Tag: derivatives

Party Games

A year and half back, my wife had gone to Gurgaon on work. One evening, she called and told me that she was “going to go for a party at the guest house”, which I duly conveyed to our daughter.

The next morning, our daughter woke up and asked me about her mother’s party. Having been appraised of the proceedings late in the night, I shared the summary. “That is all fine, Appa”, she want, “but WHAT WAS THERE at the party?”.

I was a bit puzzled by the question and said there was nothing. “Why does a party need to have anything?”, I replied, “in this case there was big people juice, which people drank and talked to each other”.

It was in the course of that conversation that I realised that most kids’ parties usually have “something”. Some have bouncy castles. Some take place in play areas. Some people organise magic shows. Others have art workshops. And so on. A lot of kids’ parties are “structured”, with “stuff to do”.

Coming to think of it, this is not true of kids’ parties alone. Even a lot of adult parties nowadays have “themes”. So people have “poker nights”, or “board game nights”, or “movie nights” for which they call other people and socialise and together perform what can sometimes be a perfectly satisfactory single player activity.

Poker nights, I can understand, since it is sport, and one that can be much better played offline. However, I can’t imagine calling a bunch of random friends for a “poker night” – if it’s a poker night, it ought to be a bunch of people who are also interested in poker.

That aside, why should you bother hosting a party for a bunch of friends, and then not give them the opportunity to talk to one another, and instead subject them to some “party game”? “What is even the point of having structured activities at a party?”, my wife wondered loudly one morning.

My theory is this – not everyone is interesting and capable of holding an intelligent conversation. However, everyone has the need to talk to other people and socialise.

So if you are not sure about the quality of conversations that the people you are inviting to a party are likely to contribute, you want to somehow ensure that the party is at least somewhat interesting to everyone that attends. And so, you get rid of the upside (of some fantastic conversation happening at the party), and instead limit the downside (of everyone there getting bored), and put some structured activity on the party.

In other words, you put a “collar” on the party.

Collar – a derivatives strategy where you give up on upside to avoid downside

I have written here about the concept of “alcohol buddies“:

My friend Hari The Kid has this concept of “alcohol buddies”. These are basically people who you can hang out with only if at least one of you is drunk (there are some extreme cases who are so difficult to hang out with that the only way to do it is for BOTH of you to be drunk). The idea is that if both of you are sober there is nothing really to talk about and you will easily get bored. But hey, these are your friends so you need to hang out with them, and the easiest way of doing so is to convert them into alcohol buddies.

Now, there are some people who you can’t hang out with in “ground state”, but when one or both of you is drunk you can have an interesting conversation. Those are alcohol buddies.

However, there is a (possibly small) set of people who are fundamentally so uninteresting that even if both of you are pissed drunk, it is impossible to have a conversation is interesting to both people. And if you are having a largish party with a diverse set of guests, it is likely that there are many such pairs of guests, who cannot talk to each other even when pissed drunk.

And that is where having a party game helps. It prevents people from having random conversations and instead corrals (notice that wordplay there) everyone into the party game collar. No upside, no downside, nobody needs to find that there are others at the party who are absolutely boring to them. They all go home happy.

So far, we have resisted this “themed party” concept, except maybe in the context of NED Talks. Even our daughter’s birthday parties, so far, have been at home (once in Lalbagh during the pandemic), with the only “planned activity” being eating cake and snacks, and kids randomly playing in her room.

Let’s see how far we can carry this on!

Christian Rudder and Corporate Ratings

One of the studdest book chapters I’ve read is from Christian Rudder’s Dataclysm. Rudder is a cofounder of OkCupid, now part of the match.com portfolio of matchmakers. In this book, he has taken insights from OkCupid’s own data to draw insights about human life and behaviour.

It is a typical non-fiction book, with a studmax first chapter, and which gets progressively weaker. And it is the first chapter (which I’ve written about before) that I’m going to talk about here. There is a nice write-up and extract in Maria Popova’s website (which used to be called BrainPickings) here.

