Monday, October 26, 2009


The volatility index, sometimes called by financial professionals and academics as “the investor gauge of fear” has developed overtime to become one of the highlights of modern day financial markets. Due to the many financial mishaps during the last two decades such as LTCM (Long Term Capital Management), the Asian Crisis just to name a few and also the discovery of the volatility skew, many financial experts are seeing volatility risk as one of the prime and hidden risk factors on capital markets. This paper will mainly emphasize on the developments in measuring and estimating volatility with a concluding analysis of the historical time series of the new volatility indices at the Deutsche Boerse.

As a result of the volatility’s increasing importance as a risk indicator and hedging instrument, many financial market operators and their institutional clients have pioneered and ventured out into developing methods of estimating and measuring volatility based on various well established academic models and eventually have even based their estimations on self-made models. Some established models have proven not to withstand the test of time and empirical data. The Black-Scholes Options Pricing model for instance, does not allocate for stochastic volatility (i.e. skewness). On the other hand, two models have gained importance over the years, namely the Stochastic Volatility Model and the GARCH (1,1). An insight into these three models will be carried out in this paper.

Two measurements which are widely used by financial and risk management practitioners to determine levels of volatility risk are the historical (realized) volatility, and the implied volatility. These two perspectives of volatility will be viewed with the emphasis being placed on the latter.
Two volatility trading strategies would be introduced, namely the straddle and trading in volatility and variance swaps. Then the old and new methodologies of calculating the volatility index at the Deutsche Börse AG will be discussed and the business case behind the concept of a volatility index will then be presented. Finally an analysis and interpretation of the calculated historical time series between years 1999 and 2004 of the new volatility indices will be done.

Volatility and its Measurements
An option is a financial contract which gives the right but not the obligation to buy (call) or to sell (put) a specific quantity of a specific underlying, at a specific price, on (European) or up to (American), a specified date. Such an option is called a plain vanilla option. An underlying of an option could be stocks, interest rate instruments, foreign currencies, futures or indices. Option buyers (long positions) usually pay an option premium (option price) to the option seller (short positions) when entering into the option contract. In return, the seller of the option agrees to meet any obligations that may occur as a result of entering the contract.

The options called exotics include Path-dependent options whereby its payoffs are dependent on the historical development of the underlying asset, such as the average price (Asian Option) or the maximum price (Lookup option) over some period of time. Then there are other options in which their payoffs are anchored on whether or not the underlying asset reaches specified levels during the contractual period. They are called Barrier options. Option traders are constantly faced with a dynamically altering volatility risk. While many speculate on the course volatility will take in the near future, some may tend to seek to hedge this risk. For instance Carr and Madan1 suggested a strategy that combines the holding of static options, all the out-of-the money ones, and dynamically trading the underlying asset. Such a strategy is very costly and most of the time not convenient for most traders. That’s why advances have been made to develop new products and strategies which allow investors and traders to hedge their portfolios of derivative assets as well as portfolio of basic assets against pure volatility exposure. Brenner and Galai2 were one of the first researchers to suggest developing a volatility index back in 1989.

Then in 1993, Robert Whaley developed the first volatility index on S&P 100 options for the Chicago Board of Options Exchange (CBOE) which was then subsequently introduced in the same year. Called the VIX, it used the model described by Harvey and Whaley [1992]3 in their research article. One year afterwards in December 1994, the Deutsche Boerse started publishing its own volatility index on DAX options called the VDAX on a daily basis. The Deutsche Boerse even went on further to introduce the first futures on volatility based on the VDAX called VOLAX in 1998.

To understand the concept behind a volatility index one must first understand the differences between the methods of volatility measurements and their forecasting abilities. Using the formula derived by Black and Scholes4 to price options, one needs among other things, the parameter volatility. They derived a formula for plain vanilla options using the parameters listed below as input.

1. The current price of the underlying at time t= S
2. The strike price of the option = K
3. The time to expiration of the option = T -t
4. The risk free interest rate = r
5. The annualized volatility of the underlying (based on lognormal returns) = s



Services sector, along with manufacturing sector, has emerged as a significant growth propellant during the current decade with its contribution to the gross domestic product (GDP) of the country sustaining at the levels more than 50 per cent, through our these years (Chart 6A). As generally known, the services sector comprises ‘trade, hotels, transport and communication’, ‘financing, insurance, real estate and business services’ and ‘community, social and rural services’.

Data on output growth across these sectors of the economy are used as services sector performance indicators since the two are closely associated; dominant among these have been enumerated in Table 6.1. While most of these have been discussed in pertinent sections of the MER, these indicators are considered as growth propellants of services sector activities.

