What are Investment banks?

Investment banks are essentially financial intermediaries, who primarily help businesses
and governments with raising capital, corporate mergers and acquisitions, and
securities trade. In USA such banks are the most important participants in the
direct market by bringing financial claims for sale. They help interested parties
in raising capital, whether debt or equity in the primary market to finance
capital expenditure.

Once the securities are sold, investment bankers make secondary markets for the
securities as brokers and dealers. In 1990, there were 2500 investment
banking firms in USA doing underwriting business. About 100 firms are so
large that they dominate the industry. In recent years some investment
banking firms have diversified or merged with other financial institutions to
become full service financial firms.

What is the difference between Investment Banks & Commercial Banks?

Investment banks have often been thought to be as Commercial banks, and rightly so.
However, both the terms have different connotations in United States. Early
investment banks in USA differed from commercial banks, which accepted
deposits and made commercial loans. Commercial banks were chartered
exclusively to issue notes and make short-term business loans. On the other
hand, early investment banks were partnerships and were not subject to
regulations that apply to corporations. Investment banks were referred to as
private banks and engaged in any business they liked and could locate their
offices anywhere. While investment banks could not issue notes, they could
accept deposits as well as underwrite and trade in securities.

As put forth earlier, the distinction between commercial banks and investment banks is
unique and is confined to the United States, where it is by legislation that they
are separated. In countries where there is no legislated separation, banks
provide investment-banking services as part of their normal range of banking
activities. Coming back to countries where investment banking and
commercial banking are combined. Such countries have what is known as
 universal banking system. Say for example, European Countries have
universal banking system, which accepts deposits, make loans, underwrites
securities, engage in brokerage activities and offer financial services.

Concept of Investment Banks

The banking scenario in India is itself huge, covering the different facets of the economy.
By and large, investment banks in India are itself an institution which
generates funds in two different ways. The first manner in which it works is by
drawing public funds via the capital market by way of selling stock in their
company. The other way in which it operates is to seek for venture capital or
private equity, as a substitute for a stake in their company.

Role of an Investment Bank

The major work of investment banks includes a lot of consulting. For instance, they offer
advices on mergers and acquisitions to companies. The other arena where
they give advice are tracking the market and determining when should a
company come out with a public offering and what is the best possible way to
manage the public assets of businesses. The role that an investment bank
plays sometimes gets overlapped with that of a private brokerage house. The
usual advice of buying and selling is also given by investment banks.

There is no demarcating line between the investment banking and other forms
of banking in India. This has been observed majorly of late. All banks
nowadays want to provide their customers the best of services and create a
niche for themselves and that is why apart from investment banks, all other
banks too are aiming at making it big.

At the macro level, investment banking is related with the primary function of
assisting the capital market in its function of capital intermediation, i.e., the
movement of financial resources from those who have them (the investors), to
those who need to make use of them for producing GDP (the issuers). Over
 the decades, investment banks have always suited the needs of the finance
community and thus become one of the most vibrant and exciting segment of
financialservices.

Globally investment banks handle significant fund-based business of their own

in the capital market along with their non-fund service portfolio which is offered
to the clients. All these activities are broadly segmented across three
platforms - equity market activity, debt market activity and merger and
acquisitions (M&A) activity. In addition, given the structure of the market, there
is also a segmentation based on whether a particular investment bank
belongs to a banking parent or is a stand-alone pure investment bank

Core investment banking activities

Investment banking is the traditional aspect of the investment banks which also involves
helping customers raise funds in the capital markets and giving advice on
mergers and acquisitions. Investment banking may involve subscribing
investors to a security issuance, coordinating with bidders, or negotiating with
a merger target. Another term for the investment banking division is corporate
finance, and its advisory group is often termed mergers and acquisitions
(M&A). A pitch book of financial information is generated to market the bank to
a potential M&A client; if the pitch is successful, the bank arranges the deal for
the client. The investment banking division (IBD) is generally divided into
industry coverage and product coverage groups. Industry coverage groups
focus on a specific industry such as healthcare, industrials, or technology, and
maintain relationships with corporations within the industry to bring in business
for a bank. Product coverage groups focus on financial products, such as
mergers and acquisitions, leveraged finance, project finance, asset finance
and leasing, structured finance, restructuring, equity, and high-grade debt and
generally work and collaborate with industry groups in the more intricate and
specialized needs of a client.

Sales and trading: On behalf of the bank and its clients, the primary function of a large
investment bank is buying and selling products. In market making, traders will
buy and sell financial products with the goal of making an incremental amount
 of money on each trade. Sales is the term for the investment banks sales
force, whose primary job is to call on institutional and high-net-worth investors
to suggest trading ideas (on caveat emptor basis) and take orders. Sales
desks then communicate their clients' orders to the appropriate trading desks,
who can price and execute trades, or structure new products that fit a specific
need. Structuring has been a relatively recent activity as derivatives have
come into play, with highly technical and numerate employees working on
creating complex structured products which typically offer much greater
margins and returns than underlying cash securities. Strategists advise
external as well as internal clients on the strategies that can be adopted in
various markets. Ranging from derivatives to specific industries, strategists
place companies and industries in a quantitative framework with full
consideration of the macroeconomic scene. This strategy often affects the
way the firm will operate in the market, the direction it would like to take in
terms of its proprietary and flow positions, the suggestions salespersons give
to clients, as well as the way structurers create new products. Banks also
undertake risk through proprietary trading, done by a special set of traders
who do not interface with clients and through "principal risk", risk undertaken
by a trader after he buys or sells a product to a client and does not hedge his
total exposure. Banks seek to maximize profitability for a given amount of risk
on their balance sheet. The necessity for numerical ability in sales and trading
has created jobs for physics, math and engineering Ph.D.s who act as
quantitative analysts.

Research is the division which reviews companies and writes reports about their
prospects, often with "buy" or "sell" ratings. While the research division may or
may not generate revenue (based on policies at different banks), its resources
are used to assist traders in trading, the sales force in suggesting ideas to
customers, and investment bankers by covering their clients. Research also
serves outside clients with investment advice (such as institutional investors
and high net worth individuals) in the hopes that these clients will execute
suggested trade ideas through the Sales & Trading division of the bank,
thereby bringing in revenue for the firm. There is a potential conflict of interest
between the investment bank and its analysis in that published analysis can
 affect the profits of the bank. Therefore in recent years the relationship
between investment banking and research has become highly regulated
requiring a Chinese wall between public and private functions.

