Hedge Funds Manoj and Sumanta

8/7/2019 Hedge Funds Manoj and Sumanta

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Hedge Funds its working requirement & itsimpact on Indian Capital Market

A Project Report

Under the guidance of

Prof. M.S. Rana

Submitted By

Manoj Kr. Dey & Sumanta Mondal

In partial fulfillment of the requirement

For the award of the degree

Of

MBA

In

Finance

March 2011


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Acknowledgement

We are very much Thankful to our Prof. M.S. Rana ( Project guide)

for giving opportunity and his guidance help us out through preparing this

report. He has provided us a valuable suggestions and excellence guidance

about this project which proved very helpful to us to utilize Theoretical

knowledge in Practical knowledge.

At last Iam also thankful to Prof. Poonam Arora who has help me

out for implementing the Two test in these project. I am also thankful to

my friends, to all known & unknown individuals who has given me their

consecutive advice, educative suggestion, encouragement, co-operation &

motivation to prepare these report.

I am highly obliged to my friends who helped and encouraged me in

my study. They have played a vital role in making this Masters degree a

very enjoyable experience.

Last but not the least I would like to thank God- The Almighty for

rendering all his blessings on me, which has helped me to achieve success

in whatever I have pursued in life and wish to continue doing so in the

future.

Manoj Kr. Dey:520952833

Sumanta Mondal:520952843


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Certified that this project report titled Hedge funds,

its working requirement & its impact on Indian

Capital Market is the bonafide work ofManoj Kr. Dey

& Sumanta Mondal who carried out the project work

under my supervision.

Signature: Signature:

Prof. B.N. Mehta Prof. M.S.Rana

HEAD OF THE DEPARTMENT FACULTY-IN- CHARGEIBMR Business School IBMR Business SchoolNear Asia school Near Asia SchoolDrive-in-road Drive-in-roadAhmedabad-380054 Ahmedbad-380054


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Examiner Certificate

The Project report of

Hedge Funds its working requirement & its impact on Indian

Capital Market

By

Manoj Kr. Dey (520952833)

Sumanta Mondal (520952843)

Accepted in Quality

Internal Examiner External Examiner

Signature: Signature:


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Executive summary

Hedge funds are an investment structure that manages a private

unregistered investment pool. They use several strategies like leveraging,

long, short and derivative positions to generate high returns and hedge

probable market risks. Hedge funds restrict their investment base to high

net worth individuals rather than allowing the general public to invest in

them.

By 2025 the Indian economy is projected to be about 60 per cent the

size of the US economy. This is due to major initiatives undertaken by the

Indian Government. One such effort was taken in 1993 when with the

notification of SEBI (Mutual Fund) Regulations; the asset management

business under private sector took its root in India. India today has much of

the necessary institutional framework for hedging, including a regulatory

regime and good information disclosure standards.

This study is written with an aim of providing a deeper insight into

hedge funds and their possible impacts on the Indian Capital Market.

Analysis has been done by using a Quantitative Research and using

Statistical techniques like chi-square and coefficient of correlation.

The main advantages or impact of Hedge funds in India are that they

bring in the much welcome volumes, and thus, liquidity in the market.

Moreover, as all market experts will concede, market liquidity leads to

better price discovery in the market.


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Table of Contents

1 INTRODUCTION :................................................................................................. 9

1.1 Objectiveofthestudy:............................................................................... 12

1.2 SCOPEOFTHESTUDY:................................................................................ 12

1.3 Rationaleofthestudy:............................................................................... 13

1.4 ListofHedgeFundinIndia:........................................................................ 14

1.5 InvestingofhedgefundsinIndia:.............................................................. 15

2 MAINBODYOFTHEPROJECT:............................................................................... 17

2.1 THEORIGINOFHEDGEFUNDS:.................................................................. 18

2.2 CHARACTERISTICSOFHEDGEFUNDS:........................................................ 19

2.3 HedgeFundsvs.MutualFunds:................................................................. 21

2.4 HOWTHEYWORK:...................................................................................... 22

2.5 STRATEGIESOFHEDGEFUNDS:.................................................................. 23

2.5.1 MarketTrend(Directional/Tactical)Strategies:............................ 24

2.5.2 EventDrivenStrategies:................................................................ 25

2.5.3 ArbitrageStrategies:..................................................................... 25

2.5.4 Fixed Income Arbitrage:............................................................... 26

2.5.5 Statistical Arbitrage:...................................................................... 26

2.6 HEDGEFUNDINVESTMENTACTIVITIESCOMPAREDTOTHOSEOF

REGISTEREDINVESTMENTCOMPANIES:............................................................... 26

2.7 LEVERAGE................................................................................................... 28

2.7.1 Background................................................................................... 28

2.7.2 Use of Leverage by Hedge Funds:................................................ 29

2.7.3 Use of Leverage by Registered Investment Companies:...............30

2.7.4 SHORT SELLING:....................................................................... 31

2.8 PERFORMANCE IN A PORTFOLIO CONTEXT:.................................. 33

2.9 Literature Review of the Indian Capital Market:....................................... 34

2.9.1 INTRODUCTION:........................................................................ 34

2.9.2 ISSUES AND PRIORTIES FOR INDIA:..................................... 35

2.9.3 SOME HIGHLIGHTS:................................................................. 38

2.10 HISTORY OF INDIAN CAPITAL MARKETS:...................................... 40


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2.11 DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS:................45

2.11.1 MUTUAL FUNDS........................................................................ 45

2.11.2 History: -....................................................................................... 46

2.11.3

FOREIGN INSTITUTIONAL INVESTOR:

................................

47

2.11.4 RETAIL INVESTORS:................................................................. 49

2.12 HEDGE FUNDS IN ASIA:........................................................................ 50

2.13 MARKET BENEFITS OF HEDGE FUNDS:............................................ 51

2.14 HEDGE FUNDS IN INDIA:...................................................................... 53

2.15 PARTICIPATORY NOTES:..................................................................... 56

2.16 WHY HEDGE FUNDS ARE LOOKING AT INDIA:.............................. 57

2.17 ADVANTAGE INDIA:............................................................................ 58

2.18 THE RISKS ASSOCIATED WITH HEDGE FUNDS:............................. 58

2.18.1 MARKET RISK: COMPONENTS:.............................................. 60

2.18.2 EQUITY RISK:............................................................................. 61

2.18.3 Volatility risk:............................................................................... 62

2.18.4 CORRELATION RISK:............................................................... 63

2.18.5 COMMODITY RISK:................................................................... 63

2.18.6 CURRENCY RISK:...................................................................... 64

2.18.7

CREDIT RISK:

.............................................................................

