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Innovative financial instruments in India

Methodology

Collection of secondary data:

  • Historical data from sites of NSE, BSE, SEBI etc
  • Getting Data from newspapers
  • Getting data from the Various Research papers published.
  • Collecting data from various Books available on the topic.
  • Review of Previous Management Research Reports
  • Getting Access to Instruments available in India from SEBI websites.

Findings and Conclusions

  • In India financial market majorly denotes equity markets.
  • Indian debt market is not well developed and still 80% of market is under Government securities.
  • Securitization has to be done on assets held by Banks.
  • Bond market needs a great consideration in terms of junk bonds
  • An effort can be made to develop Carbon Emission and National growth index.
  • Commodities Options should be developed in India.
  • Credit derivatives should be developed with consideration of all the possible types of Credit derivatives.
  • In a country with major income from Agriculture, Weather derivatives should be introduced to protect the interest of various involved parties.
  • To mitigate the Catastrophe hazards new technique for risk management should be introduced.
  • Financial development Index to measure the developments in various parameters to conclude growth in real terms.

Conclusion

Despite the accelerated industrial growth experienced this decade from recent economic reforms, most major investors around the globe do not yet see India as an ideal country for foreign investment. The competition for global capital will only get tougher in the years to come, and unless the political, judicial and economic environments are right, India will lag behind many other emerging nations. More importantly, the rising expectations of the middle-class, widening income and wealth inequalities between the haves and have-nots, require efficient initiatives from Government and corporate to attract and accommodate the funds available.

Variety of financial products like mutual funds, insurance, shares, debentures, derivative instruments, etc. are available in India. However, the reach of these products is very limited and the features of many of these products are very basic in nature. Further development and innovation in these products would be faster if they are accessed by all classes of investors in urban as well as rural areas. The thrust lies mainly on the development of new financial products to deepen the improvements in the product distribution itself. The responsibility of ensuring these improvements vests with all the stakeholders in the financial services industry.

ABSTRACT

The Indian financial market has been primarily divided into three categories namely: Equity; Debt; Derivatives. Every category has its own importance in the development of financial markets. In most of the developed nations after the development of Equity now the major focus is on Debt and Derivatives market. The reason for this focus can be many supportive benefits which accrue to a market by development of double 'D' market.

Surprisingly in financial market is used as a synonym for equity market which has completely under deployed Debt and derivative markets. The importance and potentials of debt market are still under a doubtful impression in India and no major revolution has been brought to this effect in the recent periods. Focus of more and more to just equity markets has created saturation in Indian stock market. So willingly or unwillingly now the focus has to be shifted towards other possible avenues.

Some of the possible avenues have been categorized during this research conducted on various instruments which are globally available but cannot find place in Indian markets. Now these instruments are also categorized in the various forms and accrue to a specific market.

Firstly the focus is laid on so called Backbone of Indian Financial system Vis the Indian equity market, which has incorporated every possible instrument which can be accommodated in Indian family of Equity instruments. Few instruments has been recognized which can be absorbed in Indian market, which can be Indian Depository Receipt (IDR), Non-Voting Shares, Cumulative convertible preference shares (CCPS), Debt-equity swap.

Secondly it comes the most awaited Debt market which needs great development especially in case of corporate bonds. In India 80% of bonds are Govt. issued and 80% of remaining by institutional investors. So there has to happen lot of work by GOI (Government of India). In this few instruments which can be of utmost importance for Indian environment can be Inflation linked bonds (ILB), junk bonds, Specialized debt fund for infrastructure funding, securitization of debt.

Thirdly it comes to the funds of masses i.e. pension funds and retirement schemes which are always backed by government and also has gained support from the government. In this case one of the major innovative works can be on New Pension Scheme.

Fourthly, it comes to mutual funds which has the role of UTI, SEBI, RBI, AMFI and other such authorities which are regulating the workings of mutual funds in India. One of New Direction in mutual funds can be Investment funds in international Markets.

Fifthly it comes to the derivatives market, which can be divided in two major forms futures and options. In future major development can be in the newly arrived concepts which can become,

Instruments of masses. These include Futures on the Index of Industrial and Economy growth and Index and futures for Carbon Emission in the country. Further option market again has a lot of scope for improvements in the fields of Weather derivatives, Commodity Options, Credit derivatives.

Last but not the least there is an open category which also has few innovative instruments to be captured. These can be Index for Natural Disaster and risk Management and Financial development Index.

Important consideration to be noticed here is that India is a great Economy with tremendous growth opportunities has to cater with ongoing global competition in terms of capital and Money markets developments.

Another important issue here is that India has to balance its Financial market with the equitable share of debt and equity.

It should be open for latest and innovative types of instruments suitable for the growth and development of financial system.

New concepts like Carbon Emission index should be a given a proper research and find out the ways to develop and implement it.

INTRODUCTION

INTEGRATION OF GLOBAL CAPITAL MARKETS

In this age of globalization and liberalization domestic markets alone cannot cater to the growing needs of corporate and individuals. As a result of which there is a need of finance from various new sources which has led to the integration of world markets. As a result we have seen development of various financial products in past few years. Financial globalization has brought considerable benefits to economies and to investors and has also changed the structure of markets, creating new risks and challenges for market participants and policymakers. Globalization has also increased the scope of many new financial products.

Two decades ago, someone building a new factory would probably have been restricted to borrow from a domestic bank. Today it has many more options to choose from. It can also shop around the world for loan with lower interest rate and can borrow in foreign currency if foreign-currency loans offer more attractive terms than domestic-currency loans; it can issue stocks or bonds in either domestic or international capital markets.

The evolution of new financial products has increased the size of global capital markets considerably over the years. Market capitalization and year to date turnover of twenty major stock exchanges is given below :

THE INDIAN CAPITAL MARKET

A capital market is a place where both government and companies raise long term funds to trade securities on the bond and the stock market. It consists of both the primary market where new securities are issued among investors, and the secondary markets where already existent securities are traded. In the capital market, commodities, bonds, equities and other such investment funds are traded.

There are 22 stock exchanges in India, first being the Bombay Stock Exchange (BSE), which began formal trading in 1875. Over the past few years, there has been a swift change in the Indian capital markets, especially in the secondary market. In terms of the number of companies and total market capitalization in share market, the Indian equity market is considered large relative to the country's stage of economic development.

CONVENTIONAL PRODUCTS IN INDIAN CAPITAL MARKETS

EQUITY

Equity shares are issued by the companies in primary market to raise capital from public and corporate houses. It provides a share in the earnings of the company and the equity shareholder can participate in decision making of the company also.

There are three basic types of equity:

Common stock or ordinary shares [1]

Common stock, as it is known in the United States, or ordinary shares, according to British terminology, is the most important form of equity investment. An owner of common stock is part owner of the enterprise and is entitled to vote on certain important matters, including the selection of directors. Common stock holders benefit most from improvement in the firm's business prospects. But they have a claim on the firm's income and assets only after all creditors and all preferred stock holders receive payment. Some firms have more than one class of common stock, in which case the stock of one class may be entitled to greater voting rights, or to larger dividends, than stock of another class. This is often the case with family owned firms which sell stock to the public in a way that enables the family to maintain control through its ownership of stock with superior voting rights.

