Mutual Funds in India

Mutual Funds – Concept
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

Mutual Funds Industry in IndiaThe origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry.In the past decade, Indian mutual fund industry had seen a dramatic improvements, both quality wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase, the Assets Under Management (AUM) was Rs. 67bn. The private sector entry to the fund family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it reached the height of 1,540 bn.Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian banking industry.The main reason of its poor growth is that the mutual fund industry in India is new in the country. Large sections of Indian investors are yet to be intellectuated with the concept. Hence, it is the prime responsibility of all mutual fund companies, to market the product correctly abreast of selling.The mutual fund industry can be broadly put into four phases according to the development of the sector. Each phase is briefly described as under.First Phase - 1964-87Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of assets under management. Second Phase - 1987-1993 (Entry of Public Sector Funds)Entry of non-UTI mutual funds. SBI Mutual Fund was the first followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC in 1989 and GIC in 1990. The end of 1993 marked Rs.47,004 as assets under management.Third Phase - 1993-2003 (Entry of Private Sector Funds)With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996.The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores. The Unit Trust of India with Rs.44,541 crores of assets under management was way ahead of other mutual funds. Fourth Phase - since February 2003This phase had bitter experience for UTI. It was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with AUM of Rs.29,835 crores (as on January 2003). The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of AUM and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth. As at the end of September, 2004, there were 29 funds, which manage assets of Rs.153108 crores under 421 schemes.


Performance of Mutual Funds in India

Let us start the discussion of the performance of mutual funds in India from the day the concept of mutual fund took birth in India. The year was 1963. Unit Trust of India invited investors or rather to those who believed in savings, to park their money in UTI Mutual Fund.For 30 years it goaled without a single second player. Though the 1988 year saw some new mutual fund companies, but UTI remained in a monopoly position. The performance of mutual funds in India in the initial phase was not even closer to satisfactory level. People rarely understood, and of course investing was out of question. But yes, some 24 million shareholders was accustomed with guaranteed high returns by the beginning of liberalization of the industry in 1992. This good record of UTI became marketing tool for new entrants. The expectations of investors touched the sky in profitability factor. However, people were miles away from the preparedness of risks factor after the liberalization.The Assets Under Management of UTI was Rs. 67bn. by the end of 1987. Let me concentrate about the performance of mutual funds in India through figures. From Rs. 67bn. the Assets Under Management rose to Rs. 470 bn. in March 1993 and the figure had a three times higher performance by April 2004. It rose as high as Rs. 1,540bn.The net asset value (NAV) of mutual funds in India declined when stock prices started falling in the year 1992. Those days, the market regulations did not allow portfolio shifts into alternative investments. There were rather no choice apart from holding the cash or to further continue investing in shares. One more thing to be noted, since only closed-end funds were floated in the market, the investors disinvested by selling at a loss in the secondary market.The performance of mutual funds in India suffered qualitatively. The 1992 stock market scandal, the losses by disinvestments and of course the lack of transparent rules in the whereabouts rocked confidence among the investors. Partly owing to a relatively weak stock market performance, mutual funds have not yet recovered, with funds trading at an average discount of 10­20 percent of their net asset value.The supervisory authority adopted a set of measures to create a transparent and competitive environment in mutual funds. Some of them were like relaxing investment restrictions into the market, introduction of open-ended funds, and paving the gateway for mutual funds to launch pension schemes.The measure was taken to make mutual funds the key instrument for long-term saving. The more the variety offered, the quantitative will be investors.At last to mention, as long as mutual fund companies are performing with lower risks and higher profitability within a short span of time, more and more people will be inclined to invest until and unless they are fully educated with the dos and don’ts of mutual funds.

The concept of mutual funds in India dates back to the year 1963. The era between 1963 and 1987 marked the existance of only one mutual fund company in India with Rs. 67bn assets under management (AUM), by the end of its monopoly era, the Unit Trust of India (UTI). By the end of the 80s decade, few other mutual fund companies in India took their position in mutual fund market.The new entries of mutual fund companies in India were SBI Mutual Fund, Canbank Mutual Fund, Punjab National Bank Mutual Fund, Indian Bank Mutual Fund, Bank of India Mutual Fund.The succeeding decade showed a new horizon in indian mutual fund industry. By the end of 1993, the total AUM of the industry was Rs. 470.04 bn. The private sector funds started penetrating the fund families. In the same year the first Mutual Fund Regulations came into existance with re-registering all mutual funds except UTI. The regulations were further given a revised shape in 1996.Kothari Pioneer was the first private sector mutual fund company in India which has now merged with Franklin Templeton. Just after ten years with private sector players penetration, the total assets rose up to Rs. 1218.05 bn. Today there are 33 mutual fund companies in India.Major Mutual Fund Companies in India

ABN AMRO Mutual FundABN AMRO Mutual Fund was setup on April 15, 2004 with ABN AMRO Trustee (India) Pvt. Ltd. as the Trustee Company. The AMC, ABN AMRO Asset Management (India) Ltd. was incorporated on November 4, 2003. Deutsche Bank A G is the custodian of ABN AMRO Mutual Fund.

Birla Sun Life Mutual FundBirla Sun Life Mutual Fund is the joint venture of Aditya Birla Group and Sun Life Financial. Sun Life Financial is a golbal organisation evolved in 1871 and is being represented in Canada, the US, the Philippines, Japan, Indonesia and Bermuda apart from India. Birla Sun Life Mutual Fund follows a conservative long-term approach to investment. Recently it crossed AUM of Rs. 10,000 crores.

Bank of Baroda Mutual Fund (BOB Mutual Fund)Bank of Baroda Mutual Fund or BOB Mutual Fund was setup on October 30, 1992 under the sponsorship of Bank of Baroda. BOB Asset Management Company Limited is the AMC of BOB Mutual Fund and was incorporated on November 5, 1992. Deutsche Bank AG is the custodian.

