money market and commercial papers

8/8/2019 money market and commercial papers

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HISTORY OF INDIAN MONEY MARKET

Till 1935, when the RBI was set up the Indian money market remained highly, unorganized,

shallow, disintegrated, narrow and therefore, very backward. The planned economicdevelopment that commenced in the year 1951 market an important beginning in the annals of the Indian money market.

The nationalization of banks in 1969, setting up of various committees such as the Sukhmoy

Chakraborty Committee (1982), the Vaghul working group (1986), the setting up of discountand finance house of India ltd. (1988), the securities trading corporation of India (1994) and thecommencement of liberalization and globalization process in 1991 gave a further fillip for theintegrated and efficient development of India money market.

OVER VIEW OF INDIAN MONEY MARKET

The money market is a mechanism that deals with the lending and borrowing of short term funds. The India Money Market has come of age in the past two decades. In order to study themoney market of India in detail, we at first need to understand the parameters around which themoney market in India revolves.

The performance of the Indian Money Market is heavily dependent on real interest rate that isthe interest rate that is inflation adjusted. Though the money market is free from interest rate

ceilings, structural barriers and other institutional factors can be held responsible for creatingdistortions in India Money Market. Apart from the call market rates, the other interest rates in theIndian Money Market usually do not change in the short run.

It is due to this disparity between the opposite forces that is prevalent in the money market inIndia that a well defined income path cannot be traced.

Owing to the deregulation of the interest rate in the early nineties following the economicreforms laid down by the then finance minister Dr. Manmohan Singh, studies concerning the behavior of interest rate were restricted. However the liquidity of the market makes its goodsubject for empirical research.

The Indian Money Market involves a wide range of instruments. Here, maturities range from oneday to a year, issued by banks and corporate of various sizes. The money market is also closelylinked with the Foreign Exchange Market through the process of covered interest arbitrage inwhich the forward premium acts as a bridge between domestic and foreign interest rates.

It is a centre in which financial institutions join together for the purpose of dealing in financial or monetary assets, which may be of short term maturity or long term maturity. The short term



means, generally a period up to one year and the term near substitutes to money, denotes anyfinancial asset which can be quickly converted into money with minimum transaction cost.

MONEY MARKET

INTRODUCTION TO MONEY MARKET

Money market refers to the market where money and highly liquid marketable securities are bought and sold having a maturity period of one or less than one year. It is not a place like thestock market but an activity conducted by telephone.

FINANCIAL

MARKETS

MONEY

MARKET

CAPITAL

MARKET



The money market constitutes a very important segment of the Indian financial system. Thehighly liquid marketable securities are also called as µ money market instruments¶ like

treasury bills, government securities, commercial paper, certificates of deposit, call money,

repurchase agreements etc.

The major player in the money market are Reserve Bank of India (RBI), Discount and FinanceHouse of India (DFHI), banks, financial institutions, mutual funds, government, big

corporate houses.

The basic aim of dealing in money market instruments is to fill the gap of short-term liquidity problems or to deploy the short-term surplus to gain income on that.

ELEMENTS OF MONEY MARKET

1. Call Money: Money lent for one day

2. Notice Money: Money lent for a period exceeding one day

3. Term Money: Money lend for 15 days or more in Inter-bank market

4. Held till maturity: Securities which are not meant for sale and shall be kept till maturity

5. Held for trading: Securities acquired by the banks with the intention to trade by taking

advantage of the short-term price/ interest rate movements will be classified under held for trading.

6. Available for sale: The securities which do not fall within the above two categories i.e. HTMor HFT will be classified under available for sale.

7. Yield to maturity: Expected rate of return on an existing security purchased from the market.

8. Coupon Rate: Specified interest rate on a fixed maturity security fixed at the time of issue.

9. Treasury operations: Trading in government securities in the market. An investor Bank can

purchase these securities in the primary market. Trading takes place in the secondary market.

DEFINITION OF MONEY MARKET

According to the McGraw Hill Dictionary of Modern Economics, ³money market is the termdesigned to include the financial institutions which handle the purchase, sale, and transfers of short term credit instruments. The money market includes the entire machinery for thechannelizing of short-term funds. Concerned primarily with small business needs for working



capital, individual¶s borrowings, and government short term obligations, it differs from the longterm or capital market which devotes its attention to dealings in bonds, corporate stock andmortgage credit.´

According to the Reserve Bank of India, ³money market is the centre for dealing, mainly of

short term character, in money assets; it meets the short term requirements of borrowings and provides liquidity or cash to the lenders. It is the place where short term surplus investible fundsat the disposal of financial and other institutions and individuals are bid by borrowers¶ agentscomprising institutions and individuals and also the government itself.´2 According to the Geoffrey, ³money market is the collective name given to the various firms andinstitutions that deal in the various grades of the near money.´

So after analyzing the above definitions, we can easily conclude withthe following features of MONEY MARKET .

Short-term funds are borrowed and lent.

No fixed place for conduct of operations, the transactions being conducted even over the phone and therefore, there is an essential need for the presence of well developedcommunications system.

Dealings may be conducted with or without the help the brokers.

The short-term financial assets that are dealt in are close substitutes for money, financial assets being converted into money with ease, speed, without loss and with minimum transaction cost. Funds are traded for a maximum period of one year.

Presence of a large number of submarkets such as inter-bank call money, bill rediscounting,and treasury bills, etc.

Short term credit is involved.

Institutions involved in channelizing short term credit.

Concerned with operating needs of financial institutions.

To fulfill short term obligations by government.

OBJECTIVES OF MONEY MARKET

A well developed money market serves the following objectives:

Providing an equilibrium mechanism for ironing out short-term surplus and deficits.



Providing a focal point for central bank intervention for the influencing liquidity in theeconomy.

