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A

REPORT

ON

RECENT TRENDS

IN

CAPITAL MARKET

WHERE…..HIGHER THE RISK, HIGHER THE RETURN


Derivatives

Commodities whose value is derived from the price of some underlying

asset like securities, commodities, bullion, currency, interest level, stock

market index or anything else are known as ―Derivatives‖.

In more simpler form, derivatives are financial security such as an option

or future whose value is derived in part from the value and characteristics

of another security, the underlying asset.

It is a generic term for a variety of financial instruments. Essentially, this

means you buy a promise to convey ownership of the asset, rather than

the asset itself. The legal terms of a contract are much more varied and

flexible than the terms of property ownership. In fact, it‘s this flexibility

that appeals to investors.

When a person invests in derivative, the underlying asset is usually a

commodity, bond, stock, or currency. He bet that the value derived from

the underlying asset will increase or decrease by a certain amount within a

certain fixed period of time.

Importance of derivatives

There are several risks inherent in financial transactions. Derivatives are

used to separate risks from traditional instruments and transfer these risks

to parties willing to bear these risks. The fundamental risks involved in

derivative business includes:

Credit Risk:


This is the risk of failure of a counterparty to perform its obligation as per

the contract. Also known as default or counterparty risk, it differs with

different instruments.

Market Risk:

Market risk is a risk of financial loss as a result of adverse movements of

prices of the underlying asset/instrument.

Liquidity Risk:

The inability of a firm to arrange a transaction at prevailing market prices

is termed as liquidity risk. A firm faces two types of liquidity risks

1. Related to liquidity of separate products

2. Related to the funding of activities of the firm including derivatives.

Legal Risk:

Derivatives cut across judicial boundaries, therefore the legal aspects

associated with the deal should be looked into carefully.

Types of Derivatives:

‗Futures‘ and ‗options‘ are two commodity traded types of derivatives. An

‗options‘ contract gives the owner the right to buy or sell an asset at a set

price on or before a given date. On the other hand, the owner of a

‗futures‘ contract is obligated to buy or sell the asset.

The other examples of derivatives are warrants and convertible bonds

(similar to shares in that they are assets). But derivatives are usually

contracts. Beyond this, the derivatives range is only limited by the

imagination of investment banks. It is likely that any person who has

funds invested an insurance policy or a pension fund that they are


investing in, and exposed to, derivatives – wittingly or unwittingly.

Shares or bonds are financial assets where one can claim on another

person or corporation; they will be usually be fairly standardized and

governed by the property of securities laws in an appropriate country.

On the other hand, a contract is merely an agreement between two parties,

where the contract details may not be standardized.

Derivatives securities or derivatives products are in real terms contracts

rather than solid as it fairly sounds.

A. Future contracts:

Future contracts is an agreement made and traded on the exchange

between two parties to buy or sell a commodity at a particular time in the

future for a pre-defined price. Since both the parties are unaware of each

other, the exchange provides a mechanism to give the party assurance of

honored contract. The exchange specifies standardized features of the

contract. The risk to the holder is unlimited, and because the pay off

pattern is symmetrical, the risk to the seller is unlimited as well.

Money lost and gained by each party on a futures contract are equal and

opposite. In other words, a future trading is a zero-sum game. These are

basically forward contracts, meaning they represent a pledge to make a

certain transaction at a future date. The exchange of assets occurs on the

date specified in the contract. These are regulated by overseeing agencies,

and are guaranteed by clearing houses. Hedgers often trade futures for the

purpose of keeping price risk in check.

Future contracts are often used by commercial enterprises as ‗hedging

tools‘ to reduce the risk of expected future purchases or sales of the

underlying asset. If used to speculate, risk increases. So risk depends on

the underlying instrument and the use of the future.


Advantages of Futures Contracts:

1. If price moves are favorable, the producer realizes the

greatest return with this marketing alternative.

2. No premium charge is associated with futures market

contracts.

Disadvantages of Future Contracts:

1. Subject to margin calls

2. Unable to take advantage of favorable price moves

3. Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occur

in future. But Options are contract on the underlying futures contract

where as futures are either to accept or deliver the actual physical

commodity. To make a decision between using a futures contract or an

options contract, producers need to evaluate both alternatives.

B. Option contract:

Options Contract is a type of Derivatives Contract which gives the

buyer/holder of the contract the right (but not the obligation) to buy/sell

the underlying asset at a predetermined price within or at end of a

specified period. The buyer / holder of the option purchase the right from

the seller/writer for a consideration which is called the premium. The

seller/writer of an option is obligated to settle the option as per the terms

of the contract when the buyer/holder exercises his right. The underlying

asset could include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act, 1956 options on securities

has been defined as "option in securities" means a contract for the

purchase or sale of a right to buy or sell, or a right to buy and sell,

securities in future, and includes a teji, a mandi, a teji mandi, a galli, a

put, a call or a put and call in securities;


An Option to buy is called Call option and option to sell is called Put

option. Further, if an option that is exercisable on or before the expiry

date is called American option and one that is exercisable only on expiry

date, is called European option. The price at which the option is to be

exercised is called Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right to

exercise the option at anytime on or before the expiry date. This request

for exercise is submitted to the Exchange, which randomly assigns the

exercise request to the sellers of the options, who are obligated to settle

the terms of the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settled

by delivery of the underlying asset or cash. However, unlike futures cash

settlement in option contract entails paying/receiving the difference

between the strike price/exercise price and the price of the underlying

asset either at the time of expiry of the contract or at the time of exercise /

assignment of the option contract.

Index Futures and Index Option Contracts:

Futures contract based on an index i.e. the underlying asset is the index

are known as Index Futures Contracts. For example, futures contract on

NIFTY Index and BSE-30 Index. These contracts derive their value from

the value of the underlying index.

Similarly, the options contracts, which are based on some index, are

known as Index options contract. However, unlike Index Futures, the

buyer of Index Option Contracts has only the right but not the obligation

to buy / sell the underlying index on expiry. Index Option Contracts are

generally European Style options i.e. they can be exercised / assigned

only on the expiry date.

An index in turn derives its value from the prices of securities that

constitute the index and is created to represent the sentiments of the

market as a whole or of a particular sector of the economy. Indices that


represent the whole market are broad based indices and those that

represent a particular sector are sectoral indices.

In the beginning futures and options were permitted only on S&P Nifty

and BSE Sensex. Subsequently, sectoral indices were also permitted for

derivatives trading subject to fulfilling the eligibility criteria. Derivative

contracts may be permitted on an index if 80% of the index constituents

are individually eligible for derivatives trading. However, no single

ineligible stock in the index shall have a weight age of more than 5% in

the index. The index is required to fulfill the eligibility criteria even after

derivatives trading on the index has begun. If the index does not fulfill the

criteria for 3 consecutive months, then derivative contracts on such index

would be discontinued.

By its very nature, index cannot be delivered on maturity of the Index

futures or Index option contracts therefore, these contracts are essentially

cash settled on Expiry.

C. Forward contract:

In a forward contract, two parties agree to do a trade at some future date,

at a price and quantity agreed today. No money changes hands at the time

the deal is signed.

Features of Forward contract:

The main features of forward contracts are:

1. They are bilateral contracts and hence exposed to counter-party

risk.

2. Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

3. The contract price is generally not available in public domain.

4. The contract has to be settled by delivery of the asset on

expiration date.


In case, the party wishes to reverse the contract, it has to compulsorily go

to the same counter party, which being in a monopoly situation can

command the price it wants.

D. Swap Contract:

A swap is nothing but a barter or exchange but it plays a very important

role in international finance. A swap is the exchange of one set of cash

flows for another. A swap is a contract between two parties in which the

first party promises to make a payment to the second and the second party

promises to make a payment to the first. Both payments take place on

specified dates. Different formulas are used to determine what the two

sets of payments will be.

Classification of swaps is done on the basis of what the payments are

based on.

The different types of swaps are as follows.

Interest rate swaps

Currency Swaps

Commodity swaps

Equity swaps

Structure of Derivative Markets in India:

Derivative trading in India takes can place either on a separate and

independent Derivative Exchange or on a separate segment of an

existing Stock Exchange. Derivative Exchange/Segment function as a

Self-Regulatory Organization (SRO) and SEBI acts as the oversight


regulator. The clearing & settlement of all trades on the Derivative

Exchange/Segment would have to be through a Clearing

Corporation/House, which is independent in governance and

membership from the Derivative Exchange/Segment.

various membership categories in the derivatives market:

The various types of membership in the derivatives market are as

follows:

Trading Member (TM) – A TM is a member of the

derivatives exchange and can trade on his own behalf and

on behalf of his clients.

