NIVESHAK

THE INVESTOR VOLUME 3 ISSUE 1 JANUARY 2010

Agricultural insurance pg.10 Development of secondary market in private equity PG.22

FROM EDITOR’S DESK Dear Niveshaks,
The advent of 2010 brought a remarkable change in the functioning of the
two major Indian exchanges – BSE & NSE, when they started the new trading year
Niveshak by advancing market hours by 55 minutes to 9 a.m. As many of us must have pre-
Volume III dicted, this move saw a widespread opposition from many small brokers, however
ISSUE 1 there were positive responses from institutional and retail investors. These indices
have been flat for the time being but with lots of FII money expected to pour in,
January 2010 we can predict the triggering of a bull run. The fiscal tightening by Peoples Bank
of China has had its effect on capital markets across the world but its effect seems
Faculty Mentor to have faded away. So we expect the bull to prevail over the bear for most part of
Prof. S.S Sarkar the year. Strong quarterly results for the last two quarters of FY 09-10 will surely take
the markets on an upward spiral. But if you say that is not real growth, we have the
success story of Bihar, a state that has long been epitomized as the worst governed
state. The state registered a miraculous growth rate of 11.44% in 2008-09 for which
THE TEAM its Chief Minister Mr. Nitish Kumar got the Business reformer award. Add to this, the
strong IIP numbers of last quarter and the growth posted by many states indicate
that the economy could be out of the woods now. With this ecstatic news, we
Editor welcome you all to the year 2010!!
Bhavit Sharma But the first edition of 2010 will be incomplete if we don’t have a glimpse
on what happened in 2009 and how the year 2010 is going to shape up in the
context of finance. Our cover story shall carry a broad perspective and foresee the
Sub-Editors future prospects of financial world and economy of India in the coming months
Durgesh Nandini Mohanty of 2010. At the same time, the article will also highlight some of the crucial events
Hitesh Gulati like the Dubai crisis and the trends followed by sensex & inflation of the country
Sumit Kedia during 2009.
Tanvi Arora In the present issue, we bring to you an insight on the agriculture insur-
Upasna Agarwal ance scenario in India along with a proposed product in the same industry. The
article also features the problems in the current system of agriculture insurance
and inherent risks of the agriculture sector. As we stand at the doorstep of a new
decade now, we take a look at some of the key learnings from financial misfor-
Designers
tunes and various crises which left their marks in the last decade. We also introduce
Bhavya Aggarwal
you to pension funds of India and try to acquaint you with the need of pension
Swarnabha Mukherjee fund reforms for capital market development in India. Owing to the overwhelming
responses for the recently introduced “Nivesh” from so many B school students
across India, we have decided to continue Nivesh for this edition also.
We, the new team, feel fortunate to be associated with the illustrious Nive-
shak, brainchild of the first team Niveshak including Amit, Biswadeep, Nilesh, Sa-
reet, Sarvesh, Sujal & Tripurari, who, with the support of the whole MBA fraternity
of top 50 B schools of India, took Niveshak to that height where it is today - the
All images, design and artwork only monthly finance magazine from a business school. It is a delight and pleasure
are copyright of for us to carry forward the legacy fashioned by our seniors but at the same time it
IIM Shillong Finance Club brings in a big responsibility of living up to the standards set by the brand “Nive-
shak”. We promise that with your support and appreciation, we will try to meet
your expectations and build a bigger platform to facilitate knowledge sharing for
all the finance enthusiasts of India.
©Finance Club
Indian Institute of Management
Shillong Hope you find this issue an interesting read.
Stay invested for the good times ahead.
www.iims-niveshak.com
Bhavit Sharma
Editor-Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
CONTENTS
Niveshak Times
04 The Month That Was
Finsight
19 Regulation, Reporting and
Representation

Cover Story Fingyaan

16 Footsteps to 2010 10 Agricultural Insurance

22 Development of Secondary
Market in Private Equity

Article of the month

06 Pension Funds - Need for
reforms

finlounge
21 FinToon
PERSPECTIVE
14 A Decade of Misfortunes 24 From the Horse’s mouth
26 Nivesh
 Niveshak Times www.iims-niveshak.com

The Month That Was

Tanvi Arora
IIM, Shillong
Market Watch Kraft overtakes Cadbury for $19.7 bn
It has indeed been a very significant month for After a four month long battle over the acquisi-
the stock markets. All the four weeks of this month tion of the sweetest brand of UK, Kraft has finally
(21st December – 15th January) ended on a positive been able to make a convincible offer to Cadbury.
note. The resistance for the month of January has Kraft has increased its offer from £10.2 billion to
been anticipated to be around 17800-17830, while £11.9 billion ($19.7 billion). The company has been
the support needs to be at 17,380. valued at 840 pence a share. The Cadbury share-
The market sprang back after 19 months with holders would get 500 pence per share in cash and
a whopping increase of 4% on the Sensex for the 0.1874 new Kraft Foods share. Whereas, ADS share-
week of (21st December – 24th December). This in- holders would receive 2,000 pence and 0.7496 new
crease can be attributed to Finance Minister, Pranab Kraft share for a share. Also they would get 10 pence
Mukherjee’s statement about the persistence of the a share as special dividend. Kraft would have to con-
stimulus packages for yet another fiscal year. Also, vince Cadbury’s shareholders by February 2 to final-
this was the reaction to the news of increase in ad- ize the deal by mid-February.
vance tax payments by India Inc. The Sensex con- Earlier offer was rejected unanimously by the
cluded at 17360.61 points, a rise of 640.78 points or board members of Cadbury as well as shareholders
3.83% over the last week’s close. The NSE 50-share as the company was undervalued. Also, the Cadbury
barometer, Nifty mounted by 190.70 points or 3.82% employees ranging around 45,000 in number had the
to close at 5178.40 points. fear of losing their jobs once they are taken over by
This was a second consecutive week (29th a bigger foreign brand.
December – 31st December) for the market to end Kraft would be a debt laden company as it
up gaining points. The Sensex touched a high of plans to borrow £7 billion for the deal. This is creat-
17530.94 and further ended up at 17464.81, a rise ing speculations in the market regarding the suc-
of 0.6% or 104.20 points over the previous week. cessful execution of the company and retaining of
The Nifty-fifty of NSE also shot up by 22.65 points or Cadbury’s employs by Kraft.
0.44% settling at 5201.05 points. Troubling Disinvestments
The year began by touching a 22 month high The disinvestment from various public sector
on both the major indices. The Sensex shot up to undertakings (PSUs) has not only increased govern-
17,790 during the week (4th January – 8th January) ment’s revenues but also has been beneficial to the
concluding at 17,540 points, a gain of 75 points. The traders.
Nifty (NSE) ended at 5245, a gain of 44 points.
The government raised around $78 billion
The week stretching over 11th January – 15th (Rs 3.6-lakh crore) in last 8 months. BSE’s PSU in-
January saw the Sensex closing at 17554.30 points, dex gained 23% as compared to Sensex rise of only
an increase of 14 points or 0.08% over the last 13.4% since November.
week’s close. The major NSE indicator, Nifty, ended
Hindustan Copper has reported a loss of Rs
up by 7.45 points or 0.14 per cent to end the week
10.3 crore and zero debt for the FY 09. On the other
at 5,252.20. This resulted in a sharp increase in IT
hand, Sterlite Industries is making a profit of $770
stocks. The banking shares remained weak due to
million with a PE ratio of 19.2. This leads to another
the possibility of tightening monetary policy.

4 NIVESHAK VOLUME 3 ISSUE 1 January 2010

 Niveshak Times www.iims-niveshak.com

The Month That Was

concern for some companies which is the valuation an important component till everyone gets cooking
of the investors’ profits in the loss making entities. gas and electricity.
IIP at 11.7% Inflation at 19.83%
The food inflation results led the industrial The food inflation touched an 11-year high in
growth to be pegged at 11.7%, a two-year high in No- the third week of January. The inflation rose from
vember 2009. Last year, IIP was at 2.5% for Novem- 18.65% in the second week of January. There are
ber. This helped the country to achieve an 8% eco- speculations in the market regarding further decline
nomic growth in the FY 10. The increase in growth in the prices of perishable goods due to the drop in
rate can be attributed to a 37.3% boost in consumer food articles sub-index to 287.7 on January 14. This
durables and 12.2% in capital goods. Output grew would help the central bank to increase the rates
10.3% in October 2009. This has been the biggest despite the increase in inflation.
increase since October 2007 hinting the markets that
there is no further need of stimulus packages by the Maharatna for PSU’s
government or low interest rate. After Navratna, the government has passed the
approval for Maharatna. This category would include
RIL moving towards acquiring Lyondell-
PSUs like SAIL, NTPC and ONGC, which are the top
Basell
performers. This policy would help them seek better
Reliance Industries Limited intends to access financial and operational resources from the govern-
US and Europe markets by acquiring Lyondell-Basell. ment. The Navratna was to strengthen PSUs in the
It has been doing this from past 4 months by raising local markets, whereas Maharatna would help them
money through treasury shares to the institutional to be successful global players. Under Navratna,
investors. RIL raised around Rs2,675 crore at the be- the PS board had the power to invest in projects up
ginning of the year following which it increased its to Rs 1000 crore without government intervention
bid to $13.5 billion from $12 billion Lyondell-Basell. whereas the Maharatna would increase this cap to
In third week of January, RIL yet again raised cash Rs 5000 crore.
of around $763 million by selling 33 million treasury
stock. Till now it has raised around $2 billion. Core sector grows by 5.3% in November
The 6 core sector industries grew at a rate of
Government plans to cap Kerosene supply
5.3% in November 2009 as compared to 0.8% annual
Taking into consideration the pervasive adul- growth rate in November 2008. This growth is the
teration of diesel in the country, the government main reason responsible for a high index for overall
has decided to discontinue the supply of subsidized industrial growth for industrial production (IIP) as
kerosene to people in towns and villages with ac- the core sector has a major weight in IIP. Among
cess to electricity and cooking gas. This policy would the 6 industries crude oil, refining, coal, electricity,
be implemented once it gets a nod from all the state cement, and steel, crude oil was the only company
ministers of civil supplies. Currently, kerosene is that registered a negative growth. There has also
supplied through PDS, a major part of which is adul- been an increase in the manufacturing of petroleum
terated and sold at triple prices. Though the finance to meet the continuously increasing demand in the
minister, Pranab Mukherjee, holds a differing view in domestic as well as foreign markets.
this respect as he considers the subsidized kerosene

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5

 Pension Funds
... need for reforms
Ajay Jain, Debprotim Dutta & Raghav Subramanian K
IIM Bangalore
Pension Funds (PEF) catalyse
In India, the role of
the development of capital markets
pension funds is criti- by boosting demand and liquidity of
cal for the develop- financial instruments. They act as
ment of the capital catalyst for increased local institu-
tional investment and asset diver-
market. Pension sification, improving allocation of
funds would help in financial savings and instruments.
AoM
the development of Sustainable fund inflows into local
the capital markets asset markets could contribute to re-
duced market volatility and improve
by increasing the resilience to external shocks. As the
availability of long investor base widens and access to
term funds. They can more information and analysis be-
comes available, price discovery is
also play an impor-
facilitated.
tant role in channel-
ling savings towards Capital Markets in India
financing of invest- Capital markets are needed in
an economy for efficient allocation
ment projects and in of resources across industries and
improving corporate as an extension of the society. They
governance of com- make it possible for governments to
panies that get their provide essential services, business-
es to grow and individuals to invest
investments. and build their assets.
In India, development of capi-
tal markets is needed as the primary
source of long-term funding as for-
eign investment alone will not be
enough to provide a capital of $300
billion which is required for develop-
ing infrastructure over the next few
years. To meet its growth potential,
India needs to develop capital mar-
kets to channel savings effectively
into investment, meet funding re-
quirements for infrastructure and
enhance financial stability.
India’s capital markets remain
underdeveloped when compared to
markets in US and UK. Though, over
The presence of pension funds
would increase the availabil-
ity of long term funds which is
bound to boost the corporate
debt market
6 NIVESHAK VOLUME 3 ISSUE 1 January 2010
time the equity market has grown
to become one of the most liquid
in Asia, issues with the government
and corporate debt markets remain
with volumes in the corporate debt
market going down.
Figure 1 : Capital market structure
The major reasons are:
• Restrictions on Domestic Institu-
tional Investors like Pension and In-
surance Funds
• Weak Currency, credit, interest
rate and derivatives market
• Weak Bond market
• Lack of Product diversification
In this article, the need for
development of PEF as a necessity
for development of capital markets
is the focus. The rationale for this
comes firstly from the fact that they
are a source of long term capital
which the bonds market and infra-
structure projects need. Secondly,
PEF represents the most repressed
institutional investor which is in
need of immediate reforms. Thirdly,
growth potential for PEF is huge.
India has 80 million elderly people,
which is one-eighth of world’s elder-
ly population.
Pension Funds and Capital
Markets
Pension Funds for developing debt &
equities market
The biggest need for long term

funds is in infrastructure projects which have long
gestation periods. Currently, they borrow short term
and keep rolling over their positions to meet funding
requirements. With availability of PEF as a source
of long term funding they will solve the problem of
asset liability mismatch. Also as the volumes in the
longer term securities increase, the cost of capital
would come down.
The trading in long maturity bonds will help
the Interest Rate futures market. Currently, since the
longer maturity securities are not traded, the yield
curve is theoretical and not based on trading data.
Therefore, it becomes difficult to arrive at fair price
of Interest Rate futures leading to illiquidity in the
rate futures market. With arrival of PEF into the long
term debt market, the yield curve would be based on
actual data which will boost the interest rate futures
market.
Currently, FII holding in Indian equity market is
huge. If they suddenly withdraw, the consequences
would be disastrous for the market as seen during
the 2008 global financial crisis. Hence it is prudent
to build strong countervailing domestic institutions
such as PEF. They would be able to counter irrational
pessimism in the market.
Secondly, PEF with their huge shareholdings
can play an important role in bringing the best prac-
tices of corporate governance to companies that get
their investments. In India, currently there is hardly
any shareholder activism shown by the institutional
investors. The PEF are active as shareholders and in-
strumental in bringing high standards of accountabil-
ity in corporate management in US and UK markets
AoM
where they hold 30 percent of equities. A recent
example is the decision by CalPERS (California Pub-
lic Employees’ Retirement System) to vote against
Bank of America (BOA) board re-election.
International Experience with Pension
Funds
The main features of India’s NPS are compared
with privately managed systems in other countries
(Table 1). The parameters of the pension reform en-
visaged in India appear in line with best practice.
As we see in the above table, India is considerably
late in its pension fund reforms. However, there is a
huge potential contributor base because of its large
workforce of which only 13% has been tapped. As
PEF gain more acceptance, the ratio of pension fund
assets to GDP will increase. When they reach critical
mass, it will be in a position to influence the capital
markets.
The impact of pension reforms in Latin American
countries
PEF reforms in Latin America have deeply im-
pacted their domestic markets. Huge financial re-
sources accumulated by the PEF have allowed them
to dominate their domestic financial systems. Chile
and Peru have done well in this regard. Their pen-
sion reforms were accompanied by fiscal develop-
ment by increasing the role and size of the stock
market and the mortgage bond market; together
they have helped to improve corporate governance.
Post reforms the pension fund market in Chile has
increased considerably and has assumed a signifi-
cant proportion of its GDP.

With availability of PEF as

a source of long term funding
they will solve the problem of
asset liability mismatch

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 7

 have implemented their PEF reforms some years ago,
as AUM (Asset under management) in these pension
funds may not have reached critical levels to impact
the market.

Figure 2 Market capitalization and pension fund assets

for Chile
AoM

As can be seen in the above figure, the PEF

assets and the market capitalization have shown a
positive correlation. However, post 1996, the mar-
ket capitalization decreased even though pension
funds showed a positive growth. This is due to the
low or negative returns from the domestic equity
market while the PEF started diversifying and invest-
ing in foreign securities. In Latin American countries
were pension fund reforms were introduced, we see
that the ratio of pension fund assets to GDP has in-
creased over time.
Figure 4 Pension Fund Assets with respect to Market
Capitalization
[Source: Beck, Demirguc-Kunt, and Levine (2000)]
In developed markets like US and UK, pension
funds are among the biggest investors holding a
significant portion of capital market securities. With
this, they exert significant influence on the function-
ing of these markets. We support our argument in
the following example showing the percentage of

Figure 3 Ratio of pension fund assets to GDP over a

period of 12 years
Positive impact of pension assets on market capi-
talization
We also see that the development of pension
fund market has contributed to the development of
capital markets. In the G7 countries, stock and bond
market capitalisation rose by more than 40 and 20
percent of GDP, between 1980 and 1998 as seen from
the diagram below. However, there is a lag between
the pension reforms and their effect on the capital
market. Some countries are yet to see a develop-
ment of their financial markets even though they

PEF with their huge sharehold-

ings can play an important
role in bringing the best prac-
tices of corporate governance
to companies that get their
investments.

8 NIVESHAK VOLUME 3 ISSUE 1 January 2010

holdings by PEF in corporate bond markets in the US.
From the above calculations we find that pension
funds allocation to corporate bonds account for 12% of
the entire corporate bond market. This is a significant
amount, which can really alter the dynamics of the
corporate bond industry. Moreover, since the US has
the best developed corporate bond market in the world
with numerous institutions taking part in it, this high-
lights the important role being played by the PEF. The
involvement of pension funds in the corporate bond
market provides sufficient liquidity and depth to the
market.
Recommendations
PEF reforms should aim at providing investors
with a range of choices on risk, liquidity and maturity.
Introduction of private managers for pension
funds will ensure
large-scale mobilisa-
tion of savings as they
provide the individual
with the power of ex-
ercising his choice. An
individual can choose
between compet-
ing PFM, the type of
scheme (growth or se-
cure income) and can
plan to save more in
the initial stages and
retire early! He can de-
cide on the best agent
to manage his money.
Such options are not provided under a government ad-
ministered system.
Liberalized Investment Guidelines
Overly conservative investment practices and
restrictions on investment options may constrain the
achievement of optimal risk adjusted returns by PFM.
Investment in foreign assets
Currently investment in foreign assets is not al-
lowed by the regulations of NPS. In emerging econo-
mies were the number of investable securities is very
low, it is imperative that PFM are allowed to invest
in foreign securities. Foreign investments would allow
diversification of assets and hedge downslides in the
domestic market.
Towards Prudential norms
Developed countries like the USA and UK allow
prudential norms without imposing restrictions on the
type or nature of investments. This judges the actions
of a PFM against that of a prudent person seeking rea-
sonable returns and preservation of capital. This is con-
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
sidered far superior to regulations India currently has as
it places no limits on the type of investments that can
be made.
Currently in equities, only standardized index se-
curities based on the NSE50 can be used by all pension
funds. In bond market, PFRDA imposes restrictions such
as market capitalization of at least Rs. 5000 crores, at
least 3 years of trading in exchanges, at least 95% trading
frequency in the last 1 year and no legal or regulatory
charges against the top management of the company.
These rules drastically reduce the number of corporate
bonds that can be invested in and will restrict the devel-
opment of the market.
AoM
Derivative instruments
Investing in foreign securities as well as investment
in corporate bonds will involve risk that can be hedged
using derivative instruments. Currently investment in de-
rivatives is not allowed
for the first 5 years of
operation of the pension
funds.
Investment in other as-
set classes
There are other
asset classes like real
estate, commodities
etc. which the current
system prevents invest-
ments in. These assets
can help the PFM to
diversify his portfolio
thereby reducing risk.
Apart from above recommendations, it needs to be
ensured that a critical mass is built in the pension fund
market. For a pension fund to positively influence the
functioning of the capital markets and bring in the ben-
efits of corporate governance there is a certain size of
assets under management it has to reach. To achieve this
a few steps need to be taken. Firstly, the contributions
from new workers won’t be enough. The government
needs to incentivize the existing employees to switch to
NPS. This can be done by reducing the benefits of the old
system. Secondly, outsourcing part/whole of EPF funds
to Private PFM needs to be undertaken. The EPF funds
are managed passively and are invested in Government
Securities. Thus, neither are they able to generate good
yield for the investors nor contribute to development
of capital markets. The private managers can invest in
the capital markets and generate better yield for their
investors. Thirdly, PFM need to start offering minimum
guarantee products also. Currently, due to its absence,
market participants are induced to opt for conservative
asset allocation as they seek to minimize the risk of an
unfavourable ex post return.
9
 Agricultural Insurance
Siddhartha Sen & Sourav Dutta
IIM Bangalore
The first profession known to
This paper attempts mankind, and one of the key forces
behind human development, Ag-
to introduce a crop riculture (derived from the Latin
insurance product agricultūra, from ager, “a field” and
that looks to miti- cultūra, translating literally to “till-
gate the risks inher- age of a field”) is not only a business
enterprise but also a way of living.
ent in agriculture While on one hand it involves the
and also ensure that production, distribution and trade
the hazards involved of certain basic materials indispens-
able to man, on the other hand, it is
in having such an
also a method of sustenance, both
arrangement are ad- physical and moral, for approximate-
equately addressed. ly one-third of the world’s populace.
India is a country where agriculture
is the major source of income for the
majority of the population. Agricul-
ture and the agro-based industries
support around 60% of the popu-
lation. According to the economic
survey of India 2008, agriculture
contributes to more than 28% of the
total GDP of India.
FinGyaan
Risks in Agriculture
In all its aspects and relation-
ships, agriculture is subject to a con-
siderable amount of uncertainty. As
a business venture, it is susceptible
to all the social and economic uncer-
tainties as those faced in mining or
industry. As a way of living, it has to
live with a gamut of personal uncer-
10 NIVESHAK VOLUME 3 ISSUE 1 January 2010
tainties arising from death or impair-
ment of the health of the farmer, and
from other inabilities on the part of
the farm workers to effectively em-
ploy their labour. Over and above
this is of course the uncertainties
arising out of the physical hazards
of nature since it requires, as distin-
guished from any other form of busi-
ness, an extensive and direct battle
with the natural elements. Unlike in
most other industries, the agricultur-
ist has to operate under the open
skies, and he has to be prepared
to deal with various adverse Acts
of God such as storm, flood, earth-
quake and drought. A list of all risks
faced in agriculture has been identi-
fied as given in table below.
Agriculture Insurance scene
in India
The agriculture insurance scene
in India is two-pronged. One of these
prongs, a government programme
that has a very strong social objec-
tive, loses vast sums every year.
There have been efforts to re-design
this programme, in order to make it
more efficient and sustainable, but
they have met limited success so far.
On the other hand, there are a few
insurance companies that are ac-
tive in offering commercially sound
insurance products, targeted at producers of high
quality fruits, and much developmental work is be-
ing done in India on new products and approaches.
The General Insurance Corporation (GIC) of India has
formed a specialist subsidiary for this sector, name-
ly Agricultural Insurance Corporation (AIC) in order
to provide a company/institutional focus.
One of the latest developments in this field is
the introduction of index insurance, an insurance
product covering non-irrigated farmers against the
risk of insufficient rainfall during key parts of the
cropping season. The policies are offered by ICICI
Lombard General Insurance and are marketed to
farmers through micro-finance entities which are
linked to a micro - finance entity known as BASIX
(Bhartiya Samruddhi Finance Ltd.)
The NAIS – National Agricultural Insurance
Scheme is being currently in a few selected districts
and the ‘individual’ approach is also being imple-
mented on an experimental basis. Each year a set
number of plots with the insured crops for a certain
area are being used as indicators of an individual
farmer’s losses within that area. The unit area can
be as large as a Taluka or as small as 4-5 villages.
Problems in the current systems
The main flaws in the current system are as
under:
• Under penetration: The average penetration is In-
dia is at a dismal 15.7%. The same for developed
nations like US stands at around 70%.
and can hence be taken for ride by moneylenders and
corporate houses alike who take advantage of the
price differential that exists in the market prices of ag-
ricultural produce across different time intervals in the
year. The majority of the value is hence apportioned
by the corporate houses or moneylenders and farmers
get a miniscule proportion of the profit pie.
The Proposed New Model
Tackling Systemic Risks
Increasing Geographic Spread: Currently the only
company offering agricultural insurance on a national
scale is the Government’s National Agricultural In-
surance Scheme (NAIS) which remains plagued by a
plethora of problems outlined before. However such a
wide geographical spread is an essential perquisite for
any insurance company required both for satisfying
the Law of Large Numbers on whose basis the feasibil-
ity of any insurance scheme rests, and for diversifying
the risks associated with the vagaries of nature. The
entire scheme of operations would also require the ac-

• Adverse selection: The highest penetration rates
are in Rajasthan and Madhya Pradesh, both states
having a history of highly being susceptible to crop
failures. Additionally, states like Punjab and Hary-
ana that have a robust agricultural system in place
have either opted out of NAIS or have an abysmally
low penetration (see figure below for penetration of
NAIS in Indian states)
• Lack of Bank Credit: There is a constant credit
requirement of farmers at the time of buying seeds,
hiring labour for removing weeds, purchasing fuel
for farm machinery, buying fertilizers and hiring la-
bour during harvesting time. The farmers normally
resort to taking credit from moneylenders as sourc-
es of credit.
• Lack of Access to Derivative markets: Farmers do
not have awareness or access to derivative markets
FinGyaan
tive support of Banks who already have an extensive
reach in rural India, since it would help in reducing
both operating and agency/monitoring costs for the
insurance company.
Providing Multi-crop Insurance
To further reduce the systemic risks arising out
of a failed monsoon or a major flood, we also propose
that the insurance not be for a particular crop or a
particular season but for the entire revenue earned by
the farmer in the course of a calendar year. It is often
the case that given proper financial support, the In-
dian farmer would be able to offset a disastrous Kharif
season crop by a better-than-average Rabi yield. Thus
a farmer whose Kharif crop has failed would not be
eligible for his entire claim amount unless the Rabi
crop fails too. Instead he would receive a partial claim
amount after the Kharif season to ensure that he has
enough capital to invest for the Rabi season.

One of the latest developments in

the agriculture insurance is the
introduction of index insurance,
an insurance product covering
non-irrigated farmers against
the risk of insufficient rainfall

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 11

 As of now, Agricultural insurance in India is
available only for wetland crops such as rice and
sugarcane. Non wetland crops such as wheat, pulses
and cotton which nevertheless provides the means
of sustenance for a large number of farmers which
have till now remained outside the purview of Gov-
ernment supported Insurance would also be thus
covered under this new insurance product since
they would not only achieve a higher penetration
among Indian farmers but also diversify the risk both
in terms of the number of crops as well in terms of
geographical spread.
Reducing the Insurance Premium
Traditional actuarial calculations would typical-
ly require a high premium in a field like agriculture
where the probability of a systemic failure is high,
a sum which is beyond the means of an average
farmer.
Our model addresses this issue by a system
akin to that of risk-sharing. While the farmer is as-
sured of his claim in case his crop fails, he also has
to agree to an upper cap on the potential price he
receives in case the prices are moving up. This is
equivalent to a call option written by the farmer to
the insurance company at a mutually agreed upon
strike price. For the farmer, the call premium helps
to somewhat offset the insurance premium, while for
the insurer, the potential profits from the call option
contributes to the overall settlement of claims.
FinGyaan
As an illustration, we consider an economy with
100 farmers, all of whom are under insurance. Each
of them produces either 1 unit of a hypothetical crop
(named “wheat” in this case) when his harvest is
The average penetration is
India is at a dismal 15.7%.
The same for developed na-
tions like US stands at around
70%.
12 NIVESHAK VOLUME 3 ISSUE 1 January 2010
successful and 0 unit of wheat in case his crop fails.
Let the prices be dependent on the supply ac-
cording to the following simplified model:
Assuming a “Low-Fat” (no discount rate, single
period) model,
• Let ‘p’ be the premium amount collected from
each of the 100 farmers
• ‘O’ is the operating cost of the insurance company,
and includes the return on his capital
• ‘C’ be the amount claimed by the farmer in case
his crop fails
• ‘K’ is the strike price of the call option on the crop
• ‘x’ is the number of farmers whose crop does
not fail during the year, and equals the supply of
wheat in the year. The price of wheat is thus (1000 -
6.25*(100-x))
The total claims on the insurance company as
a result = C*(100-x)
The total inflow for the insurance company =
premium collected+ profit from the call options =
100*p + ((1000 - 6.25*(100-x)) - K) * x
For this model to be sustainable, the inflows
and outflows should match for this period, and thus
we have a governing equation
C*(100-x) + O = 100*p + ((1000 - 6.25*(100-x))
- K) * x
Each of these parameters can be tailored to ar-
rive at an optimum structure as long as the above
equation is satisfied. Since ‘O’ can be assumed to be
constant once the insurer has attained a required
level of scale, the above equation has 2 degrees of
freedom for any given value of ‘x’.
For example, to make the premium affordable,
we decide to charge each farmer a premium of Rs 100
(10% of his minimum support price of 1000, which is
the minimum amount he would have earned in the
previous period). And we decide that in case of a
crop failure, the claim amount would be 60% of the
price the farmer would otherwise have received. Un-
der these circumstances, we can calculate the strike
price ‘K’ required for different number of failures
(100-x) as in the table given later:
We say the insurance is feasible or fair from
the point of societal equity if for a given value of
failures ‘x’, the amount claimed by the failed farmer
does not exceed the profit foregone by the success-
ful farmer. As seen from the above numbers, we can would also, as a by-product, promote the opening of
see that for the situation described above, insurance more bank savings accounts, which would help the
is prima facie feasible for crop failure rates of 50% insurance company in enlisting the support of more
and above. banks operating in the rural areas of India and also le-
Practical failure rates are estimated to be more in verage on their existing infrastructure and local knowl-
the range of 25%-30%, and specific and rigorous com- edge.
putational techniques needed to forecast, enumerate Addressing Moral Hazard
and estimate the failure rates and the risks arising The fact that the farmer is entitled to only 60% of
thereof. his potential loss of revenue as insurance claims en-
sures that the farmer also has to make a tangible mon-
Tackling Specific Risks
etary sacrifice in case he is contemplating a deliberate
Supply of Credit at required intervals destruction of his crop in order to collect insurance.
In order to reduce the specific risks of crop fail- This is thus a self policing mechanism for reducing
ures currently arising out of the credit requirement of any tendency for moral hazard among farmers seeking

FinGyaan
farmers at the time of buying seeds, hiring labour for insurance.
removing weeds, purchasing fuel for farm machinery,
buying fertilizers and hiring labour during harvesting Conclusion
time, we propose to provide the farmer with adequate As outlined in the paper, even though the initial
credit at these specific points in time. While the farmer investment required for attaining such a scale might
is freed from the usurious rates currently charged by be at present be prohibitive for any economic agent
unscrupulous money lenders as a source of this credit, other than the Government, it poses a tantalizing chal-
the insurance company also benefits from a reduced lenge to any private player who plans to enter this
risk of crop failures presently arising out of lack of extremely large and potentially lucrative space at the
credit at these periods. bottom of the pyramid.
To reduce agency costs in these periods, a sys-
tem of reimbursement is to be adopted for providing
this credit. The farmer would be reimbursed for the
expenses of seeds, fertilizers and fuel provided he pro-
vides proof of purchase, quality and price from a Gov-
ernment approved agent. All payments made to hired
laborers needs to be in the form of a cheque drawn on
a bank to be eligible for reimbursement. Such a system

The fact that the farmer is entitled to only 60% of his potential loss of revenue as insur-
ance claims ensures that the farmer also has to make a tangible monetary sacrifice in
case he is contemplating a deliberate destruction of his crop in order to collect insurance.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13

 A DECADE of
Himanshu Mehra
NITIE, Mumbai
The last decade has
undergone major
economy shocks
across the globe.
These troubles
ranged from the IT
bubble to the sub
prime crisis in US
and due to the glo-
balization no one
was left unaffected.
The incompetency
Perspective
of the financial mar-
kets in capital man-
agement led to risk
creation.
The expansionary monetary policy followed by the Clinton administration led to extremely low lend-
ing rates due to which more and more people were able to afford houses thus leading to growth in the
14 NIVESHAK VOLUME 3 ISSUE 1 January 2010
Misfortunes
This decade has been quite
fascinating to say the least. It ended
with a recession at its tail quite simi-
lar to the way it had started off with.
The IT bubble gave way to the real
estate bubble both of which burst
with equal tenacity leaving the tax-
payer at the mercy of the Capitalist
system. As these huge financial in-
stitutions gambled away the savings
of the common man, the brunt of the
losses was borne by the hapless tax
payer who was left in a lose-lose sit-
uation .The cherry on the other hand
was taken by the few who actually
recklessly gambled away the sav-
ings of the many who diligently paid
their dues to society. An insight into
these financial crises gives us an un-
derstanding of what happened, how
it happened and why it happened as
these are a critical part of stabilizing
the financial system in the long run.
The learnings from these crises
are one too many but the biggest of
all has been that of the importance
of regulation in our financial mar-
kets. Without adequate regulation,
markets become susceptible to ma-
nipulation and lose their self correc-
tion mechanisms. The invisible hand
remains invariably invisible.
As in the case of the recent
Global financial crisis the “invin-
cible” sector – Real Estate also re-
vealed the mess that was under-
neath the massive housing market.
Right from the late 1990’s to the mid
2000’s housing prices in US rose at a
CAGR of 8%. The expansionary mon-
etary policy followed by the Clinton
administration led to extremely low
economy in general.
lending rates due to which more
and more people were able to afford
houses thus leading to growth in the
economy in general. The graph in
the next page exemplifies this fact.
But this growth was temporary
as the housing bubble burst send-
ing a ripple effect throughout the
financial system. Default on mort-
gages and foreclosures became com-
monplace, thus leading to a credit
crunch for the banks that had lent
out these subprime loans. Soon
these banks went insolvent which
triggered the downward spiral that
engulfed the entire global financial
system. Globalization of these toxic
assets made this the local problem
global. Thus an understanding of
complex financial products requires
great expertise and judgment.
During the first half of this de-
cade American-style consumption
offered a new model of economic
development. The world revolved
around American consumerism. Dur-
ing the recession the savings rate of
the debt ridden economies shot up
due to reduction in disposable in-
come of these economies. This led
to a further deepening of the crises
while revealing the massive over-
capacity of the US retail market. So
while the last decade was an age of
Consumerism the next one is sure
to be one of the Service Economy
which would emphasize human in-
teraction more than individualistic
consumption.
Another learning from these
difficult times has been the impact
of labour and financial markets on the economy. The
inefficiencies of the labour markets lead to escalat-
ed costs on society. On the other hand capital mar-
ket failures strongly affect the labour markets. The
recent global recession has left the United States
tries continuously according to their changing envi-
ronments. The focus now should be on establish-
ing well-functioning markets that enable developing
countries to fully tap their economies’ comparative
advantage.

