A

REPORT
ON

RECENT TRENDS
IN
CAPITAL MARKET
WHERE…..HIGHER THE RISK, HIGHER THE RETURN
 Derivatives
Commodities whose value is derived from the price of some underlying
asset like securities, commodities, bullion, currency, interest level, stock
market index or anything else are known as “Derivatives”.

In more simpler form, derivatives are financial security such as an option

or future whose value is derived in part from the value and characteristics
of another security, the underlying asset.

It is a generic term for a variety of financial instruments. Essentially, this

means you buy a promise to convey ownership of the asset, rather than the
asset itself. The legal terms of a contract are much more varied and
flexible than the terms of property ownership. In fact, it’s this flexibility
that appeals to investors.

When a person invests in derivative, the underlying asset is usually a

commodity, bond, stock, or currency. He bet that the value derived from
the underlying asset will increase or decrease by a certain amount within a
certain fixed period of time.

Importance of derivatives

There are several risks inherent in financial transactions. Derivatives are

used to separate risks from traditional instruments and transfer these risks
to parties willing to bear these risks. The fundamental risks involved in
derivative business includes:

 Credit Risk:
 This is the risk of failure of a counterparty to perform its obligation as per
the contract. Also known as default or counterparty risk, it differs with
different instruments.

 Market Risk:

Market risk is a risk of financial loss as a result of adverse movements of

prices of the underlying asset/instrument.

 Liquidity Risk:

The inability of a firm to arrange a transaction at prevailing market prices

is termed as liquidity risk. A firm faces two types of liquidity risks

1. Related to liquidity of separate products

2. Related to the funding of activities of the firm including derivatives.

 Legal Risk:

Derivatives cut across judicial boundaries, therefore the legal aspects

associated with the deal should be looked into carefully.

Types of Derivatives:
‘Futures’ and ‘options’ are two commodity traded types of derivatives. An
‘options’ contract gives the owner the right to buy or sell an asset at a set
price on or before a given date. On the other hand, the owner of a ‘futures’
contract is obligated to buy or sell the asset.

The other examples of derivatives are warrants and convertible bonds

(similar to shares in that they are assets). But derivatives are usually
contracts. Beyond this, the derivatives range is only limited by the
imagination of investment banks. It is likely that any person who has
funds invested an insurance policy or a pension fund that they are
investing in, and exposed to, derivatives – wittingly or unwittingly.
Shares or bonds are financial assets where one can claim on another
person or corporation; they will be usually be fairly standardized and
governed by the property of securities laws in an appropriate country.

On the other hand, a contract is merely an agreement between two parties,

where the contract details may not be standardized.

Derivatives securities or derivatives products are in real terms contracts

rather than solid as it fairly sounds.

A. Future contracts:
Future contracts is an agreement made and traded on the exchange
between two parties to buy or sell a commodity at a particular time in the
future for a pre-defined price. Since both the parties are unaware of each
other, the exchange provides a mechanism to give the party assurance of
honored contract. The exchange specifies standardized features of the
contract. The risk to the holder is unlimited, and because the pay off
pattern is symmetrical, the risk to the seller is unlimited as well.

Money lost and gained by each party on a futures contract are equal and
opposite. In other words, a future trading is a zero-sum game. These are
basically forward contracts, meaning they represent a pledge to make a
certain transaction at a future date. The exchange of assets occurs on the
date specified in the contract. These are regulated by overseeing agencies,
and are guaranteed by clearing houses. Hedgers often trade futures for the
purpose of keeping price risk in check.

Future contracts are often used by commercial enterprises as ‘hedging

tools’ to reduce the risk of expected future purchases or sales of the
underlying asset. If used to speculate, risk increases. So risk depends on
the underlying instrument and the use of the future.
  Advantages of Futures Contracts:

1. If price moves are favorable, the producer realizes the

greatest return with this marketing alternative.
2. No premium charge is associated with futures market
contracts.

 Disadvantages of Future Contracts:

1. Subject to margin calls

2. Unable to take advantage of favorable price moves
3. Net price is subject to Basis change

Futures contracts are similar to Options. Both represent actions that occur
in future. But Options are contract on the underlying futures contract
where as futures are either to accept or deliver the actual physical
commodity. To make a decision between using a futures contract or an
options contract, producers need to evaluate both alternatives.

B. Option contract:

Options Contract is a type of Derivatives Contract which gives the

buyer/holder of the contract the right (but not the obligation) to buy/sell
the underlying asset at a predetermined price within or at end of a
specified period. The buyer / holder of the option purchase the right from
the seller/writer for a consideration which is called the premium. The
seller/writer of an option is obligated to settle the option as per the terms
of the contract when the buyer/holder exercises his right. The underlying
asset could include securities, an index of prices of securities etc.

Under Securities Contracts (Regulations) Act, 1956 options on securities

has been defined as "option in securities" means a contract for the
purchase or sale of a right to buy or sell, or a right to buy and sell,
securities in future, and includes a teji, a mandi, a teji mandi, a galli, a
put, a call or a put and call in securities;
An Option to buy is called Call option and option to sell is called Put
option. Further, if an option that is exercisable on or before the expiry date
is called American option and one that is exercisable only on expiry date,
is called European option. The price at which the option is to be exercised
is called Strike price or Exercise price.

Therefore, in the case of American options the buyer has the right to
exercise the option at anytime on or before the expiry date. This request
for exercise is submitted to the Exchange, which randomly assigns the
exercise request to the sellers of the options, who are obligated to settle
the terms of the contract within a specified time frame.

As in the case of futures contracts, option contracts can be also be settled

by delivery of the underlying asset or cash. However, unlike futures cash
settlement in option contract entails paying/receiving the difference
between the strike price/exercise price and the price of the underlying
asset either at the time of expiry of the contract or at the time of exercise /
assignment of the option contract.

Index Futures and Index Option Contracts:

Futures contract based on an index i.e. the underlying asset is the index
are known as Index Futures Contracts. For example, futures contract on
NIFTY Index and BSE-30 Index. These contracts derive their value from
the value of the underlying index.

Similarly, the options contracts, which are based on some index, are
known as Index options contract. However, unlike Index Futures, the
buyer of Index Option Contracts has only the right but not the obligation
to buy / sell the underlying index on expiry. Index Option Contracts are
generally European Style options i.e. they can be exercised / assigned only
on the expiry date.

An index in turn derives its value from the prices of securities that
constitute the index and is created to represent the sentiments of the
market as a whole or of a particular sector of the economy. Indices that
represent the whole market are broad based indices and those that
represent a particular sector are sectoral indices.

In the beginning futures and options were permitted only on S&P Nifty
and BSE Sensex. Subsequently, sectoral indices were also permitted for
derivatives trading subject to fulfilling the eligibility criteria. Derivative
contracts may be permitted on an index if 80% of the index constituents
are individually eligible for derivatives trading. However, no single
ineligible stock in the index shall have a weight age of more than 5% in
the index. The index is required to fulfill the eligibility criteria even after
derivatives trading on the index has begun. If the index does not fulfill the
criteria for 3 consecutive months, then derivative contracts on such index
would be discontinued.

By its very nature, index cannot be delivered on maturity of the Index

futures or Index option contracts therefore, these contracts are essentially
cash settled on Expiry.

C. Forward contract:

In a forward contract, two parties agree to do a trade at some future date,

at a price and quantity agreed today. No money changes hands at the time
the deal is signed.

Features of Forward contract:

The main features of forward contracts are:

1. They are bilateral contracts and hence exposed to counter-party

risk.
2. Each contract is custom designed, and hence is unique in terms of
contract size, expiration date and the asset type and quality.
3. The contract price is generally not available in public domain.
4. The contract has to be settled by delivery of the asset on
expiration date.
In case, the party wishes to reverse the contract, it has to compulsorily go
to the same counter party, which being in a monopoly situation can
command the price it wants.

D. Swap Contract:

A swap is nothing but a barter or exchange but it plays a very important

role in international finance. A swap is the exchange of one set of cash
flows for another. A swap is a contract between two parties in which the
first party promises to make a payment to the second and the second party
promises to make a payment to the first. Both payments take place on
specified dates. Different formulas are used to determine what the two sets
of payments will be.

Classification of swaps is done on the basis of what the payments are

based on.

