I-Bhayankars!

Yesterday, my dad was elated when he got back from work. His former colleague had landed in Bombay for a few days to initiate his daughter into a high profile ibanking career. My mom, like all PR-specialist moms on earth, was scandalized that her son hadnt managed to get the most lucrative job on the planet. Trivial matters like the fact that this chick was gonna be at their equity research desk, or that she is getting paid less hold no significance whatsoever…

“dint they come to your campus??” as if that’s the only formality left for me to join the firm (leave alone attending the ppts, filling a zillion page form and beating 119 other smart asses to the job…) As a friend at my engg college described me to the fresher girl both of us were hitting on, a face like that of a constipated gorilla doesn’t help at the interview either!

This i-bank craze is something I will never understand. Nobody really knows what an i-bank does. But everyone wants a piece of the action. A few days back, I was having pav bhaji with a lady… any hopes of a second date were blown when she asked me how many ibanks came to our campus!!! Can u believe it? as if that was the only topic to discuss!! Just go to any of those pre-mba forums like pagalguy…. Everyone has decided that ibanking is the career for them! Well, if you cant beat the crowd, join it! so I keep telling my less informed friends and family that I have an ibanking role in a normal bank… whatever that means….

Being a banker means we buy the ET everyday and fold it neatly under our armpits, even if we don’t understand a thing of what is written there. First of all, I’d like to find the smarty pants who decided the paper shouldn’t be white… How else would you be able to spot a banker in the stiffling mumbai local train, that has more people per sq cm than the mosquitoes in Kochi? As they say, ET is more a part of the uniform rather than anything else… half of it is full of tables on the stock and commodity exchanges. They always use a font size smaller than the one we use to put our GPAs on our resumes!

Empirical research has shown that:

20% of the crowd is too old to read this tiny font
20% is too senior up in the organization to read up prices of individual stocks
20% are stockbrokers who monitor the prices real time on the ticker and so have no use for the stale news
20% are bschool students who just want to show their colleagues that they are majoring in fin
the remaining are final year engineering students who want to show their colleagues that they are so unemployable after engineering that they are being forced to take up an MBA.

Okay, granted that the empirical research quoted above is like the one these business magazines use to rank bschools..... with a sample size of 5 ensuring that the percentages and descriptions are as accurate as a Zaheer Khan yorker... But the point here is that those pages full of tables are not there because someone reads through them, but because it is sacrilege to have a business newspaper without stock prices on them! In the words of one of my HR graduate friends, “Doesn’t the futility of it all strike you?”

Moms calling me for lunch….I’ll finish off with a slew of new PJs keeping up with the sentiment of this post….

Q: why should boyfriends beware of i-bankers?
Ans: Because they specialize in hostile takeovers!

Q: Why do investment bankers remind you of pimps?
Ans: Both make their money by taking their clients public

A Sequel to Cognitive Finance

Cognitive finance contends that investors’ motivation to buy/sell at the stock market is a function of three things:
* Logic (as per the Rationalists, the mathematics people)
* External Environment (as per the Behaviorists, the non-numbers people)
* The emotional brain (as per the…well, BMmers interested in OB)

I left the reader at this point in my blog,
Cognitivists……..the third gang of finance??

There are some things that have occurred to me since then. At this point, I’d like to thank the authors of “Why Men don’t listen & Women cant read maps” for filling in a few gaps. It is obvious that these three aspects are not mutually exclusive. Forget the fact that they act in concurrence to determine our reactions to any external stimuli. The second aspect also has a great influence on shaping the emotional brain.

Let me explain…Since the days of yore, great social scientists like Aristotle and Descartes have advocated the duality of brain. Our brain, just like a computer, has both a software part and a hardware part….Now, when I mentioned the emotional brain in my last blog, I might have given the impression that it is purely the hardwired part I am talking about.

