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credit default swaps : concepts Pg. 18


December 2011

to regulate or not to regulate pg. 16

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume IV ISSUE XII December 2011 Faculty Mentor Prof. N. Sivasankaran


Editor Rajat Sethia

Sub-Editors Alok Agrawal Deep Mehta Jayant Kejriwal Mrityunjay Choudhary Sawan Singamsetty Shashank Jain Tejas Vijay Pradhan New Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M. Vishal Goel Vivek Priyadarshi

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

‘Niveshak’ has completed yet another year. As, we enter our 5th year, we have indeed come a long way from our humble beginnings in 2008. This year we saw more than 700 article entries coming to us from b-schools across India and even more Fin-Q entries. We also published a number of interviews from dignitaries across industry and academia. Also, new sections such as Market Snapshot and Classroom were introduced this year which got a lot of appreciation from readers. Surely, these achievements wouldn’t be possible without the continued support and contribution from our readers. As we pass the baton to our new team, I on behalf of the outgoing team would like to thank all the readers for their support and hope that we lived up to the expectation of one and all by contributing our bit to this great knowledge sharing platform called ‘Niveshak’. The year 2011 was expected to be the year of growth, but instead the year turned to be just the opposite. I am not able to remember a single editorial in the last year where I have written something good about the markets or economy. The benchmark Sensex slipped by more than 20% during the year, the rupee depreciated by even more. Inflation, RBI policy, government inaction, Euro crisis continued to dominate the headlines throughout the year and I don’t remember one editorial in last year where I have not mentioned these. I remember the June issue in which our cover story was on ‘double dipped’ recession. I distinctly recollect receiving mails from some optimistic readers about falsely spreading negativity. Two months later ‘Economist’ carried a cover story on the same topic and today ‘double-dip’ is real in some parts of Europe and the global economic data point to some very difficult times ahead in other advanced economies as well. Optimists argue that the global economy has merely hit a ‘soft patch’. Firms and consumers reacted to this year’s shocks by temporarily slowing consumption, capital spending, and job creation. As long as the shocks don’t worsen confidence, growth will recover and stock markets will rally again. However, the ‘double-dip’ proponents argue that the problems of the advanced economies is that of insolvency, not illiquidity; large and rising public and private deficits and debt, damaged financial systems that need to be cleaned up and recapitalized, massive loss of competitiveness, lack of economic growth, and rising unemployment. It is no longer possible to deny that public and private debts in PIIGs nations will need to be restructured. If the problem in advanced economies aggravates, the domino effect will ensure that no part of the world remains unaffected. We sincerely hope that the optimists are right and the new team has something good to write in the next year. This issue brings to you some more interesting and insightful reads. The cover story this month focuses on Foreign Direct Investment in Indian retail sector. The issue also features an article on the critical review of the Disinvestment policy in India. Other articles in this issue focus on Alternative Investment Assets, Credit Default Swaps and regulation by Credit Ratings Agencies. The Classroom this month explains the meaning and significance of LIBOR. We would like to thank all those who have contributed articles to this issue and sent entries for FinQ. Merry Christmas and Happy New Year!! Stay Invested.

Rajat Sethia (Editor - Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Niveshak Times

Cover Story

04 The Month That Was Article of the month

08 A critique on

disinvestment policies in India

11 FDI in Retail

Perspective 16 To regulate or not to regulate: The ultimate conundrum


14 Alternative Investment Assets: Wine

Fingyaan 18 Credit Default Swaps:

Concepts and RBI regulations



The Month That Was



The Niveshak Times Team NIVESHAK

IIM, Shillong

IIP PLUNGES NEW DEPTHS India’s index of industrial production, which details out the growth of various sectors of the economy, recorded a significant decline in the month of October. T h e index fell over 5.1% in comparison to the figures obtained last year, when the growth in IIP was 11.3%. It is for the first time since June 2009 that IIP has recorded a red mark in its growth figures. While manufacturing s e c t o r, which contributes almost two-thirds of the overall IIP index, declined by 6% in October; the mining sector and capital goods output contracted by 7.2% and 25.5% respectively. Decline in production of capital goods was an unpleasant surprise, as the index logged a steep downfall from 6.8% contraction in the previous month. On the other hand, production of intermediate goods slumped by 4.7% during October; whereas non-durables consumer goods output remained static at -1.3% during the month. The electricity production was the sole rescuer, as it witnessed a strong 5.6% growth in October, as against a robust 9% growth in September 2010. However, with a better crop ahead, and RBIs current stand on taking a breather on the interest rate hike, things are expected to improve in the coming months. RBI TIGHTENS RULES TO CHECK THE FALLING RUPEE As the Indian rupee is writing and rewriting history day after day, the Reserve Bank of India swung into action to check the depreciating currency. The rupee slipped to sub-54 level for the first time in its history and touched a record low of 54.30 against the dollar on Dec 15,2011. In the

December 2011

last nearly four and half months, the rupee has declined by about 20 per cent against the dollar, making it the foremost contender for the worst performing Asian currency this year. In an effort to curb the pressure exerted by speculations, the country’s central bank has imposed restrictions with immediate effect on forward trading in the local currency. Forward contracts once cancelled now cannot be bought again. It has also reduced the limit for hedging of foreign currency risks for importers/exporters from 75 per cent to 25 of the average actual import/export turnover in the past three years. In another regulation, RBI has capped the exposure of banks to the Forex markets. Experts are of the opinion that the move will be positive for the rupee in the “short- term,” increasing transaction costs and showing the RBI is looking to curb currency-market speculation. FOOD INFLATION EASES TO 4.35% The effort of the economist finally seems to be bearing fruit, as the food inflation for the week ending Dec 3, 2011 reached a four year low of 4.35%. As per the weekly WPI data, while vegetables, on the whole turned cheaper by 12.28 per cent, prices of kitchen staples such as onions and potatoes slumped by 46.03 per cent and 33.28 per cent on a year-on-year basis. Wheat prices also eased by 4.43 per cent as compared to the data recorded in the corresponding period last year. Experts are of the opinion that the moderation in the rate of price rise of food items below the psychological 5%-mark will bring relief to the government, which has been battling high inflation for almost two years now. RBI’S MID QUARTER POLICY REVIEW Country’s central bank, the Reserve Bank of India released their mid-quarter monetary policy review statement on December 16, 2011. Taking a break from the spree of rate hikes, poli-


