INTRODUCTION AND MEANING A Bank is an important organ of the modern trade and commerce.

The word bank is derived from an Italian word banco which means a desk. It was called so, because the Renaissance or Florentines bankers, used to make their transactions above a desk recoverd by a green tablecloth. However banks today have become much more sophesticated as also well equipped to meet the day to day challenges. The journey of Banks in India has been quite a roller coaster ride. It is more compared with the ups and downs in the economy. Thus banks have to tackle the economic condition of the economy there by meeting the banking norms. HISTORY OF BANKING IN INDIA Banking in India originated in the first decade of 18th century with The General Bank of India coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are now defunct. The oldest bank in existence in India is the State Bank of India being established as "The Bank of Bengal" in Calcutta in June 1806. A couple of decades later, foreign banks like Credit Lyonnais started their Calcutta operations in the 1850s. At that point of time, Calcutta was the most active trading port, mainly due to the trade of the British Empire, and due to which banking activity took roots there and prospered. The first fully Indian owned bank was the Allahabad Bank, which was established in 1865. By the 1900s, the market expanded with the establishment of banks such as Punjab National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of which were founded under private ownership. The Reserve Bank of India formally took on the responsibility of regulating the Indian banking sector from 1935. After India's independence in 1947, the Reserve Bank was nationalized and given broader powers. THE STRUCTURE OF BANKING SYSTEM IN INDIA: The following chart gives the structure of banking industry of India. The figures in the bracket indicate the number of banks that are operational in a particular field. For eg. The bracket figure of State Bank of India and Associates shows 8. This means there are a bouquet of 8 banks under the title of State bank of India and Associates

PUBLIC SECTOR BANKS The State Bank of India.SBI group: State Bank of India, with its seven associate banks command the largest banking resources in India. SBI and its associate banks are: State Bank of India State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Indore State Bank of Mysore State Bank of Patiala State Bank of Saurashtra State Bank of Travancore

Now let us see each of the group associates in details: STATE BANK OF INDIA: State Bank of India (SBI) is the largest bank in India. It is also, measured by the number of branch offices and employees, the largest bank in the world. Established in 1806 as Bank of Bengal, it remains the oldest commercial bank in the Indian Subcontinent and also the most successful one providing various domestic, international and NRI products and services, through its vast network in India and overseas. With an asset base of $126 billion and its reach, it is a regional banking behemoth. The bank was nationalised in 1955 with the Reserve Bank of India having a 60% stake. It has laid emphasis on reducing the huge manpower through Golden handshake schemes and computerizing its operations. STATE BANK OF BIKANER AND JAIPUR State Bank of Bikaner & Jaipur (SBBJ) is an associate bank of State Bank of India. It came into existence on 25th April 1966. It was earlier comprised of two banks State Bank of Bikaner and State Bank of Jaipur before the two were merged. Currently, SBBJ has over 812 branches, mostly located in the state of Rajasthan, India. Its branch network out of Rajasthan covers all the major business centers of India. STATE BANK OF HYDERABAD State Bank of Hyderabad is an associate bank of State Bank of India and one of the scheduled banks in India. It was originally a bank started by the Nizam of Hyderabad. After India's Independence these and other banks of the princely states were renamed after the Subsidiary Banks Act was passed in 1959 and turning them into subsidiaries of SBI. SBH was the first subsidiary of State Bank of India. It's Headquarters is in Hyderabad, India.

STATE BANK OF INDORE State Bank of Indore is one of the nationalised banks in India and a subsidiary of State Bank of India. It uses the same logo as its parent company SBI. STATE BANK OF MYSORE State Bank of Mysore is one of the nationalised bank in India. State Bank of Mysore was established in the year 1913 as Bank of Mysore Ltd. under the patronage of the erstwhile Govt. of Mysore, at the instance of the banking committee headed by the great EngineerStatesman, Late Dr. Sir M.Visveswaraya. Subsequently, in March 1960, the Bank became an Associate of State Bank of India.State Bank of India holds 92.33% of shares. The Bank's shares are listed in Bangalore, Chennai, and Mumbai stock exchanges. STATE BANK OF PATIALA State Bank of Patiala is an associate bank of State Bank of India. State Bank of Patiala (SBP), originally named Patiala State Bank, and currently an associate bank of the State Bank of India, was founded on 17th November 1917. SBP was founded by Bhupinder Singh, Maharaja of the princely state of Patiala of Undivided India, and the functions of the Bank included the normal functions of commercial banks, as also some functions similar to functions of a central bank for the princely state of Patiala. After Indias independence, the Bank was made a wholly owned subsidiary of the Government of Punjab. On 1 April 1960, SBP was accorded the status of an Associate bank of the State Bank Group. Presently, the State Bank of Patiala has a network of 830 service outlets, including 750 branches, in all major cities of India, but most of the branches are located in the Indian states of Punjab, Haryana, Himachal Pradesh, Rajasthan, Jammu & Kashmir, Delhi and Chandigarh. STATE BANK OF SAURASHTRA State Bank of Saurashtra is one of the nationalised bank in India. STATE BANK OF TRAVANCORE State Bank of Travancore(SBT) is a nationalised bank in India. State Bank of Travancore (SBT), an associate bank of the State Bank Group, is a premier bank of Kerala state, India. SBT was originally established as Travancore Bank Ltd. in 1945 under the active support of the then Maharaja of the princely state of Travancore. The bank became a subsidiary of State bank of India as per the State Bank of India Subsidiary Banks Act, 1959, enacted by the Parliament of India. Many of the old private banks of Kerala like the Travancore Forward Bank, Kottayam Orient Bank, Bank of New India, Cochin Nayar Bank, The Latin Christian Bank, etc., were amalgamated with the Bank between 1961 to 1965. SBT has a network of over 670 branches spread in 14 states of the Republic of