Clearing Member (CM) –These members are permitted to

settle their own trades as well as the trades of the other non-

clearing members known as Trading Members who have

agreed to settle the trades through them.

Self-clearing Member (SCM) – A SCM are those clearing

members who can clear and settle their own trades only.

Requirements to be a member of the derivatives exchange/ clearing

corporation:

o Balance Sheet Net worth Requirements: SEBI has

prescribed a net worth requirement of Rs.3crores for clearing

members. The clearing members are required to furnish an

auditor's certificate for the net worth every 6 months to the

exchange. The net worth requirement is Rs.1crore for a self-


clearing member. SEBI has not specified any net worth

requirement for a trading member.

o Liquid Net worth Requirements: Every clearing member

(both clearing members and self-clearing members) has to

maintain atleast Rs. 50 lakhs as Liquid Networth with the

exchange / clearing corporation.

o Certification requirements: The Members are required to

pass the certification programme approved by SEBI. Further,

every trading member is required to appoint at least two

approved users who have passed the certification programme.

Only the approved users are permitted to operate the

derivatives trading terminal.

Derivative contracts are permitted by SEBI

Derivative products have been introduced in a phased manner starting

with Index Futures Contracts in June 2000. Index Options and Stock

Options were introduced in June 2001 and July 2001 followed by Stock

Futures in November 2001. Sectoral indices were permitted for

derivatives trading in December 2002. Interest Rate Futures on a notional

bond and T-bill priced off ZCYC have been introduced in June 2003 and

exchange traded interest rate futures on a notional bond priced off a

basket of Government Securities were permitted for trading in January

2004.

Requirements for a FII and its sub-account to invest in derivatives

A SEBI registered FIIs and its sub-account are required to pay initial

margins, exposure margins and mark to market settlements in the

derivatives market as required by any other investor. Further, the FII and

its sub-account are also subject to position limits for trading in derivative

contracts. The FII and sub-account position limits for the various

derivative products are as under:


Index

Options

Index

Futures

Stock

Options

Single

stock

Futures

Interest

rate

futures

FII

Level

Rs. 250

crores or

15% of

the OI in

Index

options,

whichever

is higher.

In

addition,

hedge

positions

are

permitted.

Rs. 250

crores or

15% of

the OI in

Index

futures,

whichever

is higher.

In

addition,

hedge

positions

are

permitted.

20% of

Market

Wide Limit

subject to a

ceiling of

Rs. 50

crores.

20% of

Market

Wide Limit

subject to a

ceiling of

Rs. 50

crores.

Rs. USD

100

million.

In addition

to the

above, the

FII may

take

exposure

in

exchange

traded in

interest

rate

derivative

contracts

to the

extent of

the book

value of

their cash

market

exposure

in

Governme

nt

Securities.

Sub-

accou

nt

level

Disclosure

requireme

nt for any

person or

persons

Disclosure

requireme

nt for any

person or

persons

1% of free

float

market

capitalizati

on or 5% of

1% of free

float

market

capitalizati

on or 5% of

Rs. 100 Cr

or 15% of

total open

interest in

the market


acting in

concert

holding

15% or

more of

the open

interest of

all

derivative

contracts

on a

particular

underlying

index

acting in

concert

holding

15% or

more of

the open

interest of

all

derivative

contracts

on a

particular

underlying

index

open

interest on

a particular

underlying

whichever

is higher

open

interest on

a particular

underlying

whichever

is higher

in

exchange

traded

interest

rate

derivative

contracts,

whichever

is higher.

Measures have been specified by SEBI to protect the rights of

investor in Derivatives Market:

The measures specified by SEBI include:

o Investor's money has to be kept separate at all levels and is

permitted to be used only against the liability of the Investor

and is not available to the trading member or clearing member

or even any other investor.

o The Trading Member is required to provide every investor

with a risk disclosure document which will disclose the risks

associated with the derivatives trading so that investors can

take a conscious decision to trade in derivatives.

o Investor would get the contract note duly time stamped for

receipt of the order and execution of the order. The order will

be executed with the identity of the client and without client

ID order will not be accepted by the system. The investor

could also demand the trade confirmation slip with his ID in


support of the contract note. This will protect him from the

risk of price favour, if any, extended by the Member.

o In the derivative markets all money paid by the Investor

towards margins on all open positions is kept in trust with the

Clearing House/Clearing corporation and in the event of

default of the Trading or Clearing Member the amounts paid

by the client towards margins are segregated and not utilised

towards the default of the member. However, in the event of a

default of a member, losses suffered by the Investor, if any, on

settled / closed out position are compensated from the Investor

Protection Fund, as per the rules, bye-laws and regulations of

the derivative segment of the exchanges.

o The Exchanges are required to set up arbitration and investor

grievances redressal mechanism operative from all the four

areas / regions of the country.

COMMODITY:

Any product that can be used for commerce or an article of commerce

which is traded on an authorized commodity exchange is known as

commodity. The article should be movable of value, something which is

bought or sold and which is produced or used as the subject or barter or

sale. In short commodity includes all kinds of goods. Forward Contracts

(Regulation) Act (FCRA), 1952 defines ―goods‖ as ―every kind of

movable property other than actionable claims, money and securities‖.

In current situation, all goods and products of agricultural (including

plantation), mineral and fossil origin are allowed for commodity trading

recognized under the FCRA. The national commodity exchanges,

recognized by the Central Government, permits commodities which

include precious (gold and silver) and non-ferrous metals; cereals and

pulses; ginned and un-ginned cotton; oilseeds, oils and oilcakes; raw jute

and jute goods; sugar and gur, potatoes and onions; coffee and tea; rubber

and spices. Etc.


Different dictionary defines “commodity” as under:

Any item that can be bought and sold. Taken to refer to Exchange –

traded items including sugar, wheat, soya beans, coffee and tin.

That which affords convenience, advantage, or profit, especially in

commerce, including everything movable that is bought and sold (except

animals), -- goods, wares, merchandise, produce of land and

manufacturesetc.

In the world of business, a commodity is an undifferentiated product

whose market value arises from the owner‘s right to sell rather than to

use. Example commodities from the financial world include oil (sold by

the barrel), wheat, bulk chemicals such as sulfuric acid and even pork-

bellies.

Examples of Commodity Futures: Wheat

Cotton

Pepper

Turmeric

Corn

Oats

Soybeans

Orange juice

Crude oil

Natural gas

Gold

Silver

Pork bellies, etc.

Examples of Financial Futures:

Treasuries

Bonds


Stocks

Stock-index

Foreign exchange

Euro-dollar

Deposits, etc.

COMMODITY EXCHANGES

There are three categories:

1. NCDEX

2. MCX

3. NMCEIL

A brief description of commodity exchanges are those which trade in

particular commodities, neglecting the trade of securities, stock index

futures and options etc.

In the middle of 19th century in the United States, businessmen began

organizing market forums to make the buying and selling of commodities

easier. These central marketplaces provided a place for buyers and sellers

to meet, set quality and quantity standards, and establish rules of

business.

Agricultural commodities were mostly traded but as long as there are

buyers and sellers, any commodity can be traded. In 1872, a group of

Manhattan dairy merchants got together to bring chaotic condition in New

4.


York market to a system in terms of storage, pricing, and transfer of

agricultural products.

In 1933, during the Great Depression, the Commodity Exchange, Inc.,

was established in New York through the merger of four small exchan ges

– the National Metal Exchange, the Rubber Exchange of New York, the

National Raw Silk Exchange, and the New York Hide Exchange.

The major commodity markets are in the United Kingdom and in the

USA. In india there are 25 recognized future exchanges, of which there

are three national level multi-commodity exchanges. After a gap of almost

three decades, Government of India has allowed forward transactions in

commodities through Online Commodity Exchanges, a modification of

traditional business known as Adhat and Vayda Vyapar to facilitate better

risk coverage and delivery of commodities.

The three exchanges are:

1. National Commodity & Derivatives Exchange Limited (NCDEX)

2. Multi Commodity Exchange of India Limited (MCX)

3. National Multi-Commodity Exchange of India Limited (NMCEIL)

All the exchanges have been set up under overall control of Forward

Market Commission (FMC) of Government of India.