The different types of swaps are as follows.

• Interest rate swaps
• Currency Swaps
• Commodity swaps
• Equity swaps

Structure of Derivative Markets in India:

Derivative trading in India takes can place either on a separate and

independent Derivative Exchange or on a separate segment of an
existing Stock Exchange. Derivative Exchange/Segment function as a
Self-Regulatory Organization (SRO) and SEBI acts as the oversight
regulator. The clearing & settlement of all trades on the Derivative
Exchange/Segment would have to be through a Clearing
Corporation/House, which is independent in governance and
membership from the Derivative Exchange/Segment.

various membership categories in the derivatives market:

The various types of membership in the derivatives market are as
follows:
 Trading Member (TM) – A TM is a member of the
derivatives exchange and can trade on his own behalf and on
behalf of his clients.

 Clearing Member (CM) –These members are permitted to

settle their own trades as well as the trades of the other non-
clearing members known as Trading Members who have
agreed to settle the trades through them.

 Self-clearing Member (SCM) – A SCM are those clearing

members who can clear and settle their own trades only.

Requirements to be a member of the derivatives exchange/ clearing

corporation:

o Balance Sheet Net worth Requirements: SEBI has

prescribed a net worth requirement of Rs.3crores for clearing
members. The clearing members are required to furnish an
auditor's certificate for the net worth every 6 months to the
exchange. The net worth requirement is Rs.1crore for a self-
 clearing member. SEBI has not specified any net worth
requirement for a trading member.

o Liquid Net worth Requirements: Every clearing member

(both clearing members and self-clearing members) has to
maintain atleast Rs. 50 lakhs as Liquid Networth with the
exchange / clearing corporation.

o Certification requirements: The Members are required to

pass the certification programme approved by SEBI. Further,
every trading member is required to appoint at least two
approved users who have passed the certification programme.
Only the approved users are permitted to operate the
derivatives trading terminal.

Derivative contracts are permitted by SEBI

Derivative products have been introduced in a phased manner starting

with Index Futures Contracts in June 2000. Index Options and Stock
Options were introduced in June 2001 and July 2001 followed by Stock
Futures in November 2001. Sectoral indices were permitted for derivatives
trading in December 2002. Interest Rate Futures on a notional bond and T-
bill priced off ZCYC have been introduced in June 2003 and exchange
traded interest rate futures on a notional bond priced off a basket of
Government Securities were permitted for trading in January 2004.

Requirements for a FII and its sub-account to invest in derivatives

A SEBI registered FIIs and its sub-account are required to pay initial
margins, exposure margins and mark to market settlements in the
derivatives market as required by any other investor. Further, the FII and
its sub-account are also subject to position limits for trading in derivative
contracts. The FII and sub-account position limits for the various
derivative products are as under:

Index Index Stock Single Interest

 Options Futures Options stock rate
Futures futures
Rs. 250 Rs. 250 20% of 20% of Rs. USD
crores or crores or Market Market 100
15% of the 15% of the Wide Limit Wide Limit million.
OI in OI in subject to a subject to a In addition
Index Index ceiling of ceiling of to the
options, futures, Rs. 50 Rs. 50 above, the
whichever whichever crores. crores. FII may
is higher. is higher. take
In In exposure in
addition, addition, exchange
hedge hedge traded in
FII positions positions interest
Level are are rate
permitted. permitted. derivative
contracts to
the extent
of the book
value of
their cash
market
exposure in
Governme
nt
Securities.
Sub- Disclosure Disclosure 1% of free 1% of free Rs. 100 Cr
accoun requireme requireme float market float market or 15% of
t level nt for any nt for any capitalizatio capitalizatio total open
person or person or n or 5% of n or 5% of interest in
persons persons open open the market
acting in acting in interest on a interest on a in
concert concert particular particular exchange
holding holding underlying underlying traded
15% or 15% or whichever whichever interest
 more of more of is higher is higher rate
the open the open derivative
interest of interest of contracts,
all all whichever
derivative derivative is higher.
contracts contracts
on a on a
particular particular
underlying underlying
index index

Measures have been specified by SEBI to protect the rights of investor

in Derivatives Market:

The measures specified by SEBI include:

o Investor's money has to be kept separate at all levels and is

permitted to be used only against the liability of the Investor
and is not available to the trading member or clearing member
or even any other investor.

o The Trading Member is required to provide every investor with

a risk disclosure document which will disclose the risks
associated with the derivatives trading so that investors can
take a conscious decision to trade in derivatives.

o Investor would get the contract note duly time stamped for
receipt of the order and execution of the order. The order will
be executed with the identity of the client and without client ID
order will not be accepted by the system. The investor could
also demand the trade confirmation slip with his ID in support
of the contract note. This will protect him from the risk of price
favour, if any, extended by the Member.

o In the derivative markets all money paid by the Investor

towards margins on all open positions is kept in trust with the
 Clearing House/Clearing corporation and in the event of
default of the Trading or Clearing Member the amounts paid
by the client towards margins are segregated and not utilised
towards the default of the member. However, in the event of a
default of a member, losses suffered by the Investor, if any, on
settled / closed out position are compensated from the Investor
Protection Fund, as per the rules, bye-laws and regulations of
the derivative segment of the exchanges.
o The Exchanges are required to set up arbitration and investor
grievances redressal mechanism operative from all the four
areas / regions of the country.

COMMODITY:

Any product that can be used for commerce or an article of commerce

which is traded on an authorized commodity exchange is known as
commodity. The article should be movable of value, something which is
bought or sold and which is produced or used as the subject or barter or
sale. In short commodity includes all kinds of goods. Forward Contracts
(Regulation) Act (FCRA), 1952 defines “goods” as “every kind of
movable property other than actionable claims, money and securities”.

In current situation, all goods and products of agricultural (including

plantation), mineral and fossil origin are allowed for commodity trading
recognized under the FCRA. The national commodity exchanges,
recognized by the Central Government, permits commodities which
include precious (gold and silver) and non-ferrous metals; cereals and
pulses; ginned and un-ginned cotton; oilseeds, oils and oilcakes; raw jute
and jute goods; sugar and gur, potatoes and onions; coffee and tea; rubber
and spices. Etc.

Different dictionary defines “commodity” as under:

Any item that can be bought and sold. Taken to refer to Exchange – traded
items including sugar, wheat, soya beans, coffee and tin.
That which affords convenience, advantage, or profit, especially in
commerce, including everything movable that is bought and sold (except
animals), -- goods, wares, merchandise, produce of land and
manufacturesetc.

In the world of business, a commodity is an undifferentiated product

whose market value arises from the owner’s right to sell rather than to use.
Example commodities from the financial world include oil (sold by the
barrel), wheat, bulk chemicals such as sulfuric acid and even pork-bellies.

Examples of Commodity Futures:

• Wheat
• Cotton
• Pepper
• Turmeric
• Corn
• Oats
• Soybeans
• Orange juice
• Crude oil
• Natural gas
• Gold
• Silver
• Pork bellies, etc.

Examples of Financial Futures:

• Treasuries
• Bonds
• Stocks
• Stock-index
• Foreign exchange
• Euro-dollar
• Deposits, etc.
 COMMODITY EXCHANGES

There are three categories:

1. NCDEX
2. MCX
3. NMCEIL

A brief description of commodity exchanges are those which trade in

particular commodities, neglecting the trade of securities, stock index
futures and options etc.

In the middle of 19th century in the United States, businessmen began

organizing market forums to make the buying and selling of commodities
easier. These central marketplaces provided a place for buyers and sellers
to meet, set quality and quantity standards, and establish rules of
1.
business.

Agricultural commodities were mostly traded but as long as there are

buyers and sellers, any commodity can be traded. In 1872, a group of
Manhattan dairy merchants got together to bring chaotic condition in New
York market to a system in terms of storage, pricing, and transfer of
agricultural products.

In 1933, during the Great Depression, the Commodity Exchange, Inc., was
established in New York through the merger of four small exchan ges –
the National Metal Exchange, the Rubber Exchange of New York, the
National Raw Silk Exchange, and the New York Hide Exchange.

