Economics and Politics behind demand for Smaller States

Published in Rediff on 22nd July 2011

http://www.rediff.com/business/slide-show/slide-show-1-the-economics-behind-demand-for-smaller-states/20110722.htm

The Telengana movement in the state of Andhra Pradesh has picked up momentum again and is causing losses to the tune of thousands of crores to the exchequer during Bandhs, not to mention the loss to the students who are actively involved in the movement.

The rationale of Underdevelopment stated by the Pro Telangana activists for the formation of a separate state seems a bit stretched, especially since the socio- economic data presented in the Srikrishna committee report and analysis by various other independent bodies do not point towards a dismal state of affairs.

The Gross District Level Domestic Product, which is The most important indicator of economic growth, has grown the fastest for the Telangana region, whether one includes or excludes Hyd, from 00-01 to 07-08.

Other important parameter, supply of water and electricity to the farmers, has also shown remarkable improvement over the years. For example, the Net agricultural area under Irrigation, land productivity, use of electricity for agriculture and growth of electricity consumption, have all improved much faster for the Telangana region (excluding Hyderabad) than the Coastal Andhra.

The expenditure on Education, which is one of the most important social issue, under the Sarva Shiksha Abhiyan (SSA), for the Telengana (excl Hyd) and the Coastal Andhra regions seem to be small and the difference can be easily reduced or taken care of with little bit of effort.

The numbers speak of the growth story of the region of Telangana. If the region was neglected say 20 years back, it should not be the reason for the formation of a separate state now.

If the politicians really want to help the people of Telangana, they should plan a drive to systematically get more resources from the state and central government to these regions. Rather than asking for a new state they should compete for the resources. The MLAs from these areas should put in effort for this. The common man is concerned about development and knows that forming a separate state may not be the wisest of solutions to it.

There are many other aspirants who have not yet filed the applications, but surely are watching the developments on Telangana very closely. Bodoland (Assam), Kosal (Orissa), Ladakh (Jammu and Kashmir), Vindhya Pradesh (Madhya Pradesh), Maru Pradesh (Rajasthan), are just a few examples.

As far as the economic development of these smaller aspiring regions are concerned, every state would have some developed and some not-so-developed regions. If all the not-so-developed regions start demanding for a separate state, there will be no end to the number of states that we might end up having.

While a few of these demands may be genuine, many of these cases seem to be driven entirely because of Political motivations and aspirations. The Center needs to take a strong stand and focus on the facts and figures related to the socio-economic growth in the region rather than bowing down to the bullying tactics of the politicians.

If smaller states are formed on the principles of ‘self-determination’, it is going to result in unstable states. Today, the Telangana people may get a separate state by showing intolerance towards Andhra people. Tomorrow, there will be clashes with people of other ethnic groups.

As Etzioni (1993) puts it in his research paper in “Foreign Policy”, what is required is “fuller representation, responsiveness, and democratization”. Not “self-determination by fragmentation”.

MBA Aspirants Speak UP

This post is not meant to hurt anyone. It it just a compilation of a few funny moments/experiences during interviews/presentations at a leading B-School in India. The compilation below highlights the state of primary, secondary and undergratuate education in the country.

It also highlights what the two years of going through the process of an MBA degree can do to the same students, as I have seen many of these students transform in the two years and ending up with plum jobs, doing extremely well in life.

1. Mutinity.
2. Kohfi Annan, Koffi Annan, Cophy Annan...All three in the same presentation by the same student!
3. Assacinatio....read Assasination.
4. I myself....
5. As far as my strengths are concerned, I am motivated, integrated and enlightened.
6. It extends the whole of India, except the state of J&K.
7. Mr. Natwar Singh is described as the one of the leaders of the congress party of the India.
8. Nitish Kumar is an Engineer. So he will do well.
9. Emotional Intelligence without emotions or intelligence is nothing.
10. Identifying Emotions- It is the process by which we can identify emotions.
11. Understanding Emotions-It is the process by which we can understand emotions.
12. Using Emotions- It is the process by which we can use emotions.
13. Managing Emotions- It is the process by which we can manage emotions.
14. The light gets enlightened.
15. There are many sensexes but for BSE it is the top 100 companies in the Government.
16. I want to conclude the IPO market.
17. Md. Younus has been helping very poor women with crediting.
18. Micro finance is the basic need of Indian countries like poor countries.
19. In India, the employees are paid according to their capabilities (what's the norm in other countries?)
20. They (Phillippines) have a low speaking population.
21. When the sun sets there, the people in offices there stop working. And when the sun sets there, the sun rises in India. Then we start working. So we have a 24*7 advantage...On Outsourcing.
22. Immediate effects of the flood immediately caused water clogging.
23. People died through electrician.
24. Communications through land lines and ATMs were blocked...ATMs?...used for communication?
25. What was the reason for Mumbai floods?- The drainage system...Oh! I thought it was the rains!
26. Wings are made for speed. Our country is on a speedy path...on the future of the Airlines Industry.
27. Low cost airlines do not provide foods and accommodation.
28. No frills airlines don't provide any comfort. Not even a complimentary airhostess.
29. Ordinary people could only see the plane flying on top of their heads.
30. I would like to introduce some introduction.
31. Mumbai-Pune expressway was cancelled for the first time.
32. The poor are very brand conscious.
33. Pakistan attack Kashmir to capture it.
34. The other Kashmir Government should be banned.

The Ten Experiences in a Slum

1. The first thing that would strike you in a slum is the noises that would engulf you as soon as you enter. A band playing the latest blockbuster for somebody's wedding, while a group of youngsters practising on the song "Jinke aage Ji, jinke peeche ji, jinke aage peeche ji ji,...." for the sangeet function, with the song playing at full blast on a 10,000watt player.

There would certainly be a temple close by with either the aarti playing or a group of middle aged to aged ladies singing bhajans on a microphone, with the assumption that the louder they sing, the better God will fulfil their worldly desires. And God alone save you if either the Ganesh Puja or the Durga Puja is round the corner.

Be ready to lose sleep for atleast 7-8 days while the jobless dwellers of the so called society busy themselves in dancing, dining and playing Tambola (gambling in the name of God) through the night, all ofcourse accompanied by very-very loud music.

Another very common form of noise is adults, both men and women, fighting at the top of their voices. It could be for water, for maintenance money, for maids, for the post of the society administrator, for throwing garbage near each other's houses, or any thing else that I am not even able to think of.

2. The next important aspect of any slum is the garbage. Mango and banana peels, biscuit wrappers, empty haldiram's mixture packets, disposable cups and glasses, cat, cow and buffalo shit, beer bottles, rice and dal thrown from the fourth or the fifth floor balcony, torn underwears, and most importantly the paan juice at every possible corner and walls.

Yeah, I must mention that dabur lal dant manjan's red juice and the colgate tooth paste's white froth are also patch worked on the area just below the first floor houses' balconies.

3. The stink will not be missed. Though it will take you sometime to realise its presence as you will be totally overtaken by the noise and the garbage initially. Urine, animal shit, rotten food, stink from the nearest Municipal Corporations garbage collection area (which seems to be located almost every one meter in a slum) are all common. And yes, the smell of alchohol is pretty common too.