Travel and Tourism
Though being a traditional segment of the services sector, development of travel and tourism industry has been accelerated in the recent past on account of expansion in the business and trading activities, improved standards of living and changing lifestyles of the masses, and different kind of fiscal measures. India is becoming increasingly popular for foreign visitors from the point of medical attendance, cultural activities, historical developments and tourism. This has resulted in country witnessing increasing number of inbound tourists and thereby excellent growth in foreign exchange earnings.

According to some analysts, the global campaign known as 'Incredible India' initiated by the Ministry of Tourism in 2002 had helped boost the Indian tourism industry to a great extent. For instance, the growth rate of inbound tourists accelerated to 14.7 per cent during calendar year 2003 from -6.3 registered in 2002 and trend continued in 2004 as well with the growth rate peaking to 26.4 per cent. However, growth rate of foreign tourist arrivals decelerated in 2005 to 13.3 per cent and this was sustained during calendar year 2006 as well. This growth trend has been reflected in foreign exchange earned by the sector during the same period

Retail Services
A new strategy paper prepared by Government of India has proposed to hike foreign direct investment (FDI) for single-brand retail. In view of political resistance for this proposal, the other option that is being considered is to permit 49 per cent FDI in multi-brand retail in order to widen the scope of foreign investment in the sector. The strategy paper has also suggested allowing 100 per cent foreign equity in foreign-branded, specialised retail chains like luxury brands, consumer durables and semi-durables if political resistance becomes unavoidable. The government had allowed 51 per cent FDI in single-brand retail in January, 2006 while 100 per cent FDI is permitted only for back-end operations like wholesale trade.

According to a latest study by Crisil Research, only one per cent of the Indian foodretailing sector is currently organised as against countries such as the US where the penetration is 80 per cent. The total market for staples and unprocessed fruits and vegetables is around Rs 4.7 trillion, or about $115 billion. However, huge wastages, high storage costs and commissions to various middlemen have resulted in an annual loss of Rs 1 trillion, or around US $24 billion. If organised retail manages to overcome these hurdles by its widespread penetration of the food and grocery sector, farm incomes could increase and even consumers pay lower prices.

India’s retail giants like Reliance Retail, Bharti-Wal-Mart and AV Birla Retail have plans to develop their own logistics. With logistics market for organised retail growing at 16 per cent, the organised retail, which is growing at 400 per cent, is facing a serious supply crunch. Logistics cost component of the total retail price in India is as high as 7-10 per cent, which is just around 4-5 per cent at global level. Such higher costs make it imperative for retailers to internalise most operations and cut costs.

The decline in sugar and wheat prices during the last six months has helped fast-moving consumer goods (FMCG) companies that make bread, biscuits and beverages to reap higher realisations. Wheat prices have slumped due to an increase in output from 69.5 million tonnes last year to 73.7 million tonnes and sugar prices have also dipped over the same period owing to a 45 per cent jump in output from 19.2 million tonnes to 28 million tonnes. The wheat-based industry was incurring losses when prices of these inputs were high. The beverages industry, including Coca-Cola and Pepsi, has been another gainer from the crash in sugar prices.

According to sugar industry estimates, both companies, on an average, consume 150 thousand tonnes of sugar annually. At an average monthly consumption of 25,000 tonnes, the two companies would be able to save Rs 7.5 crore every month.

After shampoos and oral care, fast-moving consumer goods (FMCG) companies are concentrating on soaps during the current year. The segment is one of the biggest FMCG categories in the country. Bathing and toilet soaps contribute around 30 per cent to the soaps market. The per capita consumption of toilet or bathing soap in the country is 800 gm, whereas it is 6.5 kg in the US, 4 kg in China and 2.5 kg in Indonesia. The industry players expect the soaps segment to grow by 15 per cent this year, as companies introduce more and more specialised products to create a differentiation in the market. For instance, Dabur India Ltd. is planning to introduce a new line of herbal and ayurvedic soaps under the Dabur brand and expand the range of soaps under its Vatika brand with newer variants. The company already has soaps under the Dabur brand in the international market. Likewise, Wipro Consumer Care, which claims to be the third-largest brand in soaps at present, is also looking at a range of soaps launch under its Santoor and Chandrika brands. According to industry estimates, Hindustan Unilever controls about 60 per cent of the soaps market, with brands including Lifebuoy, Lux, Rexona, Breeze and Hamam followed by Nirma and Godrej with their respective brands.

