Niranjan Hedge Funds

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Final Project Report

On

Hedge Funds i ts w ork ing requ i rement & i ts im pact on

Ind ian Cap i ta l Mark et

IN THE PARTIAL FULFILLMENT OF TWO YEAR FULLTIME

COURSE OF

POST GRADUATION DIPLOMA IN MANAGEMENT (FINANCE)Under the University of Mumbai

By

Mr. Niranjan Kulkarni

Roll No: A-23

Specialization: Finance

Batch : 2010-12

Under the Guidance of

Mr. Kapil Bhopatkar

Guru Nanak Institute of Management Studies and Research

Matunga, Mumbai-400019

2012


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Declaration

This is to cert ify that the study presented by Niranjan Kulkarni to the University

of Mumbai in part completion of the two year full t ime degree/diploma of Post

Graduation In Management under the title of Hedge Funds its working

requirement & its impact on Indian Capital Market has been done under my

guidance.

To the best of my knowledge this project is in the nature of original work that

has not been submitted for any degree of this University or any other

University.

Signature of the Candidate

________________________

(Name of the Candidate

Forwarded through the Research Guide

Signature of the Guide


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Acknowledgement

I am very much Thankful to our Prof. Kapil Bhopatkar for giving opportunity

and his guidance help us out through preparing this report. He has provided

us a valuable suggestions and excellence guidance about this project which

proved very helpful to us to utilize Theoretical knowledge in Practical

knowledge.


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Table of Content

Sr. No. Topics Page No.

1. Executive Summary 01

2. Literature review Hedge Funds 02 - 08

3.

Introduction Of Hedge Funds 09 20

4.Literature Review Of Indian Capital Market

Introduction Indian Capital Market21-46

5. Hypothesis 47

6. Research Methodology 48-50

7. Data Analysis& Interpretation 51-58

8. Findings,Suggestions & Recommendations 59 - 64

9. Conclusions 65

10. Bibliography 66


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Executive summary

Hedge funds are an investment structure that manages a private

unregistered investment pool. They use several strategies like leveraging,long, short and derivative positions to generate high returns and hedgeprobable market risks. Hedge funds restrict their investment base to highnet worth individuals rather than allowing the general public to invest in them.

By 2025 the Indian economy is projected to be about 60 per cent the size ofthe US economy. This is due to major initiatives undertaken by the IndianGovernment. One such effort was taken in 1993 when with thenotification of SEBI (Mutual Fund) Regulations; the asset management

business under private sector took its root in India. India today has much ofthe necessary institutional framework for hedging, including a regulatoryregime and good information disclosure standards.

This study is written with an aim of providing a deeper insight into hedgefunds and their possible impacts on the Indian Capital Market.

The main advantages or impact of Hedge funds in India are that they bring

in the much welcome volumes, and thus, liquidity in the market.Moreover, as all market experts will concede, market liquidity leads tobetter price discovery in the market.


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LITERATURE REVIEW

A hedge fund can be defined as an investment structure that manages aprivate unregistered investment pool and compensates the fundmanager with an incentive-based fee based on a percentage of the profitsearned by the fund (Nicolas J.G).

Hedge fund is an aggressively managed portfolio of investments that usesadvanced investment strategies such as leverage, long, short andderivative positions in both domestic and international markets with the

goal of generating high returns.

Legally, hedge funds are most often set up as private investmentpartnerships that are open to a limited number of investors and require avery large initial minimum investment. Investments in hedge funds areilliquid as they often require investors to keep their money in the fund for aminimum period of at least one year.

They are typical ly organized as private partnerships and often located

offshore, thus, saving on tax and regulatory issues. Also, the initial highinvestments and illiquid nature of funds keeps a check on theinvestment in hedge funds.

Hedge funds, in general, are not registered. They have avoidedregistration by limiting the number of investors and requiring that theirinvestors meet an income or a net worth standard. Furthermore, hedgefunds are also prohibited from soliciting or advertising to the general


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audience. The primary aim of most hedge funds is to reduce volatility andrisk while attempting to preserve capital, and deliver positive returns underall market conditions.

For present purposes, 3 main classes of hedge funds can be identified: -

Macro Funds

Which take large unhedged positions in national markets based on top-down analysis of macroeconomic and financial conditions. These fundstake position in either mature or key emerging markets. They spread theirholdings across equities, bonds and currencies.

Some long-established macro funds find it cheaper to use conventionalforwards and futures to take positions ahead of the market moves they

foresee. Some newer macro funds pursue more specialized tradingstrategies using complex derivative securities.

A fund of this type might take a long position in a currency that isundervalued and an equal, short position in another currency that isovervalued.

Global Funds

Which also take positions worldwide, but employ bottom- up analysis,picking stocks on the basis of individual companies' prospects.

Relative Value Funds

Which take bets on the relative prices of closely related securities(treasury bills and bonds, for example). They limit their holdings to themature markets, because their expertise is limited to

those markets. Relative value funds are also inclined to use derivatives.Hedge funds are investment pools employing sophisticated trading andarbitrage techniques including leverage and short selling, wide usage of


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derivative securities etc.Generally, hedge funds restrict share ownership tohigh net worth individuals and institutions, and do not offer theirsecurities to the general public. Some hedge funds are limited to 100investors.This private nature of hedge funds has resulted in few regulations anddisclosure requirements, compared for example, with mutual funds. Also,the hedge funds may take advantage of specialized, risk-seeking

investment and trading strategies, which other investment vehicles are notallowed to use.

Hedge funds are subject to far fewer regulations than other pooledinvestment vehicles, especially to regulations designed to protect investors.

This applies to such regulations as regulations on liquidity, requirementsthat funds shares must be redeemable at any time, Protecting conflicts ofinterests, assuring fairness of pricing of fund shares, disclosurerequirements, limiting usage of leverage, short selling etc. This is a

consequence of the fact that hedge funds investors qualify as sophisticatedhigh-income individuals and institutions.

Hedge funds offer their securities as private placements,on individualbasis, rather than through public advertisement, which allows them toavoid disclosing publicly their financial performance or assetpositions.

However, hedge funds must provide to investors some information abouttheir activity, and of course, they are subject to statutes governing fraud

and other criminal activities.

For e.g. controversies and frauds surrounding hedge funds seem to dealwith the issue of transparency, today such controversy has run into a culde sac, or dead end, because transparency of hedge funds haveincreased to the point that one can log into hedge fund information portalsand examine up to date information on hedge fund data.


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OBJECTIVE OF THE STUDY

Comparison between Hedge funds & Mutual funds.

To study Hedge fund investment Strategies.

Impact on Hedge Funds investments in Indian Capital Market.

How Hedge funds work in Indian Capital Market.

SCOPE OF THE STUDY

Though there is a large number of players who are active in the IndianCapital markets and many Indices which can be taken as benchmark forcomparison, only one index SENSEX is taken into consideration, to reduce

the complexity of analysis.

Though there are many financial crisis that has resulted in financial worldonly four main crisis has been taken into consideration because of notavailability of enough data. Study has been limited to only Indian Capitalmarkets, though Hedge Funds has a direct impact on the whole financialsystem of the country.


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List of Hedge Fund in India

Hudson Fairfax Group (HFG) Private Equity.

Avatar Investment Management (AIM) Private Equity.

India Deep Value Fund Long Term Investments in Capital Markets

and Real Estate.

Heritage Capital India Long-short Equity.

Fair Value Capital Traditional Investment Approach, Event-based

investments.

India Capital Fund Multi-strategy.

Monsoon Capital Indian Equities Investments

Karma Capital Indian Equities Investments.

Atlanta Capital Investment in Indian Equities and Precious Metals.

Baer Capital Partners Private Equity, Equity Investments.

Brahma Capital Board Asset Management.


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Eight Capital Alternative Investments.

EM Capital Management Emerging Markets.

Evolvence Capital Alternative Investments.

Jina Ventures Private Equity, M&A.

Och-ZiffAlternative Investments.

Sandstone Capital Equity Investments.

Fulcrum Investment Group, LLC Alternative Investments.

Greenwich Advisors Diversified Indian markets.

Investing of hedge funds in India

Prior to finalizing investment, take couple of months to know about thehedge fund industry in India. The age of hedge fund industry, the keyplayers, their worth, the operational risks, the pros and cons ofinvesting in hedge funds etc.

Identify potential hedge funds, refer commercial directories ordatabases. Account for your investment goals, risk tolerance level,amount allocated for investment.

Read blogs, financial magazines, websites, news articles, whitepapers on hedge funds in India. Talk to personnel; preferably interactwith hedge fund managers involved with hedge fund investments


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and those who have already invested in hedge funds.