A few other salient features, which must be mentioned, though may not have meat enough to write a paragraph about are:
4. Lack of fresh air and sunlight in houses.
5. You can see your neighbour beating his wife at night from the kitchen balcony and hear another neighbour abusing his wife from your own bedroom.
6. Mosquitoes.
7. Kids running around without footwear (everywhere....not only at home).
8. Highly decked up ladies in artificial jewellery for even festivals of lesser significance.
9. Many dwellers may own high end cars like honda cities and ford ikons, but would still throw garbage from their balconies and would still abuse their wives at the top of their voices.
10. And last but not the least, everyone, almost everyone of them, love their share of free food at temples, weddings and Ganesh Pujas.

Understanding Interest Rate Futures

Co-author: Satish Kumar

(Published in the Hindu BusinessLine on 26th October, 2009)

The Securities and Exchange Board of India (SEBI) and the Government had approved the launch of Interest Rate Futures (IRFs) in December 2008. Subsequently, on August 31, 2009, the National Stock Exchange of India (NSE) launched the 10 Year Government Bond IRFs.

IRFs, which are extremely popular derivative contracts around the world accounting for more than 70 per cent of the total derivatives trading, were introduced in India for the first time in 2003. However, they were soon suspended due to illiquidity and poor price discovery. Another attempt has been made by SEBI to launch them, albeit with greater preparations this time.

IRFs are instrumental in facilitating the management of interest rate risk faced by organisations and individuals while investing in floating rate debt instruments. Hence this move is being viewed as a step towards boosting the country’s debt markets. The market participants are also welcoming this move as IRFs will not only provide more depth to the market; it will also act as another instrument for investment.

IRFs are derivative contracts on a fixed income security, namely, bonds. The price of the bond changes with changes in interest rates (yield), both being inversely related.

This causes a number of organisations to incur capital losses when the interest rates drop. Investors in the bond market can now hedge against this loss if they anticipate that the interest rates might fall.

Contract specifications

Underlying: 10 Year Government Bonds with notion coupon rate of 7 per cent, semi-annual compounding;

Minimum contract size: Rs 2 lakh;

Minimum maturity period: 12 months;

Expiry and settlement: March, June, September and December.

Let’s say a trader ABC, buys 5,000 units of bonds with a face value of Rs 100, coupon rate 7 per cent, semi-annual compounding, and the yield to maturity (YTM) of the bond being 6.5 per cent. The price of this bond in the market is Rs 103.63 (calculated using discounted cash flow method). Hence, the investment for the trader will be Rs 103.63 x 5,000 units = Rs 5,18,150.

The trader would like to sell off his investment after one year. However, he is worried that the central bank might raise the interest rates by 100 basis points (1 per cent) in the coming year. If this happens, the bond will trade at around Rs 96.77 in one year’s time. This will result in the value of his portfolio going down by Rs 34,300 [(103.63-96.77)*5000].

What the trader can do is hedge for this loss using IRFs. He can go short on equivalent value of IRF contracts now and then close his position after one year when the bond prices go down.

Other tools

Other hedging tools such as interest rate swaps or forward rate agreements were available to the investors in India since long. However, they suffered from the usual problems associated with over-the-counter contracts, like illiquidity, high transaction costs, third party risks, etc.

Now, with IRFs, investors have access to a more liquid contract with almost negligible third-party risk as the clearing house of the NSE will act as the counter party to all the trades.

Most of the institutional investors, such as insurance companies, pension and provident funds, mutual funds and banks will benefit immensely from these contracts as they hold huge amounts of fixed income securities in their portfolios, either to fulfil statutory requirements or to have a desired level of risk.

There are two more instruments which have been approved but not yet introduced. They are 91-day Treasury Bill futures and short-term interest rate futures based on an index of actual call money market rates. Once these products are also introduced, the debt markets in India would have truly taken a leap forward. It would attract speculators too, making price discovery better and the debt market more complete and liquid.

(The authors are faculty member and doctoral student, respectively, at IBS Hyderabad.)

Charminar

The first time I visited Charminar during Eid was in 2009. Glittering shirts, glittering trousers, glittering bangles, glittering shoes, glittering bags, glittering sarees, glittering kurtas, glittering showpieces, were all on sale on the eve of Eid-ul-Fitr.

With odour as varied as from Mirchi Bajji to coconut oil, from axe deodorant to vanilla wafers, from coffee to itr, from leather to new cotton clothes, the nose was working overtime.

Everything under the sun was being bought and sold, with vendors vying in the most unique ways to attract attention of the customers. The most innovative slogan that I heard was, “Maalik mar gaya, rate gir gaya”.

There were heads all around. We stood at one end of Charminar and were pushed all the way to it (about one kilometer) by the crowd. We went and stood on the other end, and were pushed back to where our bike was parked.

At eleven in the night, people were eating chaat, dosas, haleem, mirchi bajji, paneer and chicken tikka and drinking irani chai and chaach (buttermilk). White churidar, white kurta, black burkhas with veils, dominated the crowds.

What Brindavan is to Holi, Charminar is to Id

It is fascinating to visit a place during a festival that is popularly celebrated there. What Brindavan is to Holi, Ahmedabad is to Navratri, Durga Puja is to Kolkata, Charminar is to Eid. A truly unique experience. Must experience for all.

A futures contract on real-estate?

Date:01/02/2009 http://www.thehindubusinessline.com/bline/iw/2009/02/01/stories/2009020150471400.htm
If you are wondering why such trading hasn’t taken off in India, it is because these transactions need a lot of ground work to be put in place first.
“Why don’t we have a futures contract on real-estate to hedge the risk of land prices going down?” asked Rahul, a quiet but sharp student. Professor Nicky was taken aback by his question. Where most of the students in her class had difficulty understanding the basic concepts of hedging, this young boy was asking about an instrument which was, well, not so simple, to say the least.

Professor Nicky turned the question to the class to test how much the class knew. And she was in for a pleasant surprise. There were a few hands in the air.

Rachna: “It will be difficult to introduce real-estate futures because the valuation of the underlying product would be difficult. The real-estate market in India is highly fragmented. The prices of land differ widely based on factors such as location and usability, that is commercial, industrial, residential or agricultural”
Praveen added: “Besides, such a market would be very illiquid in India as only prime commercial and residential properties would probably be traded.”
Index of prices
“But, what is the problem here?” interposed Rajshree. “Can’t we create an index of real-estate prices? Just like we have stock indices? We can club the properties belonging to a particular city according to property types”.

Professor Nicky saw a few perplexed looking faces and decided to intervene even though she was happy with the way the discussion was proceeding. She took over from where Rajshree had left.
“See, just like we have an index for FMCG companies or IT companies or banks, similarly, we can create an index of real-estate Prices. Of course these indices will be city or region-wise indices. We would need to determine a base year”.
“Since it would be very tiresome to include all residential property transactions in the index, we take transactions that are above a minimum amount of, let’s say, Rs 25 lakh.

