Archive for the ‘Trading and Investments’ Category

Forex Technical View

Thursday, June 23rd, 2011

 This is a post by CMA D.S.Kapoor.  he is at present in employment as GM-Finance with a Kanpur based listed company. he has been tracking the stock market for the last 20 years and the forex market for the last 3 years.



Weekly Chart



Last week, it was indicated that currency is getting support and is above 50 DMA (44.64) and 50MMA (44.80), as against the week’s closing at 44.82 and once, these supports get breached decisively, the targets may be around 44 – 43.85. It was also indicated that technical indicators are suggesting happening of such possibility within next fortnight. Resistances for next week were expected at 45.05 / 45.35 and Supports at 44.64 / 44.35 / 44.00.


Last week, it opened at 44.74, high / low at 44.8250 / 44.52, and closed at 44.72 as against earlier week’s closing at 44.82. Thus, during the week, though, 50MMA has been breached downside, but 50 DMA has still not been breached on closing basis on any day, though intraday, it has gone below 50 DMA. Further 5MMA is also slightly above 50MMA.   


Now, during the current week, we expect 5MMA to breach 50MMA on the lower side, which is a bearish signal. Once it happens, we expect lower targets – 44.40 or below. This view shall get negated, only if the Currency goes above 45.20 – 45.25.


Major Resistances : 44.87 / 45.06 / 45.20

Major Supports       : 44.45 / 44.10 / 43.85





Weekly Chart



Last week, our preferred view was that the Cross should consolidate around current levels and then only, up move to start again. It was also indicated that positioning of different weekly moving averages indicate towards continuation of bullish trend, however, clear bullishness will be visible, only once 50WMA(1.3580) crosses 200WMA(1.40), which may take another 2 – 3 months time. Resistances for next week were expected at 1.4725 / 1.4890 and Supports at 1.4450 / 1.4375.


Last week, it opened at 1.4627, high / low at 1.4696 / 1.4320, and closed at 1.4345 as against earlier week’s closing at 1.4634. Thus, there has been consolidation during first three days followed by weakness in next two days.   


Now, next week, it is expected that, if 1.4320 is not breached on lower side, further consolidation in between 1.4350 – 1.4600 is expected before any fresh move starts. However, if it gets breached, next support level to be watched shall be around 1.4110.


Major Resistances : 1.4417 / 1.4476 / 1.4539   

Major Supports       : 1.4320 / 1.4260 / 1.4145






Weekly Chart


Last week, it was indicated that the Cross shall not go below 50 DMA and bullish momentum should continue. In between, there is resistance around 1.6635 (200MMA). Once that is crossed decisively, further targets may be 1.6685 / 1.6840. Resistances for next week were expected at 1.6535 / 1.6685 / 1.6840 and Supports at 1.6335 / 1.6285.


Last week, it opened at 1.6425, high / low at 1.6470 / 1.6217, and closed at 1.6233 as against last week’s closing at 1.6427. Thus, on first four days, the bullish momentum was witnessed. However, there was profit booking on the 5th day of the week. Once again, the Cross has closed on Friday below 50 DMA (1.6365).


Now, next week, since 50 DMA is above 200 DMA and 5MMA, 13MMA & 21MMA are in phase, there are fair chances of bounce back or consolidation in the current range of 1.62 – 1.65.


Major Resistances : 1.6313 / 1.6360 / 1.6420

Major Supports       : 1.6195 / 1.6110 / 1.6060








CMP(10th June)





























Monday, May 9th, 2011

This is a post by Mr. Indraneel Sen Gupta. He is Financial,Economic Writer and Research Analyst.

In Ancient Egypt and Medieval Europe, Silver was often morevaluable than gold. Till today the same theory is being followed. But last weekthe world market of metals were rattled with the fall of silver and gold prices.Silver made the steepest decline compared to 1983 levels of fall in the lastweek.

Margin Crash Ride

Silver prices plunged across the world market keeping every one onthe table of quest of what made the fall of silver prices. Base metal priceswere very much over leveraged or over brought in the past couple of months on acontinuous basis. Silver is expected to have another correction from the lastweeks closing by another 5% to 10%.

