IIM Indore Presents

Volume 1 Edition 1 August 2010

Cover Story
The New Takeover Code

Expert Speak
IFRS
GST: An Overview European Stress Test- Finopedia
Implications, Hurdles A Futile Attempt? Literature review on
& Road Ahead Criticized widely, has the Option Pricing
test achieved its objective?
 Volume 1
Edition 1

Preface Contents
Cover Story
16 New Takeover Code
Invested Interest is an attempt to develop and
communicate a perspective on relevant issues
in business and finance. It provides a collation I-2 Times
of the opinions of students, industry
professionals and academicians on diverse
issues. Market Insight
Invested Interest has been written in a lucid 05 India Inc - Cooling Down?
and easy to comprehend language so as to
appeal to a much broader student base. Along
with providing information on the latest ExpertSpeak
developments taking place in the business and 11 IFRS – The Basic Framework
financial world globally, the magazine will help
readers to build an all-roundperspective
towards the issues. FinPoint
The magazine is an endeavour of IIM Indore 19 LAF Contraction by RBI
students. The first edition presents articles
written by industry experts and student 23 GST: An Overview
community at IIM Indore. The magazine is
intended to be a confluence of ideas and 26 CDS: An Indian Perspective
opinions of finance enthusiasts. Going forward,
we plan to invite the articles from the readers 14 Need for Super Regulator
around the world on wide ranging topics to
gather a diverse set of opinions.
FinDepth
We hope your interest in the magazine remains 28 Divestment Targets - Too Ambitious?
invested.
21 Listing Norms for PSUs

08 European Stress Test – A Futile Attempt?

FinoPedia
30 Option Pricing: A Literature Review

Crossword

1
 Volume 1
Edition 1

From the Team’s Desk

Dear Readers,

The pace of developments taking place in the global financial domain is on

coaster ride having witnessed the worst recession of the recent times topped up
by the Euro crisis. The economists world over are still grappling with the problem
as to what is going to be the recovery path. There have been some optimistic
signals from the markets after the results on European stress test were
announced. However, the sustenance of this upswing remains to be
questionable.

India, on the other hand, has shown good resilience towards the global downturn. Team
Indian regulatory authorities have reacted well to the situation and have come up Invested Interest
several changes which will help India to achieve convergence with the global
standards. This will strengthen the Indian business and regulatory environment, Angad Kikla
and invite the foreign investments. The changes in takeover code, GST, IFRS etc
Anshul Bansal
are seen in positive light.
Anshuman Atri
Our first edition covers a host of articles on active issues in the financial domain Anup K Agarwal
with focus on their impact on Indian business environment. The articles collate
the insight of students and the finance professionals. Mr. Naveen Agarwal, Bharat Garg
Director, Ernst and Young India Pvt. Ltd. has given an industry opinion on Rahul Jain
changes in IFRS code in the current edition. ‗Changes in the takeover code‘ Rahul Sachdeva
suggested by Achuthan committee has been an important development in the
last month and has been included as a cover story.
Vaibhav Agarwal
Vipul Bansal
Finopedia represents a unique feature of the magazine which contains an
academic review on financial concepts. ‗Market Insight‘ covers an extensive
research on the performance of Indian business in the last quarter. A brief
overview of the business news in the last month can be referred to in the I-2
section.

We hope this edition makes for an enjoyable and informative reading. Feel free
to send your comments/feedback at investedinterest.iimi@gmail.com.

Regards

Team Invested Interest

2
 Volume 1
I2
I-2Times
Times
Vedanta eyes controlling stake in
Cairn’s India biz
Vedanta Resources aims to buy a
controlling stake in oil explorer
Cairn India in the biggest domestic
takeover this year, positioning itself
as an Indian equivalent of the
world's biggest resource firm. The
London-listed Vedanta Resources
will buy 51 percent stake from
Cairn UK in the operator of India's
largest onshore oil field in
Rajasthan, and offer to buy at least
20 percent of minority holders to
meet regulatory requirements, a
person familiar with the
negotiations.
RBI issues draft paper on new
banking licenses
In the draft guidelines for new
banking licenses issued by RBI, it
has hinted that it may allow
industrial and business houses to
set up banks. It has laid out options
for the minimum capital required
and the extent of promoter
shareholding. Further, it has once
again opened the debate of
NBFC‘s being allowed to convert to
bank or promote a bank.
Mahindra set to buy Ssangyong
M&M is set to take control of
troubled South Korean auto maker
Ssangyong Motor Co. The
Company has not disclosed the bid
price. Analysts expect that
similarities in the product range of
both firms would work to M&M‘s
advantage. M&M‘s immediate
priority after the acquisition is likely
to revive Ssangyong‘s product
portfolio and chalking out a
combined sourcing strategy for
both the firms to pare costs.
3
Bharti reports 32 percent decline
in its net profit for the April-June
quarter
Bharti Airtel registered a decline of
32 percent in its consolidated net
profit at `1,682 Crore in its April-
June quarter. the total income of
Bharti Airtel rose by 17.4 percent to
`12,231 Crore in the first quarter
from `10,414 Crore in the June
quarter last fiscal. Meanwhile, the
company also announced the
acquisition of Seychelles' leading
telecom operator Telecom
Seychelles Ltd for `288 Crore.
June industrial growth to be in
single digits: Economists
Economists believe that Indian IIP
growth might have slowed down to
single digits in June‘10 after
expanding in double digits for eight
months in a row. It is felt that base
effect will come in picture which is
likely to reduce the growth rate in
the future also.
SBI-Macquarie buys stake in Viom
Network
SBI-Macquarie Infra Fund has
bought about 11 percent stake in
the Viom Network, formerly known
as Quippo-WTTIL, for USD 304
million. Viom, which now has
37,000 towers with 80,000 tenants,
plans to add up to 25,000 towers in
the next two years.
Anchor investors to buy CIL float
The government plans to ask
anchor investors to support its
share sale in Coal India Ltd, a first
for an initial public offering by a
state-owned company. Up to 30
percent of the portion reserved for
institutional investors may be sold
Edition 1
to anchor investors a day before
the IPO opens to the public.
Adani buys coal mine in Australia
Adani Enterprise (AEL), on
Tuesday, acquired the coal mines
of Australia's Linc Energy in a cash
and royalty deal worth A$2.9 billion.
The Adani group now plans to
invest about A$6 billion to create
infrastructure — ports, railway and
development of mines — Down
Under over the next five years.
Government lines up 3 more
selloffs
The disinvestment department is
readying three more state-run firms
for equity offers, confident that its
formula of attractive pricing will
ensure good investor response. It
is planning to sell stakes in Coal
India Limited (CIL) followed by
Hindustan Copper and Power Grid.
PE investment in Indian firms
crosses $5 bn for 2010
Private equity firms have invested
over $5 billion in Indian companies
so far this year, more than what
entire 2009 saw. As many as 220
companies saw PE investment
pouring in during the first seven
months of 2010, or between
January and July, while PE firms
made an exit from 73 other
companies.
RIL to buy 60 percent in US shale
gas JV for $392 mn
RIL has entered into a definitive
transaction agreement to enter into
a Marcellus Shale joint venture with
United States-based Carrizo Oil &
Gas, Inc. Reliance will acquire a 60
 Volume 1
percent interest in Marcellus Shale
acreage for $392 million.
Stellar results of Tata Motors
Tata Motors reported a net profit of
`1,988.73 Crore for the first quarter
ended June 30, 2010, against a
loss of `328.78 Crore in the
corresponding quarter last year.
The spectacular results achieved
can be attributed to turnaround of
Jaguar Land Rover which has
turned EBITDA positive for the first
time since coming under Tata
stable.
Edition 1
Demographics to slow global
economic growth: PIMCO
Decelerating global population
growth and aging populations in the
United States and other developed
economies will slow expansion
over the next five to 10 years. The
demographic factors will contribute
to a long period of more feeble
economic growth in developed
economies. PIMCO has dubbed
the outlook as "the New Normal,"
which Gross said "will likely impact
growth and financial markets for
years to come.

SBI net up by 25 percent

SBI, the country's largest lender,
posted a jump of 25 percent in net
profit for the April-June quarter to
`2,914.2 Crore, compared to
`2,330.37 Crore in the same period
a year-ago. The consolidated net
profit of the bank, however, showed
a growth of 21.5 percent to
`3,467.09 Crore for the quarter
ended June 30, 2010.

IL&FS Investment Managers

Acquires Saffron Assets
Advisors
IL&FS Investment Managers Ltd
(IIML), private equity firm with $2.8
billion under management, has
acquired the Mumbai-based private
equity real estate firm Saffron
Assets Advisors Pvt. Ltd. The deal
would make Saffron Assets, which
has $400 million under
management, a subsidiary of IIML.
The deal would make IIML the
largest private equity fund
management firms in India with
$3.2 billion in assets like
infrastructure and growth capital,
besides real estate.

