Italian Mafia might rob global financial market

In the late 19th and early 20th century America saw emergence of Mafia in cities likes New York and other metropolitan due to Italian immigrations. (Italian mafia is also known as Sicilian mafia).Last week something similar happened in the global market, the Italian government released data for GDP, which declined by 0.2 percent in April-June quarter, sending negative sentiment across the financial world. Italy slipped into recession fomafia-guysr the third time since 2008.
Italian mafia is termed as “Cosa Nostra” (“our thing”). Thanks to globalisation, this poor GDP data from Italy can’t be termed Cosa Nostra for Italians as their problem is gong to be our problem.
Not only Italy but trade sanctions against Russia, poor factory orders from Germany, fresh statement from incoming European President Jean-Claude Juncker against Grecce debt write-off, French President Francois Hollande’s appeal to ECB on deflationary risk, Portugal’s $6.6 bln rescue plan for its troubled bank Banco Espirito Santo and ECB’s concern on euro zone recovery due to heightened Ukraine crisis, and no change in interest rate played major role in the financial market.
All the above mentioned events pushed U.S. treasuries price up (so, the yields fell). The safe haven investment demand was visible in Germany too, as investors clamoured for safe haven, sending German’s 10yr bunds yield to hit all-times lows.
On Friday, U.S. 10-year notes were down 1/32, yielding 2.43 pct, earlier in the day it fell to 2.35 pct meanwhile, 30-year bonds were unchanged to yield 3.24 pct, it also dipped a low of 3.18 pct during the trading hours.
There were some encouraging signs from U.S. economy, which helped the stock market. Weekly jobless claim fell, Purchasing Manager Index (PMI) for services were good, factory orders rose and Labor Department reported quite a pleasing data on labor productivity in second quarter which boosted investors confidence.
For the week, the Dow rose 0.4 pct, the S&P 500 gained 0.3 pct and the Nasdaq was up 0.4 pct.
The U.S. dollar was up for most of the week but lost all its gain and fell to one week low against all major currencies as escalated geopolitical tension laid down perfect opportunity for profit booking. The dollar was down 0.17 pct at 81.389 as of 4:30 pm EST, Friday.
Lets focus back on Italy. Why Italy is so important? Well Italy is world’s eighth largest and Europe’s third largest economy. Its GDP is about $2.6 trillion. The debt-to-GDP ratio is well above 120 percent. Thus, Italy has got enough butterflies in its belly to disrupt global financial recovery. Europe would be the obvious and worst hit if Italy falls into deep recession. And I won’t be surprise to see Sicilian Mafia migrating toward emerging markets; just to derail their growth story.

Disclaimer: I am not promoting Mafia neither influenced by Godfather (movie).

It’s Raghuram Raj !

ImageThis Wednesday at RBI’s mid-quarter review of monetary policy an interest rate hike looks inevitable. One should blame the retail inflation (CPI) which burgeoned to 11.24% in November from 10.17 percent the previous month and not to forget Mr. Raghuram Rajan; an inflation hawk doesn’t believe in ‘Facebook  likes’. In its previous two meeting the RBI Governor has made it very clear – he won’t tolerate inflationary pressure on the economy.

Coincidentally, many socio-political analysts suggest unlike previous occasions there won’t be any pressure seen from the central government to cut the interest rate this time since Congress has blamed rise in price as one of the main reason for its poor performance in recently held four state assembly election, especially in Delhi.

To make the job little tricky for the RBI governor the factory output (IIP) contracted by 1.8% in October , down from 2% in September. But almost all polls and surveys had predicted hike in interest rate; possibly one last time in the current cycle. On the global front, the Federal Open Market Committee’s (FOMC) two day meeting will possibly paint new picture on the most expected-predicted-anticipated ‘tapering’ move. Many economists believe March 2014 would be that decisive month for the U.S. Fed to dial back its quantitative easing (QE) policy backed by good economic data. The U.S. Senate is expected to vote for new budget deal which will run till 2016 giving more room for the Fed to dial back its QE.

From RBI’s point of view a possible tapering will impact Indian currency. So far, to check the currency depreciation RBI has curbed speculation on dollar (by hiking interest rate). This month at New York, Raghuram Rajan apprised inflation as a key concern.  Market pundits are assured of WPI increase as well which is due to release Today. A higher WPI will concrete interest rate hike decision. Although, ever since Rajan became RBI’s governor, the Central Bank of India has shifted from WPI to CPI as its main guide for monetary policy. So, many market analysts expect hike in interest rate this time.
Its Raghuram Raj for sure!

Credit Default Swaps: Valuation

CDS valuation is done by calculating the ‘survival probability curve’.
The ‘survival probability curve’ is the very fundamental tool which gives market implied probabilities of reference entity that it doesn’t suffer a credit event prior to a give time horizon.

Lets do the maths

After every spread being paid by the protection buyer two things might happen:
1. Survival – which gives you a probability value of 1-q i.e. the reference entity survives for one more period.
2. Default – which gives you a probability value of q event occurred with deliverable obligation trading at the recovery value of R.

