Inefficiency and Speculation
in the Indian Capital Market
S K Barua & V Raghunathan
Is the Indian capital market inefficient ?
Does it reward low risk takers with high
returns ?
Barua and Raghunathan argued
("Inefficiency of the Indian Capital Market,"
'Vikalpa,July-September 1986) that the
Indian capital market was inefficient,
based on an illustration. Ramesh Gupta
contended, in a response article entitled "Is
the Indian Capital Market Inefficient or
Excessively Speculative?" (Vikalpa, AprilJune 1987), that their conclusion was
erroneous as it was based on many assumptions and a hypothetical example.
Barua and Raghunathan re-examine
their risk-return evaluation in the light of
the actual developments over the last year
in the case illustration used earlier. They
argue that their conclusion on market
inefficiency remains valid, notwithstanding the many changes in the assumptions.
S K Barua is Professor in the Production
and Quantitative Methods Area and V
Raghunathan is Associate Professor in the
Finance and Accounting Area at the Indian
Institute of Management, Ahmedabad.
In our article "Inefficiency of the Indian Capital
Market" (Vikalpa, July-September 1986), we had
argued that the Indian capital market was inefficient. This article was subsequently reproduced in
The Economic Scene (February 1987) under the title "Returns Much Larger Than Risks" and in
Fortune India (May 1987) under the title "Indian
Stockmarkets: Risk-Return Parity Vitiated."
The measure of inefficiency we used was the
well-known risk-return parity rule. Did the market
reward high risk takers with returns higher than for
low risk takers? To answer this question, we used,
as an illustration, the rights issue just then proposed by Reliance Industries Ltd. of series G convertible debentures to holders of series F debentures. We considered two investors C and D. Investor C operated on a cash basis, held on to the
rights debentures till maturity, and sold the equity
shares (received on conversion). Investor D
operated on a carry forward basis, presold the
shares he was due to receive on conversion. By preselling the shares he was sure to receive as rights,
investor D took less risk than investor C who exposed himself to equity price variation till the
maturity date of the debenture. Our calculations
showed that investor D earned a higher return than
did investor C. The capital market allowed a reward
for a low risk taker that was much higher than for a
high risk taker. It vitiated risk-return parity.
We argued, therefore, that the Indian capital
market was inefficient. The article received wide
attention not only in terms of its reproduction but
also in terms of criticism of our method and conclusions. Gupta in a response article "Is the Indian
Capital Market Inefficient or Excessively Speculative?" (Vikalpa, April-June 1987) criticized our
approach as based on "a hypothetical example"
and contended, therefore, that our conclusions
were "erroneous." He claimed that we did not take
into account the "peculiarities" of the -Indian
market. He argued that the Indian stock market was
not inefficient as much as excessively speculative,
using the concepts of inefficiency and speculation
somewhat interchangeably.
Concept of Efficiency: Some Clarifications
In view of the widespread interest, uninformed
criticism, and a lack of clarity in concepts of inefficiency and speculation, we have, in this article, attempted to:
In critiquing our 1986 paper, Gupta (Vikalpa, AprilJune 1987) states that investor D took no risk in
preselling his shares. Gupta has misstated our position. We did not say that D took no risks. We said
that D took less risk than C. The question in examining the inefficiency of a market is not how much
risk an investor took but whether the market was
able to maintain the risk-return parity. Gupta has
also missed the key to our argument. As stated in
our July-September 1986 article:
• clarify our position and concepts concern
ing inefficiency
• examine how robust our risk-return evalu
ation and conclusion on the inefficiency
was in the light of subsequent develop
ments
• outline the linkage between efficiency and
speculation.
Inefficiency
The concepts of efficiency and the risk-return parity are well known. However, Gupta's criticism of
our paper suffers from several misunderstandings.
We have examined his criticism separately in a box
alongside these columns under the heading "Concepts of Efficiency: Some Clarifications."
A market's efficiency is simply its ability to
maintain a risk-return parity at all times through its
pricing mechanism. We examined this in May 1986
using the issue of series G debentures by Reliance
Industries and concluded that the Indian capital
market was inefficient.