HDFC Mutual FundHDFC Mutual Fund was setup on June 30, 2000 with two sponsorers nemely Housing Development Finance Corporation Limited and Standard Life Investments Limited.

HSBC Mutual FundHSBC Mutual Fund was setup on May 27, 2002 with HSBC Securities and Capital Markets (India) Private Limited as the sponsor. Board of Trustees, HSBC Mutual Fund acts as the Trustee Company of HSBC Mutual Fund.

ING Vysya Mutual FundING Vysya Mutual Fund was setup on February 11, 1999 with the same named Trustee Company. It is a joint venture of Vysya and ING. The AMC, ING Investment Management (India) Pvt. Ltd. was incorporated on April 6, 1998.

Prudential ICICI Mutual FundThe mutual fund of ICICI is a joint venture with Prudential Plc. of America, one of the largest life insurance companies in the US of A. Prudential ICICI Mutual Fund was setup on 13th of October, 1993 with two sponsorers, Prudential Plc. and ICICI Ltd. The Trustee Company formed is Prudential ICICI Trust Ltd. and the AMC is Prudential ICICI Asset Management Company Limited incorporated on 22nd of June, 1993.

Sahara Mutual FundSahara Mutual Fund was set up on July 18, 1996 with Sahara India Financial Corporation Ltd. as the sponsor. Sahara Asset Management Company Private Limited incorporated on August 31, 1995 works as the AMC of Sahara Mutual Fund. The paid-up capital of the AMC stands at Rs 25.8 crore.

State Bank of India Mutual FundState Bank of India Mutual Fund is the first Bank sponsored Mutual Fund to launch offshor fund, the India Magnum Fund with a corpus of Rs. 225 cr. approximately. Today it is the largest Bank sponsored Mutual Fund in India. They have already launched 35 Schemes out of which 15 have already yielded handsome returns to investors. State Bank of India Mutual Fund has more than Rs. 5,500 Crores as AUM. Now it has an investor base of over 8 Lakhs spread over 18 schemes.

Tata Mutual FundTata Mutual Fund (TMF) is a Trust under the Indian Trust Act, 1882. The sponsorers for Tata Mutual Fund are Tata Sons Ltd., and Tata Investment Corporation Ltd. The investment manager is Tata Asset Management Limited and its Tata Trustee Company Pvt. Limited. Tata Asset Management Limited's is one of the fastest in the country with more than Rs. 7,703 crores (as on April 30, 2005) of AUM.

Kotak Mahindra Mutual Fund
Kotak Mahindra Asset Management Company (KMAMC) is a subsidiary of KMBL. It is presently having more than 1,99,818 investors in its various schemes. KMAMC started its operations in December 1998. Kotak Mahindra Mutual Fund offers schemes catering to investors with varying risk - return profiles. It was the first company to launch dedicated gilt scheme investing only in government securities.

Unit Trust of India Mutual Fund
UTI Asset Management Company Private Limited, established in Jan 14, 2003, manages the UTI Mutual Fund with the support of UTI Trustee Company Privete Limited. UTI Asset Management Company presently manages a corpus of over Rs.20000 Crore. The sponsorers of UTI Mutual Fund are Bank of Baroda (BOB), Punjab National Bank (PNB), State Bank of India (SBI), and Life Insurance Corporation of India (LIC). The schemes of UTI Mutual Fund are Liquid Funds, Income Funds, Asset Management Funds, Index Funds, Equity Funds and Balance Funds.

Reliance Mutual Fund
Reliance Mutual Fund (RMF) was established as trust under Indian Trusts Act, 1882. The sponsor of RMF is Reliance Capital Limited and Reliance Capital Trustee Co. Limited is the Trustee. It was registered on June 30, 1995 as Reliance Capital Mutual Fund which was changed on March 11, 2004. Reliance Mutual Fund was formed for launching of various schemes under which units are issued to the Public with a view to contribute to the capital market and to provide investors the opportunities to make investments in diversified securities.Standard

Chartered Mutual FundStandard
Chartered Mutual Fund was set up on March 13, 2000 sponsored by Standard Chartered Bank. The Trustee is Standard Chartered Trustee Company Pvt. Ltd. Standard Chartered Asset Management Company Pvt. Ltd. is the AMC which was incorporated with SEBI on December 20,1999.

Franklin Templeton India Mutual Fund
The group, Frnaklin Templeton Investments is a California (USA) based company with a global AUM of US$ 409.2 bn. (as of April 30, 2005). It is one of the largest financial services groups in the world. Investors can buy or sell the Mutual Fund through their financial advisor or through mail or through their website. They have Open end Diversified Equity schemes, Open end Sector Equity schemes, Open end Hybrid schemes, Open end Tax Saving schemes, Open end Income and Liquid schemes, Closed end Income schemes and Open end Fund of Funds schemes to offer.

Morgan Stanley Mutual Fund
IndiaMorgan Stanley is a worldwide financial services company and its leading in the market in securities, investmenty management and credit services. Morgan Stanley Investment Management (MISM) was established in the year 1975. It provides customized asset management services and products to governments, corporations, pension funds and non-profit organisations. Its services are also extended to high net worth individuals and retail investors. In India it is known as Morgan Stanley Investment Management Private Limited (MSIM India) and its AMC is Morgan Stanley Mutual Fund (MSMF). This is the first close end diversified equity scheme serving the needs of Indian retail investors focussing on a long-term capital appreciation.

Escorts Mutual Fund
Escorts Mutual Fund was setup on April 15, 1996 with Excorts Finance Limited as its sponsor. The Trustee Company is Escorts Investment Trust Limited. Its AMC was incorporated on December 1, 1995 with the name Escorts Asset Management Limited.

