Let us discuss some of the important developments in the financial environment like Globalization, Securitization, Financial reengineering, E Finance and Derivatives.

Globalization

Since the early 1990s, the financial marketplace has become truly global. Since 1992, the Indian corporate houses were permitted to directly access the overseas financial markets. This can be done through the issue of Global Depository Receipts (GDR), American Depository Receipts (ADR) to access equity finance, or through External  Commercial Borrowing (ECB) to access debt finance. A large number of Indian companies have issued GDR, ADR or ECB in recent years. Similarly, the Foreign Institutional Investors (FIIs) have been permitted to invest directly on the Indian securities exchanges. Foreign Direct Investment (FDI) norms have been considerably liberalized. Mutual funds and other entities have been allowed to invest abroad on a limited scale.

Securitization

The process of securitization allows borrowers to directly enter the capital market without any involvement of the financial intermediaries. This also allows an entity to raise fresh capital on the security of its existing assets. E.g. a housing finance company may package a part of its existing assets (outstanding home loans) into a single pool, and raise fresh capital on the security of this pool. Since default rate on home loans is rather low, the investors would be willing to lend money on the security of these loans.

Financial Engineering

This refers to the design of innovative products to suit the specific needs of the lenders as well as the borrowers. Thus securities are essentially viewed as bundles of cash flows that may be taken apart and repackaged as per the needs. Unit linked insurance plans is an excellent example of this. Here, the risk and investment elements of life insurance are unbundled and offered as a composite product – part mortality risk insurance, part mutual fund investment.

E Finance

The last few years have seen the growth of online trading. In online trading, the market participants are directly connected to the exchange through computer networks. Matching of orders is automatic. The emergence of Internet has greatly facilitated online trading as well efficient dissemination of market related information.

Derivatives

Derivatives were introduced in India only recently. These can be used both for hedging (protecting oneself against financial risks) as well as for speculation.

There are three major types of derivative contracts – futures, options, and swaps.

Futures contracts (or simply futures) are transactions where one party (the buyer) agrees to buy a particular product from the other party (the seller). The terms and conditions including the price are decided at the time of entering into the contract, but the actual execution of the contract takes place in the future (maybe after a few months). These are traded on the organized stock exchanges. They are standardized in terms of their maturity date and the amounts involved. In India, both the BSE and NSE have futures trading segments where futures on certain select individual shares and equity indices are traded.

Options are of two types – call option and put option.

In a call option, the seller of the option gives to the buyer of the option the right to buy a security at a pre specified price (strike price). These options are valid for a particular time period. Obviously, the option buyer will exercise the option if the market price of the security is more than the strike price. The option seller charges premium for sale of the option.

In a put option, the seller of the option gives to the buyer of the option the right to sell a security at a pre specified price (strike price). Again, these options are valid for a particular time period. The option buyer will exercise the option if the market price of the security is less than the strike price. In India, options are traded on market indices.

The verb swap means exchange. In a financial swap, two parties come together to exchange their assets, liabilities or cash flows. For example, Company A may need rupee financing but is better placed to access dollar finance. Company B may need dollars but has a comparative advantage in the rupee market. In this case, A will borrow dollars, B will borrow rupees and then swap the currency. This is an example of a currency swap. Similarly, in an interest rate swap, both parties swap their interest liabilities (say fixed for floating).