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Reinvestment Risk.

By: Punam Sharma

What is credit risk?
 

  • Credit risk refers to risk that issuer of bond can default in making payment of the principal amount and interest.
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  • To compensate for the credit risk, higher yield on bond is paid to the investors.
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  • Higher is the credit risk, higher the bond yield and wider will be the credit spread1.
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  • Credit risk of a bond depends on factors both internal (company financials) and external (economic conditions, interest rates etc).
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  • One of the measures to access credit risk is credit rating.
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  • Credit rating in India is conducted by credit rating agencies like CARE, Crisil, ICRA, Fitch, Brickwork and SMERA and the agencies are regulated by SEBI.
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  • In India, any bond rating BBB and above are classified as investment rate and rating BB and below are classified as speculative grade.
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  • Higher the credit rating (with rating of AAA being the highest), lower is the credit risk.
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  • Charts below shows credit spreads (with Gsec) of 1 and 10 year corporate bonds having different credit rating (AAA, A, A-, BBB).
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Credit Spreads

 

  • From the charts above, we can observe that spreads of 1 or 10 year corporate bonds having different credit rating follow same pattern of rise or fall during different economic cycles.
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  • However, the amount the spread widens or narrows is different for corporate bonds having different credit rating.
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  • We can observe lower the credit rating, higher is the spread.
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  • During economic downturn 2008, we can see the hierarchy of spread, which is higher for lower rated bonds, reflecting higher yield for taking extra risk.
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  • Table below shows minimum, maximum and average credit spread (for 1 and 10 year) corporate bond having different credit rating with Gsec reflecting higher spread for lower rated corporate bonds.
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How does credit risk affect bond yields?
 

  • The payoff for taking credit risk is higher yield on the bond.
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  • Investor to be impacted by credit risk does not always imply the bond issuer to default in its payments. Any change in bonds credit rating either upgrade or down grade also affects bond’s price and yield.
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  • A credit rating agency can either upgrade or down grade bond credit rating depending on internal or external factors which can affect bond issuer’s ability to make payment of principal amount or interest.
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  • A credit downgrade will have a negative impact for the bond holder as yields for the bond will increase to compensate for the extra risk, causing spreads to further widen.
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  • As bond’s yield rise, price of bond falls which will affect the bond holders returns.
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  • Reverse holds true when a credit upgrade takes place.
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  • Chart below shows trends in rating actions by credit rating agency Crisil.
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Crisil Rating Actions

 

  • As per the Crisil ratings round up note, downgrade rate was 11.7% while upgrade rate was 7.2% in H2-FY13.
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Trade off for taking higher credit risk
 

  • To understand how much loss an investor makes incase a corporate bond is downgraded, we have take 1, 3 and 5 year corporate bond yield data having credit ratings of AAA, AA and A as on 31 st May 2013.
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  • To illustrate the same, we have assumed a downgrade of AAA to AA, AA to A and A to BBB.
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  • Table below shows the loss in percentage one would incur for investing in corporate bonds having higher yields in case of a downgrade.
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Investing in Corporate Bonds

 

  • From the above table, we can see that when there is downgrade all the corporate bonds make loss, however the amount of loss is smaller for higher rated bonds than lower rated bonds.

 

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Arbitrage Spreads

By: Punam Sharma

Trend of Arbitrage spread and return
 

  • The difference between future price and spot price of the underlying asset is known as basis.
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  • In equity arbitrage, basis (difference) is due to the cost of carry1 (spread).
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  • Normally basis is positive i.e. future price is higher than the spot price of the underlying asset and investor will sell the underlying asset in future market and buy in the cash market.
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  • When there is negative basis reverse of the above takes place. Therefore theoretically investor can make a positive return whether there is a positive or a negative basis.
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  • Chart below shows Nifty futures average monthly and average rollover spreads.
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Nifty Future Average

 

  • From the above chart, we can see that in both cases normally there is a positive spread.
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  • Investor doing arbitrage when average spread of Nifty future was 32.24 highest in March 2012 would have made average return of 7% annualized.
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  • Similarly, if he had rolled over his futures contract taking advantage of the average spread of 53.75, average return would be 12.11% annualized.
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  • As seen, spreads are volatile every month and hence returns too earned are volatile monthly.
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  • Chart below shows Nifty futures rollover average 6 months rolling returns2 from June 2011 to June 2013.
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Nifty Futures rollover 6 months average

