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THE INVESTOR VOLUME 4 ISSUE 12 December 2011

credit default swaps : concepts

Pg. 18

to regulate or not to regulate

pg. 16


2/24Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bearsno responsibility whatsoever.

F R O M E D I T O R S D E S K

NiveshakVolume 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 TeamAnuroop Bhanu

Venkata Abhiram M.

Vishal Goel

Vivek Priyadarshi

All images, design and artwork

are copyright of

IIM Shillong Finance Club

Finance ClubIndian Institute of Management

Shillong

www.iims-niveshak.com

THE TEAM

Dear Niveshaks,

Niveshak has completed yet another year. As, we enter our 5th year, we haveindeed come a long way om our humble beginnings in 2008. This year we sawmore than 700 aricle enties coming to us om b-schools across India and even more Fin-Q enties. We also published a number of interiews om digitariesacross indust and academia. Also, new sections such as Market Snapshot andClassroom were intoduced this year which got a lot of appreciation om readers.Surely, these achievements wouldnt be possible without the continued suppor andcontibution om our readers. As we pass the baton to our new team, I on behalfof the outgoing team would like to thank all the readers for their suppor and hopethat we lived up to the exectation of one and all by contibuting our bit to this

geat knowledge sharing platfor called Niveshak.

The year 2011 was exected to be the year of gowth, but instead the yeartred to be just the opposite. I am not able to remember a single editorial in thelast year where I have wrien something good about the markets or economy. Thebenchmark Sensex slipped by more than 20% during the year, the rpee depreci-ated by even more. Ination, RBI policy, goverment inaction, Euro crisis continuedto dominate the headlines throughout the year and I dont remember one editorialin last year where I have not mentioned these. I remember the June issue in whichour cover stor was on double dipped recession. I distinctly recollect receiving mails

om some optimistic readers about falsely spreading negativit. Two months laterEconomist caried a cover stor on the same topic and today double-dip is realin some pars of Europe and the global economic data point to some ver diculttimes ahead in other advanced economies as well.

Optimists arge that the global economy has merely hit a so patch. Firsand consumers reacted to this years shocks by temporarily slowing consumption,capital spending, and job creation. As long as the shocks dont worsen condence,

gowth will recover and stock markets will rally again. However, the double-dipproponents arge that the problems of the advanced economies is that of insol-vency, not illiquidit; large and rising public and private decits and debt, dam-aged nancial systems that need to be cleaned up and recapitalized, massive lossof competitiveness, lack of economic gowth, and rising unemployent. It is nolonger possible to deny that public and private debts in PIIGs nations will need to berestctred. If the problem in advanced economies aggavates, the domino eect

will ensure that no par of the world remains unaected. We sincerely hope that theoptimists are right and the new team has something good to write in the nex year.

This issue brings to you some more interesting and insightfl reads. Thecover stor this month focuses on Foreig Direct Investent in Indian retail sector.The issue also featres an aricle on the critical review of the Disinvestent policy inIndia. Other aricles in this issue focus on Alterative Investent Assets, Credit De-

fault Swaps and reglation by Credit Ratings Agencies. The Classroom this monthexlains the meaning and sigicance of LIBOR. We would like to thank all those

who have contibuted aricles to this issue and sent enties for FinQ.

Mer Christas and Happy New Year!!

Stay Invested.

Rajat Sethia(Editor - Niveshak)


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C O N T E N T S

Niveshak Times

04The Month That Was

Article of the month

08 A critique on

disinvestment policies in India

Cover Story

11FDI in Retail

Perspective

16To regulate or not toregulate: The ultimateconundrum

Fingyaan

18 Credit Default Swaps:Concepts and RBI regulations

Finsight

14 Alternative InvestmentAssets: Wine

CLASSROOM

21 LIBOR


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IIP PLUNGES NEW DEPTHS

Indias index of industrial pro-duction, which details out thegrowth of various sectors ofthe economy, record-ed a significant decline in

the month of October.T h e index fell over 5.1%

in comparison to the figuresobtained last year, whenthe growth in IIP was 11.3%.It is for the first time sinceJune 2009 that IIP has record-ed a red mark in its growthfigures.

While manufacturing s e c t o r ,which contributes almost two-thirdsof the overall IIP index, de- c l i n e dby 6% in October; the mining sector and capi-

tal goods output contracted by 7.2% and 25.5%respectively. Decline in production of capitalgoods was an unpleasant surprise, as the indexlogged a steep downfall from 6.8% contractionin the previous month.

On the other hand, production of intermediategoods slumped by 4.7% during October; whereasnon-durables consumer goods output remainedstatic at -1.3% during the month.

The electricity production was the sole rescuer,

as it witnessed a strong 5.6% growth in Octo-ber, as against a robust 9% growth in September2010.

However, with a better crop ahead, and RBIs cur-rent stand on taking a breather on the interestrate hike, things are expected to improve in thecoming months.

RBI TIGHTENS RULES TO CHECK THE FALL-ING RUPEE

As the Indian rupee is writing and rewriting his-tory day after day, the Reserve Bank of Indiaswung into action to check the depreciating cur-rency. The rupee slipped to sub-54 level for thefirst time in its history and touched a record lowof 54.30 against the dollar on Dec 15,2011. In the

last nearly four and half months, the rupee hasdeclined by about 20 per cent against the dollar,making it the foremost contender for the worstperforming Asian currency this year.

In an effort to curb the pressure exerted byspeculations, the countrys central bank hasimposed restrictions with immediate effect onforward trading in the local currency. Forwardcontracts once cancelled now cannot be boughtagain. It has also reduced the limit for hedgingof foreign currency risks for importers/export-ers from 75 per cent to 25 of theaverage actual import/exportturnover in the past three years.In another regulation, RBI hascapped the exposure of banks tothe Forex markets.

Experts are of the opinion that themove will be positive for the rupee in

the short- term, increasing transac-tion costs and showing the RBI is lookingto curb currency-market speculation.

FOOD INFLATION EASES TO 4.35%

The effort of the economist finally seems to bebearing fruit, as the food inflation for the weekending Dec 3, 2011 reached a four year low of4.35%.

