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THOSE familiar with the Black and Scholes (B&S) model may know that it does not use
stock returns as a factor to price options. This is because the model is based on the
principles of replication and no-arbitrage. What are these principles?
2. The other day, I was looking at our household expenses and wondering where we could
cut costs. For almost always, we spend a lot on casual visits to the mall and then regret
the decision a week later. If you face a similar problem, neuroeconomics may help you
appreciate the cause for such spending. How?
3. INVESTORS are concerned about further rise in crude prices, as that would lead to
higher bond yields. What is the relationship between oil prices and bond yields?
4. BIRLA Global Finance has offered loans at 15 per cent per annum to high net worth
individuals who wish to buy units in Birla MNC Fund. Is there an economic justification
to borrow and invest in a fund?

4 A Last week, I had an interesting discussion with two gentlemen about people’s faith in
investment experts. If a professional money manager delivers higher-than-benchmark returns, we
immediately presume that he is more skillful than the other managers. Is he?

You may choose a mutual fund that has performed well in the last five years. But there is a good
chance that the fund will underperform the market in the future. Why?

5. INVESTORS want to know whether to buy puts or sell calls when they are bearish on a
stock. This article helps you decide by explaining the risks and returns for both strategies.

5 A THE Reserve Bank of India (RBI) has stated that interest rate futures should be used for
hedging purposes only. For a market to exist, we need both buyers and sellers.

But how can one market player buy futures for hedging, while another sell them for the same

6. XLRI Jamshedpur recently tied up with Riskmetrics, US, for risk management practice.
Riskmetrics made popular the concept of Value-at-Risk (VaR) in the late 1980s. What is
7. COMMERCIAL banks will have to reduce their lending exposure in the call market from
October 5. This is expected to reduce the carry trade in bonds. How?
8. What is catalaxxy?
9. A PROPERTY developer proposes to build an apartment complex adjacent to a chemical
factory. The hazardous waste disposed by the company will be unhealthy for the
apartment residents. The company should either shut shop or the developer should
abandon the project. Who will prevail?
10. CONSIDER this. Your friend asks you why Infosys trades at Rs 1,900. You explain that
a stock price reflects a company's "fundamentals". That is, the stock price is a function of
the company's revenues and EPS. Studies in behavioural economics, however, suggest
that we do not value goods (including stocks) based on "fundamentals". Instead, we
assign values based on a behaviour termed as Coherent Arbitrariness. What is this
11. Mumbai or Manhattan, traffic gridlocks are a way of life. Recently, my friend and I were
stuck for nearly an hour amidst a long line of cars and trucks on our way to the airport.
My friend wondered whether it would make sense for State governments to charge a fee
for using the arterial roads during peak hours. My friend belongs to a breed of software
engineers who understand every funny-looking electronic gadget in the town but are
woefully unaware of world economics. For what my friend commented is called
congestion pricing in economics. What is it?
12. NOT all portfolio managers do well in a market that is continually moving up. Those that
follow the constant-mix strategy tend to under perform relative to other strategies. What
is constant-mix strategy?
13. ALL of us are familiar with buy and sell recommendations given by equity analysts.
Often, we come across a "hold" recommendation. Some argue that such a
recommendation goes against the opportunity-cost principle in economics. Why?
14. THE crime rate in Bangalore may be going up. The motive behind the frequent thefts and
burglary, the murder of a software executive and the recent shootout at the Indian
Institute of Science may be different. Yet, there is some economic motive behind every
crime committed. What is the link between economics and crime?
15. NEWSPAPERS carried a report that gold prices rose sharply on Thursday, September 25,
primarily because OPEC decided to cut crude production. What could be the possible
linkage between crude oil and gold prices?
1 .Suppose you hold a stock at Rs 100. Assume that it can move by 10 per cent to Rs 90 or Rs
110 in one month. You sell one call option on the stock. If the stock moves to Rs 110, you will
lose Rs 10. Why? If the call buyer exercises the option, you will deliver the stock at Rs 100 even
though it trades at Rs 110.