Alliance Capital Mutual Fund
Alliance Capital Mutual Fund was setup on December 30, 1994 with Alliance Capital Management Corp. of Delaware (USA) as sponsorer. The Trustee is ACAM Trust Company Pvt. Ltd. and AMC, the Alliance Capital Asset Management India (Pvt) Ltd. with the corporate office in Mumbai.Benchmark Mutual FundBenchmark Mutual Fund was setup on June 12, 2001 with Niche Financial Services Pvt. Ltd. as the sponsorer and Benchmark Trustee Company Pvt. Ltd. as the Trustee Company. Incorporated on October 16, 2000 and headquartered in Mumbai, Benchmark Asset Management Company Pvt. Ltd. is the AMC.

Canbank Mutual Fund
Canbank Mutual Fund was setup on December 19, 1987 with Canara Bank acting as the sponsor. Canbank Investment Management Services Ltd. incorporated on March 2, 1993 is the AMC. The Corporate Office of the AMC is in Mumbai.

Chola Mutual Fund
Chola Mutual Fund under the sponsorship of Cholamandalam Investment & Finance Company Ltd. was setup on January 3, 1997. Cholamandalam Trustee Co. Ltd. is the Trustee Company and AMC is Cholamandalam AMC Limited.

LIC Mutual Fund
Life Insurance Corporation of India set up LIC Mutual Fund on 19th June 1989. It contributed Rs. 2 Crores towards the corpus of the Fund. LIC Mutual Fund was constituted as a Trust in accordance with the provisions of the Indian Trust Act, 1882. . The Company started its business on 29th April 1994. The Trustees of LIC Mutual Fund have appointed Jeevan Bima Sahayog Asset Management Company Ltd as the Investment Managers for LIC Mutual Fund.

GIC Mutual Fund
GIC Mutual Fund, sponsored by General Insurance Corporation of India (GIC), a Government of India undertaking and the four Public Sector General Insurance Companies, viz. National Insurance Co. Ltd (NIC), The New India Assurance Co. Ltd. (NIA), The Oriental Insurance Co. Ltd (OIC) and United India Insurance Co. Ltd. (UII) and is constituted as a Trust in accordance with the provisions of the Indian Trusts Act, 1882.


Types of Mutual Funds Schemes in India
Wide variety of Mutual Fund Schemes exist to cater to the needs such as financial position, risk tolerance and return expectations etc. The table below gives an overview into the existing types of schemes in the Industry.

TYPES OF MUTUAL FUND SCHEMES

By Structure
Open - Ended Schemes
Close - Ended Schemes
Interval Schemes

By Investment Objective
Growth Schemes
Income Schemes
Balanced Schemes
Money Market Schemes

Other Schemes
Tax Saving Schemes
Special Schemes
Index Schemes
Sector Specfic Schemes

Advantages of Mutual Funds

The advantages of investing in a Mutual Fund are:
Diversification: The best mutual funds design their portfolios so individual investments will react differently to the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the overall portfolio should gradually increase over time, even if some securities lose value.

Professional Management:Most mutual funds pay topflight professionals to manage their investments. These managers decide what securities the fund will buy and sell.
Regulatory oversight: Mutual funds are subject to many government regulations that protect investors from fraud.

Liquidity: It's easy to get your money out of a mutual fund. Write a check, make a call, and you've got the cash.

Convenience: You can usually buy mutual fund shares by mail, phone, or over the Internet.

Low cost: Mutual fund expenses are often no more than 1.5 percent of your investment. Expenses for Index Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock in companies that are listed on a specific index
Transparency
Flexibility
Choice of schemes
Tax benefits
Well regulated

Drawbacks of Mutual Funds

Mutual funds have their drawbacks and may not be for everyone:

No Guarantees: No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.

Fees and commissions: All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.

Taxes: During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.

Management risk: When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers.

MBA Colleges in Hyderabad

Acharya N.G. Ranga Agricultural University, Hyderabad - Information on academics, research, infrastructure and contacts.
Akkineni Nageswara Rao College - Offers undergraduate and graduate degrees.
Andhra University, Visakhapatnam - Includes administration, academic programs, research facilities and online results.
Aurora Education - Offers web-based education. Information on attenadance, subject wise ranking and courses.
Central Institute of English and Foreign Languages, Hyderabad - Offers degree programmes in English, Arabic, French, German, Japanese, Russian, and Spanish.
College of Defence Management, Secunderabad - Provides management education for Indian Army Officers and from friendly foreign countries. Covers human resource development, financial and logistics management, operations research, project management, statistics and management information systems.
Council for Portfolio Management & Research (CPMR) - Includes overview, FAQ, regulations, exam results and fees.
G. Narayanamma Institute of Technology and Science, Hyderabad - College for women. Offers undergraduate programs in engineering. Information about the institute, courses, departments, library and students.
Geethanjali Institute of PG Studies - Offers masters program in computer science. Information about the institute, university, courses, admissions and opportunities.
Guntur Medical College - Information about the departments, administration, facilities, alumni and contacts.
The ICFAI Institute for Management Teachers - IIMT - Offers 3 year full-time campus based Management Teacher Program (MTP) leading to Ph.D degree for the benefit of candidates interested in teaching, research and consulting.
Indian School of Business, Hyderabad - Established in partnership with Kellogg Graduate School of Management and The Wharton School. The site provides information on business programmes, admissions, faculty and founders.
The Institute of Certified Risk and Insurance Managers - Offers programs in risk and insurance management. Information about the institute, university, frequently asked questions, contacts.
Institute of Chartered Financial Analysts of India, Hyderabad - Offers programs in financial analysis and management. Information on the various centres, management, programs, courses, placements, publications and contacts.
International Institute for Insurance and Finance - IIIF - Offers diploma courses in insurance, finance and risk management. Provides information about resources, collaborations and courses.
ITUC School of Management, Hyderabad - Offers MBA, MCA-MBA and CFA-MBA programs. Information about programs offered, admissions, student activities, and contact information.
Mathiit - Includes profile, faculty, courses and examination information.
Muffakham Jah College of Engineering and Technology - Offers undergraduate engineering programs. Information about the college, academics, results, faculty, facilities, programs and alumni.
Raja Bahadur Venkata Rama Reddy Womens College - Hyderabad based institution offers degree programs. Includes information on curriculum, departments, alumni, placements and facilities.
Regional Engineering College, Warangal - Offers engineering programs. Information on departments, faculty, admissions, placements, publications, events, research and consultancy, and contacts.
Sea Horse Academy of Merchant Navy - Educational and training center situated in Kakinada, Andhra Pradesh.
V. R. Siddhartha Engineering College, Vijayawada - Contains details on courses, departments, faculty, placements, and alumni.

