SHARE MARKET IN INDIA

TABLE OF CONTENTS
Introduction Stock market Role of Stock Exchange Functions of Stock Exchange Products, Participants and Functions Size of World Stock Market History of Stock Market Purpose of Stock Market Relation of Stock Market to modern financial system Stock Market, individual investors and financial risk Behavior of stock market Stock Market Index

Sensex : Barometer of Indian capital markets

Sensex calculation methodology Maintenance of Sensex Sensex: Scrip Selection Criteria

 Bombay Stock Exchange Indian Derivatives Market Capital market at a glance Equity Market In India What is an IPO?

Case Study on Reliance Power Limited

INTRODUCTION
Stock Market A stock market, or equity market, is a private or public market for the trading of company stock and derivatives of company stock at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. Other Definitions of Stock Market A market in which shares of stock are bought and sold. A general term referring to the organized trading of securities in the various market exchanges and the over the counter (OTC) market. The organized trading of stocks, bonds, or other securities, or the place where such trading occurs.

An institution that facilitates the buying and selling of stocks. A market for the buying and selling of stocks, such as the New York Stock Exchange. A location, referred to as market, where stocks are bought and sold. These can be

private or public. The market for trading equities. The display that represents the stock market that railroad shares are traded on. This is a crude representation of a real stock market. The origin of the stock market in India goes back to the end of the eighteenth century when long-term negotiable securities were first issued. However, for all practical purposes, the real beginning occurred in the middle of the nineteenth century after the enactment of the companies Act in 1850, which introduced the features of limited liability and generated investor interest in corporate securities. An important early event in the development of the stock market in India was the formation of the native share and stock brokers 'Association at Bombay in 1875, the precursor of the present day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in Ahmedabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during depressing times subsequently. The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock Exchanges. However, the BSE and NSE have established themselves as the two leading exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and BSE are equal in size in terms of daily traded volume. Most key stocks are traded on both the exchanges and hence the investor could buy them on either exchange. The primary index of BSE is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index (Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed index. Both these indices were calculated on the basis of market capitalization but recent development has revised to free float market capitalization method

and contain the heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both the exchanges have switched over from the open outcry trading system to a fully automated computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National Exchange Automated Trading) System. It facilitates more efficient processing, automatic order matching, faster execution of trades and transparency; the scrip's traded on the BSE have been classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which are in the carry forward system (Badla). The 'F' group represents the debt market (fixed income securities) segment. The 'Z' group scrip's are the blacklisted companies. The 'C' group covers the odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs and other participants in Indian secondary and primary market is the Securities and Exchange Board of India (SEBI).

Role of Stock Exchange

Stock exchanges have multiple roles in the economy, this may include the following: Raising capital for businesses The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public. Mobilizing savings for investment When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to promote business activity with benefits for several

economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher productivity levels and firms. Facilitating company growth Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition or fusion. Redistribution of wealth Stocks exchanges do not exist to redistribute wealth. However, both casual and professional stock investors, through dividends and stock price increases that may result in capital gains, will share in the wealth of profitable businesses. Corporate governance By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations imposed by public stock exchanges and the government. Consequently, it is alleged that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privately-held companies. However, some well-documented cases are known where it is alleged that there has been considerable slippage in corporate governance on the part of some public companies. The dot-com bubble in the early 2000s, and the subprime mortgage crisis in 2007-08, are classical examples of corporate mismanagement. Companies like Pets.com (2000), Enron Corporation (2001), One.Tel (2001), Sunbeam (2001), Webvan (2001), Adelphia (2002), MCI WorldCom (2002), Parmalat (2003), Fannie Mae (2008), Freddie Mac (2008), Lehman Brothers (2008), were among the most widely scrutinized by the media. Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors. Government capital-raising for development projects Governments at various levels may decide to borrow money in order to finance infrastructure projects such as sewage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the Stock Exchange whereby members of the public buy them, thus loaning money to the government. Barometer of the economy At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.

Functions of Stock Exchange

1. Maintains active trading: shares are traded on the stock exchanges, enabling the

investors to buy and sell securities. The prices may vary from transactions to transaction. A continuous trading increases the liquidity or marketability of the shares traded on the stock exchanges.

2. Fixation of prices: Price is determined by the transactions that flow from investors

demand and suppliers preferences. Usually the traded prices are made known to the public. This helps the investors to make better decisions.
3.

Ensures safe and fair dealing: The rules, regulations and by-laws of the stock exchanges provide a measure of safety to the investors. Transactions are conducted under competitive conditions enabling the investors to get a fair deal.

4.

Aids in financing the industry: A continuous market for shares provides a favourable climate for raising capital. The negotiability and transferability of the securities helps the companies to raise long-term funds. When it is easy to trade the securities, investors are willing to subscribe to the initial public offerings. This stimulates the capital formation.

5. Dissemination of information: Stock exchanges provide information through their

various publications. They publish the share prices traded on daily basis along with the volume traded. Directory of Corporate Information is useful for the investors assessment regarding the corporate. Handouts, handbooks and pamphlets provide information regarding the functioning of the stock exchanges.

PRODUCTS, PARTICIPANTS AND FUNCTIONS Transfer of resources from those with idle resources to others who have a productive need for them is perhaps most efficiently achieved through the securities markets. Stated

formally, securities markets provide channels for reallocation of savings to investments and entrepreneurship and thereby decouple these two activities. As a result, the savers and investors are not constrained by their individual abilities, but by the economys abilities to invest and save respectively, which inevitably enhances savings and investment in the economy. Savings are linked to investments by a variety of intermediaries through a range of complex financial products called securities which is defined in the Securities Contracts (Regulation) Act, 1956 to include:

(1) Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or body corporate: (a) Derivatives; (b) Units of any other instrument issued by any collective investment scheme to the investors in such schemes; (c) Security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; (d) Units or any other such instrument issued to the investors under any mutual fund scheme; (e) Any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be. (2) Government securities: (a) Such other instruments as may be declared by the Central Government to be securities. (3) Rights or interest in securities: There are a set of economic units who demand securities in lieu of funds and others who supply securities for funds. These demand for and supply of securities and funds determine, under competitive market conditions in both goods and securities market, the prices of

securities which reflect the present value of future prospects of the issuer, adjusted for risks and also prices of funds. It is not that the users and suppliers of funds meet each other and exchange funds for securities. It is difficult to accomplish such double coincidence of wants. The amount of funds supplied by the supplier may not be the amount needed by the user. Similarly, the risk, liquidity and maturity characteristics of the securities issued by the issuer may not match preference of the supplier. In such cases, they incur substantial search costs to find each other. Search costs are minimised by the intermediaries who match and bring the suppliers and users of funds together. These intermediaries may act as agents to match the needs of users and suppliers of funds for a commission, help suppliers and users in creation and sale of securities for a fee or buy the securities issued by users and in turn, sell their own securities to suppliers to book profit.

It is, thus, a misnomer that securities market disinter mediates by establishing a direct relationship between the savers and the users of funds. The market does not work in a vacuum; it requires services of a large variety of intermediaries. The disintermediation in the securities market is in fact an intermediation with a difference; it is a risk-less intermediation, where the ultimate risks are borne by the savers and not the intermediaries. A large variety and number of intermediaries provide intermediation services in the Indian securities market as may be seen from Table.

Table : Market Participants in Securities Market

Market Participants Regulators* Depositories Stock Exchange With Equities Trading With Debt Market Segment With Derivative Trading Brokers Corporate Brokers Sub-brokers FIIs Portfolio Managers Custodians Primary Dealers Merchant Bankers Bankers to an Issue Debenture Trustees Underwriters Venture Capital Funds Foreign Venture Capital Investors Mutual Funds Collective Investment Schemes * DCA, DEA, RBI & SEBI.

Number as on Mar-31 2007 1 4 2 21 2 2 9,443 4,110 27,541 996 158 15 17 152 47 30 45 90 78 40 0 2008 1 4 2 19 2 2 9,487 4,183 44,073 1,319 205 15 16 155 50 28 35 106 97 40 0

The securities market, thus, has essentially three categories of participants, namely the issuers of securities, investors in securities and the intermediaries. The issuers and investors are the consumers of services rendered by the intermediaries while the investors are consumers (they subscribe for and trade in securities) of securities issued by issuers. In pursuit of providing a product to meet the needs of each investor and issuer, the intermediaries churn out more and more complicated products. They educate and guide them in their dealings and bring them together. Those who receive funds in exchange for

securities and those who receive securities in exchange for funds often need the reassurance that it is safe to do so.

This reassurance is provided by the law and by custom, often enforced by the regulator. The regulator develops fair market practices and regulates the conduct of issuers of securities and the intermediaries so as to protect the interests of suppliers of funds. The regulator ensures a high standard of service from intermediaries and supply of quality securities and non- manipulated demand for them in the market.

Size of world stock market

The size of the world stock market is estimated at about $36.6 trillion US at the beginning of October 2008 The world derivatives market has been estimated at about $480 trillion face or nominal value, 12 times the size of the entire world economy. It must be noted

though that the value of the derivatives market, because it is stated in terms of notional values, cannot be directly compared to a stock or a fixed income security, which traditionally refers to an actual value. Many such relatively illiquid securities are valued as marked to model, rather than an actual market price. The stocks are listed and traded on stock exchanges which are entities a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The stock market in the United States includes the trading of all securities listed on the NYSE, the NASDAQ, the Amex, as well as on the many regional exchanges. e.g. OTCBB and Pink Sheets. European examples of stock exchanges include the London Stock Exchange. Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order. Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. This type of auction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders.

Actual trades are based on an auction market paradigm where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at market means you will accept any ask price or bid price for the stock, respectively.)

When the bid and ask prices match, a sale takes place on a first come first served basis if there are multiple bidders or askers at a given price. The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchange provides real-time trading information on the listed securities, facilitating price discovery. The New York Stock Exchange is a physical exchange, also referred to as a listed exchange only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a floor broker, who goes to the floor trading post specialist for that stock to trade the order. The specialist's job is to match buy and sell orders using open outcry. If a spread exists, no trade immediately takes place--in this case the specialist should use his/her own resources (money or stock) to close the difference after his/her judged time. Once a trade has been made the details are reported on the "tape" and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there is a significant amount of human contact in this process, computers play an important role, especially for so-called "program trading". The NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock.

History of stock market

Historian Fernand Braudel suggests that in Cairo in the 11th century, Muslim and Jewish merchants had already set up every form of trade association and had knowledge of many methods of credit and payment, disproving the belief that these were originally invented later by Italians. In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers.

A common misbelief is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred ; the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders and neighboring counties and "Beurzen" soon opened in Ghent and Amsterdam. There are stock markets in virtually every part of the world at this moment.

In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens.

The Dutch later started joint stock companies, which let shareholders invest in business ventures and get a share of their profits - or losses. In 1602, the Dutch East India Company

issued the first shares on the Amsterdam Stock Exchange. It was the first company to issue stocks and bonds.