cy rates have been left unchanged, and the repo rate was maintained at 8.5%. RBI has increased policy rates 13 times since March 2010, amounting to a total of 375 percentage point worth of hikes. Though RBI has stressed that inflation and inflationary expectations continue to remain elevated, it expressed hope that it would decline due to moderating growth and declining food prices. While RBI sounded cautious on inflation, it explicitly admitted that the monetary policy cycle is likely to reverse its course to address concerns regarding risks to growth. RBI’s policy document clearly reflects a shift in focus — from inflation combat to growth promotion. The country has been battling with a falling industrial output, and the Index of Industrial Production (IIP) has recorded a negative growth for the month of October. The finance ministry has also cut its GDP growth forecast for the fiscal to around 7.5%. Moody’s downgrades Belgium’s credit rating, S&P and Fitch warn of a potential downgrade Moody’s on December 16 downgraded Belgium’s credit rating by two notches as a result of rising borrowing costs in Belgium, which as per agency can make it very difficult for Belgium to repay its huge debt. Belgium’s local- and foreign-currency government bond ratings have been downgraded from “Aa1” to “Aa3” with a negative outlook. The rising costs have hardly hit Euro Zone nations which are trying to borrow money to finance their deficits. Political problems and the possibility of more stringent austerity measures have also emerged as significant problems in Belgium. Amidst all this Fitch has also put Belgium, Italy, Ireland, Spain, Cyprus and Slovenia on negative watch, which means a possible downgrade within next three months. Standard & Poor’s had already warned 15 of the currency bloc’s 17 members of a possible downgrade.

Italy’s Economy down by 0.2% in third quarter Italy’s economy shrinks by 0.2% in third quarter ended Sept 30, for the first time since 2009 as per data released by the National Statistics Institute Istat. Economy expanded by 0.1% in the first quarter followed by expansion of 0.3% in second quarter before this contraction. The Economy is considered to be in recession only if it contracts in two successive quarters. As per the government forecasts the economy will shrink by almost 0.4 % in the fourth quarter. The Italian business federation Confindustria is also forecasting a downfall of 1.6% next year, thus raising concerns that Italian Economy may go into recession soon. Italian Industry Minister Corrado Passera had already announced that the country is in recession. As per National Statistics Institute Istat one of the reasons for this fall in GDP is decline in domestic demand, including spending by households, public-sector spending, business investments and a negative contribution from inventories. However the good news is that on a 12-month comparison Italian GDP rose by 0.2% in real terms from the third quarter of 2010. Moody’s upgrades Indian Rupee Moody’s has raised India’s local currency debt rating by one notch to Baa3. With this Indian local currency bonds have now become investment grade making them equivalent to country’s foreign currency bond grade, though Baa3 is the lowest investment grade. Moody’s said it does not now see “justification for a rating bias in favor of either local currency or foreign currency government debt”. A stable outlook on the economy is the reason for this credit upgradation. The upgradation has come as a great relief to the Indian currency which has depreciated by around 20% against dollar during last four months. Moody’s also said that the downward pressure on India’s economic growth will persist for the next two quarters.


The Month That Was

The Niveshak Times




Article Market of Snapshot the Month Cover Story

Market Snapshot


MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

53,79,251 26,27,112 12,85,512

LENDING / DEPOSIT RATES Base rate Savings Bank rate Deposit rate

10%-10.75% 4.00% 8.5% - 9.25%


CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling

52.67 69.13 67.72 82.53


6% 24%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

6% 8.50% 7.50%

Source: 25th November to 21st December 2011 Data as on 21st December 2011

December 2011


BSE Index Sensex

Open 15,781

Close 15,377

% Change -2.56%


5,591 5,989 8,398 9,702 5,745 9,267 3,918 5,947 5,501 9,965 8,009 1,886 6,657 1,553 3,329

5,141 5,517 8,129 9,416 5,293 8,013 4,037 5,841 5,749 9,521 7,925 1,780 6,354 1,386 3,376

-8.04% -7.88% -3.20% -2.95% -7.87% -13.53% 3.04% -1.78% 4.51% -4.46% -1.05% -5.62% -4.55% -10.75% 1.41%


Article Market of Snapshot the Month Cover Story

Market Snapshot



Article of the the Month Article of Month Cover Story


A critique on

disinvestment policies in India Divyansh Gupta & Subodh Jain

IIM, Ahmedabad Foreign debt repayment crisis of 1991 precipitated a slew of reforms in India, including the “delicensing” elements of the new industrial policy of 1991. In 1999, the government formed the Ministry of Disinvestment which has been given the responsibility to layout a systematic policy approach to disinvestment and privatization of Public Sector Units. In this article we take up three issues which plague divestment in India: 1)The dilemma of pre-privatization capitalization 2)Issue of post divestment autonomy and flexibility being comprosmised 3)High pricing of FPOs and forced buying by UTI and LIC Pre-privatization Capitalization Privatization of Public Sector Enterprises has been a recourse that has often been taken by governments around the globe to meet the ever-expanding fiscal deficits. With new right governments coming to power in the US and Britain, there was support for neo-classical economics and influence of organizations like World Bank and International Monetary Fund led to more private sector involvement in the economy. The challenges before government when going for disinvestment are as follows•Social Problem - Process of disinvestment is not favoured socially as it is against the interests of socially disadvantaged people and society at large. •Political Problem - The coalition government at the centre with a number of parties has posed a serious threat to this program. Conflicting interests have made it difficult to arrive at a national consensus. •Economic Problem - Most of the units identified for disinvestment are in a very bad shape which do not offer good returns. The Government, due to paucity of funds, is also not in a position to revive