Quoting Maria Popova:

What Rudder and his team found was that not all averages are created equal in terms of actual romantic opportunities — greater variance means greater opportunity. Based on the data on heterosexual females, women who were rated average overall but arrived there via polarizing rankings — lots of 1’s, lots of 5’s — got exponentially more messages (“the precursor to outcomes like in-depth conversations, the exchange of contact information, and eventually in-person meetings”) than women whom most men rated a 3.

In one-hit markets like love (you only need to love and be loved by one person to be “successful” in this), high volatility is an asset. It is like option pricing if you think about it – higher volatility means greater chance of being in the money, and that is all you care about here. How deep out of the money you are just doesn’t matter.

I was thinking about this in some random context this morning when I was also thinking of the corporate appraisal process. Now, the difference between dating and appraisals is that on OKCupid you might get several ratings on a 5-point scale, but in your office you only get one rating each year on a 5-point scale. However, if you are a manager, and especially if you are managing a large team, you will GIVE out lots of ratings each year.

And so I was wondering – what does the variance of ratings you give out tell about you as a manager? Assume that HR doesn’t impose any “grading on curve” thing, what does it say if you are a manager who gave out an average rating of 3, with standard deviation 0.5, versus a manager who gave an average of 3, with all employees receiving 1s and 5s.

From a corporate perspective, would you rather want a team full of 3s, or a team with a few 5s and a few 1s (who, it is likely, will leave)? Once again, if you think about it, it depends on your Vega (returns to volatility). In some sense, it depends on whether you are running a stud or a fighter team.

If you are running a fighter team, where there is no real “spectacular performance” but you need your people to grind it out, not make mistakes, pay attention to detail and do their jobs, you want a team full of3s. The 5s in this team don’t contribute that much more than a 3. And 1s can seriously hurt your performance.

On the other hand, if you’re running a stud team, you will want high variance. Because by the sheer nature of work, in a stud team, the 5s will add significantly more value than the 1s might cause damage. When you are running a stud team, a team full of 3s doesn’t work – you are running far below potential in that case.

Assuming that your team has delivered, then maybe the distribution of ratings across the team is a function of whether it does more stud or fighter work? Or am I force fitting my pet theory a bit too much here?

Monetising volatility

I’m catching up on old newsletters now – a combination of job and taking my email off what is now my daughter’s iPad means I have a considerable backlog – and I found this gem in Matt Levine’s newsletter from two weeks back  ($; Bloomberg).

“it comes from monetizing volatility, that great yet under-appreciated resource.”

He is talking about equity derivatives, and says that this is “not such a good explanation”. While it may not be such a good explanation when it comes to equity derivatives itself, I think it has tremendous potential outside of finance.

I’m reminded of the first time I was working in the logistics industry (back in 2007). I had what I had thought was a stellar idea, which was basically based on monetising volatility, but given that I was in a company full of logistics and technology and operations research people, and no other derivatives people, I had a hard time convincing anyone of that idea.

My way of “monetising volatility” was rather simple – charge people cancellation fees. In the part of the logistics industry I was working in back then, this was (surprisingly, to me) a particularly novel idea. So how does cancellation fees equate to monetising volatility?

Again it’s due to “unbundling”. Let’s say you purchase a train ticket using advance reservation. You are basically buying two things – the OPTION to travel on that particular day using that particular train, sitting on that particular seat, and the cost of the travel itself.

The genius of the airline industry following the deregulation in the US in the 1980s was that these two costs could be separated. The genius was that charging separately for the travel itself and the option to travel, you can offer the travel itself at a much lower price. Think of the cancellation charge as as the “option premium” for exercising the option to travel.

And you can come up with options with different strike prices, and depending upon the strike price, the value of the option itself changes. Since it is the option to travel, it is like a call option, and so higher the strike price (the price you pay for the travel itself), the lower the price of the option.

This way, you can come up with a repertoire of strike-option combinations – the more you’re willing to pay for cancellation (option premium), the lower the price of the travel itself will be. This is why, for example, the cheapest airline tickets are those that come with close to zero refund on cancellation (though I’ve argued that bringing refunds all the way to zero is not a good idea).

Since there is uncertainty in whether you can travel at all (there are zillions of reasons why you might want to “cancel tickets”), this is basically about monetising this uncertainty or (in finance terms) “monetising volatility”. Rather than the old (regulated) world where cancellation fees were low and travel charges were high (option itself was not monetised), monetising the options (which is basically a price on volatility) meant that airlines could make more money, AND customers could travel cheaper.