Now we can take a weighted average of all the transactions on a weekly or a fortnightly or monthly basis to find the changes in the index.
“However, the index may not give a true and fair picture as the recorded value of these transactions with the government is generally very low to save taxes. But then, it will still be better than having nothing. And slowly, as we move ahead and learn, the issues of heterogeneity and pricing will be sorted out”.
“Ah! If I recall correctly, Chicago Mercantile Exchange and Chicago Board of Trade have such futures traded on such contracts for cities such as New York and Los Angeles. In fact, they also have futures contracts on Real Estate Investment Trusts” exclaimed Richa.

“The students have really started reading,” thought Professor Nicky. “With the job scenario being bleak, many students have become serious and are trying to read more so that they can have an edge over their batch mates in an interview”!

Benefits of futures
“Yes, both the US and the UK have real-estate futures traded on their commodity exchanges for most of the major cities in the country. But can somebody tell me what the benefits of real-estate futures are?” asked Nicky.

Before Nicky could point towards a raised hand, Rohit rattled off, “Hedging for investors and builders, diversification, price discovery, increased information availability and flow, investment tool…”.

“Okay…okay…enough…so all of you are aware of the benefits of real-estate futures. But who has heard of the London Fox?” Thankfully no hands went up this time. Nicky was almost beginning to feel that she was not required in the classroom at all as the students had answers to all her questions.

Keeping them at bay
“London Futures and Options Exchange (FOX) started trading in four property futures contracts in May 1991 and had to suspend trading in October 1991. The reasons were mainly that these contracts were not economically viable. Arbitrage was not possible as short-selling is not allowed in the underlying spot market, which is true in India also.

“Also, the housing indices for various cities would be highly dependent on each other, albeit with lagged effect, due to the cascading effect in the real-estate markets. The transaction costs were also huge, which kept the investors and hedgers at bay.
“Hence, before introducing these futures, the government will have to do a lot of ground work to ensure that they work efficiently and provide the desired benefits to investors and hedgers”.
The class looked satisfied. Everyone had contributed something and everyone had learnt something new. Nicky looked proudly at her students and called it a day.

(Praveen, Rachna, Rahul, Rajshree, Richa and Rohit are students of IBS Hyderabad, class of 2009. Nupur is an Assistant Professor of Finance at IBS Hyderabad.)

Grasping the oil price, inflation linkage

Hindu Businessline-Racy Cases, 28.09.08 , Co-author: Arindam Mahato, IBS Hyd, Class of 2009

“Are the economic principles of demand and supply still valid?” asked a friend. We are at a loss for words for we are staunch supporter of economics. He continues, “I am scared to buy a car, for fear of oil prices touching the roof. Obviously the demand-supply position of oil has not changed drastically in the past one year, but the oil prices have more than doubled in one year and about quadrupled in the past five years.

 Now once again they are on the way down, and are now at around $100 per barrel! What’s the reason? Has the entire world economy become the playground of speculators? Are the prices purely driven by speculation?"

He was angry. Angry at everything around him. Angry at the policymakers for letting it all happen. Angry at the helplessness of the common man. We had no answers for all these questions. We too keep wondering about disillusionment cast by the entire financial and economic system around the world. However, his outburst did result in us taking a closer look at the oil prices.

Oil price drivers
A few macroeconomic factors which are said to be responsible for driving world crude oil prices are inflation, exchange rates, gold prices and OPEC’s decision on supply. These have an impact on oil prices either directly or indirectly.

Plotting the last five years’ data for all four of them along with the crude oil prices, we notice that gold and crude oil prices seem to have a very high correlation (0.9166). Oil and gold have been priced in US dollars since 1975.

Up to 1971 the dollar could be converted into gold by central banks. The price of gold was fixed at $35 an ounce and oil was steady at $3 a barrel. When the convertibility was removed, some of the oil producing countries converted the dollars into gold (this means that the demand for dollar went down and demand for gold went up). This had an impact on both oil and gold prices. Even today, an increase in the price of oil results in an increase in the price of gold and a decline in dollar value.

The euro-dollar exchange rates also seem to have a very high correlation with oil prices (0.8847). This could be due to the following: first, oil exporters have some price setting capacity; second, oil exporters receive a substantial share of their imports from Europe, particularly from euro area countries; third, oil invoicing takes place in US dollars; and, fourth, the US is itself a major importer of oil.

The OPEC supply has a much lower correlation of 0.7265. The supply of oil has remained more or less stable during the past five years. However, we can assume that the demand has been increasing due to the increasing appetite of emerging countries such as China and India. Also, oil is a finite resource and this has been recognised long back.

Depleting stock

According to a study, global oil resources are depleting at an annual rate of 6 per cent while demand is growing at an annual rate of 2 per cent. Thus, scarcity premium will continue to rise over time. This justifies the increase in prices. But what it does not justify is the sharp price rises and falls.

An increase in oil price results in inflation, which affects oil-importing countries. It also affects the cost of the finished products and prices in the economy. According to a research done by LeBlanc and Chinn of the University of California, Santa Cruz, oil price increases of as much as 10 percentage points will lead to direct inflationary increases of 0.1-0.8 percentage points in the US and the EU.

The correlation between world inflation and oil prices are the lowest amongst the four variables that we have considered (0.6879).

After doing this analysis, we went back to our friend to explain our findings. The response we got was “this is all very good and sounds logical too. But how does this have an impact on the common man? When the oil was $142 per barrel, I was paying Rs 56.60 per litre of petrol. Today, oil is around $100 a barrel and I am still paying around Rs 56 for a litre of petrol.

Unanswered questions
“The entire media quoted learned analysts and economists saying that inflation is going up because of oil prices. Now oil prices have fallen drastically but inflation has not come down. Do you have an answer for that?”

No we don’t. Now, with financial sector biggies such as Lehman Brothers and AIG collapsing, the general public is perplexed about the sanctity of the financial and economic systems, the acumen of analysts who slash the credit ratings of companies only after they actually collapses, and of the regulators who wake up only when such crises actually arise.

Currency Futures are here!

Hindu Businessline, 1st September 2008, Co-author-Zohra Zabeen
Currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility.

Ravini is in a gloomy mood. As usual, she feels let down by the management education system of which she is a part — as a student, that is. She has absolutely no clue about the recently launched currency futures on the NSE (National Stock Exchange). In the last few days, she was haunted by currency derivatives even in her sleep.

On her way to the library, Ravini tries to put together all that she had learnt about futures, and as luck would have it, she sees Prof. Nicky walking out of the library. The only link between Nicky and Ravini was that they happened to live in the same locality some ten years back, and now, Ravini was a student at the same B-School at which Nicky was a Professor of Finance. This connection in an Indian setting means, Ravini considers it her right to call on Nicky anytime, anywhere and for anything.

Professor Nicky smiles knowingly as she looks at Ravini who has a perpetual question mark on her face. Nicky wastes no time in pleasantries, before asking, “So what’s bothering you today?”
Ravini: Hello Professor! I was wondering if you had some time to discuss currency futures.
Nicky: Ah! Indeed…I should have guessed. What do you already know about it?
Ravini: As the name suggests, it must be a futures contract, with currencies as the underlying asset. Beyond that I know nothing!

Nicky: Yes. You are right. These contracts were first created at the Chicago Mercantile Exchange in 1972 to hedge the exchange rate risks faced by businesses. After the collapse of the Bretton Woods Agreement, most of the countries shifted to a floating exchange rate regime, making exchange rates volatile.
So exchange rates, which were not something that needed to be managed earlier, now became a matter of concern for many exporters and another avenue to bet on, for speculators. Last week, on August 29, they were launched for trading at the NSE as well.