4
 Volume 1
India Inc. – Cooling Down?
Sensex is trading at close to its 30 month high with a
P/E close to 21 which is much higher than its long term
average of 14-15. Economists are bullish about the
Indian economy; RBI has raised its forecast for GDP
growth this year to 8.5 percent. IMF is even more
bullish and has forecasted a GDP growth of 9.5
percent.
Business confidence in the corporate sector is good
which is reflected by HSBC Purchasing Managers‘
Index (PMI). HSBC PMI for the month of July
increased to 57.6 for India as against a drop in June
after it touched all time high in the month of May. The
exports have registered positive growth since
November 2009 which augurs well for the industry.
We carried out a detailed analysis of earnings of
companies under NSE CNX 100 to evaluate the
performance of India Inc. NSE CNX 100 was chosen
as it represents more than 70 percent of the market
capitalization and average traded value is
approximately 70 percent of the all stocks on NSE. At
the time of writing this article, 96 out of 100 companies
have reported their Q1 numbers.
Declining Margins
Y-o-Y growth in revenues for Q1 FY11 is 22.11
percent. However, the operating and net profit margins
have declined considerably on Q-o-Q basis.
500.00 18.0%
INR '000 Crores
460.00 16.0%
420.00 14.0%
380.00 12.0%
340.00 10.0%
300.00 8.0%
Sales OPM NPM
Increase in raw material prices and fuel prices have
led to decline in margins for the India Inc. Operating
5
Edition 1
By: Rahul Jain
Profit Margin (OPM) declined to 15.3 percent in Q1
FY11 from 17 percent Q-o-Q and 15.7 percent Y-o-Y.
Net Profit Margin (NPM) also declined to 10.5 percent
in Q1 FY11 from 11.8 percent Q-o-Q and 11.5 percent
Y-o-Y.
Increasing Cost Pressures
The dip in margins has also been contributed by
increasing employees cost for India Inc. Though, the
employee costs as proportion of sales is lower than
that of last year, it has been increasing over the last
three quarters.
48.0% 9.0%
RM as % of sales
47.0% 8.5%
46.0% 8.0%
45.0% 7.5%
44.0% 7.0%
43.0% 6.5%
Raw material Costs as % of sales
Employee Costs as % of sales
Sector Perspective
Automobile companies have recorded a growth of 48
percent in revenues on y-o-y basis. However, the
margins have shrunk as auto companies have not
passed on cost increases to consumer to retain market
share. The net profit margins reduced to 8.3 percent
from 9.1 percent in the last quarter. The stupendous
growth in auto sector may face deceleration in growth,
especially in commercial vehicle segment due to
impending implementation of Euro IV norms in Oct
2010. The implementation and increase in metal prices
will put cost pressures which may force auto makers to
increase prices further and thus impacting the topline
in adverse manner.
The software sector was able to clock in 12 percent
growth in top line on y-o-y basis mainly due to revival
in demand from western markets. They have been
 Volume 1
Edition 1
able to maintain their margins so far mainly by growth in double digits for eight months in a row till
controlling their personnel costs and several other cost May 2010 will impact the demand for steel.
cutting measures. However, with increase in H1B visa
fees, margins are expected to be adversely impacted. The telecom services sector recorded 16 percent
The future growth in top line will mainly depend on the growth in its revenues but there was significant margin
way in which European debt crisis pans out. erosion on y-o-y basis. The margins reduced to 18.8
percent from 24 percent a year ago. While the top line
Capital Goods sector recorded negative top line growth was driven by increasing telecom penetration
growth of 8.7 percent on y-o-y basis. The net profit in rural area, the margins were badly impacted by the
margins also shrank significantly to 11 percent mainly ongoing price war among the operators. The sector
due to increasing raw material prices. The future witnessed 3G and BWA auctions in the last quarter
growth of this sector is expected to be positive as the where the government mopped up more than `1 lakh
new stringent norms by government for equipment Crore. Telecom operators are expected to roll out 3G
import from China will help the domestic sector services by the end of this year. The growth in this
considerably. Moreover, the high economic growth and sector will mainly be driven by the success of 3G
large order books will give this sector good revenue services.
visibility in the future.
Power sector recorded a modest 6.5 percent growth in
Sales its top line. The margins declined mainly due to
Sectors Jun'09 Mar'10 Jun'10
growth increasing fuel costs over past one year. Government
Automobile 48.6% 4.2% 9.1% 8.3% has increased the prices of gas sold under
Software 12.2% 23.7% 23.3% 22.3% Administered Pricing Mechanism (APM) by more than
Capital 100 percent. This will impact several companies
-8.7% 16% 13% 11% operating gas based power plants as the cost of power
Goods
Steel 13.5% -0.70% 12.30% 8.84% generation is expected to increase by more than 33
percent. The major challenge for the sector will be to
Telecom 16% 24.0% 18.2% 18.8%
secure long term supply of coal/fuel for power plants to
Power 6.5% 18.4% 15.9% 16.6% ensure full utilization of power generation plants. The
Pharma 14.6% 30.4% 32.0% 18.9% sector is expected to have huge capacity additions as
Oil and we are in the last two years of XI five year plan.
2.7% 26.2% 21.1% 22.2%
Gas
Banks 5.2% 11.2% 11.6% 13.6% Pharmaceuticals sector witnessed 14.6 percent
Non growth in revenues in Q1 FY11 on y-o-y basis.
Ferrous 33.7% 9.5% 12.6% 11.4% However, the margins for the sector dropped to 18
Metals percent. Indian Pharmaceuticals industry is witnessing
a slew of acquisitions by major international players as
Steel sector recorded a 13.5 percent growth in they look to enhance their footprint in the country. The
revenues in Q1 FY11 on y-o-y basis. The growth was pharmaceuticals industry is expected to grow at 17-18
driven by increase in prices of steel as well as percent in the next few years which will keep this
increasing volumes. Though the prices have sector in a healthy state.
consistently decreased in the last quarter, they are still
above the last year levels. The sector profit margin Oil and Gas exploration and extraction sector had
increased from -0.7 percent last year to 8.8 percent in almost flat growth of 2.7 percent in revenues on y-o-y
this quarter. The main drivers for this sector would be basis. The major development in the last quarter for
the global economic recovery, especially the European the sector was upward revision of gas prices sold
debt crisis which has helped to limit the rise in steel under APM. This upward revision is expected to
prices. Apart from the global economic recovery, the impact bottom line of companies significantly.
domestic industrial production index which recorded Deregulation of petrol prices and increase in diesel
prices is expected to reduce the subsidy burden on
public sector oil exploration companies.
6
 Volume 1
Banks drove the performance numbers for the India
Inc. in Q1 FY11 with sales growth of 5 percent and
profit growth of more than 27 percent. The profit
margins also improved on y-o-y and q-o-q basis mainly
due to decreasing cost of funds. The credit growth in
the quarter was led by 3G auctions and increasing
consumer and corporate confidence.
Non Ferrous metals witnessed a strong growth of
33.7 percent on y-o-y basis in revenues mainly due to
increase in metal prices. Price of copper has increased
by more than 30 percent in the last quarter while price
of aluminium has increased by 17 percent in the last
quarter. With increasing risk appetite of investors
owing to global economic recovery and receding
concerns over the European debt crisis, the price
volatility is expected to increase. The demand for non
ferrous metals is also expected to be driven by
automobile sales, power sector, and rural housing
schemes initiated by the government.
Key Drivers for Future
India Inc. has shown resilience against the global
slowdown in the past few quarters. However, there are
several threats which are looming over India Inc. which
can act as party poopers. Foremost of the threat is
inflation which has been in double digits for most part
of this year. The persistent high inflation has led RBI to
increase repo and reverse repo rates. Though the
lending rates have not been tinkered by the banks as
of now, persistently high inflation can push RBI to
7
Edition 1
further increase key policy rates and thus higher
lending rates in the system.
Secondly, even though the threats from European debt
crisis have receded in the past few weeks, it still poses
significant risk to the economy and markets. The
global slowdown has led to almost zero rate regime in
west which has led to a lot of speculative money in the
markets. Thus, any deterioration or tightening of
monetary policy in developed economies may lead to
withdrawal of funds by FIIs from the market.
Third factor would be the shape of government
finances. Government has already raised more than
double of the expected amount from 3G auctions and
plans to raise `40,000 Crore this financial year through
disinvestment. Fiscal prudence by government will be
one of the major factors which will drive the markets.
Fourth factor which will determine market direction is
actual rainfall vs. the expected level. The met
department has predicted 102 percent of the normal
monsoon for the current year. Good monsoon will help
to tame the inflation and also boost the rural demand.
All the above factors will be critical in determining the
future course of the growth for India Inc. As the last
quarter‘s results have shown, all is not well with India
Inc.‘s performance. The growth rates have moderated
and margins have shrunk. With regards to market,
investors must take a great deal of caution before
jumping in the fray.
 Volume 1
European
EuropeanStress
Stress Test
Test –– AA Mere
FutileHogwash?
Attempt?
The Committee of European Banking Supervisors
(CEBS) in cooperation with the European Central
Bank (ECB), the European Commission and the EU
national supervisory authorities conducted an EU-wide
stress test exercise on European banks. The overall
objective of the 2010 exercise was to provide policy
information for assessing the resilience of the EU
banking system to adverse economic developments
and to assess the ability of banks to absorb possible
shocks on credit and market risks, including sovereign
risks.
The 2010 stress test exercise has been conducted on
a sample of 91 European banks. National supervisory
authorities from 20 EU Member States participated in
the exercise. In each of the 27
Member States, the sample has
been built by including banks, in
descending order of size, so as to
cover at least 50 percent of the
respective national banking
sector, as expressed in terms of
total assets. The exercise also
covered subsidiaries and
branches of these EU banks
operating in other Member States
and in countries outside Europe. As a result, for the
remaining 7 Member States where more than 50
percent of the local market was already covered
through the subsidiaries of EU banks participating in
the exercise, no further bank was added to the
sample. The 91 banks represent 65 percent of the total
assets of the EU banking sector as a whole.
For the stress testing of the credit risk and simulating
the profit and losses, two sets of macro-economic
scenarios (benchmark and adverse) were developed.
The scenarios were based on extreme assumptions
regarding interplay of macroeconomic factors over a
period of 2years.
Based on the results of the calculations, the aggregate
1
Tier 1 capital ratio , used as a common measure of
banks‘ resilience to shocks, would decrease under the
adverse scenario including sovereign shock from 10.3
percent in 2009 to 9.2 percent by the end of 2011. 7
1 3
Composed of core capital which consists of common stock,
retained earnings and preferred stock.
8
Edition 1
By: Vipul Bansal
out of 91 banks failed the test in the sense that their
Tier 1 capital ratios fell below 6 percent, threshold
2
defined for the test . These banks are Agricultural
Bank of Greece Hypo Real Estate of Germany and
Diada, Cajasur, Unim, Banca Civica and Espiga all of
Spain. For comparison 10 of 19 banks failed the stress
test, when the U.S. regulatory authorities conducted
stress tests in the spring 2009.
The aggregate results suggest a rather strong
resilience for the EU banking system as a whole.
Criticism
One of the most scathing criticisms of the stress test
was the treatment given to the sovereign debt of EU
countries on books of the banks.
Under the stress test, Sovereign
debt placed in the banking
books of the banks was
assumed to be held to maturity.
Only the debt placed in the
trading books was marked-to-
market. Hence the losses got
reflected only on the debt held in
trading books which was modest
and in some cases non-existent
because most of sovereign debt was included in the
banking book (80 percent). Sovereign debt concerns
by the so-called PIGS countries (Portugal, Italy,
Greece, and Spain) triggered the latest wave of
financial problems. Ignoring sovereign debt in the Euro
stress test would be like ignoring toxic real estate
assets in the U.S.
There also exists an argument that the "sovereign
shock" scenario should really have tested a
government default instead of just the market risk from
significant higher government bond yields. An obvious
case would be a Greek sovereign debt default which
3
would most likely involve considerably higher haircut
on Greek government debt as is assumed in current
test. In addition, a sovereign default would to a larger
degree impair the sovereign debt kept in the banking
book.
2
This threshold is not the regulatory minimum. The regulatory
minimum for the Tier 1 capital ratio is set to 4 percent
haircut is a percentage that is subtracted from the par value of the
assets
 Volume 1
Edition 1
Standard haircuts have been applied on respective leading US shares in July, for that matter even the
sovereign debt (see table below) in stressed S&P500 graph has shown upward trend and the
scenarios. The haircuts used in the stress test are interbank lending has thawed following the publication
arguably not that stressed. Especially for Greece, the of stress test results. The mood in the markets is
assumed 23 percent haircut used on Greek sovereign optimistic. The risk premium investors charge to hold
debt held by the end of 2009 is actually not far from the debt of peripheral euro zone state such as Spain,
what is implied indirectly current Greek government Portugal, Italy and Ireland has shrunk to the lowest
bond yields currently trading. The prices of levels since April. It can be argued that a healthy crop
government bonds have already declined by 22.4 of first half of corporate earnings may be the reason
percent. behind the upward swing, but unfortunately the
Used % Decline in markets‘ reaction do not come with a label of reason
Country Bond haircut for prices from behind the reaction. The test did the trick by providing
stress test end-2009
detailed data to show most of the banks were in
Greece 3.7% Jul'15 23.1% 22.4%
reasonable health and could withstand the main
Portugal 3.35% Oct'15 14.1% 5.5% sovereign risks.
Ireland 4.6% Apr'16 12.8% 2.7%
Talking about the assumptions around the test, the
Spain 4.4% Jan'15 12.0% 1.2%
macroeconomic assumptions used in the ―double dip‖
Italy 3.75% Aug'15 7.4% -0.6% scenario are not unreasonable, as has been criticized.
Source: Danske Markets, CEBS It might have been mild in view of the adverse macro-
economic developments seen in 2008-2009 (EU27
In that sense there really is no additional stress
GDP falling by -4.2 percent in 2009) which led to
compared to the current situation in the "sovereign
record high loan losses reported in 2009. However the
shock" scenario.
encouraging economic data for the euro-zone recently
Overall, the stress test features as a second desperate
justify the assumptions. Early 2010 witnessed
attempt to revive the economy after the bailout did not
improved macro-economic conditions which suggest
seem to serve the purpose well. On
an increase of capital ratios
May 10, the European Union
attributed to higher retained
created a $1 trillion package to
earnings affected by lower loan
save the euro. This didn't appease
losses. Also, many of the banks in
investors much as the S&P500
the exercise have significant
dropped up to 13 percent.
operations outside the EU. Some
Something else was needed to
of these countries have weathered
shore up investor confidence in an
the crisis comparably well and
entire continent's financial system.
continue to show strong economic
'Bank stress test' became the magic
growth. Further, increased revenue streams from
phrase.
those economies positively contribute to these banks
Positives overall profitability, offsetting loan losses and building
Much of the criticism has been around the statistical sizeable retained earnings.
exercise followed during the test. However the
The critics suggest that government default should
question that needs to be asked is whether the
have been a part of scenario testing. The CEBS
exercise really achieved the objective. The stress test
argument for not stress testing a sovereign default is
was done to establish the investor confidence in
that that by setting up the European Financial Stability
European banks after the debt crisis in PIGS nations
Fund (EFSF) earlier this year, the policy strategy has
triggered the latest wave of financial problems. After
been to not allow a sovereign default and for that
the stress tests, the euro has gained 10 percent
reason it will not be logical to use public money to
against the dollar, economic recovery in the euro area
capitalize banks to be resilient to a sovereign default.
is more robust than forecasted although uneven,
European stocks outperformed the S&P500 index of
9
 Volume 1
The biggest reason to believe in the current test
results has been the amount of disclosure. Most banks
except a few German banks have released detailed
information about their sovereign debt exposure. The
investors now can do their own ‗stress tests‘ on the
banks and reassure themselves. CEBS played a major
role in this regard. It supported the greater
transparency of this exercise and of the results of this
stress test exercise, and published bank individual
results, as well as detailed information on banks‘
exposures to EU sovereign debt. CEBS will also
continue with testing the resilience of the EU banking
Crossword
10
Edition 1
sector by means of periodic EU wide stress testing
exercises.
The majority of concern over the validity of the test has
been focusing on the market‘s health forming the
investor confidence. It misses the more important
reverse relationship between the two, where investor
confidence drives the market‘s health. As far as stress
testing is concerned, it has hit the bull‘s eye. It has
brought an optimistic outlook to the investor which will
further improve the market health.
 Volume 1
Edition 1

