report on capital market

8/2/2019 Report on Capital Market

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AREPORT

ON

RECENT TRENDSIN

CAPITAL MARKETWHERE..HIGHER THE RISK, HIGHER THE RETURN

PREPARED BY


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PREPARED BY

Commodities whose value is derived from the price of some underlyingasset like securities, commodities, bullion, currency, interest level, stock

market index or anything else are known as Derivatives.

In more simpler form, derivatives are financial security such as an optionor future whose value is derived in part from the value and characteristicsof another security, the underlying asset.

It is a generic term for a variety of financial instruments. Essentially, thismeans you buy a promise to convey ownership of the asset, rather than theasset itself. The legal terms of a contract are much more varied andflexible than the terms of property ownership. In fact, its this flexibilitythat appeals to investors.

When a person invests in derivative, the underlying asset is usually acommodity, bond, stock, or currency. He bet that the value derived fromthe underlying asset will increase or decrease by a certain amount within acertain fixed period of time.

Importance of derivatives

There are several risks inherent in financial transactions. Derivatives areused to separate risks from traditional instruments and transfer these risks


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Liquidity Risk:

The inability of a firm to arrange a transaction at prevailing market pricesis termed as liquidity risk. A firm faces two types of liquidity risks

1. Related to liquidity of separate products2. Related to the funding of activities of the firm including derivatives.

Legal Risk:

Derivatives cut across judicial boundaries, therefore the legal aspectsassociated with the deal should be looked into carefully.

Types of Derivatives:

Futures and options are two commodity traded types of derivatives. Anoptions contract gives the owner the right to buy or sell an asset at a set

price on or before a given date. On the other hand, the owner of a futurescontract is obligated to buy or sell the asset.


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Derivatives securities or derivatives products are in real terms contractsrather than solid as it fairly sounds.

A. Future contracts:

Future contracts is an agreement made and traded on the exchangebetween two parties to buy or sell a commodity at a particular time in thefuture for a pre-defined price. Since both the parties are unaware of eachother, the exchange provides a mechanism to give the party assurance ofhonored contract. The exchange specifies standardized features of thecontract. The risk to the holder is unlimited, and because the pay off

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

Money lost and gained by each party on a futures contract are equal andopposite. In other words, a future trading is a zero-sum game. These are

basically forward contracts, meaning they represent a pledge to make acertain transaction at a future date. The exchange of assets occurs on the

date specified in the contract. These are regulated by overseeing agencies,and are guaranteed by clearing houses. Hedgers often trade futures for the

purpose of keeping price risk in check.


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Advantages of Futures Contracts:

1. If price moves are favorable, the producer realizes thegreatest return with this marketing alternative.

2. No premium charge is associated with futures marketcontracts.

Disadvantages of Future Contracts:

1. Subject to margin calls2. Unable to take advantage of favorable price moves3. Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occurin future. But Options are contract on the underlying futures contractwhere as futures are either to accept or deliver the actual physicalcommodity. To make a decision between using a futures contract or anoptions contract, producers need to evaluate both alternatives.

B. Option contract:

Options Contract is a type of Derivatives Contract which gives the


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An Option to buy is called Call option and option to sell is called Putoption. Further, if an option that is exercisable on or before the expiry date

is calledAmerican option and one that is exercisable only on expiry date,is calledEuropean option. The price at which the option is to be exercisedis called Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right toexercise the option at anytime on or before the expiry date. This request

for exercise is submitted to the Exchange, which randomly assigns theexercise request to the sellers of the options, who are obligated to settlethe terms of the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settledby delivery of the underlying asset or cash. However, unlike futures cash

settlement in option contract entails paying/receiving the differencebetween the strike price/exercise price and the price of the underlyingasset either at the time of expiry of the contract or at the time of exercise /assignment of the option contract.

Index Futures and Index Option Contracts:

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


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represent the whole market are broad based indices and those thatrepresent a particular sector are sectoral indices.

In the beginning futures and options were permitted only on S&P Niftyand BSE Sensex. Subsequently, sectoral indices were also permitted forderivatives trading subject to fulfilling the eligibility criteria. Derivativecontracts may be permitted on an index if 80% of the index constituentsare individually eligible for derivatives trading. However, no single

ineligible stock in the index shall have a weight age of more than 5% inthe index. The index is required to fulfill the eligibility criteria even afterderivatives trading on the index has begun. If the index does not fulfill thecriteria for 3 consecutive months, then derivative contracts on such indexwould be discontinued.

By its very nature, index cannot be delivered on maturity of the Indexfutures or Index option contracts therefore, these contracts are essentiallycash settled on Expiry.

C. Forward contract:

In a forward contract, two parties agree to do a trade at some future date,at a price and quantity agreed today. No money changes hands at the timethe deal is signed.


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In case, the party wishes to reverse the contract, it has to compulsorily goto the same counter party, which being in a monopoly situation cancommand the price it wants.

D. Swap Contract:

A swap is nothing but a barter or exchange but it plays a very importantrole in international finance. A swap is the exchange of one set of cash

flows for another. A swap is a contract between two parties in which thefirst party promises to make a payment to the second and the second partypromises to make a payment to the first. Both payments take place onspecified dates. Different formulas are used to determine what the two setsof payments will be.

Classification of swaps is done on the basis of what the payments arebased on.

The different types of swaps are as follows. Interest rate swaps Currency Swaps Commodity swaps Equity swaps


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regulator. The clearing & settlement of all trades on the DerivativeExchange/Segment would have to be through a ClearingCorporation/House, which is independent in governance andmembership from the Derivative Exchange/Segment.

various membership categories in the derivatives market:

The various types of membership in the derivatives market are asfollows:

Trading Member (TM) A TM is a member of thederivatives exchange and can trade on his own behalf and on

behalf of his clients.