The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have been the first stock exchange to introduce continuous trade in the early 17th century. The Dutch "pioneered short selling, option trading, debt-equity swaps, merchant banking, unit trusts and other speculative instruments, much as we know them" (Murray Sayle, "Japan Goes Dutch", London Review of Books XXIII.7, April 5, 2001). There are now stock markets in virtually every developed and most developing economies, with the world's biggest markets being in the United States, Canada, China (Hongkong), India, UK, Germany, France and Japan.

Purpose of Stock Market

The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate.

History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an upcoming economy. In fact, the stock market is often considered the primary indicator of a country's economic strength and development. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions.

Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction.

The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity.

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via the traditional bank lending and deposit operations. The general public's heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process. Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households' financial wealth, compared to less than 20 percent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized countries. In all developed economic systems, such as the European Union, the United States, Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another.

The stock market, individual investors, and financial risk

Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).

With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtaking each other to get investors' attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.

The Behavior of the stock market

From experience we know that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occurso that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also predicts that little or no trading should take placecontrary to fact since prices are already at or near equilibrium, having priced in all public knowledge.) But the efficient-market hypothesis is sorely tested by such events as the stock market crash in 1987, when the Dow Jones index plummeted 22.6 percentthe largest-ever one-day fall in the United States. This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a definite cause: a thorough search failed to detect any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the postwar period confirms this. Moreover, while the EMH predicts that all price movement (in the

absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer. Various explanations for large price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause financial markets to overreact. Other research has shown that psychological factors may result in exaggerated stock price movements. Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's selfconfidence, reducing his (psychological) risk threshold. The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the recent Nasdaq crash, less than 1 percent of the analyst's recommendations had been to sell (and even during the 2000 - 2002 crash, the average did not rise above 5%). The media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. Irrational behavior Sometimes the market tends to react irrationally to economic news, even if that news has no real affect on the technical value of securities itself. Therefore, the stock market can be swayed tremendously in either direction by press releases, rumors, euphoria and mass panic.

Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, making the stock market difficult to predict. Emotions can drive prices up and down. People may not be as rational as they think. Behaviorists argue that investors often behave irrationally when making investment decisions thereby incorrectly pricing securities, which causes market inefficiencies, which, in turn, are opportunities to make money Crashes A stock market crash is often defined as a sharp dip in share prices of equities listed on the stock exchanges. In parallel with various economic factors, a reason for stock market crashes is also due to panic. Often, stock market crashes end speculative economic bubbles. There have been famous stock market crashes that have ended in the loss of billions of dollars and wealth destruction on a massive scale. An increasing number of people are involved in the stock market, especially since the social security and retirement plans are being increasingly privatized and linked to stocks and bonds and other elements of the market. There have been a number of famous stock market crashes like the Wall Street Crash of 1929, the stock market crash of 19734, the Black Monday of 1987, the Dot-com bubble of 2000. One of the most famous stock market crashes started October 24, 1929 on Black Thursday. The Dow Jones Industrial lost 50% during this stock market crash. It was the beginning of the Great Depression. Another famous crash took place on October 19, 1987 Black Monday. On Black Monday itself, the Dow Jones fell by 22.6% after completing a 5 year continuous rise in share prices. This event not only shook the USA, but quickly spread across the world. Thus, by the end of October, stock exchanges in Australia lost 41.8%, in Canada lost 22.5%, in Hong Kong lost 45.8%, and in Great Britain lost 26.4%. The names Black Monday and Black Tuesday are also used for October 28-29, 1929, which followed Terrible Thursday--the starting day of the stock market crash in 1929. The crash in 1987 raised some puzzles-

main news and events did not predict the catastrophe and visible reasons for the collapse were not identified. This event raised questions about many important assumptions of modern economics, namely, the theory of rational human conduct, the theory of market equilibrium and the hypothesis of market efficiency. For some time after the crash, trading in stock exchanges worldwide was halted, since the exchange computers did not perform well owing to enormous quantity of trades being received at one time. This halt in trading allowed the Federal Reserve system and central banks of other countries to take measures to control the spreading of worldwide financial crisis. In the United States the SEC introduced several new measures of control into the stock market in an attempt to prevent a re-occurrence of the events of Black Monday. Computer systems were upgraded in the stock exchanges to handle larger trading volumes in a more accurate and controlled manner. The SEC modified the margin requirements in an attempt to lower the volatility of common stocks, stock options and the futures market. The New York Stock Exchange and the Chicago Mercantile Exchange introduced the concept of a circuit breaker.

Stock Market Index

Its ironical that something as huge as a stock market which should be stable as it represents the economy of a nation, is actually extremely volatile since it is driven more by the sentiments of the people

Stock Market is a place where the stocks of a listed company are traded. A single figure that sums up the overall performance of the market on a daily basis is the Stock Index. A good Stock Index captures the movement of the well diversified and highly liquid stocks. For a lay man it is the pulse rate of the economy. Index movements reflect the changing expectations of the stock market about future dividends of the corporate sector. The index is calculated by finding the weighted average of the prices of the most actively traded companies in the market, where the weights are generally in proportion to the market capitalization of the company. But when and where did it all start? Stock Exchanges as a centre for trading were established as early as the 16th century. In Antwerp, a major financial hub in Belgium, traders gathered together in 1531 to speculate in shares and commodities. This was the world's first Stock Exchange. London and Paris set up Exchanges sometime near the end of the 17th century. Close to hundred years later, in 1792, the New York Stock Exchange (NYSE) was established, which is still one of the worlds most powerful exchanges today. The reason for establishment was primarily the need for financing businesses and for providing returns for the finances. In India, the Stock Exchange, Mumbai, was established in 1875 as "The Native Share and Stockbrokers Association" (a voluntary non-profit making association) and is now popularly known as the Bombay Stock Exchange (BSE). The other major exchange is the National Stock Exchange of India Limited (NSE) and was incorporated in November 1992. Combined the two trading zones are responsible for 99.9% of the trading done in India.

Types of Indexes available:-

 Broad-Market Index: This consists of all the large, liquid stocks of the country and becomes the benchmark for the entire capital market of the country. An example for this is the S&P CNX 500. Specialized Index: We can either have Industry or Sector specific Index for any particular sector of the economy which then serves as the benchmark for that particular industry or we can have an index for the highly liquid stocks. Taking an example for an industry specific index we have the S&P Banking Index which is a capitalization-weighted index of 26 domestic equities traded on the New York Stock Exchange and NASDAQ, The stocks in the Index are high-capitalization stocks representing a sector of the S&P 500. Similarly, The S&P CNX Nifty is a relevant example for an index composed of highly liquid stocks Determinants of a Stock Index : Liquidity: Liquidity of stocks as measured by the impact cost criterion which determines the cost faced when actually trading the index. For example if the current market price of a stock is Rs 200 and a trader purchases it at Rs 202 (due to involved transaction costs) then the market impact cost is 1% and the stock is considered highly liquid for lower impact cost. Diversification: Diversification, by putting stocks of various sectors that reflect the economy, is used to cancel out stock noise which is essentially the individual stock fluctuations and to reduce investors risks. An index must thus have a balanced representation of all sectors. Optimum size: More stocks lead to greater diversification but the limiting factor is the size of the index. Increasing number of stocks in an index from 10 to say 30 gives a sharp reduction in risks but increasing the number beyond a point does very little in risk reduction. Further it might lead to addition of illiquid stocks. For example, the optimal size for BSE Sensex is 30.

 Market Capitalization: The index should include primarily the stocks of companies that have significant market capitalization with respect to the index such that any major change in the price of the stock is reflected in the index. For example in BSE 30 Index, the scrip must have a minimum of 0.5% of the market capitalization of the Index. Averaging: Every stock primarily moves for two reasons: The news about the company and the news about the country. An ideal index is affected only by the latter, that is the news of the economy and the effect of the former is knocked out by proper averaging.

Price Weighted: The weights assigned are proportional to the stock prices. Market Capitalization Weighted: The equity price is weighted by the market capitalization of the company. Hence each constituent stock in the index affects the index value in proportion to the market value of all outstanding shares. (Current market capitalization) Index = ---------------------------------------- x Base Value (Base Market Capitalization)

Where: CMC = Sum of (current market price * outstanding shares) of all securities in the index BMC = Sum of (market price * issue size) of all securities as on base date.
Equal Weighted: The weights are equal and assigned irrespective of both market

capitalization or price Index revision is done periodically taking into consideration the factors mentioned above. The relevant index body makes clear, researched and publicly documented rules for this purpose. These rules are applied regularly, to obtain changes to the index set. However, it is ensured that the value of the index does not change significantly after the revision of the index set.

SENSEX - THE BAROMETER OF INDIAN CAPITAL MARKETS

For the premier Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "The Stock Exchange, Mumbai" by paying a princely amount of Re1. Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media. The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology. Due to this wide acceptance amongst the Indian investors; SENSEX is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the SENSEX has over the years become one of the most prominent brands in the country. The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The SENSEX captured all these events in the most judicial manner. One can identify the booms and busts of the Indian stock market through SENSEX.

SENSEX Calculation Methodology

SENSEX is calculated using the "Free-float Market Capitalization" methodology. As per this methodology, the level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the Freefloat market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time.

Maintenance of SENSEX
One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Index Cell of the exchange does the day-to-day maintenance of the index within the broad index policy framework set by the Index Committee. The Index Cell ensures that

SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity.

SENSEX - Scrip selection criteria

The general guidelines for selection of constituents in SENSEX are as follows: 1. Listed History: The scrip should have a listing history of at least 3 months at BSE. Exception may be considered if full market capitalisation of a newly listed company ranks among top 10 in the list of BSE universe. In case, a company is listed on account of merger/ demerger/ amalgamation, minimum listing history would not be required. 2. Trading Frequency: The scrip should have been traded on each and every trading day in the last three months. Exceptions can be made for extreme reasons like scrip suspension etc. 3. Final Rank: The scrip should figure in the top 100 companies listed by final rank. The final rank is arrived at by assigning 75% weightage to the rank on the basis of three month average full market capitalisation and 25% weightage to the liquidity rank based on threemonth average daily turnover & three-month average impact cost. 4. Market Capitalization Weightage: The weightage of each scrip in SENSEX based on three-month average free-float market capitalisation should be at least 0.5% of the Index.
Industry Representation: Scrip selection would generally take into account a

balanced representation of the listed companies in the universe of BSE.

Track Record: In the opinion of the Committee, the company should have an acceptable track record.

5. Index Review Frequency: The Index Committee meets every quarter to discuss index

related issues. In case of a revision in the Index constituents, the announcement of the

incoming and outgoing scrip is made six weeks in advance of the actual implementation of the revision of the Index.

