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Tarheel Consultancy Services
Corporate Training and Consulting
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Part-01
Financial Systems
Institutions, Instruments & Markets

Role of an Economic System

Role of an Economic System (Cont…)
 Collect savings and allocate them efficiently
PHRASE
Efficient Allocation

 Efficient
and free flow of funds between
economic units is critical
 The larger the flow and more efficient the
allocation
 Greater the likelihood of accommodating everyone’s
preferences
 Consequence
 Greater the output of the economy as a whole

Economic Decisions

Economic Decisions (Cont…)
 Production of
 Goods and
 Services
 Distribution of the output

Economic Decisions (Cont…)
 What is a successful economy?
 One that maximizes wealth creation
 One that makes and implements sound
economic decisions
 From what standpoints?
• Production and
• Distribution

 Why the focus on efficiency?

 Unlimited wants
 Limited and scarce resources

 What does efficiency require?
INFORMATION
10

 What kind of economic information?

 What do people need
 How best can goods and services be produced
 How best can the resultant output be distributed
11

 Types of Economic Systems

 COMMAND Economies
 FREE MARKET Economies
12

Command Economies
13

Command Economies (Cont…)
 All decisions are taken by
A CENTRAL PLANNING AUTHORITY
 Role of the planner
 Estimate the resource requirements of
economic agents
 Rank them in order of priority
 Allocate resources in descending order of need
14

15

 Why failure?
 Infeasible to process the required quantum of
information
 Poor quality of information
 Central planner was supposed to be a
`BRIHASPATI’
 Blatant political interference
16

Market Economies
17

Market Economies (Cont…)
 Make the most profitable use of resources
 Profit is determined by
 Prices of inputs – COSTS
 Prices of outputs – REVENUES
 Optimal decision is the one that

 MAXIMIZES PROFITS
18

 Decision making is decentralized
 Every agent has a required ROI (Return on
Investment)
 Minimum return = Cost of Funds
 Critical inputs for decision making - PRICES
19

 How is informational accuracy of the
pricing mechanism ensured?
 By markets that facilitate trade
20

 If price is low
 Demand > Supply
 Price will be bid up till equilibrium is reached
 If price is too high

 Supply > Demand
 Prices will decline till equilibrium is restored
21

 What is equilibrium?
 Differing
perceptions of value will lead to supply
demand imbalances
 The adjustment process will ensure that
 SUPPLY = DEMAND
 Prices accurately convey value
22

Barter
23

Barter (Cont…)
 In a world without markets our time and

energy would be spent in seeking
 Those who have the goods/services that we
want
 Those who are willing to exchange them for
what we have to offer
24

Barter (Cont…)
 Barter transaction
 Prior to the advent of money, barter was the only
means of trade.
 Historically, the development of a unit of currency has
gone hand in hand with the evolution of markets.
25

Barter (Cont…)
 Barter, or Countertrade when

 The buyer is unable to pay the seller in hard or freely
convertible currency.
 freely convertible currency : easily accepted as
value in other countries
26

Example of Barter
Telecom switches
AT&T Sevtelecom
Telecom company Currency Telecom company
USA & Apatite Russia
seller buyer
Apatite Helm AG
Trading Firm
Currency Germany
27
Buyer & Seller
Money
&
Markets
28

Prior to
advent of
MONEY
Exchange your
Could not
Consume all the goods for other
put away goods
goods you have goods and then
for later use
consume them
29

With the
advent of
MONEY
Everything could be Money gave you

The currency served
denominated in the freedom
as the medium
units of to
of exchange
the currency SAVE
30

Money and Prices
 Advantage of money
 Reduces the number of prices required
 Consider a 10 good barter economy
 We would need 45 prices
 However if we had a unit of currency
 We would require only 10 prices
31

Markets
Services
Physical
Goods MARKETS
Assets
Financial
Assets
32

Categories of Economic Units
Economic Units
transacting in
financial markets
Government Sector Business Sector Household Sector
33

Government Sector
34

Government Sector (Cont…)
 Central/Federal
government
 State governments
 Local governments a.k.a Municipalities
35

Business Sector
36

Business Sector (Cont…)
 Sole proprietorships
 Partnerships
 Private Limited Companies
 Public Limited Companies
37

Household Sector
38

Income and Expenditure
Income = Expenditure
Balanced Budget Units (BBU)

Income > Expenditure
Surplus Budget Units (SBU)

Income < Expenditure
Deficit Budget Units (DBU)

39

Function of a Financial System
funds
SBU DBU
claim
e.g. e.g.
•household •government
sector
•business
entities
•nation as a
40

whole
Economy’s Relationship with ROW
 Record of transactions between a country
and the Rest of the World (ROW)
 Is known as the Balance of Payments (BOP)
41

Balance of Payments
 Is a record of a country’s trade in
 Goods
 Services
 Financial Assets
42

Balance of Payments (Cont…)
 BOP is divided into three major categories
of accounts
 The Current Account
 The Capital Account
 The Reserve Account
43

 The Current Account
 Isa record of Imports and Exports of goods and
services
 The Capital Account
 Is a record of transactions that lead to changes
in
 Foreign assets and Foreign liabilities
44

 The Reserve Account
 Also deals with financial assets and liabilities
 But deals only with reserve assets
 What are reserve assets?
 Those used to settle deficits and surpluses on account
of current and capital accounts taken together
 Assets acceptable as a means of payment in
international transactions
 Assets held and exchanged by monetary authorities
45

 The BOP must always balance
A current account deficit must be matched by
A capital account surplus (increase in foreign
liabilities)
 Or by a depletion of reserves
46

 Important sub classifications of BOP
 Balance of Trade
 Current Account Balance
47

IMPORTS EXPORTS
BALANCE OF TRADE
IMPORTS > EXPORTS = Trade Deficit

(Net borrower from abroad)
IMPORTS < EXPORTS = Trade Surplus

(Net lender and invest abroad)
48

Current Account Balance
 Balance of Trade pertains to merchandise
imports and exports
 The current account balance is the sum
total of
 Exports of goods, services and income
 Imports of goods, services and income
 Net unilateral transfers
49

Financial Assets
 What is an asset
 a claim against the income or wealth of
a business
 a household
 Or a government agency
50

Financial Assets (Cont…)
 Manifestation of assets
 Certificates
 Receipts
 Computer record files
51

Financial Claims
funds
SBU DBU
claim
debt instrument
equity shares 52

Why de we require financial assets?
Properties of Financial Assets
Serve as a store of value Promise future returns They are fungible
53

Liability
funds
SBU DBU
claim
ASSET LIABILITY 54

Asset Classes
 Money
 Equity shares
 Debt securities
 Preferred shares
 Foreign exchange
 Derivatives
 Mortgages and mortgage-backed
securities
55

Money
56

Money (Cont…)
 Money is very much a financial asset
 It
is not just notes and coins
 One of the largest components of money
 The checking account balances held by depositors
with commercial banks
57

Money (Cont…)
 NewAvataars of
money
 Credit cards
 Debit cards
 Smart cards
58

Money (Cont…)
 Functions of money
 Unit of account
 Every good or service can be denominated in terms
of it
 Medium of Exchange
 It is the only financial asset that is always acceptable
as mode of payment
 Store of value
 It is a reserve of future purchasing power
 It is liquid
59

Liquidity
 What is a liquid asset?
 Can be quickly converted to cash with little or
no loss of value
 Why is liquidity important?
 Enables transactions at prices that are close to
the fair value of the asset
 Otherwise buyers would have to offers a large
premium
 Sellers would have to offer a large discount
60

Liquidity (Cont…)
 Ina liquid market plenty of buyers and
sellers will be available
 Such markets are said to have Depth
 Attributes of liquid assets
 Pricestability
 Ready marketability
 Reversibility
61

Liquidity (Cont…)
 There is a cost to liquidity
 The more liquid the asset – the lower is the rate
of interest
 Interest foregone is lost for ever
 Money is the most perishable of assets
62

Illustration of Perishability
 Assume we have 100MM dollars in cash
 If the rate of interest is 3.6% per annum
 Income foregone in a week is:
100,000,000x0.036x7/360 = $70,000
63

Equity
64

Equity Claims
funds
SBU DBU
Ownership or
equity shares
•Claim on profits
•Assets
remaining after
debtors have
been paid 65

 Equity shares or shares of common stock
represent ownership in a business
enterprise
shares
dividends
part owner Business

enterprise 66

Dividends
 The rate of dividends is not fixed
 It is not contractually guaranteed
 Dividends can fluctuate from year to year
 A company is under no obligation to declare

dividends
 Good companies try to keep dividends at
steady levels
67

Retained earnings
A firm will not pay out its entire profits for the
year as dividends
 A fraction will be reinvested in the company
 If a firm is forced to declare bankruptcy, then the
shareholders are entitled to the residual value if
any of the business
 After the claims of the other creditors are fully settled.
68

Equity (Cont…)
 Equity shares never mature - they have no
expiry date.
 Because when a firm is created, it comes into existence
with the assumption that it will last forever.
 No one starts a company with the expectation that he
will wind it up after a few years.
 Shareholders are given voting rights.
 They can vote on various issues at the Annual General
Meetings of companies, including the election of the
board of directors.
69

Equity (Cont…)
 Notall shares carry voting rights, however.

 There are non-voting shares.
 These shareholders are not entitled to vote
 This category is created to restrict corporate
control to only certain groups of shareholders.
70

Equity (Cont…)
 Shareholders have Limited Liability
 Unlikea sole proprietorship
 Or a partnership
 What does this mean?

 Creditors cannot make financial demands on
the shareholders
 The maximum loss for a shareholder is limited
to his investment
71

Debt
72

Debt Claims
funds
SBU DBU
debt instrument
or IOU
•Pay interest
at periodic
intervals
•Repay
principal at 73
maturity
Short term
debt
instruments
Types of
debt
instruments
Long term
debt
instruments
74

Long term debt securities
 Have a time to maturity of one year or more

 Issued by the government or by corporations
Bond Debenture
Firms also issue debt In the U.S a debenture is a
securities for which specific bond for which no assets of
assets are designated as the firm have been specified
collateral. as collateral.
Secured debt Unsecured debt
Note: In India the terms bonds and debentures are used interchangeably and thus
could refer to secured as well as unsecured debt
75

Debt notes issued by the U.S. Dept of Treasury
long term
T-bonds time to maturity
10 – 30 years
medium term
T-notes time to maturity
1 – 10 years
short term
T-bills time to maturity
13, 26, 52 weeks
Note: Terminology often differs across countries.
76
e.g. T-notes in Australia, correspond to T-bills in the U.S
Debt (Cont…)
 Interest payments on debt securities are

contractually guaranteed.
 Not a function of the profits made by a firm
 A firm is obligated to pay interest on its outstanding
debt of whether or not it has made profits
 Interest payments have to be made before any
payments can be made to equity shareholders
77

Debt (Cont…)
 Inthe event of bankruptcy, the claims of the
bondholders have to be settled first
 If a company defaults on a scheduled interest
payment, or principal repayment, the bond holders
can stake a claim on its assets.
 After liquidating the assets the claims of the
bondholders will be settled.
 Only if something were to remain will the equity
shareholders be entitled to stake a claim.
78

Negotiable vs. Non-negotiable
Negotiable Non - Negotiable
 debt instruments debt instruments

Can be freely traded Cannot be traded
Can be endorsed by one Cannot be transferred

party to another
e.g. e.g.
Treasury Bond bank loans
bank time deposits 79

Leverage
 What is leverage?
 Ability
to magnify returns on investment by
using borrowed money to partly fund the
acquisition of the asset
 Leverage is a double-edged sword
 Positivereturns get magnified
 So do negative returns
80

Leverage (Cont…)
 Take two companies A and B
 A has a paid up capital of Rs 100,000 with no debt
 B has a paid up capital of Rs 50,000 with a debt of
50,000 carrying an annual interest of 10%.
 We will take two cases
 The first where the companies make an operating profit
of Rs 25,000
 And the second where they make an operating loss of
Rs 25,000.
 To keep matters simple assume no taxes.
81

Leverage (Cont…)
82

Leverage (Cont…)
 Company A is unlevered whereas
company B is levered.
 Leverage is obviously a double edged
sword.
 In a booming market, a 25% return gets
magnified to 40%
 But in a falling market a -25% return gets
translated to a loss of -60%.
83

Balance Sheet
Assets Liabilities
FUNDS CLAIMS
or
DEBT or borrowed capital
or
EQUITY or owners capital
Total Assets = Total Liabilities

84

Balance Sheet
Assets Liabilities
Plant & Machinery $ 100 MM Share Capital $ 100 MM
Bank Deposit $ 100 MM Bonds $ 100 MM
Total Assets $ 200 MM Total Liabilities $ 200 MM

85

Preferred shares
86

Debt Preferred Equity
shares
Promise a fixed rate of If firm is unable to pay as promised

return then shareholders cannot seek legal
recourse
In the event of liquidation, Dividends on preferred shares can
preferred shareholders be paid only after a company has
get priority over equity made interest payments on its
shareholders outstanding debt
until and unless their overdue
dividends are paid the firm usually
cannot pay dividends to equity
holders 87

Pre-Tax versus Post-Tax Payments
 Equity and preferred dividends are paid out of

post-tax profits
 Interest paid by the company on debt can be
deducted from the profits while computing its tax
liability
 This reduces the tax burden for the firm or in other
words gives it a tax shield
88

Example of a Tax Shield
 Consider two companies

 Pre-tax profit  $100,000
 Company A  0 interest liability
 Company B  $20,000 interest expense
 Tax rate  30%
89

Example (Cont…)
Company A Company B
PBIT 100,000 100,000
Interest 0 20,000
PBT 100,000 80,000
Tax @ 30% 30,000 24,000
PAT 70,000 56,000

90

Example (Cont…)
 Impact of the interest expenditure on company B

= Reduction of profits by $14,000
 Effective interest paid = $14,000 (not $20,000)
 Effective interest = 14000 = 20000(1-.3) = I(1-T)
91

Foreign Exchange
FOREX markets are used to buy and sell currencies

 A currency is a financial commodity
 Each currency will have a price in terms of another
currency
 The price of one country’s currency in terms of that of
another is known as the exchange rate
 Currencies are traded amongst a network of buyers
and sellers linked by phone/fax.
92

FOREX (Cont…)
 Traders do not come face to face on an organized

exchange.
 Major participants are commercial banks and multinational
corporations (MNCs).
 Physical currency is rarely exchanged.
 Most transfers are done electronically from one bank account
to another.
93

Mortgage
A mortgage is a loan backed by real estate as
collateral
Periodic
payments
Mortgagor Mortgagee
borrower lender
Can take
over
property 94

Mortgage (Cont…)
 If the mortgagor defaults
 The lender can foreclose the mortgage
 What is foreclosure?
 Takeover and sell the property to recover the
dues
95

Mortgage (Cont…)
A mortgage is an illiquid asset
 To rotate their capital
 Lenders will pool mortgage loans
 Issue debt backed by the underlying pool
 Such securities are called MBS
 The process is called SECURITIZATION
96

An investor’s concerns
Returns
Time
Riskiness
pattern
Liquidity
97

Returns •Cash
dividends
Returns •Capital
gains/losses
Time
Riskiness
pattern
Liquidity
98

Returns (Cont…)
 Capital gains/losses arise when an asset is sold.
 If selling price of an asset > The original cost of
acquisition  Capital gain
 If selling price < cost →Capital loss
 Inthe case of bonds, the investor gets returns by
way of periodic interest payments known as
coupon payments
 There can be capital gains/losses when the bond is
sold
99

Risk
Returns
•May not
pay
dividends Time
Riskiness
pattern
•Capital
appreciation
may be
less/losses Liquidity
•Firm may
go into
bankruptcy
100

Time pattern
Returns
•Cash flows
from bonds
Time are
Riskiness
pattern
predictable
•Cash flows
from
Liquidity dividends
can be
volatile
101

A rational investor
H
Returns I
G
H
L Time
O Riskiness
W pattern
Liquidity
102

Types of Rational Investors
Young investor Retired investor
Are more likely to prefer Usually prefer to invest in
equities. May be content with bonds. For them, the key issue
the possibilities of substantial is the availability of predictable
capital gains periodic cash flows from the
asset
They may not require regular The key issue is the availability
cash flows immediately of predictable periodic cash
flows from the asset
More inclined towards risk Risk averse
Would of course demand Would be content with lower
adequate compensation by way returns 103
of higher expected returns

Classification of Markets
Markets
Primary Direct Money

vs. vs. vs.
Secondary Indirect Capital
104

Primary vs. Secondary Markets
PRIMARY SECONDARY
MARKETS MARKETS
Company offers new financial Once an asset has been
instruments to the investing bought by an investor from the
public. The very first issue of company, subsequent
shares by a company is called transactions in the instrument
an Initial Public Offering or IPO take place in the secondary
market
Companies issue shares and Secondary markets merely
bonds represent the transfer of
ownership of an asset from one
investor to another
Primary markets therefore
enable borrowers to raise funds 105

Primary vs. Secondary Markets
PRIMARY SECONDARY
MARKETS MARKETS
TCS is issuing shares for the ---

first time to the public at Rs 850
per share
Ravi applies for 1000 shares Six months later Ravi sells
and is allotted 200 shares at a these shares on the National
price of Rs 850 Stock Exchange for Rs 1250
per share
106

Are Primary Markets Alone Sufficient?
 In order to facilitate savings and investment

in the economy we need both primary as
well as secondary markets
107

Sufficiency? (Cont…)
 What if we had only primary markets?

 If we were to subscribe to a bond we would have no
option but to hold it to maturity
 In the case of equity shares the problem would be
even more serious.
 We and our heirs would have to hold on to the shares
forever.
 This will not be a satisfactory arrangement!
108

In real life…
 Welike assets which can be easily liquidated or
converted into cash.
 Liquidity needs can never be perfectly anticipated
 Nobody invests in a single asset
 Everyone likes to hold a portfolio of assets.
 Putting all your eggs in one basket is a very risky proposition.
 Investors like to spread out or diversify their risk by investing
in a pool of securities.
109

In real life
 Ourrisk propensity will not remain constant

during our lifetimes.
 Young people are more risk taking, while old people
are more risk averse.
 Consequently investors need the freedom to
periodically adjust their portfolios over a period of
time.
110

Direct versus Indirect Markets
 In a direct market, borrowers deal directly
with individual and institutional investors
who are the ultimate lenders.
 For instance, if IBM were to issue debt and you
were to subscribe to it, you would be
participating in the direct market.
 Borrowers can issue claims in the direct market
either through a Public Issue or through a
Private Placement.
111

Direct & Indirect Markets (Cont…)
 In a Public Issue securities are sold to a large
and diverse body of investors, both individual
and institutional.
 In a Private Placement, the entire issue is
placed with a single institution or a group of
institutions.
112

Intermediaries
 In either case market intermediaries are
involved who facilitate a process of
`matchmaking’.
113

Why do we need intermediaries?
 When an investor seeks to trade, the issue
is essentially one of identifying a
counterparty.
A potential buyer has to find a seller and vice
versa.
 Notonly should a counterparty be
available, there should be compatibility in
terms of
 priceand
 quantity
114

Price Compatibility
 Every trader seeks to trade at a `good’
price.
 What is a good price?
 Buyers seek sellers who are willing to offer
securities at a price which is less than or equal
to what they are willing to pay.
 Sellers seek buyers willing to offer prices
greater than or equal to what they expect.
115

Quantity Compatibility
 The quantity being offered should match
the quantity being demanded.
 Oftena large sell order may require more than
one buyer before getting fully executed.
 The same is true for large buy orders.
116

Market Intermediaries
Brokers
Market
Intermediary
Investment
Dealers
Bankers
117

Brokers
 Brokers are intermediaries who buy and sell
securities on behalf of their clients

 Arrange trades by helping clients locate suitable
counterparties.
 They receive a processing fee / commission
 They do not finance the transaction
118

Dealers
 Dealers maintain an inventory of assets and stand ready
to buy and sell at any point in time

 Dealers have funds tied up in the asset
 The dealer takes over the trading problem of the client
 Dealers specialize in types of markets like T-bill, Commercial
paper etc.
119

Dealers
Client seeking to sell:
Dealer will buy the asset

Bid price
Sell later at higher price
Client seeking to buy:
Dealer will sell the asset Ask / Offer
Replenish inventory later at lower price 120

Dealers
Sell@Ask - Buy@Bid = Profit = Spread
121

Investment Bankers
 They
are people who specialize in helping
companies bring issues to the primary market.
 They help issuers comply with legal and procedural
requirements.
 Theseinclude preparing a prospectus or offer
document
 Such a document gives full details about the issue
and the potential risk factors for investors to take
into account.
122

Investment Bankers (Cont…)
 They also provide advice on compliance with

the listing requirements of the stock exchange
where the shares are proposed to be listed for
trading
 They usually underwrite the issue.
123

Underwriting
 What is underwriting?
 An underwriter undertakes to buy that part of the
issue which remains unsubscribed if the issue is
under subscribed.
 Underwriting helps in two ways.
1. It reduces the risk for the issuer.
2. It sends a positive signal to potential investors.
 This is because, in the case of an underwritten issue, a
potential investor knows that the banker is willing to
take whatever portion of the issue is left unsubcribed
124

Underwriting (Cont…)
 An investment banker may not however like to

take on the entire risk.
 Sometimes a group of investment bankers may
underwrite an issue.
 This is called Syndicated Underwriting.
125

Best Efforts
 Attimes, an investment bank, instead of

underwriting the issue may offer to sell it on a
best efforts basis.
 It will try and do everything to ensure that the issue is
fully subscribed to
 It does not undertake to pick up the unsubscribed
portion in the event of undersubscription.
 Thus the role of the investment bank in these cases is purely
a marketing function.
126

Underwritten Issue or Best Efforts?
 Most issues are underwritten in practice.

 Issuers prefer this, because there is a greater
incentive for the banker to sell when there is a risk of
devolvement.
127

Devolvement
 What is Devolvement Risk?

 It is the risk that the bank has to buy the unsold
securities in the event of undersubscription
 Devolvement is a clear signal of negative market
sentiments.
 It will lead to a loss for the investment banker because the
acquired shares will inevitably have to be disposed off at a
lower price.
128

 The fee for underwriters in the U.S. is
about 7% of the issue amount.
 Sometimes the bank may also be offered
an option to buy additional shares at the
original issue price.
 These options can become very valuable if
the issue succeeds, for the stock price will
then rise perceptibly.
 These are known as Greenshoe options.
129

 The underwriting fee compensates the
investment bank for the sales effort as well as
for the insurance
 Since a best efforts offer does not involve
insurance the corresponding fees tend to be
lower.
 Underwriting fees are negotiated between the
investment bank and the client.
 The fee is a function of the risks involved, and the
amount of capital required to be deployed.
130

The Glass-Steagall Act
 This act, known more formally as the Banking
Act of 1933 segregated investment banking
activities and commercial banking activities.
 During the Great Depression of 1929-1933 many
commercial banks went bankrupt when the stock
markets collapsed because they had significant
exposure in the market.
 Once the Act was enacted following the depression,
bankers were given a clear choice
 Between deposit taking and lending on one hand, and
underwriting and securities dealing on the other.
131

Glass-Steagall (Cont…)
 The Act thereby segregated Investment
Banking & Brokerage Operations from
Commercial Banking.
 JP Morgan existed prior to the enactment
of the Act
 After the Act was passed
A splinter group broke off to form Morgan
Stanley – an I Bank
 JPM continued as a commercial bank
132

 The Glass-Steagall Act was repealed in 1999,

with the passage of the Financial Services
Modernization Act.
 This Act is referred to as the Gramm-Leach-Bliley Act.
133

Bloomberg’s Top 20 Investment Banks
 Citigroup  ABN AMRO Bank

 Goldman Sachs  Nomura Securities
 Morgan Stanley  RBC Capital Markets
 JP Morgan Chase  HSBC
 Merrill Lynch  Rothschild
 UBS  Daiwa Securities
 Credit Suisse  Lazard
 Deutsche Bank  Wachovia
 Lehman Brothers  Bear Stearns
 Bank of America  BNP Paribas
134

Indirect Markets BORROWE
R
LENDERS
LENDER
individual
Corporate
borrower
family
Commercial
bank
Non – corporate
Financial borrowers
claims
Financial 135
Copyright Tarheel Consultancy Services claims

Indirect Markets - Risks
 Individual / family depositors are exposed to the
risk of failure of the bank
 The banks are exposed to the risk that
corporate borrowers could fail
136

In. Market Intermediaries
Insurance
cos
I. Market
Intermediary
Pension Mutual
funds funds
137

Indirect Markets (Cont…)
 The depositors have no claim on the ultimate

borrowers in this case.
 How does the bank make money?
 By raising deposits at a rate that is lower than the
interest rate charged by it on loans made to
borrowers.
138

Benefits of Direct Markets
 When a borrower and a lender interact directly,
they can share the profit

 Profit will otherwise be made by the intermediary
139

Indirect Markets BORROWE
R
LENDERS
LENDER
individual
Corporate
borrower
family
Commonwealth
Bank
5.5% pa
4% pa
Telstra etc.
Financial
claims
Financial 140
Copyright Tarheel Consultancy Services claims

Illustration (Cont…)
 Assume that Telstra can directly issue bonds to

the public, with a coupon rate of 4.75%.
 Investors  get 0.75% extra as compared to the
bank deposit
 Telstra  Will save 0.75% as compared to borrowing
from the bank
• Bank’s margin of 1.5% has been shared by the company
& investors
141

Disadvantages of Direct Markets
 One problem is that the claims issued by the
borrowers may not match the requirements of
the individual lenders
 The problem: Denomination and/or Maturity.
 Borrowers like to borrow long term whereas lenders like to
lend short term.
• E.g. A co. issuing 20 year bonds  may not find many
takers if it directly approaches the public
 Denomination problem
• E.g. A firm issues bonds with a face value of $100,000
 small investors will be unable to subscribe.
142

Disadvantages (Cont…)
 These problems do not exist for financial
institutions
 They have access to funds deposited by many investors
 large denominations pose no problems for them
 Deposits keep getting rolled over
 These intermediaries can afford to  borrow short term
& lend long term
 These intermediaries are said to engage in
denomination transformation as well as maturity
transformation
143

Disadvantages (Cont…)
 Another problem with direct markets is that they
are critically dependent on active secondary
markets
 The cost of a public issue can be very high
 Prospectus printing costs
 Share application printing costs
 Legal fees
 Fees paid to advisors
144

Role of Intermediaries in Indirect Mkts
 Banks,mutual funds etc. have access to large
pools of money.
 They also accept deposits ranging from a few dollars to
a few million dollars.
 They can therefore easily subscribe to large
denomination assets
 They can also accept short term deposits and
lend long term.
 Deposits keep getting rolled over, either due to
renewals, or due to new clients.
145

The Role of Intermediaries (Cont…)
 Financial institutions also facilitate risk
diversification.
 Diversification means that `don’t put all your eggs in one
basket’
 It is costly for an individual investor to diversify across
assets because of transactions costs.
 In practice, each time a security is bought or sold,
the trader incurs transactions costs.

 Banks indirectly diversify because every deposit is
invested across a spectrum of projects.
 Banks can afford to employ professionals who can
assess risk related issues. 146

The Role of Intermediaries (Cont…)
 Finally financial institutions are able to take

advantage of economies of scale
 The fixed costs of their operations tend to get spread
over a vast pool of transactions and assets
 This leads to cost efficiency as compared to an
individual borrower/lender
147

Illustration
A business operation costs $ 1000 to
mount
 The cost per unit is $1
 If 1000 units are produced
 Totalcost = $ 2000
 Per unit cost = $2
 If 10000 units are produced

 Totalcost = 11000
 Per unit cost = 1.10
148

Money Mkts. vs. Capital Mkts.
Money Markets Capital Markets
Time to maturity at the time of Markets for medium to long term

issue is one year or less instruments
Money market instruments by Capital market securities include
definition have to be debt both long and medium term debt as
instruments well as equities
Money markets are used to adjust Capital markets channelize funds
temporary liquidity imbalances. In from those who wish to save to
practice, for any company, inflows those who seek to make long term
and outflows at any point in time will productive investments
rarely match
Money markets help firms to Capital markets are where
borrow short term and also to companies source funds for their
deploy surplus funds on a short long term investment needs 149
term basis Copyright Tarheel Consultancy Services

Money & Capital Markets
 Money markets tend to be wholesale markets.

 These instruments have high denomination.
 Hence small investors usually do not participate in such
markets
 Small investors can participate indirectly by investing in
Money Market Mutual Funds (MMMFs).
 These funds primarily invest in money market securities
150

Money & Capital Markets (Cont…)
 These securities carry relatively low default risk.

 The odds of a firm getting into financial difficulties in the
short run are definitely less than such an event
occurring over a longer term horizon
 Money markets tend to be very liquid

 The trading volumes are very high
151

Secondary Markets
 Financial assets are usually traded on

exchanges
 What is an exchange?
 It is a trading system where traders interact to buy and
sell securities
 A trader, to trade, has to be a member of the exchange
 Non members have to route their orders through a
member
152

Example - Secondary Markets
 If you want to trade on the NSE, you have to

approach a registered broker or a sub-broker
 He will then feed your order into the electronic system
153

Historically Today
Open-Outcry: Historically trading These days most exchanges are
on exchanges has taken place electronic communications
on trading rings / floors
The BSE used to have this
networks and most traders no
system until it introduced online longer interact face to face
trading
Many older exchanges (e.g.
NYSE) have a combination of
floor based and electronic
trading
Traditionally exchanges have Of late many exchanges are
been owned by the member characterized by corporate
ownership. Such exchanges are
brokers and dealers said to be demutualized
The NSE is owned by a
number of institutions such as
IDBI, LIC etc. 154

Stock Exchanges
 These are markets where shares of
common stocks of companies are traded
 When a corporation desires that its shares
be admitted for trading, it has to first apply
to have its shares listed
 There are approximately 2,800 stocks listed
on the NYSE
 The market capitalization of NYSE listed
companies is approximately 25 trillion dollars
155

Listing vs. Registration
 What is Listing?
 It is a process by which a company applies and gets
permission for its securities to be traded on a stock
exchange.
 The exchange will insist on certain minimum standards
before granting approval. These pertain to issues like
capital value, number of shareholders, and financial
soundness.
 What is Registration?
 This is a process required under the Securities and
Exchange Act for most publicly held corporations.
156

Listing and Registration
Listing Registration
There is no legal Registration is mandatory
requirement that a company and requires the submission
should get its shares listed of periodic financial reports
on an exchange and reports of major
corporate events to the SEC
Most exchanges require that All listed securities must be

the companies regularly registered with the SEC
report their accounts in
accordance with Generally
Accepted Accounting
Practices (GAAP) 157

Listing
 Benefits of listing:
1. Trading of listed shares is easier and the company will
attract a broader class of shareholders
2. Listing gives the company enhanced visibility
3. It becomes easier for the company to raise capital
 Once approval is granted a company has to
pay the prescribed listing fees
158

Actors or Players
 Traders in the market can be divided into two
categories.
Those who trade on their Those that arrange trades for
own account others
Proprietary traders trade on Agency traders act on behalf

their own account of or as agents of others who
wish to trade
They are also known as

brokers, commission traders,
or commission merchants (in
futures markets). 159

Long Positions
A trader who owns an asset is said to have a

Long position
 People with long positions have the ability to sell on a
future date
 They gain if prices rise and lose if prices fall
 Those wanting to take long positions attempt to buy low
and sell high
160

Short Positions
A trader is said to have a Short position in the

stock market when he has sold an asset that
was not owned by him
 Howcan you sell something that you do not
own?
 Borrow it from someone else and sell it
 Thus the trader has to eventually buy the asset and
return it to the investor who lent it to him
 Hopefully prices would have declined by then
161

Short Positions (cont…)
 When a person with a short position re-acquires
the asset, he is said to be `covering his
position’
 The objective of a short seller is:
sell high and buy low
162

Buy Side & Sell Side
 Thetrading industry
Buy side Sell side
can be classified into
traders who traders who
a buy side and a sell
seek to buy the offer the
side services services of the
 The most important of offered by the exchange
these services is exchange
liquidity traders are traders are
 The terms buy side and those in search those who
sell side have nothing of liquidity supply liquidity
to do with the actual
traders on both sides regularly
buying and selling of
buy as well as sell securities
securities 163

Buy side Sell side
Refers to the portion of Consists of brokers and
the securities business in dealers who help buy side
which primarily traders to trade at their
institutional orders convenience
originate This is selling liquidity
Funds (mutual and pension) Market makers
Firms Specialists
Governments Floor Traders
Insurance Companies Locals
Charitable and Legal Trusts Day Traders
164
Scalpers
Examples - The Sell Side
 Broker dealers in the U.S. include well known

investment banks like:
 Goldman Sachs
 Salomon Smith Barney
 Morgan Stanley Dean Witter
 Credit Suisse First Boston
165

Definitions
 Who is a market maker?

 A person/firm who on a continuous basis buys and sells
securities on his own account
 Market makers usually try and profit from a rapid
turnover in securities positions
 They do not hold open positions for long in anticipation
of gradual price movements
166

Arbitrage
 What is arbitrage?
 Arbitrage may be described as the existence of the
potential to make riskless profits by transacting in
multiple markets.
167

IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £
Borrow $18,000. Sell on LSE for

Buy 100 shares £10,000
on NYSE
Transfer
$20,000 back to NY
Profit = $2000 168
This transaction is Tarheel

Copyright costless and
Consultancy risk-less in a perfect
Services
These opportunities cannot persist for long
IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £
Buy on NYSE Sell on LSE

Price rises Price falls
Exchange rate will come down from 2 $/ £
169
Equilibrium isServices
Copyright Tarheel Consultancy restored
Arbitrage & Market Imperfections
 In practice investors have to incur transactions

costs.
 Brokerage fees have to be paid when shares are bought
and sold.
 Commissions have to be paid while buying and selling
foreign exchange.
 Such costs will certainly reduce and may even
eliminate profit opportunities for small investors.
170

The Eurocurrency Market
 What is a Eurocurrency?
 A freely traded currency deposited in a bank outside its
country of origin.
 The term Euro simply means outside the country of
origin
 E.g.:
• Dollars traded outside the U.S. are Eurodollars.

• Yen traded outside Japan are Euroyen.
• Euros traded outside Europe are Euroeuros
 The rupee is not a freely convertible currency
 E.g. If a bank in Dubai were to accept rupee deposits they would
constitute Eurorupees
171

Eurocurrency Markets
 These deposits need not be with European
banks.
 Although originally most banks which accepted
such deposits were located in Europe.
 E.g. Banks in Tokyo, Singapore and Hong Kong also
accept dollar deposits.
 These are often called ‘Asian Dollar’ markets.
172

Why Eurocurrency Markets?
 Why should a bank outside the U.S accept
deposits denominated in U.S.D.?
1. After World War II, the U.S. dollar became the
preferred currency for global trade. Everyone wished
to hold dollar balances.
2. During the cold war, Warsaw Pact countries were
reluctant to hold dollar balances with American banks.
There was a fear that such deposits could be
impounded by the U.S. government. But they needed
such balances to finance imports
3. European banks began to realize that such funds
could be profitably lent out, and consequently began
to accept such deposits. 173

Eurocurrency Markets (Cont…)
 One of the significant reasons for the

explosive growth of Eurocurrency markets
was the existence of interest rate ceilings
and high reserve requirements in the U.S.
174

Interest Rate Ceiling
 An ‘interest rate ceiling’ is easy to comprehend.

 It precluded banks from paying interest at more than the
stipulated maximum rate
 Consequently their ability to attract deposits diminished.
 What is a ‘reserve’ and how does it work?
175

Reserve
 When a bank accepts a deposit of Rs 100 in

India, it cannot lend out the entire amount.
A fraction of the deposit has to be maintained in
the form of approved government securities and
as cash with the RBI.
 This amount is known as a reserve.
 Theobjective is to bolster the safety of the
deposit holders.
176

Should we set reserves at a high level?
 Obviously the higher the reserve percentage, the

greater is the safety for the depositors
 Onthe flip side, the higher the reserves, the
lower is the income for the bank
 Government securities do not pay market rates of
interest
 It would be more profitable for the bank to lend the
money locked up as a reserve to a borrower
177

Should we set reserves at a high level?
 The issue is more serious when reserves have

to be kept in the form of cash.
 Cash reserves yield either nil returns or very low returns
178

Reserves
Statutory Liquidity Ratio (SLR):
25% of the deposit has to be maintained in the form of
approved government securities
Cash Reserve Ratio (CRR):

8% of the deposit has to be maintained as cash with the
RBI
179

CRR
 The lower the CRR, the more the funds available
with the bank for productive lending

 If so, higher will be the rates offered on deposits, and
lower will be the rates charged on loans.

 Depositors and borrowers will both benefit.
180

Example - Reserves
 Dueto high reserve requirements American
banks could not offer attractive rates on
deposits.
 Matters were made worse by imposing a ceiling on the
deposit rate
 At the same time they could not attract borrowers,
because the lending rates were high.
 Consequently European banks began attracting
both lenders as well as borrowers leading to the
growth of the Eurodollar market
181

Lack of Regulations
 Eurocurrency deposits are outside the purview

of the country to which the currency belongs
 E.g. The U.S. Federal Reserve cannot regulate
Eurodollars
 There are no statutory reserve requirements
 Even though there are no statutory requirements, banks
do keep voluntary reserves as a measure of caution
182

Petrodollars
 There was a war in the Middle East in 1973,
after which Arab countries began to use oil
prices as an economic weapon

 Rising crude prices lead to large dollar balances with
Arab countries
183

Petrodollars (Cont…)
 Why Eurobanks could attract this money?

1. There were no reserve requirements
2. The transactions costs were low due to
economies of scale.
3. Thus Eurobanks could offer high interest rates
to depositors
4. At the same time could lend the funds at
relatively low rates to borrowers
184

Floating Rate Loans
History Today
Loans have been made on The growth of the
the basis of a fixed rate Eurocurrency market has
lead to loans based on
floating rates of interest
The interest rate remains The interest rates on such
fixed for the tenure of the loans are not constant, but
loan are linked to a benchmark.
Consequently they vary with
changes in the level of the
benchmark. 185

Example - LIBOR
 The most common benchmark - London
Interbank Offer Rate (LIBOR)
 Rate at which a Eurobank is willing to lend to another
Eurobank = LIBOR
 Eurobanks will quote two rates for a currency –> bid &
offer
 Rate at which a bank is willing to borrow = LIBID
 Rate at which a bank willing to lend = LIBOR
 Average of the above two = LIMEAN
 LIMEAN is also sometimes used as a benchmark
186

Example - LIBOR
 Commercial loans made on a floating basis are

priced at LIBOR plus a ‘spread’
 The spread depends on the credit worthiness of the
borrower
 The more creditworthy the borrower, the lower will be
the spread
187

Basis Point
 What is a basis point?

 A basis point is one hundredth of one percent
 100 basis points = 1 percentage point
188

Example
 Loan amt = $ 100,000
 Interest payable -> semi-annually
FIXED RATE LOAN FLOATING RATE LOAN

 annual interest rate =  annual interest rate = LIBOR
10% + 50 basis points (0.50%)
 Interest payable every  current LIBOR = 8% pa
six months = $ 5,000  Interest payable for the next
six months:
 (.08 + .005) x 0.5 x
100,000 = $ 4,250
189

Example (Cont…)
At end of six months:

 prevailing LIBOR = 8.5%,
 interest for the following six monthly period:
 (.085 + .005) x 0.5 x 100,000 = $ 4,500.
 Interest
on the loan varies positively with the
benchmark
 Higher the LIBOR higher will be the interest rate
 Lower the LIBOR lower will be the interest rate
190

Contd.
determined in advance and paid in arrears:
Interest is payable at the end of every six monthly period,
but is based on the LIBOR that was prevailing at the
beginning of the six monthly period
determined in arrears and paid in arrears: NOT COMMON
191

Major Regulatory Changes
 1975: The U.S dismantled the system of fixed

brokerage rates
 Now clients and brokers were free to negotiate
commissions
 1985: The Tokyo Stock Exchange (TSE) started
admitting foreign brokerage firms as members.
 1986: The London Stock Exchange (LSE)
eliminated fixed brokerage commissions.
192

Regulatory Changes (Cont…)
 1986:LSE began to admit foreign brokerage
houses as members. This event is known as the
`Big Bang’
 Objective: To give London an open / competitive
international market
 London is ideally situated from the point of view of its
development as a global market
 It is located in between the capital markets of North
America, Singapore, Tokyo.
 It is the middle link for what is effectively a 24 hour
market.
193

Regulatory Changes (Cont…)
 1987: Financial institutions in London were

permitted to participate in both Investment as
well as Commercial banking.
 1999: This change was affected in the U.S.
 Banks which undertake both commercial as well as
investment banking operations are referred to as
‘Universal Banks’.
194

Universal Banking – An Indian Illustration
 Take the case of ICICI Bank

 It is a traditional commercial bank
 Accepts deposits
 Makes loans
 Has an AMC that manages mutual funds

 Collaboration with Prudential PLC
 ICICI Prudential is into life insurance
 ICICI Lombard is into general insurance
 ICICI Home Finance makes real estate loans
195

Why Globalization?
 ‘Globalization’ has acquired a lot of prominence

over the past decade.
 Many countries have substantially deregulated their
capital markets
 E.g. Big Bang at the LSE
 E.g. 1981: abolition of interest rate ceilings
 E.g. 1981: the creation of International Banking
Facilities (IBFs) by the U.S govt.
196

IBFs - Advantages
 Itallows U.S. banks to use domestic branches to
service foreign customers.
 The bank does not need to create a new physical
infrastructure
 Only a different set of books to record the
deposits/loans is required
 IBFs can receive deposits from or make loans to
nonresidents of the U.S., or other IBFs
 IBF operations are not subject to reserve
requirements / U.S. interest rate regulations /
Federal Deposit Insurance Corporation premia
197

IBFs - History
History Today
To allow U.S. banks to Over 75% of the deposits

compete effectively with are with IBFs located in New
offshore banks (Eurobanks) York State
without having to set up an
office offshore
California and Illinois are the

other states with significant
IBF activities
198

Innovations
 Another major reason for increasing
globalization:
 The pace of innovations in financial products and
services
 New products are regularly being created
 Innovative techniques for risk management
199

Innovations
 To quote Dembroski:
À borrower can now issue fixed rate debt, in a

currency and country of his choice, and by the time
the deal is closed, he may have converted to a
floating rate, switched to a different currency, and
hedged away the exposure.’
200

Tech Advances
 Integration of financial mkts would have been
infeasible without rapid advances in:
 Telecommunications
 Computer hardware
 Software
 Links can be instantly established, & funds and
securities can be transferred safely and quickly
 E.g. Reuters, Bloomberg, Telerate provide round the
clock access to prices/news from financial centres
across the world
 E.g. Most leading exchanges are now electronic and
fully automated. 201

Sophistication of Investors & Borrowers
 MNCs, HNW investors, & even Govts have
become increasingly sophisticated
 Corporate treasurers, fund managers, &
bureaucrats are highly educated and aware
 Markets these days are primarily dominated by
institutional traders.
 Institutional players can afford to employ large teams of
experts
 They can also take advantage of economies of scale
202

Tarheel Consultancy Services
Corporate Training and Consulting
1
Part-02:Interest Rates
&
The Time Value of Money
2
Interest Rates
3
Introduction
 All of us have either paid and/or received
interest at some point of time.
 Those of us who have taken loans have paid
interest to the lending institutions.
 Those of us who have invested have received
interest from the borrowers.
4
Introduction (Cont…)
 Types of Loans
 Educational Loans
 Housing Loans
5
 Automobile Loans
6
 Investments
 Savings accounts, and
 Fixed deposits (Time deposits) with banks
7
 Bonds & Debentures
8
 Definition of interest
 Compensation paid by the borrower of capital to
the lender
 For permitting him to use his funds
 An economist’s definition
 Rent paid by the borrower of capital to the
lender
 Tocompensate for the loss of opportunity to use the
funds when it is on loan
9
 Concept of rent
 When we decide not to live in an
apartment/house owned by us
 We let it out to a tenant
 The tenant pays a monthly rental
 Because as long as he is occupying our property we
are deprived of an opportunity to use it
10
 The same concept applies to a loan of funds
 The difference is
• Compensation in the case of property is called RENT
• Compensation in the case of capital is called INTEREST
11
The Real Rate of Interest
 In a free market
 Interest rates are determined by
 Demand for capital
• And
 The supply of capital
12
The Real Rate (Cont…)
 One of the key determinants of Interest is
 The Pure rate of interest a.k.a
 The Real rate of interest
13
 Definition of the Real rate:
 The rate of interest that would prevail on a risk-less
investment in the absence of inflation.
 Example of a risk-less investment
 Loan to the Federal/Central government
 Such loans are risk-less because there is no risk
of default
 The central government of a country is the only
institution authorized to print money
14
 But
they say that certain governments (in Latin
America etc.) have defaulted on debt
15
 Yesthey have defaulted on dollar
denominated debt
 The government of Argentina for instance can
print its own currency but not U.S. dollars
16
The Real Rate Illustrated
 The price of a banana is Rs 1
 Assume that the price of a banana next year

will also be Rs 1
 That is, there is no inflation
 In other words there is no erosion in the purchasing
power of money
17
 Take the case of a person who lends
Rs 10 to the Government of India (GOI)
 Obviously there is no fear of non-payment
 If the GOI pays back Rs 11 after one year
 The amount will be sufficient to buy 11
bananas.
18
 In this case a loan of Rs 10 has been
returned with 10% interest in money terms
 Since the investor is in a position to buy
10% more in terms of bananas
 The return on investment in terms of the ability
to buy goods is also 10%
 The rate of interest as measured by the ability
to buy goods and services is termed as
 THE REAL RATE of INTEREST
19
 Inthe real world price levels are not
constant.
 Erosion in the purchasing power of money is a
fact of life
 This is termed as inflation
20
Inflation
21
 Most people who invest do so by acquiring
financial assets such as
 Shares of stock
 Shares of a mutual fund
 Or bonds/debentures
 Many also keep deposits with commercial

banks
22
 Financial assets give returns in terms of
money
 Without any assurance about the investor’s
ability to acquire goods and services at the time
of repayment.
 Financial
assets therefore give a
NOMINAL or MONEY rate of return.
 Inthe example, the GOI gave a 10% return on
an investment of Rs 10.
23
 In the example the 10% money rate of
return was adequate to buy 10% more in
terms of bananas.
 This was because we assumed that the price of
a banana would remain fixed at Rs 1.
24
 But
what if the price of a banana after a year is
Rs 1.05.
 Rs 11 can then acquire only
25
 Inthis case the nominal rate of return is 10%
 But our ability to buy goods has been enhanced
only by 4.80%
 Thus the REAL rate of return is only 4.80%
 The relationship between the nominal and real
rates of return is called the FISHER hypothesis
 Because it was first postulated by Irving Fisher.
26
The Fisher Equation
 Consider a hypothetical economy
 It consists of one good – say BANANAS
 The current price of a banana is Rs P0
 So Rs 1 can buy bananas.
27
The Fisher Equation (Cont…)
 Assume that the price of a banana next period
is P1.
 P1 is known with certainty today but need not be
equal to P0
 In other words although we are allowing for inflation,
we are assuming that there is no uncertainty
regarding the rate of inflation.
 So one rupee will be adequate to buy
bananas after one period

28
 Assume that the economy has two types
of bonds available
 We have FINANCIAL bonds and GOODS
bonds
 If we invest Rs 1 in a Financial bond, we will get
Rs (1+R) after one period.
 If we invest 1 banana in a Goods bond we will
get (1+r) bananas after one period.
29
 Rs 1 in a Financial bond → Rs (1+R)→
Rs 1 in a goods bond → bananas →
bananas after one period.
30
 Inorder for the economy to be in equilibrium
both the bonds must yield identical returns.
 Therefore it must be true that:
31
 Let us denote inflation or the rate of change in
the price level by π
32
 This is the Fisher equation.
R or the rate of return on a financial bond is the
nominal rate of return
 r or the rate of return on a goods bond is the
real rate of return
33
 Ifr and π are very small, then the product
of the two will be much smaller.
 For instance if r = 0.03 and π = 0.03, the
product is 0.0009
 Ifwe ignore the product we can rewrite the
expression as
R=r+π
 This is the approximate Fisher equation.
34
Uncertainty
 Thus far we have assumed that the rate of
inflation is known with certainty.
 Inreal life inflation is uncertain
 Consequently it is a random variable
35
Uncertainty (Cont…)
 In the case of random variables
 We do not know the exact outcome in
advance
 All we know is the expected value of the
variable
 Which is a probability weighted average of the
values that the variable can take.
36
Inflation Probability
2.50% 0.20
5.00% 0.20
7.50% 0.20
10.00% 0.20
12.50% 0.20
37
 The expected value is given by
38
 The Fisher equation can therefore be re-
written as
R = r + E(π)
 Thus when inflation is uncertain
 Theactual real rate that we will eventually get is
unpredictable and uncertain
39
 Assume that the required real rate is
4.50%
 Since the expected inflation is 7.50%
 an investor will demand a nominal rate of return
of 12%
40
 Once the nominal rate is fixed, it will not
vary
 But there is no guarantee that the realized
rate of inflation will equal the expected
rate
 Inthis case if the realized inflation is 9%, the
realized real rate will be only 3%
41
 Thusin real life even a default free
security will not give an assured real rate.
 Itwill give an assured nominal rate
 But the real rate that is eventually obtained will
depend on the actual rate of inflation
42
Ex-ante versus Ex-post
 An economist will say that the ex-ante rate
of inflation need not equal the ex-post rate
 Ex-ante means anticipated or forecasted value
 Ex-post connotes actual or realized value
 Obviouslythe ex-ante real rate of interest

need not equal the ex-post real rate
43
Uncertainty & Risk Aversion
 Inthe real world investors are characterized by
RISK AVERSION.
 This does not mean that they will not take risk
 What does it mean therefore?
 To induce an investor to take a greater level of risk he
must be offered a higher expected rate of return.
44
Risk Aversion (Cont…)
 Given a choice between two investments with
the same expected rate of return
 The investor will choose the less risky option
 In the case of inflation
 The investor will not accept the expected inflation as
compensation
 Why?
 The actual inflation could be higher than anticipated
 Which implies that the actual real rate could be lower than
anticipated.
45
 To tolerate the inflation risk
 Theinvestor will demand a POSITIVE risk
premium
 That is, compensation over and above the expected
rate of inflation
 The Fisher equation may be restated as
R = r + E(π) + R.P.
 Where R.P is the risk premium
46
 Does the provision of a risk premium
guarantee that the
ex-ante real rate = ex-post real rate
 NO!
 Suppose the required real rate is 4.5%,
that E(π) = 7.5%, and that R.P = 1.5%
 Then the required nominal rate will be 13.50%
47
 In the absence of a risk premium
 A rate of inflation > 7.5% implies a realized real rate <
4.5%
 But when a risk premium is factored in
 A rate of inflation > 9% implies a realized real rate <
4.5%
 So the risk premium provides a bigger cushion
against inflation
 But it does not guarantee a minimum ex-post real rate
48
Other Determinants
 Besides
 the required real rate
 the expected inflation
 and the inflation risk premium
the following factors impact the required
nominal rate
 Length of the investment
 Credit Risk
49
Length of the Investment
 Lender like to lend short term
 Borrowers like to borrow long-term
 So how do we induce a lender to lend for
a longer period
 Offer a HIGHER nominal rate of return
50
Typical Interest Rate Schedule in a Bank
Period of Investment Interest Rate
< 1 year 7.50%
More than 1 year but < 8.00%

2years
More than 2 years but < 8.50%
3 years
More than 3 years but < 9.00%
5 years
More than 5 years 9.25% 51
Credit Risk
 We have focused on default free
investments
 Loans to a Central Government
 In reality most investments are fraught
with risk
 Interestmay not be paid
 Principal may not be repaid
52
Credit Risk (Cont…)
 This is called credit risk
 Appliesto all investments except Central
government securities
 Thereis a difference between inflation risk
and credit risk
 Inflation is an economy wide phenomenon
 Credit risk however varies from borrower to
borrower
53
 Because of credit risk
 The rate of return demanded by a lender will vary from
borrower to borrower
 Which is why
 For a given real rate
 For a given tenor of the loan
 For a given rate of inflation
a bank will charge different rates of interest on
loans made to different borrowers.
54
Simple Interest & Compound Interest
55
Measurement Period
 The unit in which time is measured is
called the Measurement Period
 Themost common measurement period is One
Year.
56
Interest Conversion Period
 The unit of time over which interest is paid
once and is reinvested to earn additional
interest is called
 The Interest Conversion Period
 The interest conversion period is typically
less than or equal to the measurement
period.
57
Nominal Rate of Interest
 The
quoted rate of interest per
measurement period is called
 The NOMINAL rate of interest
58
Effective Rate of Interest
 The interest that a unit of currency
invested at the beginning of a
measurement period would have earned
by the end of the period is called
 The EFFECTIVE Rate of Interest
59
Effective Rate (Cont…)
 If
the length of the interest conversion
period is equal to the measurement period
 The effective rate will be equal to the nominal
rate
 Ifthe interest conversion period is shorter
than the measurement period
 The effective rate will be greater than the
nominal rate
60
Variables and Symbols
P ≡ principal invested at the outset
 N ≡ # of measurement periods for which
the investment is being made
 r ≡ nominal rate of interest per
measurement period
 i ≡ effective rate of interest per
measurement period
 m ≡ # of interest conversion periods per
measurement period
61
Simple Interest
 Consider an investment of Rs P for N
periods.
 According to this principle
 Interestearned every period is a constant
 Every period interest is computed and credited
only on the original principal
 No interest is payable on any interest that has
been accumulated at an intermediate stage
62
Simple Interest (Cont…)
 If r is the nominal rate of interest
P → P(1+r) after one period→P(1+2r) after 2
periods →P(1+rN) after N periods
 So every period interest is paid only on the
original principal
 N need not be an integer
 Investments can be made for fractional periods
63
Illustration-1
 Caroline has deposited Rs 10,000 with
Corporation Bank for 3 years
 The bank pays simple interest at the rate
of 10% per annum
 10,000 will become 10000x1.1 = 11,000
after one year →10000x1.1 + 1,000 =
12,000 after two years → 13,000 after 3
years
 13,000 = 10,000(1+ .10x 3) ≡P(1+rN)
64
Illustration-2
 Amit Gulati deposits Rs 10,000 with ICICI
Bank for 5 years and 6 months.
 Bank pays simple interest at 8% per
annum.
 Maturity value
= 10,000(1+.08x5.5) = Rs 14,400
 Notice: N need not be an integer
65
Compound Interest
 Consider an investment of Rs P for N
periods.
 Assume that the interest conversion
period is equal to the measurement period
 That is, the effective rate is equal to the nominal
rate
66
Compound Interest (Cont…)
 In the case of compound interest
 Every time interest is earned it is automatically
reinvested at the same rate for the next
conversion period.
 So interest earned every period is not a
constant
 It steadily increases
 P→P(1+r) after one period →P(1+r)2 after
two periods→P(1+r)N after N periods.
67
Illustration-3
 Caroline
has deposited Rs 10,000 with
Corporation Bank
 Bankpays 10% per annum compounded
annually
 Rs10,000→11,000 after one year→
11000x 1.1 = 12,100 after 2 years →
12,100x1.1= 13,310 after 3 years
 13,310 = 10,000x (1.10)3
68
Illustration-4
 Gulatideposited Rs 10,000 with ICICI
Bank for 5 years and 6 months.
 Bank has been paying 8% compounded
annually
 P(1+r)N = 10,000(1.08)5.5 = Rs 15,269.71
69
Compound Interest (Cont…)
 Compounding yields greater benefits than
simple interest
 The larger the value of N the greater is the
impact of compounding
 Thus, the earlier one starts investing the
greater are the returns.
70
Illustration-5
 The East India Company came to India in 1600.
 Consider an investment of Rs 10 in 1600 with a
bank which pays 3% per annum compounded
annually.
 The balance in 2000 = 10x(1.10)400 = Rs 1,364,237.18
71
Properties
 If N=1, that is, the investment is for one period,
both simple as well as compound interest will
give the same accumulated value.
 If N < 1, the accumulated value using simple
interest will be higher. That is:
 (1+rN) > (1+r)N if N < 1
 IfN > 1, the accumulated value using compound
interest will be greater. That is:
 (1+rN) < (1+r)N if N > 1
72
Properties
 Simple interest is usually used for short-
term transactions – investments of one
year or less
 It is the norm for money market transactions
 Forcapital market securities – medium to
long term debt and equities – compound
interest is the norm.
73
Illustration-6
 Amit Gulati deposited Rs 10,000 with ICICI Bank
for 5 years and six months.
 The bank pays compound interest at 8% for the first 5
years and simple interest at 8% for the last six months.
 10,000(1+.08)5 = 14,693.28
 14,693.28(1 + .08x.5) = Rs 15,281.01
 On the other hand 10000(1.1)5.5 = 15,269.71
 The difference is because for the last six months simple
interest yields more than compound interest.
74
Effective versus Nominal Rates
 ICICI Bank is quoting 9% per annum
compounded annually
 HDFC Bank is quoting 8.75% per annum
compounded quarterly
 In the case of ICICI
 The nominal rate is 9% per annum
 The effective rate is also 9% per annum
 In the case of HDFC
 The nominal rate is 8.75%
 The effective rate is obviously higher
75
Effective…(Cont…)
 8.75% per annum ≡ 2.1875% per quarter
 So a deposit of Rs 1→(1.021875)4 = 1.090413
 So the effective rate offered by HDFC is
9.0413% per annum
 Thus when the frequencies of
compounding are different
 Comparisons between alternative investments
should be based on effective rates and not
nominal rates
76
Effective (Cont…)
 The nominal rate is r% per annum
 Interest is compounded m times per annum
 The effective rate is:
77
Effective…(Cont…)
 We can also derive the equivalent nominal rate
if the effective rate is given
78
Illustration-7
 HDFC Bank is paying 10% compounded
quarterly.
 If Rs 10,000 is deposited for a year what will be the
terminal amount
 The terminal value will be
The effective annual rate is 10.38%
79
Illustration-8
 Suppose HDC Bank wants to offer an effective
annual rate of 10% with quarterly compounding
 What should be the quoted nominal rate
80
Equivalency
 Two nominal rates compounded at
different time intervals are said to be
Equivalent if
 Thesame principal invested for the same
length of time
 Produces the same accumulated value in either
case.
81
Equivalency (Cont…)
 In other words two nominal rates
compounded at different intervals are
equivalent if they yield the same effective
rate
82
 ICICIBank is offering 9% per annum with semi-
annual compounding.
 What should be the equivalent rate offered by
HDFC Bank if it intends to compound quarterly.
83
 The issue is, what will be the nominal rate that
will give an effective annual rate of 9.2025% with
quarterly compounding
Thus 9% with semi-annual compounding is equivalent to

8.90% with quarterly compounding.
84
Continuous Compounding
 Consider Rs P that is invested for N periods at
r% per period.
 If interest is compounded m times per period,
the terminal value will be
85
Continuous Compounding (Cont…)
 What about the limit as m→∞
This is the case of continuous compounding.
86
Illustration-9
 Narasimha Rao has deposited Rs 10,000 with
Corporation Bank for 5 years at 10% per
annum compounded continuously.
 The final balance is:
87
Illustration-10
 Canara Bank is quoting 10% per annum
with quarterly compounding.
 What should be the equivalent rate with
continuous compounding?
 Two nominal rates are equivalent if they give
the same effective annual rate.
 Let k be the nominal rate with quarterly
compounding, and r the nominal rate with
continuous compounding.
88
Illustration-10 (Cont…)
89
 In this case:
90
The Limit
 Continuous compounding is the limit as
we go from
 Annual
 To semi-annual
• Quarterly
 Monthly
 Daily
 And shorter intervals
91
Illustration-11
 Sangeeta has deposited Rs 100 with ICICI
Bank.
 The interest rate is 10% per annum.
 What will be the terminal balance under the
following scenarios:
 Annual compounding
 Semi-annual compounding
• Quarterly compounding
 Monthly compounding
 Daily compounding
 Continuous compounding
92
Frequency of Terminal Balance
Compounding
Annual Rs 110.0000
Semi-annual Rs 110.2500
Quarterly Rs 110.3813
Monthly Rs 110.4713
Daily Rs 110.5156
Continuously Rs 110.5171
93
Future Value
 When an amount is deposited for a time period
at a given rate of interest
 The amount that is accrued at the end is called the
future value of the original investment
 So if Rs P is invested for N periods at r% per period
94
FVIF
 (1+r)N is the amount to which an investment of
Rs 1 will grow at the end of N periods.
 It is called FVIF – Future Value Interest Factor.
 It is a function of r and N.
 It is given in the form of tables for integer values of r and
N
 If the FVIF is known, the future value of any principal
can be found by multiplying the principal by the factor.
 The process of finding the future value is called
Compounding.
95
Illustration-12
 Suhasini has deposited Rs 10,000 for 5 years at
10% compounded annually.
 What is the Future Value?
Thus F.V. = 10,000 x 1.6105 = Rs 16,105
96
Illustration-13
 Swapna has deposited Rs 10,000 for 4 years at
10% per annum compounded semi-annually.
 What is the Future Value?
 10% for 4 years is equivalent to 5% for 8 half-years
Thus F.V. = 10,000 x 1.4775 = Rs 14,775
97
Illustration-14
 GIC has collected a one time premium of
Rs 10,000 from Suhasini and has
promised to pay her Rs 23,000 after 10
years.
 The company is in a position to invest the
premium at 10% compounded annually.
 Can it meet its obligation?
98
 The future value of Rs 10,000 =
10,000 x 2.5937 = Rs 25,937
 This is greater than the liability of
Rs 23,000
 So GIC can meet its commitment
99
Illustration-15
 Syndicate Bank is offering the following
scheme
 Aninvestor has to deposit Rs 10,000 for 10
years
 Interest for the first 5 years is 10% compounded
annually
 Interest for the next 5 years is 12% compounded
annually
 What is the Future Value?
100
 The first step is to calculate the future value
after 5 years:
The next step is to treat this as the principal and compute its
terminal value after another 5 years.
101
Present Value
 When we compute the future value we
seek to determine the terminal value of an
investment that has earned a given rate of
interest for a specified period.
 Now consider the issue from a different
angle?
 Ifwe want a specified terminal value, how much
should we invest at the outset, if the interest
rate is r% and the number of periods is N.
102
Present Value (Cont…)
 So instead of computing the terminal value
of a principal
 we seek to compute the principal that
corresponds to a given terminal value.
 The principal amount that we compute is
called the Present Value of the terminal
amount.
103
The Case of Simple Interest
 An investment yields Rs F after N periods.
 If the interest rate is r%, what is the present
value?
 We know that:
F = P.V.x(1+rN)
So obviously
104
Illustration-16
 Venkatachalamwants to ensure that he has
saved Rs 12,000 after 4 years.
 So he deposits Rs P with a bank
 If the bank pays 5% per annum on a simple interest
basis, what should be P?
105
The Case of Compound Interest
 An investment pays r% per period on a
compound interest basis.
 If we want Rs F after N periods, how much
should we deposit today?
106
Illustration-17
 Priyankawants to ensure that she has
Rs 15,000 after 3 years.
 The bank pays 10% compounded annually
 How much should she deposit?
107
PVIF
 1/ (1+r)N is the amount that has to be deposited to yield
Rs 1 after N periods if the periodic interest rate is r%
 It is called the Present Value Interest Factor (PVIF)
 It is a function of r and N
 It is given in the form of tables for integer
values of r and N
 If we know the factor, we can find the present value
of any terminal amount by multiplying the two.
 The process of finding the principal value of a
terminal amount is called Discounting
 PVIF is the reciprocal of FVIF
108
The Additivity Principle
 Suppose you want to find the present or future
value of a series of cash flows, where the rate of
interest is r%, and the last cash flow is received
after N periods.
 You have to simply find the present or the future
value of each cash flow and add up the terms to
compute the present or future value of the
series.
 Thus Present and Future Values are additive.
109
Illustration-18
 Consider the following vector of cash
flows.
 The interest rate is 10% compounded
annually.
YEAR Cash Flow
1 2,500
2 4,000
3 5,000
4 7,500
110
5 10,000
111
 The relationship between the present and future
values is given by
FV = PV(1+r)N
 In this case
112
The Internal Rate of Return
 Suppose that we are told that an investment of
Rs 18,000 will entitle us to the following vector of
cash flows.
 The question is what is the rate of return?
113
The IRR (Cont…)
 Therate of return is the solution to the following
equation:
114
The IRR (Cont…)
 The solution to this equation is called the
Internal Rate of Return (IRR)
 It can be obtained using the IRR function
in EXCEL.
 In this case, the solution is 14.5189%
115
Effective Rates
 Suppose we are asked to calculate the present
or future values of a series of cash flows arising
every six months.
 And we are given an annual rate of interest
without specifying the compounding frequency.
 The normal practice is to divide the interest rate by 2 to
determine the periodic interest rate
 That is, the quoted rate is treated as a nominal rate and
not as an effective rate
116
Illustration-19
 Considerthe following vector of cash flows.
 Assume that the annual interest rate is given as
10%.
117
 The Present Value will be calculated as:
•Similarly the future value will be
118
 Butwhat if it is explicitly stated that the effective
annual rate is10%?
 Then the calculations will change
•And the future value is given by
119
Effective Rates (Cont…)
 Thepresent value is greater when we use
an effective annual rate of 10% for
discounting.
 This
is because the lower the discount rate the
higher will be the present value
 And an effective rate of 10% per annum is lower than
a nominal rate of 10% with semi-annual
compounding.
 By the same logic the future value is lower when we
use an effective annual rate of 10%

120
Evaluating an Investment
 Kotak Mahindra is offering an instrument
that will pay Rs 10,000 after 5 years.
 The price that is quoted is Rs 5,000.
 If the investor wants a 10% rate of return,
should he invest.
 The problem can be approached in three
ways.
121
The Future Value Approach
 Assume that the instrument is bought for
5,000.
 If the rate of return is 10% the future value
is
5,000 x 1.6105 = Rs 8,052.50
 Since the instrument promises a terminal
value of Rs 10,000 which is greater than
the required future value, the investment is
attractive.
122
The Present Value Approach
 The present value of Rs 10,000 using a discount
rate of 10% is
10,000 x 0.6209 = Rs 6,209
 So if Rs 6,209 is paid at the outset the rate of
return will be 10%
 If we pay more at the outset, the rate of return will
be lower and vice versa.
 In this case the investment of Rs 5,000 is less than
Rs 6,209
 So the investment is attractive
123
The Rate of Return Approach
 Suppose you invest Rs 5,000 and receive
Rs 10,000 after 5 years.
 What is the rate of return?
 It is given by:
124
The Rate…(Cont…)
 The solution is 14.87%
 Since the actual rate of return is greater
than the required rate of 10%, the
investment is attractive.
125
Annuities
126
Annuities (Cont…)
 What is an annuity?
 Itis a series of identical payments made at
equally spaced intervals of time
 Examples
 House rent till it is revised
 Salary till it is revised
 Insurance premia
 EMIs on housing/automobile loans
127
Annuities (Cont…)
 In the case of an ordinary annuity
 The first payment is made one period from now
128
Annuities (Cont…)
 The
interval between successive
payments is called the
 PAYMENT Period
 We will assume that the payment period is
the same as the interest conversion period
 That is, if the annuity pays annually, we will
assume annual compounding
 If it pays semi-annually we will assume semi-
annual compounding
129
Present Value
130
131
132
Is called the Present Value Interest Factor Annuity (PVIFA)

It is the present value of an annuity that pays Rs 1 per period
The present value of annuity that pays a periodic cash flow of
Rs A can be found by multiplying A by PVIFA. 133
Illustration-20
 Apex Corporation is offering an instrument
that will pay Rs 1,000 per year for 20
years, beginning one year from now.
 If the rate of interest is 5%, what is the
present value?
 1,000xPVIFA(5,20) = 1,000 x 12.4622
= Rs 12,462.20
134
Future Value
135
Future Value (Cont…)
136
Is called the Future Value Interest Factor Annuity (FVIFA)

It is the future value of annuity that pays Rs 1 per period.
For any annuity that pays Rs A per period, the future value
can be found by multiplying A by the factor.
137
Illustration-21
 Pooja expects to receive Rs 10,000 per
year for the next 5 years, starting one year
from now.
 If the cash flows can be invested at 10%
per annum what is the Future Value?
 F.V.= 10,000 x FVIFA(10,5) = 10,000 x 6.1051
= Rs. 61,051
138
Relationship Between
PVIFA and FVIFA
139
Annuity Due
 Inthe case of an Annuity Due, the cash flows
occur at the beginning of the period.
140
Present Value
141
142
 The present value of an annuity due that makes
N payments is greater than that of an annuity
that makes N payments
 Why?
 Because each cash flow has to be discounted for one
period less.
 Example of an annuity due?
 An insurance policy
 The first premium has to be paid as soon as the policy is
purchased.
143
Illustration-22
 David has bought an LIC policy
 The annual premium is Rs 12,000 and he has to
make 25 payments.
 What is the present value if the discount rate is
10% per annum?
144
Future Value
145
 The future value of an annuity due that
makes N payments, is greater than that of
a corresponding annuity, if the future value
is computed at the end of N periods.
 Why?
 Because each cash flow has to be computed
for one period more.
146
Illustration-23
 IfDavid takes an LIC policy with a premium of
Rs 12,000 per year for 25 years, what is the
cash value at the end of 25 years?
147
Perpetuities
 An
annuity that pays forever is called a
PERPETUITY.
 The future value of a perpetuity is obviously
infinite.
 But a perpetuity has a finite present value.
148
Perpetuities (Cont…)
149
Illustration-24
A financial instrument promises to pay
Rs 1000 per year forever.
 If the investor requires a 20% rate of return, how
much should he be willing to pay for it?
150
Amortization
 The amortization process refers to the
process of repaying a loan by means of
equal installment payments at periodic
intervals.
 The installments obviously form an
annuity.
 Thepresent value of the annuity is the loan
amount.
151
Amortization (Cont…)
 Each installment consists of
 Partial
repayment of principal
 And payment of interest on the outstanding
balance
 An amortization schedule shows the
division of each payment
 into a principal component and
 interest component
 together with the outstanding loan balance after
the payment is made.
152
 Consider a loan which is repaid in N installments
of Rs A each.
 The original loan amount is Rs L, and the periodic
interest rate is r.
153
154
155
156
157
Illustration-25
 Srividya has borrowed Rs 10,000 from
Syndicate Bank and has to pay it back in five
equal annual installments.
 The interest rate is 10% per annum on the
outstanding balance.
 What is the installment amount?
158
Amortization Schedule
159
Analysis
 At time 0, the outstanding principal is 10,000
 After one period an installment of Rs 2,637.97 is made.
 The interest due for the first period is 10% of 10,000 or Rs 1,000
 So the excess payment of Rs 1,637.97 is a partial repayment of
principal.
 After the payment the outstanding principal is Rs 8,362.03
 After another period a second installment is paid.
 The interest for this period is 10% of 8,362.03 which is
Rs 836.20.
 The balance of Rs 1,801.77 constitutes a partial repayment of
principal.
160
Analysis (Cont…)
 The value of the outstanding balance at
the end should be zero.
 After each payment the outstanding
principal keeps declining.
 Since the installment is constant
 The interest component steadily declines
 While the principal component steadily
increases
161
Amortization with a Balloon Payment
 Uttara has taken a loan of Rs 100,000

from ICICI Bank.
 She has to pay in 5 equal annual
installments along with a terminal payment
of Rs 25,000
 The terminal payment which has to be
made over and above the scheduled
installment in year 5
 Is called a BALLOON payment.
162
Balloon (Cont…)
 If the interest rate is 10% per annum, the annual
installment may be calculated as
Obviously, the larger the balloon the smaller will be the periodic
installment for a given loan amount. 163
164
Types of Interest Computation
 Financial institutions employ a variety of
different techniques to calculate the
interest on the loans made by them.
 The interest that is effectively paid on the
loan may be very different from the rate
that is quoted.
 THUSWHAT YOU SEE IS NOT WHAT YOU
ALWAYS GET
165
The Simple Interest Method
 Inthis technique, interest is charged for
only the period of time that a borrower has
actually used the funds.
 Each time principal is partly repaid, the interest
due will decrease.
166
Illustration
 Alfred has borrowed $5,000 from the bank
for a year.
 The bank charges simple interest at the
rate of 8% per annum.
 If the loan is repaid at the end of one year:
 Interestpayable = 5000x0.08 = 400
 Total amount repayable = 5,400
167
 Assume the PRINCIPAL is repaid in two
equal semi-annual installments.
 After six months principal of $2,500 is repaid.
 Interest will however be charged on 5,000.
 Amount repayable = 2500 + 5000x0.08x.5
= 2700
168
 For
the next six months interest will be
charged only on $2,500.
 The amount payable at the end of the second
six-monthly period
= 2500 + 2500x0.08x.5 = $2,600
 Total outflow on account of principal plus
interest = 2700 + 2600 = 5300
 Obviously the more frequently the principal is
repaid the lower is the interest.
169
The Add-on Rate Approach
 In this case interest is first calculated on the full
principal.
 The sum of interest plus principal is divided by
the total number of payments to determine the
amount of each payment.
 In Alfred’s case if he repays in one annual
installment, there will be no difference with this
approach as compared to the simple interest
approach.
170
Add-on…(Cont…)
 What if he repays in two installments?
 Interest for the entire year = 400
 This will be added to the principal and divided
by 2.
 Thus each installment = (5000 + 400)
____________
2
= 2700
171
Add-on…(Cont…)
The quoted rate is 8% per
annum.
But the actual rate will be higher.
The actual rate is given by
172
Add-on (Cont…)
 The solution is i = 10.5758%
 Thisis of course the nominal annual rate.
 The effective annual rate is 10.8554%
173
The Discount Method
 Inthis approach the total interest is first
computed on the entire loan amount.
 Thisis then deducted from the loan amount.
 The balance is lent to the borrower.
174
Illustration
 Alfred borrows 5000 at 8% for a year.
 The interest for the year is 400.
 So Alfred will be given 4600 and will have to
repay 5000 at the end.
 The effective rate of interest
= (5000 – 4600)
___________ x 100 = 8.6957%
4600
175
Discount Loan (Cont…)
 Such loans usually do not require
installments and are settled in one lump
sum at the end.
176
Compensating Balances
 Many banks require that borrowers keep a
certain percentage of the loan amount with
them as a deposit.
 This is called a Compensating Balance.
 It raises the effective interest rate
 Sincethe borrower cannot use the entire
amount that is sanctioned
177
Illustration
 Alfred is sanctioned $ 5,000 at the rate of
8%.
 But he has to keep 10% of the loan
amount with the bank for the duration of
the loan.
 So while he pays an interest of $400, the
usable amount is only
5000x0.9 = $ 4,500
178
 The effective interest cost is
400
________ x 100 = 8.8889%
4500
 Quite obviously
 Thehigher the compensating balance, the
greater will be the effective interest rate.
179
Annual Percentage Rate (APR)
 The effective rate of interest that is paid by
a borrower is a function of the type of loan
that is offered to him.
 Since different lenders used different loan
structures, comparisons between
competing loan offers can be difficult.
180
APR (Cont…)
 Toensure uniformity the U.S. Congress
passed the
 Consumer Credit Protection Act
 This is commonly known as
 The Truth-in-Lending Act
 Thelaw requires institutions extending
credit to use a prescribed method for
computing the quoted rate.
181
APR (Cont…)
 Every lending institution is required to
compute the APR and report it before the
loan agreement is signed.
 The most accurate way to compute the
APR is by equating the present value of
the repayments made by the borrower to
the loan amount.
182
APR (Cont…)
 For
the examples that we have
considered the precise APR would be:
Loan Type APR
Simple Interest-One Installment 8%
Simple Interest-Two Installments 7.90%
Add-on Method-Two Installments 10.5758%
Discount Method-One 8.6957%

Installment
Compensating Balance-One 8.8889%
Installment
183
Part-03
Banks & Banking

Commercial Banks
 What is a commercial bank?
 The traditional definition is:
Ìt is a financial institution that accepts
deposits from members of the public
as well as business entities, and uses
the funds to make loans to individuals
and institutions in need of capital for
making productive investments.’
Commercial Banks
(Cont…)
 Banks are intermediaries in the
indirect market for funds.
 They pool money from SBUs and lend
to DBUs.
 In the process they do the following:

Denomination transformation
 Maturity transformation
 Risk diversification
Need for a New Definition
 The traditional definition is too
simplistic.
 Banks have started offering services
that have been traditionally
associated with non-banking entities.
 For instance many banks offer mutual
funds and insurance products.
Need…(Cont…)
 Non-banking institutions on the other
hand have started offering services
akin to banking.