The major commodity markets are in the United Kingdom and in the
USA. In india there are 25 recognized future exchanges, of which there
are three national level multi-commodity exchanges. After a gap of almost
three decades, Government of India has allowed forward transactions in
commodities through Online Commodity Exchanges, a modification of
traditional business known as Adhat and Vayda Vyapar to facilitate better
risk coverage and delivery of commodities.

The three exchanges are:

1. National Commodity & Derivatives Exchange Limited (NCDEX)

2. Multi Commodity Exchange of India Limited (MCX)
3. National Multi-Commodity Exchange of India Limited (NMCEIL)

All the exchanges have been set up under overall control of Forward
Market Commission (FMC) of Government of India.

National Commodity & Derivatives Exchange Limited (NCDEX)

National Commodity & Derivatives Exchange Limited (NCDEX) located

in Mumbai is a public limited company incorporated on April 23, 2003
under the Companies Act, 1956 and had commenced its operations on
December 15, 2003.This is the only commodity exchange in the country
promoted by national level institutions.

It is promoted by ICICI Bank Limited, Life Insurance Corporation of

India (LIC), National Bank for Agriculture and Rural Development
(NABARD) and National Stock Exchange of India Limited (NSE). It is a
professionally managed online multi commodity exchange. NCDEX is
regulated by Forward Market Commission and is subjected to various
laws of the land like the Companies Act, Stamp Act, Contracts Act,
Forward Commission (Regulation) Act and various other legislations.

Multi Commodity Exchange of India Limited(MCX)

Headquartered in Mumbai Multi Commodity Exchange of India Limited

(MCX), is an independent and de-mutulised exchange with a permanent
recognition from Government of India. Key shareholders of MCX are
Financial Technologies (India) Ltd., State Bank of India, Union Bank of
India, Corporation Bank, Bank of India and Canara Bank. MCX facilitates
online trading, clearing and settlement operations for commodity futures
markets across the country.

MCX started offering trade in November 2003 and has built strategic
alliances with Bombay Bullion Association, Bombay Metal Exchange,
Solvent Extractors’ Association of India, Pulses Importers Association
and Shetkari Sanghatana.

National Multi-Commodity Exchange of India Limited (NMCEIL)

National Multi Commodity Exchange of India Limited (NMCEIL) is the

first de-mutualized, Electronic Multi-Commodity Exchange in India. On
25th July, 2001, it was granted approval by the Government to organise
trading in the edible oil complex. It has operationalised from November
26, 2002. It is being supported by Central Warehousing Corporation Ltd.,
Gujarat State Agricultural Marketing Board and Neptune Overseas
Limited. It got its recognition in October 2000.

Commodity exchange in india plays an important role where the prices of

any commodity are not fixed, in an organized way. Earlier only the buyer
of produce and its seller in the market judged upon the prices. Others
never had a say. Today, commodity exchanges are purely speculative in
nature. Before discovering the price, they reach to the producers, end-
users, and even the retail investors, at a grassroots level. It brings a price
transparency and risk management in the vital market.
A big difference between a typical auction, where a single auctioneer
announces the bids, and the Exchange is that people are not only
competing to buy but also to sell. By Exchange rules and by law, no one
can bid under a higher bid, and no one can offer to sell higher than
someone else’s lower offer. That keeps the market as efficient as possible,
and keeps the traders on their toes to make sure no one gets the purchase
or sale before they do.

FOREIGN DIRECT INVESTEMENTS:

MEANING:

Foreign direct investment (FDI) is the movement of capital across national

frontiers in a manner that grants the investor control over the acquired asset. Thus it
is distinct from portfolio investment which may cross borders, but does not offer
such control. Firms which source FDI are known as ‘multinational enterprises’
(MNEs). In this case control is defined as owning 10% or greater of the ordinary
shares of an incorporated firm, having 10% or more of the voting power for an
unincorporated firm or development of a greenfield branch plant that is a permanent
establishment of the originating firm.

Types of FDI:

• Greenfield investment: Direct investment in new facilities or the expansion

of existing facilities. Greenfield investments are the primary target of a host
nation’s promotional efforts because they create new production capacity and
jobs, transfer technology and know-how, and can lead to linkages to the global
marketplace. Greenfield investments are the principal mode of investing in
developing countries.

• Mergers and Acquisitions: Occur when a transfer of existing assets from

local firms to foreign firms takes place. Cross-border mergers occur when the
assets and operation of firms from different countries are combined to
establish a new legal entity. Cross-border acquisitions occur when the control
of assets and operations is transferred from a local to a foreign company, with
the local company becoming an affiliate of the foreign company. Mergers and
acquisitions are the principal mode of investing in developed countries.
Foreign Direct Investment (FDI) is permited as under the following forms of
investments.

 Through financial collaborations.

 Through joint ventures and technical collaborations.
 Through capital markets via Euro issues.
 Through private placements or preferential allotments.

 Forbidden Territories:

FDI is not permitted in the following industrial sectors:

• Arms and ammunition.

• Atomic Energy.
• Railway Transport.
• Coal and lignite.
• Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper,
zinc.

Foreign Investment through GDRs (Euro Issues):

Foreign Investment through GDRs is treated as Foreign Direct Investment

Indian companies are allowed to raise equity capital in the international market
through the issue of Global Depository Receipt (GDRs). GDRs are designated in
dollars and are not subject to any ceilings on investment. An applicant company
seeking Government's approval in this regard should have consistent track record for
good performance (financial or otherwise) for a minimum period of 3 years. This
condition would be relaxed for infrastructure projects such as power generation,
telecommunication, petroleum exploration and refining, ports, airports and roads.

Potential for investment in India:

• The Government is focusing on expansion and modernization of roads and has
opened this up for private sector participation. 48 new road projects worth
US$ 12 billion are under construction. Development and upgradation of roads
 will require an investment of US$ 24 billion till 2008. Private sector
participation in road projects will grow significantly.

• The Government has announced ambitious plan to add around 1,00,000 MW

of additional generation capacity by the year 2012. To attract private
investment of such magnitude, Govt. of India had taken various steps to
provide for an adequate administrative & legal framework.

• Special incentives and tax-breaks are given for certain sectors such as power,
electronics, telecom, software, hydrocarbons, R&D and exports.

• The railway sector will need an investment of US$ 22 billion for new coaches,
tracks, and communications and safety equipment over the next ten years. A
10 year Corporate Safety Plan of the Indian Railways envisaging an
expenditure of US $ 7.24 bn. besides development of appropriate technology
for higher level of safety in train operation. Metro Rail Corporation projects
worth US $ 12.84 bn in cities like Delhi, Bangalore, Hyderabad, Chennai,
Ahmedabad and many other cities are on target.

• The Union railway minister projected a requirement of Rs 40.92bn for

important railway projects in the North East and Jammu and Kashmir, mega
bridge projects at Bogibeel in Assam, Munger bridge over Ganga, Patna
bridge over Ganga and Kosi bridge as well as for the Sudoor Gram Sampark
Yojana.

• Upgradation and modernization of airports will require US$ 33 billion

investment in the next ten years. Airports Authority of India has set a target of
investing 1 billion dollars for modernization of airports.

• There is potential for investment in the expansion and modernization of ports,

inland navigation and maritime transport. The Government has taken up the
US$ 22 billion 'Sagarmala' project to develop the Port and Shipping sector
under Public-Private Partnership. 100 percent FDI is permitted for
construction and maintenance of ports. The Government is offering incentives
to investors. While the government will take care of 15% of the investment,
the rest will come from the private sector.

• The investment requirements in the maritime sector are estimated at US$22

billion.

• The Ministry of Power has formulated a blueprint to provide reliable,

affordable and quality power to all users by 2012. This calls for investment of
US$ 73 billion in the next five years. Opportunities are there for investment in
 power generation and distribution and development of non-conventional
energy sources.

• There is potential for investment in urban infrastructure projects. Water supply

and sanitation projects alone offer scope for annual investment of US$ 5.71
billion.

• The entire gamut of exploration, production, refining, distribution and retail

marketing in the oil & gas sector presents opportunities for FDI.

• India has an estimated 85 billion tons of mineral reserves remaining to be

exploited. Potential areas for exploration ventures include gold, diamond,
copper, lead, zinc, cobalt, silver, tin etc. There is also scope for setting up
manufacturing units for value added products.

