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LITERATURE REVIEW

The first study on momentum based investment strategy was documented way back in 1967. Levi (1967) claims the success of trading strategy based on buying stock with current price significantly higher than the average of last 27 weeks generate significant positive abnormal returns. However Jensen & Bennington (1970) argues that the trading rule based on relative strength proposed by Levi was the one out of sixty eight trading strategies he tested and while tested for out of the sample test period it did not outperformed the buy & hold strategy and hence was attributable to selection bias.

Test of contrarian investment strategies was stealing the show fund managers were found busy picking stocks based on relative strength in US market. Majority of mutual funds examined by Grinblatt & Titman (1989) note the tendency of fund managers to buy the stocks that have seen price increase in last quarter. Apart from that Value Line rankings of mutual funds that were largely based on relative strength also enjoyed high predictive power. The success of mutual funds investing on the basis of relative strength and high predictive power of value line rankings (Copeland & Myres (1982)) provide some evidence of success of investment strategies based on relative strength.

The academic literature suggests contrarian returns generate abnormal returns whereas value line rankings and mutual funds generating abnormal returns based on relative strength strategy are in stark contrast of each other. A seminal study by Jegadeesh & Titman (1993) solves the puzzle by providing an explanation based on different of investment horizons considered by mutual funds using momentum strategies and contrarian strategies advocated by academic literature in late eighties and early nineties.

Jegadeesh and Titman (1993) using US market data from 1965-1989 found not only the evidence of long term success of contrarian investment strategy but also found that momentum strategies generate significant positive returns in medium run over 3-12-month holding periods. They documented the reversal of momentum after about nine months. Their study suggests that in short run for about 3-12 months holding period momentum strategy generate significantly positive returns while in long run for the holding period of 1-3 years contrarian strategy generates significantly positive returns.

Conrad and Kaul (1993) also find evidence from US market that the contrarian strategy is profitable for short-term (weekly, monthly) and long-term (2-5 years, or longer) intervals, while the momentum strategy is profitable for medium-term (3-12-month). As mentioned earlier the results of Jegadeesh and Titman (1993) had thrown a new light on seminal study of De Bondt & Thaler (1985, 1987) and found evidence of short term momentum precedes long term reversal. Although all the results provided strong evidence of market inefficiency, different studies documented different explanations for such returns. Fama & French (1996) presents result based on multifactor CAPM using size and MV/BV ratio to explain various anomalies in asset prices including momentum as well as contrarian returns and claim that market efficiency is intact. However the study failed to explain the presence of short term momentum using the multifactor model and hence short term momentum anomaly remains unexplained.

Several behavioural explanations were found and presented to jointly explain the short-run cross-sectional momentum in stock returns documented by Jegadeesh and Titman (1993) and the long-run cross-sectional reversal in stock returns documented by DeBondt and Thaler (1985). Daniel, Hirshleifer, and Subrahmanyam (1998) (DHS hereafter) assume that investors are overconfident about their private information and overreact to it. If these investors also have a self-attribution bias, then investors attribute success to their own skills more than they should and attribute failures to external noise more than they should. The consequence of this behaviour is that investors' overconfidence increases following the arrival of confirming news. The increase in overconfidence furthers the initial overreaction and generates return momentum. The overreaction in prices will eventually be corrected in the long-run as investors observe future news and realize their errors. Hence, increased overconfidence results in short-run momentum and long-run reversal.

As against the above cited behavioral explanation to short term momentum and long term reversal, some scholars argue that the returns from these strategies are just compensation for taking additional risk or may be the product of the data mining. Most noteworthy of all - Conard and Kaul (1998) argue that the profitability of momentum strategies may be the result of data-mining and momentum portfolio shows positive returns in any post ranking period is true irrespective of the length of test period. Thus Conard and Kaul (1998) suggest that there is no case of long term reversal. This is diagonally opposite to what the behavioral models suggests where after short term momentum prices will reverse to more fundamental levels.

In fact, the criticism of Conard and Kaul (1998) led to another study by Jegadeesh and Titman (2001) where they used out of the sample test by using data from 1991 to 1998 - an overlapping test period compared to their 1993 study where they used data form 1965-89. Their study also eliminated small firms from the study to check whether the earlier momentum returns were actually dominated by small, high-risk and illiquid stock or otherwise. Though they focus on short term momentum in their study choosing two year holding period post formation but they also tested post holding period returns from the period of two to five years after formation.

They present some very interesting results. The momentum profits of Jegadeesh and Titman (1993) continued in 2001 also with almost same magnitude for same holding period that actually has proved that the earlier momentum profits were not the result of data-mining. It also suggests that unlike small firm effect where after the published research on superior returns on small firms compared to their large counterparts, superior returns on small firms disappeared in subsequent studies using data from the periods after the small firm effect from earlier studies got published, that means market has learnt quickly and hence such superior returns disappeared however momentum returns were still present with the same magnitude in 2001 as they were in 1993 study suggest that momentum returns are not just the temporary anomaly but it may have to do with some systemic cognitive bias which sustains for a long time. It also proves that momentum profit is just not the result of some small, illiquid and risky stocks and most noteworthy the reversal found in their post holding period cumulative returns, which render support to the explanations of behavioral theorists and provides evidence against the Conard and Kaul hypothesis.

As far as studies in Asian markets are concerned Chang (1995) found abnormal profits of contrarian strategies in the Japanese markets. Chui (2000) found significant positive abnormal returns with contrarian investment strategy in Japanese and Korean markets. Hameed & Ting (2000) found evidence of market overreaction hypothesis (contrarian strategy) in Malaysia. Kang (2002) found significant short term positive returns with contrarian strategy in Chinese markets.

On the other end, Hameed & Kusandi (2002) found no evidence of contrarian profits in six Pacific Basin markets. While Rouwenhorst (1998) and Griffin & Martin (2005) found existence of momentum in many non-US countries, the quantum of momentum returns in non-US countries was small, and in the case of Asia, insignificant. For example, Griffin (2005) estimates average monthly returns of 0.78%, 0.77% and 0.40% for the Americas (excluding the US), Europe and Asia respectively.

End of the Beginning or Beginning of the End…

The big bull has fallen down, investors have lost their vision, and experts' knowledge went futile with the downturn of the global economies. When the markets were on peak, the funds across the world have flooded in the global economies. Policy makers had lot of confidence on the market, that it will help the economy to grow at faster pace. The market excelled 21000 points which was more ahead then the growth of the economy of India. But that does not seem true for the world economies, as the crisis had hit badly in USA and other parts of world which insisted FIIs and other investors to withdraw their money and markets crashed, went to 7000 points, where investor lost everything and policies could not work to take them up to the level. What was the reason of the crash? What will be the result of the market?

Is this the end of the beginning or beginning of the end?

Indian market is the strong base of determining the financial system of the country. Majority of the financial decisions are dependent on the stock market & other financial market. Indian stock market serves a link to banking and other financial policies which provides impetus to the industry. Indian stock markets heavily based on the sentiments of the clients (market players) & also of the market makers. The crash or boom (in a period/ year) determines the structure of the Indian capital system. The boom in the market (year till 2008) has brought many changes in the performance of mutual funds, insurance (ULIPS), & investment products which led the country into the inflow of the money supply in the market.

Till 2007-08 the market was running at its best, touched the heights, but the global crash in the market became a typhoon & took away major players & organizations into the quick sand of the recession. The insights from the market were not showing positive sign in anyways, so whether this was a new platform or just a time (economic) cycle.

Prologue to decline…

Earth provides enough to satisfy man's need, but not greed. -M.K.Gandhi

The market crash started with the fall of big financial organizations in the USA& in the world like Lehman Brothers, AIG, Freddie and Fannie and many more. The failures were primarily due to exposure into

Subprime loans & Credit default swaps

issued to insure these loans & the issuers devolved resulted into bank failures & steep reduction in the price of equities worldwide.

The economic crisis led many world markets to suspend the trade due to fall in price.

On October 8, 2008 Indonesian stock market halted trading, after a 10 % drop in one day. The crash of 2008 was around 21% which was little less than 1987 (Times of London). Beginning of October month was Black in the world market. The Dow Jones volumes were low and the industrial average fell over 1874 points which was worst weekly decline.

The Icelandic stock market was into pitiable situation where the markets had been suspended for 3 days i.e. 9, 10 & 13 October. On October 24 many of the world's stock market experienced the worst decline, with around 10% drop in the indices.

