Sep
6
2011
Economics By admin | No comments yet

Labor Demand Elasticity

Demand for labor will be less elastic when:-

a- at lower wage rates than at higher

b- in the long run than in the short

c- the less labor intenssive the process.

Elasticity of labor must also be looked at in terms of the substitutability with capital, the other factor of production. When the wage is low, a lot of labor has been employed. Thus, if the wage rate rises then the labor can be fired to hire more capital. You shouldn’t be thinking in terms of the demand curve because that only shows the relationship between price and quantity demanded.

Think about an isoquant (set of points at which the same quantity of output is produced while changing the quantities of two or more inputs), where you have the two factors of production on the two axes. Towards each end of the isoquant, you’re employing a lot of one factor and very little of the other, so it’s hard to switch away from the factor you’re not using much from. Not sure if that makes a lot of sense, but that’s what they’re getting at in this question.

Sep
6
2011
Economics By admin | No comments yet

Economic vs Technological Efficiency

1- Which of the following statements is accurate ?

a- An economically efficient process must be technologically efficient also

b- An economically efficient process is not necessarily technologically efficient

c- A production process cannot be technologically efficient unless it is economically efficient

The answer to the above question is: A.

There are two concepts of efficiency: Technological efficiency occurs when it is not possible to increase output without increasing inputs. Economic efficiency occurs when the cost of producing a given output is as low as possible. Technological efficiency is an engineering matter. Given what is technologically feasible, something can or cannot be done. Economic efficiency depends on the prices of the factors of production. Something that is technologically efficient may not be economically efficient. But something that is economically efficient is always technologically efficient. A key point to understand is the idea that economic efficiency occurs “when the cost of producing a given output is as low as possible”. There’s a hidden assumption here, and that is the assumption that all else being equal. A change that lowers the quality of the good while at the same time lowers the cost of production does not increase economic efficiency. The concept of economic efficiency is only relevant when the quality of goods being produced is unchanged.

Sep
6
2011
Alternatives, General By admin | No comments yet

Roll Yield

Roll yield is the amount of return generated in a backwardated futures market that is achieved by rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price. Now if the inventory of a commodity is in shortage, the spot price is above the future price (one month later price).

In other words, if on 1st September the Spot Price > Forward Price for the contract expiring on the 30th September (which is called backwardation). As the contract approaches maturity, the forward price approaches the spot price. On 30th September, a new contract which expires on 30th October would be again trading at  below the current spot (if the market is still in backwardation). Thus, the old contract which expires on the 30th September can be sold for a higher price, and the new contract can be bought at a lower price. By selling the old at a higher price and buying the new at a lower price, a return is generated. This is called roll yield.

E.g. Spot price Rs.50, Future price Rs.48 (for one month later) and Future price (of a contract 2 months later) is Rs.45. Now if the spot price does not change for the first month and you had bought the first future at 48, as the month passes, this future price of the first month will converge to Rs.50. So you would be able to book your profits of Rs.2 on the contract. But if you wish to maintain exposure of the commodity, you can buy next month contract which if again is trading in backwardation would be priced at Rs. 47 for example. You can sell the future for 50 and then buy the next month contract which was earlier on 45 and assuming has moved to 47. This way you can roll over contract into cheaper rates.

Roll Yield is, therefore, positive for the Long Position in Backwardation and Negative in Contango.

Note: For the short position the roll yield would be negative in Backwardation and positive in Contango.

May
17
2011
Uncategorized By admin | No comments yet

Economics – Terms

Crowding Out: Crowding out effect is basically when the government does fiscal deficit, it eats up into the savings of the public, and therefore leaves lesser amount of money for the private sector to use for investment. Thus, the private investment gets crowded out of the investment due to fiscal deficit of the government.
Governments often borrow money (by issuing bonds) to fund additional spending. The problem occurs when government debt ‘crowds out’ private companies and individuals from the lending market. Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow.

