Niveshak October 2009

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FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 1

CoverS

tory

AoM

Perspective

FinGyaan

FinSight

ASSET MANAGEMENT STRATEGIES P.22 WHY BHARTI-MTN DEAL FLOPPED pg. 06

THE INVESTOR VOLUME 2 ISSUE 9 OCTOBER 2009


2/28Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bearsno responsibility whatsoever.

F r o m E d i t o r s d E s k

NiveshakVolume II

ISSUE 9

October 2009

Faculty Mentor

Prof. S.S Sarkar

Editor

Biswadeep Parida

Sub-Editors

Amit ChoudharyNilesh BhaiyaSareet MishraSujal Kumar

FinToonistDilpreet S. GandhiSaurav K. Bagchi

Design Team

Bhavya AggarwalSwarnabha Mukherjee

All images, design andartwork are copyright ofIIM Shillong Finance Club

Finance ClubIndian Institute

of Management, Shillong

www.iims-niveshak.com

Dear Niveshaks,

As the Stock markets rallied in the later part of Samvat 2065 to kiss the

17000 mark on Sensex, the new financial year Samvat 2066 opened on ahigh note pushing both our benchmark indices BSE Sensex and NSE Niftyto 12 month highs. Hope this jubilation is a sign of things to come. With thishope and celebration in mind, we welcome you to Samvat 2066 and wishthat we have a great year of Bull Run.

I still remember 6 months back, newspapers were full of negative eco-nomic and financial data from across the globe. Almost all the companieswent into the negative income zone and had their shares trading at 12months low. Countries were pushed to the recession and the brink of de-pression. Multinational Banks were writing off billions of dollars of bad debtsquarter after quarter. We used to celebrate on even the slightest of any

good news like any company coming out with positive quarterly earnings,but markets dint react much to such reports. Then we got reports on thewhole of sectors recovering like positive IIP, then reports on recovery ofwhole of economies started to come. Most of these were intentionally cre-ated with forward statements to boost the morale of markets. Markets letsome of these pass by and reacted heavily to others. We used to celebrateto all these.

But all of a sudden, today I feel that we are no longer searching forpositive financial data on news sites. Market indices touching new highsevery day has just become a part of the story. The same Banks and compa-nies are making profits. M&A deals, which were either absent at that time orwere forced by banks to help some companies survive, are returning with

a bang. Have we matured or has this just been a part of life. We are nowamong reports that within the next two quarters, our financial markets willreach the levels that were prevalent just before the Sub Prime doom. We

just hope that this current Bull Run prevails for at the least two more quar-ters so that we get the cheer & jubilation that once made the Wall Streetand dalal street the most happening places of the world.

In the current edition we have a cover story on one of the most potentderivative instrument that was recently introduced in India- Currency Fu-tures. Apart from this we have articles on Asset Management and allocationstrategies, articles on the Bharti-MTN deal and the current state of PrivateEquity Industry of India. Hope this issue would prove to be an interestingread for you.

Stay Invested for the good times ahead.

Biswadeep Parida

(Editor-Niveshak)

THE TEAM

T h e E d i t o r i a l T e a m o f N i v e s h a k i s p l e a s e d t o i n t r o d u c e t o y o u o u r

n e w t e a m , w h i c h h a s b e e n s e l e c t e d t o c a r r y o n t h e b a t o n o f N i v e s h a k .

T h e y a r e : B h a v i t S h a r m a , D u r g e s h N a n d i n i M o h a n t y , H i t e s h G u l a t i ,

S u mi t K e di a , Ta nv i A ro ra U pa sn a A g ar wa l.

P l e a s e j o i n u s i n w e l c o m i n g t h e m t o T e a m N i v e s h a k . W e a r e c o n -

f i d e n t t h a t t h e y w i l l c a r r y f o r w a r d t h e l e g a c y o f N i v e s h a k w i t h y o u .


3/28

Niveshak Times

04The Month That Was

C o N t E N t s

PERSPECTIVE

08 Cash Management in ATMs

Cover Story14Interest Rate Futures

16Indian scenario of interest ratefutures

finsight

11 Bharti with MTN: What wentwrong?

19 Direct Tax Code

finlounge

10FinToon

13Fin-Q

ARTICLE OF THE MONTH

06 Private Equity in India:Strategy in economic turmoil

fingyaan

22Understanding strategies in

Asset Management Industry

24Asset Allocation: Strategieswith result


4/28NIVESHAK VOLUME 2 ISSUE9 october 2009

Market Watch

Last month (September 14 October 13) saw

a revival on all the major world stock exchanges.

In India, the monthly industrial production index

showed the highest rise in two years. As a result,

Sensex and Nifty rose to their highest value in the

last six weeks. India was also ranked the 9th best

performer this year, till date, among the 89 indices

followed by Bloomberg.

The first week (September 14 - September 18)

saw Sensex and Nifty closing at their 16-month highs

on Wednesday. Sensex closed at 16,677.04, up 1.35

per cent and Nifty at 4,958.40, up 1.36 per cent. In

the second week, Sensex neared the 17,000 mark

during the course of the week with a high of 16,943

on Tuesday. The week however ended at a mar-

ginal loss of 48 points at 16,693. Nifty regained the

5,000 mark this week, on Tuesday after a gap of 16

months. It ended the week with a loss of 17 points

at 4,959. The third week was a short three day week

in which Sensex gained 442 points and Nifty moved

up by 151 points as a result of the positive senti-

ments among the people. The fourth week saw a

loss for both Nifty and Sensex. Nifty ended the week

with a loss of 138 points at 4,945 and Sensex ended

with a loss of 2.87 per cent at 16,643. Thus, the last

two weeks saw Sensex close above the 17,000 mark,

meeting the investors expectations.

BSNL, MTNL consortium to bid for stake in

Zain telecom

Bharat Sanchar Nigam Ltd (BSNL) and Mahan-

agar Telephone Nigam Ltd (MTNL) have jointly ap-

proached the consortium formed for participating in

the bidding process of Kuwait-based Zain telecom.

The consortium is led by Delhi-based realtor Vavasi

group and Malaysian billionaire Syed Mokhtar al-

Bukhary. The consortium is looking to buy 46 per-

cent stake in the Kuwait phone company. Vavasi and

Bukhary are appointing international investment

bankers for the valuation exercise. BSNL and MTNL

would separately appoint their bankers for legal due

diligence and valuation, once they receive govern-

ment approval for the deal.

Proposed Bharti Airtel- MTN deal comes to

an end

Last month saw the proposed $23 billion deal

between Bharti Airtel and MTN coming to an end.

This was on account of the South African govern-

ments demand for the dual listing of the newly

formed entity in India as well as South Africa. Dual

listing as asked by the South African government

was not possible as it would require a policy change

on the full convertibility of rupee. As MTNs biggest

shareholder with a 24% stake in the state-owned

pension fund manager, Public Investment Corp was

reluctant in giving the control of MTN to foreign na-

tionals. The deal would have created a mobile-phoneoperator with annual sales of $20 billion and 200

million subscribers.

SBI relies on overseas bonds for $1 billion

Indias largest bank, State Bank of India, in-

tends to raise $700 million - $1 billion by the sales

of overseas bonds as a part of its medium-term note

(MTN) program, started in 2004. The amount raised

by issuance of these bonds would be used to ex-pand its overseas business. The bank also plans to

set up 40 branches abroad, including 4 in the United

Kingdom. The sales of the bonds would be handled

by Barclays Capital, Citigroup, HSBC, JP Morgan and

UBS.

Mahindra & Mahindra-Renault mull over

joint venture

After several unsuccessful attempts to makea mark in the Indian car market with their low-frill

product Logan, French company Renault has entered

into talks with their Indian representative to replace

Niveshak Times

The MonTh ThaT Was


IIM, Shillong

Tanvi Arora


5/28FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5

Mahindra & Mahindra in the Mahindra-Renault part-

nership. Mahindra & Mahindra and Renault, a 51:49

joint venture is struggling to sustain volumes due to

uncompetitive pricing. It is believed that the loss-

es and fast-declining numbers have forced the two

companies to have a relook at their entire business

plan, including the partnership. The two companies

have however stressed that the talks are regarding

under utilization of capacity of the Nashik plan and

have denied rumors regarding Bajajs proposed offerto take over from Mahindra & Mahindra.

Pay per second billing triggers war among

service providers

Tata DoComos proposed per-second billing

plan has created a wave of unrest among various

network providers, with several other operators also

expressing their intentions of opting for the plan in

various circles. These announcements have resultedin opposition from incumbent operators whose aver-

age revenues per user may decrease. The point of

deliberation for TRAI(Telecom regulatory authority of

India) is that while consumers might benefit from

the per-second plan, the margins of telecom opera-

tors, especially new ones, would come under pres-

sure. As a result, TRAI is still considering whether

to make the billing plan a mandatory option or not.

Obama wins Nobel Peace Prize; meets cyni-

cism

The news about U.S. President Barack Obama

being Nobel Peace prize recipient has been received

with mixed emotions. The Norwegian Nobel commit-

tee chose Mr. Obama for the award because of his

extraordinary efforts to strengthen international di-

plomacy and cooperation between peoples. There

was criticism for the award based on Obamas deci-

sion to send 21,000 extra troops to Afghanistan, lastMarch. On the other hand, Mohamed El Baradei, di-

rector-general of the UN International Atomic Energy

Agency has acknowledged him as the best choice for

the prize in the present scenario.

