niveshak

THE INVESTOR VOLUME 4 ISSUE 12 December 2011

credit default swaps : concepts Pg. 18

to regulate or not to regulate pg. 16

Niveshak

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

F R O M E D I T O R ’ S D E S K

NiveshakVolume IVISSUE XII

December 2011

Faculty MentorProf. N. Sivasankaran

EditorRajat Sethia

Sub-EditorsAlok AgrawalDeep Mehta

Jayant KejriwalMrityunjay Choudhary

Sawan SingamsettyShashank Jain

Tejas Vijay Pradhan

New TeamAkanksha BehlAkhil Tandon

Chandan GuptaHarshali Damle

Kailash V. MadanNilkesh 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 have indeed come a long way from our humble beginnings in 2008. This year we saw more than 700 article entries coming to us from b-schools across India and even more Fin-Q entries. We also published a number of interviews from dignitaries across industry and academia. Also, new sections such as Market Snapshot and Classroom were introduced this year which got a lot of appreciation from readers. Surely, these achievements wouldn’t be possible without the continued support and contribution from our readers. As we pass the baton to our new team, I on behalf of the outgoing team would like to thank all the readers for their support and hope that we lived up to the expectation of one and all by contributing our bit to this great knowledge sharing platform called ‘Niveshak’.

The year 2011 was expected to be the year of growth, but instead the year turned to be just the opposite. I am not able to remember a single editorial in the last year where I have written something good about the markets or economy. The benchmark Sensex slipped by more than 20% during the year, the rupee depreci-ated by even more. Inflation, RBI policy, government inaction, Euro crisis continued to dominate the headlines throughout the year and I don’t remember one editorial in last year where I have not mentioned these. I remember the June issue in which our cover story was on ‘double dipped’ recession. I distinctly recollect receiving mails from some optimistic readers about falsely spreading negativity. Two months later ‘Economist’ carried a cover story on the same topic and today ‘double-dip’ is real in some parts of Europe and the global economic data point to some very difficult times ahead in other advanced economies as well.

Optimists argue that the global economy has merely hit a ‘soft patch’. Firms and consumers reacted to this year’s shocks by temporarily slowing consumption, capital spending, and job creation. As long as the shocks don’t worsen confidence, growth will recover and stock markets will rally again. However, the ‘double-dip’ proponents argue that the problems of the advanced economies is that of insol-vency, not illiquidity; large and rising public and private deficits and debt, dam-aged financial systems that need to be cleaned up and recapitalized, massive loss of competitiveness, lack of economic growth, and rising unemployment. It is no longer possible to deny that public and private debts in PIIGs nations will need to be restructured. If the problem in advanced economies aggravates, the domino effect will ensure that no part of the world remains unaffected. We sincerely hope that the optimists are right and the new team has something good to write in the next year.

This issue brings to you some more interesting and insightful reads. The cover story this month focuses on Foreign Direct Investment in Indian retail sector. The issue also features an article on the critical review of the Disinvestment policy in India. Other articles in this issue focus on Alternative Investment Assets, Credit De-fault Swaps and regulation by Credit Ratings Agencies. The Classroom this month explains the meaning and significance of LIBOR. We would like to thank all those who have contributed articles to this issue and sent entries for FinQ.

Merry Christmas and Happy New Year!! Stay Invested.

Rajat Sethia(Editor - Niveshak)

C O N T E N T S

Niveshak Times04 The Month That Was

Article of the month 08 A critique on disinvestment policies in India

Cover Story

11 FDI in Retail

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

Fingyaan

18 Credit Default Swaps: Concepts and RBI regulations

Finsight14 Alternative Investment Assets: Wine

CLASSROOM21 LIBOR

December 2011

IIP PLUNGES NEW DEPTHS India’s index of industrial pro-

duction, which details out the growth of various sectors of the economy, record-ed a significant decline in

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

in comparison to the figures obtained last year, when the growth in IIP was 11.3%. It is for the first time since June 2009 that IIP has record-ed a red mark in its growth figures.

While manufacturing s e c t o r , which contributes almost two-thirds of the overall IIP index, de- c l i n e d by 6% in October; the mining sector and capi-tal goods output contracted by 7.2% and 25.5% respectively. Decline in production of capital goods was an unpleasant surprise, as the index logged a steep downfall from 6.8% contraction in the previous month.

On the other hand, production of intermediate goods slumped by 4.7% during October; whereas non-durables consumer goods output remained static at -1.3% during the month.

