Current methods of intellectual property exchange are inefficient and often hinder companies from easily realizing value from existing IP assets. In addition, intellectual property enforcement is costly and uncertain and entails lengthy negotiations or legal actions.
As a result, necessary IP rights are not effectively transferred, the “best price” for IP is rarely achieved, and the process itself inhibits the market adoption of new technology based products and hence their companies’ economic growth.
What is Intellectual capital ?
Intellectual capital is a term with various definitions in different theories of economics. Accordingly its only truly neutral definition is as a debate over economic "intangibles". Ambiguous combinations of instructional capital and individual capital employed in productive enterprise are usually what is meant by the term, when it is used to actually refer to a capital asset whose yield is intellectual rights.
Such use is rare, however, and the term rarely or never appears in accounting proper - it refers to a debate, and to the assumed capital base that creates intellectual property, rather than an auditable style of capital.
Perhaps due to their industry focus, the term "intellectual capital" is employed mostly by theorists in information technology, innovation research, technology transfer and other fields concerned primarily with technology, standards, and venture capital. It was particularly prevalent in 1995-2000 as theories proliferated to explain the "dotcom boom" and high valuations. During this period it was often observed that computer code and programmers were bearing a substantial premium when combined in new unproven companies. It is hard to see how this differs from the tulip boom, however, when it would have been just as likely to assign a high value to the seemingly-magical combinations of tulip bulbs and, say, the pots they grew in.
Brand as an Asset
Whether flags, brands, labels or simple fear dominate economic decisions, it seems that the underlying theories of intellectual capital and of human capital don't explain them. When attached to "capital" as prefixes, the terms "intellectual", "knowledge" and "human" often conceal more than their use can reveal. Thus the terms intellectual capital, knowledge capital and human capital more properly describe debates, not assets, as internally generated assets do not appear on a balance sheet, however International Financial Reporting Standard 3 on Business Combinations requires acquired intangible assets to be accounted for during the purchase price allocation exercise. They produce neat abstractions but so far poorly explain what actually occurs in the biologically real world: individuals buying in a social setting based on instructions.
So far, the more specific terms "individual", "instructional" and "social" from human development theory, have been preferred in Wikipedia as adjectives describing classes of capital. In part this is because these terms have definitions that arise from academic categories and practices rather than faddish marketing or management theories. There are standards for assigning value to these, e.g. the UN Human Development Index which literally ranks flags (of countries) for quality of life.
Extending such standards to labels (via mandatory labelling) and applying them positively in brand management, e.g. positioning a brand for appeal to an ethical minority, is increasingly common. Projects by Consumerium and AdBusters seek to make comprehensive outcomes more important in buying decisions. This in turn is part of a trend towards more moral purchasing.
When viewed as an asset, then, a brand is simple social capital that may have an increasing amount of instructional capital attached to satisfy an ever-rising demand for more information about product origin, production and distribution.
why should any asset be intangeible ?
Intangible assets are defined as those non-monetary assets that cannot be seen, touched or physically measured and which are created through time and/or effort.[1] There are two primary forms of intangibles - legal intangibles (such as trade secrets (e.g., customer lists), copyrights, patents, trademarks, and goodwill) and competitive intangibles (such as knowledge activities (know-how,knowledge), collaboration activities, leverage activities, and structural activities. Legal intangibles generate legal property rights defensible in a court of law. Competitive intangibles, whilst legally non-ownable, directly impact effectiveness, productivity, wastage, and opportunity costs within an organization - and therefore costs, revenues, customer service, satisfaction, market value, and share price. Human capital is the primary source of competitive intangibles for organizations today. Competitive intangibles are the source from which competitive advantage flows, or is destroyed.
To achieve the objectives of the Intellectual Property Enhancement Program, Altos will explore and develop ways to consolidate IP rights more efficiently for its IPEP participants. The development of new IP exchange practices ultimately may lead to the creation of an operating Intellectual Property Rights Exchange in the future, providing for the efficient open market trading of various direct(spot/cash) and derivative IP-based license, debt equity and hybrid investments.
Such an exchange could bring together IP owners, consumers and investors with a solution for current market inefficiency and provide companies with a mechanism for funding additional innovation, reducing their exposure to legal actions, and increasing their access to underutilized patents and technologies. It is our objective that as a result, faster commercialization of technology will accelerate long-term economic growth.
Different types of trading activities may be developed, bound by the common principles of consistent transaction termsand market pricing. Transactions might be for license rights (e.g., for a specific quantity of production), for ownership rights (e.g., via an open auction), or for various kinds of derivative rights based on specific conditions affecting the underlying asset value.
We anticipate that through our practical experience with the acquisition and out-licensing of IP
rights for IPEP participants, viable long-term mechanisms for open trading will be developed.
Companies that would be admitted into AltosIPexchange agree to participate in this development program, as may financial firm members that have investment interests in IP or IP-owning companies, thus providing a test bed for the creation of practical exchange practices. The program will direct the manner in which the intellectual property rights, either owned by these companies or acquired on their behalf, will be transferred to third parties in accordance with the owners’ objectives. This will relieve the company of the burden of establishing and
administering a licensing program to maximize the value of their IP and will provide investors in IP an avenue for marketing those rights instead of engaging in inefficient, costly and unfamiliar licensing negotiations.
Where all could the applications be ?
1. Under the most recent context global sporting events like the current (2007) world cup, an exchange for derivatives comprising of notional cash value of say runs scored by a batsman, a basket of such values could be securitized and be traded on an exchange, in lay man terms an Exchange which will have an instrument SachinAPRIL 30, i.e a derivatives instrument whose pay off would be linked to the runs scored by sachin as of april 30th or AUSTRALIAWC07APRIL30 this market could then attract participants like advertisers,media channels,branders,consumers investors and speculators.
2. Film and Movie Industry : an active and liquid market comprising of actors,technicians,financiers,producers,investors,distrubutors,advertisers media channels and end consumners(the guy who pays money and buys ticket/dvds)
3. Software and Products company.
4. Architectural firms,building, construction and real estate companies. Eg RELIANCESEZNEAR MUMBAI 2011 futures.
5. Art and artwork.
Wednesday, March 28, 2007
Thursday, March 15, 2007
The case for the First India BEAR FUND : FIB Fund.
The Methodology
The FIB Fund takes short positions in individual stocks and market proxies, and purchases put options, to benefit from a anticipated decline in particular stocks or stock market indices. The fund also holds some “long” positions, primarily stocks of gold and silver asset classes. Investors should realize that the fund is not a “market neutral” fund, but will typically have far more "short" than "long" exposure. And because most long positions are gold stocks, the long portion of the portfolio is unlikely to closely track the general stock market. The fund manager believes this portfolio of short positions and gold stocks will benefit if the long bear market continues to unfold as we expect.
The fund regularly makes short sales of securities, which involves unlimited risk including the possibility that losses may exceed the original amount invested. The fund may also use options and future contracts, which have risks associated with unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. However, a mutual fund investor's risk is limited to one's amount of investment in a mutual fund. The fund may also hold restricted securities purchased through private placements. Such securities may be difficult to sell without experiencing delays or additional costs.
How does the fund potentially benefit investors in stock market declines?
Like most mutual funds, the Fund is a broadly diversified investment vehicle. But the FIBFund is primarily engaged in "short sales." The fund may also purchase put options. An investor who sells a stock short or buys a put option profits when the stock goes down. The fund also holds short positions on indexes which act as proxies for the stock market or a segment of the market. This portfolio of "short" positions (in addition to put options) allows the fund to potentially benefit from a steep market decline. The fund does have some long positions, but these are primarily stocks of gold mining companies. We expect gold stocks to benefit during the secular bear market that we believe is ongoing. What is short selling?Typically an investor buys a stock in hopes it will appreciate. He tries to "buy low and sell high." But if you believe the price of a stock will decline you can sell a stock short. Here, the goal is to sell "high" and buy the stock back "low."An investor may short a stock because he believes it is overvalued or because there is fundamental problem with the company. Or an investor may want to protect against a broad market decline by shorting a number of stocks or an index. How do you sell a stock short?When you short a stock you borrow the stock from you broker and sell it in the market hoping to buy at back later at a lower price.
Here's how it works:
Assume you think XYZ stock will decline in price. You short 100 shares trading at Rs.100 a share. You borrow those shares from your broker who then sells them at the going price and deposits the Rs.10,000 from the sale in your account. Now you owe the broker 100 shares of XYZ regardless of the price of the stock. Now assume the price of XYZ falls to Rs.50. You buy the 100 shares in the market for Rs.5,000 and return the shares to your broker. That leaves you with a profit of Rs.5,000 excluding commissions. If you bought back the stock at a higher price, say Rs.150, you would return the shares to your broker, but you would have lost Rs.5,000:
Who sells stocks short?
Sophisticated investors including hedge funds have long used short sales as an important strategy. Especially during "bear" markets, the flexible strategies of hedge funds allow investors to prosper. A common misconception is that selling short is an ugly or unethical practice, even unpatriotic because the techniques make money when a company fails or disappoints investors.
In reality, short selling has an important role in financial and commodity markets, the most important of which is to help keep the markets efficient. Some academics have suggested that informed investors who execute short sales help set the upper limit and keep equity markets efficient. Additionally, short selling reduces the risk of manipulation, and provides liquidity. Some sophisticated investors do not invest in markets that do not have short sellers, because they consider them to be less efficient markets. Their absence tends to let the markets become too highly valued and therefore too prone to crash. The absence of short selling increases the market’s volatility.What is a put option?A put option is the right to sell a stock at a certain price sometime in the future. An investor who buys a put option pays a price (or premium) for that right with the expectation the stock price will decline. How does a put option work?