Expert
ExpertSpeak:
Speak:IFRS
IFRS –– The
The Basic Framework
Basic Framework By: Navin Agrawal

The basic concepts underlying preparation of financial currency for the primary
statements will undergo significant change upon economic environment in which it
implementation of International Financial Reporting is operating, subject to regulatory
Standards (IFRS) in India. There are three key aspects approvals. In rare circumstances,
which permeate almost each principle laid down in IFRS even allows users to adopt
IFRS. These are namely (i) substance over form, (ii) a policy that is contrary to IFRS
use of fair value, and (iii) principles if the
recognizing time value or management believes
time cost of money. that the treatment
These three items need prescribed under
to be understood IFRS would be
carefully for anyone to misleading and the
get a first cut glimpse policy proposed to be
into IFRS literature. adopted better
represents the
It is true that Indian substance of the
GAAP, like any other underlying
GAAP, also recognizes transactions. These
the importance of concepts are unheard
substance over form. of in most other GAAP
Accounting Standard 1 frameworks.
(AS-1) on 'Disclosure of
Accounting Policies'
states that substance rather than form should be the
guiding principle in selection and application of Use of fair value in measuring assets and liabilities
accounting policies. However, true application of this would increase considerably upon adoption of IFRS.
principle would be observed under IFRS. The reason IFRS will mandate use of fair value in measurement of
being that IFRS is more contemporary and therefore financial instruments, employee compensation/share
has prescribed treatment for evolving issues and based payments, and assets and liabilities acquired in
unlike Indian GAAP, it does not recognize a concept of a business combination, to name a few. It will allow
legal override. Hence, IFRS will not follow the form - it use of fair value, as opposed to cost, in relation to
will overrule the form and go by the core substance of property, plant and equipment, intangible assets and
the transaction. investment properties.

Question will now be raised whether redeemable
preference capital is debt or equity. Under Indian
GAAP, Schedule VI requires these to be shown as
part of equity; however, IFRS will require it to be
treated as debt. Based on substance of terms,
instruments such as convertible debentures are likely
to be shown partly under debt and partly under equity,
since the embedded warrant option in such
instruments would be separately identified and
presented at its fair value. Contracts for supply of
goods and services may get concluded (wholly or
partly) as leases (could be financial lease as well)!
IFRS will bring with it the concept of functional
currency. Indian entities may need to maintain their
books in US Dollars and to report in the same currency
to NSE\ BSE if the dollar is determined to be the
11
The application of these fair value principles would
require an entities management to use considerable
judgment in making estimates about the future and the
role of valuation experts in the preparation of financial
statements would increase significantly. Thus, IFRS
will be far more complex and challenging in its
application as compared to the existing regime of
accounting standards. In case of derivatives, held-for-
trading investments and investment properties, IFRS
allows gains or losses on fair valuation to be
recognized in profit or loss account for the period.
Undoubtedly, this is quite a bold move to allow even
unrealized gains to be captured in profit or loss
account. In such a situation, there would be extra onus
on the management to exercise better financial
discipline; otherwise, the Company may end up
declaring dividends out of unrealized profits.
 Volume 1
IFRS recognizes that with efflux of time, the value of
money changes. It will either be a cost or income, but
there is a difference in 100 rupees of today and 100
rupees 2 years back or 3 years
henceforth. Hence, IFRS requires
receivables and payable i.e.,
financial assets and liabilities or
monetary items to be reflected at
current values. Hence, the value
of a 100 rupees payable in 3
months will be different from a
100 rupees payable after 36
months.
Consequent to the above key
aspects, IFRS will focus on
reflecting the workings results and
state of affairs of a business more
on a current state basis rather
than on a holistic long term or historical cost basis. It
will not place unduly premium on prudence, rather it
will push for recording of market gains and reflection of
market related realities over the reporting period.
Historical costs were a convenient and easily
determinable method for recording of transactions,
assets and liabilities. IFRS being principles based will
allow flexibility to the preparers in choosing the right
accounting policy, but will also lead to enhanced
disclosure requirements. Therefore estimation efforts,
subjectivity and judgment will increase manifold in
preparing IFRS financial statements. Yes, timelines
and costs will also go up accordingly.
Tax and Regulatory Impact
The convergence of Indian GAAP with International
Financial Reporting Standard (IFRS) will
precipitate various challenges on the tax
and regulatory front, which companies,
investors and regulators will have to
grapple with. In substance, for IFRS to
become a reality in India by 2011,
significant changes in the regulatory
framework will be required.
Let us take the example of fair value
gains /losses recognized each year in
the income statement for securities
held for trading. Under the Indian tax
laws, these will be liable to tax only on
eventual sale; therefore it will result into
creation of deferred tax asset/liability in the
books. In the absence of any specific tax laws dealing
12
Edition 1
with such fair value gains/losses, it may be possible for
companies to adjust fair value losses against their
taxable income, while gains would get deferred. Tax
authorities are required to come
out with new guidance on how
unrealized fair value
gains/losses will be treated for
tax purposes.
It is also not clear how tax
authorities will treat adjustments
in carrying values of financial
assets or liabilities due to i)
market linked interest rates and
ii) discounting to net present
values if these are long term in
nature. Under IFRS, the
financial results will reflect the
substance of the transaction. Take for example, IFRIC
4 on ‗Determining whether an arrangement contains a
lease‘ or IFRIC 12 on ―Service Concession
Arrangements‖. These pronouncements will have
significant impact on the revenue recognition,
operating profits and state of affairs of dedicated
vendors/operators and infrastructure companies. It will
be interesting to see how tax authorities react to these
new concepts, for instance whether construction
revenues recognized under IFRIC 12 during the
construction phase of the public infrastructural asset
would be liable to taxes. Similarly, one would also
need to examine what implications will arise in areas
of Value Added Tax (VAT) and Service Tax, wherever
revenue or cost of goods and services are
getting impacted by IFRS.
Take another example of a tea or
coffee plantation. Under IAS 41 on
‗Agriculture‘, the changes in fair value
of such agricultural plantation will
have to be recognized each year in
the income statement. In India,
agricultural income is exempt, but
specified industries such as
tea/coffee plantations have to pay tax
on certain portion of their total income,
which is deemed to be non-agricultural
or business income. Plantation companies
will need clarity from the tax authorities as to
how such fair value gains/losses will be bifurcated
 Volume 1
between agricultural and business income, and how
these would be treated for tax purposes.
One important aspect about IFRS is that it will not
recognize any legal override, unlike the present Indian
GAAP scenario. At present most of the financial
statement presentation requirements are driven by
Schedule VI of the Companies Act, 1956 (Act).
Similarly, managerial remuneration is determined with
reference to the limits laid down in the Act. Under
IFRS, this may get challenged since the remuneration
might get restricted and will therefore be at variance
with the contracted terms and not a right benchmark
with other global players.
Section 78 of the Companies Act, allows securities
premium account to be used for various purposes
including expenses incurred for issue of fresh capital
or for premium payable on redemption of debentures
and bonds. However, these would be treated as
expenses or interest costs under IFRS to be charged
to the income statement. Another classic example is
when courts sanction a scheme of arrangement or
merger, then the accounting treatment outlined in the
approved scheme will prevail over accounting
standards, but it will not hold water anymore under
IFRS. This will be a huge challenge for India Inc on its
way to embracing IFRS which will need extensive
debate and alignment of the regulatory framework with
the IFRS framework. The Companies Act will require a
Edition 1
major overhauling, so will various other statutes such
as the IRDA Act, SEBI Act, RBI Act etc. It would be a
tall order to expect that all regulatory authorities will
accept the primacy of IFRS. There are bound to be
certain exceptions and limitations and in those areas,
there will be legal override, as has been the
experience worldwide in various non-European
countries and in Europe for some banking companies.
However, these legal overrides will distort the true
application of IFRS principles and will therefore defeat
the basic objective and benefit of convergence. It
would be in the interest of India Inc, if all the regulatory
authorities concerned can work in conjunction with
ICAI, SEBI and the Ministry of Finance to bring about
the required changes to support the implementation of
IFRS framework in India, in its true spirit.
All that said, the benefits of IFRS convergence are
expected to far outweigh the costs and hassles. Firstly
it will integrate the domestic businesses with the global
investor and financial community increasingly so that
there is no language gap and barrier. It will enhance
the global competitiveness of Indian businesses as
well as finance professionals. IFRS literate people will
fuel the next wave of Knowledge Processing
Outsourcing boom! Yes, those who are not able to
measure up to IFRS will face the threat of knowledge
obsolescence. So it is now high time to brace up for
IFRS!!

