Rajen Gala

How does price discovery take place in the stock market? Let us say a company makes Rs.1000/- as profit. Also, let us assume the company has 100 shares. So, earnings per share (EPS) i.e., profit / no. of shares = Rs.1000 / 100 = 10. Let us say the price per share in the market is Rs.100/-. Then the P/E would be Price of share / Earnings per share 100/10 = 10. Since P/E = 10, it means a buyer, Mr. Shyam is willing to pay 10 times the company’s annual earnings per share! This means that the buyer would take 10 years to recover his cost of buying. However, 10 years seems a long time to recover his investment. So, what is his motivation for investing? Let us say there is a surge in the demand for the company’s products causing its profits to go up from Rs.1,000.- to Rs.10,000/-! Now what is interesting to observe is that while the profit went up from Rs.1000/- to Rs.10,000/- the number of shares remains the same at 100. Hence, by definition, earnings per share would be Rs.100/-. Since Mr. Shyam invested Rs.100/- for a share, whose EPS has increased from Rs.10/- to Rs.100/-, he is now able to recover his investment within a year. Assuming the P/E remains at was 10 and earnings per share has gone up to Rs.100/-, the price of the share would then be Rs.1000/-. Hence, Mr. Shyam, who paid Rs.100/- per share could sell the same for Rs.1000/- and make a profit of Rs.900/-. But the story does not end here. When people see that a company, which was making Rs.10/- per share sometime back, is now making Rs.100/- per share, they all want  to buy the shares of this company and thus the demand shoots up! And this demand causes the P/E to go up from 10 to let us say 12. When the P/E moves up from 10 to 12, the market price of the shares too moves up to Rs.1200/- from Rs.1000/-. Now Mr. Shyam, who had initially bought a share for Rs.100/-, can now sell the same for Rs.1200/- and make a profit of Rs.1100/-! Thus, we have seen how the price of a share is discovered in the market. It is a function of both the earnings per share, which is the profitability of the company, as well as the sentiments and expectations of the market causing demand to rise, which increases the P/E ratio!

We know that ‘Velocity of money’ – which is a term used to denote the number of times a unit of money in an economy changes hands during a certain period, say, one year. Here, by money, economists mean currency and coins in circulation and bank reserves with the central bank. The life of money looks so simply when it is just moving from one hand to another. But what about the actual economy, where countless number of people are using different units of money for small and big transactions? How do we calculate the velocity of money in a real economy? First, the velocity of money can be known only when buy and sell transactions are over. There is no way we can know about the velocity of money on a real-time basis. We calculate velocity of money by dividing the value of the Gross Domestic Product, or GDP, which represents the total value of all goods and services produced by an economy, by the value of money supply. Mathematically, it can be expressed as: Velocity of Money = GDP / Value of Money Supply Remember… Different measurements of money supply would show different velocity. But if you are not too comfortable with the nuances of money supply, then you can just think of money as the value of the total stock of currency notes and coins available in an economy. Now… The different types of money are typically classified as M’s. In the money supply statistics, central bank money (in our case RBI) is M0 while commercial bank money (other national banks) is divided up into M1-M3 components. M0: currency (notes and coins) in circulation and in bank vaults. M0 is usually called the monetary base – the base from which other forms of money are created – and is traditionally the most liquid measure of the money supply. M1: currency in circulation + demand deposits + traveler\’s cheques. M1 represents the assets that can be used to pay for a good or service or to repay debt. M2: The sum of M1 + savings deposits, small denomination deposits & retirement accounts. M3: The sum of M2 + large deposits, Euro-dollar deposits & dollars held in foreign offices of banks. But how does one calculate the different measurements of money supply such as M0, M1, M2, M3 and so on? Here is how… You can choose any of the different measurements of money supply such as M0, M1, M2, M3 and so on. But since different measurements of money supply would show different values, you would get different velocities of money. So, if the value of GDP is, say, Rs10 lakh and the value of the base money or M0 is, say, Rs1 lakh, then the velocity of money would be ten. Likewise, if the value of M3 is, say, Rs2 lakh, then the velocity of money would be five. But you may ask, which one is the true velocity of money, ten or five? It is both. In the present example, ten is the velocity of money in its most liquid form—the currency and coins actually in circulation. As we move up the ladder of M1, M2, and M3, the liquidity of money decreases and so does its velocity. Which brings me to my original point… From one wallet to another, from one shopper to the next, that is the life of money. But we often forget that money is like a lubricant that makes the economy move smoothly. Therefore, if the money is parked in our pocket, and we do not spend it, in effect the economy slows down. Thus, money needs to move and therefore needs velocity (velocity is another word for speed) To Sum Up What: ‘Velocity of money’ is a term used to denote the number of times a unit of money in an economy changes hands during a certain period. How: Velocity of money is calculated by dividing the value of GDP with the value of money in circulation. Why: Money needs to move or have velocity for the economy to move ahead smoothly.