Other businesses that an investment bank may be involved in

Global transaction banking is the division which provides cash management, custody
services, lending, and securities brokerage services to institutions. Prime
brokerage with hedge funds has been an especially profitable business, as
well as risky, as seen in the "run on the bank" with Bear Stearns in 2008.

Investment management is the professional management of various securities (shares,

bonds, etc.) and other assets (e.g. real estate), to meet specified investment
goals for the benefit of the investors. Investors may be institutions (insurance
companies, pension funds, corporations etc.) or private investors (both directly
via investment contracts and more commonly via collective investment
schemes e.g. mutual funds). The investment management division of an
investment bank is generally divided into separate groups, often known as
Private Wealth Management and Private Client Services.

Merchant banking is a private equity activity of investment banks.[2] Current examples

include Goldman Sachs Capital Partners and JPMorgan's One Equity
Partners. (Originally, "merchant bank" was the British English term for an
investment bank.)

Commercial banking

What are the differences between the products offered by investment banks as opposed
to a basic finance company investment banks usually are more conservative,
they place your money on a sure thing like government bonds. Fix interest,
nothing radical. Finance companies take more chances with your money, they
invest on higher rates but less secured, like international stock. The risk is
higher but so might be the profit.

MerchantBanking, as a commercial activity, took shape in India through the

management of Public Issues of capital and Loan Syndication. It was
 originated in 1969 with the setting up of the Merchant Banking Division by
ANZ Grindlays Bank. The main service offered at that time to the corporate
enterprises by the merchant banks included the management of public issues
and some aspects of financial consultancy. The early and mid-seventies
witnessed a boom in the growth of merchant banking organisations in the
country with various commercial banks, financial institutions, broker's firms
entering into the field of merchant banking.

Reform measures were initiated in the capital market from 1992, starting with the
conferring of statutory powers on the Securities and Exchange Board of India
(SEBI) and the repeal of Capital Issues Control Act and the abolition of the
office of the Controller of Capital Issues. These have brought about significant
improvement in the functional and regulatory efficiency of the market, enabling
the Merchant Bankers shoulder greater legal and moral responsibility towards
the investing public.

Scenario for Investment Banking in India.

In India commercial banks are restricted from buying and selling securities beyond five
percent of their net incremental deposits of the previous year. They can
subscribe to securities in the primary market and trade in shares and
debentures in the secondary market. Further, acceptance of deposits is limited
to commercial banks. Non-bank financial intermediaries accept deposits for
 fixed term are restricted to financing leasing/hire purchase, investment and
loan activities and housing finance. They cannot act as issue managers or
merchant banks. Only merchant bankers registered with the Securities and
Exchange Board of India (SEBI) can undertake issue management and
underwriting, arrange mergers and offer portfolio services. Merchant banking
in India is non-fund based except underwriting. The following figure (figure 1),
serves as an effective tool of rightly distinguishing between the above two
banks.

What is Universal Banking?

It refers to the combination of commercial banking and investment banking including

securities business. It envisages multiple business activities and can take
number of forms ranging from the true universal bank represented by the
German Model with few restrictions to the UK model providing a broad range
of financial activities through separate affiliates of the bank and the US model
with a holding company structure through separately capitalized subsidiaries.

What are the Principal Functions of Investment Banks?

Global investment banks typically have several business units, each looking after one of
the functions of investment banks. For example, Corporate Finance,
concerned with advising on the finances of corporations, including mergers,
acquisitions and divestitures; Research, concerned with investigating, valuing,
and making recommendations to clients - both individual investors and larger
entities such as hedge funds and mutual funds regarding shares and
corporate and government bonds); and Sales and Trading, concerned with
buying and selling shares both on behalf of the bank's clients and also for the
bank itself. For Investment banks management of the bank's own capital, or
Proprietary Trading, is often one of the biggest sources of profit. For example,
the banks may arbitrage stock on a large scale if they see a suitable profit
opportunity or they may structure their books so that they profit from a fall in
bond price or yields. In short the functions of Investment banks include:

Raising Capital
Brokerage Services
Proprietary trading
Research Activities
Sales and Trading

“Raising Capital” function:

Corporate Finance is a traditional aspect of Investment banks, which involves helping

customers raise funds in the Capital Market and advising on mergers and
acquisitions. Generally the highest profit margins come from advising on
mergers and acquisitions. Investment Bankers have had a palpable effect on
the history of American business, as they often proactively meet with
executives to encourage deals or expansion.

“Brokerage Services” Function:

Brokerage Services, typically involves trading and order executions on behalf of the
investors. This in turn also provides liquidity to the market. These brokerages
assist in the purchase and sale of stocks, bonds, and mutual funds.

“Proprietary Trading” Function:

Under Investment banking proprietary trading is what is generally used to describe a

situation when a bank trades in stocks, bonds, options, commodities, or other
items with its own money as opposed to its customer’s money, with a view to
make a profit for itself. Though Investment Banks are usually defined as
businesses, which assist other business in raising money in the capital
markets (by selling stocks or bonds), they are not shy of making profit for itself
by engaging in trading activities.

“Research Activities” Function:

Research, is usually referred to as a division which reviews companies and writes

reports about their prospects, often with "buy" or "sell" ratings. Although in
 theory this activity would make the most sense at a stock brokerage where the
advice could be given to the brokerage's customers, research has historically
been performed by Investment Banks (JM Morgan Stanley, Goldman Sachs
etc). The primary reason for this is because the Investment Bank must take
responsibility for the quality of the company that they are underwriting Vis a
Vis the prices involved to the investor.

“Sales and Trading” Function:

Often referred to as the most profitable area of an investment bank, it is usually

responsible for a much larger amount of revenue than the other divisions. In
the process of market making, investment banks will buy and sell stocks and
bonds with the goal of making an incremental amount of money on each
trade. Sales is the term for the investment banks sales force, whose primary
job is to call on institutional investors to buy the stocks and bonds,
underwritten by the firm. Another activity of the sales force is to call
institutional investors to sell stocks, bonds, commodities, or other things the
firm might have on its books.

What does the Business Portfolio of Investment Banks constitute?