Providing access to users of short-term money to meet their requirements at a reasonable price.

MONEY MARKET INSTRUMENTS

Money market instruments are generally characterized by a high degree of safety of principal andare most commonly issued in units of $1 million or more. Maturities range from one day to oneyear; the most common are three months or less. Active secondary markets for most of theinstruments allow them to be sold prior to maturity. Unlike organized securities or commoditiesexchanges, the money market has no specific location.

Available from financial institutions, money markets give the smaller investor the opportunity toget in on treasury securities. The institution buys a variety of treasury securities with the money

you invest. The rate of return changes daily, and services such as check writing may be offered.

The major participants in the money market are commercial banks, governments,

corporations, government-sponsored enterprises, money market mutual funds; futures

market exchanges, brokers and dealers.

Investment in money market is done through money market instruments. Money marketinstrument meets short term requirements of the borrowers and provides liquidity to the lenders.

C ommon Money Market Instruments are as follows:

1. Treasury Bills2. Repurchase Agreements (Repo/Reverse Repo)3. Call Money4. Commercial paper 5. Certificate of Deposits6. Bankers Acceptance

INDIAN MONEY MARKET CURRENT POSITION

India market news is the topic of discussion for every investor nationwide. The global economicdownturn since the last quarter of 2008 has been gaining grounds until the Satyam scam. Thefourth-biggest software firm ± Satyam Computers, ever since its drastic crash and financialwrongdoing revelations, has been in India news and global news headlines affecting the Indiamoney market. India has many foreign investors and the economy not being very highly affecteddespite the global recession; more foreign investors are looking towards India as a safe andsecured investment destination. But as India market news make plain, the Satyam scandal may prove to be a huge loss to India, prompting foreign investors to leave India.



Strengthening of the Indian rupee and loss of dollar over the last week of December 08 and firstweek of January brought in a ray of hope amongst investors, thus raising the importance of Indiamoney market. Data released by the India news recorded buying of local shares by overseasfunds. India market news further brought to light that with the Satyam scam, stock marketindices witnessed a 7.1 percent slump. Despite the two weeks¶ rise of the rupee, it again

slumped down due to the Satyam effect.

India money market is flooded with news like µ NSE removing Satyam from Nifty, replacing the

position with Rel C apital¶ , µSatyam losing Rs 10, 000 crore in market cap¶ , etc. The Indiamarket news on 7th evening shook domestic as well as global investor confidence affectingmany other top companies. Overall, the situation is expected to improve and India money marketis again going to witness a rise. Thanks to the corrective measures taken by the RBI as well asthe government. With the lending rate cut by 350 basis points by the RBI as well as the 200

billion rupee ($4 billion) stimulus package announced by the government will help materializethe 7% growth target. Duties cut on manufactured products further add to the boost. What theIndia news reveals currently is not expected to be the same.

REVIEW OF LITERATURE

Article: India call money ends near reverse repo rate, cash ample

Reuters, 2/9/2009, Indian overnight money rates brought down to near the reverse repo rate of 3.25% on Wednesday as this cash surplus in the system will help banks meet their reserve needscomfortably. Cheaper money available at the collateralized borrowing and lending obligation(CBLO) also eased pressure on the inter-bank cash rates. At that day banks were guided to report

their position to RBI once in two weeks. This amendment crated a expectation on liquidityresistance. Some analysts said the central bank may start rolling back the liquidity as early asDecember 2009, as the already pressured consumer prices could pose significant inflationarythreat to the economy, amid easy cash conditions Overnight rates are supported around thereverse repo rate because banks holding surplus funds could also deploy the same with central bank at that rate in its daily liquidity adjustment auctions.

Article: Money Market Integration in India: A Time Series Study

Rastogi Nikhil, Says Indian financial markets have come a long way from the highly controlled pre-liberalization era. He signifies that the main focus is on achieving efficiency, which is the

hallmark of any developed financial market. This research paper tests the efficiency and extentof integration between financial markets empirically at the short end of the market. The rates,mainly taken for the purpose of this study, comprise the call market rate, CD (Certificate of Deposit) rate, CP (Commercial Paper) rate, 91-day T-bill (Treasury bill) rate and 3-monthforward premium. The results, though promising, are mixed. In his research he concluded thatalthough markets have achieved integration in some of its branches, they have still to achieve fullintegration. This has absolute implications on the monetary policy of the Reserve Bank of India



(RBI) since changes in one market (gilt market) can be used to regulate the other market (forexmarket).

Article: Market efficiency and financial markets integration in India

Prusty Sadananda, June, 2007, The author explored the impact of economic reforms on theintegration of various segments of the financial market in India through the time series toolsduring the period from March 1993 to March 2005. The major findings were: (i) varioussegments of the financial market in India have achieved market efficiency, (ii) the 91-dayTreasury bill rate is the appropriate 'reference rate' of the financial sector in India, (iii) thefinancial markets in India are largely integrated at the short-end of the market, and (iv) the long-end of the market is integrated with the short-end of the market. The above findings suggest thatmonetary policy should rely more on interest rate and asset price channels to control inflation.

MONEY MARKET- CALL/NOTICE MONEY

Meaning:

Call/Notice money is the money borrowed or lent on demand for a very short period.When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Interveningholidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day andrepaid on the next working day, (irrespective of the number of intervening holidays) is "CallMoney". When money is borrowed or lent for more than a day and up to 14 days, it is "NoticeMoney". No collateral security is required to cover these transactions.

The call/notice money market forms an important segment of the Indian Money Market. Under call money market, funds are transacted on overnight basis and under notice money market;funds are transacted for the period between 2 days and 14 days. The most active segment of themoney market has been the call money market, where the day to day imbalances in the funds position of scheduled commercial banks are eased out. The call notice money market hasgraduated into a broad and vibrant institution.