Many money market mutual funds permit
shareholders to write checks.
Universal Banking
 The trend now is towards Universal
Banking.
 That is, we have large financial
conglomerates that:
 Accept deposits and offer loans
 Deal in securities and provide
underwriting services
 Offer mutual fund products
 Offer insurance products
Illustration
 The classic example of a Universal
Bank is ICICI Bank
 It accepts deposits and makes loans.
 It has an Asset Management
Company that manages mutual
funds.
 It is into Life Insurance and General
Insurance
 It has a home finance subsidiary that
offers housing loans.
Why the word
`Commercial’?
 Historically the primary role of a
bank has been to cater to the
needs of business firms.
 And hence the word commercial.
 These days of course retail
banking is a very important part of
banking operations.
Why do we need to study
banking?
 Banks and banking warrant
attention for a number of reasons.
 Banks hold a bulk of the financial
assets held by financial institutions as
a whole.
 They are the principal source of credit
for both corporate as well as retail
borrowers.
 They are the principal conduit for
payments between economic agents.
Why…(Cont…)
 They have the ability to create and
destroy money
 They are the principal channel
through which government policies
pertaining to interest rates and credit
availability are implemented.
How did banking
originate?
 Banks originally began as money
changing facilities.
 They operated from the
commercial districts of major
towns and provided facilities for
exchanging foreign currencies into
local currencies.
 They also offered Bill Discounting
facilities to local businessmen.
Bill Discounting
 Businesses as a standard practice
offer credit to their important
customers.
 That is buyers are given the facility
to pay after a period of time.
 But in the process the seller ends
up blocking his funds.
 This is where the banks step in.
Bill Discounting (Cont…)
 When a businessmen makes a
credit sale he will draw up a `Bill of
Exchange’.
 A bill is a demand made to the
buyer to make payment after a
stated period.
 A banker may `discount’ such a bill
by buying it from the seller for an
amount that is less than what is
 The net result is that:
 The seller gets money upfront
 The banker earns interest since the
amount paid at the time of
discounting is less than the invoice
amount that is receivable from the
buyer at the end of the stated credit
period.
 This is the crux of bill discounting.
 At the end of the credit period the
buyer will pay the bank and not the
original seller.
 What if a bank needs funds
urgently before the maturity of the
credit period.
 He can always sell the bill to
another institution.
 The bill is after all a negotiable
instrument and can be freely traded
in the market.
Other Activities
 The early bankers also offered
safekeeping facilities for items such as
gold and silver.
 Merchants who shipped goods
overseas were often paid in terms of

such precious metals.
 Shipping these metals back home was
perceived as risky.
 Consequently merchants began to
keep this bullion with a bank in the

Other Activities (Cont…)
 Banks also began to offer:
`Certification of Value Services’
 That is customers would bring in
valuables which would be certified
by valuers at the bank.
 Over a period of time banks began
to accept deposits and offer check
writing facilities.
Other Activities (Cont…)
 Soon banks began to issue banknotes
that served as money.
 However after sometime problems
arose.
 Banks began to issue more notes
than could be justified by the deposits

held by them.
 Eventually countries began to set
up central banks to monitor and
control commercial banking
Central Banks
 Central banks of countries are known
by various names:
COUNTRY CENTRAL BANK
England Bank of England
U.S Federal Reserve
Japan Bank of Japan
European Union European Central
India Bank
Reserve Bank of India
Australia Reserve Bank of
Australia
Central Banks (Cont…)
 These banks are responsible for
implementing monetary policy
decisions which are devised to
influence the interest rate
structure
 They have to maintain financial
stability.
Central Banks (Cont…)
 They have to preserve the value of
the local currency in terms of
foreign currencies.
 They are responsible for printing
and issuing domestic currency.
Roles of a Modern bank
 A commercial bank is expected to:
 Identify a financial service demanded
by the public
 Produce it efficiently
 And offer it at a competitive price
 A modern commercial bank
performs a variety of economic
functions.
Intermediation
 One of the major tasks of a bank is
to accept savings from households.
 Such deposits generally tend to be for
short durations
 The bank is then expected to offer
medium to long-term loans to
businesses and individuals in need of
credit.
 This `maturity transformation’ is
feasible because deposits keep

Payments Facilitation
 Banks facilitate the process of
making payments on behalf of
their customers who have
procured goods and services from
their suppliers.
 They also take receipts of cash
flows on behalf of customers who
have sold goods and services to
other parties.
Payments (Cont…)
 These payment flows manifest
themselves in many ways.
 Checks are issued and cleared
 Wire transfers of funds are affected
 Electronic payments are facilitated
 Currencies are bought and sold
Payments (Cont…)
 Many a times payments have to be
made to or received from a party
abroad.
 Thus many banks offer foreign
exchange services.
 That is they stand ready to buy and
sell a group of specified currencies at

all times.
 Such activities demand considerable
skill and expertise.

Guarantor’s Role
 Banks provide financial guarantees
on behalf of their customers.
 One of the most common ways of
offering such a guarantee is by
way of issuing a letter of credit or
what is commonly known as an LC.
LCs
 What is a letter of credit?
 Take the case of party who is
importing goods from Japan.

 The Japanese supplier is likely to be
unfamiliar with the integrity and

creditworthiness of the importer.
LCs (Cont…)
In such cases the supplier can ask the
importer to obtain a letter of credit
from his bank.
Àn LC is an assurance that the
importer’s bank will pay for the
goods, when the exporter presents
his bill.’
Risk Management
 Banks provide advice as well as
financial instruments to customers
who are desirous of protecting
themselves against financial risk.
 Take the case of an Indian who has
shipped goods to the U.S.
 Assume that the payment is due
after 3 months in dollars.
Risk Management (Cont…)
 What is the risk here?
 The risk is that while we may be
expecting to sell the dollars at Rs
48.50 per dollar, we may eventually
have to sell it at a lower price.
 One way of avoiding such a risk, is by
entering into a FORWARD CONTRACT.
Risk Management (Cont…)
 Assume that the exporter enters
into a forward contract with a bank
at a rate of 47.75 per dollar.
 He will then be assured of this
price irrespective of what the
actual foreign exchange rate may
be 3 months hence.
Investment Advisory
Services
 All of us like to plan for the future
in order to ensure that we remain
financially secure as we grow
older.
 But each person has a different
propensity to save
 Each of us has a different appetite for
risk
 And all of us have different
anticipated liabilities in the future
Investment…(Cont…)
 Thus banks are required to offer
tailor made savings/investment
solutions for their clients.
 When it comes to offering such
services they have certain inherent
advantages.
 They can afford to employ qualified
professionals
Investment…(Cont…)
 Modern banks offer a variety of
services in this connection such as:
 Filing of income tax returns
 Planning for post-retirement etc.
Safekeeping &
Certification
 Banks provide vaults and safe
deposit lockers where customers
can keep their valuables.
 They also have professionals who
are capable of certifying the
genuineness of articles of value,
and are in a position to estimate
the true value of such articles.
The Bank as an Agent
 Banks have Personal Trust as well
as Commercial Trust departments
that manage real and financial
assets on behalf of their clients.
Personal Trust Services
 What does a personal trust
department do?
 Consider the case of an individual
who seeks to periodically set aside
money in order to ensure that his
children are able to attend college
at a later date.
(Cont…)
 A bank’s trust department can be
entrusted with the task of managing
such funds.
 For a fee, the bank will ensure that
the funds are invested prudently and
that the desired objective is met.
(Cont…)
 Or take the case of a person who
has specified that the bank is the
trustee of his estate, as per his
will.
 It is the responsibility of his bank
to ensure that:
 Such assets are safely and productively
invested
 That all genuine claims against the estate
are met
 And that all legal heirs receive their rightful
Commercial Trust Services
 Corporations often entrust banks
with managing their portfolios.
 In many cases the pension plans
for the employees of a company
are managed by a commercial
bank.
Commercial Trust Services
(Cont…)
 Besides, whenever a security is
issued by a company, a trustee will
be specified
 The trustee has to ensure that:
 Investors receive interest or dividend
when the payment is due
 And that the principal is returned to
bondholders when the bonds mature
Policy Implementation
 Governments use monetary policy
as a tool for regulating the
economy and for ensuring that
desired social objectives are met.
 The necessary directives in this
regard are issued by the central
bank of the country, and are
implemented via the banking
system.
Policy Implementation
(Cont…)
 What is monetary policy?
 The term refers to policies regarding
the growth of money supply and the
availability of credit.
 What is the objective of such
policies?
 These are intended to ensure that:

The growth rate in the economy is satisfactory

The unemployment is kept at a low level

That inflation is kept under control

The value of the domestic currency is maintained
The Top 10 Global Retail
Banks in 2008
 Citigroup
 Bank of America
 HSBC
 JP Morgan Chase
 Bank of Scotland
 Banco Santander
 Wells Fargo
 BNP Paribas
 Wachovia
 Societe Generale
Top 10…(Cont…)
 The size of the global retail
banking market = $2,036 billion in
2007
 The top 10 had a market share of
19.80%
 Citigroup was the leader with a
3.4% share
 Bank of America and HSBC had a
market share of 2.7%
Top 20 Global Banks in 2007
(in terms of shareholder’s
equity)
Bank Equity in Billions of USD
Bank of America Corporation 135.271
Citigroup Inc. 119.783
JP Morgan Chase and Co. 115.790
HSBC 114.928
Mitsubishi UFJ Financial 81.940
Group
Royal Bank of Scotland 78.730
Group
ING Group NV 78.088
Credit Agricole 77.462
Wachovia Corporation 69.716
BNP Paribas 67.378
Top 20 (Cont…)
Bank Equity
Banco Santander SA 62.072
Industrial & Commercial Bank 58.975
of China (ICBC)
Barclays PLC 53.050
Unicredito Italiano Spa 50.726
Wells Fargo & Company 45.814
Deutsche Bank AG 44.142
Bank of China Limited 44.137
China Construction Bank 42.294
Corporation
Mizuho Financial Group 40.724
UBS AG 40.703
Bank Deposits
 Banks offer a variety of products to
customers who wish to deposit
funds with them.
 The bulk of the funds obtained by
banks comes from such sources.
 There is no ideal deposit for a
customer
 An individual thus ought to evaluate
all possibilities and then choose the
Bank Deposits (Cont…)
 Deposits can be characterized as
follows:
 Demand deposits
 Savings deposits
 Time deposits
 Hybrid Deposits
Demand Deposits
What is a demand deposit?
À demand deposit is one where the
bank is required to honour
immediately, any withdrawals
made by the account holder, either
in person, or by designating a third
party as the beneficiary.’
Demand Deposits (Cont…)
 These deposits are intended for
day to day banking needs.
 Employees can have their monthly
salaries credited to such accounts.
 Customers can use such accounts for
paying the bills of third parties from
whom goods and services have been
procured.
 These are known as checking
accounts
 Because they permit account holders
to write checks against their balances
 Checks offer a convenient mechanism
for making as well as receiving
payments.
 Traditionally such accounts in the
U.S. have been non interest
bearing.
 Banks charge a fee when a check
book is ordered by a customer.
 In addition, periodic charges are
levied:
 Some banks may charge a flat
monthly fee regardless of the balance
in the account
 Others may levy a fee if the account
balance were to dip below a minimum
threshold level during the course of
 In some cases a fee will be payable if
the average balance in the account
during the month were to below a
specified threshold.
 Sometimes a bank may also charge
for
 Every check that is issued
 Or every transaction undertaken at an
Automated Teller Machine (ATM)
Savings Deposits
 What is a savings account?
Ìt is designed to attract funds from
customers who wish to set aside
money in anticipation of planned
as well as unanticipated future
expenses.’
 Depositors thus have medium to
long term investment goals while

operating such accounts.
Savings Deposits (Cont…)
 Investments in such accounts can
be used for day to day cash needs
as well.
 In practice the depositor can make
deposits and effect withdrawals as
desired.
 Legally the bank can insist on
receiving notice prior to a withdrawal.
 But such a provision is rarely, if ever,
invoked.
Savings Deposits (Cont…)
 Savings deposits do not offer
check writing facilities.
 A bank may levy charges on the
user.
 There may also be a requirement
that a minimum balance be
maintained at all times.
Regulations
 In the US regulations limit the
withdrawals, payments, and
transfers that a savings account
may perform.
 Different banks comply with these
regulations differently
 Some will immediately prevent the
transfer from happening
 Others will allow the transfer but
notify the holder
Regulations (Cont…)
 The depositor is permitted to make up
to six transfers or withdrawals per
month or statement cycle (of at least 4
weeks duration)
 The bank may authorize up to 3 of these
payments to be made by
 Check, draft, debit card or similar order by
depositors
and payable to third parties.
Time Deposits
 What is a Time Deposit?
 It is a deposit with a fixed maturity
date, corresponding to what we call a
Fixed Deposit in India.
 It pays a higher rate of interest than a
savings account
 But there are penalties for premature
withdrawals
Time Deposits (Cont…)
 By laws, such deposits must have a
minimum maturity of 7 days.
 In practice, such deposits have a
duration of 30, 60, 90, or 180 days.
 In the U.S., such deposits are
known as Certificates of Deposit or
CDs.
 They can be of two types
 Negotiable
 And Non-negotiable
 What is a non-negotiable CD?
 It cannot be transferred from one
party to another.
 In other words it is a customized
contract between the bank and a
specific individual.
 Such CDs are mainly used by retail
investors.
 Consequently they tend to be of small
denominations
 A negotiable CD can be freely
transferred from one party to
another.
 It is therefore a marketable security.
 Such CDs tend to be of large
denominations
 Usually a multiple of 1 million dollars
 They are used primarily by
institutional investors
 These instruments are a key
Hybrid Account
 A hybrid account has features of
more than one type of account.
 Examples are:
 NOW Accounts
 Money Market Deposit Accounts
 Automatic Transfer Services
NOW Accounts
 `NOW’ stands for Negotiable Order
of Withdrawal.
 It can used like a checking account
to pay for goods and services.
 But unlike a checking account,
they pay interest.
 By law they can be held only by
 Individuals
 Or Non-profit organizations
NOW Accounts (Cont…)
 Legally, a bank can insist of prior
notice before a withdrawal is
made.
 But such a provision is rarely invoked
Money Market Deposit
Accounts (MMDA)
 To understand such accounts we
need to understand the concept of
a money market mutual fund.
 What is a mutual fund?
Ìt is an entity that pools the

investment made by its
shareholders and invests the
corpus in the capital market.’
MMDA (Cont…)
 What is a money market mutual
fund?
 It is a specialized fund that invests
exclusively in money market
securities.
 As discussed earlier, money
market securities are:
 Short-term in nature
 Are highly liquid debt instruments
MMDA (Cont…)
 Over a period of time, such
accounts began permitting their
shareholders to write checks
against the balances in their
accounts.
 Thus they began to compete
directly with banks from the
standpoint of attracting funds.
MMDA (Cont…)
 Investments in these funds
therefore became no different than
checking account deposits.
 Since they could offer market
determined rates of interest, which
were higher than what banks were
offering, they began to wean away
deposits from banks.
MMDA (Cont…)
 Money market deposit accounts
were a response to these funds.
 After obtaining government approval,
banks began to offer short-term
deposits on which they could pay any
interest that was deemed necessary
to attract and hold funds.
MMDA (Cont…)
 These accounts permit up to six
pre-authorized withdrawals per
month to pay third parties.
 But only three of these withdrawals
may be by way of issuing checks to
third parties.
 There is however no limit to the
number of withdrawals that a
customer may make for personal
MMDA (Cont…)
 Banks however reserve the right
to:
 Set minimum limits for each
withdrawal
 And to regulate the frequency of such
withdrawals
 Unlike a NOW account, an MMDA can be
held by a business as well.
 In many cases a minimum balance is
required if an account is to earn
Automatic Transfer
Service (ATS)
 What is an ATS?
 It is a combination of a checking and a
savings account.
 Funds are primarily maintained as a savings
deposit
 Consequently balances earn interest
 However checks can be issued

against balances in the checking
account, with a proviso that

In the event of an overdraft, funds will be
automatically transferred from the savings to the
checking account.
Ways of Accessing a Bank
Account
 There are may ways of operating
an account.
 Over-the-counter
 A customer can always visit the branch of
a bank to make deposits or to withdraw
funds
 They can also seek information on
 Account balances
 Transactions histories
 Bank statements
 Fees
Ways…(Cont…)
 Automated Teller Machines

They can be used to withdraw cash

For depositing cash and checks
 For ascertaining account balances
 For inter-account fund transfers
Ways…(Cont…)
 Point-of-Sale (POS) Terminals

These are found at
 Supermarkets
 Gas stations
 Restaurants etc.

Payments can be made using a standard
ATM card, because
 These days most banks issue a common debit
cum ATM card
Ways…(Cont…)
 Telephone Banking

Can be used for inter-account fund
transfers

For ascertaining account balances
 To get transactions histories
 Internet Banking
 Can be used to view account balances

To view transactions histories
 To apply for loans and credit cards
 To transfer funds
 To pay bills
The Right Account
 Is there a concept of a `Right
Account’ for everyone.
 No. There is no concept of Òne Size
Fits All’.
 Every account has its own unique
features.
 The client should choose the one that
best satisfies his requirements.
 The features of a given type of
account can vary from bank to bank.
Features of Competing
Account Types
Perceived Need Availability
Demand Deposit Savings Deposit Term Deposit
Regular access to Y Y X
cash
Freedom to make Y Y X
deposits/withdraw
als
Pay by check Y X X
Use ATM/POS Y Y X
Internet/Phone Y Y X
Banking
OTC Facilities Y Y Y
Rewards for X Y Y
savings
Earn higher X X Y
interest
RBI’s Definition of Demand
Deposits
 There are two types of demand deposit
accounts in India
 Current Accounts: “A form of demand
deposit wherefrom withdrawals are
allowed any number of times depending
on the balance in the account or up to
a particular agreed amount and shall
also be deemed to include other deposit
accounts that are neither savings
deposit or term deposit”
RBI’s…(Cont…)
 Savings Accounts: “It is a deposit
account which is subject to the
restrictions as to the number of
withdrawals as also the amounts of
withdrawals permitted by the bank
during any specified period.”
Loans
 Deposit taking is one the core
activities of a bank.
 Making loans is obviously another
facet of banking operations.
 Loans offered to qualified
commercial borrowers
 Are the highest yielding portion of a bank’s
asset portfolio
 Provide a major share of its revenues from
operations
Loans (Cont…)
 In the early days banks used to
provide primarily working capital
credit to companies
 By discounting bills
 And by extending short-term loans to
finance inventories and work-in-
process
Loans (Cont…)
 In recent years the focus of bank
lending has moved to term loans
 This refers to the extension of
medium to long term loans to
businesses to build up fixed assets
such as
- Buildings
- Plant
- And machinery
Loans (Cont…)
 Banks also extend loans to
facilitate the acquisition of real
estate
 Both residential
 As well as commercial
Loans (Cont…)
 The fastest growing area among
loans are consumer loans.
 Traditionally banks have shied away
from making loans to individuals and
households.
 This is because these loans tend to be
small in size
 And the perceived level of default risk
was considered to be
disproportionate.
Loans (Cont…)
 But over a period of time this
perspective has changed.
 Banks have realized that they need to
pamper consumers.
 For, retail customers as a group, are
the largest source of funds for banks.
 In order to have access to such funds
banks have to carefully nurture their
relationships with these customers.
 One way of doing this is by extending credit when
required.
Loans (Cont…)
 Consumer loans tend to be short-
term as well as long-term.
 Short-term loans are used for:
 Purchasing non-durable goods
 And services such as

Food
 Clothing
 Medical care
 Holidays
Loans (Cont…)
 Long-term loans are used for
 Purchasing durables, such as:
 Houses
 Automobiles
 Home appliances
Loans (Cont…)
 Bank loans may be installment
based or non-installment based.
 Short-term loans generally are paid
off in the form of one lump sum
payment.
 Installment loans are paid back by
way of periodic equated installments.
 They are used to finance

Automobiles

Mobile homes
 Boats and recreational vehicles
 Furniture and home appliances
Loans (Cont…)
 Installment credit tends to be
revolving in nature.
 That is, each time the loan is paid off
in full or in part
 He can borrow again up to the
sanctioned limit
Loans (Cont…)
 Banks also extend home loans or
mortgage loans to consumers.
 Loans are made for periods ranging
from 15 to 30 years.
 They are paid off in equated monthly
installments.
Loans (Cont…)
 One of the fastest growing
segments of the consumer credit
market, are what are known as
Home Equity Loans.
 What is the difference between a
Home Loan and a Home Equity
Loan.
 A home loan is taken to acquire a
home.

Loans (Cont…)
 In the case of a home loan, the house
is pledged as collateral and the lender
has a lien on it till the loan is fully
repaid.
 Home equity loans are different
 Here too the home is pledged as
collateral.
 But the borrower is not seeking to
acquire the home.
 He wants to unlock the equity that he
Illustration
 Assume that a man owns a house
worth $250,000.
 $50,000 remains to be paid on the
original housing loan.
 The owner’s equity is therefore
$200,000.
 Assume that the lender is wiling to
lend up to 70% of the value of the
equity, which in this case is
 $140,000 is the maximum that the
homeowner can borrow by
pledging his house.
 This is known as the Borrowing
Base.
 Home equity loans also work as
revolving lines of credit.
 Under IRS regulations, interest on
such loans is tax exempt under
Credit & Debit Cards
 Credit cards are also a mechanism
for extending installment credit to
a client.
 They enable people to `Buy Now and
Pay Later’.
 Debit cards are a new innovation.
 They enable purchases to be made by
electronically transferring funds from
the customer’s account to the
merchant’s account.
Negotiable Instruments
 The negotiable instruments act
does not define such instruments It
states: “A negotiable instrument
means a promissory note, bill of
exchange or check payable to
order or bearer.”
(Cont…)
 Characteristics
 Free Transferability – transfer can be
by delivery if it is a bearer instrument
or by endorsement and delivery if it is
payable to order
 Title to transferee – Transferees who
take the instrument bond fide and for
valuable consideration get good title
despite any defect in the title of the
transferor
(Cont…)
 The maker or drawer of such
instruments cannot subsequently
deny its validity
 The capacity of the payee to
endorse the instrument cannot be
denied
 The endorser cannot, in a suit by a
holder in due course, deny the
signature or capacity of any prior
party
(Cont…)
 Such instruments may be payable
to the bearer or payable to order
 Payable to Bearer: Payment will be
made to the person who bears it or
on which the last endorsement is
in blank
 Payable to Order: Payable to a
specified person or his order
Checks
 A check is a `bill of exchange’
drawn on a specified banker
 It includes the electronic image of
a truncated check and a check in
the electronic form
Checks (Cont…)
 Check in Electronic Form: “A check
which contains the exact mirror
image of a paper check and is
generated, written and signed, in a
secure system ensuring the
minimum safety standards with
the use of digital signature
Checks (Cont…)
 Truncated Checks: “Which is
truncated during the course of a
clearing cycle either by the
clearing house or by the bank
whether paying or receiving
payment immediately on
generation of an electronic image
for transmission, substituting the
further physical movement of the
check in writing.”
Checks (Cont…)
 A check is an unconditional order
on a specified banker where the
drawer has an account
 It is payable only on demand
 It is drawn for a certain sum of
money
 It can be countermanded
Checks (Cont…)
 Crossing: It is an instruction given
to the paying bank that it should
be paid only through a bank and
not across the counter
 Who may cross?
 The drawer
 The holder
 The banker
Checks (Cont…)
 General Crossing: This is done by
drawing two lines across the face
of the check, with or without the
words `& Co’ or `non negotiable’
 The bank on whom it is drawn should
pay only through a bank
 If it is payable to order, it should be
properly endorsed by the payee
Checks (Cont…)
 Special Crossing: Within the two
lines the drawer writes specific
instructions such as the bank it
should be paid to
The objective is to ensure payment
only if it is presented through a
specific bank
 A/c Payee Checks: The check
should be paid to the account of a
Check 21
 The Check Clearing for the 21st
century or Check 21 took effect in
the US on 28 October 2004
 Payers no longer receive copies of
their cancelled checks
 Checks clear much faster – often on
the same day
Check 21 (Cont…)
 Why Check 21? It is a way to make
check processing easier and less
expensive for the financial industry
 The old method required checks to be
physically moved from one place to another
 For instance let us say that you write a
check to a store. It will be deposited in its
bank account. It will then be physically
transported back to your bank. It has to be
then cleared.
Check 21 (Cont…)
 Under check 21 the check will not
move beyond the payee’s bank
 The bank, instead of physically
transporting the check will just
transmit an electronic image
 It has been estimated that banks
will save about USD 2 billion from
check 21
 But the law does not require banks to
reduce their checking account fees
Check 21 (Cont…)
 Substitute Checks: It is a paper
copy of the front and back of the
original check. This is made by the
bank that receives the payment.
 The original check is kept by the
bank that first receives it.
 It has the freedom to decide whether
to destroy it or keep it on file.
Check 21 (Cont…)
 Disadvantages: May not be easy to
prove fraud if someone alters the check.
 Since substitute checks are copies, changes
may be harder to detect
 Traditional checks allow the drawer to
enjoy a float – there is a lag between
the time the check is written and its
clearance.
 This could lead to more bounced checks
 And higher overdraft costs
Electronic Check
Conversion
 Check 21 allows bank to process
payments electronically without
physically sending the checks from bank
to bank
 An ECC allows a merchant, a credit card
company, or other party who receives
your check to extract information from
it and process the payment
electronically
More Recent Bank
Services
 These days banks have started
offering many new types of
services such as:
 Cash management
 Equipment leasing
 Venture capital
 Insurance services
 Retirement plans
 Investment banking
Cash Management
Services
 Cash management is a marketing
term for certain services offered by
banks, primarily to large business
houses.
Cash…(Cont…)
 These include
 Account Reconcilement
 Armored Car Services
 Automated Clearing House
 Balance Reporting Services
 Cash Concentration Services
 Lockbox Services
 Positive Pay
 Sweep Accounts
 Zero Balance Accounting
 Wire Transfer
 Controlled Disbursement
Account Reconcilement
 Balancing a checkbook can be difficult for a
large business
 Since a large number are issued it is difficult to
monitor what has cleared and what the true balance
is
 Banks allow companies to upload a list of all
the checks they issue on a daily basis
 At the end of the month the bank statement will
show what has cleared and what has not
 Positive Pay: The system can prevent checks
from being fraudulently cashed if they are not
on the list.
Armored Car Services
 Large retailers who collect a great
deal of cash may have the cash
collected by the bank using the
services of an armored car
company
Automated Clearing House
(ACH)
 It is an electronic system used to
transfer funds between banks
 Companies use this to pay other
particularly employees
 Certain companies also use this
system to collect monies from
customers
Balance Reporting
Services
 Corporations that actively manage
large cash balances usually
subscribe to secure web-based
reporting of their account and
transaction information at their
lead bank.
 They may also view balances in
foreign currencies and balances with
other banks
Balance…(Cont…)
 Subscribers can view information on:
 Cash balances
 Checks in the process of collection
 Transaction specific details on all forms of
payment activities
 Deposits
 Checks
 Wire transfers
 ACH debits and credits
 Investments
Cash Concentration
Services
 Large or national retailers may operate
in areas where their primary bank has
no branches
 So it is common for them to open accounts
with local area banks
 To prevent the funds from being idle, they
enter into agreements with their primary
bank whereby the ACH is used to
electronically pull these deposits into a
single interest-bearing account
Lockbox
 Companies like utilities which
receive a large number of checks
by mail have the bank do the
following tasks for them
 Set up a post-office box
 Open their mail
 Deposit any checks found
Sweep Accounts
 Excess funds from a company’s
bank account are automatically
moved to a Money Market Mutual
Fund overnight
 The money is moved back the
following morning
 Thus companies can earn interest
overnight
Zero Balance Accounting
 Companies operating at multiple
locations can be confused if all the
locations are depositing funds into a
single bank account
 Thus banks developed a system where
each location is given its own bank
account
 However all monies deposited into the
individual accounts are automatically
swept into the main account
Wire Transfer
 A wire transfer is an electronic
transfer of funds
 This is the fastest way of
transferring funds between bank
accounts
 In this system, a message is sent
to the receiving bank requesting it
to effect payments in accordance
with the instructions given
Controlled Disbursement
 The bank provides a daily report,
usually at the beginning, that
provides the amount of
disbursements from the account
 This allows customers to deploy
any surplus in money market
securities
Equipment Leasing
 In a leasing arrangement, the bank
will first purchase the equipment.
 This will then be leased out to the
client.
 The bank, which is known as the
`Lessor’ in such cases, is the
owner of the asset.
 Consequently it can claim
depreciation as per law.
Equipment Leasing
(Cont…)
 The client is known as the
`Lessee’.
 What are the advantages for the
lessee.
 Firstly he can pay for the use of
the equipment on a monthly basis
rather that in the form of a lump
sum.
 Secondly the monthly lease rentals
constitute a tax-deductible
Venture Capital
 Who is a venture capitalist?
 He is a person who invests in a
high risk venture.
 In other words he ventures into
uncharted territory.
 Conventional wisdom has it that
nine out of ten such ventures fail.
 But the anticipation is that the returns from
the single profitable venture will more than
compensate for the losses suffered on
account of the other investments.
Insurance Services
 Banks have traditionally sold
Credit Life Insurance to customers
who borrow from them.
 How does such a policy work?
 It guarantees that the loan will be
repaid if the customer were to die or
become disabled before the loan is
fully paid off.
Insurance Services
(Cont…)
 The Glass-Steagall Act in the U.S.
prohibited commercial banks from
engaging in Insurance activities.
 But the Gramm-Leach-Bliley Act
which was passed in 1999
removed such barriers.
Retirement
 Banks play a key role in helping
companies to manage their
employee pension plans.
 They help invest the incoming funds
in accordance with the guidelines
given by the employee
 And disburse payments to recipients
who have qualified for payment on
account of retirement or disability.
Retirement (Cont…)
 Banks also offer deposit retirement
plans for individuals.
 These are known as Individual
Retirement Accounts or IRAs.
 Deposits in such accounts stay
invested until the employee becomes
eligible for post-retirement income.
 Account holders get tax benefits as
per law.
Investment Banking
 The term investment banking
refers to a bouquet of activities.
 Two of the main activities of such
institutions are:
 Brokerage services
 Underwriting services
Mutual Funds & Annuities
 Mutual funds as explained earlier
pool funds from their shareholders
and invest in marketable securities
such as stocks and bonds.
 Every fund will have a stated investment
objective which will have a bearing on its
choice of investments.
 An income oriented fund will invest more in
bonds and dividend paying stocks

 A growth oriented fund will invest more in
securities with a potential for capital gains.

Mutual Funds…(Cont…)
 What is an annuity?
 It is a sequence of identical cash flows
arising at equal intervals of time.
 A person who buys an annuity is
essentially making an investment in
return for a steady income stream
beginning at a future date.
 The income stream is structured to
commence at a critical point in time,
such as the date retirement of the
Activity Heads
 A modern bank can be divided into
a number of activity heads.
 These are:
 Retail or domestic banking
 Corporate banking
 International banking
 Group treasury
 Investment banking
 Information services
 Corporate centre
Retail Banking
 It is usually the largest area of
operations within a bank.
 Its key function is to provide
personal, business and retail
customers with
 Deposit services
 Lending services
 Fund transfer facilities
Retail Banking (Cont…)
 The crux of retail banking is
Marketing.
 The area employs a variety of
personnel.
Corporate Banking
 This facet of banking deals with
the development and management
of client relationships with leading
corporations as well as Small and
Medium Enterprises (SMEs).
 Loans and other financial products
are developed and customized to
meet the specific needs of such
borrowers.
International Banking
 The international division of a bank
provides international trade
related services such as:
 Arranging for international finance
 Arranging for shipping and customs
clearances
 Provision of remittance services
 Arranging for offshore loans
Group Treasury
 Group treasury is concerned with
the following activities
 Trading
 Risk management
 Fund management
 Asset and liability management
Group Treasury (Cont…)
 Treasury deals involve millions and
at time billions of dollars.
 Thus both speed and skill are of
essence.
 The staff is expected to:
 Be technically accomplished
 Have a sound knowledge of the state of the local and
foreign economies
 Be acquainted with
 Money markets
 Capital markets
 FOREX markets
Investment Banking
 Investment bankers provide a variety of
specialized services such as:
 Underwriting
 Portfolio management
 And mergers and acquisitions
 Merchant banking divisions make loans

available for major projects.
 Portfolio managers act as custodians for
the equity and bond portfolios of
investors.
Retail Financial Services
 Major banks have finance
companies in the form of
subsidiaries.
 Finance companies tend to employ
 Credit analysts
 Credit officers
 Loan managers
 In addition the bank also employs
professionals to handle aspects such as
 Life insurance
 Pension plans
Information Services
 The systems team is concerned
with the development and
maintenance of computer based
systems.
 Electronic banking systems such
as ATMs and POS Terminals
require extensive computer
systems operations.
 These days other internal activities
Corporate Centre
 The Corporate Centre or the
Headquarters of a bank is the
nerve centre.
 It is primarily concerned with long
range planning
 The CEO and his key management team are based
here.
 Consequently most policy decisions originate from
here.
 Related solutions and applications as well are
devised here.
The U.S. Banking Structure
 It is well known that the U.S. has
some of the largest banks in the
world.
 What is perhaps less known,
however, is the fact that it has
perhaps the largest number of
small banks in the world.
 In 1990 the 100 largest banks held about
70% of the total assets of the banking
industry.
Unit Banks
 What is a Unit Bank?
 It is an organization that offers all its
services from a single physical
location.
 However although there is a single
branch, limited services are usually
offered from additional facilities like

Drive-in windows
 ATMs
 And POS Terminals
Branch Banking
 These banks by definition offer a
full range of financial services from
multiple physical locations.
 One of these locations will be the
Head Office, while others will be
branch offers.
 In addition limited service facilities
will be available as for unit banks.
Networking
 Many commercial banks have set
up shared facilities to facilitate
 Fund transfers
 And disseminate financial information
 The most familiar of such facilities
are shared ATM networks such as:
 CIRRUS
 PULSE
 EXPRESS CASH
Networking (Cont…)
 Customers carrying credit and
debit cards issued a member of
the network, can carry out
transactions through any ATM
belonging to the network, even
though the particular ATM being
used may belong to another bank.
U.S. Banking Regulations
 Prior to commencing its
operations, every bank should
obtain a Charter of Incorporation.
 A bank may opt for a:
 State Charter
 Or a National Charter
 All nationally chartered banks must
join the Federal Reserve system.
 They must also secure a certificate
of approval for deposit insurance
from the Federal Deposit Insurance
Corporation or FIDC.
 A state chartered bank need not
join the Federal Reserve.
 Nor need it apply for FDIC cover.
 The first significant regulation from
the standpoint of the U.S. banking
industry was the McFadden-Pepper
Act of 1927.
McFadden Pepper Act
 It permitted nationally chartered
banks to branch out within the city
where they were headquartered
 Provided that the laws of the state did
not forbid such branching
 However branching across the
state was not permitted
 Unless expressly approved by the
state where such branching was
sought to be undertaken
McFadden…(Cont…)
 Thus states were given the
ultimate power to decide:
 If and where nationally chartered
banks operating within the borders of
the state should open branches
 If and where banks chartered by the
state itself should set up branches
Glass-Steagall Act
 It provided that a nationally
chartered could branch throughout
its home state
 Provided the state where the bank
was headquartered gave similar
powers to its own state chartered
banks.
 Thus the need to obtain permission
from the states was done away with.
 However branching beyond the
borders of the home state was
forbidden
 Unless the state concerned
specifically permitted inter-state
banking
 The bank thus gave greater
freedom for branch expansion
 But it away the privilege of a
 There were two sections of the Act
that had special significance.
 Section 16
 And Section 20
 Section 16 prohibited nationally chartered
banks from
 Investing in stocks
 From underwriting security issues
 It also imposed restrictions on broking and

dealing activities
 Section 20 prohibited banks that
where members of the Federal
Reserve system from becoming
affiliated with firms whose principle
operations were in the dealing and
underwriting of securities.
 Conversely, underwriting firms were
precluded from offering depository
services.
 The more restrictive provisions of
the Act were gradually relaxed.
 Many large banks were given limited
underwriting powers.
 By the end of the 1990s the FED had
approved the setting up of holding
companies which were allowed to
have subsidiaries that could engage
in securities dealing and underwriting.
 Such companies were known as
Section 20 holding companies
because

They were offering services that had
been prohibited until then by Section 20
of the Act.
 The Act also set up the FDIC
 Currently all deposits up to $250,000
are insured by the FDIC.
FDIC
 The Federal Deposit Insurance
Corporation is an independent
entity of the US government
 Protects funds that are deposited in
FDIC insured institutions
 The insurance is backed by the full
faith and credit of the US government
FDIC (Cont…)
 There is no need for a depositor to
apply for FDIC coverage
 It is automatic
 Insurance covers funds in
 Deposit accounts

Checking and savings accounts
 MMDAs
 CDs
FDIC (Cont…)
 FDIC insurance does not cover
other financial products that the
bank may offer
 Stock
 Bonds
 Mutual fund shares
 Life insurance policies
 Annuities
FDIC (Cont…)
 The standard insurance amount is
currently $250,000 per depositor
 This is permanent for certain
retirement accounts including IRAs
 It is temporary for all other deposits
accounts till December 31, 2013.
 On 1 January 2014 it will revert back
to $100,000 per depositor
FDIC (Cont…)
 The FDIC provides separate
coverage for deposits held in
different account ownership
categories
 The following chart gives limits for
the total of all deposits that an
account holder has in the same
ownership category at each FDIC
insured institution
Coverage Limits
 Single Accounts (owned by one
person) - $250,000 per owner
 Joint Accounts - $250,000 per co-
owner
 Retirement Accounts (including
IRAs) - $250,000 per owner
 Corporations and Partnership -
$250,000 per corporation or
partnership
The Riegle-Neal Interstate
Banking Law
 Prior to 1994
 Branch banking was either restricted
or prohibited by many states
 Thus to cross state lines, most banks
had to set up holding companies and
acquire banks incorporated in other
states.
 Of course, approval from the states
concerned was mandatory.
 As per Federal law, no holding company
could own more than 5% of the voting stock
of a bank located outside its home state
Riegle-Neal (Cont…)
 The Riegle-Neal law allowed
holding companies to consolidate
their banking affiliates in various
states into branch offices of a
single parent bank
 Unless of course a particular state
outlawed such branching activities
 But if a state were to deny such
permission
 Its own banks would be ineligible to
Riegle-Neal (Cont…)
 The law however stipulated that:
 No banking company would be
allowed to control more than 10% of
nationwide deposits
 No bank could hold more than 30% of
the deposits in a single state

Unless the state concerned were to waive
this restriction
The Gramm-Leach-Bliley
Act
 This law, enacted in 1994,
permitted well capitalized and well
managed banks to have affiliates
in the insurance and securities
dealing sectors.
 Brokerage firms and insurance
companies were granted
permission to form holding
companies which could then
Gramm-Leach-Bliley
(Cont…)
 The affiliation between a
commercial bank and a brokerage
or an insurance firm could take on
one of two possible forms
 A financial holding company could
have separate companies under its
umbrella for
 Banking

Insurance

Securities trading
 Or else a commercial bank could set up a subsidiary
for
The Federal Reserve
 The `FED’ is the central bank of
the U.S
 It is headquartered in D.C
 The Federal Reserve system
consists of 12 district Federal
Reserve banks.
The `FED’ (Cont…)
 The district banks are:
 Federal Reserve Bank of Boston
 Federal Reserve Bank of New York
 Federal Reserve Bank of Philadelphia
 Federal Reserve Bank of Cleveland
 Federal Reserve Bank of Richmond
 Federal Reserve Bank of Atlanta
 Federal Reserve Bank of Chicago
 Federal Reserve Bank of St. Louis
 Federal Reserve Bank of Minneapolis
 Federal Reserve Bank of Kansas City
 Federal Reserve Bank of Dallas
 Federal Reserve Bank of San Francisco
 The FED sets and implements the
monetary policy of the US
 It has implications for the level of interest
rates in the US economy
 And for the rate of inflation
 The Fed sets and targets two important
interest rates in the economy
 The Discount Rate
 The FED Funds rate
 The discount rate is actually set by
the FED
 This is the rate at which banks borrow
from the central bank
 The higher the discount rate, the
greater will be the rates charged by
commercial banks for granting credit
 The second rate which is targeted
by the FED is the FED Funds rate.
 This is the rate at which banks extend
loans to other depository institutions
 These are typically on an overnight
basis
 All nationally chartered banks are
required to be members of the
Federal Reserve.
 State chartered banks may
volunteer to join the Federal
Reserve.
 All banks have to maintain a
fraction of the deposits held with
them in the form of a reserve with
Reserves
 What is a reserve?
 It is that portion of a bank’s assets
that have not been lent out or
invested, but are held in a form that
is readily available for use.
 Legal reserves in the U.S. take on
two forms
 Currency held in the vaults of banks
 Deposits held by the banks with the
Federal Reserve
Reserves (Cont…)
 What are the implications of
holding reserves?
 Since a percentage of deposits have
to be maintained in such form only
the balance can be lent out by the
bank
 This therefore has implications for the
ability of a bank to create money
Correspondence Between
Account Types and Reserve
Requirements
 As per law
 The FED can impose a reserve requirement
ranging from 8-14% on transactions

deposits
 And up to 9% on non-personal time deposits
 What is a transaction deposit?

 It a checking or other similar account from
which payments can be made to third

parties
 What is a non-personal time deposit?
 It is a time deposit held by entities other
than individuals and sole proprietorships.

Correspondence (Cont…)
 The FED can also impose any
reserve that it deems appropriate
on the amount that U.S. depository
institutions owe on a net basis to
their foreign affiliates or to other
foreign banks.
 In order to reduce the reserve
burden
 The law provided that reserves would
be only 3% for the first 25 million of
transactions accounts
 It also stipulated that this figure
would be adjusted annually by a
factor equal to 80% of the percentage
change in total transactions accounts
in the U.S.
 Subsequent legislation stipulated
that:
 The first 2 million dollars of a bank’s
deposits would attract 0% receipts
 And that this level would be adjusted
upward if he quantum of deposits
held by U.S. banks were to increase.
 However, it was specified that no
downward adjustments would be
made for any decline in the deposit
Current Reserve
Requirements
 For transaction deposits, the
requirements as of 1st January 2009
were:
Deposit Amount Reserve %age
$0 - $10.30 million 0%
$10.30 million < X 3%

< $44.40 million
X > $44.40 million 10%
Current…(Cont…)
 On non-personal time deposits the
current reserve requirement is nil.
 The requirement is applied to
deposits over a two-week period.
Reserve Maintenance
 The reserve requirement is calculated
on a daily average basis over a two-
week period known as the Reserve
Computation Period.
 This stretches from a Tuesday to a Monday
2 weeks later
 The FED calculates the daily average of
transaction deposits held by a bank
over this period and multiplies it by the
required percentage
 This determines the required legal reserves
Reserve Maintenance
(Cont…)
 The reserves held must equal the
required amount over a 2 week
period known as the Reserve
Maintenance Period.
 This starts on a Thursday, 17 days
after the computation period gets
over, and ends on a Wednesday 2
weeks later.
Reserve Maintenance
(Cont…)
 While computing required reserves
Vault Cash is adjusted
 Vault cash may be adjusted up to the
amount of required reserves
Collections, Clearances &
Transfers
 Most of us use currency for only very
small transactions in real life.
 Large denomination transactions, which
constitute the bulk of payments
between two parties, are effected by
issuing checks.
 In the context of clearing checks, banks
that are members of the Federal
Reserve use the balances in their
reserve accounts in the same way that
Collections…(Cont…)
 When checks issued by its
customers are deposited with
another bank
 The bank’s reserve account at the
FED is debited
 On the other hand when checks
drawn on other banks are
deposited with it
 Its reserve account at the FED is
Illustration
 A firm in San Francisco has sold
software worth $25,000 to a party
in Denver, and has received a
check drawn on a Denver bank.
 The issue is, how will the check be
cleared?
 The firm will first deposit the check
with its bank in San Francisco.
 The bank will then send the check
to the Federal Reserve Bank of San
Francisco.
 The FED bank in San Francisco will
send the check to the Federal
Reserve bank of Kansas City,
which has jurisdiction over Denver.
 The FED bank in Kansas City will
send the check to the bank in
Denver.
 The bank will debit the account of
the drawer.
 The money will
 Either be remitted to the FED bank in
Kansas City
 Or else the bank will request the FED
 The FED bank in Kansas City will credit
the account of the FED Bank in San
Francisco.
 The FED bank in San Francisco will
credit the account of the drawee’s bank.
 The drawee’s bank will credit the
drawee’s account.
 The net result is a transfer of $25,000
from a party in Denver to a party in san
Francisco.
 Checks which are collected and
cleared by the Federal Reserve
system must be paid in full by the
banks on which they are drawn.
 That is, they must be paid at par
without any deduction of fees.
 Of course the drawee’s bank may
recover collection charges from the
drawee.
 In order to facilitate transfers from
one district Federal Reserve bank
to another, the 12 banks as a
whole maintain a fund in
Washington D.C.
 This is called the Interdistrict
Settlement Fund.
 Each district bank has a share in it.
 The fund enables transfers from one
district Federal Reserve bank to
 Banks which are not members of the
Federal Reserve system can maintain a
Clearing Balance with a district Federal
Reserve bank.
 When checks drawn on other banks
are deposited with a given bank, its

clearing balance will be credited.
 On the other hand when checks
drawn against it by customers are

deposited with other banks, its
Money & Its Creation
 Banks have the power to create
money, because they can offer
lines of credit, which can be used
as a medium of exchange for the
payment of goods and services.
Money…(Cont…)
 Banks create money in a variety of
ways:
 They offer checking accounts
 They make available credit card lines
of credit
 They make available ready spending
power by way of
 Debit cards
 Electronic fund transfer facilities
Money…(Cont…)
 Why is it that a bank is able to
create money?
 It is because the public readily
accepts a claim against a commercial
bank as payment for goods and
services in lieu of physical cash.
Money…(Cont…)
 Thus from economic standpoint,
money is not just currency.
 Physical currency is just a tiny
component of what we understand as
money.
 Economics define money in various
ways.
 Each definition reflects a different
view of what is implied by the terms
`money’ and `credit’.
Definitions of Money
 The narrowest view of money is as
a medium of exchange.
 This is called M1.
 The definition includes:
 Currency held by the public

That is currency other than what is held
by the government, or in the vault of
commercial banks and Federal Reserve
banks.
Definitions…(Cont…)
 Checking accounts and checkable
accounts such as NOW and ATS
accounts held by the nonbank public
are included.
 That is checking and checkable accounts
due to domestic banks, the U.S.
Government, foreign banks, and other
official institutions are excluded.
 Traveler’s checks of non-bank issuers
are also included.
 The next definition of money is called
M2.
 It treats money not just as a medium
of exchange but also as a store of

value.
 Thus M2 includes:
 M1
 Savings accounts
 Small denomination time deposits (of
denomination less than $100,000)
 Money market deposit accounts
 Shares of money market mutual
funds other than those held by
institutions
 Overnight Eurodollars issued to U.S.
residents by foreign branches of U.S.
banks worldwide
 Overnight repurchase agreements at
banks
Repurchase Agreements
 What is a repurchase agreement?
 Such an agreement, known as a
Repo, for short, is an arrangement by
which a borrower acquires money by
selling securities in his possession to
a lender, with an agreement to
repurchase them on the following day
at a higher price.
 The difference between the sale price
and the subsequent repurchase price
Repurchase…(Cont…)
 Thus a Repo is nothing but a
collateralized loan.
 Most Repos are done on an overnight
basis.
 However, they may be undertaken for
longer periods.

In this case they are known as Term
Repos.
Repurchase…(Cont…)
 From the borrowers’ perspective such
transactions are known as Repos.
 From the lenders’ perspective they
are known as Reverse Repos.
 Thus every Repo must be matched with a
Reverse Repo.
 An even broader definition of
money is called M3.
 It includes:
 M2
 Time deposits with a denomination of
$100,000 or more
 Term Repos
 Eurodollar deposits held by U.S. residents
for periods other than overnight
 Shares of money market funds held by
Creation of Money
 How do banks create money?
 The process can be best illustrated
with an example.
Illustration
 A person borrows $1,000 from a bank
and takes the money in the form of
dollar bills.
 The cash in the vault of the bank will
decrease by $1,000.
 In return the bank will have a
promissory note for $1,000 as an

asset.
 But what if the borrower decides to
keep the amount with the bank
 In this case the amount of cash in
the bank’s vault will not change.
 However deposits, which are a
liability for the bank will increase
by $1,000.
 And on the asset side a promissory
note will appear as an asset.
 Thus extensions of loans have a
bearing on the deposit base of
banks.
 But the process will not stop here.
 The bank can make a loan to
another borrower for $1,000.
 The deposit base will again rise by
$1,000.
 And a second IOU for $1,000 will be
created on the asset side.
 So can a bank expand its deposit
base without limit?
 In practice it cannot.
 Why?
 Every time bank accepts a deposit,
it is undertaking an obligation to
clear checks issued by the
borrower.
 Consequently some kind of a
 This is the rationale for requiring
banks to maintain reserves.
 Thus deposit expansion is not an
unfettered process.
 To continue with our example of deposit
expansion we will focus on a single bank
system, with a bank called Bank One.
 The arguments are however valid for a
multibanking system.
 Customer Alpha deposits $1,000
with Bank One.
 Assume that the reserve
requirement is 10%.
 The bank will have to retain $100:
 Either in its vaults
 Or else as a deposit with a Federal
Reserve bank
 Thus the amount of loanable funds
is $900.
 Let us assume that it is lent to
customer Beta who promptly
deposits it with the bank.
 After accepting a deposit from
Beta the bank will have to keep
$90 as a reserve.
 Consequently $810 will be
loanable.
 Assume that this is lent to
customer Charlie who promptly
deposits it with the bank.
 If the process is taken to its logical
conclusion, the deposit base will
expand as follows:
$1,000 + $900 + $810……
= $1,000 + 0.9 x 1,000 + (0.9)2 x
1,000…..
= 1,000
______ = $10,000
Multiplier Effect
 Thus an original deposit of $1,000
can create a deposit base of
$10,000 by a process of
expansion.
 In this case the deposit multiplier
is 10.
 What is the deposit multiplier?
 It is nothing but the reciprocal of the
reserve ratio.
Multiplier Effect (Cont…)
 Will a deposit of $1,000 always
lead to a deposit base expansion
of $10,000.
 The answer is no.
 For instance what if after making a
loan to Charlie, the bank is unable
to find takers for loans.
 In this case the deposit expansion will
only be to the tune of $2,710.
 Or assume that Charlie borrows
$810, withdraws $110 in cash and
deposits the balance with the
bank.
 Assume that:
 The amount withdrawn in cash does
not re-enter the banking system
 And that the deposit of $700 made by
Charlie leads to the maximum
possible expansion.
 In this case, the total expansion in
reserves will be:
1000 + 900 + 700
_____ = $8900
(1-0.9)
 The withdrawal of funds from the
banking system is called a
Leakage.
 Obviously, the greater the leakage
Money Contraction
 The creation of reserves has a
multiplier effect.
 Obviously the depletion of reserves
will result in contraction of money
supply.
Illustration
 Assume that customer Alpha
withdraws $1,000 from the bank in
the form of cash.
 The total reserves held by the
bank would be:
0.1x1,000 + 0.1x0.9x1,000 +
0.1x0.9x0.9x1,000……
= 0.1x10,000 = $1,000
 Thus the bank has enough
reserves to payoff Alpha.
 But the bank is still holding
deposits of $9,000.
 Thus there is a shortage of
reserves to the tune of $900.
 Obviously the bank needs to
borrow this amount.
 Assume that the bank borrows by
issuing securities to a party called
Delta who is holding a deposit of
$900 with Bank Two.
 Delta will pay by withdrawing this
amount from his bank.
 Bank Two will obviously have a
reserve shortage of $810
 The rationale is that the deposit of
$900 held by Delta would have
resulted in a deposit expansion of
$9,000 on which the bank would
have been maintaining $900 as
reserves.
 Thus a withdrawal of $900 by Delta
Taken to its logical conclusion the
withdrawal from the banking
system would be as follows:
1,000 + 900 + 810…….
= 1,000 + 0.9x1,000 +
(0.9)2x1,000…..
= $10,000
Money Contraction
(Cont…)
 Thus while a deposit of $1,000 has
the potential to increase the
deposit base by $10,000, the
withdrawal of $1,000 has the
potential to reduce the deposit
base by $10,000.
 Why do we say `potential’?
 We have already seen that leakages
can prevent the deposit expansion
Money Contraction
(Cont…)
 Similarly in the case of withdrawals, the
multiplier may be less than what theory
predicts.
 For instance assume that Alpha
withdraws $1,000.
 The bank immediately issues securities
worth $900 to Delta.
 Delta withdraws $800 from his bank and
pays $100 from his pocket in the form
of cash.
Money Contraction
(Cont…)
 Bank Two would have been holding
$900 as reserves prior to the
withdrawal.
 It will now have reserves worth
$100 against a deposit base of
$8,200.
 Thus there would be a deficit of
$720.
 If it were to issue bonds for $720,
Money Contraction
(Cont…)
Thus the contraction process will
be as follows:
1,000 + 800 + 720 + 648 + …….
= 1,000 + 800 + 0.9x800 +
(0.9)2x800….
= $9000
which is less than the maximum
possible amount of $10,000.
Federal Funds
 What are Federal Funds?
 Banks have to maintain reserve
deposits with district Federal
Reserve banks.
 These are held:
 To satisfy legal requirements
 To clear checks
 Pay for the purchase of government
securities
Federal Funds (Cont…)
 These balances can be
instantaneously transferred from
one bank to another through the
FED’s wire transfer network called
FED WIRE.
 Funds transferred in this manner
are called Federal Funds, or FED
Funds for short.
Federal Funds (Cont…)
 Why would a bank seek to borrow
FED Funds from another?
 It could be the case that its reserve
balance is less than the legal
requirement
 Or there may be a loan demand for
which funds are urgently required,
and consequently it may be required
to borrow from another bank.
 Banks do not like to hold excess
Current Trends
 Banks have started offering a wide
variety of services.
 This is partly due to increasing
competition.
 And to an extent due to the growing
sophistication of consumers
Current Trends (Cont…)
 Many of these new activities are a
source of non-interest income.
 Banking has traditionally been a fund
based activity
 That is banks raise deposits and make
loans
 The profit margin on such activities is
a function of the interest rate
differential
 The new activities that banks are
entering into are non-fund based
 These are referred to as fee based
activities
 That is, the banks provide a service
for which they are paid a fee
 Due to deregulation and rising competition the average
cost of raising deposits has gone up.
 That is banks are now forced to offer market rates of
interest to their depositors.
 Strict capital adequacy guidelines
have now been prescribed.
 This too has pushed up the cost of
funding.
 What do we mean by capital
adequacy?
 The liability of a bank consists of
 Owner’s equity capital
 And mainly of borrowed funds
 Regulators now require banks to
use more of owners’ capital.
 Equity capital is more expensive than
borrowed funds.
 This is because equity holders are residual
claimants over whom depositors are
accorded priority
 Shareholders can receive dividends only
after depositors
 In the event of liquidation depositors
have to be paid off first

 For taking greater risk,
shareholders will demand a
greater level of returns
 Besides dividends paid to
shareholders is not tax deductible
whereas interest that is paid to
depositors is.
 There has been a technological
revolution in the banking sector.
 There is a perceptible shift from
labour intensive to capital
intensive activities.
 The prominent examples are:
 ATMs: The number of ATMs in the U.S. has grown
from 139,134 in 1996 to 396,000 in 2005. However,
the per-ATM transaction volume has dropped from
6,399 to 2,214.
Globalization
 What is globalization?
`Globalization is about the formation
of seamless markets on a global
basis. In the new economic regime,
the scope of trade is global and not
just international’
 Today business or money has no
nationality.
Globalization (Cont…)
 Banks consequently cannot take
relationships with domestic
customers for granted.
 They need to cultivate clients on a
global basis.
 And need to be aware that foreign
competitors are breathing down their
necks.
To quote Frances Cairncross:
À company’s market is no longer its
locality or even its nation. Thanks
to global toll-free numbers and the
Internet’s global reach, electronic
commerce offers an inexpensive
way to sell to the world. And the
world to sell to us.’
 Cairncross predicts:
Ìnternational mail order and
electronic distribution will be big
business, bringing customers an
unprecedented range of choice
and driving competition at the
level of the electronic high street.
It will create global brands and
global pricing strategies.’
 The traditional domination of U.S.
banks is fast eroding.
 Japanese and European banks have
grown considerably in size due to

Consolidation
 Mergers & Acquisitions
 Free trade agreements such as
NAFTA and the formation of the EU
have allowed banks to operate
outside the borders of their
respective countries with the same
freedom as that enjoyed by
domestic banks in the country of
operation.
 But globalization has also
increased the risk of failure.
 Economic integration is also
accompanied by greater transmission
of risk across borders.
The Internet Revolution
 The number of people accessing
the Internet is growing at a
frenetic pace.
 But the Internet is unlikely to
eliminate the need for a bank
representative or a phone banking
officer.
 It has often been the experience that minor
problems which can be solved face to face
or over the phone, can snowball into major
Internet…(Cont…)
 The Internet is particularly relevant
for regions in countries like the U.S
and Australia which are sparsely
populated.
 Citizens often stay miles away from
the nearest city or town.
 Distance is therefore a major barrier
for executing transactions like bill
payments.
Universal Banking
 Banks have learnt the importance
of:
BEING WHERE THE CUSTOMERS
ARE
 Traditionally a bank would be
located at the centre of the main
street of the town.
 But today’s crowd does not
patronize Main Street, it prefers
Universal Banking (Cont…)
 Customers want a one-stop
banking relationship.
 One of the areas which has seen
major changes is superannuation.
 The days of secured government jobs
with lifelong pensions is now history.
 The focus is on tailor made pension
plans.
 Modern banks now function as
financial supermarkets.
 As Simon points out:
`When people want to talk about

superannuation, for example, we
also help sort out their credit
cards, their home loans, their car
loan, their boat insurance, their car
insurance etc.
More and more, people are looking
to have one relationship, one
phone number to ring, one
consultant who can answer all their
problems. This is a product of our
cash-rich but time-poor
environment.’
The Future
 What does today’s customer want?
 He wants all his financial services
delivered
 As simply
 As cheaply
 And as conveniently as possible
 And he wants 24x7x365 access
Part-04
The Market for Consumer Credit Putting

Automobile Loans in Perspective
Introduction
Modern Economy
Age of Consumer Finance
individual individual
Borrow
Lend funds
funds
financial sector
family family
Age of consumer finance
• In 2008 for the household sector in the U.S.