If the stock declines to Rs 90, the option will expire worthless.

But you still lose Rs 10 on the stock that you are holding. You will, therefore, sell the call option
at Rs 10 to breakeven. So, if you hold a stock and sell suitable number of call options, you are not
exposed to the market risk.

This is the principle of replication. It does, however, make a difference whether the stock moves
by 10 per cent or 20 per cent. Higher the volatility, higher the option premium you will demand
because of higher risk. In the above example, why should the option sell for Rs 10 and not for
more or less?

Suppose the call option trades at Rs 15. You can buy the stock at Rs 100 and sell the option. If
stock ends at Rs 110, the option will then be worth Rs 10. So, you can buy back the option and
pocket Rs 5 as profit. Since the market is smart, it will price the option at Rs 10.

This is the no-arbitrage principle.

2. It appears that we are often tricked into buying products that we do not need. You walk into a
store and see rows of luxury products displayed prominently. Understand that these products are
placed at vantage points to prime your interests. And stores often succeed in their endeavour.

Craving for a reward

You may not buy the Gucci handbag because it is frightfully expensive. But the sight of the
handbag activates your Nucleus Accumbens (NAcc), the part of the brain that creates desire and
satiates your pleasure.

The more you desire a product, the greater is the activity in your NAcc. If you were kicked about
the Gucci handbag, the NAcc would be flooded with dopamine, a naturally-producing substance
in our brain that pleasures the reward system. High on dopamine, you end up buying some other
product that is less expensive but do not require! This is because your NAcc conditions you to
crave for a reward (buy products).

What causes pain

Of course, we will not always spend just because our NAcc is activated. The other part of the
brain that helps us complete a transaction is the insula. The insula causes pain when we look at
the price tag.
If we dump a product into our shopping trolley, it is because the NAcc trumped the insula. That
is, we should believe the reward from owning the product will be more than the pain we suffer
from paying for it.

Stores are aware of this war inside our brain. They dull the insula by prominently displaying
“bargains” and “discounts” across the stores. The result? We end-up buying a cart-load of
“bargain” goods that makes us regret the decision a week later!

3. When you invest in a bank deposit or bonds, the interest you receive is the compensation for
delaying your current consumption of goods and services.

Suppose you postpone your decision to buy a house and instead invest in a 5-year fixed deposit
paying 6 per cent per annum. What if property prices rise 10 per cent in 5 years? Your decision to
postpone current consumption would be costly.

So, if you are concerned about rising inflation, you will prefer to consume now rather than invest
in fixed deposits or bonds. If you do not invest, banks will not have enough money to lend to
businesses. That will hamper business expansion and affect economic growth. To make
investments attractive, interest rate has to compensate for inflation.

Now, petrol and diesel are consumed by all businesses. If crude oil prices rise further, the cost of
producing goods and services will also increase. That will, in turn, lead to higher inflation. And
higher inflation will prompt investors to demand higher interest rates.

Interest rates and bond prices are inversely related. If interest rate moves up, bond prices decline.
Why? Suppose a 10-year bond that pays 7 per cent per annum trades at Rs 100.

Assume that a rise in inflation forces the RBI to offer an interest of 8 per cent for new issue of 10-
year bonds. There will be no demand for existing 7 per cent 10-year bonds because it offers lower
interest rate. So, its price will decline to yield the market rate of 8 per cent. And that is a cause for
concern for bond dealers.

4. Suppose you buy units in the MNC fund for Rs 30, you will receive Rs 4, as the fund has
declared a 40 per cent dividend.

The NAV will, however, fall to Rs 26 due to the distribution of dividends. This means you will
receive Rs 26 if you redeem your units after receiving dividends, assuming there is no exit load.

The rationale to buy at a higher price and redeem at a lower price is to suffer capital loss and
claim tax deductions, while enjoying the dividend receipts.

This process, called dividend stripping, now requires that you hold the units for at least three
months to claim such tax losses.