National Commodity & Derivatives Exchange Limited (NCDEX)

National Commodity & Derivatives Exchange Limited (NCDEX) located

in Mumbai is a public limited company incorporated on April 23, 2003

under the Companies Act, 1956 and had commenced its operations on

December 15, 2003.This is the only commodity exchange in the country

promoted by national level institutions.


It is promoted by ICICI Bank Limited, Life Insurance Corporation of

India (LIC), National Bank for Agriculture and Rural Development

(NABARD) and National Stock Exchange of India Limited (NSE). It is a

professionally managed online multi commodity exchange. NCDEX is

regulated by Forward Market Commission and is subjected to various

laws of the land like the Companies Act, Stamp Act, Contracts Act,

Forward Commission (Regulation) Act and various other legislations.

Multi Commodity Exchange of India Limited(MCX)

Headquartered in Mumbai Multi Commodity Exchange of India Limited

(MCX), is an independent and de-mutulised exchange with a permanent

recognition from Government of India. Key shareholders of MCX are

Financial Technologies (India) Ltd., State Bank of India, Union Bank of

India, Corporation Bank, Bank of India and Canara Bank. MCX facilitates

online trading, clearing and settlement operations for commodity futures

markets across the country.

MCX started offering trade in November 2003 and has built strategic

alliances with Bombay Bullion Association, Bombay Metal Exchange,

Solvent Extractors‘ Association of India, Pulses Importers Association

and Shetkari Sanghatana.

National Multi-Commodity Exchange of India Limited (NMCEIL)

National Multi Commodity Exchange of India Limited (NMCEIL) is the

first de-mutualized, Electronic Multi-Commodity Exchange in India. On

25th July, 2001, it was granted approval by the Government to organise

trading in the edible oil complex. It has operationalised from November

26, 2002. It is being supported by Central Warehousing Corporation Ltd.,

Gujarat State Agricultural Marketing Board and Neptune Overseas

Limited. It got its recognition in October 2000.

Commodity exchange in india plays an important role where the prices of


any commodity are not fixed, in an organized way. Earlier only the buyer

of produce and its seller in the market judged upon the prices. Others

never had a say. Today, commodity exchanges are purely speculative in

nature. Before discovering the price, they reach to the producers, end-

users, and even the retail investors, at a grassroots level. It brings a price

transparency and risk management in the vital market.

A big difference between a typical auction, where a single auctioneer

announces the bids, and the Exchange is that people are not only

competing to buy but also to sell. By Exchange rules and by law, no one

can bid under a higher bid, and no one can offer to sell higher than

someone else‘s lower offer. That keeps the market as efficient as possible,

and keeps the traders on their toes to make sure no one gets the purchase

or sale before they do.

FOREIGN DIRECT INVESTEMENTS:

MEANING:

Foreign direct investment (FDI) is the movement of capital across national

frontiers in a manner that grants the investor control over the acquired asset. Thus it

is distinct from portfolio investment which may cross borders, but does not offer

such control. Firms which source FDI are known as ‗multinational enterprises‘

(MNEs). In this case control is defined as owning 10% or greater of the ordinary

shares of an incorporated firm, having 10% or more of the voting power for an

unincorporated firm or development of a greenfield branch plant that is a permanent

establishment of the originating firm.

Types of FDI:

Greenfield investment: Direct investment in new facilities or the expansion

of existing facilities. Greenfield investments are the primary target of a host

nation‘s promotional efforts because they create new production capacity and

jobs, transfer technology and know-how, and can lead to linkages to the global

marketplace. Greenfield investments are the principal mode of investing in

developing countries.

Mergers and Acquisitions: Occur when a transfer of existing assets from

local firms to foreign firms takes place. Cross-border mergers occur when the


assets and operation of firms from different countries are combined to

establish a new legal entity. Cross-border acquisitions occur when the control

of assets and operations is transferred from a local to a foreign company, with

the local company becoming an affiliate of the foreign company. Mergers and

acquisitions are the principal mode of investing in developed countries.

Foreign Direct Investment (FDI) is permited as under the following forms of

investments.

Through financial collaborations.

Through joint ventures and technical collaborations.

Through capital markets via Euro issues.

Through private placements or preferential allotments.

Forbidden Territories:

FDI is not permitted in the following industrial sectors:

Arms and ammunition.

Atomic Energy.

Railway Transport.

Coal and lignite.

Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds,

copper, zinc.

Foreign Investment through GDRs (Euro Issues):

Foreign Investment through GDRs is treated as Foreign Direct Investment

Indian companies are allowed to raise equity capital in the international market

through the issue of Global Depository Receipt (GDRs). GDRs are designated in

dollars and are not subject to any ceilings on investment. An applicant company

seeking Government's approval in this regard should have consistent track record for

good performance (financial or otherwise) for a minimum period of 3 years. This


condition would be relaxed for infrastructure projects such as power generation,

telecommunication, petroleum exploration and refining, ports, airports and roads.

Potential for investment in India:

The Government is focusing on expansion and modernization of roads and has

opened this up for private sector participation. 48 new road projects worth

US$ 12 billion are under construction. Development and upgradation of roads

will require an investment of US$ 24 billion till 2008. Private sector

participation in road projects will grow significantly.

The Government has announced ambitious plan to add around 1,00,000 MW

of additional generation capacity by the year 2012. To attract private

investment of such magnitude, Govt. of India had taken various steps to

provide for an adequate administrative & legal framework.

Special incentives and tax-breaks are given for certain sectors such as power,

electronics, telecom, software, hydrocarbons, R&D and exports.

The railway sector will need an investment of US$ 22 billion for new coaches,

tracks, and communications and safety equipment over the next ten years. A

10 year Corporate Safety Plan of the Indian Railways envisaging an

expenditure of US $ 7.24 bn. besides development of appropriate technology

for higher level of safety in train operation. Metro Rail Corporation projects

worth US $ 12.84 bn in cities like Delhi, Bangalore, Hyderabad, Chennai,

Ahmedabad and many other cities are on target.

The Union railway minister projected a requirement of Rs 40.92bn for

important railway projects in the North East and Jammu and Kashmir, mega

bridge projects at Bogibeel in Assam, Munger bridge over Ganga, Patna

bridge over Ganga and Kosi bridge as well as for the Sudoor Gram Sampark

Yojana.

Upgradation and modernization of airports will require US$ 33 billion

investment in the next ten years. Airports Authority of India has set a target of

investing 1 billion dollars for modernization of airports.

There is potential for investment in the expansion and modernization of ports,

inland navigation and maritime transport. The Government has taken up the

US$ 22 billion 'Sagarmala' project to develop the Port and Shipping sector

under Public-Private Partnership. 100 percent FDI is permitted for

construction and maintenance of ports. The Government is offering incentives

to investors. While the government will take care of 15% of the investment,

the rest will come from the private sector.


The investment requirements in the maritime sector are estimated at US$22

billion.

The Ministry of Power has formulated a blueprint to provide reliable,

affordable and quality power to all users by 2012. This calls for investment of

US$ 73 billion in the next five years. Opportunities are there for investment in

power generation and distribution and development of non-conventional

energy sources.

There is potential for investment in urban infrastructure projects. Water

supply and sanitation projects alone offer scope for annual investment of US$

5.71 billion.

The entire gamut of exploration, production, refining, distribution and retail

marketing in the oil & gas sector presents opportunities for FDI.

India has an estimated 85 billion tons of mineral reserves remaining to be

exploited. Potential areas for exploration ventures include gold, diamond,

copper, lead, zinc, cobalt, silver, tin etc. There is also scope for setting up

manufacturing units for value added products.

The telecom market, which is one of the world's largest and fastest growing,

has an investment potential of US$ 20-25 billion over the next five years. The

telecom market turnover is expected to increase from US$ 10 billion in 2004

to US$ 13 billion by 2007.

The IT industry and IT-enabled services, which are rapidly growing offer

opportunities for FDI.

India has emerged as an important venue for the services sector including

financial accounting, call centers, and business process outsourcing. There is

considerable potential for growth in these areas.

Biotechnology and Bioinformatics, which are on Government's priority list for

development, offer scope for FDI. The industry has crossed $I billion dollar

mark, with a growth rate of 36.55%.

The Indian Auto component industry, currently estimated at US $63 billion

industry, is expected to "triple" in less than eight years time to US $17 billion

by 2012.The Indian auto industry with a turnover of US $ 12 billion and the

auto parts industry with a turnover of US$ 3 billion offer scope for FDI.

The Government is encouraging the establishment of world-class integrated

textile complexes and processing units.