Say an investor thinks XYZ Corp., now trading at Rs.50, will fall in price. Let's assume the investor buys a put option in the open market for Rs.2 that lets the investor sell the stock at Rs.50 anytime over the next 90 days. If the stock falls to Rs.40 within that 90 day period, the option would be worth at least Rs.10.* So why buy puts instead of shorting stock?
In the above example, the investor would have made Rs.10, or a 20% return, by shorting the stock (Sell at Rs.50, buy back at Rs.40.). The option investor would have made at least Rs.8 (buy at Rs.2, sell at Rs.10), a return of four times the investment.What happens if the stock price goes up?
The value of the option will decline, and will eventually be worthless if not sold before expiration. *If the option was selling for only Rs.4, for example, an investor could buy the stock for Rs.40, then buy the put option, and immediately "exercise" the option by selling the stock for Rs.50, making a risk free Rs.6.
Asset
Market position
Gold
Spot
Derivatives
Silver
Spot
Derivatives
Nifty
Cash
Derivatives
Sensex
Cash
Derivatives
The Methodology
The FIB Fund takes short positions in individual stocks and market proxies, and purchases put options, to benefit from a anticipated decline in particular stocks or stock market indices. The fund also holds some “long” positions, primarily stocks of gold and silver asset classes. Investors should realize that the fund is not a “market neutral” fund, but will typically have far more "short" than "long" exposure. And because most long positions are gold stocks, the long portion of the portfolio is unlikely to closely track the general stock market. The fund manager believes this portfolio of short positions and gold stocks will benefit if the long bear market continues to unfold as we expect.
The fund regularly makes short sales of securities, which involves unlimited risk including the possibility that losses may exceed the original amount invested. The fund may also use options and future contracts, which have risks associated with unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. However, a mutual fund investor's risk is limited to one's amount of investment in a mutual fund. The fund may also hold restricted securities purchased through private placements. Such securities may be difficult to sell without experiencing delays or additional costs.
How does the fund potentially benefit investors in stock market declines?
Like most mutual funds, the Fund is a broadly diversified investment vehicle. But the FIBFund is primarily engaged in "short sales." The fund may also purchase put options. An investor who sells a stock short or buys a put option profits when the stock goes down. The fund also holds short positions on indexes which act as proxies for the stock market or a segment of the market. This portfolio of "short" positions (in addition to put options) allows the fund to potentially benefit from a steep market decline. The fund does have some long positions, but these are primarily stocks of gold mining companies. We expect gold stocks to benefit during the secular bear market that we believe is ongoing. What is short selling?Typically an investor buys a stock in hopes it will appreciate. He tries to "buy low and sell high." But if you believe the price of a stock will decline you can sell a stock short. Here, the goal is to sell "high" and buy the stock back "low."An investor may short a stock because he believes it is overvalued or because there is fundamental problem with the company. Or an investor may want to protect against a broad market decline by shorting a number of stocks or an index. How do you sell a stock short?When you short a stock you borrow the stock from you broker and sell it in the market hoping to buy at back later at a lower price.
Here's how it works:
Assume you think XYZ stock will decline in price. You short 100 shares trading at Rs.100 a share. You borrow those shares from your broker who then sells them at the going price and deposits the Rs.10,000 from the sale in your account. Now you owe the broker 100 shares of XYZ regardless of the price of the stock. Now assume the price of XYZ falls to Rs.50. You buy the 100 shares in the market for Rs.5,000 and return the shares to your broker. That leaves you with a profit of Rs.5,000 excluding commissions. If you bought back the stock at a higher price, say Rs.150, you would return the shares to your broker, but you would have lost Rs.5,000:
Who sells stocks short?
Sophisticated investors including hedge funds have long used short sales as an important strategy. Especially during "bear" markets, the flexible strategies of hedge funds allow investors to prosper. A common misconception is that selling short is an ugly or unethical practice, even unpatriotic because the techniques make money when a company fails or disappoints investors.
In reality, short selling has an important role in financial and commodity markets, the most important of which is to help keep the markets efficient. Some academics have suggested that informed investors who execute short sales help set the upper limit and keep equity markets efficient. Additionally, short selling reduces the risk of manipulation, and provides liquidity. Some sophisticated investors do not invest in markets that do not have short sellers, because they consider them to be less efficient markets. Their absence tends to let the markets become too highly valued and therefore too prone to crash. The absence of short selling increases the market’s volatility.What is a put option?A put option is the right to sell a stock at a certain price sometime in the future. An investor who buys a put option pays a price (or premium) for that right with the expectation the stock price will decline. How does a put option work?
Say an investor thinks XYZ Corp., now trading at Rs.50, will fall in price. Let's assume the investor buys a put option in the open market for Rs.2 that lets the investor sell the stock at Rs.50 anytime over the next 90 days. If the stock falls to Rs.40 within that 90 day period, the option would be worth at least Rs.10.* So why buy puts instead of shorting stock?
In the above example, the investor would have made Rs.10, or a 20% return, by shorting the stock (Sell at Rs.50, buy back at Rs.40.). The option investor would have made at least Rs.8 (buy at Rs.2, sell at Rs.10), a return of four times the investment.What happens if the stock price goes up?
The value of the option will decline, and will eventually be worthless if not sold before expiration. *If the option was selling for only Rs.4, for example, an investor could buy the stock for Rs.40, then buy the put option, and immediately "exercise" the option by selling the stock for Rs.50, making a risk free Rs.6.
Asset
Market position
Gold
Spot
Derivatives
Silver
Spot
Derivatives
Nifty
Cash
Derivatives
Sensex
Cash
Derivatives
Why Indian Banking industry must be allowed to participate in the emerging Indian Commodity derivatives industry.
Question : What does the Farmer want[1] ?
Answer : The Farmer requires Credit ,Water and Market[2]
CREDIT
MARKET
WATER
Whereas the lenders approach has always been from the credit risk point of view , if the lender has an over all view of the business risk process and adopts suitable hedging strategies using structured derivative products, the approach would not only benefit the Lender but also the Farmer, the governments and the society at large.
So incase of the Agricultural lender in order to minimize his npa, more in particular of the “SOCIAL OBLIGATIONS” of government which may suddenly decide to waive of recoverable, This research paper tries to have an holistic approach on this area and proposes to the agricultural lender a risk hedge matrix based mathematical model on which he can offset his risk .
How to improve access of farmers to agricultural lending?
As per the author, some of the characteristics of price risk management instruments that can enhance access to agricultural credit:
Have a market-based approach.
Assess agricultural portfolio by linking it with exposure and market price of proceeds on exposure.
Create a cushion to protect against price falls.
Short positions including using derivatives like futures and options (Options is currently not available but the talk is of this instrument being made available by the financial year end.)
Provide short term insurance coverage.By cross selling insurance products through strategic alliances with Insurance firms.
Encourage intermediaries for aggregating farmers and meeting contract size.
The author state that traditional crop insurance has suffered from high administrative costs, moral hazard and adverse selection. As a result there is a need for index-based weather insurance, which the author is confident, is just a question of time before which it becomes a reality.
What does the Weather index do?
It compares a measurable, objective, correlated risk to yield.
It has a rainfall index that is designed with historical weather data. If, rainfall levels drop below threshold, then insurance pays out.
It is designed like a put option; farmers select trigger level and scope of coverage.
Innovative ways for improving access to agricultural lending:
Liquid collaterals to improve creditworthiness of agricultural producers.
Warehouse receipts to access financial support.
The reality though is that a few small farmers know in advance what price they will receive for their produce when they sell it and as a result small farmers around the world watch pensively as the prices moves throughout the season. These farmers may not know the daily movements of the international prices but they do know that the price they are being offered by local traders is constantly changing. They also know that if the price drops when they are ready to sell their produce they will not be able to cover their costs of production, send their children to school/pay for household expenditures, or pay back their creditors.
Low market prices limit the income farmers receive from their products, but it is the unpredictability or volatility of these prices that makes it difficult for farmers to optimize production technology, time sales, use assets, and, in most cases, access credit.
Financial services providers are often not willing to lend to small farmers because of farmers’ lack of traditional collateral and the possibility of default on loans in the face of a fall in commodity prices.
Attempts have been made in the past - minimum price guarantees by state owned marketing boards, international commodity agreements, and state subsidized lending institutions - to help farmers deal with volatility and access credit, but these schemes have proven difficult to sustain, costly, and inefficient.
An alternative approach - market based price risk management instruments
The use of market based price risk management instruments, derivatives, can help farmers deal with the price volatility by effectively reducing the uncertainty caused by movements in international commodity prices that affect their business. In this way, the use of price risk management instruments - called hedging - can improve the quality of the lender’s portfolio and help eliminate one of the primary reasons that farmers do not repay loans: unrealized assumptions about levels of projected income and return because of sharply or suddenly falling international commodity prices at the time of selling. These instruments could substantially reduce the risk that many lenders see in lending for commodities.
Price risk management instruments and lending institutions
The small production volumes of most individual farmers make it necessary to involve an intermediary institution that can aggregate the demands of many individual farmers for a risk management instrument into the minimum size traded on international markets. The interest for banks and other financial institutions in playing this role would be to link loans to price risk management tools in order to protect their own risk profile and provide a valuable financial service to its credit facilities.