– the total outstanding amount was in excess of 14
trillion dollars by the end of the year
Consumer
Consumer Credit Protection Act
repay loan
consumer loan
A consumer is a natural person who is primarily or

secondarily liable in a credit contract
Consumer Credit
Borrowed
funds
used for
Commercial
Personal Family Household Agricultural Or
Business
Examples
Consumer loan
automobile
Consumer loan
furniture
Consumer loan
business
Consumer loan types
Long term loans Short term loans
house recreational medical food

vehicles
automobile white goods vacation clothing

Durable goods Non durable goods
Household loans classification
Residential mortgage Installment loans Non-installment loans

loans
Installment credit is used Non installment loans are paid
They are the largest to buy durables other off in the form of 1 lump sum
component of the market than homes payment
They are retired by way Such loans include:
for consumer credit of 2 or more consecutive
payments made on a • Single payment loans for
monthly/quarterly basis personal goods
Further classified as: • Charge accounts to be paid
• Automobile loans off in full at the month end
• Revolving lines of
credit • Loans for personal services
• Mobile home loans such as health care
• Loans for other
consumer goods
Consumer Lending Institutions
Consumer Lending Institutions
• Financial institutions extend credit to

consumers
Types of
financial
institutions
Savings
Commercial and Credit Finance
banks loan Unions Companies
institutions
Commercial Banks
• The banking industry as a whole has more

consumer loans outstanding on its balance
sheet as compared to any other category of
loans, including loans to commercial
enterprises
Outstandings Outstandings on
on consumer > commercial loans /
loans other loans
About 50% of all
automobile loans are
made by commercial
banks
Banks - Advantages
Larger base of retail customers
Larger network of convenient branches
Existing relationship with depositors helps

convert them to clients when it comes to
consumer loans
Banks…
• Traditional dominance of banks has been

eroding
• Banks are being challenged by finance
companies & credit unions
• Modern electronic systems have leveled the
playing field between banks and such
institutions
S&Ls
• Savings and Loan Institutions or S&Ls have

been traditionally restricted to mortgage
lending.
• Before 1980:
– they were permitted to invest only a small
percentage of their assets in consumer loans
• After deregulation:
– they make a wide variety of consumer loans
Credit Unions
• It is a financial institution specifically

developed to serve individuals with a common
bond
Types of
Credit
Unions
based on
Same Same Same

profession religion employer
Credit Unions…
Minus-es Plus-es
They do not offer an They have certain

extensive range of regulatory and tax
services advantages that are not
available to commercial
banks
– This has enabled
them to develop and
hold their market share
Finance Companies
• These institutions specialize in making small

loans to consumers and small businesses
• They can be divided into two categories
– Personal finance companies
– Captive finance companies

Finance companies
Personal finance companies Captive finance

companies
These cater to high risk borrowers These are subsidiaries of
with a negative/unsatisfactory credit their parent companies
history
The interest charged on such loans Examples include
is well above the market average. •General Motors
Acceptance Corporation
As consumers have become more (GMAC)
aware, the pressure on such •FORD Credit
lending institutions has increased They were originally set up
causing many of them to close to help their parents market
down. their products
Commercial Banks and the Lending
Process
• Commercial banks extend consumer credit via 3
channels
Channels
buy installment
make loans to
loans from
extend loans other lending
merchants who have
directly to institutions which
extended such
consumers offer credit
loans to their
to consumers
customers
Factors that influence consumer
borrowing patterns
Background
Historically Today
Consumer is driven by
People borrowed for buying
consumption
big ticket items rather than wait
Consumers borrow to finance
till the money could be saved all kind of purchases
• Basic every day living items
• Luxury items
• Emergency needs
People did not like being in Attitude has changed - people
debt are not intimidated by the
prospect of being in debt
Factors
influencing
borrowing
patterns
Income
Life cycle Inflationary
& Business
of expecta-
wealth cycle
individual tions
levels
Income and wealth levels
• Families with larger incomes/wealth borrow

more
– absolute dollar borrowings are higher
– ratio of borrowings to income or wealth levels are
higher
Income…
They are
These
better aware
borrowers
of pros/cons of
tend to be
using borrowed
better
funds to
educated
add to incomes
For them
borrowing is a
tool to attain a
higher standard of living
not just a safety net
Life cycle of individual
• Young couples  borrow more

– Need for house/automobile is greater
• Family grows / birth of children  Consumption &
borrowing grows
– Need for funds exceeds their current income & wealth
– Confidence in higher future income levels
• Children grow older / leave home  borrowing tapers
down
– Parents likely to be earning and saving more
– Future earning power is limited and can support only reduced
level of debt
Life cycle pattern
120
100
80
60 Debt
40
20
0
25 40 60
Age of individual
Business cycle
During economic booms During economic

recessions
Unemployment decreases Unemployment increases
Citizens are more optimistic Citizens tend to be more

about the future pessimistic about the future
Borrowing patterns Due to a perceived drop in
accelerate income or the spectre of a job
loss families tend to cut back
on debt and save more out of
their current income
Inflationary expectations
• If inflation is expected to increase

– Postponing consumption would mean paying more
for the same assets
– In such cases if income is not expected to keep
pace with inflation it may be prudent to buy
immediately by borrowing
Level of Interest rates
As the economy grows
Borrowing levels in As the economy There will be

short run will rise peaks interest rates cutbacks in
due to optimism will reach a higher consumer
about the future level borrowings
As people cut back on borrowings
The level of spending This may serve to exacerbate a

the economy will recession which would in any case
reduce be a natural economic correction
Variables that influence decision to lend
Consumer loans
Very profitable use of funds for most lending institutions
Though the margins are high, so are the risks
The cost per dollar of credit extended tends to be higher

Consumer loans…
If the borrowing cost for the bank

Their contract rates do were to rise during life of the loan
not change with market • There would be an asset-
conditions during the liability mismatch
life of the loan • The bank would be exposed
to interest rate risk
Hence these loans are

usually priced well over the
cost of funding for the bank
Making consumer loans
• From the perspective of evaluating the loan

application making loans is a real challenge
– It requires a thorough knowledge of household
financial statements
– It also requires the ability to gauge the character of
the borrower
Loan application details
• Size & stability of income

• Net Salary (not Gross Income) - shows ability
to repay
– Lender will cross-verify salary details with
employer
• Verify the following details with the employer
– Length of employment
– Address
– Social Security Number
Evaluating a loan application
Positives Negatives
Loan servicing costs (excluding
housing loan) should be max
15-20% of a family’s gross
income
Duration of employment Many institutions deny loans to
borrowers who are employed at
their present job for less than a
year
Applicants who own land /
marketable securities are
considered a safer bet
Own their place of dwelling Renting place of dwelling
Evaluating a loan application
Positives Negatives
Families with multiple earning There is the risk that the single
members earning member may become
unemployed/disabled/even die
Having a telephone at home -
inexpensive way of contacting
the borrower at all times
Length of residence at a
particular location - the longer
a person stays at a given
address the more stable
Co - Applicant
• Young borrowers sometimes cannot give

collateral or have poor / no credit record
• A co-signer / co-applicant with substantial
assets may be required
– A co-applicant is more a psychological device to
ensure repayment of loan
• Technically if the borrower defaults, the co-
applicant is obligated to settle the dues
– In practice co-applicants are rarely pursued
because this may lead to loss of the co-signer’s
business
Loan application
Historically Today
Experienced loan officers fill out Automation has increased and

the application personally lenders are spending less time
with the borrower. Information
gathering evaluation are
automated
By asking pertinent financial Loans officers have very little

questions a skilled lender can information about the borrower
make a better call on the beyond what is contained in the
application. The customer’s application form.
spoken answers often tend to be
revealing about his character
and sincerity
Assessing character
• Borrower’s past payment record is the best

indicator for assessing character
– The national/regional credit bureau has the
applicant’s credit history
– These bureaus maintain files on those who have
borrowed from the market at some time
– The data indicates the applicant’s record of
repayment as well as his credit rating
– Lenders may not lend to borrowers who ‘pyramid’
their debt
• i.e. borrow from a financial institution to pay off a
loan taken from another institution
The negatives
• Sloppy money handling is viewed negatively

• E.g.
– Large outstanding balances on charge accounts
– The need to pay heavy installments on existing
loans
– Frequent late payments on past loans / defaults on
past loans
– A history of returned checks
Deposit account
• A loan application has a better chance of

being approved if the borrower has had other
business dealings with the institution, such as
a deposit account.
– If the borrower pledges a deposit account / other
liquid asset as collateral, he may be able to lower
the cost of the loan
• The daily average deposit balance
maintained by the customer, is a good
indicator of his income and stability
Deposit account…
• If applicant maintains a deposit account with

the lending institution, the lender is granted
the right to offset the loan against the deposit
– In the event of default, the lender can seize any
checking/savings deposit held with it
– In practice the borrower has to be notified 10 days
in advance
– Hence the borrower may often withdraw the credit
balance before the lender can attach it
Consumer loan vs. Business Loan
Consumer Loan Business Loan

Due to so many variables a A loan application from a
consumer loan is more difficult to business enterprise is easier to
evaluate evaluate
It is easier for an individual to
conceal pertinent information on
health and employment related
issues which have a bearing on
his ability to repay
In the event of ill health, accident, Business enterprises are
or financial problems, the obviously less dependent on an
borrower’s ability to repay can be individual
severely impacted
Example of a Loan application
Loan application
AUTOMOBILE LOAN APPLICATION

Credit application
A.B. Charlie
submitted by
Credit application
15 January 2005
submitted on
Applicant’s street
2752 Moreene Drive
address
City of residence Iowa City
State and Zip code IA 57701
Purpose of requested To purchase a new car for
loan personal use
Desired term of loan 5 years
FOR AUTO LOAN REQUESTS PLEASE FILL THE
FOLLOWING INFORMATION
Auto is New/Used Used
Year Current
Make Oldsmobile Cutlass Sierra
Model 4-door sedan
Vehicle identification No. 241499736
Air conditioning, automatic
Optional equipment on the transmission, power
vehicle steering, power brakes,
AM/FM stereo
Vehicle to be traded in 1995 Pontiac Le Baron
Model 2-door sedan
Vehicle identification No. 973649241
A/C, Automatic transmission,
Optional equipment on
power steering, power
trade-in vehicle
brakes, AM/FM stereo
Application…
DETAILS OF PROPOSED PURCHASE

Purchase price quoted by
$19,750
seller
Cash downpayment to
$2750
be made
Allowance on trade-in $0
Net value of trade-in $1,000
Total value put down $3750
Unpaid portion of
$16,000
purchase price
Other items covered in
$950
loan
Total amount of credit
$16,950
requested
CUSTOMER INFORMATION
Social Security No. 499724136
Birth date 1/26/64
Time at present
8 months
address
Phone no. 383-4315
14 Valley View
Previous home
Apartments, Coralville,
address
Iowa
How long at previous
10 months
address
Driver’s license no.
C7763904, Iowa
and state
Number of
2
dependents
Current Employer Apex Corporation
Length of employment
7 months
with current employer
Nature of work Administration
Annual salary $30,000
Employer’s phone no. 431-3835
Other income sources Investments
Annual income from
$3,000
other sources
Nearest living relative
Elaine Delta
(not spouse)
Phone no. 919-354-1543
2752 Middleton Avenue,
Address
Durham, NC-27630
Does the applicant want bank to consider
spouse’s income in evaluating this loan?
Yes/ No Yes
Spouse’s current
$9,000
annual income
Name of spouse’s
Iowa City Mortgage Union
employer
Occupation Secretary
Length of employment 6 months
The information i have given in this credit
application is true and correct to the best of my
knowledge. I am aware that the bank will keep
this credit application regardless of whether or
not the loan is approved. The bank is hereby
granted permission to investigate my credit and
employment history for purpose of verifying the
information submitted with this credit application
Customer’s
and for evaluating my credit status.
A.B. Charlie
signature
Date signed 1/15/2005
Application Evaluation
Positives Negatives
Family income - Combined Stability -
income amounts to $39,000. •Been at present address for
This figure will be verified from only 8 months
the employers. •Stayed at previous address for
only 10 months
•Worked with present employer
for only 7 months
Other debt obligations - It Other debt obligations -
includes their home mortgage Financial information gathered
loan and is only 2.5 times their from the Charlies indicates they
total annual income (less than 3 have debt obligations of $98,000
times is usually acceptable)
Application Evaluation…
Positives Negatives
Debt obligations Monthly disposable
Bulk of the debt service payments are on income
their home. If real estate market is The total monthly
strong, value of the home will provide payments on their debt
adequate security
seems rather high @
Financial record $1,125 p.m. It accounts for
They have enough insurance and above almost 35% of their annual
average holdings assets in the form of income (25% - 30% is
stocks & bonds acceptable)
Character - Verification with the
employers has revealed that husband
and wife have good prospects for
continued employment
Evaluation…
• The application was accepted based on:

– The loan is for a reasonable purpose
– It is consistent with the bank’s loan policy
– The family’s annual income is high enough to
suggest that the loan would be repaid with a high
probability
Report
Table 1.1
Name of Max Amount Outstanding Past Montly Status
creditor term owed balance due payments
Credit
Wind 6 $1600 $1600 $1600 $800 Past due

Tunnel mnths
Apts.
Visa Open $2100 $1875 $375 $125 Past due
First City 1 yr $3750 $750 $250 Current

National
Bank
Report Scrutiny
• Undesirable elements of application:

– Unpaid rent due
– Past due credit card obligations
– Unpaid and unreported bank loan
• Terming the credit history as unacceptable

the officer turned down the credit request.
Federal Requirement
Loan is denied
As per law, U.S. banks have to notify the

applicant in writing when loan is denied
1. Bank has to give 2. Bank has to give 3. Customer

reasons for the the identity of the can verify his
denial credit bureau, if credit record
applicable and demand
any errors
found to be
corrected
Analysis
• Main criteria used to judge credit quality in

consumer lending
1. Evidence of stability in employment and in residence
2. Consistency of information
• All terms and figures on the application should be
consistent with each other
3. Legitimacy of purpose for obtaining credit
4. Evidence of competent money management skills
• As reflected in a conservative assumption of debt
• A timely payment record
5. Good prospects for continuing employment
Analysis…
• A bankable loan request will not display a

significant weakness in any of these
parameters
• Evaluation becomes difficult if the application
is weak in one or more areas
– The loan officer has to then rely on intuition
– Or on an objective credit scoring system
Credit scoring
Credit Scoring
• Many banks use credit scoring systems to

evaluate the loan applications that they
receive.
• Advantages of credit scoring
– Can handle a large volume of applications quickly
and with minimal labour
– Help in reducing operating costs
– Can be an effective substitute for the use of
human judgment
– Customers like the convenience and speed
Customer friendly system
These days a The bank can then dial up And then use a credit
customer can phone in the credit bureau report scoring system to reach
a loan request or fill an through an online network a decision in minutes
internet application
How Credit Scoring works
Model
The system is based on a model in which several variables
are used jointly to establish a numerical score or ranking
Score
The score or ranking is considered to be a measure of the
credit quality of the applicant
Loan approved Loan denied

If the applicant’s score If the score falls below the
exceeds a critical cutoff cutoff the applicant will be
point then he is likely to be denied credit
approved provided that
there is no other information
that is a cause for concern
Credit Scoring…
• The most important variables used

– Credit Bureau Rating
– Age
– Marital Status
– Number of dependents
– Home ownership
– Income bracket
– Availability of a phone at home
– Number and type of bank accounts
– Type of occupation
– Time spent in the current job
Theory behind Credit Scoring system
• By observing large groups of people who have

borrowed in the past
– the bank can identify the financial, economic and
motivational factors that separate good loans from the bad
– the factors which separated good loans from the bad in the
past, will continue to do so in the future
• Assumption may not be valid if there were economic
and other changes abruptly
• Hence credit scoring systems are frequently tested
and revised as more and better predictor variables
are identified
Illustration
Illustration…
• The maximum possible score = 43
• The minimum possible score = 9
• From past records, out of 3000 customers

1200 borrowers with < 28
 had to be written off as bad debts
300 parties with < 28
 turned out to be good

Illustration…
• The average loss per bad loan = $600

• Total loss for 1200 bad loans = $720,000
• Denial of credit to the 300 good clients < 28
 would lead to a revenue loss of $180,000
• If 28 were to be used as cutoff, the bank
would stand to save
 $720,000 – $180,000 = $540,000
Illustration…
• Management can experiment with the scores

to determine the ‘optimal cutoff’
– The score that yields the ‘maximum net savings’
• If 28 is the optimal cutoff, then the bank’s

credit history could be analyzed to find out
what influence the amount of credit extended
to a customer has on the bank’s loan loss
experience
Optimal Credit Policy
• Based on analysis the bank may decide on
Point Range Decision

≤ 28 Reject
29-30 Credit up to $500
31-33 Credit up to 1000
Credit Scoring…
Advantage Disadvantage
Element of personal Strict adherence to such
judgment is eliminated systems may lead to the
alienation of customers
The decision time is Customers may feel that
reduced their financial condition has
not been fairly appraised
Customers may feel the
special circumstances
pertaining to their
application have been
ignored
Credit Scoring…
• There is a risk of being sued under

antidiscrimination laws if any of the following
variables are used as a part of the scoring
system
– Race
– Gender
– Marital status
– Other discriminatory factors
Credit Scoring (Cont…)
• Federal regulations allow the use of age /

other personal characteristics if the bank can
demonstrate that
– These attributes separate at a statistically
significant level, the good loans from the bad
– The system is frequently statistically tested and is
revised to take into account the actual credit
experience
Lending
Loans made by
financial institutions
may be classified as
Direct loans Indirect loans

Direct Lending
Direct Loan
• A loan that is made directly from the bank to

the consumer.
• It involves only two parties
– The bank
– The borrower
bank borrower
Direct Loan…
Historically Today
Face-to-face contact with a A borrower need not enter a branch until the
loan is closed. But bankers have fewer
branch officer was the only way
opportunities for face-to-face interaction.
to:
Innovations began with drive through / walk
• Make inquiries about loans through windows, telephone banking, ATMs
• Make applications for credit & access cards
Today institutions take applications through
• Finalize borrowing
• Call centres
arrangements
• Direct mail
• Internet
• Supermarket branches
• Mall loan kiosks
Centralized vs. Decentralized
Centralized lending function Decentralized lending function

Retail locations generate Every branch is individually
responsible for
applications & details are sent
• Developing applications
electronically to a central location
• Making decisions
for analysis. Post decision the • Closing loans
documentation are sent back to • Collection of payments
the retail branch. • Handling delinquencies
Software used by ‘credit approval This approach is extremely labour
section’ gives immediate access to
intensive and costly. It is
internal bank files for
• Client information appropriate for small institutions
• Credit reports etc. with low loan volumes only.

Adv. Direct Lending for institutions
It offers a high This higher

This leads to
level of control level of control
facilitates reduced credit
over the
higher quality risk and
lending
decision
process greater profits
making
Adv. Direct Lending for institutions
It makes it The lender

It leads to the
possible for may be able to
establishment recommend a
the lender to
of a personal different loan
recommend
structure, type
relationship alternative of loan or loan
with clients loan structures amount
Adv. Direct Lending for consumers
• Direct lending offers these benefits to

consumers
– Financial counseling
– Creative loan structuring

Financial Counseling
• Advice provided by officers helps customers better

manage their personal finances
Consumers can learn about
The range of
financial options available
Other credit related services

such as credit insurance
Counseling…
Lenders make suggestions about
A type of loan that they

perceive to be most suitable
Various debt restructuring options
Other financial products

that the bank can offer
Advice on strategies for enhanced

savings & wealth creation
Creative Loan Structuring
• The flexibility to structure loans can benefit

– Lowering monthly payments through consolidation
of outstanding loans
• E.g. debt consolidation may reduce the client’s debt to a
point which qualifies him for an additional loan
– Reducing the number of debts

– Lowering interest rates on accounts
– Increasing borrowing flexibility in the future
through versatile open-ended credit programs
Disadv. of Direct Lending for institutions
Problem Possible solution

Process is labour intensive Automate and centralize the process
Reliance on skilled loan officers Put more emphasis on indirect loans
Emphasize open-end credit products
which reduce the costs of handling future
borrowing needs
Requirement of convenient branch Alternative methods for taking
locations for taking applications applications include:
• Kiosks
• Telephone applications
• Direct mail applications
• Supermarket branches
• Internet banking
Disadv. of Direct Lending for consumer
• The inconvenience of coming to the branch

during business hours may be too high
• This may force the client to apply for an
indirect loan where the dealer arranges for a
loan on the spot
Indirect Lending
Indirect Lending example
• It involves three parties

– The lender/bank
– The dealer
– The consumer
• In effect the lender/bank has two clients
– The dealer
– The consumer
Dealer
Bank
Consumer
Indirect Lending example
Consumer wants GM dealer has a The loan

to buy an prior application is
automobile arrangement forwarded
borrower with a bank to electronically to
provide credit the bank for a
quick decision
Advantages of indirect lending
Banks Dealers Consumer
It offers banks an Dealers/retailers The consumer

opportunity to reach a
broader market than they increase their can purchase
may otherwise reach sales by goods and
Banks gain access to providing a arrange for
clients of other businesses
convenient credit at the
It helps financial institutions
make credit more available source of credit same time
to clients who could not for their
have been served on a
customers
direct loan basis
Primary
providers of
indirect loans
Recreational Mobile
Automobile
vehicles homes
dealers
dealers dealers
Indirect lending process
A “dealer
agreement” is Once the
Lender/bank
executed – it agreement is
must compete defines the terms signed the dealer
with other lenders & conditions for may offer the
offering credit to lender’s credit
for the dealer’s the dealer’s retail
services to his
business clients
clients
Indirect lending process…
…cont’d
The customer The dealer

chooses a will take a The lender will
product and loan review the terms
decides to application
finance a and will of the sale and
portion of the forward it to make a decision
purchase price a lender
Grant conditional
Turn it down approval
Approve the
application • Larger down
payment
• Shorter term to
maturity
Indirect lending process
…cont’d
Loan is Customer
Contract will be
approved signs the
loan contract sold to the lender
Indirect Lending…
• Usually dealers send loan applications to a

number of competing lenders
• The dealer will sell the loan to the institution
that offers the “best deal”, i.e.
– The contract terms must meet the consumer’s
requirement
– It must lead to an acceptable buy rate for the
dealer
• Usually the consumer does not know which
institution has provided the credit
Lender and Consumer
• The lender has no direct contact with the

customer until the loan is made
• First contact between the lender and the
consumer
– When the billing statement is mailed or
– The coupon book is mailed
Dealer relationship
Estb. a dealer relationship
Banks have to The bank then has

first determine the to develop strategies The next step is to
type of dealers identify particular
to attract and
with whom they dealers within each
maintain the desired
wish to do
base of dealers product group
business
Dealers are selected on the • Who will produce the

basis of: types of loans desired by
• Types of goods/brands the bank
sold • Who will maintain an
•Their reputation image, selling practices, &
•The bank’s specific creditworthiness that are
objective for the product line acceptable to the bank
Example
These dealers have

There is
• High sales
increased volumes
Many banks have
competition • Deal with
from captive car decided to focus on
customers having a
finance foreign car dealers good credit rating
companies • And are not
targeted by finance
companies
Role reversal
• New software has reversed the role between

banks and dealers
Consumers first Once the loan is
They then submit a
figure out the approved, the bank will
request to a bank for submit a complete
price of the car
financing package to a
they want a quote network of dealers
The dealers will then

bid for the consumer’s
business
The Dealer Agreement
• Agreement between the bank & the dealer

covers
– The bank’s rates
– Maturity of the loan
– Down payment requirement
– Other terms applicable to retail contracts

Info in Dealer Agreement
Info
in a
dealer
agreement
Selected
Rate bank
Max. rate Dealer Dealer
charges Down
dealer can Maximum Recourse/ recourse
on loans payment
charge loan term Dealer account
purchased requiremnt
consumer Reserve details
from dealer
option
Multiple relationships
• Dealers have indirect lending relationships

with multiple institutions
• The lender most likely to obtain most of the
dealer’s business
– Establishes the closes relationship
– Provides the quickest answers on applications
– Offers the most liberal rates or credit terms
Application Process
Application process
Dealer accepts A centralized credit

Dealer
department at the
agreement applications &
lending institution
is signed sends them to
will process the
potential lenders
application
• Applications are sent by
fax or electronically
• Thereby the dealer can
target more lenders in a The lending
short period – called personnel
“Shotgunning” concerned will take
• The bank responding first a credit decision
with the best rate usually
gets the deal
Application process
cont’d
The dealer who
Decision is
closes the loan will
conveyed by usually attempt to
The dealer will
phone or sell credit insurance
then prepare the
electronically and warranty
legal documents
to the dealer services as a part of
Many are completed the loan
Because of the automatically
competitive nature It is an addnl source of
of indirect lending it income for dealer &
salesman.
is necessary for
These extra products are
decisions to be called:
communicated • Add Ons, or
often within • After market
minutes Products
Application process
cont’d
Bank personnel The dealer will send The bank will

will review the the completed loan book the loan
contract to documents, original and disburse
ensure that it is application, and the proceeds to
properly contract to the bank the dealer
executed He will also also process
documents reqd to obtain title
and record to lender’s lien
Soon a coupon
The bank will from book or billing
then on begin direct statement will be
contact with the sent to the
consumer
consumer
Add ons
• The lender must have a policy regarding how

the add ons will be handled.
– In some cases they may be added to the amount
financed, which will be above and beyond what
the bank may have approved
– Other banks may decide not to fund such products
Indirect Lending…
• It is subject to strong competition

• It is highly price sensitive
• Customers choose their loan based on the
lowest price
• To improve efficiency some banks are
changing the indirect lending function.
– Have a centralized direct lending function
– Have started getting their indirect loan requests
reviewed through the same system.
Adv. of Indirect Lending for the Bank
1. The dealer base can be a powerful

extension of the bank’s own sale force
2. Dealers handle some of the functions
involved in the lending process
– Application
– Loan documents
– Closing the loan
• Bank can handle more applications with a
small staff - increases productivity
Dealer Recourse
Dealer Recourse
• Assumption of responsibility  Dealer

Recourse
• Risk for a bank may be mitigated if dealer is
willing to accept some responsibility for the
performance of the loan generated by him
• The bank has recourse to the dealer to
recover all or a portion of any loan that it may
suffer a loss on
Recourse options
Basic
recourse
options
Non recourse Recourse

Repurchase Limited
or or
Recourse Recourse
No liability Full Recourse
Dealer has no Dealer is resp. Dealer is resp. Dealer may agree

responsibility for reimbursing for full amount of to reimburse the
beyond normal the bank the full any losses if the bank for a flat
warranties & amount of any bank returns the amount like
recording the lien losses collateral $1,000
Dealer Recourse…
• Non recourse or No liability

– The dealer has no responsibility beyond normal
warranties and recording the lien
• Recourse or Full Recourse

– The dealer is responsible for reimbursing the bank
the full amount of any losses on its accounts
Dealer Recourse…
• Repurchase Recourse
– The dealer is responsible for the full amount of any
losses if the bank returns the collateral.
– There may be certain time constraints  the
collateral must be returned within 90 days of
delinquency on the loan
• Limited Recourse
– The dealer may agree to reimburse the bank for a
flat amount like $1,000
– Or for a specific time period such as the first 12
months any losses in excess of the amount or
after the stated time period are the responsibility
of the bank.
Dealer Recourse…
• Trend these days is towards loans with no

recourse
– Banks’ exposure on indirect loans has gone up
• Value of a given recourse plan depends on
– financial strength of dealer
– reliability of the dealer
• If dealer were to go out of business or ignore his
obligations bank can incur losses even if dealer has
signed a “full recourse” agreement.
• Many dealer recourse accounts set aside
funds to be used to handle loss payments
Dealer Recourse…
• At best
– Recourse option can enable a bank to minimize
losses
– It can also allow it to make loans to slightly high
risk customers
• At worst
– The bank may be lulled into a false sense of
security
– This may result in unexpected loan losses
– Or unacceptably high delinquencies
Indirect Lending…
• The more recourse deals a dealer signs 
the greater is his potential or contingent
liability
– This can have significant implications if a dealer
were to decide to sell his liabilities.

Shortcomings of Indirect Lending
1. Spread between the banks’ cost of funds

and buy rates on loans has been declining
– This has lead to reduced profitability
2. Many banks have been forced to give up
recourse protection in order to do greater
business
3. They have also been forced to stretch their
credit requirements in order to compete for
business
– But it is bad risk management for a bank to
reduce its credit standards
Shortcomings of Indirect Lending…
1. The indirect lending market is characterized

by shifting loyalties
– Dealers will shift from one loan source to another
given the slightest reduction in the dealer buy
rate.
– Interest subsidy programs from captive finance
companies has also caused major realignments
in the market.
• Captive finance companies make loans at below the
market rate in order to boost the sales of a particular
car model or brand.
Shortcomings of Indirect Lending…
1. Many of the problems associated with

indirect lending are on account of fraudulent
practices
– Dealers often put pressure on banks to lend to
clients who are on the margin from the
standpoint of creditworthiness
• If a dealer is giving a lot of business to a bank he may
expect it to accept a few high credit risk clients.
• Especially true if the dealer accepts some recourse on
the loan
Dealers…
• To handle dealer pressures, banks have

adopted a number of strategies.
– Requiring a higher internal authority for approval
of non-standard credit risks
– Requiring dealer recourse endorsements on high
risk applications
– Discontinuing relationships with dealers who
continue to send high risk applications
Dealer fraud…
Potential problems with dealers Possible solutions banks could
use
Documentation problems
Since the salesman’s commission Banks should determine that
may be dependent on loan
approval, there could be pressure to Dealer’s selling practices are
push an application
acceptable before establishing a
High delinquency
Discrepancies between the terms relationship - these should be
disclosed on the loan papers and
the information provided by the continuously monitored
dealer
• Fictitious loans
• Double financing
• Misrepresentation of loans
Dealer Fraud…
Problem
• Dealers may submit fictitious loan

applications and contracts for nonexistent
individuals or for those who did not eventually
enter into a transaction.
Double financing
Problem
• Applications and contracts may be submitted
to and approved by multiple lenders resulting
in the dealer being paid twice for the sale.
– This is called double financing
Solution
• Double financing is easy to detect because
the customer will receive two coupon books
Double financing
Problem
• Dealer personnel may misrepresent some terms on
the application to make it look more favorable
– Selling prices
– Down payments etc.
• May give the impression that consumer has invested
more in the sale than what the dealer has actually
received
Solution
• Reliance on sound collateral valuation guides to
determine the amount that the bank should lend
Fraud…Straw purchases
• A straw purchaser is an individual who uses

his name and credit information to help obtain
a loan for an individual who would otherwise
not qualify
• Such a party will sign the documents without
receiving any benefits from the loan
Benefits of Indirect Lending for Dealer
• Enables dealers to close sales on the spot

 avoiding loss of clients to other dealers
– Sometimes the availability of financing may
cause a person who would otherwise
procrastinate to take a decision on the spot.
Benefits of Indirect Lending for Dealer
• Dealers earn extra profits from credit sales

 constitutes a significant source of income
– Banks pay Dealer a portion of the interest
charges on loans
– These funds compensate Dealer for sales and
other effort
– The dealer’s income from loan = (the rate
charged to the retail client - bank’s buy rate)
Illustration of dealer income
Illustration of Dealer Income on a 60 mnth loan
• Amount Financed = $25,000

• Bank retention rate = 7.25%
• Consumer rate = 8%
• Total finance charge = $5414.59
• Banks retention = 4879.04
Dealer share of finance charge = 535.55
• Life insurance premium = $175

Dealer commission @ 30% = $52.50
Illustration…
• Accident and health premium = $300

Dealer commission @ 30% = $90
• Warranty policy = $625
• Cost to dealer = $325
Dealer profit on warranty = $300
• Total dealer earnings = 535.55 + 52.50 +
90.00 + 300.00 = 978.05
Dealer Reserve Account
• The dealer’s share of the finance income

goes into a Dealer Reserve Account
– It is a checking account established for the dealer
– It is controlled by the bank
– As new loans are booked funds are added to the
account during the month
– Funds are disbursed to the dealer at the end of the
month on one of two principles:
• Earn as the bank earns
• Reserves paid upfront
Earn as the Bank Earns
• The dealer receives his income in the same

way that the bank receives its income
• As loan payments are made by the consumer
the interest income is split between the bank
and the dealer
Reserves Paid Upfront
• Dealer will receive his share of the full finance

charge for all loans that are booked during
the previous month
• If account is prematurely paid off  amount
will be reduced by any income on prior loans
that must be rebated
• Loan tenure  60 month loan
• Loan paid off  in 36 months
• Hence Bank & Dealer will not earn the full finance
charge
• Hence Dealer must refund the unearned portion
that has already been paid to him
Adv. of Indirect Lending to Consumer
• Convenience
– Able to buy a product and simultaneously arrange
finance
• More flexible terms

– Loans for longer terms with lower down payments
• Liberal credit requirements

– Consumers who lack a strong credit record can
still obtain finance
Adv. to Consumer…
Convenience More Flexible Terms Liberal Credit

Requirements
Dealerships will Dealers offer loans for Car dealers advertise:
• Sell the vehicle • `First Time Buyer Plans’
longer terms with lower
• Close the loan and
down payments • `Credit To All Schemes’
• Customer can drive off
even before approval • This is because of …even to people with a
from the bank bad credit history
competitive pressures
Technology Special marketing
• “Dealer recourse” allows programs are arranged
• Websites put customer
in control of the buying banks to lend on a more • Either Dealer is willing
process liberal basis to take on part of the
• Here buyers can find credit risk
the vehicle and the loan • Competitive pressures
at the same time on banks
Disadv. of Indirect Lending to Consumer
• No opportunities for personalized credit

counseling
• Customer may not be able to compare product
and credit options
– The purchase could be an impulse than a
measured decision
• Dealers may use deceptive selling practices
– High pressure approaches
– Deals packed with unnecessary credit insurance or
warranty policies
– Unclear loan terms
Floor plan financing
Floorplan Financing
• “Floorplan lines of credit”

– From lender to retailers
• Commercial loans where the bank finances

the dealer’s inventory
– Dealership can use its funds elsewhere
• Dealers give priority to their floorplan banks

– Banks may reduce the amount of financing given
to inventory that has been in stock for a long time
Advantage of Floor Plan for Dealers
When shopping
Floorplan
for cars/white If the item is in
inventory the sale financing helps
goods customers
usually want can be closed dealers maintain
immediate immediately well stocked
delivery inventories
Secure And Unsecure loans
Secured & Unsecured Loans
• A loan for which an asset has been pledged

as collateral
• Lender has access to something tangible in
the event of default
• If Customer is unable/unwilling to pay, Lender
may take possession of the collateral
Secured loans…
Secured
loans
Depreciating Fluctuating Stable Appreciating

value value value value
collateral collateral collateral collateral
Categories according to the behavior of the collateral’s value over time

Depreciating Value Collateral
• These assets decline in value over time

• The bank takes on a collateral risk
– If it becomes necessary to take possession of the
goods, the bank may not be able to recover the full
amount due by selling the goods
• Examples of such assets

Automobiles Boats Trucks Airplanes
Recreational Mobile homes Motorcycles Equipment

vehicles
Illustration
• Cost of automobile: $30,000

• Loan amt: $25,000
• Loan period: 4 years
• After 2 years Customer defaults
• Unpaid principal: $18,330
• Bank takes possession of the car and hands it to an
agent
• Agent sells it for $16,400
• After paying agent’s fees etc. bank receives $15,500
• Loss to bank: $2,830
Factors
banks should
consider
when
securing DVC
loan
Value of
Depreciation Bank’s own
collateral at Market
pattern experience
time of environment
of the with the
making for the product
collateral product
loan
Factors…
1. Value of the collateral at time of making loan

– Value guides exist - like ‘National Automobile
Dealers Association (NADA) Used Car Guide’
2. Depreciation pattern of the collateral
– The pace of depreciation depends on:
• The type of car - Most cars depreciate; some classic
models may actually appreciate.
• The brand
• The location
• The manner of usage
– The more rapidly an item depreciates, the greater
is the credit risk for the bank.
Factors…
1. The market environment for the product

– Does a market exist for the product?
– If so, how easy is it to sell in the event of
repossession?
2. The bank’s own experience with the product type

Fluctuating Value Collateral
• The values of some items fluctuate over time

– Stocks
– Bonds
– Other marketable securities
• Fluctuations may increase credit risk and
make risk management difficult
• The bank has to assess the level of risk
– Some securities are inherently less risky.
– E.g. stock of a well established company with solid
earnings is more predictable
Stable Value Collateral
• These carry less risk than other types of

collateral
– Savings accounts
– Certificates of deposit
– Cash value life insurance
• Value can be determined from records
• Such loans are generally considered risk free
– They carry the lowest interest rates among all
types of consumer loans
– But losses may arise due to operational errors
Stable Value…Illustration
A lien on a
The client may
savings account
take advantage The bank will
that is serving as
by withdrawing then be left with
collateral is
most of the funds no collateral
suddenly
or all of it
released
Appreciating Value Collateral
• Some assets actually appreciate over time

• E.g. Real Estate appreciates over time
– There could be exceptions due to
• Neglect of the property
• Decline in the surrounding community
• Natural or man-made disasters
– These factors could cause an asset to decline in

value
Secured Loan
• A carefully made and well structured loan is

the best defense against loss.
• Collateral must be properly and legally
documented.
– Failure to properly identify and record the
collateral could result in the loss of its use as a
repayment source.
– If so the loan will effectively become unsecured.
Unsecured Loan
• A loan where no collateral is required or has

been offered
• Some banks restrict such loans to highly
qualified borrowers
• These loans are based on intangible factors
– Trust in the honesty, integrity and character of the
borrower
– The lender’s ability to properly evaluate the credit
risk
• These loans carry the highest rate of interest
and have the shortest maturities.
Bankruptcy
Bankruptcy
• Right to declare bankruptcy  envisaged as

an avenue for getting a second opportunity
for a fresh start in life
• Aims to enable parties to extricate
themselves from a crippling debt burden
Bankruptcy Law Chapter 7
• A Chapter 7 filing will normally completely

discharge all of a household’s unsecured
debt
• However the fact that a consumer has
declared bankruptcy under Chapter 7 will
remain on his credit record for 10 years
– This will impede his chances of getting a loan
subsequently
Bankruptcy…
• To file for bankruptcy the debtor has to submit
a petition listing his assets and debts to a
U.S. district court along with a filing fee

Bankruptcy…
• The court may not free the petitioner of

certain debts
– A lender may be able to establish that the debtor
submitted a false financial statement
– Or that he failed to declare all his other debts at
the time of borrowing
– Or if the debts are shown to have accrued on
account of illegal; transactions such as fraud or
embezzlement
– Any claims generated due to a drunken driving
incident are unlikely to be canceled
Bankruptcy….
• All waivers pertain only to unsecured loans
• Secured obligations such as auto loans have
to be paid off or else the asset will be seized

Bankruptcy Law Chapter 13
• A Chapter 13 filing on the other hand sets in

motion a new debt repayment plan to enable
the debtor to gradually work his way out of
trouble.
• The fact that bankruptcy has been declared
under Chapter 13 can remain on the credit
record for a maximum of 7 years.
Bankruptcy Chapter 13…
• In such cases the debtor agrees to make

regular payments to a Chapter 13 trustee who
will redirect the funds to the creditors.
• The petitioner hopes to keep possession of all
his assets, but hopes to pay less than the
total amount that is owed.
Bankruptcy Chapter 13…
• In order to be eligible for filing for bankruptcy

under Chapter 13
– The debtor must be in receipt of income from a
regular source
– He cannot owe more than $100,000 in unsecured
debt
– Or $350,000 in secured debt
• He must agree to abide by the court approved
payment plan
– And make all payments over a 3 to 5year period.
Bankruptcy…
• An individual cannot file for bankruptcy more

than once in six years.
• As a result some lenders may seek out newly
bankrupt persons
– Since these people cannot file for bankruptcy
again,
• They must repay any new debt that they take on
• And cannot escape their liabilities
Bankruptcy – last resort
• Experts say that if a borrower cannot see a

practical way to repay most of his obligations
over a five year period then bankruptcy may
be the only viable option.
• But obviously it is a measure of last resort
– Filers will experience tremendous difficulties in
borrowing afresh
– And the social stigma could persist for a long time
Laws
Laws
• Laws have been enacted to ensure

– The consumer loan market is equitable and fair
– The market operates under legal and ethical
practices
• The regulatory framework attempts to provide
protection for consumers & lenders
– Lenders Ensure equal access to credit
– Consumers  See that borrowers are well
informed
State Laws
• In addition to Federal laws there are state

laws
• The states have control over
– Interest rates charged
– Contractual provisions that may be used in credit
transactions
– Maximum loan maturities
– Fees that can be imposed
Laws pertaining to disclosure
Laws pertaining to disclosure
• Law requires that all relevant info about terms
of a loan must be made available to the
borrower before a commitment is made

Truth-In-Lending Act
• Formally known as ‘The Consumer Credit

Protection Act’
– Implemented by Regulation Z
• Protects borrowers in credit transactions < $25,000
• These credit transactions are intended primarily for
– Personal
– Family
– Household
The Consumer Credit Protection Act
1. Truthful disclosure of terms by the lender
2. Defines and prohibits extortionate credit
practices
3. Created ‘National Commission on Consumer
Finance’ to oversee enforcement of the law

TILA…
The Law for Lenders The Law for Customers

They have to provide sufficient Right of Recession 
information about a credit contract
in easily understood terms Customers can cancel a credit
agreement within 3 business
They need to assist the consumer
to make an informed and days if their home is included
intelligent decision as a part of the collateral
They must tell Customer the
annual % rate of interest (APR)
being charged on the loan
Those who fail to adhere to the
Act can be sued
TILA…
• The law does not

– Dictate who the lender should lend to
– Specify what rate of interest he should charge
Finance Charge
• Finance Charge  Total dollar cost

associated with the loan
– Sum of all charges that the customer must pay as
a condition for securing the loan
• Finance Charge has to be disclosed
• Finance Charge includes
– Credit investigation fees
– Insurance to protect the lender
– Points on the loan for recovering administrative
expenses
TILA Illustration
• Loan amount = $25,000

• To be repaid in  8 equal quarterly installments
Each installment $3412.75

amount
Total payment made 3412.75 x 8 = $27,302
by the borrower
Finance Charge $27,302 – $25,000 =
$2,302
TILA…
• Once the Finance Charge is determined, it must be

converted to the APR by comparing it with the
amount of the loan.
• The Act makes it easier to assess a loan offer since
all lenders must compute the APR in the same
manner.
– This makes it easier for the borrower to shop around.
• The Act also covers advertising.
– A lender who chooses to advertise an attractive feature of a
credit package must also disclose all other relevant terms of
the loan.
TILA…Example
A car dealer
He must also
advertises the
disclose other
fact that he is
aspects of the
asking for a low
loan
down payment
How many The quantum of

payments are each payment
required in all
The Fair Debt Collection Practices Act
• Puts a limit on how far the collection agency

may go in pressing a customer to pay up
– Bill collectors cannot harass debtors or use
misrepresentation to gain information
– Calls made at unusual times will be treated as
illegal unless they are made with the permission of
the borrower
– While making a call the collection agent cannot
disclose the purpose of the call to anyone other
than the debtor
The Fair Credit Reporting Act
– To establish – To establish requirement for

acceptable purposes handling any adverse credit
for which a consumer decisions that resulted in whole
credit report may be or in part from information
obtained contained in a credit report
– To define the – To define consumers’ rights
responsibilities of a regarding credit reports, with
credit reporting agency emphasis on
– Their right to request and
receive their reports
– A procedure for correcting
inaccurate information
Credit bureaus
• These bureaus supply lenders with

information on
– Amounts owed to various parties
– On payment records
– Credit ratings of individuals and families
• The bureau has to respond if an inaccuracy is
established
– it must either correct it
– Or it must remove it
Credit bureaus…
• Analysts recommend that customers check

their reports several months before applying
for a major loan.
• Credit bureaus cannot disclose information
that is more than 7 years old, unless
– A loan of $50,000 or more is being sought
– Life insurance is being purchased
– A job paying $20,000 or more is being applied for
– Personal bankruptcy has been declared
FCRA…
for Consumers for Lenders

The Act entitles consumers Lenders may request a
to have access to their credit report from an
credit files being agency when they have
maintained with credit received a legitimate
bureaus application for credit
The consumer can review Lenders can also obtain
his credit file at any point of updated reports on
time consumers who have
already availed of loans
FCRA…
for Consumers for Lenders

He can challenge any item and Data contained in the files can
demand an investigation be shown only to identified
individuals for approval
purposes, based on a written
request by the consumer
The consumer may sue if he can
establish that he was damaged
due to incorrect information
If consumer feels that an item in
the file is misleading & merits
clarification, he can insert his
version in 100 words or less
Prescreening
• The FCRA does not prohibit lenders from

“prescreening” prospects
– It is the process of comparing consumer names
against credit reporting agency files to identify
consumers who meet certain predetermined credit
criteria.
Prescreening process
Banks provide Credit reporting

Banks provide agencies
‘consumer name’
compare
predetermined lists to credit consumer names
‘credit criteria’ reporting against ‘credit
agencies reporting agency
files’
Credit reporting
agencies then
furnish the bank
Note: Banks do not get to see with a list of
the individual credit reports of people who meet
parties who meet the criteria the criteria
Prescreening process – post 1996
Rules for prescreening changed in 1996 Credit reporting

Banks provide agencies
‘consumer name’ compare
Banks provide consumer names
predetermined lists to credit against ‘credit
‘credit criteria’ reporting reporting agency
agencies files’
Bank must offer credit to all those Credit reporting

who meet the defined requirements agencies then
furnish the bank
with a list of
Additional requirements may not be people who meet
imposed to prune the list further the criteria
The Fair Credit Billing Act - 1974
• It permits customers to dispute billing errors

with a merchant/card company and entitles
customer to receive a prompt investigation.
FCBA…
for Consumers for Merchant

Such a consumer cannot be
The consumer may withhold reported as delinquent or be
payment on the disputed forced to pay interest penalties
until the dispute is settled
section of the bill until the Any creditor who does not
respond or does not investigate
investigation is complete
or attempt to solve the matter
must forfeit the disputed charge
up to a maximum of $50
Lenders are required to give 30
day notice before altering the
credit charges or the service fees
Consumer Leasing Act of 1976
• Companies are required to declare essential

items of a lease which involves personal
property such as a car
• Customers must be informed about
– All charges
– Any required insurance
– Cancellation terms and conditions
– Penalties for late payments
– Warranties
Laws pertaining to credit discrimination
The Equal Credit Opportunity Act of
1974
• Implemented by the Federal Reserve Board’s Regulation B
• It is an anti-discrimination law
• It prohibits a lender from treating a borrower more or less
favourably than another in any aspect of a credit
transaction
• This Act affect all aspects of consumer credit
– A bank’s procedure for taking a loan application
– Credit evaluation criteria
– Adverse action notifications
– Record keeping requirements
Equal Credit…
Race
Income Color
No
discrimintn
Age Religion
based
on
Marital National
Status Origin
Sex
Equal Credit…
1. Race and Color

– Questions about these factors are prohibited
2. Religion
– Questions about religion are prohibited
3. National Origin
– In principle nationality cannot be used as a factor
for a credit decision
– Non-citizenship and/or immigration status may
be considered to the extent that they may affect
the lender’s ability to recover the debt
Equal Credit…
1. Sex
– It cannot be used as a factor
2. Marital Status
3. Age
– Age may be considered when it is used to favour
an elderly applicant in obtaining credit
– Age can also be used as a part of a credit
scoring system provided that elderly applicants
are not penalized
Equal Credit…
1. Income
– Lenders are required to consider likely consistent
income from
• Alimony
• Child support
• Maintenance payments
– Income from welfare or public support programs
may also be taken into account
– The regulation prevents lenders from
disregarding income from
• Part time employment
• Or from a woman of child bearing age
Adverse Action
A lender refuses However he is He must make a

to grant credit to willing to make a counteroffer by
an applicant for loan on modified suggesting an
the requested terms alternative
term and amount
If the counteroffer
If the counteroffer
is accepted, no
additional is not accepted,
disclosures need an “adverse
be made by the action notice” has
lender to be sent
Adverse Action…
• According to Regulation B
– Lenders must notify applicants in writing of an
“adverse action” within 30 days of receiving a
completed application in the case of new
applications
– Or after taking adverse action on an existing
account
• Terminating a line of credit
Community Reinvestment Act of 1977
• It has no direct implications for individual loan

applications or decisions
• It however affects the bank’s
– Overall lending strategy
– Marketing efforts
– Lending policies
Community Reinvestment…
• Financial institutions have to make an

affirmative effort to meet the credit needs of
low and middle-income customers
• Every commercial and savings bank is
required to define its own local `trade
territory’.
• It must describe the services that it proposes
to offer in that area
• All services have to be offered without

discrimination to all residents of the trade
territory.
• The Act prohibits the marking out of certain
neighbourhoods as undesirable
– Lenders cannot refuse to extend credit to a party
merely because its address places it in an
excluded area
• Once a year each institution has to prepare

an updated map that shows the trade
territory, without deliberately excluding low or
moderate income households
• Customers can make written comments
concerning the lender’s performance in
meeting local credit needs.
– These comments have to be made available for
public inspection.
• Every lender’s performance in making an

affirmative effort to serve its trade territory is
evaluated by bank examiners who assign a
CRA rating.
• The rating is taken into account in the
following circumstances
– When a bank applies for permission to open a
branch
– When it requests approval for a merger or an
acquisition
– When it seeks permission to offer new services
FIRREA of 1989
• FIRREA  Financial Institutions Reforms,

Recovery and Enforcement Act
• It requires public disclosure of a bank’s CRA
rating
– This is done to ensure that customers are aware
of the extent to which a bank is providing broad
based support to its local community.
• Every bank must place its CRA evaluation in
a public file at its Head Office and in at least
one office in each community that it serves
– Within 30 days of receiving the examiner’s report
FIRREA…
• The possible CRA ratings are:

O – outstanding
S – satisfactory
N – needs to improve
SN – substantial non-compliance
• Small banks with an outstanding rating are

exempt from obtaining a rating for as long as
5 yrs. in order to reduce costs.
FIRREA (Cont…)
• CRA is intended to remind banks that they

have a special relationship with their
communities
• And that it is not acceptable to serve the
credit needs of foreign borrowers or of remote
businesses while neglecting the borrowing
needs of local businesses and individuals.
Predatory lending
Predatory Lending
• The term refers to the tendency to offer loans

to weak borrowers in return for abnormal fees
and interest rates.
• This segment of the market is called the Sub
Prime market.
• Some predators will insist on unnecessary
and expensive loan insurance well beyond
the amount required to offset the credit risk.
Trends in Consumer Lending
Trends…
Trends…Lenders Trends…Customers
Control credit quality - Lenders More convenience - Customers

will have to provide facilities while are demanding faster access to
taking care to ensure that they credit via Internet and the
have enough control to avoid a telephone.
deterioration in credit quality
Preapproved loans - Aggressive Point of Sale credit - Customers

high volume lenders are pushing want credit to be made available
the concept of instant credit by at the point of purchase.
offering Preapproved Loans
Trends…
Trends…Lenders Trends…Customers
Using dealers - Today many Prior approval - Customer

banks offer loans through mails/phones his credit
automobile / home appliance information to the bank prior to
dealers. The dealer prepares a making the purchase. Once
credit agreement and then approval is granted the
contacts the bank for quick customer can go to the
approval showroom where dealer has to
simply verify with the bank that
approval has been granted
Trends…
• Need for a customer to enter a bank for loan

has been reduced.
– Consequence  Growth in indirect lending
– Benefits 
• lower transactions costs
• greater convenience of operation
– Flip side  Since decisions are made speedily,
credit may be extended to a party who does not
merit a loan
Paying off a loan
Loan Repayment
3 ways of
repaying a loan
Equal total
Equal total
payments Equal principal
payments with a
or payments
Balloon payment
Amortized method
method
method
The Amortization Method
• The borrower pays off the loan

– in a series of equal payments
– at equally spaced intervals of time
• The payments constitute an annuity
• Present Value of the annuity = Loan amount
• Each payment consists of
– interest on the outstanding principal (as at the time
of the previous repayment)
– plus a principal repayment
Amortization…
• With each successive

payment the
outstanding principal
will decline. Outstanding
Principal
• Since the payment is Fixed payment

fixed, the interest Interest
component of each component
payment will decline
over time, while the
principal component will
Principal
increase
component
Illustration
Customer name Albert Ford
Loan purpose To buy a car
Loan amount $25,000
Loan taken from Wachovia Bank

Bank’s interest rate 8% p.a.
Loan repayment 8 equal quarterly instalments
Loan repayment period 2 yrs.

Illustration Calculations
• P.V. of the 8 quarterly payments = $25,000

• Interest rate per quarter = 2%
Illustration…
• An amortization schedule showing the break

up of each installment into an interest
component and a principal component, as
well as the outstanding balance after each
payment, can be drawn up.
Amortization schedule
Time Pmt. Interest Principal Out. Bal.

0 25,000.00
1 3412.75 500.00 2912.75 22087.25
2 3412.75 441.75 2971.00 19116.25
3 3412.75 382.33 3030.42 16085.83
4 3412.75 321.72 3091.03 12994.80
5 3412.75 259.90 3152.85 9841.95
6 3412.75 196.84 3215.91 6626.04
7 3412.75 132.52 3280.23 3345.81
8 3412.75 66.92 3345.83 -0.02
Illustration Calculations
• Outstanding balance = $25,000

• First payment = $3412.75
• First payment includes interest @ 2% on the
outstanding balance of $25,000
• Interest = $500
• Principal repayment = $2912.75
• Outstanding balance after this repayment =
$22087.25
The Equal Principal Repayment Method
• The principal is repaid by way of 8 equal
installments
• (Principal / No. of months) = Installment amount
• In previous illustration
– (25,000 / 8)= 3125

Equal Principal…
Interest
• Every period interest component
component will decline
since outstanding
principal is steadily
reducing Total payment
• Since principal Interest Principal
component component
repayment is a
constant; the interest
payment is declining;
and the total payment is
declining
Illustration
Time Interest Principal Tot. Pmt. Out. Bal.
0 25000.00
1 500.00 3125.00 3625.00 21875.00
2 437.50 3125.00 3562.50 18750.00
3 375.00 3125.00 3500.00 15625.00
4 312.50 3125.00 3437.50 12500.00
5 250.00 3125.00 3375.00 9375.00
6 187.50 3125.00 3312.50 6250.00
7 125.00 3125.00 3250.00 3125.00
8 62.50 3125.00 3187.50 0.00
Equal Principal…
Positives Negatives
It incurs less total interest It requires higher total
over the life of the loan payments in the earlier
since the principal is repaid years when the ability to
more rapidly repay may be limited
Since principal is repaid
more rapidly, interest
deductions for the purpose
of tax rebates will be lower
Equal Payments with a Balloon
• Repayment  8 equal quarterly installments
• Balloon  There is a balloon payment of
$8,000 at the end of 2 years

Illustration
Time Pmt. Interest Principal Out. Bal.

0 25000.00
1 2480.67 500.00 1980.67 23019.33
2 2480.67 460.39 2020.28 20999.05
3 2480.67 419.98 2060.69 18938.36
4 2480.67 378.77 2101.90 16836.46
5 2480.67 336.73 2143.94 14692.52
6 2480.67 293.85 2186.62 12505.70
7 2480.67 250.11 2230.56 10275.14
8 10480.67 205.50 10275.17 -0.03
Part-05
Bank Cards: An Introduction

Introduction
The Impact of Cards
• Every second of every day, someone / more than one

person, is
checking into a using an ATM Such transactions are

hotel
typically rendered with a bank
card
renting a car buying goods

Introduction
• 1950s: Bank cards were first introduced in the U.S.
• Today, in less than 50 years:
 >1.5 billion cards are in use worldwide
 accepted in 20 million+ retail locations across the world
 the preferred mode of payment for more than 10% of
global transactions
• The first bank cards to make an appearance

were Credit Cards.
• Commercial banks in U.S. East Coast were
active in the customer loan business.
– They had a well established process for
underwriting credit – it was called the
Secured Installment Loan.
Secured Installment Loans
Secured Installment Loans
Customers first selected

They then went to a bank to
an item that they intended
apply for a loan
to purchase
They made a pledge that if they

failed to pay as per the agreed
upon terms, the bank could
repossess the item for which the
debt had been created, and sell it
to recover the debt
Problems faced
• This process worked fine for the bank but not for the consumer
or the merchant
Consumer Merchant
They faced the inconvenience / They had to wait for the
delay associated with customer to return with the
–Going to the bank money to make the purchase
–Applying for a loan
–Awaiting the bank’s decision
–Receiving the funds
Be stuck with unsold
merchandise if the bank
rejected the loan application
Precursor to modern credit card
A Novel Idea
One of the banks came up with a novel idea.
For the customers
It offered to Approved
approve credit for customers were
consumers before issued a special
they found an item currency created for
to purchase this purpose
For the merchants
The bank entered into All the merchant had to do It was

agreements with local was to deposit the currency credited just
merchants to accept in its account with the bank like any
this currency other deposit
A Novel Idea
For the bank
The bank would

then in turn bill the
customer in This would be at a
installments for the previously agreed
amount of the upon rate
special currency
used
An improvement
In the early 1950s, the Franklin National Bank of New York improved
upon this idea.
For the customers
It offered to Approved
approve credit for customers were
consumers before issued a special
they found an item cardboard created
to purchase for this purpose
For the merchants
The bank entered into The merchant had to transfer And deposit
agreements with local the information contained on the slip at
merchants to accept the card to a slip that the the bank
this cardboard bank had given it
An improvement…
For the bank
The bank would credit the

merchant’s account for the
dollar value of the sale less
the bank’s discount rate for
facilitating the transaction
Advantages
Bank Merchant Customer

The bank Merchants no Consumers could
eliminated the longer had to wait buy what and when
expenses involved for loan approvals they needed
with underwriting or disapprovals without the
each individual sale inconvenience and
delay of going to
the bank
Consequently they
could better
manage their
inventories
Initial problems
Problems
• Consumers became more and more mobile.

• The issuing of cards acceptable only to
merchants in the bank’s local trade area was
limiting the growth of the business.
• The solution was devised in two very different
ways.
– by Bank Americards
– by Interbank
Bank Americards
• By the early 1960s the card phenomenon was

sweeping the country.
• Bank of America on the West Coast was the largest

issuer and had the most advanced bank card
operating system.
• Consumers demanded that cards be valid at

locations beyond the geographic scope of the issuing
bank
Bank Americards
Bank of America began to

The approach greatly
license its brand “Bank
expanded the number of Bank
Americard” and its
Americards in circulation
operating system to other
banks throughout the
country
This lead to enormous
growth in the number of
merchants accepting the
cards
Interbank
• On the East Coast however, a number of

banks were large card issuers, each
operating its own system of servicing
cardholders.
– This meant that licensing a common system and
card brand was not feasible.
• Instead 13 card issuing banks agreed to add

a common symbol to their cards and
merchant acceptance locations.
Interbank
The symbol chosen was a

The participating banks formed
small black letter ì’ for
the Interbank Card Association
Interbank
All its members agreed to

accept cards issued by
other members at their
merchant acceptance
locations
Importance of card associations
The Card Associations
• Over the next several years Bank Americard

and Interbank grew
– in terms of the number of member institutions
issuing and accepting cards
– as well the total number of cards issued
– soon it became apparent that these associations
needed to be independent of the banks that
formed them.
Associations (Cont…)
• In 1976 Bank Americard became a separate
institution called VISA.
• Interbank thereafter changed its name to
MasterCharge and later to MasterCard.

Associations (Cont…)
• VISA and MC dominate the cards market.

1. VISA accounts for >1/2 of global purchases
2. MC ranks second
3. American Express is third
• Neither VISA nor MC earn profits
– both are structured as for profit corporations.
– they are operated on a break even basis
– they cover their costs with fees levied on their
membership which runs into thousands of banks
Managing the Associations
• The associations have their own management

and employees.
• They are owned by the member banks that
issue their cards
– The BODs are elected by and have representatives
from their member banks.
• Member banks are allocated votes based on the
volume of various products that they offer
– A bank may be a member of both MC and VISA
• However it may serve on the board of directors of only
one
Responsibility of Board
• The board appoints the management which

hires the staff, and which is responsible for:
a) Developing operating regulations
b) Processing transactions and interchange
payments between members
c) Developing system wide innovations such as
interchange technologies
d) Promoting the brand through advertising
e) Coordinating matters such as fraud control
VISA membership
• Eligibility:
– Any financial institution that is eligible for FDIC
insurance is eligible for VISA membership.
• Non-eligibility:
– Companies issuing cards that compete with VISA,
are precluded from issuing VISA cards.
– E.g. Discover or American Express
Membership of Associations
• To become a member, an institution must

pay an initial service fee that depends on:
a) The type of membership that is applied for
b) The type of cards to be issued
c) The number of accounts

Acceptability
• All issuing and accepting banks can operate

one common universal technological platform
– A card issued in Belgium can be accepted in New
York
– And the transaction can be routed back to the

issuing bank in Belgium.
Acceptability (cont…)
1. Possible because merchant is willing to accept a

VISA/MC bank card due to the brand acceptance
rules created by the associations.
2. By creating and maintaining uniform rules /

standards for participation, the associations assure
all participants that their potential for profit / freedom
from loss will be protected as long as they comply
with the rules.
Card types
Card Types
• A card can be issued by any financial

institution:
– A bank
– A services firm like an insurance company
– Or any other non-bank issuer
• The card accesses a client’s financial
resources whether they are
– Funds on deposit
– Preauthorized loans that constitute an established
credit line
Card Types
• Cards are classified at times by the issuing
organization
Card types
Travel &
Bank cards Entertainment House cards
cards
These are issued by These are issued These are valid only
commercial banks. They by agencies like at the stores of one
carry logos like VISA, American Express chain. E.g. Sears is
Mastercard, Discover or Diners Club the biggest
Credit Cards
a. They have VISA / MasterCard brand on
them
b. Clients can access the credit limit assigned
to them by the financial institution
– to make purchases
– obtain cash
c. The card holder has the option to pay the
billed amount
– in full every month
– spread his repayment over time at an agreed
upon interest rate
Charge Cards
a. Function like credit cards but may not have

a credit limit
b. Card holder has to pay each month’s
charges in full
– no option to pay in installments
c. Cards may be branded as
– VISA
– MasterCard
– American Express
– Diners Club
– Carte Blanche
Debit Cards
a. Branded as VISA / MC
b. Most of those locations that accept credit
cards also accept debit cards
– to make purchases
– obtain cash
c. Debit cards access a deposit account with
the institution, not a credit line
d. Function very much like personal checks
e. They can be used
– In the online mode
– In an offline mode
Online vs. Offline
Online mode Offline mode

Online debit cards are Offline debit cards are
referred to as PIN based referred to as Signature
based
Online transactions ask The transaction may or may
customers to endorse not be authorized at the point
payments by submitting PINs of sale. Offline transactions
at the point of sale. E.g. require shoppers to sign sales
Electron and Maestro cards receipts
PIN based debit transactions
are fast, convenient, secure
Online vs. Offline
Online mode Offline mode

Money is transferred into It will be settled by the
storeowners’ accounts in two merchant and the financial
to three business days & institution at some time after
merchants pay a nominal the transaction is completed
transaction fee
Merchants authorize a debit The funds are consequently
card transaction at the Point not debited from the deposit
of Sale and the funds are account immediately.
deducted from the client’s
deposit account immediately
Requirements for online mode
• To accept online debit payments the

merchant must have
– A merchant account
– A debit processing service
– A payment terminal
– A receipt printer
– A PIN pad
• Many payment processing companies offer
both credit and debit card services
– The merchant must be approved for them
separately
Check cards
• Offline debit payments do not involve PINs

• Such cards are called Check Cards
• They may be used wherever credit cards are
accepted
• Since check card transactions are processed
through the same networks as credit cards
– They often incur the same discount rates and
transactions fees
Check cards
The process
Merchants swipe the cards

through their payment The customers then
terminals and complete the sign sales drafts that
debit sales in the same way authorize the
that they process credit card merchants to charge
transactions their accounts
Debit cards
Advantages Disadvantages
Merchants like them because It is more painful to resolve a
they get instant payment without problem with a purchase if the
worrying about bad checks money has been debited to
your account than if it is just a
demand to pay as in the case
of a credit card
Some consumers prefer them
because they allow them to only
spend the money they have
thus avoiding the temptation to
overspend on credit
Debit Cards – Investor protection
• An investor can protect himself by signing for

a debit card purchase just like he does for a
credit card purchase.
Debit Cards – Investor protection
Swipe your debit card at
the merchant terminal
Select `credit’ on the PIN. The

merchant will ask you to sign for Select `debit’ on the PIN and
the purchase instead of using enter PIN numer
your PIN on the pad
The charge will still be debited A purchase liability limited to

from your checking account on $50 is completed
the spot
But the charge gets processed This is true only if you notify
through the VISA processing the card issuer within two
network thereby activating VISA’s business days of the loss or
zero liability policy theft of your card
Other card types
Other card types
Retailer or Store
ATM cards Affinity cards
cards
ATM Only Cards
• Clients can access deposit accounts at a

financial institution using an ATM
• Such cards may sometimes also be
acceptable at local merchants for purchases
• Unlike credit cards and debit cards these
cards do not carry the MasterCard or VISA
logo
• Their use is limited to ATMs and participating
merchants
Retailer or Store Cards
• These are issued by

– Oil companies
– Departmental stores
– Specialty shops which issue their own cards
• The cards function like credit cards except

that the card and the credit line are
accessible only for purchases from the
merchant who issued the card.
What is an affinity card?
• Such cards carry the logo of an organization

in addition to VISA / MC logos
• Card users receive some sort of benefit by
using the card, such as
– Frequent flyer miles
– Points towards merchandise from a catalogue

Affinity Cards (Cont…)
• The organization solicits all its members to acquire

cards
– The idea is to keep their name in front of the card user
– And keep him loyal to them for future purchases
• The organization also receives a financial incentive
– A fraction of the annual fee or the finance charge
– Some small amount per transaction
– A combination of the two
• Organizations usually do not get much money out of
these cards
– Most of the profits go to the card issuer
• Such cards are also known as co-branded cards
Storing information on bank cards
Storing Information on Bank Cards
• There are two ways by

Storing
which a financial information
on a card
institution can store
information on a card
issued by it.
Magnetic
Chips
stripes
Magnetic Stripes
• A thin magnetic stripe on the back of the card

enables the card to carry important client data
and account information encoded on it.
• The stripe is read by ATM and Point of Sale
authorization devices when the plastic is
swiped through the card reading machine.
Chips
• Chips are an improvement on magnetic
stripes
• They have a small computer microprocessor
embedded on their face.
• It has a more powerful memory than the
traditional magnetic stripe.
• It also has some computational capability that
enables it to perform functions beyond simply
holding client account information.
• ATMs and POS authorization devices require
different technology to read Chips and
Magnetic Stripe cards.
Which is a Better Card?
• A typical question users ask is

– Is MasterCard better or is VISA?
• In the U.S. almost any establishment that

takes MasterCard also takes VISA and vice
versa.
• Thus for card users in the U.S both types of
cards may not be needed.
Better Card? - Comparison
VISA MasterCard American Express /
Diners
In the U.S. almost In some countires in These were originally
any establishment Europe (e.g. France) any aimed at the upscale
that takes bank or cash machine, can Travel and
MasterCard also give an advance on a Entertainment market
takes VISA and vice VISA card, but very few
versa can give a MasterCard
cash advance
In some countries Accepted at many
the two networks places but less than
have been merged VISA/MC. But some
and ALL merchants locations that do not
who take one also accept VISA or MC
take the other accept AMEX
Amex – Advantages in Europe
• The AMEX card used to be very handy for

traveling in Europe.
– It allowed personal checks drawn on a U.S bank to
be cashed at an AMEX Office.
• These days however, VISA or MC can give cash
advances at a local bank at a better rate.
– AMEX also holds mail for their customers at their
offices.
• If you don’t know where you are going to be staying
have the mail sent to an AMEX office.
Secured and Unsecured Cards
Secured Cards Unsecured Guaranteed

cards cards
These require client to Regular cards are It is the same
make a bank deposit up unsecured as a secured
front. Limit on the card is card
related to the deposit
amount
The bank has the right to The bank can’t It is typically
take money from the take over your offered through
deposit if you don’t pay assets in the a 900 number
your bill event that you
don’t pay your bill
Secured and Unsecured Cards…
Secured Cards Unsecured Guaranteed

cards cards
These are usually sold to It can only sue The associated
people who have credit you or force you costs may not
problem or can’t get a into bankruptcy make them
regular card worthwhile
A secured MasterCard or
VISA looks just like a
regular card and the law
ensures that it has all the
same consumer
protections
Credit types
Credit Types
• There are two types of credit that banks offer
Types of credit
Revolving credit Installment credit
Credit cards are The more traditional

always structured to form of credit
offer loans on a associated with
revolving credit basis financial institutions
Installment credit
The Borrower
A borrower He specifies the
applies for a loan amount that he
from a financial wants to borrow
institution
The Financial Institution

The institution sets the The financial It obtains
repayment terms for institution reviews additional
the amount. E.g. the application information
interest rate, number information such as a
of installments, submitted by the credit bureau
prepayment penalties borrower. report
Installment credit
If loan is approved
The borrower is A monthly

advanced the full payment plan is
amount established that is
followed till the
loan is repaid in
full
Revolving credit
The Borrower
A borrower applies With a
to the institution to He may have no
revolving
establish a credit set limit in mind
line credit plan a
borrower may
The Financial Institution get loans and
The institution It must take into pay them back
underwrites the consideration that the on numerous
application the way borrower may borrow occasions over
it would for an at any time in the future
installment loan so long as the credit a number of
line remains open. years
Risk Exposure
Installment lending Revolving lending
A. Installment lending is a A. The client decides how
one time transaction much and when to borrow
by accessing the credit line
via credit cards or checks
A. The institution has its A. The institution may have
maximum exposure the no exposure whatsoever
day the loan is approved the day the credit line is
and the funds are approved. Once the client
advanced to the borrower initiates a loan there is risk
for the institution
Risk Exposure…

A. Each month brings a A. The institution bills the
reduction in the amount of client monthly for all loans
loan exposure a financial outstanding. Each month
institution has to the client the client has the option of
– paying the full amount and
creating additional loans,
– or continuing to pay down
the balance for existing
loans thus triggering interest
and other charges.
Risk Exposure…

A. When the loan is repaid in A. The loan is never really paid
full there is no future risk in full with the institution’s
for the financial institution exposure being reduced to
zero. Even if client does not
create a new loan for
several months the credit
line remains available to the
client & he can always
initiate a loan
Risk Management

Installment loans require Revolving credit requires
the institution to make a that the institution has in
lending decision at a single place monitoring
point in time based on the capabilities to ensure that
information available from each time a client initiates
the loan application and a loan the institution is
other sources comfortable making a loan
at that point in time
Secured vs. Unsecured Loans
• Most installment loans tend to be on a

secured basis
• Unsecured lending is a more risky proposition

Secured loans Unsecured Loans
With a secured loan the The borrower is not required
institution grants credit in to offer collateral
exchange for an interest in
some type of collateral
The collateral may be the The institution makes its
item purchased or some lending decision based on
other asset that is owned by the borrower’s borrowing
the borrower such as an history and its knowledge of
amount on deposit with the any other relationships the
institution itself borrower may have with the
lending institution
Secured loans Unsecured Loans
If the borrower does not If the borrower does not
repay as agreed, the repay as agreed the
institution has the right to institution has no security
repossess the collateral and interest in any collateral
sell it to recover the amount
outstanding
Flow of a bank card transaction
Flow of a Bank Card Transaction
• How does a bank card transaction work?