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 po-tatoes slumped by 46.03 per cent and 33.28 percent on a year-on-year basis. Wheat prices alsoeased by 4.43 per cent as compared to the datarecorded in the corresponding period last year.

Experts are of the opinion that the moderationin the rate of price rise of food items below thepsychological 5%-mark will bring relief to thegovernment, which has been battling high infla-tion for almost two years now.

RBIS MID QUARTER POLICY REVIEW

Countrys central bank, the Reserve Bank of In-dia released their mid-quarter monetary policyreview statement on December 16, 2011.

Taking a break from the spree of rate hikes, poli-

The Niveshak Times


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Team NIVESHAK

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cy rates have been left unchanged, and the reporate was maintained at 8.5%. RBI has increasedpolicy rates 13 times since March 2010, amount-ing to a total of 375 percentage point worth ofhikes.

Though RBI has stressed that inflation and in-flationary expectations continue to remain el-evated, it expressed hope that it would declinedue to moderating growth and declining foodprices. While RBI sounded cautious on inflation,it explicitly admitted that the monetary policycycle is likely to reverse its course to addressconcerns regarding risks to growth.

RBIs policy document clearly reflects a shift infocus from inflation combat to growth promo-tion. The country has been battling with a fall-ing industrial output, and the Index of IndustrialProduction (IIP) has recorded a negative growthfor the month of October. The finance ministryhas also cut its GDP growth forecast for the fis-cal to around 7.5%.

Moodys downgrades Belgiums creditrating, S&P and Fitch warn of a poten-tial downgrade

Moodys on December 16 downgraded Belgiumscredit rating by two notches as a result of risingborrowing costs in Belgium, which as per agencycan make it very difficult for Belgium to repay itshuge debt. Belgiums local- and foreign-currencygovernment bondratings have beendowngraded fromAa1 to Aa3 witha negative outlook.The rising costshave hardly hit Euro Zone nations which are try-ing to borrow money to finance their deficits.Political problems and the possibility of morestringent austerity measures have also emergedas significant problems in Belgium. Amidst allthis Fitch has also put Belgium, Italy, Ireland,Spain, Cyprus and Slovenia on negative watch,

which means a possible downgrade within nextthree months. Standard & Poors had alreadywarned 15 of the currency blocs 17 members ofa possible downgrade.

Italys Economy down by 0.2% in thirdquarter

Italys economy shrinks by 0.2% in third quar-ter ended Sept 30, for the first time since 2009as per data released by the National StatisticsInstitute Istat. Economy expanded by 0.1% inthe first quarter followed by expansion of 0.3%in second quarter before this contraction. TheEconomy is considered to be in recession onlyif it contracts in two successive quarters. Asper the government forecasts the economy willshrink by almost 0.4 % in the fourth quarter.The Italian business federation Confindustria isalso forecasting a downfall of 1.6% next year,thus raising concerns that Italian Economy maygo into recession soon. Italian Industry Minis-ter Corrado Passera had already announced thatthe country is in recession. As per National Sta-tistics Institute Istat one of the reasons for thisfall in GDP is decline in domestic demand, in-cluding spending by households, public-sector

spending, business investments and a nega-tive contribution from inventories. However thegood news is that on a 12-month comparisonItalian GDP rose by 0.2% in real terms from thethird quarter of 2010.

Moodys upgrades Indian Rupee

Moodys has raised Indias local currency debtrating by one notch to Baa3. With this Indian lo-

cal currency bondshave now becomeinvestment grademaking themequivalent to coun-trys foreign curren-

cy bond grade, though Baa3 is the lowest invest-ment grade. Moodys said it does not now seejustification for a rating bias in favor of eitherlocal currency or foreign currency governmentdebt. A stable outlook on the economy is thereason for this credit upgradation. The upgra-dation has come as a great relief to the Indian

currency which has depreciated by around 20%against dollar during last four months. Moodysalso said that the downward pressure on Indiaseconomic growth will persist for the next twoquarters.

The Niveshak Times

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MARKET CAP (IN RS. CR)BSE Mkt. Cap 53,79,251

Index Full Mkt. Cap 26,27,112

Index Free Float Mkt. Cap 12,85,512

CURRENCY RATESINR / 1 USD 52.67

INR / 1 Euro 69.13

INR / 100 Jap. YEN 67.72

INR / 1 Pound Sterling 82.53

POLICY RATESBank Rate 6%

Repo rate 8.50%

Reverse Repo rate 7.50%

Market Snapshot


RESERVE RATIOSCRR 6%

SLR 24%

LENDING / DEPOSIT RATESBase rate 10%-10.75%

Savings Bank rate 4.00%

Deposit rate 8.5% - 9.25%

Source: www.bseindia.comwww.nseindia.com

Source: www.bseindia.com

Source: www.bseindia.com25th November to 21st December 2011

Data as on 21st December 2011

MarketSnapshot


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MarketSnapshot

BSEIndex Open Close % ChangeSensex 15,781 15,377 -2.56%

MIDCAP 5,591 5,141 -8.04%

Smallcap 5,989 5,517 -7.88%

AUTO 8,398 8,129 -3.20%

BANKEX 9,702 9,416 -2.95%

CD 5,745 5,293 -7.87%

CG 9,267 8,013 -13.53%

FMCG 3,918 4,037 3.04%

Healthcare 5,947 5,841 -1.78%

IT 5,501 5,749 4.51%

METAL 9,965 9,521 -4.46%

OIL&GAS 8,009 7,925 -1.05%

POWER 1,886 1,780 -5.62%

PSU 6,657 6,354 -4.55%

REALTY 1,553 1,386 -10.75%

TECK 3,329 3,376 1.41%


Market Snapshot


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Foreign debt repayment crisis of 1991 precipitateda slew of reforms in India, including the delicens-

ing elements of the new industrial policy of 1991.In 1999, the government formed the Ministry ofDisinvestment which has been given the responsi-bility to layout a systematic policy approach to dis-investment and privatization of Public Sector Units.

