Financial Markets Mms

FINANCIAL MARKETS & INSTITUTIONS
INTRODUCTION TOFINANCIAL MARKETS

There are 3 major financial markets in the country: country: - Capital Markets Equity and Debt Market - Money Market Short Term lending - Government Securities Market Long Term lending. lending. However for efficient growth of any financial markets the regulation and control of banking sector in the economy is paramount. paramount.


BANKING DEREGULATION - Nationalisation of Banks in India Mrs Gandhi is credited with nationalisation of Banks in India in 1969. Following 14 banks were then nationalised: Central Bank of India Bank of Baroda Dena Bank Punjab National Bank Indian Bank Canara Bank Syndicate Bank Indian Overseas Bank Bank of Maharashtra Union Bank Allahabad Bank United Bank of India UCO Bank Bank of India


BANKING DEREGULATION - However, much before nationalisation of above banks, Imperial Bank of India was nationalised in July 1955 as State Bank of India (SBI) under the SBI Act of 1954. It was followed by 1954. nationalisation of seven State Banks (formed subsidiary) on 19th July 1960. The final phase of nationalisation of 19th 1960. Indian banks took place in the year 1980 when seven more banks were nationalised. By then, approximately nationalised. 80% of the banking segment in India was under 80% Government ownership and control. control. After almost full regulation of banks was achieved, deregulation of financial sector began in wake of aftermath of BOP crisis in 1990. Banking sector reforms 1990. were slow to come and are still way too short of targeted level. level.

BANKING DEREGULATION - It is said that primary purpose of nationalisation of Banks in India was to take the banking services to the villages since private banks, blinded by profitability motive, were unwilling to reach out to them. them. (It is difficult to say as to how much political expediency was hidden behind this apparently altruistic motive). motive). Nonetheless, after nationalisation of banks in India, the branches of public sector banks rose to approximately 800% and advances took a huge 800% jump by 11,000%. 11,000%

BANKING DEREGULATION Monetary Control over lending and deposit interest rates. rates. Geographical Control over decision to open new branches or close unprofitable branches in India and abroad. abroad. Price and Products Freedom to introduce new products and determine their pricing. pricing. In India most of the banks are in Public Sector where major share is owned by the Government. Besides, there Government. are Co-operative Banks, Gramin (Rural) Banks, Private Coand Foreign Banks. However, Indian Banking Sector is Banks. dramatically different from other systems in Government even though Government plays an important role in functioning of the Banks. Banks.

BANKING DEREGULATION Even though every countrys banking sector is regulated by its Central bank, it was felt that since movement of Capital doesnot have boundaries a mechanism needs to be put into place wherein there are common rules for its movement. Therefore the following came into movement. existence :BIS Bank for International Settlement. It does not have any authority over Settlement. Central Bank of any country. BIS is an international organisation which fosters country. international monetary and financial cooperation and serves as a Bank for Central Banks. Besides being the Bank of Central Banks, it is a kind of forum of Banks. Central Banks of all countries for discussions and policy analysis. analysis.
Over the time, banking was becoming global but lacked international banking norms. norms. International Banking Standards were recommended by Sir Peter Middleton. Middleton. They were :(a) Risk Based Capital Ensure adequate capital to take care of risk. risk. (b) Risk Based Supervision The intensity of supervision will vary in line with the risk associated. associated.

BANKING DEREGULATION (c) Market Discipline Exposure of risk on various counts is limited ie equity, debt and depositors. If risk is not depositors. managed properly, market will give it lower value. Also, value. market will expect high rate of return from bank which does not manage its risks adequately. Supervisors can adequately. use internal and external auditors of bank for risk management. management. (d) Credit Risk Risk due to non realisation of credit; credit; failure of debtor to repay (e) Market Risk Equity Price Risk, Liquidity risk, interest rate risks (increase in deposit interest rates after committing long term loan on low interest rate). rate). (f) Operating Risks Risks which arise from people, procedures, processes from different products. products.
OVERVIEW OF INDIAN MARKETS

The financial markets are of following types Short Term, Medium Term and Long Term Short Term Call or notice money Market eg- Overnight eginterbank lending. lending. Term Money Markets Medium Term Repo Market Other Money Markets

Repo Borrowings against govt securities, Interbank short term Commercial Paper Market Commercial Bills Market

Foreign Exchange Market Buying and Selling of Foreign Currencies Govt Securities Market Buy and sell govt securities for investment purpose. purpose. Equity Markets Debt Market

Financial Institutions can be grouped as follows :(a) Banks (b) Development Banks (c) Capital Market Related Institutions (d) Other non-banking financial companies (NBFC) noninclude HFCs, equipment leasing firms, Microfinance instituions Financial Institutions can also be grouped according to their area of operation

All India FIs State Level Institutions Other institutions

Examples of Various Kinds of Financial Institutions : Development Banks

IDBI Industrial Development Bank of India (1964) SIDBI Small Industries Development Bank of India (1990) IFCI Industrial Finance Corporation of India (1948) - Gives term loans for project finance

Specialised Finance Institutions

EXIM Bank Export and Import Financing. Provides working capital finance to export oriented units, guarantees and financing Indian JVs abroad IDBI Venture Capital Fund Financing new units which do not have access to market finance. ICICI Venture Capital Finance Tourism Finance Corporation of India IDFC Infrastructure Development Finance Corporation (1997)


Examples of Various Kinds of Financial Institutions : Investment Institutions

UTI Unit Trust of India (1964) LIC Life Insurance Corporation of India GIC General Insurance Corporation of India and its subsidiaries

Refinance Institutions - Institutions which provide finance to banks and lending institutions for specific purposes
NABARD National Bank for Agriculture and Rural Development NHB National Housing Bank

Other Institutions
ECGC Export Credit and Guarantee Corporation Provides guarantees for investments abroad. DIGC - Deposit Insurance and Credit Guarantee Corporation- As the Corporationname suggests, insures deposits taken by commercial banks.

FINANCIAL SYSTEM
There are two Financial Systems prevalent in the world today: today: - Bank Dominated Financial System Stage I In undeveloped countries - Market Dominated Financial System Stage III In developed countries. countries.

In between the two, there is a second stage which is a transitory stage between Stage I and III. This stage is often found in developing countries III. like ours who are in the process of transition from Bank Dominated to Market Dominated Financial System. System. When the equity market is fully evolved, industrialists raise finance from the market. market. However, in case the market is not fully developed, govt facilitates easy finance for industrial development through banks. banks. Market Dominated Financial System is prevalent in US and UK. Such system UK. is possible only in countries where Debt and Equity market has fully evolved. evolved. Therefore, Financial System in countries like Germany and Japan, which otherwise are well developed, have still got Bank Dominated System. Even System. though we have a well developed equity market we donot have a develpoed Debt market. market.

Non Banking Financial Companies (NBFCs)
Indian Banks were of the British mindset. They preferred to deal in mindset. short term advances. However, Industry needed long term advances. finance which Commercial Banks were not willing to provide. provide. Thus, various Development Institutions, like IFCI (Industrial Finance Corporation of India), SIDBI (Small Industries Development Bank of India) etc were born. These institutions born. were funded by the RBI and the Govt at concessional rate of interest. interest. Thus, the skewed interest rate policy, wherein long term loans were cheaper than short term loans emerged. emerged. However, it was felt prudent in order to give impetus to the industrial development of the country. country. In addition to the Govt and RBI financed development/finance institutions, some other private institutions like ICICI (later reverse merged with ICICI Bank) came up. up.

Roles and Functions of Commercial Banks
1. Intermediation Common public has money (though little sum with each one but very large collectively) but few safe avenues to invest. invest. Industrialists have investment avenues but not enough money. money. Banks work as intermediatory by collecting surplus funds from public and lending them on their behalf to the industry. But this industry. intermediation costs the investors money. Their return on the money. investment is lower than what they would have got by direct lending. lending. Risks in Direct Lending Adverse Selection Investor do not have full information about business and management of the company. Therefore, they can company. land up with unscrupulous companies. Banks, being in this companies. business, have wherewithal to analyse the companys performance and credentials before investing. investing. Moral Hazard Often companies call for funds citing one purpose and then divert those funds for other purposes. Banks are able purposes. to keep tab on utilisation of funds. funds.

Roles and Functions of Commercial Banks 2. Transformation of Funds Geographical Transformation Funds that are deposited with banks cross the boundaries of state and country. Thus, funds collected from country. Mumbai investors could be utilised by an industrialist in Manipur or Manhattan. Manhattan. Maturity Transformation Few investors are willing to invest funds for 10, 15 and 20 years needed by 10, the industry. Banks convert short term maturity industry. deposits by investors into long term sources of finance for industries by rotation of funds and investors. investors.

Roles and Functions of Commercial Banks 3. Payment Role Banks facilitate payment of cash from one centre to other. (In the yester years in Gujarat, and other. to a large extent even today, this role is performed in unorganised sector by people called Angadias. But these people Angadias. work more as diamond courier than money courier). courier). 4. Guarantor Role Banks often play the role of guarantor for providing payment guarantee for loan as well as performance guarantee. (We have often heard guarantee. of Bank Guarantee to be provided in contract documents). documents).

Roles and Functions of Commercial Banks 4. Agency Role Banks also act as Trusty in many cases like Debenture Trusty. Banks usually Trusty. have a separate Trust Dept for such functions. functions. 5. Thrift Role Banks provide services for saving by the community. community. 6. Policy Role Banks are the primary medium for implementing monetary and many other policies by the Government. Government.

Roles and Functions of Commercial Banks Functions
1. Credit (Lending) 2. Thrift or Saving Function 3. Investment Banks also invest money in various market instruments like Govt Bonds to maintain liquidity. The list of liquidity. instruments in which banks can invest is specified. specified. 4. Payments By Cable Transfers, Telegraphic Transfers etc 5. Cash Management for customers 6. Investment Banking or Underwriting Functions In USA this function was not allowed for a long time after Glass Steagall Act prohibited it in 1933. It has now been permitted, though through 1933. the subsidiary. subsidiary. 7. Brokerage Function Again permitted through subsidiary, like HDFC Securities, ICICI Direct. Direct. 8. Insurance Insurance Function is also allowed through subsidiary only. only.

Regulation and Supervision of Commercial Banks Why are the banks so heavily regulated?

deposits. Safety of Public Savings Banks are mobilisers of public deposits. Placing your hard earned money in some ones elses hand is matter of tremendous faith. This faith, once broken, can have faith. contagious effect. It can quickly spread to loss of faith in the effect. entire banking system and collapse of economy. We have seen economy. country wide run on ICICI bank in 2002. 2002. Credit Creation Capacity of Banks Financial Regulations also affect credit creation capacity of banks. banks. Impact on Money Supply Banks are primary tool of controlling money supply in the market and controlling inflation and interest rates. rates.

Regulation and Supervision of Commercial Banks Why are the banks so heavily regulated?

Fairness in Bank Dealings Avoid concentration of financial resources in hands of a few individuals Large amount of liquid cash in hands of private individuals can lead to market manipulation to the detriment of general public. Resources and Credit for Govt Govts extract discounted credit from banks by manipulating SLR (Statutory Liquidity Ratio Funds to be parked in Govt Securities, gold and cash). Provide Finance for Certain Special Sectors Through regulations, govt ensures credit flow for priority sectors like agriculture, exports, housing, Small Scale Industries etc.

Regulation and Supervision of Commercial Banks Classical Tools of Bank Regulations : Bank Rate The rate at which central bank lends to other commercial banks. Bank Rate is the rate at which central banks. bank of the country (in India it is RBI) allows finance to commercial banks. Bank Rate is a tool, which central banks. bank uses for short-term purposes. Any upward revision in shortpurposes. Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Prime Lending Rate. Rate. This any revision in the Bank rate indicates could mean more or less interest on your deposits and also an increase or decrease in your EMI. EMI. (Reverse of Bank Rate is Repo rate. Repo rate is the rate. rate which RBI pays to commercial banks for its borrowings from commercial banks (purpose is to

Regulation and Supervision of Commercial Banks Classical Tools of Bank Regulations : (purpose is to suck out liquidity in short term). Call term). rate is the overnight interbank lending rate resorted to meet liquidity). liquidity).

Open Market Operations Central banks control the money supply in the market by purchase and selling of govt and other similar securities. Sale of securities securities. leads to reduced funds in the market while purchases do the opposite. opposite.

Regulation and Supervision of Commercial Banks Classical Tools of Bank Regulations : What is CRR - CRR means Cash Reserve Ratio. Banks in Ratio. India are required to hold a certain proportion of their deposits in the form of cash. cash. However, actually Banks dont hold these as cash with themselves, but deposit such case with Reserve Bank of India (RBI) / currency chests, which is considered as equivalent to holding cash with themselves.. This minimum ratio (that is themselves.. the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus, When a banks deposits increase by Ratio. Rs100, Rs100, and if the cash reserve ratio is 9%, the banks will have to hold additional Rs 9 with RBI and Bank will be able to use only Rs 91 for investments and lending / credit

Regulation and Supervision of Commercial Banks Classical Tools of Bank Regulations : What is CRR - purpose. Therefore, higher the ratio (i.e. purpose. (i. CRR), the lower is the amount that banks will be able to use for lending and investment. This power of RBI to investment. reduce the lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is lend. a tool used by RBI to control liquidity in the banking system. system.