Source:

http://en.wikipedia.org/wiki/File:OMX_Iceland_15_SEP-OCT_2008.png

The above graph shows the steep and the worst decline a market could ever witness. The Iceland stock market crashed up to unpredictable level. The trading had been suspended for 3 days because of the crash in the market. This situation was visible in all global stock markets, because of financial crisis in USA.

Hence, the worst was yet to be experienced by the global markets & market players. The Indian stock markets were also badly hit & the confidence of people was shattered. The markets were not showing the positive sign in any of the context & people had no clue about the next jump or next level of the market. Market experts were expecting the markets will be into recuperation at the earliest, but things were not going the way it had been desired.

Source: Hindubusinessline.com

Indian market which has shown strong performance till 2007, but from January it plummeted more than 3000 points on all the stock prices & by October 2008, it had touched the 7000 (BSE) line. The continuous unpredictable scenarios in the stock market led many investors and institutional investors to withdraw their money because of negative performance of the markets.

The above shown graph is depicting the dream turned into nightmare for global & domestic investors.

The Beehive capitalism…

Everything that goes up without base falls steeply & with great force. The same situation has happened with the world economies. The supreme economy of the world has become the devil for the small economies, leading major & big companies to file for the bankruptcy.

The global meltdown is the result of Financial Hybrids & Innovations, which has been actively traded all across the world markets. The investment bankers, banks, financial institutions were actively relied on these new and innovative models, which has yet to gain the acceptance across the world. The main accused element for collapse is “Credit crisis”, in which the US banks got the regulations to lend money to the people having no sufficient background to get the loans. These kind of loans were termed as NINJA loans (NO INCOME, NO JOBS, NO ASSETS), & given in abundance by the US banks.

Emerging economies like India, China and other big economies were initially considered to be the places which will remain unaffected from the distortion of crisis. But despite of the strong fundamentals Indian economy dipped into the crisis. The stock market had lost more than 50% of its value (source: economic times), which shattered the hopes of the Indians. There was continuous monitoring by the Central Bank (Reserve Bank of India) on the market trend. The tornado of crisis had destroyed most of the stock markets, banks and financial institutions after soaring to the new heights of investment.

The below mentioned graph depicts the movement of BSE Sensex & S&P CNX Nifty

Source: SEBI Bulletin November 2008.

BSE Sensex closed at 9788 on October 31, 2008 as against 12680 on September 30, 2008, a fall of 3072 points (almost 24%).The month of October 2008 had been the most volatile month, where Sensex recorded a high of 13055.67 on October 1, 2008 & low of 8509.56 on October 27. Nifty closed 2886 on October 31 against 3921 against 30 September 2008. By the end of a month Nifty registered the fall of 1035 points (almost 27%). The market had shown unpredictability of the base & stability level, dissuading more and more investors to take exit from the market.

The Financial crisis:

A Sub-prime loan is a type of mortgage loan made to borrowers who have at least one of the following characteristics:

(1) Low credit scores;

(2) The inability to post the traditional 20 percent down-payment for a home; and/or

(3) The inability to fully document their income.

The subprime crisis is not the result of recent financial innovations and developments, but it is the outcome of lax capitalism policies which had been developed by the US government. In the fifties American government passed a legislation to delink the commercial banking & investment banking. The legislation stated implied that a commercial bank cannot open an investment bank.

In 70's European & American economies faced slowdown, due to which these banks were finding difficult to invest their investible surplus. This time the East Asian economies were liberalizing their economies, due to which the capital from western economies started moving to these economies. After the huge influx of capital into these economies, Asian bubble gets burst, forcing the western economies to introduce new financial measures to invest into the markets. These circumstances and the need of new financial avenues led the US & European economies to trade into the new financial products, by liberalizing the norms for Commercial & Investment Banks.

The liberalization in the regulations led to the introduction of the Mortgaged products (a prime cause of crisis). In the late 90's US mortgage lender began offering the mortgage products to would be “home buyers” who could not qualify for a mortgage loans. Millions of Americans & Europeans, who previously could not afford to buy home, were obtaining these mortgages, due to which great Demand of home (boom) took place leading to shoot of real estate prices.

The above diagram shows how the base of subprime crisis took place in the global markets. The downfall in the economies is considered to be as the Dominoes Effect. The lax screening of borrowers, large capital accumulation & capitalized market structure created a bubble which could not be ceased from getting expand. The whole cycle got mitigated with the introduction of new instruments in the financial markets. The sub prime crisis is about the collapse of the unregulated, $3 trillion over-the-counter market for complex structured assets, some of which happen to contain sub prime residential mortgages.

The semiannual global financial stability report by IMF said that declining US housing prices and rising delinquencies on the residential mortgage market could lead to losses of $565 billion. When combining these factors with other market factors, it puts potential losses at about $945 billion which is almost 25% of the $24trillion global credit market.

Financial innovations were brought into the market to make the products work in the market. The Mortgage products started to conflagrate the US & European markets, where such loans started becoming the pool of assets (Risky) and been traded in the market. Hence, due to this many other factors got the impetus ultimately resulted into the uncontrollable bubble of mortgage, which gets burst and deepened the world economies into the recession.

The subprime crisis has affected the global economies resulting into the fall of big financial corporation like Lehman Brothers, Bear sterns, AIG, Freddie & Fannie, and many more big organizations of whom one cannot think to get fail. The sizes of the organization (exposure) were in plethora that it was not possible for the US & European government to revive these financial institutions. AIG, one of the largest insurance companies (Private) became government undertaking due to the impacts of financial crisis.

SUB PRIME OVERVIEW:

Source: The India Economic Review 2008. (Dec 08)

The whole system works in three stages, Stage First consist of Borrowers & lenders; Second stage consists of the creation of

SpecialPurpose Vehicle (SPV)

with the inclusion of legal intermediaries. The last (third) stage consists of investors those who had invested their money into the riskier assets including the investment banks.

In stage first agent enters between borrowers and lenders, accepting the collateral and also factoring the future price rise. The agents accept the loans, who previously could not even qualify for the approval, now getting loans from the banks & other lenders. The housing price bubble allowed many borrowers to get loans easily because of the high house prices. The loans were mortgaged on a larger scale by creating the pool of similar group of mortgage assets through Special Purpose Vehicle (SPV) given the risk involved on the pool of assets.

In second stage, SPVs were created & all the liabilities were transferred into bankruptcy remote securitization trust or SPV. Underwriters were used to issue & market the MBS (mortgage backed securities). These securities were divided into different tranches, which were of similar securities. The rating agencies were to give rating to these tranches of securities. The ratings were given to the tranches based on the risk, priority of payment of the funds. Higher ratings were given to those tranches benefiting from the credit enhancements the MBS generates or credit insurance purchased from third party bond insurer.

In third stage, Institutional or individual investors such as hedge funds or managers of Collateralized Debt Obligations (CDOs), purchase the securities and then re-securitize the MBS, along with other assets, into a CDO. The Commercial Papers (CP) generated in the initial years was all sold and there was demand for more. Consequently the SPVs started producing more CPs or MBS. The sale of the same only meant that the SPVs were flush with funds. These funds were to be invested somewhere so, the agents were pressed to bring in more borrowers. The lending norms were further diluted to accommodate lesser and lesser deserving borrowers in order to deploy the huge funds available. The consequent spiral that got generated only led to the continued dilution of the Capital Adequacy and Prudence norms. The system went burst once the housing prices turned negative turning the very foundation of subprime lending upside down.

The turmoil of subprime has been expected of more than $ 3 trillion, which is too big for any country to even imagine of recuperating. The impact on Indian market was slow but had been proved acute on the stock market due to the constant humongous withdrawal of FIIs & loss of confidence in the consumers (investors).

Mortgage: Huge pack of cards…

The magnanimous crisis which all started with lax policies of US government, provided impetus for the Fed Reserve to implement new structures in the economy. The capitalist policy was looking very attractive to the market players, but the policy was hollow from the fundamentals. It all started with the Alan Greenspan's reformative structures & models in the financial markets, led to turmoil in the global economies.

