Capital Markets

This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for Capital Markets.

JNU, JaipurFirst Edition 2013

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Index

ContentI. ...................................................................... II

List of FiguresII. ..........................................................VI

List of TablesIII. ......................................................... VII

AbbreviationsIV. ......................................................VIII

Case StudyV. .............................................................. 120

BibliographyVI. ......................................................... 126

Self Assessment AnswersVII. ................................... 128

Book at a Glance

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Contents

Chapter I ....................................................................................................................................................... 1Capital Market ............................................................................................................................................. 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 Categorisation of Capital Market ............................................................................................................. 31.3 Capital Market Efficiency ........................................................................................................................ 3 1.3.1 Forms of Capital Market Efficiency ........................................................................................ 41.4 Capital Market Operations ....................................................................................................................... 51.5 Capital Market in India ............................................................................................................................ 5 1.5.1 Structure of Indian Capital Market .......................................................................................... 6 1.5.2 Role of Capital Market in India ............................................................................................... 7 1.5.3 PESTEL Analysis of Indian Capital Market ............................................................................ 81.6 Capital Market Regulations ..................................................................................................................... 9Summary ..................................................................................................................................................... 12References ................................................................................................................................................... 12Recommended Reading ............................................................................................................................. 12Self Assessment ........................................................................................................................................... 13

Chapter II ................................................................................................................................................... 15Primary Market and Secondary Market ................................................................................................. 15Aim .............................................................................................................................................................. 15Objectives .................................................................................................................................................... 15Learning outcome ........................................................................................................................................ 152.1 Introduction ............................................................................................................................................ 162.2 Eligibility Norms of Primary Market ..................................................................................................... 162.3 Primary Market Design .......................................................................................................................... 17 2.3.1 Credit Rating for Debt Instruments ....................................................................................... 17 2.3.2 IPO Grading ........................................................................................................................... 17 2.3.3 Pricing and Public Issues ....................................................................................................... 17 2.3.4 Price and Price Band .............................................................................................................. 18 2.3.5 Contribution of Promoters and Lock-in ................................................................................. 18 2.3.6 Pre-issue Obligation ............................................................................................................... 18 2.3.7 Post-issue Obligation ............................................................................................................. 19 2.3.8 Credit Rating .......................................................................................................................... 20 2.3.9 Merchant Banking .................................................................................................................. 20 2.3.10 Demat Issues ........................................................................................................................ 20 2.3.11 Private Placement ................................................................................................................. 202.4 Ways to Raise Capital in the Primary Market ........................................................................................ 202.5 Intermediaries ........................................................................................................................................ 21 2.5.1 Manager to the Issue .............................................................................................................. 21 2.5.2 Underwriters .......................................................................................................................... 21 2.5.2.1 Registration ............................................................................................................. 21 2.5.2.2 General Obligations and Responsibilities of Underwriters ..................................... 222.6 Primary Target Market ........................................................................................................................... 22 2.6.1 Process of Finding Primary Target Market ............................................................................ 232.7 Indian Primary Market ........................................................................................................................... 24 2.7.1 Reforms in Indian Primary Market ........................................................................................ 24 2.7.2 Disclosure and Investor Protection (DIP) Guideline ............................................................. 242.8 Secondary Market .................................................................................................................................. 252.9 Structure and Trading System in Secondary Market ............................................................................. 252.10 Products Dealt in Secondary Market ................................................................................................... 26

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2.11 Stock Exchange .................................................................................................................................... 27 2.11.1 Investment Precautions ........................................................................................................ 272.12 Secondary Market and SEBI ................................................................................................................ 27 2.12.1 Various Departments of SEBI Regulating Trading in the Secondary Market ..................... 28 2.12.2 Secondary Market Reforms by the SEBI ............................................................................. 282.13 Changes in the Indian Secondary Market Regulation .......................................................................... 28 2.13.1 Policy Developments During 2009-10 ................................................................................ 30Summary ..................................................................................................................................................... 31References ................................................................................................................................................... 31Recommended Reading ............................................................................................................................. 31Self Assessment ........................................................................................................................................... 32

Chapter III .................................................................................................................................................. 34Securities and Exchange Board of India .................................................................................................. 34Aim .............................................................................................................................................................. 34Objectives .................................................................................................................................................... 34Learning outcome ........................................................................................................................................ 343.1 Introduction ............................................................................................................................................ 353.2 Objectives of SEBI ................................................................................................................................ 363.3 Securities and Exchange Board of India Act, 1992 ............................................................................... 363.4 Management of the Board ...................................................................................................................... 363.5 Powers of SEBI ...................................................................................................................................... 373.6 Functions of SEBI .................................................................................................................................. 373.7 Registration of Intermediaries ................................................................................................................ 383.8 Departments and Their Functions .......................................................................................................... 39 3.8.1 Market Intermediaries Regulation and Supervision Department (MIRSD) .......................... 39 3.8.2 Market Regulation Department (MRD) ................................................................................. 39 3.8.3 Derivatives and New Products Department (DNPD) ............................................................ 39 3.8.4 Corporation Finance Department (CFD) ............................................................................... 39 3.8.5 Investment Management Department (IMD) ........................................................................ 40 3.8.6 Integrated Surveillance Department (ISD) ............................................................................ 40 3.8.7 Investigations Department (IVD) .......................................................................................... 40 3.8.8 Enforcement of Department (EFD) ....................................................................................... 40 3.8.9 Legal Affairs Department (LAD) ........................................................................................... 40 3.8.10 Enquiries And Adjudication Department (EAD) ................................................................. 40 3.8.11 Office of Investor Assistance and Education (OIAE) .......................................................... 41 3.8.12 General Services Department (GSD) ................................................................................... 41 3.8.13 Department of Economic and Policy Analysis (DEPA) ...................................................... 41 3.8.14 Office of Chairman .............................................................................................................. 41 3.8.15 Information Technology Department ................................................................................... 42 3.8.16 The Regional Offices (RO's) ................................................................................................ 423.9 Limitation of SEBI ................................................................................................................................. 42Summary ..................................................................................................................................................... 43References ................................................................................................................................................... 43Recommended Reading ............................................................................................................................. 43Self Assessment ........................................................................................................................................... 44

Chapter IV .................................................................................................................................................. 46Derivative Market ...................................................................................................................................... 46Aim .............................................................................................................................................................. 46Objectives .................................................................................................................................................... 46Learning outcome ........................................................................................................................................ 464.1 Introduction ............................................................................................................................................ 474.2 Types of Derivatives .............................................................................................................................. 474.3 Exchange-traded and Over-the-counter Derivative Instruments ........................................................... 48

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4.4 Index ...................................................................................................................................................... 49 4.4.1 Catergorisation of Index ........................................................................................................ 49 4.4.1.1 Total Returns Index ................................................................................................. 49 4.4.1.2 Impact Cost ............................................................................................................. 49 4.4.1.3 BETA ....................................................................................................................... 52 4.4.2 Risk ............................................................................................................................ 52 4.4.3 Who Decides What Stocks to Include and How .................................................................... 52 4.4.4 Uses of an Index .................................................................................................................... 53 4.4.5 Types of Index ........................................................................................................................ 534.5 Forward and Future Contracts ............................................................................................................... 544.6 Options ................................................................................................................................................... 54 4.6.1 Categorisation of Options ...................................................................................................... 55 4.6.1.1 Call Options ............................................................................................................ 55 4.6.1.2 Put Options .............................................................................................................. 56 4.6.2 Options Pricing ...................................................................................................................... 584.7 Market Players ....................................................................................................................................... 594.8 Derivative Market in India ..................................................................................................................... 594.9 Derivative Users in India ....................................................................................................................... 614.10 Commodity Derivatives ....................................................................................................................... 614.11 Exchange-traded vs. OTC (Over The Counter) Derivatives Markets .................................................. 624.12 Accounting and Taxation of Derivatives Transactions ........................................................................ 624.13 Measures Specified by SEBI to Protect the Rights of Investor in Derivatives Market ....................... 62Summary ..................................................................................................................................................... 64References ................................................................................................................................................... 64Recommended Reading ............................................................................................................................. 64Self Assessment ........................................................................................................................................... 65

Chapter V .................................................................................................................................................... 67Money Market and Bond Market ............................................................................................................ 67Aim .............................................................................................................................................................. 67Objectives .................................................................................................................................................... 67Learning outcome ........................................................................................................................................ 675.1 Introduction ............................................................................................................................................ 685.2 Characteristics of Money Market ........................................................................................................... 685.3 Functions of Money Market ................................................................................................................... 695.4 Importance of Money Market ................................................................................................................ 695.5 Indian Money Market Instruments ......................................................................................................... 705.6 Drawbacks of Indian Money Market ..................................................................................................... 725.7 Reforms in Indian Money Market .......................................................................................................... 735.8 Bond Market .......................................................................................................................................... 74 5.8.1 Corporate Bond Market ......................................................................................................... 75 5.8.2 Municipal Bond Market ......................................................................................................... 76 5.8.3 Government Bond Market ..................................................................................................... 77 5.8.4 Mortgage Backed and Collateralized Debt Obligation Bond Market .................................... 77 5.8.5 Development of Bond Market in India .................................................................................. 78Summary ..................................................................................................................................................... 80References ................................................................................................................................................... 80Recommended Reading ............................................................................................................................. 80Self Assessment ........................................................................................................................................... 81

Chapter VI .................................................................................................................................................. 83Mutual Fund ............................................................................................................................................... 83Aim .............................................................................................................................................................. 83Objectives .................................................................................................................................................... 83Learning outcome ........................................................................................................................................ 83

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6.1 Introduction ............................................................................................................................................ 846.2 NAV or Net Asset Value ......................................................................................................................... 846.3 Objectives of Mutual Fund .................................................................................................................... 856.4 Advantages of Mutual Funds ................................................................................................................. 856.5 Disadvantages of Mutual Funds ............................................................................................................. 866.6 Types of Mutual Funds .......................................................................................................................... 876.6.1 By Investment Objective ..................................................................................................................... 876.6.2 By Structure ........................................................................................................................................ 906.7 Investing in Mutual Funds ..................................................................................................................... 91 6.7.1 How to Invest in Mutual Fund ............................................................................................... 936.8 Benefits of Investing in Mutual Funds ................................................................................................... 946.9 Mutual Fund Industry in India ............................................................................................................... 956.10 Private Sector Mutual Funds ................................................................................................................ 976.11 Schemes of Mutual Fund ..................................................................................................................... 986.12 Mutual Fund Regulations ..................................................................................................................... 98Summary ................................................................................................................................................... 100References ................................................................................................................................................. 100Recommended Reading ........................................................................................................................... 100Self Assessment ......................................................................................................................................... 101

Chapter VII .............................................................................................................................................. 103Credit Rating and Venture Capital ........................................................................................................ 103Aim ............................................................................................................................................................ 103Objectives .................................................................................................................................................. 103Learning outcome ...................................................................................................................................... 1037.1 Introduction to Credit Rating ............................................................................................................... 1047.2 Determinants of Ratings ...................................................................................................................... 1047.3 Rating Methodology ............................................................................................................................ 1047.4 Credit Rating Agencies in India ........................................................................................................... 1057.5 Credit Rating Symbols ......................................................................................................................... 1067.6 Benefits of Credit Rating .................................................................................................................... 1077.7 Rating and Default Risk ....................................................................................................................... 1077.8 Rating and Yields ................................................................................................................................. 1087.9 Limitations of Credit Ratings ............................................................................................................... 1097.10 Venture Capital ....................................................................................................................................110 7.10.1 Aim of Venture Capital Financing ......................................................................................111 7.10.2 Forms of Financing used by Venture Capitalists ................................................................112 7.10.2.1 Types of Securities ..............................................................................................112 7.10.2.2 Advantages of Debts to a Venture Capitalist ........................................................113 7.10.2.3 Percentage of Ownership Needed ........................................................................113 7.10.2.4 Estimation of the risk associated with the venture financing. ..............................114 7.10.3 Advantages of Venture Capital............................................................................................114 7.10.4 Funding Process in Venture Capital ....................................................................................114 7.10.5 Types of Funding ................................................................................................................115 7.10.6 Non-Disclosure Agreements and Term Sheet .....................................................................116Summary ....................................................................................................................................................117References ..................................................................................................................................................117Recommended Reading ............................................................................................................................117Self Assessment ..........................................................................................................................................118

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List of Figures

Fig. 1.1 The financial system ......................................................................................................................... 3Fig. 1.2 Indian capital market ........................................................................................................................ 6Fig. 1.3 Structure of capital market in India .................................................................................................. 7Fig. 4.1 Types of risk ................................................................................................................................... 52Fig. 4.2 Payoff from call buying/long .......................................................................................................... 56Fig. 4.3 Payoff from put buying/long .......................................................................................................... 57Fig. 4.4 Effect of increase in the relevant parameter on option prices ........................................................ 58Fig. 5.1 Types of bond markets .................................................................................................................... 75Fig. 6.1 Concept of mutual fund .................................................................................................................. 84Fig. 6.2 Objectives of mutual fund .............................................................................................................. 85Fig. 6.3 Mutual funds ................................................................................................................................... 93Fig. 6.4 Growth of assets under management .............................................................................................. 97

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List of Tables

Table 2.1 Merchant bankers ......................................................................................................................... 20Table 4.1 The Global derivatives industry ................................................................................................... 48Table 4.2 An order book for a stock at a point in time ................................................................................. 50Table 4.3 Buy orders .................................................................................................................................... 50Table 4.4 Sell orders .................................................................................................................................... 51Table 4.5 Share execution ............................................................................................................................ 51Table 4.6 Features of forward contract and future contract ......................................................................... 54Table 4.7 Payoff from call buying/long ....................................................................................................... 55Table 4.8 Payoff from put buying/long ........................................................................................................ 57Table 4.9 Business growth and future of option market .............................................................................. 60Table 6.1 Public sector fund ......................................................................................................................... 95Table 6.2 Gross fund mobilisation ............................................................................................................... 96Table 6.3 Assets under management ............................................................................................................ 96Table 7.1 Rating symbols and their explanation as employed by Moody’s and S&P ............................... 108Table 7.2 Downgrades of ratings (in percentage) in 1997 ..........................................................................110

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Abbreviations

ADP – Alternative Delivery ProcedureADR – American Depositary ReceiptAMC – Asset Management CompaniesAMFI – Association of Mutual Funds in IndiaAPR – Annual Percentage RateAPY – Annual Percentage YieldASBA – Application Supported by Blocked AmountBOD – Bought Out DealsBSE – Bombay Stock ExchangeCARE – Credit Analysis and Research LimitedCBO – Collateralized bond obligationsCCI – Controller of Capital IssuesCCIL – Clearing Corporation of India limitedCD – Certificate of DepositCDO – Collateralized Debt ObligationCFD – Corporation Finance DepartmentCIA – Capital Issues Control ActCIO – Collateralized Insurance ObligationsCLO – Collateralized loan obligationsCMO – Collateralized Mortgage ObligationCNX – CRISIL NSE IndicesCP – Commercial PapersCRA – Credit Rating AgenciesCRE CDO – Commercial Real Estate Collateralized Debt ObligationCRISIL – Credit Rating and Information Services of India LimitedCRR – Cash Reserve RationDEA – Division of Economic AnalysisDEPA – Department of Economic and Policy AnalysisDFHI – Discount and Finance House of IndiaDFI – Development Financial InstitutionsDIL – Division of Issues and ListingDIP – Disclosure and Investor ProtectionDNPD – Derivatives and New Products DepartmentsDPA – Division of Policy AnalysisDvP – Delivery versus PaymentEAD – Enquiries And Adjudication DepartmentECB – European Central BankEFD – Enforcement of DepartmentELOB – Electronic Limit Order BookELSS – Equity-linked Savings SchemesEPRA – Earnings Prospects and Risk AnalysisETF – Exchange Traded FundsF&O – Future and OptionsFCCB – Foreign Currency Convertible Bonds FI – Financial InstitutionsFII – Foreign Institutional InvestmentFMCG – Fast Moving Consumer GoodsFRN – Floating Rate NotesFVCI – Foreign Venture Capital InvestorsGDR – Global Depository ReceiptsGIC – General Insurance Corporation

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GOI – Government of IndiaGSD – General Services DepartmentG-Secs – Government SecuritiesICAI – Institute of Chartered Accountants of IndiaICICI – Industrial Credit and Investment Corporation of IndiaICRA – Investment Information and Credit Rating Agency of India Limited IDBI – Industrial Development Bank of IndiaIFCI – Industrial Finance Corporation of IndiaIIBI – Industrial Investment Bank of IndiaIMD – Investment Management DepartmentIPO – Initial Public OfferingISD – Integrated Surveillance DepartmentIVD – Investigations DepartmentKYC – Know Your ClientLAD – Legal Affairs DepartmentLAF – Liquidity Adjustment FacilityLEAPS – Long-Term Equity Anticipation SecuritiesLIBRO – London Interbank Offered RateLIC – Life Insurance CorporationMCA – Member Client AgreementMF – Mutual FundMIRSD – Market Intermediaries Registration and Supervision departmentMMMF – Money Market Mutual FundMOU – Memorandum of Understanding MRD – Market Regulation DepartmentNAV – Net Asset ValueNBF – Non-banking Financial InstitutionsNDA – Non-Disclosure AgreementsNDS – Negotiated Dealing SystemNSE – National Stock ExchangeOCH – Office of the ChairmanOIAE – Office of Investor Assistance and EducationOTC – Over-the-counterOTCEI – Over the Counter Exchange of IndiaPAN – Permanent Account umberPCD – Partly Convertible DebenturesPNB – Punjab National BankQIB – Qualified institutional BuyerRBI – Reserve Bank of IndiaRDD – Risk Disclosure DocumentRIA – Regulatory Impact AssessmentRO – Regional OfficeRoC – Registrar of CompaniesS&P – Standard & Poor's Financial Information ServicesSBTS – Screen Based Trading SystemsSCRA – Securities Contracts (Regulation) ActSEBI – Securities and Exchange Board of IndiaSENSEX – Sensitive IndexSFC – State Financial CorporationSFCDO – Structured Finance Collateralized Debt ObligationSGL – Subsidiary General LedgerSLR – Statutory Liquidity RatioT-Bills – Treasury Bills

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TDS – Tax Deducted at SourceTR – Total ReturnUS – United StatesUTI – Unit Trust of IndiaVaR – VariableVC – Venture CapitalWDM – Wholesale Debt Market

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Chapter I

Capital Market

Aim

The aim of this chapter is to:

introduce financial market•

explain the Indian financial market•

elucidate Capital Market •

Objectives

The objectives of this chapter are to:

enlist the PESTEL analysis of Indian capital market•

elucidate the reforms of Capital Market•

explain the capital market Regulations•

Learning outcome

At the end of this chapter, the students will be able to:

understand the structure of Indian Capital market•

comprehend the difference between Capital market and Money market•

infer different forms of capital efficiency•

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1.1 IntroductionThe economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units are placed in a surplus/deficit/balanced budgetary situations.

There are some people with surplus funds and some other with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Financial market A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend.A financial market can be categorized as money market, capital market, forex market and derivative marketMoney Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions.

Capital marketThe capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. Herbert K. Dougall defines the term Capital Market as “a complex of institutions and mechanisms whereby intermediate term funds (Loans up to 10 years maturity) and long lean funds (longer maturity loans and corporate stocks) are pooled and made available to business, government and individuals and where instruments that are already outstanding are transferred.” The Capital Market is a medium through which small and scattered savings of investors are directed into productive activities of corporate entities. It also provides the essential attributes of liquidity, marketability, and safety of investments to the investors.

Forex marketThe Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.

Credit marketCredit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

Derivative marketsThe Derivatives market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. Value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices.

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Fig. 1.1 The financial system

1.2 Categorisation of Capital MarketCapital Market/ Securities Market can be further categorised as:

Primary capital market• Secondary capital market•

1.3 Capital Market EfficiencyCapital market facilitates the buying and selling of securities, such as shares and bonds or debentures. They perform two valuable functions: liquidity and pricing securities.

LiquidityLiquidity means the convenience and speed of transforming assets into cash, or transferring assets from one person to another without any loss of value. Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person without any decline in value. Capital market makes securities liquid. They facilitate the buying and selling of securities by a large number of investors continuously and instantaneously without incurring significant costs. They help to reduce, if not eliminate, transaction costs. For ensuring the liquidity, capital markets do require certain investors who are always ready to buy or sell securities. These market makers enhance liquidity and reduce transaction costs.

Pricing securitiesHow are the prices of securities determined? Are these prices fair? In the capital markets, hundred of investors make several deals a day. The screen-based trading makes these deals known to all in the capital market. Thus, a large number of buyers and sellers interact in the capital markets. The demand and supply forces help in determining the prices. Since all information is publicly available, and since no single investor is large enough to influence the security prices, the capital markets provide a measure of fair price of securities. A financial manager borrows and lends (invests) funds on the capital market. Capital markers facilitate the allocation

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of funds between savers and borrowers,. This allocation will be optimum if the capital markets have efficient pricing mechanism.

1.3.1 Forms of Capital Market EfficiencyThe finance theory refers to three forms of capital market efficiency:

Weak form of market efficiencyThe security prices reflect all the past information about the price movements in the weak-form of efficiency, it is, therefore, not possible for any investor to predict future security price by analysing historical prices, and achieve a performance (return) better than the stock market index such as Bombay Stock Exchange Share Price Index or the Economic Times Share Price Index. It is so because the capital market has no money, and the stock market index has already incorporated past information about the security prices in the current market price.

How does one know that the capital market is efficient in its weak form? To answer this question, it is necessary to find out the correlation between the ‘security prices over time’. In an efficient capital market, there should not exist a significant correlation between the security prices over time. Most empirical tests have shown that there exists serial independence between the security prices over time. Hence, the weak form of efficiency is referred to as the random walk hypothesis. An alternative method to testing the weakly efficient market hypothesis is to formulate the trading strategies using the security prices and compare their performance with the stock market performance.

Semi-strong form of market efficiencyIn semi-strong form of efficiency, asset prices already reflect all information that is publicly available, i.e., earnings, dividends, analyst forecasts, expectations of the future, etc. Most tests show that material public announcements are accompanied by an immediate change in price. In a semi-strong efficient market, the market's reaction to new and material information should be both instantaneous and unbiased, i.e., without any systematic pattern of over or under reaction. In addition, the market should only react to the extent that new information differs from what had been expected. Semi-strong efficiency also means that most financial analysis work or fundamental analysis, based on using public information, should not work.

Opportunities may occasionally exist that produce above normal or excess returns. However, after the information or strategies become known to the public, they should no longer produce excess returns; for exaple, the January effect in small stocks has vanished. Also, a talented investment analyst might still be able to beat the market, provided that he/she is able to consistently interpret information better than the competition can.

Implications of semi-strong form of market efficiency are as detailed below.Stock prices are expected to increase over time, but future returns are expected to be consistent with the • systematic risk. Investments in financial assets are expected to be ZERO Net Present Value. This means that you should expect • to earn an average future return that is determined by the systematic risk of the investments. What if no one performed security analysis? Then the first person that becomes an analyst will find countless • mispriced assets and trading rules that earn excess or abnormal returns. Such profitable opportunities would certainly lead to many more individuals entering the analyst field. Competition will quickly begin to eliminate most of the mispriced assets. Due to intense competition, it will become difficult to earn abnormal returns. The marginal benefit of analysis • will just equal the marginal cost of analysis for the average analyst or investor. It thus follows that individuals should be exceedingly suspicious of anyone that advertises some investment • technique that earns abnormal returns. If the method really works, then any rational person would keep the technique undisclosed. This holds for the weak-form market efficiency as well, as many attempt to sell methods for technical analysis.

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Strong-form of market efficiencyIn the strong-form of efficiency, the security prices reflect all published and unpublished, public and private information, this is a significantly strong assertion, and empirical studies have not borne out the validity of the efficient market hypothesis in the strong form of efficiency, people with private or inside information have been able to outperform the market.

1.4 Capital Market OperationsCapital market operations consist mainly of primary market operations and secondary market operations. Primary market or new issue market deals with the issue of new securities to the investors and facilitates the corporate sector in raising funds. The primary market is made up of two components: where firms go public for the first time through initial public offerings and where firms which are already traded raise additional capital through seasoned equity offerings.

Initial capital is raised by issuing only ordinary and preference shares whereas further capital can be raised by • selling debentures as well. In order to effectively control the activities in the new issue market and to ensure that investments in the country • are made in a planned manner and in accordance with the priorities laid down in the plans, the government has instituted the Controller of Capital Issues (CCI) under the Capital Issues (Control) Act, 1947. CCI laid stringent controls on pubic and right issues and in their pricing. As a result, capital issues were generally • underpriced. But when Capital Issues (Control) Act was repealed and free pricing was introduced by SEBI in 1992 the market saw a plethora of issues. Hefty premiums were charged by the issuing companies as there was no restriction on fixing of premiums. • Many fly-by-night companies also accessed capital market. • But in many cases, investors lost heavily as the post issue listings were quoted far below issue prices. • It is estimated that around 1000 companies which came out with issues and collected about Rs. 3000 crores in • 1995 and 1996 have disappeared completely.With a view to protect the interest of investors Malegam Committee recommended the introduction of • Book Building as an alternative device to the existing system of fixed pricing and it was adopted by SEBI in 1996. Book Building helps to find a better price for an issue to be made. Under this method, the issuing company will mention an indicative price at which securities will be offered and gives the investors an opportunity to bid collectively. Then a consensus price will be arrived at and allotment will be finalised at the agreed price. Buy-back of shares• is a device which facilitates capital restructuring of a company. It helps in arresting wide fluctuation in share prices and paves the way for efficient allocation of resources. Earlier, buy-back of shares was prohibited in India by the Companies Act, 1956, however, buy- back was allowed in India through an amendment ordinance in 1998. Now Indian companies are free to buy its own shares and other securities up to 25 per cent of their net worth out of its free reserves, or securities premium account, or proceeds of an earlier issue other than a fresh issue made specifically for buy- back purposes. In another development, companies are given the option to issue shares of any denomination without a uniform par value.

1.5 Capital Market in IndiaIndian capital market is one of the oldest and largest capital markets of the world. Its history can be traced back to the 19th century. The first instance of organised trading in corporate securities in India is related to the trading in securities of East India Company.

There are 22 stock exchanges in India, the first being the Bombay Stock Exchange (BSE), which began formal trading in 1875, making it one of the oldest in Asia. Over the last few years, there has been a rapid change in the Indian securities market, especially in the secondary market. Advanced technology and online-based transactions have modernised the stock exchanges. In terms of the number of companies listed and total market capitalisation, the Indian equity market is considered large relative to the country’s stage of economic development.

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Fig. 1.2 Indian capital market(Source: http://www.scribd.com)

The changes in economic scenario (after the liberalisation) and the economic growth have raised the interest of Indian as well as Foreign Institutional Investors (FII’s) in the Indian capital market. The recent massive structural reforms on the economic and industry front in the form of de-licensing rupee convertibility, tapping of foreign funds, allowing foreign investors to come to India, have resulted, on one hand, in the quantum leap in activities/volume in the Indian capital market, and on the other hand and more importantly, that the Indian capital market has undergone a metamorphosis in terms of institutions, instruments, etc. The capital market in India is rightly termed as an emerging and promising capital market. During last 20 years or so, the Indian capital market has witnessed growth in volume of funds raised as well as of. The buoyancy in the capital market has appeared as a result of increasing industrialisation, growing awareness globalisation of the capital market, etc. Several financial institutions, financial instruments, and financial services have emerged as a result of economic liberalisation policy of the Government of India.

1.5.1 Structure of Indian Capital MarketBroadly speaking, the capital market is classified in to two categories: Primary market (New Issues Market) and the Secondary market (Old (Existing) Issues Market). This classification is done on the basis of the nature of the instrument brought in the market. However on the basis of the types of institutions involved in capital market, it can be classified into various categories such as the Government Securities market or Gilt-edged market, Industrial Securities market, Development Financial Institutions (DFIs) and financial intermediaries. All of these components have specific features to mention. The structure of the Indian capital market has its distinct features. These different segments of the capital market help to develop the institution of capital market in many dimensions. The primary market helps to raise fresh capital in the market. In the secondary market, the buying and selling (trading) of capital market instruments takes place. The following chart will help in understanding the organisational structure of the Indian Capital market.

Indian Capital Market

Market Instruments Intermediaries Regulator

Primary Secondary

SEBIBrokers• Investment bankers• Stock Exchanges• Underwriters•

Equity Hybrid DebtPlayers

CRA Corporate Intermediaries Individual Banks/FI FDI /FII

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Fig. 1.3 Structure of capital market in India(Source: http://kalyan-city.blogspot.com)

Government securities marketThis is also known as the Gilt-edged market. This refers to the market for government and semi-government securities backed by the Reserve Bank of India (RBI).

Industrial securities marketThis is a market for industrial securities, i.e., market for shares and debentures of the existing and new corporate firms. Buying and selling of such instruments take place in this market. This market is further classified into two types; New Issues Market (Primary) and Old (Existing) Issues Market (secondary). In primary market, fresh capital is raised by companies by issuing new shares, bonds, units of mutual funds and debentures. However, in the secondary market already existing, i.e., old shares and debentures are traded. This trading takes place through the registered stock exchanges. In India, there are three prominent stock exchanges which are Bombay Stock Exchange (BSE), National Stock Exchange (NSE) and Over The Counter Exchange of India (OTCEI).

Development Financial Institutions (DFIs) This is yet another important segment of Indian capital market. This comprises various financial institutions. These can be special purpose institutions like IFCI, ICICI, SFCs, IDBI, IIBI, UTI, etc. These financial institutions provide long term finance for those purposes for which they are set up.

Financial intermediaries The fourth important segment of the Indian capital market is the financial intermediaries. This comprises various merchant banking institutions, mutual funds, leasing finance companies, venture capital companies and other financial institutions.These are important institutions and segments in the Indian capital market.

1.5.2 Role of Capital Market in IndiaThe capital market influences the Economic conditions of a country. The Capital Market plays the roles mentioned below.

Capital formation - • The capital market encourages capital formation in the country. Rate of capital formation depends upon savings in the country. Though the banks mobilise savings, they are not sufficient to match the requirements of the industrial sector. The capital market mobilises savings of households and of the industrial concern. Such savings are then invested for productive purposes. Thus, saving and investment leads to capital formation in country.

Capital market in India

Government Securities

(Gilt-edged market)

Industrial Securities Market

Development Financial

Institutions (DFIs)

Financial Intermediaries

New Issues Market

Merchant Banks

Mutual Funds

Leasing Companies

Venture Capital Companies

Other Financial Organisations

Old Issues Market [Stock Exchange]

IFCI ICICI SFcs IDBI IIBI UTI

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Economic growth - • Capital market facilitates the growth of the industrial sector as well as other sectors of the economy. The main function of the capital market is to transfer resources (funds) from masses to the industrial sector. The capital market makes it possible to lend funds to various projects in public as well as private sector.Development of backward areas - • The capital markets provide funds for the projects in backward areas. This facilitates the economic development of the backward areas. Employment - • Capital market generates employment in the country in two different ways:

Direct employment in the capital markets such as stock markets, financial institutions, etc. �Indirect employment in all sectors of the economy, because of the funds provided for developmental �projects.