Silver will correcting is not only due to over bought ad overstretched valuations but also due to New York Comex exchange. They have hikedthe margin requirements for silver trading to 84% making the requirements to riseup from $11,745 to $21,600. The margin requirements for hedgers are increasedfrom $8,700 to $16,000.

Two days prior to this, the COMEX had also raised marginrequirements. On April 27th, margin for initial contracts were increased from$11,745 to $12,825 and margin for maintenance contracts was increased from$8,700 to $9,500. As margin prices increases, this forces the market players tocome up with more margins for playing in silver.

The collapse in silver prices on Thursday May 5th, triggered bythe COMEX margin increases, indicates that many players were forced toliquidate positions to match the margin requirements going to hit floor from9th of May. Before the increases, margins were about 5% of the value of afutures contract, which is for 5,000 ounces. After the plunge in prices, thecost after May 9 would be about 12% of a contract, using last settlement. Thelast two margin increases by the COMEX, after silver had already declined byover 17%.To add fuel to the fire liquidation of silver holdings by a hedge fundrun by George Soros was also executed at that point of time. This is why thesilver was in the headlines of financial streets.

You’re Demand and My SilverInvestments.

In my last article I depicted the story of the upcoming growth ofdemand of silver which played according to its vomited words in the article.Silver is not only a being treated a as a substitute of Gold but also beingextensively used in alternative energy segment. The industrial applications ofsilver increased by almost 21% to 487.4 million ounce.

In 2010 we find the demand for silver coming from globalinvestment and fabrication demand. According to World Silver Survey demand ofsilver during 2010 increased despite of a 38% average increase in the price ofsilver to $20.19. The increase in silver prices during 2010 was the largestprice gain since 1980.Silver investments demand increased by 40% in 2010 to279.3 million ounces, double of 2009.

When we sneak into the ETF growth of silver globally we find astaggering growth to 582.6 million ounces during 2010, an increase of 114.9million ounces over 2009. When we dig into the global use of silver in primarycomponents we find some interesting growth demand:

• Silver used in coin and medal production rose by 28% to 101.3million ounces.

• Sales of U.S. Silver Eagles reached 34.6 million, far ahead ofthe previous record of 29 million reached in 2009.

• Sales of bullion coins by mints in Australia and Canada also hitnew highs.

• Investors also purchased 55.6 million ounces of silver in theform of bullion bars during 2010.

• Silver fabrication demand hit a ten year high of 878.8 millionounces, an increase of almost 13% over 2010.

• Jewelry increased by 5%, showing the biggest increase in demandsince 2003.

Silver is going to make new records not only in 2011 but also inthe next 3 years. We made an extensive research where we found that new demandfor silver consumption is increasing.

• New industrial applications using silver are expected to accountfor an additional 40 million ounces of demand by 2015.

• Silver’s unique chemical properties are constantly leading tonew industrial demand, one example being the development of products usingsilver as an antibacterial agent.

But with the increase of the demand of silver we need to keep inmind that procurement of silver form mines needs higher attention. Silverproduction increased by a very modest 2.5% during 2010 to 753.9 million ounces.We need to keep an eye on the explorations being carried out by the largestsilver producer in 2010.The biggest mining zones are  Mexico, followed by Peru, China, Australia andChile.

So by now my investors, my research colleges and other layman ofthe industry might be clear about the upcoming demand of silver the Substituteof Gold .This demand will make the price of silver to touch new heights in thecoming days. The recent crash of silver price is a buying opportunity and itshould be used accordingly. I have come across few investors who are fightingwith anxiety of the recent fall as they have purchased at higher levels. Asimple advice for them is that silver is a long term assets and not like shortterm. It’s a commodity and should not be entangled with other asset classes.Since every commodity has a life cycle and when the cycle end at the maturitystage the value of the asset increases along with its demand and price. Silveris just witnessing one of these types of cycles.

I between all I forgot to accentuate your attention that China isnow on the buying spree of Silver along with Gold. Earlier we knew that chinawas accumulating gold and now silver has found the new address of accumulationin China. China desires to replace dollar as the safe currency and convert thesavings into Gold and Silver. If china desires to replace dollar as a currencyfor reserves then China will have to accumulate gold to the tune of two timeswhat US gold reserve has within the next two years. China has 1054 tonnes ofGold and US has 8133 tonnes of gold. So one can imagine how aggressive Chinawill become in coming days for buying Gold.