65

2.18.8 LIQUIDITY RISK:....................................................................... 66

2.18.9 OPERATIONAL RISK:................................................................ 68

2.18.10MODEL RISK:............................................................................. 68

2.18.11HUMAN RISK:............................................................................ 69

2.19 RESEARCH DESIGN:.............................................................................. 70

2.19.1 INTRODUCTION:........................................................................ 70

2.19.2 RESEARCH METHODS:............................................................. 70

2.19.3 RESEARCH DESIGN:................................................................. 71

2.19.4 STATEMENT OF THE PROBLEM:........................................... 71

2.19.5 LIMITATIONS OF THE STUDY:............................................... 72

3 ANALYSIS&INTERPRETATION............................................................................... 73

3.1 CORRELATIONBETWEENHEDGEFUNDINFLOWSANDSENSEXRETURNS:75


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3.2 ESTABLISHING A RELATIONSHIP BETWEEN THE FINANCIAL

CRISIS AND HEDGE FUND PERFORMANCE:............................................... 89

3.3 SUMMARYOFFINDINGS:........................................................................... 95

3.4 SUGGESTIONS:..................................................................................... 101

3.5 CONCLUSION:....................................................................................... 103

4 BIBLIOGRAPHY:.............................................................................................. 104

5 INDEX................................................................................................................... 105

List of Figures:

Figure1:HowtheyWork............................................................................................................ 22

Figure2:WorkingofMutual Fund............................................................................................. 45

Figure3:RiskGalaxy.................................................................................................................. 59

Figure4:marketrisk................................................................................................................... 60

Figure5:InternalRatereturn..................................................................................................... 60

Figure6:Equityrisk..................................................................................................................... 61

Figure7:Commodityrisk............................................................................................................ 63

Figure7:OperationalRisk........................................................................................................... 68

Figure8:BarDaigram2003........................................................................................................ 77

Figure9:BarDaigram2004........................................................................................................ 80

Figure10:BarDaigram2005...................................................................................................... 82

Figure11;Bardaigram2006....................................................................................................... 85

List of Tables:

Table1:HedgefundvsMutualfund........................................................................................... 21

Table 2 : Flow of Hedge Funds from 2003 and SENSEX return for the corresponding year....76

Table3:Hedgefundsinflow&sensexreturnfortheyearApr03toApr04............................. 78

Table4:Hedgefundsinflow&sensexreturnfortheyear2004................................................ 79

Table5:Hedgefundsinflow&sensexreturnforthefinancialyearApr04toMar05..............80

Table6:Hedgefundinflow&sensexreturnfortheyear2005................................................. 81

Table7:Hedgefundinflow&sensexreturnforthefinancialyearApr05toMar06...............83

Table8:Hedgefund&sensexreturnfortheyear2006............................................................ 84

Table9:Hedgefund&sensexreturnforthefinancialyearApr06toMar07............................ 85


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1 INTRODUCTION :

A hedge fund can be defined as an investment structure that managesa private unregistered investment pool and compensates the fund

manager with an incentive-based fee based on a percentage of the profits

earned by the fund (Nicolas J.G).

Hedge fund is an aggressively managed portfolio of investments that

uses advanced investment strategies such as leverage, long, short and

derivative positions in both domestic and international markets with thegoal of generating high returns.

Legally, hedge funds are most often set up as private investment

partnerships that are open to a limited number of investors and require a

very large initial minimum investment. Investments in hedge funds are

illiquid as they often require investors to keep their money in the fund for a

minimum period of at least one year.

They are typically organized as private partnerships and often

located offshore, thus, saving on tax and regulatory issues. Also, the initial

high investments and illiquid nature of funds keeps a check on the

investment in hedge funds.

Hedge funds, in general, are not registered. They have avoidedregistration by limiting the number of investors and requiring that their

investors meet an income or a net worth standard. Furthermore, hedge

funds are also prohibited from soliciting or advertising to the general


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audience. The primary aim of most hedge funds is to reduce volatility and

risk while attempting to preserve capital, and deliver positive returns under

all market conditions.

For present purposes, 3 main classes of hedge funds can be identified: -

Macro Funds, which take large unhedged positions in national markets

based on top-down analysis of macroeconomic and financial conditions.

These funds take position in either mature or key emerging markets. They

spread their holdings across equities, bonds and currencies.

Some long-established macro funds find it Cheaper to use

conventional forwards and futures to take positions ahead of the market

moves they foresee. Some newer macro funds pursue more specialized

trading strategies using complex derivative securities.

A fund of this type might take a long position in a currency that is

undervalued and an equal, short position in another currency that is

overvalued.

Global Funds:Which also take positions worldwide, but employ bottom-

up analysis, picking stocks on the basis of individual companies' prospects.

Relative Value Funds:Which take bets on the relative prices ofclosely related securities (treasury bills and bonds, for example). They limit

their holdings to the mature markets, because their expertise is limited to

those markets. Relative value funds are also inclined to use derivatives.


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Hedge funds are investment pools employing sophisticated trading

and arbitrage techniques including leverage and short selling, wide usage

of derivative securities etc.

Generally, hedge funds restrict share ownership to high net worth

individuals and institutions, and do not offer their securities to the general

public. Some hedge funds are limited to 100 investors.

This private nature of hedge funds has resulted in few regulations

and disclosure requirements, compared for example, with mutual funds.

Also, the hedge funds may take advantage of specialized, risk-seeking

investment and trading strategies, which other investment vehicles are not

allowed to use.

Hedge funds are subject to far fewer regulations than other pooled

investment vehicles, especially to regulations designed to protect investors.

This applies to such regulations as regulations on liquidity,

requirements that funds shares must be redeemable at any time,Protecting

conflicts of interests, assuring fairness of pricing of fund shares, disclosure

requirements, limiting usage of leverage, short selling etc. This is a

consequence of the fact that hedge funds investors qualify as sophisticated

high-income individuals and institutions.

Hedge funds offer their securities as private placements, on

individual basis, rather than through public advertisement, which allows

them to avoid disclosing publicly their financial performance or asset

positions.


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However, hedge funds must provide to investors some information

about their activity, and of course, they are subject to statutes governing

fraud and other criminal activities.

For e.g. controversies and frauds surrounding hedge funds seem to

deal with the issue of transparency, today such controversy has run into a

cul de sac, or dead end, because transparency of hedge funds have

increased to the point that one can log into hedge fund information portals

and examine up to date information on hedge fund data.

1.1 Objective of the study: Comparision between Hedge funds & Mutual funds. To study Hedge fund investment Strategies. Impact on Hedge Funds investments in Indian Capital Market. How Hedge funds work in Indian Capital Market.

1.2 SCOPE OF THE STUDY:Though there is a large number of players who are active in the Indian

Capital markets and many Indices which can be taken as benchmark for

comparison, only one index SENSEX is taken into consideration, to reduce

the complexity of analysis.


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Though there are many financial crisis that has resulted in financial

world only four main crisis has been taken into consideration because of

not availability of enough data.

Study has been limited to only Indian Capital markets, though Hedge

Funds has a direct impact on the whole financial system of the country.

1.3 Rationale of the study:These project is based on fundamental analysis, technical analysis &

efficient market hypothesis.

It helps pool assets with those of other investors in managing theirportfolio to give good return

It help with prudent fund hedging.

It is a method to access the alternative statement investmentstrategies used by the manager.

It helps in liquidity management.


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1.4 List of Hedge Fund in India:Hudson Fairfax Group (HFG) Private Equity.

Avatar Investment Management (AIM) Private Equity. India Deep Value Fund Long Term Investments in Capital Markets

and Real Estate.

Heritage Capital India Long-short Equity.

Fair Value Capital Traditional Investment Approach, Event-basedinvestments.

India Capital Fund Multi-strategy.

Monsoon Capital Indian Equities Investments

Karma Capital Indian Equities Investments.

Atlanta Capital Investment in Indian Equities and Precious Metals.

Baer Capital Partners Private Equity, Equity Investments.

Brahma Capital Board Asset Management.

Eight Capital Alternative Investments.


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EM Capital Management Emerging Markets.

Evolvence Capital Alternative Investments.

Jina Ventures Private Equity, M&A.

Och-ZiffAlternative Investments.

Sandstone Capital Equity Investments. Fulcrum Investment Group, LLC Alternative Investments.

Greenwich Advisors Diversified Indian markets.

1.5 Investing of hedge funds in India:Prior to finalizing investment, take couple of months to know about

the hedge fund industry in India. The age of hedge fund industry, the

key players, their worth, the operational risks, the pros and cons of

investing in hedge funds etc.

Identify potential hedge funds, refer commercial directories ordatabases. Account for your investment goals, risk tolerance level,

amount allocated for investment.