• How is it that a customer living in Bangalore
is able to use a credit card issued by a bank
in Mumbai, at a retail outlet in Singapore?
• A simple credit card transaction may be
broken up into the following steps.
The Flow
A cardholder He offers the If required to do so
decides to merchant a card to by card association
purchase an item pay for it rules, the merchant
will obtain an
authorization for the
transaction amount
The merchant will send the and will complete
transaction data to its the sale
acquiring financial
institution
Flow…(cont…)
• Who is the acquiring financial institution?

– It is the entity that clears the transaction on behalf
of the merchant
– It is the entity that takes the responsibility for

paying the merchant the value of the transaction.
The Flow
The acquiring institution will The associations, through the
transfer the transaction data Interchange System, route the
into the Interchange System transaction to the issuing
operated by the card financial institution
associations The issuing institution is
the one that issued the
credit card
The issuing institution will then

post the transaction on the
cardholder’s monthly billing
statement and will collect the
payment from him
Participants’ Roles & Responsibilities
• Each of the participants supplies a number of

critical inputs to the process.
• It is important to understand what each
participant does in order to make the process
work.
International Interchange system
• We will look at the following roles in the
system
– Role of the Merchant
– Role of the Acquiring Bank
– Role of the Association
– Role of the Issuing Institution
– Role of the Cardholders
The Role of the Merchant
• The merchant is required to

A. Capture data about the cardholder
• By reading the chip embossed on the card or by
swiping the magnetic stripe contained in it
B. Initiating the processing of the transaction

• This may include checking the cardholder’s
identity by asking for a signature or a PIN
C. Starting the authorization process

Authorization
• This is a critical input because it provides the

confidence for the cardholder being in a
position to pay
– for the issuing institution,
– to the acquiring institution,
– to the merchant himself
Online Authorization
• Most transactions are authorized online.

– by the card issuer who instructs a specific
payment to be made from one of the cardholders’
accounts
• The percentage of transactions authorized
online varies from country to country.
– In France it is less than 30%
– In the U.K it is more than 70%
– In the U.S it is more than 99%
Authorization (Cont…)
• Every merchant in the MasterCard and VISA

networks has a limit for transactions at their
stores.
• The details of these limits are held either by

the merchant or by the acquiring bank.
Authorization (Cont…)
• When the magnetic card is swiped in the

terminal it sends an authorization request
containing
– The card number
– Transaction amount and currency
– Transaction time and date
– Merchant ID, name, location and type
– Acquirer and issuer IDs
– Other card security information
Authorization process
Authorization The bank will The Association
request information transmit to MC / concerned will send
is sent to the VISA it to the
merchant’s bank cardholder’s bank
requesting
authorization
The Association will then The Issuing Bank

pass the information will approve the
back to the merchant’s purchase and send
bank for transmission to the approval to
the merchant MC/VISA
Authorization time
Authorization The bank will The Association
request information transmit to MC / concerned will send
is sent to the VISA it to the
merchant’s bank MC/VISA carry out their cardholder’s bank
part in milliseconds requesting
The banks involved authorization
can be anywhere in The total time taken depends on how
the world long the cardholder’s / merchant’s
The Associationbanks
will then
take to process the request
The Issuing Bank
pass the information will approve the
back to the merchant’s purchase and send
bank for transmission to the approval to
the merchant MC/VISA
The Role of the Acquiring Bank
A. It enables merchants to sell to millions of

people worldwide by allowing them to accept
cards in payment for purchases.
B. It provides merchants the equipment and
training needed to accept cards.
C. It acts as the interface between the
merchant and MC / VISA.
D. It works with the merchant to resolve any
cardholder disputes.
The Role of the Associations
A. They manage their brands & create and
maintain worldwide brand acceptance.
B. They provide the clearing and settlement
systems required by issuing and acquiring
institutions.
– The clearing systems used for authorization and
the exchange of transaction information are
known as
• BASE I in VISA
• INAS in MC
– The settlement system used to transfer funds is
known as
• BASE II in VISA
• GCMS (Global Clearing Management System) in MC
…Associations (Cont…)
A. The associations create and maintain the

rules that govern the use of the interchange
system thereby ensuring that transactions
will be paid and funds transferred as long as
the rules are followed.
The Issuing Institutions
A. They issue cards to cardholders who can use

them in all merchant locations signed up to
accept MC / VISA
B. They extend credit or manage cardholder funds
on deposit in order to facilitate transactions at
merchant locations
The Issuing Institutions …
A. Pay the acquiring bank for transactions carried

out by the issuer’s cardholders – this is called
Settlement
B. They fund cardholders’ transactions including
the grace period and periodically bill and collect
payments from cardholders – rather than doing
so on a transaction by transaction basis
The Cardholders
A. They use the cards for purchases

• For availing of credit in the case of credit cards
• or For availing of cash advances
B. Their responsibility consists of using the

cards as per the agreement with the banks,
and for repaying debts promptly.
Card charges and expenses
Charges - Merchant
• The merchant who sends the bank card data
to the acquiring financial institution is not
credited with the full amount of the
transaction.
The acquiring institution deducts a fee for
providing its services - called the Merchant
Service Commission (MSC) or the Discount Rate.
MSC = %(transaction amount)
E.g. if MSC = 2.5%, then on a $100 transaction
• The merchant will get $97.50
• And the acquiring institution will get $2.50
Charges – Acquiring Institution
• The acquiring institution does not keep the full

commission with itself.
– It must pay a fee to the issuing institution
– The fee compensates the issuer for

• the expenses incurred
• the risk taken in issuing a card

Expenses - Issuer
• The issuer incurs the following expenses in

connection with credit card transactions
– He must first pay and then collect from the
cardholder.
– He must send monthly bills to the cardholders.
– He must collect payments from them.
– He must offer a grace period to the cardholders.
Fee - Issuer
• The fee that is paid to the issuer by the

acquirer is a part of the clearing process.
• The fee is set by the card association
concerned.
• They may vary by
– The type of the merchant
– The location of the transaction
– The manner and timing of the transaction
Charges - Cardholder
• Why do MC or VISA cards carry different

rates and fees?
• The rate is set independently by the bank that
issues the card.
• A given bank may have several different rates
and fee schedules.
– Sometimes a customer can pick what he wants
– At other times he is offered a single set of terms
with no option
– This however is not true for a T&E card
• One AMEX green card is as good as any other
Charges – Cardholder (Cont…)
• Different credit cards use different methods

of calculations to determine the final interest
bill on outstanding balances.
– A card with an APR of 12% might be more
expensive to use than a card carrying an APR of
14%.
• There are three methods for calculating the
balance on the credit card
a. Average daily balance
b. Adjusted balance
c. Previous balance
Average Daily Balance
• It is the most commonly used method of

calculation
• Issuer tracks the user’s balance on a daily
basis
 User’s daily balance = charges (on account of
purchases) – payments (as and when they occur)
• Finance charge = Avg. (daily totals) x monthly
interest rate
– New purchases may or may not be added to the
balance
– But cash advances are typically included
Illustration - 1
• User balance for first 15 days of billing cycle

=0
• User activity on 16th day of billing cycle  he
buys an item for $2,500
• User’s average balance for the cycle is 

{(15x0) + (15x2500)} / 30 = 1,250
Illustration - 2
• A user has a carried forward balance of

$1,000 from the previous month
• On the 12th of the month  he makes a
payment on $500
• On the 15th of the month  he makes a
purchase for $2,500
• His average daily balance may be calculated

in one of two ways
Illustration – 2 (Cont…)
Including New Purchases

• (1000x12) + (500x3) + (2500x15) = 51000
• 51000 / 30 = 1700
• Average daily balance = 1700
Excluding new purchases

• (1000x12) + (500x18) = 21000
• 21000 / 30 = 700
• Average daily balance = 700
Illustration - 2 (Cont…)
• If the annual APR is 18%, the monthly rate

will be 1.5%
• The Finance charge when new purchases are
included is:
 0.015 x 1700 = $25.50
• The Finance charge when new purchases are
excluded is:
 0.015 x 700 = $10.50
The Adjusted Balance Method
• The balance carried forward is taken from the

previous statement
• New charges are added
• Payments made are subtracted
• The final figure is multiplied by the monthly

interest rate
Illustration
• Opening balance = 1000
• Less payments = -500
• Plus new charges = 2500
• Balance for the month = 3000
• Finance charge = 0.015 x 3000 = $45

The Previous Balance Method
• The amount owed at the end of the previous

billing period is taken into account
• Payments, credits and new purchases during
the current billing period are not included
– Thus you can be charged interest on your
previous debit balance even after you have paid it
off
Illustration
• Carried forward balance = 1000
• Finance charge = 0.015 x 1000 = $15

Income - Issuers
• Card issuers receive revenues from two

sources
– From merchants who accept their cards
– From consumers who use their cards
• Finance charges on credit card loans

comprise over three-quarters of the revenue
for card issuers
Income - Issuers (Cont…)
• Issuers must manage a number of expenses

– Cost of funds
– Bad debt charge offs
– Labour
– Data processing
– System development and maintenance
– New card solicitation

Clearing and Settlement
Clearing and Settlement
• In 2004 MC and VISA processed more than

45 billion card payments
• Approximately 3 trillion dollars was cleared
and settled between their member banks.
• The clearing process entails the calculation
and reconciliation of who owes what and to
whom.
The Flow
The merchant’s bank This includes:
1. The basic authorization
brings together the full
already sent to the issuing
payment transaction bank
details 2. The authorization code
3. Data on the transaction
4. Local tax and VAT details
The banks have to make this data

MC / VISA collect the data available by specified cutoff times
which vary by currency to
from member banks in the currency:
morning of day 2 • In Europe there is
one cutoff time for
the Euro and one for
other currencies
The Flow (Cont…)
MC / VISA then prepare • The debit transactions from
different acquirers are
files for delivery to the
consolidated into one file for
acquirer and issuer banks each issuer bank
• The overall net balance to be
paid or received by each
member bank is computed
At a specified time and To participate in MC and VISAs

settlement systems member
date the member banks
banks must open an account at a
are debited/credited at the
specified bank
settlement banks for the
net balances outstanding
for each of their settlement
currencies
Clearing Currency
• A fully reconciled daily clearing data file is prepared

for each member bank.
• Each bank can choose the currency or currencies
they will settle in
– This is usually the local currency
• Both MCs and VISAs volumes of FX are huge
– So they get exceptional rates from the bank they use
• For some currencies, MC and VISA add a very small
markup for currency conversion costs.
– For instance VISA charges a wholesale rate plus 0.84% for
currency conversion outside Europe
– There is no markup within Europe
Clearing Currency (Cont…)
• The member banks can pass on the currency

conversion costs to the consumer and/or
include an additional service fee.
– The market is highly competitive and each bank
decides what is to be done.
• Typically Euros and dollars are settled on the
day following the transaction.
• Other currencies are typically settled two
days later.
Clearing dates
• Most card issuers debit the cardholder’s

funds on Day 1, the date of the purchase
even though they are not debited for the fully
cleared transaction until Day 2.
• Most acquiring banks credit the merchant’s
account on the same day that the funds are
received from MC and VISA.
• If the merchant is very large and has
considerable bargaining power he may get
paid on the day of the transaction itself.
The Future
The Future
• MC and VISA are locked in a battle to set up state-of-
the-art systems.
Mastercard VISA
MC recently rolled out a new VISA is reportedly spending
clearing system that is a $160m more than $200m to overhaul its
upgrade to deliver its next computer system which already
generation Global Payments can handle upto 4,000
Processing Platform transactions per second
This platform, in conjunction VISA says that it is aiming to
with Banknet, a new IP based connect buyers and sellers
Virtual Private Network (VPN), instantly and securely, whether
offers faster transaction capacity a purchase is made in person,
and growth potential over phone, handheld device, or
internet
The Future
Mastercard VISA
MC has a new technology that VISA has a smart card program
will let consumers with specially as well. It has developed a new
equipped credit cards to just payment specification that
wave them at a reader to make removes the need to physically
a payment, rather than having to insert a smart card into a reader
swipe the card. The technology and even works with mobile
uses embedded computer chips phones
and tiny radio devices. Its called
MasterCard PayPass
• The idea is to make micropayments easier
– At fast food chains
– Movie halls etc.
The Future (Cont…)
• Both the associations employ sophisticated

machinery.
• VISANet for instance comprises
– 25 large mainframes
– And more than 250 mid-range systems
– It runs more than 50 million lines of code
• Of which 2-3 million lines are modified annually
Profitability statistics
Profitability Statistics
• These statistics are taken from the Morgan

Stanley Dean Witter Global Credit Card
Report
• Risk-adjusted revenue = (Gross Revenue) -
(Cost of Funds & Credit Losses)
• Global risk-adjusted revenues = $68 billion
• Profits (before tax) = $30 billion
• At the end of 2000 balances outstanding on
all credit cards globally = $752 billion
• Sales volume globally on all credit cards =
$2.2 trillion
Credit card revenues
Credit Card Revenues
• Credit card revenues consist of the following

components.
1. Finance Charges (76%)
2. Service Fees (13%)
3. Interchange (9%)
4. Periodic Fees (2%)
• The exact share of each source may vary
from issuer-to-issuer but the figures are
representative of the industry as a whole.
1. Finance Charges
• It refers to the interest collected by the issuer

from the cardholders
• Finance charges constitute by far the largest

source of revenue for issuers.
2. Service Fees
• These fees represent the income from

assessment of certain fees based on
cardholder behaviour.
• They are collected only when the cardholder
exhibits the behaviour associated with the
fee. These include:
– Late payment fees
– Over-limit fees
– Cash advance fees
3. Interchange
• This is the amount of each cardholder
transaction that the issuer receives from the
acquiring institution.
4. Periodic Fees
• This is the annual fees charged by the issuer
for allowing the holder to have a card.
• In some markets cardholders pay no fees
which is why the share of the total revenue
from this source is very low.

Credit card expenses
Credit Card Expenses
• The following are the key components of

credit card expenses.
1. Credit Losses (38%)
2. Cost of Funds (33%)
3. Direct Expenses (20%)
4. Other Expenses (9%)

1. Credit Losses
• This figure represents the loans advanced to

cardholders that are not paid back.
• Credit card outstandings are unsecured
loans.
– The institution has no collateral to seize and sell in
order to recover the loan.
– If cardholders refuse to pay the loan must be
written off.
2. Cost of Funds
• The card issuer bills the holders once a

month for all loans initiated by them.
– The holder has the option to
• pay off the entire loan by the due date
• or extend the loan payments over time by paying a
percentage of the outstanding amount immediately
and financing the rest.
– The period between the initiation of the loan and
the time that it must be paid back (in whole or in
part) is called the Grace Period.
Cost of Funds…
• Though the cardholder has to make

payments only once a month, the issuing
institution has to make payments every day
through the clearing and settlement system.
– It is responsible for funding all the transactions
made by its cardholders so that merchants receive
prompt payments.
• The issuer is effectively lending money to its
cardholders for purchases until it is able to bill
and collect payments.
Cost of Funds…
• The cost of funds = the interest the issuer has
to pay those entities from whom it obtains
funds for lending to the cardholders.

3. Direct Expenses
• These include the costs associated with
generating & servicing credit card accounts.
– Marketing and promotion
– Application processing
– Plastics Issuance
– Transaction authorization, processing & settlement
– Cardholder billing and payment processing
– Customer service
– Fraud and security
– Collections
– Credit Card Administration
Direct Expenses - Marketing & Promotion
• It includes all the solicitation expenses

associated with generating new accounts
• It also includes promoting activation and
usage by existing cardholders.
• The following expenses are included
– Advertising expenditure
– Direct mail costs
– Branch signage
– Client communication expenses
Direct Expenses - Application Processing
• This consists of the costs associated with

evaluating a client’s application for a credit
card account.
• Expenses include:
– Credit bureau reports
– Employment verifications
– Credit Scoring
– Staffing
Direct Expenses - Plastics Issuance
• These expenses are related to production

and issuance:
– physical credit card
– delivery expenses such as postage
Direct Expenses - Transaction
authorization, processing & settlement
• These expenses are associated with the

operation of credit cards within the
interchange systems.
• They include
– Computer systems & technology required for
participation in the card associations
– Costs associated with tracking and accounting for
transactions
Direct Expenses - Cardholder Billing
and Payment Processing
• These costs relate to the production and
mailing of monthly bill statements
• It includes expenses related to the processing
of payments received from cardholders

Direct Expenses - Customer Service
• They pertain to the support of cardholder

inquiries
• E.g. the systems required for handling
– Cardholder disputes
– Chargebacks and retrievals
• E.g. staff and computer hardware and

software related expenditure such as
– Operating a call centre
Direct Expenses – Fraud & Security
• This refers to all the expenses incurred with

monitoring and investigating suspected
fraudulent applications such as
– Costs of computer software
– Payments made to the investigative staff
– Losses incurred because of fraudulent credit card

activity
Direct Expenses – Collections
• These are the costs incurred in connection

with identifying, finding, and contacting
cardholders who have not made their monthly
payments on time.
Direct Expenses – Credit Card Administration
• This refers to all management and
administrative expenses associated with the
daily operation of the credit card operations
center.
4. Other Expenses
• These include
– Overhead allocations from the parent company
– Occupancy expenses for buildings
– Services purchased from third parties
– General supplies
Factors Influencing Card Profitability
Factors Influencing Card Profitability
• To maximize profitability it is necessary to

understand the driving factors behind each
component of revenue and expenditure, so
that the issuer can influence the variables
concerned.
• The factors influencing revenues are
1. Interest Income
2. Interchange Income
3. Service Fees
4. Periodic Fees
1. Interest Income
• This depends on the outstanding balances in the
accounts - not the number of accounts.
– The issuer needs to invest in marketing to existing
accounts in order to increase the balances.
• Promotional exercises to accounts that are already in
rollover can help increase the finance charges from
outstanding balances. E.g.
– Balance transfer offers
– Limited time lower interest rate offers
• Remember: Outstanding account balances are the
single most important source of revenue for the issuers.
Interest Income (Cont…)
• Promoting cash advances also increases

profitability.
– This is because cash advances begin accruing
finance charges immediately unlike purchases
which are subject to an interest free grace period.
• Interchange income is a function of sales
volume
– To derive more income the issuer needs to launch
promotional programs to boost sales volume
– Common promotional programs include offers like
• $2.50 cash back on every $100 that is spent on the
card.
– Issuers also employ programs to promote
increases in credit lines to qualified borrowers, so
as to encourage greater use.
3. Service Fees
• Income from service fees relates to
cardholder behaviour the issuer would like to
discourage. E.g.
– Taking cash advances
– Going over the credit limit
– Delinquency
• The key to generating service fee income
– Is to be sure that a fee is being levied for all such
behavioural patterns
– And that the fee is high enough to discourage
such behaviour.
4. Periodic Fees
• These fees should always be charged in any
market where they are acceptable.
• In a competitive market such fees are difficult
to impose
– In such cases the key is to find value-added
services to attach to the credit card that justify
such fees
• Examples include co-branded or affinity offers
• E.g. services such as free insurance and other
value enhancements
Factors Influencing Card Expenses
Factors Influencing Expenses
• These include:
1. Credit Losses
2. Cost of Funds
3. Direct Expenses
1. Credit Losses
• The key to risk management of a card

portfolio is to employ all available technology
at every stage of the card issuance and
management process so as to reduce the
possibility of a loss.
• Techniques include
– Using credit scorecards as a part of the application
underwriting process
– Using behaviour scorecards as a part of
monitoring cardholder behaviour in order to detect
early warning signs of increased risk.
2. Cost of Funds
• The issuer’s cost of funds depends on

– its general mix of commercial and consumer
deposits
– how that mix of funds is allocated to various
lending units
• The more core deposits that an institution has

– the less is has to borrow from other sources
– consequently lower will be the cost of funds
Cost of Funds - fund pools
• Institutions use their Treasury function to

create pools of funds for supporting their loan
portfolios
– Each fund pool will have a different rate of interest
• Depending on the mix of deposits contained
• And the average length to maturity
– Normally a pool consisting of checking accounts
will have a lower rate than a pool that contains
long-term funds such as CDs.
Cost of Funds - Securitization
• A newer and more sophisticated fund

management technique is Securitization.
– An institution that wishes to securitize its credit
card receivables can transfer a portion of its credit
card accounts to a Special Purpose Vehicle
(SPV), along with the corresponding revenues and
credit losses.
– The SPV can then issue securities that entitle the
owners to cash flows emanating from the
underlying pool.
Cost of Funds - SPV (Cont…)
• Banks benefit from securitization in several

ways.
1. By assigning credit card assets to the SPV the
bank frees up capital that was previously used to
back the receivables on its book of accounts.
2. By moving the securitized assets off its balance
sheet, the bank will have fewer assets and a
lower requirement for loan loss reserves.
3. Direct Expenses
• Technology can be effectively used to control

expenses. E.g.
– Operating sophisticated telephone switches and
voice response units (VRUs) in customer service
can reduce telecommunications and staffing
expenses
– Outsourcing of core processing and servicing
functions
– Periodic cleansing of the portfolio by closing long-
inactive accounts
Debit cards
Debit Cards
• Such cards are viewed not as stand alone

products but as another device that allows
customers to access a current or a savings
account.
• Debit cards are generally managed from
existing retail banking operations.
– This makes the identification of expenses difficult
because they are generally mixed up with retail
banking expenses.
– But there are clearly identifiable incremental
revenues and expenses.
Debit Card Revenues
Debit Card Revenues
• These include
1. Interchange income
2. Overdraft loan interest income
3. Service fee income
4. Periodic fee income

• As with a credit card this is a function of sales

volume and transactions conducted on a
debit card create interchange income for the
card issuer
• Other means of accessing an account create
no such revenue for the banks. E.g.
– Check writing
– ATM withdrawals
– OTC withdrawals
• Interchange income is an incremental source
of revenue
2. Overdraft Loan Interest Income
• Overdraft loan  Debit card transactions that

are honoured when the cardholder does not
have the required account balance
– Provided an overdraft facility has been established
for the account
• The income is the incremental income that is
generated over and above the interest
income for overdraft facilities availed of by
other means such as checks.
3. Service Fee Income
• Debit cards create new sources of income by

assessing service fees for specific types of
behaviour.
• These include:
– Fees for declined debit transactions
– Copies of transactions
– Fees for foreign exchange transactions

4. Periodic Fee Income
• Many issuers charge an annual fee
– for a debit card
– for any additional cards issued against the same
account.
Debit card expenses
Origin of Debit Card Expenses
• Like credit cards, debit cards require that a

number of functions be performed to
– Create the cards
– Get them into the hands of consumers
– Make them operational
• There are certain incremental functions as

compared to accounts operated without a
card.
Debit Card Expenses
1. Marketing and promotion

2. Application processing
3. Plastics issuance
4. Transaction authorization, processing, and
settlement
5. Cardholder billing
6. Customer service
7. Fraud and security
8. Bad debt management
1. Marketing and Promotion
• The issuer must advertise to encourage
clients to apply for and obtain debit cards.

2. Application Processing
• Contrary to popular belief not every account

holder should be issued a debit card.
• A process must be established for evaluating
which applicants should be issued cards,
based on the incremental risk posed by
global acceptance of the debit card.
3. Plastics Issuance
• There are expenses incurred in connection

with production of the card
• There are also costs associated with sending
it to the account holder. E.g.
– Postage charges
– Courier charges
4. Authorization, Processing and
Settlement
• As with credit cards there are expenses

associated with participating in the global
interchange systems of VISA and
MasterCard.
• These include investments in technology as
well as expenses related to tracking and
accounting.
5. Cardholder Billing
• All debit card transactions have to be tracked
and reflected in the relevant account
statement.
6. Customer Service
• Debit cards create new and different

consumer service issues as compared to
normal account operations.
• These include:
– Chargebacks and retrievals
– Transaction disputes
– Service disputes
7. Fraud and Security
• Global acceptance of debit cards gives rise to

a need for constant monitoring and
investigation of potential fraud.
• These expenses include investments in
technology and manpower to monitor and
investigate potential fraud.
• Besides, actual losses incurred on account of
fraud constitute an expense for the issuer.
8. Bad Debt Management
• There is a need to collect overdraft loans if
created by the use of the debit card.
• Manpower needs to be deployed to contact
delinquent cardholders and collect past due
amounts.
Influencing debit card profitability
Profitability
• Debit card usage replaces the other types of
transactions associated with account
operation
– Checks
– ATM
– OTC transactions
• Debit cards leverage the association global
interchange systems, which are well
established and extremely efficient
– This reduces the operating expenses of retail
banking
– This makes debit card transactions are generally
less expensive
Debit card revenues
• Debit card revenue sources
1. Interchange revenues
2. Sometimes foreign exchange revenue

Profitability (Cont…)
• The profitability of debit cards is influenced

almost exclusively by a single factor
– Transaction Volume
• The major question in measuring profitability

is:
– How many transactions previously conducted
using checks, ATMs, or OTC contact, have been
replaced by the debit card?
• Profitability in debit cards can be encouraged

by:
– Promoting debit cards to current account clients as
a more convenient device
– Encouraging them to replace higher cost
transactions with debit cards
– E.g. through promotions that reward debit card
usage
Credit and Risk Management
Credit and Risk Management
• The bank card business is highly specialized

and innovative consumer payment product.
• Nevertheless the card business is primarily a
lending business.
• The fundamentals of prudent ‘credit granting’
and continuous ‘risk management’ are the
cornerstone of a successful card issuer.
Bank card issuance
Bank plays the role of a financial intermediary
individual individual
Borrow
Lend funds
funds
financial sector
family family
Credit card loan
Traditional loan Credit cards

Bring depositors and Bring depositors and borrowers
borrowers together and make together and make profit for
profit for shareholders shareholders
This is a conventional Cards are more complicated because
borrowing tool like an of the revolving nature of credit
installment loan
Approving a client for a loan is Approving a client for a credit card in
a one-time process and not a one-time decision but the
decision. beginning of a continuous process of
assessing creditworthiness of the
cardholder as long as he continues
to hold the card
Functions of a credit card department
• The key functions of a credit card
department are the following.
A. Credit underwriting
B. Application processing
C. Portfolio risk management

A. Credit Underwriting
• Underwriting parameters are decided on and
monitored by the credit policy group.
• It regularly reviews approved and declined
applications to ensure adherence to stated
policies.
B. Application Processing
• This group manages the development and
maintenance of credit scorecards.
• It takes all steps necessary to gather
information required to take a credit decision.

C. Portfolio Risk Management
• The group ensures continuous risk
management of the entire portfolio including
– Compliance with all regulations
– Periodic audits of internal compliance with
departmental policies and procedures.

Policies and procedures
Policies and Procedures
• Why policies & procedures?
– In order to derive consistency between the credit
and risk management strategies of the financial
institution and its credit risk division
– Set of guidelines will govern how credit will be
granted and maintained for card applicants

Policies and Procedures Manual
• It contains prescribed rules that govern how a

credit decision will be taken.
• It will also specify the types of information that
ought to be collected in order to process an
application.
– Issues of pertinence
– Application form
Application decision process
Processing of an Application: Issues of
Pertinence
1. Minimum age required for a card

2. Minimum income
3. Data from the credit card application
• Name
• Address
• Employer
• Income
• Other debts and obligations
4. Credit references and minimum credit
history required for approval
Issues of Pertinence (Cont…)
5. Parameters for when the application

information must be verified with
– Employers
– Co-borrowers
– Financial institutions given as references
6. Parameters for when to obtain a credit

bureau report
Issues of Pertinence (Cont…)
7. Minimum standards for credit approval such

as:
– At least one year at current residence
– At least one year with current employer
8. Parameters for the other required data and

the standards to be followed while granting a
card.
The Application Form
• The design and content of the form and data

gathered must
– meet the requirements of a number of different
areas within the card division.
– contain all the elements prescribed by the credit
policy group
– meet all the regulatory requirements which are
monitored by the compliance group
The Application Form (Cont…)
• Application forms are generally divided into

four critical areas:
1. Applicant data
2. Co-applicant data
3. Credit experience
4. Disclosures and signatures

1. Applicant Data
• The following information is generally

required
– Name
– Address
– Date of birth
– Type of residence – own/rented/living with
parents
– Years at residence
– Phone number
– Monthly rent or mortgage payment
Applicant Data (Cont…)
– Employer name and address

– Employer phone number
– Years on the job
– Previous employer’s name and phone number
– Years at the current job
– Annual salary
– Financial institution checking and savings
references
– Fraud prevention information such as
• Mother’s maiden name
• Name of nearest relative not living with the applicant
2. Co-applicant Data
• Relevant only if the card is to be co-owned

with another person who will also be
responsible for debts incurred on the card.
• The co-applicant must essentially furnish the
same information as that required from the
applicant.
3. Credit Experience
• This section requires the applicant and co-

applicant to list all currently outstanding debt
obligations such as:
– Mortgage loans
– Automobile loans
– Other loans from financial institutions
– Other bank cards owned by the applicant/co-
applicant
– Any store cards owned
– Any other debt obligations
4. Disclosures and Signatures
• This section contains all the required legal

disclosures associated with the offer of a card
• Both the applicant and the co-applicant must
sign this section after completing the form,
and attest to the truthfulness of the
information provided.
Determining Creditworthiness
Determining Creditworthiness
• The creditworthiness of Determine

an applicant may be creditworthiness
using:
determined using
1. Judgmental factors
2. In an objective fashion
using a credit scoring Credit
Judgmental
system
scoring
factors
system
1. Exercising Judgment
• Loan officers or credit analysts are trained in

– Using the information gathered by way of the
credit card application
– Recognizing elements in the credit application that
are consistent with previous applicants who were
approved and then exhibited either good/poor
credit performance
– Rendering a decision to approve or reject a
request
• They also use
– Any data obtained from a credit bureau
– Rely on the evaluator’s past experience
Exercising Judgment (Cont…)
• Judgmental credit decisions must be

monitored at the individual loan officer and
credit analyst level.
• This is accomplished by a loan review
process.
– Each individual with a loan approving authority
should be given a personal code to be entered on
every application that is reviewed by him,
irrespective of whether the application is approved
or denied.
2. Credit Scoring
The card issuer creates a The issuer will use statistical
credit scorecard that assigns analysis to determine the
point values to the likelihood of an applicant
application and other going bad at each possible
borrower information score level
The credit cut-off score is Issuer will then

set. Applications scoring at determine the level
or above the cutoff are that meets his
automatically approved while minimum credit and
others are automatically risk requirements
rejected
Advantages of Credit Scoring
• It improves the consistency of the credit

decision-making process.
• It approves more of the good applicants and
rejects more of the bad.
• It makes it possible to automate much of the
decision making process thereby increasing
efficiency
• It provides a statistical basis for determining
approval rates and bad debt rates making
credit decision making easier.
Credit Scoring (Cont…)
Types of
credit
scoring
models
Generic Customized
models models
Generic Credit Scoring
• These models are used primarily in markets

where good credit bureau data is available.
– The credit scorecard is built based on the general
population of a given market, using data that is
available to all lenders.
– Thus any lender can access the score and use it
to take a credit decision.
• These scores are fairly good for
– separating the good credit risks from the bad
– offer the advantage of providing a decision making
tool to all issuers, even to those who have just
entered the market.
Customized Credit Scoring
• Scores are based on a scorecard developed

by a particular card issuer using its own
history of approved and rejected applications.
• These models rely on the card issuer to
define
– what makes a good and a bad account
– what is a decline
– what is an indeterminate
Illustration
Definition Credit Card Debit Card

Good Current or no more than Checking balance not
two payments past due less than $0
in the past twelve
months
Bad Four or more payments Two or more
past due, bankrupt or overdrafts in the past
charged off 12 months
Indeterminate Three payments past One overdraft in the
due past 12 months
Decline Turned down for credit Turned down for card
Customized scoring steps
1. Go back into the issuer’s record and find

statistically representative sample
applications and other data from all of the
four groups in the table
2. Then analyze them to determine which
application, data and credit bureau variables
best predicted the outcome defined.
Customized (Cont…)
• A variety of accounts must be selected

including:
– Current  paying as agreed
– Delinquent  defined by the definition of `bad’
– Declined
– Indeterminate  defined by the user

Customized (Cont…)
• Each variable is weighted based on its

predictive capability compared to other
alternatives.
• The basis for a credit scorecard is all the
variables that have proven predictive of future
credit performance.
• Each variable is assigned a weighting and a
range of possible values.
– Values are assigned even for missing information.
Illustration
Most predictive scoring Good accounts Bad accounts
variables
Type of housing – A high incidence of
own/rent/live with renting
parents
Time at current 3+ years at <6 months at
residence current residence current residence
Time at current job 4+ years in current <1 year in current
job job
Number of current No loans One or more
existing loans on which 3 outstanding that current loans that
or more payments are are 3 or more are three or more
past due months past due payments past due
Automated Application Processing
Automated Application Processing
• Automated processing uses software that
– Allows data to be entered into a computer terminal
– Data is routed through steps where it is organized
and enhanced
• The steps can be customized to meet each
individual user’s credit policy and procedure needs
– Data is delivered to either a credit scorecard or to
an analyst for decision making.
• The system will be set up in such a way that
the application cannot move from one step to
another unless all the required elements have
been completed
Advantages - Automated Processing
• Advantages of the automated process of
application review
– Its reduces costs
– Provides for consistency

Automated …(Cont…)
• Once an application and data are entered,

the information can be routed through the
various internal steps prescribed by the
institution’s policies and procedures such as
1. Information verification
2. Debt-to-income calculation
3. Policy verifications
1. Information Verification
• Applications that meet the threshold levels

may require that employment or income be
verified to ensure that the information is
accurate, in order to prevent application
fraud.
2. Debt to Income Calculation
• Issuers may require that a ratio be calculated

that shows the sum of an applicant’s monthly
debt payments relative to his monthly income.
• This is useful in helping to determine whether
the applicant has the capacity to repay debts
on the card being requested.
3. Policy Verifications
• The applicant’s age and income can be

compared to the minimum required
• This is to ensure that further efforts are not
wasted on applications that do not meet the
policy thresholds
Exception handling
Exception Handling
• No policy or procedure can contemplate

every possible application scenario.
• There will always be exceptions to the rules.
Judgmental Decision Making
• Exceptions are less likely when judgmental

decision making is being used
– The decision process is less rigid than credit
scoring
• Credit officers and analysts can render
decisions within the basic framework of the
credit policy.
• The exceptions that do arise are usually
referred to a more senior credit officer for a
final decision.
Credit Scoring
• In cases where a credit scoring model is

being used, exceptions fall under two general
categories.
– Overriding high score applications
– Overriding low score applications

Overriding High Score Applications
The applicant meets the cut- A review of the application
off criteria by an analyst still leads to a
decline recommendation
In these cases the analyst Possible reasons include:

believes that he has • Current or recent
discovered one of the delinquency on other
potential future bad accounts
applicants the score cut-off • Low income
• High debt to income ratio
would let through as an
• Lack of employment
approval
stability
• Lack of residence stability
Overriding Low Score Applications
• In the case of certain applicants whose points

do not add up to the cut-off score, a credit
analyst may review the application and
recommend that it be approved.
• Possible reasons may be:
– Other high value relationships with the issuer
– Good prior credit experience
– High income
– Low debt-to-income ratio
Using Caution
• Credit scoring exceptions need to be handled

with extreme caution.
– Too many overrides will ultimately undermine the
impact and predictability of the scorecard
– Exceptions are too easily used for the wrong
reasons
– There are no hard and fast rules regarding which
exceptions are justified and which are not
– If there are too many exceptions credit decision
making will become inconsistent over time.
Risk management
Risk Management - Introduction
• A bank card is unique in the sense that the

initial sale is just the start of the product’s life
cycle.
• Responsibility of credit and risk department:
– Credit and risk management group  Processing
& making decisions about applications
– Risk management group  Monitoring and
managing the usage and payment behaviour of
the client
Risk Management Group
• The group must track the portfolio’s

performance over time to ensure that its risk
characteristics are within the parameters of
the issuer’s risk policy.
• The goals of managing risk of a card portfolio
are:
– Identify risk at the account level
– Retain and grow good accounts
– Guide the portfolio through economic and social
changes
– Create and implement strategies and tactics for
minimizing risk.
Credit Risk Management
Credit Risk Management
• Credit and risk management group can

influence the total risk of a card portfolio in a
number of ways
• These include:
1. Authorization controls
2. Plastics reissue controls
3. Credit line management
4. New account monitoring
5. Behaviour scoring
1. Authorization Controls
Card is swiped On-line real time Risk managers can

at the terminal transaction approve/decline
authorization request transactions based
information is sent to on the cardholder
the merchant’s bank account that is
initiating the
authorization request
• Way of mitigating risk:

– The issuer can minimize new loans to cardholders
who are not paying on existing ones.
2. Plastics Reissue Controls
• Card loans begin with the issuance of a card
– By not reissuing cards to clients who have
exhibited poor payment performance in the past

3. Credit Line Management
• Active management of credit limits can

impact the portfolio’s risk
– Increasing lines of credit for good accounts
– Decreasing them for bad accounts

– Screening accounts periodically,
– Grow activity on good accounts
– Reduce exposure on bad accounts by eliminating
unused credit lines before they can be turned into
additional loans
4. New Account Monitoring
• Certain behavioural patterns exhibited early in

a new account are warnings of future credit
risk problems
– E.g. if first transaction on a new account is a cash
advance of a significant amount the odds are high
that the account is likely to be a poor paying one in
the future
– E.g. if a new cardholder does not pay the very first
billing statement on time, it is a warning of future
problems
New Account Monitoring (Cont…)
• Ways of mitigating risk:

– allowing only a portion of the card’s credit limit to
be used for cash advances when it is first
approved
– reduce unused credit lines on new accounts that
take a cash advance right at the outset
– first payment defaulters should be aggressively
collected right away
5. Behaviour Scoring
• Behaviour scoring uses past performance to
predict likely future outcomes.
– Cardholder characteristics statistically proven to
be indicative of future behaviour are weighed and
assigned point values
– A behaviour score is calculated each month on
every account in the portfolio
– Lower the score, more likely that the account will
have delinquency problems
Behaviour Scoring (Cont…)
• Behaviour scoring enables the issuer to

– segment a portfolio of existing accounts into
groups by risk level
– deploy different strategies for groups that have
different risk characteristics
Behaviour Scoring (Cont…)
• Ways of mitigating risk:

– Decrease credit lines
– Increase aggressiveness in collections
– Reprice accounts to compensate for higher risk

Risk based pricing
Risk Based Pricing
• This is based on the principle that increased

risk equals increased price.
– Risk based pricing compensates the issuer for the
additional risk incurred with a more risky party
– At the same time it encourages the cardholder to

alter his behaviour.
Risk Based Pricing Method
Thresholds that, if breached, These are communicated to
will trigger off an increase in the card holders
interest rates are established
Once the cardholder meets

the on-time payment When a rate increase is
triggered off the interest rate
threshold the interest rate on will be hiked by 3-9%
the account is brought down
to its previous level
Advantages of Risk Based Pricing
1. It increases the revenue for the issuer that

helps offset the increased credit losses
arising from such accounts.
2. It motivates accountholders to change their

behaviour so as to avoid the higher rate.
Early warning signals
Early Warning Signals
• Main purpose of the risk management group

is to
– identify areas of increasing risk as early as
possible and
– take suitable action before they lead to significant
losses for the issuer
• There are no definite rules for identifying
behaviour patterns that are accurate in
predicting risk.
– There are certain typical warning signals that are
indicative of future problems.
Early Warning Signals (Cont…)
• These are:
1. First transaction cash advances
2. First-payment defaults
3. Repeated requests for credit line increases
4. Repeated over-limit transactions

Early Warning Signals (Cont…)
1. Accounts that abruptly revolve a large balance

2. Inactive accounts that suddenly activate at a high
level
3. Payment checks that are returned due to
insufficient funds
4. Accounts that use 90% or more of their credit line
continuously
Part-06
Introduction
to
Derivatives
Derivatives
• What is a Derivative Security?
• Why is it called a Derivative?
• Derivative securities are more appropriately
termed as `Derivative Contracts’.
– For they represent a contract between two parties.
– Depending on the nature of the contract, a party to it
will be conferred with a right or an obligation.
Derivatives (Cont…)
• Such contracts owe their existence to an
underlying asset or a portfolio of assets on
which they are written.
– The underlying asset may be termed as a
Primary Asset.
– Since these contracts are derived from the
primary securities they are termed as
Derivatives.
• The Securities Contracts (Regulation) Act of
1956 defines the word `derivative’ to include:
– A security derived from a
• debt instrument
• share
• loan whether secured or unsecured
• risk instrument
• or contract for differences
• or any other form of security
– A contract which derives its value from the prices, or
index of prices, of underlying securities.
• The three major categories of derivative
securities are:
– Futures and Forward contracts
– Options contracts
– Swaps
Cash Transactions
• These are also known as Spot
Transactions
• In these as soon as the deal is struck
– The buyer has to pay for the asset
– The seller has to transfer the rights to the
asset
Forward/Futures Contracts
• The actual transaction does not take place
when an agreement is reached.
– At the time of negotiating the deal, the two
parties merely agree on the terms on which
they will transact at a future point in time
• The terms include the price to be paid per unit of
the underlying asset.
Forward/Futures Contracts
(Cont…)
• The actual transaction per se occurs only
at a future date that is decided at the
outset.
– So no money changes hands when a contract
is negotiated
• Both parties have an obligation to go
ahead with the transaction on the pre-
decided date.
• Mitoken Solutions has entered into a
forward contract with ICICI Bank
– To acquire $100,000 after 90 days at an
exchange rate of Rs 45.50 per dollar.
• 90 days later:
– The company is obliged to pay Rs 4,550,000
to the bank
– The bank is obliged to deliver $100,000
Long and Short Positions
• Every forward/futures contract has a
Buyer and a Seller.
• The party who agrees to buy the
underlying asset is called the LONG
– He is said to assume a Long position
• The counterparty who agrees to sell the
underlying asset is called the SHORT
– He is said to assume a Short position.
Options
• Futures/Forwards impose an obligation on
both the long as well as the short.
• Options contracts however give a Right to
the buyer.
• But impose an obligation on the seller
– Option buyers are referred to as Holders
– Option sellers are referred to as Writers
Options (Cont…)
• What is the difference between a Right
and an Obligation?
• A right need be exercised only if it is in the
interest of the holder.
– So in the case of an option the long is under
no compulsion to go through with the
transaction.
– The short however has an obligation
• If the long exercises his right, the short has to carry
out his part of the deal.
Calls and Puts
• When a person is given a right with respect to an
asset, it can take on two forms
– Right to Buy
– Right to Sell
• An option which gives the holder the right to buy
the underlying asset is called a Call option
• An option which gives the holder the right to sell
the underlying asset is called a Put option.
Calls and Puts (Cont…)
• If a call holder exercises the option
– The writer has to deliver the underlying asset
• If a put holder exercises his option
– The writer has to take delivery of the
underlying asset
Comparison
European and American Options
• The holder of an option is given a right
• If the right can be exercised only on a
fixed date in the future the contract is
called a European option
– The date on which exercise is permissible is
called the Expiration Date of the option
• If the right can be exercised at any time
after it is acquired till the Expiration Date,
the contract is called an American option.
European… (Cont…)
• The expiration date is:
– The only point in time at which a European
option can be exercised
– The last point in time at which an American
option can be exercised.
European…(Cont…)
• Most contracts which are traded on organized
exchanges like the CBOE are American
European…(Cont…)
• Valuation of European options is easier.
– They can be exercised at only one point in
time
– So we need consider possible cash flows only
at that instant
Option Price versus Exercise Price
• Option price also known as Option
premium
– Is the price paid by the buyer to the writer at
the outset, for permitting him to acquire the
right to transact
– It is a sunk cost
• If the option is not exercised subsequently it
cannot be recovered
Option Price…(Cont…)
• The exercise price enters the picture only
if the holder chooses to exercise the
option
– It is the price payable by the buyer per unit of
the underlying asset if a call is exercised
– It is the price receivable by the buyer per unit
of the underlying asset if a put is exercised
• It is also known as the Strike price.
Illustration
• Komal has taken a long position in a call option
on Reliance with an exercise price of Rs 400and
three months to maturity
– The options have been written by Kinkini
• If the spot price at expiration is greater than Rs
400 per share, Komal will exercise the option
and buy the shares at Rs 400 each
– Else she could simply forget the options and buy in
the spot market at a price which by assumption is
lower.
• No one can compel Komal to exercise for
she has a right and not an obligation
– But if she exercises Kinkini has no choice but
to deliver the shares at Rs 400 each
– This is because option contracts impose a
performance obligation on the writer.
Premium for Futures?
• In the case of options the buyer has to pay
a premium to the writer
– This is because the buyer is acquiring a right
whereas the writer is taking on an obligation
– Rights are never free and have to be paid for
– Consequently the buyer has to pay the writer
for acquiring the right to transact.
Premium for Futures (Cont…)?
• Futures and forwards are different from
options
– They impose equivalent obligations on both
parties
– The futures price, which is the price at which
the long will acquire the asset at a future date,
will be set such that the value for both parties
is zero at inception
• Thus the two equal and opposite obligations
ensure that neither party has to pay the other at
the outset.
Swaps
• A swap is a contract between two parties to
exchange cash flows calculated on the basis of
pre-specified criteria at predefined points in time.
– These cash flows represent interest payments on a
specified principal calculated using two different
yardsticks.
• One payment may be based on a fixed rate of interest
• The other may be based on a variable rate such as LIBOR
LIBOR
• LIBOR stands for the London Interbank
Offer Rate
– It is the rate at which a bank in London is
willing to lend to another bank
• The most widely used LIBOR is the value
computed by the British Bankers
Association (BBA).
BBA
• The BBA computes the LIBOR for 10
international currencies. These are:
– Australian Dollar
– Canadian Dollar
– Swiss Franc
– Danish Krone
– Swedish Krone
– Euro
– Sterling Pounds
– Japanese Yen
– New Zealand Dollar
– US Dollar
BBA (Cont…)
• The BBA Libor is released shortly after
11:00 a.m. London time everyday.
• The BBA obtains quotes from a panel
consisting of a minimum of 8 banks per
currency.
• To eliminate possible outliers, the quotes
in the top and bottom quartiles are
disregarded and the remaining rates are
averaged.
Swaps (Cont…)
• All interest rate swaps need not be on a
fixed rate – floating rate basis.
• We can have floating rate – floating rate
swaps where each rate is based on a
different benchmark.
– For instance one leg could be based on Libor
and the other on the US T-bill rate
• Such swaps are called BASIS Swaps
Swaps (Cont…)
• In a pure interest rate swap the two cash
flows are denominated in the same
currency.
– So obviously we cannot have a fixed rate –
fixed rate swap.
• But we have swaps where the cash flows
are in two different currencies.
– These are called currency swaps
Swaps (Cont…)
• In a currency swap we have all
possibilities
– Fixed to Fixed
– Fixed to Floating
– Floating to Floating
Principal
• In an interest rate swap there is no need
to exchange the principal
– This is because both interest streams are
computed in the same currency
– However we need to specify a principal
• This is purely to facilitate the computation of
interest
• This principal which is never exchanged is called a
Notional principal
Principal (Cont…)
• In the case of a currency swap two
different currencies are involved.
– So in this case the principal amount is actually
arranged.
Forward versus Futures Contracts
• There are some obvious similarities
between forward and futures contracts.
– Both require the long to acquire the asset and
the short to deliver it.
– Thus there is an obligation for both parties
• But there is a crucial difference
– Futures contracts are standardized while
forward contracts are customized
Customization versus
Standardization
• In such contracts certain terms and conditions
need to be made explicit.
– How many units of the underling asset is the long
required to acquire or in other words how many units
does the short have to deliver
– What are the acceptable grade(s) allowable for
delivery
– What are the acceptable location(s) for delivery
– When can delivery be made
• Is it only on a particular day or is there a specified period
during which delivery can be made
Customization…(Cont…)
• In a customized contract, these terms and
conditions have to be negotiated between
the buyer and the seller.
– The two parties can incorporate any features
that can be mutually agreed upon.
• In a standardized contract there is a third
party that specifies the allowable terms
and conditions.
– This third party in the case of a futures
contract is the futures exchange.
Customization…(Cont…)
• The long and the short in the case of a
futures contract can design a contract
within the boundaries specified by the
exchange
– But they cannot incorporate features other
than those that are specifically allowed.
Illustration
• Rice futures are trading on the Trivandrum
futures exchange.
– Each contract is for 100 kg.
– Allowable grades are IR-7 and IR-8.
– Allowable locations are Trivandrum, Kollam,
and Nagarcoil.
– Delivery can be made at any time during the
last week of the month.
• Jacob wants to acquire 5,000 kg of IR-7
rice in Trivandrum during the last week of
the month.
• Vishant seeks to sell 5,000 kg of IR-7 rice
in Trivandrum during the last week of the
month.
• So the listed futures contract is suitable for
both parties.
• So if they were to meet on the floor of the
exchange at the same time a trade could
be executed for 50 contracts.
– Assume that the agreed upon price is Rs 16
per kg.
– The price is one feature that is not specified
by the exchange.
– It has to be negotiated between the two
parties.
• And is a function of supply and demand conditions.
• Take a slightly different scenario.
• Jacob wants to acquire 4,750 kg of BY quality
rice in Kochi during the last week of the month.
• Vishant is looking to deliver the same quantity of
BT rice in Kochi during that period.
– The terms that are being sought are not within the
framework specified by the futures exchange.
– So a futures contract is unsuitable for the two parties.
• However nothing prevents the two men from
negotiating an agreement with the desired
features.
– This would be a customized or tailor-made
agreement.
– This would be a forward contract.
• Thus futures contracts are exchange traded
products like stocks and bonds.
– Forward contracts are however private contracts.
Multiple Grades/Locations
• If the contract permits delivery of more than one
specified grade and/or at multiple locations, the
question is
– Who gets to choose what and where to deliver?
• Traditionally the right to choose the location and
the grade, as well as the right to initiate the
delivery process has been given to the short
– Thus a long cannot demand delivery.
Multiple…(Cont…)
• If a long cannot demand delivery,
investors who have no desire to take
delivery will exit the market before the
delivery period commences.
– How will they exit the market?
– By offsetting or taking an offsetting position.
• What is the risk if they do not offset?
– They can be called upon to take delivery
without having the right to refuse.
Clearinghouse
• What does a clearinghouse do?
– It essentially guarantees both the long as well
as the short against the possibility of the other
party defaulting.
– Once a deal is struck the clearinghouse
positions itself as the effective counterparty
for each of the two original parties to the
trade.
• That is, it becomes the effective buyer for every
seller, and the effective seller for every buyer.
Clearinghouse (Cont…)
– Thus each party to a transaction needs to
worry only about the financial strength and
integrity of the clearinghouse.
– However, neither party actually trades with the
clearinghouse.
• It enters the picture only after an agreement is
reached between the two parties.
Why do we need a clearinghouse?
• A futures contract imposes an obligation on both
parties.
• On the expiration date, depending on the
movement of prices in the interim, it will be in the
interest of one of the two parties to go through
with the transaction.
• But a price move in favour of one party would
translate into a loss for the other.
– Thus, given an opportunity, one of the two parties
would like to default on the expiration date.
Why…?(Cont…)
• Consider two parties to a trade Poonam
and Kunal.
– Poonam has gone long in a futures contract to
buy an asset five days hence at a price of
Rs 400.
– Kunal has taken the opposite side.
Why…?(Cont…)
• Assume that the spot price five days hence is Rs
425.
• If Kunal already has the asset
– He is obliged to deliver at Rs 400 thereby foregoing
an opportunity to sell it in the spot market for Rs 425.
• If he does not have the asset he is required to
acquire it for Rs 425 and then deliver at Rs 400.
• Quite obviously Kunal would like to default given
an opportunity.
Why…?(Cont…)
• Now assume that the spot price five days hence
is Rs 375.
– If Kunal already has the asset he would be happy to
deliver it for Rs 400.
– If he does not have it he would be more than happy to
buy it for Rs 375 and then deliver it.
• The problem is that Poonam would like to default
if possible.
– If she does not want the asset she would have to take
delivery and then sell it for Rs 375.
– Even if she wants it, she would rather buy it in the
spot market for Rs 375.
Why…?(Cont…)
• The presence of a clearinghouse ensures that
such defaults do not occur.
• It ensures protection for both parties by requiring
them to post a performance bond or collateral
called a margin.
• The collateral is adjusted daily to reflect any
profit or loss compared to the previous day.
– By doing so the clearinghouse effectively takes away
the incentive to default.
Margins
• In a futures contract there is always the
risk of default, because given an
opportunity one of the two parties would
like to back out.
• In practice compliance is ensured by
requiring both parties to deposit collateral
with their respective brokers.
– The deposit, referred to as the Initial Margin is
a performance guarantee.
Margins (Cont…)
• The collateral represents the potential loss
for a party.
• Once it is collected the incentive to default
is taken away.
– For even if the losing side were to default, the
collateral posted by it would be adequate to
take care of the interests of the other party.
Clearing Margin
• Since the clearinghouse gives a guarantee
to both sides, it also collects margin.
– This is known as Clearing Margin.
• In practice both parties deposit margins
with their respective brokers.
– The brokers in turn deposit margins with the
clearinghouse.
Offsetting
• What is offsetting?
– It means taking a counter-position.
– So if a party has originally gone long it should
subsequently go short and vice versa.
– The effect of offsetting is to cancel an existing
long or short position.
Offsetting (Cont…)
• A forward contract is a customized
contract between two parties.
– So if a party wants to cancel the original
agreement it must seek out the counterparty.
• Canceling a futures contract is a lot easier.
– For a contract between two parties, say Jacob and
Vishant, will be identical to a similar contract between
two other parties, say Kripa and Priyanka.
– This is because both the contracts would have been
designed according to the features specified by the
exchange.
– Besides the moment Jacob and Vishant trade, they
effectively enter into a contract with the clearinghouse
and the link between them is broken.
• So if Jacob who has gone long wishes to get out
of his position, he need not seek out Vishant.
– He has ot simply go back to the floor and offer to take
a short position.
• This time the opposite position may be taken by a new party,
say Rahul.
– Thus by entering into an initial long position followed
by a subsequent short position, Jacob is effectively
out of the market and has no further obligations.
• As far as the clearinghouse is concerned
Jacob has bought and sold an identical
contract and consequently his net position
is zero.
• The profit/loss for a party who trades and
subsequently offsets is equal to the
difference between the futures price
prevailing at inception, and the price at the
time of cancellation.
Marking to Market
• Why are margins collected?
– To protect both parties against default by the
other.
– The potential for default occurs because once
a position is opened it will invariably lead to a
loss for one of the two parties if it complies
with the contract.
Marking to Market (Cont…)
• The loss from a futures position will not arise all
of a sudden at the time of expiration of the
contract.
• As the futures price fluctuates from trade to
trade, one party will experience a gain while the
other will experience a loss.
• So the total loss from the point of inception till
the time the time of expiration (or offsetting if
that were to happen earlier), is the sum of these
small losses/profits corresponding to each
observed price in the interim.
• Marking to market is the process of
calculating the gain/loss for a party at a
specified time with reference to the price
that was prevailing when the contract was
previously marked to market.
• When a futures contract is entered into it will be
marked to market at the end of that day.
• Subsequently it will be marked to market at the
end of every day
– Till the contract expires
– Or an offsetting position is taken
• The party with a profit will have his margin
account credited
– The other party will have his margin account debited.
Illustration
• Take the case of Poonam who has gone
long in a futures contract expiring five
days hence with Kunal at a price of Rs
425.
• Assume that the prices at the end of each
day are as depicted in the following table.
Day t Futures Price
0 400
1 405
2 395
3 380
4 405
5 425
• Assume that the contract is for 100 units
of the underlying asset.
• The initial collateral (Initial Margin) is
Rs 5,000.
• At the end of the first day, the futures price
for a contract being entered into at the end
of the day is Rs 405.
– If Poonam were to offset she would be
agreeing to sell at Rs 405 per unit.
– So she would have a profit of Rs 5 per unit or
Rs 500 in total
• While marking the contract to market, the
broker would behave as if she is offsetting.
– He would credit Rs 500 to her margin
account.
• But since she has not expressed a desire
to offset he would act as if she were re-
establishing a long position at the new
price, that is, at Rs 405.
• The futures price at the end of the next
day is Rs 395.
– When the contract is marked to market
Poonam would have a loss of Rs 1,000
– Once again a new long position would be
established, this time at a price of Rs 395.
• The process will continue either until the
delivery date
• Or until the day that the position is offset, if
that were to happen earlier.
• As can be seen
– Rising futures prices lead to profits for the
long
– Declining futures prices lead to losses for the
long
• Now let us look at the situation from
Kunal’s perspective.
– At the end of the first day, marking to market
when the price is Rs 405 would imply a loss of
Rs 500.
– By the same logic, on the next day his margin
account will be credited with Rs 1,000.
– So shorts lose when prices rise and gain
when they fall.
• So the profit/loss for the long is identical to
the loss/profit for the short.
– Futures contracts are consequently referred
to as Zero Sum Games.
• One man’s gain is another man’s loss.
• By the time the contract expires the loss
incurred by one of the two parties, in this
case the short, would have been totally
recovered.
– In this case Poonam’s account would have
been credited with Rs 2,500
– Kunal’s account would have been debited with
Rs 2,500
• Now if Kunal were to default Poonam
would not be at a disadvantage.
– She already has a profit of Rs 2,500
– She can now take delivery at the spot price of
Rs 425, in lieu of taking delivery under the
futures contract.
– Thus the effective price paid by her would be
Rs 400
• Which is what was contracted for in the first place.
The Clearinghouse and MTM
• The clearinghouse essentially plays the
role of a banker.
– It will debit the margin account of the broker
whose client has incurred a loss
– And credit the margin account of the broker
whose client has made a profit.
Forward Contracts
• Unlike futures contracts, forward contracts
are not marked to market.
– So both the parties are exposed to default
risk.
– Consequently parties to a forward contract
tend to be large and well known, such as
• Banks
• Financial institutions
• Corporate houses
• Brokerage firms
Maintenance Margin and Variation
Margin
• In a futures contract
– Both longs and shorts have to deposit a
performance bond known as the Initial Margin
• If a party makes a profit his margin account will be
credited
• Else if he makes a loss his margin account will be
debited
Maintenance…(Cont…)
• The broker has to ensure that the client
always has adequate funds in his margin
account
– Otherwise the entire purpose of margining
can be defeated
• Consequently the broker will specify a
threshold balance called the Maintenance
Margin
– This will obviously be less than the initial
margin level
• If due to adverse market movements, the
balance in the margin account declines below
the maintenance level, the client will be asked to
deposit additional funds to take the balance back
to the initial level
• A call for additional margin is referred to as a
Margin Call.
• The additional funds deposited in response to a
margin call are referred to as Variation Margin.
Illustration
• Take the case of Poonam
• She went long in a contract for 100 units at a
price of Rs 400 per kg, and deposited an initial
margin of Rs 5,000.
• Assume the maintenance margin is Rs
4,000
• If the contract lasts for five days and the daily
futures prices are as depicted earlier, the impact
on the margin account will be as follows.
• Initial margins need not be always deposited in
the form of cash.
– Brokers will accept securities like T-bills and equity
shares as collateral.
– But the value assigned to these assets will be less
than their current market values.
• This to protect the broker against a sharp decline in the value
of the collateral.
• For instance a security worth $100 may be valued at $90
– Technically the broker would be said to have applied a Haircut
of 10%
• Variation margins however must always
be paid in cash.
– This is because while the Initial Margin
represents a performance guarantee
– The variation Margin is a manifestation of
actual losses suffered by the client.
Value at Risk
• If the amount of collateral that is collected
from the parties is adequately high, the
potential for default will be considerably
reduced.
• So the margins specified by the exchange
would depend on the estimate of the
potential loss.
• Value at Risk (VaR) is a statistical
technique for estimating the loss.
Value at Risk (Cont…)
• A priori we cannot be sure as to what the
quantum of loss will be from one day to
the next.
• At best we can say that with a given level
of probability, the loss cannot exceed a
specified amount.
– This is the concept of Value at Risk.
• VaR is a summary statistical measure of
the possible loss of a portfolio of assets
over a pre-specified time horizon.
– For instance if we say that the 99% VaR over
a one day horizon is Rs 1,000, it means that
there is only a 1% probability that the loss of
value of the asset over a one day holding
period will exceed Rs 1,000.
• A VaR number is meaningless unless the
probability level and the holding period are
both specified.
– Obviously the VaR for a one day holding
period will be different from the VaR for a
three day holding period.
– Similarly the 99% VaR for a portfolio will differ
from the 95% VaR.
• Is VaR a measure of the maximum
possible loss that a portfolio can suffer?
– No!
• In principle the value of a portfolio can
always go to zero.
– Thus the maximum loss that a portfolio can
potentially suffer is its entire current value.
Gross Margins versus Net Margins
• Some clearinghouses collect margins on a
Gross basis while others do so on a Net
basis.
• We will illustrate the difference between
the two with the help of an example.
Illustration
• A broker has three clients A, B, and C
– A is long in 100 contracts
– B is long in 50 contracts
– C is short in 70 contracts
• Assume that the initial margin is Rs 1 per
contract.
• The broker will collect
– Rs 100 from A
– Rs 50 from B
– And Rs 70 from C
• So in all he will collect Rs 220.
• If the clearinghouse collects margins on a gross
basis, the broker will have to deposit the entire
Rs 220 with it.
– This is the meaning of Gross or Client Level
margining.
• On the other hand if a net margining
system were to be used the clearinghouse
would calculate the broker’s position as 80
long
– He has 150 long and 70 short contracts
routed through him.
– Thus in this case the broker has to deposit
only Rs 80 with the clearinghouse.
Gross…(Cont…)
• What are the relative merits and demerits
of the two?
• Let us assume that the futures price goes
up by Rs 1.
– The broker will need Rs 150 to pay the longs.
– Of this, Rs 70 should come from C, while the
balance should come through the
clearinghouse since the broker has a net long
position with it.
Gross…(Cont…)
• Assume that party C defaults and the
broker too has become insolvent.
– If a gross margining system is used, the
clearinghouse has the resources to pay both
A and B since the broker has deposited
Rs 220 with it.
– However if net margining is used the
clearinghouse can only guarantee payment
for 80 contracts, since the broker has
deposited only Rs 80 with it.
Gross…(Cont…)
• Thus, in the case of net margining clients
need to be more concerned with the
financial strength and integrity of the
broker.
• They cannot bank on the clearinghouse to
always bail them out.
Gross…(Cont…)
• Gross margining, however comes with an
economic price tag.
– Firstly clients may not pay adequate attention
to the credit-worthiness of the brokers.
– Secondly the cost of operations of the
clearinghouse will increase.
• For it has to provide guarantees on a much larger
scale.
Default
• Default can occur at two points in time
– Either before maturity
– Or at the time of maturity
Default (Cont…)
• Let us consider default before maturity
• We will use the same data used earlier.
Default (Cont…)
Default (Cont…)
• At the end of the third day the balance in
the margin account falls to Rs 3,000
• So a margin call will issued for Rs 2,000
• If the client fails to pay the variation
margin the broker will actually offset the
position
– In this case he will offset the long position by
going short at the market price
Default (Cont…)
• The price at the time the margin call was issued
was Rs 380.
• Assume that by the time the position is offset,
the price has fallen to Rs 377
• If so the investor would have incurred a further
loss of Rs 300 for 100 units.
• This loss along with transactions costs incurred
by the broker will be deducted from the balance
of Rs 3,000 in the account.
– The remaining amount will be refunded to the client.
Default (Cont…)
• If a broker fails to respond to a margin call
from the clearinghouse, the futures
exchange will close his account at the
prevailing market price.
Default (Cont…)
• What about default at expiration?
• If the short defaults, that is he fails to deliver, the
broker will acquire the asset in the spot market
and deliver it to the long.
• If the long defaults, the broker will acquire the
asset from the short and sell it in the cash
market.
– In either case the broker will deduct his costs and
losses from the balance in the defaulter’s margin
account.
Profit Diagrams
• Investors who are long in futures gain if
the futures price rises.
– However the lose if the price declines
• For shorts it is the opposite
• They gain if the futures price falls
– But lose if the price rises
Profit Diagrams (Cont…)
• The profit for a long may be expressed as
FT – F0
0 represents the point of time at which the
contract is initiated
T is the point of time at which the contract
either expires or is offset
• So for every rupee increase in the terminal
futures price, the profit is one rupee more
– However for every rupee decrease in the
terminal futures price the profit is one rupee
less
• If we plot the profit versus the terminal
futures price, we get a linear graph.
• The maximum loss occurs when FT is zero
and is equal to F0 in magnitude.
• The maximum profit is unbounded
– Since FT has no upper bound.
The position breaks even if FT = F0.
• For a short futures position, the profit is
F0 – FT.
• Thus the profit diagram for a short position
is also linear.
• The maximum profit occurs when FT = 0,
and is equal to F0 in magnitude.
• The maximum loss is unlimited.
Illustration
• Nitin has gone long in a futures contract at a
price of Rs 400 and the opposite short position
has been taken by Maya
• If the futures price at expiration is Rs 421 then
due to marking to market, Nitin’s margin account
would have been credited with Rs 21 while
Maya’s account would have been debited with
Rs 21.
• Thus the profit for Nitin = FT-F0 = 421-400
• And the profit for Maya = F0-FT = 400-421
FCMs
• A Futures Commission Merchant is a broker who
is authorized to open an account on behalf of a
client.
• What does the maintenance of an account
entail?
– Collection of margin money
– Maintenance of balances in the margin account
– Recording and reporting of all trading activities
FCMs (Cont…)
• All brokers are not FCMs
• We also have Introducing Brokers
– They help a client to get acquainted with an
FCM
– That is they accept orders and route it through
an FCM
– They are however not authorized to maintain
margin accounts.
FCMs (Cont…)
• Every FCM is not a clearing member
• Who is a clearing member?
– He is a member of the clearinghouse.
– He is authorized to maintain clearing margins
with the clearinghouse and clear transactions
through it.
• So if your FCM is not a clearing member
he must route the order through a clearing
member.
Leverage
• A strategy is said to be Levered or Geared
if a fairly small market movement tends to
have a disproportionately large impact on
the funds deposited.
• We will first illustrate leverage in the
context of companies.
Leverage (Cont…)
• Take two companies A and B
– A has a paid up capital of Rs 100,000 with no debt
– B has a paid up capital of Rs 50,000 with a debt of
50,000 carrying an annual interest of 10%.
• We will take two cases
– The first where the companies make an operating
profit of Rs 25,000
– And the second where they make an operating loss of
Rs 25,000.
– To keep matters simple assume no taxes.
Leverage (Cont…)
Leverage (Cont…)
• Company A unlevered whereas company
B is levered.
• Leverage is a double edged sword.
– In a booming market, a 25% return gets
magnified to 40%
– But in a falling market a -25% return gets
translated to a loss of -60%.
Leverage (Cont…)
Leverage (Cont…)
• Futures and options also provide leverage
• Take the case of an investor who goes
long in rice futures at a price of Rs 10 per
kg and deposits a margin of Rs 250.
– Each contract is for 100kgs.
• If the price moves to Rs 11, the profit is
Rs 100
– Which is 40% of the initial deposit
Leverage (Cont…)
• However had he bought 100kgs spot by paying
Rs 1000 a profit of Rs 100 would mean a gain of
only 10%
• What if the futures price were to fall to Rs 9.
– A loss of Rs 100 would mean an erosion of 40% of
the margin deposit
• However if he had bought spot, a loss of Rs 100
would amount to 10% of the initial investment
– Clearly leverage is a double edged sword.
Arbitrage
• Arbitrage is the ability to make cost-less risk-less
profits by transacting in two or more markets.
• The rationale is the following.
– If you invest in a risky asset you must get a
commensurate expected rate of return
– If the asset is risk-less you should get a risk-less rate
of return
– But what if you can get a risk-less return without
making an investment.
Arbitrage (Cont…)
• This is termed as an arbitrage opportunity.
– An investor would be irrational not to exploit it.
– He would exploit it till it vanishes.
Illustration
• A share is trading at Rs 100 on the BSE
and Rs 102 on the NSE.
• A person borrows Rs 1,000,000 for an
infinitesimal period of time.
– He buys 10,000 shares on the BSE and
immediately sells it for Rs 1,020,000 on the
NSE.
– After repaying the loan he is left with a profit
of Rs 20,000
• This is Cost-less and Risk-less
Arbitrage (Cont…)
• Such opportunities cannot last for long
– As people start buying on the BSE the price
will rise
– As they start unloading shares on the NSE the
price will fall.
– The factors will quickly eliminate the profit
opportunities.
Arbitrage (Cont…)
• We have assumed that there are no transactions
costs like
– Bid-ask spreads
– Brokerage fees
• For small investors such costs will be significant
– These may preclude them from exploiting perceived
arbitrage opportunities
• Large investors however face much lower costs
– They will exploit such opportunities so as to maximize
profits.
Price Convergence
• At the time of expiration of the futures
contract, the futures price must be the
same as the cash or spot price.
– That is FT = ST
• Why?
• What is a futures contract?
– It is a contract to transact at a future point in
time
Price Convergence (Cont…)
• A futures contract entered into at the point
of expiration must lead to an immediate
transaction
– This is because the contract is scheduled to
expire immediately
– Hence it is valid only for an instant
– Thus it is effectively equivalent to a spot
contract
• If the futures price at expiration is not
equal to the spot price, there will be
arbitrage opportunities.
• What if the futures price is greater?
• Assume that the futures price is Rs 425
whereas the spot price is Rs 422.
– An arbitrageur will acquire the asset and go
short in a futures contract.
– Since the contract is expiring he will
immediately deliver at Rs 425.
– There is obviously an arbitrage price of Rs 3.
• What if the futures price is less?
• Assume that the futures price is Rs 422
whereas the spot price is Rs 425.
– An arbitrageur will go long in a futures
contract
– He will immediately take delivery at Rs 422
and sell spot at Rs 425
– Obviously there is an arbitrage profit of Rs 3.
Settlement Price
• What is the settlement price?
– It is the price that is used to compute the daily gains
and losses for the longs and the shorts when the
contracts are marked to market.
• In many cases it is set equal to the closing price
– If there is heavy trading at the close it may be set
equal to the average of the observed prices in the last
half-hour or hour of trading.
– If there are no trades at the close it may be set equal
to the average of the observed bid and ask quotes.
Delivery
• Both forward and futures contracts call for
delivery at expiration
– But there are fundamental differences
between them
• First most forward contracts are settled by
delivery
– But only a small fraction of futures contracts
result in actual delivery
– The rest are offset prior to expiration
Delivery (Cont…)
• Second, a forward contract is a
customized agreement between two
parties
– So unless it is cancelled before expiration, it
will result in the short delivering to the original
party who had gone long.
Delivery (Cont…)
• In the case of futures, after the trade, the link
between the two is broken by the clearinghouse.
– Subsequently one or both parties may offset and exit
the market.
– So when the short seeks to deliver the long with
whom he traded may no longer have an option
position.
– So the exchange has to decide who should accept
delivery
• In practice the person with the oldest outstanding long
position is called upon to take delivery.
Delivery (Cont…)
• Finally, the price paid by the long at the
time of taking delivery under a forward
contract would be different from what he
would have to pay under a futures contract
• A forward contract is not marked to market
– So at expiration the long has to pay the price
that was negotiated at the outset in order to
take delivery.
Delivery (Cont…)
• But a futures contract is marked to market
on every day.
– So to ensure delivery at the price that was
agreed upon at the outset, the long has to pay
the prevailing futures price at expiration.
– Which is the same as the prevailing spot price
at expiration.
Delivery (Cont…)
• Consider a futures contract that was
entered into at time `0’ and which expires
on day `T’.
– The corresponding prices are F0 and FT
– The contract would be marked to market on
days 1,2,3…up to day T.
Delivery (Cont…)
• The cumulative profit for the long is:
Delivery (Cont…)
• To ensure that the long is able to acquire the
asset at F0, he must be asked to pay a price `P’
at delivery such that
P – (FT – F0) = F0
⇒ P = FT = ST
• In the case of forward contracts there are no
intermediate cash flows.
– So at the time of delivery the price paid must be what
was agreed upon originally. That is:
P = F0
Illustration
• A futures contract on rice was entered into
at a price of Rs 15 per kg.
• The contract lasts for 5 days.
• The prices on subsequent days are as
depicted below.
• In this case F0 = 15 and FT = 20.
• A person who goes long in a futures contract
would have to pay Rs 20 at the time of delivery.
– Taking into account the profit of Rs 5 due to marking
to market the effective price paid is Rs 15.
• However a person who goes long in a forward
contract would have to pay Rs 15 to take
delivery.
Delivery (Cont…)
• Once a short declares his intention to
deliver, the process of delivery will take 3
days.
• One the day of announcement by the
short
– Called the Notice of Intention Day
the short’s broker will convey his intention
to the clearinghouse.
Delivery (Cont…)
• The notice will state:
– How many contracts are being delivered
– The location of delivery
– The grade being delivered
• On the next business day, called the
Position Day, the exchange will select the
person with the oldest outstanding long
position to accept delivery.
Delivery (Cont…)
• On the following day, called the Delivery
Day
– The long will pay the short
– And will get a warehouse receipt granting him
title to the goods.
Delivery (Cont…)
• Trading need not stop as soon as delivery
commences.
• For many assets
– The first day on which the short can declare
his intention is before the last day of trading
– The last notice day is however after the last
day of trading.
Delivery Schedule for Corn Futures
on the CBOT
Cash Settlement
• Certain futures contracts do not allow for
physical delivery of the underlying asset
– In such cases the contract is marked to
market till the last day and all positions are
declared closed.
– Both parties will exit the market with their
profit/loss since inception.
– But the short will not deliver the underlying
asset at the end.
Cash Settlement (Cont…)
• Cash settlement is the prescribed mode
for stock index futures.
– To form a portfolio that mimics the index the
investor has to buy all the stocks in the index
and in exactly the same proportions.
• Obviously physical delivery is cumbersome.
Trading Volume versus Open
Interest
• The trading volume on a given day is the
number of contracts that were traded
during the course of the day.
• What then is open interest?
– It is the total number of outstanding contracts
at any point in time.
– Since every long position must have a
corresponding short position
• Open interest is the number of open long positions
• Or equivalently the number of open short positions
Trading Volume…(Cont…)
• The relationship between the trading
volume for a day and the change in open
interest from the previous day depends on
the nature of the transaction.
Illustration
• A new contract in silver futures has just opened
for trading and three trades have taken place.
• The trading volume for the day is 200 contracts.
• Since no one has subsequently offset any
contracts the number of open positions is also
200 contracts.
• We will now consider three scenarios for the
next day.
• Case A
• Meera goes long in 50 contracts and Amit goes
short.
• Thus both parties are entering into a trade that
increases their open positions.
– The trading volume is obviously 50 contracts
– The open interest at the end of the day is 250
contracts
– The change in open interest from the previous day is
+50 contracts.
• Thus if a trade involves two parties who
are establishing new positions by entering
into a contract with each other, the open
interest will rise.
• Meera goes long in 50 contracts and Radhika
goes short
• The trading volume is once again 50 contracts.
• But no new positions have been opened.
– Radhika who was long in 100 contracts has partially
offset and her place has been taken by Meera.
– The number of open positions is still 200
– The change in open interest compared to the previous
day is zero.
• Thus if a trade involves one party taking a
counterposition by trading with a part who
is opening a position, then open interest
will remain unchanged.
• Case C
• Amit goes long in 50 contracts and Radhika
goes short
• The trading volume is 50 contracts
• Radhika has partially offset by going short and
Amit has also partially offset by going long.
– Thus the number of open positions is 150
– The change compared to the previous day is -50
• If a trade involves a party taking a
counterposition by trading with another
party who is also taking a counterposition,
then the open interest will fall.
Trading…(Cont…)
• A high trading volume on a given day
signifies greater liquidity.
• High open interest at the end of a day
indicates more potential for
counterpositions on subsequent days
– It is a signal that future trading volumes are
likely to be high.
Economic Role of Derivatives
• Reallocation of Risk: All investors do not
have the same appetite for risk.
– Hedgers seek to avoid risk
– Speculators consciously take risk
• Derivatives can be used to transfer risk
from those who seek to avoid it to those
who are willing to bear it.
Economic…(Cont…)
• Price Discovery: In a free market prices
are the critical variables of interest.
– Fair and accurate prices are imperative for
ensuring correct allocation of resources.
• Supply and demand information tends to
percolate derivative markets more easily.
– Thus they help facilitate the dissemination of
such information.
• Why?
– Taking a long spot position requires the
investor to pay the full price
– Taking a long futures positions requires the
deposit of a small margin
– Besides it is easier to go short in derivatives
than to short sell the asset.
• Thus from the point of view of both longs
and shorts trading in derivatives is
attractive.
– This fuels the level of activity in such markets.
• Consequently transaction costs are lower
in derivatives markets.
• Secondly derivative markets are
characterized by greater liquidity.
Liquidity
• What is liquidity?
– It is the ability of market participants top
transact quickly at prices which are close to
the true or fair value of the asset.
– In liquid markets buyers and sellers can
discover each other quickly, and do not have
to offer a large premium or discount to induce
a transaction.
• Market Efficiency: Since trading in
derivatives is easy and cheap, perceived
market inefficiencies can be arbitraged
away.
• Thus derivatives facilitate market
efficiency.
• Ease of Speculation: Speculation is
essential for the functioning of free
markets.
• Derivatives help speculators to take
positions by depositing only a small
amount of collateral.
Introduction to Options
Introduction
• Options contracts are by design different from
futures contracts.
– The buyer of an option is called a Long
• He has a right to transact
– The seller of the option is called the Short or the
Writer
• He has an obligation
• So the long has the freedom to decide whether
or not he wishes to transact
– But if he chooses to exercise the short has no choice
but to carry out his part of the agreement.
• Unlike in the case of futures, both parties
need not deposit collateral.
– For if a person has a right there is no fear of
non-compliance
• If it is in his interest he will exercise
• He will not do so otherwise
– Thus only the shorts need deposit margin
Options versus Stocks
• Exchange traded options contracts have
certain features in common with equity
shares. However there are critical
differences.
– The trading mechanism for exchange traded
options is similar to that of equities of listed
companies.
• Price discovery takes place through a continuous
bilateral auction process.
Options…(Cont…)
• But equity shares do not have an expiry
date, whereas options have a limited life
span.
• The supply of equity shares is limited to
the quantity issued by the firm.
– However the number of contracts outstanding
at any point in time is dependent entirely on
the number of buyers and sellers seeking to
buy and write options.
Options…(Cont…)
• In certain markets shares are still
represented by physical certificates.
– However with dematerialization, scrip less
trading is becoming the norm.
• Options are however not backed by
certificates of ownership.
– Evidence of a position is indicated by a
printed statement issued by the brokerage
firm.
Options…(Cont…)
• Finally stock ownership confers certain
privileges on the shareholders such as
– The right to vote in annual general meetings
– And partake in cash dividends
• However option owners stand to benefit
solely from the upward or downward
movement of the stock price, depending
on whether they own call or put options.
Terms Associated with Options
• Exercise price
• Expiration date
• Option premium
Exercise Price
• The price which a call holder has to pay
the writer per unit of the underlying asset if
the option is exercised.
• It is the price receivable by a put holder
per unit of the underlying asset if a put is
exercised.
• It is also known as the Strike Price.
Exercise Price (Cont…)
• The exercise price enters the picture only
if the option is exercised.
• Since the holder has a right and not an
obligation
– The option may or may not be exercised
– Which means that the exercise price may or
may not be paid/received.
Expiration Date
• It is the point in time after which the contract
becomes void.
• It is the only point in time at which a European
• It is the last point in time at which an American
• It is also known as
– Exercise date
– Strike date
– Maturity date
Option Premium
• It is the price paid by the holder to the
writer at the outset, in order to acquire the
right to exercise.
• It is a sunk cost?
– That is, if the holder were to subsequently
choose not to exercise, the premium cannot
be recovered.
Option Premium (Cont…)
• Why is a premium required?
– The buyer is acquiring a right from the writer
who is taking on a contingent obligation.
– No body will ever give a right away for free.
– They have to be paid for in order to acquire
them.
Exercising Options
• An investor buys a call option on Reliance
expiring on the last Thursday of
December, with an exercise price of
Rs 1,260.
• The premium is Rs 20 per share.
– Option premia are always quoted per unit of
the underlying asset.
• In this, on a per share basis.
Exercising Options (Cont…)
• The contract size for stock options
contract in the U.S. is 100 shares.
• In India it varies from company to
company.
– For Reliance the lot size is 150 shares
• So as soon as the deal is struck:
– The buyer has to pay 150 x 20 = Rs 3000 to
the writer.
Exercising Options (Cont…)
• When will the right be exercised?
– Obviously only if the stock price at the time of
expiration is greater than Rs 1260.
– Else it is better to let the option expire
worthless.
Sunk Cost
• Would it not make sense to exercise the
option only if the stock price at expiration
is greater than the exercise price + the
premium
– That is only if ST > 1260 + 20 = Rs 1280
• The answer is no.
Sunk Cost (Cont…)
• Assume that the terminal stock price is
Rs 1275.
• If the options are exercised the profit is:
π= (1275 – 1260)x150 – 3,000 = (750)
• If the options are not exercised the profit
will be (3000).
• The maxim is that:
`Sunk Costs are Irrelevant’ while taking
investment decisions.
Exercising Puts
• What if the option were to be a put and not
a call?
• Obviously exercise would be profitable
only if ST < 1260.
• Else it is better to let the option expire
worthless.
Exercising Puts (Cont…)
• Assume that the terminal stock price is
1150 and that the premium is 75.
• The profit is:
π= (1260 – 1150)x 150 -11250 = Rs 5,250
Payoffs and Profits - Symbolically
• For a call holder the payoff at expiration is
ST – X if ST > X or 0 if ST ≤ X
• Combing the two conditions the payoff
may be expressed as:
Max[0, ST – X]
• The profit = Max[0, ST – X] – Ct where Ct is
the premium paid at the time of
acquisition.
Payoff…(Cont…)
• What about the writer?
• Payoff = -Max[0, ST – X]
= Min[0, X – ST]
• Profit = Min[0, X – ST] + Ct
Observations
• The maximum profit for the call holder is
unlimited.
– The stock price at the time of exercise has no upper
limit.
• The maximum loss is limited to the premium
paid at the outset.
• For writers the situation is the reverse.
– The maximum loss is unlimited.
– The maximum profit is the premium paid at the outset.
Puts
• For a put holder the payoff is X – ST if ST
< X, else it is equal to 0.
• This can be represented as Max[0,X - ST]
• The profit can be represented as:
π= Max[0, X – ST] – Pt, where Pt is the
premium paid at the outset.
Puts (Cont…)
• From the writer’s standpoint the payoff is:
-Max[0,X - ST] = Min[0, ST – X]
• The profit for the writer is:
Min[0, ST – X] + Pt
Observations
• For a put holder the maximum profit is
equal to the exercise price minus the
premium.
– This is because stocks have limited liability.
– Consequently the premium cannot go below
zero.
• The maximum like in the case of calls, is
equal to the option premium.
Observations (Cont…)
• For a put writer:
– The maximum profit is equal to the premium
– The maximum loss is equal to the exercise
price minus the premium.
Zero Sum Games
• Thus both calls and puts may be said to
be Zero Sum Games.
– The holder’s profit is equal to the writer’s loss
and vice versa.
Exchange Traded versus OTC
Options
• Exchange traded options were introduced
by the CBOE in 1973.
– Until then the only way to trade options was
over the counter.
• An OTC option is a customized contract.
– What is the meaning of customization?
• The exercise price, the date of expiration, and the
contract size are decided in the process of
negotiations between the buyer and the writer.
Exchange…(Cont…)
• Exchange traded options are standardized
agreements.
– The exercise prices and the expiration dates for which
contracts can be negotiated are specified by the
exchange.
– Buyers and sellers can incorporate any of the
allowable exercise prices and expiration dates into the
agreement, but cannot design contracts on their own
terms.
– The contract size is also specified by the exchange.
Advantages of Standardization
• First, since only certain exercise price and
expiration dates are permitted, the number
of types of contracts available is limited.
– If individuals were free to design their own
contracts there would be far too many
contracts.
• Consequently because of standardization t
– Trading volumes tend to be high
– Transactions costs tend to be low
Advantages…(Cont…)
• Higher trading volumes mean more
Liquidity.
• What is liquidity?
– It is the ability of traders to transact quickly at
prices that are close to the fair value of the
asset.
– Market participants in such markets can enter
and exit quickly and easily and do not have to
induce transactions by offering large
premiums or discounts.
• Standardization facilitates the taking of
counterpositions.
• What is a counterposition?
– The assumption of a short position by a trader
who has originally gone long and vice versa.
Illustration
• Aditi bought an options contract on
Reliance from Rakesh a week ago.
– The exercise price is Rs 1260
– Contract expires at the end of June.
• Now Aditi wants to get out of her position.
– All that she has to do is to find a trader who
would like to buy an option on Reliance, which
• Expires in June
• Has an exercise price of Rs 1260
• This party need not be Rakesh.
• Notice the following.
– To offset a call an opposite position must be
taken in a call with the same exercise price
and maturity date.
– The same holds true for puts.
• Such offsetting is feasible because the
contract is standardized.
• If the contract were to be customized:
– There would be an infinite number of exercise
prices and expiration dates that can be
specified
• Consequently the odds of finding a third party who
would facilitate the taking of a counterposition
would be very low.
• How does one get out of a customized
contract?
– Such contracts can be abrogated by the long
or the short only by seeking out and getting
the approval of the original counterparty.
• In the case of exchange traded options,
credit risk is minimized.
• Why?
– There is a clearinghouse associated with each
exchange.
• It enters the picture once the trade is executed.
– Once the trade is consummated it becomes
the effective seller for every buyer and the
effective buyer for every seller.
• In the case of futures contracts the
clearinghouse has to guarantee the performance
of both parties
– In the case of an options contract only the
performance of the writer has to be guaranteed.
• The presence of a clearinghouse facilitates
offsetting
– After the trade the link between the long and the short
is broken
– Consequently both parties need only deal with the
clearinghouse thereafter.
• The clearinghouse consists of member
firms called Clearing Firms.
– All orders must eventually be routed through
such firms.
– So if your broker is not a clearing member he
must route the order through a clearing
member.
• All writers have to maintain margins with
their brokers.
• If the broker is not a member he has to
maintain a margin with a clearing member.
• The clearing member concerned has to
maintain a margin account with the
clearinghouse.
Moneyness
• Call Options:
– If St > X the call is In-the-money
– If St = X the call is At-the-money
– If St < X the call is Out-of-the money
– If St ≈ X the call is Near-the-money
Illustration
• Stock is currently trading at Rs 500
– A call with an exercise price of Rs 500 will be
at-the-money.
in-the-money
out-of-the-money.
• A call will be exercised only if it is in-the-
money.
Moneyness (Cont…)
• Put Options:
– If St > X the put is Out-of-the-money
– If St = X the put is At-the-money
– If St < X the put is In-of-the money
– If St ≈ X the put is Near-the-money
Illustration
• A stock is currently trading at Rs 500.
– A put with an exercise price of Rs 500 will be
at-the-money.
out-of-the-money.
in-the-money.
• A put too will be exercised if it happens to
be In-the-money.
Exercise by Exception
• The OCC, which is the clearing
corporation in the U.S. has devised a
procedure to automatically exercise
expiring options.
– This is known as Exercise by Exception or
Ex-by-Ex.
• The OCC has established in-the-money
thresholds for expiring options.
Exercise…(Cont…)
• Contracts whose payoff if exercised will be
greater than or equal to the applicable
threshold, will be automatically exercised.
– Unless of course the clearing firm explicitly
instructs the OCC to the contrary.
• Contracts whose payoffs if exercised will
be les than the applicable threshold will
not be exercised.
– Unless the clearing firm specifically instructs
the OCC to do so.
Contract Specification
• Since exchange traded options are
standardized contracts, the exchange will
have to specify the following features.
– The underlying asset
– The contract size
– Expiration date
– Exercise price
Contract Size
• The number of units of the underlying
asset that are deliverable per contract has
to be specified.
– In the U.S. all stock option contracts are for
100 shares.
– In India the contract size varies from stock to
stock.
Expiration Dates
• Options are referred to by the month in
which they expire.
– For instance a January call is a call option
expiring in January.
• In the U.S., stock options contracts expire
on the Saturday following the third Friday
of the month.
– It means the 4th Saturday if the first day of the
month is a Saturday, else the third Saturday,
Expiration Dates (Cont…)
• In India, index as well as stock options
expire on the last Thursday of the month.
– If the market is closed on that day, then the
contracts will expire on the previous business
day.
Expiration Month
• In the U.S., stock options are designed to be on
a Quarterly Cycle.
– There are three cycles: January, February, and March
• A January cycle comprises of the following
months: January, April, July and October
• February cycle comprises of: February, May,
August and November
• The March cycle comprises of: March, June,
September and December.
Expiration Month (Cont…)
• At any point in time, contracts will be
available for:
– The current month
– The following month
– The next two months of the cycle to which the
company is assigned.
Illustration
• Assume that today is 1st September 2006.
• A company is assigned to the February
cycle.
• Contracts will therefore be available for
the following expiration months:
– September
– October
– November and
– February 2007
• September represents the current month
• October is the following month
• November and February 2007 are the
next two months after October 2006 from
the February cycle.
• When the September contracts expire, the
following expiration months will be
available:
– October
– November
– February
– May
• When the October options expire the
following months will be available:
– November, December, February and May
• When the November options expire the
following months will be available:
– December, January, February and May
• And finally after the December contracts
expire we will have:
– January, February, May and August
LEAPS
• The CBOE and the AMEX offer contracts
on stocks as well as indices with up to
three years to expiration.
• These are called Long Term Equity
Anticipation Securities or LEAPS.
• LEAPS expire in January each year on the
Saturday following the third Friday of the
month.
System in India
• SEBI guidelines allow for contracts with a
maximum time to expiration of 12 months.
– But the exchanges have offered contracts with
a maximum life span of 3 months.
• At any time there will be contracts for the
current month and the next two months.
Illustration
• Assume that today is December 14 2006.
– Contracts will be available for December,
January, and February.
• December contracts will expire on 29th
December – the last Thursday of the
month
– Thus on 29 December, March contracts will
be allowed.
– The January and February contracts will of
course continue to trade.
Exercise Prices
• At any point in time there will always be an
at-the-money or near-the-money contract
that is available for trading.
– This is true for both calls and puts.
• There will also be other contracts which
are in-the-money or out-of-the money to
varying degrees.
The U.S. System
• When contracts for a fresh expiration date
are being introduced, two strike prices that
are closest to the prevailing stock price will
be chosen.
• If the stock price moves outside the band
formed by these two exercise prices, then
contracts with a fresh exercise price will
be introduced.
The U.S. System (Cont…)
• The CBOE usually follows the following
rules
– If the stock price is less than $25 the strike
prices will be intervals of $2.50
– If the stock price is between $25 and $200 the
strike prices will be spaced $5 apart.
– If the stock price exceeds $200 the strike
prices will be spaced $10 apart.
Illustration
• Company XYZ has been assigned to the
February cycle, and the May contract is
just being introduced. The prevailing stock
price is $87.
• At the outset call and put contracts with
exercise prices of $85 and $90 will be
permitted for trading.
– If the stock price remains between $85 and
$90, only contracts with these two exercise
prices will be permitted.
• If the stock price were to go above $90
new call and put contracts with an
exercise price of $95 will be introduced.
• If the stock price were to fall below $85,
new contracts with an exercise price of
$80 will be permitted.
The U.S. System (Cont…)
• At any point in time, contracts with many
different exercise prices will be trading for
each expiration month.
• The number of exercise prices observable
at any point in time would depend on the
movement in the price of the stock from
the inception of trading for that particular
month.
– Not all contracts will be equally active.
Option Class
• All contracts on a given stock which are of
the same type – either calls or puts – are
said to constitute an option class.
• Thus all calls on IBM irrespective of the
exercise price or expiration date will
constitute an option class.
• Similarly all puts on the stock will
constitute another class.
Option Series
• All contracts in a given class – Call Class
or Put Class – with the same exercise
price and expiration date are said to
constitute an Options Series.
• For instance all calls on IBM with X = $100
and a time to expiration of 3 months
would belong to the same series.
FLEX Options
• Institutional traders usually find exchange
traded products to be inadequate.
– Thus they desire the freedom to design
contracts to meet their specific requirements.
• Traditionally such investors had to
approach other institutions, like
commercial banks for writing options with
the desired features.
FLEX Options (Cont…)
• This growing relationships between institutional
investors and the OTC market, was a matter of
concern for the exchanges.
• To attract institutional business the exchanges
devised two products to address their needs.
– These are FLEX options for stock indices and E-FLEX
options for equity shares.
• The world FLEX stands for Flexible Exchange.
• To trade Flex options, an investor has to
submit a RFQ – Request for Quote.
• This will contain the details if the contract
being sought.
– Is it a call or a put
– The exercise price
– Time to expiration
– European or American
• The RFQ will be acted upon by market
makers on the exchange.
– They will submit quotes for the option
premium.
• The advantage of such options is that
while they provide the flexibility of an OTC
product, from the standpoint of contract
design, they are cleared by the OTC.
• To open a new E-Flex series a trade must
be for a minimum of 250 contracts.
• Each RFQ is assigned a Request
Response Time (RRT).
– This ranges from 2-20 minutes after the
receipt of the RFQ.
• During this period exchange members
may submit bids and offers on behalf of
their customers.
Flex Options (Cont…)
• Quotes may be modified at any time
during the RRT.
• At the end of the RRT the best bid and
offer are reported to the member who
submitted the RFQ.
– He may accept a part or all of it.
– Improve it
– Or reject it
• The member who submits the RFQ is not
obliged to accept the best BBO.
• If it declines it, any member may accept it.
• Similarly if the submitting member accepts the
BBO, but there is excess size available, then
other members may trade the balance.
• Once it is determined that there is no further
interest in the response to the RFQ, the market
for that RFQ is deemed to be closed.
• All quotes are no longer valid.
• For a series that is already in existence,
the procedure is essentially the same.
• Quotes are made available only on
submission of an RFQ.
• Trades in preexisting series must be for a
minimum of 100 contracts and increments
of 100 contracts thereafter.
Assignment of Contracts
• When a holder decides to exercise his
option, it is not necessary that the writer
with whom the original trade took place,
be still be present in the market.
• In practice the holder has to inform his
clearing firm, which will then place an
exercise order with the clearinghouse.
Assignment (Cont…)
• The clearinghouse will then randomly
select a clearing firm through which an
investor has written an option with the
same features.
• The clearing firm that is selected has to
then choose a particular writer.
– The writer who is chosen is said to be
assigned.
Adjusting for Splits and Stock
Dividends
• Exchange traded options have to be
adjusted for stock splits and stock
dividends.
• What does a split do?
– It alters the number of shares owned and the
corresponding stock price.
Adjusting…(Cont…)
• Consider a share that is priced at $P.
• Assume that there is an n:m split.
• The new theoretical price will be mP/n
– For instance if there is a 5:2 split, the new
price will be 2P/5.
Adjusting (Cont…)
• In the event of a split, the terms of the
option contract will be adjusted as follows.
• The exercise price will be changed from X
to mX/n.
• The number of shares per contract will be
changed n/m x original # of shares.
Illustration
• An investor is holding a call which entitles
them to 100 shares at $100 each.
• The company then announces a 5:2 split.
• The new exercise price will be
2 x 100/5 = $40
• The # of shares will be 5/2 x 100 = 250
Adjustments…(Cont…)
• Similar adjustments will take place for
stock dividends.
• Take the case of a 40% stock dividend.
– It means 0.4 extra shares for every share that
is held or two extra shares for every five
existing shares.
• Thus it is like a 7:5 split.
• Thus when the contract is adjusted the
stock dividend is treated like a 7:5 split.
Part-07
FOREIGN EXCHANGE
1
Introduction
 Foreign exchange or FOREX is not
traded on organized exchanges.
 Thus the market is purely OTC
 It is a network of dealers which is
primarily dominated by commercial
banks.
 In India all dealers have to obtain
prior approval from the RBI.
 Such dealers are called Authorized
Dealers or ADs.
2
FOREX Quotes
 The exchange rate for a currency
is the amount of that currency that
can be exchanged per unit of
another currency.
 In other words it is the price of one
currency in terms of another
currency.
3
Two Quoting Conventions
 Think of an asset such as a share.
 We usually quote the price as Rs
100 per share.
 We can also quote it as .10 shares
for Rs 10.
 However we always quote as units of
currency per unit of the asset and not
as units of the asset per unit of the
currency.
4
Conventions (Cont…)
 The difference in the case of
FOREX is that we are quoting the
price of one currency (which is also
an asset), in terms of the price of
another currency.
 Thus we can quote in terms of
Rupees per Dollar or equivalently
in terms of Dollars per Rupee.
5
Direct Quotes
 If the price of the foreign currency
is quoted as the number of units of
the Domestic currency per unit of
the Foreign currency, it is called a
Direct Quote.
 For example Rs 43.75 per dollar is an
illustration of a direct quote.
6
Currency Symbols
 Before we proceed let us list the
internationally accepted symbols of
various currencies.
 Australian Dollar – AUD
 Canadian Dollar – CAD
 Indian Rupee – INR
 Japanese Yen – JPY
 Pound Sterling – GBP
 Singapore Dollar – SGD
 Swiss Franc – CHF
 US Dollar - USD
7
Direct Quotes (Cont…)
 Consider a quote of INR 43.75 per
USD.
 If the rate increases to INR 44.25
per USD
 It implies that every dollar is worth
more in terms of Rupees
 And we would say that the dollar has
appreciated or the rupee has
depreciated.
8
 However if the rate were to decline to
INR 43.20 per USD