Long term capital to the industrial sector - • The capital market provides a permanent long-term capital for the companies. Once, the funds are collected through issues, the money remains with the company. The company is left free with the funds while investors exchange securities among themselves. Foreign capital - • Capital market makes possible to generate foreign capital. Indian firms are able to generate capital form overseas markets though bonds and other securities. Such foreign exchange funds are vital for the economic growth of the nation. Developing role of financial institutions - • The various agencies of capital market such as industrial Financial Corporation of India (IFCI), State Finance Corporations (SFC), industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India (UTI(, life insurance Corporation of India (LIC), etc. have been rendering useful services for industrial growth. They finance, promote, and underwrite the functions of the capital market.Investment opportunities - • Capital markets provide excellent investment opportunities to the public members. The public can have alternative source of investment, i.e., bonds, shares and debentures, etc.

1.5.3 PESTEL Analysis of Indian Capital MarketThe various aspects considered during PESTEL Analysis are given below.

Political• The capital market of India is very vulnerable. India has been politically instable in the past but it is a little politically stable now-a-days. The political instability of the country has a very strong impact on the capital market. The share market of India changes as the political changes took place. The BSE Index, SENSEX goes up and down with any kind of small and big political news, like, if there is news that a particular political party has withdrawn its support from the ruling party, and then the capital market will go down with a bang. The political stability of the country is very important for the stability and growth of capital market in India. The political imbalance or balance of the country is the major factor in deciding the capital market of India. The political factors include:

employment laws �tax policy �trade restrictions and tariffs �political stability �

EconomicalThe economical measures taken by the government of India has a very strong relationship with the capital market. Whenever the annual budget is announced the capital market goes up and down with the economical policies of the government .If the policies are supportive to the companies then the capital market takes it positively and if there is any other policy that is not supportive and it is not welcomed then the capital market goes down. Like, in the case of allocation of 3-G spectrum, those companies that got the license for 3-G, they witnessed sharp growth in their share values so the economic policies play a major part in the growth and decline of the capital market and again if there is relaxation on any kind of taxes on items of automobile industry then the share of automobile sector goes up and virtually strengthen the capital market .The economical factors include:

inflation rate �economic growth �

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exchange rates �interest rates �

SocialIndia is a country of unity in diversity. India is socially rich but the capital market is not very attached with the social factors .Yes, there is some relation between the social factors with the capital market. If there is any big social factor then to some extent it affects the capital market but small social factors don’t impact at all. Like, there was opposition of reliance fresh in many cities and many stores were closed. The share prices of the reliance fresh went down but the impact was on and individual firm there was not much impact on the capital market on a whole the social factors have not much of impact on the capital market in India. The social factors include:

emphasis on safety �career attitudes �population growth rate �age distribution �health consciousness �

TechnologicalThe technological factors have not that much effect on the capital market. India is technological backward country. Same as social factors, technological factor can have an effect on an individual form but it cannot have a big impact on a whole of capital market. The Bajaj got a patent on its dts-i technology, and launched it in its new bike but it does not effect on capital market. The technological change in India is always on a lower basis and it doesn’t effect on country as a whole. The technological factors include:

R&D activity �technology incentives �rate of technological change �automation �

Environmental factorsInitially, the environmental factors don’t play a vital role in the capital market. But, in changing time, people are becoming more eco-friendly. This is really bothering them that if any firm or industry is environment friendly or not. An increasing number of people, investors, and corporate executives are paying importance to these facts; the capital markets still see the environment as a liability. They belie that it is of no use for their strategy. The environmental performance is even under-valued by the markets.

Legal factorsLegal factors play an important role in the development and sustain the capital market. Legal issues relating to any industry or firm decides the fate of the capital market. If the govt. of India or the parliament introduces a new law that can affect the running of the industry then the industry will be demotivated and this demonisation will lead to the demonisation of the investors and will result in the fall of capital market. Like after the Hardhat Mehta scam, new rules and regulations were introduced like PAN card was made necessary for trading, if any investor was investing too much money in a small firm, then the investors were questioned, etc. These regulations were meant to maintain transparency in the capital market, but at that time, investment was discouraged. Legal factors are necessary for the improvement and stability of the capital market.

1.6 Capital Market RegulationsConsidering the broad thrust of the ongoing programs of economic reform, the mechanism of administrative controls over capital issues has been dismantled and pricing of capital issues is now essentially market determined. Regulation of the capital markets and protection of investor's interest is now primarily the responsibility of the Securities and Exchange Board of India (SEBI), which is located in Bombay.Accordingly, SEBI's functions include the following:

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Regulating the business in stock exchanges and any other securities markets• Registering and regulating the working of collective investment schemes, including mutual funds.• Prohibiting fraudulent and unfair trade practices relating to securities markets• Promoting investor's education and training of intermediaries of securities markets• Prohibiting insider trading in securities, with the imposition of monetary penalties, on erring market • intermediariesRegulating substantial acquisition of shares and takeover of companies• Calling for information from, carrying out inspection, conducting inquiries and audits of the stock exchanges • and intermediaries and self regulatory organisations in the securities market. Keeping this in view, SEBI has issued a new set of comprehensive guidelines governing issue of shares and other financial instruments, and has laid down detailed norms for stock-brokers and sub-brokers, merchant bankers, portfolio managers and mutual funds

On the recommendations of the Patel Committee report, SEBI on 27 July 1995, permitted carry forward deals. Some of the major features of the revised carry-forward transactions as directed by SEBI are:

Carry forward deals permitted only on stock exchanges which have screen based trading system.• Transactions carried forward cannot exceed 25% of a broker's total transactions on any one day.• 90-day limit for carry forward and squaring off allowed only till the 75th day (or the end of the fifth • settlement).Daily margins to rise progressively from 20% in the first settlement to 50% in the fifth. • On 26 January1995, the government promulgated an ordinance amending the SEBI Act, 1992, and the Securities • Contracts (Regulation) Act, 1956. In accordance with the amendment adjudicating mechanism will be created within SEBI and any appeal against • this adjudicating authority will have to be made to the Securities Appellate Tribunal, which is to be separately constituted. These appeals will be heard only at the High Courts.

The main features of the amendment to the Securities Contract (Regulation) Act, 1956, are:The ban on the system of options in trading has been lifted.• The time limit of six months, by which stock exchanges could amend their bye-laws, has been reduced to two • months.Additional trading floors on the stock exchanges can be established only with prior permission from SEBI.• Any company seeking listing on stock exchanges would have to comply with the listing agreements of stock • exchanges, and the failure to comply with these, or their violation, is punishable.

Fraudulent and Unfair Trade PracticesSEBI is vested with powers to take action against these practices relating to securities market manipulation and misleading statements to induce sale/purchase of securities.

Inspection and EnforcementSEBI has the powers of a civil court in respect of discovery and production of books, documents, records, accounts, summoning and enforcing attendance of company/person and examining them under oath. SEBI can levy fines for violations related to failure to submit information to SEBI / to enter into agreements with clients / to redress investor grievances, violations by mutual funds/stock brokers and violations related to insider trading, takeovers etc.

Reforms in the Capital MarketOver the last few years, SEBI has announced several far-reaching reforms to promote the capital market and protect investors’ interests. Reforms in the secondary market have focused on three main areas: structure and functioning of stock exchanges, automation of trading and post trade systems and the introduction of surveillance and monitoring systems. Computerised online trading of securities, and setting up of clearing houses or settlement guarantee funds

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were made compulsory for stock exchanges. Stock exchanges were permitted to expand their trading to locations outside their jurisdiction through computer terminals. Thus, major stock exchanges in India have started locating computer terminals in far-flung areas, while smaller regional exchanges are planning to consolidate by using centralised trading under a federated structure. Online trading systems have been introduced in almost all stock exchanges. Trading is much more transparent and quicker than in the past. Until the early 1990s, the trading and settlement infrastructure of the Indian capital market was poor.

Trading on all stock exchanges was through open outcry, settlement systems were paper-based, and market intermediaries were largely unregulated. The regulatory structure was fragmented and there was neither comprehensive registration nor an apex body of regulation of the securities market. Stock exchanges were run as “brokers clubs” as their management was largely composed of brokers. There was no prohibition on insider trading, or fraudulent and unfair trade practices. Since 1992, there has been intensified market reform, resulting in a big improvement in securities trading, especially in the secondary market for equity.

Most stock exchanges have introduced online trading and set up clearing houses/corporations. A depository has become operational for scripless trading and the regulatory structure has been overhauled with most of the powers for regulating the capital market vested with SEBI. The Indian capital market has experienced a process of structural transformation with operations conducted to standards equivalent to those in the developed markets. It was opened up for investment by foreign institutional investors (FIIs) in 1992 and Indian companies were allowed to raise resources abroad through Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs). The primary and secondary segments of the capital market expanded rapidly, with greater institutionalisation and wider participation of individual investors accompanying this growth. However, many problems, including lack of confidence in stock investments, institutional overlaps, and other governance issues, remain as obstacles to the improvement of Indian capital market efficiency.

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SummaryA capital market is a part of the Financial Market of the country. Financial market is a market where financial • instruments are exchanged or traded and helps in determining the prices of the assets that are traded in and is also called the price discovery process. Capital market facilitate the buying and selling of securities, such as shares and bonds or debentures. They • perform two valuable functions: liquidity and pricing securities.The finance theory refers to three forms of capital market efficiency, viz., Weak-form of efficiency, Semi-strong • form of efficiency and Strong-form of efficiency.Indian capital market is one of the oldest and largest capital markets of the world. Its history can be traced back • to the 19th century.Broadly speaking the capital market is classified in to two categories: Primary market (New Issues Market) and • the Secondary market (Old (Existing) Issues Market). This classification is done on the basis of the nature of the instrument brought in the market.Capital market operations consist mainly of primary market operations and secondary market operations.• Over the last few years, SEBI has announced several far-reaching reforms to promote the capital market and • protect investor interests. Reforms in the secondary market have focused on three main areas: structure and functioning of stock exchanges, automation of trading and post trade systems, and the introduction of surveillance and monitoring systems.

ReferencesGopalsmay, N., 2005. • Capital market: the Indian financial scene, India: Macmillan.Choudhry, M., 2002. • Capital market instruments: analysis and valuation, Volume 1, FT Press.Fabozzi, F.J., and Modigliani, F., 2003. • Capital Markets, 3rd ed., Prentice Hall.

Recommended ReadingKanuk, A.R., 2002. • Capital markets of India: an investor's guide, John Wiley and Sons.Rathore, S., 2003. • Indian Capital Market: An Empirical Study, Anmol Publications PVT. LTD. Shah, A., Dr. Thomas S., and Gorham M., 2008. • India's financial markets: an insider's guide to how the markets work, Elsevier.

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Self Assessment

____________ market is a market where financial instruments are exchanged or traded.1. Financiala. Capitalb. Moneyc. Creditd.

Which market is designed to finance the long-term investments?2. Financial marketa. Capital marketb. Money marketc. Credit marketd.

Which statement is true?3. The capital market is a wholesale debt market for low-risk, highly-liquid, short-term instrument.a. The forex market is designed to finance the long-term investments.b. The financial market deals with the multicurrency requirements, which are met by the exchange of c. currencies.Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate d. and individuals.

Match the following.4.

Indian Financial System1. Secondary MarketA.

Financial Instruments2. Credit MarketB.

Financial Markets3. Money Market InstrumentsC.

Money Market4. Regulators D.

1-A, 2-B, 3-C, 4-Da. 1-D, 2-C, 3-B, 4-Db. 1-B, 2-C, 3-A, 4-Dc. 1-C, 2-D, 3-A, 4-Bd.

Which market is known as the Gilt-edged market?5. Industrial securities marketa. Financial marketb. Government securities marketc. DFId.

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_______________or new issue market deals with the issue of new securities to the investors and facilitates the 6. corporate sector in raising funds.

Primary marketa. Secondary Marketb. Money Marketc. Capital Marketd.

Capital Issues (Control) Act was repealed and free pricing was introduced by SEBI in ______________.7. 1991a. 1992b. 1993c. 1994d.

Capital market makes possible to generate____________.8. Financial marketa. Primary marketb. Foreign marketc. Money marketd.

________________ were permitted to expand their trading to locations outside their jurisdiction through 9. computer terminals.

Stock exchangesa. Financial marketsb. Financial intermediariesc. Financial instrumentsd.

Which statement is false?10. On 26 January1995, the government promulgated an ordinance amending the SEBI Act.a. On the recommendations of the Patel Committee report, SEBI on 27 July 1995, permitted carry forward b. deals.The social imbalance or balance of the country is the major factor in deciding the capital market of India.c. The capital market of India is very vulnerable.d.

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Chapter II

Primary Market and Secondary Market

Aim

The aim of this chapter is to:

introduce primary market•

explain secondary market•

elucidate stock exchange •

Objectives

The objectives of this chapter are to:

enlist the ways to raise capital in primary market•

elucidate the reforms in secondary market•

explain the primary target market•

Learning outcome

At the end of this chapter, the students will be able to:

understand the policy developments in primary and secondary markets•

comprehend the products dealt in secondary market •

infer the problems in indian primary market•

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2.1 IntroductionPrimary market provides opportunity to issuers of securities, Government, as well as corporate sector, to raise resources to meet their requirements of investment and/or discharge some obligation. The issuers create and issue fresh securities in exchange of funds through public issues and/or as private placement. When securities are exclusively offered to the existing shareholders it is called ‘Rights Issue’ and when it is issued to selected mature and sophisticated institutional investors as opposed to general public it is called ‘Private Placement Issues’. Issuers may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt or some hybrid instruments. The issuers may issue securities in domestic market and /or international market through ADR/GDR/ECB route.

Secondary market refers to the network/system for the subsequent sale and purchase of securities. An investor can apply and get allotted a specified number of securities by the issuing company in the primary market. However, once allotted the securities can thereafter be sold and purchased in the secondary market only. An investor who wants to purchase the securities can buy these securities in the secondary market. A security emerges or takes birth in the primary market but its subsequent movements take place in secondary market. The firms do not obtain any new financing from secondary market. The secondary market provides the life-blood to any financial system in general, and to the capital market in particular.

2.2 Eligibility Norms of Primary MarketAny company issuing securities has to satisfy the following conditions at the time of filing the draft offer document and the final offer document with SEBI and Registrar of Companies (RoCs)/Designated Stock Exchange respectively.

File a draft offer document with SEBI, along with specified fees through an eligible merchant banker, at least • 30 days prior to the filing of red herring prospectus or shelf prospectus with the Registrar of Companies (RoCs) or filing the letter of offer with the designated stock exchanges as the case may be.Obtain In-principle approval from recognised stock exchanges.• Enter into an agreement with the depository for dematerialisation of its securities already issued or proposed to • be issued.A company can make an IPO as per the following conditions.It has net tangible assets of at least Rs. 3 crores in each of the preceding 3 full years, of which not more than 50% • is held in monetary assets; provided that if more than 50% of the net tangible assets are held in monetary assets, the company has made firm commitments to deploy such excess monetary assets in its business/project.It has a net worth of at least Rs. 1 crores in each of the preceding 3 full years• It has a track record of distributable profits in terms of section 205 of the Companies Act, 1956, for at least 3 • out of the immediately preceding 5 years; provided further that extraordinary items shall not be considered for calculating distributable profits in terms of section 205 of Companies Act, 1956The aggregate of the proposed issue and all previous issues made in the same financial year in terms of size • does not exceed five times its pre-issue net worth and In case the company has changed its name within the last one year, at least 50% of the revenue for the preceding • one full year is earned by the company from the activity suggested by the new name.

In case the above mentioned conditions are not satisfied, an issuer can still make an IPO on compliance of the guidelines as specified:

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A. issue should be made through the book building process with at least 50% of net offer to public being allotted • to the QIBs, if not, then the full subscription monies has to be refunded, ORthe project should have at least 15% of the cost of project contribution by public financial institutions or scheduled • commercial banks of which at least 10% should come from the appraiser. In addition, at least 10% of the issue size should be allotted to QIBs, otherwise, the full subscription monies would be refunded;

AND

B. minimum post-issue face value capital of the company should be Rs. 10 crores, OR• there should be compulsory market making for at least 2 years from the date of listing subject to certain conditions • as specified in the regulations.

A company can make an initial public offer of convertible debt instruments without making a prior public issue of its equity shares and can list the same. Pursuant to a public issue, no allotment can be made if the number of prospective allottees is less than one thousand.

2.3 Primary Market DesignThe primary market is governed by the provisions of the Companies Act, 1956, which deals with issues, listing and allotment of securities. Additionally the SEBI - prescribes the eligibility and disclosure norms to be complied by the issuer, promoter for accessing the market.

2.3.1 Credit Rating for Debt InstrumentsNo public issue or rights issue of convertible debt instruments can be made unless a credit rating of not less than investment grade is obtained from at least one credit rating agencies registered with SEBI. In case the credit rating is obtained from more than one credit rating agencies, all the credit rating/s including the unaccepted credit ratings, should be disclosed. All the credit ratings obtained during the three years preceding the public or rights issue of debt instrument (including convertible instruments) for any listed security of the issuer company should be disclosed in the offer document.

2.3.2 IPO GradingNo issuer should make an IPO of equity shares or any other security which may be converted into or exchanged with equity shares at a later date, unless the following conditions are satisfied as on the date of filing of Prospectus (in case of fixed price issue) or Red Herring Prospectus (in case of book built issue) with ROC.

The issuer has obtained grading for the IPO from at least one credit rating agency.• Disclosures of all the grades obtained along with the rationale/description furnished by the credit rating agency(ies) • for each of the grades obtained, have been made in the Prospectus (in case of fixed price issue) or Red Herring Prospectus (in case of book built issue)The expenses incurred for grading IPO have been borne by the unlisted company obtaining grading for IPO.•

Every company obtaining grading for IPO should disclose the grades obtained, along with the rationale/description furnished by the credit rating agency(ies) for each of the grades obtained in the prospectus, abridged prospectus, issue advertisements and at all other places where the issuer company is advertising for the IPO.

2.3.3 Pricing and Public IssuesAn issuer may determine the price of specified securities, coupon rate and conversion price of convertible debt instruments in consultation with the lead merchant banker or through the book building process. An issuer making an initial public offer may determine the face value of equity shares subject to the provisions of the Companies

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Act, 1956, SEBI Act and regulations. If the issue price per equity share is Rs. 500 or more, the issuer shall have the option to determine the face value at below Rs.10 per equity share, subject to the condition that the face value shall not be less than Rs. 1 per equity share.

In case the issue price per equity share is less than Rs. 500 per equity share, the face value of the shares shall be Rs. 10 per equity share.

The above clause does not apply to initial public offer made by any government company, statutory authority, or corporation or any special purpose vehicle set up by any of them, which is engaged in infrastructure sector.

The disclosure about the face value of equity shares (including the statement about the issue price being “X” times of the face value) shall be made in the advertisements, offer documents and application forms.

2.3.4 Price and Price BandThe issuer can mention the price or price band in the draft prospectus (In case of a fixed price issue) and the floor price or price band in the red herring prospectus (in case of a book built issue) and determine the price at a later date before registering the prospectus with the Registrar of Companies which would require to contain only one price or the specific coupon rate, as the case may be.The cap on the price band shall be less than or equal to 120% of the floor price. The floor price or the final price shall not be less than the face value of the specified securities. The “cap on the price band” includes cap on the coupon rate in case of convertible debt instruments.

2.3.5 Contribution of Promoters and Lock-in

The promoters’ contribution in case of initial public offer should not be less than 20% of the post issue • capital. In case of further public offer, promoters should contribute to the extent of 20% of the proposed issue or should • ensure post-issue share holding to the extent of 20% of the post-issue capital.For a composite issue, the promoters’ contribution should either be 20% of the proposed issue size or 20% of • the post-issue capital.At least one day prior to the opening of the issue the promoters should bring in the full amount of the promoters • contribution including premium which should be kept in an escrow account with a Scheduled Commercial Bank and the said contribution/amount should be released to the company along with the public issue proceed.The minimum promoters’ contribution should be locked in for a period of 3 years in case of public issues, • however. However, if the promoters’ contribution exceeds the required minimum, then the excess is locked in for a period of one year.The lock-in period starts from the date of commencement of commercial production (the last date of the month • in which commercial production in a manufacturing company is expected to commence as stated in the offer document) or date of allotment in the public issue, whichever is later.

In case of pre-issue share capital of an IPO, the entire pre-issue share capital, other than promoter’s �contribution shall be locked for a period of one year. Securities allotted in firm allotment basis are also locked in for a period of one year from the date of commencement of commercial production or the date of allotment in the public issue whichever is later. The locked-in securities held by promoters may be pledged only with banks or FIs as collateral security for loans granted by such banks or FIs.

2.3.6 Pre-issue ObligationThe lead merchant banker has to exercises due diligence and satisfy himself about all aspects of issue including offering, veracity and adequacy of disclosures in the offer document. The liability of the merchant banker will continue even after the completion of issue process.

The lead merchant banker has to pay the requisite fee in accordance with regulation 24A of the Securities and Exchange Board of India (Merchants bankers) Rules and Regulations, 1992 along with draft offer document filed

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with the Board. In case of a fast track issue, the requisite fee shall be paid along with the copy of the red herring prospectus, prospectus, or letter of offer, as the case may be.

Each company issuing securities through public or rights issue has to enter into a Memorandum of Understanding with the lead merchant banker, which specifies their mutual rights, liabilities, and obligations.

The lead merchant banker responsible for drafting of the offer documents has to submit to the Board the copy • of the MOU entered into with the issuer company and the draft of the offer document.In case a public or rights issue is managed by more than one merchant banker the rights, obligation, and • responsibilities of each merchant banker should be demarcated.In case of under subscription of an issue, the Lead Merchant Banker responsible for underwriting arrangements • should invoke underwriting obligations and ensure that the notice for devolvement containing the obligations of the underwriters is issued in terms of the regulations. The lead Merchant Banker should furnish to the Board a due diligence certificate along with the draft offer • document.In case of a fast track issue of convertible debt instruments the lead merchant banker should furnish a due • diligence certificate to the Board as per the format specified.

The lead merchant bankers should satisfy themselves about the ability of the underwriters to discharge their under writing obligations. In respect of every underwritten issue, the lead merchant banker(s) should undertake a minimum underwriting obligation of 5% to the total underwriting commitment of Rs.25 lakhs whichever is less. The outstanding underwriting commitments of a merchant banker should not exceed 20 times its net worth at any point of time. In respect of an underwritten issue, the lead merchant banker should ensure that the relevant details of underwriters are included in the offer document.

The draft offer documents filed with the Board should be made public for a period of 21 days from the date of filing the offer document with the Board and filed with the stock exchanges where the securities are proposed to be listed. Further, the draft offer documents should be put on the websites of the lead managers/syndicate members associated with the issue and also ensure that the contents of documents hosted on the websites are the same as that of their printed versions.

Twenty-one days after the draft offer document has been made public, the lead merchant banker should file a statement with the Board giving a list of complaints received, a statement as to whether it is proposed to amend the draft offer document or not, and highlighting those amendments.The lead manager should also ensure that the issuer company has entered into agreements with all the depositories for dematerialisation of securities.

An issuer company has to appoint a compliance officer who will directly liaise between the Board and the issuer company with regard to compliance of various laws, rules, regulations, and other directives issued by the Board.

2.3.7 Post-issue ObligationSubsequent to the post issue, the lead merchant banker should ensure that the post-issue monitoring reports are submitted irrespective of the level of subscription. Also, the merchant banker should be associated with allotment, refund, and dispatch and also monitor the redressal of investor grievances arising therefrom.

In a public issue, the Executive Director/Managing Director of the Designated Stock Exchange along with the post issue lead merchant banker and the registrars to the Issue are responsible for the finalisation of allotment in a fair and proper manner as specified in Schedule XV.

The lead merchant banker should ensure that the dispatch of share certificates/refund orders and demat credit is completed and the allotment and listing documents submitted to the stock exchanges within 2 working days of the date of allotment.

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2.3.8 Credit RatingCredit rating agencies (CRA) can be promoted by public financial institutions, scheduled commercial banks, and foreign banks operating in India, by any body corporate having continuous minimum net worth of Rs.100 crores for the previous five years. Further, foreign credit rating agencies recognised by or under any law for the time being in force in the country of its incorporation, having at least five years experience in rating securities can also operate in the country. The SEBI (Credit Rating Agencies) Regulations, 1999 cover the rating of the securities listed and not fixed deposits, foreign exchange, country ratings, and real estates. No company can make a public issue or rights issue of debt instruments (whether convertible or not), unless credit rating is obtained from at least one credit rating agency registered with the Board and disclosed in the offer document. Where ratings are obtained from more than one credit rating agencies, all the ratings including the unaccepted ratings should be disclosed in the offer document.

2.3.9 Merchant BankingThe merchant banking activity in India is governed by SEBI (Merchant Bankers) Regulations, 1992. Consequently, all the merchant bankers have to be registered with SEBI. The details about them are presented in the table below:

Category of merchant banker

Permitted activity

Category 1 To carry on activity of the issue management, to act as adviser, consultant, manager, underwriter, portfolio manager

Category 2 To act as adviser, consultant, co-manager, underwriter, portfolio manager

Category 3 To act as underwriter, adviser, consultant to an issue

Category 4 To act only as adviser or consultant to an issue

Table 2.1 Merchant bankers

Only a corporate body other than non-banking financial company having necessary infrastructure, with at least two experienced persons employed can apply for registration as a merchant banker. The capital adequacy requirement should be a net worth of Rupees Fifty million. The regulations cover the code of conduct to be followed by merchant bankers, responsibilities of lead managers, payments of fees and disclosures to SEBI.

2.3.10 Demat IssuesSEBI has mandated that all new IPOs compulsorily should be traded in dematerialised form only. Further, the section 68B of the Companies Act, 1956, requires that every listed public company making IPO of any security for Rs. 10 crores or more should issue the same only in dematerialised form.

2.3.11 Private PlacementThe private placement involves issue of securities, debt or equity, to selected subscribers, such as banks, FIs, MFs and high net worth individuals. It is arranged through a merchant/investment banker, who acts as an agent of the issuer and brings together the issuer and the investor(s). Since these securities are allotted to a few sophisticated and experienced investors, the stringent public disclosure regulations and registration requirements are relaxed. The Companies Act, 1956, states that an offer of securities to more than 50 persons is deemed to be public issue.

2.4 Ways to Raise Capital in the Primary MarketThere are 4 ways in which a company can raise the capital in the primary market as detailed below.

Public issue - • In Public Issues the company offers the shares directly to the public/institutions. The shares are allotted at a stated price. It is done through document called a “prospectus.” It is one of the most common

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methods followed all over the world.

Offer of sale - • In this type the company sells off all its securities to one issue houses or the share brokers. The share brokers sell these securities at higher price than the price at which they have purchased them from the company. The difference in the purchasing and selling price is called as “turn or spread or Bought Out Deals (BOD)”. The advantage of this kind of sale is that the company need not print and advertise the prospectus. Rights issue - • This is an FPO. In this type the company distributes the new shares or securities amongst the existing share holders. The distribution depends on the capital that has to be raised by the company and the number of the shares that the existing investors possess.Private placement - • In this type the share brokers or issue houses purchase all the shares out-rightly from the company and issue them to their own clients at the same price or at the premium price.

2.5 IntermediariesStock Exchange member companies, merchant and commercial banks, insurance companies, investment and finance companies work as intermediaries to play the following roles.

2.5.1 Manager to the IssueThe manager to the issue prepares the prospectus and is responsible for ensuring full and fair disclosure about the issue and the issuer. The issue manager has to impart a Due Diligence Certificate which is published along with the prospectus.

2.5.2 UnderwritersUnderwriter is an important intermediary in the new issue/primary market is the underwriters to the issues of capital who agree to take u securities which are not fully, subscribed. They make a commitment to get the issue subscribed either by other or by them. Though underwriting is not mandatory after April 1995, its organisation is an important element of the primary market. They are appointed by the issuing companies in consultation with the lead manager/ merchant banker to the issues. A statement to the effect that in the opinion of the lead manager, the underwriters asset are adequate to meet their obligation should be incorporated in the prospectus certificate.

2.5.2.1 RegistrationTo act as underwriter, a certificate of registration must be obtained from the SEBI in granting the registration, the SEBI considers all matters relevant relating to the underwriting and in particular,

the necessary infrastructural like adequate office space, equipment and manpower to effectively discharged the • activitypast experience in underwriting/ employment of at least two persons with experience in underwriting• any person directly/ indirectly connect with the applicant is not registered with the SEBI as underwriter or • previous application of any such person has been rejected or any disciplinary action has been taken against such person under the SEBI act/rules/regulationcapital adequacy requirement of not less than the net worth (CAPITAL + free reserve) of Rs. 20 lakh• the applicant/ director/ principle officer/ partner has been convicted of offence involving moral turpitude or • found guilty of any economic offence. Fee underwriters, had to, for grant or renewal of registration, pay a fee to the SEBI from the date of initial grant of certificate, Rs. 2 lakh for the first and second year and Rs. 1 lakh for the third year. A fee of Rs. 20,000 was payable every year to keep the certificate in force or for its renewal. Since 1999 the registration fee has been raised to Rs. 5 lakh. To keep the registration in force, renewal fee of Rs. 1 lakh. Every three years from the forth year the date of initial registration is payable. Failure to pay the fee would result in the suspension of the certificate of registration

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2.5.2.2 General Obligations and Responsibilities of UnderwritersBelow mentioned are certain obligations and responsibilities that an underwriter has to follow.

Code of Conduct - • Every underwriter has at all time to abide by a code of conduct; he has to maintain high standard of integrity, dignity and fairness in all his dealings with his clients and, other underwriters in the conduct of his business. He has to ensure that he and his personal act in an ethical manner in all dealing with the issuers of capital. An underwriter has to rendered high standard of service exercise due diligence, ensure proper care and exercise independent professional judgment. He must disclose to the issuer his possible source/ potential areas of conflict of duties and interest of other underwriters to place them in a disadvantageous position in relation to him while competing for/carrying out any assignment. He must not make any written or oral statement to misrepresent.

The service that he to be capable of performing for the issuer/ or has rendered to other issuer or �The underwriting commitment: He should not reveal to other issuer/ any party any confidence information �about his issuer, which forms the come to his knowledge and deal in securities of any issuer without disclosing to the SEBI or to the board of director of the issuer. An underwriter should not wilfully make untrue statement/suppress material fact in any document, reports, papers or information furnished to the SEBI.

