Bhujbal

1) In 1973, Thackeray helped him become a BMC corporator. Bhujbal would later go on to become Mayor twice. In 1985, he became Shiv Sena MLA from Mazagaon, which he represented twice.

2) In 1991, at the peak of Mandal agitation, Bhujbal decided to quit Sena to join Congress. saying the party was against OBC reservations. He had by then fashioned himself as an OBC politician, but those who know him always maintained that the real reason he left the party was that he felt sidelined by the rise of tactful and soft spoken Manohar Joshi. 

3) In 1999, when Sharad Pawar left Congress to float his own party NCP, Bhujbal followed him. The same year, Shiv Sena lost power to Congress-NCP coalition. Bhujbal was made Deputy CM with additional Home portfolio.

Against globalisation

1) The scepticism against globalisation is really scepticism against plutocracy.

2) Proponents of globalisation underestimated the political and cultural challenges to assimilation.

3) The idea behind globalisation was that it is possible to imagine a system of economic interdependencies which are structured in such a way that mitigated the zero sum aspects of global trade.

4) The desire for deepening global interconnections was never driven by technical economic argument. 

5) Globalisation is more uneven and complex than presented in caricatures. At its best, it had an ethical impulse, a new imagination about the possibilities of organising human society. At its worst, it was elites and special interests seeking new pastures of opportunity even when the overall benefits were in doubt.

5) As nationalism gains ground, there is a real danger that nuanced debates on globalisation will be replaced by more atavistic revolt against its possibilities.

How to enable a bank collapse

Halfway through the economic liberalisation program by the Narasimha Rao government in 1995-96, the Indian Bank losses mounted to ₹1727 Cr. Wiping out its entire capital base. Over the next couple of years, the losses multiplied, as bad loans reached 40% of its loan book.

Other banks like UCO and United Bank of India too had piled up bad loans, given the inherent weakness in their region, with many cyclical industries going through trouble and operational inefficiencies. 

By the time Vajpayee led NDA government came to power in 1999, the government had sunk a total of ₹6750 Cr in the form of capital in them.

For the government struggling with finances and with global slowdown, pouring in more capital wasn't an option. Nor was shuttering the banks, given the political sensitivities.

Then RBI governor, Bimal Jalan formed an advisory group with ex-chairman of SBI as its head. The advisory group didn't recommend any closure, merger or privatisation of these banks. Instead, operational changes were recommended like reducing operational cost, resolving bad loans, induction of technology etc.

The efforts paid off and by 2001-02, these banks were back to reporting modest profits. It helped that the indian government provided capital to Indiam bank, and as interest rates fell sharply during that period, many banks including weak ones were able to gain on the portfolio of bonds on their books.

BREXIT

1) Britain is more dependent on EU rather than other way round. The EU takes almost half of Britain's exports, whereas Britain takes less than 10% of EUs. And Britain's trade deficit is mostly with Germans and Spanish, not with the remaining 25 countries that would have to agree with the new deal.

2) The long term costs would go beyond economics. Brexit might well break up the UK itself. Scotland, more europhile than England, is again agitating for divorce. And the Irish government is among the most vocal foreign supporters of the campaign for Britain to stay in.

3) EU leaders know that brexit would weaken a club already mired in migrant and Euro crises. The EU has become increasingly important part of the west's foreign and security policy. Whether it comes to nuclear deal with Iran, threat of Islamic terrorism or sanctions against Russia.  

4) The 'Leave' campaign has proved aggressive and well financed. It has skirted past lack of clarity over alternatives to membership, instead playing up concerns over migration and loss of sovereignty to Brussels. Portraying those doubting if Britain could do better outside the EU as unpatriotic.

Questions

Him: What are you doing these days?

Me: Nothing. Just lounging at home, searching for a job.

Him: You shouldn't have left that teaching assignment.

Me: (Gasping for words)

Him: Didn't you wanted to be a teacher all your life? 

Me: (nodding my head not due to lack of words but because of the weight of thoughts I could barely hold in my head)

Him: Then what made you do something that none of us - not your friends, none is able to come to terms with.

