What is finance for?

… is a question that is not asked often enough, not taught enough and not reflected upon enough.

Noah Smith reminds us that this question is very underrated:

We often forget this fact in the modern world of hedge funds and trading platforms, but finance is supposed to actually finance stuff. Ultimately, the purpose of finance is to channel capital to productive businesses so that the economy can grow. The “high finance” of fancy derivatives and ETFs and hedge funds and junk bonds and all that stuff is just a superstructure that’s built on the foundation of real productive assets. Sometimes the superstructure can outgrow the foundation and collapse, as we saw in 2008. But the foundation is still there.


That’s it, that’s today’s post.

If you are a student of finance (and even better, financial economics) I urge you to bring this paragraph up for discussion in class. Please.

On Valuing Zomato, But Don’t Stop There

If you are a student of economics, you should be able to understand the basics of valuation. It is up to each one of us to determine our level of expertise, but at the very least, we should be able to understand valuations that others have arrived at.

And a great way to learn this is to devour, as greedily as possible, every single blog post written by Professor Aswath Damodaran.

Here’s an excerpt from his blogpost on valuing Zomato:

Eating out and prosperity don’t always go hand in hand, but you are more likely to eat out, as your discretionary income rises. Thus, it should come as no surprise that the number of restaurants increases with per capita GDP, and that one reason for the paucity of restaurants(and food delivery) in India is its low GDP, less than a fifth of per capital GDP in China and a fraction of per capital GDP in the US & EU.


Read the whole thing, and if it is your first time reading about this topic, read it three times. I’m quite serious! Also download the spreadsheets, and play around with the assumptions in them. It is a great way to teach yourself Excel and valuations at the same time. Excel and valuations is also a great way to understand the concept of complementary goods, and I’m only half joking.

So, ok, you have now got a little bit of a grip on valuation. That’s great, but you shouldn’t stop there. Valuing a company is fine, but how does one think about the valuation of this company (Zomato) in the context of this sector (online food delivery)?

Here are some facts. Zomato raised $1.3 bn through an IPO which was oversubscribed 38 times and which valued it at $14.2 bn. At about the same time, its competitor Swiggy raised $1.25 bn in a Series J fund raise which gave it a post-money valuation of $5.5 bn.
The post-IPO public market price discovery of Zomato shows that Swiggy is 2.6 times under-valued.


Also from that post, a great way to understand how to start to think about the price one can get in the market. That is, you can learn all the theory you want about valuation, and pricing and what not. At the end of the day, the price you command in the market is about so much more than that:

4. But, if markets stay as frothy as it’s now, Swiggy’s promoters and investors need not worry. Unlike Zomato’s promoters who, judging from the first day pop left huge money on the table, Swiggy’s promoters could rake in much more by pricing its IPO closer to the comparator market price. Swiggy and other could benefit from the later mover advantage.
5. There appears to have been a first mover disadvantage for Zomato in leaving money at the table and not maximising its IPO takings. Conversely there may have been a first mover advantage for its investors in maximising their returns.


And you shouldn’t stop there either! Valuing a company is fine. Thinking about that company in the context of its competitors is great. Thinking about the IPO rush in the start-up world, and what it means in the context of the overall economy is fantastic.

The Indian startup scene has been set ablaze by the spectacular IPO of Zomato. In a largely conservative market this constitutes a huge collective leap of faith since the company has consistently made increasing losses and several questions hang on its profitability. With some more blockbuster IPOs lined up, the party is likely to go on for some time. Some high-profile boosters even think of it as a new dawn in risk capital raising. The problem is with those left standing when the party ends, as it must. And it’s most likely to be not pretty.


The world’s unicorn herd is multiplying at a clip that is more rabbit-like. The number of such firms has grown from a dozen eight years ago to more than 750, worth a combined $2.4trn. In the first six months of 2021 technology startups raised nearly $300bn globally, almost as much as in the whole of 2020. That money helped add 136 new unicorns between April and June alone, a quarterly record, according to cb Insights, a data provider. Compared with the same period last year the number of funding rounds above $100m tripled, to 390. A lot of this helped fatten older members of the herd: all but four of the 34 that now boast valuations of $10bn or more have received new investments since the start of 2020.


