• UGI USER
  • May 10, 2024
  • 18 Likes
  • 2 Comments

FINANCIAL MARKET IN INDIA

Financial System

The concept of a financial system is integral to understanding how economies operate. It encompasses a broad array of components including instructions, actors, procedures, markets, transactions, claims, and liabilities that interact in complex ways to facilitate the flow of financial resources throughout an economy. The essence of finance itself involves the study of money—its creation, behavior, rules, and management. Therefore, the financial system is a structured framework within which all financial operations occur, playing a vital role in the efficient allocation of resources from those who save to those who invest in productive activities.

Key Elements of the Financial System

Financial Institutions

  • Financial institutions are organizations that facilitate the flow of money and the expansion of financial services. They include banks, insurance companies, pension funds, and investment companies, serving as intermediaries between savers and borrowers. These entities collect funds from savers and allocate them to investors, thereby playing a critical role in the financial system.

Financial Markets

  • Financial markets are platforms where financial assets such as stocks, bonds, and other securities are bought and sold. These markets enable the efficient distribution of financial resources by matching those who need funds to those who have excess funds. Financial markets can be categorized into two main segments: one serving short-term financial needs (money markets) and the other catering to long-term financial requirements (capital markets).

Financial Instruments

  • Financial instruments, or securities, are contracts that represent a claim to financial assets. These instruments—including stocks, bonds, and derivatives—serve as a means for transferring resources from savers to borrowers. Unlike physical goods, financial assets are not consumed but instead provide their holders with a claim to future income or capital gains.

Financial Services

  • The services provided by banks and other financial institutions form an essential part of the financial system. These services include transaction processing, financial advising, asset management, and risk management. Through these services, financial institutions facilitate the smooth operation of financial markets and the broader economy.

Importance of the Financial System in the Economy

  • The financial system is crucial for the functioning of the economy as it enables the efficient allocation of resources. By facilitating the transfer of funds from those who have surplus savings to those who seek to invest in productive activities, the financial system supports economic growth and development. It helps in mobilizing savings, allocating capital efficiently, managing risks, and facilitating international trade and capital flows.

Role of Financial Market

  • Financial markets play a pivotal role within the financial system by providing a venue or mechanism for buying, selling, and trading financial assets. These transactions can occur on physical platforms like stock exchanges or through electronic means. The existence of financial markets allows for the liquidity of financial assets, meaning they can be quickly bought or sold with minimal loss of value.

Segmentation of Financial Markets

  • Financial markets are divided into segments to cater to different funding needs. The money market deals with short-term funds, providing liquidity for the short-term financial requirements of borrowers. Conversely, the capital market caters to long-term funding needs, facilitating the raising of capital for long-term investments.

Interest Rates as the Cost of Money

  • In financial markets, the cost of borrowing money is reflected in the interest rate, which is influenced by various factors such as the amount of funds, loan duration, and associated risks. The interest rate, therefore, represents the price of obtaining present funds in exchange for committing to repay a greater amount in the future, functioning as a critical indicator in financial decision-making processes.

Role of Financial Markets

Economic Development Funding

  • All countries rely on financial markets to facilitate the funding necessary for economic development. These markets are essential in channeling funds from savers, who have surplus resources, to borrowers, who have productive uses for these funds but lack immediate resources.

Transmission Mechanism

  • The core function of financial markets is the efficient allocation of resources through the transmission mechanism. This involves transferring funds from those with surplus (savers) to those with a deficit (borrowers), enabling investment and spending beyond current income levels.

Enhancing Social and Economic Well-being

  • By fostering investment and economic expansion, financial markets contribute significantly to societal well-being and quality of life improvements. Efficient and diverse financial markets are crucial for supporting rapid industrial growth and achieving national development goals.

Functions of Financial Markets

Price Discovery and Determination

  • Financial markets are instrumental in setting the prices of various assets through supply and demand dynamics and investor interactions. This pricing function ensures that resources are allocated efficiently.

Mobilization and Allocation of Funds

  • One of the primary roles of financial markets is to mobilize savings and channel them into productive investments, thereby contributing to capital formation and economic growth.

Ensuring Liquidity

  • Financial markets provide liquidity, making it possible for investors to buy and sell securities quickly and with minimal loss in value. This liquidity is vital for the smooth functioning of a capitalist economy.

Cost and Time Efficiency

  • By offering a centralized platform for trading, financial markets save time and money for participants by providing crucial information and reducing the effort needed to find trading partners.

Types of Financial Markets

Organised Markets

  • These markets operate under regulatory frameworks and are subdivided into money markets (short-term credit) and capital markets (medium to long-term financial transactions). Regulatory bodies ensure compliance with laws and standards.

Unorganised Markets

  • Comprising informal entities like moneylenders and local bankers, unorganised markets play a role in credit provision, especially in areas not adequately served by organised financial systems.

Money Markets

Short-term Financing

  • Money markets specialize in short-term debt instruments, providing a mechanism for managing short-term liquidity needs for various entities, including governments and corporations.

Regulatory Oversight

  • In many countries, central banks or similar regulatory authorities oversee money markets to ensure stability and manage liquidity levels in the economy.

Evolution and Reform

  • The evolution of money markets, especially in countries like India, reflects ongoing reforms aimed at deepening and broadening these markets for enhanced efficiency and inclusiveness.

Instruments of Money Market

Call/Notice/Term Money

  • These instruments allow banks to manage short-term liquidity through borrowing and lending with varying maturities.

Repos and Reverse Repos

  • Repo (repurchase agreements) transactions are crucial for short-term borrowing and lending, involving the sale of securities with an agreement to repurchase them at a later date. These instruments are key for managing liquidity and facilitating central bank policies.

Treasury Bills (T-Bills)

Definition and Characteristics

  • Treasury Bills are short-term securities issued by the Central Government of India. They are considered one of the safest investments since they are backed by the government’s credit, virtually eliminating default risk. T-Bills are issued with three main maturities: 91 days, 182 days, and 364 days, allowing investors to choose based on their liquidity needs and investment horizon.

Historical Background

  • The issuance of Treasury Bills has been a practice since India’s independence. However, the system was organized and formalized only in 1986, marking a significant development in the country’s financial market infrastructure.

Yield and Valuation Changes

  • Originally, T-Bills were sold at a discount to their face value, with yields calculated on a 360-day year basis. However, from October 27, 2004, the Reserve Bank of India (RBI) revised this norm to consider a year as 365 days for yield calculations, aligning it more closely with international standards.

Secondary Market and DFHI

  • The Discount and Finance House of India (DFHI) was established in November 1986, primarily to promote a secondary market for T-Bills and other money market instruments. This initiative has facilitated greater liquidity and trading flexibility for these securities.

Auction System and Investor Base

  • In January 1993, the RBI introduced an auction system for the allocation of 91-day T-Bills, further streamlining the process. The investor base for T-Bills is diverse, including banks, primary dealers, financial institutions, provident funds, insurance companies, Non-Banking Financial Companies (NBFCs), Foreign Institutional Investors (FIIs), and state governments.

Commercial Paper (CP)

Definition and Usage

  • Commercial Papers are unsecured, short-term borrowings used by large, financially stable corporations with high credit ratings. These instruments allow companies to meet their short-term liquidity needs without the need for collateral, making them a flexible financing option.

Eligibility and Maturity

  • CPs can be issued by non-financial corporates, primary dealers, and all India Financial Institutions that meet specific net worth and credit rating criteria. The maturity of CPs ranges from 7 days to one year, offering versatility in financing terms.

Certificates of Deposit (CD)

Overview and Issuers

  • CDs are short-term borrowing instruments issued by commercial banks and All India Financial Institutions (AIFIs). These instruments can have maturities ranging from 15 days to one year for banks and one to three years for AIFIs. CDs are issued in denominations of ₹5 lakh and multiples thereof.