with approximately 8 million jobless while the glob-
al unemployment levels have reached to around 220
million. Such weakness in the job market takes a
huge toll on economic and personal well-being.
We also know that not all innovation leads to
a more efficient and productive economy. Financial
engineering did not create products that would help
ordinary citizens manage the simple risk of home
ownership. Instead, innovation was directed at per-
fecting the exploitation of those who are less ed-
ucated, and at circumventing the regulations and
accounting standards that were designed to make
markets more efficient and stable. As a result, fi-
nancial markets, which are supposed to manage
risk and allocate capital efficiently, created risk and
misallocated wildly. Thus to check the excessive le-
verage of the last decade, stiffer capital adequacy
norms need to be put in place.
In the current crisis, China, India, and certain
other emerging-market countries are coping fairly
well. These countries all had strong external balance
sheets and ample room for fiscal maneuver before
the crisis, which allowed them to apply countercy-
clical policies to combat external shocks. They have
also nurtured industries in line with their compara-
tive advantage, which has helped them weather the
storm. In today’s competitive global marketplace,
countries need to upgrade and diversify their indus-
Perspective
With the advent of globalization, integration
and synchronization of the business cycles across
the world has become a common fact. It has its pros
as well as its cons. Increased financial integration
can lead to a positive effect on the exports of neigh-
bouring countries through inter-linkages between
monetary policies of these nations. On the other
hand we can also have demand shocks in one coun-
try severely affecting the output of another. As was
the case when the demand in US declined it affected
the exports of India and as well as China immensely.
The developing economies need to build up their
own demand levels and reduce the burden on ex-
ports to mitigate the impact of such crisis on their
growing economies. Decoupling of major economies
is not a viable option as the self-sustained growth
can only be possible after decades of superlative
growth.
All in all this decade has proven to be one
great hurdle which has taught us important lessons
about the role of greed and fear in the markets.
We need to take our learnings forward and make
sure that the next decade can handle all the impedi-
ments that come across its path.

Decoupling of major economies

is not a viable option as the
self-sustained growth can only
be possible after decades of
superlative growth.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 15

Cover Story
SUMIT KEDIA & UPASNA AGARWAL
Team Niveshak
At this crucial juncture when we have just barely
managed to recover from one of the worst financial
disasters ever while entering into the new decade, a
critical analysis of the whole financial spectrum is nec-
essary to assess the past and while appreciating its
implications for the future.
Through the hour glass
Satyam fiasco
The year began with the major jolt to the entire
Indian economy and to the world over when the Saty-
am case of corporate fraud came to the fore when the
founder of Satyam, Mr. Raju confessed to the fraud.
He is still awaiting trial and admitted to fabricating
“fictitious” cash and other non-existent assets worth
more than 1 bn pounds. With possibilities of stringent
laws in corporate governance this may lead to more
responsible management in all companies.
Sensex rally
On a whole the year was that of contrasting for-
tunes. The sensex rallied since March 2009 to achieve
the levels of 17500 where it is currently hovering
around. This was further fuelled by greater foreign in-
flows. Over the last one and half years, markets have
seen one of the most turbulent times in history. Mar-
kets all over the world dried out of cash as Indices
crashed to rock bottom levels. Since, the rally began
the markets all over the world have almost doubled
from their lowest levels within 6-9 months. The Bull
Run has started once again, or has it? We will take a
closer look to this question in the latter part once we
have seen the factors which might affect this.
Spiralling inflation
On the other hand, the country suffered with one
of the poorest monsoon in decades thereby endan-
gering the entire economy and the livelihood of the
country since the agriculture being the most important
means for living. This fact, coupled with many other
facts, political and non-political alike has fuelled the
inflation especially of food items to ominous levels
reaching 20% at around end of 2009. Over the next few
16 NIVESHAK VOLUME 3 ISSUE 1 January 2010
To 2010
months, we will see the higher inflation due to sup-
ply side exertion. Supply side concern may include
shortage of food grains; higher stock of money in the
system due to spiralling government borrowings will
doubtlessly push inflation on the higher side. We will
expect the monetary action from Reserve Bank of In-
dia (RBI) in response to the microeconomic develop-
ments.
The Convalescence
Primarily, capital inflows into India have sup-
ported the “V” shape recovery in the Sensex. For-
eign investments, positive growth outlook, consumer
confidence, good corporate earnings, better reforms
prospect might be a specific reason of overall growth
in the financial markets. The recovery is on the path
as these figures show. Although, developed econo-
mies would the lead in garnering the recovery it is
however going to be the Asian economies which will
be leading the overall economic recovery.
Companies around the world have posted better
than expected earnings in the last couple of quarters
showing signs of recovery in their operations. How-
ever the growth in their earnings was ushered by cost
cutting measures such as layoff and restructuring of
their businesses. In general, their growth would be
sustainable once the consumer confidence revives in
the developed economies.
The current crisis which started in 2008 contin-
ued for at least 5 quarters made us see the worst pos-
sible fallacies of the world of finance and along with
it brought about the down fall of the biggest of em-
pires. The major beating was taken by the consumer
confidence which had a multiplier effect on all the as-
sociated factors ranging from consumption to prices
to unemployment to the overall growth rate of the
economy, there by further extending the recessionary
period. Stimulus package was extended in all econo-
mies, where millions of dollars were infused into the
capital economy to provide apt liquidity in the debt
and equity markets and bridge back the consumer
and banks confidence.
 The latest scare of the Dubai debt crisis in the Now, at this juncture since the economies around
early December which had kept the rumour mills run- the world have started giving positive signals about

Cover Story
ning for quite few days that it is going to be the next growth and revival, the stimulus packages infused in at
big thing. But, the times of emer-
the spread gency needs to
out exposure be withdrawn. All
of other coun- the manufacturing
tries on the and industrial in-
Dubai banks dices have shown
did not re- good positive
sult such in signs, the likes of
magnanimous PMIR and IIP which
proportions of have grown at the
the effect on fastest pace in 2
the economy. Various measures of inflation (Y-o-Y) years, when it rose
Another recent addition to this not so elite list was by 12% in November 2009 from a year earlier. These fac-
that of Greece, when they asked the help of IMF of- tors along with the numerous positive signs, has further
ficials in assessing their economic situation and help strengthened the case of the central banks of India and
them formulate and take necessary steps to come out around the world to tighten the monetary policies to tem-
of the situation in which they currently are. per the inflationary trends and expectations. Here, lies
Early signs of the end of global recession that the biggest challenge with all the policy makers of each
started to emerge in the second quarter of 2009, be- country. The withdrawal must be slow and steady and
came clearly evident by the 3rd quarter with all G-20 should be such that the increase in tax rates, the interest
countries (excluding UK) witnessing positive economic rates and/or the other important rates that govern the
growth. In the advanced economies, however, there is liquidity situations in the country are altered with due
significant uncertainty about the sustainability of the considerations to the sudden impact that each of such
recovery. The excessive dependence of the recovery on move might bear on the economy. Although the growth
the policy stimulus operates as the key risk to sustain- figures and the industry outperforming figures might get
ability of recovery, and hence the generalized prefer- subdued, once the stimulus recovery measures are in
ence has been towards the policy stance to err on the place but the more must be strategise the fall in such
side of caution. Presence of significant negative output a way that it’s spread out evenly over a period of 12-24
gap on account of the output losses suffered over 4 months. The figure below shows the investment of bank
to 5 quarters by the advanced economies in relation finance in commercial sector over the years:
to their production has minimized the risk to infla- It can be seen in 2009, the recovery started from
tion from excess liquidity, notwithstanding though the March when the banks regained the faith and started
concerns about risks to asset price bubbles. The com- investing in the commercial sector leading to the start of
pulsion of exit for different countries, thus, could arise the revival and the fighting of the recession. There was
at different points of time, depending on the risks to again a dip in along the line but overall the total picture
inflation, extent of recovery in relation to the potential shows that the revival is well underway but that it is not
growth path and the policy assessment of risk to sus- going to be a smooth and neither going to be a rapid
tainable recovery from errors in exit. one. It is due to have hiccups along the way coupled

