Inefficiency and Speculation in the Indian Capital Market

Transcription

1 Inefficiency and Speculation in the Indian Capital Market S K Barua & V Raghunathan Is the Indian capital market inefficient? Does it reward low risk takers with high returns? Barua and Raghunathan argued ("Inefficiency of the Indian Capital Market," 'Vikalpa,July-September 1986) that the Indian capital market was inefficient, based on an illustration. Ramesh Gupta contended, in a response article entitled "Is the Indian Capital Market Inefficient or Excessively Speculative?" (Vikalpa, April- June 1987), that their conclusion was erroneous as it was based on many assumptions and a hypothetical example. Barua and Raghunathan re-examine their risk-return evaluation in the light of the actual developments over the last year in the case illustration used earlier. They argue that their conclusion on market inefficiency remains valid, notwithstanding the many changes in the assumptions. S K Barua is Professor in the Production and Quantitative Methods Area and V Raghunathan is Associate Professor in the Finance and Accounting Area at the Indian Institute of Management, Ahmedabad. In our article "Inefficiency of the Indian Capital Market" (Vikalpa, July-September 1986), we had argued that the Indian capital market was inefficient. This article was subsequently reproduced in The Economic Scene (February 1987) under the title "Returns Much Larger Than Risks" and in Fortune India (May 1987) under the title "Indian Stockmarkets: Risk-Return Parity Vitiated." The measure of inefficiency we used was the well-known risk-return parity rule. Did the market reward high risk takers with returns higher than for low risk takers? To answer this question, we used, as an illustration, the rights issue just then proposed by Reliance Industries Ltd. of series G convertible debentures to holders of series F debentures. We considered two investors C and D. Investor C operated on a cash basis, held on to the rights debentures till maturity, and sold the equity shares (received on conversion). Investor D operated on a carry forward basis, presold the shares he was due to receive on conversion. By preselling the shares he was sure to receive as rights, investor D took less risk than investor C who exposed himself to equity price variation till the maturity date of the debenture. Our calculations showed that investor D earned a higher return than did investor C. The capital market allowed a reward for a low risk taker that was much higher than for a high risk taker. It vitiated risk-return parity. We argued, therefore, that the Indian capital market was inefficient. The article received wide attention not only in terms of its reproduction but also in terms of criticism of our method and conclusions. Gupta in a response article "Is the Indian Capital Market Inefficient or Excessively Speculative?" (Vikalpa, April-June 1987) criticized our approach as based on "a hypothetical example" and contended, therefore, that our conclusions were "erroneous." He claimed that we did not take into account the "peculiarities" of the -Indian market. He argued that the Indian stock market was not inefficient as much as excessively speculative, using the concepts of inefficiency and speculation

2 somewhat interchangeably. In view of the widespread interest, uninformed criticism, and a lack of clarity in concepts of inefficiency and speculation, we have, in this article, attempted to: clarify our position and concepts concern ing inefficiency examine how robust our risk-return evalu ation and conclusion on the inefficiency was in the light of subsequent develop ments outline the linkage between efficiency and speculation. Inefficiency The concepts of efficiency and the risk-return parity are well known. However, Gupta's criticism of our paper suffers from several misunderstandings. We have examined his criticism separately in a box alongside these columns under the heading "Concepts of Efficiency: Some Clarifications." A market's efficiency is simply its ability to maintain a risk-return parity at all times through its pricing mechanism. We examined this in May 1986 using the issue of series G debentures by Reliance Industries and concluded that the Indian capital market was inefficient. In examining the risk-return parity between investors C and D, we had to make several assumptions such as on the price of an equity share at the time of issue and at the time of conversion and carry forward rates. Assumptions were necessary because all the steps for the issue were not complete in May 1986 when we wrote that paper. Between then and May 1987, several things have happened. Obviously they are not exactly as per our assumptions. For example, the intention of the company was to issue a major portion of the series G convertible debentures as rights to series F debenture holders and shareholders. The government did not allow rights issue to the debenture holders. The company was allowed to issue part of the series G convertible debentures as rights to its equity shareholders and the rest to the public. There have been several other changes as well such as the issue price of a series G debenture, the ratio of conversion, and, of course, the market prices. Using the actual case situation, we have reexamined the same question regarding inefficiency. Concept of Efficiency: Some Clarifications In critiquing our 1986 paper, Gupta (Vikalpa, April- June 1987) states that investor D took no risk in preselling his shares. Gupta has misstated our position. We did not say that D took no risks. We said that D took less risk than C. The question in examining the inefficiency of a market is not how much risk an investor took but whether the market was able to maintain the risk-return parity. Gupta has also missed the key to our argument. As stated in our July-September 1986 article: The risk taken by investor C is clearly higher than the risk taken by investor D. If the expected returns are to be commensurate with risks assumed, then the return earned by C should be higher than that of D. The test of efficiency of a market is its ability to adjust prices such that the rewards are proportionate to risks, that is, the maintenance of a parity between risks and returns. Prices of Primary Issues. Gupta has said that we have found fault with the Controller of Capital Issues because he fixes prices at which companies issue capital (primary issue prices) which are lower than the prevailing market prjces. Here again there is confusion in understanding our position. The government follows certain policies with respect to the primary market through the Controller of Capital Issues and its representatives on the stock exchange. What we said was that its policies sometimes undermined the market. One example we gave was its policy of fixing low or no premia, in relation to prevailing market prices, on new share issues by existing companies. While the policy ensures adequate returns in the primary market, it ends up adversely affecting the risk-return parity in the secondary market. It creates opportunities in the secondary market for high returns incommensurate with the risks taken. This is precisely what we tried to show with an illustration. We argued that an efficient market has to take the policy in its stride as it processes a variety of information. The test of efficiency of a market is its ability to adjust security prices quickly so that abnormal returns do not accrue to those who do not take abnormal risks. While we were pointing out some problems that government policy creates for the market, our test for evaluating the efficiency of the market was clear and unaffected by government policy. Peculiarities of the Market. Gupta points out four peculiarities of the Indian market. These are: (continued) 54 Vikalpa