Notice annual events like Hedge funds world India to gain anassessment of the burgeoning Indian hedge fund industry.

Approach wealth manager in wealth management companies,securities broker or licensed investment consultant for advice on

hedge fund investments in India.

Understand terms related to hedge funds, remittance, managementfee and performance fee, withdrawal and redemption fees.

Check the pros and cons of long-term hedge funds vs. short-termhedge funds.

Ensure your activities are that of an accredited investor (with a networth of more than $1 million).

Involve financial advisor in the process of investing in hedge fundsin India.


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INTRODUCTION

THE ORIGIN OF HEDGE FUNDS

The year was 1949, WW II just ended, and the world was in a unifiedcelebration. Alfred Winslow Jones, a sociologist, was working onassignment for Fortune magazine investigating fundamental and technical

research on forecasting the stock market. The article reported on a newclass of stock market timers, in addition to unorthodox methods ofinvesting, all to achieve positive returns and call the market. Jones wasvery intrigued by these trading methods and became absolutely consumedwith his own concept of an investment fund.

Prior to the release of his Fortune article, Jones setup an investment fundwith himself as general partner. The fund was designed as a market-neutral strategy, whereby the long positions in undervalued equities wouldbe offset by short positions in others.

This hedged position would allow capital to be leveraged, while alsoenabling large wagers to be made with limited resources. Another geniusfeature was having an incentive fee amounting to 20% of any realizedprofits or gains with no fixed fees.

However, Jones greatest notoriety stems from his innovation that specificlimited partnerships, if structured correctly, are exempt fromregulatory control under the Investment Company Act of 1940.

This exemption allows managers to utilize techniques, such asleverage and short-selling which typically binds other mutual funds andinvestment companies. Consequently, many copy -cats mimicked the feestructure, but not the hedge mentality and philosophy that Jones inspired.It was not until another Fortune magazine article, in 1966, which brandedthe market-neutral strategy that Jones designed as a hedge fund.

CHARACTERISTICS OF HEDGE FUNDS

Although financial service providers, regulators and the mediacommonly refer to hedge funds, the term has no precise legal oruniversally accepted definition. The term generally identifies an entity that


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holds a pool of securities and perhaps other assets that does not register itssecurities offerings under the Securities Act and which is not registered asan investment company under the Investment Company Act.

Hedge funds are also characterized by their fee structure, whichcompensates the adviser based upon a percentage of the hedge fundscapital gains and capital appreciation. Hedge fund advisory personnel often

invest significant amounts of their own money into the hedge funds thatthey manage.

Schneeweis, Spurgin and Karavas (2001) suggest that an allocation of 10to 20% to hedge funds optimally improves traditional portfolioperformance. The investment goals ofhedge funds vary among funds, butmany hedge funds seek to achieve a positive, absolute return rather thanmeasuring their performance against a securities index or other benchmark.This does not mean however that all hedge funds have comparable riskand return characteristics. In reality, there exists a variety of trading

strategies that determine the funds risk and return profiles. Improperlyincluded, an allocation to hedge funds can have disastrous consequences(Soueissy, M. & Sidani, R).

Hedge funds utilize a number of different investment styles andstrategies and invest in a wide variety of financial instruments. Hedgefunds invest in equity and fixed income securities, currencies, over-the-counter derivatives, futures contracts and other assets.

Some hedge funds may take on substantial leverage, sell securities shortand employ certain hedging and arbitrage strategies. Hedge fundstypically engage one or more broker-dealers to provide a variety ofservices, including trade clearance and settlement, financing and custodyservices.

Hedge funds often provide markets and investors with substantial benefits.For example, based on our observations, many hedge funds takespeculative, value-driven trading positions based on extensive researchabout the value of a security. These positions can enhance liquidity and

contribute to market efficiency.

In addition, hedge funds offer investors an important risk


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management tool by providing valuable portfolio diversification becausehedge fund returns in many cases are not correlated to the broader debt andequity markets. On the other hand as Jeremy Siegel at Wharton BusinessSchool(2005) pointed out that there is a risk that many hedge fundsmaking similar bets could suffer bigger losses all at once ,damaging otherinvestors.

Hedge Funds vs. Mutual Funds

Hedge funds are institutional investors, just like mutual funds.However, this is where the similarity ends. Typically, only high networth individuals and institutions invest in hedge funds, while mutualfunds are the main investment vehicle of the small and retail investors.Additionally, mutual funds are highly regulated institutions that file a lotof information like inflows and outflows, breakup of investments andother statutory details with the regulatory authority.

Table 1: Hedge fund vs Mutual fund

Feature Mutual Fund Hedge Fund

Number ofowners

Very large (in thousands)Few high net worthindividuals or institutions

Regulation Regulated strictly by the Minimum regulation

Transparency

Publishes annual reportsand monthly informationsheets that showinvestment and profits

Information given only toinvestors. Not accountableto any other body

InvestmentStyle

Invests in equity, debt and Follows many investmentderivatives, but follows a strategies, including goinglong strategy short on some securities


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ManagementFees

Fee not linked toperformance. Usually apercentage of assetsmanaged

Fee linked to performance-managers charge a highpercentage of profits made

HOW THEY WORK

To achieve pre-set returns target, these funds do not restrict themselves totheir country of origin and operate on a global scale. Hedge fund managerstypically seek absolute positive investment performance. This means that,the hedge funds target a specific range of performance, and attempt toproduce targeted returns irrespective of the stock market trends.

This is in contrast to investments by mutual funds, where success or failureis often measured in terms of performance in relation to a stock index,like the Sensex or Nifty in India.

Figure 1: How they Work

For investors, this structure-


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1. Helps pool assets with those of other investors.

2. Is a way to access talented hedge fund managers

3. Is a method to access the alternative investment strategies used by themanager.To achieve this "absolute return", hedge fund managers havethe flexibility to incorporate different strategies and techniques thatmay include:

Short-selling: Sale of a security that you do not own, with the anticipationof purchasing it in the future, at a reduced cost.

Arbitrage: Simultaneous buying and selling of a financial instrument indifferent markets to profit from the difference between the prices

Hedging: Buying/selling a security to offset a potential loss on aninvestment.

Leverage:Borrowing money for investment purposes.

STRATEGIES OF HEDGE FUNDS

Hedge funds do not constitute a homogeneous asset class. The bulk ofhedge funds describe themselves as long / short equity, perhaps becausethis is the least specific of the available descriptions, but many differentapproaches are used taking different exposures, exploiting different marketopportunities, using different techniques and different instruments: Hedgefunds use a wide variety ofinvestment styles and strategies.

Even among hedge funds that claim to use the same investment strategyor invest within the same asset class, there is a wide range of investment

activities, performance and risk levels. Because the investment activitiesof hedge funds are so diverse, the hedge funds assigned to a particular


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investment category are likely to exhibit less similarity than more traditionalinvestment vehicles, such as registered investment companies.

Although classification systems vary, hedge funds may generally beclassified according to broad style and strategy categories, including:

Market Trend (Directional/Tactical) Strategies

Macro:

These funds may take positions in currencies (often unhedged) based ontheir opinion ofvarious countries' macroeconomic fundamentals.

For example, if a country's economic policies look inconsistent and itsability to sustain its exchange rate appears questionable, macro funds maytake positions designed to profit from devaluation, usually by sellingthe currency short.

Long/Short:

(includes sector and market neutral/relative value funds): These funds tryto exploit perceived anomalies in the prices of securities. For example, ahedge fund may buy bonds that it believes to be under priced and sell shortbonds that it believes to be overpriced.

No matter what happens to overall interest rates, as long as the spreadbetween the two narrows, the fund profits. Conversely, if spreads widen,

gains can turn quickly into losses. Long/short equity is the mostfrequently used strategy among hedge funds.

Event-Driven Strategies

Distressed Securities:

These funds may take long and/or short positions to attempt to profit frompricing anomalies among securities issued by companies going throughbankruptcy or reorganization.

Risk/Merger Arbitrage:


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These funds attempt to profit from pending merger transactions by, forexample, taking a long position in the stock of the company to be acquiredin a merger, leverage buyout or takeover and simultaneously taking a shortposition in the stock of the acquiring company.

Arbitrage Strategies

Convertible Arbitrage

This strategy involves taking long positions in a company's convertiblebonds, preferred stock, or warrants that are deemed to be undervaluedwhile taking short positions in the company's common stock.

Fixed Income Arbitrage

Hedge funds in this category seek to provide stable, positive returns byexploiting the relatively small pricing inefficiencies of fixed incomeinstruments.

