT for some solution to business problems he needs to select best from variety of alternatives available. This is very subjective since it has to take into consideration variety of constraints like budget, available skill set and future business outlook. But do all the necessary factors are factored in while making such decision? How is the cost-benefit done for each option? More often than not CIO would determine cost of implementation and the value of direct benefits from it and then select one which gives maximum value for given cost which should be within the budget. But is this the best way to take such decision? I will give simple example. Given business problem say introducing online shopping can be solved by solution A and solution B. Cost of solution A is say Rs 1 lakh while of solution B say 1.2 lakh which provides same functionality but with flexibility to add auction feature within a year. Now given above method of decision making CIO would select solution A since there is no way to factor the value of limited (time bounded) flexibility that solution B offers. So here if CIO is able to find the value of flexibility then he can make better decision. Then how to find its value?
The answer to this problem is call option from finance industry. This case is similar to concept of the call option which gives the buyer of the option a right to buy the underlying at strike price before expiry date of the option. Here also solution B offers CIO a right to implement auction functionality at certain determined cost within a year. The call options have value for the right they provide and similarly this flexibility should also have value. Call options price is found using Black Scholes option pricing formula:-
c= s*f(d1) –xe-rt f(d2)
d1={log(s/x) + (r + v2 /2)t}/v*sqrt(t)
d2 = d1 – v*sqrt(t)
where ,
s= price of underlying
x= strike price
r= risk free rate of interest
t= time duration for expiration of option
v = volatility for stock
f= standard normal cumulative distribution function.
We can use same formula to find value of the flexibility to make more informed decision since the concept is same. In our case
c= value of the flexibility provided
s= return on implementation of auction feature
x = cost of implementation of auction feature
t = 1 year here i.e. time available to avail the flexibility
v= volatility of industry can be used to predict volatility of business and hence technology usage.
So using this above option we can find value of this flexibility and that value can be deducted from option B to make it comparable with option A. This would enable better decision making for CIO than obvious methods that are used today. Further it provides him an opportunity to deliberate on future features that might be required and may facilitate him to provide more objective explanation to CFO for budgetary approval of flexible IT solution that may help business in longer term.
I know you may question lot of assumption like that of volatility and usage of normal distribution and most important the assumption made by Black-Scholes in pricing model etc. But this post is meant to bring to your knowledge entire new dimension of using the financial knowledge in IT decision making. We can always debate out the viewpoint and criticize the shortcoming of any model but at same time I think we should appreciate the new perspective.
Performance management for Risk Managers: A question unanswered
This thing struck me especially after I myself started working on risk management. I had taken extra course on compensation management much to surprise of most of my friends. One of the important take away from the course was the importance of tying of compensation with performance. In nutshell, right performance must be rewarded with right (desired) compensation technique. Thus performance management is tightly coupled with compensation management and can have far reaching impact on employee’s satisfaction. You may be wondering why am I writing this “gyaan “but this has to do with the current debate regarding executive compensation and its role in financial crisis.
To measure the performance for any role we must first define the metrics and the process for the same. Revenue generated, number of customer added etc are various metrics used to measure the performance of sales personnel. So what could be metrics for risk manager just try to think? It should be how well company performs or withstand during the adverse business conditions. But now consider how you would have appraised risk managers during 2003-05 when global economy was booming and nothing wrong or unexpected was happening. The companies earning were growing year on year basis. At this time imagine particular risk manager not allowing banks to give out loans for housing, asking to maintain high liquidity and not taking exposure to CDO and other complex instruments since he recognized they were dangerous. At same time all its competitor were doing exactly opposite and thus were able to grow at twice the rate of the other bank. How would have that risk manager been appraised at end of 2003? He would have been criticized for being risk averse and would have lost his job in year or two to other set of risk managers. This is because metrics to measure risk manager performance is not that clear. During that period there were no crisis so how you measure their performance. In absence of the adverse conditions everyone were able to “so called withstand” the year but some made more profits than the others so people tend to appraise the other risk manager with better grade and hence better compensation. Even the sophisticated technique like balance scorecard would fail to measure the performance of risk manger. Since here we would look from all perspective so on revenue and profit front the risk manager would score low. I know someone fresh out of MBA would like to use some business terms and explain me that performance should be in how well risk has been managed with respect to defined risk appetite of the company. I agree to this but who defines the risk appetite? If it is board or CEO then if risk manager followed that then why are they being condemned for their action today? It was in line with the goals set for them.
