Dividend Policy And Its Effect On Market Pricing"

by Rohit Mehrotra *

The term "dividend" usually refers to a cash distribution of earnings. It is

nothing but a part of profit (earning per share) which company decides to
share with its shareholders in form of cash on a regular basis, usually
annually (sometimes semiannually). My study is all about the DIVIDENDS
and its effect on the price fluctuations of the stock, i.e. how individual
investor perceives dividends and how corporate world perceive their
payouts. The controversy is that there are two school of thoughts with
respect of Dividends, one shows that dividends has no effect on market
pricing and other explains that how dividends positively influence the market
pricing of particular stock.
In U.S, earnings are doubled taxed i.e. firstly company pays the corporate
tax on its earnings and secondly when the same amount is distributed
among the members it is taxed as their personal income. The rate of tax in
U.S on capital gain is less than income from dividends. Thus to avoid this
double taxation, generally investor are reluctant towards dividends and hold
the shares for long term prospective. But what if the dividends are not
taxable in the hand of investor and capital gains is taxable at higher rates
than that of dividends, as in case of India.
Taking these views, in Indian scenario, I have started this project, and tried
to explore the payout mechanism and tried to scrutinize the consequence on
stock pricing with respect to the dividends paid by the companies.
Why companies paying dividends is still a controversy. In Indian scenario if
we take some top traded 50 companies in Bombay Stock Exchange, there is
hardly any company which is not paying dividends, moreover a thorough
study shows that even those companies which were making losses, also
paying some nominal dividends, using their prior reserves (subject to The
Companies (Transfer to reserves) Rules -1975). Here are some illustrations
that represent the dividend policy of selected companies and its effect on its
stock pricing in stock market.
Wipro ltd is one of the renowned IT company in India but still if we compare
the stock price of Wipro and Infosys we find that Wipro is lagging behind
owing to conservative dividend policy (@ 25% continuously) unlike as
Infosys Technologies ltd, having an excellent payout (continuous growth in
dividends).
The market risk of any security depends on its Beta (b), which shows the
relation ship between the Sensex Returns and Security returns and measure
the relative risk associated with the security with respect to market. Higher
the beta, greater the risk associated with the security. Theoretically if the
Beta of security is less than one, the security will be affected lesser than
proportion with market Sensex.
Companies like Novartis, NIIT, Satyam Comp, Glaxo, P&G Health Care,
Wipro, Infosys, etc representing 37% of the sample size, performed as per
the market (Sensex) movement. All these companies have a very good track
record of dividend payment, and were appreciated by investors. But since
April 2000 our Stock Market is bearish, caused by continuous chain of

negative sentiments i.e. U.S Slowdown, TAHALKA Issue, Ketan Parekh

Scam, GTB and UTI debacle and now UTI's failure, these stocks price also
came down drastically.
Companies like HLL, ITC, Ranbaxy, Dr.Reddy's Lab, Reliance Ind. Etc
representing 26% of sample size, performed extraordinarily well, even after
all the debacle in Sensex (BSE). These are the stocks that are continuously
paying handsome dividends and showing positive trend in the price
movement and had never experienced any significant downfall in past 6
years. It is the excellent dividend payout record of these companies owing to
which these companies are still showing positive trend in the price
fluctuation even after the shambles in Sensex in recent past.
Study of companies revealed that about 26% companies in sample size,
consisting BSES, L&T, ACC, Nirma, Voltas etc, having a very fluctuating
price movement in last 6 years. Mostly all the company in this group is
paying dividends from last 8-12 years continuously. The reason of their
uneven fluctuating movement may be due economic reasons. For example,
L&T and ACC's price fluctuation does due to the liberalized industrial policy
and strict Govt. policy in Cement sector, against the cartel formed by the
cement manufacturing companies in recent past. Company like Voltas has
an average record of dividend payment, paid dividend even after posted loss
for the financial year 98-99. BSES having a continuous dividend payment
record find no appreciation in its stock price for last 5 years the stock price is
continuously traded in between Rs 270 to Rs 350, we can say that only
dividend is not sufficient for the investors, along with it they want good
performance by the company so that they can earn some capital gains also.
Moreover investors do consider the overall performance of sector, and its
future prospects, despite of good dividend by BSES there is hardly any
appreciation in the stock price because of the industry specific factors.
Companies like MTNL, TELCO, etc representing 11% of sample size,
performed negatively. All these companies, having different Business
segments, performed haphazardly owing to different reasons. The similarity
to be considering for all these companies is that all of them are paying
dividends continuously. MTNL is paying dividends at fixed rate, TELCO is
paying dividends even after having declining trend in PAT and EPS since 96.
These companies are paying regular dividends and even then the stock
price is declining continuously from last 5 years, which shows that investors
are very rational about their current as well as future earnings. They cannot
accept any window dressing.
To sum-up the investors make equity investments with the expectation of
capital gains irrespective of whether they are short term or long term
investors. Typically there is no company, which can ensure capital gains to
investors with out declaring continuously dividends.
In other words the investors do care about dividends how ever small its
impact on their wealth. Its not only the investors care about dividends, but
also growth in dividends and profitability of the companies in which they
maid investments. The technical analysis and the survey conducted amply
prove this point. Unlike U.S markets where treatment of tax is a major
concern for the investors for accepting dividends, Indian investors do not
give greater weightage for the tax matters since the dividends are taxed in
the hands of the companies but not in the hands of investors.

"Beware Corporate, Investors do need Dividends and their Continuous Growth"

Monetary Policy
The Reserve Bank of India will announce its Monetary and Credit Policy for the first half of the financial year 2003-04 on
April 29. In simple terms, this policy determines the supply of money in the economy and the rate of interest charged by
banks. The policy also contains an economic overview and presents future forecasts.
Objectives of Monetary Policy
The Monetary and Credit Policy is the policy statement, through which the Reserve Bank of India seeks to ensure
adequate liquidity to meet credit growth and support investment demand while maintaining price stability. Stability for the
national currency (after looking at prevailing economic conditions), growth in employment and income are also looked
into.
The main parameters are - money supply, interest rates and inflation. In banking and economic terms money supply is
referred to as M3 - which indicates the level (stock) of legal currency in the economy, and it mainly consists of currency
with public and Demand and Time Deposits with banks.
Besides, the RBI also announces norms for the banking and financial sector and the institutions, which are governed by it.
Monetary Policy Announcement schedule
Earlier, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy.
This was commensurate with the agricultural cycles and April to September was called the slack season policy and
October to March was the Busy season policy. But now, as the share of credit to agriculture has come down and credit to
industry being granted year round, monetary policy is announced only once with a mid term review. Moreover, Monetary
Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the
economy.
Impact of Monetary Policy on Corporates/ Individuals
It impacts Corporates and individuals on the Interest rate front.
Depending upon interest rate stance of RBI, banks lower/increase their lending rates and borrowing rates. Since the rates
of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very
important to them. Similarly, rates of interest affect the interest earnings of individuals on their bank deposits.
Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario.
This means that banks are free to decide on interest rates on term deposits and loans.
CRR & SLR
CRR (Cash Reserve Ratio) refers to portion of aggregate deposits banks need to keep/ maintain with the RBI. It ensures
that a portion of bank deposits is totally risk-free and secondly it enables RBI to control liquidity in the system, and
thereby, inflation.
Besides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their
statutory liquidity ratio (SLR) requirements.
The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to
meet its excess of expenditure over receipts. Although the bonds are long-term in nature, they are liquid as they can be
traded in the secondary market.

Since 1991, as the economy has recovered and sector reforms increased, the CRR has fallen from 15 per cent in March
1991 to 4.75 per cent in November 2002. The SLR has fallen from 38.5 per cent to 25 per cent over the past decade.
Impact of CRR cut on interest rates
A cut in CRR requires Banks to keep lesser portion of deposits with banks and thus more liquidity to them to lend/ invest
in gilts. Thus yield on Government securities comes down thus aiding softer interest rates.
Effect of Monetary Policy on Exporters
RBI announces Export refinance rate, or the rate at which the RBI will lend to banks, which have advanced pre-shipment
credit to exporters.
A lowering of the Export Refinance rate would mean lower borrowing costs for the exporter.
Relation between Money supply, wages, Employment and Output
RBI tries to maintain money supply at such levels that economy operates at its full potential while minimizing the
inflationary impact. If economy is operating at its full potential at its maximum possible level of employment, an increase in
money supply will cause a rise in inflation. If economy does not operate at full potential, inflation can still be caused by
other factors like supply situations (OPEC cartel increasing prices of Oil). If inflation is high, traditionally it leads to
increase in employment as real wages decrease. Lower inflation, similarly should lead to lower employment as real wages
increase. Moreover, GDP growth rate might suffer as people due to lower fears of future price increases might postpone
consumption. But on the opposite higher inflation adversely affect exports as our goods become price incompetitive in the
international markets.
Regulating Money Supply by RBI
RBI uses Private placement of Government Debt, Open market operations and CRR cut to regulate money supply in the
market.
Under Open market Operations, RBI buys or sells Government Bonds in the secondary market. It sells bonds to absorb
liquidity from the market if interest rates are falling sharply.
A CRR cut requires the banks to keep lesser money with the RBI and releases more funds for the banks to lend/ invest in
Government securities. This results in increase in money supply.
Private placement of bonds by the Government with RBI allows the Government to borrow at lower interest rate, which
otherwise Government would have issued at higher interest rate from the market. Private placement increases money
supply, as Government gets money straight from RBI to spend.

Expectations from the Forthcoming Monetary Policy:

Bank Rate: At present Bank rate is at 6.25%. In its Oct 29, 2002 monetary policy review, RBI clearly indicated of the
current week link between average lending rates of banks and the bank rate due to:

High proportion of long term deposits at old and fixed interest rates
Relatively high transaction costs
Continued preference of depositors for fixed rather than variable interest rates

In-spite of lesser reduction in Lending rates of banks, Non food credit has shown a healthy pick-up in the current year and
as on March 7, the non-food credit offtake in this year, net of ICICI and ICICI Bank merger effect is Rs. 84562 crores,
compared to same period last year figure of 50786 crores. Thus sensitivity of credit off-take to interest rates is not as
significant as other economic factors.
However, to put emphasis on softer interest rate bias, RBI should reduce bank rate by around 50 basis points to 5.75%
and this would match with the currently prevailing call money rates. The market would similarly expect so.