In this article we take up three issues which plaguedivestment in India:

1)The dilemma of pre-privatization capitalization

2)Issue of post divestment autonomy and flexibil-ity being comprosmised

3)High pricing of FPOs and forced buying by UTIand LIC

Pre-privatization Capitalization

Privatization of Public Sector Enterprises has beena recourse that has often been taken by govern-ments around the globe to meet the ever-expand-ing fiscal deficits. With new right governmentscoming to power in the US and Britain, there wassupport for neo-classical economics and influenceof organizations like World Bank and InternationalMonetary Fund led to more private sector involve-

ment in the economy.The challenges before government when going fordisinvestment are as follows-

Social Problem - Process of disinvestment is not

favoured socially as it is against the interests ofsocially disadvantaged people and society at large.

Political Problem - The coalition government at

the centre with a number of parties has posed aserious threat to this program. Conflicting interestshave made it difficult to arrive at a national con-

sensus.Economic Problem - Most of the units identified

for disinvestment are in a very bad shape whichdo not offer good returns. The Government, due topaucity of funds, is also not in a position to revive

them. (Verma, 2009)

This capitalization poses an important public fi-

nance question to the government. The govern-ment is forced to infuse this capital into the PSU tomake the issue (IPO/FPO) attractive. The opportu-nity cost of this capital is to be compared againstits use in social infrastructure build-up or R&D ac-tivities. The quandary that the government facesis whether to use the money for a sick unit, so asto turn it around (as also face the risk of its ero-sion), or to put that money into other investmentrequirements.

However what is commonly seen is that govern-

ments often pays this premium so as to avoidthe aforementioned problems, more so the politi-cal problem. Sometimes this premium is deemedso high by the incumbent government so as toeven surpass the possible pay offs from the priva-tization deal. Hence many such deals were calledoff (Chakraborty, A., Nair, V., & Mehta, B., 2009).

Post-Divestment Autonomy and Conicts

There may be conflicts between profit maximizingobjectives of a divested firm with other non com-mercial objectives or social purposes as a formerstate-owned firm. This issue is more likely to beprominent in case of partial divestment i.e. mixedprivate-government ownership. Such enterpriseshave important implications in terms of corporategovernance.

Many a time divestment face opposition from vari-ous stakeholders raising concerns of public inter-ests like unemployment, price increase, etc. Thetype of goods and services is a key factor in de-termining the extent of public interest. Protests

are more common in case of public utilities likeelectricity, water, railways, petrol, etc. And there-fore government needs to address these issues byintervening through regulatory bodies, or by in-fluencing ownership or management of divested

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Divyansh Gupta & Subodh Jain

A critique on

disinvestmentpolicies in India



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entities. This becomes more significant in caseswhere divestment opposing stakeholders are wellorganized.

To take an illustration, Indian government tries tocontrol inflation through price control on oil andprovides subsidies to downstream marketing firms.ONGC, with state ownership of 74.11%, needs to

contribute 38.8% to the subsidy burden (EconomicTimes, 2011). Such interventions by governmentputs ONGC in a double role as a state-owned firmand a listed commercial entity. ONGC corporategovernance is accused of forsaking minority share-holder interests and being operationally inefficient.

Figure 1 shows that since 2003-04, ONGC has pro-vided about Rs. 1436 million in subsidies. Thisconverts to a huge loss to minority shareholdersas compared to situation with no subsidy. Thegovernment being the major shareholder has legalpower over minority shareholder. Time and againONGCs stock prices take a hit due to such inter-ventions. Also ONGCs capabilities to make futurecapital investments are hugely curtailed.

Post divestment without sufficient autonomy givento such organizations, the status as a listed com-pany does not necessarily protect the long terminterests of various investors. This affects the in-vestment climate in the country and confidence ofdomestic and foreign investors.

One important lesson to be learned from the ONGCepisode is that the participation of relevant stake-holders at the stage of policy formulation of di-vestment is necessary. This should help the gov-ernment in understanding various concerns ofstakeholders better and also help potential and ex-isting stakeholders in understanding post-divest-ment arrangements. More transparency in the sys-

tem will reduce the conflicts and a better balancein conflicting interests could be achieved. Such asystem might hamper the financial attractivenessof public listings initially but it is very critical togive due recognition to the post-divestment regu-lation beforehand.

Arm-twisting by government

In order to achieve better fiscal figures the gov-ernment has gone on the path of disinvesting inthe PSUs. Even though the IPO/FPOs have beenover-subscribed, it is surprising to notice that thedomestic institutions that have been subscribingto the issue are government controlled entitieslike LIC and UTI. The government has a 100 percent holding in these institutions (Saugata Bhat-tacharya and Urjit R. Patel, 2002) and thus, moneyraised from them is like transferring money fromone pocket to another.

NTPC is the largest state-owned power generatingcompany in India. GoI owned 89.5% of NTPCs eq-uity share capital and planned to divest 5% of itsstake in the company through a FPO in Feb-2010,with an aim to raise Rs. 8,300 crore. The issue gotlukewarm response and on the first-two days ofthe issue, only 80% of the issue was subscribed,

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Shareholders Dec-09 Sep-10 Dec-10 Jul-11

Central Government/State Government (S) 89.5 84.5 84.5 84.5

Foreign 0 0 0 0Sub Total 89.5 84.5 84.5 84.5

Public Shareholding

Mutual Funds/UTI 1.46 1.86 1.52 1.4

Financial Institutions/Banks 3.4 6.95 6.91 6.9

Foreign Institutional Investors 2.38 2.85 3.36 3.54

Sub Total 7.24 11.66 11.79 11.84

Non-Institutions

Bodies Corporate 1.21 1.56 1.45 1.5

Individual shareholders up to 1 lakh 1.99 1.92 1.93 1.9

Individual shareholders over 1 lakh 0.2 0.21 0.18Any Others 0.06 0.16 0.12 0.08

Total 100 100 100 100

Fig. 2: NTPC holding at different points of time

(Source: moneycontrol.com)

Fig. 1: Subsidy Payouts by ONGC

(Source: www.ongcindia.com)


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of this nearly 80% came from the state-owned LICand SBI (in which the government holds 51% eq-uity share holding). One of the reasons cited forthe poor response has been the aggressive pric-ing strategy adopted by the government for theFPO. The state owned firms have put their bids atRs. 209 for the Qualified Institutional Buyers (QIB)(NTPC FPO fully subscribed, 2010) against the baseof Rs. 201, when the stock itself was trading inthe range of Rs.201 - Rs.205 and thus crowded outthe institutional investors who would rather preferto buy the shares in the secondary markets itself.