Preferred stock [2]

Also called preference shares, preferred stock is more akin to bonds than to common stock. Like bonds, preferred stock offers specified payments on specified dates. Preferred stock appeals to issuers because the dividend remains constant for as long as the stock is outstanding, which may be in perpetuity. Some investors favor preferred stock over bonds because the periodic payments are formally considered dividends rather than interest payments, and may therefore offer tax advantages. The issuer is obliged to pay dividends to preferred stock holders before paying dividends to common shareholders. If the preferred stock is cumulative, unpaid dividends may accrue until preferred stock holders have received full payment. In the case of non cumulative preferred stock, preferred stock holders may be able to impose significant restrictions on the firm in the event of a missed dividend.

Warrants [3]

Warrants offer the holder the opportunity to purchase a firm's common stock during a specified time period in future, at a predetermined price, known as the exercise price or strike price. The tangible value of a warrant is the market price of the stock less the strike price. If the tangible value when the warrants are exercisable is zero or less the warrants have no value, as the stock can be acquired more cheaply in the open market. A firm may sell warrants directly, but more often they are incorporated into other securities, such as preferred stock or bonds. Warrants are created and sold by the firm that issues the underlying stock. In a rights offering, warrants are allotted to existing stock holders in proportion to their current holdings. If all shareholders subscribe to the offering the firm's total capital will increase, but each stock holder's proportionate ownership will not change. The stock holder is free not to subscribe to the offering or to pass the rights to others. In the UK a stock holder chooses not to subscribe by filing a letter of renunciation with the issuer.

RECENT DEVELOPMENT IN EQUITY MARKET

  1. Free pricing- The abolition of office of the controller of capital issue resulted in the emergence of new era in primary markets. All controls on designing, pricing and tenure were abolished. The investors were given the freedom to price an instrument.
  2. Entry Norms- Hitherto no restrictions for a company to tap the capital markets. This resulted in massive surge of small cap issues. The need for transparent free entry was felt by SEBI.
  3. Disclosures- the quality of disclosure in the offer document was really poor. A lot of vital adverse information was not disclosed. SEBI stringent discloser norms were introduced.
  4. Book Building- It is the process of price discovery. One of the drawbacks of free pricing was price mechanism. The issue price has to be decided around 60-70 days before the opening at issue. Introduction to price building has overcome the limitation of price mechanism.
  5. Streamlining the procedures- all the procedures was streamlined. Many aspects of the operations have been made transparent.

SCOPE OF FURTHER EQUITY INSTRUMENTS

INDIAN DEPOSITORY RECEIPTS (IDR)

After the success of American Depository Receipts and Global Depository Receipts the Indian regulatory body, SEBI also allowed foreign companies to raise capital in India through INDIAN DEPOSITORY RECEIPTS (IDRs). IDRs can be understood as a mirror image of well-known ADRs/GDRs. In an IDR, foreign companies issue the shares to an Indian Depository, which would, issue Depository Receipts to investors in India. The Depository Receipts would be listed in Indian stock exchanges and would be freely transferable. The actual shares of the IDRs would be held by an Overseas Custodian, who shall authorize the Indian Depository to issue the IDRs. The Overseas Custodian must be a foreign bank having business in India and needs approval from the Finance Ministry for acting as a custodian while the Indian Depository needs to be registered with the SEBI.

Following rules were established by SEBI for listing through IDR:

ISSUERS ELIGIBILITY CRITERIA: [4]

  • Must have an average; turnover of US$ 500 million during the previous 3 financial years.
  • Must have capital and free reserves which must aggregate to at least US$100 million.
  • Must be making a profit for the previous 5 years and must have declared a dividend of 10% in each such year.
  • The pre issue debt-equity ratio must be not more than 2:1.
  • Must be listed in its home country.
  • Must not be prohibited by any regulatory body to issue securities
  • Must have a good track record with compliance with securities market regulations.
  • Must comply with any additional criteria set by SEBI

REASONS FOR DORMANCY IN ISSUE OF IDR:

  • Stringent rules set by SEBI made foreign companies stay away from Indian market.
  • The rules were made more stringent after the Global economic crisis.
  • Availability of easy funds in foreign markets.
  • Rate of interest in foreign banks is also less which made them prime source of funds for companies.
  • Uncertainty of subscription in Indian markets.

Indian companies have been highly active in foreign markets by raising funds through ADR and GDR but till date no foreign company has raised money through IDRs. Standard Chartered is the first company to allow its plan to issue IDR and has received the clearance from RBI also. The bank has yet to announce the size of the IDR issue, though the figures are expected to vary from Rs 2,500 to Rs 5,000 crore.

Non -Voting Shares

A non- voting share is more or less similar to the ordinary equity shares except the voting rights. It is different from a preference share in the sense that in case of a possible winding up of the company, the preference shareholders get their shares of dividends repaid before the owners of the non-voting shareholders. The companies with the constant track record and a strong dividend history can issue these kinds of instruments. They are basically focused to small investors who are normally not interested in the management of the firm. Hence non promoting share are a good tool for the promoters of the company to increase the share capital without diluting the control. However if the company does not fulfill the commitment of higher dividend then these shares are automatically converted to shares with voting rights.

Hence it is very important for the companies to assess the characteristics of future cash flow and determine whether paying a higher rate of dividend is practicable for them or not.

Debt for equity and equity for debt swaps

Adebt for equity swapis not an instrument but a situation where a company offers its shareholders and creditors debt in exchange for equity or stock. The value of the stock is determined on current market rates. The company may, however, offer a higher value to attract more shareholders and debt holders to participate in the swap. Equity for debt swapis the opposite of the above process. In this swap, the creditors to the company agree to exchange the debt for equity in the business.

How do creditors benefit

Creditors such as banks and other financial institutions provide capital to large businesses. If the business gets into financial trouble, it may sometimes not be a good idea to allow the company to close down and go bankrupt. In these situations, these creditors find it easier to allow the business to take the form of going concern and become the shareholders in this business. The debt or the assets of the company may be so big that there would be no any profit or advantage to the banks in seeking its closure. At times, the company may also be seeking a restructuring of its capital for certain reasons. These include meeting contractual obligations, taking advantage of current stock valuation in the market or to avoid making coupon and face value payments.

How debt for equity swap takes place

Let us assume that a shareholder or investor of some company has $1000 worth of stock. The company offers the option to swap equity withdebtat a rate of 1:1. This means that for $1000 worth of stock, the investor would get $1000 worth of debt or bonds in the company. At times, the company may offer a ratio of 1:2 to attract more stock for its debt. This could mean an additional gain in the form of $1000 worth of stock for the investor. But it is also important to note that the investor would lose their rights as a shareholder, the moment he swaps his stock orequity for debt. Original shareholders often find themselves deprived of their voting rights when such swaps take place.

DEBT MARKET

Traditionally, the Indian capital markets are more synonymous with the equity markets - both on account of the common investors' preferences and the huge capital gains it offered - no matter what the risks involved are. On the other hand, the investor's preference for debt market has been relatively a recent phenomenon - an outcome of the shift in the economic policy, whereby the market forces have been accorded a greater leeway in influencing the resource allocation. If we talk about the Indian debt market bond market has formed its own place in the financial systems. All the recent developments are accrued to bonds market in India.