Regulation and Supervision of Commercial Banks What is SLR - Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The unsecurities. ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is 24%. (reduced (SLR). 24% w.e.f. 8/11/208, from earlier 25%) RBI is empowered to 11/208, 25% increase this ratio up to 40%. An increase in SLR also restrict 40% the banks leverage position to pump more money into the economy. economy. SLR stands for Statutory Liquidity Ratio. This term Ratio. is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of securities.

Regulation and Supervision of Commercial Banks Classical Tools of Bank Regulations : Reserves Various statutory reserves, like SLR, CRR (Cash Reserves Ratio percentage of deposits kept in cash and with RBI in order to satisfy withdrawal demands of customers), etc. customers), etc. Higher these reserves, lesser the money available for lending to the customers. There was a time in late customers. 1980s, 1980s, when available funds for commercial lending had fallen to just about 19% of resources generated 19% from deposits. deposits. Moral Suasion These are informal communications to commercial banks to do the bidding of central bank

Regulation and Supervision of Commercial Banks What are Repo rate and Reverse Repo rate? Repo (Repurchase) rate is the rate at which the RBI lends shotshot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate Reverse Repo rate is the rate at which banks park their shortshortterm excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the

Regulation and Supervision of Commercial Banks What are Repo rate and Reverse Repo rate? RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks

Regulatory Set up in India
Reserve Bank of India is the regulator of financial services industry in India. India. History The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Commission. Bank of India Act, 1934 (II of 1934) provides the statutory basis of the 1934) functioning of the Bank, which commenced operations on April 1, 1935. 1935. The Bank was constituted to :- Regulate the issue of banknotes - Maintain reserves with a view to securing monetary stability and - To operate the credit and currency system of the country to its advantage. advantage.

The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. debt.

Till 1949, RBI had only supervisory role and no regulatory powers. Banking Companies 1949, powers. Act was passed in 1949 which conferred various powers like licensing of banks, etc. In 1965, the Act was modified and also renamed as Banking etc. 1965, Regulation Act. Act. Some of the important sections of amended act are as follows: follows: Section 5(b) Defines banking business as acceptance of deposits from public repayable on demand or otherwise and withdrawable by cheque/draft/order or otherwise. otherwise. Section 6 Deals with other functions that banks can perform. perform. Section 8 Prohibits certain activities on part of banks like trading in goods or commodities. commodities. Section 11 Owned funds and capital Section 19 Formation of subsidiaries Section 20 Loans and advances restrictions. restrictions. Section 42(2) Cash Reserve Ratio (To be maintained between 3 15%). 42( 15%

Section 46 Punitive actions

CRR (Cash Reserve Ratio) CRR is percentage of funds which are kept in the form of cash in bank vaults and RBI to meet demand liabilities. Demand Liabilities/Deposits Are those which have to be met on demand/paid instantaneously like savings account and current account deposits. Time Liabilities/Deposits Are those which are not demand liabilities (Whose maturity date is known). SLR (Statutory Liquidity Ratio) Percentage of demand and time liabilities (in simple terms total deposits) which are to be kept in certain forms, like. In cash, or In gold valued at a price not exceeding the current market price, or In unencumbered approved securities valued at a price as specified by the RBI from time to time

CRR (Cash Reserve Ratio) CRR is percentage of funds which are kept in the form of cash in bank vaults and RBI to meet demand liabilities. Demand Liabilities/Deposits Are those which have to be met on demand/paid instantaneously like savings account and current account deposits. Time Liabilities/Deposits Are those which are not demand liabilities (Whose maturity date is known). SLR (Statutory Liquidity Ratio) Percentage of demand and time liabilities (in simple terms total deposits) which are to be kept in certain forms, like. In cash, or In gold valued at a price not exceeding the current market price, or In unencumbered approved securities valued at a price as specified by the RBI from time to time

Money Market borrowings are excluded from SLR calculations. calculations. Similarly, NRI deposits were excluded for calculating SLR requirement. Like stated earlier, there requirement. was a time when 67% of the funds generated from 67% deposits mobilisation were to be kept in SLR and CRR. CRR. Out of the remaining 33%, 40% were to be lent to 33% 40% priority sectors. Thus, only 19% of the funds were sectors. 19% available for market lending. The returns on SLR, CRR lending. and priority sector loans were quite low. Bad debts on low. priority sector loans were high. Thus, market rate of high. loans were considerably high touching almost 19-20%. 19-20%
MONEY MARKETS

Money Market - Money market means market where money or its
equivalent can be traded. Money is synonym of liquidity. Money traded. liquidity. market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better known as a place liquidity. where large institutions and government manage their short term cash needs. For generation of liquidity, short term borrowing and needs. lending is done by these financial institutions and dealers. Money dealers. Market is part of financial market where instruments with high liquidity and very short term maturities are traded. Due to highly traded. liquid nature of securities and their short term maturities, money market is treated as a safe place. Hence, money market is a market where place. short term obligations such as treasury bills, commercial papers and bankers acceptances are bought and sold. sold.
MONEY MARKETS
Benefits and functions of Money Market - Money markets exist to facilitate efficient transfer of shortshortterm funds between holders and borrowers of cash assets. assets. For the lender/investor, it provides a good return on their funds. funds. For the borrower, it enables rapid and relatively inexpensive acquisition of cash to cover short-term shortliabilities. liabilities. One of the primary functions of money market is to provide focal point for RBIs intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the economy. money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives. objectives.
MONEY MARKETS
Money Market & Capital Market - Money Market is a place for short term lending and borrowing, typically within a year. year. It deals in short term debt financing and investments. investments. On the other hand, Capital Market refers to stock market, which refers to trading in shares and bonds of companies on recognized stock exchanges. Individual players cannot invest exchanges. in money market as the value of investments is large, on the other hand, in capital market, anybody can make investments through a broker. Stock Market is associated with high risk broker. and high return as against money market which is more secure. secure. Further, in case of money market, deals are transacted on phone or through electronic systems as against capital market where trading is through recognized stock exchanges. exchanges.
MONEY MARKETS
Money Market Instruments - Investment in money market is done through money market instruments. Money market instruments. instrument meets short term requirements of the borrowers and provides liquidity to the lenders. Common Money Market lenders. Instruments are as follows: follows: Treasury Bills (T-Bills) - Treasury Bills, one of the safest money market instruments, are short term borrowing instruments of the Central Government of the Country issued through the Central Bank (RBI in India). They are zero risk instruments, India). and hence the returns are not so attractive. It is available both attractive. in primary market as well as secondary market. It is a promise market. to pay a said sum after a specified period. T-bills are shortperiod. shortterm securities that mature in one year or less from their issue date. date. They are issued with three-month, six-month threesix-
MONEY MARKETS
Money Market Instruments Treasury Bills (T-Bills) - They are issued with three-month, sixthreesixmonth and one-year maturity periods. The Central oneperiods. Government issues T- Bills at a price less than their face value (par value). They are issued with a promise to pay full face value). value on maturity. So, when the T-Bills mature, the maturity. government pays the holder its face value. The difference value. between the purchase price and the maturity value is the interest income earned by the purchaser of the instrument. Tinstrument. Bills are issued through a bidding process at auctions. auctions.
MONEY MARKETS
Money Market Instruments Treasury Bills (T-Bills) The bid can be prepared either (Tcompetitively or non-competitively. In the second type of non-competitively. bidding, return required is not specified and the one determined at the auction is received on maturity. Whereas, in maturity. case of competitive bidding, the return required on maturity is specified in the bid. At present, the Government of India bid. issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills issued 91182364-day. by State Governments. Treasury bills are available for a Governments. minimum amount of Rs.25K and in its Rs.25K multiples. multiples. While 91-day T-bills are auctioned every week on 91-
MONEY MARKETS
Money Market Instruments Treasury Bills (T-Bills) While 91-day T-bills are auctioned (T91every week on Wednesdays, 182-day and 364-day T-bills are 182364auctioned every alternate week on Wednesdays. The Reserve Wednesdays. Bank of India issues a quarterly calendar of T-bill auctions which is available at the Banks website. It also announces the website. exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. auction. RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking terms, supply. this is called Reverse Repurchase (Reverse Repo). On the Repo). other hand, when RBI purchases back these instruments at a specified date mentioned at the time of transaction, liquidity is infused in the market. This is called Repo (Repurchase) market.
MONEY MARKETS
Money Market Instruments (Taken from RBI website) Date : 13 Jul 2011 Reserve Money for the week ended July 8, 2011 and Money Supply for the fortnight ended July 1, 2011 - With a view to providing quicker information, the Reserve Bank of India has decided to disseminate the data relating to Reserve Money on every Wednesday and data relating to Money Supply (M3) on every alternate Wednesday, or the following working day in case of a holiday, through a press release. These data were earlier being released first through the Weekly Statistical Supplement on Friday. The data dissemination through other sources viz. Weekly Statistical Supplement, viz. Monthly Bulletin and Real-Time Handbook of Statistics of the RealIndian Economy (http://dbie.rbi.org.in) would continue. (http://dbie.rbi.org.in)
MONEY MARKETS
Money Market Instruments Repurchase Agreements: Repurchase transactions, called Agreements: Repo or Reverse Repo are transactions or short term loans in which two parties agree to sell and repurchase the same security. security. They are usually used for overnight borrowing. borrowing. Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved securities viz. viz. GOI Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under repurchase agreement the seller sells etc. specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the price. buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. price.
MONEY MARKETS
Money Market Instruments Commercial Paper: Commercial paper is a low-cost Paper: lowalternative to bank loans. It is a short term unsecured loans. promissory note issued by Corporates and financial institutions at a discounted value on face value. They are value. usually issued with fixed maturity between one to 365 days and for financing of accounts receivables, inventories and meeting short term liabilities. Say, for example, a company has liabilities. receivables of Rs 1 lacs with credit period 6 months. It will not months. be able to liquidate its receivables before 6 months. The months. company is in need of funds. It can issue commercial papers funds. in form of unsecured promissory notes at discount of 10% on 10% face value of Rs 1 lacs to be matured after 6 months. The months. company has strong credit rating and finds buyers easily. The easily.
MONEY MARKETS
Money Market Instruments Commercial Paper: The company is able to liquidate its Paper: receivables immediately and the buyer is able to earn interest of Rs 10K over a period of 6 months. They yield higher 10K months. returns as compared to T-Bills as they are less secure in comparison to these bills; however chances of default are bills; almost negligible but are not zero risk instruments. instruments. Commercial paper being an instrument not backed by any collateral, only firms with high quality credit ratings will find buyers easily without offering any substantial discounts. They discounts. are issued by corporates to impart flexibility in raising working capital resources at market determined rates. Commercial rates. Papers are actively traded in the secondary market since they are issued in the form of promissory notes and are freely
MONEY MARKETS
Money Market Instruments Certificate of Deposit - It is a short term borrowing more like a bank term deposit account. It is a promissory note issued by account. a bank in form of a certificate entitling the bearer to receive interest. interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any denomination. value. denomination. They are stamped and transferred by endorsement. Its term endorsement. generally ranges from three months to five years and restricts the holders to withdraw funds on demand. However, on demand. payment of certain penalty the money can be withdrawn on demand also. The returns on certificate of deposits are higher also. than T-Bills because it assumes higher level of risk. While risk. buying Certificate of Deposit, return method should be seen. seen. Returns can be based on Annual Percentage Yield (APY) or
MONEY MARKETS
Money Market Instruments Certificate of Deposit - or Annual Percentage Rate (APR). In (APR). APY, interest earned is based on compounded interest calculation. calculation. However, in APR method, simple interest calculation is done to generate the return. Accordingly, if the return. interest is paid annually, equal return is generated by both APY and APR methods. However, if interest is paid more methods. than once in a year, it is beneficial to opt APY over APR. APR.
MONEY MARKETS
Money Market Instruments Bankers Acceptance - It is a short term credit investment created by a non financial firm and guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a payment. person and accepted by a bank. It is a buyers promise to pay bank. to the seller a certain specified amount at certain date. The date. same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral. The person drawing the bill collateral. must have a good credit rating otherwise the Bankers Acceptance will not be tradable. The most common term for tradable. these instruments is 90 days. However, they can very from 30 days. days to180 days. For corporations, it acts as a negotiable time to180 days. draft for financing imports, exports and other transactions in goods and is highly useful when the credit worthiness of the
MONEY MARKETS
Money Market Instruments Bankers Acceptance - foreign trade party is unknown. The unknown. seller need not hold it until maturity and can sell off the same in secondary market at discount from the face value to liquidate its receivables. receivables.
CAPITAL MARKETS