Paper currency is now longer a value growth based asset. Therising defaults (bailouts of every economy) and rising crude import bill ofevery economy in the coming next 10 years will force all the nations to savetheir savings in Gold and Silver.

Silver should be bought at lower levels as they long term demandmakes the price of silver to shine more than the original shine of silver.Silver should be brought and regarding these margin hikes and other activitiesone needs to treat them as a buying opportunity. Invest in silver for long termwithering out the short term hiccups.


Friday, February 11th, 2011

This is a post by Mr. Indraneel Sen Gupta. Indraneel is an economic and financial writer and a research analyst.




With Global imbalances on the never ending rise and huge budget deficits of the Developed economies currency fluctuation is the new tremor of the quakes being felt. With the recent debacle of European nations we find


In other words in the coming year of 2011 we will find Europe and US going for massive budget cuts and imposition of higher rate of taxes. This will create burden and slower growth opportunities to the tune of 100% .Since budget cuts will lead to slower growth and imposition of higher taxes will result to less savings for the consumer. All these will exert pressure on the Euro, Pound and US dollar. Their will be a huge reflection of fluctuation in all these currencies. Moreover when we look towards the Asian and Developing economies we find interest rates pull back from post recession levels to pre-recession levels will exert further pressure on Yen, Rupee primarily.


In the past couple of months many economist across the world have raised their voices on currency war and many such subjects. Well say as diplomat one should make money from any war. Hence these currency wars need to be exploited and money needs to make from the war. Currencies are driven by the macro environment which is it a hot topic, and because currencies are valued relative to other currencies, if one goes up then the other one is going down. Thus an investor is always able to profit through currencies, regardless of the market direction.



If we look globally we find that their have been huge demand and financial products related to Currency ETF. In the developed economies currency ETF have made investments and currency fluctuation a profit making game of the financial streets. If we make a quick look towards the probable currency ETF we find on the ladder of Developed economies then one will find the proof of the pudding.


Broad Currency ETFs


• AYT – Barclays Global Emerging Markets Strategy (GEMS) Asia 8 Index ETN


• ICI – Barclay’s iPath Optimized Currency Carry ETN


• DBV – PowerShares DB G10 Currency Harvest ETF


• CCX - WisdomTree Dreyfus Commodity Currency Fund


• CEW – WisdomTree Dreyfus Emerging Currency ETF


• JEM - Barclays GEMS Index ETN


• PGD - Barclays Asian & Gulf Currency Reval ETN


ETFs that Track a Single Currency


United States Dollar ETFs


• UUP - PowerShares US Dollar Bullish ETF


• UDN - PowerShares US Dollar Bearish ETF

United States Dollar / Foreign Currency ETFs


• GBB – iPath GBP / USD Exchange Rate ETN


• CNY – Market Vectors Chinese Renminbi / USD ETN


• ERO – iPath EUR / USD Exchange Rate ETN


• INR – Market Vectors Indian Rupee / USD ETN


• JYN – iPath JPY / USD Exchange Rate ETN


• ADE - ELEMENTS Australian Dollar / USD Exchange Rate ETN


• EGB - ELEMENTS British Pound /USD Exchange Rate ETN


• ERE - ELEMENTS Euro / USD Exchange Rate ETN


• CUD - ELEMENTS USD / Canadian Dollar Exchange Rate ETN


• SZE - ELEMENTS USD / Swiss Franc Exchange Rate ETN


Euro ETFs


• FXE - CurrencyShares Euro Trust


• ERO – iPath EUR / USD Exchange Rate ETN


• EU – WisdomTree Dreyfus Euro ETF


• ULE – ProShares Ultra Euro ETF


• EUO – ProShares UltraShort Euro ETF


• URR – Market Vectors Double Long Euro ETN


• DRR - Market Vectors Double Short Euro ETN


• ERE - ELEMENTS Euro / USD Exchange Rate ETN


British Pound ETFs


• FXB – CurrencyShares British Pound Sterling Trust


• GBB – iPath GBP/USD Exchange Rate ETN


• EGB - ELEMENTS British Pound /USD Exchange Rate ETN


Even when we look into the pockets of Developing economies and Asian economies we will not find such numbert of ETF as compared to Developed Economies.


