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INSIGHT

SPECIAL

Interview

with

Professor

Raghuram

Rajan

Thomas Friedman

FinancialRisk Management

Rs. 100

C O V E R S T O R Y


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3/52December 2007|ISB insight|

ISB Insight Team

Bhuvana RamalingamVarshaa RatnaparkeMonidipa MukherjeePallavi Dutt

Sulagna Bishoi

Photography:Kasarla Visual Communications

Design & Cover Illustration:Trapeze

Resources:Learning Resource Centre at the ISB

Printed atKala Jyothi Process Pvt Ltd

Indian School of Business

Gachibowli, Hyderabad 500032, IndiaPhone: 91 40 23007000, Fax: 23007012Email: [email protected]

Inside Cover:Section of the ISB Learning Resource Centre

Dear Reader,

It has been a season of conferences here at the ISB. Students and faculty organised

conferences on a wide spectrum of management subjects - from real estate to healthcareand pharma, from social responsibility to supply chain and logistics.

The student clubs have been very active indeed, vying with one another to get excellent

speakers on campus, with the result that now everyone is beginning to feel extremely

knowledgeable about various industries and the issues that drive them in todays business

environment. The most scintillating discussion was organised by the Media club where

Editors and CEOs from the media sparred with one another, at the same time sharing

common problems that the media industry faces, and what the regulators should be doing

to support the Indian media industry instead of putting spokes in their wheel.

The ISB has been fortunate to attract visionary speakers, so when Thomas Friedman,

the author of The World is Flat spoke at the ISB, the Khemka auditorium was packed

and spellbound. The effect was the same when Sadhguru Jaggi Vasudev spoke on a

completely different matter inner engineering. We learnt yet another lesson fromCaptain Gopinaths (of Air Deccan fame) passionate story of an entrepreneur who dared

to reinvent himself again and again, and his journey from the armed forces to farming to

the airline business.

To top it all we had artist Julius Macwan, this years Artist in Residence, paint a

controversial picture of a lady on the cross. It set everyone wondering whether this was

the depiction of the death of the MBA, while Julius enigmatically smiled and said that

it was up to everyone to interpret art to make sense personally. Kalpna Lajmi, in her

inimitable and fiery style, regaled us with the history of financing of the Indian cinema.

In all, an intense and thought provoking three months, and the ISBInsight team brings

snippets of all these experiences to you along with interesting cover stories on Financial

Risk Management.

Bhuvana Ramalingam

Editor

From theeditors desk

Copyright, 2007. Indian School of Business (ISB). Allrights reserved. All articles have been copyrighted byISB and no part of this magazine may be reproducedeither in part or full, or electronically stored intoa retrieval system, or disseminated in any form(electronic, mechanical, photocopying, recording orotherwise) without ISBs prior written permission.

Subscriptions: For details contact:[email protected]


4/522|ISB insight|December 2007

M Rammohan Rao, Dean, ISB, with TiE-ISB Connect guests

During the ISB Media Conclave

The Real Estate Conclave

Contents

4 Cover Story: Financial RiskManagement

Given the inherentunpredictability of markets

across the world, financial risk

management is imperative for all,

be it economies, capital markets,

or individual investors

6 Preparing for the NextDownturnForecasting the time and depth

of the next downturn is never

easy. Managers, at the crest of

an upbeat economy should also

be ready for a recession that will

follow inevitably, and find ways

to make the most out of such a

downturn

10 The future of currencyderivatives in India

Professor RamabhadranThirumalai makes an impressive

case for introducing currency

futures in the Indian markets

14 Offshore betting on the IndianRupee

Professor Rajesh Chakrabarti addsanother idea to the futures market

the non-deliverable forward

market

17 Risk Management in India a view from NSE

NSE shares brief comments on

managing risks in the complexand unique Indian market An

insight into risk parameters and

the value at risk principle

18 ISB Insight Special- The Wave ofEconomic Reforms

The next generation of reforms haveto focus on how to bring growth

to the rest of the country, shares

Raghuram Rajan, Professor of

Finance, Graduate School of Business,

University of Chicago, in conversation

with Sudip Gupta, Assistant Professor

of Finance, ISB

22 TiE ISB Connect - On the RightTrackThe catalytic forum of TiE -ISB

Connect this year, focused on new

and emerging sectors like retail, media

& entertainment health-care among

others. Each track reviewed global

trends in the sector and predicted

sector opportunities

24 Realty Concerns - A Global ViewEminent industry leaders gathered

for a panel discussion to address the

impending concerns in the real-estate

sector in India. Professor JosephGyourko, Director of Zell-Lurie Real

Estate Centre, The Wharton School,

University of Pennsylvania, observed

that a lot of fundamentals can be

replicated across borders

26 Creating a Life Balance in a FlatWorld

Three times Pulitzer Prize winnerThomas L Freidman, shares the

genesis of his best seller, the three

eras of globalisation, the forces thatcreated the flat world, and how to stay

ahead in the flat-world platform


5/52December 2007|ISB insight|3

Artist-in Residence, Julius Macwan interacts with students

Union Minister Shivraj Patil visits the ISB

Sadhguru Jaggi Vasudev

30 On Managing Healthcare and

EducationTwo conclaves, organised by the

student Clubs at the ISB, addressed

the corner-stones of social

infrastructure - education and basic

healthcare. Access to basic healthcare,

the economics of healthcare in India,

empowerment through education -

such were some issues of deliberation

32 Getting to Know the India FactorTo further their understanding about

the Indian economy and market ethos,Belgium based investment company,

GIMV, attended a CEE Programme at

the ISB. Chairman of Board, Herman

Daems, shares the scope of his visit

33 Is it the Death of Broadcast? Students chat up with media stalwarts

during the ISB Media Conclave, on

issues of consolidation, media ethics,

and the future of broadcast. They ask

upfront - Is the media selling out?

36 From Sourcing Deals to Managing

Exits A Venture Capital Development

Programme equipped participants to

deal better across the investment table

and imparted an acute understanding

of financing entrepreneurial businesses.

Also, Coach John Mullins shares how to

assess a business opportunity

38 Operation Goal Ram Bala, Assistant Professor at the

ISB, recounts how a book inspired

him in his journey of Operation

Management. He is keen to pursue

India-centric solutions through his

current research in the pharmaceutical

industry

40 The Limitless Classroom The Business and Arts

programme seamlessly mergesclassroom learning at the ISB,

with the inspirational world of

art. Director Kalpana Lajmi and

artist Julius Macawn, during their

recent visit, helped merge the

binaries between art and business

42 Tryst with a Guru Spiritual guru Sadhguru Jaggi

Vasudev talks on the ingredients

of successful life and a successfulbusiness and adds that the beauty

of life lies in the fact that it has no

meaning

44 Taking Logistics to the Next

Level The Centre for Global Logistics

and Manufacturing Strategies

(GLAMS) at the ISB hosted its

flagship event of the year, the

Global Supply Chain Summit,

and explored challenges andopportunities in rural and

global supply chains in emerging

markets

46 ISB Happenings Festivals, visits by dignitaries,social initiatives, inspirational

talks these and more were

some oncampus glimpses of the

quarter. Never a dull moment,

this time of the year at the ISB

48 Book ReviewAlan Greenspans personal and

intellectual legacy is available

to those interested in managing

finance in the 21st century in TheAge of Turbulence



FinancialRisk Management


7/52December 2007|ISB insight|

Managing risk can probably be

defined as the ability to foretell

what is going to happen tomorrow,

next week, next month, and next year. And

to have the ability afterwards to explain why

it didn`t happen, said Winston Churchill

1874-1965, British prime minister and

writer.

Tongue in cheek quotes apart, as

financial markets become more volatile

and competition increases, managers need

a clearer understanding of the risks they

are taking to protect the physical, financial,

human, and intellectual assets of their

companies. Catalysed by Basel II, financial

institutions around the world are taking a

fresh look at managing market, operational,

and credit risk. In the process, they areredefining the role of risk management

in achieving objectives and, ultimately,

increasing shareholder value. Their main

goal is not to eliminate uncertainty, but

rather to be proactive in assessing and

managing risk for their own advantage.