According to media reports LIC pumped in $950million in the FPO of NTPC. By doing this, the gov-ernment effectively maintained its control on thecompany and got funds from the FPO proceedings.As can be seen from Figure 2 the holding patternshows that the Mutual Funds and Financial Insti-tutions/Banks holding significantly increased, andlater on decreased, as the share price dropped dra-matically from Rs. 201 to Rs. 170 due to globalheadwinds. These companies actually sufferedlosses due to their exposure and squaring off oftheir positions.

LICs balance sheet (Saugata Bhattacharya and UrjitR. Patel, 2002) shows that the exposure of LIC topublic sector stands at 84 per cent followed byprivate sector 14 per cent, and the total assets onLICs balance sheet to Central and State govern-ment securities is at 54 per cent, showing the de-pendence that the government has towards LIC inbailing out its IPOs and FPOs.

As the government tried to meet its fiscal targetsit has speeded up its process of FPOs and IPOs to

raise funds. During the years 2009-10 and 2010-11 the government raised Rs. 23552.93 crore andRs. 22762.96 crore through disinvestment in vari-ous companies. The list of the companies throughwhich the government has raised these amounts

are given in Figure 3.

The biggest IPO in the Indian stock markets historywas that of Coal India which raised Rs. 15199.44crore, and even in this issue LIC pumped in a sig-nificant amount of money (Public Sector Disinvest-ment: A Greedy Government?, 2010), and again inthe issue of NMDC, LIC had to step in again whereit bid more than US $1.5 million. This raises thequestion of whether the government is being toogreedy for its own good, and pricing the issue atexcess premium thus discouraging the retail andFII participation?

The government issues the stocks at premium tak-ing the stand that the stocks are a good long terminvestment and it wants to share with the publicthe ownership of the company, but considering thepast record of the performance of the IPOs thisdoesnt seems credible.

Of all the issues of PSUs issued during the period2009-11, only three are trading above their issueprices, that of Coal India, OIL and Power Grid Cor-poration India. For Coal India, the government wasactually praised (Coal India: In a sweet spot, 2010)

for pricing at cheap valuations attracting the par-ticipation from retail players.

Conclusions

Lesser interference from the government and aneffective board and managerial team are neces-sary if the goals of disinvestment are to be met.From public finance perspective this would be inthe interest of the government given the enhancedrevenue they would obtain from both the directshareholding and the added tax revenues. Themultiplier effects emanating from these companies

would add a significant boost to the GDP and thatis another plus for using a hands-off approach bythe government.

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Year Company Amount raised(Rs. crore)

Issue Price (Rs.) CMP (as on25-Aug-2011)

2009-10 NHPC 2012.85 36 23.95

2009-10 OIL 2247.05 1050 1321.00

2009-10 NTPC 8480.098 201 170.10

2009-10 REC 882.52 105 177.00

2009-10 NMDC 9330.942 300 221.402010-11 SJVN 1062.74 26 22.05

2010-11 EIL 959.65 285 255.10

2010-11 COAL INDIA 15199.44 245 373.85

2010-11 PGCIL 3721.17 90 101.85

2010-11 MOIL 1237.51 375 301.35

2010-11 SCI 582.45 140 82.75

Fig. 3: Amounts raised through disinvestment in PSUs during 2009-11



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of trade in India accounting for 94% of total re-tail in the country.

Critical issues in the Indian Retail sector

The growth potential in the sector is huge, butthere are few challenges that could slow down

the growth for new entrants. Some of the chal-lenges are rigid regulations, high personnelcosts, lack of basic infrastructure, real estatecosts, and a highly competitive retail market.Adding to this, the entry of many retailers isgetting disrupted because of delay in comple-tion of shopping mall projects due to resourceconstraints. Some of the other critical aspectsfound wanting in the Indian retail sector are:

Supply chain management: It is one of the fac-tors for growth and profitability of modern retail

industry. It takes care of regional variances, val-ues conscious consumers and assists retailersin creating a strong customer value proposition

Branding

Workforce Management

Sustainability

Green Marketing

Improving on these will enable Indian retailersto significantly enhance overall competitivenessand successfully deploy growth initiatives. Theycan also enjoy the effects of the dual GST. Thedual GST implemented nation-wide is the nextlevel of tax reforms intended to eliminate theobstacles of trade through a common function-

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TeAM NIveshAkNilkesh Patra & Kailash V. Madan

The retail sector in India is one of the most at-tractive sectors in the economy. This industry isestimated at INR 15.5 trillion growing at a CAGRof 15 to 20%. According to the Indian Council forResearch on International Economic Relations(ICRIER), India is the seventh-largest retail mar-

ket in the world. A recent report by AT Kearney,the well-known international consulting firm, ac-knowledged India as the fourth most attractiveretail destination worldwide out of thirty devel-oping markets. The combined retail and whole-sale sector in India accounts for approximately22% of GDP. This sector is also helping the econ-omy in terms of employment by providing morethan 8% of the jobs and is the countrys secondlargest employer. Organized retail accounts foronly 6% of the total retail in the country. The

organized sector which includes licensed retail-ers, retail chains and privately owned large re-tail businesses has been growing at a CAGR of35%. Companies like Reliance, Tata, and AdaniEnterprise have been investing considerably inthis sector. The major factors contributing to thegrowth of the organized retail sector are glo-balization, high economic growth, and changinglifestyles of the people. Additionally, increasedspending over the years by the young popula-

tion and sharp rise in disposable income aredriving the growth of the Indian organized retailsector. On the other hand, the unorganized re-tail sector which includes local kirana shops andconvenience stores is the more prevalent form

FDI in Retail

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make their presence felt in the growing Indianeconomy. Unfortunately, this move has faced a lotof resistance not only from the Opposition partyof the country but also from some of UPAs keyallies like DMK, Trinamool Congress etc. In orderto understand what the hullabaloo is all about,we need to examine the intricacies of the bill inquestion.