December 2011

them. (Verma, 2009) This capitalization poses an important public finance question to the government. The government is forced to infuse this capital into the PSU to make the issue (IPO/FPO) attractive. The opportunity cost of this capital is to be compared against its use in social infrastructure build-up or R&D activities. The quandary that the government faces is whether to use the money for a sick unit, so as to turn it around (as also face the risk of its erosion), or to put that money into other investment requirements. However what is commonly seen is that governments often pays this ‘premium’ so as to avoid the aforementioned problems, more so the political problem. Sometimes this premium is deemed so high by the incumbent government so as to even surpass the possible pay offs from the privatization deal. Hence many such deals were called off (Chakraborty, A., Nair, V., & Mehta, B., 2009). Post-Divestment Autonomy and Conflicts There may be conflicts between profit maximizing objectives of a divested firm with other non commercial objectives or social purposes as a former state-owned firm. This issue is more likely to be prominent in case of partial divestment i.e. mixed private-government ownership. Such enterprises have important implications in terms of corporate governance. Many a time divestment face opposition from various stakeholders raising concerns of public interests like unemployment, price increase, etc. The type of goods and services is a key factor in determining the extent of public interest. Protests are more common in case of public utilities like electricity, water, railways, petrol, etc. And therefore government needs to address these issues by intervening through regulatory bodies, or by influencing ownership or management of divested



Shareholders Central Government/State Government (S) Foreign Sub Total Public Shareholding Mutual Funds/UTI Financial Institutions/Banks Foreign Institutional Investors Sub Total Non-Institutions Bodies Corporate Individual shareholders up to 1 lakh Individual shareholders over 1 lakh Any Others Total

Article of Month Article of the the Month Cover Story

entities. This becomes more significant in cases where divestment opposing stakeholders are well organized. To take an illustration, Indian government tries to control inflation through price control on oil and provides subsidies to downstream marketing firms. ONGC, with state ownership of 74.11%, needs to contribute 38.8% to the subsidy burden (Economic Times, 2011). Such interventions by government puts ONGC in a double role as a state-owned firm and a listed commercial entity. ONGC corporate governance is accused of forsaking minority shareholder interests and being operationally inefficient. Figure 1 shows that since 2003-04, ONGC has provided about Rs. 1436 million in subsidies. This converts to a huge loss to minority shareholders as compared to situation with no subsidy. The government being the major shareholder has legal power over minority shareholder. Time and again ONGC’s stock prices take a hit due to such interventions. Also ONGC’s capabilities to make future capital investments are hugely curtailed. Post divestment without sufficient autonomy given to such organizations, the status as a listed company does not necessarily protect the long term interests of various investors. This affects the investment climate in the country and confidence of domestic and foreign investors. One important lesson to be learned from the ONGC episode is that the participation of relevant stakeholders at the stage of policy formulation of divestment is necessary. This should help the government in understanding various concerns of stakeholders better and also help potential and existing stakeholders in understanding post-divestment arrangements. More transparency in the sys-

Fig. 1: Subsidy Payouts by ONGC (Source:

tem will reduce the conflicts and a better balance in conflicting interests could be achieved. Such a system might hamper the financial attractiveness of public listings initially but it is very critical to give due recognition to the post-divestment regulation beforehand. Arm-twisting by government In order to achieve better fiscal figures the government has gone on the path of disinvesting in the PSUs. Even though the IPO/FPO’s have been over-subscribed, it is surprising to notice that the domestic institutions that have been subscribing to the issue are government controlled entities like LIC and UTI. The government has a 100 per cent holding in these institutions (Saugata Bhattacharya and Urjit R. Patel, 2002) and thus, money raised from them is like transferring money from one pocket to another. NTPC is the largest state-owned power generating company in India. GoI owned 89.5% of NTPC’s equity share capital and planned to divest 5% of its stake in the company through a FPO in Feb-2010, with an aim to raise Rs. 8,300 crore. The issue got lukewarm response and on the first-two days of the issue, only 80% of the issue was subscribed, Dec-09 89.5 0 89.5

Sep-10 84.5 0 84.5

Dec-10 84.5 0 84.5

Jul-11 84.5 0 84.5

1.46 3.4 2.38 7.24

1.86 6.95 2.85 11.66

1.52 6.91 3.36 11.79

1.4 6.9 3.54 11.84

1.21 1.99

1.56 1.92 0.2 0.16 100

1.45 1.93 0.21 0.12 100

1.5 1.9 0.18 0.08 100

0.06 100

Fig. 2: NTPC holding at different points of time (Source:



Article of the the Month Article of Month Cover Story




Amount raised (Rs. crore)

Issue Price (Rs.)

CMP (as on 25-Aug-2011)

2009-10 2009-10 2009-10 2009-10 2009-10 2010-11 2010-11 2010-11 2010-11 2010-11 2010-11


2012.85 2247.05 8480.098 882.52 9330.942 1062.74 959.65 15199.44 3721.17 1237.51 582.45