Financial institutions could combine hedging with lending in three main ways:
1. Hedging for themselves the exposure of their overall portfolio to seasonal falls in commodity prices.
This could allow financial institutions to restructure their portfolio, extend repayments, or even forgive part of the interest and/or principal repayments when a severe price shock occurs;
2. Hedging on behalf of their borrowers, thus attaching a hedge to each loan;
3. Requiring that borrowers provide evidence of price protection measures taken when they come to negotiate a loan (in this final case, farmers would have already accessed risk management instruments through their producer organisation or exporter).
This would allow banks to expand or restart their agricultural loan portfolios, while giving farmers better access to credit and/or opportunity to borrow at better terms.
Who can access these instruments?
Tools to insulate producers and businesses from the negative effects of short- term price volatility are very widely used in high-income countries, but the vast majority of agricultural producers in developing countries have been, in general, unable to access these markets to date.
Some traditional barriers to entry have prevented small holders from accessing these tools including:
Contract size
Lack of knowledge of such market-based price insurance instruments
Limited knowledge about how to utilize them
An unwillingness of sellers of such instruments, generally international banks and brokerage houses, to engage with a new and unfamiliar customer base
Some regulatory barriers
The adoption of several basic financial management practices is examined. The study provides estimates of the extent to which various business analysis and control, investment analysis and decision-making, and capital acquisition practices have been adopted. Many practices, such as net present value analysis, are not widely adopted by farmers. The relationship between the adoption of financial management practices and farm profitability is also examined. Results suggest that the adoption of financial management practices, such as using investment analysis techniques, significantly impacts farm financial performance.
The real question though is, are we using the lessons that we’ve learned? In today’s environment it is critical that we use all of the “lessons” on how to make sound loans and minimize risk while still serving the credit needs of agriculture. Increasing pressure to build business may have allowed lenders to become complacent, and rising farm incomes may have helped them avoid paying the price. There is nothing new or startling in the “lessons” chronicled here. They all call for attention to the basics, doing your homework on all aspects of the borrower’s operation. As competition intensifies among agricultural lenders, and borrowers are more susceptible to market pressures, agricultural lenders that follow these “lessons” will be the ones to survive and prosper.
Simple Road Maps and Blocks ahead.
1. Educate farmers on the use of commodity derivatives, and price knowledge.
The author would like to state an example of ‘Khargone’ a village in the border of Madhyapradesh where farmer’s where educated and based on future prices of cotton their cropping intention was re examined.
2. Taxation issue to be re –examined since hedging transaction is still treated as ‘speculation’, actually it is to be realized that “NOT” hedging is actually speculation.
3. Experts and policy makers to reach out to farmers as well as agro lenders and make them aware of the benefits of the commodity derivative industry.
4. Amendment to the FMC Act, which enable banks and financial institutions to participate directly in these markets.
--------------------------------------------------------------------------------
[1] What Does the Farmer really want ? Case for Agriculture revolution –3 Commodity Derivatives – Internal Publication Zone Equity Pte Ltd Singapore . Shravan Kumar,S.Venkataraghavan ,Nelson Lee 1997.
[2] Walk the Talk NDTV 2004 M.S.Swaminathan, Swaminathan et al , MS S Research Foundation
Review of the Risk Arbitrage opportunities under the context of the current Indian Banking and Financial Sector
The Banking Sector with consolidation imminent thanks to proposed reforms on Basel-II and need for enhanced capital requirements to meet regulatory needs in India.
In particular, generic research questions are pursued-
(1) What is the present landscape for Merger and Acquisition Trend on risk arbitrage activities in the Indian Financial markets specific to Banks & FI’s..
(2) What is the current trend and effect of the Indian financial regulatory mechanism on risk arbitrage(M&A Arbitrage) ?
Returns associated with risk arbitrage are more pronouncedly decreased in down/severely depreciating stock market and business conditions especially when there is possibility of deal failure but remain rather uncorrelated with market returns when the market is flat and appreciating.
There has also been a growing trend in Indian financial market regulatory mechanism toreduce systemic risk, eliminate legal uncertainty and control regulatory and to have a
closer look on derivatives trading, over the counter derivatives including P-Notes which could be potentially used for fraud or manipulation. The current focus of the financial regulatory mechanism is to curb illegal trading in risk arbitrage activities through limits on trading volume and control of regulatory arbitrage opportunities which should continue into the future.
Acknowledgements
I would like to thank my team of analysts at Altos who have been patient enough with my tantrums,mood swings and have contributed considerably.
My sincere thanks are due to Raj Venkatraman New York a M& A arbitrageur, guru for his guidance and valuable suggestions.
Disclosures:
Investments & Exposure to Banks and Financial Institution
Proprietary Position : No
Family and Friends : Yes
Clients : No
Other Conflicts : Maybe
Introduction
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions specifically in India .
INDIAN BANKING stands at the threshold of a mega change in the next five years. Many new situations as compared to the present scenario are predicted to emerge. However, participants and analysts in the industry too see the opportunities and failures in distinctively different ways. While the core area of discussion in the recent reports published on the industry relates to consolidation and foreign direct investment, "Social Banking,'' an area of concern, has got short shrift.
Standard & Poor's, which compares Indian and Chinese banking, prescribes risk management as a thrust area for the former. McKinsey, however, suggests different goals (and ways of achieving them) to different sets of bankers — public sector, old private, new private and foreign — while visualizing different scenarios of Indian banking five years from now. The Independent Commission of Bank Officers analyses, in detail, the issues that had hampered the Indian banking system in the past and argues how the Government's recent proposals — foreign direct investment (FDI) and consolidation of public sector banks — will not ensure systemic transparency and efficiency as projected.
One has to see these reports in the light of the United Progressive Alliance (UPA) Government's priorities in the rural and agrarian sector, and the future growth of the economy as well as employment generation. These reports also focus on the emerging scenario in April 2009, when the second phase of the "Road Map for Foreign Banks' Presence in India" begins. In the second phase, the removal of limitations on the operations of the wholly owned subsidiaries and the treating of foreign banks on a par with domestic banks to the extent appropriate will be implemented after reviewing the experience with phase one (March 2005 to March 2009), and after due consultations with all stakeholders in the banking sector. While rating the country's top 20 banks (most of them are public sector banks), Standard & Poor's narrates the key challenges in the system, with priority given to "the need for banking sector consolidation.'' It expects that "rationalisation will ultimately occur among the Indian public sector banks, albeit at a moderate pace.'' At the same time, consolidation could occur between foreign banks and private sector banks, "although any sharp increase in such activity is only expected after March 2009,'' as per the guidelines for the Road Map for the presence of foreign banks.
The banking sector reforms undertaken in India from 1992 onwards were basically aimed at ensuring the safety and soundness of financial institutions and at the same time at making the banking system strong, efficient, functionally diverse and competitive. The reforms included measures for arresting the decline in productivity, efficiency and profitability of the banking sector. Furthermore, it was recognized that the Indian banking system should be in tune with international standards of capital adequacy,
prudential regulations, and accounting and disclosure standards. Financial soundness and consistent supervisory practices, as evident in our level of compliance with the Basel Committees Core Principles for Effective Banking Supervision, have made our banking system resilient to global shocks.
Potential scenarios
In an interesting futuristic study, McKinsey uncovers "three potential scenarios'' that could emerge in the banking sector by 2010 (after the entry of a large number of foreign players), based on the interplay between policy and regulatory interventions and management strategies. The first is a "high performing'' scenario, where policy makers intervene only to the extent required to ensure system stability and protection of consumers' interest, and bank managements step up the drive for far-reaching change.
In the second, "evolving'' scenario, policy makers adopt a pro-market stance but are cautious on pushing reform. The share of the banking sector value added would be 4.7 per cent of GDP. And in the third scenario — stagnating — policy makers intervene to set restrictive conditions and management is unable to execute changes to deliver value to shareholders or customers. Here, the share of the banking sector value added would be only 3.3 per cent of GDP.
The evidence from many emerging market economies, particularly Latin America, shows that a greater reliance on banking FDI has given rise to conditions of: stalled overall growth in credit with domestic banks also reducing loan exposure; far greater financial instability during episodes of shock to the domestic economy; and uncertainty and slow economic growth due to foreign banks acting as conduits for transmission of contagion and strategic decisions from parent banks onto developing markets. "It is to be noted that these consequences are but an expression of the loss of economic sovereignty. We can choose to ignore these lessons only at our own peril,'' states the Independent Commission of Bank Officers.
Consolidation of banks
On consolidation of banks, especially public sector banks, the Commission says that "while the gains from consolidation are expected along greater economies of scale and scope available to bigger banks, the evidence does not support an automatic association between large size and profitability.
On the other hand, bigger banks tend to rely much more on arm's length transactions and standardised balance sheets and loan accounts, on fee based income that seek to avert credit and interest risk, and on trading risk at the securities market. These tendencies give rise to the phenomenon of financial exclusion (whereby a large segment of the population remains unbanked) at the same time that it engenders financial fragility via a greater exposure to financial markets.''
Today, the overall level of non-performing loans (NPLs) in the entire financial system is around Rs. 1,20,000 crore. Of this, around Rs. 50,000 crore are NPLs on account of the corporate sector, the rest accounted for by the rural and cooperative sector. The cooperative sector is not ruined by the rural poor, but by politicians and other manipulators. What India needs is a proper banking structure to ensure that these funds reach the end user.