But does it pay to borrow and buy units to receive the dividends? The problem is that you cannot
claim tax deduction for the interest on borrowings. This is because the dividend you receive from
the investment is tax exempt.
Your tax loss then will be modest because it only accounts for the loss in NAV value, Rs 4 in the
above example, assuming that the NAV does not increase from the dividend distribution date till
you redeem the units.

Thus, the benefit of the tax loss is lower than the interest cost you pay, which is not tax exempt.

And if you wait for the NAV to appreciate to cover for the interest cost, you may not be able to
claim considerable capital losses!

Of course, if you are able to prove that you used the borrowings for purposes other than earning
tax-exempt income, the interest paid can be claimed as tax deduction. And that may justify your
borrowing to invest in the fund.

4A Luck or skill

We do not know if that portfolio manager has beaten the market due to luck or skill. There may
be so many variables that would have made the fund successful. The manager’s investment
strategy need not be the only cause for it.

As one Hollywood executive put it, “If I had said yes to all the projects I turned down, and no to
all the other ones I took, it would have worked out about the same.”

Of course, if the portfolio manager were to manage money for a really long time, we will then
know if he has luck or skill. For it is argued that over the really long run, luck will run out and
only skill will remain. Statisticians call this process ergoditicity.

Hot-hand effect

Psychologists have long studied our behaviour to see pattern in seemingly random events. One
such study is the hot-hand effect. This essentially refers to the performance of a player during a
particular match being far better than his normal record. Researchers found that if a player were
to shoot three or four times in a row early in the game, the team would feed him through the
match, thinking he had a “hot hand”. The study, however, showed that players do not have a “hot

Behavioural economists argue that is the same with portfolio managers. This is not to say that
portfolio managers do not have skill. It is just that we may be unable to differentiate skill from
luck. Or as the Wall Street adage goes “Do not confuse brains with the bull market”!

5. Suppose you buy the August 3000 puts on Infosys, expecting the stock to fall from Rs 3,200.
While the puts will rise in value if Infosys falls from the current levels, they will rise sharply if
the stock falls below Rs 3,000. Why?

Buying 3,000 puts effectively means you can sell the Infosys stock for Rs 3,000 even if it trades
at Rs 2,800 in the spot market.

So, the puts will rise one point for every point decline in the stock below Rs 3,000. What if
Infosys stock moves up? Your maximum loss is the amount that you paid to buy the puts.
Suppose you sell the August 3400 calls instead. This effectively means that you will have to sell
Infosys at Rs 3,400 even if the price in the spot market is Rs 3,600!

Now, you will receive money for selling the calls. If the stock moves down, the calls will also fall
in value. You can increase your profits by buying back the calls at lower levels and closing your
short call position.

But as the stock price falls, call prices will fall at a slower rate. Why?

If Infosys falls to Rs 3,000, not many will be interested in buying the August 3400 calls, as these
calls will start generating huge profits only if the stock moves beyond Rs 3,400.

You will, however, incur huge losses if the stock moves up; for the August 3400 calls will also
rise in value. So, you will to have to buy the calls at a higher price to close your short position.

In short, risks are higher for selling calls even though the profits are not always higher.

5 A Consider this. As a bond portfolio manager, you typically run the risk of falling bond prices.
So, you take a short position (sell) in the futures market to hedge the portfolio. The objective is to
offset loss from the portfolio with gains from the futures position.

But who will buy from you? Since the RBI has stipulated that only hedgers can participate in the
market, it has to be an investor who runs the risk of rising bond prices. Why?

Remember, hedging means reducing the risk of your existing position by taking an opposite
position in another instrument.

So, if an investor buys interest rate futures as a hedge, it means that this investor's existing
position will generate losses if bond prices rise. Now, consider a portfolio manager who expects
to receive Rs 25 crore in October. He, however, expects bond prices to move up by then. This
means he will be able to buy fewer bonds with the Rs 25 crore he receives then.