Money Multiplier: The expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement. The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues – as more people deposit money and more banks continue lending it – until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect. The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

Rent seeking occurs when an individual, organization or firm seeks to earn income by capturing economic rent through manipulation or exploitation of the economic or political environment, rather than by earning profits through economic transactions and the production of added wealth. While there may be few people in modern industrialized countries who do not gain something, directly or indirectly, through some form or another of rent seeking, rent seeking in the aggregate can impose substantial losses on society. Rent seeking can be performed by either buying a monopoly or by creating a monopoly.
Hence, the firm’s rent seeking costs are treated as fixed costs, which get added to the total fixed costs and to the average total cost. The ATC curve shifts upward until, at the profit maximisation price, the firm breaks even. This means that a firm which is a rent seeker only makes a normal profit.

Monte Carlo Simulation: A problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables. Monte Carlo simulation is a computerized mathematical technique that allows people to account for risk in quantitative analysis and decision making. The technique is used by professionals in such widely disparate fields as finance, project management, energy, manufacturing, engineering, research and development, insurance, oil & gas, transportation, and the environment. Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the probabilities they will occur for any choice of action.. It shows the extreme possibilities—the outcomes of going for broke and for the most conservative decision—along with all possible consequences for middle-of-the-road decisions.

Feb
22
2011
General, Quantitative Techniques By admin | No comments yet

F-Test

The F-Test is the appropriate test statistic to check the equality of two population variances. It does this by comparing the ratio of two variances. So, if the variances are equal, the ratio of the variances will be 1. The decision rule is to reject the null hypothesis, of the equality of the two variances, if the calculated test statistic is larger than critical value.

It is important to note the following points:

  • The larger variance should always be placed in the numerator
  • The test statistic is F = s1^2 / s2^2 where s1^2 > s2^2
  • Divide alpha by 2 for a two tail test and then find the right critical value i.e. even if the hypothesis is stated as a 2 tailed, there is only one critical value.
  • If standard deviations are given instead of variances, they must be squared
  • When the degrees of freedom aren’t given in the table, go with the value with the larger critical value (this happens to be the smaller degrees of freedom). This is so that you are less likely to reject in error (type I error)
  • The populations from which the samples were obtained must be normal.
  • The samples must be independent
  • The test statistic has two degrees of freedom (n1 – 1) for the numerator and (n2 – 1) for the denominator

Nov
15
2010
Corporate Finance, General By admin | No comments yet

Pure Play Beta

The pure play approach or pure play method is a method for estimating the cost of capital for a proposed new project or product line.

The basis of the approach is that the company has two main sources of risk: a) the risk that is inherent in the business (operating risk) and b) the risk due to leverage of the financial structure. Now the point is, the the first risk which is operational in nature is comparable among companies in the same industry, whereas the financial risk is more of a management decision. So, therefore, when calculating the beta of a company in the pure play method or the method of comparables, we remove the financial risk from the beta of the comparable companies and only take into account the operating beta. The operating beta is then levered up for the risk of the company we are analyzing. The steps to be used are as follows:

Estimate the beta, based upon comparable firms, and after adjusting for risk.

  • Step 1: Collect a group of publicly traded comparable firms, preferably in the same line of business, but more generally, affected by the same economic forces that affect the firm being valued.
    • A Simple Test: To see if the group of comparable firms is truly comparable, estimate a correlation between the revenues or operating income of the comparable firms and the firm being valued. If it is high (and positive), of course, your have comparable firms.
  • Step 2: Estimate the average beta for the publicly traded comparable firms.
  • Step 3: Estimate the average market value debt-equity ratio of these comparable firms, and calculate the unlevered beta for the business.
    • bunlevered = blevered / (1 + (1 – tax rate) (Debt/Equity))
  • Step 4: Estimate a debt-equity ratio for the private firm. The basic problem, however, is that you have only book values for the private firms. This can be corrected in one of two ways ñ
    • Assume that the private firm will move to the industry average debt ratio. The beta for the private firm will then also converge on the industry average beta. This might not happen immediately but over the long term.