In examining the risk-return parity between investors C and D, we had to make several assumptions such as on the price of an equity share at the
time of issue and at the time of conversion and
carry forward rates. Assumptions were necessary
because all the steps for the issue were not complete in May 1986 when we wrote that paper. Between then and May 1987, several things have happened. Obviously they are not exactly as per our
assumptions. For example, the intention of the
company was to issue a major portion of the series
G convertible debentures as rights to series F debenture holders and shareholders. The government
did not allow rights issue to the debenture holders.
The company was allowed to issue part of the series
G convertible debentures as rights to its equity
shareholders and the rest to the public. There have
been several other changes as well such as the issue
price of a series G debenture, the ratio of conversion,
and, of course, the market prices.
Using the actual case situation, we have reexamined the same question regarding inefficiency.
54
The risk taken by investor C is clearly higher than the
risk taken by investor D. If the expected returns are to
be commensurate with risks assumed, then the return
earned by C should be higher than that of D.
The test of efficiency of a market is its ability to
adjust prices such that the rewards are proportionate to risks, that is, the maintenance of a parity between risks and returns.
Prices of Primary Issues. Gupta has said that we
have found fault with the Controller of Capital Issues because he fixes prices at which companies
issue capital (primary issue prices) which are lower
than the prevailing market prjces. Here again there
is confusion in understanding our position. The
government follows certain policies with respect to
the primary market through the Controller of Capital Issues and its representatives on the stock exchange. What we said was that its policies sometimes undermined the market. One example we
gave was its policy of fixing low or no premia, in
relation to prevailing market prices, on new share
issues by existing companies. While the policy ensures adequate returns in the primary market, it
ends up adversely affecting the risk-return parity in
the secondary market. It creates opportunities in the
secondary market for high returns incommensurate
with the risks taken. This is precisely what we tried
to show with an illustration.
We argued that an efficient market has to take
the policy in its stride as it processes a variety of
information. The test of efficiency of a market is its
ability to adjust security prices quickly so that abnormal returns do not accrue to those who do not
take abnormal risks. While we were pointing out
some problems that government policy creates for
the market, our test for evaluating the efficiency of
the market was clear and unaffected by government
policy.
Peculiarities of the Market. Gupta points out four
peculiarities of the Indian market. These are:
(continued)
Vikalpa
• category A shares (specified shares in
which trading can be done with a facility
to carry forward the transaction) do not
constitute a "forward market"
• carrying forward an outstanding position
is not always possible. Therefore, counting
on carrying forward for a whole year, as
our investor D does, is risky
• speculators and regulators determine the
carry forward rates and prices
• small investors do not have an easy access
to trading on a forward basis.
If these are the peculiarities, Gupta does not show
how we have ignored" them. In fact, we have taken
all these into account fully.
The first so-called peculiarity mentioned above
is not a peculiarity. It is a matter of terminology.
What it is is immaterial as long as we abide by the
trading rules, prescribed for category A shares. Our
analysis conformed to these rules fully.
The second so-called peculiarity is a fact that
can be verified. We have, in fact, tried to do that as
part of the second objective of this paper, namely to
test the robustness of our conclusion on inefficiency taking into account the actual developments.
The third peculiarity mentioned above may be
true. But that is not the issue. We tested our findings for various carry forward rates and prices before coming to the conclusion that the market consistently gave a higher return to the low-risk
strategy of investor D than it did to C for plausible
parameter values.
The fourth so-called peculiarity that small investors may not be able to trade on a carry forward
basis may be true. We did not say or assume that
investor D had to operate on a small scale. Why
should he? Especially when he is so handsomely
rewarded despite a low level of risk. Gupta has misread our use of a small number of shares for illustrative purposes as implying that D is a small operator.
The "peculiarities" of the market pointed out
by Gupta do not affect our testing the efficiency of
the market.
In this paper, we have gone further than imaginary or real peculiarities and assessed the postfacto evidence on the risk-return parity. We have
taken cognizance of the actual carry forward rates
and prices to re-examine our hypothesis regarding
the inefficiency of the Indian capital market.