Why is this happening now? Is it because of loose monetary policy the world over? Is it because of optimism about what the world will look like post-covid? Neither, and something else altogether? Or both and something else also? What might the ramifications be? How should that influence your thinking about the next three to five years in your life – when it comes to going abroad to study, or starting an MBA, or being in the job market?

Note the chain of thought in this blogpost: valuing a company, thinking about that specific sector, thinking about IPO’s in general, thinking about the overall economy… and getting all of that back to your life. Apply this to all of the news you read, everyday, and you’ll soon start to build your own little picture of the world. That is, you’ll start to see the world like an economist. And trust me, that is a superpower. 🙂

Buckle Up For the Ride

This from the Livemint:

As of March 2012, retail loans amounted to about 18% of the total loans outstanding in Indian banks. By March 2021, this had increased to 29%. By comparison, the share of loans given to industrial entities of all sizes has dropped from 45% to 30%. Retail loans grew at a compounded annual rate of 15.5% in this period, against 4.5% for loans to industry. The rebalancing accelerated after 2015 as retail loans maintained their pace, while the growth rate in loans to industry fell below 2%, showed data from the Reserve Bank of India (RBI).


Not just since the pandemic, then, but for a while now, retail loans have been more dominant.

But as the article goes on to say:

During the covid-19 pandemic, only two of the four main borrower segments have managed to borrow more from banks than earlier, the data showed. The retail segment is one of them, the other being agriculture and allied activities. Loans given to the services sector and industry saw a decline during the pandemic.


And then this, yesterday, from Deepak Shenoy:

There’s things textbooks and definitions, and there is practical experience:

But the takeaway is this: if other financial institutions are reporting “better” numbers, what weightage should you give this tweet in your mental model of the financial sector? Should this tweet worry you more than those numbers reassure you, or should it be the other way around? Why? What is Bayes’ theorem?

Finally, it is one thing to speak about the increase in retail loans. What about the increase in NPA’s?

If you are a student reading this, these are the questions I recommend you should be asking yourselves:

  1. What have NPA’s been like in past crises?
  2. Why have NPA’s risen so sharply for auto loans in this firm’s case?
  3. What can you conclude about all NBFC’s from this one report? Should you take a look at other firms reports? If so, which ones? Why? Re: the tweet above, how much can you trust them? Why or why not?
  4. What else might firms do to make their numbers look better, besides putting in cheques on the 30th of June? What does Google tell you about this? What do professionals tell you about this?
  5. What conclusion can you reach about the finance sector in India from your answers to the first four questions?
  6. If you were a finance trader, how would you have acted on your conclusions? What trades would you have tried to engineer?
  7. Do you see signs of such trades in the market?
  8. If yes, should you be reassured or worried?
  9. If no, have you figured out a way to trade that others have not? In other words, how confident are you of your conclusions, relative to what the market is saying? Why?
  10. Do you have the gumption to put your money where your mouth is? Will you bet your own money on the basis of your conclusions?
  11. Which questions have I missed out on asking? What else should I be asking, and why?

Try answering these questions, however basic your answers may be. After answering them, reach out to a finance prof, or a person from the industry, and ask them to help you make the list of questions longer, and your answers better.

It’d be a pretty good way to learn finance, irrespective of whether or not you “formally” study it as a subject, in my opinion.

The Long Puts of our Civilization

I don’t think I’ve (yet) explained on these pages what options theory is in detail, but I have mentioned it in passing. I might come back to writing basic explanatory posts about the four basic kinds of options (long call, short call, long put and short put) some time later. The basic idea, however, is this:

It is always a good idea to have options.

You can complicate it by asking what kind of options under what kind of circumstances for what purposes – and that opens a rather large can of worms – but at is heart, options theory is really telling you that if you have choices to make, consider making a choice that opens up other choices later.

At it’s simplest, this is why Indian parents are so fond of saying take science in the 11th standard. They’re asking you to make a choice that gives you more options later.1

Let’s talk for a while about the long put. A long put is – this is the technical definition – the purchase of an option to sell something for a fixed price down the line. Here is one way to think about it.