India. The bank is one of the leading banks in Kerala, with 552 branches, out of 670, located in Kerala. As of the 12th of September 2005, the State Bank of Travancore went online with core banking implemented across all its branches. It is the second associate bank of State Bank Of India to have implemented core banking. The entire state bank group is expected to implement core banking by September 2006. FOREIGN BANKS Currently (as in Jan 2007), overall, banking in India is considered as fairly mature in terms of supply, product range and reach-even though reach in rural India still remains a challenge for the private sector and foreign banks. Even in terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets-as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the Bank on the Indian Rupee is to manage volatilitywithout any stated exchange rate-and this has mostly been true. With the growth in the Indian economy expected to be strong for quite some timeespecially in its services sector, the demand for banking services-especially retail banking, mortgages and investment services are expected to be strong. M&As, takeovers, asset sales and much more action (as it is unraveling in China) will happen on this front in India. In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time an investor has been allowed to hold more than 5% in a private sector bank since the RBI announced norms in 2005 that any stake exceeding 5% in the private sector banks would need to be vetted by them. Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively. TYPES OF ACCOUNTS: Every bank maintains transactions of its customers. These transactions allow debit and credit transactions on an account. A bank has to maintain various accounts like savings bank account, fixed deposit account, current account, etc. Every account has a few unique features. For example, a savings account can be operated only ten times in a month.

Similarly, it needs to have a minimum balance against it. On the other hand, a current account allows unlimited transactions to be performed. So we can create more specific classes to maintain different kinds of accounts from the same account class. These classes can use the basic functionality of the account class and add their own account-specific functionality. SAVINGS DEPOSIT ACCOUNT Savings deposit is a form of demand deposit. However it is subject to number of withdrawals as also the amounts of withdrawals permitted by the bank under their savings account rules during any specified period and would include special savings deposits. TERM DEPOSIT ACCOUNT Term deposit means a deposit received by the bank for a fixed period and which is withdraw able only after the expiry of the said fixed period. At present the term deposits are deposits with a fixed maturity of not less than 15 days (7 days in the case of term deposits of Rs. 15 lakh) or subject to notice of not less than 15 days. They would also include (a) deposits including inter-bank deposits payable after 14 days notice, (b) cash certificates (c) cumulative, recurring, annuity or reinvestment deposits, (d) Kuri and chit deposits (e) certificates of deposits, (f) non-resident deposits in the nature of term deposits, and (g) any other special deposits in the nature of term deposits. Interest accrued and payable on these deposits should be treated as Other liabilities and should NOT, therefore, be included in this part of the return. CURRENT ACCOUNT Current Account is a form of demand deposit wherefrom withdrawals are allowed any number of times depending upon the balance in the account or upto a particular agreed amount and shall also include other deposit accounts which are neither Savings Deposit nor Term Deposit. At present the Current accounts comprise (a) deposits subject to withdrawal on demand (other than savings deposits) or with a maturity period of less than 15 days (7 days in the case of term deposits of Rs. 15 lakh and above), or on notice of less than 15 days, (b) call deposits withdrawable not later than 15 days, (c) unclaimed deposits, (d) overdue fixed deposits, (e) credit balance in cash credit and overdraft accounts and (f) contingency unadjusted accounts if in the nature of deposits. It must be noted that deposits from banks, UTI, LIC, etc. at call or short notice not exceeding 14 days are to be treated as borrowings and should not be included in this return. However, inter-bank deposits in current accounts should be included. Even under all these accounts there can be n number of permutation and combinations with regard to the first holder account, second holder account, nomination facility, NRI account, NRE account, etc

Mutual Funds Birth of Mutual Funds: Mutual Funds are perhaps the most appropriate investment opportunity for the small investors. Until 1992, the investors in the primary market were assured of a good return on their investment as the pricing of new issues was controlled & were relatively low. As a consequence, when the listing took place, the shares were traded at a premium. Subsequently with liberalization taking off in every sector, pricing of new issues was also decontrolled. This led to higher pricing of shares in the IPO and diminishing returns. With volatility being an added concern, there were instances of investors having lost money and hence turned away from investing in the markets. This led to the emergence of Mutual funds. In India, the Unit Trust of India was the only Capital Market Intermediary from its establishment in 1964 until 1987. Subsequently the Government allowed private sponsors to set up Mutual Funds. A mutual fund is an institution that mobilizes a large amount of capital from investors having similar objectives and invests that capital in a wide range of financial instruments ranging from Equity, Debt, and Fixed Income Securities etc. Since the capital invested in contributed by all investors in certain proportion the ownership of the fund is also shared by the contributors in the same proportion that the amount has been invested by each of them. In India, a Mutual Fund is constituted as a trust and the investor subscribes to the units of a scheme launched by the Mutual Fund.

Mutual funds are mainly classified into Open Ended Funds & Close Ended Funds. Open Ended Funds are those funds, the units of which can be purchased from the fund and also sold to the fund without the Capital Market coming into the picture. Hence to ensure that fairness exists, the purchase and the sell price take place at the fair value of the unit of the fund. This value known as the Net Asset Value per Unit is calculated by

dividing the Total Assets held by the fund on a given date by the Total Number of units Outstanding on the same day. This concept can be better illustrated with the help of the following example: Assume that the Assets of a mutual fund are Rs.1, 000 and the fund has 10 investors, with nine investors having bought 95 units and the 10th investor having purchased 5 units the calculation of the NAV Per Unit will be done as : (Total Assets of the Fund) / (No. of Units Outstanding) i.e. (1,000) / (100) = 10. Since one investor owns five units ownership in the fund will be Rs. 50. As the investments of the fund are revalued at market prices, assume that cumulative value of the Funds assets has risen to 1,200 with the number of units remaining constant at 100. Investor having five units will therefore see capital appreciation to the tune of Rs. 10. The calculation will be as follows: (1,200 / 100) * 5 = 60. This value fluctuates on a daily basis, depending on the market value of the funds assets. TYPES OF FUNDS: Mutual funds can be classified into two types according to their structure Open Ended Mutual Funds. Close Ended Mutual Funds Open ended mutual funds are those in which the unit holders can purchase and sell units at all times from the fund itself. Close ended mutual funds are those in which unit holders have to wait until a certain duration of time, known as maturity so that the units can be redeemed. These funds are listed on the stock exchanges. Schemes of mutual funds are classified into Load & No Load funds depending on whether certain charges are levied on the investors, which are a percentage of the NAV Per Unit at the time of Purchasing/ redemption.

