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1. My friend travels to a nearby city for two days every week.

After several such trips, he


noticed a pattern in his taxi bills. He always ran a larger bill on Tuesdays than on
Mondays though he travelled to the same places on both days! A self-styled economist,
he reasoned that the difference was due to the effect of credence goods. What are
credence goods?
2. My friend's neighbour has, in the last six months, invested heavily in the oil sector,
especially in the companies located in Alberta. The reason? He read reports that oil prices
are likely to remain high and that all professional managers believe that the sector will
generate high returns in the next two years.
3. Consider this. My friend recently found a stock trading at Rs 100. He placed a limit order
at Rs 97.65. His order was not executed as the stock moved to Rs 115. He refused to buy
the stock at that price even though the profit potential was good. Studies on "affective
forecasting" throw some light on my friend's behaviour. What is affective forecasting?
4. COMPANIES in India declare dividends this time of the year. Those familiar with the
Modigliani-Miller (MM) proposition know that investors should be indifferent to
receiving dividends. But companies do declare dividends. So, what accounts for this
corporate phenomenon? Behavioural finance provides an answer to the question.
5. THEORETICALLY, closed-end funds ought to perform better than open-end funds. The
reason: Portfolio managers of closed-end funds have better control over their
investments, as such funds do not suffer from continual purchases/redemption of units.
Yet, open-end funds are more popular. Why?

6A WE make decisions based on some reference point. Behaviour finance professionals term
this as the "anchoring" effect. What is anchoring?Suppose you decide to buy a second-hand car.
A well-trained salesman who attends to your needs may initially quote a price that may appear
high. Why?

6. MORE information can sometimes confuse when it comes to stock picking. Studies in
behavioural finance show that people who pick stocks based on "recognition heuristics"
can successfully outperform informed investors! What is recognition heuristics?
7. IN THE recent Credit Policy, the RBI Governor suggested that the central bank might
introduce a "when-issued" market in consultation with the government. What is a when-
issued market?
8. YOU may have noticed a street full of shops selling only, say, paper and related products,
or a road with just cinema theatres. Have you ever wondered what drives such behaviour?
9. A corporate trainer I met recently shared a not-so-surprising experience. He said he was
comfortable training clients he did not know than he was training people who were his
friends. This effect is contrary to the home-crowd advantage that drives some football
teams to perform well. What compels some to do well in front of a crowd and others to
falter?
10. It is really difficult being a HR manager or a supervisor in charge of a team. You may
carefully promote people who have performed well in their current roles only to see their
efficiency slump after the promotion. Why do people perform poorly after a promotion?
Can economics provide a solution?

10 A Consider this. Your friend tells you that he bought his dream car with the profits he made
from trading in the stock market. This encourages you to dabble in the markets too.Your
portfolio, however, declines 25 per cent. Will you blame ill-luck or worse still conclude that your
friend was just lucky? If you do, you are not alone. Some of us always consider ourselves
unlucky and others lucky. Why?

11. A RECENT news report stated that traders take advantage of the arbitrage opportunities
between the NSE and the BSE. What is arbitrage?

11 A The 2006 Nobel Peace Prize was recently awarded to Professor Muhammad Yunus, the
founder of the Grameen Bank in Bangladesh. He pioneered micro-credit lending to the poor
without any collateral. His business throws more light on the economics of trust. What is it?

12 My friend considers himself an unlucky equity trader. Half the time, his buy/sell orders do not
get filled.

He always places an order at a price, a whole number, which is more than the current market
price if he is selling, or lower than the current price if he is buying. His orders do not get executed
because of the psychology of prices. What is this?

13 MUTUAL funds often claim to outperform the market index. But comparing a fund with a
market index is not always correct. Why?

14. My friend and I were recently watching a recording of the 2006 World Cup Soccer
quarterfinal between England and Portugal. My friend loves to watch England lose, as it did in
that match against Portugal. But what has soccer got to do with economics?

15. SEVERAL floating rate bond funds have been launched lately. Why are such funds in
demand?

16. AS INVESTORS, we typically lengthen our investment horizon when faced with losses.
Suppose you buy, say, Arvind Mills at Rs 80 hoping to sell when the stock moves to Rs 100. You
intend to hold the stock for one month. At the end of this period, the stock trades at Rs 60. What
would you do? Chances are you will extend your time horizon! Why?