Morgan Stanley rebounds as the best merg-

er adviser

Morgan Stanley, under the leadership of new

merger chief, Robert Kindler, stands above rival Gold-

man Sachs for 2009s busiest adviser on mergers.

This could be a result of the easing financial crisis

across the globe. It has been a sort of rebound forthe bank from its 5th position in 2008. With global

M&A shooting by 41% to $1.392 trillion, Morgan has

worked on deals worth $490.9 billion. According to

Kindler, this means that the credit markets are re-

covering but have volatile equity.

Barclays secure earnings

Owing to credit market volatility, Barclays Plc

has decided to sell its $12.3 billion debts to a fundmanaged by 2 former executives. Barclays plans to

sell its assets, including bonds backed by US sub-

prime mortgages, to Protium Finance LP. They aim to

finance these assets with a $12.6 billion loan from

Barclays and $450 million from investors. This ex-

change would not be reflected on Barclays balance

sheet as it is just a regulatory measure to prevent

its earnings from changes in the fair value of assets.

The bank has also said that it would take a write

down on the loan only if the cash flows from theassets are impaired.

Niveshak Times

The MonTh ThaT Was




FMS, DelhiSushil Pasricha & Peeyush Anand

Private Equity in India

A couple of years ago, privateequity players were spoilt for choicein terms of investing opportunities.Funds were flowing in and there wasroom for everyone, as evidenced bythe frenetic pace of deals and theever expanding competitive land-scape, even in the face of increas-ing valuations. With Stock marketsreaching new heights and frenziedM&A Activity, there were enoughexit opportunities for Private Equity

Investments. With the arrival of eco-nomic downturn and credit crunch,Private Equity players faced newchallenges and now, in future theyneed to rethink about their strat-egy in terms of timing of enteringand exiting and also managing theirportfolios. Strategies for Private Eq-uity players with respect to timing ofentry and exit:

Right Vintage Year:

With economy showing somesigns of revival and valuations againpicking-up in last 6-8 months, itsimportant for PE players which areplanning to establish new fundsto enter the market at right time.Vintage year or the calendar yearin which draw down of capital forfund starts, has a great implicationon the returns the fund will gener-ate. Vintage year at the peak of theeconomy can lead to lower returns

as valuations will be high when thefund was established and can leadto false start. As the valuations atthis point of time are rational, at thesame time increasing, its importantfor PE firms to time their entry right.

Right Exit Opportunities:

Capital Markets have revived inlast couple of months but still thereis lot of volatility present in the mar-kets and also signs of IPO markets

are not that encouraging with IPOsof Adani Group and NHPC falling flat.Keeping all of this in mind, PE firmsshould follow wait and watch policyfor exiting from some of the existing

portfolio companies. 6-12 monthsfrom now will be a good time to ac-cess the markets and decide uponexiting from some of the presentholdings of private equity players.

Strategies for Private Equityplayers with respect to PortfolioManagement:

Add-on acquisitions:

Based on the robust models ofsome of the existing portfolio com-

panies and existing rational valua-tions and limited exit opportunities,Private Equity players can look forexpanding their Investment horizonby making add-on acquisitions ofexisting portfolio companies. Cheapasset prices have lead to relative in-crease in add-on acquisitions versustraditional private equity deals. Ac-cording to a deal type breakdown forthis years first quarter, add-ons ac-counted for 51% of all private equity

deals.

Secondary vs. Primary Transac-tions:

The recent turmoil in the finan-cial markets and the resulting liquid-ity crunch drove many institutionalinvestors to cash out, including pen-sion funds, university endowmentfunds, corporations and funds offunds. This provided secondary mar-ket to expand and buyers to look

for discounted prices of assets. Sofar this year, secondary deals havetaken place at discounted 37% oftheir face value. Secondary invest-ments also give access to estab-lished PE players to selective fundsand quicker returns on investment.Secondary market will be encourag-ing in short-term in 12 to 18 monthson the basis of cheap asset pricesand consolidation in PE market buton the longer horizon of 3-5 years,

primary transactions based on therobustness of the business modelsof prospective portfolio companieswill drive the profitability of PrivateEquity players.

Strategy in Economic Turmoil

With the economyshowing evidentsigns for recovery,is the time ripe forPrivate Equity firmsto make their muchawaited comeback?PE firms should plan

their entry and exittimes from the mar-ket very cautiously.Cheap asset pricescan lead to add-onacquisitions of exist-ing portfolio com-panies. Also there isuntapped potential

for the PE firms inthe Indian Educationand Health Sectors.

oM



Early vs. Late Stage Transactions:

Late stage transactions in present scenariomake sense because firstly businesses have sur-vived the down-turn and still are sustainable andsecondly it gives a better perspective to PE Inves-tor while evaluating the performance of a businessmodel. Investor will be much more certain about the

investment in case of late stage transaction and itbecomes extremely important when presently everyplayer is making cautious moves in market. Goingforward early stage transactions will also come into the picture with the volatility in stock marketsbecoming less and overall market coming out of thisturmoil.

PE firms also need to be sure about investingin specific sectors with the present economic down-turn affecting most of the sectors. In Indias con-text, Education sector holds lot of promise in terms

of growth and hence is a good prospect for gettinggood returns for Private Equity players. According toestimates, Education in India happens to be a hugemarket of around $40 billion with a CAGR of around14%. Hence it provides an opportunity of 20% to 25%profitability on good deals. Some of the segmentsof interest within Education sector for Private Equityplayers will be:

Segment Size (Current) Growth Size (2012)

Pre School $1.8 Bn 30% $5.5 Bn

Vocational Training $1.4 Bn 22% $3.0 Bn

Professional Colleges $7 Bn 17% $11.9 Bn

K-12 ( Schools till

Class 12th)

$20 Bn 13% $29 Bn

K-12 Schools include all schools till class 12,currently owned by trust, structured as non-profitentities, many of them political/religious backed.Professional Colleges include Engineering, Medicaland Business Schools. Around 75 % of Professionalcolleges are Private entities. Vocational training ba-sically include training for English speaking, stafftraining for Finance, Retail and hospitality. This sec-tor provides right size for the Private Equity deals

($10-$15 Mn) and going forward potential scalablebusiness and low real estate exposure.

Another important aspect in terms of Educationsector is the good deal flow for Private Equity play-ers and hence this gives them the right opportunityfor choosing profitable deals. Some of the recent ac-tivity in Education space for Private Equity players:

Investor Investment Amount Location

Blackstone Group,New Vernon PrivateEquity and DeutscheSecurities

Everonn Sys-tems India

$ 20.43Mn

Gurgaon

Educomp Solutions Ltd EuroKids $ 8.7 Mn Mumbai

Sequoia Capital andLightSpeed Venture

TutorVista $ 18 Mn Bangalore

In one of the largest exits by a private equityfirm in India, UTI Ventures has made 50 times its

investment in e-learning firm Excelsoft Technologiesby selling its 35.5% stake for Rs 125 crore to hedgefund DE Shaw. In another exit from Education sec-tor, ICICI Ventures exit from Infoedge fetched it 17.5times higher returns.

Another sector which has great prospects innear future is Healthcare and Life Services. Whether

it is consolidation of hospitals within India or theimpact of the push for generic drugs by the new USadministration there is no lack of buzz and opportu-nity for the Indian Healthcare & Life Sciences (HLS)industry. Some of the key segments are diagnosticproducts and services, Medical Devices and Equip-ment and Wellness Products and Services which aregrowing at a CAGR of over 20%. Given the fragment-ed nature of both the hospitals and pharmaceuti-cals sectors, investors see clear potential for tappinginto consolidation opportunities in partnership withgrowth-oriented entrepreneurs.

Penetration of Health Care facilities from non-metros will provide boost to the Industry and pro-vides a great opportunity for expansion and growth- opportunities like Tele-Medicine and hub & spokemodels. Once the delivery and business models arehoned, non-urban India will provide healthcare com-panies with a large and scalable market and hence agreat opportunity for Private Equity Investors in next3-5 years. Key Segments:

Segment Size (Current) Growth Size (2012)

Hospitals $32 Bn 13% $50 Bn

DiagnosticProducts

$900 Mn 25% $1.8 Bn

CRAMs $12 Bn 25% $24 Bn

DiagnosticLaboratories

$870 Mn 20% $1.5Bn

Drivers for this sector will be increasing per-capita spending, improving health care infrastruc-ture, increasing health insurance coverage, increas-ing disease profiles and penetration of healthcareservices in to tier 2 cities and rural areas in India.With the present state of healthcare in India andmost of the players having big expansion plans in-

vestors will get right multiples in healthcare sector.

So to conclude, keeping all these points inmind, it can be said that Private Equity industry inIndia is in for challenging as well as exciting time innear future. With existing businesses again lookingfor capital, Private Equity will be a much sought aftersource for required capital. At the same time it willbe extremely important for Private Equity players tocreate value for the portfolio companies in termsof expertise and knowledge in addition to providingcapital.

