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Innovative Financial Instruments

Disclaimer: This work has been submitted by a student. This is not an example of the work written by our professional academic writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Wed, 28 Feb 2018

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 lon


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