Although uncertainty has always been

a factor in corporate decision-making,

financial institutions are now seeking a

comprehensive, integrated approach to

identifying and managing risks. The broader

issues of risk have become a top priority forthe senior management CFOs, treasurers.

Risk officers are working to build risk

management processes and embed them

into management practices at all levels.

Developments in the financial sector

have led to an expansion in its ability to

spread risks. The increase in the risk bearing

capacity of economies, as well as in actual

risk taking, has led to a range of financial

transactions that earlier were not possible,

and has created much greater access to

finance for firms and households. Overall,

this has made the world much better off.

However, we have also seen the emergence

of a whole range of intermediaries, whose

size and appetite for risk may expand over

the cycle. Not only can these intermediaries

accentuate real fluctuations, they can also

leave themselves exposed to certain small

probability risks that their own collective

behaviour makes more likely. As a result,

under some conditions, economies may be

more exposed to financial-sector-induced

turmoil than in the past. It becomes vital

therefore to be forewarned about the cyclical

turns of the economy and prepare for a

downturn when things are going good.

The great decisions of human life have

as a rule far more to do with the instinctsand other mysterious unconscious factors

than with conscious will and well-meaning

reasonableness, said Carl Gustav Jung,

Swiss psychiatrist and founder of Analytical

Psychology. Nevertheless, much energies are

spent in planning, measuring, and managing

risk. Given the portent of economies of

nations, the innumerable investors and

exchanges that participate in the stock

market and the mind boggling capital

outflow across the world, it is important

to give careful thought to financial riskmanagement.

This issue features cover stories on

Financial Risk Management from academiciansas well as industry executives. Foreseeing the

cyclical turns of the economy, the regulators

pivotal role in influencing the markets, the

option of currency futures, are the topics

that have been covered. ISBInsight gathers

perspectives from the NSE on managing

risks. We hope you gain some valuable

insights in the following pages.



Economists, Nobel laureate Paul Samuelson

famously quipped, have correctly predicted

nine of the last five recessions. Impossible

as it is to forecast the timing or the depth the

next downturn, executives enjoying todays

upbeat economy should also be preparing

for the recession that will inevitably follow.

Many werent ready for the last one; by our

reckoning, nearly 40 percent of leading US

industrial companies toppled from the first

quartile in their sectors during the 2000-01recession, and a third of leading US banks met

the same fate. At the same time, 15 percent of

companies that had not been industry leaders

prior to the last recession vaulted into those

positions during it.

To understand how to make the most

of a recessionary environment, we

analysed the performance before,

during, and after the 2000-01 recessions

of some 1300 US companies from a broad

range of sectors1 and identified which of

these companies emerged from it having

gained or maintained leadership status2.

For these industry leaders, we analysed

which characteristics they exhibited before

the recession that might help explain why

they outperformed their peers. Although

recessions strike different sectors indifferent ways and at different times,

the post recession leaders in most of the

sectors we explored had characteristics

in common. Entering the downturn, they

typically maintained lower leverage on

their balance sheets, controlled operating

costs well, and diversified their product

offerings and business geographies. Such

fundamentals gave them a greater degree

of strategic flexibility, which became

even more valuable during the recession.

And although previous recessions arentnecessarily a guide to future ones, we

believe that flexibility can make a notable

difference by allowing managers to take

advantage of the opportunities that that

next recession might provide.

Balance Sheet Flexibility

Whatever the positions the companies

had within their sectors before the

downturn, many that emerged from it as

leaders expanded their businesses during

the recession, both organically (through

internal investment) and through inorganic

activities such as M&A, alliances, and

joint ventures. And although the leader

increased their asset bases through capita

expenditures or acquisitions at the same

pace as less successful companies did

before the recession, the focus of their

growth was different: the more successfu

companies spent less on M&A, on average

and focused more on organic growth. In

1999, for example, leading companies had

on average, capital expenditures that were8 percent higher and growth through M

& A that was 13 percent lower than their

less successful counterparts did. During the

recession itself, however, better performers

leapfrogged the competition by continuing

to invest and to grow inorganically: in the

year 2000, companies that emerged in the

top quartile spent 15 percent more on capita

expenditure and conducted 7 percent more

M&A possibly buying cheaper assets from

distressed sellers. In addition, they were

able to pay their suppliers faster, probablyin an effort to negotiate lower prices and

better service.

Arguably, winning companies leveraged

the benefits of balance sheet flexibility tha

they had achieved before the recession

At industrial companies that ultimate

emerged as sectors leaders, for example

the average net debt-to-equity (D/E) ratio

before the recession was roughly half tha

of their less successful competitors. Whats

more, the post recession leaders also held

Preparing for the

Next Downturn



Executives can build flexibility into a companysbalance sheet by reducing the capital intensity of

the business model, for example, or by resisting

the urge to use additional debt to finance

dividend growth or share buybacks.

Exhibit 1: Pre-recession approaches to increase flexibility

Top quartile companies are better prepared

Strategic Lever

Balance Sheet Flexibility

Operating Flexibility

Flexibility of product

offering

Industrial Companies

Steady increases in capacity

Continue and increase capacity organically

Reduction in inventories but also payables

Maintain lean inventories, continue to improve

levels in pre-recession years

Maintain ability to pay suppliers sooner to

secure good contract terms

Financing capacity for taking advantage of

opportunities

Reduce leverage compared to industry

Boost ability to finance internally higher cash

balance, lower dividend payout

Cost variability

Reduce selling, general, and administrative

costs during recession, but not before

Build ability to quickly refocus, reduce spending

Maintain higher employee productivity

No across-the-board head count reduction at

beginning of recession

Healthy Diversification

By segment

By geography

Value Based Product Innovation

Understand customer segment

Introduce innovations to increase volume

without discounting prices

Continue focused advertising

Additional characteristics of banks

Financing capacity for taking advantage of

opportunities

Control portfolio deterioration, use quality measure

in investing

Improve capital adequacy ratio

Ability to preemptively reduce costs

Improve interest spread

Reduce both personnel and non personnel costs

Restructured product mix, innovative product offering

Offer products

Tailored to profitable customers

Identify, reduce exposure to unprofitable

customers



more cash on their balance sheets prior to

the recession than those that weathered it

less successfully.

Starbucks was one company that used

such tactics to good effect in holding onto its

leader status before and after the recession.

In 1996 it had a D/E ratio of 8 percent,

compared to an average of 14 percent of the

restaurant sector, and managers consistently

reduced the companys leverage every yearuntil 19993. That year the D/E ratio of

Starbucks dropped to only 2 percent, as the

industry average hit a high of 31 percent.

Managers achieved this target by expanding

the proportion of licensed outlets from

7 percent in 1998 to 13 percent in 1999

and 23 percent in 2000. Licensing and

international expansion through alliances

allowed Starbucks to accelerate its growth

during the recession. Currently alliances

contribute 14 percent of the companys

revenues but account for 39 percent of its

profits.

Executives can build flexibility into a

companys balance sheet by reducing the

capital intensity of the business model, for

example, or by resisting the urge to use

additional debt to finance dividend growth

or share buybacks. In our study, as profits

grew during the expansion, the companies

that emerged as winners refrained from

increasing their dividends: their dividend

payout ratio gradually decreased from apeak of 40 percent in 1995 to 32 percent

in 1999. Then they cut dividend payouts

aggressively at the first signs of recession,

reducing the payout ratio to 28 percent in

2000. In contrast, before the recession their

less successful counterparts kept dividend

payouts roughly stable at 35 percent in

1995 and 33 percent in 1999 and even

increased them to an average of 38 percent

in 2000 as the recession began.

Operating flexibility

Many companies that emerged from the last

recession as industry leaders also focused on

reducing costs without damaging the long-

term health of their businesses. Although,

selling, general, and administrative (SG&A)

costs are typically difficult to cut in short

term, winning companies did so by making

their overhead costs and operations more

flexible before the recession. Consequently,

they could redeploy their funds, assets, and

personnel as conditions changed. When the

recession began, they quickly readjusted

their SG&A to the new environment, cutting

these costs even further, to a level 3 percent

below that of their successful rivals4, in spite

of having comparable starting levels.