Let us say you have Rs.1,00,000/- with you. With the Rs.1,00,000/- you start a business. The business earns Rs.20,000/- per year. You have added to the value of Rs.1,00,000/- By Rs.20,000/- This is known as investment because you increase the value of the money. Let us say you buy a Car with this Rs.1,00,000/-. If you did not have a car of your own earlier, this car brings comfort and enhances your efficiency. The car takes you to your office in more comfort. You can work more and work better. Your social status increases and your boss is pleased by your performance. He gives you both a promotion and a raise. If you were earning  Rs.50,000/- per month earlier, your new raise has let us say taken it to Rs.75,000/- per month You have thus increased your wealth by 50% per month. This car purchased too can be considered an investment because it helps to increase your wealth. Now let us say you spent Rs.20,000/- on the car by changing its upholstery. Clearly this spending is consumption because the changed upholstery would hardly have an impact on increasing your overall wealth. So, the spending that increases your overall  wealth is an investment  while the spending that does not increase your overall wealth is consumption. Investment and consumption are also two sides of a coin. If you were to buy shares of the company making upholstery which you bought, it would be investment while purchase of the upholstery was consumption. So how are you impacted if the price of upholstery goes up? If the price of the upholstery goes up, you will certainly feel the pinch as a consumer. However, as an investor you may laugh all the way if the share prices go up on account of high demand for upholsteries. Hence, clearly it is important that there is both consumption and investment in an economy for the economy to grow in a balanced manner. On the other hand, even you as an individual need to partake both in consumption and investment to enjoy a balanced life which gives you returns while at the same time allowing you to enjoy some luxuries of life.

LIBOR is an acronym for London Inter Bank Offered Rate. LIBOR serves as a benchmark that gives an indication of the rate at which banks can borrow from London interbank market for a given period of time. The interbank borrowing is undertaken by financial institutions either to make profits or to cover short-term liquidity shortfalls. Basically, it represents the cost of funds — an average of what banks believe they would have to pay to borrow a “reasonable” amount for a specified short period. LIBOR is compiled by the British Bankers’ Association (BBA) in conjunction with Reuters and are released for 15 different time periods and for 10 currencies every day. How is LIBOR calculated? Every weekday 18 large banks participate in setting LIBOR. The banks individually submit figures for the interest rate at which each bank borrows money from the others. The BBA receives the rates, discards the highest and lowest ones, and then averages the remaining ones The resulting figure is the LIBOR (There are actually multiple rates for different borrowing periods and currencies). LIBOR serves as a key factor in determining a wide range of Interest rates paid by consumers and businesses, including for credit cards, student loans and some mortgages. Why do we need LIBOR? LIBOR was created in the 1980s as banks called for a reliable source to set interest rates for derivatives. The first LIBOR rate was announced in 1986 for three currencies: the U.S. dollar, the British sterling and the Japanese Yen. LIBOR is viewed as the most important benchmark in the world for short-term interest rates. On the professional financial markets LIBOR is used as the base rate for a large number of financial products such as futures, options and swaps. Banks also use the LIBOR interest rates as the base rate when setting the interest rates for loans, savings and mortgages. It currently serves as a benchmark rate for millions of contracts worth billions of dollars written everyday all over the world. Let’s consider an example: Suppose an Indian Company ABC wants to borrow money from the international market. The lender will charge Libor plus X%, depending on the risk profile of the Company ABC and the country, where X is the risk premium. Libor also serves some macro purposes. If LIBOR is rising continuously, it may be an indication of tight liquidity or rising stress in the financial markets. The movement of Libor also reflects market expectation on how the central bank will shape its monetary policy.