Participants in call/notice money market currently include banks (excluding RRBs) and Primarydealers both as borrowers and lenders. Non Bank institutions are not permitted in the call/noticemoney market with effect from August 6, 2005. The regulator has prescribed limits on the banks

and primary dealers operation in the call/notice money market.6Call money market is for very short term funds, known as money on call. The rate at which fundsare borrowed in this market is called `Call Money rate'. The size of the market for these funds inIndia is between Rs 60,000 million to Rs 70,000 million, of which public sector banks accountfor 80% of borrowings and foreign banks/private sector banks account for the balance 20%. Non-bank financial institutions like IDBI, LIC, and GIC etc participate only as lenders in this



market. 80% of the requirement of call money funds is met by the nonbank participants and 20%from the banking system.

In pursuance of the announcement made in the Annual Policy Statement of April 2006, anelectronic screen-based negotiated quote-driven system for all dealings in call/notice and term

money market was operational zed with effect from September 18, 2006. This system has beendeveloped by Clearing Corporation of India Ltd. on behalf of the Reserve Bank of India. TheNDS -CALL system provides an electronic dealing platform with features like Direct one to onenegotiation, real time quote and trade information, preferred counterparty setup, online exposurelimit monitoring, online regulatory limit monitoring, dealing in call, notice and term money,dealing facilitated for T+0 settlement type for Call Money and dealing facilitated for T+0 andT+1 settlement type for Notice and Term Money. Information on previous dealt rates, ongoing bids/offers on re al time basis imparts greater transparency and facilitates better rate discovery inthe call money market. The system has also helped to improve the ease of transactions, increasedoperational efficiency and resolve problems associated with asymmetry of information.

However, participation on this platform is optional and currently both the electronic platform andthe telephonic market are co-existing. After the introduction of NDS-CALL, market participantshave increasingly started using this new system more so during times of high volatility in callrates.

VOLUMES IN THE CALL MONEY MARKET

Call markets represent the most active segment of the money markets. Though the demand for funds in the call market is mainly governed by the banks' need for resources to meet their statutory reserve requirements, it also offers to some participants a regular funding source for

building up short -term assets. However, the demand for funds for reserve requirementsdominates any other demand in the market. Figure:1 displays the average daily volumes in thecall markets.



FIGURE:1

COMMITTEE RECOMMENDATION ON CALL MONEY MARKET

The Sukhumoy C hakravarty C ommittee:

The call money market for India was first recommended by the Sukhumoy ChakravartyCommittee, which was set up in 1982 to review the working of the monetary system. They feltthat allowing additional non-bank participants into the call market would not dilute the strengthof monetary regulation by the RBI, as resources from non-bank participants do not represent anyadditional resource for the system as a whole, and their participation in call money market wouldonly imply a redistribution of existing resources from one participant to another. In view of this,the Chakravarty Committee recommended that additional nonbank participants may be allowedto participate in call money market.

The Vaghul C ommittee Report:

The Vaghul Committee (1990), while recommending the introduction of a number of moneymarket instruments to broaden and deepen the money market, recommended that the call marketsshould be restricted to banks. The other participants could choose from the new money marketinstruments, for their short -term requirements. One of the reasons the committee ascribed tokeeping the call markets as pure inter-bank markets was the distortions that would arise in anenvironment where deposit rates were regulated, while call rates were market determined.



The Narasimham C ommittee II Report:

The Narasimham Committee II (1998) also recommended that call money market in India, likein most other developed markets, and should be strictly restricted to banks and primary dealers.Since non- bank participants are not subject to reserve requirements, the Committee felt that such

participants should use the other money market instruments, and move out of the call markets.

Following the recommendations of the Reserve Banks Internal Working Group (1997) and the Narasimham Committee (1998), steps were taken to reform the call money market bytransforming it into a pure interbank market in a phased manner. The nonbanks exit wasimplemented in four stages beginning May 2001 whereby limits on lending by nonbanks were progressively reduced along with the operationalization of negotiated dealing system (NDS) andCCIL until their complete withdrawal in August 2005. In order to create avenues for deploymentof funds by non-banks following their phased exit from the call money market, several newinstruments were created such as market repos and CBLO.

Various reform measures have imparted stability to the call money market. With thetransformation of the call money market into a pure inter-bank market, the turnover in thecall/notice money market has declined significantly. The activity has migrated to other overnightcollateralized market segments such as market repo and CBLO.

PARTICIPANTS IN THE CALL MONEY MARKET

As lenders and borrowers: Banks and institutions such as commercial banks, both Indian andforeign, State Bank of India, Cooperative Banks, Discount and Finance House of India ltd.(DFHL) and Securities Trading Corporation of India (STCI).

As lenders: Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), GeneralInsurance Corporation (GIC), Industrial Development Bank of India (IDBI), National Bank for Agriculture and Rural Development (NABARD), specified institutions already operating in billsrediscounting market, and entities/corporate/mutual funds.

The participants in the call markets increased in the 1990s, with a gradual opening up of the callmarkets to non-bank entities. Initially DFHI was the only PD eligible to participate in the callmarket, with other PDs having to route their transactions through DFHI, and subsequently STCI.In 1996, PDs apart from DFHI and STCI were allowed to end and borrow directly in the callmarkets. Presently there are 18 primary dealers participating in the call markets. Then from 1991onwards, corporate were allowed to lend in the call markets, initially through the DFHI, and later through any of the PDs. In order to be able to lend, corporate had to provide proof of bulk lendable resources to the RBI and were not suppose to have any outstanding borrowings with the banking system. The minimum amount corporate had to lend was reduced from Rs. 20 crore, in a phased manner to Rs. 3 crore in 1998. There were 50 corporate eligible to lend in the callmarkets, through the primary dealers. The corporate which were allowed to route their transactions through PDs, were phased out by end June 2001.