CORE BUSINESS PORTFOLIO

1 NON-FUND BASED
Merchant Banking Services for management of Public offers of equity and debt
instruments

Open offers under the Takeover Code

Buy back offers
De-listing offers
Advisory and Transaction service in
Project Financing
Syndicated Loans
Structured Finance
Venture Capital
Private Equity
Preferential Issues
Private Placements of equity and debt
Business advisory and structuring
Financial restructuring
Corporate Reorganisations such as mergers and de-mergers, hive-offs, asset sales, sell-
off and exits, strategic sale of equity.
Acquisitions and takeovers
Government disinvestments and privatization
Asset Recovery agency services (presently in take off stage)

2. FUND BASED

Underwriting
Market Making
Bought Out deals
Investments in primary market

Investment banks are essentially financial intermediaries, who primarily help businesses
and governments with raising capital, corporate mergers and acquisitions, and
securities trade.

Early investment banks in USA differed from commercial banks, which accepted
deposits and made commercial loans.
Distinction between commercial banks and investment banks is unique and is confined
to the United States, where it is by legislation that they are separated.

Countries where investment banking and commercial banking are combined have
universal banking system.

Universal Banking refers to the combination of commercial banking and investment

banking including securities business

Sales and Trading is often referred to as the most profitable area of an investment bank,
it is usually responsible for a much larger amount of revenue than the other
divisions

How did Investment banking evolve in India?

For more than three decades, the investment banking activity was mainly confined to
merchant banking services. The foreign banks were the forerunners of
merchant banking in India. The erstwhile Grindlays Bank began its merchant
banking operations in 1967 after obtaining the required license from RBI.
Soon after Citibank followed through. Both the banks focussed on syndication
of loans and raising of equity apart from other advisory services. In 1972, the
Banking Commission report asserted the need for merchant banking activities
in India and recommended a separate structure for merchant banks totally
different from commercial banks’ structure. The merchant banks were meant
to manage investments and provide advisory services. The SBI set up its
merchant banking division in 1972 and the other banks followed suit. ICICI
was the first financial institution to set up its merchant banking division in
1973.

How did the formation of SEBI boost the Development of Investment banking in
India?
The advent of SEBI in 1988 was a major boost to the merchant banking activities in India
and the activities were further propelled by the subsequent introduction of free
pricing of primary market equity issues in 1992. Post-1992, there was lot of
fluctuations in the issue market affecting the merchant banking industry. SEBI
started regulating the merchant banking activities in 1992 and a majority of the
merchant bankers were registered with it. The number of merchant bankers
registered with SEBI began to dwindle after the mid nineties due to the
inactivity in the primary market. Many of the merchant bankers were into issue
management or associated activity such as underwriting or advisory. Many
merchant bankers succumbed to the downturn in the primary market because
of the over-dependence on issue management activity in the initial years. Also
not all the merchant bankers were able to transform themselves into full-
fledged investment banks. Currently bigger industry players who are in
investment banking are dominating the industry.

What were the major constraints in Indian Investment banking industry?

The major constraints were:

The Indian investment banks depended on issue management to a greater extent and
so some of them had to perish due to the primary market downturn in the 90’s.
The bigger industry players were the only ones to survive because of a general lack of
institutional financing in a big way to fund capital market activity, which would
have otherwise paved way for other smaller players.
The lack of depth in the secondary market, especially in the corporate debt market could
not supplement the primary market for any major development.

What are the Characteristics of Indian Investment Banking Industry?

Till the 1980s, the Indian financial services industry was characterised by debt services
in the form of term lending by financial institutions and working capital
financing by banks and non-banking financial companies. A capital market
was still an unorganised industry and was mostly restricted to stock broking
activity. In the early nineties, when the capital markets opened up, merchant
banking and asset management services flourished. Many banks, NBFCs and
financial institutions entered the merchant banking, underwriting and advisory
services driven by the boom in the primary market.

Over the subsequent years, the merchant banking industry had faced a huge downturn
due to recession in the capital markets. Also, the capital markets and
investment banking activities came under lot of regulatory developments that
required separate registration, licensing and capital controls. This proved to be
an impediment for the growth of the investment banking industry.

What is the Structure of Indian Investment Banking Industry?

The Indian investment banking industry has a heterogeneous structure for the following
reasons:

The regulations do not permit all investment banking functions to be performed by a

single entity for two reasons:

1. To prevent excessive exposure to business risk

2. To prescribe and monitor capital adequacy and risk mitigation mechanisms.

The commercial banks are prohibited from getting exposed to stock market investments
and lending against stocks beyond certain specified limits under the provisions
of RBI and Banking Regulation Act.
Merchant banking activities can be carried out only after obtaining a merchant-banking
license from SEBI.
Merchant bankers other than banks and financial institutions are not authorised to carry
out any business other than merchant banking.
The Equity research activity has to be carried out independent of the merchant banking
activity to avoid conflict of interest.
Stock broking business has to be separated into a different company

Regulatory framework for Investment banking:

An overview of the regulatory framework is furnished below:

All investment banks incorporated under the Companies Act, 1956 are governed by the
provisions of that Act.
Those investment banks that are incorporated under a separate statute are regulated by
their respective statute. Ex: SBI, IDBI.
Universal banks that function as investment banks are regulated by RBI under the RBI
Act, 1934.
All Non-banking Finance Companies that function as investment banks are regulated by
RBI under RBI Act, 1934.
SEBI governs the functional aspects of Investment banking under the Securities and
Exchange Board of India Act, 1992.
Those investment banks that carry foreign direct investment either through joint ventures
or as fully owned subsidiaries are governed by Foreign Exchange
Management Act, 1999 with respect to foreign investment.

Who are the major Players in the Indian Industry?

Several big investment banks have set many group entities in which the core and non-
core business segments are distributed. SBI, IDBI, ICICI, IL&FS, Kotak
Mahindra, Citibank and others offer almost all of the investment banking
activities permitted in the country. The long-term financial institutions like ICICI
and IDBI have converted themselves into full service commercial banks
(called as Universal banks). The Indian investment banks have not gone
global so far though some banks do have a presence in the overseas. The
middle level constitutes of some niche players and a few subsidiaries of the
public sector banks. Certain banks like Canara bank and Punjab National
bank have had successful merchant banking activities while some other
 subsidiaries have either closed their operations or sold off their business due
to a couple of securities scam in the industry.