Clearing Member (CM) These members are permitted tosettle their own trades as well as the trades of the other non-clearing members known as Trading Members who haveagreed to settle the trades through them.

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

members who can clear and settle their own trades only.


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clearing member. SEBI has not specified any net worthrequirement for a trading member.

o Liquid Net worth Requirements: Every clearing member(both clearing members and self-clearing members) has tomaintain atleast Rs. 50 lakhs as Liquid Networth with theexchange / clearing corporation.

o

Certification requirements: The Members are required topass the certification programme approved by SEBI. Further,every trading member is required to appoint at least twoapproved users who have passed the certification programme.Only the approved users are permitted to operate thederivatives trading terminal.

Derivative contracts are permitted by SEBI

Derivative products have been introduced in a phased manner startingwith Index Futures Contracts in June 2000. Index Options and StockOptions were introduced in June 2001 and July 2001 followed by Stock

Futures in November 2001. Sectoral indices were permitted for derivativestrading in December 2002. Interest Rate Futures on a notional bond and T-

bill priced off ZCYC have been introduced in June 2003 and exchange


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Options Futures Options stock

Futures

rate

futures

FIILevel

Rs. 250crores or15% of theOI inIndex

options,whicheveris higher.Inaddition,hedge

positionsare

permitted.

Rs. 250crores or15% of theOI inIndex

futures,whicheveris higher.Inaddition,hedge

positionsare

permitted.

20% ofMarketWide Limitsubject to aceiling of

Rs. 50crores.

20% ofMarketWide Limitsubject to aceiling of

Rs. 50crores.

Rs. USD100million.In additionto the

above, theFII maytakeexposure inexchangetraded in

interestratederivativecontracts tothe extentof the book

value oftheir cashmarket


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more ofthe open

interest ofallderivativecontractson a

particular

underlyingindex

more ofthe open

interest ofallderivativecontractson a

particular

underlyingindex

is higher is higher ratederivative

contracts,whicheveris higher.

Measures have been specified by SEBI to protect the rights of investor

in Derivatives Market:

The measures specified by SEBI include:

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

permitted to be used only against the liability of the Investorand is not available to the trading member or clearing member

or even any other investor.

o The Trading Member is required to provide every investor with


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Clearing House/Clearing corporation and in the event ofdefault of the Trading or Clearing Member the amounts paid

by the client towards margins are segregated and not utilisedtowards the default of the member. However, in the event of adefault of a member, losses suffered by the Investor, if any, onsettled / closed out position are compensated from the InvestorProtection Fund, as per the rules, bye-laws and regulations ofthe derivative segment of the exchanges.

o

The Exchanges are required to set up arbitration and investorgrievances redressal mechanism operative from all the fourareas / regions of the country.

COMMODITY:

Any product that can be used for commerce or an article of commercewhich is traded on an authorized commodity exchange is known ascommodity. The article should be movable of value, something which is

bought or sold and which is produced or used as the subject or barter orsale. In short commodity includes all kinds of goods. Forward Contracts

(Regulation) Act (FCRA), 1952 defines goods as every kind ofmovable property other than actionable claims, money and securities.


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That which affords convenience, advantage, or profit, especially incommerce, including everything movable that is bought and sold (exceptanimals), -- goods, wares, merchandise, produce of land andmanufacturesetc.

In the world of business, a commodity is an undifferentiated productwhose market value arises from the owners right to sell rather than to use.

Example commodities from the financial world include oil (sold by thebarrel), wheat, bulk chemicals such as sulfuric acid and even pork-bellies.

Examples of Commodity Futures:

Wheat

Cotton Pepper Turmeric Corn Oats Soybeans

Orange juice Crude oil Natural gas


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COMMODITY EXCHANGES

There are three categories:

1. NCDEX2. MCX3. NMCEIL

A brief description of commodity exchanges are those which trade inparticular commodities, neglecting the trade of securities, stock index

futures and options etc.

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


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established in New York through the merger of four small exchan ges the National Metal Exchange, the Rubber Exchange of New York, the

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

The major commodity markets are in the United Kingdom and in theUSA. In india there are 25 recognized future exchanges, of which thereare three national level multi-commodity exchanges. After a gap of almostthree decades, Government of India has allowed forward transactions in

commodities through Online Commodity Exchanges, a modification oftraditional business known as Adhat and Vayda Vyapar to facilitate betterrisk coverage and delivery of commodities.

The three exchanges are:

1. National Commodity & Derivatives Exchange Limited (NCDEX)2. Multi Commodity Exchange of India Limited (MCX)3. National Multi-Commodity Exchange of India Limited (NMCEIL)

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

Market Commission (FMC) of Government of India.


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Forward Commission (Regulation) Act and various other legislations.

Multi Commodity Exchange of India Limited(MCX)

Headquartered in Mumbai Multi Commodity Exchange of India Limited(MCX), is an independent and de-mutulised exchange with a permanentrecognition from Government of India. Key shareholders of MCX are

Financial Technologies (India) Ltd., State Bank of India, Union Bank ofIndia, Corporation Bank, Bank of India and Canara Bank. MCX facilitatesonline trading, clearing and settlement operations for commodity futuresmarkets across the country.

MCX started offering trade in November 2003 and has built strategicalliances with Bombay Bullion Association, Bombay Metal Exchange,Solvent Extractors Association of India, Pulses Importers Associationand Shetkari Sanghatana.