So then how should we appraise risk manager? What should be metrics and process? All human resource manager needs to work this out. I believe that we should now look at long term for appraisal and compensation management for risk managers. But then what should be this long term? I have no answer to this. The question is open for all of you to answer. Maybe someone can point to honorable Robert Kaplan to work out special metrics for risk manager or throw some light on this area. What say guys?
To measure the performance for any role we must first define the metrics and the process for the same. Revenue generated, number of customer added etc are various metrics used to measure the performance of sales personnel. So what could be metrics for risk manager just try to think? It should be how well company performs or withstand during the adverse business conditions. But now consider how you would have appraised risk managers during 2003-05 when global economy was booming and nothing wrong or unexpected was happening. The companies earning were growing year on year basis. At this time imagine particular risk manager not allowing banks to give out loans for housing, asking to maintain high liquidity and not taking exposure to CDO and other complex instruments since he recognized they were dangerous. At same time all its competitor were doing exactly opposite and thus were able to grow at twice the rate of the other bank. How would have that risk manager been appraised at end of 2003? He would have been criticized for being risk averse and would have lost his job in year or two to other set of risk managers. This is because metrics to measure risk manager performance is not that clear. During that period there were no crisis so how you measure their performance. In absence of the adverse conditions everyone were able to “so called withstand” the year but some made more profits than the others so people tend to appraise the other risk manager with better grade and hence better compensation. Even the sophisticated technique like balance scorecard would fail to measure the performance of risk manger. Since here we would look from all perspective so on revenue and profit front the risk manager would score low. I know someone fresh out of MBA would like to use some business terms and explain me that performance should be in how well risk has been managed with respect to defined risk appetite of the company. I agree to this but who defines the risk appetite? If it is board or CEO then if risk manager followed that then why are they being condemned for their action today? It was in line with the goals set for them.
So then how should we appraise risk manager? What should be metrics and process? All human resource manager needs to work this out. I believe that we should now look at long term for appraisal and compensation management for risk managers. But then what should be this long term? I have no answer to this. The question is open for all of you to answer. Maybe someone can point to honorable Robert Kaplan to work out special metrics for risk manager or throw some light on this area. What say guys?
Risk management experience
This is my first hand experience in area of risk management. Risk management has been researched and practiced by companies in American and European countries. Even after putting in various processes and mitigation techniques financial crisis could not be avoided. At same time even though Indian companies do not have formal enterprise risk management practice in place, they are not in that trouble. So does that mean risk management is of no use and entire work done in that area has no value? Is it mere exhibition of mathematical supremacy of some geeks? Are those models part of problem or solution to today’s problems?
The answer I found when I started working for developing risk model for my company. After few days at work I was taken aback when there were no formal strategies in place nor any guidance or processes in area I was working. To start my work I decided to talk to various stakeholders and quickly realized that how could they manage without knowledge of risk involved and still earned profit. The answer lies in first blog post of mine. We Indians by nature are risk averse. In initial part of my career when I was involved in software development I had to estimate the effort for the development. I always use to pad it up by 20-30% to ensure timely delivery. But when my lead forwarded that estimates she would further pad it up by other 10% and so on till entire estimates gets padded up by almost 200%. Then client would negotiate and we would end up having at least 100% padded estimate. Though we did not have formal project risk management practice in place we ensure timely delivery. The same is true with most of Indian companies. They have mostly hierarchical organization structure rather than flat one and further at each level each one of them adds its own estimate of risk premium which ensures sufficient buffer, in fact more than required. Thus they have been able to withstand any deviation from expected.
Risk management is thus very important for Indian companies since it would free up lot of capital (or bring down estimates to appropriate level) and would help them to be more competitive. It would help them to improve their estimation. So unlike western countries where risk management increases capital requirement, eastern countries it might have opposite impact. But the fact remains risk management would certainly be of importance to both of them.
