financial management meaning of financial...
TRANSCRIPT
Management Chapter I
Management of funds is an important aspect of financial management.
Meaning of Financial Management
- Financial management is that managerial activity which is concerned
with planning and controlling of the firm’s financial resources. - It is concerned with acquiring, financing and managing assets to
accomplish the overall goal of a business enterprise (mainly to maximise
the shareholder’s wealth). - Financial management comprises the forecasting, planning, organizing,
directing, coordinating and controlling of all activities relating to
acquisition and application of the financial resources of an undertaking in keeping with its financial objective.”
- Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm.
- Financial Management is concerned with efficient acquisition (financing) and allocation(investment in assets, working capital etc) of funds
What does Financial Management mean-
Efficient use of economic resources namely capital funds.
According to Phillippatus, "Financial management is concerned with the
managerial decisions that result in the acquisition and financing of short
term and long term credits for the firm".
Here it deals with the situations that require selection of specific assets
(or combination of assets), the selection of specific size and growth of an enterprise.
Here the analysis deals with the expected inflows and outflows of funds and their effect on managerial objectives.
So the analysis simply states two main aspects of financial management namely procurement of funds and an effective use of funds
to achieve business objectives.
Procurement of funds:
As funds can be obtained from different sources, the procurement of funds is considered as an important aspect of business concerns.
Funds procured from different sources have different characteristics in terms of risk, cost and control.
Funds raised by issue of equity shares are the best from the point of view of risk for the company, as there is no question of repayment of equity
capital except when the company is under liquidation.
From the cost point, equity capital is the most expensive source of funds
as dividend expectations of shareholders are normally higher than the prevalent interest rates.
Financial management constitutes risk, cost and control. The cost of funds should be at minimum for a proper balancing of risk and control.
In the Globalised competitive scenario mobilization of funds plays a very significant role.
Funds can be raised either through domestic market or international market. Foreign Direct Investment (FDI) as well as Foreign Institutional
Investors (FII) is two major sources of raising funds. The mechanism of procurement of funds has to be modified in the light of requirements of foreign investors.
Utilization of Funds:
1. Effective utilization of funds is an important aspect of financial management as it avoids the situations where funds are either kept idle or under-utilised.
2. Funds procured involve a certain cost and risk.
3. If the funds are not used properly, then running business will have difficulties.
4. In case of dividend decisions we also consider this. So it is crucial to employ the funds properly and profitably.
How do we measure the wealth of a company ?
Value of a firm is represented by the market price of the company's
common stock. The market price of a firm's stock represents the focal judgment of
all market participants as to what the value of the particular firm is.
It takes into account present and prospective future earnings per share,
the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock.
The market price serves as a performance index or report card of the
firm's progress. It indicates how well management is doing on behalf of stockholder
Investment Decisions :
Decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured from different sources have to be invested in various kinds of assets.
Long term funds are used in a project for various fixed assets and also for current assets.
The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting.
Part of the long term funds is also kept for financing the working
capital requirements. Asset management policies are to be laid down regarding various
items of current assets. The inventory policy would be determined by the production
manager and the finance manager, keeping in view the
requirement of production and the future price estimates of raw materials and the availability of funds.
Financing decisions:
Decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively
managed. The financial manager needs to possess a good knowledge of the
sources of available funds and their respective costs and needs to
ensure that the company has a sound capital structure, i.e. a proper balance between equity capital and debt.
Managers need to have a very clear understanding as to the
difference between profit and cash flow, bearing in mind that profit is of little avail unless the organisation is adequately supported by
cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of
risk, e.g. excessive debt carries high risk for an organization’s
equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading,
where an organisation is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures such as hedging (it is a strategy designed to minimize,
reduce or cancel out the risk in another investment available to him).
Dividend decisions:
Decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders.
The owner of any profit-making organization looks for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be
termed as drawings and for a limited liability company the term is dividends.
What is the importance of Financial Management?