Before any foreign retailer can make its way intoIndian shores, it needs to meet certain pre-condi-tions 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 in-ternationally

Half the investment should be made in back-end

infrastructure development

30% of the required raw materials must be pro-

cured from Indian Small and Medium Scale Indus-tries

ing market in India.

FDI in retail Implications

India being a signatory to World Trade Organiza-tions General Agreement on Trade in Services,which include both wholesale and retailing ser-vices, had to allow foreign investment in the re-tail sector. There were initial hesitations towardsthese investments in the retail sector, because of

the fear of losing jobs, competition and loss ofbusiness opportunities. However, the governmentis slowly taking steps in the right direction. In1997, FDI in cash and carry (wholesale) with 100percent ownership was permitted by the Govern-ment. In 2006, it was brought under the automat-ic route. 51% FDI was also permitted in a singlebrand retail outlet in 2006. 2011 saw a new reformin the retail sector. The UPA government proposeda bill permitting 100% FDI in single brand retailand 51% FDI in multi brand retail.

This paves the way for global retailing heavy-weights like Wal-Mart, Tesco and Carrefour to

Indian Retail vs Global Retail

Logistics cost as %of price

Inventory Turns Stock-out Percent Shrinkage Percent

Indian Retailers ~10% 3 to 14 5 to 15 3.1

Global Retailers 5% Average 18 Below 5 Average 1

Fig. 1: Indian retail industry breakup

Opening up the economy to for-

eign retail players would ensure

better infrastructure by means of

improved storage and harvesting

facilities



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prehensions regarding the bill. They believe thatthe local kirana shops (mom and pop shops)stand to suffer huge losses. Considering the factthat 94% of Indias retail is presently unorganized,a large number of people will be affected. But,judging from the results in countries like China,Brazil, Argentina and Singapore where 100% FDI

in multi-brand retail is allowed, it is clear thatkirana traders can co-exist with the organized sec-tor. Also, the bill warrants setting up of malls byforeign players only in 53 cities, where space isalready a constraint. Hence, most of these malls

would be situated on the out-skirts of the city and hence itis not necessary that the con-venient neighborhood kiranastore runs out of business.Also, if predatory pricing iswhat the opposition is con-cerned about, the Competi-tion Commission of India willensure that the prices remainfair and competitive.

Currently, the bill has beensuspended until a consensusis reached in the Parliament.While there are pros and consto this issue, we feel that

the benefits of passing thebill would far outweigh itsill effects. The bill, in effect,would bring a bulk of Indiasunorganized retail sector un-der the organized sector. Thiswould make it much easierto implement labor lawsand would also create a lotof employment, not to men-tion tremendous infrastruc-

ture improvement. Kiranastore traders may be affecteda little, but over time, theywill find ways and means tocarve a niche for themselves.

Conclusion

It is not possible for the Government to step inand provide the required infrastructure facilitiesto boost this sector and hence opening it up tothe tried and tested foreign players is the next

best thing they can do. It is a small but steadystep towards Indias goal of liberalization.

Can set up malls only in 53 Indian cities which

have a total population in excess of 10 lakh

First and foremost, we observe that allowing thismove would bring in a lot of capital investmentto the Indian market and would increase the al-ready diminishing Forex reserves of the nation. Itwould also help improve the infrastructure of the

country, by way of shopping malls and high rises.Secondly, since the international players need toprocure about a third of their raw materials fromIndian small scale industries, it will boost employ-ment in this sector. Such apolicy would also ensure thatthe Customer is the King.Increased competition in theretail space would ensurethat he gets the best qual-ity products and the most af-fordable prices.

The major beneficiary of al-lowing FDI in multi-brand re-tail would be the Indian ag-ricultural sector. Agricultureemploys about two-thirds ofthe countrys population butcontributes only 16% to thenations GDP. The major rea-sons for this are the lack of

infrastructure and the pres-ence of middle-men who eataway a major chunk of thefarmers profits. Openingup the economy to foreignplayers would ensure bet-ter infrastructure by meansof improved storage andharvesting facilities. For ex-ample, India is the secondlargest producer of fruits

and vegetables in the world,but is not able to capitalizeon this owing to poor infra-structure. Allowing FDI wouldsee huge investments in back-end infrastructurethus improving the present scenario. At present,the farmers are getting only 10-15% of the pricethe customers pay for their products. Bulk of theprofits are eaten by the middle-men, who canbe eliminated by allowing FDI in retail as theirbusiness models thrive on procuring materialsdirectly from the farmers. It would also provideemployment to a large number of people eitherdirectly or indirectly.

However, the opposition party has their own ap-

Opening up foreign

investments will bring in

funds required for expan-

sion of the nascent mod-ern retail sector in India.

The market opportunity is

large and we do not see

much impact at a national

level from new players. We

support opening up of the

sector to FDI. Most of the

opposition is related to

the food sector, wherestakeholders are not sure of

its impact on suppliers and

on agriculture. Specifically

for the food sector, the

government may adopt a

calibrated approach of

opening it up to FDI

- Mr Kishore Biyani

Managing Director,Pantaloon Retail


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Finsight

Wine drinkers have come a long way from holdingthe stem glass and swirling the red or white liquid torelease aromas to now converting it into a liquid as-set. Wine as an asset class has sparsely been studiedand the recommendations are mixed. But one needsto keep in mind the fact that although a good asset todiversify ones risk, it is still considered very volatile

and risky due to the small number of players in thisniche market.