The US Fed Bank & Clinton government in 1999 passed

Gramm-Leach-Bliley Act

(GLBA) which had abjured the old

Glass-Steagall Act

which had regulated the Investment Banks, Banks & Insurance industries. The new legislation has unregulated the Wall Street Investment Banks and commercial banks. This deregulation has enlarged the gamut of activities in the financial activities of the commercial banks & other financial institutions. The deregulation had been further reintroduced by legalizing gambling activities into financial sector, a prohibition that had been in place after 1907 financial crisis. The steps towards deregulation of the US markets had converted the US markets into a big casino.

Securities Exchange Commission (SEC) in 2004 took a step towards the deregulation on the financial activities by removing the ceiling on risk that the largest American investment banks could take on Securitized loans. By this time, no one would have thought that the deregulation will result into large speculation & create a bubble in the market. Lastly, the

Securities and Exchange Commission took the last step toward deregulating financial markets when in the month of July 2007, weeks before the onset of the subprime crisis; it removed the “uptick” rule for short selling any security.

The housing bubble was fed by extraordinarily low interest rates & low lending standards (norms) for mortgages. The excessive monetary liquidity & short term interest rates fell to 1%, which led to high borrowing of loans from the banks, resulted into the big bubble of mismanagement of financial activities. After the tech bubble burst in 2001 & the recession, the Fed (Greenspan) aggressively lowered the Federal funds rate from 6.5 percent to 1 percent in 2004, the lowest since 1958. The lowered interest rates & reduced lending standards made the banks to lend the money known as ‘

Predatory Lending'

to the borrowers who did not have capabilities to qualify for the loans, but with the mortgage lending, excessive loans were provided to these lenders as they (banks) were getting big bonuses for bearing risk on these loans. Non-traditional home loans were advanced to borrowers who had no documented incomes.

Some loans were interest only loans with down payments of 5% or less

. Some were Adjustable Rate loans (ARMs), with low interest rates for one or two years to be reset later at much higher rates. In 2006 around 25% of American mortgages were subprime and close to 20% were ARMs. Mortgage lenders and Home buyers presumed that home prices were not going to fall on a national basis.

THE NEW ALCHEMY OF FINANCE

The subprime crisis is the result of new financial products in the market & the deregulation of the financial activities for the FIs. The main reason of such lending was the facility with which subprime lenders could sell their risky mortgages upstream to bigger players, investments banks for example, which undertook to buy them, pool them into mortgage bonds and re-channel them into new financial instruments through a process of aggressive securitization. The Structured Investment Vehicles (SIVs) which fall into the large class of derivative products came under various names such as

Collateral Debt Obligations

(CDOs). They had the characteristics of short term asset based commercial paper that were backed by the underlying income producing mortgage assets downstream and were graded according to a certain risk of default. More than 1 trillion & half dollars of these asset backed financial products were sold in all over the world.

Another new financial instrument that made matters much worse and led directly to the crisis: the Credit Default Swaps. Due to lack of government regulation, this product has become a weapon of mass destruction. In order to protect against the risk of default on the new asset-backed securities (ABS), some insurance companies but also some investment banks themselves began to issue bilateral “insurance” contracts against the newly created ABS. These were called Credit Default Swaps (CDS), which were supposed to protect the investment instruments against the default on asset based securities. The issuer of ABS could buy the protection against the default by paying a premium. This was a financial innovation, the so-called “insurance against default”, that opened the floodgates of money to be invested in the new financial instruments. Indeed, it allowed investors such as pension funds and other institutions which have a fiduciary obligation to buy only high-quality securities, to legally buy artificially highly rated (but risky) ABS securities, or to invest in hedge funds which specialized in leverage trading in derivative products. But the problem was that the issuance and use of such financial “insurance” contracts were not regulated by any government agency, because the word “insurance” was not used; instead, they were considered as simply a protection against the “default” of payment on a financial security. And that's where the gambling part enters the picture: only ten percent of CDS are genuine insurance contracts held by investors who really own asset-backed securities (these are covered CDS); 90 percent of them are rather held by speculators who trade CDS, while not owning any asset-backed securities to be protected (these are naked CDS).

Economy as Casino:

The gamut of gambling that US government & Fed has created was even unimaginable, allowed big participation into these new investment instruments.

Credit Default Swaps (CDS) can be bought and sold by speculators who are not directly involved in the mortgage business. Because of the 2000 Commodity Futures Modernization Act passed by Congress, no state has the power to regulate this new form of sophisticated gambling. The result is astounding: it is estimated that the notional value of credit default swaps outstanding today is about $ 62 trillion (four times the size of the US economy). This is an indication of popularity of the “naked” CDS innovation was as a way to bet on the collapse of the entire asset-backed securities construction. This was also a clear sign that, in a crisis, it would be all but financially impossible for the issuers of CDS to meet their obligations. In other words, disaster was just around the corner. This is an event that any regulatory agency should have seen coming. When housing prices hit the expected top of their cycle, in the 2005, and began falling, especially in 2006, the price for CDSs was still relatively low. So, some astute speculators undertook to buy CDSs and simultaneously began selling short the ABS that had been issued by investment banks, such as Lehman Brothers, in the correct expectation that mortgage-backed securities were bound to lose value with the expected rise in home foreclosures and mortgage defaults. This is how unimaginable spiral got created by the steps undertaken by Fed Reserve & US government which ultimately result into the great burst ever faced in the history globally.

GRAMM-LEACH- BILLEY ACT 1999

The Gramm Leach Billey Act 1999 (GLBA) passed by US government in the year 1999 with a view of security & data integrity in the market. The GLBA repealed the part Glass Steagall act of 1933, which had opened the market among the banking companies, securities companies & insurance companies. The GSA had prohibited any one institution from acting as any combination of an investment bank, a commercial bank and or an insurance company. But the GLBA allowed commercial banks, investment banks, securities firms, & insurance companies to consolidate.

The act was announced in the 1993 & finalized in 1994, allowing many big corporations to merge to enhance their range of activities & take the benefit of the deregulation. The law was passed to legalize these mergers on a permanent basis. The law has not fully deregulated the previous act, but they had relaxed the norms and allowed the FIs to have non financial assets. GLBA was amended with some part of the Bank Holding Company act of 1956. The crucial aspect of the GLBA stated that

no merger can go ahead until the financial holding institutions, or affiliates receives a “less than satisfactory (SIC) rating at its most recent CRA exam”.

GLBA compliance was mandatory; whether a financial institution discloses non public information or not, there must be a policy in place to protect the information from prospective threats in security & data integrity. The law was segregated into three main aspects:

FINANCIAL PRIVACY RULE:

This rule requires FIs to provide each consumer with a privacy notice at the time the consumer relationship is established and annually afterwards. The notice must explain the information collected about the consumer, where that information is shared, how that information is used and how that information about the consumer is protected. The consumer must be notified & give consent about any change at any point of time. Each time the privacy notice is reestablished the consumer has the right to opt it again.

SAFEGUARDS RULE:

The safeguards rule requires FIs to develop a written information security plan that describes how the company is prepared for, and plans to continue to protect clients' non public personal information. This plan must include the following;

  • Denoting at least one employee to manage the safeguards.
  • Constructing a thorough on each department handling the non public information.
  • Develop, monitor & test a program to secure the information.
  • Change the safeguards as needed.

The Safeguards Rule forces financial institutions to take a closer look at how they manage private data and to do a risk analysis on their current processes.

PRETEXTING PROTECTION:

The GLBA encourages the organizations covered by GLBA to implement safeguards against pre texting. Pre texting means when someone tries to access the personal nonpublic information without proper authority & approval. Thus the institutions having covered under the GLBA, needs to have control & safeguard the information of their client, to prevent the details from any misuse.

CRITICISM AND DEFENSE:

There are severe criticisms done after the Subprime crisis, but the act had been defended also. According to Barack Obama, the act helped cause the subprime financial crisis. The statement given by

Chairman of US Senate for Banking Phil Gramm:

The financial services modernization legislation is the most important banking legislation in 60 years. The people it will benefit most are working families. It is legislation that we can be proud of, and it will become law because it will pass both houses of Congress by large margins and will be signed by the President.

"The hallmark of the bill is that it will make an array of financial services available to every American consumer that will provide lower prices and one-stop shopping at financial supermarkets in every city and town in the country.

"The bill has very strong Community Reinvestment Act reforms. For the first time, payments of vast sums of money that flow under the requirement of CRA agreements will be made public, and those who receive the money will have to file an annual report on how they are spending that money in the public interest. This will promote real accountability and assure that the money is used to benefit the working families that it is supposed to help.