MBA colleges in A.P University wise

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About Capital Market

Study material for this module

About Securities Market

Study material for this module

International Financial Management (IFM)

AN OVERVIWE OF
INTERNATIONAL FINANCE MANAGEMENT
Importance / Need / Scope of International Financial Management


International business activity is not new. The transfer of goods and services across national borders has been taking place for thousand of years. However, international business has undergone a revolution out of which has emerged one of the most important economic phenomena which is termed as MULTINATIONAL CORPORATION.

Generally, the MNCs are interested in International Financial Management. A Multinational Company is a company involved in producing and selling goods and services, in more than one country. It usually consists of a parent company located in its home country with numerous foreign subsidiaries.

Initially a company may start as a domestic company but as the awareness of opportunities in foreign markets also increases the domestic company may become a MNC.

It is important to study IFM because we are now living in a highly globalizes and integrated world economy. Due to the rapid advance in telecommunications and also the continuous liberalization trade, the world economy will become more integrated. Hence, the need to study the IFM.


The knowledge of INTERNATIONAL FINANCE is crucial fir MNCs in two important ways:

First, it helps the multinational companies and financial managers to decide how international events will effect the firm and what steps can be taken to gain from positive developments and insulate from harmful ones.

Second, it helps the companies to recognize how movements in EXCHANGE RATES, INTEREST RATES and ASSET VALUES will affect the firm.

The consequences of events affecting the stock markets and interest rates of one country immediately show up around the world. This is due to the integrated ad interdependent financial environment. Which exists around the world.

Global Links: Globalisation increases the ability of firms to do business across the national boundaries. The barriers to crossing these boundaries are coming down gradually. What once took days now takes hours and what once took weeks now take minutes or even seconds. All this is opening opportunities for everyone everywhere – BUT GLOBALISATION NOT REALLY RISK FREE.

Foreign trade has grown more quickly than the world economy in recent years. A trend that is likely to continue for developing countries like India. Foreign trade is the way for realizing the benefits of globalization.

MNC have become central actors of the world economy and linking foreign direct investment, trade technology and finance; they are drivingforce of economic growth.

World is reduced to an electronic village and global finance has become a reality.

Trade in services has grown even faster, aided by the revolution of telecommunication and computers.


INTERNATIONAL ECONOMICS: International Financial Management deals with the Financial Decisions taken in the area of international business.

International business is not new, nor is the study of the IFM. However, it was, for long, a part of international economics in general. It is only the fast growing dimensions o international business in the second half of the twentieth century and the growing complexities associated with it that the study of IFM has turned significant enough to become an independent branch of study.

International Financial Management covers the following:

Foreign Exchange Markets.

Exchange Rate Determination.

Exchange Rate Risk and Risk Management.

MNC’s Investment Decisions.

International Working Capital Decisions.

Financing Decisions of the MNC’s.

International Accounting.

International Indebtedness.

It can be observed that above areas are related to the FINANCIAL DECISIONS of the International Business. However, it can also be said that a financial manager of the DOMESTIC CORPORATION carries pit the above functions in one form or the other also. Now it is necessary that we have to understand the difference between DOMESTIC FINANCIAL MANAGEMENT and INTERNATIONAL FINANACIAL FINANCIAL MANAGEMENT.


INTERNATIONAL FINANCIAL MANGEMENT Vs DOMESTIC FINANCIAL MANAGEMENT.

INTRODUCTION: It is to be observed that both IFM and DFM are having the same objectives and scope. IFM is, to a great extent, similar to domestic corporate financial management.

A domestic company takes up a project for investment only, when the Net Present Value of cash flows is positive and it shapes the working capital policy in a way that maximizes the profitability and ensures desired liquidity. It is not different in case of MNC’s.

Further the financing decisions, in respect of whether a domestic or an international company, aim at minimizing the overall cost of capital and providing optimum control.


OBJECTIVES OF IFM: The main objective of both DFM and IFM is same. The main objective of IFM is to MAXIMISE SHAREHOLDERS WEALTH. The shareholders wealth is measured in the market share price. This means that IFM deals with making investment decisions and financing decisions that add value to the firm . The focus on shareholders value arises from the fact that the shareholders are the legal owners of the firm and management has a fiduciary obligation to act in their best interest.

The basic principle of financial management is always same even if the project involves foreign currency or a foreign project is accepted. The basic rule is that a project with higher present value be accepted and a capital mix with lowest cost is desirable.

However, the IFM has a wider scope than a domestic corporate finance and it is designed to cope with greater range of complexities then the domestic financial management. The reasons for the broader scope of the IFM are as follows:

The MNCs operate in different economic, political, legal, cultural and tax environments.

They operate across and within varied rages of product and factor markets which vary to a large extent.

They trade in large number of different currencies as a result of which their dependence on the foreign exchange market is quite substantial.

They mobilize funds not only from domestic capital market but also from the international capital markets.