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Get to understand the ground realities of regulatory factors, itsimplications, how business is run in India all helps.

Read blogs, financial magazines, websites, news articles, whitepapers on hedge funds in India. Talk to personnel; preferably interact

with hedge fund managers involved with hedge fund investments

and those who have already invested in hedge funds.

Notice annual events like Hedge funds world India to gain anassessment of the burgeoning Indian hedge fund industry.

Approach wealth manager in wealth management companies,securities broker or licensed investment consultant for advice on

hedge fund investments in India.

Understand terms related to hedge funds, remittance, managementfee and performance fee, withdrawal and redemption fees.

Check the pros and cons of long-term hedge funds vs. short-termhedge funds.

Ensure your activities are that of an accredited investor (with a networth of more than $1 million).

Involve financial advisor in the process of investing in hedge fundsin India.


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Chapter: -

2MAINBODYOFTHEPROJECT:


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2.1 THE ORIGIN OF HEDGE FUNDS:The year was 1949, WWII just ended, and the world was in a unified

celebration. Alfred Winslow Jones, a sociologist, was working on

assignment for Fortune magazine investigating fundamental and technical

research on forecasting the stock market. The article reported on a new

class of stock market timers, in addition to unorthodox methods of

investing, all to achieve positive returns and call the market. Jones was

very intrigued by these trading methods and became absolutely consumed

with his own concept of an investment fund.

Prior to the release of his Fortune article, Jones setup an investment

fund with himself as general partner. The fund was designed as a market-

neutral strategy, whereby the long positions in undervalued equities would

be offset by short positions in others.

This hedged position would allow capital to be leveraged, while

also enabling large wagers to be made with limited resources. Another

genius feature was having an incentive fee amounting to 20% of any

realized profits or gains with no fixed fees.

However, Jones greatest notoriety stems from his innovation that

specific limited partnerships, if structured correctly, are exempt from

regulatory control under the Investment Company Act of 1940.

This exemption allows managers to utilize techniques, such as

leverage and short-selling which typically binds other mutual funds and


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investment companies. Consequently, many copy -cats mimicked the fee

structure, but not the hedge mentality and philosophy that Jones inspired.

It was not until another Fortune magazine article, in 1966, which branded

the market-neutral strategy that Jones designed as a hedge fund.

2.2 CHARACTERISTICS OF HEDGE FUNDS:Although financial service providers, regulators and the media

commonly refer to hedge funds, the term has no precise legal or

universally accepted definition. The term generally identifies an entity that

holds a pool of securities and perhaps other assets that does not register its

securities offerings under the Securities Act and which is not registered as

an investment company under the Investment Company Act.

Hedge funds are also characterized by their fee structure, which

compensates the adviser based upon a percentage of the hedge funds

capital gains and capital appreciation. Hedge fund advisory personnel ofteninvest significant amounts of their own money into the hedge funds that

they manage.

Schneeweis, Spurgin and Karavas (2001) suggest that an allocation

of 10 to 20% to hedge funds optimally improves traditional portfolio

performance. The investment goals of hedge funds vary among funds, but

many hedge funds seek to achieve a positive, absolute return rather than

measuring their performance against a securities index or other benchmark.

This does not mean however that all hedge funds have comparable

risk and return characteristics. In reality, there exists a variety of trading


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strategies that determine the funds risk and return profiles. Improperly

included, an allocation to hedge funds can have disastrous consequences

(Soueissy, M. & Sidani, R).

Hedge funds utilize a number of different investment styles and

strategies and invest in a wide variety of financial instruments. Hedge

funds invest in equity and fixed income securities, currencies, over-the-

counter derivatives, futures contracts and other assets.

Some hedge funds may take on substantial leverage, sell securities

short and employ certain hedging and arbitrage strategies. Hedge funds

typically engage one or more broker-dealers to provide a variety of

services, including trade clearance and settlement, financing and custody

services.

Hedge funds often provide markets and investors with substantial

benefits. For example, based on our observations, many hedge funds take

speculative, value-driven trading positions based on extensive research

about the value of a security. These positions can enhance liquidity and

contribute to market efficiency.

In addition, hedge funds offer investors an important risk

management tool by providing valuable portfolio diversification because

hedge fund returns in many cases are not correlated to the broader debt and

equity markets. On the other hand as Jeremy Siegel at Wharton Business

School(2005) pointed out that there is a risk that many hedge funds

making similar bets could suffer bigger losses all at once ,damaging other

investors.


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2.3 Hedge Funds vs. Mutual Funds:Hedge funds are institutional investors, just like mutual funds.

However, this is where the similarity ends. Typically, only high net worth

individuals and institutions invest in hedge funds, while mutual funds are

the main investment vehicle of the small and retail investors. Additionally,

mutual funds are highly regulated institutions that file a lot of information

like inflows and outflows, breakup of investments and other statutory

details with the regulatory authority.

Table 1: Hedge fund vs Mutual fund

Feature Mutual Fund Hedge Fund

Number ofowners

Very large (in thousands)Few high net worthindividuals or institutions

RegulationRegulated strictly by thecapital markets regulator

Minimum regulation

Transparency

Publishes annual reports

and monthly informationsheets that showinvestment and profits

Information given only toinvestors. Not accountableto any other body

InvestmentStyle

Invests in equity, debt andderivatives, but follows along strategy

Follows many investmentstrategies, including goingshort on some securities

Management

Fees

Fee not linked toperformance. Usually a

percentage of assetsmanaged

Fee linked to performance-

managers charge a highpercentage of profits made


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2.4 HOW THEY WORK:To achieve pre-set returns target, these funds do not restrict themselves to

their country of origin and operate on a global scale. Hedge fund managers

typically seek absolute positive investment performance. This means that,

the hedge funds target a specific range of performance, and attempt to

produce targeted returns irrespective of the stock market trends.

This is in contrast to investments by mutual funds, where success or

failure is often measured in terms of performance in relation to a stock

index, like the Sensex or Nifty in India.

Figure 1: How they Work


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For investors, this structure-

1. Helps pool assets with those of other investors.

2. Is a way to access talented hedge fund managers

3. Is a method to access the alternative investment strategies used by the

manager.

To achieve this "absolute return", hedge fund managers have the

flexibility to incorporate different strategies and techniques that may

include:

Short-selling: Sale of a security that you do not own, with the anticipation

of purchasing it in the future, at a reduced cost.

Arbitrage: Simultaneous buying and selling of a financial instrument in

different markets to profit from the difference between the prices

Hedging: Buying/selling a security to offset a potential loss on an

investment.

Leverage: Borrowing money for investment purposes.

2.5 STRATEGIES OF HEDGE FUNDS:Hedge funds do not constitute a homogeneous asset class. The bulk

of hedge funds describe themselves as long / short equity, perhaps because

this is the least specific of the available descriptions, but many different

approaches are used taking different exposures, exploiting different market


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opportunities, using different techniques and different instruments: Hedge

funds use a wide variety of investment styles and strategies.

Even among hedge funds that claim to use the same investment

strategy or invest within the same asset class, there is a wide range of

investment activities, performance and risk levels. Because the investment

activities of hedge funds are so diverse, the hedge funds assigned to a

particular investment category are likely to exhibit less similarity than more

traditional investment vehicles, such as registered investment companies.

Although classification systems vary, hedge funds may generally be

classified according to broad style and strategy categories, including:

2.5.1 Market Trend (Directional/Tactical) Strategies:Macro:

These funds may take positions in currencies (often unhedged) based

on their opinion of various countries' macroeconomic fundamentals.

For example, if a country's economic policies look inconsistent and

its ability to sustain its exchange rate appears questionable, macro funds

may take positions designed to profit from devaluation, usually by selling

the currency short.