Biologists have long claimed that it the the neural structure that determines how we react to situations, why men and women behave differently. Damasio (1994) conducted a study among mentally challenged people. He then compared them with more privileged people, and said that lesser neural activity in this part of the brain is responsible for this particular shortcoming in decision making…But this reverse engineering technique only offers a partial view at best.

In addition to the neural structure of the limbic brain and the amygdala, our reactions are also shaped by the software installed in them. This is precisely where cognitivists come into the picture. Several neuroscience techniques have evolved to substantiate these findings. There are several theories that concern cognitivism. They may be grouped into three generations

* Appraisal Theories
* Cognititve Architectures
* Self Regulation models

We can use the last and the latest version here….that of self regulation. It goes something like this…. Suppose this guy buys100 shares of company XYZ. Sensex rises, stock price of XYZ also rises, maybe lesser because beta is lesser than 1. This chap doesn’t even know there is something called beta… But continued exposure to the effect of Sensex on his share price conditions him to the fact that when sensex rises, my stock will rise but to a lesser extent.

Take another case. Mumbai bomb blasts… this may be captured by the rationalists by conducting event studies… Say immediately after the first blasts (when was it, 1991?), share prices fell. This chap sold shares and when the stock returned to its normal values three days later, he realized he had suffered huge losses…Now the software part of the brain compares the result of the whole sequence to his long term goals and his individual perception of success…. If his perception of being successful is to become rich, then obviously there is a mismatch between losing money and being successful.

Self regulation theory says that the external stimuli (bomb blast), this guy’s reaction to the external stimuli (selling shares) and the result of the sequence (mismatch with long term goals) are fed back into his brain. This is some kind of a learning experience. The next time stock market crashes, his behavior will depend on the external stimuli (as claimed by the behaviorists), but also by the long term learning that has occurred to him. The behaviorist school of thought ignores this aspect, calling for a more integrated view.

It has puzzled many people why experienced professionals perform better than more intelligent Ivy League fresh MBA recruits. This whole explanation provided by the theory of self regulation might come in handy! The experienced people are consciously ignorant that this principle exists. But continued exposure causes their subconscious to be aware of the effects of this principle!!! Something like how people felt about gravity before it was discovered by Newton….

The Macroeconomics of Sport

"Ater he and his team successfully bid for the 2010 Commonwealth Games Indian Olympic Association President Suresh Kalmadi has now set his sights on bringing the 2016 Olympic Games to New Delhi.".... so blared the headlines one fine morning...

As always, it evoked mixed responses....A political party was screaming for his neck.. What was the need to spend so much on matters of trivial importance like Commonwealth Games and the Olympics, when millions are battling far more grave problems like hunger and poverty? Yet another group was buoyant... This will put our country on the world map! Millions of foreign tourists will visit our country and spend their money here, buying our products..

To confess, I was on the skeptical side. Forget the fact that it has been a long time since we won even a single Olympic gold..... Does the huge investment demanded by mega events like Olympics and Commonwealth actually make sense? We could conduct a simplistic event study to verify using emperical evidence whether hosting the Olympics has had any significant bearing on the GDP growth rate.

Event: Hosting the Olympics
Variable: GDP growth rate (pre-event vs post-event)
Time window: +/- 3 years

Here, we have taken the growth rate as the variable because it takes care of scale effects. Thus, while computing the average results across all hosting countries we can assign equal weightages to all of them.

The results of this study are startling!!! We see from the table that in fact, hosting the Olympics is a huge liability. It retards GDP growth rate by 0.07% We can observe from the table that this is in fact a conservative figure. By excluding the US from the table, the GDP growth actually slows down by a much larger rate of 0.76%.




We could also conduct a similar study for an event on a much smaller scale - The Cricket World Cup. The results we obtain in this case are totally contradictory. We can see a net benefit of 0.43% for the host country, on an average...

What are the causes for the above observations? I wouldnt dare to offer an explanation....
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References : http://en.wikipedia.org/wiki/Event_study (Event Study)

Cognitivists……..the third gang of finance??