For example, a newly issued (on the run) 10-year Treasury bond maytrade at a slightly higher price than a similar previously issued (off- the-run) 10-year Treasury bond. A hedge fund may seek to profit from thisdisparity by purchasing off-the-run Treasuries and selling on-the-runTreasuries short.

Statistical Arbitrage

Funds in this category attempt to profit from pricing inefficienciesidentified through the use of mathematical models. Statistical arbitrageattempts to profit from the likelihood that prices will trend toward ahistorical norm.


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HEDGE FUND INVESTMENT ACTIVITIES COMPARED TO THOSE

OF REGISTERED INVESTMENT COMPANIES

Registered investment companies typically seek positive returnscompared to the performance of a particular asset class or index(benchmark). Websters dictionary de fi ne s a be nch ma rk asastandard or point of reference in measuring or judging quality, value

etc.Thus, in a declining market, a registered investment company may beconsidered successful even if it loses money, so long as the companyoutperforms its benchmark (i.e., its relative return is positive). In a risingmarket the registered investment company may be considered unsuccessfulif the company, though profitable, underperforms the benchmark (i.e., itsrelative return is negative).

In brief, in the relative return paradigm, downside risk means the risk offailing to perform as well as the benchmark. In contrast, a hedge fund

that utilizes an absolute return strategy may be considered successful onlyif it is profitable in both rising and declining markets.

In the absolute return paradigm, downside risk means the risk of failingto make money.

Registered investment companies generally have less flexibility to changetheir investment objectives than do most hedge funds.

As a result, these funds provide investors with greater certainty of the

risks their advisers will take, but provide their advisers with adiminished ability to take alternative investment approaches when marketconditions change.

LEVERAGE

Background

Goldman Sachs (2000) extend their previous study to new data and believethat hedge funds pursue a variety of investment strategies as well as employ

differing degrees of leverage. Leverage is an important component of manyhedge fund investment strategies.


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Leverage can be defined in numerous ways. As a general matter, however,leverage, can be viewed as a means of potentially increasing aninvestments value or return without increasing the amount invested.

Although leverage historically was obtained primarily by purchasingsecurities with borrowed money, today futures, options and other derivativecontracts may be a major source of leverage.

The use of leverage may have a significant impact on investment resultsbecause, while it may enhance investment gains, it may alsomagnify investment losses. Leverage also may increase the risk caused byholding assets that are illiquid or whose full value cannot be realized in aquick sale.

Use of Leverage by Hedge Funds

The degree to which a hedge fund uses leverage depends largely on itsinvestment strategy. Macro funds and funds that attempt to capitalize onsmall inefficiencies in relative values (e.g., fixed income arbitrage andstatistical arbitrage) are more likely to engage in leverage and to take morehighly leveraged positions than are hedge funds that use other investmentstrategies, such as investing in distressed securities situations.

A hedge funds limitation on its use of leverage is often dictated by anymargin or collateral requirements imposed on lenders or on others (e.g.,

broker-dealers), and the willingness of lenders or other counterparties toprovide it with credit.

For example, a broker-dealer extending credit to a hedge fund inconnection with a short sale would have to comply with Regulation Tissued by the Board of Governors of the Federal Reserve System.

The hedge fund could also be required to provide additionalmaintenance margin for transactions in short sales under marginrequirements imposed by self-regulatory organizations.


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Use of Leverage by Registered Investment Companies

Although registered investment companies may use leverage and sell short,their ability to use these tools is more limited than is the case with hedgefunds.

For example, the Investment Company Act generally allows open- endinvestment companies to leverage themselves only by borrowing from abank, and provided that the borrowing is subject to 300 percent assetcoverage. Closed-end investment companies are subject to less restrictivelimits.

The Commission and staff have applied the Investment Company Actprovisions governing use of leverage to permit registered investmentcompanies to engage in certain transactions involving leverage (senior

security transactions), generally, however, only if the registered fundcovers the transaction by setting aside liquid assets in an amount equaltothe potential liability or exposure created by the transaction.

A registered investment companys board of directors has certainresponsibilities in connection with the companys use of leverage, andinformation about the characteristics and risks of permitted leveragetransactions must be disclosed to investors in fund prospectuses.

SHORT SELLING

A short sale is the sale of a security that the seller does not own or a salethat is consummated by the delivery of a security borrowed by, or for theaccount of, the seller. In order to deliver the security to the purchaser, theshort seller borrows the security, typically from a broker-dealer or aninstitutional investor.

The short seller later closes out the position by returning the security to the

lender, typically by purchasing equivalent securities on the open market,or by using an equivalent security that it already owns.


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In general, short selling is utilized to profit from an expecteddownward price movement, to provide liquidity in response tounanticipated demand or to hedge the risk of a long position in the same ora related security.

Short selling can provide the market with important benefits,

including market liquidity and pricing efficiency. Market liquidity isprovided through short selling by market professionals, such as marketmakers (including specialists) and block petitioners, who offset temporaryimbalances in the supply and demand for securities.

Short sales affected in the market by securities professionals add to thetrading supply of stock available to purchasers and thus may reduce therisk that the price paid by investors is artificially high.

Short selling also can contribute to the pricing efficiency of the markets.Efficient markets require that prices fully reflect all buy and sell interest.

When a short seller speculates on or hedges against a downwardmovement in a security, the transaction is a mirror image of the personswho purchases the security based upon speculation that the securitys pricewill rise or in order to hedge against such an increase. The strategiesprimarily differ in the sequence of transactions.

Market participants who believe a stock is overvalued may engage in shortsales in an attempt to profit from a perceived divergence of prices fromtrue economic values. Such short sellers add to stock pricingefficiency because their transactions inform the market of their evaluationof future stock price performance. This evaluation is reflected in theresulting market price of the security.

Although short selling serves useful market purposes, it also may be usedto manipulate stock prices. One example is the bear raid where an equity

security is sold short in an effort to drive down the price of the security bycreating an imbalance of sell-side interest.


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Unrestricted short selling can also exacerbate a declining market in asecurity by eliminating bids and causing a further reduction in the price ofa security by creating an appearance that the price is falling forfundamental reasons.

PERFORMANCE IN A PORTFOLIO CONTEXT:

An important attribute of hedge funds which makes them even morepopular are its diversification benefits on addition in a traditional portfolioof stocks and bonds. Among the studies which brought this out, Edwardsand Lien (1999) studied the diversification benefits of hedge funds andmanaged futures funds and found them to enhance portfolio performance.

Purcell and Paul Crowleys (1999) study too supports the diversificationadvantage hedge funds provide as the inclusion increases expected

portfolio return by 200 basis points. A major plus point in a portfoliocontext is that They too state that hedge funds have a lowcorrelation with all the other asset classes including the S&P 500.

The benefits of including hedge funds in plan sponsors portfolios is alsoevident as shown by Goldman Sachs and Co. (1998) in terms of therisk/return, correlation and other performance characteristics of four majorcategories (Market Neutral or Relative Value, Event Driven, Long/Shortand Tactical Trading) of hedge funds.

Though the hedge funds are excellent diversifiers they are extremely riskyalong another dimension: as the cross sectional variation and the rangeof individual hedge fund returns are far greater than they are fortraditional asset classes, the investors in hedge funds face a substantial riskof selecting a dismally performing fund or a failing one as pointed out byMalkiel and Saha (2005).

One can conclude here by saying that over concentration in any

particular fund produces improper risk for the manger which can bereduced by limiting exposure to any one fund. Moreover tighteningrestrictions shifts the efficient frontier downwards.


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Literature Review of the Indian Capital Market

INTRODUCTION

Economics experts and various studies conducted across the globeenvisage India and China to rule the world in the 21st century.

For over a century the United States has been the largest economy in theworld but major developments have taken place in the world economysince then, leading to the shift of focus from the US and the rich countriesof Europe to the two Asian giants- India and China.

The rich countries of Europe have seen the greatest decline in global GDPshare by 4.9 percentage points, followed by the US and Japan with adecline of about 1 percentage point each.

Within Asia, the rising share of China and India has more than made up thedeclining global share of Japan since 1990. During the seventies and theeighties, ASEAN countries and during the eighties South Korea, alongwith China and India, contributed to the rising share of Asia in world GDP.

According to some experts, the share of the US in world GDP is expectedto fall (from 21 per cent to 18 per cent) and that of India to rise (from 6percent to 11 per cent in 2025), and hence the latter will emerge as thethird pole in the global economy after the US and China. By 2025 the

Indian economy is projected to be about 60 per cent the size of the USeconomy.

The transformation into a tri-polar economy will be complete by2035, with the Indian economy only a little smaller than the US economybut larger than that of Western Europe.

By 2035, India is likely to be a larger growth driver than the six largestcountries in the EU, though its impact will be a little over half that of theUS. India, which is now the fourth largest economy in terms of

purchasing power parity, will overtake Japan and become third majoreconomic power within 10 years.