Working capital management in an MNC is more complex because it involves cash movement of inventory from parent company to subsidiary company and vice- versa.

Expanded opportunity set.

About Derivatives

Introduction to derivatives

The origin of derivatives can be traced back to the need of farmers to protect them against actuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favorable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the
Farmer and the merchant to come together and enter into a contract whereby the price of the grain
to be delivered in September could be decided earlier. What they would then negotiate happened
to be a futures type contract, which would enable both parties to eliminate the price risk.
In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and
merchants together. A group of traders got together and created the `ton arrive' contract that
permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts
proved useful as a device for hedging and speculation on price changes. These were eventually
standardised, and in 1925 the first futures clearing house came into existence.
Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton,
wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial
underlying like stocks, interest rate, exchange rate, etc.

1.1 Derivatives defined
A derivative is a product whose value is derived from the value of one or more underlying
variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity

Introduction to derivatives
or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their
harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction
is an example of a derivative. The price of this derivative is driven by the spot price of wheat
which is the underlying in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in
commodities all over India. As per this the Forward Markets Commission (FMC) continues to
have jurisdiction over commodity forward/ futures contracts. However when derivatives trading
in securities was introduced in 2001, the term insecurity in the Securities Contracts (Regulation)
Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently,
regulation of derivatives came under the preview of Securities Exchange Board of India (SEBI).
We thus have separate regulatory authorities for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of derivatives is governed
by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956
(SC(R)A) defines “derivative” to include

1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
2. A contract, which derives its value from the prices, or index of prices, of underlying securities.

Products, participants and functions

Derivative contracts are of different types. The most common ones are forwards, futures, options
and swaps. Participants who trade in the derivatives market can be classified under the following
three broad categories - hedgers, speculators, and arbitragers.

1.Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

2. Speculators: Speculators are participants who wish to bet on future movements in the price of an
asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of
money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions. _ Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

The derivatives market helps to transfer risks from those who have them but may not like them to
those who have an appetite for them.
_ Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher trading volumes because of
participation by more players who would not otherwise participate for lack of an arrangement to
transfer risk.
_ Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new
entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well educated
people with an entrepreneurial attitude. They often energize others to create new businesses, new
products and new employment opportunities, the benefit of which are immense.
Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.

Derivative markets can broadly be classified as commodity derivative market and financial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts for
which the underlying asset is a commodity. It can be an agricultural commodity like wheat,
soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives
markets trade contracts that have a financial asset or variable as the underlying. The more
popular financial derivatives are those which have equity, interest rates and exchange rates as
the underlying. The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later.

1.3.1 Spot versus forward transaction
Using the example of a forward contract, let us try to understand the difference between a
spot and derivatives contract. Every transaction has three components ñ trading, clearing and
settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading.
Clearing involves finding out the net outstanding that is exactly how much of goods and money
the two should exchange. For instance A buys goods worth Rs.100 from B and sells goods worth
Rs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging
money and goods.
In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. “on
the spot. Consider this example. On 1st January 2004, Aditya wants to buy some gold. The
goldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Ad
itya buys 20 grams
of gold. He pays Rs.12,000, takes the gold and leaves. This is a spot transaction.
Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it
a month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the forward
price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays
the goldsmith Rs.12,030 and collects his gold. This is a forward contract, a contract by which
two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period.
A forward is the most basic derivative contract. We call it a derivative because it derives
value from the price of the asset underlying the contract, in this case gold. If on the 1st of
February, gold trades for Rs.6,050 in the spot market, the contract becomes more valuable to
Aditya because it now enables him to buy gold at Rs.6,015. If however, the price of gold drops
down to Rs.5,990, he is worse off because as per the terms of the contract, he is bound to pay
Rs.6,015 for the same gold. The contract has now lost value from Aditya's point of view. Note
that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its
value for Aditya.

1.3.2 Exchange traded versus OTC derivatives
Derivatives have probably been around for as long as people have been trading with one another.
Forward contracting dates back at least to the 12th century, and may well have been around before
then. These contracts were typically OTC kind of contracts. Over the counter(OTC) derivatives
are privately negotiated contracts. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre- arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
many of these contracts were standardised in terms of quantity and delivery dates and began to
trade on an exchange.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralised and located within individual
institutions.
2. There are no formal centralised limits on individual positions, leverage, or margining.
3. There are no formal rules for risk and burden sharing.
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for
safeguarding the collective interests of market participants.

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-
regulatory organisation, although they are affected indirectly by national legal systems, banking
supervision and market surveillance.
The OTC derivatives markets have witnessed rather sharp growth over the last few
years, which has accompanied the modernisation of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology have
contributed to a great extent to these developments. While both exchange-traded and OTC
derivative contracts offer many benefits, the former have rigid structures compared to the latter.
The largest OTC derivative market is the inter bank foreign exchange market. Commodity
derivatives the world over are typically exchange-traded and not OTC in nature.

1.3.3 Some commonly used derivatives
Here we define some of the more popularly used derivative contracts. Some of these, namely
futures and options will be discussed in more details at a later stage.

Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer dated options are called warrants
and are generally traded over-the-counter.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are :

Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the opposite
direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap.

Q: Futures trading commenced first on
Ans. Chicago Board of Trade


Q: Derivatives first emerged as products
Ans. Hedging

Q: Which of the following exchanges offer commodity derivatives trading
Ans. National Commodity Derivatives Exchange

Q: OTC derivatives are considered risky because
Ans.
1. There is no formal margining system.
2. They do not follow any formal rules or mechanisms.
3. They are not settled on a clearing house.

Q: The first exchange traded financial derivative in India commenced with the trading of
Ans. Index futures

Q: is the simplest derivative contract
Ans. Forward

Q: In a transaction, trading involves
Ans. The buyer and seller agreeing upon a price.