Capital Marketing is defined as the process of increasing the major part of financial capital required for starting a business through issue of shares to public. The issue may be Shares, public. Debentures , Bonds, etc. etc. Capital market is a market for long term debts and equity shares. A shares. capital market is simply any market where a government or a company can raise money (capital) to fund their operations and long term investment. Selling bonds and selling stock are two ways investment. to generate capital. The instruments used for this long-term capital. long-
financing are equity instruments, insurance instruments and derivative instruments .
CAPITAL MARKETS

Why Capital Markets Exist

- Capital markets facilitate the transfer of capital (i.e. financial) (i. assets from one owner to another. another. - They provide liquidity. liquidity. - Liquidity refers to how easily an asset can be transferred without loss of value
CAPITAL MARKETS

Importance of Capital Markets

Pooling the capital resources and Developing enterprises investors Solve the problem of paucity of funds Mobilize the small and scattered savings Augment the availability of investible funds Growth of joint stock business Provide a number of profitable investment opportunities for a small savers. savers.
CAPITAL MARKETS
Depository
A depository is like a bank wherein the deposits are securities (viz. shares, debentures, bonds, government securities, units etc.) in electronic form. There are two types of Depositories in our country NSDL CDSL
CAPITAL MARKETS
NSDL is promoted by Industrial Development Bank of India Limited (IDBI) - the largest development bank of India, Unit Trust of India (UTI) - the largest mutual fund in India and National Stock Exchange of India Limited (NSE) - the largest stock exchange in India NDSL FIGURES: FIGURES: Number of certificates eliminated (Approx.) : 619 Crore. (Approx. Crore. NSDL has crossed more than one Crore demat account. account. Number of companies in which more than 75% shares are 75% dematted : 4250 Presence of demat account holders in the country : 79% of all pin 79% codes in the country
CAPITAL MARKETS
NSDL aims at ensuring the safety and soundness of Indian marketplaces by developing settlement solutions that increase efficiency, minimise risk and reduce costs. costs. In the depository system, securities are held in depository accounts, which is more or less similar to holding funds in bank accounts. accounts. Transfer of ownership of securities is done through simple account transfers. This method does away with all the risks transfers. and hassles normally associated with paperwork. paperwork. Consequently, the cost of transacting in a depository environment is considerably lower as compared to transacting in certificates Promoters / Shareholders
CAPITAL MARKETS

CDSL CDSL was set up with the objective of providing convenient, dependable and secure depository services at affordable cost to all market participants. participants. Some of the important milestones of CDSL system are: are: CDSL received the certificate of commencement of business from SEBI in February, 1999. 1999. Honorable Former Union Finance Minister, Shri Yashwant Sinha flagged off the operations of CDSL on July 15, 1999. 15, 1999. All leading stock exchanges like the National Stock Exchange, Calcutta Stock Exchange, Delhi Stock Exchange, The Stock Exchange, Ahmadabad, etc have established connectivity with CDSL. CDSL.
CAPITAL MARKETS

CDSL At the end of Dec 2009, over 6500 issuers have admitted their 2009, securities (equities, bonds, debentures, commercial papers), units of mutual funds, certificate of deposits etc. into the etc. CDSL system. system. CDSL was promoted by Bombay Stock Exchange Limited (BSE) jointly with leading banks such as State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank, Union Bank of India and Centurion Bank. Bank.
CAPITAL MARKETS
Investment bankers operate in Capital Markets. They help in floating Markets. the new issues. Capital Markets have been in existence for a long issues. time. time. However, prior to 1960, there were not many new issues. 1960, issues. 1970s 1970s saw a large number of public issues by private companies primarily due to reason that companies having large share holding by foreign companies needed to dilute it as per new regulation. regulation. That started a new chapter in Financial Markets in the form of Merchant Banking and SBI took the lead in offering this service. service. Equity market has two segments. Primary Market and Secondary segments. Market. Market. While primary market provides finance for the companies, secondary markets provide the liquidity which is a pre-requisite for prepeople to invest in primary market. (Thus, even though secondary markets market. are as speculative a place as Mahalakshmi Race Course and serve no direct purpose in providing capital for industrial development, yet they serve a very vital purpose). purpose).
CAPITAL MARKETS
Capital Markets
Primary Markets Secondary Markets Bonus Issue Stock Market
Public Issue
Right Issue
Private placement
CAPITAL MARKETS

In Primary Market, Securities are offered to the public for subscription, for the purpose of raising the capital or funds. funds. The issue of securities in the primary market is subjected to fulfillment of a number of pre-issue guidelines by SEBI and compliance to various preprovision of the Company Act. Act. An unlisted issuer making a public issue i.e. (making an IPO) is required to satisfy the following provisions: provisions: The Issuer Company shall meet the following requirements: requirements: (a) Net Tangible Assets of at least Rs. 3 crores in each of the preceding Rs. three full years. years. (b) Distributable profits in at least three of the immediately preceding five years. years. (c) Net worth of at least Rs. 1 Crore in each of the preceding three full Rs. years. years.
CAPITAL MARKETS

(d) If the company has changed its name within the last one year, atleast 50% revenue for the preceding 1 year should be from the activity 50% suggested by the new name. name. (e) The issue size does not exceed 5 times the pre issue net worth as per the audited balance sheet of the last financial year
CAPITAL MARKETS
PUBLIC ISSUE :It involves raising of funds directly from the public and get themselves listed on the stock exchange In case of new companies, the face value of the securities is issue at par and in the case of existing companies, the face value of securities are issued at premium Initial public offer (IPO): When an unlisted company makes either a fresh (IPO): issue of securities or offers its existing securities for sale or both for the first time to the public, it is called an IPO. This paves way for listing and IPO. trading of the issuers securities in the Stock Exchanges. Exchanges. Further public offer (FPO): When an already listed company makes either a (FPO): fresh issue of securities to the public or an offer for sale to the public, it is called a FPO. FPO.
CAPITAL MARKETS
RIGHT ISSUE:ISSUE: Right issue is the method of raising additional finance from existing members by offering securities to them on pro rata bases. bases. The rights offer should be kept open for a certain minimum and should be announced within one month of the closure of books. books. BONUS ISSUE:ISSUE: Companies distribute profits to existing shareholders by way of fully paid bonus share in lieu of dividend. dividend. These are issued in the ratio of existing shares held. held. The shareholders do not have to make any additional payment for these shares PRIVATE PLACEMENT: PLACEMENT: Private Placement is an issue of shares by a company to a select group of persons under the Section 81 of the companies act 1956. It is a faster 1956. way for a company to raise equity capital. capital.
CAPITAL MARKETS

Preference shares: shares: These shareholder do not have voting rights. rights. Owners of these shares are entitled to a fixed dividend or a dividend calculated at a fixed rate to be paid regularly before any dividend can be paid in respect of equity shares. shares. These shareholders also enjoy priority over the equity shareholders in the payment of surplus. surplus. Cumulative Preference Shares: Shares: This is a type of preference shares on which dividend accumulates if it remains unpaid. unpaid. Cumulative Convertible Preference Shares: Shares: This is a type of preference shares on where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be paid. converted into equity capital of the company. company.
CAPITAL MARKETS

Participating Preference Shares: Shares: This refers to the right of certain preference shareholders to participate in profits, after a specified fixed dividend contracted for is paid. paid. Debentures: Debentures: Debentures are bonds issued by a company bearing a fixed rate of interest usually payable half-yearly, on specific dates and the principal halfamount repayable on a particular date on redemption of the debentures. debentures. Debentures are normally secured against the asset of the company in favour of the debenture holder. holder.
CAPITAL MARKETS
The various type of bonds are as follows: follows: Coupon Bonds: Bonds: These are normal bonds on which the issuer pays the investor interest at the predetermined rate at agreed intervals, normally twice a year. year. Zero Coupon Bonds: Bonds: A bond issued at a discount and repaid at a face value is called as Zero coupon bonds. No periodic interest is paid in this case. bonds. case. Convertible Bond: Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price is referred to as a Convertible Bond. Eg - FCCB Bond. Treasury Bills: Bills: These are short term bearer discount security, issued by the Government as a means of meeting its cash requirements. requirements.
CAPITAL MARKETS

Securities Transaction Tax(STT) - Securities Transaction Tax is a tax Tax(STT) being levied on all transaction done on the stock exchanges at rates prescribed by the central government from time to time. time. Rolling Settlement - In Rolling Settlement, trades executed during the day are settled, based on the Net obligations for the day. Presently the day. trade pertaining to the rolling settlement are settled on a T+2 day basis , T+2 where T stands for the trade day. day. PayPay- in Day and Pay-out Day - Pay-in day is the day when the brokers PayPaymake payments or delivery of securities to the exchange. exchange. PayPay-out day is the day when the exchange makes payment or delivery of securities to the broker. broker. Settlement cycle is on a T+2 rolling settlement basis. T+2 basis.
CAPITAL MARKETS
Settlement Cycle of Normal Settlement
CAPITAL MARKETS
To list on the stock markets following is essential :- Obtaining approval of SEBI (erstwhile Controller of Capital Issues)

Fulfil listing requirements Appointment of Collecting Bankers (Where you deposit your application and money), underwriters, brokers, etc. money), Decide pattern of advertisement, publicity and marketing. Monitor daily reports about the collections. Finalising basis of allotment in consultation with SEBI.
CAPITAL MARKETS

History of Deregulation Efforts
In 1991, a committee to suggest reforms in Banking Sector was 1991, appointed which came to be known as Narasimham Committee on Banking Sector Reforms. (Subsequently in 1998 Reforms another committee under the chairman of same Mr Narsimhnan was constituted to draw further roadmap for reforms) Reforms in non financial sector had already been initiated by Mr Rajeev Gandhi in 1984. But it was realised that Real Sector reforms 1984. could not succeed without reforms in the financial sector. sector. How could a producer, with cost of finance exceeding 161617%, compete with foreign manufacturers whose cost of 17% funds was just 2-3%?
CAPITAL MARKETS

History of Deregulation Efforts

Prior to Narasimham Committee, a Banking Commission was set up in 1969 to suggest reforms in Banking Sector. There Sector. was a clamour for nationalisation of banks at that time. This time. committee was set up essentially to find ways and means of achieving the growth objectives (social banking lending to priority sectors and marginalised sections of society at less than commercial rates) without nationalisation. However, report got junked after nationalisation. banks were nationalised in a hurry by Mrs Gandhi. Gandhi. Narasimham Committee Report had a very broad sweep and was comprehensive. It covered the issues in great details and comprehensive. covered Non Banking Finance Companies as well. Following well. issues were covered in the report: report:
CAPITAL MARKETS

Issues covered in Narsimhan Committee report -Committees approach to financial sector reforms. reforms. Two decades of progress in Financial Sector (after 1969) 1969) Major issues in financial sector Directed investments (SLR and CRR) and credit (Priority Sector lending) and regulated interest rates. rates. Capital Adequacy, Accounting policies and other related matters to ensure that deregulation does not lead to unregulation. unregulation. Structural organisation of Banks. Banks. Development Financial Institutions Other money and capital market institutions Regulation and supervision of financial sector. sector. Legislative Measures. Measures.
CAPITAL MARKETS

Committees Approach to Financial Sector Reforms - The committee approached the issue with the premise that it is just not enough to remove the negative features currently ailing the system; but there is also a need to look behind those features to understand the underlying reasons. Then prevalent policies had induced rigidity in functioning of banks. Every function in the banks, including internal management, was being regulated and administered from outside under specified norms with political interference at all levels being order of the day.
CAPITAL MARKETS

Two Decades of Progress in Financial Sector - The primary objective of Nationalisation of Banks were: were: Branch Expansion Credit growth in rural areas. areas. Deposit mobilisation Committee noted that each of the above objectives set out for nationalisation of banks were adequately met. There was approx met. 800% 800% growth in branch expansion and credit disbursement in rural areas. areas. Even deposit mobilisation had a 300% growth in GDP 300% percentage terms in the period (from 13% of GDP to 38% in 13% 38% 1970) 1970). But committee went beyond the obvious. Growth and fulfilment obvious. of objectives was there alright. But at what cost did it come? alright.
CAPITAL MARKETS

Decline in Profits of the Banks - Profits of all the banks had declined since nationalisation. However, Committee also nationalisation. noted that this phenomenon of decline in profits was not exclusive to India. There was worldwide decline in profitability India. of the banks. In fact, decline worldwide was on an average banks. higher than in India. India. SLR, which was supposed to be a prudential measure to ensure liquidity of banks, became a tool for low cost borrowings for the govt. govt. Directed lending at highly subsidised rate to the priority sector was another reason for reduced profitability. profitability. Political influence in lending decisions led to higher incidences of bad debts and NPAs. NPAs.
CAPITAL MARKETS