I had gained similar learning from my experience with startup. They were quite successful growing at almost 20-30% a year. They also did not risk management practice in place and neither believed in that. After detailed study of their company for a year or so I realized the risk aversion and management was inherently in culture and style of the entrepreneurs. All that I could suggest as part of process was indirectly implemented by them as part of their business.
Sometimes after learning lot of complex stuff, models we might miss out these socio-cultural factors that are very important for risk consultants. They might look silly but can have important consequences if you are working as risk consultants in different countries across the globe with companies of different size. Today I realized that small company without any knowledge of risk could have better risk management practice ingrained in its business than billion Dollar Company armed with professional from best of the B-schools.
Other side of Google Story
Before you start reading this blog I want to make you aware that I am big fan of Google like many of you but I am playing the devil advocate to fuel debate. I am in minority group who though being an ardent reader didn’t like the book Google Story because I perceived the book to be one of the marketing techniques of Google rather than its true story. There were only positives about Google and that is what I see is the perception of most of the people. People have been made to believe that Google stands for philanthropy, they want to make life of people better by providing them access to vast amount of information at low cost. At same time Microsoft is being perceived as giant monopoly crushing any opponents in the industry with only aim to earn huge profits. Every computer science graduate dreams to be in Google and brand Google now stands for innovation, noble cause. There are ample of articles and cases that document work culture at Google, their success story and their noble intention. People are speculating that there is nothing that can stop Google’s growth. But there are few people who have raised doubts on Google. Most famous being by Dr. Benjamin Edelman, assistant Professor at Harvard Business School, whose article in HBR about how Google’s Ad deal with Yahoo is nothing sort of monopoly was really alarming. This blog has been inspired, in fact most of points have copied from famous article ‘Google Engima’, published by Booz Allen and I am just putting my interpretation of that. So credit goes to them for these insights which I think we should know before we try to emulate Google in our business.
Let’s first see the Google’s claim of providing information for free as no noble vision but rather perfect business strategy. It is similar to Microsoft strategy of providing Internet Explorer for free to destroy Netscape. However Microsoft was criticized for its action while Google actions are being considered as noble. That’s strength of good marketing communication. I know many of you won’t agree on this so let’s get some clarity. If anyone looks at Google revenue stream then it would be crystal clear that online advertisement business is its cash cow which generates more than 80-90% of its revenue. Now answer simple question when would online advertising industry thrive? Only when there are more users online i.e. using Internet. So who are the competitors of Google? Anyone who provides users with utility that doesn’t require user to use Internet. So if Google provides those utility online and with reduced cost in fact for free and similar or better performance then users would prefer online version then offline one. Thus it is a direct competition for Microsoft. It is very famous strategy of using complements to drive the main product. Google by its support to open source, developer group is doing nothing but reducing the cost of complements. Now look at all the product that Google gives out for free like Blogger, Google Docs, Maps etc and you will this why they are free. Because they make people connect to Internet and moreover by using Google products they get more information about the user preferences which turn helps it search engine. In fact the success of search engine lies with heavy usage of Google by people. Microsoft office suite is expensive and offline utility so Google came with its online suite. Gmail provides Google with one more avenue to earn through advertisement. So get out of philanthropy its business and Google derives its strength from this strategy which acts as big barrier of others. Let’s understand that now.
Lot has been written about 20% time which Google employees are given to work on areas of their interest and the liberty they enjoy. People have concluded this has been reason of Google being highly innovative and ahead of everyone. This strategy works for Google because the cost of failure of its new product is much cheaper for them. This is because Google normally introduces half developed product as Beta version in market and entire Google devoted fan club starts using it and promoting it. It provides them revenue from that stage itself through advertising and also provides important data on customer behavior. Other fact is that range of the compliments that can be developed are also huge. So any work done by its employees in those 20% time doesn’t go wasted. In fact it provides lot of learning which is most essential in knowledge industry, satisfaction to employees (which implies low attrition and low cost of attracting new talent) and huge marketing for the Google. If any product is developed successfully then more revenue is generated for itself. However that is not the case for others since cost of failure is too high for them. In fact closer analysis would suggest that this initiative also has complete business sense.