Me: I believed that I will find myself a better teaching position.

Him: Do you remember the last time you taught students? FIVE YEARS have elapsed and you are yet to find someone and something to teach.

FiraaQ

shaam-e-firaaq ab na puuchh aaii aur aake Tal gaii 

dil thaa ke phir bahal gayaa, jaa.N thii ke phir sambhal gaii 

bazm-e-Khayaal me.n tere husn kii shamaa jal gaii 

dard kaa chaa.Nd bujh gayaa, hijr kii raat Dhal gaii 

jab tujhe yaad kar liyaa, subha mahak mahak uThii 

jab teraa Gam jagaa liyaa, raat machal machal gaii 

dil se to har muaamalaa karake chale the saaf ham 

kahane me.n unake saamane baat badal badal gaii 

aaKhir-e-shab ke hamasafar 'Faiz' na jaane kyaa hue 

rah gaii kis jagah sabaa, subha kidhar nikal gaii 

Monetary and Fiscal policy

1) In 2004, both Hungary and Poland, the two fastest growing economies in Eastern Europe were ready to join the EU. Since the 1980s, both the countries had experienced unfavourable political and economic conditions. Both had a history of hyperinflation, high levels of foreign debt and poor institutional and economic framework. 

2) While Poland was largely successful in curbing inflation (1993: 35.3%, 2002:1.9%) with an efficient interest rate policy. Hungary was struggling with high interest rates ( 2003: 12.5% p.a). 

3) In Hungary, period 1990-94 had two important weakness. The first was the loose fiscal policy leading to huge fiscal deficits and high foreign debt. The second was ineffective monetary policy. The liberalisation of forex operations and the continuous appreciation of the currency resulted in significant capital inflows, which narrowed the scope of monetary policy in controlling the money supply. 

4) In the late 1980s, Poland's economy initiated its transition process under less favourable conditions when compared to Hungary. 

5) Fiscal policy is necessarily expansionary in a developing economy. Governments always want to increase their expenditures beyond their resources in the hope that in the subsequent stage, output will catch up with increased expenditures. But the question is whether  monetary policy can achieve anything when the fiscal policy is expansionary?

Heavily indebted poor countries

1) The world's 137 poorest nations owe a total of $ 2.6 tn in international debt, and these countries on average spend 25% of their national budget in repaying the debt depleting the countries resources to invest in infrastructure, education, health care and other social programs.

2) Fearing that debt repayment will rob these countries of their future, a number of policy makers and international activists groups called on the lenders to write off the debt of the poor countries.

3) On the other hand, multilateral lenders like the International Monetary Fund and the World Bank cited that debt cancellation was not beneficial for the financial health of the international creditors and it might affect the poor countries more than helping them. 

4) But several African countries prefer an increase in the flow of other resources from the developed countries rather than cancellation of debt. While the African nations should focus on implementing poverty reduction programs and economic growth strategies. The lenders should increase their aid, encourage free trade by opening up their markets and reducing trade barriers, encourage immigration and link the interest payment on the debt to the nation's growth.

Taxation

With low inflation, stable interest rates and falling unemployment rates, the UK economy in the early 2000 had been the strongest in Europe. 

Britain avoided recession in 2001 when the GDP growth rate was around 1.5%. But much of the growth rate was sustained by domestic consumption rather than exports growth.

Among the industrialised countries, Britain was considered to be among the high tax paying countries. CoE had already imposed more than 60 indirect taxes, which was expected to further reduce disposable income in the hands of consumers who had been propping up the economy. Moreover, these taxes were spent more on welfare programs than capital investment.

Revenue secretary (2002) was of the view that the argument of those batting against taxing dividends received by individual shareholders was flawed. His line: if the company and promoter were treated as two separate entities, then the responsibility of handling the liabilities too should rest with the promoter and the  benefits couldn't be treated as tax exempt. But a powerful lobby managed to keep up the portrayal of the move as amounting to double taxation.

In 2007, Vodafone acquired 67% stake in Hutchison india for $ 11 bn. On February, 2016, the IT Deptt issued Vodafone a reminder over its ₹ 14,200 Cr tax demand and threatened to seize its assets over non-payment.