Banks and PDs technically can operate on both sides of the call market, though in reality, onlythe P Ds borrow and lend in the call markets. The bank participants are divided into twocategories: banks which are pre- dominantly lenders (mostly the public sector banks) and bankswhich are pre- dominantly borrowers (foreign and private sector banks). Currently, the participants in the call/notice money market currently include banks (excluding RRBs) and

Primary Dealers (PDs) both as borrowers and lenders.

OPEREATIONS IN CALL MONEY

Borrowers and lenders contact each other over telephone.

The borrowers and lenders arrive at a deal specifying the amount of loan and the rate of interest.

After the deal is over, the lender issues FBL cheque in favor of the borrower.

The borrower in turn issues call money borrowing receipt.

When the loan is repaid with interest, the lender returns the duly discharged receipt.

The deal can be directly negotiated by routing it through the Discount and Finance House of India (DFHI).

The borrowers and lenders inform the DFHI about their fund requirement and availability at aspecified rate of interest.

Once the deal is confirmed, the Deal Settlement Advice is exchanged.

In case the DFHI borrows, it issues a call deposit receipt to the lender and receives RBI chequefor the money borrowed. The reverse takes place in the case of lending by the DFHI.

The duly discharged call deposit receipt is surrendered at the time of settlement.

´ C all loans can be renewed upto a maximum period of 14 days only and such renewals

are recorded on the back of the deposit receipt by the borrower.



CALL MONEY RATES

The rate of interest on call funds is called money rate. Call money rates are characteristics in thatthey are found to be having seasonal and daily variations requiring intervention by RBI and other institutions.

The concentration in the borrowing and lending side of the call markets impacts liquidity in thecall markets. The presence or absence of important players is a significant influence on quantityas well as price. This leads to a lack of depth and high levels of volatility in call rates, when the participant structure on the lending or borrowing side alters.

Short-term liquidity conditions impact the call rates the most. On the supply side the call ratesare influenced by factors such as: deposit mobilization of banks, capital flows, and banks¶

reserve requirements; and on the demand side, call rates are influenced by tax outflows,

government borrowing programme, seasonal fluctuations in credit off take. The external

situation and the behavior of exchange rates also have an influence on call rates, as most

players in this market run integrated treasuries that hold short term positions in both rupee andforex markets, deploying and borrowing funds through call markets.

Table 2: Call Money Rates



During normal times, call rates hover in a range between the repo rate and the reverse repo

rate. The repo rate represents an avenue for parking short -term funds, and during periods

of easy liquidity, call rates are only slightly above the repo rates. During periods of tight liquidity, call rates move towards the reverse repo rate. Table provides data on the

behavior of call rates. Table: displays the trend of average monthly call rates.

The behavior of call rates has historically been influenced by liquidity conditions in the

market. Call rates touched a peak of about80% in March 2006-07, reflecting tight liquidity

on account of high levels of statutory pre-emotions and withdrawal of all refinance

facilities, barring export credit refinance.

PRUDENTIAL LIMITS

The prudential limits in respect of both outstanding borrowing and lending transactions incall/notice money market for banks and PDs are as follows:-Table: 3 Prudential Limits for Transactions in Call/Notice Money Market



Non-bank institutions are not permitted in the call/notice money market with effect from August6, 2005.

REPORTING REQUIREMENT

All dealings in call/notice money on screen-based negotiated quote-driven system (NDS-CALL)launched since September 18, 2007 do not require separate reporting. It is mandatory for all Negotiated Dealing System (NDS) members to report their call/notice money market deals (other than those done on NDS-CALL) on NDS. Deals should be reported within 15 minutes on NDS,irrespective of the size of the deal or whether the counterparty is a member of the NDS or not. Incase there is repeated non-reporting of deals by an NDS member, it will be considered whether non-reported deals by that member should be treated as invalid.

The reporting time on NDS is up to 5.00 pm on weekdays and 2.30 pm on Saturdays or as

decided by RBI from time to time.

With the stabilization of reporting of call/notice money transactions over NDS as also to reducereporting burden, the practice of reporting of call/notice/term money transactions by fax to RBIhas been discontinued with effect from December 11, 2004.13However, deals between non-NDS members will continue to be reported to theFinancial Markets Department (FMD) of RBI by fax as hitherto.

HOW AND WHY CALL MONEY MARKET

W hy does a bank borrow in the call market?

Banks borrow in the call market to meet any temporary shortfall PROBLEM OF Liquidityfunds on any given day. There are mainly two reasons why a bank may face such a shortfall.Banks normally lend out of the deposits that they mobilize. But there are temporary gaps, or mismatches. The call money market is used to manage these gaps.

The second reason is to meet the cash reserve ratio (CRR ) which is the cash reserves it must

maintain with the Reserve Bank of India, to meet daily cash needs of the banks¶ clientele. InIndia, banks have to keep 4.5 percent (it fluctuates with changing economic conditions) of alltheir borrowings from the public (in the form of savings and term deposits) and other banks withRBI. The CRR is calculated on the basis of the bank¶s borrowing or net time and demandliabilities (NDTL), broadly its deposit base, every alternate Friday. This day is also called thereporting Friday, on which the banks report their positions to the RBI.



F or how long can a bank borrow these funds?

Technically, the call money market is an overnight money market. But a bank can borrow thesefunds for one day up to 14 days. Normally, funds are borrowed for one day, and up to three dayson weekends.

How is the rate of interest paid?

The rate of interest is calculated on a daily basis; but the rate quoted in the market is anannualized one. Once the deal is struck the funds are immediately available to the borrowing bank and are returned with interest the next day. The funds are lent and paid back through a banker¶s pay order which is cleared by the special high value banker¶s clearing cell in the RBI.