The electricity production was the sole rescuer, as it witnessed a strong 5.6% growth in Octo-ber, as against a robust 9% growth in September 2010.

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

RBI TIGHTENS RULES TO CHECK THE FALL-ING RUPEEAs the Indian rupee is writing and rewriting his-tory day after day, the Reserve Bank of India swung into action to check the depreciating cur-rency. The rupee slipped to sub-54 level for the first time in its history and touched a record low of 54.30 against the dollar on Dec 15,2011. In the

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

In an effort to curb the pressure exerted by speculations, the country’s central bank has imposed restrictions with immediate effect on forward trading in the local currency. Forward contracts once cancelled now cannot be bought again. It has also reduced the limit for hedging of foreign currency risks for importers/export-ers from 75 per cent to 25 of the average actual import/export turnover in the past three years. In another regulation, RBI has capped the exposure of banks to the Forex markets.

Experts are of the opinion that the move will be positive for the rupee in the “short- term,” increasing transac-tion costs and showing the RBI is looking to curb currency-market speculation.

FOOD INFLATION EASES TO 4.35%The effort of the economist finally seems to be bearing fruit, as the food inflation for the week ending Dec 3, 2011 reached a four year low of 4.35%.

As per the weekly WPI data, while vegetables, on the whole turned cheaper by 12.28 per cent, prices of kitchen staples such as onions and po-tatoes slumped by 46.03 per cent and 33.28 per cent on a year-on-year basis. Wheat prices also eased by 4.43 per cent as compared to the data recorded in the corresponding period last year.

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

RBI’S MID QUARTER POLICY REVIEWCountry’s central bank, the Reserve Bank of In-dia released their mid-quarter monetary policy review statement on December 16, 2011.

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

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

Though RBI has stressed that inflation and in-flationary expectations continue to remain el-evated, it expressed hope that it would decline due to moderating growth and declining food prices. While RBI sounded cautious on inflation, it explicitly admitted that the monetary policy cycle is likely to reverse its course to address concerns regarding risks to growth.

RBI’s policy document clearly reflects a shift in focus — from inflation combat to growth promo-tion. The country has been battling with a fall-ing industrial output, and the Index of Industrial Production (IIP) has recorded a negative growth for the month of October. The finance ministry has also cut its GDP growth forecast for the fis-cal to around 7.5%.

Moody’s downgrades Belgium’s credit rating, S&P and Fitch warn of a poten-tial downgradeMoody’s on December 16 downgraded Belgium’s credit rating by two notches as a result of rising borrowing costs in Belgium, which as per agency can make it very difficult for Belgium to repay its huge debt. Belgium’s local- and foreign-currency government bond ratings have been downgraded from “Aa1” to “Aa3” with a negative outlook. The rising costs have hardly hit Euro Zone nations which are try-ing to borrow money to finance their deficits. Political problems and the possibility of more stringent austerity measures have also emerged as significant problems in Belgium. Amidst all this Fitch has also put Belgium, Italy, Ireland, Spain, Cyprus and Slovenia on negative watch, which means a possible downgrade within next three months. Standard & Poor’s had already warned 15 of the currency bloc’s 17 members of a possible downgrade.

Italy’s Economy down by 0.2% in third quarter

Italy’s economy shrinks by 0.2% in third quar-ter ended Sept 30, for the first time since 2009 as per data released by the National Statistics Institute Istat. Economy expanded by 0.1% in the first quarter followed by expansion of 0.3% in second quarter before this contraction. The Economy is considered to be in recession only if it contracts in two successive quarters. As per the government forecasts the economy will shrink by almost 0.4 % in the fourth quarter. The Italian business federation Confindustria is also forecasting a downfall of 1.6% next year, thus raising concerns that Italian Economy may go into recession soon. Italian Industry Minis-ter Corrado Passera had already announced that the country is in recession. As per National Sta-tistics Institute Istat one of the reasons for this fall 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 the good news is that on a 12-month comparison Italian GDP rose by 0.2% in real terms from the third quarter of 2010.

Moody’s upgrades Indian RupeeMoody’s has raised India’s local currency debt rating by one notch to Baa3. With this Indian lo-

cal currency bonds have now become investment grade making them equivalent to coun-try’s foreign curren-

cy bond grade, though Baa3 is the lowest invest-ment grade. Moody’s said it does not now see “justification for a rating bias in favor of either local currency or foreign currency government debt”. A stable outlook on the economy is the reason for this credit upgradation. The upgra-dation has come as a great relief to the Indian currency which has depreciated by around 20% against dollar during last four months. Moody’s also said that the downward pressure on India’s economic growth will persist for the next two quarters.