About The Author

Navin Agrawal is a fellow member of the Institute of Chartered Accountants of India.
Post graduation from St Xaviers College, Calcutta, he qualified in year 1992 with merit rank
in both intermediate and final examinations. He is a Director with Ernst & Young India Pvt.
Ltd. and is based out of Bangalore. He has been advising domestic and MNC corporate
clients on various accounting and regulatory matters for past 18 years. Recently he has also
advised clients on IFRS and its implications. He is a frequent speaker at various
seminars and has contributed to various thought leadership initiatives.

13
 Volume 1
Need
Needfor
forSuper
Super Regulator
Regulator
The latest tussle between SEBI and IRDA over Unit-
Linked Insurance Plans (ULIPs) has heated up the
debate over the need for an apex regulatory body in
the country. The proposal for setting up of a Financial
Stability and Development Council (FSDC) was
announced in this year‘s budget speech. The proposal
comes on the lines of Raghuram Rajan Committee‘s
recommendation for two distinct bodies on 18th
September 2008, one for risk assessment and co-
ordination across regulatory spheres and another as a
working group on financial sector reforms.
Under the current set up SEBI functions in the equity
markets, IRDA concentrates on
the insurance and related areas;
RBI is responsible for monetary
policy and banking regulation
whereas the government takes
care of the fiscal policy. The High-
Level Coordination Committee on
Capital and Financial Markets
(HLCCFM) which was formed in
1992 after the securities scam,
manages inter regulatory issues and works for
development of Financial markets. The HLCCFM has
not been up to the mark in inter-regulatory co-
ordination as well as on development of the financial
markets. It again came under fire for its failure to
resolve the turf war between SEBI and IRDA on
ULIPs. The setting up of FSDC, expected to have
more regulatory power, will effectively replace
HLCCFM.
Features of the Current Proposal
As per the proposal, FSDC would be multi- layered
with the heads of current financial regulatory
organizations as its members. The Finance Secretary
and chief economic adviser of the Ministry of Finance
will also be members of the council. FSDC will monitor
macro-prudential supervision of the economy, address
inter-regulatory coordination issues, and focus on
financial literacy and financial inclusion. The council
will have two committees working under it, namely the
Financial Sector Regulatory Co-ordination Committee
(FSRCC) and Financial Sector Reforms and Stability
Committee (FSRSC). FSRCC is proposed to be
14
Edition 1
By: Rahul Sachdeva
headed by the RBI governor and will be similar to the
High-Level Committee on Capital Markets and all the
regulators will be its members and would tackle the
inter regulatory issues. FSRSC will be headed by the
Finance Secretary and all the regulators will be its
members other than the RBI Governor. The Deputy
Governor of the RBI will be its member. The
Committee would look into issues relating to the
financial stability.
International Scenario
Internationally, there are examples of unified as well
as separate regulators but both kinds of models have
failed the empirical test of the
great crisis. In UK, regulation of
banks was taken away from the
Bank of England and transferred
to a single (super) regulator, the
Financial Services Authority
(FSA). The recent crisis
demonstrated the flaw of
separating regulation of the
banking sector from the Bank of
England to FSA. On the other hand regulators in US
were not unified under one council but the
arrangement did not work for them as well. On the
contrary it collapsed more spectacularly than
elsewhere. However, the current regulatory setup in
India has responded well to the economic crisis. It
prevented the crisis from affecting the domestic market
severely and thus the need to make drastic changes to
it is unfounded.
Another apprehension regarding the recommendations
is that this would make the babus of Finance Ministry
the super bosses of current regulators, SEBI, IRDA
and RBI. This would render these independent
regulatory bodies insignificant as the financial entities
would make a bee line for the Finance ministry where
the power would reside. Thus, in turn this move would
emasculate the effectiveness of independent financial
regulators.
Objections Raised by RBI
RBI wants the council to deal with financial literacy and
inclusion only and leave the issue of financial stability
 Volume 1
Edition 1
for itself. It believes that RBI with its access to the motivated by different sectoral considerations. Such
micro economic level data is in a better position to deal differences can be helpful in coming out with new
with financial stability. Since RBI is responsible for products as has been the case in US. The court battle
macro prudential regulation and micro prudential between SEC and the derivatives exchange led to the
supervision together with an introduction of Index
implicit mandate for Futures in US. The
systemic oversight, the Proposal ignores the need
Reserve Bank is in a better to take cognizance of the
position to track changes different compulsions
across various dimensions. governing each sector in
the Indian context.
Thus, from an effectiveness
and accountability RBI has also opposed the
perspective and for suggestion of Finance
preventing as well as Minster heading the FSDC.
managing a crisis, it is Instead it has proposed that
necessary to enjoin the executive responsibility for FDSC should operate through an empowered
financial stability to a single entity. Internationally as committee to be chaired by the RBI governor, with
well in major developed economies the central banks, other regulators and the finance secretary as
such as the US Federal Reserve, Bank of England, members.
European Central Bank and Bank of France, have the
final say in their country/region over issues concerning It has been an interesting debate with both the sides
financial stability. However, the Indian government has coming out with arguments and counter arguments
argued that the final call in case of a crisis should be supporting their point of view. It is hoped that the
taken by it as it is the tax payer‘s money that is at outcome would be based on reason rather than a
stake. bulldozer approach by the government.

Some experts also suggest that there should be

differences among regulators as each of them is

15
 Volume 1
Edition 1

Cover
CoverStory
Story––New
New Takeover
Takeover Code
Code By: Bharat Garg

The Takeover Regulations Advisory Committee 100 percent open offer is also in line with the takeover
(TRAC) headed by Mr. C. Achuthan recommended regulations in many European nations.
raising the open offer threshold to 25 percent from 15
percent and a mandatory minimum open offer of 100 The panel has suggested the overall timeline for an
percent versus the existing 20 percent. The new open offer to be brought down from 97 days to 57
takeover code came business days.
after a period of 13 The panel has also
years after Justice recommended that
Bhagwati drafted the creeping
first Takeover Code acquisition be
for India Inc. in permitted only for
1997. The 1997 acquirers who hold
takeover code has more than 25
been amended as percent of the
many as 23 times in voting capital. It
its 13 years of has, however, left
existence to the annual
accommodate creeping
specific acquisition limit
circumstances. unchanged at 5
percent.
The new takeover code has emerged as a strategic
response to the changing business environment in In order to enhance the corporate governance norms
India. ―The existing trigger threshold of 15 percent has the committee has made it mandatory for the
outlived its contextual relevance and requires an independent directors of the target company to provide
upward revision. A their view of the takeover proposal and make a
significant change in recommendation to
the shareholding the shareholders of
pattern in listed the company. The
companies has been acquirer cannot have
observed over the last its representative on
few years,‖ said the the board of the target
committee. According company. This would
to the report, the mean lessen the probability
of promoter of acquirers
shareholdings in the influencing the board
listed companies in the of the target company.
India is 48.90 percent Source: http://www.sebi.gov.in/commreport/tracreport.pdf
The changes are
with about 14.41
intended to enhance the transparency and make the
percent of the companies have promoter holdings
takeover conditions equitable for all classes of the
below the level of 25 percent.
shareholders. The panel has recommended the
The 25 percent threshold limit recommended by the mandatory minimum open offer of 100 percent to
advisory panel also converges with the limits followed provide the equal exit opportunities to the minority
globally by countries such as Hong Kong (35 percent), shareholders. The non-compete fee/control premium
the UK (30 percent), and Singapore (30 percent). The that is paid to promoters for agreeing not to enter the