Repo Rate: The repo rate was reduced thrice last year and is presently at 5%. This should further be reduced by 25 basis
points to 4.75%. The markets might expect 50 basis points cut, but the RBI is unlikely to reduce it by this magnitude.
CRR: Cash Reserve Ratio, which at present stands at 4.75%, is expected to be reduced by 50 basis points to 4.25%, for
the following reasons:

RBI plans to reduce CRR to the statutory minimum level of 3% in a phased manner.
This will provide liquidity support to the tune of around Rs. 6500 crores in the year of fresh borrowing program
of the Government. If Food credit, which in the current year showed an absolute decline, rises, then Banks
might get into some liquidity pressure due to healthy non-food credit offtake coupled with lesser increase in
aggregate deposits, which might be a result of rapid reductions in deposit rates over the last two years.

Some Monetary Policy terms:

Bank Rate
Bank Rate is the rate at which Scheduled commercial banks borrow from the RBI. It is a signaling rate for banks to
determine their lending and deposit rates. Bank rate directly affects the Bank's borrowing costs from RBI and any
decrease in Bank rate spur banks to reduce their lending and deposit rates. A reduction also indicates to banks that RBI is
following a softer interest rate policy.
Cash Reserve Ratio
All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the
cash reserve ratio. The current CRR requirement is 4.75%.
Inflation
Inflation is a measure of price level prevailing in the economy. Higher inflation means higher prices over previous year
level and vice-versa.
Money Supply (M3)
Money supply (M3) refers to amount of currency in the economy and is a sum of currency in circulation with public,
demand and time deposits with banks and other deposits with RBI.
Statutory Liquidity Ratio
It is the ratio of banks investments in Government securities and other approved securities to aggregate deposits. The
currently prescribed level of SLR is 25%.
Repo
A repurchase agreement or ready forward deal is a secured short-term loan by one bank to another against government
securities.
Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing
term, it will buy back the securities at a slightly higher price, the difference in price representing the interest.
To monitor liquidity in the market on a daily basis, RBI conducts LAF (Liquidity Adjustment Facility) repo auction, which are
of 1 day, 3 days and 14 days duration. The current repo rate is 5%.
Open Market Operations
An important instrument of credit control, the Reserve Bank of India purchases and sells securities in open market
operations.

In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of
money, RBI purchases securities.

"EVA - Demystified"
- by Manish Daga *
Introduction
The aim of any organization is to maximize the wealth of the shareholder, who own the organization and expect good
long-term yield on their investment. This goal has often been ignored or at least misinterpreted. Earnings per share and
Return on investment are used as the most important performance measures, although they do not theoretically correlate
with the shareholder value creation very well. Stern Stewart & Co. pioneered the development of Economic Value Added
(EVA) framework, which offers a consistent approach to setting goals and measuring performance, communicating with
investors, evaluating strategies and allocating capital. EVA as a value based performance metric seeks to measure the
periodic performance in terms of change in value. Maximizing EVA means the same as maximizing long-term yield on
shareholders' investment. It is the measure that captures the true economic profit of the organization.
Economic Value Added Defined
Economic Value Added (EVA) may be defined as the net operating profits after tax minus an appropriate charge for the
opportunity cost of all capital invested in an enterprise. Thus,
EVA = Net Operating Profit after tax - Weighted Average Cost of Capital
Weighted average cost of capital is defined as the cost of equity share capital plus the post tax cost of debt multiplied by
the debt equity ratio. Cost of equity capital is the opportunity return from an investment with same risk as the company
has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally
more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest
expenses. EVA can be rewritten as:
EVA = (ROI - WACC) x CAPITAL EMPLOYED
EVA captures the fact that equity should earn at least the return that is commensurate to the risk that the investor takes. In
other words equity capital has to earn at least same return as similarly risky investments at equity markets. If that is not
the case, then there is no real profit made and actually the company operates at a loss from the viewpoint of
shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement because the
shareholders have earned a return that compensates the risk.
Market Value Added Defined
A return greater than the cost of capital adds to the value of the organization. Market Value Added for listed companies
have been defined as the difference between the company's market and book value. In other words if the total market
value of a company is more than the amount of capital invested in it, the company has managed to create shareholder
value. If the case is opposite, the market value is less than capital invested the company has destroyed shareholder
value.
Market Value Added = Company's total Market Value - Capital invested
And with simplifying assumption that market and book value of debt are equal, this is the same as:
Market Value Added = Market Value of Equity - Book Value of Equity
Book value of equity refers to all equity equivalent items like reserves, retained earnings and provisions. In other words, in
this context, all the items that are not debt (interest bearing or non-interest bearing) are classified as equity. Thus market

value added tells us how much has been added or reduced from the shareholder's investment. If a company's rate of
return exceeds its cost of capital, the company will have a positive MVA and will sell on the stock markets with premium
compared to the original capital. On the other hand, companies that have rate of return smaller than their cost of capital
sell with discount compared to the original capital invested in company. Thus whether a company has positive or negative
MVA depends on the level of rate of return compared to the cost of capital. All this applies also to EVA. Thus positive EVA
means also positive MVA and vice versa.
Market Value Added = Present value of all future EVA
This relationship between EVA and MVA has its implications on valuation. By replacing the market value added with the
present value of future EVA we can obtain the value of the company as:
Market Value of Equity = Book Value of Equity + Present value of all future EVA
Diagrammatically it can be shown as:

Advantages of Economic Value Added

Measuring Profits the way shareholders count them: Peter Drucker has put the matter in a Harvard
Business Review article as, "Until a business returns a profit that is greater than its cost of capital, it operates at
a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy
than it devours in resources... Until then it does not create wealth; it destroys it." EVA corrects this error by
explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage.
Management System: EVA can give companies a better focus on how they are performing, its true value
comes in using it as the foundation for a comprehensive financial management system that encompasses all
the policies, procedures, methods and measures that guide operations and strategy. The EVA system covers
the full range of managerial decisions, including strategic planning, allocating capital, pricing acquisitions or
divestitures, setting annual goals-even day-to-day operating decisions. In all cases, the goal of increasing EVA
is paramount and thus removes a lot of confusion.

Financial measure line managers understand: EVA has the advantage of being conceptually simple and
easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a
charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or
assembly line.
Ending the confusion of multiple goals: Most companies use a numbing array of measures to express
financial goals and objectives. Strategic plans often are based on growth in revenues or market share.
Companies may evaluate individual products or lines of business on the basis of gross margins or cash flow.
Business units may be evaluated in terms of return on assets or against a budgeted profit level. Finance
departments usually analyze capital investments in terms of net present value, but weigh prospective
acquisitions against the likely contribution to earnings growth. EVA is the only financial management system
that provides a common language for employees across all operating and staff functions and allows all
management decisions to be modeled, monitored, communicated and compensated in a single and consistent
way - always in terms of the value added to shareholder investment.
Pitfalls of EVA

EVA is a value based measure, and it gives in valuations exactly same the answer as discounted cash flow, the periodic
EVA values still have some accounting distortions because EVA is after all an accounting-based concept, suffering from
the same problems of accounting rate of returns (ROI etc.). In other words the historical asset values that distort ROI do
distort EVA values also. EVA is the excess of ROI over WACC multiplied by the capital employed and thus as the ROI
suffers from serious limitations of wrong periodizing and distortions caused by inflation the same gets incorporated in EVA
also.

Wrong Periodizing: In case on a single project the normal depreciation schedules cause the ROI and
consequently EVA to be small at the beginning of a project and big at the end of the project. ROI is low at the
beginning of the project as the capital base is high while at the latter stages the ROI shoots up because of the
low capital base.
Distortions caused by Inflation and Capital Structure: EVA is affected by the accounting policies. Thus in
long run a higher EVA will be reported if for example R&D costs are charged to the income statements and are
not capitalized. Similarly inflation brings about distortion in the value of assets and affects EVA.

Paradox of EVA: We know that

Market Value of Equity = Book Value of Equity + PV of all future EVA

Thus the EVA valuation has two components book value and future EVA and by increasing the book value of
equity we actually reduce the future EVA because of the capital costs and vice versa.
Implications
EVA is based on the common accounting based items like interest bearing debt, equity capital and net operating profit and
it is usually always good when EVA increases and always bad when EVA decreases. Industries like telecom, forestry
products, pharmaceuticals, semiconductors etc are the ones with very cyclical investments (not smooth over the years)
and/or industries with very long investment horizon suffer most from the pitfalls of EVA. But even in such industries the
EVA financial management system can be successfully implemented with changes in the accounting procedure like
changes in depreciation schedule. In other industries with a lot of current (instead of fixed) assets and with short
investment period EVA can be easily used to the benefit of the shareholders.

* Contributed by Manish Daga,

II Year, Xavier Institute of Management,
Bhubaneswar.

"P/E Ratio Unplugged"

- by Harit Shroff & Suneet Pal Singh *
If you are thinking about stocks you are thinking about P/E ratio. This is one of the most
commonly used valuation multiples in the stock market community. Although very simple to
calculate, it is one with gargantuan implications.
The P/E ratio is the market's assessment of a company's future prospects. It is calculated by
dividing the market price of the stock by the EPS (this figure for EPS excludes extra ordinary
items). The market judges a company on various parameters and assigns a multiple to the
future growth. Why is that Infosys commands such a high multiple say as compared to Polaris?
There are a number of factors on which the market distinguishes between Infosys and Polaris
and then assigns the multiple. What are these factors and how do they affect the valuation of a
company?
There are broadly seven determinants of a stock's P/E ratio. These are:

Growth: This is one of the most important factors that affects the valuation of a
company. The market is always appreciative of a company that is able to define and
achieve its growth path. Hence every company makes an endeavour to increase its
after tax earnings. This is also one of the causes that prompted many Wall Street
companies to fudge their financials to show an increase in the EPS. The market is
always wary of companies that are unable to increase after tax earnings. Thus we
find that HLL, one of the most prominent Indian companies quoting at a low P/E. This
is because the company has been able to maintain its profitability only through cost
cutting and better supply chain management and there has not been much growth in
the top line. This company had at one time been the darling of the bourses but now is
languishing at very low prices.
Dividends: A bird in hand is worth two in the bush. This seems to be the idiom
guiding the Indian investors. A company paying good dividends is generally favoured
by the markets than a company that retains its earnings. Investors want ready cash
and generally discount companies that donot share their earnings. This is one of the
primary reason why MNC stocks command higher P/E than their Indian counterparts.

Stability of Earnings: This is another important determinant of the P/E ratio of a

stock. Stocks, which grow in a stable predictable way, find favour with the investors
and generally command a high P/E. One recent example of this is software
companies, which at one time were commanding very high P/E but are now
languishing primarily because of highly volatile earnings.