In India the Food Processing Industry is relatively nascent and offers

opportunities for FDI. It accounts for Rs 1,280 billion (US$29.4 billion), in a

total estimated market of Rs 3,990 billion (US$91.66 billion). There is a

rapidly increasing demand for processed food caused by rising urbanization

and income levels. To meet this demand, the investment required is about

US$28 billion. Food processing has been declared a priority sector.

The outlay in the Food Processing Sector has been increased from US$19.5

million in 2004-05 to US$41.35 million the next year, more than twice the

earlier amount. The government is also considering investing US$22.97

million in at least 10 mega food parks in the country besides working towards

offering 100 per cent foreign direct investment and income tax benefits in the

sector.

The Healthcare industry is expected to increase in size from its current US$

17.2 billion to US$ 40 billion by 2012. Healthcare spending in the country

will double over the next 10 years. Private healthcare will form a large chunk

of this spending, rising from Rs 690 billion ($14.8 billion) to Rs 1,560 billion

($33.6 billion) in 2012. This figure could rise by additional Rs 390 billion

($8.4 billion) if health insurance cover is available to the rich and the middle

class.

With the expected increase in the pharmaceutical market, the total healthcare

market could rise from Rs 1,030 billion ($22.2 billion) currently (5.2 percent

of GDP) to Rs 2,320 billion ($50 billion)-Rs 3,200 billion ($69 billion) (6.2-

8.5 percent of GDP) by 2012.

The Government has recently established Special Economic Zones with the

purpose of promoting exports and attracting FDI. These SEZs do not impose

duty on imports of inputs and they enjoy simplified fiscal and foreign

exchange procedures and allow 100% FDI.

The travel and tourism industry, which has grown to a size of US$ 32 billion,

offers scope for investment in hotels, resorts and tourism infrastructure.

Foreign Investment - Policies and Procedures:

India's Foreign Investment policies and procedures are simple, transparent and

investor friendly.

The Common Minimum Programme of the Government states that, "FDI will

continue to be encouraged and actively sought particularly in areas of


infrastructure, high technology and exports where local assets and

employment are created on a significant scale. The country needs and can

easily absorb at least two to three times the present level of FDI inflows".

Foreign investment can be freely channeled into all sectors except for the

following sectors: retail trade, agriculture (excluding floriculture, horticulture,

development of seeds, animal husbandry, pisciculture & cultivation of

vegetables, mushrooms etc. under controlled conditions and services related to

agro & allied sectors), plantations (other than tea plantations), atomic energy,

gas pipelines, courier services, trading and lottery and gambling. In most of

the sectors, foreign investors can go through the Automatic Route without

need for any approvals. The investor has to merely keep the Reserve Bank of

India informed of the flow of funds and issue of shares.

Maximum limits on foreign investment in some sectors are being

progressively liberalized, eg: telecommunications (74%), insurance (26%),

banking (74%), mining (74%) aviation (49%), defence equipment (26%),

cable networks (49%), trading (51%), print media (26%) and small-scale

industries (24%). FDI in excess of 24% is permitted in small-scale industry

with 50% export obligation.

100% FDI is allowed in non news publications, which means all foreign non-

news scientific, technical, specialty magazines, periodicals and journals are

allowed to be published and sold throughout the country.

Retail Trading is permitted under automatic route with FDI up to 51%

provided it is in primarily in export activities, and the undertaking is an export

house/trading house/super trading house/star trading house.

Wholesale trading activity is allowed subject to prior approval of Foreign

Investment Promotion Board (FIPB).

The Government has decided to allow FDI up to 100% under the automatic

route in townships, housing, built-up infrastructure and construction-

development projects (which would include, but not be restricted to, housing,

commercial premises, hotels, resorts, hospitals, educational institutions,

recreational facilities, city and regional level infrastructure), subject to the

following guidelines. Minimum area to be developed under each project

would be as under:

o In case of development of serviced housing plots, a minimum land area

of 10 hectares

o In case of construction-development projects, a minimum builtup area

of 50,000 sq.mts


o In case of a combination project, anyone of the above two conditions

would suffice

In respect of the companies in infrastructure sector, where there is a

prescribed cap for foreign investment, only the direct investment will be

considered for the prescribed cap and the foreign investment in an investing

company will not be set off against this cap provided the foreign direct

investment in such investing company does not exceed 49 % and the

management of the investing company is with the Indian owners. The

automatic route is not available.

Prior approval of the Government is needed in those cases, which require

industrial license (examples: alcoholic beverages, cigarettes, defence

equipments, gunpowder and hazardous chemicals) and those involving

investment beyond the maximum limits. Such cases are cleared by the Foreign

Investment Promotion Board in a transparent, efficient, time-bound and

predictable manner. The FIPB meets once a week.

The Department of Industrial Policy and Promotion is the nodal agency for

information and assistance to foreign investors. Their website

www.dipp.nic.in has comprehensive information for foreign investors and

gives weekly updates on proposals for foreign investment under consideration.

It also gives information on projects available for foreign investors and

contains online applications for clearances.

The various State Governments in India extend incentives and competitive

offers to foreign investors.

Intellectual Property Rights Laws of India are well on track with the rest of

the world.

Full capital account convertibility is allowed for foreign investors.

FOREIGN INVESTMENT SUMMARY:

In the April - August period of 2005-06 total FDI jumped to 2302 $ million

about 156% rise over the previous year.

Foreign Investment Inflows for the period April - August 2005-06 stood 6,369

million US$ (Direct investment + Portfolio investment).


The Economic Times of India (Dec 9th, 2005) featured the news: India has

emerged stronger on the global investment radar in 2005, overtaking the

United States to become the second-most attractive FDI destination in the

world. An annual survey of executives from the world's largest companies

ranked India second only to China in the FDI attractiveness ranking, scoring

1.951 on a scale of 0-3.

MNCs, which have invested in India include GE, Dupont, Eli Lily, Monsanto,

Caterpillar, GM, Hewlett Packard, Motorola, Bell Labs, Daimler Chrysler,

Intel, Texas Instruments, Cummins, Microsoft, IBM, Toyota, Mitsubishi,

Samsung, LG, Novartis, Bayer, Nestle, Coca Cola and McDonalds.

FII investments in India touched a record US$9.05bn (on a net basis) on

December 12, 2005. This is higher than the '04 figure of US$8.4bn. Foreign

funds have been pouring in huge sums of money into the Indian market over

the past three years.

They have pumped in over US$23bn over the past three years as India is

emerging as a major investment destination for both US and Asian investors.

FIIs bought shares worth US$ 862.94 million in the first quarter (April-June

05) and US$ 3.73 bn worth shares in the second quarter (July-September

2005).

A BS Research Bureau study, based on BSE-500 index companies, shows that

FIIs bought 803 million shares in April-September 2005.

Between January 5 and February 14, 2005, FIIs invested more in Indian

equities than in Korean or Taiwanese equities. While the Korean market

received over US$1 billion, Taiwan had US$947 million, India's share

amounted to US$1.1 billion.

Companies that have seen a major jump in FII holding include TASC Pharma

(22.3%), IFSL (16.3%), Shringar Cinema (14%), S Kumar Nationwide

(13.35%), Four Soft (11.9%), Alok Industries (11%) and Sesa Goa (10%).

Bill Gates, Chairman of Microsoft Corp, the world's largest software

company, said that the company will invest US$ 1.7 billion in India over the

next four years to expand its operations.

The IT sector saw phenomenal growth in FDI in 2005 with $6.5 billion of

investment. The total investment in IT bypassed the India's ITeS exports in

2004 ($5.7 billion) and was 48.3% of total IT exports.


Sector caps and entry routes (as on 26 February 2006)

A. Infrastructure

B. Services

C. Manufacturing

D. Resources Based Sectors

E. Knowledge Economy

A. Infrastructure:

Sector Ownership

Limit

Entry

Route Remarks

Power 100% Automatic

Includes

generation

(except nuclear

power where

FDI is

prohibited),

transmission

and distribution

of power

Telecom

Basic, cellular and

value-added services 74%

ISP with gateways 74%

FIPB

beyond

49%

ISP without gateways 100%

FIPB

beyond

49%

http://www.investmentcommission.in/sector.htm#a

http://www.investmentcommission.in/sector.htm#b

http://www.investmentcommission.in/sector.htm#c

http://www.investmentcommission.in/sector.htm#d

http://www.investmentcommission.in/sector.htm#e


Email, Voice mail 100%

FIPB

beyond

49%

Subject to

licensing and

security

requirements;

FDI cap of 74%

for global

mobile personal

communications

by satellite

Radio Paging 74%

FIPB

beyond

49%

End-to-End

Bandwidth 74%

FIPB

beyond

49%

Infrastructure

Providers providing

Dark Fibre

100%

FIPB

beyond

49%

Telecom

Manufacturing 100% Automatic

Roads 100% Automatic

Includes

construction

and

maintenance of

roads,

highways,

bridges and

tunnels

Ports 100% Automatic

Applies to

construction

and

maintenance of

ports

Civil Aviation


Airports 100%

FIPB

beyond

74%

100% FDI

under automatic

route is

permissible for

greenfield

airports.