16
 Volume 1
same business, would be scraped or need to be added
to offer price.
The price paid in the mandatory open offer would be
equal for all shareholders and would be at least as
high as is required under current rules. The price
would be based on the highest of four different
parameters, including the market price and the highest
price paid by the acquirer to any shareholder. Lastly,
the acquirers will have to make the up-front disclosure
of any plans of delisting the target company.
Implications for the Acquirer
The takeover code will have varying implications
depending on whether the acquirer wants to have
controlling stake or not or whether the acquirer is
based out of India or overseas.
The new takeover code will provide
more headroom to investors like private
equities, hedge funds and other
institutional investors, who want to
increase their investments in companies
but do not want the controlling stake or
take part in the day-to-day operations of
the target company. The regulations
provide a good opportunity to such
investors to raise their stakes from 15
percent to 25 percent.
On the other hand, the investors who
want to acquire the target company and assume full
control will now have to deal with more funding
requirements as the minimum open offer has been
increased to 100 percent. Acquirers may not have the
inclination to go for the 100 percent stake initially.
Financing large takeovers with bank finance or private
equity will be more costly. This may impede the plans
of several investors to have controlling stake in the
target company.
The foreign investors have easier access to larger
quantum of capital at a comparatively lower cost to
fund the acquisitions. While there is a fair amount of
capital available to the Indian companies to support
their acquisition plans within India, the debt comes at a
higher cost and is not readily available to all
companies. Thus, it creates a non-level playing field
in favor of the foreign investors.
17
Edition 1
Implications for Target Company
Firms looking to raise more capital under the Private
Investment in Public Equity (PIPE) route will now have
easier access to more funds. The current 15 percent
threshold restricts the quantum of capital that could be
mobilized by the companies to fuel their future growth.
There would be an outbreak of clandestine deals,
where many Indian promoters with stakes between 15
percent and 25 percent would transfer shares from
benami accounts back to their own names. Close to
300 listed companies — mostly mid and small-cap —
have a promoter holding of between 15 percent and 25
percent.
Promoters with minority stakes in their companies will
now be exposed to significant hostile
threats, as a potential acquirer will have
the flexibility to acquire up to 25 percent
before having to make an open offer.
Nearly 584 listed companies in India
have promoter holdings of less than 25
percent with 458 of them coming from
the SME sector. The recommendations
would also ensure that the companies
operate efficiently otherwise they will
face acquisition threats at sub-optimal
prices.
The recent mandate by the finance
ministry to have a minimum 25 percent
public shareholding to remain listed, would lead to a
significant decrease in the promoter‘s shareholding in
the company. It implies that the promoters would be
under extra pressure to keep their holdings sufficient
enough to avoid hostile takeovers as well as ensure
minimum public float requirements.
Implications for Shareholders
The advisory panel recommendations are based to
provide each shareholder an equal opportunity to exit
his investment in the target company when a
substantial acquisition of shares or takeover of a target
company takes place. The increase in the open offer
requirement for 100 percent of the shares upon
crossing the threshold of 25 percent provides a fair
opportunity to all shareholders to exit the firm, which is
fair and equitable for the incumbent shareholders. The
non-compete fee/control premium (if paid to
 Volume 1
promoters) needs to be added to offer price, bringing
all the shareholders to an unbiased ground.
Financing a large takeover offer through bank finance
or private equity firms (mandatory open offer of 100
percent) is bound to make the acquirer more reckless,
as such financing typically increases the principal
agency conflict. The acquirer may be willing to take
extra risk with the borrowed money as compared to
what he would have otherwise taken with a self
financed acquisition. Large funding requirements may
significantly hinder acquisitions to a point where the
inefficient companies, with lower risk of being taken
over, would be able to rule. It is not a healthy sign as
far as the interest of the minority shareholders is
concerned.
The proposed takeover regulations also permit
delisting of a company by an
acquirer by paying the price closer
to the market price. It is unjust for
the shareholders to be asked to exit.
It is also substantially different from
the present regulation which allows
delisting only if the shares are
acquired though the reverse book
building procedure, which better
takes care of the shareholder‘s
interests.
By large the new regulations, if implemented, will keep
incumbent managements focused on delivering value
(to avoid hostile takeovers) to stakeholders and hence
benefit shareholders, particularly the minority ones.
Impact on M&A
Although, the M&A market in India has grown
drastically in the recent years – the domestic
transactions increased from $4.9 billion in 2006 to $6.7
4
billion in 2009 and $16.5 billion in first half of 2010 , it
is still less than 1 percent of the global M&A activities.
The TRAC proposal could mean that cost of an M&A
transaction may significantly increase, particularly in
case of widely-held companies. The takeover financing
cost may go up by three folds. M&A deals may also
become expensive due to proposed changes in the
calculation of offer price. In scenarios where budget for
4
Source: Grant Thornton Dealtracker
18
Edition 1
M&A deals is a constraint, it could lead to some of
these decisions being reconsidered. The number of
acquisitions may thus decline in the short term.
However increased cost of acquisitions will weed out
non-serious bidders and attract only the serious
players and those who have the capability – both
financial and strategic. As a result, the deal sizes in
M&A arena would increase. Given that this model is
being followed internationally, the proposed
regulations could mean a stronger and more
robust M&A system in the longer run.
Is India ready for the new takeover code?
Although the objective of the new takeover regulations
is to increase transparency and equitability in the M&A
activities, the increase in minimum open offer to 100
percent would receive the maximum resistance from
the corporate India. The
inadequate availability of capital
and the restrictions imposed by
the RBI on leverage for
acquisition financing would
result in Indian companies
taking a back seat in M&A
activities.
There is a greater need for
relaxation of some of the
borrowing caveats to ensure that the debt/bond market
in India picks up, before the proposed regulations are
implemented.
Conclusion
The takeover proposal successfully addresses some
of the key issues raised in past by practitioners. The
code is certainly a positive step towards improving the
efficiency of capital markets in India by incorporating
best practices from the developed markets. The
proposal clearly indicates the growth mindset of Indian
regulator, SEBI, to make the market more robust and
more efficient M&A market.
Overall, the TRAC proposal is comprehensive in
nature and would play a deterministic role in
shaping the future M&A market in the country. It
would help in aligning the takeover regulations with
those of the developed markets across the world.
 Volume 1
Edition 1

LAF
LAFContraction
Contraction by
by RBI
RBI By: Kikla Angad Vinod

RBI has been concerned by the high levels of inflation

in the economy. It started due to poor monsoons in
2009, resulting in double digit food inflation. It soon
extended to manufacturing sector as well. In fact, non-
food WPI inflation for June ‘10 is 10.6 percent
contributing 70 percent to the overall inflation. This
suggests that current high level of inflation is a general
phenomenon. Moreover current deregulation of fuel
prices, increase in gas prices & nutrient based
subsidies will put an upward pressure on the inflation
rate. Reflecting its concerns, RBI has raised its March
WPI inflation forecasts from 5.5 percent to 6 percent.

Policy rate changes Source: RBI policy document

In order to tame the inflation, RBI, in its First Quarter
Review of Monetary Policy 2010-11 made following
changes in its policy rates – Increased the Repo Rate
(Rate at which banks borrow from RBI) by 25 bps to
5.75 percent; Increased the Reverse Repo Rate (Rate
at which banks parks its funds with RBI) by 50 bps to
4.5 percent; CRR (Cash Reserve Ratio) was left
untouched at 6 percent.
Liquidity adjustment facility (LAF)
One obvious result of these policy changes is the
contraction in Liquidity Adjustment Facility (LAF) –
Difference between Repo Rate and Reverse Repo
Rate - from 150 bps to 125 bps. When the liquidity in
the economy is in deficit, Reverse Repo rate becomes
the operative rate i.e. Inter-bank call money rates
come closer to the Repo Rates. Reverse happens in
case of surplus liquidity. Ideally RBI would like the
operative rate to be in the middle of the LAF corridor.
That is difficult to maintain though.
After remaining in surplus for almost 18 months, the
system turned into deficit in liquidity in May 2010.
Current liquidity in the economy is running in deficit at
around 50,000 Crore negative as on July 28, 2010.
―We expect systemic liquidity will be more in the deficit
mode going forward‖ Subbarao said in a
teleconference with analysts and researchers. The
tight liquidity condition has made the call money rates
move towards the upper end of the LAF corridor –
Repo Rates.
LAF has historically been high, around 300 bps till
2006. When LAF was first introduced in 2000, the idea
was to have a LAF corridor of 100 bps. It went up to a
high of 300 bps before eventually coming down to
current levels of 125 bps. Ideally, LAF corridor should
be broad enough not to prompt market participants to
park their excess funds with RBI. Neither should it be
narrow enough to curb the interest rate volatility to
distort any policy signal by the RBI.
When LAF corridor is kept wide, it signals uncertainty
in the market and interest rates are allowed to
fluctuate within a wider corridor. Narrowing down of
the LAF corridor indicates stability. Oscillation between
the upper band and lower band of the LAF corridor
causes uncertainty and instability in the money
markets. Since the economy seems to have recovered
partly from the recession, current move to narrow
down the corridor is seen as one to effectively manage
the growth and inflation. Narrowing of the band is the
outcome of the intention to reduce this uncertainty.
Logically, narrowing of the corridor makes sense
during monetary contraction and widening makes
sense during monetary expansion. Narrowing LAF
corridor leads to effective transmission of the policy
intention of tightening. This is exactly what RBI has
currently done. By reducing the corridor, the market
participants will eventually raise the lending rates. This
will increase the impact of the policy moves.