The British telecom major says that no tax was due as the transaction was done offshore. But the tax deptt contention is that capital gains were made on assets in India.

Gas Tax

By early 2004, with political instability in Iraq and tensions in the Middle East, crude oil prices skyrocketed in the international market. Prices increased by 33% between Dec 2003 and Feb 2004. Historically any sharp increase in crude oil prices hs pushed the U.S. economy into recession.

Analyst warned that any programme to reduce oil consumption must be a long term affair as a drastic or abrupt drop in demand could even be counterproductive. As even small change in capacity or demand 'can bring big swings in prices'. The economic turmoil in Asia in the mid 1990s reduced demand only by about 1.5 mbpd, but it caused oil prices to plunge to nearly $10 a barrel. 

European drug pricing

Due to lower drug prices in EU, per capita spending on drugs had been much less as compared to US. Despite huge savings, economists feared that EU might be losing in terms of investment and innovation destination for big pharma cos. 

1) Germany and Netherlands were the first countries in Europe to adopt a system of Reference pricing. Under this system the government established a reimbursement level for a particular drug and if the price of any drug exceeded that level, that patient had to bear the difference. 

In theory, reference pricing limits reimbursement, not prices. 

2) Traditionally, Europeans had been monopolist price setters ( public health under the government) for drugs, thereby keeping drug prices low. European nations followed two basic models for healthcare syatems. The first was comprehensive social insurance model with public and private funding. SeconD was NHS, which was funded through taxpayers money. 

Drug price distortions

In recent times, the high prices of prescription drugs in the U.S. have contrary to the welfare policy for its elderly citizens who are the intended beneficiaries of the state run public healthcare programs. And with the rising number of US citizens sourcing their personal drug needs from low cost overseas market, the issue of disparity between the drug prices in the U.S. and other countries is gaining potency.

The Americans pay the highest prices in the world for prescription drugs. Patent regulations by FDA means that the consumers pay an exorbitant price for their prescription drugs, than they would if they use its generic counterparts.

The US spends more money on healthcare than any other country in the world. Still 44 mn of its population is denied healthcare insurance. The U.S. healthcare industry is one in which top companies rake in huge profits, spending encor amounts on marketing and advertising. For example, Pfizer's M&A budget is half of its expenses but R&D budget is just a quarter of it.

The WHO has been advocating the concept of 'Differetial Pricing' for quite some time. It advocates that essential drug prices should in some way reflect countries' ability to pay as measured by their level of income. The concept of differential pricing can thus, also provide a mechanism to ensure not only the affordability of a patented drug in a developing country but also advocate incentives for innovation.

Role of Central banks

The Dominican Republic's economic problem was a problem of liquidity rather than solvency. The high volume of short-term CDs had created high rollover risk. Tax hikes and elimination of subsidies were unpopular with the people. The country was to default on yet another coupon payment of $20 mn on September 9, 2004. 

By July 2004, inflation was 55%. The peso had depreciated from 18 to 50 for a dollar. While fiscal deficit was 8% of GDP.

The government made efforts to get the finances under control. To fill the gap created by the bailouts, the government had issued short term CDs with high yields upto 40%. 

Solvency is an enterprise's ability to meet its long-term financial obligations. While liquidity refers to its ability in the short term. An insolvent enterprise must enter bankruptcy. While an enterprise lacking liquidity can be forced into bankruptcy even if it is solvent.

The monetary program envisaged a build up of government deposits at the central bank, as a means of limiting the money supply. To improve liquidity and develop the domestic yield curve, the Central bank planned to lengthen the maturity period of its certificates.

1) There are five functions associated with central bank: power to issue notes, banker's bank, government's bank, lender of last resort and controller of credit.

2) There are three ways to control credit:

Altering bank rate; open market ops and varying reserve requirements.

