The Hindu Business Line : Stock market and global cues

Rational investor behaviour can be grounded not just in the perfect knowledge of actions of others but also in the perception of their prospective behaviour.

The Chairman of the Securities and Exchange Board of India was right when he said it is an over-simplification to link the recent sharp price fall in Indian equities to the health of the securities representing housing loans given to sub-prime borrowers in the United States. It is true that no single factor can drive price movements in markets where there is a multiplicity of players with differing expectations on returns and the time horizon within which these are to be a chieved, and institutional investors with very different profiles. But the connection between the woes of the US mortgage market and the behaviour of investors in the Indian market is somewhat nuanced.

When it comes to capital flows, the Indian market is well and truly part of the international architecture. Indeed the recent rally in equity values has been triggered as much by the new-found enthusiasm of foreign institutional investors as by the rising capacity of Indian corporate sector to measure up to global standards of productivity and profits. It is entirely possible that the FIIs, having assessed sub-prime lending by others as a case of reckless adventurism, now begin to wonder if they themselves would be so judged for their flirtation with emerging markets. Even if FIIs do not actually see it that way, domestic investors cannot be faulted for taking the view that foreign investors could sooner or later come around to such a conclusion and hence wish not to be stuck with their portfolios when the FII music stops. In other words, rational investor behaviour can be grounded not just in the knowledge of actions of others but also in the perception of their prospective behaviour.

Investors in any market, in their quest for perfect value in financial assets, are at once rational and adventurous with each step, pushing the frontiers of risk to the point where the next step becomes a case of adventurism. This is as it should be. For only in the determination of such perfect value, can they exploit to the hilt the potential for profit inherent in the situation. Nothing exemplifies this as well as the behaviour of lenders in the US housing mortgage market where the ‘sub-prime’ status is a function of the credit appraisal framework that assigns scores to individual borrowers without regard for any variations in their current status. The situation is ripe for some lender to take the view that sub-prime borrowers are not sub-prime after all as to be denied credit. When such behaviour is rewarded with higher returns, the case becomes all the more compelling. But somewhere along the way doubts begin to show up, first in the mind of that lender and much later in others intent on guessing the extent of such a folly of the first. The process of correction can thus be said to be well and truly on.

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