Ravini: So, currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility?
Nicky: Yes, it allows exchange of one currency with another at a specified date in future at a prefixed price. Currency futures work the same way as futures in stocks.

Ravini: We already had Over the Counter currency forwards amounting to a huge daily turnover of $34billion in India, right? Then why do we need currency futures?

Nicky: The purpose of both is to protect the investors or companies from unfavourable movements in exchange rates. But the difference lies in the contract specifications. Forwards are customisable in terms of the amount and time for which the hedge is required. On the other hand, futures are standardised as per the specifications of the exchange.

Ravini: But then wouldn’t everyone want a customised contract?
Nicky: No. Exchange-traded futures (ETFs) would be preferred by many as the default risks would be limited due to the daily mark-to-market settlement and the involvement of National Securities Clearing Corporation (NSCCL) as the legal counterparty to all the trades that are executed at the NSE. Also, while exchange traded currency futures would be very liquid in nature, forwards are not liquid, they cannot be bought and sold as and when desired.

Also, in the case of forwards, trading takes place only between large players, typically between banks and corporations or between banks themselves. This causes lack of transparency in the pricing of the products.

Ravini: Oh! This means investors, fund managers, and companies can now hedge currency risk without the fear of default and illiquidity risks and with better price discovery mechanism.

Nicky: Absolutely. The step taken forward by the RBI and SEBI (Securities and Exchange Board of India) to introduce currency futures in India is indeed laudable and bears utmost importance keeping in mind current macroeconomic conditions. Fear of forex losses are haunting Indian corporates and this initiative is expected to bring some respite.

Currency futures offer several advantages to companies with international operations, fund managers, individuals, exporters, importers, hedge funds, non-banking institutions and speculators alike.
From the corporate perspective, currency risk hedging has assumed greater importance in the wake of excess volatility in the foreign exchange market, which has impacted the export performance and balance-sheet of the companies.

Many reputed companies have reported huge foreign exchange losses in the quarter ended June 30, 2008.
Moreover, in the current scenario where Indian companies are acquiring or buying foreign companies and seeking loans and funds abroad, the risk of exposure to various currencies have increased all the more.
From the investor’s point of view, a well-balanced portfolio through diversification and low systematic risk is beneficial. According to a few empirical studies price fluctuations in currency futures have very low correlations with price movements in stock market values and interest rates. Hence, this low correlation can reduce portfolio risk when equities and bonds are in depressed state.
Ravini: I read that RBI’s working group has suggested the contract size of $1000 with a maximum maturity of 12 months only for these contracts. Is there any specific reason for doing so?
Nicky: Yes, a small-sized contract (in value) would encourage more participants with even small currency exposures to take advantage of these contracts.
Ravini: If the currency futures have so many benefits, why are the FIIs and NRIs being barred from entering the market?

Nicky: As of now, there are many apprehensions regarding the success of currency futures launch. Hence, RBI and SEBI are being cautious in order to reduce the fear of speculation and volatility. However, this is a big step by them and must be applauded.
I am sure this is the first step towards creating a full fledged foreign exchange derivative market in India and would take the country closer to full capital account convertibility. Now, if you excuse me please, I must rush for a class.
Ravini: Sure professor. Thanks you very much and I hope to see you soon if I have further queries.

Happy and contented with the answers of Prof. Nicky, Ravini takes a U-turn to the canteen to show off her newly acquired gyan to her friends!
(http://Racycases.blogspot.com)

Futures’ cool, but options’ smarter

DNA, 15th August 2008
The derivative tool can be used by investors to good effect

Kishorilal switches on the telly a few minutes before the programme on investment strategies is to begin. In the last episode, he had watched Nicky, a professor in finance at a renowned business school explain how futures could be used as an investment tool. Today, she would be dealing with options.They are still playing advertisements, but Kishorilal desists from switching channels for fear he would miss out on parts of the programme. He even catches himself humming the familiar refrain of a paint company: “Jab ghar ki raunak badhani ho, deewaron ko jab sajaana ho…” If only he could own his dream bungalow... May be Nicky’s tips would help him realise that.He doesn’t have to wait long. The smiling professor soon appears and runs the viewers through the basics of option contracts, explaining how options allow the buyer more freedom than futures contracts do.Options are contracts that give one the right to buy (call option) or sell (put option) a stock at a predetermined price (exercise price) sometime in the future, she says. This right comes at a price, known as the premium.In a call option, if the market price of the asset is lower than the exercise price on the expiry date, the buyer of the call option will simply let the contract lapse. He is not obliged to buy the asset from the seller. Whereas, if the price is higher, the buyer will decide to exercise the option and the seller must deliver the asset. Hence, in this case, the buyer of a call option has limited his losses, but can also take advantage of unlimited gains if the price of the asset falls.A put option, on the other hand, gives the buyer of the contract the option to sell an asset at a predetermined price in the future. Just as in the case of call options, the buyer of the put option will simply let the contract lapse if the market price of the asset is higher than the exercise price on the expiry date.So far so good, thinks Kishorilal. But, how does one actually make money using these contracts?Nicky seems to be reading his mind. She starts explaining how various combinations of option contracts (known as strategies) could be used in different circumstances.“For example, if you know that the share price is going to move substantially, but are not sure in which direction, up or down, you can enter into a ‘straddle’,” she says.Now what’s a straddle? Well, it involves a call and a put option with the same exercise price and same expiry date. So, if an investor believes the price of Reliance shares will move substantially in the coming days, he can buy call options and at the same time buy put options which expire on the same date. The exercise price for both the options must be the same.From the investor’s point of view, the maximum loss in this case is the premium paid for obtaining the options. But, the maximum profit is unlimited.Kishorilal finds himself nodding. Certainly, the maximum loss will be the premium paid to obtain the call and put options in the event that both are not exercised. But how can the profit potential be unlimited?Say the exercise price of Reliance call and put options is Rs 2,160, Nicky explains. Now, upon expiration, if the stock price of Reliance goes up to Rs 3,000, the investor can exercise the call option, which gives him the right to buy the shares at Rs 2,160. Then, he can sell those shares in the market for Rs 3,000, making a profit of Rs 840 per share. Higher the price of Reliance shares, higher will be the gain from exercising the call option. Also, in a scenario where the price of the shares rises, the put options expire unused.On the other hand, if the price of Reliance falls to say Rs 1,600, the investor can exercise his put option, which gives him the right to sell the shares for Rs 2,160. Thus, he buys the shares from the market at Rs 1,600 and sells them for Rs 2,160, making a profit of Rs 560 per share. Lower the price of Reliance shares, higher will be the gain from exercising the put option. Also, in a scenario where the price of the shares falls, the call options expire unused. In order to calculate the net profit, the premium paid for buying the options must be deducted from the profits. Let’s assume that the premium paid to buy the call option was Rs 65 and the put option was Rs 100. Even after deducting the total premium of Rs 165, the investment in a straddle turns out to be very profitable.Nicky closes the session with a quote from Walter D Hopps: “Derivatives are nothing more than a tool. And just as a saw can build your house, it can cut off your arm if it isn’t used properly.”“The statutory disclosure,” thinks Kishorilal, but agrees that it can cut both ways. He is glad to have sat through the session, for now he knows he can invest in derivatives and get higher returns while keeping his maximum losses under control. He decides to study a few stocks closely for sometime before taking the plunge. His dream house couldn’t be very far away.

