Derivatives for dummies - Currency Forwards

The valuation of currency forwards are based on some of the very basic principles of Macroeconomics.

Interest rate parity:- According to the Interest rate parity principle, suppose you invest in your home country and earn a return, this return has to be equal to the return you achieve by borrowing a foreign currency and investing in that country and then converting it back to your home currency. To understand this better let us consider a small example.

Suppose you are an NRI and you live in US, the interest rate in India is 10% and the interest rate in US is say 5%. Superficially it might look that there is this great investment opportunity in India. Borrow in US at 5% and invest in India. Doing so earn 10% in India, pay back 5% as interest and hence make a clear riskless profit of 5%. But to our dismay this isn’t the case. Interest rate parity says that you will earn the same 5% return if you are a US investor. To understand this let us extend this example.

Suppose you are sitting in US having $1million to invest. You decide to invest this sum in India which is “An emerging market”. The current exchange rate is INR 45/$. Therefore you invest a total of 1million*45= 45 million Indian rupees in India. After a year at 10% you earn a handsome 10%*45 million= 4.5 million. As you are a US investor you want your returns to be in US$, so you convert the Indian rupee returns to $. Now the question is what will be the exchange rate one year from now. This is where INTEREST RATE PARITY comes into play. It says that there is no incentive of remaining unhedged in foreign currency. In other words you will get a return of only 5% that is the return you will get by investing in US markets. This can only be because of currency rate movements. Here are two golden principles to remember

·         The country whose return is higher in nominal terms with respect to another country’s return, currency will depreciate for that country with respect to the other country.

·         The country whose return is lower in nominal terms with respect to another country’s return, currency will appreciate for that country with respect to the other country.

In our example as we have seen that the Indian nominal rate of return (10%) is higher than that of US (5%). Therefore the Indian rupee will depreciate and the US $ will appreciate so that the return in both the currencies is same. Going back to the example, the US investor has 45+4.5 million INR. And we know that he gets only 5% return in US $ terms or 1.05 million US dollars, the exchange rate after 1 year has to be 49.5/1.05= 47.14INR/$ or the rupee has depreciated and the $ appreciated. To make it more generalized

Expected spot rate after t years = S_o * (1+R_dc)^T/(1+R_fc)^T

Where

 S_o= Current (spot) exchange rate domestic currency in foreign currency terms. (ex 45/$ is S_o for an Indian investor.

R_dc= Interest rate in domestic market.

R_fc= Interest rate in foreign market.

As forward rate is an unbiased predictor of Expected spot rate. Forward rate = Expected spot rate.

In the next issue we will see how the forward contracts are priced before expiry.

Shubham Goel

IIM Rohtak

Continue Reading - Derivatives for dummies - Currency Forwards

Derivatives for dummies: Hedging strategies using forward contracts

An important question that the investors face is how to protect their portfolio in times of volatility. One way is getting out of the cash markets (stock market) for now and entering again when market stabilizes. But this strategy may lead to a lot of uncertainty about the price that the investors will have to pay to enter again. To hedge this uncertainty and lock in the futures price the investor can make use of the derivatives products. In this article we will be talking mainly about how to hedge a portfolio by using futures and forward contracts (as both are almost similar in nature).

To learn this strategy one must know a very important   concept of beta (β).

Beta is the relative movement of the stock with respect to market. Suppose Nifty moves 1 point up the stock of the company with a beta of 1.2 will move 1.2 points up. Beta is actually the systematic risk measure of the company. Actual in depth discussion will be done in subsequent articles.

β = covariance (stock index, stock)/variance of the stock

This may sound too mathematical for the common investor so in simple words to find the β of a stock an investor can Google to find the β of a stock or use a simple excel tool to find out the same. What the investor would need is the historical weekly closing price of the stock for two years and the weekly closing price of NIFTY for two years. Our website want2rich.com will soon have the same. After you have the data, put the data of the stock in column A and data of NIFTY in column B. Use the function =slope(range of stock, range of NIFTY). The value is the β of the stock. To calculate the β of the whole portfolio use the following formula

Beta of the portfolio = weighted average of betas of individual stocks=∑ βi*wi

Where wi= market value of investment in stock i/ market value of the whole portfolio.