ROIC: The basic idea of this concept is to determine the returns generated by the
operating assets of a company. The ROA tries to gauge the returns generated by all
the assets of a company. This includes assets, which are not used in the operations
of a company. However the ROIC aims at judging the performance of a company in
terms of returns generated only by the operating assets. Thus assets such as
marketable securities are excluded in the calculation of the operating assets. A
company with a high ROIC is looked favourably by the markets. Ranbaxy had been
accorded a low P/E as compared to DrReddy labs primary because of low ROIC.

Debt in the capital structure: One of the most significant items in the check list of
Warren Buffett ,the world's most famous investor ,while making an investment
decision is leverage. Presence of reasonable amount of debt in the capital structure

helps to gain the advantages of Trading on Equity. However unreasonable amounts

of debt can lead to fiscal distress. Thus companies with high debt in their capital
structure are looked down by the markets and generally trade at low P/E's.

General Market Trends: This is another significant factor that affects the P/E of a
stock. In the short run the markets are generally irrational in valuing a company.
There are certain sectors that find favour with the markets. For example in the
software boom tech stocks commanded exceedingly high P/E's. The pharma stocks
were in vogue some time back and then it was Bio tech... some sector is in general
fancied by the market.

Interest Rates: The level of interest rates in an economy has a big effect on the price
earning multiple of stocks. With a fall in the level of interest rates the fixed income
market becomes unattractive because of low interest and hence money is diverted to
the stock markets. Also because the fall in the interest rates lowers the interest
burden of the companies there is a surge in their profits.

Though a very useful valuation multiple the P/E ratio must be used with caution. The higher the
P/E the more you are paying for the estimated stream of future earnings. However it must be
remembered that with high P/E the downsides are also high. If estimated earnings are not
realised or if the stock falls out of favour with the stock market then such an investment may
turn out to be an expensive proposition. Suppose, a company goes from a P/E of 50 to 25 but
still maintains an earnings of 1$ a share then the value will fall from 50$ to 25$ even though the
company is in profits. It is essential to keep in mind that the P/E is the net result of a number of
factors and this valuation multiple should be judiciously used along with other valuation
methods.

* Contributed by Harit Shroff, PGPM (2002-2004), MDI, Gurgaon.

and
Suneet Pal Singh, MCKC, Gurgaon.

Securitization in India - Opportunities & Obstacles"

- by V. Sridhar
Part - I
Abstract
Securitization has emerged globally as an important technique for bundling
assets and segregating risks into marketable securities. This paper
discusses the present nascent state of the securitization market in India, its
potential and attempts to identify what needs to be done by various
stakeholders in this market for securitization to grow to its full potential in
India.
Introduction
Securitization is the process of pooling and packaging Financial Assets,
usually relatively illiquid, into liquid marketable securities. Securitization
allows an entity to assign (i.e. sell) its interest in a pool of financial assets
(and the underlying security) to other entities. Figure 1 below presents the

structure of a Collateralized Loan Obligation (CLO) *, a typical securitization

transaction.
Figure 1: Sample CLO structure

In the above CLO transaction, the originator packages a pool of loans and
assigns his interest therein, including the underlying security, to a
bankruptcy remote & tax neutral entity which, in turn, issues securities to
investors. The idea of such an exercise is to completely transfer the interest
in pool of loans to the investors (a "true sale") and achieve a rating higher
than that of the Originator **.
Next
* CLOs are securities backed or collateralized by a diversified portfolio of secured or unsecured loans
made to a variety of corporate commercial and industrial loan customers of one or more lending
banks.
** Structured rating analytical criteria focus on how much credit enhancement is needed to achieve
such a rating, and accompanying legal criteria focus on isolation of the assets from the credit risk of
the seller.

With the help of securitization transaction, an originator can transfer the credit and other risks
associated with the pool of assets securitized. Securitization can provide much needed liquidity to
an Originators balance sheet; help the originator churn its portfolio and make room for fresh
asset creation; obtain better pricing than through a debt-financing route; and help the originator in
proactively managing its asset portfolio. Securitization allows investors to improve their yields
while keeping intact or even improving the quality of investment.
Securitization in India

As of June 30, 2001, the outstanding securitized assets in the US were over USD 5 trillion (ABS USD 1.2 trillion, MBS - USD 3.8)[3], a staggering 25% of all debt outstanding. For India, this
figure is a paltry 1.6% with less than INR 100 billion of outstanding securitized debt. [3]
While there has been a lot of discussion about the potential of securitization in India, actual deal
activity has not kept pace. While some early adopters like ICICI, TELCO and Citibank have been
actively pursuing securitization, almost all the transactions in the market so far have been
privately placed with a majority of them being bilateral fully bought out deals.
Lack of appropriate legislation and legal clarity, unclear accounting treatment, high incidence of
stamp duties making transactions unviable, lack of understanding of the instrument amongst
investors, originators and, till recently, even rating agencies are some of the glaring reasons for
the lack of activity in the area of securitization in India.
Need for Securitization in India
The generic benefits of securitization for Originators and investors have been discussed above. In
the Indian context, securitization is the only ray of hope for funding resource starved infrastructure
sectors like Power *. For power utilities burdened with delinquent receivables from state electricity
boards (SEBs), securitization seems to be the only hope of meeting resource requirements. As on
December 31, 1998, overall SEB dues only to the central agencies were over Rs. 184 billion [1].
Securitization can help Indian borrowers with international assets in piercing the sovereign rating
and placing an investment grade structure. An example, albeit failed, is that of Air Indias aborted
attempt to securitize its North American ticket receivables. Such structured transactions can help
premier corporates to obtain a superior pricing than a borrowing based on their non-investment
grade corporate rating.
A market for Mortgage backed Securities (MBS) in India can help large Indian housing finance
companies (HFCs) in churning their portfolios and focus on what they know best - fresh asset
origination. Indian HFCs have traditionally relied on bond finance and loans from the National
Housing Bank (NHB). MBS can provide a vital source of funds for the HFCs.
After the merger of Indias largest financial institution ICICI with ICICI Bank, ICICI, faced with SLR
and other requirements, is actively seeking to launch a CLO to reduce its overall asset exposure
[6]. It appears to be only a matter of time before other Public Financial Institutions merge with
other banks. Such mergers would result in the need for more CDOs in the foreseeable future.
Current Securitization activity in India
To analyze the potential of securitization India, we split the securitization market into the following
four broad areas: Asset Backed Securities (ABS)
Asset backed Securities are the most general class of securitization transactions. The asset in
question could vary from Auto Loan/Lease/Hire Purchase, Credit Card, Consumer Loan, student
loan, healthcare receivables and ticket receivables to even future asset receivables. The split of
outstanding ABS in the US is given in Figure 2.

In the Indian context, there has been moderate amount of activity on the Auto Loan securitization
front. Companies like TELCO, Ashok Leyland Finance, Kotak Mahindra and Magma Leasing
have been securitizing their portfolio of auto loans to buyers like ICICI and Citibank over the past
2-3 years, with several of the recent transactions rated by rating agencies like CRISIL and ICRA.
While many of the deals are bilateral portfolio buyouts, ICICI has used the SPV structure * and
placed the issuance privately to corporate investors and banks.
In April last year, Global Tele-Systems Ltd. raised approximately USD 32 million by securitizing
the future receivables of its consumer telecom business to an SPV named Integrated Call
Management Centre. Tata Finance was the sole investor in the passthrough certificates issued by
the SPV.
One of the first publicized structured finance transactions in India was the Rs. 4.09 billion non
convertible debenture program by India Infrastructure Developers Ltd (IIDL), an SPV set up for
building and operating a 90 MW captive co-generation power plant for IPCL (March, 1999). IIDL
raised finances on the BOLT (Build Operate Lease Transfer) model on the strength of its future
cash flows from IPCL and limited support from L&T. The transaction was rated AA- (SO) by
CRISIL.
ICICI has done several bilateral asset backed securitization deals including securitizing DOT
(Department of Telegraph) receivables from Sterlite Industries and Usha Beltron.
While the activity in the ABS market is picking up in India, the number of investors for securitized
paper is very limited. In the absence of a Securitization Act, there are taxation and legal
uncertainties with the securitization vehicle. In India, transfer of secured assets as required for
securitization, can attract a stamp duty as high as 10% in some states precluding transaction
possibilities. With favorable legislation and taxation regime, the ABS market in India can hope to
see a lot of activity in future.
Mortgage Backed Securities (MBS, RMBS, CMBS)
As we discussed above, MBS constitutes about 76% of the securitized debt market in the US. In
contrast, the MBS market in India is nascent - National Housing Bank (NHB), in partnership with
HDFC and LIC Housing Finance, issued Indias first MBS issuance in August 2000 *.
The potential of MBS in India, however, is huge. With NHB actively looking towards the
development of a Secondary Mortgage Market (SMM) in the country [2], the MBS market in India
could soon overtake the other securitization transactions in the country. An MBS market can help

small HFCs with good origination capabilities and limited balance sheet strength in staying
profitable and concentrate on the housing loan origination. The most important roadblocks for
MBS in India are lack of mortgage foreclosure norms and the high incidence of stamp duty for
assignment of mortgage necessary for securitization.
Collateralized Debt Obligations (CDO, CLO, CBO)
In this era of bank consolidations, CDOs can help banks to proactively manage their portfolio.
CDOs can also help banks in restructuring their stressed assets. ICICI made an aborted attempt
to do a CBO issuance in August 2000. The CDO market in India is, however, likely to grow slowly
owing to its complexities. The taxation and accounting treatment for CDOs needs to be clarified.
Asset Backed Commercial Paper (ABCP)
Asset Backed Commercial Paper (ABCP) is usually issued by Special Purpose Entities (ABCP
Conduits) set up and administered by banks to raise cheaper finances for their clients **. ABCP
conduits are usually ongoing concerns with new CP issuances taking out the previous ones.
Apart from legal requirements, an active ABCP market requires a large number of investors who
understand the instrument and have appetite. Indias securitization market may not be mature
currently for instruments like ABCPs.
Next
* The deal size was Rs. 10.35 billion comprising 11,106 individual housing loans HDFC and LIC Housing finance Ltd.
** An ABCP conduit issues commercial paper to finance the purchase of assets ranging from credit card, auto and trade
receivables to CBO and CLOs.

