A REPORT ON

RECENT TRENDS IN CAPITAL MARKET

WHERE..HIGHER THE RISK, HIGHER THE RETURN

PREPARED BY:JAYRAJ JOSHI ROLL NO : 22 MEB SEM 2 SEMCOM

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, its 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:

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.
1.

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 nonclearing 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. 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 Tbill 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 Rs. 250 crores or 15% of the OI in Index options, whichever is higher. In addition, hedge positions are permitted.

Futures Rs. 250 crores or 15% of the OI in Index futures, whichever is higher. In addition, hedge positions are permitted.

Options 20% of Market Wide Limit subject to a ceiling of Rs. 50 crores.

stock Futures 20% of Market Wide Limit subject to a ceiling of Rs. 50 crores.

rate futures Rs. USD 100 million. In addition to the above, the FII may take exposure in exchange traded in interest rate derivative contracts to the extent of the book value of their cash market exposure in Governme nt Securities. Rs. 100 Cr or 15% of total open interest in the market in exchange traded interest

FII Level

SubDisclosure Disclosure accoun requireme requireme t level nt for any nt for any person or person or persons persons acting in acting in concert concert holding holding 15% or 15% or

1% of free float market capitalizatio n or 5% of open interest on a particular underlying whichever

1% of free float market capitalizatio n or 5% of open interest on a particular underlying whichever

more of the open interest of all derivative contracts on a particular underlying index

more of is higher the open interest of all derivative contracts on a particular underlying index

is higher

rate derivative contracts, whichever is higher.

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 owners 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, endusers, 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 elses 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 nations 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 ($69 billion) (6.28.5 percent of GDP) by 2012. The Government has recently established Special Economic Zones with the purpose of promoting exports and attracting FDI. These SEZs do not impose duty on imports of inputs and they enjoy simplified fiscal and foreign exchange procedures and allow 100% FDI. The travel and tourism industry, which has grown to a size of US$ 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 nonnews 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 constructiondevelopment 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:

Sector

Ownership Limit

Entry Route

Remarks

Power

100%

Includes generation (except nuclear power where Automatic FDI is prohibited), transmission and distribution of power

Telecom Basic, cellular and value-added services ISP with gateways

74% 74% FIPB beyond 49% FIPB beyond 49% Subject to licensing and security requirements; FDI cap of 74% for global mobile personal communications by satellite

ISP without gateways

100%

Email, Voice mail

100%

FIPB beyond 49%

Radio Paging End-to-End Bandwidth Infrastructure Providers providing Dark Fibre Telecom Manufacturing

74%

74%

100% 100%

FIPB beyond 49% FIPB beyond 49% FIPB beyond 49% Automatic Includes construction and maintenance of Automatic roads, highways, bridges and tunnels Applies to construction and Automatic maintenance of ports 100% FDI under FIPB automatic route beyond is permissible 74% for greenfield airports. Subject to no direct or indirect equity participation by Automatic foreign airlines. FDI up to 100% allowed for NRIs

Roads

100%

Ports Civil Aviation

100%

Airports

100%

Domestic Airlines

49%

Petroleum & Natural Gas Petroleum refining Petroleum product pipelines

100% 100%

Automatic Automatic Subject to divestment of 26% equity in Automatic favour of the Indian partner / public within 5 years. FIPB Includes associated real estate Automatic development in all metropolitan cities Subject to SEZ Act 2005 and Automatic Foreign Trade Policy. FIPB

Petroleum product marketing

100%

Petroleum refiningPSUs Others

26%

Mass Rapid Transport System

100%

EOU/SEZ/Industrial park construction Satellite establishment and operation

B. Services:
Sector Banking Indian Private Banks

100%

74%

Ownership Limit 74%

Entry Route

Remarks

Automatic Foreign banks can take an

PSU Banks

20%

NBFCs

100%

Automatic

Insurance

26%

Automatic

Real estate and construction Townships Housing Construction Development Projects Build-up Infrastructure