The US cataloguer and retailer Talbots,

for example, increased the flexibility of its

workforce in the years before the recession,

adding part time workers during the growth

period of 1990s at almost double the pace

at which it added salaried workers. From1998 to 2000, the companys hourly part-

time workforce grew by 14 and 16 percent

a year, respectively, the salaried staff only by

9 percent. Then, as the recession took hold

in 2000 and 2001, Talbots also radically

shifted its advertising mix away from TV and

catalogue operations and toward focused

activities targeting customer groups with

the highest sales potential. Although, this

strategy somewhat reduced the companys

ratio of advertising expenses to revenues(from 5.5 percent of revenues in 2000 to

4.3 percent in 2001), Talbots maintained

advertising levels far above the sector in

general; its ratio of advertising expenses

to revenues was 120 percent higher than

the sector average in 2000 and 80 percent

higher than it in 2001. Such measures

helped Talbots emerge from the recession

as a leader in its sector, though it entered

the recession as a challenger.

In contrast, less successful companies

cut their R & D and advertising more deeply

putting them at a disadvantage at tapping

the opportunities these expenditures

might create. Before the recession, their

productivity per employee was lower than

that of the leaders, and so they had to lay

off more employees during the downturn

perhaps damaging their ability to attract

and retain talent in the future.

Product Offerings

Companies that emerged from therecession as industry leaders generally had

9

8

7

6

5

4

3

2

1

0

CAGR1 of outlets, % 30 34 32 40 35 25 23 19

Number of Starbuck outlets, thousands

1996 1997 1998 1999 2000 2001 2002 2003 2004

1 Compound annual growth rate. Source: Starbuck; McKinsey analysis

Prerecession recession Postrecession

Owned

Licensed

Exhibit 2: Starbucks extreme flexibilityStarbucks accelerated its growth during the recession in partby increasing the number of licensed and owned locations.



1In our past research, we analyzed what helps companies succeed during a recession, as well as in the expansion periodsbetween recessions. See Richard F.Dobbs, Tomas Karakolev, and Francis Malige, Learning to love recessions, The McKinse

Quarterly, 2002, special edition: Risk and resilience, pp 6-9. In this article, we focus on the years immediately preceding a

recession to identify how companies prepared for it. Although everyone is different, we believe our research can be useful in

helping managers and boards prepare when they conclude that a recession is imminent.

2 For the pre and post recession periods (1998-99 and 2001-02, respectively), we define the industry leaders as companiein the top quartile of their industries, measured by returns on invested capital (ROIC) and market-to-book ratios (M/B)

For banks we used returns on equity (ROE) and M/B. Companies in the other three quartiles we refer to as challengers. Ou

sample included 1024 US companies in 27 industrial sectors and 264 US banks. We investigated the financial performanc

of each company during the period from 1995 to 2005.

3The D/E ratios of the companies in this analysis were not adjusted for the capitalized value of operating leases and retiremen

liabilities. Although such adjustments do affect the absolute degree of leverage, they do not significantly affect the relativeranking of companies.4Normalized for revenue.

more diversified product offerings and a

greater geographic presence before, during,

and after the recession than did their less

successful counterparts. This pattern was

particularly true of companies that led

their industries before the recession and

retained this status after it: their sales were

twice as diversified by segment as those of

companies that ceased to be leaders. By

geography, the difference was smaller, butleaders that retained their status were about

20 percent more diverse in this respect.

In addition, successful companies

proactively managed their customer and

product portfolios before the recession.

Consider the US telecommunications

company Verizon, which coupled an

expanding customer base with increasing

average revenues per user to offset falling

call prices. Average revenues per user fell

throughout the industry as per minute

revenues dropped by nearly 20 percent

annually from 2000 to 2003. By altering its

service mix toward broadband and value-

added services, Verizon maintained its

winning status through the recession.

Consider also the experience of

Starbucks, which drove up sales during

the late 1900s by boosting both prices and

traffic; its comparable store sales growth

increased by 5 percent in 1997 and 1998

and by 7 percent in 1999. When the

recession struck, Starbucks avoided massivediscounts, instead adding innovative value-

added services (including Wi-Fi internet

access in its stores), the Starbucks Card,

and improved customer service. As a

result, in 2002 the company again posted

comparable-store sales growth of 6 percent,

achieved through traffic growth of over 8

percent.

If past is prologue, managers and

boards wont forecast with any precision

the timing of the next recession. But they

should be asking themselves today whetherthey are building the financial, operating,

and product flexibility to make the most of

the next downturn.

This article was first published in the Spring2007 issue of McKinsey on Finance and can be

found on The McKinsey Quarterly Websitewww.mckinseyquarterly.com.

Copyright 2007 McKinsey & Company.All rights reserved. Reprinted with permission.)

110

108

106

104

102

100

98

96

94

92

0

1999 2000 2001 2002 2003

0.30

0.25

0.20

0.15

0.10

0.05

0

1999 2000 2001 2002 2003

Verizon US industry average

Exhibit 3: Success in the face of declineTo offset falling call prices, Verizon combined an expandingcustomer base with increasing average revenues per user.

Average revenue per user;index: average

revenue per user in 1999 = 100

Revenue per minute, $

1 For 4th quarter only.

Source: Global Wireless Matrix IQ04, July 7, 2004, Merrill Lynch; McKinsey analysis



In this article, Ramabhadran S Thirumalai

explores the pros and cons of introducing

currency futures in India. Thirumalai is an

Assistant Professor of Finance at the ISB.

Prior to joining the ISB, he was teaching at the

Kelley School of Business, Indiana University.

His current research interests are in market

microstructure and corporate governance.

Derivatives In IndiaThe Future Of Currency

The Indian rupee (INR) has appreciated

by around 12 percent relative to the

US dollar (USD) in 2007 alone. This

has led to reduced profitability of a number

of Indian companies. Consequently, the

push for introduction of currency futures

in India has gained momentum. The

Reserve Bank of Indias (RBI) Committeeon Fuller Capital Account Convertibility

has recommended the introduction of

currency futures in India. Based on this, the

RBI, in its Annual Policy Statement for the

Year 2007-08, set up an Internal Working

Group on Currency Futures to recommend

a suitable framework within which currency

futures can be traded in India. Further,

the Ministry of Finances High Powered

Expert Committee on Making Mumbai

an International Finance Centre (IFC) in

its report points out to the lack of, amongother things, a currency derivatives market

that could hurt Mumbais chance of being

an IFC.

While the RBI and other government

bodies debated the introduction of currency

futures in India, the Dubai Gold and

Commodities Exchange became the first to

list and trade futures contract on the INR

in June 2007. It introduced futures on the

INR-USD exchange rate with each contract

on INR 2 million. These are physically

deliverable contracts. The market started of

with a bang with contracts worth over INR1

billion being traded on each day for the first

few days. The market has since cooled of

and by the end of November 2007 around

INR80 million worth of contracts have been

traded each day. Though trading volume o

the INR-USD futures has dropped sinceintroduction of the contract in Dubai, i

does not undermine the importance o

introducing currency futures in India.

In the current environment in India

entities wanting to hedge their exposure to

exchange rate risk have to do so in the over-

the-counter (OTC) markets using forwards

options, and swaps. Being private party

agreements between a dealer (typically

a bank) and a private entity, the dealer

attempts to reduce default risk by entering

into these contracts only with highlycreditworthy entities. As a result, smal

companies and individuals may not be able

to hedge their exchange rate risk through

OTC markets. This potential problem may

be dealt with by having exchange-traded

derivatives like futures.

Currency futures, by definition, trade

on exchanges. Futures are like forwards in

that they are obligations to trade currencie

at a specified exchange rate at a specified

future date. Both these contracts typically



While the RBI and other government bodies

debated the introduction of currency futures

in India, the Dubai Gold and CommoditiesExchange became the first to list and trade

futures contract on the INR in June 2007.

It introduced futures on the INR-USD

exchange rate with each contract on INR

2 million.

have a life of a few months up to a maximum

of one year. However, while forwards are

customised, futures are standardised to

facilitate a liquid market. The counterparty

to all futures contracts is the exchange

clearinghouse, thereby reducing default

risk on one side of these contracts. The

clearinghouse, in turn, imposes dailysettlement on entities that have open

futures positions. Daily settlement involves

determination and immediate realisation of

a daily gain or loss on each futures position.