AoM



p

Bankers dilemma:how to meet cus-tomers demand

yet manage cost ofholding cash in an

ATM. The answer tothis predicament liesin improvising thecash managementprocesses of thebank.

NITIE, MumbaiNeeraj Gaur &Varun Mangalvedi

With ATMs mushrooming innook and corners of India the aver-age cost of personal banking trans-actions has come down but at sametime has increased the difficulties

in cash management at these ATMs.Customer demand for cash availabil-ity anytime and anywhere throughAutomated Teller Machines (ATMs)must be balanced with organiza-tional mandates for increased capi-tal availability, cost reductions andregulatory compliance.

New and increasing pressuresin the financial services marketpresent unique core challenges fororganizations oper-

ating and managinga cash supply chain.Organizations arechallenged to pro-vide an adequatesupply of currencyto the various cash-points where cash isrequired to servicetheir customers suchas ATMs. In a fiercelycompetitive market,

running out of cash at an ATM canhave far reaching impacts to cus-tomer satisfaction and revenue gen-eration. These missed opportunitiesalso reduce revenue generation fromlost surcharge fees and can increaseexpenses related to costly emer-gency cash deliveries to correct theoutage.

On the other side of the coin,overstocking cash at ATMs due to

poor forecasting or to avoid outagesis also costly to the organization.When cash sits idle, this non-earningasset cannot be invested to generate

interest income. Even the slightestcash reduction can potentially freeup capital for greater leverage inother areas of the organization.

Bank ATMs by FY 2009

State Bank of India 8581

ICICI Bank 4816

HDFC 2540

Punjab National Bank 2150

Canara Bank 2000

Bank of Baroda 1100

Bank of Maharashtra 345

ATM Cash Management: Vari-ous Banks

Costs

C a s hcirculationis mainlydriven bythe demandfor cash bycustomersfor transac-tion purpos-

es. Banks face the usual dilemmawhen setting their cash level: theymust hold a sufficient amount tomeet customer demand at all times,but they also want to minimize theamount held, since cash in inven-tory generates a cost of lost oppor-tunity. The demand for cash variesconsiderably within a week, within amonth, and within a year, as well asvarying between ATMs. An effectivecash management must reduce the

cost of circulating cash throughoutthe entire lifecycle. The various coststhat banks face at different stages inthe cash management:



Perspective

Customer demand for cash availability anytime and anywhere through ATMs must be bal-anced with organizational mandates for increased capital availability, cost reductions and

regulatory compliance.

1. Transportation: The transportation cost iscomputed by multiplying the number of bundles ofbills moved by the number of miles traveled, by thecarriers transportation fee.

2. Sort and Count: Sorting by denomination andcounting the cash occurs only at the Brinks Vault ora Bank Vault. The cost is computed per bundle and

the rate per bundle is fixed.3. Fit-Sort: The cost of separating ATM-fit cash,

non-ATM fit cash, and unfit cash in deposits made bycustomers and commerce is computed per bundle,and the amount of deposited cash that is fit-sortedcan be modified at the banks discretion. Banks mayhave a third-party.

4. In-transit inventory: The cost of having cur-rency that is not available because it is travelingbetween locations is computed by multiplying thenumber of bundles in transit on a given day by the

cost of funds, by the number of bills per bundle,and by the bill denominations. Cost of funds is anopportunity cost.

5. Vault Inventory: This is the cost of holdinginventory either at a Bank Vault, the Brinks Vault,or both, depending on the particular scenario thatis being used. This cost is computed by multiplyingthe number of bundles in the vault at the end of theday by the cost of funds, by the number of bills perbundle, and by the bill denominations.

6. Cross-shipping cost: The cost that a bank willincur once the new recirculation policy issued by the

Fed takes effect is computed each week by multiply-ing the cross-shipping fee by the number of bundlesthat are cross-shipped.

Reducing the overall cost of cash handlingin ATMs: - Use of Cash Supply Management:

A good Cash Supply Management should beable to reduce the Various Banks Costs of runningATMs while ensuring the availability of cash to allthe ATMs. Below are the methods through whichmay help in cost optimization:

1. Optimize cash holdings by implementing dy-namic cash forecasting: it is required to accuratelycalculate the cash requirement for each cash pointby analyzing up to date, cash point usage data.

2. Reduce cost and risk through process con-trol and standardization: It is required to standardizeand automate these processes, requiring less timefor accounting and reconciliation of cash orders. Thisincreased control allows significant cost savings, re-

duced time to resolve customer enquiries and miti-gates exposure to risk by decreasing the amount ofcash in the network.

3. Improve supplier management through net-work visibility: By seamlessly integrating cash cen-ters and cash in transit suppliers, all aspects of thecash supply can be linked, allowing total network

visibility and control. Improved accuracy of infor-mation flows enables supplier management basedon services performed and greater control of trans-portation schedules. Flexible order planning allowsregular planned orders or ad-hoc replenishments,depending on user requirements.

4. Reduce cash out costs: The combination offlexible ordering processes and the increased net-work visibility helps eliminate expensive unplannedemergency orders and cash outs, enabling addition-al cost savings and a reduction of ATM outage costs.

5. Benefit from the flexible process optimiza-tion: It is required to have integration of any kindof cash point, including bank branches and all typesof ATM machines. In order to achieve the maximumlevel of process optimization, user settings are re-quired to be flexible and product customizationshould be present.

Cash Supply Management in ATMs

Automated Cash Management:

Product that had smarts around statisticalanalysis, forecasting capability, data management,


10/280 NIVESHAK VOLUME 2 ISSUE9 october 2009

p

A well designed and cong-

ured currency managementsystem can save ATM op-

erators anywhere from $500 -$2000 per machine per year.

cost analysis tools and reporting functionality. Auto-mate every aspect of their cash logistics business:cash forecasting, cost balancing, ordering, monitor-ing, expense tracking.

It employs a traffic light approach that makesmonitoring every single ATM as easy as watchingfor red, yellow and green. Some observers believethat a well designed and configured currency man-agement system can save ATM operators anywherefrom $500 - $2000 per machine per year.

A good automated cash management system:

Eliminates excess cash inventories by 20 to 40percent

Reduces cash handling, transportation and

ATM outage costs

Improves transportation scheduling and ven-dor management

Standardizes cash handling procedures andcontrols

Mitigates exposure to risk and losses

Provides effective audit, reconcilement and re-porting capabilities

Increases ATM, currency processing and trans-portation productivity

Offers a cost-effective solution for any size in-stitution



FinSight

Bharti with MTN ....what went wrong?

Bharti had proposeda merger bid withMTN which wouldhave created a $61billion telecom giantbut it didnt workout. In this article wewill try to find out

why it didnt materi-alize.

IIM ShillongBhavit Sharma

Indian telecom industry is wit-nessing whopping 10 million newsubscribers each month but thesenew subscribers are not adding muchvalue and the telecom revenues arestagnant. This arises a doubt as tohow many are new subscribers andhow many are just existing subscrib-ers buying new sim cards to availdiscounts/schemes on them. Aver-age revenues per user (ARPU) are de-clining in India and projected to get

worse because of the fact that urbanIndia is already 95% penetrated andall telecom growth is coming from ru-ral India (24 million rural subscriberswere added in the June quarter ascompared to 21 million urban ones).Bharti, in order to grow, has to reachout to the outside India market andMTN was a pertinent solution given itspre-eminent status in a growing mar-ket like Africa (across 21 countries)

and its ARPUs that are three timesthat of Bhartis. MTN would have beena good fit for Bharti Airtel given thatthe two companies are equal-sizedentities in market value. MTNs mar-ket cap of $35 billion compares with$42 billion for Bharti. MTNs 68 millionwireless subscriber base also com-pares with Bhartis 62 million.

The deal

In May 2009, Bharti Airtel

launched its audacious merger bidwith MTN that could have created a$61 billion transnational telecom gi-ant with combined revenues of $20billion and over 200 million subscrib-ers across Africa, Asia and MiddleEast. As per the original plan, SunilMittal promoted Bharti Airtel, Indiaslargest telecom company with over107 million subscribers was to acquire49 percent economic interest in MTN.Airtel had also planned to acquirearound 36% of MTNs current paid upcapital from its shareholders at $10.2per share, entailing a cash outgo of$6.8 billion. On the other hand, MTNwas to acquire a 25 per cent eco-

nomic interest in Bharti Airtel for $2.9billion and MTN shareholders wasto acquire another 11 percent. MTNwas supposed to issue new sharesto Bharti which would have broughtBharti shareholding in MTN to 49 per-cent. In return, Bharti would have is-sued 0.5 GDRs for every MTN share itacquires. The deal would have causeddilution of the Indian promoters 45.3% stake in the Indias largest mobileservice provider.

