Final Project Report On Hedge Funds its working requirement & its impact on Indian Capital Market IN THE

PARTIAL FULFILLMENT OF TWO YEAR FULLTIME COURSE OF POST GRADUATION DIPLOMA IN MANAGEMENT (FINANCE) Under the University of Mumbai

By Mr. Niranjan Kulkarni Roll No: A-23 Specialization: Finance Batch : 2010-12

Under the Guidance of Mr. Kapil Bhopatkar

Guru Nanak Institute of Management Studies and Research Matunga, Mumbai-400019 2012

Declaration

This is to certify that the study presented by Niranjan Kulkarni to the University of Mumbai in part completion of the two year full time degree/diploma of Post Graduation In Management under the title of Hedge Funds its working requirement & its impact on Indian Capital Market has been done under my guidance.

To the best of my knowledge this project is in the nature of original work that has not been submitted for any degree of this University or any other University.

Signature of the Candidate ________________________ (Name of the Candidate

Forwarded through the Research Guide Signature of the Guide

Acknowledgement

I am very much Thankful to our Prof. Kapil Bhopatkar for giving opportunity and his guidance help us out through preparing this report. He has provided us a valuable suggestions and excellence guidance about this project which proved very helpful to us to utilize Theoretical knowledge in Practical knowledge.

Table of Content

Sr. No.
1. 2.

Topics
Executive Summary Literature review Hedge Funds Introduction Of Hedge Funds

Page No.
01 02 - 08 09 20

3.

4. 5. 6. 7. 8. 9. 10.

Literature Review Of Indian Capital Market Introduction Indian Capital Market Hypothesis Research Methodology Data Analysis & Interpretation Findings,Suggestions & Recommendations Conclusions Bibliography

21-46 47 48-50 51-58 59 - 64 65 66

Executive summary

Hedge funds are an investment structure that manages a private unregistered investment pool. They use several strategies like leveraging, long, short and derivative positions to generate high returns and hedge probable market risks. Hedge funds restrict their investment base to high net worth individuals rather than allowing the general public to invest in them. By 2025 the Indian economy is projected to be about 60 per cent the size of the US economy. This is due to major initiatives undertaken by the Indian Government. One such effort was taken in 1993 when with the notification of SEBI (Mutual Fund) Regulations; the asset management business under private sector took its root in India. India today has much of the necessary institutional framework for hedging, including a regulatory regime and good information disclosure standards. This study is written with an aim of providing a deeper insight into hedge funds and their possible impacts on the Indian Capital Market. The main advantages or impact of Hedge funds in India are that they bring in the much welcome volumes, and thus, liquidity in the market. Moreover, as all market experts will concede, market liquidity leads to better price discovery in the market.

LITERATURE REVIEW

A hedge fund can be defined as an investment structure that manages a private unregistered investment pool and compensates the fund manager with an incentive-based fee based on a percentage of the profits earned by the fund (Nicolas J.G). Hedge fund is an aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for a minimum period of at least one year. They are typically organized as private partnerships and often located offshore, thus, saving on tax and regulatory issues. Also, the initial high investments and illiquid nature of funds keeps a check on the investment in hedge funds. Hedge funds, registration by investors meet funds are also in general, are not registered. They have avoided limiting the number of investors and requiring that their an income or a net worth standard. Furthermore, hedge prohibited from soliciting or advertising to the general

audience. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital, and deliver positive returns under all market conditions. For present purposes, 3 main classes of hedge funds can be identified: -

Macro Funds Which take large unhedged positions in national markets based on topdown analysis of macroeconomic and financial conditions. These funds take position in either mature or key emerging markets. They spread their holdings across equities, bonds and currencies. Some long-established macro funds find it cheaper to use conventional forwards and futures to take positions ahead of the market moves they foresee. Some newer macro funds pursue more specialized trading strategies using complex derivative securities. A fund of this type might take a long position in a currency that is undervalued and an equal, short position in another currency that is overvalued. Global Funds Which also take positions worldwide, but employ bottom- up analysis, picking stocks on the basis of individual companies' prospects. Relative Value Funds Which take bets on the relative prices of closely related securities (treasury bills and bonds, for example). They limit their holdings to the mature markets, because their expertise is limited to those markets. Relative value funds are also inclined to use derivatives. Hedge funds are investment pools employing sophisticated trading and arbitrage techniques including leverage and short selling, wide usage of

derivative securities etc.Generally, hedge funds restrict share ownership to high net worth individuals and institutions, and do not offer their securities to the general public. Some hedge funds are limited to 100 investors. This private nature of hedge funds has resulted in few regulations and disclosure requirements, compared for example, with mutual funds. Also, the hedge funds may take advantage of specialized, risk-seeking investment and trading strategies, which other investment vehicles are not allowed to use. Hedge funds are subject to far fewer regulations than other pooled investment vehicles, especially to regulations designed to protect investors. This applies to such regulations as regulations on liquidity, requirements that funds shares must be redeemable at any time, Protecting conflicts of interests, assuring fairness of pricing of fund shares, disclosure requirements, limiting usage of leverage, short selling etc. This is a consequence of the fact that hedge funds investors qualify as sophisticated high-income individuals and institutions. Hedge funds offer their securities as private placements,on individual basis, rather than through public advertisement, which allows them to avoid disclosing publicly their financial performance or asset positions. However, hedge funds must provide to investors some information about their activity, and of course, they are subject to statutes governing fraud and other criminal activities. For e.g. controversies and frauds surrounding hedge funds seem to deal with the issue of transparency, today such controversy has run into a cul de sac, or dead end, because transparency of hedge funds have increased to the point that one can log into hedge fund information portals and examine up to date information on hedge fund data.

OBJECTIVE OF THE STUDY Comparison between Hedge funds & Mutual funds. To study Hedge fund investment Strategies. Impact on Hedge Funds investments in Indian Capital Market. How Hedge funds work in Indian Capital Market. SCOPE OF THE STUDY Though there is a large number of players who are active in the Indian Capital markets and many Indices which can be taken as benchmark for comparison, only one index SENSEX is taken into consideration, to reduce the complexity of analysis. Though there are many financial crisis that has resulted in financial world only four main crisis has been taken into consideration because of not availability of enough data. Study has been limited to only Indian Capital markets, though Hedge Funds has a direct impact on the whole financial system of the country.

List of Hedge Fund in India Hudson Fairfax Group (HFG) Private Equity. Avatar Investment Management (AIM) Private Equity. India Deep Value Fund Long Term Investments in Capital Markets and Real Estate. Heritage Capital India Long-short Equity. Fair Value Capital Traditional Investment Approach, Event-based investments. India Capital Fund Multi-strategy. Monsoon Capital Indian Equities Investments Karma Capital Indian Equities Investments. Atlanta Capital Investment in Indian Equities and Precious Metals. Baer Capital Partners Private Equity, Equity Investments. Brahma Capital Board Asset Management.

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 Eight Capital Alternative Investments.

EM Capital Management Emerging Markets. Evolvence Capital Alternative Investments. Jina Ventures Private Equity, M&A. Och-Ziff Alternative Investments. Sandstone Capital Equity Investments. Fulcrum Investment Group, LLC Alternative Investments. Greenwich Advisors Diversified Indian markets. Investing of hedge funds in India Prior to finalizing investment, take couple of months to know about the hedge fund industry in India. The age of hedge fund industry, the key players, their worth, the operational risks, the pros and cons of investing in hedge funds etc. Identify potential hedge funds, refer commercial directories or databases. Account for your investment goals, risk tolerance level, amount allocated for investment. Read blogs, financial magazines, websites, news articles, white papers on hedge funds in India. Talk to personnel; preferably interact with hedge fund managers involved with hedge fund investments

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and those who have already invested in hedge funds. Notice annual events like Hedge funds world India to gain an assessment of the burgeoning Indian hedge fund industry. Approach wealth manager in wealth management companies, securities broker or licensed investment consultant for advice on hedge fund investments in India. Understand terms related to hedge funds, remittance, management fee and performance fee, withdrawal and redemption fees. Check the pros and cons of long-term hedge funds vs. short-term hedge funds. Ensure your activities are that of an accredited investor (with a net worth of more than $1 million). Involve financial advisor in the process of investing in hedge funds in India.