Features and Transferability

  • Unlike bank fixed deposits, CDs are freely transferable through endorsement. They are issued at a discount to their face value, and the discount rate or yield is negotiated between the issuer and the purchaser. CDs are accessible to individuals, corporations, trusts, and investment firms, enhancing their appeal as investment options.

Bills Rediscounting/Commercial Bill/Bill of Exchange

Definition and Function

  • A bill of exchange, under the Negotiable Instruments Act of 1881, is a written instrument that contains an unconditional order to pay a certain amount. It facilitates trade by allowing sellers to receive payment earlier than the agreed upon future date, through the discounting process with banks.

Rediscounting by Central Bank

  • Banks can also rediscount these bills with the central bank to obtain funds for their lending activities, creating a mechanism for liquidity management within the banking sector.

Money Market Mutual Fund (MF)

Introduction and Liberalization

  • Money Market Mutual Funds, introduced in 1992, offer individuals short-term investment opportunities in the money market. The regulation and oversight of MFs have evolved, with the Securities and Exchange Board of India (SEBI) and the RBI playing significant roles in their governance.

Diverse Sponsorship

  • A wide range of financial organizations, including commercial banks, public and private financial institutions, and private sector companies, are allowed to establish MFs, contributing to the diversity and depth of the money market in India.

Cash Management Bills (CMBs)

  • Introduced in August 2009, CMBs are short-term instruments issued by the Government of India, in consultation with the Reserve Bank of India (RBI), to manage temporary cash flow shortfalls. Unlike regular treasury bills with a minimum maturity of 91 days, CMBs have maturities of less than 91 days, making them an essential tool for short-term liquidity management.

Unique Features and Utility

  • Short-term Nature: They are specifically designed to meet the government’s short-term funding requirements efficiently.
  • Discounted Instruments: CMBs are issued at a discount to their face value, making them attractive for investors seeking short-term investment opportunities.
  • Marketability: These bills are marketable, allowing investors to buy and sell them in the secondary market, enhancing liquidity.
  • SLR Eligibility: Investments in CMBs are considered eligible for the Statutory Liquidity Ratio (SLR), making them a preferred choice for banks to manage their SLR requirements.
  • Exemption from WMA Provisions: Unlike traditional treasury bills, CMBs are not subject to Ways and Means Advances (WMA) regulations, offering the government greater flexibility in managing its short-term funding needs.

Unorganized Money Market

  • Historically, before the organized growth of the money market in India, an unorganized sector existed, which continues to operate alongside its regulated counterpart. This segment plays a crucial role in providing access to credit in areas and sectors where the organized money market does not have a strong presence.

Components and Characteristics

  • Unregulated Non-Bank Financial Intermediaries: This includes chit funds, Nidhis, and lending firms, often characterized by high-interest rates and selective reach.
  • Indigenous Bankers and Money Lenders: Individuals or enterprises that accept deposits and lend money, with a significant presence across various regions of India. They include Marwari Kayas, Chettiars, Gujarati Shroffs, and Multani or Shikarpuri Shroffs, among others.
  • Challenges and Concerns: These entities often operate in a more exploitative manner, especially in the case of professional and non-professional money lenders, leading to concerns about high interest rates and financial vulnerability for borrowers.

Capital Market

  • The capital market is a vital component of India’s financial system, facilitating the exchange of long-term securities like stocks, bonds, and debentures. It plays a critical role in mobilizing savings and directing them towards productive investments, thereby contributing to national economic growth and development.

Structure and Functions

  • Organized and Unorganized Sectors: The capital market in India comprises both organized and unorganized sectors, with the latter including indigenous bankers and money lenders.
  • Long-term Financing: It provides both fixed and working capital to businesses and funds the medium and long-term requirements of various government levels.
  • Investment and Growth: By enabling the efficient allocation of financial resources, the capital market drives capital formation, productive investment, and national income growth.

Significance and Impact

  • Funds Mobilization: It pools savings from individuals and institutions, directing them towards entities in need of funds.
  • Capital Formation and Productive Investments: Encourages saving and investment, leading to capital formation and redirecting resources from unproductive channels to productive uses.
  • Market Efficiency: A well-developed capital market contributes to the efficient valuation of securities, reducing speculation and promoting economic stability.

Financial Institutions in the Capital Market

  • The capital market plays a pivotal role in the economic development of a country, serving as a critical channel for mobilizing the savings of individuals and institutions and directing them towards productive investment avenues. Within this ecosystem, financial institutions and agencies that either participate directly in the capital markets or facilitate the processes therein are of paramount importance. These entities can be broadly categorized into Banking Institutions and Non-Banking Financial Institutions (NBFI), each playing distinct yet complementary roles.

Banking Institutions

  • Banking institutions are the backbone of the financial system, primarily engaging in accepting deposits and lending funds. They vary in type, including commercial banks, cooperative banks, land development banks, foreign banks, and regional rural banks, among others.

Role and Functions

  • Deposit Mobilization: Banks are pivotal in collecting long-term deposits from the public, offering a safe avenue for individuals to park their savings.
  • Lending Activities: These institutions cater to the borrowing needs of various segments, including micro, small, medium, and large enterprises, by providing long-term financing options.
  • Diverse Financing: Apart from businesses, banks extend their lending services to transport operators, traders, farmers, professionals, and self-employed individuals, fulfilling a broad spectrum of financial needs across the economy.

Non-Banking Financial Institutions (NBFI)

  • NBFIs complement the banking sector by engaging in capital market activities, bridging the gap between savers and investors without accepting traditional deposits as banks do.

Subcategories and Roles

  • Investment Banks:
    • Act as intermediaries, channeling savings into commercial ventures.
    • Offer services including corporate venture financing, marketing of shares and debentures, and acting as security intermediaries.
  • Merchant Banks:
    • Provide specialized financial advisory and intermediary services.
    • Engage in business restructuring, project counseling, capital restructuring, issue management, and more, tailored to corporate needs.
  • Investment Companies:
    • Aggregate funds from the public to invest in a diversified portfolio of securities.
    • Aim to maximize returns through efficient management of pooled resources.
  • Insurance Companies:
    • Offer coverage against various risks including life, general, and marine insurance, protecting against losses from unforeseen events.
  • Development Banks:
    • Focus on accelerating industrialization through financial support and expertise.
    • Offer long-term financial support for industrial and developmental projects.
  • Pension Funds:
    • Manage retirement savings, investing in various financial instruments to ensure the financial security of pensioners.
  • Finance Companies:
    • Raise funds through various means to lend or invest, playing a critical role in the financial market though their performance has been mixed in some regions.

Understanding Capital Markets: A Deep Dive into Primary and Secondary Markets

  • Capital markets play a pivotal role in the global financial landscape, serving as a bridge between investors seeking to put their funds to work and entities in need of capital for growth and expansion. These markets are categorized into two main types: the primary market and the secondary market. Each serves distinct functions and offers unique features and benefits to the economy and its participants.

Primary Market: The Launchpad for Securities

  • The primary market is where the journey of securities begins. This market is crucial for companies, governments, and other entities looking to raise new capital through the issuance of securities.

Key Features of the Primary Market

  • Fresh Issues Market: The primary market deals exclusively with the issuance of new securities, making it the first stop for companies seeking to raise capital.
  • Direct Capital Formation: Funds flow directly from investors to issuers, aiding in the direct capital formation process critical for economic growth and development.
  • Initial Public Offerings (IPOs): A significant activity in the primary market is the launching of IPOs, where companies offer their shares to the public for the first time.
  • No Physical Location: Unlike stock exchanges, the primary market isn’t tied to a physical location; it’s a process involving the issuance of new securities.