Japanese Yen ETFs


• FXY – CurrencyShares Japanese Yen Trust


• JYN – iPath JPY / USD Exchange Rate ETN


• JYF – WisdomTree Dreyfus Japanese Yen ETF


• YCL – ProShares Ultra Yen ETF


• YCS – ProShares UltraShort Yen ETF


Australian and New Zealand Dollar ETFs


• FXA - CurrencyShares Australian Dollar Trust


• BNZ – WisdomTree Dreyfus New Zealand Dollar ETF


• ADE - ELEMENTS Australian Dollar / USD Exchange Rate ETN


Broad and Sector China ETFs


• CHIB - Global X China Technology ETF


• CHIE - Global X China Energy ETF


• CHII - Global X China Industrials ETF


• CHIM - Global X China Materials ETF


• CHIQ - Global X China Consumer ETF


• CHIX - Global X China Financials ETF


• CHXX - China Infrastructure Index ETF


• CQQQ - Claymore China Technology ETF


• CZI - Dixerion Daily China Bear 3x Shares ETF


• CZM - Dixerion Daily China Bull 3x Shares ETF


• ECNS - iShares MSCI China Small-Cap Index Fund


• EWGC - Rydex Russell Greater China Large Cap Equal Weight ETF


• EWH - iShares MSCI Hong Kong Index ETF


• FXI - iShares FTSE/Xinhua China 25 Index ETF


• FXP - UltraShort FTSE/Xinhua China25 Proshares ETF




• HAO - Claymore/AlphaShares China Small Cap ETF


• PEK - Market Vectors China ETF


• PGJ - PowerShares Golden Dragon Halter USX China ETF


• SNO - NETS Hang Seng Index ETF


• TAO - Claymore/AlphaShares China Real Estate ETF


• YAO - Claymore/AlphaShares China All-Cap ETF


• YXI - Proshares Short FTSE / Xinhua China 25 ETF


Chinese Currency ETFs


• CYB - WisdomTree Dreyfus Chinese Yuan ETF


• CNY - Market Vectors Renminbi/USD ETN


Broad Currency ETFs that include China Currency


• AYT - Barclays GEMS Asia-8 ETN


• CEW - WisdomTree Dreyfus Emerging Currency ETF


• PGO - Barclays Asian & Gulf Currency Reval ETN


This clearly indicates that Asian economies and developing economies are becoming new island of new financial products. The last several years have seen tremendous innovation on the product development front in the ETF industry. As a result, investors now have more options than ever before, including increasingly targeted products and access to increasingly complex asset classes and investment strategies. The industry remains very top-heavy, with a handful of funds accounting for the bulk of assets and trading volume. “The last several years have seen tremendous innovation on the product development front in the ETF industry. As a result, investors now have more options than ever before, including increasingly targeted products and access to increasingly complex asset classes and investment strategies. The industry remains very top-heavy, with a handful of funds accounting for the bulk of assets and trading volume. The economies are coming up with new currency products since earlier this type of global currency imbalance was not their. As the word of globalization has spreads the more demand to protect the downside risk of currency fluctuation have been developed.



Investors are shifting from traditional financial products to new globalised products. Earlier financial products used to remain with the wall of a particular country where as now with the wind of globalization in trade practices currency ETF is picking up in the Developing economies. While designing investment portfolio Currency ETF is now becoming a new trend of demand. We will find currency ETF demand coming primarily from IT industry. Since they are prune to the highest degree to currency fluctuation. Global cross border investments needs currency ETF and this demand of trade is picking up each day in the Asian as well as developing economies.


Earlier currency ETF was acclaimed as risky product since it was quite hard to predict and speculate the movement of the currency. But after recession and further blast of financial time bombs across the world have rattled the currency market and hence brought imbalances as the new guest. Currency fluctuation is the new child which will keep on growing as long as Developed economies will not bring down fiscal deficit and GDP and other economic wheels don’t pick up the pre-recession growth numbers. Until then we will find money being printed from currency ETF. Interest rate fluctuation across the global market is another boon for the currency ETF market.