Real Estate
The real estate activities in India has remained buoyant in recent times and is also witnessing a
number of changing trends within the country; besides attracting vast interest from foreign

New Trends: One such major trend is of developers shifting focus towards Tier II & III cities. Consistent rise in the cost, scarcity of space and saturation in certain areas like Delhi, Mumbai, and Bangalore has forced the real estate developers to turn to Tier II & III cities, which provide cost advantages of 20-40 per cent over Tier I cities. Apart from being state capitals, educational
hubs or satellite cities, these cities have gained commercial interest with IT, ITES and BPO firms
setting up their offices in these cities. The Tier II cities in India poised to emerge as major
centers for the offshoring of activities by IT companies over the next few years as they have a
hand over the Tier I cities in terms of land availability, costs of labour and real estate, business
environment as well as physical and social infrastructure.

Another trend observed is of builders acquiring land and setting up residential complexes in ‘extended suburbs’ of Mumbai. Extended suburbs on the western suburbs in Mumbai include areas beyond Vasai and Virar apart from Dombivali, Thane on the eastern belt and Panvel on the harbour route. A very high land acquisition cost in south Mumbai and the suburbs seems to be the main driving force that has caused developers to search for the land in these peripheral areas. For instance, Akruti Nirman has decided to acquire about 500 acres of land in the eastern and western suburbs spread across Vasai, Virar, Thane, Dombivali and Panvel to develop mini townships to include residential buildings and factory outlets on a lease model business. While Kalpataru is acquiring 300 to 500 acres of land, Hiranandani Construction is planning to acquire 300 to 400 acres of land in extended suburbs. K Raheja Universal, JLL Meghraj also have similar plans. However, many of these projects would work out to be long-term activities.

Shooting up of Commercial Rent: Limited supply of office space is leading to an increase in commercial rental rates by 10- 20 per cent on a quarterly basis in most Indian cities. While Delhi has registered an increase in rentals by 7-8 per cent (in central business district) and 15-20 per cent (in the secondary business 46 district), in Bangalore it is to the tune of 10-20 per cent. Chennai has seen a moderate increase in commercial rental rates by 8-15 per cent, Hyderabad by 5-10 per cent, Kolkata by 10 per cent and Mumbai by 15 per cent. Pune is the only exception, with rentals showing no appreciation owing to high vacancy levels in the city. According to real estate consultants DTZ, rentals continued to increase in the Delhi due to steady demand generated by expansion plans of companies.

New Civil Aviation Policy: The central government has constituted a high powered group of ministers (GoM) headed by External Affairs minister Pranab Mukherjee to which the proposed new civil aviation policy, known as ‘Vision 2020’, has been referred as the cabinet ministers could not reach to an unanimous decision on the crucial aviation policy, which focuses on the revamping of the Airports Authority of India (AAI) and recommends far-reaching changes in the country’s aviation sector.

As a part of the new policy, the ministry of civil aviation (MoCA) is planning to increase the foreign direct investment (FDI) limit in cargo carrier companies to 74 per cent from the current 49 per cent. MoCA is also planning to set up a cargo hub at Nagpur, which would be positioned as the national cargo hub.

Airport Development: Changi Airport International (CAI) is planning to enter Indian airport development business through joint venture route to develop greenfield airports and the 35 non-metro airports in the country. For instance, forming a consortium with the Tata Group, it has already undertaken development of Shimoga, Gulbarga and Bijapur airports in Karnataka. CAI is also interested in taking up joint venture projects with an Indian counterpart for the development of regional airports in India.

Proposition for Introduction of Differential Tariffs: The civil aviation ministry has once again mooted the proposal of introducing differential tariffs for peak and non-peak hours in an attempt to curtail congestion at busy airports. The ministry had proposed to double charges during the peak hours and to half those in the non-peak hours three months back. The decision was put on hold due to hefty opposition from airline companies. Now, the government has once again floated the idea to specifically incentivise nonpeak hour travel in order to better utilise the airport infrastructure between midnight and 5 am.

IT and ITeS
According to the National Association of Software and Services Companies (Nasscom), the Indian IT-ITeS industry has recorded 30.7 per cent growth in its revenue to US $39.6 billion in 2006-07, exceeding the projected growth of 27 per cent for the year on account of buoyant growth in exports and strong domestic demand. The software and services exports has grown by 33 per cent to register revenues of US $31.4 billion in financial year 2006-07 up from US $23.6 billion of the previous year. The IT services exports have surged by 35.5 per cent to $18 billion 48 from US $13.3 billion in 2005-06. While the ITES-BPO exports have risen by 33.5 per cent to US $8.4 billion from US $6.3 billion over the period of one year, the engineering services exports have improved to US $4.9 billion from US $4 billion during the same period. The country’s software and services revenues expected to grow by 24-27 per cent to touch $ 49-50 billion in the current financial year 2007-08 with the IT software and services exports contributing US $28-29 billion, followed by ITeS/BPO between $10.5-11 billion.