Open Ended Funds V/s Close ended Funds: An Open ended fund is one that purchases and sells units at all times. NAV is obtained by dividing the market value of the Assets of the Fund ( Plus Accrued income Minus Funds liabilities ) by the number of units Outstanding. Variation in Unit Capital is a function of the variance of the number of Units. The fund is obliged to repurchase units that are tendered by the investor. Close ended fund on the other hand makes a one time sale of its units, as a result of which its Unit Capital is Fixed. In order to ensure liquidity to investors, close ended funds are listed on the exchanges. The number of units of close ended mutual fund does not change when investors purchase or sell units from each other. In certain instances the mutual fund themselves offer BUY BACK of FUND SHARES/ UNITS so as to provide liquidity. Tax Exempt V/s Non tax exempt Funds: Dividend income received from any of the mutual funds is tax free in the hands of the investor. However funds other than equity funds have to pay a dividend distribution tax before distributing income to investors. STCG arising out of repurchase of units is taxed @ 15% and STT is payable on sale/ purchase of equity oriented mutual funds @ 0.20%

Types of Mutual Funds: Broad Fund Types by Nature of Investments: Funds Money Market, Liquid assets fall under this category. that invest in equities, Bonds,

Broad Fund Types by Investment Objective: This classification in based on the investment objective. Growth Funds invest for medium to long term capital appreciation, while Income Funds generate regular income. Value funds invests in stocks that the fund houses believe are undervalued and offer potential for capital appreciation in the short to medium term. Broad Fund Types by Risk Profile: This classification represents the risk that the investments of the fund face. Generally Equity funds have the higher risk when compared to debt funds which seek to protect capital whereas Liquid funds face even lesser risk when compared to Bond Funds as the duration of their investments is lesser than those of Bond Funds. Money Market / Liquid Funds: These funds have the lowest risk as their investments are in debt securities of durations less than one year. These include Treasury Bills, Commercial Deposit issued by banks, Commercial Paper issued by companies. Gilt Funds: Gilts are government securities with medium to long term maturities, normally exceeding one year. Since these securities are issued by the government the risk of default is negligible. However these securities face the interest rate risk, meaning that the prices of securities fall when interest rate rises and vice versa. Debt Funds: Debt Funds invest primarily in fixed income generating debt instruments. These funds distribute a substantial part of their surplus to investors. The types of debt funds are as follows: Diversified Debt Funds: These funds invest in all kinds of debt instruments issued by entities across all industries and sectors. Diversification ensures that the risks are lesser on account of diversification. However the risks exists in that the issuer can default on payment of interest or principal. Focussed Debt Funds: Debt funds that invest in securities of specific industry or sector are known as focused debt and consequentially carry a higher level of risk than Diversified debt funds. Examples of focused debt funds include Corporate Debentures and Bonds or Tax Free Infrastructure. Funds that invest in the housing sector are known

as Mortgage Backed Bond Funds, invest in securities that are created after the securitization of loan receivables of housing finance companies. High Yield Debt Funds: These funds invest in securities that carry a high risk of default but seek to provide a higher rate of return. They tend to be more volatile than other debt instruments but may end up earning higher than other debt funds. Assured Return Funds: These funds offer a rate of return that is fixed and informed to the investors. The shortfall in the returns would be borne by the AMC/Sponsors. These funds are essentially Debt/Income Funds. These funds reduce the risks to the investor compared to all other debt / equity funds. Fixed term Plans: They are essentially close ended in nature, in that the AMC issues a fixed number of units for each series only once and close the issue after an initial offering. They can be held for duration of less than one year and are not listed on the stock exchange. Equity funds: These funds are those that invest a significant part of their assets in equities with a minor portion in other classes such as Debt/Fixed Income etc. Investors need to appreciate that equity a class has the potential to provide the highest possible returns but also carries a high level of risk. There are various types of equity funds: Aggressive Growth Funds Growth Funds Speciality Funds Diversified Equity Funds These funds invest only in equities with a small portion in liquid money market securities. A variant of this is Equity Linked Savings Schemes that provide tax breaks on investing in equities but do come with a lock in period. Exchange Traded Funds: An Exchange traded fund is a mutual fund scheme that combines the best features of Open and Close ended Mutual funds. It tracks a particular index and trades like a single stock on the exchange. It offers the investor the benefit of holding a single share and offers a diversification and cost efficiency of the index. Units can be bought directly from the AMC at NAV which is applicable to all investors. These can be bought and sold through intermediaries who are market makers - buying and selling unts with two way price quotes.

Derivatives
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines equity derivative to include 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract, which derives its value from the prices, or index of prices, of underlying securities. The derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R) A.

Types of derivatives
The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or

before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Forward contracts & Futures & Options

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counterparty risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

4.1 Limitations of forward markets

Forward markets world-wide are afflicted by several problems: Lack of centralization of trading Illiquidity, and Counter party risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset

prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

Distinction between futures and forwards contracts

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more liquidity. Futures Trade on an organized exchange Standardized contract terms Hence more liquid Requires margin payments Forwards OTC in nature Customised contract terms Hence less liquid No margin payment

Option Terminology
Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price which the option buyer pays to the option seller. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. A call option on the index is out-of- the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call isNP which means the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the (St K). Similarly, the intrinsic value of a put is Max [0, (K -S t )] ,i.e. the greater of 0 or (K - St ). K is the strike price and St is the spot price.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. A call that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is a calls time value, all else equal. At expiration, a call should have no time value. Distinction between futures and options

Futures Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk LEASING

Options Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short at risk.