But before one goes to buy wine off the racks, onemust remember that there is only a very narrowgroup of wine regions which are considered invest-ment worthy. It mostly includes the top wines fromthe Bordeaux region in France and a dash of winesfrom Burgundy, the Rhone, Italy, Champagne and the

New World (California). The five best fine wines inthe world, all from the Bordeaux region in France, arecalled First Growths: Lafite Rothschild, Margaux Med-oc, Latour Medoc, Haut-Brion and Mouton-Rothschild.Most professionally managed investment portfolioshave between 80-90 percent by value invested in justeight brands or vineyards the First Growths, ChevalBlanc, Petrus and Ausone. There are basically threeways to invest in wine:

Recently an article on a major website talked aboutthe lessons one can learn from the rich. It spokeabout the ownership and investment patterns of thesuper rich and how they have been able to maintaintheir net worth even in this turmoil. A recent reportby Capgemini and Ernst & Young reckons that oneof the most prominent trends among the rich is that

they put around 10% of their wealth into alternativeasset classes.

Investment in real assets has fast become a modusoperandi to diversify the risk of financial assets (likestocks and bonds) and also earn real returns in theprocess. The advantage of investing in real assets isthat they have an intrinsic value due to their utility.The most popular real asset today is Gold. It hasgiven manifold returns over the last few years, withthe real price increasing from $800 to about $1800per ounce. But a new asset class has also come up

today which is bound to take the world in a swirl,quite literally; Wine.

The following table helps us compare the returns ofvarious asset classes.

Alternative

Investment

Assets:

WINE

.

Although a good asset todiversify ones risk, wine is still

considered very volatile and

risky due to the small number

of players in this niche market

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

TWIF Gold Oil FTSE Hang sang

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

sIbM bANgAloreRishi Sonthalia



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1) Buying physical bottles:As trading in winestill remains a concept that India is warming up to,one has to rely on brokers in other countries. Butremember, one has to pay duties on imports whichwill result in an upward push on the purchaseprices. Only 1% of the worlds wines (approx. 268.7million hectoliters) are investible, and these wines

last for around 50 to 100 years, appreciating withage. One should remember that profits can rangefrom 10-50% on every bottle, but the key is to in-vest 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 existsa minimum lock-in period for these funds and anet asset value per share is issued. The upside ofinvesting in wine funds is that there are no stor-age or commission charges. The only set back hereis the minimum investment limit which goes into

a few lakhs and needs to be deposited into Euro-pean accounts.

3) Wine Futures: Another way to invest is bybuying wine even before they are bottled. There isa dedicated index called the Liv-ex 100 Index whichtracked the trading pattern of the 100 most soughtafter fine wines in the world. It has gained morethan 25% year to date (as of November 2010) andover 30% year on year (and outpacing most otherinvestment vehicles). The high-risk investor can gothrough a broker at the Liv-ex at a commission of1 to 2 percent. If you know your wines, one caninvest in wine futures known as Primeurs.

The Wine Investment Fund (TWIF), one of the mostpopular of such funds, announced its latest pay-out as its 2005 Tranche matured; and it expects themarket will rise by around 21% in 2011. Investorsare receiving returns equivalent to 13.25% per an-num (+86.3%) over the last five years. Over thesame 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 be-tween fine wine and equities. TWIF generated re-turns of over 30% in 2010 alone.

But before making an investment one needs togain extensive knowledge of the asset, especiallyif one plans to invest directly into the bottles orthe Primeurs. Online ratings by reputed societiesand wine tasters are a reliable source for such in-formation about brand, vintage longevity and con-sistency.

So go ahead and find a fund or even a bottle foryourself. Its only just fair for you to become theKing of Good Times (or Wines maybe).

FIN-Q Solutions

November 2011

1. ICBC

2. Suspense Account

3. Vostro

4. Capital Adequacyand Earnings

5. Payment Float

6. Fiat Money

7. Green shoe option

8. CHIPS

9. Miami Masters/Sony Ericsson Open

10. King George VI


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P

erspective

The World of finance is passing through a taxingtime in the recent past. Financial services havebeen stereotyped as being over aggressive andavaricious in their approach. The Financial crisishas brought forward an important question of theneed of regulation over the financial and ancil-lary services. One such area under purview is theCredit Rating System.

A credit rating is an independent opinion on thecreditworthiness of a debt, security or derivativeissue. The rating ideally does not provide guidanceon the related aspects for investment deci-sions, such as marketability or marketvolatility. It says nothing aboutthe systemic risk. Creditrating agencies work asservice providers to cor-porates who want tohave an independent

credit rating for theirinstruments andprojects. However,the main flaw inthe system comeswhen the remu-neration for theservices are re-ceived from thesame corporateswho want their

securities rated.View of Credit rating Agencies

The main contention of credit rating agencies isthe fact that their ratings are opinions and notrecommendations to purchase, sell or hold anysecurities and they act as expert advisors. Hencethe work they do should not be under the purviewof any law with regard to the scope and tools of

analysis used. They are not responsible for theopinions they give as the same are based on thedata received from the issuers. In the UnitedStates, rating agencies assert that they have thesame status as that of the financial journalistsand are therefore protected by the constitution-al guarantee of freedom of press. This has beentraditionally shielding them from investor litiga-

tion and has prevented direct regulation of theirpractices. Till recently, the agencies have arguedthat their reputation is at stake and the users will

approach them for rating only if their opinionscarry credibility with the investors. Hence

there were no regulations on theCredit Rating Agencies.

Current regulations onthe Credit Rating

Agencies

The regulatory treatmentfor rating agencies hasbeen rather paradoxi-cal: regulatory stan-dards have beenbased on credit rat-ings, but there hasbeen little directcontrol on how theratings are made.Despite the limited

oversight, regula-tors have depend-ed heavily on these ratings in setting regulatorypolicies.