The Niveshak Times

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MARKET CAP (IN RS. CR)BSE Mkt. Cap 53,79,251Index Full Mkt. Cap 26,27,112Index Free Float Mkt. Cap 12,85,512

CURRENCY RATESINR / 1 USD 52.67INR / 1 Euro 69.13INR / 100 Jap. YEN 67.72INR / 1 Pound Sterling 82.53

POLICY RATESBank Rate 6%Repo rate 8.50%Reverse Repo rate 7.50%

Market Snapshotwww.iims-niveshak.com

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.com www.nseindia.com

Source: www.bseindia.com

Source: www.bseindia.com 25th November to 21st December 2011

Data as on 21st December 2011

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arket Snapshot

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 precipitated a slew of reforms in India, including the “delicens-ing” elements of the new industrial policy of 1991. In 1999, the government formed the Ministry of Disinvestment 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 plague divestment 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 UTI and LIC

Pre-privatization Capitalization

Privatization of Public Sector Enterprises has been a recourse that has often been taken by govern-ments around the globe to meet the ever-expand-ing fiscal deficits. With new right governments coming to power in the US and Britain, there was support for neo-classical economics and influence of organizations like World Bank and International Monetary Fund led to more private sector involve-ment in the economy.

The challenges before government when going for disinvestment are as follows-

•Social Problem - Process of disinvestment is not favoured socially as it is against the interests of socially disadvantaged people and society at large.

•Political Problem - The coalition government at the centre with a number of parties has posed a serious threat to this program. Conflicting interests have made it difficult to arrive at a national con-sensus.

•Economic Problem - Most of the units identified for disinvestment are in a very bad shape which do not offer good returns. The Government, due to paucity of funds, is also not in a position to revive

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 to make the issue (IPO/FPO) attractive. The opportu-nity cost of this capital is to be compared against its use in social infrastructure build-up or R&D ac-tivities. The quandary that the government faces is whether to use the money for a sick unit, so as to turn it around (as also face the risk of its ero-sion), or to put that money into other investment requirements.

However what is commonly seen is that govern-ments often pays this ‘premium’ so as to avoid the aforementioned problems, more so the politi-cal problem. Sometimes this premium is deemed so high by the incumbent government so as to even surpass the possible pay offs from the priva-tization deal. Hence many such deals were called off (Chakraborty, A., Nair, V., & Mehta, B., 2009).

Post-Divestment Autonomy and Conflicts

There may be conflicts between profit maximizing objectives of a divested firm with other non com-mercial objectives or social purposes as a former state-owned firm. This issue is more likely to be prominent in case of partial divestment i.e. mixed private-government ownership. Such enterprises have important implications in terms of corporate governance.

Many a time divestment face opposition from vari-ous stakeholders raising concerns of public inter-ests like unemployment, price increase, etc. The type 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 like electricity, water, railways, petrol, etc. And there-fore government needs to address these issues by intervening through regulatory bodies, or by in-fluencing ownership or management of divested

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entities. This becomes more significant in cases where divestment opposing stakeholders are well organized.

To take an illustration, Indian government tries to control inflation through price control on oil and provides subsidies to downstream marketing firms. ONGC, with state ownership of 74.11%, needs to contribute 38.8% to the subsidy burden (Economic Times, 2011). Such interventions by government puts ONGC in a double role as a state-owned firm and a listed commercial entity. ONGC corporate governance is accused of forsaking minority share-holder interests and being operationally inefficient.

Figure 1 shows that since 2003-04, ONGC has pro-vided about Rs. 1436 million in subsidies. This converts to a huge loss to minority shareholders as compared to situation with no subsidy. The government being the major shareholder has legal power over minority shareholder. Time and again ONGC’s stock prices take a hit due to such inter-ventions. Also ONGC’s capabilities to make future capital investments are hugely curtailed.

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

One important lesson to be learned from the ONGC episode is that the participation of relevant stake-holders at the stage of policy formulation of di-vestment is necessary. This should help the gov-ernment in understanding various concerns of stakeholders 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 balance in conflicting interests could be achieved. Such a system might hamper the financial attractiveness of public listings initially but it is very critical to give due recognition to the post-divestment regu-lation beforehand.

