Optionality of Cash

A blog post after some time: Optionality of Cash

Standard Chartered IDR issue: To apply or not?

I have done a bit of research on the Indian Depository Receipt (IDR) issue of Standard Chartered PLC. My analysis is based on following three high level concepts which need to be looked when we want to decide on an IDR:

• Business Risk: It refers to the overall expected performance of the firm considering its portfolio composition, geographies of operation and its standalone performance metrics.
• Systematic Risk: It refers to the correlation of the underlying stock’s performance with that of FTSE. Since the IDR’s value is ‘derived’ from the stock price of Standard Chartered PLC in FTSE, there would be a component of the IDR’s price impacted by the movements in FTSE – which would be captured in the Systematic risk associated.
• Currency Risk: It refers to the relationship between the underlying stock’s currency and the IDR’s currency. Any big, multinational financial institution will have exposure to multiple currencies and there is an inherent currency risk element which should be analysed at a business-as-usual risk; however, since the investment in IDR is in Indian Rupee while the underlying is GBP, there has to be a considerable amount of analysis to assess the GBP/INR movements

Business Risk
Lots of research articles have come on this; in particular I read and liked the content in the following ones – however, not all of them addressed the systematic and currency risk components of the IDR issue.

• Article 1
• Article 2

The primary areas of focus of these articles have been:

• the diversification benefits offered to an Indian investor,
• the geographical coverage of Standard Chartered with presence in some of the faster developing countries. Following is the distribution of operating income across countries

• Though it is understandable to state India and China (as captured in Other Asia & Pacific) and Korea are among the better placed economies coming out of the financial crisis; more thought and analysis needs to be undertaken before stating the same for Hong Kong and Singapore as both these city-states’ health is, more or less, derived from outside – an effect that can be gauged only after looking into the portfolio composition of Standard Chartered in these countries.
• lower cost of capital,
• better risk management system enabling it to be not adversely impacted by the financial crisis,
• healthy proportion of fee based income contribution (22%) to the total operating income.

Systematic Risk
Though the business of Standard Chartered is more concentrated outside Europe, the current IDR represents 10% of the Standard Chartered stock traded in the London Stock exchange (Link). Through all of finance literature, it is continuously found that a major portion of risk-return profile of a stock is systematic factors – which is linked to the overall market – and the remaining portion of risk-return profile is the stock’s own – a.k.a. unsystematic factors. The unsystematic factors are addressed in the ‘Business Risk’ section as outlined in the previous section. Next the investors have to look into the systematic component of the risk in the Standard Chartered IDR issue.

With FTSE 100 being the major index for Standard Chartered, I computed the beta, using data from beginning of 2003, which came to about 1.46. Statistically speaking, a beta of 1.46 infers a high degree of impact of FTSE 100 is in the price of Standard Chartered. Considering the commotion in the Euro zone with respect to Greece and the fate of Euro as a currency hanging in balance and the obvious correlation of FTSE 100 with rest of Europe, the negative impact of the Greece crisis on FTSE 100 would be much more than that on the Indian indices. Numerically inferring from the beta number, a drop of 10% in FTSE 100 would lead to a drop of 14.6% in the Standard Chartered’s stock. This is a major risk which many articles I have come across have missed.

Currency Risk
By currency risk here, I am not referring to the risk the banks encounter as a result of foreign exchange currency movements of its assets, but to the difference in currency of the underlying stock and the IDR – the former being in GBP while the latter is in INR. This means the returns from the IDR is very much linked to the GBP/INR movements. Any appreciation in the INR value against GBP will adversely affect the returns from the IDR. Consider a simple scenario, say Standard Chartered PLC moves from 1630p today to 1800p in a year’s time – giving an appreciation of 10%, but the INR appreciates from 68 INR/GBP to 60 INR/GBP (an appreciation of 12%), the net return from the IDR would be, approximately, a negative 2%. It is very much open to question whether INR would appreciate so much in the next year, but considering the drop of GBP from 80 INR/GBP to 68 INR/GBP now, such a 12% drop does not seem incredulous. However, it is mandatory that the investors look into this factor as well before their decision on investing in the IDR is taken.

Final Call
Considering the above three broad categories of risk, the investors need to make a holistic view of the IDR in relevance to their respective portfolios and then take the final call on investing in the issue if and only if it serves to mitigate certain specific risk for their portfolio. For an individual investor, I would suggest not to invest in the Standard Chartered IDR, but do so with Indian banks.

Booking Profits

In the last 5 days the Indian markets have gone up by 5-6%; all those who entered at sub 2700 levels would be better off (IMHO) booking their profits now. If you are a small retail investor with exposure to multiple stocks, booking profits would incur substantial transaction costs; to avoid the same, the best way out is to enter into suitable number of long put option contracts. The only risk is that the number of option contracts may not exactly match the underlying stock holding. But this strategy will help at least to book profits for major portion of your holdings. I prefer long put than shorting the futures as the downside risk (in case the markets go up from current levels) of long put is limited to the premium paid, while the downside risk of futures is unlimited.

Constructive Sales – Is it a Tax Haven?

(This is probably the most anachronistic post I could ever make, but still…)

If you are one of those who holds a low basis stock - e.g., you are some one who had shareholdings in a private company, which later got listed and still trading at a premium or you bought into some shares and they are now trading (still) at a substantial premium (eg. Educomp Solutions) – and want to exit those positions, you would have to encounter capital gains tax at 10% + the surcharges. (N.B.: Capital gains tax for shares traded through the exchanges is levied only if profits are booked within one year). There is a way out to defer these taxes and probably end up not paying any tax ‘legally’ (as Indian Capital Gains taxation window is just one year) if you enter into some form of ‘constructive sales’.