17. SMARTMONEY.COM recently carried an article on stock picking based on the price-to-
earnings-growth rate (called PEG ratio). What is the PEG ratio?

18. CONSIDER this: You observe that the December (near month) Nifty 1640 calls trade at Rs
28 per option, and the January Nifty 1640 calls (farther month) trade at Rs 65 per option. You
buy the January calls, and simultaneously sell the December calls to reduce your cost; your net
outflow will be Rs 37 (Rs 64 less Rs 28) per option. You have constructed a long-time spread.

19. YOU may have noticed advertisements from consultants who offer you government bonds
that pay interest as high as 11 per cent. Beware! The actual returns on such bonds will be
substantially lower. Why?

20 BUSINESS LINE recently carried a report on banks charging penalty for prepayments of loans.
The banks do so because they run a re-investment risk from such prepayments. This is the risk of
having to re-invest the proceeds at a lower rate.
21 AN EXPERIMENT in the area of financial economics shows that sometimes our behaviour is
similar to that of the birds. No wonder we are sometimes accused of being bird-brained!Involving
hungry pigeons, the experiment documented that the birds prefer smaller quantities of food
immediately to larger quantities in the future.

1. Suppose you visit a doctor with a stomach problem. The doctor also advises you to undergo a
surgery for tonsils. What do you do? Chances are, you will go with what the doctor tells you.
Why? You decide that the doctor knows better . The doctor's service is an example of credence
goods. These are products and services that you buy in good faith because the service provider
has more information about your need than you do.

How does this explain my friend's experience with taxis? Though my friend visits the city
regularly, he is so engrossed in conference calls on his Blackberry that he does not know the
routes to his destination. He is at the mercy of the taxi drivers (read credence goods).

But why the difference in taxi fares on Mondays and Tuesdays? Most executives in the city are
usually coping with a hang over on Monday mornings and, therefore, prefer not to drive to work.
So, the demand for taxis on Mondays is higher. There is, therefore, no incentive for taxi drivers to
take naïve passengers on an unnecessary tour of the city.

On Tuesdays, the executives are sober enough to drive their own cars. And as demand for taxis
go down, the incentive for taxi drivers to cheat goes up.

2. Think about it. As more people buy oil stocks, its prices will go up sharply till one day
everybody thinks the sector is "overvalued." And that would be the beginning of the decline of oil
stocks. The neighbour's behaviour to imitate the actions of money managers and other investors is
not different from a similar behaviour documented in sociology. It is called the Werther effect.

Johann Wolfgang von Goethe wrote a very popular book The Sorrows of Young Werther in the
1770s. The book is about a young man who kills himself, having been depressed about failed
love. The book prompted many young men in Germany to imitate the Werther suicide.

David Phillips, a sociologist, coined the term "Werther effect." His studies, since the 1970s,
showed that a well-publicised suicide led to an increase in suicides in the general population.
Similarly, people are more likely to exhibit aggressive behaviour after watching a violent movie.

The Werther effect refers to mimicking highly publicised destructive behaviour, but can be
extended to attention-grabbing actions.

The neighbour wanted to imitate many others who were investing in the oil sector. His behaviour
exemplifies that of a momentum trader. Such people attempt to catch on to a trend in the market
— the Werthers, if you can call them that!

3. It refers to forecasting our feelings in the future. Studies have shown that we tend to
overestimate our feelings for future events.

Suppose you believe that having Rs 10 crore will give you happiness. You win a lottery and you
find that having the desired money does not bring you happiness! This feeling is popularly called
as "Wombassa" — What you think you are going to get, and what you don't get, when you get
what you want.
One reason we suffer from Wombassa is "focalism." That is, we only think about how that
particular event will impact us and not about other events that may happen then to reduce our
happiness or cause pain. After your lottery win, some unexpected expenses may occur that may
rob you of your happiness.

My friend thought that buying the stock at Rs 115 would make him regret his decision of not
buying at Rs 97.65. So, he did not buy the stock. But what if he had got an inheritance from his
great-grand aunt just after he bought the stock at Rs 115? Surely, the joy from the inheritance
would overwhelm the feeling of regret. Of course, it is very difficult for us to foresee such events.
Yet, researchers arefinding out how affective forecasting will lead us to make better decisions.