It’s like money was being created out of thin air. And that was because we monetised volatility.

I had the same idea for another part of the business, but unfortunately we couldn’t monetise that. My idea was simple – if you charge cancellation fees, our demand will become more predictable (since people won’t chumma book), and this means we will be able to offer a discount. And offering a discount would mean more people would buy this more predictable demand, and in the immortal jargon of Silicon Valley, “a flywheel would be set in motion”.

The idea didn’t fly. Maybe I was too junior. Maybe people were suspicious of my brief background in banking. Maybe most people around me had “too much domain knowledge”. So the idea of charging for cancellation in an industry that traditionally didn’t charge for cancellation didn’t fly at all.

Anyway all of that is history.

Now that I’m back in the industry, it remains to be seen if I can come up with such “brilliant” ideas again.

Tiered equity structure and investor conflict

About this time last year, I’d written this article for Mint about optionality in startup valuations. The basic idea there was that any venture capital investment into startups usually comes with “dirty terms” that seek to protect the investor’s capital.

So you have liquidity preferences that demand that the external investors get paid out first (according to a pre-decided formula) in case of a “liquidity event” (such as an IPO or an acquisition). You also have “ratchets”, which seek to protect an investor’s share in the company in case the company raises a subsequent round at a lower valuation.

These “dirty terms” are nothing but put options written by existing investors in a firm in favour of the new investors. And these options telescope. So the Series A round has options written by founders, employees and seed investors, in favour of Series A investors. At the time of Series B, Series A investors move to the short (writing) side of the options, which are written in favour of Series B investors. And so forth.

There are many reasons such clauses exist. One venture capitalist told me that his investors have similar optionality on their investments in his funds, and it is only fair he passes them on. Another told me that “good entrepreneurs” believe in their idea so much that they don’t want to even consider the thought that their company may not do well – which is when these options pay out, and so they are happy to write these options. And then you know that an embedded option can increase the optics of the “headline valuation” of a company, which is something some founders want.

In any case, in my piece for Mint I’d written about such optionality leading to potential conflicts among investors in different classes of stock, which might sometimes be a hindrance to further capital raises. Quoting from there,

The latest round of investors usually don’t mind a “down round” (an investment round that values the company lower than the preceding round) since their ratchets protect them, but earlier investors are short such ratchets, and don’t want to see their stakes diluted. Thus, when a company is unable to find investors who are willing to meet its current round of valuation, it can lead to conflict between different sets of investors in the company itself.

And now Mint reports that such conflicts are a main reason for Indian e-commerce biggie Snapdeal’s recent struggles, which has led to massive layoffs and a delay in funding. The story has played out exactly as I’d written in the paper last year.

Softbank, which invested last in Snapdeal and is long put options on the company’s value, is pushing the company to raise more funds at a lower valuation. However, Nexus and Kalaari, who had invested earlier and stand to lose significantly thanks to these options, are resisting such moves. And the company continues to stall.

I hope this story provides entrepreneurs and venture capitalists sufficient evidence that dirty terms can affect everyone up and down the chain, and can actually harm the business’s day-to-day operations. The cleaner a company keeps the liabilities side of the balance sheet (in having a small number of classes of equity), the better it is in the long run.

But then with Snap having IPOd by offering only non-voting shares to the public, I’m not too hopeful of equity truly being equitable any more!

More football structuring

I’ve commented earlier on innovative structuring of football player contracts, with call options and put options and all other exotic options being involved. Now I see another interesting transfer structure, this time in the contract of Juventus (and Spain) striker Alvaro Morata.

In 2014, Real Madrid sold Morata to Juventus for a transfer fee of €20 million, but the sale had a “buy back clause”. Embedded in the sale was an option for Real Madrid to buy back Morata at any time for €30 million, and now it seems like they’re exercising it!

While this might be based on Morata’s performances (both for Juventus and Spain) in the last couple of years, the interesting thing about the buyback is that Real Madrid are unlikely to keep hold of Morata. Instead, talk is that they plan to sell him on, with PSG and Manchester United being interested in the forward.