A Very Bad Man is hired to go put a bomb on the maiden flight of a brand new aeroplane, due to fly out of Miami airport. If that bomb had gone off as per plan, it’s safe to assume that the stock price of the airline in question would nosedive whenever markets opened next. So what, you ask? Here’s a simple example.
Say pre-successful-explosion, the stock price of the airline in question was a hundred dollars. Le Chiffre, the villain in Casino Royale, would buy an option today to sell a share of the firm tomorrow at maybe ninety-nine dollars. What Le Chiffre has purchased is known as a long put. Translated into English, it is the purchase of an option to sell something at a predetermined price. Let’s say that this purchase of the option happens for the price of one dollar.
If the plane blows up, the price of that same share tomorrow may well be fifty. Le Chiffre, because he has the option to sell at ninety-nine, can make a whole lot of money by buying the share in the spot market at fifty, and selling it at ninety-nine, pocketing a cool forty-nine dollars in the process. And if forty-nine seems like a very non-Bond-villain number to you, buy one hundred million long puts.


Watch the movie after reading this, by the way. How many times do you get to watch Casino Royale and get to claim that you’re studying finance, eh?

Health insurance is another way of understanding the concept of a long put. Health insurance is effectively a bet that you will not fall ill, but if you do, the health insurance company picks up the tab. All that the health insurance company asks is that you pay them some money for them taking this bet. This is, of course, the health insurance premium. But like I said, in essence, a long put.

A long put in and of itself isn’t bad! Sure, a Bond villain can use it, but so can your parents when they purchase health insurance. Blaming options for a financial crisis is like blaming the atom for the atom bomb. It all depends on what you do with it.

Now, the question that I really wanted to ask: where are the long puts of our civilization?

What are we going to do, as a civilization, if we fall “sick”? Have we purchased insurance? Sick could mean mad climate change – so what happens if there is a catastrophe? Is there a “health insurance” scheme that we have purchased? As it turns out, yes, a rather extreme one.

A group of scientists are proposing that the inhabitants of Earth build a “lunar ark” as a global insurance policy against total annihilation. The idea, reminiscent of a backup hard drive to reboot a dead Earth, is to create a vault on the surface of the moon that would store the cryogenically frozen genetic material of our planet’s 6.7 million species of plants, animals and fungi, reports Harry Baker for Live Science.


So for really and truly extreme events, there is at least talk of providing insurance. That’s good!

But I would argue that for other not-so-extreme events, we are not providing insurance. For example:

To get the giant container ship blocking the Suez Canal unstuck, engineers needed the stars to align. Actually, the sun, Earth and moon.
After several days trying to dislodge the Ever Given cargo ship, which had veered off course and embedded itself in the side of the canal, the salvage team pinned their hopes on this week’s full moon, when, beginning Sunday, water levels were set to rise a foot-and-a-half higher than normal high tides. That would make it easier to pull the 1,300-foot vessel out from the side of the canal without unloading a large number of the 18,000 or so containers it was carrying.


If, in the 21st year of the 21st century, our long put consists of consulting the lunar calendar in order to get big ships unstuck, then I’d argue that we are not quite doing things right. We need better plan B’s.

And so the question, worth thinking about at both the individual and the civilizational level: where are our long puts?

And another point, especially applicable as a student of economics: don’t get bogged down in the diagrams and minutiae of options pricing theory alone. That stuff is fun to learn, and cool to explore, sure. (Of course, if you are not a finance nerd, it is the exact opposite, and you can’t wait to be done with the subject. But then my point is even more applicable.)

Ask, instead, where else I can apply the idea of options theory, outside of finance. A lunar ark on the moon, a ship stuck in a canal and a Very Bad Guy in a James Bond movie are all great ways to learn about long puts – and certainly more entertaining than the ninth and the tenth chapter of John C Hull.


  1. “But you can always do arts after the 12th! This way, all three options are available two years down the line!” Yeah, right.[]

Understanding Risk and Return

You actually don’t need to learn risk and return if you are an Indian, because it is built into our culture.

One reason why IAS type jobs are so very revered by all Indian parents is because they’re so very risk averse. And when I say “they” I mean both Indian parents and IAS type jobs. The biggest draw of being an IAS office is that “naukri pakki hai“. Sure, being an IAS officer will mean that you can’t become the next Zuckerberg, but again, “naukri pakki hai“.