Investment of bank finance in commercial sector

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 17

 with a stable and slow growth out of it.
We indicated that huge bailout packages, lower-
ing of interest rates and opening of multiple liquidity
Cover Story
windows to flush out the menacing bear from the
markets. This has created a huge problem. One is that
this has pushed most of the countries into a severe
fiscal deficit, in the 8-10% range which may take gov-
ernments a couple of years to bring them down to
2-3% range. This can have fatal impacts leading to
lesser government spending in the next few years
leading to lower growth rate. The value of major cur-
rencies with the dollar has been very volatile over
the past few months. Problems with huge inflow and
outflow of money, heavy volatility in currency values,
fiscal deficit prevailing in most of the countries may
lead them to taking drastic measures on capital ac-
count convertibility. So the possibility of a Currency
bubble also may not be ruled out.
In 2009-10, however, CPI inflation remained in-
flexibly high and WPI inflation has also started
firming up – led by significant accelera-
tion in food prices – which has
raised the risk of endanger-
ing generalized inflation
through adverse inflation
expectations. The strong
recovery in growth in the
second quarter of 2009-10 at
7.9 per cent has now created
an ‘inflation-growth’ outcome
for India, which is divergent from
the pattern being seen in the ad-
vanced economies as well as several
major emerging economies.
Peeking into 2010
In their quarterly review, Reserve Bank of India
marked an end to the easy money era which was
continuing since the recessionary times. Now credit
would not be as easy as it was until now. This so
called start of liquidity squeeze may have an impact
on the expansionary plans of corporate India. This
is not just the case in India; many economies of the
world have tried to control fiscal deficit and over-
heating of economy due to drastic recovery steps by
marking an end to the easy money regime. Now this
may stop the economy from recovering at the rate at
which it was earlier expected.
Another major angle of study in this domain
must the purview under which one sees the growth
or the revival of the economy. If one sees the current
Indian economy, the major industry is the Services in-
dustry which is never mentioned when signifying the
growth figures, rather more focus is on industrial and
manufacturing activities. The services industry con-
tributes to around 50% to emerging economies and
18 NIVESHAK VOLUME 3 ISSUE 1 January 2010
more than 70% to developed countries along with the
significantly high employment opportunities along with
incentives, both personal and social.
Most of the new economic theorists may reason
that recessions have become shorter in recent decades
that they have not been caused by a fall in consumer
spending, unlike the long recessions of the 19th cen-
tury caused by falling investment. The main reason is
the massive global shift from goods to services; the de-
mand for services is more stable than for goods. Unlike
goods, services cannot be stored. Unsold commodities
can be kept for later sale which affects the inventory
cycle for manufacturing sector. When demand for goods
falls, inventories pile up, and production is cut with a
lag which brings about a downswing in industrial pro-
duction during recovery phase. So recovery is delayed
too in an economy dominated by manufacturing
but this may not be the case in most service
dominated economies. Falling demand
translates instantly into empty airline
and theatre seats, but without ac-
cumulation of unsold inventories.
The downswing may be sharp,
but so is the upswing. But are
we forgetting that during our
recovery we have created
several demons which will
come to haunt us soon.
According to RBI,
“in India due to deficit mon-
soon prices of Prices of essential
commodities have been steadily increas-
ing during 2009-10, and the inflation in this
group was 21.2 per cent in November 2009 on a y-o-y
basis
However while the other commodities like oil saw
reduced prices due to external factors the coming year
will not have that cushion as the increase in prices
is largely driven by domestic factors like that of con-
strained supply of food. Factors that could counter the
increase in prices are better rabi crop, selective import
of essential crops and release of stocks by the govern-
ment.
The policy regime thus has to be a fine blend of
measures to ensure the following - the growth momen-
tum, regained of late, is not lost; inflation, particularly
asset price inflation, does not reach unmanageable lev-
els; and foreign capital inflows are absorbed and chan-
nelized into productive use such as building infrastruc-
ture. Anticipating future risks is hard. But the scorching
experience of the past few months ought to push all
countries to try harder—and think carefully about the
kind of world economy they want to see emerge from
the current crisis.
Regulation,Reporting&Representation
Since the capital market re-
forms of 1992-93, the Indian Capital
Markets, both primary and second-
ary have significantly grown in size.
In fact, with financial integration,
developing countries have become
increasingly attractive destinations
for international investors who are
seeking a higher return than what is
available in the developed economies
while diversifying their risk (Agarwal,
1998). Despite the increased attrac-
tiveness and growth, Indian capital
market is still a long way behind its
peers in the areas like protection of
investors’ interests, corporate gover-
nance, and representation of larger
saving population in the markets.
This article tries to explore some of
these challenges which come across
as hurdles in growth of the capital
markets. However they have a long
way to go overcoming the above
challenges.
The first part of the article
deals with the issue of low participa-
tion of common saver in the Indian
markets and underdeveloped mar-
kets for sources of funds other than
equity. The second half of the article
elaborates on the issue of protection
of investors’ interests.
Participation of Retail Inves-
tors
The first and foremost chal-
lenge for the Indian Capital Markets
is to increase the investor base. The
number of individual investors was
around 20 million in 2008 represent-
ing only about 2% of the popula-
tion as against over 15-20 per cent
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Dipesh Jain & Nidhi Kaicker
FMS, Delhi
in most of the developed countries
of the world. Even the existing re- Though the world
tail participants are not confident is more cognisant
about the direction of Indian Stock about the protec-
Markets due to which the daily av-
erage turnover has dipped from
tion of investors’
Rs. 24000 crores in June 2009 to Rs. interests, India still
18000 crores in October 2009. The stumbles upon the
route to increasing the investor base problems of enforce-
should be increasing the investor
confidence in the markets. The main
ment of the newly
objectives of any regulator are to adopted regulations.
improve market efficiency, enhance There is a need for
transparency, and prevent unfair the country to win
practices. The past two decades in
India have been hit by scams (like back investors’ confi-
Harshad Mehta, Ketan Parekh and dence to boost their
the recent Saytam outbreak) which participation in the
have affected people on a very large
scale. Encouraging and protecting
market.
the rights of retail investors is an im-
portant issue. To encourage retail in-
vestors to participate in the primary
market, regulators have already tak-
en steps such as application money
stays in the account of the inves-
tor till the allotment is made. Steps
should also be taken in enhancing
investor education. Investors should
have more choices and information
on investment products, easier ac-
cessibility to any market they wish
to trade on, and better and cheaper
services from intermediaries.
FinSight
Growth of Derivatives Markets
Globally, the derivatives vol-
umes are dominated by Options
Contracts however in India it is the
Futures Contracts which dictates the
derivatives markets. This is because
Retail investors had concerns regard-
ing limited volumes and spreads for
The retail participation is
low because of an illiquid
secondary market along with
relatively high rates offered on
small savings schemes.
19
 Options. However, the volatility in May 2009 enabled
traders to make sufficient profits on these products and
this asset class is becoming more popular. The Deriva-
tives segment on the Indian Capital Markets has wit-
nessed an increase in average volumes by 10% from
June 2009 to October 2009.
As commented by Mr. Bagchi of ICICI Securities, In-
creased global investor participation (more hedge funds
coming in), product innovations involving the deriva-
tives segment (structured products) and introduction of
derivatives in different asset classes (interest rate fu-
tures) should lead to the derivative segment command-
ing a larger share in the overall turnover (The Economic
Times, November 2009 )
Under Developed Debt Markets
According to ADB Working Paper (2008), corporate
debt market accounts for 3.9% of GDP in India, while the
same accounts for 61% in Korea and 37.5%
in Malaysia. While the ratio of equity
market capitalization to GDP in-
creased from 32.1% in 1996
to 108% in March 2008.
Over the same period, the
bond market grew to 40 % of
GDP from 21.3%. Out of that Gov-
ernment bond market represented 36.1% of GDP while
the corporate bond accounted for a meagre 3.9%. In-
dian Corporates rely heavily on bank loans and depend
very less on the public issue market. The reason for low
participation includes regulatory restrictions like man-
datory SLR requirements which lead to Banks holding
government bonds rather than corporate bonds. The re-
tail participation is low because of an illiquid secondary
market along with relatively high rates offered on small
savings schemes. Further, most of the debt is raised
through the private placement mechanism which pre-
vents the emergence of a liquid market. Making the
process of issuing corporate debt relatively less time
consuming, and less expensive combined with tax ben-
efits could lead to development in the Debt Markets
FinSight
grievances and dealing with the cases of fraud and ma-
nipulation becomes too prolonged to reduce the faith of
the potential investors in the system. The Satyam Fraud
case is testimony to this fact. It has taken almost a year
to file a charge sheet in the case; one can only imagine
how much time it will take to deliver the justice, if at
all it is delivered.
The investors’ faith can only be restored by ex-
pediting the procedures. This calls for integrating and
unifying the plethora of bodies that are involved in gov-
erning the markets. Also there is a need to remove the
conflicting provisions in the various acts that hampers
the smooth functioning of the legal proceedings.
Shareholders’ Democracy
Protection and participation of investors lies at
the centre of an efficient capital market. Despite sev-
eral steps taken over the years by the various bodies,
shareholder democracy has still no takers in the Indian
markets. More than eighty percent of the companies are
promoter run in India . With promoters holding control-
ling stakes in large proportion of the listed companies
in India one share one vote norm risks the abuse of
voting powers by the promoters.
A more rigorous disclosure, accompanied by an
increased participation of the shareholders in the deci-
sion making procedure of the companies is essential to
maintain the sanctity of the investors’ interests.
Watering down the Equity
Private placement and QIPs (Qualified Institutional
Placements) have increasingly become popular meth-
ods of raising funds in the Indian markets. The following
table shows the share of various categories of capital
market products for the last four years in India.
(in Rs. Crores) Calendar Year
Mode 2005 2006 2007 2008P
Debt 66 399 594 0
Equity 30325 32672 58722 49485