Effectively the deal is something like “as long as Morata’s perceived market value is  < €30M, Juventus can keep him, but once his perceived market value goes up, all the upside goes to Real Madrid”. The downside (in case Morata regressed as a player and his market value went below €20M), of course, remained with Juventus. To put it simply, Madrid is exercising its call option on the player.

While loan agreements have earlier had clauses such as “right but obligation to make deal permanent” or “obligation but not right to make deal permanent”, this is the first time I’m seeing an actual transfer deal with this kind of a clause, which is being exercised. So why did Juventus and Real Madrid hammer out such a complicated-looking structure?

For Juventus, the simple answer is that the option they wrote reduced the cost of buying the player. While they have given up on significant upside in writing this call option, this is what perhaps made the purchase possible for them, and in some ways, it’s worked out by giving them two more Scudetti.

The answer is less clear from Real Madrid’s perspective. Clearly, the fact that they got a call option meant that they believed there was a significant chance of Morata improving significantly. At the point of time of sale (2014), however, he was surplus to their requirements and they believed sending him elsewhere would help in this significant improvement.

It is possible that the market in 2014 wasn’t willing to bear the price implied by Real Madrid’s expectation of Morata’s improvement, but was only willing to pay based on his then abilities and form. In other words, while Morata’s current abilities were fairly valued, his future abilities were grossly undervalued.

And Madrid did the smart thing by unbundling the current and future values, by structuring a deal that included a call option!

Again, this is only my speculation of how it would have turned out, but it’s indeed fascinating. Given how global financial markets are performing nowadays, it seems like structuring of football deals is now far more interesting than structuring financial derivatives! But then the market is illiquid!

The problem with Indian agriculture, and government

The problem with the Indian agriculture sector is that the government takes a very “cash view” of the sector while what is required is a “derivative view”. 

So Congress VP Rahul Gandhi railed on in a rally about how the current Narendra Modi government is anti-farmer, and pointed out at the land acquisition amendment bill and the lack of raising of “minimum support price” as key points of failure. Gandhi was joined at the rally by a large number of farmers, who reports say were primarily very pissed off about the failure of their rabi crops thanks to unseasonal rains in the last month and a bit.

If the government were to take Gandhi’s criticism seriously, what are they expected to do? Not amend the land acquisition act, or amend it in a different way? Perhaps, and we will not address that in this post, since it is “out of syllabus”. Increase the Minimum Support Price (MSP)? They might do that, but it will do nothing to solve the problem.

As I had pointed out in this post written after a field trip to a farm, what policymakers need understand is that farming is fundamentally a business, and like any other business, there is risk. In fact, given the number of sources of uncertainty that exist, it can be argued that farming is a much riskier business than a lot of other “conventional” businesses.

So there is the risk of high prices of inputs, there is risk of bad weather, there is risk of a glut in supply that leads to low prices, there is a risk that the crop wasn’t harvested at the right time, there is a risk that elephants trampled the field, or there is a risk that there might be a new strain of bugs that might destroy the crops. And so forth. And given that most farmers in India are “small”, with limited land holdings, it needs to be kept in mind that they don’t have diversification as a (otherwise rather straightforward) tool to mitigate their risks.

And when the farmers face so many risks, what does the government do? Help them mitigate at max one or two of it. One of them is the “minimum support price” which is basically a put option written by the government, for free, in favour of the farmers. All it entails is that the farmer  is assured of a minimum price for his wares if market prices are too low at the time of harvest. In other words, it helps the farmer hedge against price risk.

What other interventions do Indian governments do in farming? There are straightforward subsidies, all of the input variety. So farmers get subsidised seeds, subsidised fertilisers, subsidised (or in several cases, free) electricity, occasional subsidies in irrigation, subsidised loans (“priority sector lending” rules), and occasionally, when shit hits the fan, a loan waiver.

Barring the last one, it is easy to see that the rest are all essentially input subsidies, making it cheaper for the farmer to produce his produce (I’m proud of that figure of speech here, and I don’t know what it’s called in English). Even loan waivers, while they happen when market conditions are really bad, are usually arbitrary political decisions, and never targeted, meaning that there are always significant errors, of both omission and commission.

