Yesterday, the Securities and Exchange Board of India (SEBI) issued regulations requiring all Research Analysts to be registered with SEBI. The problem is that the regulations use a very expansive definition of research analyst. This reminds me of my note of dissent to the report of the Financial Sector Legislative Reforms Commission (FSLRC) on the issue of definition of financial service. I wrote in that dissent that:

Many activities carried out by accountants, lawyers, actuaries, academics and other professionals as part of their normal profession could attract the regitration requirement because these activities could be construed as provision of a financial service … All this creates scope for needless harassment of innocent people without providing any worthwile benefits.

Much the same could be said about the definition of the definition of research analyst. Consider for example this blog post by Prof. Aswath Damodaran of the Stern School of Business at New York University on the valuation of Twitter during its IPO. It clearly meets the definition of a research report in Regulation 2(w):

any written or electronic communication that includes research analysis or research recommendation or an opinion concerning securities or public offer, providing a basis for investment decision

Regulation 2(w) has a long list of exclusions, but Damodaran’s post does not fall under any of them. Therefore, clearly Damodaran would be a research analyst under Regulation 2(u) under several of its prongs:

a person who is primarily responsible for:

  • preparation or publication of the content of the research report; or
  • providing research report; or
  • offering an opinion concerning public offer,

with respect to securities that are listed or to be listed in a stock exchange

Under Regulation 3(1), Prof. Damodaran would need a certificate of registration from SEBI if he were to write a similar blog post about an Indian company. Or, under Regulation 4, he would have to tie up with a research entity registered in India.

Regulations of this kind are a form of regulatory overreach that must be prevented by narrowly circumscribing the powers of regulators in the statute itself. To quote another sentence that I wrote in the FSLRC dissent note: “regulatory self restraint … is often a scarce commodity”.

A couple of weeks ago, Matt Levine at Bloomberg View described a curious incident of a company that was a public company for only six days before cancelling its public issue:

  1. On July 30, 2014, an Israeli company, Vascular Biogenics Ltd. (VBL) announced that it had priced its initial public offering (IPO) at $12 per share and that the shares would begin trading on Nasdaq the next day. The registration statement relating to these securities was filed with and was declared effective by the US Securities and Exchange Commission (SEC) on the same day.
  2. On August 8, VBL announced that it had cancelled its IPO.

What happened in between was that on July 31, the shares opened at $11.00 and sank further to close at $10.25 (a 15% discount to the IPO price) on a large volume of 1.5 million shares as compared to the total issue size of 5.4 million shares excluding the Greeshoe option (Source for price and volume data is Google Finance). This price drop was bad news for one of the large shareholders who had agreed to purchase almost 45% of the shares in the IPO. This insider was unwilling or unable to pay for the shares that he had agreed to buy. Technically, the underwriters were on the hook now, and the default could have triggered a spate of law suits. Instead, the company cancelled the IPO and the underwriting agreement. Nasdaq instituted a trading halt but the company appears to be still technically listed on Nasdaq.

Matt Levine does a fabulous job of dissecting the underwriting agreement to understand the legal issues involved. I am however more concerned about the relationship between the insider and the company. The VBL episode seems to suggest that if you are an insider in a company, a US IPO is a free call option. If the stock price goes up on listing, the insider pays the IPO price and buys the stock. If the price goes down, the insider refuses to pay and the company cancels the IPO.

Last month, the US Securities and Exchange Commission (SEC) adopted rules allowing money market funds (MMFs) to restrict (or “gate”) redemptions when there is a liquidity problem. These proposals have been severely criticized on the ground that they could lead to pre-emptive runs as investor rush to the exit before the gates are imposed.

I think the criticism is valid though I was among those who recommended the imposition of gates in Indian mutual funds during the crisis of 2008. The difference is that I see gates as a solution not to a liquidity problem, but to a valuation problem. The purpose of the gate in my view is to protect remaining investors from the risk that redeeming investors exit the fund at a valuation greater than the true value of the assets. An even better solution to this valuation problem is the minimum balance at risk proposal that I blogged about two years ago.