In the developed economies we can foresight a prolonged lower rate of interest rates and no near future of rise in rates. Where as in developing nation we have witnessed interest rates hike followed with more hikes to come up in 2011.Infaltion is one of the most important game players behind currency ETF. When ever inflation goes up as incase of India and China monetary measures are applied resulting surge in currency ETF gains. When ever inflation don’t come up as in case of US printing of money brings gains for currency ETF. So in either of the both ways currency ETF will bring growth for the investments.





Currency ETF is not like the derivative products where complexity is the other name of its identity. Currency ETF are much safe as compared to them. Indian economy is yet to witness products of currency ETF particularly from the mutual fund industry. The mutual fund industry can find lot of opportunities from Currency ETF products. As less people are interested to keep their savings under any currency form as its quite impossible to predict which currency will devalue the savings, in that case currency ETF will give them a balanced position to and risk control over fluctuating currency.


Currency ETF favors an investment opportunity in many ways. Shedding away the unnecessary part of the advantages of currency ETF and just finding out the prime growth drivers of the product we find:


Foreign Exposure


If you feel there are some foreign regions that are potential growth areas or emerging markets, a country ETF may be the perfect asset to increase your international exposure.




If your portfolio is heavy on domestic investments, some foreign exposure may help balance your overall stratagem. Adding a country or region ETF to your portfolio can expand your investment horizon.


Risk Management


If your portfolio or business has exposure to a certain region, investing in a foreign ETF may be a good way to reduce that risk and protect you against negative developments in certain countries.



Indian mutual fund industry needs to bring currency ETF into the market so as investors in this segment are not from only HNI or retail. We will find Indian corporate doing parking of funds to rep the profits of currency fluctuation. Apart from profit one makes diversification and risk management will be the key driver of Indian Currency ETF products. I will not be surprised to find debt funds loosing sheen and surge in currency ETF investment avenues.


The Indian mutual fund industry is yet to grow in product specification. We have developed a number of funds of same nature but less new diversified products matching the global risk management have been developed. We need products where domestic as well as global investments in Indian mutual funds will take new shape and size. We might see many new mutual funds in India in the new decade. But we need to design them accordingly.

Indian steel industry-in a capsule

Thursday, November 18th, 2010

This is a guest post by Mr.Indranil Sen Gupta.  Indranil is an economic,financial writer and research analyst.



Indian steel industry-in a capsule.

This article is an continuation from the ASIAN STEEL INDUSTRY-SERIES 1 CHINA.


To read that part please click below.


If we look at India we find that historically the Indian steel industry entered into a new development stage from 2005–06, resulting in India becoming the 5th largest producer of steel globally.

• Producing about 55 million tonnes (MT) of steel a year, today India accounts for a little over 7% of the world’s total production.


• Steel production reached 28.49 million tonne (MT) in April-September 2009. Further, India, which recorded production of 22.14 MT of steel during April-August 2009, is likely to emerge as the world’s third largest steel producer in the current year.


• The National Steel Policy has fixed a target of taking steel production up to 110 MT by 2019–20. Nonetheless, with the current rate of ongoing green-field and brown-field projects, the Ministry of Steel has projected India’s steel capacity is expected to touch 124.06 MT by 2011–12.


• India’s steel consumption rose by 5.7% to 26.49 MT in the first six months of the current fiscal over the same period a year ago on account of improved demand from sectors like automobile and consumer durables.

The chart below shows the growth of India steel production.

Indian demand for steel consumption is increasing in the coming days. We get proof of the putting when we analyzed and found that steel players like JSW Steel and Essar Steel are increasing their focus on opening up more retail outlets pan India with growth in domestic demand. JSW Steel currently has 50 such steel retail outlets called JSW Shoppe and is targeting to increase it to 200 by March 2010. They expect at least 10-15%of their total production to be sold by their retail outlets. Huge flow of investments will happen in the coming days in the steel sector due to increasing trend of domestic consumption.

Investments in Indian steel industry.


Even if we look into the type of investments that have happened after recession in India we get very impressive an bullish outlook on the sector.


• According to the Investment Commission of India investments of over US$ 30 billion in steel are in the pipeline over the next 5 years.