The strategy

Suppose a manager has a portfolio consisting of three securities of Rs20 lakh, with a beta value of 1.17. The investor speculating turmoil in near future wants to reduce the beta of the portfolio to:

·         0 or no matter how the markets move investor will not incur a loss.

(a) To decrease the portfolio beta from 1.17 to 0, the portfolio manager may sell off a portion of equities and use the proceeds to buy risk free securities.

If we designate the existing portfolio as asset 1 and the risk free security as asset 2, we have,

β_p =w₁β₁ + w₂β₂= w₁β₁ + (1-w₁) β₂

(Since the new portfolio consists of only two assets), we have β_p = 0, β₁ = 1.17, and β₂ = 0(this being a risk free asset).

Substituting the known values, we get

0 = w₁ x1.17 + (1- w₁)0

Or, w₁ = 0

Or the investor will have to sell of the whole portfolio and invest in risk free securities like govt. bonds.

(b) Alternatively, the manager can sell stock index futures contracts. Rupee value of the spot position to be hedged = 20 lakh .The amount of future contract of NIFTY to be sold= 1.17 x 20 lakh =Rs 23.4 lakh.

This way whatever will be the loss in the cash portfolio it will be offset by the forward/ future contract. Let us see how

Suppose the market (NIFTY) dips by 10%. The loss in the cash market portfolio will be equal to 20lakh*10%*1.17(β)= 2.34 lakhs. By shorting the NIFTY contracts the profit investor will make here = 23.4 lakh * 10%= 2.34 lakhs. Total loss = 2.34 lakhs- 2.34 lakhs=0.

Thus we can clearly see that by using derivatives instrument you can hedge your portfolio without exiting the cash market. The investor can also reduce the β of the portfolio if he does not want to completely hedge his position. Let us extend our previous example and now suppose the investor wants to reduce the β of the portfolio to .9 from an initial 1.17.

•          (a) To decrease the portfolio beta from 1.17 to 0.9, the portfolio manager may sell off a portion of equities and use the proceeds to buy risk free securities. Using the same formula              β_p =w₁β₁ + w₂β₂= w₁β₁ + (1-w₁) β₂

We have β_p = 0.9, β₁ = 1.17, and β₂ = 0(this being a risk free asset). Substituting the known values, we get             0.9 = w₁ x1.17 + (1- w₁) 0 , Or, w₁ = 0.76923 or the investor will have to sell of (1-.76923)*20 lakh= Rs4.6154 lakh of equities and invest in govt. bonds.

(b) OR rupee value of the spot position to be hedged = Rs4.6154 lakh (1-.76923)*20 lakh.The amount of future contract to be sold= 1.17 x Rs4.6154 lakh =Rs 5.4 lakh. Investor has sold future for Rs5.4 lakh .If future price reduce by 10% because of general decline of market of 10%, he will earn from future selling = Rs 5,40,000x.1 = Rs 54,000. Now, since they are holding the same portfolio having β=1.17, portfolio value will reduce by 11.7% for a 10% decline of market price.Thus portfolio reduces by Rs20 lakh x(.117)=Rs2,34,000.                                                            Less: Earning from future selling   =   54,000. Total loss = Rs1,80,000  (loss of 9% when market falls by 10%)  or a β of 0.9.