" If one conservatively assumes that more than 5% of Bank loans to Chinese firms and local governments is non-performing, this would imply $1.15 tn in loan write-offs, dwarfing the amount of the U.S. bank rescue package of $700 bn in 2008. Since Chinese banks cannot absorb such a hit on their capital, the Chinese state will have to step in to recapitalise the banking sector, either by issuing bonds or printing money. The former will reduce the creditworthiness of the Chinese states and the latter will further put pressure on the Chinese currency to depreciate.

The objectives of Monetary Policy have changed with time. Since WWII, the primary objective has been growth & development. As economy grows more money is needed to facilitate the settlement of increased transactions.

Deflation in Japan

Deflation has made world's second largest economy its home for almost 3 years since 1999. According to Keynes, Japan had fallen into the abyss of liquidity trap where conventional monetary and fiscal policy becomes ineffective. 

The CPI had declined for 41 months in a row, and there were no signs that the situation would get better.

The ratio of gross government debt to GDP had risen to 146%, a sign of financial instability.

Cyclically, the Chinese economy has experienced one of the world's largest credit bubbles. The massive creation of credit since 2008 took China's debt-to-GDP ratio from 125% in 2008 to 280% in  mid 2015.

The BoJ had warned the government of possible bankruptcy of top four banking conglomerates.

Japan was trapped in a viscous cycle of deflation backed by a gigantic banking crises. It was believed that the crises was caused by shortfall in demand and consequent decrease in private spending.

During the 1980, BoJ kept interest rate low to boost demand. This was being done to counter the appreciating Yen, which was damaging exports. This artificial lowering of interest rates led to huge monetary expansion, and the resulting inflationary effect led to the increase in the price of the real estate

There is a asymmetry in the operation of the bank rate. The ultimate impact of the change in bank rate depends on a number of intervening factors which may not always hold good.

While a rise in a bank rate may have a restraining effect on the borrowers, the necessary expansionary effect may not be forthcoming because of the fall in the lending rate. A fall in the lending rate may at best offer an inducement to borrow. But whether or not borrowings will increase, will depend on the customer's assessment of the economic situation. If the business conditions are not favourable, the lowering of interest rate may not induce customers to borrow more.

Import commodities & Export inflation

1)In 1970, OPEC gave an unexpected blow to the U.S. economy by hiking oil prices. And in 2004, China was exerting a direct influence on American economic life. Global prices of commodities like oil, copper, steel, coal, cement and aluminium were rising sharply to the extent of 60-100%. 

2) China was pumping inflationary and deflationary price on the U.S. economy.

i.e. China's booming economy appeared to be pushing up prices for the global commodities while at the same time pushing down prices for goods via low cost exports. 

3) China's consumption expenditure was just 45% of GDP, a low proportion when judged by the standards of US, Europe or Japan, where it was 60-70% of GDP. 

4) Chinese economy needed a growth rate  of at least 7% to generate enough jobs to absorb surplus labour rural labour and the workers laid off by state owned enterprises.

5) Chinese were against currency pegging, as it might hamper the country's successful exporters. 

6) Slowing Chinese economy will affect developing and developed countries differently. While fast growth of developing economies was fuelled by demand for commodities from China. The developed economies are at risk of deflation as they were net importers of Chinese products. So if the Chinese firms start dumping their excess output on the global market (like steel), deflation could wreck the global economy.

Chilean pension model

Inherent weakness in the pay-as-you-go system and political expediencies, which contributed to the problems in the pension system, necessitated pension reforms in 1981. Since, then this model has been attracting much interest across the world.

Problems In the existing system, active workers finance the pension of retired or inactive workers through obligatory contributions or premiums. Any shortfall in the payments is made good by the state. The system experienced financial strains due to unfavourable dependency ratio and loopholes in rules and regulations.

New System Workers can open individual accounts with newly created private fund management companies, which is similar to a savings account. The contributions had two components: mandatory (tax free) and voluntary.

Each worker was allowed to have one account with one AFP, and each AFP was allowed to operate only one fund. AFP is allowed to invest only in low risk domestic instruments.

Competition among the AFPs themselves was an integral part of the plan. 