19
 Volume 1
Impact
The obvious impact of LAF contraction is reduced
volatility in the call rates leading to lower fluctuations in
the interest rates. With reduced volatility in interest
rates and increases in the policy rates, the shorter
ends of the yield curve are expected to stay up. Banks
with surplus cash will gain more by depositing it with
RBI than in call money market. RBI will also achieve
its objective of tightening. Current M3 growth rate at
15.2 percent against a credit growth
at 22 percent indicates demand
side inflation. To incentivize banks
to park their excesses, RBI has
narrowed the LAF corridor.
Increase in repo rate and a
narrower LAF corridor will increase
the short term lending rate. This will
put a break on the overheating of
the economy and eventually the demand side inflation.
When the liquidity again gets back in surplus, with
narrower LAF corridor RBI has ensured that short term
interest rates are still higher anchored at Reverse
Repo Rate.
RBI has also revised GDP growth rate projections from
8 percent to 8.5 percent. This shows that RBI expects
higher growth and potential overheating due to
demand side pressures. This is manifested by its
20
Edition 1
increased WPI forecast. Therefore tighter monetary
policy is expected to continue till inflation is
successfully tamed.
What Can Go Wrong
Major question that needs to be asked at this point is
whether there is a realistic threat of overheating in the
economy. During the growth years of 2006, 2007 &
2008, the economy was growing at a similar rate of
around 9 percent. The domestic
drivers of the economy currently
look strong. The difference in the
present situation though is the
global outlook. With Chinese
economy cooling down due to
increase in lending rate,
commodity prices still remaining
soft and possibility of a double dip
in the western world, and
uncertainty in capital inflows, demand side inflation is
still questionable.
Also monsoons this year have been relief on food
prices. Lastly, the lagged effect of the monetary
tightening initiated earlier may lead to moderate
inflation.
With these uncertainties, is it the right time for
monetary tightening and LAF contraction as we may
be risking growth to curtail inflation?
 Volume 1
Listing
ListingNorms
Norms for
for the
the PSUs
PSUs
On June 4, 2010, the Government
amended the Securities Contract
(Regulations) Act by ordering all
listed companies, including public
sector firms, to lower their
promoters‘ holding in a phased
manner till a minimum of 25
percent was with the public.
The objective was to let investors benefit from India‘s
economic growth and promote better price discovery.
It was also expected to bring India on par with the
globally followed norms related to free float for listed
companies.
Under the norms, all listed companies were required to
dilute at least 5 percent every year until public holding
reached 25 percent. For any new listing, the
notification mandated that if the public offer was over
`4,000 Crore, the company could list with just 10
percent public holding and reach the 25 percent
requirement with an annual increase of 5 percent over
the next three years.
The new rules stated that in case of a listed PSU
whose public holding falls below 10 percent at any
given time, it would be required to bring the public
shareholding to 10 percent within a maximum period of
12 months from the date of such a fall.
The Standing Conference of Public Enterprises
(SCOPE) had opposed the
“..All listed
mandatory 25 percent
companies were minimum public holding norm,
required to dilute fearing that this would lead to
at least 5 percent a spate of follow-on public
offers by PSUs, which would
every year until lower their valuations. This
public holding view was backed by the
reached 25 Department of Disinvestment,
which said that the
percent.”
government‘s hopes to raise about `40,000 Crore from
stake sales in public sector units could be in jeopardy
as the norms could make PSUs wary of listing.
There are 183 Companies with the public shareholding
less than 25 percent. For these companies, the new
guidelines would have triggered host of stake sales
(from FPOs / QIPs / Open Market stake sale by the
21
Edition 1
By: Vaibhav Agarwal
promoters) amounting to a total of about `1,50,527
Crore. Of this, the share of PSUs would have been
about `1,24,547 Crore (i.e. 83 percent of the total) and
that of private sector would have been about `25,981
Crore (i.e. 17 percent of the total).
Where would money for such a huge investment have
come from?
Some of it would have been fresh money coming into
the stock markets.
“In a pure economic
However, a lot of it might
have just been money sense, this would
churned away from other have led to a
stock investments – reduction in share
people and Mutual Funds
(MFs) selling other shares
prices created by
held by them in order to artificially high
buy shares from these supply of shares...”
public offers. In a pure economic sense, this would
have led to a reduction in share prices created by
artificially high supply of shares, and not because of
any change in the fundamentals of the companies.
Of the PSUs, the prominent companies that would
have needed to come out with stake sale were
Hindustan Copper, MMTC, Neyveli Lignite, NMDC,
Engineers India, PFC, SJVN, MRPL, NTPC, NHPC,
SAIL, Power Grid, United Bank, IOC, Bharat
Electronics, etc.
The Amendment
Shortly after the announcement, the finance ministry
had sought the views of SEBI on a possible waiver of
the norms for government-promoted companies. SEBI
had, however, responded saying that there should not
be two sets of rules for firms — with one providing a
favorable treatment for state-run companies.
The government administers the Securities Contract
Regulation Act, which stipulates the mandatory level of
public holding in a listed entity. The finance ministry
can take the final call on this issue.
th
On Monday, 09 August 2010, the government diluted
the guidelines by lowering the minimum public float
requirement for state-owned enterprises to 10 percent
against 25 percent prescribed earlier. It also provided
some freedom to private sector companies by
 Volume 1
Edition 1
dispensing the 5 percent annual floor rule for The latest amendment would go a long way in the
companies with float below 25 percent. Under the new government realizing high premium for the PSUs in the
rules, government as well as private companies can event of an IPO/FPO in future and thus fulfill its
raise the public shareholding level within three years disinvestment targets. It will also ensure that there is
without any annual floor. no stampede of new issues
causing enormous stress on
“The biggest
The changes could have been a result of the lukewarm
primary and secondary beneficiary is the
response that the government received to the
IPOs/FPOs of PSUs this year. markets. But while the focus government
of this exercise was to get
After this latest amendment, it is estimated that only 15 because by
public ownership, it is strange
PSUs will be subjected to the requirement of FPOs as that the stipulated public divesting 10
against 35 estimated earlier. The cumulative value of shareholding of a public percent, it really
stake sales from these 15 PSUs would be of the order sector company is less than
of about `20,404 crore. The PSUs that now need not gets the market
the stipulated public
shareholding of a private valuation for the
sector company. 90 percent stock
There has been criticism from it holds.”
various quarters. Experts have called it a mockery in
the sense that the whole objective behind PSU
divestment of having a share of a PSU in each
household has been forgotten. For the above objective
Source: The Telegraph to materialize, a large chunk of PSU divestment should
come out with an FPO to meet the minimum public have been earmarked for the retail, against the
shareholding norm include, among others, SJVNL (90 present norms (around 65 percent for FIIs or for the
percent promoter holding), Power Finance Corporation corporates, and about 35 percent for retail)
“After this latest (90 percent), National accompanied by an aggressive discounting policy.
Aluminum (87 percent),
amendment, it is NHPC (86 percent), SAIL (86 The investor base is stuck at 1 Crore whereas it
should be at about 5 Crore to achieve the objective.
estimated that percent), NTPC (85 percent)
The government has demonstrated in the last one year
only 15 PSUs will and Shipping Corporation (80 that while it talks of PSU share ownership by every
percent), analysts said. The
be subjected to the 15 PSUs that still need to household, when it comes to pricing it is looking at the
requirement of institutional investors to give it the maximum price.
comply with the guideline
And retail gets only 5 percent discount to the
FPOs as against include, among others,
institutional price.
MMTC (99.33 percent),
35 estimated As a result, the retail investors have become
Neyveli Lignite (93.56
earlier.”
percent), Hindustan Copper (99.59 percent) and apprehensive about investing in a PSU which is
National Fertilizers (97.64 percent). evident from the response to some of the IPOs and
FPOs this year. The biggest beneficiary of divestment
Before and After Amendment
is actually the government because by divesting 10
Before After percent, it really gets the market valuation for the 90
Issue Size Issue Size percent stock it holds.
Cos. Cos.
(`Cr) (`Cr)
So while amending the free float norms for PSUs do
PSU 35 124,547 15 20,404 make sense in a way, there is still a need to refocus on
Private 148 25,981 148 25,981 the PSU divestment by looking at the retail segment,
Total 183 150,528 163 46,385 the pricing, and also the distribution.
Source: SMC Capital

22
 Volume 1
GST:
GST:An AnOverview
Overview
a tax structure in India is probably among
The indirect
the most complex and inefficient tax structures in the
world. The taxation powers are shared between the
centre and the states. The first move towards
rationalizing the indirect taxes was made in 2005 with
the introduction of VAT – CENVAT and State VAT.
While indirect taxes paid by the producing firms get
5
offsets under state VAT and CENVAT, the producers
do not receive full offsets particularly at the state level.
The multiplicity of taxes further adds to the difficulty in
getting full offsets. Thus the value added tax (VAT)
system has been partially able to fulfill the goals
towards reforming the indirect
taxes in India.
The differential multiple tax
regime across sectors of
production leads to distortions
in allocation of resources, thus
introducing inefficiencies in the
system. With regard to India‘s
exports, this leads to lack of
international competitiveness of the sectors which Source: Report on GST by NCAER deduction for input tax is not
would have been relatively efficient under distortion
free indirect tax regime. India‘s external trade growth
and the robust domestic
consumption warrants for a
rationalized tax structure which is
more effective and uniform.
The proposed structure is a three-
layer rate structure – 20 percent for
goods, 16 percent for services and
12 percent for essential items. The
Centre and the States will share
the tax revenues equally. The three-tier GST structure
will eventually move towards the single rate (16
percent) for all goods and services, in line with the
international norms.
5
Tax offsets directly reduce the amount of tax one must
pay. They are not the same as deductions, which are taken
off income before tax is worked out. With a tax offset, tax proposed GST structure will help reduce the inefficient
due on taxable income is worked out and the same is
reduced from the total amount of tax offsets
23
Edition 1
By: Anup Agrawal & Bharat Garg
The GST target is to have a lower uniform tax rate
over a large taxpayer base. The proposed limit beyond
which GST is to be paid by producer is with turnover
above `10 lacs. This is almost similar to the current
limit except for Small Scale Industries (SSIs) in
manufacturing sector which are exempted from central
excise up to a turnover of `150 crore The decreased
limit on SSI is likely to increase the tax payer base 5
fold to 50 lacs.
Effect on Industry
The objective of GST is to make the market of goods
and services seamless across
the country. The current multi-
tax indirect tax structure does
not make a pure VAT system
and induces inefficiency into
the system and leads to
cascading effect of taxes. For
example state VAT is paid on
both the basic value and
excise duty there on. Again,
available on interstate sales tax (CST) breaking the
chain and inflating the price of goods. GST (in its three
forms central GST, state GST
and interstate GST as proposed
recently) is always chargeable
only on the basic value and thus
no tax-on-tax effect. Also, the
credit of input taxes (that is taxes
already paid on interstate
purchase can be set off against
tax payable good sold within the
state) is interchangeable and would not artificially
inflate the price of the goods.
Currently, there are variations in tax rates across the
various states. This makes some states attractive for
particular industries. The GST code proposes a
uniform rate across the country and the products. This
will remove the tax competition among the states and
give a level playing field for domestic producers. The
 Volume 1
resource allocation and political lobbying for
exemptions and reduced rates by industries.
The current machinery of indirect taxes requires
separate registration and compliance for each of
Service tax, Excise duty, State VAT, Central Sales tax
and the like. GST will make the compliance easy for
the industry as it requires a single registration and all
the duties and taxes (merged into a single tax) will be
deposited together. Moreover, it will reduce paperwork
and physical visits to tax offices as most of the
processes like registration & return filing will go online,
the funds will be transferred electronically making the
tax regime simplified and less costly to comply with.
The GST regime will induce efficiency into the system
and make the Indian goods and services more
competitive with that of rest of the world. The exports
are expected to gain from 3.2 percent to 6.3 percent
while imports are expected to gain from 2.4 percent to
4.7 percent.
Impact on Consumers
The net incidence of the indirect taxes (both central
and state) on the ultimate consumer comes to be
around 20-25 percent. The benefits of the proposed
GST structure would reach the consumers in two folds
– price reduction due to lower indirect tax incidence
and the decreased cost of production coming from the
efficient resource allocation.
However the single GST rate at
16 percent would have the
inflationary effect on services.
The exempted goods list is also
shortened and thus would
increase the prices of some
goods. Though the prices of
certain goods and services
are likely to increase but certain
products become cheaper for the common man
and based on GST implementation experience
worldwide, it is not likely to have an overall inflationary
or deflationary effect on price level.
Central v/s State Government
Indirect taxes contribute around 60 percent of total tax
revenues of the government (central and states). The
objective of GST rollout is not to increase the
government revenues. However, wider tax base, and
24
Edition 1
increased economies and efficiency in collection are
likely to have a positive impact.
The old system was a production based tax i.e. the
producer state receives the revenue of sales tax.
Under GST, which is a destination based tax; the state
consuming the good will receive the revenue. Also,
under the GST, the state governments would for the
first time levy taxes on services.
State governments fear that the GST implementation
would result in loss of their tax revenues and would
reduce their fiscal autonomy (deciding the tax
structure). To counter that, Finance Minister has
proposed to compensate the states for any loss of
revenue in the transition phase. Also to make GST
more acceptable to the states, petroleum products,
electricity and alcohol, which make one third of state
revenues, have been kept out of ambit of GST.
What remains to be done
The GST rollout, earlier scheduled to be on April 01,
2010 and later revised to April 01, 2011, has met with
hurdles time and again. Firstly, the consent of all the
states is required to go forward with an agreement on
tax rates, control, exemption and revenue sharing for
which consensus is required between both the houses.
Secondly, a lot depends on the quality of the IT system
– crucial for both governance and compliance. The
system is required to be in place at least 3 months
before the
implementation for
testing and training.
Thirdly, the existing
infrastructure of excise
and state tax, from
commissioners and
officers to tribunals needs
to be overhauled to make it
suitable for GST and also
the existing staff needs to be trained to the new
system. Lastly, a clearing house needs to be set up for
online payment of taxes and many finer details like
credit on existing stock, accumulated credit of old
system, etc. are required to be carved out and
discussed before transition. The NSDL (National
Securities Depository Limited) has the required
experience in implementing the tax information system
 Volume 1
and is expected to help in setting up the clearing
house.
Conclusion
The Central Government seems to have put GST back
on the fast-track mode, and the efforts to make it
happen on time are apparent.
Edition 1
In sum, implementation of a comprehensive GST in
India is expected to lead to efficient allocation of
factors of production thus leading to gains in GDP and
exports. This would translate into enhanced economic
welfare and returns to the factors of production, viz.
land, labor and capital. Moreover the GST
implementation would propel the Indian economy to
the $2 trillion mark in a shorter than expected span of
time.