Methods of Floating Capital in the Primary Market

  • Public Issue: Companies invite the general public to subscribe to new securities through a prospectus.
  • Offer for Sale: Securities are first sold to financial intermediaries, who then sell them to the public.
  • Private Placement: Securities are sold directly to a select group of institutional investors or wealthy individuals.
  • Rights Issue: Companies offer new shares to existing shareholders at a pre-determined price, often at a discount.
  • Electronic Initial Public Offers (e-IPOs): Companies issue securities electronically, leveraging the internet and technology to reach investors.

Benefits of the Primary Market

  • Lower Risk of Price Manipulation: With fresh issues, there’s less scope for price manipulation, making it a safer investment avenue.
  • Market Timing Unnecessary: Investors get the securities at the issue price, eliminating the need to time the market.
  • Direct Investment: Investors directly contribute to and become part of the company’s growth story.

Primary Market Applications

  • It involves various stages like appointing merchant bankers, pricing the issue, marketing, risk disclosure, public subscription, and finally, allotment of securities.

Secondary Market

  • The secondary market is where the trading of existing securities happens. This market is essential for providing liquidity and facilitating price discovery for securities.

Key Features of the Secondary Market

  • Liquidity Provider: The secondary market allows investors to buy and sell securities, thus providing liquidity.
  • Post-Issue Market: It operates after securities have been issued in the primary market.
  • Role of Stock Exchanges: Most secondary market transactions occur through stock exchanges, which are regulated environments ensuring fair trading practices.

Benefits of the Secondary Market

  • Asset Liquidity: Investors can sell their securities and access their funds, offering financial flexibility.
  • Investment Opportunities: The secondary market provides opportunities for investors to buy and sell securities, potentially earning returns over time.

Secondary Market Applications

  • It encompasses securities trading, risk management, trade clearing and settlement, and the delivery of securities and funds.

Primary Vis-A-Vis Secondary Market

Point of Distinction Primary Market Secondary Market
Traded By Sale of securities by new companies or for further capital. Only the existing shares can be traded.
Intermediaries The company sells securities directly to the investor (or through a middleman). Investors exchange ownership of existing securities. The company is not involved in any way.
The flow of Funds The flow of funds is from savings to investors. Increases share encashability (liquidity), implying that the secondary market indirectly promotes capital formation.
Buy/Sell The primary market only permits the purchase of securities but does not allow for the sale of securities. The stock exchange allows for both the buying and selling of securities.
Determination of Price It was decided by the company’s management. Prices are determined by the security’s demand and supply.
Location It doesn’t have any fixed geographic location. Located in specific locations.

Instruments of the Capital Market

  • Capital markets play a vital role in the financial ecosystem, serving as a medium for raising capital through the issuance of various complex financial products. These instruments include shares, debentures, bonds, and other marketable securities, enabling corporations and governments to fund capital-intensive projects, expansion activities, or manage their financial operations.
Feature Equity Shares Preference Shares Sweat Equity Shares
Definition Shares that represent ownership in a company. They give shareholders a stake in the company’s profits and losses, as well as rights to its assets. Shares that provide shareholders with a preference over equity shares in terms of dividend payments and capital repayment, but typically do not offer voting rights. Shares issued at a discount or for consideration other than cash, to employees or directors for their contribution in terms of services or know-how.
Dividends Variable dividends based on the company’s profitability. Equity shareholders are paid after preference shareholders. Fixed dividend, which is paid out before equity shareholders receive any dividend. Not directly related to dividends but represents an ownership stake that could benefit from future dividends based on company performance.
Voting Rights Yes, equity shareholders usually have voting rights on corporate affairs, including the election of the board of directors. No, preference shareholders typically do not have voting rights in company affairs. Usually, yes, as they are a form of equity share, granting holders the same rights as other equity shareholders, including voting rights, unless specified otherwise.
Risk Higher risk due to variable dividends and last claim on assets in case of liquidation. Lower risk with fixed dividends and a higher claim on assets than equity shareholders in case of liquidation. Similar to equity shares, but often issued to recognize the non-monetary contributions of employees or directors, thus carrying a different type of investment risk.
Priority Last in line for dividend payment and in claiming assets during liquidation, after creditors, bondholders, and preference shareholders. Higher priority than equity shareholders for dividend payments and asset claims in liquidation, but still behind creditors and bondholders. Similar priority to equity shares for dividends and asset liquidation, depending on the terms of issuance.
Purpose To raise capital for the company’s operations, expansion, or other financial needs. Allows shareholders to benefit directly from the company’s growth. To raise capital with a lower risk compared to equity shares, providing a fixed income investment option for shareholders. To compensate, motivate, and retain employees or directors by giving them a stake in the company, recognizing their non-financial contributions.

Debt Instruments

  • Debt instruments are essential tools for raising funds in the capital market. They establish a borrower-creditor relationship between the issuer and the investor, without granting the investor ownership in the issuing entity. The key characteristics of debt instruments include a fixed term of maturity and regular interest payments to the investor.

Debentures

  • Debentures are a type of long-term debt instrument used by corporations and governments to raise capital. They are essentially loan agreements that guarantee the holder a fixed return and the principal amount upon maturity. Unlike equity, debentures offer a fixed income and carry no voting rights but are often freely transferable by the holder.

Bonds

  • Bonds are formal contracts to repay borrowed money with interest at fixed intervals. They can be issued by corporations, municipalities, institutions, and governments. Bonds are categorized based on the issuer:
  • Government Bonds: Issued by national governments.
  • Municipal Bonds: Issued by local government entities.
  • Institutional Bonds: Issued by institutions like universities or public utilities.
  • Corporate Bonds: Issued by corporations.
  • Bonds can offer secured or unsecured claims against the issuer’s assets, with the interest rate reflecting the risk involved. The yield on bonds can be understood through two primary measures: the interest yield (or running yield) and the yield to maturity (or redemption yield).

Innovative Bond Types

  • Green Bonds: Green Bonds are designed to fund projects that have positive environmental and climate benefits. The World Bank was a pioneer in this area, issuing the first Green Bond in 2007. These bonds have been used globally, including in India, to finance renewable energy projects and other environmentally friendly initiatives.
  • Blue Bonds: Similar to Green Bonds, Blue Bonds focus on funding projects that promote water conservation and sustainable water management, contributing to climate resilience and environmental sustainability.
  • Masala Bonds: Masala Bonds are rupee-denominated bonds issued outside India by Indian entities, allowing them to raise capital without exposing investors to currency exchange risks. These bonds have been utilized for funding infrastructure projects in India, with the International Finance Corporation being notable for issuing such bonds to support Indian projects.

Derivative Instruments

  • Derivatives are financial securities with a value that is reliant upon or derived from, an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset. The most common types of derivatives include:
  • Futures
  • Options
  • Forwards
  • Swaps
  • These instruments allow investors to hedge risk or speculate on price movements of the underlying asset. Derivatives can be traded on exchanges or over-the-counter.

Differences Between Bonds and Debentures

  • Understanding the distinction between bonds and debentures is crucial for investors and issuers alike. Bonds generally offer more security than debentures and are often backed by collateral. They have a fixed interest rate, which is less influenced by the issuing company’s profitability. In contrast, debentures may offer higher interest rates due to the increased risk, as they are typically unsecured and subordinate to bonds in case of liquidation. This differentiation highlights the varying levels of risk and reward associated with each capital market instrument, allowing investors to align their investment choices with their risk tolerance and financial goals.