The Author believes that at current juncture due to the above stated factors the opportunities in the area of Risk Arbitrage or what is commonly reffered to as M&A Arbitrage in the Indian Banking & FI sector are phenomenal.
In Risk Arbitrage, large excess returns have been documented in literature i.e. in previous studies(in the US in 1990’s) .
Two reasons can be attributed to this-
a) Transaction Costs and other practical limitations prevent investors from realizing these
extraordinary returns.
b) Risk arbitrageurs receive a risk premium to compensate for the risk of deal failure. The
risk arbitrage premium is defined as the spread between the current market price and the price to be paid for the shares in the deal at the time of the tender offer announcement. Another possible explanation for the extraordinary returns to risk as documented in previous studies is that they simply reflect the compensation for bearing
extraordinary risk. The paper by Mitchell, Mark and Todd Pulvino (2001) attempts to understand the effect of stock market and business conditions as well as the M&A trend on risk arbitrage in US financial markets confirms that returns associated with risk arbitrage are said to expect more of a downturn in down stock market and business conditions especially when there is possibility of deal failure.
However under the Present Indian Context it is totally different.
Domestic mergers The Narrow RBI Approach.
Under the Banking Regulation Act, banking companies cannot merge without the approval of the Reserve Bank of India. The government and the Reserve Bank do not play a proactive role in either encouraging or discouraging mergers. It is our endeavour that the government and the RBI should only provide the enabling environment through an appropriate fiscal, regulatory and supervisory framework for the consolidation and convergence of financial institutions, at the same time ensuring that a few large institutions do not create an oligopolistic structure in the market. Mergers should be
based on the need to attain a meaningful balance sheet size and market share in the face of heightened competition and driven by synergies and locational and business-specific complementarities.
While there is no regulatory deterrence to bank mergers, their incidence has not been significant and hence no problems have occurred in India. Mergers of banks help to reduce the gestation period for launching/promoting new places of business,
strengthen product portfolios, minimise duplication, gain competitive advantage, etc. They are also recognized as a good strategy for enhancing efficiency.
Ideally, mergers under the present context according to the RBI ought to be aimed at
exploiting synergies, reducing overlap in operations, right-sizing and redeploying surplus staff either by retraining, alternate employment or voluntary retirement, etc.
As banks are leveraged and the credibility of the top management has tremendous supervisory implications, we prefer consensual mergers to hostile takeovers. The takeover codes should, therefore, reflect the supervisory concerns.
Issues in banks mergers with non-banks (NBFC’S)
The RBI endeavor’s to preserve the integrity and identity of banks. The activities that the banks and their subsidiaries can undertake are restrictive, to ensure that the interests of existing and future depositors are fully protected. Banks are also not allowed to undertake trading in commodities(and since yours truly began his career as a Comodity broker I am consistent on my role as a RBI basher) .
In pursuit of these objectives, the merger of a bank with a non-bank is generally not favored.
However, the merger of a non-bank financial company with a bank is allowed subject to the prior approval of the Reserve Bank of India and compliance with all the regulatory and supervisory standards applicable to banks. The issues that may arise in such mergers would be the bank’s ability to comply with statutory and regulatory requirements in respect of liabilities and assets taken over by it from the non-bank.
Mechanism for preserving competition
There is no separate agency/mechanism for preserving competition in the banking sector. Promoting competition is, however, one of the key objectives of the new proposed financial sector reforms.
The entry of new private sector and foreign banks and introduction of new products and technology and operational freedom to banks have ensured a competitive environment in the financial market.
Impact of consolidation
Since the consolidation process has not gone very far in India, its impact has not been significant.Mergers of certain foreign banks at the global level have also not affected the Indian market, as their market share is currently very low. However, the deregulation process has brought in more competition in the banking sector, resulting in delivery of innovative financial products at competitiverates. The consolidation of banks may not significantly affect the functioning of various segments of the financial markets. In a liberalised environment, the mere size of the bank may not be an enabling condition for distorting the pricing mechanisms or liquidity in the market. The presence of large banks
would result in more competition and narrowing spreads.
Role of banks and development finance institutions (DFIs)
India being a geographically vast country with its rural population constituting almost 70% of the total, the role of regional rural banks remains important. The banking sector, characterised by the presence of internationally active banks, national-level banks and regional rural banks, is likely to be preserved to cater to the needs of a varied customer base. Consequent to liberalisation and financial sector reforms, there has been some blurring of distinction between the activities of banks and DFIs. In
particular, the traditional distinction between commercial banking and investment banking has tended to narrow somewhat. Banks have been moving into certain areas which were the exclusive domain of the DFIs, eg project finance and investment banking. DFIs have recently been given the option to convert themselves into universal banks with the RBI’s approval.
To this end, a DFI would need to prepare a transition path in order to comply fully with the statutory and regulatory requirements applicable to banks
Research Purpose and Contribution
This paper analyses risk arbitrage in Indian financial markets specific to the Banking and Financial services sector. An attempt has been made to the paper by studying the Indian financial regulatory mechanism and its related impact on risk arbitrage in terms of controlling trading limits as well as illegal trading.
Questions that are pursued include,
(1) What are the effects of financial market and business conditions as well as the Merger and Acquisition Trend on risk arbitrage activities in the Indian Banking and financial services space ?
(2) What is the effect of the Indian financial regulatory mechanism on risk arbitrage?
(3) The Dichotomy that exists in the current regulatory structure where by “slaves” who have two masters become free – Especially in the Indian context where Banks are regulated by the Reserve bank of India and as listed entities regulated by the SEBI and its prescribed take over code of conduct.
The first signigicant M& A arbitrage opportunity was observed in the HDFC Bank, Times Bank Merger in the year 1998.
There have been swings on subsequent deals, like that of The OBC –GTB deal and the lastest Centurion Bank –Bank of Punjab deal.
Definitions
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread.
A Takeover in the modern day business world refers to one company (the acquirer) purchasing another company (the target).
An Overview
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread. After the announcement of a merger or acquisition, the stock of the target company is typically traded at a discount to the stock of the acquired company.
In fact the difference in the price of stock between that of the target company and the acquiring company is known as the arbitrage spread.
In the event of the merger being successful the arbitrageur incurs a profit based on the arbitrage spread. However in the event of a merger failure the risk arbitrageur incurs loss , which is usually much more than the profits he would have earned, had the merger been successful.
Institutional Background of mergers in the US
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions. This has been particularly observed in the U.S.A where takeover activity has been most observed in the 1990s.
There was an encouragement for merger activity, due to the removal of geographical restrictions for banks and thrifts under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Also observed was the removal of preferential tax treatment of bad debt reserves under a special provision of the Small Business Jobs Protection Act of 1996 eliminated previous impediments for thrift to bank conversions and mergers. Another significant change observed during that time was the Gramm-Leach-Bliley Act (Financial Modernization Act) of 1999 that permitted the creation of Financial Holding Companies which could practice all functions ‘financial in nature’ under one umbrella removed further deterrents to bank/thrift mergers.
What we are seeing in the Indian Context is an adaptation of the best practices of the above with a new Jargon of Shri Kamath Chief of ICICI “ The Universal Banking”
Limited Arbitrage in Mergers and Acquisition
Firstly arbitrage is limited to the extent of buying the acquiring firms shares, with a direct
purchase and an indirect purchase. While the direct purchase would involve buying the shares from the acquiring firm, an indirect purchase would involve buying the target firm’s shares and waiting for the deal to come through, during which the target firm’s shares are exchanged for the acquirer’s shares.
Both the above methods of transacting in shares have identical payoffs if the
merger deal comes through. The arbitrageur also faces an inherent fundamental risk, that of deal failure which could lead to exorbitant losses. The phenomenon of deal failure can be described as any risk arbitrage deal where the arbitrageur loses money.
Nature of Risk Arbitrage
While understanding the nature of risk arbitrage, it is important to know that it can be categorized into two –
a) Pre-emptive Arbitrage-In this kind of arbitrage opportunity, the arbitrageur buys the
shares of the acquired company well in advance. This kind of arbitrage is quite speculative and depends on the success of the merger. In the event of the merger being carried out, the arbitrageur does benefit from the price paid and the tender offer of the share. Pre-emptive arbitrage is guided by instinct and predictions made by the arbitrageur who attempts to forecast potential mergers and acquisitions in the coming weeks and months.
b) Post-Tender Arbitrage-As far as post-tender arbitrage is concerned the acquiring
company makes a tender offer about shares and the arbitrage profit is determined by the price differential between the offer price of the share and the selling price of the share on a particular day, post merger. For example say BIHAR BANK(fictious bank) is planning to acquire UTTAR PRADESH BANK in the near future. BIHAR BANK makes a predictable tender offer of the stock of UTTAR PRADES for Rs. 25;
however the common stock of UTTAR PRADESH BANK sells for Rs. 27 in the market. In such a case the arbitrageur seeks to make a profit from the Rs. 2 differential.
The process of post-tender arbitrage is very dynamic wherein the investment is held for a very short time with very high potential for profits.
Risks associated with risk arbitrage
The main risk associated with risk arbitrage is that of deal failure, otherwise called the completionrisk. If at some stage the management of either company decides not to go through with the deal, then the benefits of arbitrage accruing to the transaction of shares may not materialise. Some shareholders may wish to insure this risk by selling of their shares. As a result of this selling pressure, the price of the target firm can fall below its efficient market price and lead to a market inefficiency thereby resulting in abnormal profits. Arbitrage is also limited to the extent of supply of capital which is a prerequisite for its smooth functioning; it has been observed that the lender typically requires 105-110 % of the short position as collateral.