For the equity riches, try derivatives

DNA, 9th August 2008
Ek bangla bane nyara… ek bangla bane nyara…

Listening to Saigal sing his favourite song on the radio transports Kishorilal to his long-cherished vision of this huge house, with grills of silver, etc, where he lives happily with his entire family. Alas, he is nowhere close to realising this dream yet.Having retired last year, Kishorilal gets a pension of Rs 15,000 per month. During his working life, while he was never in an uncomfortable position financially, he could not chase his own dreams in the race to fulfill the needs of his family.
 And today, he just isn’t earning enough to realise any dream.With an income of Rs 15,000 per month, he is left with only about Rs 6,000 by the end of the month. The bank assures him that if he opens a recurring account with them, depositing Rs 6,000 per month, he will have Rs 12 lakh in 10 years. That translates into a return of approximately 9% per year, Kishorilal calculates. “That’s far too low a return and the Rs 12 lakh he gets at the end of 10 years won’t be enough for the bungalow of my dreams.”
The other alternative is to invest in the stock market. His neighbour Ravi recently made a lot of money by buying the shares of Reliance at Rs 1,960 apiece in September last year and selling them at around Rs 3,000 per share in January this year, getting over 100% annualised returns.However, Kishorilal feels the market is too volatile.

Besides, it isn’t exactly booming right now. He also remembers this former colleague who was forced to commit suicide after losing lakhs in the stock market in 1994. Kishorilal turns on the TV and switches channels nonchalantly. Images blur in front of his eyes, but suddenly, a few words catch his attention. A young lady (the banner at the bottom of the screen identifies her as Nicky, professor in finance at a renowned business school) is talking about making big bucks with small investments on CNBC. Take to derivatives trading, she says.Kishorilal always thought these contracts were for the likes of Warren Buffett and J P Morgan.

 But, Nicky says anyone can invest in derivatives. How come?Nicky is giving an example. To cash in on the rising share prices, one can invest in stocks that he thinks are going to rise in value in the coming days. However, investing in stocks can be a very expensive affair. Instead, one can buy the futures of that stock. Let’s say one now invests in Reliance futures, which expire on September 25 (last Thursday of the month). Say the price of one Reliance futures is Rs 2,300 currently.A good point about futures is that one only needs to pay a small percentage of the total contract value as margin initially. Let us say that the initial margin that the investor needs to pay is approximately 10%.

Each contract has a lot size; for Reliance, the lot size is 75. Thus, the initial investment is only 10% of the value of contract (which is 75 times Rs 2,300 = Rs 1,72,500). This equals an investment of only Rs 17,250 per contract. Kishorilal’s face lights up. His savings last year totalled more than Rs 70,000.

Going by Nicky’s calculations, he could invest in 4 Reliance futures contracts, which would cost him only Rs 69,000.But what will happen on September 25, when the contract expires? Nicky goes on to explain that upon expiry, the investor will receive his initial investment and the profit or loss on the futures contract.

Suppose the shares of Reliance are trading at Rs 3,000 at that time. The gain will be (Rs 3,000-Rs 2,300)*75, i.e. Rs 52,500 per contract, or Rs 2,10,000 for four contracts. This is a gain of 304% in just two months.Kishorilal runs some mental calculation and concludes that if he keeps reinvesting his profits and the initial investment after every three months, he will have enough money to buy his dream house in just two years.This is too good to be true, he thinks. There has to be a catch.

There is, he remembers from experience. Haven’t experts always advised investors to be careful in judging where the stock prices are headed? Imagine Ravi’s plight had the prices of Reliance shares had fallen instead of rising.Ben Golub’s famous words come to mind, “Risk management is akin to a dialysis machine. If it doesn’t work, you might have a noble obituary, but you’re dead.” Nicky’s not finished yet, though. According to her, if you are convinced that the share price of Reliance will go up in the next three months, you must take advantage of the Reliance futures.

 However, if there is any chance of the share prices falling, a different strategy may be adopted.Kishorilal sees a glimmer of hope. He switches off the TV and puts on the radio. Luckily for him, the music isn’t over yet.

Use 'weather derivatives' to weather droughts

(Interview by D. Murali and Kumar Shankar Roy, Hindu Businessline)

Chennai: With drought looming large over 14 meteorological sub-divisions, spare a thought for the planted crops that are in grave danger. For the farmers in Maharashtra, Andhra Pradesh, Karnataka and Kerala this monsoon has brought everything except the much-needed moisture. "Come rainy season and nearly 59 per cent of the Indian population, the people dependent on agriculture, keep their fingers crossed. Some pray to the rain God to ensure that it does not pour so hard that their crops get destroyed. On the other hand, in some villages, the farmers tie two frogs to a pole and get them married, a superstition which is supposed to bring good rainfall," quips Dr Nupur Pavan Bang, Faculty Member at ICFAI Business School (Hyderabad).

Superstitions apart, the seriousness of weather cannot be over-emphasized. "When livelihoods are dependent on rainfall, it is only fair that people will go to any extent to make sure that their farms get adequate amounts of rains...the farmers and various other businesses in the US have been using the weather derivatives since 1997, to mitigate risks due to adverse weather conditions," Dr Bang told Business Line. Weather derivatives, what are those? These derivative contracts are being used successfully by farmers, theme parks, ski resorts, ice-cream manufacturers, energy and utilities companies etc. since over a decade now. Read the short Q&A on 'weather derivatives' with Dr Bang done over the email to gain new insights.

Does India's size often become a disadvantage?
India, as a country, faces great variations in weather conditions due to its diverse geographical structure. While some places are hit by flood, some other by drought, rising temperatures are scaling new peaks and chilling winters are breaking old records. Such diversity in weather conditions affects the business processes of many industries directly or indirectly. The aviation industry takes the toll of fog in northern India during winters; floods in many parts leave their impact not only on agriculture but also on the tourism industry.

Tell us about these weather derivatives.
Weather derivatives are unique in many ways. The primary being, there is no physical underlying asset. The underlying asset is the weather, that is, the temperature measured in degrees Celsius or Fahrenheit or rainfall measured in centimeters. On the Chicago Mercantile Exchange, the values of these contracts are calculated based on a weather index. The index can represent either a Heating Degree Day (HDD) or a Cooling Degree Day (CDD). A HDD is the difference between a baseline temperature and the average temperature for a day in winters. A CDD is the difference between the average temperature for a day and a baseline temperature in summers. The baseline temperature is fixed; it is 65 degrees Fahrenheit in the US and 18 degrees Celsius in Europe.

From where will the derivatives derive their value?
The value of the contract would be some multiple of the HDD or the CDD. The contract can be valued on a daily basis, or weekly, or fortnightly or monthly or for a season; depending on the contract specifications. In 2005, NCDEX launched a rain day index for the Mumbai city for informational purposes only.