Reasons for failure

Bharti and MTN had to abandontalks after the second revised dead-line for an agreement expired on Sep-tember 30. The structure of the dealfailed to get approval from the SouthAfrican government. South AfricasPresident Jacob Zumas inclinationtowards more state involvement inthe economy to protect jobs and local

industries are considered to be oneof the major reasons behind his deci-sion to block this $ 23- billion mergerbetween MTN group and Indias BhartiAirtel. As the South African economyis also going through recession, Presi-dent Zuma, having backed by labourunions, is under tremendous pressureto stem the loss of thousands of jobs.It has been reported that South Afri-can authorities didnt like the mergerand wanted MTN to remain a South

African company. As the governmentof South Africa has played a majorrole in facilitating MTNs growth andowns 21 percent stake in it throughPublic Investment Corporation, theydidnt want this entity to move intothe hands and management of for-eign nationals.

During May 2009, Bharti hadentered into exploratory discussionswith the MTN Board wherein a num-

ber of structures were discussed andevaluated between the lead bankerson both sides and an in-principleagreement was reached on May 16.However, MTN later presented a com-



g

pletely different structure, from what was agreed,which envisaged Bharti Airtel becoming a subsidiaryof MTN and exchange of majority shares of Bharti Air-tel held by the Bharti family and Singtel in exchangefor a controlling stake in MTN. Agreeing to this condi-tion would have been a compromise by Airtel towardstheir vision of transforming into an Indian multina-

tional telecom giant. So, this was completely unac-ceptable to Bharti group.

Some takeover code and voting rights associ-ated with the deal are also responsible for the fail-ure of the talks .Recently, SEBI decided to amend theTakeover Code to mandate an open offer (An openoffer is an offer made by a quoted company to itsshareholders inviting them to buy new shares in thecompany at a set price, which is normally lower thanthe current market price. The purpose, as with arights issue, is to raise new capital for the company)

if American Depository Receipts (ADRs) and Global De-pository Receipts (GDRs) with voting rights cross theprescribed threshold. This could have direct impacton the talks between Bharti and South Africas MTN.Under the Takeover Code, a stake acquisition of morethan 15 per cent triggers the open offer requirement.Depository receipts, however, were not consideredpart of this requirement until they were convertedinto Indian shares. But now, the depository exercisesvoting rights on behalf of holders of ADRs and GDRs.The recent decision by SEBI has reversed the infor-mal guidance that had exempted MTN from making

an open offer to Bharti shareholders. At that time,Sebi had said an open offer would be triggered onlyonce the GDRs issued to MTN and its shareholdersby Bharti Airtel were converted into local shares withvoting rights. With a holding of 25 per cent, MTN couldhave exercised voting rights even without convertingthe underlying shares into Indian securities. With thelatest amendment, the South African firm would haveto make an open offer. But it made no sense for MTNto put in money in Bharti and have no voting rights.That is why they had to look for different structures,which are dual listed companies.

Dual listing

Dual listing implies segregation of the two le-gal entities which are based and listed in differentcountries, while maintaining a single economic struc-ture. A dual-listed company (DLC) is a structure thatcomprises of two listed companies with different setsof shareholders sharing ownership of common opera-tional businesses. In a traditional takeover one com-pany acquires the shares of another. However whena DLC is created, both companies continue to exist,

and to have separate bodies of shareholders, but theyagree to share all the risks and rewards of the owner-ship of all their operating businesses in a fixed pro-portion.

The deal came to a standstill after South Afri-

can government wrote to government of India sayingthat it does not, as per the policy, allow companiesincorporated in South Africa to be reincorporated off-shore or delisted from the Johannesburg SecuritiesExchange (JSE) with a possible subsequent listingoffshore as the same company or as part of a newentity which would have been the case if MTN and

Bharti had merged. South Africa wanted India to al-low MTN to have dual listing which is nonexistent inIndia. Indian law doesnt permit companies to mergetheir business operations while keeping their existingshareholding structures intact because it would tan-tamount to capital account convertibility. The issue ofDual listed entities has to be cleared not only by SEBIbut also by Reserve Bank of India since it involved fullcapital account convertibility. Dual listing would haveallowed both telecom companies to stay as separateentities but listed in each others stock exchangesand run by a common board. The model primarily in-tends to address the sensitivities of the South Africangovernment which has reservations about one of itslargest companies delisting from the Johannesburgstock exchange in the event of a merger.

Conclusion

This would have been a win-win deal for boththe companies. But the problems existed at the SouthAfrican end since MTN is considered crown jewel, soissues of control of the company are key for them.Indias stand on the deal was more supportive which

is evident from the fact that Indias Finance MinisterPranab Mukherjee had told the South African FinanceMinister Pravin J Gordhan on the sidelines of the G20summit that the Indian government would be open toallowing dual-listed companies but did not offer firmassurances. Prolonged discussions between Indianregulatory authorities and South African officials sug-gested that though the Indian government was opento the idea, the policy would take a long time to beoperational owing to the need for major changes interms of foreign exchange legislation and capital ac-count convertibility.

In September 2009, the Securities and Exchang-es Board of India (Sebi) also added to the complica-tions by announcing that global depository receipts(GDRs) will now be treated on a par with equity andcannot be exempted from an open offer. After thischange either MTN would have had to make an openoffer, which it was unwilling to do since it would haveraised acquisition costs, or Bharti would have to seeka special exemption on the ground that the two wouldmerge, which could have been tough to obtain.



FinLounge

1. Name the international treaty which came into existence to prevent undesirable obstacles

to trade by standards, regulations, testing and certification procedures of a country.

2. Few months back, company X was sold to Y for as low as ten dollars per share, a price far

below the 52-week high of $133.20 per share, traded before the crisis, although not as low as

the two dollars per share originally agreed upon by the companies. Identify X and Y.

3. A credit rating agency recently announced its entry into equity research. It will address the

two most important parameters in investment process: fundamentals (Fundamental Grade),

and valuation (Valuation Grade). Name the company and its product.

4. Launched in 1935 as a chocolate crisp, it was later renamed after an 18th century London

Club. Name the product.

5. In Search of Excellence. Identify?

6. Issued since 1948 by Institute for Supply Management in Tempe, AZ. If the index is above

50 remarks, the economy is supposed to be expanding else contracting. What is it and which

firm is most commonly associated with it?

7. In 1985, he had joined an investment banking boutique as an analyst; later became thehead of research in 1987 and then the president in 1991, at the age of 34. His focus area was

the electronics industry. He started a hedge fund which is in news these days. Identify him.

8. Name the program started by US government in 2008 to purchase equity and assets from

financial institutions to strengthen its financial sector.

9. France was the first country to introduce this system in 1954. Today, it has spread to

over 140 countries. The central and state governments have proposed to implement it in

India from 2010.

F i N - Q

All entries should be mailed at [email protected] by 5th November 2009 23:59 hours

One lucky winner will receive cash prize of Rs. 500/--



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IIM ShillongRitika gupta & Amranikunj upadhyay

Why do you think IRFs are necessaryin India? The reasons can be postulatedas follows:

Expand the scopeof financial markets in India andintegrate it with the global econ-omy

Boost the Indian bond market

Empower corporations tohedge interest rate risk

Efficient asset-liabilitymanagement avenuesfor banks and finan-cial institutions

Empower house-hold sector to man-age loans and in-vestments

Interest ratefutures, has openedup a lot of interestingoptions for an individu-al. For a high net worth indi-

A dream debut with a trading volume of Rs 276crores was clocked by interest rate futures when theywere traded for the first time on 1st September 2009 onthe National Stock Exchange (NSE). This and the fact thatit is the first major product to be introduced in India afterthe launch of currency futures in August 2008 has made itas the buzz word in the Indian market.

Taking a close look at what interest rate futures are, it

can be defined as A future contract with an interest bear-ing instrument as the underlying asset. In simpler termsAn interest rate future contract is an agreement to buy orsell a debt instrument at a specified date at a price fixedwhile drawing up the contract. These contracts can haveshort-term (less than one year) or long-term (more thanone year) interest bearing instruments as the underlyingasset. Public deposits, certificate of deposit, commercialpapers are some which are classified as short-term interestbearing instruments, whereas bonds and debentures fall inthe latter category.

The minimum contract size for Interest rate futures(IRF) on the NSE is Rs 2 lakhs. The contracts that weretraded on 1st September were based on 10 year govern-ment bonds, bearing a notional coupon of 7% per annum,compounded every six months.



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The introduction of trading in-

terest rate futures in India isone more step towards integra-tion of Indian Securities Mar-ket with the rest of the world.

viduals (HNIs), IRFs could be a good hedge againstloans or existing fixed deposits. Suppose a personhas taken a home loan of Rs 40 lakhs (Rs 4 million)at 8 per cent floating rate for 15 years. His equatedmonthly installment would be Rs 38,226. If the in-terest rate goes up to 10 per cent next year, theoutstanding principal will be Rs 39,77,919 and the

fresh EMI will come to Rs 44,083 - a rise of Rs 5,857per month. Supposing the person was expecting therate to go up, as is the case now where there areexpectations that any rise in inflation would resultin higher rates, he can sell IRFs (go short) in thefutures market for the same time frame (one year)now to hedge against this risk. The instrument willbe a 10 year notional coupon bond bearing the Gov-ernment of India security. Since one contract size ofIRF is Rs 200,000, he needs to deal in 20 lots. Afterone year, when home loan rates rise, benchmark

yields of the notional coupon would also have in-creased (earlier in fact, to indicate a rising interestrate regime). Consequently, the yields of IRFs wouldalso rise.

