Coming to terms
With the world at our doorstep, not only has our stockmarket changed, but also its vocabulary. We take a look at the new words and terms that have suddenly gained alarming currency on our bourses and among its oracles
Sub-prime: Relates to a section of the US mortgage market where high interest home loans were given to people not creditworthy enough to qualify for loans. While lenders gave money to get higher income, these loans were risky since there was a high chance of repayment default. The loans were further bundled together and converted into securities (a financial instrument) to be sold to other investors.
How am I affected? Many hedge funds, among other investors, had bought these high-risk, high-return securities made out of sub-prime loans to get higher returns. To buy these securities, hedge funds took loans, at low interest rates, from banks and other financial institutions in other markets like Japan. The current international financial crisis started when borrowers in the US sub-prime mortgage market started defaulting on their loans as interest rates went up. This forced hedge funds to sell off their assets, including those in emerging markets such as India, to repay their loans, something that sent the Sensex into a tailspin.
Carry Trade: A method of interest rate arbitrage by global investors- borrow in low-interest economies, primarily Japan, and invest in high- interest economies, like Australia. The difference between the interest earned and paid was the profit. Because of the sub-prime crisis, investors need to get money they had put into carry trade back into the US. To do so, they have to repay Japanese loans. So are buying yen, making it appreciate. This is wiping out arbitrage gains, pushing others to get out too.
How am I affected? A substantial part of the surge in our markets over the last three years has been because of money pumped in by foreign institutional investors (FIIs). Flush with funds earned through various measures, including carry trade, billions of dollars were invested in our markets also. The unwinding of carry trade makes FII liquidity scarce. Also, the resetting of valuations of the dollar against currencies makes it less attractive for FIIs to invest in India, at least for the short term.
Credit Crunch: When Tata bought Corus for over $8 billion, it used an instrument known as leveraged buyout (LBO). LBOs have become very popular and a large part of global M&A in the last couple of years have been through LBOs. Banks that financed these deals underwrite the loans and sell them to bond investors. These are called collateral debt obligations (CDOs). With the current crises, banks are finding it increasingly difficult to get customers for CDOs, leading to lower liquidity for them and a credit crunch.
How am I affected? To avoid undue risks, investors began selling off their less liquid CDOs. This caused the interest rates on CDOs to rise. So, the companies had to pay higher interests on these loans and their net profit got affected. With future earnings eroded, share prices are bound to crash. Also, the whole euphoria of large deals kept the sentiment of the stockmarket buoyant. But now, with the bad news, buyout activity could slow down. That would mean yet another reason not to buy shares.
Cutting the discount: This is a new term, one that entered our lexicon on 17 August 2007. The US central bank, the Federal Reserve (popularly referred to as the Fed), cut the discount rate by 0.5 per cent. Now, the Fed would charge banks a discount rate of only 5.75 per cent for direct loans as against the earlier 6.25 per cent. The discount rate is the interest rate charged to commercial banks and other depository institutions on short-term loans they receive from their central bank’s lending facility.
How am I affected? Directly speaking, you are not. But, this move implies that the Fed is pushing liquidity into the US economy. With markets all over the world witnessing a terrible week, Fed’s move injected some cheer into the otherwise gloomy forecasts. Whether this cheer would last long enough or not is anybody’s guess. But, experts, who have a view on the size of the sub-prime crisis, say it won’t. Outlook money