Shubham Goel
IIM Rohtak

Continue Reading - Derivatives for dummies: Hedging strategies using forward contracts

Derivatives for Dummies II

FORWARD MARKETS AND CONTRACTS

FORWARD CONTRACTS

A forward contract is a contract between two parties in which one party agrees to buy and one party agrees to sell a particular asset at a particular date in future. Suppose today is June 13^th and the two parties go into a contract, one party agrees to buy 1000 quintals of wheat at INR. 2000/ quintal on August 30^th and one party agree to sell. The buying party is said to be LONG the forward contract and the selling party is said to be SHORT the forward contract. At the initiation of the contract there is no exchange of money. If the price of the asset increases over the time period before the expiration of the contract the long party wins otherwise the short wins. Considering the same example, suppose on July 10^th the price of wheat becomes INR.2500 in the cash market. The long party wins because it has the right to buy a quintal of wheat at INR 2000 where as the current price for buying the same quintal of wheat is INR 2500. So the long party makes a profit of clean INR 500/ quintal or a total of 500*1000= INR 500000 and the short party makes a loss of the same amount. If the future price of the asset falls below the contract price( say INR 1500/ quintal), the result is opposite and the short party which has the right to sell at an above-market price( INR 2000/ quintal) makes a profit of INR 500*1000= INR 500000 in this case . The forward contract can be thought of as a simple bet between two parties in which one party expects the price of the asset to go up and the other party expects the price of the asset to go down.

More often FORWARD contracts are used by large companies to hedge their risk of buying or selling at a price which is uncertain. They want to lock in the price and reduce the risk (uncertainty). The other parties involved are speculators who want to earn profit on changes in prices and the arbitragers who earn when there are market inefficiencies.

Each party in a forward contract is exposed to default risk (or counterparty risk) as the forward contracts are over the counter contracts and are not backed by a clearing house. So there is a probability that the party which has lost the bet will not pay its obligations. This  risk  is absent in the case of futures contracts as these are highly standardized and are backed by a clearing house and both parties are required to deposit a margin money (typically 10% of the contract value).

Settlement Procedure:

Settlement can be done by:

·         Delivering the asset

·         Cash settlement

Consider the previous example in which the price of the quintal reaches INR 2500 on August 30^th. The long party has the incentive to buy wheat at below market price (in this case the contract price i.e. INR 2000/ quintal) and sell at the market price (INR 2500/ quintal).  This is one procedure for settling a forward contract at the settlement date or expiration date specified in the contract. An alternative settlement method is cash settlement. Under this method, the party that has a position with negative value is obligated to pay that amount to the other party. In the example, the short party can directly pay the difference between the contract price and the market price on the expiration date.  In this case (2500-2000)/quintal * 1000 quintals= INR 500000. Ignoring transactions costs, this method yields the same result as asset delivery. On the expiration (or settlement) date of the contract, the long receives a payment if the price of the asset is above the agreed-upon (forward) price; the short receives a payment if the price of the asset is below the contract price. It can be seen as a zero sum game and can be visualised as a simple bet on the prices, the winnings of which will be decided by the price of the asset under consideration.

How to Terminate a Position Prior to Expiration

A party to a forward contract can terminate the position prior to expiration by entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract. Recall our example and assume that ten days after inception (June 23^rd), the short, expecting the price to go even higher on the termination date wants to terminate the contract. Since the short is obliged to sell the asset only on August 30^th it can effectively terminate the contract by entering in a long contract with the same expiration date as the short contract of the original forward contract i.e. entering into a forward agreement with expiration date August 30^th and date of inception of contract June 23^rd with a contract price of say INR 2200/ quintal. The position of the original short now is two-fold, an obligation to sell wheat at INR 2000/ quintal and an obligation to buy wheat at INR 2200/quintal. Thus he locks in a loss of INR 200/quintal*1000quintals=INR. After that he is effectively out of the Forward contract or has terminated the contract regardless of the market price of wheat at the settlement date. No matter what the price of a quintal of wheat 2 months from now, he has the contractual right and obligation to buy a thousand quintals at INR 2200/ quintal and an obligation to sell at INR 2000/quintal. However, if the short's new forward contract is with a different party than the first forward contract, some credit risk remains as the other party may not pay up the profit. An alternative is to enter into the second (offsetting) contract with the same party as the original contract. This would avoid credit risk since the short party can pay only the difference to the long party.