Arm-twisting by government

In order to achieve better fiscal figures the gov-ernment has gone on the path of disinvesting in the PSUs. Even though the IPO/FPO’s have been over-subscribed, it is surprising to notice that the domestic institutions that have been subscribing to the issue are government controlled entities like LIC and UTI. The government has a 100 per cent holding in these institutions (Saugata Bhat-tacharya and Urjit R. Patel, 2002) and thus, money raised from them is like transferring money from one pocket to another.

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

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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 0

Sub 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 0.18

Any Others 0.06 0.16 0.12 0.08

Total 100 100 100 100Fig. 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 LIC and SBI (in which the government holds 51% eq-uity share holding). One of the reasons cited for the poor response has been the aggressive pric-ing strategy adopted by the government for the FPO. The state owned firms have put their bids at Rs. 209 for the Qualified Institutional Buyers (QIB) (NTPC FPO fully subscribed, 2010) against the base of Rs. 201, when the stock itself was trading in the range of Rs.201 - Rs.205 and thus crowded out the institutional investors who would rather prefer to buy the shares in the secondary markets itself.

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

LIC’s balance sheet (Saugata Bhattacharya and Urjit R. Patel, 2002) shows that the exposure of LIC to public sector stands at 84 per cent followed by private sector 14 per cent, and the total assets on LIC’s balance sheet to Central and State govern-ment securities is at 54 per cent, showing the de-pendence that the government has towards LIC in bailing out its IPOs and FPOs.

As the government tried to meet its fiscal targets it has speeded up its process of FPOs and IPOs to raise funds. During the years 2009-10 and 2010-11 the government raised Rs. 23552.93 crore and Rs. 22762.96 crore through disinvestment in vari-ous companies. The list of the companies through which the government has raised these amounts

are given in Figure 3.

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

The government issues the stocks at premium tak-ing the stand that the stocks are a good long term investment and it wants to share with the public the ownership of the company, but considering the past record of the performance of the IPOs this doesn’t seems credible.

Of all the issues of PSUs issued during the period 2009-11, only three are trading above their issue prices, that of Coal India, OIL and Power Grid Cor-poration India. For Coal India, the government was actually 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 an effective board and managerial team are neces-sary if the goals of disinvestment are to be met. From public finance perspective this would be in the interest of the government given the enhanced revenue they would obtain from both the direct shareholding and the added tax revenues. The multiplier effects emanating from these companies would add a significant boost to the GDP and that is another plus for using a hands-off approach by the government.

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Year Company Amount raised (Rs. crore)

Issue Price (Rs.) CMP (as on 25-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 9330.942 300 221.40

2010-11 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 PSU’s 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 sectorThe growth potential in the sector is huge, but there are few challenges that could slow down the growth for new entrants. Some of the chal-lenges are rigid regulations, high personnel costs, lack of basic infrastructure, real estate costs, and a highly competitive retail market. Adding to this, the entry of many retailers is getting disrupted because of delay in comple-tion of shopping mall projects due to resource constraints. Some of the other critical aspects found wanting in the Indian retail sector are:

• Supply chain management: It is one of the fac-tors for growth and profitability of modern retail industry. It takes care of regional variances, val-ues conscious consumers and assists retailers in creating a strong customer value proposition

• Branding

• Workforce Management

• Sustainability

• Green Marketing

Improving on these will enable Indian retailers to significantly enhance overall competitiveness and successfully deploy growth initiatives. They can also enjoy the effects of the dual GST. The dual GST implemented nation-wide is the next level of tax reforms intended to eliminate the obstacles of trade through a common function-

Cover Story

TeAM NIveshAkNilkesh Patra & Kailash V. Madan

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

FDI in Retail

Has India geared up for the change?

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make their presence felt in the growing Indian economy. Unfortunately, this move has faced a lot of resistance not only from the Opposition party of the country but also from some of UPA’s key allies like DMK, Trinamool Congress etc. In order to understand what the hullabaloo is all about, we need to examine the intricacies of the bill in question.

Before any foreign retailer can make its way into Indian shores, it needs to meet certain pre-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 – ImplicationsIndia being a signatory to World Trade Organiza-tion’s 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 towards these investments in the retail sector, because of the fear of losing jobs, competition and loss of business opportunities. However, the government is slowly taking steps in the right direction. In 1997, FDI in cash and carry (wholesale) with 100 percent ownership was permitted by the Govern-ment. In 2006, it was brought under the automat-ic route. 51% FDI was also permitted in a single brand retail outlet in 2006. 2011 saw a new reform in the retail sector. The UPA government proposed a bill permitting 100% FDI in single brand retail and 51% FDI in multi brand retail.