National Multi-Commodity Exchange of India Limited (NMCEIL)

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


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A big difference between a typical auction, where a single auctioneerannounces the bids, and the Exchange is that people are not onlycompeting to buy but also to sell. By Exchange rules and by law, no onecan bid under a higher bid, and no one can offer to sell higher thansomeone elses lower offer. That keeps the market as efficient as possible,and keeps the traders on their toes to make sure no one gets the purchaseor sale before they do.

FOREIGN DIRECT INVESTEMENTS:

MEANING:

Foreign direct investment (FDI) is the movement ofcapital across national

frontiers in a manner that grants the investor control over the acquired asset. Thus itis distinct fromportfolio investment which may cross borders, but does not offersuch control. Firms which source FDI are known as multinational enterprises(MNEs). In this case control is defined as owning 10% or greater of the ordinaryshares of an incorporated firm, having 10% or more of the voting power for anunincorporated firm or development of a greenfieldbranch plant that is a permanentestablishment of the originating firm.

Types of FDI:


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

investments.

Through financial collaborations. Through joint ventures and technical collaborations.

Through capital markets via Euro issues.

Through private placements or preferential allotments.

Forbidden Territories:

FDI is not permitted in the following industrial sectors:

Arms and ammunition. Atomic Energy. Railway Transport. Coal and lignite. Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper,

zinc.

Foreign Investment through GDRs (Euro Issues):


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will require an investment of US$ 24 billion till 2008. Private sectorparticipation in road projects will grow significantly.

The Government has announced ambitious plan to add around 1,00,000 MWof additional generation capacity by the year 2012. To attract privateinvestment of such magnitude, Govt. of India had taken various steps to

provide for an adequate administrative & legal framework.

Special incentives and tax-breaks are given for certain sectors such as power,electronics, telecom, software, hydrocarbons, R&D and exports.

The railway sector will need an investment of US$ 22 billion for new coaches,tracks, and communications and safety equipment over the next ten years. A10 year Corporate Safety Plan of the Indian Railways envisaging anexpenditure of US $ 7.24 bn. besides development of appropriate technologyfor higher level of safety in train operation. Metro Rail Corporation projectsworth US $ 12.84 bn in cities like Delhi, Bangalore, Hyderabad, Chennai,

Ahmedabad and many other cities are on target.

The Union railway minister projected a requirement of Rs 40.92bn forimportant railway projects in the North East and Jammu and Kashmir, mega

bridge projects at Bogibeel in Assam, Munger bridge over Ganga, Patnabridge over Ganga and Kosi bridge as well as for the Sudoor Gram SamparkYojana.

Upgradation and modernization of airports will require US$ 33 billioninvestment in the next ten years. Airports Authority of India has set a target ofi ti 1 billi d ll f d i ti f i t


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power generation and distribution and development of non-conventionalenergy sources.

There is potential for investment in urban infrastructure projects. Water supplyand sanitation projects alone offer scope for annual investment of US$ 5.71billion.

The entire gamut of exploration, production, refining, distribution and retailmarketing in the oil & gas sector presents opportunities for FDI.

India has an estimated 85 billion tons of mineral reserves remaining to beexploited. Potential areas for exploration ventures include gold, diamond,copper, lead, zinc, cobalt, silver, tin etc. There is also scope for setting upmanufacturing units for value added products.

The telecom market, which is one of the world's largest and fastest growing,has an investment potential of US$ 20-25 billion over the next five years. The

telecom market turnover is expected to increase from US$ 10 billion in 2004to US$ 13 billion by 2007.

The IT industry and IT-enabled services, which are rapidly growing offeropportunities for FDI.

India has emerged as an important venue for the services sector includingfinancial accounting, call centers, and business process outsourcing. There isconsiderable potential for growth in these areas.

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


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The outlay in the Food Processing Sector has been increased from US$19.5million in 2004-05 to US$41.35 million the next year, more than twice theearlier amount. The government is also considering investing US$22.97

million in at least 10 mega food parks in the country besides working towardsoffering 100 per cent foreign direct investment and income tax benefits in thesector.

The Healthcare industry is expected to increase in size from its current US$17.2 billion to US$ 40 billion by 2012. Healthcare spending in the country willdouble over the next 10 years. Private healthcare will form a large chunk of

this spending, rising from Rs 690 billion ($14.8 billion) to Rs 1,560 billion($33.6 billion) in 2012. This figure could rise by additional Rs 390 billion($8.4 billion) if health insurance cover is available to the rich and the middleclass.

With the expected increase in the pharmaceutical market, the total healthcaremarket could rise from Rs 1,030 billion ($22.2 billion) currently (5.2 percent

of GDP) to Rs 2,320 billion ($50 billion)-Rs 3,200 billion ($69 billion) (6.2-8.5 percent of GDP) by 2012.

The Government has recently established Special Economic Zones with thepurpose of promoting exports and attracting FDI. These SEZs do not imposeduty on imports of inputs and they enjoy simplified fiscal and foreignexchange procedures and allow 100% FDI.

The travel and tourism industry, which has grown to a size of US$ 32 billion,offers scope for investment in hotels, resorts and tourism infrastructure.


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vegetables, mushrooms etc. under controlled conditions and services related toagro & allied sectors), plantations (other than tea plantations), atomic energy,gas pipelines, courier services, trading and lottery and gambling. In most of

the sectors, foreign investors can go through the Automatic Route withoutneed for any approvals. The investor has to merely keep the Reserve Bank ofIndia informed of the flow of funds and issue of shares.