There are also merchant banks structures as NBFCs such as Alpic Finance, Rabo India
Finance ltd and so on. Some of the pure advisory firms that operate in the
Indian market are Lazard Capital, Ernst & Young, KPMG, and Price Water
Coopers etc.

What are the Core Services of Indian Investment banks?

They are:-

Merchant Banking, Underwriting and Book Running

Mergers and Acquisition Advisory
Corporate Advisory

What are the Support services and Businesses of Indian Investment banks?

They are:-

Secondary Market Activities

Asset Management Services
Wealth Management Services (Private Banking)
Institutional Investing

How does the Future of Investment banking in India look like?

The scope for investment banking in India is very big, as much of it has not been
exploited so far. This proves to be a significant point for a bright future for the
Indian investment banks. A lot of pure merchant banks and advisory firms
have an opportunity to convert themselves in to full service investment banks.
With this, their markets are bound to broaden and their service deliveries
poised to be more efficient. The technological and market developments
influencing the capital market will also provide an additional impetus to the
growth of the investment banks.
What is a global depository?

A Company in one jurisdiction can issue depository receipts in other jurisdictions where
such issues are permitted. DRs are issued with the support of an agency that
acts as a global depository.

The functions of a global depository are:

To administer the DRs for the individual investors

Handling transfer of DRs arising out of secondary market trades
Dividend distribution
Recovery of withholding tax
Conversion of the DRs into shares etc.

The DRs are listed and then traded on the exchanges where they are listed. The Issuing
Company issues the requisite shares underlying the DRs in its domestic
jurisdiction to a domestic custodian against receipt of cash from the investors
for the DRs. These shares represent the issued capital of the company. The
underlying shares are not allowed to be traded in the domestic market
because the DRs representing

The depository mechanism creates two distinct pools of securities

One being the issued shares

The other being the DRs representing those shares.

ADRs are American Depository Receipts.

They are Certificates issued by a U.S. depository bank, representing foreign shares held
by the bank, usually by a branch or correspondent in the country of issue. One
ADR may represent a portion of a foreign share, one share or a bundle of
shares of a foreign corporation. ADRs are subject to the same currency,
political, and economic risks as
What is the relationship between depository receipts and the shares underlying
them?

The following figure depicts the relationship between the two.

Why should there be a complicated issue of DRs instead of issuing shares directly to
investors?

Answers to the above question:

Under current regulations, Indian companies are not supposed to make an issue of its
shares abroad to the foreign public and list these shares directly on global
exchanges.
To invest in depository receipts, foreign investors need not register with SEBI whereas to
invest in shares, they have to register with SEBI.
A capital gain through investment in shares in India by foreign investors is subject to
taxes whereas there is no tax for capital gains made on DRs.
Settlement of transactions in DRs happens through international settlement systems,
which are more convenient for the foreign investors whereas settlement in
shares have to be cleared in domestic clearinghouses in India.
Lastly, compliance with Foreign Exchange Management Act and RBI approvals is not
required for sale of depository receipts by foreign investors.
Shares are listed only on the domestic stock exchanges and not on international stock
exchanges.

What do you mean by Fungibility of Depository Receipts?

Fungibility refers to the convertibility of depository receipts in to the shares underlying

them. This provides for a two-way exit route to the foreign investors. They can
exit either through the sale of DRs in the overseas market or through the sale
of shares in the domestic market. Fungibility makes the prospects for the
investor better since the price differential between the depository and the
underlying shares can be exploited to make arbitrage gains. The ADRs
 became fungible in US market in 1990. The Indian government had initially
prescribed two year lock-in-period for GDRs to become fungible. This
restriction is now removed.

Meaning of “Fungible”?

You can't tell them apart. Something is fungible when any one single specimen is
indistinguishable from any other. Somebody who is owed $1 does not care
which particular dollar he gets. Anything that people want to use as MONEY
must be fungible, whether it is GOLD bars, beads or shells.

What does Two-way Fungibility of Depository Receipts mean?

Two-way Fungibility of DRs implies that DRs and the shares underlying them are
convertible both ways but within their respective jurisdictions. This means that
an overseas investor may convert DRs in to shares but they can be traded
only in the domestic market. Similarly, a domestic investor may convert shares
into tradable DRs but they can be traded in markets wherein the DRs are
listed. The reverse Fungibility process is being governed by RBI guidelines.

What are Foreign Currency Convertible Bonds?

A company can issue bonds that are convertible in to depository receipts at a later date.
These are known as Foreign Currency Convertible Bonds or FCCBs in India.
When such bonds are issued in the euro market they are known as euro
convertibles.

Indian Depository Receipts (IDRs):

Under the IDR mechanism, foreign companies incorporated outside India may take an
issue of IDRs in the Indian Capital market to raise funds. A domestic
depository in India issues these IDRs against shares of the issuing company,
which are held by an overseas custodian bank. The IDR mechanism is exactly
the inverse of ADR/GDR mechanism. The IDRs would be listed and traded in
India like any other domestic shares issued by Indian companies. The issue of
IDRs is subject to the guidelines issued by the Indian Government.
What is a Derivative?

A Derivative can be defined as a financial instrument whose value is derived from the
values of the underlying traded assets. For example, a stock option is a
derivative whose value is dependent on the price of a stock. Derivatives can
be made of any variable (not necessarily financial assets) like price of sugar to
the amount of snow falling at a certain location. With the developments
happening in the derivatives market, there is now active trading in credit
derivatives, electricity derivatives, weather derivatives and insurance
derivatives. Also, extensions of the existing products like interest rate, foreign
exchange and equity derivative products have been created.

What are the types of derivatives?

Derivatives are either Financial Derivatives or Commodity Derivatives.

Financial Derivatives - Financial Derivative Contracts are interest futures, currency

futures, futures and options on stock indices, options on stocks, etc.
Commodities Derivatives - These contracts are futures and options on standard
contracts of various commodities transacted in wholesale. For example: Tea,
oilseeds, metals and other products like energy, bandwidth etc.