Many magazines mention that “to improve exports, the central banks need to depreciate the currency.” However, what does it mean and how do exports get a boost by depreciating the currency? To understand how lowering the exchange rate of a currency affects exports of the country, Let us understand through a story…. Mr. A is a mango seller. His mangoes are amongst the best in the market. He sells them for Rs.1000/- per dozen. He also exports mangoes to Mr. M in USA. Let us say the exchange rate is Rs.80/- to a dollar. In other words, it means that if Mr. M were to pay $1, he could buy Rs.80/- from a currency exchange. So, if $1 gets him Rs.80/-, he would need $12.5 to buy Rs.1000/- (1000/80 = 12.5) So, he first purchases Rs.1000/- by paying $12.5. Then he pays the Rs.1000/- to Mr. A for a dozen mangoes. Suddenly one day Mr. M stops purchasing mangoes from Mr. A. On enquiring, Mr. A find out that Mr. M is buying from another country as he is getting them for $10. To sell at $10, it would mean that Mr. A would have to sell a dozen for Rs.800/-. Mr. A realizes that it is impossible to sell at this price. Far from earning profits he would be making a huge loss. Now Mr. A go to the union of mango sellers who send a representative to the government with a request that instead of selling Rs.1000/- for $12.5, they should make the rupee cheaper and sell Rs.1000/- for $10 only. Since the representative is strong and since even exporters of other products had made similar requests, the government relents and makes the rupee cheaper such that Rs.1000/- would be sold for $10. So now for $10 Mr. M can once again buy Rs.1000/- or for $1 he can now buy 100 rupees. Thus, the upwards movement from Rs.80/- to Rs.100/- is the lowering of value of the rupee because now $1 can fetch Rs.100/- instead of the Rs.80/- which was possible before the depreciation ( or value reduction) Since, rupee depreciation brought the value of the Rs.1000/- down to $10 (which Mr. M was paying for mangoes in another country), he now restarts his business relationship with Mr. A. Thus, by depreciating the rupee the Indian government helps exporters like Mr. A.