The Obstacles & Policy recommendations

Lack of appropriate legislation
As we discussed earlier, there are no laws specially governing securitization transactions in India.
The Government of India constituted a Working Group on Asset Securitization in July 2000. This
Working Group submitted a comprehensive draft Securitization Bill to the Government. However,
the bill has not been tabled in the parliament yet. A comprehensive securitization Act can give a
much-needed thrust to securitization activity in India. The following are the key areas where
legislation is required: a) True Sale (Isolation from bankruptcy of the Originator)
The central idea of a securitization transaction is to isolate the assets of the Originator from
Originators balance sheet and seek a higher credit rating than the Originators own rating. A key
requirement for that is to achieve a "true sale" of the assets to the Special Purpose Entity.
b) Tax neutral bankruptcy remote SPE
The special purpose entity that buys assets from the Originator should be a bankruptcy remote
conduit for distributing the income from the assets to the investors. While banks have
experimented with company revocable trust and mutual fund structures, no clear vehicle has
emerged for performing securitization. This should be addressed by the Securitization act.
c) Stamp Duties

Stamp Duty is a state subject in India. Stamp Duties on transfer of assets in securitization can
often make a transaction unviable. While five Indian states have recognized the special nature of
securitization transactions and have reduced the stamp duties for them, other states still operate
at stamp duties as high as 10% for transfer of secured receivables. The Working Group of RBI
has recommended a uniform rate of 0.1% duty on all transactions. The acceptance of these
recommendations by other states can boost the securitization activity in India especially in the
MBS area.
d) Taxation & Accounting
At present there are no special laws governing recognition of income of various entities in a
securitization transaction. Certain trust SPE structures actually can result in double taxation and
make a transaction unviable. The Securitization Act, when it comes to force, should address all
taxation matters relating to securitization.
Securitization legislation should also specify requirements for off balance sheet treatment for
securitization and regulatory capital requirements for Originator and Investors.
e) Eligibility
Only recently Mutual funds have been allowed to invest in PTCs. The government should lay
down norms governing investment eligibility for various securitization instruments.
Debt market
Lack of a sophisticated debt market is always a drawback for securitization for lack of benchmark
yield curve for pricing. The appetite for long ended exposures (above 10 years) is very low in the
Indian debt market requiring the Originator to subscribe to the bulk of the long ended portion of
the financial flows. The development of the Indian debt market would naturally increase the
securitization activity in India.
Lack of Investor Appetite
Investor awareness and understanding of securitization is very low. RBI, key drivers of
securitization in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should
actively educate corporate investors about securitization. Mandatory rating of all structured
obligations would also give investors much needed assurance about transactions. Once the
private placement market for securitized paper gathers momentum, public retail securitization
issuances would become a possibility.
Conclusions
The securitization market in India, though in its infancy, holds great promise especially in the MBS
area. While more complex securitization transactions and public issuance of securitized paper are
still a distant dream, appropriate legislation and investor education can give the securitization
market in India a much-needed thrust.

Beta - A Simplified Analysis"

- by Pinak Rudra Bhattacharyya *

The true measure of the performance of a firm is the value created by a firm
over a period of time. However the value of a firm largely depends on the
value of beta which denotes the riskiness of the stock of a firm vis--vis
market. However a firm is largely prone to unsystematic risk which tends to
affect individual firms over a large period of time. Over a long period the firm
is however able to break free from the shackles of such unsystematic risk.
But it must be admitted that the firm continues to suffer from market risk
which affects the entire market portfolio. Even MM proposition I and II
strongly depend on proper valuation of beta particularly in determining the
value of an all equity firm. MM proposition measures value of firm in a world
of corporate taxes as

But the question that arises is how should beta measured to determine the
actual riskiness of a stock?
One approach usually taken is the stock market approach wherein beta is
taken as the sensitivity of stock movement to market indexes beta is
measured as:
Beta = COV (i, m)/Variance (m)
Where I = ith stock and m = market movement.
It must be admitted that this method is perhaps one of the easiest to put into
action. However this method takes a myopic view of beta as it considers
only the past performance of an individual firm vis--vis the market.
Moreover unsystematic risk is inherent in these methods of beta or firm
analysis.
Therefore, the question that must plague any researcher is what is the
definite approach to go forward? Perhaps the best measure in such
circumstances is the valuation of beta using the bottom up approach which
will help to not only to overcome the unsystematic risk but will also help to
have stable beta taking into account the perspective of the entire industry.
This can be accomplished in a simple five stage process:
1. Look for comparable firms in the same industry. Preferably the firms
should be belonging to the same quartile in the industry.
Comparable parameters may be sales, profits, installed capacity etc.
2. Compute the historical beta using stock market index and relevant
stock movement of comparable firms. This will give us Beta equity

3. Unlever the beta using the formula:

This will give us Beta Assets.
4. Find out the Market value weighted capitalization of Beta Assets
using the market values of all the comparable firms mentioned

above. This will give us a stable industry Beta Assets thus

eliminating unsystematic risk.
5. Finally beta may be levered using the formula mentioned in (3) to
get back Beta assets of individual firms.
This can be amply demonstrated by an example taken from the Indian fertilizer industry.
Statement Showing Calculation of Beta (Using Bottom Up Approach)
Beta Equity
Name of (From stock
Company & market
movements)

Debt/
Equity Beta
(Market (Assets)
Value)

Market
Value of
Firm (in
cr)

Market
Beta Equity
Industry
Value
(From
Beta
Weighted
Bottom-up
Assets
Avg. Beta
Approach)

Chambal
Fertilizes &
0.3
Chemicals
Ltd.

0.671

0.208892 738.92

0.025667 0.491715 0.70617684

Gujarat
Narmada
Valley

0.92

0.497

0.695363 720.66

0.083331 0.491715 0.65056385

GSFC

0.84

0.7765

0.558242 422.86

0.039254 0.491715 0.73989622

NFL

0.30514 0

1717.02 0

0.491715 0.58924253

Oswal
Chemical & 0.58
Fertilizer

0.9548

0.357888 108.12

RCF Ltd.

0.212

0.878889 2306.06 0.337029 0.491715 0.5594736

0.006435 0.491715 0.79688355

In this example a set of five firms have been taken from the Indian Fertilizer Industry. The bottom
up approach has been used in the computation of Beta.
If we analyze the calculations here we find that there are significant differences in the value of
beta that we get in our analysis. For example Chambal Fertilizes & Chemicals Ltd of only 0.3 this
is highly understated. The correct evaluation of beta shows that its beta is around 0.7 similarly for
Gujarat Narmada and GSFC, the value of beta is overstated which might affect adversely the
value of the firm.
However, it is imperative to note that although this method tries to eliminate some of the problems
in the existing method of analysis. It is by no foolproof. Analysis of comparable firms can be a
highly subjective process. It is also observed that the consideration of Beta Assets for the industry
and its use to relever beta makes hardly any sense as each firm is unique and deserves to be
evaluated on the basis of its unique profile.
In spite of these faults, such a mode of valuation should always be considered as it makes
valuation objective and tries to eliminate some of the defects in the existing system.

* Contributed by Pinak Rudra Bhattacharyya,

Ist Year,
IMT Ghaziabad.

Basic E-S-C Analysis

- by Nidhi Sharma *
Page - 1
Several hundred years ago, mankind, through the creation of money, began
to accumulate capital to build productive facilities that no one person could
afford. This was the beginning of the need for the stock market. Investors
needed a way to sell their investments as their circumstances changed.
From an original arrangement where investments were illiquid, we
now have very liquid markets where investments can be bought and
sold with relative ease and with a fairly low cost of transaction.
Over the last two decades, the common investor has discovered new arenas
of investment. The liberalization and opening up of economy has opened
new doors to the proverbial treasure, apart from the regular orthodox modes.
Most of the investors look for best returns from their investment barring
those orthodox lots who avoid risks. There is a plethora of opportunities
available to park surplus funds, the most interesting and the most volatile
being the stock market.
To invest successfully over a lifetime in the stock market does not require
any unusual business insights or inside information. What is required is faith
in your investment decision and the patience to watch the stock grow. If a
layman follows the general rules to investing, he would be able to make
handsome profits over a period of time. In order to beat the averages, what
is required is an understanding of what we call in financial terminology, E-SC, i.e., Economy-Sector-Company Analysis.
Economy
Before investing, due consideration should be given to the state of the
economy. If the economy is doing well, the money which is invested has a
lesser probability of getting eroded, whereas in an economy which is not
doing well, money invested can be lost if not put in the right companies.
The Indian Economy has significantly grown in recent years. Both social and
economic indicators have reflected their respective positive impact for the
development of the economy. A strong BOP position in recent years has
resulted in a steady accumulation of foreign exchange reserves. The main
contributors to capital account surplus being the banking capital inflows,
foreign institutional investments and other capital inflows.
Page - 2
The stock market has been growing at a fast pace. From 2003 to 2006, the Sensex has risen
from 3000 levels to 9000 plus levels. Steady inflow from the FIIs and confidence of the individual
investors makes investing in India lucrative.
Sector
It has long been the prevalent view that the art of successful investment lies first in the choice of
those industries or sectors that are most likely to grow in the future, and then identifying the most

promising companies in these industries. Also, the sectors should be picked according to your
own comfort zone. Only those sectors should be picked in which you have basic understanding of
the nature and workings of the industry. This understanding helps in making wise decisions about
your investment portfolio as per the changes and movements in the sector. Analysis of a sector
should be done with a lot of caution. A sector, which is bound to get affected most by changes in
government policies and the budget, should be avoided as there are risks associated with such
sectors. But it is not as easy as it looks in retrospect because obvious prospects for physical
growth do not translate into obvious profits for the investors.
Company Analysis
After decades of research, thousands of Equity Analysts and Advisors still debate on one
question: How to pick a stock? The truth is, there is no fool-proof method. There is no infallible
strategy or technique that can guarantee success. The term "fundamentally strong" has been
overused so much that it has somewhat become a clich.
Company Analysis is not as complicated as it seems. A general idea about the financials of the
company and common sense can qualify a layman to use the term "fundamentally strong".
The goal of analyzing a company's fundamentals is to find a stock's "intrinsic value" - a fancy
term for what you believe a stock is really worth - as opposed to the value at which it is being
traded in the marketplace. If the intrinsic value is more than the current share price, it makes
sense to buy the stock.
Investing, like most other things, requires that you have a general philosophy about how to do
things in order to avoid careless errors. Since all individuals differ in their own unique ways, their
philosophies too differ from each other. What might have worked for Mr. Warren Buffet might not
have worked for Mr. Peter Lynch.
The point that I am trying to make is that every investor should have a strategy of his own.
Many Fundamentalists rightly believe that when you buy a share of stock, you are buying a
proportional share in a business. So stock selection, according to them, is determined purely on
the financial health of the company, i.e., its cash flow, dividends, liquidity, returns on capital, book
value, etc. There are several steps associated with fundamental analysis following which decent
returns can be earned over a period of time.
Over the last few decades, tonnes of research papers have been published by various Analysts
on Equity Analysis. These Analysts can be broadly classified into seven categories, i.e., Value
Investors, Growth Investors, Income Investors, GARP Investors (Growth at a Reasonable Price),
Quality Investors, Momentum Investors, and of course, CANSLIM Followers. The logic behind
their mandate is quite similar to one another, and more often than not, Analysts use a
combination of the above-mentioned techniques to forecast future earnings and growth.
For the sake of simplicity, we'll analyze only the common links between these techniques.
The first and the most talked about in financial circles is Book Value of a share. The book value
of a company is theoretically what a company could be sold for, i.e., its liquidation value. Many
times when investors refer to book value, they actually mean book value per share, which is the
shareholder's equity (or book value) divided by the number of shares outstanding. Though there
are many stocks which have a book value higher than that of its market value, but on the whole
such companies have poor financial health and can be considered penny stocks.