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ISSUES AND PRIORTIES FOR INDIA

As India prepares herself for becoming an economic superpower, it mustexpedite socio-economic reforms and take steps for overcominginstitutional and infrastructure bottlenecks inherent in the system.Availability of both physical and social infrastructure is central to

sustainable economic growth.

Since independence Indian economy has thrived hard for improving itspace of development. Notably in the past few years the cities in India haveundergone tremendous infrastructure up gradation but the situation in notsimilar in most part of rural India. Similarly in the realm of health andeducation and other human development indicators India's performance hasbeen far from satisfactory, showing a wide range of regional inequalitieswith urban areas getting most of the benefits.

In order to attain the status that currently only a few countries in the worldenjoy and to provide a more egalitarian society to its mountingpopulation, appropriate measures need to be taken. Currently Indianeconomy is facing these challenges:

Sustaining the growth momentum and achieving an annual averagegrowth of 7-8 % in the next five years.

Simplifying procedures and relaxing entry barriers for business

activities.

Checking the growth of population; India is the second highestpopulated country in the world after China. However in terms ofdensity India exceeds China as India's land area is almost half ofChina's total land. Due to a high population growth, GNI per capitaremains very poor. It was only $ 2880 in 2003 (World Bank figures).

Boosting agricultural growth through diversification anddevelopment of agro processing.

Expanding industry fast, by at least 10% per year to integrate not only the


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surplus labor in agriculture but also the unprecedented number ofwomen and teenagers joining the labor force every year.

Developing world-class infrastructure for sustaining growth in all thesectors of the economy. Allowing foreign investment in more areasEffecting fiscal consolidation and eliminating the revenue deficit throughrevenue enhancement and expenditure management..

Empowering the population through universal education and healthcare. India needs to improve its HDI rank, as at 127 it is way below manyother developing countries' performance.

The UPA government is committed to furthering economic reforms anddeveloping basic infrastructure to improve lives of the rural poor and boosteconomic performance.

Government had reduced its controls on foreign trade and investment in

some areas and has indicated more liberalization in civil aviation, telecomand insurance sector in the future.

SOME HIGHLIGHTS

India has more billionaires than China. This year there were 15billionaires in China but last year in India, there were 20 billionaires,according to the Forbes magazine.

India has emerged as the world's fastest growing wealth creator,thanks to a buoyant stock market and higher earnings

Ninan (2003) states that medium to long-term outlook for the Indianstock is positive in the coming years.

A number of Indian companies surpassed last year's net profit in just sixmonths of the current fiscal, reflecting an accelerated growth incorporate earnings.

Forty-four per cent of Top 100 Fortune 500 companies are present inIndia.The economy has grown by 8.9 per cent for the April-July quarter


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of'06-07, the highest first-quarter growth rate since '00-01 and is poisedto grow more than 9% this fiscal.

Due to a global liquidity glut, the Indian equity market is soaring alongwith the rest of the emerging markets. The Morgan Stanley EmergingMarket index, the benchmark used by most international fundmanagers, gained 23.05% in the year to date (YTD) in 2005 while the

MSCI India index recorded one of the smartest rises ever gaining24.54% YTD (Lohade, 2005).

The Indian IT industry has been growing at a rapid rate with itssilicon city being named as the back office of the world. Further, thegovernment has been continuously promoting this sector as it hasidentified it as one of the potential employment generators and foreignexchange earner by making the labor laws more flexible in this labor-intensive sector (Jagnani and Dagli, 2005).

Barua (2006) emphasizes that the Indian growth rate is likely toaccelerate in the long-term on back of few fundamentals.

First, infrastructure spending is increasing by leaps andbounds.

Second, India is experiencing a service industries boom due to arbitrage

of human intelligence. More and more people are recognizing the smart,hard working Indian worker not only as cost saving but also asproductivity enhancing.

Third, the availability of jobs through outsourcing is leading to higherconsumption that is also fuelled by expansion of retail credit andchanging demographics.

With positive indicators such as a stable 8-9 per cent annual growth,rising foreign exchange reserves of close to US$ 180 billion, a booming

capital market with the popular "Sensex" index topping the majestic14,000 mark, the Government estimating FDI flow of US$ 12 billion inthis fiscal, and a more than 35 per cent surge in exports, it is easy to


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understand why India is a leading destination for foreign investment.

HISTORY OF INDIAN CAPITAL MARKETS

The history of the Indian capital markets and the stock market, inparticular can be traced back to 1861 when the American Civil War

began. The opening of the Suez Canal during the 1860s led to atremendous increase in exports to the United Kingdom and United States.

Several companies were formed during this period and many bankscame to the fore to handle the finances relating to these trades. Withmany of these registered under the British Companies Act, the StockExchange, Mumbai, came into existence in 1875.

It was an unincorporated body of stockbrokers, which started doing

business in the city under a banyan tree. Business was essentiallyconfined to company owners and brokers, with very little interestevinced by the general public. There had been much fluctuation in thestock market on account of the American war and the battles in Europe.

The planning process started in India in 1951, with importance beinggiven to the formation of institutions and markets The SecuritiesContract Regulation Act 1956 became the parent regulation after theIndian Contract Act 1872, a basic law to be followed by security markets

in India.

The stock markets have had many turbulent times in the last 140 yearsof their existence. The imposition of wealth and expenditure tax in1957 by Mr. T.T. Krishnamachari, the then finance minister, led to ahuge fall in the markets. War with China in 1962 was anothermemorably bad year, with the resultant shortages increasing prices allround.

This led to a ban on forward trading in commodity markets in 1966,

which was again a very bad period, together with the introduction ofthe Gold Control Act in 1963. The markets have witnessed severalgolden times too. Retail investors began participating in the stock


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markets in a small way with the dilution of the FERA in 1978.

The next big boom and mass participation by retail investorshappened in 1980, with the entry of Mr. Dhirubhai Ambani. Dhirubhaican be said to be the father of modern capital markets.

The Reliance public issue and subsequent issues on various Reliancecompanies generated huge interest. The general public was sounfamiliar with share certificates that Dhirubhai is rumored to havedistributed them to educate people.

Mr. V.P. Singhs fiscal budget in 1984 was path breaking for itstarted the era of liberalization. The removal of estate duty and reductionof taxes led to a swell in the new issue market and there was a delugeof companies in 1985.

Mr. Manmohan Singh as Finance Minister came with a reform

agenda in 1991and this led to a resurgence of interest in thecapital markets, only to be punctured by the Harshad Mehta scam in1992.

The end-1990s saw the emergence of Ketan Parekh and theinformation; communication and entertainment companies came intothe limelight. This period also coincided with the dotcom bubble in theUS, with software companies being the most favored stocks.

There was a meltdown in software stock in early 2000. Mr. P

Chidambaram continued the liberalization and reform process, openingup of the companies, lifting taxes on long-term gains and introducingshort- term turnover tax. The markets have recovered since then andwe have witnessed a sustained rally that has taken the index over 13000.


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Chhabria (2006) states that the good thing about the Indian market,riding on the backof an economy that has grown by over 7 per cent inthe last two years, is that investors can't miss being part of the growth ifthey invest in the Indian stock markets carefully.

On an average 70% of Indian population of below 35 yrs present a rosy

picture with a lot of money to be spent. It is estimated that everymonth around Rs.50-60 crore flows into the capital markets in the wayof SIP and some other instruments which helps in increasing themarket capitalization.

The surge in SENSEX and NIFTY, the benchmark indices of Indian stockmarket is also attracting many retail investors to look for morereturns there by directly increasing their investments in stocks.

There are many equity analysts who assert Indian capital markets toachieve quantum leaps in the future. Based on technical analysis usingGlen Neelys Neowave Theory, Karandikar (2005) predicts the Sensexto be between 18000- 40000 till 2010.

He emphasized that the Sensex would have to grow earnings at acompounded annual growth rate (CAGR) of 17% to get to 18000 infive years and at 36% to get to 40000. Further, other analysts likeJhunjhunwala (2002), Jhunjhunwala (2006) and Barua et al (2006)

advocated that investing in the Indian equity market would giveattractive returns over thelong run backed by strong fundamentals..

Moreover, Krishnamurthy (2004) studied that Indian stocks offerextraordinary high sustainable returns and are expected to maintain thistrend.

Recently a study conducted by the Economic Times Investors Guide

consisted of over 1300 Indian companies listed on the Indianstock exchange.


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The net profits for the sample had grown 37% over the first quarter ofthe year 2006 (Q1FY07). This appeared way above market expectations,which were in the 15-20% range for financial year 2007 as a whole. Itwas concluded that corporate India surprised the market with its stronggrowth in the first quarter of financial year 2007.