4. Suppose you hold 500 shares of Company "X". Assume that the company paid Rs 10 per share
as dividends last year, but has decided to skip the payout this year. Had the company maintained
Rs 10 per share as dividends, you would have received Rs 5,000 (Rs 10 per share times 500
shares) this year.

You had decided to buy a Nokia handset with the money received as dividends. Now that the
company has not paid dividends, what do you do? MM argue that you will sell enough shares of
Company "X" to generate Rs 5,000 to buy the Nokia handset. In other words, you will create
"home-made" dividends. So, MM argue that dividends are irrelevant.

But investors do not react that way. Dividends, hence, become relevant. Why? The reason is to do
with regret theory. What if the stock price of Company "X" moves up after you sell some shares?
You will no doubt regret having sold the shares for a lower price.

The regret you feel buying a Nokia handset with "home-made" dividends does not exist when you
use the money received as dividends from the company. Why? The decision to sell shares to
create "home-made" dividends is your responsibility. So, when the stock price moves up, you
experience regret. Receiving dividends from the company does not carry such responsibility.
There is, hence, no regret.

Investors do not, therefore, consider "home-made" dividends as a substitute for dividends paid by
the company. This is, perhaps, one reason why companies continue to pay dividends.

5. You invest in a closed-end fund. The fund's performance is not satisfactory. So, you sell the
units in the secondary market. Unfortunately, closed-end funds typically trade at substantial
discount to their net asset value (NAV).

You would, therefore, prefer to invest in an open-end fund because units can be redeemed at
NAV. Your choice has its costs.

The portfolio manager has to invest in short-term instruments to adjust the cash inflows/outflows
from purchases and redemption of units. The returns earned on these instruments are lower than
that on stocks or bonds. This lowers the total returns.

But suppose investors prefer closed-end funds because returns are attractive after adjusting for
these costs. Fund-houses will then have to launch only closed-end funds.
Now, some portfolio managers will be superior to others. The professional fee that portfolio
managers receive is a function of the total assets they manage. It is, therefore, in the interest of
these superior managers to shift from closed-end to open-end structure. Why?

An open-end fund structure is a positive signal to investors that these managers can handle the
cash inflows/outflows without comprising on fund returns. That is, the investors can enjoy high
returns as well as easy exit options.

Naturally, the investors will buy more units of these open-end funds. That means more fees for
the portfolio managers. Obviously, other closed-end funds will be forced to follow suit.
Otherwise, they may lose out on business. These two reasons, perhaps, explain why we have
more open-end funds today.

6A. It is easier for the dealer to sell the car if he later brings down the price from, say, Rs 1.5 lakh
to Rs 1.25 lakh. As a consumer, you will typically relate the final price to the one that was quoted
first. And chances are you may pride yourself for bargaining with the dealer. Your decision-
making is "anchored" to the price quoted first.

Some portfolio managers take advantage of "anchoring" to buy/sell stocks. Suppose a company
recorded 20 per cent earnings growth last quarter. We may expect a similar growth rate this
quarter as well.

But what if the company actually reports a 40 per cent growth in earnings? We may initially
brush aside this growth rate as temporary, based on our "anchor" rate of 20 per cent.

In other words, we under-react to the information. This provides smart portfolio managers a
chance to buy the stock cheap before the market realises the under-reaction.

Anchoring is essentially a mental shortcut (or heuristic) we adopt for taking decisions.
Kahnemann and Tversky first recorded this effect in 1974.

It is perhaps also the reason we have "support" and "resistance" levels for stocks. Suppose you
buy Infosys at Rs 2,500, and the stock thereafter moves to Rs 2,800 but immediately declines to
Rs 2,550. The next time the stock moves to Rs 2,800, you and I are likely to sell our holding. The
reason is that we are "anchored" to the previous stock behaviour.

6. Suppose you want to buy orange juice. You would most likely choose a brand that you are
familiar with. That is recognition heuristic or simply mental short-cut. It refers to the signal
triggered by our mind to pick a recognised option over an unknown one.

Only people who are "beneficially ignorant" can apply recognition heuristics. If you were familiar
with all the brands of orange juice, you will obviously not apply heuristic. Similarly, if you were
not aware of any brand, there would be no recognition at all.