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INTRODUCTION THE ORIGIN OF HEDGE FUNDS The year was 1949, WW II just ended, and the world was in a unified celebration. Alfred Winslow Jones, a sociologist, was working on assignment for Fortune magazine investigating fundamental and technical research on forecasting the stock market. The article reported on a new class of stock market timers, in addition to unorthodox methods of investing, all to achieve positive returns and call the market. Jones was very intrigued by these trading methods and became absolutely consumed with his own concept of an investment fund. Prior to the release of his Fortune article, Jones setup an investment fund with himself as general partner. The fund was designed as a marketneutral strategy, whereby the long positions in undervalued equities would be offset by short positions in others. This hedged position would allow capital to be leveraged, while also enabling large wagers to be made with limited resources. Another genius feature was having an incentive fee amounting to 20% of any realized profits or gains with no fixed fees. However, Jones greatest notoriety stems from his innovation that specific limited partnerships, if structured correctly, are exempt from regulatory control under the Investment Company Act of 1940. This exemption allows managers to utilize techniques, such as leverage and short-selling which typically binds other mutual funds and investment companies. Consequently, many copy -cats mimicked the fee structure, but not the hedge mentality and philosophy that Jones inspired. It was not until another Fortune magazine article, in 1966, which branded the market-neutral strategy that Jones designed as a hedge fund. CHARACTERISTICS OF HEDGE FUNDS Although financial service providers, regulators and the media commonly refer to hedge funds, the term has no precise legal or universally accepted definition. The term generally identifies an entity that

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holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act. Hedge funds are also characterized by their fee structure, which compensates the adviser based upon a percentage of the hedge funds capital gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts of their own money into the hedge funds that they manage. Schneeweis, Spurgin and Karavas (2001) suggest that an allocation of 10 to 20% to hedge funds optimally improves traditional portfolio performance. The investment goals of hedge funds vary among funds, but many hedge funds seek to achieve a positive, absolute return rather than measuring their performance against a securities index or other benchmark. This does not mean however that all hedge funds have comparable risk and return characteristics. In reality, there exists a variety of trading strategies that determine the funds risk and return profiles. Improperly included, an allocation to hedge funds can have disastrous consequences (Soueissy, M. & Sidani, R). Hedge funds utilize a number of different investment styles and strategies and invest in a wide variety of financial instruments. Hedge funds invest in equity and fixed income securities, currencies, over-thecounter derivatives, futures contracts and other assets. Some hedge funds may take on substantial leverage, sell securities short and employ certain hedging and arbitrage strategies. Hedge funds typically engage one or more broker-dealers to provide a variety of services, including trade clearance and settlement, financing and custody services. Hedge funds often provide markets and investors with substantial benefits. For example, based on our observations, many hedge funds take speculative, value-driven trading positions based on extensive research about the value of a security. These positions can enhance liquidity and contribute to market efficiency. In addition, hedge funds offer investors an important risk

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management tool by providing valuable portfolio diversification because hedge fund returns in many cases are not correlated to the broader debt and equity markets. On the other hand as Jeremy Siegel at Wharton Business School(2005) pointed out that there is a risk that many hedge funds making similar bets could suffer bigger losses all at once ,damaging other investors. Hedge Funds vs. Mutual Funds Hedge funds are institutional investors, just like mutual funds. However, this is where the similarity ends. Typically, only high net worth individuals and institutions invest in hedge funds, while mutual funds are the main investment vehicle of the small and retail investors. Additionally, mutual funds are highly regulated institutions that file a lot of information like inflows and outflows, breakup of investments and other statutory details with the regulatory authority.
Table 1: Hedge fund vs Mutual fund

Feature Number of owners Regulation

Mutual Fund Very large (in thousands) Regulated strictly by the capital markets regulator Publishes annual reports and monthly information sheets that show investment and profits Invests in equity, debt and derivatives, but follows a long strategy

Hedge Fund Few high net worth individuals or institutions Minimum regulation Information given only to investors. Not accountable to any other body Follows many investment strategies, including going short on some securities

Transparency

Investment Style

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Management Fees

Fee not linked to performance. Usually a percentage of assets managed

Fee linked to performancemanagers charge a high percentage of profits made

HOW THEY WORK To achieve pre-set returns target, these funds do not restrict themselves to their country of origin and operate on a global scale. Hedge fund managers typically seek absolute positive investment performance. This means that, the hedge funds target a specific range of performance, and attempt to produce targeted returns irrespective of the stock market trends. This is in contrast to investments by mutual funds, where success or failure is often measured in terms of performance in relation to a stock index, like the Sensex or Nifty in India.

Figure 1: How they Work

For investors, this structure-

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1. Helps pool assets with those of other investors.

2. Is a way to access talented hedge fund managers

3. Is a method to access the alternative investment strategies used by the manager.To achieve this "absolute return", hedge fund managers have the flexibility to incorporate different strategies and techniques that may include: Short-selling: Sale of a security that you do not own, with the anticipation of purchasing it in the future, at a reduced cost. Arbitrage: Simultaneous buying and selling of a financial instrument in different markets to profit from the difference between the prices Hedging: Buying/selling a security to offset a potential loss on an investment. Leverage: Borrowing money for investment purposes.

STRATEGIES OF HEDGE FUNDS Hedge funds do not constitute a homogeneous asset class. The bulk of hedge funds describe themselves as long / short equity, perhaps because this is the least specific of the available descriptions, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments: Hedge funds use a wide variety of investment styles and strategies. Even among hedge funds that claim to use the same investment strategy or invest within the same asset class, there is a wide range of investment activities, performance and risk levels. Because the investment activities of hedge funds are so diverse, the hedge funds assigned to a particular

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investment category are likely to exhibit less similarity than more traditional investment vehicles, such as registered investment companies. Although classification systems vary, hedge funds may generally be classified according to broad style and strategy categories, including: Market Trend (Directional/Tactical) Strategies Macro: These funds may take positions in currencies (often unhedged) based on their opinion of various countries' macroeconomic fundamentals. For example, if a country's economic policies look inconsistent and its ability to sustain its exchange rate appears questionable, macro funds may take positions designed to profit from devaluation, usually by selling the currency short. Long/Short: (includes sector and market neutral/relative value funds): These funds try to exploit perceived anomalies in the prices of securities. For example, a hedge fund may buy bonds that it believes to be under priced and sell short bonds that it believes to be overpriced. No matter what happens to overall interest rates, as long as the spread between the two narrows, the fund profits. Conversely, if spreads widen, gains can turn quickly into losses. Long/short equity is the most frequently used strategy among hedge funds. Event-Driven Strategies Distressed Securities: These funds may take long and/or short positions to attempt to profit from pricing anomalies among securities issued by companies going through bankruptcy or reorganization. Risk/Merger Arbitrage:

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These funds attempt to profit from pending merger transactions by, for example, taking a long position in the stock of the company to be acquired in a merger, leverage buyout or takeover and simultaneously taking a short position in the stock of the acquiring company. Arbitrage Strategies Convertible Arbitrage This strategy involves taking long positions in a company's convertible bonds, preferred stock, or warrants that are deemed to be undervalued while taking short positions in the company's common stock. Fixed Income Arbitrage Hedge funds in this category seek to provide stable, positive returns by exploiting the relatively small pricing inefficiencies of fixed income instruments. For example, a newly issued (on the run) 10-year Treasury bond may trade at a slightly higher price than a similar previously issued (off- therun) 10-year Treasury bond. A hedge fund may seek to profit from this disparity by purchasing off-the-run Treasuries and selling on-the-run Treasuries short. Statistical Arbitrage Funds in this category attempt to profit from pricing inefficiencies identified through the use of mathematical models. Statistical arbitrage attempts to profit from the likelihood that prices will trend toward a historical norm.

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HEDGE FUND INVESTMENT ACTIVITIES COMPARED TO THOSE OF REGISTERED INVESTMENT COMPANIES Registered investment companies typically seek positive returns compared to the performance of a particular asset class or index (benchmark). Websters dictionary defines a benchmark as astandard or point of reference in measuring or judging quality, value etc. Thus, in a declining market, a registered investment company may be considered successful even if it loses money, so long as the company outperforms its benchmark (i.e., its relative return is positive). In a rising market the registered investment company may be considered unsuccessful if the company, though profitable, underperforms the benchmark (i.e., its relative return is negative). In brief, in the relative return paradigm, downside risk means the risk of failing to perform as well as the benchmark. In contrast, a hedge fund that utilizes an absolute return strategy may be considered successful only if it is profitable in both rising and declining markets. In the absolute return paradigm, downside risk means the risk of failing to make money. Registered investment companies generally have less flexibility to change their investment objectives than do most hedge funds. As a result, these funds provide investors with greater certainty of the risks their advisers will take, but provide their advisers with a diminished ability to take alternative investment approaches when market conditions change. LEVERAGE Background Goldman Sachs (2000) extend their previous study to new data and believe that hedge funds pursue a variety of investment strategies as well as employ differing degrees of leverage. Leverage is an important component of many hedge fund investment strategies.