The second important criteria is Earnings Per Share (EPS). EPS is nothing but the earnings of a
company over a year divided by the total number of shares outstanding. The higher the EPS, the
wider is the grin on an investors face.
The third is Price/Equity Ratio (P/E). EPS alone means absolutely nothing. In order to
get a sense of how expensive or cheap a stock is, investors look at earnings relative to
the stock price. To do this, most investors employ the price/earnings (P/E) ratio. The P/E ratio
takes the stock price and divides it by the EPS. This P/E ratio is then compared to the P/Es of
other companies in the same sector to get an idea of how the company is valued as opposed to
its peers.
Another criteria for stock selection is the Market Capitalization, which is the total number of
shares multiplied by the present value of the stock. On the basis of Market Capitalization,
classification can be made in terms of the size of the company (small cap, mid cap, large cap,
nano cap, etc.). Some investors use this classification to base their buying decisions.
Dividend Yield is another criteria Income Investors lay a lot of stress on. It is the ratio of a
company's annual cash dividends divided by its current stock price expressed in the form of a
percentage. Many investors prefer to invest in non-volatile companies with assured dividends.
Then there are other criteria like beta, revenue, sales, volume, management of the company and
shareholding pattern which need no explanation.
A very important and significant factor is the nature of business of the company. In case of a
manufacturing company, capacity utilization, cost of the product relative to the peers and
correlation of the stock to stocks in other sectors also play a major role in the investment
decision. Especially if the investor want to diversify his portfolio in, the lower the correlation of
securities in the portfolio, the less risky the portfolio would be. This is true regardless of how risky
the stocks of the portfolio are when analyzed in isolation.
To generate maximum returns, an Investor must learn how to calculate risk. The general
guidelines to investing are just a tool which can be handy while picking stocks. There are many
factors which effect a stock's performance. The trick to investing is to guage with reasonable
amount of accuracy when to hold a stock and when to sell it off.
Even the most astute investors across the globe have an accuracy rate of around eighty
percent. The more companies you analyze, the better you will get at it.
To conclude, I would just like to say, successful investing is about managing risk, not avoiding it.
And these days, headlines in newspapers are full of fearful facts and unresolved risks:
geopolitical situations, inflation and fear of a bear market. Investors have never liked uncertainty,
yet it is the most enduring condition of the investing world. It always has been, and will always be.
To be an investor, you must be a believer in a better tomorrow.
Concluded.

* Contributed by Nidhi Sharma,

MBA (Global), Batch 2005-07,
IMT, Nagpur.

Effect of Globalization on Asian Markets (India, Hong Kong, Japan)

& the Diary of Recent Indian Stock Slump
- by Viswanath G. K. Akella *
Page - 1
It's true that opening up of capital markets, i.e., attracting FIIs would improve a country's
economy, and India also opened up its markets since 1990s. Since then, FIIs invested heavily in
Indian stock equity and the market's dependency on the FIIs increased equally. With the help of
globalization, the stock markets around the world became correlated to an astounding degree.
Now the correlation between DJ index and emerging market's indices is around 90%.
Figure 1 shows the stock indices of BSE and DJIA since April 17, 2006. It can be observed that
when there is a dip in DJIA by 1%, there is almost a dip of 10% in sensex, Figure 2 shows that
the correlation between these two indices since April 17th is found to be 93%. The fact that
emerging markets (majorly South Asian markets) are dependent heavily on the US markets as
can be viewed from Figure 3. It can be interpreted that if there is a little dip in DJIA, soon
afterwards, markets in Japan, Hong Kong and Mumbai will dip.

Figure 1: BSE Sensex & DJIA Points Since April 17th

Page - 2

Figure 2: DJIA & Sensex % Change Since Last 3 Months

Figure 3: Stock Indices of Japan, Mumbai, Hong Kong & US Since Last 3 Months
Page - 3
Generally, Asian companies are listed through American Depository Receipts in US Stock
Exchange. Almost all the top-notch Indian companies that constitute the BSE 30 are listed
through ADRs in US (there are approximately 80). So if the Dow dips or rises, Indian ADRs too
dance to the same tune (not always, but in general).

Its evident that globalization has interlinked countries to such an extent that any change in
the major stock market will reflect changes in the others too. Trade and capital flows have
increased to enormous volumes. As US accounts for more than 1/4th of the world's GDP show,
any little change in US stocks will immediately show on the other emerging markets. Increased
investments in US will enhance software developments and BPO industries in India. Good growth
in US economy will improve the tourism industry around the world. Any decision by US Fed
(monetary policies) will affect the performance of other markets.
In May '06, when US Fed members hinted about the concerns of inflation, markets crashed
across the world (of course there was little effect on European markets). Investors interpreted this
to mean higher interest rates, more savings in the bank, lesser investments by public/firms,
slower the economic growth. It may be that this is a test by US Fed to check their influence on
other economies. Now US is in a position to threaten any country directly (war) or indirectly
(hurting economies), and India may have to revisit their policies to reduce the influence of FIIs on
the country's growth.
Globalization brings in many advantages, and Indian companies have gained hugely with the
access to global capital markets. India itself is propelling with growth in all sectors because of the
reforms bought in by government due to the pressure of FIIs. But there are also few
disadvantages, like loss of control on the nation's economy. It would be better if RBI takes this
point seriously and finds out the ways to cut down the dependency of our economy on FIIs.
Page - 4

Figure 4: Diary of Events of the Recent Indian Stock Slump

Is Mergers and Acquisitions a Growth Strategy?

- by Ravi Kumar *
Page - 1
Companies that do not pay attention to the key issues often find a merger or
acquisition to be an expensive failure.
Merger of two companies is like, a male (Company A) and a female
(Company B) of equal strengths getting married (Merged) to add
value (Strengthening their position in Market place) in their life. Acquisition
on the other hand can be more like a male dominating a female or a female
dominating a male in the course of getting married, thereby adding value in
their life journey. The question here is whether the Merger and Acquisition is
going to add value to the organization or its going to be a failure in the
longer run.
Happiness is one of the basic parameters used to measure a successful
marriage life. Mind you, happiness here doesnt only mean individuals
happiness but also includes the overall happiness of the family. Similarly,
Merger and Acquisition success can also be measured on the growth of the
company, which depends upon the employee and other stakeholders
happiness.
In todays competitive environment, due to globalization all seem to be in a
hurry to become global size players within a short time. Presently, India has
the second highest growth rate in M&A, with only Japan ahead of it in the
first half of the FY 2005. In the IT sector, there were around 43 deals with
respect to Mergers and Acquisitions. From the above details, we can find
that companies are looking at Mergers and Acquisitions as a strategic tool to
develop their businesses, and to compete with major players in the global
market.
Mergers and Acquisitions can be considered as an inorganic method by
which companies try entering into newer markets, or try consolidating their
positions in existing markets, there by positioning themselves as more
important players in their segments. This also provides them competitive
advantage over other companies in different product segments, there by
increasing their stockholders' wealth. All the above information related to
Merger and Acquisition shows mostly the happiest moment of their journey,
but not the true picture of their relationship.
Merger or Acquisition at times can be a failure due to various reasons, but a
successful merger is possible if both the companies decide to continue their
relationship even after their honeymoon. Even if any differences occur in
their relationship, they should be tolerant and highly matured to overcome,
especially the cultural aspects, management styles and their position.
The latest example in the Indian IT Business scenario is Wipro Acquiring QuanTech (company
providing services in the area of CAD/CAM), New Logic, and Enabler. Further, in the last six
months they have acquired four companies. The sizes of the acquisitions are bigger in terms of

market ratings. They are confident that they will derive significant value from these companies in
the upcoming years.
These acquisitions were meant to build certain geographical footprint, particularly in
Europe. Through acquisitions, Wipro is also looking at building domain expertise,
acquiring intellectual property and patents, and basically strengthening its consultancy skills.
Acquisitions are done to help to be compatible with industry growth rates. Looking at revenues
after Acquisition, there was a slight increase in Wipros overall revenue by two percent. Their
business strategy is to acquire companies with a range of business that were not present in their
vertical. They are also looking for second tier cities to expand their operation, in order to minimize
costs. To reap maximum benefits, Wipro has to work closely with the employees to understand
their grievances and expectations after Acquisition.
Similarly, Satyam Computers acquired two companies, Knowledge Dynamics, a high-end
consulting solutions provider in Business Intelligence, and Citisoft, a highly specialized European
business and systems consulting firm. Acquiring companies of different countries is not always
going to provide better ROI. The reasons like high pay package, less working hours, strict law
policies are going to be major threats to the Indian IT top management in building their
businesses in foreign soils. Extracting maximum value from the second and third tier organization
is going to be a tough bargain.
IBM's acquisition of Daksh, a call centre in India, provided competitive edge to them over other
companies. Presently, Indus Logic, a US Company, acquired Lambent Technologies in India (a
company providing engineering services for the mobile industry) helping the company to get key
clients like Sony, Autodesk. For companies situated in countries like USA, Europe, etc., acquiring
companies in India and extracting benefits from them is not going to be as tough as for their
Indian counter-parts. The simple reason is that they compensate by providing higher salary and
bonus to employees working here. Hence, some Indian workers who give preference to higher
salary rather than quality work can be easily managed in case of problems arising out of
Acquisition. This is more like people who feel happy in getting Dowry from their partner.
Another typical case is the HP-Compaq merger which was not as successful as expected by
industry analysts. After merger, the top-level management thought that they can become market
leaders in higher segment (high-end server market) as well as lower segment (PCs, Printers) by
pushing down IBM, Sun Microsystems and Dell from their positions.
They could not do it as expected, and their strategic plan failed totally, they were losing
revenues in many parts of their business units. The share price of the company drastically
lowered after the merger took place. The reason is that, IBM, Sun Microsystems, Dell and Canon
provided a tough strategic entry barrier to HP-Compaq plans by announcing their strategic
initiatives to enter into different business segments of HP-Compaq. Apart from that there were
many inner conflicts in their technology units and they were unable to convince their employees.
If relationship after marriage is to last and happiness is to prevail forever, the members in the
family should learn to cooperate and help each other, even at tougher moments. Families with
good values and happiness imbibed in their system always remain a reason of envy to others.
Similarly, companies with good value system and the ability to understand and react towards
cultural differences can really see a successful Merger or Acquisition implementation taking
place, there by formation of a bigger and healthy family (organization).
Page - 1