C an the RBI lend in the call market? W hat does intervention by the central bank mean?

The RBI is the market regulator and cannot lend or borrow funds in the call market. However,

as a regulator, it can intervene in the market as it did when rates go through the roof. Itintervenes in the market through two market intermediaries ± the Securities Trading

Corporation of India and Discount Finance House of India. The STCI lends funds against thegovernment securities that a bank holds with an offer to sell back the security (calledrepurchases or repos), while the DFHI lends funds that it receives from the central bank against

repos of certain securities specified as eligible for them. The RBI also allows banks torediscount proceeds of export bills of exchange.

W hy do rates fluctuate? W hat does this indicate?

The rates fluctuate in the market depending on the demand and supply of money in the market.High rates indicate a tightness of liquidity position. In India, rates in the call market are prone tofluctuations and are unidirectional. This is due to the fact that it has a limited number of playerswhose needs are similar.

COMMERCIAL PAPERS

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It was introduced in India in 1990 with a view to enabling highly ratedcorporate borrowers/ to diversify their sources of short-term borrowings and to provide an

additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations.

A commercial paper is an unsecured short-term instrument issued by the large banks andcorporations in the form of promissory note, negotiable and transferable by endorsement anddelivery with a fixed maturity period to meet the short-term financial requirement. There are four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit.



It is generally issued at a discount by the leading creditworthy and highly rated corporate.Depending upon the issuing company, a commercial paper is also known as ³Financial paper,industrial paper or corporate paper´. Commercial paper was initially meant to be used by thecorporate borrowers having good ranking in the market as established by a credit rating agencyto diversify their sources of short term borrowings at a rate which was usually lower than the

bank¶s working capital lending rate.

Commercial papers can now be issued by primary dealers, satellite dealers, and all- Indiafinancial institutions, apart from corporatist, to access short-term funds. Effective from 6thSeptember 1996 and 17th June 1998, primary dealers and satellite dealers were also permitted toissue commercial paper to access greater volume of funds to help increase their activities in thesecondary market. It can be issued to individuals, banks, and companies and other registeredIndian corporate bodies and unincorporated bodies. It is issued at a discount determined by theissuer company. The discount varies with the credit rating of the issuer company and the demandand the supply position in the money market. In India, the emergence of commercial paper hasadded a new dimension to the money market.

SALIENT FEATURES

They are unsecured debts of corporate and are issued in the form of promissory notes,redeemable at par to the holder at maturity.

Only corporate who get an investment grade rating can issue CPs, as per RBI rules.

It is issued at a discount to face value.

Attracts issuance stamp duty in primary issue.

Has to be mandatorily rated by one of the credit rating agencies.

It is issued as per RBI guidelines.

It¶s held in De-mat form.

CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by asingle investor should not be less than Rs.5 lakh (face value).

Issued at discount to face value as may be determined by the issuer.

Bank and FI¶s are prohibited from issuance and underwriting of CP¶s.

Can be issued for a maturity for a minimum of 15 days and a maximum up to one year fromthe date of issue.



Figure 4. Commercial Paper Issue Mechanism

ADVANTAGES OF COMMERCIAL PAPER

High credit ratings fetch a lower cost of capital. Wide range of maturity provides more flexibility. It does not create any lien on asset of the company. Tradability of Commercial Paper provides investors with exit options.

DISADVANTAGES OF COMMERCIAL PAPER

Its usage is limited to only blue chip companies. Issuances of Commercial Paper bring down the bank credit limits. A high degree of control is exercised on issue of Commercial Paper. Stand-by-credit may become necessary.

ISSUANCE PROCESS OF COMMERCIAL PAPER



In the developed economies, a substantial portion of working capital requirement especiallythose that are short-term, is promptly met through flotation of commercial paper. Directlyaccessing market by issuing short-term promissory notes, backed by stand-by or underwritingfacility enables the corporate to leverage its rating to save on interest costs.

Typically commercial paper is sold at a discount to its face value and is redeemed at face value.Hence, the implicit interest rate is function of the size of discount and the period of maturity.Scheduled commercial banks are major investors in commercial paper and their investment isdetermined by bank liquidity conditions. Banks prefer commercial paper as an investmentavenue rather than sanctioning bank loan. These loans involve high transaction costs and moneyis locked for a longer time period whereas a commercial paper is an attractive short-terminstrument for banks to park funds during times of high liquidity. Some banks fund commercial papers by borrowing from the call money market. Usually, the call money market rates are lower than the commercial paper rates. Hence, banks book profits through arbitraged between the twomoney markets. Moreover, the issuance of commercial papers has been generally observed to beinvested related to the money market rates.

Illustration 3.1.

X co.ltd issued commercial paper as per following details:

Date of issue 17th January, 2009 No. of days 90 daysDate of maturity 17th April, 2009 Interest rate 11.25% p.a.

What was the net amount received by the company on issue of commercial paper?

Let us assume that the company has issued commercial paper worth Rs.10 crores?

No of days = 90 daysInterest rate = 11.25 % p.a.

Interest for 90 days = 11.25% p.a. X 90 days/ 365 days = 2.774%

= 10 Crores X 2.774 / 100+2.774 = Rs. 26, 99,126 Crores

= or 0.27 Crores

Therefore, net amount received at the time of issue = 10 crores ± 0.27 crores= Rs. 9.73 crores

RBI GUIDELINES ON ISSUE OF COMMERCIAL PAPER

The summary of RBI guidelines for issue of Commercial paper is given below:



Corporate, primary dealers, satellite dealers and all India financial institutions are permitted toraise short term finance through issue of commercial paper, which should be within the umbrellalimit fixed by RBI.18 A corporate can issue Commercial Paper if:

1. Its tangible net worth is not less than Rs.5 Crores as per latest balance sheet.2. Working capital limit is obtained from banks/ all India financial institutions, and3. Its borrowable account is classified as standard asset by banks/ all India financial institutions.