Tarek Hassan and Rui Mano have an interesting NBER conference paper (h/t Econbrowser (Menzie Chinn) that comes pretty close to saying that there is really no forward premium puzzle at all. Their paper itself tends to obscure the message using phrases like cross-currency, between-time-and-currency, and cross-time components of uncovered interest parity violations. So what follows is my take on their paper.

Uncovered interest parity says that ignoring risk aversion, currencies with high interest rates should be expected to depreciate so as to neutralise the interest differential. If not risk neutral investors from the rest of the world would move all their money into the high yielding currency and earn higher returns. Similarly, currencies with low interest rates should be expected to appreciate to compensate the interest differential so that risk neutral investors do not stampede out of the currency.

Violation of uncovered interest parity therefore have a potentially simple explanation in terms of risk premia. The problem is that the empirical relationship between interest differentials and currency appreciation is in the opposite direction to that predicted by uncovered interest parity. In a pooled time-series cross-sectional regression, currencies with high interest rates appreciate instead of depreciating. A whole investment strategy called the carry trade has been built on this observation. A risk based explanation of this phenomenon would seem to require implausible time varying risk premia. For example, if we interpret the pooled in terms of a single exchange rate (say dollar-euro), the risk premium would have to keep changing sign depending on whether the dollar interest rate was higher or lower than the euro interest rate.

This is where Hassan and Mano come in with a decomposition of the pooled regression result. They argue that in a pooled sample, the result could be driven by currency fixed effects. For example, over their sample period, the New Zealand interest rate was consistently higher than the Japanese rate and an investor who was consistently short the yen and long the New Zealand dollar would have made money. The crucial point here is that a risk based explanation of this outcome would not require time varying risk premia – over the whole sample, the risk premium would be in one direction. What Hassan and Mano do not say is that a large risk premium would be highly plausible in this context. Japan is a net creditor nation and Japanese investors would require a higher expected return on the New Zealand dollar to take the currency risk of investing outside their country. At the same time, New Zealand is a net debtor country and borrowers there would pay a higher interest rate to borrow in their own currency than take the currency risk of borrowing in Japanese yen. It would be left to hedge funds and other players with substantial risk appetite to try and arbitrage this interest differential and earn the large risk premium on offer. Since the aggregate capital of these investors is quite small, the return differential is not fully arbitraged away.

Hasan and Mano show that empirically only the currency fixed effect is statistically significant. The time varying component of the uncovered interest parity violation within a fixed currency pair is not statistically significant. Nor is there a statistically significant time fixed effect related to the time varying interest differential between the US dollar and a basket of other currencies. To my mind, if there is no time varying risk premium to be explained, the forward premium puzzle disappears.

The paper goes on to show that the carry trade as an investment strategy is primarily about currency fixed effects. Hasan and Mano consider “a version of the carry trade in which we never update our portfolio. We weight currencies once, based on our expectation of the currencies’ future mean level of interest rates, and never change the portfolio thereafter.” This “static carry trade” strategy accounts for 70% of the profits of the dynamic carry trade that rebalances the portfolio each period to go long the highest yielding currencies at that time and go short the highest yielding currencies at that time. More importantly, in the carry trade portfolio, the higher yielding currencies do depreciate against the low yielding currencies. It is just that the depreciation is less than the interest differential and so the strategy makes money. So uncovered interest parity gets the sign right and only the magnitude of the effect is lower because of risk premium. There is a large literature showing that the carry trade loses money at times of global financial stress when investors can least afford to lose money and therefore a large risk premium is intuitively plausible.

Last month, the Permanent Subcommittee on Investigations of the United States Senate published a Staff Report on how hedge funds were using basket options to reduce their tax liability. The hedge fund’s underlying trading strategy used 100,000 to 150,000 trades per day and many of those trading positions lasted only a few minutes. Yet, because of the use of basket options, the trading profits ended up being taxed at the long term capital gains rate of 15-20% instead of the short term capital gains rate of 35%. The hedge fund saved $6.8 billion in taxes during the period 2000-2013. Perhaps, more importantly, the hedge fund was also able to circumvent leverage restrictions.