Despite the growing presence of hedge funds in the world, financial and investment
circles' hedge funds are still enveloped in a veil of mystery. This article discusses the
basic hedge fund structure, and also reviews their present state in INDIA, and the various
regulations that they are subjected to.
Introduction
A hedge fund can be defined as an investment structure that manages a private unregistered pool
and compensates the fund manager with an incentive-based fee based on a percentage of the
profits earned by the fund.
Hedge funds, in general, are not registered. They have avoided registration by limiting the
number of investors and requiring that their investors meet an income or a net worth standard.
Furthermore, hedge funds are also prohibited from soliciting or advertising to the general
audience. The primary aim of most hedge funds is to reduce volatility and risk while attempting to
preserve capital, and deliver positive returns under all market conditions.
How They Work
To achieve pre-set returns target, these funds do not restrict themselves to their country of origin
and operate on a global scale. Hedge fund managers typically seek absolute positive investment
performance. This means that, the hedge funds target a specific range of performance, and
attempt to produce targeted returns irrespective of the stock market trends. This is in contrast to
investments by mutual funds, where success or failure is often measured in terms of performance
in relation to a stock index, like the Sensex or Nifty.

Next
The hedge fund structure helps the investor turn market opportunities into investment returns.
The investor brings funds to the industry, these funds are pooled in investment structures called
hedge funds, and this structure gives the investor access to hedge fund managers who provide
investment expertise and use alternative investment strategies.

For investors, this structure

helps pool assets with those of other investors

is a way to access talented hedge fund managers

is a method to access the alternative investment strategies used by the manager

Only for Heavy-weights (The Investment Size)

Hedge funds specifically target high net worth investors with huge investible corpus. Most of
these funds limit the number of investors by setting a high minimum investment. The minimum
investment size for hedge funds ranges from $100,000 to $10 million. Huge inflows are required
because of the risks and the type of instruments they deal in.
As most hedge funds do not allow their corpus size to exceed $100 million, they normally allow
only about 100 investors.
Lock-up Periods
A lock-up period is the length of the time that investors must remain invested before their
investments can be redeemed. The lock-up period for the hedge fund ranges from 6 months to 5
years.
For example, if the lock period is one year, an investor who invests on April 1 cannot redeem until
March 31 of the next year.
Fees & Expenses
These funds have a dual fee structure, i.e., they normally charge two types of fees - a
management fee and an incentive fee. The management fee is based on a percentage of the
assets in the fund, usually 1% or 2% each year. This fee is automatically deducted pro rata from
each investor's account.
The incentive fee is the hedge fund manager's share in the funds' profits, which is usually
20%, depending on the relationship with the investors.
Two terms should be noted in case of incentive fees - hurdle rate and high water mark. A hurdle is
the return that must be earned each year before the manager starts participating in the profits.
Use of a high water mark requires a manager to attain performance above the highest previous
level before earning additional incentive fees.
Specialization
Most hedge fund managers are highly specialized and trade only within their area of expertise
and competitive advantage. Hedge funds benefit by heavily weighting hedge fund managers'
remuneration towards performance incentives, thus, attracting the best brains in the investment
business. In addition, hedge fund managers usually have their own money invested in their fund.
Lack of Liquidity

Liquidity here means the time periods for which investors may redeem their investments and
have their money returned from the fund.
Most of the hedge funds suffer from low liquidity. Usually, hedge funds open their 'redemption
window' two to four times a year, for a few days.
The investors also have to take into account the notice period that they are required to observe
before they redeem their investment. For example, if the fund allows the investor a redemption at
the end of each quarter and a 30 day notice, an investor wishing to redeem on September 30
must notify the fund by August 31.
Seek Absolute Returns
Hedge funds seek positive absolute returns regardless of the performance of an index or sector
benchmark. Unlike mutual funds which are "long-only" (make only buy-sell decisions), a hedge
fund has more aggressive strategies and positions, such as short selling, trading in derivative
instruments like options, and using leverage (borrowing) to enhance the risk/reward profile of their
bets.
The absolute return goals of hedge funds vary, but a goal might be stated as something
like "6 to 9% annualized return regardless of the market conditions".
The absolute returns that are promised by hedge funds are due to no restrictions with respect to
investment positions, liquidity, fee structure, and registration.
No reliable estimates exist of the number of hedge funds and the value of hedge fund capital.
Commercial services that report on hedge funds rely on fund managers for information. This may
bias upward average returns, since the worst performing managers are least likely to provide
information.
Above all, there is the problem of who to include. Should one include individuals or family groups
taking highly levered positions? Should one include limited partnerships or limited liability
companies that invest primarily in assets other than public securities and financial derivatives, or
which do not use leverage or short selling? Should one include managed future funds, which limit
their activities to future markets? Differences in how the various commercial services answer
these questions help to account for their widely varying estimates of the total number of hedge
funds and hedge fund capital under management.
Scenario in India
There is a sense of shock and awe amongst most participants in the Indian markets whenever
they refer to hedge funds. What is it that gives these funds such an aura?
Hedge funds come into the limelight whenever the markets go into an overdrive, either upward or
downward. In any case, the emergence of hedge funds in the Indian market can be viewed as a
sign of the domestic market's realignment with the global market.
Another fact that must be taken into account is the likely impact these funds will have on
other institutional investors in the market. With the entry of these fast-moving funds into
the market, other institutional players might be forced to realign their investment style to a shorter
duration. They might be constrained to keep booking profits regularly due to the fear of a sudden
sell-off by hedge funds. This, in turn, will boost speculative trading.

Furthermore, in order to match the very high returns generated by these funds, some of the
institutional players may adopt a high risk-high reward strategy without having adequate expertise
as compared to hedge funds.
Due to globalization and economic liberalization, many developing countries have experienced
financial turbulence caused by the operations of hedge funds. In India, a common opinion is that
these market players might bring in too much volatility in the market.
To prevent such a situation, SEBI has penned down certain rules regarding the operation of
hedge funds in India: At least 20 per cent of the corpus of hedge funds seeking to register in India as foreign
institutional investors should be contributed by pension funds, university funds, charitable trusts,
endowments, banks, and insurance companies.
The presence of institutional investors in the fund may help the fund managers to take a longterm perspective of the market and also ensure better governance on the part of the fund
manager and fund administrators.

The investment advisor to hedge funds should be regulated. Investment advisors under the
relevant Investor Advisor Act or the fund should be registered under the Collective Investment
Fund Regulations or Investment Companies Act.

Another criteria is that the fund should be broad-based, meaning it should invest in a basket of
30-40 stocks. This stipulation arises because hedge funds, which seek absolute returns, usually
invest in a few stocks that catch their fancy.

SEBI's FII regulations require a more broad-based investment philosophy.

The rules also say that the fund manager or investment advisor must have a minimum threeyear track record in managing funds with an investment strategy that is similar to that of the
applicant fund.

According to SEBI, this provision is expected to allow well-managed funds to access the market
and at the same time, keep the markets insulated from the possible adverse effects of 'trial and
errors' by uninitiated rookies.
Recently, hedge funds have been showing interest in the private markets and are looking to
invest in unlisted companies. They have realized that there is huge potential in this sector and
with just a handful of private equity investors in India, there are a lot of investment opportunities to
be tapped among private companies. These funds have people who are capable of identifying
new investment options and valuations differences. But they generally do not have partners with
operational expertise of running companies - something that most private equity investors have.
However, this has not prevented hedge funds from aligning themselves with venture capital and
private equity funds. Some of the new offerings to investors by hedge funds are positioned as
"venture hedge funds". These new funds invest in both short- and long-term assets to leverage
the short-term earning in true-blue hedge fund style, while gaining from long-term profits from
ventures, and to deliver returns consistently and regularly over their life cycle. Also, with
secondary markets at a historic high, hedge funds are looking at new investment options in the
country.

Hedge funds cause steep dips in prices, whenever they exit the markets, shaking sentiments
badly. Also, the activities, modus operandi, and even the identities of these players are kept a
secret.
However, one of the pluses of hedge funds is that they provide a lot of liquidity, which
enhances the price discovery mechanism at the bourses. While their operations do result
in unlocking the potential value of stocks, it is normally only in the short term. Also, they aim for
absolute returns - in most cases a certain percentage return, year in and year out, regardless of
how well the market does and since hedge funds do not track the market on a pin-point basis and
undertake high-speed entries and exits, they guard the investor's portfolio from the vagaries of
market trends.