So, how can recognition heuristic be applied for stock picking? Suppose your friend is provided a
list of 30 stocks and asked to pick five. Being "beneficially ignorant," he will pick stocks of five
companies she knows by name.
Studies show that stocks picks based on recognition heuristics beat actively managed portfolios.
There is a logical explanation for this. The study was conducted when the market was moving up.

Typically, large companies that form part of the index tend to do well in a market rally. And
chances of picking such companies based on recognition heuristic are very high. Why? When we
are "beneficially ignorant," we recall the names of the companies that are leaders in their
business. And such companies form part of the market index.

What about market downturns? You can still employ recognition heuristic. But this time, you
simply pick stocks that are unknown to you! For such companies, being smaller, typically do not
decline as sharply as the index. Behavioural economists call such application of heuristics as
"ecologically rational".

7 Suppose the RBI is planning to sell 10-year government bonds. A when-issued market is one
where trading takes place in that bond before the issuer sells the securities in the primary
market.A when-issued market is very active in government bonds in the US. Why have a when-
issued market? Government bonds are typically sold through auctions conducted by the RBI. This
is not like the book-building process that we have for stocks.

In a book-building process, you are aware of the bids at various price levels. This helps you
decide whether to apply for the shares at a particular price. Bond auctions are, however, not
transparent. That is, one bond investor does not know the price at which the other is bidding. This
leads to a condition called a winner's curse.

If an investor quotes a high price, she may be allotted the bonds bid for. But what if the bonds
trade at a lower price in the secondary market? The investor actually losses though she was
successful at the auction. So, what do the buyers at the auction do? They do not quote a high price
lest they should suffer from winner's curse. But, that is bad for the government! If the buyers do
not quote a high price, the government's borrowing cost will increase.

A when-issued market helps in this regard, as the RBI (the auctioneer) gets an idea of what the
market is willing to pay for the bonds. And that helps the central bank set an optimal price for the
issue.

8. Economists have studied such behaviour by observing ant groups! Suppose you drop lumps of
sugar in two adjacent areas. If you are a student of statistics, you may expect the ants to divide
themselves between the two food areas. This is because there is no reason why ants should prefer
one food area to the other.

But you may be surprised to find that the train of ants moves toward only one food area. Why?
The behaviour of individual ants influences the group. The first ant may randomly choose one
location. Its decision may influence others that follow.

Such behaviour is said to have "positive feedback". This essentially means that an initial action is
magnified many times over. The choice of the first ant, the initial action, resulted in a train of ants
following suit, which magnifies the initial action.

You and I are not very different from the ants. Suppose you decide to buy an audio system, but
are uncertain about the brand. You are most likely to buy the brand your friend has. You are,
therefore, influenced by the choices of other people, just as ants are. Economists study such
behaviour as part of the interacting agent models.

That is also the reason why Bangalore first housed all software companies in India, as did the
Silicon Valley in the US. Or why a particular street has all shops selling paper products. A
businessman may have randomly selected a street to establish his shop. As consumers of paper
products flock to that street, other businessmen wanting to sell paper may also think it fit to set
shop there. And so goes the positive feedback.

9. Take my daughter. She exerts her individuality when it comes to eating alone. Place her among
her friends and she gobbles her food in quick time. Why? Social psychologists attribute it to the
“social-facilitation effect”. It is the tendency of people to perform better in the presence of others.
My daughter eats without much fuss when she is with her friends.

Social-facilitation effect

But the social-facilitation effect is not always true, as the corporate trainer will testify. Studies
have shown that we sometimes perform badly amidst people we know.

If you are giving your first dance performance or violin concert, you will be more nervous if your
parents or spouse were present. Why do we have this seemingly contradictory effect?

Robert Zajonc, a social psychologist, conducted studies that seem to explain this behaviour.
Through several experiments, he found that people do well in groups when the work involved is
not complex. On the other hand, complex tasks such as painting or writing is better performed
alone.

Handling unknown clients

Likewise, some perform better when they are delivering to an audience that they are not intimate
with. This sociological effect, perhaps, explains why some football teams perform well at home
while others do well away from home. This phenomenon can be seen among portfolio managers
too. I met one who claimed that he was more comfortable handling unknown clients than friends.