That’s our cultural fascination with the whole engineer/doctor trope too – these used to be educational options that would guarantee you jobs. It didn’t matter if you wanted to do these jobs or not – that wasn’t the point. What mattered is that you stood a fairly decent chance of getting jobs if you had an engineering/medical degree. I should know – I am an engineering dropout.

Given what our economy went through in the 70’s, 80’s and at least the early 90’s, it is an entirely understandable societal response. Screw everything else, land up a job first.

The point I am trying to make is that we, as a nation, were risk-averse. The returns from doing something that you wanted to, whether psychic or financial, weren’t the point. It was about minimizing risk. For all I know, most of us still are risk-averse. The MBA degree isn’t about being an entrepreneur, it is in fact the exact opposite – it is about landing a job.

This risk-aversion spills over into other areas of life as well. Fixed deposits over mutual funds, mutual funds over stocks, and gold and land above all else are also about risk-aversion. Mind you, there is nothing wrong about being risk-averse. Or right, for that matter. At the end of the day, your risk appetite is a function of a whole variety of things, not all of which can (or should) be viewed from the lens of economic theory.

But the one thing that economic theory (well, finance, really) can tell you is the following. If you want risk aversion, you can’t get high returns at the same time. High returns come with high risk, and that’s just the way it is.

Source: Investopedia

This takes us back to our discussion on hedging:

A hedger is somebody who ain’t worried about missing out on a high-paying job later. A hedger prizes certainty. A hedger mitigates risk. The price you pay for mitigating risk – the opportunity cost of risk mitigation – is that you lose the potential upside.


Read the whole post if you haven’t already, but the basic point is that the opportunity cost of safety is low returns. And it cuts both ways: the opportunity cost of aiming for high returns is high risk. A batsman aiming to hit a six is an example of high risk, high returns, and a batsman aiming to defend well is an example of low risk, low returns.

Now, you’ll often hear finance folks talk about barbell portfolios:

Taleb presents the barbell strategy as a bimodal attitude of exposing oneself to extreme outcomes: one extremely risk averse and another very risk loving, while ignoring the middle. The objective of the strategy is to limit downside and to get exposure to extreme upside outcomes. The possible outcomes are more certain, and the risk of exposure to “black swan” events is much smaller.


But rather than think about it in terms of financial theory, think about it in terms of MS Dhoni’s innings. He’d perfected the portfolio of shots he’d play in his limited overs innings, and it was a pretty good barbell portfolio. Extremely risk averse at the beginning, and god didn’t we all love the fireworks at the end?

The point is, don’t expect to get high returns when you’re minimizing risk, and vice-versa. But also, don’t try to have the same attitude (completely risk-averse, or completely risk-loving) for every single asset in your portfolio. Minimize risks with most, and go all out on the ones that remain. Nassim Nicholas Taleb and MS Dhoni are telling you the same thing.

And of course, as a student, you should always be asking yourself, where else is this applicable?

Understand the beast that is finance

We’ve been building a series on finance here, and we’re not even at basecamp level just yet in terms of our ascent on Mount Finance. But I just realized that while I’ve started the series, I have not laid out two ideas that I think are central to thinking about finance. One idea for today, and the other for tomorrow.

Today’s idea is about zero sum games.

I’m big on non-zero sum games. Students at GIPE are probably sick and tired of hearing me uttering the phrase now, but it’s never going to stop. The world is where it is today precisely because of the fact that it is a non-zero sum game, and most of our problems in life and society would go away if only we understood and applied the principle in all walks of life. But that’s a separate post, and I’ll get to it one day.

For those of you who are unfamiliar with the concept, a trade in which both parties are left better off than they were before is called a non-zero sum game. Also called a double thank you moment, by the way.

Here’s the thing about finance.

It is not a non-zero sum game.

For me to win, you have to lose. There’s debate about whether this is true for all of finance or only a part of it, but options theory in particular is (at least in my view) definitely a zero sum game.

Options and futures trading is the closest practical example to a zero-sum game scenario because the contracts are agreements between two parties, and, if one person loses, then the other party gains. While this is a very simplified explanation of options and futures, generally, if the price of that commodity or underlying asset rises (usually against market expectations) within a set time frame, an investor can close the futures contract at a profit. Thus, if an investor makes money from that bet, there will be a corresponding loss, and the net result is a transfer of wealth from one investor to another.