It was also observed that the growth momentum was as broad-based asever in this rally and not that only a handful of companies werecontributing to net profits (Economic Times, 2006).

On the contrary Varadarajan (2000) argues that share prices of the Indianstocks are overvalued which would eventually lead to a downfall in theshare prices. He uses two indicators to determine whether current shareprices are overvalued: the price-to-earnings ratio of stocks and thespread between the yield on bonds and shares.

He argues that such a correction has been on the cards for quite some timenow; the only element missing is a proximate trigger which wouldsooner or later burst the share bubble. JP Morgan identifies levelsof uncertainties that are generating volatility in the Indian equity marketand suggest that India should correct by 4-5% for the markets to lookattractive in the future years (www.moneycontrol.com). In addition, Zoreand Sen (2006) analyze that both globally as well as in India there are alot of issues that cause concern. The global interest rate scenario will

slacken the growth of the Indian economy to a great extent.


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DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS

MUTUAL FUNDS

Mutual fund is a form of collective investment that pools money frommany investors and invests their money in stocks, bonds, dividends,

short-term money market instruments, and/or other securities. In amutual fund,the fundmanager trades the fund's underlyingsecurities,realizing capital gains or losses, and collects the dividendor interest income. The investment proceeds are then passed along tothe individual investors. The value of a share of the mutual fund,known as the net asset value per share (NAV), is calculated daily basedon the total value of the fund divided by the number of shares currentlyissued and outstanding. The flow chart below describes broadly theworking of a mutual fund.

History

The origin of mutual fund industry in India is with the introduction of theconcept of mutual fund by UTI in the year 1963. Though the growth wasslow, but it accelerated from the year 1987 when non-UTI players enteredthe industry.

In the past decade, Indian mutual fund industry had seen dramaticimprovements, both quality wise as well as quantity wise. Before, the

monopoly of the market had seen an ending phase; the Assets UnderManagement (AUM) was Rs. 67bn.


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The private sector entry to the fund family rose the AUM to Rs. 470 bn inMarch 1993 and till April 2004, it reached the height of 1,540 bn. Puttingthe AUM of the Indian Mutual Funds Industry into comparison, the total ofit is less than the deposits of SBI alone, constitute less than 11% of the totaldeposits held by the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry inIndia is new in the country. Large sections of Indian investors are yet to befamiliarized with the concept. Hence, it is the prime responsibility of allmutual fund companies, to market the product correctly abreast of selling.

FOREIGN INSTITUTIONAL INVESTOR

Foreign Institutional Investor [FII] is used to denote an investor - mostlyof the form of an institution or entity, which invests money in thefinancial markets of a country different from the one where in theinstitution or entity was originally incorporated.

An investor or investment fund that is from or registered in a country outsideof the one in which it is currently investing. Institutional investors includehedge funds, insurance companies, pension funds and mutual funds.

The term is used most commonly in India to refer to outsidecompanies investing in the financial markets of India. Internationalinstitutional investors must register with the Securities and ExchangeBoard of India to participate in the market. One of the major marketregulations pertaining to FIIs involves placing limits on FII ownership in

Indian companies.FII investment is frequently referred to as hot money for the reason that itcan leave the country at the same speed at which it comes in.India opened its stock markets to foreign investors in September 1992 andhas, since 1993, received considerable amount of portfolio investment fromforeigners in the form of Foreign Institutional Investors (FII) investment inequities.

This has become one of the main channels of international portfolioinvestment in India for foreigners13. In order to trade in Indian equity

markets, foreign corporations need to register with the SEBI as ForeignInstitutional Investors (FII). SEBIs definition of FIIs presently includes


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foreign pension funds, mutual funds etc.

The trickle of FII flows to India that began in January 1993 has graduallyexpanded to an average monthly inflow of close to Rs. 1900 croresduring the first six months of 2001. By June 2001, over 500 FIIs wereregistered with SEBI.

The total amount of FII investment in India had accumulated to aformidable sum of over Rs.50,000 crores during this time . In terms ofmarket capitalization too, the share of FIIs has steadily climbed to about9% of the total market capitalization of BSE (which, in turn, accounts forover 90% of the total market capitalization in India).

The sources of these FII flows are varied. The FIIs registered with SEBIcome from as many as 28 countries (including money managementcompanies operating in India on behalf of foreign investors). US-basedinstitutions accounted for slightly over 41%, those from the UK constitute

about 20% with other Western European countries hosting another 17% ofthe FIIs that these national affiliations do not necessarily mean that theactual investor funds come from these particular countries.

Given the significant financial flows among the industrial countries,national affiliations are very rough indicators of the home of the FIIinvestments. In particular institutions operating from Luxembourg, CaymanIslands or Channel Islands, or even those based at Singapore or Hong Kongare likely to be investing funds largely on behalf of residents in othercountries.

RETAIL INVESTORS

Retail investors according to SEBI rules are those investors whoseinvestment corpus is not more than Rs. 1 lakh. In India, retail investors playa very small role in capital markets. This is mainly due to the risk aversion.

The retail investors are mainly concentrated in four metros and

Ahmedabad. Ahmedabad has major chunk of retail investors who are verymuch active in the stock investors.


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But slowly this scenario is changing with the increase in the number ofDemat accounts through which these investors mainly invest. Slowly theretail investors confidence has increased in the Indian Stock markets.

Their total share in the market capitalization is around 3%which is verymuch less compared to that of USA where it is around 20-25%. But withIndian capital markets gaining popularity, there is high scope that theparticipation of retail investors will gradually increase.

HEDGE FUNDS IN ASIA

Though Hedge funds seek absolute return strategies, but due to the herdingmentality the returns are getting diminished. And some of the majordebacles of Hedge funds like the AMARANTH Advisors LLC and LONGTERM CAPITAL MANAGEMENT LLC forced the hedge funds to lookinto some greener pastures like Asia where the market is in premature stage.

Hedge funds started investing in Asian markets after the Tech Bubblewhich forced many hedge funds to liquidate their net positions.

According to Asia Hedge magazine, some 150 hedge funds operate inAsia, till year 2002 which together managed assets estimated at around US$ 15 billion. In Japan, too hedge funds are becoming the focus of moreattention.

Recently, Japans Government Pension Fund one of the worlds largest

pension fund with US $ 300 billion has announced plans to start allocatingmoney to hedge funds. Industry participants believe that Asia could bethe next region of growth for the hedge fund industry. Thepotential of Asian hedge funds is well supported by fundamentals.

From an investment perspective, the volatility in the Asian markets inrecent years has allowed long-short and other strategic players to outperform regional indices.

The relative inefficiency of the regional markets also presents arbitrageopportunities from a demand stand point US and European investorsare expected to turn to alternatives in Asia as capacity in their home


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markets diminish.

Further, the improving economic climate in South East Asia should helpforeign fund managers and investors to refocus their attention on theregion. Overall, hedge funds look set to play a larger role in Asia.

MARKET BENEFITS OF HEDGE FUNDS

Hedge funds can provide benefits to financial markets by contributing tomarket efficiency and enhance liquidity. Many hedge fund advisors takespeculative trading positions on behalf of their managed hedge fundsbased extensive research about the true value or future value of a security.They may also use short term trading strategies to exploit perceived mis-pricings of securities.

Because securities markets are dynamic, the result of such trading is thatmarket prices of securities will move toward their true value. Trading on

behalf of hedge funds can thus bring price information to the securitiesmarkets, which can translate into market price efficiency. Hedge funds alsoprovide liquidity to the capital markets by participating in the market.

Hedge funds play an important role in a financial system where variousrisks are distributed across a variety of innovative financialinstruments. They often assume risks by serving as ready counter parties toentities that wish to hedge risks.

For example, hedge funds are buyers and sellers of certain derivatives,such as securitized financial instruments, that provide a mechanism forbanks and other creditors to un-bundle the risks involved in real economicactivity.

By actively participating in the secondary market for these instruments,hedge funds can help such entities to reduce or manage their own risksbecause a portion of the financial risks are shifted to investors in the form ofthese tradable financial instruments.By reallocating financial risks, this market activity provides the added

benefit of lowering the financing costs shouldered by other sectors of theeconomy. The absence of hedge funds from these markets could lead to


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fewer risk management choices and a higher cost of capital.

Hedge fund can also serve as an important risk management tool forinvestors by providing valuable portfolio diversification. Hedge fundstrategies are typically designed to protect investment principal. Hedgefunds frequently use investment instruments (e.g. derivatives) andtechniques (e.g. short selling) to hedge against market risk and construct aconservative investment portfolio one designed to preserve wealth.