36 1050 201 105 300 26 285 245 90 375 140

23.95 1321.00 170.10 177.00 221.40 22.05 255.10 373.85 101.85 301.35 82.75

Fig. 3: Amounts raised through disinvestment in PSU’s during 2009-11

of this nearly 80% came from the state-owned LIC and SBI (in which the government holds 51% equity share holding). One of the reasons cited for the poor response has been the aggressive pricing strategy adopted by the government for the FPO. The state owned firms have put their bids at Rs. 209 for the Qualified Institutional Buyers (QIB) (NTPC FPO fully subscribed, 2010) against the base of Rs. 201, when the stock itself was trading in the range of Rs.201 - Rs.205 and thus crowded out the institutional investors who would rather prefer to buy the shares in the secondary markets itself. According to media reports LIC pumped in $950 million in the FPO of NTPC. By doing this, the government effectively maintained its control on the company and got funds from the FPO proceedings. As can be seen from Figure 2 the holding pattern shows that the Mutual Funds and Financial Institutions/Banks holding significantly increased, and later on decreased, as the share price dropped dramatically from Rs. 201 to Rs. 170 due to global headwinds. These companies actually suffered losses due to their exposure and squaring off of their positions. LIC’s balance sheet (Saugata Bhattacharya and Urjit R. Patel, 2002) shows that the exposure of LIC to public sector stands at 84 per cent followed by private sector 14 per cent, and the total assets on LIC’s balance sheet to Central and State government securities is at 54 per cent, showing the dependence that the government has towards LIC in bailing out its IPOs and FPOs. As the government tried to meet its fiscal targets it has speeded up its process of FPOs and IPOs to raise funds. During the years 2009-10 and 201011 the government raised Rs. 23552.93 crore and Rs. 22762.96 crore through disinvestment in various companies. The list of the companies through which the government has raised these amounts

December 2011

are given in Figure 3. The biggest IPO in the Indian stock markets history was that of Coal India which raised Rs. 15199.44 crore, and even in this issue LIC pumped in a significant amount of money (Public Sector Disinvestment: A Greedy Government?, 2010), and again in the issue of NMDC, LIC had to step in again where it bid more than US $1.5 million. This raises the question of whether the government is being too greedy for its own good, and pricing the issue at excess premium thus discouraging the retail and FII participation? The government issues the stocks at premium taking the stand that the stocks are a good long term investment and it wants to share with the public the ownership of the company, but considering the past record of the performance of the IPOs this doesn’t seems credible. Of all the issues of PSUs issued during the period 2009-11, only three are trading above their issue prices, that of Coal India, OIL and Power Grid Corporation India. For Coal India, the government was actually praised (Coal India: In a sweet spot, 2010) for pricing at cheap valuations attracting the participation from retail players. Conclusions Lesser interference from the government and an effective board and managerial team are necessary if the goals of disinvestment are to be met. From public finance perspective this would be in the interest of the government given the enhanced revenue they would obtain from both the direct shareholding and the added tax revenues. The multiplier effects emanating from these companies would add a significant boost to the GDP and that is another plus for using a hands-off approach by the government.



Cover Story Article of the Month Cover Story

FDI in Retail

Has India geared up for the change? Nilkesh Patra & Kailash V. Madan

Team Niveshak

The retail sector in India is one of the most attractive sectors in the economy. This industry is estimated at INR 15.5 trillion growing at a CAGR of 15 to 20%. According to the Indian Council for Research on International Economic Relations (ICRIER), India is the seventh-largest retail market in the world. A recent report by AT Kearney, the well-known international consulting firm, acknowledged India as the ‘fourth most attractive retail destination’ worldwide out of thirty developing markets. The combined retail and wholesale sector in India accounts for approximately 22% of GDP. This sector is also helping the economy in terms of employment by providing more than 8% of the jobs and is the country’s second largest employer. Organized retail accounts for only 6% of the total retail in the country. The organized sector which includes licensed retailers, retail chains and privately owned large retail businesses has been growing at a CAGR of 35%. Companies like Reliance, Tata, and Adani Enterprise have been investing considerably in this sector. The major factors contributing to the growth of the organized retail sector are globalization, high economic growth, and changing lifestyles of the people. Additionally, increased spending over the years by the young population and sharp rise in disposable income are driving the growth of the Indian organized retail sector. On the other hand, the unorganized retail sector which includes local kirana shops and convenience stores is the more prevalent form

of trade in India accounting for 94% of total retail in the country. Critical issues in the Indian Retail sector The growth potential in the sector is huge, but there are few challenges that could slow down the growth for new entrants. Some of the challenges are rigid regulations, high personnel costs, lack of basic infrastructure, real estate costs, and a highly competitive retail market. Adding to this, the entry of many retailers is getting disrupted because of delay in completion of shopping mall projects due to resource constraints. Some of the other critical aspects found wanting in the Indian retail sector are: • Supply chain management: It is one of the factors for growth and profitability of modern retail industry. It takes care of regional variances, values conscious consumers and assists retailers in creating a strong customer value proposition • Branding • Workforce Management • Sustainability • Green Marketing Improving on these will enable Indian retailers to significantly enhance overall competitiveness and successfully deploy growth initiatives. They can also enjoy the effects of the dual GST. The dual GST implemented nation-wide is the next level of tax reforms intended to eliminate the obstacles of trade through a common function-



Article Cover of the Story Month Cover Story


Fig. 1: Indian retail industry breakup

ing market in India. FDI in retail – Implications India being a signatory to World Trade Organization’s General Agreement on Trade in Services, which include both wholesale and retailing services, had to allow foreign investment in the retail sector. There were initial hesitations towards these investments in the retail sector, because of the fear of losing jobs, competition and loss of business opportunities. However, the government is slowly taking steps in the right direction. In 1997, FDI in cash and carry (wholesale) with 100 percent ownership was permitted by the Government. In 2006, it was brought under the automatic route. 51% FDI was also permitted in a single brand retail outlet in 2006. 2011 saw a new reform in the retail sector. The UPA government proposed a bill permitting 100% FDI in single brand retail and 51% FDI in multi brand retail. This paves the way for global retailing heavyweights like Wal-Mart, Tesco and Carrefour to