There are different types of forward rate contracts with various asset classes as their underlying. We will review each one separately including the pricing of each in the coming article. Just to give you an idea below is the list of different asset classes on which forward agreements are customised:

·         Equity Indexes

·         Zero coupon bonds

·         Coupon bonds

·         Floating rate bonds (LIBOR, EURIBOR, MIBOR)

·         Currency exchange rates

Shubham Goel

IIM Rohtak

Continue Reading - Derivatives for Dummies II

Derivatives for Dummies-An Overview

A derivative instrument, broadly, is a financial contract whose pay off structure is determined by the value of an underlying commodity, security, interest rates, share price index, exchange rate, oil price etc. Just think of a contract whose price or value depends on the underlying. Some of you may be shocked to know that the price of variables can depend on anything; it can as strange as weather or the life of a person.

Derivatives are majorly divided into four classes namely

·         Forwards

·         Futures

·         Options

·         Swaps

Now who are the major players in the derivatives market?

1.       Hedgers

The party who wants to remove the uncertainty about the price it will have to pay for buying an asset at a particular time in future.

2.       Speculators

The party which believes that it can gain by the price movements be it increase or decrease in price

3.       Arbitrageurs

Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous long and short positions and making a risk free profit.

What exactly is an arbitrage?

Arbitrage is an important concept in valuing (pricing) derivative securities. In its purest sense, arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding a portfolio of assets that produces a certain (riskless) return, then an arbitrage opportunity exists.

Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient (no-arbitrage) levels.

There are two arbitrage arguments that are particularly useful in the study and use of derivatives.

The first is based on the “law of one price”. Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price. If A and B have the identical future payoffs, and A is priced lower than B, buy A and sell B. you have an immediate profit, and the payoff on A will satisfy the (future) liability of being short on B.

The second type of arbitrage is used where two securities with uncertain returns can be combined in a portfolio that will have a certain payoff. If a portfolio consisting of A and B has a certain payoff, the portfolio should yield the risk-free rate. If this no-arbitrage condition is violated in that the certain return of A and B together is higher than the risk-free rate, an arbitrage opportunity exists. An arbitrageur could borrow at the risk-free rate, buy the A+B portfolio, and earn arbitrage profits when the certain payoff occurs. The payoff will be more than is required to pay back the loan at the risk-free rate.

Now let us analyze each instrument in a brief

A physical exchange exists for many options contracts and futures contracts. Exchange traded derivatives are standardized and backed by a clearinghouse.

Forwards and swaps are custom instruments and are traded/ created by dealers in a market with no central location. A dealer market with no central location is referred to as an over the counter market. They are largely unregulated markets and each contract is with a counterparty, which may expose the owner of a derivative to default risk.

Forward commitments:

In a forward contract, one party agrees to buy and counterparty to sell, a physical asset or security at a specific price on a specific date in the future. If the future price of the asset increases, the buyer (at the older, lower price) has a gain, and the seller a loss.

Future Contracts:

A future contract is a forward contract that is standardized and exchange-traded. The main differences with forwards are that futures traded in an active secondary market, are regulated, backed by the clearinghouse, and require a daily settlement of gains and losses.

Futures v/s Forwards

•          Exchange traded & transparent v/s Private contracts

•          Standardized v/s Customized

•          Settlement through Clearing House v/s Settlement between Buyers and Sellers

•          Require margin payment v/s no margins

•          Mark - to - Market margins v/s no margins

•          Counter - party risk is absent in Futures (settlement of trades is guaranteed)

•          Most settled by offset and very few by delivery v/s most settled by actual delivery.

Swaps:

A swap is a series of forward contracts. In the simplest swap, one party agrees to pay the short-term (floating) rate of interest on some principal amount, and the counterparty agrees to pay a certain (fixed) rate of interest in return. Swaps of different currencies and equity returns are also common.

Options:

An option to buy an asset at a particular price is termed a call option. The seller of the option has an obligation to sell the asset at the agreed-upon price, if the call buyer chooses to exercise the right to buy the asset.

An option to sell an asset at a particular price is termed as a put option. The seller of the option has an obligation to purchase the asset at the agreed-upon price, if the put buyer chooses to exercise the right to sell the asset.