Then each dollar would be worth less in
terms of rupees and we would say that
 The dollar has depreciated or that the
rupee has appreciated.
9
 Thus in the case of direct quotes:
 An increase in the quoted value
signals an appreciating foreign
currency and a depreciating domestic
currency
 A decrease in the quoted value
signals a depreciating foreign
currency and an appreciating
domestic currency
10
Indirect Quotes
 We can also quote an exchange
rate as the number of units of
foreign currency per unit of the
domestic currency.
 For instance if we have a quote of
USD 2.25 per INR 100, it would be
an indirect quote in India.
11
Indirect Quotes (Cont…)
 If the rate were to increase to USD
2.40 per INR 100, it would imply
that
 The dollar has depreciated or the
rupee has appreciated.
 Thus an increase in the value
connotes a depreciating foreign
currency and an appreciating home
currency.
12
 If the rate were to decline to USD
2.10 per INR 100, it would imply an
appreciating dollar and a
depreciating rupee.
 Thus a decline in the rate connotes an
appreciating foreign currency and a
depreciating home currency.
13
Confusion
 It appears that an increase in the
rate connotes an appreciating
foreign currency if rates are
quoted directly and a depreciating
foreign currency if they are quoted
indirectly.
 How do we avoid errors?
14
Numerator/Denominator
 Always think in terms of numerator and
denominator currencies.
 In a direct quote in India like INR 43.75
per USD, the rupee is the numerator
currency and the dollar is the
denominator currency.
 If the rate increases it means that the
numerator currency has depreciated.
 Else if it decreases it means that the
numerator currency has appreciated.
15
(Cont…)
 In the case of an indirect quote like
USD 2.25 per INR 100, the dollar is
the numerator currency and the
rupee is the denominator currency.
 Once again an increase in the rate
would mean that the numerator
currency which is the dollar has
depreciated.
16
(Cont…)
 On the other hand, a decline in the
value would mean that the
numerator currency has
appreciated.
17
Direct or Indirect
 Until 1993 banks in India were
using the indirect quotation
system.
 Subsequently they have switched
to the direct method.
 We will use the direct method for
most of our illustrations.
18
Purchase & Sale
 Whenever we say buying or selling
rates we always mean it from the
dealer’s perspective.
 When rates are quoted there will
be two rates, one for buying and
the other for selling.
19
Purchase & Sale (Cont…)
 Consider the Direct Quoting
system.
 43.25/43.70 INR/USD
 For the dealer purchase involves
conversion of foreign exchange
into rupees.
20
Illustration-1
 BHEL has exported turbines to
Libya and has received a check for
10 MM USD.
 When it presents it to its bank
asking for the equivalent amount
in rupees to be credited to its
account, it constitutes a purchase
transaction.
21
Illustration-2
 An NRI from Dubai has remitted
10000 USD to his relative in Kochi.
 When the bank converts it to the
rupee equivalent and credits the
relative’s account it constitutes a
purchase.
22
Purchase/Sales (Cont…)
 Conversion of domestic currency
into foreign currency by a bank will
be termed as a sale of foreign
exchange.
23
Illustration-3
 Tata Steel has imported iron ore
from Australia and needs to pay
the party in Sydney.
 It therefore requests SBI to
prepare a check for 50 MM AUD
and debit its current account.
 This constitutes a sale for the
bank.
24
Bid and Ask
 For a given currency, the price at which
the dealer is willing to buy the currency
will obviously be lower than the price at
which he is willing to sell it.
 So in the direct quotation system the
bid will be lower than the ask.
 For instance, a quote for USD may read:
43.2400-43.3100.
25
Bid and Ask (Cont…)
 However in the indirect system, the bid
will be greater than the ask.
For instance a quote for USD may read:
2.2200-2.1500
 This means that when the AD is buying
dollars he will give 100 rupees for every
2.22 dollars purchased.
 However when he is selling USD he will
charge 100 rupees for every 2.15
dollars sold.
26
Arbitrage
 Arbitrage in the FOREX market can
arise on various counts.
 We have situations conforming to
what are called:
 One point arbitrage
 Two point arbitrage
 Triangular or three point arbitrage
 Covered interest arbitrage
27
One Point Arbitrage
 ICICI bank is quoting: 43.2400-
43.3100
 SBI is quoting: 43.3500-43.4200
 Consider the following strategy:
 Borrow 433,100 rupees
 By 10000 USD from ICICI.
 Sell 10000 USD to SBI
 Receive 433,500 from SBI
 There is an arbitrage profit of INR
400. 28
One Point Arbitrage
(Cont…)
 Now consider the following quotes:
 ICICI: 43.2400-43.3100
 SBI: 43.3000-43.3700
 Clearly arbitrage is not possible.
 Or:
 ICICI: 43.2400-43.3100
 SBI: 43.1800-43.2500
 Once again no arbitrage
29
One Point Arbitrage
(Cont…)
 So to rule out arbitrage the quotes
of two banks must overlap by at
least one point.
 What is a point, for most
currencies it is 1/10000 of the
domestic currency.
 For instance a point in India is
0.0001 rupees.
30
Two Point Arbitrage
 ICICI is quoting:
 27.2500-27.3500 INR/SGD
 DBS Singapore is quoting:
 3.7000-3.7250 SGD/100 INR
 This is an arbitrage opportunity
31
Two Point Arbitrage
(Cont…)
 Consider the following strategy:
 Borrow 10000 SGD and sell it to
ICICI.
 You will get 272500 INR.
 Sell this to DBS in Singapore in
return for: 3.7000 x 2725 =
10082.50
 There is an arbitrage profit of
82.50 SGD. 32
Why Arbitrage?
 Consider ICICI’s quote of:
27.2500-27.3500
 When ICICI is quoting 27.2500 for
buying 1 SGD it is effectively
saying that it is willing to sell 1 INR
for
1/27.2500 = 0.036697 Ξ 3.6697
SGD/100INR
33
Why? (Cont…)
 Similarly a quote of 27.3500 for
selling SGD amount to a quote of:
1/27.3500 = 3.6563 SGD/100INR
for buying rupees.
 Thus 27.2500-27.3500 INR/SGD
corresponds to 3.6563-3.6697
SGD/100INR.
34
Why? (Cont…)
 This does not overlap with 3.7000-
3.7250 which is what DBS is
quoting in Singapore.
 Hence the potential for arbitrage.
 Thus two-point arbitrage is nothing
but the logic of one point arbitrage
extended to two markets.
35
Triangular or Three-Point
Arbitrage
 To do triangular arbitrage we need
three currencies.
 Assume that Bank Mitsubishi is
offering the following rates:
 75.2150-75.2750 JPY/AUD
 150.2025-150.2925 JPY/USD
 Citibank NYC is offering:
 0.5220-0.5280 USD/AUD
36
Arbitrage Strategy
 Borrow 752750 yen in Tokyo and
buy 10000 AUD.
 Sell it in NYC for 5220 USD.
 Sell the USD in Tokyo in return for
5220 x 150.2025 = 784057.05 JPY
 Clearly there is an arbitrage profit
of:
784057.05 – 752750 = 31307.05
37
Arbitrage (Cont…)
 Hence the condition required to
preclude arbitrage is that:
 (JPY/AUD)ask ≥ (USD/AUD)bid x
(JPY/USD)bid
 Similarly it can be shown that:
 (JPY/AUD)bid ≤ (USD/AUD)ask x
(JPY/USD)ask
 The LHS in the above expressions is the
natural rate for a currency.
 The RHS represents the synthetic rate 38
Arbitrage (Cont…)
 Thus the no arbitrage conditions
may be stated as:
 The natural ask should be greater
than or equal to the synthetic ask.
 The natural bid should be less than
or equal to the synthetic bid.
39
Forward Rates
 Forward trading is very common in
foreign currency markets.
 Although futures trading is very
active in certain countries,
particularly in the US, the volume
of trading in the forward market is
much higher than in the futures
market.
40
Forward Rates (Cont…)
 The forward market is an OTC
market.
 The majority of the participants are
commercial banks.
41
 In the case of direct quotes, if the
forward rate is greater than the
spot rate then the foreign currency
is said to be trading at a forward
premium.
 However if the forward rate is less
than the spot rate, then the foreign
currency is said to be trading at a
forward discount. 42
 If the forward rate is equal to the
spot rate, then the currency is said
to be trading flat.
43
Illustration-1
 Spot: 43.2500-43.2800 INR/USD
 1 M Forward: 43.2650-43.3050
 Obviously the US dollar is at a
forward premium.
44
Illustration-2:
 Spot: 43.2500-43.2800
 1 M Forward: 43.2250-43.2600
 Obviously the US dollar is at a
forward discount.
45
Illustration-3
 Spot: 43.2500-43.2800
 1 M Forward: 43.2500-43.2800
 The dollar is trading flat
46
 In the above cases the full forward rate
has been specified for both buying and
selling.
 These are called Outright Forward
Rates.
 However sometimes only the difference
between the spot rate and the forward
rate called the Forward Margin or the
Swap Points will be given.
47
 Consider the following data:
 Spot: 43.2500-43.2800
 Forward: 45/75
 Obviously the forward figure
represents the swap points.
 However we do not know whether
the dollar is at a premium or at a
discount.
48
 Thus should the swap points be
added to the spot rates or should
they be subtracted.
 The point to remember is that the
spot market has the maximum
liquidity.
 The further we go in time, the less
will be the liquidity and the higher
will be the spread.
49
 Hence when the swap points are
specified as a/b where a < b, then
adding the points will widen the
spread.
 Thus a specification of a/b where a
< b indicates that the foreign
currency is at a forward premium
and that the points should
therefore be added to the spot 50
 In this case the rates would be:
 Spot: 43.2500-43.2800
 1 M Forward: 43.2545-43.2875
 However what if the swap points
had been specified as 75/45.
 In this case subtracting the swap
points from the spot rates will
widen the spread.
51
 Thus a quote of 75/45 indicates
that the foreign currency is at a
forward discount.
 The corresponding forward rates
are:
 43.2425-43.2755
52
Indirect Quotes
 In the case of indirect quotes the
logic will have to be reversed.
 In such cases the bid will be higher
than the ask.
 Thus if the swap points are
specified as a/b where a < b, then
subtracting the points will widen
the spread.
53
 Thus while a/b where a < b does
indicate a forward premium, the points
must be subtracted in order to arrive at
the outright forward rates.
 Similarly a/b where a > b indicates a
forward discount.
 However the points will have to be
added in order to arrive at the outright
forward rates.
54
Merchant Rates &
Exchange Margins
 Whenever a dealer buys or sells to
a client he will have to interact
with the Inter-bank market either
prior to the deal or subsequent to
it.
 Consider a purchase transaction.
 In this case after acquiring the
foreign currency from the client,
the dealer will have to sell it in the
inter-bank market. 55
Merchant…(Cont…)
 Had it been a sale transaction, the
dealer would have had to acquire the
currency in the inter-bank market prior
to selling it to the client.
 Clearly there has to be a relation
between the rates in the inter-bank
market and the rates quoted by the
dealer to the client, which are called
merchant rates.
56
 Let us take a purchase transaction.
 After the purchase the dealer will
have to dispose off the currency in
the inter-bank market.
 The relevant rate is therefore the
bid in the inter-bank market.
 Thus the Base Rate for purchase
transactions is the inter-bank bid.
57
 If the dealer has to make a profit
on the deal, the bid price quoted
by the dealer has to be lower than
the bid in the inter-bank market.
 Similarly in a sale transaction the
dealer has to acquire the currency
at the ask rate in the inter-bank
market before selling it to the
client. 58
 The relevant base rate in this case
is the ask rate in the inter-bank
market.
 In order for the dealer to make a
profit the ask rate quoted by him
must be higher than the inter-bank
ask rate.
 The profit margins applied by the
dealer is known as the exchange 59
 As should be obvious, in a
purchase transaction the exchange
margin will be subtracted from the
base rate before a buying rate is
quoted to the client.
 In a sale transaction the exchange
margin will be added to the base
rate before a selling rate is quoted
to the client. 60
Illustration-1
 The inter-bank rates on a given
day for the US dollar are:
 44.2000-44.2500
 An exporter has just received a
draft for USD 10000 which he then
presents to the bank.
 The bank as a matter of policy
levies an exchange margin of
0.05%.
61
 Given the fact that the dealer is
buying his base rate is the bid of
44.2000.
 The rate quoted to the client will
therefore be:
44.2000(1 – 0.0005) = 44.1779
62
Illustration-2
 The inter-bank rates on a given
day are as follows:
 Spot: 44.2000-44.2500
 1 M Forward: 125/75
 A client comes to the bank seeking
to make an outward remittance of
10000 USD after one month.
63
 The first step is to calculate the
outright one-month forward rates.
 These are:
44.1875-44.2425
 Since the AD is selling the relevant
rate is the ask which is 44.2425.
 Assume that the exchange margin
is 0.08%.
64
 The rate that will be charged to the
client will therefore be:
44.2425(1 + 0.0008) = 44.2779
65
Inter-bank Swap Deals
 Banks regularly enter into deals
with each other where they either
buy spot and sell forward or vice-
versa or else buy forward for one
maturity and sell forward for
another maturity.
 These are called Swap transactions
and Forward to Forward Swap
transactions respectively. 66
Swap Deals (Cont…)
 Since banks routinely enter into such
deals with each other they ignore the
bid-ask spread implicit in the inter-bank
spot quote and focus solely on the
premium or discount applicable for a
forward trade with the required
maturity.
 The following examples will illustrate
this.
67
Swap Deals…(Cont…)
 The rates in the inter-bank market are
as follows.
 Spot: 44.2000-44.2500
 Forward: 125/75
 ICICI Bank is selling spot to HDFC and
buying 1M forward.
 The number of concern here is the
discount applicable for a one month
forward sale which is 75 points.
68
Swap Rates…(Cont…)
 The spot rate chosen for the transaction
may be any rate between the current
quotes of 44.2000 and 44.2500.
 Assume that a rate of 44.2200 is
chosen.
 ICICI will therefore sell spot at this rate.
 Since it is buying 1M forward and the
dollar is at a discount, the applicable
rate will be 44.2200 - .0075 = 44.2125.
69
Option Forwards
 Sometimes while entering into a
forward contract the client may not
know the exact date on which he would
need to buy or sell.
 For instance an importer is expecting a
shipment which is likely to arrive
between one to two months from now.
 However he is not sure of the precise
date.
70
Option Forwards (Cont…)
 The importer can in such cases
negotiate a forward contract with the
option to take delivery of the foreign
currency at any time between one to
two months from now.
 The question is how should the bank
quote a rate.
 Should it assume that the transaction
will take place one month later or
should it assume that it will take place
two months later.
71
Option Forwards (Cont…)
 The AD will always assume that
the transaction will take place at
the worst possible time from his
point of view.
 What is the worst possible
situation?
 It would depend on:
 Is the AD buying or selling
 Is the currency at a premium or at a
discount 72
Illustration-1
 Indian Rayon is importing
machinery and requires dollars
between two and three months
from now.
 It wants a forward contract with an
option to buy at any time between
two and three months from now.
73
 The inter-bank rates are:
 Spot: 45.4500-45.8525
 1M Forward: 45/85
 2M Forward: 70/110
 3M Forward: 110/155
74
 The relevant rate in this case is the
selling rate since the dealer is
selling.
 If the contract is completed after 2
months the applicable premium is
110 points.
 However if it is completed after
three months the applicable
premium will be 155 points.
75
 Since a premium is being charged,
the dealer will levy the higher of
the two amounts.
 So the applicable rate for the
option forward will be:
45.8525 + 0.0155 = 45.8680
76
Rule
 In a sale transaction where a
premium is applicable, charge the
premium for the latest date of
delivery.
77
Illustration-2
 Assume that the spot rate is the
same as earlier but that the dollar
is trading at a discount.
 Spot: 45.4500-45.8525
 1M: 75/35
 2M: 115/75
 3M: 140/95
78
 If the transaction is completed after two
months the applicable discount will be
75 points.
 Whereas if it is completed after three
months, the applicable discount will be
95 points.
 Since the dealer is giving a discount he
will give the lower of the two values.
 So the applicable rate will be:
45.8525 – 0.0075 = 45.8450
79
Rule
 For a sale transaction where the
foreign currency is trading at a
discount, the rule is allow the
discount applicable for the earliest
date of delivery.
80
Illustration-3
 A party has exported a
consignment and will be paid in
dollars at a point in time between
one and two months from today.
 The rates in the inter-bank market
are:
 Spot: 45.3500-45.7320
 1M: 35/80
 2M: 65/115
81
 The relevant base rate here is the
bid of 45.3500.
 If the transaction occurs after one
month the applicable premium will
be 35 points.
 However if it occurs after two
months the applicable premium
will be 65 points.
82
 Since the AD is buying, he will give
the lower of the two premia.
 So the applicable rate in this case
will be:
45.3500 + 0.0035 = 45.3535
83
Rule
 So the rule for a purchase transaction
where the currency is quoting at a
premium is:
 Offer the premium for the earliest
delivery date.
 If the currency had been quoting at a
discount, the rule would have been:
 Offer the discount for the latest date of
delivery.
84
Covered Interest Arbitrage
 The strategies that result in the no-
arbitrage condition for foreign
exchange forward contracts are
called Covered Interest Arbitrage
strategies.
85
Cash and Carry
 Consider the following information:
 Spot rate: 25.2025 INR/SGD
 3M Forward rate: 25.5075 INR/SGD
 Interest rate for 3M loan in India:
7.5% p.a.
 Interest rate for 3M loan in Singapore:
4.5% p.a.
86
Cash and Carry (Cont…)
 Borrow 252025 INR and buy 10000
SGD.
 Invest it in Singapore at 4.5%.
 Future value = 10000(1.01125) =
10112.50 SGD
 At the outset go short in a forward
contract to sell this amount after 3
months.
 Proceeds in INR = 10112.50 x 25.5075
= 257944.59
87
Cash and Carry (Cont…)
 Amount due in India =
252025(1.01875) = 256750.46
 Arbitrage profit = 257944.59 –
256750.46
= 1194.13 INR
88
Reverse Cash and Carry
 Consider the following information:
 Spot: 25.2025
 3M Forward: 25.3075
 3M rate in India = 7.5% p.a.
 3M rate in Singapore = 4.5% p.a.
89
 Borrow 10000 dollars in Singapore.
 Convert it into 252025 INR.
 Invest it in India.
 Future value = 252025(1.01875) =
256750.46
 Amount due in Singapore =
10000(1.01125) = 10112.50
90
 Go long in forward contract at the
outset to buy this amount.
 Cost = 25.3075 x (10112.50) =
255922.09
 Arbitrage profit = 256750.46 –
255922.09
= 828.37 INR
91
Symbolic No-Arbitrage
Condition
 Spot: S INR/FCR
 M Period Forward: F INR/FCR
 Indian M-period rate = id
 Foreign M-period rate = if
 No arbitrage requires that:
S(1+id) = F(1+if)
So: F = S x (1+id)
______
(1+if)
92
Interest Rate Parity
 This is called the interest rate
parity condition.
 It can be written:
F–S id - if
_______ = ________ ≈ id - if
S (1+if)
93
Reality Check
 What looks like an arbitrage opportunity
in practice may not be exploitable.
 One reason is the presence of
transactions cost.
 The issue is therefore can we make a
profit after taking such costs into
account.
 Secondly a country may not permit free
movement of currencies across borders.
94
Reality Check (Cont…)
 Thus a perceived opportunity may
not be exploitable in practice.
 In fact even a perception that
exchange controls may be
imposed may preclude
arbitrageurs from trying to take
advantage of such opportunities.
 Take the case of the arbitrageur
who buys and invests 10000 95
Reality Check (Cont…)
 His arbitrage profit is realizable
subject to the condition that he is
able to repatriate the amount from
Singapore after 3 months.
 The other key factor is the tax
regulations in the two countries.
 The issue of relevance is the
possibility of a post-tax profit.
96
Futures Markets
 The biggest futures exchange for
foreign exchange is the International
Monetary Market (IMM) at the Chicago
Mercantile Exchange (CME).
 Currencies traded include:
Australian Dollars; Canadian Dollars,
Brazilian Reals; Euro; Japanese Yen;
Pound Sterling; Mexican Peso; NZ
Dollar; Swiss Francs
Russian Rubles; South African Rands 97
Illustration on Hedging using
Futures Contracts
 Eli Lilly is scheduled to receive 25 MM
Swiss Francs after 2 months.
 The worry is obviously that the dollar
will appreciate and that since the
invoice is denominated in Swiss Francs,
the proceeds in dollars may be less than
anticipated.
 Since Swiss Francs have to be sold, the
company needs to go short in futures.
 Assume that it uses 3 month contracts. 98
 On the IMM each Swiss Francs
futures contract is for 125,000
CHF.
 So for 25 MM CHF
25,000,000
_____________ = 200 contracts will
be
125,000 required.
 The rates in the futures market
99
 Obviously the applicable rate is the
bid of 0.5150.
 Assume that the rates after two
months are as follows:
Spot: 0.4985-0.5025
1M Futures: 0.4985-0.5025
 If the company had not hedged, it
would have had to sell 25 MM CHF
at 0.4985 which would have
yielded 12,462,500USD 100
 Since it has hedged it will receive:
25,000,000 x (0.5150 – 0.5025) =
312,500 as a profit from the
futures market.
 The proceeds from the cash
market = 12,462,500
 Total proceeds = 12,775,000
101
 Effective rate: 12,775,000
__________ = 0.5110
25,000,000
102
Illustration-2
 An airline in the US has ordered parts
from the US worth 4MM pounds.
 The payment is due after one month.
 The worry is that the dollar will
depreciate for if it does, the payment in
dollars will go up.
 Since pounds have to be acquired the
firm needs to go long in a futures
contract.
 Assume that two month contracts are 103
 Current rates are:
Spot: 1.4025-1.4075
2M Forward: 1.4120-1.4190
 Assume that the rates after one
month are:
Spot: 1.4150-1.4220
1M Forward: 1.4250-1.4335
104
 If the company had not hedged it
would have paid
4,000,000 x 1.4220 = 5,688,000
 The effective cost if it hedges can
be calculated as follows.
 Buy spot at 5,688,000
 Profit from futures =
4,000,000(1.4250-1.4190) =
24000 105
 Total payment in dollars =
5688000 - 24000 = 5664000
 Effective exchange rate:
5664000
__________ = 1.4160
4000000
106
FOREX Options
 Foreign currency options are
traded on a number of exchanges.
 In the U.S. the Philadelphia exchange
is a major centre for such contracts.
 In addition to exchange traded
options, customized contracts are
traded by banks and other
financial institutions.
107
Hedging
 For a party who wants to hedge a
foreign currency exposure, options
provide an alternative to forward
contracts.
108
Illustration
 An Indian exporter is expecting to be
paid in pounds after a month.
 His worry is that the pound will
depreciate and that he may receive
fewer rupees than anticipated.
 He can hedge by buying put options on
Sterling.
 He can then be sure that the value of the
Sterling will never be below the exercise
price.
109
 Similarly, a party who is due to
make a payment in Sterling at a
future date will be afraid that the
Sterling may appreciate.
 One way for it to hedge is by
buying calls on Sterling.
 This way it can ensure that the
currency will not cost more than the
exercise price.
110
Part-08
Financial Statement Analysis

with
Perspectives from a Commercial Bank
Who Needs Accounting
Statements?
• As the modern economy grows the
number of people who are impacted by
the modern corporation is constantly
increasing.
– Thus the list of legitimate users of accounting
information is not easy to specify.
– A comprehensive list of user groups would
include the following
User Groups
• Owners of a business • Customers
• Managers of a • Suppliers
business • The government
• Employees of a • Donors & Sponsors
business • The public
• Prospective • Financial analysts
employees
• Advisers
• Lending organizations
• Prospective lenders
Why?
• Why would people need information on
the financial health of a company?
– There is no standard answer
– Each group has its own needs
– The scope of information thus varies from
user group to user group
Sole Proprietorships
• In such entities, owners and managers are
synonymous.
• They need to know:
– Is the business profitable
– Is the cash position comfortable from the point
of view of bills to be paid in the short run
• They need to keep tabs on creditors and
debtors
Creditors & Debtors
• Creditors
– Are people who have supplied goods and
services to the business
– And have given it time to pay
• Debtors
– Are people to whom the firm has supplied
goods and services
– And to whom its has given time to pay
Companies
• Such entities have a broad class of
shareholders who are the owners
• While day to day operations are managed
by professional managers
• Share holders have a keen interest in the
profitability of the company
Returns for Shareholders
• They get returns in two forms
– Dividends
– Capital gains
Dividends
• The ability to pay cash dividends
– Is a function of the current level of profitability
– And the accumulated reserves built up with
profits from previous years
• Financial statements are indispensable for
gathering such information
Capital Gains
• Capital gains arise if the market value of
the shares were to steadily increase
• And forecast of share prices require
– An in depth analysis of published financial
statements
Potential Investors
• It is not only current shareholders who are
interested in the performance of a
company
• So are potential investors
– People who are contemplating the possibility
of making investments
• Will have a keen interest in the past performance
of the firm
• And its implications for future growth and profits
Managers
• They need to know the pulse of the
business
– So that they can take corrective measures if
required
• Analysis of current and past performance
– Is critical for monitoring the health of the firm
– And exerting required controls to keep it on
the targeted growth path
Employees
• Employees and trade union members
need to keep track of the business while
formulating strategies for bargaining with
the management.
• The bargaining power is often a function of
the financial health of the firm.
• The state of the firm’s finances has
implications for the future career path of
employees.
Employees (Cont…)
• Past employees too have a stake in the
firm’s performance.
– Any salary arrears due
– Or payouts in later years from pension plans
• May depend on the ability of the firm to deliver the
growth that was anticipated at the outset.
Lenders
• Potential lenders would be concerned with
– The asset base of the venture
– Its anticipated future profitability
• They need to perform a thorough analysis
of the financial state of the firm
– Their ability to recover loans would be a
function of the performance of the business
Lenders…(Cont…)
• Lenders such as bankers look at
prospective borrowers from two
perspectives
– First is the business generating sufficient
profits to be in a position to repay principal
and interest
– Seconds do the assets have sufficient value
to ensure recovery of loans in the event of
liquidation or bankruptcy.
Customers
• Existing and potential customers too have
reason to take interest in a firm’s
performance.
– Take the case of a software firm in India
– The client in the U.S would be keen on
knowing if the Indian firm will remain in
business in the foreseeable future
• For the consequences of changing vendors may
no only be financially costly but may also be
operationally difficult.
Suppliers
• Vendors who supply goods and services
to the firm would always be concerned
that
– Their money should be recoverable
The Government
• Government agencies such as the Income
Tax department have obvious reasons to
be concerned with the financial affairs of
the firm.
– The IRS has to ensure that the tax liability as
computed by a firm represents a fair and true
picture of the what the firm owes to the
government.
The Government (Cont…)
• Other regulators too have reasons to be
concerned.
– For instance if a firm is listed on the NYSE the
exchange authorities would monitor its
financial performance
– They would like to ensure that the audited
statements of accounts represent an accurate
picture of the financial health of the firm
Financial Analysts
• Analysts such as
– Brokers
– Dealers
– Investment Bankers
• Will take keen interest in the financial
health of a company
Financial Analysts (Cont…)
• Their conclusions about the health of an
enterprise
– Has repercussions on the buy/sell decisions
taken by the broker/dealer firm
– Or on the advice given by such firms to their
clients
Regulation
• As can be seen it is essential that the
published financial information of a firm
give a true and fair picture of its health and
state of affairs.
• Consequently regulatory bodies play a key
role.
Regulation (Cont…)
• Some regulations are statutory in nature
– And are embodied in the Companies Act
passed by the government
• Other guidelines are non-statutory in
nature
– And are provided by way of a series of
accounting standards which are issued by the
Accounting Standards Board.
• In the U.S., accounting standards are
provided by
– The Federal Accounting Standards Board
(FASB)
• The standards are called
– Financial Reporting Standards (FRSs)
– And
– Statements of Standard Accounting Practice
(SSAPs)
• These standards contain guidelines on a
wide range of issues, ranging from
– Valuation of assets
– Prescribed formats for accounting statements
– Accurate reflection of taxes
• The regulatory system is dynamic and
standards are constantly evolving
• New standards are published as and when required and
existing guidelines are revised and modified if and when
the need arises.
• The standards board is composed of professional
accountants
• Before issuing guidelines they will circulate draft
proposals called Financial Reporting Exposure Draft
(FRED)
– Comments from the public are factored in before the
financial standards are issued.
Types of Financial Statements
• Most organizations publish three types of
statements on a regular basis.
• They are often published once a year but
can be generated more frequently if the
need were to arise.
• These statements are
– The Income Statement
– The Balance Sheet
– The Cash Flow Statement
Need for Financial Statements
• These statements are generated in order
to answer various questions that may
arise during the perusal of financial
statements.
• The issues that normally arise in
connection with the review of financial
statements are broadly three
– What is the rate of return for the business
– What is the level of risk associated with the
business
Rate of Return
• The rate of return of a business is of
concern for
– Investors
– Income Tax Officials
– Business Competitors
Rate of Return (Cont…)
• They typically need answers to the
following questions
– What are the revenues for the business
– What are the costs that have been incurred in
generating the reported revenue
– Is there a surplus or deficit of revenues over cash
– How have the profits been deployed
• How much has been retained within the firm to fuel
future growth
• How much has been distributed as dividends to
shareholders
Rate of Return (Cont…)
• The answers to these and related
questions can be found in
– The Profit and Loss Account (P&L)
– Also known as the Income Statement
Level of Risk
• Lenders such as bankers will always be
concerned about the possibility that they
may not be able to recover their
investment
• Creditors will be worried about no
receiving payments for the goods supplied
• Consequently they will be worried about
the risks of the business
Level of Risk (Cont…)
• The issues of concern are
– How much does the organization owe its
creditors
– What assets or collateral does the
organization possess for loans availed by it
– What is the proportion of funds that has been
raised from shareholders
– How much of the firm’s capital is borrowed or
in other words is Debt capital
Level of Risk (Cont…)
• The answers to these and related
questions can be found by an analysis of
– The Balance Sheet of the firm
The Cash Position
• An organization that is generating large
profits may however be faced with a
severe cash crunch.
• Thus the level of cash that is available
may not be commensurate with the
profitability of the enterprise
The Cash Position (Cont…)
• The issues are
– How much cash is the business generating
from its activities
– Is there enough cash to cover the venture’s
planned investments
– If the cash flows from operations are
inadequate, how is the shortfall being met
The Income Statement
• This is the term used in the U.S
• In Britain and other Commonwealth
countries it is called the
– Profit and Loss Account
• It is a document that reflects the income
earned and the expenditure incurred
during the financial year
– The final item on the statement is the profit
earned or the loss incurred during the period
in question
Illustration
ITEM Amount in `000
Sales revenue 9,000
Cost of sales 6,500
Gross profit 2,500
Other expenses 750
PBIT 1,750
Interest 150
PBT 1,600
Tax @30% 480
Net Profit 1,120
Dividends 220
Retained 900
Earnings
The Income Statement (Cont…)
• The income statement shows the profit or
loss earned by a company during a
specified period.
• Assume for instance that the financial year
runs from 1 January 2004 till 31 December
2004.
– So every item of revenue or expenditure that
is shown in the income statement should
pertain to 2004.
• For instance
– If the firm were to have made an advance
payment for 2005
– Or were to have received a payment in
advance
• Such items would not be reflected in the statement
for the year 2004.
– Similarly if an item of income of expenditure
that is received/paid in 2004 pertains to 2003
• The it should be reflected in the P&L for 2003 and
not during 2004.
The Accruals Concept
• The principle of recognizing revenues and
expenditure in the period in which they are
earned or incurred, irrespective of when
they are actually received or paid
– Is called the Accruals Concept
Items on the Income Statement
• The sales revenue reflects the amount to
be received from customers in return for
the provision of goods and services during
the year
– Such revenue will be reflected as soon as the
goods are sold or the services rendered
– Irrespective of when the payment is received
Items…(Cont…)
• Thus a company may show substantial
revenues by way of sales and
consequently commensurate profits
– Even though it may have little to show by way
of a cash balance
Items…(Cont…)
• The cost of goods sold is subtracted from
the sales revenue.
• The cost of sales comprises of Direct
Costs
– Or the costs that are incurred in connection
with the production of the good or service
Items…(Cont…)
• For instance in the case of a physical
good, such costs would comprise of
– Cost of materials
– Wages paid to the labour force
– The overhead costs associated with running
the factory
Items…(Cont…)
• Note that Indirect Costs such as
advertising expenses and salaries paid to
white collared professionals will not be
included in the Cost of Sales
– These would be reflected under other
expenses
Items…(Cont…)
• The first measure of a firm’s profit for a
year is the Gross Profit for the year
– It is the difference between the Sales
Revenue and the Cost of Sales
– It clearly indicates whether the sales revenues
were adequate to cover the cost of production
– All other expenses incurred during the year
are paid out of the Gross Profits.
Items…(Cont…)
• In order to calculate the Net Profit for the
year, other expenses must be subtracted
from the Gross Profit.
• The main items of other expenses are
– Distribution costs
– Selling costs
– Administrative costs
• Notice that interest expenses are not
included
Items…(Cont…)
• While dealing with expenses
– Ensure that only the expenditure pertaining to
the financial year is taken into account
Examples
• For instance in the month of September
the firm may have paid an insurance
premium for the next half year
– The entire amount cannot be treated as an
expense for the year
– Only the amount that pertains to the
remaining three months in the year ought to
be considered.
• Failure to do so will understate the profits for the
current year
• And will overstate the profits for the following year
Examples (Cont…)
• Similarly the electricity bills may have
been paid only until 31 October 2004.
– If so the amount for the remaining two months
must be estimated and reflected.
• Thus there could arise situations where
the expenses that are yet to be paid may
have to be subjectively estimated.
Items…(Cont…)
• The Profit Before Interest and Tax (PBIT)
is known as the Operating Profit for the
year.
• This is the measure of profit over which
the operational managers of the firm can
exercise control.
– For, in the case of items such as interest and
taxes, which are yet to be factored in, they
have no control.
Items…(Cont…)
• The interest payable for the year is the
amount that is assessed on all the
borrowings of the firm. These include:
– Bonds and debentures
– Term loans from banks
– Overdrafts on current accounts
• Subtracting the interest for the year gives
the Profit Before Tax
– When the tax bill is deducted from this, we get
the net profit for the year.
Items…(Cont…)
• It is the net profit for the year that actually
belongs to the shareholders.
– The net profit can be either paid out in the
form of cash dividends
– Or else it can be retained within the firm
• In practice the entire net profits will not be
paid out as dividends
– A part will be retained to finance planned
investment and facilitate projected growth.
Items…(Cont…)
• In practice shareholders may have reason
to prefer that the firm retains net profits
rather than distribute them in the form of
cash dividends.
Items…(Cont…)
– This is because dividend income is typically
clubbed with other income and is
consequently taxed at the regular income tax
rate.
– On the other hand retained earnings will
manifest themselves as enhanced share
values in the market and will lead to capital
gains when the shares are sold.
• Capital gains, especially if it is long term in nature
will attract a lower tax rate.
Question
• How is it that loss making firms declare
dividends in practice.
– The reason is that they have retained
earnings from operations in preceding years.
– Such funds can be used to pay dividends.
Balance Sheet
• What is a balance sheet?
– It is a financial statement that shows
• The things of value that a company owns called
the Assets
• As well as what it owes to others called its
Liabilities
• The sum total of assets must match the
sum total of liabilities
– That is, the balance sheet must always
balance
Balance Sheet (Cont…)
• Every increase in an item on the liabilities
side must lead to
– A reduction in another item on the liabilities
side or
– To an increase in an item on the asset side
• Every decrease in an item on the liabilities
side must lead to
– An increase in another item on the liabilities
side
– Or to a decrease in an item on the assets side
• Thus the two sides of a balance sheet
must always balance
– This is a feature of the Double Entry System
of bookkeeping
• Every transaction has equivalent an simultaneous
impact on both sides of the balance sheet
• Unlike the income statement that captures
the activity during a specific period. The
balance sheet presents the state of affairs
as of a point in time.
– Thus the balance sheet is a snapshot of the
business on a particular day
– Typically the balance sheet is presented as of
the last day of the financial year
Illustration of an Asset Side
ITEM Amount in ‘000
Fixed Assets
Intangible Assets 200
Tangible Assets 3,200
Investments 50
Total Fixed Assets 3,450
Current Assets
Stock 500
Debtors 500
Cash at hand 150
Total Current Assets 1,150
Total Assets 4,600
Illustration of a Liabilities Side
ITEM `000
Shareholders’ Funds
Paid-up Capital 2,800
Reserves and Surplus 800
Total 3,600
Long Term Loans 600
Current Liabilities
Creditors 400
Total Liabilities 4,600
Capital Expenditure
• When money is invested in a business
– It can be used for the acquisition of assets
that are likely to be with the business for
along period of time
– Or else it can used to pay for items that will be
used quickly in the day to day running of the
business
• The first category of expenditure is called
capital expenditure and the assets so
acquired are termed as Fixed Assets
Capital Expenditure (Cont…)
• Such assets include:
– Buildings
– Machinery
– Equipment
– Motor Vehicles
Revenue Expenditure
• Money that is used to defray day to day
running expenditure is termed as revenue
expenditure
• Items include:
– Wages
– Salaries
– Telephone bills
– Stock intended for resale
Fixed Assets
• Such assets are going to be with a
business for more than a year, typically for
several years
– They may be sub classified as
• Tangible fixed assets
• Intangible fixed assets
Fixed Assets (Cont…)
• Tangible assets have a physical identity
• These include:
– Land
– Buildings
– Machinery
Fixed Assets (Cont…)
• Intangible assets have no physical identity
but nevertheless have value for the firm
• These include
– Patents
– Trademarks
Depreciation
• Take the case of a physical asset that is
going to be used for a period of 5 years
• The question is
– Is its fair to charge the entire cost of the asset
as an expense in the income statement in the
year of acquisition?
– Quite obviously it is not
– For if we were to do so
• Profits for the year will be understated
• Profits for subsequent years will be overstated
Depreciation (Cont…)
• In such cases the original cost of the asset
will be spread over the years during which
the firm will derive benefits.
Example
• Suppose a firm buys a machine worth
$50,000 that is going to be used over a
period of 5 years.
• Assume that the salvage value after 5
years is likely to be $5,000
• One way of dealing with depreciation is to
charge for the benefits accrued, on a
uniform basis for the years during witch it
will provide value
Example (Cont…)
• In this case, the cost per annum will be
calculated as:
50,000 – 5,000
_______________ = $ 9,000 per annum
5
• This is called Straight Line depreciation
– In this case the annual depreciation charge
per annum is $9,000
• The impact on the balance sheet will be as
follows
– For the first year
• 9,000 will be shown as an expense on the income
statement
• The balance 41,000 will be shown on the balance
sheet at the end of the year as the net book value
of the machine, under the category of tangible
fixed assets.
– In the second year another 9,000 will be
charged to the income statement
– And 32,000 will be shown as an asset on the
balance sheet at the end of the year
– At the end of 5 years the value on the balance
sheet will be the residual value of $5,000
• Yet another method of calculating the
depreciation is called the Written Down
Value method.
– In this case a fixed percentage of the residual
value of the asset as at the beginning of the
year, will be treated as an expense for the
year.
• Here is an illustration for depreciating an
asset worth $50,000 on a WDV basis at a
rate of 20% per annum for 5 years.
Illustration
Year Depreciation Residual Value
1 10,000 40,000
2 8,000 32,000
3 6,400 25,600
4 5,120 20,480
5 4,096 16,384
• In the case of the WDV method the
residual value will always be positive
– It will tend towards zero but will never become
zero.
Amortization
• The principle behind amortization is similar
to depreciation
– But the term is used in connection with
intangible fixed assets
• Take the case of a pharmaceuticals
company with a license that is expected to
be of value over a period of 10 years
– It may decide to amortize the cost over a
period of 10 years on a straight line basis
• The effect of amortization will be identical
to that of depreciation
– That is the cost of the license will be spread
over the income statements for the years
during which it is likely to be of benefit to the
firm.
Revaluation of Fixed Assets
• Some assets may actually increase in
value rather than depreciate.
– For instance the value of property may go up
over time
– In such cases the firm may have to have the
property revalued
– If so, depreciation in subsequent years must
be based on the revalued figure
Revaluation (Cont…)
• This is why certain balance sheets have a
statement
`Tangible fixed assets are shown at Cost or
Valuation, less accumulated depreciation’
• What this means is that the value of the
asset on the balance sheet is the historical
cost or the revalued figure, less the
amount charged by way of depreciation.
Investments
• A firm may buy securities issued by
another company and hold them on a long
term basis
– The value of such securities would be shown
on the balance sheet under the category of
fixed assets as Ìnvestments’.
Working Capital
• The part of an organization’s money that is
not invested in fixed assets will be
invested in Working Capital.
• Money that is invested in Working Capital
actually flows through a cycle.
– Cash Raw Materials WIP
Finished Goods Credit sales
Cash
Working Capital (Cont…)
• In certain businesses it may take a long
while for cash to come back as cash after
moving around the cycle.
– However cash will have to be pumped into the
cycle on a daily basis
– Unless cash is quickly returned back to the
firm at the end of the cycle, it operations will
come to a grinding halt.
– Thus it is essential to control the cycle and
keep the cash moving quickly.
• Some relief is provided to the business
because of the willingness of other parties
to provide materials on credit.
– For instance raw materials may be acquired
on credit and pumped into the cycle.
– To this extent the need for cash will be
reduced.
Current Assets
• One of the key components of current
assets is the goods in stock
• Stock may be subdivided into three
categories:
– Raw materials
– Work in progress
– Finished goods
Raw Materials
• Raw materials have to be valued at the
lower of cost or market value.
• Market value represents the amount for
which the materials can be sold less any
amount that has to be spent to complete
the sale.
• But the issue is that the same item may
have been purchased at different points in
time at varying prices.
Illustration
• A firm procured raw materials at
– $3.00 per unit in March
– $4.50 in July
– $6.00 in November
• The question is:
– If we are going to value at cost, which of the
three prices are we going to use?
– In practice one of two approaches is used
• The first is called First In First Out or
FIFO.
– That is the stock should be valued at the price
paid for the most recent purchase
• The alternative is called the Weighted
Average Method
– As an illustration assume that the items have
been procured as per the following schedule.
Price # of Units
3.00 200
4.50 300
6.00 500
• Assume that 400 units are in stock at the
end of the financial year.
– As per FIFO the units will be valued at $6.00
each.
– As per the Weighted Average method the
valuation will take place as follows
3 x 200 + 4.50 x 300 + 6 x 500
__________________________ = 4.95
1,000
• The value of the 400 units that are in stock
will be taken to be:
400 x 4.95 = $ 1,980
• The firm can choose whichever method it
considers appropriate
– But once a method is chosen it cannot
repeatedly be changed
Work in Process
• To value work in progress at cost, we
have to determine the value of:
– the materials that have gone into the
production of the item
– the wages incurred in the process of
manufacture
– and a reasonable charge for overheads
Work in Progress (Cont…)
• Since wages and overheads are being
factored in
– A unit of the semi-finished product will have a
higher value than a unit of raw material
• A relevant question is:
– Should WIP be valued at its net market
value?
Work in Progress (Cont…)
• Answer:
– Selling WIP is very difficult compared to
selling raw materials
– Typically the market value will be lower than
what it is worth to the firm
• The rationale used in practice is that the
firm is not in the business of selling WIP
– Its intention is to process the goods further
and convert them to the finished product.
– Thus WIP is valued on the basis of the cost
allocated by the firm and not on the basis of
its realizable market value.
Finished Goods
• They are valued at the lower of cost or
market value.
Debtors
• It is not difficult to compute the amount
that is owed to a business.
• The problem is to determine how much of
it will actually be received.
– If a business will know for sure that a party will
not pay, it will write off the amount as a bad
debt.
Debtors ( Cont…)
– Usually management will also know that a
percentage of what is outstanding is unlikely
to be recovered although it may not know for
certain as to which specific party or parties
may default.
– Thus it is a common practice to make a
provision for doubtful debts, in addition to
writing off bad debts.
Pre-payments
• Take the case of a firm that has paid
insurance premium for an entire year on 1
October.
– Obviously 75% of the amount is for the
forthcoming year and is a prepayment.
– The amount of the pre-payment is an asset
• Since the business can function for another 9
months without paying any additional insurance
premium.
Current Liabilities
• A liability is an amount that is owed by the
firm.
• A current liability is an amount that is
falling due within one year.
• We will look at two items
– Bank loans & Overdrafts
– Accruals
Bank Loans and Overdrafts
• Bank loans which are due after a year will
be shown as a long-term liability.
– But if a loan is scheduled to mature within the
current financial year, then it should be shown
as a current liability.
– A bank overdraft is a like a long-term loan
because it represents a revolving line of
credit.
• But a bank can recall it at any point in time.
• Consequently it is considered to be a current
liability.
Accruals
• If bills for an item of expenditure are still
pending, like telephone charges, then an
estimate of the amount has to be treated
as an expense while calculating the profit
for the year.
– The amount, till is paid, will be classified as a
current liability.
Goodwill
• This item appears on the asset side of
certain balance sheets.
• It arises in the following connection.
– When a business is acquired by a party, the
buyer will typically pay more than the book
value of the assets acquired.
– The extra amount that is paid for intangible
assets such as the reputation of the acquired
firm is called Goodwill.
• Goodwill is an intangible fixed asset.
• Its cost will be amortized over a period of time.
– The balance will be reflected on the balance sheet.
Capitalization of Costs
• When an item of expenditure is
capitalized, it means that the entire
expense is not written off.
– Rather a portion of its is treated as capital
expenditure and is shown on the balance
sheet along with other fixed assets.
– It is amortized every year and is thus written
off over a period of time.
Capitalization…(Cont…)
• A cost can be capitalized if it can be
shown that the expenditure that is incurred
will provide benefits in future years.
• A typical item that is capitalized is interest.
– Sometimes the interest that is paid on funds
borrowed to acquire a fixed asset is not
charged against the profit for the year.
– Instead it is added to the value of the asset
and the total amount is depreciated over the
life of the asset.
Capitalization…(Cont…)
• Other items that may be capitalized
include:
– Expenses included in developing software
– Cost of setting up an Internet site
The Cash Flow Statement
• Cash planning and cash management are
vital facets of the process of running a
business.
• A sound, potentially profitable business
may come to a grinding halt because of a
temporary shortage of cash.
– In such cases unless an external loan can be
arranged the survival of the business itself
may be at stake.
The Cash Flow …(Cont…)
• Prudent management requires anticipation
of cash requirements and making
provisions for the same.
• A cash flow statement is an integral part of
the books of account.
– It enables the user to assess the
• Amount
• Timing
• And uncertainty
– Of an organization’s cash flows during a financial
year.
Why?
• There are a number of reasons why a
profitable business may be low on cash
– Profits may have been reinvested in building
up stocks
– Sales may be in form of credit sales
– Cash may have been invested in fixed assets
• If so the expenditure would not be fully reflected in
the income statement because the assets would
be depreciated over a period of time.
• So profits may be high while cash balances are
low.
Illustration
ITEM `000
Net cash flow from operations 975
Return on investments and (75)
servicing of finance
Tax paid (225)
Capital expenditure (400)
275
Equity dividend paid (150)
Net cash inflow before financing 125
Financing (25)
Increase in cash 100
Net Cash Flow From Operations
• This is the cash generated by the day-to-
day activities of the business.
– It can be calculated by determining the cash
received from the customers during the year
less any cash paid for supplies and services.
Returns on investments and
servicing of Finance
• This would include:
– Dividends from shares and
– Interest from bonds
That the firm is holding as investments
Less
– Any interest on loans taken by the firm
• In the illustration the figure is negative
– It signifies a debt servicing burden
Tax Paid
• It is the actual amount of cash that is paid
to the tax authorities during the year
• This need not be equal to the tax liability
that is reflected in the income statement
– This is because a portion of the previous
year’s tax bill may be paid in the current year
– Or else payment of a portion of the current
year’s bill may be postponed to the next fiscal.
Capital Expenditure
• Refers to the net addition to fixed assets
– It reflects the assets bought during the year
by paying in cash
Less
– The cash that is received on account of the
sale of old assets
Equity Dividends Paid
• This need not be the same as the
declared dividend for the year
– This is because a portion of the dividends
declared in the previous financial year may be
paid this year
And/or
– A portion of the current year’s dividends may
not be paid by the end of this financial year
Financing
• These are the cash flows arising on
account of sources of capital
– The term includes inflows from the issue of
shares and bonds
Less
– Any outflows on account of
– Redemption of bonds
– Or buyback of shares
Cash Forecasts
• The cash flow statement in the annual
accounts helps external parties to monitor
the ability of the firm to generate cash.
• But its of little use to managers who are
trying to ensure that the business does not
run into a cash crunch.
Cash Forecasts (Cont…)
• The internal planning document that is
used for forecasting future cash
requirements is called a Cash Forecast.
– It will show the cash effects of all decisions
taken by the management.
– It can give advance warning of potential cash
problems so that managers can be prepared
for all contingencies.
Cash Forecast (Cont…)
• There are four possible cash positions that
could arise
• Each will demand a different course of
action.
• These are:
– Short-Term Deficit
– Long-Term Deficit
– Short-Term Surplus
– Long-Term Surplus
Short-Term Deficit
• Possible corrective actions include:
– Arranging of a bank overdraft
– Reduction of debtors
– Reduction of stocks
– Increase of creditors
Long-Term Deficit
• Possible corrective actions include:
– Raising long term finance such as a loan
– Issuance of additional shares
Short-Term Surplus
• Possible actions include
– Making short-term investments
– Increase debtors
– Increase stocks
– Pay creditors and avail of a discount
Long-Term Surplus
• Possible actions include:
– Expand or diversify operations
– Replace or increase fixed assets
Cash Forecast (Cont…)
• Thus the type of action that is taken by the
management will depend not only on
whether a surplus or a deficit is expected
but also on how long the situation is
expected to last.
• For instance it would not be prudent to
issue bonds or raise a term loan
– If the deficit is expected to last only for a few
months.
Illustration
Item Cash Flow In `000 For The Month Of
Jan Feb Mar Apr May Jun
Receipts
Sales 125 125 175 175 150 150
Others 15 15 15 15 15 15
Total 140 140 190 190 165 165