Calculating Annual Return for Risk Arbitrage
The formula for calculating the returns for risk arbitrage, in other words the potential arbitrage
commitment, was invested by Benjamin Graham in the book Security Analysis (1951).
Indicated Annual Return = [GC-L (100%-C)] /YP (Rockwood, Richard M (2001))
G=Expected gain in points in the event of success.
L=Expected loss in points in the event of failure.
C=Expected change of success as a percentage.
Y=Expected time of holding of shares, in years
P=Current Price of the security
Risk Arbitrage in Bank &FI Takeovers
In the modern day business world a takeover refers to one company (the acquirer) purchasing another company (the target). Though takeovers resemble mergers they are different in the sense that while a merger leads to the formation of a new company, a takeover does not. Corporate takeovers are common in USA and the United Kingdom. However they are a rare occurrence in Germany because of the dual board structure, in Japan because of kereitsu or the interlocking sets of ownerships in the corporate structure and in China because a majority of the publicly listed companies are owned by the state.
Under the present Indian context especially in the Banking and financial services sector it is far more complicated and are backed by various legislations of the Parliament.
Takeovers are of the following kinds-
a) Friendly Takeover-A friendly takeover involves the straight buyout of a company and is observed frequently. In such a takeover the shareholders are the recipients of cash or a number of shares which is contractually agreed upon in advance.
b) Hostile Takeover-In a hostile takeover one company agrees to buy out another company regardless of the consent of the company or otherwise. The mode of conducting a hostile takeover is through publicly traded shares. The rationale behind this mode of performing a hostile takeover is that the acquiring company is actually required to bypass the board the directors and purchase shares from other sources. The process of carrying out a hostile takeover through publicly traded shares is rather difficult unless the shares of the company are otherwise widely available and can be easily purchased.
c) Reverse Takeover-A reverse takeover can take place through either a smaller firm taking over a larger firm, a private company taking over a public company by bypassing a majority of security regulations. This cannot be ruled out in the later economic landscape of corporate India.
Rationale behind takeovers
A variety of reasons can be attributed to why one Bank would like to acquire another
Bank .
One reason is profitability, the target company in such a case may be reasonably priced
and so the acquiring company may make a decision that within a certain time period purchasing that company would be a profitable move.
Takeovers can also be strategic in the sense that the acquiring Bank has motives other than profit to purchase another Bank. In such a case the company that is to be acquired could be quite profitable on its own but may harbour other capabilities that could be beneficial to the acquiring firm. For example a target Bank may
have a well developed distribution network,best practices or information technology capabilities which could lead to an acquiring Bank wishing to takeover it. The acquiring Bank as a result of this takeover will be able to benefit strategically from the capabilities of that Bank apart from earning a profit. An acquiring Bank may decide to takeover another bank as it enables the company to enter into a new market. In some cases in order to eliminate competition, one bank may decide to acquire another and also to be able to defend itself against another competitor. It has very often been the case that very large companies enter into takeovers for the purpose of boosting their reported revenues without much care for the profit involved and the company’s profitability does stand a chance of being affected if there are large costs involved.
There is a premium involved if the target company is financially healthy which may not always be the case. Following a takeover the stock price of the target company may rise forcing down the price of the acquiring company Takeovers and the legal system
In the US takeovers are governed by the Williams Act, which was enacted in July 1968. (Gomes, Armando, 2001)Takeovers are also governed by corporate laws and the state jurisdiction. The purpose of the Williams Act is to enable shareholders of a company to have fair and full disclosure to information and sufficient time to be able to act upon information. US Takeover rules are contained in the in Section 14(d)(1) of the Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rules 14D and 14E.
Indian Scenario SEBI’s guide lines on take over.(refer appendix A 4)
Risk Arbitrage in Takeovers: An overview
Arbitrageurs are strategically important in the market for corporate control. Following a tender offer there is often a drastic rise in risk arbitrageur activity. Risk arbitrageurs take long positions in a target stock with the notion that the takeover will go through. Based on the cooperative Nash bargaining game, the idea that blocking of shares may be relevant for pricing of takeovers wasfirst developed by Bergström, Clas, Peter Högfeldt, and Kenneth Högholm (1993).These arbitrageurs are often hedged by taking short positions in the acquirers stock. Factors contributing to a rise in risk arbitrage activity include the emergence of Ivan Boesky(a prominent arbitrageur on Wallstreet who had been involved in an Insiders Trading Scandal) and an increase in the number of corporate takeover deals contributing to its visibility. Due to the large volume of new arbitrage capital in recent times there is a rise in the narrowing of spreads and the increase in
share price following a takeover announcement which has on an average reduced profit margins in this activity. Despite the odds that prevail, risk arbitrageurs continue to make profits and are considered as important players in the success of a takeover. Usually in an arbitrage deal the number of risk arbitrageurs contributes to 30-40% of the stock and they are considered an important element in the very many deals that are happening.
Rationale behind Risk Arbitrage in Takeovers
Risk arbitrageurs enjoy an information advantage which arises from their choice to enter the field of risk arbitrage. (Larcker, D. and T. Lys,(1987)) If the presence of risk arbitrageurs increases the likeliness of a takeover occurring, then one risk arbitrageur buying shares is relevant for the entire value of shares. Risk arbitrageurs expend a large effort in understanding how other risk arbitrageurs would behave. The number of arbitrageurs who decide to take positions, the number of shares that they will purchase and the price of shares are often determined in equilibrium of an endogenous kind. The value of shares in a takeover does depend on the probability of a takeover occurring. Share value should be higher in the event of there being a larger number of risk arbitrageurs in the market. The informational advantage that a risk arbitrageur enjoys enables and makes him willing to pay a price high enough to persuade smaller shareholders to sell their shares. In most cases the risk arbitrageurs do not have any initial private information. The private 14 information that they enjoy arises endogenously when they start buying shares. However arbitrageurs have to be controlled to ensure that they don’t compete away their rent.
Conclusion
1. With consolidation in Banking and FI imminent in India , a tremendous opportunity in the area of Risk arbitrage(M&A arbitrage) largely remains untapped.
2. Players who have exposure to sophisticated risk management tools and systems (barra et all) and best practices that are currently being used in the developed financial markets for assessing Risk Arbitrage opportunities have a significant competitive advantage over the local Indian players.
3. Market driven reforms will make Indian regulators to strive to reduce the cost associated with “regulatory arbitrage” opportunities.
In particular, generic research questions are pursued-
(1) What is the present landscape for Merger and Acquisition Trend on risk arbitrage activities in the Indian Financial markets specific to Banks & FI’s..
(2) What is the current trend and effect of the Indian financial regulatory mechanism on risk arbitrage(M&A Arbitrage) ?
Returns associated with risk arbitrage are more pronouncedly decreased in down/severely depreciating stock market and business conditions especially when there is possibility of deal failure but remain rather uncorrelated with market returns when the market is flat and appreciating.
There has also been a growing trend in Indian financial market regulatory mechanism toreduce systemic risk, eliminate legal uncertainty and control regulatory and to have a
closer look on derivatives trading, over the counter derivatives including P-Notes which could be potentially used for fraud or manipulation. The current focus of the financial regulatory mechanism is to curb illegal trading in risk arbitrage activities through limits on trading volume and control of regulatory arbitrage opportunities which should continue into the future.
Acknowledgements
I would like to thank my team of analysts at Altos who have been patient enough with my tantrums,mood swings and have contributed considerably.
My sincere thanks are due to Raj Venkatraman New York a M& A arbitrageur, guru for his guidance and valuable suggestions.
Disclosures:
Investments & Exposure to Banks and Financial Institution
Proprietary Position : No
Family and Friends : Yes
Clients : No
Other Conflicts : Maybe
Introduction
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions specifically in India .
INDIAN BANKING stands at the threshold of a mega change in the next five years. Many new situations as compared to the present scenario are predicted to emerge. However, participants and analysts in the industry too see the opportunities and failures in distinctively different ways. While the core area of discussion in the recent reports published on the industry relates to consolidation and foreign direct investment, "Social Banking,'' an area of concern, has got short shrift.
Standard & Poor's, which compares Indian and Chinese banking, prescribes risk management as a thrust area for the former. McKinsey, however, suggests different goals (and ways of achieving them) to different sets of bankers — public sector, old private, new private and foreign — while visualizing different scenarios of Indian banking five years from now. The Independent Commission of Bank Officers analyses, in detail, the issues that had hampered the Indian banking system in the past and argues how the Government's recent proposals — foreign direct investment (FDI) and consolidation of public sector banks — will not ensure systemic transparency and efficiency as projected.
One has to see these reports in the light of the United Progressive Alliance (UPA) Government's priorities in the rural and agrarian sector, and the future growth of the economy as well as employment generation. These reports also focus on the emerging scenario in April 2009, when the second phase of the "Road Map for Foreign Banks' Presence in India" begins. In the second phase, the removal of limitations on the operations of the wholly owned subsidiaries and the treating of foreign banks on a par with domestic banks to the extent appropriate will be implemented after reviewing the experience with phase one (March 2005 to March 2009), and after due consultations with all stakeholders in the banking sector. While rating the country's top 20 banks (most of them are public sector banks), Standard & Poor's narrates the key challenges in the system, with priority given to "the need for banking sector consolidation.'' It expects that "rationalisation will ultimately occur among the Indian public sector banks, albeit at a moderate pace.'' At the same time, consolidation could occur between foreign banks and private sector banks, "although any sharp increase in such activity is only expected after March 2009,'' as per the guidelines for the Road Map for the presence of foreign banks.