Maximum limits on foreign investment in some sectors are beingprogressively liberalized, eg: telecommunications (74%), insurance (26%),banking (74%), mining (74%) aviation (49%), defence equipment (26%),

cable networks (49%), trading (51%), print media (26%) and small-scaleindustries (24%). FDI in excess of 24% is permitted in small-scale industrywith 50% export obligation.

100% FDI is allowed in non news publications, which means all foreign non-news scientific, technical, specialty magazines, periodicals and journals areallowed to be published and sold throughout the country.

Retail Trading is permitted under automatic route with FDI up to 51%provided it is in primarily in export activities, and the undertaking is an exporthouse/trading house/super trading house/star trading house.

Wholesale trading activity is allowed subject to prior approval of ForeignInvestment Promotion Board (FIPB).

The Government has decided to allow FDI up to 100% under the automaticroute in townships, housing, built-up infrastructure and construction-d l t j t ( hi h ld i l d b t t b t i t d t h i


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investing company does not exceed 49 % and the management of the investingcompany is with the Indian owners. The automatic route is not available.

Prior approval of the Government is needed in those cases, which requireindustrial license (examples: alcoholic beverages, cigarettes, defenceequipments, gunpowder and hazardous chemicals) and those involvinginvestment beyond the maximum limits. Such cases are cleared by the ForeignInvestment Promotion Board in a transparent, efficient, time-bound and

predictable manner. The FIPB meets once a week.

The Department of Industrial Policy and Promotion is the nodal agency forinformation and assistance to foreign investors. Their website www.dipp.nic.inhas comprehensive information for foreign investors and gives weekly updateson proposals for foreign investment under consideration. It also givesinformation on projects available for foreign investors and contains onlineapplications for clearances.

The various State Governments in India extend incentives and competitiveoffers to foreign investors.

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

Full capital account convertibility is allowed for foreign investors.

FOREIGN INVESTMENT SUMMARY:


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Intel, Texas Instruments, Cummins, Microsoft, IBM, Toyota, Mitsubishi,Samsung, LG, Novartis, Bayer, Nestle, Coca Cola and McDonalds.

FII investments in India touched a record US$9.05bn (on a net basis) onDecember 12, 2005. This is higher than the '04 figure of US$8.4bn. Foreignfunds have been pouring in huge sums of money into the Indian market overthe past three years.

They have pumped in over US$23bn over the past three years as India isemerging as a major investment destination for both US and Asian investors.

FIIs bought shares worth US$ 862.94 million in the first quarter (April-June05) and US$ 3.73 bn worth shares in the second quarter (July-September2005).

A BS Research Bureau study, based on BSE-500 index companies, shows thatFIIs bought 803 million shares in April-September 2005.

Between January 5 and February 14, 2005, FIIs invested more in Indianequities than in Korean or Taiwanese equities. While the Korean marketreceived over US$1 billion, Taiwan had US$947 million, India's shareamounted to US$1.1 billion.

Companies that have seen a major jump in FII holding include TASC Pharma(22.3%), IFSL (16.3%), Shringar Cinema (14%), S Kumar Nationwide(13.35%), Four Soft (11.9%), Alok Industries (11%) and Sesa Goa (10%).

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


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C. ManufacturingD. Resources Based SectorsE. Knowledge Economy

A. Infrastructure:

SectorOwnership

Limit

Entry

RouteRemarks

Power 100% Automatic

Includesgeneration(except nuclear

power whereFDI is

prohibited),transmission anddistribution of

power

Telecom

Basic, cellular and

value-added services 74%

ISP with gateways 74%FIPBbeyond
http://www.investmentcommission.in/sector.htm#chttp://www.investmentcommission.in/sector.htm#dhttp://www.investmentcommission.in/sector.htm#ehttp://www.investmentcommission.in/sector.htm#chttp://www.investmentcommission.in/sector.htm#dhttp://www.investmentcommission.in/sector.htm#e


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Radio Paging 74%FIPB

beyond49%

End-to-EndBandwidth

74%FIPB

beyond49%

InfrastructureProviders providing

Dark Fibre

100%FIPB

beyond

49%

TelecomManufacturing

100% Automatic

Roads 100% Automatic

Includesconstruction and

maintenance ofroads, highways,bridges andtunnels

Ports 100% Automatic

Applies toconstruction and

maintenance ofports

Civil Aviation


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Petroleum &

Natural Gas

Petroleum refining 100% AutomaticPetroleum product

pipelines100% Automatic

Petroleum productmarketing 100% Automatic

Subject todivestment of26% equity in

favour of theIndian partner /

public within 5years.

Petroleum refining-

PSUs

26% FIPB

Others

Mass Rapid TransportSystem

100% Automatic

Includesassociated realestatedevelopment in

all metropolitancities

Subject to SEZ


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equity stake ofmore than 5%(up to 74%)

only in theprivate sectorbanks whichhave beenidentified by theRBI forrestructuring

PSU Banks 20%Subject tocompliance withRBI guidelines

NBFCs 100% Automatic

Includes 19specifiedactivities;

Subject tominimumcapitalisationnorms andcompliance withRBI guidelines

Includes bothLife and Non-Life Insurance;S bj t t


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developmentprojects. Alsominimum

Trading

Retail Trade 51% FIPBOnly for single

brand products

Trading (Export House, SuperTrading House, Star TradingHouse)

51% Automatic

Trading (Export, Cash and CarryWholesale)

100% FIPB

Tourism

Hotels, restaurants, beach resorts 100% Automatic

Includesfacilities for

providingaccommodationand foodservices

Tour and travel agencies 100% AutomaticBroadcasting

Subject to


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at 26%

Cable network 49%

Subject tomaximum

foreign equityup to 49%includingFDI/NRI/FII

DTH 20%

Subject tomaximum

foreign equityupto 49%includingFDI/NRI/FII.FDI not toexceed 20%

Terrestrial Broadcast FM 20%

Subject tolicensee being acompanyregistered inIndia under theCompanies Act,1956

Terrestrial TV Broadcast NotPermitted

Print Media


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Permitted

Defence and Strategic Industries 26% FIPB

Subject tosecurity and

licensingrequirement; to

be soldprimarily to theMinistry ofDefence

R&D activities 100% Automatic

C. Manufacturing:

SectorOwnership

Limit

Entry

Route

Remarks

Metals 100% Automatic

Includesmanufactureof Steel,Aluminiumetc.