Credit rating should be obtained by all eligible participants in cp issue from the specifiedcredit rating agencies like CRISIL, ICRA, CARE, and FITCH. The minimum rating shall beequivalent to P-2 of CRISIL.

Commercial paper can be issued for maturities between a minimum of 15 days and amaximum of up to one year from the date of issue.

The maturity date of commercial paper should not exceed the date beyond the date up towhich credit rating is valid.

It can be issued in denomination of Rs. 5 lakhs or in multiples thereof.

Amount invested by a single investor should not be less than Rs. 5 lakhs (face value).

A company can issue commercial paper to an aggregate amount within the limit approved by board of directors or limit specified by credit rating agency, whichever is lower.

Banks and financial institutions have the flexibility to fix working capital limits duly takinginto account the resource pattern of company¶s financing including commercial papers.

The total amount of commercial paper proposed to be issued should be raised within a periodof two weeks from the date on which the issuer opens the issue for subscription.

Commercial paper may be issued on a single date or in parts on different dated provided thatin the latter case, each commercial paper shall have the same maturity date.

Every commercial paper should be reported to RBI through issuing and paying agent (IPA).

Only a scheduled bank can act as an IPA.19 Commercial paper can be subscribed by individuals, banking companies, corporate, NRIs andFIIs.

It can be issued either in the form of a promissory note or in a dematerialized form.

It will be issued at a discount to face value as may be determined by the issuer.



Issue of commercial paper should not be underwritten or co-accepted.

The initial investor in commercial paper shall pay the discounted value of the commercial paper by means of a crossed account payee cheque to the account of the issuer through IPA.

On maturity, if commercial paper is held in physical form, the holder of commercial paper shall present the investment for payment to the issuer through IPA.

When the commercial paper is held in De-mat form, the holder of commercial paper will haveto get it redeemed through depository and received payment from the IPA.

Commercial paper is issued as a µstand alone¶ product. It would not be obligatory for banksand financial institutions to provide stand-by facility to issuers of commercial paper.

Every issue of commercial paper, including renewal, should be treated as a fresh issue.

GROWTH IN THE COMMERCIAL PAPER MARKET

Commercial paper was introduced in India in January 1990, in pursuance of the VaghulCommittee¶s recommendations, in order to enable highly rated non-bank corporate borrowers todiversify their sources of short term borrowings and also provide an additional instrument toinvestors. Commercial paper could carry on an interest rate coupon but is generally sold at adiscount. Since commercial paper is freely transferable, banks, financial institutions, insurancecompanies and others are able to invest their short-term surplus funds in a highly liquid

instrument at attractive rates of return.

A major reform to impart a measure of independence to the commercial paper market took placewhen the µstand by¶ facility* of the restoration of the cash credit limit and guaranteeing funds tothe issuer on maturity of the paper was withdrawn in October 1994. As the reduction in cashcredit portion of the MPBF impeded the development of the commercial paper market, theissuance of commercial paper was delinked from the cash credit limit in October 1997. It wasconverted into a standalone product from October 2000 so as to enable the issuers of the servicesector to meet short-term working capital requirements.

Banks are allowed to fix working capital limits after taking into account the resource pattern of the company¶s finances, including commercial papers. Corporate, PDs and all-India financialinstitutions (FIs) under specified stipulations have permitted to raise short term resources by theReserve Bank through the issue of commercial papers.

There is no lock in period for commercial papers. Furthermore, guidelines were issued permitting investments in commercial papers which has enabled a reduction in transaction cost.In order to rationalize the and standardize wherever possible, various aspects of processing,settlement and documentation of commercial paper issuance, several measures were undertaken



with a view to achieving the settlement on T+1 basis. For further deepening the market, theReserve Bank of India issued draft guidelines on securitization of standard assets on April 4,2005.Accordingly the reporting of commercial papers issuance by issuing and paying agents (IPAs) on NDS platform commenced effective on April 16, 2005. Activity in the commercial paper market

reflects the state of market liquidity as its issuances tend to rise amidst ample liquidity conditionswhen companies can raise funds through commercial papers at an effective rate of discountlower than the lending rate of bonds.

Banks also prefer investing in commercial papers during credit downswing as the commercial paper rate works out higher than the call rate. Table shows the trends in commercial papers ratesand amounts outstanding.

Table Commercial Papers - Trends in Volumes and Discount Rates.

Characteristics of CP Market in India vis-à-vis Other Major CP Markets in the

World

ISSUERS

Initially, only highly rated corporate borrowers were allowed to issue CP to diversify their short-term borrowings. Primary Dealers (PDs) were allowed in this market, subject to fulfilling the



eligibility criteria, on April 15, 1997. Thereafter, all-India financial institutions (FIs) that have been permitted to raise short-term resources under umbrella limit fixed by RBI were permitted toissue CP since October 10, 2000.Internationally, there is no restriction on issuers in UK. In USA, both financial and nonfinancialissuers are allowed to issue CP. In France, CPs are mainly issued by investment firms, public

companies, community institutions and international organizations of which France is a member.22

MATURITY PERIOD

Initially, corporate were permitted to issue CP with a maturity between a minimum of threemonths and a maximum of upto six months from the date of issue. Since October 18, 1993, themaximum maturity period of CP was increased to less than one year.

Subsequently, the minimum maturity period had been reduced from time to time and since May25, 1998, it was reduced to 15 days. Presently, CP can be issued for maturity period between aminimum of 15 days and a maximum upto one year from the date of issue.