Speaking of the “for me to win, you have to lose” line of argument, consider this snippet of an excellent conversation between Tyler Cowen and Clifford Asness:

AUDIENCE MEMBER: How confident can you be that there will continue to be the steady supply of stupider investors on the other side of the trade so that you continue to make money?
ASNESS: That’s a great set of questions.
Backing up, you’re not going to believe me, you’re going to think I’m just copying you. But myself and a colleague, Antti Ilmanen — he’s Finnish, he didn’t just have odd parents — have been planning, we haven’t written it yet, to write a paper with the literal title, “Who is On the Other Side?” Just a little shorter version of what you said, because we do think that is a very disciplining question.


In fact, if you ask me, this is the core differentiator between economics and finance. The study of economics is (ought to be?) about non-zero sum games. The study of finance is about zero sum games. It’s confrontational, it’s risky, it’s like sports. For there to be a winner, there has to be a loser.

Why I like watching and playing sports even when sports is very much a zero-sum game is also another post by the way. One day.

Still, back to my main point: finance is a zero sum game.

If you want to get into this jungle, do so with eyes wide open. I’m just sayin’.

Understanding margins

This is part of a series that is building up over time, in gloriously random, unplanned fashion. We started with a post about understanding forward markets, then moved on to understanding leverage, then arbitrage. Today is about margins.

Imagine that you and your friends have decided to get together and throw a surprise birthday party for one of your friends. Now, birthday party implies cake. It’s the law, right?

And so you decide to go and book a cake, delivery three weeks from now (because that’s when the birthday is).

In the language of the financial markets, you’ve gone long on the forward contract for the cake, and the baker is the counterparty – she has gone short on the forward contract for the cake.

The baker says, well, ok, fine. The chocolate cake that you’re asking for will cost you a thousand bucks. And he asks that you pay, say, two hundred rupees now, and the rest on the day of delivery.

That is the basic idea behind margins. When applied to financial markets, the same principle is at work. If you have entered into a forward contract, you should pay part of the money up front. And the principle exists for the same reason in financial markets that it does in the market for chocolate cakes.

Boss, I don’t want to be left high and dry on the day of delivery. If you have paid me some money today, there’s a much higher chance that you’ll follow through on the deal. You now have, as they say, skin in the game.

So far, so simple, correct? Now let’s complicate the story a little bit.

Imagine that, a week from now, the government announces that flour, eggs, vanilla, salt, sugar, baking powder and all dairy products are free, for everybody. Yes, this is an unrealistic assumption, but I’m an economist. We get to pull these stunts.

Is the baker going to be happy? Well, in general yes. Lower prices for her ingredients means that she will be able to produce cakes at much lower prices. Of course, if markets are efficient, this will also mean that the prices of cakes will fall. And therefore, in the specific case of the contract that you have with her, she is going to be less than happy.

Because she knows, as you do, that you can now get an equally good cake from another baker, at say, seven hundred rupees. The ingredients are free, after all! And she can do math as well as you can – so she realizes that it is in your interests to forget about the two hundred rupees that you paid her, and book a cake from another baker at seven hundred.

Total costs to you? Nine hundred: two hundred rupees that you paid her, plus seven hundred for the cake from the other guy. You’re still saving a hundred bucks!

And so she comes to you and says, hey listen. We have a deal, you and I. I think there’s a chance that you are going to back out of this deal, given these low prices for the ingredients. So I’m sorry, but I need you to pay me another two hundred rupees right now.

(By the way, if your response is “Aur nahi diya to kya?”, we enter the world of enforceable contracts, property rights and the law. But we won’t go down that path today.)

What the baker has done is she has MTM’ed your contract. Marked To Market.

That essentially means that every single day, the baker monitors the situation, and asks how much is the contract worth if it was deliverable today, and adjusts the initial deposit accordingly.

It cuts both ways, of course: if the price of the ingredients were to quadruple, you would go to the baker and not only ask for your initial deposit back… but also ask that the baker gives you money instead. Because now she has the incentive to back out of your original deal.