 

  • From above chart, we can observe that over 6months returns smoothen out and one gets average return of between 6 to 8%.
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  • Chart below shows Nifty futures rollover average 1 year rolling returns from June 2011 to June 2013.
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Nifty 1 year average rolling return

 

  • From above chart, we can observe that returns further smoothen out during 1 year investment horizon.
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Rollover of futures contract
 

  • When expiry date nears, investors start squaring off their positions and if arbitrage opportunity exist they rollover their futures contract.
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  • The demand and trend for the underlying asset can be understood with open interest.
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  • Open interest (OI) is the total number of future contracts not closed out on particular day i.e. contracts which have purchased or outstanding on that particular day.
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  • Chart below shows OI for expiry month and rollover.
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OI for expiry month & rollover

 

  • From the above chart, we can see the contracts towards expiry OI for current month (in purple) declines and rollover (in orange) month increases showing investors rolling over their future contracts.
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  • Decline in roll over OI shows investors have squared off their positions instead of rolling over. This is seen during March 2013 expiry as OI have declined for April 2013 contract.

 

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Arbitrage

By: Punam Sharma

What is arbitrage?
 

  • Price discrepancy of same asset class in two different markets provides opportunity to make risk free profit by buying in the cheap market and selling in the overpriced market. This opportunity to make risk free profit is known as arbitrage.
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  • Arbitrage opportunity to make risk free profit also takes place between a cash market and derivative markets (forward, future or option market).
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  • Derivative is referred to contracts whose price is derived from its underlying assets like equities, debt, currencies, commodities etc.
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  • Cash market or spot market is where securities are sold for cash and delivery happens immediately after settlement date. Price of the security traded in cash market is known as spot price.
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  • NSE cash market is known as capital market segment and settlement date is on T+2 basis.
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  • Future market (contract) is a exchange traded standardized contract where settlement date is fixed by the exchange. Price at which the security will be delivered at a specified future date (expiry date of the contract) is known as future price.
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  • Futures contract’s expiry takes place on last Thursday of the month.

 
How arbitrage opportunity arises?
 

  • In general, fair value of future price of the underlying asset should equal to spot price of the underlying asset + cost of carry. When there is mispricing in cost of carry and future price of the underlying asset is at premium or discount to its fair value, arbitrage opportunity arises.
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  • Cost of carry (CoC) is the cost of holding the asset till expiry. It includes storage cost, interest cost etc and excludes any income earned on the asset.
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  • For equity derivatives, cost of carry is the interest cost incurred on holding the security till expiry minus any dividends on the security and is calculated as difference between future and spot price of the underlying security (spread).
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  • Spreads are determined by market sentiments, interest rate levels in the economy, FII holdings.

 
How will you make risk free profit?
 

  • As mentioned above, we know how arbitrage opportunity arises. Now let’s see how can one make a risk free profit from the mispricing opportunity.
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  • Suppose on 1st May 2013, Nifty is trading at 2000 in cash market and one month Nifty futures contract is trading at 2100.There is an arbitrage opportunity of 100 to gain.
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  • To gain, you will buy Nifty for 2000 in the cash market and simultaneously sell in futures market for 2100 and lock the gain of 100.
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  • At expiry, you will offset your position i.e. sell Nifty in cash market and buy Nifty futures contract in order to make gain.
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  • Also at expiry, spot price and future price converge i.e. future price of Nifty will equal spot price of Nifty.
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  • On expiry 30th May 2013 (last Thursday of the month) irrespective of prevailing Nifty price, you will make 100 risk free profit.
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  • Chart below shows 3 different Nifty closing prices on expiry and how the risk free profit made.

 

Nifty Closing Prices

 

  • From above, we can see that you can make risk free profit irrespective of the direction of the closing price of the security on expiry date.
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  • For the above example, you make annualized return of 5.04%.
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  • Same holds true, when arbitrage opportunity arises when future price is below spot price but transaction will be vice versa.
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  • Charts below show the spread between Nifty 1 month futures price and spot price for March, April and May expiry showing that on expiry futures price converges with spot price.