The main types of derivatives are:

Forwards
Futures
Option markets

Forward Contracts:

They are simplest form of derivatives

They are basically agreements to buy or sell an asset at a certain future time for a
certain price.
They are traded in the over-the-counter market usually between two financial institutions
or between a financial institution and its clients
Forward Contracts on foreign exchange are very popular
They can be used to hedge foreign currency risk
Both the parties to a contract have a binding commitment in the contract
One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price
The other party assumes a short position and agrees to sell the asset on the same date
for the same price

Futures Contracts:

They are basically agreements between two parties to buy or sell an asset at a certain
time in the future for a certain price.
They are traded on exchanges unlike forward contracts
They carry certain standardised features as per exchange specifications
They carry a guarantee given by the exchange to both the parties that the contract will
be honoured
The underlying assets are a very wide range of commodities and financial assets

Options:

The right to buy or sell an asset is referred to as an Option

Options are traded both on exchanges and in the over-the-counter market
There are two basic types of options namely “call option” and “put option”
Call option gives the holder the right to buy the underlying assets by a certain date for a
certain price
Put option gives the holder the right to sell the underlying asset by a certain date for a
certain price
The price in the contract is known as the “exercise price” or the “strike price”
The date in the contract is known as the “expiration date” or “maturity”
The holder of an option does not have to exercise his right whereas in forwards and
futures, the holder is obligated to buy or sell the underlying asset
There is a cost to acquiring an option whereas it costs nothing to enter into forwards and
futures.

What is a Derivatives Exchange?

A derivatives exchange is a market where standardized contracts, which have been

defined by the exchange, are traded. Derivatives exchanges have been in
existence for a long time. The Chicago Board of Trade, 1848 and the Chicago
Mercantile Exchange, 1919 are considered to be pioneer derivatives
exchanges. The underlying assets include foreign currencies and futures
contracts as well as stocks and stock indices.

The Euro Market is a market in which financial instruments – both short and long terms
that are denominated in a variety of currencies other than the domestic
currency of the host currency are transacted.

The debt market consists of a bond market that is very vibrant and much sought after by
foreign issuers

A Depository receipt (DR) is a security that represents ownership in a foreign security

The depository receipt mechanism is an indirect way of inviting the foreign investors by
issuing the shares in a foreign jurisdiction with a surrogate listing mechanism

Fungibility refers to the convertibility of depository receipts in to the shares underlying

them

Under the Indian Depository Receipts (IDR) mechanism, foreign companies incorporated
outside India may take an issue of IDRs in the Indian Capital market to raise
funds

A Derivative – It can be defined as a financial instrument whose value is derived from

the values of the underlying traded assets
A derivatives exchange is a market where standardized contracts, which have been
defined by the exchange, are traded

An initial public offering (IPO) – It referred to simply as an "offering" or "flotation," is

when a company (called the issuer) issues common stock or shares to the public for the
first time. They are often issued by smaller, younger companies seeking capital to
expand, but can also be done by large privately-owned companies looking to become
publicly traded.

In an IPO the issuer may obtain the assistance of an underwriting firm, which helps it
determine what type of security to issue (common or preferred), best offering price and
time to bring it to market.

An IPO can be a risky investment. For the individual investor, it is tough to predict what
the stock or shares will do on its initial day of trading and in the near future since there is
often little historical data with which to analyze the company. Also, most IPOs are of
companies going through a transitory growth period, and they are therefore subject to
additional uncertainty regarding their future value

Reasons for listing

When a company lists its shares on a public exchange, it will almost invariably look to
issue additional new shares in order at the same time. The money paid by investors for
the newly-issued shares goes directly to the company (in contrast to a later trade of
shares on the exchange, where the money passes between investors). An IPO,
therefore, allows a company to tap a wide pool of stock market investors to provide it
with large volumes of capital for future growth. The company is never required to repay
the capital, but instead the new shareholders have a right to future profits distributed by
the company and the right to a capital distribution in case of a dissolution.

The existing shareholders will see their shareholdings diluted as a proportion of the
company's shares. However, they hope that the capital investment will make their
shareholdings more valuable in absolute terms.

In addition, once a company is listed, it will be able to issue further shares via a rights
issue, thereby again providing itself with capital for expansion without incurring any debt.
This regular ability to raise large amounts of capital from the general market, rather than
having to seek and negotiate with individual investors, is a key incentive for many
companies seeking to list.

Benefits of being a public company-

• Bolster and diversify equity base
• Enable cheaper access to capital
• Exposure and prestige
• Attract and retain the best management and employees
• Facilitate acquisitions
• Create multiple financing opportunities: equity, convertible debt, cheaper bank loans,
etc.

Procedure

IPOs generally involve one or more investment banks as "underwriters." The company
offering its shares, called the "issuer," enters a contract with a lead underwriter to sell its
shares to the public. The underwriter then approaches investors with offers to sell these
shares.

The sale ( allocation and pricing) of shares in an IPO may take several forms. Common
methods include:

 Best efforts contract

 Firm commitment contract
 All-or-none contract
 Bought deal
 Dutch auction
 Self distribution of stock

A large IPO is usually underwritten by a "syndicate" of investment banks led by one or

more major investment banks (lead underwriter). Upon selling the shares, the
underwriters keep a commission based on a percentage of the value of the shares sold
(called the gross spread). Usually, the lead underwriters, i.e. the underwriters selling the
largest proportions of the IPO, take the highest commissions—up to 8% in some cases.
Multinational IPOs may have as many as three syndicates to deal with differing legal
requirements in both the issuer's domestic market and other regions. For example, an
issuer based in the E.U. may be represented by the main selling syndicate in its
domestic market, Europe, in addition to separate syndicates or selling groups for
US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also
the lead bank in the other selling groups.

Because of the wide array of legal requirements, IPOs typically involve one or more law
firms with major practices in securities law, such as the Magic Circle firms of London and
the white shoe firms of New York City.

Usually, the offering will include the issuance of new shares, intended to raise new
capital, as well the secondary sale of existing shares. However, certain regulatory
restrictions and restrictions imposed by the lead underwriter are often placed on the sale
of existing shares.

Public offerings are primarily sold to institutional investors, but some shares are also
allocated to the underwriters' retail investors. A broker selling shares of a public offering
to his clients is paid through a sales credit instead of a commission. The client pays no
commission to purchase the shares of a public offering; the purchase price simply
includes the built-in sales credit.

The issuer usually allows the underwriters an option to increase the size of the offering
by up to 15% under certain circumstance known as the greenshoe or overallotment
option.

