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.

James Altucher narrates a fascinating story about how a guy claiming to be related to Middle Eastern royalty almost succeeded in borrowing $10 million from a fund manager against forged shares representing $25 million of restricted stock of a private internet company (h/t Bruce

To me the red flag in the story was that the borrower agreed without a murmur to the outrageous terms that the fund manager asked for:

  • 15% interest, paid quarterly
  • the full loan is due back in two years
  • $600,000 fee paid up front.
  • 25% of all the upside on the full $25 million in shares for the next ten years

Assuming that the loan is for all practical purposes without recourse to any other assets of the borrower because of the uncertainties of local law, all this can be valued using call and put options on the stock. The upside clause is just 25% of an at-the-money call option on the stock. The default loss is just the value of a put with a strike of $10 million. To discount the interest payments, we need the risk neutral probability of default which I conservatively estimate as the probability of exercise of the two year put option (In fact, the interest is paid quarterly and some interest payments will be received even if the loan ultimately defaults).

For simplicity, I assume the risk free rate to be zero which is realistic for the first two years, but probably undervalues the ten year call. To add to the conservatism, I assume that the volatility of the stock is 100% for the first two years (life of the loan) and drops sharply to 30% for the remaining life of the ten year period of the call option. Taking the square root of the weighted average variance gives the volatility of the call option to be 52%. Since it is an internet stock, one can safely assume that the dividends are zero.

Under these assumptions, the fund manager expects to lose $3 million (put option value) out of the $10 million loan, but expects to make $3.7 million on the call, $1.4 million in interest and $0.6 million upfront fee. That is a net gain of $2.7 million or 27%. If the short term volatility is reduced to 50%, the default loss drops to less than $0.5 million and the net gain rises to 52%. Even if the short term volatility is raised to 160% (without raising the long term volatility), the deal still breaks even.

If a deal looks too good to be true, it usually is. The fund manager should have got suspicious right there.

As an aside, forged shares were a big menace in India in the 1990s, but we have solved that problem by dematerialization. (It is standard while lending against shares in India to ask for the shares to be dematerialized before being pledged.) The Altucher story suggests that the US still has the forged share problem.

Andrew Odlyzko has an interesting paper entitled “Economically irrational pricing of 19th century British government bonds ” (available on SSRN) which demonstrates that more liquid perpetual bonds (consols) issued by the UK government often traded at prices about 1% higher than less liquid bonds with almost identical cash flows. Given that interest rates in that era were around 3%, these perpetual bonds would have a duration of well over 30 years. So the 1% pricing disparity would correspond to a yield differential of about 3 basis points. That is much less than the yield differential between long maturity on-the-run and off-the-run treasuries in the US in recent decades, let alone the differentials in the Indian gilt market.

In other words, contrary to what Odlyzko seems to imply, the 19th century UK gilt market would appear to have been more efficient than modern government bond markets! Odlyzko provides a solution to this puzzle. Most of UK consols in the 19th century were held by retail investors and very little was held by financial institutions. As Odlyzko rightly points out, this would substantially depress the premium for liquidity. Odlyzko argues that the liquidity premium should be zero because the stock of the liquid consols was more than adequate to meet any reasonable liquidity demands. I do not agree with this claim. The experience with quantitative easing since the global financial crisis tells us that the demand for safe and liquid assets can be almost insatiable. That might well have been true two centuries ago.

Today was another reminder that India still does not have a national stock market. The Indian stock markets are closed because Mumbai goes to the poll today. The country as a whole goes to the polls on ten different days spread over more than a month. Either the stock market should be closed on ten days or on none.

It is high time that the regulators required that the exchanges should operate out of their disaster recovery location when Mumbai has a holiday and most of the country is working. That would also be a wonderful way of testing whether all those business continuity plans work as nicely on the ground as they do on paper. But something tells me that this is unlikely to happen anytime soon

Two decades ago, we abolished the physical trading floor in Mumbai. But the trading floor in Mumbai lives on in the minds of key decision makers, and it will take long to liberate ourselves from the oppression of this imaginary trading floor.

The European Court of Human Rights (ECHR) has an interesting judgement (h/t June Rhee) upholding the human rights of those guilty of insider trading (The judgement itself is available only in French but the Press Release is available in English).

Though the fines and penalties imposed by the Italian Companies and Stock Exchange Commission (Consob) were formally defined as administrative in nature under Italian law, the ECHR ruled that “the severity of the fines imposed on the applicants meant that they were criminal in nature.”. As such, the ECHR found fault with the procedures followed by Consob. For example, the accused had not had an opportunity to question any individuals who could have been interviewed by Consob. Moreover, the functions of investigation and judgement were within the same institution reporting to the same president. The only thing that helped Consob was that the accused could and did challenge the Consob ruling in the Italian courts.

The ECHR ruling that the Consob fines were a criminal penalty brought into play the important principle that a person cannot be tried for the same offence twice. Under Italian law (based on the EC Market Abuse Directive), a criminal prosecution had taken place in addition to the Consob fines. ECHR ruled that this violated the human rights of the accused.

It is important to recognize that the ECHR is not objecting to the substance of the insider trading statutes and the need to penalize the alleged offences. The Court clearly states that the regulations are “intended to guarantee the integrity of the financial markets and to maintain public confidence in the security of transactions, which undeniably amounted to an aim that was in the public interest. … Accordingly, the fines imposed on the applicants, while severe, did not appear disproportionate in view of the conduct with which they had been charged.” Rather, the Court’s concerns are about due process of law and the protection of the rights to fair trial.

I think the principles of human rights are broadly similar across the free world – US, Europe and India. The judgement therefore raises important issues that go far beyond Italy.


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