Bombay Stock Exchange

Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich heritage. Popularly known as "BSE", it was established as "The Native Share & Stock Brokers Association" in 1875. It is the first stock exchange in the country to obtain permanent recognition in 1956 from the Government of India under the Securities Contracts (Regulation) Act, 1956.The Exchange's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized and its index, SENSEX, is tracked worldwide. Earlier an Association of Persons (AOP), the Exchange is now a demutualised and corporatised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE(Corporatization and Demutualization) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). With demutualisation, the trading rights and ownership rights have been de-linked effectively addressing concerns regarding perceived and real conflicts of interest. The Exchange is professionally managed under the overall direction of the Board of Directors. The Board comprises eminent professionals, representatives of Trading Members and the Managing Director of the Exchange. The Board is inclusive and is designed to benefit from the participation of market intermediaries. In terms of organisation structure, the Board formulates larger policy issues and exercises overall control. The committees constituted by the Board are broad-based. The day-to-day operations of the Exchange are managed by the Managing Director and a management team of professionals. The Exchange has a nationwide reach with a presence in 417 cities and towns of India. The systems and processes of the Exchange are designed to safeguard market integrity and enhance transparency in

operations. During the year 2004-2005, the trading volumes on the Exchange showed robust growth. The Exchange provides an efficient and transparent market for trading in equity, debt instruments and derivatives. The BSE's On Line Trading System (BOLT) is a proprietory system of the Exchange and is BS 7799-2-2002 certified. The surveillance and clearing & settlement functions of the Exchange are ISO 9001:2000 certified. For the premier Stock Exchange that pioneered the stock broking activity in India, 125 years of experience seem to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "Bombay Stock Exchange Limited" by paying a princely amount of Re1. Since then, the stock market in the country has passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no measure or scale that could precisely measure the various ups and downs in the Indian stock market. Bombay Stock Exchange Limited (BSE) in 1986 came out with a Stock Index that subsequently became the barometer of the Indian Stock Market. SENSEX, first compiled in 1986 was calculated on a "Market Capitalization-Weighted" methodology of 30 component stocks representing a sample of large, well-established and financially sound companies. The base year of SENSEX is 1978-79. The index is widely reported in both domestic and international markets through print as well as electronic media. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. From September 2003, the SENSEX is calculated on a free-float market capitalization methodology. The "free-float Market CapitalizationWeighted" methodology is a widely followed index construction methodology on which majority of global equity benchmarks are based. The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. More recently, the bourses in India witnessed a similar frenzy in the 'TMT' sectors. The SENSEX captured all these happenings in the most judicial manner. One can identify the booms and bust of the Indian equity market through SENSEX.

The launch of SENSEX in 1986 was later followed up in January 1989 by introduction of BSE National Index (Base: 1983-84 = 100). It comprised of 100 stocks listed at five major stock exchanges in India at Mumbai, Calcutta, Delhi, Ahmedabad and Madras. The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then it is calculated taking into consideration only the prices of stocks listed at BSE. The Exchange launched dollarlinked version of BSE-100 index i.e. Dollex-100 on May 22, 2006. With a view to provide a better representation of the increased number of companies listed, increased market capitalisation and the new industry groups, the Exchange constructed and launched on 27th May, 1994, two new index series viz., the 'BSE-200' and the 'DOLLEX200' indices. Since then, BSE has come a long way in attuning itself to the varied needs of investors and market participants. In order to fulfill the need of the market participants for still broader, segment-specific and sector-specific indices, the Exchange has continuously been increasing the range of its indices. The launch of BSE-200 Index in 1994 was followed by the launch of BSE- 500 Index and 5 sectoral indices in 1999. In 2001, BSE launched the BSE-PSU Index, DOLLEX-30 and the country's first free-float based index - the BSE TECk Index. The Exchange shifted all its indices to a free-float methodology (except BSE PSU index) in a pahsed manner. The Exchange also disseminates the Price-Earnings Ratio, the Price to Book Value Ratio and the Dividend Yield Percentage on day-to-day basis of all its major indices. The values of all BSE indices are updated every 15 seconds during the market hours and displayed through the BOLT system, BSE website and news wire agencies. All BSE-Indices are reviewed periodically by the "Index Committee" of the Exchange. The Committee frames the broad policy guidelines for the development and maintenance of all BSE indices. Department of BSE Indices of the Exchange carries out the day to day maintenance of all indices and conducts research on development of new indices. BSE Ltd places great deal of emphasis on Information Technology to strengthen its functioning and performance.

'Operations & Trading Department' continuously upgrades the hardware, software and networking systems, thus enabling the Exchange to enhance the quality and standard of service provided to its members and other market intermediaries. To facilitate smooth transaction, BSE had replaced its open outcry system with BSE On-line Trading (BOLT) facility in 1995. This totally automated screen based trading in securities was put into practice nation-wide within a record time of just 50 days. The BOLT platform capacity has been enhanced to 40 lakh orders per day by upgrading the hardware. BOLT has been certified by DNV for conforming to BS7799 security standards. With this, BSE is the second stock exchange in the world to have this certification. Exchange has also introduced the world's first centralized exchange based Internet trading system, BSEWEBx.com. The initiative enables investors anywhere in the world to trade on the BSE platform. BSE's website http://www.bseindia.com/provides comprehensive information on the stock market. It is one of the most popular financial websites in India and is regularly visited by financial organizations and other stakeholders for updates. BSE's team of experts and professionals, along with its strategic partners have put into place several critical systems such as Derivatives Trading & Settlement System (DTSS), Electronic Contract Notes (ECN), Unique Client Code registration (UCC), Real time data dissemination -system - Datafeed, Integrated Back office System - CDB / IDB, Book Building System (BBS) & Reverse Book Building System (RBBS) etc. BSE also operates one of the largest private networks in India, comprising campus LAN; WAN set up within Mumbai and across some major metros in India and VSAT set up across the country. BSE's Campus LAN covers around 350 member offices across three BSE buildings P.J. Towers, Rotunda and Cama building. BSE WAN setup connects approximately 2000 member offices within Mumbai and some major metros to BSE systems. Leased MLLN circuits from MTNL / BSNL are provided with ISDN / TTML leased circuit backup. Around 300 circuits are of 2Mbps capacity and rests all are of 64Kbps capacity. In year 2000 BSE set up its own VSAT Master Earth Station (HUB), which uses full transponder on INSAT 3B satellite to cater to roughly 2000 locations in over 400 cities

across the country? Regional Hubs for local fan out of leased lines within Metros backed by high availability trunk backbone to BSE. The regional technology hubs are commissioned in Ahmedabad, Bangalore, Chandigarh, Chennai, Delhi, Hyderabad, Indore, Jaipur, Kolkatta, Ludhiana, Pune and Rajkot provide cost-effective reliable services to members. The trading and settlement activities of the member-brokers are closely monitored through Online Real Time System known as BSE Online Surveillance System (BOSS). The system enables the Exchange to detect market abuses at a nascent stage, improve the risk management system and strengthen the self-regulatory mechanisms. Currently, BSE is in the process of evolving an integrated system for online surveillance of Cash and Derivatives Segment through BSE Online Surveillance System - Integrated (BOSS - i). BSE uses higher end fault tolerant systems for its trading and related functionalities. It uses Integrity Non-stop S88000 systems for its online trading systems (BOLT). The systems have been designed to deliver the best performance without compromising on key factors of availability, scalability, ROI and TCO. There are powerful RISC based Unix severs rp8400 from hp for our Derivatives, Settlement, Backoffice, Datafeed, BBS, RBBS and other systems related to trading / non-trading and related functionalities. The systems are facilitated by the use of the robust and high available storage subsystems from hp. BSE use one of the most powerful RISC based Alpha GS140 and ES40 servers for our Internet based trading system (ITS) enabling the end user to carry out the trading activities from any location facilitated by the internet. BSE also use Intel 8 way and 4 way servers for bseindia.com web site, one of the best portal on information related to capital markets. BSE strictly adheres to IS policies and IS Security policies and procedures for its day to day operational activities on 24 x 7 basis which has enabled us to achieve the BS7799 certification. In addition, BSE has also been successful in maintaining systems and processes uptime of 99.99%

Indian Derivatives Market 1. Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues.2 Derivative securities provide them a valuable set of tools for managing this risk.

This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term. 2. Definition and Uses of Derivatives A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures, options and swaps. Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe Indias long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge; market frictions and regulatory impediments have led to low levels of capital employed in arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved. 3. Exchange-Traded and Over-the-Counter Derivative Instruments

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in havala or forwards markets. An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements and daily marking-tomarket of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.

4. Development of Derivative Markets in India Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.

In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination.

In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1

shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991.7 The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving. As interest rates in India have fallen, companies have swapped their fixed rate borrowings into floating rates to reduce funding costs.10 Activity in OTC markets dwarfs that of the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004 (Fitch Ratings, 2004).

Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward markethedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less (Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap its rupee denominated debt into another currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTC currency options is still muted. There are no exchange-traded currency derivatives in India. Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four times in the same period (Nair, 2004). However, many contracts barely trade and, of those that are active, trading is fragmented over multiple market venues, including central and regional exchanges, brokerages, and unregulated forwards markets. Total volume of commodity derivatives is still small, less than half the size of equity derivatives (Gorham et al, 2005). 6. Derivatives Users in India The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003).Corporations are active in the currency forwards and swaps markets, buying these instruments from banks. Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives.11 Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as a brokerdealer.12 FIIs have a small but increasing presence in the equity derivatives markets. They have no incentive to trade interest rate derivatives since they have little investments in the domestic bond markets (Chitale, 2003). It is possible that unregistered foreign investors and hedge funds trade indirectly, using a local proprietary trader as a front (Lee, 2004). Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the markets for commodity

derivatives, due in part to their long-standing expertise in trading in the havala or forwards markets.

7. Summary and Conclusions In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets.13 While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding. There remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent. Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area (Fitch Ratings, 2004). A lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. Financial statements currently provide misleading information on institutions use of derivatives. Further, there is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed.

Further regulatory reform will help the markets grow faster. For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop.14 As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading.

Capital Market at a Glance

Primary market Stocks available for the first time are offered through new issue market. The issuer may be a new company. These issues may be of new type or the security used in the past. In the new issue market the issuer can be considered as a manufacturer. The issuing houses, investment bankers and brokers act as the channel of distribution for the new issues. They take the responsibility of selling the stocks to the public. A total of Rs. 2,520,179 million were raised by the government and corporate sector during 2002-03 as against Rs. 2,269,110 million during the preceding year. Government raised about two third of the total resources, with central government alone raising nearly Rs. 1,511,260 million.