Difference Between Debt and Equity

Basis for Comparison Debt Equity
Definition Debt refers to monetary funds owed by the company to another party. It represents a loan that must be repaid over time, along with interest. Equity involves the funds that a business raises through the issuance of shares. It represents ownership in the company and entitles shareholders to a portion of the profits.
Issued By Companies registered with the Securities and Exchange Board of India (SEBI). Companies and governments can issue equity. However, only companies issue shares as a form of equity.
Status Represents an obligation on the part of the issuer to repay the borrowed amount plus interest. Represents ownership in the company. Equity holders are essentially co-owners of the business.
Risk Generally considered less risky than equity, as debt instruments offer a fixed return and have priority over equity in case of liquidation. Higher risk compared to debt because equity returns depend on the company’s performance and profitability. Equity holders are also last in line during liquidation.
Nature of Return Offers fixed and regular returns in the form of interest payments, making it a predictable income source. Provides variable and irregular returns, as dividends are paid out of profits and can fluctuate based on the company’s performance.
Payoff The lender of debt receives interest income along with the repayment of the principal amount at the end of the loan term. Shareholders (equity holders) receive dividends or a share in the profits based on the number of shares they hold. These payments are not guaranteed and depend on the company’s financial health.
Regulator The Securities and Exchange Board of India (SEBI) oversees debt instruments issued by companies. Corporate bonds are also regulated by RBI in conjunction with SEBI. Equity issuance and trading are regulated by SEBI. For companies, this includes regulations around public offerings, disclosures, and shareholder rights.

Forward Contract Vis-A-Vis Future Contract

Basis for Comparison Forward Contract Futures Contract
Definition A customized contract between two parties to buy or sell an asset at a specified price on a future date. A legal contract to buy or sell a specific commodity asset, security, or timeshare at a predetermined price and time in the future.
Regulation Self-regulated Regulated by a stock exchange
Collateral Not required Initial margin required
Default Risk Higher, as they are private agreements Lower, due to regulatory oversight and the margin system
Trading Platform Over-the-counter (OTC); no secondary market Organized stock exchange
Customization Tailor-made contracts according to the needs of the contracting parties Standardized contracts with fixed terms
Settlement Occurs on the maturity date Daily settlement, which can mitigate some risk due to regular adjustments to account balances
Maturity Agreed upon as per the terms of the contract Predetermined date set by the exchange
Size of the Contract Depends on the contract terms and can vary significantly between contracts Fixed and standardized across all contracts of the same type
Risk Higher, due to the lack of regulation, the possibility of default, and the absence of a daily settlement Lower, because of the regulated nature of the market, margin requirements, and daily settlement process

Angel Investors Viz-A-Viz Venture Capitalist

Aspect Angel Investors Venture Capitalists
Operator Operate independently, often as individual investors. Operate as companies or firms with a structured team.
Support Type Offer mainly financial assistance, potentially with some mentoring. Seek a strong, competitive product or service with significant market potential and often provide comprehensive support including financial, strategic, and operational guidance.
Specialty Specialized in early-stage companies and startups. Participate not only in early-stage firms but also in more mature businesses looking for growth or expansion capital.
Control Generally do not seek significant control or influence over the company. Often require significant influence or control over the firm, including board representation and substantial say in strategic decisions.

State Development Loans (SDLs)

  • State Development Loans (SDLs) are instruments through which the state governments in India manage their finances, particularly to finance the fiscal deficits that arise when their expenditures exceed receipts. These are essentially bonds issued by state governments with the primary aim of bridging budgetary gaps.

Characteristics and Management

  • Term and Interest: SDLs generally have a maturity period of around 10 years. They pay interest at half-yearly intervals and repay the principal amount at the time of maturity.
  • Regulatory Oversight: The Reserve Bank of India (RBI) manages SDLs but does not guarantee them. The RBI’s role includes ensuring that interest and principal payments on SDLs are made promptly.
  • Trading and Participants: SDLs are traded online in a manner similar to the government bond market. Participants include banks, mutual funds, insurance companies, provident funds, and more.

Benefits of State Development Loans

  • Lower Risk: SDLs carry a lower risk compared to AAA-rated corporate bonds due to the sovereign backing. Though the RBI does not explicitly guarantee these loans, its involvement in managing SDL repayments and maintaining a contingency fund implies a level of security.
  • Higher Yields: Typically, SDLs offer yields that may be higher than those on central government bonds, making them an attractive investment option. They are traded through auctions, similar to central government bonds.

Current Status in India

  • As of a specific snapshot, over a period from April to September in a fiscal year, 27 states and two union territories raised a significant amount through market borrowings, indicating a considerable increase from the previous fiscal year. This reflects the growing reliance and importance of SDLs in state financing strategies.

Exchange Traded Funds (ETFs)

  • ETFs are investment funds traded on stock exchanges, much like stocks. They offer the flexibility of buying and selling shares throughout the trading day at market price, unlike mutual funds which are traded at the end of the trading day at the net asset value price.

Characteristics

  • Diversification: ETFs can hold a mix of investments, such as stocks, commodities, and bonds. They may target specific industries, sectors, or geographical areas, offering a diversified investment portfolio.
  • Types of ETFs: There are various types, including passive ETFs (which track an index), active ETFs (managed by portfolio managers), bond ETFs, stock ETFs, sector or industry ETFs, commodity ETFs, and currency ETFs.

Advantages

  • Flexibility and Liquidity: ETFs can be bought and sold at any time during the trading day, providing liquidity and flexibility.
  • Diversification: By holding a wide range of assets, ETFs allow for broad diversification, which can reduce investment risk.

External Commercial Borrowings (ECBs)

  • ECBs are loans obtained by Indian entities from foreign lenders. These are crucial for accessing foreign funds by Indian businesses and public sector enterprises, facilitating the inflow of foreign capital.

Regulation and Usage

  • Supervision: The Department of Economic Affairs, along with the RBI, oversees the regulations concerning ECBs, ensuring a structured approach to foreign borrowing.
  • Purpose and Policy: ECBs serve various purposes, including refinancing existing debt. The government has a policy in place to regulate the amount and use of ECBs, promoting a balanced approach to foreign borrowing.

Evolution and Impact

  • ECBs have evolved as a significant source of foreign capital in India’s post-reform era, contributing to the development of the corporate debt market. Recent policies have further liberalized ECB standards, expanding the sectors that can access these funds, reflecting India’s broader development strategy and approach to managing foreign debt.

The Securities Market in India

  • The securities market in India forms a crucial part of the financial ecosystem, facilitating the efficient transfer of funds from savers to entities in need of capital. This detailed overview covers its structure, participants, regulatory framework, and more, providing a comprehensive insight into how the securities market operates within the country.

Introduction to the Securities Market

  • The securities market is a regulated environment designed for the transaction of financial instruments such as stocks and bonds. It acts as a conduit for channeling funds from investors to businesses, playing a significant role in capital formation and economic development.

Characteristics of Securities

  • Function as a Medium of Exchange: Securities represent a contract between a buyer and a seller for the exchange of money.
  • Tool for Fundraising: Issuers raise funds at reasonable costs while offering investors ownership.
  • Regulated Issuance: Securities are issued within a regulated and monitored framework to ensure the protection of investor interests.
  • Types of Securities: Securities are broadly classified into stocks (equity) and debt, with the former representing ownership and the latter a claim on cash flows.

Structure of the Securities Market

  • Primary Market: Focuses on the issuance of new securities, either as fresh issues or offers for sale.
  • Secondary Market: Provides a platform for the trading of existing securities.
  • Derivatives Market: Trades futures and options, which are contracts based on the underlying security.

Functions of the Securities Market

  • Capital Allocation: Directs financial resources from those willing to bear risk to entities requiring capital for growth.
  • Economic Growth: Converts savings from numerous small investors into long-term wealth, facilitating participation in economic advancement.
  • Liquidity Provision: Ensures that stocks and bonds remain liquid, thereby encouraging further investment.
  • Price Discovery: Utilizes the collective intelligence of market participants to ascertain the true value of assets.

Participants in the Securities Market

  • Investors: Individuals or institutions with surplus funds looking to invest in securities.
  • Issuers: Entities that issue securities to raise capital.
  • Intermediaries: A range of professionals who facilitate the smooth operation of the securities market.