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Leverage can be defined in numerous ways. As a general matter, however, leverage, can be viewed as a means of potentially increasing an investments value or return without increasing the amount invested. Although leverage historically was obtained primarily by purchasing securities with borrowed money, today futures, options and other derivative contracts may be a major source of leverage. The use of leverage may have a significant impact on investment results because, while it may enhance investment gains, it may also magnify investment losses. Leverage also may increase the risk caused by holding assets that are illiquid or whose full value cannot be realized in a quick sale. Use of Leverage by Hedge Funds The degree to which a hedge fund uses leverage depends largely on its investment strategy. Macro funds and funds that attempt to capitalize on small inefficiencies in relative values (e.g., fixed income arbitrage and statistical arbitrage) are more likely to engage in leverage and to take more highly leveraged positions than are hedge funds that use other investment strategies, such as investing in distressed securities situations. A hedge funds limitation on its use of leverage is often dictated by any margin or collateral requirements imposed on lenders or on others (e.g., broker-dealers), and the willingness of lenders or other counterparties to provide it with credit. For example, a broker-dealer extending credit to a hedge fund in connection with a short sale would have to comply with Regulation T issued by the Board of Governors of the Federal Reserve System. The hedge fund could also be required to provide additional maintenance margin for transactions in short sales under margin requirements imposed by self-regulatory organizations.

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Use of Leverage by Registered Investment Companies Although registered investment companies may use leverage and sell short, their ability to use these tools is more limited than is the case with hedge funds. For example, the Investment Company Act generally allows open- end investment companies to leverage themselves only by borrowing from a bank, and provided that the borrowing is subject to 300 percent asset coverage. Closed-end investment companies are subject to less restrictive limits. The Commission and staff have applied the Investment Company Act provisions governing use of leverage to permit registered investment companies to engage in certain transactions involving leverage (senior security transactions), generally, however, only if the registered fund covers the transaction by setting aside liquid assets in an amount equal tothe potential liability or exposure created by the transaction. A registered investment companys board of directors has certain responsibilities in connection with the companys use of leverage, and information about the characteristics and risks of permitted leverage transactions must be disclosed to investors in fund prospectuses.

SHORT SELLING A short sale is the sale of a security that the seller does not own or a sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller borrows the security, typically from a broker-dealer or an institutional investor. The short seller later closes out the position by returning the security to the lender, typically by purchasing equivalent securities on the open market, or by using an equivalent security that it already owns.

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In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand or to hedge the risk of a long position in the same or a related security. Short selling can provide the market with important benefits, including market liquidity and pricing efficiency. Market liquidity is provided through short selling by market professionals, such as market makers (including specialists) and block petitioners, who offset temporary imbalances in the supply and demand for securities. Short sales affected in the market by securities professionals add to the trading supply of stock available to purchasers and thus may reduce the risk that the price paid by investors is artificially high. Short selling also can contribute to the pricing efficiency of the markets. Efficient markets require that prices fully reflect all buy and sell interest. When a short seller speculates on or hedges against a downward movement in a security, the transaction is a mirror image of the persons who purchases the security based upon speculation that the securitys price will rise or in order to hedge against such an increase. The strategies primarily differ in the sequence of transactions. Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security. Although short selling serves useful market purposes, it also may be used to manipulate stock prices. One example is the bear raid where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest.

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Unrestricted short selling can also exacerbate a declining market in a security by eliminating bids and causing a further reduction in the price of a security by creating an appearance that the price is falling for fundamental reasons. PERFORMANCE IN A PORTFOLIO CONTEXT: An important attribute of hedge funds which makes them even more popular are its diversification benefits on addition in a traditional portfolio of stocks and bonds. Among the studies which brought this out, Edwards and Lien (1999) studied the diversification benefits of hedge funds and managed futures funds and found them to enhance portfolio performance. Purcell and Paul Crowleys (1999) study too supports the diversification advantage hedge funds provide as the inclusion increases expected portfolio return by 200 basis points. A major plus point in a portfolio context is that They too state that hedge funds have a low correlation with all the other asset classes including the S&P 500. The benefits of including hedge funds in plan sponsors portfolios is also evident as shown by Goldman Sachs and Co. (1998) in terms of the risk/return, correlation and other performance characteristics of four major categories (Market Neutral or Relative Value, Event Driven, Long/Short and Tactical Trading) of hedge funds. Though the hedge funds are excellent diversifiers they are extremely risky along another dimension: as the cross sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes, the investors in hedge funds face a substantial risk of selecting a dismally performing fund or a failing one as pointed out by Malkiel and Saha (2005). One can conclude here by saying that over concentration in any particular fund produces improper risk for the manger which can be reduced by limiting exposure to any one fund. Moreover tightening restrictions shifts the efficient frontier downwards.

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Literature Review of the Indian Capital Market INTRODUCTION Economics experts and various studies conducted across the globe envisage India and China to rule the world in the 21st century. For over a century the United States has been the largest economy in the world but major developments have taken place in the world economy since then, leading to the shift of focus from the US and the rich countries of Europe to the two Asian giants- India and China. The rich countries of Europe have seen the greatest decline in global GDP share by 4.9 percentage points, followed by the US and Japan with a decline of about 1 percentage point each. Within Asia, the rising share of China and India has more than made up the declining global share of Japan since 1990. During the seventies and the eighties, ASEAN countries and during the eighties South Korea, along with China and India, contributed to the rising share of Asia in world GDP. According to some experts, the share of the US in world GDP is expected to fall (from 21 per cent to 18 per cent) and that of India to rise (from 6 percent to 11 per cent in 2025), and hence the latter will emerge as the third pole in the global economy after the US and China. By 2025 the Indian economy is projected to be about 60 per cent the size of the US economy. The transformation into a tri-polar economy will be complete by 2035, with the Indian economy only a little smaller than the US economy but larger than that of Western Europe. By 2035, India is likely to be a larger growth driver than the six largest countries in the EU, though its impact will be a little over half that of the US. India, which is now the fourth largest economy in terms of purchasing power parity, will overtake Japan and become third major economic power within 10 years.

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ISSUES AND PRIORTIES FOR INDIA As India prepares herself for becoming an economic superpower, it must expedite socio-economic reforms and take steps for overcoming institutional and infrastructure bottlenecks inherent in the system. Availability of both physical and social infrastructure is central to sustainable economic growth. Since independence Indian economy has thrived hard for improving its pace of development. Notably in the past few years the cities in India have undergone tremendous infrastructure up gradation but the situation in not similar in most part of rural India. Similarly in the realm of health and education and other human development indicators India's performance has been far from satisfactory, showing a wide range of regional inequalities with urban areas getting most of the benefits. In order to attain the status that currently only a few countries in the world enjoy and to provide a more egalitarian society to its mounting population, appropriate measures need to be taken. Currently Indian economy is facing these challenges: Sustaining the growth momentum and achieving an annual average growth of 7-8 % in the next five years. Simplifying procedures and relaxing entry barriers for business activities. Checking the growth of population; India is the second highest populated country in the world after China. However in terms of density India exceeds China as India's land area is almost half of China's total land. Due to a high population growth, GNI per capita remains very poor. It was only $ 2880 in 2003 (World Bank figures). Boosting agricultural growth development of agro processing. through diversification and

Expanding industry fast, by at least 10% per year to integrate not only the

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surplus labor in agriculture but also the unprecedented number of women and teenagers joining the labor force every year. Developing world-class infrastructure for sustaining growth in all the sectors of the economy. Allowing foreign investment in more areas Effecting fiscal consolidation and eliminating the revenue deficit through revenue enhancement and expenditure management.. Empowering the population through universal education and health care. India needs to improve its HDI rank, as at 127 it is way below many other developing countries' performance. The UPA government is committed to furthering economic reforms and developing basic infrastructure to improve lives of the rural poor and boost economic performance. Government had reduced its controls on foreign trade and investment in some areas and has indicated more liberalization in civil aviation, telecom and insurance sector in the future. SOME HIGHLIGHTS India has more billionaires than China. This year there were 15 billionaires in China but last year in India, there were 20 billionaires, according to the Forbes magazine. India has emerged as the world's fastest growing wealth creator, thanks to a buoyant stock market and higher earnings Ninan (2003) states that medium to long-term outlook for the Indian stock is positive in the coming years. A number of Indian companies surpassed last year's net profit in just six months of the current fiscal, reflecting an accelerated growth in corporate earnings. Forty-four per cent of Top 100 Fortune 500 companies are present in India.The economy has grown by 8.9 per cent for the April-July quarter

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of'06-07, the highest first-quarter growth rate since '00-01 and is poised to grow more than 9% this fiscal. Due to a global liquidity glut, the Indian equity market is soaring along with the rest of the emerging markets. The Morgan Stanley Emerging Market index, the benchmark used by most international fund managers, gained 23.05% in the year to date (YTD) in 2005 while the MSCI India index recorded one of the smartest rises ever gaining 24.54% YTD (Lohade, 2005). The Indian IT industry has been growing at a rapid rate with its silicon city being named as the back office of the world. Further, the government has been continuously promoting this sector as it has identified it as one of the potential employment generators and foreign exchange earner by making the labor laws more flexible in this laborintensive sector (Jagnani and Dagli, 2005). Barua (2006) emphasizes that the Indian growth rate is likely to accelerate in the long-term on back of few fundamentals.