The banking sector reforms undertaken in India from 1992 onwards were basically aimed at ensuring the safety and soundness of financial institutions and at the same time at making the banking system strong, efficient, functionally diverse and competitive. The reforms included measures for arresting the decline in productivity, efficiency and profitability of the banking sector. Furthermore, it was recognized that the Indian banking system should be in tune with international standards of capital adequacy,
prudential regulations, and accounting and disclosure standards. Financial soundness and consistent supervisory practices, as evident in our level of compliance with the Basel Committees Core Principles for Effective Banking Supervision, have made our banking system resilient to global shocks.
Potential scenarios
In an interesting futuristic study, McKinsey uncovers "three potential scenarios'' that could emerge in the banking sector by 2010 (after the entry of a large number of foreign players), based on the interplay between policy and regulatory interventions and management strategies. The first is a "high performing'' scenario, where policy makers intervene only to the extent required to ensure system stability and protection of consumers' interest, and bank managements step up the drive for far-reaching change.
In the second, "evolving'' scenario, policy makers adopt a pro-market stance but are cautious on pushing reform. The share of the banking sector value added would be 4.7 per cent of GDP. And in the third scenario — stagnating — policy makers intervene to set restrictive conditions and management is unable to execute changes to deliver value to shareholders or customers. Here, the share of the banking sector value added would be only 3.3 per cent of GDP.
The evidence from many emerging market economies, particularly Latin America, shows that a greater reliance on banking FDI has given rise to conditions of: stalled overall growth in credit with domestic banks also reducing loan exposure; far greater financial instability during episodes of shock to the domestic economy; and uncertainty and slow economic growth due to foreign banks acting as conduits for transmission of contagion and strategic decisions from parent banks onto developing markets. "It is to be noted that these consequences are but an expression of the loss of economic sovereignty. We can choose to ignore these lessons only at our own peril,'' states the Independent Commission of Bank Officers.
Consolidation of banks
On consolidation of banks, especially public sector banks, the Commission says that "while the gains from consolidation are expected along greater economies of scale and scope available to bigger banks, the evidence does not support an automatic association between large size and profitability.
On the other hand, bigger banks tend to rely much more on arm's length transactions and standardised balance sheets and loan accounts, on fee based income that seek to avert credit and interest risk, and on trading risk at the securities market. These tendencies give rise to the phenomenon of financial exclusion (whereby a large segment of the population remains unbanked) at the same time that it engenders financial fragility via a greater exposure to financial markets.''
Today, the overall level of non-performing loans (NPLs) in the entire financial system is around Rs. 1,20,000 crore. Of this, around Rs. 50,000 crore are NPLs on account of the corporate sector, the rest accounted for by the rural and cooperative sector. The cooperative sector is not ruined by the rural poor, but by politicians and other manipulators. What India needs is a proper banking structure to ensure that these funds reach the end user.
The Author believes that at current juncture due to the above stated factors the opportunities in the area of Risk Arbitrage or what is commonly reffered to as M&A Arbitrage in the Indian Banking & FI sector are phenomenal.
In Risk Arbitrage, large excess returns have been documented in literature i.e. in previous studies(in the US in 1990’s) .
Two reasons can be attributed to this-
a) Transaction Costs and other practical limitations prevent investors from realizing these
extraordinary returns.
b) Risk arbitrageurs receive a risk premium to compensate for the risk of deal failure. The
risk arbitrage premium is defined as the spread between the current market price and the price to be paid for the shares in the deal at the time of the tender offer announcement. Another possible explanation for the extraordinary returns to risk as documented in previous studies is that they simply reflect the compensation for bearing
extraordinary risk. The paper by Mitchell, Mark and Todd Pulvino (2001) attempts to understand the effect of stock market and business conditions as well as the M&A trend on risk arbitrage in US financial markets confirms that returns associated with risk arbitrage are said to expect more of a downturn in down stock market and business conditions especially when there is possibility of deal failure.
However under the Present Indian Context it is totally different.
Domestic mergers The Narrow RBI Approach.
Under the Banking Regulation Act, banking companies cannot merge without the approval of the Reserve Bank of India. The government and the Reserve Bank do not play a proactive role in either encouraging or discouraging mergers. It is our endeavour that the government and the RBI should only provide the enabling environment through an appropriate fiscal, regulatory and supervisory framework for the consolidation and convergence of financial institutions, at the same time ensuring that a few large institutions do not create an oligopolistic structure in the market. Mergers should be
based on the need to attain a meaningful balance sheet size and market share in the face of heightened competition and driven by synergies and locational and business-specific complementarities.
While there is no regulatory deterrence to bank mergers, their incidence has not been significant and hence no problems have occurred in India. Mergers of banks help to reduce the gestation period for launching/promoting new places of business,
strengthen product portfolios, minimise duplication, gain competitive advantage, etc. They are also recognized as a good strategy for enhancing efficiency.
Ideally, mergers under the present context according to the RBI ought to be aimed at
exploiting synergies, reducing overlap in operations, right-sizing and redeploying surplus staff either by retraining, alternate employment or voluntary retirement, etc.
As banks are leveraged and the credibility of the top management has tremendous supervisory implications, we prefer consensual mergers to hostile takeovers. The takeover codes should, therefore, reflect the supervisory concerns.
Issues in banks mergers with non-banks (NBFC’S)
The RBI endeavor’s to preserve the integrity and identity of banks. The activities that the banks and their subsidiaries can undertake are restrictive, to ensure that the interests of existing and future depositors are fully protected. Banks are also not allowed to undertake trading in commodities(and since yours truly began his career as a Comodity broker I am consistent on my role as a RBI basher) .
In pursuit of these objectives, the merger of a bank with a non-bank is generally not favored.
However, the merger of a non-bank financial company with a bank is allowed subject to the prior approval of the Reserve Bank of India and compliance with all the regulatory and supervisory standards applicable to banks. The issues that may arise in such mergers would be the bank’s ability to comply with statutory and regulatory requirements in respect of liabilities and assets taken over by it from the non-bank.
Mechanism for preserving competition
There is no separate agency/mechanism for preserving competition in the banking sector. Promoting competition is, however, one of the key objectives of the new proposed financial sector reforms.
The entry of new private sector and foreign banks and introduction of new products and technology and operational freedom to banks have ensured a competitive environment in the financial market.
Impact of consolidation
Since the consolidation process has not gone very far in India, its impact has not been significant.Mergers of certain foreign banks at the global level have also not affected the Indian market, as their market share is currently very low. However, the deregulation process has brought in more competition in the banking sector, resulting in delivery of innovative financial products at competitiverates. The consolidation of banks may not significantly affect the functioning of various segments of the financial markets. In a liberalised environment, the mere size of the bank may not be an enabling condition for distorting the pricing mechanisms or liquidity in the market. The presence of large banks
would result in more competition and narrowing spreads.
Role of banks and development finance institutions (DFIs)
India being a geographically vast country with its rural population constituting almost 70% of the total, the role of regional rural banks remains important. The banking sector, characterised by the presence of internationally active banks, national-level banks and regional rural banks, is likely to be preserved to cater to the needs of a varied customer base. Consequent to liberalisation and financial sector reforms, there has been some blurring of distinction between the activities of banks and DFIs. In
particular, the traditional distinction between commercial banking and investment banking has tended to narrow somewhat. Banks have been moving into certain areas which were the exclusive domain of the DFIs, eg project finance and investment banking. DFIs have recently been given the option to convert themselves into universal banks with the RBI’s approval.
To this end, a DFI would need to prepare a transition path in order to comply fully with the statutory and regulatory requirements applicable to banks
Research Purpose and Contribution
This paper analyses risk arbitrage in Indian financial markets specific to the Banking and Financial services sector. An attempt has been made to the paper by studying the Indian financial regulatory mechanism and its related impact on risk arbitrage in terms of controlling trading limits as well as illegal trading.
Questions that are pursued include,
(1) What are the effects of financial market and business conditions as well as the Merger and Acquisition Trend on risk arbitrage activities in the Indian Banking and financial services space ?
(2) What is the effect of the Indian financial regulatory mechanism on risk arbitrage?
(3) The Dichotomy that exists in the current regulatory structure where by “slaves” who have two masters become free – Especially in the Indian context where Banks are regulated by the Reserve bank of India and as listed entities regulated by the SEBI and its prescribed take over code of conduct.
The first signigicant M& A arbitrage opportunity was observed in the HDFC Bank, Times Bank Merger in the year 1998.
There have been swings on subsequent deals, like that of The OBC –GTB deal and the lastest Centurion Bank –Bank of Punjab deal.
Definitions
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread.
A Takeover in the modern day business world refers to one company (the acquirer) purchasing another company (the target).
An Overview
Risk Arbitrage otherwise called as merger arbitrage, refers to an investment strategy whereby an attempt is made to profit from what is known as an arbitrage spread. After the announcement of a merger or acquisition, the stock of the target company is typically traded at a discount to the stock of the acquired company.
In fact the difference in the price of stock between that of the target company and the acquiring company is known as the arbitrage spread.
