FINANCIAL MARKETS IN INDIA

A Research Initiative

RAKESH SHAHANI
 CONTENTS'

. Preface to the Third Edition 13

Preface to the First Edition 15

1. NATURE AND ROLE OF FINANCIAL

MARKETS IN INDIA 17
Why are the financial markets important? 17
Difference between Financial Markets, Capital Markets
and Stock Markets 18
The Economy and Capital Markets Linkages 19
Bulls and Bears in Stock Markets 19
What affects stock markets? 20
Are Indian Markets Integrated with World Markets 21
Global Clue and the concept of coupling 23
Have the Indian Markets Matured? 25
India and the other emerging markets 30
Impact of the two recent Financial Crisis on World Markets 31
2. MATHEMATICAL AND BEHAVIOURAL ASPECTS
OF FINANCE WITH USEFUL APPLICATIONS 33
A Mathematical Aspects of Finance 33
B. Behavioural/Psychological Aspects of Finance 40
• Psychological aspects having direct bearing on
the stock markets 40
• Rationality and Decision Making by an Investor 46
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• Behavioural Concepts borrowed from principles

of nature 48
e Behavioural Concepts applicable to fund investing 48
• Other concepts in Behavioural Finance 49

3. THE PRIMARY MARKET FOR CORPORATE

SECURITIES IN INDIA 54
Mechanism in which Corporates Issue Securities 54
• Public Issue through Prospectus 54
c Offer for Sale • . - 57
» Placement Method ' 58
. • Rights Issue 60
e Book Building 60
o Disinvestment 65
« Employees Stock Option 70
• Preferential Issue of Shares 74
j • •

o Venture Capital 75
o Private Equity 80
« American Depository Receipt and Global
Depository Receipt (ADR/GDR) * 82
Performance of Primary Market in India (Recent Trends) 85
© From Controlled pricing to free pricing 85
o Institutional interest in the IPO/FPO 87
o How to measure the success of an IPO 88
"o Book Building vs. Fixed Price Offers 88
o 'Unscrupulous Promoters' 89
o The Corporate Debt Market in India 89
4. ROLE OF INVESTMENT AND MERCHANT
BANKING AS INTERMEDIARIES IN THE
FIELD OF FINANCIAL MARKETS 94
Merchant Banking vs. Investment Banking 99
A note on debenture trustees as intermediaries in
the issue of debt securities 101
The Rise of Investment Advisers in India 101
Investment B anking in India 102
Investment Banking in India and the sub prime crisis impact 102

5. STOCK MARKET VOLATILITY IN INDIA 104

Reasons for increase in volatility on Indian Stock Markets 106
 CONTENTS 7

Reasons for increase in the popularity of day trading

on Indian Exchanges 107
Steps taken by SEBI to control increased volatility 112

6. SECURITIES TRADING IN INDIA . 116

Selection of a Broker 116
Opening an account with a broker . 124
Placing an order for purchase or sale of shares 130
Preparing a contract note and specifying the choice of
delivery " 135
Settlement of contracts on a stock exchange 136

7. INDIAN STOCKMARKET INDICES 140

Indian Stock Indices 141
Constructing a stock market Index 144
Classification of securities to be included in the index 145
Other important indices other than the stock index 148
Maintenance problems with the index 148
Calculation of the value weighted index 151
Calculation of the price weighted index 152

8. FUTURES, OPTIONS AND OTHER FINANCIAL

DERIVATIVES 154
The Badla System . 154
Fall of Badla and switching to Options and Futures 156
The beginning of the derivatives trading on Indian Stock
. Exchanges 157
Types of Derivatives 158
Commodity Futures Trading in India 160
Commodity Transaction Tax 161
Other types of futures 162
Trading of Nifty Futures on Singapore Stock Exchange
(SGX) 163
Options 164
• Combination Strategies 170
» Neutralising the risk of a long position in a share 170
e Put Call Parity 171
o Straddle 174
o Collars 175
o Spread 175
8 CONTENTS .

Other Futures and Options Strategies 176

Option Pricing Models 179
• Binomial Model of Options Valuation . 180
• Black-Scholes Options Premium Valuation Model 182
Incorporating Cash Dividends in Black-Seholes Formula 186
B/S Model and Implied Volatility 187
Risks to an Option Writer 188
A Note on Open Interest 188
Options Trading on Stock Exchanges . 189
Swaps - 190
• Interest Rate Swaps 190
• Currency Swaps 191
• Swap broker arid Swap dealer 192
• Equity Swaps 193
Weather Derivatives . 194