Q: In a transaction, clearing involves
Ans. The buyer and seller calculating the net outstanding.

Q: In a transaction, settlement involves
Ans. The buyer and seller exchanging goods and money.

Commodity derivatives

Derivatives as a tool for managing risk first originated in the commodities markets. They were
then found useful as a hedging tool in financial markets as well. In India, trading in commodity
futures has been in existence from the nineteenth century with organised trading in cotton through
the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities
were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted
in virtual dismantling of the commodities future markets. It is only in the last decade that
commodity future exchanges have been actively encouraged. However, the markets have been
thin with poor liquidity and have not grown to any significant level. In this chapter we look at
how commodity derivatives differ from financial derivatives. We also have a brief look at the
global commodity markets and the commodity markets that exist in India.

2.1 Difference between commodity and financial derivatives
The basic concept of a derivative contract remains the same whether the underlying happens to
be a commodity or a financial asset. However there are some features which are very peculiar
to commodity derivative markets. In the case of financial derivatives, most of these contracts
are cash settled. Even in the case of physical settlement, financial assets are not bulky and do
not need special facility for storage. Due to the bulky nature of the underlying assets, physical
settlement in commodity derivatives creates the need for warehousing. Similarly, the concept
of varying quality of asset does not really exist as far as financial underlying are concerned.
However in the case of commodities, the quality of the asset underlying a contract can vary
largely. This becomes an important issue to be managed. We have a brief look at these issues.

2.1.1 Physical settlement
Physical settlement involves the physical delivery of the underlying commodity, typically at an
accredited warehouse. The seller intending to make delivery would have to take the commodities
to the designated warehouse and the buyer intending to take delivery would have to go to the
designated warehouse and pick up the commodity. This may sound simple, but the physical
settlement of commodities is a complex process. The issues faced in physical settlement are
enormous. There are limits on storage facilities in different states. There are restrictions on
interstate movement of commodities. Besides state level octroi and duties have an impact on
the cost of movement of goods across locations. The process of taking physical delivery in
commodities is quite different from the process of taking physical delivery in financial assets.
We take a general overview at the process _ow of physical settlement of commodities. Later on
we will look into details of how physical settlement happens on the NCDEX.

Delivery notice period
Unlike in the case of equity futures, typically a seller of commodity futures has the option to
give notice of delivery. This option is given during a period identified as `delivery notice period'.
Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller
in an options market. However what is interesting and different from a typical options exercise
is that in the commodities market, both positions can still be closed out before expiry of the
contract. The intention of this notice is to allow verification of delivery and to give adequate
notice to the buyer of a possible requirement to take delivery. These are required by virtue of the
fact that the actual physical settlement of commodities requires preparation from both delivering
and receiving members.
Typically, in all commodity exchanges, delivery notice is required to be supported by
a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of
commodities being delivered. Some exchanges have certified laboratories for verifying the
quality of goods. In these exchanges the seller has to produce a verification report from these
laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts
as quality verification documents while others like BMF Brazil have independent grading and
classification agency to verify the quality.

In the case of BMF-Brazil a seller typically has to submit the following documents:
1.A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods.
2. A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.
3. A warehouse certificate showing that storage and regular insurance have been paid.

Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identifies
the buyer to whom this notice may be assigned. Exchanges follow different practices for the
assignment process. One approach is to display the delivery notice and allow buyers wishing
to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT
and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to
buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges
have adopted this method.
Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to
square off positions till the market close of the day of delivery notice. After the close of trading,
exchanges assign the delivery intentions to open long positions. Assignment is done typically
either on random basis or first – in - first out basis. In some exchanges (CME), the buyer has the
option to give his preference for delivery location.
The clearing house decides on the daily delivery order rate at which delivery will be settled.
Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for
quality and freight costs. The discount/ premium for quality and freight costs are published by
the clearing house before introduction of the contract. The most active spot market is normally
taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined
based on the previous day closing rate for the contract or the closing rate for the day.

Delivery
After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The
exchange also informs the respective warehouse about the identity of the buyer. The buyer is
required to deposit a certain percentage of the contract amount with the clearing house as margin
against the warehouse receipt.
The period available for the buyer to take physical delivery is stipulated by the exchange.
Buyer or his authorised representative in the presence of seller or his representative takes the
physical stocks against the delivery order. Proof of physical delivery having been effected is
forwarded by the seller to the clearing house and the invoice amount is credited to the seller's
account.
In India if a seller does not give notice of delivery then at the expiry of the contract the
positions are cash settled by price difference exactly as in cash settled equity futures contracts.

2.1.2 Warehousing
One of the main differences between financial and commodity derivatives is the need for
warehousing. In case of most exchange-traded financial derivatives, all the positions are cash
settled. Cash settlement involves paying up the difference in prices between the time the contract
was entered into and the time the contract was closed. For instance, if a trader buys futures
on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he
does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in
cash. Similarly the person who sold this futures contract at Rs.100, does not have to deliver the
underlying stock. All he has to do is pay up the loss of Rs.20 in cash.
In case of commodity derivatives however, there is a possibility of physical settlement. Which
means that if the seller chooses to hand over the commodity instead of the difference in cash, the
buyer must take physical delivery of the underlying asset. This requires the exchange to make
an arrangement with warehouses to handle the settlements. The efficacy of the commodities
settlements depends on the warehousing system available. Most international commodity
exchanges used certified warehouses (CWH) for the purpose of handling physical settlements.
Such CWH are required to provide storage facilities for participants in the commodities markets
and to certify the quantity and quality of the underlying commodity. The advantage of this system
is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades
but also for other purposes too. In India, the warehousing system is not as ef_cient as it is in
some of the other developed markets. Central and state government controlled warehouses are
the major providers of agriñproduce storage facilities. Apart from these, there are a few private
warehousing being maintained. However there is no clear regulatory oversight of warehousing
services.