Agreements with clients - • Every underwriter has to enter into an agreement with the issuing company. The agreement, among others, provides for the period during which the agreement is in for amount of underwriting obligations, the period within which the underwriter has to subscribe to the after being intimated by/on behalf of the issue, the amount of commission/ brokerage, and detail of arrangement, if any, made by the underwriter for fulfilling the underwriting obligations.

General responsibilities - • An underwriter cannot derive any direct or indirect benefit from underwriting the issue other than by the underwriting commission. The maximum obligation under all writing agreements of an underwriter cannot exceed 20 times his net worth; underwriters have to subscribe for securities under the agreement within 45 days of the receipt of intimation from he issuer.

Inspection and disciplinary proceedings - • The framework of the SEBI right to undertake the inspection of the book of account, other record documents of the underwriters, the procedure for inspection and obligation of the underwriters is on the same pattern as applicable to the lead manager.

Action in case of default - • The liability for action in case of default arising out of the following:Non-compliance with any conditions subject to which registration was granted �Contravention of any provision of the SEBI act/rules/ regulation underwriter involves the suspension/ �cancellation of registration: the effect of suspension/ cancellation on the lines followed by the SEBI in case of lead manager

2.6 Primary Target MarketPrimary target market is the main cluster of customers (the people who truly need the product and will buy it) that a company wants to go for. Primary target market basically comprises the potential customers who are targeted by the companies. Many companies have failed to determine their primary target market by reason of their inefficient marketing strategies. In today's competitive world, every company has to set their target audiences through customer survey, and then only their primary target market will be fixed for a longer period irrespective of market conditions.

The Primary Target Market of any company basically consists of potential customers whom are targeted by that company. The database for the primary target market of a company represents the functional list of promising customers, that is, the target audiences having the potential of spending. Many companies fail to set their primary target market due to their inefficient market strategy.

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Most of the big companies determine their primary target market through customer survey. That is, they actively communicate with their target audiences and try to understand their needs. In one word, they try to adapt themselves with the market needs that are changing every now and then. A strategic customer survey enables the companies to know better about the customer expectations and dissatisfactions. This is also referred as target marketing.

Today, with the help of information technologies, the companies can run an efficient data base management system through which they can keep track of their customers' record. The list of the potential customers can be indexed and classified in many ways, for example, by size, credit status, geographic location, pricing preferences, specific product interests etc.

The companies will only be able to set their primary target market by managing their customer databases strategically. It is the way through which the companies can interact with their past and present customers.

2.6.1 Process of Finding Primary Target MarketThe process of finding and studying primary target market for a venture doesn't have to be complex or expensive, but it is extremely important. In a nutshell, it requires finding out everything about the customers who are intended to be pursued. Once all the information is gathered, there is a much better chance of capturing those customers for business.

Demographics Start the research by checking the demographics of the region that you plan to target. You'll want to know the population's makeup in terms of age, gender, income level, occupation, education, and family circumstances: married with children, singles, or retired. To find that information, you'll need to spend some time online. Do a Google search to find the most recent edition of the Country and City Data Book, published by the U.S. Department of Commerce. This research will give you the most recent census data on the area you wish to target.

Geographic and lifestyle factors Give some thought to where and how your target customers live. Are they urbanites who walk everywhere (foot traffic will bring them into a store) or suburban soccer moms who spend most of their time in the car (do you need to provide a lot of parking space)? What is the weather like? Are people more likely to spend a lot of time outdoors, or are indoor activities more popular? Are these people conservative with their money, or are they spenders? The answers will help determine what you can sell to them, how you should sell it, and at what price.

Customer needs Consider all of the reasons why people might purchase your product or service. For example, if you're opening a health club, what are the priorities of your clients. Do they want to take exercise classes, work out with a trainer, or play racquet sports with friends? Will you need to be open early in the morning to accommodate commuters who need to leave for work? Are there a lot of stay-at-home or work-from-home parents who need child care services in order to attend classes? Find out by talking to people in the local fitness industry and by quizzing friends or acquaintances who go to health clubs. Then you can design and market your club accordingly.

Thinking about opening a coffee shop? Stake out the area where you think you'd like to start the business. Notice the traffic, car and foot, at various times throughout the day to see how many people might frequent your shop. Do people dash in and out of shops, or would they linger? This might help you determine whether you should also sell small pastry items or full meals as well as coffee.

Once you have considered the key demographic factors, you can begin to assemble a customer profile, a more focused statement that describes your target market in detail. Consult that profile when you make decisions about issues such as what products and services to offer or advertise, how much to charge for various products, and expansion plans.

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2.7 Indian Primary MarketPrimary market provides opportunity to issuers of securities, Government as well as corporate, to raise resources to meet their requirements of investments and/or discharge some obligation. Primary market, also known as New Issue Market, deals with new securities which were not previously available and offered to the investing public for the first time. The primary market enjoys neither any tangible form nor any administrative organisational set-up and is not subject to any centralised control and administration for the execution of its business. It is recognised by the services that it renders to the lenders and borrowers of capital. The main function of primary market is to facilitate the ‘transfer of resources’ from savers market, i.e., channelising of investible funds, can be divided, from the operational stand- point, into a triple- service function; organisation, underwriting and distribution.

2.7.1 Reforms in Indian Primary MarketThe basic task of securities market to help in process of capital formation in the economy, this can only is possible by services of systematic measures which would build their confidence in the systems and process and protect investor’s interest fully. The rising of capital issues were controlled by the office of the Controller of Capital Issues (CCI) under the Capital Issues Control Act (CIA) 1947. The CIA 1947, repealed office of the controller of capital issues abolished and initial share pricing decontrolled. In 1991-92 Finance minister announced the repeal of the act and transfer of power from CCI to SEBI from control to disclosure based regulation. Since then SEBI put some reforms in the primary market operations in India. Following are the important guidelines put by SEBI in the primary market from time to time. As per this regulation all the information pertaining to and available with an issue is provided so as the investor takes an informed decision whether to invest or not to invest.

2.7.2 Disclosure and Investor Protection (DIP) Guideline

Eligibility criteria for issues: • Companies eligible to make an issue can decide on their standard denomination and price of a security. Some parameters that need to be in offer documents are minimum holding by promoters, size of public issue, issue expenses, information disclosure and advertisement etc.Free pricing of securities: • Issuer is free to determine the level of security price. The process of Book- Building helps discover price and assist small investor to take an investment decision.Book building: • It refers to the process of ascertaining demand for and price of securities through bids. In 1998 SEBI introduced guidelines for issuing shares through the book building process based on the recommendations of the Malegam Committee, 1995. SEBI defines “book building mechanism as a process undertaken by which demand for the securities proposed to be issued by a body corporate is elicited and build up and the price for such securities is assessed for the determination of the quantum of securities to be issued by means of notice, circular, advertisement, document or information memoranda or offer document”. The issuing company should disclose either the floor price of the securities offered through it or a price band along with a range within which the price can move. In case the price band is disclosed, the lead book runner should ensure that the cap of the price band should not exceed 20 percent of the floor. The price band can be revised during the bidding period. The maximum revision on either side should not exceed 20 percent. The book shall be open for a minimum period of five days and not more than ten days subject to a maximum of bidding period of 13 days in the case of the price band is revised. Therefore it appears a little restrictive but book building gives ample opportunities for price discovery.Green Shoe Option: It is the market stabilization mechanism by which stabilizing agent acts on behalf of Issuer • Company, buys a merely issued security for the limited purpose of preventing a decline in the new security’s open market price in order to facilitate its distribution to the public. After listing the IPO, if process in open market falls below the issue price, small investor may start selling their securities their securities to minimize losses. Therefore, there was a vital need of a market stabilizer to smoothen the swing in the open market price of newly listed share, after an IPO. Market stabilization is the mechanism by which stabilizing agent acts on behalf of the issuer company, buys newly issued security for the limited purpose of presenting a decline in the new security’s open market price in order to facilitate its distribution to the public. Such mechanism is called Green Shoe Option. The company shall appoint one of the lead book runners, amongst the issue management team, as the Stabilizing Agent (SA), who will be responsible for the price stabilization process, if required.The SA shall enter into an agreement with the promoters who will lend their shares, specifying the maximum •

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number of shares that may be borrowed from the promoters, which shall not be in excess of fifteen percent of the total size. The stabilization mechanism shall be available for the period disclosed by the company in the prospectus, which shall not exceed thirty days from the date when trading permission was given by the exchange.Application Supported by Blocked Amount (ASBA):• Is an application containing an authorization to block the application money in the bank account, for subscribing to an issue. When investors apply for an Initial Public Offering, they have to pay the entire money upfront to the banker and hence stand to lose returns on the money that is locked until the shares are allotted. The new move, Application Supported by Blocked Amount(ASBA), will protect the money of investors and will also make IPO issue process more efficient and less time consuming. This process enables the banker to block the money in investors’ account when they bid for an initial public offerings and the money is released on the basis of number of shares being allotted. The remaining money will be unblocked by the banks. As a result, the initial public offering process is expected to be completed within 15 days of the closing date of the issue.

2.8 Secondary MarketThe secondary market is represented by the stock exchanges in any capital market. The stock exchanges provide an organised market place for the investors to trade in the securities. This may be the most important function of stock exchanges. For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

2.9 Structure and Trading System in Secondary MarketThe securities market has essentially three categories of participants, viz., the issuer of securities, investors in securities and the intermediaries. The issuers are the borrowers or deficit-units, who issue securities to raise funds for their business activities. The investors, who are surplus savers, deploy their savings by subscribing to these securities and issue funds for the business activities. The intermediaries are the agents who match the needs of users and suppliers of funds for a commission. The stock exchange, theoretically speaking, is a perfectly competitive market, as a large number of sellers and buyers participate in it and the information regarding the securities is publicly available to all the investors. A stock exchange permits the security prices to be determined by the competitive forces. They are not set by negotiations off the floor, where one party might have a bargaining advantage. The bidding process flows from the demand and supply underlying each security. This means that the specific price of a security is determined, more or less, in the manner of an auction. The stock exchanges provide market in which the members of the stock exchanges (the share brokers) and the investors participate to ensure liquidity to the latter.

The secondary market or the stock exchange system in India is represented by 23 stock exchanges including the National Stock Exchange of India (NSE), the Over The Counter Exchange of India, the Inter connected Stock Exchange of India and 20 other stock exchanges located at different places. However at present, trades take place only at NSE and BSE and other stock exchanges have become redundant. The operations of stock exchanges are regulated, supervised and controlled by the Securities and Exchange Board of India (SEBI).

SEBI uses 3 types of controls in respect of stock exchanges as follows:It makes stock exchanges to impose minimum capital requirements on the members.• It prohibits and checks the price of a security from rising or falling too fast. The prices are allowed to move • within fixed limits over a day. The circuit-breakers are applied to cool down the volatility in prices of a particular share.It makes the stock exchanges to impose various types of margins on their members. The SEBI has imposed 6 • types of margins on the transactions of the share brokers. These are :

Carry forward margins �Incremental carry forward margins �

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Mark to market margins �Concentrations margins �Volatility margins �Special ad-hoc margins �

The trading mechanism at all stock exchanges is online fully automated Screen Based Trading systems (SBTS) in which orders from customers are matched electronically on a strict price/time priority. The system is highly efficient and allows a large number of participants to trade with one another.

2.10 Products Dealt in Secondary MarketFollowing are the main financial products/instruments dealt in the secondary market:

Equity Shares: • An equity share, commonly referred to as ordinary share also represents the form of fractional ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have voting rights. Rights issue / Rights shares: • The issue of new securities to existing shareholders at a ratio to those already held.Bonus shares: • Shares issued by the companies to their shareholders free of cost by capitalization of accumulated reserves from the profits earned in the earlier years.Preferred stock / Preference shares:• Owners of these kinds of shares are entitled to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the company’s creditors, bondholders/debenture holders.Cumulative preference shares: • A type of preference shares on which dividend accumulates if remains unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.Cumulative convertible preference shares: • A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company. Participating preference share:• The right of certain preference shareholders to participate in profits after a specified fixed dividend contracted for is paid. Participation right is linked with the quantum of dividend paid on the equity shares over and above a particular specified level.Security receipts:• Security receipt means a receipt or other security, issued by a securitisation company or reconstruction company to any qualified institutional buyer pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title, or interest in the financial asset involved in securitisation.Government securities (G-Secs): • These are sovereign (credit risk-free) coupon bearing instruments which are issued by the Reserve Bank of India on behalf of Government of India, in lieu of the Central Government's market borrowing programme. These securities have a fixed coupon that is paid on specific dates on half-yearly basis. These securities are available in wide range of maturity dates, from short dated (less than one year) to long dated (up to twenty years).Debentures: • Bonds issued by a company bearing a fixed rate of interest usually payable half yearly on specific dates and principal amount repayable on particular date on redemption of the debentures. Debentures are normally secured / charged against the asset of the company in favour of debenture holder. Bond:• A negotiable certificate evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. The various types of Bonds are as follows-

Zero coupon bond: � Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond.Convertible bond: � A bond giving the investor the option to convert the bond into equity at a fixed conversion

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price.

Commercial paper: • A short term promise to repay a fixed amount that is placed on the market either directly or through a specialised intermediary. It is usually issued by companies with a high credit standing in the form of a promissory note redeemable at par to the holder on maturity and therefore, doesn’t require any guarantee. Commercial paper is a money market instrument issued normally for tenure of 90 days.Treasury Bills: • Short-term (up to 91 days) bearer discount security issued by the Government as a means of financing its cash requirements.

2.11 Stock ExchangeIndia Stock Exchanges can either be a conglomerate/ firm or mutual group. The affiliates act as intermediaries to their patrons or as key players for their own accounts. Stock Exchanges in India also assist the issue and release of securities and other monetary tools incorporating the fortification of revenues and dividends. The book keeping of the trade is centralized but the buying and selling is associated to a particular place as advanced marketplaces are mechanized. The buying and selling on an exchange is only open to its affiliates and brokers.

2.11.1 Investment PrecautionsHere are some useful pointers to bear in mind before investing in the markets:

Make sure that the broker is registered with SEBI and the exchanges and do not deal with unregistered • intermediaries.Ensure that the broker gives contract notes for all the transactions within one working day of execution of the • trades.All investments carry risk of some kind. Investors should always know the risk that they are taking and invest • in a manner that matches their risk tolerance.Do not be misled by market rumours, luring advertisement or ‘hot tips’ of the day.• Take informed decisions by studying the fundamentals of the company. Find out the business the company is • into, its future prospects, quality of management, past track record etc Sources of knowing about a company are through annual reports, economic magazines, databases available with vendors or the financial advisor.If the financial advisor or broker advises to invest in an unknown company, be cautious. Spend some time • checking out about the company before investing.Do not be attracted by announcements of fantastic results/news reports, about a company. Do proper research • before investing in any stock.Do not be attracted to stocks based on what an internet website promotes, unless the investor has done adequate • study of the company.Investing in very low priced stocks or what are known as penny stocks does not guarantee high returns.• Be cautious about stocks which show a sudden spurt in price or trading.•

2.12 Secondary Market and SEBIThe SEBI is the regulatory authority established under Section 3 of SEBI Act 1992 to protect the interests of the investors in securities and to promote the development of, and to regulate, the securities market and for matters connected therewith and incidental thereto.

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2.12.1 Various Departments of SEBI Regulating Trading in the Secondary Market

Sr. No. Name of the Department Major Activities

1. Market Intermediaries Registration and Supervision department (MIRSD)

Registration, supervision, compliance monitoring and inspections of all market intermediaries in respect of all segments of the markets viz. equity, equity derivatives, debt and debt related derivatives.

2. Market Regulation Department (MRD)

Formulating new policies and supervising the functioning and operations (except relating to derivatives) of securities exchanges, their subsidiaries, and market institutions such as Clearing and settlement organisations and Depositories (Collectively referred to as ‘Market SROs’.)

3. Derivatives and New Products Departments (DNPD)

Supervising trading at derivatives segments of stock exchanges, introducing new products to be traded, and consequent policy changes

2.12.2 Secondary Market Reforms by the SEBISince the establishment of Securities and Exchange Board of India (SEBI) in 1992, the decade old trading system in stock exchanges has been under review. The main deficiencies of the system were found in two areas:

the clearing and settlement system in stock exchanges whereby physical delivery of shares by the seller and • the payment by the buyer was madeprocedure for transfer of shares in the name of the purchaser by the company. The procedure was involving a lot • of paper work, delays in settlement and non-transparency in costs and prices of the transactions. The prevalence of ‘Badla’ system had often been identified as a factor encouraging speculative activities. As a part of the process of establishing transparent rules for trading, the ‘Badla’ system was discontinued in December 1993. The SEBI directed the stock exchanges at Mumbai, Kolkata, Delhi and Ahmadabad to ensure that all transactions in securities are concluded by delivery and payments and not to allow any carry forward of the transactions

The floor-based open outcry system has been replaced by on-line electronic system. The period settlement system has given way to the rolling settlement system. Physical share certificates system has been outdated by the electronic depository system. The risk management system has been made more comprehensive with different types of margins introduced. FII’s have been allowed to participate in the capital market. Stringent steps have been taken to check insider trading. The interest of minority shareholders has been protected by introducing takeover code. Several types of derivative instalments have been introduced for hedging.

As a result of the reforms/initiatives taken by Government and the Regulators, the market structure has been refined and modernized. The investment choices for the investors have also broadened. The securities market moved from T+3 settlement period to T+2 rolling settlement with effect from April 1, 2003. Further, straight through processing has been made mandatory for all institutional trades executed on the stock exchange. Real time gross settlement has also been introduced by RBI to settle inter-bank transactions online real time mode.

2.13 Changes in the Indian Secondary Market RegulationThe Indian securities market is in transition. Several important changes were brought for the smooth and effective functioning of stock exchanges from the time to time by the SEBI. The revolutionary changes have been taking place

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over a period of time. In fact, on almost all the operational and systematic risk management parameters, settlement system, disclosures, accounting standards, the Indian securities market is at par with the global standards. Some of those initiatives taken place in the secondary market are discussed below:

Overall administration, supervision and control of the stock exchanges The central government for the first time in April 1988 constituted an administrative body viz. securities and exchange board of India and in January 1992, the central government enacted an Act granting a statutory recognition to the securities and exchange board of India as a regulator of the securities/ markets. The governing board of the council to be consisting of total 10 members, 4 from stock exchanges, 4 from government, corporate finance, commerce, accountancy, management and law and 2 from investment and development finance institutions.Membership of the stock exchange Minimum basic educational qualification is 12th standard or equivalent and graduation after 5 years. Members to have reasonable background in economics, corporate finance, taxation, etc. The stock exchanges have to approve members (trainers) to impart adequate knowledge and training to aspirants for membership. Financial institutions, commercial banks, and companies are also eligible for membership of stock exchanges. Membership is to be open to a qualified person at any time. Multiple memberships are allowed to member to encourage provision of better services to the investing public and to further the healthy development of capital market.

Public issuesThe companies eligible to make a public issue can freely price their equity shares or any security convertible into equity at a later date in cases of public/ rights issues by listed companies and public issue by unlisted companies. In addition, eligible infrastructure companies can freely price their equity shares subject to compliance of disclosure norms of SEBI. The public and private sector banks can also freely price their shares subject to approval by RBI. A company may issue shares to applicants in the firm allotment category at higher price than the price at which securities are offered to public. Further an eligible company is free to make public/ rights issue in any denomination determined by it in accordance with sub-section (4) of section 13 of the companies Act, 1956 and SEBI norms.

Risk managementIn the equipment leasing industry, application of the liquidity and hedging tools of modern corporate finance has lagged behind other sectors of the financial services business. The creation of a deep and liquid secondary market for lease assumptions will enable liquidity to be made available and provide more flexibility to both lessees and lessors. For a better appreciation of how this might come about, this article presents an economic and financial analysis of the developing secondary market for lease assumption. A continuing development in corporate finance has been the sophisticated risk management methodologies involving credit enhancement, hedging through derivative securities, and techniques and structures such as securitization for improved liquidity. This paper presents a brief economic and financial analysis of the developing secondary market for lease assumption, focusing on the incentive structure and the underlying rationale for a secondary market. The enhanced optional and liquidity that this advance in the state of the art permits has the potential to create value for all market participants and, in particular, significant risk management benefits for lessors.

Systems audit Trading, settlement and risk management system of stock exchanges are almost completely automated. For this reason, it becomes very important that the systems do not have deficiencies which can impair their efficacy. It also becomes important to ensure that the stock exchanges have suited disaster recovery sites and business continuity plans and that the systems are adequately secure. Active stock exchanges have been asked to carry out system audit through external agencies competent to carry system audit exercise. SEBI does follow-up for rectification of deficiencies pointed out in the systems audit reports, in 2004-2005 too. Such follow-up was done through offsite analysis of compliance reports from stock exchanges and meeting with the senior management of stock exchanges.

Institutionalisation Capital market are said to be more efficient when they have more participants, instruments, processes and other alternatives. Indian capital market was dominated by individual investors till early part of the 1990’s. Earlier

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institutional investors such as life insurance Corporation of India, General Insurance Corporation of India and its four subsidiaries, Development financial institutions, banks etc., used to take minor role in the capital market activity. Unit trust of India, the only mutual fund then, used to play active role in the primary market and secondary capital market. 1990s saw entry of many new participants to the capital market. SEBI permitted private sector and joint sector (Indian as well as foreign), mutual funds. Government of India and SEBI allowed foreign institutional investors, non-resident Indians, and overseas corporate bodies to trade in securities. Additionally, non-banking finance companies also have been taking interest in dealing in securities. Thus, the variety of participants taking interest in the Indian capital market substantially increased and the current variety is as large as is available in any other developed market.

2.13.1 Policy Developments During 2009-10

It is mandatory for the transferee(s), in case of securities market transactions and off-market/private transactions • involving transfer of shares in physical form of listed companies, to furnish a copy of the PAN card to the Company/RTAs for registration of such transfer of shares. In order to bring in more transparency in the grievance redressal mechanism available in stock exchanges, it was • decided that they will henceforth disclose the details of complaints lodged by clients/investors against trading members and companies listed in the exchange, on their website. The aforesaid disclosure shall also include details pertaining to arbitration and penal action against the trading members. With a view to instilling greater transparency and discipline in dealings between clients and stockbrokers, • stockbrokers have been advised to register a client by entering into an agreement with him. The registration requirements include both mandatory and non-mandatory documents. The former include (a) a member-client agreement (MCA)/tripartite agreement in case a sub-broker is involved, (b) a know-your-client (KYC) form and (c) a risk disclosure document (RDD). A copy of all the documents executed by the client shall be given to him, free of charge, within seven days from the date of execution of the documents by him. In case a stock exchange has no trading for a period of less than six months, it shall ensure that necessary • regulatory requirements have been complied with before resuming trading and the matter may be placed before its Board with reasons, if any.Stock exchanges have been permitted to set their trading hours (in cash and derivatives segments) subject to • the condition that these are between 9 am and 5 pm and the Exchange has in place a risk-management system and infrastructure commensurate with the trading hours.Taking note of the fact that stock exchanges had reduced/waived transaction charges, they were advised, while • revising such transaction charges, to ensure that their systems were capable of handling additional load and it did not affect the existing risk- management system. The revised charges should be uniformly applied to trades of similar nature and implemented in a fair and transparent manner.SEBI-registered stockbrokers (including trading members) of stock exchanges have been allowed to provide • access to clients through authorized persons. It was decided that in case of a buy transaction in the cash market, VaR margins, extreme loss margins and • mark-to-market losses together should not exceed the purchase value of the transaction. However, in case of a sale transaction in the cash market, the existing practice would continue, namely VaR margins and extreme loss margins together shall not exceed the sale value of the transaction and mark-to-market losses would also be levied.It was decided to bring in parity between domestic venture capital funds and foreign venture capital investors • (FVCIs). Applicants desirous of registering with SEBI as FVCIs are required to obtain firm commitment from their investors for contribution of an amount of at least US$ 1 million at the time of submission of applications seeking registration.

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SummaryPrimary market provides opportunity to issuers of securities, Government, as well as corporate sector, to raise • resources to meet their requirements of investment and/or discharge some obligation.Any company issuing securities has to satisfy the following conditions at the time of filing the draft offer • document and the final offer document with SEBI and Registrar of Companies (RoCs)/Designated Stock Exchange respectively.The primary market is governed by the provisions of the Companies Act, 1956, which deals with issues, listing • and allotment of securities.Stock Exchange member companies, merchant and commercial banks, insurance companies, investment and • finance companies work as intermediaries.Underwriter is an important intermediary in the new issue/primary market is the underwriters to the issues of • capital who agree to take u securities which are not fully, subscribed.The process of finding and studying primary target market for a venture doesn't have to be complex or expensive, • but it is extremely important. In a nutshell, it requires finding out everything about the customers who are intended to be pursued.Secondary market refers to the network/system for the subsequent sale and purchase of securities. An investor • can apply and get allotted a specified number of securities by the issuing company in the primary market.The securities market has essentially three categories of participants, viz., the issuer of securities, investors in • securities and the intermediaries.India Stock Exchanges can either be a conglomerate/ firm or mutual group. The affiliates act as intermediaries to • their patrons or as key players for their own accounts. Stock Exchanges in India also assist the issue and release of securities and other monetary tools incorporating the fortification of revenues and dividends.

ReferencesKhan, 2006. • Indian Financial System, 5th ed., Tata McGraw-Hill Education.Pathak, 2007. • The Indian Financial System: Markets, Institutions And Services, 2nd ed., India, Pearson Education.Bhole, L.M., 2004. • Financial institutions and markets: structure, growth and innovations, 4th ed., Tata McGraw-Hill Education.

Recommended ReadingKhan, M.Y., 2004. • Financial services, 3rd ed., Tata McGraw-Hill Education.Babu, R.G., 2005. • Financial Services In India, Concept Publishing Company.Bhole, 2009. • Financial Institutions & Markets, 5th ed., Tata McGraw-Hill Education.

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Self AssessmentThe issuers may issue securities in domestic market and/or ________market through ADR/GDR/ECB route.1.

primarya. internationalb. secondaryc. capitald.

File a draft offer document with________, along with specified fees through an eligible merchant banker, at 2. least 30 days prior to the filing of red herring prospectus.

NSEa. RBIb. BSEc. SEBId.

The primary market is governed by the provisions of the Companies Act, ________.3. 1956a. 1957b. 1958c. 1959d.

Which statement is false?4. No public issue or rights issue of convertible debt instruments can be made unless a credit rating of not less a. than investment grade is obtained from at least one credit rating agencies registered with SEBI.An issuer may determine the price of specified securities, coupon rate and conversion price of convertible b. debt instruments in consultation with the lead merchant banker or through the book building process.The floor price or the final price shall not be less than the face value of the specified securities.c. The promoters’ contribution in case of initial public offer should not be less than 10% of the post issue d. capital.

Rights Issue is _________5. IPOa. Marketb. FPOc. Derivatived.

The trading mechanism at all stock exchanges is online fully automated __________ in which orders from 6. customers are matched electronically on a strict price/time priority.

Screen Based Trading systems (SBTS)a. Bombay Stock Exchange (BSE)b. National Stock Exchange (NSE)c. IPOd.

India Stock Exchanges can either be a conglomerate/firm or7. Companya. Mutual groupb. Institutionc. Foundation d.

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The SEBI is the regulatory authority established under Section 3 of SEBI Act ______ to protect the interests 8. of the investors in securities.

1991a. 1992b. 1993c. 1994d.

Match the columns.9. Public Issue1. The share brokers or issue houses purchase all the shares out-rightly from a.

the company and issue them to their own clients at the same price or at the premium price

Offer of Sale2. This is an FPOb.

Rights Issue3. The company sells off all its securities to one issue houses or the share c. brokers

Private Placement4. The company offers the shares directly to the public/institutionsd.

1-A, 2-B, 3-C, 4-Da. 1-D, 2-C, 3-B, 4-Ab. 1-B, 2-C, 3-D, 4-Ac. 1-C, 2-D, 3-B, 4-Ad.

Since the establishment of Securities and Exchange Board of India (SEBI) in 1992, the decade old trading 10. system in _________ has been under review.

capital marketa. money marketb. stock marketc. primary marketd.

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Chapter III

Securities and Exchange Board of India

Aim

The aim of this chapter is to:

introduce SEBI•

explain SEBI Act, 1992•

elucidate management of the board •

Objectives

The objectives of this chapter are to:

enlist different departments of SEBI•

elucidate the limitations of SEBI•

explain the functions of various departments of SEBI•

Learning outcome

At the end of this chapter, the students will be able to:

understand powers of SEBI•

comprehend the functions of SEBI •

infer the registrations of intermediaries•

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3.1 IntroductionIn 1988, the Government of India established the Securities and Exchange Board of India (SEBI) through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992, with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both, development and regulation of the market and independent powers have been set up. Paradoxically, this is a positive outcome of the Securities Scam of 1990-91.

The basic objectives of the Board were identified as:to protect the interests of investors in securities• to promote the development of Securities Market• to regulate the securities market• for matters connected therewith or incidental thereto•

Since its inception, SEBI has been working targeting the securities and is attending to the fulfilment of its objectives with commendable zeal and dexterity. The improvements in the securities markets like capitalisation requirements, margining, establishment of clearing corporations etc. reduced the risk of credit and also reduced the market.

SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the eligibility criteria, the code of obligations and the code of conduct for different intermediaries, like bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws, risk identification and risk management systems for clearing houses of stock exchanges, surveillance system etc., which have made dealing in securities both, safe and transparent to the end investors.

Another significant event is the approval of trading in stock indices (like S&P CNX Nifty & Sensex) in 2000. A market Index is a convenient and effective product because of the following reasons:

It acts as a barometer for market behaviour.• It is used to benchmark portfolio performance.• It is used in derivative instruments like index futures and index options.• It can be used for passive fund management as in case of Index Funds.•

Two broad approaches of SEBI are to integrate the securities market at the national level, and also to diversify the trading products, so that there is an increase in number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc. to transact through the exchanges. In this context, the introduction of derivatives trading through Indian stock exchanges permitted by SEBI in 2000 AD is a real landmark.

SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for derivatives trading and suggest bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Board of SEBI, in its meeting, held on May 11, 1998 accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-laws" as recommended by Dr. L. C. Gupta Committee for Regulation and Control of Trading and Settlement of Derivatives Contracts.

SEBI then appointed the J. R. Verma Committee to recommend Risk Containment Measures (RCM) in the Indian Stock Index Futures Market. The report was submitted in November 1998.

However, the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to include "derivatives" in the definition of securities to enable SEBI to introduce trading in derivatives. The necessary amendment was then carried out by the Government in 1999. The Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999, the new framework was approved.

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Derivatives have been accorded the status of ̀ Securities'. The ban imposed on trading in derivatives in 1969 under a notification issued by the Central Government was revoked. Thereafter, SEBI formulated the necessary regulations/bye-laws and intimated the Stock Exchanges in the year 2000. The derivative trading started in India at NSE in 2000 and BSE started trading in the year 2001.