Textiles and Garments 100% Automatic

Electronics Hardware 100% Automatic

Chemicals and Plastics 100% AutomaticIncludes


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Other Manufacturing

Items reserved for Small Scale 24% Automatic

100% FDIpermitted

throughFIPB routesubject toundertakingof exportobligation of

50%

D. Resources Based Sectors:

SectorOwnership

LimitEntry Route Remarks

Coal and Lignite

Coal Processing 100%Automatic up to50%

Captive Coal mining 100% Automatic

Subject toprovision ofCoal Mines

(Nationalisation)Act 1973.

Other Mining and


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E. Knowledge Economy:

SectorOwnership

Limit

Entry

RouteRemarks

Pharma and Biotech 100% Automatic

FIPB route is neededif industrial licence isrequired or involvesrecombinant DNA

technology,cell/tissueformulations

Healthcare 100% Automatic

Information Technology 100% Automatic


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Foreign Institutional Investor - FII

An investor or investment fund that is from or registered in a country outside of theone in which it is currently investing. Institutional investors include hedge funds,insurance companies, pension funds and mutual funds.

The term is used most commonly in India to refer to outside companies investing inthe financial markets of India. International institutional investors must register withthe Securities and Exchange Board of India to participate in the market. One of the

major market regulations pertaining to FIIs involves placing limits on FII ownershipin Indian companies.

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


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markets of the world. Calendar year 2004 ended with net FII inflows of US$9.2billion, an all-time high since the liberalization.


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The buoyant inflows continued in 2004-05. This weight was further increased to 5.9per cent in April, 2004. In 2004-05, after reversing direction briefly during the periodMay -June, FII inflows became robust again, leading to net inflows of US$ 10.25

billion during the year. The buoyancy continued in 2005-06, with net inflowsaggregating to US$ 3.26 billion in the first seven months up to end-October, 2005.

FIIs registered with SEBI fall under the following categories:

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

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

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


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Benefits and costs of FII investments:

The terms of reference asking the Expert Group to consider how FII inflows can beencouraged and examine the adequacy of the existing regulatory framework toadequately address the concern for reducing vulnerability to the flow of speculativecapital do not include an examination of the desirability of encouraging FII inflows.Yet, for motivating the consideration of the policy options, it is useful to brieflysummarise the benefits and costs for India of having FII investment. Given theGroups mandate of encouraging FII flows, the available arguments that mitigate thecosts have also been included under the relevant points.

Benefits:

1.Reduced cost of equity capital:

FII inflows augment the sources of funds in the Indian capital markets. In a commonsense way, the impact of FIIs upon the cost of equity capital may be visualised byasking what stock prices would be if there were no FIIs operating in India. FIIinvestment reduces the required rate of return for equity, enhances stock prices, andfosters investment by Indian firms in the country.

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

F ti th i d l i t h I di th i d t


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3. Knowledge flows:

The activities of international institutional investors help strengthen Indian finance.

FIIs advocate modern ideas in market design, promote innovation, development ofsophisticated products such as financial derivatives, enhance competition in financialintermediation, and lead to spillovers of human capital by exposing Indian

participants to modern financial techniques, and international best practices andsystems.

4. Strengthening corporate governance:Domestic institutional and individual investors, used as they are to the ongoing

practices of Indian corporates, often accept such practices, even when these do notmeasure up to the international benchmarks of best practices. FIIs, with their vastexperience with modern corporate governance practices, are less tolerant ofmalpractice by corporate managers and owners (dominant shareholder). FII

participation in domestic capital markets often lead to vigorous advocacy of soundcorporate governance practices, improved efficiency and better shareholder value.

5.Improvements to market efficiency:

A significant presence of FIIs in India can improve market efficiency through twochannels. First, when adverse macroeconomic news, such as a bad monsoon,unsettles many domestic investors, it may be easier for a globally diversified

portfolio manager to be more dispassionate about India's prospects, and engage instabilising trades Second at the level of individual stocks and industries FIIs may


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volatility, and push prices away from fair values. FIIs behavior in India, however, sofardoes not exhibit these patterns. Generally, contrary to herding, FIIs are seen to

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

(2003) find evidence against positive-feedback trading with FIIs buying afternegative returns and vice versa.

2. BOP vulnerability:

There are concerns that in an extreme event, there can be a massive flight of foreigncapital out of India, triggering difficulties in the balance of payments front. India's

experience with FIIs so far, however, suggests that across episodes like the Pokhranblasts, or the 2001 stock market scandal, no capital flight has taken place. A billionor more of US dollars of portfolio capital has never left India within the period ofone month. When juxtaposed with India's enormous current account and capitalaccount flows, this suggests that there is little evidence of vulnerability so far.

3. Possibility of taking over companies:

While FIIs are normally seen as pure portfolio investors, without interest in control,portfolio investors can occasionally behave like FDI investors, and seek control ofcompanies that they have a substantial shareholding in. Such outcomes, however,may not be inconsistent with India's quest for greater FDI. Furthermore, SEBI'stakeover code is in place, and has functioned fairly well, ensuring that all investors

benefit equally in the event of a takeover.