• Very recently Tata Steel has raised US$ 500 for its expansion of Jamshedpur plant and overseas mining projects.


• Many Steel companies have committed US$ 122.50 million for setting up sponge iron units in Koppal and Bellary in Karnataka.

• Even SAIL have declared that they will invest US$ 724.12 million to set up a 4-million tonne per annum steel mill at its Bhilai Steel Plant.


• Uttam Galva Steel plans a capital expenditure of US$ 62.8 million-US$ 104.6 million over the next two years for setting up of a 60 MW power plant. The power plant will help reduce its production costs.


Fortune of steel prices in 2010.

• Steel prices are set to go up from January 2010 due to increase in raw material costs, like iron ore and metal scrap.

• Led by demand from China, prices of iron ore—the key raw material for pig iron—have gone up sharply over the past two months to $106 per tonne from almost $81-$82 per tonne.


• Coking coal prices have also gone up to $165-$170 per tonne from $128 per tonne as China imported more coking coal this year.

If we look into the distribution of iron ore inventories we find:

• According to a report by industry consultancy, this week, iron ore inventories at China’s major ports rose by 830,000 tonnes to end at 66.75 million tonnes,


• While stockpiles of ore originating from Brazil increased by 180,000 tonnes to 19.1 million tonnes, and Indian ore rose by 830,000 tonnes at 13.18 million tonnes.


• Australian ore inventories fell by 480,000 tonnes to end at 21.95 million tonnes by the end of the week.


• Chinese iron ore prices remained steady, the average price of imported iron ore increased by 2.3%. Iron ore prices are 25.8% higher than December 2008.


So raw material prices followed with stringent position of inventories of iron ore steel prices are on the track of a  major jump of prices of raw materials.

In Indian and global context the raw material negotiations are slated to start in January and indications are that the increase in new contract prices could be between 10% and 30%. Last year, iron ore contract prices were sealed at $80 a tonne (Rs 3,742). Currently, spot iron prices in China are trading at $126 a tonne (Rs 5,893), an increase of 13.5 per cent in the past six months. Coking coal prices have increased to $186 (Rs 8,692) a tonne since May. Last year, contract prices were $129 (Rs 6,033) a tonne.

Industrial analysts see iron ore prices going up by about 10% to 20% next year on increasing demand as the world economy recovers. In the coming quarters steel sector is set to make a living in a Competitive Economy from an Easy economy that took birth from recession.2010 will be a period for steel industry where growth will be high along with huge wave of demand, but with many twist. Like wise RBI rate hikes which will push up the cost of borrowing , higher commodity prices and inventory position of iron ore. But among all these we are bullish on the steel industry in the log run with few hiccups in short term.

Does Taxation System Distort Investment Decisions?

Tuesday, June 29th, 2010

Does taxation system distort investment decisions?

This is a guest post by Mr.Sacha Singh. Sacha consults in change management, firm valuation and process evaluation. He enjoys ghazals and thumris and at times bhajans.

You can read his blogs on

Tax is what a society pays for consuming societal goods – roads, security from marauders, judicial services… and so on. If society is to prosper the taxes can not be higher than the aggregate excess income left with the society after it has met its consumption needs for survival; else the society, unable to consume enough for its survival, will gradually shrink into nothingness. Clearly, all taxes – income tax, excise duty, VAT etc must come from this excess income.

State can tax the society’s income in different ways. It can directly tax the income, or it can tax the consumption. VAT and excise duties are essentially taxes on our consumption and income tax is levied directly on our income. Income tax is not levied uniformly on all our incomes, even if we exclude agricultural income. By and large, tax is heavier on labour income (income earned by labour – i.e. wage) than on capital income (income earned from capital assets such as dividend). Typically all labour income is fully taxed but only a part of the capital income is fully taxed, rest is either fully or partially exempted. Dividend income is a ready example. I buy shares and receive dividends that are not taxed in my hands at all. I sell the shares after a few years and gains if any again are not taxed. The interests I earn on my debentures are fully taxed. These incomes came out of my capital; on the other hand the income I earn from my labour, i.e. my wage, is fully taxed.