9. COLLECTIVE INVESTMENT VEHICLES 196

Introduction 196.
The NAV of the Fund 197
Four distinct phases of mutual fund industry in India 198
Classification of Mutual Fund Schemes 200
Faith Based Funds 208
A note on hedge funds and arbitrage funds 208
A note on tracking error risk for passive index funds 210
A note on tactical asset allocation and rebalancing of
portfolios 210
A note on overseas investments by Indian Mutual Funds 211
Mutual Fund on Commodities 212
Mutual Fund Industry in India 213
Measuring Performance of Mutual Funds 214
A note on the systematic (market) risk and unsystematic '
(unique) risk and the roje of diversification 224
A note on the different Benchmarks available for mutual
funds 225
Malpractices by Mutual Funds 227
Steps taken by SEBI to control malpractices 236
Qualities of consistently strong fund managers 237
Portfolio management service (PMS) as an alternative
to investing in mutual funds 239
A note on individual investing vs. mutual funds 240
 CONTENTS 9

10. MONEY MARKET IN INDIA 244

Money market segments 245
• Call money market 245
• Treasury bill market 248
• Commercial paper market 250
• Certificate of deposit market 251
• Commercial bills market 252
A note on securities trading corporation of India (STCI) 254.
11. THE MARKET FOR GOVERNMENT SECURITIES
IN INDIA 256
A Market for Government Securities 258
• When issued market 259
• Secondary Market of GILTS: Wholesale and
the Retail Market 261
• Oversubscription and Devolvement of Govern-
ment Securities 266
• Fiscal Responsibility and Budget Management
Act 267
• TheRepos 268
• The Automatic Finance Facility vs. The Liquidity
Adjustment Facility 268
• Impact of the repo hike and its comparison with
Cash Reserve Ratio (CRR) 270
• Switch Deals 271
* State Government GILTS 272
• Merits and Demerits of holding Government
Securities by an Individual 274
• Benchmarking GILTS 276
• Corporate Bonds vs. GILTS 276
B. Valuation of Government Securities (including
Corporate Bond Valuation) 278
• Current Yield 278
• Holding Period Yield 278
. Yield to Maturity (YTM) 279
• Bonds with same maturity 281
C. Term structure of interest rates 283
• Yield Curve 288
• The Risk Structure of Interest Rates 290
. Default Risk 291
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• Partial payment 292

• Duration of a bond 294
• Duration and Modified Duration 300
• Bond Convexity • 302
• Interest Rate Immunization 304
o Rebalancing of Immunized Portfolios 308
12. FOREIGN INVESTMENT IN INDIA 312
What is Foreign Investment? 312
FDI ' . 314
The China Story . 316
Studies done by International Organisations 317
Remittances 320
Indo-China similarities 321
Portfolio investment in India 323
Socially Responsible Investing (SRI) and Shariah
Compliant FIIs * 325
Investment approach of FIIs over the years 326
FIIs are highly volatile 327
Games FIIs play . 328
Mechanism of Entry of FIIs in Indian Markets 330
e Direct Registration with SEBI 330
» Popularity of Participatory Notes 331
o Third Party sub accounts 332
Size of FII Investment in Indian Markets 333
FIIs in the Indian Debt Market 334
Tax Havens are one of the most favourite route of FIIs 334
How the FII Flows have undergone a change post sub
prime crisis 335
FDI vs. FII: The Distinction 337

13. THE CHANGING FACE OF BANKS AND

INSTITUTIONAL FINANCE IN INDIA 340
The March towards Universal Banking 340
Advantages of a Universal Bank . 341
Why Development Financial Institutions are converting
to banks? 341
IDBI: Journey from an Institution to a Bank 343
Changing face of B anks of India 346
A Note on New Initiatives by Public Sector Banks 349
 CONTENTS n.

A Note on the Strategic Alliance in Banks: An Alternative '

toM&A 356
Challenges of the Banks in the New Era 356
14. LIQUIDITY, TURNOVER AND IMPACT COSTS
OF INDIAN EXCHANGES 3 61
Liquidity 361
Transaction Costs 363
Spread and the Impact Costs 363
Turnover • . _- • . 364
Turnover Velocity • 365
15. LISTING AND DELISTING OF SECURITIES 367
Listing 367
Delisting: For and Against 369
Introduction of Reverse Book Building 369
Delisting Controversies and Complexities 373
Listing, Delisting and small companies 374
A note on open offers 375
Centralised Listing Authority 377
Problems Associated with regional stock exchanges 377
Traditional vs. Modern Stock Exchanges of India 381
A note on the International Stock Exchanges:
Reforming according to the needs of the hour 384
. Demutualisation of Stock Exchanges 385
The Competition amongst the major stockexchanges in
India 388
Alternate Trading System: A Threat to all the exchanges 389
16. MAJOR FINANCIAL SERVICES OPERATING IN
THE INDIAN FINANCIAL MARKETS 391
• • Credit Rating Services 391
. » Insurance Services 422
a Housing Finance 447
• Leasing and Hire Purchase Services 455
• Factoring 475
17. TOPICS OF RECENT INTEREST IN THE FIELD
OF FINANCIAL MARKETS 480
• Corporate Governance 480
• • Non Performing Assets (NPAs) in banking sector 491
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• Insider Trading 500

• Prime and Sub Prime Lending Rate, Benchmark PLR
and the Base Rate System of the Banking Sector " 506
• Financial Engineering: Issues and Challenges 511

Appendices 517
Selected References 561
Index 563