Leasing is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax-deductible payments.

 The lessee is the receiver of the services of the assets under a lease contract. The lessor is the owner of the assets that are being leased. An operating lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain use of the asset. Generally, the total payments over the term of the lease are less than the lessors initial cost of the leased asset. If the operating lease is held to maturity, the lessee returns the leased asset over to the lessor, who may lease it again or sell the asset. A financial lease is a longer-term lease than an operating lease. Financial leases are non-cancelable and obligate the lessee to make payments for the use of an asset over a predefined period of time. The total payments over the term of the lease are greater than the lessors initial cost of the leased asset. Financial leases are commonly used for leasing land, buildings, and large pieces of equipment. A direct lease is a lease under which a lessor owns or acquires the assets that are leased to a given lessee. A sale-leaseback arrangement is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset. A leveraged lease is a lease under which the lessor acts as an equity participant, supplying about 20 percent of the cost of the asset with a lender supplying the balance. Operating leases normally require maintenance clauses requiring the lessor to maintain the assets and to make insurance and tax payments. Renewal options are provisions that grant the lessee the option to re-lease assets at the expiration of the lease. Finally, purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the asset at maturity -- usually at a pre-specified price. Advantages of Leasing: The firm may avoid the cost of obsolescence if the lessor fails to accurately anticipate the obsolescence of assets and sets the lease payment too low. A lessee avoids many of the restrictive covenants that are normally included as part of a long-term loan. Leasing -- especially operating leases -- may provide the firm with needed financial flexibility. Sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which may then be used as working capital. Leasing allows the lessee, in effect, to depreciate land, which is prohibited if the land were purchased.

 Because it results in the receipt of service from an asset possibly without increasing the assets or liabilities on the firms balance sheet, leasing may result in misleading financial ratios. Leasing provides 100 percent financing. When the firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is 3 years of lease payments, and the lessor gets the asset back. Difference between Financial & Operating Lease: FINANCIAL LEASE Asset selected for lessee Risks and reward incident ownnership passed on to lessee Lessee bears the risk of obsolescence Lease is normally non cancelable Lease period coincides with economic life of asset Lease period is divided into primary and secondary Lessor does not bear these costs Lessor is only a financier Lease is a full pay out lease to OPERATING LEASE. Common use utility Lesse is provided limited time access Lessor bears this risk Lease period is small Perpetual lease is the base Lessor bears cost maintenance, operation of repairs,

Lessor is specialsed in operating the asset Lease is non pay out lease

Venture Capital

The venture capital fund

Venture capital is a form of high-risk, but high-return investing. In search of high returns, a venture capital firm raises a fund usually of between $10m to $350m.

Fund structure
Historically, venture capital investing was done through a limited partnership. Investors in the fund purchased one or more units of limited partnership interests. The managers of the fund, those who invest its money in developing companies (i.e., the venture capitalists), were the general partners of the limited partnership. Usually, the limited partners contributed 99 per cent of the committed capital of the fund through their purchase of limited partnership interests. The general partners contributed 1 per cent of the committed capital of the fund by purchasing their general partnership interests.

Fund development stages

A venture capital fund passes through four stages of development that can last for a total of ten years. During the first stage, the venture capital fund goes through its fund raising. Typically, the general partners of the fund spend from six months to a year obtaining capital commitments from potential limited partners. Potential limited partners include private and public pension funds, insurance companies, banks, corporations, wealthy individuals, charitable foundations and endowments. Once the venture capital fund is infused with capital, the second stage it would enter would comprise identifying, reviewing and investing in portfolio companies. This stage lasts from three to six years. During this stage, the venture capital fund general partners identify potential portfolio companies through reading trade press, attending trade conferences and speaking to those familiar with the particular industry. Once a particular company is identified as a potential investment, extensive research is done on the company and its market. This process, called due diligence', may ultimately convince the general partners to make an investment in that company. Then, the company in which the investment is made becomes a portfolio company' of the venture capital fund. During the third stage of the fund, the general partners spend their time working with the fund's portfolio companies to grow their value. The venture capital fund's investment in the portfolio company generally includes a combination of preferred stock, warrants to purchase stock and convertible debt securities. In addition to this financing, the venture capital fund through its general partners places a representative on the board of directors of the portfolio company. As a board member, this representative offers strategic advice to the portfolio company's management and assures that the venture capital fund's interests are considered. The fourth and final stage in the life of a venture capital fund is its closing. By the expiration of the fund, it should have liquidated its position in all of its portfolio companies. Liquidation usually occurs in one of three ways: an initial public offering of the stock of the portfolio company, the sale of the company to a third party.

Venture capital volume

India scenario
The investment of venture capitalists in Indian industries in the first half of 2006 is $3 million and is expected to reach $6.5 million at the end of the year

Early Days
In the absence of an organised Venture Capital industry until almost 1995, individual investors and development financial institutions played the role of venture capitalists in India. Entrepreneurs have largely depended upon private placements, public offerings and lending by the financial institutions. In 1973 a committee on Development of Small and Medium Enterprises highlighted the need to foster venture capital as a source of funding new entrepreneurs and technology. Thereafter some public sector funds were set up but the activity of venture capital did not gather momentum as the thrust was on high-technology projects funded on a purely financial rather than a holistic basis.