In addition, hedge funds investment performance can exhibit lowcorrelation to that of traditional investments in the equity and fixed incomemarkets. Institutional investors have used hedge funds to diversify theirinvestments based on this historic low correlation with overall marketactivity.

HEDGE FUNDS IN INDIA

With the notification of SEBI (Mutual Fund) Regulations 1993, the assetmanagement business under private sector took its root in India. In thesame year SEBI, also notified Regulations and Rules governingPortfolio Managers who pursuant to a contract or arrangement with clients,advise clients or undertake the management of portfolio of securities orfunds of the client.

Recently, RBI through liberalized remittance scheme, allowed residentindividuals to remit up to US $ 25,000 per year for any current or capital

account transaction. The liberalized scheme will allow Indianindividual investors to explore the possibility of investing in offshorefinancial products.

Considering the existing limit being only US $ 25,000 per year, Indianmarket may not be attractive to hedge fund product marketing. Aslong as there will be restriction on capital account Convertibility, foreignhedge funds, by virtue of their minimum investment limit being $ 100,000or higher, do not seem to be excited to access investment from Indian

investors in India.

Some hedge funds have invested in offshore derivative instruments (PNs)


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issued by FIIs against underlying Indian securities. Through this routehedge funs can derive economic benefit of investing in Indiansecurities without directly entering the Indian market as FIIs or their sub-accounts.

Through recent amendments to the FII Regulations (Regulation 15A and20A), the regulatory regime has been further strengthened andperiodic disclosures regime has been introduced.

As at the end of March, 2004, total investment by hedge funds. In theoffshore derivative instruments (PNs) against Indian equity, are Rs.8050 crores which represent about 8% total net equity investments of allFIIs.

On the basis of market value, the hedge funds account for about 5% of the

market value of the total assets held by the FIIs in India. The fiscal year(2003-2004) has seen a spectacular increase in FII activities in Indianmarket. Till this report is filed FIIs have already invested US $ 10 bn.during this year alone which is a record.

Robust economic fundamentals, strong corporate earnings andimprovement in market micro structure are driving the FII interest in India.Investors all over the world are keen to come to Indian market.

From informal discussions with institutional investors including some

reputed and well established hedge funds, one could gauge the extent ofinterest they have about Indian markets.

From informal discussions with institutional investors including somereputed and well established hedge funds, one could gauge the extent ofinterest they have about Indian markets.

During the discussions they have requested whether India, like otherAsian emerging markets, can provide a regulatory framework that willallow them to directly invest in Indian market in a transparent manner.


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PARTICIPATORY NOTES

Participatory notes are instruments used by foreign funds / investors whoare not registered with the SEBI but are interested in taking exposure inIndian securities.

Participatory notes are generally issued overseas by the associates of India-based foreign brokerages. Brokers buy or sell securities on behalf of their

clients on their proprietary account and issue such notes in favor of suchforeign investors.

Participatory Notes are simple derivative instruments that investors notregistered in India or Mauritius use to trade in Indian markets. Theseinvestors place their order through brokerage houses that have Mauritius-based FII accounts.

The brokerage houses then repatriate the dividends and capital gains backto these entities. In this case, the broker acts like an exchange: it executes

the trade and uses its internal accounts to settle the trade. They keep theinvestors name anonymous. That is why capital market regulators dislikeP-notes.

WHY HEDGE FUNDS ARE LOOKING AT INDIA

Unlike China, where stock markets are not well developed andcompany information is relatively opaque, experts note that India has muchof the necessary institutional framework for hedging, including a regulatoryregime and good information disclosure standards.

"Investors look at multiple markets around the world," says Marti G.Subrahmanyam, a professor of finance at New York University's SternSchool of Business. "There is a sense that the changes taking place in Indiaare going to result in superior performance in the economy, and that thecorporate sector will be a big beneficiary.

Now, obviously the Chinese economy is larger, but the capital marketsare better developed in India. If you look at the stock market, even if youwere to include Hong Kong, the market cap in China relative to its GDP islower. So if you're looking for investment opportunities where you won't


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suffer the consequences of illiquidity, India is the more attractiveopportunity."

In addition, notes Subrahmanyam (2002), India is the largest market forsingle stock futures in the world and has a well developed derivativesmarket in index futures and options."This gives you hedging possibilitiesnot available in other emerging markets," he says. There is also enoughliquidity in the big stocks for [domestic] investors to sell short. Eventhough there are restrictions, these are less binding than in other emergingmarkets.

ADVANTAGE INDIA

Since hedge funds are investors shrouded in mystery, they are madescapegoats whenever there is a crisis of some sort in the market. Kamdar(2004) concurs and says, "The only matter that I find worrisome is that

most of the time, without any substantial evidences the world over, anycrisis in stick market is conveniently attributed to hedge funds. This wasone of the causes stated by market participants for the May 17, 2004downfall of 15% in the stock price."

Hedge funds also bring in the much welcome volumes, and thus, liquidity

in the market. Moreover, as all market experts will concede,market

liquidity leads to better price discovery in the market. Now, with the

transaction tax levied on trades carried out in the stock market, these

increased volumeswill also lead to revenue for thegovernment.

THE RISKS ASSOCIATED WITH HEDGE FUNDS

Although hedge fund strategies vary significantly, they project a generalset of risk factors to the markets they invest in. According to the authorsof Sound Practices for Hedge Fund Managers (2000), the threequantifiable risks, market risk, credit risk and liquidity risk are interrelatedand as such should be studied separately as well as together, i.e. theiroverlap should be properly identified and evaluated.Furthermore, the effect

of leverage on all three key risk factors should also be properly assessed,as insolvency risk becomes a vital point.


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Botteron and Villager(Risk Management Overview 2002) go further anddivide the risk universe into exogenous intertwining risks, common to allmarkets, which include market, credit and liquidity risks, and endogenousrisks, addressed by internal measures and regular due diligence, includingoperational and model risks.

Figure 3 : Risk Galaxy


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Figure 5: Internal Rate return

One of the major sources of risk by Hedge funds investment is MarketRisk. Due to global macroeconomic perspectives their can be an event ofmarket sudden slump. And the herding mentality of the Hedge Funds addsto this slump by continuously withdrawing money from the markets.

This leads to the devaluation of the funds NAV and also culminates intoshareholder value depreciation. Mostly interest rates, bond yields and thesecurity prices are inter-related. So a small slump in one market leads to anadverse effect in other markets also.

MARKET RISK: COMPONENTS

Interest rate risk: This risk is mostly the impact of fixed incomeinstruments; when interest rates go up, bond prices go down. Thestrategy of Fixed income instruments is to invest in corporate bondsand government bonds, so as to get risk free rate of return. The bondyields depends a lot on the Interest rate prevailing and also inflationfigures.

Figure 4: market risk


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The spread between long-term interest rates and short-term interest ratesreflects, for example, the degree of inflation risk. When anxiety is highregarding inflation, the spread widens as investors demand higher long-term rates as compensation.

Hedge funds known as Hot Money, if they sense in any risk in nearfuture they exit the market. But due to the huge investments and hugeleveraged positions it carries out results in turmoil in the bond market.

The 1994 Bond market is a classical example to show the effect ofthis kind of investment strategy.

EQUITY RISK

This includes delta risk and volatility risk Delta tells how sensitive theoption is to changes in the underlying stock price. A position with adelta of zero is called delta neutral or delta hedged. Rebalancing or

periodic adjustment is necessary to

keep a position delta hedged as delta changes all the time. This provides

Figure 6: Equity risk


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protection against small stock price movements. However, for largermovements, gamma1 neutrality is required.

Here we can point out that India is known for single largest futures andoptions in the world and Futures & Options price directly impacts theunderlying price of that particular script or commodity. This is also one ofthe impacts on the Indian Capital Market.

Volatility risk

There are two main causes for stock market volatility: the random arrival ofnew information about a stocks future returns and the level of tradingactivity (Hull 1999).

The Greek letter Vega measures the impact of the change involatility on the value of an option. When Vega is high, the option is verysensitive to small changes in stock price volatility. Vega neutrality protectsfrom such situations.

Gamma is the first derivative of delta; it measures the deltasensitivity to changes in the underlying stock price. The larger the gamma,the more sensitive is the delta to stock price changes and the more frequentthe required rebalancing.

CORRELATION RISK

It measures the degree to which two series of returns move up or downtogether. For example the correlation between the stock prices andtheir derivative instruments.Correlation between different industries like the construction and steeland cement industry. There is also reverse correlation between stockprices plummeted and bond markets rose and vice-versa (Jaeger, R.2000).