In the event of the merger being successful the arbitrageur incurs a profit based on the arbitrage spread. However in the event of a merger failure the risk arbitrageur incurs loss , which is usually much more than the profits he would have earned, had the merger been successful.
Institutional Background of mergers in the US
With the global financial services scenario having changed in the recent past, there is a growing trend of mergers and acquisitions which has taken place recently in numerous financial institutions. This has been particularly observed in the U.S.A where takeover activity has been most observed in the 1990s.
There was an encouragement for merger activity, due to the removal of geographical restrictions for banks and thrifts under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Also observed was the removal of preferential tax treatment of bad debt reserves under a special provision of the Small Business Jobs Protection Act of 1996 eliminated previous impediments for thrift to bank conversions and mergers. Another significant change observed during that time was the Gramm-Leach-Bliley Act (Financial Modernization Act) of 1999 that permitted the creation of Financial Holding Companies which could practice all functions ‘financial in nature’ under one umbrella removed further deterrents to bank/thrift mergers.
What we are seeing in the Indian Context is an adaptation of the best practices of the above with a new Jargon of Shri Kamath Chief of ICICI “ The Universal Banking”
Limited Arbitrage in Mergers and Acquisition
Firstly arbitrage is limited to the extent of buying the acquiring firms shares, with a direct
purchase and an indirect purchase. While the direct purchase would involve buying the shares from the acquiring firm, an indirect purchase would involve buying the target firm’s shares and waiting for the deal to come through, during which the target firm’s shares are exchanged for the acquirer’s shares.
Both the above methods of transacting in shares have identical payoffs if the
merger deal comes through. The arbitrageur also faces an inherent fundamental risk, that of deal failure which could lead to exorbitant losses. The phenomenon of deal failure can be described as any risk arbitrage deal where the arbitrageur loses money.
Nature of Risk Arbitrage
While understanding the nature of risk arbitrage, it is important to know that it can be categorized into two –
a) Pre-emptive Arbitrage-In this kind of arbitrage opportunity, the arbitrageur buys the
shares of the acquired company well in advance. This kind of arbitrage is quite speculative and depends on the success of the merger. In the event of the merger being carried out, the arbitrageur does benefit from the price paid and the tender offer of the share. Pre-emptive arbitrage is guided by instinct and predictions made by the arbitrageur who attempts to forecast potential mergers and acquisitions in the coming weeks and months.
b) Post-Tender Arbitrage-As far as post-tender arbitrage is concerned the acquiring
company makes a tender offer about shares and the arbitrage profit is determined by the price differential between the offer price of the share and the selling price of the share on a particular day, post merger. For example say BIHAR BANK(fictious bank) is planning to acquire UTTAR PRADESH BANK in the near future. BIHAR BANK makes a predictable tender offer of the stock of UTTAR PRADES for Rs. 25;
however the common stock of UTTAR PRADESH BANK sells for Rs. 27 in the market. In such a case the arbitrageur seeks to make a profit from the Rs. 2 differential.
The process of post-tender arbitrage is very dynamic wherein the investment is held for a very short time with very high potential for profits.
Risks associated with risk arbitrage
The main risk associated with risk arbitrage is that of deal failure, otherwise called the completionrisk. If at some stage the management of either company decides not to go through with the deal, then the benefits of arbitrage accruing to the transaction of shares may not materialise. Some shareholders may wish to insure this risk by selling of their shares. As a result of this selling pressure, the price of the target firm can fall below its efficient market price and lead to a market inefficiency thereby resulting in abnormal profits. Arbitrage is also limited to the extent of supply of capital which is a prerequisite for its smooth functioning; it has been observed that the lender typically requires 105-110 % of the short position as collateral.
Calculating Annual Return for Risk Arbitrage
The formula for calculating the returns for risk arbitrage, in other words the potential arbitrage
commitment, was invested by Benjamin Graham in the book Security Analysis (1951).
Indicated Annual Return = [GC-L (100%-C)] /YP (Rockwood, Richard M (2001))
G=Expected gain in points in the event of success.
L=Expected loss in points in the event of failure.
C=Expected change of success as a percentage.
Y=Expected time of holding of shares, in years
P=Current Price of the security
Risk Arbitrage in Bank &FI Takeovers
In the modern day business world a takeover refers to one company (the acquirer) purchasing another company (the target). Though takeovers resemble mergers they are different in the sense that while a merger leads to the formation of a new company, a takeover does not. Corporate takeovers are common in USA and the United Kingdom. However they are a rare occurrence in Germany because of the dual board structure, in Japan because of kereitsu or the interlocking sets of ownerships in the corporate structure and in China because a majority of the publicly listed companies are owned by the state.
Under the present Indian context especially in the Banking and financial services sector it is far more complicated and are backed by various legislations of the Parliament.
Takeovers are of the following kinds-
a) Friendly Takeover-A friendly takeover involves the straight buyout of a company and is observed frequently. In such a takeover the shareholders are the recipients of cash or a number of shares which is contractually agreed upon in advance.
b) Hostile Takeover-In a hostile takeover one company agrees to buy out another company regardless of the consent of the company or otherwise. The mode of conducting a hostile takeover is through publicly traded shares. The rationale behind this mode of performing a hostile takeover is that the acquiring company is actually required to bypass the board the directors and purchase shares from other sources. The process of carrying out a hostile takeover through publicly traded shares is rather difficult unless the shares of the company are otherwise widely available and can be easily purchased.
c) Reverse Takeover-A reverse takeover can take place through either a smaller firm taking over a larger firm, a private company taking over a public company by bypassing a majority of security regulations. This cannot be ruled out in the later economic landscape of corporate India.
Rationale behind takeovers
A variety of reasons can be attributed to why one Bank would like to acquire another
Bank .
One reason is profitability, the target company in such a case may be reasonably priced
and so the acquiring company may make a decision that within a certain time period purchasing that company would be a profitable move.
Takeovers can also be strategic in the sense that the acquiring Bank has motives other than profit to purchase another Bank. In such a case the company that is to be acquired could be quite profitable on its own but may harbour other capabilities that could be beneficial to the acquiring firm. For example a target Bank may
have a well developed distribution network,best practices or information technology capabilities which could lead to an acquiring Bank wishing to takeover it. The acquiring Bank as a result of this takeover will be able to benefit strategically from the capabilities of that Bank apart from earning a profit. An acquiring Bank may decide to takeover another bank as it enables the company to enter into a new market. In some cases in order to eliminate competition, one bank may decide to acquire another and also to be able to defend itself against another competitor. It has very often been the case that very large companies enter into takeovers for the purpose of boosting their reported revenues without much care for the profit involved and the company’s profitability does stand a chance of being affected if there are large costs involved.
There is a premium involved if the target company is financially healthy which may not always be the case. Following a takeover the stock price of the target company may rise forcing down the price of the acquiring company Takeovers and the legal system
In the US takeovers are governed by the Williams Act, which was enacted in July 1968. (Gomes, Armando, 2001)Takeovers are also governed by corporate laws and the state jurisdiction. The purpose of the Williams Act is to enable shareholders of a company to have fair and full disclosure to information and sufficient time to be able to act upon information. US Takeover rules are contained in the in Section 14(d)(1) of the Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rules 14D and 14E.
Indian Scenario SEBI’s guide lines on take over.(refer appendix A 4)
Risk Arbitrage in Takeovers: An overview
Arbitrageurs are strategically important in the market for corporate control. Following a tender offer there is often a drastic rise in risk arbitrageur activity. Risk arbitrageurs take long positions in a target stock with the notion that the takeover will go through. Based on the cooperative Nash bargaining game, the idea that blocking of shares may be relevant for pricing of takeovers wasfirst developed by Bergström, Clas, Peter Högfeldt, and Kenneth Högholm (1993).These arbitrageurs are often hedged by taking short positions in the acquirers stock. Factors contributing to a rise in risk arbitrage activity include the emergence of Ivan Boesky(a prominent arbitrageur on Wallstreet who had been involved in an Insiders Trading Scandal) and an increase in the number of corporate takeover deals contributing to its visibility. Due to the large volume of new arbitrage capital in recent times there is a rise in the narrowing of spreads and the increase in
share price following a takeover announcement which has on an average reduced profit margins in this activity. Despite the odds that prevail, risk arbitrageurs continue to make profits and are considered as important players in the success of a takeover. Usually in an arbitrage deal the number of risk arbitrageurs contributes to 30-40% of the stock and they are considered an important element in the very many deals that are happening.
Rationale behind Risk Arbitrage in Takeovers
Risk arbitrageurs enjoy an information advantage which arises from their choice to enter the field of risk arbitrage. (Larcker, D. and T. Lys,(1987)) If the presence of risk arbitrageurs increases the likeliness of a takeover occurring, then one risk arbitrageur buying shares is relevant for the entire value of shares. Risk arbitrageurs expend a large effort in understanding how other risk arbitrageurs would behave. The number of arbitrageurs who decide to take positions, the number of shares that they will purchase and the price of shares are often determined in equilibrium of an endogenous kind. The value of shares in a takeover does depend on the probability of a takeover occurring. Share value should be higher in the event of there being a larger number of risk arbitrageurs in the market. The informational advantage that a risk arbitrageur enjoys enables and makes him willing to pay a price high enough to persuade smaller shareholders to sell their shares. In most cases the risk arbitrageurs do not have any initial private information. The private 14 information that they enjoy arises endogenously when they start buying shares. However arbitrageurs have to be controlled to ensure that they don’t compete away their rent.