The deregulation in the market had enhanced the abilities of the FIs to trade in to the market and introduce new financial products. The policy would create a moral hazard on the tax payers where the taxpayers have to pay the high taxes.

DEFENSE:

The criticism that the act has helped & allowed the market players (FIs) to misuse the advantage of GLBA by enhancing the involvement in the market on scattered basis. But prior to the passage of GLBA in 1999, investment banks were already capable of holding and trading the very financial assets claimed to be the cause of the mortgage crisis, and was also already able to keep their books as they had. After GLBA passed, most investment banks did not merge with depository commercial banks. In fact, the few banks that did merge weathered the crisis better than those that did not.

Thus, improper implication of the act led to the subprime financial crisis subsequently with the other factors.

GLASS-STEAGALL ACT 1933:

This was an old act enacted by the Congress government in the year 1933 also known as Banking Act that prohibits commercial banks to engage into the business of investment banks. The act was enacted after the failure of nearly 5000 banks during the Great depression 1929. It gave tighter regulation of national banks to the Federal Reserve System; prohibited bank sales of securities; and created the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits with a pool of money appropriated from banks.

In the initial years of last century, the commercial banks have established security affiliates that issues bond and underwritten the corporate stocks. The exposure of banks had shoot up to a high level & the impact of 1929 depression was very acute on these banks which resulted into the closure of many banks due to the over exposure into the securities & stocks.

As a result, nearly 4000 banks closed permanently alone in US, shattering the consumer confidence & percolated a chaotic situation in the economy. So, to protect the economy from the repetition of chaotic scenario, US government had enacted the Glass Steagall Act in the year 1993. The act forced a separation of commercial and investment banks by preventing commercial banks from underwriting securities, with the exception of U.S. Treasury and federal agency securities, and municipal and state general-obligation securities. In the same way, investment banks may not engage in the business of receiving deposits. The Glass-Steagall Act restored public confidence in banking practices during the Great Depression.

Hence, the act has been criticized by many of the laureate economists & policy makers about the regulation on the market performance. So, in 1999, US government headed by President Bill Clinton enacted the law called Gramm-Leach-Bliley Act (GLBA) and repealed some of the clauses of Glass Steagall act, with a view to provide liberalization to the FIs. The GLBA enactment provided the FIs freedom to consolidate & increase their reach on the trade of the financial products.

REAL ESTATE DRIVEN GROWTH MODEL BACKFIRED

Alan Greenspan, who relied on the real estate model by deregulating the norms to boost the economy at a greater pace, proved to be a flaw policy. The model proposed by Greenspan has essentially liberalized the lending standards to the real estate borrowers. Basic idea behind the implementation of this model will enable free movement of cash in the economic system from banking institutions to real estate borrowers and hence, activate the economic system to avoid the recession.

However, the original idea as conceived by Alan Greenspan in this model has been ‘misused' by the greedy banks and financial institutions in the urgency of earning extra yield on the loans given to borrowers with relatively sub-standard credit ratings, without giving due significance to their discipline of lending standards. But the Alan Greenspan's liberalized real estate growth model, so called ‘self-regulated' where, banking institutions have taken full advantage of the situation to increase their lending to Sub-prime clients to earn extra yield on their lending.

The misuse of the model has given rise to the concept of “Home Equity”, where if you ask for $1 million loan to buy a house, US banks has provided $1.3 million in belief that real estate prices will only go up and never come down. Greenspan's thinking was that lenders would use the extra funds to spend on other items of consumption and recession would be beaten. The banks, to increase their market, have lent to people of doubtful creditworthiness.

The banks & FIs have taken undue advantage of the policy to increase their Top Level & Bottom Level.

As a result of reckless lending & breached lending standards, people started borrowing loans and started buying homes & use the amount to fulfill their standard of living, due to which the real estate prices shoot up leading to the exponential rise in the value of the assets. As real estate prices rose in the early years of this decade, and securitization provided more working capital for mortgages, lenders relaxed their underwriting criteria in order to issue more mortgages. At the same time, investors demanded higher returns on their investments and raised demand for MBSs and CDOs backed by subprime mortgages. Between 1995 and 2005, subprime mortgages increased from 5 percent to 20 percent of the mortgage market. In 1994, $35 billion in subprime mortgages were originated, and by 2006, that number had increased to more than $600 billion.

In 2006, short-term interest rates rose while the value of homes leveled off or dropped. Borrowers with financial difficulties could not refinance or sell their homes to pay off mortgages when they were unable to make monthly payments. Further, in 2006 and 2007, borrowers suffered “payment shock” when teaser rates on many hybrid ARMs expired and higher variable rates became effective.

As a result, default rates on subprime and Alt-A mortgages increased significantly in late 2006 and 2007. Early payment defaults, where a borrower fails to make a payment within the first several months of the loan, became more common in 2006. With rising defaults, purchasers of mortgages sought to force lenders/originators to buy back nonperforming mortgages. Many smaller lenders that were inadequately reserved and unable to comply with such repurchase demands filed for bankruptcy.

Thus the idea of Greenspan flunked as the inappropriate balance created in the market. The deregulation in the economy had helped the speculators to speculate the market and create a bubble which ultimately got burst, lead chaotic situation which impacted the global economies in negative manner.

ANALYSIS OF MELTDOWN & ITS IMPACT (INDIA)

The initiative towards the meltdown had been taken by the US government, when they have enacted the new laws & deregulated the market. Deregulation might not the prime cause of the meltdown but the improper screening & monitoring of the government is the cause of the mammoth. Every one has equally played their role in helping the bubble to grow exponentially & let it burst. To analyze, it must be initiated from the macro-economic point of view.

1.

DEREGULATING THE MARKETS

The crisis erupted with the deregulation of the market, allowing the commercial banks, investment banks, security lenders & other players to consolidate with each other to take the advantage of the deregulation (benefits). But the things do not turned the way it had been expected by Alan Greenspan, who relied heavily on the real estate model for the growth

By enacting the Gramm Leach Billey Act 1999

US government has provided a large free ground to the FIs who can fulfill their greed of increasing their Top & Bottom lines.

The financial deregulation that took place in the economy with the acts enacted, opened the door to greater competition and new financial product. With the affirmation & consolidation in the financial market, the FIs started diversifying their business in the other financial businesses make the most out of the deregulated market. Investment banks started collaborating with the commercial banks & other FIs to earn maximum from the yield generated through the mortgage bubble. Hence, the implications of policies were misused by the FIs to satisfy their greed to earn maximum.

2. UNDUE ADVANTAGE TAKEN BY FINANCIAL INSTITUTIONS:

The financial institutions were previously prohibited to enter into any other arm of financial services or products. For example: Investment banks cannot open commercial banks under Glass Stegall act, but the act was liberalized & having influx of capital in the economy, Fed Reserve allowed consolidation of the FIs. With the enactment of GLBA, the greed of FIs erupted to a larger extent that they have started introducing new financial products like

“Home Equity”

, CDOs, MBAs, ARMs & many other products.

The basic idea of the Fed Reserve was to protect the economy from recessionary impacts, and they thought that larger financial institutions will act with due diligence to protect their long run viability. But the things went opposite, with the greater competition in the market, the FIs have deteriorated their level of operations by manipulating the whole structure of lending the money to the borrowers. They have given loans to the people who even cannot qualify to get the home loans because of their zero creditworthiness. Not only that the FIs have provided loans to everybody but also of the higher amount then the mortgage of home. The perception that institutions were carrying was really absurd, and not at all resembling with the fundamentals.

Source: www.urbandigs.com

The above figure shows the tranche of mortgage assets created by the financial institutions. In step 1, the borrower borrows the money for home and mortgages the home which is converted in a group or pool (based on the amount & risk on loans) of mortgage assets.

The banks create the pool of these similar assets and the assets are rated based on the characteristic of the pool of assets. The ratings to the pool were given on the basis of risk, higher the risk of default, higher will be the yield. Here, first loss in case of default will be suffered by the investors who have invested in the

unrated pool or mortgage assets, and then the least will be suffered by the AAA ratings investors.

In case of return, highest return will be earned by the investors holding unrated pool of mortgage & vice versa. In this way the whole tranche of the assets were created.