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COMMODITY RISK

This risk arises from the sudden change in the price of commodities.This is particular to Managed Futures. Just like equities, commoditiesare subject to delta and volatility risks. When the market environmentchanges, the price of commodities fluctuates.

Figure 7: Commodity risk

Delta tells us how responsive the option is to changes in theunderlying commodity price. Rebalancing or periodic adjustment isnecessary to keep a position delta hedged as delta changes all the time.Due to alternative positions of hedging the volatility of the derivative

prices increases. In order to get absolute gains, Hedge Funds try to increasebets on one position and keep on adding to that net position. AmaranthLLC is the best example to suit this type of risk.

Amaranth LLC kept on playing on the derivative options of Feb & MarCrude futures. Due to huge leverage positions build up in these twofutures, the losses kept on accumulated. Due to huge losses the fund has tobe liquidated there by impacting to a great extent the futures price of thecrude.


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CURRENCY RISK

This risk arises from the sudden change in the foreign exchange. This isparticular to Managed Futures. The strategy of managed futures is to getmoney out of the arbitrage of currency fluctuations. Hedge Funds are notlong-term players and they invest for a short period of time. So this Hot

money may try to capitalize the currency fluctuations that happenregularly.

East Asian crisis and the recent Yuan Carry of trade phenomenon can beattributed to this type of Managed Futures trading strategy of HedgeFunds.

The impact of the East Asian crisis which materialized in the middle

of1997, and the subsequent turbulence that swept the worldsfinancial markets over the next 12-18 months, has been significant not onlyin term of the financial, economic and social consequences that theseevents wrought on emerging market economies, but also in terms of

drawing the worlds attention to outstanding issues concerning thestructure, operation and regulation of the international financial system.

Currency speculators pursued a so-called double play aimed at playingoff the Hong Kong currency board system against the administrations

stock and futures markets. This led to the Asian Financial Crisis.

CREDIT RISK

This refers to the risk of downgrades (and possibly default) in the creditquality of the funds investments or that of counterparties dealing withthe fund. This type of risk becomes critical while handlingderivatives. When investors perceive a high credit risk, they demand a

higher yield on the money they lend and vice-versa.

Indian markets follow the system of Mark-to-Market settlement. But this


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system is not exercised in case of private players who take a largeleverage positions. Due to the large leverage position builds up and due tothe increase in volatility of the prices of derivative instruments this type ofrisk arises.

The mayhem created in the stock markets in May 2006 can beattributed to the credit risk arising of the Distressed securities and

Convertible arbitrage strategies.

The index was down by 10% on a single day because of the marginsystem problems. In May 2006 there was news going around that someFIIs were banned to invest in Indian markets and also the capital gains thatare earned by the way of investment in Indian markets will be treated asBusiness income.

Due to this their was a slump in the market to a certain extent. But due tothe drop in prices their was a call by many players to withdrew from the

market.

Due to this selling many big investors suffered and to cut down the lossesand pay the margin money their was an across the board selling. Thus ifbig and hot money like Hedge Funds leads to this type of marginpressures there could be a bigger slump and increased volatility in the stockprices.

LIQUIDITY RISK

Liquidity risk is defined as the decline in a funds liquidity leading todevaluation in its NAV or a decline in its ability to fund its investment. Itcan be further subdivided into three risks. The First one is related to shortselling activity; a manager might be forced to repurchase a borrowed assetdue to an adverse market condition.

The second risk affects the cash reserves of a fund, as it may have toredeem part of its debt obligations or pay margin calls. The third risk is


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faced when investors seek to redeem their shares in the fund creating amismatch in the assets and liabilities of the fund (Botteron and Villiger2002).

Liquidity is one of the main problems in the Indian Stock markets. Themain players in the Indian markets are FIIs, Mutual Funds andPromoters and to a small extent retail investors. Liquidity problem is the

main problem facing FIIs.

Till now FIIs have invested around $22 bn in Indian markets till the end of2006. But they cant liquidate their positions because of the huge chunk ofstocks they own. Unfortunately for them, even after investing more than$20 billion in the Indian markets, they are unable to sell beyond Rs 20crore to 75 crore in a day.

The reason is simple: they dont have any buyers from the Indian side.The only option for FIIs is to trade among themselves. If they dont trade

among themselves and try to sell aggressively, they cannot exit from themarket in the first instance. There is also the danger that they may losevalueof their investments if they sell in a big way.

OPERATIONAL RISK

Figure 8: Operational

Risk

It encompasses human risk, or human error and internal fraud, model


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risk, physical events such as destruction by fire or other catastrophes, andexternal risk, for example external fraud.

MODEL RISK

It occurs due to the incorrect valuation of an investment opportunity by afinancial instrument. Sophisticated software has been heavily relied uponin the past and will continue to do so and erroneous results could

jeopardize a whole strategy.

The simplest example would be an out dated model that is no longerreliable to correctly evaluate present new market conditions. It is worthy tomention here executive risk arising from an error in hedging againstcurrency risk, due both to managers and/or technology.

Indeed, all funds that are faced with foreign exchange issues try to put in

place effective hedging techniques using futures, forwards and other swapinstruments; sometimes, they fail and losses arise.

HUMAN RISK

Inappropriate fund allocation: manager choosing to allocate fundsinto the wrong sector, strategy or instruments and as a result harmingreturns.

Style drift manager changes direction from the proclaimed style (andarea of expertise) of the fund to seek better long term or short term(bets) opportunities elsewhere and consequently changes therisk/return profile, while failing to inform investors.

For example, in 1995, Fenchurch Capital Management, a fixedincome arbitrage fund switched from U.S. bond basis trading andU.S. yield curve arbitrage to European bonds and equities, an area

virtually unknown to its managers causing large undeclared losses.


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HYPOTHESIS

1. Whether investment in hedge funds is helping to grow the Indian

capital market.

2. Fair understanding about working of hedge funds and different types

of techniques used in hedge funds.

3. Comparison between Hedge funds and mutual funds.


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RESEARCH DESIGN

INTRODUCTION

This chapter will provide a plan of the study which should include

statement of the problem, objectives, scope of the study/significance of theDissertation, methodology, sample design, sources of data, tools andtechniques for data collection, plan of analysis, limitations.

RESEARCH METHODS

a) Type of Study: In the study carried out the exact problem is notknown. The study has been done to get an insight into the HedgeFunds and their investment strategies, so as to make an analyticalstudy about their impact on Indian Capital markets. Hence, the

research type is Exploratory.

b) Type of data: The type of data collected is mainly secondarydata

c) Technique of Analysis :First the a the relationship between thekey Index and the Hedge Fund inflows is established so as to

justify whether there is any impact of Hedge Funds is their inIndian capital

markets.


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After the relationship is established, a detailed analysis of the hedge fundstrategies of investment is done. Also an analytical study of Hedgefunds impact on Indian Capital markets is done based onindividual investment strategy.

RESEARCH DESIGN

A research design lays the base for conducting the project andensures that the research plan is conducted efficiently and effectively.This research has been undertaken to explore the possible impacts ofhedge funds on the Indian Capital Market. For this as discussed earlierQuantitative research is adopted in which certain statistical techniquesare utilized.

STATEMENT OF THE PROBLEM

In view of the increasing popularity among the Hedge funds as well as

their increasing interest in the Indian market, this dissertation tries tounravel the myth behind the working of Hedge Funds.

This study is to elucidate the different strategies of Hedge Fundmanagers and their possible impact on Indian Capital markets andto understand how hedge funds are beneficial.

LIMITATIONS OF THE STUDY

Problems of Inflation: Huge amounts of FII fund inflow into thecountry create a lot of demand of rupee & the RBI pumps the amountof rupee in the market as a result of demand created.

Problems of small investors: The FII profit from investing inemerging financial stock market. If the cap is High they can bring ahuge amounts of funds in countrys stock market & is influence in stockmarket is going up or down.

Adverse impacts on exports: F II flow leading to appreciation of thecurrency may lead to the exports.

Hot money: Hot Money refers to the that are controlled byinvestors who actually seeks short term return. These investors scan


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the market for short term, high interest rate investment opportunities.

Hot money can have economic & financial repercussions ofcountries & bank. When money is injected in the country, theexchange rate for the country gaining the money strengthens, where theexchange rate of the country losing the money weakens. If the money

is withdrawn on the short term notice, the banking instution willexperience a shortage offunds.


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ANALYSIS & INTERPRETATION

This study entitled HEDGE FUNDS AND THEIR POSSIBLEIMPACT ON INDIAN CAPITAL MARKETS was carried outto address the problem related to study whether their would be anypossible impact on Indian markets if Hedge Funds were allowed freely

to invest in India rather than through indirect routes like ParticipatoryNotes.