At the time an entity opens a new position

in a futures contract, the exchange requires

it to deposit a percentage of the notional

value of the contract, typically less than 10

percent, in a margin account with its broker.

This margin account is adjusted daily to

reflect that days gains or losses. Given that

the daily settlement process is imposedon all investors trading in futures markets,

reducing default risk, smaller investors may

find it easier to trade in these markets rather

than in forwards.

Before further comparing forwards and

futures, an example of how forwards and

futures may be used to hedge exchange rate

risk would be beneficial. Say, the current

one-month forward exchange rate between

INR and USD is 40.00. A company is

expecting an inflow of USD1 million in a

months time at which time it will convert

the USD to INR. It wants to hedge its

exposure to exchange rate fluctuations over

this period. The company will enter into

an obligation to sell USD and receive INR

in a months time at 40.00INR/USD. The

company knows that, regardless of what

happens to the spot exchange rate overthe next month, it will be able to convert

the USD1 million to INR40 million. The

company could also use a futures contract to

hedge its risk. In this case, the hedge works

a little differently. Say, the current futures

price is 40.50INR/USD. Here we assume

that the futures contract expires after the

company receives and converts the USD

1 million. On the day the company receives

the USD, the futures price is 39.75INR/

USD and the spot rate is 40.00INR/USD.

It closes its position in the futures contractand realizes a gain of 0.75INR/USD (total

gain of INR750,000 on USD1 million) on

its futures position. The company would

sell USD1 million in the spot market and

receive INR40 million. The net realised

cash flow in INR would be 40.75 million.

While this is not a perfect hedge, the risk

is lower than staying un-hedged. The

difference between the spot and futures

price on the day the hedge is unwound is

called the basis. The ex-ante uncertainty Professor Ramabhadran Thirumalai



of this basis (called basis risk) causes the

hedge to be less than perfect.

From a market structure perspective,

futures trade on centralised exchanges

whereas forwards trade on fragmented

OTC markets. The potential benefit of

trading on a centralised market vis--vis a

fragmented market is unclear. Biais (1993)

shows that, all else being equal, expected

bid-ask spreads are similar in both markets.

However, de Frutos and Manzano (2002)

show that expected spreads in fragmented

markets are narrower. Both these studiesignore search costs incurred by investors

in fragmented markets. Yin (2005) shows

that when these search costs are considered

centralised markets have narrower bid-ask

spreads than fragmented markets. While

there may be perceived benefits of having

a centralised trading location for futures,

it is not clear whether futures markets

will have better liquidity than forward

markets.

There are a few drawbacks of using

futures to hedge exchange rate risk. Asthey are standardised contracts, investors

cannot choose the size and the expiration

date of the contracts. This may result in

an imperfect hedge. On the other hand,

forward contracts can be customised in

terms of size and expiration dates among

other dimensions. Hence it is possible to

create a hedge that is closer to a perfect

one. This does not mean that a hedger

should always choose forwards over futures

to hedge foreign exchange (hereafter forex)

exposure. Any hedger still has to decide

between a forward and futures contract

Lioui (1998) provides some insight about

this choice. In the presence of stochastic

interest rates, he finds that when hedging

effectiveness is measured by volatility

minimisation of the hedged portfolio, both

forwards and futures give identical hedges

even if prices in both markets are different

However, if the hedging effectiveness is

measured by the risk-return trade-off of the

two strategies, hedgers will prefer one over

the other under different circumstances.Globally, OTC markets for forex

contracts are huge, relative to exchange-

traded contracts. A recent report from the

Bank for International Settlements (BIS)

finds that the notional value of outstanding

forex contracts in global OTC markets was

close to USD49 trillion at the end of June

2007. These include outright forwards and

forex swaps (50 percent), currency swaps

(25 percent), and options (25 percent)

The notional value of exchange-traded forex

products was a meagre USD303 billionThese include futures and options. Given

the relative size of global forwards and

futures markets, is it really necessary to have

a forex futures market in India? The answer

is yes. One reason is the aforementioned

access to forex hedging instruments by smal

companies and individuals, who may no

have access to OTC instruments. A second

reason for having a forex futures market i

that it would facilitate timely dissemination

of future expected exchange rates to al

While there may be perceived

benefits of having a centralised

trading location for futures, it is

not clear whether futures markets

will have better liquidity than

forward markets.



interested entities leading to better price

discovery in this market. Rosenberg and

Traub (2006) find that when compared to

a fragmented and opaque spot market for

currencies, the futures market accounts

for 80 to 90 percent of price discovery in

currencies despite its small size relative

to the OTC markets. The existence of a

forex futures market clearly improves the

efficiency of currency markets.

To be able to attract small companies

and individuals to forex futures, the size

underlying each contract should be small. A recent report by the RBIs Internal

Working Group on Currency Futures has

suggested that each contract should have

a notional value of USD1,000. Assuming

that the exchange rate stays at around 40

INR/USD and the margin is no more than

10 percent, this would imply that investors

would be required to post an initial margin

of no more than INR4,000 per contract,

which would be fairly affordable to small

investors. The same RBI report has also

recommended that the futures contractbe cash-settled in INR because the INR is

currently not fully convertible on the capital

account. Eventually, when the INR becomes

fully convertible on the capital account, it

is hoped that these futures will be settled

with physical delivery of foreign currency,

much like it is at other forex futures

markets around the world like the Chicago

Mercantile Exchange.

A major roadblock to introduction of

forex futures in India is the regulation of

its exchange. In India, it is the RBI that

controls the forex market and hence it

wants to control the forex futures market

also. On the other hand, the Securities

and Exchange Board of India (SEBI) is in

charge of creating and regulating security

exchanges in India. The aforementioned

RBI report recommends that the RBI

regulate the forex futures market and set-

up a dedicated exchange for forex futures. A

potential downside of the RBI regulating this

exchange is its inexperience in regulating

organised markets. The SEBI has moreexperience with regulating exchanges and

it has been fairly successful doing so. One

can argue whether the RBI or SEBI should

be given the responsibility of regulating

forex futures markets in India but given the

reports recommendation only time will

tell if the RBIs attempt at regulating an

organised market for forex futures will be

successful. This report further adds that the

dedicated forex futures exchange could be

run by one or more of the Indian exchanges

provided they meet the eligibility criteria. Itlists some of the advantages of doing this,

namely, lower set-up costs and the expertise

and experience that these exchanges bring.

Involving any of the existing stock or

commodities futures exchanges is a good

idea. Most of these exchanges are fairly

young and have a first-hand experience in

dealing with the growing pains of a young

exchange. This experience will go a long

way in setting up a successful forex futures

market in India.

There are a few drawbacks of

using futures to hedge exchange

rate risk. As they are standardise

contracts, investors cannot choos

the size and the expiration date o

the contracts. This may result in

an imperfect hedge.



Rajesh Chakrabarti is Assistant Professor

of Finance in the Indian School of Business.

Educated at the Presidency College, Kolkataand IIM, Ahmedabad, he has a PhD from the

University of California, Los Angeles (UCLA)

and is currently focusing his research on the

financial sector in India. He has published in

top-tier academic journals and has authored

two books including The Financial Sector in

India Emerging Issues, published by the

Oxford University Press in 2006. He has taught

in the USA, Canada, France, and India and

currently teaches the courses International

Finance and Indian Financial System to

students of the Post Graduate Programme in

Management at the ISB.

I

t has been exciting times for the Indian

Rupee lately. Its exchange rate dynamics

has experienced quite a reversal from the

time-honoured trend. The familiar regime

of the declining rupee has been replaced

by swelling foreign exchange reserves

and government efforts to control an

appreciating rupee. Trading volumes in the

Indian Rupee have risen close to four times

in the last 3 years and the Indian Rupees

share of world currency transactions has

more than doubled from about 1.5 percent

of total currency transactions in the world

in 2004 to about 3.5 percent in 2007.

A large part of this is driven by foreigninvestors discovery of India. There has

been a surge of foreign investment flows

into the country in recent years. In the last

five years foreign investment inflows have

grown at a compounded annual growth

rate (CAGR) of over 26 percent (see Figure

1). The sources of these funds have been

numerous. Foreign Institutional Investors

seeking pure portfolio investments, private

equity firms picking up large blocks of

shares and all-out foreign direct investment

have all contributed to the surge of capitalinflows, aided by external commercial

borrowings (ECBs) by Indian companies.