3.2 Objectives of SEBIThe objectives of SEBI are mentioned below.

to provide a degree of protection to the investors and safeguard their rights and to ensure that there is a steady • flow of funds in the marketto promote fair dealings by the issuer of securities and ensure a market where they can raise funds at a relatively • low costto regulate and develop a code of conduct for the financial intermediaries and to make them competitive and • professionalto provide for the matters connecting with or incidental to the above•

3.3 Securities and Exchange Board of India Act, 1992Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947, in May 1992. With this, Government’s control over issues of capital, pricing of the issues, fixing of premia and rates of interest on debentures etc. ceased and the office which administered the Act was abolished: the market was allowed to allocate resources to competing uses. However, to ensure effective regulation of the market, Securities and Exchange Board of India Act, 1992 was enacted to establish SEBI with statutory powers for:

protecting the interests of investors in securities• promoting the development of the securities market• regulating the securities market•

Its regulatory jurisdiction extends over companies listed on Stock exchanges and companies intending to get their securities listed on any recognised stock exchange in the issuance of securities and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI can specify the matters to be disclosed and the standards of disclosure required for the protection of investors in respect of issues; can issue directions to all intermediaries and other persons associated with the securities market in the interest of investors or of orderly development of the securities market; and can conduct enquiries, audits and inspection of all concerned and adjudicate offences under the Act. In short, it has been given necessary autonomy and authority to regulate and develop an orderly securities market. All the intermediaries and persons associated with securities market, viz., brokers and sub-brokers, underwriters, merchant bankers, bankers to the issue, share transfer agents and registrars to the issue, depositories, Participants, portfolio managers, debentures trustees, foreign institutional investors, custodians, venture capital funds, mutual funds, collective investments schemes, credit rating agencies, etc., shall be registered with SEBI and shall be governed by the SEBI Regulations pertaining to respective market intermediary.

3.4 Management of the BoardThe Board shall consist of the following members, namely,•

the Chairman �two members from amongst the officials of the [5][Ministry] of the Central Government dealing with Finance �[6][and administration of the Companies Act, 1956(1 of 1956)];one member from amongst the officials of [7][the Reserve Bank]; �five other members of whom at least three shall be the whole-time members] to be appointed by the central �Government

The general superintendence, direction and management of the affairs of the Board shall vest in a Board of • members, which may exercise all powers and do all acts and things which may be exercised or done by the Board.

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Save as otherwise determined by regulations, the Chairman shall also have powers of general superintendence • and direction of the affairs of the Board and may also exercise all powers and do all acts and things which may be exercised or done by that Board. The Chairman and members referred to in clauses (a) and (d) of sub-section (1) shall be appointed by the Central • Government and the members referred to in clauses (b) and (c) of that sub-section shall be nominated by the Central Government and the [9][Reserve Bank] respectively. The Chairman and the other members referred to in clauses (a) and (d) of sub-section (1) shall be persons of • ability, integrity and standing who have shown capacity in dealing with problems relating to securities market or have special knowledge or experience of law, finance, economics, accountancy, administration or in any other discipline which, in the opinion of the Central Government, shall be useful to the Board.The Board shall meet at such times and places, and shall observe such rules of procedure in regard to the transaction • of business at its meetings (including quorum at such meetings) as may be provided by regulations. The Chairman or, if for any reason, he is unable to attend a meeting of the Board, any other member chosen by • the members present from amongst themselves at the meeting shall preside at the meeting. All questions which come up before any meeting of the Board shall be decided by a majority votes of the • members present and voting, and, in the event of an equality of votes, the Chairman, or in his absence, the person presiding, shall have a second or casting vote.

3.5 Powers of SEBISection 11 of the SEBI Act deals with the powers and functions of the SEBI as follows:

Powers relating to stock exchanges and intermediariesSEBI has wide powers regarding the stock exchanges and intermediaries dealing in securities. It can ask information from the stock exchanges and intermediaries regarding their business transactions for inspection / scrutiny and other purpose.

Powers relating to monetary penaltiesSEBI has been empowered to impose monetary penalties on capital market intermediaries and other participants for a range of violations. It can even impose suspension of their registration for a short period.

Powers to initiate actions relating to functions assignedSEBI has a power to initiate actions in regard to functions assigned. For example, it can issue guidelines to different intermediaries or can introduce specific rules for the protection of interests of investors.

Powers relating to insider tradingSEBI has power to regulate insider trading or can regulate the functions of merchant bankers.

Powers under securities contracts (Regulation) ActFor effective regulation of stock exchange, the Ministry of Finance issued a Notification on 13 September, 1994 delegating several of its powers under the Securities Contracts (Regulations) Act to SEBI. SEBI is also empowered by the Finance Ministry to nominate three members on the Governing Body of every stock exchange.

Powers to regulate business of stock exchangesSEBI is also empowered to regulate the business of stock exchanges, intermediaries associated with securities market as well as mutual fund, fradulant and unfair trade practices relating to securities and regulation of acquisition of shares and takeovers of companies.

3.6 Functions of SEBIThe functions of SEBI are as follows.

To create a proper and conducive atmosphere required for raising money from the capital market. The atmosphere • includes the rules, regulations, trade practices, customs and relations among institutions, brokers, investors and

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companies. It shall endeavour to restore the trust of investors and particularly safeguard the interest of the small investors. This can be achieved by meeting the needs of the persons connected with the securities market and establishing proper coordination among the three main groups directly connected with its operations namely, (a) Investors,. (b) Corporate sector, and (c) Intermediaries. To educate investors and make them aware of their rights in clear and specific terms. It shall provide investors with formation and see that the market maintains liquidity, safety and profitability of the securities which are crucial for any investment.To create a proper investment climate to enable the corporate sector to raise industrial securities easily, efficiently • and at affordable minimum cost.To develop a proper infrastructure so that the market automatically facilitates expansion and growth of business • of middlemen like brokers, commercial banks, merchant bankers, mutual funds, etc. Thus, it will ensure that they provide efficient ser vices to their constituents, namely, investors and the corporate sector at competitive prices.To create the framework for a more open, orderly and unprejudiced conduct in relation to takeover and mergers • in the corporate sector to ensure fair and equal treatment to all the security holders and to facilitate such takeovers and mergers in the interest of efficiency by prescribing a mechanism.To achieve its objectives, the SEBI shall play a dual role by working as a controlling authority and a development • institution. The role of SEBI in brief is as under -To devise laws with unified sets of objectives, single administrative authority and an integrated framework to • deal with all the aspects of the securities market.To introduce a system of two-stage disclosure at the time of initial issue and make compulsory for the companies • to provide detailed information to all the stock exchanges, journalists and investors on demand.To work as an authoritative institution to see that the intermediaries are financially sound and equipped with • professional and competent manpower.To make law-making and observance flexible enough to suit the prevailing market conditions and circumstances. • It will ensure that the rules are versatile and non-rigid to provide automatic and self-regulatory growth.To establish an effective inspection machinery which is expected to act like an umpire. It will provide to its • players, timely guidance, encouragement and incentives as well as impose upon them a self discipline to observe the rules of the game.To strive to prohibit the malpractices prevailing in the market such as insider trading, share cornering.•

3.7 Registration of IntermediariesThe intermediaries and persons associated with securities market shall buy, sell or deal in securities after obtaining a certificate of registration from SEBI, as required by Section 12:

Stock-broker• Sub- broker• Share transfer agent• Banker to an issue• Trustee of trust deed• Registrar to an issue• Merchant banker• Underwriter• Portfolio manager• Investment adviser• Depository• Participant• Custodian of securities•

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Foreign institutional investor• Credit rating agency• Collective investment schemes• Venture capital funds• Mutual fund• Any other intermediary associated with the securities market•

3.8 Departments and Their FunctionsSEBI has many departments working under the Act of 1992. The various departments and their functions are detailed below.

3.8.1 Market Intermediaries Regulation and Supervision Department (MIRSD)This department is responsible for the registration, supervision, compliance monitoring and inspections of all market intermediaries in respect of all segments of the markets, viz., equity, equity derivatives, debt and debt related derivatives. The department also handles the work related to action against the intermediaries for regulatory. The following divisions perform the functions of the department.

3.8.2 Market Regulation Department (MRD)The Market Regulation Department is responsible for supervising the functioning and operations of securities exchanges, their subsidiaries, and market institutions such as clearing and settlement organisations and depositories. The following divisions perform the functions of the department:

Division of Policy• Division of SRO Administration• Division of Market supervision• Investor Complaints Cell•

3.8.3 Derivatives and New Products Department (DNPD)The Division is responsible for supervising the functioning and operations of derivatives exchanges and related market organisations. In order to accomplish its tasks, this division would be responsible for the following.

Derivatives market policy issues• Approval of new derivative products• Monitoring the functioning of derivatives exchanges including conducting inspections and compliance exams• Prescribing and Monitoring risk management and settlement practices in derivatives exchanges• Developing the trading and settlement framework for new products• Regulatory action were required. As regards action it is clarified that the current practice of issuing show cause • notices, appointment of Enquiry/Adjudication officers and consequential action up to serving of Chairman’s order and maintenance of database will be with the Division

3.8.4 Corporation Finance Department (CFD)The Corporation Finance Department deals with matters relating to (i) Issuance and listing of securities, including initial and continuous listing requirements (ii) corporate governance and accounting/auditing standards (iii) corporate restructuring through Takeovers / buy backs (iv) delisting etc. The following divisions form part of this Corporation Finance Department.

Division of Issues and Listing (DIL)• Division of Corporate Restructuring•

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3.8.5 Investment Management Department (IMD)The Investment Management department is responsible for registering and regulating mutual funds, venture capital funds, foreign venture capital investors, and collective investment schemes, including plantation schemes, Foreign Institutional Investors, Portfolio Managers, and Custodians. The following divisions will perform the functions of the Department.

Division of Funds • Investor Complaints Cell• Division of Foreign Institutional Investors and Custodian• Investor Complaints Cell• Division of Collective Investment Schemes•

3.8.6 Integrated Surveillance Department (ISD)The integrated Surveillance department is responsible for monitoring market activity through market systems, data from other departments and analytical software. The department would be responsible for:

developing, maintaining and operating an integrated market surveillance system including monitoring of all • segments of the marketsmethodologies for capturing information from media review, public complaints and tips, other agencies, • exchanges, and direct solicitations; assignment of staff to handle functions; method of logging and cataloguing information; criteria for evaluating and distributing information; input into tracking and other systemsrecognising potentially illegal activities and referrals to Investigations, Enforcement or other departments•

3.8.7 Investigations Department (IVD) The Investigations department is responsible for:

conducting investigations on potentially illegal market activities• providing referrals to the enforcement department• assisting the enforcement department in enforcing SEBI action against violators•

As regards action, the current practice of issuing show cause notices, appointment of Enquiry/Adjudication officers and consequential action up to serving of Chairman’s order and maintenance of database will be with the Department.

3.8.8 Enforcement of Department (EFD)Enforcement Department is responsible for proceedings related to regulatory action and obtaining redress for violations of securities laws and regulations against all market participants, issuers and individuals and other entities that breach securities laws and regulations. The following Divisions will perform the functions of the Department;

Division of Regulatory Action• Division of Prosecutions•

3.8.9 Legal Affairs Department (LAD)The Department of Legal Affairs would be responsible to provide legal counsel to the Board and to its other departments, and to handle non-enforcement litigation. The following Divisions will handle the functions of the Department.

Division of Policy• Division of Regulatory Assistance•

3.8.10 Enquiries And Adjudication Department (EAD)The Enquiries and Adjudication Department would handle quasi judicial matters and provide timely hearings and initiate adjudication brought by the other Departments against alleged violators who are within SEBI’s disciplinary jurisdiction. The department would directly report to Chairman.

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3.8.11 Office of Investor Assistance and Education (OIAE)The Office will support SEBI’s operations by handling investor complaints centrally and be the focal point of SEBI’s investor education effort. The Office would be the single point interface with investors and would receive complaints relating to all departments, forward to the concerned departments, follow up and respond to investors. The office shall set up necessary systems and procedures to handle his function.The office will also receive complaints relating to issues, transfer of shares, dividends, compliance with listing conditions, corporate governance issues under the purview of the Corporation Finance department (Division of Issues and Listing) and take follow up action. 3.8.12 General Services Department (GSD)This department would support all of the internal operations of SEBI. The Department will have the following divisions.

Treasury and Accounts Division• Facilities Management Division• Official Language Division• Office of the Secretary to the Board• Protocol and Security Division•

3.8.13 Department of Economic and Policy Analysis (DEPA)The department handles its functions through the following Divisions:Division of Policy Analysis (DPA)This division would look after the following:

Partnering/vetting of policy/concept papers• Need based research• Regulatory Impact Assessment (RIA) and benchmarking of regulations• Research Support to Committees and Working Groups set up by SEBI• Development of Strategic Action Plan/Vision Statement• Any other tasks that may be assigned• Division of Economic Analysis (DEA)•

Office of the Chairman (OCH)This division would look after the following:

Tracking and analysis of market developments• Tracking and analysis of other economic developments• Repository of data (and data analysis)• Preparation and publication of Annual Report• Preparation and publication of SEBI Bulletin and Handbook of Statistics• Conducting periodic Investor Survey• History of Securities Market Project• Any other tasks that may be assigned.•

3.8.14 Office of Chairman

Office of the Executive Assistant to Chairman• The office will be responsible to provide such administrative and other support as the Chairman may require. The functions would include strategic planning and managing new initiatives.

Office of International Affairs •

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The office would perform the following: Implement information-sharing initiatives with international regulators �Participate in international regulatory organisations �Handle all matters related to Foreign assisted projects �Establish guidelines for interaction with foreign Government agencies and foreign jurisdictions, including �providing technical assistance

3.8.15 Information Technology DepartmentThis department performs its role as the technical support group for SEBI.

3.8.16 The Regional Offices (RO's)The Regional Office will handle work as per existing delegation and shall continue to report to functional heads for specific departmental functions while reporting administratively to SEBI Executive Directors

3.9 Limitation of SEBIThe Central Government has authorised SEBI to frame its rules and regulation for actively monitoring capital • markets. These rules and regulations will have to be approved by the government first. This will cause unnecessary delay and interference by the Finance Minister.SEBI will have to seek prior approval for filling criminal complaints for violations for the regulations. This will • again cause delay at government level.SEBI has not been given autonomy. Its Board of Directors is dominated by government nominees. Out of 5 • directors only 2 can be from outside and these are to represent the Ministries of Finance, Law and Reserve Bank of India.

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SummaryIn 1988, the Government of India established the Securities and Exchange Board of India (SEBI) through an • executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992, with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992.SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for derivatives • trading and suggest bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts.Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947, in May 1992.• Section 11 of the SEBI Act deals with the powers and functions of the SEBI.• The intermediaries and persons associated with securities market shall buy, sell or deal in securities after obtaining • a certificate of registration from SEBI, as required by Section 12.

ReferencesKhan, 2006. • Indian Financial System, 5th ed., Tata McGraw-Hill EducationSecurities and Exchange Board of India, • Functions of Departments / Divisions [Online] (Updated 2010) Available at: < http://www.sebi.gov.in/> [Accessed on: 26 March 2011].Gurusamy. • Capital Markets, 2nd ed., Tata McGraw-Hill Education

Recommended ReadingMurthy, D.K. & Venugopal, K.R., 2005. • Indian Financial System, I. K. International Pvt LtdPathak, 2007. • The Indian Financial System: Markets, Institutions And Services, 2nd ed., India: Pearson EducationChakrabarti, R & De, S., 2010. • Capital Markets in India, SAGE Publications Ltd.

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Self Assessment

What is the full form of SEBI?1. Securities and Exchange Board of Indiaa. Sheet Electron Beam Irradiationb. Sheet Electron Beam of Indiac. Sheet and Exchange Board of Indiad.

The ___________ would be responsible to provide legal counsel to the Board and to its other departments, and 2. to handle non-enforcement litigation.

Enforcement departmenta. Department of Legal Affairsb. Investigations departmentc. Integrated Surveillance departmentd.

Which department supports all of the internal operations of SEBI?3. Department of Legal Affairsa. Investigations departmentb. Integrated Surveillance departmentc. General Services Departmentd.

Which statement is true?4. Enforcement department performs its role as the technical support group for SEBI.a. Investigations department performs its role as the technical support group for SEBI.b. Information Technology Department performs its role as the technical support group for SEBI.c. General Services Department performs its role as the technical support group for SEBI.d.

Which statement is false?5. SEBI has not been given autonomy.a. SEBI will have to seek prior approval for filling criminal complaints for violations for the regulations.b. Out of 5 directors only 2 can be from outside and these are to represent the Ministries of Finance, Law and c. Reserve Bank of India.The State Government has authorised SEBI to frame its rules and regulation for actively monitoring capital d. markets.

The Enquiries and Adjudication Department would directly report to __________.6. President of Indiaa. Chief Election Commissionerb. Chairmanc. Prime Minister of Indiad.

The Investigations department is responsible for assisting the enforcement department in enforcing SEBI action 7. against ____________.

violatorsa. prisonersb. culpritsc. membersd.

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The market intermediaries regulation and supervision department also handles the work related to action 8. __________ the intermediaries for regulatory.

froma. againstb. overc. amongd.

___________ has power to regulate insider trading or can regulate the functions of merchant bankers.9. SBIa. RBIb. SEBIc. CBId.

Which statement is true?10. SEBI has a power to initiate actions in regard to functions assigned.a. SBI has a power to initiate actions in regard to functions assigned.b. SEBI has a power to initiate actions in regard to functions re-assigned.c. SEBI has a power to initiate actions in regard to functions re-assigned and developed.d.

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Chapter IV

Derivative Market

Aim

The aim of this chapter is to:

introduce derivative market•

explain the types of derivatives•

elucidate the exchange-traded and over-the-counter derivative instruments•

Objectives

The objectives of this chapter are to:

introduce accounting and taxation of derivatives transactions•

explain commodity derivatives•

elucidate the derivatives market in India•

Learning outcome

At the end of this chapter, the students will be able to:

understand rise of derivatives•

discuss derivative market instruments in India•

comprehend Indian derivative market•

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4.1 IntroductionA derivative security is a financial contract and its value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. It is a part of the financial market of the country.

The term "Derivative" indicates that it has no independent value, i.e., its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock, or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act.

Derivatives include:a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract • for differences or any other form of securitya contract which derives its value from the prices, or index of prices, of underlying securities•

Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some pre-existing risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e., taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient.

4.2 Types of DerivativesThe various types of deruvatives are discussed below.

Forwards: A forward contract is a customised contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

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Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps: • These entail swapping only the interest related cash flows between the parties in the same currency.Currency swaps: • These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Table 1 The Global derivatives industry: Outstanding contracts (in $ billion)

1995 1996 1997 1998 1999 2000Exchange traded instruments 9283 10018 12018 13932 13522 14302Interest rate futures and options 8618 9257 11221 12643 11669 12626Currency futures and options 154 171 161 81 59 96Stock Index futures and options 511 591 1021 1208 1793 1580Some OTC instruments 17713 25453 29035 80317 88201 95199Interest rate swaps and options 16515 23894 27211 44259 53316 58244Currency swaps and options 1197 1560 1824 5948 4751 5532Other instruments - - - 30110 30134 31423Total 26996 35471 41438 94249 101723 109501

Source : Bank for International Settlements(OTC : Over The Counter traded instruments, discussed later.)

Table 4.1 The Global derivatives industry(Source: http://www.iimcal.ac.in/community/finclub/dhan/dhan1/art16-idm.pdf)

4.3 Exchange-traded and Over-the-counter Derivative InstrumentsOTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customised to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardised format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organised exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.

Development of exchange-traded derivativesDerivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts

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with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.

4.4 IndexAn Index is a number used to represent the changes in a set of values between a base time period and another time period. In order to benchmark the portfolio against the market we need some efficient proxy for the market. Indexes arose out of this need for a proxy.

4.4.1 Catergorisation of IndexThe concept of Index mainly includes the following three categories detailed below.

4.4.1.1 Total Returns IndexNifty is a price index and hence reflects the returns one would earn if investment is made in the index portfolio. However, a price index does not consider the returns arising from dividend receipts. Only capital gains arising due to price movements of constituent stocks are indicated in a price index. Therefore, to get a true picture of returns, the dividends received from the constituent stocks also need to be factored in the index values. Such an index, which includes the dividends received, is called the Total Returns Index. Total Returns Index reflects the returns on the index arising from (a) constituent stock price movements and (b) dividend receipts from constituent index stocks.

The following information is a prerequisite for calculation of TR Index:Price Index close• Price Index returns• Dividend payouts in Rupees• Index Base capitalisation on ex-dividend date•

Dividend payouts as they occur are indexed on ex-date.

Indexed dividends are then reinvested in the index to give TR Index.

Total Return Index = [Prev. TR Index + (Prev. TR Index * Index returns)] + [Indexed dividends + (Indexed dividends * Index returns)]

Base for both the Price index close and TR index close will be the same. An investor in index stocks should benchmark his investments against the Total Returns index instead of the price index to determine the actual returns vis-à-vis the index.

4.4.1.2 Impact CostImpact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time. Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread. Some of the features of impact cost are as mentioned below.

impact cost is separately computed for buy and sell• impact cost may vary for different transaction sizes• impact cost is dynamic and depends on the outstanding orders• where a stock is not sufficiently liquid, a penal impact cost is applied•

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In mathematical terms, it is the percentage mark up observed while buying / selling the desired quantity of a stock with reference to its ideal price (best buy + best sell) / 2. Liquidity in the context of stock markets means a market where large orders can be executed without incurring a high transaction cost. The transaction cost referred here is not the fixed costs typically incurred like brokerage, transaction charges, depository charges etc. but is the cost attributable to lack of market liquidity as explained subsequently. Liquidity comes from the buyers and sellers in the market, who are constantly on the look out for buying and selling opportunities. Lack of liquidity translates into a high cost for buyers and sellers.

The electronic limit order book (ELOB) as available on NSE is an ideal provider of market liquidity. This style of market dispenses with market makers, and allows anyone in the market to execute orders against the best available counter orders. The market may thus be thought of as possessing liquidity in terms of outstanding orders lying on the buy and sell side of the order book, which represent the intention to buy or sell.

When a buyer or seller approaches the market with an intention to buy a particular stock, he can execute his buy order in the stock against such sell orders, which are already lying in the order book, and vice versa.

An example of an order book for a stock at a point in time is detailed below:Buy Sell

Sr. No. Quantity Price Sr. No. Quantity Price

1 1000 3.50 5 2000 4.00

2 1000 3.40 6 1000 4.05

3 2000 3.40 7 500 4.20

4 1000 3.30 8 100 4.25

Table 4.2 An order book for a stock at a point in time

There are four buy and four sell orders lying in the order book. The difference between the best buy and the best sell orders (in this case, Rs.0.50) is the bid-ask spread. If a person places an order to buy 100 shares, it would be matched against the best available sell order at Rs. 4 i.e. he would buy 100 shares for Rs. 4. If he places a sell order for 100 shares, it would be matched against the best available buy order at Rs. 3.50 i.e. the shares would be sold at Rs.3.5.

Hence, if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask spread. This spread may be regarded as the transaction cost which the market charges for the privilege of trading (for a transaction size of 100 shares).

Progressing further, it may be observed that the bid-ask spread as specified above is valid for an order size of 100 shares upto 1000 shares. However for a larger order size the transaction cost would be quite different from the bid-ask spread.

Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the following buy orders Sr. No. Quantity Price

1 1000 3.50

2 1000 3.40

3 1000 3.40

Table 4.3 Buy orders

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while the buy order will hit the following sell orders :

Sr. No. Quantity Price

5 2000 4.00

6 1000 4.05Table 4.4. Sell orders

This implies an increased transaction cost for an order size of 3000 shares in comparison to the impact cost for order for 100 shares. The "bid-ask spread" therefore conveys transaction cost for a small trade.

This brings us to the concept of impact cost. We start by defining the ideal price as the average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e. 3.75. In an infinitely liquid market, it would be possible to execute large transactions on both buy and sell at prices which are very close to the ideal price of Rs.3.75. In reality, more than Rs.3.75 per share may be paid while buying and less than Rs.3.75 per share may be received while selling. Such percentage degradation that is experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost. Impact cost varies with transaction size.

For example, in the above order book, a sell order for 4000 shares will be executed as follows:

Sr. No. Quantity Price Value

1 1000 3.50 3500

2 1000 3.40 3400

3 2000 3.40 6800

Total Value 13700

Wt. Average price 3.43Table 4.5 Share execution

The sale price for 4000 shares is Rs.3.43, which is 8.53% worse than the ideal price of Rs.3.75. Hence, we say "The impact cost faced in buying 4000 shares is 8.53%".

Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time.

Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread.

It should however be emphasised that :impact cost is separately computed for buy and sell �impact cost may vary for different transaction sizes �impact cost is dynamic and depends on the outstanding orders �where a stock is not sufficiently liquid, a penal impact cost is applied �

In mathematical terms it is the percentage mark up observed while buying / selling the desired quantity of a stock with reference to its ideal price (best buy + best sell) / 2.

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4.4.1.3 BETAThe degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationships with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market return. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good reflector of the market.Beta is calculated as:

where,Y is the returns on your portfolio or stock - DEPENDENT VARIABLEX is the market returns or index - INDEPENDENT VARIABLEVariance is the square of standard deviation

Covariance is a statistic that measures how two variables co-vary, and is given by:

Where,N denotes the total number of observations

and respectively represent the arithmetic averages of x and y

In order to calculate the beta of a portfolio, multiply the weightage of each stock in the portfolio with its beta value to arrive at the weighted average beta of the portfolio.

4.4.2 RiskRisk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected. Risks can be classified as Systematic risks and Unsystematic risks.

Fig. 4.1 Types of risk

4.4.3 Who Decides What Stocks to Include and HowMost index providers have a index committee of some sort that decides on the composition of the index based on standardised selection and elimination criteria. The criteria for selection of course depend on the philosophy of the index and its objective.Selection criteria

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Most indexes attempt to strike a balance between the following criteria.Better Industry representation• Maximum coverage of market capitalisation• Higher Liquidity or Lower Impact cost•

Industry representationSince the objective of any index is to be a proxy for the market it becomes imperative that the broad industry sectors are faithfully represented in the Index too. Though this seems like an easy enough task, in practice it is very difficult to achieve due to a number of issues, not least of them being the basic method of industry classification.

Market capitalisationAnother objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalisation of the entire market. As a result within every industry the largest market capitalisation stocks tend to select themselves. However it is quite a balancing act to achieve the same minimum level for every industry.

Liquidity or impact costIt is important from the point of usability for all the stocks that are part of the index to be highly liquid. The reasons are two-fold. An illiquid stock has stale prices and this tends to give a flawed value to the index.Further for passive fund managers, the entry and exit cost at a particular index level is high if the stocks are illiquid. This cost is also called the impact cost of the index.

4.4.4 Uses of an IndexIndex based fundsThese funds tend to replicate the index as it is in order to match the returns on the market. This is also known as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence it’s better to replicate the index. Examples in India are:

UTI’s fund on the Sensex• IDBI MF’s fund on the Nifty• Exchange traded funds (ETFs)•

These are similar to index funds that are traded on an exchange. These are pretty popular world wide with non-resident investors who like to take an exposure to the entire market. S&P’s SPDRs and MSCI’s WEBS products are amongst the most popular products.

Index futuresIndex futures are possibly the single most popular exchange traded derivatives products today. The S&P 500 futures products are the largest traded index futures product in the world.In India both the BSE and NSE are due to launch their own index futures product on their benchmark indexes the Sensex and the Nifty.

4.4.5 Types of IndexThe different index types are mentioned below.

Stock indexA Stock Index is a number that helps you measure the levels of the market. Most stock indexes attempt to be proxies for the market they exist in. Returns on the index thus are supposed to represent returns on the market i.e. the returns that you could get if you had the entire market in your portfolio.

Benchmark indexAn index which acts as the benchmark in the market has an important role to play. While it has to be responsive to the changes in the market place and allow for new industries or give up on dead industries, at the same time it

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should also maintain a degree of continuity in order to survive as a benchmark index.

Sectoral indexThese indexes provide the benchmark for sector specific funds. Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing, or Infrastructure use these indexes to keep track of the sector performance.

4.5 Forward and Future ContractsA forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India). Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. Forward contracts suffer from poor liquidity and default risk.

Future contracts are organised/ standardised contracts, which are traded on the exchanges. These contracts, being standardised and traded on the exchanges are very liquid in nature. In futures market, clearing corporation/ house provides the settlement guarantee.

Every future contract is a forward contract. They entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. They are of standard quantity; standard quality (in case of commodities). They have standard delivery time and place.

Features Forward Contracts Future Contracts

Operational Mechanism Not traded on exchange Traded on exchange

Contract Specifications Differs from trade to trade. Contracts are standardised contracts.

Counterparty Risk Exists Exists, but assumed by Clearing Corporation/ house.

Price Discovery Poor; as markets are fragmented.

Better; as fragmented markets are brought to the common platform.

Liquidation Profile Poor Liquidity as contracts are tailor maid contracts.

Very high Liquidity as contracts are standardised contracts.

Table 4.6 Features of forward contract and future contract

4.6 OptionsOptions are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer • desires to exercise his optionOption Buyer - One who buys the option. He has the right to exercise the option but no obligation.• Call Option - Option to buy• Put Option - Option to sell• American Option - An option which can be exercised anytime on or before the expiry date• European Option - An option which can be exercised only on expiry date• Strike Price/ Exercise Price - Price at which the option is to be exercised• Expiration Date - Date on which the option expires•

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Exercise Date - Date on which the option gets exercised by the option holder/buyer• Option Premium - The price paid by the option buyer to the option seller for granting the option.•

Options on stocks were first traded on an organised stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts.

4.6.1 Categorisation of OptionsOptions are of two basic types: The Call and the Put Option

4.6.1.1 Call OptionsThe following example would clarify the basics on Call Options.

Illustration 1:An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contract matures on 30 September . The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

Payoff from Call Buying/Long (Rs.)

S Xt c Payoff Net Profit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -2

60 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

65 60 2 5 3

66 60 2 6 4

Table 4.7 Payoff from call buying/long

A European call option gives the following payoff to the investor: max (S - Xt, 0).The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).Notes:S - Stock Price

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Xt - Exercise Price at time 't'C - European Call Option PremiumPayoff - Max (S - Xt, O )Net Profit - Payoff minus 'c'

Fig. 4.2 Payoff from call buying/long(Source: http://www.derivativesindia.com/scripts/glossary/indexobasic.asp)

Exercising the Call Option and its implications for the Buyer and the SellerThe Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts the seller under the obligation to sell the shares on that specific date and specific price. The Call Buyer exercises his option only when he/ she feel it is profitable. This Process is called "Exercising the Option". This leads us to the fact that if the spot price is lower than the strike price then it might be profitable for the investor to buy the share in the open market and forgo the premium paid.