Pricing

The underpricing of initial public offerings (IPO) has been well documented in different
markets (Ibbotson, 1975; Ritter 1984; Levis, 1990; McGuinness, 1992). While Issuers
always try to maximize their issue proceeds, the underpricing of IPOs has constituted a
serious anomaly in the literature of financial economics. Many financial economists have
developed different models to explain the underpricing of IPOs. Some of the models
explained it as a consequences of deliberate underpricing by issuers or their agents. In
general, smaller issues are observed to be underpriced more than large issues (Ritter,
1984, Ritter, 1991, Levis, 1990) Historically, IPOs both globally and in the United States
have been underpriced. The effect of "initial underpricing" an IPO is to generate
additional interest in the stock when it first becomes publicly traded. Through flipping,
this can lead to significant gains for investors who have been allocated shares of the IPO
at the offering price. However, underpricing an IPO results in "money left on the table"—
lost capital that could have been raised for the company had the stock been offered at a
higher price. One great example of all these factors at play was seen with theglobe.com
IPO which helped fuel the IPO mania of the late 90's internet era. Underwritten by Bear
Stearns on November 13, 1998 the stock had been priced at $9 per share, and famously
jumped 1000% at the opening of trading all the way up to $97, before deflating and
closing at $63 after large sell offs from institutions flipping the stock . Although the
company did raise about $30 million from the offering it is estimated that with the level of
demand for the offering and the volume of trading that took place the company might
have left upwards of $200 million on the table.

The danger of overpricing is also an important consideration. If a stock is offered to the

public at a higher price than the market will pay, the underwriters may have trouble
meeting their commitments to sell shares. Even if they sell all of the issued shares, if the
stock falls in value on the first day of trading, it may lose its marketability and hence
even more of its value.

Investment banks, therefore, take many factors into consideration when pricing an IPO,
and attempt to reach an offering price that is low enough to stimulate interest in the
stock, but high enough to raise an adequate amount of capital for the company. The
process of determining an optimal price usually involves the underwriters ("syndicate")
arranging share purchase commitments from leading institutional investors

Issue Price

A company that is planning an IPO appoints lead managers to help it decide on an

appropriate price at which the shares should be issued. There are two ways in which the
price of an IPO can be determined: either the company, with the help of its lead
managers, fixes a price or the price is arrived at through the process of book building.

Note: Not all IPOs are eligible for delivery settlement through the DTC system, which
would then either require the physical delivery of the stock certificates to the clearing
agent bank's custodian, or a delivery versus payment (DVP) arrangement with the
selling group brokerage firm.

Quiet period

There are two time windows commonly referred to as "quiet periods" during an IPO's
history. The first and the one linked above is the period of time following the filing of the
company's S-1 but before SEC staff declare the registration statement effective. During
this time, issuers, company insiders, analysts, and other parties are legally restricted in
their ability to discuss or promote the upcoming IPO.

The other "quiet period" refers to a period of 40 calendar days following an IPO's first
day of public trading. During this time, insiders and any underwriters involved in the IPO
are restricted from issuing any earnings forecasts or research reports for the company.
Regulatory changes enacted by the SEC as part of the Global Settlement enlarged the
"quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over,
generally the lead underwriters will initiate research coverage on the firm. Additionally,
the NASD and NYSE have approved a rule mandating a 10-day quiet period after a
Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-
up agreement" for a securities offering.

Underwriting

Different service obligations depending upon the way it has evolved as an area of
capital market SEBI DIP guidelines as ‘an agreement with or without conditioned to
subscribe to the securities of a body corporate when the existing share holders of the
body corporate or the public do not subscribe to the security offered to them’ an
underwriter, according to the SEBI (underwriters) rules 1993 means ‘ a person who
engages in the business of underwriting of an issue of securities of a body corporate’ let
us analysis this definition.
Firstly, underwriting is always in connection with proposed issue securities by a body
corporate. It is not a general undertaking between company and an underwriter. The
specific underwriter commitment has to be documented through underwriting agreement.
Secondly, underwriting is an agreement by the underwriter to subscribe to the security
being issued in case the persons to whom they are offered donor subscribed to them.
Therefore, underwriting is service that consists of taking a contingent obligation to
subscribe to an agreed number of securities in an issue if such securities are not
subscribed to by the intended investors. The underwriter’s job is to market the
underwritten securities to investors and procure subscriptions for such securities
Thirdly, underwriting is primarily a fee based service provide by underwriter since there
is no fundamental obligation to subscribe to the underwritten securities. If the issue is
fully subscribed to by the investors, the underwriter has no further obligation to the issue.
However, if investors do not subscriber to the issue fully, the obligating falls upon the
underwriter to pickup unsubscribed portion of the issue in such a situation, underwriting
becomes a fund based service since the underwriter has to purchase the security that
have remained unsubscribed by the invesrots.it is due to this reasons that underwriting
is the risky activity for investment banks that requires careful assessment of issue before
they can be taken up for underwriting. In addition, underwriting require sufficient financial
resources to be allocated to such activity.

Sub underwriting

Sub underwriting used by an underwriter to spread the risk assumed in underwriting an

issue of shares. Sub underwriting is a process under which the underwriter appoints
other persons to underwrite his/her own underwriting obligation. The underwriter
normally shares the underwriting fee with the sub-underwriter for their efforts. The
underwriter enters into sub-underwriting directly with the sub-underwriter through a sub-
underwriting agreement.
Notwithstanding a sub underwriting arrangement, the underwriter shall remain primarily
responsible for the underwritten shares and any failure part of the sub-underwriters to
fulfill their obligations shall not absolve or discharge the underwriter’s obligations to the
issuer company. In other words, the issuer company is not a part to sun-underwriting
arrangement. It is required to take cognizance of any sub-underwriting arrangements of
its underwriters and can require the underwriters to fulfill their obligation even if their
sub-underwriters have not done so. Since sub-underwriting agreements do not concern
the issuer or lead manager, these do not become a part of essential documentation for a
public issue. However, for the purpose of ascertaining the fulfillment of obligation by an
underwriter, the subscriptions procured by the sub- underwriters are also included along
with those procured by the underwriter directly.
Underwriting commission