Of course, the social-facilitation effect has a lot to do with each individual. If you are not
concerned about other’s opinion, you may not bother about their influence — even if you perform
a complex task like a violin recital to a group that includes your spouse or if you manage your
mother-in-law’s portfolio.

10. Years ago, Lawrence Peter, a Canadian psychologist, argued that people in the workplace are
promoted till they reach their level of incompetence. This came to be called as the Peter's
Principle.

The argument is that we wrongly assume that if a person does well in her job as, say, a team
member, she would do just as well as a team leader.

Peter's Principle
Can we promote people so that they do not reach their level of incompetence and bring down the
efficiency of the organisation? A couple of scientists who ran computer models to solve the
Peter's Principle suggest that we should promote people at random! Why?

You anyway do not know if a person you promote will do well at the next level. So, promoting
the best performers may not be optimal. Indeed, the computer model that the scientists developed
showed that the organisation that followed random promotions was most efficient. Even a model
that promoted the best and the worst performers performed better than the convention promotion
model.

The paradox

The strategy is based on game theory model called “Parrondo's Paradox”. It is a game where you
are given two choices, each having a higher probability of losing than winning. The paradox is
that you can still win by alternating between the two choices.

But can random promotions work? True, there will be loss of employee morale. But one
argument in favour of such a model is that intrinsic motivators become more important. That is,
when you know that your promotion is random, you will work because you like the job and enjoy
creativity. And that could improve productivity and fetch you a higher salary. Just what you and
your supervisor wanted?

10 A Research has shown that lucky people are positive and take action. It is then that luck
favours them. So, it all starts in the mind. In one study, the subjects were asked to imagine that
they were shot in the hand by a robber. Some reacted saying that they were lucky not to be shot in
the head! Others replied that it was their misfortune to be shot at.

Expectedly, the people who considered themselves lucky to be alive were more successful in real
life. Prof Richard Wiseman discusses the traits that such people have in his book The Luck
Factor.

In one experiment, he gave lucky and unlucky people a newspaper each and asked them to count
the number of photographs in it. The lucky ones took a few seconds while the unlucky ones
averaged two minutes. Why? The newspaper contained information on the number of
photographs, which the lucky ones noticed and the unlucky ones did not.

It is the same in the market. The lucky traders (the successful ones) are quick to observe a pattern
and take advantage of it. The unlucky ones do not and then blame fate. Are you a successful
trader? If not, remember this if nothing else: The man who wins is the man who thinks he can.

11 Suppose bananas are priced at Rs 50 a dozen in a wholesale market. You notice that the same
quality retails for Rs 55 a dozen in your neighbourhood. If you buy bananas at Rs 50 and sell at
Rs 55, you are taking advantage of the price differential after adjusting for the transportation cost.

Exploiting such a price differential in the financial markets is referred to as arbitrage. But note
that the academic definition states that arbitrage is essentially a transaction that carries no risk.

Suppose BHEL trades for Rs 575 on the NSE and at Rs 580 on the BSE. You would buy shares
on the BSE and sell on the NSE and pocket the difference after paying brokerage. If you do the
transactions simultaneously, you do not run the risk of the prices moving against you. That is
conventional arbitrage.

Arbitrage plays an important role in valuing assets. Suppose the spot price of Reliance Industries
is Rs 550. What will be the theoretical price of Reliance in the futures market? If you buy 100
shares of Reliance, you pay Rs 55,000 after your broker executes the buy order.

You do not pay the entire amount if you buy a futures contract. You can, therefore, invest the
money and earn interest on it.

Assume that the interest earned on Rs 550 for one month is Rs 2. The theoretical futures prices
will be then set at Rs 552. This is the spot price plus the interest earned on the spot price till the
maturity of the futures contract. At this price, there is no arbitrage opportunity between the spot
price and futures.

In financial economics, this is called the no-arbitrate condition.

11 A If a poor entrepreneur in Bangladesh wants a loan, the Grameen Bank will ask him to bring
along four of his friends as well. In the traditional banking business, you would call his four
friends guarantors.

Not so with Grameen Bank. They are just a five-member borrowing circle. Should the borrower
default on his loan, the other four will not be asked to repay the amount. All of them simply lose
access to credit till the loan is repaid.