Vol. 12, No. 3, July-September 1987
Did the market maintain the risk-return parity by
adjusting prices in the light of unfolding events?
Actual Returns
To answer this question we re-examine the two
strategies outlined in the earlier paper in the light
of actual developments between May 1986 and
May 1987. The two strategies are: one operating on
cash basis only and the other involving preselling
of shares to be received and of carrying forward
the transaction until May 1, 1987.
To recapitulate the facts, series G debenture
issue was for Rs 400 crore. We can fix the date of
issue as December 1, 1986. The issue price of a
debenture was Rs 145. Each debenture is to be converted into two equity shares of Rs 10 each on
January 31,1988. Of the total issue of Rs 400 crore,
Rs 150 crore worth of debentures were allotted to
equity holders as rights in the ratio of one debenture for five equity shares.
Prices. The market price of a Reliance equity share
was Rs 212 around December 1, 1986, and about Rs
130 on May 1, 1987. The price of a convertible
debenture was about Rs 200 on May 1, 1987.
In the light of these actuals, the strategies of
the two investors C and D each having five equity
shares of Reliance as of December 1986 can be laid
down as below:
Investor C: C exercises his right to one debenture
by investing Rs 145 on December 1, 1986. He sells
the debenture on May 1, 1987, for Rs 200.
Investor D: D exercises his right to one debenture
by investing Rs 145 on December 1, 1986. On the
same date, he sells two equity shares on a carry
forward basis. D squares out his forward position
on May 1, 1987, by buying back two equity shares
at Rs 130 each. He sells his debenture for Rs 200 on
May 1, 1987.
How much did the market reward C and D?
According to our calculations, investor C got 38
per cent over the five month period or 107 per cent
per annum.
Investor D had to carry forward his sold position of two shares from December 1, 1986, to May
1, 1987. The amounts he paid or received in each
settlement period for carrying forward a sale of
two shares on the Ahmedabad Stock Exchange are
given in Table 1.
55
Table 1: Amount Received or Paid for Carrying
Forward a Sale of Two Shares
*The amount received/paid) shown in column 3 is obtained
by subtracting figure in column 2 from that in column 1 and
multiplying the difference by 2 (for the two shares). This is the
amount on account of both price difference and carry forward
charges. The carry forward charge can be computed separately
by subtracting the sell price from the immediately preceding
buy price. If the value is negative then it is a backwardation
charge.
We can complete D's cashflows by adding to
the amounts shown in Table 1 the effect of his
squaring out the forward transaction and selling of
the debenture for Rs 200. The return to D works out
at 104 per cent for the five-month period or 402 per
cent per year.
The market actually rewarded D, who took less
risk than C, nearly four times as handsomely as it
rewarded C. The market could not maintain the
risk-return parity. It is inefficient. This statement
assumes that the actual drop in price of Reliance
shares is in line with the expectation of the market.
basis to contain the selling pressure on Reliant
shares. The margin was substantially reduced from
March 1987 after persistent allegations that the
company was delaying dispatches of share certificates to reduce the floating stock of shares in the
market. However, to be conservative, we can assume that this margin of Rs 50 remains imposed
throughout the period under consideration. This
would imply that investor D, in addition to investing Rs 145 in one convertible debenture, would also
be required to deposit Rs 100 with the stock exchange on December 1, 1986. The deposit would be
returned on May 1, 1987, after he squares out the
forward transaction. Even with this conservative assumption, the return to investor D works out to 66.7
per cent for the five-month period which is equivalent to an annual return of about 217 per cent.
These are still far higher than those for C. Thus, in
spite of a high margin, returns are not commensurate with risks.
Normally, margins are not paid in full by the
brokers because of a squaring out of the transactions for each broker. Suppose a broker has two
clients; one sells 100 shares of a company through
him and the other buys 50 shares of the same company through him. Then the broker's net position
would be 50 shares sold and he has to pay a margin
only on these 50 shares, through he actually sold
100 shares. The client who has sold 100 shares may
then have to pay only one half of the officially
specified margin. The margins actually paid rarely
turn out to be as high as those announced by the
stock exchange authorities. In this particular instance, the actual margins varied between Rs 10 and
Rs 20 a share. We have computed the returns earned
by D with margins varying from Rs 50 to Rs 20, and
for no margin. These results are presented in Table
2.