Constructive sales is just that for whatever profitable positions you hold, the realization of which might entail capital gains tax, you can enter into an offsetting position like shorting its future, or direct shorting of the stock (if allowed, at present it is not allowed). The day you enter into such a transaction, you have virtually locked in your profits; you are more or less insulated from future price movements, at the same time you are technically not liquidated your position which means you have eliminated your risk, essentially booked your profits but do not have to pay the capital gains tax. Let’s see how the second leg of the ‘short sales’ work. After one year of your initial share purchase, you can sell your initial shareholdings in the market which attracts zero capital gains tax and also close your short position simultaneously (or sometime later).

Let’s see a hypothetical example. I bought 10 shares of Educomp Solutions on June 1, 2008 @ INR 1000/share. On July 1, 2008, Educomp solutions had reached INR 1900 per share and I decide to close out the position and book profit. If I do a direct sale of the share, I would have booked a short term gain of INR 9000 (900x10), for which I need to pay tax of at least INR 900 (10% of INR 9000). The constructive sales alternative: On July 1 2008, I enter into a short position in the far month futures contract of Educomp, say at INR 1950. On expiry of this futures contract, I roll it over with the far month contract available then. I keep doing this till June 2009. In July 2009, I decide on closing out the short position in futures. If in July 2009, the futures contract of Educomp is trading at INR 2500, I will incur a short term loss of INR 550 (2500 minus 1950) in FY 2009-10 which can be set off against any short term gains and a long term gain of INR 1500 (2500 minus 1000) which attracts zero tax. Effectively, my net gain from the entire set of transaction is INR 950 (1500 minus 550), but I do not end up paying any tax even though I eliminated any risk after just one month of entering into the deal (June 2008 to July 2008).
The above is called constructive sales and the same is disallowed in US. But I am unsure about the same in India and so as long as it is not disallowed, we can make some amount of tax avoidance (and not tax evasion ;) ) All of the above has an assumption, the individual has enough liquidity for the futures contract margins and the transaction costs are not very high (I assume the latter is true in case of an HNI with adequate investible amount and transactions).

When Newspapers are wrong

As a person with prospective investible money, I was eager to know about various ‘value-picks’ (hee hee, yes, you can get bamboozled once more) based on Price-to-Earnings and Price-to-Book ratios in the Indian capital markets. There was a huge hue-and-cry in the recent days (months?) that Tata Steel is quoting at a P/E of 1.0. The source of this information is none other than Economic Times, the leading pink paper has been highlighting that the company’s P/E is 1.0 (in its hard copy and not on their website). And based on that the self-proclaimed investment gurus omnipresent in my surroundings keep suggesting to buy the stock. Luckily, owing to not having any better thing to do, I checked Tata Steel’s financial statements of FY 2007-08 and for the first half of FY 2008-09 - according to which the Earnings per share (EPS) comes to Rs.67.17 (based on full year FY 07-08) and Rs.87.92 (annualized based on first half of FY 08-09). Given this and the fact that Tata Steel is quoting in the range of Rs.160-165, the P/E for the same is in the range of 1.8 to 2.4 and NOT 1. If you are one of those who look at the ratios given in Economic Times and think they are sacrosanct and proceed to invest, beware!

I presume this to be an error from Economic Times side as their website shows the actual P/E and not the one (and 1.0) appearing in their hard paper.

Cash is King

It is absurdly late for a post on the topic, but still I am an earnest believer of 'better late than never'. All those enthusiastic dabblers and knowledgeable charlatans in the capital markets it is better to keep your money 'safely' (stress here) put in Fixed Deposits and the like.  I expect the current interest rates to be the peak in the immediate future, so you can lock in a nice premium if you enter into the 10% fixed deposits which are currently in the market. I expect the worldwide credit crisis to trigger a wave of liquidity infusing strategy across central banks - the same might be followed by RBI and the interest rates can be expected to drop.  Keep your money safe and at the same time earn more by entering into fixed deposits NOW.

Profiting from Mortality

There is no limit to the creativity of man, especially those from Wall Street.

At the outset, it may seem like a simple Asset backed investment. The finance engineers have cooked up a product which is backed by the Life Insurance settlements of numerous people - the earlier the underlying policy holders' death - the sooner the profits. No wonder these products are termed as 'Death' Bonds. The best part about this is well summarized in the following,

Firms say death bonds should return around 8% a year, right between the expected returns of stocks and Treasury bonds. Moreover, they're "uncorrelated assets," meaning their performance isn't tied to what's happening in other markets. After all, death rates don't rise or fall based on what's happening to commodities, say. Uncorrelated assets like these are highly prized in an increasingly connected global financial system.

I now clearly understand what an 'uncorrelated' investment is worth - life. What is not clear to me in such products is how the underlying policy holders are ready to accept the securitization concept when people are placing (though not explicitly) their bets on their death. The speculators may take out policies on the individual's behalf, pay them something up front, cover the premiums and then wait for the people to die. Seriously macabre. The most important of all questions in my mind is how these bonds be valued? The underlying policies may be those of healthy 30 year olds or octogenarians or terminally ill patients.

Free Fall