Investors eagerly purchased these assets without sufficient understanding of the risks. After all, the US economy has been expanding since 2001, why should investors worry too much about risk. Unfortunately, the bond rating agencies had no experience in rating these new products, but after a back-and-forth negotiating process with the issuer the rating agencies gave the products high marks. Investors would not have purchased these products to such a large extent if they thought they were overly risky. Between 2000 and 2006 the growth in these products was exponential from$500 billion to $2.6 trillion.

In order to produce these new products, mortgage lenders followed an

“originate-to-distribute”

model where they made their money on the origination fees of the loan and then passed the set of loans on to investors, who relied on the rating agencies to assess the risk. But the mortgage lenders did not have to worry about the ability of borrowers to repay since they only acted as a conduit. If lenders (financial firms) are not performing adequate due diligence on the borrowers, and if rating agencies are negotiating ratings (with the issuers pay them) instead of making an independent assessment on the packaged securities, then the investor is purchasing something that contains far more risk than expected. These risk management problems can be characterized as principal-agent relationships, where the agents - the lenders and raters - are assumed to be acting on behalf of the principals the investors; but instead the agents are acting on their own short-term interest. The agents clearly had more information than the principals, who presumably could have managed the risks better with full information. Full information (complete transparency) on the risks might have dissuaded some risk adverse investors from purchasing these CDOs and MBSs, which would have meant less profit for the agents. The flaws in this type of incentive structure, which lead to lax corporate governance, are all too evident now.

Another flaw in the governance of financial corporations was that the large financial firms believed they were too big to fail. They thought that the Fed would step in with a fresh injection of liquidity. This belief caused them to take more risks than they would have without the assurance of Fed action. This problem is called a moral hazard, where the presence of insurance fosters more risky behavior than would have otherwise occurred. If only one financial firm had taken excessive risks, the system could have handled the outcome. But when almost all large financial firms took excessive risks, the system collapsed. The risk management models did not capture systemic risk.

3.DEBT EQUITY MISMATCH:

The financial innovation & deregulation in the market aggravated FIs to go for more debt to invest in these financial products. The fall of big organizations reveal that up to huge extent they have taken debt of large amount. In a normal organizations, Debt to Equity ratio remains around 1:2 or maximum up to 1:2.7 times, but in the banking industry, the debt-equity ratio is always much higher because the deposits of banks are considered as debts of the bank.

When, Goldman Sachs got into trouble, it had debts of about $1.04 trillion against its own equity capital of only $40 billion. This means it had a debt to equity ratio of 24.7:1. Another example is of Lehman brothers, where they had a debt ratio were almost 30 times of its equity. In this situation, it becomes almost impossible for any firm to go debt free & would definitely result in close down of firm.

It is very usual for any bank or financial institutions to make a mistake in lending or investment decisions. In the real estate boom of 2002-06, banks had lent an imprudent share to Alt A mortgages and Sub-prime borrowers. The loss or delinquency from borrowers would definitely cost huge for these organizations. For Example: if they make loss of $15 million (Debt Equity: 1:33), then they will loose $5 million as their money, plus they will loose $10 million (without interest).

The loss was unimaginable and it becomes difficult for any institution to survive the blow with the huge debt.

4.ASSET LIABILITY MISMATCH

In any organization the balance in the balance plays a vital role in determining their creditworthiness. But in US, banks have not taken into the consideration the balancing of the balance sheet. US banks have advanced money to the borrowers till 20 years tenure; to do this they have taken loans & deposits to provide money to the borrowers. They started financing the real estate loans to their clients using six monthly revolving credits.

For example:

Bank is giving a real estate loan for 20 year period to a borrower and bank will get repaid the same in EMIs over that period of 20 years. US banks have financed such real estate loan using a six month revolving credit wherein banks will need to repay to their lenders that amount in the next six months. How can you repay something in six months when you are supposed to get back that amount in EMIs over 20 year period? Hence, the banks started to revolve that credit every six months, meaning they will repay that amount after six months by using a fresh borrowing. In effect, they have revolve that amount

40 times

(that is two times a year, for 20 years stretch) before they get their money back from their borrowers. If there is tightness in the market then it becomes difficult for bank to repay and ultimately results in bankruptcy under cash crunch, which is exactly had happened with US & other European banks.

5.RISKY MORTGAGE PRODUCTS & LAX LENDING STANDARDS

Along with the rise of unregulated lenders came a rise in the kinds of subprime loans that economists say have sounded an alarm. The large number of adjustable rate mortgages, interest-only mortgages and “stated income” loans are an example of this thinking. “Stated income” loans, also called “no doc” loans and, sarcastically, “liar loans,” are a subset of Alt-A loans. The borrower does not have to provide documentation to substantiate the income stated on the application to finance home purchases. Such loans should have raised concerns about the quality of the loans if interest rates increased or the borrower became unable to pay the mortgage.

In many areas of the country, especially those areas with the highest appreciation during the bubble days, such non-standard loans went from being almost unheard of to prevalent. Eighty percent of all mortgages initiated in San Diego County in 2004 were adjustable-rate, and 47 percent were interest-only loans. In addition to increasingly higher-risk loan options like ARMs and interest-only loans, lenders increasingly offered incentives for buyers. An estimated one-third of ARMs originated between 2004 and 2006 had “teaser” rates below 4 percent. A “teaser” rate, which is a very low but temporary introductory rate, would increase significantly after the initial period, sometimes doubling the monthly payment. Programs such as seller-funded down payment assistance programs (DPA) also came into being during the boom years. DPAs are programs in which a seller gives money to a charitable organization that then gives the money to buyers. From 2000 to 2006, more than 650,000 buyers got their down payments via nonprofits. According to the Government Accountability Office (GAO), there are much higher default and foreclosure rates for these types of mortgages. A GAO study also determined that the sellers in DPA programs inflated home prices to recoup their contributions to the nonprofits.

This type of innovations to combat competition of the deregulation provoked the bubble to grow and support the subprime. The banks have adopted false practices to combat competition without thinking any step further & heavily relying on the housing market that had deceived the whole economy.

6.EMERGENCE OF NEW KIND OF LENDERS:

With the boom in the mortgage market, new kind of lenders came & started lending to the borrowers. These lenders were not regulated as are traditional banks. In the mid-1970s, traditional lenders carried approximately 60 percent of the mortgage market. Today, such lenders hold about 10 percent. During this time period, the share held by commercial banks had grown from virtually zero to approximately 40 percent of the market.

This kind of lenders have lax the market & given equal contribution in helping the crisis to evolve at the peak.

7.INADEQUATE RISK MODELING & OVER RELIANCE ON CREDIT RATINGS:

The risk modeling that the banks have adopted was totally unreliable & absurd. Their main predictions were based on the real estate prices. Once the loans were booked, both brokers and lenders received a commission, with credit risk rapidly being transferred to other market participants via securitization of the loans. Consequently, while under most circumstances originators stand in the best position to analyze the credit risk of the individual loans they make, as a practical matter they appear to have a reduced incentive to do so since their risk of loss is greatly diminished when the risk is transferred to others. For similar reasons, the arrangers and sponsors of the structured finance transactions, who might otherwise be in a position to monitor the degree to which the originators conducted adequate due diligence regarding the underlying assets of a structured transaction, likewise appear to have a reduced incentive to do so given how these transactions were structured and marketed. Some institutional investors when purchasing the more complex CDOs appear to have had little understanding of the instruments or the underlying cash flow and security upon which the instruments derived their value.

The other aspect is that the FIs were heavily relying on real estate & credit ratings given to the mortgages (pool) by the agencies. But the absurdity was the credit rating agencies did not know the parameters to rate the pool of subprime assets. They did not have sufficient base to provide ratings to the pool of mortgages, because previously these agencies had not encountered the cases and mortgages like this. So, lack of information, absurd base of ratings & non compliance of due diligence are the main cause of the crisis.

Hence, the causes of the crisis are many, but the above mentioned causes are the acute and directly co-related with the suffering in global markets.

Global Downturn:

The above mentioned diagram explains in nut shell the critical elements which lead the world in the arms of recession and depression. The top circle describes the policies that had been framed & imposed to make the market deregulated lead to the crisis. With the deregulation in the country, the banks, investment banks & other financial institutions took the benefit to increase the figures in their balance sheet (asset side). To raise the bottom lines they started increasing their top lines by providing the loans & finances to the sub prime people, with a view to recover the money (in default) from the real estate. The mortgage based financing boosted the economies, excelled the market & finally shattered as the model adopted was not backed by proper policy frame work (Glass Steagall act & GLB act).