Credit ratings are normally used for following pur-poses:-

1)Determining the capital adequacy requirementsfor financial service providers

TeAM NIveshAkHarshali Damle

TO REGULATEor NOT TO REGULATE

: THE ULTIMATE CONUNDRUM

Credit rating ideally does

not provide guidance on the

related aspects for investment

decisions, such as marketabil-

ity or market volatility



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Perspecti

ve

2)Identifying or classifying assets for investmentsto be made

3)Evaluating the credit risk of assets in securitiza-tion or bond offerings

Concentration of power of the CRAs

Another major problem is the fact that the credit

rating industry is highly concentrated, with threecompanies (Standard & Poors, Fitch and Moodys)dominating the market in most countries. Thiscan be attributed to high entry barriers, stemmingfrom goodwill and the reach and reputation builtby successful rating agencies over time. CRISILis a S&P Company in India. CRISIL has extendedits operation to rating B-Schools and real estateprojects also. These are purely based on dataprovided to CRISIL. The reliability of suchratings is surely questionable.

Need for ChangeCredit rating agencies playan important role as defacto capital market gate-keepersdespite theirreluctance to assume anysuch accountability. Hence,another positive step in theregulatory system can be toreduce the undue importance givento the Credit Rating Agencies. Regula- tions will

only succeed if it understands what ratings canand cannot achieve.

While corporate debt and security ratings arebased on publicly available and audited finan-cial statements, structured instrument ratings arebased on non-public, non-standard and unauditedinformation supplied by the issuer. Also, the rat-ing agencies have no obligation to perform anydue diligence to assess the accuracy and reliabil-ity of the information and often wrongly rely onrepresentations and warranties from the issuers

about the quality of the data. Their computer-driven simulation models are highly based on themarket assumptions that proved to be faulty orincomplete.

Extent of regulation

Though regulators agree on the fact of the needfor regulations on Credit Rating Agencies, the ma-jor question is the extent of regulation. The meth-

odologies cannot be standardized as this will killall possibilities of innovation and competition inthe field.

The range of possible methods of regulation nev-ertheless remains extremely broad. At one end ofthe spectrum is the idea that CRAs should imposeself-regulation. The success of any such self-regu-

latory regime stands or falls with the question ofcontrol and integrity.

At the other end of the regulatory framework, thereare demands for the rating processto be complete- ly entrustedto the pub - lic sector to

e n s u r eefficientf u n c -

t ion ing.However

the reg-u lators

are the samepeople who were

a part of the entire chainthat caused the financial crisis.

What effective regulations can one ex-pect from them?

The basic steps in the direction of regulation canbe:

1)Structure for assessing the credibility of datareceived from management and analysis of theextent and quality of data

2)Identifying potential conflict of interests andavoiding the same

3)Avoiding anti-competitive and unhealthy prac-tices

4)Maintaining professionalism and independence

5)Determining disclosure requirements

6)Determining framework for credit upgrades and

downgradesConclusion

There has been a broad consensus regarding theneed for regulation over the Credit Rating Agen-cies to ensure financial stability. There is a needto seek balance between the benefits and costs ofregulation. This is the ultimate conundrum thatneeds to be addressed.

There is a need to seek a bal-

ance between the benefts and

costs of any proposed

regulation


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Credit Default Swap canbe used effectively byentities to manage creditrisk by transferring therisk to the seller of pro-tection for a premium.However, as seen in therecent financial mess,it has the potential tobring down even the socalled too-big-to-fail en-tities. Hence, RBI whileallowing trading in CDS,judiciously regulates op-

eration in this space

mode of contract size is between $10million to $20 million when expressed

in notional amount. The mode for ma-turity is 5 years and the range liesbetween 1-10 years.

c) Trigger Events :

Pricing and Settlement of CDS

Traditional market making involvesplacing limit orders to buy & sell inorder to earn the bid-ask spread. Butfor an HFT firm, the bid-ask spread isnot the only source of money. Sincemarket makers provide additional li-quidity to the market by being coun-terparty to incoming market orders,they get rebates from exchanges for

CDS provide credit protection to cor-porate bond buyers because there

is a guarantee of the credit wor-thiness of the product by the sell-ers of the swap. This arrangementensures that there is a transfer ofrisk of default from fixed incomesecurity holder to the seller of theswap. Hence, CDS can be visualizedas a kind of insurance against creditrisks associated with bonds.

Features of CDS

a) CDS Spreads :Spread is defined as the premiumpaid by the protection buyer to theseller. The premium is usually ex-pressed as basis points and is paidby the buyer of protection on aquarterly basis. CDS spreads are ex-pressed in basis points of notionalvalue. CDS can also be viewed asput option for a corporate bond.

b) Contract Size and Maturity:Though limit on either size or matu-rity of CDS contract does not exist,

sJMsoM,IIT boMbAyRoy Paul Mathew

credit default SwapS : Concepts and RBI

regulations

Fig. 1: CDS spreads



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an

quotes that lead to execution. So, if an HFTs 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 re-bates while breaking even on the spread. Build-ing up such market making strategies typicallyinvolves precise modeling of the target marketstructure & trading volumes using stochasticcontrol techniques.

Ticker Tape Tradinga) Settlement of CDS

Upon the occurrence of a credit event, either theseller/buyer issues a Credit Event Notice.

The compensation is received by the buyer fromthe seller of the protection through two means:

1) Physical Settlement

Physical settlement is the most common form ofsettlement in the swap market where the pro-tection seller buys the distressed loan or bond

(in CDS parlance called as Deliverable Obliga-tion) at par from the buyer. Physical settlementhappens within 30 days of the occurrence of thecredit event.

2) Cash Settlement:

The difference that exists between the notionalvalue of CDS and the final value of the referenceobligation is calculated to decide the paymentto be made by the seller of the protection to thebuyer. The time period for cash settlement usu-

ally range from 0-5 days from the occurrence ofcredit event.

b) Pricing of CDS

CDS price or CDS spread is defined as the annual

amount which the protection buyer is liable topay the seller over the duration of the contract.The two basic approaches for the pricing ap-proach followed for CDS are:

1) Structural Approach

This approach estimates the correlation betweenprice of credit risk instruments and economicdeterminants of financial distress for pricing ofCDS. The main factors which impact probability

and severity of default are a) Financial leverageb) Volatility and c) Risk free term structure. Forexample, Moodys KMV model is widely used forpricing of CDS. Much research in this domainhas been carried out by Black & Scholes (1973)and Merton (1974).