4. Complexities of monetary management:


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Investment Fund Pooled Trust, the Growth Fund of America, and AIM FundsManagement Inc.

In terms of country of origin, the USA topped the list with a share of 40 per cent ofthe number of FIIs registered in India, followed by UKs 17 per cent. Other countriesof significance in terms of origin of FIIs investing in India are Luxemburg, HongKong, and Singapore. In terms of net cumulative investments by FIIs, US-based FIIsdominate with 29 per cent of the net cumulative FII investments in India, followed

by UK at 17 per cent. In recent months, European and Japanese FIIs have started toevince an increasing interest in India, and of the FIIs that registered with SEBI in

October 2004, a significant number belonged to Europe and Japan. Thesedevelopments have helped improve the diversity of the set of FIIs operating in India.


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The total market capitalization on BSE on 7th October, 2005 was Rs 2,245,005 Crore(over 510 billion $).

The recent stock market rally saw FII investment reach 8.65 billion $ in 2005 tilldate compared to 8.51 billion $ in whole of 2004. In addition, Indias GDP growthrate is expected to be around 6.5-7% in the next two years. The most importantrequirement is to make the capital markets more integral to the Indian growth story.To sustain, match and accelerate this growth, the Indian economy needs a growingmean rate of capital supply without sudden shocks. To analyze whether capitalmarkets are poised to grow and play a more important role in this growth, we ask

these key questions classified in three categories.

The net FII investment during the year FY06 (till February 2006) was at $7.9 billionagainst $10.2 billion during FY05. Total foreign exchange reserves as of February2006 stood at $141.2 billion, down from last fiscal's level. The decline in reserveshas been on account of the widening current account deficit and valuation losses onaccount of a strengthening dollar.

THE RECENT UPS AND DOWNS OF FII:

Positive tidings about the Indian economy combined with a fast-growing markethave made India an attractive destination for foreign institutional investors (FIIs).

Th f i I i i l I ' (FII ) i i h I di k k


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The Japanese have, in fact, been increasing their foothold in India. Mizuho CorporateBank's decision to successfully expand base in the country has managed to convincealmost 60-65 major Japanese corporates to set up manufacturing or marketing base in

India.

This list of corporates includes big names in auto sectors such as Honda,Toyota and Yamaha, as well as those in home appliances, pharmaceuticals,and communications.

While Nissan has already set up its base in India, other new entrants includeJapanese business conglomerate Mitsui Metal, Sanyo, and pharma major Eisai.

Japanese Telecom major Nippon Telegraph (NTT) is also in the process ofentering the Indian market.

Sabre Capital and Singapore's Temasek Holding have teamed up to float afund that will invest up to US$ 5 billion in Indian equities as well as fixedincome instruments over the next five years.

Fidelity International, a leading foreign institutional investor, has picked upabout 9 per cent in the Multi Commodity Exchange of India Ltd (MCX) for

US$ 49 million.

If FIIs have been flocking to India, it is obvious the returns are handsome. Accordingto Kamal Nath, the Indian Minister for Commerce and Industry, of all the foreigninvestors in India, at least 77 per cent make profit and 8 per cent break even.

These facts are corroborated by recent research on the trend. A landmark survey bythe Japan Bank for International Co-operation (JBIC) shows that in the next threeyears, India will be the third most favoured investment destination for Japaneseinvestors in a list which includes US and Russia


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Year

New CapitalIssues

Net Investmentof FIIs

(at monthlyexchange rate)

No. of

Issues

Amount

Raised

(Rs.Crore

)

Amount

(US $ Mn.)

1993-94 1143 24372 1634

1994-95 1692 27633 1528

1995-96 1725 20804 2036

1996-97 882 14276 2432

1997-98 111 4570 16491998-99 58 5587 -386

1999-00 93 7817 2339

2000-01 151 6108 2160

2001-02 35 7543 1846

2002-03 26 4070 562

2003-04 57 23272 9949

2004-05 60 28256 10172


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RECENT TRENDS OF CAPITAL MARKET:

Indian equities have performed very well in the past three years (2003 to 2005). TheBombay Sensitive Index (SENSEX), which is a common proxy for the performanceof blue-chip companies in the Indian bourse, rose 78% in 2003, 14.1% in 2004 and39.8% in 2005 (returns are in SGD terms without dividends reinvested). If we add upthe market returns for the past three years, the Indian bourse returned 184%. Thatmeant that the market almost tripled in three years. The rally continued into 2006,and on 4 th January 2006, the SENSEX reached a historical high of 9648.1 points.Chart 1 shows us the strong upturns experienced by the Indian market through theyears.


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investors again regained their confidence in the bourse in the later part of 2004 and2005. Considering that the market has done so well in the last 3 years, someinvestors have begun to question if the rally can last. To answer that question, we

first need to delve deeper into the factors behind the bull run. Will the main driversfor the Indian market continue to drive the bull run in the medium term.

Foreign Fund Inflows An Important Driver:

One of the factors that caused the market to rally strongly was the strong interestfrom foreign fund investors. There was strong growth in Foreign Direct Investments(FDIs) and Foreign Institutional Investments (FIIs) in the past three years. One ofreasons for the strong foreign fund inflow is that foreign investors were generallyquite positive on the measures the new Indian government has taken includingliberalizing sectors such as telecommunication, insurance and civil aviation (in July2004), as well as cutting taxes on non-agricultural projects from 20% to 15% and

lowering effective corporate tax rate to 33% from 35% (both measures taken inMarch 2005). Table 1 shows the size of the foreign fund inflows against the marketreturn (in INR). From 2003 to 2005, when the Indian bourse was doing well, the FIIsincreased from USD 6.6 billion to USD 10.8 billion. Although, we do not know forcertain how much of the total market capital in India is made up of FIIs, we do notethat the SENSEX tends to move in tandem with foreign fund inflows. And thevolatility in the FII tends to contribute to the increased level of volatility in the

SENSEX.