Can you explain the utility of weather derivatives with an example?
Let's consider a farmer growing paddy in a village in Andhra Pradesh. He is worried because of the expectations of unusually low rainfall in the state this year. He usually produces 50 quintals of paddy in his farm. But this year, he thinks the production will drop to 40 quintals. The Minimum Support Price for paddy is Rs770/quintal. This means that the farmer fears losing Rs 7,700 this season due to poor rainfall.

If the farmer had access to weather derivatives, he could have bought or sold (depending on the future outlook for rainfall) rain day futures contracts today and entered into an equal but opposite contract at a later date, making a profit on the transaction, thus offsetting the losses due to low volumes produced.

What are the other uses of these weather derivatives?
Apart from applying weather derivative as a measure of hedging risk against adverse weather conditions it can also be used as the mode of trading in derivatives. The most advantageous factor of weather derivatives is the fact that they can't be manipulated by any means like insider trading as the raining patterns are natural and beyond the scope of humans.

Are there challenges to a widespread adoption of this type of financial instrument?
The key challenge is to educate the people about such contracts and their usage. The knowledge of derivatives in itself is limited to certain segments of the society, leave alone the weather derivatives. In spite of the challenges, it is time the Government speeded up the process of launching weather derivatives in India too.

InterviewsInsights.blogspot.com

Understanding options, the Greek way

DNA, 14thJuly 2008

Walking down eat street, lost in thoughts of Hari Puttar (the greatest wizard of all times), Monsoon bumps into her friend Nicky, once neighbor and now a professor of finance at a business school,.
She is delighted, “Hey Nicky, I have been hunting for you since the past few months. I had a strange dream on one of those days when I slept in the middle of reading Hari Puttar and the Quarter Muscle King. I saw some ghosts in a graveyard, discussing a ghostly contract known as options. It sure looked like a great financial discovery which could be used to make humongous amounts of money on the stock markets at low risk.

I brushed off the dream thinking that I have been reading too much about wizards and broomsticks and shadows. But lo-behold, just a few days later, my Security Analysis professor at the Business School started teaching us Derivatives! It was as though I was reliving my dream in the class. The ghosts sure were absolutely right.

 But what I learnt in the class is that one has to pay a premium to acquire an Option. The premium is calculated based on some scary looking models namely the Black-Scholes Model or the Binomial Option Pricing Model. However, the option premium is not constant. They keep changing like the share prices. Now I am puzzled. Why do the premiums change? What are the factors that affect the price of the option contacts? When I asked my professor about it, she said “It’s not in your syllabus”.

My interest is piqued by the wonderful world of options. And who else is better than you at explaining the nuances of derivative products?

Clearly pleased about meeting Monsoon, Nicky thinks, “Something’s never change. And one of them is the non-stop chattering of Monsoon”. Having been declared an expert on derivatives, Nicky is all enthusiastic about clearing Monsoon’s doubts.

She chuckles, “You are absolutely right. The option premium keeps changing due to changes in various factors like the volatility of the underlying asset, the time to maturity of the contract, the risk free rate and the price of the underlying asset”.

Monsoon looks lost and says “Nicky, it all seems like Greek to me. Can you speak in plain English?” Nicky laughs at the unintended pun. “You are right Monsoon. It is indeed called the Greeks. The changes in Option Premiums with changes in variables that affect the premiums are known as the Greeks.” Monsoon looks further lost.

 Nicky explains, “When the price of the underlying asset increases, the price of a call option will increase and the price of a put option will fall. The sensitivity of Option price to a change in the price of the underlying is measured by Delta. Similarly, when interest rates rise, the value of the call option rises as the opportunity cost of buying stocks will be higher due to high borrowing cost.”

Monsoon is beginning to understand how the option premiums change due to changes in various variables. She nods at Nicky in complete understanding and poses another question, “How about the time to expiration and the volatility of the underlying stocks? How do they affect the premium?”

Nicky is ready as usual, “If the time to maturity, or the expiration period of the option contract is increased, the premiums will increase as the writer of the option will have to bear the risk for a longer period of time and the writer would want to be compensated for the time value of money. This is measured by Theta.”

Nicky further explains, “Monsoon, as you know, the primary objective of options is to ascertain a certain amount of cash flows at some time in the futures. Traders and investors use options extensively to hedge the risk of changing prices in the spot market.

Thus, higher the changes in price of an asset, greater will be the demand for option contracts. That is, greater the volatility of the underlying asset, higher will be the option premium. The sensitivity of option premiums to changes in volatility is measured by Vega”

Monsoon is not satisfied. She has another question, “Will the premiums for both Call and Put options be higher with higher time to maturity and higher volatility of the underlying asset?” Nicky is pleased that Monsoon’s thoughts are going on the right track. She says, “You are absolutely right Monsoon. Both call and put option will be more valuable when the time to maturity is higher and the volatility of the underlying asset is higher.”

Before Monsoon could pose another question, Nicky quickly added, “Now that you know about Delta, Rho, Theta and Vega, let me tell you something about Gamma too. Gamma is the sensitivity of the delta with respect to changes in underlying asset prices. This means that Gamma is a second order derivative. Higher the gamma, higher is the risk of changes in option premium due to changes in prices of the underlying.”

Monsoon finally breathes easy. She has finally learnt the meaning of the Greeks. Just as she is fascinated by Hari Puttar and his world of magic, she is awestruck by Options and the world of Greeks. She profusely thanks Nicky and in her characteristic chatter-pattar begins to fill in Nicky with all the gossip in the colony from where Nicky had moved out after being offered a house at the University campus.