FDI's & other mode of investments were increasing in the western countries, resulted into increase in the real estate price & boost in the economies. These boosts were shifting to the eastern & developing countries (BRICM), enhanced their markets, created demand, gave the hope of quick development. But the countries could not succeed those who had diverted their focus from growth of domestic market to expanding & dependence on the export markets.

The gamut of the global crisis was too large that no economy had been able to keep itself away from the waves of the crisis. The wave had hit the world economies too hard that it will take long to recuperate & resurrect in full capacity. India, the country had seen the glimpses of the crisis in the financial sector & the other areas too. One side it was battling with domestic turbulence & pressure and on the other hand, India had to take necessary & vital decisions to escape the blow of the crisis.

The growth expectation of world became too pessimistic, that experts were confused to reveal the approximate growth of the countries. The market & economy became unpredictable because of the volatility & pressure. The crude oil prices touched $150 (approx) & went low till $35 in the span of 8 months.

Source:

http://www.iitrade.ac.in

The above graph depicts the volatility in crude prices because of the financial crisis & volatile US dollar prices globally. Here within a span of 5 months the price of crude barrel comes almost 50% low from around $ 150 to $ 70. The imbalance in the economies made the prices too volatile, which pushed the demand low

. For e.g. Indian Oil Corporation stock price during this period was around Rs. 500 in February 2008 and went low till Rs 310 by June 2008 because of the volatility in the crude price.

The crude oil prices were not though considered to be the reasons for slump in the economies. But it was one of the reasons in slowing the demand in the economies.

GLOBAL FALL & INDIA RELATIONS:

The blow of global financial crisis has trapped majority of the countries, directly or indirectly. India, though not heavily victimized but the deregulation has infected some of the zones (sectors/ areas) of the country. Impact of financial crisis on India can be measured in three broader ways:

the financial sector, exports & exchange rates.

The Indian banking system, due to strong foundation had not been impacted largely of the “Sub-prime mortgage crisis”.

The exports of India have been majorly affected due to the slump experienced by the Service sector. The IT & ITES companies suffered a drastic downfall in their Top & Bottom line because of Global financial crisis, as outsourcing ratio has decreased in the country. The fall of big companies like Lehman Brothers, AIG, Bear stern, Freddie & Fennie etc. had crumbled the confidence of consumers & investors. The exchange rates (INR to USD) were too fragile & volatile, that it has broken the past trends of markets. The Indian economy seemed to be relatively insulated from the blow of global financial crisis which surfaced in the U.S. in August 2007. The RBI was raising interest rates until July 08 with the view to cooling the growth rate & control inflationary pressure on the economy. But the waves of financial crisis & the tight regulatory policies from the government & RBI dried up the credit flows & overnight, money market interest rates rose to about 20 percent and remained at the peak for a month. It was, perhaps, judicious to assume that the impacts of the global economic turmoil, on the Indian economy were still unfolding. The severity and suddenness of the crisis can be judged from the IMF's forecast for the global economy, where for the first time in 60 years, IMF had forecasted negative growth for the world GDP in 08-09.

The impact of crisis on the Indian banks were also inevitable, as Only one of the larger banks, ICICI, was partly affected but managed to thwart a crisis because of its strong balance sheet and timely action by the Indian government, which virtually guaranteed its deposits.

The equity markets had seen near 60 percent decline in the index and a wiping off of about USD1.3 trillion in market capitalization since January 2008 when the Sensex had peaked at about 21,000. This is primarily due to the withdrawal of about USD12 billion from the market by foreign portfolio investors between September and December 2008.

The foreign investors withdrew these funds in order to strengthen the balance sheet of their parent companies

. Commercial credit, both for trade finance and medium-term advances from foreign banks has virtually dried-up. This has had to be replaced with credit lines from domestic banks but at higher interest costs and has caused the Rupee to depreciate raising the cost of existing foreign loans. Simultaneously, the remittance from the Indians had reportedly fallen as oil producing economies began to suffer due to sharp decline in the oil prices from $ 145 to $ 30 per barrel.

Hence, India had experienced the decline in exports about 21 percent, which was the steepest in the last two decades of the economy. The industries like diamond, garments, infra projects, automobile sectors were facing the huge slump because of dried markets of export & fewer investments from outside the country. The growth prediction was totally vague & uncertain, as the markets directions were not on a single side.

IMPORTS & REMITTANCES

Thus, the scenario of the economy was vague and volatile, increased the inquisitiveness among the policy makers for the economic & business cycle. The equity market squeezed due to liquidity problem & large amount of withdrawals of FIIs from the country. The economy had faced one of the worst phases of FII withdrawals. Hence, the economy had been impacted directly and indirectly from the financial turmoil.

IMPACT ON INDIAN STOCK MARKET: LOOSING FAITH

The year 2008-09 would be the worst year any economy & the stock market would have witnessed in their history. The Indian investors have lost their confidence because unpredictable trends & volatility in the market after the crash in early 2008. The world stock markets have witnessed the turbulence due to the subprime crisis that took place in US & European markets.

India, being worried of contagion impact of the crisis, somehow managed the crisis up to the extent but could not remain untouched of the financial disturbance. India had a fear from both the sides, but more from the global cues which were affecting the performance of the market. Inflation in the country & rising prices of crude has mostly impacted the share prices of the companies. The Indian stock market that once touched 21000 points mark, seen a bizarre when it crumbled down to 7000-8000 by October 2008.

The VIX (Volatility Index) of Indian stock market went to more than 60 & after 40 the market become unpredictable, giving rise to more speculation. Whether it is IT sector, Banking sector, Petroleum sector all have witnessed crumbling stock prices of their company. The crumble happened because of the global cues & persistent withdrawal of FIIs & other foreign investors. There was large selling done by FIIs in India during 2008-09 because of the crisis in US & Europe.

Source; urbandigs.com

The above graph depicts the movement of closing stock prices (Sensex) from June to October 08 because by this time Indian markets lost its value to 8500. The period of 4 months was totally unpredictable & the trends were fragile, making daily new base in the stock market. The fall of Lehman bros. has crumbled & crashed the market sentiments leading market to fall steeply. The emergence of the crisis has caused huge demand for US dollars in the global market where in comparison to INR, US dollar almost touched Rs 50 mark which is too high (below graph).

Source: www.articlebase.com

Thus, the Indian market was impacted heavily due to the withdrawals of FIIs & negative global cues. RBI, the governing bank of India has put in lots of effort to prevent the market from further crash. The reserve ratios had been continuously changing to maintain the proper liquidity in the market. Government has also provided indirect relief package for Auto & other industry. Despite of many efforts from the government Indian could not remain untouched from the financial turbulence.

ESCAPING FIIS:

India, which became one of the most lucrative places of investment (Equity) for the Foreign Institutional Investors in the recent past, but as the financial crisis hit the US & other western markets, FIIs started selling their stakes in the market. Sell of from FIIs lead the market to go drastically down in January 2008 till the end of the calendar year. During 2008-09, there was an outflow from the equity segment amounting to Rs.47, 706 crore & the highest outflow from FIIs were in the month of October 2008 of Rs 15347 crore. The investors' confidence crumbled and shattered, withdrawing from the markets & holding the portfolio with a view to get a satisfactory price, but the worst was yet to hit the market. FIIs bulk exit made the market more volatile, panic & unpredictable.

INVESTMENT BY FIIs

IN CRORE Rs

YEAR

GROSS PURCHASE

GROSS SALES

NET INVESTMENT

1992-93

18

4

13

1993-94

5593

467

5126

1994-95

7631

2835

4796

1995-96

9694

2752

6942

1996-97

15554

6980

8574

1997-98

18695

12737

5958

1998-99

16116

17699

-1583

1999-00

56857

46735

10122

2000-01

74051

64118

9933

2001-02

50071

41308

8763

2002-03

47062

44372

2690

2003-04

144855

99091

45764

2004-05

216951

171071

45880

2005-06

346976

305509

41467

2006-07

520506

489665

30841

2007-08

948018

881839

66179

2008-09

614576

660386

-45810

SOURCE: ANNUAL REPORT (SEBI 2008-09)

The above table shows the Trade in and trade out done by FIIs from the country. The gross purchases of debt and equity by FIIs declined by 35.2 per cent to Rs.6,14,576 crore in 2008-09 from Rs.9,48,018 crore in 2007-08. The net flow went negative for the first time after a smooth decade of inflows from the outside countries. The major reason of plough back was the pity situation of the banks & financial institutions in the western economies due to the financial crunch. The persistent inflow of funds from outside the country has ignited confidence in the minds of domestic investors, which started the vicious chain of fall.