2.1.3 Quality of underlying assets
A derivatives contract is written on a given underlying. Variance in quality is not an issue in
case of financial derivatives as the physical attribute is missing. When the underlying asset is a
commodity, the quality of the underlying asset is of prime importance. There may be quite some
variation in the quality of what is available in the marketplace. When the asset is specified, it
is therefore important that the exchange stipulate the grade or grades of the commodity that are
acceptable. Commodity derivatives demand good standards and quality assurance/ certification
procedures. A good grading system allows commodities to be traded by specification.
Currently there are various agencies that are responsible for specifying grades for
commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer
Affairs specifies standards for processed agricultural commodities whereas AGMARK under the
department of rural development under Ministry of Agriculture is responsible for promulgating
standards for basic agricultural commodities. Apart from these, there are other agencies like
EIA, which specify standards for export oriented commodities.

The NCDEX platform
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity
exchange. It is a public limited company registered under the Companies Act, 1956 with the
Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

NCDEX is regulated by Forward Markets Commission in respect of futures trading in
commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act,
Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations,
which impinge on its working. It is located in Mumbai and offers facilities to its members in
about 91 cities throughout India at the moment.
NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, re_ned
soy bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude
palm oil and cotton ñ medium and long staple varieties. At subsequent phases trading in more
commodities would be facilitated.

3.1 Structure of NCDEX
NCDEX has been formed with the following objectives:
1. To create a world class commodity exchange platform for the market participants.
2. To bring professionalism and transparency into commodity trading.
3. To inculcate best international practices like de-modularization, technology platforms, low cost
solutions and information dissemination without noise etc. into the trade.
3.To provide nation wide reach and consistent offering.
4.To bring together the entities that the market can trust.

3.1.1 Promoters
NCDEX is promoted by a consortium of institutions. These include the ICICI Bank Limited
(ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and
Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). NCDEX
is the only commodity exchange in the country promoted by national level institutions. This
unique parentage enables it to offer a variety of benefits which are currently in short supply
in the commodity markets. The four institutional promoters of NCDEX are prominent players
in their respective fields and bring with them institution building experience, trust, nationwide
reach, technology and risk management skills.

3.1.2 Governance
NCDEX is run by an independent Board of Directors. Promoters do not participate in the day to
day activities of the exchange. The directors are appointed in accordance with the provisions of
the Articles of Association of the company. The board is responsible for managing and regulating
all the operations of the exchange and commodities transactions. It formulates the rules and
regulations related to the operations of the exchange. Board appoints an executive committee
and other committees for the purpose of managing activities of the exchange.
The executive committee consists of Managing Director of the exchange who would be acting
as the Chief Executive of the exchange, and also other members appointed by the board.
Apart from the executive committee the board has constitute committee like Membership
committee, Audit Committee, Risk Committee, Nomination Committee, Compensation
Committee and Business Strategy Committee, which, help the Board in policy formulation.

3.2 Exchange membership
Membership of NCDEX is open to any person, association of persons, partnerships, co-operative
societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members
of the exchange have to register themselves with the competent authority before commencing
their operations. The members of NCDEX fall into two categories, Trading cum Clearing
Members (TCM) and Professional Clearing Members (PCM).
3.2.1 Trading cum clearing members (TCMs)
NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who
fulfill the specified eligibility criteria for trading in commodities. The TCM membership entitles
the members to trade and clear, both for themselves and/ or on behalf of their clients.

3.3 Capital requirements
Table 3.1 Fee/ deposit structure and net worth requirement: TCM
Particulars (Rupees in Lakh)
Interest free cash security deposit 15.00
Collateral security deposit 15.00
Annual subscription charges 0.50
Advance minimum transaction charges 0.50
Net worth requirement 50.00


Table 3.2 Fee/ deposit structure and net worth requirement: PCM
Particulars (Rupees in Lakh)
Interest free cash security deposit 25.00
Collateral security deposit 25.00
Annual subscription charges 1.00
Advance minimum transaction charges 1.00
Net worth requirement 5000.00

3.2.2 Professional clearing members (PCMs)
NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons
who ful_ll the speci_ed eligibility criteria for trading in commodities. The PCM membership
entitles the members to clear trades executed through Trading cum Clearing Members (TCMs),
both for themselves and/ or on behalf of their clients. Applicants accepted for admission as
PCMs are required to pay the following fee/ deposits and also maintain net worth as given in
Table 3.2.

3.3 Capital requirements
NCDEX has specified capital requirements for its members. On approval as a member of
NCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. Base
Minimum Capital comprises of the following:
1. Interest free cash security deposit
2. Collateral security deposit
All Members have to comply with the security deposit requirement before the activation of
their trading terminal. Members can opt to meet the security deposit requirement by way of the
following:
_ Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited.

_ Bank guarantee: Bank guarantee in favour of NCDEX as per the speci_ed format from approved banks. The minimum term of the bank guarantee should be 12 months.
_ Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period of 36 months from any of the approved banks.
_ Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. The securities are valued on a daily basis and a haircut of 25% is levied.
Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in case
of TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls
below the minimum required level, NCDEX may initiate suitable action including withdrawal of
trading facilities as given below:
_ If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be
withdrawn with immediate effect.
_ If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks' time to replenish the shortages and if the same is not done within the speci_ed time the trading facility would be withdrawn.
Members who wish to increase their limit can do so by bringing in additional capital in the
form of cash, bank guarantee, _xed deposit receipts or Government of India securities.

3.4 The NCDEX system
As we saw in the _rst chapter, every market transaction consists of three components ñ trading, clearing and settlement. This section provides a brief overview of how transactions happen on the NCDEX's market.