How venture capital funding works

May 08, 2007, www.rediff.com, Co-author-Puneet Bambha

It is popularly believed that venture capitalists fund only established players and proven products. There is a lot of cynicism amongst many about all the hype that private equity and venture capital is getting in India of late.
However, the truth is that, in recent times in India, the VCs have actually provided capital to relatively new, start-up companies that have a reasonable, though not certain, prospects to develop into highly profitable ventures. Travelguru.com is a case in point, funded by Sequoia Capital and Battery Ventures.
The advent of firms like Helion Ventures with a $140 million corpus is helping the VC scenario to improve in the country. The three key people behind Helion Ventures, Ashish Gupta, Sanjeev Aggarwal and Kanwaljit Singh, all carry with them a successful track record across various companies in the international arena.
What is interesting is that for first time in India, venture capital will be backed by successful entrepreneurs who themselves have a hands-on experience in handling and developing businesses.
The National Venture Capital Association defines venture capital as: "Money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors."
Innovation is the key driver of competitiveness within organisations as well as within countries. It has been well said: "Nothing is more powerful than an idea whose time has come." However, innovative ideas need more than research and knowledge to succeed.
They need not only financial, but also, managerial (technical, marketing and HR), support to achieve success. This support is lent in many forms by private funding and incubation organisations such as venture capitalists.
Akhil Gupta, JMD & CFO of? Bharti Airtel, once remarked, "While we could have raised funding from other sources, Warburg Pincus' involvement helped us in scaling up significantly." Almost identical has been the findings of a research conducted recently by Venture Intelligence (founded by Arun Natarajan, a leading provider of information and networking services to the private equity and venture capital ecosystem in India) with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, to study the economic impact of PE and VCs on the Indian businesses.
The following are some of the interesting observations of this study:
The study shows that the PE and VC backed companies grew faster compared to the non-PE backed peers and even better than the benchmark indices like the NSE Nifty. They found that the sales of listed PE-backed companies grew at 22.9% as compared to 10% for non-PE-backed listed firms.
PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew at around 32% as compared to 6% for non-PE-backed firms.
An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate, while only about 4% felt that they would have developed the same way even without PE funding.
The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities.
Thus venture capital has become an important source of finance for innovative ideas that are risky and have a potential for high returns over a long-term horizon. Venture capitalist investment is driven by the expectation that the start-ups invested in could give them a higher rate of return than other firms.
In the process venture capitalists have created some of the best known companies in the world. Without VCs we might not have seen companies such as Apple, Compaq, Sun Microsystems, and Intel to name a few.
Some of the unique features of a VC firm are:
Investment in high-risk, high-returns ventures: As VCs invest in untested, innovative ideas the investments entail high risks. In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent).
Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, they may also at times expect participation in management.
Expertise in managing funds: VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed.
Raises funds from several sources: A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any.
Diversification of the portfolio: VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket.
Exit after specified time: VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.
Buyouts and second-stage financing are the most popular stages of venture capital financing. Globally, according to a report by PricewaterhouseCoopers, around 80 per cent of the total private equity investment is done at these stages.
However, in spite of the venture capital scenario improving, several specific VC funds are setting up shop in India, with the year 2006 having been a landmark year for VC funding in India.
Sumir Chadha, MD of Sequoia Capital India, feels that a slowdown could be on the cards for the year 2007 as the companies and investors may try to give some time and test the investment decisions made by them over the last year.
The first quarter of the calendar year 2007 is already over. There is no sign of the VC story slowing down. This is a good sign for all the entrepreneurs out there with an idea! If you have an idea, this is the time to tell it. You never know, someone might be listening round the corner!

Valuation, Structuring & Monitoring Of The Deals By Vcs

3rd May 2007, www.indiainfoline.com, Co-author-Puneet Bambha

During the late 1990s, as the internet boom was at its peak so was the Venture Capital
(VC) and Private Equity (PE) activity. Led by the huge expectations of the Y2K coupled
with the soaring success of the large number of software startups, various VC firms were
enticed to promote and fund such kind of businesses. It is pertinent to note that ripple
effect of private funding was felt not only in US but across the globe including emerging
markets like India.
But what followed was nothing short of disaster. Firstly, there was the dotcom bust which
badly affected the fortunes of several leading firms including ChrysCapital, eVentures
India, Draper International and ConnectCapital etc. The damage was further accentuated
by the 9/11 attacks in the US followed by the general US economic slowdown. The US
being the largest source of private funding in the Indian markets, these events resulted in
premature death of private funding in India.
However what is interesting to note is that once again the VCs and PE players have
staged a comeback not only in developed markets but also in emerging markets like India
and China. The tide started turning again from 2003 and since then there has been no
looking back. See Graph 1 for the VC and PE investments in India since the year 2003.

The combined total investment of the PE and VC firms for the year 2003-2005 has been
close to $505 billion globally. Notably the share of VC firms has been close to $100
billion out of the total pie. For India, although the year 2006 saw record investments
which were far ahead of the expected $6bn for the year, the Indian share of the global pie
is still just close to 6-7%. While China still takes the lion’s share of the pie in the Asia
Pacific region.

An interesting observation is that slowly other emerging markets like South America,
Middle East and Asia Pacific have been increasing their respective shares over the last
few years. Also, over the past few years it has been noted that the various PE/VC firms
have been globalizing their investment base so as to diversify the risks and as well gain
from the world wide opportunities.
With so much of improvement in the VC scenario globally, and especially in India, and
with so much scope for improvement of the market share for India, understanding the
various aspects related to VC investments become pertinent for Indian businesses. In this
article, we look at the various approaches used by the VCs for valuation of a deal.
Valuation is one of the most important factors when obtaining VC funding. It gives rise
to maximum conflicts at the time of negotiation between the management & VCs. This is
because valuation is not an absolute but a relative factor, which may change from one
situation to another.
The Cost Based approach to business valuation is based on the premise that the
economic value of an asset can be determined by the cost of an asset. However, there is
usually controversy over definition of cost and the usage of different types of cost
(historical or current). Also, estimating the cost of Intangibles can be very judgmental.
The Market Based approach assumes that the value of the business can be assessed by
observing the value at which comparable business ownership interests presently are being
exchanged in either the public or private markets. But obtaining data in case of private
market deals can be difficult and there can be arguments over what is comparable.
Income Approach to business valuation estimate the value of the expected economic
benefits of ownership of the business as equal to the present value of expected future
income streams. The problems with this approach are that income forecasts are uncertain
and based on assumptions. Also, the process of estimating an appropriate discounting rate
for future earnings can become controversial.
Amongst the above three approaches, the Income approach is the one which is considered
to be the better one. The discount rate used in the calculation of the present value of
future earnings is generally very high if the VC is providing the funding at the start-up
stage (it can be as high as 70-80%). However, this approach may not work when it comes
to valuation of the early stage of enterprises where there is no certainty in case of future
cash flows or some tangible assets.
In early-stage investing, valuation is simpler. Valuation has little to do with the
company’s worth at that point of time. Valuation is derived from how much capital the
company needs and the percentage of the company the VCs would like to own, given the
high-risk nature of the investment. Except for a vague sense that the market being
addressed is adequately large, there is no pretense of knowing future revenues or
profitability. In fact, most VCs in this situation ignore all future earning forecasts after 18
to 24 months.

At the other extreme, valuation of large publicly-listed companies is much simpler.
Besides the traded stock price, these companies have dozens of equity analysts figuring
out what the stock is worth and which way it will move. The true value of these stocks is
as much a function of supply-demand and investor preferences, as they are of cash flows
and discount rates. Analyst estimates and the actual stock price typically fall within a
reasonable band.
This leaves the companies which are somewhere between the above two extremes. In
India, most investment opportunities are in such cases. These are often privately-held and
almost always project rapid growth (that’s why they need the funds in the first place).
The valuation process may get messy, as these are neither here nor there. Given the small
size and relatively early stage in their lifecycle, their future performance is subject to a
high level of variability.
The Valuation in such cases is a lot more about the softer factors – supply-demand for
deals, relationships, competitive dynamics, bull or bear nature of the investing
environment. The actual projections and valuation techniques may at times tend to be
more distracting than helpful.
Once a value is agreed upon by both the VC and the company, the next challenge is to
structure the deal. The objective is to choose an instrument (or a mix of instruments)
which would protect the interests of both the parties involved, that is, VCs and the
entrepreneur. The various instruments commonly used are Equity Shares, Convertible
and Non-Convertible Preference Shares, and Convertible and Non-Convertible
Debentures.
Investments made by VCs in early stages are usually in the form of debt or debt related
instruments, which allow them to keep their principal safe to guard against failure of an
enterprise. In case of later stage investments, they are usually made in the form of equity
or similar instruments. This is because during this stage, there is lesser uncertainty and
more chances of success of the enterprise. Thus, the deals are generally structured in a
way that would involve safety of principle and a chance to participate in the super profits
(if they occur). Thus, the usual deal structuring is that about 2/3rd of the investment is in
the form of debt related instruments and one third is in the form of pre-decided
proportion of equity.
Once a deal has been made, Monitoring the Project becomes of utmost importance to
the VCs. It has been well said that "A venture is most prone to failure during its first
three years of operation - the so-called 'valley of death'. A key to getting through these
early years is to avoid the obvious mistakes." – ‘Devising Venture Strategies' by Invest-
Tech Ltd.
Hence to safeguard their interest and to ensure the success of the project VCs usually
monitor the project on an ongoing basis. Their involvement in the venture can range from
sitting on the board of the company (in general about 30-60% board seats may be held by
the VCs) to providing consultancy services to reviewing the internal documents and
reports of the company on a regular basis. Seats on the board of the company are
generally a point of contention between the company’s management and the VCs. The
company management usually prefers to share less number of seats with the VCs.