He, therefore, runs the risk of rising bond prices. To hedge this risk, he buys interest rate futures.
This way, he actually buys the bonds at the current price. How?

Suppose the spot price of a bond moves up from Rs 110 to Rs 115 by October, the long futures
position will also gain Rs 5. The increase in the spot price is offset with the gain in the futures

This essentially amounts to buying the bond at the spot price of Rs 110

6 VaR is a measure of portfolio risk. Suppose the one-day VaR on your Rs 50-lakh portfolio is 2
per cent based on a 95 per cent confidence level. This means that in 95 out of 100 days, your
portfolio is likely to lose 2 per cent on a trading day. It also means that your portfolio can lose
more than 2 per cent in five of 100 days.

Some firms use 99 per cent confidence levels to be more certain of their likely portfolio loss.
Suppose the one-day VaR for a bank is 5 per cent on its Rs 1,000-crore portfolio. This means that
in 99 out of 100 days, the bank is likely to lose 5 per cent of Rs 1,000 crore on a single day. So,
the bank will have enough capital to support expected losses.

How is VaR computed? The simplest VaR model is based on the normal distribution.

Suppose you find that the standard deviation of daily returns on your portfolio is 5 per cent; that
is, your portfolio can move up or down by 5 per cent on any day. Since you are bothered about
losses on your portfolio, you have to find the area on the left side of the normal curve for a certain
confidence level.

You can find the value of the normal distribution in any statistics book. The left side area under
the normal curve for a 95 per cent confidence level is 1.65.

You have to multiply the portfolio standard deviation with 1.65 to get the portfolio VaR. This
VaR model is similar to the semi-deviation, except that the latter does not involve confidence

7 The call market is one where banks and primary dealers (PDs) borrow money for one day to,
typically, 14 days.

While banks mostly borrow in this market to meet their cash reserve ratio (CRR) requirement,
sometimes they do so to engage in bond trading.

Suppose the call rate is 5.75 per cent per annum, and the 2-year bond yield is 5.91 per cent. Bank
"A" will borrow at 5.75 per cent and buy the 2-year bonds. This gives the bank a 0.16 per cent
yield differential (or 16-basis-point spread).

A trade that gives such a positive yield differential is said to have a positive carry.

The reduction in lending limits in the call market means that banks and PDs should also look to
the repo market to borrow money to buy bonds.

This is a market where these players can borrow money by offering bonds as collateral.

Suppose Bank "A" borrows money from Institution "B" to buy 2-year bonds at Rs 109. The
agreement may be that Bank "A" will buy back the bond in one month at Rs 108.70.

The difference of Re 0.30 is the interest that Bank "A" pays Institution "B" for borrowing money.

But the repo market will discourage banks from engaging in carry trade. The reason is that banks
have to provide bonds as collateral for borrowing money.

Banks cannot, therefore, actively trade in these bonds unless they repay their borrowings.
Besides, there is the likelihood of losses as prices may fall when the lender holds these bonds.

In all, borrowing in the repo market is more restrictive than borrowing in the call market. This
may discourage banks to engage in carry trade.
8. Friedrich Von Hayek, for instance, argued that the market could evolve its own rules and
discipline as people come together to transact business. He called such self-organisation
"catallaxy". Most people, therefore, believe that the government should just frame policies,
allowing the market to transact business. These rules may work because they are unbiased. Just as
the traffic lights.

The Austrian school of economics is a strong supporter of free market.

9 According to the Coase Theorem, the property developer and the company will come to an
agreement that is economically efficient, provided the transaction cost is low. Ronald Coase, who
proposed this theory, won the Nobel Prize in economics in 1991 for this significant contribution.

Suppose the chemical company earns Rs 10 crore in revenue each year. Assume that the property
developer will generate Rs 5 crore in revenue from the housing project.

If the developer abandons the project, the Rs 5 crore in revenue will be lost. If the chemical
company is forced to shut shop, revenue of Rs 10 crore will be lost. Neither alternative is efficient
because that amount of economic activity is lost.