So if you ask the question of whether the government, through all these interventions, make the business of farming easier, it should be clear that an answer is no, for while it makes inputs cheaper and helps farmers hedge against price risk, it doesn’t help at all in mitigation of any other risks. Instead, what the government is essentially doing is by paying the farmers a premium (subsidised inputs, free options) and expecting them to take care of the risks by themselves. In other words, small “poor” farmers, who are least capable of handling and managing risk, are the ones who are handling the risk, and at best the government is just providing them a premium!

The current government has done well so far in terms of recognising risk management as a tool for overall wellbeing. For example, the Jan Dhan Yojana accounts (low-cost bank accounts for the hitherto unbanked) come inbuilt with a (albeit small) life insurance cover. In his budget speech earlier this year, the Finance Minister mentioned a plan to introduce universal insurance against accidental death. Now it is time the government recognises the merits of this policy, and extends it to other sectors, notably agriculture.

What we need is a move away from “one delta” cash subsidies and a move towards better risk management. The current agricultural policies of successive governments basically ensure that the farmer makes more when times are good (lower inputs costs, free put options (MSP) with high strike price), and makes nothing when times are bad. Rudimentary utility theory teaches us that the value of a rupee when times are good is much lower than the value of a rupee when times are bad. And for the government, it doesn’t really matter as to when it spends this money, since its economic cycle is largely uncorrelated with farmers’ economic cycles. So why waste money by spending it at a time of low marginal utility as opposed to spending it at a time of high marginal utility?

In other words, the government should move towards an institutionalised system of comprehensive crop insurance. Given the small landholdings, transaction costs of such insurance is going to be high, and the government should help develop this market by providing subsidies. And this subsidy can be easily funded – remember that the government is already paying some sort of a premium to farmers so that they manage their own risk, and part of this can go towards helping farmers manage their risk better.

It is not going to be politically simple, for the opposition (like Rahul Gandhi) will rail that the government is taking money away from farmers. But with the right kind of messaging, and subsidies for insurance, it can be done.

The problem with real estate taxation

I spent a year working in an India-focused high frequency trading hedge fund. I used to trade stocks and equity derivatives there. We were primarily an arbitrage hedge fund, and our aim was to make money by trading on assets that were mispriced, in order to make riskless profits. For example, if the price of a certain stock at a certain instant was Rs 100 on the BSE and Rs. 99 on the NSE, we would buy the stock at the NSE and sell it at the BSE, simultaneously, thus making riskless profits. Contrary to what some of the “99%ers” say, we saw social value in what we did. We were making prices fairer for the rest of the market, and removing anomalies.

There was one big problem though, this beast called “securities transaction tax”. Every transaction in securities in India attracts this tax. While it seems to be a fairly small number, when you are trading large volumes and looking to arbitrage out wafer-thin margins, it ends up being significant. This tax, we figured, was a big hindrance in true arbitrage-free pricing of securities in India. The tax meant that assets could be mis-priced up to a certain limit, because wiping out that mispricing through a trade was unprofitable thanks to this tax. This “flow tax”, thus, makes financial markets inefficient.

The problem is bigger when it comes to real estate. Historically, property taxes have been really low, but property transaction taxes have been high. There is a good reason for this. Back in the old days where record-keeping was inefficient and incomplete, it was impossible for the government to map out who owned which piece of land. Instead, they figured that they would have a record on all property transactions, and thus put a tax on that. This is a worldwide phenomenon.

It has led to two big problems in India. First is the market inefficiency that I spoke about with my equities example. High transaction taxes means that property markets are illiquid, and this prevents more people from entering and investing in the market. This also means that any price changes in the broad market are not reflected easily enough across a vast majority of property. Secondly, the high transaction taxes means there is massive under-reporting of the actual prices at which transactions take place. Both the buyer and the seller have an incentive to do so, and deprive the government of tax money. This leads to creation of massive amounts of black money in real estate. The problem is similar to the creation of all those Swiss bank accounts back in the days of 99% marginal tax rates.

There is a side-effect also, one that our socialist-minded government and the National Advisory Council (NAC) might be sympathetic to. Low reported prices of land transactions also implies lower realization for farmers and other villagers when land is forcibly acquired by the government. Though compensation might be declared as multiples of the “market value”, the true market value in most cases is so depressed that farmers usually get paid a pittance.