The implications for a buyer are that it is his/her decision whether to exercise the option or not. In case the investor expects prices to rise far above the strike price in the future then he/she would surely be interested in buying call options. On the other hand, if the seller feels that his shares are not giving the desired returns and they are not going to perform any better in the future, a premium can be charged and returns from selling the call option can be used to make up for the desired returns. At the end of the options contract there is an exchange of the underlying asset. In the real world, most of the deals are closed with another counter or reverse deal. There is no requirement to exchange the underlying assets then as the investor gets out of the contract just before its expiry.

4.6.1.2 Put OptionsThe European Put Option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better:

Illustration 2:An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price.

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Payoff from Put Buying/Long (Rs.)

S Xt p Payoff Net Profit

55 60 2 5 3

56 60 2 4 2

57 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -2

63 60 2 0 -2

64 60 2 0

Table 4.8 Payoff from put buying/long

The payoff for the put buyer is :max (Xt - S, 0)The payoff for a put writer is : -max(Xt - S, 0) or min(S - Xt, 0)

Fig. 4.3 Payoff from put buying/long(Source: http://www.derivativesindia.com/scripts/glossary/indexobasic.asp)

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These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives create a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations.

Exotic Options are often mistaken to be another kind of option. They are nothing but non-standard derivatives and are not a third type of option.

4.6.2 Options PricingPrices of options commonly depend upon six factors. Unlike futures, which derives there prices primarily from prices of the undertaking. Option's prices are far more complex. The table below helps understand the affect of each of these factors and gives a broad picture of option pricing keeping all other factors constant. The table presents the case of European as well as American Options.

Fig. 4.4 Effect of increase in the relevant parameter on option prices(Source: http://www.derivativesindia.com/scripts/glossary/indexobasic.asp)

Spot prices: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favourable for the buyer. It is the other way round for the seller, more the Spot Price higher is the chances of his going into a loss. In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing.

Strike price: In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option.

Time to expiration: More the time to Expiration more favourable is the option. This can only exist in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity.

Volatility: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table show all effects on the buyer side of the contract.

Risk free rate of interest: In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices Discounting factor increases making the price fallIn case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value becomes lesser.

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In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favourable on the call option.

Dividends: When dividends are announced then the stock prices on ex-dividend are reduced. This is favourable for the put option and unfavourable for the call option.

4.7 Market PlayersHedgers: The objective of these kind of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiralling oil prices have to be tamed using the security in derivative instruments.

Speculators: They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down.

Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one market and selling in another, buying two products in the same market are common. They could be making money even without putting there own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as the situation arises, arbitrageurs take advantage and demand-supply forces drive the markets back to normal.

4.8 Derivative Market in IndiaThe first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.

Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX.

Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O):

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Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per • cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.On relative terms, volumes in the index options segment continue to remain poor. This may be due to the low • volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.Put volumes in the index options and equity options segment have increased since January 2002. The call-put • volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even • the next month was non-existent.Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) • to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.

Business growth of futures and options market: NSE Turnover (Rs. Cr)

Month Index futures Stock futures Index options Stock options TotalJun-00 35 - - - 35Jul-00 108 - - - 108Aug-00 90 - - - 90Sep-00 119 - - - 119Oct-00 153 - - - 153Nov-00 247 - - - 247Dec-00 237 - - - 23701-Jan 471 - - - 47101-Feb 524 - - - 52401-Mar 381 - - - 38101-Apr 292 - - - 29201-May 230 - - - 23001-Jun 590 - 196 - 78501-Jul 1309 - 326 - 78501-Aug 1305 - 284 1107 269601-Sep 2857 - 559 2010 528101-Oct 2485 - 559 2433 547701-Nov 2484 2811 455 3010 876001-Dec 2339 7515 405 2660 1291902-Jan 2660 13261 338 5089 2134802-Feb 2747 13939 430 4499 2161602-Mar 2185 13989 360 3957 204902001-02 21482 51516 3766 25163 101925

Table 4.9 Business growth and future of option marketSource: National Stock Exchange

(http://www.iimcal.ac.in/community/finclub/dhan/dhan1/art16-idm.pdf)

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4.9 Derivative Users in IndiaThe use of derivatives varies by type of institution. These are mentioned below.

Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, • and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. • Non- financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies.In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their • contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives • (which are used more by institutions than by retail investors). In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great • interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003). Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing • positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives. 11 Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, • and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as a broker-dealer. 12 FIIs have a small but increasing presence in the equity derivatives markets. They have no incentive to trade • interest rate derivatives since they have little investments in the domestic bond markets (Chitale, 2003). It is possible that unregistered foreign investors and hedge funds trade indirectly, using a local proprietary trader • as a front (Lee, 2004).Retail investors (including small brokerages trading for themselves) are the major participants in equity • derivatives, accounting for about 60% of turnover in October 2005, according to NSE. The success of single stock futures in India is unique, as this instrument has generally failed in most other • countries. One reason for this success may be retail investors’ prior familiarity with “badla” trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. • Retail investors also dominate the markets for commodity derivatives, due in part to their long-standing expertise in trading in the “havala” or forwards markets.

4.10 Commodity DerivativesFutures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses.

With commodity futures, delivery is best affected using warehouse receipts (which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading.

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The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998.

4.11 Exchange-traded vs. OTC (Over The Counter) Derivatives MarketsThe OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded derivatives:The management of counter-party (credit) risk is decentralised and located within individual institutions,• There are no formal centralised limits on individual positions, leverage, or margining,• There are no formal rules for risk and burden-sharing,• There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the • collective interests of market participants, andThe OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory • organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

4.12 Accounting and Taxation of Derivatives TransactionsAccounting of derivativesThe Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations, a trade in equity index futures is similar to a trade in, say shares, and does not pose any peculiar accounting problemsTaxationThe income-tax Act does not have any specific provision regarding taxability from derivatives. The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years .As a result an investor’s losses or profits out of derivatives even though they are of hedging nature in real sense, are treated as speculative and can be set off only against speculative income.

4.13 Measures Specified by SEBI to Protect the Rights of Investor in Derivatives MarketThe measures specified by SEBI include:

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.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.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.

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This will protect him from the risk of price favour, if any, extended by the Member.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. The exchanges are required to set up arbitration and investor grievances redressal mechanism operative from • all the four areas / regions of the country.

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SummaryA derivative security is a financial contract and its value is derived from the value of something else, such as a • stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. It is a part of the financial market of the country. OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The • terms of an OTC contract are flexible, and are often customised to fit the specific requirements of the user.Derivatives have probably been around for as long as people have been trading with one another.• An Index is a number used to represent the changes in a set of values between a base time period and another • time period.The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular • portfolio.Index futures are the future contracts for which underlying is the cash market index. • Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific • asset at a specific price on or before a specific date.The Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts • the seller under the obligation to sell the shares on that specific date and specific price.

ReferencesWhaley, R. E., 2006. • Derivatives: markets, valuation, and risk management, John Wiley and Sons.McDonald, R.L., 2006. • Derivatives Market, 2nd ed., Addison-Wesley.Arditti, F.D., 1996. • Derivatives: a comprehensive resource for options, futures, interest rate swaps, and mortgage securities, 4th ed., Island Press.

Recommended ReadingChakrabarti, R. & De, S., 2010. • Capital Markets in India, SAGE Publications Ltd.Kumar, 2007. • Financial Derivatives, PHI Learning Pvt. Ltd.Schofield, N.C., 2007. • Commodity derivatives: markets and applications, John Wiley and Sons.

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Self Assessment

_________ has been included in the definition of Securities.1. Marketsa. Capital marketsb. Derivativesc. Bonds d.

Match the columns2.

Forwards1. two types - calls and putsA.

Futures2. longer-dated options areB.

Options3. a customised contract between two entitiesC.

Warrants4. an agreement between two parties to buy or sell an asset at a certain D. time in the future at a certain price

1-A, 2-B, 3-C, 4-Da. 1-A, 2-C, 3-B, 4-Db. 1-B, 2-C, 3-D, 4-Ac. 1-C, 2-D, 3-A, 4-Bd.

_________ are private agreements between two parties to exchange cash flows in the future according to a 3. prearranged formula.

Swapsa. Basketsb. LEAPSc. Warrantsd.

_________ are options to buy or sell a swap that will become operative at the expiry of the options.4. Swaptionsa. Basketsb. LEAPSc. Warrantsd.

An ________ is a number used to represent the changes in a set of values between a base time period and 5. another time period.

contracta. optionb. indexc. warrant d.

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The degree to which different portfolios are affected by these systematic risks as compared to the effect on the 6. market as a whole, is different and is measured by

BETAa. Indexb. Impact costc. Optionsd.

_________ is a practical and realistic measure of market liquidity.7. BETAa. Indexb. Impact costc. Optionsd.

Risk can be divided into how many categories?8. Onea. Twob. Threec. Fourd.

_________ are the future contracts for which underlying is the cash market index. 9. BETAa. Index Futureb. Impact Costc. Forward Contractsd.

The minimum price difference between two quotes of similar nature is10. Contract montha. Tick sizeb. Contract sizec. Volumed.

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Chapter V

Money Market and Bond Market

Aim

The aim of this chapter is to:

introduce money marker•

explain the bond market•

elucidate the characteristics of bond market•

Objectives

The objectives of this chapter are to:

introduce characteristics of money market•

explain different types of bond markets•

elucidate Indian money market instruments•

Learning outcome

At the end of this chapter, the students will be able to:

understand importance of money market•

discuss functions of money market•

enlist development of bond market in India•

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5.1 IntroductionMoney market means market where money or its equivalent can be traded. Money is synonym of liquidity. Money market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better known as a place where large institutions and government manage their short term cash needs. For generation of liquidity, short term borrowing and lending is done by these financial institutions and dealers. Due to highly liquid nature of securities and their short term maturities, money market is treated as a safe place.

Definitions of money market help to identify the basic characteristics of a money market. Various financial instruments are used for transactions in a money market. There is perfect mobility of funds in a money market. The transactions in a money market are of short term nature.

According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; • it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government."

According to Nadler and Shipman, "A money market is a mechanical device through which short term funds • are loaned and borrowed through which a large part of the financial transactions of a particular country or world are degraded. A money market is distinct from but supplementary to the commercial banking system."

5.2 Characteristics of Money MarketThe important characteristics of money market are as follows:

Short term credit market• In the money market funds are made available for a short period only. The funds are borrowed or lent for one day, a week or for three to six months or in exceptional cases for the period of more than six months but less than one year.

Funds against different types of instruments• The funds are usually borrowed against different types of securities which are called as near-money. The important instruments against which funds are borrowed are trade bills or bills of exchange, promissory notes, banker’s acceptance, treasury bills or suitable commercial papers of maturity up to sic months.

Composition of sub-marketsIn the money market funds are borrowed against various securities,. The transactions of borrowing of funds against a particular security are carried out in a particular part which is called as a sub-part or a sub-market of the money market i.e. transactions of borrowing against bills of exchange are carried out in a bill market, there are following important sub-markets in the money market, which are

Call money market• Acceptance market• Bill market• Treasury Bill market• Collateral Loans market•

No definite locationThe money market has no definite location where borrowers and lenders meet, negotiations between borrowers and lenders may be carried on through telephone, telegraphs and through mails or any other arrangement. Thus, money market is an arrangement that brings about a direct or indirect contract between the borrower and the lender.

Specific institutionsSome financial institutions deal in short term finance and long term finance at one and the same time. But there

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are certain agencies which deal only in the short term credit. For example, discount houses and acceptance houses.

Purpose of loansThe money market provides short term loans for various purposes such as loan for meeting short terms financial needs of industry, commerce, trade, agriculture, government developmental activities and for meeting short term financial needs of stock exchange brokers, etc.

Settlement of financial transactionsFrom the definition given by Madden and Nadler one can say that a money market is an agency through which many financial transactions of the country are settled. In case of developed money market many financial transactions of the world are settled. This conveys the importance of money markets in the world economy.

5.3 Functions of Money MarketMoney market is an important part of the economy. It plays very significant functions. As mentioned above, it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors.

The major functions of money market are given below:To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money • for short term monetary transactionsTo promote economic growth. Money market can do this by making funds available to various units in the • economy such as agriculture, small scale industries, etc.To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly • it also provides facility of discounting bills of exchange for trade and industryTo help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the • monetary policyTo help in Capital Formation. Money market makes available investment avenues for short term period. It helps • in generating savings and investments in the economyMoney market provides non-inflationary sources of finance to government. It is possible by issuing treasury • bills in order to raise short loans. However this dose not leads to increases in the prices

Apart from these, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money.

5.4 Importance of Money MarketA developed money market plays an important role in the financial system of a country by supplying short-term funds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed money market helps the smooth functioning of the financial system in any economy in the following ways:

Development of trade and industry Money market is an important source of financing trade and industry. The money market, through discounting operations and commercial papers, finances the short-term working capital requirements of trade and industry and facilities the development of industry and trade both – national and international.

Development of capital marketThe short-term rates of interest and the conditions that prevail in the money market influence the long-term interest as well as the resource mobilisation in capital market. Hence, the development of capital depends upon the existence of a development of capital money market.

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Smooth functioning of commercial banksThe money market provides the commercial banks with facilities for temporarily employing their surplus funds in easily realisable assets. The banks can get back the funds quickly, in times of need, by resorting to the money market. The commercial banks gain immensely by economizing on their cash balances in hand and at the same time meeting the demand for large withdrawal of their depositors. It also enables commercial banks to meet their statutory requirements of cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR) by utilising the money market mechanism.

Effective central bank control A developed money market helps the effective functioning of a central bank. It facilities effective implementation of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the economy in slump and siphons if off in boom. The central bank, thus, regulates the flow of money so as to promote economic growth with stability.

Formulation of suitable monetary policy Conditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon the monetary conditions prevailing in the market.

Non-inflationary source of finance to Government A developed money market helps the Government to raise short-term funds through the treasury bills floated in the market. In the absence of a developed money market, the Government would be forced to print and issue more money or borrow from the central bank. Both ways would lead to an increase in prices and the consequent inflationary trend in the economy.

5.5 Indian Money Market InstrumentsInvestment in money market is done through money market instruments. Money market instrument meets short term requirements of the borrowers and provides liquidity to the lenders. Common Money Market Instruments are as follows:

Treasury Bills (T-Bills)Treasury Bills, one of the safest money market instruments, are short term borrowing instruments of the Central • Government of the Country issued through the Central Bank (RBI in India). They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market • as well as secondary market. It is a promise to pay a said sum after a specified period. T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-• month, six-month, and one-year maturity periods. The Central Government issues T-Bills at a price less than their face value (par value). They are issued with • a promise to pay full face value on maturity. So, when the T-Bills mature, the government pays the holder its face value. The difference between the purchase price and the maturity value is the interest income earned by the purchaser • of the instrument. T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-• competitively. In the second type of bidding, return required is not specified and the one determined at the auction is received • on maturity. Whereas, in case of competitive bidding, the return required on maturity is specified in the bid. In case the return specified is too high then the T-Bill might not be issued to the bidder. At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182-• day and 364-day. There are no treasury bills issued by State Governments. Treasury bills are available for a minimum amount of Rs.25K and in its multiples. While 91-day T-bills are •

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auctioned every week on Wednesdays, 182-day and 364-day T-bills are auctioned every alternate week on Wednesdays. The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks’ website. • It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their/ custodian’s current account. T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their • bids on the system. NDS is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments. RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking • terms, this is called Reverse Repurchase (Reverse Repo). On the other hand, when RBI purchases back these instruments at a specified date mentioned at the time of • transaction, liquidity is infused in the market. This is called Repo (Repurchase) transaction.

Repurchase AgreementsRepurchase transactions, called Repo or Reverse Repo are transactions or short term loans in which two parties • agree to sell and repurchase the same security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved • securities viz. GOI and State Govt Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the seller sells specified securities with an agreement to repurchase the same at a • mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the • transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. • Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties • independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions.

Commercial Paper (CP)Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured promissory note issued • by corporates and financial institutions at a discounted value on face value. They are usually issued with fixed maturity between one to 270 days and for financing of accounts receivables, • inventories, and meeting short term liabilities. Say, for example, a company has receivables of Rs 1 lakh with credit period 6 months. It will not be able to liquidate its receivables before 6 months. The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at • discount of 10% on face value of Rs 1 lakh to be matured after 6 months. The company has strong credit rating and finds buyers easily. The company is able to liquidate its receivables immediately and the buyer is able to earn interest of Rs 10K • over a period of 6 months. They yield higher returns as compared to T-Bills as they are less secure in comparison to these bills; however • chances of default are almost negligible but are not zero risk instruments.Commercial paper being an instrument not backed by any collateral, only firms with high quality credit ratings • will find buyers easily without offering any substantial discounts.

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They are issued by corporates to impart flexibility in raising working capital resources at market determined rates. • Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely transferable in demat form.

Certificate of DepositIt is a short term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in • form of a certificate entitling the bearer to receive interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any • denomination. They are stamped and transferred by endorsement. Its term generally ranges from three months to five years • and restricts the holders to withdraw funds on demand. However, on payment of certain penalty the money can be withdrawn on demand also. • The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk. • While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage • Yield (APY) or Annual Percentage Rate (APR). In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest • calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt APY over APR.

Banker’s AcceptanceIt is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. • It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the seller a certain specified amount at certain date. The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person • drawing the bill must have a good credit rating otherwise the Banker’s Acceptance will not be tradable. The most common term for these instruments is 90 days. However, they can very from 30 days to180 days. • For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods • and is highly useful when the credit worthiness of the foreign trade party is unknown. The seller need not hold it until maturity and can sell off the same in secondary market at discount from the • face value to liquidate its receivables.

5.6 Drawbacks of Indian Money MarketThough the Indian money market is considered as the advanced money market among developing countries, it still suffers from many drawbacks or defects. These defects limit the efficiency of our market. Some of the important drawbacks Indian Money Market are:

Absence of integration The Indian money market is broadly divided into the Organised and Unorganised Sectors. The former comprises • the legal financial institutions backed by the RBI. The unorganised statement of it includes various institutions such as indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two segments.

Multiple rate of interest In the Indian money market, especially the banks, there exist too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors.

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Insufficient funds or resourcesThe Indian economy with its seasonal structure faces frequent shortage of financial recourse. Lower income, lower savings, and lack of banking habits among people are some of the reasons for it.

Shortage of investment instruments In the Indian money market, various investment instruments such as Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. are used. But taking into account the size of the population and market these instruments are inadequate.

Shortage of commercial billIn India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Similarly since a large number of transactions are preferred in the cash form the scope for commercial bills are limited.

Lack of organised banking system In India even through we have a big network of commercial banks, still the banking system suffers from major weaknesses such as the NPA, huge losses, poor efficiency. The absence of the organised banking system is major problem for Indian money market.

Less number of dealersThere are poor number of dealers in the short-term assets who can act as mediators between the government and the banking system. The less number of dealers leads to the slow contact between the end lender and end borrowers.

5.7 Reforms in Indian Money MarketIndian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the Indian monetary system. Later Narayanan Vaghul working group and Narasimham Committee was also set up. As per the recommendations of these study groups and with the financial sector reforms initiated in the early 1990s, the government has adopted following major reforms in the Indian money market.

Deregulation of the interest rate: In recent period the government has adopted an interest rate policy of liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the interest rate change that takes place within the limit. There was a further deregulation of interest rates during the economic reforms. Currently interest rates are determined by the working of market forces except for a few regulations.

Money Market Mutual Fund (MMMFs): In order to provide additional short-term investment revenue, the RBI encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and individuals. The upper limit of 50 crore investments has also been lifted. Financial institutions such as the IDBI and the UTI have set up such funds.

Establishment of the DFI: The Discount and Finance House of India (DFHI) was set up in April 1988 to impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has played an important role in stabilizing the Indian money market.

Liquidity Adjustment Facility (LAF): Through the LAF, the RBI remains in the money market on a continue basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection of financial resources.

Electronic TransactionsIn order to impart transparency and efficiency in the money market transaction the electronic dealing system has been started. It covers all deals in the money market. Similarly it is useful for the RBI to watchdog the money market.

Establishment of the CCIL: The Clearing Corporation of India limited (CCIL) was set up in April 2001. The CCIL clears all transactions in government securities, and repose reported on the Negotiated Dealing System.

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Development of new market instruments: The government has consistently tried to introduce new short-term investment instruments. Examples: Treasury Bills of various durations, Commercial papers, Certificates of Deposits, MMMFs, etc. have been introduced in the Indian Money Market.

These are major reforms undertaken in the money market in India. Apart from these, the stamp duty reforms, floating rate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude that the Indian money market is developing at a good speed.

5.8 Bond MarketThe bond market is called the debt market. In this market, business finance traders trade bonds. In real sense, a bond is a kind of security for a debt taken. Issuers (borrowers) of the bond will be liable to repay the holders of it. Interest needs to be paid until the bond reaches maturity. After this, the principal of the bond needs to be paid. So in other words, a bond can be classified as a kind of loan.

More than equity markets, the bond market is sought by the business finance community all over the world. But in India this has not been the case. However, things have changed in India over the last decade or so. After the financial reforms in 1992, the bond market started to make progress. Banks were asked to drop off a part of their mediation in the financial markets. Ecosystem of the market was set as the control system; which meant that the market was not dictated by the government and national banks. In the early 1990′s old government securities were put under the hammer. Ending the era of rehearsed interest rates, the financial reform ushered in a fresh wave of business finance management. On account of this, demand and supply of business finance was the controlling factor in the bond market.

There are different types of bond markets in India. They are namely, corporate bond market, funding bond market, municipal bond market, and government bond market. Systems like delivery versus payment in the Indian bond market, ensures smooth settlement of outstanding business finance issues. The reserve bank of India has created a controlling system called the trade for trade system. Under this system no settlement other than bonds or funds are used to close bond transaction. Foreign investors with business finance of up to thirty percent as fixed income can now invest in the bond market in India.

There have been a slew of other measures taken by the government of India, to enhance the workings of the Indian bond market. The bond market in India has got enormous business finance potential. The major bond market participants are: governments, institutional investors, traders, and individual investors. According to the specifications given by the Bond Market Association, there are five types of bond markets. They are as depicted below:

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Fig. 5.1 Types of bond markets

5.8.1 Corporate Bond MarketA corporate bond is a bond issued by major corporations and can be divided into five major groups: industrials, transportations, utilities, banks and other finance companies, and finally international. Bonds issued from the industrial sector would include manufacturing, mining, and retail oriented companies. Transportation bonds would then be issued by airlines, trucking companies, and even railroads. Utilities would include companies which would fall into the following groups; water, electric, and telephone. International bonds would be issued by foreign entities such as foreign countries, municipalities, and agencies.

Event risk mitigationPoison pill provisions, floating rate notes, and putable bonds are a few key features that were added to corporate bonds to ease the investors' mind.

Poison pill provisionThe poison pill provision is probably the most important risk prevention measure that a corporation can make; it allows shareholders to buy the stock of the acquiring company or more of the same stock at a heavily discounted price, usually half of the market rate, during a takeover situation. The provision attempts to thwart would be takeover attempts by forcing the acquirer to negotiate terms with the board of directors on the terms of the takeover. If the board is amenable to the terms, they will recant the pill. If not, the pill could be triggered; and shareholders can exercise the option to purchase shares at a deep discount. This would have negative ramifications to the acquirer as it would dilute their interest in the company.

Floating rate notesFloating rate notes (FRN) are corporate bonds that have a variable coupon structure to protect purchasers against interest rate risk. The coupon is reset usually every three months using a benchmark index as a basis; usually a short term treasury instrument or LIBOR. Sometimes, floaters will have a floor in place to provide that much more protection to the corporate bond holder against interest rate movements. The idea behind a floating rate note is to protect the bond holder against rate fluctuations and at the same time keeping the bond value close to par.

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Putable bondsA corporate bond with a putable feature allows the bond holder to return, or "tender", the bond back to the issuer at par before the bond's maturity date. This feature is designed to protect a bonds value against interest rate fluctuations. The intervals in which this put feature can be executed are specified in the bond indenture. Effectively, a corporate bond with a putable option turns the security into a shorter term instrument.

Putable bonds are not as great in interest rate environments that are shifting sharply; this is so due to the fact that the bond holder will need to wait for specific intervals in which they may tender the bond back to the issuer. Additionally, similar to its callable bond counterpart, the putable bond carries an option premium which will reduce your yield.

Credit riskAnalyzing credit risk for corporate bonds is a little more complex than a more simple method in which municipal bonds are be evaluated. Corporate bonds have a tiered repayment structure, similar in concept to the one that a CMO has. Each bond issuer may have multiple issuances; each of these issues will receive different ratings from the credit agencies due to the fact that they have different repayment structures and conditions. For example, there may be a senior class of debt, and then a subordinated class of debt which is less senior. Obviously, the senior class will bear a higher credit rating.

Junk bondsThe term "junk bonds" refers to high-yield corporate bond issuances which are classified as non-investment grade. They are speculative in nature and have very low credit ratings. Standard and Poors defines junk bonds as issues with a rating lower than BBB while Moody's classifies a bond as junk below Baa3. Typically, issuers of junk bonds have just gotten into deep financial issues and need to raise cash immediately; other times, issuers may be trying to re-emerge from bankruptcy. In either case, the corporate bonds credit quality is low and investors who purchase them are speculating on the future of the company. Junk bonds are typically purchased at tremendous discounts to par; many times you can get them for 10 to 20 cents on the dollar.

5.8.2 Municipal Bond MarketThe municipal bond market deals in municipal bonds. In a municipal bond market the buyers purchase the municipal bonds from the issuers. The municipal bonds in the United States are provided by a variety of governmental bodies.

There are two types of municipal bond markets - the primary municipal bond market, and the secondary municipal bond market. In the municipal bond markets the investor needs to place some capital.

The bond holder gets his payments in lieu of his investments. The accumulated interest on his investment also makes up the payments.

Primary Municipal Bond MarketThe holders of municipal bonds can buy them from both the primary and the secondary market. In the primary market the holders can purchase them straight from the issuer. In the primary municipal bond market, the holders can also buy municipal bonds when they are being issued.

Secondary Municipal Bond MarketThe bond holders are the primary providers of municipal bonds in the secondary municipal bond market. In the secondary municipal bond market, the buyers purchase the bonds at a time after the particular bond has been issued, from other municipal bond holders.

Municipal Bond IssuersThe municipal bonds are issued in the United States by a number of governmental bodies or their representative bodies. They may be mentioned as below:

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Governmental entities• Cities• School districts• Counties• Publicly owned Airports and Seaports• Redevelopment agencies•

Municipal Bond IncomeThe holders of municipal bonds earn their income from the interest of these bonds. This income is normally exempted from the federal income taxes, and the income taxes of the respective states. However, certain municipal bonds, that are brought for special purposes, are not exempted from taxation.

Municipal Bond RepaymentThe time of payment received varies according to the type of municipal bond. Normally, the interest from the municipal bonds is received after every six months. However the income from the short term bonds are obtained by the holder after the bond matures.

In case of the long term municipal bonds, the payments are made on the principal and on a yearly basis. Often the short and long term municipal bonds are merged into a single bond.

In such cases the payments are made by the issuer, on the interest of the bond and the amount invested. The payments are made on a yearly basis.

5.8.3 Government Bond MarketBonds issued by government in the bond market are amongst the safest forms of investment. These are designated in the currency of the country, where the bond is issued.

Sovereign bondsSovereign bonds, principally issued by the Economic and Monetary Union of the European Union, are also supplied by national governments. Mainly available in the European bond market, they are normally brought out in foreign currencies.

Risk free Government BondsGovernment bonds can be redeemed at any time by the government. This is done by printing more currency notes and increasing tax rates.

Government Bond RisksThere are several types of risks associated with the government bonds and are described as follows:

Inflation risk: this is applicable if the levels of inflation are more than expected. In such cases the principal, • which is paid at maturity, is lower than expected.Currency risk: this is applicable to foreign investors. If the value of a currency decreases, lower returns might • be received on bonds issued in that currency.

Inflation-indexed BondsInflation-indexed bonds are brought out by the national governments and are supposed to protect the investors from any risk of inflation.

5.8.4 Mortgage Backed and Collateralized Debt Obligation Bond MarketCollateralized Debt Obligation, which first appeared in the late 1980s, are considered to be the most important innovation in the structured finance market in the past two decades.

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The two main types of CDOs are:Collateralized loan obligations (CLOs) - backed primarily by leveraged bank loans• Structured finance CDOs (SFCDOs) - backed primarily by asset-backed securities and mortgage-backed • securities

Other types of CDOs include:Commercial Real Estate CDOs (CRE CDOs) - backed primarily by REIT assets • Collateralized bond obligations (CBOs) - backed primarily by corporate bonds • Collateralized Insurance Obligations (CIOs) - backed by insurance or reinsurance contracts • CDO-Squared - CDOs backed primarily by the tranches issued by other CDOs. • CDO^n - Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs. •

CDOs can also be categorized on the basis of the motivation of the issuer of a CDO. If the motivation of the issuer is to earn the difference between the average yield of the collateral assets and the payments made to the various tranches of the CDO, then the transaction is called an arbitrage CDO. If the motivation of the issuer is to remove debt instruments from its balance sheet, then the transaction is called a balance sheet CDO.A CDO can be structured as either a cash flow or a synthetic transaction, or a hybrid of both. In a cash flow transaction, the CDO is backed by a pool of cash assets that are truly owned by the CDO sponsor. A synthetic CDO makes use of CDS to transfer the credit risk of a pool of reference entities to tranche investors. The main difference between a cash flow CDO and a synthetic CDO is that no transfer of securities takes place in the latter. Cash flow CDOs dominated the CDO market in the early days, while synthetic CDOs account for a large portion of the overall present CDO market, partially due to the high liquidity of the CDS market and the appearance of the standard credit indexes.

5.8.5 Development of Bond Market in IndiaPrior to 1992, money was collected and lent according to Plan. Lacunae in institutional infrastructure and inefficient market practices characterized the government securities market. In fact the sole objective pursued was to keep the cost of government borrowing as low as possible. If planning went awry, the government sent word to its banker. The central bank made a few phone calls to the heads of banks and bonds were issued and the money arranged. No questions asked, no explanations given. The GOI bond market did not use trading on an exchange. It featured bilateral negotiation between dealers. The market thus lacked price-time priority and the bilateral transactions imposed counterparty credit risk on participants. This narrowed down the market into a “club” with homogeneous credit risk. This was the state of the government debt market in India ten years ago. The major thrust of Financial Reforms commenced in 1992. This was when the contours of the debt market began taking shape. The idea of the financial reform movement was to have more and more different markets and not necessarily have whole financial intermediation left to the banks. The reform process attempted at doing away with regulations in favour of controls based on market forces i.e. an era where the interest rates are governed more by the market forces of demand and supply and less by centralized supervision. Slowly, but steadily, the market grew, adding fresh players and novel instruments. Several measures have added greater transparency and have brought the issuances closer to the market levels.