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Illustrates this point. During the Indian elections held in May in 2004, the marketwas down by 17.8% in that month alone . In the same month, foreign fund outflowstotaled more than USD 700 million. In October 2005, global equity markets suffered

from a temporary correction. The Indian bourse was down 10.5%, and during thatmonth there was an outflow of more than USD $860 million from the market. Ingeneral, when the market rallied, there were strong pick-ups in the inflows as well. In2005 when the market gained 39.8%, more than USD 10 billion was invested in theIndian market (see Table 1; all returns are stated in SGD without dividendsreinvested).


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When we assess the attractiveness of markets, we look specifically at the potentialearnings growth for the next three years and the valuations of the market

(represented by the estimated PE ratio), other than the economic fundamentals anddriving factors. Based on Table 2, the PE ratios are 19.3X, 16.7X and 15.4X for thefinancial year ending March 2006, 2007 and 2008 respectively. After the Indian

bourse experienced a strong market rally for the past three years, valuations havesurpassed the attractive levels in 2003 to early 2005 of about 14X to 15X to levels of19X (based on end March 2006 earnings).

At such valuation levels, the market appears to be at a premium to a historicalaverage of about 15X, and is at the higher range of valuations (the historical range is10X to 21X). As for earnings growth, it is relatively strong for 2006 at 15.9%, andfor 2007 at 8.2%. However, after the market rally in the past three years (2003, 2004and 2005), we think that the optimism over earnings growth potential is more or less

priced into the market already. Chart 3 illustrates that the valuations for the marketare now at a higher range, especially after the strong market rally in the past threeyears. The bold lines at the top and bottom of the chart shows the range of valuationsthe market has been trading at since June 2000, and the dotted line shows the averagevaluation. From the chart, we note that valuations are not cheap at this moment oftime. Another measure used in our analysis is excess earnings yield. Excess earningsyield for the market, which looks at the yield of the market given a certain PE vis--vis the local fixed income instrument is at 0.6%. That means that the fixed income

market seems to be yielding more than the equitymarket at this moment (as at 13 Jan 2006).


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increased sourcing of auto parts and software services from India by 32.5% in 2005to USD 87.8 million.

Trade is another economic driver for the Indian economy. The average monthly year-on-year growth for exports for 2005 was quite strong at 16.6%. Exports grewstrongly boosted by manufacturing of automobile parts, medium and heavycommercial vehicles, textile machinery, cement and pharmaceuticals. Aside frommanufacturing and trade, it is widely expected that domestic demand will pick up forthe market as well. According to Nilesh Shah, the Chief Investment Officer forPrudential ICIC Asset Management, India is likely to continue its infrastructure

projects including adding power plants and telecom networks. Also, consumption ofgoods and services is likely to double as the demand for housing increases andconsumers are more confident about spending on bigger ticket items in the future.The rise in the proportion of affluent individuals is also one important growth driver,the portion expected to rise from 5.6% (2005 to 2006E) to 9.0% (2009 to 2010E).With these positive economic factors in mind, the Indian government expectseconomic growth to be 7% in the fiscal year ending March 2006. We think that willmost of these economic factors going for India, the economy is likely to enjoy strongeconomic growth in the next 3 to 5 years.

Conclusion What Should Investors Do?

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

that have propelled the Indian bourse in the past three years (2003 to 2005). We dothink that the economy is at the early stages of development and with infrastructuregrowth underway, the Indian economy is likely to continue to do well in the next 5


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Business Growth in Derivatives segment

Month/Year

Index Futures Stock Futures Index Options Stock OptionsInterest Rate

Futures

Total Average DailyTurnover (Rs. cr.)

No. ofcontracts

Turnove

r (Rs.cr.)

No. of

contracts

Turnover(Rs. cr.)

Call Put Call PutNo. of

contracts

Turnover(Rs.

cr.)

No. ofcontracts

NotionalTurnover(Rs. cr.)

No. ofcontracts


No. ofcontracts


No. ofcontracts


No. ofcontracts

Turnover (Rs.cr.)

Current Month

Mar.06 5,952,206192,03

210,844,

400473,250 683,979 22,406 772,372 24,691 444,604 18,574 92,657 3,889 0 0 18,790,218

734,842

33,402

Feb.06 5,186,835156,35

87,443,1

78288,712 506,714 15,526 559,682 16,806 326,233 12,349 75,740 2,913 0 0 14,098,382

492,664

25,930

Jan.06 5,760,999166,12

67,134,1

99265,037 663,684 19,392 666,782 19,130 365,493 14,265 90,562 3,630 0 0 14,681,719

487,580

24,379

Dec.05 6,613,032

183,29

0

7,571,3

77 280,280 775,216 21,863 764,964 21,125 361,268 13,631 95,261 3,614 0 0 16,181,118

523,80

3

23,80

9

Nov.05 5,238,175135,47

46,252,7

36216,524 595,900 15,584 604,657 15,490 287,136 10,068 77,052 2,705 0 0 13,055,656

395,845

19,792

Oct.05 6,849,732170,09

66,526,9

19214,396 695,311 17,630 715,208 17,954 309,120 10,753 80,134 2,822 0 0 15,176,424