First, infrastructure spending is increasing by leaps and bounds. Second, India is experiencing a service industries boom due to arbitrage of human intelligence. More and more people are recognizing the smart, hard working Indian worker not only as cost saving but also as productivity enhancing. Third, the availability of jobs through outsourcing is leading to higher consumption that is also fuelled by expansion of retail credit and changing demographics. With positive indicators such as a stable 8-9 per cent annual growth, rising foreign exchange reserves of close to US$ 180 billion, a booming capital market with the popular "Sensex" index topping the majestic 14,000 mark, the Government estimating FDI flow of US$ 12 billion in this fiscal, and a more than 35 per cent surge in exports, it is easy to

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understand why India is a leading destination for foreign investment. HISTORY OF INDIAN CAPITAL MARKETS The history of the Indian capital markets and the stock market, in particular can be traced back to 1861 when the American Civil War began. The opening of the Suez Canal during the 1860s led to a tremendous increase in exports to the United Kingdom and United States. Several companies were formed during this period and many banks came to the fore to handle the finances relating to these trades. With many of these registered under the British Companies Act, the Stock Exchange, Mumbai, came into existence in 1875. It was an unincorporated body of stockbrokers, which started doing business in the city under a banyan tree. Business was essentially confined to company owners and brokers, with very little interest evinced by the general public. There had been much fluctuation in the stock market on account of the American war and the battles in Europe. The planning process started in India in 1951, with importance being given to the formation of institutions and markets The Securities Contract Regulation Act 1956 became the parent regulation after the Indian Contract Act 1872, a basic law to be followed by security markets in India. The stock markets have had many turbulent times in the last 140 years of their existence. The imposition of wealth and expenditure tax in 1957 by Mr. T.T. Krishnamachari, the then finance minister, led to a huge fall in the markets. War with China in 1962 was another memorably bad year, with the resultant shortages increasing prices all round. This led to a ban on forward trading in commodity markets in 1966, which was again a very bad period, together with the introduction of the Gold Control Act in 1963. The markets have witnessed several golden times too. Retail investors began participating in the stock

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markets in a small way with the dilution of the FERA in 1978. The next big boom and mass participation by retail investors happened in 1980, with the entry of Mr. Dhirubhai Ambani. Dhirubhai can be said to be the father of modern capital markets. The Reliance public issue and subsequent issues on various Reliance companies generated huge interest. The general public was so unfamiliar with share certificates that Dhirubhai is rumored to have distributed them to educate people. Mr. V.P. Singhs fiscal budget in 1984 was path breaking for it started the era of liberalization. The removal of estate duty and reduction of taxes led to a swell in the new issue market and there was a deluge of companies in 1985. Mr. Manmohan Singh as Finance Minister came with a reform agenda in 1991and this led to a resurgence of interest in the capital markets, only to be punctured by the Harshad Mehta scam in 1992. The end-1990s saw the emergence of Ketan Parekh and the information; communication and entertainment companies came into the limelight. This period also coincided with the dotcom bubble in the US, with software companies being the most favored stocks. There was a meltdown in software stock in early 2000. Mr. P Chidambaram continued the liberalization and reform process, opening up of the companies, lifting taxes on long-term gains and introducing short- term turnover tax. The markets have recovered since then and we have witnessed a sustained rally that has taken the index over 13000.

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Chhabria (2006) states that the good thing about the Indian market, riding on the back of an economy that has grown by over 7 per cent in the last two years, is that investors can't miss being part of the growth if they invest in the Indian stock markets carefully. On an average 70% of Indian population of below 35 yrs present a rosy picture with a lot of money to be spent. It is estimated that every month around Rs.50-60 crore flows into the capital markets in the way of SIP and some other instruments which helps in increasing the market capitalization. The surge in SENSEX and NIFTY, the benchmark indices of Indian stock market is also attracting many retail investors to look for more returns there by directly increasing their investments in stocks. There are many equity analysts who assert Indian capital markets to achieve quantum leaps in the future. Based on technical analysis using Glen Neelys Neowave Theory, Karandikar (2005) predicts the Sensex to be between 18000- 40000 till 2010. He emphasized that the Sensex would have to grow earnings at a compounded annual growth rate (CAGR) of 17% to get to 18000 in five years and at 36% to get to 40000. Further, other analysts like Jhunjhunwala (2002), Jhunjhunwala (2006) and Barua et al (2006) advocated that investing in the Indian equity market would give attractive returns over the long run backed by strong fundamentals.. Moreover, Krishnamurthy (2004) studied that Indian stocks offer extraordinary high sustainable returns and are expected to maintain this trend. Recently a study conducted by the Economic Times Investors Guide consisted of over 1300 Indian companies listed on the Indian stock exchange.

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The net profits for the sample had grown 37% over the first quarter of the year 2006 (Q1FY07). This appeared way above market expectations, which were in the 15-20% range for financial year 2007 as a whole. It was concluded that corporate India surprised the market with its strong growth in the first quarter of financial year 2007. It was also observed that the growth momentum was as broad-based as ever in this rally and not that only a handful of companies were contributing to net profits (Economic Times, 2006). On the contrary Varadarajan (2000) argues that share prices of the Indian stocks are overvalued which would eventually lead to a downfall in the share prices. He uses two indicators to determine whether current share prices are overvalued: the price-to-earnings ratio of stocks and the spread between the yield on bonds and shares. He argues that such a correction has been on the cards for quite some time now; the only element missing is a proximate trigger which would sooner or later burst the share bubble. JP Morgan identifies levels of uncertainties that are generating volatility in the Indian equity market and suggest that India should correct by 4-5% for the markets to look attractive in the future years (www.moneycontrol.com). In addition, Zore and Sen (2006) analyze that both globally as well as in India there are a lot of issues that cause concern. The global interest rate scenario will slacken the growth of the Indian economy to a great extent.

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DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS MUTUAL FUNDS Mutual fund is a form of collective investment that pools money from many investors and invests their money in stocks, bonds, dividends, short-term money market instruments, and/or other securities. In a trades the fund's underlying mutual fund,the fundmanager securities,realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding. The flow chart below describes broadly the working of a mutual fund.

History The origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry. In the past decade, Indian mutual fund industry had seen dramatic improvements, both quality wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase; the Assets Under Management (AUM) was Rs. 67bn.

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The private sector entry to the fund family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it reached the height of 1,540 bn. Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian banking industry. The main reason of its poor growth is that the mutual fund industry in India is new in the country. Large sections of Indian investors are yet to be familiarized with the concept. Hence, it is the prime responsibility of all mutual fund companies, to market the product correctly abreast of selling. FOREIGN INSTITUTIONAL INVESTOR Foreign Institutional Investor [FII] is used to denote an investor - mostly of the form of an institution or entity, which invests money in the financial markets of a country different from the one where in the institution or entity was originally incorporated. 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. FII investment is frequently referred to as hot money for the reason that it can leave the country at the same speed at which it comes in. India opened its stock markets to foreign investors in September 1992 and has, since 1993, received considerable amount of portfolio investment from foreigners in the form of Foreign Institutional Investors (FII) investment in equities. This has become one of the main channels of international portfolio investment in India for foreigners13. In order to trade in Indian equity markets, foreign corporations need to register with the SEBI as Foreign Institutional Investors (FII). SEBIs definition of FIIs presently includes

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foreign pension funds, mutual funds etc. The trickle of FII flows to India that began in January 1993 has gradually expanded to an average monthly inflow of close to Rs. 1900 crores during the first six months of 2001. By June 2001, over 500 FIIs were registered with SEBI. The total amount of FII investment in India had accumulated to a formidable sum of over Rs.50,000 crores during this time . In terms of market capitalization too, the share of FIIs has steadily climbed to about 9% of the total market capitalization of BSE (which, in turn, accounts for over 90% of the total market capitalization in India). The sources of these FII flows are varied. The FIIs registered with SEBI come from as many as 28 countries (including money management companies operating in India on behalf of foreign investors). US-based institutions accounted for slightly over 41%, those from the UK constitute about 20% with other Western European countries hosting another 17% of the FIIs that these national affiliations do not necessarily mean that the actual investor funds come from these particular countries. Given the significant financial flows among the industrial countries, national affiliations are very rough indicators of the home of the FII investments. In particular institutions operating from Luxembourg, Cayman Islands or Channel Islands, or even those based at Singapore or Hong Kong are likely to be investing funds largely on behalf of residents in other countries.

