Recent Trends in Financial Innovation towards Nurturing
the Growth of Capital Markets in Indian Corporate


By

Mr. P. Aranganathan
Asst. Professor
Miss. T.Sarunya
Final MBA
M.I.E.T. Engineering College
Trichy
 


ABSTRACT

India is on board towards robust growth to achieve the position within top 5 economies of the world. In order to achieve that benchmark, India requires massive development in infrastructure, industrial & manufacturing front. Hence there is a significant need for financial innovation in the Indian industries, which is a key to the development. However, Indian Companies have been using a wide range of innovative financial instruments to raise their required capital for achieving the broad corporative goals and objectives. They have the potential to help Indian companies to overcome the severe financing constraints they have been experiencing over a long period of time. Companies in their quest of reducing the cost of capital, put a premium on such instrument which will help in achieving such an objectives.  Also the introduction of new instruments of finances have provided opportunities to Indian Companies in designing instruments which could give them the freedom to address their varying needs of investors group to make an attempt to lower the cost of capital.  Introduction of new financing increased the chances for more and more investor's participation in future offerings of companies.  This may enhance the chances for raising more and more funds.  The introduction of such new instruments will definitely fetch many benefits to the companies and the investors. In this paper the authors spotlight the essence of financial innovations and also the various innovative financial products that have great impact on the capital market.

Key words: Financial innovation, Product innovation, Process innovation, spot market, index funds, index futures, index options, etc

INTRODUCTION  

Financial innovation has been a continuous and integral part of growth of the capital markets. Greater freedom and flexibility have enabled companies to reinvent and innovate financial instruments. Many factors such as increased interest rate, volatility, frequency of tax and regulatory changes etc. have stimulated the process of financial innovation. The deregulation of financial service industry and increased competition within investment banking also led to increased activities to design new products, develop better processes, and implement more effective solution for increasingly complex financial problems. Financial instrument is a combination of characteristics such as promised yield liquidity, maturity, security and risk. The process of financial innovation involves creating new instruments and technique by unpackaging and rebinding the same characteristics in different fashion to suit the constantly changing needs of the issuers and the investors.  At times it leads to introduction of revolutionary new products such as swap, mortgage, and zero coupon bonds to finance leveraged buyouts. Some times it involves the piecing together of existing products and process to fit in a particular set of circumstances.  Many companies consider the types of securities (debt and equity), and a handful of simple financial institutions (banks or exchanges). However, there is a range of financial products, types of financial institutions and a variety of processes that these institutions employ to do business.  

'Financial innovation' is the act of creating and popularizing new financial instruments as well as new financial technologies, institutions and markets.  The "innovations" are classified into

1. Product innovation- The product innovations may be represented by new derivative contracts, new corporate securities or new forms of investment products.

2. Process innovation- The process improvements can be represented by new means of distributing securities, processing transactions, or pricing transactions. 

In terms of financial innovations, securities innovations include instruments such as debt, preferred stock, convertible securities, and common equities.  They help in reallocating risk, increasing liquidity, reducing agency costs, transactions costs, taxes and sometimes circumventing regulatory constraints.  

FUNCTIONS OF FINANCIAL INNOVATIONS

The financial innovations help in

  • moving funds across time and space;
  • pooling of funds;
  • managing or reallocating risk;
  • extracting information to support decision-making;
  • addressing asymmetric information problems;
  • facilitating the sale or purchase of goods and services through a payment system;
  • reducing agency cost, and enhancing liquidity

INNOVATIONS IN FINANCIAL PRODUCTS  

After the liberalization measures were announced in 1991, Indian Company under took issuance of new instruments seriously in order to attract large section of investors.  Essar Steel used convertible debentures with warrants and loyalty coupons, Tata Iron and Steel Company Limited issued secured Premium Notes with warrants, Flex Industries  issued partly convertible debentures and non convertible debentures with warrant attached to each instrument DLF aments issued multiple option bonds, Essar oil issued optionally fully convertible debentures and Reliance Petroleum issued triple option convertible with equity warrant and Esab India issued partly convertible debenture. This burst of innovation has seen a typical shift in the design and development of new instrument.  The classic conversion is that of debt in to equity.  Offering the investor the option of conversion keeps the cost of his convertible debt lower than straight debt, thus minimizing the cash out flows during the gestation period.  Once the project yields steady profits, the equity conversion results in a relatively- expensive dilution.  The use of fectures like warrants makes the equity and convertible less expensive for the investor.  It creates possibilities for their full subscription by the investors and also turns out to be cheaper for the issuing company.

The worldwide financial industry is filled with innovative product design.   New financial products become popular because people find them useful. New products like index funds, index futures, index options, etc., became internationally successful because they fulfil basic economic objectives of people in the economy.