The problem is that derivatives blur a number of distinctions that are at the foundation of the tax law everywhere in the world. Alvin Warren described the problem in great detail more than two decades ago (“Financial contract innovation and income tax policy.” Harvard Law Review, 107 (1993): 460). More importantly, Warren’s paper also showed that none of the obvious solutions to the problem would work.

We have similar problems in India as well. Mutual funds that invest at least 65% in equities produce income that is practically tax exempt for the investor, while debt mutual funds involve substantially higher tax incidence. A very popular product in India is the “Arbitrage Mutual Fund” which invests at least 65% in equities, but also hedges the equity risk using futures contracts. The result is “synthetic debt” that has the favourable tax treatment of equities.

In some sense, this is nothing new. In the Middle Ages, usury laws in Europe prohibited interest bearing debt, but allowed equity and insurance contracts. The market response was the infamous “triple contract” (contractus trinus) which used equity and insurance to create synthetic debt.

What modern taxmen are trying to do therefore reminds me of Einstein’s definition of insanity as doing the same thing over and over again and expecting different results.

My colleagues, Prof Sobhesh Kumar Agarwalla, Prof. Joshy Jacob, Mr. Ellapulli Vasudevan and I have written a working paper on “Betting Against Beta in the Indian Market” (also available at SSRN)

Recent empirical evidence from different markets suggests that the security market line is flatter than posited by CAPM and a market neutral portfolio long in low-beta assets and short in high-beta assets earns positive returns. Frazzini and Pedersen (2014) conceptualize a Betting against Beta (BAB) factor that tracks such a portfolio. They find that the BAB factor earns significant returns using data from 20 international equity markets, treasury bond markets, credit markets, and futures markets. We find that a similar BAB factor earns significant positive returns in the Indian equity market. The returns on the BAB factor dominate the returns on the size, value and momentum factors. We also find that stocks with higher volatility earn relatively lower returns. These findings are consistent with the Frazzini and Pedersen model in which many investors do not have access to leverage and therefore overweight the high-beta assets to achieve their target return.

Like our earlier work on the Fama-French and momentum factor returns in India (see this blog post), this study also contributes to an understanding of the cross section of equity returns in India. Incidentally, the long promised update of the Fama-French and momentum factor returns is coming soon. We wanted to put the data update process on a more sound foundation and that has taken time. While the update has been delayed, we expect it to be more reliable as a result.

Last month, the Bank of England (BOE) published a Financial Stability Paper entitled “An investigation into the procyclicality of risk-based initial margin models”. After the Global Financial Crisis, there has been growing concern that procyclical margin requirements (margins are higher in times of market stress and lower in calm markets) induce complacency in good times and panic in bad times. There is therefore a desire to reduce procyclicality, but this is difficult to do without sacrificing the risk sensitivity of the margin system.

The BOE paper uses historical and simulated data to compare various margin models on their risk sensitivity and their procyclicality. Though they do not state this as a conclusion, their comparison does show that the exponentially weighted moving average (EWMA) model with a floor (minimum margin) is one of the better performing models on both risk sensitivity and procyclicality. This is gratifying in that India uses a system of this kind.

However, the study leaves me quite dissatisfied. First procyclicality is measured in terms of elevated realized volatility. Market stress in my view is better measured by implied volatility (for example, the VIX) and by measures of funding liquidity. Second, the four models that the paper compares are all standard pre-crisis models. Even when they use simulated data from a regime switching model, they do not consider margin model based on regime switching. Nor do they consider models based on fat tailed distributions. There are no models that adjust margins slowly to reduce liquidity stresses in the system. Finally, they do little to quantify the tradeoff between risk sensitivity and procyclicality – how much risk sensitivity do we have to give up to achieve a desired reduction in procyclicality.

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