1981:12 AFPs 1994: 21 2003: 07

Caribbean sugar woes

The Caribbean region with ten exporting countries, was among the top 10 exporters in the world till mid 1960s and had peaked annual production of 1.4 million tons in 1965. Thirty years later, in 1995, the region's production dropped to 0.4 million tons. By 2002, only 6 exporting countries were left. 

Cuba shifted its focus from sugar to tourism as a major growth area of economy. In 1990, more than 90% of the foreign exchange earnings of Cuba were from sugar exports to erstwhile Soviet Union. But I. 2001, the major earnings came from tourism, $2 bn as compared to $441 mn from sugar. 

Australian CAD

From 1991 to 2003, the GDP growth rate of Australia had averaged at almost 4% every year. The increase in domestic demand, low level of public debt, low inflation, sound financial system and sound record of structural reforms were the other factors that contributed to its growth.

1980s 

The CAD had increased to about 5% of the GDP. The upswing was because of slow increase in exports. In 1988, the reserve bank tightened the monetary policy and the Australian dollar appreciated against major currencies. Thus in early 1990s CAD narrowed to 3.7% of GDP. 

1990s

The CAD reached a peak of 5.8%. There was a growing domestic demand in the country and increase in imports. The government and private firms had been borrowing funds from abroad to finance their investments.

At the end of 1997, the CAD started decreasing as Australia diversified its exports from Asian to other countries. In the fiscal year 1997-98, Australian exports grew by 8.4%. 

The CAD increased from 5% of GDP in 1998 to 5.7% in 1999. The East Asian countries recovered after the crises in 1999 and their devalued currencies were able to grab major import markets across the world. 

At the end of the year 1999-00, the government recorded a fiscal surplus of 2.1% of GDP. Higher tax revenues and less expenditure contributed to the rise. But most of the improvement was due to the shift in the accounting standards. 

2000s

2000-01:2.7%~increased exports due to tax reforms and weak AUD.

2001-02:3.1%~slow world economic recovery and increased imports.

2002-03:6.7%~decline in exports coupled with growth in consumer spending which inflated household debt.

American Pension Funds

YAmerican Pension Funds performed extremely well during stock market boom of the 1990s prompting both institutional and individual investors to bet their savings in the stock market. The corporates went even a step further and ignored the basic accounting principle of Conservatism and assumed discount rate that suited them best when calculating their pension liabilities. The stock market decline of latter 2000 wiped off all the gains of the previous years. The use of higher interest rates to discount future liabilities may have two opposing effects. On one hand they would reduce sponsor's contribution. Thus improve their financial position and decreases their likelihood of bankruptcy. On the other hand, lower contributions would mean under funding of pension funds. Thus increasing the likelihood that the fund will be bailed out/taken over by a government agency.

The idea behind this mechanism is to encourage people to invest in pension products rather than withdraw and use the entire corpus after retirement.

Ageing Japan

The ageing population of Japan was making it difficult to finance the pension bill, which in turn was putting pressure on the national fiscal deficit. To combat this problem economist suggested three options.

1) Cut in public expenditure.

2) Broadening of the tax base.

3) Hike in the consumption tax.

In Japan, the public investment was significantly higher at 60% of the GDP. It would generated long term welfare gains but was economically risky.

Broadening the tax base means increasing the retirement age from 62 to 65. Increasing the consumption tax meant hiking it from the present level of 5%(2004), which was relatively low by international standards. But the government was not in its favor, because in 1997 when the taxes were hiked, the economy slid into recession due to cut in consumer's expenditure.

Definition

Notional principal: The principal used to calculate payments in an interest rate swap. The principal is 'notional' because it's neither paid nor received.

Systematic risk: The risk which cannot be diversified away.

Maximum Likelihood Method: A method of choosing the values of the parameters by maximising the probability of a set of observations occurring.

Monetary policy: Monetary Policy is a central bank process of managing money supply to achieve specific goals, such as constraining inflation, maintaining exchange rate, achieving full employment  or economic growth. Monetary policy can involve changing interest rate directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets. 

Portfolio insurance

Q: How is portfolio insurance done?

A: One way to insure return on a portfolio is to buy a put option on the portfolio which will protect it against market decline while preserving the potential for gains when market rises. Another method is to create option position synthetically.