The major reforms that took place in the 1990’s were:Introduction of the auction system for sale of dated government securities in June1992. This signalled the end • of the era of administered interest rates. The RBI moved to computerize the SGL and implement a form of a ‘delivery versus payment’ (DvP) system. • The DvP enabled mitigating of settlement risk in securities and ensured the smoothness of settlement by synchronizing the payment and delivery of securities. Innovative products in form of Zero Coupon Bonds and Capital Indexed Bonds (Ex. Inflation Linked) were • issued to attract a wider gamut of investors. However, the pace of innovation suffered due to non-sophistication of the markets and lack of persistence with some of the new bonds like Inflation Indexed bonds after the initial lukewarm response.

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The system of Primary Dealers was established in March 1995. These primary dealers have since then acquired • a large chunk of share in the GOI bond market and have played the role of market makers. The RBI setup “trade for trade” regime, a strong regulatory system which required that every trade must be • settled with funds and bonds. All forms of netting were prohibited. Wholesale Debt Market (WDM ) segment was set up at NSE, A limited degree of transparency came about • through the WDM at NSE, where roughly half the trading volume of India’s GOI bond market is reported. The Ways And Means agreement put an end to issuance of ad hoc treasury bills, the government’s favourite • instrument of funding its profligacy. Interest Income in G-Secs was exempted from the purview of TDS. • FIIs with 100% Debt Schemes were allowed to invest in GOI Securities and T-Bills while other FIIs were • allowed 30% investment in these instruments.Dematerialised forms of securities in G-Secs was done through the SGL and Constituents SGL accounts.•

The above-mentioned measures have served in bringing about greater market orientation of the sovereign issues. This is particularly important as the sovereign borrowing parameters have a direct bearing on the cost of capital for other non-sovereign issuers. The Primary market for G-Secs registered an almost ten-fold increase between 1990-91 and 1998-99. The broadening of the market was also apparent from the fact that RBI’s participation, as reflected by absorption of primary issues, came down from 45.90% in 1992-93 to 0.74% in 1994-95.

Though significant improvements have been made in the primary market, the secondary market continued to be plagued by certain shortcomings like dominance of a few players (acted as a deterrent to lending width in the market), strategy of holding to maturity by leading players (prevented the improvement in the depth of the market), the pre-1992 “telephone market” continued to exist (prevents information dissemination and hence price discovery is limited) and low retail participation in G-Secs continues to exist even today. Experts believe that there is tremendous potential for widening the investor base for Government securities among retail investors. This requires a two-pronged approach, increasing their awareness about Government securities as an option for investment and improving liquidity in the secondary market that will provide them with an exit route. Also infrastructure is seen as the vital element in the further development and deepening of the market.

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SummaryMoney market means market where money or its equivalent can be traded. Money is synonym of liquidity. • Money market consists of financial institutions and dealers in money or credit who wish to generate liquidity.Money market has to provide facility for adjusting liquidity to the banks, business corporations, non-banking • financial institutions (NBFs) and other financial institutions along with investors.A developed money market plays an important role in the financial system of a country by supplying short-• term funds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy.Investment in money market is done through money market instruments. Money market instrument meets short • term requirements of the borrowers and provides liquidity to the lenders.Indian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review • the Indian monetary system. Later Narayanan Vaghul working group and Narasimham Committee was also set up. The bond market is called the debt market. In this market, business finance traders trade bonds. In real sense, • a bond is a kind of security for a debt taken.A corporate bond is a bond issued by major corporations and can be divided into five major groups: industrials, • transportations, utilities, banks and other finance companies, and finally international.

ReferencesBenson, E.F., 2004. • The Money Market, Kessinger Publishing.Stigum, M L. and Crescenzi, A., 2007. • Stigum's money market, 4th ed. McGraw-Hill Professional.Stigum, M.L. and Robinson, F. L., 1996.• Money market and bond calculations, Irwin Professional Publ.

Recommended ReadingChoudhry, M & Securities & Investment Institute, 2006. • An introduction to bond markets, 3rd ed. John Wiley and Sons.Choudhry, M, 2001. • The bond and money markets: strategy, trading, analysis, Butterworth-Heinemann.Brown, P. J., 2006. • An introduction to the bond markets, John Wiley and Sons.

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Self Assessment

____________ consists of financial institutions and dealers in money or credit who wish to generate liquidity.1. Money marketa. Bond marketb. Capital marketc. Primary marketd.

Match the Columns.2.

1. T-Bills Short term borrowing instruments of the Central Government of the Country a. issued through the Central Bank

2. Repurchase Agreements

A low-cost alternative to bank loansb.

4. Commercial Papers

Repo or Reverse Repoc.

5. Certificate of Deposit

A short term borrowing more like a bank term deposit accountd.

1-A, 2-B, 3-C, 4-Da. 1-A, 2-C, 3-B, 4-Db. 1-B, 2-C, 3-D, 4-Ac. 1-C, 2-D, 3-A, 4-Bd.

Which money market instruments are issued through a bidding process at auctions?3. Repurchase agreementa. Bankers acceptanceb. Certificate of depositc. Treasury billd.

_________________ is a short term credit investment created by a non financial firm and guaranteed by a bank 4. to make payment.

Repurchase agreementa. Bankers acceptanceb. Certificate of depositc. Treasury billd.

A debt market is also known as _____________.5. money marketa. capital marketb. bond marketc. primary marketd.

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Which statement in true?6. Interest needs to be paid until the bond reaches maturity.a. The major money market participants are: governments, institutional investors, traders and individual b. investors.A corporate bond is a bond issued by major corporations and can be divided into four major groups.c. Putable bonds are corporate bonds that have a variable coupon structure to protect purchasers against interest d. rate risk.

The __________bond market deals in municipal bonds.7. corporatea. municipalb. putablec. junkd.

How many types of municipal bond markets are there?8. Onea. Twob. Threec. Fourd.

The bond holders are the __________ providers of municipal bonds in the secondary municipal bond market.9. secondarya. importantb. primaryc. newd.

____________ issued by government in the bond market are amongst the safest forms of investment.10. Bondsa. Stockb. Sharec. Instrumentsd.

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Chapter VI

Mutual Fund

Aim

The aim of this chapter is to:

introduce mutual fund•

explain advantages of mutual fund•

elucidate objectives of mutual fund •

Objectives

The objectives of this chapter are to:

enlist mutual fund regulations•

elucidate private sector mutual fund•

explain benefits of mutual fund•

Learning outcome

At the end of this chapter, the students will be able to:

understand mutual funds industry in India•

comprehend how to invest in mutual fund•

infer disadvantages of mutual fund•

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6.1 IntroductionA Mutual Fund is a special type of investment institution which collects or pools the savings of the community and invests large funds in variety of Blue-chip Companies which are selected from a wide range of industries with the objects of maximising returns/incomes on investments. Mutual Funds are basically a trust which mobilise savings from the people and invest them in a mix of corporate and government securities. Money collected by the investors is invested in various issues of primary and secondary markets in order to gain profits on such investments.

A mutual fund is a trust, which combines the investments of various investors having similar financial goals. The Trust issues units to the investors in the proportion of their investments. A fund manager then invests these funds in different types of assets, which provide returns in the form of dividends, interests, and capital appreciation. This is distributed to the various investors in the proportion of their contribution to the pool funds. Ordinary investors, who want to invest their savings, neither understand the complexities of financial markets nor have the time to watch, research, and analyse different equities, securities or any other investments opportunities that are available in the market.

Fig. 6.1 Concept of mutual fund(Source: http://www.mutualfundsindia.com/primer.asp#a)

At present, all the markets, viz., the debt market, the equity market, the money market, real estates, derivatives, and the market dealing with the other assets have now reached a stage where a minimal information affect the markets. Besides this, the economy has opened up and global events influence their performance.

It is very difficult for a lay person to keep track of various investments, transactions, brokerages etc. In the present scenario mutual funds are some of the most efficient financial instruments as it offers above services like managing investments at a very low cost.

6.2 NAV or Net Asset ValueNAV of the Fund is the market value of all the assets of the Fund subtracting the Liabilities. NAV reflects the Fund that will be available to the shareholders if the Fund is liquidated and all the liabilities are paid. In the mutual fund industry NAV refers to Net Asset Value per unit holder, which NAV of the Fund divided by the outstanding number of the units. It shows the performance of the Fund.Calculation of NAV= Net Asset Value of the fund sum of market value of shares/debentures + Liquid assets/cash Dividends/interest accrued – All liabilitiesNet asset value per unit = NAV of the fund / Outstanding number of units

Investors

Income/Dividend/Appreciation

Mutual Fund Flow Chart

Professional Manager

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Market value of the shares and debentures is calculated by multiplying the number of shares/units by the closing price of the shares/debentures. The closing price will be of the previous day of the stock exchange from where the shares have been purchased.

If the shares were not traded in the previous day in that stock exchange, then the closing price of the shares of any other stock exchange is taken where the shares were traded. If the shares were not traded in any stock exchange the previous day, then the closing price of the shares when they were last traded is taken. For untraded shares, the value has to be determined by the other methods such as Book Value, comparable company approach, etc. Value of the illiquid bond is estimated on the basis of yields of comparable liquid bonds.

6.3 Objectives of Mutual Fund

Fig. 6.2 Objectives of mutual fund

6.4 Advantages of Mutual FundsSince their creation, mutual funds have been a popular investment vehicle for investors. Their simplicities along with other attributes provide great benefit to investors with limited knowledge, time, or money. To help investors decide whether mutual funds are best for an investor and for the situation, here are some reasons why one might want to consider investing in mutual funds.

DiversificationThe top Indian mutual funds create their portfolio designs in such a manner that the interested individuals who invest in mutual funds react differently even under similar economic conditions. This can be explained with an example. An increase in the rates of interest may lead to the diminishing of the asset value of securities in the portfolios. Again, an increase in the value may result to the appreciation in value of the other set of portfolio securities. Over time, a balance is created in the portfolio which leads to an overall increase of the portfolio, even if some security values diminish.

Professional managementA majority of the mutual funds in India employ the leading professionals in their investments management. These managers make decisions on what securities, the buying and selling of the funds will take place.

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Regulatory oversightThere are certain rules and regulations framed by the government which every Mutual fund are required to follow. This is to protect the investors from any fraudulent activities.

LiquidityGetting the money out from the mutual fund is no difficult task. All you have to do is just write a check, make a telephone call and all is done.

ConvenienceMutual fund shares can be bought via phone, mail, or even over Internet.

Low costThe expenses of the Mutual fund seldom cross the 1.5 % mark of the investment you make. The Index Funds expenses are usually lesser. Instead, the company stocks are bought by them which are found on the specific index.

Ease of processInvesting in a mutual fund is easy if the investor is a bank account holder and posses a PAN card. It is necessary to fill up the application form, attach the PAN card (for transactions over Rs 50,000), sign the cheque and the Mutual Fund investment is complete.

Well regulatedThe SEBI (Securities Exchange Board of India) regulates the India mutual funds for the security and convenience of the investors. SEBI ensures that a transparency is maintained by keeping a strict vigilance on the mutual funds. This keeps the investor informed and helps him/her to make his/her choice. To keep a track whether the investment in Mutual Fund is in line with the objective or not, SEBI demands the disclosure of portfolios once in every six months.

6.5 Disadvantages of Mutual FundsThe Drawbacks of Mutual Funds are the major obstacles for the growth of the same. Management risks, trading limitations and absence of taxes are some of the major drawbacks of mutual funds.

Fees and commissionsThe Mutual funds charge administrative fees to meet the daily expenses. Many funds charge brokerage or 'loads' to pay financial planners or financial consultants, brokers. In case a shareholder does not use the services of financial adviser, he still has to pay a sales commission.

No guaranteesAll investments bear risk factors. The Mutual Funds are no different. It depends on the stock market. A fall in the stock market would trigger a fall in the value of the mutual fund shares. Although the risk factor pertaining to Mutual funds are much lower compared to Mutual Funds.

Inefficiency of cash reservesThe Mutual Funds maintain big cash reserves, for situations such as a number of large withdrawals. The investors are provided with liquidity, and a major portion of the financial resources is maintained as cash, and it is not invested in some assets.

Management riskThe investment pertaining to the Mutual Funds depends on the fund manager and his selection of the mutual fund portfolio, which is based on speculation. If things do not go as expected, the investments may not earn enough money.

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TaxesThe proceeds from the sale of mutual funds are taxable, even if the same is reinvested in mutual funds.

No insuranceThe mutual funds are regulated by the central government. However mutual funds are still not insured against losses.

Trading limitationsThe mutual funds usually have high liquidity, but most of the mutual funds, such as open-ended funds, are bought or sold at the end of the day

Loss of controlIn case, if the mutual funds are managed by the investor himself, the portfolio management may go bad and have an adverse effect on the earnings from the investment.

6.6 Types of Mutual FundsMutual funds are divided into two major categories, by structure and by investment objective. The further classification is as follows:

6.6.1 By Investment ObjectiveA scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such schemes may be classified mainly as follows:

Growth/Equity oriented SchemesThe aim of growth funds is to provide capital appreciation over the medium to long-term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time.

Equity fundsAs explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:

Index fundsThese funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy.

Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor “tracking error”. Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.

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To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.

Diversified fundsSuch funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.

This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.

The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.

Tax-saving fundsAlso known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.

In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.

Sector fundsThe riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.

Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.

Income/Debt oriented schemeThe aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities, and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.

Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.

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Income fundsBy definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.

Gilt fundsThey invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.

Liquid fundsThey invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.

The ‘risk’ in debt fundsAlthough debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.

Interest rate risk:• This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities. Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.Credit risk: • This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies. The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper. Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.Liquidity risk: • This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper. As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.

Balanced FundThe aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.

As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere

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between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.

Money market or Liquid fundThese funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.

6.6.2 By StructureOpen-ended schemesOpen-ended or open mutual funds are much more common than closed-ended funds and meet the true definition of a mutual fund – a financial intermediary that allows a group of investors to pool their money together to meet an investment objective– to make money! An individual or team of professional money managers manage the pooled assets and choose investments, which create the fund’s portfolio.

They are established by a fund sponsor, usually a mutual fund company, and valued by the fund company or an outside agent. This means that the fund’s portfolio is valued at “fair market” value, which is the closing market value for listed public securities. An open-ended fund can be freely sold and repurchased by investors.

Buying and selling:Open funds sell and redeem shares at any time directly to shareholders. To make an investment, you purchase a number of shares through a representative, or if you have an account with the investment firm, you can buy online, or send a check. The price you pay per share will be based on the fund’s net asset value as determined by the mutual fund company. Open funds have no time duration, and can be purchased or redeemed at any time, but not on the stock market. An open fund issues and redeems shares on demand, whenever investors put money into the fund or take it out. Since this happens routinely every day, total assets of the fund grow and shrink as money flows in and out daily. The more investors buy a fund, the more shares there will be. There’s no limit to the number of shares the fund can issue. Nor is the value of each individual share affected by the number outstanding, because net asset value is determined solely by the change in prices of the stocks or bonds the fund owns, not the size of the fund itself. Some open-ended funds charge an entry load (i.e., a sales charge), usually a percentage of the net asset value, which is deducted from the amount invested.

Advantages:Open funds are much more flexible and provide instant liquidity as funds sell shares daily. You will generally get a redemption (sell) request processed promptly, and receive your proceeds by check in 3-4 days. A majority of open mutual funds also allow transferring among various funds of the same “family” without charging any fees. Open funds range in risk depending on their investment strategies and objectives, but still provide flexibility and the benefit of diversified investments, allowing your assets to be allocated among many different types of holdings. Diversifying your investment is key because your assets are not impacted by the fluctuation price of only one stock. If a stock in the fund drops in value, it may not impact your total investment as another holding in the fund may be up. But, if you have all of your assets in that one stock, and it takes a dive, you’re likely to feel a more considerable loss.

Risks:Risk depends on the quality and the kind of portfolio you invest in. One unique risk to open funds is that they may be subject to inflows at one time or sudden redemptions, which leads to a spurt or a fall in the portfolio value, thus affecting your returns. Also, some funds invest in certain sectors or industries in which the value of the in the portfolio can fluctuate due to various market forces, thus affecting the returns of the fund.

Close-ended schemesClose-ended or closed mutual funds are really financial securities that are traded on the stock market. Similar to a

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company, a closed-ended fund issues a fixed number of shares in an initial public offering, which trade on an exchange. Share prices are determined not by the total net asset value (NAV), but by investor demand. A sponsor, either a mutual fund company or investment dealer, will raise funds through a process commonly known as underwriting to create a fund with specific investment objectives. The fund retains an investment manager to manage the fund assets in the manner specified.

Buying and Selling:Unlike standard mutual funds, you cannot simply mail a check and buy closed fund shares at the calculated net asset value price. Shares are purchased in the open market similar to stocks. Information regarding prices and net asset values are listed on stock exchanges; however, liquidity is very poor. The time to buy closed funds is immediately after they are issued. Often the share price drops below the net asset value, thus selling at a discount. A minimum investment of as much as $5000 may apply, and unlike the more common open funds discussed below, there is typically a five-year commitment.

Advantages:The prospect of buying closed funds at a discount makes them appealing to experienced investors. The discount is the difference between the market price of the closed-end fund and its total net asset value. As the stocks in the fund increase in value, the discount usually decreases and becomes a premium instead. Savvy investors search for closed-end funds with solid returns that are trading at large discounts and then bet that the gap between the discount and the underlying asset value will close. So one advantage to closed-end funds is that one can still enjoy the benefits of professional investment management and a diversified portfolio of high quality stocks, with the ability to buy at a discount.

6.7 Investing in Mutual FundsMutual fund companies [also known as Asset Management Companies (AMCs)] collect funds from public (mainly from small investors) and invest such funds in market and distribute returns/surpluses in the form of dividends. Surpluses can also be reflected in higher Net Asset Value (NAV) of the scheme. In simple words, a mutual fund company collects savings of small investors (pool their money); the fund managers of the concern invest such pool of funds to market (securities); when returns are generated from such investment, passed back to the investors.

This is how a mutual fund works. First an offer document (containing details of the scheme, its investment horizon, and class (es) of securities it intends to invest etc.) is issued to the public. Then the collected money is pooled together to constitute a fund. This fund is managed by fund managers of AMC who take major investment decisions. A trust takes care that the mutual fund investments are in accordance with the scheme of the fund and is being managed in the interest of the investors. The returns from such investment activities are distributed in accordance with the scheme of the fund. NAV of a mutual fund (or in other words NAV per unit) refers to the total asset managed by the fund at its market value divided by the number of outstanding (issued and sold) units of the fund. For instance, a fund having net asset worth of Rs.100 crores and Rs.10 crore units are outstanding then the NAV per unit of the fund would be Rs.10. The NAV of a scheme depends on the market value of its investments and hence it fluctuates with the fluctuating share prices of its investment. An increase in NAV means capital appreciation for investors.

Since mutual funds are managed by professionals who have requisite experiences and qualifications in the areas of stock market, as far as a new entrant in the stock markets are concerned, these funds act as a safe vehicle for investment. Moreover, as mutual funds invest in a number of scrips, the impact of risks associated with individual securities is minimised. To put in financial language, the aim is to diversify the unsystematic risk in the portfolio. Also, since the pooled funds are invested in different sectors and stocks, there is a diversification effect reducing overall risk of the portfolio.

Since mutual funds generally trade in large number of securities at the same time, there is advantage of economies of scale. In other words, there is savings in transaction costs.

According to the investment objective, mutual funds can be classified as: (a) growth funds, (b) income funds and (c) balanced funds. Growth funds invest majority of their pooled amount with the objective of achieving long term

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capital appreciation. Income funds provide periodic returns to investors in the form of dividends. Balanced funds are a midway between growth funds and income funds. They balance their investment in such a way that investors not only get periodical return, but their capital also tends to appreciate which is reflected in higher NAV.

If you are an investor who seek for a suitable fund, then it depends on your risk bearing capacity (your risk profile). If you are a highly risk averse investor who requires periodic return, then you should always prefer investment in income funds. If you have a high risk taking capability and you have surplus funds to invest, then go for growth funds. If you want a small periodic return along with capital appreciation, then go for balanced funds.

Investment in mutual funds should never be looked upon from the point of view of return. It is the risk return paradigm which can help us to optimise our return over a period of time. Another point you should remember is that, you should never attempt to compare two schemes of mutual fund with different investment objectives on the basis of the returns provided by them, if you do so, it would be like comparing apples with mangoes.

Sharpe ratio and Treynor Ratio are the tools to measure the performance of mutual funds over a period of time. Sharpe Ratio is obtained by dividing the difference between return of the portfolio and risk free rate of interest to the standard deviation of the portfolio return. This ratio takes into account surplus return earned by the fund over risk free rate of interest and then divides it by standard deviation of the portfolio return (which is basically a representative of risk which measures deviation of actual return of the portfolio with respect to mean return). Higher the return better is the fund. Treynor Ratio also takes into account surplus return earned over risk free return but the measure of risk here is beta (a measure of systematic risk) rather than standard deviation. Thus, Treynor ratio is obtained by dividing the difference between return of the portfolio and risk free rate of interest to the beta (market risk/systematic risk) of the portfolio.

There are some absolute performance measures such as Jenson’s Alpha, Fama’s Measure and Expense Ratio which provide an indication about the performance of a mutual fund as a whole. Jenson’s Alpha Measure helps us in identifying whether the fund has been able to outsmart its expected return.The expected return of a security is equal to:

)

Where,Rf is the risk free returnβ is the systematic riskRm is the return on market index (return earned by the fund)

Fama’s measure is obtained by the following formula:

Fama’s measure =

Where,= actual return of portfolio = risk free return

= return on market index = standard deviation of portfolio return = standard deviation of market index return

Thus, instead of β, which takes into account only systematic risk, this measure takes into account standard deviation of stock return as well as standard deviation of market returns. Expense ratio refers to the total amount of expenses of the fund as a percentage of total assets of the fund. The expenses include all the charges in the form of administrative overheads, salary of staff etc. However, expenses do not include brokerage.

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6.7.1 How to Invest in Mutual FundStep One - Identify your Investment needs Your financial goals will vary, based on your age, lifestyle, financial independence, family commitments, and level of income and expenses among many other factors. Therefore, the first step is to assess your needs. You can begin by defining your investment objectives and needs which could be regular income, buying a home or finance a wedding or educate your children or a combination of all these needs, the quantum of risk you are willing to take and your cash flow requirements.

Step Two - Choose the right Mutual FundThe important thing is to choose the right mutual fund scheme which suits your requirements. The offer document of the scheme tells you its objectives and provides supplementary details like the track record of other schemes managed by the same Fund Manager. Some factors to evaluate before choosing a particular Mutual Fund are the track record of the performance of the fund over the last few years in relation to the appropriate yardstick and similar funds in the same category. Other factors could be the portfolio allocation, the dividend yield and the degree of transparency as reflected in the frequency and quality of their communications. For selecting the right scheme as per your specific requirements, click here.

Step Three - Select the ideal mix of SchemesInvesting in just one Mutual Fund scheme may not meet all your investment needs. You may consider investing in a combination of schemes to achieve your specific goals.

Fig. 6.3 Mutual funds(Source: http://www.mutualfundsindia.com/primer.asp#a)

Step Four - Invest regularlyThe best approach is to invest a fixed amount at specific intervals, say every month. By investing a fixed sum each month, you buy fewer units when the price is higher and more units when the price is low, thus bringing down your average cost per unit. This is called rupee cost averaging and is a disciplined investment strategy followed by investors all over the world. You can also avail the systematic investment plan facility offered by many open end funds.

Step Five - Start earlyIt is desirable to start investing early and stick to a regular investment plan. If you start now, you will make more than if you wait and invest later. The power of compounding lets you earn income on income and your money multiplies at a compounded rate of return.

Step Six - The final stepAll you need to do now is to Click here for online application forms of various mutual fund schemes and start investing. You may reap the rewards in the years to come. Mutual Funds are suitable for every kind of investor - whether starting a career or retiring, conservative or risk taking, growth oriented or income seeking.

Lower Risk/ Lower Return Potential

Balanced Funds

Bond Funds

Equity Funds

Money Market Funds

Global International Equity Funds

Higher Risk/ Higher return Potential

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6.8 Benefits of Investing in Mutual FundsThe benefits of investing in mutual funds are as mentioned below.

Professional management of the investments Each Mutual fund appoints an experienced and professional funds manager and several research analysts, who research before investing, thus adding value to the common investor. These professional constantly keep track of the market changes and news, predict the impact they will have on the investments and take quick decision regarding the adjustments to be made in the portfolio.

Low costs of investmentsDue to the large amount of funds manages; very low costs accrue per investor. Mutual fund achieves economics of scales in research, transactions, and investments. It lowers the cost of brokerage, custodial and other charges.

Diversification A common investor has limited money, which he can invest only in a few securities and faces a great risk. If their values go down, the investor loses all his money. Since Mutual Funds have huge amounts of funds to invest, the Fund manager invests in the securities of many industries and sectors; (called diversifying the risk). This diversification reduces the risk involved because all the sectors and industries will never go down at the same time. Investors get this diversification by investing a small amount in Mutual Funds.

Convenient record keeping and administrationMutual funds take care of all record keeping including paperwork. It also deals with the problem of bad deliveries, broker’s commission etc.

Various types of SchemesMutual Funds offer various types of schemes such as regular income plan, growth plan, equity funds, debt Funds, and balanced Funds. So an investors can select a plan according to his needs.

FlexibilityMutual funds offers various schemes, giving the investor the option to shift from one scheme to another at various times depending on his needs, the risk he is willing to take, and the type of return the wants.

Scope for good returnMutual fund invest in various industries and sectors, therefore the portfolio gets diversified, resulting in mutual funds generating equitable return.

Enables investing in high value stocksThe individual investors have less money to invest and cannot invest in high value stocks such as Infosys. With Rs 12000 an investors can purchase only 2 shares of Infosys, which is like putting all his eggs in one basket. Mutual funds have huge amount of funds and can invest in these high value stocks. The benefits from this high value stock can pass on to all the investors.

Easy liquidityMutual fund provides easy liquidity. In the case of open-ended scheme units can be purchased/sold at NAV from/to the mutual fund on any day. In the case of closed-ended funds units are traded on the stock exchange at the market prices, or the investors can repurchase the units from the mutual fund at the prevailing NAV related prices.

Tax benefitsThere are certain schemes that offer tax benefits o the customers. So the investor also tax benefits from mutual fund.

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Provides transparencyMutual funds keep the customers informed about the competition of all the investments in various asset classes from time to time. During the launch of the mutual fund the offer document provides information on the objective of the funds, cost to be incurred, entry/exist load to be charged to the investor, risk associated with the funds, & detail about the fund mariners, sponsors, members of trust etc.

Regulated by SEBIJust like equities, mutual funds are also regulated by the SEBI. This is to safeguard the interests of investor.

6.9 Mutual Fund Industry in IndiaThe Evolution - The formation of Unit Trust of India marked the evolution of the Indian mutual fund industry in the year 1963. The primary objective at that time was to attract the small investors and it was made possible through the collective efforts of the Government of India and the Reserve Bank of India. The history of mutual fund industry in India can be better understood divided into following phases:

Phase 1. Establishment and Growth of Unit Trust of India - 1964-87Unit Trust of India enjoyed complete monopoly when it was established in the year 1963 by an act of Parliament. UTI was set up by the Reserve Bank of India and it continued to operate under the regulatory control of the RBI until the two were de-linked in 1978 and the entire control was transferred in the hands of Industrial Development Bank of India (IDBI). UTI launched its first scheme in 1964, named as Unit Scheme 1964 (US-64), which attracted the largest number of investors in any single investment scheme over the years.

UTI launched more innovative schemes in 1970s and 80s to suit the needs of different investors. It launched ULIP in 1971, six more schemes between 1981-84, Children's Gift Growth Fund and India Fund (India's first offshore fund) in 1986, Mastershare (India’s first equity diversified scheme) in 1987 and Monthly Income Schemes (offering assured returns) during 1990s. By the end of 1987, UTI's assets under management grew ten times to Rs 6700 crores.

Phase II. Entry of Public Sector Funds - 1987-1993The Indian mutual fund industry witnessed a number of public sector players entering the market in the year 1987. In November 1987, SBI Mutual Fund from the State Bank of India became the first non-UTI mutual fund in India. SBI Mutual Fund was later followed by Canbank Mutual Fund, LIC Mutual Fund, Indian Bank Mutual Fund, Bank of India Mutual Fund, GIC Mutual Fund, and PNB Mutual Fund. By 1993, the assets under management of the industry increased seven times to Rs. 47,004 crores. However, UTI remained to be the leader with about 80% market share.

1992-93 Amount Mobilised Assets Under Management

Mobilisation as % of gross Domestic Savings

UTI 11, 057 38, 247 5.2%

Public Sector 1, 964 8, 757 0.9%

Total 13, 021 47, 004 6.1%

Table 6.1 Public sector fund

Phase III. Emergence of Private Sector Funds - 1993-96The permission given to private sector funds including foreign fund management companies (most of them entering through joint ventures with Indian promoters) to enter the mutual fund industry in 1993, provided a wide range of choice to investors and more competition in the industry. Private funds introduced innovative products,

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investment techniques and investor-servicing technology. By 1994-95, about 11 private sector funds had launched their schemes.

Phase IV. Growth and SEBI Regulation - 1996-2004The mutual fund industry witnessed robust growth and stricter regulation from the SEBI after the year 1996. The mobilisation of funds and the number of players operating in the industry reached new heights as investors started showing more interest in mutual funds.

Inventors' interests were safeguarded by SEBI and the Government offered tax benefits to the investors in order to encourage them. SEBI (Mutual Funds) Regulations, 1996 was introduced by SEBI that set uniform standards for all mutual funds in India. The Union Budget in 1999 exempted all dividend incomes in the hands of investors from income tax. Various Investor Awareness Programmes were launched during this phase, both by SEBI and AMFI, with an objective to educate investors and make them informed about the mutual fund industry.

In February 2003, the UTI Act was repealed and UTI was stripped of its Special legal status as a trust formed by an Act of Parliament. The primary objective behind this was to bring all mutual fund players on the same level. UTI was re-organised into two parts: 1. The Specified Undertaking, 2. The UTI Mutual Fund

Presently Unit Trust of India operates under the name of UTI Mutual Fund and its past schemes (like US-64, Assured Return Schemes) are being gradually wound up. However, UTI Mutual Fund is still the largest player in the industry. In 1999, there was a significant growth in mobilisation of funds from investors and assets under management which is supported by the following data:

GROSS FUND MOBILISATION (RS. CRORES)

FROM TO UTI PUBLIC SECTOR

PRIVATE SECTOR TOTAL

01-April-98 31-March-99 11679 1732 7966 21377

01-April-99 31-March-00 13536 4039 42173 59748

01-April-00 31-March-01 12413 6192 74352 92957

01-April-01 31-March-03 4643 13613 146267 164523

01-April-02 31-Jan-03 5505 22923 220551 248979

01-Feb-03 31-March-03 * 7259* 58435 65694

01-April-03 31-March-04 - 68558 521632 590190

01-April-04 31-March-05 - 103246 736416 839662

01-April-05 31-March-06 - 183446 914712 1098158

Table 6.2 Gross fund mobilisation

Assets Under Management (Rs. Crores)

As on UTI Public Sector Private Sector Total

31-March-99 53320 8292 6860 68472

Table 6.3 Assets under management

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Phase V. Growth and Consolidation - 2004 OnwardsThe industry has also witnessed several mergers and acquisitions recently, examples of which are acquisition of schemes of Alliance Mutual Fund by Birla Sun Life, Sun F&C Mutual Fund and PNB Mutual Fund by Principal Mutual Fund. Simultaneously, more international mutual fund players have entered India like Fidelity, Franklin Templeton Mutual Fund etc. There were 29 funds as at the end of March 2006. This is a continuing phase of growth of the industry through consolidation and entry of new international and private sector players.