By taxing capital income selectively, the taxation system distorts the capital investment choices made by the society. The distortion takes place in both legs of capital budgeting exercise – in investment decision as well as in financing decision. Tax considerations play a crucial role in deciding where to invest (Will the income be tax exempt – fully or partially?) and how to finance the venture (Will the servicing cost of capital be a deductible expenditure for calculating taxes– fully or partially?)

The impact of this distortion is that the investment decisions are not efficient. They are, instead, tax-efficient. In a free economy investment decisions should be made based on the considerations of costs and benefits. To be sure, this is the way they are being made; but both costs and benefits being considered are not true costs and benefits as both are affected by the tax regime. This is admittedly a vast field; I am limiting my enquiries to the differential treatment of equity capital and debt capital.

For a company, interest payments are tax deductible but dividend payments are not. This has added a bias favouring debt financing. And as accumulation of debt is often cited as one of the gravest sources of systemic instability, I think, it can be said that taxation system has contributed to systemic risk, often without adding any offsetting benefit.

Let us take a simple example. A firm is expected to generate FCFE of 100 every year for all time to come. Its cost of equity is 15%. The value of the firm would be 1000/0.15 = 666.67. We also suppose that it is a well run firm and its performance cannot be improved by controlling it. There should not be any economic incentive to purchase such a firm. Nevertheless a private equity fund decides to buy it. Its incentive comes from taxation system. It decides on a debt equity ratio of 3 to finance this transaction. Raises 166.67 in equity and 500 in debt (at 11%) and acquires the undertaking of our firm for 666.67. The FCFE it can now expect will be 100-11%*500(1-Tax rate). If tax rate is 35%, it works out to be 64.25 which means FCFE now is 39% of equity investment.

Now, suppose the PE firm is a group concern of a major bank. The bank needs to increase its business, income …. Even if no new proposals are coming by buying this efficiently run firm (thus giving no particular benefit to the society – adding nothing to the physical capital stock of the economy) the bank can increase its interest income and non-interest income! To be sure as long as the PE firm can raise debt at post tax cost of less than 15% (cost of equity of our firm) a leveraged buy out will be beneficial but tax break on interest makes available huge margin of error and makes it that much more attractive.

Can we say that tax policy, by making interest a deductible expense, makes the capital structure debt heavy and sub-optimal and it thus encourages firms to add to their risks? Can we say that many Americans would not have bought the houses if mortgage servicing were not tax deductible?

Some time back Germany and Denmark placed caps on deductibility of interest expenses. This has been hailed by some and derided by some others as Nordic nonsense. An interesting analysis is here:

The only major argument against the idea is that as firms have built their businesses over years on deductibility of interest expenses, any change will be “severely disruptive”. Accountancy fraternity should spot the opportunity. ;)

Impact of Inflation on Share Prices

Saturday, June 26th, 2010

Impact of Inflation on Share Prices

This is a guest post by Mr.Sacha Singh. Sacha consults on change management, process evaluation and valuation of firms. He also enjoys ghazals and thumris and at times bhajans. You can read his blogs at


Here is a piece of simple and intuitive reasoning. Shares represent residual claims on real assets; i.e. claims on assets after creditors’ claims are met; (Equity = Assets – Liabilities). Inflation increases the prices of real assets but does not increase the creditors’ claims. Thus inflation should increase the nominal value of equity. The problem with this simplistic reasoning is that it assumes the value of firm to be the same as the value of the real assets owned by the firm.

It can be argued that if “other things remain the same” (ceteris paribus) and if it is assumed that inflation is uniform i.e. if prices and costs increase uniformly across the board then a firm will be able to pass on all increased costs (raw material, wages etc) to its buyers and its real earnings should remain unaffected. The problem with this argument is that cetera rarely remain at par, i.e. other things do change and inflation is rarely uniform. Some firms manage to pass on increased costs to their customers while some others fail to do so and go bust. Inflation increases earning volatility and hence should reduce value. Thus the value of firms may become lower on onset of inflation even though the prices of its real assets go up in response to the rising prices.