Now, consider this. The chemical company can invest Rs 1 crore to make the air less unhealthy
for the residents. Alternatively, the developer can invest Rs 0.75 crore to protect the residents
from pollution.

If the law favours the property developer, the chemical company will pay Rs 0.75 crore to the
developer to lower pollution. If, however, the law favours the company, the developer will bear
that cost. Either way, the most efficient alternative is chosen.

Ronald Coase argued that such an efficient outcome is possible if the transaction cost is low.
What if the transaction cost is Rs 30 lakh? Both parties may not negotiate. If the law favours the
developer, the company has to spend Rs 1 crore to make the air less polluting. And that means a
social deadweight loss of Rs 0.25 crore (Rs 1 crore less Rs 0.75 crore).

10. Professor George Lowenstein of Carnegie Mellon University coined this term based on a
series of experiments that he conducted with two MIT Profs. The basis of this experiment was the
1974 study by behavioural psychologists Kahneman and Tversky.

These psychologists spun a wheel of fortune with numbers ranging from 0 to 100. The subjects
were asked if the fraction of African countries in the UN were less or more than that number. The
subjects used the number spun on the wheel as the reference to guess the answer!

Lowenstein and his co-authors similarly provided some reference values to their subjects and then
asked them what compensation they would require to hear an unpleasant sound for certain
duration. The subjects quoted arbitrary values linked to the reference values.

The professors then asked the subjects the price they would want for longer duration. The
subjects quoted values that there consistent with the initial price. That is, if a subject demanded
Rs 100 for one minute, she demanded Rs 200 for two minutes.
As the initial price is arbitrary and the subsequent price consistent with the initial price, the
behaviour is termed coherent arbitrariness.

Economists argue that we buy stocks the same way! Your decision to buy Infosys at, say, Rs
1,900 may be arbitrary, while the subsequent buy/sell decisions will be strongly anchored to this

11Congestion pricing refers to a structure where prices increase during certain period to charge
the users for negative externalities. A negative externality occurs when a transaction or an event
incurs costs for third-party.

Negative externality

Driving a car on the road causes negative externality for two reasons. One, it causes pollution
which damages the environment and causes health problems for all. And two, it causes traffic
gridlocks, leading to wasted time and frustration for the road users.

Congestion pricing is about charging higher fees for using the road during peak hours — exactly
what my friend mentioned.

William Vickerey who won the Nobel Prize in 1996 first proposed congestion pricing for the
New York subway. Congestion pricing is now part of the road system in Singapore and London.

Traffic gridlocks

It makes sense to introduce such a system in India too. At present, our government is busy
building more roads and freeways. While newer roads will increase the traffic speed, it could
eventually lead to more negative externality! Perverse as it may seem, freer roads will prompt
more people to use cars. And more cars will lead to more gridlocks leading to greater negative

Traffic congestion has become an integral part of urban economics. Economists who are
mathematically initiated use laws of fluid dynamics to understand traffic flows!

Physicist-economists can help us balance infrastructure development and negative externalities.

Using congestion pricing and converting some roads into pedestrian walks could discourage
unnecessary use of cars.

12 Suppose you have Rs 1 lakh to invest. You decide to put 60 per cent in stocks and the rest in
bonds. Your objective is to maintain this mix of stocks and bonds through the life of the portfolio.
This form of investment is called constant-mix strategy.

Why does this strategy under perform when the market is moving up? Assume that the stock
market declines by 10 per cent. Your stocks will now be worth only Rs 54,000 (90 per cent of Rs
60,000) and your total portfolio, Rs 94,000.

This means that stocks constitute only 57.5 per cent (Rs 54000/94000) of the total portfolio. To
increase it to 60 per cent, you will naturally have to buy more shares. You will do this by selling
required amount of bonds that you bought earlier.
But what if the market moves up by 10 per cent? Your stocks will now be worth Rs 66,000 and
your total portfolio, Rs 1,06,000. That means stocks now constitute 62 per cent of the portfolio
(Rs 66,000/1,06,000).