As against this, in USA, there is no prescription of minimum and maximum maturity period of CP but for practical matter, it is limited upto 270 days. However, 1-day to 7- day CPs is very popular of which 1-day CP constitutes the substantial component of the CP market. In UK also,there is no restriction but in France, initial maturity ranges from 1 day to up to 1 year.

C REDIT RATINGS

All eligible participants are required to obtain credit rating for issuance of CP from either theCredit Rating Information Services of India Ltd. (CRISIL) or such other credit rating agency(CRA) as approved by the Securities and Exchange Board of India (SEBI) from time to time for the purpose. Initially, the minimum credit rating was stipulated at P1+ of CRISIL. It wassoftened to P1 of CRISIL or such equivalent rating by other agencies on April 24, 1990 andfurther to P2 of CRISIL or its equivalent on May 13, 1992. As of now, the minimum credit ratingshall be P2 of CRISIL or its equivalent.

In UK, France and USA, rating is not compulsory. However, in US, CPs should generally havethe rating of A1/P1 (the highest category) for generating investor interest.

LIMITS AND THE AMOUNT OF ISSUE OF C P

The entry criteria for issuance of CP have been relaxed considerably over the years. In 1990, acorporate was eligible to issue CP provided the tangible net worth of the company, as per thelatest audited balance sheet, was not less than Rs.10 crore. This was reduced to Rs.5 crore onApril 24, 1990 and further to Rs.4 crore on October 18, 1993. Also, initially, issuance of CP hadto be carved out of the working capital (fund based) limit. Accordingly, in 1990, a companycould issue CP upto 20 per cent of its working capital (fund based) limit which was stipulated to be not less than Rs.25 crore.



Thereafter, while the working capital limit had been reduced progressively to enable morecorporate to issue CP, the amount to be carved out of the working capital limit for issuance of CPwas also increased over the years for facilitating the growth of this market. Accordingly, whilethe working capital (fund based) limit was reduced to "not less than Rs.4" crore on October 18,1993, the amount of CP that could be issued out of the working capital was also raised upto 100

per cent of the companies' working capital limit of Rs.20 crore or more since June 20, 1996.The organic link of issuance of CP in relation to working capital (fund based) limit was severedon October 10, 2000 when CP was allowed to be issued as a "stand alone" product.

The aggregate amount of CP from an issuer, however, has to be within the limit as approved byits Board of Directors or the quantum indicated by the credit rating agency for the specifiedrating, whichever is lower. Banks and FIs, however, have the flexibility to fix working capitallimits duly taking into account the resource pattern of companies¶ financing needs including CPs.An FI can issue CP within the overall umbrella limit fixed by the RBI i.e., issue of CP together with other instruments viz., term money borrowings, term deposits, certificates of deposit andinter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest

audited balance sheet.

In USA and UK, there is no limit on the amount of CP that the entities may issue.

DENOMINATION

At the time of introduction, with effect from January 1, 1990, it was stipulated that CP may beissued in multiple of Rs.25 lakh and the amount to be invested by a single investor should not to be less than Rs.1 crore (face value). Subsequently, on April 24, 1990, the minimumdenomination was reduced to Rs.10 lakh and amount to be invested by a single investor was alsoreduced to Rs.50 lakh. At present, CP can be issued in denominations of Rs.5 lakh or multiplethereof and amount invested by a single investor should not be less than Rs.5 lakh (face value).24Internationally, in USA, there is no required minimum size of issue. However, it is usually issuedin minimum denomination of $1, 00,000. In France, the minimum amount stands at EUR 1, and50,000 and in UK, it stands at EUR 40,000.

INVESTORS IN THE C P MARKET

Initially, it was stipulated that CP can be issued to and held by individuals, banks, companies,other corporate bodies registered or incorporated in India and unincorporated bodies. CP may beissued to a non-resident Indian (NRI) on a non-repatriation basis and that those CPs shall not betransferable. Also, Foreign Institutional Investors (FIIs) were added as eligible investors in CPmarket in October 2000. However, investment by FIIs would be within the limits set for their investments by SEBI.

In USA, investors include money market mutual funds, banks, insurance companies and pensionfunds.

DEMATERIALIZATION



With effect from June 30, 2001, banks, FIs and PDs have been encouraged to make freshinvestments and hold CP only in dematerialized form. Outstanding investments in scrip form inthe books of banks, FIs and PDs were to be converted into dematerialized form by October 31,2001.

Internationally, in USA and France, CPs are issued in dematerialized form. In UK, fullydematerialized system does not exist though by market convention, Euro CP is issued in the formof an immobilized global certificate lodged with a central depository e.g., Euro clear/Clear stream.

Factors Hampering Growth of CP Market

Some of the factors which have hampered active growth of CP market in India are as follows:

(i) The linking of CP to working capital limits. Market participants have suggested that CP

should be made a "stand alone" product.

(ii) At present, for issuance of CP approval or NOC is required from the Financing BankingCompany. This NOC/approval is valid for a period of two weeks from the date of its issuance.Furthermore, rating for the issuance of CP has to be current and not more than 2 months old.Market participants perceive these stipulations as impediments to the development of CP market.

(iii) The difference in stamp duty rates as between banks and other entities has createdoperational difficulties. There is at present, inter-state disparities as also investor-wisedifferences in stamp duty rates. Further, there is tenor-wise slab structure of stamp duty as

given below:

TENOR RATE FOR

BANKS NON-BANKS

UPTO 90 days 0.05 0.125

91-180 days 0.15 0.375

181-364 days 0.20 0.50

Secondary market transactions in CP, however, do not attract any stamp duty. This divergence instamp duty for banks and non-banks has created some distortions in the market and alsoencouraged some mal-practices. All primary issues of CP are almost exclusively subscribed to by

banks and non-banks buy CP from banks in the secondary market. Further, CP issues withmaturity of less than 90 days are generally not preferred.