Fig. 6.4 Growth of assets under management(Source: http://www.appuonline.com/mf/knowledge/industry.html)

6.10 Private Sector Mutual FundsThe mutual fund business was the sole preserved of the giant public sector banks and insurance companies. In its guidelines announced in 14th February 1992 for mutual funds the finance ministry has flagged of private and joint sector funds

It has been widely accepted that mutual fund is a powerful vehicle through which the saving of a large number of small investors is pooled for deployment in various stock/money market securities, thereby giving the investors the benefit of high returns coupled with safety of their investments.

Despite all attempts of public sector financial investors in the last few years, the conversion of household savings into investment in our country has remained much below comparable levels, in the western world. Perhaps this realisation has prompted the government to throw the door open to joint/private sector mutual funds to supplement the efforts of public sector mutual funds in covering household savings of investors, specially those from rural and semi urban centres, into risk hedged investments and hereby spread the equity/stock market investment culture in those hitherto neglected areas.

The new industrial policy announced by the government seeks to pursue a sound policy framework encompassing abolition of industrial licensing encouragement of entrepreneurship development of the capital markets and increasing competitiveness for the benefit of the common man. Industrial development, triggered off by such policies of liberalisation, cannot be complete without a healthy and well developed capital market. Private sector mutual funds will have an important role to play in aiding the growth of Indian capital market on healthy and mutual lines.

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The induction of private sector mutual finds will aid the development of the capital market in the following ways:By acting as market makers, they will provide more liquidity to the listed company’s shares• They will provide stability to the market for a healthier capital market growth• They will help to spread the equity cult among rural/semi-urban savers, thereby transforming them from savers • into investorsThey will provide the much needed healthy competition to their public sector counterparts, which may force • the public sector also to perform more effectively in the long run

6.11 Schemes of Mutual FundWithin a short span of four to five years mutual fund operation has become an integral part of the Indian financial scene and is poised for rapid growth in the near future. Today, there are eight mutual funds operating various schemes tailored to meet the diversified needs of savers. UTI has been able to register phenomenal growth in the mid eighties. Now there are 121 mutual fund schemes are launched in India including UTI’s scheme attracting over Rs. 45,000 Crores from more than 3 Crore investor’s accounts Out of this closed-end scheme are offered by mutual fund of India to issue shares for a limited period which are traded like any other security as the period and target amounts are definite under such security as the period and target amounts are definite under such schemes. Besides open-end schemes are lunched by mutual fund under which unlimited shares are issued by investors but these shares are not traded by any stock exchange.

However, liquidity is provided by this scheme to the investors. In addition to this off shore mutual funds have been launched by foreign banks, some Indian banks, like SBI, Canara Bank etc, and UTI to facilitate movement of capital from cash-rich countries to potentially high growth economics. Mutual funds established by leading public sector banks since 1987-SBIMF, Can Bank, Ind Bank, PNBMF and BOIMF, emerged since 1987-SBIMFo, as major players by offering bond like products with assurance of higher yields. The latest schemes of BOI mutual fund goes to the extent of allowing each individual investor to choose the date for receiving the income. Besides the bank mutual funds have also floated a few open-ended schemes, pure growth schemes, and tax saving schemes. The LIC, GIC mutual funds offer insurance linked product providing various types of life and general insurance benefits to the investors. Also the income growth oriented schemes are operated by mutual fund to cater to an investor’s needs for regular incomes and hence, it distributes dividend at intervals.

6.12 Mutual Fund RegulationsThe Indian mutual fund industry witnessed robust growth and stricter regulation from SEBI since 1996. The mobilisation of funds and the number of players operating in the industry reached new heights as investors started showing more interest in mutual funds. Safeguarding the interests of investors is one of the duties of SEBI. Consequently, SEBI (Mutual Funds) Regulations, 1996 and certain other guidelines have been issued by SEBI that sets uniform standards for all mutual funds in India.

SEBI (Mutual Funds) Regulations

03-Dec-1996 Securities and Exchange Board of India (Mutual Funds) Regulations, 1996

12-Jan-2006 SEBI (Mutual Funds) (Amendment) Regulations, 2006

AMFI Codes and guidelinesThe Indian mutual fund industry witnessed a number of public sector players entering the market in the year 1987. In November 1987, SBI Mutual Fund from the State Bank of India became the first non-UTI mutual fund in India. SBI Mutual Fund was later followed by Canbank Mutual Fund, LIC Mutual Fund, Indian Bank Mutual Fund, Bank of India Mutual Fund, GIC Mutual Fund, and PNB Mutual Fund. By 1993, the assets under management of the industry increased seven times to Rs. 47,004 crores. However, UTI remained to be the leader with about 80% market share.

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Codes Codes of ethics to be followed by the members/mutual fund companies

GuidelinesRegulatory framework along with a code of conduct for intermediaries like individual agents, brokers, distribution houses and banks engaged in selling of mutual fund products

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SummaryA Mutual Fund is a special type of investment institution which collects or pools the savings of the community • and invests large funds in variety of Blue-chip Companies which are selected from a wide range of industries with the objects of maximising returns/incomes on investments.NAV of the Fund is the market value of all the assets of the Fund subtracting the Liabilities.• The Mutual funds charge administrative fees to meet the daily expenses. Many funds charge brokerage or 'loads' • to pay financial planners or financial consultants, brokers.Mutual funds are divided into two major categories, by structure and by investment objective.• The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities • and fixed income securities in the proportion indicated in their offer documents.Money market or Liquid funds are also income funds and their aim is to provide easy liquidity, preservation of • capital and moderate income.Mutual fund companies [also known as Asset Management Companies (AMCs)] collect funds from public • (mainly from small investors) and invest such funds in market and distribute returns/surpluses in the form of dividends.The formation of Unit Trust of India marked the evolution of the Indian mutual fund industry in the year 1963. • The primary objective at that time was to attract the small investors and it was made possible through the collective efforts of the Government of India and the Reserve Bank of India.

ReferencesMobius, M., 2007. • Mutual funds: an introduction to the core concepts, John Wiley and SonsGupta, A., 2002. • Mutual funds in india: a study of investment management, India: Anmol Publications PVT. LTD

Recommended ReadingJones, C.P., 2003. • Mutual funds: your money, your choice : take control now and build wealth wisely, FT Press.Haslem, J.A., 2003. • Mutual funds: risk and performance analysis for decision making, Wiley-BlackwellTripathy, N.P., • Mutual funds in India: emerging issues, Excel Books

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Self Assessment

A ____________ is a Trust, which combines the investments of various investors having similar financial 1. goals.

mutual funda. balance fundb. premiumc. insuranced.

Which statement is true?2. The Index Funds expenses are usually greater.a. The Mutual Funds expenses are usually lesser.b. The Index Funds expenses are usually lesser.c. The Provident Funds expenses are usually lesser.d.

Investing in a mutual fund is easy if the investor is a bank account holder and posses a _________ card.3. credita. rationb. PANc. identityd.

All investments bear __________ factors.4. currencya. riskb. creditc. cultured.

Which statement is true?5. Mutual funds are divided into two major categories.a. Mutual funds are divided into three major categories.b. Mutual funds are divided into four major categories.c. Mutual funds are divided into five major categories.d.

What is the full form of BSE?6. Best Stock Exchangea. Better Service Every-timeb. Bombay Stock Exchangec. Best Semester Everd.

The aim of income funds is to provide regular and steady income to______________.7. borrowersa. loanerb. lendersc. investorsd.

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_______________sell and redeem shares at any time directly to shareholders.8. Close-endeda. Open fundsb. Balance fundsc. Mutual fundsd.

Which statement is false?9. Shares are purchased in the open market similar to stocks.a. Information regarding prices and net asset values are listed on magazines.b. The time to buy closed funds is immediately after they are issued.c. Often the share price drops below the net asset value, thus selling at a discount.d.

______________ is obtained by dividing the difference between return of the portfolio and risk free rate of 10. interest to the standard deviation of the portfolio return.

Treynor Ratioa. Total Ratiob. Sharpe Ratioc. Expense Ratiod.

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Chapter VII

Credit Rating and Venture Capital

Aim

The aim of this chapter is to:

introduce credit rating•

explain determinants of rating•

elucidate venture capital •

Objectives

The objectives of this chapter are to:

enlist rating methodology•

elucidate credit rating agencies in India•

explain benefits of credit rating•

Learning outcome

At the end of this chapter, the students will be able to:

understand forms of financing used by venture capitalists•

comprehend advantages of debts to a venture capital•

infer limitations of credit ratings•

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7.1 Introduction to Credit RatingThe removal of strict regulatory framework in recent years has led to a spurt in the number of companies borrowing directly from the capital markets. There have been several instances in the recent past where the "fly-by-night” operators have cheated unwary investors. In such a situation, it has become increasingly difficult for an ordinary investor to distinguish between 'safe and good investment opportunities' and ‘unsafe and bad investments'. Investors find that a borrower's size or name is no longer a sufficient guarantee of timely payment of interest and principal. Investors perceive the need of an independent and credible agency, which judge s impartially a n d in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on the relative capacities of the borrowers to meet their obligations. These Credit Rating Agencies, thus, assist and form an integral part of a broader programme of financial disintermediation and broadening and deepening of the debt market.

Credit rating is used extensively for evaluating debt instruments. These include long-term instruments, like bonds and debentures as will as short-term obligations, like Commercial Paper. In addition, fixed deposits, certificates of deposits, inter-corporate deposits, structured obligations including non-convertible portion of partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irrespective of their maturity. Earlier only debt issues of over 18 months maturity had to be compulsorily rated.

Credit Rating Agencies rate the aforesaid debt instruments of companies. They do not rate the companies, but their individual debt securities. Rating is an opinion regarding the timely repayment of principal and interest thereon; it is expressed by assigning symbols, which have definite meaning. A rating reflects default risk only, not the price risk associated with changes in the level or shape of the yield curve.

7.2 Determinants of RatingsThe default-risk assessment and quality rating assigned to an issue are primarily determined by the following three factors:

The issuer's ability to pay• The strength of the security owner's claim on the issue• The economic significance of the industry and market place of the issuer•

Ratio analysis is used to analyse the present and future earning power of the issuing corporation and to get insight into the strengths and weaknesses of the firm. Bond rating agencies have suggested guidelines about what value each ratio should have within a particular quality rating. Different ratios are favoured by rating agencies. For any given set of ratios, different values are appropriate for each industry. Moreover, the values of every firm's ratios vary in a cyclical fashion through the ups and downs of the business cycle. To assess the strength of security owner's claim, the protective provisions in the indenture (legal instrument specifying bond owners' rights), designed to ensure the safety of bondholder's investment, are considered in detail. The factors considered in regard to the economic significance and size of issuer includes: nature of industry in which issuer is, operating (specifically issues like position in the economy, life cycle of the industry, labour situation, supply factors, volatility, major vulnerabilities, etc.), and the competition faced by the issuer (market share, technological leadership, production efficiency, financial structure, etc.)

7.3 Rating MethodologyRating is a search for long-term fundamentals and the probabilities for changes in the fundamentals. Each agency's rating process usually includes fundamental analysis of public and private issuer-specific data, industry analysis, and presentations by the issuer's senior executives, statistical classification models, and judgement. Typically, the rating agency is privy to the issuer's short and long-range plans and budgets. The analytical framework followed for rating methodology is divided into two interdependent segments. The first segment deals with operational characteristics

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and the second one with the financial characteristics. Besides, quantitative and objective factors; qualitative aspects, like assessment of management capabilities play a very important role in arriving at the rating for an instrument. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Key areas considered in a rating include the following:

Business risk To ascertain business risk, the rating agency considers Industry's characteristics, performance and outlook, operating position (capacity, market share, distribution system, marketing network, etc.), technological aspects, business cycles, size and capital intensity.

Financial riskTo assess financial risk, the rating agency takes into account various aspects of its Financial Management (e.g. capital structure, liquidity position, financial flexibility and cash flow adequacy, profitability, leverage, interest coverage), projections with particular emphasis on the components of cash flow and claims thereon, accounting policies and practices with particular reference to practices of providing depreciation, income recognition, inventory valuation, off-balance sheet claims and liabilities, amortization of intangible assets, foreign currency transactions, etc.

Management evaluation Management evaluation includes consideration of the background and history of the issuer, corporate strategy and philosophy, organisational structure, quality of management and management capabilities under stress, personnel policies etc.

Business environmental analysisThis includes regulatory environment, operating environment, national economic outlook, areas of special significance to the company, pending litigation, tax status, possibility of default risk under a variety of scenarios. Rating is not based on a predetermined formula, which specifies the relevant variables as well as weights attached to each one of them. Further, the emphasis on different aspects varies from agency to agency. Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates. The rating agency employs qualified professionals to ensure consistency and reliability. Reputation of the Credit Rating Agency creates confidence in the investor. Rating Agency earns its reputation by assessing the client's operational performance, managerial competence, management and organisational set-up and financial structure. It should be an independent company with its own identity. It should have no government interference. Rating of an instrument does not give any fiduciary status to the credit rating agency. It is desirable that the rating be done by more than one agency for the same kind of instrument. This will attract investor's confidence in the rating symbol given.

A rating is a quality label that conveniently summarizes the default risk of an issuer. The credibility of the issuer's proposed payment schedule is complemented by the, credibility of the rating agency. Rating agencies perform this certification role by exploiting the economies of scale in processing information and monitoring the issuer. There is an ongoing debate about whether the rating agencies perform an information role in addition to a certification role. Whether agencies have access to superior (private) information, or if agencies are superior processors of information; security ratings provide information to investors, rather than merely summarizing existing information. Empirical research confirms the information role of rating agencies by demonstrating that news of actual and proposed rating changes affects the price of issuer's securities. Most studies document numerically larger price effects for downgrades than for upgrades, consistent with the perceived predilection, of management for delaying bad news.

7.4 Credit Rating Agencies in IndiaIn India, at present, there are four Credit Rating Agencies:

Credit Rating and Information Services of India Limited (CRISIL). • Investment Information and Credit Rating Agency of India Limited (ICRA) . • Credit Analysis and Research Limited (CARE). • Duff and Phelps Credit Rating of India (Pvt.) Ltd. •

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CRISILThis was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the instruments are being used. CRISIL’s market share is around 75%. It has launched innovative products for credit risks assessment viz., counter party ratings and bank loan ratings. CRISIL rates debentures, fixed deposits, commercial papers, preference shares, and structured obligations. Of the total value of instruments, rated debentures accounted for 31.1%, fixed deposits for 42.3% and commercial paper 6.6%. CRISIL publishes CRISIL rating in SCAN that is a quarterly publication in Hindi and Gujarati, besides English. CRISIL evaluation is carried out by professionally qualified persons and includes data collection, analysis and meeting with key personnel in the company to discuss strategies, plans and other issues that may effect, evaluation of the company. The rating ,process ensures confidentiality. Once the company decides to use rating, CRISIL is obligated to monitor the rating over the life of the debt instrument.

ICRA ICRA was promoted by IFCI in 1991. During the year 1996-97, ICRA rated 261 debt instruments of manufacturing companies, finance companies and financial institutions equivalent to Rs. 12,850 crore as compared to 293 instruments covering debt volume of Rs. 75,742 crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for debentures (including long term instruments), 49.4% for Fixed Deposit programme (including medium- term instruments), and 22.1% for Commercial Paper Programme (including short- term instruments). The corresponding figures of amount involved for these three broad rated categories w a s 23.8% for debentures, 52.2% for fixed deposits, a n d 24.0% for Commercial Paper. The factors that ICRA takes into consideration for rating, depends on the nature of borrowing entity. The inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of management, human resource development policies a n d practices, hedging of risks, trends in cash flows and potential liquidity, financial flexibility, asset quality and past record of servicing of debt as well as government policies affecting the industry are examined. Besides determining the credit risk associated with an instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity. This requires examination of almost all parameters pertaining to the fundamentals of the company including relevant sectoral perspectives. This quality analysis is reinforced and completed by way of the unbiased opinion and informed perspective of one analyst and wealth of judgement of committee members. ICRA opinions help the issuing company to broaden the market for their equity. As the name recognition is replaced by objective opinion, the lesser known companies are also able to access the equity market.

CARE CARE is a credit rating and information services company promoted by IDBI jointly with investment institutions, banks, and finance companies. The company commenced its operations in October 1993. In January 1994, CARE commenced publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the rationale of all accepted ratings, CAREVIEW often carries special features of interest to issuers of debt instruments, investors, and other market players.

7.5 Credit Rating SymbolsCredit Rating Agencies rate an instrument by assigning a definite symbol. Each symbol has a definite meaning. These symbols have been explained in descending order of safety or in ascending order of risk of non-payment. For example, CRISIL has prescribed the following symbols for debenture issues: AAA indicates highest safety of timely payment of interest and principal AA indicates high safety of timely payment of interest and principal A indicates adequate safety of timely payment of interest and principal BBB offers sufficient safety of payment of interest and principal for the present BB offers inadequate safety of timely payment of interest and principal B indicates great susceptibility to default C indicates vulnerability to default. Timely payment of interest and payment is possible only if favourable circumstances continue

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D indicates that the debenture is in default in payment of arrears of interest or principal or is expected to default on maturity.

As the value of symbol is reduced say from AAA to AA, the safety of timely payment of interest and principal is decreased. While AAA indicates highest safety of timely repayment, D indicates actual default or expected default on maturity. Different symbols indicate different degrees of risk of repayment of principal and interest. It is the assessment of the Rating Agency based on the methodology already explained.

7.6 Benefits of Credit Rating Rating serves as a useful tool for different constituents of the capital market. For different classes of persons, different benefits accrue from the use of rated instruments.

Investors: Rating safeguards against bankruptcy through recognition of risk. It gives an idea of the risk involved in the investment. It gives a clue to the credibility of the issuer company. Rating symbols give information on the quality of instrument in a simpler way that can be understood by lay investor and help him in taking decision on investment without the help from broker. Both individuals and institutions can draw up their credit risk policies and assess the adequacy or otherwise of the risk premium offered by the market on the basis of credit ratings.

Issuers of debt instruments: A company whose instruments are highly rated has the opportunity to have a wider access to capital, at 0lower cost of borrowing. Rating also facilitates the best pricing and timing of issues and provides financing flexibility. Companies with rated instruments can use the rating as a marketing tool to create a better image in dealing with its customers, lenders, and creditors. Ratings encourage the companies to come out with more disclosures about their accounting systems, financial reporting, and management pattern. It also makes it possible for some category of investors who require mandated rating from reputed rating agencies to make investments.

Financial intermediaries: Financial intermediaries like banks, merchant bankers, and investment advisers find rating as a very useful input in the decision relating to lending and investments. For instance, with high credit rating, the brokers can convince their clients to select a particular investment proposal more easily thereby saving on time, cost and manpower in convincing their clients.

Business counter-parties: The credit rating helps business counter-parties in establishing business relationships particularly for opening letters of credit, awarding contracts, entering into collaboration agreements, etc.

Regulators: Regulators can, with the hel of credit ratings, determine eligibility criteria and entry barriers for new securities, monitor financial soundness of organisations and promote efficiency in debt securities market. This increases transparency of the financial system leading to a healthy development of the market.

7.7 Rating and Default RiskMost investors prefer to use credit ratings to assess default risk. Internationally acclaimed credit rating agencies such as Moody’s, Standard and Poor’s and Duff and Phelps have been offering rating services to bond issuers over a very long time. The bond issuers pay the rating agency to evaluate the quality of the bond issue in order to increase the information flow to the investors and hopefully increase the demand for their bonds. The rating agency determines the appropriate bond rating by assessing various factors. For example, Standard and Poor’s judges the credit quality of corporate bonds largely by looking at the bond indenture, assets protection, financial resources, future earning power, and management. More specifically, Standard and Poor’s focuses on cash flow to judges a firm’s financial viability. The bond categories are assigned letter grades. The highest grade binds, whose risk of default is felt to be negligible, are rated triple A (Aaa or AAA). The rating agencies assign pluses or minuses (e.g., Aa+ A+) when appropriate to show the relative standing within the major rating categories. The following table gives the rating symbols and their explanation as employed by Moody’s and S&P, the well-known rating agencies.

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Moody’s Explanation Standard & Poor’s Explanation

Aaa Best quality AAA Highest grade

Aa High quality AA High grade

A Higher-medium grade A Upper medium grade

Baa Medium grade BBB Medium grade

Ba Possess speculative elements BB Lower medium grade

B Generally lack characteristics of desirable investment B Speculative

Caa Poor standing; may be default CCC-CCC Outright speculation

Ca Speculative in a high degree; often in default C Reserved for income bonds

C Lowest grade DDD-DD

In default, with rating indicating relative salvage value

Table 7.1 Rating symbols and their explanation as employed by Moody’s and S&P

Not all bonds are rated by the agencies. Small issues and those placed privately are generally not rated. For those bonds that are rated, the competing services generally rank the same bond in the same rating category; seldom do they disagree by more than one grade. The research has shown that there is a high degree of correlation between bond quality ratings and actual defaults. Large number of firms with low ratings usually comes under default. This suggests that knowledge about credit rating does help in assessing the financial risks that can lead to default.

7.8 Rating and YieldsThe ratings assigned to a bond issue directly affects its yield. Issuers of high-risk securities have to pay higher rates of return than issuers of low risk securities. Junk bonds, for instance, are high risk and a high yield instrument. Investment may be limited in such instruments. A study of average yields to maturity for different categories of bonds (bonds index) over various time periods (1955-67, 1968-79, and 1981-85) reveals that market yields increase with increased risk. Investors dislike risk. Risk avoidance is visible not only in the long-run but also in short-run. Bonds rated poorly must pay higher yield in the market place to attract risk-averse investors. The difference in yield is termed as the yield spread. The yield spread between two rating categories provides a measure of the default risk premium. While yield spreads related to default risk are not constant over time, they do remain in the appropriate relative pattern. That is, AAA rated bonds always sell at lower yields than Aa bond, which in turn sell at lower yields than A rated bonds, and so forth. Investors often use the highest rating category as a benchmark yield and compute yield spreads for lower-rated bonds.

In India, on can say, the relationship between ratings and cost funds is, at best, tenuous. It has been observed that many times similar rated companies are accessing funds at widely disparate rates of interest. This signifies that the market perception of the investment risk of such companies is different even though credit rating agency has placed them in the same category (symbol). One can conclude that as ratings fail to capture the markets’ perception of risk, there is indeed something wrong with ratings assigned to these companies.

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A number of research studies suggest that the determinants of credit rating and yield spread for corporate bonds include:

Debt ratios• Earnings-levels• Earnings-variability• Interest coverage• Pension obligations•

Since about 75% of yield spread and ratings variability are explained with these variables, other subjective factors may play an important role. The yield-spread pattern also changes in magnitude over the business cycle; yield spreads widen (narrows) during recessions (prosperous periods). A reasonable explanation of expanding and contracting yield spreads is that during recession, default risk rises more than proportionally for lower-quality firms because of reduced cash flows. Also, investors may become risk-averse as their wealth decreases during recessions.

7.9 Limitations of Credit RatingsThere are several limitations of credit ratings. First, credit ratings are changed when the agencies feel that sufficient changes have occurred. The rating agencies are physically unable to constantly monitor all the firms in the market. The opinions of rating agencies may turn wrong in the context of subsequent events that may have an adverse impact on asset quality of the issuer.

Second, the use of credit ratings imposes discrete categories on default risk, while in reality default risk is a continuous phenomenon. Moody's recognised this way back in 1982 by adding numbers to the letter system, thereby increasing its number of rating categories from 9 to 19. Nevertheless, this limitation still pertains. The letter grades assigned by rating agencies serve only as a general, somewhat coarse form of discrimination.

Third, owing to time and cost constraints, credit ratings are unable to capture all characteristics for an issuer and issue. A borrowing company can reduce the cost of borrowing, if it obtains a higher rating for its contemplated issue. The stakes and pressures, consequently, to get a good quality rating are high. If the company comes to know that its issue is going to get a low quality rating, it may approach another agency and then use the best rating among them since it is not under obligation to disclose all ratings. According to the practice in the rating industry in India, a corporate entity has the option of not agreeing to the first rating given to its debt issue and can choose not to get rated by that agency at all. In such a situation, the rating agency cannot divulge its assessment to anybody, and the corporate entity is free to go to any other agency. But once the corporate entity agrees with the first rating, it has no option of getting out of the rating discipline imposed by the rating agency. This may tempt rating agencies to woo clients with the help of an initial favourable rating, but the freedom may eventually be misused by the rating agency because corporate client doesn't have the option to differ with the agency, once it initially agrees to get rated by it. To ensure that corporate clients are not dependent on one rating agency, the system of compulsory dual ratings of all instruments could be considered. Sometimes, the rating agency may reduce the rigor of their criteria on their own to enlarge the business and improve profits especially if they are a listed company. Investors should, therefore, not follow blindly the ratings of different agencies in regard to the safety of fixed income instruments. The investors should explore other alternative evaluation sources so that they become aware of the true risks involved. The rating agencies have to be alert to ensure that their rating decisions are not driven by volume and profitability with a view to ensure favourable impact on the price of its share. It may be asserted that the rating agencies should be judged by overall performance and not by one or two defaults. There are instances of default in the instruments rated as investment grade of high safety by top agencies of the world.

Once the corporate agrees with the first rating, the rating agency is obliged to assess the debt issue till its maturity and publish the rating as part of its surveillance system. It has been observed that rating agencies have miserably failed in predicting the brewing crisis and have continued to give investment grade rating to companies, which have eventually defaulted. It has been argued that CRB scam would not have taken place if we had a better credit rating agency that would have cautioned in time on the status of the company. After the crisis, rating agencies became

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overcautious and resorted to drastic downgrades of ratings in respect of specific companies. For instance, CRISIL, ICRA, and CARE downgraded respectively 140, 35, and 50 companies in 1997. Of the rating changes effected by CRISIL, ICRA, and CARE-36%, 40% and 64% respectively were by three or more notches.

CRISIL ICRA CARE

By one notch 35.0 28.6 22.0

By two notches 29.3 31.4 14.0

By three notches 12.9 8.6 20.0

By four notches 7.9 8.6 4.0

By more than four notches

15.0 22.9 40.0

Total downgrades 140 35 50

Table 7.2 Downgrades of ratings (in percentage) in 1997(Source: http://www.egyankosh.ac.in/bitstream/123456789/25902/1/Unit13.pdf)

The high proportion of companies whose investment grade rating was overnight changed to non-investment grade is not conducive for enhancing the faith of investors in ratings. In India, as in the developed countries, rating changes often lag the variations in stock prices. Of the 157 rating downgrades made by the three rating agencies in 1997, in 130 companies, the change in ratings lagged the decline in share prices. Despite evidence that stock price movements do eventually lead to a change in ratings, there is reason to believe that further changes are urgently needed when the ratings of companies and their stock prices are compared. This need is more prominent in the case of the investment grade ratings granted to NBFCs by CRISIL and ICRA than to the companies which are trading below par, yet command investment grade rating.

7.10 Venture CapitalVenture Capital is investing in companies that have undeveloped or evolving products or revenue. It lays particular stress on entrepreneurial attempts and less mature businesses. Venture Capitalists are those who are desirous to accept high risk in order to attain a much higher rate of return. A Venture Capital fund invests for a very long term, has a relatively small number of “stocks,” and seeks very high returns. If we try to explain Venture Capital financing from both perspectives of the investor side and the entrepreneur side, we should ask and answer those two questions: What does an Investor (also known as a Venture Capitalist) have and what does an entrepreneur have? Venture Capitalists have funds, or they have the ability to raise capital. They have experience in building companies creating wealth from the very beginning of a company up to the exit event. They have associates to help in formation of the company’s network. On the other hand, entrepreneurs have avant-garde ideas, processes, or products. They have the needed skill and practice to build and retain this business. The Venture Capitalists invests in companies, because they are looking for opportunities of gaining considerably higher returns than in stock market returns. And entrepreneurs just need the money to fully cash in on the opportunity of their product/service. Thus, the Venture Capital industry makes these two counterparties to come together and meet each other’s needs. There are four stages in Venture Capital financing. They can be summarised as:

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Seed stageFinancing provided to research, assess and develop an initial concept before a business has reached the start-up phase.

Start-up stageFinancing for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their products commercially and will not yet be generating a profit.

Expansion stageFinancing for growth and expansion of a company which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. This stage includes bridge financing and rescue or turnaround investments.

Replacement capitalPurchase of shares from another investor or to reduce gearing via the refinancing of debt.

7.10.1 Aim of Venture Capital FinancingInvestors are interested in Venture Capital by the anticipation of earning higher yields than they can by investing in publicly traded firms. Likewise, entrepreneurs may be attracted by the feasibility of higher returns on their human and financial assets. In that point of view, the aim of Venture Capital financing is to increase the value of innovating companies, to allow today's "emerging" companies to advance into tomorrow's leading firms – by that means providing investors with noteworthy returns on their investment. Venture Capital firms invest in a lot of different new ventures, at least one of which should be successful. Apart from financing the new company, Venture Capital firms usually bring in their experience in the field and a network of relations – social capital. Venture capital is an important source of equity for start-up companies. VCs want two things:

Equity: because if and when the business achieves considerable success, that equity stake will be worth the • invested capital. Control: because VCs want to reduce the risk that the entrepreneur will run a promising idea into the ground.•

Depending on the main purpose of financing, there exists three major types VC investors:

Investors concerned with economic gainThese investors are motivated by the prospect of a large economic reward, especially if the company gains public recognition. Entrepreneurs who seek these types of Venture Capitalists should not only stress the purpose of their business idea(s) but also mention shareholder percentages and ROI in their pitch and business plans.

Hedonistic investorsThese investors are attracted to investing because of the thrill associated with risky ventures. They also believe that the entrepreneur’s concepts are worthwhile and desire to help the entrepreneur market their innovative ideas. Thus, new business owners who seek funding from these investors should have a well-prepared, convincing pitch and business plan.