Size of debt market

If we look at worldwide scenario, debt markets are three to four times larger than equity markets. However, the debt market in India is very small in comparison to the equity market. This is because the domestic debt market has been deregulated and liberalized only recently and is at a relatively nascent stage of development.

Interest rate deregulation

The last two decades witnessed a gradual maturing of India's financial markets. Since 1991, key steps were taken to reform the Indian financial markets. With the introduction of auction systems for rising Government debt in the 1990s, along with the decision to put an end to the monetization of Government deficits, started the gradual process of deregulation of interest rates. While the immediate effect of deregulation of interest rates was associated with rising interest rates, deft debt management policy by the RBI and the improvements in the market micro structure saw a gradual decline in the interest rates.

Abolition of tax deduction at source

Tax deduction at source (TDS) used to be major barrier to the development of the government securities market in India. Recognizing this, the RBI convinced the Government to abolish it. The removal of TDS on Government securities was apparently a small but a major reform in removing pricing distortions for Government securities.

Introduction of auctions

For Auctions a major policy shift from administered interest rate regime to a market based regime, the choice of auction system needed to be carefully drawn, in order to give a comfort level to the government as a borrower as also to moderate the risks that might be faced by the uninitiated market participants. Accordingly, it was decided to begin with "the sealed bid auction system with a post bid reserve price" (since the RBI as an agent to government participates in the auctions as a non-competitive bidder.)

Banks investments in Government securities valuation/accounting norms

Concomitantly, regulatory initiatives in introducing international best practices in valuation/accounting norms for the banks' investment portfolios (comprising mainly government securities) also necessitated the banks to mark to market their investment portfolios and forced them to actively trade. This gave an added impetus to the incipient trading activity.

Consolidation of stocks

Primary issuance strategy was further fine tuned towards issuance of benchmark securities to improve liquidity. Alignment of coupon payment dates for the new issuances has been consciously attempted to promote stripping of government securities (STRIPS), which if once materializes, can facilitate the establishment of zero coupon yield curve and also can take care of the segmental needs in terms of asset liability matching.

Zero coupon curve for pricing[5]

To bring further improvements in the pricing mechanism in debt market, a need was felt to promote a zero coupon yield curve (ZCYC). As indicated earlier, STRIPS (Separate Trading of Registered Interest and Principal of Securities) can facilitate a ZCYC. This curve is being used for pricing NSE's interest rate futures transactions. FIMMDA/PDAI, publishes a monthly ZCYC for the market participants to value their government securities portfolios. However, the ZCYC based pricing has not been popular with the Indian market participants.

SCOPE OF INNOVATIONS IN BOND MARKET

Inflation linked bonds (ILB)[6]

The recent Monetary Policy released by RBI laid its thrust on controlling the spiraling inflation, especially the food price inflation. One of the reasons behind the CRR hike was to "curtail the rising inflationary expectations (higher expected price trends)"

In the past RBI has been concerned about the fact that a common man does not have any protection against rising prices, Vis No Inflation Hedge. The common man has to rely on traditional but inefficient methods to hedge the real inflation risks, such as Gold and real assets such as commodities or real estate or even excessive stocking of goods

In developed markets like US, the government has issues "Treasury Inflation Protected Securities" known as TIPS. Globally more than USD 1 trillion worth inflation linked bonds must be outstanding.

Inflation linked bonds (ILB) securities give an opportunity to market participants and investors to hedge against inflation. The coupon (interest rate) of ILB is fixed but the underlying principal would move in tandem with the inflation levels in the country. At redemption of the securities the higher of the value (adding inflation) thus arrived or face value is paid off. Banks and Financial Institutions usually buy wholesale and create retail market for such securities. With right access retail investor can easily buy such securities to protect himself from inflation and this could have following advantage to investors and the government.

  1. The inflation linked bonds can make the governments accountable for higher inflation since the cost of borrowings will be linked to inflation (if coupon paid is inflation hedged). Rising inflation will also raise the repayment of inflation linked bonds.
  2. It will help government to broaden the investor base by offering inflation linked bonds at the retail level, where the participation now is minimal.
  3. Government can diversify the debt service costs in a deflationary (falling prices) scenario.
  4. It is very likely that the existence of inflation linked bonds might reduce the inflation risk premium embedded in government bonds.
  5. For the inflation linked bonds to be an effective hedge GOI should ensure that the underlying inflation index is representative of real or actual inflation on the streets.
  6. RBI can precisely quantify & control the inflationary expectations embedded in the economy as well as in the markets. RBI can use inferences from trading in such bonds in formulating its monetary policy stance
  7. The onus on monetary policy tools such as interest rates, to contain inflation will reduce if RBI can guide or influence the inflationary expectations through the demand/supply of inflation linked bonds and with an excellent communication policy.

For Investors in general, inflation linked bonds would provide distinct advantages:

  1. It allows investors to hedge the purchasing power (inflation) risk. The capital is inflation risk protected and the income (coupon) can be structured that way too.
  2. Inflation linked bonds universally are regarded as a separate asset class & would provide diversification benefits to a portfolio due to its negative co relation with returns from traditional asset classes.
  3. Such bonds provide positive risk reward relationship too.
  4. Inflation linked bonds are effective vehicle for hedging risks for institutional investors, where the long term liabilities are inflation linked or linked to future wage levels or banks who face the inflation risk on their assets side due to their GOI Bond holdings.
  5. Access of FIIs to the inflation linked bonds can allow them to hedge their inflation risks in India which are currently expressed in the currency markets. The USD/INR (currency) volatility can hence come down hence.

Junk bonds

Sharp movements in the Indian equity market may be par for the course. But when it comes to the market for corporate bonds, it's constantly stagnant. The reason is, we don't have a corporate bond market. But this is overwhelmingly dominated by government securities (about 80% of the total). Of the remaining, close to 80% again comprises privately placed debt of public financial institutions. An efficient bond market helps corporate reduce their financing costs. It enables companies to borrow directly from investors, bypassing the major intermediary role of a commercial bank. One of the important instruments in corporate market is Junk Bonds which could be great source of financing for countries like India where markets are not much regulated.

A speculative bond rated BB or below. "Junk bonds" are generally issued by corporations of questionable financial strength or without proven track records. They tend to be more volatile and higher yielding than bonds with superior quality ratings."Junk bond funds" emphasize diversified investments in these low-rated, high-yielding debt issues. Thus, these are high-yielding, high-risk securities issued by companies with less robust finances.[7]

Need for Junk Bonds in India

The major issue amongst Indian bond markets has been how companies with poorer ratings can raise funds. At times the banks and FIs are reluctant to invest in even the 'AAA-rated' companies. In fact for progress of a developing nation like India, this would give a wonderful opportunity for the smaller companies to get funds and implement their ideas. However, a proper regulatory mechanism also needs to be set-up to avoid high risk of default in the case of junk bonds.