• The telecom market, which is one of the world's largest and fastest growing,
has an investment potential of US$ 20-25 billion over the next five years. The
telecom market turnover is expected to increase from US$ 10 billion in 2004
to US$ 13 billion by 2007.

• The IT industry and IT-enabled services, which are rapidly growing offer
opportunities for FDI.

• India has emerged as an important venue for the services sector including
financial accounting, call centers, and business process outsourcing. There is
considerable potential for growth in these areas.

• Biotechnology and Bioinformatics, which are on Government's priority list for

development, offer scope for FDI. The industry has crossed $I billion dollar
mark, with a growth rate of 36.55%.

• The Indian Auto component industry, currently estimated at US $63 billion

industry, is expected to "triple" in less than eight years time to US $17 billion
by 2012.The Indian auto industry with a turnover of US $ 12 billion and the
auto parts industry with a turnover of US$ 3 billion offer scope for FDI.

• The Government is encouraging the establishment of world-class integrated

textile complexes and processing units.

• In India the Food Processing Industry is relatively nascent and offers

opportunities for FDI. It accounts for Rs 1,280 billion (US$29.4 billion), in a
total estimated market of Rs 3,990 billion (US$91.66 billion). There is a
rapidly increasing demand for processed food caused by rising urbanization
and income levels. To meet this demand, the investment required is about
US$28 billion. Food processing has been declared a priority sector.
 • The outlay in the Food Processing Sector has been increased from US$19.5
million in 2004-05 to US$41.35 million the next year, more than twice the
earlier amount. The government is also considering investing US$22.97
million in at least 10 mega food parks in the country besides working towards
offering 100 per cent foreign direct investment and income tax benefits in the
sector.

• The Healthcare industry is expected to increase in size from its current US$
17.2 billion to US$ 40 billion by 2012. Healthcare spending in the country will
double over the next 10 years. Private healthcare will form a large chunk of
this spending, rising from Rs 690 billion ($14.8 billion) to Rs 1,560 billion
($33.6 billion) in 2012. This figure could rise by additional Rs 390 billion
($8.4 billion) if health insurance cover is available to the rich and the middle
class.

• With the expected increase in the pharmaceutical market, the total healthcare
market could rise from Rs 1,030 billion ($22.2 billion) currently (5.2 percent
of GDP) to Rs 2,320 billion ($50 billion)-Rs 3,200 billion ($69 billion) (6.2-
8.5 percent of GDP) by 2012.

• The Government has recently established Special Economic Zones with the
purpose of promoting exports and attracting FDI. These SEZs do not impose
duty on imports of inputs and they enjoy simplified fiscal and foreign
exchange procedures and allow 100% FDI.

• The travel and tourism industry, which has grown to a size of US$ 32 billion,
offers scope for investment in hotels, resorts and tourism infrastructure.

Foreign Investment - Policies and Procedures:

• India's Foreign Investment policies and procedures are simple, transparent and
investor friendly.

• The Common Minimum Programme of the Government states that, "FDI will
continue to be encouraged and actively sought particularly in areas of
infrastructure, high technology and exports where local assets and employment
are created on a significant scale. The country needs and can easily absorb at
least two to three times the present level of FDI inflows".

• Foreign investment can be freely channeled into all sectors except for the
following sectors: retail trade, agriculture (excluding floriculture, horticulture,
development of seeds, animal husbandry, pisciculture & cultivation of
 vegetables, mushrooms etc. under controlled conditions and services related to
agro & allied sectors), plantations (other than tea plantations), atomic energy,
gas pipelines, courier services, trading and lottery and gambling. In most of
the sectors, foreign investors can go through the Automatic Route without
need for any approvals. The investor has to merely keep the Reserve Bank of
India informed of the flow of funds and issue of shares.

• Maximum limits on foreign investment in some sectors are being

progressively liberalized, eg: telecommunications (74%), insurance (26%),
banking (74%), mining (74%) aviation (49%), defence equipment (26%),
cable networks (49%), trading (51%), print media (26%) and small-scale
industries (24%). FDI in excess of 24% is permitted in small-scale industry
with 50% export obligation.

• 100% FDI is allowed in non news publications, which means all foreign non-
news scientific, technical, specialty magazines, periodicals and journals are
allowed to be published and sold throughout the country.

• Retail Trading is permitted under automatic route with FDI up to 51%

provided it is in primarily in export activities, and the undertaking is an export
house/trading house/super trading house/star trading house.

• Wholesale trading activity is allowed subject to prior approval of Foreign

Investment Promotion Board (FIPB).

• The Government has decided to allow FDI up to 100% under the automatic
route in townships, housing, built-up infrastructure and construction-
development projects (which would include, but not be restricted to, housing,
commercial premises, hotels, resorts, hospitals, educational institutions,
recreational facilities, city and regional level infrastructure), subject to the
following guidelines. Minimum area to be developed under each project would
be as under:
o In case of development of serviced housing plots, a minimum land area
of 10 hectares
o In case of construction-development projects, a minimum builtup area
of 50,000 sq.mts
o In case of a combination project, anyone of the above two conditions
would suffice

• In respect of the companies in infrastructure sector, where there is a prescribed

cap for foreign investment, only the direct investment will be considered for
the prescribed cap and the foreign investment in an investing company will not
be set off against this cap provided the foreign direct investment in such
 investing company does not exceed 49 % and the management of the investing
company is with the Indian owners. The automatic route is not available.

• Prior approval of the Government is needed in those cases, which require

industrial license (examples: alcoholic beverages, cigarettes, defence
equipments, gunpowder and hazardous chemicals) and those involving
investment beyond the maximum limits. Such cases are cleared by the Foreign
Investment Promotion Board in a transparent, efficient, time-bound and
predictable manner. The FIPB meets once a week.

• The Department of Industrial Policy and Promotion is the nodal agency for
information and assistance to foreign investors. Their website www.dipp.nic.in
has comprehensive information for foreign investors and gives weekly updates
on proposals for foreign investment under consideration. It also gives
information on projects available for foreign investors and contains online
applications for clearances.

• The various State Governments in India extend incentives and competitive

offers to foreign investors.

• Intellectual Property Rights Laws of India are well on track with the rest of the
world.

• Full capital account convertibility is allowed for foreign investors.

FOREIGN INVESTMENT SUMMARY:

• In the April - August period of 2005-06 total FDI jumped to 2302 $ million
about 156% rise over the previous year.

• Foreign Investment Inflows for the period April - August 2005-06 stood 6,369
million US$ (Direct investment + Portfolio investment).

• The Economic Times of India (Dec 9th, 2005) featured the news: India has
emerged stronger on the global investment radar in 2005, overtaking the
United States to become the second-most attractive FDI destination in the
world. An annual survey of executives from the world's largest companies
ranked India second only to China in the FDI attractiveness ranking, scoring
1.951 on a scale of 0-3.

• MNCs, which have invested in India include GE, Dupont, Eli Lily, Monsanto,
Caterpillar, GM, Hewlett Packard, Motorola, Bell Labs, Daimler Chrysler,
 Intel, Texas Instruments, Cummins, Microsoft, IBM, Toyota, Mitsubishi,
Samsung, LG, Novartis, Bayer, Nestle, Coca Cola and McDonalds.

• FII investments in India touched a record US$9.05bn (on a net basis) on

December 12, 2005. This is higher than the '04 figure of US$8.4bn. Foreign
funds have been pouring in huge sums of money into the Indian market over
the past three years.

• They have pumped in over US$23bn over the past three years as India is
emerging as a major investment destination for both US and Asian investors.

• FIIs bought shares worth US$ 862.94 million in the first quarter (April-June
05) and US$ 3.73 bn worth shares in the second quarter (July-September
2005).

• A BS Research Bureau study, based on BSE-500 index companies, shows that

FIIs bought 803 million shares in April-September 2005.

• Between January 5 and February 14, 2005, FIIs invested more in Indian
equities than in Korean or Taiwanese equities. While the Korean market
received over US$1 billion, Taiwan had US$947 million, India's share
amounted to US$1.1 billion.

• Companies that have seen a major jump in FII holding include TASC Pharma
(22.3%), IFSL (16.3%), Shringar Cinema (14%), S Kumar Nationwide
(13.35%), Four Soft (11.9%), Alok Industries (11%) and Sesa Goa (10%).