Cross Subsidy Low cost funds to priority sector and to NBFCs (from SLR pool) were cross subsidised by charging higher rate of interests from other borrowers. As indicated borrowers. earlier, available resources for commercial lending were rendered to approx 19% of the deposits. Thus, lending rates 19% deposits. to even best rated borrowers had risen to 16-17% which 16-17% affected price competitiveness of Indian manufactured goods in international market.Political influence in lending decisions market. led to higher incidences of bad debts and NPAs. NPAs.
CAPITAL MARKETS

House Keeping House Keeping refers to periodical balancing of accounts by the banks. As a rule, saving bank accounts are banks. balanced once in month and current accounts are balanced once in a week with journal entries. Reports are rendered to entries. Head Office and RBI. This process was greatly affected RBI. leading to high deficit in both accounts. Quick expansion of accounts. branches and lending, especially in rural areas and among the marginalised section of the society, led to explosion of small accounts, both deposit as well as loan accounts which increased the work enormously. enormously.
CAPITAL MARKETS

Capital Adequacy Norms Prior to 1988, there were no capital 1988, adequacy norms being followed any where in the world. It world. started with Basle Committee Report on International Convergence of Capital Measurement and Capital Standards published in July Standards 1988. 1988. The framework suggested a flat minimum of eight percent capital to risk-weighted assets ratio which includes riskboth on and off balance-sheet items. Argument in India was balanceitems. that there was no need for this solvency based measure for government owned banks since govt can not default on domestic loans (Govt can ask central bank to print as much currency as required to meet the payment requirement. However, such action will requirement. lead to higher inflation and effective devaluation of money.) money.
CAPITAL MARKETS

But international community refused to buy this argument. argument. NonNon-adherence to international capital adequacy norms led to severe erosion in confidence in Indian banks. Indian banks. corporates could not raise foreign currency loans despite Indian banks guarantees. And when they could, it came at a guarantees. steep premium of approx 3% over the LIBOR. Committee LIBOR. recommended maintenance of Capital Adequacy Standards to restore international communitys confidence in Indian banking system. However, health of Indian banks was not system. good enough to implement this suggestion in one go. Other go. option was that the govt provides banks with capital. But capital. financial position of the govt as it was then (Struggling with BOP crisis and drawing approx 1,00,000 crores per annum as loans from 00, domestic market) precluded even this option. option.
CAPITAL MARKETS
Committee recommended maintenance of Capital Adequacy Standards to restore international communitys confidence in Indian banking system. However, health of Indian banks was not good enough to implement this suggestion in one go. Other option was that the govt provides banks with capital. But financial position of the govt as it was then (Struggling with BOP crisis and drawing approx 1,00,000 crores per annum as loans from domestic market) precluded even this option.
Capital Adequacy norms were reviewed by Bank of International Settlements in 1991 to align it with risks faced by the individual bank rather than a flat percentage of advances.
CAPITAL MARKETS
IRAC Norms (Income Regulation and Asset Classification Norms) Old Asset Classification Norms (Health Code System) It was introduced in 1985 and attempted to classify the quality or health of individual advances through classification in eight categories; 1. Satisfactory, 2. Irregular, 3. Sick-viable, 4. Sick-non viable, 5. Sticky, advances recalled, 6. Suit file accounts, 7. Decreed debts, 8. Bad and doubtful debts. NPA - An asset is considered non-performing in case of interest or instalments of principal or both remaining unpaid for more than two quarters. Committee recommended that banks follow the much simpler four fold classification system being practiced worldwide: Standard Assets Assets where all payments, principal and interest, are being received timely.
CAPITAL MARKETS
IRAC Norms (Income Regulation and Asset Classification Norms) Sub Standard Assets Assets which have some weaknesses like payments getting delayed occasionally. An advance is to be classified as substandard if it remains NPA up to a period of two years .

Doubtful Assets If it remains NPA for more than two years Or portion of loan is not covered by collaterals due to fall in the value of collateral over time Loss Assets An account will be classified as loss without any waiting period, where dues are considered uncollectible or only marginally collectable for any reason. These assets are to be provided for or are to be written off from the balance sheet. Banks are required to make provision against the NPAs @ 100 per cent for loss assets.
CAPITAL MARKETS

Structural Organisation Committee made following recommendations: - Constitution of Board of Directors It said that directors should be of sufficient seniority against then prevalent practice of placing people even of Under Secretary Rank (Junior most in IAS hierarchy) in Board of Directors of Associated Banks of SBI. - Longer Tenure for Directors It also recommended longer tenures of 5 years for Directors. - Separating Role of Chairman and Managing Director CMD post to be abolished and instead separate Chairman and Managing Directors to be appointed.
CAPITAL MARKETS
- Structural Organisation Committee made following recommendations: - Executive Directors Increasing number of executive directors to two from existing one. This recommendation has been just accepted (after a gap of 15 years!!!). years!!!).
INTEREST RATES
Nominal & Real Interest Rates. Rates. Nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without rate); adjustment for the full effect of compounding. (also compounding. referred to as the nominal annual rate). Eg You invest rate). Rs 1000 in a bank at 10% interest. You will get Rs 1100 at 10% interest. the end of the year. However what that Rs 1100 will buy year. is not known as inflation may be over 10%. Several 10% indices track the level of prices. The best known are CPI prices. and WPI. The change in CPI determines the change in WPI. inflation from one year to the next year. The real cash year. flow differs from the nominal cash flow. Suppose the rate flow. of inflation is 5% then at the end of the year then each
INTEREST RATES

Nominal & Real Interest Rates. Goods worth 5% less Rates. ie it will buy goods worth Rs 1,047/- only. The nominal 047/ only. payoff is Rs 1100 but the real payoff is Rs 1,047/-. If the 047/ lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net equal. benefit from such a loan because inflation fully diminishes the value of the loan's profit. The relationship between real and profit. nominal interest rates can be described in the equation: equation: (1 + r) (1 + i) = (1 + R) where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate. rate.
INTEREST RATES
Nominal & Real Interest Rates. In this analysis, the Rates. nominal rate is the stated rate and the real interest rate is the interest after the expected losses due to inflation. Since the inflation. future inflation rate can only be estimated, real interest rates may be different; the premium paid to actual inflation may be different; higher or lower. In contrast, the nominal interest rate is lower. known in advance. advance. The general formula for converting nominal cash flows at a future period t to real cash flow is Real CF = Nominal CF/ (1 + inflation rate)^t

INTEREST RATES

Nominal & Real Interest Rates. Eg If you were to Rates. invest Rs 1,000 for 20 yrs at 10% your future nominal 10% payoff would be Rs 6737. However, with an inflation of 6737. 6% the real value of payoff would be 6737/1.06^20 = Rs 6737/ 06^ 2100. 2100. The inflation rate will not be known in advance. People advance. often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The errors. real interest rate ex-post may turn out to be quite different exfrom the real interest rate that was expected in advance. advance. Borrowers hope to repay in cheaper money in the future, while lenders hope to collect on more expensive money. money. When inflation and currency risks are underestimated by lenders, then they will suffer a net reduction in buying power. power.
INTEREST RATES

Nominal & Real Interest Rates. The complexity increases Rates. for bonds issued for a long term, where the average inflation rate over the term of the loan may be subject to a great deal of uncertainty. uncertainty. In response to this, many governments have issued real return bonds (also known as inflation indexed), in which the principle value and coupon rises each year with the rate of inflation, with the result that the interest rate on the bond is a real interest rate. In the US, Treasury Inflation rate. Protected securities (TIPS)) are issued by the US Treasury. (TIPS)) Treasury. The expected real interest rate can vary considerably from year to year. The real interest rate on short term loans is strongly year. influenced by the monetary policy of Central banks. The real banks. interest rate on longer term bonds tends to be more market driven, and in recent decades, with globalized financial
INTEREST RATES

Nominal & Real Interest Rates. markets, the real interest Rates. rates in the industrialized countries have become increasingly correlated. correlated. Real interest rates have been low by historical standards since 2000, due to a combination of factors, 2000, including relatively weak demand for loans by corporations, plus strong savings in newly industrializing countries in Asia. Asia. The latter has offset the large borrowing demands by the US Federal Government which might otherwise have put more upward pressure on real interest rates. rates. Related is the concept of "risk return", which is the rate of return minus the risks as measured against the safest (least(leastrisky) investment available. Thus if a loan is made at 15% with available. 15% an inflation rate of 5% and 10% in risks associated with 10% default or problems repaying, then the "risk adjusted" rate of
INTEREST RATES

Nominal & Real Interest Rates. return on the investment Rates. is 0%. Economic Decisions influencing Interest Rates. Rates. Economics relies on measurable variables, chiefly price and objectively measurable production. Since production is "real", production. while prices are relative to the general price level, in order to compare an economy at two points in time, nominal price variables must be converted into "real" variables. For example, variables. the number of people on payrolls represents a "real" variable, as does the number of hours worked. But in order to measure worked. productivity, the nominal prices of the goods and services that labor produces must be converted to the "real" purchasing power. power. To do this requires adjusting prices for inflation. inflation.
INTEREST RATES
Economic Decisions influencing Interest Rates. Rates. The same is true of investment. Investment produces real investment. gains in efficiency and purchases productive capacity factories, machines and so on - which is also real. To find the real. return on this capital, it is necessary to subtract the increases in its nominal value that are the result of increases in the general level of prices. To do this means subtracting the prices. inflation rate from the nominal rate of return. For example, a return. portfolio of stocks that returns 10%, when inflation is running 10% at 4% has a 6% real rate of return. return. The real interest rate is used in various economic theories to flight, explain such phenomena as the Capital flight, business cycle and economic bubbles. When the real rate of interest is high, bubbles.
INTEREST RATES
Economic Decisions influencing Interest Rates. Rates. that is demand for credit is high, then money will, all other things being equal, move from consumption to savings. savings. Conversely, when the real rate of interest is low, demand will move from savings to consumption. Different economic consumption. theories have had different explanations of the effect of rising and falling real interest rates. Thus, international capital moves rates. to markets that offer higher real rates of interest from markets that offer low or negative real rates of interest triggering speculation in equities, estates, commodities and exchange rates. rates.
INTEREST RATES
Economic Decisions influencing Interest Rates. Rates. Capital flight, occurs when assets and/or money rapidly flow flight, out of a country, due to an economic event (such as an increase in taxes on capital and/or capital holders or the government of the country defaulting on its debt) and that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength. This leads to a disappearance of wealth strength. and is usually accompanied by a sharp drop in the exchange rate of the affected country (depreciation in a variable exchange rate regime, or a forced devaluation in a fixed exchange rate regime). regime). This fall is particularly damaging when the capital belongs to the people of the affected country, because not only are the
INTEREST RATES
Economic Decisions influencing Interest - citizens now burdened by the loss of faith in the economy and devaluation of their currency, but probably also their assets have lost much of their nominal value. This leads to dramatic decreases value. in the purchasing power of the country's assets and makes it increasingly expensive to import goods. goods. In the SE Asian crisis, the International Monetary Fund (IMF) estimated that capital flight amounted to roughly half of the outstanding foreign debt of the most heavily indebted countries of the world. world. Capital flight was seen in some Asian and Latin American markets in the 1990s. The Argentine economic crisis of 2001 1990s
INTEREST RATES
Economic Decisions influencing Interest Rates. Rates. Capital flight - was in part the result of massive capital flight, induced by fears that Argentina would default on its external debt (the situation was made worse by the fact that Argentina had an artificially low fixed exchange rate). This was also seen rate). in Venezuela in the early 1980s with one year's total export 1980s income leaving through illegal capital flight. flight. In the last quarter of the 20th century, capital flight was 20th observed from countries that offer low or negative real interest rate (like Japan, Russia and Argentina) to countries that offer higher real interest rate (like China). China). A 2010 article in The Washington Post gave several examples of private capital leaving France in response to the countrys
INTEREST RATES
Economic Decisions influencing Interest Rates. Rates. Capital flight - changed wealth tax rules. The article stated rules. that it was estimated that the wealth tax earned the government about $2.6 billion a year but had cost the country more than $125 billion in capital flight since 1998. 1998. A 2011 paper published by Global Financial Integrity estimated capital flight, also called illicit financial flows to be "out of developing countries are some $850 billion to $1 trillion a year." year. Capital also flows out of states was seen in Punjab during militancy and also in states like Bengal & Kerala after the Communist took over. over.
Interest Rate Risk Management

Introduction Due to the very nature of its business, a bank should accept interest rate risk not by chance but by choice. And when the choice. bank has to take risk as a choice, then it should ensure that the risk taken is firstly manageable and secondly it does not get transformed into any other undesirable risk. As stated earlier, risk. the focal point in managing any risk will be to understand the nature of the risk. This is especially essential for interest rate risk. risk management. Interest rate risk is the gain/loss that arises management. due to sensitivity of the interest income/interest expenditure or values of assets/liabilities to the interest rate fluctuations

Types of Interest Rate Risks The sensitivity to interest rate fluctuations will arise due to the mixed effect of a host of other risks that comprise the interest rate risk. These risks when segregated fall into the following risk. categories: categories: Rate Level Risk: During a given period there is possibility Risk: for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention. This intervention. phenomenon will, in the long run, affect decisions regarding the type and the mix of assets/liabilities to be maintained and their maturing periods

Types of Interest Rate Risks Volatility Risk: In addition to the long run implications of Risk: the interest rate changes, there are short-term fluctuations shortwhich are to be considered in deciding on the mix of the assets and liabilities, the pricing policies and thereby the business volumes. However, the risk will acquire serious volumes. proportions in a highly volatile market when the impact will be felt on the cash flows and profits. The 2006 volatility profits. witnessed in the Indian money markets explains the presence and the impact of the volatility risk. The interest rates in the risk. money markets, which generally hovered at around 5-7 percent, zoomed to higher rates, within a couple of weeks during September, 2006. While some banks 2006.