Corporate Securities Average annual capital mobilization from the primary market, which used to be about Rs.70 crore in the 1960s and about Rs.90 crore in the 1970s, increased manifold during the 1980s, with the amount raised in 1990-91 being Rs. 4,312 crore. It received a further boost during the 1990s with the capital raised by non-government public companies rising sharply to Rs. 26,417 crore in 1994-95. The capital raised which used to be less than 1% of gross domestic saving (GDS) in the 1970s increased to about 13% in 1992-93. In real terms, the capital raised increased 4 times between 1990-91 and 1994-95. During 1994-95, the amount raised through new issues of securities from the securities market accounted for about four-fifth of the disbursements by FIs. Issuers have shifted focus to other avenues for raising resources like private placement.

There is a preference for raising resources in the primary market through private placement of debt instruments. Private placements accounted for about 93% of total resources mobilized through domestic issues by the corporate sector during 2002-03. Rapid dismantling of shackles on institutional investments and deregulation of the economy are driving growth of this segment. There are several inherent advantages of relying on private placement route for raising resources. While it is cost and time effective method of raising funds and can be structured to meet the needs of the entrepreneurs, it does not require detailed compliance with formalities as required in public or rights issues. It is believed in some circles that private placement has crowded out public issues. However, to prevent public issues from being passed on as private placement, the Companies (Amendment) Act, 2001 considers offer of securities to more than 50 persons as made to public. Indian market is getting integrated with the global market though in a limited way through euro issues. Since 1992, when they were permitted access, Indian companies have raised about Rs. 34,264 million through ADRs/GDRs. By the end of March

2003, 502 FIIs were registered with SEBI. They had net cumulative investments over of US $ 15.8 billion by the end of March 2003. Their operations influence the market as they do delivery-based business and their knowledge of market is considered superior. The market is getting institutionalized as people prefer mutual funds as their investment vehicle, thanks to evolution of a regulatory framework for mutual funds, tax concessions offered by government and preference of investors for passive investing. The net collections by MFs picked up during this decade and increased to Rs. 199,530 million during 1999-00. This declined to Rs. 111,350 million during 2000-01 which may be attributed to increase in rate of tax on income distributed by debt oriented mutual funds and lackluster secondary market. The total collection of mutual funds for 2002-03 has been Rs. 105,378 million. Starting with an asset base of Rs. 250 million in 1964, the total assets under management at the end of March 2003 was Rs. 794,640 million. The number of households owning units of MFs exceeds the number of households owning equity and debentures. At the end of financial year March 2003, according to a SEBI press release 23 million unit holders had invested in units of MFs, while 16 million individual investors invested in equity and or debentures.

Government Securities The primary issues of the Central Government have increased many-fold during the decade of 1990s from Rs. 89,890 million in 1990-91 to Rs. 1,511,260 million in 2002-03. The issues by state governments increased by about twelve times from Rs. 25,690 million to Rs. 308,530 million during the same period. The Central Government mobilized Rs. 1,250,000 million through issue of dated securities and Rs. 261,260 million through issue of T-bills. After meeting repayment liabilities of Rs. 274,200 million for dated securities, and redemption of T-bills of Rs. 195,880 million, net market borrowing of Central Government amounted to Rs. 1,041,180 million for the year 2002-03. The state governments collectively

raised Rs. 305,830 million during 2002-03 as against Rs. 187,070 million in the preceding year. The net borrowings of State Governments in 2002-03 amounted to Rs. 290,640 million. Along with growth of the market, the investor base has become very wide. In addition to banks and insurance companies, corporate and individual investors are investing in government securities. With dismantling of control regime, and gradual lowering of the SLR and CRR, Government is borrowing at nearmarket rates. The coupons across maturities went down recently signifying lower interest rates. The weighted average cost of its borrowing at one stage increased to 13.75% in 1995- 96, which declined to 7.34% in 2002-03. The maturity structure of government debt is also changing. In view of bunching of redemption liabilities in the medium term, securities with higher maturities were issued during 2002-03. About 64% of primary issues were raised through securities with maturities above 5 years and up to 10 years. As a result the weighted average maturity of dated securities increased to 13.83 years from 6.6 years in 1997-98.

Relationship between the Primary and Secondary Market

1. The new issues market cannot function without the secondary market. The secondary market or the stock market provides liquidity for the issued securities. The issued securities are traded in the secondary market offering liquidity to the stocks at a fair price. 2. The stock exchanges through their listing requirements, exercise control over the primary market. The company seeking for listing on the respective stock exchange has to comply with all the rules and regulations given by the stock exchange.

3. The primary market provides a direct link between the prospective investors and the company. By providing liquidity and safety, the stock markets encourage the public to subscribe to the new issues. The marketability and the capital appreciation provided in the stock market are the major factors that attract the investing public towards the stock market. Thus, it provides an indirect link between the savers and the company. 4. Even though they are complementary to each other, their functions and the organizational set up are different from each other. The health of the primary market depends on the secondary market and vice versa.

Functions of Primary Market

The main service functions of the primary market are organization, underwriting and distribution. Origination deals with the origin of the new issue. The proposal is analyzed in terms of the nature of the security, the size of the issue, and timing of the issue and floatation method of the issue. Underwriting contract makes the share predictable and removes the element of uncertainty in the subscription. Distribution refers to the lead managers and brokers to the issue. In the new issue market stocks are offered for the first time. The functions and the organization of the new issue market is different from the secondary market. In the new issue the lead mangers manage the issue, the underwriters assure to take up the unsubscribed portion according to his commitment for a commission and the bankers take up the responsibility of the collecting the application form and the money. Advertising agencies promote the new issue through advertising. Financial institutions and underwriter lend term loans to the company. Government agencies regulate the issue. The new issues are offered through prospectus. The prospectus is drafted according to SEBI guidelines disclosing the needed information to the investing public. In the bought out deal banks or a

company buys the promoters shares and they offer them to the public at a later date. This reduces the cost of raising the fund. Private placement means placing of the issue with financial institutions. They sell shares to the investors at a suitable price. Right issue means the allotment of shares to the previous shareholders at a pro-ratio basis. Book building involves firm allotment of the instrument to a syndicate created by the lead managers. The book runner manages the issue. Norms are given by the SEBI to price the issue. Proportionate allotment method is adopted in the allocation of shares. Project appraisal, disclosure in the prospectus and clearance of the prospectus by the stock exchanges protect the investors in the primary market along with the active role played by the SEBI

Secondary market
The market for long-term securities like bonds, equity stocks and preferred stocks is divided into primary market and secondary market. The primary market deals with the new issues of securities. Outstanding securities are traded in the secondary market, which is commonly known as stock market or stock exchange. In the secondary market, the investors can sell and buy securities. Stock markets predominantly deal in the equity shares. Debt instruments like bonds and debentures are also traded in the stock market. Well-regulated and active stock market promotes capital formation. Growth of the primary market depends on the secondary market. The health of the economy is reflected by the growth of the stock market. Corporate Securities The number of stock exchanges increased from 11 in 1990 to 23 now. All the exchanges are fully computerized and offer 100% on-line trading. 9,413 companies were available for trading on stock exchanges at the end of March 2003. The trading platform of the stock exchanges was accessible to 9,519 members from over 358 cities on the same date.

The market capitalization grew tenfold between 1990-91 and 1999-00. It increased by 221% during 1991-92 and by 107% during 1999-00. All India market capitalization is estimated at Rs. 6,319,212 million at the end of March 2003. The market capitalization ratio, which indicates the size of the market, increased sharply to 57.4% in 1991-92 following spurt in share prices. The ratio further increased to 85% by March 2000. It, however, declined to 55% at the end of March 2001 and to 29% by end March 2003. The trading volumes on exchanges have been witnessing phenomenal growth during the 1990s. The average daily turnover grew from about Rs.1500 million in 1990 to Rs. 120,000 million in 2000, peaking at over Rs. 200,000 million. One-sided turnover on all stock exchanges exceeded Rs. 10,000,000 million during 1998-99, Rs. 20,000,000 million during 1999-00 and approached Rs. 30,000,000 million during 2000-01. However, the trading volume substantially depleted to Rs.9, 689,541 million in 2002-03. The turnover ratio, which reflects the volume of trading in relation to the size of the market, has been increasing by leaps and bounds after the advent of screen based trading system by the NSE. The turnover ratio for the year 2002-03 increased to 375 but fell substantially due to bad market conditions to 119 during 2001-02 regaining its position accounted 153.3% in 200203. The relative importance of various stock exchanges in the market has undergone dramatic change during this decade. The increase in turnover took place mostly at the large big exchanges and it was partly at the cost of small exchanges that failed to keep pace with the changes. NSE is the market leader with more 85% of total turnover (volumes on all segments) in 2002-03. Top 5 stock exchanges accounted for 99.88% of turnover, while the rest 18 exchange for less than 0.12% during 2002-03. About ten exchanges reported nil turnovers during the year.

Role of the Secondary Market

When company management has different objectives than its outside investors, "agency and "information" problems may result. For example, management may exert less than optimal effort, may pursue goals that simply enhance its own power and control, or may squander or divert company resources. In addition, to the extent that management is better informed than outside investors about the company's financial situation, this creates an informational asymmetry. This, in turn, may result in management being unable to convince its outside investors of the true value of the company as well as of management's intentions. As a consequence, management also may find that it is not able to raise as much capital as it wants or needs to finance new projects, or that management may have to surrender too much of the value of the firm to raise the capital it wants or needs. "Governance" refers to the various mechanisms that exist to mitigate these agency and information problems. These mechanisms are numerous, some involving capital markets (e.g., facilitation of corporate control via takeover) while others do not, at least not directly (e.g., the role of the board of directors as a monitoring device). These major mechanisms will be discussed. We use the term "market-based governance" to refer to the role of capital markets in alleviating the agency and information problems, by functioning as an effective conduit for monitoring and controlling management's sub optimal behavior. Market-based governance may take different forms. However, generally speaking, such governance takes the form of facilitating the monitoring of management by outsiders, and aggregating informationin the form of equilibrium prices (or price discovery)to help guide management decisions within the firm.

A. Monitoring and Control.

As noted, secondary equity markets serve as a conduit for monitoring and controlling management by outsiders. First, markets generate information that helps outside investors Evaluate the quality of past management decisions. Second, the threat of a takeover may mitigate management inefficiencies. Third, information on stock-market prices provides for effective incentives for management. And fourth, the rich menu of contracts provided in the market allows private workouts of financial distress, easing the transfer of control. For purposes of our analysis below, we have divided monitoring into two categories Market-based monitoring Non market-based monitoring

I. Market-Based Monitoring
1 Active Shareholders: The secondary equity market can facilitate effective monitoring by providing the ability to build positions so as to influence management decisions in situations where a change in corporate policies could increase a firm's value. 2 The Market for Corporate Control: The threat of a corporate takeover by outside investors could serve as a deterrent to mismanagement. Secondary equity markets provide the means for launching a credible takeover threat, which could influence actions by management. 3 Facilitation of Incentive-Based Compensation: Management could be aligned with its outside shareholders through a proper structuring of incentive-based compensation. Management's equity ownership and stock options provide management with additional incentives to act in the interest of outside shareholders. 4 Certification by Investment Banks: When issuing securities to the public, the underwriting investment bankers monitor management. When certifying a firm that hires

them to sell its securities, these investment bankers place their own reputations and capital at stake.