Key Intermediaries

  • Asset Management Companies/Portfolio Managers
  • Investment Bankers
  • Underwriters
  • Brokers
  • Clearing Members
  • Depository Participants
  • Trustees

Regulatory Framework

  • The Indian securities market is regulated by SEBI, with additional oversight from the Reserve Bank of India (RBI), the Ministry of Finance’s Department of Economic Affairs (DEA), and the Ministry of Corporate Affairs (MCA). This comprehensive regulatory framework ensures the market’s integrity and the protection of investor interests.

Key Regulatory Bodies

  • Securities and Exchange Board of India (SEBI): The primary regulator focused on market expansion, investor protection, and maintaining integrity.
  • Reserve Bank of India (RBI): Regulates the money market segment and manages government debt.
  • Ministry of Corporate Affairs (MCA): Governs corporate operations and securities issuance.
  • Ministry of Finance (MOF): Oversees market supervision and regulatory reforms.

Issuers in the Indian Security Market

  • Issuers range from government entities to private sector companies, each utilizing different instruments to raise capital. These include government securities, corporate bonds, equity shares, and more.

Types of Issuers

  • Government: Utilizes instruments like G-Secs and Treasury Bills for funding.
  • Public Sector Units (PSUs): Raise funds through shares, bonds, and tax-exempt bonds.
  • Private Sector Companies: Access capital markets through equity and debt instruments.
  • Banks and Financial Institutions: Issue various securities to meet capital requirements.

Innovations in Market Access

  • The introduction of the Retail Direct Scheme by the RBI exemplifies efforts to democratize access to government securities for retail investors. This initiative allows individuals to directly invest in government securities, promoting broader participation in the financial markets.

Stock Exchanges in India

  • The structure of stock exchanges in India plays a pivotal role in the nation’s economic framework, facilitating capital formation, investment opportunities, and a transparent mechanism for trading securities. The key aspects and operations of stock exchanges in India, covering their role, trading systems, and settlement procedures.
  • India’s stock market infrastructure comprises 23 stock exchanges, including the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), which are among the most prominent. The BSE, established in 1875, is India’s oldest stock exchange, while the NSE, founded in the early 1990s, has rapidly become the country’s leading stock exchange due to its nationwide network and modern trading mechanisms. Another notable entity is the Over the Counter Exchange of India (OTCEI), a newer national exchange designed to accommodate and facilitate smaller companies.
  • Stock exchanges in India operate either as voluntary non-profit organizations or as public limited companies. They are registered with the Central Government and function under the Securities Contracts (Regulation) Act of 1956, which dictates their formation, management, membership, and operational modalities.

Role of Stock Exchanges

Promoting Industrial Progress

  • Stock exchanges are instrumental in raising capital for businesses, thus fueling the country’s industrial growth. They offer a platform for the public to invest directly in companies, supporting entrepreneurial endeavors and innovation.

Defending Investors’ Interests

  • By setting and enforcing strict operational standards for listed companies, stock exchanges safeguard investors’ interests, ensuring transparency and fairness in corporate conduct.

Facilitating Secondary Markets

  • Stock exchanges enable the trading of various financial instruments, including bonds and sovereign gold bonds (SGBs), providing liquidity to investors seeking to sell their holdings before maturity.

Price Determination

  • Through continuous trading activities, stock exchanges assist in the price discovery of listed securities, ensuring that the prices reflect the current market conditions based on supply and demand.

Stock Exchange Trading System

Traditional Trading System

  • Historically, trading on the stock exchange floor was the norm. This system only allowed the trading of listed securities, which are securities officially recognized and approved for trading by the exchange. Traditional trading differentiated between “cash list” securities, available for immediate delivery, and “forward list” securities, which permitted forward trading.

On-Line Trading System

  • The introduction of online trading systems, like the BOLT system by BSE, revolutionized stock trading by eliminating the need for physical trading floors and enabling efficient, electronic transactions.

Settlement Procedure for Traded Securities

  • Settlements for traded securities are categorized into specified and non-specified securities. The specified securities include highly traded shares from prominent companies, whereas non-specified securities encompass the rest. The settlement processes have evolved from the Carry Forward System (Badla) to the Rolling Settlement System, which is now prevalent. The Rolling Settlement System mandates the completion of payment and delivery within three days of the transaction (T+3 basis), enhancing efficiency and reducing risks.

Securities Dematerialization (Demat)

  • The dematerialization process marks the transition from physical share certificates to electronic record-keeping. This change, facilitated by the Depository Act of 1996 and the establishment of the National Securities Depository Limited (NSDL), has significantly improved the efficiency and security of securities trading and settlement in India. Dematerialized securities are fungible, meaning they do not have unique identifying features, simplifying the trading process.

International and National Stock Exchanges

  • The global financial landscape is dotted with various stock exchanges, each playing a pivotal role in the economic development of their respective countries and regions. These exchanges are platforms where stocks and other securities are bought and sold, providing companies with access to capital and investors with ownership stakes and investment opportunities.

Bombay Stock Exchange (BSE)

  • The Bombay Stock Exchange (BSE) holds the distinction of being Asia’s oldest stock exchange, established in 1875 by Jain industrialist Premchand Roychand. It has grown to become a significant player in the global financial market, situated on Dalal Street in Mumbai.

Significance

  • Despite only 1.3% of Indians investing in the stock market, compared to higher percentages in countries like the US and China, BSE has been instrumental in the financial sector’s development in India. It was the first to be recognized under the Securities Contracts Regulation Act in 1957 by the Indian government.

Innovations

  • The BSE introduced the S&P BSE SENSEX index in 1986, a benchmark index to measure the exchange’s overall performance. Additionally, it launched India INX in 2016, the country’s first international exchange, broadening its scope and reach.

National Stock Exchange (NSE)

Establishment

  • The National Stock Exchange (NSE) is a more recent addition to India’s financial market, suggested by the Pherwani Committee in 1991 and operational since 1994. It is known for its technological advancements and is headquartered in Mumbai.

Contributors

  • Foundational support for the NSE came from major financial institutions like IDBI, IFCI, ICICI, LIC, GIC, and others, demonstrating a collaborative effort to enhance India’s financial infrastructure.

Indices and Innovations

  • NSE’s primary index, the Nifty 50, represents 21 diverse economic sectors, making it a crucial gauge for the Indian economy. The NSE has also been a pioneer in introducing various financial products and services to cater to a broad spectrum of investors.

Calcutta Stock Exchange (CSE)

Historical Perspective

  • Originating under a Neem Tree in the 1830s, the CSE is one of India’s oldest stock exchanges. It was officially recognized by the Government of India in 1980, highlighting its long-standing presence in the financial market.

Metropolitan Stock Exchange (MSE)

Recognition

  • The MSE, established with recognition from the Ministry of Corporate Affairs in 2012, offers a range of financial products similar to those found on other stock exchanges, including derivatives and debt market products.

India International Exchange (India INX)

  • India INX, a subsidiary of the BSE and operational since 2017, is India’s first international stock exchange located in Gujarat’s International Financial Services Centre (IFSC), GIFT City. It focuses on offering debt instruments and derivative products, expanding India’s reach in the global financial market.

NSE IFSC

Establishment

  • Similar to India INX, NSE IFSC is a subsidiary of NSE, focusing on providing an international trading platform. It is based in the same IFSC, GIFT City in Gujarat, showcasing India’s ambition to become a hub for international financial services.

Regulatory Framework: Securities and Exchange Board of India (SEBI)

Role and Reforms

  • SEBI, established in 1988 and given statutory powers in 1992, is the regulatory authority overseeing India’s capital markets. It aims to protect investors, promote fair trading practices, and regulate market intermediaries. Following financial scandals in the 1990s and early 2000s, SEBI introduced reforms to enhance market transparency, implement stricter regulations against insider trading, and improve overall market integrity.

Initiatives and Regulations

  • SEBI has introduced various measures, such as reforms in stock exchange governance, capital adequacy norms for brokers, and requirements for corporate transparency. It has also implemented the “Anchor Investor” concept to attract significant institutional investors to initial public offerings, reflecting its proactive approach to market regulation and investor protection.