Indeed, monetary authorities as well as

industry are concerned that this deluge

of inflows may inundate the system and

is already causing an appreciation of the

Rupee, casuing an erosion of Indias

competitiveness in key export markets like

textiles and software.

Amidst all these excitements in

Indias external sector, the offshore non-

deliverable forward (NDF) market for the

Indian Rupee is often completely forgotten

The growth in activity in this market, has

however, surpassed both the impressive rise

in rupee denominated forex transactions a

well as investment inflows. In 2007-08 so

far, transaction volumes in the NDF market

for the Rupee has reportedly soared to

over $750 million a day from about $100

million a day in 2003-04.

From a foreign investors point of view

fluctuations in the Indian Rupee clearly

present a risk that needs to be managed, as

the value of their investments and cash flows

directly hinge upon the value of the rupeein their home currencies. Non-deliverable

forwards (NDF) provides foreign investors

with a method to hedge their currency risk

associated with movements in the rupee

Before the launch of the Indian Rupee

Futures Contract in Dubai earlier this year

the NDF provided foreign players with

the only offshore hedging tool to manage

Indian Rupee risks. A clearer understanding

of the NDF market, therefore, provides

insights into the currency risk managemen

practices as well as speculative activitieinvolving the Indian Rupee, occurring

outside Indias borders.

How does an NDF contract work? The

NDF market is essentially a forward market

for the Indian Rupee, where forward

contracts on the Rupee are written against

typically the US Dollar or the Euro with the

difference that, on maturity, the contract is

settled not by delivery of the Indian Rupee

against that of the counterpart currency, as

is the norm in the usual forward market

Offshore Betting on the Indian Rupee

The Non-Deliverable

Forward (NDF) Market



but rather through the exchange of Dollars

or Euros depending upon the spot price on

the settlement date. Let us take an example

of the Rupee-Dollar NDF for 38 million

Rupees with a price of Rs.38 per USD

maturing on, i.e. with a settlement date

of, December 31, 2007. The fixing datefor this contract is one business day before

settlement, i.e. December 30, 2007. The

fixing rate is the RBI reference USD-INR

rate on the fixing day. Now let us say this

rate turns out to be Rs. 39 per USD. Since

the rupee is weaker in the spot market as

opposed to the NDF contract, the seller of

the NDF contract on the Rupee makes a

profit, in the sense that he can notionally

purchase Rupee in the spot market at the

rate of Rs 39 per USD and settle the NDF

at the higher (Rs 38) rate. The buyer has

made a corresponding loss. If the buyer had

taken delivery he would have had to pay

USD 1 million for the contract. Selling the

38 million Rupees in the market would have

fetched him USD 38/39 million or USD

0.9744 million, indicating a difference of

USD 0.0256 million or USD 25,600. Instead

of actually settling the NDF contract on

December 31, with the buyer taking delivery

of Indian Rupees as in the usual forward

market, here the buyer pays the seller theloss (gain for the seller) and the contract is

settled. In our example, therefore, the buyer

pays the seller approximately USD 25,600

and the contract is considered settled. Of

course, if the Rupee had strengthened in

the spot market relative to the NDF rate,

the direction of cash flow would have been

reverse, i.e., from the seller to the buyer.

Therefore the actual cash transactions in

the NDF market are a small fraction of the

notional values of the contracts transacted.

The NDF market is typically an offshoremarket, free from regulatory control of the

currencys home monetary authority. New

York, Singapore, and London are major

centres with the first two specialising in Latin

American and Asian currencies respectively

and the third spanning both sets. Hong

Kong is an important trading centre for

Asian currency NDFs as well. In 2003,

six Asian Currencies the Korean Won,

Chinese Renminbi, New Taiwan Dollar,

Indonesian Rupiah, Philippine Peso, and

the Indian Rupee constituted a majority

of global NDF markets with the remaining

volume coming largely from Latin Americancurrencies and the Russian Rouble. For the

Indian Rupee, NDFs are traded primarily in

Singapore and Hong Kong with Dubai and

Bahrain showing some activity as well.

The NDF market for the Indian Rupee

started back in the 1990s when it provided

the foreign investors in India the only avenue

of hedging currency risk in the presence of

severe exchange restrictions in a scenario

where the Rupee was expected to have a

secular decline. Foreign investors would

generally sell the NDF Rupee contractsto hedge their underlying positions. The

opposite side would typically be taken by

Indian trading companies and exporters

who could make arbitrage profits as they

had access to both the onshore currency

markets as well as Dollar flows outside the

country.

The NDF market typically flourishes

when capital controls prohibit foreign

players from having unlimited access to

the onshore forward market. In India, RBI

rules now allow importers and exporters tobuy forward contracts up to their previous

years turnover or previous 3 years average

import or export, whichever is higher, but

at least 80 percent of their forward cover

should be in the form of deliverables. FIIs

are allowed to hedge their equity and debt

exposures. FDI investors can have forward

cover not exceeding six months. Non

residents can buy but not issue currency

derivatives.

Though the size of the Indian Rupee

NDF market is small compared to both

those in other Asian currencies like the

Korean Won, Chinese Renminbi, and the

Taiwan Dollar, and other Rupee exchange

markets (it is less than a quarter of the Spot

market as well as the onshore forward/swap

market), it has witnessed a phenomenal risein recent years. Accurate numbers are hard

to come by as NDFs are over the counter

(OTC) instruments. However in 2003

the outside estimate for daily volumes in

the Indian Rupee NDF market was $100

million. In 2007 it is estimated to be over

$750 million. The bidding volume on

NDFs (essentially quote enquiries and

expressions of interest without necessarily

resulting in deals, including multiple quote

seeking) is over $4.6 billion (Mishra and

Behera (2007)). Bidding volume is spread

almost evenly across the different maturities

ranging from 1 month to 1 year with the

latter end showing slightly higher volume.

All derivative markets serve tw

constituents hedgers and speculators

and the Indian Rupee NDF market

is no exception. Hedging of the Indian

Rupee risks by foreign investors is clearly

one major activity for the NDF market.

With the gradual relaxation of exchange

restrictions in India over the years,however, the NDF market now primarily

serves non-residents like currency hedge

funds interested in speculating on India.

Multinationals also use the Indian Rupee

NDF market to hedge their exposure.

There is also a demand from arbitrageurs

playing the two forward markets. Onshore

financial institutions are prohibited from

participating in the NDF market. Several

major global banks like Deutsche Bank,

UBS, and Citibank are active traders in the

Rupee NDF market. The activity here hasrisen by over 7.5 times in the last few years

while total foreign investment in India has

roughly trebled during the period and with

easing currency restrictions.

As compared to the onshore spot and

forward markets, however, the relative

liquidity in the NDF market mirrors these

lower relative volumes. The average bid-ask

spread in the 1-month NDF is estimated

to be about 11 basis points (of the mid-

quote value), close to four times that in the

Professor Rajesh Chakrabarti



ForeignInvestments($millions)

30,000

25,000

20,000

15,000

10,000

5,000

0

-5,000 1990-91

1990-92

1990-93

1990-94

1990-95

1990-96

1990-97

1990-98

1990-99

1990-00

2000-01

2001-02

2002-03

2003-04

2004-05P

2005-06P

2006-07P

P: Provisional Portfolio DirectSource: Handbook of Statistics on the Indian Economy, Reserve Bank of India

Figure 1: Foreign Investments inflows into India

Figure 2: The NDF differential : NDF one month rate (INR/USD) Onshore forward rate

1M NDF Differential30 per. Mov. Avg. (1M NDF Differential )Linear (1M NDF Differential)

0.50

0.40

0.30

0.20

0.10

0.00

-0.10

-0.20-0.30

-0.40

9-28-05

10-28-05

11-28-05

12-28-05

1-28-06

2-28-06

3-28-06

4-28-06

5-28-06

6-28-06

7-28-06

8-28-06

9-28-06

10-28-06

11-28-06

12-28-06

1-28-07

2-28-07

3-28-07

4-28-07

5-28-07

6-28-07

7-28-07

8-28-07

9-28-07

10-28-07

Ratedifferential(INR/USD)

spot market and over 20 percent higherthan in the onshore forward market. These

spreads are worse than those for NDFs

in the Chinese Yuan and the Korean Won

but better than those for the Philippine

Peso and considerably better than those

for the Indonesian Rupiah. Liquidity falls

sharply for longer term contracts for

the Indian Rupee NDFs, average spreads

almost double as one goes from the 1-

month to the 3-month horizon and rises to

29 basis points for the 6-month contracts.