• Bill Gates, Chairman of Microsoft Corp, the world's largest software company,
said that the company will invest US$ 1.7 billion in India over the next four
years to expand its operations.

• The IT sector saw phenomenal growth in FDI in 2005 with $6.5 billion of
investment. The total investment in IT bypassed the India's ITeS exports in
2004 ($5.7 billion) and was 48.3% of total IT exports.

Sector caps and entry routes (as on 26 February 2006)

A. Infrastructure
B. Services
C. Manufacturing
D. Resources Based Sectors
E. Knowledge Economy

A. Infrastructure:

Ownership Entry
Sector Remarks
Limit Route
Includes
generation
(except nuclear
power where
Power 100% Automatic FDI is
prohibited),
transmission and
distribution of
power
Telecom
Basic, cellular and
74%
value-added services
FIPB
ISP with gateways 74% beyond
49%
FIPB
ISP without gateways 100% beyond
49%
Subject to
licensing and
security
FIPB requirements;
Email, Voice mail 100% beyond FDI cap of 74%
49% for global
mobile personal
communications
by satellite
 FIPB
Radio Paging 74% beyond
49%
FIPB
End-to-End
74% beyond
Bandwidth
49%
Infrastructure FIPB
Providers providing 100% beyond
Dark Fibre 49%
Telecom
100% Automatic
Manufacturing
Includes
construction and
maintenance of
Roads 100% Automatic
roads, highways,
bridges and
tunnels
Applies to
construction and
Ports 100% Automatic
maintenance of
ports
Civil Aviation
100% FDI under
FIPB automatic route
Airports 100% beyond is permissible
74% for greenfield
airports.
Subject to no
direct or indirect
equity
participation by
Domestic Airlines 49% Automatic
foreign airlines.
FDI up to 100%
allowed for
NRIs
 Petroleum &
Natural Gas
Petroleum refining 100% Automatic
Petroleum product
100% Automatic
pipelines
Subject to
divestment of
26% equity in
Petroleum product
100% Automatic favour of the
marketing
Indian partner /
public within 5
years.
Petroleum refining-
26% FIPB
PSUs
Others
Includes
associated real
Mass Rapid Transport estate
100% Automatic
System development in
all metropolitan
cities
Subject to SEZ
EOU/SEZ/Industrial Act 2005 and
100% Automatic
park construction Foreign Trade
Policy.
Satellite establishment
74% FIPB
and operation

B. Services:

Ownership Entry
Sector Remarks
Limit Route
Banking
Indian Private Banks 74% Automatic Foreign banks
can take an
 equity stake of
more than 5%
(up to 74%)
only in the
private sector
banks which
have been
identified by the
RBI for
restructuring
Subject to
PSU Banks 20% compliance with
RBI guidelines
Includes 19
specified
activities;
Subject to
NBFCs 100% Automatic minimum
capitalisation
norms and
compliance with
RBI guidelines
Includes both
Life and Non-
Life Insurance;
Subject to
Insurance 26% Automatic licence from
Insurance
Regulatory &
Development
Authority
Real estate and construction Subject to
Townships 100% Automatic minimum land
area of 10
Housing 100% Automatic
hectare for
Construction – Development serviced
100% Automatic
Projects housing plot
Build-up Infrastructure 100% Automatic and built-up
area of 50,000
sq. mts. for
construction
 development
projects. Also
minimum
Trading
Only for single
Retail Trade 51% FIPB
brand products
Trading (Export House, Super
Trading House, Star Trading 51% Automatic
House)
Trading (Export, Cash and Carry
100% FIPB
Wholesale)
Tourism
Includes
facilities for
providing
Hotels, restaurants, beach resorts 100% Automatic
accommodation
and food
services
Tour and travel agencies 100% Automatic
Broadcasting
Subject to
maximum
foreign equity
TV software production 100%
up to 49%
including
FDI/NRI/FII
Hardware facilities - (Uplinking, 49% Subject to
HUB, etc.) maximum
foreign equity
up to 49%
including
FDI/NRI/FII;
FDI in news and
current affairs
channels which
uplink from
India is capped
 at 26%
Subject to
maximum
foreign equity
Cable network 49%
up to 49%
including
FDI/NRI/FII
Subject to
maximum
foreign equity
upto 49%
DTH 20%
including
FDI/NRI/FII.
FDI not to
exceed 20%
Subject to
licensee being a
company
Terrestrial Broadcast FM 20% registered in
India under the
Companies Act,
1956
Not
Terrestrial TV Broadcast
Permitted
Print Media
Scientific/Technical journals 100%
Other non-news/non-current
74%
affairs/specialty publications
Newspapers, Periodicals dealing
26%
with news and current affairs
Other Services
Includes all film
Advertising and Film 100% Automatic
related activities
Includes all
postal services
Courier services 100% FIPB except the
distribution of
letters
Lottery, Betting and Gambling Not —
 Permitted
Subject to
security and
licensing
requirement; to
Defence and Strategic Industries 26% FIPB
be sold
primarily to the
Ministry of
Defence
R&D activities 100% Automatic

C. Manufacturing:

Ownership Entry
Sector Remarks
Limit Route
Includes
manufacture
Metals 100% Automatic of Steel,
Aluminium
etc.
Textiles and Garments 100% Automatic
Electronics Hardware 100% Automatic
Includes
Chemicals and Plastics 100% Automatic
plastics
Includes
Two
-wheelers,
Automobiles 100% Automatic
Cars and
Commercial
Vehicles
Auto Components 100% Automatic
Gems and Jewellery 100% Automatic
Food and Agro Products
Food Processing 100% Automatic
Agriculture (including contract Not
-
farming) Permitted
Not
Plantations (except Tea) -
Permitted
 Other Manufacturing
100% FDI
permitted
through
FIPB route
Items reserved for Small Scale 24% Automatic subject to
undertaking
of export
obligation of
50%

D. Resources Based Sectors:

Ownership
Sector Entry Route Remarks
Limit
Coal and Lignite
Automatic up to
Coal Processing 100%
50%
Subject to
provision of
Captive Coal mining 100% Automatic Coal Mines
(Nationalisation)
Act 1973.
Other Mining and
Quarrying
Including Gold,
Mineral Ores 100% Automatic Silver and other
mineral ores
Diamonds and precious
100% Automatic
stones
Includes only
mining, mineral
Atomic Minerals 74% FIPB separation and
subsequent value
addition
Oil and Natural Gas
100% Automatic
Exploration
E. Knowledge Economy:

Ownership Entry
Sector Remarks
Limit Route
FIPB route is needed
if industrial licence is
required or involves
Pharma and Biotech 100% Automatic recombinant DNA
technology,
cell/tissue
formulations
Healthcare 100% Automatic
Information Technology 100% Automatic
 Foreign Institutional Investor - FII
An investor or investment fund that is from or registered in a country outside of the
one in which it is currently investing. Institutional investors include hedge funds,
insurance companies, pension funds and mutual funds.

The term is used most commonly in India to refer to outside companies investing in
the financial markets of India. International institutional investors must register with
the Securities and Exchange Board of India to participate in the market. One of the
major market regulations pertaining to FIIs involves placing limits on FII ownership
in Indian companies.

Net FII inflows into India increased steadily through the decade of the 1990s to reach
an annual peak of US$10.25 billion in 2004-05. Cumulatively, FII investments as on
October 31, 2005 have been US$ 39.27 billion.

Every year since FIIs were allowed to participate in the Indian market, FII net
inflows into India have been positive, except for 1998-99. This reflects the strong
economic fundamentals of the country, as well as the confidence of the foreign
investors in the growth with stability of the Indian market. The year 2003 marked a
watershed in FII investment in India. FIIs started the year 2003 in a big way by
investing Rs. 985 crore in January itself. Meanwhile, corporate India continued to
report good operational results. This, along with good macroeconomic fundamentals,
growing industrial and service sectors led FIIs to perceive great potential for
investment in the Indian economy. In April 2003, prices of commodities like steel
and aluminium went up, propelling FII investment in May 2003 to Rs. 3,060 crore.
Around the same time, Morgan Stanley Capital International (MSCI) in its MSCI
Emerging Markets Index gave a weight of 4.3 per cent to India among the emerging
markets of the world. Calendar year 2004 ended with net FII inflows of US$9.2
billion, an all-time high since the liberalization.
The buoyant inflows continued in 2004-05. This weight was further increased to 5.9
per cent in April, 2004. In 2004-05, after reversing direction briefly during the period
May -June, FII inflows became robust again, leading to net inflows of US$ 10.25
billion during the year. The buoyancy continued in 2005-06, with net inflows
aggregating to US$ 3.26 billion in the first seven months up to end-October, 2005.