Although, it is possible to hedge your loanagainst a rise or fall in interest rates, the correlationbetween IRFs and mortgage rates is not absolute.Importantly, investors will need margin money forbuying the contract and pay for transaction costs.While the National Stock Exchange is not charginganything at present, the financial institution could

charge around Re 0.02 to Re 0.03 per contract.

Interest Rate Futures and Indian marketreactions:

Till date there has been a mixed reaction forIFRs. Though on one side they got enthusiastic re-sponse from market participants across India as14559 trades were completed during five hours oftrading,on the other hand, mutual funds, for exam-ple, are adopting a wait and watch approach. Thesubstantial volumes seen in the first few sessions ofIRF trading could not tempt the managers enough.However they are keeping a close watch on how theproduct moves in line with bond prices and also on ifmore papers will be allowed as benchmark. Thoughvolume seems to be promising in the first few days,but they want to ensure that it just does not turnsout to be spark which fizzles out later.

Although interest rate futures provide us with

opportunity to hedge our bets, there are associatedpitfalls as well by way of market and operationalrisks. IRF is based on ones view on the future in-terest rate movements. A wrong call can cost theinvestor the margin of three to five per cent and thebroker charges.

Then, at least a month ahead of expiry-thatis November-end for December expiry - one has tosquare off the position and take a fresh one basedon this future perception, to continue the hedge. Ifthe investor fails to square off the position, then hehas to deliver the specified GSecs in the physicalform. That is difficult as odd lots are hard to find,given that individual investors are almost absentfrom this market, despite the governments efforts,that could prove costly for the individual investor.

A third problem is that at the expiry, if thereis any change in the interest rates-profit or loss-compared to what was projected, the investor wouldsuffer a loss, which would be met out of the marginmoney.

Another problem arises when interest ratemovements of the asset/ liability and the benchmarkare blurred, like it happened in recent months dueto high liquidity. G- Sec yields were going up whilehome loan and FD rates were falling. This made tak-ing a call difficult. Clarity will emerge only after thepresent liquidity dries up.

Thus, according to analysts, risks heavily out-weigh the benefits for a retail investor taking a posi-tion in this market unless the person is discerning interms of the market dynamics.

Besides, banks are not allowed to take expo-sure in the market on behalf of their clients. Thismakes individual investors to approach brokers. Butby virtue of their risk management systems and ex-perience, banks are better placed than others to of-fer better advice to investors.

Future interest rates are definitely a new lease

of life during the time of recession. Ending on posi-tive note, J. Moses Harding, Head of global marketsat IndusInd Bank said, It is a welcome move for themarket participants and other than the OIS (over-night indexed swaps) market, we really do not haveany liquid product for hedging, trading and arbitrageactivities.



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Interest rate futures are one of the mostwidely-traded derivatives instrument in the worldand account for almost 70% of the total derivativetransactions across the world. The introduction ofinterest rate futures will helpus to bridge the gap betweenthe fixed income securitiesmarket of India with the restof the world. The currency fu-tures was launched aroundone year back and it becamea huge success with almost1500% growth during itsfirst year. Though this might

have boosted the confidenceof the exchanges to launchmore products, appropriatedesign of the derivative in-struments will be crucial inthe success of it. India is justbeginning to come out of thecredit crisis which shook thefinancial systems all over theworld and it is very importantat this juncture to take right

steps towards the growth ofthe economy. We will try tounderstand the importance of these instruments inthe current market scenario and how it benefits theeconomy.

NSE re-launched the interest rate derivativeson 31st August, six years after its debut. During itsfirst stint the markets conditions were not so con-ducive and it could never take off in the plannedmanner. There are lot of differences between thesetwo launches which includes the market scenario,

product design and other instrument features. Wewill look at those differences and also the necessaryfactors for the success of this derivative.

Interest Rate Futures

Derivatives are financial instruments derivedfrom some underlying asset and are integral partof the economy. In the case of interest rate futures,

the underlying asset is a debt in-strument like government bond.The interest rate futures contractis an agreement to buy or sellthis bond at a specified date ata specified price. It helps theinvestors to hedge interest raterisk which is primarily the uncer-tainty in the interest rates. Theinflation and the interest rates

have been changing rapidly inthe last few years prompting theinvestors, with good exposure todebt, to look for various waysto hedge this risk. Forward rateagreements (FRA) and Interestrate swaps traded in the over thecounter market help to alleviatethe short term interest changesto some extent. For example theseller of FRA will receive a fixed

rate of interest on a notionalprincipal over the specified pe-

riod in exchange for giving a floating rate of interest.Futures contracts are similar to the exchange tradedFRAs.

Market scenario

In India, interest rate futures debuted during2003 but was not a big success. At that time theinstrument was a 10 year zero coupon bond and 10year 6 percent bond. The main reasons for its failurewere:

The valuation of the bond was based on zerocoupon yield curve (ZCYC) which was more or lessindependent of the prices of other securities in the

Indian Scenario

IIM KozhikodeAnoop Chekkoli

ofInterest Rate Futures



CoverS

tory

It ts in the large theme of getting

more derivatives contracts, thingsthat you can protect yourself, thingswhere you can take a position.

bond market.

Banks and FIs (Financial Institutions) were notallowed to take trading positions. They were allowedto hedge only on their investment portfolio and itlimited the use of the instrument.

This time the instrument is the highly liquid 10

year bond which is normally been traded in thou-sands of crores.

Currently the only interest rate derivative avail-able to institutions was the less versatile interestrate swap (IRS) where an investor could exchange astream of interest payouts with interest payouts ofanother investor. These were OTC derivatives i.e. pri-vate contract between the two people which makesit very difficult to measure. The real impact of thesecontracts during some financial crisis can never beestimated. In exchange traded derivatives, margins

make sure that there are no counter party risks. Alsointerest rate futures are more transparent comparedto the OTC interest rate swaps.

Interest rate derivatives in Indian market

The newly launched Interest rate futures arebased on the ten year government securities witha contract size of Rs 2 lakh and with a maximummaturity of 12 months. The notional coupon rate willbe 7% payable half yearly. Two quarterly contractsexpiring in March and December in a year were of-fered to the investors. Daily settlement price was

the closing price for the ten year government secu-rity as determined by the exchanges on that trad-ing day. It has to be settled by physical delivery ofgovernment bonds using the electronic book entrysystem of the existing depositories and public debtoffice of the RBI

Banks, primary dealers, mutual funds, insur-ance companies, corporate houses, financial institu-tions and member-brokers will be eligible to partici-pate in IRF trading on the exchange.

Launch and aftermathOn the first day 1,475 trades were recorded re-

sulting in 14,559 contracts being traded at a totalvalue of Rs 267.31 crore. With only around 5 hoursof trading on the day of inauguration these volumesindicate an enthusiastic response towards the prod-uct. Futures for December 2009 were the most activewith 13,789 contracts being traded out of the total14,559 contracts. Nearly 638 members have regis-

tered for IRF out of which 21 are banks. The bankscontributed around 32.48% out of the total gross vol-ume.

After 10 days of trading, the daily volume oftrade has dropped by 76.33% to Rs 63.27 crore on10 September from Rs 267.31 crore on 31st August,the day of launch. The number of contracts tradedhas also decreased substantially from 14,559 on 31August to 3,439 on 10 September. In 2003 the tradevolumes had dropped 95% within the initial twodays. The situation looks similar but the conditionsare different.

According to the various banks, liquidity andlimited participation by mutual funds, insurancecompanies and retail investors is affecting the tradevolumes. Currently only mutual funds that invest ingovernment securities will be allowed to participatein IRFs and that too they will be allowed to trade onlyto hedge their investment portfolio. Bankers havealso been complaining about the lack of transpar-ency in the delivery system and many of them arewaiting for more clarity regarding the regulations.

Path ahead

Volatility of interest rates: The annualized vola-tility of yield of 10 year government securities forthe year 2008 has been 19.75 per cent compared to8.44 per cent in 2007. The interest rate volatility isat its peak now and with the economy recovering

from the crisis we can expect more changes in theinterest rate. Refer the figure 1 for the annualizedvolatility from 2000 to 2008.

Annualized volatility of yield rates of 10 year governmentsecurity



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Interest rate derivatives ac-count for over 70% of total

outstanding positions in thederivatives space worldwide,

according to Bank for Interna-tional Settlements statistics

This will force the investors who have good ex-posure towards the government securities to tradein the futures market. The inflation rates also havebeen highly volatile during the last few years andthis shows that Indian economy needs instrumentslike interest rate futures to distribute the risk associ-ated with interest rates among the investors across

the nation.

Role of Banks: In India about 27% of all thebanking assets are in government bonds. The re-turns from bank assets will vary because of the in-terest rate volatility and IRFs can be used to de-crease the sensitivity of the returns to interest rates.Thus banks have a big incentive to trade in the in-terest rate futures to reduce the portfolio volatility.

Role of mutual funds: The mutual fund indus-try has about 73 per cent of its assets under man-agement in the debt category. Of the total debt assetbase of Rs 4,72,393 crore, the industrys exposureto government securities is close to Rs 11,600 croreas on July-end. Mutual funds have not keenly par-ticipated in the IRF trading and they seem to haveadopted a wait-and-watch approach. This may dueto the fact that they cannot trade in futures as aninvestment option.