Regulatory Guidelines & Framework

Later, a study was undertaken by the World Bank to examine the possibility of developing Venture Capital in the private sector, based on which the Government of India took a policy initiative and announced guidelines for Venture Capital Funds (VCFs) in India in 1988. However, these guidelines restricted setting up of VCFs by the banks or the financial institutions only. Thereafter, the Government of India issued guidelines in September 1995 for overseas investment in Venture Capital in India. For tax-exemption purposes, guidelines were also issued by the Central Board of Direct Taxes (CBDT) and the investments and flow of foreign currency into and out of India have been governed by the Reserve Bank of India's (RBI) requirements. Further, as a part of its mandate to regulate and to develop the Indian capital markets, the Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. These guidelines were further amended in April 2000 with the objective of fuelling the growth of Venture Capital activities in India.

Industry Size, Activity and Participants

Pursuant to the regulatory framework mentioned above, some domestic VCFs were registered with SEBI . Some overseas investment has also come through the Mauritius route. However, the venture capital industry, understood globally as "independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies", is relatively in a nascent stage in India. Figures available from private sources indicate that overall funds committed are around US$ 1.3 billion. Investable funds are less than 50% of the committed funds and actual investments are lower still.

Policy Support
Given the proper environment and policy support, there is undoubtedly tremendous potential for venture capital activity in India. The Finance Minister of India, has announced that "for boosting high-tech sectors and supporting first generation entrepreneurs, there is an acute need for higher investment in venture capital activities." The SEBI committee on Venture Capital was set up to identify the impediments and suggest suitable measures to facilitate the growth of venture capital

activity in India. Also keeping in view the need for a global perspective it was decided to associate Indian entrepreneurs from Silicon Valley in the committee.

Objectives and Vision for Venture Capital in India

Venture capitalists finance innovation and ideas which have potential for high growth but with inherent uncertainties. This makes it a high-risk, high return investment. Apart from finance, venture capitalists provide networking, management and marketing support as well. In the broadest sense, therefore, venture capital connotes financial as well as human capital. In the global venture capital industry, investors and investee firms work together closely in an enabling environment that allows entrepreneurs to focus on value creating ideas and allows venture capitalists to drive the industry through ownership of the levers of control, in return for the provision of capital, skills, information and complementary resources. This very blend of risk financing and hand holding of entrepreneurs by venture capitalists creates an environment particularly suitable for knowledge and technology based enterprises. Scientific, technology and knowledge based ideas properly supported by venture capital can be propelled into a powerful engine of economic growth and wealth creation in a sustainable manner. In various developed and developing economies venture capital has played a significant developmental role. India, along with Israel, Taiwan and the United States, is recognized for its globally competitive high technology and human capital. India has the second largest English speaking scientific and technical manpower in the world. Recently, there has also been greater visibility of Indian companies in the US. Given such vast potential not only in IT and software but also in the field of service industries, biotechnology, telecommunications, media and entertainment, medical and health services and other technology based manufacturing and product development, venture capital industry can play a catalytic role to put India on the world map as a success story.

Where are VCs Investing In India?

IT and IT-enabled services Software Products (Mainly Enterprise-focused) Wireless/Telecom/Semiconductor Banking PSU Disinvestments Media/Entertainment Bio Technology/Bio Informatics Pharmaceuticals Electronic Manufacturing Retail

Issues and Challenges

Indian VC yet to be established as a sustainable asset class among institutional investors. Moreover a limited amount of true risk-capital impacts entrepreneurial activity. Exit challenges exist mainly due to shallow capital markets and dull M&A environment for small companies. Most importantly, India is yet to create a brand-name for IP-led companies, like Israel has successfully done

Two aspects of venture capital funds create significant risk exposures. First, in recent years investors have enjoyed extraordinary returns on their investment in these funds leading them to invest staggering sums of money in them. The historical levels of return cannot be met

indefinitely. When the inevitable fall-off occurs, investors will be scrutinizing the investment decisions made by their fund's general partners to determine: (1) whether they complied with the fund's investment guidelines; and (2) even if so, whether they resulted from adequate due diligence. If the limited partner investors conclude that neither condition was met, litigation will surely follow. Second, venture capital funds promote themselves to potential portfolio companies by the business experience of their general partners. The fund promises that if the start-up company accepts an investment from the fund, the fund will place a representative on its board that can then help the portfolio company in a myriad of ways. If this aid does not lead to a successful public offering or sale of the portfolio company, however, the other constituents of the portfolio company, such as its founders or other shareholders, may then claim that the venture capital fund's assistance was merely designed to protect its own investment and not to advance the general interest of the portfolio company. Likewise, employees of the portfolio company may claim that adverse employment decisions involving them were the product of unfair and improper meddling in the portfolio company's business affairs by the venture capital fund. By understanding the business of venture capital funds and the various relationships within that business, a clearer understanding of the risk exposures for that business develops.

Factoring:

Whenever an exporter exports goods to another country it is not necessary that the exporter may know the importer. There is always an element of risk involved for the exporter like the buyer defaulting and other political and commercial risks. The exporter would always prefer to get his payment as soon as possible because money today is better than money tomorrow. Factoring makes it possible for the exporter to eliminate these risks and also helps the exporter to obtain his export proceeds as soon as possible. Factoring is the purchase of account receivable at a discount. The purchasing of this receivable is done by a factoring agency. Factoring is a complete financial package that combines: Credit protection Accounts receivable bookkeeping Collection services Financing

Factoring is an agreement between factoring agency and the exporter in which factoring agency purchases the exporters accounts receivable (without recourse) and assumes responsibility for the importers' financial ability to pay. If the importer is financially unable to pay its debts, the factoring agency incurs the responsibility for payment. The factoring agency extends credit to the importer, collects the accounts receivable from the importer and performs the related bookkeeping functions. As needed, the factoring agency can also provide cash advances against open receivables prior to collection. Factoring contracts are signed for a maximum period of one year. To take advantage of factoring, the exporter should have an account opened with a factoring agency.