Of which IPOs 9918 24779 33912 18393

(Mitra, 2009)
Number of IPOs 55 75 100 37
Slow legal procedure Mean IPO Size 180 330 339 497
Indian capital markets are no exception to the Private Placement 83812 117407 184855 175061
abysmally slow legal proceedings in India. With the Euro Issues (ADRs/ 9788 11301 33136 6271
multitude of bodies (SEBI, MCA, IT Department, ICAI GDRs)
etc) and laws (Companies Act, Securities Act, Income Total 123991 161769 277307 230877
Tax Act 1961 etc), the process of addressing investors

A convergence of Indian
GAAP with the international
standards seems to be a win-
win proposition for investors,
companies and industry.

20 NIVESHAK VOLUME 3 ISSUE 1 January 2010

 Although they come with their respective ben-
efits like saving in terms of both time and cost, re-
duced regulatory hurdles, reduced dependence on the
foreign funds (specifically for QIPs), these sources of
funds come at the cost of diluting the shareholders’
equity in favour of Institutional Investors. QIPs and
private placements were definitely more feasible in
the year 2009 due to poor primary market conditions;
however participation of the retail investors must be
increased.
Also as this source of fund does not have too
many regulatory checks and balances, a proper mech-
anism must be introduced to ensure that the share-
holders’ interests are protected.
IFRS: Investors’ interests but a tough road
ahead
With the increased exposure of the Indian players
in the global markets and foreign investors’ increasing
their pie in the Indian bourses, a need was felt to in-
tegrate the Indian accounting and reporting standards
with the global standards. A mandatory adoption of
IFRS (International Financial Reporting Standard) from
1 April 2011 is a positive step in this direction. This
will not only help Indian companies to gain access to
international markets to raise funds, but it will also
go a long way in increasing the transparency in re-
porting and representation of the financial statements.
A convergence of Indian GAAP with the international
standards seems to be a win-win proposition for in-
vestors, companies and industry. However there are
still some concerns regarding the implementation of
the IFRS which may spoil the party.
Almost 29 months have passed since ICAI de-
cided to start a staggered implementation of IFRS in
India from April 2011 , but still issues like availability
of trained experts, clarity on the current regulations,
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
conflicts with the tax laws etc have not been dealt
comprehensively.
IFRS require technical knowhow for proper imple-
mentation. Out of about 145,000 CAs in country , only
4000 have been trained by ICAI so far to handle the
new accounting system . This process needs to be ex-
pedited for smooth implementation of IFRS (even the
CA final examination scheduled for May 2010 does not
cover the IFRS comprehensively).
Policy clarity is also an issue that must be ad-
dressed by the regulators. In a recent survey con-
ducted by Ernst and Young covering senior finance
executive of companies where IFRS adoption is appli-
cable (112 responses were received), 56% respondents
agreed that tax laws are still unclear. While 58% per-
cent felt that the regulations on IFRS adoption are still
not clear. Although according to them prohibitive cost
of implementation was not a significant hurdle accord-
ing to them (14% respondents mentioning this) but
since the survey included only a few companies which
will be implementing the IFRS first, we can not ignore
the cost aspects. The cost of compliance will range
from Rs 10-12 crore for a big company to Rs 8-10 lakh
for a small company . This implies that several hun-
dred crores rupees will be spent by the companies for
IFRS implementation.
Conclusion
Indian capital markets still have a long way to
travel in terms of increasing representation (of both
investor base and the type of products as well) and
improving reporting (to enhance transparency and
improve corporate governance). Although some steps
were taken in the year 2009 to achieve this objective,
more needs to be done to put Indian markets in the
league of the developed markets.
FinSight
21
 DEVELOPMENT OF SECONDARY MARKET IN
Chaitanya Jee Srivastava
IIM Calcutta
There has been grow-
ing interest in private
equity as an asset class
for higher return and
diversification. Private
equity space witnessed
lot of activities in 1980s
and 90s. The downturn
in 1990s gave fillip to
secondary market in
PE. Secondary market
in PE further gained
momentum post 2001,
after dotcom burst. The
financial meltdown in
2008 has also stressed
the importance of sec-
ondary market in PE to
improve liquidity in the
FinGyaan
market. It has emerged
as an important vehicle
for restructuring the
portfolio and exiting
the investments by ex-
isting PE funds
22 NIVESHAK VOLUME 3 ISSUE 1 January 2010
PRIVATE EQUITY
Private equity secondary mar-
ket refers to the buying and selling
of the commitments and invest-
ments of LP’s (Limited Partners) by
another investor. The private equity
asset class is illiquid. This leads to
contraction in no. of deals during re-
cession as the investors become risk
averse. The emergence of secondary
market in private equity would give
the required boost to the private
equity transactions. This article ex-
plores the development of phenom-
enon of secondary market in private
equity, types of secondary transac-
tions and the recent developments
in this space.
History of development of
secondary market in Private
equity
The transaction in private eq-
uity secondary market started in
1980s. Earlier the trend was for one
LP to buy the stakes of another LP
who wanted to exit before the matu-
rity of the investments.
During the downturn in 1990s,
there was a contraction in PE mar-
ket. This period saw emergence of
secondary PE funds such as Coller
capital, Paul capital, Lexington part-
ners etc. Commitments to secondary
Fund of funds grew from less than
$100 million in the 1980s to approxi-
mately $ 1 billion in 1996 and to
more than $4 billion in 2001.
Following the downturn in 2000,
many secondary funds used the op-
portunity to raise large amount of
capital. More no. of players entered
into this market including some in-
vestment banks and hedge funds.
Types of PE Secondaries
The secondaries can be broadly
classified under the following cate-
gories;
Acquisition exit
It is a sort of merger and acqui-
sition phenomenon where PE inves-
tors sell their stake in portfolio com-
panies to strategic buyers and make
an exit.
Secondary buyout
Secondary buyouts have tradi-
tionally been treated as exit of last
resort. It differs from acquisition exits
in so far as the counterparty of seller
(PE investor) is not a strategic buyer
but another PE investor.
Secondary buyouts require more
due diligence on part of the buyer.
For the seller also, it requires longer
time of transaction. Also, many funds
lack the ability to manage the port-
folio companies operating in different
industry and many funds lack the re-
sources to invest in a new company
mid stream.
Secondaries
Secondaries like secondary buy-
outs have existed as exit of the last
resort for PE companies. Secondar-
ies are different from the secondary
buyouts because secondary buyouts
purchase the PE company’s stake as
a whole through direct acquisition
of stake in the portfolio companies,
whereas, the secondaries refer to sale
of stake of individual LPs or the sale
of entire portfolio of LPs.
There are two kinds of markets
in secondaries. The first is retail mar-
ket consisting of individual LPs who
want to sell their interest. This trans-
action, on average is less than $1 mil-
lion. The second is the institutional
market having complex secondary
transactions and involving big institu-
tional players.
Secondaries have come to be re-
garded not as distressed asset class
but a product category traded by spe-
cialist funds looking to actively man-
age their portfolio. Pension funds use
the secondaries to manage their port-
folio.
Secondary funds
Secondary funds are a subcat-
egory of FOF (funds of funds). Second-
ary funds negotiate secondary private placements directly
with investors seeking early exit from their primary private
equity funds.
Secondary funds differ from FOF in some respects.
GPs (General partners) of a FOF receive only small portion
of the fund’s investment (usually 5%) as carried interest,
whereas, secondary GPs generally take 20%. GPs of sec-
ondary funds like FOFs leave the active management of
the portfolio company to GPs of primary fund. However,
FOF are generally passive investors, looking to diversify
their investment in the new asset class of private equity,
whereas, the secondary funds are active investors looking
to realize the same abnormal returns as primary funds.
Publicly traded private equity vehicles
Recent deals by KKR (Kohlberg Kravis Roberts) and
Blackstone group in public market (IPOs) have drawn at-
tention to this mode of secondary transaction.
These private equity investment vehicles allow public
shareholders to share the fee and carried interest earned
by GPs for managing the un-
derlying fund. Hence, the sta-
tus of these public sharehold-
ers is that of passive GPs as
for as returns are concerned.
There are three types of
investment vehicles for pub-
licly traded private equity.
a) BDC (Business devel-
opment company)
b) SPAC (Special purpose acquisition company)
c) STAC (Structured trust acquisition companies)
Status of PE secondary market in India
The secondary market in PE is yet to mature in India,
though the Indian PE players have not been slow to catch
the phenomenon of secondary market. Private equity re-
search firm Venture Intelligence tracked at least 17 promi-
nent secondary market deals in 2009 between April 1 and
June 10. These 17 deals were worth $134 million compared
to just eight deals worth about $70 million in the preced-
ing three months since January 2009.
Prominent secondary market deals since April this
year include ChrysCapital off-loading a third of its holding
worth $60 million (about Rs 300 crore) in Shriram Transport
Finance to ICICI Prudential Life Insurance in May 2009; and
Citibank Venture Capital India exiting Lupin Labs and HT
Media by selling stakes worth Rs 96 crore and Rs 69 crore,
respectively. PE firm 2i Capital, which has been steadily di-
vesting its holding in freight wagon manufacturer Titagarh
Wagons has offloaded stocks worth $4.5 million (Rs 21.6
crore) till 2009. In June 2009, ICICI Venture is understood
to have divested its holding in a healthcare firm in which
it had invested way back in 2001. In March 2009, Merrill
Lynch Capital off-loaded a 3.6 per cent stake in IT firm
MphasiS to Baring India PE Fund for $25 million to improve
its liquidity position.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
New developments in PE secondary market
Lately, the secondary market in private equity has
seen large growth in terms of no. of transactions as well
as no. of participants. The big new and active players in
this market are hedge funds, family offices and struc-
tured vehicles.
Also, there has been increasing specialization in PE
secondary market built around industry, geography, capi-
tal structure and years to maturity.
The following are the key developments in private
equity secondary market.
Securitization
Securitization is a process where a SPV (Special pur-
pose vehicle) is created which issues notes of various
categories to third party investors and uses the proceeds
of the issuance to buy the portfolio of assets. The future
cash flow generated by this underlying asset is used to
pay back the third party investors.
Due to volatile nature of the
cash flows of the PE investment
and special nature of PE as an
asset class, it was thought that
securitisation was not possible in
PE. However, the same has taken
off lately.
The rationale of LP going for
securitisation is to free up cash
flow to increase his investment
capacity. Also, the LPs are seeking to have more liquidity
in PE asset class and to reduce the cost of financing of
FinGyaan
their investments
Targeted investment strategies
There is a trend towards more specializations and
development of niche investment strategy. Funds dedi-
cated to investments in real estate, infrastructure, en-
ergy, education and healthcare and media and enter-
tainment are getting active in the market. The strategy
behind these funds is to focus on areas where they can
add value and help the investee company grow.
Hybrid fund strategies
Hedge funds are targeting private equity space to
diversify, increase their return and attract more capital.
Hedge funds are increasingly buying the debt issued by
the portfolio companies of PE funds, thus creating com-
petition in the secondary market space.
The huge amount of capital flowing to private equi-
ty and hedge funds has given rise to the development of
the hybrid fund strategy where the traditional distinction
between PE and hedge fund is getting blurred.
23
 ....
From the Horse's mouth...
They created Niveshak. It was their en-
Cover Story