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

Indian Retail vs Global Retail

Logistics cost as %

of priceInventory 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 that the local kirana shops (mom and pop shops) stand to suffer huge losses. Considering the fact that 94% of India’s 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 that kirana traders can co-exist with the organized sec-tor. Also, the bill warrants setting up of malls by foreign players only in 53 cities, where space is already a constraint. Hence, most of these malls

would be situated on the out-skirts of the city and hence it is not necessary that the con-venient neighborhood kirana store runs out of business. Also, if predatory pricing is what the opposition is con-cerned about, the Competi-tion Commission of India will ensure that the prices remain fair and competitive.

Currently, the bill has been suspended until a consensus is reached in the Parliament. While there are pros and cons to this issue, we feel that the benefits of passing the bill would far outweigh its ill effects. The bill, in effect, would bring a bulk of India’s unorganized retail sector un-der the organized sector. This would make it much easier to implement labor laws and would also create a lot of employment, not to men-tion tremendous infrastruc-ture improvement. Kirana store traders may be affected a little, but over time, they will find ways and means to carve a niche for themselves.

ConclusionIt is not possible for the Government to step in and provide the required infrastructure facilities to boost this sector and hence opening it up to the tried and tested foreign players is the next best thing they can do. It is a small but steady step towards India’s 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 this move would bring in a lot of capital investment to the Indian market and would increase the al-ready diminishing Forex reserves of the nation. It would also help improve the infrastructure of the country, by way of shopping malls and high rises. Secondly, since the international players need to procure about a third of their raw materials from Indian small scale industries, it will boost employ-ment in this sector. Such a policy would also ensure that the “Customer is the King”. Increased competition in the retail space would ensure that 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. Agriculture employs about two-thirds of the country’s population but contributes only 16% to the nation’s GDP. The major rea-sons for this are the lack of infrastructure and the pres-ence of middle-men who eat away a major chunk of the farmer’s profits. Opening up the economy to foreign players would ensure bet-ter infrastructure by means of improved storage and harvesting facilities. For ex-ample, India is the second largest producer of fruits and vegetables in the world, but is not able to capitalize on this owing to poor infra-structure. Allowing FDI would see huge investments in back-end infrastructure thus improving the present scenario. At present, the farmers are getting only 10-15% of the price the customers pay for their products. Bulk of the profits are eaten by the middle-men, who can be eliminated by allowing FDI in retail as their business models’ thrive on procuring materials directly from the farmers. It would also provide employment to a large number of people either directly 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, where

stakeholders 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 BiyaniManaging Director,

Pantaloon Retail

December 2011

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

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

Recently an article on a major website talked about the lessons one can learn from the rich. It spoke about the ownership and investment patterns of the super rich and how they have been able to maintain their net worth even in this turmoil. A recent report by Capgemini and Ernst & Young reckons that one of the most prominent trends among the rich is that they put around 10% of their wealth into alternative asset classes.

Investment in real assets has fast become a modus operandi to diversify the risk of financial assets (like stocks and bonds) and also earn real returns in the process. The advantage of investing in real assets is that they have an intrinsic value due to their utility. The most popular real asset today is Gold. It has given manifold returns over the last few years, with the real price increasing from $800 to about $1800 per ounce. But a new asset class has also come up today which is bound to take the world in a swirl, quite literally; Wine.

The following table helps us compare the returns of various asset classes.

Alternative Investment Assets:

WINE

.Although a good asset to

diversify ones risk, wine is still considered very volatile and

risky due to the small number of players in this niche market

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

TWIF Gold Oil FTSE Hang sang

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

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

sIbM bANgAloreRishi Sonthalia


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1) Buying physical bottles: As trading in wine still remains a concept that India is warming up to, one has to rely on brokers in other countries. But remember, one has to pay duties on imports which will result in an upward push on the purchase prices. Only 1% of the world’s wines (approx. 268.7 million hectoliters) are investible, and these wines last for around 50 to 100 years, appreciating with age. One should remember that profits can range from 10-50% on every bottle, but the key is to 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 exists a minimum lock-in period for these funds and a net asset value per share is issued. The upside of investing in wine funds is that there are no stor-age or commission charges. The only set back here is the minimum investment limit which goes into a few lakhs and needs to be deposited into Euro-pean accounts.