Role of other investors: Primary dealers, insur-ance companies and provident funds will also ben-efit from participation in interest rate futures. Sincethe proposed lot size of interest rate future is Rs.

2 lakhs, individual investors having a deposit/loanwith a bank can also hedge their risk. But it may bedifficult to attract individual investors in the begin-ning as they may stay away from these complicatedinstruments.

Other factors:

Mutualfundsshouldbeallowedtotradenot

only for hedging the risk for the investment but alsoas an investment. This will increase the participa-tion of the mutual funds in the IRF market. MFs cancome out with innovative products using the futuresto attract more retail investors.

Thereisahugepotentialmarketinmidsize

corporates which are currently very conservative inderivatives. Since many of these raise capital usingthe debt instruments attracting these to the futuresmarket will enhance its growth.

Lastbutnottheleast,RBIandSEBIhaveto

play an important role in developing an active IRFmarket. It is their duty to set uniform standards andwell established procedures to bring transparency sothat the IRF market thrives.

Conclusion

We can observe that powerful derivative instru-

ments like interest rate futures are required to sup-port the debt market in the current market scenario.The economy is pulling itself from the recessionand this will follow a period of high investment incapital, but with caution. It is imperative that theyprotect themselves from the interest rate risk. Nowmany investors are apprehensive about these in-struments due to the lack of clarity in regulations.With appropriate steps taken by SEBI and RBI withtime, these will die down as the market tends togrow and mature by itself.

FIN-Q SolutionsSEPTEMBER 2009

1. Harshad Mehta2. X-Accenture, Y- Arthur

Anderson Consulting3. The Economic Times4. Prometric, will be the online

testing company for CAT 20095. Financial Times6. AXIS Bank7. Q8. Bank of England

9. Barings' Bank10.Vatican



FinSight

The maximum limit for tax

deductions on account of sav-ings in prescribed instrumentshas been increased from Rs 1

lakh to Rs 3 lakhs.

The Direct Tax Codeintends to introducemoderate levels oftaxation, widen thetax base and im-prove the efficiencyand equity of the taxsystem by eliminat-ing distortions in theexisting tax struc-ture. It will bringall the direct taxesunder a single codewhich will eventu-

ally pave the wayfor a single unifiedtaxpayer reportingsystem. Keepingin mind the broadprinciple that lowertaxes lead to taxwidening and im-proved compliance,

the code is expectedto be revenue-posi-tive for the govern-ment.

JBIMS, MumbaiWasim Merchant & Harshil Suvarnkar

The draft of the New Direct TaxCode was introduced by the FinanceMinister Mr. Pranab Mukherjee onAugust 12, 2009. The draft is open forpublic discussion and would be pre-sented in the Winter session of theParliament subject to a reasonablelevel of discussion. The draft wouldcome into effect from April 1, 2011after approval by the Parliament.

The salient features of the Di-rect Tax Code (DTC) are:

Single Code for direct taxes: Taxlaws relating to income tax, wealthtax, dividend distribution tax, fringebenefit tax have been consolidatedunder a single Code. Bringing all thedirect taxes under a single Code willeventually pave the way for a singleunified taxpayer reporting system.

Simplified language: The Codehas sought to convey by using sim-ple language, the intent, scope andamplitude of the provisions of thetax laws.

Equitable tax system: The DTCintends to introduce moderate levelsof taxation, widen the tax base andimprove the efficiency and equity of

the tax system by eliminating distor-tions in the existing tax structure.

The major changes and theirimpact under the various heads ofincome are detailed below:

Income from Employment:

Change in tax slabs: The

income tax slabs have been signifi-

cantly increased to take into accountrealistic income levels. The proposedslabs are tabled below.

Income Tax rate Women Seniorcitizens

0 - 1.6 L No tax 0 -1.9 L 0 -2.4 L

1.6 L -10 L 10% 1.9 L -10 L 2.4 L -10 L

10 L -25 L 20% 10 L - 25 L 10 L-25 L

>25 L 30% >25 L >25 L

Tax deduction limit: The

maximum limit for tax deductionson account of savings in prescribedinstruments (under the popular Sec-tion 80C) has been increased fromRs 1 lakh to Rs 3 lakhs. However, thelist of investments eligible for suchdeductions has shrunk. Included areinsurance premiums, contributions

to approved provident fund, newpension system trusts and approvedsuperannuation fund. An interestingnew item in the list is payment oftuition fees towards children educa-tion (for two children).

Removal of exemptions:

It is proposed that tax deductionwhich is currently available to em-ployed persons on account of HouseRent Allowance (HRA) provided theemployee actually pays rent be re-moved. Some other allowances andreimbursements which are at pres-ent fully or partly tax-free and aresought to be taxed under the Codeare: leave travel allowance, medicalreimbursement, leave encashmentetc. Housing loan interest in case ofself-occupied property will also not



FinSight

Corporate tax rate has been

reduced to 25% for both do-mestic and foreign companiesfrom 34% and 43% respec-

tively.

be available for deduction from taxable income.

EET-based taxation: In terms of long term

savings, the Code aims to replace the current EEE-scheme with the universally practiced EET-schemewhere contributions and accruals are tax-free butwithdrawals are taxed in the hands of the taxpayer.

Impact on individual taxpayer: The proposedchanges in the income tax slab rates would imme-diately increase the amount of take-home pay toall categories of tax payers. However the proposedrates will be regressive in the sense that they willbe favorable to the higher salaried individuals. Theelimination of exemptions under LTA, HRA is boundto cause disappointment. The govern- m e n thas also given a thrust to the socialsecurity schemes like PPF, New Pen-sion Scheme and life insurance byrestricting the deductions to theseschemes. The government hastried to encourage an invest-ment-led growth by moving toan EET-scheme from an EEE-scheme.

Corporate taxation:

Reduction in cor-porate tax rate: The Codehas taken a leaf out of theChinese tax code and pro-

posed to reduce corporate taxrate to 25% for both domestic and foreigncompanies from 34% and 43% respectively(inclusiveof surcharges and education cess). Domestic com-panies would pay 15% dividend distribution taxwhile foreign companies would be required to pay abranch profit tax at the same rate whether or notthey remit profits outside the country.

MAT-related changes: The biggest surprise

for India Inc. under the new DTC is the drastic changein the structure of the Minimum Alternate Tax (MAT).

MAT is proposed to be charged on the companysgross assets rather than on book profits. A levy of0.25% for banking and 2% for all other companies onthe gross assets as on the last day of the financialyear is prescribed. MAT will also be a final tax andwill not be allowed to be carried forward.

Taxholidays:TheCodeproposestosubsti-tute profit-based incentives with investment-based

incentives. The period of the tax holiday would nowbe determined by the time taken by the companyto recover all its capital and revenue expenditure.It also proposes to do away with area-based incen-tives currently enjoyed by certain establishments instates like Uttaranchal, Himachal Pradesh, Sikkimand the North-East region.

Emphasis on scientific research: Scientific

research has received a boost with the benefit of150% weighted deduction proposed to be extendedto all industries. But, the term scientific researchshall be comprehensively defined.

Impact on Corporate India: The reduction inthe corporate tax rates will be a welcome relief for

India Inc. Companies paying MAT will be negative-ly impacted. Since the base has been

changed from book prof-its to gross assets,it would include fixedassets, capital work-in-

progress as well as allother assets. The Codewould therefore discour-

age companies to go onan asset-creating spree and

instead focus on improvingreturn on assets. It may also

culminate into higher dividendpayouts for shareholders. Realty

companies would also be affect-ed as they would not be able to

sit on land banks but undertakeconst ruc- tion on the acquired land. Capitalintensive companies like power, steel, cement thathave large gestation period might also have to payMAT during construction period when cash flows areabsent. Companies like technology companies oper-ating out of SEZs may be severely hit as they mightnot enjoy long period-based tax holidays.

Income on Capital Gains

Removal of distinction between long-term

and short-term: The present distinction betweenlong-term and short-term investment assets basedon the length of the holding period has been elimi-nated. Indexation benefit would continue for capitalassets held for more than a year. However, the basedate for indexation has been shifted from April 1,



FinSight

The present distinction be-

tween long-term and short-term investment assets basedon the length of the holding

period has been eliminated.

1980 to April 1, 2000 and capital gains between 1981and 2000 will not be liable to tax.

Abolition of STT: Securities transaction tax

(STT) is proposed to be abolished and tax on long-term gains would be reinstated causing stock mar-ket players to shell out more tax.

Deductionsundercapitalgains:Deductionswith respect to capital gains restrict new investmentassets to one or more pieces of agricultural land,residential house and deposits under Capital GainsSavings Scheme. Investments in bonds of NHAI, RECand in bonds, debentures, shares of a public com-pany as specified by the gov-ernment would no longer beallowed.

Carry forward of loss-es: As per the new Code, losses

will be allowed to be carriedforward indefinitely for set off.