With the Software Technology Parks in India (STPI) Policy-specific tax holidays expiring in March 2009, several small and midsize ITeS companies have started searching for space in special economic zones (SEZs). For the ITeS companies moving to SEZs would impose restrictions to get high-quality manpower apart from entailing huge investments. As per the industry analysts, according to SEZ regulations, an IT/ITeS company with facilities in areas not in SEZs can move into an SEZ facility only by starting a fresh and setting up new infrastructure, instead of merely transferring physical assets from its existing set-up. Thus these small and midsize ITeS companies would have to bear additional capital burden.

The government of India is planning to invest Rs 100 crore in the Indore Auto Proving ground for developing climatic wind tunnel to design aerodynamics of cars. The climatic wind tunnel can simulate solar radiation, rainfall, and snowfall as well as temperature and humidity. It is a unique facility to test car air-conditioner performance and engine cooling performance. If created this facility would be first in India and probably one of its kind in the world.

According to the International Organisation of Automobile Manufacturers (OICA), India has stood at 14th position in the 2006 world rankings for growth in passenger car production, three ranks lower compared to world rankings for 2005. India has posted a growth of 16.5 per cent in 2006 compared with 7 per cent in 2005. Yet, it was pushed down the ranking list largely because countries such as Finland and Nigeria, have posted growth of over 50 per cent. However, in absolute terms, India, with a production of 14.73 lakh cars, moved up one place to the seventh position in 2006 replacing the UK, which produced a total of 14.42 lakh cars, recording a drop of 9.7 per cent from the previous year. Japan ranks first with a production of 97.56 lakh cars followed by Germany with about 54 lakh and China with 52.33 lakh cars.

To see the full report: SERVICES SECTOR


What's changed: Over the last few weeks, the government has announced and proposed for discussion a number of policy initiatives that are aimed at making road projects more attractive for contractors (Ex 1). Our analysis of these proposals suggests that the biggest impact of these initiatives would be in increasing the pace of land acquisition for new projects, and for clearing ownership and exit clauses for the developers, both of which have been major constraints to the execution of road projects in India. In tandem with these policy actions, there has also been an increase in the pace of execution of the National Highway projects, with the avg. per day Km addition even over the traditionally slower monsoon period June–Aug 2009 increasing to 8Kms from the 5Km per day seen over 2008.

Implications: IRB and IVRCL are our preferred picks for exposure to the Road Infrastructure segment. On the back of the above policy actions, we expect a significant increase in both the number of projects put up for bidding (NHAI targeting $20bn in the next 12 months) and also an increase in participation by both Indian and foreign contractors.

Policy reforms in place, strong orders likely next 3m; Buy IRB, IVRCL

Despite the increase in competition, we expect IRB to maintain its market share (about 8%) – driven by its strong execution track record and strong cash flow generation from existing assets. On Oct 14 2009, NHAI announced the award of the Jaipur-Deoli road project (146.3km, $300 mn) to the company, strengthening our view of continued awards for IRB.

We estimate that IRB’s free cash flow generation over the next two years positions it to add about $1bn of new projects (70:30 debt: equity) without any equity dilution. We expect an EPS CAGR of 64% over FY09-11E and value the stock at Rs289, implying 16% upside from the current level.

Valuation: IRB and IVRCL currently trade at FY11E PE of 17.4X and 13.5X vs historical median 12–mo fwd PE of 13.8X (since listing in Feb 08) and 14.8X (5-yr) respectively. We consider these multiples reasonable, given our outlook of strong growth and expanding returns over the next 12-18 months.

Risks: 1) Lower traffic growth; 2) Volatile interest rates and raw material costs.

To see the full report: CONSTRUCTION SECTOR


At IndusInd Bank (IndusInd), an era of renewed vigour has been ushered in, engineered by a new management. The past six quarters symbolize a marked improvement in IndusInd’s operating metrics, as evident in a 140bp expansion in NIM to 2.9% in Q2FY10, 5.5% increase in CASA ratio to 21.2% and steep drop in C/I ratio – all converging into an impressive RoA expansion of 80bp to 1.1%. With focus on fortifying the liability profile and adding fee based revenue streams, we expect the bank to exhibit a 66% CAGR in earnings over FY09-11. Led by RoA expansion to ~1.15% by FY11E, we see a strong case for re-rating of the stock on market cap to assets metric, where it lags peers by 40-50%. We expect the stock to outperform the 20% CAGR in assets estimated over FY09-11. Current valuations of 2.4x FY11E adjusted book offer an attractive entry point. Initiating coverage with Outperformer.

