Comment on the Revised Draft Indian Financial Code

My comments on the draft IFC which I sent to the FSLRC:

I appreciate the hard work put in by the Commission to come up with a draft legislation that will aid greatly in enhancing the transparency within the financial system in India. This is a much needed bill and the formation of an MPC as an entity separate from the RBI and the Union Govt is a welcome step in this direction.

However, I wish to make one comment regarding the following clause in the draft code: 

(available at: http://finmin.nic.in/suggestion_comments/Revised_Draft_IFC.pdf )

Chapter 65, Clause 255: 

“Inflation target for each financial year will be determined in terms of the Consumer Price Index by the Central Government in consultation with the Reserve Bank every three years.”

The resetting or review of the inflation-target every three years by the Central Government is undesirable for the following reasons, even if it is done in consultation with the RBI:

  1. Monetary policy actions have indeterminate lags with respect to their effects being actually felt in the economy. A hard review timeline of three years is probably counter-productive and may lead to policy targets being based on noisy data
  2. A major channel through which monetary policy operates is through expectations of future inflation. Adding a three-year review adds uncertainty about the path of the real-rates in the future, especially at the review-tenor. This uncertainty, which is purely an artifact of the clause above, will add an unnecessary term-spread for borrowers in the markets.
  3. It takes time for inflation targets to be institutionalized and the market to adapt to them with savings, insurance and credit products – especially if the products are inflation-linked. The three-year review process will hinder the expansion and liquidity of such markets. Another disadvantage of this would be that market-implied measures of medium-term inflation – such as the breakeven inflation rate on index-linked securities – would be quite useless – which would not be beneficial for the MPC when setting rates.

While an assessment of the inflation target/range an economy should adopt may be necessary from time-to-time, especially for an emerging market like India, it is necessary to:

  • Let an independent body like the MPC decide the target – this will enhance the credibility of the monetary policy
  • Let the target be reviewed over a longer time-span – say 7-10 years – which would allow for short-term aggregate demand/supply shocks to dissipate enough so that potential output and output-gaps can be assessed accurately – based on which an inflation-target/range may be determined

Black-Litterman Portfolio Allocation and Bayesian Analysis – Part 1: Introduction

I have thought about doing an introductory post on Bayesian Analysis for a a while now. There were several real-world applications that I considered – finance, machine-learning, election-forecasting etc.

Among these, the topic I can deal with most thoroughly, without inadvertently misleading the reader (or myself!), is probably finance. And one of the most accessible areas of mathematical finance is portfolio theory.

Beginning with a crash course in elementary statistical concepts, I hope to introduce what portfolio theory is about – the basics of the Capital Asset Pricing Model (CAPM) – where it works and where it fails – both in terms of theory and, more importantly, in terms of application to real-world scenarios.

An introduction to basic Bayesian reasoning will then follow. I do intend to use some concepts from probability and statistics to explain the ideas – but will focus more on the intuition than the mathematics.

I will then introduce a Bayesian take on portfolio allocation – the Black-Litterman model. The emphasis will be on the inherent intuitiveness of the model and how the allocations made using it are more robust than those suggested by CAPM.

Hopefully, this series of posts will be helpful to people who want to design portfolio-allocation frameworks of their own to manage investments (whether as a hobby or in a professional capacity).

So, stay tuned for the next part – where I will introduce some basic statistics and how it can help characterize the various attributes of a financial portfolio.

An Aside on Mathematical Prerequisites

I will use as little mathematics as possible to explain the concepts (referring to more rigorous articles, when necessary). I will also supplement the analysis with Python/R code to help the reader grasp these ideas (because nothing aids the understanding of a concept than writing code that implements it).

As a prerequisite, some familiarity with matrix algebra would be very helpful – as it helps make the notation very succinct and the concepts easier to follow (nothing too advanced, if you know how to multiply matrices together, then you know enough). Some basic calculus and algebra would be useful as well.

I do wish to point out, however, that there is no substitute to actually doing the math to really understand any conceptual model and the assumptions behind it. Intuition helps, but it can only get you so far. My intent here is to ignite your interest in these areas without being daunted and discouraged by the mathematical aspects of the theory at the outset.

It would be a great outcome if you would be willing to explore these areas further in a mathematically rigorous fashion as a result of reading these posts. It might be a bit cumbersome – but I assure you, the rewards, intellectual and otherwise, are worth it.

 

Back online!

Did a big rehaul of the entire website along with rejigging hosting to make it faster (DNS magic, CDNs, mobile-viewing optimizations etc). Plus, connections are now HTTPS by default as all visitors are entitled to a secure browsing experience.

Hopefully, now I will be able to post more often and with richer content.

Welcome!