Now next point of contention is Google success because of all this practices or are this practices are being used by management guru’s to be cause for its success. Is there cost-effect relationship? If you consider most of the successful products in Google bouquet have been acquired. Google video was failure but Youtube an acquired entity is success. Other examples are Google Earth, Blogger, Feedburner, Orkut, wiki developer JotSpot are nothing but acquisition. So where is its innovation? Rather it spots and buys innovation and reinforces its own brand as innovator. In fact even the concept of bidding for advertisement was taken from GoTo by Google and it perfected the process later. It was also not its creation.Hey Google fans don’t swear at me I am just providing other side of story which is neither publicized nor communicated. All those fight against copyright restriction for free information is for their business. Ask any student how much dependent he is on Google for code, papers, forums, assignments etc. Google has been involved in battle against copyright material, privacy issues time and again and every time it gets away because it has been able to create an image of a noble organization working in larger interest of society. Its ties with academic world have also help to create this perception. So now answer is Google a case study for innovation or its marketing strategy?
As I told you all before I am big fan of Google and this blog is just one side of tale which is never thought of by anyone. At end of day Google is one the most successful business venture and there is huge learning for every one of us and I sincerely believe that.
Let’s first see the Google’s claim of providing information for free as no noble vision but rather perfect business strategy. It is similar to Microsoft strategy of providing Internet Explorer for free to destroy Netscape. However Microsoft was criticized for its action while Google actions are being considered as noble. That’s strength of good marketing communication. I know many of you won’t agree on this so let’s get some clarity. If anyone looks at Google revenue stream then it would be crystal clear that online advertisement business is its cash cow which generates more than 80-90% of its revenue. Now answer simple question when would online advertising industry thrive? Only when there are more users online i.e. using Internet. So who are the competitors of Google? Anyone who provides users with utility that doesn’t require user to use Internet. So if Google provides those utility online and with reduced cost in fact for free and similar or better performance then users would prefer online version then offline one. Thus it is a direct competition for Microsoft. It is very famous strategy of using complements to drive the main product. Google by its support to open source, developer group is doing nothing but reducing the cost of complements. Now look at all the product that Google gives out for free like Blogger, Google Docs, Maps etc and you will this why they are free. Because they make people connect to Internet and moreover by using Google products they get more information about the user preferences which turn helps it search engine. In fact the success of search engine lies with heavy usage of Google by people. Microsoft office suite is expensive and offline utility so Google came with its online suite. Gmail provides Google with one more avenue to earn through advertisement. So get out of philanthropy its business and Google derives its strength from this strategy which acts as big barrier of others. Let’s understand that now.
Lot has been written about 20% time which Google employees are given to work on areas of their interest and the liberty they enjoy. People have concluded this has been reason of Google being highly innovative and ahead of everyone. This strategy works for Google because the cost of failure of its new product is much cheaper for them. This is because Google normally introduces half developed product as Beta version in market and entire Google devoted fan club starts using it and promoting it. It provides them revenue from that stage itself through advertising and also provides important data on customer behavior. Other fact is that range of the compliments that can be developed are also huge. So any work done by its employees in those 20% time doesn’t go wasted. In fact it provides lot of learning which is most essential in knowledge industry, satisfaction to employees (which implies low attrition and low cost of attracting new talent) and huge marketing for the Google. If any product is developed successfully then more revenue is generated for itself. However that is not the case for others since cost of failure is too high for them. In fact closer analysis would suggest that this initiative also has complete business sense.