A contingent claim is a claim (to a payoff) that depends on a particular event. Options are contingent claims that depend on a stock price at some future date, rather than forward commitments. While forwards, futures, and swaps have payments that are made based on a  price or rate outcome whether the movement is up or down, contingent claims only require a payment if a certain threshold price is broken (e.g., if the price is above X or the rate is below Y). It takes two options to replicate a future or forward.

Criticism and benefits of derivatives:

The criticism of derivatives is that they are “too risky”, especially to investors with limited knowledge of sometimes complex instruments. Because of the high leverage involved in derivatives payoff, they are sometimes likened to gambling.

The benefits of derivatives market are that they:

·         Provide price information.

·         Allow risk to be managed and shifted among market participants.

·         Reduce transactions costs.

In the coming articles we will try and go deeper into each derivative instrument and learn how to diversify your portfolio by using them according to your risk appetite. How to see if a true arbitrage opportunity exist  and how to make a risk free profit through these opportunities.

Shubham Goel

IIM Rohtak

Continue Reading - Derivatives for Dummies-An Overview

Role of PE firms

PE firms perform a number of roles in the investee company. They can be majorly classified as follows:

·       Source of Capital

The main role of PE firm in any investee organization is to provide capital which may not be available through other sources. They help to recapitalise the company for future expansions. They also provide access to new channels of funding. Many a times a PE company is ready to invest in a company if it is already backed by another PE firm. For example, Vriti Infocom raised $5 million in series-B funding led by JAFCO Asia along with a follow-on investment from existing backer Intel Capital.

·       Strategic Support

Sometimes PE firm regard itself more as a strategic investor rather than a PE or a VC investor. In this role, the PE firm generally provides strategic inputs for growth and helps the company access new markets. It may also help the company in building a global outlook. They help find new acquisition targets or strategic partners for future expansion. A big company might invest in a smaller company which makes similar products or in a smaller company which will eventually become a client of the big company. This arrangement is beneficial for the smaller company as it allows the company to remain autonomous and in turn attract other investors. Larger companies also benefit because they carry less risk than an acquisition.For example, Intel Capital regards itself as a strategic investor and generally invests in technology related companies.

·       Operational Management

PE firms may also invest in a company to improve upon the management process and controls and thus better the efficiency of the company. They help the company to inculcate better corporate governance practices and new ways of management reporting.

·       Brand Building

Backing by a reputed PE firm helps in improving the quality perception of the company. This will help them in furthering their business prospects and help the company in acquiring new clients. It will also help the company to develop a network of contacts which can be utilized when need arises. A better brand will also help the company in attracting talent at senior management level as well as the entry levels.

By Prince Kumar (pgp01030@iiml.ac.in)

Continue Reading - Role of PE firms

STOCK PRICES JUGGLING IN 2011

There has been turmoil of sorts in the Indian stock market in the recent months. On 4^th of February, investors lost a mammoth Rs 1.2 trillion. We have tried to capture the reasons behind the convulsion in the points listed below.

Inflation: In January, inflation touched the dreaded double digit mark. The food inflation reached almost 14-15%. Investors were forced to pull out their money under such circumstances. Sensing this risk in Indian stock market, even FIIs started selling their holdings.

Increment in Interest rate: In February RBI increased BPLR (Benchmark Prime Lending Rate) by 50 basis points or 0.5%. As a result of this monetary policy by RBI, the sentiment among the investors turned negative which directly got reflected in the SENSEX.

Egyptian Crisis: India is rapidly becoming an important player in the global economy. So, the turmoil in Egyptian market hit the global economy as well as the Indian stock market. Restoration of stability in Egypt, as expected, led to a positive bearing on the SENSEX as well.

Financial Budget:  The Financial Budget was released by honorable finance minister, Mr. Pranab Mukherjee. There have been few issues discussed in recent budget. FII investment in corporate bonds will be raised to USD 40 billion. This helped attract world attention once again. Individual income tax exempt slab has been increased from ₨1.6 lacs to ₨1.8 lacs. As a result, a group of people will be able to save more and will be attracted to the high risk high return stock market. The SENSEX is expected to be positively affected owing to these incentives.