Altruistic Angel investorsThese investors take pleasure in helping young companies thrive and enjoy promoting community development and job growth. Entrepreneurs who seek capital from these types of investors should perhaps stress the advantages of economic growth in communities and economically sound technologies.

At first glance, Venture Capital investors basically look for six important components when agreeing on an investment:

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The promise of a large ROIVC investors seek a profitable return on an investment since their investments tend to be highly risky.

The rationale behind every investmentEntrepreneurs should give VC investors a legitimate reason to invest in their company and cherish the skills and expertise a VC investor will bring to their enterprise.

A promising pitch and convincing business proposalVC investors want to see an entrepreneur’s business plan, detailing the ideas and objectives of their company. This business plan should include any financial projections, comprehensive marketing plans, concise details about the target industry, and who the prospective consumers will be.

Proper business structure and organisationAn entrepreneur’s business must be properly structured for investment. This includes the investor’s percentage of ownership as part of the business deal. Investors are also likely to be involved in company operations through active mentoring, management, or being a member of the board. Most investors will expect this type of formal agreement, as well as a large return on investment, in exchange for providing the new company with the needed business capital.

A well-defined exit strategyThe entrepreneur and Venture Capital investor should agree upon a time frame for the investment. This means that for a given period of time, the VC investor will provide the needed capital, expect to be actively involved in a company, and will anticipate an exit after that phase comes to an end. The most common exit strategy of a VC investor is through the sale or merger of a company. The aim for the entrepreneur of using Venture Capital financing is obvious; to raise money for his/her business (at whichever state it is, either start-up or expansion). However, it should be asked that why an entrepreneur prefers raising money by using Venture Capital in place of other forms of financing. First of all, Venture Capitalists can provide large sums of equity finance and bring a wealth of expertise to the business. Also, if you successfully attract a VC to your business, you're likely to find it easier to secure further funding from other sources. Secondly, the right Venture Capitalists can bring valuable skills, contacts and experience to the business and can assist with strategy and key decision making. In Venture Capital financing, investors have a vested interest in the business' success, i.e. its growth, profitability and increase in value. Besides, investors are often prepared to provide follow-up funding as the business grows. On top of them, since Venture Capital investment is considered as long-term investment, entrepreneurs are not supposed to pay interest or principal back, at least not at the short-run. However, there are certain handicaps of Venture Capital financing.

7.10.2 Forms of Financing used by Venture CapitalistsA venture financing can be structured using one or more of several types of securities ranging from straight debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock. Each type of security offers certain advantages and disadvantages to both the entrepreneur and the investor. The characteristics of entrepreneur’s situation and current market forces will impact the type and mix of security package that is right for both parties.

7.10.2.1 Types of Securities The various kinds of securities are discussed below.

Senior debt - It is usually for long-term financing for high-risk companies or special situations such as bridge financing. Bridge financing is designed as temporary financing in cases where the company has obtained a commitment for financing at a future date, which funds will be used to retire the debt. It is used in construction, acquisitions, anticipation of a public sale of securities, etc.

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Subordinated debt - It is subordinated to financing from other financial institutions, and is usually convertible to common stock or accompanied by warrants to purchase common stock. Senior lenders consider subordinated debt as equity. This increases the amount of funds that can be borrowed, thus allowing greater leverage.

Preferred stock - It is usually convertible to common stock. The venture's cash flow is helped because no fixed loan or interest payments need to be made unless the preferred stock is redeemable or dividends are mandatory. Preferred stock improves the company's debt to equity ratio. The disadvantage is that dividends are not tax deductible.

Common stock - It is usually the most expensive in terms of the percent of ownership given to the Venture Capitalist. However, sale of common stock may be the only feasible alternative if cash flow and collateral limits the amount of debt the company can carry.

While each of these securities has unique characteristics, they can be grouped into two categories: debt or equity. In structuring a venture financing, the primary question is whether the financing should be in the form of debt or equity.

From a company's viewpoint, there are two potential disadvantages to debt. An excessive amount of debt can strain a company's credit standing, thereby reducing its flexibility in meeting • future long-term financing requirements on a favourable basis. It can also negatively affect a company's ability to obtain short-term credit. Of course, the form of debt the venture financing takes makes a difference. For example, subordinated debt will have less impact on borrowing capacity than senior debt. The Venture Capitalist has the option of calling his loan if the company is in default of the loan agreement. • This remedy, which is not available to him under other financing agreements, puts him in a better position to influence the company's affairs when it is in default.

7.10.2.2 Advantages of Debts to a Venture Capitalist

From the Venture Capitalist's point of view, there are three principal advantages to debt. There is a greater • likelihood that the Venture Capitalist will get his principal back and, at least, a small return. Many of the companies in the average Venture Capitalist's portfolio are referred to as "the living dead." Needless to say, their performance has turned out to be disappointing. In some cases, these companies are able to repay principal with interest but have limited appeal to potential acquirers or the public. As a result, a Venture Capitalist with an investment in such a company's common stock may be unable to recover his investment within a reasonable period, if at all.As previously discussed, under certain circumstances the Venture Capitalist is in a better position to influence • the company's affairs.The Venture Capitalist has a senior claim. However, it should be emphasized that the meaningfulness of a • senior claim depends on the marketability of a company's assets and the amount of equity it has to cushion its creditors' position. For example, in the case of a start-Lip situation with little or no equity, a senior claim means little or nothing.

7.10.2.3 Percentage of Ownership NeededWhile the difference may not be great, depending on the particular circumstances of the company, a debt position involves less risk than an equity position for the Venture Capitalist. Accordingly, a company should not have to relinquish as much ownership when a financing is in the form of debt. However, this advantage must be weighed against the disadvantages of debt. No matter how the venture financing is structured, it must be priced so that it is attractive to the Venture Capitalist. There is no clear-cut answer as to how much ownership a company will have to relinquish to make a financing attractive. Broadly speaking, the greater the potential return perceived by the Venture Capitalist, the less ownership he will demand. In other words, if a company has a patented product which a Venture Capitalist thinks is revolutionary and highly marketable, he will undoubtedly settle for less ownership

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than he would in the case of 4 company with a relatively less attractive product. Thus, his ultimate position will be a business judgment based on his potential return. Before the entrepreneurs enter negotiations with the Venture Capitalist, one should determine what the company is worth and how much of the company one want to sell. The following procedure can be used to get a rough idea of how much ownership the entrepreneur will have to give up to make the financing attractive.

7.10.2.4 Estimation of the risk associated with the venture financing. If the investment is very risky, the Venture Capitalist may be looking for a return as high as 15 times his investment over five years. Conversely, if a relatively low degree of risk is involved, the Venture Capitalist may be satisfied with doubling or tripling his investment over five years.

Making a reasonable estimate of the price/earnings ratio applicable to comparable publicly held companies: The market value of the company can then be projected by multiplying forecasted annual earnings by the estimated price/earnings ratio for comparable companies. Dividing the estimate of the total value of return the Venture Capitalist wants by the projected market value of the company:This yields the percentage ownership the Venture Capitalist will need, as oil the future date, to realize his desired return. It is important to note that any equity financing required during the interim period must be considered in making these calculations.

7.10.3 Advantages of Venture Capital

Financing expertise and strategic support Financing expertise and strategic support • Confidentiality • Independence of the capital markets volatile Independence of the capital markets volatile • Bridge financing to a future successful IPO Bridge financing to a future successful IPO •

However, there are certain handicaps of Venture Capital financing compared to other forms of finance. Giving up an equity stake, for example, may not "feel" like a big sacrifice in the beginning, but in fact it's a huge concession. That's because equity holders are entitled to a percentage of a company's cash flows forever--as opposed to, say, payments over the life of a bank loan. From a cost-of-capital perspective, giving away preferred stock costs entrepreneurs the worst of two worlds. Like bondholders, preferred stockholders charge interest on their money, and they get paid before common equity holders in a sale. The second major issue is control. Ideally, most entrepreneurs want to be in charge--otherwise, they would choose to work for somebody else. If structured properly, loans or even common stock arrangements usually allow founders to maintain significant control. VCs, on the other hand, want a firm hand--if not two--on the wheel.

7.10.4 Funding Process in Venture CapitalStep 1: Business Plan Submission The first step in approaching a VC is to submit a business plan. At minimum, your plan should include:

a description of the opportunity and market size• resumes of your management team• a review of the competitive landscape and solutions• detailed financial projections• a capitalisation table•

You should also include an executive summary of your business proposal along with the business plan. Once the VC has received your plan, it will discuss your opportunity internally and decide whether or not to proceed. This part of the process can take up to three weeks, depending on the number of business plans under review at any

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given time. Don’t be passive about your submission. Follow up with the VC to check the status of your proposal and to find out if there’s additional information you could be providing that might help the VC with its decision. If you are asked for further information, respond quickly and effectively. If possible, always try to get a face-to-face meeting with the VC. Keep in mind that most VCs receive an average of 200 business plans each month. Of those, less than five percent will be invited to meet with the VC’s partners. Just two percent will reach the due diligence phase, and less than one percent will be offered a term sheet. Some 0.3 percent of those submitting a business plan will ultimately obtain VC funding.

Step 2: Introductory conversation/Meeting If your firm has the potential to fit with the VC’s investment preferences, you will be contacted in order to discuss your business in more depth. If, after this phone conversation, a mutual fit is still seen, you’ll be asked to visit with the VC for a one- to two hour meeting to discuss the opportunity in more detail. After this meeting, the VC will determine whether or not to move forward to the due diligence stage of the process.

Step 3: Due diligence The due diligence phase will vary depending upon the nature of your business proposal. The process may last from three weeks to three months, and you should expect multiple phone calls, emails, management interviews, customer references, product and business strategy evaluations and other such exchanges of information during this time period.

Step 4: Term sheets and funding If the due diligence phase is satisfactory, the VC will offer you a term sheet. This is a non-binding document that spells out the basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed upon by all parties, after which you should expect a wait of roughly three to four weeks for completion of legal documents and legal due diligence before funds are made available.

7.10.5 Types of FundingThe first professional investor to a deal at the start-up stage is referred to as the Series A investor. This investment is followed by middle and later stage funding – the Series B, C, and D rounds. The final rounds include mezzanine, late stage, and pre-IPO funding. A VC may specialize in provide just one of these series of funding, or may offer funding for all stages of the business life cycle. It’s important to know the preferences of the VC you’re approaching, and to clearly articulate what type of funding you’re seeking:

Seed capitalIf you’re just starting out and have no product or organised company yet, you would be seeking seed capital. Few VCs fund at this stage and the amount invested would probably be small. Investment capital may be used to create a sample product, fund market research, or cover administrative set-up costs.

Start-up capitalAt this stage, your company would have a sample product available with at least one principal working full-time. Funding at this stage is also rare. It tends to cover recruitment of other key management, additional market research, and finalizing of the product or service for introduction to the marketplace

Early Stage capitalTwo to three years into your venture, you’ve gotten your company off the ground, a management team is in place, and sales are increasing. At this stage, VC funding could help you increase sales to the break-even point, improve your productivity, or increase your company’s efficiency.

Expansion capitalYour company is well established, and now you are looking to a VC to help take your business to the next level of growth. Funding at this stage may help you enter new markets or increase your marketing efforts. You should seek out VCs that specialise in later stage investing.

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Late Stage capitalAt this stage, your company has achieved impressive sales and revenue and you have a second level of management in place. You may be looking for funds to increase capacity, ramp up marketing, or increase working capital.

You may also be looking for a partner to help you find a merger or acquisition opportunity, or attract public financing through a stock offering. There are VCs that focus on this end of the business spectrum, specializing in initial public offerings (IPOs), buyouts, or recapitalizations. If you are planning an IPO, a VC may also assist with mezzanine or bridge financing – short-term financing that allows you to pay for the costs associated with going public.

A key factor for the VC will be risk versus return. The earlier a VC invests, the greater are the inherent risks and the longer is the time period until the VC’s exit. It follows that the VC will expect a higher return for investing at this early stage, typically a 10 times multiple return in four to seven years. A later stage VC may be seeking a two to four times multiple returns within two years.

7.10.6 Non-Disclosure Agreements and Term SheetIt’s not advisable to ask a VC for a non-disclosure agreement, and may even risk stopping your potential VC deal in its tracks. Venture capitalists may review hundreds or thousands of business plans in any given year. Even if you think your ideas are proprietary, they may be just similar enough to another entrepreneur’s that the VC takes on the added risk of legal action against it just by signing your NDA. Also, for the VC, accepting NDAs adds the administrative burden of having to keep track of which NDA covers what entrepreneur’s ideas. Rather than focus on an NDA, do your homework to find a reputable VC that can be trusted with your information.

A term sheet is a document that sets out the basic terms and conditions under which the VC will invest in your company. Work completed in the due diligence phase of the funding process is used to draft this document. The term sheet is generally non-binding and is used as a template, along with further due diligence, to draw up more detailed legal documents. You will, no doubt, be particularly concerned with the valuation of your company set forth in the term sheet. To arrive at this figure, the VC takes into account your management team, your company’s market and competitive advantage in the marketplace, and your earning potential. The various factors that go into a valuation are determined during the due diligence phase. Note the difference between pre-money valuation – the valuation of your company before a VC invests in it, and post-money valuation – the pre-money valuation plus the contemplated investment amount.

A good tip for negotiating the best valuation is to have multiple VCs interested in investing in your company. In negotiating your term sheet, keep in mind that there are two central issues for the VC. The first is the economics of the deal, i.e. the return on investment and the terms that dictate that return. The second is control, meaning how the VC will be able to exercise control over your company’s decisions. The pertinent negotiations will revolve around these two issues.

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SummaryCredit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders • to form an opinion on the relative capacities of the borrowers to meet their obligations.Rating is an opinion regarding the timely repayment of principal and interest thereon; it is expressed by assigning • symbols, which have definite meaning. Ratio analysis is used to analyse the present and future earning power of the issuing corporation and to get • insight into the strengths and weaknesses of the firm.Credit Rating Agencies rate an instrument by assigning a definite symbol. Each symbol has a definite • meaning.Rating serves as a useful tool for different constituents of the capital market. For different classes of persons, • different benefits accrue from the use of rated instruments. The ratings assigned to a bond issue directly affects its yield. Issuers of high-risk securities have to pay higher • rates of return than issuers of low risk securities.There are several limitations of credit ratings. First, credit ratings are changed when the agencies feel that • sufficient changes have occurred. The rating agencies are physically unable to constantly monitor all the firms in the market.Venture Capital is investing in companies that have undeveloped or evolving products or revenue. It lays • particular stress on entrepreneurial attempts and less mature businesses.Investors are interested in Venture Capital by the anticipation of earning higher yields than they can by investing • in publicly traded firms.A venture financing can be structured using one or more of several types of securities ranging from straight • debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock.The first professional investor to a deal at the start-up stage is referred to as the Series A investor. This investment • is followed by middle and later stage funding – the Series B, C, and D rounds.

ReferencesRasero, B.C., 2008. • Credit Rating, VDM Verlag.Arora, M.,2003. • Credit rating in India: institutions, methods and evaluation, New Century Publications.Taneja, S.K., 2002. • Venture Capital in India, Galgotia Publishing Co.

Recommended ReadingVerma, J.C., 1997. • Venture capital financing in India, Response Books.Haislip, A., 2001. • Essentials of Venture Capital, John Wiley and Sons.Cardis, J., 2001. • Venture capital: the definitive guide for entrepreneurs, investors, and practitioners, John Wiley and Sons.

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Self Assessment

Which statement is true?1. Rating is a search for short-term fundamentals and the uncertainties for changes in the fundamentals.a. Rating is a search for long-term fundamentals and the uncertainties for changes in the credit.b. Rating is a search for long-term fundamentals and the probabilities for changes in the fundamentals.c. Rating is a search for short-term fundamentals and the probabilities for changes in the fundamentals.d.

In which year, ICRA was promoted by IFCI?2. 1981a. 1991b. 2001c. 2011d.

The factors that ICRA takes into consideration for rating, depends on the nature of _____________ entity.3. lendinga. contributingb. addingc. borrowingd.

___________ is a credit rating and information services company promoted by IDBI jointly with investment 4. institutions, banks, and finance companies.

CAREa. CRISILb. IFCIc. ICRAd.

Credit Rating Agencies rate an instrument by assigning a definite____________.5. signala. symbolb. locationc. priced.

_____________ is investing in companies that have undeveloped or evolving products or revenue.6. Budget Capitala. Working Capitalb. Venture Capitalc. Risk Capitald.

Which statement is true?7. Venture Capital investors basically look for three important components when agreeing on an investment.a. Venture Capital investors basically look for four important components when agreeing on an investment.b. Venture Capital investors basically look for five important components when agreeing on an investment.c. Venture Capital investors basically look for six important components when agreeing on an investment.d.

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It is usually the most expensive in terms of the percent of ownership given to the Venture Capitalist.8. Common Stocka. Preferred stockb. Subordinated Debtc. Senior Debtd.

Which statement is true?9. Venture capitalists may review hundreds or thousands of business plans in any given ventures.a. Risk capitalists may review hundreds or thousands of business plans in any given plans.b. Venture capitalists may review hundreds or thousands of business plans in any given year.c. Working capitalists may review hundreds or thousands of business plans in any given year.d.

A key factor for the VC will be risk _________ return.10. froma. betweenb. toc. versusd.

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Case Study I

Venture CapitalOver the last few years of Mr. Pande's career as a venture capital consultant, he worked on a number of fund-raising assignments for small and mid size companies. Some of these transactions were successful while others failed at some stage of the fund-raising process. This case study shows the analysis of a successful transaction.

The Company in this case study is a Delhi based small logistic services provider. The company’s business is to provide third-party logistics (3PL) service like warehousing, packing, unpacking etc for a number of large FMCG, Auto, Electronics companies.

Things that were working for the Company:

Team: The owner of the Company is a first generation entrepreneur who has built a good team by hiring two senior industry professionals to manage the future proposed growth of the company. Along with the promoter, these two provided enough expertise and credentials to the team. The team was a good combination of entrepreneurship skills of the promoter and professional experience of the other team members.

Clients: The Company had some of the best names in their industry as its clients to boast of though the revenue from each client was quite small. The company was providing its services to large and reputed clients in FMCG, Auto, Electronics and Beverages industry. This proved to the investor that the company has the ability to acquire, deliver, and retain the best clients in their field.

Hot Growing Industry: Logistics has been a huge area of interest in the venture capital community in India for quite some time now. There have been a number of transactions in this industry already and most investors are still looking for good projects. Unfortunately, most Indian players who call themselves logistics companies are essentially transport companies but this Company was a good mix of warehousing, cold storage and transport business.

Things that were NOT working for the company:

Small size of operations: Though the company had some of the blue chip clients however the Company’s profits were very low. At the time of fund-raising process, the company was making net profits of close to Rs. 10 lacs. The proposed investment was quite large in comparison to the Company’s current scale of operations and it took some skill on the promoter’s part to convince the investors that the company can manage a comparatively large operations.

No experience of some proposed businesses like Cold Storage: Some of the businesses proposed by the Company were completely new. No member of company’s current team had any expertise in those businesses. However, inclusion of those businesses made tremendous strategic sense and that’s why they were able to convince investors about inclusion of new businesses.

Valuation: Since the required investment was significantly large in comparison to the Company’s current operations, the valuation became quite a challenge. Any standard valuation technique was leading to a very small stake for the promoters. The problem was solved by a performance linked valuation structure where promoters were rewarded by equity every time they met a performance benchmark.

Questions:

Introduce the company mentioned in this case study1. Answers The Company in this case is a Delhi based small logistic services provider. The company’s business is to provide third-party logistics (3PL) service like warehousing, packing, unpacking etc for a number of large FMCG, Auto,

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Electronics companies.

Explain the term ‘Hot Growing Industry’ in respect to the above case study.2. AnswerLogistics has been a huge area of interest in the venture capital community in India for quite some time now. There have been a number of transactions in this industry already and most investors are still looking for good projects. Unfortunately, most Indian players who call themselves logistics companies are essentially transport companies but this Company was a good mix of warehousing, cold storage and transport business.

How was the problem of valuation solved?3. AnswerThe problem of valuation was solved by a performance linked valuation structure where promoters were rewarded by equity every time they met a performance benchmark.

Why was 'Small size of operations' not working for the company?4. AnswerThough the company had some of the blue chip clients however the Company’s profits were very low. At the time of fund-raising process, the company was making net profits of close to Rs. 10 lacs. The proposed investment was quite large in comparison to the Company’s current scale of operations and it took some skill on the promoter’s part to convince the investors that the company can manage a comparatively large operations.

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Case Study II

Indian Capital Market

Company profile A major financial services company based in Japan, providing knowledge and IT solutions for financial business worldwide. Anshinsoft has been a very key strategic outsourcing partner for design and development of a comprehensive back-office IT solution.

Business situation Indian Capital market systems have evolved to be at par with the advanced systems of the world in the last 10 years. Business process, functionality, monitoring/regulating mechanisms, hardware, software etc. are all revamped to compete with the global leaders. With the internal systems & monitoring mechanism properly in place, the time is ripe for India to join itself to the global capital market network. At present, India stands in the door step of full convertibility of the Indian Rupee in Capital Account, Cross border trading in the securities market is a very bright possibility in the near future. One major customer of the IT solution provider, a leading securities broker based in Japan, has shown keen interest in venturing into the Indian Capital Market. The company has asked Anshinsoft to provide a very high level overview of the Indian Secondary market.

Technical situationsThe IT solution provider has been looking for credible market research in the Indian Capital Market space, keeping in mind that their end customer has shown keen interest in venturing into the Indian market in near future. Getting an overview of the market is extremely important – since eventually the brokerage firm would like to use the same back-office solution while operating in the Indian market. The initial overview document is a stepping stone towards large scale gap analysis of their existing solution.

Solution Anshinsoft delivered a very high level overview of the Indian Secondary Market with emphasis on the following areas:

Key secondary market intermediaries • Trading and Settlement systems • Settlement cycle • Legal framework of the Securities market • Typical activity flow and downloadable reports for a Broker firm • Key Indian vendors in the Securities market product space•

Benefits Even though lots of information and market research documents are available in today’s world, the company specifically selected Anshinsoft to prepare a report that objectively answers what they have been looking for. They were extremely satisfied with the report that Anshinsoft prepared not only did it cover the major areas of the Indian secondary market, but it also provided information that are specific to the Indian market in particular so that they could spot the operational differences quite early. Also, being the long term Back Office solution development partner of the same company, Anshinsoft could highlight important gaps in their existing solution having known the fact that they would eventually customize and deploy the solution for Indian operation as well. The report encouraged their Senior Management to conduct a detailed gap analysis of the existing solution where Anshinsoft will be one of the key partners.

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Services used Anshinsoft solely relied on the experience and expertise of its own business analysts and market experts to prepare the report. Public market data available in the internet was included for reference purpose.

Questions:How is the current scenario of Indian Capital Market system explained?1. Who is showing keen interest in venturing into the Indian Capital Market?2. What is the high level overview of the Indian Secondary Market mentioned above?3. What did the report given by Anshinsoft provided to the client?4.

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Case Study III

Primary Target Markets & Positioning Strategy of Dell

Business activities of Dell are organised in each region incorporating different customer segments. Which includes the following include:

Large corporate (Relationship) customers• Home and small business (Transaction) customers• Public sector (government and educational) customers•

Dell segments its customers into Relationship, Transaction, and Public/International customers. Dell’s segmentation of customers helps it respond to changes in demand among different customers, to develop new customer segments. Relationship customers are Fortune 1000 companies. They currently number about 50 companies, including Boeing, Exxon, Ford, Goldman Sachs, MCI, Microsoft, Mobil, Oracle, Procter &Gamble, Sears, Shell Oil, Toyota, and Wal-Mart.

Transaction customers, which represent 30% of U.S. sales, are small and medium-sized enterprises (about 20%) and Individual Customers and consumers (about 10%). Transaction customers are served by several thousand inside sales representatives who can call up historical sales records to assist the customers in choosing systems that match their prior purchase pattern.

The basic strategies in Dell’s marketing communications are:

Simplify technology for customersMaking quality personal computers, servers, storage, and services affordable is Dell’s legacy. They are focused on making information technology affordable for millions of customers around the world. As a result of direct relationships with customers. They are best positioned to simplify how customers implement and maintain information technology and deliver hardware, services, and software solutions tailored for their businesses and homes.

Customer’s choice and custom-tailored servicesDell’s systems & services can be accessed easily by customer via telephone and purchase from website www.dell.com, where they may review, configure, and price systems within entire product line. Although the focus of Dell’s business strategy has been selling directly to its customers, it also uses some indirect sales channels when there is a business need. Dell began offering Dimension desktop computers and Inspiron notebook computers in retail stores in the Americas and announced partnerships with retailers in the U.K., Japan, and China. Dell first steps in retail strategy, which will allow extending business model and reaching customers that have not been able to reach directly.Dell’s business base has been built on direct sales, build-to-order strategy for producing and selling PCs. Dell offered competitive prices, high levels of support, and a focus on selling and supporting PCs without the distraction of offering a number of hardware and services. Dell has made the most of the inherent advantages of its business model to grow rapidly and profitably. A key advantage of direct sales and build-to-order production is that expensive inventory does not build up in the channel and lose value before it can be sold.

Advantages of Direct salesDell’s inventory turnover rate of 60 times per year compares to 12-15 times for most indirect vendor Perhaps most important are the benefits that Dell gains from the direct customer relationship. Flexible, build-to-order manufacturing process enabled us to turn over inventory every five days on average, thereby reducing inventory levels, and rapidly bring the latest technology to customers. The market and competition has evolved, and now exploring the utilization of original design manufacturers and new distribution strategies to better meet customer needs and reduce product cycle times

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Unlike indirect vendors whose channel partners generally refuse to reveal even who the final customer is, Dell knows who the end user is, what equipment it has bought from Dell, where it was shipped, and how much the customer has spent with Dell. Dell uses that information to offer add-on products and services, to coordinate maintenance and technical support, and to help the customer plan its PC replacement and upgrade cycle.

Environment FriendlyThey built environmental consideration into every stage of the Dell product life cycle — from developing and designing energy-efficient products, to reducing the footprint of manufacturing and operations, to customer use and product recovery.

Questions:State the advantages of direct sales.• What are the basic strategies in Dell’s marketing communications?• How does Dell’s segmentation of customers help?• State the business activities of Dell which are organised in each region incorporating different customer • segments.

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Bibliography

ReferencesArditti, F.D., 1996. • Derivatives: a comprehensive resource for options, futures, interest rate swaps, and mortgage securities, 4th ed., Island PressArora, M.,2003. • Credit rating in India: institutions, methods and evaluation, New Century PublicationsBenson, E. F., 2004. • The Money Market, Kessinger Publishing.Bhole, L.M., 2004. • Financial institutions and markets: structure, growth and innovations, 4th ed., Tata McGraw-Hill EducationChoudhry, M., 2002. • Capital market instruments: analysis and valuation, Volume 1, FT Press.Fabozzi, F.J., and Modigliani, F., 2003. • Capital Markets, 3rd ed., Prentice Hall. Gopalsmay, N., 2005. • Capital market: the Indian financial scene, India: Macmillan.Gupta, A., 2002. • Mutual funds in india: a study of investment management, India: Anmol Publications PVT. LTDGurusamy. • Capital Markets, 2nd ed., Tata McGraw-Hill EducationKhan, 2006. • Indian Financial System, 5th ed., Tata McGraw-Hill Education.McDonald, R.L., 2006. • Derivatives Market, 2nd ed., Addison-WesleyMobius, M., 2007. • Mutual funds: an introduction to the core concepts, John Wiley and SonsPathak, 2007. • The Indian Financial System: Markets, Institutions And Services, 2nd ed., India, Pearson Education.Rasero, B.C., 2008. • Credit Rating, VDM VerlagSecurities and Exchange Board of India, Functions of Departments / Divisions [Online] (Updated 2010) Available • at: < http://www.sebi.gov.in/> [Accessed on: 26 March 2011].Stigum, M. L. & Crescenzi, A., 2007. • Stigum's money market, 4th ed. McGraw-Hill Professional.Stigum, M. L. & Robinson, F. L., 1996. • Money market and bond calculations, Irwin Professional Publ.Taneja, S.K., 2002. • Venture Capital in India, Galgotia Publishing Co.Whaley, R. E., 2006.• Derivatives: markets, valuation, and risk management, John Wiley and Sons.

Recommended ReadingBabu, R.G., 2005. • Financial Services In India, Concept Publishing CompanyBhole, 2009. • Financial Institutions & Markets, 5th ed., Tata McGraw-Hill EducationBrown, P. J., 2006. • An introduction to the bond markets, John Wiley and Sons Cardis, J., 2001. • Venture capital: the definitive guide for entrepreneurs, investors, and practitioners, John Wiley and SonsChakrabarti, R & De, S., 2010. • Capital Markets in India, SAGE Publications LtdChoudhry, • M & Securities & Investment Institute, 2006. An introduction to bond markets, 3rd ed. John Wiley and Sons.Choudhry, M, 2001. • The bond and money markets: strategy, trading, analysis, Butterworth-Heinemann.Haislip, A., 2001. • Essentials of Venture Capital, John Wiley and SonsHaslem, J.A., 2003. • Mutual funds: risk and performance analysis for decision making, Wiley-BlackwellJones, C.P., 2003. • Mutual funds: your money, your choice : take control now and build wealth wisely, FT Press.Kanuk A., R., 2002. • Capital markets of India: an investor's guide, John Wiley and Sons.Khan M., Y., 2004. • Financial services, 3rd ed., Tata McGraw-Hill Education

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Kumar, 2007. • Financial Derivatives, PHI Learning Pvt. LtdMurthy, D.K. & Venugopal, K.R., 2005. • Indian Financial System, I. K. International Pvt LtdPathak, 2007. • The Indian Financial System: Markets, Institutions And Services, 2nd ed., India: Pearson EducationRathore S., 2003. • Indian Capital Market: An Empirical Study, Anmol Publications PVT. LTD., Schofield, N.C., 2007. • Commodity derivatives: markets and applications, John Wiley and Sons.Shah A., Dr. Thomas S., and Gorham M., 2008. • India's financial markets: an insider's guide to how the markets work, ElsevierTripathy, N.P., • Mutual funds in India: emerging issues, Excel Books Verma, J.C., 1997. • Venture capital financing in India, Response Books

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Self Assessment Answers

Chapter Ia1. b2. d3. b4. c5. a6. b7. c8. a9. c10.

Chapter IIb1. d2. a3. d4. c5. a6. b7. b8. b9. c10.

Chapter IIIa 1. b2. d3. c4. d5. c6. a7. b8. c9. a10.

Chapter IVa11. b12. d13. b14. c15. a16. b17. b18. c19. a20.

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Chapter Vc1. d2. a3. a4. c5. a6. c7. b8. b9. b10.

Chapter VIa1. c2. c3. b4. a5. c6. d7. b8. b9. c10.

Chapter VIIc1. b2. d3. a4. b5. c6. d7. a8. c9. d10.