The underwriters compensation for the service rendered is the fee that is paid by the
issuer company. This fee, which is known as underwriting commission, is paid as a
percentage of the value of underwriting (the total number of securities underwritten
multiplied by the offer price per security). Underwriting commission is payable is
irrespective of whether the underwriter ultimately has any requirement to purchase the
underwritten securities or not. Underwriter commission should not be confused with
‘brokerage’ this is paid to a stock broker for dealing in share or for procuring
subscriptions. Broke is merely a marketing commission while underwriting commission is
compensation for taking underwriting risk besides procuring subscriptions.
This payment of underwriting commission is governed by section 76 of the company’s
act, which stipulates a ceiling of 5% with respect to shares and 2.5% with respect to
debentures. This is further subject to authorization under the article of association of the
company and if the article prescribes a lower rate, the lower rate shall apply. Within the
above said ceiling, the government of India (ministry of finance) fixed a cap of 2.5% with
respect of equity shares. In case of other securities wherein the total issue size is more
than Rs 500,000 the applicable ceiling is 1% if the issue is fully subscribed by the
investors, incase, the issue is under subscribed, the underwriters can be paid an
additional 1% on the securities picked up by them. Within the above ceilings fixed by the
government, an issuer company is free to negotiable lower rates of commission with
underwriters.

Underwriting agreement

The underwriting agreement is the document that establishes the contract between the
underwriter and the issuer company. It forms a part of material contracts for the issue
and requires to be approved by the concerned stock exchange part from being filed with
the ROC as part of prospectus registration. The SEBI evolved a model underwriting
agreement, which is recommendatory and should be followed to the extent possible by
all underwriters. The model agreement list out the following main clauses:
 Amount being underwritten

 Provisions for sub underwriting

  Computation of development

 Procedure for effecting or discharge of underwriting obligation

 Right to receive commission within statutory stipulation

 Statutory declarations

Regulatory framework

Underwriting activity in India is regulated under the SEBI (underwriters) Rules 1993 and
SEBI (underwriters) Regulations 1993. The regulatory framework for underwriting activity
under the above side Rules and Regulations is summarized below:
 Underwriting business can be taken up by the financial institutions, commercial
banks, mutual funds, merchant bankers registered with SEBI, stock brokers and
NBFCs. All the above entities except registered merchant bankers require
registering as underwriters with SEBI.

 All underwriters shall have necessary infrastructure, past experience, minimum of

two employees and shall comply with the minimum capital adequacy requirement
as stipulated from time to time and further comply with additional capital
adequacy requirement of the concerned stock exchanges.

 Underwriters have to enter into legally binding agreement with the issuer
companies. The underwriting agreement has to be approved by the stock
exchange wherein the shares are proposed to be listed.

 In the case of financial institutions, banks and mutual funds, the issuer company
has to apply separately prior to finalization of the issue for underwriting support.

 Underwriting commission cannot exceed the statutory ceilings.

 All underwriting contracts have to be classified as material contracts and disclose

as such in the offer document and filed with the Registrar of companies prior to
the issue of the offer document.

 Sub-underwriting is permissible provided there are contracts to evidence the

same.
Besides the above, underwriter should also comply with a code of conduct in conducting
their business. The code prescribes inter alia, the following main provisions:
 Underwriter should avoid conflict of interest and make necessary disclosures of
their interests if any.

 An underwriter should abide by the award of the ombudsman incase of disputes

with the issuer company in arriving at contractual obligations a liabilities.

 An underwriting firm or any of its employees shall nor rendered directly or

indirectly, any investment advice about any security publicly unless a discloser of
its interest has been made as prescribed.

 Underwriters or their employees, directors etc.cannot indulge in insider trading in

the securities they underwrite.

Development
THE AMOUNT OF FINACIAL SUPPORT TO BE PROVIDED BY AN UNDERWRITER
IN AN UNDER Subscribed issue of securities is known as devolvement development
happen when an underwriting firm procures lesser subscriptions from investors than
what has been underwritten by it . however the extent of devolvement on an underwriter
also depends upon the extent of subscriptions procured by other underwriters to the
issue and the overall performance of the issue. If a particular underwriter has been able
to market the issue and procure enough subscriptions to cover his or her underwriting
completely such underwriter will not face any devolvement event if the issue has been
under subscribed overall.
The following method of computation is recommended by SEBI for the purpose of
arriving at devolvement of underwriters.
a) All eligible applications received from investors towards subscriptions for the
securities in the issue shall go to reduce underwriters obligations to that extent.
However,to ascertain each underwriter’s devolvement if any, the following steps should
be followed in sequence.
b) All procurements made by a particular underwriter or his/her sub-underwriters out of
(a) above shall be allocated to that underwriter.
c) All applications forming part of (a) above but invested directly by investors without
being routed through underwriters/ sub-underwriters shall be allocated pro-rata to all
underwriters in the ratio of their underwriting obligations.
d) After following steps (b) and (c),if any underwriter has been allocated more than
his/her have a deficiency.
e) Devolvement is the positive balance that remains in the account of a particular
underwriter after the above steps are completed. If the issue is fully underwritten, the
total of all the individual amounts of underwriter devolvement shall be amount of under-
subscription in the issue.