Japan Crisis: The recent tsunami and earthquake made Japan’s condition worst since WWII. As Japan is one of the main members of the global economy, this economic as well as social crisis in Japan has badly affected the world economy. Some companies like Toyota and Honda have been at receiving side.

Rise of SENSEX: But again, the downturn of SENSEX has been to a limited extent. The main reason behind this is the uncertainty of the Indian market. After downfall some people assumed a rise after this fall. So they started investing again. This resulted in sudden rise in market after mid February.

We hoped for a recovery after the budget. The Egyptian scenario showed some positive signs. Now, the over looming Japan crisis is shaping a slight negative trend. But the expectations are that the SENSEX will regain its pace and we will see the bull raging again.

By – Arun Marik (pgp01014.iimrohtak@iiml.ac.in)

Abhishek Verma (pgp01006.iimrohtak@iiml.ac.in)

Continue Reading - STOCK PRICES JUGGLING IN 2011

PTC India Financial Services IPO (update)

The price band has been fixed at Rs. 26-28 per share for the IPO that will be open from 16th March to 18th March, 2011. The shares are to be offered through a 100% book building process.
The company is to raise Rs. 407-439 crore depending upon the issue price. The company proposes to come out with a fresh issue of 12.75 crore equity shares and an offer for sale of 2.92 crore equity shares by Macquarie India Holdings Ltd as the selling shareholder. The face value of the shares will be Rs. 10.
The company has decided to offer discount of Re 1 to the issue price to retail individual bidders, PFC Financial Services Chairman T N Thakur told reporters here.
The Book Running Lead Managers (BRLM) to the offer are Almondz Global Securities Limited, ICICI Securities Limited, JM Financial Consultants Private Limited and SBI Capital Markets Limited.
Registrar of the Issue: Karvy Computershare Private Limited Hyderabad.
By:
Vismaya Agarwal (pgp01049.iimrohtak@iiml.ac.in)

Continue Reading - PTC India Financial Services IPO (update)

PTC Financial Services IPO by mid-March

PTC India Financial Services (PFS), an arm of the state-run PTC India, has received a nod from market regulator SEBI for an initial public offering (IPO) and plan to come out with it by mid-March. This clearly shows that firms are still upbeat about investor appetite despite a weak run in the markets this year.

The company can raise between Rs. 500-800cr through the IPO but they have not yet set a target. Thakur said that the fundraising will depend on the book value of their shares, which currently stands at Rs. 15.21.

The funds are to be used for the company’s growing operations, as well as to improve their debt raising ability and credit ratings. "Once you do the IPO, for subsequent (fund) raises, you have a benchmark," said T N Thakur, Chairman and Managing Director, PTC.

"PFS is on a steep growth path and the growing power requirements in the country will help the company grow further," PFS Director Ashok Haldia said.

PTC has a 77% stake in PFS’s present equity capital of Rs 600cr and will have 60% holding post the IPO. GS Strategic Investments, a unit of Goldman Sachs and Macquarie India Holdings, a unit Macquarie Group Ltd, each hold 11.20% and will have 8.7% and 3.5% stakes in the company, respectively, post the issue. The issue will consist of 12.75cr fresh equity shares in the market.

Avendus Capital, SBI Capital Markets, JM Financial Services, ICICI Securities and Almondz Global Securities are the arrangers to the issue.

PFS posted a profit of Rs 254.52 million, on total income of Rs 534.90 million for fiscal 2010, according to the draft red herring prospectus it filed with the Securities and Exchange Board of India

PFS is promoted by PTC India as a special purpose investment vehicle to provide financial services to the entities in energy value chain, which includes investing in equity and extending debt to power projects in generation, transmission, distribution, fuel related infrastructure like gas pipelines, LNG terminals, ports, equipment manufacturers and EPC contractors, etc.

PFS also provides non-fund based financial services, adding value to Greenfield and Brownfield projects at various stages of growth and development.