Domestic Airlines 49% Automatic

Subject to no

direct or

indirect equity

participation by

foreign airlines.

FDI up to 100%

allowed for

NRIs

Petroleum &

Natural Gas

Petroleum refining 100% Automatic

Petroleum product

pipelines 100% Automatic

Petroleum product

marketing 100% Automatic

Subject to

divestment of

26% equity in

favour of the

Indian partner /

public within 5

years.

Petroleum refining-

PSUs 26% FIPB

Others

Mass Rapid Transport

System 100% Automatic

Includes

associated real

estate

development in

all metropolitan


cities

EOU/SEZ/Industrial

park construction 100% Automatic

Subject to SEZ

Act 2005 and

Foreign Trade

Policy.

Satellite

establishment and

operation

74% FIPB

B. Services:

Sector Ownership

Limit

Entry

Route Remarks

Banking

Indian Private Banks 74% Automatic

Foreign banks

can take an

equity stake of

more than 5%

(up to 74%)

only in the

private sector

banks which

have been

identified by

the RBI for

restructuring

PSU Banks 20%

Subject to

compliance

with RBI

guidelines

NBFCs 100% Automatic

Includes 19

specified

activities;

Subject to

minimum

capitalisation


norms and

compliance

with RBI

guidelines

Insurance 26% Automatic

Includes both

Life and Non-

Life Insurance;

Subject to

licence from

Insurance

Regulatory &

Development

Authority

Real estate and construction Subject to

minimum land

area of 10

hectare for

serviced

housing plot

and built-up

area of 50,000

sq. mts. for

construction

development

projects. Also

minimum

capitalisation

and completion

norms

Townships 100% Automatic

Housing 100% Automatic

Construction – Development

Projects 100% Automatic

Build-up Infrastructure 100% Automatic

Trading

Retail Trade 51% FIPB Only for single

brand products

Trading (Export House, Super

Trading House, Star Trading

House)

51% Automatic

Trading (Export, Cash and Carry

Wholesale) 100% FIPB

Tourism

Hotels, restaurants, beach resorts 100% Automatic Includes


facilities for

providing

accommodation

and food

services

Tour and travel agencies 100% Automatic

Broadcasting

TV software production 100%

Subject to

maximum

foreign equity

up to 49%

including

FDI/NRI/FII

Hardware facilities - (Uplinking,

HUB, etc.) 49%

Subject to

maximum

foreign equity

up to 49%

including

FDI/NRI/FII;

FDI in news

and current

affairs channels

which uplink

from India is

capped at 26%

Cable network 49%

Subject to

maximum

foreign equity

up to 49%

including

FDI/NRI/FII

DTH 20%

Subject to

maximum

foreign equity

upto 49%

including

FDI/NRI/FII.

FDI not to

exceed 20%

Terrestrial Broadcast FM 20% Subject to


licensee being a

company

registered in

India under the

Companies Act,

1956

Terrestrial TV Broadcast Not

Permitted

Print Media

Scientific/Technical journals 100%

Other non-news/non-current

affairs/specialty publications 74%

Newspapers, Periodicals dealing

with news and current affairs 26%

Other Services

Advertising and Film 100% Automatic

Includes all

film related

activities

Courier services 100% FIPB

Includes all

postal services

except the

distribution of

letters

Lottery, Betting and Gambling Not

Permitted —

Defence and Strategic Industries 26% FIPB

Subject to

security and

licensing

requirement; to

be sold

primarily to the

Ministry of

Defence

R&D activities 100% Automatic

C. Manufacturing:


Sector Ownership

Limit

Entry

Route Remarks

Metals 100% Automatic

Includes

manufacture

of Steel,

Aluminium

etc.

Textiles and Garments 100% Automatic

Electronics Hardware 100% Automatic

Chemicals and Plastics 100% Automatic Includes

plastics

Automobiles 100% Automatic

Includes

Two -

wheelers,

Cars and

Commercial

Vehicles

Auto Components 100% Automatic

Gems and Jewellery 100% Automatic

Food and Agro Products

Food Processing 100% Automatic

Agriculture (including contract

farming)

Not

Permitted -

Plantations (except Tea) Not

Permitted -

Other Manufacturing

Items reserved for Small Scale 24% Automatic

100% FDI

permitted

through

FIPB route

subject to

undertaking

of export

obligation

of 50%


D. Resources Based Sectors:

Sector Ownership

Limit Entry Route Remarks

Coal and Lignite

Coal Processing 100% Automatic up to

50%

Captive Coal mining 100% Automatic

Subject to

provision of

Coal Mines

(Nationalisation)

Act 1973.

Other Mining and

Quarrying

Mineral Ores 100% Automatic

Including Gold,

Silver and other

mineral ores

Diamonds and precious

stones 100% Automatic

Atomic Minerals 74% FIPB

Includes only

mining, mineral

separation and

subsequent

value addition

Oil and Natural Gas

Exploration 100% Automatic

E. Knowledge Economy:

Sector Ownership

Limit

Entry

Route Remarks

Pharma and Biotech 100% Automatic

FIPB route is needed

if industrial licence

is required or

involves


recombinant DNA

technology,

cell/tissue

formulations

Healthcare 100% Automatic

Information Technology 100% Automatic


Foreign Institutional Investor - FII

An investor or investment fund that is from or registered in a country outside of the

one in which it is currently investing. Institutional investors include hedge funds,

insurance companies, pension funds and mutual funds.

The term is used most commonly in India to refer to outside companies investing in

the financial markets of India. International institutional investors must register with

the Securities and Exchange Board of India to participate in the market. One of the

major market regulations pertaining to FIIs involves placing limits on FII ownership

in Indian companies.

Net FII inflows into India increased steadily through the decade of the 1990s to

reach an annual peak of US$10.25 billion in 2004-05. Cumulatively, FII investments

as on October 31, 2005 have been US$ 39.27 billion.

Every year since FIIs were allowed to participate in the Indian market, FII net

inflows into India have been positive, except for 1998-99. This reflects the strong

economic fundamentals of the country, as well as the confidence of the foreign

investors in the growth with stability of the Indian market. The year 2003 marked a

watershed in FII investment in India. FIIs started the year 2003 in a big way by

investing Rs. 985 crore in January itself. Meanwhile, corporate India continued to

report good operational results. This, along with good macroeconomic fundamentals,

growing industrial and service sectors led FIIs to perceive great potential for

investment in the Indian economy. In April 2003, prices of commodities like steel

and aluminium went up, propelling FII investment in May 2003 to Rs. 3,060 crore.

Around the same time, Morgan Stanley Capital International (MSCI) in its MSCI

Emerging Markets Index gave a weight of 4.3 per cent to India among the emerging

markets of the world. Calendar year 2004 ended with net FII inflows of US$9.2

billion, an all-time high since the liberalization.


The buoyant inflows continued in 2004-05. This weight was further increased to 5.9

per cent in April, 2004. In 2004-05, after reversing direction briefly during the

period May -June, FII inflows became robust again, leading to net inflows of US$

10.25 billion during the year. The buoyancy continued in 2005-06, with net inflows

aggregating to US$ 3.26 billion in the first seven months up to end-October, 2005.

FII‘s registered with SEBI fall under the following categories:

(a) Regular FIIs – those who are required to invest not less than 70 per cent of their

investment in equity -related instruments and up to 30 per cent in non-equity

instruments.

(b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debt

instruments.


Benefits and costs of FII investments:

The terms of reference asking the Expert Group to consider how FII inflows can be

encouraged and examine the adequacy of the existing regulatory framework to

adequately address the concern for reducing vulnerability to the flow of speculative

capital do not include an examination of the desirability of encouraging FII inflows.

Yet, for motivating the consideration of the policy options, it is useful to briefly

summarise the benefits and costs for India of having FII investment. Given the

Group‘s mandate of encouraging FII flows, the available arguments that mitigate the

costs have also been included under the relevant points.