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Long/Short:

(includes sector and market neutral/relative value funds): These funds try

to exploit perceived anomalies in the prices of securities. For example, a

hedge fund may buy bonds that it believes to be under priced and sell short

bonds that it believes to be overpriced.

No matter what happens to overall interest rates, as long as the

spread between the two narrows, the fund profits. Conversely, if spreads

widen, gains can turn quickly into losses. Long/short equity is the most

frequently used strategy among hedge funds.

2.5.2 Event-Driven Strategies:Distressed Securities:

These funds may take long and/or short positions to attempt to profit from

pricing anomalies among securities issued by companies going through

bankruptcy or reorganization.

Risk/Merger Arbitrage:

These funds attempt to profit from pending merger transactions by, for

example, taking a long position in the stock of the company to be acquired

in a merger, leverage buyout or takeover and simultaneously taking a short

position in the stock of the acquiring company.

2.5.3 Arbitrage Strategies:Convertible Arbitrage: This strategy involves taking long positions in a

company's convertible bonds, preferred stock, or warrants that are deemed


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to be undervalued while taking short positions in the company's common

stock.

2.5.4 Fixed Income Arbitrage:Hedge funds in this category seek to provide stable, positive returns by

exploiting the relatively small pricing inefficiencies of fixed income

instruments.

For example, a newly issued (on the run) 10-year Treasury bond

may trade at a slightly higher price than a similar previously issued (off-

the-run) 10-year Treasury bond. A hedge fund may seek to profit from

this disparity by purchasing off-the-run Treasuries and selling on-the-run

Treasuries short.

2.5.5 Statistical Arbitrage:Funds in this category attempt to profit from pricing inefficiencies

identified through the use of mathematical models. Statistical arbitrage

attempts to profit from the likelihood that prices will trend toward a

historical norm.

2.6 HEDGE FUND INVESTMENT ACTIVITIES COMPARED TOTHOSE OF REGISTERED INVESTMENT COMPANIES:

As discussed, registered investment companies typically seek

positive returns compared to the performance of a particular asset class or

index (benchmark). Websters dictionary defines a benchmark as a

standard or point of reference in measuring or judging quality, value etc.


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Thus, in a declining market, a registered investment company may

be considered successful even if it loses money, so long as the company

outperforms its benchmark (i.e., its relative return is positive). In a rising

market the registered investment company may be considered unsuccessful

if the company, though profitable, underperforms the benchmark (i.e., its

relative return is negative).

In brief, in the relative return paradigm, downside risk means the risk

of failing to perform as well as the benchmark. In contrast, a hedge fund

that utilizes an absolute return strategy may be considered successful only

if it is profitable in both rising and declining markets.

In the absolute return paradigm, downside risk means the risk of

failing to make money.

Registered investment companies generally have less flexibility to

change their investment objectives than do most hedge funds.

As a result, these funds provide investors with greater certainty ofthe risks their advisers will take, but provide their advisers with a

diminished ability to take alternative investment approaches when market

conditions change.


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2.7 LEVERAGE:2.7.1 Background

Goldman Sachs (2000) extend their previous study to new data and

believe that hedge funds pursue a variety of investment strategies as well as

employ differing degrees of leverage. Leverage is an important component

of many hedge fund investment strategies.

Leverage can be defined in numerous ways. As a general matter,

however, leverage, can be viewed as a means of potentially increasing an

investments value or return without increasing the amount invested.

Although leverage historically was obtained primarily by purchasing

securities with borrowed money, today futures, options and other derivative

contracts may be a major source of leverage.

The use of leverage may have a significant impact on investment

results because, while it may enhance investment gains, it may also

magnify investment losses. Leverage also may increase the risk caused by

holding assets that are illiquid or whose full value cannot be realized in a

quick sale.


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2.7.2 Use of Leverage by Hedge Funds:The degree to which a hedge fund uses leverage depends largely on

its investment strategy. Macro funds and funds that attempt to capitalize

on small inefficiencies in relative values (e.g., fixed income arbitrage and

statistical arbitrage) are more likely to engage in leverage and to take more

highly leveraged positions than are hedge funds that use other investment

strategies, such as investing in distressed securities situations.

A hedge funds limitation on its use of leverage is often dictated by

any margin or collateral requirements imposed on lenders or on others

(e.g., broker-dealers), and the willingness of lenders or other counterparties

to provide it with credit.

For example, a broker-dealer extending credit to a hedge fund in

connection with a short sale would have to comply with Regulation T

issued by the Board of Governors of the Federal Reserve System.

The hedge fund could also be required to provide additional

maintenance margin for transactions in short sales under marginrequirements imposed by self-regulatory organizations.


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2.7.3 Use of Leverage by Registered Investment Companies:Although registered investment companies may use leverage and sell

short, their ability to use these tools is more limited than is the case with

hedge funds.

For example, the Investment Company Act generally allows open-

end investment companies to leverage themselves only by borrowing from

a bank, and provided that the borrowing is subject to 300 percent asset

coverage. Closed-end investment companies are subject to less restrictive

limits.

The Commission and staff have applied the Investment Company

Act provisions governing use of leverage to permit registered investment

companies to engage in certain transactions involving leverage (senior

security transactions), generally, however, only if the registered fund

covers the transaction by setting aside liquid assets in an amount equal

tothe potential liability or exposure created by the transaction.

A registered investment companys board of directors has certain

responsibilities in connection with the companys use of leverage, and

information about the characteristics and risks of permitted leverage

transactions must be disclosed to investors in fund prospectuses.


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2.7.4 SHORT SELLING:A short sale is the sale of a security that the seller does not own or a

sale that is consummated by the delivery of a security borrowed by, or for

the account of, the seller. In order to deliver the security to the purchaser,

the short seller borrows the security, typically from a broker-dealer or an

institutional investor.

The short seller later closes out the position by returning the security

to the lender, typically by purchasing equivalent securities on the open

market, or by using an equivalent security that it already owns.

In general, short selling is utilized to profit from an expected

downward price movement, to provide liquidity in response to

unanticipated demand or to hedge the risk of a long position in the same or

a related security.

Short selling can provide the market with important benefits,

including market liquidity and pricing efficiency. Market liquidity is

provided through short selling by market professionals, such as market

makers (including specialists) and block petitioners, who offset temporary

imbalances in the supply and demand for securities.

Short sales affected in the market by securities professionals add to

the trading supply of stock available to purchasers and thus may reduce the

risk that the price paid by investors is artificially high.


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Short selling also can contribute to the pricing efficiency of the

markets. Efficient markets require that prices fully reflect all buy and sell

interest.

When a short seller speculates on or hedges against a downward

movement in a security, the transaction is a mirror image of the persons

who purchases the security based upon speculation that the securitys price

will rise or in order to hedge against such an increase. The strategies

primarily differ in the sequence of transactions.

Market participants who believe a stock is overvalued may engage in

short sales in an attempt to profit from a perceived divergence of prices

from true economic values. Such short sellers add to stock pricing

efficiency because their transactions inform the market of their evaluation

of future stock price performance. This evaluation is reflected in the

resulting market price of the security.

Although short selling serves useful market purposes, it also may be used

to manipulate stock prices. One example is the bear raid where an equity

security is sold short in an effort to drive down the price of the security by

creating an imbalance of sell-side interest.

Unrestricted short selling can also exacerbate a declining market in a

security by eliminating bids and causing a further reduction in the price of

a security by creating an appearance that the price is falling for

fundamental reasons.