3) Wine Futures: Another way to invest is by buying wine even before they are bottled. There is a dedicated index called the Liv-ex 100 Index which tracked the trading pattern of the 100 most sought after fine wines in the world. It has gained more than 25% year to date (as of November 2010) and over 30% year on year (and outpacing most other investment vehicles). The high-risk investor can go through a broker at the Liv-ex at a commission of 1 to 2 percent. If you know your wines, one can invest in wine futures known as ‘Primeurs’.

The Wine Investment Fund (TWIF), one of the most popular of such funds, announced its latest pay-out as its 2005 Tranche matured; and it expects the market will rise by around 21% in 2011. Investors are receiving returns equivalent to 13.25% per an-num (+86.3%) over the last five years. Over the same period the FTSE 100 rose just 1.9% or 0.4% per annum. These double figure returns of TWIF is calculated after charging all fees and expenses, and serves to emphasize the low correlation be-tween fine wine and equities. TWIF generated re-turns of over 30% in 2010 alone.

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

So go ahead and find a fund or even a bottle for yourself. It’s only just fair for you to become the “King of Good Times (or Wines maybe)”.

FIN-Q SolutionsNovember 2011

1. ICBC

2. Suspense Account

3. Vostro

4. Capital Adequacy and Earnings

5. Payment Float

6. Fiat Money

7. Green shoe option

8. CHIPS

9. Miami Masters/ Sony Ericsson Open

10. King George VI

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The World of finance is passing through a taxing time in the recent past. Financial services have been stereotyped as being over aggressive and avaricious in their approach. The Financial crisis has brought forward an important question of the need of regulation over the financial and ancil-lary services. One such area under purview is the Credit Rating System.

A credit rating is an independent opinion on the creditworthiness of a debt, security or derivative issue. The rating ideally does not provide guidance on the related aspects for investment deci-sions, such as marketability or market volatility. It says nothing about the “systemic risk”. Credit rating agencies work as service providers to cor-porates who want to have an independent credit rating for their instruments and projects. However, the main flaw in the system comes when the remu-neration for the services are re-ceived from the same corporates who want their securities rated.

View of Credit rating AgenciesThe main contention of credit rating agencies is the fact that their ratings are opinions and not recommendations to purchase, sell or hold any securities and they act as expert advisors. Hence the work they do should not be under the purview of any law with regard to the scope and tools of

analysis used. They are not responsible for the opinions they give as the same are based on the data received from the issuers. In the United States, rating agencies assert that they have the same status as that of the financial journalists and are therefore protected by the constitution-al guarantee of freedom of press. This has been traditionally shielding them from investor litiga-tion and has prevented direct regulation of their practices. Till recently, the agencies have argued that their reputation is at stake and the users will

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

there were no regulations on the Credit Rating Agencies.

Current regulations on the Credit Rating

AgenciesThe regulatory treatment

for rating agencies has been rather paradoxi-cal: regulatory stan-dards have been based on credit rat-ings, but there has been little direct control on how the ratings are made. Despite the limited oversight, regula-tors have depend-

ed heavily on these ratings in setting regulatory policies.

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

1)Determining the capital adequacy requirements for financial service providers

TeAM NIveshAk

Harshali Damle

TO REGULATE or NOT TO REGULATE : THE ULTIMATE CONUNDRUM

Credit rating ideally does not provide guidance on the

related aspects for investment decisions, such as marketabil-

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2)Identifying or classifying assets for investments to be made

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

Concentration of power of the CRAsAnother major problem is the fact that the credit rating industry is highly concentrated, with three companies (Standard & Poor’s, Fitch and Moody’s) dominating the market in most countries. This can be attributed to high entry barriers, stemming from goodwill and the reach and reputation built by successful rating agencies over time. CRISIL is a S&P Company in India. CRISIL has extended its operation to rating B-Schools and real estate projects also. These are purely based on data provided to CRISIL. The reliability of such ratings is surely questionable.

Need for ChangeCredit rating agencies play an important role as de facto “capital market gate-keepers”—despite their reluctance to assume any such accountability. Hence, another positive step in the regulatory system can be to reduce the undue importance given to the Credit Rating Agencies. Regula- tions will only succeed if it understands what ratings can and cannot achieve.