So, why should four other people form a group with the primary borrower? The reason is that
when it comes to each one's turn to borrow, the others in the group will form the borrowing
circle.

In one such experiment called "Trust Game," economists found that people were comfortable
trusting their community. In car-pooling, for instance, a study found that Afro-Americans found it
easier to car-pool if they lived in an area with other Afro-Americans.

The "Trust Game" experiment may, perhaps, explain why the Grameen Bank is successful at
what it does. The bank helps poor people. These people share a common characteristic — they
are economically-challenged. This brings about camaraderie. And that gives rise to trust — the
factor that helps Grameen Bank provide loans without collateral.

12 Products are rarely priced to end in fifties or hundreds. A trouser is priced at Rs 1,299, not at
Rs 1,300.

A marketing study shows that nearly two-thirds of product prices end with the digit 9. Bata's
pricing strategy may immediately come to your mind.

There are various arguments to explain the psychology behind the pricing strategies. One is that
consumers do not pay much attention to the last digits. Kaushik Basu, a US economist, came to a
similar conclusion based on his study using game theory. It, therefore, makes sense for firms to
end prices with 9 or 99, be it rupees or paise.
Another argument is that an odd-price makes customers believe that a company offers products at
the lowest possible price. The rationalists will, of course, choose to differ on this point.

So, what has this pricing psychology got to do with my friend's buy-sell strategies? For some
reason, stock prices also behave in a similar manner. When you buy or sell shares, do not use
whole numbers.

Suppose you want to buy a share for Rs 200, place a limit order instead at Rs 200.25 or Rs
200.45. Likewise, if you want to sell, place the order at Rs 199.95 or Rs 199.55. The chances of
your order getting filled are higher.

13 Suppose the tech sector and Nifty returns are 10 per cent and 4 per cent respectively. A tech
fund will no doubt outperform the Nifty. But this amounts to comparing apples and oranges,
because the fund invests only in tech stocks, whereas the Nifty comprises stocks in various
sectors. The best way to evaluate performance is to construct an index that reflects the fund's
investment style. A tech fund's performance should, therefore, be compared with a tech index.

Here again, any tech index may not serve the purpose. Suppose the fund states that it will invest
40 per cent in second-tier tech stocks, 10 per cent in third-tier, and the balance in frontline tech
stocks. Using a tech index that does not include third-tier stocks, and only giving 10 per cent
weight to second-tier stocks may not be correct.

The tech index should reflect the fund's stated objective or investment style. Only then can the
fund's performance be compared with the index. Suppose the fund returned 10 per cent, and the
tech index moved up only 5 per cent. The fund's better performance may be due to 60 per cent
investment in frontline tech stocks against 40 per cent stated. This is termed as the asset
allocation decision.

The better performance may have also been due to its stock selection decision. The fund may
have bought only Infosys and Satyam in the frontline tech group; this group in the index may
have comprised Infosys, Satyam, Wipro, and HCL Tech.

In short, performance evaluation requires constructing correct benchmark, and decomposing


returns into asset allocation and stock selection decisions. Simply stating that the fund
outperformed the market index may not be correct.

14 You may have observed that goalkeepers were the stars of the 2006 World Cup. In fact, the
grand finale was settled with penalty shootouts with Italy beating France 5-3. Our relation
between soccer and economics starts with goalkeepers.

If you play soccer, you will appreciate the difficult task that goalkeepers face during penalty
shootouts; there is little time for goalkeepers to judge the flight of the ball and save the penalty.

So, how would an economist play ball if he were a goalkeeper? Tim Harford, the author
of Undercover Economics, provides some clues on this.

In an interesting article in Slate.com, he suggests that game theory may come in handy while
keeping goal. Game theory is a study that uses mathematics and economics to help people take
actions that maximise their returns.
Using game theory, the economist-goalkeeper would follow an unpredictable strategy. That is, he
will not always dive in one direction when the ball is kicked from the spot. Instead, he will follow
a random strategy to confuse the penalty shooter.

Of course, the penalty shooter will also want to do the same — not always shoot to his stronger
side. It essentially comes to the smart brains of the best penalty shooters against that of the
goalkeepers. Gianluigi Buffon came on top in the 2006 World Cup for Italy. Not for nothing is he
is the costliest goalkeeper in the world. That, perhaps, makes him a good game theorist as well!