3.4.1 Trading
The trading system on the NCDEX, provides a fully automated screen based trading for
futures on commodities on a nationwide basis as well as an online monitoring and surveillance
mechanism. It supports an order driven market and provides complete transparency of trading
operations. The trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has
also been proposed for implementation at a later stage.
The NCDEX system supports an order driven market, where orders match automatically.
Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity
fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued in the re spective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.
NCDEX trades commodity futures contracts having one month, two month and three month expiry cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day. New contracts will be introduced on the trading day following the expiry of the near month contract.

3.4.2 Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades
executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX.
Only clearing members including professional clearing members (PCMs) only are entitled to
clear and settle contracts through the clearing house. At NCDEX, after the trading hours on the
expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price.

3.4.3 Settlement
Futures contracts have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last
trading day of the futures contract. On the NCDEX, daily MTM settlement and final MTM
settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward, created during the day or closed out during the day, are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day.
On the date of expiry, the final settlement price is the spot price on the expiry day. The
responsibility of settlement is on a trading cum clearing member for all trades done on his own
account and his client's trades. A professional clearing member is responsible for settling all
the participants trades which he has confirmed to the exchange. On the expiry date of a futures
contract, members submit delivery information through delivery request window on the trader
workstations provided by NCDEX for all open positions for a commodity for all constituents
individually. NCDEX on receipt of such information, matches the information and arrives at a
delivery position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated warehouse.
These commodities have to be assayed by the exchange specified assayer. The commodities
have to meet the contract specifications with allowed variances. If the commodities meet the
specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor's electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer's clearing member. On an appointed date, the buyer goes to the warehouse and takes physical possession of the commodities.

Q: Which of the following futures do not trade on the NCDEX?
Ans. Energy futures

Q: NCDEX is regulated by
Ans. The Forward Markets Commission

Q: The net worth requirement for a TCM is
Ans. Rs.50 Lakh

Instruments available for trading

In recent years, derivatives have become increasingly popular due to their applications for
hedging, speculation and arbitrage. Before we study about the applications of commodity
derivatives, we will have a look at some basic derivative products. While futures and options
are now actively traded on many exchanges, forward contracts are popular on the OTC market.
In this chapter we shall study in detail these three derivative contracts. While at the moment
only commodity futures trade on the NCDEX, eventually, as the market grows, we also have
commodity options being traded.

5.1 Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price.
One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are:
1.They are bilateral contracts and hence exposed to counter-party risk.

2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

3.The contract price is generally not available in public domain.

4. On the expiration date, the contract has to be settled by delivery of the asset.

5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardised, as in the case
of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This
process of standardisation reaches its limit in the organised futures market.

Forward contracts are very useful in hedging and speculation. The classic hedging application
would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate actuations. By using the currency forward market to sell
dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer
who is required to make a payment in dollars two months hence can reduce his exposure to
exchange rate actuations by buying dollars forward.

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

5.1.1 Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
1. Lack of centralisation of trading,
2. Illiquidity, and
3. Counter party risk
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable.
Counter party risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when
forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counter party risk remains a very serious issue.

5.2 Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies
certain standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,
(or which can be used for reference purposes in settlement) and a standard timing of such
settlement. A futures contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:

Table 5.1 Distinction between futures and forwards
Futures Forwards

Trade on an organised exchange OTC in nature
Standardized contract terms Customised contract terms
hence more liquid hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period

1. Quantity of the underlying
2. Quality of the underlying
3. The date and the month of delivery
_4.The units of price quotation and minimum price change Location of settlement

5.2.1 Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because
both serve essentially the same economic functions of allocating risk in the presence of future
price uncertainty. However futures are a significant improvement over the forward contracts as
they eliminate counter party risk and offer more liquidity. Table 5.1 lists the distinction between
the two.

5.2.2 Futures terminology

_ Spot price: The price at which an asset trades in the spot market.

_ Futures price: The price at which the futures contract trades in the futures market.

_ Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day of the delivery month. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a new contract having a three-month expiry is introduced for trading.

_ Expiry date: It is the date speci_ed in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

_ Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the Gold futures contract is 1 kg.

_ Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

_ Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

_ Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

_ Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking to market.

_ Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

5.3 Introduction to options
In this section, we look at another interesting derivative contract, namely options. Options are
fundamentally different from forward and futures contracts. An option gives the holder of the
option the right to do something. The holder does not have to exercise this right. In contrast, in
a forward or futures contract, the two parties have committed themselves to doing something.
Whereas it costs nothing (except margin requirements) to enter into a futures contract, the
purchase of an option requires an up front payment.

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member _rms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honour the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early '80s, the number of shares underlying the option contract sold each day exceeded the
daily volume of shares traded on the NYSE. Since then, there has been no looking back.
Box 5.7: History of options.

5.3.1 Option terminology
_ Commodity options: Commodity options are options with a commodity as the underlying. For
instance a gold options contract would give the holder the right to buy or sell a speci_ed quantity of gold at the price speci_ed in the contract.
_ Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
_ Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer.
_ Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
_ Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
_ Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
_ Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
_ Expiration date: The date speci_ed in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
_ Strike price: The price speci_ed in the options contract is known as the strike price or the exercise price.

Instruments available for trading
_ American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.

_ European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyse than American options, and properties of an American option are frequently deduced from those of its European counterpart.

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

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

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

_ Intrinsic value of an option: The option premium can be broken down into two components – intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

_ Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

5.4 Basic payoffs
A payoff is the likely profit/ loss that would accrue to a market participant with change in the
price of the underlying asset. This is generally depicted in the form of payoff diagrams which
show the price of the underlying asset on the X axis and the profits/ losses on the Y axis. In this
section we shall take a look at the payoffs for buyers and sellers of futures and options. But first
we look at the basic payoff for the buyer or seller of an asset. The asset could be a commodity
like gold or cotton, or it could be a financial asset like a stock or an index.