The relationship between the underlying spot market, index funds, index futures and index options: are explained as follows:  

  • The prerequisites for an index fund are program trading facilities and an index where all components are liquid and convenient to trade. Index funds fulfilling these conditions have now come to exist in India.
  • Index funds make it possible for people to sell options on the index while being covered this could happen on exchanges which trade index options or over the counter.
  •  Index futures make the implementation of index funds easier.
  • Index funds generate an order flow for index futures markets, and help make them more liquid.
  • Index futures markets enable index options markets.
  • Access to index futures and index options make index funds more attractive, since users can couple their investments in index funds with risk management using the futures and options.
  • Index options make possible innovative new products like 'guaranteed return funds'.

Technology Driven Financial Innovations  

Advancements in Information Technology have facilitated a number of innovations, such as

  • new methods of underwriting securities
  • assembling portfolios of stocks
  • new markets for securities
  • new means of executing security transactions

New intellectual technologies, such as derivative pricing models, are credited with stimulating the growth and popularization of a variety of new contracts. Many new forms of derivatives have been made possible because business people could have some confidence in the methods of pricing and hedging the risks of these new contracts.  Various forms of innovations such as new risk management systems and measures, on-line retirement planning services and new valuation techniques were clearly facilitated by both intellectual and information technology innovations.  

CLASSIFICATION OF FINANCIAL PRODUCTS  

The classification of the Financial Products is illustrated as below:

Sl.No

Product

Elements

1

Payment products

Retail, corporate and trade-related products, and financial/securities products.

2

Trade finance

bills of exchange, collection bills, letters of credit, factoring, forfeiting, performance/bank guarantee, and export and import bills

3

Commercial lending

overdrafts, cash-credits, open loans, goods loans, hypothecation of stock-in-trade facilities, medium-term loans, syndicated loans, financial guarantees, acceptance instruments, etc

4

Structured finance

commercial and real-estate finance, project and start-up finance or equity loans, buy-outs of management or leveraged buy-outs, subordinated debts, etc.

5

Equipment finance

project loans or long-term acceptance bills, leasing and hire purchases

6

Money market products

certificate of deposits, commercial paper, treasury receipts/bills and repurchase agreements and also, money market mutual fund units

7

Capital market products

bonds and debentures, government bonds/gilt-edged securities, equities of all types, including preference and ordinary

8

Derivative products & Risk Management products

foreign exchange forward covers, rate agreements, financial futures, swap and options

9

Consumer products

personal loans, housing loans, car loans, hire-purchase and lease arrangements, mutual and pension-related funds and Credit/debit cards/ other types of cards

 

Indigenous products

both local and ethnic financial products such as chit funds and benefit funds

 

Postal products

National Saving schemes


Some of the innovative financial instruments used by the companies in the Indian Financial Market are explained as follows:

1)   TRIPLE OPTION CONVERTIBLE DEBENTURES (TOCD):

  • First Issued by Reliance Power Limited with an issue size of Rs. 2,172 Cr.
  • There was no outflow of interest for first five years.
  • Equity increase was in phases.
  • No put option to investors and no takeover threat.
  • Reduced dependence on the financial institutions.
  • The expenses for floating the issue was just 2.62% of the issue size which was very less when compared to the 10-12% for a general public issue.

2)   DEEP DISCOUNT BONDS:

  • The investor got a tax advantage and could eliminate the re-investment risk.
  • From the issuer's point of view also, the issue cost was saved as it involved no immediate service cost and lower effective cost. The refinancing risk was also eliminated.

3)   FLOATING RATE NOTES:

  • First issued by Tata Sons with a floor rate of 12.5% and a cap of 15.5% and a reference rate of 364 T-Bill yield, which was 9.85% at the time of issue.
  • The investors would get a minimum return of the floor rate and the maximum return was the cap rate. They would get higher than floor rate depending upon the fluctuations in the reference rate.

4)   ZERO COUPON BONDS:

  • It did not involve any annual interest on the bonds. But it had a higher maturity value on the initial investment for a particular time period.

5)   CONVERTIBLE AND ZERO COUPON CONVERTIBLE BONDS:

  • Similar to the zero coupon bonds except that the effective interest was lower because of the convertibility.

6)   SECURED PREMIUM NOTES (SPNS):

  • First issued by TISCO in July, 1992.
  • These financial instruments were secured against the assets of the company but the investors had to pay a premium over the market price for these types of instruments.

7)   EQUITY WITH DIFFERENTIAL VOTING RIGHTS:

  • Issued by Tata Motors, in which the shares were classified as  "Ordinary Shares" and "A Ordinary Shares".
  • The ordinary shares were issued at Rs. 340 per share, had a voting right of one vote per share.
  • On the other hand, the A ordinary shares were issued at Rs. 305 per share but the voting rights were limited to one vote for every 10 shares. In addition, they were paid extra dividend of five percentage points.
     

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Source: E-mail March 19, 2011

          

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