15 Such funds primarily invest in floating rate bonds (or floaters). A floater is one where interest
payments are linked to a benchmark rate. A bond that pays, say, one per cent more than SBI's
three-year deposit rate is a floater.

If SBI's three-year deposit rate increases from 5.5 to 6 per cent, your bond will earn 7 per cent for
the next six months or one year depending on the next reset date.

Suppose you hold a 5-year bond that pays a fixed-rate of 6 per cent per annum for five years.
What if interest rate rises after you buy this bond?

Assume that a new 5-year bond will be issued at 6.5 per cent. You will be unable to sell the 6 per
cent bond at its face value of Rs 100. Why?

Your bond carries lower interest rate than what the market currently demands. The 6 per cent
bond will, therefore, decline in value so that it yields 6.5 per cent. This risk of a bond declining in
value due to rise in interest rate is called the interest rate risk.

Now, floaters carry low interest rate risk. Why? Assume that the interest rate increases after you
buy a floater. You will receive higher interest rate on your floater from the next reset date. The
floater, therefore, pays you market interest rate after sometime.

You do not enjoy this benefit with a fixed-rate bond. So, the decline in value for a floater will be
lower than that for a fixed-rate bond if interest rate increases.

With the market now expecting a rise in interest rate, small wonder that there is demand for
floating rate bond funds.

16. The reason is that you believe that some day, the stock will move to Rs 100. This is a logical
extension of the general belief that stocks are less risky in the long run.

Empirical evidence does, indeed, suggest as much. But this should not be reason enough for you
to hold stocks for the long term. Why?

If you are philosophically inclined, you may have heard of the black swan problem. It relates to
the theory of induction put forth by Sir Karl Popper and later by David Hume.
It was, however, John Stuart Mill, an economist and philosopher, who put it in perspective: "No
amount of observations of white swans can allow the inference that all swans are white, but the
observation of a single black swan is sufficient to refute that conclusion."

How does this link to the above issue on stocks? That stocks have outperformed all investments
in the long run (and therefore less risky) does not necessarily mean that it will continue to do so
in the future. In other words, your decision should not be based just on history.

What is the implication of the black swan problem? Suppose you, a risk-averse investor, are
planning for your retirement income. Your financial advisor might allocate a sizable proportion
of your investment to stocks because they are less risky in the long run. You can, perhaps,
mention the black swan problem to your advisor.

17 It is the ratio of price-earnings (PE) to the expected growth of a company.

Suppose HDFC is trading at Rs 600 with EPS of Rs 60, we say that the stock's PE ratio is 10 (Rs
600/Rs 60). If you expect the company to register a growth rate of 20 per cent in the next three-
five years, the PEG ratio will be 0.5, which is PE ratio divided by the expected growth rate.

The rule of thumb is that you pick stocks that have PEG ratio less than one.

Does financial theory support the PEG ratio? Not really. Here is why.

Consider HDFC and LIC Housing Finance. Suppose you believe that HDFC is less risky than
LIC Housing, you may settle for a lower return from your investments in the HDFC stock.

This means you will be willing to pay more for every Re 1 of HDFC's EPS.

In other words, lower the risk of a stock, higher its PE ratio.

The flip side is that higher the risk, lower the PE ratio. Take LIC Housing.

Since you expect this stock to be more risky, its PE ratio will be lower than that of HDFC.

Suppose the PE ratio for HDFC is 10, and that of LIC Housing is 5.

If the expected growth rate for HDFC and LIC Housing is 20 per cent, and 15 per cent
respectively, the PEG ratio for HDFC will be 0.5, while that for LIC will be just 0.33.

You may, therefore, choose LIC Housing based on the PEG ratio, even though you perceive
HDFC to a better stock. Basing your stock picks just on the PEG ratio may be wrong, as the ratio
is biased towards stocks that have low PE ratio.

18 Beware the risk! Such a strategy will be profitable only if Nifty does not move or moves very
slowly till the near month contract expires. The reason? The slower the Nifty moves, the faster
the near-month option will lose value because of time decay.
When you buy a call option, you expect the underlying stock to move up before the expiry of the
contract. The slower the stock moves, the lesser the possibility of the call option becoming
profitable before the contract expires.