Q: What are the benefits of hedging a portfolio synthetically?

A: First, options market do not possess enough liquidity to absorb the trades fund managers carry out. Second, fund managers require options with strike price and maturity that are different from those traded on ET markets.

Q: How a synthetic option created?

A: To insure a portfolio synthetically, funds are divided between stock portfolio to be insured and risk less assets. When the value of the portfolio increases, the risk less assets are sold to buy stocks for the portfolio. But when the value of the portfolio decreases, then stocks are sold to buy risk less assets. The cost of insurance arises from the fact that the fund manager is always buying stocks when market rises and selling stocks when market declines.

Greek Letters

Q: What are Greek letters?

A: These are hedge parameters such as Delta, Gamma, Vega and Theta. Each represents a risk associated with the change in the market variable. When a FI writes an option in an OTC market it has to hedge its position in an OTC market itself. Where hedging is far more difficult than an ET market because the products are customised instead standardised. Each Greek letter measure a different dimension of risk in an option position. Aim of the trader is to manage all the Greeks in a manner that the risks become acceptable.

Q: What is Delta Hedging?

A: It's a hedging scheme designed with the purpose of making the price of the portfolio of derivatives insensitive to the changes in the price of the underlying asset i.e making the portfolio delta neutral. Since, delta of an option is always less than 1, number of shares needed to hedge an option position is always less than the number of shares on which the FI writes an option. Since the delta of an option is not constant and it keeps changing, the portfolio needs rebalancing i.e the number of shares required for hedging also keeps changing. There are two types of hedging schemes: Dynamic and Static.

Numerical Procedures

Q: What are the methods available to value derivatives contracts?

A: When the Black-Scholes formula is not applicable i.e the option payoff is path dependent and the option can be exercised prior to maturity as in the case of American options, there are three methods available. First, Binomial tree approach where the movement of the asset price is mapped on a tree. Second, Monte Carlo simulation where simulated value of future asset price is used to value derivatives. Third, Finite Difference Method where the differential equation is converted to a set of difference equations and then solved iteratively.

Q: What are the conditions under which these methods are applied?

A: MCS works from the beginning to the end of the life of the derivative. While both tree and FDM work in reverse. But MCS becomes less time consuming and more efficient when the number of underlying variable increases. But all three methods can be applied to both American and European options.

VaR: Value at Risk

Q: How VaR different from credit risk?

A: While the credit risk is associated with the probability of default by a counterparty in a derivatives contract. The VaR is about changes in the market variables to which any FI is exposed. It's a single number summarising the total risk to a portfolio of financial assets. Moreover, Central bankers also use this number to arrive at the capital required by the bank to reflect the risk its bearing. Specifically, VaR calculation is aimed at making a statement of the form: "We are X % certain that we are not going to lose more than $ V in the next N days."

Q: How is VaR calculated?

A: There are two ways of calculating VaR: The Historical Simulation approach and model building approach. The first approach uses past data to arrive at The joint probability distribution of market variables. But it is computationally slow and doesn't incorporate volatility updating schemes. The second approach is faster and can be used in conjunction with volatility updating schemes. But it assumes that market variables follow multivariate normal distribution, which may not be the case in practice.

EWMA, GARCH ...

Q: What EWMA and GARCH stand for?

A: EWMA is Exponentially Weighted Moving Average. While GARCH is Generalised Autoregressive Conditional Heteroscedasticity. These are models for estimating current and future levels of volatilities and correlations of assets for calculating VaR of a portfolio and valuing derivatives respectively.

Q: Among EWMA and GARCH, which is a better model for estimating volatilities and correlations?

A: Both model estimate present volatility using value of previous day's volatility and previous day's % change in market variable. Moreover, the weights assigned to observations decrease exponentially as observations become older. But in GARCH model additional weight is given to long run average variance rate, LRAV. Thus, theoretically GARCH is more appealing than EWMA model. The weights (model parameters) are estimated using MLM. Finally, a model is judged by how well it removes autocorrelation from the historical data using Ljung Box Statistics.