Benefits:

1.Reduced cost of equity capital:

FII inflows augment the sources of funds in the Indian capital markets. In a common

sense way, the impact of FIIs upon the cost of equity capital may be visualised by

asking what stock prices would be if there were no FIIs operating in India. FII

investment reduces the required rate of return for equity, enhances stock prices, and

fosters investment by Indian firms in the country.

2.Imparting stability to India's Balance of Payments:

For promoting growth in a developing country such as India, there is need to

augment domestic investment, over and beyond domestic saving, through capital

flows. The excess of domestic investment over domestic savings result in a current

account deficit and this deficit is financed by capital flows in the balance of

payments. Prior to 1991, debt flows and official development assistance dominated

these capital flows. This mechanism of funding the current account deficit is widely

believed to have played a role in the emergence of balance of payments difficulties

in 1981 and 1991. Portfolio flows in the equity markets, and FDI, as opposed to

debt-creating flows, are important as safer and more sustainable mechanisms for

funding the current account deficit.


3. Knowledge flows: The activities of international institutional investors help strengthen Indian finance.

FIIs advocate modern ideas in market design, promote innovation, development of

sophisticated products such as financial derivatives, enhance competition in financial

intermediation, and lead to spillovers of human capital by exposing Indian

participants to modern financial techniques, and international best practices and

systems.

4. Strengthening corporate governance:

Domestic institutional and individual investors, used as they are to the ongoing

practices of Indian corporates, often accept such practices, even when these do not

measure up to the international benchmarks of best practices. FIIs, with their vast

experience with modern corporate governance practices, are less tolerant of

malpractice by corporate managers and owners (dominant shareholder). FII

participation in domestic capital markets often lead to vigorous advocacy of sound

corporate governance practices, improved efficiency and better shareholder value.

5.Improvements to market efficiency: A significant presence of FIIs in India can improve market efficiency through two

channels. First, when adverse macroeconomic news, such as a bad monsoon,

unsettles many domestic investors, it may be easier for a globally diversified

portfolio manager to be more dispassionate about India's prospects, and engage in

stabilising trades. Second, at the level of individual stocks and industries, FIIs may

act as a channel through which knowledge and ideas about valuation of a firm or an

industry can more rapidly propagate into India.

For example, foreign investors were rapidly able to assess the potential of firms like

Infosys, which are primarily export-oriented, applying valuation principles that

prevailed outside India for software services companies.

Costs:

1.Herding and positive feedback trading:

There are concerns that foreign investors are chronically ill-informed about India,

and this lack of sound information may generate herding (a large number of FIIs

buying or selling together) and positive feedback trading (buying after positive

returns, selling after negative returns). These kinds of behaviour can exacerbate


volatility, and push prices away from fair values. FIIs behavior in India, however, so

far does not exhibit these patterns. Generally, contrary to ‗herding‘, FIIs are seen to

be involved in very large buying and selling at the same time. Gordon and Gupta

(2003) find evidence against positive-feedback trading with FIIs buying after

negative returns and vice versa.

2. BOP vulnerability:

There are concerns that in an extreme event, there can be a massive flight of foreign

capital out of India, triggering difficulties in the balance of payments front. India's

experience with FIIs so far, however, suggests that across episodes like the Pokhran

blasts, or the 2001 stock market scandal, no capital flight has taken place. A billion

or more of US dollars of portfolio capital has never left India within the period of

one month. When juxtaposed with India's enormous current account and capital

account flows, this suggests that there is little evidence of vulnerability so far.

3. Possibility of taking over companies:

While FIIs are normally seen as pure portfolio investors, without interest in control,

portfolio investors can occasionally behave like FDI investors, and seek control of

companies that they have a substantial shareholding in. Such outcomes, however,

may not be inconsistent with India's quest for greater FDI. Furthermore, SEBI's

takeover code is in place, and has functioned fairly well, ensuring that all investors

benefit equally in the event of a takeover.

4. Complexities of monetary management:

A policymaker trying to design the ideal financial system has three objectives. The

policy maker wants continuing national sovereignty in the pursuit of interest rate,

inflation and exchange rate objectives; financial markets that are regulated,

supervised and cushioned; and the benefits of global capital markets. Unfortunately,

these three goals are incompatible. They form the ―impossible trinity.‖ India's

openness to portfolio flows and FDI has effectively made the country‘s capital

account convertible for foreign institutions and investors. The problems of monetary

management in general, and maintaining a tight exchange rate regime, reasonable

interest rates and moderate inflation at the same time in particular, have come to the

fore in recent times. The problem showed up in terms of very large foreign exchange

reserve inflows requiring considerable sterlisation operations by the RBI to maintain

stable macroeconomic conditions. The Government had to introduce a Market

Stabilisation Scheme (MSS) from April 1, 2004.


The diversity of FIIs has been increasing with the number of registered FIIs in India

steadily rising over the years (Table 2). In 2004-05, with 145 new FIIs registering

with Securities and Exchange Board of India (SEBI), as on March 31, 2005, there

were 685 FIIs registered in India. The names of some prominent FIIs registered

during 2004-05 are: California Public Employees‘ Retirement System (CalPERS),

United Nations for and on behalf of the United Nations Joint Staff Pension Fund,

Public School Retirement System of Missouri, Commonwealth of Massachusetts

Pension Reserves Investment Trust, Treasurer of the State North Carolina Equity


Investment Fund Pooled Trust, the Growth Fund of America, and AIM Funds

Management Inc.

In terms of country of origin, the USA topped the list with a share of 40 per cent of

the number of FIIs registered in India, followed by UK‘s 17 per cent. Other

countries of significance in terms of origin of FIIs investing in India are Luxemburg,

Hong Kong, and Singapore. In terms of net cumulative investments by FIIs, US-

based FIIs dominate with 29 per cent of the net cumulative FII investments in India,

followed by UK at 17 per cent. In recent months, European and Japanese FIIs have

started to evince an increasing interest in India, and of the FIIs that registered with

SEBI in October 2004, a significant number belonged to Europe and Japan. These

developments have helped improve the diversity of the set of FIIs operating in India.

As is evident from figure 1, I argue that foreign investment, (in form of around 800

and growing registered FIIs), will continue to chart the growth of Indian capital

(equity) markets for at least 10-15 years until domestic institutions catch up. Hence

there is a need to attract and spread low volatility reliable capital from FIIs

across sectors while developing domestic institutional investment capabilities to

take over.


The total market capitalization on BSE on 7th October, 2005 was Rs 2,245,005

Crore (over 510 billion $).

The recent stock market rally saw FII investment reach 8.65 billion $ in 2005 till

date compared to 8.51 billion $ in whole of 2004. In addition, India‘s GDP growth

rate is expected to be around 6.5-7% in the next two years. The most important

requirement is to make the capital markets more integral to the Indian growth story.

To sustain, match and accelerate this growth, the Indian economy needs a growing

mean rate of capital supply without sudden shocks. To analyze whether capital

markets are poised to grow and play a more important role in this growth, we ask

these key questions classified in three categories.

The net FII investment during the year FY06 (till February 2006) was at $7.9 billion

against $10.2 billion during FY05. Total foreign exchange reserves as of February

2006 stood at $141.2 billion, down from last fiscal's level. The decline in reserves

has been on account of the widening current account deficit and valuation losses on

account of a strengthening dollar.

THE RECENT UP’S AND DOWN’S OF FII:

Positive tidings about the Indian economy combined with a fast-growing market

have made India an attractive destination for foreign institutional investors (FIIs).

The foreign Institutional Investors' (FIIs) net investment in the Indian stock markets

in calendar year 2005 crossed US$ 10 billion in the 2005 calendar, the highest ever

by the foreign funds in a single year after FIIs were allowed to make portfolio

investments in the country's stock markets in the early 90s.

As per the Securities Exchange Board of India (SEBI) figures, FIIs made net

purchases of US$ 587.3 million on December 16, 2005, taking the total net

investments in the 2005 calendar to US$ 10.11 billion.

India's popularity among investors can be gauged from the fact that the number of

FIIs registered with SEBI has increased from none in 1992-93 to 528 in 2000-01 to

803 in 2005-06. In 2005 alone, 145 new FIIs registered themselves, taking the total

registered FIIs to 803 (as on October 31, 2005) from 685 in 2004-05.