3 category A shares (specified shares in which trading can be done with a facility to carry forward the transaction) do not constitute a "forward market" carrying forward an outstanding position is not always possible. Therefore, counting on carrying forward for a whole year, as our investor D does, is risky speculators and regulators determine the carry forward rates and prices small investors do not have an easy access to trading on a forward basis. If these are the peculiarities, Gupta does not show how we have ignored" them. In fact, we have taken all these into account fully. The first so-called peculiarity mentioned above is not a peculiarity. It is a matter of terminology. What it is is immaterial as long as we abide by the trading rules, prescribed for category A shares. Our analysis conformed to these rules fully. The second so-called peculiarity is a fact that can be verified. We have, in fact, tried to do that as part of the second objective of this paper, namely to test the robustness of our conclusion on inefficiency taking into account the actual developments. The third peculiarity mentioned above may be true. But that is not the issue. We tested our findings for various carry forward rates and prices before coming to the conclusion that the market consistently gave a higher return to the low-risk strategy of investor D than it did to C for plausible parameter values. The fourth so-called peculiarity that small investors may not be able to trade on a carry forward basis may be true. We did not say or assume that investor D had to operate on a small scale. Why should he? Especially when he is so handsomely rewarded despite a low level of risk. Gupta has misread our use of a small number of shares for illustrative purposes as implying that D is a small operator. The "peculiarities" of the market pointed out by Gupta do not affect our testing the efficiency of the market. In this paper, we have gone further than imaginary or real peculiarities and assessed the postfacto evidence on the risk-return parity. We have taken cognizance of the actual carry forward rates and prices to re-examine our hypothesis regarding the inefficiency of the Indian capital market. Did the market maintain the risk-return parity by adjusting prices in the light of unfolding events? Actual Returns To answer this question we re-examine the two strategies outlined in the earlier paper in the light of actual developments between May 1986 and May The two strategies are: one operating on cash basis only and the other involving preselling of shares to be received and of carrying forward the transaction until May 1, To recapitulate the facts, series G debenture issue was for Rs 400 crore. We can fix the date of issue as December 1, The issue price of a debenture was Rs 145. Each debenture is to be converted into two equity shares of Rs 10 each on January 31,1988. Of the total issue of Rs 400 crore, Rs 150 crore worth of debentures were allotted to equity holders as rights in the ratio of one debenture for five equity shares. Prices. The market price of a Reliance equity share was Rs 212 around December 1, 1986, and about Rs 130 on May 1, The price of a convertible debenture was about Rs 200 on May 1, In the light of these actuals, the strategies of the two investors C and D each having five equity shares of Reliance as of December 1986 can be laid down as below: Investor C: C exercises his right to one debenture by investing Rs 145 on December 1, He sells the debenture on May 1, 1987, for Rs 200. Investor D: D exercises his right to one debenture by investing Rs 145 on December 1, On the same date, he sells two equity shares on a carry forward basis. D squares out his forward position on May 1, 1987, by buying back two equity shares at Rs 130 each. He sells his debenture for Rs 200 on May 1, How much did the market reward C and D? According to our calculations, investor C got 38 per cent over the five month period or 107 per cent per annum. Investor D had to carry forward his sold position of two shares from December 1, 1986, to May 1, The amounts he paid or received in each settlement period for carrying forward a sale of two shares on the Ahmedabad Stock Exchange are given in Table 1. Vol. 12, No. 3, July-September