FII’s registered with SEBI fall under the following categories:

(a) Regular FIIs – those who are required to invest not less than 70 per cent of their
investment in equity -related instruments and up to 30 per cent in non-equity
instruments.

(b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debt
instruments.
 Benefits and costs of FII investments:

The terms of reference asking the Expert Group to consider how FII inflows can be
encouraged and examine the adequacy of the existing regulatory framework to
adequately address the concern for reducing vulnerability to the flow of speculative
capital do not include an examination of the desirability of encouraging FII inflows.
Yet, for motivating the consideration of the policy options, it is useful to briefly
summarise the benefits and costs for India of having FII investment. Given the
Group’s mandate of encouraging FII flows, the available arguments that mitigate the
costs have also been included under the relevant points.

Benefits:

1.Reduced cost of equity capital:

FII inflows augment the sources of funds in the Indian capital markets. In a common
sense way, the impact of FIIs upon the cost of equity capital may be visualised by
asking what stock prices would be if there were no FIIs operating in India. FII
investment reduces the required rate of return for equity, enhances stock prices, and
fosters investment by Indian firms in the country.

2.Imparting stability to India's Balance of Payments:

For promoting growth in a developing country such as India, there is need to

augment domestic investment, over and beyond domestic saving, through capital
flows. The excess of domestic investment over domestic savings result in a current
account deficit and this deficit is financed by capital flows in the balance of
payments. Prior to 1991, debt flows and official development assistance dominated
these capital flows. This mechanism of funding the current account deficit is widely
believed to have played a role in the emergence of balance of payments difficulties in
1981 and 1991. Portfolio flows in the equity markets, and FDI, as opposed to debt-
creating flows, are important as safer and more sustainable mechanisms for funding
the current account deficit.
3. Knowledge flows:

The activities of international institutional investors help strengthen Indian finance.

FIIs advocate modern ideas in market design, promote innovation, development of
sophisticated products such as financial derivatives, enhance competition in financial
intermediation, and lead to spillovers of human capital by exposing Indian
participants to modern financial techniques, and international best practices and
systems.

4. Strengthening corporate governance:

Domestic institutional and individual investors, used as they are to the ongoing
practices of Indian corporates, often accept such practices, even when these do not
measure up to the international benchmarks of best practices. FIIs, with their vast
experience with modern corporate governance practices, are less tolerant of
malpractice by corporate managers and owners (dominant shareholder). FII
participation in domestic capital markets often lead to vigorous advocacy of sound
corporate governance practices, improved efficiency and better shareholder value.

5.Improvements to market efficiency:

A significant presence of FIIs in India can improve market efficiency through two
channels. First, when adverse macroeconomic news, such as a bad monsoon,
unsettles many domestic investors, it may be easier for a globally diversified
portfolio manager to be more dispassionate about India's prospects, and engage in
stabilising trades. Second, at the level of individual stocks and industries, FIIs may
act as a channel through which knowledge and ideas about valuation of a firm or an
industry can more rapidly propagate into India.

For example, foreign investors were rapidly able to assess the potential of firms like
Infosys, which are primarily export-oriented, applying valuation principles that
prevailed outside India for software services companies.

Costs:
1.Herding and positive feedback trading:

There are concerns that foreign investors are chronically ill-informed about India,
and this lack of sound information may generate herding (a large number of FIIs
buying or selling together) and positive feedback trading (buying after positive
returns, selling after negative returns). These kinds of behaviour can exacerbate
volatility, and push prices away from fair values. FIIs behavior in India, however, so
far does not exhibit these patterns. Generally, contrary to ‘herding’, FIIs are seen to
be involved in very large buying and selling at the same time. Gordon and Gupta
(2003) find evidence against positive-feedback trading with FIIs buying after
negative returns and vice versa.

2. BOP vulnerability:

There are concerns that in an extreme event, there can be a massive flight of foreign
capital out of India, triggering difficulties in the balance of payments front. India's
experience with FIIs so far, however, suggests that across episodes like the Pokhran
blasts, or the 2001 stock market scandal, no capital flight has taken place. A billion
or more of US dollars of portfolio capital has never left India within the period of
one month. When juxtaposed with India's enormous current account and capital
account flows, this suggests that there is little evidence of vulnerability so far.

3. Possibility of taking over companies:

While FIIs are normally seen as pure portfolio investors, without interest in control,
portfolio investors can occasionally behave like FDI investors, and seek control of
companies that they have a substantial shareholding in. Such outcomes, however,
may not be inconsistent with India's quest for greater FDI. Furthermore, SEBI's
takeover code is in place, and has functioned fairly well, ensuring that all investors
benefit equally in the event of a takeover.

4. Complexities of monetary management:

A policymaker trying to design the ideal financial system has three objectives. The
policy maker wants continuing national sovereignty in the pursuit of interest rate,
inflation and exchange rate objectives; financial markets that are regulated,
supervised and cushioned; and the benefits of global capital markets. Unfortunately,
these three goals are incompatible. They form the “impossible trinity.” India's
openness to portfolio flows and FDI has effectively made the country’s capital
account convertible for foreign institutions and investors. The problems of monetary
management in general, and maintaining a tight exchange rate regime, reasonable
interest rates and moderate inflation at the same time in particular, have come to the
fore in recent times. The problem showed up in terms of very large foreign exchange
reserve inflows requiring considerable sterlisation operations by the RBI to maintain
stable macroeconomic conditions. The Government had to introduce a Market
Stabilisation Scheme (MSS) from April 1, 2004.
The diversity of FIIs has been increasing with the number of registered FIIs in India
steadily rising over the years (Table 2). In 2004-05, with 145 new FIIs registering
with Securities and Exchange Board of India (SEBI), as on March 31, 2005, there
were 685 FIIs registered in India. The names of some prominent FIIs registered
during 2004-05 are: California Public Employees’ Retirement System (CalPERS),
United Nations for and on behalf of the United Nations Joint Staff Pension Fund,
Public School Retirement System of Missouri, Commonwealth of Massachusetts
Pension Reserves Investment Trust, Treasurer of the State North Carolina Equity
Investment Fund Pooled Trust, the Growth Fund of America, and AIM Funds
Management Inc.

In terms of country of origin, the USA topped the list with a share of 40 per cent of
the number of FIIs registered in India, followed by UK’s 17 per cent. Other countries
of significance in terms of origin of FIIs investing in India are Luxemburg, Hong
Kong, and Singapore. In terms of net cumulative investments by FIIs, US-based FIIs
dominate with 29 per cent of the net cumulative FII investments in India, followed
by UK at 17 per cent. In recent months, European and Japanese FIIs have started to
evince an increasing interest in India, and of the FIIs that registered with SEBI in
October 2004, a significant number belonged to Europe and Japan. These
developments have helped improve the diversity of the set of FIIs operating in India.

As is evident from figure 1, I argue that foreign investment, (in form of around 800
and growing registered FIIs), will continue to chart the growth of Indian capital
(equity) markets for at least 10-15 years until domestic institutions catch up. Hence
there is a need to attract and spread low volatility reliable capital from FIIs
across sectors while developing domestic institutional investment capabilities to
take over.
The total market capitalization on BSE on 7th October, 2005 was Rs 2,245,005 Crore
(over 510 billion $).

The recent stock market rally saw FII investment reach 8.65 billion $ in 2005 till
date compared to 8.51 billion $ in whole of 2004. In addition, India’s GDP growth
rate is expected to be around 6.5-7% in the next two years. The most important
requirement is to make the capital markets more integral to the Indian growth story.
To sustain, match and accelerate this growth, the Indian economy needs a growing
mean rate of capital supply without sudden shocks. To analyze whether capital
markets are poised to grow and play a more important role in this growth, we ask
these key questions classified in three categories.

