I ask Rupee: Are you ‘Tumblr’ or ‘Tumbling’?

The headline seems funny, right? But it is a grave concern for the Indian economy.
Tumblr was worth so, Yahoo! bought it. But do you think rupee is worth in the current market situation? The Indian rupee is no more blockbuster currency among Asian currencies as it has fallen miserably this year.

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If we see the quantum of fall this month itself, it fell more than 10 percent. To  evaluate how rupee has performed, read the article from moneycontrol.com; Rupee to see worst quarter in 10 years.

Now if we come to the basics, rupee’s downward spiral can be attributed majorly to the current account deficit, sudden policy change by major central banks, read: U.S. Fed and Bank of Japan (BoJ) and the Indian economic bottlenecks. To understand more about economic bottlenecks please check one well written article by Mr. Swaminathan Aiyar; Why RBI’s fears about India’s growing current account deficit are misplaced.

In the present market scenario everybody expects more exports from the country and more internal consumption driven system. To do so banking entirely on Reserve Bank of India to cut the interest rate so that we can boost the competition and make money easily available in the economy is not justified. When your currency has depreciated to a level where foreign investors are dumping bonds and getting rid of the Indian stock market, plus overall investment to the country is low, an interest rate cut is definitely not a wise step. Thus, RBI is not in position to cut the interest rate even though the headline inflation has eased a bit.

Situation has become tricky for the Indian economy which has lost many opportunities in past few years. Its failure to implement GST, lack of clear cut investment policy, tax regime for corporates and FIIs/FDIs are few major points to be noted here.  Now, the Indian economic system has to wait and get played by other influential central banks else accept the new level of its currency value against the dollar for the coming months- expecting it will get subsidise soon.

When India had chance to grab investment flow it failed to capitalize. So far, asian counterparts have done good enough to keep their currency level under control and they are still favoured as investment avenues when compared to India. I wish, the Indian currency could have shined just like Tumblr. Alas! rupee is tumbling indeed.

Why so serious? The QE3 therapy is over huh?

Finally, the Federal Reserve had an acceptance tone – yes, it is enough as we have manipulated (read: damage) the bond market significantly, now let the economy decide the price. Thus, the situation is such that in the last two days the price discovery dynamics came into the picture as investors dumped treasuries in heavy number and amount.ImageThe yield for 10-yr bonds surpassed 2.55 percent, first time in 22 months.
According to ICAP, the last trading day of the week (ended June 21) witnessed a surge of almost 14 percent in trade (compared with 20-days average) to around $490 billion. Traders started offloading longer-dated treasuries (most vulnerable to these sort of circumstances), but the surprising factor was they also sold 7-yr and 5-yr notes in huge amount, betting the Fed will soon raise short-term interest rate. The market sentiment could be even judged by  changes in Eurodollar futures. The three month borrowing rates for December 2014 contract increased on the expectation that short-term rate will rise in the coming quarters.
According to Bloomberg report, the 5- yr TIPS have changed dramatically, so have the Eurodollar futures. Based on technical charts, many analysts expect the 10-yr bond yield to touch 2.75 percent in the coming days. The sell-off in the bond market has spiked mortgage rate. According to Paul Krugman, the nobel prize-winning economist, the Fed has played dangerously with the interest rates in the last five years,  and he suggests the Fed should accept inflation target of 3-4 percent. It is very pertinent to mention that Krugman wrote and affirms the importance of the determination of natural rate of interest in the current context of the U.S. economy.

Since the U.S. Fed has already played its cards, now time will tell us how the interest rate regime will turnaround. It would be interesting to see how the wider market spectrum of equity, debt and derivatives are going to behave.

‘Pair Trading’ using correlation

When a trader takes different position on two stocks in the market it is known as ‘pairs trade’. In pair trading the trader goes long in one stock and short in another stock. It is very pertinent to mention the selection of stocks are not that easy and it requires many statistics technique to build up the pair trade position on the selected stocks.
If executed properly, even when both stocks are up, the stock in which you were long will go up much faster than the stock in which you were short. And, when both stocks are down, the stock you were short will decline faster than the stock you were long.
Since selection of stocks in pairs trade is complex, correlation plays very important role here. Once correlation is established between the two stocks then trading is a cake walk.

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Lets say, the trader zeroed down on Google and Yahoo, so if both the stocks move up and down at the same time then the correlation will be positive (+1). If Google move up and Yahoo move down at the same time then the correlation will be negative (-1). If both stocks move randomly then there will be no correlation (0).
How to get correlation? You will get correlation by dividing covariance of the percentage change in stock price by product of standard deviations of the two stock. Ideally, traders chose those stocks pair were correlation is 0.80 or above as it gives a very consistent relationship. When this correlation breaks or weakens i.e. Google moves up on the other hand Yahoo moves down, the trader bets on the price spread of these two stocks. When you decide to use correlation make sure that data taken is for more than six month or so. We can use beta as one more tool to do pair trading.  Happy trading!

Equity long short strategy in hedge funds

Hedge funds follow unique strategies of trading in the market. Equity long short strategy is one of them. As the name suggests the strategy takes long positions in those stocks which are expected to rise and short positions in those stocks which are expected to fall in the market. So, the hedge fund or the hedge fund manager applies this strategy to buy undervalue stocks and sell overvalue stocks in the market.