Page - 1
Introduction
Microfinancing is the provision of financial services to poor and low income households without
access to formal financial institutions.
As defined by the Asian Development Bank (ADB), it is - A provision of a broad range of financial
services such as deposits, loans, payment services, money transfers, and insurance to poor and
low-income households and their micro-enterprises. In the late 90s, numerous agencies
involved in micro-financing operations in India started adding other financial services, including
micro-insurance to its micro-finance operations.
The situation of micro-financing in India has thereby improved with certain steps taken by the
government and now, the private players, banks etc as well.
Need for Micro - Financing
Since independence, various governments in India have experimented with a large number of
grant and subsidy based poverty alleviation programmes. These programmes were based on
grant/subsidy and the credit linkage was through commercial banks only. As a result, these
programmes became unsustainable, perpetuated a dependant status on the beneficiaries and
depended ultimately on the govt. employees for delivery. This not only led to misuse of both credit
and subsidy but banks never looked at it as a profitable and commercial activity as well.
Hence was adopted the concept of micro-credit in India. Success stories in neighboring countries,
like Grameen Bank in Bangladesh, Bank Rakiat in Indonesia, Commercial & Industrial Bank in
Philippines etc, gave further boost to the concept in India in the 1980s. India thus adopted the
similar model of extending credit to the poorest sector and took a no. of steps to promote microfinancing in the country.
Types of Organizations and Composition of the Sector
Microfinance providers in India can be classified under three broad categories: formal,
semiformal, and informal.
Formal Sector

The formal sector comprises of the banks such as NABARD, SIDBI and other regional rural
banks (RRBs).
They primarily provide credit for assistance in agriculture and micro-enterprise
development and primarily target the poor. Their deposits at around Rs. 350billion and of
that, around Rs. 250billion has been given as advances. They charge an interest of 12-13.5% but
if we include the transaction costs (number of visits to banks, compulsory savings and costs
incurred for payments to animators/staff/local leaders etc) they come out to be as high as 2124%.
Semi - formal Sector
The majority of institutional microfinance providers in India are semi-formal organizations broadly
referred to as MFIs. Registered under a variety of legal acts, these organizations greatly differ in
philosophy, size, and capacity. There are over 500 non-government organizations (NGOs)
registered as societies, public trusts, or non-profit companies.
Informal Sector
In addition to friends and family, moneylenders, landlords, and traders constitute the informal
sector. While estimates of their importance vary significantly, it is undeniable that they continue to
play a significant role in the financial lives of the poor.
Steps taken by India to promote micro-financing
It set up development banks, such as SIDBI, NABARD which focused on rural credit and microfinancing. NGOs and SHGs were encouraged to become the govts arm in extending micro-credit
to the poor. They were provided supplementary credit needed to fund the credit, paper work was
reduced between them and the banks. Also, the govt assisted in mobilizing funds from formal
financial institutions to meet the larger credit needs of these organizations.
Focus on Women for micro - credits
A lot of Micro-financing schemes are now increasingly focusing on women primarily as well.
There are compelling reasons for this.
Among the poor, the poor women are the most disadvantaged - they are characterized
by lack of education and access to resources, both of which are required to help them
work their way out of poverty and for upward economic and social mobility.

The problem is more acute for women in countries like India, despite the fact that womens
labor makes a critical contribution to the economy.
Evidence shows that groups of women are better customers than men - they are better
managers of resources - benefits of loans are spread wider among the household if loans are
routed through women - mixed groups are often inappropriate in Indian society - record of allmale groups is worse than that of all-women groups, everywhere.
Current Scenario of Micro - financing in India
With 75 million poor households potentially requiring financial services, the microfinance market
in India is among the largest in the world. Estimates of household credit demand vary from a
minimum of Rs. 2,000 to Rs. 6,000 in rural areas and Rs. 9,000 in urban settings. Given that 80

percent of poor households are located in rural areas, total credit demand ranges between Rs.
255 billion and Rs. 500 billion. However, only Rs.18 billion of this amount has been generated so
far. The reason for this is that major portion for rural crediting has been from the informal sector
and this is at a very high interest rate, thus reducing the volumes of such credits, and by far has
been for investment purposes (13%) and more for family emergencies (29%) and social
expenditures (19%).
There are a number of factors why rural crediting by the formal sector has not taken pace so far.
High fiscal deficits have meant that Government is appropriating a large share of financial
savings for itself.
Persisting interest rate restrictions reduce the attractiveness of lending, particularly to small,
rural clients.
On the other hand, informal credits have been attractive albeit high interest rates due to:

Flexible repayment options

Convenience and frequency with which such loans can be accessed

Less reliance on collateral (only 16.5% of households report providing collateral against the
loan)

Meeting the Demands

Inadequacies in rural access to formal finance and the seemingly extortionary terms of informal
finance for the poor provide a strong need and ample space for innovative approaches to serve
the financial needs of Indias rural poor. A gap of as high as 85%-90% in supply and demand
cannot be closed by only the existing MFIs because many, particularly the younger and smaller
organizations, lack the institutional capacity to expand.
Key Concerns
All said and done however, there are certain key issues that need to be tackled before ensuring
the benefits of micro-financing would reach their optimum levels.
Scaling-Up Microfinance: Microfinancing through formal and semi-formal can reach selfsustainability only when there is substantial volume which they can generate.
Effective policy, legal and regulatory framework - An enabling policy, legal and regulatory
framework is critical to scaling-up. For this the govt. needs to take certain steps as:
Reducing minimum start-up capital requirements to facilitate the transformation of MFIs into
NBFCs

Encouraging multiple sources of equity for MFIs

Developing a set of prudential norms that are more appropriate to institutions serving the poor,
and set up supervision mechanisms around those norms.

Inclusiveness and competition in the microfinance sector can generate high payoff. This will
not only give the borrower a no of options for raising debt, but also drive the costs down to raise
them.
Proven Impact of Micro-financing
The effects of micro-financing trickling down to the poorest of Indians can already be observed in
the Indian economy.
Improvement in Asset Position
The average increase in assets was about 72%, from Rs6,843 to Rs11,793 in real terms (in one
to three years) in most of the households where micro-financing has been extended. Before given
the credit, one in three households had no assets; after that, it changed to one in six.
Increase in Savings
While most households given micro-credits were having negligible or no savings, this improved to
Rs. 160-Rs. 460 and in some cases, the average household savings rose to as high as Rs. 1444.
Changes in Borrowing Patterns
With improvement in above two factors, people were more ready to borrow from the semi-formal
and formal sector rather than their traditional creditors i.e. friends and family, moneylenders,
landlords.
Impact on income
The average net income per household increased from Rs 20177 to Rs. 26889.
Looking Ahead
What will it take for micro credit to become a mainstream mode for lending? One option is to
provide other financial services similarly built around small
amounts of money, such as micro insurance. There is tremendous scope to design welladapted insurance products for the poor in the insurance sector as well. A number of
initiatives that should be taken in this area as :
Mothering of Development Innovations
The institution aims to promote and nurture new ideas on different development themes, which
have larger potential to address the livelihoods and development of the poor in a region viz.,
microfinance, small scale irrigation, dry land agriculture, ICT for poor, working with panchayats.
Promoting Institutions to reach Scale
Exclusive thematic organizations will be promoted to undertake development work with a subsectoral focus. The primary role of the institutions is promotional and to ensure that benefits reach
a large number of poor with quality.
Human Resource Development

The institution would bring young professionals into the development sector and provide them an
opportunity to practice and develop relevant knowledge, attitudes and skills to work long term in
the development sector.
Self help groups today handle Rs.5600 crores of disbursement. Over a quarter of poor Indian
households will by 2009 likely have access to formal financial services if current trends continue.
Hence, with proper regulation and a major thrust given by the govt to provide a suitable
environment for micro-financing, it would certainly bring out the most optimum results in
alleviating poverty from the country and allowing the poorest on Indian in joining the bandwagon
of prosperity and growth, that India is poised to achieve in the years to come.
Concluded.

Contributed by: Varun Ahuja,

FII Inflows - Is It Really Hot Money?

- by Subhasree Chakraborty & Ambar Roy *
Page - 1
Executive Summary
FIIs share in the Indian capital markets has shown a steady increase from
US$ 200 million in 1991-92, to $8.8 billion in 2004. This marked growth in FII
is due to the financial liberalization policies followed by India from 1991
onwards. This buoyant foreign investment flows into the country have
continued to demonstrate the high level of confidence that the international
investors repose in the Indian economy.
A number of new FIIs and FII sub-accounts got registered in 2004.
The most significant new FII registered in 2004 is California Public
Employees Retirement Plan (CalPERS) - the largest pension fund in the US.
CalPERS, which has assets totaling $ 162 billion under its management, has
already started investing in the Indian market. One reason for the surge in
FII inflow is the strengthening of the rupee against the US dollar. The
strengthening of the rupee is due to the weakening of dollar across global
currencies. Until about two years ago, FIIs used to bear losses on their
portfolio investment when the rupee would continuously depreciate. With the
rupee strengthening, that's not the case now.
Debate about FII being "the hot money"
Given the perception about FIIs as market leaders in the domestic stock
market, the increasing importance of FII trading at the margin and the
dominant position of FIIs in the Sensex companies, we can understand that
FIIs are in a position to influence the movement of Sensex in a significant
way. The influence of FIIs on the movement of Sensex became apparent

after the general election in India when the sudden reversal of FII flows
triggered a panic reaction, which resulted in very high volatility in the Indian
stock market. During this period, the Sensex experienced its worst singleday decline in its history and in the three-month period between April to June
2004, it declined by about 17 percent. And it all started because of the
selling pressure exerted by the FIIs after the post election phase when they
became less confident about the continuation of reform process in India.
Page - 2
The following figure shows the relation between the Sensex and the FII Inflows for 2004

However, when we look at the shareholding pattern of FIIs in the Sensex companies, we see that
the shareholding pattern of FIIs have remained relatively unchanged between March and June
2004.
Change in FII Shareholding in Sensex companies for March - June 2004

Moreover, even sharp changes in Sensex do not necessarily indicate a significant alteration of
actual shareholding pattern of different investor groups even in the Sensex companies
In the first year of the crisis, 1997-98, there was a large FII net inflow of $1,828 million. In the
second and worst year, 1998-99, there was a tiny outflow of $68 million. And in the last year of
the crisis, 1999-2000, there was again a net inflow of $3,024 million.
FIIs would love to sell at high prices and exit during a panic, but this might be really
impossible for them. Even a small sale of $100 million by the FIIs causes the Sensex to
plummet by 10%.
The following are some of the appropriate measures to ensure a positive impact of FII
inflows.

Short-term controls can help economies cope with the downside of FII flows.
Long-term, the best armour is to strengthen domestic financial systems, only then can
countries benefit from FII inflow without falling victim to its costs.

Addressing fundamental issues such as strengthening SEBI, encouraging the domestic

household savings, banks, mutual funds to invest in capital markets would make our
economy more robust and less dependent on the volatility of FII inflows.