Rising interest rates come as sad news for those who wish to take a home loan or a car loan. However, rising interest rates bring several opportunities with them as well… And one opportunity in this regard is that of ‘Carry Trade,’ which means borrowing in one market where interest rates are lower and investing in another market where interest rates are high and thereby making a gain. But it is not that simple because it involves two different currencies. One currency is of the country where interest rates are low while the other currency is of the country where interest rates are high. For example… For ‘Carry Trade’ to be profitable, it is crucial that the exchange rates between the countries remain stable. Otherwise instead of a gain one could end up making a serious loss. Thus ‘Carry Trade’ is not devoid of risk. How are ADRs priced? Now, as we always do, let us try and get a better understanding of the concept with the help of an example. Let us assume that the interest rate in US is 2% whereas is in India it is 7% And let us say  someone borrows $100 in USA to invest in India at 7%. It is evident that the differential of 5% (7% – 2%) is the opportunity to make a profit by taking an exchange rate risk. Let us assume the exchange rate is Rs.80/- = $1. Now if someone in the US wants to invest in India, he must invest Indian Rupees for which he has to purchase Indian Rupees. So, if the amount in question is $100, then as per assumed exchange rate of Rs.80/-, it would amount to Rs.8000/-. So, when Rs.8000/- is invested for one year in India at 7%, it would earn an interest of Rs 7% x 8000 = Rs.560/-. Thus, at the end of the period the total amount would be Rs.8560/-. On conversion assuming no change in exchange rate, it would be $ 8560/80 = $107 or net earnings of $7. Now had the investment been made in the USA itself at 2%, it would have earned net $2 only. Hence by participating in carry trade an additional $5 profit opportunity emerged because of differential interest rates between two countries. But here we have made a huge assumption that the exchange rate remained stable across the investment time period. This, however, may not be the case most of the time & in the event of exchange rate variation, the consequence can be painful for the investor. Let us see this by looking at the same example. We had assumed the exchange rate as Rs.80/- = $1 At 7% we saw that the investor in our example made Rs.560/- and the final amount that he received was Rs.8560/-. At the exchange rate of Rs.80/- = $1 he received $107. However, if the rupee grew weaker in the interim period to Rs.90/-  = $1, he would now receive only $ 8560/90 = $95.11. Thus, he would make a loss of nearly $6 instead of a gain of $2 he would have made had he invested in USA itself. This is the currency risk that one must take in carry trade. If the currency of investment becomes weaker the consequences for the investor are painful and if the currency on the other hand were to get stronger its gains too would get stronger. Conversely, if the exchange rate had become Rs.70/- = $1, he would have made USD 8560*/70$ =$122.29 which would have given him a significant gain of $22.29 vs. $2 if he had invested in USA itself. Since ‘Carry Trade’ involves borrowing in one market to fund investments in another market, both ‘gains’ and ‘losses can get magnified due to the currency fluctuations. However, in real life, the moment the traders get a feel that exchange rates are changing unfavorably, they rapidly unwind their positions by withdrawing their investments, and converting them into dollars. This is famously known as ‘Carry Trade Unwinding.’ While I have explained ‘Carry Trade’ in fixed income investment in my example, one must understand that ‘Carry Trade’ also refers to investments in any other asset class like shares, commodity, real estate, etc. in one country by taking leverage from another country.

India Inflation Rate reported at 0.27% for the week ending March 14, 2009! This had been the lowest since 1977. Did we go into negative space ? Yes, it was around – 0.36%. Will it happen next time? Did we head for deflation or was its disinflation? What are these terms and how do they affect us? Let us first understand deflation and in this bargain, we will understand disinflation. In economics, deflation is a sustained decrease in the general price level of goods and services. Also… Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate which we saw in 2009. Inflation reduces the real value of money over time, conversely, deflation increases the real value of money. Now let’s understand disinflation… Deflation refers to a sustained reduction in the level of prices below zero percent based on year-on-year inflation. Disinflation, on the other hand, denotes a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive). But what are the effects of deflation on the economy? Deflation is caused by a fall in the aggregate level of demand. This means that there is a fall in the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces economic activity even further. Lack of demand leads to an increase in the idle capacity, bringing down the rate of investments leading to unemployment and lower disposable income and hence a further fall in demand and increase in loan defaults. This is known as the Deflationary Spiral. So, what can one do about it? An answer to falling aggregate demand is: Stimulus, either from the Reserve Bank of India, by expanding the money supply. Suitable monetary policies such as lowering of interest rates so that the consumers are encouraged to borrow and spend of goods and services. While a fall in prices may sound like good news to most, economists see this as an ominous sign of a collapse in demand in the economy. How does one counteract against deflation? Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention. This view was challenged in the 1930s during the Great Depression by the economist Keynes who argued that the economic system was not self-correcting with respect to deflation. What did Keynes say? According to him, governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Today, to counter deflation, the Reserve Bank of India (RBI) can use monetary policy to increase the money supply and deliberately induce price rise. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and this takes some of the depressive pressures off them. To Sum Up What: Deflation is a sustained decrease in the general price level of goods and services. How: Deflation occurs when the annual inflation rate falls below zero percent and prices continue to fall on a sustained basis. Why: Deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand.