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MONEY MANAGER AUG 2010

When the entire world was engulfed in the economic crisis, there was still some hope in certain

quarters. The hope that the growth in a select few markets could still compensate for the downturn

witnessed in the developed economies. One of those rays of hope was India: the silver lining in this

cloud of recession.

India has been the talk of the town for the past few decades as it has amazed the pundits around the

world through its growth rate, its presence at global forums as well as robustness of its financial set

up. The investors around the world through their investment patterns have given the Indian markets a

literal “thumbs up”. This can be witnessed through the large amount of capital inflows in the recent

past. At the same time, the Indian economic policies have been appreciated by one and all because of

it inherent strengths as well as strong fundamentals. If the ability of the Indian markets to successfully

tackle a downturn of such magnitude surprised everyone, its high rates of growth after just a year of

the crisis has left everybody spellbound. But it doesn‟t mean that there are no cynics. Some have

downplayed India‟s successful recovery as fallout of its relative detachment from the global economy

whereas some feel that India escaped as its population has inadequate access to credit thus lower

exposure to risk. So, whatever may be the reason, there is little doubt that story of Indian financial

markets is not just interesting but it‟s also captivating.

Money Manager 8 with its theme, “Unleashing India: The Story of Indian Financial Markets” is a

humble attempt on our part to narrate this story through the prism of industry as well as academia.

This edition has tried to capture views from different quarters that more than just influence the way

the market behaves. The interviews present international outlook on the Indian market and provide

macroeconomic insights on the government policies. The articles from the academia give financial as

well as regulatory view of the Indian financial developments. The student articles through its variety

and conceptual clarity have touched down upon different aspects of Indian economy. We have also

incorporated articles that relate finance with our day-to-day activities be it poker or relationships.

On behalf of the Money Manager team, I would like to express our deepest gratitude to the eminent

personalities who shared their views and perspectives on this theme, the distinguished faculty who

kindly agreed to judge the student entries and our sponsors of this edition, UBS AG Hong Kong. We

thank you, our discerning and ever supportive readers, for the encouragement and succour you have

provided us. We hope that this edition of Money Manager will add value through its variety of

offerings.

Please send in your valuable suggestions to [email protected].

Happy reading!

Saket Saurabh (IIM-C)

FROM THE EDITOR’S DESK

From The Editor’s Desk


We at The Finance & Investments Club, IIM

Calcutta would like to sincerely thank all those

who have been instrumental in helping us

release this edition of „The Money Manager‟.

We‟d like to thank our sponsors, UBS for their

support and encouragement. Their patronage

and contributions have helped create a much

richer and more appealing Money Manager, one

that we hope the readers will enjoy.

The Money Manager team would like to express

its deepest gratitude to the leading luminaries

from the industry and academia for their

contributions through insightful articles and

thought provoking interviews. We would like to

thank UBS for their cover interview, Dr. Golaka

C. Nath for his interview, Prof. Asish K.

Bhattacharyya and Prof. V.K. Unni for their

articles.

We were quite overwhelmed by the phenomenal

response from the student community across the

country – the broad range of topics covered and

analytical depth of the articles was

extraordinary. A big thank you to all those who

sent in articles for this issue – we hope to have

your continued support in forthcoming editions

as well.

We would like to express our gratitude to all the

members of FinClub for their valuable inputs

and feedbacks. Last, but by no means least, we

would like to thank you, our readers, whose

unstinting support has helped the Money

Manager grow to the national presence it enjoys

today. We hope you will enjoy reading this

edition as much as we enjoyed putting it

together!

ACKNOWLEDGEMENTS

Acknowledgements

THE

MONEY

MANAGER

Editor-in-Chief Saket Saurabh

Editorial Board Aditya Damani

Ashish Agarwal Pavan Adarsh

Rahul Singh Thakur Sethu Chidambaram

Smitalee Prusty

Coordinating Committee

Priyesh Jaipuriar

Anindya Dutta (IIM-A) Priyank Patwari (IIM-B)

Design

Abhishek Verma

Nitin Sahai

Feedback/ Queries

[email protected] http://www.iimc-finclub.com/


Contents

Cover Article : Indian Fi‐nancial Markets

Expert Opinion

6 An Outlook on Indian Markets UBS

9 The Changing Face of Indian Markets Dr. Golaka C. Nath

12 IFRS : Internationalizing Indian Accounts Prof. Asish K. Bhattacharyya

14 Viewing Reforms Through The Regulatory Prism Prof. V.K. Unni

Editorial Articles 17 The Basics of Base Rate 20 ULIPs: Whose Product Is It Anyway?

23 Financial Inclusion in India 27 What Drives Indian Equity Markets?

31 Oil Price Deregulation

Student Articles 36 Exchange Traded Funds (ETF) : Opportuni‐

ties to Deepen

41 Mutual Funds Industry in India

45 Developed Corporate Bond Market in India

51 Capital Accounting Convertibility: Is India Ready?

The Lighter Side of Fi‐nance 65 On Bonds and Bondings

67 Great Poker Players Make Great Trad‐ers, Or Do They?

Financial Crossword

60

56 Arm Chair Investing on Nifty: A P/E Based Approach.

Why the Indian Markets Will Not Fail


1

The Money Manager was started with an aim to collect the views of students, practitioners and academicians on the current developments and most relevant issues in finance. Its stated objective was to provide a platform for management students to express their views on all areas of finance from private equity to capital markets, corporate finance to insurance. The Money Manager is not a “research journal”; rather, it is a collection of interesting and current ideas in finance. It is the first of its kind, a joint endeavor of the finance clubs of IIM Ahmedabad, Bangalore and Calcutta. To provide not just an Indian perspective, but a truly global one, we try and get contributions from professionals and academicians from across the world. Interviews with professors in world-renowned institutes and practitioners in the highest echelons of the world of finance feature in the pages that follow. Student articles are solicited from reputed institutions around the world. The articles are then screened for originality and then judged by an elite panel of professors from IIM A, B and C. The winning articles are tested on originality, depth of analysis, relevance of topic and presentation style. We hope to include eminent industry persons in the panel of judges for future editions. Seven editions of the Money Manager have been published before this and we hope to continue to provide relevant and thought-provoking articles to read for anyone who is interested in finance. To enable the Money Manager to reach an even wider audience, it will be available for download online. All current and past editions are available on our websites, including http://iimc-finclub.com/, the website of Finance & Investments Club of IIM Calcutta. These will be updated regularly, so do keep checking in! - Finance Clubs of IIM A, B & C

PREFACE

Preface


2

Cover Article : Indian Financial Markets Since the beginning of this decade the Indian capital markets have been receiving global at-tention due to the improving macroeconomic fundamentals. The presence of a great pool of talent, rapid integration with the world economy and liberalization measures taken by the govern-ment have increased India’s global competitive-ness and have helped the capital markets grow by leaps and bounds. In this issue we take a look at the major turning points and focus on the most recent developments in the markets. The major revolution in the capital markets started with the establishment of the Securities and Exchange Board of India (SEBI), the regu-latory authority for Indian securities market in 1992. It aimed at protecting the investors and improving the infrastructure of capital markets in India. Since then a flurry of improvements have been initiated by the Government of India and the SEBI which has resulted in transition of exchanges to screen-based order matching sys-tems for better transparency, dematerialization of shares, online trading facility and adoption of market oriented economic policies. This led to faster and cheaper transactions, and increased the volumes traded by many folds. This along with the liberalization measures undertaken by government since 1993 has helped deliver India on the global platform. This decade has also seen the rise of the derivatives markets which are now being used by many Indian corporations for hedging their risks. Mobile phone banking being implemented around the country indicates that much of the system is at the Internet age and beyond. However despite these efforts our markets have not been able to reach the levels desired. Even now less than 1 per cent of our population invests directly in the equity market. In terms of depth, participation and geographical spread, Indian capital markets are nowhere close to the developed nations; not even close to their Asian counterparts.

A multitude of reasons surface when we probe these shortcomings of the Indian Capital mar-kets. The primary market which used to be the retail investors’ favorite investment avenue and an entry point till a few years ago, has been dwindling of late. This was reflected in the re-cent IPO’s of some public-sector firms, which have traditionally enjoyed a sound and safe in-vestment image among public investors. Retail Investor participation in the market remains dis-mal even in the secondary market. To put the picture in perspective, the Indian retail investor saves over $300 billion but allocates less than 5 per cent to financial market instruments other than low return bank deposits. Even in terms of geographical spread, more than 90 per cent of exchange trade is largely confined to 10 cities and 100 companies.

The biggest reason for this lackluster allocation to capital markets remains lack of confidence and limited financial literacy. In the last two decades, India has seen scams and frauds which has left the investor nervous. The allocation fraud of Yes bank IPO where multitude of retail accounts were opened by a single investor to get maximum allocation through retail route rather than HNI route is one such example. It repre-sented not only the pervasiveness of the menace

COVER ARTICLE


3

but also the inability of our legal and financial control systems in dealing with it. It takes an era to uncover a scam of this magnitude in any country. To punish the perpetrators takes even longer in India! Compensation if any is hard to come by. Several such scams have left the Indi-an investor suspicious of the capital markets and those with weaker hearts have instead chosen to invest in the low return fixed deposit schemes. Regaining their confidence will require speedy indictments and compensation for which an overhaul of the legal system is required. There has been some good news on that front with the recent disgorgement of undue profits from the IPO scam and compensation to the wronged in-vestors. Whether it will be enough to entice the retail investor, only time will tell. The Government and SEBI have been doing

their part by spreading investor education and using product innovation and technology to bridge the urban-rural divide for a more equita-ble and inclusive growth. The dwindling interest in the primary markets can also be rejuvenated by allocating higher retail portion in the IPO and simplifying the procedures and cost of opening Demat accounts to encourage people beyond the top 10 centers to invest directly in equities. Cur-rently, the application forms being used for bid-

ding in initial and follow-on public offers are unnecessarily long and enquire redundant data which can be done away with. There are various proposals currently being discussed by SEBI’s Primary Market Advisory Committee to remove these details from the forms and make them more investor friendly. The SEBI in its role of protector of investors and capital market regulator recently got into a battle with the IRDA over regulation of ULIPs. Earlier last year, SEBI had banned entry loads on Mutu-al funds which made the product unprofitable for the insurance agents. They focused their at-tention on the new product called ULIPs which still had entry loads ranging from 15-20%. Dur-ing the last year, the premium collected from these products was a total 20 billion dollars which is about 60% of the net FII inflows of the previous year. This huge amount of money, most of which is invested in the capital markets, was not under the purview of the SEBI. This prompted SEBI to ban 14 private insurers from selling any new ULIP product without register-ing with SEBI. Although the verdict has ended with the court siding with the IRDA and ULIPS still remain under its purview, it has helped be-ing the truth about this product in front of inves-tors who would now think twice before invest-ing in them. An overhaul in the nature of these products is being contemplated without which the product may die a natural death due to all the bad publicity it has gathered during this battle. For more information on the battle between SEBI and IRDA do check out the article ‘ULIPS: Whose product is it anyway?’ in the current issue. Indian debt market Debt Market plays a very critical role for any growing economy which need to employ a large amount of capital and resources for achieving the desired industrial and financial growth. The Indian debt market is today one of the largest in Asia which includes government securities, pub-lic sector undertakings, other government bod-

COVER ARTICLE


4

among the Indian corporations rather than the domestic corporate bonds. A slew of reasons have been cited for this, most notably, the lengthy issuance procedure for public issues, the information disclosure requirements, higher costs of public issues and inability of the public segment in handling larger issues. However, the most important factor remains that the corporate bond market remains a cheap source of funds only for AAA rated paper. This limits the num-ber of entities which would find it profitable and cheaper to raise money by this route. As a result, the corporate bond segment is dominated only by very credit worthy PSU’s. The biggest inves-tors in this segment of the market, namely LIC, GIC and UTI prefer to hold the instruments to maturity, thereby truncating the supply of paper in the market. If there ever was a need to devel-op the corporate bond market, its time has quite definitely come. Indian authorities are targeting an increase in infrastructure spending of some $500 billion during the current five-year plan which cannot be financed through the usual bank loan route. Most of the resources raised by banks are by way of deposits, which are short-term in nature, while infrastructure projects have a long-gestation period creating an asset liability mis-match. This kind of financing can only be ar-ranged by the bond market. Going forward the emphasis in the debt market shall remain on financial innovation by means of newer products within a sound regulatory and supervisory framework. In 2010, India has pro-posed to introduce exchange-traded rupee op-tions and interest-rate futures based on a wider range of debt securities and step up efforts to further develop a derivatives market that can help investors guard against financial risk. Bourses will be permitted to introduce dollar-rupee options and futures based on two- and five-year government bonds and 91- day treasury bills. The Reserve Bank of India also plans to finalize regulations for customized foreign-exchange derivatives.

ies, financial institutions, banks and corporate. In most of the economies of the world the debt markets have been more popular than the equity markets. However in India the reverse remains true. The debt markets had been plagued by ex-cessive controls and administered rates to pave way for any development. Before1992, only a handful of institutions participated in the gov-ernment bond market with no trading activity on any exchange and a system of administered rates. Money was lent according to the plan pre-pared by the government of India and any fall-out of the plan was funded by issuance of more government bonds. The exponential growth of India’s government bond market during last decade can be attributed mainly to structural changes pioneered by the Government and the Reserve Bank of India to improve transparency in market dealings, meth-od of primary auctions, deepening the market with new market participants like Primary Deal-ers, borrowings at market determined rates, and creating technology platforms like NDS to rec-ognize the institutional characteristics of the market. In the wake of deregulation of interest rates as part of financial sector reforms, there was a need for introducing hedging instruments to manage interest rate risks. RBI introduced Over the Counter hedging instruments like Inter-est Rate Swaps (IRS), Forward Rate Agreements(FRA), Interest Rate futures(IRF), zero coupon bonds, convertible bonds, callable (put-able) bonds and step-redemption bonds over the years. However the same kind of impetus has been lacking in the corporate bond markets in India. As a result this, major source of corporate fund-ing is all but non-existent. The corporate in India still prefer to borrow on loans from financial institutions which they can keep on their books at book value rather than by bonds which need be marked to market. These financial institutions divert the huge domestic savings which never find way into the equities market, for corporate consumption. Even the foreign currency borrow-ings by way of FCCB’s and ECB’s are favorites

COVER ARTICLE


5

ing, maintaining proper loan underwriting and following sound risk management policies is a must. Thankfully we have the SEBI and RBI which quite skillfully handled this during the crisis keeping India somewhat protected from the magnitude of turmoil in the west. However there have been criticisms of excessive control which have hampered product innovation. India still has significant opportunities for productive and prudent financial innovation, leaving it in the enviable position of learning from the expe-rience of others. Product innovation in multiple asset classes such as bonds, interest rate futures, equity and SME will surely bring about the much-needed multifold capital formation and a scope for huge employment generation in India.

The Reserve bank of India (RBI) has also pro-posed to introduce credit default swaps, or CDS, in Indian markets to enable firms to hedge against any possible default by a bond issuer. Although such a proposal has been drafted twice before, the introduction of CDS remained stalled in the wake of the financial crisis of 2008. At a time when the entire world is shying away from CDS, its introduction in Indian markets is trig-gered more by necessity than by anything else, especially for infrastructure bonds to fund In-dia’s growth story. However caution will have to be observed knowing the explosive nature of this product. If there is anything that we have learnt from the last crisis it’s that maintaining adequate capital, avoiding excessive reliance on short term fund-

COVER ARTICLE

About the Author : Smitalee Prusty is a 2nd year PGP student at IIM Calcutta. She holds a masters degree in Mathematics and Computing from Indian Institute of Technology Kharagpur. She can be reached at [email protected]


6

An Outlook On Indian Markets An interview with UBS

SEBI has proposed new takeover norms. According to you what are the likely implications of its introduction on the capital market activity in the Indian Equity markets? We believe that by increasing the trigger point for making an open offer 15% to 25% will help Indian companies to get meaningful funding with out worrying about hitting the open offer limit.. Also, many strategic investors such as PE,

overseas corporate will be able to increase their existing stake in Indian companies to 25% with out reaching the open offer limit.

The proposal to increase the open offer

size to 100% from current minimum 20% will only bring serious players to the table.

Another positive outcome of the 100%

open offer size means that it is easier for the company to delist instead of the cumbersome process of reverse book building.

We believe use of volume weighted

average price (VWAP) and the inclusion

of non-compete fee for determining the final offer price are welcome steps as these would lead to better price discovery for minority shareholders and ensure equitable treatment for all shareholders

Will the new takeover norms affect the attractiveness of the Indian firms as takeover targets or will it prevent sham bids? Which of the two seems more probable? We view the new proposed take over norms as progressive and inline with international standards. We do not think these norms will impact the attractiveness of Indian firms as take over targets. Rather, we think that the attractiveness will be determined by the domestic market growth story and the company’s fundamentals. Also, as mentioned above, we think that provisions such as open offer size of 100% will only solicit interest from serious players who will be attracted by domestic market fundamentals. With Coal India IPO expected to hit the markets by October, and the Government making it mandatory for listed companies to raise public shareholding to 25%, how well

EXPERT OPINION


7

do you think the markets are prepared to handle so much weight on market liquidity? The minimum 25% public shareholding rule primarily impacts public sector enterprises (PSUs) as our analysis of BSE 500 companies suggests that out of the total amount needs to be raised to comply with the rule, ~86% will have to be raised by PSUs. We believe that PSU divestment in FY11

either through complying by 25% public shareholding rule or through other primary sector offerings (IPOs) will not hamper stock market momentum because of the following factors:

We believe Indian stocks will continue to

attract flows from FIIs and domestic insurance companies, driven by positive momentum in data points such as quarterly GDP, earnings growth, good monsoon, government policies, and better fiscal situation.

We expect domestic institutional investors

to continue to support public sector divestment in FY11. Domestic investor demand (including insurance companies) contributed 63% to PSU divestment proceeds in FY10.

There was significant FII interest (more

than 30% of total subscriptions) in four of the six PSU public offerings in FY10. FIIs invested 16.6% in total PSU offerings in FY10.

Non-institutional investors (retail,

employees and high net worth individuals) have also shown significant interest in PSU divestment in FY10 provided the valuations are reasonable (as was evident by non- ins t i tu t iona l inves tors ’ participation in NMDC’s and NTPO’s FPO).

How big of a concern is the uptrend in inflation in India. Do you think that RBI has been proactive enough in controlling inflation or do you think it needs to hike rates again? Inflation is one of the primary concerns for Indian capital markets. Foreign institutional investors are looking at inflation figures very closely. We expect WPI inflation rate to decline towards 5-6% levels by fiscal year-end. Our India Economist, Philip Wyatt, in his report in his note India: Inflation Zenith dated 2 July 2010 looked at 4 main angles - aggregate demand, WPI measurement, global price pressures and re-pricing of oil & food – and concluded that: India is at or close to the peak in headline

inflation and over the next 12 months the rate should drop.

If oil prices turn out to stabilise, then fuel

price deregulation is a distraction. The real issue is that high food price inflation should drop lower because it simply mirrors oil inflation trends with a lag.

Absent fuel price deregulation distortions

and new official indices we would expect WPI inflation rate to decline towards 5-6% by fiscal year-end.

But in reality the 1-2% impact of the jump

-up due to deregulation could be partly offset by a drop-down due to the introduction of a new index, otherwise the new WPI should be little different.

More importantly, global disinflation/

deflation pressures could also push it lower still, conceivably to under 5%.

We think RBI has been proactive enough in dealing with inflation when compared to other central banks. The central bank (RBI) has started tightening by hiking reserve requirement

EXPERT OPINION


8

ratio (CRR) by 100bp to 6% and the policy interest rate corridor, repo rate and reverse repo rate, by 100bp and 125bp respectively (repo and reverse repo at 5.75% & 4.50%). The recent hike of repo and reverse repo rates on 27 July 2010 also again shows RBI’s resoluteness to fight inflation proactively.

But it has much further to go to wind back its easy money of 2008-09. Market yields have risen to reflect this situation and upward pressure on local rates should persist, 3m t-bill yields have risen from 3-3.5% at the low to 5-5.5% today. We expect monetary tightening to continue in FY11 till nominal rates move up and more in line with inflation trends.

There have been big concerns on the credit quality with regards to the funds raised by the telecom sector in India, especially after the mega spending in the 3G auctions. Do you think such concerns are warranted? As per inputs from banks, part of 3G lending is expected to be refinanced via external commercial borrowings (ECBs) which will result in shifting some of the credit risks externally. Also we understand that banks are comfortable with their lending to incumbents (Bharti, Idea, Vodafone) as compared to new operators (STel, Tata DoCoMo). However, some mid cap banks have supported new operators with stricter underwriting standards. According to media reports, telecom exposure as a percentage of overall bank lending is estimated to be 5%. We believe that telecom exposure is well diversified among large operators mitigating the credit quality risk to an extent, in our view. What are your top picks in this market environment and what do you think

would be a good investing strategy in today's markets? We remain bullish on India stocks with Mar11 Sensex target of 22,000. We believe that the combination of several positive factors such as a good monsoon, government policies, a better fiscal situation, lower inflation outlook, and earnings growth will enable Indian stock markets to re-rate further from current levels. Our key overweight sectors are banks, infrastructure, power and real estate while our key underweight sectors are consumer goods, IT services and Telecom.

EXPERT OPINION


9

The Changing Face Of Indian Markets An interview with Dr. G. C. Nath

Dr. Golaka C Nath is a Senior Vice President at the Clearing Corporation of India Ltd. (CCIL). He has over 21 years of experience in the banking and financial sector, having previously worked with the National Stock Exchange of India Ltd. and Vijaya Bank. In the past, he has worked on a World Bank Project on “Developing Bond Market in South Asia”. He has also provided secretarial service to the High Powered Committee on “Corporate Bonds and Securitization” appointed by the Ministry of Finance, Government of India.

Inflation has become the biggest challenge for the Indian economy right now. Where do you see the inflation rate going in the next few months? It is, no doubt, a very important negative factor for the economy which has the potential for destabilising growth expectations. It is a challenge to control inflation with the present policy prescription. We have to understand that initially inflation started with supply side constraints and mostly in food but later percolated to other non-food sector. Today fuel accounts for a large part of the inflation. Both food and fuel inflation are difficult to control unlesss and until we take some structural decisions to augment the supplies. A good monsoon may bring some respite. However, monetarily speaking, you can not control inflation with unlimited supply of liquidity at 5%-6% repo rate when inflation is more than 10%. More monetary tightening is required if we have to monetarily control inflation. It has been witnessed especially in the Indian context that the high growth period is followed by a period of high inflation. Do you think that we should compromise our growth to rein in inflation? If yes then should it take place because the Indian growth is inequitable in nature but the inflation pervasive? What impact could it have on the economic recovery?

Yes high inflation is not sustainable for high growth as equilibrium will break as per economic theory. Spiralling inflation will destabilize growth in the long run and the cost will be castratropic at times. We have seen in Latin American countries - It took a very long time for these economies to come back on the growth trail with lot of pain and support from US due to political reasons. We can not expect such kind of assurance. Our infrastructure can not sustain growth rate of 9% in the long run. In my opinion, if we can achieve an 8% long term growth with this infrastructure, it should be good enough. Given the non-equitable distribution of development, we should do better to control inflationary pressure as it wipes out wealth from poor faster than the rich. In the recent past we witnessed an unprecedented liquidity crunch due to 3G and Wireless broadband auction. But even this development didn't result in any change in spending cycle of the government. Do you think that there should be a change in the current spending policy? Spending policy is well defined for the government and it is desirable that Govt. maintains the planned expenditure schedules. Liquidity crunch is a temporary problem and it will change as government pays out salaries, funding for various departments. However, government should restrain its non-plan

EXPERT OPINION


10

expenditure so that it will not have an impact on the market. Money goes out and comes back. As the auction of 3G and BWA was not a routine inflow, Government took its time to allocate funds in excess of their budgeted figures from such auctions. In the long run, the auction proceeds will be helpful to reduce our fiscal deficit. After the base rate system, there are now talks of freeing up of interest rates of savings account. Do you think that it is really needed and what could be its probable implications? Yes, freeing of SB interest rate is required. It will create competition and customers will have better resouces. However, as it is, banks provide swipe–in facility to most of their customers and hene SB accounts earn better return. Changing SB interest rate will further this process. Do you see the setting up of the Financial Stability and Development Council (FSDC) as a threat to the autonomy of the financial sector regulators? The scope is not properly defined and it is going to create a lot of confusion in future. The autonomy of the regulators will be questioned. I personally do not agree with the proposal. To my mind FSDC will be a political intereference in the working of independent regulators as Finance Ministry will be putting its hand everywhere and at times will interefere in day to day workings of the regulators. Even though bond markets are not as easily and frequently manipulated as equity markets but still the possibilities of misconduct remain. Can you tell us the probable ways in which manipulation occurs and what are the steps that the regulators intend to take in order to avoid them? Manipulation can happen in many ways, specifically in less liquid markets like India. However, due to the surveillance system, it can

be easily traced today and provides a negative incentive for traders to do that. In illiquid stocks, the order book is very thin. Hence traders can talk to each other and execute a deal at an agreed price which may be away from the market. However, with the MTM system in place for centralised settlement, this can be controlled to a large extent. But pricing an illquid security away from the curve will finally go the the books even if you charge margins. It is a longer call. But given the systems in palce today in India, it is extremely difficult to manipulate the market without the regulator knowing it. The foreign banks have a dominant market share in the bond markets as well. Do you see this as an outcome of existing regulations being too stringent for the national banks or it is due to the local banks lacking the required capabilities? Should their participation be encouraged even if it requires comprising with the existing regulations? It is the strategy and policy of a bank that drives its participation in the market. If you have a buy and hold policy, you will rarely trade, you will dump at least 25% of NDTL in HTM category. Foreign banks follow their parent system which is generally a mark to market kind of system for all portfolio. Hence there is an incentive for trading. Further, the compensation structure also is responsible for trading. More I trade, more profit I possibly generate which increases by bonus. Given the current US legislation putting lots of restriction on proprietary trading, things will change so some extent. However, we have to also acknowledge, the skillset in foreign banks will be far better in quality than the public banks. Most of the students from top institutes like IIMs amd IITs will surely not look at public banks as a career but they will jump to join a foreign bank irrespective of its global reputation. So PSU banks have to manage with what ever skill set they get with their limited resource allocation for compensation.

EXPERT OPINION


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What are the steps that are needed to encourage the participation of retail investors in the debt markets or you are happy with the status quo i.e. limited participation of retail investors? Retail investors do not come to this market very easily. Education is very important for retail investors. Given many competing products, few investors will be willing to put their money in a 30 year bond with 8.32%. Globally, you hardly find retail investors in this market, the way you find them in Mutual funds or equity market. I do not see Indian retail investors coming to this market in next 10 years or so. The major chunk of Indian bond market is comprised of government bonds. What have been the main hurdles in developing an equally liquid corporate bond market? What can be done to develop the corporate bond market? Corporate bonds have been a good topic for conferences and seminars for last 10 years or more. A good deal of things have been suggested by Dr. R H Patil committee report. We have to follow those steps. The cost of issuance including creating charge is prohibitive. This must change if you want corporate debt to improve. Debenture trustees must work with responsibility. RBI has been pretty cautious in introducing new products in the Fixed Income Markets with the US financial crisis further adding to the aversion of the central bank. Now that we are recovering from the pangs of the crisis, do you see a push for introduction of instruments like CDS in the Indian markets? Further, do you see the market for products like STRIPS which was recently introduced, growing in India? The new products like STRIPS are more suitable for trading in a kind of market where churning portfolio is regualar. In our kind of market, most

of the guys buy and hold. So STRIPS will take time to pick up. We have to understand that a STRIP is more risky than a bond of similar maturity due to interest rate sensitivity. Products like CDS will come at some point in time. However, it will be difficult to have successful market for these products. In a plain vanila OTC derivatives product where banks are allowed to participate, PSU banks have negligible market share (less than 0.5%) while they hold about 65% of the total banking assets in the country. When they are reluctant to come to this simple plain vanilla product, I do not expect them to come to more complicated markets like CDS immediately. It may go the OTC derivatives way – concentration of few banks. Disclaimer: The views presented here are solely of Dr. Golaka C. Nath and have no relation to CCIL.

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International Financial Reporting Standards (IFRS) are issued by International Accounting Standards Board (IASB), which is an arm of IFRS Foundation, a global body headquartered in London. Earlier it was known as International Accounting Standards Committee (IASC). IASC was formed in 1973. IASC was dissolved in the year 2001 to form IFRS Foundation. Accounting standards issued by IASB are called IFRS. Accounting standards issued by IASC are called International Accounting Standards (IAS). IFRS refers to the complete set of IFRSs issued by IASB, IASs issued by IASC and not withdrawn by IASB and interpretations issued by the Interpretation Committee of IASB and interpretations issued by the Interpretation Committee of IASC and not withdrawn by IASB. With the globalization of capital markets, the need of a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards was felt. Accordingly, a movement for convergence of national accounting standards with IFRS began. The movement gained momentum in the year 2000, when the Internal Organisation of Securities Commission (IOSCO) assessed and approved the Core Standards issued by IASC. More than 100 countries (including European Union) have

IFRS : Internationalizing Indian Accounts An article by Prof. Asish K. Bhattacharyya

Asish K. Bhattacharyya, D.Phil., is Professor, Finance and Control, Indian Institute of Management Calcutta (IIM-C). Prior to joining IIM-C, he was the Technical Director, Institute of Chartered Accountants of India, and a senior faculty member at the S.P. Jain Institute of Management and Research, Mumbai. Besides, he has about 20 years experience in the industry. A Fellow of the Institute of Chartered Accountants of India, Professor Bhattacharya is a member of the accounting committee of IRDA.

adopted accounting standards, which are fully converged with IFRS. India is committed to implement accounting standards fully convergent with IFRS by April 1, 2011. As per the road map issued by the Ministry of Corporate Affairs, NIFTY 50 companies, SENSEX 30 companies and companies whose net worth was more than INR 10,000 million will apply accounting standards fully convergent with IFRS. For convenience, in subsequent paragraphs we shall refer those standards as INFRS.

Convergence Convergence gives flexibility to carve out of IFRS some accounting principles, methods and disclosures and also to carve in some accounting principles, methods and disclosures to address unique requirements of the country and to

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address special concerns expressed by regulators and users. However, this flexibility is used judiciously to ensure that the objective of convergence is not lost. Therefore, INFRS are expected to be substantially same as IFRS. Fair value IFRS uses fair value, as measurement basis, much more extensively that the extant Indian GAAP. For example, ESOPs issued to employees are recognised at fair value; revenue is measured at the fair value of the consideration received; financial assets and financial liabilities are initially measured at fair value; Financial instruments, except a few exceptions are measured at fair value; intangible assets acquired in a business combination are initially measured at fair value; and biological assets are measured at fair value. In some cases, the change in the fair value between two balance sheet dates is recognised as profit or loss in the profit and loss account for the period. It is a myth that IFRS requires fair value measurement of all assets and liabilities in the balance sheet. Intensive use of fair value as measurement attribute is debated across the globe. In India, many accountants believe that the adoption of fair value measurement will lead to accounting fraud. The concern is triggered by the fact that in absence of an active market for an asset or a liability, fair value is determined using economic models. Fair value determined using an economic model is an opinion because the value reflects large number of assumptions made by the valuer. Therefore, there is ample scope for engineering the fair value. Moreover, valuation is more an art than a science. Therefore, valuation skills can be developed only by practicing valuation. In absence of wide spread use of fair value in India, there is shortage of valuation experts. These concerns can be addressed by the government by developing a well regulated profession of valuers at an accelerated speed.

Relevance and reliability Standard setters always endeavor to establish a balance between relevance and reliability in formulating accounting standards. Earlier the emphasis was on reliability. Now the emphasis has been shifted to relevance. Users of financial statements find fair value measurement of certain assets and liabilities (e.g. financial instruments) more relevant (in decision making) than the historical cost measurement. Accountants and auditors are more comfortable with historical cost measurement because they are comfortable with estimates that are auditable. Therefore, they oppose fair value measurement of assets and liabilities. But IFRS is using fair value measurement intensively because ‘decision usefulness’ is the overriding principle for the preparation and presentation of financial statements. Conclusion It is a huge challenge for all stake holders to successfully manage the transition from the Indian GAAP to INFRS. The present discomfort is similar to the discomfort of the Indian corporate sector when India opened up the economy in early 1990. But, Indian companies have taken the challenge and have emerged stronger and more resilient and many of them are now global players. Let us hope that Indian managers and accountants will manage the transition successfully.

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An article by Prof. V. K. Unni

Viewing Reforms Through The Regulatory Prism

EXPERT OPINION

Dr. V.K. Unni, faculty member of IIM Calcutta, currently holds the Max Planck Fellowship instituted by Max Planck Society Germany. He also has the rare distinction of serving in the Fulbright Fellowship Selection Panel for three consecutive terms. He has been consulted on various projects/initiatives undertaken by Columbia University, European Commission, German Ministry of Research, IIT Bombay, IIT Kharagpur, Microsoft Corporation, Herbert Smith LLP, UNCTAD, etc. He is an alumnus of the prestigious International Visitor Leadership Program established by US Department of State.

India which got its independence from Great Britain in 1947 used an economic model of self reliance which continued for almost 45 years. During this period India, tried to put certain barriers on foreign trade, which also included a ban on foreign investment. During those days the fundamental policy objective for the government was to have economic self-reliance whereby the country’s economy was supported by domestic resources rather than international investments. The common perception at that time was that public ownership of basic industries was very crucial to ensure development in the interest of the whole nation. Since it was believed that global trade was biased towards developing countries, the policy of the government was aimed at self-sufficiency in most products through import substitution. The government made sure that the role of Foreign Direct Investment (FDI) in the country would be a marginal one by enacting laws like Foreign Exchange Regulations Act (FERA) and Monopolies and Restrictive Trade Practice Act (MRTP). FERA limited foreign equity participation at forty percent so as to restrict foreign exchange outflows arising out of dividend and royalty payments. MRTP Act prevented large enterprises from being developed which eventually disallowed the companies from reaping the benefits associated

with economies of scale. The Constitution of India also played a major role in forcing the policymakers to subscribe to laws like MRTP. The Indian Constitution has a chapter dealing with directive principles that provides overall guidance in state policymaking and this includes the concept that the economic system should function in a manner that does not lead to the concentration of wealth in the hands of a select few. During the initial decades, India’s economic development strategy was inward-looking and there were numerous industrial licensing requirements, widespread public ownership of heavy industry, very high tariff barriers, tight restriction on the operations of foreign firms and on imports and exports through laws like FERA and excessive bureaucratic control. In the year 1991 India was forced to make many major changes in its earlier approach because of the grave balance of payment crisis which it had to face. Thus India slowly began to embrace the globalization model which essentially was premised on the idea that national economies were intertwined and any barriers imposed on trade would stifle national development. In the years which followed after 1991 the government continued with the process of systematic economic reforms, which marked a clear departure from the four decades of planning


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based on self-reliance. As a result of this policy change, the Indian government was compelled to make laws and regulations which reflected the new economic model. The history behind the new economic regulations in India has a strong relationship to the process of liberalization, privatization, and globalization which was kick-started in 1991. Major Regulatory Changes Post 1991 After 1991 India witnessed some major changes with respect to regulation of capital markets, foreign exchange markets as well as monopolies and restrictive trade practices. Even prior to 1991 India had laws dealing with the establishment of companies and the existing law i.e, the Companies Act 1956 specified the general legal framework for setting up, functioning, and closing down of Indian companies. All registered companies in India, public as well as private, are governed by the Companies Act. While setting in motion the plans for India's economic liberalization and development of domestic capital markets, the central government set up Securities and Exchange Board of India (SEBI) to exercise regulatory control over the stock markets. In the year 1988 SEBI was established as an advisory body, but in 1992 it was empowered to regulate the securities market under the Securities and Exchange Board of India Act of 1992 (SEBI Act). However it should be noted that there were several laws enacted prior to 1992 that established a foundation for securities regulation. The Capital Issues (Control) Act 1947 regulated the manner in which a company may issue debt and equity. Under the said law companies needed approval from the Controller of Capital Issues (CCI) for raising capital and there existed some stringent pricing norms. This law was abolished in 1992. The Securities Contract Regulation Act of 1956 empowered the Central Government to protect investor interest

by following a system of self-regulation where the stock exchanges would supervise transactions involving securities. But the absence of a central regulator was badly felt when self regulating organisations like stock exchanges could not create a fair and efficient system of trade. All these factors led to the establishment of SEBI as the market regulator in 1992.

Since its inception SEBI has been very active in framing legal provisions dealing with fundamental market problems such as insider trading. The SEBI (Insider Trading) Regulations prohibit "insiders" from dealing in exchange-traded securities on his or another's behalf based on unpublished price sensitive information. SEBI has drafted various regulations which are intended to protect the rights of ordinary investors/share-holders and notable amongst them are SEBI (Merchant Bankers) Regulations 1992, SEBI (Mutual Funds) Regulations 1996, SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997, SEBI (Delisting of Equity Shares) Regulations 2009, SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 etc.

Amongst the regulations mentioned above the one dealing with takeovers popularly known as the Takeover Code and the provisions dealing with public issues called as the ICDR

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regulations always attract significant attention from the business community. To SEBI’s credit it has been trying to innovate with various new regulations and have introduced fresh avenues for raising capital like Qualified Institutional Placements (QIP) and Indian Depository Receipts (IDR). With regard to the regulations affecting the foreign exchange market there has been significant changes post 1991. Foreign Exchange Management Act (FEMA) has replaced the draconian FERA. Reserve Bank of India (RBI) has been given to mandate to regulate the capital account foreign exchange transactions done by any person resident in India and any person resident outside India. Thus RBI has issued numerous regulations in the field of foreign investments and this broadly covers areas like FDI, investments made by foreign institutional investors under the portfolio investment scheme, investments made by Non Resident Indians under the portfolio investment scheme, investments by venture capital funds etc. Similar regulations have been framed to deal with overseas investments made by Indian companies in joint ventures and subsidiary companies. Regulations framed under FEMA have been highly successful in bringing foreign investment to the country and it has also played a significant role in facilitating the overseas investments made by Indian companies. Another important area of law which has witnessed a major revamp is the MRTP Act. The said law has been repealed and has been substituted with a brand new Competition Act. The new law dealing with competition has been framed after considering the present day market conditions and it fully reflects the sentiments of the various stakeholders. Thus there are provisions dealing with anti-competitive agreements, abuse of dominant position and combinations involving mergers and acquisitions. Unlike its predecessor the Competition Act will only target the conduct of parties which are having an appreciable adverse

effect on competition. However the provisions in the law dealing with combinations are yet to be notified Conclusion Needless to mention, the economic liberalization has triggered the need to have a set of new regulations which can match the spirit of free enterprise, entrepreneurship and risk taking. It is quite evident that the policy makers are trying hard to make many of the laws consistent with this objective. India has undoubtedly done reasonably well in the last two decades on this front. However with one-third of the world's poor and one billion people, India desperately needs rapid growth and employment opportunities to eliminate poverty further and sustain the recent income increases. For India to achieve its realistic rate of growth, the government needs to implement regulations which correctly embody its potential. Till then India the sleeping giant will have its existence in a near somnolent state.

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The Basics Of Base Rate There hardly is an adult nowadays who hasn't felt the need or has gone ahead to avail a loan. You can blame it on the increasing consumerism or the inflationary forces. Anyways, I am not going to discuss the rate of inflation or conspicuous consumption rather I will focus on the rate of interest on these loans. These rates were affected by a major change that took place on the 1st of July, 2010. This happening was; "coming into effect of Base Rate System".

So, the first question that would come to our minds would be, why was a new system needed? To answer this, I will first explain the old regime. The rate that took the centre stage in the previous era was Base Prime Lending Rate (BPLR). BPLR indicated the rate of interest at which banks lent to favoured customers, i.e., those with high credibility. So, one might be tempted to say that it was the best available rate of interest. BPLR of SBI was 11.75% in Jun'10. But unfortunately almost 70% of the loans carried an interest rate below BPLR. So what was so unfortunate about it? The disturbing aspect was cross-subsidization. The blue chip companies walked away with lowest of rates whereas the SME compensated for them by

paying a higher rate. This was because there was no transparency involved in the process of arriving at BPLR and the large firms could arm-twist their way to lower rates. So let me now define Base Rate System (BRS) in a little detail. BRS is a system to fix interest rates for borrowers which will serve as the minimum rate for all loans i.e. a bank can't lend below the base rate. As was the case with BPLR, each bank can have its own Base Rate. Its basis of calculation will mainly include cost of deposits, profit margin etc. This is the illustrative methodology released by RBI for computation of Base Rate: Base Rate=a+b+c+d a - Cost of Deposits=Dcost b - Negative Carry on CRR and SLR= [{(Dcost− SLR*Tr)/ (1− CRR+SLR)} *100– Dcost] c - Unallocatable Overhead Cost= (Uc / Dply) 100

d - Average Return on Net Worth= [(NP/NW) *(NW/TL)] 100 Where: Dcost Cost of Deposits D: Total Deposits= Time Deposits + Current Deposits + Saving Deposits Dply: Deployable Deposits =Total deposits less share of deposits locked as CRR and SLR balances,.e. =D* (1− CRR+SL ) CRR: Cash Reserve Ratio SLR: Statutory Liquidity Ratio Tr: 364 T-Bill Rate Uc Unallocatable Overhead Cost NP : Net Profit NW : Net Worth = Capital + Free Reserves TL : Total Liabilities Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while

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the return on SLR balances (proxied using the 364-day Treasury bill rate) is lower than the cost of deposits. Unallocatable overhead cost for banks could include aggregate employee compensation relating to administrative functions in corporate office, directors' and auditors' fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending and cost incurred towards deposit insurance. The Base Rate has to be revised every quarter. Though so far an option is available to the existing borrowers to move to the BRS price from the BPLR one, but in near future a sunset clause from RBI might make the transfer mandatory. Most of the PSB (public sector banks) have announced their base rate as 8% whereas SBI has declared 7.5% as its rate. On the other hand private banks like ICICI have pegged it at 7.5% and HDFC has fixed it at 7.25%. So, let's point out some of the advantages of this new system: This could usher into a era of interest rates that are set by scientific methods which was not the case with BPLR An effort has been made towards transparency in the interest rate calculation for the loans i.e. the credit spread above the Base Rate which could be different for different types of customers will have to be calculated in a transparent manner. Cross-subsidization as evidenced from the SMEs paying higher interest rates to compensate for the low rates of blue chip firms has finally caught the attention of the policy makers. It could lead to a "rate war" thus lowered cost of borrowings esp. for SME can't be ruled out. A transparent regime will result in credit worthy customers availing loan at suitable rate who may have been refused loan in the past regime.

BPLR as the ceiling rate for loans up to Rs. 2 lakh has been withdrawn which reinforces the third point. It could prove to be a blessing in disguise for alternative short term debt instruments like Commercial Papers (CP) or non-convertible debentures (NCD) or Certificate of deposit (CD). This system can also lead to innovation in the fixed income markets with products being designed to suit the needs of the lenders and borrowers But even BRS has its share of doubts and concerns: The banks can still provide benefits to the large borrowers by say paying higher interest rates on their deposits though large borrowers would normally not keep high deposits as loan interest rate will always be higher than deposit rates. Why quarterly revision, why not daily even when computerization (of above 85%) is the norm at the Indian banks? It could lead to banks shying away from lending (with low interest rates) rather they might prefer investing in CP or CDs. Segments which are perceived as more risky may see their effective lending rates going up. Excluding the agri-loans, loans to banks’ own employees, loans against deposits from the purview of BRS is a dampener The announced base rates expose the cartelization of banks else how come most banks have the exactly same base rates or the difference being in multiples of 25 basis points?

So, the road ahead for the Base Rate would be to link it apart from the fully covered cost plus rate, to a benchmark rate like 5YR sovereign Bond Rate. Now, both will be dynamic as the rates would be monthly reset and it would take into account all possible costs a Bank can incur for running its business. This would be a big improvement from the past regime as BPLR did nothing of the sort and the method was also not

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known to public. This would make the system scientific. As macroeconomic indicators could have a more pronounced and immediate impacts on the lending rates now so dynamic regulations would be the need of the hour. As Mr. G.C. Nath, Sr. V.P., CCIL (Clearing Corporation of India) while sharing his insights on BRS says, “Daily revision of Base rates is not advised because the regulatory cost will drastically increase by doing the same. And you do not get much benefit as we do not expect banks to increase their deposit rates on daily basis - neither other cost increase on daily basis. So, quarterly reset is fine as it maps with the policy announcements." So we may continue with quarterly revision of Base Rates in near future as well. Though the trade-off remains as a one-year cost might not have reflected the current cost while a three-month cost may not reflect the historic cost. Mr. Nath adds that roll over (reinvesting funds from a mature security into a new issue of the

same or a similar security) cost of average CP/CD could be very high as they have a life cycle of 3 months. So, a banker has to find a loan customer if it wants to survive competition." With banking having an oligopolistic structure and their business dealing in homogeneous products, most banks offer the same kind of rates for deposits - a few bps here and there. Also due to competition, banks also try to keep the customers with them. The customers compare rates across banks and then bargain with banks for the best rate. So, cartelizations of banks say they forming groups like PSU banks, foreign banks, private banks, co-op banks, etc. and developing some kind of informal structure to deal with various issues could still be the norm. So whether BRS will be the dawn of a new era or will it prove to be an exercise in futility? For now it would be safe to say that “Only time will tell.

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About the Author : Saket Saurabh is a 2nd year PGP student at IIM Calcutta. He holds a bachelors degree in Electronics and

Communication Engineering from National Institute of Technology, Patna. He can be reached at

[email protected]. He maintains a blog at http://saketvaani.blogspot.com


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So why was SEBI, the capital market regulator so concerned about regulating an insurance product – in this case ULIPs. Well, the genesis of this issue lies in an August 2009 verdict by SEBI which banned the entry loads on Mutual Funds. Entry load is the commission that an in-vestor has to pay while purchasing units of a mutual fund. After this verdict, entry loads on Mutual Funds had to be cut down to as low as 0.5-1%. In contrast, ULIPs had entry loads rang-ing from 15-20%. One of the biggest assets of MFs is their wide distribution network which can reach out to a large number of investors. However, with the reduction in the upfront com-missions, selling Mutual Fund units was no longer a very attractive proposition for the agents in this distribution network. This is where ULIPs came into the picture. As these products still continued to have large upfront commis-sions, most distributors shifted their attention from selling MFs to selling ULIPs.

Just to give you a sense of how every distributor jumped on to the ULIP bandwagon, fathom this: during the previous financial year, over 1.6 mil-lion ULIP policies were sold, with the total pre-mium involved in these products amounting to over $20 billion. Most of these funds are invest-ed in the capital market. To put this figure in

ULIPs : Whose Product Is It Anyway ? Earlier this summer, when IPL frenzy had cov-ered the cricket fanatic nation, teams were bat-tling to win yet another T20 championship, it’s organizers and team owners fighting legal bat-tles off the field, there was another battle unfold-ing in the financial circles: the tussle between SEBI (Securities and Exchange Board of India) and IRDA (Insurance Regulatory and Develop-ment Authority) for the right to regulate ULIPs (Unit Linked Insurance Plans). This episode has brought to fore various issues surrounding this product. The size of the market for life insurance products in India, estimated to be the fifth larg-est in the world, is over $40 billion and growing at a rapid pace of over 30% per annum. ULIPs account for over 80% of the business in this market. Through this article we will give an overview of ULIPs, the much publicized tussle between the two regulators over this, the recent changes brought about by IRDA and its impact on the life insurance industry and the investors. So what are ULIPS? ULIPs or Unit Linked In-surance Plans as the name suggests, are insur-ance plans linked to investment units. It is a fi-nancial product that offers you life insurance as well as an investment like a mutual fund. Part of the premium you pay goes towards the sum as-sured (amount you get in a life insurance policy) and the balance is invested in whichever invest-ments you desire - equity, fixed-return or a mix-ture of both. Why are ULIPS in news now? In April 2010, SEBI issued a notice asking all insurers to stop the sale of ULIPs, which according to SEBI, should come under its regulations. Insurance regulator IRDA immediately struck down on this call and asked insurance companies to ig-nore SEBI's order. What followed was a bitter public spat between the two regulators with the Finance Minister intervening and calling for a joint application before the judiciary.

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perspective, the net FII inflow in the previous fiscal was around $32 billion. The effect that FIIs can have on the movement in the Indian markets has been well documented. So, the bur-geoning size of the ULIP products meant that SEBI essentially had no control over a major investor segment in the capital markets. This finally culminated in SEBI’s April 10 order ban-ning 14 private insurers from selling any new ULIP product without registering with SEBI. Was SEBI justified in putting in place this ban? The main contention by SEBI was that ULIPs ultimately are investment products. As men-tioned earlier, they have a very significant in-vestment in the capital markets. So, it does make sense to bring such products under the purview of the capital market regulator. But a couple of things regarding SEBI’s ban order stuck out. Firstly, it quite conspicuously left out the public sector insurers (read LIC) from the ambit of the ban. Given the size of these insurers, it’s hard to explain why they were treated differentially than the private insurers. Secondly, the manner in which it placed the ban. It should never have been a unilateral decision. The insurance regula-tor IRDA was not kept in the loop while taking this drastic step which ultimately gave rise to the bitter public dispute between the two regulators. The central government had to finally step in to resolve this turf war between the regulators. The verdict was finally ruled in favor of IRDA with the government promulgating an ordinance to amend existing laws to include ULIPs under the life insurance business. So what next for ULIPs? This highly publicized tussle brought various aspects of ULIPs into limelight. There already were a number of concerns being raised by vari-ous stakeholders regarding some of the prob-lems this product had. First of all, it had a signif-icant entry load – as high as 30% in some cases. This encouraged distributors to push the product to the investors and often led to misrepresenta-tion of information related to the product in or-der to sell more and more of them. Secondly, the surrender charges, imposed on premature en-

cashment of investment units, were exorbitant. In some cases, surrender charges went up to as high as 90% if the policy was surrendered in the first three years. IRDA had already started the process of instituting more stringent rules to overcome these aspects of ULIPs. However, the events over the past few months precipitated in some sweeping changes being suggested by the regulator. Let’s analyze some of the new guide-lines it has provided on the product and its pos-sible impacts on the insurers and the investors: Increasing the Lock-in Period to five years

from the current three. To spread out the front end expense over

the lock-in period. This is good news for the investors as it would insure that the insurance seller is not ‘mis-selling’ the product to realize short term gains.

Capping the surrender charges to 15% of fund value as well as in absolute terms. Again, this would be beneficial for the in-vestors as they would now incur a smaller cost while switching from one policy to another. However, this would mean a big loss in revenues for the insurers. Accord-ing to estimates, around 25-30% of the policies lapse within the current lock-in period of three years with surrender charg-es ranging from 50%-90%. This combined with the spreading out of the entry load would mean a significant reduction in the revenues of the insurers as well as an in-crease in their time to break even.

The risk cover has been increased to at least 10 times the annual premium being paid. This would mean that the insurers would have to set aside larger capital which would dampen their profitability. It would also deter marginal companies from entering in this segment.

So it is quite evident that the new regulations, which the insurance companies are required to comply with by September 1st, would serve to reduce the attractiveness of ULIPs for these companies. However, looking on the positive

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other products like Mutual Funds whose popu-larity had waned significantly over the past year. And most importantly, the investors will most certainly be better off with these changes. On how the insurance companies would deal with

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References

http://economictimes.indiatimes.com/articleshow/6069224.cms http://economictimes.indiatimes.com/personal‐finance/insurance/analysis/Ulip‐norms‐Insurers‐may‐have‐a‐long‐wait‐to‐break‐even/articleshow/6116820.cms http://www.journaloffinance.in/?p=806

these changes, only time will tell. But I have a strong feeling that after MFs and ULIPs, it’s time for another new kid on the block. An year from now, the dialectic may shift to yet another product. But again, only time will tell.

About the Authors Aditya Damani is a 2nd year PGP student at IIM Calcutta. He holds a masters degree (Integrated) in Mathe-matics and Scientific Computing from Indian Institute of Technology Kanpur. He can be reached at [email protected].

Priyesh Jaipuriar is a 2nd year PGP student at IIM Calcutta. He holds a bachelors degree in Computer Sci-ence and Engineering from Indian Institute of Technology Kharagpur. He can be reached at [email protected]


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Financial Inclusion in India: A myth or possibility Financial inclusion, one of the cornerstones of inclusive growth, aims at the extension of bank-ing services to the deprived and marginalized sections of society, who have so far been denied access to credit facilities by banks. It is to be achieved by ensuring timely availability of cheap credit to the needy, particularly those be-low poverty line. Other aspects are likely to in-clude extension of banking services such as bank accounts (savings, checking), insurance, mortgages and financial planning. Indian economy has been growing at a rapid pace. It witnessed a GDP growth rate of 7.4% in 2009-10 [1], the second highest among sizeable economies of the world in that fiscal year, and was only marginally affected by the recession-ary trends in the developed world. To make the growth more equitable and to ensure that the benefits of economic growth trickle down to the deprived sections of society, the Government of India has adopted a multi-pronged approach to facilitate inclusive development. Various schemes targeting rural employment, education, access to information, financial inclusion, rural electrification, healthcare and sanitation, rural infrastructure and food security have been launched to enable the masses, especially those below poverty line, to empower themselves and become both a beneficiary of and a contributor to the Indian growth story. Currently, approximately ten percent of Indians hold ninety percent of the resources. While loans are easily available to the affluent, banks are generally unwilling to give loans to the poor because of the costs and risks associated with the recovery of debt. Thus, the poor have no oth-er option than to knock at the doors of unscrupu-lous local money lenders, who charge exorbitant interest rates. Unable to service the interest, they lose all their possessions, fall into a debt trap, and at times end up working as bonded labor or even committing suicides. Lack of education &

general financial awareness exacerbates their condition. Credit might be needed either to meet some exi-gencies or to pursue entrepreneurial ideas. In the latter case, many enterprising individuals, with viable entrepreneurial ideas, are unduly denied opportunities to pursue their dreams for lack of funds. Several questions need to be addressed to identi-fy the scope of financial inclusion in India: a) How much is the Government of India, with a fiscal deficit of 6.6% [2] in 2009-10, willing to invest in this initiative? What should be its role? b) What should be the criteria for loan approval or rejection? c) Is financial inclusion through business corre-spondence model, as proposed in the Union Budget, a viable idea and what is the profit po-tential? d) Should there be some laws and regulations? Or can banks be incentivized into lending? e) Who bears the responsibility for bad debt, the bank or the government of India? f) What infrastructure, technology, and supple-mentary changes are needed to support this initi-ative? g) What should be the mode of development? Should it be public led, private led or through PPP? The 2010-2011 Government of India budget provides for recapitalization of regional rural banks, increased targeted agricultural credit flow, allowing people affected by natural calam-ities more time to pay their debt off, extension of banking facilities to habitations having popu-lation of more than 2000 by 2012, insurance and other services to be provided through Business Correspondence model, and augmentation of Financial Inclusion Fund and Financial Inclu-sion Technology fund [3].

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Therefore, the government, despite its current focus on reducing fiscal deficit, looks committed to the cause of promoting balanced growth. It should develop plans to monitor the implemen-tation of the schemes so that corruption is mini-mized and taxpayers' money is well utilized. The UIDs could be used to introduce greater trans-parency in the overall lending process. Generally, the person seeking loan is too poor to offer anything as a collateral. Also, the interest rate has to be low, unlike in the subprime loans provided in the US at high interest rates. There-fore, banks should base their lending criteria on the viability or sustainability of the proposed utilization of funds and not on the basis of per-sonal wealth of the individual seeking loan. A delicate balance has to be struck between easy approval process of the loans without much red tape and examination of the potential of credit recovery. Single window clearance facility for loan approval should be setup. The banks must be friendly and flexible even if an idea is not viable to be supported, and must encourage the loan seeker to come up with more viable alterna-tives, instead of discouraging him/her by out rightly rejecting the loan. Banks should also be flexible to extending the deadlines for paying off the debt on a case to case basis. The Business Correspondence model ([3], [6]) has the potential to be viable in the long term. The model will work through a local financial services provider, called the Business Corre-spondent (BC), who will have a tie-up with a regional unit of a bank. According to the current RBI guidelines, NGOs, mutual fund institutions, companies, post offices, retired bank employees, ex-servicemen and retired government employ-ees can act as BCs of banks [7]. Thus, through the BC model, the loan seekers can have easy access to financial services with the bank not having to invest in infrastructure to reach the un-banked areas [5]. The bank will provide the ini-tial capital to the BCs. The BCs will need to ed-ucate the target masses and incentivize them to save by opening bank accounts. The BCs can

charge a commission fee from the bank for each new account opened and for each transaction (deposit) that takes place. They can start doling out credit to the needy after a thorough inspec-tion and interrogation into the potential use of funds. They will need to periodically monitor any misappropriation of funds and the recovera-bility of the loans. The agents of the BC (if the BC is not an individual), trained not harass the poor for debt recovery, will be paid a fraction of the revenue earned by the BC from the bank, based on the services they render. The BCs must actively pursue only those cases where the loss

potential is substantial, more than the costs in-curred in ensuring recoverability of loans. Since this is a high risk and low profit business, private players will be initially reluctant to enter this field. Therefore, regulatory bodies such as the RBI, banks such as NABARD, and public sector banks such as the SBI and the PNB will have to take lead. The RBI could formulate laws mandating all the banks operating in India, whether public or private, to allocate small per-centage of their capital to this initiative. This will nullify any initial competitive advantage any bank might have by not entering the micro-credit business. The government could fund pi-

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lot projects to assess the effectiveness of the ide-as aimed at promoting financial inclusion. It also has a role in making the environment more con-ducive for lending by providing tax subsidies to BCs and banks involved in the business. Initial profits generated by banks and BCs, if any, and the interest expense on loans taken by the poor should be exempt from tax. The government should underwrite to cover some percentage of the debt recovery losses incurred by the banks and BCs by providing them government bonds (GSecs). Outstanding banks and BCs who pro-vide exemplary service and deliver excellent results and individuals who utilize the loans for constructive purposes should be identified and rewarded. Gradual proliferation of technology such as ATMs, internet infrastructure for online banking and facilities such as mobile banking to reach out to those who live in far flung areas is needed to make the financial services accessible to all. The Government of India set up two funds [3] dedicated to this cause: Financial Inclusion Fund, for capitalizing the BCs, imparting financial education and literacy, supporting pilot projects aimed at achieving fi-nancial inclusion. Financial Technology Inclusion Fund, for set-ting up banking technology infrastructure, such as ATMs & Kiosks, mobile banking facilities and IT infrastructure for internet based banking in backward areas. These funds should be utilized judiciously and voluntary tax-free donations and anonymous donations, with no upper limit, should be sought from well-off people for augmenting the funds. All the aspects of inclusive growth are mutually reinforcing and should not be viewed in isola-tion. For example, working under NREGS would provide the much needed finances to the rural people. Some of them would deposit these funds in banks and these funds would eventually be used to provide credit to the needy. Introduc-

tion of UID would eliminate corruption occur-ring through fake job cards in NREGS. A NREGS worker might work on digging ponds or wells to promote water harvesting, which in turn will help to reduce dependence on monsoons. Reduced dependence on monsoons will lead to stability in food production, thereby boosting rural economy. Better rural economy would ena-ble the rural youth to invest further in their edu-cation and computer literacy. Greater percola-tion of IT will empower the masses and help them seek better price for their produce. Better education would help them understand the im-portance of saving. They would also be able to use RTI to enquire into the utilization of funds allocated for their respective villages and high-light any irregularities. It would also help in re-ducing class differences, prejudices and biases prevalent in our society. Better living standards in rural areas would also help prevent mass exo-dus of rural population into cities in search of better means of livelihood. The recent success of microcredit and micro-finance, pioneered by Mohammad Yunus of No-bel Prize fame, in Bangladesh, gives us hope. Micro-insurance also presents a big opportunity, where the farmers could insure their losses in case of crop failure. India has close to six lakh villages [4]. The rural economy presents a low profit, but a largely untapped mass market. Therefore, if the concept is successful in the ini-tial phases, private players would also gradually enter. A more prosperous rural India is a win-win situation for all. However, banks and bank correspondents must be cautious to guard against complacency and negative practices. The whole concept of finan-cial inclusion will be defeated if the banks don’t act in good faith. They should treat everyone equal and not give preferential access to funds to the rich farmers and rural corporate households. Also, private banks entering this business should be monitored closely as they might tend to devi-ate from the social equity aspect and focus more on the profits. Therefore, public private partner-

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References : http://economictimes.indiatimes.com/news/economy/indicators/Manufacturing-helps-GDP-grow-74-in-FY10/articleshow/5996613.cms http://www.business-standard.com/india/news/2009-10-fiscal-deficit-stands-at-66gdp/396788/ http://indiabudget.nic.in/ub2010-11/bh/bh1.pdf http://www.financialexpress.com/news/The-disappearing-Indian-village/660376/ http://www.fino.co.in/news-pdf/Performance%20Of%20The%20Business%20Model%20-%20A%20Mixed%20Bag%20Aug%2028.pdf http://rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=2718 http://www.deccanherald.com/content/20513/campus-corner.html

EDITORIAL ARTICLES

ship model could also be pursued, with in-creased responsibility of oversight on the public agency. Therefore, even though the idea is risky, the government must make all efforts to see it through despite some initial losses. Several hier-archical monitoring levels must be set up, start-ing from villages, blocks, and going up to dis-tricts, states and center where the potential and

actual losses could be periodically monitored at each level through reports generated using data warehousing and MIS technologies, the problem areas identified and corrective steps taken. Once the rural economy could be put on the platform of growth, it would prove to be a self-perpetuating engine. All it needs is a helping hand.

About the Author : Vipul Singh is a 1st year PGP student at IIM Calcutta. He holds a bachelors degree in Computer Science and

Engineering from Indian Institute of Technology Kanpur. He can be reached at [email protected]


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What Drives Indian Equity Markets ? Introduction India's equity markets hold one of the keys, if not the key, to the country's future growth trajec-tory. A growing and increasingly complex mar-ket-oriented economy, and its rising integration with global trade and finance, require deeper, more efficient and well-regulated financial mar-kets. The Indian Equity Market is the third big-gest market in Asia after China and Hong Kong. As of March 2009, the market capitalization was around $598.3 billion (Rs 30.13 lakh crore) [1] which is one-tenth of the combined valuation of the Asia region. Today, Indian stock markets have become in-tensely technology and process driven, giving little scope for manipulation. Electronic trading, digital certification, straight through processing, electronic contract notes, online broking have emerged as major trends in technology. Risk management has become robust thus reducing the recurrence of payment defaults. Product ex-pansion taken place in a speedy manner. Indian equity markets now offer, in addition to trading in equities, opportunities in trading of deriva-tives in futures and options in index and stocks. In this article, we will look at what are the major factors that affect the Indian equity markets and how do they do so. These can be broadly classi-fied into 2 categories: Internal & External Internal Factors Monsoons: In India, agriculture provides around 70% of employment either directly or indirectly. This is the major reason for the eco-nomic growth of India to depend on Monsoon season. Monsoon season in India starts from June and continue till September. A good mon-soon means government can ease restrictions on the export of wheat and rice, boost output of grain and oil seeds and help calm inflation. On the other hand, scarce rainfall implies prices of

agricultural products will go up and affect the consumers drastically. It might lead to a condi-tion of drought in several states of India which forces the government to drop import tax on a number of commodities. It also causes shortage of water supply for production of power and electricity. Electricity shortage has a strong ef-fect on almost all sectors, which also causes de-lay in productions or increase in costing of prod-ucts. Less rain affects the purchasing power in the rural areas and contract demand for products and services. This is not good news for FMCG companies which depend on agricultural and rural market. Inflation and Interest Rates: Although higher inflation rates spur higher growth rates but the vast disparity of income in Indian population makes it impossible for the poorest in India to buy basic commodities. In times of raging infla-tion, by increasing the base interest rate, RBI attempts to lower the supply of money by mak-ing it more expensive to obtain. This reduces the amount of money in circulation, which works to keep inflation low. It makes borrowing mon-ey more expensive, which affects how consum-ers and businesses spend their money; for busi-nesses, this leads to higher interest expenses (for those with a debt to pay) & lower earnings from their consumers & hence lower profits. Since a stock price represents the sum of all the ex-pected future cash flows from that company dis-counted back to the present, the stock price falls. Government Policy and Political Factors: The political situation, stability & commitment of the government to structural reforms in the econo-my greatly affect the market sentiments. Dereg-ulating an industrial sector will have a positive impact on the stock market. War periods and periods of a stagflation and unemployment are likely to have telling effects on the stock market performance and the economy may be headed towards a recession.

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Elections affect the Indian equity market in a huge way. In the 2004 general elections, the Na-tional Democratic Alliance led by BJP, unsuc-cessfully tried to ride on the market sentiments to power. When NDA was voted out of power, the sensex recorded the biggest fall in a day amidst fears that the Congress-Communist coali-tion would stall economic reforms. Later Prime Minister Manmohan Singh's assurance of 'reforms with a human face' cast off the fears and market reacted sharply to touch 8500 which was the highest ever mark then. SEBI: Securities Exchange Board of India (SEBI) supervises the functions of the Equity Market in India. It provides major guidelines to who can operate in the market and how. For ex-ample: It decides which investors can comprise a QIB (Qualified Institutional Buyer). Then it specifies that QIBs shall not be promoters or related to promoters of the issuer, either directly or indirectly. Besides, QIBs cannot have either veto rights or the right to appoint any nominee director to the board because that would also be considered to be related to the promoter. Hence, policies of SEBI have a huge role to play in In-dian Equity markets. Market Sentiments, news & market shocks: Stock market performance is largely seen as an indicator of the development of a particular country and over expectations about its perfor-mance could lead to stock market bubbles which might burst any time. Market sentiment is the general prevailing atti-tude or consensus of the investment community as to the anticipated price development in a mar-ket. This attitude is the accumulation of a variety of fundamental and technical factors, including price history, economic reports, seasonal factors, and national and world events. If the investors expect upward price movement in the stock mar-ket, the sentiment is said to be bullish. On the contrary, if the market sentiment is bearish, most

investors expect downward price movement. Traders monitor market sentiment since it is known that investors follow a buy high, sell low strategy. Therefore, according to traders, "fading" the investors' movements will eventual-ly lead to taking money from them [2]. The following figure demonstrates how all the factors mentioned in the article affected the Indi-an stock market in 2002.

External Factors Global Economic Outlook: In the present eco-nomic scenario, where the countries are highly

Investor sentiments at different price levels

How various internal factors affected movement of stock market in 2002 [3].

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reliant on Foreign Trade & Foreign Investors, the impact of a recession in one country perco-lates down to all the linked industries. As we saw recently, due to fears of Greece defaulting on its loans, there was a huge FII/FDI withdraw-al from the Indian Equity Market as well. In 2008, the collapse of one bank in US led to a “Liquidity Crunch” all over the world. We were slightly better protected from the recent finan-cial meltdown, largely because of the still large role of the nationalized banks and other controls on domestic finance. But this is likely to change in the near future.

FDI/FIIs: An important feature of the develop-ment of stock market in India in the last 15 years has been the growing participation of Institu-tional Investors, both foreign institutional inves-tors and the Indian mutual funds. Foreign Direct Investment (FDI) comes in the form of involvement in direct production activi-ties and is of a medium-long term nature. The investor acquires the ownership of assets for the purpose of controlling the production, distribu-tion and other activities of the firm. FDIs facili-tate international trade and transfer of knowledge. A Foreign Institutional Investment (FII) is any investment fund that is registered in a country

outside of the one in which it is currently invest-ing [4]. These include hedge funds, insurance companies, pension funds and mutual funds. The growing Indian economy has resulted in several FIIs to invest in Indian equity markets. FIIs are, however, a short term investment and can have bidirectional causation with the returns of other domestic financial markets such as money markets, stock markets, and foreign ex-change markets. Hence understanding the dy-namics of FII is very important for any emerg-ing economy. A sudden withdrawal by FIIs leads to a sharp depreciation of the rupee. FDI and FIIs are generally preferred over other forms of external finance, because they do not create any debt, they are non-volatile and their returns depend upon the projects financed by the inves-tor [5].

Policies of Other countries: Any decision taken by other countries that affects the amount of in-vestment that will be done in India will definite-ly affect the Indian equity market. For example, when US Senate ratified the Indo-US Civil Nu-clear Deal, the Indian equity market jumped as it expected more and more investments coming to India. Another example is that recently, Chinese news of Yuan free float had its affect on crude oil as well and it started rising but fell later on

Most global economies go through unending cycles of Booms and Glooms

FII Investment in Indian equity markets in last 10 years [6]

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when it was realized that the impact of this would be very limited. Exchange Rates: The performance of exchange rate markets also plays a role in the determina-tion of the financial market. When the Indian rupee had appreciated to about Rs. 41 against the US dollar, it lowered the country's import prices but it also hit the exporters hard thus driv-ing down their equity. A sharp depreciation of the rupee may be good for India’s exports that were adversely affected by the slowdown in global markets; it is not so good for those who have accumulated foreign exchange payment commitments. Moreover, a depreciating rupee doesn’t help the Government to rein in inflation. Crude Oil Price Shocks: When international

crude oil prices rise suddenly, the stock markets around the world tend to fall. The main reason behind this is the fear of the investors that the profit margin of the companies will decrease because of an increase in the operational cost, fuel cost, and transportation cost of the compa-nies. This is the reason that the buyers become susceptible about the future of the companies that are hugely dependent on oil. Also, there is more pressure on the government to raise do-mestic petrol/diesel prices. If the government does that, stock prices of oil majors like IOC, BPCL, HPCL and other related oil and gas com-panies like Reliance petrol, Essar oil, RNRL go up. However, such a step increases inflation & more importantly food inflation which has fur-ther implications on the economy. Conclusion and Future Outlook The prevailing economic conditions, both do-mestic and global, suggest the Indian stock mar-ket is poised to continue to rally in 2010, with a minimum 12-15% average ROI per annum for next 5 years [8]. Key factor remains the impact of Q4 results and strong GDP growth of around 8%. However point of caution needs to be the phase wise withdrawal of financial support giv-en by Indian government to the market. So far, the recovery in India has been driven by domes-tic consumption and government expenditure. However, corporate investment is expected to surge in 2010 due to the strong GDP growth which will increase capacity utilization.

Movement of Sensex in last 10 years [7]

References :‐

http://en.wikipedia.org/wiki/List_of_stock_exchanges http://en.wikipedia.org/wiki/Market_sentiment BSE Annual Capital Market Review Report 2003 http://www.investopedia.com/ Role of Institutional Investors in Indian Stock Markets, S.S.S. Kumar Statistics released by SEBI (http://www.sebi.gov.in/)

EDITORIAL ARTICLES

About the Author : Mayank Mishra is a 1st year PGP student at IIM Calcutta. He holds a bachelors degree in Mechanical Engi-

neering from Indian Institute of Technology Bombay. He can be reached at [email protected]


31

Oil Price Deregulation: What it entails for the Indian Economy? Oil price regulation has been a hotly debated and contentious issue that the Government has faced over the last many months. Oil Price de-regulation, proposed by the Empowered Group of Ministers (EGoM) on the recommendations of the Kirit Parikh Panel, is not something that has suddenly occurred to the current establish-ment. The BJP-led NDA government had decon-trolled petrol and diesel prices on April 1, 2002, and they were being revised every fortnight for nearly 21 months. However, political compul-sions forced the then establishment to abandon the practice just a few months before the general elections in May 2004. Subsequently the NDA was voted out of power and the Congress led UPA, propped by the Left emerged as the ruling combination. Suddenly, no one seemed interest-ed in talking about price deregulation anymore. A ten-worded anti-disinvestment statement clearly stated the intentions of the Left – that as long as the government had their backing, eco-nomic reforms were an anathema. With a reas-suring victory of the Congress in 2009 and the near annihilation of the Left, things looked set to change – reforms that had been earlier put on the backburner were expected to be carried out. Ma-jor reforms were expected in a number of sec-tors including oil and gas. The government did not disappoint India Inc. and promptly set up the Kirit Parikh Panel which advocated the follow-ing in its report: Total decontrol of oil prices (both diesel

and petrol), and Immediate increase in prices of kerosene

by Rs 6 per litre and LPG rates by Rs 100 a cylinder.

The committee headed by economist Kirit Parikh [1], [7] also pegged the losses of state-run oil marketing companies at Rs 40,000 crores (approx $8.4 bn) on account of having to sell transport fuels at below cost. Also, concern was raised over the Standard & Poor’s decision to cut Indian Oil’s credit rating on account of

shrinking profits and declining cash flows caused by delays in government compensation for selling fuels below cost. The subsidies were creating a fiscal deficit to the tune of $25.6 bn. The step was therefore natural for the govern-ment if it intended to aggressively pursue its agenda of “inclusive development” for all sec-tions of the society. Schemes like the NREGA were suffering as a substantial amount of budget allocation had been earmarked for oil subsidies. In view of all these factors the government de-cided to go ahead with the deregulation of petrol and diesel prices, the outcome of which was an increase of Rs 3.50 a litre for petrol and Rs. 2.50 a litre for diesel. Before revision, oil marketing companies (OMCs) were making under-recoveries of Rs.3.73 a litre on petrol, Rs.3.80 on diesel, Rs.17.92 on kerosene, and Rs.261.90 a cylinder on domestic LPG [2]. Post-revision there would be almost no under-recovery on pet-rol, but the OMCs will still incur a loss of Rs.1.50 and Rs.15 a litre on sale of diesel and kerosene respectively, and Rs. 227 on a cylinder of LPG. However, even the existing changes in prices will go a long way in improving the con-fidence of an already bleeding oil industry.

The impact of price revision for the Indian Economy can be enumerated as: One of the foremost impacts, as has been

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briefly mentioned above, will be on the fiscal deficit of India – it currently stands at Rs. 4.34 lakh crores (around $90.4 bn) [3]. India’s reliance on oil imports stands roughly at 75% its energy needs and the government sets fuel prices to cushion the poor from inflation. The decision to dereg-ulate will help mobilise an amount of around Rs. 1.3 lakh crores (around $27 bn) which is close to 30 % of total deficit. Al-so, in the last fiscal year ended March 31, India spent 149.5 billion rupees (3.35 bil-lion U.S. dollars), or nearly 1.5 percent of all public expenditure in subsidies to oil, compared with initial estimates of 31.1 billion rupees. This is a substantial ex-penditure and will be written off as a result of this price increase.

As already mentioned, increased availabil-

ity of funds for its social policies is going to be a major impact – the NREGA and the Right to Education Bill, to just men-tion a few, need a substantial inflow of funds for their continued sustenance.

Deregulating prices will cut down revenue

losses in public sector oil companies – both upstream and downstream. Also, the move will improve cash flows of the pub-lic oil marketing companies (OMCs), and the private companies can now expect a level playing field to compete with their public counterparts. Private refiners and marketers like Reliance and Essar Oil are already considering and evaluating options to restart their petrol pump stations and improve on existing distribution infra-structure to cater to a larger market. Also, the improved cash flows will have a direct bearing on the credit ratings of PSUs.

International OMCs, which are currently

represented in India through the limited presence of Shell, will be following this keenly since it has the potential to open the doors for them to enter the retail mar-

ket in India, which is growing in terms of the quantity of oil products sold annually.

Increased competition in this sector is ex-

pected to lead to greater efficiency. Previ-ous precedence is available in the form of reforms in telecom sector. Telecom re-forms led to increased competition and market efficiency with the end consumer being the ultimate beneficiary.

Newer technologies of alternate fuel

source cars may get a fillip owing to in-creasing fuel prices and the need for cheaper transportation solutions.

However some negatives will also result out of this, chief among them being: The change in oil prices will have a trickle

-down effect on the whole economy in general. As a result, inflation figures are going to be affected unless price pressure of essential commodities ease from the supply side. At a time when the govern-ment is already battling double-digit food inflation and a fuel inflation of almost 20% in the week ended June 26, 2010, in-creasing fuel prices will only add to the burden of the people. Headline inflation in June was 10.55%, and this can be ex-pected to go up in the near future. Also an upward movement of 90 to 100 basis points on the wholesale price index is ex-pected.

Industries that will bear a direct impact of

this will be sectors such as Auto Transportation Crude oil based input industries such as chemicals, manmade textiles (polyester) and pharma companies Distribution based businesses such as

FMCG and cement would also bear the brunt as high speed diesel has also seen a

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price revision. [4] Cost of infrastructure is expected to go up.

The upmove will affect India Inc. with a lag of three months and the overall impact on the cost structure is expected to be around 4 to 5%. Quarter results (July – Sep) are therefore expected to be signifi-cantly poor. So even though the oil com-panies will remain optimistic, in the short run, other sectors may be forced to take some beating in their earnings. Since transportation costs are expected to go up, the end consumers will end up paying a higher cost for the oil not only directly but also indirectly through other products.

Railways, serve an excellent case in point.

The railway minister in her budget speech had already mentioned no upward revision in ticket prices with an eye on the upcom-ing polls in her home state. As a result of this, revenues of the railways can be ex-pected to come down. Since the price of ATF had already been decontrolled as ear-ly as 2002, airlines industry should not be affected.

Clearly, the effect of this major policy reform is going to have far-reaching consequences. De-spite being an important step in the reforms pro-cess of India, this new policy has faced criticism for a variety of reasons. First, experts are questioning whether the

government really has its heart in decon-trolling prices of fuels with its recent deci-sion of not to decontrol diesel prices.

Secondly, genuine concerns exist as to

what will happen when crude shoots past $100. Price bands of petrol price may then severely restrict options to increase fuel prices. An international crisis in an oil pro-ducing nation cannot be ruled out at this particular point of time with tensions ex-isting Iran and the US and Israel on the

other side. Under such circumstances, In-dia may be forced to undergo a situation similar to the US oil regulation of 1973. Also any subsequent deregulation may pan out the way it did in the US in 1979 after deregulation of gas prices.

Thirdly, hoarders are another source of

concern. History has time and again proved that when essential products are scarce and have high prices, it results in stocking to create an artificial demand. Although onions and sugar are not nearly the same as oil but the crisis in onion pric-es and more recently in the prices of sugar show that high prices may lead to creation of hoarding.

Fourthly, adulteration of fuel is another

major concern. Instead of going for fuel efficient vehicles, consumers may go over to the adulterated oil market. This black market will result in substantial losses to the exchequer.

Fifth, political pressures cannot be dis-

counted. Trinamool Congress with its 19 MPs is a key government ally. Mamata Banerjee, the Trinamool chief, is facing elections in her home state of West Bengal next year. She has already expressed her displeasure by skipping cabinet meetings on this issue. She would not prefer risking her constituency to the Left on this issue. Besides the Congress at present is not hav-ing a comfortable majority. With a thread-bare majority of 278 members, in the worst case scenario, this policy may be forced out for political compulsions.

Sixthly, Also, with mounting opposition

pressure, it is not known how the govern-ment will react to the flak it will receive from all parties including many sections of the Congress who have serious misgivings about this policy decision. Also, the cru-cial state of Bihar is going to polls soon

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and a lot may depend on the performance of the Congress in that state.

Seventhly, the government has been lucky

in the sense that so far a normal monsoon is on the cards. If per chance the situation worsens, it will drive food inflation north-wards with the result that the ultimate los-er will be the oil companies with the re-peal of this policy.

Concerns also exist about the speculation

in prices as a result international oil fu-tures and options.

In spite of all the criticisms, oil price regulation remain an important step in the introduction of next generation reforms in India which will have far reaching consequences in not only helping the bleeding oil companies but also the general economy in the long run. It is interesting to note that on the 6th of July after the revision in prices the bourses saw positive trends driven by strong openings by oil companies. At the current stage, even with rising costs in the near future of es-sential commodities, it can be safely concluded that on the whole deregulation is going to have a positive impact on the overall economy of India.

References : http://economictimes.indiatimes.com/news/news-by-industry/energy/oil-gas/Kirit-Parikh-panel-for-freeing-

petrol-diesel-prices/articleshow/5531478.cms http://www.hindu.com/2010/06/27/stories/2010062763900800.htm http://beta.profit.ndtv.com/news/show/apr-jan-fiscal-deficit-soars-34-to-rs-3-5-lakh-cr-28299 http://www.thehindubusinessline.com/2010/07/01/stories/2010070152241000.htm http://www.stockmarketsreview.com/recommendations/

oil_price_deregulation_report_on_the_path_of_reforms_20100701_18642/ http://radicalnotes.com/journal/2010/07/13/the-political-economy-of-oil-prices-in-india/ http://petroleum.nic.in/reportprice.pdf http://www.deccanchronicle.com/business/diesel-price-won%E2%80%99t-be-deregulated-centre-009 http://marketpublishers.com/lists/7603/news.html http://www.dnaindia.com/money/report_deregulation-of-oil-likely-to-improve-price-stability_1401308 http://economictimes.indiatimes.com/articleshow/5533705.cms

EDITORIAL ARTICLES

About the Author : Abhinav Gupta is a 1st year PGP student at IIM Calcutta. He holds a bachelors degree in Computer Science and Engineering from Indian Institute of Technology Kharagpur. He can be reached at [email protected]

Student Articles Winning Articles 1st Prize

Exchange Traded Funds (ETF): Opportunities to Deepen Akshay Mishra (LSE), Sailesh Pati (IIM-A) & Tuhin Chatterjee (IIM-B)

2nd Prize

Mutual Funds Industry in India Abhishek Rawale & Saurabh Rai (IIM-B)

3rd Prize

Developing Corporate Bond Market in India Jaideep Singh, Ritambara Vasudeva & Shefali Omer (MDI Gurgaon)


36

STUDENT ARTICLES

Introduction to Current Structure of Indian Capital Markets Post Liberalization in 1990s, India’s capital mar-kets have transformed themselves with SEBI being established in 1992. With establishment of NSE in 1994, competition in the markets in-creased and the volume of transactions increased significantly and new instruments emerged. For over a century, India’s capital markets, which consist primarily of debt and equity mar-kets, have increasingly played a significant role in mobilising funds to meet public and private entities’ financing requirements. The advent of exchange-traded derivative instruments in 2000, such as options and futures, has enabled inves-tors to better hedge their positions and reduce risks Essentially India’s capital markets deal with three types of Instrument 1. Debt 2. Equity 3. Derivatives (Exchange traded derivatives

started in 2000) In the Debt market, government bonds dominate due to high fiscal deficit which has crowded out the corporate bonds which are still small in size. India’s Equity markets in India are vibrant and broad based. However there is a need to broaden the shareholder pattern and bring in more insti-tutional investors. Second, Participation in Indi-an markets by retail investors is also low. Indian households are ultra conservative with about 50% of savings deposited in banks and 18% in provision and pension funds. A mere 5% are in-vested in stock exchange. A joint survey by the Securities and Exchange Board of India and Na-tional Council for Applied Economics Research (SEBI-NCAER) in March 2003 estimated that only 13 million households out of the total 177 million surveyed have investments in the capital markets.

Exchange Traded Funds (ETF) ‐

What are ETFs An ETF is an investment fund that tracks a bas-ket of assets. These could be an index, a com-modity or a basket of commodities. ETFs are essentially chunks or pieces of portfolios that investors trade in instead of stocks. Tracking is achieved by holding all the securi-ties which make up the class, and in the same proportions. ETFs can be traded like a stock wherein prices experience changes throughout the day as they can be bought and sold almost anytime during the day. Figure 1 - Global ETF asset growth, as at end of Aug 2009 Source: ETF Research and Implementation Strategy Team, Barclays Global Investors, Bloomberg

ETFs were first introduced in 1989 but its growth has picked up only in the last 10 years wherein the assets under management in ETFs in Europe and the US have grown at an average annual rate of 40% over the last decade. Figure 1 shows the growth in global ETF assets since the start of the decade. Global ETF assets reached $725 billion by end 2008. Morgan Stan-ley estimates, global ETF assets should be worth

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$2 trillion by 2012.

Creation of ETFs The creation of ETFs is initiated by an institu-tional investor depositing a specified block of shares with the ETF to get a fixed amount of ETF shares. These blocks are called creation units. The institutional investor then can sell all or a part of these ETFs in an exchange where in retail investors can trade such ETFs like they would buy or sell any equity stock. To redeem the ETF, the institutional investor will have to deposit all the ETF shares that he received while depositing the block of shares . Passive Management versus Active Manage-ment The philosophy of managing an ETF is what is known as passive management where in the fund manager makes minor and periodic adjust-ments to keep the ETF in line with the underly-ing which it is tracking. The principle of an ETF is to match an index or a commodity instead of beating that index. Hence, an investor one harnesses the benefits of the market, the country, the sector etc. They help the investor focus on what is most important- choice of asset classes. This is in contrast with the mutual funds concept where the fund manager actively tries to beat the market.

Types of ETFs 1. Based on Market Capitalization: ETFs

can be tracking a pool of companies segre-gated based on their market capitalization

2. Based on Emerging and Developed Markets: ETFs formed to track emerging economies like BRIC countries or devel-oped companies.

3. Industry Based: ETFs track the trends in prices of stocks of a particular industry

like real estate, biotechnology etc. 4. Commodity / Currency Based: Gold,

Silver, Wheat Sugar or even currencies 5. Index Based: Companies like S&P and

Dow Jones, issue indexes comprised of stocks related to a particular industry, or shares representing the stock markets

Advantages of ETFs ETFs provide investors with an easy mechanism for diversification, which is also provided by mutual and index funds. In comparison, ETFs provide some additional benefits which are men-tioned below. 1. Low Cost: The expense ratio (fund operat-

ing costs as a percentage of assets under management) of ETFs is lower than ac-tively managed funds due to lower man-agement fees. This is due to the passive management philosophy of ETFs which does not require continuous monitoring and rebalancing of the fund’s portfolio. ETF’s management expense is 18% lower than the same for mutual funds. The cost benefits would be negated by the broker-age charges during trading, but the net benefit can be increased by balancing in-vestment size with trading frequency.

2. Trading Flexibility: Since ETFs are trad-ed like stocks, their prices are continuous-ly updated as trades occur unlike mutual funds which are revalued only at the end of the day. Thus ETFs permit an active investor to make money out of possible market inefficiencies through intraday trading. Unlike index and mutual funds, short selling in ETFs is permitted which implies that an investor could make money even when the market is falling. Since ETFs could be designed to track different indices, commodities and any desirable portfolio combination in the capital mar-ket, they provide investors with plenty of trading options.

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3. Tax efficiency: ETFs are more tax-efficient than mutual and index funds due to their transaction structure. During ETF creation, there are no tax-implications as all transactions are in kind (no cash trans-fer takes place). The institutional investor deposits a block of securities in exchange for ETF shares which are then sold in the market. During redemption of large hold-ings, ETF shares are redeemed with shares having the lowest cost basis in the fund, thereby minimizing capital gains tax for the ETF. In contrast mutual and index funds may have to sell securities they hold for redemption claims, which results in capital gain tax. Thus existing investors are affected due to tax implications from the ones exiting the fund, which is not the case in ETFs.

Transparency: ETFs provide transparency to investors by disclosing their holdings on a daily basis. The transparency prevents price manipu-lations and help investors make informed deci-sions.

Opportunities in Indian Market Traditionally Indian investors have been con-servative with over 50% preferring to keep their savings in bank deposits as shown in Figure 2. In the last five years, mutual funds have grown at a CAGR of 35% indicating that this is the pre-ferred medium for Indians investing in capital markets (Figure 3). Despite this rapid growth, penetration of mutual funds among retail inves-tors has been quite low. In a recent survey by KPMG, this has been mainly attributed to lack of knowledge among investors in understanding and selecting from various complicated schemes (Figure 4).

Figure 2 - Investment Preferences of Indian Investor Source: Sebi Handbook of Statistics, 2008 Figure 3: Mutual Funds - NAV in Rs. Cr

Source: Sebi In this scenario, ETFs provide a much simpler and hassle-free medium for Indian investors to obtain the same benefits which they would get in a mutual fund. Considering the low trading volumes of ETFs in India relative to their for-eign counterparts, the first step needed to make this happen is to create awareness about ETFs among retail investors. Secondly, investors need to be provided with more portfolio choices when

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investing in ETFs. Currently there are about on-ly 16 ETFs traded in India. This is in sharp con-trast to developed capital markets like US and Europe which have 706 and 753 listed ETFs re-spectively. A good starting point would be the portfolio allocation of MSCI India relative to MSCI World (Figure 5). Sectors like IT and En-ergy which have relatively higher weightage in the index should be given higher priority by in-stitutional investors while developing sector spe-cific ETFs.

Figure 4 - KPMG survey

Source: KPMG

Challenges of implementing ETFs in India

There are various issues that have restricted growth of ETFs in India and have not allowed them to sprout as freely as they have in more developed markets such as the US. The main amongst those can be narrowed down to:

Management Challenges: Most traditional ETFs are passively managed. This works in the

case of major index trackers and actively traded commodities. But tracking small-cap stocks or corporate bonds which are thinly traded be-comes infeasible for passive strategies as the number of securities required to replicate the sector/index becomes too low and requires arti-ficial structuring. In such cases, active manage-ment of the fund remains the only viable solu-tion. This is also the prime reason why many product categories in India are under-represented in terms of ETF availability. There are issues, however, with active management. “Active” management, by its very nature, would require a higher fund management fee from in-vestors – thus making it unattractive for them. Also, the real-time nature of ETFs is affected if the security-selection strategies are intended to be applied during intra-day trading. It remains to be seen whether a trade-off between letting go of some of the inherent advantages of ETFs and having a more diversified set of ETFs which represent most sectors in India is feasible or not.

Structuring Issues: Management of ETFs not only involves picking of the securities that repli-cate a sector or an index but also replicating the underlying asset even if those securities are not physically available. Most commodity indices are tracked in this way by using say, crude oil call options along with a bond of appropriate maturity such that the payoffs are similar to those of the underlying asset. Equity tracking for sectors that do not allow for direct equity owner-ship (maybe due to less common stock being available) can also be performed in this way – that is, by using derivatives to replicate the un-derlying stocks. This, however, leads to tracking errors which can be attributed to: (1) differences in liquidity between the derivatives and the un-derlying markets which leads to failure of arbi-trage pricing and (2) most derivatives engi-neered using options are susceptible to be priced according to their implied volatilities rather than the price of the underlying. Thus, although, ETFs are claimed to “replicate” an index – tracking errors are always present due to ineffi-cient markets and different pricing models. To

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remedy this issue, it requires an increase in the number of ETFs operating in India – which can lead to standardization of the financial structures being used to replicate individual securities.

Fragmentation of equity markets: The tradi-tional stronghold of ETFs has been the equity markets. However, the equity markets in India are extremely fragmented – the stocks compris-ing the popular indices such as the BSE30 and the S&P CNX Nifty are heavily traded while the small-caps are thinly traded leading to ineffi-cient tracking. This is a problem encountered in the developed markets as well. However, in those markets, the extreme liquidity of the deriv-atives market allows for efficient replication. Therefore, unless the exchange-based deriva-tives market in India itself matures to allow hy-brid securities to be traded, there will always be a challenge for ETF managers

to represent all the sectors of the equity markets.

Exchange capabilities: As mentioned earlier, ETF replication may require, at times, innova-tive financial engineering. This requires multiple capabilities of the exchanges the ETFs are being traded on: (1) All the constituent products mak-ing up an ETF structure must have a significant volume-base on the exchange, (2) the exchange should allow the decomposition of a unit ETF order into its constituent products automatically – which will lead to reduced transaction costs, more efficient straight-through processing and less redundant margin account maintenance. Most exchanges in India are not sophisticated enough to allow such features. In the absence of these, active management of ETFs and higher fees remain the only option to replicate com-plex/thinly-traded securities.

References www.world-exchanges.org http://www.nseindia.com/content/products/etfmktwtch_All.htm

About the Authors Akshay Mishra is a graduate student in the Department of Finance at the London School of Economics and Political Science. He completed his B.Tech and M.Tech in Mechanical Engineering from IIT Kharagpur and can be contacted at [email protected]

Sailesh Pati is a second year MBA student at IIM Ahmedabad. He completed his B.Tech and M.Tech in Electronics Engineering from IIT Kharagpur and can be contacted at [email protected] Tuhin Chatterjee is a second year MBA student at IIM Bangalore. He completed his B.Tech and M.Tech in Chemical Engineering from IIT Kharagpur and can be contacted at [email protected]

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Mutual Funds Industry in India

Mutual Fund Industry in India The Mutual Funds industry is considered as one of the most dominant players in the world econ-omy and is an important constituent of the finan-cial sector. It has witnessed startling growth in terms of the products and services offered, re-turns churned, volumes generated and the num-ber of international players. The market has graduated from offering plain vanilla and equity debt products to an array of diverse products such as gold funds, exchange traded funds (ETF’s), and capital protection oriented funds. The major benefits of investing in a mutual fund are to capitalize on the opportunity of a profes-sionally managed fund by a set of fund manag-ers who apply their expertise in investment. It also gives the investors an opportunity to invest in a variety of stocks without incurring high transactional costs. With India being one of the fastest growing economies in the world, the mutual funds sector is expected to have huge growth potential. With a saving rate of more than 35% of GDP and 80% of the population who save, these savings

could be channelized in the mutual funds sector as it offers a wide investment op-tion. The rapid growth of tier I and tier II cities in India augurs well for this sector. India has been amongst the fastest growing markets for mutual funds since 2004, witnessing a CAGR of 29 percent in the five-year period from 2004 to 2008 as against the global average of 4 percent.

Usage of Derivatives in India The last decade has witnessed a significant growth in the number and the variety of deriva-tive instruments available to investors in India. The options available for investors in India are Equity derivatives, fixed income derivatives and foreign currency derivatives. Nevertheless, there has been little participation of institutional in-vestors in derivatives market even though mutu-al funds have been allowed to invest in deriva-tives by SEBI since 2006. The intensity of deriv-atives usage by any institutional investor is a function of its ability and willingness to use de-rivatives for either risk mitigation or for risk trading. A study of derivatives usage by mutual funds in India throws up some interesting ques-tions like - do the funds that use derivatives have returns better than those funds that do not? What factors influence the ‘decision to use deriva-tives’ and the 'extent of usage’? Does derivative usage have a positive impact on selectivity and timing skills of mutual funds? The article reports the findings of our empirical study aimed at answering the above questions and compares the return characteristics of funds that use derivatives to those that do not. Our fo-cus is on three alternative ways such investment strategies by fund managers may affect the dis-tribution of a mutual fund’s returns: Funds that invest in derivatives may have higher or lower risk than funds that do not invest in de-rivatives.

Abstract Mutual funds in India now have the flexibility to invest in derivatives and foreign securities. But do such investment strategies benefit the mutual fund performance? This article answers the question through an empirical study of equity diversified mutual funds. We find that most In-dian mutual fund managers do not employ de-rivatives in their portfolios. The decision to use derivatives is associated with fund size and number of fund managed by Asset Management Company. Also, the extent of derivative usage was found to be solely dependent on fund size. It was found that use of derivatives did not im-prove the performance of funds significantly.

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Managers investing in derivatives may improve net portfolio performance, either due to lower transaction costs or because managers better uti-lize information. Managers may use derivatives to affect inter-temporal changes in the fund’s risk exposure.

Sample data for the study We perform a comparative study of the risk and performance of users vs. non users of deriva-tives. We focused on typical mean-variance and market model related performance measures and we also tested for selectivity and timing skills. For the study, 273 equity diversified mutual funds were chosen. In the mutual funds studied the instruments used were Options, Futures and Warrants. The time period used for analysis is 1 year. The Mutual Funds studied belonged to 35 different fund houses (AMCs), with each fund house having 1 to 24 MF schemes. Out of the 273 MFs, 45 (19.3%) had exposure to deriva-tives, the extent of exposure ranging from 0.03% to 77.29% of total portfolio size. The fund size of the MFs studied ranged from INR 11.16 crores to INR 3662.65 crores. None of the funds had an Entry load, although the exit load ranged from 0 to 5%, with typical value of exit load be-ing 1% for a period of less than 1 year. Out of the 35 fund houses, 13 had exposure in the de-rivative markets through one or more MF schemes. Whether this increased exposure modi-fied the funds’ performance or risk profiles is the main objective of this study.

Factors affecting the decision to use derivatives Based on the findings of similar empirical stud-ies for the US, Italian and Spanish mutual funds markets, following factors were chosen for the study – Fund size(Assets under management) Fund age (Inception year of fund) Management experience (presence of oth-

er users of derivatives in same fund fami-

ly) Cash management (entry and exit load) The brackets indicate the mutual fund attributes identified to act as surrogate for the chosen fac-tors. With the variables defined above, a Logit model was formulated with above variables as inde-pendent variables and a binary flag (0 or 1) as the dependent variable to indicate whether or not the fund invests in derivatives. This model indicates whether or not one of the aforementioned factors has an influence on the decision to invest in derivatives. We found that only the variables fund size and management

experience are significant and rest of the varia-bles are not useful in explaining the derivative usage. This implies that the probability of using derivatives increases with the number of funds in the family and with the size of the fund. The-se results highlight the key role of economies of scales in the decision to use derivatives. The sig-nificance of size also supports the idea that larg-er funds are more willing to use derivatives to manage their positions. The variables that do not affect the decision to use derivatives are the fund’s age, the load fees and the presence of other funds in the family using derivatives.

Factors affecting the extent of derivative usage For identifying factors influencing the extent of derivative exposure, we again chose the same explanatory variables. The dependent variable this time was the percentage exposure of the fund to derivatives i.e. ratio of investment in de-rivatives to total assets under management. A linear regression equation was formulated for this purpose. The study showed that the extent of derivative

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usage is independent of the number of funds in the family also. It depends only on the size of the fund. Again, economies of scale play a sig-nificant role. The fund size plays a significant role in deciding the extent of derivative expo-sure. So, we can conclude that the decision to use derivatives and extent of usage is related to economies of scale and users are more likely to be funds that belong to a large family of funds having a large fund size.

Risk return profile To assess the risk return profile of users versus non-users, the returns of the mutual funds over past one year were compared with the market returns. The performance of users and non-users were compared on parameters like Sharpe ratio, Treynor ratio and Jensen alpha. The risk free rates used were the Government of India 91 day T-bill rates. Market rate used is the monthly re-turn on Nifty over past one year. If we look at the returns of the funds and com-pare the key ratios, following results were ob-tained: It can be observed that there is no significant difference between the Sharpe ratio for users and non-users of derivatives indicating that ex-posure to derivative does not lead to superior performance in terms of volatility adjusted re-

turns. The Jensen’s alpha is the measure of per-formance of interest for well diversified inves-tors. Both users and non-users of derivatives in-dicate a positive alpha, indicating that they per-form better than the market owing to their diver-sified portfolios. A positive alpha for users of derivative funds indicates is evidence of superi-or performance. The Treynor Index indicates if the fund outperforms the risk free rate and if the

Performance Criteria Users Non-users

Beta 0.831 0.903

Jenson’s Alpha 0.556 0.203

Sharpe Ratio 0.402 0.377

Treynor Index 4.338 4.566

performance is achieved with lower market ex-posure. Again, there is no significant difference in the performance of users and non-users of funds.

Selectivity and timing skills To establish the hypothesis that the usage of de-rivatives had any substantial effect on the timing of investments by mutual fund, we extended the CAPM model by incorporating a factor that cap-tures market increases. This factor is defined as the square of the market excess return. This model allows for separation of timing skills in fund management. Both users and non-users of derivatives show a negative timing coefficient indicating that they

did not time the market efficiently. The timing skill of users of derivatives was found to be worse than that of non-users.

Conclusion We find that most Indian mutual fund managers do not employ derivatives in their portfolios. Only 19.3% of the 273 funds in our sample use derivatives. The results are generally consistent with the findings in Koski and Pontiff (1999), who report that 20.8% of US equity fund man-agers employ derivatives in their funds. We also find that, for funds that invest in derivatives, the use of derivatives as a percentage of a fund’s total holdings are moderate, with averages of 8.4%. We find some evidence that the decision to use derivatives is associated with fund size and number of fund in the fund family. The extent of

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derivative use was found to be solely dependent on fund size. Surprisingly, in terms of returns - the use of derivatives did not improve the per-formance of funds. Users of derivatives did not exhibit superior timing skills when compared to non-users. We view our results as evidence that the inci-dence and extent of derivatives usage by Indian

mutual funds are modest and the use of deriva-tives does not adversely affect fund return and risk profiles. Our findings are of particular im-portance to regulatory agencies as well as mutu-al funds investors. We believe that the evidence presented herein can lessen regulators’ concern about the abuse of derivatives by mutual funds in India.

References Koski Jennifer Lynch, Pontiff Jeffrey, 1996, How Are Derivatives Used? Evidence from the Mutual Fund In-dustry, Financial Institutions Centre 96-27 Delib Daniel N., Vermaa Raj, 2000: Contracting in the investment management industry: evidence from mutual funds, Journal of Financial Economics 63 (2002) 79–98 Emilia Garcia-Appendini and Thomas A. Rangel-Hilt, 2009, Do derivatives enhance or deter mutual fund risk-return profiles? Evidence from Italy, CAREFIN Research Paper No. 7/09

About the Authors Abhishek Rawale: The author is a Second Year student of Post Graduate Program in Management at Indian Institute of Management, Bangalore. After completing his Bachelor of Engineering (Computer Science) from Netaji Subhas Institute of Technology (NSIT), New Delhi, he worked in the Semiconductor Industry for three years. He can be reached at [email protected]. Saurabh Rai: The author is a Second Year student of Post Graduate Program in Management at Indian Institute of Management, Bangalore. Prior to this he completed his Bachelor of Technology (Mechanical Engineering) from Institute of Technology, BHU. He did his summer internship at ICICI Bank. He can be reached at [email protected].

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Developing Corporate Bond Market in India

Introduction

Capital market in any country consists of equity and the debt markets. Within the debt market there are govt securities and the corporate bond market. For developing countries, a liquid cor-porate bond market can play a critical role in supporting economic development as

It supplements the banking system to meet corporate sector’ requirements for long-term capital investment and asset creation.

It provides a stable source of finance in case of volatile equity market.

A well structured corporate bond market can have implications on monetary policy of a country as bond markets can provide relevant information about risks to price stability

Despite rapidly transforming financial sector and a fast growing economy India's corporate bond market remains underdeveloped. It is still dominated by the plain vanilla bank loans and

govt securities. The dominance of equities and banking system can be gauged from the fact that since 1996, India's stock market capitalisation as a percentage of GDP has increased to 108% from 32.1%, while the banking sector's ratio to GDP has risen from 46.3% to 78.2% in 2008. In contrast, the bond markets grew to a modest 43.4 percent of GDP from 21.3 percent. Of this corporate bonds account for around 3.2% of GDP and government bond market accounts for 3 8 . 3 % o f G D P . ( F i g u r e 1 ) Source: RBI

India’s government bond market stands ahead of

most East-Asian emerging markets but most of it is used as a source of financing the deficit. The size of the Indian corporate debt market is minuscule in comparison with not only the de-veloped markets, but also some of the emerging economies in Asia like Thailand, Malaysia and China (Figure 2)

Characteristics and features

Innovation and a Plethora of options:

Over time great innovations have been wit-nessed in the corporate bond issuances, like

Figure 1

Abstract For developing countries like India, a liquid cor-porate bond market can play a crucial role in supporting economic development. Despite ex-istence of a support structure necessary develop-ment of Corporate bond market, the market in India cripples due to lack of a well structured primary and secondary market, issuers and well defined regulations. In the paper we intend to cover these problems and the correctives measures that have been taken till date and les-sons that can be learnt from countries like Aus-tralia and Korea.

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floating rate instruments, convertible bonds, callable (put-able) bonds, zero coupon bonds and step-redemption bonds. This has brought a variety that caters to a wider customer base and helps them maintain strike a risk-return balance.

Over time great innovations have been wit-nessed in the corporate bond issuances, like floating rate instruments, convertible bonds, callable (put-able) bonds, zero coupon bonds and step-redemption bonds. This has brought a variety that caters to a wider customer base and helps them maintain strike a risk-return balance.

Preference for private placement:

In India, issuers tend to prefer Private Placement over public issue as against USA where majority of corporate bonds are publically issued.

In India while private placement grew 6.23 times to Rs. 62461.80 crores in 2000-01 since 1995-96, the corresponding increase in public issues of debt has been merely 40.95 percent from the 1995-96 levels. (Figure 3).This leads to a crunch in market liquidity. A number of fac-tors are responsible for such preference. First,

Figure 2

the companies can avoid the lengthy issuance procedure for public issues. Second is the low cost of private placement. Third, the amounts that can be raised through private placements are typically larger. Fourth, the structure of debt can be negotiated according to the needs of the issu-er. Finally, a corporate can expect to raise debt from the market at finer rates than the PLR of banks and financial institutions only with an AAA rated paper. This limits the number of en-tities that would find it profitable to enter the market directly. Even though the listing of pri-vately placed bonds has been made mandatory, a proper screening mechanism is missing to take care of the quality and transparency issues of private placement deals. Figure 3: Resource mobilization through debt

Source: Equity and corporate debt report: RBI

Figure 4 Source: RBI

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Dominance of financial institutions: The public issues market has over the years been dominated by financial institutions. The issuers who are the main participants in other corporate bond markets (that is, private sector, non-financial), represent only a small proportion of the corporate debt issues in the Indian market. Most of the privately placed bonds (which are about 90% of the total issue of corporate bonds) are issued by the financial and the public sector. (Figure 4) Inefficient secondary market: Further the secondary market for non-sovereign debt, especially corporate paper still remains plagued by inefficiencies. The primary problem is the total lack of market making in these secu-rities, which consequently leads to poor liquidi-ty. The biggest investors in this segment of the market, namely LIC, UTI prefer to hold these instruments to maturity, thereby holding the sup-ply of paper in the market. The listed corporate bonds also trade on the Wholesale Debt Segment of NSE. But the per-centage of the bonds trading on the exchange is small. Number of trades in debt compared to equity on an average for August 2007 is only 0.003%.

Figures are turnover on the wholesale debt market segment of NSE. Source: NSE

Challenges and issues

Dominance of private placements

Dominance of large corporations. The credit rating system encourages only the large

corporations with an AAA rating. (Table 1)

Non-existent repo market for corporate bonds unlike the government bonds where there is an active repo market.

Complicated and slow issuance procedure.

Regulators in India are reactive rather than proactive.

Illiquid secondary market- part of it is due to the fact that the number of issuers is low and part of it is due to the fact that the large investors prefer to hold these securi-ties till maturity.

Lack of formal market makers

Limited demand for bond financing. The corporate debt market in India continues to be dominated by banks

Limited investor base. A successful corpo-rate bond market requires non banking in-vestors which are limited and restricted in case of India.

Inadequate credit assessment skills cou-pled with lack of transparency in trades

There is a lot of confusion in the market regarding both regulations and the trading floors.

To sum up, corporate bond the market in India suffers from deficiencies of participants, prod-ucts and a comprehensive institutional frame-work.

Recent developments

Figure 5

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local rating agencies to international rating agencies. In January 2007 SEBI was declared as the sole body responsible for regulating and co-ordinating the primary and secondary corporate bond market. It was a major step in remove the lack of coordination that existed due to two reg-ulators (SEBI and RBI). In April 2007, SEBI permitted both BSE and NSE to set up trading platforms. In April 2007, SEBI reduced the shut period in corporate bonds, to align it with that applicable for Government Securities, and trada-ble lots in corporate bonds. In December 2007 SEBI made further amendments in issuance pro-cedures to reduce the cost and ease issuance. It also gave green signal to FMMIDA to start trade reporting platform for CBs. Moreover, the gov-ernment has made changes in the Companies Act and on simplification and reduction in the stamp duty w.e.f. 2007. From December 1, 2009 all corporate bonds traded OTC or on the debt segment of the stock exchanges will have to be cleared and settled through the National Securities Clearing Corporation Ltd (NSCCL) or the Indian Clearing Corporation Ltd (ICCL). It will help in eliminating the counter party risk in trade settlement and ensure a smooth receipt and payment system. In June 2008, the investment limit for FIIs in corporate debt was increased from $1.5 billion to $3 billion and further to $15 billion in January 2009. Ministry of Finance has hinted towards corporate market becoming Repo-able from 2010.

India’s learning from the Australi‐an corporate bond market Australian economy has been very much regu-lated before 1980 like Indian economy. In Aus-tralia, too, government bond market was devel-oped much before the development of the corpo-rate bond market through deregulation. Thus a deregulation will help the Indian market. Moreo-ver the following reforms can also be imple-mented. The secondary market has to be developed

for the bonds.

Given the importance of a well developed cor-porate bond market, the government, the RBI and SEBI have initiated measure to develop the corporate bond market in India. Most measures were aimed at improving the disclosure norms. The corporate bond market got its due attention by the government in the Union Budget of 2004-05where in the High Level Expert Committee on Corporate Bonds and Securitisation, chaired by Dr. R. H. Patil, was set up to look into the regu-latory, legal, tax and mortgage design issues for the development of the corporate bond markets. The suggestions made by the committee were to develop the market infrastructure. Some of the suggestions made in the report include the re-moving the stamp duty, simplifying the issuance and disclosure norms, to bring the cost of corpo-rate bonds at par with those of government secu-rities by having similar TDS norms, enhance the investor base by encouraging participation of mutual funds, pension funds, insurance compa-nies and gratuity funds and also retail participa-tion through better primary and secondary mar-kets. It also suggested a regulatory framework for a transparent and efficient secondary market for corporate bonds should be put in place by SEBI in a phased manner. It also recommended having a trade reporting system, introduction of repo in corporate bonds and better clearing and settlement system. Both RBI and SEBI have fundamentally agreed to these recommendations and steps are being taken to implement the same. Some of the steps include: Dematerialization of holdings, as required by SEBI since 2002; increased trading transparency from compulsory reporting of trades, linking

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Like in Australia, GOI bonds in India are also purchased by insurance companies and gratuity funds. They hold these bonds till maturity. As such there is no secondary market for these bonds. The Forex market in India is to be deregu-

lated to attract foreign investors. As of now the forex market is highly regulated by RBI. India needs to develop cross cur-rency swap market so that the foreign in-vestors can hedge their investment. How-ever this will bring instability to the Indian currency in the beginning.

India can also construct Bond Indices to

provide a benchmark for investment. This will also make the bonds acceptable among the retail investors.

Policy lessons from the Korean corporate bond market Unlike, many developing economies including India, corporate bond were lot more popular in Korea, basically because of the reluctance of the government of Korea to issue government bonds. Moreover, the bonds issued by compa-nies were guaranteed by government as such they were risk free. Corporate bond market in Korea has weathered crisis in late 1990s and early 2000s but has recovered afresh from each crisis, stronger. Korean bond market grew both in quality and size due to various government reforms even in the midst of various crisis. Es-tablishment of market infrastructure and en-hancement of overall liquidity and transparency of the primary and secondary market has helped in the long run.

Corporate bonds were first introduced in 1972. But the real development of these bonds was seen after the development of

an efficient government bond market. Thus its development is the first step in developing corporate bonds.

Essential market infrastructure and institu-tional arrangements are the basic require-ment for the development of efficient bond markets. Korea introduced many systems such as a Dutch auction system, a reopen-ing and marked-to-market system and a primary dealer system. Moreover it also took steps to develop the futures repur-chase market for government bonds. These institutional and legal infrastructures and framework in a very short period were able to induce liquidity in the market.

Instead of being satisfied with OTC mar-ket, Korean Government took real steps to promote electronic trading. It introduced ETS (electronic trading system) for the government bond market. It was mandato-ry to trade in benchmark issues using the system. This has not only improved trans-parency but also liquidity in the market.

Many companies in India are not able to issue bonds because of low rating. Korea also faced the same problem after the IMF Crisis. To overcome this problem it used securitization and credit guarantee meth-ods. This helped even small companies to raise funds not only from domestic market but also from the international market.

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References

Asia Bond Monitor- ADB, April 2008 Bank for International Settlements. 2006. ‘‘Developing Corporate Bond Markets in Asia.’’ BIS Papers No.26, February. India’s Bond Market-Development and Challenges Ahead, Stephen Wells and Lotte Schou-Zibell, Working paper series on regional economic integration no.22, ADB, December 2008. CS Update, august 2008, ICSI Equity and corporate debt report 2007, RBI An overview of the Australian corporate bond market by Ric Battellino and Mark Chambers, Reserve Bank of Australia

About the Authors Jaideep Singh has done his mechanical engineering from Delhi College of Engineering, Delhi. He is currently pursuing his MBA from Management Development Institute, Gurgaon. He has consistently been among top students and has also won prizes in various inter B-school competition Ritambara Vasudeva after graduating in Eco.(Hons) from Indraprastha College, Delhi University, is pursuing her MBA from Management Development Institute, Gurgaon. She is a member of Monetrix, Economics and Finance club of MDI. Shefali Omer has done her B.Com from Kanpur University. She also secured an A.I.R. 28 in CA-CPT and has cleared CA-PCE. She is currently pursuing MBA from Management Development Institute, Gurgaon. She is a member of Monetrix, Economics and Finance club of MDI, Gurgaon

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Capital Account Convertibility: Is India Ready?

Overview of Full Capital Account Convertibility: Full Capital Account Convertibility implies free-dom of currency conversion in relation to capital transactions in terms of both inflows and out-

flows. Thus, CAC for Indian economy refers to the abolition of all restrictions with respect to movement of capital from India to different countries across the globe and vice versa. Move-ment towards FCAC will ensure that all non-residents i.e. corporate and individuals would be treated equally. This would mean removal of the tax benefits accorded to NRIs via special bank deposit schemes.

Evolution of Capital Account Con‐vertibility in India: In 1994 August, the Indian economy had to adopt the present form of Current Account Con-vertibility, on account of compulsions by the International Monetary Fund (IMF) Article No. VII. The primary objective behind the adoption of CAC in India was to make the movement of capital and the capital markets open and inde-pendent so that it would exert less pressure on the Indian financial markets. The proposal for the introduction of CAC was present in the rec-ommendations suggested by the Tarapore Com-mittee appointed by the Reserve Bank of India in 1997. The status of Capital Account Convertibility in India for various non residents is as follows: For Foreign Corporate and Institutions, there is reasonable amount of convertibility For non-resident Indians, there is approximately an equal convertibility, but one accompanied by procedural and regulatory impediments For individuals, foreigners other than PIOs, there is near zero convertibility Objectives of CAC in the Indian Context:

To facilitate growth in the economy by minimising the cost of equity and debt capital

To improve the efficiency of the Indian

Abstract: Background Capital Account Convertibility for the Indian economy refers to the abolition of all re-strictions with respect to movement of capital from India to different countries across the globe and vice versa. The Reserve Bank of In-dia, in consultation with the Government of In-dia, appointed a committee chaired by S.S. Tar-apore to set out a roadmap towards adopting full CAC. This article, while evaluating India’s readiness towards capital account liberalization, examines India’s performance on the precondi-tions laid down by the Tarapore committee [1] in 1997 and the feasibility of the Tarapore Com-mittee [2] recommendations. The article also attempts to analyse the effect of CAC on the Indian economy in the backdrop of the financial crisis. Conclusions India has not met most of the prerequisites set by the Tarapore committee. India is not yet ready for full Capital Account Convertibility but it should prepare a robust roadmap for adopting CAC in future. Adoption of the second Tarapore committee recommendations still remains infea-sible as the preconditions set by the committee in the prior period itself have not been met. Even as moving to fuller convertibility of cur-rency may benefit the capital markets, the possi-bility of a financial/currency crisis cannot be completely ruled out since India’s financial inte-gration is still in its nascent stage.

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financial sector through greater compe-tition, thereby minimising the interme-diation costs

To provide opportunities for diversifi-cation of investments by residents

Concomitants for a move to Full Capital Account Convertibility: The fiscal-monetary policies, exchange rate management, prudential, regulatory and supervi-sory safeguards and measures for development of financial markets, all assume importance. The implementation of these measures and the pace of liberalisation are a simultaneous process. Pre-Conditions of Full CAC in India: Tarapore Committee Recommendations (I) The 1997 committee had laid down the follow-ing preconditions to be satisfied before India adopted CAC gradually (over a period of 3 years from 1997-2000) a. Gross Fiscal Deficit/GDP ratio to come

down to 3.5% b. The annual average rate of inflation for the

previous 3 years to lie between 3-5% c. Gross Non-Performing Assets of public

sector banks to come down to 5% in 2000 from 13.7% in 1997

d. Average Cash Reserve Ratio should come down to 3%

India’s Performance on the above criteria post-2000: The fiscal deficit to GDP ratio came below the 4% mark only in 2006-07 followed by 3.3% in 2007-08. However, due to the fiscal stimulus measures adopted by the Government of India in 2008-09, the fiscal deficit to GDP ratio in-creased to 6.8%, the highest since 1998-99. This indicates that India has performed poorly on the fiscal front. Considering that the target of 3.5% deficit set out by the Tarapore committee has only been accomplished once, this criterion would not be a stable one in judging India’s readiness to adopting Full Capital Account Con-vertibility. Three Years’ Average Inflation Rate During 1997-2000, the average inflation rate decreased continuously from 5.6% to 4.5%. However, since 1999-2000, the average inflation rate has hovered above the 5% limit, which is above the recommended band set by the Tara-pore Committee.

The gross NPAs of public sector banks have been on a decline. The NPAs came below the 5% mark only in 2004-05 as opposed to the target of 2000-2001. However, the gross NPAs of these banks have come down remarkably since 2000-01.

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Average Effective Cash Reserve Ratio

The lowest level of average CRR has been in the year 2003-04, at 4.5%. The average CRR is well above the Tarapore committee’s prescribed limit of 3%. It is only in the year 2009-10, that the CRR has come down drastically due to fears of the slowdown, but it still remains higher than the floor. Hence, this criterion is not met while eval-uating India’s readiness to adopting full Capital Account Convertibility. Debt-Servicing Ratio

Thus, India has not met most of the prerequisites set by the Tarapore committee for moving to-wards full Capital Account Convertibility. Bar-ring the NPAs of the Public Sector Banks which have come down drastically, India has per-formed poorly on other fronts, including on the fiscal front. The Fiscal Responsibility and Budg-et Management Act (FRBM) was enacted to eliminate the revenue deficit and to reduce the central fiscal deficit to 3% by March 31, 2009. However, due to the economic stimulus package unveiled by the government in response to the acute economic slowdown, there has been a sharp increase in the central fiscal deficit and as a result, the FRBM Act has been temporarily suspended.

Adequacy of Reserves: The adequacy of reserves is considered an im-portant parameter for capital account liberaliza-tion as it helps in gauging an economy’s ability to withstand external shocks. The RBI has been pursuing a policy of maintaining an adequate level of foreign exchange reserves to meet In-dia’s import requirements, unforeseen contin-gencies and liquidity risks. Compared to US $5.8 billion in the financial year 1990-91, India now has a foreign reserve base of $283.6 billion (as on December 18, 2009). Thus, from an im-port cover of just 2 months in 1990-91, India now has an import cover of more than 14 months, which is way above the prescribed ‘safe’ level of 6 months. The Reserves/Debt-Service ratio has also shot up from 0.5 to 7.2 over the period, which indicates a comfortable level of debt servicing using the foreign reserves during periods of exigency. India’s total foreign reserves well exceed India’s overall external debt.

The panels indicate that the debt servicing ratio has never touched the required 20% limit set by the Tarapore com-mittee.

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Tarapore Committee II: Recom‐mendations The second round of Tarapore committee set up to suggest a roadmap for full Capital Account Convertibility came out with the following set of recommendations: a. The sequential full Capital Account Con-

vertibility to be adopted in three phases: 2006-07 (Phase-I), 2007-09 (Phase-II) and 2009-10 and 2010-11 (Phase-III)

b. FIIs to be banned from investing fresh capital through the issue of fresh Participa-tory Notes; PNs to be gradually phased out

c. Industrial houses to be allowed and en-couraged to set up banks

d. Discriminatory tax treaties (such as Dou-ble Tax Avoidance Treaty or DTAA) to be abolished, since they are incompatible with the concept of capital Account Con-vertibility

e. For resident corporates, the ceiling for fi-nancial capital transfer abroad to be re-laxed from 25% of their net worth

f. External Commercial Borrowing limit per annum to be increased

g. Ceiling for loans and borrowings by resi-dent banks from overseas banks to be re-laxed from 25% of their unimpaired tier-I capital

Why Tarapore Committee II rec‐ommendations remain infeasible? Even as the government attempted a move to-wards phasing out Participatory Notes, a mere rumour of the news resulted in a stock market crash. (P-notes formed approximately over 55% component of FIIs in 2007. It is only recently,

amid global turmoil, that share of P-notes has fallen to 15.55%) The DTAA is needed to promote International trade. Hence, it can only be abolished if full cap-ital account convertibility is implemented simul-taneously, else there are expected to be serious repercussions in term of our exports The ECB limit was increased to $500 million but that was more in response to the liquidity crunch rather than moving towards capital ac-count convertibility. The present government has been thinking of rolling back this increased ceiling. Possible Hiccups: a. The effect of a financial crisis on the Indi-

an economy with full capital account con-vertibility is difficult to predict. Other economies with full capital account con-vertibility are highly coupled with the world economy. This means that global problems directly impacted these domestic economies as well. The recent examples of Ireland and Iceland are not very encourag-ing.

b. There is no clarity regarding the regulatory measures required to prevent abuse of cap-ital account convertibility. Speculators are known to move markets recklessly and increase the risk for common investors.

Conclusion: Accordingly, it can be concluded that the issue of India adopting full Capital Account Converti-bility still remains questionable. Many require-ments of first Tarapore committee recommenda-tions were relaxed in the second Tarapore com-mittee recommendations; however, the move

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towards full account convertibility still seems infeasible. Even as advancing to fuller converti-bility of currency may benefit the capital mar-kets by bringing in cheaper capital, the possibil-ity of a financial/currency crisis cannot be com-pletely ruled out since India’s financial integra-tion is still in its nascent stage. The recent global meltdown hasn’t helped either. As of now, India needs a rigorous regulatory and monitoring body which would have an effective system for inter-vening at the right time to ensure domestic sta-bility and prevention of disruption in the Indian capital markets. It can be concluded that India is not yet ready for full Capital Account Converti-bility, but it should prepare a robust roadmap for adopting CAC in future.

Exhaustive studies conducted by international rating agencies prove the point that full capital account convertibility by itself does not make a country a more attractive investment destination. More important parameters in this respect are a strong financial sector and fiscal rectitude. The-se are exactly the signposts that the Tarapore committee has advocated. With many signposts that are difficult to reach, it is unlikely that India will move towards fuller convertibility by adher-ing to the path and the timelines set out. In that respect, the value of the Tarapore committee report might well lie in its emphasis on crucial procedural and macroeconomic issues rather than Full Capital Account Convertibility per se.

References http://dbie.rbi.org.in Indiastat.com/banksandfinancialinstitutions/3/stats.aspx rbi.org.in Indiastat.com/economy Tarapore Committee Report on Capital Account Convertibility in India, 2006 “Why capital Account Convertibility in India is Premature” Williamson (2006) “Capital Account Convertibility and Risk management in India”, Amadou N.R.Sy, IMF Working Paper WP/07/251

About the Authors Gaurav Anand is presently pursuing Post Graduate Diploma in Management from Management Development Institute, Gurgaon. He can be reached at [email protected] Hitesh Seth is presently pursuing Post Graduate Diploma in Management from Management Development Institute, Gurgaon. He can be reached at [email protected] Srikanth Rayasam is presently pursuing Post Graduate Diploma in Management from Management Development Institute, Gurgaon. He can be reached at [email protected]

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Arm‐chair Investing on Nifty: A P/E based approach

Introduction If you’re a Warren Buffet or a Rakesh Jhunjhun-wala, or any experienced investor with both the knowledge and time to study the market, you would be better off handpicking stocks and monitoring them. But what if you wanted the thrill of investing in the stock market, and yet not spending too much time pouring over the business pages each day? This P/E based ap-proach to investing in Exchange traded funds hopes to achieve that. It does not claim it can beat the returns of careful handpicking. It’s a method for the busy executive, with better than SIP returns.

Conceptual Framework This is inspired by an excellent book “Buffetology” written by Mary Buffet, the daughter-in-law of the legendry investor Warren Buffet. Mary Buffet explains that Warren Buffet views stocks as bonds with variable rate of inter-est (returns). The main difference between a fixed income instrument (e.g. fixed deposits or bonds) and stocks is that while fixed income in-struments offer a fixed rate of return, the stocks offer variable returns. However, the returns from high quality, well established stocks can be pre-dicted with a fair degree of certainty. The proce-dure for calculating the expected returns from high quality stocks with established track record is described below: Firstly, we need to examine the average growth of the earning per share (EPS) of the stock over a long period (usually 10 years). It is assumed that the average growth in EPS over the last 10 years will be sustained over the next few years (5 to 10 years). Based on this, we estimate the future EPS of a stock by compounding the cur-rent EPS at the average EPS growth rate. For example, if the 10 years average growth rate of

EPS is 12% and the current EPS is 100, then it is estimated that the EPS at the end of five years from now will be 176. Also, assume that the cur-rent stock price is 1500 (PE of 15). Then we examine the average Price-Earnings Ratio (PE) of the stock over the last 10 years. We assume that this average will be sustained over the next few years. Based on this assump-tion, we estimate the future price of the stock (in our case five years from now) by multiplying the future EPS with the historical average PE ratio. If the historical average PE of the stock in our example is 18, then the future price of the stock is expected to be 3168 (176X18). Of course, there are no guarantees but past record demonstrates that for high quality stocks, this is usually the case. The next step is to estimate the expected return on our investment. In our example, we have the option to buy the stock at current market price of Rs. 1500 with an expectation that the stock price at the end of five years will be Rs. 3168. The rate of return on this investment works out to 16.12% per annum. Finally, we compare the expected rate of return on the stock with the risk free return available in the market over the same period. Let us assume that the rate of return on five year fixed deposits is 7%. We can now see that the investment in stock is expected to yield much higher return (16.12%) than the return on fixed deposit. In such a situation, it is better to invest in stock ra-ther than fixed deposit. So our decision is made! We will invest in stock. However, what happens if the current market price of the stock is 2200 (PE of 22)? In that case, the expected rate of return from investment in stock will yield only 7.56% per annum, just a shade higher than the 7% return on fixed depos-it. Now we are not sure whether we should in-vest in stock or fixed deposit. Is it worth taking the risk of investing in stock if we are getting only 0.56% % higher return but with uncertainty

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that we may even lose a part of our capital. Per-haps not. Therefore, we would invest in stock only if the expected return from the stock is sig-nificantly higher than the return on fixed depos-it. In our case, we have assumed that we would not invest unless the expected return from the stock is at least 10% per annum. The example above shows that if invest when the PE levels are low, then we get higher returns. Also, it fol-lows that when the PE levels are high, it makes sense for us to sell the stock and book profits, as the expected return from that point onwards are likely to be lower and we are better off switch-ing to investment in risk free instruments i.e. fixed deposit. Our methodology is based on the above ap-proach. We have replaced individual stocks with an exchange traded fund (NIFTY Bees), also called ETFs. An index fund offers better diversi-fication and therefore reduces the risk of invest-ment. The index fund represents investment in high quality and large mid cap stocks with ex-cellent liquidity. The ETF has very low expense ratio and can be easily bought and sold over in-ternet, which makes it very easy for a busy exec-utive to invest in. The research has shown that over a long period of time, most other types of funds (diversified equity funds or sectoral funds) are not able to beat the performance of

the index funds. For all these reasons, we decided to invest in NIFTY Bees. We examined the last 10 years data and came up with following facts: 1. Average growth rate of the EPS of NIFTY over the last 10 years is 13 % per annum. For future, we have assumed 12% per annum, to be on conservative side. 2. Average PE over last 10 years has been around 18. 3. The highest level of PE is just over 28 and lowest level is just over 10. Only twice in the last 10 years, have these levels been reached. Most of the time, PE hovers in the range of 15-20, with sporadic upwards and downwards Figure 1 below shows this more clearly. As mentioned earlier, we decided that we will not invest in stock (NIFTY BeeS in our case) unless the expected rate of return is at least 10%. Based on above historical data, the investment in NIFTY BeeS is expected to yield 10% or more return, if we invest when the PE levels are 19.75 or less. Therefore, we decided that we will invest in stock if the PE is 19.75 or less. If PE is higher, then we are better off keeping money in a cash fund, which gives low returns (we have assumed 4%) but does not suffer from the risk of loss of capital. We chose cash fund over fixed deposits because it is much easier to get in and out of cash funds. Also, the after tax return on cash fund is quite similar to return on fixed de-posits.

Exhibit 1

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The Methodology Let us briefly describe how the method works. Basically, we start off with a sum of money (say Rs. 30,000) and allocate it for investing in the Nifty Bees. Part of it is directly put into buying the equity, part left in Cash that may in future be used to buy equity, but for the time being earns interest for you. So how much in equity, and how much in cash? It depends on the P/E of the benchmark at that time. Every decision in this model, for that matter, will depend on P/E. Based on the frequency distribution of the NIF-TY PE curve, we decided to use the following model for allocation of investible funds between cash fund and NIFTY Bees. So what now once we’ve committed our initial capital? Now we follow a monthly systematic invest plan, by putting in Rs 1,000 at the begin-ning of every month. But unlike a Passive SIP, where we blindly invest every month, here we again turn to our indicator, the P/E. Economic Times publishes daily, the P/E of the Nifty Benchmark, else it is available online. At the beginning of each month we make a note of the P/E and recalculate the percentage of our invest-ment that should be in equity and the percentage that should be in cash based on the above table. So if we now find the P/E to be 24, we would rather keep only 10% in equity. So we calculate the value of our current portfolio (equity +cash + Rs. 1000 to deployed for the month) and take 10% of that and keep it in equity while keeping the rest in cash.

This is achieved by selling excess equity and parking the sale proceeds in cash fund. Then we set the portfolio aside till next month. And re-peat the same again. Thus, what is clear is that we’re spending minimal time (once a month) on managing the investment and putting in minimal analysis (just tracking the P/E). But are we actu-a l l y m a k i n g m o n e y ?

The Results We did a simulation of this exercise over a 10 year period (31 May 1999 to 01 June 2009). We find that if we had followed our method over this period, we would have earned a compound-ed rate of return of 20.7% per annum! Compare this to a simple SIP plan, which would have fetched a return of 13.7% per annum. We have earned about 7 % higher return over simple SIP. By any standards, this kind of return over a 10 year period is superb. What is more, we didn’t spend any time in researching and tracking stocks. All we needed was one simple decision one day in a month. Finally, the risks assumed are very low as we stay invested only when the market is cheap and there is higher margin of safety. As market starts getting overvalued we start selling and hold larger and larger propor-tion of portfolio in cash fund, which is risk free. In a SIP you would be invested fully even dur-ing the time when markets are overvalued and hence risky. Finally, we also computed 5 year rolling returns under our methodology and under traditional SIP methodology to check the con-sistency of returns under our methodology. Un-

Exhibit 2

PE Range % of funds in equity <14 at least 90% 14<PE<16 at least 80% 16<PE<18 at least 70%

18<PE<20 at least 60% 20<PE<22 no buying/no selling . SIP amount to be invested in cash

fund. 22<PE<23 Not more than 50% 23<PE<24 Not more than 25% PE>24 Not more than 10

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der SIP, we sometimes got returns as high as 41%, but then sometimes as low as 6%, with a standard deviation of 0.11. With our method we had a narrower range, in between 11 and 38%, with a standard deviation of 0.08. Our returns were more consistent and predictable and still gave a higher overall return over a 10 year peri-od. What more do we want? There exist funds like FT India Dynamic PE Ra-tio Fund of Funds (FTDPEF), which follow a similar methodology.

However, the differences and some advantages of the above discussed method are 1) Use of cash while not invested in stock, instead of fixed deposits, which have their own inherent risks 2) Entry/Exit loads of a managed fund 3) No flexi-bility in adjusting PE trigger values to suit an individual’s personal risk propensity 4) last but not the least, the thrill of doing it yourself! *A P/E of 19.75 means that at current market price, the stock is giving a return of 5.06%. However, the EPS, gets compounded at the rate of 12% per annum (historical), thus giving us an average return of 10% over a 5 year pe-riod.

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About the Author Puneet Gupta is presently pursuing Post Graduate Diploma in Management from Indian Institute of Management Bangalore. He can be reached at [email protected]


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Why the Indian Markets Will Not Fail

Introduction A market, as defined by the Merriam Webster dictionary, is “a meeting together of people for the purpose of trade by private purchase and sale and usually not by auction”1. Extending the def-inition, a financial market can thus be defined as a market for the exchange of capital and credit2 that helps businesses grow and also helps inves-tors make money3. The financial market com-prises of all vehicles of investment – the stock market, the bond market, the commodities mar-ket and the foreign exchange market. They can also be classified into money markets (which include short term financial instruments) and capital markets (which include long term finan-cial instruments) The Indian financial market – A brief history

Indian financial history dates back to the days of Arthshastra who developed a sophisticated taxa-tion system and laid the foundations of what we call today a sophisticated financial system. James Wilson is considered as the father of the Indian Financial system whose roots originate from the British Empire. He gave India its first ever Budget that brought stabilization amidst the chaos. His other pioneering works include cen-tralization of the financial control and creation of a system of taxes. The Indian financial Mar-ket has evolved since then from half a dozen brokers in 1839 to more a million brokers today. The early nineties’ financial market was domi-nated by commodities trading and cities like Ah-medabad and Bombay gained commercial im-portance. As industrialization proliferated, the need for official trading houses developed and this gave birth to various regional stock markets during the 1940s. At present there are 21 stock ex-changes in India excluding the NSE and OTCEI.

The evolution and current state

There have been much turbulence in the Indian markets like the various scams, world economic recessions but Indian economy has evolved a long way due to the various reforms and prudent policy moves.

The financial market today provides the much

Sl.No. As on 31st December

1946 1961 1971 1975 1980 1985 1991 1995

1 No. of Stock Exchanges

7 7 8 8 9 14 20 22

2 No. of Listed Cos.

1125 1203 1599 1552 2265 4344 6229 8593

3 No. of Stock Issues of Listed Cos.

1506 2111 2838 3230 3697 6174 8967 11784

Abstract: The paper tries to understand the In-dian Financial markets with respect to the Indi-an people. It explores the risk assuming tenden-cy of Indians and links it to their investment and saving patterns and behavior. This along with the history of the markets is used to analyze a linkage between the two. Finally, it brings out that inherent nature of the Indian markets and its constituents which will keep the market afloat despite the volatility and cyclicity.

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needed fuel for growth of the Indian economy. Our regulatory framework has strengthened as the financial system has become more and more complex.

A peep into the Indian mind

Let us try to understand the mindset of Indians. Why is it important? It is because a market thrives on people and their investments/buying and on what they think 4. And the people in In-dia believe in bargaining and saving intelligently i.e. frugality in general5. The savings rate in In-dia when compared to others is in general high-er.

As the stage for achieving an astounding growth has been set, the onus is on the financial market, to provide the much needed stimulus to the Indi-an Growth story. The ultimate aim of the Indian Financial market remains to empower every In-dian to achieve his dream by enabling him with judicious credit flows, astute financial guidance and an efficient investment mechanism.

India's saving rate has been uneven over the past four decades but has still shown substantial growth. Table 2 gives the domestic savings rate from year 2000. Just as the savings rate, the composition in the saving too has undergone a

4 Capital of Listed Cos. (Cr. Rs.)

270 753 1812 2614 3973 9723 32041 59583

5 Market value of Capital of Listed Cos. (Cr. Rs.)

971 1292 2675 3273 6750 25302 110279 478121

6 Capital per Listed Cos. (4/2) (Lakh Rs.)

24 63 113 168 175 224 514 693

7 Market Value of Capital per Listed Cos. (Lakh Rs.) (5/2)

86 107 167 211 298 582 1770 5564

8 Appreciated value of Capital per Listed Cos. (Lak Rs.)

358 170 148 126 170 260 344 803

considerable amount of change in India. On proper observation of the saving trend in India we can see that in the earlier years, household savings in the physical assets used to dominate the domestic saving in the country. But slowly the saving trend in India changed.

The current increase in the saving rate in India is mainly driven by the savings made by the finan-cial household. Financial institutions in India are currently making inroads into the rural areas and also there is an increase in the trend of easy ac-cessibility to other investment opportunities which is actually increasing the saving trend of India6. The knowledge of an average Indian re-garding the various tools of investment has in-creased in the past few decades, still the central and the most popular investment tool remains the fixed deposit schemes, insurance and postal deposits. A look at table 3 shows that Financial Saving in Indian households is predominated by Deposits with banks, followed by claims on Government and Insurance Funds. Moreover, an Indian average investor invests a lot more than what his American counterpart who would pre-fer to invest in various short term investment schemes than going for fixed returns scheme.

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Table 2: Gross domestic savings rate

Source: Economic Survey 2007-08

Table 3: Financial Saving of Household Sector (Gross) in India (2003-2004 to 2008-2009)

Period 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Savings rate 24.80% 23.70% 23.50% 26.40% 29.80% 31.80% 34.30% 34.80%

(Rs. in Crore) Item 2003-

04(P) 2004- 05(P)

2005- 06(P)

2006- 07

2007- 08(P)

2008- 09#

Financial Saving (Gross) 380090 435706 588656 650412 715994 746865 a) Currency 42675 36977 51954 66274 81278 93056 b) Deposits 145657 161416 278985 319385 374088 436710 i) With Banks 141973 158393 274704 311215 360727 409678 ii) With Non-banking Compa-nies

3803 3370 4567 1516 3751 13453

iii) With Cooperative Banks and Societies

-6 -134 -64 131 266 133

iv) Trade Debt (Net) -114 -213 -222 6523 9345 13446 c) Shares and Debentures 492 4967 29008 58598 89134 19349 i) Private Corporate Business 4275 6124 7851 23755 31565 31124 ii) Banking 111 263 290 206 766 995 iii) Units of Unit Trust of India -8586 -3146 -444 -310 -324 -2737 iv) Bonds of Public Sector un-dertakings

173 176 172 237 328 446

v) Mutual Funds (Other than UTI)

4519 1550 21139 34709 56799 -10478

d) Claims on Government 87372 106420 86755 19198 -28315 -23479 i) Investment in Government securities

28469 21313 14390 1654 -14714 -33879

ii) Investment in Small Savings, etc.

58903 85106 72364 17544 -13601 10400

e) Insurance Funds 52240 69572 83340 114851 128930 150337 i) Life Insurance Funds 49427 65577 79426 110965 124422 145876 ii) Postal Insurance 1098 1414 1215 2200 2729 2594 iii) State Insurance 1715 2581 2699 1686 1779 1868 f) Provident and Pension Funds 51655 56354 58615 72106 70878 70891 Memo: GDP at Market Prices (at cur-rent prices)

2760224 3121414 3531451 4129173 4723400 5321753

Risk and No risk India’s saving rate has grown substantially in the last few decades and its composition has also

changed. The table below shows the change in savings in the three tiers of the total savings.

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Source: Economic Survey 1999-2000

It can be seen from the above data that house-hold savings (individual, non-corporate business and private collectives) and private savings (joint stock companies and cooperative institu-tions) have increased at the expense of public savings which have declined by almost 109 times in percentage terms over a period of two decades. This has been aided by growth in con-sumerism and a liberalized environment (increased internal and foreign competition as well as FDI in various sectors).

Over a period of rising savings rate in the econo-my and household savings constituting more and more of the total pie, it is an obvious disad-vantage for a growing economy like India. In light of a further rise in savings rate caused by multiple factors in future, an obvious risk for the financial markets is apparent. More so, with the Indian psyche which is slightly risk averse and tends to favor savings as per the above distribu-tion, the apparent risk seems greater.

But, over the years, the composition of house-hold savings has undergone a transition. Earlier, savings in financial instruments dominated the savings in financial assets but at present, the trend has reversed and almost 52% of the house-hold savings are in physical properties as com-pared to 44% around the 1990s. But as the sav-ings rate has risen substantially, a fall of a few percentage points does not mean much of a re-duction. Infact, with an increase in household savings which may be held either in the form of liquid assets like currency bank deposits and gold or financial assets like shares, securities or policies, it indirectly helps as savings in these

Saving Mode Percentage

1980-81 1990-91 1998-99

Household saving 75.9 84.4 82.7

Private saving 8 11.5 17.2

Public Saving 16.2 4.2 0.15

modes finally find their way into the financial markets by investment bankers and traders. Thus, a part of the risk by higher savings is done away with.

Indian markets are thriving well because of the ability to mitigate the above risk by modes of savings which aid in doing so. This also forms the basis for optimism in future where a growing savings rate may prove to be a blessing in dis-guise: it fulfills the purpose of financial invest-ment prudence and also satisfies the investment needs of the economy.

So Why the Indian markets will not Fail

Indian investor population consists of a con-servative mix of people, dominated by risk averse individuals. Our financial institutions like RBI are known to be conservative amongst the various economies of the world. Although stock market is an important part of our financial sys-tem, the volatility does not truly reflect the fi-nancial soundness of the system. This can be inferred because of the observations which show that these short term investments are just a part of their robust and versatile project portfolio. According to Clarence Wong (Head- economic research and consulting, Asia at Swiss Re), “The fact that only around 10 per cent of Indians are covered by any form of pension scheme helps us understand the low financial risk tolerance of Indian respondents.”

These risk averse individuals along with a small-er percentage of risk lover population constitutes

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a healthy mix of investors for the country. The strength of well balanced investor population was tested during the recession and it is because of the prudence shown by the investors and reg-

ulators, Indian financial markets did not suc-cumb to the global recessionary waves and will continue to thrive successfully.

References 1. http://www.merriam-webster.com/netdict/market 2. https://www.rbfcu.org/NB/html/Investments/Dictionary_F.htm 3. http://useconomy.about.com/od/themarkets/a/capital_markets.htm 4. http://toostep.com/trends/investment-trends-in-india 5. http://www.nytimes.com/2008/12/18/world/asia/18iht-letter.html?_r=1 6. http:// finance. mapsofworld. Com / savings /india/rate.html 7. Salam, M. A., & Kulsum, U. (2000). Savings Behaviour in India: An Empirical Study. 8. Binswanger, H. P. (1980). Attitudes toward Risk: Experimental Measurement in Rural India. American Journal of Agricultural Economics,Vol. 62, No. 3 , 395-407. 9. Shetty, S. L., & Menon, K. A. (1980). Savings and Investment without Growth. Economic and Political Weekly, Vol. 15, No. 21 , 927-936 10. Ferrari, A., & Dhingra, I. S. (2008). India's Investment Climate : Voices of Indian Business. The World Bank 11. BUREAU, E. E. (2006, Feb 28). Story behind India’s savings, investment boom. Retrieved Jan 29, 2010, from The Indian Express: http://www.indianexpress.com/res/web/pIe/full_story.php?content_id=88731 12. Spastic Markets. (2005, July). Shareowner, 18(6), 5,22. Retrieved January 30, 2010, from ABI/INFORM Global. (Document ID: 865581741) 13. Berg, W. (2006). The Indian Stock Market. Retrieved Jan 29, 2010, from Ezine Articles: http://ezinearticles.com/?The-Indian-Stock-Market&id=118673 14. Vadlamannati, K. C. (2009). Indian Economic Reforms and Foreign Direct Investment: How Much Differ-ence Do they Make to Neighbours? South Asia Economic Journal 2009; 10; 31 , 31-59.

About the Authors Akanksha Verma is a Comp. Sc. Gold Medalist from SGSITS Indore. She has rich experience in the financial services division of USA. She has cleared the Level 1 FLMI Insurance certification. She is a writer and a poetess.

Shalin Gupta a Mech Engg Silver Medalist from Pantnagar Univ. possesses in-depth problem solving and quantitative skills. His stint with Maruti exposed him to operational and financial linkages. He is a guitarist and an active member of SPIC MACAY. Udayan Bhattacharya is an IT Engg from BMSCE Bangalore. He has worked with reputed clients across the world. He has a knack in financial modeling and has handled various aspects of project management. He is a ‘Sangeet Visharad’ and an excellent badminton player.

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Have you ever tried to find out what similarities do the financial instruments have with our day-to-day activities? Some might be wondering for the logic behind this question whereas some might say that it’s too obvious as the instru-ments are meant to take care of our day-to-day financial needs depending upon our incomes and risk taking capabilities. Let me put a more spe-cific question; what are the similarities between Fixed Income instruments and relationships in real life? Before you start guessing let me sim-plify the task by defining the two terms. By fixed income instruments, I mean those financial instruments that help you earn low but fixed re-turns on your investments thereby reducing your risk. The most well known example is bond. On the other hand by relationships, I mean those existing between a boy and a girl or a man and a woman. I am counting out relationships arising out of family ties, friendships or those existing between same sexes. In better words let’s limit ourselves to those relations that might culminate into marriages.

Any fin guy would tell you that fixed income is one of the most specific areas of finance. So, if you don’t aim to be an I-banker and thus intend to turn the page over, I would still request you to join me in this exploration. First of all, why the need for fixed income mar-ket exists? The answer is the need an alternative to the volatile equity markets. Aren’t relation-ships too aimed at helping you counter the va-garies of loneliness? They help in sharing happi-ness as well as sorrows thereby mitigating the upheavals in life thus mirroring the impact of debt markets on your returns. Let’s us now focus on the characteristics of a debt instrument say bond. The longer the maturity of the bond the more risks it entails so greater are our expecta-tions in terms of yields. On the same lines, a long-term relationship is much more demanding. If you still doubt me, ask any husband who has forgot his anniversary or wife’s birthday. On the other hand a short duration instrument like T-bill finds many takers even at low yields as in short term relationships that prosper because of low level of commitments. While looking for an analogy between source of bonds and motive behind relationships, on the basis of issuer, we can broadly classify bonds into two types; corporate and government with the offerings being named corporate bonds and G-Sec (government securities) respectively. Buying a G-Sec is like having a relationship with a guy or a girl whom you love as a person. Nothing else matters. The emotional security is valued more even if it comes at the cost of eco-nomic benefits akin to sovereign bonds where the government guarantee outscores low returns. On the other hand having a corporate bond in your portfolio is a sign that one is hoping to earn a little more than a normal debt instrument and so he is guided by the fundamentals of the issu-ing firm. At the same time, there are occasions

On Bonds And Bondings

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when you find a man or a woman falling for a partner because of features like his/her attractive looks or his/her bank balance. Though one bene-fits materialistically but they result in frequent break-ups due to incompatibilities as is the case with corporate bonds which have much higher rate of defaults. Some of you who have a Facebook (social net-working site) account would have come across the option of “it’s complicated” while filling your relationship status. In such complex rela-tionships one isn’t sure of the future prospects of the companionship. In short, they are indecisive and thus face a lot of anxiety. Similar is the case with complex instruments in debt market that enhance the risk attached to your investments as outcomes are very unpredictable. The advent of technology has impacted the markets as well as relationships. On one side virtual platforms like social networking sites, chat rooms etc. facilitate real life relationships and on the other hand we have dematerialised securities being traded on electronic avatars like NDS-OM (negotiated dealing systems-order matching) which is an electronic, screen based, anonymous, order driv-en trading system for dealing in G-Secs. Though NDS-OM brings transparency to the trading sys-tem but same can’t be said of the online relation-ships. How about money markets where banks trade with compatible lenders or borrowers in repo and call market to meet their short duration fi-nancing needs? Aren’t they desperate to meet

the CRR (credit reserve ratio) and SLR (statuary liquidity ratio) requirements? Can we find an analogy in the money markets for the disco-theque where guys and girls are desperate to let their hair down after a tiring day with a few dance rounds sometimes resulting in a few casu-al or serious relationships? I think we can. With DJ controlling the Disco through his set, it’s the RBI who makes the market participants dance to its tune in the money markets. And if you thought that only the fixed income market allows you to diversify through instru-ments of varying maturity and returns, think again. The Casanovas and the playboys have mastered the art long ago by romancing multiple beauties at a given time. By the way, aren’t relationships also known as bonds?


About the Author : Saket Saurabh is a 2nd year PGP student at IIM Calcutta. He holds a bachelors degree in Electronics and

Communication Engineering from National Institute of Technology, Patna. He can be reached at

[email protected]. He maintains a blog at http://saketvaani.blogspot.com


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Poker is a microcosm of all we admire and dis-dain about capitalism and democracy. It can be rough-hewn or polished, warm or cold, charita-ble and caring, or hard and impersonal, fickle and elusive, but ultimately it is fair, and right, and just. - Lou Krieger Have you ever had a chance to play a hand of poker? Did you ever think poker can be one of the best training grounds for wannabe traders? Increasing number of hedge funds and broker-age houses are looking to recruit from the most unusual of a talent pool – the poker players. There is a growing awareness that a great poker player has all the requisite skills that a success-ful financial trader needs: a calculated and ra-tional approach to risk, ability to take quick de-cisions under intense pressure, discipline and a good memory. Before we get into the litany of how poker helps in honing your skills as a trader, here is a quick snapshot of what poker is. Poker is a set of card games of which the most famous is the No-Limit Texas Hold ‘Em where each player is dealt two cards initially and a set of five ‘community’ cards is dealt on the table which is common to all the players. There are four rounds of betting – first, immediately after you are dealt the first two cards (called the pre-flop), second – after the first three community cards (called the flop) are dealt and the final two rounds of bet-ting after each of the fourth and the fifth card are dealt (called the turn and the river respectively). You can either check or bet or raise or call or fold at any point in the game. Information Asymmetry There is a substantial element of information asymmetry in a poker game. And that’s precise-ly the reason why poker is so hugely popular. You have a bit of information on the current hand and you need to solicit or deduce informa-

tion about your opponents’ hands. The more the information, the more the chances you will win. There are two ways to do it: You calculate the odds, the implied odds, and the probability of making your hand and go about in a logical and scientific manner as to how you play a given hand. The other is deducing information about your opponents – through his playing style, his betting pattern, his body language and the myri-ad other signals which he might be giving out even without his knowledge – and controlling your emotions. These two ways of eliciting in-formation and taking a decision are never re-warding, when practiced in isolation. In fact, it would suffice to say, you will never make money in the long run if you are extraordi-nary in one and come a cropper in the other. This article delves into the psychological issues involved in playing poker and likens it to the real-world trading decisions.

As Frank Murtha, a behavioral finance consult-ant puts it point-blank, “The stock market and Texas Hold ‘em are games of investing based on incomplete and unfolding information. The goal of each is to accumulate wealth by making deci-sions based on that information.” The best way to play a game of poker is to

Great Poker Players Make Great Traders, Or Do They?



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weigh the marginal cost and benefit, without considering past losses and gains and to treat each hand independently. In reality, past results do matter because players reassess the percep-tions of their skill levels and outcomes do have lasting psychological effects. There are five common psychological errors – Greed, Over-confidence, Regret, Seeing pat-terns, Holding on to losers. Greed The best cards to be dealt before the flop in pok-er are bullets (Two Aces). Probabilistically, this hand will win the most no. of times than any other two cards. The problem arises when you start counting the chickens even before they are hatched. Sure, a pocket aces is a great way to start a hand with. But there are so many ways your bullets could be busted as the hand pro-gresses. A typical instance is when three cards of the same suit, which is not of the suit of one of your aces, open on the flop, and the turn card also is of the same suit as the flop. The chances of a flush busting your bullets are extremely high. But you still keep betting or calling, at a point when you should be folding. The same happens so often in our portfolio when we bet and bet big on a stock which we think is a sure winner in the hope of a massive kill in a short time period. When there is unex-pected negative news about the company, we tend to remain rigid and not change our initial perceptions, popularly referred to as Bayesian Rigidity in behavioral finance parlance. The probability of winning big, even if the chances are ridiculously small, blinds us from the fact that this is the opportune time to quit. If only that one minute of rationality prevailed, you would have known the most obvious deci-sion in almost all the cases would be to quit. Or rather to fold and look for the next hand. If only, that is.

Over Confidence Over-confidence – Oh, that most ruining of feel-ings. Let’s say, you win a series of hands in your table, partly due to your adeptness and partly due to all your lucky stars in place. That’s when most, if not all, players tend to start ‘thinking’ they are better than what they ‘thought’ they were just a few hands earlier. That’s precisely the point when all hell starts breaking loose and you start playing rashly than you would normal-ly. What could have been a great killing, swiftly results in a position where your stack might even become smaller than it initially was. Not letting your emotions take control of you, and steadily playing the subsequent hands based solely on the merit of that individual hand is the blatantly evident ploy that should be employed. But trust me it’s infinitely more difficult to fol-low that day in and day out. Therein lies the dif-ference between a good player and a truly great player. In real world, overconfidence results in two tan-gible implications: Traders tend to make un-called for and unjustified bets based on their perceived ability to interpret information, when in actuality they do not have all the information to form unbiased projections. Secondly, traders tend to trade more frequently than can be justi-fied by the information. Regret Minimization In an investment framework, regret is the feeling in hindsight of making a bad decision. It is that “If only I had done that…” feeling that we get once in every while. In poker, there will be many a hand which you will feel, in hindsight, you should never have got in. You have a mar-ginal hand right from pre-flop and you keep on calling all your opponent’s bet till the river, only to find out to your dismay that he had, as ex-pected, a far better hand from the beginning and you had lost quite a bit of your chip stack in the process. The other case is when you had the best hand from the pre-flop stages till the turn, but



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your opponent forms a better hand right at the river. You curse yourself, if only I had bet a lit-tle more, he would have folded earlier. Many poker pros concede that the most difficult thing to master is the art of folding in poker. To call it quits when it ought to be quit. When fac-ing themselves in a situation where they have a feeling of regret, a large majority of players do either of the following two: They bet large even on very weak hands else they play so tightly that they don’t win as much as they could have, even on very good hands.

Contrast this to the real world. In behavioral fi-nance, regret minimization framework states that investors, in order to avoid the feeling of regret, tend to be too risk averse and stay put in safe instruments like bonds and bills leading to a lack of diversity in their portfolio. They also tend to stick on to profitable investments rather than sell it. Diametrically opposite is the case of an investor who, in order to reduce his regret levels, harps on to very risky investments hop-ing that the windfall from the new investments will offset his previous losses. Seeing patterns

Seeing patterns where none exists is another of the major emotional errors. A famous study by two professors – Werner DeBondt of DePaul University and Richard Thaler of the University of Chicago – showed that investors relying on past information and market return patterns be-came over-optimistic about past winners and over-pessimistic about past losers. But in reality the stock returns patterns never repeated. Holding onto losers According to behavioral finance, loss aversion refers to the individual’s reluctance to accept a loss. And when seen from the loss aversion framework, even though a stock might have come down considerably from its cost price, in-vestors tend to hold it, hoping that it will recov-er. Relate this to a poker player, who, even though on a losing spree, keeps taking re-buyins and keeps on playing hoping that he will win one big hand which will make up his losses. And, so goes on the search for that one elusive hand like those French searching eternally for that elusive Scarlet Pimpernel. Another instance in poker is when, even though you know you have a very weak hand, you still call your opponent’s bet for the sole reason that you have already invested so much in the pot in that particular hand. Whereas the logic of eco-nomics and sunk cost tells you that you need to fold, that god-forsaken ego of yours doesn’t al-low you to admit that you have taken a bad deci-sion and that you are losing. So what ensues? In majority cases, you refuse to accept that you are holding on to a losing hand and you keep on calling. Conclusion As poker pros often tell you, you should reward yourself on taking good decisions and not on winning huge pots. There will be times when the pot’s outcome is out of your control. As Stephen Covey would tell you, the pot’s outcome is your circle of concern, but taking good decisions and



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playing good poker is in your circle of control. ‘Bad beats’ are a way of life. You can’t pick winners all your life. But if your decisions are based on solid research, then you are bound to make money in the long run. Any smart player will know – the short run nev-er matters. It’s the long run which determines

how good a player or trader you are. And re-member, in the long run, the theory of probabil-ity is always true. Always. And as your Strategy Professor would have it, “Hope is never a strate-gy.”

References : http://economics-files.pomona.edu/GarySmith/PokerPlayers.pdf http://articles.chicagotribune.com/2010-01-31/news/1001280626_1_professional-poker-players-poker-face-poker-table http://www.kiplinger.com/features/archives/how-texas-hold-em-simulates-investing.htmlhttp://www.bloomberg.com/apps/news?pid=newsarchive&sid=alximP6.Eta8


About the Author : Sethu Chidambaram is a 2nd year PGP student at IIM Calcutta. He can be reached at [email protected]


Financial Crossword

Across 2.To assume financial responsibility for or guarantee against failure 6.A writedown in the valuation or return of an asset to partially forgive a debt 11.A psychological phenomenon whereby people do something primarily because other people are doing it 12.Recurring stream of fixed payments over a specified period of time 13.A trade where you borrow and pay interest in order to buy something else that has higher interest 14.To pledge securities as collateral for a loan when the same securities have already been pledged for another loan 16.A measurement of the income distribution of a coun-try's residents, helps define the gap between the rich and the poor 17.The gradual elimination of a liability, such as a mort-gage, in regular payments over a specified period of time 18.The synthetic collateralized debt obligation at the heart of SEC charges against Goldman Sachs 20.Degree of similarity between a given time series and a lagged version of itself over successive time intervals 21.An option with a built in mechanism to expire worth-less should a specified price level be exceeded

Down 1.A derivative security issued by the company that gives the holder the right to purchase securities from the issuer at a specific price within a certain time frame 3.When a parent company sells a portion or all of its inter-est in a subsidiary to the public in an IPO 4.A fund that tracks an index, but can be traded like a stock 5.A condition of slow economic growth and relatively high unemployment 7.The process of removing coupons from a bond and then selling the separate parts as a zero coupon bond and inter-est paying coupons 8.A procedure used to calculate the zero-coupon yield curve from market figures 9.The amount of benefit that is associated with physically owning a particular good, rather than owning a futures contract for that good 10.Instruments used by foreign investors or hedge funds that are not registered with the SEBI 15.A condition in which distant delivery prices for futures exceed spot prices 19."A financial product that offers you life insurance as well as an investment like a mutual fund "


Financial Crossword

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