By:-

Vismaya Agarwal (pgp01049.iimrohtak@iiml.ac.in)

Prashant Chourasia (pgp01028.iimrohtak@iiml.ac.in)

Continue Reading - PTC Financial Services IPO by mid-March

Budget 2011-12 - Analysis

This budget has been presented when rising inflation worries are overshadowing Indian growth story. Inflation rate of more than 8% and food inflation in double digits has already brought the SENSEX to its 6 months low. Finance Minister had the daunting task of checking the inflation while also maintaining the growth momentum of the Indian economy. Since the budget announcement, BSE index has risen by more than 700 points. Is this the short term rhetoric of budget or indication of some fundamental changes? Here, we will discuss main highlights of the budget and their possible effects on future prospects of the Indian Industry.

Fiscal Deficit:

For FY12, the Government estimates the fiscal deficit to fall to 4.6% of GDP from 5.1% in FY11 (estimated) primarily, on account of increase in both direct and indirect taxes and moderate growth of 3.5% in Govt. expenditure due to reduction in subsidies and reining in of unplanned expenditure. This will be a very difficult task to accomplish considering the fact that fiscal deficit for FY11 would have been 6.3% of the GDP without the spectrum auction.

Reduction in Subsidies:

The Govt. estimates to reduce subsidy bill by 12.5% this fiscal year to tame the rising fiscal deficit. But, the budget has remained silent on the issue of how to reduce subsidies in the backdrop of record high prices of oil, food and fertilizers thus raising speculations of increase in fuel prices after the budget or after state assembly elections in May. With already soaring inflation of more than 8%, it will be a hard task to achieve both the targets of reduction in subsidy and bringing inflation low.

A new system has been proposed to be implemented, under which direct cash subsidy will be given to the BPL (Below Poverty Line) families to buy fertilizers and cooking fuel. This will help in checking the alleged diversion of the kerosene for adulteration and LPG for commercial purposes. A committee headed by Nandan Nilekani has been formed to work out the modalities for this system. This step has been taken very positively by the market.

Direct Tax:

a.)    Exemption limit for the general category individual taxpayers has been enhanced from Rs. 160000 to Rs. 180000 giving tax relief of Rs. 2000 to all tax payers whose taxable income is more than Rs. 180000.

b.)    Reduced the qualifying age for senior citizens from 65 years to 60 years along with enhanced exemption limit from Rs. 240000 to Rs. 250000.

c.)    Created a new category of Very Senior Citizens (80 years and above), who are eligible for a higher exemption limit of Rs. 500000.

d.)    Rate of Minimum Alternative Tax (MAT) proposed to increase from 18% to 18.5% of book profits.

e.)    Proposed a lower rate of 15% tax on dividends received by an Indian company from its foreign subsidiary.

f.)     Proposed extension of Rs. 20000 exemption for investment in long-term infrastructure bonds by one more year.

Infrastructure Sector:

Growth of Infrastructure Sector is vital for the consistent growth of the Indian economy. And the budget has taken many steps, like 27% increase in the budget for infrastructure expenditure, extension of exemption for investment in Infrastructure bonds and increase in long term infrastructure bond limit for FIIs to encourage investments in Indian Infrastructure sector. But the implementation part of the infrastructure projects was neglected. There have been huge delays in awarding the infrastructure projects and later in land acquisition processes.  The government needs to consider the implementation part as well to bring major turnaround in this sector.

Agriculture:

Agriculture has been given adequate importance and loans at concessional interest rate of four per cent have been announced for farmers who pay their dues in time and the credit target for farm sector has been increased.

Liberalization of FDI:

Allowing the foreign money through Mutual Funds is a major step taken by Govt. and the market has whole heartedly welcomed it, as it will help in routing foreign money into Indian markets. However, the budget has been silent on the issue of liberalization of FDI in the retail and insurance sectors.

By:
      Amit Tayal (pgp01009.iimrohtak@iiml.ac.in)

Continue Reading - Budget 2011-12 - Analysis