RETAIL INVESTORS Retail investors according to SEBI rules are those investors whose investment corpus is not more than Rs. 1 lakh. In India, retail investors play a very small role in capital markets. This is mainly due to the risk aversion. The retail investors are mainly concentrated in four metros and Ahmedabad. Ahmedabad has major chunk of retail investors who are very much active in the stock investors.

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But slowly this scenario is changing with the increase in the number of Demat accounts through which these investors mainly invest. Slowly the retail investors confidence has increased in the Indian Stock markets. Their total share in the market capitalization is around 3%which is very much less compared to that of USA where it is around 20-25%. But with Indian capital markets gaining popularity, there is high scope that the participation of retail investors will gradually increase. HEDGE FUNDS IN ASIA Though Hedge funds seek absolute return strategies, but due to the herding mentality the returns are getting diminished. And some of the major debacles of Hedge funds like the AMARANTH Advisors LLC and LONG TERM CAPITAL MANAGEMENT LLC forced the hedge funds to look into some greener pastures like Asia where the market is in premature stage. Hedge funds started investing in Asian markets after the Tech Bubble which forced many hedge funds to liquidate their net positions. According to Asia Hedge magazine, some 150 hedge funds operate in Asia, till year 2002 which together managed assets estimated at around US $ 15 billion. In Japan, too hedge funds are becoming the focus of more attention. Recently, Japans Government Pension Fund one of the worlds largest pension fund with US $ 300 billion has announced plans to start allocating money to hedge funds. Industry participants believe that Asia could be the next region of growth for the hedge fund industry. The potential of Asian hedge funds is well supported by fundamentals. From an investment perspective, the volatility in the Asian markets in recent years has allowed long-short and other strategic players to out perform regional indices. The relative inefficiency of the regional markets also presents arbitrage opportunities from a demand stand point US and European investors are expected to turn to alternatives in Asia as capacity in their home

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markets diminish. Further, the improving economic climate in South East Asia should help foreign fund managers and investors to refocus their attention on the region. Overall, hedge funds look set to play a larger role in Asia. MARKET BENEFITS OF HEDGE FUNDS Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhance liquidity. Many hedge fund advisors take speculative trading positions on behalf of their managed hedge funds based extensive research about the true value or future value of a security. They may also use short term trading strategies to exploit perceived mispricings of securities. Because securities markets are dynamic, the result of such trading is that market prices of securities will move toward their true value. Trading on behalf of hedge funds can thus bring price information to the securities markets, which can translate into market price efficiency. Hedge funds also provide liquidity to the capital markets by participating in the market. Hedge funds play an important role in a financial system where various risks are distributed across a variety of innovative financial instruments. They often assume risks by serving as ready counter parties to entities that wish to hedge risks. For example, hedge funds are buyers and sellers of certain derivatives, such as securitized financial instruments, that provide a mechanism for banks and other creditors to un-bundle the risks involved in real economic activity. By actively participating in the secondary market for these instruments, hedge funds can help such entities to reduce or manage their own risks because a portion of the financial risks are shifted to investors in the form of these tradable financial instruments. By reallocating financial risks, this market activity provides the added benefit of lowering the financing costs shouldered by other sectors of the economy. The absence of hedge funds from these markets could lead to

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fewer risk management choices and a higher cost of capital. Hedge fund can also serve as an important risk management tool for investors by providing valuable portfolio diversification. Hedge fund strategies are typically designed to protect investment principal. Hedge funds frequently use investment instruments (e.g. derivatives) and techniques (e.g. short selling) to hedge against market risk and construct a conservative investment portfolio one designed to preserve wealth. In addition, hedge funds investment performance can exhibit low correlation to that of traditional investments in the equity and fixed income markets. Institutional investors have used hedge funds to diversify their investments based on this historic low correlation with overall market activity. HEDGE FUNDS IN INDIA With the notification of SEBI (Mutual Fund) Regulations 1993, the asset management business under private sector took its root in India. In the same year SEBI, also notified Regulations and Rules governing Portfolio Managers who pursuant to a contract or arrangement with clients, advise clients or undertake the management of portfolio of securities or funds of the client. Recently, RBI through liberalized remittance scheme, allowed resident individuals to remit up to US $ 25,000 per year for any current or capital account transaction. The liberalized scheme will allow Indian individual investors to explore the possibility of investing in offshore financial products. Considering the existing limit being only US $ 25,000 per year, Indian market may not be attractive to hedge fund product marketing. As long as there will be restriction on capital account Convertibility, foreign hedge funds, by virtue of their minimum investment limit being $ 100,000 or higher, do not seem to be excited to access investment from Indian investors in India. Some hedge funds have invested in offshore derivative instruments (PNs)

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issued by FIIs against underlying Indian securities. Through this route hedge funs can derive economic benefit of investing in Indian securities without directly entering the Indian market as FIIs or their subaccounts. Through recent amendments to the FII Regulations (Regulation 15A and 20A), the regulatory regime has been further strengthened and periodic disclosures regime has been introduced. As at the end of March, 2004, total investment by hedge funds. In the offshore derivative instruments (PNs) against Indian equity, are Rs. 8050 crores which represent about 8% total net equity investments of all FIIs. On the basis of market value, the hedge funds account for about 5% of the market value of the total assets held by the FIIs in India. The fiscal year (2003-2004) has seen a spectacular increase in FII activities in Indian market. Till this report is filed FIIs have already invested US $ 10 bn. during this year alone which is a record. Robust economic fundamentals, strong corporate earnings and improvement in market micro structure are driving the FII interest in India. Investors all over the world are keen to come to Indian market. From informal discussions with institutional investors including some reputed and well established hedge funds, one could gauge the extent of interest they have about Indian markets. From informal discussions with institutional investors including some reputed and well established hedge funds, one could gauge the extent of interest they have about Indian markets. During the discussions they have requested whether India, like other Asian emerging markets, can provide a regulatory framework that will allow them to directly invest in Indian market in a transparent manner.

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PARTICIPATORY NOTES Participatory notes are instruments used by foreign funds / investors who are not registered with the SEBI but are interested in taking exposure in Indian securities. Participatory notes are generally issued overseas by the associates of Indiabased foreign brokerages. Brokers buy or sell securities on behalf of their clients on their proprietary account and issue such notes in favor of such foreign investors. Participatory Notes are simple derivative instruments that investors not registered in India or Mauritius use to trade in Indian markets. These investors place their order through brokerage houses that have Mauritiusbased FII accounts. The brokerage houses then repatriate the dividends and capital gains back to these entities. In this case, the broker acts like an exchange: it executes the trade and uses its internal accounts to settle the trade. They keep the investors name anonymous. That is why capital market regulators dislike P-notes. WHY HEDGE FUNDS ARE LOOKING AT INDIA Unlike China, where stock markets are not well developed and company information is relatively opaque, experts note that India has much of the necessary institutional framework for hedging, including a regulatory regime and good information disclosure standards. "Investors look at multiple markets around the world," says Marti G. Subrahmanyam, a professor of finance at New York University's Stern School of Business. "There is a sense that the changes taking place in India are going to result in superior performance in the economy, and that the corporate sector will be a big beneficiary. Now, obviously the Chinese economy is larger, but the capital markets are better developed in India. If you look at the stock market, even if you were to include Hong Kong, the market cap in China relative to its GDP is lower. So if you're looking for investment opportunities where you won't

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suffer the consequences of illiquidity, India is the more attractive opportunity." In addition, notes Subrahmanyam (2002), India is the largest market for single stock futures in the world and has a well developed derivatives market in index futures and options."This gives you hedging possibilities not available in other emerging markets," he says. There is also enough liquidity in the big stocks for [domestic] investors to sell short. Even though there are restrictions, these are less binding than in other emerging markets. ADVANTAGE INDIA Since hedge funds are investors shrouded in mystery, they are made scapegoats whenever there is a crisis of some sort in the market. Kamdar (2004) concurs and says, "The only matter that I find worrisome is that most of the time, without any substantial evidences the world over, any crisis in stick market is conveniently attributed to hedge funds. This was one of the causes stated by market participants for the May 17, 2004 downfall of 15% in the stock price." Hedge funds also bring in the much welcome volumes, and thus, liquidity in the market. Moreover, as all market experts will concede, market liquidity leads to better price discovery in the market. Now, with the transaction tax levied on trades carried out in the stock market, these increased volumes will also lead to revenue for the government. THE RISKS ASSOCIATED WITH HEDGE FUNDS Although hedge fund strategies vary significantly, they project a general set of risk factors to the markets they invest in. According to the authors of Sound Practices for Hedge Fund Managers (2000), the three quantifiable risks, market risk, credit risk and liquidity risk are interrelated and as such should be studied separately as well as together, i.e. their overlap should be properly identified and evaluated.Furthermore, the effect of leverage on all three key risk factors should also be properly assessed, as insolvency risk becomes a vital point.