II. Non Market-Based Monitoring

1 Board of Directors: A board of directors is the primary method of non market-based monitoring. Management reports directly to the board, and the board has a fiduciary obligation to stay informed of management's major activities. The board has the power to terminate management that does not act in the best interests of the company's shareholders. The key to a board's being an effective monitoring mechanism is its independence. In this regard, the composition of the board, especially the presence of outside board members, is critical to its effectiveness as a monitor. 2 Financial intermediaries as delegated monitors: Banks closely monitor their business borrowers, and collect information and scrutinize major investment and financing decisions. In doing so, they can threaten to withhold financing should management act in a manner contrary to the banks' interests. Monitoring via business groups. In some countries, such as Japan and Korea, corporate actions are coordinated within a family of interrelated firms, with a main bank at the center. Firms in the group are interconnected through intricate vertical and horizontal business relationships and cross-ownership. Members of the business group, with the lead participation of the main bank, closely monitor the actions of a member firm's management.

Research in Securities Market

In order to deepen the understanding and knowledge about Indian capital market, and to assist in policy-making, SEBI has been promoting high quality research in capital market. It has set up an in-house research department, which brings out working papers on a regular basis. In collaboration with NCAER, SEBI brought out a Survey of Indian Investors, which estimates investor population in India and their investment preferences. SEBI has also tied up with reputed national and international academic and research institutions for conducting research studies/projects on various issues related to the capital market. In order to improve market efficiency further and to set international benchmarks in the securities industry, NSE administers a scheme called the NSE Research Initiative with a view to develop an information base and a better insight into the working of securities market in India. The objective of this initiative is to foster research, which can support and facilitate (a) stock exchanges to better design market micro-structure, (b) participants to frame their strategies in the market place, (c) regulators to frame regulations, (d) policy makers to formulate policies, and (e) expand the horizon of knowledge. A testing and certification mechanism that has become extremely popular and is sought after by the candidates as well as employers is a unique on-line testing and certification programme called National Stock Exchanges Certification in Financial Markets (NCFM).

It is an online fully automated nation-wide testing and certification system where the entire process from generation of question paper, invigilation, testing, assessing, scores reporting and certifying is fully automated - there is absolutely no scope for human intervention. It allows tremendous flexibility in terms of testing centres, dates and timing and provides easy accessibility and convenience to candidates as he can be tested at any time and from any location. It tests practical knowledge and skills, that are required to operate in financial markets, in a very secure and unbiased manner, and certifies personnel who have a proper understanding of the market and business and skills to service different constituents of the market. It offers 9 financial market related modules.

Market Design Primary Market

1. Corporate Securities: The Disclosure and Investor Protection (DIP) guidelines prescribe a substantial body of requirements for issuers/intermediaries, the broad intention being to ensure that all concerned observe high standards of integrity and fair dealing, comply with all the requirements with due skill, diligence and care, and disclose the truth, whole truth and nothing but truth. The guidelines aim to secure fuller disclosure of relevant information about the issuer and the nature of the securities to be issued so that investors can take informed decisions. For example, issuers are required to disclose any material risk factors and give justification for pricing in their prospectus. An unlisted company can access the market up to 5 times its pre-issue networth only if it has track record of distributable profits and net worth of Rs. 1 crore in 3 out of last five years.

A listed company can access up to 5 times of its pre-issue networth. In case a company does not have track record or wishes to raise beyond 5 times of its pre-issue networth, it can access the market only through book building with minimum offer of 60% to qualified institutional buyers. Infrastructure companies are exempt from the requirement of eligibility

norms if their project has been appraised by a public financial institution and not less than 5% of the project cost is financed by any of the institutions, jointly or severally, by way of loan and/or subscription to equity. The debt instruments of maturities more than 18 months require credit rating. If the issue size exceeds Rs. 100 crore, two ratings from different agencies are required. Thus the quality of the issue is demonstrated by track record/appraisal by approved financial institutions/credit rating/subscription by QIBs. The lead merchant banker discharges most of the pre-issue and post-issue obligations. He satisfies himself about all aspects of offering and adequacy of disclosures in the offer document. He issues a due diligence certificate stating that he has examined the prospectus, he finds it in order and that it brings out all the facts and does not contain anything wrong or misleading. He also takes care of allotment, refund and despatch of certificates. The admission to a depository for dematerialisation of securities is a prerequisite for making a public or rights issue or an offer for sale. The investors, however, have the option of subscribing to securities in either physical form or dematerialised form. All new IPOs are compulsorily traded in dematerialised form. Every public listed company making IPO of any security for Rs. 10 crore or more is required to do so only in dematerialised form. 2. Government Securities: The government securities market has witnessed significant transformation in the 1990s. With giving up of the responsibility of allocating resources from securities market, government stopped expropriating seigniorage and started borrowing at near - market rates. Government securities are now sold at market related coupon rates through a system of auctions instead of earlier practice of issue of securities at very low rates just to reduce the cost of borrowing of the government. Major reforms initiated in the primary market for government securities include auction system (uniform price and multiple price method) for primary issuance of T-bills and central government dated securities, a system of primary dealers and non-competitive bids to widen investor base and promote retail participation, issuance of securities across maturities to develop a yield curve from short to long end and provide benchmarks for rest of the debt market,

innovative instruments like, zero coupon bonds, floating rate bonds, bonds with embedded derivatives, availability of full range ( 91-day and 382-day) of T-bills, etc.

Secondary Market
(a) Corporate Securities: The stock exchanges are the exclusive centres for trading of securities. Though the area of operation/jurisdiction of an exchange is specified at the time of its recognition, they have been allowed recently to set up trading terminals anywhere in the country. The three newly set up exchanges (OTCEI, NSE and ICSE) were permitted since their inception to have nationwide trading. The trading platforms of a few exchanges are now accessible from many locations. Further, with extensive use of information technology, the trading platforms of a few exchanges are also accessible from anywhere through the Internet and mobile devices. This made a huge difference in a geographically vast country like India. (b) Exchange Management: Most of the stock exchanges in the country are organized as mutuals which was considered beneficial in terms of tax benefits and matters of compliance. The trading members, who provide brokering services, also own, control and manage the exchanges. This is not an effective model for self-regulatory organisations as

the regulatory and public interest of the exchange conflicts with private interests. Efforts are on to demutualise the exchanges whereby ownership, management and trading membership would be segregated from one another. Two exchanges viz. OTCEI and NSE are demutualised from inception, where ownership, management and trading are in the hands of three different sets of people. This model eliminates conflict of interest and helps the exchange to pursue market efficiency and investor interest aggressively.

(c) Membership: The trading platform of an exchange is accessible only to brokers. The broker enters into trades in exchanges either on his own account or on behalf of clients. No stock broker or sub-broker is allowed to buy, sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI. A broker/sub-broker complies with the code of conduct prescribed by SEBI. Over time, a number of brokers - proprietor firms and partnership firms have converted themselves into corporates. The standards for admission of members stress on factors, such as corporate structure, capital adequacy, track record, education, experience, etc. and reflect a conscious endeavour to ensure quality broking services. (d) Listing: A company seeking listing satisfies the exchange that at least 10% of the securities, subject to a minimum of 20 lakh securities, were offered to public for subscription, and the size of the net offer to the public (i.e. the offer price multiplied by the number of securities offered to the public, excluding reservations, firm allotment and promoters contribution) was not less than Rs.100 crore, and the issue is made only through book building method with allocation of 60% of the issue size to the qualified institutional buyers. In the alternative, it is required to offer at least 25% of the securities to public. The company is also required to maintain the minimum level of non-promoter holding on a continuous basis. In order to provide an opportunity to investors to invest/trade in the securities of local companies, it is mandatory for the companies, wishing to list their securities, to list on the regional stock exchange nearest to their registered office. If they so wish, they can seek listing on other exchanges as well.

Monopoly of the exchanges within their allocated area, regional aspirations of the people and mandatory listing on the regional stock exchange resulted in multiplicity of exchanges. The basic norms for listing of securities on the stock exchanges are uniform for all the exchanges. These norms are specified in the listing agreement entered into between the company and the concerned exchange. The listing agreement prescribes a number of requirements to be continuously complied with by the issuers for continued listing and such compliance is monitored by the exchanges. It also stipulates the disclosures to be made by the companies and the corporate governance practices to be followed by them. SEBI has been issuing guidelines/circulars prescribing certain norms to be included in the listing agreement and to be complied with by the companies. A listed security is available for trading on the exchange.

The stock exchanges levy listing fees - initial fees and annual fees - from the listed companies. It is a major source of income for many exchanges. A security listed on other exchanges is also permitted for trading. A listed company can voluntary delist its securities from non-regional stock exchanges after providing an exit opportunity to holders of securities in the region where the concerned exchange is located. An exchange can, however, delist the securities compulsorily following a very stringent procedure.

(e) Trading Mechanism: The exchanges provide an on-line fully-automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching order from a counter party. SBTS electronically matches orders on a strict price/time priority and hence cuts down on time, cost and risk of error, as well as on fraud resulting in improved operational efficiency. It allows faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enables market participants to see the full market on real-time, making the

market transparent. It allows a large number of participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market. It provides full anonymity by accepting orders, big or small, from members without revealing their identity, thus providing equal access to everybody. It also provides a perfect audit trail, which helps to resolve disputes by logging in the trade execution process in entirety.

Factors responsible for the fluctuation of Sensex and Nifty

Think of a liquid stock as a good thermometer, one which gives accurate data about the true price of the stock, because it trades actively with a tight spread. The prices observed for an illiquid stock are like readings from a low quality thermometer, which reports noisy data about the phenomenon of interest (the true price of the security).

We try to find the fifty best thermometers in the country and average their values to make the S&P CNX Nifty. As time passes, better thermometers become available (in the form of large, liquid stocks that are not in the S&P CNX Nifty). We would like that S&P CNX Nifty always uses the best thermometers possible. So we remove the weakest thermometer from inside the S&P CNX Nifty and accept the new stock into it. The world changes, so the index should change. Yet, the change should not be sudden - for that would disrupt the character of the index. In 1996, after a decade of near-silence, the BSE removed 14 out of 30 stocks in their `sensitive' index. This completely changed the character of the index - older data for this index is not comparable with new data. Such sudden changes should be avoided. They serve to illustrate the proverb those who make peaceful change difficult make violent change inevitable. S&P CNX Nifty believes in steady, peaceful changes. S&P CNX Nifty uses clear, publicly documented rules for index revision. These rules are applied regularly, to obtain changes to the index set IDBI was once not listed; SBI was once illiquid; Infosys was once an obscure software startup. The world changes, and one by one, these stocks have come into the S&P CNX Nifty. Each change in the S&P CNX Nifty is small, so the continuity of the index is maintained. Yet, at all times, S&P CNX Nifty represents the 50 most important liquid stocks in the country, the best thermometers to build an index out of. There are mathematical formulas which ensure that yesterday's value and today's are comparable, even if a change in composition takes place in-between. Think of an index as a portfolio. The composition of the portfolio changes, but it is still meaningful to keep measuring the overnight returns on the portfolio from day to day. These returns, cumulated up, are the index level. There are no speculators on the internal committee of IISL which manages the index revisions. Further, there are objective, publicly defined rules which determine when stocks come in and go out of the index. There isn't much room for personal judgement here. Every stock price moves for two possible reasons: news about the company (e.g. a product launch, or the closure of a factory, etc.) or news about the country (e.g. nuclear bombs, or a budget announcement, etc.).