Indian Retailers Global Retailers

make their presence felt in the growing Indian economy. Unfortunately, this move has faced a lot of resistance not only from the Opposition party of the country but also from some of UPA’s key allies like DMK, Trinamool Congress etc. In order to understand what the hullabaloo is all about, we need to examine the intricacies of the bill in question. Before any foreign retailer can make its way into Indian shores, it needs to meet certain pre-conditions as stipulated by the Government. • The minimum investment to be made is $ 100mn • The foreign investor should own the brand and must sell it under the same name as it does internationally • Half the investment should be made in back-end infrastructure development • 30% of the required raw materials must be procured from Indian Small and Medium Scale Industries

Indian Retail vs Global Retail Logistics cost as % Inventory Turns Stock-out Percent of price ~10% 3 to 14 5 to 15 5% Average 18 Below 5

.. Opening up the economy to foreign retail players would ensure better infrastructure by means of improved storage and harvesting facilities

December 2011

Shrinkage Percent 3.1 Average 1



Article of the Month Cover Story

• Can set up malls only in 53 Indian cities which prehensions regarding the bill. They believe that have a total population in excess of 10 lakh the local kirana shops (mom and pop shops) First and foremost, we observe that allowing this stand to suffer huge losses. Considering the fact move would bring in a lot of capital investment that 94% of India’s retail is presently unorganized, to the Indian market and would increase the al- a large number of people will be affected. But, ready diminishing Forex reserves of the nation. It judging from the results in countries like China, would also help improve the infrastructure of the Brazil, Argentina and Singapore where 100% FDI country, by way of shopping malls and high rises. in multi-brand retail is allowed, it is clear that Secondly, since the international players need to kirana traders can co-exist with the organized secprocure about a third of their raw materials from tor. Also, the bill warrants setting up of malls by Indian small scale industries, it will boost employ- foreign players only in 53 cities, where space is already a constraint. Hence, most of these malls ment in this sector. Such a would be situated on the outpolicy would also ensure that skirts of the city and hence it the “Customer is the King”. “Opening up foreign is not necessary that the conIncreased competition in the investments will bring in venient neighborhood kirana retail space would ensure funds required for expanstore runs out of business. that he gets the best qualAlso, if predatory pricing is sion of the nascent modity products and the most afwhat the opposition is confordable prices. ern retail sector in India. cerned about, the CompetiThe major beneficiary of alThe market opportunity is tion Commission of India will lowing FDI in multi-brand relarge and we do not see ensure that the prices remain tail would be the Indian agfair and competitive. much impact at a national ricultural sector. Agriculture Currently, the bill has been level from new players. We employs about two-thirds of suspended until a consensus the country’s population but support opening up of the is reached in the Parliament. contributes only 16% to the sector to FDI. Most of the While there are pros and cons nation’s GDP. The major reaopposition is related to to this issue, we feel that sons for this are the lack of the food sector, where the benefits of passing the infrastructure and the presbill would far outweigh its stakeholders are not sure of ence of middle-men who eat ill effects. The bill, in effect, away a major chunk of the its impact on suppliers and would bring a bulk of India’s farmer’s profits. Opening on agriculture. Specifically unorganized retail sector unup the economy to foreign for the food sector, the der the organized sector. This players would ensure betgovernment may adopt a would make it much easier ter infrastructure by means to implement labor laws calibrated approach of of improved storage and and would also create a lot harvesting facilities. For exopening it up to FDI” of employment, not to menample, India is the second - Mr Kishore Biyani tion tremendous infrastruclargest producer of fruits Managing Director, ture improvement. Kirana and vegetables in the world, store traders may be affected Pantaloon Retail but is not able to capitalize a little, but over time, they on this owing to poor infrawill find ways and means to structure. Allowing FDI would carve a niche for themselves. see huge investments in back-end infrastructure thus improving the present scenario. At present, Conclusion the farmers are getting only 10-15% of the price It is not possible for the Government to step in the customers pay for their products. Bulk of the and provide the required infrastructure facilities profits are eaten by the middle-men, who can to boost this sector and hence opening it up to be eliminated by allowing FDI in retail as their the tried and tested foreign players is the next business models’ thrive on procuring materials best thing they can do. It is a small but steady directly from the farmers. It would also provide step towards India’s goal of liberalization. employment to a large number of people either directly or indirectly. However, the opposition party has their own ap-


Article Finsight of the Month Cover Story



WINE Alternative Investment Assets: Rishi Sonthalia

SIBM Bangalore

Recently an article on a major website talked about the lessons one can learn from the rich. It spoke about the ownership and investment patterns of the super rich and how they have been able to maintain their net worth even in this turmoil. A recent report by Capgemini and Ernst & Young reckons that one of the most prominent trends among the rich is that they put around 10% of their wealth into alternative asset classes. Investment in real assets has fast become a modus operandi to diversify the risk of financial assets (like stocks and bonds) and also earn real returns in the process. The advantage of investing in real assets is that they have an intrinsic value due to their utility. The most popular real asset today is Gold. It has given manifold returns over the last few years, with the real price increasing from $800 to about $1800 per ounce. But a new asset class has also come up today which is bound to take the world in a swirl, quite literally; Wine. Sharpe ratios perus unitcompare of risk) for wine The following table(return helps the and returns of variuos classes. asset classses, March 2004 - August 2011 various asset

Wine drinkers have come a long way from holding the stem glass and swirling the red or white liquid to release aromas to now converting it into a “liquid asset”. Wine as an asset class has sparsely been studied and the recommendations are mixed. But one needs to keep in mind the fact that although a good asset to diversify ones risk, it is still considered very volatile and risky due to the small number of players in this niche market.