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2.8 PERFORMANCE IN A PORTFOLIO CONTEXT:An important attribute of hedge funds which makes them even more

popular are its diversification benefits on addition in a traditional portfolio

of stocks and bonds. Among the studies which brought this out, Edwards

and Lien (1999) studied the diversification benefits of hedge funds and

managed futures funds and found them to enhance portfolio performance.

Purcell and Paul Crowleys (1999) study too supports the

diversification advantage hedge funds provide as the inclusion increases

expected portfolio return by 200 basis points. A major plus point in aportfolio context is that They too state that hedge funds have a low

correlation with all the other asset classes including the S&P 500.

The benefits of including hedge funds in plan sponsors portfolios is

also evident as shown by Goldman Sachs and Co. (1998) in terms of the

risk/return, correlation and other performance characteristics of four major

categories (Market Neutral or Relative Value, Event Driven, Long/Short

and Tactical Trading) of hedge funds.

Though the hedge funds are excellent diversifiers they are extremely

risky along another dimension: as the cross sectional variation and the

range of individual hedge fund returns are far greater than they are fortraditional asset classes, the investors in hedge funds face a substantial risk

of selecting a dismally performing fund or a failing one as pointed out by

Malkiel and Saha (2005).


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One can conclude here by saying that over concentration in any

particular fund produces improper risk for the manger which can be

reduced by limiting exposure to any one fund. Moreover tightening

restrictions shifts the efficient frontier downwards.

2.9 Literature Review of the Indian Capital Market:2.9.1 INTRODUCTION:

Economics experts and various studies conducted across the globe

envisage India and China to rule the world in the 21st century.

For over a century the United States has been the largest economy in

the world but major developments have taken place in the world economy

since then, leading to the shift of focus from the US and the rich countries

of Europe to the two Asian giants- India and China.

The rich countries of Europe have seen the greatest decline in global

GDP share by 4.9 percentage points, followed by the US and Japan with a

decline of about 1 percentage point each.

Within Asia, the rising share of China and India has more than made

up the declining global share of Japan since 1990. During the seventies and

the eighties, ASEAN countries and during the eighties South Korea, along

with China and India, contributed to the rising share of Asia in world GDP.

According to some experts, the share of the US in world GDP is expected

to fall (from 21 per cent to 18 per cent) and that of India to rise (from 6 per


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cent to 11 per cent in 2025), and hence the latter will emerge as the third

pole in the global economy after the US and China. By 2025 the Indian

economy is projected to be about 60 per cent the size of the US economy.

The transformation into a tri-polar economy will be complete by

2035, with the Indian economy only a little smaller than the US economy

but larger than that of Western Europe.

By 2035, India is likely to be a larger growth driver than the six

largest countries in the EU, though its impact will be a little over half that

of the US. India, which is now the fourth largest economy in terms of

purchasing power parity, will overtake Japan and become third major

economic power within 10 years.

2.9.2 ISSUES AND PRIORTIES FOR INDIA:As India prepares herself for becoming an economic superpower, it

must expedite socio-economic reforms and take steps for overcoming

institutional and infrastructure bottlenecks inherent in the system.

Availability of both physical and social infrastructure is central to

sustainable economic growth.

Since independence Indian economy has thrived hard for improving itspace of development. Notably in the past few years the cities in India have

undergone tremendous infrastructure up gradation but the situation in not

similar in most part of rural India. Similarly in the realm of health and

education and other human development indicators India's performance has


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been far from satisfactory, showing a wide range of regional inequalities

with urban areas getting most of the benefits.

In order to attain the status that currently only a few countries in the

world enjoy and to provide a more egalitarian society to its mounting

population, appropriate measures need to be taken. Currently Indian

economy is facing these challenges:

Sustaining the growth momentum and achieving an annual averagegrowth of 7-8 % in the next five years.

Simplifying procedures and relaxing entry barriers for businessactivities.

Checking the growth of population; India is the second highestpopulated country in the world after China. However in terms of

density India exceeds China as India's land area is almost half of

China's total land. Due to a high population growth, GNI per capita

remains very poor. It was only $ 2880 in 2003 (World Bank figures).

Boosting agricultural growth through diversification anddevelopment of agro processing.

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

the surplus labor in agriculture but also the unprecedented number of

women and teenagers joining the labor force every year.


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Developing world-class infrastructure for sustaining growth in all the

sectors of the economy. Allowing foreign investment in more areas

Effecting fiscal consolidation and eliminating the revenue deficit through

revenue enhancement and expenditure management..

Empowering the population through universal education and health

care. India needs to improve its HDI rank, as at 127 it is way below many

other developing countries' performance.

The UPA government is committed to furthering economic reforms and

developing basic infrastructure to improve lives of the rural poor and boost

economic performance.

Government had reduced its controls on foreign trade and investment in

some areas and has indicated more liberalization in civil aviation, telecom

and insurance sector in the future.


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2.9.3 SOME HIGHLIGHTS: India has more billionaires than China. This year there were 15

billionaires in China but last year in India, there were 20 billionaires,

according to the Forbes magazine.

India has emerged as the world's fastest growing wealth creator,thanks to a buoyant stock market and higher earnings.

Ninan (2003) states that medium to long-term outlook for the Indianstock is positive in the coming years.

A number of Indian companies surpassed last year's net profit in justsix months of the current fiscal, reflecting an accelerated growth in

corporate earnings.

Large funds from the US, Europe, Japan and other developedcountries continue to hedge their investments in markets like India

to improve returns (Shashikant, 2006).

Forty-four per cent of Top 100 Fortune 500 companies are present in

India.The economy has grown by 8.9 per cent for the April-July quarter of

'06-07, the highest first-quarter growth rate since '00-01 and is poised to

grow more than 9% this fiscal.


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Due to a global liquidity glut, the Indian equity market is soaring

along with the rest of the emerging markets. The Morgan Stanley Emerging

Market index, the benchmark used by most international fund managers,

gained 23.05% in the year to date (YTD) in 2005 while the MSCI India

index recorded one of the smartest rises ever gaining 24.54% YTD

(Lohade, 2005).

The Indian IT industry has been growing at a rapid rate with its

silicon city being named as the back office of the world. Further, the

government has been continuously promoting this sector as it has identified

it as one of the potential employment generators and foreign exchange

earner by making the labor laws more flexible in this labor-intensive sector

(Jagnani and Dagli, 2005).

Barua (2006) emphasizes that the Indian growth rate is likely to accelerate

in the long-term on back of few fundamentals.

First, infrastructure spending is increasing by leaps and bounds.

Second, India is experiencing a service industries boom due to arbitrage of

human intelligence. More and more people are recognizing the smart, hard

working Indian worker not only as cost saving but also as productivity

enhancing.


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Third, the availability of jobs through outsourcing is leading to higher

consumption that is also fuelled by expansion of retail credit and changing

demographics.

With positive indicators such as a stable 8-9 per cent annual growth,

rising foreign exchange reserves of close to US$ 180 billion, a booming

capital market with the popular "Sensex" index topping the majestic 14,000

mark, the Government estimating FDI flow of US$ 12 billion in this fiscal,

and a more than 35 per cent surge in exports, it is easy to understand why

India is a leading destination for foreign investment.

2.10HISTORY OF INDIAN CAPITAL MARKETS:The history of the Indian capital markets and the stock market, in

particular can be traced back to 1861 when the American Civil War began.The opening of the Suez Canal during the 1860s led to a tremendous

increase in exports to the United Kingdom and United States.

Several companies were formed during this period and many banks

came to the fore to handle the finances relating to these trades. With many

of these registered under the British Companies Act, the Stock Exchange,

Mumbai, came into existence in 1875.

It was an unincorporated body of stockbrokers, which started doing

business in the city under a banyan tree. Business was essentially confined


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to company owners and brokers, with very little interest evinced by the

general public. There had been much fluctuation in the stock market on

account of the American war and the battles in Europe.