A number of these investors are Japanese and European funds aiming to cash in on

the rising equity markets in India. In addition, there was increased registration by

non-traditional countries like Denmark, Italy, Belgium, Canada and Sweden.

The Japanese have, in fact, been increasing their foothold in India. Mizuho

Corporate Bank's decision to successfully expand base in the country has managed

to convince almost 60-65 major Japanese corporates to set up manufacturing or

marketing base in India.

This list of corporates includes big names in auto sectors such as Honda,

Toyota and Yamaha, as well as those in home appliances, pharmaceuticals,

and communications.

While Nissan has already set up its base in India, other new entrants include

Japanese business conglomerate Mitsui Metal, Sanyo, and pharma major

Eisai. Japanese Telecom major Nippon Telegraph (NTT) is also in the process

of entering the Indian market.

Sabre Capital and Singapore's Temasek Holding have teamed up to float a

fund that will invest up to US$ 5 billion in Indian equities as well as fixed

income instruments over the next five years.

Fidelity International, a leading foreign institutional investor, has picked up

about 9 per cent in the Multi Commodity Exchange of India Ltd (MCX) for

US$ 49 million.

If FIIs have been flocking to India, it is obvious the returns are handsome.

According to Kamal Nath, the Indian Minister for Commerce and Industry, of all the

foreign investors in India, at least 77 per cent make profit and 8 per cent break even.

These facts are corroborated by recent research on the trend. A landmark survey by

the Japan Bank for International Co-operation (JBIC) shows that in the next three

years, India will be the third most favoured investment destination for Japanese

investors in a list, which includes US and Russia.

A Smith Barney (a Citigroup division) study says the estimated market value of

FII investment in the top 200 companies (including ADRs and GDRs) at

current market prices is a whopping US$ 43 billion. This is 18 per cent of the

market capitalisation of the BSE 200. CAPITAL MARKET DEVELOPMENT

TABLE 8

NEW CAPITAL (PUBLIC & RIGHTS) ISSUES & INVESTMENT


MADE BY FOREIGN INSTITUTIONAL INVESTORS (FIIs)

Year

New Capital Issues

Net Investment of FIIs

(at monthly exchange rate)

No. of

Issues

Amount

Raised

(Rs.Crore)

Amount

(US $ Mn.)

1993-94 1143 24372 1634

1994-95 1692 27633 1528

1995-96 1725 20804 2036

1996-97 882 14276 2432

1997-98 111 4570 1649

1998-99 58 5587 -386

1999-00 93 7817 2339

2000-01 151 6108 2160

2001-02 35 7543 1846

2002-03 26 4070 562

2003-04 57 23272 9949

2004-05 60 28256 10172

2005-06* 71 10392 3789

RECENT TRENDS OF CAPITAL MARKET:


Indian equities have performed very well in the past three years (2003 to 2005). The

Bombay Sensitive Index (SENSEX), which is a common proxy for the performance

of blue-chip companies in the Indian bourse, rose 78% in 2003, 14.1% in 2004 and

39.8% in 2005 (returns are in SGD terms without dividends reinvested). If we add

up the market returns for the past three years, the Indian bourse returned 184%. That

meant that the market almost tripled in three years. The rally continued into 2006,

and on 4 th January 2006, the SENSEX reached a historical high of 9648.1 points.

Chart 1 shows us the strong upturns experienced by the Indian market through the

years.

As illustrated in the chart above, it has not always been a straight ride up for

the Indian bourse. From Jan 2000 to Dec 2002, the market along with other Asian

bourses, experienced lackluster market sentiment, which pulled the market down by

more than 30%. In 2003, investors regained their confidence, as economic

conditions in India turned more favourable. Foreign institutional investments (FIIs)

also began to flow into the market as global investors became more interested in

investing in this booming emerging market. There was some volatility in the Indian

bourse in 2004 as the surprise victory of the Coalition Party led by Sonia Gandhi

rattled the confidence of investors. Nonetheless,

investors again regained their confidence in the bourse in the later part of 2004 and

2005. Considering that the market has done so well in the last 3 years, some


investors have begun to question if the rally can last. To answer that question, we

first need to delve deeper into the factors behind the bull run. Will the main drivers

for the Indian market continue to drive the bull run in the medium term.

Foreign Fund Inflows An Important Driver:

One of the factors that caused the market to rally strongly was the strong interest

from foreign fund investors. There was strong growth in Foreign Direct Investments

(FDIs) and Foreign Institutional Investments (FIIs) in the past three years. One of

reasons for the strong foreign fund inflow is that foreign investors were generally

quite positive on the measures the new Indian government has taken including

liberalizing sectors such as telecommunication, insurance and civil aviation (in July

2004), as well as cutting taxes on non-agricultural projects from 20% to 15% and

lowering effective corporate tax rate to 33% from 35% (both measures taken in

March 2005). Table 1 shows the size of the foreign fund inflows against the market

return (in INR). From 2003 to 2005, when the Indian bourse was doing well, the FIIs

increased from USD 6.6 billion to USD 10.8 billion. Although, we do not know for

certain how much of the total market capital in India is made up of FIIs, we do note

that the SENSEX tends to move in tandem with foreign fund inflows. And the

volatility in the FII tends to contribute to the increased level of volatility in the

SENSEX.

Illustrates this point. During the Indian elections held in May in 2004, the market

was down by 17.8% in that month alone . In the same month, foreign fund outflows


totaled more than USD 700 million. In October 2005, global equity markets suffered

from a temporary correction. The Indian bourse was down 10.5%, and during that

month there was an outflow of more than USD $860 million from the market. In

general, when the market rallied, there were strong pick-ups in the inflows as well.

In 2005 when the market gained 39.8%, more than USD 10 billion was invested in

the Indian market (see Table 1; all returns are stated in SGD without dividends

reinvested).

This indicates that strong inflow of foreign monies might be one of the significant

drivers of Indian market rallies. This is not an unusual occurrence for an emerging

market such as India, where foreign investors are generally interested in plowing

monies into a market that is in the development stage and shows strong growth

potential. There is a concern, however, that further inflows of FIIs might cause more

volatility in the bourse. Investors might have to be aware that volatility in this

respect will continue to affect the Indian bourse. In addition, in the past three years,

about USD 26 billion has been invested into the Indian bourse. With the market at

the higher range of valuations, we are concerned that foreign fund inflows might

have reached a peak in the medium term. In order to understand why higher

valuations may spell bad news for the market, we need to look more closely at the

price-to-earnings ratio and the earnings growth of Indian companies for 2006 and

2007.

Valuation & Earnings:


When we assess the attractiveness of markets, we look specifically at the potential

earnings growth for the next three years and the valuations of the market

(represented by the estimated PE ratio), other than the economic fundamentals and

driving factors. Based on Table 2, the PE ratios are 19.3X, 16.7X and 15.4X for the

financial year ending March 2006, 2007 and 2008 respectively. After the Indian

bourse experienced a strong market rally for the past three years, valuations have

surpassed the attractive levels in 2003 to early 2005 of about 14X to 15X to levels of

19X (based on end March 2006 earnings).

At such valuation levels, the market appears to be at a premium to a historical

average of about 15X, and is at the higher range of valuations (the historical range is

10X to 21X). As for earnings growth, it is relatively strong for 2006 at 15.9%, and

for 2007 at 8.2%. However, after the market rally in the past three years (2003, 2004

and 2005), we think that the optimism over earnings growth potential is more or less

priced into the market already. Chart 3 illustrates that the valuations for the market

are now at a higher range, especially after the strong market rally in the past three

years. The bold lines at the top and bottom of the chart shows the range of valuations

the market has been trading at since June 2000, and the dotted line shows the

average valuation. From the chart, we note that valuations are not cheap at this

moment of time. Another measure used in our analysis is excess earnings yield.

Excess earnings yield for the market, which looks at the yield of the market given a

certain PE vis-à-vis the local fixed income instrument is at –0.6%. That means that

the fixed income market seems to be yielding more than the equity

market at this moment (as at 13 Jan 2006).

Despite Valuation Concerns, Indian Economy Enjoying Strong Growth:

Despite the concerns that we have on the market becoming less attractive in terms of

valuations, the economy is still likely to experience strong growth in the years to

come. In the past three years (for financial year ended March 2003, March 2004 and

March 2005), economic growth in India has been strong averaging 7.5%. In the

fiscal year ended March 2005, sectors including trade (11.4%), manufacturing

(9.2%) and banking and finance (7.1%) stood out as the strongest contributors to

economic growth (refer to Table 3). Investments into these sectors have been on a

rise. For example, for the manufacturing sector, production of automobiles has been

picking up as car manufacturers such as Toyota, Hyundai, Honda and Fiat invested

capital in building manufacturing sites in India to export cars and sell cars

domestically. Increasingly, India is also becoming a popular ground for car

manufacturers to outsource auto parts. Daimler Chrysler, in a report on 9 Jan 2006,

said that they increased sourcing of auto parts and software services from India by

32.5% in 2005 to USD 87.8 million.