Now next point of contention is Google success because of all this practices or are this practices are being used by management guru’s to be cause for its success. Is there cost-effect relationship? If you consider most of the successful products in Google bouquet have been acquired. Google video was failure but Youtube an acquired entity is success. Other examples are Google Earth, Blogger, Feedburner, Orkut, wiki developer JotSpot are nothing but acquisition. So where is its innovation? Rather it spots and buys innovation and reinforces its own brand as innovator. In fact even the concept of bidding for advertisement was taken from GoTo by Google and it perfected the process later. It was also not its creation.Hey Google fans don’t swear at me I am just providing other side of story which is neither publicized nor communicated. All those fight against copyright restriction for free information is for their business. Ask any student how much dependent he is on Google for code, papers, forums, assignments etc. Google has been involved in battle against copyright material, privacy issues time and again and every time it gets away because it has been able to create an image of a noble organization working in larger interest of society. Its ties with academic world have also help to create this perception. So now answer is Google a case study for innovation or its marketing strategy?
As I told you all before I am big fan of Google and this blog is just one side of tale which is never thought of by anyone. At end of day Google is one the most successful business venture and there is huge learning for every one of us and I sincerely believe that.
Skyrocketed SENSEX : A Mirage
This post is meant for the novice investors who would have sudden jump in SENSEX and NIFTY and would have concluded end of the bear market. Suddenly one can see people talking again of SENSEX reaching 20000. Popular TV channels creating the excitement and hype around the frenzy market. At this moment I would like everyone to introspect and understand what has suddenly changed so much that we see such confidence. We must understand what this index numbers suggest.
First let us remove the misconception if anyone has that these numbers are real number. On NSE website one can get following statistics about the equity market:-
Traded Qty. (lakh shares) 84.3
Traded Value (Rs. crores) 170.32
This numbers should ring bell in anyone's mind. They clearly suggest that hardly any trading took place on NSE. Thus the stock prices at end of the day are some random prices which got matched. It might be just one trade which took place at that valuation and subsequently there were no buyers at that price.
Second let's look at other important data about the activities of DII's (domestic institutional investors)
DII trading activity on NSE and BSE in Capital Market Segment(In Rs. Crores)
Category Date Buy Value Sell Value Net Value
DII 18-May-2009 41.62 50.03 -8.41
This clearly suggests the intention of the institutional buyers. They were invested in the markets during the bear phase and booked profits today i.e. buy at low price and sell at high price.
Now let's look at NSE F&O market statistics
Index Futures and Index Options
Index futures saw a trading volume of Rs.1372.38 crores arising out of 65288 contracts and Index options saw 31003 contracts getting traded at a notional value of Rs.599.21 crores. The total turnover of the Futures & Options segment of the Exchange was around Rs.2599.35 crores.
Options on individual securities
Out of 233 securities, options on 48 underlying securities got traded. The total number of contracts traded was 360 with a notional value of Rs.16.24 crores.
Futures on individual securities
Out of 233 stock futures on 197 underlying securities got traded. The total number of contracts traded was 12467 with a traded value of Rs.611.51 crores.
Index Futures
Symbol | Open interest (Qty.) as at end of trading hrs. |
NIFTY | 39342850 |
MINIFTY | 1268460 |
BANKNIFTY | 961650 |
CNXIT | 8400 |
Index Options
Symbol | Open interest (Qty.) as at end of trading hrs. |
NIFTY | 82245650 |
MINIFTY | 10800 |
BANKNIFTY | 8400 |
CNXIT | 0 |
It is these huge open positions which people are trying to cover up which led to this sudden jump in the market. It was general expectation that people would elect hung house and thus speculators had taken positions in the market accordingly. But with the people mandate for single alliance without support of Left clearly raised hopes for reforms and more possibility of foreign investment pouring in. So in order to avoid huge losses speculators started to cover up positions. These open positions also suggest that such activity can be seen even tomorrow or in near future but this does not indicate any long term trend.
I know many of you would be against entire explanation of mine. You may say that markets are leading indicators and they reflect the future health of the Indian economy. Stable non-Left government indicates possibility of reforms and high growth. However my answer to all this explanation is that nothing has change in the neither global economy nor Indian economy in a day. The impact of the action which we speculate would be taken by government in near future can be seen only after a year or so at earliest. Further the valuation of any company cannot change by more than 30% in a day. The fundamentals haven't changed to that significant level. There is liquidity crunch at global level, less demand and a change in government cannot impact this in a day or a month or so. If we go by theory then the information of change in government is known to everyone and by efficient market hypothesis we cannot make profits because of this publicly know fact.