Types of Interest Rate Risks Volatility Risk: defaulted in maintenance of CRR, many Risk: banks borrowed funds at high rates which had substantially reduced their profits. Thus, it can be seen that the effect of profits. fluctuations in the short-term have a greater impact since the shortadjusting period is very short. short. Prepayment Risk: The fluctuations in interest rates may Risk: sometimes lead to prepayment of loans. For instance, in a loans. situation where the interest rates are declining, any cash inflows that arise due to prepayment of loans will have to be redeployed at a lower rate invariably resulting in lowered yields. yields.

Types of Interest Rate Risks Call/Put Risk: Sometimes when funds are raised by the issue Risk: of bonds/securities, they may include call/put options. A call options. option is exercised by an issuer to redeem the bonds before maturity, while the put option is exercised by the investor to seek redemption before maturity. These two options expose maturity. the investor to a risk when the interest rates fluctuate. A call fluctuate. option is generally exercised in a declining interest rate scenario. scenario. This will affect the bank if it invests in such bonds since the intermediate cash inflows will have to be reinvested at a lower rate. Similarly, when the investor exercises the put rate. option in an increasing interest rate scenario, the bank, which issues the bonds, will have to face greater replacement costs. costs.

Types of Interest Rate Risks Reinvestment Risk: This risk can be associated with the Risk: intermediate cash flows arising due to the payment of interest, installment on loans, etc. These intermediate cash inflows etc. arising from a security/loan are usually reinvested and the income from such reinvestment will depend on the prevailing interest rate at the time of the reinvestment and the reinvestment strategy. Due to the volatility in the interest strategy. rates, these intermediate cash flows when received may have to be reinvested at lower rates resulting in lower yields. This yields. variability in the returns from reinvestment due to changes in the interest rates is called the reinvestment risk. risk.

Types of Interest Rate Risks Real Interest Rate Risk: Yet another dimension of the interest Risk: rate risk is the inflation factor, which has to be considered in order to assess the real interest cost/yields. This occurs cost/yields. because the changes in the nominal interest rates may not match with the changes in inflation. inflation. The presence of the above mentioned risks will either individually or collectively result in interest rate risk. These risk. risks will affect the income/expenses of the bank's asset/liability portfolio. This, further, will also have an impact portfolio. on the value of the assets and liabilities of the bank, thereby affecting even the market value of the bank


Interest Rate Risk Management Mere identification of the presence of the interest rate risk will not suffice. A system that quantifies the risk and manages the suffice. same should be put in place so that timely action can be taken. taken. Any delay or lag in the follow up action may lead to a change in the dimension of the risk i.e. lead to some other risks like credit risk, liquidity risk, etc. and make the situation etc. uncontrollable. uncontrollable. Initiating the risk exposure control process requires classification of all assets and liabilities based on their rate sensitivity. sensitivity. For this classification, a bank should first be able to forecast the interest rate fluctuations. Based on these fluctuations. fluctuations, it should identify the rate sensitive assets/liabilities within the forecasting period. period.

Interest Rate Risk Management Thus, all assets/liabilities that are subjected to repricing within the planning horizon are categorized as Rate Sensitive Assets (RSAs)/Rate Sensitive Liabilities (RSLs). The need for (RSLs). repricing arises from the fact that in a going concern, all assets and liabilities are replaced as and when they mature. mature. Replacement of these assets/liabilities may subsequently lead to repricing especially in the following three situations: situations: When assets/liabilities approach maturity; maturity; When the assets/liabilities have floating rate of interest; interest; When regulations prescribe repricing. repricing.

Interest Rate Risk Management Replacement of the assets/liabilities subsequently leads to repricing which explains their sensitivity to rate fluctuations. fluctuations. The need for such a classification of assets and liabilities based on their sensitivity is essential since a consequential effect of the rate fluctuation has its impact on the net income of the firm. firm. There are two aspects that need to be taken care of in order to understand the total impact of the rate fluctuation on the net income. income. These two aspects refer to the effect of the rate changes on the non-interest income and the interest income. nonincome. In the first case, there can be a rise/fall in the non-interest nonincome since rate fluctuations affect the value of the

Interest Rate Risk Management assets/liabilities. assets/liabilities. While in the second case, the interest rate changes will in certain situations create a mismatch in the pricing of the assets and liabilities, which affect the net interest income. income. Thus, it can be observed that the effect of rate fluctuations is extended to both the balance sheet and the income statement of a financial intermediary. However, while measuring the intermediary. interest rate risk, greater emphasis is laid on its effect on interest income. This is due to a high degree of correlation income. between the rate fluctuations and its effect on RSAs/RSLs, which further gives greater scope for maneuverability. maneuverability.

Interest Rate Risk Management Once the bank is exposed to the interest rate risk, the immediate step to be followed is the quantification of the same by means of a suitable methodology. Some of the approaches used to methodology. tackle interest rate risk are given below :Approaches adopted to quantify interest rate risks: risks: Maturity Gap Method Rate Adjusted Gap Duration Analysis Hedging Sensitivity Analysis Simulation and Game Theory. Theory.

Portfolio Management Theory

Introduction to Portfolio Management WHAT IS INVESTMENT? INVESTMENT? Man, it is said, lives on hope. But, hope is only a necessary hope. condition for life, but not sufficient. There are many other sufficient. materialistic things that he needs - food, clothing, shelter, etc. etc. And, like his hope, his needs too keep changing through his life. life. To make things more uncertain, his ability to fulfill the needs too changes significantly. When his current ability significantly. (current income) to fulfill his needs exceeds his current needs (current expenditure), he saves the excess. The savings may be excess. buried in the backyard, or hidden under a mattress. Or, he mattress. may feel that it is better to give up the current possession of these savings for a future larger amount of money that can be used for consumption in future. future.

Introduction to Portfolio Management WHAT IS INVESTMENT? INVESTMENT? In contrast to the above situation, if the amount available for current consumption is less than the current needs, he has to engage in negative saving, or borrowing. The funds thus borrowing. borrowed may be used for current consumption. But, the consumption. lender of the money who foregoes his current possession and hence its consumption will ask for more than what he has lent. lent. That is the borrower should be willing to pay more than he has borrowed. borrowed. This trade off between the amount available for present consumption and future consumption is at the heart of all savings and investments. The ratio between the amount of investments.

Introduction to Portfolio Management WHAT IS INVESTMENT? INVESTMENT? current consumption that can be exchanged for a certain future consumption is called the pure or risk-free rate of riskinterest or pure time value of money. This relationship is money. influenced by the forces of supply and demand and is determined in the capital markets. If foregoing Rs.100 of markets. Rs. certain income today gives a certain income of Rs.104 after Rs. one year, the pure rate of exchange or pure rate of interest is said to be 4 percent. percent.

Introduction to Portfolio Management The pure rate of interest referred to above is a real rate as it is based on two amounts of money that are fully certain. If the certain. lender expects the purchasing power of money to fall during the time he lends money, he expects, in addition to the pure or riskrisk-free rate, an amount to compensate him for the fall in the purchasing power of money. If the realization of the future money. amount is uncertain, he will expect much more and such excess is called the risk premium. premium. Keeping all the above in view, it can be said that an investment is an agreement for a current outflow of money for some period of time in anticipation of a future inflow that will compensate for the changes in the purchasing power of

Introduction to Portfolio Management money, as well as the uncertainty relating to the inflow of the money in future. This understanding describes well all the future. possible investments, like stocks, bonds, commodities or real estate by all classes of investors like individuals, institutions, governments, etc. In all these investments, the trade off is etc. between a known amount that is invested today, in return for an expected amount in future. While the amount being future. invested is certain, as it is now in our hands or rather is going out of our hands, the expected future inflow carries with it uncertainties regarding its realization and its real worth will be known only when it is due for realization. realization.

Are all investments speculative? We know that investment means sacrificing or committing some money today in anticipation of a financial return later. later. The investor indulges in a bit of speculation as to how much return he is likely to realize. There is an element of speculation realize. involved in all investment decisions. It does not follow though decisions. that all investments are speculative by nature. nature. Genuine investments are carefully thought out decisions. They decisions. involve only calculated risks. The expected return is consistent risks. with the underlying risk of the investment

Are all investments speculative? Speculative investments on the other hand are not carefully thought out decisions. They are based on rumors, hot tips, decisions. inside dopes and often simply on hunches. The risk assumed hunches. is disproportionate to the return expected from speculation. speculation. The intention is to profit from short-term market fluctuations. shortfluctuations. In other words, a speculator is relatively less risk averse and has a short-term perspective for investment. shortinvestment. So, an investment can be distinguished from speculation by (a) the time horizon of the investor and (b) the risk-return riskcharacteristics of the investments. A genuine investor is investments. interested in a good rate of return, earned on a rather consistent basis for a relatively long period of time. The time.

Are all investments speculative? speculator, on the other hand, seeks opportunities promising very large returns, earned rather quickly. In this process, he quickly. assumes a risk that is disproportionate to the anticipated return. return. Investment Objectives and Constraints Investment Objectives Rationally stating, all personal investing is designed in order to achieve a goal, which may be tangible (e.g., a car, a house, etc.) (e. etc. or intangible (eg., social status, security etc.). Goals can be eg. etc. classified into various types based on the way investors approach them viz: viz:

Investment Objectives a. Near-Term High Priority Goals: These are goals which NearGoals: have a high emotional priority to the investor and he wishes to achieve these goals within a few years at the most. Eg: A new most. Eg: house. house. As a result, investment vehicles for these goals tend to be either in the forms equivalent to cash or as fixed-income fixedinstruments with maturity dates in correspondence with the goal dates. Because of the high emotional importance these dates. goals have, investor, especially the one with moderate means will not go for any other form of investment which involves more risk especially where his goal is just in sight. sight.

Investment Objectives b. Long-Term High Priority Goals: For most people, this LongGoals: goal is an indication of their need for financial independence at a point some years ahead in the future. Eg: Financial future. Eg: independence at the time of retirement or starting a fund for the higher education of a three-year old child. Normally, we threechild. find that either because of personal preference or because the discounted present value is large in relation to their resources, the time of realization for such goals is set around 60 years of age for people of moderate means. Because of the long-term means. longnature of such goals, there is not a tendency to adopt more aggressive investment approaches except perhaps in the last 5 to 10 years before retirement. Even then, investors usually retirement. prefer a diversified approach using different classes of assets. assets.

Investment Objectives c. Low Priority Goals: These goals are much lower down Goals: in the scale of priority and are not particularly painful if not achieved. achieved. For people with moderate to substantial wealth, these could range from a world tour to donating funds for charity. charity. As a result, investors often invest in speculative kinds of investments either for the fun of it or just to try out some particular aspect of the investment process. process.

Investment Objectives d. Enterpreneurial or Money Making Goals: These goals Goals: pertain to individuals who want to maximize wealth and who are not satisfied by the conventional saving and investing approach. approach. These investors usually put all the spare money they have into stocks preferably of the company in which they are working/owning and leave it there until it reaches some level which either the individual believes is enough or is scared of losing what has been built-up over the years. Even then, the builtyears. process of diversification and building up a conventional portfolio usually takes him a long time involving a series of opportunities and sales spread over many years. years.

Investment Constraints An investor seeking fulfillment of one of the above goals operates under certain constraints: constraints: Liquidity Age Need for Regular Income Time Horizon Risk Tolerance Tax Liability The challenge in investment management, therefore, lies in choosing the appropriate investments and designing a unit that will meet the investment objectives of the investor subject to his constraints. constraints.

Investment Motives or Goals The desire to postpone current consumption for higher consumption in future manifests itself in many ways. To take a ways. look at their investment motives, let us divide investors into two classes - individuals and institutions. institutions. - The common investment goals of individuals are - Buying a new house - Financing child's education - Saving for independence in old age - Saving for a trip abroad - Saving now to start a venture later. later.

Investment Motives or Goals The goals of institutions generally stem from their source of funds and the promises they have made to the providers of funds. funds. Their goals are frequently like : To generate at least the promised return for the investors. investors. To generate the maximum possible return for all the subscribers. subscribers.

RISKS IN INVESTMENT Before proceeding to know how risk arises in investments, let us first understand the two terms that are often used interchangeable - risk and uncertainty. In the context of an uncertainty. investment, a situation of certainty is one in which the return from the investment is known for sure. Let us say, an sure. individual invests in government securities and holds them to maturity. maturity. The individual can be sure about the redemption of the amount invested on maturity and payment of interest. interest. Therefore, his rate of return is known for sure. sure. The term risk, in the context of investments, refers to the variability of the expected returns. It is an attempt to quantify returns. the probability of the actual return being different from the expected return. return.

NEED FOR PORTFOLIO MANAGEMENT A portfolio is a collection of assets. But the question is, why should we invest in a collection or group of assets, rather than a single asset? And, why does it become necessary to manage a group of assets? Let us consider these questions now. To help us understand the answers better, we take the help of the following data. (in MS Word)

NEED FOR PORTFOLIO MANAGEMENT Having established the need for investing in portfolios rather than individual assets, we can now move on to the question of management of portfolios. Portfolios are (or rather, should portfolios. be) built to suit the return expectations and/or the risk appetite of the investor. That is, a combination of assets or investor. securities is formulated which meets the level of return he expects provided he is willing to meet the associated risk, or the return possible at the level of risk he is willing to bear. bear. This is because, often, building a portfolio which meets both the return expectations and the risk taking ability of the investor is not possible. After all, who does not like to own a possible. portfolio of risk-free assets yielding (at least) 100 percent per riskannum?

NEED FOR PORTFOLIO MANAGEMENT Designing portfolios to suit investor requirements often involves making several projections regarding the future, based on the current information. When the actual situation is information. at variance from the projections portfolio composition needs to be changed. One of the key inputs in portfolio building is changed. the risk bearing ability of the investor. Change in it also calls investor. for a change in the portfolio composition to match the current risk bearing ability. Investment presupposes some future ability. needs; needs; changes in the needs will demand changes in the portfolio composition. Lastly, the returns and the risk composition. characteristics of the assets which make up the portfolio may undergo a change, warranting changes in the composition of the portfolio. portfolio.

THE PROCESS OF PORTFOLIO MANAGEMENT In MS Word Portfolio Management: An Evaluation Management: Portfolio managers, to be successful, have to work on any one or more of the following strategies: strategies: - Timing the market. market. - Selection of superior stocks or groups of stocks. stocks. - Making changes in the portfolio structure and/or strategy. strategy. - Having a long-term investment philosophy. longphilosophy. While the above strategies do look impressive on paper, empirical studies made on the performance of the fund managers have proved that it is very unlikely that a fund manager consistently outperforms the market from these

THE PROCESS OF PORTFOLIO MANAGEMENT The reasons cited in the studies for the failure of market timing are as follows: follows: The market performs just as well when the investor is in, as when he is out of it. That is, the returns from the market will it. be the same, whether the investor has invested into stocks or is holding cash. By being invested for part of the time and cash. moving out of the market rest of the time, the investor is losing the gains during that period of time. Therefore, it is not time. possible to beat the market with market timing. timing. If, from the gains obtained by portfolio managers (like pension funds) over a period of time of about eight years, the gains from those obtained during the ten best days during the

THE PROCESS OF PORTFOLIO MANAGEMENT The reasons cited in the studies for the failure of market timing are as follows: follows: period are reduced, the gains obtained from them reduced drastically. drastically. If the gains from twenty best days are reduced, the returns fell below those on Government securities. This securities. means, the trick lies in being invested in stocks during the twenty crucial days than the whole period. And, the period. proportion of those twenty days being a small fraction of the total period under consideration, it can be concluded that it is highly unlikely that anybody would succeed in timing the market. market.

THE PROCESS OF PORTFOLIO MANAGEMENT Similarly, the studies have revealed that the stocks rejected from their investment or sold expecting a fall in prices have performed as well as the stocks selected by them. Portfolio them. strategies like investing in growth stocks and investing based on technical too have their share of bad reputation for giving exceptionally high returns during some periods and large negative returns during the other periods. And, very few periods. investment philosophies have been formulated in the past few decades that have stood the test of time. time. Continued in MS Word

CAPITAL MARKET THEORY. THEORY. Continued in MS Word CAPITAL ASSET PRICING MODEL The CAPM was developed in mid-1960s. The model has mid-1960s generally been attributed to William Sharpe. , but John Linter Sharpe. and Jan Mossin made similar independent derivations. derivations. Consequently, the model is often referred to as Sharpe-LinterSharpe-LinterMossin (SLM) Capital Asset Pricing Model. The CAPM Model. explains the relationship that should exist between securities' expected returns and their risks in terms of the means and standard deviations about security returns. Because of this returns. focus on the mean and standard deviation the CAPM is a direct extension of the portfolio models developed by

CAPITAL MARKET THEORY. THEORY. Continued in MS Word CAPITAL ASSET PRICING MODEL Markowitz and Sharpe. Sharpe. Using a set of simplifying assumptions, the CAPM is an equation that expresses the equilibrium relationship between security's (or portfolio's) expected return and its systematic risk. risk. Because the CAPM is relatively a simple model, it has been employed in a wide variety of academic and institutional applications such as measuring portfolio performance, testing of market efficiency, identifying under and overvalued securities, determining consensus price of risk implicit in the current market prices and capital budgeting. budgeting.

CAPITAL MARKET THEORY. THEORY. Continued in MS Word CAPITAL ASSET PRICING MODEL Markowitz and Sharpe. Sharpe. Using a set of simplifying assumptions, the CAPM is an equation that expresses the equilibrium relationship between security's (or portfolio's) expected return and its systematic risk. risk. Because the CAPM is relatively a simple model, it has been employed in a wide variety of academic and institutional applications such as measuring portfolio performance, testing of market efficiency, identifying under and overvalued securities, determining consensus price of risk implicit in the current market prices and capital budgeting. budgeting.

Assumptions for CAPM Common to both the Markowitz model and CAPM Investors are risk-averse, expected utility maximizers. risk Investors chose portfolios on the basis of their expected mean and variance of return. Additional assumptions for CAPM Borrowing and lending at the risk-free rate are unrestricted. risk All investments are perfectly divisible.. All investors have uniform, single period investment horizon and expectations regarding means, variances and covariances of security returns are homogeneous. There are no imperfections in the market and Capital markets are the equilibrium.

Market Portfolio Since every investor should choose to hold portfolio M, it follows that portfolio M must be a portfolio containing all securities in the market. Such a portfolio market. that contains all securities is called the Market Portfolio. Portfolio. Because all investors should choose the market portfolio, it should contain all available securities. securities. If it did not, securities not included would not be demanded by any investor and prices of these securities, therefore, would fall and their expected return would rise. At some point the increased rise. expected returns would be attractive to some

Market Portfolio Now let us see why this must be the case. At case. equilibrium, market value of the risky assets should be equal to the funds available for investing in the risky assets. assets. Now, consider a security A, which constitutes one percent of market value of all risky securities. securities. Assume that each investor places only 0.50 percent of his risky portfolio in security A. That is, 0.50 percent of total funds at risk are invested in security A. But, security A constitutes of one percent of the market value of the total risky assets. These two figures are assets. not consistent since both indicate one and the same
Market valueof asset Total market value of all assets i n market portfolio M

Market Portfolio thing. thing. This is because the market value of risky assets is nothing but the amount of funds invested in risky assets by all the investors. Therefore, under the investors. assumptions made in this model, the optimal combination of risky securities is that existing in the market. market. Hence, M is the market portfolio where each risky asset i has the weight (Wi) equal to Wi = . Market value of security . Total mkt value of all assets in mkt portfolio
MONETARY POLICY
The actions of a central bank determine the size and rate of growth of the money supply, which in turn affects interest rates. rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves). reserves). In India the monetary policy is controlled by the RBI. In the RBI. United States, the Federal Reserve is in charge of monetary policy. policy. Monetary policy is one of the ways that the U.S. government attempts to control the economy. If the economy. money supply grows too fast, the rate of inflation will increase; increase; if the growth of the money supply is slowed too much, then economic growth may also slow. In general, the slow. U.S. sets inflation targets that are meant to maintain a steady inflation of 2% to 3%.
MONETARY POLICY

Monetary policy is the process by which the government, Central bank or Monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary economy. theory provides insight into how to craft optimal monetary policy. policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy money. uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where unemployment. currency is under a monopoly of issuance, or where there is a
MONETARY POLICY
regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). goals). It is important for policymakers to make credible announcements. announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise . If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wages to match these prices. Hence, the expectation of lower wages is prices. reflected in wage-setting behavior between employees and wageemployers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull
MONETARY POLICY
inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages
MONETARY POLICY

Monetary policy is the process by which the government, Central bank or Monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary economy. theory provides insight into how to craft optimal monetary policy. policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy money. uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where unemployment. currency is under a monopoly of issuance, or where there is a .
MONETARY POLICY
regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). goals).
MONETARY POLICY
Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy contractionary, increases the total supply of money in the economy more rapidly than usual and contractionary policy expands the money supply more slowly than usual or even shrinks it. it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. values. Monetary policy differs from fiscal policy, which refers to taxation, government spending and associated borrowing. borrowing.
MONETARY POLICY
There are several monetary policy tools available to achieve these ends: ends: increasing interest rates; reducing the monetary base; rates; base; and increasing reserve requirements. All have the effect of requirements. contracting the money supply; and, if reversed, expand the supply; money supply. Since the 1970s, monetary policy has generally supply. 1970s, been formed separately from fiscal policy. policy. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central bank, the Peoples Bank of China and the bank of Japan) exist which have the task of executing the monetary policy and often independently of the Executive. Executive. In general, these institutions are called Central banks and often have other responsibilities such as supervising the smooth operation of the financial system. system.
MONETARY POLICY
The primary tool of monetary policy is open market operations.. operations.. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds or foreign currencies. currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation. circulation. Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other target. instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the gold. Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, overnight; the monetary policy of China is to target the exchange rate
MONETARY POLICY
between the Chinese renminbi and a basket of foreign currencies. currencies. The other primary means of conducting monetary policy include: include: (i) Discount window lending (lender of last resort); (ii) resort); Fractional deposit lending (changes in the reserve requirement); requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth outcomes); operations" (talking monetary policy with the market). market).
MONEY MARKETS
There are various types of Money Markets Instruments (MMI). (MMI). They are also known as Fixed Income securities. securities. A security is after all, a contract giving the investor certain rights to the future prospects of the issuer. issuer. There are a large number of FIs as rights given to investors differ from one security to another. another. FIS typically promise the investor that he will receive specified cash flows at specified times in the future. It future. may be one cash flow in which security is known as PurePure-Discount security. (Issued at less than face value). security. value). Alternatively, it may involve multiple cash flows. If all of flows. the cash flows (except the last one) are of same size, they are generally referred as Coupon Payments. The Payments. specified period beyond which the investor will not
MONEY MARKETS
maturity date. The investor also receives the principal on date. this date. date. Certain types of short term (less than a year) highly tradeable instruments play a major role in investing and borrowing of both financial and nonfinancial Corporations. Corporations. Some money market instruments are negotiable and traded actively in secondary markets; markets; others are not. Many are also sold on discount basis. Eg not. basis. A 90 day note with face value of Rs 1,00,000 may be 00, sold for Rs 98,000. The difference of Rs 2,000 represents 98,000. interest income. Interest rates on such money market income. instruments are called as bank discount basis. This basis. implies that the instrument carries 2% per quarter or 8% per annum. However, the discount does not represent annum.
MONEY MARKETS
true interest rate. The true interest rate in this case would rate. be 2000/98000 = 2.04% per quarter or 8. 16 per annum. 2000/ 04% annum. The money market is a market for short-term financial assets shortthat are close substitutes of money. The most important money. feature of a money market instrument is that it is liquid and can be turned over quickly at low cost and provides an opportunity for balancing the short-term surplus funds of shortlenders and the requirements of borrowers. By convention, borrowers. the term "Money Market" refers to the market for short-term shortrequirement and deployment of funds. Money market funds. instruments are those instruments, which have a maturity period of less than one year. The most active part of the year. money market is the market for overnight call and term money between banks and institutions and repo transactions. transactions.
MONEY MARKETS
Call Money / Repo are very short-term Money Market products. shortproducts. There is a wide range of participants(banks, primary dealers, financial institutions, mutual funds, trusts,provident funds etc. etc.) dealing in money market instruments. Money Market instruments. Instruments and the participants of money market are regulated by RBI. RBI. The below mentioned instruments are normally termed as money market instruments: instruments: Call/ Notice/ Term Money Repo/ Reverse Repo Inter Corporate Deposits Commercial Paper Certificate of Deposit
MONEY MARKETS
The below mentioned instruments are normally termed as money market instruments: instruments: T-bills Inter Bank Participation Certificate Some of the MMIs are note. 1. Commercial Paper. It is an unsecured promissory note. Paper. Instruments of this type are issued by both financial and nonnon-financial companies. This is a widely used source of companies. raising finance. This is generally used by financial finance. companies like banks, NBFCs, leasing etc. This was etc. started in India only in 1990 whereas abroad this is a very widely used instrument. instrument.
MONEY MARKETS