Receipts
Item Cash Flow In `000 For The Month Of
Payments
Materials 75 75 80 80 60 60
Labor 45 45 45 45 45 45
O/H 35 35 35 35 35 35
Capital 100 100

expenditure
Total 155 255 160 260 140 140

Payments
Item Cash In `000 For The Month Of
Flow
Net Cash (15) (115) 30 (70) 25 25

Flow
Opening 125 110 (5) 25 (45) (20)

Balance
110 (5) 25 (45) (20) 5

Analysis
• The firm needs a short-term overdraft
facility from February to May.
• Otherwise the managers need to rework
some of their decisions.
• Possible actions include
– Changing the amount of inventories held
– Renegotiating policies with respect to
creditors
– Renegotiating policies with respect to debtors
The Balance Sheet of a
Commercial Bank
• The format in which financial information about a
business is presented is fairly standardized.
• Thus bank balance sheets are prepared
following the normal conventions.
• However although the purpose of preparing a
balance sheet is the same in all cases
– The statements are likely to differ in terms of content
and structure
– Depending on the services being offered by the
organization and the size and scope of its operations
• The balance sheet of a bank shows the
amount and composition of the funds
sourced by the bank
– Which constitute the financial inputs for it
• And the uses of these funds by the bank
to finance its lending and investing
activities
– Which is reflected in the allocation to various
heads such as
• Loans
Balance Sheet…(Cont…)
• A typical bank balance sheet will contain
the following Inputs and Outputs where
Inputs represent liabilities and outputs
represent assets.
Liabilities or Financial Assets or Financial
Inputs Outputs
Equity Capital Loans and Leases
Non-deposit borrowings Investments in securities
Deposits from the public Cash and deposits in

other institutions
• On the asset side of the balance sheet we
typically find four major item heads
– Cash in the vault and deposits held at other
institutions ( C )
– Holdings of government and private interest
bearing securities ( S )
– Loans and lease financing made available to
customers ( L )
– Miscellaneous Assets ( MA )
Balance Sheet … (Cont…)
• Liabilities fall into two broad categories
– Deposits made by and owed to various
customers ( D )
– Non-deposit borrowings raised in the money
and capital markets ( NDB )
• Finally equity capital constitutes an
important item on the liabilities side
• Since assets must equal liabilities:
C + S + L + MA = D + NDB + EC
• The liabilities side:
– Represents accumulated sources of funds for
the bank
– Represents the spending power of the bank
– Represents what the bank owes
• The assets side:
– Represents the accumulated uses of funds
• Thus liabilities when put to use generate
assets
• These assets enable the bank to:
– Generate income for the shareholders
– Pay interest to deposit holders
– To pay remuneration to its employees
Cash
• It is an immediately spendable asset
• It is the most liquid asset for a bank
• It can be used for:
– Meeting withdrawals by depositors
– Meeting demands for loans by potential
customers
– For unexpected emergency needs
Cash (Cont…)
• If cash is used to pay off an existing
depositor
– It will lead to a reduction in the cash account
on the asset side
– Lead to a reduction in the deposits account on
the liabilities side
Cash (Cont…)
• If cash is used to meet a demand for a
loan by a customer
– It will lead to a reduction in the cash account
on the asset side
– And will simultaneously lead to an increase in
the Loans account on the asset side
Security Holdings
• Most banks invest in government
securities and other approved securities
• They are a backup source of liquidity for
the bank
– In the event of a sudden cash requirement
these securities can be converted into cash
• The more liquid the security the greater will be th
ease of conversion into cash
Security Holdings (Cont…)
• Unlike cash which yields nil income, these
securities will yield periodic income in the
form of interest or dividends
• Besides when the security is finally sold,
there will be a capital gain or loss
Loans
• Making loans is a core business activity
for a bank
• Loans are a bank’s principal source of
income
Miscellaneous Assets
• Every bank will have fixed assets such as:
– Buildings
– Vehicles
– Computers
– Furniture and Fixtures
• Many banks will also have investments in
their subsidiaries
Deposits
• Deposit taking is a core business activity
for a bank
• It is the primary means of fund raising
Non-deposit Borrowings
• These sources of funds supplement deposits
– A bank may take a loan from a government agency
– Or an international multilateral lending institution
– Or else it may issue a bond
• Such fund raising enables a bank to expand its
scale of operations beyond what deposits alone
would make possible
• Besides while most deposits can be withdrawn
with little or no notice, repayments of non-
deposit borrowings are more predictable.
Equity Capital
• No business can rely on debt alone
• There has to be an element of owners’ equity
– An equity holder is the ultimate risk taker
– His income is profit dependent and is not contractually
guaranteed
– In the event of liquidation he is a residual claimant
• Equity capital is long-term stable capital
– While shares can change hands they never mature
Assets of a typical US Bank
– Cash and deposits with banks
– Securities held as investments
– Securities in the trading account
– Federal funds sold and securities purchased
under resale agreements
– Loans under the following categories
• Real estate
• Commercial
• Agricultural
• Institutional
• Consumer
• Leases
Assets (Cont…)
– Unearned discount on loans
– Loans (Net)
– Lease receivables
– Bank premises and equipment
– Customer’s liabilities or acceptances
– Miscellaneous assets
Account wise Analysis
• We will analyze each account head on the
asset side
The Cash Account
• The item head includes
– Cash held in the bank’s vaults
– Deposits placed with other banks
– Items in the process of collection (mainly
uncollected checks)
– Reserves held with the Federal Reserve
(corresponds to the CRR in India)
The Cash Account (Cont…)
• The cash account balance is often labeled
as the Primary Reserves of a bank
– It is the first line of defense against deposit
withdrawals
– It is the first source of funds when an
unexpected loan request is received
• Normally cash balances are kept as low
as possible
– Since they yield nil or no returns
Investment Securities
• They can be categorized into two sub
groups
– Liquid securities
– Income generating securities
• Liquid securities are called Secondary
Reserves
– They are a second line of defense against
deposit withdrawals and unexpected loan
requests
Liquid Securities
• These typically include
– Short-term Federal, State , and Local
government securities
– Privately issued money market securities
– Interest bearing time deposits held with other
banks
– Commercial paper issued by companies
• Secondary reserves act as a source of
income
– But they are held primarily because they can
be converted into cash at short notice
Income Generating Securities
• These include
– Bonds
– Notes
– And other securities
Which are held primarily for their expected
return or yield
Trading Account Securities
• These are the security holdings which a
bank accumulates while discharging the
role of a dealer or a market maker.
– This account sees rapid turnover
– Most of the securities are sold well before
their maturity
The Loan Account
• This will typically be the largest of asset
heads for a bank
– Accounting for 50-75% of its asset base
• One way of categorizing loans is by
breaking then down into groups of similar
loans
– A common approach is to segregate loans
based on the purpose for which money was
lent
The Loan Account (Cont…)
• Typical loan categories are:
– Commercial and industrial or business loans
– Consumer or household loans
– Real estate or property based loans
– Loans made to financial institutions
– Agricultural production loans for raising crops
and livestock
– Security loans to help investors and brokers
to finance their trading activities
– Leasing
The Loan Account (Cont…)
• The sum total of all loans will be shown
under a head called Gross Loans.
– However, loan losses or loans which have
proven to be irrecoverable or are projected to
be irrecoverable, are deducted from this gross
figure.
– In most countries banks have to build a
reserve for anticipated loan losses called a
Reserve for Doubtful Debts.
Reserve for Doubtful Debts
• In practice what happens is the following
– A bank will estimate as to what portion of its
loan portfolio is likely to be irrecoverable.
– These potentially irrecoverable assets will be
deducted as a non-cash expense from its
income for that financial year.
– This is called
• Provision for doubtful debts
• Or Provision for loan losses
Reserve…(Cont…)
– This amount will show up as a reserve on the
liabilities side of the balance sheet.
– When it is finally clear that a certain amount of
the outstanding loans cannot be recovered,
the amount will be deducted from both the
loan account on the assets side, and the
reserve account on the liabilities side.
Illustration
• A bank has made a loan of 10MM USD to
a party.
• It feels that 1MM is not recoverable.
• So while preparing the income statement
for the year it will show a 1MM loan loss
provision as a non-cash expenditure.
• Thus the balance sheet will have a loan
loss or doubtful debt reserve of 1MM on
the liabilities side.
• Now suppose that during the next financial
year, the bank discovers that 500,000
USD is actually irrecoverable.
• It will reduce the loan amount by 500,000
and the reserve account by 500,000.
Reserve…(Cont…)
• Sometimes it may so happen that a loan which had been
written off as irrecoverable may suddenly be recovered.
– What happens in practice is that banks can at times
take possession of assets pledged by defaulting
borrowers.
– These repossessed assets can then be sold to
recover the loan in part or in full.
– When the funds come in, the cash account on the
asset side will show an increase.
– Simultaneously an increase will be shown in the loan
loss reserve account on the liabilities side.
Reserve…(Cont…)
• Loan reserves are at times divided into
two categories
– Specific Reserves and
– General Reserves
• Specific reserves are set aside to cover a
particular loan or a set of loans that are
expected to be a problem.
• However a provision made in general for
unanticipated loan losses as a matter of
abundant caution, will lead to the creation
of a general reserve.
Unearned Discount
• This is yet another item that is deducted from the
gross loans figure in order to arrive at the net
loans figure.
• These discounts consist of interest income on
loans that have been paid by borrowers, but
have not yet been earned by the bank under the
accrual system of accounting.
• For instance a customer may take a loan and
pay all or some portion of the interest upfront.
Unearned Discount (Cont…)
• This cannot be shown as income for the
current period.
• Consequently it will be shown as an
Unearned Discount on the assets side of
the balance sheet.
• As an when the actual interest is earned
by the bank the amount will be transferred
from the Unearned Discount account to
the interest income account.
Federal Funds
• What are federal funds?
– Banks are required to maintain a reserve with the
central bank of the country.
• In India banks have to maintain a 5% CRR with the RBI.
– A U.S. bank’s reserve account balance with the FED
is called Federal Funds or FED Funds for short.
• Typically a bank will either have a surplus or a deficit.
• Banks with a deficit will usually borrow overnight from those
with a surplus.
• The interest rate on such borrowings is the Fed Funds rate.
• It is benchmark of likely changes in the US interest rate
structure.
Repurchase Transactions
• A Repo is nothing but a collateralized
loan.
• Under such an arrangement, a lender will
buy the securities with an agreement to
resell them the on the following day at a
higher price.
• The difference between the purchase
price and the subsequent sale price,
constitutes income for the lender on the
overnight loan.
Repurchase (Cont…)
• The party which is borrowing is said to be
doing a Repo.
• The party which is lending is said to be
doing a Reverse Repo or a Reverse.
• If a bank purchases securities with an
agreement to resell, it is a reverse repo for
it, and will therefore show up as an asset.
Customers’ Liabilities on
Acceptances
• When a bank stands guarantee for a
customer, usually to enable him to import
goods from overseas, it is creating an
asset and a liability simultaneously.
• For instance a bank may issue an LC
authorizing the overseas exporter to draw
up a draft or a bill of exchange against the
bank for payment on a future date.
• When the exporter presents the bill to the
bank it will stamp Àccepted’ and return it.
Customers’…(Cont…)
• The accepted bill becomes a negotiable
instrument.
• As soon as the bank accepts the bill, the
exporter will release the shipping
document allowing the importer to take
possession of the goods.
• The importer in whose favor the LC has
been issued must pay the bank in full on
or before the due date.
• On the due date the bank will pay the bill
when presented by the exporter.
Customers’…(Cont…)
• This kind of a Bankers’ Acceptance
transaction simultaneously creates an
asset and a liability.
– The customer’s liability to the bank constitutes
an asset for the bank.
– The bank’s promise to honor the bill of
exchange constitutes a liability for the bank
Miscellaneous Assets
• These include:
– The net value of bank buildings and
equipment
• By net we mean after depreciation
– And investments in subsidiary firms
Liabilities of a typical US Bank
• Deposits
– Non-interest bearing demand or checking
accounts
– Savings accounts and NOW accounts
– Money market accounts
– Time deposits
– Deposits at foreign branches
Liabilities…(Cont…)
• Non-deposit borrowings
– Federal funds purchased
– Securities sold under agreement to
repurchase
– Other short-term debt
– Mortgage indebtedness
– Subordinate notes & debentures
Liabilities…(Cont…)
• Other liabilities
– Acceptances outstanding
– Miscellaneous liabilities
• Equity Capital
– Common stock
– Preferred stock
– Capital surplus
– Retained earnings
– Treasury stock
Deposits
• These are the principal liability for a bank
– Non-interest bearing demand deposits or
regular checking accounts
• They permit holders to write checks without limit
• But bank’s do not pay any interest
– Savings deposits
• They generally carry the lowest rate of interest
• Deposits may be of any denomination, although
most banks impose a minimum requirement
• Customers may withdraw at will
Deposits (Cont…)
– Negotiable Order of Withdrawal (NOW)
Accounts
• They can be held only by individuals and not for
profit organizations
• They pay interest
• Holders can write checks
– Money market deposit accounts
• Banks can pay whatever interest they feel is
competitive
• Holders have limited check writing privileges
Deposits (Cont…)
– Time deposits
• They carry a fixed maturity and a stipulated rate of
interest
• They may be of any denomination, maturity or
yield
• The bulk of such deposits are held by individuals
and businesses
• However governments – federal, state, and local –
also hold such deposits
Borrowings from Non-deposit
Sources
• Banks also raise funds-from non-deposit
sources.
• The importance of these sources has
increased in recent years because
– There are no reserve requirements on such
funds
– As a consequence of which the cost of
funding is lower
Borrowings…(Cont…)
• These funds are to a large extent raised in
the money market
– They can be arranged at a moment’s notice
– And can be wired immediately from one party
to another
– Interest rates on such funds are however
volatile
Borrowings (Cont…)
• The most important of such sources is
– Federal Funds which are purchased from
other banks to tide over a temporary shortfall
of reserves
– Securities sold under an agreement to
repurchase are also a source of short term
funds
– Other sources are
• Borrowing of reserves from the discount window of
the FED
• Eurodollar borrowings from multinational banks
• Eurodollar borrowings from the bank’s own
overseas branches
Capital Accounts
• These accounts represent the shareholders’ stake in the
business
– Banks are highly leveraged businesses
– That is they are run primarily with borrowed funds
– For most banks shareholders’ capital is usually less
than 10% of the assets held by them
• The common stock account reflects the face or par value
of the shares
• Undivided profits show up as Retained Earnings
• Contingency reserves are held as protection against
unforeseen losses
• Treasury stock represents shares that have been
repurchased
The Income Statement
• The income statement indicates the amount of revenue
received and expenses incurred over a period of time.
• There is usually a close correlation between the income
statement and the balance sheet.
– This is to be expected.
– For, assets on the balance sheet account for
revenues from operations
– Liabilities on the balance sheet account for the
operating expenses
• The principal sources of revenue for a
bank are the following
– Interest income generated by loans
– Interest income generated by securities held
by the bank
– Interest from deposits held with other banks
– Rental income from property
– Income generated by subsidiaries
• The major expenditure heads are
– Interest paid to depositors
– Interest on non-deposit borrowings
– Cost of equity capital
– Employee salaries and wages
– Overhead expenses
– Loan loss provisions
– Income taxes and other taxes
– Miscellaneous expenses
• The difference between revenues and
expenses is the Net Income for the bank.
Illustration of an Income
Statement
• Interest Income
– Interest and fees on loans
– Interest on investment securities
• Taxable revenue
• Tax-exempt revenue
– Other interest income
• Interest Expenses
– Deposit interest costs
– Interest on short-term debt
– Interest on long-term debt
Illustration…(Cont…)
• Net Interest Income = Interest Income –
Interest Expenses
• Provision for doubtful debts
• Non-interest Income
– Service charges on deposits
– Trust department income
– Other operating income
• Non-interest expenses
– Wages & Salaries
– Net occupancy and equipment expenses
Illustration…(Cont…)
• Net Non-Interest Income = Total non-
interest income – Total non-interest
expenses
• Income or loss before taxes = Net Interest
Income + Net Non-interest Income – Less
Provision for Doubtful Debts
• Income or loss before taxes – Provision
for Income Tax = Net Income or Loss after
Taxes
Item-wise Analysis
• Interest Income
– Interest and fees from loans account for the
bulk of bank revenues
– They are followed in importance by
• Earnings from taxable and tax-exempt securities
• Interest on Federal Funds sold
• Interest on repurchase agreements
• Interest income from time deposits placed with
other banks
Item-wise Analysis
• Interest expenses
– The main item is interest on deposits
– A rapidly growing expense is interest on short-
term money market borrowings
• Borrowing of Federal Funds
• Interest paid on repurchase agreements
• Net Interest Income
– Is equal to interest income minus interest
expenses
– It is also referred to as Interest Margin
Item-wise Analysis
• Loan Loss Expenses
– It is a provision for doubtful debts
– This is a non-cash expense that reduces the
tax liability for the bank
• Non-interest Income
– Fees from offering trust services
– Service charges on deposits
– Miscellaneous fees and charges
Non-Interest Income
• These days banks have begun to target non-interest or
fee based income more aggressively.
• By focusing more on
– Security brokerage
– Insurance
– And Trust services, banks hope to
Tap alternative sources of income
Diversify income sources and consequently the risk
Insulate their margins from fluctuating interest rate
Item-wise Analysis (Cont…)
• Non-interest expenses
– Wages and salaries
– Other employee related expenses
– Costs of maintaining property and rental or
office space
• This is reflected in net occupancy and equipment
expense
– Cost of bank furniture and equipment
– Miscellaneous expenses
• Legal fees
• Office supplies
Off-Balance-Sheet (OBS)
Activities
• What is an OBS activity
– It is an activity that by its very nature is not
recorded as either an asset or as a liability on
the balance sheet
– These activities are however shown as
footnotes
• The importance of such activities has
grown substantially in recent years
– Banks today derive a substantial portion of
their income from such activities
OBS Activities (Cont…)
• As per the Reserve Bank of Australia,
OBS business may be divided into four
major categories
– Direct credit substitutes
– Trade and performance related items
– Commitments
– Market-rate-related transactions
• Both direct credit substitutes and trade
and performance related items involve the
bank in supporting or guaranteeing the
obligation of a client to a third party.
• As per such guarantees the bank need
pay only if the client were to default.
• A direct credit substitute may take the
form of a stand-by letter or credit
– This is an undertaking by a bank to make
payments to a specified third party if the client
fails to meet his obligations.
– With the strength of such a guarantee
• The client should be able to raise funds in the
money or the capital markets since the lender is
virtually assured that the loan and interest will be
repaid
• Trade and performance related items are also
guarantees made by banks on behalf of their clients
– However thy are made to support non-financial
obligations
• For instance a client may have an obligation to provide
goods or services to a third party
– The bank may in such cases provide a
guarantee on behalf of its client that it will
compensate the third party in the event of the
client not fulfilling his commercial obligations
as per the contract.
• Commitments involve the bank in an undertaking to
advance funds or to acquire an asset or assets at some
future date. Examples include
– Outright forward purchase agreements where the
bank contracts to buy a specified asset from the client
at a specified price on a pre-determined date
– Provision of an underwriting facility where the bank
agrees to buy the unsubscribed portion of the public
issue of a security, if the issue were to remain
undersubscribed.
– Loans approved but not yet drawn
– Credit card limit approvals that have not yet been
availed by card holders
• Market related items include derivatives such as
– Futures
– Options
– FX contracts
– Swaps
Part-09
The Money Market
1
Introduction
2
Introductio
n
Introduction
 All debt markets have a common
feature
On one hand we have On the other hand we
parties ready to borrow have parties willing to
by issuing securities lend in the process of
acquiring securities
 All security for cash transactions are not

identical
 A 30 year mortgage loan
vs.
 3 month loan to meet a corporation’s working
capital needs 3
Introductio
n
Purpose of borrowing
 The purpose for which money is

borrowed differs from
 borrower-to-borrower
 transaction-to-transaction
1. A corporation may issue long term bonds to
finance the construction of a building
2. It may issue short-term promissory notes to
fund the acquisition of raw materials.
4
Introductio
n
Types of financial assets
 Money is borrowed to create different
kinds of financial assets with

 different maturities
 different risk profiles
 short-term securities
5
Introductio
n
Term to maturity
 Loans in the money market have an
original term to maturity of <1 year
Original term to Actual term to

maturity maturity
The original term to The actual term to
maturity of a security is maturity is the current
its term to maturity at term to maturity of the
the time of issue security
It cannot change once a It will obviously keep
security is issued declining with the
passage of time
6
Introductio
n
Money Markets
 Money market securities have to be
debt securities
 Since equity shares have no maturity date.
 Money market consists of transactions
to meet short-term cash needs
 Meant for current account, not for capital
account
 It is the mechanism through which
holders of ‘temporary cash surpluses’
interact with parties with ‘temporary
cash deficits’
7
 The nature of transactions range from
Introductio
n
Why?
 Why do we need money markets?

 For most individuals / institutions inflows &
outflows of cash will rarely match.
 Inflows may happen at a time different from
when outflows are required to be met
8
Example
Example – The Government
It collects revenues by Taxes arrive in lumpy

way of taxes amounts and do not arise
uniformly throughout the
year
Disbursements must be
made throughout the When tax revenues arrive
year to meet expenses the government will be
such as Wages, Salaries, temporarily flush with
Office supplies, Fuel funds
costs At such points in time it
will enter the money
market as a lender
9
Example
Example – The Government
However during most This will be true even if it

months of the year the were to have a budget
government will have a surplus for the year as a
cash deficit whole
During periods of a
shortfall of cash the
government will enter
the money market as a
borrower
When the government During those months
has a deficit it will when it has a temporary
borrow short-term by surplus it will buy back
issuing Treasury Bills Treasury Bills to reduce
its borrowings
10
Example
Example – Business
Businesses collect The checking account of

revenues from sales a firm will fluctuate from
large surpluses to low or
non-existent cash
balances
The points of time at
which such revenue is During periods when it
realized may not has a surplus , a firm will
however coincide with enter the money market
budgeted expenses to as a lender
cover wages, salaries, The objective is to earn
and other operational some returns however
expenses moderate on idle money
11
Example
Example – Business
During periods when it One way is to issue short

has a cash deficit the term unsecured
business will enter the promissory notes called
money market as a Commercial Paper
borrower
12
Introductio
n
Why the attention?
 Why are we so concerned about short-
term transactions?
 Money is an extremely perishable
commodity
 When idle cash is not invested there is an
opportunity cost - interest income is
foregone
 Income that is lost is lost forever
 When large amounts of funds are involved,
the income that is lost from not profitably
investing idle funds for even a day can be 13
Introductio
n
Example
 A firm has 12MM dollars available
overnight.
 Assume interest rate @ 12% p.a.
 Assume the year has 360 days
 A common assumption in money markets
 If money is kept idle the lost income will
be:
12,000,000 x 0.12 x (1/360) = $4,000
 If the money were to remain idle for a
14
Introductio
n
Borrowers & Lenders
 It is very difficult to classify an
economic entity as a borrower or a
lender.
 The same institutions frequently operate on
both sides of the market
 E.g. Citibank
Borrower Lender
It will borrow regularly At the same time it will
in the money market by be making short term
way of Certificates of loans to corporate
Deposit, borrowings of borrowers
Federal Funds etc. 15
Introductio
n
Borrowers & Lenders
Borrower Lender
Frequently a corporation will Only to come back into
borrow millions of dollars on the market as a lender a
a single day few days hence due to a
sudden upsurge in cash
Institutions that are presentreceipts
on both sides of the
market include Large banks, Finance companies, Non-
financial corporations, Central Banks of countries
One institution that is usually
always on the demand side is
the government. At any point
in time the U.S. Treasury is
the largest borrower in the
world 16
Introductio
n
What do investors want?
 Investors in the market primarily seek

 Safety and liquidity
 An opportunity to earn some extra income
 Liquidity is of paramount concern
because participants may seek to enter
and exit the market in a sudden
unanticipated fashion. 17
Introductio
n
Liquidity
 A liquid market is characterized by the
presence of a large number of buyers
and sellers at all time.
 What would happen if the market were
to be illiquid?
 If there is excess demand large buy orders
will send prices shooting up
 If there is excess supply large sell orders
will send prices crashing down.
18
Introductio
n
Liquid market
 In a liquid market large trades can be
executed without a major price impact
 Liquid markets are characterized by low
bid-ask spreads
 Since transactions are frequent dealers
can afford to operate with a smaller
profit per round trip transaction
 Bid  the price at which the dealer buys
from the public
 Ask  the price at which the dealer sells to
the public
 Round trip  a purchase followed by a
subsequent sale
19
Introductio
n
Safety
 Safety is important because

 Investments are made for short periods
 Investments may be liquidated at any time
 Money market investors are very
sensitive to default risk
 Even a hint of trouble regarding the
financial condition of a borrower may have a
strong impact on the market.
20
Introductio
n
Safety - Examples
 1970: Penn Central Transportation
Company defaulted on its short-term
commercial notes.
 The short-term commercial paper market
ground to a halt
 Investors refused to buy even paper issued
by top grade companies
 1980s: Continental Illinois Bank had to
be propped up by government loans.
 Immediately rates on all short-term bank
CDs rose
 There was a fear that all large bank CDs had
21
Introductio
n
Risks in the Market
Risks
Re-
Market Default Inflation Currency Political
investment
Risk Risk Risk Risk Risk
Risk
22
Introductio
n
Risks in the Market
1. Market risk - the possibility that the value of

an existing security will fall when interest
rates rise, thereby leading to a capital loss.
2. Reinvestment risk - the possibility of having
to reinvest cash flows arising from securities
at lower rates, due to a decline in rates.
3. Default risk - the risk that the borrower will
fail to make principal or interest payments.
23
Introductio
n
Risks…(Cont…)
1. Inflation risk - the risk that the purchasing

power of cash flows received from a security
could erode.
2. Currency risk - the risk that the domestic
currency may appreciate with respect to a
foreign currency.
 This will lead to lower cash inflows in terms of
domestic currency when foreign currency is
converted.
3. Political risk - the risk that changes in
24
regulations may result in reduced returns or
Introductio
n
Risks…(Cont…)
 Money market securities generally offer

more protection against such risks as
compared to other instruments.
 The prices of such securities tend to be
relatively stable over time.
 Thus while they may not offer prospects of
significant capital gain
 There is also a lower possibility of a
significant capital loss.
25
Introductio
n
Reasons for lower risk
1. Interest rate movements over
relatively short periods tend to be
usually moderate
2. The impact of a given interest rate
change is greater the longer the term
to maturity of the cash flow
3. Default risk is also minimal in money
markets
 Borrowers have to be well established with
impeccable credit ratings.
 Else their securities will not attract
sufficient investor interest. 26
Introductio
n
Other Risks
 Money market securities are subject to

inflation risk
 But they offer some compensation by way
of enhanced liquidity.
 Currency and political risks are also less
in money markets
 Due to the short-term nature of the
investments.
27
Introductio
n
Features
1. The money market is broad and deep
 It can absorb large volumes of transactions
with minimal impact on security prices and
interest rates.
2. Investors can usually sell securities at
short notice
 Often in just a matter of minutes
3. The market consists of a wide network
of
 Securities dealers
 Major banks
 Fund brokers 28
Introductio
n
Features (Cont…)
 Traders are constantly on the look out

for arbitrage opportunities.
 Money has no loyalty
 It can move from one corner of the globe
to another in a matter of minutes in search
of higher interest rates.
29
Introductio
n
Central Banks
 The market is overseen by the Federal Reserve
Bank in the U.S. and by the central banks of
other countries. These are:
 U.K. – Bank of England
 Canada – The Bank of Canada
 Switzerland – The Swiss National Bank
 Japan – Bank of Japan
 Europe – European central bank
 Germany – Bundesbank
 Australia – Reserve Bank of Australia
30
Introductio
n
Features (Cont…)
 There is no central trading arena.

 It is a market connected by telephones and
computers
 Speed is of the essence since money is
perishable.
 Transactions are conducted in a matter of
seconds and payments are made
instantaneously 31
Categories of Money Market
Instruments
32
Categories of
MMI
Categories
Money
Market
Instruments
Off-balance-sheet Derivative
Cash Instruments
Instruments Instruments
33
Categories of
MMI
Categories
 Cash instruments - A contract for the
immediate borrowing or lending of
funds
 Off-balance-sheet instruments (OBS) -
Arrangements for borrowing or lending
at a future point in time
 The price is fixed in advance
 This cannot be recorded on the balance
sheet of the parties

Balance sheet can only reflect current
borrowing/lending 34
Categories of
MMI
Cash Instruments
Cash
Instru-
ments
Bank bills
Certifi- Re-
Deposits & Commer-
Treasury cates Euro purchase
& Bankers’ cial
Bills Of notes Agreee-
Loans Accept- Paper
Deposit ments
ances
35
Categories of
MMI
Illustration
 A bank makes a commitment to make a
3-month loan 6 months from today @ 5
% p.a.
36
Categories of
MMI
Derivative Securities
 Some off-balance-sheet-instruments do
not involve future borrowing / lending
 They are used for managing risk
 Only a return is paid
Instruments
Forward Money Money Market Interest

Rate Market Interest Rate Rate
Agreements Futures Swaps Options
37
Categories of
MMI
Illustration
 A bank buys a $50MM FRA @ 5%
 If 3 month LIBOR 6 months later were
higher than 5%
 The bank will be paid a return by its
counterparty equal to the interest rate
differential times $50MM
 If 3 month LIBOR 6 months later were
lower than 5%
 The counterparty will have to be paid a
return equal to the differential times $50MM
38
Categories of
MMI
Notional Principal
 In the illustration $50MM is not paid or

received
 It is used for the calculation of return 
this is Notional Principal’
 It is not recorded on the balance sheets
39
Key Dates in Cash Market
Instruments
40
Key Dates
Key Dates
 Transaction date
 Value date
 Maturity Date
41
Key Dates
Transaction Date
 Date on which terms and conditions of a

financial instruments are agreed upon
 Date on which parties enter into a
contract
 Also known as Trade date, Dealing date,
Done date
42
Key Dates
Value Date
 Date on which instrument starts to earn

or accrue a return
 This date may/may not be same as
transaction date
43
Key Dates
Types of Value Dates
Value Date
Same Day Value Next Day Value

Or Or Spot Value
Value Today Value Tomorrow
Value Date = Value Date = Value Date =

Transaction Transaction Transaction
Date Date + 1 Date + 2
44
Key Dates
Maturity Date
 The date on which the instrument
ceases to accrue a return
 Maturity date is often not a date
 It is a term to maturity which is a whole
number of weeks/months after the value
date
 Date of maturity follows two
conventions
 The Modified Following Business Day
Convention 45
The Modified Following Business Day
Convention
 This convention consists of the following
three rules
 1. Maturity is set for the same date as the
value date
 If the value date is 21 March
 The one month maturity will be 21 April
 The two month maturity will be 21 May
 2. If the maturity as per rule 1 is a non-
business day, then it is moved to the
following business day
46
Modified…(Cont…)
 3. If the following business day according to
rule 2 falls in the next calendar month, then
the maturity date is moved back to the last
business day of the calendar month.
47
The End/End Rule
 If the value date is the last business day
of the current calendar month, then the
maturity date will be the last business
day of the relevant calendar month.
 Consider a one month deposit with a value
date of 31 May.
 It will mature on 30 June if it is a business
day.
date of 30 June
 It will mature on 31 July if it is a business day
48
The End/End Rule (Cont…)
date of 31 January
 It will mature on 28 or 29 February
date of 28 or 29 February

It will mature on 31 March
 If the maturity date as per this rule were
to be a holiday then the modified
following business day convention
would apply.
49
Fed Funds & Clearinghouse
Funds
50
Fed Funds
Fed Funds & Clearinghouse Funds
 How do funds move so fast in the

money market?
 Money market traders usually trade in
Federal Funds.
 What are Federal Funds?
 Deposit balances of commercial banks held
at the regional Federal Reserve Banks or at
large correspondent banks.
51
Fed Funds
Fed Funds…(Cont…)
When a dealer firm buys
securities from a trader…
It will contact its bank and

request that funds be These transactions take
transferred from its account place via a public or private
to the trader’s account at wire network
another bank
The central bank will remove The transaction is so quick

funds from the reserve that the seller of securities
account of the buyer’s bank has funds available to use
and transfer the same to the on the same day that the
reserve account of the seller’s trade is carried out or a 52
bank
Fed Funds
Immediately Available Funds
 Federal funds are known as
‘Immediately Available funds’
 This is because of the speed with which
money moves from one bank’s reserve
account to that of another.
53
Fed Funds
Clearing House Funds
 Method of payment in the capital

markets for transactions involving
businesses and households
 Most large transactions are paid for by
check or by issue of a check following a
payment by a credit card
 Funds transferred by check are called
Clearinghouse Funds.
54
Fed Funds
Process
The buyer writes a check
It goes to the seller’s If the two institutions are

bank which forwards that in the same community
check eventually to the they will exchange
depository institution bundles of checks drawn
upon which it was drawn against each other every
day, through the local
clearinghouse
55
Fed Funds
Funds availability
 Clearinghouse funds are not accepted in
money markets
 For money market transactions these
transactions are far too slow and risky
Federal Funds Clearinghouse funds

Money is available on Compared to Federal
same day and hence Funds it takes at least a
interest can be earned day to clear local checks
on the same and 2-3 days for outstation
Money is transferred checks
Funds have an element of
safely risk since check may be
56
returned
Global Money Markets
57
Global Money Mkts
Global Money Markets

 Money market throughout the world
share certain characteristics
a. They support borrowing and lending for
periods ranging from 1 day to 1 year
b. They help reconcile cash imbalances for
 Public / private businesses
 Individuals / Institutions
c. They aid governments in financing their
deficits (fiscal deficit)
d. They help governments manage the growth
of money and credit and maintain stability
of currency rates (monetary policy)
58
Global Money Mkts
National / Intl. Money Markets
 Every nation has its own money market

 Some are poorly developed.
 Others like that of the U.S extend beyond
the borders of a country or a continent.
 National money markets may be

 Security markets dominated
 Bank dominated
59
Types of National MoneyGlobal Money Mkts
Markets
 Securities dominated market  most
borrowing and lending is through open
market trading of financial instruments.
 Western markets are largely securities
dominated.
 Bank dominated market  bank
borrowing and lending is at the centre
of most transactions.
 Asian markets tend to be largely bank
dominated.
 These markets have a potential weakness -
they yield more easily to government 60
Global Money Mkts
International Money Markets
 International money market ties all

domestic markets together.
 At its heart is the Eurocurrency market.
 Here large bank deposits are traded outside
the boundaries of the country where the
particular currency is issued.
61
Interbank Market
62
Interbank
Mkt
Interbank Market
 It is a market for large or wholesale
loans and deposits
 It is an arena for transactions between
commercial banks
 Borrowing / lending is for periods <= 12
months
 Participants
 Commercial banks
 Insurance companies
 Pension funds
63
Interbank
Mkt
Need for Interbank Market
 All commercial banks are required to

maintain an account with the central
bank
 Banks with surplus lend to banks with
deficit
 The lending bank earns some interest
 The bank with deficit covers its deficit
64
Interbank
Mkt
Features of Interbank Market
 Loans are unsecured
 Interest rates are lower
 Banks with high credit rating play role of
intermediary
65
Interbank
Mkt
Types of Loans
1. Overnight money: Money lent on a

given day is scheduled to be repaid on
next banking day
2. Day to Day money: The deposit is for
an unspecified time. Funds can be
called back at any time and will be
repaid on same day
 Also called ‘money at call’
66
Interbank
Mkt
Types of Loans
1. Notice money: Money lent with a short

notice of withdrawal
 E.g. 2 days or 7 days notice
2. Fixed money: Money lent for a fixed

period
 E.g. 1 week or 1 month
3. Intra day money: Money lent and

repaid on same day
67
Interbank
Mkt
Role of Brokers
 Provide up-to-date indicative interest

rates to market
 They charge a standard commission
 Their success depends on:
 Ability to provide good and accurate
information
 Ability to facilitate quick execution of
trades
68
 Ability to maintain confidentiality
Interbank
Mkt
LIBOR
 LIBOR  London Interbank Offer Rate
 Rate at which bank with high credit rating is
prepared to lend to a similar bank
 LIBOR is quoted for different tenors
 Each bank quotes its own indicative LIBOR rate
69
Interbank
Mkt
BBA LIBOR
 BBA  British Bankers’ Association
 It is the most widely used benchmark
for short term interest rates
 Rate is complied by BBA and Reuters
and released after 11 a.m. London time
 BBA maintains a panel of 8 banks
 It provides a reference panel which
reflects the balance of the market by
 Country
 Type of institution
70
Interbank
Mkt
LIBID
 LIBID  London Interbank Bid Rate
 It is rate at which a London bank with
good credit rating will pay on funds
deposited with it by another top rated
bank
 LIBID is quoted for different tenors

71
Interbank
Mkt
LIBID vs. LIBOR
LIBID LIBOR
Rate that banks with Rate that banks
surplus funds might seeking to borrow
have to accept on might have to pay
interbank deposit
Rate is lower Rate is higher
Some banks use LIMEAN, the average, as the

agreed upon rate
72
Interbank
Mkt
SONIA & EURONIA
SONIA EURONIA
(Sterling Overnight Index (Euro Overnight Index
average) average)
These indices track actual market overnight funding
rates
Weighted average to 4 Weighted average to 4
decimal places of all decimal places of all
unsecured sterling unsecured euro overnight
overnight transactions
Brokered by WMBA transactions
Brokered by WMBA
between midnight and 4.15 between midnight and 4
p.m. p.m. overnight deposit
The indices are weighted average
rates for each business day. Both are published by 5
73
p.m. London time.
Interbank
Mkt
EURIBOR
 It is a benchmark rate used by
international market for the Euro
 Produced by European Banking
Federation – Brussels
 Quotes are taken from 57 banks in the
euro zone countries
 Euribor is reported at 11 a.m. Brussels
time everday
 The rates are spot rates
 Interest is computed on Actual/360
basis 74
Interbank
Mkt
Calculating
 Interest payable on assumption of a 360
day year
P x (r/100) x (T/360)
P  Principal
T  No. of days
r  Rate of interest
75
Interbank
Mkt
Illustration
 Bank makes a loan = $7.5 MM
 Period: 1 year (365 days)
 Interest rate = 5.25% p.a.
Interest = 7,500,00 x (5.25/100) x

(365/360)
= $ 399,218.75
76
Securities and Relative Interest
Rates
77
Sec & Rel. Int.
Rates
T-Bills
 The foundation of the market’s

structure is the level of yields on T-bills
 These securities have zero default risk
 They carry minimal market risk
 Secondary market for T-bills is the most
active and deep of all securities markets.
 Due to combination of low risk and
ready marketability T-bills carry the
lowest yields 78
Sec & Rel. Int.
Rates
Other market securities

 Federal agency securities  One set of
yields that stays close to T-bill rates is
the yield on federal agency securities.
 These are considered to be virtually riskless.
 They are less marketable than T-bills.
 Federal Funds  The rate on Federal
funds also stays fairly close to the T-bill
rate
79
Sec & Rel. Int.
Rates
Relative Rates (Cont…)
Instrument Yield Instrument Yield
Federal Funds 3.72 6-M CD 4.27
2-M Non- 3.83 1-M ED 3.87
financial CP
3-M Non- 3.86 3-M ED 4.07
financial CP
1-M Financial 3.82 6-M ED 4.25
CP
2-M Financial 3.91 Bank Prime 6.75
CP
3-M Financial 4.02 Rate
4-week T-bills 3.31
CPCD
1-M 3.89 3-M T-bills 3.65
3-M CD 4.08 6-M T-bills 3.96
80
Treasury Bills
81
T-Bills
Treasury Bills
 Purchases / Sales of T-bills often
represent the largest volume of daily
transactions in the money market.
 Interest rates on such bills are the
benchmark for all other money market
rates.
 What are the important features of T-
bills?
a. Zero default risk
b. Ready marketability 82
T-Bills
U.S. T-Bills
 U.S T-bills are direct obligations of the U.S.
government
 By law T-bills in the U.S must have an original
maturity of <1 year
 The government’s fiscal year runs from 1 Oct to
30 Sep
Uptil April April & Post April

Even in years with a budget Income tax, the main
surplus the government is source of revenue for the
likely to have a deficit in government, is not fully
most months collected tillthe
In April and April
months
immediately following it will
be flush with funds
83
T-Bills
T- Bills for deficits / surplus
 T-bills are ideally suited to manage
these deficits / surpluses because

a. Their maturities are short
b. They are readily marketable
c. Their prices adjust quickly to changing
market conditions
84
T-Bills
Volumes of U.S. T-Bills

 The volume of U.S. T-bills outstanding
grew rapidly in the 1980s and 1990s
 The main reasons were
1. Record fiscal deficits
2. Occasional recessions that reduced
revenues from income tax
3. Rapid expansion of defense programs
4. Extension of welfare subsidies to low
income individuals.
5. The global economy had grown rapidly
creating a greater need for such liquid
assets to aid institutions in the efficient
management of their cash positions
85
T-Bills
Regular Series Bills
 Regular series bills are issued routinely

every week or month by way of
competitive auctions.
 3 and 6 month bills are issued every week
 1 year bills are issued every month
 Of the above maturities 6 month bills
provide the maximum revenue for the
Treasury.
86
T-Bills
Irregular Series Bills

 Irregular series bills are issued only
when the Treasury has a special need
a. Strip bills
 A package of a series of bills with different
maturities
 Investors have to bid for the entire series
b. Cash management bills
 Consist of re-opened issues of bills that were
issued earlier
 E.g. assume that 6-months bills were issued 2
months ago. If we were to now issue 4-month
bills we would be adding to the amount that
is outstanding
 Normally occurs when there is an unusual or
unexpected need for funds.
87
T-Bills
On / Off the run securities
On the run securities Off the run securities

Newly issued securities Securities for the same
for a given maturity maturity that were
issued earlier
E.g. a 3 month bill E.g. a 6 month bill
issued recently issued 3 months ago
Have 3 months to Have 3 months to
maturity, but are more maturity
liquid
88
T-Bills
On-the-run bills more liquid
 Why are on-the-run bills more liquid?

 For a short period after issue, securities
tend to be very actively traded
 Thereafter, most securities pass into the
hands of investors who are quite content to
hold them till maturity.
 Thus compared to on-the-run securities, off-
the-run securities tend to be less liquid.
89
T-Bills
T-Bills selling process

 T-bills are sold by an auction process.
 Prices and yields are determined by the
market and not by the Treasury.
 The process:
 Issue of a new regular bill is announced by
the Treasury on Thursday of every week
 Bids are due on the following Monday before
1:00 P.M. New York time.
 The bills are issued on the Thursday
following Monday’s auction.
90
Competitive & Non-Competitive
T-Bills
bids
 The Treasury entertains 2 types of bids.
 Competitive bids  typically are submitted
by large investors including banks and
securities dealers.
 They bid for several million dollars worth of
securities at a time.
 Non-competitive bids  submitted by small
investors who agree to accept the price set
at the auction.
 The Treasury generally fills all non-
competitive bids. 91
T-Bills
At the auction
Bids are arranged in descending All competitive bids
order from the highest price or in must be submitted to
ascending order from the lowest three decimal places
yield
Lowest price at which at least No one bidding < stop-

some bills are awarded is called out price will receive
‘stop-out’ price any bills in an auction
Once bills are acquired by All bills are issues only

successful bidders, many will be in ‘book-entry’ form,
sold right away in the secondary not physical form
market 92
T-Bills
Illustration
Discount Rates Bid Equivalent Prices

3.540 96.460
3.545 96.455
3.550 96.450
3.555 96.445
3.560 96.440
3.565 96.435
3.570 96.430
93
T-Bills
Pricing at auctions
 All prices are expressed on a $100 basis

as though the bills have a face value of
$100
 In actual fact the minimum denomination
for bills is $1,000
 And they are issued in multiples of $1000
thereafter.
94
T-Bills -
Yields
Yields
 The quoted yield for T-bills is a discount
yield.
DR = Face Value – Price 360

________________ x _____
Face Value Tm
 DR  quoted discount rate

 Tm  number of days till maturity
95
T-Bills -
Yields
Example 1
 Assume that a T-bill with
 Face value = $100
 90 days to maturity
 Selling price = $97.50
DR = 100 – 97.50 360

____________ x _____ = 10%
100 90
96
T-Bills -
Yields
Example (Cont…)
 In the market the price will not be

quoted as 97.50
 The dealer will quote the yields as 10%
 An investor must use the yield to calculate
the price.
97
T-Bills -
Yields
Example – Investment Rate
 Rate of return for an investor who buys a bill at
a discount rate of DR will always be higher
than the quoted yield
Investment rate
IR = Face Value – Price 365

________________ x ____
Price Tm
= 100 – 97.50 365

___________ x _______ = 10.40%
97.50 90 98
T-Bills -
Yields
Example (Cont…)
 Both the discount rate and the

investment rate are calculated under
the assumption that the bill will be held
till maturity.
99
T-Bills
Primary Dealers
 The money market depends heavily on
the buying and selling activities of
securities dealers.
 Primary Dealer
 A dealer firm which is qualified to trade
securities directly with the Federal Reserve
Bank of New York
 The firm must agree to be available to trade
securities at all times and post a capital of
at least $50m
100
Funding of Dealer Positions
101
Dealer
Positions
Funding of Dealer Positions
 Government security dealers supply a

large volume of securities to the market
 They depend heavily on the money market
for borrowed funds
 Most dealers invest very little of their own
equity
 Ratios of security portfolios held to owners’
capital of even 40:1 are common.
 The bulk of their operating capital is
borrowed from banks and other financial 102
Dealer
Positions
Sources of Dealer Funds
Most heavily used

sources of dealer funds
Demand loans from Repurchase agreements

banks with banks / lenders
103
Dealer
Positions
Demand Loans
 Every major bank posts rates at which it
is willing to make short-term loans to
dealers.
 Generally two rates are quoted
 One for new loans
 A lower rate for the renewal of existing
loans
 A demand loan may be called at any
time.
104
 Such loans are virtually riskless because
Repurchase agreements
105
Repurchase
Agreements
Repos
 Repurchase agreements are an
increasingly popular alternative to
demand loans.
 They represent a temporary extension
of credit collateralized by marketable
securities
Dealer Sells securities Lender
Makes commitment to buy the

securities back at a later date
106
Repurchase
Agreements
Types of Repos
 Term Repos  Some repos called Term

Repos are for a fixed length of time.
 Continuing Contracts  Continuing

Contracts carry no explicit maturity date
but may be terminated at short notice
by either party
107
Repurchase
Agreements
Providers of Repos
Providers
of Repos
Non- Foreign
Large State Local Insurance
Finance Financial
Banks Govts Govts Cos
Cos Institutions
108
Repurchase
Agreements
Custodial Account
 Securities for the collateral are
supposed to be placed in a ‘custodial
account’ at a bank.
 When loan is repaid the dealer’s liability is
canceled and the securities are returned
 There is evidence that this safety
feature is not scrupulously followed.
 If a dealer goes out of business, lender may
have difficulty in recovering the securities
 Dealer firms have collapsed and many S&Ls
lost money from inadequately collateralized
loans.
 Fed authorities have imposed strict 109
Repurchase
Agreements
Types of Repos
 Term Repos  Contracts for terms
longer than overnight e.g. contracts for
periods ranging from 1 - 3 months or
even longer
 Dollar repos  They permit the
borrower to repurchase securities that
are similar to but not necessarily the
same as the securities originally sold
 FLEX repos  They permit lenders to
withdraw a part of the loan whenever
cash is needed.
110
Repurchase
Agreements
Value of Collateral
 The interest rate of repos is closely
linked to other money market rates.
 Usually the collateral is valued at the
current market price plus accrued
interest less a small discount called a
Haircut to reduce the lender’s exposure
to market risk.
 The longer the term of the repo, and the
riskier and less liquid the security that is
pledged, the larger will be the Haircut. 111
Repurchase
Agreements
Value of Collateral
 Repos are periodically market to
market.
 If the price of the collateral has declined the
borrower may need to pledge additional
collateral.
112
Repurchase
Agreements
Example of Repo - 1
 A party has made an overnight loan of
$100 MM to a dealer at 7.2%
 Thus the interest payable the next day
is:
100,000,000 x 0.072 x 1
___ = $20,000
360
113
Repurchase
Agreements
Illustration - 2
 Take the case of a dealer who is looking
for a 30 day loan and is willing to pledge
T-notes as collateral.
 Assume accrued interest = $205,700
 The quoted price per $100 of face value
is $100.9375
 The repo is for 30 days
 The rate of interest is 9% p.a.
 The haircut is 0.005 price points
114
Repurchase
Agreements
 The amount that can be borrowed against the
securities is:
5,000,000 (1.009375 - 0.005) + 205,700
= $5,227,575
 The amount due at maturity is this principal

plus interest.
Interest = 5,227,575 x 0.09 x (30/360)
= $39,206.81
115
Repurchase
Agreements
 During these 30 days there will be

fluctuations in the value of the
collateral.
 These must be regularly monitored to
ensure adequate collateralization.
 Most repos are collateralized by government
securities.
 Sometimes other money market 116
Repurchase
Agreements
Credit Risk
 In practice both borrower and lender are

subject to credit risk
 There is no strategy which will reduce
the risk for both the parties.
 Increasing protection for one means
enhanced risk for the other.
117
Repurchase
Agreements
Credit Risk
Interest rates rise Interest rates
If interest rates rise decline
If interest rates decline,
sharply, the value of the value of the
the collateral will collateral will rise.
decline and the lender
will be vulnerable
In this case, if the If the lender goes
borrower were to go bankrupt, the borrower
bankrupt, the lender will be left with an
will be left with assets amount that is less
which may be worth than the market value
less than the loan of the securities.
amount.
118
Repurchase
Agreements
Margins
 The lender can ask for margin.

 i.e. he can lend less than the market value
of the assets.
 This will increase the risk for the borrower
 The borrower can ask for reverse
margin.
 i.e. he can ask the lender to lend more than
the market value of the securities.
 This will increase the risk for the lender
119
Repurchase
Agreements
Margins (Cont…)
 In practice it is the lenders who receive

margins.
 This is because they are parting with cash
which is the more liquid of the two assets.
 Thus the market value of the collateral
will exceed the loan amount.
 The excess is called a ‘Haircut’
120
Repurchase
Agreements
Reverse Repo
 Such transactions offer a convenient
route for lenders to park excess funds
for short periods.
 From the perspective of the lender such
an arrangement is called a reverse
repurchase agreement or a reverse
repo.
 Thus every repo must be matched by a
reverse repo.
 A dealer looking to borrow funds will do a
repo.
 A dealer looking to place funds will do a 121
Repurchase
Agreements
Matched Book
 Some dealers will do a repo for one

maturity with a party and a reverse
repo for another maturity with another
party.
 They hope to profit from the interest
rate differential.
 Such dealers are said to be maintaining
a ‘matched book’
122
Repurchase
Agreements
Rates
 General collateral rate  Most
government securities can be bought at
a rate called the general collateral rate.
 Thus most securities are close substitutes
for each other.
 Special repo rates  Sometimes a
security may be in high demand and the
lender may charge a lower rate.
 Such rates are called special repo rates.
123
Repurchase
Agreements
Repos (Cont…)
 To promote a smoothly functioning

market the Federal Reserve frequently
participates in repos with primary
dealers.
 It may buy securities on a short-term basis
and then sell them back
 It may sell securities with an agreement to
buy back
124
Repurchase
Agreements
Repos (Cont…)
 By selling securities to dealers the FED

temporarily absorbs dealer funds and
reduces the ability of the dealers’ banks
to make loans.
 Thus while dealers use repos to
increase their earnings from trading, the
FED uses them to steady the money
market.
125
Repurchase
Agreements
Settlement
 Parties will have accounts with the
Central Securities Depositories
 Sale of securities will be transacted by
book entry
 Payments will be made by an assured
payment system of the CSD
 Settlement may take place 1-2 days
after the date of the repo transaction
agreement
126
Repurchase
Agreements
Repo Rates
 Bid price  Rate that the dealer is
willing to accept in return for purchasing
bonds and agreeing to sell them back
 Bid rate is the customer’s repo rate and the
dealer's reverse repo rate
 Offer rate  Rate that the dealer is
willing pay to sell and then repurchase
the bonds
 Offer rate is the customer’s reverse repo
rate and the dealer’s repo rate
 The Bid will always be higher than the
Ask 127
Federal Funds
128
Fed Funds
Federal Funds
 They are the principal means of making

payments in the money market.
 Definition  The term Federal Funds
refers to money that is available for
immediate payment.
 Transferred from one depository institution
to another by simple book-keeping entries
129
Fed Funds
Federal Funds
History Today
The name federal funds Today the Fed funds
came about because in the market is far broader in
earlier years the principal scope than just reserves on
source of immediately deposit with Federal
available money was the Reserve Banks
reserve balance that each
bank held with the regional
Federal
If a bankReserve
neededBank
to Virtually all banks maintain
transfer funds to another it deposits with large
needed to only contact the correspondent banks in
regional FRB and funds major cities. These
would be transferred in a deposits may be readily
matter of seconds by transferred from the
computers account of one bank to that
130
Fed Funds
Federal Funds Today
 S&Ls, Credit Unions, and Savings Banks
maintain deposits with commercial
banks or with Federal Reserve Banks
that are available for immediate
transfer to a customer or to a financial
institution.
131
Fed Funds
Borrowers of Fed Funds

Borrowers
of Fed
Funds
State &
Securities Corpora- Insurance Commercial
Local S & Ls
dealers tions Cos banks
Govts
They are the most important of all

borrowers since they use Federal Funds a
the principal way to adjust their legal
132
reserve account at the district Federal
Mechanics of Federal Funds Fed Funds
Trading
 The mechanics of Fed Funds trading
depends on the locations of the
borrowing and lending institutions.
133
Fed Funds
Illustration 1
Take for example two banks that are located in New York
This is payable
The borrower would be
immediately. Fed funds
handed a check drawn on the
would be transferred to the
lender’s reserve account at
borrower’s reserve account
the Federal Reserve Bank of
before the close of business
New York
The lender on the other hand This is one day money

may be given a check drawn because it must pass
on the borrower through the New York
Clearinghouse
134
Alternative Mechanism
 The lending bank can simply contact the

New York Fed
 It can ask it to electronically move funds
from the lender’s reserve account to the
borrower’s
 The transaction can be reversed on the
following day.
135
Fed Funds
Illustration 2
If the institutions are not located within the same
district the transaction would proceed in the same
way except that two Federal Reserve banks would be
involved
The borrower and the lender agree on the
terms of the loan
The lending institution directly or indirectly

through a correspondent bank contacts
the district Federal Reserve bank
requesting a wire transfer of funds
The reserves are then transferred to the

borrowing bank through the Fed’s wire
network FEDWIRE 136
Fed Funds
Contact Mechanisms
 Fed Funds borrowers and lenders

contact each other using the following
mechanisms
a. Computer networks
b. Telephone
c. There are also Fed Funds brokers who

indicate by telephone and computer
screens what funds are available and at
137
Fed Funds
Fed Funds loans features
 Most Fed Funds loans are

 Overnight transactions
 Continuing contracts with no specific
maturity date
 Continuing contracts can be terminated
without advance notice by either party
138
Fed Funds
Fed Funds loans

 One day loans  They carry a fixed rate
of interest but continuing contracts do
not
 Term Federal Funds  Loans lasting
beyond a day.
 They are being supplied by foreign banks
and other lenders
 They are considered as a safe and profitable
way to warehouse funds until they are
needed for long-term loan commitments 139
Negotiable CDs
140
Nego CDs
What is a CD?
 It is an interest bearing receipt for funds left

with a depository institution for short periods
of time.
 The minimum maturity as per U.S. law is 7
days.
 There is no maximum limit.
 CDs are issued at par and pay interest
explicitly.
141
Nego CDs
True Money Market CDs

 True money market CDs are negotiable
instruments that can be resold before
maturity
 They carry a minimum denomination of
$100,000
 The round lot for trading is $1,000,000
 They may be registered on the books of the
issuing banks or else may be issued in
bearer form.