There are rules about how margins work, and as usual, financial markets have their own little cottage industry of jargon around this. There’s the initial margin, the maintenance margin, margin calls and so on. But the point behind margins is very simple – you should have an incentive to not walk out of the deal, if things change in the market.

Financial markets, in other words, don’t take people at their word.

And on balance, that’s a good thing.

Imagine if companies said to students on the day of the job offer that you keep one hundred thousand rupees with us, and we’ll give it back to you six months after you join us. Are you likelier to stop searching for better, more high-paying jobs?

Or if the placement cell said you need to keep ten thousand rupees on deposit with us, and only then can you sit for an interview. Would that stop the “I just wanted to see what the process was like, I didn’t actually want a job offer from this company” students from sitting for the placement process?

Neither of these things is going to happen, relax. But that, in essence, is the point of margins.

Understanding Arbitrage

Part 1 and Part 2 here. I’d recommend you read those before you start this one.

Now, what if at the end of the academic year, you find yourself without a job offer? We all hope and pray that this doesn’t happen to anybody, but the sad reality is that there will always be such cases.

What could be done?

What I am about to describe doesn’t actually happen in any college that I know of, but it helps me build my story, so let’s go with it for the moment:

What a university could do is that it could hire the services of a placement agency. Said placement agency would take on the responsibility of getting these students placed in one firm or the other. These wouldn’t be glamorous jobs, of course, and they wouldn’t be high-paying ones. But hey, at that stage, any job offer is a good offer – and you could always try and shift as soon as possible into a better job, no?

The placement agency wouldn’t do this for free, of course. The college would have to pay the placement agency for each student placed.

Here’s the interesting part, though. It is quite likely that the placement agency would be taking a fee from the firm in which this student got placed. That is, the placement agency gets a fee from the college, but it also gets a fee from the firm.

(There are variants, of course. But we’re talking Zomato, Uber, Dunzo and old school real estate agents and all that. Middlemen, essentially. The equilibrium of who pays, and how much, and why are all excellent questions for an intermediate micro class.)

So what is the placement agency doing? In the language of the financial markets, it is engaging in arbitrage. Arbitrageurs make markets more efficient, by connecting supply and demand. The type of supply and demand that wouldn’t have been able to connect otherwise.

The student that didn’t get placed, and the firm that wanted a new employee hadn’t been able to meet so far, and the placement agency facilitated this deal. We’re talking economics, of course, and the placement agency therefore deserves a fee for providing this service.

This fee can be collected in two ways. First, the way that I just described above: take a flat fee from both sides of the transaction. Or, think of a bank. What does a bank do? It connects people who are willing to loan money to people, with people who are looking for a loan. The bank acts as the middleman, and offers a lower rate of interest to depositors. It also charges a higher rate of interest to people who want to take a loan.

This is known as the bid-ask spread. The middleman bids a lower rate while buying, and asks for a higher rate while selling.

An efficient market is one in which there are no arbitrage opportunities. Or in the language of the economist, an efficient market is one in which there are no search costs. It’s mostly the same thing. I have fixed deposits in the bank that pay me a painfully low rate of interest. In my neighbourhood is a person who has taken a loan from the same bank in which I have my fixed deposit. She is being charged an eye-wateringly high rate of interest.

In effect, I am loaning my money to her. Because I do not know of her existence (nor she of mine), we both use the bank to “complete” the transaction. The difference between the rate of interest I get and she is charged is what pays for the rent of the bank, its employees salaries and so on.

(By the way, what if the bank gives out a new loan to another person before my neighbor has repaid hers? Leverage!)

Real estate agents made the real estate market more efficient than it would have been otherwise, but their margins were so high, that Magic Bricks, and Housing.com and their ilk had a reason to enter and promise lower commissions. So also Uber, so also Airbnb, so also (think about it) Amazon.

Perfect competition, which we learn about in microeconomics, is best thought of as an always ongoing process, not as a static equilibrium. One aspect of which is better, more efficient arbitrage. That’s not how the textbooks do it, and more’s the pity.

Anyways, arbitrage is a good thing, because it makes markets more efficient in two ways:

  1. It makes trades happen that wouldn’t have taken place otherwise
  2. Competition between arbitrageurs drives the “market-making” fee downwards, making more trades happen at cheaper rates.