Commodity Exchanges

Role in the Market

  • Commodity exchanges in India offer platforms for trading commodity futures, playing a critical role in price discovery and risk management. Exchanges like the Indian Commodity Exchange (ICEX), Multi-Commodity Exchange (MCX), and National Commodity and Derivatives Exchange (NCDEX) facilitate the trading of a wide range of commodities, from agricultural products to precious metals, contributing to the diversity and depth of India’s financial markets.
  • The commodity markets represent a vital component of the global financial system, facilitating the trading of raw materials and agricultural products which form the backbone of the world’s economy. These markets allow producers, consumers, and investors to hedge against price volatility, invest, and manage risk.

Understanding Commodity Markets

Essence of Commodity Trading

  • Commodity markets are platforms where various goods, including raw materials and basic agricultural products like wheat, gold, and crude oil, are traded. These markets serve not just as venues for buying and selling physical goods but also for trading derivatives like futures and options, providing a mechanism for price discovery and risk management.

Diversification of Portfolio

  • Trading in commodities is a strategic approach to diversification, allowing investors to spread their risk across different asset classes. This diversification can protect against volatility in other markets, such as equities and bonds.

Types of Commodities

Commodities are generally categorized into two main types:

  • Hard Commodities: This group includes natural resources that are mined or extracted, such as gold, copper, and crude oil. These commodities often serve as indicators of economic health, with oil, in particular, being a critical energy source globally.
  • Soft Commodities: Agricultural products like wheat, soybeans, cotton, and livestock fall into this category. Prices for soft commodities can be highly volatile, influenced by factors like weather conditions, geopolitical tensions, and changes in consumer preferences.

Commodity Trading Entities

The list of tradable commodities is extensive, including but not limited to:

  • Edible oils (mustard seed, soybean oil)
  • Grains (wheat, maize)
  • Metals (gold, silver, copper)
  • Spices (turmeric, pepper)
  • Others (cotton, rubber, natural gas)

Gold, crude oil, and silver are among the most actively traded commodities due to their significant economic impact and investment demand.

Regulation and Reforms in Commodity Markets

Evolution of Regulatory Frameworks

  • Initially overseen by the Forward Markets Commission (FMC) since 1952, the regulatory landscape for commodities trading in India saw a significant shift in 2015 when the FMC merged with the Securities and Exchange Board of India (SEBI). This move aimed to harness SEBI’s robust surveillance and enforcement capabilities to enhance market integrity.

SEBI’s Reform Measures

Post-merger, SEBI introduced several reforms to revitalize and strengthen the commodity markets, including:

  • Allowing stockbrokers to deal in commodity derivatives, facilitating common broking for equities and commodities.
  • Permitting national exchanges like the NSE and BSE to start commodity trading.
  • Enabling Foreign Portfolio Investors (FPIs) and Category III Alternative Investment Funds (AIFs) to participate under certain conditions, thereby broadening market participation.

These reforms are part of India’s broader effort to modernize its commodity trading infrastructure and practices, enhancing its efficiency and global competitiveness.

Benefits of Commodity Markets

Portfolio Diversification

  • Commodities offer low correlation with traditional financial assets like stocks and bonds, making them an excellent tool for portfolio diversification. This diversification can lead to reduced portfolio risk and improved returns over the long term.

Inflation Hedge

  • Traditionally, commodities are seen as a hedge against inflation. As the prices of goods and services increase, the value of commodities used to produce these goods and services often increases as well, helping investors preserve their purchasing power.

Protection from Event Risks

  • Commodities can provide a safeguard against event risks such as natural disasters, economic crises, or geopolitical conflicts that might disrupt supply chains. By strategically engaging in commodity trading, investors can potentially leverage price movements to mitigate losses.

Strategic Disinvestment

  • Strategic disinvestment represents a significant shift in how public-sector enterprises (PSEs) operate, moving from government to private sector ownership. This process not only aims to make these enterprises more efficient and lucrative but also seeks to address the challenges faced by loss-making or underperforming public entities.

Categories of Strategic Disinvestment

Strategic disinvestment can be classified into three main categories, each representing a different level of government withdrawal from the enterprise’s ownership and control:

  • Minor Disinvestment: This occurs when the government sells a minor share of its stake but retains a majority, typically 51%, to maintain managerial control.
  • Major Disinvestment: In this scenario, the government sells the majority of its stake in the company but might retain a minor share.
  • Complete Privatisation: This is when the government sells its entire stake to a private player, completely relinquishing management and control.

Disinvestment

The narrative of disinvestment in India starts with the over-reliance on the public sector post-independence, which, over time, exhibited significant inefficiencies. By 1991, in light of these shortcomings and the economic crisis, India embarked on a path of disinvestment. The journey from the initial disinvestment in 1991-92, through the establishment of the Disinvestment Commission in 1996 and various organizational changes leading to the creation of the Department of Investment and Public Asset Management (DIPAM) in 2016, reflects the evolving approach towards managing public assets.

National Investment Fund (NIF)

Established in November 2005, the NIF was designed as a repository for the proceeds from the disinvestment of Central Public Sector Enterprises. The fund’s purpose is to strengthen the government’s ability to manage its finances, particularly in supporting social welfare initiatives and infrastructure development.

Benefits of Strategic Disinvestment

The benefits of strategic disinvestment are multifaceted, including:

  • Reduction in Government Debt: By selling stakes in PSEs, the government can reduce its debt and budgetary imbalances.
  • Support for Social Expenditure: Proceeds from disinvestment can be redirected towards social welfare, healthcare, and education.
  • Infrastructure Development: Disinvestment funds can be used for large-scale infrastructure projects, stimulating economic growth.
  • Enhanced Private Sector Growth: Reducing government involvement in non-strategic sectors can foster a more competitive market environment, leading to job creation and better services for consumers.
  • Improved PSU Efficiency: Diversification of ownership can lead to better management practices and operational efficiency in PSUs.
  • Fiscal Health Improvement: Strategic disinvestment provides a crucial revenue stream for the government, aiding in fiscal stabilization.

Challenges with Strategic Disinvestment

Despite its benefits, strategic disinvestment faces several challenges:

  • Loss of Regular Revenue: Selling profit-making PSUs means the government loses out on regular dividends and revenue.
  • Cultural Inertia: Retaining a majority stake can mean that the inefficiencies and culture of loss within PSUs persist despite private investment.
  • Lack of Competition: Privatization does not automatically lead to competitive markets.
  • Bureaucratic Influence: The disinvestment process is often mired in bureaucracy, which can hinder efficient execution.
  • Asset Stripping Risks: Strategic partners may prioritize short-term gains by selling off valuable PSU assets.
  • National Security Concerns: Disinvestment in strategic sectors like oil can be seen as a threat to national security.
  • Short-term Financial Strategy: Using disinvestment funds to bridge budget deficits is criticized as a myopic approach.
  • Monopoly Risks: There’s a risk that public monopolies may simply transform into private monopolies, potentially harming consumers.

Real Estate Investment Trusts (REITs)

  • Real Estate Investment Trusts (REITs) offer a unique opportunity for individuals to participate in the ownership and income of real estate properties without directly buying or managing them. Drawing a parallel to mutual funds, which invest in a variety of stocks or bonds, REITs focus on generating revenue through a diverse range of real estate assets. They have become a significant component of the investment landscape, providing an accessible means for investing in large-scale real estate.

Concept and Functionality

  • REITs pool funds from numerous investors to purchase, manage, and operate income-generating real estate assets. This can include a variety of property types such as office buildings, apartment complexes, shopping malls, hospitals, warehouses, and hotels. Much like stocks, REITs are listed on stock exchanges, providing liquidity and the opportunity for capital appreciation to investors. They are structured as trusts, with an independent trustee holding the assets on behalf of the unit holders, ensuring a level of security and governance in their operations.