deavour that took it to such great heights.

As they hand over the baton after 16 issues, let us
listen to what they have to say about Niveshak.
AoM
Perspective
FinGyaan
FinSight

24 NIVESHAK VOLUME 3 ISSUE 1 January 2010

 Cover Story
AoM
Perspective
FinGyaan
FinSight

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 25

 Looking at the overwhelming response for Nivesh in the December issue, Team Niveshak is back with
Nivesh with a new fervor. The rules remain the same to maintain the simplicity of the game and to make
it a learning experience for aspiring Niveshaks. All the budding Niveshaks can test there investing acumen
in here. Nivesh is a simple yet interesting game. You are given a total initial capital of Rs 1,00,00,000. This
amount is to be invested amongst some or all of the Stocks from the BSE SENSEX 30, Gold (India Price) and
Currency i.e. US Dollar. You have to build a portfolio so as to maximize your return and at the same time
diversify your risks.
The investment options are as follows:
Investment Category Maximum Amount
Stocks Sensex 30 stocks Rs 20,00,000
Metal Gold ( in Lot of 10 grams- India price) Rs 40,00,000
Currency US Dollar Rs 40,00,000
Rules:
1. The purchase prices for the stocks, currencies and metals will be the closing prices as of January 29,
FinLounge

2010. For example the closing price of US Dollar on January 29 is 46.5 INR and you invest all your allocated
Rs 40, 00,000 in USD then you can buy 86021 USD.
2. Your portfolio will be evaluated according to the closing prices as on February 12, 2010.
3. Risk free return for unallocated capital is 7% per annum.
4. You need to mail us an excel sheet (the formal for which is stated below) containing the details of
your stock portfolio (no. of shares of the companies you choose from the BSE SENSEX-30), amount of gold
purchased in grams, and the amount of currencies you purchased in each category by 9:00 am February
1, 2010.
The format for the portfolio which you are supposed to send is as follows:
Investment Category Quantity Closing Price Total Amount Uninvested Target Price Stop Loss
(Q) as on January invested in Rs. Capital (optional) (optional)
29, 2010(P) (QxP), I (Total Amount)
Stock 1 No. of
shares
Stock 2
Stocks
Stock 3
(and so
on)
Gold (India 10 grams
Metal
Price)
US Dollar No. of cur-
Currencies
rency
5. The results will be declared in the next issue of Niveshak.
6. It is not necessary to invest in all three i.e. stocks, metal and currencies. It is not necessary to
invest in all the SENSEX-30 companies or in both the currencies.
7. You can also give Target Price (for Buying) and Stop Loss (for Selling) for any particular stock, al-
though this is not mandatory.
8. For further queries in this regard you can mail Team Niveshak on niveshak.iims@gmail.com
Prize:
The Niveshak with the maximum return as on February 12, 2010 will be declared the winner and will
be awarded a cash prize of Rs 1000.

26 NIVESHAK VOLUME 3 ISSUE 1 January 2010

ANNOUNCEMENTS
ARTICLE OF THE MONTH
The article of the month winners for November 2009 are
Ajay Jain,Debprotim Dutta & Raghav Subramanian K
of IIM Bangalore
They receive a cash prize of Rs.1000/-

Nivesh Winner
The Nivesh Winner for the month October 2009 is
Niraj Murarka
of IIM Calcutta
He receives a cash prize of Rs.1000/-
CONGRATULATIONS!!

ALL ARE INVITED

Team Niveshak invites article from B Schools all across India. We are looking
for original articles related to finance & economics. Students can also contrib-
ute puzzles and jokes related to finance & economics. References should be
cited wherever necessary. The best article will be featured as the “Article of the
Month.” and would be awarded cash prize of Rs.1000/-

Instructions
»» Please submit your article with the file name and the email subject as <Title of
the Article>_<Institute Name>_<Author’s name/Group’s name> by 10 December ‘09.
»» Article must be sent in Microsoft Word Document (doc/docx), Font: Times New
Roman, Font Size: 12, Line spacing: 1.5
»» Please ensure that the entire document has 1500-2000 words
»» The cover page of the article should only contain the Title of the Article, the
Author’s Name and the Institute’s Name
»» Mention your email id/ blog if you want the readers to contact you for further
discussion
»» Also, if certain entries which could not make the cut to the Niveshak will get
figured on our Blog in the ‘Specials’ section

SUBSCRIBE!!
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Drop a mail at niveshak.iims@gmail.com
Thanks
Team Niveshak
www.iims-niveshak.com
COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com
http://iims-niveshak.com
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Finance Club
Indian Institute of Management, Shillong
Mayurbhanj Complex,Nongthymmai
Shillong- 793014