That aside, so what prevents us from dismantling these distortionary transaction taxes on property? Firstly, they are a massive source of income to state governments and local bodies, and if they are to be dismantled they need to be replaced with another equivalent tax. Economists usually advocate property holding taxes as a less distortionary and more stable means of funding local governments. Till recently, however, bad record-keeping meant those weren’t enforceable. You already have nominal property taxes that are collected, but reports in newspapers suggests that implementation is lax, and there is significant tax evasion there.

Even if all property records are formalized and computerized, there is another major hurdle in dismantling property transaction taxes and increasing property holding taxes. Higher property holding taxes means that the value of property will see a sudden drop (lower “free cash flow” each year, and all that). Markets might become more efficient and liquid, but real estate companies who have sunk in millions assuming a certain valuation of their properties will see a sudden erosion in that value, and see value in lobbying against this change taking place. In the long run, they will benefit, in terms of greater investment, greater liquidity and faster disposal of the properties they have built. But the initial “shock” in terms of reduced valuations will mean they will lobby against this change.

Thus, unless something drastic happens in terms of reforms, it is likely that we will be stuck in this inefficient regime of high property transaction tax.

Cross posted at The INI Broad Mind

Tailors

In a little street called Narayana Pillai Street, off Commercial Street in the Shivajinagar area of Bangalore there stands a building called “Ganesh complex” which can be called a tailoring hub. There are some ten to twelve shops (forgive my arithmetic if I’ve counted too low) all of which are occupied by tailors who stitch women’s clothes, primarily salwar kameez and its derivatives. I don’t know if there’s much to choose between the stores, and I think it’s a question of “tailor loyalty” the way it’s practiced among beach shacks at Baga beach in North Goa.

The wife is friends with a tailor called Ahmed, who runs a shop called HKGN tailors in this complex. Till recently (when he took two weeks with a consignment) his USP was “one hour tailoring”, where upon receiving cloth and measurements, he would stitch your dress in about an hour. I hear that there are a large number of tailors in the vicinity (though not sure if they’re in Ganesh complex) who offer the same terms. In fact, I know a lot of women who travel to that area to get their clothes stitched both for the quick delivery and also for the network of tailors that is present there.

While waiting for Ahmed to deliver the wife’s latest consignment yesterday (the one he took two weeks with), I was watching tailors in neighbouring shops working. The thing that struck me was that there isn’t much economies of scale in bespoke tailoring. Each piece  of cloth needs to be cut separately, in its own size, and there’s nothing that can be “batch processed” across different samples. Of course, there is tremendous scope for specialization and division of labour, so you see “masters” who measure, mark out and cut cloth, and “stitchers” who stitch up the stuff together.

However, across the city, except for the handful of tailors in the Shivajinagar area, the standard turnaround time for stitching seems to be about two weeks. And given the wife’s experiences (I usually buy readymade garments so not much insight there) it is a fairly disorganized industry and requires several rounds of follow-ups and waiting at the tailor’s shop in order to get the goods.

The economics of the industry (that there are no economies of scale) makes me wonder why the two-week-turnaround time has become standard in this industry. Isn’t the turnaround time solely because of inventory piled up at the tailor’s? Can the tailor not manage his inventory better (like say going a few days without fresh orders or hiring a few extra hands temporarily or working a weekend) and thus lead to much shorter turnaround time? Given the individual nature of the job, what prevents tailors from offering instant turn-around like the handful of people in Shivajinagar do? Or is it that bulk orders (one person coming with a bunch of clothes to stitch) mess up any “quick turnaround model” the tailors could offer?

There is only one explanation I can think of. “Sales” and “production”, for the tailors happens at the same spot (their storefronts). For “sales” purposes they need to be there all the time, though they don’t need to be actively doing anything. Hence, it suits them if production is also a continuous full-time process, so that the time they spend at the storefront isn’t all “wasted”. By piling up an inventory of orders, tailors are always assured of having something to do even if no fresh customers are forthcoming.

So as the wife’s experience with Ahmed has shown, the “quick turnaround” hasn’t been sustainable at all.