The net FII investment during the year FY06 (till February 2006) was at $7.9 billion
against $10.2 billion during FY05. Total foreign exchange reserves as of February
2006 stood at $141.2 billion, down from last fiscal's level. The decline in reserves
has been on account of the widening current account deficit and valuation losses on
account of a strengthening dollar.

THE RECENT UP’S AND DOWN’S OF FII:

Positive tidings about the Indian economy combined with a fast-growing market
have made India an attractive destination for foreign institutional investors (FIIs).

The foreign Institutional Investors' (FIIs) net investment in the Indian stock markets
in calendar year 2005 crossed US$ 10 billion in the 2005 calendar, the highest ever
by the foreign funds in a single year after FIIs were allowed to make portfolio
investments in the country's stock markets in the early 90s.

As per the Securities Exchange Board of India (SEBI) figures, FIIs made net
purchases of US$ 587.3 million on December 16, 2005, taking the total net
investments in the 2005 calendar to US$ 10.11 billion.

India's popularity among investors can be gauged from the fact that the number of
FIIs registered with SEBI has increased from none in 1992-93 to 528 in 2000-01 to
803 in 2005-06. In 2005 alone, 145 new FIIs registered themselves, taking the total
registered FIIs to 803 (as on October 31, 2005) from 685 in 2004-05.

A number of these investors are Japanese and European funds aiming to cash in on
the rising equity markets in India. In addition, there was increased registration by
non-traditional countries like Denmark, Italy, Belgium, Canada and Sweden.
The Japanese have, in fact, been increasing their foothold in India. Mizuho Corporate
Bank's decision to successfully expand base in the country has managed to convince
almost 60-65 major Japanese corporates to set up manufacturing or marketing base in
India.

• This list of corporates includes big names in auto sectors such as Honda,
Toyota and Yamaha, as well as those in home appliances, pharmaceuticals,
and communications.
• While Nissan has already set up its base in India, other new entrants include
Japanese business conglomerate Mitsui Metal, Sanyo, and pharma major Eisai.
Japanese Telecom major Nippon Telegraph (NTT) is also in the process of
entering the Indian market.
• Sabre Capital and Singapore's Temasek Holding have teamed up to float a
fund that will invest up to US$ 5 billion in Indian equities as well as fixed
income instruments over the next five years.
• Fidelity International, a leading foreign institutional investor, has picked up
about 9 per cent in the Multi Commodity Exchange of India Ltd (MCX) for
US$ 49 million.

If FIIs have been flocking to India, it is obvious the returns are handsome. According
to Kamal Nath, the Indian Minister for Commerce and Industry, of all the foreign
investors in India, at least 77 per cent make profit and 8 per cent break even.

These facts are corroborated by recent research on the trend. A landmark survey by
the Japan Bank for International Co-operation (JBIC) shows that in the next three
years, India will be the third most favoured investment destination for Japanese
investors in a list, which includes US and Russia.

A Smith Barney (a Citigroup division) study says the estimated market value of
FII investment in the top 200 companies (including ADRs and GDRs) at
current market prices is a whopping US$ 43 billion. This is 18 per cent of
the market capitalisation of the BSE 200. CAPITAL
MARKET DEVELOPMENT
TABLE 8
NEW CAPITAL (PUBLIC & RIGHTS) ISSUES
& INVESTMENT
MADE BY FOREIGN INSTITUTIONAL
INVESTORS (FIIs)
 Net Investment
of FIIs

New Capital (at monthly

Issues exchange rate)
Amount

Raised
No. of Amount
(Rs.Crore
Year Issues ) (US $ Mn.)
1993-94 1143 24372 1634
1994-95 1692 27633 1528
1995-96 1725 20804 2036
1996-97 882 14276 2432
1997-98 111 4570 1649
1998-99 58 5587 -386
1999-00 93 7817 2339
2000-01 151 6108 2160
2001-02 35 7543 1846
2002-03 26 4070 562
2003-04 57 23272 9949
2004-05 60 28256 10172
2005-
06* 71 10392 3789
 RECENT TRENDS OF CAPITAL MARKET:

Indian equities have performed very well in the past three years (2003 to 2005). The
Bombay Sensitive Index (SENSEX), which is a common proxy for the performance
of blue-chip companies in the Indian bourse, rose 78% in 2003, 14.1% in 2004 and
39.8% in 2005 (returns are in SGD terms without dividends reinvested). If we add up
the market returns for the past three years, the Indian bourse returned 184%. That
meant that the market almost tripled in three years. The rally continued into 2006,
and on 4 th January 2006, the SENSEX reached a historical high of 9648.1 points.
Chart 1 shows us the strong upturns experienced by the Indian market through the
years.

As illustrated in the chart above, it has not always been a straight ride up for
the Indian bourse. From Jan 2000 to Dec 2002, the market along with other Asian
bourses, experienced lackluster market sentiment, which pulled the market down by
more than 30%. In 2003, investors regained their confidence, as economic conditions
in India turned more favourable. Foreign institutional investments (FIIs) also began
to flow into the market as global investors became more interested in investing in
this booming emerging market. There was some volatility in the Indian bourse in
2004 as the surprise victory of the Coalition Party led by Sonia Gandhi rattled the
confidence of investors. Nonetheless,
investors again regained their confidence in the bourse in the later part of 2004 and
2005. Considering that the market has done so well in the last 3 years, some
investors have begun to question if the rally can last. To answer that question, we
first need to delve deeper into the factors behind the bull run. Will the main drivers
for the Indian market continue to drive the bull run in the medium term.

Foreign Fund Inflows An Important Driver:

One of the factors that caused the market to rally strongly was the strong interest
from foreign fund investors. There was strong growth in Foreign Direct Investments
(FDIs) and Foreign Institutional Investments (FIIs) in the past three years. One of
reasons for the strong foreign fund inflow is that foreign investors were generally
quite positive on the measures the new Indian government has taken including
liberalizing sectors such as telecommunication, insurance and civil aviation (in July
2004), as well as cutting taxes on non-agricultural projects from 20% to 15% and
lowering effective corporate tax rate to 33% from 35% (both measures taken in
March 2005). Table 1 shows the size of the foreign fund inflows against the market
return (in INR). From 2003 to 2005, when the Indian bourse was doing well, the FIIs
increased from USD 6.6 billion to USD 10.8 billion. Although, we do not know for
certain how much of the total market capital in India is made up of FIIs, we do note
that the SENSEX tends to move in tandem with foreign fund inflows. And the
volatility in the FII tends to contribute to the increased level of volatility in the
SENSEX.
Illustrates this point. During the Indian elections held in May in 2004, the market
was down by 17.8% in that month alone . In the same month, foreign fund outflows
totaled more than USD 700 million. In October 2005, global equity markets suffered
from a temporary correction. The Indian bourse was down 10.5%, and during that
month there was an outflow of more than USD $860 million from the market. In
general, when the market rallied, there were strong pick-ups in the inflows as well. In
2005 when the market gained 39.8%, more than USD 10 billion was invested in the
Indian market (see Table 1; all returns are stated in SGD without dividends
reinvested).

This indicates that strong inflow of foreign monies might be one of the significant
drivers of Indian market rallies. This is not an unusual occurrence for an emerging
market such as India, where foreign investors are generally interested in plowing
monies into a market that is in the development stage and shows strong growth
potential. There is a concern, however, that further inflows of FIIs might cause more
volatility in the bourse. Investors might have to be aware that volatility in this respect
will continue to affect the Indian bourse. In addition, in the past three years, about
USD 26 billion has been invested into the Indian bourse. With the market at the
higher range of valuations, we are concerned that foreign fund inflows might have
reached a peak in the medium term. In order to understand why higher valuations
may spell bad news for the market, we need to look more closely at the price-to-
earnings ratio and the earnings growth of Indian companies for 2006 and 2007.

Valuation & Earnings:

When we assess the attractiveness of markets, we look specifically at the potential
earnings growth for the next three years and the valuations of the market
(represented by the estimated PE ratio), other than the economic fundamentals and
driving factors. Based on Table 2, the PE ratios are 19.3X, 16.7X and 15.4X for the
financial year ending March 2006, 2007 and 2008 respectively. After the Indian
bourse experienced a strong market rally for the past three years, valuations have
surpassed the attractive levels in 2003 to early 2005 of about 14X to 15X to levels of
19X (based on end March 2006 earnings).