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Botteron and Villager(Risk Management Overview 2002) go further and divide the risk universe into exogenous intertwining risks, common to all markets, which include market, credit and liquidity risks, and endogenous risks, addressed by internal measures and regular due diligence, including operational and model risks.

Figure 3 : Risk Galaxy

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One of the major sources of risk by Hedge funds investment is Market Risk. Due to global macroeconomic perspectives their can be an event of market sudden slump. And the herding mentality of the Hedge Funds adds to this slump by continuously withdrawing money from the markets. This leads to the devaluation of the funds NAV and also culminates into shareholder value depreciation. Mostly interest rates, bond yields and the security prices are inter-related. So a small slump in one market leads to an adverse effect in other markets also. MARKET RISK: COMPONENTS Interest rate risk: This risk is mostly the impact of fixed income instruments; when interest rates go up, bond prices go down. The strategy of Fixed income instruments is to invest in corporate bonds and government bonds, so as to get risk free rate of return. The bond yields depends a lot on the Interest rate prevailing and also inflation figures.

Figure 4: market risk Figure 5: Internal Rate return

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The spread between long-term interest rates and short-term interest rates reflects, for example, the degree of inflation risk. When anxiety is high regarding inflation, the spread widens as investors demand higher longterm rates as compensation. Hedge funds known as Hot Money, if they sense in any risk in near future they exit the market. But due to the huge investments and huge leveraged positions it carries out results in turmoil in the bond market. The 1994 Bond market is a classical example to show the effect of this kind of investment strategy.

EQUITY RISK This includes delta risk and volatility risk Delta tells how sensitive the option is to changes in the underlying stock price. A position with a delta of zero is called delta neutral or delta hedged. Rebalancing or periodic adjustment is necessary to

keep a position delta hedged as delta changes all the time. This provides

Figure 6: Equity risk

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protection against small stock price movements. However, for larger movements, gamma1 neutrality is required. Here we can point out that India is known for single largest futures and options in the world and Futures & Options price directly impacts the underlying price of that particular script or commodity. This is also one of the impacts on the Indian Capital Market. Volatility risk There are two main causes for stock market volatility: the random arrival of new information about a stocks future returns and the level of trading activity (Hull 1999). The Greek letter Vega measures the impact of the change in volatility on the value of an option. When Vega is high, the option is very sensitive to small changes in stock price volatility. Vega neutrality protects from such situations. Gamma is the first derivative of delta; it measures the delta sensitivity to changes in the underlying stock price. The larger the gamma, the more sensitive is the delta to stock price changes and the more frequent the required rebalancing. CORRELATION RISK It measures the degree to which two series of returns move up or down together. For example the correlation between the stock prices and their derivative instruments. Correlation between different industries like the construction and steel and cement industry. There is also reverse correlation between stock prices plummeted and bond markets rose and vice-versa (Jaeger, R. 2000).

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COMMODITY RISK This risk arises from the sudden change in the price of commodities. This is particular to Managed Futures. Just like equities, commodities are subject to delta and volatility risks. When the market environment changes, the price of commodities fluctuates.

Figure 7: Commodity risk

Delta tells us how responsive the option is to changes in the underlying commodity price. Rebalancing or periodic adjustment is necessary to keep a position delta hedged as delta changes all the time. Due to alternative positions of hedging the volatility of the derivative prices increases. In order to get absolute gains, Hedge Funds try to increase bets on one position and keep on adding to that net position. Amaranth LLC is the best example to suit this type of risk.

Amaranth LLC kept on playing on the derivative options of Feb & Mar Crude futures. Due to huge leverage positions build up in these two futures, the losses kept on accumulated. Due to huge losses the fund has to be liquidated there by impacting to a great extent the futures price of the crude.

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CURRENCY RISK This risk arises from the sudden change in the foreign exchange. This is particular to Managed Futures. The strategy of managed futures is to get money out of the arbitrage of currency fluctuations. Hedge Funds are not long-term players and they invest for a short period of time. So this Hot money may try to capitalize the currency fluctuations that happen regularly. East Asian crisis and the recent Yuan Carry of trade phenomenon can be attributed to this type of Managed Futures trading strategy of Hedge Funds. The impact of the East Asian crisis which materialized in the middle of1997, and the subsequent turbulence that swept the worlds financial markets over the next 12-18 months, has been significant not only in term of the financial, economic and social consequences that these events wrought on emerging market economies, but also in terms of drawing the worlds attention to outstanding issues concerning the structure, operation and regulation of the international financial system. Currency speculators pursued a so-called double play aimed at playing off the Hong Kong currency board system against the administrations stock and futures markets. This led to the Asian Financial Crisis. CREDIT RISK This refers to the risk of downgrades (and possibly default) in the credit quality of the funds investments or that of counterparties dealing with the fund. This type of risk becomes critical while handling derivatives. When investors perceive a high credit risk, they demand a higher yield on the money they lend and vice-versa. Indian markets follow the system of Mark-to-Market settlement. But this

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system is not exercised in case of private players who take a large leverage positions. Due to the large leverage position builds up and due to the increase in volatility of the prices of derivative instruments this type of risk arises. The mayhem created in the stock markets in May 2006 can be attributed to the credit risk arising of the Distressed securities and Convertible arbitrage strategies. The index was down by 10% on a single day because of the margin system problems. In May 2006 there was news going around that some FIIs were banned to invest in Indian markets and also the capital gains that are earned by the way of investment in Indian markets will be treated as Business income. Due to this their was a slump in the market to a certain extent. But due to the drop in prices their was a call by many players to withdrew from the market. Due to this selling many big investors suffered and to cut down the losses and pay the margin money their was an across the board selling. Thus if big and hot money like Hedge Funds leads to this type of margin pressures there could be a bigger slump and increased volatility in the stock prices.

LIQUIDITY RISK Liquidity risk is defined as the decline in a funds liquidity leading to devaluation in its NAV or a decline in its ability to fund its investment. It can be further subdivided into three risks. The First one is related to short selling activity; a manager might be forced to repurchase a borrowed asset due to an adverse market condition. The second risk affects the cash reserves of a fund, as it may have to redeem part of its debt obligations or pay margin calls. The third risk is

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faced when investors seek to redeem their shares in the fund creating a mismatch in the assets and liabilities of the fund (Botteron and Villiger 2002). Liquidity is one of the main problems in the Indian Stock markets. The main players in the Indian markets are FIIs, Mutual Funds and Promoters and to a small extent retail investors. Liquidity problem is the main problem facing FIIs. Till now FIIs have invested around $22 bn in Indian markets till the end of 2006. But they cant liquidate their positions because of the huge chunk of stocks they own. Unfortunately for them, even after investing more than $20 billion in the Indian markets, they are unable to sell beyond Rs 20 crore to 75 crore in a day. The reason is simple: they dont have any buyers from the Indian side. The only option for FIIs is to trade among themselves. If they dont trade among themselves and try to sell aggressively, they cannot exit from the market in the first instance. There is also the danger that they may lose value of their investments if they sell in a big way. OPERATIONAL RISK

Figure Risk

8:

Operational

It encompasses human risk, or human error and internal fraud, model

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risk, physical events such as destruction by fire or other catastrophes, and external risk, for example external fraud. MODEL RISK It occurs due to the incorrect valuation of an investment opportunity by a financial instrument. Sophisticated software has been heavily relied upon in the past and will continue to do so and erroneous results could jeopardize a whole strategy. The simplest example would be an out dated model that is no longer reliable to correctly evaluate present new market conditions. It is worthy to mention here executive risk arising from an error in hedging against currency risk, due both to managers and/or technology. Indeed, all funds that are faced with foreign exchange issues try to put in place effective hedging techniques using futures, forwards and other swap instruments; sometimes, they fail and losses arise. HUMAN RISK Inappropriate fund allocation: manager choosing to allocate funds into the wrong sector, strategy or instruments and as a result harming returns. Style drift manager changes direction from the proclaimed style (and area of expertise) of the fund to seek better long term or short term (bets) opportunities elsewhere and consequently changes the risk/return profile, while failing to inform investors.

For example, in 1995, Fenchurch Capital Management, a fixed income arbitrage fund switched from U.S. bond basis trading and U.S. yield curve arbitrage to European bonds and equities, an area virtually unknown to its managers causing large undeclared losses.