Regulatory Framework

  • In India, the Securities and Exchange Board of India (SEBI) mandates that all REITs must be listed on the stock market and go through an initial public offering (IPO) process. This regulatory oversight aims to ensure transparency, protect investors, and provide a structured environment for these investment vehicles to operate within.

Tax Advantages

  • REITs enjoy favorable tax treatment, including exemption from dividend distribution tax and certain relaxations on capital gains tax, making them an attractive investment option from a tax efficiency perspective.

Types of REITs

  • Equity REITs: These trusts primarily invest in and own properties, generating income through the leasing, rent, and appreciation of their real estate assets.
  • Mortgage REITs: Focus on lending money to real estate owners and operators either directly through mortgages and loans or indirectly through the acquisition of mortgage-backed securities.
  • Hybrid REITs: Combine the investment strategies of both equity and mortgage REITs, providing a blend of income and capital appreciation opportunities.

Significance of REITs

  • Liquidity Solution for Developers: By allowing the monetization of real estate assets, REITs provide a much-needed liquidity option for developers, enabling them to unlock the value of their holdings and invest in new projects.
  • Diversification and Risk Management: REITs invest in a diversified portfolio of real estate assets, mitigating the risks associated with individual property investments. The requirement for a significant portion of a REIT’s assets to be in income-generating, completed properties further lowers investment risk.
  • Professional Management: Managed by experienced professionals, REITs offer investors access to high-quality real estate investments, which might be out of reach for individual investors due to capital requirements or expertise.
  • Accessibility and Affordability: REITs lower the barrier to entry for investors interested in real estate, allowing them to invest in property with a relatively small amount of capital and enjoy the benefits of property ownership, including income through rent and potential capital gains.

Infrastructure Investment Trusts (INVITS)

Role Definition and Functions
Trustee A trustee is an independent individual or entity appointed to oversee the performance of an InvIT.

They ensure that the InvIT operates in the best interest of its investors, maintaining a check on the activities without being directly linked to the sponsor or manager.

Their primary role is to protect the interests of the unitholders by ensuring compliance with regulatory frameworks and the trust deed.
Sponsor A sponsor is typically a company or a business entity with a net worth of at least ₹100 crore that initiates the formation of the InvIT and is recognized as such when the application is made to SEBI (Securities and Exchange Board of India).

Sponsors are required to hold a minimum of 25% of the total units of the InvIT for at least three years, unless a specific administrative requirement or concession agreement specifies otherwise. This requirement ensures the sponsor’s skin in the game and alignment of interests with the investors.
Investment Manager The investment manager is a company, limited liability partnership (LLP), or organization responsible for managing and administering the InvIT’s assets and investments.

They make strategic decisions regarding the acquisition, management, and disposal of infrastructure assets within the trust’s portfolio, which may include operational and revenue-generating assets like gas pipelines, highways, and electricity transmission lines.

InvITs are required to distribute at least 90% of their net dividend cash flow to investors, ensuring a steady income stream. Furthermore, if an asset is sold, the investment manager can decide to either reinvest the proceeds into another infrastructure project or distribute 90% of the sale proceeds to unitholders, maintaining the investment focus on infrastructure projects.

Risks Associated with Infrastructure Investment Trusts (InvITs)

  • Infrastructure Investment Trusts (InvITs) have become an increasingly popular vehicle for financing infrastructure projects, offering a means for investors to gain exposure to real assets. However, like any investment, InvITs come with their own set of risks that investors need to consider carefully.

Project Valuation and Growth Assessment Risks

  • Complex Valuation: The real value of projects within an InvIT can be challenging to ascertain. Since the growth and success of an InvIT depend significantly on how it acquires concession assets through bidding processes, investors may find it difficult to fully understand the intrinsic value of the assets.
  • Account-based Evaluation: Investors must rely on the trust’s financial accounts to evaluate its growth, which might not always provide a clear picture of the underlying asset’s performance or potential.

Project Failure Risks

  • Revenue Estimation Errors: InvITs, especially those involved in projects like toll roads, depend on revenue projections based on traffic estimates. Misjudging traffic flow can lead to revenue shortfalls.
  • Alternative Routes: The risk is compounded if the government decides to build alternate toll-free routes, significantly impacting the projected revenues of the toll-based project within the InvIT.

Political and Regulatory Risks

  • Government Concessions: Many InvITs operate under government-granted concessions, which are susceptible to changes in political and regulatory landscapes. A shift in policy or priorities can adversely affect the terms or viability of these concessions.
  • Demand and Price Fluctuations: InvITs are exposed to risks related to demand for the infrastructure services they provide and the prices they can charge, which can be influenced by broader economic and policy factors.

Benefits of Infrastructure Investment Trusts (InvITs)

Despite the risks, InvITs offer several advantages, both to the economy at large and to individual investors.

Boost to the Economy

  • Crowding in Private Investment: At times of reduced private sector investment, funds raised through InvITs for infrastructure projects like those managed by the National Highways Authority of India (NHAI) can stimulate the economy and attract further private investment.
  • Alternative Funding Source: InvITs provide a mechanism for the government to access alternative funding sources, thereby increasing public expenditure on essential infrastructure without straining public finances.

Financial Benefits to Corporations and Investors

  • Quick Financial Commitment Fulfillment: Corporations can meet their financial commitments more swiftly through InvITs by raising funds directly from the market.
  • Tax Advantages: Investors in InvITs benefit from favorable tax regulations, including exemption from dividend income tax and no capital gains tax on the sale of units held for more than three years, making InvITs an attractive investment from a tax perspective.

Difference Between Reit and Invit

Parameter REITs InvITs
Growth Visible to investors through remodeling existing properties, new construction, or acquisition of new assets. Determined by examining books, primarily through the acquisition of concession properties via bidding.
Minimum Requirement Each allotment lot is worth at least ₹50,000, and each lot should contain 100 units. Each allotment must be worth at least ₹1 lakh, and each lot should include 100 units.
Structure Focused on investment in the real estate sector. Focused on investment in the infrastructure sector.
Listing Can be publicly listed, privately listed, or privately unlisted. Must be publicly listed, ensuring a broader and more regulated market presence.
Liquidity Generally higher liquidity due to more accessible small investors, lower unit prices, and smaller trading lots. Somewhat poor liquidity compared to REITs, as InvITs have a larger trading lot size, making it less accessible for smaller investors.

Depository Receipts (DR)

  • Depository Receipts (DRs) serve as a vital financial instrument in the global market, enabling investors to participate in foreign stock markets with relative ease.

What are Depository Receipts (DRs)?

  • Depository Receipts are negotiable financial instruments issued by a depository bank that represent a certain number of shares in a foreign company. These shares are traded on a local stock exchange. The primary purpose of DRs is to allow investors the opportunity to invest in overseas companies without the complexities of dealing with foreign securities regulations and transactions.

Key Characteristics of Depository Receipts

Representation of Foreign Shares

  • A single DR may represent a fraction, a single, or multiple shares of the foreign stock. The underlying shares are held by a custodian bank in the company’s home country, while the DRs are traded on a stock exchange in another country.

Negotiability

  • DRs are negotiable, meaning they can be freely bought and sold in the market like any other security traded on the exchange.

International Investment Opportunity

  • By facilitating the trading of foreign securities on a local exchange, DRs provide investors an accessible route to diversify their investment portfolios across different geographical markets and economies.

Types of Depository Receipts

American Depositary Receipts (ADRs)

  • ADRs are a type of DR specifically designed for American markets. They allow U.S. investors to invest in non-U.S. companies while the shares themselves trade on a U.S. stock exchange, such as the New York Stock Exchange (NYSE) or NASDAQ. ADRs are denominated in U.S. dollars, simplifying the investment process for U.S. investors by avoiding the need to deal with foreign currencies.