4 Table 1: Amount Received or Paid for Carrying Forward a Sale of Two Shares *The amount received/paid) shown in column 3 is obtained by subtracting figure in column 2 from that in column 1 and multiplying the difference by 2 (for the two shares). This is the amount on account of both price difference and carry forward charges. The carry forward charge can be computed separately by subtracting the sell price from the immediately preceding buy price. If the value is negative then it is a backwardation charge. We can complete D's cashflows by adding to the amounts shown in Table 1 the effect of his squaring out the forward transaction and selling of the debenture for Rs 200. The return to D works out at 104 per cent for the five-month period or 402 per cent per year. The market actually rewarded D, who took less risk than C, nearly four times as handsomely as it rewarded C. The market could not maintain the risk-return parity. It is inefficient. This statement assumes that the actual drop in price of Reliance shares is in line with the expectation of the market. basis to contain the selling pressure on Reliant shares. The margin was substantially reduced from March 1987 after persistent allegations that the company was delaying dispatches of share certificates to reduce the floating stock of shares in the market. However, to be conservative, we can assume that this margin of Rs 50 remains imposed throughout the period under consideration. This would imply that investor D, in addition to investing Rs 145 in one convertible debenture, would also be required to deposit Rs 100 with the stock exchange on December 1, The deposit would be returned on May 1, 1987, after he squares out the forward transaction. Even with this conservative assumption, the return to investor D works out to 66.7 per cent for the five-month period which is equivalent to an annual return of about 217 per cent. These are still far higher than those for C. Thus, in spite of a high margin, returns are not commensurate with risks. Normally, margins are not paid in full by the brokers because of a squaring out of the transactions for each broker. Suppose a broker has two clients; one sells 100 shares of a company through him and the other buys 50 shares of the same company through him. Then the broker's net position would be 50 shares sold and he has to pay a margin only on these 50 shares, through he actually sold 100 shares. The client who has sold 100 shares may then have to pay only one half of the officially specified margin. The margins actually paid rarely turn out to be as high as those announced by the stock exchange authorities. In this particular instance, the actual margins varied between Rs 10 and Rs 20 a share. We have computed the returns earned by D with margins varying from Rs 50 to Rs 20, and for no margin. These results are presented in Table 2. Table 2: Impact of Margins on Returns to Investor D Impact of Margins on Returns A suggestion often made for correcting high returns on forward transactions is that the stock exchange authorities should impose margin money for carrying transaction forward. What this amounts to is to increase the investments of those pursuing strategies such as those of D. In the beginning of December itself the Bombay Stock Exchange authorities imposed a margin of Rs 50 a share on sale of Reliance shares on forward The returns of D are more than 200 per cent a year for all levels of margin. This compares with about 100 per cent return for C. D earns about twice what 56 Vikalpa

5 C earns although he takes lesser risk than C. Would Stiffer Margins Help? It is often suggested, as does Gupta, that the stock exchange authorities should impose stiffer margins on forward transactions to curb speculation. Imposition of higher margins would make investor D's scheme less attractive compared with investor C's scheme. What should have been the margin to ensure that the returns for the two schemes are equal? Our computations show that the margin should be Rs. 155, almost equal to the price of a Reliance share at the time. Levying such a margin would amount to removing Reliance from the specified list (A category) and putting it in the cash list. This further bears out our contention that, except in extreme cases when forward transaction is banned by the stock exchange, the strategy of preselling the rights share in the forward market would always fetch returns much higher than what is commensurate with the risk assumed. Efficiency and Speculation There is a tendency to refer to investor D's scheme as speculative and hence it should be curbed. Such views exist because speculation is a term which is grossly misunderstood by laymen, practitioners, and academics alike. We mention a few misconceptions about the term to illustrate the general misunderstanding. Speculation is often equated with investment for short-term returns. Trading every day or every week is labelled as speculation. Most large scale operations are also viewed as speculative; it is rarely used for small scale operations. High volatility of prices is invariably ascribed to speculators; rarely would anyone say that wide fluctuations could be the result of extreme political and economic uncertainties. The ambiguity in the definition and understanding of speculation provides a convenient ghost to whom all the ills of the Indian stock market are attributed. Gupta also subscribes to this widely held belief that speculation is undesirable and the Indian market suffers from a high incidence of undesirable speculation. Unfortunately, Gupta has neither provided any definition of speculation nor has he provided any justification of why he feels that the Indian market is excessively speculative. We shall first define speculation and then argue that some degree of speculation is desirable for the health of stock markets. What is Speculation? Speculation simply refers to the act of operating in the market without the requisite resources: buying without having adequate financial resources or selling without holding the necessary number of share certificates. This implies that, irrespective of his size or frequency of trading, a speculator has a finite chance of not honouring his commitment on the day of settlement. Let us try to understand the operational meaning of speculation in the light of carry forward business allowed in the Indian, stock market. Suppose, on the day of settlement, the sellers refuse to carry the transaction to the next settlement day and insist that buyers take delivery of shares. If the buyers have speculated they would not have adequate resources to take delivery. They would then have to borrow from the short-term money market. But instead of borrowing from others, they could borrow from the sellers themselves by offering a suitable rate of interest. If the sellers agree, it would in effect imply postponing the settlement of the transaction to the next settlement date. The rate of interest at which sellers agree ;to carry the transaction forward is known as the carry forward charge. This is unlikely to exceed the short-term interest rate at the time in the unorganized money market. Suppose, on the settlement, day, the buyers insist on delivery of shares and refuse to carry the transaction to the next settlement date. If the sellers have speculated, they would be in difficulty because, unlike money, share certificates cannot be obtained easily. The buyers demand a penalty from the sellers known as the backwardation charge. Theoretically, it can be any amount, unlike the limit which governs the carry forward charge. In an extreme situation, when buyers become too punitive, the stock exchange authorities have to intervene to avoid a breakdown of the market mechanism. Margins to Curb Speculation. Speculation can thus affect both buyers and sellers, depending on the aggregate situation in the market. To restrict.the volume of operations within what can be supported by the resource position of a person, the stock exchange imposes margins which are monetary deposits with the exchange for transacting on a carry forward basis. Gupta points out that, since the margins are usually very low (only about 5 per cent of the prevailing prices), most operators have highly-levered portfolios, which leads to excessive Vol. 12, No. 3, July-September