1.4 1.2 1 0.8 0.6 0.4 0.2 0 -0.2 TWIF




Hang sang

Fig. 1: Sharpe ratios (return per unit of risk) for wine and variuos asset classses, March 2004 - August 2011

But before one goes to buy wine off the racks, one must remember that there is only a very narrow group of wine regions which are considered ‘investment worthy’. It mostly includes the top wines from the Bordeaux region in France and a dash of wines from Burgundy, the Rhone, Italy, Champagne and the New World (California). The five best fine wines in the world, all from the Bordeaux region in France, are called First Growths: Lafite Rothschild, Margaux Medoc, Latour Medoc, Haut-Brion and Mouton-Rothschild. Most professionally managed investment portfolios have between 80-90 percent by value invested in just eight brands or vineyards — the First Growths, Cheval Blanc, Petrus and Ausone. There are basically three ways to invest in wine:

. Although a good asset to diversify ones risk, wine is still considered very volatile and risky due to the small number of players in this niche market

December 2011


FIN-Q Solutions November 2011 1. ICBC 2. Suspense Account 3. Vostro 4. Capital Adequacy and Earnings 5. Payment Float 6. Fiat Money 7. Green shoe option 8. CHIPS 9. Miami Masters/ Sony Ericsson Open 10. King George VI


Article Finsight of the Month Cover Story

1) Buying physical bottles: As trading in wine still remains a concept that India is warming up to, one has to rely on brokers in other countries. But remember, one has to pay duties on imports which will result in an upward push on the purchase prices. Only 1% of the world’s wines (approx. 268.7 million hectoliters) are investible, and these wines last for around 50 to 100 years, appreciating with age. One should remember that profits can range from 10-50% on every bottle, but the key is to invest for a duration of 5 to 15 years. 2) Wine Funds: As in the case with gold and art, an investor can opt for wine funds. There exists a minimum lock-in period for these funds and a net asset value per share is issued. The upside of investing in wine funds is that there are no storage or commission charges. The only set back here is the minimum investment limit which goes into a few lakhs and needs to be deposited into European accounts. 3) Wine Futures: Another way to invest is by buying wine even before they are bottled. There is a dedicated index called the Liv-ex 100 Index which tracked the trading pattern of the 100 most sought after fine wines in the world. It has gained more than 25% year to date (as of November 2010) and over 30% year on year (and outpacing most other investment vehicles). The high-risk investor can go through a broker at the Liv-ex at a commission of 1 to 2 percent. If you know your wines, one can invest in wine futures known as ‘Primeurs’. The Wine Investment Fund (TWIF), one of the most popular of such funds, announced its latest payout as its 2005 Tranche matured; and it expects the market will rise by around 21% in 2011. Investors are receiving returns equivalent to 13.25% per annum (+86.3%) over the last five years. Over the same period the FTSE 100 rose just 1.9% or 0.4% per annum. These double figure returns of TWIF is calculated after charging all fees and expenses, and serves to emphasize the low correlation between fine wine and equities. TWIF generated returns of over 30% in 2010 alone. But before making an investment one needs to gain extensive knowledge of the asset, especially if one plans to invest directly into the bottles or the Primeurs. Online ratings by reputed societies and wine tasters are a reliable source for such information about brand, vintage longevity and consistency. So go ahead and find a fund or even a bottle for yourself. It’s only just fair for you to become the “King of Good Times (or Wines maybe)”.



Article Perspective of the Month Cover Story




Harshali Damle

Team Niveshak

The World of finance is passing through a taxing time in the recent past. Financial services have been stereotyped as being over aggressive and avaricious in their approach. The Financial crisis has brought forward an important question of the need of regulation over the financial and ancillary services. One such area under purview is the Credit Rating System. A credit rating is an independent opinion on the creditworthiness of a debt, security or derivative issue. The rating ideally does not provide guidance on the related aspects for investment decisions, such as marketability or market volatility. It says nothing about the “systemic risk�. Credit rating agencies work as service providers to corporates who want to have an independent credit rating for their instruments and projects. However, the main flaw in the system comes when the remuneration for the services are received from the same corporates who want their securities rated. View of Credit rating Agencies The main contention of credit rating agencies is the fact that their ratings are opinions and not recommendations to purchase, sell or hold any securities and they act as expert advisors. Hence the work they do should not be under the purview of any law with regard to the scope and tools of

analysis used. They are not responsible for the opinions they give as the same are based on the data received from the issuers. In the United States, rating agencies assert that they have the same status as that of the financial journalists and are therefore protected by the constitutional guarantee of freedom of press. This has been traditionally shielding them from investor litigation and has prevented direct regulation of their practices. Till recently, the agencies have argued that their reputation is at stake and the users will approach them for rating only if their opinions carry credibility with the investors. Hence there were no regulations on the Credit Rating Agencies. Current regulations on the Credit Rating Agencies The regulatory treatment for rating agencies has been rather paradoxical: regulatory standards have been based on credit ratings, but there has been little direct control on how the ratings are made. Despite the limited oversight, regulators have depended heavily on these ratings in setting regulatory policies. Credit ratings are normally used for following purposes:1)Determining the capital adequacy requirements for financial service providers

Credit rating ideally does not provide guidance on the related aspects for investment decisions, such as marketability or market volatility

December 2011


odologies cannot be standardized as this will kill all possibilities of innovation and competition in the field. The range of possible methods of regulation nevertheless remains extremely broad. At one end of the spectrum is the idea that CRAs should impose self-regulation. The success of any such self-regulatory regime stands or falls with the question of control and integrity. At the other end of the regulatory framework, there are demands for the rating process to be completely entrusted to the p u b lic sector to ensure efficient functioning. However the regulators are the same people who were a part of the entire chain that caused the financial crisis. What effective regulations can one expect from them? The basic steps in the direction of regulation can be: 1)Structure for assessing the credibility of data received from management and analysis of the extent and quality of data 2)Identifying potential conflict of interests and avoiding the same 3)Avoiding anti-competitive and unhealthy practices 4)Maintaining professionalism and independence 5)Determining disclosure requirements 6)Determining framework for credit upgrades and downgrades Conclusion There has been a broad consensus regarding the need for regulation over the Credit Rating Agencies to ensure financial stability. There is a need to seek balance between the benefits and costs of regulation. This is the ultimate conundrum that needs to be addressed.