Apart from Valuation, Structuring of the deal and Monitoring the Project, the Exit Route
is one of the most important factors in the VCs evaluation process. The VCs normally
invest for a range of 3-7 years and if the smooth exit route is not available then the VCs
might not like to commit funds no matter how attractive the project is. The various exit
options used by the VCs range from IPO’s, Secondary Offering, Acquisitions, Buy-Back,
and Third Party Sale.
It has been seen in the past that IPO’s and Acquisitions provide the maximum gain to the
VCs, averaging approximately 300% of the initial investment. Hence, they are also the
most commonly used exit routes. An IPO is also a preferred option by the company’s
management and/or the entrepreneur. IPO allows the original management to stay in
place and retain control of the company and also allows management who hold shares to
realize their value in the business or retain a share and benefit from the future growth of
the company. Example: SHAREKHAN, an Indian stock broking firm provided exit route
to three of its VCs (HSBC, Intel and Carlyl) holding 49% stake in the company in 2002
through an IPO.
Apart from the above, it is pertinent to note that the period 2003 – 04 onwards when the
private investors staged a comeback in the Indian Territory, the stock markets were at the
lower level and the valuations of the companies were not stretched. But now with such
high valuations, the private investors would be skeptical about investing liberally and
would be all the more choosy in making their investment decision in future. However,
investment bankers feel that even though now private investors would have to be choosy
but still there are several opportunities available in the Indian markets. To quote Mr.
Nandakumar Ranganathan, Head, Investment Banking, DBS Bank, “Going ahead, the
challenge for PE players will be to go beyond the obvious opportunities and mine out
undiscovered sectors. Companies need to be convinced about the value proposition,
which companies bring to the table, in addition to the funding”.

What VCs look for while funding a business

April 11, 2007, www.rediff.com, Co-author-Puneet Bambha

"In the world today, there's plenty of technology, plenty of entrepreneurs, plenty of money, plenty of venture capital. What's in short supply are great teams." -- John Doerr, Partner, KPCB.

Early investors in amazon.com, Apple Computers and the Body Shop got returns of 260, 1,692 and 10,500 times their initial investments, respectively. That's mind boggling. Now let's look at some other numbers.
According to http://www.1000ventures.com/, only six out of 1,000 business plans get funded on an average. Only about 5 per cent of the business plans are read beyond the executive summary and 10 per cent of proposals pass initial screening. Only and only 10 per cent of these screened proposals pass due diligence and receive funding.

The investor, at whichever stage of the venture he might be investing, as per a report by Lehman Brothers, makes detailed evaluation of the quality of people, quality of business and the quality of investment involved. A decision to invest is reached after several rounds of presentations and negotiations.

The most difficult to assess is however the quality of people. As John Doerr rightly put it, 'What's in short supply are great teams.'
So given a great idea, a great business plan, and plenty of money, will the people involved be able to pull the project through to make great returns possible for the investors?
Before deciding to invest in a project, venture capitalists (for the purpose of ease, we are using venture capitalists as the term representative of incubators, angel investors, private equity investors and mezzanine financiers) undertake a series of steps to evaluate the project.
The following paragraphs broadly explain the various steps of the evaluation process.

Initial Screening: VCs are in the business of making more than the average returns and only the proposals which can match or exceed the VCs expectation will get an attention from them. Thus initial screening is a step in which the venture capitalist reaches an initial decision to investigate further the investment (or not).

The initial screen is a cursory glance at the business plan to determine whether or not the proposal fits within the investor's areas of expertise. VCs carry out initial screening of all projects on the basis of some broad criteria.
For example, the screening process may limit projects to areas with which the venture capitalist is familiar in terms of product, technology or market scope. The size of investment, stage of financing and geographical location could also be used as the broad screening criteria.
Detailed Business Plan: If the plan manages to clear the initial screening round then the VCs call for the detailed business plan from the entrepreneur. The business plan is the main tool with the help of which VC would make up his mind. Thus the entrepreneur should present clarity of thinking about the business in the plan as the "Surprises can be great for parties, but potentially could be fatal for businesses."
Due Diligence: In the next and the most important phase, due diligence is conducted by the VC to verify the accuracy of the statements made by the entrepreneur. The two main types of due diligence conducted are Business and Legal.
The legal due diligence involves verification of the documents by the lawyers of the VC. These documents include Memorandum and Articles of the Association, important contracts, patents, copyrights, et cetera.

Business due diligence involves looking at the quality of people, quality of business and the quality of investment. Quality of people is one of the most important criteria. There is unanimity among theorists that venture capitalists prefer a Grade A team with a Grade B idea to a Grade B team with a Grade A idea. However, how the quality of team is evaluated is a source of controversy.

Many feel that the integrity of the team members is the most important criterion. Past research shows that trustworthiness, enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. It has also been seen that about 50-60 per cent of the projects which are seriously considered for financing but are ultimately rejected is due to the factors related to the entrepreneur.
The other major consideration is quality of business. Some VCs, especially the early stage ones, may not give a lot of importance to details; however, the idea must necessarily and clearly signify a distinct and unique competitive advantage.
Generally, market potential and attractiveness are an integral part of a marketing plan.
Though visibility and transparency in a business may not necessarily increase its attractiveness, it is more of a necessity. One of the most important considerations for VCs while judging an investment proposal is clarity of the exit mode and the expected return from the project, which is quality of the investment. This is because the VC is ultimately a fund and they (like mutual fund managers) need to manage their portfolio to get maximum return.
Dr A K Mishra of IIM Lucknow, conducted a detailed study in the year 2001 on the investment evaluation criteria used by the Indian venture capitalists. Even though the study was conducted six years back, its findings are still relevant and confirm the findings of researchers globally.
Mishra found the entrepreneurs' personality (integrity, attention to detail, long term vision, etc.) to be the most important criteria for the VC, followed by growth prospects of the business.
Finally, if the VC is positive after the due diligence, he will issue a term sheet which is an indication that he is seriously looking at the proposal. It is pertinent to note that the term sheet is not the final document, but only a basis for further negotiations.
So, behind those mind boggling returns lies serious evaluation. Apart from luck and being in the right business at the right time, venture capitalists must also be given due credit for the detailed evaluation that they carry out before deciding to invest.