Thus its right market to sell and book profit or get out of bad investment. That's my advice.
China's Dilemma
In my previous post, I elaborated on the one of the point of debate that Dr. D. Subbarao (Governor, RBI ) discussed in his speech at RBI-BIS. In this post I am going to elaborate on his second point of debate. He believed most of the Asian countries especially China have held huge amount of foreign reserves as measure of self-insurance.Asian Economic Crisis in 1997 saw IMF impose strict conditions on bailout recipients.Most of these emerging countries felt that they hadn’t been treated fairly and thus to avoid themselves getting into such trouble they have maintained huge reserves. But is this self insurance viable policy? Is it serving the purpose?
India’s foreign reserve was more to do with capital inflows and with the crisis that turned negative and now we have deficit. China’s foreign reserve was from trade surplus and seems to be real. This would suggest that China should not face any problems at surface but that’s not the case. Problems are twofold. To earn this huge reserves China has made herself dependent on exports. Now this has become liability because the growth of your nation is now dependent on foreign economy for which you have no control. Current crisis exhibits the same problem.Next problem is are thess reserves for real?
There is a set of people who do not believe on Dr. D. Subbarao’s logic of self insurance. They believe China deliberately bought US dollars to manage the value of the yuan which provided the Chinese manufacturer cost leadership in market and thereby gain competitive advantage. In doing so China's foreign exchange reserves have increased from $216 billion in 2001 to $1.52 trillion in 2007, then $1.95 trillion in 2008, according to a Congressional Research Service (CRS) report published in March. Economists estimate that about 70% of those reserves are held in dollar-backed assets. These numbers on the face indicates the power China has over US by helping them finance their huge debt of $11 trillion. But then why does China not exhibit the same? Because the fact is that she cant without damaging herself. Lets look at Chinese investment portfolio. As risk averse nation it initially used to invest on US Treasury bonds which were considered risk free. Later on it diversified to riskier assets like investment in PE firm Blackstone and Morgan Stanley. They had bought $3 billion share worth $31 each of Blackstone whose value fall to $8 in October 2008. Similarly they had exposure to asset backed securities thus they lost of foreign reserves in such investments. Paul Krugman writes humorously in one of this article that they supplied us with poisonous toys and we gave them false assets so its like what you give you get. China subsequently purchased $44.5 billion and $65.9 billion of U.S. Treasury securities in September and October of 2008.Now China’s huge reserves are in form of US dollars and US bonds. If they starts to sell their dollar reserve then there is none presently in world to buy them thus it would bring value of dollar down. This implies value of China’s foreign reserve would also decrease by similar amount.To invest in its own country also she would have to sell dollar and buy RMB which would appreciate its currency and depreciate dollar.This would again affect its exports which have already dipped. If it does nothing then worry is that the value of the US bonds would decrease significantly due to rising inflation.
Thus China is in huge dilemma with what can be done with its huge foreign reserves. Neither can it invest nor sell. It would be great if some of the valuation guru’s of the world try to find the true value their foreign reserves. Further to add to her woes there is no other currency on which China can rely upon. So recently China has voiced the need for new global currency and its concerns about any action taken by US government which affects value of US dollar.So I still ponder is China really rich? Was her export oriented policy not correct? Is success story of China just limited to its even more reliance on US? In this struggle to be global powerhouse who has edge over other US or China? Co-opetition at its best.
India’s foreign reserve was more to do with capital inflows and with the crisis that turned negative and now we have deficit. China’s foreign reserve was from trade surplus and seems to be real. This would suggest that China should not face any problems at surface but that’s not the case. Problems are twofold. To earn this huge reserves China has made herself dependent on exports. Now this has become liability because the growth of your nation is now dependent on foreign economy for which you have no control. Current crisis exhibits the same problem.Next problem is are thess reserves for real?