100% 100% 100% 100%

Automatic Automatic Automatic Automatic

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 compliance with RBI guidelines Includes 19 specified activities; Subject to minimum capitalisation norms and compliance with RBI guidelines Includes both Life and NonLife Insurance; Subject to licence from Insurance Regulatory & Development Authority Subject to minimum land area of 10 hectare for serviced housing plot and built-up area of 50,000 sq. mts. for construction

development projects. Also minimum Trading Retail Trade Trading (Export House, Super Trading House, Star Trading House) Trading (Export, Cash and Carry Wholesale) Tourism 51% 51% 100% FIPB Automatic FIPB Includes facilities for providing Automatic accommodation and food services Automatic Subject to maximum foreign equity up to 49% including FDI/NRI/FII Subject to maximum foreign equity up to 49% including FDI/NRI/FII; FDI in news and current affairs channels which uplink from India is capped Only for single brand products

Hotels, restaurants, beach resorts

100%

Tour and travel agencies Broadcasting

100%

TV software production

100%

Hardware facilities - (Uplinking, HUB, etc.)

49%

Cable network

49%

DTH

20%

Terrestrial Broadcast FM

20%

at 26% Subject to maximum foreign equity up to 49% including FDI/NRI/FII Subject to maximum foreign equity upto 49% including FDI/NRI/FII. FDI not to exceed 20% Subject to licensee being a company registered in India under the Companies Act, 1956

Terrestrial TV Broadcast Print Media Scientific/Technical journals Other non-news/non-current affairs/specialty publications Newspapers, Periodicals dealing with news and current affairs Other Services Advertising and Film

Not Permitted 100% 74% 26% Includes all film related activities Includes all postal services except the distribution of letters

100%

Automatic

Courier services

100%

FIPB

Lottery, Betting and Gambling

Not

Permitted Subject to security and licensing requirement; to be sold primarily to the Ministry of Defence

Defence and Strategic Industries

26%

FIPB

R&D activities

100%

Automatic

C. Manufacturing: Sector Ownership Limit Entry Route Remarks

Metals

100%

Textiles and Garments Electronics Hardware Chemicals and Plastics

100% 100% 100%

Automobiles

100%

Auto Components Gems and Jewellery Food and Agro Products Food Processing Agriculture (including contract farming) Plantations (except Tea)

100% 100% 100% Not Permitted Not Permitted

Includes manufacture Automatic of Steel, Aluminium etc. Automatic Automatic Includes Automatic plastics Includes Two -wheelers, Automatic Cars and Commercial Vehicles Automatic Automatic Automatic -

Other Manufacturing 100% FDI permitted through FIPB route Automatic subject to undertaking of export obligation of 50%

Items reserved for Small Scale

24%

D. Resources Based Sectors: Ownership Limit 100%

Sector Coal and Lignite Coal Processing

Entry Route Automatic up to 50%

Remarks

Captive Coal mining

100%

Automatic

Subject to provision of Coal Mines (Nationalisation) Act 1973.

Other Mining and Quarrying Mineral Ores Diamonds and precious stones 100% 100% Automatic Automatic Includes only mining, mineral separation and subsequent value addition Including Gold, Silver and other mineral ores

Atomic Minerals

74%

FIPB

Oil and Natural Gas Exploration

100%

Automatic

E. Knowledge Economy: Ownership Limit Entry Route

Sector

Remarks

Pharma and Biotech

100%

Healthcare Information Technology

100% 100%

FIPB route is needed if industrial licence is required or involves Automatic recombinant DNA technology, cell/tissue formulations Automatic 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. FIIs 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 Groups 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 debtcreating 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 countrys 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 UKs 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, Indias 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 UPS AND DOWNS 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 No. of Raised Amount (US $ Mn.)