Why Factoring
The primary reason why companies turn to factoring is for protection against customer credit losses. Many companies are concerned about the credit worthiness of their customers. The second most important reason why companies turn to factoring is for the collection services that the factoring company provides. Another important reason companies use factoring is for the benefit of borrowing against their accounts receivable.

Advantages of Factoring

Improves cash flow. Eliminates bad debts.

Reduces operating expenses. Expands working capital. Strengthens balance sheet and enhances borrowing potential. Improves management information. Provides quick alternative source of financing. Provides supplemental financing beyond what current lender may be able or willing to provide. Funds business growth/expansion without increased bank debt or selling equity. Provides immediate access to working capital. Enables Company to increases sales and profitability. Preserves companys existing lender arrangements. Provides professional collection and credit checking support Provides complete and detailed reports about accounts receivable portfolio

Advantages to Exporter

Increase sales in foreign markets by offering competitive 'open account' terms of sale. Obtains financing from the factor without recourse to the exporter. Receives cash immediately upon delivery of the goods or services. The factor bears the risks of buyers credit, currency and interest rate fluctuations. Gains protection against credit losses from foreign sales. Generates accelerated cash flow through faster international collections. Obtains lower costs than the normal aggregate charges for L/C transactions. Relieved of the process of collecting the money at maturity. Avoids high cost of an international sales credit department. Obtains on the appropriate terms and conditions to fit each export sale customer.

Check on the credit history and reputation of your overseas buyer. Obtains advice on international trade documentation and shipping issues. Flexible and hassle free

Advantages to Importer Pays the invoice amount to the factoring company in his own country in the same way as he pays domestic suppliers. It is very convenient for the importer as he is dealt with his own language in his own time zone and according to his commercial customs and practices. He doest not have to accept bill of exchange

How does factoring work? This can be best illustrated in the following seven steps: Step1 The exporter gets an order from the buyer situated in a foreign country, based on this order he will enter in to factoring contract with a factoring agency. Step2 The exporter will apply for credit approval from the factoring agency this credit approval will be sanctioned by the factoring agency according to the credibility of the buyer which may be some percent of the invoice value it can also be 100 percent of the invoice value also if the credibility of the importer is excellent. Step 3 The Factoring agency then gives the credit approval to the exporter according to the importers credibility. The factoring agency checks for the credibility of the buyer it obtains credit information about the buyer situated in the foreign country. Step4 The exporter then ships and invoices the goods to the buyer which is payable to the factoring agency. Step5 The exporter then sells the invoice to the factoring agency once the shipment is done. Step 6 The factoring agency will provide the exporter with cash advances prior to the maturity date

of the invoices. This allows the client to be paid upon shipment while actually offering credit terms to its customers. Typical advance rates are up to 90% of the value of the invoice. These advances are subsequently liquidated by collection proceeds from their customers. Step7 On the due date the factoring agency will collect the payment from the importer.

Costing
The cost for factoring breaks down into two elements. The first is the factoring charge, which is paid to the factoring agency for their services which consist of book-keeping, customer follow-up, debt collection and guarantee. This charge is in the region of 0.5 to 3% of turnover. It is determined according to the characteristics of each companys turnover, invoicing procedure, clientele, etc The second element of the charge, the financing fee which is the interest rate. Generally the interest rate charged for forfaiting transactions is LIBOR which when compared with current short-term rates is lower. Service Fee: This fee represents the cost of outsourcing to the factor the exporters sales invoices. For this fee the factor will issue your invoices, perform credit checks and install credit control, follow up and chasing of customers. The service fee is a percent charged against your turnover. The fee usually varies from 0.5% to 3.0%. Some of the services the factor may perform may be not feasible for the exporter to do on a regular basis and this may improve the speed of payment and decrease the chance of non-payment. Interest Charge: The interest is charged on the actual amount of your invoices that you advance. This will usually be expressed as a fixed percent i.e. Bank base rate + Bank spread which is variable. The bank spread is decided by the bank which could be around 1.5%-3%. The cost of borrowing against factoring should be cheaper than a traditional overdraft. Another benefit is that the amount you can advance from a factor should grow with your turnover, while the amount you can borrow on an overdraft depends on the credit limit set by our bank. Cost Structure for factoring Financing Fee= Bank base rate (Fixed) + Bank spread (Variable)

Service charge= Ranges between 0.5%-3% of exporters turnover

Note- The interest charged and factor service fee will vary from company to company and time to time.

Forfaiting: Forfaiting is a proven method of providing fixed-rate financing for international trade transactions. In recent years, it has assumed an important role for exporters who desire cash instead of deferred payments, especially from countries where protection against credit, economic and political risks has become more difficult.

Forfaiting goes beyond credit insurance cover provided by government and private institutions, which usually require partial risk retention by the exporter, and provides the exporter with cash at the time of shipment, and on a non-recourse basis. In Forfaiting, the importers bank usually guarantees a series of promissory notes or bills of exchange, which cover repayment of a suppliers credit, provided by the exporter to the importer, for a period of from 180 days to 7 years. These notes or bills (notes) are usually structured to mature semiannually, and the face amounts of such notes include principal, and a fixed interest rate paid by the importer for the suppliers credit. The notes are initially given to the exporter at the time of shipment (or performance of other services) and become his property. These notes represent the unconditional and irrevocable commitment of the buyer and/or its bank (where the latter has added its guarantee) to pay the notes at maturity. The payment of these notes is independent of, and without any direct relationship to, the underlying commercial contract, which usually provides for other remedies to ensure the exporters due performance. Once the exporter becomes the bona fide owner of the notes, he can sell them to a third party at a discount from their face amounts, for immediate cash payment. This sale is without recourse to the exporter, and the buyer of the notes assumes all of the risks. The buyers security is the guarantee of the importers bank. The notes can be denominated in U.S. Dollars or almost any major currency.