GST: An Overview
Crossword Solution

25
 Volume 1
Edition 1

GST:
CDS:An
AnOverview
Indian Perspective By: Anshul Bansal

Credit Default Swaps (CDS), the derivative instrument Salient Features of Guidelines
which has been blamed as the single largest reason RBI has tried to regulate the CDS instruments to a
for the recent financial crisis is likely to find its home in
large extent by allowing CDS on the corporate bonds
India. RBI has issued draft guidelines for introducing only. It has
CDS in the proposed to
Indian markets. introduce Plain
To put in simple Vanilla CDS
terms, CDS is instruments
insurance to the only with no
debt holder naked
against the positions (i.e.
default by the any entity not
issuer of debt. holding the
Against this underlying
insurance the cannot buy a
buyer pays CDS). It has
regular made it
payments to the mandatory that
seller of CDS can only
insurance. be issued on
the rated
It is important to bonds. The
point out that only exception
RBI had issued being unrated
guidelines on bonds issued
introduction of by a Special
CDS way back Purpose Vehicle (SPV set up by rated infrastructure
in 2007 but due to financial crisis RBI postponed the companies. Currently, only Banks, NBFCs and
process. Now that the storm created by the financial Primary Dealers (PDs) can sell the CDS. It has also
crisis is beginning to settle, RBI has once again got recommended a
into action and has come centralized trade
Guidelines Summary
up with the fresh repository and mandatory
guidelines. RBI‘s critiques  CDS on Corporate bonds only
trade reporting within 30
have been arguing that it  Plain Vanilla CDS with no naked positions
minutes of transaction.
has ignored the lessons  CDS on rated bonds only Further, RBI has
taught by the financial recommended setting up a
crisis. However, it is important to note that RBI has central counterparty (CCP) system, where trades will
taken a very calculated approach and the proposed be guaranteed by a third party.
guidelines take due care of the risks arising out of the
CDS market. It cannot be said conclusively that the It is expected that going forward the financial
mere existence of CDS was primarily responsible regulators across the globe want CDS trades to have a
for the financial meltdown. Instead, it was the lack of standardized format which can be easily monitored.
regulation which led to creation of complex Since RBI is planning to allow only the plain vanilla
instruments and the complex transactions undertaken CDS, which can be easily standardized, this could be
by financial institutions which added to the chaos. a good opportunity for starting an exchange traded

26
 Volume 1
Edition 1
platform for CDS. However, it seems to be a wasted bonds. Since CDS will provide protection against the
opportunity as the guidelines are silent on this issue. default by the issuing entity, greater number of
participants will now be willing to trade in lower rated
Issues of Contempt bonds. RBI has further indicated its desire to support
An issue of contempt for the financial services industry the growth of bond market by banning the writing of
is the ban on naked positions. Industry experts feel CDS on issues with original maturity up to one year
that presence of naked positions make the CDS e.g., Commercial Paper, Certificate of Deposits etc.
market liquid and also help in price discovery. Further, This seems to be a step in the right direction as India
it reduces the cost of hedging for the bearer of the needs a developed bond market which will further help
underlying. Though the in improving the efficiency of
arguments put forward by financial markets.
industry experts are valid but
one must remember that Impact on Infrastructure
these naked positions were Financing
primarily responsible for the Given that RBI has given
global financial meltdown. In exemption to bonds issued
addition to this, naked by SPVs of rated
positions start acting as an infrastructure companies, it
effective tool for is being speculated that this
speculators (e.g., a single or can provide a much needed
a group of market participants boost to infrastructure
can buy huge amount of CDS financing in the country.
protection on a reference However, the general feeling
entity which may lead to perception in the market that is that there is still some time before the impact of
reference entity is vulnerable). In lieu of arguments CDS on this sector can be felt. As the time
given above, it is felt that RBI is correct in banning the progresses and infrastructure projects turn cash
naked positions in CDS market. positive, the number of participants willing to take
risk on them will increase. This will primarily be
RBI has mandated that one party in a CDS transaction because of the insurance which CDS will provide. But
should be a RBI regulated entity. This limits the for the projects which are yet to turn cash positive the
number of participants in the market as large corporate door for financing still remains shut.
houses as well as other financial institutions such as
hedge funds and private equity firms will not be able to Concluding Remarks
sell CDS to other parties. Given the cautionary It is felt that RBI has been over regulative in its
environment market currently operates in; this step is guidelines and as a result CDS markets may suffer the
to ensure that the systemic risk remains at a minimal same fate as the interest rate futures market. This
level. Regulated institutions face lower risk as situation becomes inevitable when a regulator designs
compared to shadow banking system (Hedge funds a financial product. World over, it is observed that
and PEs). regulators are not involved in the nitty-gritty of
product development. Nevertheless, RBI has taken a
Support to Bond Markets step in the right direction of promoting Indian financial
Experts feel that the introduction of CDS can provide a markets. It now has to strike a right balance between
fillip to bond markets in India. The argument put the regulatory vigilance and the incentives to market
forward is that currently the bond market in India is participants in order to grow this market in India.
only for AAA rated bonds or for some of the AA rated