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HYPOTHESIS

1. Whether investment in hedge funds is helping to grow the Indian capital market.

2. Fair understanding about working of hedge funds and different types of techniques used in hedge funds.

3. Comparison between Hedge funds and mutual funds.

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RESEARCH DESIGN INTRODUCTION This chapter will provide a plan of the study which should include statement of the problem, objectives, scope of the study/significance of the Dissertation, methodology, sample design, sources of data, tools and techniques for data collection, plan of analysis, limitations. RESEARCH METHODS a) Type of Study: In the study carried out the exact problem is not known. The study has been done to get an insight into the Hedge Funds and their investment strategies, so as to make an analytical study about their impact on Indian Capital markets. Hence, the research type is Exploratory. b) Type of data: The type of data collected is mainly secondary data c) Technique of Analysis :First the a the relationship between the key Index and the Hedge Fund inflows is established so as to justify whether there is any impact of Hedge Funds is their in Indian capital markets.

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After the relationship is established, a detailed analysis of the hedge fund strategies of investment is done. Also an analytical study of Hedge funds impact on Indian Capital markets is done based on individual investment strategy. RESEARCH DESIGN A research design lays the base for conducting the project and ensures that the research plan is conducted efficiently and effectively. This research has been undertaken to explore the possible impacts of hedge funds on the Indian Capital Market. For this as discussed earlier Quantitative research is adopted in which certain statistical techniques are utilized. STATEMENT OF THE PROBLEM In view of the increasing popularity among the Hedge funds as well as their increasing interest in the Indian market, this dissertation tries to unravel the myth behind the working of Hedge Funds. This study is to elucidate the different strategies of Hedge Fund managers and their possible impact on Indian Capital markets and to understand how hedge funds are beneficial. LIMITATIONS OF THE STUDY Problems of Inflation: Huge amounts of FII fund inflow into the country create a lot of demand of rupee & the RBI pumps the amount of rupee in the market as a result of demand created. Problems of small investors: The FII profit from investing in emerging financial stock market. If the cap is High they can bring a huge amounts of funds in countrys stock market & is influence in stock market is going up or down. Adverse impacts on exports: F II flow leading to appreciation of the currency may lead to the exports. Hot money: Hot Money refers to the that are controlled by investors who actually seeks short term return. These investors scan

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the market for short term, high interest rate investment opportunities. Hot money can have economic & financial repercussions of countries & bank. When money is injected in the country, the exchange rate for the country gaining the money strengthens, where the exchange rate of the country losing the money weakens. If the money is withdrawn on the short term notice, the banking instution will experience a shortage of funds.

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ANALYSIS & INTERPRETATION This study entitled HEDGE FUNDS AND THEIR POSSIBLE IMPACT ON INDIAN CAPITAL MARKETS was carried out to address the problem related to study whether their would be any possible impact on Indian markets if Hedge Funds were allowed freely to invest in India rather than through indirect routes like Participatory Notes. The objectives of this study were to study the Hedge Fund investment strategies, as these investment vehicles are dreaded in many countries. After doing a detailed study of the strategies, an analytical framework is done whether there is any potential for Hedge Funds in India and also to study the possible impact of Hedge Funds on the Indian Financial Markets. Towards this, first a relationship between the key Index (SENSEX) and the Hedge Fund inflows is established so as to justify whether there is any impact of Hedge Funds in the Indian capital markets. After the relationship is established, a small study on the relationship between the key Hedge Fund indices and the corresponding Strategy Index is taken to establish whether the Hedge Fund strategies has any direct relationship to four biggest crisis in the Financial World. The four crises taken for study are: 1) 1994 Bond Crisis 2) 1997 Thai Crisis 3) 1998 Russian Crisis 4) 2000 TMT Crisis After the relationship is established, a detailed analysis of the hedge fund strategies of investment is done. Also an analytical study of Hedge funds impact on Indian Capital markets is done based on individual investment strategy.

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Tables showing the flow of Hedge Funds from 2003 and SENSEX return for the corresponding year

Table 2: Flow of Hedge Funds from 2003 and SENSEX return for the corresponding year 2003 Jan Feb Mar April May June July Aug Sep Oct Nov Dec HF INFLOWS (In Million Rs) 115.20 80.40 -14.40 2.40 65.20 201.2 300.80 192.00 383.20 616.40 300.8 633.20 SENSEX RETURN (%) -3.76 1.02 -7.15 -2.92 7.47 13.41 5.14 11.92 4.91 10.19 2.81 15.74

ESTABLISHING A RELATIONSHIP BETWEEN THE FINANCIAL CRISIS AND HEDGE FUND PERFORMANCE In order to establish a relationship between the Hedge funds and the different Financial crisis, the returns of various hedge fund strategies indices is compared with the returns during that particular crisis. The different crisis taken into consideration are The 1994 Bond Crisis, The 1997 Thai Currency Crisis, 1998 Russian Crisis and The

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2000 Technology, Media & Telecom Crisis. The returns are compared and an analytical framework is arrived in the end by observing the returns. CONVERTIBLE ARBITRAGE 1994 Bond Crash: CSFB/Tremont Convertible Arbitrage Sub index lost 3.32% in the three months from February to April and losing 8.5% in the year since January The HFRI Convertible Arbitrage Index lost 4.62%. 1997 Asian Crisis: CSFB/Tremont Sub-index was up by 5.64% during this period, and 14.5% for the whole 1997 year. The HFRI was up by 5.67%. 1998 Russian Crisis: The CSFB/Tremont Sub-index was down 12.03%. This was its worst performance on record. The HFRI was down by 4.69%.

TMT Crash: The CSFB/Tremont Sub-index was up 28.44%. The HFRI was up by 20.74%. FIXED INCOME ARBITRAGE Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the fixed income arbitrage. 1994 Bond Crash: CSFB/Tremont Sub-index HFRI was was up by 3.85%. up by 3.58%. CSFB/Tremont Sub-index HFRI lost lost 11.75%. 13.18%. CSFB/Tremont Sub-index HFRI was was up 12.06%. up 7.57%.

1997 Asian Crisis TMT Crash:

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EQUITY MARKET NEUTRAL: Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the equity market neutral. 1994 Bond Crash: 1997 Asian Crisis 1998 Russian Crisis TMT Crash: CSFB/Tremont Subindex was up 0.25%. CSFB/Tremont Subindex was up 4.65%. CSFB/Tremont Subindex was up 2.56%. CSFB/Tremont Subindex was up 18.52%. HFRI was up 1.94%. HFRI was up 7.31%. HFRI was down 1.48%. HFRI was up 21.43%.

MERGER ARBITRAGE: Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the merger arbitrage. 1994 Bond Crash: 1997 Asian Crisis 1998 Russian Crisis TMT Crash: CSFB/Tremont was up 0.44%. CSFB/Tremont was up 6.54%. CSFB/Tremont was down 4.52%. Sub-index HFRI was up 0.77%. Sub-index HFRI was up 9.91% Sub-index HFRI was down 2.00%. up

CSFB/Tremont Sub-index HFRI was was up 15.14%. 13.78%.

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DISTRESSED SECURITIES Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the distressed securities.

1994 Bond Crash:

CSFB/Tremont

Sub- HFRI 1.38%.

was

down

index was down 2.86%. 1997 Asian Crisis CSFB/Tremont index was up 9.32%. 1998 Russian Crisis CSFB/Tremont

Sub- HFRI was up 6.98%.

Sub- HFRI 12.43%.

was

down

index was down 12.94%. TMT Crash CSFB/Tremont index was up 15.51%

Sub- HFRI was up 8.32%

GLOBAL MACRO Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the global macro.
1994 Bond Crash: CSFB/Tremont Sub-index was HFRI was down 10.70%. down 11.12%. 1997 Asian Crisis CSFB/Tremont Sub-index was HFRI was up 8.88%.

up 20.01%. 1998 Russian Crisis TMT Crash: CSFB/Tremont Sub-index was HFRI was down 5.93%. down 20.14%. CSFB/Tremont Sub-index was HFRI was up 3.98%. up 28.75%.

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LONG/SHORT EQUITY: Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in the Long/Short Equity. 1994 Bond Crash: 1997 Asian Crisis 1998 Russian Crisis TMT Crash: CSFB/Tremont Sub-index was down 7.74%. CSFB/Tremont Sub-index was up 13.45%. CSFB/Tremont Sub-index was down 6.76%. CSFB/Tremont Sub-index was down 9.72%. HFRI was down 2.85%. HFRI was up 13.5%. HFRI was 2.38%. HFRI was 7.89%. down down

EMERGING MARKETS: Here we compare the movements in the CSFB/ Tremont sub index and HFRI during the four financial crisis in Emerging Markets.

1994 Bond Crash:

CSFB/Tremont Sub-index was down 13.58%.

1997 Asian Crisis 1998 Russian Crisis TMT Crash:

CSFB/Tremont Sub-index was down 3.49%. CSFB/Tremont Sub-index was down 27.53%. CSFB/Tremont Sub-index was down 16.59%.