Probabilities build up stage

Situation            Payment               Probability          Probability of survival    Probability of Event
Survival            -s  (spread)                        1-q(1)                  p(1)*{1-q(1)}                  1-p(1)
Credit event     (1-R)-s                   q(1)

Survival            -s  (spread)                        1-q(2)                   p(2)*{1-q(2)}                 p(1)-p(2)
Credit event     (1-R)-s                   q(2)

Hence, when you calculate the NPV of a CDS then formula goes like this:

NPV= Summation {(1-R)*( probability of credit event )* risk free discount} – Summation { cash flow during survival) * probability of survival * risk free discount}
NPV= Summation [ (1-R)* { p( i-1 )-p( i ) } * d ( i ) – Summation [ s *p ( i -1 )* d( i ) ]

Here, (1-R) is assumed loss in default and d ( i ) is LIBOR

consider at t=1, NVP = 0 then solving the equation will give you  q (1) =   s

This equation tells the conditional default probability on the spread.

Lets assume 1 year  CDS at 50 bps spread having recovery (R) at 50%, what would be the probability of survival or default ?

q(1)= 0.005/(1-0.5)= 0.01

thus p(1)= 1-q(1) = 1-0.01
= 99% is the probability of survival.

So, we got to know how to calculate NPV on CDS, probability of survival on which we can make series of probabilities thus the ‘survival probability curve’ as well.

Credit Default Swaps: Trading mechanism

What is CDS?

CDS stands for credit default swap; a bilateral over-the-counter derivative contract. It transfers the risk of the loss on the face value of a reference debt issuer over a specified period (underlying asset). The core idea in CDS is to isolate the credit risk from potential default, interest rate and foreign exchange risks. One interesting point, you may enter the CDS contact even if you do not own any credit asset/ reference asset.

The trading mechanism:

When you trade in CDS there are few term which are universal and must be known.
Reference Entity-The corporate or sovereign whose credit risk is transferred.
Term– Time period of the contract/ maturity date.
Notional Amount– Amount of credit (money) being under the contact for protection i.e. $10 million. A standard contact will have $10 million as notional amount.
Premium– The money being paid by the protection buyer to the protection seller. In trading term it is known as “spread”.
Credit Event– An event of default.

Once the protection buyer enters the contact he/she makes timely payments to the protection seller which is called “spread”. The spread is calculated on notional amount of the contact. When the contract ends i.e. at the end of maturity or in case of credit event the buyer stops premium payment aka spread to the seller.

There are two mode of settlement- 1) Physical and 2) cash.
In physical settlement, buyer delivers a basket of deliverable obligations with face value equal to the notional to the seller in exchange of Notional amount ( in simple term buyer has to deliver the bond). While in cash settlement, seller pays notional minus price assigned to the reference obligation ( in simple term seller will pay notional minus recovery rate aka existing spread on the CDS).


To make it more clear, lets assume you buy a protection on $10mln at 100 bps. Now the next day spread widens to 150 bps. So, in mark to market term you made a profit of :

$10mln* (0.0150-0.0100)*4.10= $205,150
Notional amount*(change in spread)*spread PV01

Note: Spread PV01 is the change in CDS value caused by a 1basis point of spread move; a tedious calculation. Spread PV for particular CDS are available in many financial databases.

Tomorrow we will have calculation of spread PV and CDS pricing in detail. Keep reading!

Fee-based income holds the key for Banking system

ImageIn the era of quantitative easing and significant market competition, maintaining profitability through interest-based income is becoming very tough for banks. In the last two decades, interest margins have come under tremendous pressure. In modern times, banks prefer non-interest income i.e. fee based income to drive profitability and return on capital.

The 2008 financial crisis was a big blow for banks, especially for those depending broadly on interest-based income. As the global economic recovery still looks fragile, banks are finding it hard to do loan- and mortgage-based business i.e. interest-based business. The ultra-low central bank interest rate regime was supposed to spur economic activity, as it (theoretically) supports more lending activity, but many banks are hesitant in lending due to potential bad loan losses and slow demand for loans. It would be worth to mention the ultra-low interest rate regime has also dampened savings account activities in banks.

Most of the fee-based incomes (advisory and management fees) are fairly risk-free, as these services don’t involve significant capital investment.

In recent times, banks have reported handsome revenues from fee-based income; thanks to the spur in M&A activities and private equity deals (mainly in US). Since we are living in a globalized society, there are no boundaries for banks and they can reach out to any corner of the world, thus making many potential M&A and private equity activities lucrative.

It would be pertinent to mention that fee-based driven income cushions banks against market competition. In coming days, implementation of new banking rules and regulations are going to take a paradigm shift (Dodd Frank rule, Basel III). This might curb the freedom of leverage banks take on their reserves and provisions, which in turn will leave banks with limited capital or liquidity to do the traditional business of loans and advances –further constraining interest-based income.