 

Nifty future price & spot price

 
What is rollover of futures contract?
 

  • At expiry, investors square off their positions and let futures contract expire. However investors can also carry forward their position by entering into a similar contract at a future date. This is known as rollover of futures contract.
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  • It is a process where investors carry forward their futures contract from one expiry date to another.
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  • For example, investor has Nifty long futures (buy) which expires in May, if investor decides to rollover his contract means he will square off his position on expiry date and buy Nifty futures expiring in June i.e. carry forward his Nifty futures contract.
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Capital Account of India

By: Punam Sharma

What is capital account?
 

  • Capital account records all capital inflows and outflows of a country and forms part of balance of payment (BoP).
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  • It tracks the capital movement for investments and loans into and out of a country.
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  • When there is capital account surplus it means a country is receiving more capital inflows. This results in increase in overall increase in BoP, thereby resulting increase in country’s foreign exchange reserves*.
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  • Current account deficit is financed by capital account surplus*.
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  • Chart below shows annual capital account and current account and overall balance of payment trend in absolute term.
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Balance of Payment

 

  • From the above chart, we can see that India has always had a capital account surplus.
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  • Capital account has always exceeded current account and been able to finance current account deficit except in the years 2009 & 2012.
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  • Although in the years 2009 & 2012, there has been capital account surplus, but it has not been enough to fund the current account deficit resulting in negative BoP.
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Components of Capital account
 

  • Capital inflows and outflows are classified into foreign investments, loans, banking capital, rupee debt service and other capital.
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  • Foreign investment is divided into two components foreign direct investments (FDI) and foreign portfolio investments.
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  • FDI refers to foreign investment made in and by India through mergers & acquisitions or setting up new operations while foreign portfolio investments include FII investments in Indian capital market.
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  • Loans are further classified into external assistance, commercial borrowings (medium and long term) and short term loan.
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  • External assistance refers to loans given to India from foreign government and loans given by India to other foreign government.
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  • Commercial borrowings include all medium and long term loans from India through EXIM bank to other countries and loans to Indian companies through FCCB, floating rate notes etc.
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  • Short term loans include loans up to 1 year to India for imports directly by overseas supplier. Its components include supplier’s credit up to 180 days, buyer’s credit and supplier’s credit greater than 180 days.
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  • Banking Capital includes foreign assets and liabilities of commercial banks like NRI deposits, foreign currency holdings etc and movement in balances of foreign central banks and international institutions like Asian Development bank, International Bank for Reconstruction and Development, International Development Association etc.
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  • Rupee debt service includes interest payments and principal repayments on account civilian and non civilian debt in respect of Rupee Payment Area.
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  • Other capital includes all other capital flows not included above categories like delayed export receipts, quota payments to IMF, India’s subscriptions to international institutions etc.
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  • Table below shows net break up of capital account over the years.
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Net break up of capital account

 

  • We can see that the capital flows peaked in 2008 to 106.8bn and fell to 6.8bn in 2009 during the crisis.
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  • India capital flow composition has changed over period of time.
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  • Foreign investment component contribution to capital account surplus has increased over years as against loans component contribution except for year 2009.
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  • 2009 due to portfolio investment outflows, overall foreign investment flows declined.
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  • Foreign investment flows comprised around 60% of capital account in 2012 while loans comprised around 30% of capital account.
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  • Portfolio investment flows have been major contributor to overall foreign investments although it has decreased off late. From around 80% contribution to foreign investment flows in 2006 it has fallen to 44% in 2012.
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  • Chart below shows sectors attracting highest FDI equity inflows as % of total FDI equity inflows from April 2000 till March 2013 (in terms of USD).
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Sectors attracting high FII equity flow

 

  • From above chart, it can be seen service sector has attracted highest FDI inflows since April 2000.
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  • The above 10 sectors have attracted around 70% of FDI inflows till March 2013.
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  • Chart below shows FII flows in equity and debt from financial year 1993 to 2013.
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FII Flows in equity& debt

 

  • From above chart, it’s seen that FII flows to debt market have only being increased in recent years.
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  • Majority of FII flows are into equity market.
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  • Except for 1999 and 2009, India has had positive FII equity inflows.
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