Evolution of Foreign Institutional Investors

India embarked on a gradual shift towards capital account convertibility with the launch of the
reforms in the early 1990s. Although foreign natural persons - except NRIs - were prohibited from
investing in financial assets, such investments were permitted by FIIs and Overseas Corporate
Bodies (OCBs) with suitable restrictions. Ever since September 14, 1992, when FIIs were first
allowed to invest in all the securities traded on the primary and secondary markets, including
shares, debentures and warrants issued by companies, which were listed or were to be listed on
the Stock Exchanges in India and in the schemes floated by domestic mutual funds, the holding
of a single FII and of all FIIs, Non-resident Indians (NRIs) and OCBs in any company were
subject to the limit of 5 percent and 24 per cent of the company's total issued capital, respectively.
Furthermore, funds invested by FIIs had to have at least 50 participants with no one holding more
than5 per cent to ensure a broad base and preventing such investment acting as a camouflage
for individual investment in the nature of FDI and requiring Government approval.
Initially, the idea of allowing FIIs was that they were broad-based, diversified funds,
leaving out individual foreign investors and foreign companies. The only exceptions were
the NRI and OCB portfolio investments through the secondary market, which were subject to
individual ceilings of 5 per cent to prevent a possible "take over." Individuals were left out
because of the difficulties in checking on their antecedents, and of their lack of expertise in
market matters and relatively short-term perspective. OCB investments through the portfolio route
have been banned since November 2001.
In February 2000, the FII regulations were amended to permit foreign corporate and high net
worth individuals to also invest as sub-accounts of Securities and Exchange Board of India
(SEBI)-registered FIIs. Foreign corporate and high net worth individuals fall outside the category
of diversified investors. FIIs were also permitted to seek SEBI registration in respect of subaccounts for their clients under the regulations. While initially FIIs were permitted to manage the
sub-account of clients, the domestic portfolio managers or domestic asset management
companies were also allowed to manage the funds of such sub-accounts and also to make
application on behalf of such sub-accounts. Such sub-accounts could be an institution, or a fund,
or a portfolio established or incorporated outside India, or a broad-based fund, or a proprietary
fund, or even a foreign corporate or individual. So, in practice there are common categories of
entities, which could be registered as both FIIs and sub-accounts. However, investment in to a
sub-account was to be made either by FIIs, or by domestic portfolio manager or asset
Management Company, and not by FII directly.
Who can be registered as an FII?
The applicant should belong to any of the following categories: Page - 5
1. Pension Funds

2. Mutual Funds
3. Investment Trust
4. Insurance or reinsurance companies
5. Endowment Funds
6. University Funds
7. Foundations or Charitable Trusts or Charitable Societies who propose to invest on their
own behalf, and
a. Asset Management Companies
b. Nominee Companies
c. Institutional Portfolio Managers
d. Trustees
e. Power of Attorney Holders
f. Banks
who propose to invest their proprietary funds or on behalf of "broad based" funds or of
foreign corporates and individuals
The figure below shows the growth of FII investment in India

Sources of FII in India

FII Inflows: Really Hot Money

FII inflows are popularly described as "hot money", because of the herding behaviour and
potential for large capital outflows. Herding behavior, with all the FIIs trying to either only buy or
only sell at the same time, particularly at times of market stress, can be rational. With
performance-related fees for fund managers, and performance judged on the basis of how other
funds are doing, there is great incentive to suffer the consequences of being wrong when
everyone is wrong, rather than taking the risk of being wrong when some others are right. Value
at Risk models followed by FIIs may destabilize markets by leading to simultaneous sale by
various FIIs.
Foreign funds have invested Rs 69,495 crore ($17.53 billion) in Indian markets in the last nine
years. This is almost 10 per cent of the total market capitalization of around Rs 7,20,000 crore.
Though this is not a big amount, if FIIs pull out this money suddenly, it can create a major
collapse of the market. For example, Foreign institutional investors (FIIs) pumped around Rs
7,100 crore (over $1.5 billion) into the Indian markets (equity and debt) in May and June of 2003.
Next

Due to this huge inflow of FIIs, the Sensex vaulted by over 700 points (nearly 24 per cent) to
3,622.34 in those two months. The massive inflow had taken the net FII inflow in the first six
months of 2003 beyond the Rs 10,000-crore mark to Rs 10,546 crore. Most of these funds were
brought in by hedge funds, which were not directly registered with market regulator Sebi.
As they issue participatory notes or operate through FII sub-account route, they can pull
out even faster, thereby creating turbulence in the Indian market.
Another example is the sharp decline in the Sensex after the first few phases of general elections
in India in 2004.Largely owing to selling pressures from foreign institutional investors (FIIs), the
Bombay Stock Exchange Sensitivity Index (Sensex) declined from about the 5,900 on 22nd April
to around 4,500 on May 18th. On 17th May, it registered a record 800-point decline, which was
the steepest fall in the 130-year-old history of the stock exchange.
For the period 23rd April to 17th May, the correlation between daily net FII equity investment and
the Sensex was as high as 0.70.

The figure below shows the relation between the movement of sensex and net FII
investment in India in the mentioned period.

Though the volume of trades done by FIIs is not very high as compared to other market
participants, they are the driving force in determination of market sentiments and price trends.
This is so because they do only delivery-based trades and they are perceived to be infallible in
their assessment of the market.
Average shareholding pattern of Sensex Companies, June 2004

As we can see from the above figure that FIIs constitute a major part of the shareholding pattern
of the Sensex companies. Hence we can understand the significant influence of FII on these
companies. Also often the free float adjusted shareholding pattern of FII is much greater than the
observed shareholding pattern of FII.
The following figure shows a scatter diagram of how the percentage change in the number
of equities held by FIIs is related with the price change of Sensex companies for the period
March and June 2004.

Another aspect is that the other market participants perceive the FIIs to be infallible in their
assessment of the market and tend to follow the decisions taken by FIIs. This 'herd instinct'
displayed by other market participants amplifies the importance of FIIs in the domestic stock
market in India.
FII Inflows: Not Really Hot Money
FII inflows are not hot money. Let us evaluate as to what happened during the Asian financial
crisis. In the first year of the crisis, 1997-98, there was a large FII net inflow of $1,828 million. In
the second and worst year, 1998-99, there was a tiny outflow of $68 million. And in the last year
of the crisis, 1999-2000, there was again a net inflow of $3,024 million.
There are five types of foreign capital inflows: foreign direct investment (FDI) in factories; FII
investment in shares; FII investment in bonds; long-term forex loans; and short-term forex loans.
FII investment in shares is a relatively cool inflow. FIIs would love to sell at high prices and exit
during a panic, but this might be really impossible for them. As we saw in the preceding months,
even a small net sale of $100 million by FIIs caused the Sensex to sink 10%, and mid-cap shares
to sink by 20%.
Indian buyers are few and fragmented, and do not buy in crashing markets. The total FII
investment in India is over $35 billion. If FIIs try to dump even one-tenth of this - $3.5
billion - there will be no buyers and the stock market will crash by 80% or more. FIIs find it
cheaper to stay put than exit at such a huge loss.
The bond market represents somewhat hotter money. Bond prices also fall in a panic, but less
than shares. FIIs are very modest purchasers of bonds, and such purchases are capped anyway.
FIIs - Managing Uncertainty and Controlling Risks
FIIs promote financial innovation and development of hedging instruments. Institutions, for
example, because of their interest in hedging risks, are known to have contributed to the
development of zero-coupon bonds and index futures. FIIs, as professional bodies of asset
managers and financial analysts, not only enhance competition in financial markets, but also
improve the alignment of asset prices to fundamentals.

The figure below shows the movement of the Sensex and certain key events which
possibly led to an upswing or downswing in the Sensex.

From this we can conclude that there are various factors that govern the volatility in Sensex and
FII outflow is not the only deciding parameter for the same.
Conclusion
Why did India survive unscathed in 1997 during the South East Asian crisis? Because Indians
were absolutely forbidden to convert rupees into dollars. By contrast, foreign investors had
complete freedom to exit. Yet, they did not leave. India's policy was based on the implicit
assumption that foreigners could be trusted with freedom to exit, but Indians could not.
The lesson is clear. We do not need to cap FII inflows. But, even as we liberalize dollar purchases
by Indians in good times, we should retain the option to clamp controls in an emergency. In a
panic, nothing will be hotter than Indian money.

Source: SEBI

Foreign institutional investors (FIIs) have driven the current rally - that has been one of the most
unequivocal statements about this current rally. And people fear that the rally will trip the day FIIs
pull out. This theory is partially true. Though in absolute numbers, FII investments have been

phenomenally large last year; their share in market turnover is actually down to 11% from a high
of 24%.
And even that 24%, while indicating a high level of participation, is still not high enough to
justify the hype and hoopla about FIIs alone driving the market. There are obviously a lot
of large Indian investors who are equally, if not more active. The FIIs have adopted short-term
trading strategies and bought on most market dips. In August, they probably realized that the
Sensex was in a new take-off zone. And so they entered the market in late August even at 4000levels. And right now, they have decreased their exposure and seem to be waiting, no doubt, for
the next level of support from where they can join the ride again. In fact, a lot of market
participants believe that FII ownership in India is about 10-12% of the overall market. If we look at
countries like Taiwan and Korea, it is about 40%. In countries like Malaysia and China, it is 20%
of the market capitalization. So, compared to those, India is still under-owned as far as FIIs go.
FII flows may remain positive in the coming years but if they drop to a trickle, as they did in 200102 in the event of a global crisis, then the impact on the stock market, IPO prospects and the
general investment climate could be adverse. The recent resurgence in industrial production and
investments could fade. Some argue that the impact of the FII activity on the real economy is
limited given that there is only a weak and, perhaps, non-existent link between foreign money
inflows and domestic credit creation.
It is a matter of worry about hot money given the lack of sensitivity of the political class to fiscal
discipline. However, given that the FII flows are concentrated in equities; fiscal deficit might only
have a relatively minor impact on their attitude towards Indian stocks. In fact, the deterioration in
the quality of Indian public finances has hardly bothered them in the last several years.
Just taking a look around and one sees much greater amount of foreign money going into
emerging markets like Taiwan, South Korea, Hong Kong, Thailand, etc. By that measure, what
India gets is minimal. But no one talks of controls in the developed markets as a solution to these
large inflows and outflows. These risks have to be managed through sound policies, and not by
unnecessary controls. FII inflows or outflows are caused by fundamental issues.
So it is important to look for the fundamental issues rather than trying to catch the FII moves.
Another point to be noted here is that sustained stability in the markets could see a meaningful
shift of domestic household savings into equities.
In 2003, equity accounted for a piffling 1.5 per cent of the gross financial assets of the
household sector. Given this underinvestment, even a 1 per cent shift in the stock of household
savings to equity would make the Indian investor a more powerful force than the FIIs.
According to the Reserve Bank of India's annual report for 2003-04, the household sector's
investment in shares and debentures has actually fallen from 4.1 per cent in 2000-01 of its total
investment in financial assets to 1.4 per cent in 2003-04. The moot point, though, is how long the
Indian investor will take to shed his risk-aversion attitude.