RWP vs RNP

Q: Why are the default intensities implied from historical data (RWP) much less than those implied from bond prices/equity prices (RNP)?

A: First, the corporate bonds are illiquid securities and bond traders demands extra returns to compensate for it. Second, bonds returns are highly skewed with limited upside. Thus, it's difficult to diversify risks in a bond portfolio than an equity portfolio. In practice, a bond portfolio is rarely fully diversified. Thus, a bond trader requires extra return for bearing this unsystematic risk in addition to the systematic risk. Third, bonds rarely default independent of each other, bonds defaults are correlated. The default rates vary from year to year depending upon economic conditions or that default by one company has a ripple effect resulting in default by other companies (credit contagion). This represents systematic risk and traders demand return for bearing this risk. 

Q: When one should use RWP and when RNP?

A: When valuing credit derivatives or  estimating the impact of default risk on the pricing of contracts one should use RNP. But for calculating expected future losses from possible defaults one should use RWP.

Market risk, Credit risk and default probabilities

Q: What is the difference between market risk and credit risk?

A: Market risk is a systematic risk to which any FI exposed. While the credit risk is a probability of default by borrowers or counterparties in a derivatives transaction.

Q: What are the methods for calculating these risks?

A: Market risk is calculated using VaR and Greek letters like Gamma, Vega and Theta etc. While the default probabilities for credit risk are calculated using historical data or Bond prices/Equity prices. The default probabilities calculated from historical data are real-world probabilities. While those calculated from bond prices/equity prices are called risk-neutral probabilities.

Q: Are these two probabilities different and if yes then why?

A: Yes, they are different because of the presence of expected excess returns over the risk free rate. If there were no expected excess return then the two probabilities would be same.

OTC versus Exchange traded products

Q: How the OTC market precipitated the whole financial crises?

A: OTC market is generally non-transparent, highly leveraged and provides higher profit margins to financial intermediaries than exchange traded products. And in some cases the contracts are not marked to market and no collateral is posted with the custodian. Commonly traded contracts on OTC market are currency and interest rate swaps and CDS. Thus, OTC traders are exposed to each other's credit risk. But the nominal value of outstanding OTC derivatives contracts at the end of 2008 stood at $592 tn, 10 times more than nominal value of $57.6 tn for ET contracts. When housing market sank and with it the mortgage backed securities, AIG took a hit as the seller of CDS written on MBS. And a CDS is an OTC contract.

Q: What is a Credit Default Swap?

A: A CDS is a derivative contract bought by lenders as an insurance against a possible default of credit by the borrowers. The FI writing the CDS agrees to buy the bonds at their face value ( principal amount) in the case the borrower defaults on its payment. The total face value of the bonds of which CDS is written is known as notional principal of that CDS. During late 90s and early 2000s, banks made extensive use of CDS to transfer credit risk to other parts of financial system.

Low quality debt into high quality

Q: What went wrong with the process of securitisation?

A: This financial crises had roots in the way Mortgage market evolved. In the 1970s Federal Home loan mortgage corporation was established. It securitised the home loans by creating Mortgage Backed Securities and allowed US government to transfer market risk to investors. But a Wall Street investor cannot invest in sub-investment grade instrument. An MBS was a sub-investment grade security. To improve the quality of an MBS, they were pooled with other high quality debt instruments in the form of Collateralised Debt Obligation, CDO.

Q: What went wrong with CDOs?

A: CDO is a way of creating securities with different risk characteristics from a portfolio of debt instruments. These different securities are called tranches. The tranch which takes on the initial losses offers the highest return or yield. While the tranch which incurs residual losses receives the lowest return. In the year preceding the crises, outstanding CDO volume stood at $ 900 bn. Of which 17% was created from sub-prime mortgages. 

Arrogance

Q: If eventually the Banking system had to be "bailed out" then why Bear Sterns and Lehman Brothers were allowed to go bankrupt in the first place?