While corporate debt and security ratings are based on publicly available and audited finan-cial statements, structured instrument ratings are based on non-public, non-standard and unaudited information supplied by the issuer. Also, the rat-ing agencies have no obligation to perform any due diligence to assess the accuracy and reliabil-ity of the information and often wrongly rely on representations and warranties from the issuers about the quality of the data. Their computer-driven simulation models are highly based on the market assumptions that proved to be faulty or incomplete.

Extent of regulationThough regulators agree on the fact of the need for regulations on Credit Rating Agencies, the ma-jor question is the extent of regulation. The meth-

odologies cannot be standardized as this will kill all possibilities of innovation and competition in the field.

The range of possible methods of regulation nev-ertheless remains extremely broad. At one end of the spectrum is the idea that CRAs should impose self-regulation. The success of any such self-regu-latory regime stands or falls with the question of control and integrity.

At the other end of the regulatory framework, there are demands for the rating process to be complete- ly entrusted to the pub - lic sector to

e n s u r e efficient f u n c -

t ion ing . However the reg-u lators

are the same people who were

a part of the entire chain that caused the financial crisis.

What effective regulations can one ex-pect from them?

The basic steps in the direction of regulation can be:

1)Structure for assessing the credibility of data received from management and analysis of the extent and quality of data

2)Identifying potential conflict of interests and avoiding the same

3)Avoiding anti-competitive and unhealthy prac-tices

4)Maintaining professionalism and independence

5)Determining disclosure requirements

6)Determining framework for credit upgrades and downgrades

ConclusionThere has been a broad consensus regarding the need for regulation over the Credit Rating Agen-cies to ensure financial stability. There is a need to seek balance between the benefits and costs of regulation. This is the ultimate conundrum that needs to be addressed.

There is a need to seek a bal-ance between the benefits and

costs of any proposed regulation

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

mode of contract size is between $10 million to $20 million when expressed in notional amount. The mode for ma-turity is 5 years and the range lies between 1-10 years.

c) Trigger Events :

Pricing and Settlement of CDSTraditional market making involves placing limit orders to buy & sell in order to earn the bid-ask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market makers provide additional 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 arrangement ensures that there is a transfer of risk of default from fixed income security holder to the seller of the swap. Hence, CDS can be visualized as a kind of insurance against credit risks associated with bonds.

Features of CDSa) CDS Spreads : Spread is defined as the premium paid by the protection buyer to the seller. The premium is usually ex-pressed as basis points and is paid by the buyer of protection on a quarterly basis. CDS spreads are ex-pressed in basis points of notional value. CDS can also be viewed as put option for a corporate bond.

b) Contract Size and Maturity:Though limit on either size or 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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quotes that lead to execution. So, if an HFT’s bid (buy order) of $15 for XYZ shares is matched, it might immediately post an offer (sell order) for the same price, hoping to capture two re-bates while breaking even on the spread. Build-ing up such market making strategies typically involves precise modeling of the target market structure & trading volumes using stochastic control techniques.

Ticker Tape Tradinga) Settlement of CDSUpon the occurrence of a credit event, either the seller/buyer issues a “Credit Event Notice”.

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

1) Physical SettlementPhysical settlement is the most common form of settlement 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 settlement happens within 30 days of the occurrence of the credit event.

2) Cash Settlement:The difference that exists between the notional value of CDS and the final value of the reference obligation is calculated to decide the payment to be made by the seller of the protection to the buyer. The time period for cash settlement usu-ally range from 0-5 days from the occurrence of credit event.

b) Pricing of CDSCDS price or CDS spread is defined as the annual

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

1) Structural ApproachThis approach estimates the correlation between price of credit risk instruments and economic determinants of financial distress for pricing of CDS. The main factors which impact probability and severity of default are a) Financial leverage b) Volatility and c) Risk free term structure. For example, Moody’s KMV model is widely used for pricing of CDS. Much research in this domain has been carried out by Black & Scholes (1973) and Merton (1974).

2) Reduced Form ApproachThese 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, Jacobs and Oviedo (2004)). A variant of this approach is based on estimation of default probabilities and loss given default through the employment of statistical functions.

Benefits and Risks of CDSBenefits 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 of capital 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 it enhances spread of risk it is ideally suited for

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corporate as well.

(ii) CDS pricing acts like a liquid, efficient and transparent pricing standard for new issuance since there is a direct correlation between CDS price and cost of funds on corporate borrowing.