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Inference Market Impact Hedge fund strategies Convertible arbitrage Fixed inc arbitrage Eq. market neutral Merger\Risk arbitrage Distressed securities Global Macro Short Sellers Long\Short Equity Emerging Market 1994 crisis High(-) High(+) Low(+) Low(+) Medium(-) High(-) High(+) High(-) High(-) Medium(+) 1997 crisis High(+) Medium(+) High(+) High(+) High(+) High(+) Low(+) High(+) High(-) Medium(+) 1998 crisis High(-) High(-) Medium(+) High(-) High(-) High(-) High(+) High(-) High(-) High(+) TMT Crash High(+) High(+) High(+) High(+) High(+) High(+) High(+) High(-) High(+) Medium(+)

From the above data it is clear that there is a high correlation between the Hedge Funds returns and the corresponding indices. This proves that Hedge Funds played a vital role in the culmination of the above said crisis. Hedge funds as a whole are becoming an important segment of the asset management industry and gaining popularity from investors particularly from the high net worth investors, universities, charitable funds, endowments, pension funds, insurance and other institutional investors. The assets under management of the hedge funds are growing on a double

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digit rate. All hedge funds are not necessarily speculative funds though most of them provide an alternative investment options for the investors through innovative investment strategy.

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SUMMARY OF FINDINGS After doing a detailed analysis of Hedge funds and their investing strategies, one can infer that Hedge funds are both a boon and bane for any capital markets. Some of the advantages and disadvantages associated with these funds are listed below: 1. Research and trading strategies of a large number of hedge funds are aimed at deriving profits from the perceived mispricing of securities. Mispricing between assets arises because market traders do not have costless and immediate access to all publicly available markets, exchanges and information while trading. For example, an option on the S&P500 index trades in Chicago, while the underlying stocks trade on various exchanges, like NASDAQ and NYSE. If the derivatives price and the underlying stock prices do not properly reflect each other (e.g. do not satisfy the relevant noarbitrage relationships), mispricing occurs. Of course, very few mispricings are quite so obvious, perhaps exactly because hedge funds by their trading push prices towards and inside the noarbitrage set. 2. Traders profiting from the resulting arbitrage opportunities induce prices to move towards the true price, and hence allow trades to happen that otherwise would not have taken place. Such activities can further aid efficiency by increasing the competitive pressures on

market makers or intermediaries, whose bread and butter are the various spreads. To cite the regulator (SEC, 2003b), The absence of hedge funds from these markets [of innovative financial instruments] could lead to fewer risk management choices and a higher cost of capital.

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3. Traditional fund managers are usually constrained by their mandates in choosing trading strategies, while individual investors are usually constrained both by transaction costs and technological know-how. Hedge funds are not subject to such constraints and so may provide investment strategies preferred by investors, but otherwise unobtainable.

4. Considerable empirical and theoretical evidence demonstrates that hedge funds provide investors with riskreturn tradeoffs not available from traditional funds. Caution should, however, be applied to any such analysis due to the inherent biases and nonlinearities in hedge fund data. Patton for instance studies the empirical properties of so-called market-neutral hedge funds, in particular in view of the fact that hedge funds self-classify themselves into categories such as market-neutral.

5. Rapid advances in financial technology and data availability, encouraged by BaselII, have brought advanced trading and risk management techniques within the reach of just about any financial institution and investor. This has resulted in the information available to market participants and their resulting behavior being more uniform than at any other time. This phenomenon is especially damaging during financial crises, where highly correlated information and behavior conspire to amplify the severity of financial crises, by leading to a reduction of liquidity at a time when it is needed most. Furthermore, since hedge funds are unencumbered by mandated risk limits and generally operate at the top end of the technological chain, they have the possibility to act counter cyclically during a crisis, providing liquidity and reducing volatility.

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6. Hedge funds are frequently accused of destabilizing the international financial system. This is especially true for macro funds, which take large positions on the longterm direction of macroeconomic developments. While a hedge funds interest in a country may not be to the governments liking, this does not mean that the hedge fund is necessarily predatory or destabilizing. It may simply be exploiting the difference between the real state of the economy and market prices. 7. The available empirical evidence on whether hedge funds are destabilizing is mixed. Hedge funds are considered to have exerted a significant market impact during the ERM crisis, but not during the Asian crisis. Indeed, during the Asian crisis, foreign hedge funds sometimes seem to have had a stronger belief in the economic fundamentals of the crisis countries than the often better-informed domestic investors. 8. Hedge funds, unlike regulated financial institutions, do not have an upper limit on allowable leverage. This leverage is argued to increase both the likelihood and severity of hedge fund defaults, potentially leading to financial crises. Whilst such concerns have long been expressed, they were amplified following the LTCM collapse. At present, hedge funds do not appear to employ very high levels of leverage.

9. Since hedge funds are unencumbered by mandated leverage restrictions, with primary activities focussed on relatively high risk trading, hedge fund defaults may be more likely and more damaging than in the case of regulated financial institutions. Essentially, hedge funds cause counterparty risk for regulated trading partners (such as prime brokers) and investors, thus increasing credit risk in the regulated part of the financial system.

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10.Counterparty risk was an important issue in the LTCM crisis, where a key concern was the high exposure of major investment banks to LTCM settlement risk, and lack of information about overall exposures. Because of network linkages of their interbank exposures, both LTCM creditor banks, and financial institutions with no direct connection to LTCM were exposed to indirect counterparty risk. The main worry in such networks is the triggering of domino style defaults throughout the banking system.

11.Hedge funds are often accused of herding, with the ERM and Asian currency crises cited as prime examples. The academic notion of herding refers to the phenomenon by which funds mimic other funds, despite the fact that their own private information or proprietary model suggests different strategies. The latter informational requirement implies that herding is inefficient as it prevents the release of valuable information.

12.Hedge funds of course may act as a catalyst, by triggering (whether accidentally or on purpose) herding by other investors. Intentional herd induction goes counter to the casual observation that hedge funds could always reveal trades so as to encourage herding, but hardly ever do. Available empirical eventstudies have not found evidence of such triggered herding. Fung and Hsieh find indirect evidence that hedge funds were late comers to the trade during the Asian crisis, while Eichengreen and Mathieson find no evidence that other traders were guided by the positions taken by hedge funds in prior periods.

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SUGGESTIONS In view of the increasing popularity among the institutions as well as their increasing interest in the Indian market, it might be time to provide a limited window to this growing segment of asset management industry within the existing framework of the SEBI (Foreign Institutional Investors) Regulations. While opening up our market one cannot be oblivious to the special concerns associated with the creative fund management strategies used by these funds. In this context, following additional provisions have been suggested with respect to hedge funds seeking registration as FII: 1. The investment adviser to the hedge funds should be a regulated investment advisor under the relevant Investor Advisor Act or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act. 2. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds, university funds, charitable trusts or societies, endowments, banks and insurance companies. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further, institutional investors may help fund managers to take a long term perspective of the market.

3. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations, particularly in terms of the explanation to Regulation 6(1)(d). 4. The fund manager or investment adviser must have experience of at least 3 years of managing funds with similar investment strategy that the applicant fund has adopted.This provision is expected to allow well

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managed funds to access our market and at the same time, keep our markets insulated from the possible adverse effects of trial and errors by uninitiated rookies.

5. The fund should have a stipulated lock-in period so as to avoid any adverse impact like increase in volatility. The conditions for minimum period of investment should be clearly stipulated.

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CONCLUSION Hedge funds as a whole are becoming an important segment of the asset management industry and gaining popularity from investors particularly from the high net worth investors, universities, charitable funds, endowments, pension funds, insurance and other institutional investors. The asset under management of the hedge funds is growing on a double digit rate. All hedge funds are not necessarily speculative funds though most of them provide an alternative investment options for the investors through innovative investment strategy. Based on the dissertation I can conclude by saying that though Hedge funds investments have a direct bearing to the culmination of some of the worst crisis in the world, they bring with them a lot of advantages too. If SEBI is considering allowing of Hedge Funds to directly invest in Indian markets it should bring in some regulations as mentioned in the suggestions part, so that their investments may add to share holder value appreciation. Also the fact of current account convertibility should be taken into account, because if Hedge Funds are freely allowed into Indian Capital markets, there is also a possibility of free flight of money outwards thus created mayhem in the markets as well in the whole Economy.

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BIBLIOGRAPHY Knowledge @whorton India journal Bloomberg market magazine Soueissy, M. & Sidani, R (2003), The Risks Underlying Hedge Funds Strategies Knowledge@Wharton (2005) - hedge funds are growing: is this good or bad? Hedge Fund Review-risk book(magazine) Web Pages www.hedge fund review.com www.hedge week.com/news www.hedge fund.net www.hedge co.net

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