The above mentioned graph explains the clear cut trend visible in flow of FIIs in India. Started in the year 1992-93, the investment is increasing but the growth is not drastic as much as it showed in from the year 2003-04. The inflow growth had been phenomenal during the last 3-4 years but the in the year 2008-09, the financial crisis in the western economies has changed the scenario in the Indian economy.

NET INVESTMENTS EQUITY (Rs CRORE)

YEAR/MONTH

MF

FII

2006-07

9062

25236

2007-08

16306

53404

2008-09

6984

-47706

Apr-08

-112

1075

May-08

64

-5012

Jun-08

3179

-10096

Jul-08

1412

-1837

Aug-08

-369

-1212

Sep-08

2292

-8278

Oct-08

1432

-15437

Nov-08

-373

-2598

Dec-08

341

1750

Jan-09

-864

-4245

Feb-09

-1497

-2437

Mar-09

1476

530

SOURCE: ANNUAL REPORT (SEBI 2008-09)

During the year 2008-09, the market could not make its mark by giving the proper information about the prices & trends of the market. October 2008 was the worst month in terms FII withdrawals from the country. The highest ever single time withdrawal has taken place in the economy with the vague government policies & ambiguous global cues. Around Rs 15500 crore was ploughed back by FIIs due to which market sentiments were crashed.

The policy impact of government was clearly visible in the equity deals, as government started releasing the liquidity in the market. The market has shown one of the most volatile phases of global and Indian stock market. SENSEX has crumbled down and touched almost 7000 mark in the October 2008, while NIFTY touched the ground of 2500.

Thus, the market was showing inquisitiveness towards the stock market movements. The economy of India was shocked with the surprises given by Foreign Institutional Investor on financial meltdown of the economies by the way of plough backs. The trends were broken on weekly basis & the investors were playing in murky field, without any indication of the movement of the market. The past winners (the most traded stocks) were failing to prove their value for the investors succumbing to the financial meltdown. It would be crucial & vital for the stocks that whether they over react or not? In, a nut shell, TODAY'S WINNER WOULD BE THE TOMORROW'S WINNER, OR TODAY'S WINNER IS TOMORROW'S LOSER.

DOES STOCK MARKET OVER REACT???

The market performance is dependent on the behavior portrayed by the investors & the information prevailing in the market with investors. Stock prices vary on the basis of confidence of investors, who carries the information about the particular company. The models & analytical studies have been developed to know the functioning of the stock market. The models analyses the various aspects of the investor behavior and implement on the market variants. The market performance is not always in the proportion to investor behavior but also dependent on the efficiency of the market.

The market performances rely on the efficient markets. An efficient capital market is one in which stock prices fully reflect available information. Efficient market hypothesis predicts that the price of shares on next day will reflect the prices on the based of information available in the market with the investors. It has implications for investors and for firms.

  • Information related is reflected in prices immediately, investors should only expect to obtain normal rate of return. Awareness of information when it is released does no good to investors. The price adjusts before the investors have time to trade on it.
  • Firms can have fair rate of return for securities that they sell. Fair means that the price they receive for the securities they issue is the present value.

The efficient market is also dependent on the three basic things which decide the ways of market performance. (1). Rationality (2). Arbitrage & (3) Independent deviations from rationality

Source: theorypedia.com

1.

Rationality:

When the new information is released in the marketplace, all investors will adjust their estimates stock prices in a rational way. The price will instantaneously adjust & fully reflects new information. Here, either market will overreact to the information, adequately respond or give delayed response to react on the information.

2.

Independent deviations from rationality:

The information released in the market is not clear and they hope that the information will bring positive impact then they will over pay for the shares & vice versa. If any of these would likely to dominate the market then the market will either rise beyond the market efficiency or go beyond the market efficiency.

3.

Arbitrage

:If there are two type of investors: Irrational & Rational; the irrational will get catch in the emotions and will believe that the stock is undervalued and other time believe it opposite. If these wont get cancel then the prices will either go below the market efficiency or will go above market efficiency.

Different types of efficiency:

The market responds immediately to all available information, in actuality certain information may affect stock prices more quickly than other information. The efficiency depends on the form of markets, which is classified in three categories: Weak form of market, Semi-strong, & Strong form of market.

1.

WEAK FORM:

A capital market is consider to be weakly efficient, if it fully incorporates the information in the past stock prices. It does not use any other information such as earnings, forecasts, M &A etc. It is about the weakest type of efficiency that one can expect in a financial market to display historical price information is the easies kind of information stock. It is hardly possible to make huge profits out of the weak form of efficiency as the price changes are inclusive of the information.

2.

SEMI STRONG:

A market is semi strong form efficient, if prices reflect all publicly available information, including the information published for the firm as well as historical prices information. The semi strong efficient market requires not only that the market be efficient with respect to historical price information, but that all of the information available to public be reflected in price.

3.

STRONG:

A market is said to be strong form efficient if prices reflects all the information whether private or public.

Hence if today's price reflects only information on past prices, the markets is weak form efficient. If today's price reflects all publicly available information, the market is semi- strong form efficient. If today's price reflect all information both public and private then the market is strong form efficient.

Momentum is a simple trading strategy where past winners are bought and past losers sold short in the stock markets. The basic idea of the strategy is that winners and losers maintain their historical pattern of return in future periods and buying the winners and short selling the losers should generate above average returns. If the markets were efficient as the efficient market hypothesis asserts then it should not be possible to profit from historical trends using a simple, costless strategy such as momentum trading. These kinds of researches had been taken by many well known professors and financial associates. The phenomenon was first studied by

Jegadeesh & Titman (1993)

who studied US stocks during the period 1965-89 and found that the strategy of selecting stocks based on their past 6 months returns and holding them for 6 months generated an excess return per year on average. Their results also indicated that the profitability of the strategy was not due to the systematic risk.

Data & Methodology:

The objective of the study is to test the presence of momentum in Indian stock market using 6×6 months momentum investment strategy.

` The sample for the study is selected from the Universe of the stocks listed on the National Stock Exchange of India. The sample consists of stocks in which F&O trading is permitted. The logic behind selecting the samples in which F&O trading is permitted is that the criteria for selection for F&O trading used by NSE are based on free float market cap and liquidity and hence the sample has stocks which are reasonably large and having high liquidity and hence resolve the problems of results getting driven and distorted by small and illiquid stocks having problems of high risk and bid-ask bounce. The other advantage of using the sample of stocks in which F&O trading is permitted is to eliminate the hurdle in executing the momentum strategy of buying winners and selling losers. While buying winners is not an issue, selling losers in Indian market is not possible as short selling can be done only on intraday basis and not beyond that. Having selected stocks where in F&O trading is permitted makes it possible to short loser portfolio using futures market.

The data of monthly returns are calculated using monthly adjusted closing price form CMIE's Prowess for a period between January 2001 to July 2009. All stocks having non missing returns in formation and testing period are considered for analysis.

The study employs Jegadeesh & Titman (1993, 2001), at the end of each month the stocks in the samples are ranked using their past six months market adjusted abnormal returns. The stocks grouped into ten equally weighted equal size portfolio on the basis of these ranks. The top performing portfolio is named as Winner portfolio (W) and worst performing portfolio is named as Loser portfolio (L). Each portfolio is held for six months following ranking month. The exercise is repeated every month for the entire period for the study. Eighty six such iterations performed over entire sample period. Using the overlapping period for the study has an advantage that it improves the power of the test.

In the first step, the winner and loser stocks are determined by the past abnormal returns over 6 months portfolio formation period by simply ranking the stocks in terms of their performance as indicated by the six months CAR (Cumulative Abnormal Returns) data. The top deciles stocks are assigned to the winner portfolio (W), while the bottom deciles stocks make up the loser portfolio (L), both winner portfolio and loser portfolio are equal weighted portfolios of the member stocks in respective deciles.