Wealth tax: The DTC

proposes to substantially raisethe threshold limit for levy ofwealth tax to Rs. 50 crores fromRs 30 lakhs. The rate of wealthtax according to the draft DTCshould be reduced to 0.25 percent from one per cent current-ly.

Impact of changes inCapital Gains: The abolition inSTT may bring back more vol-umes to the equity markets as the transaction taxfor brokers and day-traders had increased consider-ably. However long-term investors may suffer dueto the higher long-term capital gains tax. Wealth taxwould save many people paying tax on their wealthbut would ensure capture of income tax avoided orevaded.

Changes in Litigation and compliance:

Establishment ofNational TaxTribunal:An

aggrieved tax payer can now appeal against the or-ders of the Income Tax Appellate Tribunal (ITAT) inthe National Tax Tribunal within 30 days of the re-ceipt of the order. This would help in minimizingHigh Court pendencies.

Removalofpreviousyearandassessment

year jargons: The use of the two expressions hascaused confusion in both compliance and assess-ment. The separate concepts will be replaced by aunified concept of financial year. This change willnot change the existing system of deduction of taxat source and payment of advance tax in the year ofearning of income and payment of self-assessment

tax in the following year before filing of tax return.

Change indatesof filing returns:Thedue

date for filing returns will be 30th June of the yearfollowing the financial year for all non-business,non-corporate taxpayers and 31st August of the year

following the financial yearfor all other taxpayers.

Impact of Legal Chang-es: The establishment of Na-tional Tax Tribunal is a step inthe right direction. However,the Code must seek greatertransparency and minimizescope for corruption. Toachieve this, we need to in-vest more in training, tech-nology infrastructure and re-sources.

A Final Word:

The freshly unveiledDTC is an idea which was

long overdue. Although thegovernment claims it to berevenue neutral, it is ex-

pected to be revenue positive keeping in mind thebroad principle that lower taxes lead to tax wideningand improved compliance. There might be severalchanges to the proposed clauses before the Draftfinally comes into effect. It will be a test of the per-severance and political will to ensure its early en-actment and more importantly prevent any seriousdilution of its basic features.



FinGyaan

Mutual funds, themost used vehicleof investment bygeneral public quiteoften underper-form the market.The problem es-

sentially arises fromthe flawed incentivestructure which inspite of a competi-tive market cannotwipe out the overlyrisky behaviourundertaken by thefund managers.

Understanding the Strategies in the

Asset Management Industry

Life can only be understood

looking backward. It must be lived

forward.

The phrase uttered in the movieThe Curious Case of Benjamin But-ton reflects on lifes reality. This isa perfect example illustrated by in-vestment gurus all over the worldevery day. To see the future, look at

the past. To estimate how to con-struct a profitable portfolio, look atthe individual pieces in retrospect.Some of the theories they proposeare definitely true, but they are onlytheories and only about half of themturn out to be true.

Now, investment in any kindof market instrument, be it stocksor commodities, is given a BUY or aSELL recommendation by looking at

their past behaviour. Mutual fundsare no different. Studies show thatmost funds underperform the market.These funds are managed by fundmanagers who are more experiencedand better informed than the averageinvestor. Yet, they dont even matchup to the market. Why? The reason isthat their incentives are not perfectlyaligned with that of their investorsand they dont necessarily try to earnthe best returns for the fund in the

first place.Bill Parker, former Director of

William Partners and Laredo Petro-leum, claims that because of theirexcessive annual fees and poor exe-cution, approximately 80% of mutualfunds underperform the stock mar-kets returns in a typical year. Well,the perfect number changes everyyear, but the truth sadly remains. Ma-jority of mutual funds do not match

up to the market. Despite their miser-able performance all over the world,the number of mutual fund inves-tors continues to rise. In 1988, 22.2mAmerican families owned stock funds.

This figure has risen to 52.5m in 2008,approximating 45% of its populationrepresenting 92m individual fundshareholders. Asset Under Manage-ment (AUM) has increased from $808billion to $11.7 trillion in the sameperiod. In India in the year 2008, 90%of investors, at one instant or theother, invested in a mutual fund. As-

sets under management in the IndianMutual Fund Industry have increasedby 18.97% from mid-2008 to mid-2009.How? How do mutual fund ownerskeep running the business? The an-swer lies in the root of the incentivestructure. A similar problem (albeitwith incentive payoffs in the oppositedirection) exists in the Insurance In-dustry and is more commonly knownas the Problem of Moral Hazard.

Moral Hazard in the AssetManagement Industry

The incentive structure in theasset management industry creates aserious moral hazard problem. Moralhazard is defined as the prospectthat a party insulated from risk maybehave differently from the way itwould behave if it were fully exposedto the risk. In the asset managementindustry, the fund managers and thefund management company itselfare mostly insulated from the risk ofheavy losses on the investors mon-ey. Under most incentive structurescommonly in place, the asset man-agers get a performance linked feeif the fund does well, but the worstcase for them can only be zero fees.They never have to share the lossesof the investors.

It has been argued that poorperformance of the fund leads to low-

er volume of business in the futureas investors study the performanceof the fund over the past many yearsbefore making an investment. Thissolves the moral hazard problem to

IIM AhmedabadRohit Choudhry & Sheetal Sehgal



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80% of mutual funds under-

perform the stock marketsreturn every year

- Bill Parker

an extent. However, there exists investment/tradingstrategies for which the fund seems to be giving asteady yet high return for a significant period of timeeven though it is exposing the investors to very highrisks.

The Model

Consider a portfolio management strategy in-

volving a Taleb distribution. Named after Nassim Nich-olas Taleb, a Taleb distribution involves a high prob-ability of medium returns and a low probability ofvery high losses in any period, such that the expectedvalue is negative. However, this distribution createsan illusion of low risk and steady returns. To take asimplified example, consider a distribution with a 99%chance of making Rs 5 and a 1% chance of losing Rs500. The expected value of this distribution is 0.99*5- .01*500 = -0.05 Rupees. Clearly, it is not a good beteven for a risk neutral investor. Considering that most

investors are actually risk averse, this would be a verybad idea for most investors. Yet, it is an attractiveproposition for the asset management company andthe fund managers for two reasons:

Compensation Structure: The compensationstructure in the asset management industry meansthat the Asset Management Company (AMC) wouldmake a good fee in the 99% years that the fund givesa good return, while leaving the investors with theentire loss in the bad year. This implies that a risky,negative expected value investment for the investoris actually a profitable bet for the asset management

company. The asset management company, no matterhow the market conditions are, makes a certain in-come based on its Net Asset Value (NAV). For instance,let us take the example of Indian MF Industry. EveryAMC charges a fixed amount of money, called EntryLoad from its investors depending upon their invest-ment. This figure, currently, varies between 2-2.5%.Thus for every Rs.100 invested to buy a mutual fundwith unit value of Rs.10, this investor does not receive10 units, but only 100/(10*1.025) = 9.76 units (takingentry load to be 2.5%). Now for a 7% return on the

mutual fund, operating charges and other expensesare deduced from these returns, which includes thesalaries paid to the investment managers, operating,marketing and administrative expenses. These ex-penses, from various figures (audited and unaudited)quoted by various MFs, has been found to vary be-tween 2-2.75%. For convenience sake, let us take itto be 2%. Hence, investment returns to investors areonly 7-2 = 5% only. These costs, though seem small,

are running the industry. Take for instance; the stan-dard returns of an industry are close to 10%. For aninvestment of Rs.10,000 over a time period of 50 yearswill return a compounded return of Rs. 11,70,000, butthat at 8% will earn only Rs. 4,70,000. Thus the inves-tor is donating Rs.7,00,000 to the mutual fund industryand paying the high salaries to all the IIM Graduates!!

The illusion of low risk and high returns: Nor-mally, one would expect that a fund which exposesinvestors to high risks without giving proportionallyhigh returns would lose investors and go out of busi-ness. Thus, the asset management company wouldonly be able to make money for a short period oftime and only the companies which actually give theirinvestors superior returns would survive in the longterm. However, a strategy involving a Taleb distribu-tion makes most prospective investors believe thatthe fund is giving a good return at almost no risk. Inthe example above, the loss would happen only in

one year in 100 years. Most investors study the past5-10 years performance of the fund before investing.The fund would appear to be giving Rs 5 steadily atno risk.

What happens to the frm when the loss

eventually hits?

Nothing! When the loss occurs, the existing in-vestors of the firm suffer heavy losses. The firm doesnot get any fees for this year but does not have to payfor the loss. In the succeeding years, the asset man-agement company faces a few years of low business.

However, as it again generates the steady returns overthe next many years, and the huge loss fades out ofpublic memory, it starts gaining the investors back.Thus, the firm survives even the catastrophic loss andonly suffers a few years of low business.

Market Effect

The problem of moral hazard in the asset man-agement industry leads to market failure. This createsa problem in letting the markets function laissez faire,as some risk-averse or risk-neutral investors whoknow nothing about the markets need to be assuredthat their money will not evaporate. The above, addedwith the fact that the asset management industry hasthe potential to create an illusion of low risk and highreturns (which can be best represented by the Talebdistribution) led to a natural reaction by the govern-ments Regulation of the Mutual Fund Industry, al-though the Hedge Fund Industry still remains mostlyunregulated.