A turnaround…: The management’s enhanced strategic clarity and execution capabilities are reflected in consistent uptick in the bank’s operating metrics for the last six quarters. Shrugging off past tribulations, IndusInd now has streamlined systems and processes to grow ahead of the industry average. Network expansion, improvement in CASA & retail deposit share, traction in fee income and stable provisioning requirements are expected to converge into margin expansion (~115bp over FY09-11E) and strong earnings growth in the near term.

…and subsequently a high growth trajectory…: A stronger liability franchise and expanding footprint would drive rapid growth in the bank’s loan book. Well entrenched in the CV financing industry, IndusInd would also benefit from receding competition. The bank is equipped to gain market share, and derive operating leverage from better productivity of the existing network.

…make a case for stock’s re-rating: Growth momentum would gather pace and correction in asset-liability pricing is expected to ease the pressure on margins. Driven by a 66% CAGR in earnings over FY09-11E, we expect IndusInd’s RoA to increase from 0.58% in FY09 to ~1.15% by FY11. Current valuations of 2.7x FY10E and 2.4x FY11E adjusted book appear attractive in view of the strong earnings growth and improving return ratios. With substantial RoA expansion in the offing, we expect the stock to be rerated on the market cap to assets parameter, where it lags peers by 40-50%.

To see the full report: INDUSIND BANK


2Q FY 2010 results: Rallis India Ltd. (Rallis) 2Q FY 10 net sales were in line with our estimates, while profitability was above our estimates. The company reported robust growth in net sales despite deficient monsoons and decline in product prices. The company's net sales growth was driven by strong domestic volumes growth on account of realignment of product mix. However, decline in realizations coupled with poor demand internationally muted the margin growth.

Outlook and valuations: Despite a tough environment during 2Q FY 10, Rallis reported better-than-expected results on account of proactive management and focus on cost reduction. Looking ahead, the early October rains have been heavy in many areas in the country which has resulted in increase in reservoir levels in India. This is expected to benefit Rallis as it will result in higher sales of pesticides during rabi season. Hence, we have revised our FY 2010 net sales and profitability estimates upwards. Over the long-to-medium term, we expect Rallis' revenue growth to be driven by its International business and domestic volume growth. Margins are expected to improve given that Rallis continues to optimize its cost structure coupled with declining input costs. Rallis also has significant excess land bank. As a part of ongoing restructuring programme, the company may sell some of its non-core assets which may pose an upside risk upside to our target price estimate.

At the current market price of Rs. 975, the stock is currently trading at 10.2x FY 11E EPS of Rs. 95.18. We maintain our positive outlook on the stock and maintain a BUY. Using the discounted cash flow-based model, we derive a target price of Rs. 1,195.

Financial highlights:
Net sales grew 13.2% y-o-y in 2Q FY 10 on the back of strong domestic volumes growth. The company recorded increase in net sales despite deficient & erratic monsoon, low pest incidence and poor international demand. Timely and proactive realignment of product portfolio drove its domestic volume growth. Pre-monsoon (March-May 2009) rains were deficient by 29%, and hence kharif acreage was lower by 6-7%. Export business was a drag during 2Q FY 10 as realizations declined on the back of high inventory levels internationally.

EBITDA margins declined 174 bps y-o-y mainly due to decline in realizations in domestic as well as international markets.

PAT (excluding extra-ordinary items) declined 2.0% y-o-y.

Key updates:
The company redeemed preference share capital of Rs. 880 mn during 2Q FY 10. Rallis aims to raise approximately Rs. 900 mn via share sale to upto 98 mn on a preferential basis to Tata Chemicals Limited.

The company has launched a fungicide ERGON, which not only protects the crop but also enhances the yield. The company will have three years of exclusivity for ERGON as it has registered it earlier than others in India. The company expects significant contribution from ERGON over the medium term.

The company expects Dahej plant to be operational from June 2010. The company continues to target Rs. 5,000 mn of net sales from this plant over the next three years.

The company has appointed a professional who is working on a long-term business development plans for Rallis.

Valuation: At the current market price of Rs. 975, the stock is currently trading at 10.3x FY 11E EPS of Rs. 95.18. Using the DCF valuation method, our revised target price is Rs. 1,195 per share for the Rallis common stock.

To see the full report: RALLIS INDIA




To see the full report: STOCK EXCHANGE