433,651

21,683

Sep.05 4,701,774118,90

46,995,1

69236,941 523,948 13,371 583,081 14,550 363,872 12,913 85,897 3,071 0 0 13,253,741

399,750

19,036

Aug.05 4,278,829100,80

57,124,2

66234,817 444,294 10,619 485,001 11,373 350,370 11,934 81,453 2,751 0 0 12,764,213

372,301

16,923

Jul.05 3,451,684 77,3956,537,7

94199,637 358,867 8,127 389,154 8,643 376,129 11,736 84,989 2,622 0 0 11,198,617

308,160

15,408

Jun.05 3,626,288 77,2155,783,4

28 163,097 421,480 9,089 331,753 7,044 385,640 11,678 104,478 3,119 0 0 10,653,067271,24

211,79

3

May.05 3,545,971 70,4654,466,4

04112,878 382,530 7,724 353,975 7,058 288,137 7,641 100,602 2,609 0 0 9,137,619

208,375

9,472

Apr.05 3,332,361 65,5954,225,6

23106128 361,544 7,293 295,020 5,981 307,994 8,203 105,955 2,763 0 0 8,628,497

195,962

9,798

2004-05

21,635,449

772,147

47,043,066

1,484,056 1,870,647 69,371 1,422,911 52,572 3,946,979 132,0541,098,13

336,782 - - 77,016,465

2,546,986

10,107

2003-04

17,191,668

554,446

32,368,842

1,305,939 1,043,894 31,794 688,520 21,022 4,243,661 167,967 1,339,410

49,240 10,78

20

56,886,776 2,130,612

8,388
http://www.nse-india.com/content/fo/fo_dailyturnover.htmhttp://www.nse-india.com/content/fo/fo_turnmar2006.htmhttp://www.nse-india.com/content/fo/fo_turnfeb2006.htmhttp://www.nse-india.com/content/fo/fo_turnjan2006.htmhttp://www.nse-india.com/content/fo/fo_turndec2005.htmhttp://www.nse-india.com/content/fo/fo_turnnov2005.htmhttp://www.nse-india.com/content/fo/fo_turnoct2005.htmhttp://www.nse-india.com/content/fo/fo_turnsep2005.htmhttp://www.nse-india.com/content/fo/fo_turnaug2005.htmhttp://www.nse-india.com/content/fo/fo_turnjul2005.htmhttp://www.nse-india.com/content/fo/fo_turnjun2005.htmhttp://www.nse-india.com/content/fo/fo_turnmay2005.htmhttp://www.nse-india.com/content/fo/fo_turnapr2005.htmhttp://www.nse-india.com/content/fo/fo_busgrow2004-05.htmhttp://www.nse-india.com/content/fo/fo_busgrow2004-05.htmhttp://www.nse-india.com/content/fo/fo_busgrow2003-04.htmhttp://www.nse-india.com/content/fo/fo_busgrow2003-04.htmhttp://www.nse-india.com/content/fo/fo_dailyturnover.htmhttp://www.nse-india.com/content/fo/fo_turnmar2006.htmhttp://www.nse-india.com/content/fo/fo_turnfeb2006.htmhttp://www.nse-india.com/content/fo/fo_turnjan2006.htmhttp://www.nse-india.com/content/fo/fo_turndec2005.htmhttp://www.nse-india.com/content/fo/fo_turnnov2005.htmhttp://www.nse-india.com/content/fo/fo_turnoct2005.htmhttp://www.nse-india.com/content/fo/fo_turnsep2005.htmhttp://www.nse-india.com/content/fo/fo_turnaug2005.htmhttp://www.nse-india.com/content/fo/fo_turnjul2005.htmhttp://www.nse-india.com/content/fo/fo_turnjun2005.htmhttp://www.nse-india.com/content/fo/fo_turnmay2005.htmhttp://www.nse-india.com/content/fo/fo_turnapr2005.htmhttp://www.nse-india.com/content/fo/fo_busgrow2004-05.htmhttp://www.nse-india.com/content/fo/fo_busgrow2004-05.htmhttp://www.nse-india.com/content/fo/fo_busgrow2003-04.htmhttp://www.nse-india.com/content/fo/fo_busgrow2003-04.htm


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1 2

2002-03

2,126,763 43,95210,676,

843286,533 269,674 5,669 172,567 3,577 2,456,501 69,643

1,066,561

30,488 - - 16,768,909439,86

31,752

2001-02

1,025,588 21,4821,957,8

5651,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383 - - 4,196,873

101,925

410

2000-01

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

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

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

and November 2001, respectively

Business Growth: Capital Market | Retail Debt Market | Wholesale Debt Market
http://www.nse-india.com/content/fo/fo_busgrow2002-03.htmhttp://www.nse-india.com/content/fo/fo_busgrow2002-03.htmhttp://www.nse-india.com/content/fo/fo_busgrow2001-02.htmhttp://www.nse-india.com/content/fo/fo_busgrow2001-02.htmhttp://www.nse-india.com/content/fo/fo_busgrow2000-01.htmhttp://www.nse-india.com/content/fo/fo_busgrow2000-01.htmhttp://www.nse-india.com/content/fo/fo_busgrow2002-03.htmhttp://www.nse-india.com/content/fo/fo_busgrow2002-03.htmhttp://www.nse-india.com/content/fo/fo_busgrow2001-02.htmhttp://www.nse-india.com/content/fo/fo_busgrow2001-02.htmhttp://www.nse-india.com/content/fo/fo_busgrow2000-01.htmhttp://www.nse-india.com/content/fo/fo_busgrow2000-01.htm

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