6 speculation. Gupta, thus, views margin as equity or owned funds, the rest of the total investment being borrowed from the market. He suggests imposition of a uniform margin of about 65 per cent on all forward transactions as is the practice in the American market. This raises two questions: Do low margins necessarily imply that there is excessive speculation in the market? Is it necessary to raise margins to 65 per cent which would almost stifle the carry forward business? The answer to the first question is in the negative. A low margin certainly is conducive to speculation, but whether a person would speculate or not and the degree of risk he would assume in the market is dictated to a large extent by his risk-return trade-off and not by the presence of opportunities to take high risks. The answer to the second question is also in the negative. But to understand this, a look at the role played by margins is essential. Role of Margins Carrying a transaction forward is permitted primarily to increase the volume of operations. The stock exchange authorities would in fact like investors to operate with a levered portfolio. At the same time, they would also like to ensure smooth functioning of the market by preventing defaults in payment on settlement dates. Margins are imposed primarily to reduce the chance of default in payment. When an investor is unable to pay the difference in price and the carry forward charge on a settlement day, the margin money is used to meet his liability and the person is not allowed to carry the transaction to the next settlement date. This view of margin differs considerably from the "equity" view discussed earlier. The important question is whether a 5 per cent margin on an average is adequate against defaults in payment. We feel, after an examination of the market index, that the chance of the index changing by more than 5 per cent in a fortnight (the normal length of a settlement period) is very low and hence an average margin of 5 per cent ought to contain incidence of defaults in payments. Needless to say, in exceptional circumstances, the stock exchange may and does impose margins which are higher for a particular scrip. Besides imposing margins, the stock exchange authorities limit volume transactions by putting ceiling on the outstanding position each broker can have in a scrip. More extreme steps, such as transferring a scrip from the specified list to the cash list, have also been taken. From our discussions, Gupta's suggestion of imposing a uniform 65 per cent margin even in normal circumstances appears unacceptable because such a measure would have a stifling effect on the volume of transactions. Since the Indian stock market is small we need to encourage higher volumes of trading to ensure efficient pricing of securities. In general, margins should be low and abnormal situations should be handled by using other ways of controlling the volume of transactions in conjunction with margins. A certain amount of speculation is desirable for the market to be efficient and the margin in general should be well below the level where speculation stops altogether. Efficiency of the Stock Market A well functioning stock market should be efficient. This implies that the price of a security should reflect all the information available on the long run, funds would be available for economically more productive activities. Investors should be skilled enough to adjust their portfolios by trading quickly on the basis of new information as it becomes available. In the Indian market, most investors have very long holding periods and much of the information made available is unprocessed and does not result in a quick reshuffle of portfolios. In such a situation, presence of speculators who take a far greater risk compared to investors would ensure that the information is processed and acted upon more keenly. Without speculators the market would be less efficient. Lack of expertise and inaction on the part of most investors in the Indian market makes the presence of speculators far more imperative than in the well developed American market. Conclusions Based on actual returns by following different strategies, we have verified that the Indian capital market is inefficient in pricing its securities. There are instances where returns are not commensurate with risks. The attempts of stock exchange authorities to reduce the disparity have not proved adequate. Since the Indian market is small and not well developed, a certain amount of speculation to ensure efficient pricing of securities is desirable. Condemning speculation and suggesting ways of curbing it completely would be shortsighted because in the long run an inefficient market could destroy the primary market completely. 58 Vikalpa