A truly efficient market is one in which there are no further arbitrage opportunities, and market-maker fees can’t possibly be any lower. No, as it were, dollar bills lying in the streets. See if the joke now makes sense.

So, over the past three days, we’ve learnt about the following:

  1. Forwards markets
  2. Hedgers
  3. Speculators
  4. Arbitrageurs
  5. Efficient markets

Next week (for there is only so much finance we can take at a time) we’ll get back to trying to understand finance, beginning Monday.

Optional homework: watch (and try to make sense of) Arbitrage. And if you want an example of how to write well, read this review of the movie – whether you watch it or not.

What is leveraging?

You may want to give this a read (if you haven’t already) before starting in on today’s post.

In my fourth semester while I was a Masters student at Gokhale Institute, I took this paper called Econometrics-II.

Let’s just say that it wasn’t the best decision ever. The paper was theoretical, abstruse and full of jargon, even by the standards of academia. And because it was my fourth semester, we weren’t exactly a motivated bunch. Placements had happened a little while earlier, you see, and the fourth semester was essentially us killing time until we joined whichever company we had been placed in.

And the combination of a difficult paper and a lack of motivation is a dangerous thing. By the time I and the rest of my batch trooped in to the examination hall for writing this particular paper, we knew it wasn’t going to be a pleasant experience.

And as it turned out, even adjusting for our expectations, it was a truly difficult paper. By the time we left the examination hall, all of us felt that there was a very real chance we wouldn’t pass this particular paper.

The trouble was, I had already entered into a forward contract with a firm to sell my services to them, five hours a day, eight hours a week. My services, that is, as a Masters student.

I had promised, in other words, to sell them something I didn’t possess: the services of a person with a Masters degree.

I was, in other words, leveraged.

What is leverage? The technical term is slightly different than the context in which I am using it over here, but I was in effect betting on the fact that I would be a Masters student by June 2006, in the month of January 2006. And I had promised (in January 2006) to deliver to the firm a service I didn’t have in my possession at that point of time.

To use the language we learnt about yesterday: I had shorted my services, when I didn’t actually have what they wanted.

The firm that had decided to hire me had also used leverage. It had promised to deliver (had sold) to its client a team of analysts. These analysts (one of them being me) would be ready to start work in 2006. So if you think about it:

  • the client was going to pay money to a firm…
  • …assuming that the firm would have a team ready to go in June 2006.
  • The firm, in turn, had assumed that the person they had hired in January 2006 would actually be a Masters student come June 2006.
  • And the student had blithely assumed that Trix-II (which is how all students at my college referred to that horrible paper) would be dealt with one way or the other.

When this last assumption breaks down, so do all the others, causing a chain reaction of sorts. In financial markets, this chain reaction can grow monstrously large, with extremely unpleasant consequences.

<Cough> Subprime <Cough> Crisis <Cough>

When a bank assumes:

  • that a loan that it has made will be repaid, with interest…
  • …and uses those presumed profits to buy an asset…
  • …and uses that asset as collateral to buy something else,
  • exactly the same thing is happening!

When the first loan ain’t repaid, bad things happen.

So is leveraging bad?

As I said yesterday, it depends on whom you’re asking. The student in question is unlikely to view leveraging as a very bad thing. That’s what got the student the job!

The firm will have a rather more bleak view of the affair, but so long as they can find a replacement easily enough, this won’t be an out and out disaster.

In the case of financial markets, leveraging is a (really big) problem when the losses are systemic. That is if all graduates from all colleges suddenly flunked in one year, they’d all be in trouble. As would the firms that had decided to hire them. As would the firms who had hired these firms. And so on.

But as today’s post hopefully makes clear, leveraging itself isn’t bad, so long as it isn’t overused, and that too systemically.

This is a rule that gets broken in a rather prominent fashion every now and then in financial markets the world over, with the attendant mess gaining a lot of attention.

But leveraging itself? It’s used all the time, and by all of us, one way or the other.

So what are forward markets? What is speculation?

Definitions don’t make sense unless they’re applied, and applications aren’t useful unless they’re relatable. So to understand forward markets, let’s work the other way around. Let’s start with a relatable example, and work backwards to arrive at the definition.

And what, pray tell, is more relatable than placements for students?