The planning process started in India in 1951, with importance being

given to the formation of institutions and markets The Securities Contract

Regulation Act 1956 became the parent regulation after the Indian Contract

Act 1872, a basic law to be followed by security markets in India.

The stock markets have had many turbulent times in the last 140

years of their existence. The imposition of wealth and expenditure tax in

1957 by Mr. T.T. Krishnamachari, the then finance minister, led to a huge

fall in the markets. War with China in 1962 was another memorably bad

year, with the resultant shortages increasing prices all round.

This led to a ban on forward trading in commodity markets in 1966,

which was again a very bad period, together with the introduction of the

Gold Control Act in 1963. The markets have witnessed several golden

times too. Retail investors began participating in the stock markets in a

small way with the dilution of the FERA in 1978.

The next big boom and mass participation by retail investors

happened in 1980, with the entry of Mr. Dhirubhai Ambani. Dhirubhai can

be said to be the father of modern capital markets.


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Moreover, Krishnamurthy (2004) studied that Indian stocks offer

extraordinary high sustainable returns and are expected to maintain this

trend.

Recently a study conducted by the Economic Times Investors Guide

consisted of over 1300 Indian companies listed on the Indian stock

exchange.

The net profits for the sample had grown 37% over the first quarter

of the year 2006 (Q1FY07). This appeared way above market expectations,

which were in the 15-20% range for financial year 2007 as a whole. It was

concluded that corporate India surprised the market with its strong growth

in the first quarter of financial year 2007.

It was also observed that the growth momentum was as broad-based

as ever in this rally and not that only a handful of companies were

contributing to net profits (Economic Times, 2006).

On the contrary Varadarajan (2000) argues that share prices of the

Indian stocks are overvalued which would eventually lead to a downfall in

the share prices. He uses two indicators to determine whether current share

prices are overvalued: the price-to-earnings ratio of stocks and the spread

between the yield on bonds and shares.

He argues that such a correction has been on the cards for quite some

time now; the only element missing is a proximate trigger which would


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sooner or later burst the share bubble. JP Morgan identifies levels of

uncertainties that are generating volatility in the Indian equity market and

suggest that India should correct by 4-5% for the markets to look attractive

in the future years (www.moneycontrol.com)

In addition, Zore and Sen (2006) analyze that both globally as well as

in India there are a lot of issues that cause concern. The global interest rate

scenario will slacken the growth of the Indian economy to a great extent.

2.11DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS:

2.11.1MUTUAL FUNDSMutual fund is a form of collective investment that pools money

from many investors and invests their money in stocks, bonds, dividends,

short-term money market instruments, and/or other securities. In a mutual

fund, the fund

manager trades the

fund's underlying

securities, realizing

capital gains or

losses, and collects

the dividend or

interest income. The

investment proceeds

are then passed

Figure2:WorkingofMutual Fund


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along to the individual investors. The value of a share of the mutual fund,

known as the net asset value per share (NAV), is calculated daily based on

the total value of the fund divided by the number of shares currently issued

and outstanding.The flow chart below describes broadly the working of a

mutual fund.

2.11.2History: -The origin of mutual fund industry in India is with the introduction

of the concept of mutual fund by UTI in the year 1963. Though the growth

was slow, but it accelerated from the year 1987 when non-UTI players

entered the industry.

In the past decade, Indian mutual fund industry had seen dramatic

improvements, both quality wise as well as quantity wise. Before, the

monopoly of the market had seen an ending phase; the Assets Under

Management (AUM) was Rs. 67bn.

The private sector entry to the fund family rose the AUM to Rs. 470

bn in March 1993 and till April 2004, it reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the

total of it is less than the deposits of SBI alone, constitute less than 11% of

the total deposits held by the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry

in India is new in the country. Large sections of Indian investors are yet to


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be familiarized with the concept. Hence, it is the prime responsibility of all

mutual fund companies, to market the product correctly abreast of selling.

2.11.3FOREIGN INSTITUTIONAL INVESTOR:

Foreign Institutional Investor [FII] is used to denote an investor -

mostly of the form of an institution or entity, which invests money in the

financial markets of a country different from the one where in the

institution or entity was originally incorporated.

An investor or investment fund that is from or registered in a country

outside of the one in which it is currently investing. Institutional investors

include hedge funds, insurance companies, pension funds and mutual

funds.

The term is used most commonly in India to refer to outside

companies investing in the financial markets of India. International

institutional investors must register with the Securities and Exchange

Board of India to participate in the market. One of the major market

regulations pertaining to FIIs involves placing limits on FII ownership in

Indian companies.

FII investment is frequently referred to as hot money for the reason

that it can leave the country at the same speed at which it comes in.


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India opened its stock markets to foreign investors in September 1992 and

has, since 1993, received considerable amount of portfolio investment from

foreigners in the form of Foreign Institutional Investors (FII) investment in

equities.

This has become one of the main channels of international portfolio

investment in India for foreigners13. In order to trade in Indian equity

markets, foreign corporations need to register with the SEBI as Foreign

Institutional Investors (FII). SEBIs definition of FIIs presently includes

foreign pension funds, mutual funds etc.

The trickle of FII flows to India that began in January 1993 has

gradually expanded to an average monthly inflow of close to Rs. 1900

crores during the first six months of 2001. By June 2001, over 500 FIIs

were registered with SEBI.

The total amount of FII investment in India had accumulated to a

formidable sum of over Rs.50,000 crores during this time . In terms of

market capitalization too, the share of FIIs has steadily climbed to about

9% of the total market capitalization of BSE (which, in turn, accounts for

over 90% of the total market capitalization in India).

The sources of these FII flows are varied. The FIIs registered with

SEBI come from as many as 28 countries (including money management

companies operating in India on behalf of foreign investors). US-based

institutions accounted for slightly over 41%, those from the UK constitute


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about 20% with other Western European countries hosting another 17% of

the FIIs that these national affiliations do not necessarily mean that the

actual investor funds come from these particular countries.

Given the significant financial flows among the industrial countries,

national affiliations are very rough indicators of the home of the FII

investments. In particular institutions operating from Luxembourg,

Cayman Islands or Channel Islands, or even those based at Singapore or

Hong Kong are likely to be investing funds largely on behalf of residents in

other countries.

2.11.4RETAIL INVESTORS:Retail investors according to SEBI rules are those investors whose

investment corpus is not more than Rs. 1 lakh. In India, retail investors playa very small role in capital markets. This is mainly due to the risk aversion.

The retail investors are mainly concentrated in four metros and

Ahmedabad. Ahmedabad has major chunk of retail investors who are very

much active in the stock investors.

But slowly this scenario is changing with the increase in the number

of Demat accounts through which these investors mainly invest. Slowly the

retail investors confidence has increased in the Indian Stock markets.


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Their total share in the market capitalization is around 3%which is

very much less compared to that of USA where it is around 20-25%. But

with Indian capital markets gaining popularity, there is high scope that the

participation of retail investors will gradually increase.

2.12HEDGE FUNDS IN ASIA:Though Hedge funds seek absolute return strategies, but due to the

herding mentality the returns are getting diminished. And some of the

major debacles of Hedge funds like the AMARANTH Advisors LLC and

LONG TERM CAPITAL MANAGEMENT LLC forced the hedge funds to

look into some greener pastures like Asia where the market is in premature

stage. Hedge funds started investing in Asian markets after the Tech

Bubble which forced many hedge funds to liquidate their net positions.

According to Asia Hedge magazine, some 150 hedge funds operatein Asia, till year 2002 which together managed assets estimated at around

US $ 15 billion. In Japan, too hedge funds are becoming the focus of more

attention.