Currently, there are only two instruments that FIIs can invest in India, i.e., equity and debt. The cap on FII debt investment varies from time to time between $1.5 billion and $2 billion. The Asset Reconstruction Company of India Ltd. (ARCIL), India's first asset reconstruction company, has vied for permitting FIIs to invest in a new instrument in India - distressed assets. ARCIL has recommended SEBI, RBI and the Finance Ministry to allow FII investment in a new category, which is neither equity nor debt but a separate lucrative instrument - security receipts with underlying distressed assets.

Proposed Junk Bond Market in India - Scenario (Optimistic & Realistic)

Anoptimistic scenariowould be having junk bonds in the market ideally for funding by FIIs and Institutions for financing the small Indian companies. However, considering the risk associated with these bonds it might not be possible in near future because economy is still in its nascent phase and on a fast development track.So any move which is risky and can affect future inflows of foreign funds and investor confidence would not be ideal.

The only way an investor should invest in junk bonds is by diversifying. A selection of at least half a dozen issues will afford the investor some protection. High risk is inherent in high yield bonds. Nevertheless, your portfolio may well have a place for some of these securities if you are not risk-averse. By having junk bond markets, it would in fact signify deepening and maturing of Indian debt markets. In India, companies are hamstrung by the fact that investment relaxations may come in only when the debt markets get deeper, so that insurance companies can increase their portfolio yield without exposing themselves to risk for long tenures by investing in junk bonds.

Impact of Junk Bonds on Indian Economy[8]

A well-functioning corporate bond market allows firms to tailor their assets and liability profiles. If companies fear they will not be able to raise long-term resources, they are likely to stay away from long-term investments or entrepreneurial ventures that have a long-term payoff. In the long run, this can affect economic growth. The corporate bond and the junk bond market could fill this vacuum. In the absence of a corporate bond market, a large part of debt funding comes from banks. In the process, banks assume a significant amount of risk due to maturity mismatch between short-term deposits that can be readily withdrawn and relatively long-term illiquid loan assets resulting in high NPAs.

An active and efficient bond market gives companies an alternative means of raising debt capital in the event of a credit crunch. It also leads to better pricing of credit risk (since expectations of all market participants are incorporated into bond prices).

FIIs are major players in the equities market. However, thanks to the ceiling on their investment in the debt market (currently, there is a cumulative sub-ceiling of $0.5 bn on investment in corporate debt), they are present only in a limited way in the bond market.

Pension funds and the insurance sector could be another constituency, but the absence of pension funds and low insurance penetration has meant limited demand for long-term bonds. All these would help in establishing a corporate bond market for sub-investment grade.

Specialized debt funds for infrastructure financing[9]

As recommended by the High Level Expert Committee on Corporate Bonds and Securitization (HLECCBS), there is a case for creation of specialized Debt Funds to cater to the needs of the infrastructure sector. Such Debt Funds registered with SEBI should be given the same tax treatment as the one extended to venture capital funds.

The resource requirements for infrastructure development in India are enormous. An estimate indicates that the requirements are to the tune of US$ 150 billion or more during the next five years. Considering the long gestation period involved in infrastructure projects and given their liabilities (mainly deposits) which are short to medium term in nature, banks are constrained to finance this sector since their asset liability side is short term in nature. This certainly requires bond financing.

There exists a strong case for creation of specialized long term Debt Funds to cater to the needs of the infrastructure sector. A regulatory and tax environment that is suitable for attracting investments from Qualified Investment Banks is the key for channeling long term capital into infrastructure development. Currently, most banks lack in-house capacity to evaluate project finance risk. As such, they provide debt financing for infrastructure projects largely only to the extent that they are able to participate in loan syndicates led by a handful of specialists.

Facilitating the creation of infrastructure focused Debt Funds and making it easier for banks to participate in such funds would allow much larger volumes of debt financing from the banks to be deployed to infrastructure development while distributing the associated risks more evenly across a greater variety of projects.

Securitization of Debt[10]

Securitizationis astructured financeprocess that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. The term "Securitisation" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities. As a portfolio risk backed by amortizing cash flows - and unlike general corporate debt - the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of Securitisation processes are termedasset-backed securities(ABS). From this perspective, Securitisation could also be defined as a financial process leading to an issue of an ABS.

A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay XYZ a premium in addition to the interest on the money they borrow. XYZ will then take these ten loans, and put them in a pool. They will sell this pool to a larger investor, ABC. ABC will then split this pool (which consists of high risk loans and low risk loans) into equal pieces. The pieces will then be sold to other smaller investors, (as bonds).

Mortgage Backed Securities (MBS)[11]

A type of asset-backed security that is secured by amortgage or collection of mortgages. These securities must also begrouped inone of thetop tworatings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments.Furthermore, the mortgage must have originated from a regulated and authorized financial institution. When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS isa way for a smaller regional bank to lend mortgages toits customers without having to worryabout whetherthe customershave the assets to cover the loan. Instead, thebank acts as a middleman between the home buyer and the investment markets.

This type of security is alsocommonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they areclassified under the MBS.

However, the long-term tenure of MBS and the lack of liquidity in the secondary market discourage investors from getting actively involved in the market. Also home loans in India get pre-paid or re-priced, thus exposing the structures to significant interest rate risk and leading to higher credit enhancement requirements.

Issues faced by securitization in India[12]

Regulatory issues

Stamp Duty: One of the biggest hurdles facing the development of the securitization market is the stamp duty structure. The process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitization commercially unviable in several states.

Foreclosure Laws

Lack of effective foreclosure laws also prohibits the growth of securitization in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default.

Taxation related issues

Tax treatment of MBS SPV Trusts and NPL Trusts is unclear. Currently, the investors (PTC and SR holders) pay tax on the income distributed by the SPV Trusts and on that basis the trustees make income pay outs to the PTC holders without any payment or withholding of tax.

Legal Issues

Listing of PTCs on stock exchange: Currently, the SCRA definition of 'securities' does not specifically cover PTCs, While there is indeed a legal view that the current definition of securities in the SCRA includes any instrument derived from, or any interest in securities, the nature of the instrument and the background of the issuer of the instrument, not being homogenous in respect of the rights and obligations attached, across instruments issued by various SPVs, has resulted in a degree of discomfort among exchanges listing these instruments. Some issues under the SARFAESI Act: The ambiguity about whether or not Asset Reconstruction Companies (ARCs) and Securitization Companies (SCs) registered with the RBI can establish multiple SPV Trusts, has been resolved by a specific provision in the form of sec.7 (2A) of the SARFAESI Act. In view of this, it is now possible to unambiguously adopt the trust SPV structure even under the SARFAESI Act for MBS, ABS or NPL securitization.

So all these contribute to the problems that are faced by Securitization in India.

PENSION FUNDS AND RETIREMENT SCHEMES[13]

International experience shows that pension funds have indeed provided the much-needed boost to the development of corporate debt markets both in terms of demand for corporate bonds as also liquidity apart from improving the market microstructure. Pension funds have also been major stimulators of financial innovation as they have directly or indirectly supported product innovation by supporting the development of asset backed securities, structured finance, derivative products and so on. Pension fund presence in the bond market is likely to increase the availability of long term funds in the market, which in turn will improve the asset liability mismatch that often arises in projects with long gestation periods.