The world of finance is increasingly being gripped by gang wars….Their turf? Market efficiency…. Its probably the most brow-beaten research topic in the field of finance…My hunch is that more than 80% of the PhDs walking on the world today should say thanks to it…. But most of the work in this field is deductive in nature…In the sense that they process some empirical data and draw conclusions from it as to whether markets are efficient or not…But if we were to follow an inductive approach, some new ideas might crop up… So here, we’ll piece together small building blocks and construct the factors that explain how the market moves….

Yeah, lemme introduce the gangs to you…the first, well…. They don’t have a name, but we’ll call them the rationalists…. They are the people who love math…and equations… they attempt to find the logic and rationale in everything… they claim markets are efficient….so that they can keep themselves busy by doing a lot of research and finding many more models (of the mathematical variety, not the fashion one.. just to set the record straight)….

Anyways, the second gang has the behaviorists…. They claim the markets are not efficient…. Again, probably they are not good at math…hmm… I better fit into this…This school of thought has its roots in social psychology… and contends that well, external factors are responsible for the behavior of a person…and this behavior ultimately affects the market in a non-rational sort of sense… something like there is a bomb blast or a terrorist strike… this instills fear in people… this fear causes them to be skeptical of markets in general…they sell shares…and stock prices fall… in this case, the external environmental factor (bomb blast) determines the behavior of a person….

If we pause and study the evolution of behaviorism as a school of thought in psychology, it evolved because the psychologists of yore spent too much time brooding inwards, studying childhood experiences and attempting to rationalize the thought process…. This frustrated a lot of people because in this process, they never found the answers they were looking for….what motivates people to act the way they do? Championed by psychologists such as John B. Watson, Edward Thorndike, and B.F. Skinner, behaviorists argued that psychology should be a science of behavior, not the mind.

However, it became increasingly clear that although behaviorism had made some important discoveries, it was deficient as a guiding theory of human behavior. Noam Chomsky demonstrated that language could not purely be learned from conditioning, as people could produce sentences unique in structure and meaning that couldn't possibly be generated solely through experience of natural language, implying that there must be internal states of mind that behaviorism rejected as illusory. Similarly, work by Albert Bandura showed that children could learn by social observation, without any change in overt behavior, and so must be accounted for by internal representations.

This takes us to something that I’d like to name cognitive finance…. Put together the rationalists and the behaviorists…and throw in a new chota mota gang…and lo! We have a new school of thought!!! Lemme explain…. See, who make up the markets? It’s the people.. right? Now, when people determine the stock price in a free market, it makes sense for us to study their motivations…. Why they act in a certain way….for this we study their brains…

Human brain has 3 parts…first, the primal brain….which is present in all animals….this gives us our survival instincts…second, the emotional brain or the limbic brain… this explains why we act irrationally when we get emotional…and the last part is the neocortex, or the thinking brain…the behaviorist school of thought contends that man’s behavior is driven by external factors…yes, but this is a highly incomplete view…the way the human brain perceives and process these external stimuli is equally important…. The rationalists seem to think that the neocortex is the sole driver of human actions…but men are not robots… there are two more brains that drive human behavior which need to be taken into consideration…here comes in the cognitive school of thought…

Finance is an art…studying it will be a lot more fun if we were to adopt this integrated model, rather than just focus on one of the factors which drive the market….
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References:
1. Brealey Myers - The Principles of Corporate Finance (7th ed) Pg 347 for market efficiency
2. http://en.wikipedia.org/wiki/Psychology#Cognitive_psychology for the evolution of behaviorism
3. Daniel Goleman - Emotional Intelligence Pg 10-14 for the structure of the human brain

Culture - The sculptor of Financial Structure?

USA and Japan are the two largest economies in the world today. Have you ever wondered why one has a predominant market centric economy and why the other is dominated by its banks? Why do countries differ so drastically in the configuration of their financial systems? Read on…

In modern economies, financial systems play a major role in allocating scarce resources. They help channel household savings to the corporate sector and allocate investment funds among companies. When these companies make profits, the system also helps funnel some of the returns back to the individual savers. But financial systems in different countries have evolved in different ways in serving this function in the nation’s economy. My contention here is that the culture prevalent in the country plays a major role in this evolution.