That is, after all, the point of an education. No?

So, anyways, placements. Here is how placements work: a company lands up on campus in the month of (say) October 2021, interviews a bunch of students, selects some of them, and offers them a job. Let’s say one of these students, who’ve been offered a job, accepts the offer.

Does the job start in October 2021? Of course not! It begins in June 2022.

In other words, a company and a student have entered into a contract. This contract says that the student will give the company eight hours of her day, Monday to Friday, in return for which the company will pay her a salary.

But the deal has not been struck for immediate delivery. The student doesn’t start work in October 2021. A price has been agreed, the terms of the contract have been agreed, and both the student and the company have signed on the dotted line – but for a transaction that will take place in June 2022. That, my friends, is a forward contract.

Now, having gotten the point, let’s learn the language that the beasts of this jungle like to use. The student, because she is selling eight hours of her time, five days a week, is the party with the short contract. The firm, because it is buying eight hours of the student’s time, five days a week, is the party with the long contract.

(Why the hell don’t they just say buy and sell, then, these financial folks? Lyk, srsly, ryt? Lmao. Brb.)

The price that the two parties have agreed upon is known as the strike price, because it is the price at which the deal has been struck.

So, quick recap: going long | going short | strike price | forward contract.

Here is how the placement process works in almost all colleges in India. If you sit for an interview, and you’re made an offer, you’re “out” of the placement process. There are variations to this rule, but in essence, the logic is that once you and the company have struck a deal, you can’t sit for any other firm that comes on campus later.

So here’s a conundrum for you: what if the company in October is a firm called HDFC, and it is offering you a package worth 8 lakh rupees (INR 800,000). The conundrum is that there is a very strong rumor (but it is, unfortunately, a rumor) that Google will be on campus next month, and they’ll be offering 20 lakh rupees (INR 2,000,000).

HDFC will pick up 20 students, but Google will pick up only 5.

Do you sit for the HDFC process or not?

There’s no right answer to this question, of course, and because of the uncertainty, cases such as these cause a lot of angst among students every year. But let’s assume that a student decides to “play it safe” and does sit for the HDFC process.

Here is what the student is thinking: sure, lower salary, and sure, no Google. But hey, a bird in hand is worth two in the bush, no? Better a low paying job for sure than the risk of not being placed by June 2022. Us economists would say the student is being risk-averse. Those finance guys would call her a hedger.

A hedger is somebody who ain’t worried about missing out on a high-paying job later. A hedger prizes certainty. A hedger mitigates risk. The price you pay for mitigating risk – the opportunity cost of risk mitigation – is that you lose the potential upside.

Choosing to put money in an FD rather that investing in stocks is hedging. Doing an MBA rather than starting a business is hedging. Locking in a job, even at a lower price, rather than waiting for a better one that may or may not come along – that is hedging. You’ll sleep soundly at night, knowing that HDFC is waiting for you in June 2022. You’ll feel a twinge of regret when your BFF lands that job at Google (of course you will), but hey – you played it safe, and that’s no bad thing.

OK, so you’re the hedger. What about HDFC, or Google? What should we call them?

Well, how much does a recruiter learn about you in a 15 minute interview anyway? All that they have to go on is that interview, and your CV. We know all about CV’s!

So when Google, or HDFC, or whoever, really – when they give you a job offer, they’re taking a bet on you. You may be the next CEO of those firms, who’s to say? Or you may be fired six months after starting your job. Who’s to say? Like I said: they’re taking a bet on you. They’re speculating.

Folks who take risks in financial markets: they’re called speculators.

Me, personally, I always get a little nervous when folks start to talk about excessive speculation, or banning speculation. Because, as an economist, I think about the student and HDFC as entering into a transaction in which the student sells the risk of being unemployed, and buys peace of mind in return. HDFC, on the other hand, sells the peace of mind of having money in the bank, and speculates on the student.

If you ban speculation, where’s the hedger to go?

A market needs people on the sell side, but also on the buy side. Without both of these animals – the hedger and the speculator – the jungle called financial markets can’t function. Just like without firms willing to punt on students, the market called placements can’t function.

I’ve yet to meet a student, past or present, who complained about “too many firms coming on campus”. And what’s good for one market, is also good for the other.