In the global money market, commercial paper is an unsecured Promissory Note with a fixed maturity of 15 to 365 days. Commercial Paper is a money-market security issued days. money(sold) by large Banks and Corporations to get money to meet short term debt obligations (for eg - payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since note. it is not backed by collateral, only firms with excellent Credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial price. paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the bonds. longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with pay.
MONEY MARKETS

market conditions, but are typically lower than banks' rates. rates. RBI had launched CPs in India with a view to enabling highly rated Corporate borrowers to diversify their sources of short term borrowings and also providing an additional instrument to investors. investors.
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI Introduction Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP as a note. privately placed instrument, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to shortprovide an additional instrument to investors. Subsequently, investors. primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding shortrequirements for their operations. CPs are unsecured; they are operations. unsecured; backed only by the general credit rating of the issuing companies. companies. They are highly liquid instruments. They are also instruments.
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI Introduction known to be simple and flexible instrument in respect of the documentation needed and spread of maturities available. available. Guidelines for issue of CP are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. time.
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI Who can issue CPs CPs are generally issued in a bearer form or discount to face value. They are generally issued in value. large denominations. Corporates, primary dealers (PDs) and denominations. Corporates, satellite dealers (SDs) and the all-India financial institutions all(FIs) that have been permitted to raise short-term resources shortapproved Reserve Bank of India are eligible to issue CP. CP. A corporate would be eligible to issue CP provided (a) the tangible net worth of the company, as per the latest audited balance sheet is not less than Rs. 4 crore; Rs. crore; (b) company has been sanctioned working capital limit by bank/s or all-India financial institution/s; and allinstitution/s; (c) the borrower account of the company is classified as a
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI Rating Requirement- All eligible participants shall obtain the Requirementcredit rating for issuance of Commercial Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or Ltd. the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. Ltd. Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other Pvt. Ltd. credit rating agency (CRA) as may be specified by the Reserve Bank of India from time to time, for the purpose. The purpose. minimum credit rating shall be B-2 of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at agencies. the time of issuance of CP that the rating so obtained is current and has not fallen due for review. review.
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI Maturity CP can be issued for maturities between a minimum of 15 days and a maximum upto one year from the date of issue. In the US, the maturity period varies from 03 to issue. 270 days, in UK it varies from 07 to 364 days and upto 185 days in Australia. Australia. Denominations - CP can be issued in denominations of Rs. Rs.5 lakh or multiples thereof. Amount invested by single thereof. investor should not be less than Rs.5 lakh (face value). Rs. value). Limits and the Amount of Issue of CP CP can be issued as a "stand alone" product. The aggregate product. amount of CP from an issuer shall be within the limit as approved by its Board of Directors. Banks and FIs will, Directors. however, have the flexibility to fix working capital limits duly
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI financing including CPs. An FI can issue CP within the overall CPs. umbrella limit fixed by the RBI i.e., issue of CP together with other instruments viz., term money borrowings, term deposits, viz. certificates of deposit and inter-corporate deposits should not interexceed 100 per cent of its net owned funds, as per the latest audited balance sheet. The total amount of CP proposed to be sheet. issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP subscription. may be issued on a single date or in parts on different dates provided that in the latter case, each CP shall have the same maturity date. Every CP issue should be reported to the Chief date. General Manager, Industrial and Export Credit Department (IECD), Reserve Bank of India, Central Office, Mumbai
MONEY MARKETS
Guidelines for issue of Commercial Paper issued by RBI through the Issuing and Paying Agent (IPA) within three days from the date of completion of the issue. Every issue of CP, issue. including renewal, should be treated as a fresh issue. issue. Who can act as Issuing and Paying Agent (IPA) - Only a scheduled bank can act as an IPA for issuance of CP. CP. Investment in CP - CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, NonNon-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be (FIIs). within the limits set for their investments by Securities and Exchange Board of India (SEBI). (SEBI).
MONEY MARKETS
Problems hindering growth of CP Market in India The foremost problem in growing the secondary markets for CPs is the eligibility conditions laid down by RBI. The market RBI. could develop further if procedural issues were resolved. The resolved. prime being the necessity of taking approval of a credit rating agency everytime one wants to raise a CP. The window of two CP. months is restrictive, time consuming and costly. It is costly. attractive to raise funds through CPs than banks only if the cost is less. Another problem which hinders the growth of less. CPs is the stipulation that the borrowers will lose a portion of their working capital limits with banks once they issue CPs. So CPs. CP finance is not an additional finance but a substitute for bank finance. finance.
MONEY MARKETS
Certificates of deposit (CDs) CDs are negotiable money market instrument issued in demat form or as a Promissory Notes. CDs issued by banks should Notes. not have the maturity less than seven days and not more than one year. Financial Institutions are allowed to issue CDs for a year. period between 1 year and up to 3 years. years. CDs are like bank term deposits but unlike traditional time deposits these are freely negotiable and are often referred to as Negotiable Certificates of Deposit. CDs normally give a Deposit. higher return than Bank term deposit. CDs are rated by deposit. approved rating agencies (e.g. CARE, ICRA, CRISIL, and (e. FITCH) which considerably enhance their tradability in the secondary market, depending upon demand. demand.
MONEY MARKETS
Guidelines for issue of CDs issued by RBI Introduction Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. They period. are bank deposit accounts transferable from one party to another. another. They are marketable instruments or registered form of funds deposited in a bank for a specified period, at a specified rate of interest. They can be sold to someone else, interest. and are traded on the secondary markets. Liquidity and markets. marketability are said to be hallmark of CDs. CDs are riskless CDs. in terms of default of payment of interest and principal. principal.
MONEY MARKETS
Guidelines for issue of CDs issued by RBI Introduction CDs are the obligations of banks just as Commercial Paper is the obligation for issuing organisation. CDs are usually issued organisation. at facevalue, on which fixed rates of interest are paid, and they facevalue, are tarded on bond yield basis. CDs are similar to T basis. billsGuidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. time. Eligibility CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (ii) select all-India Financial Institutions that have been all-
MONEY MARKETS
Guidelines for issue of CDs issued by RBI permitted by RBI to raise short-term resources within the shortumbrella limit fixed by RBI. RBI. Aggregate Amount Banks have the freedom to issue CDs depending on their requirements. requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e. issue of CD together with other instruments, viz., term money, term deposits, commercial papers viz. and inter-corporate deposits should not exceed 100 per cent of its internet owned funds, as per the latest audited balance sheet. sheet. Minimum Size of Issue and Denominations Minimum amount of a CD should be Rs.1 lakh, i.e., the Rs. lakh, minimum deposit that could be accepted from a single
MONEY MARKETS
Aggregate Amount subscriber should not be less than Rs. 1 lakh and in the Rs. multiples of Rs. 1 lakh thereafter. Rs. thereafter. Who can Subscribe CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non-Resident Indians (NRIs) etc. Nonmay also subscribe to CDs, but only on non-repatriable basis nonwhich should be clearly stated on the Certificate. Such CDs Certificate. cannot be endorsed to another NRI in the secondary market. market. Maturity The maturity period of CDs issued by banks should be not less than 7 days and not more than one year not exceeding 3 years from the date of issue. issue.
MONEY MARKETS
Certificates of deposit (CDs) Features of CD All scheduled banks (except RRBs and Co-operative banks) Coare eligible to issue CDs. CDs. They can be issued to individuals, corporations, trusts, funds and associations. associations. NRIs can also subscribe to CDs, but on non-repatriable basis nononly. only. In secondary market such CDs cannot be endorsed to another NRI. NRI. They are issued at a discount rate freely determined by the issuer and the market/investors. market/investors. CDs issued in physical form are freely transferable by endorsement and delivery. Procedure of transfer of dematted delivery.
MONEY MARKETS
Certificates of deposit (CDs) Features of CD CDs is similar to that of any other demat securities. securities. For CDs there is no lock-in period. lock- period. CDs are issued in denominations of Rs.1 Lac and in the Rs. multiples of Rs. 1 Lac thereafter. Discount/Coupon rate of Rs. thereafter. CD is determined by the issuing bank/FI. Loans cannot be bank/FI. granted against CDs and Banks/FIs cannot buy back their own CDs before maturity. maturity.
MONEY MARKETS
Discount/ Coupon Rate CDs may be issued at a discount on face value. Banks/FIs are value. also allowed to issue CDs on floating rate basis provided the methodology of compiling the floating rate is objective, transparent and market-based. The issuing bank/FI is free to market-based. determine the discount/coupon rate. The interest rate on rate. floating rate CDs would have to be reset periodically in accordance with a pre-determined formula that indicates the prespread over a transparent benchmark. benchmark. Reserve Requirements Banks have to maintain the appropriate reserve requirements, i.e., cash reserve ratio (CRR) and statutory liquidity ratio (SLR), on the issue price of the CDs. CDs.
MONEY MARKETS
Transferability Physical CDs are freely transferable by endorsement and delivery. delivery. Dematted CDs can be transferred as per the procedure applicable to other demat securities. There is no securities. locklock-in period for the CDs. CDs. Loans/BuyLoans/Buy-backs Banks/FIs cannot grant loans against CDs. Furthermore, they CDs. cannot buy-back their own CDs before maturity. buymaturity. Format of CDs Banks/FIs should issue CDs only in the dematerialised form. form. However, according to the Depositories Act, 1996, investors 1996, have the option to seek certificate in physical form. There will form. be no grace period for repayment of CDs. If the. CDs. the.
MONEY MARKETS
Format of CDs maturity date happens to be holiday, the issuing bank should make payment on the immediate preceding working day. day. Banks/FIs may, therefore, so fix the period of deposit that the maturity date does not coincide with a holiday to avoid loss of discount / interest rate. rate. Security Aspect Since physical CDs are freely transferable by endorsement and delivery, it will be necessary for banks to see that the certificates are printed on good quality security paper and necessary precautions are taken to guard against tampering with the document. They should be signed by two or more document. authorised signatories. signatories.
MONEY MARKETS
Payment of Certificate Since CDs are transferable, the physical certificate may be presented for payment by the last holder. The question of holder. liability on account of any defect in the chain of endorsements may arise. It is, therefore, desirable that banks take necessary arise. precautions and make payment only by a crossed cheque. cheque. The holders of dematted CDs will approach their respective depository participants (DPs) and have to give transfer/delivery instructions to transfer the demat security represented by the specific ISIN to the CD Redemption Account maintained by the issuer. The holder should also issuer. communicate to the issuer by a letter/fax enclosing the copy of the delivery instruction it had given to its DP and intimate
MONEY MARKETS
Payment of Certificate the place at which the payment is requested to facilitate prompt payment. Upon receipt of the Demat credit of CDs in payment. the CD Redemption Account, the issuer, on maturity date, would arrange to repay to holder/transferor by way of Bankers cheque/high value cheque, etc. cheque/high cheque, etc. Accounting Banks/FIs may account the issue price under the Head CDs issued and show it under deposits. Accounting entries deposits. towards discount will be made as in the case of cash certificates. certificates. Banks/FIs should maintain a register of CDs issued with complete particulars. particulars.
MONEY MARKETS
FOREIGN EXCHANGE MARKET

A market for the purchase and sale of foreign currencies is called a Foreign Exchange Market. The purpose of such a market is to Market. facilitate international trade and investments. The need for a foreign investments. exchange market arises because of the presence of the multifarious international currencies such USD, UK pound sterling, Euro Yen etc. etc. Characteristics 1. Electronic Market FEM doesnt have a physical place. It is a market place. where trading in foreign currencies takes place through electronically linked through network of banks, FE brokers and dealers whose function is to bring together buyers & sellers of FE. FE. 2. Geographical Dispersal A redeeming feature of the FE market is that it is not to be found in one place. It is dispersed in a large noof cities place. across the world. world. 3. Transfer of Purchasing Power FEM aims at permitting the transfer of purchasing power denominated in one currency to another whereby one currency is traded for another currency. A healthy FEM permits currency. businesses to settle their dues in respective currencies. currencies.

Characteristics 4. Intermediary. Intermediary. FEMs provide a convenient way of converting the currencies earned into currencies wanted their respective countries. For this purpose it acts as an countries. intermediary between buyers & sellers of FE. FE. 5. Volume. Volume. A special feature of the FEM is that out of the total trading transactions that take place in the FEM around 95% takes for trading and cross border purchase and sale of 95% assets ( Government securities, Bonds, Bills etc). Only 5% etc). relates to export & import activities. activities. 6. Provision of Credit. Credit. A FEM provides credit through specialised instruments like Bankers acceptance & letter of credits. credits. 7. Minimising Credits. The FEM helps importer & exporter Credits. in foreign trade to minimise their risk of trade. This is done trade. through Hedging mechanism. mechanism.