These higher spreads appear to be justified by the higher volatility. The 1

month Rupee NDF rates are about 50

percent more volatile than the spot rates, and

almost 25 percent more unstable than the

onshore forward rates, with volatility rising

for longer-term contracts. It is conjectured

that RBI involvement in domestic currency

markets is a reason behind these volatility

differences.

Finally, the difference between the

onshore forward rates and the NDF rates

reflect the effectiveness of capital controlsin India, given that RBI is active in both the

onshore spot and forward markets. Between

2004 and 2007 this difference appears to

reveal a pressure for appreciation of the

Rupee that has been resisted by monetary

interventions. The extent of the gap is

however, about a third of what it used to

be around the turn of the century. Clearly

the Rupee has become significantly more

convertible during this period. Data from

late 2005 to now shows the extent to which

these markets have become integrated

through arbitrage activities (figure 2). The

average differential is nil, though there are

moderately long-lived swings on either side

of the zero line.

As the Rupee moves towards fu

convertibility (anticipated in 2009) and

new instruments for hedging currency

risk (and speculating on them) emerge

the first Rupee future is trading in

Dubai, and RBI is considering introducing

exchange-traded Rupee futures in Indiaas well the NDF market is expected to

wither away. The Rupee futures is likel

to become the venue for betting on the

Rupee (or hedging underlying exposures

for all parties, domestic and foreign, and

substitute the NDF market. Till that time

the NDF market would continue to serve

as an important currency risk managemen

tool for many foreign investors as well as

for speculators betting on the Indian Rupee

away from the regulators gaze.


19/52December 2007|ISB insight|1December 2007|ISB insight|1

Financial risk management in the National

Stock Exchange (NSE), similar in both

the equities and the derivatives markets,

has evolved over a period of time and is as

prescribed by SEBI (Securities Exchange

Board of India). SEBI employs a consultative

approach in involving the exchanges to arriveat an efficient risk management system. The

risk management system has proved itself

time and again as a robust one. Even in

tumultuous and volatile times during this

decade, no broker has defaulted.

The major risk that needs to be

measured in order to be managed is, the

amount of loss that may be suffered by the

clearing corporation, in the event of a broker

not fulfilling his obligation. In the process of

honouring the obligation, the clearing party

may entail a loss. So the value at risk on

a position becomes important for managing

the risk and this is the principle followed

everywhere. The value at risk principle

tries to find out the amount by which the

underlying asset or position could fluctuate.

If that probable loss could be made available

upfront as margin, the risk gets managed.

The effort lies in measuring the volatility

and ensuring a robust system by which a

margin can be collected upfront. Typically,

exchanges collect it post the transaction,mostly at the clearing member level. Some

exchanges go up to the client level but face a

time lag in collection. In India, where there

are significant number of small brokers

operating, the regulator has prescribed

an online, real time, client level, upfront,

mechanism to ensure the robustness of the

risk management mechanism. This is where

the Indian system is unique.

Risk measurement also depends upon

The following article is a direct response from the National Stock

Exchange, Mumbai.

the type of risk parameters applied. In

the equities market, the price of the stock

is one of the risk parameters; the more i

changes the more the risk changes In the

case of derivatives and options pricing, there

are five different parameters - strike price

interest rate, spot price, time to expiry, andthe volatility. The spot price and volatility

change perennially. Therefore, the frequency

of resetting the risk parameter become

very important in risk management. SEB

has stipulated that it has to be reset multiple

times during a day. Updation of risk

parameters multiple times during the day

makes the Indian system, in a way, unique.

Besides, this information provided

by the exchanges to the members enable

the clearing member to manage his own

risk even at a client level. Indian market

have many brokers with small outlays. The

support provided by the Indian exchange

along with the guiding principles monitored

by SEBI make for a good regulatory and

infrastructural framework.

NSE is the third largest exchange in

terms of number of transactions in the

equities market segment. In the derivative

markets, NSE is one of the budding

big markets in the world. Indian marke

mechanisms are very sophisticated. Goingright down to the client level, and that too

online and real time, is a unique feature.

India is a diverse nation, with a diverse

population. The numbers of brokers

the categories, the risk perceptions, the

volatilities, are all different. SEBI h

successfully brought in a robust system

to take care of these needs and manage

the situation very efficiently, much to the

admiration of the global community.

Risk Management in India a view from NSE

December 2007|ISB insight|1



Sudip Gupta, Assistant Professor of Finance,

ISB, spoke with Raghuram Rajan, Eric J

Gleacher Distinguished Service Professor

of Finance, Graduate School of Business,

University of Chicago, about the economic

reforms in India, and a host of issues

including competitiveness, forex reserves,

policy-making, and integration of India

with the world. Professor Rajan laid the

foundations for the Centre for Analytical

Finance at the ISB, and is the Centres

Academic Fellow this year.

Professor Sudip Gupta: It is 16 years

since the structured economic reforms

were introduced. There are still complaints

that we are not doing well enough, in terms

of the employment opportunities generated

by these reforms. This is a major barrier for

pushing ahead with the next generation of

financial reforms. So, what lies ahead?

Professor Raghuram Rajan: First, we

shouldnt diminish the value of what has

happened so far. Very few countries have

grown at that rate. We shouldnt doubt the

fact that we have grown at 8.59 percent.

But, the fact is that there have been fast

growers in the past who have moved from

poverty to become a rich country. There

have been very few stories like that, but

they are very important examples Japan,Taiwan, Korea, and now increasingly,

China.

Therefore, it is very important that

we make sure the growth continues at this

pace. For that, its very important that

the growth spreads through the economy,

rather than just in coastal areas, or certain

sectors, or just in skill industries. The next

generation of reforms has to focus on how

to bring growth to the rest of the country.

Some natural spill-over will take place. But,

we need to connect the large portion of our

economy to the areas that are doing well, and

to the outside. By this, I mean, agriculture

has to be empowered. The same factors tha

are needed for agriculture are also generally

needed for the whole economy.

All the second or third generatio

reforms have to take place throughout

the country. There has been very little

agricultural growth. If we can bring more

value-added growth to agriculture, connect

urban India to rural India first, and then

to European markets and to the rest of the

world, then there could be a tremendou

pace of growth, which would be more widely

spread. Most people think of reforms as a

good thing. Some people argue that it has

bypassed the poor. But, I dont think that ithe case. We have the potential to build in

such a way that the poorer sections can bepart of the economy.

Some states are doing quite well inagriculture. Agriculture is witnessingone percent growth, while the economyis growing at eight and nine percentSomehow, there is a feeling of a possiblebarrier to this spill-over. If we can substitutelow productive agricultural labour with

The Wave OfEconomic Reforms

18|ISB insight|December 2007



I N S I G H T S P E C I A L

industrial workers some states are actuallydoing that that would be great. Do youthink that setting up a Special EconomicZone (SEZ) like China would be a bigpolitical question for India? Are there anyimplications?There are two dangers in any reformprocess. One is being unique, and therefore,learning nothing from outside. The otheris extrapolating the experience of othercountries too closely, and saying that is theanswer. We need to think more carefully forourselves, not replicate what we did in thepast. We should not only change and learnfrom other countries experiences, but alsofind our own way. There were some specialcircumstances when China set up the SEZ.When India is trying to set up SEZ, there

is a comparison with China which may notbe correct.

Already Chinese companies are sufferingbecause they are competing with eachother. Wal-Mart keeps reducing the price ofChinese goods, and Chinese manufacturerscompete with each other and reduce itfurther. So, there is a problem. Are we goingto go head-to-head with China? Or, shouldwe think about our own path?