27
 Volume 1
GST: An Overview
Divestment Targets – Too Ambitious?
According to new divestment policy cleared by CCEA
th
(Cabinet Committee on Economic Affairs) on 6 Nov
2009, 60 PSUs (Public Sector Undertaking) are
eligible for stake dilution. This policy mandates a
minimum public float of 10 percent in profitable PSUs.
Currently 10 PSUs are already listed on exchange and
other 50 will follow the suit in coming years at
opportune moments.
GOI (Government of India) was able to garner
`23,552 Crore last year through stake sale in OIL (Oil
India Ltd, `2,247 Crore), NHPC (`2,012 Crore), REC
(Rural Electrification Corporation, `882 Crore) and
NTPC (`8,480 Crore), NMDC (`9,930 Crore).
GOI has setup aggressive revenue target of `40,000
Crore for the current fiscal year through divestment.
PSUs which are expected to be divested in the current
year are Coal India Ltd., Hindustan Copper Ltd., SAIL,
Power Grid Corporation, Indian Oil Corporation,
Manganese Ore India Ltd., MMTC and Shipping
Corporation of India Ltd. FPO (Follow-on Public Offer)
of Engineers India Ltd. has already fetched `977 Crore
while SJVNL‘s (Satluj Jal Vidyut Nigam Ltd) IPO has
fetched over `1,000 Crore in the current year.
Road Ahead
Total divestment revenue earned currently stands at
`2,000 Crore. GOI has planned to divest 5 percent
stake in ONGC and 10 percent stake in IOL, which
together may earn `21,000 Crore this year. Coal
India‘s IPO is expected to earn `15,000 Crore while
SAIL is expected to earn `8,000 Crore from first
tranche of FPO this year. These four big ticket sales
are expected to earn `44,000 Crore this year.
CCEA has already approved divestment in SAIL
through additional equity to the extent of 10 percent
and through divestment of government stake by 10
percent to be done in two separate tranches.
Divestment of 10 percent paid up equity in Hindustan
Copper Ltd is to be done out of government‘s current
holdings and an equal equity issuance in domestic
market. Divestment of 10 percent of paid up capital of
Coal India Ltd will be from government‘s current
holdings and that of Power Grid Corporation is to be
28
Edition 1
By: Ansuhman Atri
done through FPO of 20 percent paid up capital with
10 percent as fresh issue and 10 percent as
divestment of stake by selling shareholder (The
President of India).
Issues to ponder over
25 percent mandatory float
SEBI has mandated a minimum float of 25 percent for
all the listed companies. According to CRISIL, there
are 179 listed companies with public holdings of less
than 25 percent. These companies will raise
`1,600,000 Crore if they opt for sale of shares and
`2,100,000 Crore if they opt for issue of new shares.
The amount to be raised due to 25 percent stake
dilution is greater than total money raised using public
offerings during 2004-2010. Thus there will be
downward pressure on prices and valuation for new
public offerings considering the short time span in
which companies have to obtain mandatory float
target.
Low Staff Participation in PSU Divestment
Companies Employee portion
subscribed (%)
REC 75%
United Bank of India 68%
Engineers India Ltd 60%
SJVNL 26%
NTPC 44%
NMDC 05%
Source: Hindu Business Line
PSU employees have given lukewarm response to
current divestment process. Employee portion of
shares were not fully subscribed in recent public
offerings. Low subscription can be attributed to a host
of factors, two of which are lack of awareness amongst
the employees and lack of interest in the company
(which may be due to low quality of the issue). Few
PSUs are located in remote parts of country and it is
difficult for employees to open up a Demat account.
This can also be one of the reasons for low
subscription.
Foreign companies like to be part of companies in
which top management themselves hold shares and,
 Volume 1
looking at current response from employees, this might
not act as a positive signal.
Cumulative Divestment at `76,975 Crores in
1992-2010
Looking at the cumulative divestment over the past 19
years, government was able to collect `76,975 Crore,
with `23,552 Crore in last year. This year government
wants to generate an amount that is more than half of
total amount generated in past 19 years. Looking at
past figures, current divestment target looks very
aggressive. But on the other hand, we can say that
divestment as a policy has got fillip only in past few
years. Further, high fiscal deficit has accelerated the
divestment process.
25
20
15
10
5 20
0 0
Divestment (Rs. Thousand Crore)
Cumulative Divestment (Rs.Thousand Crores)
Source: http://www.divest.nic.in/
29
Edition 1
Positives for current year target
I-Bankers to Speedup Divestment
In order to speed up divestment process, CCEA has,
th
on 26 May 2010, approved appointment of merchant
bankers and other intermediaries of merchant bankers.
Thus, approval for divestment and appointment of
merchant bank will now be done simultaneously,
thereby speeding up the divestment process.
Divestment of Crown Jewels of India
Coal India, ONGC, OIL and SAIL are big ticket
enterprises and government will not have much
difficulty in selling stake in these companies.
Divestment target in these four would together fetch
more than `40,000 Crore provided that there is
appetite for these issues in stock market.
80
70
60 Though the current target level is very ambitious,
50 government should be able to achieve it considering
40 the companies that are to be divested. Government
30
needs to carefully tread over the tradeoff between
10 large number of divestments and high valuation of
companies. If large numbers of companies are
divested, then these companies will not get a premium
on listing. So, government should not hasten the
divestment process at the cost of lower valuation of
these PSUs.
 Volume 1
GST: An Overview
Finopedia: Option Pricing Models
Options are financial instruments that convey the
right, but not the obligation, to engage in a future
transaction on some underlying security, or in a futures
contract. In other words, the holder does not have to
exercise this right, unlike a forward or futures. For
example, buying a call option provides the right to buy
a specified quantity of a security at a set strike price at
some time on or before expiration, while buying a put
option provides the right to sell. Upon the option
holder's choice to exercise the option, the party who
sold, or wrote, the option must fulfill the terms of the
contract.
The theoretical value of an option can be determined
by a variety of techniques. These models, which are
developed by quantitative analysts, can also predict
how the value of the option will change in the face of
changing conditions. Hence, the risks associated with
trading and owning options can be understood and
managed with some degree of precision compared to
some other investments.
The most popular model for pricing options, both in
financial literature as well as in practice has been the
one developed by Fischer Black & Myron Scholes.
Black Scholes Model
The payoff of a call option with strike K on an
underlying asset whose price at expiry is S is max(S −
K,0). At any time before expiry, the market price of the
call, c, must satisfy the equation c = E [ max(St-K, 0) ].
The Black-Scholes model rationalizes the market
price, c, in terms of S, under the following
assumptions:
 The price of the underlying instrument St follows a
Brownian motion Wt with constant mean μ and
volatility σ, and the price changes are log-normally
distributed:
St = μSt dt + σSt dWt
 It is possible to short sell the underlying stock.
 There are no arbitrage opportunities.
 Trading in the stock is continuous.
 There are no transaction costs or taxes.
 All securities are perfectly divisible (e.g. it is
possible to buy any fraction of a share).
30
Edition 1
By: Vaibhav Agarwal
 It is possible to borrow and lend cash at a constant
risk-free interest rate.
 The stock does not pay a dividend.
The above assumptions lead to the following formula
for a European call option with price c, exercise price
K & maturity T, on a stock currently trading at price S,
(i.e., the right to buy a share of the stock at price K
after T years). The constant interest rate is r, and the
constant stock volatility is σ.
-rt
c = SΦ(d1) – Ke Φ(d2)
where
d1 = [ ln(S/K) + (r + σ /2)T ] / σT
2
d2 = [ ln(S/K) + (r - σ /2)T ] / σT
2
Here Φ is the standard normal cumulative distribution
function.
Intuitively, Φ(d1) represents non-discounted delta
hedge ratio in the underlying asset; and Φ(d2) gives
the unit price of a binary call option, (the conditional
likelihood that S > K at expiry).
The price of a put option may be computed from this
by using put-call parity equation and it simplifies to
P(S,T) = Ke-rtΦ(-d2) - SΦ(-d1)
Limitations of B-S formula
It is observed that BS Formula:
 Under-prices deep-in-the-money or deep-out-of-
the-money options
 Over-prices at-the-money options
Consider put or call options on a given underlying
security, having different strikes but the same
expiration. If we obtain market prices for these options,
we can apply the Black-Scholes model to find-out
implied volatilities. The implied volatility of an option
contract is the volatility implied by the market price of
the option based on an option pricing model (BS
model in this case). In other words, it is the volatility
that, given a particular pricing model, yields a
theoretical value for the option equal to the current
market price. Intuitively, we might expect the implied
volatilities to be identical. In practice, it is likely that
they will not be.
 Volume 1
The pattern of implied volatilities forms a "smile"
shape, which is called a volatility smile. Such a smile
persists over time in the options markets with in-the-
money and out-of-the-money volatilities generally
higher than at-the-money volatilities.
Most derivatives markets exhibit persistent patterns of
volatilities varying by strike. In some markets, those
patterns form a smile. In others, such as equity index
options markets, it is more of a skewed curve. This
has motivated the name volatility skew. In practice,
either the term "volatility smile" or "volatility skew" (or
simply skew) may be used to refer to the general
phenomena of volatilities varying by strike.
There are various explanations for why volatilities
exhibit skew. Different explanations may apply in
different markets. In most cases, multiple explanations
may play a role. Some explanations relate to the
idealized assumptions of the Black-Scholes approach
to valuing options. Almost every one of those
assumptions—lognormally distributed returns,
return homoskedasticity, etc.—could play a role. For
example, in most markets, returns appear more
leptokurtic than is assumed by a lognormal
distribution. Market leptokurtosis would make way out-
of-the-money or way in-the-money options more
expensive than would be assumed by the Black-
Scholes formulation. By increasing prices for such
options, volatility smile could be the markets' indirect
way of achieving such higher prices within the
imperfect framework of the Black-Scholes model.
Other explanations relate to relative supply and
demand for options. In equity markets, volatility skew
could reflect investors' fear of market crashes—which
would cause them to bid up the prices of options at
strikes below current market levels.
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Another dimension to the problem of volatility skew is
that of volatilities varying by expiration. It indicates
what is known as a volatility surface—a three-
dimensional graph indicating implied volatilities by both
strike and expiration.
Source: www.hoadley.net
Further Study – Stochastic Volatility (SV)
An important assumption of the B-S model is the
homoskedasticity of returns. In practice, however, the
standard deviation of returns is a stochastic or time-
varying variable.
For a derivative asset f with a price that depends upon
some security price, S, and its instantaneous variance,
2
V = σ . S & V which are assumed to obey the following
stochastic processes:
dS = φS dt + σS dw
dV = μV dt + ξV dz
The variable φ is a parameter that may depend on S,
σ, and t. The variables μ and ξ may depend on σ and
t, but it is assumed, for the present, that they do not
depend on S. The Wiener processes dz and dw have
correlation ρ. The actual process that a stochastic
variance follows is probably fairly complex. It cannot
take on negative values, so the instantaneous
2
standard deviation must approach zero as σ
2
approaches zero. Since S and σ are the only state
variables affecting the price of the derivative security,
f, the risk-free rate, which will be denoted by r, must be
constant or at least deterministic.
Some of the breakthrough SV models are – Merton
(1973), Hull-White (1987), Stein & Stein (1991),
Heston (1993), Derman Kani (1994), etc.
 Volume 1
Edition 1
The Team

Angad Kikla is a second year student at IIM Indore. Rahul Jain is a second year student at IIM Indore.
He graduated with a Dual Degree in Chemical He graduated from IIT Delhi with a B. Tech. in
Engineering from IIT Delhi. A CFA Level 2 candidate, Mechanical Engineering. A CFA Level 3 candidate, he
he has worked as a Management Trainee with ICI has worked as Senior Investment Analyst with
India Ltd. and interned with SAB Miller. He is a Evalueserve Ltd. and interned with the Corporate
national level table tennis player. Finance unit of PepsiCo India. He is an avid follower of
English Premier League.
Anshul Bansal is a second year student at IIM
Indore. He graduated from IIT Bombay with a B. Tech. Rahul Sachdeva is a second year student at IIM
in Mechanical Engineering. A CFA Level 3 candidate, Indore. He graduated from IIT Roorkee with a B. Tech.
he has worked as a Telecom Analyst with BDA in Industrial Engineering. A CFA Level 1 candidate, he
Connect India and has worked as
interned with the Credit Software Engineer
Analysis Unit of J.P. with CSC India and
Morgan India Pvt. Ltd. interned with Astro
He likes to play with Overseas Ltd. He is a
numbers. food connoisseur and
a budding
Anshuman Atri is a photographer.
second year student at
IIM Indore. He graduated Vaibhav Agarwal is
from BMSCE, Bangalore a second year student
with a B. E. in ISE. A at IIM Indore. He
CFA Level 3 candidate, graduated from IIT
he has worked as Senior Delhi with an

Software Engineer (Behind L to R) Rahul Jain, Anshul Bansal, Vaibhav Agarwal, Vipul Bansal, Anshuman Atri integrated M. Tech. in
(Front L to R) Rahul Sachdeva, Bharat Garg, Anup K Agarwal, Angad Kikla
with SAP Labs India. Mathematics and
His interests include technical analysis and reading. Computing. A CFA Level 2 candidate, he has interned
with Bloomberg and Ernst & Young. He is passionate
Anup K Agarwal is a second year student at IIM about football and is a staunch Manchester United
Indore. He graduated with a B.Com. Hons. in supporter.
Accounting and Finance from St. Xavier's College,
Calcutta. He has cleared C.A. Intermediate and has Vipul Bansal is a second year student at IIM Indore.
interned with Unicon Investments in the area of Wealth He graduated from Thapar University with a B.E. in
Management. He is passionate about data analysis. ECE. A CFA Level 2 and CAIA Level 1candidate, he
has worked as an Analyst with Inductis and interned
Bharat Garg is a second year student at IIM Indore. with Credit Risk Division of Deutsche Bank India. He
He graduated from Thapar University with a B.E. in likes to solve puzzles.
ECE. A CFA Level 2 candidate, he has worked as a
Software Engineer with Infosys Tech. Ltd. and interned
with Corporate Finance in Water division of HUL. His
interests include playing Snooker.

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