Forex market is open almost 24 hrs a day. It starts in Tokyo and day. ends in West Coast of USA. By the time it closes in USA West USA. Coast, it is within 2.5 hrs of opening of Tokyo market for the next day. day. Total trade in the Forex market is to the tune of over US$ 7 trillion US$ per day. The Indian Forex Market turnover itself averages US$ 25 day. US$ billions/day. billions/day. One peculiarity of Forex Market is that it is mostly unregulated and completely driven by the Demand-Supply principal. There are few Demandprincipal. benchmarks. benchmarks. Rates fluctuate minute by minute, dealer by dealer, and customer by customer. There is nothing fixed. Two people customer. fixed. doing a sell deal with the same dealer at the same time in the same place and of same currency may end up with vastly different rates. rates. Money changers are free to quote their own rate for buying and selling any currency (technically called Bid and Ask rates respectively) based on customer, size of deal, their own current positions, etc. etc.

Constituents The activities of FEM are primarily carried out through worldwide Interbank Market. Trading is primarily through Market. Internet, Telephone & SWIFT (Society for Worldwide Interbank financial Telecommunication) system. The system. various constituents are :1. Interbank Market. Market. It is an important segment of the FEM. FEM. It is a wholesale market through which most currency transactions are done. 95% of trade is carried out through done. 95% this route. The three constituents of IBM are Spot, Forward route. & Swap market. market. - Spot Market accounts for 60 % of trade. Currencies are trade. traded for immediate delivery not extending a period of two days after completion of transaction. transaction.

Constituents - In Forward market delivery takes place at a future date and the contracts for buying and selling take place at current date. date. It accounts for 10% of FEM. 10% FEM. - Swap accounts for 30 % of FEM. FEM. SWIFT is an important mode of trading of FE. It is an FE. international bank communications network links electronically all brokers and traders in FEM. FEM. Participants. Participants. Five categories of participants take part in operations of FEM. FEM. They are bank and non bank dealers, individuals and firms conducting commercial & investment transactions, speculators and arbitragers, central banks, treasuries & FE brokers. brokers.

1.
2.
FE dealers. Banks & Non Banks make up the FE dealers. dealers. dealers. They deal actively in FE for their own accounts. They buy & accounts. sell major currencies on a continuous basis. Their profit basis. comes from buying FE at bid price and reselling it at a slightly higher offer/ask price. price. Individuals & Firms. These are exporters & importers, Firms. International portfolio investors, MNCs, tourists who use FEM to facilitate the execution of commercial or investment transactions. transactions. Firms that operate internationally must pay suppliers & workers in local currency of each country in which they operate and may receive payments from customers in different countries. Eg FDI requires investor countries. to obtain currency of foreign country. FII flows country.

1.
4.
Speculators & Arbitragers. Speculators buy & sell currencies Arbitragers. to solely profit from anticipated changes in the exchange rate, without engaging in other sorts of business dealings for which FE is essential. Currency speculation is often essential. combined with speculation in short term financial instruments such as treasury bills. Large part of speculation bills. takes place on behalf of large banks. banks. Central banks & Trasuries. Central banks may trade Trasuries. currencies for the purpose of affecting exchange rates. A rates. Govts deliberate attempt to buy one & sell other currency is called Intervention. It varies from country to country, Intervention. currency to currency. CBs use FEM for buying & selling currency. countrys FE reserves. They also aim at influencing value of reserves. their own currency in accordance with National prioritites. prioritites.

Foreign exchange Brokers. They are commission Brokers. agents who bring together suppliers & buyers of FE. FE. They deal in all major currencies. currencies. Transactions. Transactions. Several types of transaction take place in Fe market. Primarily are Spot, forward & Swap. market. Swap. Spot Transaction An Interbank transaction whereby purchase of FE & delivery & payment for the same take place between banks usually on the second business day is called ST. The rate quoted is called ST. Spot Rate. Date of settlement is known as Value Rate. date. date.
1.

Transactions. Transactions. Forward Transaction Where a specified amount of one currency is exchanged for a specified amount of another currency at a future value date is called Forward Transaction. Only the delivery & payment take Transaction. place at a future date, the exchange rate being determined at the time of the agreement. The rate quoted in such a transaction is called agreement. Forward rate. rate. Swap Transaction The simultaneous purchase and sale of a given TransactionThe amount of foreign exchange for different value dates is referred to as Swap transaction. Both the sale and purchase are with the same transaction. counter party. There are two types of STs. They are Spot-Forward and party. STs. SpotForwardForward-Forward swaps. In case of Spot-Forward swaps the dealer swaps. Spotbuys currency in the spot market and simultaneously sells the same amount to the same bank in the forward market. market. A more sophisticated STs viz-Forward-forward swap facilitates viz-Forwardborrowing another currency on a fully collateralised basis. basis.

How to make a Quote? Quote? All money changers are connected to Reuters through SWIFT. The SWIFT. Reuters screen continuously flashes current going rate for various currencies at different centres. However, the rates are only indicative. centres. indicative. They are representative rates for market as a whole. Individual rates whole. with various dealers vary. vary. Exchange Rates are quoted in following format: format: (a) USD/INR = Above represents amount of currency in denominator (here INR) to be paid for each unit of currency in numerator (here USD). Quotation is always in double numbers with USD). minor difference between the two. two. First number is called the Bid Rate and second number is called Ask Rate. Rate. Bid rate is always lower than the Ask Rate. Rate. Bid Rate is the rate at which the money changer is willing to buy a particular currency. currency. Ask Rate is the rate at which the money changer is willing to sell same currency. currency.

How to make a Quote? Quote? Spread As stated earlier, there is always a positive difference between Ask Rate and Bid rate. This difference is called rate. Spread and it is the profit margin that the dealer earns by trade. trade. Spread = Ask Rate Bid Rate

Spread % = Forex market behaves like any other commodity market. Here too, there is whole sale and retail market. market. market. Whole sale market consists of Authorised Dealers and Big Corporate Houses like TCS, Infosys and Wipro who have high forex exposures. But spreads in whole sale market are lower. exposures. lower. Retail Market is populated by money changers, ordinary citizens, small exporters and importers and small Corporates. Corporates.

Positions In any financial market, two positions can be taken Long or overbought position and Short or oversold position. Why are positions created ? Positions are taken in anticipation of currency exchange rate movement in one direction. direction. If a position is taken and the trend appears to be reversing (currency depreciates against expectation of appreciation or vicevice-versa), the positions are liquidated by manipulating the Bid and Ask rates. rates.

The quotations are normally in four decimal places. If a dollar is places. being quoted against Rupee, it will be quoted as follows: follows: 46.5230/46.5250 46.5230/46.

Why are positions created ?

First figure of quote is Bid Rate and second figure is Ask Rate. Rate. Third and fourth decimal places are called PIPS. Thus, in the PIPS. above case, 30 and 50 are pips. pips. In most cases, quotations are abbreviated to give only two or three digit pips in place of Ask Rate. Thus, above quote could Rate. also be represented as: as: 46.5230/50 46.5230/ Inter dealer quotes are further abbreviated to only three digit pips on both sides since base rate of up to first decimal place is common across all dealers and therefore assumed to be known. known.


Arbitrage
As in any other trade, arbitrage opportunities exist in Forex trade also. also. Arbitrage is basically taking advantage of differential in rates at two locations or markets or sources. For instance, Bid sources. (Buying) Rate of one dealer may be higher than Ask (Selling) Rate of another dealer. A smart operator can buy from second dealer. dealer and sell to first dealer and earn some money. This money. transaction is called Arbitrage. Let us see the above process Arbitrage. in numbers. numbers.

Dealer A 46.5030/46.5080 46.5030/46.
Dealer B 46.5090/46.5095 46.5090/46.
In the above case, Bid Rate of Dealer B (46.5090) is higher 46.5090) than Ask Rate of Dealer A (46.5080). If a person Buys one 46.5080) million dollars from Dealer A and sells to Dealer B, he earns 0.0010 x 1,000,000 = Rs 1000 000,

Quote. Inverse Quote Also called Indirect Quote. Normally, value of other currency is quoted in local currency, ie amount of local currency to be paid for each unit of foreign currency. In currency. India, all currencies are quoted using INR as the base, ie value of other currency is quoted in Indian Rupees. Similar Rupees. practice is adopted by all other countries, using their local currency as base and indicating number of local currency to be paid for each unit of other currency. currency. Thus, a person will obtain USD/INR quote = 46.3020/46.3090 from a dealer in India 46.3020/46. and INR/USD quote = 0.0213/0.0224 from another dealer in 0213/ USA (US currency used as base in USA. So, the quotation will be number of USA. USD to be paid for each INR). If the bases of quotes are different, INR). how do we compare the quotes? Comparison of two quotes becomes difficult. Therefore, there is a need to INVERSE difficult. one of the quotes so that the base is common. common.

Inverse Quote USD/INR = 46.3020 46. Inverse the quote INR/USD = 1/ (USD/INR) = 1/46.3020 = 0.0216

Inverse Quote USD/INR = 46.3020/46.3090 INR/USD (ASK) = 1/(USD/INR)BID = 1/46.3020 = 0 . 021597 INR/USD (BID) = 1/(USD/INR) ASK = 1/46.3090 = 0 . 021594 (Please note that for finding BID rate, we have to inverse ASK rate and for finding ASK rate we have to inverse BID rate. What is the logic for this?

Currency trade is basically a BARTER trade. In any other trade, commodity is traded against a currency. However, in currency trade, both sides have currencies but of different type. It is like one side having wheat and the other side having rice and both ready to exchange their commodity for the others for a negotiated exchange rate. In such a

Inverse Quote situation there is no seller and no buyer. Saying it other way round, both are buyer. sellers and both are buyers. When one buys others commodity, he buyers. simultaneously sells his commodity. So, when one trader says I am willing commodity. to sell one dollar for Rs 47, it can also be interpreted as - he is willing to buy Rupee for 1/47 47, dollar. dollar. Thus, his ASK rate of Rs 47 for a dollar has become his BID rate for a Rupee in inverse quote at 1/47 dollar. Therefore, when currency dollar. quotes (exchange rates) are inversed, Bid and Ask rates also have to be inversed). inversed).

Interest Arbitrage Interest Arbitrage refers to the international flow of short term liquid capital (Fixed Deposits denominated in Foreign Currencies or Convertible local currency) to earn a higher interest abroad. In abroad. India we have NRIs investing in fixed deposits to earn higher interest rates. Interest arbitrage can be uncovered or covered. rates. covered. Uncovered Interest Arbitrage In order to be able to take benefit of higher interest opportunity in foreign country, it is often necessary to convert the domestic currency to foreign currency while investing in foreign country and then reconverting principal and interest earned to local currency at the time of maturity. maturity. In countries where interest rates are higher, inflation is also higher. higher. (nominal interest rate is mostly equal to real interest rate + inflation). When inflation is higher, the currency mostly inflation). depreciates over time. Thus, there is a risk of depreciation of time. investment due to lower exchange rate during the re-conversion re-

Interest Arbitrage Uncovered Interest Arbitrage after maturity. If such a foreign exchange risk is covered, we maturity. have covered interest arbitrage, else, we have uncovered interest arbitrage. arbitrage. Suppose, interest rate in India is 11% where as it is 5% in US. A 11% US. US investor will earn 6% extra per year or 3% every 6 months if he invests in India. However, since inflation rate is also high in India. India at 5% compared to just 2% in US, INR is likely to depreciate. depreciate. If INR depreciates by 3% over one year, net return on investment by US investor falls to barely 3%. However, in case INR depreciates by more than 6%, the US investor will end up as net loser (and we have not even considered the transaction costs in conversion and reconversion processes). processes).

Interest Arbitrage Covered Interest Arbitrage The scenario given above is not beyond real life events. In order events. to insure against exchange rate risks, investors usually go for covered interest rate arbitrage. arbitrage. In this case, investor converts his investment into foreign currency at spot rate and at the same time sells forward the amount of foreign currency he is investing plus the interest he would earn to coincide with maturity date of investment. investment. Though, he would be paying some premium for forward cover, he is insured against depreciation of currency. His return on currency. investment will reduce by the amount of premium paid for forward deal compared to uncovered interest arbitrage but that is the price to be paid for insurance. insurance. But such opportunities do not last long due to two reasons. reasons. - As funds move out of the home country, the interest rates rise there due to resultant paucity of funds. Vice versa as additional funds. funds flow in to foreign country, excess liquidity of capital causes interest rates to soften. soften.

Interest Arbitrage Covered Interest Arbitrage . - As demand for foreign currency rises, exchange rates move in favour of foreign currency. Currency appreciation coupled with currency. excess demand for forward deals raise premium on forward deals. deals. Thus, the cost of conversion and reconversion of currency to foreign currency increases and eats into profits to be earned from interest rate arbitrage. arbitrage. - Thus, the interest rate differential keeps reducing and forward premium keeps increasing till it comes to a level where it is no more advantageous to invest in foreign country. country.

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