Conclusion
1. With consolidation in Banking and FI imminent in India , a tremendous opportunity in the area of Risk arbitrage(M&A arbitrage) largely remains untapped.
2. Players who have exposure to sophisticated risk management tools and systems (barra et all) and best practices that are currently being used in the developed financial markets for assessing Risk Arbitrage opportunities have a significant competitive advantage over the local Indian players.
3. Market driven reforms will make Indian regulators to strive to reduce the cost associated with “regulatory arbitrage” opportunities.
Monday, March 12, 2007
Sharia Compliant Islamic Commodity Structures
Sharia Compliant Islamic Structures-The Commodity world.
Whereas every exchange in the world worth its salt has been trying to come out with Islamic structrures which are compliant as per the sharia, however we believe that this is a domain not for exchanges which have the cash and carry concept of financing deeply ingrained into every single aspect, this is a problem for intermediary who absorb and can counter this problem with out of the box approach.
Essentially this means that SHARIA ISLAMIC products would be essentially OTC in nature since otherwise the uncertainty of counterparty would make the transaction 'ghariar' instead the Exchange could clear these OTC trades.
It is the arab world that thought the world algebra, it also taught the the world, two –ve’s make a positive, this is the basis of the proposed approach to this Islamic Structure- The Venkataraghavan, & Altos trade et all (SM) service based approach to sharia compliant structre.
A Brief history of sharia compliance
The Problem with Interest or ‘Riba’
As Shari’ah considers money to be a measuring tool for value and not an ‘asset’ in itself, it requires that one should not be able to receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically interest) is ‘Riba’, and is forbidden. The implications for Islamic financial institutions is that the trading/selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible.
The Problem of Uncertainty or ‘Gharar’
This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract and this causes issues for Islamic scholars when considering the application of derivatives. Shari’ah also incorporates the concept of ‘Maslahah’ or ‘Public benefit’, denoting that, if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks, may fall into this category but there is still much discussion yet to come.
Takaful (Islamic Insurance)
In modern business, one of the ways to reduce the risk of loss due to misfortunes is through insurance. The basic idea behind insurance is the sharing of risk. The concept of insurance where resources are pooled to help the needy does not contradict Shariah.
Conventional insurance involves the elements of uncertainty (Al-gharar) in the contract of insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and interest (Al-riba) in the investment activities of the conventional insurance companies which contravene the rules of Shariah. It is generally accepted by Muslim Jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah.
Takaful is an alternative form of cover which a Muslim can avail himself against the risk of loss due to misfortunes. The concept of takaful is not a new concept; in fact, it had been practised by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1400 years ago.
Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.
Another Interesting Arabic Discovery Algebra is a branch of mathematics concerning the study of structure, relation and quantity. The name is derived from the treatise written by the Persian mathematician Muḥammad ibn Mūsā al-Ḵwārizmī titled Al-Kitab al-Jabr wa-l-Muqabala (meaning "The Compendious Book on Calculation by Completion and Balancing"),
So what happens when two Gharars meet ?
Gharar + Gharar = YASIR , YASIR is a permissible financial transaction.
Translated as risky transaction + risky transaction = low risk or zero risk transaction.so what could be that magic transaction which is sharia compliant ? An arbitrage,in the current commodity derivative markets.more specifically in agricultural commodities halal by nature (no transaction will be done on Gold & Silver and other haram transactions.) is a Yasir transaction and hence any product in these lines is perfectly sharia compliant.
At Altos We propose to come out with the Altos Sharia Compliant Arbitrage Sukuk. This structure comprises of combination of sharia compliance product and at no stage is there a possibility of a riba pay out. The combination of the below mentioned sharia compliant transaction leads us to a remarkable elegant and profitable financial structure for all stake holders.
Murabahah (Cost Plus)
This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of interest determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e. the bank cannot charge additional interest on late payments); however, the asset remains in the ownership of the bank until the loan is paid in full.
Bai' Bithaman Ajil (Deferred Payment Sale)
This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. This is similar to Murabahah, except that the debtor makes only a single installment, on the maturity date of the contract.
Bai' al-Inah (Sell and Buy Back Agreement)
The financier sells an asset to the customer on a deferred payment basis and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the broker to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency.
Murabahah (Cost Plus)
This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs and the profit MURABAHA
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit is stipulated in advance.
IJARAH
Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.
IJARAH-WAL-IQTINA
A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum alongwith with profit over the period of lease.
MUSAWAMAH
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.
ISTISNA A
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna’a can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways.
BAI MUAJJAL
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.
MUDARABAH
It is a partnership in profit between capital and work where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.
MUSHARAKAH
Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.L
BAI SALAM
Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Barring this, Bai?Salam covers almost everything, which is capable of being definitely described as to quantity, quality and workmanship.
Whereas every exchange in the world worth its salt has been trying to come out with Islamic structrures which are compliant as per the sharia, however we believe that this is a domain not for exchanges which have the cash and carry concept of financing deeply ingrained into every single aspect, this is a problem for intermediary who absorb and can counter this problem with out of the box approach.
Essentially this means that SHARIA ISLAMIC products would be essentially OTC in nature since otherwise the uncertainty of counterparty would make the transaction 'ghariar' instead the Exchange could clear these OTC trades.
It is the arab world that thought the world algebra, it also taught the the world, two –ve’s make a positive, this is the basis of the proposed approach to this Islamic Structure- The Venkataraghavan, & Altos trade et all (SM) service based approach to sharia compliant structre.
A Brief history of sharia compliance
The Problem with Interest or ‘Riba’
As Shari’ah considers money to be a measuring tool for value and not an ‘asset’ in itself, it requires that one should not be able to receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically interest) is ‘Riba’, and is forbidden. The implications for Islamic financial institutions is that the trading/selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible.
The Problem of Uncertainty or ‘Gharar’
This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract and this causes issues for Islamic scholars when considering the application of derivatives. Shari’ah also incorporates the concept of ‘Maslahah’ or ‘Public benefit’, denoting that, if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks, may fall into this category but there is still much discussion yet to come.
Takaful (Islamic Insurance)
In modern business, one of the ways to reduce the risk of loss due to misfortunes is through insurance. The basic idea behind insurance is the sharing of risk. The concept of insurance where resources are pooled to help the needy does not contradict Shariah.
Conventional insurance involves the elements of uncertainty (Al-gharar) in the contract of insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and interest (Al-riba) in the investment activities of the conventional insurance companies which contravene the rules of Shariah. It is generally accepted by Muslim Jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah.
Takaful is an alternative form of cover which a Muslim can avail himself against the risk of loss due to misfortunes. The concept of takaful is not a new concept; in fact, it had been practised by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1400 years ago.
Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.
Another Interesting Arabic Discovery Algebra is a branch of mathematics concerning the study of structure, relation and quantity. The name is derived from the treatise written by the Persian mathematician Muḥammad ibn Mūsā al-Ḵwārizmī titled Al-Kitab al-Jabr wa-l-Muqabala (meaning "The Compendious Book on Calculation by Completion and Balancing"),
So what happens when two Gharars meet ?
Gharar + Gharar = YASIR , YASIR is a permissible financial transaction.
Translated as risky transaction + risky transaction = low risk or zero risk transaction.so what could be that magic transaction which is sharia compliant ? An arbitrage,in the current commodity derivative markets.more specifically in agricultural commodities halal by nature (no transaction will be done on Gold & Silver and other haram transactions.) is a Yasir transaction and hence any product in these lines is perfectly sharia compliant.
At Altos We propose to come out with the Altos Sharia Compliant Arbitrage Sukuk. This structure comprises of combination of sharia compliance product and at no stage is there a possibility of a riba pay out. The combination of the below mentioned sharia compliant transaction leads us to a remarkable elegant and profitable financial structure for all stake holders.
Murabahah (Cost Plus)
This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of interest determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e. the bank cannot charge additional interest on late payments); however, the asset remains in the ownership of the bank until the loan is paid in full.
Bai' Bithaman Ajil (Deferred Payment Sale)
This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. This is similar to Murabahah, except that the debtor makes only a single installment, on the maturity date of the contract.
Bai' al-Inah (Sell and Buy Back Agreement)
The financier sells an asset to the customer on a deferred payment basis and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the broker to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency.
Murabahah (Cost Plus)
This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs and the profit MURABAHA
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him. The bank does that for a definite profit is stipulated in advance.
IJARAH
Ijarah is a contract of a known and proposed usufruct against a specified and lawful return or consideration for the service or return for the benefit proposed to be taken, or for the effort or work proposed to be expended. In other words, Ijarah or leasing is the transfer of usufruct for a consideration which is rent in case of hiring of assets or things and wage in case of hiring of persons.
IJARAH-WAL-IQTINA
A contract under which an Islamic bank provides equipment, building or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum alongwith with profit over the period of lease.
MUSAWAMAH
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.
ISTISNA A
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. Istisna’a can be used for providing the facility of financing the manufacture or construction of houses, plants, projects and building of bridges, roads and highways.
BAI MUAJJAL
Literally it means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the bank earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.
MUDARABAH
It is a partnership in profit between capital and work where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne only by the provider of the capital.
MUSHARAKAH
Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions.L
BAI SALAM
Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver or currencies. Barring this, Bai?Salam covers almost everything, which is capable of being definitely described as to quantity, quality and workmanship.
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