Correlation......is it All?

A recent article by Prof. Krishnamurthy Subramanian of ISB ('Why research that establishes causality is better than just correlation?', The Economic Times, 10 August 2012) caught my attention.  This article talks about some issues in research that I have been discussing with some of my co-researchers during our week-end meetings.  Correlation is a statistical tool that is widely used in research in social sciences.  This measures the strength of the relationship between the movements of two variables.  But, unfortunately, it measures only that and nothing more.  Many times I have seen researchers trying to look at correlation from the point of view of causality.  But correlation only indicates a possible causality; but does not confirm the same.

Garry Koop ('Analysis of Financial Data', John Wiley & Sons, 2006) explains this with a beautiful example.  In a study conducted on a group of smokers, it was found that there was a very high positive correlation between smoking and the incidence of lung cancer.  Incidentally, a large proportion of these smokers also consumed alcohol and hence, smoking and consumption of alcohol were also highly correlated.  As a result, there was positive correlation between consumption of alcohol and incidence of lung cancer.  Now let us examine each of the above cases.  In case of correlation between smoking and lung cancer, there exists causality and it runs from smoking to cancer. That is, smoking causes lung cancer and not the other way round.  In the second case, the correlation between smoking and alcohol consumption, there is no causality as neither would lead to the other.  Here, the correlation arises from a social behaviour.  As far as the third case is concerned, the correlation (between consumption of alcohol and lung cancer) is just a coincidence as these two are neither related, nor exhibit any causality.  So, based on the third measure of correlation, if one were to conclude that alcohol consumption leads to lung cancer, it would be a Himalayan blunder!

Correlation, being a mathematical measure, can be computed across any variables!  But whether there exists a relationship between these variables, that merits inferences based on correlation, is something that the researcher has to decide based on his intellectual and intuitive capabilities.  Hence, while using correlation as a measure to draw inferences, the following issues become important:
a) Are the variables related to each other?
b) Is there causality between the variables?
c) If there is causality, in which direction does it flow?

As Prof. Subramanian argues, one should not be satisfied with correlation while drawing conclusions on causality.  Correlation can only be the first step towards establishing causality.  In order to confirm causality, one has to move beyond correlation, and use some advanced Econometric tools specially designed for this purpose.

Commodity & Equity Markets

The commodity derivatives markets in India remained subdued for almost 4 decades due to prohibitions and excessive regulations till 2002, when the Government decided to permit national level electronic exchanges like MCX to trade in futrures contracts on commodities.  Since then, the commodity derivatives markets have witnessed phenomenal growth in trading.  The equity markets, on the other hand, were well established much before.  During stock markets went through prolonged bearish state starting from January 2008 and continue to remain so, with minor improvements now and then.  Commodity derivatives markets witnessed a steady growth during the same period, lead primarily by the growth in trade in bullion contracts. The volume of trade in bullion rose from Rs.17.26 trillion in 2007-08 to Rs.101.82 trillion in 2011-12, with CAGR of 156%.  This kind of growth pattern raised several questions like whether there is any relationship between the equity and commodity market movements in India or are they moving independently.

In a recent research work, it was found these two markets do not exhibit statistically significant co-movements (or long term equilibrium in movements).  The study was conducted based on the relationship between the movements of equity markets (measured by NSE Nifty and BSE Sensex) and commodity markets (measured by MCX Comdex, Metal and Energy indices).  Period of the study was 4 years from January 2008 to December 2011.  Correlation and Engle-Granger Test for Cointegration were used to analyse the data.  Though there was positive correlation between both the markets (about 0.60), the Cointegration test proved that there was no significant co-movement between these two markets.

(The above post is based on a research paper co-authored by me and Dr. M R Shollapur, which was presented in an International Conference recently at Bangalore)

Series on Financial Markets - VI

After a brief gap (due to various preoccupations), let me resume my blogs.  Let me brief on the past posts in the above series.  The first one dealt with basics of real assets and financial assets.  The second one explained the characteristics of financial assets; the third one was about the financial system and the fourth and fifth dealt with raising funds (capital) from through borrowing and from the shareholders through the primary markets respectively.  The last post ended with a question: when raising funds directly from public involves lot of costs (in various forms), why do firms raise funds from the public?  Let me try to answer.

Let us first understand why firms do not like too much of debt.  Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages.  Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not.  Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases.  Secondly, the lenders start insisting on certain operational restrictions.  They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc.  Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders.  This is exactly what the aviation sector is facing now.

Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs.  The equity capital is almost a permanent source of capital.  The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares.  Here again, the decision to buyback the shares is not demanded by the shareholders.  The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned.  A firm with more equity capital attracts a better image in the business circles and financial markets.  Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.

Interest on Small Saving Schemes - Clarification

Let me wish a Very Happy New Year to all my readers. In my blog on Small Saving Schemes dated Nov 15, I had brought to your notice that the Government had accepted the suggestions of a Committee to link the interest rates on small saving schemes to the market yield. It also said that the Government would announce the rates applicable to various investments on 1st of April every year. Even though the implications were well understood, some people had a doubt whether the interest rates on an existing instrument would be revised every year. The ministry of finance has now given a clarification that the interest on all small saving schemes, except Public Provident Fund (PPF) will remain fixed till its maturity. That means, when the rates are announced on 1st April, it would apply to all the investments made in instruments (other than PPF) during the relevant financial year. New rate, when announced during the next year would apply to subsequent investments only. So, if one invests in NSC on 15th June 2012, the rate announced by government on 1st April 2012 would apply to his investment and the same would remain fixed till its maturity. When the government announces new rates on 1st April 2013, such rate would apply only to those who invest in NSC during 2013-14.