Betaprivate firm = Betaunlevered (1 + (1 – tax rate) (Industry Average Debt/Equity))

  • Estimate the optimal debt ratio for the private firm, based upon its operating income and cost of capital. Use this optimal debt ratio to calculate the beta. (Be consistent about then using the same debt ratio in your cash flow estimates)

Betaprivate firm = Betaunlevered (1 + (1 – tax rate) (Optimal Debt/Equity))

Step 5: Estimate a cost of equity for the private firm, based upon this beta.

Oct
14
2010
General, Quantitative Techniques By admin | No comments yet

Hypothesis Testing – terms

Explaining in this entry some of the common terms used in Hypothesis Testing:

Null Hypothesis: The null hypothesis, H0, represents a theory that has been put forward, either because it is believed to be true or because it is to be used as a basis for argument, but has not been proved. For example, in a clinical trial of a new drug, the null hypothesis might be that the new drug is no better, on average, than the current drug. We would write

H0: there is no difference between the two drugs on average.

We either “Reject H0 in favour of H1” or “Do not reject H0“; we never conclude “Reject H1“, or even “Accept H1“. If we conclude “Do not reject H0“, this does not necessarily mean that the null hypothesis is true, it only suggests that there is not sufficient evidence against H0 in favour of H1. Rejecting the null hypothesis then, suggests that the alternative hypothesis may be true.

Alternative Hypothesis: The alternative hypothesis, H1, is a statement of what a statistical hypothesis test is set up to establish. For example, in a clinical trial of a new drug, the alternative hypothesis might be that the new drug has a different effect, on average, compared to that of the current drug. We would write

H1: the two drugs have different effects, on average.

The alternative hypothesis might also be that the new drug is better, on average, than the current drug. In this case we would write
H1: the new drug is better than the current drug, on average.

The final conclusion once the test has been carried out is always given in terms of the null hypothesis. We either “Reject H0 in favour of H1” or “Do not reject H0“.

Note: The equal to (=) sign is always used in the Null Hypothesis.

Test Statistic: A test statistic is a quantity calculated from our sample of data. Its value is used to decide whether or not the null hypothesis should be rejected in our hypothesis test. The choice of a test statistic will depend on the assumed probability model and the hypotheses under question.

Critical Value: The critical value(s) for a hypothesis test is a threshold to which the value of the test statistic in a sample is compared to determine whether or not the null hypothesis is rejected. The critical value for any hypothesis test depends on the significance level at which the test is carried out, and whether the test is one-sided or two-sided.

P-Value: It is equal to the significance level of the test for which we would only just reject the null hypothesis. The p-value is compared with the actual significance level of our test and, if it is smaller, the result is significant. That is, if the null hypothesis were to be rejected at the 5% signficance level, this would be reported as “p < 0.05″.

Small p-values suggest that the null hypothesis is unlikely to be true. The smaller it is, the more convincing is the rejection of the null hypothesis. It indicates the strength of evidence for say, rejecting the null hypothesis H0, rather than simply concluding “Reject H0‘ or “Do not reject H0“.

Oct
12
2010
Alternatives, Equity, General By admin | No comments yet

Exchange Traded Funds

Exchange Traded Funds: Exchange Traded Funds are essentially Index Funds that are listed and traded on exchanges like stocks. They enable investors to gain broad exposure to entire stock markets in different Countries and specific sectors with relative ease, on a real-time basis and at a lower cost than many other forms of investing. An ETF is a basket of stocks that reflects the composition of an Index, like S&P CNX Nifty or BSE Sensex. The ETFs trading value is based on the net asset value of the underlying stocks that it represents. Think of it as a Mutual Fund that you can buy and sell in real-time at a price that change throughout the day. By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you’d pay on any regular order.