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Fill your basket with the most

diverse of options, they will seeyou through the worst of times

and still earn you the best ofrewards.

Deciding where toinvest isnt a peren-nial dilemma for theinvestor anymorethanks to the optionof a healthy assetallocation in diverseinvestment vehicles.The question of atrade-off betweenrisk and return canbe rightly answeredby choosing a judi-cious mixture ofinvestment optionslike Bonds, Stocks,Cash and Gold.

ASSET ALLOCATIONSTRATEGIES WITH RESULTS

SIBM, PUNESHWETA GAHLOT

What is Asset Allocation?Asset allocation means diver-

sifying your money among differenttypes of investment categories, suchas stocks, bonds and cash. The goalis to help reduce risk and enhancereturns.

Designing of our model port-folio

Establishing a well-diversified

portfolio may allow you to avoid therisks associated with putting all youreggs in one basket. A permanentportfolio is an example of passiveasset allocation, wherein you even-ly distribute your money in stocks,bond, cash and gold.

The idea in constructing a per-manent portfolio is that in any ofthe economic scenarios, one of theassets will outperform others in the

portfolio, maintain the returns; Infla-tion- Gold, Deflation- Bonds, Prosper-ity- Stocks, Recession- Cash. Takingpermanent portfolio as a prototype,we can see a few strategies withtheir respective risks and returns.

The objective is to create alow maintenance and high yieldingmodel. Those investing in mutualfunds know that heavy managementcharges are levied for professional

advice in allocation. No doubt thoughthat mutual funds beat market quitea number of times. But they grosslyfailed when stock market crumbled.So the main question is.can we ex-pect a steady and good growth fromthe stock market without having totake expert advice. The risk and re-turn profile has changed sharply in

recent times.Maximizing returns for a given

risk, according to the theory of Effi-cient Frontier, should combine a riskfree asset with risky ones. Bondsinevitably find way into the portfo-lio to give it stability and efficiency.What we do here is that we hold thebond till maturity; hence the interestrate risk is done away with.

Considering 10 year GOI yields,

we need a proper risky asset tocomplete our portfolio. An empiricalstudy of gold and NIFTY both showsthat the returns improved and riskbecame negligible when a very longterm perspective is taken.

Hence, a 10 year portfolio be-ginning with cash, stock, bonds andgold is taken. Initial investment is400 Rs. And no further investmentis made here to keep the model

simple. Risk, Returns and EfficiencyAnalysis of the same was done.

Parameters considered

Returns- Compounded annualGrowth rate

Risk- Standard deviation of10 year returns of NIFTY and goldthat come out to be approximately4.409% and 5.07% respectively

Correlation Considering that we

have 2 apparently risky assets in theportfolio, the correlation betweenthe returns is taken as a measureof risk.

Pearson Coefficient of returnson Gold and NIFTY were calculated.The value came out to be 0.769. Datafrom 1994 was considered.



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Thus, the CAPM model is used to calculate theRisk.

Efficiency- On research, it was found that oneof the most common measures of efficiency, i.e. riskand return profile of a portfolio is indicated by theSHARPE RATIO. It indicates that whether the returnsobtained on taking a particular amount of risk is ef-ficient or not. It is calculated as a ratio of Return onportfolio in excess of Risk free returns over Risk ofthe portfolio.

Strategies undertaken

1. Investment(Timing) Strategy

An analysis of the rolling returns from NIFTYshowed that investment without consideration ofmarket timing, would lead to lower than averagereturns. The much quoted 15% CAGR from marketsis obtained when you either regularly invest, so as

to average out your buying or if you invest in lumpsum, use some strategy like we have done.

Thus, an employment of 52-week low strategywas done. You begin with idle cash in your hand.You wait till you find your 1st 52 week low of themarket, where you invest 33% of your cash set asidefor stocks. On subsequent low, you invest next 33%while on the third 52 week low, the rest of the mon-ey is invested. Sufficient care is taken so as to notinvest on very close levels and hence a buffer of atleast 2 weeks is taken between two 52 week periods.

Also, a close but a very attractive 52 week low canbe chose depending on the value of previous low.

2. Idle cash appreciation

Now, in the previous scenario, cash was seento be sitting idle. But now various instruments areavailable in the market that can be used to parkyour idle cash. Liquid funds provide good liquiditywith returns up to 6%. Hence effectively, your in-vestment in stock market at right time is adequatelygrown. Generally Liquid funds have performed quitesatisfactorily in delivering 5-6% return, hence for ourexample we consider 6% on cash as riskless.

Results on application of the two above strate-gies in conjunction are as below:

YEAR RISK RETURN SHARPE RATIO

1995 3.97% 11.74% 1.1933

1996 4.01% 12.72% 1.4247

1997 4.14% 15.93% 2.1551

1998 4.05% 14.02% 1.7321

AVERAGE 4.04% 13.60% 1.6263

A 10 year portfolio with Stock 60%, Bond 20%, Gold 20%

3. Reallocation in the 5th year

Studies have shown that proper asset allocationis more important to long-term returns than specificinvestment choices. But since guessing which asset

category will do best at a certain time is very dif-ficult, it can make sense to divide your investmentsamong asset categories. Understanding this strategycan be key to investment success. For eg..

If your portfolio consisted majorly of stocks,plus you did not take into consideration any rebal-ancing when equity outperformed other asset class-es from 2005-06 to 2007-08, then:

100 Rs. invested in

2003 with given pro-

portions

STOCK

(50%)

GOLD (20%) BONDS (30

%)

JAN 2003(NIFTY level &

GOLD per 10 gm prices)

1085 6235 --

JAN 2008(NIFTY level &

GOLD per 10 gm prices)

6074.25 12571

MARKET VALUE

(2008)**

280 (77.3%) 40 (11.05%) 42 (11.6%)

EFFECTIVE

RETURNS(CAGR)***

16.67% 12.71% 7%*

PORTFOLIO RETURNS ---------- ------12.98%---- ---------------

REBALANCING(to

original proportions)

182 (50%) 73 (20%) 108 (30%)

EFFECTIVE

RETURNS(CAGR)

8.51% 24.28% 25.33%

PORTFOLIO RETURNS ----------- ----16.71 %-- ---------------

*10 year government bond yield

**Illustration: [6074.25*50/1085]=280

***Illustration: [(280/50)^0.2]-1=0.1667

As is evident from above, the exercise of as-set allocation is very useful when considering longterm returns. Not only thus the diversification pro-

vided a cushion here, the rebalancing has not let thewealth erode to a large extent. The returns before2008 meltdown, on equity, were 41% CAGR which fellto 16% in one year itself. Thus, booking profits andrebalancing equity at the right time has evidentlygiven better returns.

Reallocating at the end of 5 years is a philoso-phy of reallocating at a fixed interval without anystrategy. One of the conclusions drawn was, that itreduced the risk all the time while giving better re-turns around half the time. It is a mechanical exer-

cise without much consideration.

YEAR RISK RETURN SHARPE RATIO

1995 4.13% 12.07% 1.228567

1996 4.12% 12.91% 1.436059

1997 4.18% 15.88% 2.121084

1998 3.84% 13.82% 1.777104

AVERAGE 4.07% 13.67% 1.6407

10 year portfolio with Stock 60%, Bond 20%, Gold 20%

Though, risk has increased in some cases com-pared to before, the increase in Sharpe ratio explains

the efficiency being increased.4. Reallocation in the 7th year

For those who want to reduce their risk fur-ther without compromising much on returns, wouldhave to consider a different type of reallocation.



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As three year returns on NIFTY and Gold arefound to be more volatile than 5 or 10 year returns,the strategy is to exit both the markets in a majorway, book the profits, and make the profits safe. Theway adopted is that whatever be your level of equityand gold allocation in the beginning, bring it downto 15% each while keeping 70% of market value of

portfolio in only bonds. This would limit the risk as

well as not let the opportunity of a better returnsuffer.

Further, if a still safer route is to be adopted,one can transfer all the money invested in stock andgold into bond. Thus, risk is effectively reduced tozero 3 years prior to money requirement.

WITHOUT REBALANCING COMPLETE REBALANCING 100% INBOND 7TH YEAR

15-15-70% 70% IN BOND 7THYEAR

YEAR RISK RETURN RISK RETURN RISK RETURN

1995 3.87% 11.41% 0.00% 8.25% 1.04% 7.95%

1996 3.92% 12.41% 0.00% 5.44% 0.77% 7.52%

1997 4.07% 15.58% 0.00% 10.84% 0.87% 12.47%

1998 3.98% 13.88% 0.00% 12.48% 1.25% 13.55%

AVERAGE 3.96% 13.32% 0.00% 9.25% 0.98% 10.37%


27/28

t E A m N i V E s H A kARTICLE OF THE MONTH

The article of the month winners for September 2009 areSushil Pasricha & Peeyush Anand

of FMS, DelhiThey receive a cash prize of Rs.1000/-

Fin-Q WinnerThe Fin-Q Winner for the month September 2009 is

Arnab Chakrabortyof IIM Shillong

He receives a cash prize of Rs.500/-CONGRATULATIONS!!

ALL ARE INVITEDTeam Niveshak invites article from B Sc

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