Why Forfaiting
Forfaiting allows the exporter to offer extended repayment terms to his customers. Naturally, the exporter would prefer to have all of his customers pay him in advance on cash basis. Most of the customers will desire to have a credit period as long as possible to repay the

exporter for their purchase. Forfaiting resolve this common dilemma by providing a solution that suits both the needs of the exporter as well as the importer. When using a forfaiter, commodities can be financed for a period as short as 180 days to as long as 18 months. Capital goods, such as medical equipment, can be financed from 1 to 4 years. Heavy industrial equipment can be financed from 4 to 10 years. You would use a factoring house, in most cases, for consumer goods that are financed up to 180 days. Advantages of Forfaiting Immediate receipt of payment The supplier receives payment as soon as shipment has been satisfactorily carried out. No default risk No matter how long the credit terms, once a forfaiting transaction has been completed, the supplier has no risk of bad debt, as forfaiting agency has no recourse to the exporter. No political risk The exporter needs no longer fear that his buyer will not pay as a result of any changes of foreign policy, nationalisation, political disorder or imposition of laws affecting the transfer of currency out of the buyer's country. No currency exposure If the exporter is selling in currency other than his own, forfaiting eliminates any risk associated with fluctuations in rates of exchange during the period of credit given to the buyer.

Documents required in Forfaiting

Promissory Notes / Bills of Exchange in international format with bank guarantee or Conformed copy of underlying letter of credit including any amendments

Conformed copy of commercial invoice and shipping documents Confirmation of the authenticity and validity of all signatures appearing on the documentation

The following additional documentation is required for transactions where there is Letter of Credit Conformed copy of Letter of credit and any amendments. Conformed copy of all letter of credit documentation. Assignment of proceeds in favour of the financing bank. Notification of assignment to the issuing and advising banks. Acknowledgement of issuing bank and advising/confirming bank of the assignment and confirmation that they will at maturity directly to the financing bank. Confirmation by letter of credit issuing and advising/confirming banks that documents under the letter of credit have been up by the applicant.

How does Forfaiting Work?

Flow of transaction

1. Forfaiting contract

Exporter

2. Hands over documents

Forfaiting Agency

5. Buy out 3. Deliver Documents 4. Acceptance

6. Pay at maturity

Issue bank

1. The Exporter should enter a forfaiting contract with a forfaiting agency. This forfaiting agency can also be a bank. 2. The Exporter should present his documents to the forfaiting agency 3. The forfaiting agency delivers the documents to the issuing bank or the financing bank of the importer.

4. Under deferred payment L/C, confirmed maturity date and acceptance by the issue bank are required. Under collection, the draft is in need to be signed and accepted by proper bank; 5. Under deferred payment L/C, confirmed maturity date and acceptance by the issue bank are required. Under collection, the draft is in need to be signed and accepted by proper bank; 6. Discount for the entire period of credit involved is deducted by the Forfaiter from the face amount of the Promissory Notes or Bill of Exchange before payment to the exporter/seller. On the due date the importers bank i.e. the issuing bank pays off agency at a specified interest rate. the forfaiting

Costing
As far as possible, Forfaiting agency will ensure that the buyer, not the seller, incurs charges involved in a Forfait transaction. Sometimes this will involve changing the structure of deal, but Forfaiting agency stress their flexibility in tailoring deals to suit the exporter's needs. Exporters may sometime choose to absorb some of the fees or financing cost to make the transaction more attractive to their buyer. Charges depend on the level of interest rates relevant to the currency of the underlying contract at the time of the Forfaiter's commitment. Briefly, the interest cost is made up of: A charge for the money received by the exporter, which covers the Forfaiter's interest rate risk. In effect, this covers the Forfaiter's refinancing costs and is invariably based on the cost of funds in the market. The Forfaiting agency calculate this charge on the LIBOR (LIBOR is the London Interbank Offer Rate) rate applicable to the average life of the transaction. On a five year deal, for example, repayable by ten semiannual installments, the average life of the transaction is 2-3/4 years which is decided by the forfaiting agency. The LIBOR rate for this period would be used. A charge for covering the political, commercial, and transfer risks attached to the guarantor. This is referred to as the margin, and it varies from country to country, and guarantor to guarantor.

Additional costs (which are also included in the Forfaiter's calculations) include a "days of grace" charge; and when necessary, a commitment fee. Days of grace are an additional number of days interest charged by the Forfaiter which reflect the number of days delay normally experienced with payments made from the debtor country. These range from none to, say, 10 days on some countries.

Credit Rating CREDIT RATING OF INSTRUMENTS Credit rating is the process of assigning standard scores which summarize the probability of the issuer being able to meet its repayment obligations for a particular debt instrument in a timely manner. Credit rating is integral to debt markets as it helps market participants to arrive at quick estimates and opinions about various instruments. In this manner it