There is a need to seek a balance between the benefits and costs of any proposed regulation © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article Perspective of the Month Cover Story

2)Identifying or classifying assets for investments to be made 3)Evaluating the credit risk of assets in securitization or bond offerings Concentration of power of the CRAs Another major problem is the fact that the credit rating industry is highly concentrated, with three companies (Standard & Poor’s, Fitch and Moody’s) dominating the market in most countries. This can be attributed to high entry barriers, stemming from goodwill and the reach and reputation built by successful rating agencies over time. CRISIL is a S&P Company in India. CRISIL has extended its operation to rating B-Schools and real estate projects also. These are purely based on data provided to CRISIL. The reliability of such ratings is surely questionable. Need for Change Credit rating agencies play an important role as de facto “capital market gatekeepers”—despite their reluctance to assume any such accountability. Hence, another positive step in the regulatory system can be to reduce the undue importance given to the Credit Rating Agencies. Regula- tions will only succeed if it understands what ratings can and cannot achieve. While corporate debt and security ratings are based on publicly available and audited financial statements, structured instrument ratings are based on non-public, non-standard and unaudited information supplied by the issuer. Also, the rating agencies have no obligation to perform any due diligence to assess the accuracy and reliability of the information and often wrongly rely on representations and warranties from the issuers about the quality of the data. Their computerdriven simulation models are highly based on the market assumptions that proved to be faulty or incomplete. Extent of regulation Though regulators agree on the fact of the need for regulations on Credit Rating Agencies, the major question is the extent of regulation. The meth-



Article of the Month Cover Story FinGyaan



Default Swaps : Concepts and RBI


Roy Paul Mathew


Credit Default Swap can be used effectively by entities to manage credit risk by transferring the risk to the seller of protection for a premium. However, as seen in the recent financial mess, it has the potential to bring down even the so called too-big-to-fail entities. Hence, RBI while allowing trading in CDS, judiciously regulates operation in this space

CDS provide credit protection to corporate bond buyers because there is a guarantee of the credit worthiness of the product by the sellers of the swap. This arrangement ensures that there is a transfer of risk of default from fixed income security holder to the seller of the swap. Hence, CDS can be visualized as a kind of insurance against credit risks associated with bonds. Features of CDS a) CDS Spreads : Spread is defined as the premium paid by the protection buyer to the seller. The premium is usually expressed as basis points and is paid by the buyer of protection on a quarterly basis. CDS spreads are expressed in basis points of notional value. CDS can also be viewed as put option for a corporate bond. b) Contract Size and Maturity: Though limit on either size or maturity of CDS contract does not exist,

mode of contract size is between $10 million to $20 million when expressed in notional amount. The mode for maturity is 5 years and the range lies between 1-10 years. c) Trigger Events :

Pricing and Settlement of CDS Traditional market making involves placing limit orders to buy & sell in order to earn the bid-ask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market makers provide additional liquidity to the market by being counterparty to incoming market orders, they get rebates from exchanges for

Fig. 1: CDS spreads

December 2011



Article of the Month Cover Story FinGyaan

quotes that lead to execution. So, if an HFT’s bid (buy order) of $15 for XYZ shares is matched, it might immediately post an offer (sell order) for the same price, hoping to capture two rebates while breaking even on the spread. Building up such market making strategies typically involves precise modeling of the target market structure & trading volumes using stochastic control techniques. Ticker Tape Trading a) Settlement of CDS Upon the occurrence of a credit event, either the seller/buyer issues a “Credit Event Notice”. The compensation is received by the buyer from the seller of the protection through two means: 1) Physical Settlement Physical settlement is the most common form of settlement in the swap market where the protection seller buys the distressed loan or bond (in CDS parlance called as “Deliverable Obligation”) at par from the buyer. Physical settlement happens within 30 days of the occurrence of the credit event. 2) Cash Settlement: The difference that exists between the notional value of CDS and the final value of the reference obligation is calculated to decide the payment to be made by the seller of the protection to the buyer. The time period for cash settlement usually range from 0-5 days from the occurrence of credit event. b) Pricing of CDS CDS price or CDS spread is defined as the annual

amount which the protection buyer is liable to pay the seller over the duration of the contract. The two basic approaches for the pricing approach followed for CDS are: 1) Structural Approach This approach estimates the correlation between price of credit risk instruments and economic determinants of financial distress for pricing of CDS. The main factors which impact probability and severity of default are a) Financial leverage b) Volatility and c) Risk free term structure. For example, Moody’s KMV model is widely used for pricing of CDS. Much research in this domain has been carried out by Black & Scholes (1973) and Merton (1974). 2) Reduced Form Approach These models exogenously postulate the dynamics of default probabilities and use market data to obtain the parameters needed to value credit-sensitive claims (Ericsson, Jacobs and Oviedo (2004)). A variant of this approach is based on estimation of default probabilities and loss given default through the employment of statistical functions. Benefits and Risks of CDS Benefits of CDS: Since CDS is an effective tool which allows hedging of credit risk, trading it makes markets complete. It results in a better and efficient use of capital among institutions owing to better managed credit risk transfer. (i) CDS is a better avenue for supply of liquidity and credit for sovereign debtors and since it enhances spread of risk it is ideally suited for



Article of the Month Cover Story FinGyaan


Protection buyer

Protection seller Does not usually own underlying credit asset Selling Credit Protection Long Credit Exposure

Payment only if credit event occurs

Credit Default Swap premium paid periodically

Tends to own underlying credit asset Purchasing Credit Protection Short Credit Exposure

Fig. 2: A common Credit Default Swap transaction

corporate as well. (ii) CDS pricing acts like a liquid, efficient and transparent pricing standard for new issuance since there is a direct correlation between CDS price and cost of funds on corporate borrowing. Risks of a CDS market: (i) There is an increased vulnerability and susceptibility of systemic shocks as witnessed in recent financial crisis due to fact that unwise transaction of CDS lead to concentration of risk across few entities which are of pivotal importance.