I would love people to create theenvironment not try and decide on a path

for growth and see what happens. We didthat in telecom, and eventually got it right.Now, you have six million cell phones beingsold every month. The poor are benefitingtremendously from a free competitivemarket. If we had listened to the babus at thattime, we would be nowhere. We followed apath which learned from other experiencesbut was different. Who would have thoughtIndia was a natural place for cell phones? So,lets not ape the Chinese, or aim for export-led growth. Sure, exports are going to bepart of our growth. But, already, the Chineseare running into political roadblocks in therest of the world, as people resist the flow ofChinese made goods.

There is concern about outsourcing toIndia, which will increase if there is a world

recession. Do we want to expose ourselves tothat kind of work willingly? Why not insteadallow the natural innovativeness of our peopleto emerge by creating an environment? Stoptrying to determine a particular industry,and wanting special favours. Compete, andjust create the environment. You dont wantan overvalued exchange rate, but nor do youwant to have a hugely undervalued exchangerate, penalising the rest of the economy atthe expense of the export sector. Lets find

something in between.

Lets not ape the Chinese, or

aim for export-led growth. Sure,

exports are going to be part

of our growth. But, already,

the Chinese are running into

political roadblocks in the rest

of the world, as people resist the

flow of Chinese made goods.

In Discussion Professor Raghuram Rajan and Professor Sudip Gupta




You rightly pointed out the competitiveness

within India, and with respect to China and

the rest of the world. One major institution

which actually maintains competitiveness

in the US is the Federal Trade Commission

(FTC) or Department of Justice (DOJ) or

the Federal Communications Commission

(FCC). We do not have any such thing

in India right now. The Competition

Commission of India (CCI) is in a stagnantstate since 2002, and is pending in the

Parliament. Until 1991, the Monopolies

and Restrictive Trade Practices (MRTP) Act

was bullish. There are, of course, 3G and

other sectors. There is a lack of attitude

towards scientific evaluation, leading to

adhocism in the MRTP rating. What is your

perspective on that?

I agree with you fully on that. We need

a professional body, which is apolitical,

determines what kinds of activities impede

competition, not biased towards the privateor public sector, thinks about the welfare

of Indians, and bases itself on useful, well-

recognised economic principles. With the

tremendous amount of change, integration,

and mergers that are taking place in India,

we have to be careful about them. We

should recognise that imports and foreign

competition does help, and changes

what you allow in terms of domestic

concentration in different industries. But,

at the same time, we should make sure that

we reduce barriers with respect to import

when we have a concentrated Indian sector

and make sure that the Indian consumer

rich or poor benefits.

For too long, our public policy has been

governed by narrow producer interests

than wider public interest. And, time

and again, whenever arguments are made

in public forums, it is couched in terms

of producer interests, and employmenin narrow sectors, than thinking of the

economy as a whole. Building these

institutions is very important. Also, we

need to create the frameworks of the firs

world economy which do not allow a

hoc interventions by the politicians or the

government. It should be a professiona

body, independent of the government. We

need to build those institutions and their

reputation, and then, we will have a much

better functioning economy.

One of the major sources of risk sharing is

that we need more people, which is lacking

in terms of individual investor taking par

in the stock markets in India. Mostly

they are being driven away because of the

high volatility. For example, the Sensex

suddenly dropped 500 points, and the

average investor is forced to think abou

the volatility of the markets, as it is getting

impacted by the rest of the world. So

there is a puzzling question in the average

Sudip Gupta, Assistant Professor, ISB

20|ISB insight|December 2007



investors mind that If he/she is getting

associated with the rest of the world,

he/she has more ways to share your risk,

similar to the portfolio way of sharing the

risk. Do you see such market fluctuations

happen very often? What is your take on

that? Does it imply that the individuals

basket is riskier, or that the financial risk

has gone down?

We are not necessarily more volatile thanother emerging markets. Brazils market

is also very volatile in a day. If this sort of

fear catches on, I do think we should be

exploring by letting our investor become

more diversified, rather than investing

only in India. Having $220 billion in the

Reserve Bank reserves makes less sense

than having a lower amount in the Reserve

Bank books, and a reasonable amount in

the books of private investors, especially,

households. For them, to be diversified

across the world, we should allow capital

outflows in very controlled ways such that

you can very easily buy stocks in the US or

anywhere else. Of course, you can never

be protective against the world contagion,

but certainly one can protect against an

idiosyncratic fall in the Indian market. I

have made proposals in the past as to how

to make outflows happen without exposing

oneself to excessive risks as a country. In

theory, the RBI allows it.

What implications do Indias 17 years of

reform process have for the rest of the world

both developed and under-developed?

What can they learn from it? We have

learned a lot from Chinas reform process.

What, in your opinion, is striking?

Far more than China, Indias development

process, especially in the IT, and now in

pharmaceuticals and financial services, is

suggesting that through knowledge, youcan make the leap from Third World to

First World, and, compete with the First

World in a very short period of time. With

manufactured goods, it took longer because

you had to make your way up the scale from

low-skilled to high-skilled manufacture. So,

Korea made that transition over a long period.

We are at the frontiers of some

areas without spending a long period of

apprenticeship. Thats worrying for people

in the West. Accountants are competingfor accounting jobs, lawyers are competing

for lawyers jobs, and other areas that are

not too far away from the frontiers in any

way. And, we dont need special technology.

In fact, the single biggest technology is the

knowledge of English. Thats how India is

different from the growth of other emerging

economies, and that certainly has a lot of

people in the West worried and thinking. It

is worth looking back at the past experience

to understand what went right.

We need to create the frameworks of the

first world economy which do not allow ad-

hoc interventions by the politicians or the

government. It should be a professional body,

independent of the government. We need to

build those institutions and their reputation,

and then, we will have a much better

functioning economy.

Indias development process,

especially in the IT, and now in

pharmaceuticals and financial

services, is suggesting that

through knowledge, you can

make the leap from Third World

to First World, and, compete

with the First World in a very

short period of time.

I N S I G H T S P E C I A L

Professor Raghuram Rajan, University of Chicago




On the Right TrackFour hundred business plans, six new tracks,

fifty Venture Capitalists, addresses by

renowned economic and business thought-

leaders that was this years TiE- ISB Connect,

hosted at the ISB, bringing together early stage

venture capitalists, start-up and growth stageentrepreneurs, and academicians to interact

and help build successful enterprises.

A joint initiative of the Wadhwani

Centre for Entrepreneurship

Development (WCED) at the ISB

and TiE, Hyderabad Chapter, the TiE-ISB

Connect, a popular network-forum, in its

third year, was significantly scaled up in

scope and magnitude this year.Present at the inaugural session of this

event was K Suresh Reddy, Honourable

Speaker of Andhra Pradesh Legislative

Assembly. Speaking to an audience of venture

capitalists and budding entrepreneurs, Reddy

said, Fire the zeal in you, but remember to

include those who are deprived even of basic

amenities. Professor M Rammohan Rao,

Dean ISB, in his address, mentioned, Dont

just script ideas but take them forward and

build businesses. Dr V Chandrasekar,

Executive Director, WCED and co-convenor

of TiE ISB Connect said that the event was

an attempt by the academia to reach out to

the industry. Entrepreneurship happens in

the real world, and not in the classrooms. TiE

ISB Connect has managed to excite all the

players in the entrepreneurial ecosystem,

he said.

Other speakers of note were

Dr. Anji Reddy, Chairman, Reddys Labs,

C. Rangarajan, Economic Advisory Council

to the Prime Minister of India and TomCampbell, Dean of Haas School of Business,

UC Berkley.

Key note speaker, Dr Campbell,gave a special address on Leading throughInnovation, while Dr Reddy addressed asession themed, Innovation and Researchas Growth Engines.

Addressing a plenary session on Indian

Economy Challenges and Opportunities,

Dr Rangarajan, said that in order to sustain

Indias economic growth, which has

averaged 8.6 per cent per annum over the

last four years, we need to translate growth

into poverty reduction. He elaborated

on the uniqueness of Indias economic

reforms - a journey from licence regime

to entrepreneurial freedom, from state

ownership to private enterprise, and from

an inward looking trade policy to being

integrated in the world economy. Indian

economic reforms are unique because

first, they are implemented in a democratic

context, and second they are pursued in a

decentralising context, he said.

This democracyfederalism model ha

often meant restraint and compromise

noted the renowned economist and policy

maker, and added that it pays to cross theriver by feeling the stones.

