Why markets are so volatile

The Indian stock markets started falling from mid-February after reaching an all time high of 14,700-plus. Initially it fell on local factors like inflation worries, the government's controversial anti-inflation measures and Budget-related uncertainties.

Before investors could digest this, the Chinese markets fell at the end of February, dragging world markets along with them, followed by more big falls on worries related to the yen carry trade. The markets then rebounded but in India, they continued to fall in response to the government's pressure on key industries to cut prices.

Subsequently, the markets kept falling as the expectations of a slowdown in the US and worries related to sub-prime housing lending re-emerged. Despite these much-reported developments, few understand what's really going on. Why are the markets so volatile? Why do they fall one day and rise another? Many research reports say there is no need to panic. So is the worst over? Here are some key explanations:

Global factors

Unwinding of the yen carry trade

Japan was a country with the world's cheapest money. A year ago money was available virtually free. Then the Bank of Japan raised interest rates for a second time in the third week of February.

But the trigger came from former Fed Chairman Alan Greenspan when he talked of a possible slowdown in the US during a recent speech. Thus, the dollar weakened against currencies like the yen.

Those who had borrowed in yen and bought dollar assets, and equities started worrying. One, their cost of fund went up as interest rates in Japan rose.

Among these investors, many were short-term players like hedge funds that had not hedged their currency risks. Therefore, the rising yen will mean they will get less money-yen when they bring their money back in Japan to repay their borrowing.

Not surprisingly, such hot money players went on a selling spree wherever they had invested and India was no exception. "Nobody has a clue about the volume of the carry trade and how much of it is hot money," said Ashish Agrawal of Edelweiss Securities.

A forex dealer said that the Bank of Japan generally does not allow the yen to appreciate beyond a point and it intervenes to keep it down, which is why many hedge funds kept their yen borrowing unhedged. In short, the future unwinding of the yen carry trade remains a grey area and investment banks have different views on it.

Sub-prime lending

Sub-prime lending refers to lending to risky borrowers. Such lenders will suffer the most when the US economy slows. And if interest rates, which are rising worldwide, increase further, the risk of recovery rises for such lenders. Nor surprisingly, the US market saw a big fall on Tuesday on such worries but the beginning was made earlier.

Last week HSBC announced that its bad debt provision had increased by $2.8 billion, owing to problems in sub prime assets in the housing. HSBC's announcement did not have much of an impact because it reported good profits despite higher provisioning for bad debt.

But when more cases started surfacing many funds turned sellers. Yet, the next day, the markets rose because of some comments that the risks were not as big as initially assumed. "There were too many differing views that were confusing and making markets volatile. If some funds feel that the risk is rising then they sell across the regions and that is why the fall percolates to the Indian market also," said Agarwal.

Higher valuations across the globe, equity markets rose along with other asset classes.

Since the valuations were so stretched, investors are seen reducing the risks. Said a senior executive of a global investment banker, "Investors are reducing their risky portfolios and that is happening everywhere. And this may continue till the risk becomes bearable." Although it will take some time before equities emerge as consistently attractive again, he says the volatility is a blessing in disguise for investment bankers. "In our research team many new researchers have joined in the last three or four years who have not seen falling markets. This is good learning and training for them!"

Local factors

Inflation and interest rate worries

It is still not clear whether the government's inflation management will work or whether more measures should be expected. Inflation and interest rates have raised questions about the whole issue of share valuations issue and sustainability of earnings.

Government pressures

It is true that the government wants to control inflation. But the market takes a negative view of when the government pressures steel makers to roll back a price rise or asks cement producers to hold the price for a year or bans some exports for which industry had created capacities.

In general, markets hate uncertainty. Uncertainty encourages volatility. Whatever reason may be ascribed to the fall -- China's over-valued markets, US's sub-prime mortgage crisis or India's inflation management -- market participants are repricing the risks across the asset class.

At this point, what should investors do? A prudent investor would not think twice about booking profits in this highly-risky market. And a wise one would wait for the right time to re-enter.