The loss in option value due to passage of time is called time decay. Since you have sold the near
month contract, you will profit from time decay. The option will either expire worthless or you
can buy it at a lower price and close the position. The farther month contract (January) will also
lose value due to time decay. But that contract still has more time to expiration. So, the loss due
to time decay will be slower for farther month contract than for the near month contract.

Suppose the Nifty moves up soon after you buy the time spread. Both calls will also move up
sharply. But the profits from the January calls will be offset by the losses from the December
calls. That is, the price difference between both calls will be zero or near zero. You will, hence,
lose money because you bought the spread at Rs 37 per option.

19 Take a 10-year bond of Rs 100. Suppose the coupon rate is 11 per cent, but the current 10-year
rate is 6 per cent. The government will offer you the bond at a price that will equal the current
rate of 6 per cent. That means a substantially higher price than the bond's face value of Rs 100.

This rate of 6 per cent is called the yield-to-maturity (YTM). It refers to the rate at which the
interest payments and redemption value are discounted to equal the current market price of the
bond.

Suppose you pay Rs 102 for a two-year bond that pays Rs 5 as annual interest, and carries a
redemption value of Rs 100. The YTM (4 per cent) will be the rate at which the discounted value
of Rs 10 (annual interests) plus Rs 100 (redemption value) will equal the market price of Rs 102.

But the YTM is not the return on your investment. Why? The YTM assumes that the coupon
payments are reinvested at the YTM rate.

That is, the Rs 5 you receive in the first year will have to be reinvested at 4 per cent for you to
realise the YTM rate. But if the yields prevailing then are lower, you cannot reinvest at that rate.
So, you will not earn the YTM rate.

The best way to measure your returns is to add the total cash inflows and divide it by the initial
investment.

In the above case, your cash inflows are Rs 110, and your investment is Rs 102, so your holding-
period return is 8 per cent.

20 Suppose Bank A made a 15-year loan in 1992 at 19 per cent, with a prepayment right given to
the borrower. If the interest rate falls to 11 per cent in 2002, the borrower will prepay the loan and
borrow afresh at a lower rate.

The bank will now be forced to lend at a lower rate, as the interest rates have fallen. In this case,
Bank A is said to run a reinvestment risk in 1992 when it issued the loan with a prepayment right.

As an investor, even you can run a reinvestment risk. How? Suppose you choose to buy a bond
paying 8 per cent annual interest. What will happen if the interest rate falls later?
You will, no doubt, continue to earn the same 8 per cent on your bond, but you still run a
reinvestment risk!

This is because the interest you receive will have to be reinvested at a lower rate. But why
reinvest the interest and not spend it?

The reason is that reinvestment of interest income is assumed for the calculation of the yield-to-
maturity on the bond.

This means that a lower return on the reinvested interest income will lower your effective return.

This is an important risk that you run especially if you are investing in long-term bonds.

And that is not all. Suppose the company has a right to recall the bond after five years.

Now, the company will recall the bond only if the interest rate after five years is lower than the 8
per cent interest it pays currently.

Notice that you again run the reinvestment risk.

21 Those familiar with corporate finance will recognise that Gordon's dividend model is based on
similar concept. This theory argues that people prefer cash flows now to the chances of receiving
larger returns in the future.

"A bird in the hand is worth two in a bush" does indeed have meaning!

The bird experiment also revealed another behaviour. When offered a choice between smaller
quantity of food after, say, 20 seconds (and not immediately) to large quantity in the future, the
birds preferred the latter.

This change in behaviour is called preference reversal. It shows that the pigeons are impatient in
the short term and relatively patient in the long.

Studies have shown that you and I exhibit similar behaviour. Think about this: If you were
offered Rs 10 lakh in 13 months or Rs 15 lakh in 24 months, which would you choose?

The way we behave has important implications for modelling in finance. The above experiment
shows that we do not use the same discount factor for valuing short-term and long-term cash
flows.

It also throws some light on our savings behaviour. We are generally reluctant to save more for
retirement out of our current income.

This is because we cannot wait to derive benefits way into the future.

But we would not mind saving more out of our future salary increases because we are patient in
the long run.

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