ETFs offer several advantages to investors: -

1. Can easily be bought / sold like any other stock on the exchange through terminals across the country.

2. Can be bought / sold anytime during market hours at a price close to the actual NAV of the Scheme.

3. No separate form filling. Just a phone call to your broker or a click on the net.

4. Ability to put limit orders.

5. Minimum investment is one unit.

6. Enjoy flexibility of a stock and diversification of index fund.

7. Expense Ratio is lower.

8. Provides arbitrage between Futures and Cash Market
In Kind creation and redemption of ETFs:

The authorised participant – generally a large financial institution – creates ETF shares by depositing a portfolio of stocks into the applicable fund in exchange for an institutional block of ETF shares (usually 50,000). This is known as “in kind” creation because a basket of stocks is exchanged for ETF shares rather than using cash. The basket of shares that is deposited by the authorised participant represents the weighting of such shares in a particular index (e.g., the NASDAQ-100 Index). Similarly the redemption of the ETF’s can also be done In-kind.

Oct
12
2010
Equity, General By admin | No comments yet

Growth vs Value Stocks

Growth stocks are associated with high-quality, successful companies whose earnings are expected to continue growing at an above-average rate relative to the market. Growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book ratios. The open market often places a high value on growth stocks; therefore, growth stock investors also may see these stocks as having great worth and may be willing to pay more to own shares. Investors who purchase growth stocks receive returns from future capital appreciation (the difference between the amount paid for a stock and its current value), rather than dividends. Although dividends are sometimes paid to shareholders of growth stocks, it has historically been more common for growth companies to reinvest retained earnings in capital projects.

At times, growth stocks may be seen as expensive and overvalued, which is why some investors prefer value stocks, which are considered undervalued by the market. Value stocks are those that tend to trade at a lower price relative to their fundamentals (including dividends, earnings, and sales). Value stocks generally have good fundamentals, but they may have fallen out of favor in the market and are considered bargain priced compared with their competitors. They may have prices that are below the stocks’ historic levels or may be associated with new companies that aren’t recognized by investors. It’s possible that these companies have been affected by some problem that raises some concerns about their long-term prospects.Value stocks generally have low current price-to-earnings ratios and low price-to-book ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which would result in rising share prices. Thus, they hope that if they buy these stocks at bargain prices and they eventually increase in value, they have the ability to make more money than if they had invested in higher-priced stocks that increased modestly in value.


Growth Stocks are usually characterized by:
1. High expected growth of earnings
2. High ROE as compared to its peers in the industry
3. High Price Multiples as the future growth is priced into the prices. If the actual growth comes out to be lower than expected, the stock could take a beating and vice versa.

Value Stocks are usually characterized by:
1. Low Price multiples. These stocks have similar fundamentals to those in the industry, but are currently undervalued. Thus, the price appreciation is expected due to correction in the market.
2. Low PEG ratio – i.e. the PE / growth ratio is less than 1. This means the that company’s PE is less than the expected growth of the company.
3. Debt to Equity is about 1. The company is not heavily leveraged, therefore the financial risk is not high of the company.

Oct
11
2010
Economics, General By admin | No comments yet

Price Floor & Price Ceiling

Why should Price Ceiling be set below the current market price and price floor be set above the current market price:

Well price ceiling is like a maximum price that can be charged. It is legally set by the government to help the consumers. So if the Oil prices were say Rs75 per liter the government sets is at Rs50 per liter to help the consumer. If the government was to set the limit as Rs100 as the max price, then how would that help the consumer. In fact this price limit would be of no use, as the seller is willing to sell at 75 and the consumer is still having to pay 75. So a limit like 100 will not be effective. Thats why to make the price ceiling work, the ceiling must be below the existing price, otherwise it will have no effect.


Same is a the case of the price floor which is applied to benefit the producer. So If the price in the market is Rs.100 per KG for wheat, the government would like to support the farmer and therefore sets the price as Rs120 per Kg. Now the farmer would benefit as he can sell the produce at a higher price. While if the government was to set this price floor below the existing price, how would that help the farmer ? It wouldn’t and the price floor would be ineffective.

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