Culture is the software of the mind, shaped and reinforced by our daily interactions, education, friends, upbringing, religious beliefs and other factors. Philosophers like Aristotle and Descartes have believed in the concept that every individual has patterns of thinking, the software of the mind, which he picks up during the course of his lifetime. This explains for example, the differences in behavior of a Chinese man and an American woman at a party. Based on a study conducted for IBM in 72 different countries, Geert Hoefstede has identified five dimensions, or differences in mental programming. For want of a quantifiable measure of culture, I will be falling back on this model particularly the Uncertainty Avoidance dimension. I conjecture that countries with stronger uncertainty avoidance as a cultural dimension are more likely to be associated with a bank-based financial system.

A quick literature review throws up two broad alternate explanations for the disparity of financial systems across countries: legal-system (Rajan & Zingales 1998, Boot & Thakor 1997) and risk-reduction (Allen & Gale 1997). However, these two explanations are not mutually exclusive. The former theory contends that markets require supporting enforcement mechanisms in the form of strong laws. Where laws are weak, banks arise to internalize the transactions because they can enforce contracts extra judicially via their market standing. The latter theory argues that bank-based systems may have a comparative advantage in providing a better mechanism in smoothing financial risks over time. This article takes off from here by putting forward the idea that the culture of a country determines the extent to which people want their risks to be smoothened. Businesses emerge to satisfy people’s needs. Thus, it is but natural that in countries where there is a compelling need to smoothen financial risks, there is a lot of business opportunity for banks.

We can proceed to conduct a regression analysis of the Equity Market Capitalization / GDP ratio of the country with its UAI index. We take the EMC/GDP ratio in order to nullify the differences in the scale of the GDP. We note a significant standard error in this analysis. This indicates that there are other factors in addition to risk-reduction that explain the differences in financial structure. This supplements the existence of legal-based theories.We can now use this regression model to nullify the cultural aspects and then proceed to judge the legal climate of countries and its impact on the financial structure. We do this by estimating the best-fitting regression line. It was found to be

Equity Market Capitalization = { UAI * -0.004792991 + 0.912064436 } * GDP

Using this regression line, we can proceed to calculate the estimated market capitalization of each country using its UAI index. This estimation takes into account the cultural differences among countries. Hence, whatever discrepancy remains can be attributed solely to the legal climate of the country.

To take an example, our analysis shows that currently Japan has a EMC/GDP ratio of 0.66 and US has a ratio of 1.22. The discrepancy is to the extent of 0.56. After standardizing for cultural effects, the corresponding ratios are calculated to be 0.5 and 0.7. The discrepancy here is to the extent of 0.2. We contend that this 0.2 difference is on account of differences in legal climate of the two countries and the remaining 0.36 is on account of cultural factors.

In countries where the UAI index is high, the people are more risk averse and prefer to invest in safe avenues like fixed deposits. This leads to a higher lending to the industry. On the other hand, in countries like US where the UAI index is low, investors demand high returns and save in riskier assets like stocks. This leads to very well-developed markets, around which the entire financial system is structured.

We can observe these factors in India’s brief history. In the 1960’s, India was largely pro-Russia which has a UAI score of 95. India’s key industries were nationalized, and the nationalized banks dominated the financial landscape of the country. Compare that to the situation now, when India has very high economic and strategic alliances with the US. This cultural orientation has played a major part in the India that we see today, one where several key industries have opened up to FDI and one where investors flock to the stock markets. In fact, recently a research by Morgan Stanley has put forward the idea that reducing risk premiums have largely been responsible for the bull runs that we’ve witnessed in the recent past. Cultural factors??? Could be!!!
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this blog is based on some amount of quantitative data crunching.. dint put that here for fear of boring ppl out of this page... interested ppl can mail me for that....