The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a mixture of these two elements - stock news and index news. When we take an average of returns on many stocks, the individual stock news tends to cancel out. On any one day, there would be good stock-specific news for a few companies and bad stock-specific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks. That is what the index will capture. They reflect the changing expectations of the stock market about future dividends of India's corporate sector. When the index goes up, it is because the stock market thinks that the prospective dividends in the future will be better than previously thought. When prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant-to-instant readings about how the stock market perceives the future of India's corporate sector.

Weak Form Efficiency in Indian Stock Markets

The term market efficiency in capital market theory is used to explain the degree to which stock prices reflect all available, relevant information. The concept of Efficiency Market Hypothesis (EMH) is based on the arguments put forward by Samuelson (1965) that anticipated price of an asset fluctuate randomly. Fama (1970) presented a formal review of theory and evidence for market efficiency and subsequently revised it further on the basis of development in research (Fama 1991). Efficiency of equity markets has important implications for the investment policy of the investors. If the equity market in question is efficient researching to find miss-priced assets will be a waste of time. In an efficient market, prices of the assets will reflect markets best estimate for the risk and expected return of the asset, taking into account what is known about the asset at the time. Therefore, there will be no undervalued assets offering higher than expected return or overvalued assets offering lower than the expected return. All assets will be appropriately priced in the market offering optimal reward to risk. Hence, in an efficient market an optimal investment strategy will be to concentrate on risk and return characteristics of the asset and/or portfolio. However, if the markets were not efficient, an investor will be better off trying to spot winners and losers in the market and correct identification of miss-priced assets will enhance the overall performance of the portfolio Rutterford (1993). EMH has a twofold function - as a theoretical and predictive model of the operations of the financial markets and as a tool in an impression management campaign to persuade more people to invest their savings in the stock market (Will 2006). The understanding of efficiency of the emerging markets is becoming more important as a consequence of integration with more developed markets and free movement of investments across national boundaries. Traditionally more developed Western equity markets are considered to be more efficient. Contribution of equity markets in the process of development in developing countries is less and that resulted in weak markets with restrictions and controls (Gupta, 2006). In the last three decades, a large number of countries had initiated reform process to open up their economies.

These are broadly considered as emerging economies. Emerging markets have received huge inflows of capital in the recent past and became viable alternative for investors seeking international diversification. Among the emerging markets India has received its more than fair share of foreign investment inflows since its reform process began. One reason could be the Asian crisis which affected the fast developing Asian economies of the time (also sometimes collectively called tiger economies). India was not affected by the Asian crisis and has maintained its high economic growth during the period (Gupta and Basu 2005).

Today India is one of the fastest growing emerging economies in the world. The reform process in India officially started in 1991. As a result, demand for investment funds is growing significantly and capital market growth is expected to play an increasingly important role in the process. The capital market reforms in India present a case where a judicious combination of competition, deregulation and regulation has led to sustained reforms and increased efficiency (Datar and Basu 2004). At this transitional stage, it is necessary to assess the level of efficiency of the Indian equity market in order to establish its longer term role in the process of economic development. However, studies on market efficiency of Indian markets are very few. They are also dated and mostly inconclusive. The objective of this study is to test whether the Indian equity markets are weak form efficient or not. EMH, similar to other theories that require future expected prices or returns, use past actual prices or returns for the tests. Sets of share price changes are tested for serial independence. Random walk theory for equity prices show an equities market in which new information is quickly discounted into prices and abnormal or excess returns cannot be made from observing past prices (Poshakwale 1996). The next section of this paper provides a brief background of the Indian equity market and a brief literature review of studies testing market efficiency in emerging markets. Section 3 explains the methodology used in this study and data sources, followed by the results of the analysis in section 4. The last section summarizes the conclusions and their implications.

Equity Market in India

The reform process in India began in early 1990s with stock exchanges and then spread to banks, mutual funds, NBFCs and of late, to insurance companies. However, reforms in equity market in particular commenced in mid-1980s (Datar & Basu 2004). Mumbai (formerly known as Bombay) Stock Exchange (BSE) has always played the dominant role in the equity market in India. Traditionally, stock exchanges were governed by brokers leading to conflict of interest situation between the interest of common investors and those of brokers/owners of stock exchanges. With the establishment of National Stock Exchange (NSE), a new institutional structure was introduced in India that could ensure smooth functioning of market through a combination of new technology and efficient market design. The Securities Exchange Board of India (SEBI) was set up as a market regulator with statutory powers to control and supervise operations of all participants in the capital market viz. stock exchanges, stock brokers, mutual funds and rating agencies. The development of debt market is another significant development, which has been facilitated by deregulation of administered interest rates. Opening of stock exchange trading to Foreign Institutional Investors (FIIs) and permission of raising funds from international market through equity linked instruments have introduced a degree of competition to domestic exchanges and other market participants. Operations of FIIs have facilitated introduction of best practices and research inputs in trading and risk management systems. Mumbai stock exchange (BSE), the premier stock exchange of India is probably the oldest stock exchanges in Asia, established in 1875. It was initially named as Native Share and Share Broker Association (Poshakwale 1996). Stability in prices for the BSE was considered to be an important feature. During the period

1987 to 1994, average annual price fluctuations of ordinary shares on BSE were 25.1% as compared with London Stock Exchange (22%), and the New York Stock Exchange (23.9%) (Poshakwale 1996). In this study, to determine market efficiency of equity markets in India, we considered two stock exchanges BSE and NSE. Market capitalization of BSE in July, 2006 was INR 19,871 billion and that of NSE at the same time was INR 18,487 billion. BSE is the oldest stock exchange in India and has the longest data series available. NSE is one of the newer stock exchanges in India. The purpose of establishing NSE was to provide transparency and a better functioning market for the investors. Because of governments support, NSE is fast becoming more accessible market to domestic and foreign investors. The perceived liquidity and accessibility of the NSE market is an important factor and may have different impact on the market efficiency. High liquidity in the market is an important pre-condition for the market efficiency, since a thinly traded market is notin a position to adjust to the new information quickly and accurately. Thus, analysis of two major equity markets in India together should provide a more comprehensive and complete picture. Studies on Market Efficiency The efficient market hypothesis is related to the random walk theory. The idea that asset prices may follow a random walk pattern was introduced by Bachelier in 1900 (Poshakwale 1996). The random walk hypothesis is used to explain the successive price changes which are independent of each other. Fama (1991) classifies market efficiency into three forms - weak, semi-strong and strong. In its weak form efficiency, equity returns are not serially correlated and have a constant mean. If market is weak form efficient, current prices fully reflect all information contained in the historical prices of the asset and a trading rule based on the past prices cannot be developed to identify miss-priced assets. Market is semi-strong efficient if stock prices

reflect any new publicly available information instantaneously. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The strong form efficiency suggests that security prices reflect all available information, even private information. Insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. Studies testing market efficiency in emerging markets are few. Poshakwale (1996) showed that Indian stock market was weak form inefficient; he used daily BSE index data for the period 1987 to 1994. Barua (1987), Chan, Gup and Pan (1997) observed that the major Asian markets were weak form inefficient. Similar results were found by Dickinson and Muragu (1994) for Nairobi stock market; Cheung et al (1993) for Korea and Taiwan; and Ho and Cheung (1994) for Asian markets. On the other hand, Barnes (1986) showed a high degree of efficiency in Kuala Lumpur market. Groenewold and Kang (1993) found Australian market semi-strong form efficient. Some of the recent studies, testing the random walk hypothesis (in effect testing for weak form efficiency in the markets) are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test and find the market to follow a random walk process if the price limits are relaxed during the period March 1988 to Dec 1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable, authors use GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001; authors use a variance ratio test in this study and find that Hang Seng index on the Hong Kong stock exchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002), Czech Republic (Hajek, 2002), Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002; Appiah-kusi and Menyah, 2003) and the Middle East (Abraham et al. 2002; this study uses variance ratio test and the runs test to test for random walk for the period 1992 to 1998 and find that these markets are not efficient).

METHODOLOGY & DATA To test historical market efficiency one can look at the pattern of short-term movements of the combined market returns and try to identify the principal process generating those returns. If the market is efficient, the model would fail to identify any pattern and it can be inferred that the returns have no pattern and follow a random walk process. In essence the assumption of random walk means that either the returns follow a random walk process or that the model used to identify the process is unable to identify the true return generating process. If a model is able to identify a pattern, then historical market data can be used to forecast future market prices, and the market is considered not efficient. There are a number of techniques available to determine patterns in time series data. Regression, exponential smoothing and decomposition approaches presume that the values of the time series being predicted are statistically independent from one period to the next. Some of these techniques are reviewed in the following section and appropriate techniques identified for use in this study.

Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay 1988) are used to test the weak form efficiency and random walk hypothesis. Runs test determines if successive price changes are independent. It is non-parametric and does not require the returns to be normally distributed. The test observes the sequence of successive price changes with the same sign. The null hypothesis of randomness is determined by the same sign in price changes. The runs test only looks at the number of positive or negative changes and ignores the amount of change from mean. This is one of the major weaknesses of the test. LOMAC variance ratio test is commonly criticised on many issues and mainly on the selection of maximum order of serial correlation (Faust, 1992). Durbin-Watson test (Durbin and Watson 1951), the augmented Dickey-Fuller test (Dickey and Fuller 1979) and different variants of these are the most commonly used tests for the random walk hypothesis in recent years (Worthington and Higgs 2003; Kleiman, Payne and Sahu 2002; Chan, Gup and Pan 1997). Under the random walk hypothesis, a market is (weak form) efficient if most recent price has all available information and thus, the best forecaster of future price is the most recent price. In the most stringent version of the efficient market hypothesis, t is random and stationary and also exhibits no autocorrelation, as disturbance term cannot possess any systematic forecast errors. In this study we have used returns and not prices for test of market efficiency as expected returns are more commonly used in asset pricing literature (Fama (1998). Returns in a market conforming to random walk are serially uncorrelated, corresponding to a random walk hypothesis with dependant but uncorrelated increments. Parametric serial correlations tests of independence and non-parametric runs tests can be used to test for serial dependence. Serial correlation coefficient test is a widely used procedure that tests the relationship between returns in the current period with those in the previous period. If no significant autocorrelation are found then the series are expected to follow a random walk. A simple formal statistical test was introduced was Durbin and Watson (1951). DurbinWatson (DW) is a test for first order autocorrelation. It only tests for the relationship

between an error and its immediately preceding value. One way to motivate this test is to regress the error of time t with its previous value. ut = ut-1 + vt where vt ~ N (0, 2v) DW test can not detect some forms of residual autocorrelations, e.g. if corr(ut, ut-1) = 0 but corr(ut, ut-2) 0, DW as defined earlier will not find any autocorrelation. One possible way is to do it for all possible combinations but this is tedious and practically impossible to handle. The second-best alternative is to test for autocorrelation that would allow examination of the relationship between ut and several of its lagged values at the same time. The Breusch-Godfrey test is a more general test for autocorrelation for the lags of up to rth order

Because of the abovementioned weaknesses of the DW test we do not use the DW test in our study. An alternative model which is more commonly used is Augmented Dickey Fuller test (ADF test). Three regression models (standard model, with drift and with drift and trend) are used in this study to test for unit root in the research, (Chan, Gup and Pan 1997; Brooks 2002). In this study we followed the test methodologies from Brooks (2002) with slight adjustments

Where: St = the stock price u* and u** = the drift terms T = total number of observations t, t*, t** = error terms that could be ARMA processes with time dependent variances.

Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, is the change in the index and t is a random disturbance term. Equation (3) is for the standard model; (4) for the standard model with a drift and (5) for the standard model with drift and trend. Augmented Dickey-Fuller (ADF) unit root test of nonstationarity is conducted in the form of the following regression equation. The objective of the test is to test the null hypothesis that = 1 in:

against the one-sided alternative < 1. Thus the hypotheses to be tested are: H0: Series contains a unit root against H1: Series is stationary

In this study we calculate daily returns using daily index values for the Mumbai Stock Exchange (BSE) and National Stock Exchange (NSE) of India. The data is collected from the Datastream data terminal from Macquarie University. The time period for BSE is from 24th May 1991 to 26th May 2006 and for NSE 27th May to 26th May 2006. Stock exchanges are closed for trading on weekends and this may appear to be in contradiction with the basic time series requirement that observations be taken at a regularly spaced intervals. The requirement however, is that the frequency be spaced in terms of the processes underlying the series. The underlying process of the series in this case is trading of stocks and generation of stock exchange index based on the stock trading, as such for this study the index values at the end of each business day is appropriate (French 1980).

Table 1 presents the characteristics of two data sets used in this study. During the period covered in this study, the mean return of the NSE index is much lower than that of the BSE, similarly the variance of NSE is lower as compared with BSE index suggesting a lower risk and a lower average return at NSE as compared with BSE. It is relevant to note that NSE was established by the government of India to improve the market efficiency in Indian stock markets and to break the monopolistic position of the BSE. NSE index is a more diversified one as compared to the same of BSE. This can also be due to the unique nature of Indias equity markets, the settlement system on BSE was intermittent (Badla system up until 2nd July 2001) and on NSE it was always cash.

Table 1: Data characteristics BSE and NSE 1991-2006 Index BSE NSE Mean 0.068138 0.000591 Variance 2.652610 0.000256 Minimu m 11.25151 8562 0.133402 8662 Maximu m 18.10558 5826 0.132911 3192 Observat ions 3915 3915 Skewness 0.328482 Kurtosis 9.051393

-0.209051 8.192904

RESULTS This study conducts a test of random walk for the BSE and NSE markets in India, using stock market indexes for the Indian markets. It employs unit root tests (augmented DickeyFuller (ADF)). We perform ADF test with intercept and no trend and with an intercept and trend. We further test the series using the Phillips-Perron tests and the KPSS tests for a confirmatory data analysis. In case of BSE and NSE markets, the null hypothesis of unit root is convincingly rejected, as the test statistic is more negative than the critical value, suggesting that these markets do not show characteristics of random walk and as such are not efficient in the weak form. We also test using Phillip-Perron test and KPSS test for confirmatory data analysis and find the series to be stationary. Results are presented in Table 2. For both BSE and NSE markets, the results are statistically significant and the results of all the three tests are consistent suggesting these markets are not weak form efficient.

Table 2: Results of ADF, PP Index ADF Test Statistic (5 lags with intercept and no trend) ADF Test Statistic (5 lags with intercept and trend) PP unit root test, KPSS (Tau with intercept and 4 lags in error process statistic) for lag parameter 4, 3 and 2 respectively

BSE NSE

-24.80770 -24.16392

-24.80455 -24.16776

-56.22748 -54.82289

.13264, .13762, . 14178 .11710, .12203, . 12576

Results of the study suggest that the markets are not weak form efficient. DW test, which is a test for serial correlations, has been used in the past but the explanatory power of the DW can be questioned on the basis that the DW only looks at the serial correlations on one lags as such may not be appropriate test for the daily data. Current literature in the area of market efficiency uses unit root and test of stationary. This notion of market efficiency has an important bearing for the fund managers and investment bankers and more specifically the investors who are seeking to diversify their portfolios internationally. One of the criticisms of the supporters of the international diversification into emerging markets is that the emerging markets are not efficient and as such the investor may not be able to achieve the full potential benefits of the international diversification.

CONCLUSIONS & IMPLICATIONS This paper examines the weak form efficiency in two of the Indian stock exchanges which represent the majority of the equity market in India. We employ three different tests ADF, PP and the KPSS tests and find similar results. The results of these tests find that these markets are not weak form efficient. These results support the common notion that the

equity markets in the emerging economies are not efficient and to some degree can also explain the less optimal allocation of portfolios into these markets. Since the results of the two tests are contradictory, it is difficult to draw conclusions for practical implications or for policy from the study. It is important to note that the BSE moved to a system of rolling settlement with effect from 2nd July 2006 from the previously used Badla system. The Badla system was a complex system of forward settlement which was not transparent and was not accessible to many market participants. The results of the NSE are similar (NSE had a cash settlement system from the beginning) to BSE suggesting that the changes in settlement system may not significantly impact the results. On the contrary a conflicting viewpoint is that the results of these markets may have been influenced by volatility spillovers, as such the results may be significantly different if the changes in the settlement system are incorporated in the analysis. The research in the area of volatility spillover has argued that the volatility is transferred across markets (Brailsford, 1996), as such the results of these markets may be interpreted cautiously. For future research, using a computationally more efficient model like generalized autoregressive conditional heteroskesdasticity (GARCH) could help to clear this.

What is IPO?

An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuers securities. The sale of securities can be either through book building or through normal public issue.

Who decides the price of an issue?

Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have provided that the issuer in consultation with Merchant Banker shall decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role in price fixation. The company and merchant banker are however required to give full disclosures of the parameters which they had considered while deciding the issue price. There are two types of issues, one where company and Lead Merchant Banker fix a price (called fixed price) and other, where the company and the Lead Manager (LM) stipulate a floor price or a price band and leave it to market forces to determine the final price (price discovery through book building process).

Companies launching IPO for 2010 and Recommendations

Case Study on Reliance Power Limited

Company Background:

Reliance Power Limited (Rel Power) is a part of the Reliance Anil Dhirubhai Ambani (ADA) group and was established to develop, construct and operate power projects domestically and internationally. The prevailing and expected electricity demand and supply imbalance in India presents significant opportunities in the power generation sector. Rel Power is currently developing 13 medium and large sized power projects with a combined planned installed capacity of 28,200 MW, one of the largest portfolios of power generation assets under development in India. The 13 power projects are planned to be diverse in geographic location, fuel type, fuel source and off-take, and each project is planned to be strategically located near an available fuel supply or load center. The identified project sites are located in western India (12,220 MW), northern India (9,080 MW), northeastern India (2,900 MW) and southern India (4,000 MW). They include seven coal-fired projects (14,620 MW) to be fueled by reserves from captive mines and supplies from India and abroad, two gas-fired projects (10,280 MW) to be fueled primarily by reserves from the Krishna Godavari Basin off the east coast of India, and four hydroelectric projects (3,300 MW), three of them in Arunachal Pradesh and one in Uttarakhand. Rel Power intends to sell the power generated by these projects under a combination of long-term and short-term PPAs to state-owned and private distribution companies and industrial consumers. The projects include: Rosa Phase I, a 600 MW coal-fired project in Uttar Pradesh which is currently under construction and scheduled to be commissioned in March 2010. Rosa Phase II, a 600 MW expansion of Rosa Phase I which is scheduled to be commissioned in September 2010.

 Butibori, a 300 MW coal-fired project, which will supply power to a group of industrial consumers in Maharashtra and is scheduled to be commissioned in June 2010. Sasan, one of the first UMPPs promoted and awarded by the Government of India. This 3,960 MW supercritical coal-fired power project is expected to be the largest pithead coalfired power project at a single location in India and as stated in the PPA, it is scheduled to be commissioned by April 2016. Shahapur, a 4,000 MW coal-fired (1,200 MW) and combined cycle gas-fired (2,800 MW) project in Shahapur, Maharashtra, which would be developed in two phases: Shahapur Coal, a supercritical coal-fired project, is scheduled to be commissioned in December 2011, and Shahapur Gas, a combined cycle gasfired project, is scheduled to be commissioned in March 2011. Urthing Sobla, a 400 MW, run-of-the-river hydroelectric project, will be located on the Daulinganga River in Uttarakhand and is scheduled to be commissioned in March 2014.

Six other projectsthe gas-fired Dadri (7,480 MW), the coal-fired MP Power (3,960 MW) and Krishnapatnam (4,000 MW) projects and three run-of-the-river hydroelectric projects, Siyom (1,000 MW), Tato II (700 MW) and Kalai II (1,200 MW)are in various stages of development. Dadri, a 7,480 MW project to be located in Uttar Pradesh, is expected to be the largest gas-fired power project at a single location in the world. Krishnapatnam, a 4,000 MW coal-fired power project, will be located in Andhra Pradesh and is the most recently awarded UMPP. In addition to the 28,200 MW of power projects that Rel Power is currently developing, it intends to develop additional power projects to help meet the increasing demand for power in India. Rel Power is considering the development of Coal Bed Methane power generation projects based on fuel from CBM blocks being explored by a consortium that includes its affiliates. Rel Power also intends to invest in overseas opportunities that are a strategic fit with its business.

The Reliance ADA group intends Rel Power to be its primary vehicle for investments in the power generation sector in the future. However, there is no non-compete agreement in place between REL and Rel Power.