(iv) Procedure to issue CP in physical form is quite cumbersome. The concerned corporate haveto arrange for stamping of all the certificates, which is time consuming. Furthermore, copies of all the documents have to be given to all the investors along with the CP certificate.

(v) No reliable bench mark is available in the market for pricing CP.



Findings

181. A corporate can issue Commercial Paper if:

y Its tangible net worth is not less than Rs.5 Crores as per latest balance sheet.

y Working capital limit is obtained from banks/ all India financial institutions, andy Its borrowable account is classified as standard asset by banks/ all India financial

institutions.

2. Commercial paper can be issued for maturities between a minimum of 15 days and amaximum of up to one year from the date of issue.

3. It can be issued in denomination of Rs. 5 lakhs or in multiples thereof and the amountinvested by a single investor should not be less than Rs. 5 lakhs (face value).

4. A company can issue commercial paper to an aggregate amount within the limit approved

by board of directors or limit specified by credit rating agency, whichever is lower.

5. The total amount of commercial paper proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription.

6. Commercial paper may be issued on a single date or in parts on different dated providedthat in the latter case, each commercial paper shall have the same maturity date.

7. Every commercial paper should be reported to RBI through issuing and paying agent(IPA). Only a scheduled bank can act as an IPA.

8. 19

9. On maturity, if commercial paper is held in physical form, the holder of commercial paper shall present the investment for payment to the issuer through IPA.

10. When the commercial paper is held in De-mat form, the holder of commercial paper willhave to get it redeemed through depository and received payment from the IPA.

11. Commercial paper is issued as a µstand alone¶ product. It would not be obligatory for banks and financial institutions to provide stand-by facility to issuers of commercial paper.

12. Every issue of commercial paper, including renewal, should be treated as a fresh issue.

13. Short-term funds are borrowed and lent.

14. No fixed place for conduct of operations, the transactions being conducted even over the

phone and therefore, there is an essential need for the presence of well developed

communications system.



15. Dealings may be conducted with or without the help the brokers.

16. The short-term financial assets that are dealt in are close substitutes for money, financial

assets being converted into money with ease, speed, without loss and with minimum

transaction cost.

17. Funds are traded for a maximum period of one year.

18. Presence of a large number of submarkets such as inter-bank call money, bill

rediscounting, and treasury bills, etc.

y 26

Recommendation on Indian Money Market:

Financial sector reforms and monetary policy measures the governor announced certain

structural and other policy recommendation to strengthen and rationalize the functioning of

money market.

1) C all/Notice Money Market:

y RBI may migrate from OF (Owned Fund) to capital funds (sum of Tier I and Tier II

capital) as the benchmark for fixing prudential limits for call/notice money market for

scheduled commercial banks. RBI may, however, continue with the present norm

associated with co-operative banks (i.e., Aggregate Deposit), PDs (i.e., Net Owned Fund)and non-banks (i.e., 30 per cent of their average daily lending during 2000-01).

y Call/notice money market transactions should be conducted on an electronic negotiated

quote driven platform.

y Banks and PDs with appropriate risk management systems in place and balance sheet

structure may be allowed more flexibility to borrow in call/notice money market.



y Upon accomplishing the call/notice money market into a pure inter-bank one, larger

freedom in lending in call/notice market should be afforded to banks and PDs.

5)Commercial Paper

y Asset-backed CP should be introduced in the Indian market.

Development of a transparent benchmark

Presence of a term money market

Development of policies that provide incentives for banks and financial institutions to

manage risk and maximize profit.

Increasing secondary market activity in commercial paper and certificate of deposit. In

case of commercial paper, underwriting should be allowed and revolving underwriting

finance facility and Asset backed commercial paper should be introduced. In case of

Certificate of deposits the tenure of those of the financial institutions certificate of

deposits should be rationalized. Moreover, floating rate certificate of deposits can be

introduced.

Rationalization of the stamp duty structure. Multiple prescription of stamp duty leads to

in the administrative costs and administrative hassles.

Change in the regulatory mindset of the Reserve Bank by shifting the focus of control

from quantity of liquidity to price which can lead to an orderly development of money

market.

Good debt and cash management on the part of the government which will not only be

complementary to the monetary policy but give greater freedom to the Reserve Bank in

setting its operating procedures.

Conclusion-



Investors need to be, however, wary of the expense ratio. The fund¶s expense ratio of one per cent is somewhat high. This essentially means that if the fund earns 5 per cent on its portfolio,the unit-holders will receive only 4 per cent, because the fund will deduct one per cent for managing the portfolio. Of course, given that the interest rate on savings bank account is verylow, the fund provides good returns even after adjusting for the expense ratio.

The return differential will narrow only if the RBI cuts the repo rate and continues to administer the savings bank rate at the current level; a cut in repo rate will lead to lower rates on call moneyand other money market instruments. On balance, retail investors who want to enhance returnson their savings bank account can buy units in this fund.

BIBLIOGRAPHY AND REFERENCES

Research Paper:

Ghosh and Bhattacharyya, Spread, Volatility and Monetary Policy: Emprical Evidences fromthe Indian Overnight Money Market,pg1

Books:

Vshaley & Mittal, Call Money Market, p1.90

Internet:

1. http://forex-arbitrage.org/overview-of-indian-money-market

2. http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=254&Mode=0

3. http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=254&Mode=0

4. http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=179

5. http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=179

6. http://www.livemint.com/2009/09/02141025/India-call-money-ends-nearrev.

7. html?d=1

8. http://findarticles.com/p/articles/mi_m1TSD/is_1_6/ai_n25012617/

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