CDs issued in bearer form are more
convenient for resale.
142
Nego CDs
Negotiable CDs
 Denominations range from $25,000 to $10MM

 A true money market CD has a minimum
denomination of $100,000
 Maturities range from a few months to 18
months
 Most CDs have a maturity of 6 months or less
 Term CDs  CDs with maturities beyond a

year are called Term CDs
143
Nego CDs
Non-negotiable Time Deposits vs.
Negotiable CDs
Time Deposits CDs

An investor will deposit The depositor will be
a sum of money with a issued a bearer security
bank for a stated period
of time is paid interest Investor is entitled to
Investor
at a specified rate claim deposit with
interest at the end of
It cannot be easily the period
It can be liquidated at
terminated until it any time at the
matures prevailing marker rate144
Nego CDs
Calculations
 Consider a CD with a face value of V.
 The funds owed on maturity is given by:
V + Tm
____ x V x i
360
where:
Tm  original term to maturity
i  interest rate
145
Nego CDs
Example
 A firm purchases a $100,000 CD

 Duration = 6 months
 Interest rate @ 7.5%
 It would receive:
100,000 x {1 + (0.075 x 180/360)} =

$103,750
146
Nego CDs
Calculations (Cont…)
 To convert the yield to a true yield for a
365 day year, multiply the quoted rate
by 365/360.
 Thus
YTMCD = i x 365
____
360
147
Nego CDs
Example
 i = 0.075
 YTM = 0.075 x (365/360) = 7.6%
148
Nego CDs
Yield on CDs
 The yield on CDs is normally higher than

the T-bill rate due to
 Greater default risk
 A thinner resale market
 Tax exemptions granted to T-bills by state
and local governments.
149
Nego CDs
Global CDs - Euro

 Eurodollar CDs are negotiable dollar
denominated time deposits issued by
foreign branches of U.S. banks and
foreign owned banks.
 They carry higher rates than comparable
domestic CDs due to greater perceived risk.
 They can carry maturities in excess of one
year and rates are adjusted every 3 to 6
months to match changes in the LIBOR.
150
Nego CDs
Yields on CDs
 These are a function of demand and
supply.
 CDs are not riskless because the issuing
bank could fail.
 For the issuing bank, the effective cost of
the CD is greater than the quoted rate of
interest because of reserve requirements

151
and insurance premia.
Nego CDs
Illustration
 A bank is quoting 8% p.a. on a 3 month
deposit
 Reserves @ 5% and are non-interest
bearing
 Effectively $8 interest is being offered
on $95 of usable funds
 Effective rate =
8
95 = 8.42%
152
Nego CDs
Illustration
 The insurance premium is 8 b.p.
 Effective cost is
8.42 + 0.08 = 8.50%
153
Commercial Paper
154
Comm
Paper
Commercial Paper
 Unsecured promissory notes are known
as commercial paper
 Large corporations borrow billions of
dollars in the money market through
these
 A study in U.S. found that 1000+
corporations were regularly selling
commercial paper to money market
investors
 Such paper consists of short-term
unsecured promissory notes issued by
well known companies that are
155
financially strong and carry high credit
Comm
Paper
Funds raised for
 The funds raised are normally used for

current transactions such as:
 Purchase of raw materials
 Payment of accrued taxes
 Meeting of wage and salary obligations
 Other short-term obligations rather than for
capital account transactions.
156
Comm
Paper
Bridge Financing
 These days a substantial number of

paper issues are used to provide
`bridge financing for long-term projects’
 Issuing firms usually plan to convert their
short-term paper into more permanent
financing when the capital market looks
more favourable.
157
Comm
Paper
Buyers of Commercial Paper
 Paper is generally issued in multiples of
$1,000 & in denominations designed to
meet the needs of the buyer.
 It is traded mainly in the primary
market.
 Opportunities for resale in secondary
market are limited
 Investors are careful to purchase those
issues whose maturity matches their
planned holding periods. 158

Comm
Paper
Credit rating
 Most issuers of paper enjoy a high credit
rating.
 To reduce risk for investors, borrowers
usually secure a line of credit at a
commercial bank for a small fee or a
deposit.
 The line of credit cannot be used to directly
guarantee payment if company goes
bankrupt.
 The lender may renege on the credit line if
the borrower has had a `material adverse
change’ in his condition. 159
Comm
Paper
Letters of Credit
 Many issuers also take out irrevocable
letters of credit prepared by their banks.
 Such a letter of credit makes a bank
unconditionally responsible for repayment if
the corporation defaults.
 Banks usually charge 50 to 150 b.p. on
the amount of the guarantee that is
issued.
 Insurance companies and parent
companies of paper issuers also
guarantee issues of commercial paper.
160
Comm
Paper
Types of Commercial Paper
 There are two major types of

commercial paper
 Direct paper
 Dealer paper
161
Comm
Paper
Direct Paper
 The main issuers of direct paper are
 Large finance companies
 Bank holding companies
 Issuers deal directly with investors
rather than use securities dealers as
intermediaries.
 Such companies announce the rates
that they are paying on various
maturities
 Investors select maturities that closely
match their expected holding periods and
buy the paper directly from the issuer.
 Interest rates may be adjusted during the 162
day that the paper is sold to regulate the
Comm
Paper
Direct Paper (Cont…)
 Leading finance companies that borrow
in the direct paper market include
 General Motors Acceptance Corporation
(GMAC)
 General Electric Capital Corporation (GE
Capital)
 Such firms have
 An ongoing need for short-term money
 Possess top credit ratings
 Have established working relationships with
163
Comm
Paper
Direct Paper (Cont…)
 Directly placed paper must be sold in
large volume to cover the substantial
costs of distribution and marketing.
 On an average each direct issuer in the U.S.
borrows at least $1bn per month
 Issuers of direct paper do not have to
pay dealers’ commissions
 They must maintain a marketing division to
maintain constant contact with active
investors
 Issuers like Citicorp sell paper in weekly
auctions in which buyers bid for 164
Comm
Paper
Funds used for
 Sometimes direct issuers must sell their
paper even when they have no need for
funds
 They have to maintain a good working
relationship with active investor groups.
 They also have to pay fees to banks for
supporting lines of credit.
 They have to pay agencies that rate their
issues
 They have to pay agents like trust
165
companies that collect funds and disburse
Comm
Paper
Industrial Paper
 The other variety of commercial paper
is dealer paper that is issued by security
dealers on behalf of their corporate
customers.
 Such paper is also known as Industrial
Paper.
 This is issued mainly by non-financial
companies, smaller bank holding
companies and financial companies
 These borrow less frequently than
companies that issue direct paper. 166
Comm
Paper
Buyers of Industrial Paper
 The issuing company may sell the paper
directly to the dealer who buys it less a
discount and commissions, and then
attempts to resell it at the highest
possible price in the market.
 Alternatively the issuing company may
bear all the risk with the dealer only
agreeing to sell at the best price
available less commissions.
 This is referred to as a best efforts
transaction.
167
Comm
Paper
Value of Paper
 The value of paper outstanding has

grown rapidly due to various reasons.
 For large well known corporations
commercial paper is usually a cost
effective substitute for bank loans and
other forms of borrowing.
 This is especially true for non-financial firms
that issue paper through dealers.
168
Comm
Paper
Growth of the Market
 The paper market has also grown
because of cutbacks in bank lending.
 Due to loan quality issues banks have
become more cautious.
 Another reason for the market’s rapid
growth is the high quality of most
paper.
 Many investors regard paper as a high
quality substitute for T-bills and other
money market instruments. 169
Comm
Paper
Credit Enhancements
 The expanding use of credit

enhancements has also contributed to
the growth of the paper market. E.g.
 Standby letters of credit
 Indemnity bonds
 Other irrevocable payment guarantees
170
Comm
Paper
Yankee Paper
 Yankee paper  Foreigners also issue
paper in the U.S. market.
 Issuers can often issue Yankee paper at
a cheaper rate than what it would cost
them to borrow outside the U.S.
 Foreign issuers generally pay higher
rates than American issuers of
comparable credit quality.
 This is to compensate American investors
for the difficulty of gathering information on
foreign issuers and the lack of name
recognition.
171
Comm
Paper
International Paper - Yen
 Yen denominated paper was allowed in

1987 after Japanese companies
threatened to move their short-term
borrowing programs abroad.
 In 1988 foreigners were allowed to issue
Samurai paper in Japan.
172
Comm
Paper
International Paper - Euro
 The Euro-paper market evolved in the

1980s.
 The market sees large volumes because
issuers can tap foreign investors.
 Many U.S. firms which have had
difficulty borrowing at home due to low
credit quality have found the Euro
market to be less quality conscious.
173
International Paper – Euro Comm
Paper
(Cont…)
 Large investors in Euro-paper include:
 International banks
 Private corporations
 Foreign central banks
 In contrast U.S. paper is bought mainly
by money market mutual funds.
 Euro-paper is priced below the face
value and appreciates in value as
maturity approaches.
 The quoted interest rate is a discount
rate like in the case of T-bills. 174
Comm
Paper
Example – Euro (Cont…)
 Assume that we wish to acquire Euro-

paper with a face value of $100MM and
a time to maturity of 90 days
 If the discount rate is 6%, the price
would be
100,000,000 - 100,000,000 x 0.06 x
(90/360)
= 98,500,000 175
Comm
Paper
Maturity of US Paper
 Maturities of US paper range from 3
days (weekend paper) to 270 days
 Most paper has an original maturity of
60 days or less with an average
maturity of 20 to 45 days
 US paper is generally not issued with a
maturity exceeding 270 days
 Because any security with a maturity in
excess of 270 days must be registered with
the SEC
176
Comm
Paper
Yield on Commercial Paper
 Yields are quoted on a discount basis

like in the case of T-bills
 Most commercial paper is issued in
discount form.
 Some corporations do sell interest
bearing or coupon paper
177
Comm
Paper
Denomination for Paper
 The minimum denomination for paper is
usually $25,000
 Among institutional investors the
minimum denomination is usually
$1,000,000
 Notes are typically issued in bearer form
to make resale easier.
 On maturity, payment is made on
presentation to the bank which is
designated as the agent.
 Settlement is made in Federal Funds on
the same day.
178
Comm
Paper
Advantages with paper market
 Advantages for companies that are

able to tap the paper market.
a. Generally rates are less than on bank
loans.
b. The effective rate on bank loans is higher

than what is quoted due to the need to
keep a compensating deposit.
179
Comm
Paper
Example
 Take the case of a firm that borrows
$100MM @ 8% with a compensating
balance of 20%
 The effective rate is

8,000,000
___________ = 10%
80,000,000
180
Comm
Paper
Advantages with paper market
a. Another advantage of borrowing in the

paper market is that rates are often
more flexible than bank rates.
 A company in need can quickly raise funds
through either dealer paper or direct
paper.
 Dealers maintain close contact with the
market and generally know where funds
can be found.
 Notes can be issued and funds raised on
181
the same day.
Comm
Paper
Lending money
 Federal & state regulations limit the
amount of money that a bank can lend
to a single borrower
 For nationally chartered banks the
maximum unsecured loan that can be
granted to a borrower is 15% of the bank’s
capital and surplus.
 Corporate needs frequently exceed an
individual bank’s loan limit.
 A consortium of banks can be assembled -
but this takes time.
 In the paper market it is much easier to
arrive at agreements for large issues.
182
Comm
Paper
Lending Money (Cont…)
 The ability to issue paper gives a

corporation considerable leverage when
negotiating with a bank.
 A banker who knows that his customer
can draw on the paper market is likely
to be more receptive and offer more
advantageous terms.
183
Comm
Paper
Risk of Paper
 One risk of issuing paper is that of

alienating banks whose loans may be
needed should a real emergency arise.
 It must be remembered that paper cannot
be paid off at the issuer’s discretion but
must remain outstanding till maturity.
 In contrast many bank loans can be paid off
prematurely without penalties.
184
Comm
Paper
Ratings and Rating Agencies
 Depending on the credit standing of the
issuer paper is rated as:
 Prime
 Desirable or
 Satisfactory
 Firms issuing paper generally seek
ratings from multiple issuers.
 It is extremely difficult to market unrated
paper.
 About 75% of the firms that currently sell
paper are prime rated.
 Generally notes bearing ratings from at
least two agencies are preferred by 185
investors.
Comm
Paper
Rating Agencies
 Prominent rating agencies include:
 Moody’s Investors Service
 Standard & Poor’s Corporation
 Fitch Investor’s Service
 Canadian Bond Rating Service
 Japanese Bond Rating Institute
 Dominion Bond Rating Service
 IBCA Ltd.
186
Comm
Paper
Summary of the Rating Systems
Company Higher Lower Speculati Defaulte

A/ Prime A/ Prime ve d
Below
Prime
Moody’s P-1 P-2, P-3 NP NP
S&P A-1+, A-2, A-3 B, C D

A-1
Fitch F-1+,F-1 F-2,F-3 F-5 D
187
Comm
Paper
Credit Rating
 We will illustrate using S&P’s rating

scale.
 A-1= strong degree of safety for timely
repayment
 A-2 = satisfactory degree of safety
 A-3 = adequate safety
 B,C = risky or speculative
188
 D = default history
Comm
Paper
Credit Rating
 Agencies are paid by the issuers of

paper.
 A good rating makes it easier and
cheaper to borrow
 However rating agencies always look at
the issue from the perspective of a
potential investor.
 Their credibility is based on their track
record from the standpoint of accuracy. 189
Comm
Paper
Evaluation Criteria
 Rating agencies use the following

criteria.
 Strong management.
 Good position for the company in a well
established industry.
 Good earnings record.
 Adequate liquidity.
 Ability to borrow to meet both anticipated
and unanticipated needs. 190
Bankers’ Acceptances
191
BAs
What is a bill?
 It is an undertaking to pay a specified
amount of money at a future date –
upto 12 months in the future
 It is a form of short-term finance for the
debtor
 Bills can be sold in the money market at
any time prior to their maturity date
 Bills are classified on basis of the entity
which gives the undertaking to pay
 T-Bills
 Bank bills
 Trade bills
192
BAs
Bills of Exchange
 In international trade when goods are
exported the exporter will draw up a
Draft or a Bill of Exchange.
 A Draft is an instrument that instructs
the importer to pay the amount
mentioned upon presentation.
 A Draft may be a
 Sight Draft
 Time Draft
193
BAs
Sight Drafts
 In such cases the importer has to pay

for the goods on sight of the draft.
 His bank will not release the shipping
document until he pays.
 Such transactions are known as
‘Documents Against Payment’
transactions.
194
BAs
Time Drafts
 These are also known as Usance Drafts.
 The bank will release the shipping
documents in such cases as soon as the
importer accepts the draft by signing on
it.
 The importer need not pay immediately.
 In other words the exporter is offering
him credit for a period.
 When the importer accepts a draft it
becomes a ‘Trade Acceptance’. 195
BAs
Letters of Credit (LCs)

 Most international transactions are
backed by LCs
 An LC is a written guarantee given by
the importer’s bank to honour any
drafts or claims for payment presented
by the exporter.
 LC based transactions are more secure.
 Shipments under an LC can be on the basis
of a sight draft or a time draft.
196
BAs
LC Based Transactions
 In the case of a sight draft the
importer’s bank will pay on
presentation.
 In the case of a time draft it will accept
it by signing on it.
 A draft that is accepted by a bank is
called a Banker’s Acceptance
 It is obviously more marketable than a trade
acceptance. 197
BAs
The Market for BAs

 In the U.S. there is an active secondary
market for BAs.
 They are short term zero coupon assets
which are redeemed at the face value on
maturity
 BAs with a face value of 5MM USD are
considered to constitute a round lot.
 Once a BA is issued the exporter can get it
discounted by the accepting bank.
 i.e. he can sell it for its discounted value.
 he can sell it to someone else in the
secondary market.
198
BAs
Credit Risk for BAs
 The credit risk involved in holding a BA

is minimal.
 It represents an obligation on the part of the
accepting bank.
 It is also a contingent obligation on the part
of the exporter.
 i.e. if the bank fails to pay, the holder has
recourse to the exporter who is the drawer of
the draft
199
BAs
Trade Bills
 These are issued by a commercial
enterprise
 They are bills drawn by one non-bank
company on another demanding
payment for a trade debt
 They may be used for domestic /
international trade transactions
 Financial institutions will buy only the
finest trade bills in the market
200
BAs
Bank Bills
 These are bills of exchange drawn on
and payable by a commercial bank
 A common form is a bankers’
acceptance
201
Buying and Selling Bills - BAs
Illustration
 A co. has drawn a bill on HSBC for

$5,000,000
 Maturity  150 days
 The bank accepted it and sold it to
Barclays at a discount @ 5.25%
 30 days hence Barclays sold the bill to
ABN Amro at a discount @ 4.75%
202
BAs
 Purchase price:
5,000,000 [1 – (5.25/100) * (150/360)]
= $4,890,625
 Sale price:
5,000,000 [1 – (4.75/100) * (120/360)]
= $4,920,833.33
203
BAs
 Profit:
$4,920,833.33 - $ 4,890,625 = $
30,208.33
 ROI on a 360-day year basis
(30,208.33/4,890,625) * (360/30)
= 7.41%
204
Eurocurrency Deposits
205
Eurocurrency
Deposits
What is Eurocurrency?
 It is a freely convertible currency
deposited outside the country to which
it belongs.
 Dollars deposited outside the US are
Eurodollars
 Yen deposited outside Japan are Euroyen
206
Eurocurrency
Deposits
Illustration
 A french exporter ships champagne to a
New York importer accompanied by a
bill for $10,000
 The importing firm pays for the
champagne by issuing a cheque
denominated in dollars and deposits it
in a US bank – First American bank –
where the French firm has a checking
account
207
Eurocurrency
Deposits
 After the check clears the results are:
French Exporter’s Account
Assets Liabilities
Deposit in US Bank = $10,000
First American Bank’s Account
Assets Liabilities
Deposit owed to French Exporter
= $10,000
208
Eurocurrency
Deposits
 This is not a Eurodollar deposit since

deposit occurs in the US
 The French Exporter is offered an
attractive rate of return on its dollar
deposit by its own local Paris bank
 It moves its dollar deposit there
 Paris bank wants to loan these dollars to
other customers in the US
209
Eurocurrency
Deposits
 The 4 transactions will be:
French Exporter’s Account
Assets Liabilities
Deposit in US Bank = - $10,000

Deposit in Paris Bank = + $10,000
First American Bank’s Account
Assets Liabilities
Reserves transferred to Deposit owed to French Exporter
Correspondent Bank = - $10,000 = - $10,000
210
Eurocurrency
Deposits
US Correspondent Bank’s Account
Assets Liabilities
Reserves transferred from Deposit owed to Paris Bank =
First American Bank = $10,000
$10,000
Paris Bank’s Account
Assets Liabilities
Deposit with US Correspondent Deposit owed to French Exporter
Bank = $10,000 = $10,000
211
 Assume the Paris bank makes a loan of

$10,000 to a small oil company in
Manchester.
 The British company needs US dollars to
pay for shipment of petroleum drilling
equipment from Texas
212
Eurocurrency
Deposits
Assets Liabilities
Loan to British company = +
$10,000
Deposit in Correspondent
Bank = - $10,000
British Oil Company’s Account
Assets Liabilities
Deposit with US Correspondent Loan from Paris Bank = $10,000
Bank = $10,000
213
Eurocurrency
Deposits
Assets Liabilities
Deposit owed to French
Amount owed by British Oil
Company = + $10,000
exporter = $10,000
214
Part-10
Introduction to Credit Risk

Introduction
 What is credit?
 It is an amount of money that is
scheduled to be paid at a future date
 In return for benefits received earlier
 Benefits may be monetary or non-
monetary
Illustrations of Extensions
of Credit
 A party supplies goods or services
without insisting on immediate
payment
 A bank makes a loan
 The repayment of principal and
interest being scheduled for a later
date.
Credit Risk
 What is credit risk?
 It is the risk that the anticipated
inflow of cash may not occur
 It is the potential loss due to the
potential refusal or inability of the
client to repay
 Credit risk is a form of
Counterparty Risk
 What is Counterparty Risk?
 It is the risk that the party on the
other side of the transaction will fail
to perform
 A company that borrows from a
bank may fail to repay
 The risk for the bank is:
 There could be losses on account of a
bad debt
 Or a loss due to a delay in receiving
the payment
 Trade related transactions too are
fraught with danger
 The customer may not pay in full
 He may take longer than what was
agreed upon to make the payment
Risk-Reward Trade-off
 When a decision is taken to extend
credit
 There has to be a trade-off between
the risk and reward for the lender or
supplier.
Risk Reward…(Cont…)
 In the case of trade credit the risk
of non-payment or late payment
depends on
 The business situation
 The character of the recipient
 At times a customer may take credit
with a pre-decided intention of not
paying
 However usually non-payment or late
payment is caused by these factors
 The customer may be unable to pay on time
or in full
 A large institutional client may deliberately
delay payments to a lender who is less
powerful

In such cases, payment, though delayed, is
usually made in full eventually
 The larger the magnitude of the
credit
 Or the longer the period for which
it is granted
 The greater is the risk for the
lender/supplier
 Risk reward trade-offs call for decisions
regarding:
 How much risk is acceptable to generate
extra sales
 What should be the price markup ito
compensate for the credit risk

 What should be the credit limit for the
company as a whole
 What should be the credit limit for each
customer
 Should existing limits be increased or
decreased
 Should an order or a loan request be
accepted or rejected
 An optimal credit decision
 Would maximize total income net of
the costs of bad debts and delayed
payments
Illustration
 A company expects to sell 25MM of
goods each year
 The gross profit margin is 30%
 Bad debts are 2.50% of the turnover
 It believes that by offering more
liberal credit terms
 The turnover can be increased by
30%
 But average debtors would be 4MM
higher
 Bad debts would probably increase to
5% of the turnover
 The cost of funding debtors is
Analysis
 Current gross profit = 25,000,000
x 0.3 = $7,500,000
 Bad debts = 25,000,000 x 0.025 =
$625,000
 The change in policy will boost
gross profit by:
 7,500,000 x 0.3 = $2,225,000
Analysis (Cont…)
 It will increase bad debts by:
 25,000,000 x 1.30 x 0.05 -625,000
= $1,000,000
 The extra financing cost =
4,000,000 x 0.125 = $500,000
 The net benefit is:
 2,250,000 – 1,000,000 – 500,000 =
$750,000
Analysis (Cont…)
 The net benefit is positive
 So the change in the credit policy is
beneficial
Credit Risk: Banks
 When a bank makes a loan to a
client
 There exists credit risk for the bank
 As well as for the customer
 What is the risk for the bank?
 The client may be unable to pay
interest
 He may be unable to repay the loan
principal
Bank Loans: Sources for
Repayment
 A bank loan can have three
sources for repayment:
 The cash flows of the borrower
 Security in the form of a fixed or
floating charge on the borrower’s
assets
 A guarantee from a third party
Bank Loans…(Cont…)
 Banks look for at least two of these
sources of repayment
 In the case of corporate borrowers
 Banks expect loans to be usually
repaid out of operational cash flows
 It will try and get assurance that the
borrower will have the liquidity to
repay
 Taking security such as a charge
on an asset is a fallback source
 In the event of non-payment, the
bank can seek repayment from the
sale of secured assets
 In the case of a guaranteed loans
 The bank will ask the guarantor for
repayment
 Even if the loan were to be
secured, the bank may not be fully
protected
 The market value of the secured
assets may fall below the amount of
the loan
Fixed Charge
 When a company borrows money the
lender will usually take security
 The lender may have provided money
to acquire an asset like
 Land
 Buildings
 Automobiles
 The borrower cannot sell such assets
without the lender’s permission
Fixed Charge (Cont…)
 Take the case of a mortgage loan
 The mortgagor cannot own the house
outright till the loan is repaid
 It cannot be sold without the lender’s
permission till the loan is repaid

Consequently it is a fixed charge
Floating Charge
 If a lender may take a general or
floating charge against the assets of the
borrower
 Such assets may include
 Stock: Finished goods or Raw Material
 Work in Process
 Debtors
 Fixtures and Fittings
 Cash
 Vehicles and assets not subject to fixed
charges
Floating Charge (Cont…)
 A floating charge is an interest
over a fund of changing assets
 It floats or hovers until conversion
to a fixed charge
 At that point it attaches to specific
assets
 This conversion is known as
`Crystallization’
Restricting Bad Debts
 There are many ways of keeping
bad debts to a tolerable level
 Avoid loans to risky customers
 Monitor loan payments
 Renegotiate loans when the borrower
gets into difficulties
Restricting…(Cont…)
 Loans should be made only to
parties who are unlikely to
become insolvent
 Credit analysis is required to gauge
credit risk
 Loan payments should be monitored and
action taken in the event of default
 The customer may fail to pay interest by the
due date
 If necessary the loan should be called in
 A bank may support a borrower
who is unable to meet the
repayment schedule
 If so the conditions of the loan may
be altered
 Loan covenants may be made less
restrictive
 An interest holiday may be allowed
 The term of the loan may be
 A lender may agree to a re-financing
package
 A borrower is given new loans to payoff
maturing loans with interest
 Bank support for borrowers in difficulty
can be extensive during recessions
 The lenders in such circumstances
might hope that
 The economy will eventually recover
 Borrowers’ businesses would improve,
enabling them to repay
 Such consideration will help
 Banks to avoid bad debts write-offs
 Such write-offs may cause them to report
lower profits or even losses
 Maintain their existing customer base
 The flip side is:
 The credit exposure to the party
increases
 If the borrower goes bankrupt, the
bad debt will be even higher
Illustration
 ABC Corp has borrowed
$10,000,000 from First National
Bank
 The interest rate is 10%, payable
quarterly.
 Subsequently the company is
unable to repay
 The bank agrees to add the unpaid
interest to the loan
 ABC is a bad credit risk
 Because of the holiday the loan will
increase from $10MM to $10.25MM
 Thus while the bank has received
no cash income
 Its credit risk exposure is $250,000
higher
Covenants
 What is a covenant?

It is a condition that the borrower must
comply with in order to adhere to the
loan agreement
 If the borrower does not act in
accordance, the loan can be considered
to be in default
 If so, the lender has the right to
demand payment (usually in full)

Covenants (Cont…)
 Why do banks add covenants to
loans:
 Maintain loan quality
 Keep adequate cash flow
 Preserve Equity
Covenants (Cont…)
 Common Covenants include:
 Hazard Insurance/Content Insurance
 The borrower is required to insure the
plant/equipment or inventory
 Key-man life insurance

The borrower must insure the life of an
indispensable owner or manager
 The lender usually gets an assignment of the
policy
Covenants (Cont…)
 Payment of taxes/fees/licenses

Borrower has to keep these payments up
to date
 Failure could lead to a lien from the
government
 This would take precedence to a lien from the
bank
 Financial information on borrower and
guarantor
 Borrower agrees to submit financial
statements for assessment by the bank
 The statements are usually submitted yearly
Covenants (Cont…)
 Minimum financial ratios

The borrower has to maintain a certain
level in key financial ratios like
 Quick and Current Ratios (Liquidity)
 Minimum ROA and ROE (profitability)
 Minimum Equity; Working Capital and
maximum D:E ratio (leverage)
Covenants (Cont…)
 Restrictions on the borrower
 No change of management or merger
without prior approval
 No further loans without prior
approval
 No dividends/withdrawal or limited
dividends/withdrawals
Credit Risk and Interest
Rates
 One way for a bank to protect itself
is by increasing the interest cost
on loans
 The income from good loans can help
offset bad debt losses
Illustration
 Central Bank has a loan portfolio of
$100MM
 It wants an annual interest of 8MM
net of bad debt write-offs
 In the absence of bad debts a
standard rate of 8% could be
charged
 But because of bad debts, the rate on
performing loans will have to be
%age of Amt. of Perform. NI Interest Rate
bad bad loans required Income
debts debts required
0 0 100 8 8 8%
2 2 98 8 10 10/98 =
10.20
5 5 95 8 13 13/95 =
13.68
10 10 90 8 18 18/90 =
20.00
Risk for the Customers
 Customers too face credit risk
while dealing with a bank.
 If the bank were to collapse their
deposits are at risk
 Examples

BCCI
 Barings Bank
Risks…(Cont…)
 A bank may refuse to extend a
loan to support temporary cash
flow problems
 A borrower can prevent this by paying
interest and principal as per schedule
 Nevertheless, business uncertainties
may always require
 larger borrowings
 or an extension in maturity
Credit Management
 Credit management is concerned with
 managing debtors and
 financing debts
 The objective of credit management is
 Safeguarding investments in debtors
 Optimizing operational cash flows
 Policies and procedures are required for
 Granting credit to customers
 Collecting payments
 Limiting risks of non-payment
Credit Control
 This is an important function of
credit management
 It is a process for:
 Deciding how much credit should be
given to a borrower
 Ensuring compliance with credit
terms
Credit Control (Cont…)
 Why is credit control required?
 It helps avoid a liquidity shortage due to
excessive investments in debtors
 It is required to strike a balance between
 Giving credit to make more sales and
 Financial risks from non-payment or late payment
 Poor control increases the risks to
 liquidity and
 profitability
 A credit control system should
include procedures for
 How much credit to take
 And how much credit to give
 Risks can arise from overexposure
to
 A particular bank for loans obtained
 To a particular supplier for trade
credit
 If debtors are not well managed there
could be several consequences
 Amount of unpaid debts will be high
 Excessive debtors will add to the cost of
business assets and will
 Reduce the return on assets

Debtors represent unpaid invoices that have to be
financed and

This creates an interest cost
 The risk of bad debts will be greater

This has a direct effect on profits
Illustration
 A company has total assets of $6MM
including debtors of $1.5MM
 Annual sales are 10MM
 The company has a bank overdraft
 It could be reduced if debtors paid more
promptly
 But it will increase if the total amount of
unpaid debt increases
 Interest is 10% per annum
 Because of poor credit
management debtors increase to
$2MM
 Bad debts rise to 0.75% of sales
turnover
 Consequences
 Profits will fall by $75,000 due to
higher bad debts
 The increase in debtors has to be
financed

The annual interest cost will rise by
$50,000
 Lower profits and higher assets
(debtors) will lead to a fall on ROA
Achieving Credit Control
 It is a continuous process
 Entails:
 Establishing lending principles
 Formulating and implementing a credit
policy
 Deciding credit terms to customers
 Setting maximum credit limits for the debtors in
total
 Credit assessment of individual customers

To decide whether or not to grant credit
Achieving…(Cont…)
 Operational management of the credit cycle

Invoicing procedures

Collection procedures

Query control
 Monitoring the creditworthiness and credit
limits of customers
 Arranging secured methods of payment

Where normal credit terms cannot be offered
without unacceptable risk
Credit Control and
Marketing
 Credit control is an element of the
marketing mix
 It is a part of the customer service
function
 Handling credit requests and
establishing credit terms is a part of
the selling service
 If a client is not given what he requires
 The business relationship could be in
jeopardy
Credit Control and
Marketing
 Credit needs to be controlled
 But is should be comparable with
what competitors offer
 Credit can be a feature of price
 A price of $10,000 for cash payment
is equivalent to $10,300 with 3
months credit if the interest rate is
12% per annum
Influences on Credit
Management
 High interest rates
 Availability of bank loans
 Low profits and cash flow problems
 Growing use of computers
High Interest Rates
 High rates are a feature of an
economic recession
 They are used as a policy to control
inflation
 It has implications for the cost of
granting credit
Availability of Bank Loans
 Availability of bank credit is
dependent on the capital adequacy
rules
 It also depends on the state of the
economy
 The bank may be recovering from
major bad debt losses
Availability…(Cont…)
 In bad times small companies are
more vulnerable
 They rely more on bank loans
 Unlike large companies they cannot
easily issue bonds or commercial
paper
 Cutbacks in bank lending may
force companies to rely more on
trade credit
Low Profitability and Poor
Cash Flows
 The cost of granting credit may be
greater for companies with low
profits/cash flow problems
 A party may delay payments to
ease its cash flow difficulties
 But it will be passing on similar
difficulties to its suppliers
Computerized Credit
Information
 There has been a gradual increase
in the use of computers for credit
management
 Credit reference agencies maintain a
business database
 Large agencies can transmit credit
information electronically to clients
Computerized…(Cont…)
 Companies can use their own
computerized sales ledger systems
to generate credit management
reports
 Regular aged debtor analysis
 Listing of overdue debts
Credit Management in
Banks
 Banks and other companies face similar
credit management issues
 All organizations require a credit policy
 For banks granting credit is their
business
 A policy framework is essential
 Individual applications for credit have to be
vetted

Banks have routine procedures and systems
Credit Management…
(Cont…)
 Banks have the staff expertise to
rely mainly on in-house
assessments
 Smaller companies usually rely on
external assessments
(Cont…)
 There are some differences in the way
banks manage credit.
 Trade suppliers must establish
procedures for
 Invoicing
 Collecting payments
 Chasing non-payers
 Banks can often simply debit the
checking account of a client
(Cont…)
 Chasing of non-payments is necessary
for a bank only
 If the customer has an account with another
bank
 Or the account balance is insufficient
 There are also differences in the
approach of banks to security of
payment
 Banks can ask for a fixed or floating charge
 Or for a third party guarantee
(Cont…)
 If the risk is perceived to be high,
the bank can also ask for a higher
interest rate
Principles of Good Lending
 The initial lending/borrowing
proposition must come from the
client
 It may ask to borrow an amount for a
stated period and purpose
 This will give an idea to the bank as to
how it can expect to be repaid.
Principles…(Cont…)
 The banker has to decide
 Is the proposal acceptable in its
current form
 Or will it be acceptable if amended
 Or is it unacceptable in any form
 If the bank agrees to lend it will
want to structure the loan to
match the purpose
Analyzing Lending
Propositions
 Many lending decisions are based on
experience and instinct
 Even so the approach should be
structured
 Consider each important factor
 Assess whether the proposal satisfies
certain criteria
 Banks’ principles of good lending can be
reduced to a simple framework
 CAMPARI and ICE
CAMPARI
 C – Character
 A – Ability
 M – Means
 P – Purpose
 A – Amount
 R – Repayment
 I – Insurance
ICE
 I – Interest
 C – Commissions
 E – Extras
Character
 The borrower’s character is a prime
factor
 Banks will often lend on the assurance
of
 A person
 Management team
 Company name
 Taken to an extreme this can result in
bad debts
 Lenders must be vary of borrowers who can
Character (Cont…)
 Integrity and honesty are not the only
aspects
 An honest customer may not be
creditworthy
 It is important to assess character in
terms of whether:
 The owners or directors have a financial
interest in the business
 The management is of good caliber
 The company has well-regarded financial
advisers
Character (Cont…)
 Either or both of the following methods
may be used to judge character
 Past Record: A banker can look at the
history of the customer’s account with the
bank

If he does not have an account the issue is why is
he not approaching his own bank
 Personal Interview
 Character can be assessed from a personal
meeting

Reinforced by a visit to the customer’s premises

This is however no substitute for factual
Ability
 Let us suppose the borrower is a part of a
larger group
 It is necessary to identify its status within the group
 In order to assess the potential credit risk for the lender
 A group of companies is not necessarily a legal
entity
 If a group company borrows money the bank’s
transaction is not with the group as a whole
 In the event of default
 The lender cannot take action against the group or
the parent company
 He can take action only against the borrowing entity
Ability (Cont…)
 The lender can rely on the
collective financial strength of the
group only if
 The borrowing company is the parent
 The parent or another group company
provides a guarantee to the bank
Ability (Cont…)
 A parent company could create a
subsidiary
 Specifically for the purpose of borrowing
 Or carrying out other specific transactions
on behalf of the group
 If so the lender would have a credit
exposure only to this entity
 And would have no claim on the group’s
assets in the event of default
Ability (Cont…)
 Even if the subsidiary is a part of a
group that has a AAA rating
 The lender will have a high credit risk
exposure if the subsidiary is financially
weak
 Thus a lender should refuse a loan to a
subsidiary
 Unless it is financially strong
 Or unless other group companies are willing
to provide guarantees
Means
 Means or Capacity refers to the
borrower have
 Technical
 Managerial
 Financial
abilities to operate profitably and
succeed in business
Means (Cont…)
 A corporate borrower should give the
appearance of coping with changes in
business and technology
 Should have
 The premises
 Equipment
 Transport
 Staff
adequate for the planned use of funds

Means (Cont…)
 Management should be well
trained and have adequate
experience
 Directors and managers should be
well balanced with a spread of
 Skills
 Expertise
 Preferably including financial expertise
 A one man business is a high credit
risk
Means (Cont…)
 The business should have
 good financial systems and controls
 If there is a history of financial
troubles
 The management’s record in
resolving them should be significant
Purpose
 The purpose of granting credit
must be clear and acceptable to
the lender
 A bank should know what the
money is meant for
 The purpose should not be risky
 Or outside the borrower’s normal
course of business
Finance for Working
Capital
 If the purpose of the loan is to finance
an increase in stocks or debtors
 The bank should consider the liquidity of the
borrower’s business
 The risk of funding WC is that the
borrower may require increasing
amounts of finance over time
 Even if the business is profitable
 This could happen if the business is growing
fast
 Growth in business will result in
more stocks and debtors
 Even when normal credit terms are
applied
 These have to be financed
 And a bank may be willing to provide
credit
 But credit should not be given to
support excessive growth
Illustration
 An airline company already has a
fleet of 20 planes
 It asks for credit to buy an additional
plane
 Such a request may be approved
 But what if its seeks to buy 3 extra
planes
 This could create doubts in the mind of
the lender
 Growth looks too rapid and difficult to
Finance for New Ventures
 All new ventures are risky
 Many succeed
 But many also fail
 Such loans are highly risky
 Should be referred to a specialist
lender like a venture capitalist
Finance to repay Existing
Debts
 A bank may decide that with good
security and a high rate of interest
 It would grant a loan to enable the
client to pay off existing debts
 Such as pay taxes
 Dividends

Trade debts
Existing Debts (Cont…)
 However such loans are unusual
 The customer’s reasons for
requesting such funds should be
questioned
 Remember
 The bank is giving money to pay off
the borrower’s other creditors
 And is itself becoming the borrower’s
main creditor
Amount of the Loan
 The amount should be consistent
with the purpose
 It should not exceed the
borrower’s capacity on repay in full
and on time
 It should not be excessive
 Given the size of the business
 And the company’s equity stake
Amount (Cont…)
 The lending proposition must state how
much the client wants to borrow
 The bank cannot suggest how much it will
lend
 The amount asked for should not be
excessive
 This is specially true for overdrafts
 The amount asked for should not be too
little
 Else the bank may have to lend more later to
safeguard the initial loan
Amount (Cont…)
 How does the bank determine whether
the amount asked for is appropriate
 It can study budgets and cash flow forecasts
 It can analyze the balance sheet of the
borrower
 Assess its WC position after the advance has been
made
 To decide whether more finance is needed than
what the client has asked for
 Examine the business plan for the project
Amount (Cont…)
 If the bank feels that the customer
will be short of funds even after
approval
 It should ask the proposal to be
revised and re-submitted
 The bank should also assess the
equity that the client might have to
bring
Amount (Cont…)
 A bank should not be expected to
provide risk capital
 If the investment were to go wrong
and the customer has no or little
equity
 The bank will have to bear most of
the risk if the borrower cannot repay
 However if the client has sufficient
equity

Losses will be borne by the client before
the bank’s stake is threatened
Repayment
 The source of repayment must be
known in advance
 Evidence of the repayment ability:
 Should be demonstrated by its cash flows in
the past
 Or by cash flow projections for the future
 The primary source of repayment is
normally the activities that the loan will
finance
 Cash flows from normal trading operations
 Or from a specific project
Repayment (Cont…)
 To check the likelihood of the
customer’s ability to repay the banker
must:
 Calculate what the repayments with
interest will be
 For a term loan - the amortized payments will
have to be estimated
 For overdrafts it has to be checked whether the
customer will have enough cash income in the
future to pay the interest
 And be able to gradually reduce the size of the OD
Repayment (Cont…)
 The banker must obtain evidence that
the source of repayment will be
sufficient
 Proceeds from an asset sale
 Or operational cash flows
 The repayment source should be clear
from the outset
 The banker must check the budgets
and management accounts of the
customer
 To supplement the evidence obtained by
its own credit analysis
Repayment (Cont…)
 A corporate borrower should be
expected to pay out of cash
income from trading operations
 This is referred to as - Operational
Cash Flows
Operational Cash Flows
 Operational cash flows consist of
 Cash receipts from sale of goods and
services
 Cash payments for purchase of goods
and services
 Payments for wages and salaries
 Payments for income tax
(Cont…)
 Cash receipts should normally
exceed cash payments
 To give a positive net inflow of cash
from operations
 Operating cash flow is not the
same as trading profits
 But in the long run profitable
companies should have a net
operating cash surplus
(Cont…)
 Operational cash flows are used to
make other essential payments
known as `Priority Payments’
 These if not made would lead to the
liquidation of the firm
 These include
 Interest on loans
 Payment of corporate taxes
(Cont…)
 If a company does not have
enough operational net cash
inflows to pay for priority items
 It must borrow to bride the deficit
 Else it will collapse
Repayment (Cont…)
 A company also must continue to
invest in new or replacement
equipment
 These are discretionary items of
expenditure
 They can be deferred
 However in the long run some
CAPEX is essential
Repayment (Cont…)
 A company with a healthy financial
position
 Should have a sufficient surplus from
its trading operations – after making
priority payments
 To pay for much of its CAPEX program
Repayment (Cont…)
 Net Operational Cash Flows – Priority
Payments should be POSITIVE
 Cash for discretionary spending –
Investment Spending should normally
be POSITIVE
 If cash after investment spending is
negative
 The company has to obtain funds from non-
trading sources – perhaps by BORROWING
Repayment (Cont…)
 Many bad loans are granted in
prosperous times
 Banks do not expect businesses to
fold up
 But bankers should try and
anticipate the consequences of a
business decline
 Will the cash flows be adequate to
withstand a downturn
Repayment (Cont…)
 If a company can achieve positive net
cash flows after making priority
payments
 In good times and bad times
 IT IS A LOW CREDIT RISK
 Capital expenditures can always be deferred
 If a company cannot achieve positive
net cash flows after making priority
payments
 In good times and bad times

Terms of Borrowing
 The length of the credit period must be
suitable and appropriate
 A long credit period means more risk for the
lender
 Traditionally banks have been short to
medium-term lenders
 In recent years there has been a move
towards longer term loans
 Commercial mortgages
 Business development loans
Terms of Borrowing
(Cont…)
 Banks can make a distinction
between
 Asset conversion lending
 Cash flow lending
 Asset protection lending
Terms of Borrowing
(Cont…)
 Asset Conversion Loans
 These are short term
 Self-liquidating
 To finance a temporary build up of current
assets
 They are appropriate for companies
with a seasonal business
 Need high levels of inventory and accounts
receivable for short periods

Eg. A manufacturer specializing in Christmas
decorations
Terms of Borrowing
(Cont…)
 A bank that makes such loans
expects the principal to be repaid
quickly out of the OCF from peak
seasonal trading
 The payment source is the successful
conversion of stock into cash
Terms of Borrowing
(Cont…)
 The risk is that the borrower may
not have a successful sales season
 Poor demand
 Production delays
 Distribution bottlenecks
 If so, it could be left with unsold
stock
Terms of Borrowing
(Cont…)
 The loan structure may be-
 A line of credit with the customer
being able to borrow on demand up
to a preset limit
 Or could be on the basis of short-term
loan notes
Terms of Borrowing
(Cont…)
 Cash Flow Lending
 Is medium term lending
 To finance permanent working capital or
investment activities
 The operational cash flows should be
sufficient to cover
 Interest payments
 Repayment of principal
 The borrower’s ability to repay is a
function of the strength of its
operational cash flows
Terms of Borrowing
(Cont…)
 The risk is that cash flows may be less
than anticipated
 Due to poor profitability
 Or poor management of working capital
 The protection for the bank is:
 Borrower’s trading position
 Stability of profits and financial strength
 Suitable loan covenants are required
 To enable the bank to regularly monitor the
borrower’s performance
Terms of Borrowing
(Cont…)
 Medium term loans are normally
granted for such purposes – 5-10
years
 Bankers are often willing to renew
such loans
 If the company demonstrates its
ability to service the debt
Terms of Borrowing
(Cont…)
 Asset protection lending is short-term
lending to finance long-term needs for
working capital
 A borrower may have insufficient profits
and cash flows to repay quickly
 A ban may therefore provide an EVERGREEN
loan

This a short-term loan that is continuously rolled
over
 Principal repayment is not expected as long as
the company is a going concern
Terms of Borrowing
(Cont…)
 The bank should be confident that the
loan can be repaid by liquidating the
assets being financed by it
 These loans may be secured or unsecured
 They are usually granted to finance the
working capital of businesses such as
 Wholesalers
 Commodity traders
 Import and Export merchants
Terms of Borrowing
(Cont…)
 These intermediaries make small profit
margins on a high volume of turnover
 They need a large amount of working
capital to finance a large volume of stocks
 The loan may be evergreen in the sense
that no repayment term is agreed at the
outset
 The risk for the banker is that the realizable
value of the asset may be less than the loan
amount
Insurance
 Insurance in this context refers to
security
 For high-risk and high-value loans,
a bank will often want an
alternative source of repayment
 This provides a safety net for the
bank in case things go wrong
Insurance (Cont…)
 If a bank requires security as a
condition for a loan, it must:
 Establish whether there is any
security available
 If so, can it be sold easily if the need
arises
 Will the sale proceeds be sufficient to
cover the loan
Insurance (Cont…)
 As a general rule:
 The current value of a security must
provide a sufficient margin over the
loan amount
 If the security were to decline in value,
the proceeds should still be sufficient to
repay the loan
Insurance (Cont…)
 Property is often regarded as a
good security
 But property prices can rise as well as
fall
 A distress sale may require a price
concession
 There are transactions costs
associated with a property sale
 If it takes time to sell the property
there is an implied interest cost
Interest, Commission and
Extras
 A bank lends money to make money
 So it must consider the rate at which it is
prepared to lend
 And the commission and fees
 The lending policies of most banks
stipulate rates for different customers
and loan types
 A loan for a high-risk venture will carry a
higher interest rate
ICE (Cont…)
 A secured loan to a customer of good
credit quality will be offered at a lower
rate
 This is because not only is the risk lower
 The customer can usually go elsewhere
 The risks of non-payment even for
secured loans have to be compared
with:
 The potential profits from extra lending
 Or higher interest rates
Measuring Credit Risk
Who Is Exposed to Credit
Risk
 The credit risk for banks consists of
the amounts owed by borrowers
 On loans for both interest payments
and principal repayments
 For customer debts on other
transactions

Such as swaps
 Letters of credit
 Performance bonds
 Forward Rate Agreements
Illustration
 ABC Corp has an overdraft of
$8MM with First National Bank
 It is overdrawn by $6MM on the
account
 The bank decides to cut the O/D
facility to $3.5MM
 Unless the company can reduce the
O/D by $2.5MM immediately, which is
unlikely
 The directors will have to put the
Size and Duration of Credit
Risk
 Exposure to credit risk lasts for the
duration of the credit period
 In the case of a trade debt:
 It is from the time of sale to the receipt of
payment
 If goods or projects are tailor made to a
client’s requirements the risk begins earlier

As soon as the supplier commences work on the
project
 For bank loans the period of exposure is
the remaining term to maturity of the
Size…(Cont…)
 The size of the credit risk is the amount
that could be lost if the risk were to be
realized
 That is, non-payment or late payment were
to occur
 The maximum potential loss is the full
amount of the debt
 A bad debt on a bank loan would create
a loss equal to the unpaid principal
 Plus any overdue unpaid interest
Size (Cont…)
 In an extreme case, a bad debt could
force the lender into liquidation
 This could happen if the amount is large
 And the lender has been relying on
payments to settle its own debts
 When a bad debt occurs the actual loss
could be less than the full amount owed
 Unpaid creditors may receive some
payment on liquidation of assets
 Even then unsecured creditors may have to
wait for a long time to receive any payment
Size (Cont…)
 Unlike bad debts late payments do
not result in a direct loss
 But there are indirect losses
 The interest cost of having to finance
debtors for longer than necessary
 Or the loss of interest that could have
been earned if the money had been
received sooner and placed on
deposit
Illustration
 XYZ Corp sells goods worth $5MM
to Charlie at monthly installments
of $500,000
 The buyer has arranged credit
terms of one month (30 days) but
invariably pays two months later
(60 days)
 The supplier is financing debtors
by taking a loan on which the
interest rate is 10% per annum
 Since the buyer is taking 30 days
extra , the supplier has $500,000
less in cash than he should
 Thus it is permanently financing
extra debtors of $500,000
 The cost of 0.10x 500,000 =
$50,000 per annum
Risk and Return
 When a bank has $1BN of loans to
customers outstanding in theory the
potential credit risk is the full amount of
the loan
 In practice only a small proportion of
the debt will remain unpaid
 Most customers will pay in full
 The actual costs will be
 A small proportion of bad debts
 Place the interest costs due to a relatively
large proportion of delayed payments
Risk and Return (Cont…)
 The concern for the credit managers is
 The risk of bad debts from marginal customers
 The potential cost of overdue payments
 A company may offer more attractive credit
terms to boost sales
 The intended benefit is the extra profits from higher
sales
 The risk is that a large proportion of additional
customers could be high risk
 Similarly a bank could make more loans to
new clients
 But the new customers could be a bigger credit risk
than existing customers
 A market downturn will also
increase bad debts
 Banks tend to lose more on corporate
loans and mortgage loans during
recessions
 This is because a higher proportion of
loans fall into arrears and many are
eventually written off
 Although credit risk is greater for
marginal lending, banks must grant
credits to make profits
 Lending money is after all how a bank
makes profits
 Thus some credit risk is unavoidable –
without risk there will be no returns
 Banks can compensate themselves for
the extra risk on marginal loans by
charging higher rates of interest
 Decisions have to be taken regarding
how much credit should be granted
 Is giving more credit justified by the
higher anticipated returns or is it too
risky considering the higher potential
losses
 The aim of credit management should
be to contain the level of credit risk
 Systems should be put in place to
identify unacceptable risk before credit
is granted

 Once credit is granted the
customer’s situation should be
monitored
 Signs of late payments can then be
identified early
 Rigorous debt collection
procedures can be installed
Warning Signs
 Credit management is all about
identifying high-risk customers
 Usually bad debts originate when the
economy is strong
 Companies are profitable
 Have a confident outlook and seek loans to
expand
 Lenders who make judgments based on
current profitability and who have an
optimistic view will be willing to lend
under these circumstances
Warning Signs (Cont…)
 But what if a recession hits?
 Optimism disappears
 Profits shrink
 Companies struggle to repay loans
 By then it is too late
 The loans have been availed off and
 Bad debts are inevitable
 Thus the problem for banks during an
economic boom is to decide
 If the client would be a high credit risk if its
business were to decline or fail to grow
quickly
 In contrast the credit risk in lending
decisions during a recession is much
lower
 If the borrower is making profits in a
recession he is likely to prosper further
when the economy improves
 Thus the seeds of credit risk are sown in
times of prosperity
 And the harvest of bad debts is reaped
in the winter of business depression
 Bankers will have their own views
on why bad debts occur and when
a credit decision is at fault
 Bad debts may be due to adverse
changes in the borrower’s
circumstances
 But they can also occur due to
weaknesses in the credit-granting
process
Frequent Causes of Bad
Lending Decisions
 Over trading by the borrower
 Adverse trading for the borrower
 A liquidity run on the borrower’s
business
 Excessive capital commitments by the
borrower
 Faulty credit analysis by the lender
 Creative accounting by the borrower
 Masks his true financial position
 Deceit by the borrower
Over Trading
 Over trading occurs when a
company is over-extending its
resources
 Trying to support too much of sales
volume with too little capital funding
 A typical symptom is:
 Increasing reliance on trade credit
and bank loans to support a rapid
increase in stock levels and unpaid
debtors
Over Trading (Cont…)
 A business that is increasingly
dependent on short-term credit
 Taking longer to pay suppliers and
taxes
 Extending its loans
will eventually face a cash flow crisis

 For
 Unpaid creditors could demand
immediate payment
 Banks may withdraw loan facilities
Adverse Trading
 Business costs consist of
 Fixed costs and
 Variable costs
 Fixed costs remain much the same in

total, despite any rise or fall in business
activity
 Variable costs increase when sales
volumes rise and fall when sales
volumes decline
 Companies whose costs are largely
fixed
Adverse Trading (Cont…)
 If sales volume falls
 Income will be loss
 But costs will roughly be the same
 Profits and net cash flows will be
lower
 Thus companies with high fixed
costs which operate in a market
characterized by volatile sales
ARE POTENTIALLY VULNERABLE and A
HIGH CREDIT RISK
Illustration
 A company has annual fixed
expenditures of $3.5MM
 It also has variable expenses of
10% of turnover
 Sales turnover is currently $4MM
per annum.
 Thus while the company is
currently trading at a profit it has a
high volume of fixed costs relative
to variable costs
ITEM $ %age of
Revenue
Fixed Costs 3,500,000 87.50
Variable Costs 400,000 10.00
Total Costs 3,900,000 97.50
Profit 100,000 2.50
Sales 4,000,000 100.00

 For each $ increase in sales, the profits
will increase by 90 cents
 Because variable costs are just 10
cents per dollar of sales
 However for each $ fall in sales profits
will fall by 90 cents
 Thus the company is vulnerable to a
decline in sales
 Assume that sales fall by 10% to $3.6MM
per annum
ITEM Dollars
Fixed Costs 3,500,00
Variable 360,000
Costs
Total Costs 3,860,000
Sales 3,600,000
Loss (260,000)
 The risk in giving credit to the
company would depend on the
volatility of its sales
 If sales are likely to fluctuate
sharply up or down the risk of
failure could be high
Liquidity Run
 Sometimes, for unexpected
reasons. A company may suffer a
loss of an income source or see a
step-up in spending
 A food manufacturer may suffer due
to false rumors about his products

Sales volumes could decline sharply
 A supermarket chain could stop
stocking a manufacturer’s item and
switch over to a rival producer
Liquidity Run (Cont…)
 Such events could strain a
company’s cash flows
 Even if the loss of income or increase
in spending is short-lived
 A bank cannot predict such a
liquidity problem
 But it can assess whether the
company could have sufficient
liquidity or access to extra funds to
survive such setbacks
Excessive Capital
Commitments
 A company may take on excessive
capital commitments and sign
contracts for large-scale
expenditures
 If it is unable to honor its
commitments it could be forced into
liquidation
 A lender may unable to control
such spending but can try to
Faulty Credit Analysis
 A bank may make a bad lending
decision
 Not because of any unexpected
changes in financial circumstances
 But because the borrower was a high
risk from the outset

 That is the original lending decision
itself was flawed

 The frequency of such loans can be
contained by using a structured
approach and entrusting the task to
Creative Accounting
 This is use of corporate accounting
policies to put a misleading gloss on a
company’s reported financial position
 Profits can be inflated
 Assets can be made to seem more valuable
 Liabilities can be hidden and kept off
balance sheet
 It is important for a bank to realize that
many corporations will seek to take
advantage of opportunities for creative
accounting
 If a bad debt were to occur for such
reasons
Methods of Assessment
 Sources: Credit assessments can be
obtained externally from specialist
agencies or carried out inhouse
 Large companies, banks, governments
and government agencies have credit
ratings for their existing debt
 Ratings are provided by agencies such
as:
 Moody’s
 Standard and Poor’s
 IBCA
Assessment (Cont…)
 Banks can use a company’s ratings
to decide what rate of interest to
charge on a fresh loan
 A company with a lower rating
would be charged a higher rate
 Companies too can use the relative
ratings of commercial banks to
decide their deposit limits with
each bank
 Credit ratings apply only to large
firms
 Information about smaller firms
can be obtained from credit
reference agencies
 They charge a fee for their services
 Information can also be sought
from the borrower’s bank
 But this may be less detailed and
 The three main credit reference
agencies are
 Equifax
 Experian
 and Callcredit.
Credit Ratings
 What is a rating?
 It is a formal opinion given by a rating
agency of the creditworthiness of an
entity
 The entity could be:

A government

Government agency
 Financial institution
 Or large company
Credit Ratings (Cont…)
 The main purpose of ratings is to
provide information to investors in
public issues of debt
 A rating is a guide to investment
risk
 The probability that investors will
receive interest in full and on time
and repayment pf principal at
maturity
 Ratings have gained a more
widespread acceptance outside
investment analysis
 Banks may look at the ratings for
the debt securities of a company
 To take a lending decision
 And if yes, to set the rate of interest
 Banks also use ratings to set limits
on the value of transactions with a
company
 There maybe a limit on the size of the
loan
 The amount of a performance bond
 Size of an FX transaction
 Ratings are provided by specialist
agencies
 A.M. Best Company Inc.
 Dominion Bond Rating Service
 Fitch Ratings Ltd
 Moody’s Investors Service
 Standard and Poor’s
 Agencies will carry out a rating exercise
on request
 The request for a rating will
 Come from the issuer of new debt capital
 Or its financial advisers
 The rating exercise is carried out on the
issuer but the rating is applied to a
specific issue
 Thus the rating is applied not to an
organization itself but to its debt
 The rating once issued is kept
under review
 If the creditworthiness of the issuer
declines or improves the rating will be
changed
The Rating Process for a
Company
 The agency will first do a preliminary
assessment of about 5 years of
published financial data and other
publicly available information – like
press releases
 Financial ratios are calculated and
analyzed
 Comparisons are made with the company’s
peer group
 Trends in financial ratios are also
studied
 S&P gives the analysis of historical
The Rating Process
(Cont…)
 The preliminary assessment is
discussed with the firm before a
detailed review begins
 The company will be told about the
likelihood of obtaining the sought-
after rating
 The detailed review will commence
only if the client is willing to carry on
The Rating Process
(Cont…)
 The agency’s investigators hold
detailed discussions with senior
management of the client
 This gives a better perspective of
the company’s position and its
creditworthiness
 But the standard of such
investigations depends on the
amount and quality of information
given by the management
The Rating Process
(Cont…)
 In the detailed review phase, financial
ratio analysis is an important issue
 In addition
 The business risk
 Industry risk
 And country risk
of the company’s operations are also
investigated to obtain a long-term view
 Thus there are two key components
 Business or competitive analysis
 Financial analysis
The Rating Process
(Cont…)
 The market share for the company’s
products and services is important for
assessing its competitive position
 The ability to protect market share can
be inferred from:
 Volume of long-term sales contracts
 New product developments
 Backlog of confirmed orders
 Ownership of a comprehensive distribution
network
The Rating Process
(Cont…)
 Industry risk analysis is more general
than product-market analysis
 It considers
 The core strengths of the industry
 Its long-term prospects
 Vulnerability to economic cycles
 History of labor unrest
 Government interference
 Need for spending on capital equipment and
R&D
The Rating Process
(Cont…)
 Industry risk analysis sets an upper
limit to a rating
 A firm with a very good
competitive position in an industry
facing long-term decline; or in a
cyclical industry is unlikely to be
given a high rating
The Rating Process
(Cont…)
 Country risk can also be significant
 The rating for a company based in
a particular country will not
normally be above the actual or
implied rating for that country
 Other factors in country analysis
includes:
 State support for industry
 Whether the company is partially or
fully nationalized
Financial Ratio Analysis
 Financial ratios often set the
boundaries for a credit rating –but
are not used themselves to fix a
rating
 There is no standard formula for
converting financial ratios into a
credit rating
Financial…(Cont…)
 S&P usually considers the following
ratios:
 For assessing the Ability to Make
Interest Payments on Time
The operating profit (before deducting
depreciation) as a percentage of sales
Depreciation is not deducted from
profit because depreciation policies
vary significantly between companies
 Fixed Charge Cover
This is the ratio of operating profits to fixed
charges that the company must pay
 Fixed charges include:

Gross interest cost

Contractual payments under operating leases

Preference dividends
For an investment grade rating, S&P takes the view

that a company must not be expected to defer a
preferred dividend
 For assessing the ability to repay debt
principal on time
Cash flow is regarded as a better measure of
ability to repay debts on time than a
company’s balance sheet structure
There is no ideal minimum NCF/DEBT ratio

It varies across industries

For instance a retailing company will have a
higher ratio than a property company
 The cash cycle in retailing is faster
 The need to borrow to finance properties and other
assets is less
Financial …(Cont…)
 Financial flexibility is also included in
the assessment
 This refers to the ability to borrow
additional amounts should the need
arise
 From bank borrowings
 Or issue of debt
 Or issue of equity
 The presence of non-core businesses or
surplus assets with substantial resale
value is also a factor
Moody’s Debt Ratings
 Moody’s uses three ratings for
short-term debt
 Prime 1
 Prime 2
 Prime 3
 Issues which do not fall into any of
these categories are rated Not Prime
 They obviously carry a higher credit risk
Moody’s (Cont…)
 It uses nine categories for long-term
debt
 Aaa
 Aa
 A
 Baa
 Ba
 B
 Caa
 Ca
 C
Moody’s (Cont…)
 One of the features of Moody’s
ratings of banks
 If a subsidiary or a branch issues debt
in a country
 The debt rating for the branch will be
the lower of

The bank’s (parent) own rating
 And the sovereign rating for the country
itself
Moody’s (Cont…)
 The subsidiary of a US bank which
has an Aaa rating issues debt in
Australia
 If the sovereign rating for Australia
is A then the issue will not get a
rating higher than A
Standard and Poor’s Credit
Ratings
 S&Ps short-term ratings are:
 A-1
 A-2
 A-3
 B
 C
 D
S&P (Cont…)
 Long-term ratings are grouped into two
main categories
 Investment Grade: AAA,AA,A, BBB
 Speculative Grade: BB,B,CCC,CC,C
 Other grades: C1 and D
 C1: A bond on which no interest is being
paid
 D: Payment is in default; or else a
bankruptcy petition has been filed and
default is likely
 Ratings AA to CCC may be modified by
Multiple Ratings
 It is common for an issue to be
rated by more than one agency
 S&Ps ratings are usually
comparable with Moody’s although
there are instances where their
views differ
 When the agencies differ in their
views it is called a Split Rating
Fitch
 Fitch has a specialized rating
system for banks
 The system is designed to help
users judge whether the bank will
receive support if it were to run
into difficulties – so called
SUPPORT ratings
and also ratings to assess its
current performance – an
Support Ratings
 1. There is a clear legal guarantee on
the part of the state OR a bank of such
importance both nationally and
internationally that state support would
be forthcoming if required
 2. A bank for which state support would
be forthcoming even in the absence of a
legal guarantee – this could be because
of the bank’s importance to the
economy or its historic relationships
with the authorities
Support Ratings (Cont…)
 3. A bank or bank holding company that
has institutional owners of sufficient
reputation and possessing such
resources that support would be
forthcoming if necessary
 4. A bank for which support is likely but
not certain
 5. A bank or holding company for which
support although possible cannot be
relied upon
Individual Ratings
 These asses how a bank would be
viewed if
 It were entirely independent
 And cannot rely on external support
 They are designed to assess a bank’s
exposure to; appetite for and
management of RISK
 They represent the likelihood that it
would run into difficulties such that it
would require support.
Individual Ratings (Cont…)
 A – A very strong bank
 Outstanding profitability
 Balance sheet integrity
 God management
 Good operating environment
 Good future prospects
Individual ratings (Cont…)
 B – A strong bank
 No major concerns
 Strong profitability
 Good balance sheet integrity
 Good management
 Good operating environment
 Good prospects
 C – An adequate bank
 Possesses one or more troublesome
aspects
 May be concerns regarding
 Profitability

Balance sheet integrity
 Management
 Operating environment
 Prospects
 D – A bank that has weaknesses of
internal or external origin
 There are concerns regarding
 Profitability
 Balance sheet integrity
 Management
 Operating environment
 Prospects
 E – A bank with very serious
problems
 Requires or is likely to require
external support
Fitch (Cont…)
 Fitch has also developed
international credit ratings, both
long as well as short term, that are
applied to
 Sovereign
 Banks
 Corporates
 Specific debt issues
 + or – may be added to a rating to
denote relative status
Fitch (Cont…)
 Long Term Investment Grade
 AAA
 AA
 A
 BBB
Fitch (Cont…)
 Long term speculative grade
 BB
 B
CCC
 CC
 C
 DDD
 DD
 D
Fitch (Cont…)
 Short Term Ratings
 F1
 F2
 F3
 B
 C
 D
Credit Watch
 Periodically, an agency may reassess its
rating for a debt issue
 Circumstances may have changed
 There may be greater doubts about
creditworthiness
 Before downgrading an issue it may
announce
 That is has put the rating under review
 And may downgrade in the future
 This is referred to as being put on credit watch or
rating watch
 If a debt issue is on credit watch, the agency will advise
investors to use the rating with caution
Influence of Rating
Agencies
 A rating will affect the rate at
which organizations can borrow
new funds
 Ratings are based on analysts’
judgments
 Thus a rating by S&P can occasionally
differ from a rating for the same issue
by Moddy’s
External Information
Sources
 When a customer applies for credit for
the first time
 The credit manager has to decide
 Should an account be opened?
 If so, what should be the credit limit and
terms
 The purpose of credit related
information is to give the potential
lender some reassurance that
 The amount owed will be paid in full and on
time
Sources (Cont…)
 The credit manager needs to
decide:
 For how long can the credit be
granted
 What amount can be risked as a
potential bad debt?

That is, how much credit can be given
without taking an over-exposure to risk
Sources (Cont…)
 Credit Bureaus
 They provide information about:
 Companies
 Partnerships
 Sole proprietorships
 But bureaus differ in the services they
offer
 Some simply supply historical accounting
records
 Large bureaus provide online information

So that immediate credit decisions can be taken
 Some bureaus offer their own credit
Sources?
 Why should a business use the
services of a bureau?
 The objective is to obtain extra
information that will help decide
about credit terms
 Information can be sought about
potential new customers

Or else more information can be sought
about an existing client that could affect
its credit standing
Sources (Cont…)
 Rating agencies assess large
organizations
 Bureaus can however provide
information on small businesses
 Credit risk stems from fraud as
well as financial weakness
 Information from a bureau may
help detect a fraudulent customer.
Sources (Cont…)
 Much of the information available
to bureau is published or in public
domain
 Such as published accounts
 But bureaus have certain core
competencies
 The have a huge database of credit
information that is kept up-to-date
 They know where to obtain relevant
information
Sources (Cont…)
 They could have access to
information about a party’s payment
records
 Or to trade related information
supplied by the party’s clients
 Such information may be useful for
the bureau’s other clients
 They can seek information directly
 A bureau has the experience and skills to
ask relevant questions and to judge the
replies
Sources (Cont…)
 The type of report available varies from
agency to agency
 Large agencies provide a variety of
reports
 A report could be limited to information
about
 The capital structure of a company
 Its registered office
 Directors’ names and addresses
 A list of shareholders where available
Sources (Cont…)
 A status report gives up-to-date
financial information about a
business that is extracted from the
database
 Includes records of any hire purchase
defaults
 And records of unfavorable court
judgments
 These reports can be
supplemented by an ongoing
Sources (Cont…)
 Some agencies consist of member
organizations that grant credit to
customers as a part of normal trading
operations
 Records are maintained of credits
granted to customers by each member
 Of bad debts that the members have
suffered
 Bankruptcies, insolvencies, unsatisfied
court judgments involving the clients
Sources (Cont…)
 A member before granting credit
can check with the agency
whether there is anything on
record about the client
Sources (Cont…)
 Dun & Bradstreet is a well known credit
reference agency
 It has a large payment profile data bank
 Contains information about payments
records of companies
 A payment score report can be obtained
from this data
 This is a numerical score that rates a
company’s performance in paying its bills
 It is based on an analysis of payment
records on the database
Choosing a Bureau
 There are many agencies
 Each has its own sources of
information
 And its own approach to credit
assessment and reporting
 Reports may be provided in hard
copy format or on-line
 For a corporate credit controller
seeking information - it may be
appropriate to obtain reports from
Trade References and Bank
Status Reports
 If a credit controller doesn’t want
to use an agency to obtain
information – there are other
options
 Asking for trade references from a
potential new customer
 Asking for a bank status report
Trade References
 The potential customer can be
asked to give the names and
addresses of existing suppliers
 They can give a reference indicating
whether the party is reliable and has
a history of prompt payments
 The referees must be provided
with evidence that the party has
consented to the reference being
Bank Status Reports
 Such reports can be sought from
the potential client’s bank
 This is a banker’s opinion about a
customer
 The protocol is for a company to
seek a report through its own bank
 With an indication of the amount of
credit envisaged
 The bank will then pass on the
request to the potential customer’s
Inhouse Assessments
 A company can establish a system
for the assessment of customers
by inhouse analysts
 This can be instead of or in
addition to information from
external agencies
 Banks for instance do most of their
analyses inhouse
 Companies use a team of analysts
or a credit manager
Methods of Credit Risk
Analysis
 The most common form of analysis
is financial
 This involves studying the
available financial information –
often drawn from the annual
reports and accounts
 A number of different financial
ratios can be computed
Methods…(Cont…)
 Ratios provide some indications
about a company’s:
 Profitability
 Capital strength
 Liquidity
 Control over working capital
 The adequacy of cash flows can
also be assessed
Method…(Cont…)
 In addition to ratio analysis other methods can
be used
 The techniques are complementary and not a
substitute for financial analysis
 They are however usually unreliable if used on their
own
 Such methods include:
 Collecting information from newspapers,
journals and other sources to build up a
company profile
 Credit scoring
 Profit/cash flow projections
Building a Profile
 The activities of may publicly held
companies are widely reported
 Stock price information is available in
the press
 This shows price movements and
market capitalization
 Daily stock trading volumes are
reported
 As are reasons for significant price
rise or decline
Share Price
 A large fall in the share price of a
firm could be a prelude to its
financial collapse
 Some firms will recover
 Many will not
 Suppliers and banks could decide
to limit the credit offered to
companies in trouble
 Unless there is a recovery in the share price
Dividend Cover
 Dividends are important to
investors
 So public companies try to
maintain if not increase the
dividend payout from one year to
the next
 If the profits decline, the ability to
pay dividends out of current profits
could be at risk
Dividend Cover (Cont…)
 During prosperous companies are
able to maintain a ratio of profits
to dividends of about 2.5:1
 This is the dividend cover ratio
 For instance if the PAT is $10MM and
a dividend of $4MM is declared, the
dividend cover ratio will be 10:4
 If profits fall but dividends are not
cut – the dividend cover ratio will
Dividend Cover (Cont…)
 In a recession, some companies
may pay an uncovered dividend –
a dividend that is higher than the
current year’s profits
 When the dividend cover is low
 Cash flows and liquidity could come
under strain
Illustration
 A company had a PAT of $5MM in year 1
 The dividend declared was $4MM
 Next year the profits fell to $2.4MM
 But the dividend was maintained at
$4MM
 In the first year the dividend cover was
1.25 and the company retained $1MM
of profits to reinvest in the company
 If it had a high capital budget it would
need extra funding from other sources
 In year 2 the dividend cover is 0.60
 Dividend payments exceed profits
by $1.6MM
 Obviously the cash has to come
from elsewhere
 Unless the profits improve in
subsequent years or the dividend
is cut – the cash flow problems will
intensify
Part-11
Introduction to
Financial Ratios
And Cash Flow Analysis
What is a Ratio?
 Itis a measured comparison of the size or
amount of an item in relation to the size and
amount of another
 They are widely used to analyze company
accounts
 They give meaning to numbers
 Such meaning may not be apparent from the detailed
numbers themselves
 Help to simplify analysis
 Focus on key performance aspects
Illustration
A company has increased its turnover
from 52.50MM USD last year to 57.75MM
this year
 It is simpler and more meaningful to state that
sales turnover has increased by 10%
Ratios (Cont…)
A statement like - `profits were $5MM this year’
are meaningless
 We have to relate the figure to the size of the company
 Or to the profit for the preceding financial year
A statement that - `current assets are $5MM’ is
equally meaningless
 It must be related to the turnover of the business
 Or compared with Fixed Assets or Current Liabilities of
the business
Ratios (Cont…)
 Ratios
are useful because they are based
on comparisons
 Performance
can be judged only on the basis of
such comparative analysis
Purpose of Ratios
 The objective of computing ratios is to
obtain information about a firm’s financial
position
 This is achieved by comparing the ratio with
 Trends in the same ratio over a period of time
 `Standards’ that are considered to be desirable
 Ratios for similar companies in the same industry

Variety of Ratios
 There are many different financial ratios
that can be computed
 Each lender will have his own preferred
set
 The same ratio can be calculated in different
ways by various users
 The method chosen will depend on the
preference of the individual
Categories of Ratios
 Profitability
Ratios
 Financial Risk Ratios
 Liquidity Ratios
 Working Capital and Cash Cycle Ratios
 Suitable ratios in each category can be
computed from the financial statements of
the company.
Profitability
 Issues are:
 How profitable is the company?
 How does it make profits?
 Why is this important?