Risks of a CDS market: (i) There is an increased vulnerability and sus-ceptibility of systemic shocks as witnessed in recent financial crisis due to fact that unwise transaction of CDS lead to concentration of risk across few entities which are of pivotal impor-tance.

(ii) Default by counterparty lead to increased correlation of credit risk. There is stimulation in the risk appetite of financial institutions due to viability of CDS.

(iii) When CDS is coupled with securitization it leads to loop holes in risk assessment due to fact that assets and credit protection can be transferred.

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

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

(v) Since payoff of a CDS is linked with default of a borrower or a security (e.g Bonds) and both depends on the state of the economy, expected pay off on CDS will be on increase during reces-sionary fears. Hence, huge impact on systemic risk can be attributed to pro-cyclicality.

CDS in India – RBI Stand RBI issued new regulations and guidelines on the operational aspects of Credit Default Swap (CDS).

1) Direct market participants have to report CDS trades in a time span of 30 minutes to online repository of Clearing Corporation.

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

3) Commercial banks who wishes to play the role of market makers are allowed to both buy and sell CDS provided they have a minimum CRAR (capital to risk weighted assets ratio) of 11 per cent with core CRAR (Tier I capital) of at least 7 per cent. RBI’s pivotal objective in in-troducing CDS on corporate bonds is to enable and equip market participants with a tool which can be employed to transfer and manage credit risk 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 Credit Protection

Long Credit Exposure

Protection buyer

Tends to own underlying credit

asset

Purchasing Credit Protection

Short Credit Exposure


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Sir, I was going through a newspaper article yesterday, and I came across LIBOR. I did not quite understand what it meant. Could you please throw some light on it and its significance?

Ok, I’ll explain. But before I do, I want you to tell me something. How do the banks benchmark the lending rates for their cus-tomers? What do you think?

I have read about this Sir. The banks fix a rate known as the Prime Lending Rate (PLR), which is actually the interest rate charged by the banks to their largest, most secure and most credit worthy customers

on short term basis. This rate is then used as the basis for computing interest rates for other borrowers.

Very well. Similarly, on a larger scale the interest rate one bank charges another on a loan is called as LIBOR or London In-terbank Offered rate. It is the world’s most widely used benchmark interest rate for

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

So who determines this rate?

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

What do you mean by compiling and calculating? Can you please elaborate?

Look, LIBOR is determined by a poll of 16 leading international banks. At 11 a.m. Lon-don time, BBA asks the rates at which the deposits are quoted to prime banks in the

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

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

So, this means that any trading that happens on any particular day between the banks happens at this rate.

No, that is not true. The rates at which banks trade with each other change every minute like all the other markets rates do. This depends upon the markets’ expectation of the economic activity and

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

It doesn’t look that important a tool to me, then.

Well, without a benchmark or a guideline, the trades would happen in a very random manner. This rate gives an idea about the market’s sentiments to

both the investors and the borrowers. Hence, it’s very important.

I can understand how LIBOR will affect the banks. But, how does it affect an individual like me?

As the world becomes integrated by the day, anything that happens even at the international institutional level, affects every individual directly or indirectly.

Since, LIBOR is the rate that banks charge when they make short term unsecured loans to other banks. It in turn also affects the interest rates for student loans, mortgages, value of major cur-rencies etc. For example, almost half of all lend-ers peg the interest rate charged to LIBOR, including the students’ education loan. If the rates go up, the loans become more expensive and can significantly increase your cost of education. Especially in times of economic crisis, the availability of student loans just like other loans is adversely affected.

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

CLASSROOMFinFunda

of the Month

LIBOR

NIVESHAK 21C

lassroomIIM Shillong Shubhi Bansal

December 2011

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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 Petra

c) Happened in the month Sukanya Roy won

3. Name the country with the ISO 4217 code meaning drinkware.

4. This financial organization is based in Mumbai having around 10 million 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 by Frank 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 companies listed in it.

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

10. Connect the dots

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

Article of the MonthPrize - INR 1000/-

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W I N N E R S

A N N O U N C E M E N T SALL ARE INVITED

Team Niveshak invite articles from B-Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puz-zles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month” and would be awarded cash prize of Rs.1000/-

Instructions » Please email your article with the file name and the subject as <Title of the

Article>_<Institute Name>_<Author’s name/Group’s name> by 10 January 2012. » Article must be sent in Microsoft Word Document (doc/docx), Font: Times New

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thor’s Name and the Institute’s Name » Mention your e-mail id/ blog if you want the readers to contact you for further

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