cumulating massive speculative positions and coordinated manipulation do exists since regulatory controls are minimal and bypassed due to the fact that CDS are traded as OTC derivative. (v) Since payoff of a CDS is linked with default of a borrower or a security (e.g Bonds) and both depends on the state of the economy, expected pay off on CDS will be on increase during recessionary fears. Hence, huge impact on systemic risk can be attributed to pro-cyclicality. CDS in India – RBI Stand RBI issued new regulations and guidelines on the operational aspects of Credit Default Swap (CDS). 1) Direct market participants have to report CDS trades in a time span of 30 minutes to online repository of Clearing Corporation. 2) Banks are not allowed to sell CDS on corporate bonds on the issue date and employment of these contracts as bank guarantee is prohibited. 3) Commercial banks who wishes to play the role of market makers are allowed to both buy and sell CDS provided they have a minimum CRAR (capital to risk weighted assets ratio) of 11 per cent with core CRAR (Tier I capital) of at least 7 per cent. RBI’s pivotal objective in introducing CDS on corporate bonds is to enable and equip market participants with a tool which can be employed to transfer and manage credit (ii) Default by counterparty lead to increased risk in the most eficient way through risk recorrelation of credit risk. There is stimulation in distribution. the risk appetite of financial institutions due to viability of CDS. (iii) When CDS is coupled with securitization it leads to loop holes in risk assessment due to fact that assets and credit protection can be transferred. (iv) There is an ever increasing possibility of ac-

December 2011


LIBOR Shubhi Bansal

IIM Shillong

setting too high or too low a number. The average of the remaining 8 is then fixed as LIBOR for each tenor.

Sir, I was going through a newspaper article yesterday, and I came across LIBOR. I did not quite understand what it meant. Could you please throw some light on it and its significance? Ok, I’ll explain. But before I do, I want you to tell me something. How do the banks benchmark the lending rates for their customers? What do you think? I have read about this Sir. The banks fix a rate known as the Prime Lending Rate (PLR), which is actually the interest rate charged by the banks to their largest, most secure and most credit worthy customers on short term basis. This rate is then used as the basis for computing interest rates for other borrowers. Very well. Similarly, on a larger scale the interest rate one bank charges another on a loan is called as LIBOR or London Interbank Offered rate. It is the world’s most widely used benchmark interest rate for short term loans. One important thing to keep in mind is that it is an inter-bank rate. So who determines this rate? Well, the British Banker’s Association (BBA) compiles and calculates the rate, and publishes it every day at about 11.45 a.m. GMT in conjunction with Reuters. What do you mean by compiling and calculating? Can you please elaborate? Look, LIBOR is determined by a poll of 16 leading international banks. At 11 a.m. London time, BBA asks the rates at which the deposits are quoted to prime banks in the London inter-bank market. The sixteen quotes thus received are arranged in ascending order. The highest 4 and the lowest 4 of the quotes are discarded, to avoid

So, this means that any trading that happens on any particular day between the banks happens at this rate. No, that is not true. The rates at which banks trade with each other change every minute like all the other markets rates do. This depends upon the markets’ expectation of the economic activity and the future direction of interest rates. LIBOR only acts as a benchmark or a guideline. It doesn’t look that important a tool to me, then. Well, without a benchmark or a guideline, the trades would happen in a very random manner. This rate gives an idea about the market’s sentiments to both the investors and the borrowers. Hence, it’s very important. I can understand how LIBOR will affect the banks. But, how does it affect an individual like me? As the world becomes integrated by the day, anything that happens even at the international institutional level, affects every individual directly or indirectly. Since, LIBOR is the rate that banks charge when they make short term unsecured loans to other banks. It in turn also affects the interest rates for student loans, mortgages, value of major currencies etc. For example, almost half of all lenders peg the interest rate charged to LIBOR, including the students’ education loan. If the rates go up, the loans become more expensive and can significantly increase your cost of education. Especially in times of economic crisis, the availability of student loans just like other loans is adversely affected. Hmm, I think I will now understand the market movements better. Thank you, Sir.


Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month



FIN-Q 1. Connect the dots

2. Which event are we talking about? a) Event held in “Land of Mountains, Land by the River� b) Related to Petra c) Happened in the month Sukanya Roy won 3. Name the country with the ISO 4217 code meaning drinkware. 4. This financial organization is based in Mumbai having around 10 million investors and a Joint Venture with Shinsei Bank in Singapore. 5. Who are the Governor and Alternate Governor of IMF India? 6. What is the unit used by websites for billing based on a movie directed by Frank Coraci starring Adam Sandler. 7. Which accounting concept is also related to Neutral Monism, a famous philosophical view? 8. Name the Chairman of the Indian Stock Exchange having 464 companies listed in it. 9. Name this complete accounting software that is also the name of a street in Atlanta. 10. Connect the dots

All entries should be mailed at by 10th January, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

December 2011


WINNERS Article of the Month

Prize - INR 1000/-

Divyansh Gupta & Subodh Jain IIM, AHMEDABAD


Prize - INR 500/-


ANNOUNCEMENTS ALL ARE INVITED Team Niveshak invite articles from B-Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month” and would be awarded cash prize of Rs.1000/Instructions »» Please email your article with the file name and the subject as <Title of the Article>_<Institute Name>_<Author’s name/Group’s name> by 10 January 2012. »» Article must be sent in Microsoft Word Document (doc/docx), Font: Times New Roman, Font Size: 12, Line spacing: 1.5 »» Please ensure that the entire document has a wordcount between 1200 - 1500 »» The cover page of the article should only contain the Title of the Article, the Author’s Name and the Institute’s Name »» Mention your e-mail id/ blog if you want the readers to contact you for further discussion »» Also certain entries which could not make the cut to the Niveshak will get figured on our Blog in the ‘Specials’ section


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