Objects of Issue: The objects of the issue include funding subsidiaries to part-finance the construction and development costs of certain of Rel Power projects. Rel Power is pursuing the development of 13 power generation projects which are currently under various stages of development. Out of these projects, Rel Power is executing one and 11 projects are being developed by nine subsidiaries, which have been set up to develop these projects. One project is expected to be executed through a subsidiary that remains to be transferred to Rel Power. The details of investment is under

Highlights of the issue:

One of the Largest Portfolios of Power Generation Projects under Development in India The 13 projects that Rel Power is developing have a combined planned installed capacity of 28,200 MW and comprise one of the largest power generation portfolios under development in India. Rel Powers portfolio includes some of the most significant power projects in the

industry. Sasan, a 3,960 MW coal-fired UMPP to be located in Madhya Pradesh, is expected to be the largest pithead coal-fired power project at a single location in India. Dadri, a 7,480 MW gas-fired project to be located in Uttar Pradesh, is expected to be the largest gas-fired power project at a single location in the world. Krishnapatnam, a 4,000 MW coal-fired project, is the third and the most recently awarded UMPP. Given the size of the portfolio and these projects, Rel Power can benefit from economies of scale in dealings, including in sourcing fuel and equipment supplies. Diversified Portfolio of Power Projects Rel Power has planned projects that are diverse in geographic location, fuel type, fuel source and off-take. The identified project sites are located in western India, northern India, north-eastern India and southern India. They include seven coal-fired projects (14,620 MW) employing supercritical (13,120 MW) and subcritical (1,500 MW) PCC technology, two gas-fired projects (10,280 MW) employing combined cycle gas turbine technology and four run-of the-river hydroelectric projects (3,300 MW). It plans to source coal from captive mines and supplies from India and abroad, and also plan to source gas from the KG Basin through RNRL and from other sources. The hydroelectric projects will be run-of-the-river projects, three of them to be located in Arunachal Pradesh and one to be located in Uttarakhand. Rel Power intends to maintain a judicious mix of off-take arrangements, including longterm PPAs to provide a level of committed revenues and short-term PPAs to maximize revenues. It plans to sell power to state-owned and private distribution companies and industrial consumers. Further it intends to invest in overseas opportunities that are a strategic fit with its business. Strategically Located Power Projects Rel Power has located majority of the projects in the northern, western and north-eastern regions of India to cater to the significant unmet demand in the northern and western regions of India. According to the CEA, the peak deficit was 9,639 MW in western India

and 2,813 MW in northern India for the period between April and September 2007. As the peak demand for the fiscal year ended March 31, 2007 was 104,867 MW and CEA expects it to grow to 152,746 MW and 218,209 MW by the fiscal years ending March 31, 2012 and March 31, 2017, respectively. Hence the projects are well positioned to serve expected demand. In addition, Rel Power has planned for each project to be situated either close to its fuel source or load center.

Reliance ADA groups Experience and Position in the Indian Power Sector Reliance Energy Ltd (REL) and its affiliates have expertise in the development and operation of power projects and the distribution, transmission and trading of power in India. Rel Power expect to draw on the expertise of REL in providing EPC services and to benefit from the rights that RNRL has to these fuel reserves. Rel Power has entered into an MOU with REL under which it may approach REL to negotiate a contract for its EPC services on a project-by-project basis in the future. Further it has entered into MOUs with RNRL to negotiate a definitive GSTA to supply 28 mmscmd plus additional option volume and to negotiate a definitive Coal Supply Agreement for the supply of imported coal. In addition, Rel Power has entered into an MOU with Reliance Energy Transmission under which it may approach Reliance Energy Transmission to negotiate a contract for transmission services on a project-by-project basis in the future. It also expects to enter into off-take arrangements with REL and Reliance Energy Trading. Capitalizing on the Growth of the Indian Power Generation Sector: The power sector in India has historically been characterized by power shortages that have consistently increased over time. According to CEA, the total peak shortage was 13,897 MW as of March 31, 2007. In the 11th Plan (2007-2012), the Government of India recommended a capacity addition of 78,577 MW, assuming a 9.5% growth in the demand for power, and the 11th Plan Working Group recommended a capacity addition in the range of 82,200 MW to 94,300 MW for the 12th Plan (2012-2017), assuming a 9% GDP growth

rate. In addition to the 28,200 MW of power projects that Rel Power is currently developing, it intends to develop or acquire additional power projects in the future to meet the high demand for power and reduce the power deficits. Securing Fuel Supplies Securing adequate supplies of fuel is critical to the success of a power project. Rel Power intends to secure fuel for its projects by seeking captive fuel sources, procuring long-term contracts with domestic and foreign suppliers and entering into supply arrangements with its affiliates, including RNRL It will source the coal needed for 3,960 MW Sasan project from three captive mines in the Singrauli coalfields. It intends to seek supplies of coal for the supercritical coal-fired projects, Shahapur Coal (1,200 MW) and Krishnapatnam (4,000 MW), through RNRL or third parties. In addition, it is planning to seek supplies of natural gas from RNRL for its gas-fired projects at Shahapur (2,800 MW) and Dadri (7,480 MW), primarily from its rights to KG Basin gas reserves. It is also considering opportunities for securing fuel for other power generation projects with the supplies expected to be available from CBM exploration activities led by RNRL Industry: The power industry in India has historically been characterized by energy shortages, which have been increasing over the years. The gap between demand and supply has been increasing, leading to increased power shortages. The following table highlights the peak deficit over the years:

According to the 17th EPS, India's peak demand will reach 152,746 MW with an energy requirement of 968 billion units by fiscal year 2011-12. By the fiscal year 2016-17, peak demand will reach 218,209 MW with an energy requirement of 1,392 BUs.

Consumption Levels: The per capita consumption of energy in India is extremely low in comparison to most other parts of the world, in part due to unreliable supply and inadequate distribution networks. According to World Energy Outlook, 2006, over 400 million of the population in India did not have access to electricity. Installed Generation Capacity

According to the Ministry of Power, as of September 30, 2007, India has an installed generation capacity of approximately 135,782 MW. Despite the fact that the economic liberalization policies of the government, which began in 1992, were designed to fuel growth across all sectors, the power industry has not grown sufficiently to meet demand. The economy still faces an acute shortage of power. Currently, India pursues all available fuel options and conventional, non-conventional and emerging power generation technologies. Thermal power plants powered by coal, gas, naphtha or oil accounted for approximately 64.42%, hydroelectric stations accounted for approximately 25.2%, nuclear stations accounted for approximately 3.0% and energy sources accounted for approximately 7.5% of total power capacity.

Reforms:
Realising the opportunities presented by power sector reforms. In 1991, the Indian power sector began a process of deregulation that is continuing till date. The Electricity Act of 2003 and subsequent reforms have generated significant opportunities in the power sector. These changes include the following: Power generation has been made a non-licensed activity and techno-economic clearance from CEA has been waived for thermal power projects, which expedites the thermal power project development process. Distribution licensees can now procure power through a process of international competitive bidding; projects are no longer awarded on a cost-plus basis. Power generation companies can now sell power to any distribution licensees, or where allowed by the state regulatory commissions, directly to consumers, which expands the market.

The market has evolved for short-term PPAs, which allows for the supply of peak power at premium rates.

Power generation companies have open access to transmission lines, which will facilitate the direct sale of power to distribution and trading licensees.

The Government of India is promoting the development of large power projects, including Ultra Mega Power Projects. Certain UMPPs allow obtaining rights to large captive fuel supplies such as the mines for pithead coal based UMPPs. UMPP project companies are transferred to the successful bidder with certain key approvals in place, which helps expedite the implementation process.

Concerns:
Projects under development have a long gestation period. The completion targets for this projects are estimates and are subject to risks including delays in obtaining fuel supply and government approvals, which could give rise to delays, cost overruns or the termination of a projects development. The failure to complete project development within the required period may result in higher costs, penalties or liquidated damages, lower returns on capital or reduced earnings. The promoter company Reliance Energy has under-performed as far as generation capacity additions are concerned. Its proposal to set up the largest gas based power generation unit (announced 4 years ago) is yet to materialize. Any future issuance of equity shares or linked securities may dilute the equity capital. The proceeds of the current issue will be used for six of the total 13

projects. REL Power may issue additional equity shares to finance the other seven projects that are being developed. Rel Powers operation will have significant fuel requirements, and may not be able to ensure the availability of fuel at competitive prices. Nine of the power projects under development are planned to be coal-fired or gas-fired thermal projects. The success of the operations will depend on ability to source fuel at competitive prices. The major source of raw material procurement is sourced through RNRL. Currently, RNRL does not have any rights to coal resources of its own. In addition, RNRL is in litigation with respect to gas reserves of Reliance Industries Limited, which may impact the availability or the pricing of fuel for its two gas-fired thermal projects. Also, one of the three coal blocks allotted to Sasan project is the subject of litigation between the Ministry of Coal and third parties. Rel Power may not be able to successfully conduct mining operations to extract coal for Sasan project. It has been allotted three coal blocks to source fuel for Sasan project. REL Power is responsible for mining the coal, but have no prior experience in mining. Coal mining operations require substantial expertise and are subject to associated risks.

Changes to tariff regulations may adversely affect results of operations and cash

flow from operations. Power tariffs in India are established through competitive bidding or determined by central or state regulators. Although it is expected that tariffs with respect to most of power projects will be set through a process of competitive bidding, state regulators determined the tariff for Rosa Phase I project and it is possible that some of the other projects that developed in the future will be subject to central or state tariff regulation. Any change in tariff regulations may have a material adverse impact on the business and results of operations.

 REL Powers business is subject to government regulation, and changes in these regulations or in their implementation could disrupt operations and adversely affect results of operations. The business is subject to extensive government regulation. To conduct the business, Rel Power must obtain various licenses, permits and approvals The power generation and government agencies are facing an acute shortage of power equipments in India. According to the current estimates only 22% of equipment requirements of the total Rs.7,800 crore have been met while the residual equipment needs to be tied up. This may be a stumbling block in meeting the total power requirements in the country. Rel Power has however indicated to enter in the business of manufacturing power equipments and thereby have a captive unit to meet the equipment needs.

Conclusion and Recommendation:

We havent presented the financials of Rel Power as there is little financial history to the company. Rel Power lacks operational experience and the earliest the revenues could start flowing would be in FY2010 on the assumption that the projects are executed on schedule. The full benefit of the complete capacity could be only year 2017. Rel Power is offering shares at valuations, which are on higher side compared to, more established and proven experienced players like Tata Power and NTPC.

Inspite of the concerns, the current momentum in the power utility stocks and low free float (90% of the equity post listing would be held by the promoters) could mean that the stock may command a premium on listing. Promoters past ability to create shareholder value over the medium term and to put capital to its best use till deployment are some factors on which investors could take a bet on. At the valuations offered, one may not expect too much upside if one considers the issue from traditional investment valuation theories. Lack of sufficient free float and expected oversubscription could result in listing gains, which may not last long enough to provide a sufficient return on investment.

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