A: It was a sort of moral posturing by the Fed that eventually failed. The Fed was perceiving it as a creative destruction process which was expected to remove the imbalances in the system. After all it is the absence of state intervention in the markets that makes America different from other developed or large economies like Japan and China. But the gambit failed because the next day when Merrill Lynch was staring at the same fate, BoA had to buy it.

Q: But aren't the treasury guilty of another crime. That of running a low interest rate economy which led to excess liquidity and consequent high inflation and finally stock market bubble?

A: Yes, the Bush administration ran unprecedented fiscal and current account deficits to finance- wars, tax cuts and public over consumption, all fuelled by debt. And until 2007 i.e before the crash, all of this excess liquidity was absorbed by asset price ( about $8 tn) and commodity price inflation ( especially oil prices, $3 tn). But why blame the treasury. It is only the supplier of credit. Aren't the borrowers ( like banks, industry and consumers) equally culpable of succumbing to the temptation.

Quantum of Loss

Q: The losses were huge in number, running into billions and trillions of dollars. So huge that they can expressed as a percentage of US GDP?

A: To keep the numbers in perspective. First, The US GDP stood at $17 trillions in 2015. Second, during and after the crises $600 bn of net worth was written down by the financial firms. Finally, the budget for Troubled Assets Recovery Program (TARP) proposed by Fed and U.S. treasury stood at $700 bn.

Q: The net worth of executives running these banks also ran into billions of dollars. How much hit they took when the market crashed?
A: A major chunk of the compensation given to the bankers was in the form of stock options. When the markets crashed, with them the the value of stock options also took the plunge. Overall, major bankers saw their valuations falling about 60-100% of their net worth. Jimmy Cayne's (Bear Sterns) worth was reduced to $61 mn from $1.6 bn. Similarly, Richard Fuld's (Lehman Brothers) billion dollar valuation was not even worth half a million dollars after the crash.

Q: Should we be sympathetic to these bankers for like the retail investors they too felt the pain of the crash?
A: How can you expect the "retail investor" to be sympathetic to someone with a net worth of millions even after the crash. Moreover, the havoc they unleashed over the financial universe was of their own making.

Q: The fact that they received compensation in the form of stock option speaks of the belief they had in the financial system?
A: It is difficult to say whether it was their "belief" or was it simply their "arrogance" in the financial architecture they created and ran.

Crossing the line

Q: How a derivatives transaction be speculative in nature?

A: In any transaction involving two counterparties, if one party is reducing its risk then the other side is assuming it. For example, in case of options, the side buying the option by paying "option premium" is reducing its risk. While side receiving "option premium" is assuming the risk, i.e "writing option". Now writing an option is no doubt an speculative activity. 

Q: Is there any other speculative activity which resulted in huge losses for these banks?

A: Yes. Currency swaps i.e. swapping one currency exposure with a low interest currency was another major loss making derivatives transaction. Other activity was taking on "Leverage" i.e. making investments based on borrowed capital.

Q: But what forced or encouraged these banks to participate in speculation?

A: Traditionally banks relied on passive depositors - mainly working, middle class people, who keep their savings accounts, as a source of funds- for their financing requirements. But now these same passive depositors are becoming active investors in the stock market. In essence, banks are now dependent on "volatile" investors that the securities markets depends upon.

Role of regulators

Q: The banks which went bankrupt were not operating in isolation. If they were meddling in instruments as complex as derivatives then why the banking regulators didn't intervene when they could have made a difference?

A: First, these were no ordinary banks. Lehmann Brothers e.g is more than 150 years old. Nobody expected them to fail. Second, if it were ordinary lending-borrowing type banking. Then there are strict Basel regulations to govern them. So, even though use of derivatives has recently become widespread. They are still in nascent stage and hence not strictly regulated.

Q: But how can a bank incur such huge losses by trading in derivatives? Isn't it a known fact that derivatives have limited downside for loss while retaining unlimited upside potential for profits. 

A: Derivatives are used for the purpose of reducing your risk, i.e. a bank's exposure to market uncertainties, also known as hedging. But since there is also a possibility that one can reap profits by entering into such a derivatives contract, the counterparties cross the line from hedging to speculation. An activity a good banker should strictly avoid.