There are six challenges on the way

forward, Dr Rangarajan mentioned, which

warrants priority attention - steppin

up growth rate in agriculture sector

meeting infrastructure deficit, need for

fiscal consolidation, investing in socia

infrastructure (basic healthcare and primaryeducation), managing globalisation, andgood governance.

Some of the well known and leading

TiE ISB Connect

Dr Anji Reddy, Chairman, Reddy Labs

C Rangarajan, Economic Advisory Council to the Prime

Minister of India



VCs attending this years event were NEA

IndoUS Ventures, Sandalwood Partners, DFJ

Ventures, Google, Yahoo, Greylock Partners,

Cannon Partners, Sequoia Capital, Light

Speed Ventures, Seed Fund and many others.

Track RecordParticipantcentric discussion tracks on

diverse and emerging sectors like Mobile

Convergence, Life Sciences and Health

Care, Security and Biometrics, Retail

Industry, Real Estate and Infrastructure,

and New Media and Entertainment, gave

a review of global trends in the sector

by domain analysts. Additionally a panel

discussion by venture capitalists and

successful entrepreneurs deliberated on

sector opportunities.

One of the common themes in all the

tracks was about how the boom in the

Indian economy would positively affect

various sectors. The speakers in the The

Emerging Technologies panel were bullish

about enhanced usages of mobile phones,

the increasing use of nanotechnology in

several industries, continued evolution of

web services and the wireless.

The Media and Entertainment track

was organised under the theme Gaming

and Animation Opportunities for the IndianMarket. Panellists emphasised the increasing

importance of mobile phones for media, the

rapid rise of Indian animation and gaming

companies, bottlenecks of broadband

spectrum and low internet penetration

holding back growth of industry. They also

deliberated on the localisation of gaming and

animation content for the Indian market, and

that Indian companies must look at foreign

markets to get returns on their investments

in games.

The Infrastructure and Real Estate track

focused on the opportunities in various

segments including residential spaces,

hospitality, SEZs, integrated townships,

industrial, and IT and ITES parks. The

need for professionals and managers in this

sector was felt by all the eminent panellists.Problem areas such as land acquisition and

taxation were also addressed.

Various speakers in the Pharma track

spoke of emerging trends in the industry

including consolidation, growth of

biotechnology, and rapid innovation by small

companies. The speakers also discussed

about the partnerships Indian companies

can have with foreign companies, low-cost

advantage for India, and need for Indian

firms to invest more in R&D and be more

innovative.The speakers in the Retail Track spoke

on a variety of issues. However, one of their

common concerns was how to ensure that

both organised retail and small vendors

can co-exist or even have a symbiotic

relationship. Another concern was how the

benefits of growth in organised retail can

benefit the Bottom of the Pyramid through

better profit-sharing structures, lower

prices, better quality of merchandise, and

more variety of relevant products.

The other highlights of this event was

the popular Investor Pitch, where budding

entrepreneurs presented their projects to

potential investors, and the Jumpstart your

Venture which is an interactive workshop,

preparing aspiring entrepreneurs for an

exciting future.

In all, TiE- ISB Connect was once again

the proven hub of energy, enterprise, idea,

and implementation; a must-stop on the

journey of successful business.

Speaker K Suresh Reddy lights the TiE-ISB Lam

Thomas Campbell, Dean of Haas School of Business, UC Ber



The Wadhwani Centre for Entrepreneurship

Development (WCED) and the Real Estate Club

at the ISB, in association with Indu Projects

Real Estate Research Chair, hosted a Real

Estate and Urban Studies Panel Discussion at

the ISB- Indian Real Estate Scenario Bringing

Up-to Date.

The highlight of the panel discussion was

the presentation made by Professor Joseph Gyourko, Director of Zell-

Lurie Real Estate Centre, The Wharton

School, University of Pennsylvania. The

presentation titled Re-evaluating Residential

and Commercial Property Market provided

good insights into the current real estate

scenario. Gyourko observed that global

markets are highly idiosyncratic, and a lot

of fundamentals could be replicated across

international borders.

Professor Gyourko also presented anoverview of the US Real Estate markets

and evaluated the two recent booms in the

US property markets. He attributed the

distress of the American housing market

to oversupply. The Professor attributed

parallel replications of the dot-com boom

and availability of data in the US, and

predicted that it would impact the ReaEstate future in India. He said that doing

well in Real Estate involved knowledge o

supply and demand, possessing economic

intuition, and implementing it in business.

The panel attributed the surging

growth of the Real Estate sector to severa

fundamental factors such as growing

economy, increasing business needs, etc

However, they observed that the Real Estate

boom is restricted to few areas such as

commercial office space, retail, and housingsectors. The panel stressed on the need to

address the sectors impending concerns

such as shortage of skills, non-availability

of timely data, lack of sustainability and

affordable housing, and high prices.

The Panel saw some o

the eminent leaders of the Rea

Estate sector come together. The members

included Syam Prasad Reddy, CEO & MD

Indu Group, Suresh Marasawamy, Assistant

VP, Citigroup, Nayan Shah, MD, Mayfai

Housing, Sourav Goswami, Walton Stree

Capital, Avnish Singh, GE Real Estate, Amit

Bhagat, ICICI Home Finance, KokHuat

Goh, TSI Ventures, Anuj Puri, JLLM, and

Sumit Anand, Lehman Brothers. Members

from renowned real estate firms like

Cushman & Wakefield, DLF, JLLM, and

Vornado, were also present, along with the

ISB alumni and students. The event was

sponsored by Indu Group, while Ernst &

Young ser ved as the knowledge partner.

Realty concerns-A Global View

Speakers at the Real Estate and Urban Studies Panel Discussion



V Chandrasekar, Clinical Professor and ExecutiveDirector of the WCED at the ISB, in an exclusiveinterview with Joseph Gyourko, Director of Zell-Lurie Real Estate Centre, The Wharton School,University of Pennsylvania, discusses the Real

Estate scenario in the US in the wake of the sub-prime crisis. We present excerpts from thediscussion:

Professor V Chandrasekar: What is the

real estate market scenario in the US? Can

you explain the sub-prime issues affecting

the US and global credit markets?Professor Joseph Gyourko: We havethe sub-prime mess or debacle becauseit involved a great rise in lending to riskyborrowers with less than sterling creditrecords. These people used to be rentersprimarily. The seize up in the credit market is

largely due to default rates in the sub-primemarkets that spooked the broader creditmarkets on good credit quality, in not justresidential mortgage backed security, butalso in regular credit backed security. Thesub-prime market is going to shrink radically.The commercial markets are generally prettyhealthy. There are two reasons for that: one,the economy continues to grow; two, outsidethe owner occupied housing, we have notoverbuilt in our commercial and retail

sectors. I believe that the commercial market

is reasonably healthy with more downside

risks than upside risks.

Is this situation in the US likely to affect

real estate prices in emerging markets like

India?

It is hard for me to tell. I certainly dont

think that a drop in house values or slowing

of the housing market in Philadelphia should

have an effect on real estate in Mumbai or

Hyderabad.

Do you think, to some extent, some of

the job loss in the sub-prime markets will

transfer to the call centre jobs losses in

India?

That is a good point. In the Indian context,

to the extent that your city has outsourced

work from sub-prime lenders, it is going

to go away because the sub-prime markets

are going to shrink dramatically. So, if there

are office districts in Bangalore or otheroutsourcing centres, which are processing

information to those sub-prime lenders, I

would expect a decrease in demand from

those folks.

The government has controlled the debt

access of real estate investors considerably,

and what is available today is a lot of

equity investments. Do you think this

differentiation between debt and equity

will have some implications for the Indian

market, with regard to difficulty of accessingdebt?

There is actually a good side to that. What

went wrong in our housing markets is

that we got leveraged too highly with risky

borrowers. Equity is the great discipliner. It

will lower returns. The investors wont like

it much, but I suspect that as much equity

you have in the system, there will be much

less financial distress than exists in the US

housing finance system at the moment. In

the long-run, there are two ways to get

down the cost of capital for real estate. One

is to integrate real estate finance with the

regular capital markets, and two, to develop

a securitised debt market.

Do you think India is over-regulated?

What do we need to do? Do we need more

information on what is happening?

I suspect India is over-regulated. On

dec insight

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