facilitates trading in debt and money market instruments especially in instruments other than Government of India Securities. Rating is usually assigned to a specific instrument rather than the company as a whole. In the Indian context, the rating is done at the instance of the issuer, which pays rating fees for this service. If it is unsatisfied with the rating assigned to its proposed instrument, it is at liberty not to disclose the rating given to it. There are 4 rating agencies in India. These are as follows: CRISIL - The oldest rating agency was originally promoted by ICICI. Standard & Poor, the global leader in ratings, has recently taken a small 10% stake in CRISIL. ICRA - Promoted by IFCI. Moodys, the other global rating major, has recently taken a small 11% stake in ICRA. CARE - Promoted by IDBI. Duff and Phelps - Co-promoted by Duff and Phelps, the worlds 4th largest rating agency. CRISIL is believed to have about 42% market share followed by ICRA with about 36%, CARE with 18% and Duff and Phelps with 4%. Grading system Each of the rating agencies has different codes for expressing rating for different instruments; however, the number of grades and sub-grades is similar eg for long term debentures/bonds and fixed deposits, CRISIL has 4 main grades and a host of subgrades. In decreasing order of quality, these are AAA, AA+, AA, AA-, A+, A, A-, BBB-, BBB, BBB+, BB+, BB, BB-, B+, B, B-, C and D. ICRA, CARE and Duff and Phelps have similar grading systems. Credit rating is a dynamic concept and all the rating companies are constantly reviewing the companies rated by them with a view to changing (either upgrading or downgrading) the rating. They also have a system whereby they keep ratings for particular companies on "rating watch" in case of major events, which may lead to change in rating in the near future. Ratings are made public through periodic newsletters issued by rating companies, which also elucidate briefly the rationale for particular ratings. In addition, they issue press releases to all major newspapers and wire services about rating events on a regular basis. Factors involved in credit rating Credit rating depends on several factors, some of which are tangible/numerical and some of which are judgmental and intangible. Some of these factors are listed below: Overall fundamentals and earnings capacity of the company and volatility of the same Overall macro economic and business/industry environment Liquidity position of the company (as distinguished from profits) Requirement of funds to meet irrevocable commitments

Financial flexibility of the company to raise funds from outside sources to meet temporary financial needs Guarantee/support from financially strong external bodies Level of existing leverage (borrowings) and financial risk As mentioned earlier ratings are assigned to instruments and not to companies and two different ratings may be assigned to two different instruments of the same company eg a company may be in a fundamentally weak business and may have a poor rating assigned for 5 year debentures while its liquidity position may be good, leading to the highest possible rating for a 3 month commercial paper. Very few companies may be assigned the highest rating for a long term 5 or 7 year instrument eg CRISIL has only 20 companies rated as AAA for long term instruments and these companies include unquestionable blue chips like Videsh Sanchar Nigam, Bajaj Auto, Bharat Petroleum, Nestle India apart from institutions like ICICI, IDBI, HDFC and SBI. Derived ratings and structured obligations Sometimes, debt instruments are so structured that in case the issuer is unable to meet repayment obligations, another entity steps in to fulfil these obligations. Sometimes there is a documented, concrete mechanism for recourse to the third party, while on other occasions the arrangement is loose. On such occasions, the debt instrument in question is said to be "credit enhanced" by a "structured obligation" and the rating assigned to the instrument factors in the additional safety mechanism. The extent of enhancement is a function of the rating of the "enhancer", the nature of the arrangement etc and usually there is a suffix to the rating which expresses symbolically that the rating is enhanced eg A bond backed by the guarantee of the Government of India may be rated AAA (SO) with the SO standing for structured obligation. Limitations of credit rating - rating downgrades Rating agencies all across the world have often been accused of not being able to predict future problems. In part, the problem lies in the rating process itself, which relies heavily on past numerical data and standard ratios with relatively lower usage of judgment and understanding of the underlying business or the country economics. Data does not always capture all aspects of the situation especially in the complex financial world of today. An excellent example of the meaningless over reliance on numbers is the poor country rating given to India. Major rating agencies site one of the reasons for this as the low ratio of Indias exports to foreign currency indebtedness. This completely ignores two issues firstly, India gets a very high quantum of foreign currency earnings through remittances from Indians working abroad and also services exports in the form of software exports which are not counted as "merchandise" exports. These two flows along with other "invisible" earnings accounted for almost US$11bn in FY 99. Secondly, since India has tight control on foreign currency transactions, there is very little error possible in the foreign currency borrowing figure. As against this, for a country like Korea, the figure for foreign currency borrowing increased by US$50bn after the exchange crisis began. This was on account of hidden forward liabilities through swaps and other derivative products. In general, Indian rating agencies have lost some amount of their credibility in the last two years due to their inability to predict defaults in many companies, which they had rated quite highly. Sometimes, some of the agencies had an investment grade rating in

place when the company in question had already defaulted to some of the fixed deposit holders. Further, rating agencies resorted to mass downgrading of 50-100 companies as a reaction to public criticism, which further eroded their credibility. The major reasons for these downgrades are as follows Corporate earnings fell very sharply due to persistent recessionary conditions prevailing in the economy. Many of the corporates are in commodity sectors where fluctuations in selling prices of products can be very sharp - leading to complete erosion of profitability. This problem was compounded by the Asian crisis, which led to increased competition from cheap imports in many product categories. Rating agencies substantially overestimated financial flexibility of corporates especially from traditional corporate houses. Much of the financial flexibility was implicit on raising money from new issues from the capital market, which has been impossible in the last 3 years. In the case of finance companies, widespread defaults like CRB and tightening of regulations made it virtually impossible for them to raise money in any form. These finance companies had been in the habit of investing in longer term, illiquid assets by borrowing shorter term fixed deposits. When the flow of credit stopped, they faced liquidity problems. These were further compounded by defaults by some of the companies to which they had on lent money. The experience is no different from the international scenario where reputed and highly experienced rating agencies like Standard & Poor (S&P) and Moodys were unable to predict the Asian crisis and had to face the embarrassment of seeing the credit rating of South Korea as a country go from A+ to BB+ in a short span of 3 months. By and large, the rating is a very good estimate of the actual creditworthiness of the company; however, it is not able to predict extreme situations such as the ones described above, which are unlikely to have been predicted by most investors in any case. Investors should realize that a credit rating is not sacrosanct and that one has to do ones own due diligence and investigation before investing in any instrument. They should use the rating as a reference and a base point for their own effort. One good way of doing this is examining the behavior of the stock price in case the stock is listed. As a collective, the market is far smarter at predicting problems than any credit rating agency. Witness the sharp erosion in stock prices of companies much before their credit ratings were downgraded. Witness also the fact that foreign currency bonds from Indian issuers trade at yields lower than countries which have been rated higher by rating agencies.