2) Reduced Form Approach

These models exogenously postulate the dy-namics of default probabilities and use mar-ket data to obtain the parameters needed to

value credit-sensitive claims (Ericsson, Jacobsand Oviedo (2004)). A variant of this approachis based on estimation of default probabilitiesand loss given default through the employmentof statistical functions.

Benets and Risks of CDS

Benefits of CDS:

Since CDS is an effective tool which allows hedg-ing of credit risk, trading it makes markets com-plete. It results in a better and efficient use ofcapital among institutions owing to better man-aged credit risk transfer.

(i) CDS is a better avenue for supply of liquid-ity and credit for sovereign debtors and since itenhances spread of risk it is ideally suited for


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corporate as well.

(ii) CDS pricing acts like a liquid, efficient andtransparent pricing standard for new issuancesince there is a direct correlation between CDSprice and cost of funds on corporate borrowing.

Risks of a CDS market:

(i) There is an increased vulnerability and sus-ceptibility of systemic shocks as witnessed inrecent financial crisis due to fact that unwisetransaction of CDS lead to concentration of riskacross few entities which are of pivotal impor-tance.

(ii) Default by counterparty lead to increasedcorrelation of credit risk. There is stimulation inthe risk appetite of financial institutions due toviability of CDS.

(iii) When CDS is coupled with securitization it

leads to loop holes in risk assessment due tofact that assets and credit protection can betransferred.

(iv) There is an ever increasing possibility of ac-

cumulating massive speculative positions andcoordinated manipulation do exists since regu-latory controls are minimal and bypassed due tothe fact that CDS are traded as OTC derivative.

(v) Since payoff of a CDS is linked with defaultof a borrower or a security (e.g Bonds) and bothdepends on the state of the economy, expectedpay off on CDS will be on increase during reces-sionary fears. Hence, huge impact on systemicrisk can be attributed to pro-cyclicality.

CDS in India RBI Stand

RBI issued new regulations and guidelines onthe operational aspects of Credit Default Swap(CDS).

1) Direct market participants have to report CDStrades in a time span of 30 minutes to onlinerepository of Clearing Corporation.

2) Banks are not allowed to sell CDS on corpo-rate bonds on the issue date and employmentof these contracts as bank guarantee is prohib-ited.

3) Commercial banks who wishes to play therole of market makers are allowed to both buyand sell CDS provided they have a minimum

CRAR (capital to risk weighted assets ratio) of11 per cent with core CRAR (Tier I capital) of atleast 7 per cent. RBIs pivotal objective in in-troducing CDS on corporate bonds is to enableand equip market participants with a tool whichcan be employed to transfer and manage creditrisk in the most eficient way through risk re-distribution.

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Fig. 2: A common Credit Default Swap transaction

Payment only if credit event occurs

Credit Default Swap premium paid

periodically

Protection seller

Does not usually own

underlying credit

asset

Selling CreditProtection

Long Credit Exposure

Protection buyer

Tends to own

underlying credit

asset

Purchasing CreditProtection

Short Credit Exposure


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Sir, I was going through a newspaperarticle 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, Ill explain. But before I do, I want

you to tell me something. How do the banksbenchmark the lending rates for their cus-tomers? What do you think?

I have read about this Sir. The banksfix a rate known as the Prime Lending Rate(PLR), which is actually the interest ratecharged by the banks to their largest, mostsecure 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 anotheron a loan is called as LIBOR or London In-terbank Offered rate. It is the worlds mostwidely used benchmark interest rate for

short term loans. One important thing to keep in mindis that it is an inter-bank rate.

So who determines this rate?

Well, the British Bankers Association(BBA) compiles and calculates the rate, andpublishes it every day at about 11.45 a.m.GMT in conjunction with Reuters.

What do you mean by compiling andcalculating? Can you please elaborate?

Look, LIBOR is determined by a poll of 16leading international banks. At 11 a.m. Lon-

don time, BBA asks the rates at which thedeposits are quoted to prime banks in the

London inter-bank market. The sixteen quotes thus re-ceived are arranged in ascending order. The highest 4and the lowest 4 of the quotes are discarded, to avoid

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

So, this means that any trading thathappens on any particular day betweenthe banks happens at this rate.

No, that is not true. The rates atwhich banks trade with each other changeevery minute like all the other marketsrates do. This depends upon the marketsexpectation of the economic activity and

the future direction of interest rates. LIBOR only actsas a benchmark or a guideline.

It doesnt look that important atool to me, then.

Well, without a benchmark or aguideline, the trades would happen in avery random manner. This rate gives anidea about the markets sentiments to

both the investors and the borrowers. Hence, itsvery important.

I can understand how LIBOR willaffect the banks. But, how does it affectan individual like me?

As the world becomes integrated bythe day, anything that happens even atthe international institutional level, affectsevery individual directly or indirectly.

Since, LIBOR is the rate that banks charge

when they make short term unsecured loans toother banks. It in turn also affects the interest ratesfor student loans, mortgages, value of major cur-rencies etc. For example, almost half of all lend-ers peg the interest rate charged to LIBOR, includingthe students education loan. If the rates go up, theloans become more expensive and can significantlyincrease your cost of education. Especially in timesof economic crisis, the availability of student loansjust like other loans is adversely affected.

Hmm, I think I will now under-stand the market movements better.Thank you, Sir.

CLASSROOM

FinFundaof theMonth

LIBOR

NIVESHAK 21

Classroom

IIM ShillongShubhi Bansal


22/24December 2011

2222

F I N - Q1. Connect the dots

2. Which event are we talking about?

a) Event held in Land of Mountains, Land by the River

b) Related to Petrac) 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 in-vestors 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 byFrank Coraci starring Adam Sandler.

7. Which accounting concept is also related to Neutral Monism, a famous philo-sophical view?

8. Name the Chairman of the Indian Stock Exchange having 464 companieslisted in it.

9. Name this complete accounting software that is also the name of a street inAtlanta.

10. Connect the dots

All entries should be mailed at [email protected] by 10th January, 2012 23:59 hrs

One lucky winner will receive cash prize of Rs. 500/-


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