There is a set of people who do not believe on Dr. D. Subbarao’s logic of self insurance. They believe China deliberately bought US dollars to manage the value of the yuan which provided the Chinese manufacturer cost leadership in market and thereby gain competitive advantage. In doing so China's foreign exchange reserves have increased from $216 billion in 2001 to $1.52 trillion in 2007, then $1.95 trillion in 2008, according to a Congressional Research Service (CRS) report published in March. Economists estimate that about 70% of those reserves are held in dollar-backed assets. These numbers on the face indicates the power China has over US by helping them finance their huge debt of $11 trillion. But then why does China not exhibit the same? Because the fact is that she cant without damaging herself. Lets look at Chinese investment portfolio. As risk averse nation it initially used to invest on US Treasury bonds which were considered risk free. Later on it diversified to riskier assets like investment in PE firm Blackstone and Morgan Stanley. They had bought $3 billion share worth $31 each of Blackstone whose value fall to $8 in October 2008. Similarly they had exposure to asset backed securities thus they lost of foreign reserves in such investments. Paul Krugman writes humorously in one of this article that they supplied us with poisonous toys and we gave them false assets so its like what you give you get. China subsequently purchased $44.5 billion and $65.9 billion of U.S. Treasury securities in September and October of 2008.Now China’s huge reserves are in form of US dollars and US bonds. If they starts to sell their dollar reserve then there is none presently in world to buy them thus it would bring value of dollar down. This implies value of China’s foreign reserve would also decrease by similar amount.To invest in its own country also she would have to sell dollar and buy RMB which would appreciate its currency and depreciate dollar.This would again affect its exports which have already dipped. If it does nothing then worry is that the value of the US bonds would decrease significantly due to rising inflation.
Thus China is in huge dilemma with what can be done with its huge foreign reserves. Neither can it invest nor sell. It would be great if some of the valuation guru’s of the world try to find the true value their foreign reserves. Further to add to her woes there is no other currency on which China can rely upon. So recently China has voiced the need for new global currency and its concerns about any action taken by US government which affects value of US dollar.So I still ponder is China really rich? Was her export oriented policy not correct? Is success story of China just limited to its even more reliance on US? In this struggle to be global powerhouse who has edge over other US or China? Co-opetition at its best.
Can we have negative market risk premium? What does that imply?
This is post meant for all finance guys. First let us get basics correct.What do you mean by market risk premium? It simply means the excess returns over the risk free rate that is expected on his investment in market by the investor because of the risk he undertakes. Next is how do we calculate this risk premium? The most commonly used method is to use historical data. We calculate average return on the market and subtract average return of risk-free bonds for the same period to determine market risk premium. So in normal scenario we assume that at going concern the future market risk premium would be same as the past.Now the problem has arisen because of the current financial crises which has led to situation that long term risk free bonds have yielded more than the market during the same period. So if we continue to use this method then we would have negative market risk premium.
I know many of us would have at first instance not agreed to negative market risk premium. Does this actually make sense or method needs to be modified? Let us consider the investment with positive beta in which case cost of equity would become less than risk free rate. So it implies that company would have to pay its shareholders less than risk free rate!! Then instantaneously most of us would suggest that any sane person would sell off his shares and rather invest at risk free rate. This is what happens at outbreak of financial crisis.Investors withdraw the money from stock market and markets tumbled. People invest this money in the bonds of the banks which are considered to be risk free. Under normal circumstances, Banks would cut the risk free rate with huge inflow of capital. This will continue till market risk premium turns positive. Thus for short time market risk premium can be negative but over longer horizon it would always remain positive.
But is this what happen in current financial crisis? In that sense current crisis in US was quite unique due to high leverage in the economy.First of all risk free rate i.e. interest rate in US(if you still consider it to be risk free) were already very low which implied lower deposits with the banks. Second the securitization had created system which was highly leveraged i.e. in simple words people consuming more than money they held. It worked fine till leverage became so high that financial institution itself defaulted. This broke the chain which circulated money in economy. People withdrew money from stock,bond markets but unlike other crisis instead of depositing it with bank they needed them for their consumption. So banks faced liquidity crunch and their investments weren't yielding the expected returns due to fall of stock market. Rate were cut to almost zero but market returns remained negative.Thus we never reached a situation wherein market risk premium became positive. At that point cost of equity was negative which implied that investor expects nothing as return in fact expects to pay to get invested. This is what US government did by means of bail out package wherein it bought stakes in Citibank and others.They enhanced liquidity in system and tried to reinstate confidence in market so that the expected market returns become higher than risk free rate leading to positive market risk premium.