Recent Government Initiatives and Pension Fund Reform

Two parallel sets of initiatives have been taken during the last 4-5 years. The first initiative was for the organized sector and the second initiative was for the unorganized sector. OASIS (Old Age Social and Income Security) project was commissioned by the Ministry of Social Justice and Empowerment, which submitted its report in January 2000. OASIS report recommended a scheme based on Individual Retirement Accounts (IRAs) to be opened anywhere in India. Banks, Post Offices etc., were identified to serve as "Points of Presence" (POPs) where the accounts could be opened or contributions deposited. Their electronic interconnectivity would ensure "portability" as the worker moves from one place/employment to another. There would be a depository for Centralized record keeping, fund managers to manage the funds and annuity providers to provide the benefit after the age of 60. The OASIS report brought forth important reforms in the field of pension fund investments and paved the way for later initiatives like the announcement of the New Pension System in the Budget of 2003-04, which got introduced on 1 January 2007.

Scope of Development

The New Pension System (NPS)

The New Pension System (NPS) is a pension system that is intended to initially cater to newly recruited Central Government employees (except the armed forces) and to workers in the unorganized sector. Even within unorganized sector, the NPS will cater to only workers who are taxpayers and can be motivated to join the scheme through tax incentives. As with Government employees, they can ask for investment protection guarantees on investments under various pension schemes offered by Pension Funds. However, this guarantee would be implemented using private financial markets. Persons being covered by schemes offered by the EPFO and other provisions administered under any statutes would not be covered under this NPS scheme. Thus, no existing arrangement of pension provision applicable to already existing persons are proposed to be changed, only new/additional persons are going to avail the benefit of the NPS. Although the NPS has started with covering Central Government employees who joined service after 1 January 2007, State Governments are likely to join this NPS scheme going forward. In due course, private sector employees too may join the NPS scheme.

The uniqueness of the NPS is two-fold:

  1. It creates a system where both the Government employees as well as workers in the unorganized sector are covered by one scheme and supervised by one regulator and
  2. The choice about fund managers or about different schemes of a fund manager can be exercised independent of the fund manager through the mechanism of the Central Record-keeping Agency (CRA).

MUTUAL FUNDS[14]

Mutual funds are supposed to be the best mode of investment in the capital market since they are very cost beneficial and simple, and do not require an investor to figure out which securities to invest into. A mutual fund could simply be described as a financial medium used by a group of investors to increase their money with a predetermined investment.

The responsibility for investing the pooled money into specific investment channels lies with the fund manager of said mutual fund. Therefore investment in a mutual fund means that the investor has bought the shares of the mutual fund and has become a shareholder of that fund. Diversification of investment Investors are able to purchase securities with much lower trading costs by pooling money together in a mutual fund rather than try to do it on their own. However the biggest advantage that mutual funds offer is diversification which allows the investor to spread out his money across a wide spectrum of investments. Therefore when one investment is not doing well, another may be doing taking off, thereby balancing the risk to profit ratio and considerably covering the overall investment.

The best form of diversification is to invest in multiple securities rather than in just one security. Mutual funds are set up with the precise objective of investing in multiple securities that can run into hundreds. It could take weeks for an investor to investigate on this kind of scale, but with investment in mutual funds all this could be done in a matter of hours.

Scope of Innovation in mutual funds

Investing In International Markets

In 2007 RBI increased the limits of international investments for individuals from $50,000 to $100,000 and for Mutual funds from 3 billion to 4 billion dollars. This has made a lot of mutual funds have offered product to Indian customers that invest abroad. Performance of some of those products is:

Though some of these funds give better returns than normal domestic equity and provide better diversification but still people are reluctant in investing abroad due to following reasons:

CHANGE IN EXCHANGE RATES

When the exchange rate between the foreign currency of an international investment and the Indian Rupee changes, it can increase or reduce your investment return. Due to this reason it gets more complicated and risky for people not only their investment should be in right stock/fund the foreign exchange rate should also work in their favor

POLITICAL SOCIAL AND ECONOMIC EVENTS

It is difficult for investors to understand all the political, social and economic factors that influence foreign markets. These factors provide diversification, but they also contribute to the risk of international investing.

COST OF INVESTMENT

International investing can be more expensive than investing in Indian companies. In smaller markets, you may have to pay a premium to purchase shares of some popular companies. Transaction costs such as fees, broker's commissions, and taxes often are higher than in Indian markets. Mutual funds that invest abroad often have higher fees and expenses than funds that invest in Indian stocks, in part because of the extra expense of trading in foreign markets.

RELIANCE ON FOREIGN LEGAL REMEDIES

If you have a problem with your investment, you may not be able to sue the company in India. You may have to rely on whatever legal remedies are available in the company's home country.

DERIVATIVES IN INDIA

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmarkS&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on179 securitiesstipulated by SEBI.

Futures [15]

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features:

  • Buyer
  • Seller
  • Price
  • Expiry

Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.

The difference between the price of the underlying asset in the spot market and the futures market is called 'Basis'. (As 'spot market' is a market for immediate delivery) The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost, insurance premium etc., That is, if you buy the asset in the spot market, you will be incurring all these expenses, which are not needed if you buy a futures contract. This condition of basis being negative is called as 'Contango'.

Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For eg: if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend.

When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is called 'Backwardation'. Backwardation generally happens if the price of the asset is expected to fall.

It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them i.e. the basis slowly becomes zero.

Scope of innovation in futures Market

Economy growth futures

This is a unique type of futures contract that can be raised in India as in this there should be an index which measures the economy growth and futures can be predicted on the underlying growth. In this there should be a hypothetical index created on the basis of growth of an economy. It can be measured on the growth 3, 6, 9, 12 months. Every quarter the growth can be measured and compared with future contract. Based on the conditions prevailing in the economy and also the world scenario should be predicted and accordingly the moment of the future contract can be decided.

Carbon Emission Index and futures

We all know one issue that is troubling the whole world is global warming and climatic changes. The adverse effects of global warming on the Indian subcontinent vary from low-lying islands and coastal lands to the melting of glaciers in the Himalayas, threatening the huge flow rate of many of the most important rivers of India and South Asia. In India, such effects are projected to impact billions of lives. As a result of increased carbon emmisions, the climate of India has become increasingly volatile over the past several decades; this trend is expected to continue. Another consideration in this aspect is every country doesn't want to take responsibility for contributing to Global Warming. One of the steps in this context is forming an Index for Carbon Emission which measures the carbon emission of each country based on the preset parameters. Now on that index there can be Future contract which can just book the level of index based on which the premium and all should be decided.

An interesting fact to notice here is that the value of contact will be directly measured by the central authority formed for this purpose.

Another important guideline for measuring the emission is Industrial Production Index (IPI).

Options [16]

Optionis a different type of investment, which is very useful and can provide real protection to the investors when the markets are going down. At the same time, the characters of the options are designed in such a manner that they meet the investors need in any situation.So that it can be used for both as a protective measure and also as an investment tool, which can produce high yields.

Options are essentially securities and provide the holder with the right to trade an asset on certain time and value. On the other hand the holder is not bound to do the trade and the whole process of trading depends on the opinion of the holder. If the holder does not sells the option on a particular date, the price of the option becomes zero and the holder faces 100% loss of the price, which has been paid for the option. But in some particular situations, the holders follows this type of strategy.