Trade is another economic driver for the Indian economy. The average monthly

year-on-year growth for exports for 2005 was quite strong at 16.6%. Exports grew

strongly boosted by manufacturing of automobile parts, medium and heavy

commercial vehicles, textile machinery, cement and pharmaceuticals. Aside from

manufacturing and trade, it is widely expected that domestic demand will pick up for

the market as well. According to Nilesh Shah, the Chief Investment Officer for

Prudential ICIC Asset Management, India is likely to continue its infrastructure

projects including adding power plants and telecom networks. Also, consumption of

goods and services is likely to double as the demand for housing increases and

consumers are more confident about spending on bigger ticket items in the future.

The rise in the proportion of affluent individuals is also one important growth driver,

the portion expected to rise from 5.6% (2005 to 2006E) to 9.0% (2009 to 2010E).

With these positive economic factors in mind, the Indian government expects

economic growth to be 7% in the fiscal year ending March 2006. We think that will

most of these economic factors going for India, the economy is likely to enjoy strong

economic growth in the next 3 to 5 years.

Conclusion – What Should Investors Do?

Positive economic growth and strong foreign inflows were two of the many factors

that have propelled the Indian bourse in the past three years (2003 to 2005). We do

think that the economy is at the early stages of development and with infrastructure

growth underway, the Indian economy is likely to continue to do well in the next 5

years. However, given the strong run-up in the Indian market in recent years, we

have turned more cautious on the Indian bourse. One main reason is that the market

valuation (or PE ratio) is at a premium at this point of time, relative to historical

levels as well as other Asian markets. In addition, excess earnings yield is at –0.6%

at this point of time, indicating that local fixed income instruments appear to be

more attractive than local equities. Given all these factors, within an investment

horizon of three years, we are neutral on the Indian market now, and have given it a

rating of 2.5 stars. We think that it is unlikely that the Indian bourse will continue to

enjoy very strong run-ups, similar to what we have seen in the past few years. With

that, we advise investors who have a substantial holding in equities to shift their

exposure to more attractively valued markets.


Business Growth in Derivatives segment

Month/ Year

Index Futures Stock Futures Index Options Stock Options Interest Rate

Futures

Total Average Daily Turnover (Rs.

cr.)

No. of contracts

Turnover (Rs.

cr.)

No. of contra

cts

Turnover (Rs. cr.)

Call Put Call Put No. of

contracts

Turnover (Rs

. cr.)

No. of contracts

Notional Turnove

r (Rs. cr.)

No. of contracts

Notional

Turnover (Rs.

cr.)

No. of contracts

Notional Turnove

r (Rs. cr.)

No. of contract

s

Notional Turnover (Rs. cr.)

No. of

contracts

Turnover (Rs. cr.)

Current Month

Mar.0

6

5,952,20

6

192,0

32

10,84

4,400 473,250 683,979 22,406 772,372 24,691 444,604 18,574 92,657 3,889 0 0

18,790,21

8

734,8

42

33,4

02

Feb.06

5,186,835

156,358

7,443,178

288,712 506,714 15,526 559,682 16,806 326,233 12,349 75,740 2,913 0 0 14,098,38

2 492,6

64 25,9

30

Jan.06

5,760,999

166,126

7,134,199

265,037 663,684 19,392 666,782 19,130 365,493 14,265 90,562 3,630 0 0 14,681,71

9 487,5

80 24,3

79

Dec.05

6,613,032

183,290

7,571,377

280,280 775,216 21,863 764,964 21,125 361,268 13,631 95,261 3,614 0 0 16,181,11

8 523,8

03 23,8

09

Nov.05

5,238,175

135,474

6,252,736

216,524 595,900 15,584 604,657 15,490 287,136 10,068 77,052 2,705 0 0 13,055,65

6 395,8

45 19,7

92

Oct.05

6,849,732

170,096

6,526,919

214,396 695,311 17,630 715,208 17,954 309,120 10,753 80,134 2,822 0 0 15,176,42

4 433,6

51 21,6

83

Sep.05

4,701,774

118,904

6,995,169

236,941 523,948 13,371 583,081 14,550 363,872 12,913 85,897 3,071 0 0 13,253,74

1 399,7

50 19,0

36

Aug.05

4,278,829

100,805

7,124,266

234,817 444,294 10,619 485,001 11,373 350,370 11,934 81,453 2,751 0 0 12,764,21

3 372,3

01 16,9

23

Jul.05 3,451,68

4 77,39

5 6,537,

794 199,637 358,867 8,127 389,154 8,643 376,129 11,736 84,989 2,622 0 0

11,198,617

308,160

15,408

Jun.05

3,626,288

77,215

5,783,428

163,097 421,480 9,089 331,753 7,044 385,640 11,678 104,478 3,119 0 0 10,653,06

7 271,2

42 11,7

93

http://www.nse-india.com/content/fo/fo_dailyturnover.htm

http://www.nse-india.com/content/fo/fo_turnmar2006.htm

http://www.nse-india.com/content/fo/fo_turnmar2006.htm

http://www.nse-india.com/content/fo/fo_turnfeb2006.htm

http://www.nse-india.com/content/fo/fo_turnfeb2006.htm

http://www.nse-india.com/content/fo/fo_turnjan2006.htm

http://www.nse-india.com/content/fo/fo_turnjan2006.htm

http://www.nse-india.com/content/fo/fo_turndec2005.htm

http://www.nse-india.com/content/fo/fo_turndec2005.htm

http://www.nse-india.com/content/fo/fo_turnnov2005.htm

http://www.nse-india.com/content/fo/fo_turnnov2005.htm

http://www.nse-india.com/content/fo/fo_turnoct2005.htm

http://www.nse-india.com/content/fo/fo_turnoct2005.htm

http://www.nse-india.com/content/fo/fo_turnsep2005.htm

http://www.nse-india.com/content/fo/fo_turnsep2005.htm

http://www.nse-india.com/content/fo/fo_turnaug2005.htm

http://www.nse-india.com/content/fo/fo_turnaug2005.htm

http://www.nse-india.com/content/fo/fo_turnjul2005.htm

http://www.nse-india.com/content/fo/fo_turnjun2005.htm

http://www.nse-india.com/content/fo/fo_turnjun2005.htm


May.05

3,545,971

70,465

4,466,404

112,878 382,530 7,724 353,975 7,058 288,137 7,641 100,602 2,609 0 0 9,137,619 208,3

75 9,47

2

Apr.05

3,332,361

65,595

4,225,623

106128 361,544 7,293 295,020 5,981 307,994 8,203 105,955 2,763 0 0 8,628,497 195,9

62 9,79

8

2004-05

21,635,449

772,147

47,043,066

1,484,056

1,870,647

69,371 1,422,91

1 52,572

3,946,979

132,054 1,098,1

33 36,782 - -

77,016,465

2,546,986

10,107

2003-04

17,191,668

554,446

32,368,842

1,305,939

1,043,894

31,794 688,520 21,022 4,243,66

1 167,967

1,339,410

49,240

10,781

202

56,886,776

2,130,612

8,388

2002-03

2,126,763

43,952

10,676,843

286,533 269,674 5,669 172,567 3,577 2,456,50

1 69,643

1,066,561

30,488 - - 16,768,90

9 439,8

63 1,75

2

2001-02

1,025,588

21,482

1,957,856

51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383 - - 4,196,873 101,9

25 410

2000-01

90,580 2,365 - - - - - - - - - - - - 90,580 2,365 11

Note: Notional Turnover = (Strike Price + Premium) * Quantity

Index Futures, Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001

and November 2001, respectively

Business Growth: Capital Market | Retail Debt Market | Wholesale Debt Market

http://www.nse-india.com/content/fo/fo_turnmay2005.htm

http://www.nse-india.com/content/fo/fo_turnmay2005.htm

http://www.nse-india.com/content/fo/fo_turnapr2005.htm

http://www.nse-india.com/content/fo/fo_turnapr2005.htm

http://www.nse-india.com/content/fo/fo_busgrow2004-05.htm










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