In nutshell market risk premium has to be always positive and if turns negative then steps are taken to make it positive. In other words for the survival of the economy expectation from the market should be positive at any point in time. Long term negative market risk premium i.e. negative market expectation indicates failure of the economy.
I have done quite complex analysis and have written complex blog about the current crisis. I hope it makes sense.
Financial Crisis Gyaan Part1
I was thinking topic for my next post and decided upon to write about something that has affected us badly especially all 2009 graduates. Almost three financial quarters have passed to fall of great Lehman Bros but still discussion about the crisis have not ended and neither crisis itself. I can recollect every professor coming from US giving their own perspective (“gyaan”) about the crisis. Initially as management student we were quite interested to know their views but later became wary of the same. Financial crisis was topic of discussion be it academician, industrialist, regulator, blogger or politician. Now that I am MBA I am obliged to share some of my esoteric gyaan on the topic. So out of innumerable articles and studies that I have read today I plan to write from Dr. D Subbarao (Governor, RBI ) speech delivered at one of the RBI-BIS seminar. He presented 5 points of debates and this post I aim to cover the first one. His views are more from macroscopic view of crisis and he rather question imbalance at economy level. I think I need not expand more than just few sentence since we all are aware of the same. He commented on high amount of spending by US and their high trade account deficits on one end and high saving and huge trade surpluses by China on other end. In order to provide liquidity in their system, highly sophisticated financial products that were engineered by financial experts created base for the crisis. There is broad level agreement on this but important is the questions this generates for the future. Consider we have magic wand which can get us all out of this present crisis and we are entrusted to develop system that would prevent such crisis in future. So what’s next? How do we act upon this imbalance?
Consider demographics most of the developed countries have aging population which are going to consume more than they produce and emerging economies have young population which would produce more than it can consume. Consider psycho-graphics, population in developed countries are used to luxurious lifestyle and have high propensity to spend. They have not faced many hardships during their life and thus do not attach more importance to saving. While population in emerging economies have fought their way through difficult times and therefore have more tendency to save. How are we going to change this? Is there any solution once we overcome this short term financial crisis? We can neither change the demographics in few years nor psychology of the population. So what it points to that after we overcome present situation we would have few good years maybe decades but again such crisis would surface since there is no way we can change or alter global imbalances. Maybe in few centuries we could also see reversals of roles among countries or Asian economies being replaced by African and American-European economies being replaced Asian economies. Who knows? Maybe good topic for Harvard guys to research and publish.
Also I am wondering after reading the post how would you view now the recent news item that increase in American spending has been observed after three quarters and China and India also showing increase in industrial production. Every news channel showed this with stock markets going up and most of the people were considering this as end of crisis except for one individual that is me.
Consider demographics most of the developed countries have aging population which are going to consume more than they produce and emerging economies have young population which would produce more than it can consume. Consider psycho-graphics, population in developed countries are used to luxurious lifestyle and have high propensity to spend. They have not faced many hardships during their life and thus do not attach more importance to saving. While population in emerging economies have fought their way through difficult times and therefore have more tendency to save. How are we going to change this? Is there any solution once we overcome this short term financial crisis? We can neither change the demographics in few years nor psychology of the population. So what it points to that after we overcome present situation we would have few good years maybe decades but again such crisis would surface since there is no way we can change or alter global imbalances. Maybe in few centuries we could also see reversals of roles among countries or Asian economies being replaced by African and American-European economies being replaced Asian economies. Who knows? Maybe good topic for Harvard guys to research and publish.
Also I am wondering after reading the post how would you view now the recent news item that increase in American spending has been observed after three quarters and China and India also showing increase in industrial production. Every news channel showed this with stock markets going up and most of the people were considering this as end of crisis except for one individual that is me.