The option gets or derives its value from the stock or the index and thus it is dependent on some other assets for its value. For this reason, options are also called derivatives. There are two types of option available in the market. These are called Call and Put.

The 'call' provides the holder with the right to purchase a particular security. But the price for purchasing the security, the time of executing the purchase and the amount of the security, all remain fixed. At the same time, the holder is not bound to do the trade and it all depends on his or her own concern. With the growth in the stock price, the call also gains some extra value and because of this the holders always expect the stock value to rise. There are several exchanges that uses the call period as an important time to match and carry out a bulk of orders before the opening and closing.

On the other hand the 'put' holders always expect the stock prices to go down because in such situations, the put-holders can have extra profit. At the same time it provides the holder with the right to sell a particular amount of stock (underlying asset) at a certain price and time.

COMMODITY TRADING [17]

Commodity Trading in India started long time back, but the commodity trading in the country gained its' momentum after removal of certain restrictions by the Indian Government.

History of Commodity Trading in India

The Commodity Trading Market of established itself in India as a dominant market form much before the 1970s. In fact, in the last phase of 1970s, the commodity trading market of India started to losing its' vibrancy. This happened because, from the late 1970s, numerous regulations and restrictions started to be introduced in the commodity market of India and these restrictions were acting as obstacles in the path of smooth functioning of the commodity trading market.

In the recent years, many restrictions, which were negatively affecting commodity trading market, have been removed. So, now the commodity trading market of India has again started to grow in a fast pace.

In order to promote the commodity futures trading in India, Forward Markets Commission has been formed. This Forward Markets Commission actually regulates the futures trade in commodities.

In India, there are 21 commodity exchanges, which enhance the efficiency and competitiveness of the commodity trading market. Many of these commodity exchanges are regional, while many of them are commodity specific. Some of these 21 commodity exchanges provide online commodity trading facility.

Government Initiatives for promoting Commodity Trading

  • In the year 2003, the Indian Government approved the establishment plan of four commodity exchanges of national level. These national commodity exchanges would operate futures trading contracts for multiple commodities. The Indian Government has included more commodities in the list of permitted commodities, constructed under the Forward Contracts(Regulation) Act.
  • Earlier there was a rule that every spot market transaction has to be completed within 11 days. In order to promote commodity trading, the Government of India has removed this restriction. Indian Government has removed NTSD(Non-Transferable Specific Delivery Contract) option from the Forward Contracts(Regulation) Act.

COMMODITY DEREVATIVES

HISTORY

After the Indian economy embarked upon the process of liberalization and globalization in 1990, the Government set up a Committee in 1993 to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also recommended strengthening of the Forward Markets Commission, and certain amendments to Forward Contracts (Regulation) Act 1952, particularly allowing options trading in goods and registration of brokers with Forward Markets Commission. The Government accepted most of these recommendations and futures trading was permitted in all recommended commodities.

Commodity futures trading in India remained in a state of hibernation for nearly four decades, mainly due to doubts about the benefits of derivatives. Finally a realization that derivatives do perform a role in risk management led the government to change its stance. The policy changes favouring commodity derivatives were also facilitated by the enhanced role assigned to free market forces under the new liberalization policy of the Government. Indeed, it was a timely decision too, since internationally the commodity cycle is on the upswing and the next decade is being touted as the decade of commodities. [18]

WHY ARE COMMODITY DERIVATIVES REQUIRED

India is among the top-5 producers of most of the commodities, in addition to being a major consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian economy. It employees around 57% of the labor force on a total of 163 million hectares of land. Agriculture sector is an imposrtant factor in achieving a GDP growth of 8-10%. All this indicates that India can be promoted as a major center for trading of commodity derivatives.

It is unfortunate that the policies of FMC during the most of 1950s to 1980s suppressed the very markets it was supposed to encourage and nurture to grow with times. It was a mistake other emerging economies of the world would want to avoid. However, it is not in India alone that derivatives were suspected of creating too much speculation that would be to the detriment of the healthy growth of the markets and the farmers. Such suspicions might normally arise due to a misunderstanding of the characteristics and role of derivative product.

It is important to understand why commodity derivatives are required and the role they can play in risk management. It is common knowledge that prices of commodities, metals, shares and currencies fluctuate over time. The possibility of adverse price changes in future creates risk for businesses.

Derivatives are used to reduce or eliminate price risk arising from unforeseen price changes. A derivative is a financial contract whose price depends on, or is derived from, the price of another asset. Two important derivatives are futures and options. [19]

FUTURE PROSPECTS

After the setting up of first commodity derivative exchange in 2002 our markets have travelled a long distance. While only 8 commodities were allowed for futures trading in 2000 the figure increased to 80 in 2003-04 and market size increased from 1 trillion USD in 2006 from 3trillion in 2009.

COMMODITY OPTIONS:

Trading in commodity options contracts has been banned since 1952. The market for commodity derivatives cannot be called complete without the presence of this important derivative. Both futures and options are necessary for the healthy growth of the market. While futures contracts help a participant (say a farmer) to hedge against downside price movements, it does not allow him to reap the benefits of an increase in prices. No doubt there is an immediate need to bring about the necessary legal and regulatory changes to introduce commodity options trading in the country. The matter is said to be under the active consideration of the Government and the options trading may be introduced in the near future.

Like futures, options are also financial instruments used for hedging and speculation. The commodity option holder has the right, but not the obligation, to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date. Option contracts involve two parties - the seller of the option writes the option in favor of the buyer (holder) who pays a certain premium to the seller as a price for the option. There are two types of commodity options: a 'call' option gives the holder a right to buy a commodity at an agreed price, while a 'put' option gives the holder a right to sell a commodity at an agreed price on or before a specified date (called expiry date).

The option holder will exercise the option only if it is beneficial to him; otherwise he will let the option lapse. For example, suppose a farmer buys a put option to sell 100 Quintals of wheat at a price of $25 per quintal and pays a 'premium' of $0.5 per quintal (or a total of $50). If the price of wheat declines to say $20 before expiry, the farmer will exercise his option and sell his wheat at the agreed price of $25 per quintal. However, if the market price of wheat increases to say $30 per quintal, it would be advantageous for the farmer to sell it directly in the open market at the spot price, rather than exercise his option to sell at $25 per quintal. [20]

Weather Derivatives[21]

Introduction

A weather derivative contract may be termed as a financial weather dependent contract whose payoff will be determined by future weather events. The settlement value of these weather events associated with a particular instrument is determined from a weather index, expressed as values of a weather variable measured at a stated location at a particular time.These derivatives are financial instruments that can be used by organizations or individuals to reduce the risk associated with adverse or unexpected weather outcomes. The difference from other derivatives is that the associated asset (rain/temperature/snow) has no direct value to price the weather derivative. Weather Derivatives can be an important tool to hedge against losses occurring from uncertain weather conditions and can help reduce the impact of adverse weather on a company's profitability.