Global Depositary Receipts (GDRs)

  • GDRs are similar to ADRs but are typically used to access a broader international market. GDRs are often listed on European stock exchanges, such as the London Stock Exchange (LSE) or the Luxembourg Stock Exchange. Like ADRs, GDRs allow investors to hold shares in foreign companies, but they are more commonly used by non-U.S. companies looking to attract investment from global investors.

Advantages of Depository Receipts

Portfolio Diversification

  • DRs provide investors with an easy way to diversify their investment portfolios by including foreign stocks, thus spreading risk across different markets and economies.

Cost-Effectiveness and Accessibility

  • Investing in DRs is generally less expensive and more straightforward than directly purchasing shares in foreign markets. This is because DR transactions avoid many of the legal and financial hurdles associated with international securities trading.

Exposure to International Markets

  • DRs offer investors exposure to the growth potential and returns of foreign markets without the need to engage directly with those markets, overcoming barriers such as language, time zones, and regulatory differences.
Feature American Depositary Receipts (ADRs) Global Depositary Receipts (GDRs)
Definition A financial instrument issued by US banks representing a specified number of shares in a foreign company that is traded on a US stock exchange. A financial instrument issued by international depository banks representing ownership of a foreign company’s shares, allowing it to be traded on global stock exchanges outside its home country.
Trading Venue Traded on US exchanges such as the NASDAQ and AMEX. Often traded on European stock exchanges like the London Stock Exchange, but can be listed on various international exchanges.
Currency Transactions and dividends are in US dollars. Can be issued in US dollars or Euros, although US dollars are more common.
Primary Purpose Allows US investors to invest in foreign companies without the complexities of dealing in foreign currencies and navigating foreign stock exchanges. Enables companies, including those from the US, to raise capital and have their shares traded on international stock exchanges, expanding their investor base.
Underlying Security Holder A US financial institution holds the actual underlying security. The depositary receipt agreement is with a bank in the location where the GDR is listed (e.g., a London bank for shares listed on the London Stock Exchange).
Benefits to Investors Provides access to foreign investments with the convenience of US dollar transactions and US regulatory standards. Capital gains and dividends are paid in US dollars. Offers a way for investors to diversify their portfolio internationally with the convenience of trading in familiar currencies and through accessible international markets.

CREDIT DEFAULT SWAP (CDS)

  • The Credit Default Swap (CDS) is a sophisticated financial instrument within the derivatives market, serving as a form of insurance against the default of a debtor. By understanding the mechanics, significance, and the types of credit events associated with CDS, investors and financial professionals can better manage credit risk.

Understanding Credit Default Swaps (CDS)

Function and Purpose

  • A CDS is a financial derivative that allows an investor to swap or offset their credit risk with another investor. Essentially, a CDS provides a mechanism for a lender to hedge against the risk of default by a borrower. The buyer of a CDS pays a premium to the seller, who, in turn, agrees to compensate the buyer in the event of a default by the reference entity.

Mechanism of Operation

  • The operation of a CDS resembles that of an insurance policy. The buyer of the CDS makes periodic payments (similar to insurance premiums) to the seller. In return, the seller agrees to cover the losses if the borrower defaults on the underlying debt. It’s crucial to note that while a CDS mitigates the risk of default, it does not eliminate it; the risk is transferred from the CDS buyer to the seller.

Credit Risk Transfer

  • In a CDS agreement, the credit risk associated with the reference asset is transferred from the buyer to the seller of the CDS. This transfer allows lenders and investors to manage their exposure to credit risk more effectively.

Credit Events in CDS Contracts

  • Credit events are specific conditions under which the protection provided by a CDS is triggered, requiring the seller to compensate the buyer.

Types of Credit Events

  • Inability to Pay: The debtor fails to make required payments.
  • Obligation Acceleration: Debt obligations are demanded earlier than the original terms.
  • Repudiation/Moratorium: Legal disputes over the contract’s validity or suspension of obligations.
  • Restructuring: The terms of the underlying debt are altered, potentially impacting the debtor’s ability to repay.
  • Government Intervention: Actions by governmental entities that affect the contract.

Significance of Credit Default Swaps

Risk Reduction for Lenders

  • By purchasing a CDS, lenders can mitigate the risk of borrower default, effectively obtaining insurance against potential losses. This risk mitigation tool is particularly valuable in uncertain economic times.

Flexibility without Underlying Asset Exposure

  • Investors can use CDS to hedge against credit risk without needing to own the underlying debt securities. This flexibility allows for strategic risk management without requiring direct investment in debt instruments.

Risk Spreading for Sellers

  • Sellers of CDS can manage their risk exposure by issuing multiple swaps. By diversifying their CDS agreements, sellers can spread the risk of default across various contracts, reducing the impact of any single credit event.

 

UPSC PREVIOUS YEAR QUESTIONS

 

1.  Consider the following statements:(2023)

1.  Statement-I: Interest income from the deposits in Infrastructure Investment Trusts (InvITs) distributed to their investors is exempted from tax, but the dividend is taxable.

2.  Statement-II: InviTs are recognized as borrowers under the ‘Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002’.

Which one of the following is correct in respect of the above statements?

(a) Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-1
(b) Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-1
(c) Statement-1 is correct but Statement-II is incorrect
(d) Statement-I is incorrect Statement-II is correct

2.  Consider the following markets: (2023)

1.  Government Bond Market
2.  Call Money Market
3.  Treasury Bill Market
4.  Stock Market

How many of the above are included in capital markets?

(a) Only one
(b) Only two
(c) Only three
(d) All four

3.  In the context of finance, the term ‘beta’ refers to: (2023)

(a) the process of simultaneous buying and selling of an asset from different platforms
(b) an investment strategy of a portfolio manager to balance risk versus reward
(c) a type of systemic risk that arises where perfect hedging is not possible
(d) a numeric value that measures the fluctuations of a stock to changes in the overall stock market

4.  With reference to India, consider the following statements: (2021)

1.  Retail investors through Demat account can invest in ‘Treasury Bills’ and ‘Government of India Debt Bonds’ in the primary market.
2.  The ‘Negotiated Dealing System-Order Matching’ is a government securities trading platform of the Reserve Bank of India.
3.  ‘Central Depository Services Ltd’ is jointly promoted by the Reserve Bank of India and the Bombay Stock Exchange.

Which of the statements given above is/are correct?

(a) 1 only
(b) 1 and 2
(c) 3 only
(d) 2 and 3

5.  With reference to the Indian economy, consider the following statements: (2020)

1.  ‘Commercial Paper is a short-term unsecured promissory note.
2.  ‘Certificate of Deposit’ is a long-term instrument issued by the Reserve Bank of India to a corporation.
3.  ‘Call Money ‘is a short-term finance used for interbank transactions.
4.  ‘Zero-Coupon Bonds are interest-bearing short term bonds issued by the Scheduled Commercial Banks to corporations.

Which of the statements given above is/are correct?

(a) 1 and 2 only
(b) 4 only
(c) 1 and 3 only
(d) 2, 3 and 4 only

6.  Consider the following statements: (2018)

1.  The Reserve Bank of India manages and services Government of India Securities but not any State Government Securities.
2.  Treasury bills are issued by the Government of India and there are no treasury bills issued by the state Governments.
3.  Treasury bills are issued at a discount from the par value.

Which of the statements given above is/are correct?

(a) 1 and 2 only
(b) 3 only
(c) 2 and 3 only
(d) 1, 2 and 3

7.  Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly? (2019)

(a) Certificate of Deposits
(b) Commercial Paper
(c) Promissory Note
(d) Participatory Note

8.  Why is the Government of India disinvesting its equity in the Central Public Sector Enterprises (CPSEs)? (2011)

1.  The Government intends to use the revenue earned from the disinvestment mainly to pay back the external debt.
2.  The Government no longer intends to retain the management control of the CPSEs.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2