Year

(Rs.Crore Issues )

1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 200506*

1143 1692 1725 882 111 58 93 151 35 26 57 60 71

24372 27633 20804 14276 4570 5587 7817 6108 7543 4070 23272 28256 10392

1634 1528 2036 2432 1649 -386 2339 2160 1846 562 9949 10172 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-toearnings 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-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 yearon-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

Index Futures Stock Futures Index Options Stock Options Interest Rate Futures Put Notional No. of Turnover contracts (Rs. cr.) No. of contracts Notional Turnover (Rs. cr.) Turn over (Rs. cr.) Total Average Daily Turnover (Rs. cr.)

Month/ Year

No. of contracts

Turnove No. of Turnover r (Rs. contract (Rs. cr.) cr.) s

Call Notional Turnover (Rs. cr.)

Put Notional Turnover (Rs. cr.)

Call

No. of contracts

No. of contracts

No. of contracts

No. of contracts

Turnove r (Rs. cr.) 734,84 33,40 2 2 492,66 25,93 4 0 487,58 24,37 0 9 523,80 23,80 3 9 395,84 19,79 5 2 433,65 21,68 1 3 399,75 19,03 0 6 372,30 16,92 1 3 308,16 15,40 0 8 271,24 11,79 2 3 208,37 9,472 5 195,96 9,798 2 2,546,9 10,10 86 7

Current Month Mar.06 5,952,206 Feb.06 Jan.06 5,186,835 5,760,999 192,03 10,844, 2 400 156,35 7,443,1 8 78 166,12 7,134,1 6 99 183,29 7,571,3 0 77 135,47 6,252,7 4 36 170,09 6,526,9 6 19 118,90 6,995,1 4 69 100,80 7,124,2 5 66 6,537,7 94 5,783,4 28 4,466,4 04 4,225,6 23 473,250 288,712 265,037 280,280 216,524 214,396 236,941 234,817 199,637 163,097 112,878 106128 683,979 506,714 663,684 775,216 595,900 695,311 523,948 444,294 358,867 421,480 382,530 361,544 1,870,647 1,043,894 22,406 15,526 19,392 21,863 15,584 17,630 13,371 10,619 8,127 9,089 7,724 7,293 69,371 31,794 772,372 559,682 666,782 764,964 604,657 715,208 583,081 485,001 389,154 331,753 353,975 295,020 1,422,911 688,520 24,691 16,806 19,130 21,125 15,490 17,954 14,550 11,373 8,643 7,044 7,058 5,981 52,572 21,022 444,604 326,233 365,493 361,268 287,136 309,120 363,872 350,370 376,129 385,640 288,137 307,994 3,946,979 4,243,661 18,574 12,349 14,265 13,631 10,068 10,753 12,913 11,934 11,736 11,678 7,641 8,203 132,054 92,657 75,740 90,562 95,261 77,052 80,134 85,897 81,453 84,989 104,478 100,602 105,955 1,098,13 3 3,889 2,913 3,630 3,614 2,705 2,822 3,071 2,751 2,622 3,119 2,609 2,763 36,782 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 18,790,218 14,098,382 14,681,719 16,181,118 13,055,656 15,176,424 13,253,741 12,764,213 11,198,617 10,653,067 9,137,619 8,628,497 77,016,465

Dec.05 6,613,032 Nov.05 5,238,175 Oct.05 6,849,732

Sep.05 4,701,774 Aug.05 4,278,829 Jul.05 Jun.05

3,451,684 77,395 3,626,288 77,215

May.05 3,545,971 70,465 Apr.05 200405 200304 3,332,361 65,595

21,635,44 772,14 47,043, 1,484,056 9 7 066 17,191,66 554,44 32,368, 1,305,939 8 6 842

167,967 1,339,41 0

49,240 10, 2 78 0

56,886,776 2,130,6 8,388 12

1 2 200203 200102 200001 10,676, 2,126,763 43,952 843 1,025,588 21,482 90,580 2,365 1,957,8 56 286,533 51,516 269,674 113,974 5,669 2,466 172,567 61,926 3,577 1,300 2,456,501 768,159 1,066,56 69,643 1 18,780 269,370 30,488 6,383 16,768,909 4,196,873 90,580 439,86 1,752 3 101,92 5 2,365 410 11

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