Concept of Weather Derivative

The first transaction in the weather derivatives took place in 1997 in the U.S. The first exchange traded weather derivative trading was done on September 22, 1999 at the Chicago Mercantile Exchange. These Derivatives are unique in many ways. The primary being, there is no physical underlying asset. The underlying asset is the weather change. The values of weather derivatives arecalculated based on a centralized weather index. The index can be represented either as a Heating Degree Day (HDD) or a Cooling Degree Day (CDD). A Heating Degree Day (HDD) is the difference between a baseline temperature and the average temperature for a day in winters. A Cooling Degree Day (CDD) is the temperature difference between the average temperature for a day and a baseline temperature in summers. The baseline temperature is fixed as 65oFahrenheit in the U.S and 18oCelsius in Europe. The Earth Satellite Corporation, an independent organisation, calculates HDD and CDD index ensuring transparency in the benchmark.

Utility of Weather Derivatives

Let's take a farmer growing Wheat in a village in Rajasthan. He is worried due to the expectations of low rainfall in the state this year. He usually produces 1000 quintals of Wheat in his farm but this year, he thinks the production will drop to 800 quintals. The Minimum Support Price for Wheat is Rs. 1000 per quintal. This means that the farmer fears losing Rs 2,00,000 this season due to poor rainfall. If the farmer had knowledge and access to weather derivatives in India, he could have bought or sold (depending on the future outlook for rainfall) rain day futures contracts today and entered into an equal but opposite contract at a later date, making a profit on the transaction, thus offsetting the losses due to low volumes produced.Apart from using weather derivative for hedging risk against adverse weather conditions it can also be used as the mode of trading in derivatives.

Beneficiaries Of Weather Derivatives

Any company or profession whose revenue is affected by weather changes has a potential need for weather derivatives. Some of these industries include -

  • Agriculture
  • Soft drinks and confectionery retailers
  • Hotels and leisure industry
  • Sports
  • Engineering and construction industry
  • Energy producers and distributors
  • Insurance, re-insurance companies
  • Banks and financial institutions
  • Breweries, pubs and restaurants
  • Transport and distribution companies

Weather Derivatives in India

India is a country where still agriculture is the major source of income for majority of the population. Agriculture and the related industries support around 60% of Indian population. According to the economic survey agriculture contributes more than 25% of the total GDP of India. But the Indian agriculture performance is still dependent heavily on the south west monsoons. Every year a lot of crops get destroyed because of floods or draught. But it still doesn't have an efficient irrigation system to support its farmers. The south west monsoon is very important to the agriculture performance of India. Hence Weather Derivatives have a good scope and it is most likely that weather derivatives in India should have the monsoon or rainfall as their underlying.

Weather instrument trading in India has a long way to go. Until and unless the regulatory bodies allow trading on intangibles such as rain in financial markets, weather trading will be a dream. Even if the bill is passed and weather instruments are traded on the exchange a very strong infrastructure is required so as to have a far reaching effect. Farmers from each and every part of the country should be able to hedge of their risks. This can be done with proper programs through the local Gram Panchayats and e-choupals. Farmers and traders should be given exposure and educated properly about the benefits of weather trading.

.In India ABN Amro Bank is exploring sales of weather derivatives and catastrophe bonds for the first time. The bank is talking to different companies in the beverage and cement sectors, to airlines and oil majors to get them interested in the product.

CREDIT DERIVATIVES IN INDIA

Credit derivatives are over the counter financial contracts. They are usually defined as "off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling the asset". It, therefore, "unbundles" credit risk from the credit instrument and trades it separately.[22]

Types of credit derivatives

The Credit Default Swaps (CDS)

CDS have grown rapidly in the credit risk market since their introduction in the early 1990s. It is believed that current usage is but a small fraction of what it will ultimately represent in the credit risk markets. In particular, the CDS market will become as central to the management of credit risk as the interest rate swap market is to the management of market risk.

The Credit-Linked Note (CLN)

CLN market is one of the fastest growing areas in the credit derivatives sector. It is, a combination of a regular note (bond or deposit) and a credit-option. Since it is a regular note with coupon, maturity and redemption, it is an on-balance sheet equivalent of a credit default swap. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk and investors a higher yield for buying a credit exposure synthetically rather than buying it in the publicly traded debt.

Credit Linked Deposits (CLDs)

CLD are structured deposits with embedded default swaps. Conceptually they can be thought of as deposits along with a default swap that the investor sells to the deposit taker. The default contingency can be based on a variety of underlying assets, including a specific corporate loan or security, a portfolio of loans or securities or sovereign debt instruments, or even a portfolio of contracts which give rise to credit exposure. If necessary, the structure can include an interest rate or foreign exchange swap to create cash flows required by investor.

Collateralised Debt Obligations (CDOs)

CDOs are specialized repackaged offerings that typically involve a large portfolio of credits. Both involve issuance of debt by a SPV based on collateral of underlying credit(s). The essential difference between a repackaging programme and a CDO is that while a simple repackaging usually delivers the entire risk inherent in the underlying collateral (securities and derivatives) to the investor, a CDO involves a horizontal splitting of that risk and categorizing investors into senior class debt, mezzanine classes and a junior debt. CDO may be subject to local debt registration / regulatory requirements.

Need and Scope for Credit Derivatives in India

Credit risk requires an effective transmission mechanism. It is now imperative that a mechanism be developed that will allow for an efficient and cost effective transmission of credit risk amongst market participants. The current architecture of the financial market is either characterized by lumpiness in credit risk with the banks and development financial institutions (DFIs) or lack of access to credit market by mutual funds, insurance companies, etc.

The major hedging mechanism now available with banks and DFIs to hedge credit risk is to sell the loan asset or the debentures it holds. Banks and Development Financial Institutions require a mechanism that would allow them to provide long term financing without taking the credit risk if they so desire. They could also like to assume credit risk in certain sectors / obligors.

On the other side, investors, including banks and DFIs, would also be looking for additional yields. In an environment of declining yields, investors would welcome mechanisms where they can earn an additional yield by taking on credit risk. There exists now in India an investor base, which can be segmented along tenor lines.

Credit derivatives will give substantial benefits to all kinds of participants, including the financial system as a whole, such as:

Banks would stand to benefit from credit derivatives mainly due to two reasons - efficient utilisation of capital and flexibility in developing/ managing a target risk portfolio.

Currently, banks in India face two broad sets of issues on the credit leg of their asset - blockage of capital and loss of opportunities, for example:

  1. Banks generally retain assets - and hence, credit risk - till maturity. This results in a blocking up of bank's capital and impairs growth through churning of assets.
  2. Due to exposure norms that restrict concentration of credit risk on their books, banks are forced to forego attractive opportunities on existing relationships.

Credit derivatives would help resolve these issues. Banks and the financial institutions derive four main benefits from credit derivatives:

Credit derivatives allow banks to transfer credit risk and hence free up capital, which can be used in productive opportunities.

Banks can conduct business on existing client relationships in excess of exposure norms and transfer away the risks.

SOME OTHER INNOVATIVE CONCEPTS IN FINANCIAL MARKET

Innovative Financial Instruments for Natural Disaster Risk Management

Natural disasters can cause immense damages to people, their productive assets and the overall economic infrastructure of entire regions. This may have adverse effects on economic development when catastrophic natural events strike densely populated areas with high concentrations of economic assets. The patterns are recognizable across the world, but the economic effects have been most prominent in developing countries where human and social vulnerability is high. Due to better risk mitigation and insurance coverage the socioeconomic consequences are generally less dramatic in developing countries.