UNDERWRITING IN BOOK-BUILT OFFERS

AS PER PREVALENT REGULATIONS, UNDERWRITING IS compulsory in book-built
offers to the Extent of the NPOand the issuer company does not have any discretion
therein. Therefore, if a company opts for the 75% book-building route, underwriting
would be necessary to the extent of 75% of the NPO. Under the 100% book-builiding
route, underwriting becomes mandatoryfor the entire NPO. Underwriting has to be done
by the book runners and the syndicate members. However, this requirement does not
apply to issues wherein 50% of the NPO has to be mandatorily allotted to QIBs. In such
issues, only the balance portion of the NPO,i.e. 25% or 50% as the case may be shall be
subject to mandatory underwriting.
In book built offers, the book runner assumes the responsibility for the overall
underwriting. Incase there is more than one book runner, the inter-se allocation among
the book runners determines the extent of their obligation. The book runner (s) enter
into underwriting agreement with issuer company. In the case of asyndn under-
subscription in the issue, it devolves on the book runners.
In order to spread the risk, the whole underwriting obligation is shared between the book
runners and the syndicated members and is co-ordinate by the book- runners in-charge
of syndicating the underwriting . The syndicate members enter into an un derwriting
agreement with the book runner(s) indicating the number of securities that they wish to
subscribe at the predetermined price. However, in the event of the syndicate member (s)
failing to fulfill their underwriting obligation, the book runner(s) shall be responsible for
bringing in the amount required to make good the devolvement.
The standard disclosure of an underwriting agreement and the obligations of the
underwriters in an offer document for a book-built offer would be as follows.
The company and the underwriters have entered into an underwriting agreement for the
equity shares propose to be preferred through the offer. Pursuant to the terms of the
underwriting agreement, the book running lead managers (BRLMs) shall be responsible
for bringing in the amount devolved in the event that the members of the syndicate do
not fulfill their underwriting obligations. Pursuant to the terms of the underwriting
agreement, the obligations of the underwriters are subject to certain conditions to
closing, as specified therein, the above underwriting agreement is dated- In the opinion
of our board of directors and the BRLM (based on a certificate given by the
underwriters.) The resources of all the above- mentioned underwriters are sufficient to
enable them to discharge their respective underwriting obligations in full. All the above-
mentioned underwriters are registered with SEBI under section 12 (1) of the SEBI act or
registered as brokers with the stock exchange (s).Allocation among underwriters may
not necessarily be in proportion to their underwriting commitments. Notwithstanding the
above table, the BRLMs and the syndicate members shall be responsible for ensuring
payment with respect to equity shares allocated to investors procured by them. IN the
event of any default in payment, the respective underwriting, in addition to other
obligations defined in the underwriting agreement, will also be required to
procured/subscribe to the extent of the defaulted amount as specified in the underwriting
agreement. Allotment to QIBs is discretionary as per the terms of this prospectus and
may not be proportionate in any way and the patterns of allotment to the QIBs could be
different for the various underwriters

DEVOLVEMENT NOTICE

As per SEBI’S Model Underwriting Agreement, the Following Procedure is Envisaged in

the case of an under -Subscribed issue.

• The issuer company shall within 30 days after the date of closure of the
subscription list communicate in writing to the underwriter ( the devolvement
notice ) the total number of securities remaining unsubscribed, and the
number of securities to be taken up by the underwriter or subscriptions to
procured therefore.
 • The company shall make available to the underwriter the manner of
computation of devolvement and also furnish a certificate in support of such
computation from the company’s auditors.

• The underwriter on being satisfied about the extent of devolvement, shall

within 30 days after the receipt of the devolvement notice, make or procure
the applications to subscribe to the securities and submit them along with the
required payment to the company.
• In the event of failure of the underwriter to do so,the company shall be free to
make alternative arrangements without prejudice to legal remedies against
the underwriter for failure to meet devolvement requirements, including the
right to claim damages.

From the above mechabism, it is evident that if a company has to enforce

devolvement on underwriters, it has to initially close the issue and declare it to be an
under-subscribed issue. Thereafter, it has to send devolvement notices to respective
underwriters. Many a time, issuer companies hesitate to go through the devolvement
route since that would cause humiliation in public. In addition, the company has to
live with the stigma of a devolved public issue, which could even affect its market
prospects and the opportunity to make future public offers. Due to this reason,
several issuer companies prefer to get underwriters to bail out an issue prior to
closure of subscription lists so that the issue can be officially closed as a successful
issue .

It may be understood from the above that when an issue has not fared well , the
company has two options-(a) to get the issue bailed out prior to close of the
subscription lists with help of underwriters, brokers and other large investors and (b)
to go through the devolvement route by declaring the issue under-subscribed and
issuing devolvement notices to underwriters. In borderline cases, more often than
not, companies prefer option (a).Only if the issue is heavily under- subscribed and
they are compelled, companies go through option(b).

Assesement of an issue for underwriting

 As explain above the critical risk factor underwriting business is (a) development
probability, (b) development quantum and (c) capital loss from developed securities.
As a corollary in order to mitigate these risks, the critical success factors are capital
adequacy and the capacity to procure subscriptions. Capital adequacy comes
through financial strength but it would not suffice unless the capacity to procure is
augmented with it. The capacity to procure depends upon the distribution network
and investor base of the underwriter and the marketability of an issue. While
underwriters build an expansive network of brokers, sub-brokers and marketing
agents over a period of time they have to carefully assess the marketability of every
issue that they underwrite.
Assessment of an issue for underwriting should always be made from an
investor’s perspective since the issue is successful only when it finds favour with
investors. As explained in chapter 4 . institutional investors look at primary issues
from the perspective of medium term growth while the retail investor by and
largen more by the, look for short-term profit booking within the first three to six
months after listing.Institutional investors are driven more by the fundamentals of
the issue and are therefore keen to wait for appreciation in the market price over a
longer time frame of one to two years. A lot depends on factors such as the
industry, pricing of the issue, fundamentals at the time of issue, past track record,
soundness of the business plan, financial performance, level of brand visibility etc.
These factors determine the equilibrium price of the company’s share in the market
that a large investor looks for. However, retail investors are driven more by profit
motive and arbitrage opportunities than by fundamentals. Therefore what matter
more to retail investors is the affordability of the share, post-issue floating stock and
possibility of piece appreciation.
Keeping the above mind-set of institutional, HNI and retail investors in minda,
underwriters have to look at the potential of the issue to meet these expectations
and their oown distribution strengths to reach these investors. Many underwriters
and brokers develop a strong and loyal investor base that can support significant
number of issues. Underwriters have to convince these investors and recommend
the issue strongly. Needless to say, unless investors make money through such
recommendations, the support will not continue. Therefore, underwriters have to
assess the above factors thoroughly and arrive at the optimum level of subscription
 they can expect from their own investors base for a particular issu3e before entering
into an underwriting commitment.

Summary

The erstwhile Grindlays Bank began its merchant banking operations in 1967 after
obtaining the required license from RBI
The advent of SEBI in 1988 was a major boost to the merchant banking activities in India
and the activities were further propelled by the subsequent introduction of free
pricing of primary market equity issues in 1992
Till the 1980s, the Indian financial services industry was characterised by debt services
in the form of term lending by financial institutions and working capital
financing by banks and non-banking financial companies
The Indian investment banking industry has a heterogeneous structure
The commercial banks are prohibited from getting exposed to stock market investments
and lending against stocks beyond certain specified limits under the provisions
of RBI and Banking Regulation Act
The Indian investment banks have not gone global so far though some banks do have a
presence in the overseas