Irving Fischer was perhaps the first economist to investigate into impact of inflation on share prices. He concluded that shares should be a good hedge against inflation. Fisher observed, nominal interest rates consist of two components: a required real return on monies lent and an expected loss in value of money because of inflation. He argued that the required real return is determined by real factors and is unrelated to expected inflation. In other words, the real rate of return required by the investors does not change with expected inflation. During inflation the cash flows from shares go up (because of rise in selling prices). The increased cash flows, discounted with the same old required rate of real returns, would give a higher value and thus share value should go up during inflation, making them a good hedge.

This has not been observed. Periods of inflation, in the USA, have been noted for low returns from stocks. Cohn & Modigliani investigating into failure of equities to act as hedge against inflation concluded that a major part of the apparent undervaluation of shares was due to cognitive errors on the part of the investors. Investors, they felt, fail to realize that in a period of inflation, part of interest expense is not truly an expense but rather a repayment of real principal. The second and more serious error was the capitalization of long-run profits, a real variable, not at a real rate but rather at a rate that varied with nominal interest rates.

Fama & Schwert found evidence that the lowering of share prices (due to inflation) can be explained by two correlations: first between inflation and expected level of economic activities, which are negatively correlated (higher inflation bodes lower economic activities) and second between expected economic activities and share prices, which are positively correlated (higher level of economic activities imply higher stock prices). Taking them together would suggest that inflation should lower the stock prices. Inflation here acts as a proxy for lower economic activities in near future and this line of reasoning is called the proxy effect or the proxy hypothesis. They also distinguished between expected inflation and unexpected inflation.

If we assume that the markets are efficient and inflation will get reflected in risk free rate then onset of inflation would increase investors’ required rate of return from equities and even if a firm’s revenues keep up with inflation, its value will suffer because of higher discount rate.

There are other effects of inflation. If inflation rate moves up, in the first year post higher inflation, the accounting statements may be under-reporting the COGS (and thus, over-reporting profits) if the firm follows FIFO accounting; with LIFO accounting this impact will be insignificant.

Inflation increases the value of fixed assets, but depreciation continues on historical values. Thus, an older firm would charge considerably less depreciation (and pay, ceteris paribus, higher taxes) than a newer firm. The accounting profit of older firm may be high but the cash flow of the newer firm would be stronger.

In India reliable data of index PE is conveniently available only from 1999 onwards. I did a regression of quarterly PEs of Nifty and inflation numbers (derived from CPI – industrial workers). I could find no correlation. But Nifty PE regressed with inflation as recorded after two quarters gave an interesting straight line (with R2 at a little over 40%)! If PE goes up (down) today, inflation would be up (down) after two quarters!!

I do not know what to make of it. A somewhat bold reasoning could go like this. PE’s are going up because of increasing money supply. And broad measure of money supply (M3) generally co-integrates with inflation). FII funds that come to the stock market increase PE today and affect the inflation after some time. I call it bold because it is being hypothesized without examining the data (of FII inflows) and the transmission mechanism.

Who should pay for Credit Rating?

Monday, June 21st, 2010

Who should pay for Credit Rating?

This is a Guest post by Mr. Sacha Singh. He consults on change management, process evaluation and valuation of firms and he also enjoys ghazals and thumris and at times bhajans.

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Who should pay for rating – investors or issuers? In the aftermath of the GFC this has become a point of serious debate. Credit Rating Agencies (CRAs) maintain that their internal systems and procedures are adequate to take care of any conflict of interest between their marketing (get more business) and rating functions. Others are not so sure. Many seem to be thinking that an investor-pays-model will be better. CRAs are quick to point out that an investor-pays-model too will give rise to pressures for favourable (better) ratings as any down-gradation will force the investors to take a hit on their profits. I think we need to be more imaginative about the model and we also need to be clear about the role and functions of a rating agency.

Credit ratings started as investment recommendations, paid for by the investors. Only after the Second War the issuer-pays-model really took off. This model permitted CRAs to recruit an array of professionally qualified analysts, streamlined the rating process & methodology and to some extent it took the mystique away from the business of rating. In practice an issuer asks beforehand what the likely rating of their next issue is. CRAs play demure but hint at what could be done to improve rating. (Often they have made special teams that work closely with their marketing wings to educate the issuers on structuring (read rating) of unusual instruments.) GFC, many insinuate, came from the failure of CRAs. I make no such insinuation. I assert it. They had / have a fiduciary role and they failed. I have posted about it earlier too, see here.