Major losses happened in the world in the recent past.

As conditions for the reinsurance of catastrophe risk exposure continued to tighten in the mid-1990s, there was a search for alternative financial structures to transfer catastrophe risk. With a finite reinsurance capacity, insurance companies looked toward the large global capital market for takers of catastrophe risk exposures.

The first capital market instrument that is linked to catastrophe risk was placed in the capital market in 1994 when Kover, a captive of Hannover Re, issued a US$85 million catastrophe bond linked to worldwide property losses due to catastrophes. Since this inaugural transaction, many other risk linked securities transactions have followed, amounting to a total coverage of around US$6 billion. The market for disaster risk-linked securities is now well established.

The Catastrophe Risk Exchange (CATEX) was established in early 1996 in US as an Internet-based business-to-business exchange for all types of insurance contracts and related risk management products. CATEX does not trade standardized futures and options contracts but provides a technology platform that allows multinational institutions to post particular insurance needs to a wide international audience of insurance and reinsurance companies.

Through the issuance of catastrophe risk linked bonds, generally referred to as cat-bonds, the issuer (typically an insurance or reinsurance company) was able to obtain coverage for particular exposures (e.g., property damage, auto liability, etc.), in case of predefined catastrophic events, such as windstorms, hurricanes and earthquakes. The new catastrophe risk transfer opportunities have primarily been exploited by insurance and reinsurance companies as a way to obtain complementary coverage in the capital market.

The risk transfer characteristics of cat-bonds can be replicated through a mechanism called catastrophe risk swaps. In the risk swap the cedant makes fixed payments equal to the premiums paid in a cat-bond structure against receipt of claims compensation in case losses occur (indemnity basis). Just like the risk-linked securities, the catastrophe risk swap can be based on different types of triggers such as indemnity losses, loss indices, physical indicators, or parametric formulas.

The eventual choice of risk transfer mechanism is influenced by the characteristics of the financial instruments and their implications for moral hazard, adverse selection, basis risk and credit risk exposures.

We can see the above diagram that the process of catastrophe risk transfer which shows the combination Traditional Insurance process to mitigate the risk and also the combination of securitization process which gives the investors to invest in the risk at a return that is the premium paid by the insured.

Financial Development Index[23]

There have been attempts to measure financial development of economies using different sets of indicators. The indicators traditionally used include monetary measures (such as narrow money to GDP, central bank domestic credit as percentage of GDP, money multiplier etc), financial institutions assets to GDP, stock market liquidity, regulation and supervision of banks, coverage and structure of deposit insurance schemes, indicators of barriers to banking access in developing and developed countries etc. However, there was hardly an attempt made to develop a comprehensive index of financial development.

In a recent development, the International Financial Cooperation of the World Bank Group commenced publishing a "Doing Business Database" for over 183 countries since 2003. This Database provides a quantitative measure of regulations for starting a business, dealing with construction permits, employing workers, registering property, getting credit, protecting investors, paying taxes, trading across borders, enforcing contracts and closing a business- as they apply to domestic small and medium-size enterprises. A fundamental premise of Doing Business is that economic activity requires good rules.

In another attempt to measure financial development, an occasional paper of the European Central Bank, brought out in April 20091, constructs composite indices to measure domestic financial development in 26 emerging economies for 2008. The study uses 22 variables, grouped according to three broad dimensions:

  1. institutions and regulations;
  2. size of and access to financial markets and (iii) market performance. According to this index, South Korea is ranked 6 among 30 countries, China 14 and India is at the position 22. This paper finds that India performed relatively better as regards its financial markets and non-bank institutions, but requires improvements in the business environment as well as bigger and efficient banks.

The FDR recognizes that limitations also exist in the light of rapidly changing environment and the unique circumstances of some of the economies covered. Yet, in its attempt to establish a comprehensive framework and a means for benchmarking, it provides a useful starting point. The Report is unique in the comprehensiveness of the framework it provides and the richness of relevant data it brings to bear on financial system development.

"One of the reasons this crisis could take place is that while many agencies and regulators were responsible for overseeing individual financial firms and their subsidiaries, no one was responsible for protecting the whole system from the kinds of risks that tied these firms to one another. Regulators were charged with seeing the trees, but not the forest. And even then, some firms that posed a so-called "systemic risk" were not regulated as strongly as others; they behaved like banks but chose to be regulated as insurance companies, or investment firms, or other entities that were under less scrutiny.

As a result, the failure of one firm threatened the viability of many others. The effect multiplied. There was no system in place that was prepared for this kind of outcome. And more importantly, no one has been charged with preventing it." The proposal of US Government is to create an oversight council, as put forward by President Obama, as follows:

"And even as we place the authority to regulate these large firms in the hands of the Federal Reserve - so that lines of responsibility and accountability are clear -- we will also create an oversight council to bring together regulators from across markets to coordinate and share information, to identify gaps in regulation, and to tackle issues that don't fit neatly into an organizational chart. We're going to bring everyone together to take a broader view -- and a longer view -- to solve problems in oversight before they can become crises."

Conclusion

There is unanimity in the opinion that India has come a long way on the path of development of its financial sector- deregulating, liberalizing and increasing competitiveness along the way. However, there is no room for complacency. The imperatives of changing time, technology and needs of the economy, require us to take further steps to build up on the financial sector's capabilities, already achieved, in the form of the next generation reforms. This would help our financial markets achieve their full potential growth. The CFSR aptly summarises the necessity of financial reforms as-"Financial sector reform is both a moral and economic imperative".

The starting point for the same could be working on the lines of recommendations of two important recent government committee reports, viz. HPEC on MIFC and CFSR.

Findings of the project

  • In India financial market majorly denotes equity markets.
  • Indian debt market is not well developed and still 80% of market is under Government securities.
  • Securitization has to be done on assets held by Banks.
  • Bond market needs a great consideration in terms of junk bonds
  • An effort can be made to develop Carbon Emission and National growth index.
  • Commodities Options should be developed in India.
  • Credit derivatives should be developed with consideration of all the possible types of Credit derivatives.
  • In a country with major income from Agriculture, Weather derivatives should be introduced to protect the interest of various involved parties.
  • To mitigate the Catastrophe hazards new technique for risk management should be introduced.
  • Financial development Index to measure the developments in various parameters to conclude growth in real terms.

CONCLUSION

Despite the accelerated industrial growth experienced this decade from recent economic reforms, most major investors around the globe do not yet see India as an ideal country for foreign investment. The competition for global capital will only get tougher in the years to come, and unless the political, judicial and economic environments are right, India will lag behind many other emerging nations. More importantly, the rising expectations of the middle-class, widening income and wealth inequalities between the haves and have-nots, require efficient initiatives from Government and corporate to attract and accommodate the funds available.

Variety of financial products like mutual funds, insurance, shares, debentures, derivative instruments, etc. are available in India. However, the reach of these products is very limited and the features of many of these products are very basic in nature. Further development and innovation in these products would be faster if they are accessed by all classes of investors in urban as well as rural areas. The thrust lies mainly on the development of new financial products to deepen the improvements in the product distribution itself. The responsibility of ensuring these improvements vests with all the stakeholders in the financial services industry

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Books

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