At such valuation levels, the market appears to be at a premium to a historical

average of about 15X, and is at the higher range of valuations (the historical range is
10X to 21X). As for earnings growth, it is relatively strong for 2006 at 15.9%, and
for 2007 at 8.2%. However, after the market rally in the past three years (2003, 2004
and 2005), we think that the optimism over earnings growth potential is more or less
priced into the market already. Chart 3 illustrates that the valuations for the market
are now at a higher range, especially after the strong market rally in the past three
years. The bold lines at the top and bottom of the chart shows the range of valuations
the market has been trading at since June 2000, and the dotted line shows the average
valuation. From the chart, we note that valuations are not cheap at this moment of
time. Another measure used in our analysis is excess earnings yield. Excess earnings
yield for the market, which looks at the yield of the market given a certain PE vis-à-
vis the local fixed income instrument is at –0.6%. That means that the fixed income
market seems to be yielding more than the equity
market at this moment (as at 13 Jan 2006).

Despite Valuation Concerns, Indian Economy Enjoying Strong Growth:

Despite the concerns that we have on the market becoming less attractive in terms of
valuations, the economy is still likely to experience strong growth in the years to
come. In the past three years (for financial year ended March 2003, March 2004 and
March 2005), economic growth in India has been strong averaging 7.5%. In the fiscal
year ended March 2005, sectors including trade (11.4%), manufacturing (9.2%) and
banking and finance (7.1%) stood out as the strongest contributors to economic
growth (refer to Table 3). Investments into these sectors have been on a rise. For
example, for the manufacturing sector, production of automobiles has been picking
up as car manufacturers such as Toyota, Hyundai, Honda and Fiat invested capital in
building manufacturing sites in India to export cars and sell cars domestically.
Increasingly, India is also becoming a popular ground for car manufacturers to
outsource auto parts. Daimler Chrysler, in a report on 9 Jan 2006, said that they
increased sourcing of auto parts and software services from India by 32.5% in 2005
to USD 87.8 million.

Trade is another economic driver for the Indian economy. The average monthly year-
on-year growth for exports for 2005 was quite strong at 16.6%. Exports grew
strongly boosted by manufacturing of automobile parts, medium and heavy
commercial vehicles, textile machinery, cement and pharmaceuticals. Aside from
manufacturing and trade, it is widely expected that domestic demand will pick up for
the market as well. According to Nilesh Shah, the Chief Investment Officer for
Prudential ICIC Asset Management, India is likely to continue its infrastructure
projects including adding power plants and telecom networks. Also, consumption of
goods and services is likely to double as the demand for housing increases and
consumers are more confident about spending on bigger ticket items in the future.
The rise in the proportion of affluent individuals is also one important growth driver,
the portion expected to rise from 5.6% (2005 to 2006E) to 9.0% (2009 to 2010E).
With these positive economic factors in mind, the Indian government expects
economic growth to be 7% in the fiscal year ending March 2006. We think that will
most of these economic factors going for India, the economy is likely to enjoy strong
economic growth in the next 3 to 5 years.

Conclusion – What Should Investors Do?

Positive economic growth and strong foreign inflows were two of the many factors
that have propelled the Indian bourse in the past three years (2003 to 2005). We do
think that the economy is at the early stages of development and with infrastructure
growth underway, the Indian economy is likely to continue to do well in the next 5
years. However, given the strong run-up in the Indian market in recent years, we
have turned more cautious on the Indian bourse. One main reason is that the market
valuation (or PE ratio) is at a premium at this point of time, relative to historical
levels as well as other Asian markets. In addition, excess earnings yield is at –0.6%
at this point of time, indicating that local fixed income instruments appear to be more
attractive than local equities. Given all these factors, within an investment horizon of
three years, we are neutral on the Indian market now, and have given it a rating of
2.5 stars. We think that it is unlikely that the Indian bourse will continue to enjoy
very strong run-ups, similar to what we have seen in the past few years. With that,
we advise investors who have a substantial holding in equities to shift their exposure
to more attractively valued markets.
 Business Growth in Derivatives segment
Interest Rate
Index Futures Stock Futures Index Options Stock Options
Futures
Turn Total Average Daily
No. of over Turnover (Rs. cr.)
Month/ Call Put Call Put
Turnove No. of contracts (Rs.
Year No. of Turnover
r (Rs. contract cr.)
contracts (Rs. cr.)
cr.) s Notional Notional Notional Notional Turnove
No. of No. of No. of No. of No. of
Turnover Turnover Turnover Turnover r (Rs.
contracts contracts contracts contracts contracts
(Rs. cr.) (Rs. cr.) (Rs. cr.) (Rs. cr.) cr.)
Current Month
192,03 10,844, 734,84 33,40
Mar.06 5,952,206 473,250 683,979 22,406 772,372 24,691 444,604 18,574 92,657 3,889 0 0 18,790,218
2 400 2 2
156,35 7,443,1 492,66 25,93
Feb.06 5,186,835 288,712 506,714 15,526 559,682 16,806 326,233 12,349 75,740 2,913 0 0 14,098,382
8 78 4 0
166,12 7,134,1 487,58 24,37
Jan.06 5,760,999 265,037 663,684 19,392 666,782 19,130 365,493 14,265 90,562 3,630 0 0 14,681,719
6 99 0 9
183,29 7,571,3 523,80 23,80
Dec.05 6,613,032 280,280 775,216 21,863 764,964 21,125 361,268 13,631 95,261 3,614 0 0 16,181,118
0 77 3 9
135,47 6,252,7 395,84 19,79
Nov.05 5,238,175 216,524 595,900 15,584 604,657 15,490 287,136 10,068 77,052 2,705 0 0 13,055,656
4 36 5 2
170,09 6,526,9 433,65 21,68
Oct.05 6,849,732 214,396 695,311 17,630 715,208 17,954 309,120 10,753 80,134 2,822 0 0 15,176,424
6 19 1 3
118,90 6,995,1 399,75 19,03
Sep.05 4,701,774 236,941 523,948 13,371 583,081 14,550 363,872 12,913 85,897 3,071 0 0 13,253,741
4 69 0 6
100,80 7,124,2 372,30 16,92
Aug.05 4,278,829 234,817 444,294 10,619 485,001 11,373 350,370 11,934 81,453 2,751 0 0 12,764,213
5 66 1 3
6,537,7 308,16 15,40
Jul.05 3,451,684 77,395 199,637 358,867 8,127 389,154 8,643 376,129 11,736 84,989 2,622 0 0 11,198,617
94 0 8
5,783,4 271,24 11,79
Jun.05 3,626,288 77,215 163,097 421,480 9,089 331,753 7,044 385,640 11,678 104,478 3,119 0 0 10,653,067
28 2 3
4,466,4 208,37
May.05 3,545,971 70,465 112,878 382,530 7,724 353,975 7,058 288,137 7,641 100,602 2,609 0 0 9,137,619 9,472
04 5
4,225,6 195,96
Apr.05 3,332,361 65,595 106128 361,544 7,293 295,020 5,981 307,994 8,203 105,955 2,763 0 0 8,628,497 9,798
23 2
2004- 21,635,44 772,14 47,043, 1,098,13 2,546,9 10,10
1,484,056 1,870,647 69,371 1,422,911 52,572 3,946,979 132,054 36,782 - - 77,016,465
05 9 7 066 3 86 7
2003- 17,191,66 554,44 32,368, 1,305,939 1,043,894 31,794 688,520 21,022 4,243,661 167,967 1,339,41 49,240 10, 2 56,886,776 2,130,6 8,388
04 8 6 842 0 78 0 12
 1 2
2002- 10,676, 1,066,56 439,86
2,126,763 43,952 286,533 269,674 5,669 172,567 3,577 2,456,501 69,643 30,488 - - 16,768,909 1,752
03 843 1 3
2001- 1,957,8 101,92
1,025,588 21,482 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383 - - 4,196,873 410
02 56 5
2000-
90,580 2,365 - - - - - - - - - - - - 90,580 2,365 11
01

Note: Notional Turnover = (Strike Price + Premium) * Quantity

Index Futures, Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001
and November 2001, respectively

Business Growth: Capital Market | Retail Debt Market | Wholesale Debt Market