ImageAn equity L/S strategy can be applied to a sector, country and region specific area. In general, the hedge fund manager makes profits by keeping the healthy margin of spreads between long and short positions. Lets say, a hedge fund manager buys $1 million of Apple shares and sells $1 million of Nokia shares at Nasdaq, thinking, the upcoming event at Apple’s WWDC meet will lift Apple’s shares in the market and might impact the shares of Nokia (so going short on it). Imagine, if the manager has made perfect call on both the stocks – going long on Apple will fetch profits and going short on Nokia will give profits as well. But if the manager misses the call then what? So, consider another situation where both the stocks rise due to some event/news . In this case, the manager has to make sure how he/she has allocated  money for these stocks. It depends if the manager was using “130/30” strategy i.e. 130 percent exposure to long position to long and 30 percent exposure towards the short position i.e. long bias, this formula is purely up-to the manager to decide some even take 120/20 equity L/S.  In the above mentioned case since both the stocks were from the same sector, this kind of trading is also known as “pairs trading“. Overall, this strategy works when the manager predicts a perfect call.

RBI’s never ending dilemma

ImageIt seems the Reserve Bank of India (RBI) is having very hard times these days. No wonder if they complain the current bond yield and rupee fall is all because of the U.S. Fed and Bank of Japan (BoJ). Meanwhile, RBI has got entangled in the current account deficit and inflation problem, adding more headache to it is – the fall of Indian currency against the U.S. dollar. The fall in Indian Rupee has forced FIIs to dump the G-sec (Indian Bonds), and they had dumped bonds at record level during last few trading sessions. For the FIIs there is no point to hold their investment in the Indian bond market as the U.S. 10-year bonds are looking much more attractive. Plus the weakening of Indian rupee will hurt further investments (read article from Economic Times). The yield differential of U.S. 10-yr bond with Indian debt is at one year low.  According to the bond spread calculator of Bloomberg, the spread between US 10-yr bond and Indian 10-yr bond is around 504 basis point or 5 percent, it was at 7 percent, last year . It is very pertinent to mention that not only G-sec even yield for corporate bonds have also fallen in the market. Many fear the banks (PSU and private) might play the spoil sports and sell bonds in the market to book profits.

The Indian currency  is down almost 10 percent since first week of May, now hovering around 59 against the dollar. Today, traders reported RBI sold dollars in the market to curb the fall of rupee but previously done acts by RBI suggests it has failed to curb the fall of rupee due to structural economic problem. Meanwhile, chief economic advisor, Raghuram Rajan believes the rupee’s fall is a temporary phenomenon. Many economists think more liquidity in the market will ease the pressure from rupee.  In the coming weeks macro economic data will decide if the RBI is willing to cut the rates in July. RBI might give its  stance regarding the comfort zone with rupee in the currency economic circumstances on its June 17 monthly meeting.

Delta Hedging (Tutorial version)

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A trader in option market always looks for delta hedging for his/her portfolio. A delta hedging gives an opportunity to the trader to keep his/her trading position neutral from market movement.

What is Delta?
Delta is the ratio which measures change in price of the derivative with respect to the change in price of underlying asset  . So, if delta (∆) for an option is 0.5 then it implies for every one dollar change in the price for the underlying asset (whether it is an increase or decrease), there will be a change of 50 cents to the option price.

Characteristics of Delta

For a call option, delta moves between 0 and +1 while, for a put option it fluctuates between -1 and 0. Delta will be close to zero if the option (call or put) is ‘out of the money‘. When the call option is ‘in the money‘, delta will tick close to +1 while, for put option, it will be close to -1. Options, ‘at the money‘ will have delta around +0.50 for call, and -0.50 for put.

The mechanism behind delta

A trader tries to hedge his/her portfolio by establishing delta long or delta short position in accordance with the underlying assets. For example, a trader takes a call option of $10 which gives right to buy 100 shares of Apple Inc (trading at $ 430) with a delta at 0.70 (i.e. in the money). Suppose if the market price of shares are now at $450 then what will be the option price? Since, delta is 0.70 an increase in underlying price of $20 ($450-$430) will increase the call option price by 0.70*20= $1.40. So, the new call option price will be $10+$1.4=$11.4.

Thus, an increase of $20 in the Apple Inc share will increase the call option price to $1.40 or call option price for share of Apple Inc trading at $450 will be $11.40.

Delta Neutral Hedging

The objective of Delta Neutral Hedging is to remove price risk regardless of how the stock moves. According to the trading jargon, an option contract with 0.50 delta is referred as “50 deltas”. So, 100 deltas are related to 100 shares thus each share will have delta value equals to 1. To sum up, if you are long on 100 deltas then increase of $1 in stock price will give a gain of $100 and if it fall $1 then you will end up having loss of $100. If a position is long on 50 deltas then increase in price of stock for $1 will fetch you $50 and in case of decrease in stock price, a loss of $50.

So, if a trader buys 100 shares of a stocks to get his/her portfolio a delta neutral position, he/she has to buy 2 put contracts; at the money with a delta value of -50 per contract.

Thus, 100(delta value of 100 shares)- 100( 2 put contacts* 50 deltas)= 0 delta.

For example, if a trader held 100 shares of Apple Inc for $400 per share on 14 March 2013. On 14 May, when Apple Inc was trading at $430, the trader performed a delta neutral hedge against possible price change while being able to make profit. The trader bought 2 ‘contracts of July31 put’ to get the delta neutral hedge on his/her position.
100 (delta of 100 shares) – 100 (delta of 2 contracts of at the money put options of 50 deltas) = 0 delta

Now what will happen is if the stock moves up by $1, trader will make  $100 with shares, but loses $50 with each put, so $100 lost in the puts; overall no gain or loss in his position.  Although ideally it would not happen as the put option price would change with the change is stock price and since the position is long (i.e. long straddle) the trader will end up with some profits. So, if Apple rallies from $430 put option will expire being worthless and the trader will gain from increase in the price of stock by keeping his position alive in the market and the put option loss will be offset by the profits he/she would make.
There are many permutations and combinations among call and put option to get a delta neutral hedging. We will have more on the topic later.  Keep reading and learning.