Fee-based income is more volatile than interest-based income, but a range of services like wealth management, transaction banking, treasury, and investment banking are covered under fee-based income. The wide spectrum of fee-based service provides room for banks to shuffle service strategies.

In the prevailing economic situation, banks would look for more fee-based income, but they won’t be able to ignore interest-based income completely. They have to build up modus operandi for various possible economic situations. For example, they will have to understand, what would be good for business if the Fed will increase the short-term interest rate or possible ‘tapering’ in coming months? How to benefit from the global corporate houses’ quest for M&A?

Cut in MSF, FCNR swap: A win-win situation

Yesterday, RBI cuts MSF rate by 50 basis points (0.50%) which was inevitable indeed. It tightened the short term rates couple of months back and tried hard to curb the liquidity in the market so that the banks should not speculate against the US Dollar. Now the MSF rate stands at 9 percent.

One of the major factor which helped RBI to cut down the MSF rate is the “no tapering” decision by US Fed which in turn helped not only Indian Rupee but other EM currencies as well. “No tapering” or continuing in QE policy is bad for dollar as it will weaken dollar against other currencies.

Cut in MSF rate is most welcomed part but the most exciting part is the new FCNR swap offered by RBI to the Indian Banks.

The FCNR account (abbreviated as Foreign Currency Non-Repatribale accounts are offered by Indian banks to the NRIs) is a term deposit account meant only for NRIs. The Indian banks accepts only those currency deposits which are freely convertible i.e.US Dollar, British Pound (Sterling), Japanese Yen, Australian Dollar, Canadian Dollar, Swiss Frank.

The FCNR account can be open for minimum 1 year and maximum of 5 years term. An NRI can use the deposit balance to make local payment and yes the interest rate fetched will be tax free in India.

As the Indian banks raise funds through FCNR channel, they take the deposits in other currencies and exchange that with Indian Rupee in the market with prevailing forex rates for domestic lending.Once the term of deposit is over they return the fund with promised interest rate. Since the deposit term ranges from 1 year to 5 years, they hedge FCNR deposits by entering into the derivative market (Forwards contacts, NDFs etc).

Now, how does RBI’s FCNR swap going to work? Currently, in the forward market banks are paying per annum 7 percent premium for the US dollars.But RBI promises 3.5 percent premium per annum for 3 years FCNR deposits. Thus overall cost of hedging is going to be reduced for Indian Banks. On the side note, this facility is only for US Dollar deposits.

The Missing Sense: Indian Economy

“Expect the unexpected”. I must say today’s monetary policy decision by RBI (worth to mention the US Fed as well few days back)has made it clear to the market.

When everyone at financial street were expecting for a repo cut and more ease in the liquidity the RBI Governor kept the ‘inflation mandate’ intact.

The main reasons for RBI to increase rate (further tightening of liquidity) was primarily based on the CPI data and possible ‘Fed tapering’ in coming months which might drag the economy further.

Meanwhile, RBI Governor made it clear, he can’t ignore the inflationary pressure on the behest of so called liquidity ease; which banks are demanding from past few months.

In its mid-quarter policy, the RBI gave respite to short term borrowing by decreasing the Marginal Standing Facility (MSF) rate to 9.5 percent from 10.25 percent. Although it increased the repo rate by 25 basis points (0.25%) to 7.5 percent.

On the side note, most of the banks channelise short term funds through MSF, when the common way of borrowing dries up in the market. So, reduction in the MSF would bring down Certificate of Deposit (CD) rate in the market i.e. short term borrowing rates will gradually come down to sub 9.5 percent level. MSF rate was increased in July to curb the rupee depreciation.

With all the concerns on liquidity and growth I would like to bring some missing links which many of market pundits are ignoring. So, here are few missing sense which we need to check:

1. Our first quarter GDP ticked at 4.4 percent versus 5.4 percent year on year; lowest in four years.

2. One of the main components of Service Sector – Trade, hotel, transport and communication which comprises of small shops, restaurants and rickshaw-wala grew just at 3.9 percent (having 25 percent of weightage in the service sector). The slow pace of growth in the ‘trade, hotel, transport and communication‘ means there is slow employment growth for low income and low skill people.

3. Mining contacted by 2.8 percent in first quarter so were the manufacturing sector and capital formation by 1.2 percent, indicating the investment and consumption cycle are weak.

4. The Gross Fixed Capital Formation (GFCF) which accounts property, plant and equipment and excludes land purchase and depreciation was at 32.6 percent of GDP. The GFCF is a gauge used to check how good the economy is in utilising its capital. Previously estimated figures suggest the GDP should be around the level of 6.5 to 7 percent if the GFCF is 30 percent of the GDP but in the present scenario its is way behind that observed level. 

The bottom-line remains the same for our economy – we are failing to utilise our capital. If we can channelise our investment capital the economy will definitely shape up in a proper direction letting the RBI concentrate on the inflation check .