Recently, Japans Government Pension Fund one of the worlds

largest pension fund with US $ 300 billion has announced plans to start

allocating money to hedge funds. Industry participants believe that Asia

could be the next region of growth for the hedge fund industry. The

potential of Asian hedge funds is well supported by fundamentals.


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From an investment perspective, the volatility in the Asian markets

in recent years has allowed long-short and other strategic players to out

perform regional indices.

The relative inefficiency of the regional markets also presents

arbitrage opportunities from a demand stand point US and European

investors are expected to turn to alternatives in Asia as capacity in their

home markets diminish.

Further, the improving economic climate in South East Asia should

help foreign fund managers and investors to refocus their attention on the

region. Overall, hedge funds look set to play a larger role in Asia.

2.13MARKET BENEFITS OF HEDGE FUNDS:Hedge funds can provide benefits to financial markets by

contributing to market efficiency and enhance liquidity. Many hedge fund

advisors take speculative trading positions on behalf of their managed

hedge funds based extensive research about the true value or future value

of a security. They may also use short term trading strategies to exploit

perceived mis-pricings of securities.

Because securities markets are dynamic, the result of such trading isthat market prices of securities will move toward their true value. Trading

on behalf of hedge funds can thus bring price information to the securities

markets, which can translate into market price efficiency. Hedge funds also

provide liquidity to the capital markets by participating in the market.


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Hedge funds play an important role in a financial system where

various risks are distributed across a variety of innovative financial

instruments. They often assume risks by serving as ready counter parties to

entities that wish to hedge risks.

For example, hedge funds are buyers and sellers of certain

derivatives, such as securitized financial instruments, that provide a

mechanism for banks and other creditors to un-bundle the risks involved in

real economic activity.

By actively participating in the secondary market for these

instruments, hedge funds can help such entities to reduce or manage their

own risks because a portion of the financial risks are shifted to investors in

the form of these tradable financial instruments.

By reallocating financial risks, this market activity provides the

added benefit of lowering the financing costs shouldered by other sectors

of the economy. The absence of hedge funds from these markets could lead

to fewer risk management choices and a higher cost of capital.

Hedge fund can also serve as an important risk management tool for

investors by providing valuable portfolio diversification. Hedge fund

strategies are typically designed to protect investment principal. Hedge

funds frequently use investment instruments (e.g. derivatives) and


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techniques (e.g. short selling) to hedge against market risk and construct a

conservative investment portfolio one designed to preserve wealth.

In addition, hedge funds investment performance can exhibit low

correlation to that of traditional investments in the equity and fixed income

markets. Institutional investors have used hedge funds to diversify their

investments based on this historic low correlation with overall market

activity.

2.14HEDGE FUNDS IN INDIA:With the notification of SEBI (Mutual Fund) Regulations 1993, the

asset management business under private sector took its root in India. In

the same year SEBI, also notified Regulations and Rules governing

Portfolio Managers who pursuant to a contract or arrangement with clients,

advise clients or undertake the management of portfolio of securities or

funds of the client.

Recently, RBI through liberalized remittance scheme, allowed

resident individuals to remit up to US $ 25,000 per year for any current or

capital account transaction. The liberalized scheme will allow Indian

individual investors to explore the possibility of investing in offshore

financial products.

Considering the existing limit being only US $ 25,000 per year,

Indian market may not be attractive to hedge fund product marketing. As

long as there will be restriction on capital account Convertibility, foreign


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hedge funds, by virtue of their minimum investment limit being $ 100,000

or higher, do not seem to be excited to access investment from Indian

investors in India.

Some hedge funds have invested in offshore derivative instruments

(PNs) issued by FIIs against underlying Indian securities. Through this

route hedge funs can derive economic benefit of investing in Indian

securities without directly entering the Indian market as FIIs or their sub-

accounts.

Through recent amendments to the FII Regulations (Regulation 15A

and 20 A), the regulatory regime has been further strengthened and

periodic disclosures regime has been introduced.

As at the end of March, 2004, total investment by hedge funds. In

the offshore derivative instruments (PNs) against Indian equity, are Rs.

8050 crores which represent about 8% total net equity investments of allFIIs.

On the basis of market value, the hedge funds account for about 5%

of the market value of the total assets held by the FIIs in India. The fiscal

year (2003-2004) has seen a spectacular increase in FII activities in Indian

market. Till this report is filed FIIs have already invested US $ 10 bn.

during this year alone which is a record.


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Robust economic fundamentals, strong corporate earnings and

improvement in market micro structure are driving the FII interest in India.

Investors all over the world are keen to come to Indian market.

From informal discussions with institutional investors including

some reputed and well established hedge funds, one could gauge the extent

of interest they have about Indian markets.

From informal discussions with institutional investors including

some reputed and well established hedge funds, one could gauge the extent

of interest they have about Indian markets.

During the discussions they have requested whether India, like other

Asian emerging markets, can provide a regulatory framework that will

allow them to directly invest in Indian market in a transparent manner.


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2.15PARTICIPATORY NOTES:Participatory notes are instruments used by foreign funds / investors

who are not registered with the SEBI but are interested in taking exposure

in Indian securities.

Participatory notes are generally issued overseas by the associates of

India-based foreign brokerages. Brokers buy or sell securities on behalf of

their clients on their proprietary account and issue such notes in favor of

such foreign investors.

Participatory Notes are simple derivative instruments that investors

not registered in India or Mauritius use to trade in Indian markets. These

investors place their order through brokerage houses that have Mauritius-

based FII accounts.

The brokerage houses then repatriate the dividends and capital gains back

to these entities. In this case, the broker acts like an exchange: it executes

the trade and uses its internal accounts to settle the trade. They keep the

investors name anonymous. That is why capital market regulators dislike

P-notes.


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2.16WHY HEDGE FUNDS ARE LOOKING AT INDIA:Unlike China, where stock markets are not well developed and

company information is relatively opaque, experts note that India has much

of the necessary institutional framework for hedging, including a regulatory

regime and good information disclosure standards.

"Investors look at multiple markets around the world," says Marti G.

Subrahmanyam, a professor of finance at New York University's Stern

School of Business. "There is a sense that the changes taking place in India

are going to result in superior performance in the economy, and that the

corporate sector will be a big beneficiary.

Now, obviously the Chinese economy is larger, but the capital

markets are better developed in India. If you look at the stock market, even

if you were to include Hong Kong, the market cap in China relative to its

GDP is lower. So if you're looking for investment opportunities where you

won't suffer the consequences of illiquidity, India is the more attractiveopportunity."

In addition, notes Subrahmanyam (2002), India is the largest market

for single stock futures in the world and has a well developed derivatives

market in index futures and options."This gives you hedging possibilities

not available in other emerging markets," he says. There is also enough

liquidity in the big stocks for [domestic] investors to sell short. Even

though there are restrictions, these are less binding than in other emerging

markets.


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2.17ADVANTAGE INDIA:Since hedge funds are investors shrouded in mystery, they are made

scapegoats whenever there is a crisis of some sort in the market. Kamdar

(2004) concurs and says, "The only matter that I find worrisome is that

most of the time, without any substantial evidences the world over, any

crisis in stick market is conveniently attributed to hedge funds. This was

one of the causes stated by market participants for the May 17, 2004

downfall of 15% in the stock price."

Hedge funds also bring in the much welcome volumes, and thus,

liquidity in the market. Moreover, as all market experts will concede,

market liquidity leadstobetterpricediscovery in themarket.Now,with

thetransactiontaxleviedontradescarriedoutinthestockmarket,these

increasedvolumeswillalsoleadtorevenueforthegovernment.