The objectives of this study were to study the Hedge Fundinvestment strategies, as these investment vehicles are dreaded inmany countries. After doing a detailed study of the strategies, ananalytical framework is done whether there is any potential for HedgeFunds in India and also to study the possible impact of HedgeFunds on the Indian Financial Markets.

Towards this, first a relationship between the key Index (SENSEX) andthe Hedge Fund inflows is established so as to justify whether there isany impact of Hedge Funds in the Indian capital markets. Afterthe relationship is established, a small study on the relationship betweenthe key Hedge Fund indices and the corresponding Strategy Index istaken to establish whether the Hedge Fund strategies has any directrelationship to four biggest crisis in the Financial World.

The four crises taken for study are:

1) 1994 Bond Crisis2) 1997 Thai Crisis3) 1998 Russian Crisis4) 2000 TMT Crisis

After the relationship is established, a detailed analysis of the hedge fundstrategies of investment is done.Also an analytical study of Hedge funds impact on Indian Capitalmarkets is done based on individual investment strategy.


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Tables showing the flow of Hedge Funds from 2003 and SENSEX

return for the corresponding year

Table 2: Flow of Hedge Funds from 2003 and SENSEX return for the

corresponding year

2003 HF INFLOWS

(In Million Rs)

SENSEX RETURN

(%)

Jan 115.20 -3.76

Feb 80.40 1.02

Mar -14.40 -7.15

April 2.40 -2.92

May 65.20 7.47

June 201.2 13.41

July 300.80 5.14

Aug 192.00 11.92

Sep 383.20 4.91

Oct 616.40 10.19

Nov 300.8 2.81

Dec 633.20 15.74

ESTABLISHING A RELATIONSHIP BETWEEN THE FINANCIAL

CRISIS AND HEDGE FUND PERFORMANCE

In order to establish a relationship between the Hedge funds and thedifferent Financial crisis, the returns of various hedge fundstrategies indices is compared with the returns during that particularcrisis.The different crisis taken into consideration are The 1994 BondCrisis, The 1997 Thai Currency Crisis, 1998 Russian Crisis and The


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2000 Technology, Media & Telecom Crisis. The returns are comparedand an analytical framework is arrived in the end by observing thereturns.

CONVERTIBLE ARBITRAGE

1994Bond Crash:CSFB/Tremont Convertible Arbitrage Sub index lost 3.32% in thethree months from February to April and losing 8.5% in the year sinceJanuary The HFRI Convertible Arbitrage Index lost 4.62%.

1997Asian Crisis:CSFB/Tremont Sub-index was up by 5.64% during this period, and14.5% for the whole 1997 year. The HFRI was up by 5.67%.

1998Russian Crisis:

The CSFB/Tremont Sub-index was down 12.03%. This was its worstperformance on record. The HFRI was down by 4.69%.

TMTCrash:The CSFB/Tremont Sub-index was up 28.44%. The HFRI was up by20.74%.

FIXED INCOME ARBITRAGE

Here we compare the movements in the CSFB/ Tremont sub index andHFRI during the four financial crisis in the fixed income arbitrage.

1994Bond Crash: CSFB/Tremont Sub-indexwas up by 3.85%.

HFRI wasup by3.58%.

1997Asian Crisis CSFB/Tremont Sub-indexlost 11.75%.

HFRI lost13.18%.

TMTCrash: CSFB/Tremont Sub-indexwas up 12.06%. HFRI wasup 7.57%.


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EQUITY MARKET NEUTRAL:Here we compare the movements in the CSFB/ Tremont sub

index and HFRI during the four financial crisis in the equity marketneutral.

1994Bond Crash: CSFB/Tremont Sub-indexwas up 0.25%. HFRI was up1.94%.

1997Asian Crisis CSFB/Tremont Sub-indexwas up 4.65%.

HFRI was up7.31%.

1998Russian Crisis CSFB/Tremont Sub-indexwas up 2.56%.

HFRI was down1.48%.

TMTCrash: CSFB/Tremont Sub-indexwas up 18.52%.

HFRI was up21.43%.

MERGER ARBITRAGE:

Here we compare the movements in the CSFB/ Tremont subindex and HFRI during the four financial crisis in the merger arbitrage.

1994Bond Crash: CSFB/Tremont Sub-indexwasup 0.44%.

HFRI was up0.77%.

1997Asian Crisis CSFB/Tremont Sub-index

wasup 6.54%.

HFRI was up

9.91%

1998Russian Crisis CSFB/Tremont Sub-index HFRI was down

was down 4.52%. 2.00%.

TMTCrash: CSFB/Tremont Sub-indexwas up 15.14%.

HFRI was up13.78%.


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DISTRESSED SECURITIES

Here we compare the movements in the CSFB/ Tremont subindex and HFRI during the four financial crisis in the distressedsecurities.

1994Bond Crash: CSFB/Tremont Sub-

indexwas down 2.86%.

HFRI was down

1.38%.

1997Asian Crisis CSFB/Tremont Sub-

indexwas up 9.32%.

HFRIwas up 6.98%.

1998Russian Crisis CSFB/Tremont Sub-

indexwas down 12.94%.

HFRI was down

12.43%.

TMT

Crash

CSFB/Tremont Sub-

indexwas up 15.51%

HFRIwas up 8.32%

GLOBALMACRO

Here we compare the movements in the CSFB/ Tremont sub index and

HFRI during the four financial crisis in the global macro.

1994 Bond Crash: CSFB/Tremont Sub-index was

down 11.12%.

HFRI was down 10.70%.

1997 Asian Crisis CSFB/Tremont Sub-index was HFRI was up 8.88%.

up 20.01%.

1998 Russian Crisis CSFB/Tremont Sub-index was

down 20.14%.

HFRI was down 5.93%.

TMT Crash: CSFB/Tremont Sub-index wasup 28.75%.

HFRI was up 3.98%.


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LONG/SHORT EQUITY:

Here we compare the movements in the CSFB/ Tremont sub index andHFRI during the four financial crisis in the Long/Short Equity.

1994Bond Crash: CSFB/Tremont Sub-index

was down 7.74%.

HFRI was down

2.85%.1997Asian Crisis CSFB/Tremont Sub-index

was up 13.45%.HFRIwas up 13.5%.

1998Russian Crisis CSFB/Tremont Sub-indexwas down 6.76%.

HFRI was down2.38%.

TMTCrash: CSFB/Tremont Sub-indexwas down 9.72%.

HFRI was down7.89%.

EMERGING MARKETS:

Here we compare the movements in the CSFB/ Tremont sub index andHFRI during the four financial crisis in Emerging Markets.

1994Bond Crash: CSFB/Tremont Sub-index was down 13.58%.

1997Asian Crisis CSFB/Tremont Sub-index was down 3.49%.

1998Russian Crisis CSFB/Tremont Sub-index was down 27.53%.

TMTCrash: CSFB/Tremont Sub-index was down 16.59%.


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Inference

Market

Impact

1994 crisis 1997 crisis 1998 crisis TMT Crash

Hedge fund

strategies

High(-) High(+) High(-) High(+)

Convertiblearbitrage

High(+) Medium(+) High(-) High(+)

Fixed incarbitrage

Low(+) High(+) Medium(+) High(+)

Eq. marketneutral

Low(+) High(+) High(-) High(+)

Merger\Riskarbitrage

Medium(-) High(+) High(-) High(+)

Distressedsecurities

High(-) High(+) High(-) High(+)

Global Macro High(+) Low(+) High(+) High(+)

Short Sellers High(-) High(+) High(-) High(-)

Long\ShortEquity

High(-) High(-) High(-) High(+)

EmergingMarket

Medium(+) Medium(+) High(+) Medium(+)

From the above data it is clear that there is a high correlation between theHedge Funds returns and the corresponding indices. This proves thatHedge Funds played a vital role in the culmination of the above said crisis.

Hedge funds as a whole are becoming an important segment of the assetmanagement industry and gaining popularity from investors particularlyfrom the high net worth investors, universities, charitable funds, endowments,pension funds, insurance and other institutional investors.

The assets under management of the hedge funds are growing on a double


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digit rate. All hedge funds are not necessarily speculative funds though mostof them provide an alternative investment options for the investors throughinnovative investment strategy.


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SUMMARY OF FINDINGS

After doing a detailed analysis of Hedge funds and their investingstrategies, one can infer that Hedge funds are both a boon and bane for anycapital markets. Some of the advantages and disadvantages associated withthese funds are listed below:

1. Research and trading strategies of a large number of hedge fundsare aimed at deriving profits from the perceived mispricing ofsecurities. Mispricing between assets arises because market tradersdo n

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