But in case of PPF, this doesn’t work. PPF, unlike many other instruments, is a long term (15 year) deposit on which interest is paid on the outstanding balance every year. So, the interest on PPF account will be revised every year. From the point of view of Interest Rate Risk, it means the yield from all small saving instruments, other than PPF would remain constant, once invested. But when it comes to re-investments or investments planned annually over a period of time for availing tax benefits, one would have to face the fluctuations in interest rates.

Reliability of the Most Reliabale

Any research, analysis or even a commentary on the economy draws heavily on the macro-economic data.  When it comes to data, analysts all over the world unanimously agree that the most reliable data source is the Government.  They just accept the data provided by the government without even the slightest doubt on its reliability.  The data released by governments has various roles to play.  (a) It indicates the direction and momentum of the economy, which has great influence on the confidence levels of business enterprises; (b) It acts as guiding tool for attracting both domestic and foreign capital; (c) It influences the decisions of Foreign as well as Domestic Institutional Investors, and (d) It sends signals to the financial markets, taking them to new levels.  Such is the importance of data provided by the government, that many people eagerly wait for the release of the most recent data.  Now let us look at some recent headlines:

(a) Govt Admits Subsidy Math has Gone Awry (Economic Times, 8 Dec)
(b) $9B Goof-up in Export Numbers, Admits Govt (Economic Times, 10 Dec)
(c) Export Nos. Gaffe Adds $7.2B Headache to Govt (Economic Times, 15 Dec)
(d) Rangarajan Spots Sampling Errors in IIP Data (The Hindu, 21 Dec)

The first one is an error of forecasting, where the subsidy bill has overshot the budget estimates by a huge margin.  This is very much possible and does happen at times.  But the last three are calculation/estimation errors.  In the second case, "computer and human errors overstated India's export figures", says the report.  It gives further reasons as "wrong data entry, double counting of certain items and computer malfunction".  The difference was to the tune of $8.8Billion.  Within 5 days of revising the export numbers downwards, the government got the next shock.  The export data compiled by RBI for 2011-12 exceeded the government estimates by $7.2Billion.  The RBI data is considered to be more reliable as it is based on the actual payments received.  Then came the big announcement of IIP's contraction by 5.1% during October 2011.  This sent shock waves among the business fraternity and the financial markets alike.  And today, Dr. Rangarajan, Chairperson of the Prime Minister's Economic Advisory Council spots sampling errors in the IIP numbers for Oct 2011.  He had expressed his shock and disbelief when the IIP numbers were released last week.

If one were to make any conclusion on the conditions of the economy based on the data released by the government, the data needs to be compiled properly and computed scientifically without errors.  With the advent of advanced computing technology, we have increased the frequency of reporting by shrinking the reporting interval.  In some cases, this type of increased frequency in reporting can only create unwanted panic in the market.  It looks like a doctor monitoring the temperature of his patient every 15 minutes and reporting the same to the patient.  It only adds to his panic, especially when the news is not good.  What is worse is that the doctors is using a flawed thermometer! 

Series on Financial Markets - V

Continuing with the discussion on raising capital by business entities, unlike what I mentioned in my earlier post, capital can also be raised directly from the savers.  Small businesses borrow money from the friends/relatives of the promoter directly; whereas large corporate houses raise money from public at large.  (There are various reasons why businesses do not fully depend on banks and financial institutions for capital, which is not explained here).  A business enterprise can raise capital in the form of debt or equity (ownership).  When an enterprise raises capital directly from the public, it is said to be raising the money from the 'Primary Market'.  Unlike many other forms of market, primary market is a notional one, with no specific location or office.  However, this market is regulated by the government through appropriate regulatory bodies.

Since there is no specific location; and savers, who would be interested in supplying capital to the firm are geographically scattered throughout the country, the firm has to put in place a complete system to reach the prospective suppliers of capital.  It resorts to the following processes and depends on the respective intermediaries in the process.
(a) Obtaining regulatory approvals (wherever required)
(b) Releasing advertisement inviting public to subscribe to the bonds/shares
(c) Preparing and printing prospectus containing various details of the issue
(d) Printing application forms
(e) Approaching brokers/sub-brokers to promote the issue
(f) Appointing registrars to manage the issue
(g) Appointing bankers to collect the payment etc.

Thus, as against loan from a bank or financial institution, the process of raising capital directly from the public involves lot of money (spent on the above activities) and it is time consuming.  Then why do businesses raise capital directly from public?

Series on Financial Markets - IV

Let us now understand the role of Financial Institutions in an economy.  These institutions act as intermediaries between the suppliers of capital and those in need of it.  It is always possible for the business enterprises to raise capital directly from the individuals who have surplus money.  But there are few problems:
(a) many individuals may have only small amounts of money as surplus
(b) the individual investors do not have the expertise to analyse the business that the firm is engaged in
(c) the individuals find it difficult to understand and assume the risks involved
(d) there is a question of credibility as the business enterprise may cheat the investors

This is where the role financial institutions becomes relevant.  Lets take commercial banks for example.  Banks collect small as well as large amounts of money from those who are willing to invest their surplus, make a big pool of money, which is then used for lending to business enterprises or individuals placing demand for money.  Thus the surplus money that would have directly flowed from the investors to the firm, now takes a detour through the bank.  This solves most of the above concerns.  Lets see how:
(a) individuals can deposit even small amounts as banks pool the funds
(b) banks have the expertise to analyse the business projects
(c) banks can reduce the risk of lending as they lend to many enterprises and thus diversify the risk
(d) banks are regulated by the government which brings in credibility (though not all banks share the same credibility and risk)

Similarly, the financial institutions like insurance companies, mutual funds, pension funds etc. act as financial intermediaries.  They are all regulated, though the extent of regulation differs.  The process of financial institutions bringing suppliers and users of funds together is known as 'Financial Inter-mediation'.