Table 2: Impact of Margins on Returns to
Investor D
Impact of Margins on Returns
A suggestion often made for correcting high returns
on forward transactions is that the stock exchange
authorities should impose margin money for carrying transaction forward. What this amounts to is to
increase the investments of those pursuing strategies such as those of D.
In the beginning of December itself the Bombay
Stock Exchange authorities imposed a margin of
Rs 50 a share on sale of Reliance shares on forward
56
The returns of D are more than 200 per cent a year
for all levels of margin. This compares with about
100 per cent return for C. D earns about twice what
Vikalpa
C earns although he takes lesser risk than C.
What is Speculation?
Would Stiffer Margins Help?
Speculation simply refers to the act of operating in
the market without the requisite resources: buying
without having adequate financial resources or selling without holding the necessary number of share
certificates. This implies that, irrespective of his
size or frequency of trading, a speculator has a finite chance of not honouring his commitment on
the day of settlement.
It is often suggested, as does Gupta, that the stock
exchange authorities should impose stiffer margins
on forward transactions to curb speculation. Imposition of higher margins would make investor D's
scheme less attractive compared with investor C's
scheme. What should have been the margin to ensure that the returns for the two schemes are equal?
Our computations show that the margin should be
Rs. 155, almost equal to the price of a Reliance
share at the time. Levying such a margin would
amount to removing Reliance from the specified list
(A category) and putting it in the cash list. This
further bears out our contention that, except in extreme cases when forward transaction is banned by
the stock exchange, the strategy of preselling the
rights share in the forward market would always
fetch returns much higher than what is commensurate with the risk assumed.
Efficiency and Speculation
There is a tendency to refer to investor D's scheme
as speculative and hence it should be curbed. Such
views exist because speculation is a term which is
grossly misunderstood by laymen, practitioners,
and academics alike. We mention a few misconceptions about the term to illustrate the general misunderstanding. Speculation is often equated with investment for short-term returns. Trading every day
or every week is labelled as speculation. Most large
scale operations are also viewed as speculative; it is
rarely used for small scale operations. High volatility of prices is invariably ascribed to speculators;
rarely would anyone say that wide fluctuations
could be the result of extreme political and
economic uncertainties. The ambiguity in the definition and understanding of speculation provides
a convenient ghost to whom all the ills of the Indian
stock market are attributed. Gupta also subscribes
to this widely held belief that speculation is undesirable and the Indian market suffers from a high
incidence of undesirable speculation. Unfortunately, Gupta has neither provided any definition
of speculation nor has he provided any justification
of why he feels that the Indian market is excessively
speculative. We shall first define speculation and
then argue that some degree of speculation is desirable for the health of stock markets.
Vol. 12, No. 3, July-September 1987
Let us try to understand the operational meaning of speculation in the light of carry forward business allowed in the Indian, stock market. Suppose,
on the day of settlement, the sellers refuse to carry
the transaction to the next settlement day and insist
that buyers take delivery of shares. If the buyers
have speculated they would not have adequate resources to take delivery. They would then have to
borrow from the short-term money market. But instead of borrowing from others, they could borrow
from the sellers themselves by offering a suitable
rate of interest. If the sellers agree, it would in effect
imply postponing the settlement of the transaction
to the next settlement date. The rate of interest at
which sellers agree ;to carry the transaction forward
is known as the carry forward charge. This is unlikely to exceed the short-term interest rate at the
time in the unorganized money market.
Suppose, on the settlement, day, the buyers insist on delivery of shares and refuse to carry the
transaction to the next settlement date. If the sellers
have speculated, they would be in difficulty because, unlike money, share certificates cannot be
obtained easily. The buyers demand a penalty from
the sellers known as the backwardation charge.
Theoretically, it can be any amount, unlike the
limit which governs the carry forward charge. In an
extreme situation, when buyers become too punitive, the stock exchange authorities have to intervene to avoid a breakdown of the market
mechanism.