This step is repeated eighty six times for using monthly overlapping period starting January 2001 and ending on July 2009 as mentioned above. This method of ranking is widely accepted and used in past studies (see De Bondt & Thaler (1985) and Conrad & Kaul (1993), Jegadeesh & Titman (1993, 2001)). Therefore, for every stock i in the sample, the cumulative abnormal returns for the prior 6 months will be calculated:

CAR = (1)

The second step of testing momentum strategy involves measuring the performance of winner and loser portfolios over the next 6 months. For both portfolios in each of the eighty six overlapping 6 months periods, the Average Abnormal Returns (AARs) is obtained by taking the mean of abnormal return of average the selected stocks. The monthly AARs are used to calculate the Cumulative Average Abnormal Returns (CAARs) in each t, where t=1,…, 6 during test period, this step is repeated eighty six times and average the CAARs for these eighty six test periods are used to get Mean Cumulative Average Abnormal Returns (MCAARs).

Where n= number of stocks in each portfolio

n = Number of stocks in each portfolio

t= 1 to 6

k = no of times test repetition (86 in our case)

Test of Significance

Therefore, MCAARW (MCAARL) indicates how much cumulated excess returns stocks in the winner (loser) portfolio earn on an average during 6 months in test period. If markets are efficient and weak form of EMH is in force then MCAARW - MCAARL must be equal to zero. The momentum hypothesis implies that MCAARW > 0and MCAARL < 0. Alternatively, the null hypothesis can be written as MCAARw - MCAARL> 0. In order to assess whether there is any statistically significant difference in investment performance, we need a pooled estimator of population variance in CAAR t

St2 = [2 + 2]/2 (K-1) (5)

With two samples of equal size K, the variance of difference of sample means equals 2St2 /K and the t statistics is therefore

Tt = (MCAARW, t - MCAARL, t)/ SQRT (2St2 /K).

(6)

Relevant t statistics can be found for the each of the 6 post formation months but they don't represent independent variance.

In order to judge whether, for any month t, the average residual return makes a contribution to either MCAARW,t or MCAARL,t, we can test whether it is significantly different from zero. The sample standard deviation of the winner portfolio is equal to

St = SQRT (2 /2(K-1)

(7)

Since St/SQRT (K) represents the sample estimate of the standard error of MAARw,t the t-statistic equals

Tt = MAAR w,t / {St/SQRT (K)}

(8)

The similar formulas and method would be again applied for the looser portfolio of the stocks/ F & O.

CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) is a market equilibrium model used to determine the price of risky assets. This model will be used as a market model in the analysis that follows. The model is derived with the following assumptions:

  • Investors are risk-averse individuals who maximize the expected utility of their wealth.
  • Investors have homogeneous expectations about future returns and the returns have a normal distribution
  • Investors may borrow or lend unlimited amounts at a risk free interest rate using a risk free asset.
  • There are no frictions in the capital markets. This means that there are no transaction costs, taxes on capital gains or dividends. It also assumes that there are no restrictions on short selling.
  • Information is costless and flows freely between all investors.
  • All assets are marketable and divisible
  • The assumption that investors have homogeneous expectations means that they all perceive the same investment opportunity set.

Hence, CAPM is used to know the market variations from the average price of the stock. Thus, it provides vital information to the investors about the riskiness of the stocks.

Does market over react (Calculations)

Mean cumulative Average Abnormal Returns of winner (W), loser (L) and a momentum portfolio (W-L)

Table-1 reports mean cumulative average abnormal returns of winner portfolio (W), loser portfolio (L) and a momentum portfolio consisting of long winner and short loser portfolios (W-L) (based on the past six months returns) held for next six months along with their respective t statistics. The sample of the stocks consists of all the stocks listed on NSE in which F&O trading is permitted and having no missing returns both in formation and test period. The stocks are ranked using their cumulative abnormal returns over six months formation period and an equally weighted portfolio consisting of best performing 10% stocks is defined as winner portfolio (W). Similarly an equally weighted portfolio consisting of the worst performing 10% stocks is defined as loser portfolio (L).

MCCARW,t

TW

MCAARL,t

TL

MCAARW-MCAARL

TW-L

0.99

1.72*

-0.79

-1.42**

1.78

2.22

1.40

1.95*

-1.26

-0.90

2.66

2.54

2.29

2.64*

-2.17

-2.50*

4.46

3.64

2.24

2.09*

-2.60

-2.57*

4.84

3.29

2.56

2.14*

-2.68

-2.48*

5.24

3.26

2.59

1.84*

-3.11

-2.54*

5.70

3.06

*significant at 5%, ** significant at 10%

Figure 1

Table-2 tries to measure contributions of a specific month in momentum returns. MAAR of winner portfolio in the first month shows 0.99% returns with t-stat of 1.72 which is significant at 5%. MAAR for the third month is 0.89% with t-stat of 1.82 again significant at 5%. Even though all five out of six MAAR are positive for winner portfolio; all of them are not significant. Looking at MAAR of loser portfolio similar picture emerges. MAAR for the first month of test period is -0.79 with t-stat of -1.42 which is significant at 10%. MAAR for the third month is -0.91% with t-stat of -1.79% which is significant at 5%. MAAR for all the other months is negative but statistically not significant. As a result, MAAR of momentum portfolio (W-L) also shows similar trend, where despite having all the MAARs positive only the first and the third month figures are significant at 5% level with returns of 1.78% and 1.8% and t-stat of 2.22 and 2.55 respectively. It can be interpreted that the momentum is at its peak during the first three months and slows down a bit from there on. Though momentum stays thorough out the test period but it is not significant for each month of the test period. However each months return contributes to cumulative momentum profits throughout the test period.

Table-2

Mean average Abnormal Returns of winner (W), loser (L) and momentum portfolio (W-L)

Table-1 Reports Mean average abnormal returns of winner portfolio (W), loser portfolio (L) and a momentum portfolio consisting of long winner and short loser portfolio (W-L) (based on the past six months returns) held for next six months along with their respective t statistics. The sample of the stocks consists of all the stocks listed on NSE in which F&O trading is permitted and having no missing returns both in formation and test period. The stocks are ranked using their cumulative abnormal returns over six months formation period. An equally weighted portfolio consisting of best performing 10% stocks is defined as winner portfolio (W). Similarly an equally weighted portfolio consisting of the worst performing 10% stocks is defined as loser portfolio (L).

MAARW,t

TW

MAAR L,t

TL

MAARW-MAARL

TW-L

0.99

1.72*

-0.79

-1.42**

1.78

2.22*

0.41

0.77

-0.47

-0.90

0.88

1.18

0.89

1.82*

-0.91

-1.79*

1.80

2.55*

-0.05

-0.08

-0.43

-0.84

0.38

0.48

0.32

0.62

-0.08

-0.17

0.40

0.58

0.03

0.05

-0.43

-0.78

0.46

0.54

*significant at 5%, ** significant at 10%

As shown in table-3, momentum portfolio (W-L) outperforms the market portfolio by an abnormal return of 0.95% per month during the six months test period which is statistically significant at 5% with t-stat as high as 3.06 and it is contributed almost equally by winner and loser portfolios with the returns of 0.43% and 0.52% respectively. Both of them are statistically significant at 5%. As can be seen from table-2, bulk of the momentum returns are contributed by first three months of the test period.

Table-3

Average Monthly Abnormal Returns for winner (W), loser (L) and momentum portfolio (W-L)

Table 3 reports monthly abnormal returns of winner portfolio (W), Loser portfolio (L) and a momentum portfolio consists of long winner and short loser portfolios (W-L) along with their respective t statistics.

MAARw /month

t statistics

MAARL/month

t statistics

MAARw-L/month

t statistics

0.43

1.84*

-0.52

-2.54*

0.95

3.06*

*significant at 5%

CONCLUSION

The results provide enough evidence of presence of momentum in Indian stock markets. The sample consists of reasonably large and liquid stocks and momentum profits of as high as 0.95% per month is still present, which proves that momentum profits are not resulted from small-risky and largely illiquid stocks having problems such as bid-ask bounce but it. Results can be explained by behavioral explanations given by DHS and HS explaining momentum profits as a result of initial under-reaction of traders followed by subsequent overreaction leading to momentum returns. To conclude, there is a strong evidence of momentum returns form Indian stock markets even in large and liquid stocks and there is also sufficient evidence present against weak form of market efficiency.

Thus, it signifies that Today's winner stocks are going to be tomorrow's winner stock & they shall be bought in the stock market. While Today's looser stocks are going to be tomorrow's looser stocks & shall short sell.

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