To reduce it to 60 per cent, you will have to sell shares and buy more bonds. This is precisely the
time you should be holding more shares so that you can profit from the increase in prices. That is
the reason the constant-mix strategy under performs when the market is moving up.

This strategy, however, delivers good returns when the market moves up and down.

It is for this reason that some portfolio managers prefer this to a simple buy-and-hold strategy in a
volatile market.

13 Suppose you decide to invest Rs 1 lakh in Bata India at Rs 100 per share. The brokerage-house
through which you trade gives a "hold" recommendation on the stock. It essentially means that
the stock is not worth buying now. Perhaps, the analyst believes that the stock may not move up
substantially from the current level.

Economists argue that if you will not buy a good now because of its price, you should also be
prepared to sell if you own the good.

Assume that you bought Bata India at Rs 70 per share. Suppose the analyst expects the stock to
move to Rs 125. If you sell now, you will forego a likely gain of Rs 25 per share (Rs 125 minus
Rs 100).

But selling now fetches Rs 1 lakh that you can invest in another stock. Suppose you invest in
Archies Greetings at Rs 100 per share, and the stock moves to Rs 140. The additional profit that
you gain (Rs 40 less Rs 25) is the opportunity cost of holding Bata at the current level.

Is this argument not powerful? Of course, it assumes that you have invested all your money.
Otherwise, a "hold" recommendation may still be valid. Why?

Suppose you also have Rs 1 lakh in your savings account. You might as well use that cash to buy
another stock. For, interest on savings account will be lower than the return you can earn by
holding Bata. Either way, it is clear that opportunity cost is important to manage your portfolio.

14. The reward for committing burglary is the proceeds received from the sale of the stolen
articles. The reward may be non-monetary too. The terrorists may, for instance, demand the
release of their fellow terrorists held in prison.

What about the costs of crime? If a person is not a burglar, he may be engaged in some gainful
employment, perhaps, earning Rs 10,000 per month. The cost of engaging in a crime is the
opportunity lost in earning Rs 10,000 a month.

Of course, the opportunity cost is low for criminals. If a person can earn a decent salary, why
would he engage in criminal activity? Which brings us to the second and the most important cost
of crime — punishment. If a criminal is caught, he may be jailed.
So, just like you weigh the pros and cons before starting a business or taking up a new job, a
criminal will also weigh the costs and benefits before engaging in unlawful activity.

Consider a person who does not buy a ticket in the local train. The cost of the crime is the fine
levied if caught by the ticket inspector. The reward is the money saved by not buying the ticket.
A person will commit this crime if he believes that the benefits far outweigh costs. Criminals in
Bangalore may be no different.

15. When OPEC cuts production, crude price moves up. This will increase the input cost for
companies using petroleum products as intermediate goods. As a follow-up action, these
companies will hike their product prices to protect their margins. If all companies follow suit, the
country that imports crude oil will witness increase in general price levels.

Such an increase in the price of goods and services because of a jump in input costs is called cost-
push inflation. When inflation rises, stocks and bonds typically decline in value. Why? Banks
may have to pay higher interest to the depositors to compensate for the rise in price levels. In
turn, banks, to protect their margins, may demand higher interest on loans to companies. Since
bond prices and interest rates are inversely related, bond prices will decline if interest rates move

Similarly, stock prices typically decline when inflation increases. This is because the quality of
earnings during high inflation is perceived to be lower. So, investors tend to give lower price-
earnings multiple to stocks during this period. With stocks and bonds likely to move down,
investors are left with few investment avenues. Now, gold is typically considered a hedge against
inflation. This means that gold price rises if inflation increases. Perhaps, in anticipation of a
possible decline in stocks and bonds due to the OPEC cut, investors started demanding gold on
Thursday. The spurt in demand may have led to higher gold prices.

The link suggested above may seem tenuous, considering that we are rationalising a one-day
movement in crude prices. But, remember, sentiment moves asset prices. And gold is no