2.18THE RISKS ASSOCIATED WITH HEDGE FUNDS:Although hedge fund strategies vary significantly, they project a

general set of risk factors to the markets they invest in. According to the

authors of Sound Practices for Hedge Fund Managers (2000), the three

quantifiable risks, market risk, credit risk and liquidity risk are interrelated

and as such should be studied separately as well as together, i.e. their

overlap should be properly identified and evaluated.

Furthermore, the effect of leverage on all three key risk factors

should also be properly assessed, as insolvency risk becomes a vital point.


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Botteron and Villager(Risk Management Overview 2002) go further and

divide the risk universe into exogenous intertwining risks, common to all

markets, which include market, credit and liquidity risks, and endogenous

risks, addressed by internal measures and regular due diligence, including

operational and model risks.

Figure3:RiskGalaxy


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Source: - The Risks Underlying Hedge Funds Strategies.

One of the major sources of risk by Hedge funds investment is

Market Risk. Due to global macroeconomic perspectives their can be an

event of market sudden slump. And the herding mentality of the Hedge

Funds adds to this slump by continuously withdrawing money from the

markets.

This leads to the devaluation of the funds NAV and also culminates

into shareholder value depreciation. Mostly interest rates, bond yields and

the security prices are inter-related. So a small slump in one market leads to

an adverse effect in other markets also.

2.18.1MARKET RISK: COMPONENTS: Interest rate risk: This risk is mostly the impact of fixed income

instruments; when interest rates go up, bond prices go down. The

strategy of Fixed income instruments is to invest in corporate bondsand government bonds, so as to get risk free rate of return. The bond

yields depends a lot on the Interest rate prevailing and also inflation

figures.

Figure5:InternalRatereturnFigure4:marketrisk


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The spread between long-term interest rates and short-term interest rates

reflects, for example, the degree of inflation risk. When anxiety is high

regarding inflation, the spread widens as investors demand higher long-

term rates as compensation.

Hedge funds known as Hot Money, if they sense in any risk in near

future they exit the market. But due to the huge investments and huge

leveraged positions it carries out results in turmoil in the bond market.

The 1994 Bond market is a classical example to show the effect of

this kind of investment strategy.

2.18.2EQUITY RISK:This includes delta riskand volatility risk

Delta tells how sensitive the option is to changes in theunderlying stock price. A position with a delta of zero is called delta

neutral or delta hedged. Rebalancing or periodic adjustment is necessary to

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

Fi ure 6: E uit risk


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protection against small stock price movements. However, for larger

movements, gamma1 neutrality is required.

Here we can point out that India is known for single largest futures

and options in the world and Futures & Options price directly impacts the

underlying price of that particular script or commodity. This is also one of

the impacts on the Indian Capital Market.

2.18.3Volatility risk:There are two main causes for stock market volatility: the random arrival ofnew information about a stocks future returns and the level of trading

activity (Hull 1999).

The Greek letter Vega measures the impact of the change in

volatility on the value of an option. When Vega is high, the option is very

sensitive to small changes in stock price volatility. Vega neutrality protects

from such situations.

Gamma is the first derivative of delta; it measures the delta

sensitivity to changes in the underlying stock price. The larger the gamma,

the more sensitive is the delta to stock price changes and the more frequent

the required rebalancing.


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2.18.4CORRELATION RISK:It measures the degree to which two series of returns move up or

down together. For example the correlation between the stock prices

and their derivative instruments.

Correlation between different industries like the construction and

steel and cement industry. There is also reverse correlation between

stock prices plummeted and bond markets rose and vice-versa (Jaeger,

R. 2000).

2.18.5COMMODITY RISK:This risk arises from the sudden change in the price of

commodities. This is particular to Managed Futures. Just like equities,

commodities are subject to delta and volatility risks. When the market

environment changes, the price of commodities fluctuates.

Delta tells us how responsive the option is to changes in the

underlying commodity price. Rebalancing or periodic adjustment is

necessary to keep a position delta hedged as delta changes all the time.

Due to alternative positions of hedging the volatility of the derivative

prices increases. In order to get absolute gains, Hedge Funds try to increase

Figure7:Commodityrisk


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bets on one position and keep on adding to that net position. Amaranth

LLC is the best example to suit this type of risk.

Amaranth LLC kept on playing on the derivative options of Feb &

Mar Crude futures. Due to huge leverage positions build up in these two

futures, the losses kept on accumulated. Due to huge losses the fund has to

be liquidated there by impacting to a great extent the futures price of the

crude.

2.18.6CURRENCY RISK:This risk arises from the sudden change in the foreign exchange. This

is particular to Managed Futures. The strategy of managed futures is to get

money out of the arbitrage of currency fluctuations. Hedge Funds are not

long-term players and they invest for a short period of time. So this Hot

money may try to capitalize the currency fluctuations that happenregularly.

East Asian crisis and the recent Yuan Carry of trade phenomenon can

be attributed to this type of Managed Futures trading strategy of Hedge

Funds.

The impact of the East Asian crisis which materialized in the middle of

1997, and the subsequent turbulence that swept the worlds financial

markets over the next 12-18 months, has been significant not only in terms

of the financial, economic and social consequences that these events


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wrought on emerging market economies, but also in terms of drawing the

worlds attention to outstanding issues concerning the structure, operation

and regulation of the international financial system.

Currency speculators pursued a so-called double play aimed at

playing off the Hong Kong currency board system against the

administrations stock and futures markets. This led to the Asian Financial

Crisis.

2.18.7CREDIT RISK:This refers to the risk of downgrades (and possibly default) in the

credit quality of the funds investments or that of counterparties dealing

with the fund. This type of risk becomes critical while handling

derivatives. When investors perceive a high credit risk, they demand a

higher yield on the money they lend and vice-versa.

Indian markets follow the system of Mark-to-Market settlement. But

this system is not exercised in case of private players who take a large

leverage positions. Due to the large leverage position builds up and due to

the increase in volatility of the prices of derivative instruments this type of

risk arises.

The mayhem created in the stock markets in May 2006 can be

attributed to the credit risk arising of the Distressed securities and

Convertible arbitrage strategies.


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The index was down by 10% on a single day because of the margin

system problems. In May 2006 there was news going around that some

FIIs were banned to invest in Indian markets and also the capital gains that

are earned by the way of investment in Indian markets will be treated as

Business income.

Due to this their was a slump in the market to a certain extent. But

due to the drop in prices their was a call by many players to withdrew from

the market.

Due to this selling many big investors suffered and to cut down the

losses and pay the margin money their was an across the board selling.

Thus if big and hot money like Hedge Funds leads to this type of margin

pressures there could be a bigger slump and increased volatility in the stock

prices.

2.18.8LIQUIDITYRISK:Liquidity risk is defined as the decline in a funds liquidity leading

to devaluation in its NAV or a decline in its ability to fund its investment.

It can be further subdivided into three risks. The First one is related to short

selling activity; a manager might be forced to repurchase a borrowed asset

due to an adverse market condition.


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The second risk affects the cash reserves of a fund, as it may have to

redeem part of its debt obligations or pay margin calls. The third risk is

faced when investors seek to redeem their shares in the fund creating a

mismatch in the assets and liabilities of the fund (Botteron and Villiger

2002).

Liquidity is one of the main problems in the Indian Stock markets.

The main players in the Indian markets are FIIs, Mutual Funds and

Promoters and to a small extent retail investors. Liquidity problem is the

main problem facing FIIs.

Till now FIIs have invested around $22 bn in Indian markets till the

end of 2006. But they cant liquidate their positions because of the huge

chunk of stocks they own. Unfortunately for them, even after inves

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Hedge Funds Manoj and Sumanta

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