Margins to Curb Speculation. Speculation can thus
affect both buyers and sellers, depending on the
aggregate situation in the market. To restrict .the
volume of operations within what can be supported
by the resource position of a person, the stock exchange imposes margins which are monetary deposits with the exchange for transacting on a carry
forward basis. Gupta points out that, since the
margins are usually very low (only about 5 per cent
of the prevailing prices), most operators have
highly-levered portfolios, which leads to excessive
57
speculation. Gupta, thus, views margin as equity or
owned funds, the rest of the total investment being
borrowed from the market. He suggests imposition
of a uniform margin of about 65 per cent on all
forward transactions as is the practice in the American market.
This raises two questions:
• Do low margins necessarily imply that
there is excessive speculation in the
market ?
• Is it necessary to raise margins to 65 per
cent which would almost stifle the carry
forward business ?
The answer to the first question is in the negative. A
low margin certainly is conducive to speculation,
but whether a person would speculate or not and
the degree of risk he would assume in the market is
dictated to a large extent by his risk-return trade-off
and not by the presence of opportunities to take
high risks. The answer to the second question is
also in the negative. But to understand this, a look
at the role played by margins is essential.
Role of Margins
Carrying a transaction forward is permitted primarily to increase the volume of operations. The stock
exchange authorities would in fact like investors to
operate with a levered portfolio. At the same time,
they would also like to ensure smooth functioning
of the market by preventing defaults in payment on
settlement dates. Margins are imposed primarily to
reduce the chance of default in payment. When an
investor is unable to pay the difference in price and
the carry forward charge on a settlement day, the
margin money is used to meet his liability and the
person is not allowed to carry the transaction to the
next settlement date. This view of margin differs
considerably from the "equity" view discussed
earlier.
The important question is whether a 5 per cent
margin on an average is adequate against defaults
in payment. We feel, after an examination of the
market index, that the chance of the index changing
by more than 5 per cent in a fortnight (the normal
length of a settlement period) is very low and hence
an average margin of 5 per cent ought to contain
incidence of defaults in payments. Needless to say,
in exceptional circumstances, the stock exchange
may and does impose margins which are higher for
a particular scrip.
Besides imposing margins, the stock exchange
authorities limit volume transactions by putting
ceiling on the outstanding position each broker can
58
have in a scrip. More extreme steps, such as transferring a scrip from the specified list to the cash list,
have also been taken.
From our discussions, Gupta's suggestion of
imposing a uniform 65 per cent margin even in normal circumstances appears unacceptable because
such a measure would have a stifling effect on the
volume of transactions. Since the Indian stock
market is small we need to encourage higher volumes of trading to ensure efficient pricing of securities. In general, margins should be low and abnormal situations should be handled by using other
ways of controlling the volume of transactions in
conjunction with margins. A certain amount of
speculation is desirable for the market to be efficient and the margin in general should be well below the level where speculation stops altogether.
Efficiency of the Stock Market
A well functioning stock market should be efficient.
This implies that the price of a security should reflect all the information available on the long run,
funds would be available for economically more
productive activities. Investors should be skilled
enough to adjust their portfolios by trading quickly
on the basis of new information as it becomes available. In the Indian market, most investors have very
long holding periods and much of the information
made available is unprocessed and does not result
in a quick reshuffle of portfolios. In such a situation, presence of speculators who take a far greater
risk compared to investors would ensure that the
information is processed and acted upon more
keenly. Without speculators the market would be
less efficient. Lack of expertise and inaction on the
part of most investors in the Indian market makes
the presence of speculators far more imperative
than in the well developed American market.
Conclusions
Based on actual returns by following different
strategies, we have verified that the Indian capital
market is inefficient in pricing its securities. There
are instances where returns are not commensurate
with risks. The attempts of stock exchange authorities to reduce the disparity have not proved
adequate. Since the Indian market is small and not
well developed, a certain amount of speculation to
ensure efficient pricing of securities is desirable.
Condemning speculation and suggesting ways of
curbing it completely would be shortsighted because in the long run an inefficient market could
destroy the primary market completely.
Vikalpa