 Long run survival is linked to profitability
 Margins should be adequate
 Else prices may have to be raised
 Or else costs may have to be cut
Capital Structure and Financial Risk
 What is the debt:equity ratio?

 Is there over-reliance on debt?
 Implications:
A party should not be over-reliant on debt
 Debt is a contractual obligation
 Interestpayment obligations should be
serviceable out of profits
 Excessive debt could lead to liquidation if profits
decline
Liquidity
 Is there enough operational liquidity
 Is there enough working capital to sustain
liquidity
 Issues:
 There should be enough cash from operations
to meet operational requirements
 Liquidity is vital for survival in the long run
 Butcould display seasonal patterns if the firm is in a
cyclical industry
Uses of Cash
 How does the company generate cash?
 How does it spend cash?
 Issues:
 Operational cash flows must be adequate for
 Paying taxes
 Paying dividends
 To repay maturing loans
 Do contribute towards discretionary spending
(CAPEX)
Uses of Cash (Cont…)
 In adequate cash flows can result in:
 Over-reliance on borrowing
 Poor liquidity
Profitability
 Inthe long-run companies must be profitable if
they are to survive
 For a bank, giving credit to a loss-making firm or to a
firm making marginal profits is a bigger risk
 It is not that profitable companies cannot run into
liquidation
 Their debts may be very high
 However it is a key indicator of the long-term
liquidity and solvency of a firm
 Issues for the analyst:
 Vulnerabilityto a sales downturn
 And its potential consequences for profits
 Profitability has to be judged

 In relation to the size of the firm
 In relation to the volume of business
 Key profitable ratios are:
 Return on Assets (ROA) or Return on Capital
Employed (ROCE)
 Profit/Sales Ratio (Profit Margin)
 Asset Turnover
ROCE
 Thisratio compares the amount of profit to
the size of the firm
ROCE = Profit x 100%
____________
Capital Employed
Issues
 Thereis no unique way of defining profits
or assets employed
Possible Definitions of Profit
 Profit before Interest and Tax – PBIT
 Profit After Interest but before Tax
 Profit After Tax
Definitions of Capital Employed
 Stockholder’s funds
 Share capital plus reserves plus LTD
 Share capital plus reserves plus Total Debt
 Long-term debt
 Short-term debt
 Financial leases
 Share capital plus reserves plus total debt plus

provisions
Issues
 The analyst should take a view on:
 Should assets include intangible fixed assets
such as Brand Values or Development Costs
 It is important to be consistent over time
 Else ratios cannot be used fro comparisons
over time
 Or inter-company comparisons
Common Definition of ROCE
 Profit
Before Interest and Tax x 100%
÷Shareholder’s Funds + LTD
Illustration
A company had a PBIT of $1.8MM in the
current year as compared to $1.6 MM in
the previous year.
 The assets and liabilities at the end of
each year are depicted below.
Item Year-1 Year-2
Fixed Assets 4,500,000 5,500,000
Current Assets 2,500,000 3,000,000
Total Assets 7,000,000 8,500,000
Current 2,000,000 2,500,000
Liabilities
LTD 2,500,000 2,500,000
Share Capital + 2,500,000 3,500,000
Reserves
Analysis
 ROCE for Year-1:
1,600,000 x 100% ÷ 5,000,000 = 32%
 ROCE for Year-2:
1,800,000 x 100% ÷ 6,000,000 = 30%
 Total Profits are higher in Year-2
 But there is a fall relative to the size of the business
 ROCE declined from 32% to 30%
 Deterioration in performance despite growth in profits
and assets
Profit Margin
 Size of profit relative to sales turnover
 May be Gross Profits
 Or Net Profits
 Gross Profits: Value of Sales – Costs

directly related to Sales
 Net Profits: Gross Profits – Other Costs
 Such as administrative and distribution costs
 Net Profit may be :
 PBIT, PBT or PAT
Profit Margin (Cont…)
 Gross Margin = Gross Profit x 100% ÷
Sales Turnover
 Net Margin = Net Profit x 100% ÷ Sales
Turnover
Issues for an Analyst
 Margins should be compared from year to
year
 And across companies in the same
business
 Whyis the margin lower than that of its nearest
competitor?
 Costs could be relatively higher
 The firm may be losing its competitive edge
Issues (Cont…)
 Falling margins across time is also an issue of
concern
A combination of rising costs and static
sales is generally a symptom of a
recession
Illustration
A firm has a Gross Profit of $125,000
 It has a Turnover of $625,000
 PBIT is $50,000
 PAT is $30,000
Analysis
 Gross Margin = 125,000 x 100 ÷ 625,000
= 20%
 Net Margin = 50,000 x 100 ÷ 625,000 =
8%
 Or Net Margin = 30,000 x 100 ÷ 625,000
= 4.80%
Analysis
 One way of analyzing changes in
profitability is:
 compare the ratios of various items of cost to
the sales turnover.
Illustration
Item Year-2 in % of Year-1 % of
Turnover Turnover
Turnover 1,000,000 100 800,000 100
Cost of sales 750,000 75% 560,000 70%
Gross Profit 250,000 25% 240,000 30%
Distribution 50,000 5% 32,000 4%
Costs
Admin. 125,000 12.5% 100,000 12.5%
Expenses
Trading 75,000 7.50% 108,000 13.5%
Profit
Interest 25,000 2.5% 10,000 1.25%
PBT 50,000 5% 98,000 12.25%
Tax 15,000 1.5% 29,400 3.675%
PAT 35,000 3.5% 68600 8.575%
Analysis
 The profit margin (PAT÷Turnover) has declined
from 8.575% to 3.5%.
 This is due to the following factors
 Cost of sales has gone up by 5c per dollar
 Distribution cost has gone up by 1c per dollar
 Interest costs have gone up by 1.25c per dollar
 Taxes have declined by 2.175c per dollar
 Overall profit has declined by 5.075c per dollar
Asset Turnover
 This ratio is used to assess whether the
volume of sales in commensurate with the
assets invested in operations
Asset Turnover = Sales÷Assets Employed
 It is a useful indicator of how successful
the firm is at generating sales
Illustration
A company generated sales of $1,000,000
 It employed a capital of $ 250,000
 Thus the asset turnover is:
1,000,000 ÷ 250,000 = 4
Thus the company generated $4 of sales
for every dollar employed
Relation
 The three ratios are interrelated
 ROCE = Profit Margin x Asset Turnover
 Profit ÷ Capital Employed = (Profit ÷ Sales) x (Sales ÷
Capital Employed)
A firm can earn a ROCE of 20% by earning a
margin of 10% on a low asset turnover of 2 or by
earning a margin of 2.5% on a turnover of 8
 Returns depend on profit margins as well as turnover
 Both are important for the financial health of a business
Analyzing Financial Risk
 Financialrisk is the risk that a firm cannot
repay its debt in full or on time because of
a large debt burden.
Financial Risk (Cont…)
 Debtcan be repaid from three main
sources:
 Cash from trading operations
 Cash raised from the sale of fixed assets,
stocks or investments
 New funds raised – by way of a loan or a Rights
Issue
Financial Risk (Cont…)
 While making a lending decision it should
be assumed that the opportunity to raise
fresh funds does not exist
 Granting loans for repaying old loans is a bad
practice
Leverage
 Leverage is the ratio of `prior charge
capital’ relative to the size of equity capital
or to the size of total capital
Leverage = Prior Charge Capital x 100 ÷
Equity
OR
Leverage = Prior Charge Capital x 100 ÷
Total Capital
Leverage (Cont…)
 Either balance sheet values or market values
can be used - for both prior charge capital as
well as for equity
 If balance sheet values are used, the
computation is as follows:
 Equity = Common stock in issue plus balance sheet
reserves
 Prior Charge Capital = All long-term capital that has a
prior claim ahead of equity
 It consists of bank loans, and debentures falling due after
more than a year
 Preferred stock may or may not be included
Leverage (Cont…)
 Short-term bank loans may also be
included
 The assumption is that the firm will need to
renew for a further term and so it is effectively a
form of LTD
 If a firm has a lot of debt nearing maturity and
short-term loans and O/Ds then they cannot be
ignored
 Some bankers add preferred capital to
equity
Leverage (Cont…)
A firm is said to be highly levered when
the leverage ratio exceeds 100%
 There is no maximum or ideal level
 Higher leverage indicates higher risk
 Rising leverage over time indicates greater

financial risk
 After a point lenders may not sanction further loans
Illustration
A firm has common stock and reserves of
$1,000,000; preferred capital of $250,000 and
long-term debt of $250,000
 It has approached the bank for a loan of
$250,000
 The current leverage is 500,000 x 100 ÷
1,000,000 = 50%
 The new loan will increase leverage to 75%
 The bank may feel that despite the increase, leverage is
still acceptable for it is below 100%
Illustration-2
ITEM End of Year-2 End of Year-1
Equity 1,000,000 1,000,000
Long-Term 750,000 600,000

Debt
Short-Term 1,250,000 900,000
Debt
Total Debt 2,000,000 1,500,000
Analysis
 Ifwe base leverage only on LTD, it is 60%
in Year-1 and 75% in Year-2
 This looks acceptable
 However if STD is also included, it is
150% in Year-1 and 200% in Year-2
 This indicates a heavy reliance on short-term
funding
 A banker is likely to perceive this as a high risk
venture
Priority in the Event of Liquidation
 Secured creditors with a fixed charge
 Liquidation expenses must then be paid before
any other creditors
 Creditors who must be paid ahead of others
 Debts due to the IRS
 Unpaid VAT
 Unpaid wages and salaries
 Secured creditors with a floating charge
 Unsecured creditors
 Preferred shareholders
 Equity shareholders
Interest Cover
 This shows the risk in terms of profits
rather than in terms of capital values
 It monitors the borrower’s ability to meet
interest commitments
Interest Cover Ratio = PBIT ÷ Interest
Charges
 If interest costs are high relative to PBIT,
any fall in profits could lead to a situation
where interest obligations cannot be met
Interest Cover (Cont…)
A ratio of below 3.0 is considered low by many
analysts
 Most treasurers and analysts look for a cover of
at least 5.
 However a low ratio at a point in time may be
temporary problem
 If profits rise subsequently or interest costs fall, the ratio
will rise
A ratio that deteriorates over time is worrisome
Interest Cover (Cont...)
 Banks often include a covenant on interest
cover in the loan agreement
 The borrower has to maintain a minimum cover
 The ratio focuses only on interest
obligations
 Itdoes not consider payment or repayment of
principal
Debt Ratio
 This measures the percentage of Total
Assets that are being financed by credit
Debt Ratio = Total Creditors ÷ (Net Fixed
Assets + Total Current Assets)
 A higher ratio indicates greater financial
risk
 Any ratio in excess of 50% indicates a high
level of borrowing
 But there is no ideal maximum
Working Capital and Liquidity
 Working Capital – is the money invested
by a business in its working assets
 Working assets primarily consist of:
 Stock in trade
 Work in Progress
 Debtors
Working Capital…(Cont…)
 These short-term assets, in the near
future, provide cash from trading
operations
 Stockin trade will be sold
 Debtors will pay what they owe
 Every business must buy goods and incur
expenses in connection with the sale of
goods and services before its customers
pay
 No business can operate with 100% cash
sales
 Thusworking capital has to be invested to
maintain stocks and debts
 The required WC can be reduced by
taking short-term credit
 Aninvestment in stocks can be reduced if
suppliers give credit
 Stocks, debtors, and creditors continually
change
 Stocks are used or sold on credit
 Debtors pay what they owe
 Suppliers are paid
 New stocks are purchased
 New sales are made

 The value of stocks, creditors and debtors
is never fixed
 The WC will therefore fluctuate as
 Stocks
 Debtors
 Cash Balances
 Creditors
 And bank overdrafts change in amount

Significance
 Fora credit analyst, WC is significant for
three reasons
A company may have excess WC – in particular
stocks and debtors
 It represents a wasteful use of capital
 While sanctioning a bank loan to finance an

increase in current assets the analyst needs to
ask
 Are the additional assets really necessary?
Significance (Cont…)
A company could have insufficient WC
 Due to an over-reliance on short-term liabilities
 Like trade credit
 And bank O/Ds
 A banker needs to ask – is further extension of short-
term credit warranted or is an injection of long-term

capital like equity more appropriate
Significance (Cont…)
 There is a connection between WC and cash
flows and liquidity
 Cash flows and liquidity are a matter of serious
concern for any analyst
 Cash is generated when stocks are sold and
when debtors repay
 Cash is used to pay creditors
 The amount of cash coming in should always

be adequate to cover what is going out
Trade Cycle
 The cycle starts with the purchase of
resources
 Raw materials, labor etc
 Itends with the sale of finished goods and
services
Cash Cycle
 The cash cycle starts with the payment for
resources purchased and ends with cash
receipts from customers
 There is a continuous cycle
 Cash In → Cash Out → Cash In
Coincide?
 The two cycles do not coincide in practice
 WHY?
 Credit is usually taken from suppliers
 Credit is given to customers
Measuring The Cycle
 Both trade as well as the cash cycle can be
measured in terms of time
 The cash cycle is the average time elapsed
 Between payments for purchase of R/M, components or
supplies
 And receipt of cash from purchasers of the finished
product or service
 Thus it is the average time between paying out cash
and receipt of cash from trading operations
Illustration of a Trade Cycle
 R/M held in stock = A days
 + Production Cycle = B days
 + Finished goods held in stock = C days
 Thus trade cycle = A=B+C days
Illustration of a Cash Cycle
 Time to pay creditors = D days
 Time given to debtors for payment = E
days
 Cash Cycle = A + B + C – D + E
Relationship
 Cash Cycle and WC investment are
directly related
A longer cash cycle means a bigger investment
in WC
 Ifthe cash cycle is too long, there could be
excessive investment in WC
 Debtors may be given too long to pay
 Stock turnover may be low
 Trade credit availed may be for a short period
Relationship
 The investment in WC could also be
insufficient
 This is called OVERTRADING
 Insuch cases the cash cycle may be too
short
 Suppliersgive credit for long periods
 Debtors are given a short time to pay
Cash Cycle Ratios
 The length of a cash cycle can be
estimated using the following ratios
 Average stock turnover
 Creditor Days – average period of credit taken
from suppliers
 Debtor Days – average period of credit given to
customers
Cash Cycle Ratios (Cont…)
 The ratios can only be approximated from
the published accounts
 They will not be exact
 But if measured consistently over time trends in
the length of the cycle will become apparent
 There could be a generally accepted cycle
for an industry
 Theissue is with respect to other firms in the
industry is the cycle too long or too short
Stock Turnover
 Averageperiod of time between purchase
and eventual sale of end-product or
service
 Stocks in Hand x 365 ÷ Cost of Goods Sold
 The cost of goods sold figure is obtainable
from the P&L account
 Stocks and creditors are valued in the
balance sheet at cost
Creditor Days
 Averagelength of Credit Period obtained
from suppliers
 Trade Creditors x 365 ÷ Cost of Goods Sold
Debtor Days
 Averagelength of Credit Period given to
customers
 Trade Debtors x 365 ÷ Sales
 Debtors are valued at the invoice amount
 Consequently sales is used in the denominator
Illustration
A company has
 Sales of $200,000 per annum
 The cost of goods sold is $110,000 per annum
 Average stocks are $25,000
 Average trade creditors = $12,000
 Average debtors are = $55,000
 Customer are asking for more credit

 Stock Turnover = 25,000 x 365 ÷ 110,000
= 82.95 days
 Creditor Days = 12,000 x 365 ÷ 110,000 =
39.82 days
 Debtor Days = 55,000 x 365 ÷ 200,000 =
100.375 days
 Suppose the debtor days are increased
from 100.375 days to 125 days
 This will lead to an increase in average
debtors from $55,000 to $68,500
 The company would need extra WCX
funding of $13,500
 It
could take extra credit from suppliers
 Or borrow more from a bank on a O/D
Liquidity
 EfficientWC management can optimize the cash
flow cycle and investment in WC
 A company should always have enough liquidity
 Ready access to short-term cash
 Liquid assets are
 Cash
 Other current assets that can be turned into cash if
required
 Or will become cash in the normal course of trading
Liquidity (Cont…)
A firm must have sufficient short-term
liquidity to meet its payment obligations as
they fall due
 The alternative is to borrow
 Banks would like to ensure that borrowers do
not rely too heavily on borrowings
Liquidity (Cont…)
 While taking a credit decision, liquidity is a
prime factor
 Liquidity risk is crucial short-term credit
risk
A company must have enough cash to meet
current payment obligations
Liquidity and Working Capital
 Thinkof working capital as the amount of
long-term capital that is invested in current
assets
 Current Assets – Current Liabilities = WC
 A simple balance sheet may be represented as:
Long-Term Debt + Stockholders’ Funds =

Fixed Assets + Working Capital
Liquidity and WC (Cont…)
 What if a company needs more funding for WC?
 There are three sources
 It could raise more funds
 Rise either debt capital or equity or both
 It could decrease its fixed assets
 Do not replace assets that are being phased out
 Dispose off old assets for cash
 It could reduce dividend payouts

 More profits will be retained in the business
• Stockholder’s funds will go up as will investment in WC
Liquidity and WC (Cont…)
 There are also three ways in which WC can be
reduced
 Repay long-term debt
 Incur trading losses
 This will reduce investment in WC
 Buy more fixed assets and use a reduction in WC to
fund it
 IfWC is reduced a firm must decrease its
current assets or increase its current liabilities
 Raise an O/D or seek more trade credit
 This could pose liquidity problems
Liquidity Ratios
 These ratios compare the firm’s liquid
assets with its short-term repayment
requirements
 Liquid assets are usually defined as:
 Totalcurrent assets (including stocks)
 Or current assets excluding stocks
Liquidity Ratios (Cont…)
 Stocks are generally less liquid than
debtors and other current assets
 There could be exceptions however
A supermarket selling non-durables will have
very liquid stocks with a short shelf-life
 Thus
the definition of a liquid asset
depends on the business the firm is in
Current Ratio
 Current Ratio = Current Assets ÷ Current
Liabilities
 Current liabilities include creditors to
whom payments are falling due within a
year
 If the ratio is less than 1:1 the company
may be unable to pay its debts on time.
Quick Ratio a.k.a Acid-Test Ratio
 Inpractice all current assets may not be

easily convertible to cash
 Some firms may have large stocks of raw
material
 Others like aircraft manufacturing firms may
have large production cycles
 Stock of finished goods may have to be
warehoused for long periods prior to sale
 In such cases a more conservative
liquidity ratio is required
Quick Ratio (Cont…)
 Quick ratio = (Current assets – Stocks) ÷
Current liabilities
 For companies with a slow stock turnover,
or a long cash cycle, this ratio must be at
least 1:1
 However for entities like supermarkets
with a quick stock turnover, a ratio less
than 1:1 may be acceptable.
Liquidity Ratios (Cont…)
A lender or an analyst is likely to interpret
a poor current ratio as an indication of
credit risk
 But the ratios are not perfect
 Current liabilities include those that a week
away to those that are a year away
 O/Ds can be renewed and may therefore
represent medium-term funding
Liquidity Ratio (Cont…)
A high current ratio could lead to liquidity
difficulties for an expanding firm.
 As it grows it will need more WC to fund its
operations as compared to a firm with a lower
current ratio
Inverse of Current Ratio
 Some analysts prefer to look at:
 Current Liabilities/Current Assets
 This shows the proportion of current assets that
are being funded by current liabilities
 If this ratio is say 0.75 it would mean
 75% of current assets are being financed by short-term
liabilities
 And 25% are being financed by long-term liabilities
No Credit Interval
 NCI is an estimate of the length of time
that firm can finance its expenses at
current levels of activity by drawing on itys
own liquid resources
 Theassumption is that it will make no further
sales
NCI (Cont…)
 Current assets (excluding) stocks will soon
be realized
 Current liabilities have to be paid soon
 Thus the net current assets – stocks
would soon be available as cash
 This should be compared with the volume
of the firm’s regular expenditures
NCI (Cont…)
 NCI = [(Current Assets – Stocks) –
Current Liabilities] ÷ Daily Operating
Expenses
 Daily Operating Expenses = (Sales - PBT
– Depreciation and Amortization) ÷ 365
 Depreciation and Amortization are
excluded because they are non-cash
expenses
Illustration
ITEM Year-2 Year-1
Sales 200,000 160,000
PAT 50,000 40,000
Sales-PAT 150,000 120,000
Depreciation 55,000 40,000
Annual Operating 95,000 80,000

Expenses
Daily Operating 260.27 219.18
Expenses
ITEM Year-1 Year-2
Current Assets 70,000 30,000
Less Stocks 25,000 10,000
Less Current 30,000 10,000

Liabilities
Net Current 15,000 10,000
Assets – Stocks
NCI 57.63 days 45.62 days
Cash Flow (CF) Analysis
 Cash flow analysis can be used to assess
the creditworthiness of customer
 We can use historical accounting information
about cash flows
 Or a customer’s forecasts of future cash flows
 Cash flow analysis is important

A company must be able to generate adequate
cash to meet its debt obligations
CF Analysis (Cont…)
 There are four sources of cash generation
 Operational cash flows
 Operational flexibility
 Financial flexibility
 Third party guarantees

 Thisrefers to cash generated from
operational activities
 An analyst will look to see if operational
cash flows are adequate
Operational Flexibility
 This
refers to the ability to liquidate an
asset or sell part of the business to raise
CASH if the need were to arise
Financial Flexibility
 This refers to the ability to raise cash in
the financial markets
 Or to the ability to re-finance maturing
debts
 Ratios such as Gearing Ratio and Interest
Cover can be used to gauge financial
flexibility
Third Party Guarantees
A bank may have recourse to a third party
guarantor in the event of default
 For instance the parent of a subsidiary
who is borrowing my give such a
guarantee
CF Analysis (Cont…)
A creditor will look to one or more of these
sources for repayment
 The principal source will normally be
operational cash flows
A company should be able to pay what it owes
from what it earns
 Bankers
usually look for at least one
secondary source for repayment
Illustration
A company was established on 1 January 2008
with a share capital of $50,000
 The shares were subscribed to in cash
 During the next year the firm raised additional
share capital of $50,000
 It also issued bonds worth $100,000
 Fixed assets worth $125,000 were acquired
during the year
 The depreciation charged for the year was $25,000
 Stock worth $125,000 was purchased during the year
 Out of this payment was due for $25,000 at the end of the year
 The sales for the year was $250,000
 $50,000 of this was yet to be realized at the end of the year
 Stocks held in inventory at the end of the year had a
value of $15,000
 Wages, salaries and other cash expenses for the year
were $75,000
 Interest charges were $10,000. This had been fully paid
by the end of the year
 Cash in hand at the end of the year was $40,000
P&L Account
 Let us prepare a P&L A/c from the data
 Sales = $250,000
 Cost of Sales (125,000 – 15,000) = 110,000
 Gross Profit = $140,000
 Wages etc. = $75,000
 Depreciation = $25,000
 Interest = $10,000
 Net Profit Before Tax = $30,000

Balance sheet at the start of the year
Liabilities Assets
Share Capital Cash = $50,000
= $50,000
Balance Sheet at the end of the year
 Assets
 Fixed assets = $125,000
 Less: Depreciation = $25,000
 Net Book Value = $100,000
 Stock = 15,000
 Debtors = $50,000
 Cash = $90,000
 Current assets = $105,000
 Total Assets = $255,000
B/S (Cont…)
 Liabilities
 Share capital = $100,000
 Long-term debt = $100,000
 Profit for the year = $30,000
 Creditors = $25,000
 Total Liabilities = $255,000

Analysis
 Cash Flow may be defined as
 Net Cash Flow
 Traditional Cash Flow
 Operational Cash Flow
 Net Cash Flow
 Is the difference between closing cash balance and
opening cash balance.
 In this case it is $90,000 - $50,000 = $40,000
 This has no informational value unless the component
elements or causes are analyzed
Analysis (Cont…)
 Traditional Cash Flow
 It is a rough estimate of cash flows from operations
 It assumes that cash flows can be estimated by adding
non-cash items of cost to the net profit
 Typically this means adding back depreciation.
 In this case
 Net Profit = $30,000
 Depreciation = $25,000
 Traditional Cash Flow = $55,000

Analysis (Cont…)
 Advantages of Traditional Cash Flow
 Easy to calculate
 Reasonably accurate considering the analyst’s
requirements
 A more accurate calculation can be time
consuming
Analysis (Cont…)
 Operational Cash Flow
 Refers to the cash flows from operations
 May or may not include finance costs like interest
 In our case we will include interest
 Cash Flow from sales = 200,000
 Cash paid for purchases = 100,000
 Wages = $75,000
 Interest = $10,000
 Operational Cash Flow = $15,000

Analysis
 A categorized cash flow sets out all cash flows of the
business and not just those from operations
 Cash flow from sales = $200,000
 Cash paid for purchases = ($100,000)
 Cash paid for wages = ($75,000)
 Interest payments = ($10,000)
 Fixed Asset Costs = ($125,000)
 Inflow from debt = $100,000
 Inflow from equity = $50,000
 Net Cash Flow = $40,000
 Thus a categorized cash flow statement gives the
component-wise breakup of the Net Cash Flow
Categories of Cash Flows
 An analyst can categorize cash flows in any way
to suit his requirements
 But common classifications are:
 Operational
 Priority
 Discretionary
 Financial
 There is no correct definition just like in the case
of profits
 But it is important to precisely define the version that
one chooses to use
 Thisis the cash flow from trading operations
 Can be sub-categorized
 Receipts from customers
 Cash payments for purchases
 Wage payments
 It
is often defined as Earnings Before Interest,
Tax, Depreciation and Amortization - EBITDA
 However adjustments have to be made for working
capital
Priority Cash Flows
 These are payments for non-trading cash
items
 They are required to keep the firm afloat
 They have priority over non-operational
items
 They are all cash outflows
 Interest
payments
 Tax payments
 Repayment of principal on maturing loans
Discretionary Cash Flows
 These are receipts and payments that do
not have to be made
 Cash payments can be deferred is necessary
 Income can be earned if required
 Examples
 CAPEX
 Payments for acquisitions
 Purchase of financial securities
 Payout of dividends
Discretionary (Cont…)
 On the receipts side:
 Sale of fixed assets
 Sale of subsidiaries
 Sale of financial investments
 Some discretionary outflows are more

urgent than others
A minimum CAPEX may be desirable
 A minimum dividend may have to be declared
Financial Cash Flows
 These arise from variations in long-term capital
 Inflows include:
 Cash from issue of shares
 Raising of new debt
 Outflows include:
 Repayment of debt principal – If it is not treated as a
priority item
 Share buyback
 Redemption of other long-term instruments
The Cash Tank and Cascading
 For an analyst the main consideration is a
company’s need for cash and the ability to
promptly pay what is owed
 In the case of a bank loan
 Interest and possibly principal repayments are priority
cash flows
 They have to be met by inflows from one or more of
these sources
 Operational cash flows
 Net inflows from discretionary items
 Net inflows from long-term financing sources

Cascading…(Cont…)
 Operational cash flows will often be the
source from which all or most of the other
payments will be made, in descending
order of priority
 If OCF is positive the surplus can be used
for priority cash flows
 If after paying these there is still a surplus,
the balance can be used for discretionary
uses
Cascading (Cont…)
 IfOCF is insufficient, a top-up will be
required
 From discretionary sources
 Financial sources
 Or cash brought forward from the previous year
 There could be times when OCF is

insufficient or even negative
A large CAPEX or acquisition is required
 Or principal has to be repaid on a large loan
OCF and Profits
 Operating cash flows are normally the
primary source for meeting interest and
principal obligations
 OCF may be inadequate if a firm is
making low profits or trading at a loss
 Problems may also arise if a firm is
growing too fast
OCF and Profits (Cont…)
A company may have a loss but still have a
positive OCF
 Or it can make profits but have a OCF deficit
 One reason is that non-cash items like
depreciation will make profits lower than OCF
 Secondly there will be changes in working
capital items such as:
 Stocks
 Debtors
 Creditors
 Consider a simple firm that buys and re-
sells products
 Profit = Sales – Cost of Sales
 OCF = Cash In – Cash Out
 Cash In =:
Sales
+ Opening Debtors
– Closing Debtors
 Cash Out =
Cost of Sales
+ Closing Stock
– Opening Stock
+ Opening Creditors
– Closing Creditors
 Profits is simple
 It is sales minus cost of sales
 OCF is the difference between cash received
and cash paid
 Cash received could be different from sales
because of changes in the amount of debtors
 If the amount of debtors were to increase, Cash In will
be lower than sales
 Else if it were to decrease it will be higher
 Cash Out differs from the cost of sales
due to changes in inventory and creditors
 If there is a build-up of inventory Cash Out will
be more than cost of sales
 Else it will be less
 If Creditors increase, cash out will be reduced
 Else it will increase

Illustration
 Turnover for a firm was $500,000
 Cost of sales was $350,000
 Initial inventory was $125,000
 Closing inventory was $75,000
 Opening debtors was $100,000
 Closing debtors was $150,000
 Opening creditors was $125,000
 Closing creditors was $80,000
 Profit = Turnover – Cost of Sales = 500,000 – 350,000 =
$150,000
 Cash In = Sales + Opening Debtors – Closing Debtors =
500,000 + 100,000 – 150,000 = $450,000
 Purchases = Cost of Sales + Closing Stock – Opening
Stock = 350,000 + 75,000 – 125,000 = 300,000
 Change in Creditors = 125,000 – 80,000 = $40,000
 Cash Out = Purchases + Change in Creditors = 300,000
+ 40,000 = $340,000
 OCF = Cash In – Cash Out = 450,000 – 340,000 =
$110,000
 Thedifference between profits and cash
flows has implications for credit analysis
 If a company is profitable but short on cash one
reason could be an increase in WC
 The analyst will ask – WAS THIS NECESSARY
 If a company were to seek a bank loan to fund

an increase in WC, the bank may ask – CAN
WC BE SQUEEZED
 WC can be squeezed by:
 Reducing debtors
 Reducing stocks
 Availing of more trade credit
 BetterWC control could remove the need

to borrow
Overtrading
 When a firm is expanding rapidly it could
be profitable but still have a cash flow
problem
 There will be a growing need for WC investment
to finance the expansion
 Companies that are rapidly expanding and
are unable to finance the additional WC
from their operational cash flows are said
to be OVERTRADING
Illustration
 Sales = 500,000
 Cost of Sales = $450,000
 Profit = $50,000
 Average stock = 20% of cost of sales
 Average creditors = 10% of cost of sales
 Average debtors = 40% of annual sales
 If the company were to continue to operate at
this level its operations would lead to a cash
inflow of $50,000 per annum
 But what if it were to double its sales and the working
capital turnover periods were to remain the same?
 Sales = 1,000,000
 Cost of Sales = 900,000
 Profit = 100,000
 Increase in stocks = (90000)
 Increase in debtors = (200,000)
 Increase in creditors = 45,000
 OCF = -145,000
 If the company were to expand at this rate the OCF
would remain negative
 Remember we have not factored in priority and discretionary
outflows
Overtrading (Cont…)
 Overtrading
can lead to a cash flow crisis
 The company is living hand to mouth
 Debtors are given minimum time to pay
 Suppliers are being asked to extend the
maximum possible credit
 Ifa bank were to be approached for a
larger overdraft by a such a firm
 It would either refuse or charge a high rate of
interest
Overtrading (Cont…)
 What is the cure for overtrading?
 Avoid rapid growth
 Consolidate after a period of rapid growth,
before expanding further
Negative OCF
 Negative OCF normally indicates a part in
financial distress
 Unless a company is rapidly growing and
investing heavily in WC
 Thiscould lead to negative OCXF despite
growing profits
Interpreting Cash Flow Statements
 Cash flow problems do not happen
overnight
 Thus an analysis of historical cash flows and
past trends can be very informative
 Cashflow analysis begins with the
company’s ability to generate profits and
goes on to assess its ability to manage
cash and finances
Interpretation (Cont…)
 Key issues are:
 How much cash is being generated from
operations
 Is this adequate
 Is it possible to estimate or project future cash

flows
Absolute Figures
 Cash flow statements can be studied by
looking at absolute figures
 Whatis the cash flow from operations after
paying
 Interest
 Taxes and
 Dividends if any
 Thisconstitutes the amount available to finance

CAPEX and the amount available to repay the
principal on loans
Ratio Analysis
 The focus of cash flow analysis is primarily
on OCF
 This ratios tend to compare OCF with the
other items of the cash flow
 The issue is are operational cash flows
adequate to cover non-operational cash
outflows
OCF and Priority Cash Flows
 This
is called the Debt Service Ratio
(DSR)
 Measures the ability to pay priority cash flows
out of operational cash flows
 DSR = OCF ÷ Priority Cash Flows
 The term Priority Cash Flow refers to Interest

and Taxes
 A ratio of less than 2 is normally considered to
be undesirable
OCF, Priority Cash Flows and Dividends
 Itis often assumed that the directors will

use OCF to pay dividends to shareholders
whenever possible
 Thus a useful ratio is:
OCF ÷ (Priority Cash Flows + Dividends)

 A ratio above 2 is considered to be
desirable
CAPEX
 This is important for all businesses
 Connotes current outflows to reap future inflows
 It is critical for long-run survival
 We have called it a discretionary cash

outflow
 This is valid to an extent
 Unless contracts have been signed and funds have
been committed such expenditure can be postponed
or even scrapped
CAPEX (Cont…)
 However some amount of expenditure on
this score is essential to keep the
business running
 Most fixed assets have to be replaced some
day
 A difficult task for the analyst is to estimate the
inevitable component of CAPEX
CAPEX (Cont…)
 Ata minimum, CAPEX should be equal to
the annual provision for depreciation
Internal Financing Ratio
 In the long-run a company should be able
to finance most of its CAPEX from its own
OCF with only a marginal reliance on fresh
borrowings
 This should be true even if dividends are
factored in
 Thus in the long-run, OCF – (Priority Cash
Flows and Dividends) should be roughly
equal to CAPEX related outflows
Internal Financing Ratio (Cont…)
 This ratio is defined as:
CAPEX including payments for acquisitions ÷
(OCF – Priority Cash Flows – Dividends)
 In the long-run the ratio must be close to 1:1
 If it is greater tan 1:1, then it implies that fresh

borrowings are being relied on
 The financing of CAPEX by such borrowings is
a matter of interest from the standpoint of the
credit analyst
Predicting Corporate Failures
 Ratioanalysis, although helpful, is beset
with problems.
A large number of ratios have to be monitored
 There are no clear-cut rules as to how to
identify danger signals
 In many cases ratios could give conflicting
signals
A company may have good liquidity and low
leverage, but may display low profitability
Predicting (Cont…)
 Thus decisions based on ratio analysis
tend to depend heavily on the
 Experience
 Judgment
 Opinion of the analyst rather than on objective

facts
 The issue therefore is, can we compute a
single number which indicates the
financial position of a firm
Models
 Researchers have developed models,
based on ratio analysis, which can be
used to identify companies at risk
 The focus is on whether financial ratio analysis
can be used to predict business failure
 Some models try to identify a single key ratio
 These have not been very successful
 Others use several ratios in combination
Z Scores
A Z score is a figure which can be
calculated from a small number of
financial ratios.
 Most of the required data can be obtained from
the published account of a company
Z score models are constructed by
analyzing a large number of ratios for a
sample of healthy companies as well as a
sample of failed companies.
Z Scores (Cont…)
 Statistical analysis is then used
 To identify a small number of key ratios which help
distinguish between healthy and failed companies
 To calculate coefficients for each ratio is order to
compute a Z score
 The formula is:
Z = C1R1 + C2R2 + -------------CnRn
 The Rs are the key ratios identified
 The Cs are the corresponding coefficients
Z Scores (Cont…)
A high Z score indicates health while a low
score indicates potential failure
 Altman who built this model analyzed 22
ratios for a selection of successful as well
as failed companies
 Fivekey indicators emerged
 These were used to derive a Z score
Z Scores (Cont…)
 The model emerged as:
Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 +
0.0099X5
 X1 = Working Capital/Total Assets

 X2 = Retained Earnings/Total Assets
 X3 = EBIT/Total Assets
 X4 = Market value of Equity/book value of total
debt
 X5 = sales/Total Assets
Z Scores (Cont…)
 Altman found that a score above 2.99
indicated non-failure
 A score below 1.81 indicated potential
failure
 1.81-2.00 is a Grey Area
 Inthis range eventual failure or success was
uncertain
Drawbacks
 Altman’s sample size was small and restricted to
US firms
 Subsequent research has produced different
models based on the same methodology
 I has been argued that Z score models
appropriate for US conditions are different from
Z score models for other countries
 Similarly different models of the same genre
may be appropriate for different industries.
Secure Methods of
Payment
Options for a Bank
 When a bank is concerned about
the credit risk of a borrower it has
various options:
 Refuse to lend
 Lend at a high rate of interest and
perhaps for a shorter term
 Lend with protection in the form of

Security

Guarantee
 Or loan covenants
Options for Companies
 The company can ask for Cash in
Advance
 The risk is that they will lose business
 Or they can arrange for secure
methods of payment
 These fall into two brackets
 Agreements with the customer that
provide security to the supplier
 Agreements with third parties
Third Party Based Methods
 These reduce the risk of non-
payment by customers
 But do not impact the customer
directly
 Examples include:

Credit insurance
 Factoring
 Forfaiting
Options for Export Sales
 In general there is a greater
variety of secure payment
methods for export sales
 The payment risk is more difficult to
control
Payment in Advance
 This entails full payment in
advance of the delivery of the
good or service
 To avoid the risk of dishonored
checks the supplier should ship after
the funds have been received in his
bank account
 This system is not common
 Buyers will not usually pay till they
have seen and checked the goods
Payment in Advance
(Cont…)
 A cash in advance policy is not
usually feasible for cross-border
trading
 Particularly for high value items
 If a buyer agrees to an advance
payment he could in return ask for
an
 Advance payment guarantee or bond
 This is a guarantee by the
exporter’s bank
Retention-of-title Clauses
 A supplier may specify that legal
title to the goods (or ownership)
should remain with it till full
payment is made
 The issue usually is
 What rights does the supplier have if
the buyer goes into liquidation
without paying?
Typical Scenario
 If a customer were to go into a
liquidation, a bank with a floating
charge over its assets would apply
to a court to have a receiver to be
appointed
 The receiver would arrange for the
assets to be sold and use the
money to repay the bank
 In such situations unsecured
creditors would usually get very
Retention of Title Scenario
 If such a clause were to exist the
receiver would not have claim to
the goods
 That is the supplier would be
entitled to return of the goods
 In theory if the goods have been
sold the supplier can be entitled to
payment equivalent to the sale
value
Retention (Cont…)
 A retention clause puts unpaid
creditors in a better position of
avoiding or minimizing losses
 Such clauses however have
limitations
 They can be applied to the sale of
services
 A supplier cannot reclaim goods that
have been used to make another
product
 The supplier must be able to identify
Retention (Cont…)
 The intent to use such a clause
must be categorically stated to the
customer
 It must be included in the wording
of the sales contract
 It must be appropriately worded –
use a legal expert
 If the customer goes into
receivership the receiver must be
informed at the earliest about the
Export Sales
 Export sales often present a
greater credit risk than domestic
sales
 The credit cycle could be very long
 A buyer will often not pay till the
goods are delivered
 Delivery periods can be long because
of transit times and customs
formalities
Export Sales (Cont…)
 Suppliers are often unfamiliar with
the laws and customs in the
foreign country
 This creates doubts about the buyer’s
ability to repay
 Recovery in the event of nonpayment
is more difficult in an alien legal
system
 Exchange control regulations could
prevent or delay payments in hard
Export Sales (Cont…)
 The high risks inherent in exports
have lead to special methods for
extending credit and obtaining
payment
 One very common tool that is used
is a LETTER of CREDIT or LC
Letter of Credit
 Letters of credit are also known as
Documentary Credits
 It requires the role of a bank
 A confirmed LC involves two banks
 LC based transactions can
overcome the problem of
unfamiliar foreign laws
 Banks operate in accordance
UCPDC
UCPDC
 This stands for Uniform Customs
and Practice for Documentary
Credits
 This is formulated by the
International Chamber of
Commerce or ICC based in Paris
LCs
 The exporter and the buyer agree
on a sales contract the provides for
payment by way of an LC
 It should be specified if the LC is to
be confirmed
 Credit risk is much lower with
confirmed LCs
 The buyer will ask a bank, usually
in his own country, to issue an LC
in the exporter’s favor
LCs (Cont…)
 The bank will assess the
creditworthiness of the buyer
 If it agrees to proceed it becomes
the issuing bank for the LC
 The buyer is the APPLICANT
 The exporter is the BENEFICIARY
LCs (Cont…)
 By issuing an LC the issuing bank
guarantees payment to the
beneficiary
 Provided the beneficiary complies
with the specified terms and
conditions
 The issuing bank will ask a bank in
the exporter’s country to advise
the credit to the beneficiary

LCs (Cont…)
 The advising bank agrees to
handle the credit
 Do the administrative work in the
exporter’s country
 It does not make a commitment to
guarantee payment to the exporter
 The guarantee comes from the
issuing bank
LCs (Cont…)
 In the case of a CONFIRMED LC the
advising bank will be asked by the
issuing bank to add its own confirmation
to the LC
 If so the advising bank will add its
conditional payment guarantee to the
original guarantee provided by the
issuing bank
 The bank that confirms the credit is
known as the CONFIRMING BANK or the
LCs (Cont…)
 Thus a confirmed LC carries the
guarantee of two banks
 One in the exporter’s country – the
Confirming Bank
 One in the buyer’s country – the
Issuing Bank
LCs (Cont…)
 The charges levied by the bank for an
LC are usually borne by the buyer.
 After the goods have been shipped, the
exporter must present certain specified
documents to the advising bank
 These include:
 A transport document like a Bill of Lading
 Copies of the Invoice
 And if insurance is payable by the exporter,
an insurance policy
LCs (Cont…)
 The exporter will be usually
required to present a bill of
exchange with the other
documents.
 A Bill of Exchange is an order in
writing from the drawer requiring
the drawee to pay a specified sum
 On demand or
 At a specified future date
LCs (Cont…)
 If the supplier is providing credit
the drawee will sign his
acceptance on the bill
 The accepted bill is an unconditional
promise to pay
 The bill of exchange used for
payment with an LC could be
drawn on the issuing bank or the
confirming bank
LCs (Cont…)
 The documents will usually be
presented to the advising bank
 It will examine them to ensure that
they are in order and have been
presented on time
 If there are any discrepancies, or
have been presented late
 The exporter could lose the guarantee of
payment from the issuing bank and the
confirming bank
LCs (Cont…)
 When the settlement is by a bill of
exchange the exporter will be paid
as per the terms of the bill
 Immediately or on a future date
 If it is a term bill, instead of waiting
till maturity, the exporter can have
it discounted by a bank
Presentation of Documents
after Shipping
 The checking of documents by the
advising bank is a crucial process
 Very often the bank will find an error when
it does so
 The bank checks to ensure that:
 All the required documents have been
presented
 They are correct from the standpoints of –
Number, Type and Content
 They conform exactly to the requirements
of the LC
 They are consistent with one another
Presentation (Cont…)
 That they have been presented within
the time stipulated and within the
validity period of the LC

An LC may say that documents must be
presented within 7 days of the issuance
of the Bill of Lading
 The LC itself expires on 31 July 2009
 That the insurance documents are
correct
 A large proportion of LCs are invalidated
because the exporter fails to present
error free documents
 The bank will reject the LC even if a small
error is found
 If a discrepancy is found the documents
will be returned to the beneficiary
without payment
 The errors should be corrected and the
documents presented again
 But within the time limit specified in the LC
 A bank may choose to make a
payment despite a discrepancy but
it would require an INDEMNITY
 That is if the buyer subsequently
refuses to allow the discrepancy the
exporter must reimburse the paying
bank
Typical Discrepancies
 The LC has expired
 The documents have been presented
after the period specified in the LC
 The bill of lading is not clean
 It contains a clause stating the goods and/or
packaging is defective
 The bill of lading is not marked Freight
Paid, when the LC calls for shipping on a
CIF or CF basis
 In such cases the supplier will have to pay
the freight charges
Typical Discrepancies
(Cont…)
 The goods are being shipped between
different ports from those stated in the LC
 The insurance policy does not cover the
required risks
 The shipment is underinsured
 The amount insured is in a different currency
from that specified in the LC
 The description of goods on the invoice differs
from their description on the LC
 The weight of goods mentioned differs across
documents
 The amount on the invoice differs from the
amount on the bill of exchange
 The bill of exchange has been drawn on the
Forfaiting
 Forfaiting is a very flexible form of
trade financing
 The technique is widely used in
Europe
 London is the major centre
 It involves the purchase of trade
receivables from the beneficiary on
a 100% without-recourse basis
Factoring and Invoice
Discounting
 A factoring organization specializes
in trade debts
 Manages the administration of a
client’s sales and debtors on his
behalf
 A company can use a factor to
manage, finance and insure its
trade debtors
Services Provided by a
Factor
 Sales, that is, debtor
administration
 Credit protection
 Providing finance up to 85% of the
value of approved invoices
 Services are available for domestic
credit sales as well as for export
credit sales
 This is referred to as EXPORT
Sales Administration
 Companies can use factors to off-
load the administration of debtors
 Factors will maintain the sales
ledgers – record credit sales in the
client’s accounting system
 Send out invoices
 Send reminders and statements
 Collect payments
Benefits to a Client
 The benefits from outsourcing sales
administration are:
 Cost savings due to reduction in or elimination of in-
house sales management
 A more efficient debtor management system
 Very often a company may become sloppy in
debtor management
 Rapid growth in credit sales could overload the
internal sales administration system
 Factors will also argue that their efficiency
results in speedier collection
 Factors charge between 0.5-2.5% of the value
of the invoices handled.
Credit Protection
 Factors can provide a credit control
service
 They can vet applications for credit
 Decide how much credit to allow
 If they offer credit control services they
will also underwrite their clients’ debts
 If a debtor turns bad, the risk is borne by
the factor
 This is known as NON-RECOURSE
FACTORING
NON-RECOURSE
 For such deals, the factor must be
given full responsibility for credit
control
 They will approve the amount of
credit to be extended to individual
customers
 They will continuously monitor
receivables
 They will consult the client if a debt
becomes overdue
Recovery
 When a debt becomes overdue the
factor will consult the client
 The client may decide to take over the bad
debt risk from the factor
 If so, the client must bear any bad debt loss
 But the client has an advantage
 He may be able to resolve the issue without
creating illwill
 Persistent pressure from the factor may lead to
illwill
 Alternatively the client may give the factor
the go-ahead to chase the debtor through
Recovery (Cont…)
 A factor is not a debt-collection agency
 It is a provider of a sales administration
service
 The credit control system is intended to
limit the number of problem customers
 Every factor may not offer without
recourse financing
 For large debts they may provide with
recourse financing
 If so the client will bear the full risk of a bad
Finance
 Companies can arrange to obtain
finance from a factor to fund their
debtors
 Finance can be provided in the
form of an advance payment for up
to 80% of approved invoices
 The factor provides the cash
against the security of unpaid
invoices
Example
 A factor agrees to advance funds to a
client Alpha Ltd. against unpaid
invoices
 It will pay 80% of approved invoices
 The factor has approved credit sales of
$100,000 per month
 Thus the factor will pay $80,000 to
Alpha every month.
 The rate of interest will be tied to the bank’s
base rate but could be higher than what the
client would pay for an O/D
 Alpha will receive the balance when the
debts are repaid or after an agreed
Example (Cont…)
 If Alpha continues to use the
factor’s services there will be a
continuous cycle
 Cash advances
 Repayments
 Fresh advances
 Thus Alpha will get continuous
finance for 80% of its approved
debtors
Example (Cont…)
 Assume that Alpha gives every
customer two month’s credit
 It would receive continuous finance
of $160,000
 2 months x 80,000 per month or
 80% of 200,000 (average debtors)
 The factor will also levy an
administrative charge – maybe
0.5% of the client’s gross annual
turnover
Export Factoring
 Factoring is available for export
sales
 This is used by companies that
make exports on open account
terms, and do not use a secured
method such as LCs
 Export factoring agencies work in
collaboration with a factor in the
country where the debt is to be
Export Factoring (Cont…)
 The import factor helps the export
factor in credit control
 The process of credit assessment and
granting of credit
 It will collect payments on behalf of
the export factor
 It will provide assistance for pursuing
defaulters in their own country
Export Factoring (Cont…)
 Some export factors are prepared
to provide credit protection – that
is non-recourse factoring, but only
if the client asks for it.
 Most exporters rely on credit
insurance
Who Uses Factors
 In the past mainly small firms were
using factors.
 However these days many large
companies also do so
 A factor may refuse to service
 Very small companies
 Companies in a high-risk market
 Or companies with a history of bad debts
 The administrative difficulties and credit
risk would be termed as too high in such
Invoice Discounting
 This is related to factoring and many
factors provide an invoice discounting
services
 It refers to the purchase of selected
invoices at a discount
 This is similar to a factor’s financing service
 However the invoice discounter does
not take over the administration of the
sales function.
 The arrangement is purely for a cash
advance
Example
 In May a company asked a
discounter to provide finances
against certain invoices
 The discounter agreed to finance 75%
of their value
 Which came to $400,000
 The interest rate was fixed at 10% per
annum
 The finance was paid in May
 $200,000 were obtained from debtors
Example (Cont…)
 The discounter would provide $300,000
in May
 75% of $400,000
 At the end of July the company would
receive $50,000 minus charges
 25% of 200,000
 At the end of August it would receive
the balance $50,000 minus charges
 Administrative charges range from 0.2
to 0.7% of turnover
Mortgage Banking
Introduction
• What is mortgage banking?
– It refers to the Origination, Sale and Servicing of loans
secured by residential property
• A mortgage banker is a financial intermediary
who facilitates the mortgage transaction
• He is not in the business of accepting deposits
and extending loans
– Such entities fund their operations with short-term
borrowings, usually from commercial banks
• Once the loan is made, it is pooled with similar
loans and sold to investors in the secondary
mortgage market
• This regenerates funds for the mortgage banker
who can commence the cycle again
• By repeatedly originating and selling loans
mortgage bankers ensure the availability of
capital in regions that are deficient in funds
Origination
• Refers to the creation of mortgages
• Loan officers will initiate the process by
locating borrowers and accepting
applications
Processing
• This refers to the collection of the required
documents to support the application
• And the verification of facts and figures
• Typically it will include an appraisal to
confirm the value of the property
• And a credit report to verify the borrower’s
credit history
Underwriting
• This refers to the evaluation of the
documentation and the decision whether
or not to grant the loan
• While assessing the quality of a loan the
underwriter will look for specific facts to
ensure its salability in the secondary
market
Closing
• This refers to the signing and recording of
the loan documentation
• And disbursement of funds to the borrower
Warehousing
• This refers to the financing of the loan
from the time it is closed till it is
subsequently sold
• Short-term revolving lines of credit are the
most common sources of finance for
mortgage bankers
Shipping and Delivery
• This refers to the packaging of closed
loans for delivery to an investor
• This consummates the sale of a loa n
Loan Administration
• This refers to the collection and remittance
of monthly mortgage payments to
investors
• This is also termed as LOAN SERVICING
Secondary Marketing
• This is the process of selling pools of
existing loans to investors
• Normally sale is arranged simultaneously
with origination
• Commitments are used to secure the
future sale of loans
– To protect against interest rate changes
between the time of origination and that of the
subsequent sale
Revenues for Mortgage Bankers
• Income is generated from the following
sources
– Origination fees
– Warehouse spread
– Secondary market sales
– Servicing fees
Origination Fees
• They are paid by borrowers to cover the costs
associated with originating loans
• In practice the expenses associated with
origination exceed the income from such fees
• The fee is a percentage of the loan amount
– Usually 1%
• Additional fees may be levied based on the loan
type
• Fees for appraisal and credit reports are usually
collected separately
Warehouse Spread
• This is the difference between the rate
being paid on the lender’s short-term
credit line and the interest being received
on the mortgages funded by it
Secondary Market Sales
• This income comes from the sale of
mortgages to investors in the secondary
market
• Purchases include federal and quasi-
federal housing agencies as well as
private players
• These entities then issue securities
backed by the underlying mortgages
Secondary (Cont…)
• The banker stands to make a profit if the
loans can be sold at a price that is greater
than the price at the time of origination
• Commitments are used to lock in prices
Servicing Fee
• Loan administration is where mortgage bankers
derive their greatest income
• The banker will receive a fee ranging from 25 to
44 basis points of a loan’s outstanding principal
per year
– For performing the collection and remittance functions
• Servicing also provides the opportunity to sell
related products like insurance and consumer
loans
Participants in the Mortgage
Banking Industry
• Borrowers
• Lenders
• Government Sponsored Agencies
• Private Agencies
• Investors
Borrowers
• They are typically consumers who are
financing primary or secondary residences
• And developers who are developing
residential properties
Lenders
• These include:
– Mortgage bankers
– Commercial banks
– Savings banks
– Thrifts
– Credit Unions
• They may choose to hold the mortgages
as an investment or else sell them in the
secondary market
Government Sponsored Agencies
• Such agencies like:
– Ginnie Mae
– Freddie Mac
– Fannie Mae
• Facilitate the secondary mortgage market
by providing a network for the purchase,
sale and guarantee of existing mortgages
and mortgage pools
Private Agencies
• Commercial banks and others purchase
loans from lenders
• These are pooled to form mortgage-
backed securities and are sold to investors
either directly or through an investment
bank
Investors
• They purchase mortgages and mortgage backed
securities for the purpose of investment
• They invest large sums in long-term instruments
• They include Life Insurance Companies and
Pension Funds
• Government sponsored agencies are also
referred to as investors because they also
purchase mortgages
Primary versus Secondary
Mortgage Markets
• The primary mortgage market is the arena
where new loans are created
• Borrowers in search of credit to finance
real estate use the primary market to seek
out lenders
• The secondary market is where mortgage
bankers and investors buy and sell
existing loans
– Thus the market provides liquidity
Primary…(Cont…)
• The secondary market allows mortgage
bankers to meet their immediate needs for
capital
• It enables investors to easily invest in
mortgages
• It also facilitates portfolio diversification
Credit Evaluation
• Before extending a loan the originator will
make a credit check.
• There are two main factors to be
evaluated.
– The Payment to Income Ratio (PTI)
• It is the ratio of the monthly installment due from
the mortgage to the applicant’s monthly income.
• The lower the PTI the better the chances of getting
the loan.
Credit Evaluation
– Loan to Value Ratio (LTV)
• It is the ratio of the loan amount to the market
value of the property.
• The lower the ratio, the more is the protection for
the lender.
Mortgage Servicing
• Once a loan is made, it has to be serviced.
• Servicing can be done by the lender
himself, or can be contracted out to an
external agency.
Servicing
• Servicing involves the following activities.
– Collection of monthly payments.
– Sending payment notices to the mortgagors.
– Sending reminders for overdue payments.
– Maintaining records of outstanding principal.
– Initiating foreclosure proceedings if required.
Sources of Income For The
Servicer
• He gets a servicing fee.
– The fee is a fixed percentage of the
outstanding mortgage balance.
– As each installment is made, the outstanding
balance will decline.
– Hence so will the servicing fee.
Servicing Income
• Servicers also earn a float on the monthly
mortgage payment.
– This is because there is a delay between the
time they receive the payment and the time
they pass it on to the lender.
• They also earn a late fee if payments are
overdue.
Mortgage Insurance
• Lenders require mortgage insurance as a
safeguard against default.
– The cost is borne by the borrowers in the form of a
higher rate of interest.
• Many mortgagors acquire Credit Life Insurance
from life insurance companies.
– Such insurance provides for a continuation of monthly
payments even if the mortgagor were to die.
– Thus dependents will not lose possession of the
property.
Features of a Traditional
Mortgage
• A traditional mortgage is known as a Level
Payment Mortgage.
– Borrowers make fixed monthly payments
consisting partly of principal repayment and
partly of interest on the outstanding balance.
– Loans which are paid off in such a fashion are
called Amortized Loans.
Features of Amortized Loans
• Mortgages are usually for 20 years (240
months) or for 30 years (360 months).
– The interest component is equal to one twelfth
the annual rate of interest multiplied by the
amount outstanding at the beginning of the
previous month.
– With the payment of each installment, the
interest component will keep declining and the
principal component will keep increasing.
Amortization
– It refers to the process of repaying a loan by
means of equal installments at periodic
intervals.
– The installment payments form an annuity
whose present value is equal to the original
loan amount.
– A Amortization Schedule is a table that shows
the division of each payment into principal
and interest, and the outstanding loan
balance after each payment.
Calculating The Installment
• Consider a loan to be of $L to be repaid by
way of N installments of $A each.
– Let the periodic interest rate be `r’.
– L = A x PVIFA(r,N) =
A 1
x[1 − ]
r (1 +r ) N
Example
• A person has taken a loan of $10,000.
• It has to be paid back in 5 equal annual
installments.
• Interest rate is 10% per annum.
– L = A x PVIFA(10,5) = A x 3.7908
– A = 2,637.97
Year Payment Interest Principal Outstanding

Repayment Principal
0 10,000
1 2637.97 1000 1637.97 8362.03
2 2637.97 836.20 1801.77 6560.26
3 2637.97 656.03 1981.94 4578.32
4 2637.97 457.83 2180.14 2398.18
5 2637.97 239.82 2398.15 .03
Prepayments
• The mortgagor has a right to payoff the
mortgage prematurely either in part or in full
without significant penalties.
– Thus the borrower has a Call Option.
– For the lender it introduces cash flow uncertainty.
– The uncertainty about when and how a borrower will
prepay is called Prepayment Risk.
– Because of this risk the valuation of mortgages and
mortgages related securities is more complex.
Reasons For Prepayment
– The borrower may be selling the house
because he is changing jobs.
– He may be scaling up to a more expensive
place.
– He may be getting a divorce.
– Interest rates may have declined. If so he can
pay off the existing loan and take a fresh loan
at a lower rate.
Reasons for Prepayment
– The lender may be selling the property due to
non payment of dues.
– There could be a fire or a natural calamity
which destroys the property. If so, the
insurance company will pay.
Pooling of Mortgages
• Mortgage originators do not usually hold
on to the loans made by them, but rather
sell them.
• In order to sell these loans, many small
loans are put together as a collection,
called a Mortgage Pool.
Rationale for Pooling
• Consider ten separate loans of $100,000 each.
• Assume that each loan has been made by a
separate lender.
– Every lender therefore faces prepayment risk.
– It is not easy for a lender to forecast prepayments,
since each is dealing with an individual borrower.
– Prepayment behaviour will obviously differ from
borrower to borrower.
Rationale for Pooling
– If these ten loans were to be pooled, then the
average prepayment is likely to be more
predictable and statistical tools of analyses
can be used.
– However it is expensive for one party to own
the pool since it would entail an investment of
10MM.
– However the pooled loans can be used as
collateral to issue securities in large numbers
to enable individual investors to invest.
Securitization
• Securitization is a process of converting a pool
of illiquid assets into liquid financial instruments.
– In the case of mortgages, the pool serves as the
source for the payments which have to be made on
the assets which are issued with the pool as
collateral.
– Because of the ability to securitize, lenders can
repeatedly rollover their investments in mortgages
and the country as a whole gets greater access to
housing finance.
Standardization
• Before pooling mortgage loans care is taken to
standardize the loans.
• This means that all the pooled loans will have:
– The same rate of interest.
– The same period to maturity.
– The same kind of insurance.
– The same kind of property.
– And will come from the same geographical location.
Standardization
• The advantage of standardization is that the
cash flows from the pool are easier to predict.
• Although each mortgage loan is insured
individually, some times the pool as a whole is
additionally insured.
• A mortgage pool is therefore like a large loan
with a coupon rate and term to maturity.
Special Purpose Vehicles
(SPVs)
• Before securitization, the pool of mortgages is
transferred to an SPV.
– An SPV is a separate legal entity that is set up for the
purpose of issuing mortgage backed securities.
– The objective is to ensure that there is a distance
between the originators and the pool.
– Thus even if the originators were to go bankrupt, it
would not affect the pool held by the SPV.
Mortgage Backed Securities
• The net result of securitization is the
creation of assets which are backed by the
underlying pool of mortgages.
• These assets are claims on the cash flows
that are generated by the underlying pool.
Federal Agencies
• These are organization which are
essentially private, but are sponsored by
the U.S. government.
– Their mandate is to serve as intermediaries in
specified sectors of the economy.
– They were created to enable special interest
groups like homeowners, farmers, and
students to borrow at affordable rates.
Major Agencies
• Federal Home Loan Bank.
• Federal National Mortgage Association –
Fannie Mae.
• Federal Home Loan Mortgage Corporation
– Freddie Mac
• Student Loan Marketing Association –
Sallie Mae
Major Agencies
• Freddie Mac and Fannie Mae operate in
the mortgage market.
– They were set up to promote a liquid
secondary market for mortgages.
• Sallie Mae was set up to promote a
market for student loans.
– All three are listed on the NYSE and are
publicly owned.
Ginnie Mae
• The Government National Mortgage
Association – Ginnie Mae also promotes a
liquid secondary market for mortgages by
guaranteeing mortgage backed securities.
– However it is not a private agency, but is a
government owned corporation.
– Thus all securities guaranteed by Ginnie Mae
are effectively guaranteed by the Federal
Government.
Pass-throughs
• A pass-through is a type of mortgage
backed security.
– It is formed by pooling mortgages and
creating undivided interests.
– Undivided, means that each holder of a pass-
through has a proportionate interest in each
cash flow that is generated from the
underlying pool.
Illustration
• Consider 10 loans of $100,000 each that are
pooled together.
• Assume that an agency purchases these loans
and issues fresh securities using these loans as
collateral.
– This is the function of Ginnie Mae, Fannie Mae,
Freddie Mac etc.
• Assume that 40 units of such securities are sold.
Illustration
– Thus each security will be worth $25,000.
– Each security will be entitled to
1/40 th or 2.5% of each cash flow emanating from the
underlying pool.
– The net result is that by investing $25,000 an investor
gains exposure to the total pre-payment risk of all ten
loans rather than to the risk of a single loan.
– This is appealing from the point of risk reduction.
Collateralized Mortgage
Obligations (CMOs)
• Now consider the case where the ten loans are
pooled to issue three categories of securities.
– Class A Bonds: Par Value of $400,000
– Class B Bonds: Par Value of $350,000
– Class C Bonds: Par Value of $250,000
• For each class, multiple units of a security that
represents that particular class are issued.
CMOs
• For instance if 50 units of class A bonds
are issued, then each will have a face
value of $8000.
– Each will be entitled to 2% of the cash flows
receivable by the class as a whole.
• Assume that the cash flows are distributed
according to certain pre-decided rules.
Example Of Distribution Rules
– Class A securities will receive all principal payments –
both scheduled and unscheduled until the entire par
value is paid off.
– Once class A securities have been fully retired, class
B bondholders will start receiving principal payments
– scheduled and unscheduled, until the entire par
value is paid off.
– After class B securities are retired, class C security
holders will start receiving principal payments.
CMOs
• All security holders will receive interest every
period, based on the amount of the par value
that is outstanding for that particular class.
• This is an example of a CMO.
• In this case certain categories of securities will
receive payments before others.
• Unlike a pass-through, all securities are not
equally exposed to pre-payment risk.
CMOs
• Class A bonds will absorb prepayments
first, followed by class B, and then by
class C.
– Class A bonds will have a shorter term to
maturity than the other two categories.
– Class C securities will have the longest
maturity.
A Pass-Through
A Detailed Illustration
• A person has borrowed $4800 to buy a house.
– He agrees to pay $100 every month as principal
repayment, and to pay interest every month on the
outstanding principal at the rate of 6% per annum.
– A total of 48 payments are due.
– The first payment will be $124 which consists of $100
by way of principal repayment and $24 by way of
interest.
Illustration Cont…
– The last payment due will be $100.50 which
will consist of $100 by way of principal
repayment and $0.50 by way of interest.
– We will assume that there are 4 owners who
agree to share each payment equally.
– If payments are made as per schedule, each
party will receive $31 after the first month, and
$25.125 in the last month.
Illustration Cont…
– Assume that at the end of three months the
mortgagor pays an extra $40 by way of principal.
– So each of the four owners will get an extra payment
of $10.
– Since $10 is prepaid the monthly interest in
subsequent months will go down by 20 cents.
– In the last month (48th) the mortgagor will pay $60 by
way of principal and 30 cents by way of interest.
Illustration of CMO
• Assume that instead of agreeing to share the
payments equally, the four owners want the
following system.
– Party A wants his principal back by the end of the first
year.
– Party B wants his principal by the end of the second
year.
– Party C wants his principal by the end of the third
year.
– Party D wants his principal during the last year.
CMO Illustration Cont…
• So every month all the investors will get
interest on the amount outstanding to
them.
– But all principal payments will go first to A.
– Once A is fully paid, B will start receiving
principal payments.
– After B is fully paid, C will start receiving
principal payments.
– Finally D will start getting principal payments.
• In the first year A will get $100 every month plus
interest on the outstanding balance.
– The other three will get interest of $6 per month.
• From the 13th month B will start receiving $100
per month plus interest on the outstanding
balance.
• From the 25th month C will start receiving $100
per month.
• From the 37th month D will start receiving $100
per month.
• Each class of ownership is called a tranche.
• A CMO must obviously have a minimum of 2
tranches.
• Now assume that in the third month the
mortgagor makes an extra payment of $40.
– This will entirely go to party A.
– In subsequent months he will continue to get $100 by
way of principal repayments, but will receive 20 cents
less by way of interest.
– In the 12th month he will get only $60.
– The remaining $40 will go to B.
– In the 24th month, B will get $60 and C will get
$40.
– In the 36th month, C will get $60 and D will get
$40.
• Such a distribution principle is called
Sequential Pay Prepayment.
Differences Between Conventional
Bonds and Mortgage Backed Securities
• In a conventional bond the principal is returned
in one lump sum at maturity.
• Holders of mortgage backed securities receive
their principal back in installments, as the
underlying loans are paid off.
• Since the speed and timing of principal
repayments can vary, the cash flows on
mortgage backed securities can be very
irregular.
Mortgage Backed Securities
• When a homeowner prepays, the remaining
stake of the holders of the mortgage backed
securities will be reduced by the same amount.
• Since the principal outstanding will reduce, the
interest income will also decrease.
• The monthly cash flow for a mortgage backed
security will be less than the monthly amount
paid by the mortgagors.
• The difference is equal to the servicing and
guaranteeing fees.
Categories of Pass-throughs
– Ginnie Maes
– Fannie Maes
– Freddie Macs
– Private Label
Features of Ginnie Maes
• They are backed by the full faith and credit
of the U.S. government.
• The underlying mortgage pools are
assembled by private parties, but are
approved by Ginnie Mae before sale to the
public.
• The U.S. Treasury guarantees interest
and principal payments on Ginnie Maes.
Freddie Mac
• Freddie Mac issues participation
certificates or PCs.
• These are not guaranteed by the
Treasury.
• FHLMC itself provides the guarantee.
• Consequently yields on Freddie Mac PCs
are higher than those on Ginnie Maes.
Fannie Maes
• These are similar to Freddie Mac PCs.
• The guarantee to holders is provided by FNMA
and not by the Treasury.
• Yields are higher than those on Ginnie Maes but
are comparable to the yields on Freddie Mac
PCs.
• Common perception is that the U.S. government
will never allow FNMA to default.
• Thus there is an implicit guarantee.
Private Label Pass-throughs
• These are issued by independent
organizations like commercial banks.
• They have no connection with the
government.
• Consequently the yields on them tend to
be higher.
Asset Backed Securities
• These are similar to mortgage backed
securities.
• But the assets which are pooled are not
home loans.
• Examples of such assets include credit
card receivables, automobile loan
receivables etc.

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 Distribution of the output

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 Why the focus on efficiency?

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 What kind of economic information?

 How best can the resultant output be distributed

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 Types of Economic Systems

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 Allocate resources in descending order of need

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 Central planner was supposed to be a

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 Optimal decision is the one that

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 Critical inputs for decision making - PRICES

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 If price is too high

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 In a world without markets our time and

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 Historically, the development of a unit of currency has

gone hand in hand with the evolution of markets.

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 Barter, or Countertrade when

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Everything could be Money gave you

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Government Sector Business Sector Household Sector

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Balanced Budget Units (BBU)

Surplus Budget Units (SBU)

Deficit Budget Units (DBU)

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 The Reserve Account