The importance of good financial management is to describe some of the tasks that it involves:-
Avoidance of over investment in the fixed assets Balancing cash-outflow with cash-inflows
Ensuring that there is a sufficient level of short-term working capital
Setting sales revenue targets that will deliver growth
Increasing gross profit by setting the correct pricing for products or services
Controlling the level of general and administrative expenses by finding more cost efficient ways of running the day-to-day business
operations Tax planning that will minimize the taxes a business has to pay.
What are scopes of Financial Management ?
Determination of size of the enterprise and determination of rate of growth.
Determining the composition of assets of the enterprise. Determining the mix of enterprise’s financing i.e. consideration of level of
debt to equity, etc.
Analysis, planning and control of financial affairs of the enterprise. A sound financial management is essential in all types of organizations
whether it may be profit or non-profit.
Financial management is essential in a planned Economy as well as in a capitalist set-up as it involves efficient use of the resources.
From time to time, it is seen that many firms have been liquidated not because their technology was obsolete or because their products were not in demand or their Labour was not skilled and motivated but there
was a complete mismanagement of financial affairs. Even in a boom period, when a company make high profits there is also a
fear of liquidation because of bad financial management. Financial management optimizes the output from the given input of
funds.
In the country like India where resources are scarce and the demand for funds are many, the need of proper financial management is required.
In case of newly started companies with a high growth rate it is more
important to have sound financial management since finance alone guarantees their survival.
Financial management is very important in case of non-profit organizations, which do not pay adequate attentions to financial management.
However a sound system of financial management has to be cultivated among bureaucrats, administrators, engineers, educationalists and public at a large.
Present Value
- “Present Value” is the current value of a “Future Amount”.
- It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equal the “Future Amount”.
Annuity
- An annuity is a stream of regular periodic payment made or received for
a specified period of time.
- In an ordinary annuity, payments or receipts occur at the end of each period.
Perpetuity
Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and continue indefinitely or perpetually.
Fixed coupon payments on permanently invested (irredeemable) sums of
money are prime examples of perpetuities.
Financial Management In India
In the country like India there is a changing scenario of financial
management.
As the economy is opening up and global participation is increasing very fast, the opportunities have no limits.
Presently financial management passes through an era of experimentation as a larger part of finance activities are carried out.
Highlights Context:
Interest rates are free from regulations. Rupee is fully convertible in current account.
Optimum debt equity mix is possible. Maintaining share prices are also crucial. In liberalized scenario the
capital market is an important avenue of funds for business. Ensuring management control is vital especially in the light of foreign
participation.
Financial Management Objectives
1) Profit Maximization:
Objective of financial management is same as the objective of a company
that is to earn profit.
But profit maximization cannot be the sole objective of a company. It is a
limited objective.
If profits are given undue Importance then problems may arise as
discussed below.
The term profit is vague and it involves much more contradictions. Profit maximization has to be attempted with a realization of risks
involved. A positive relationship exists between risk and profits. So both risk and profit objectives should be balanced.
Profit Maximization does not take into account the time pattern of
returns. Profit maximization fails to take into account the social considerations
2) Wealth Maximization:
- It is commonly agreed that the objective of a firm is to maximize value or
wealth.
- Value of a firm is represented by the market price of the company's
common stock.
The market price of a firm's stock represents the focal judgement of all
market participants as to what the value of the particular firm is.
It takes in to account present and prospective future earnings per share, the timing and risk of these earning, the dividend policy of the firm and
many other factors that bear upon the market price of the stock. Market price acts as the performance index or report card of the firm's progress.
- Prices in the share markets are largely affected by many factors like
general economic outlook, outlook of particular company, technical factors
and even mass psychology.
Normally this value is a function of two factors as given below,
The anticipated rate of earnings per share of the company The capitalization rate.
The likely rate of earnings per shares (EPS) depends upon the assessment as to how profitably a company is growing to operate in the future.
The capitalization rate reflects the interest of the investors for the company. Methods of Financial Management:
In the field of financing there are various methods to procure funds.
Funds may be obtained from long-term sources as well as from short-term sources.
Long-term funds may be availed by owners that are shareholders, lenders by issuing debentures, from financial institutions, banks and public at large.
Short-term funds may be availed from commercial banks, public
deposits, etc. Financial leverage or trading on equity is an important method by which a finance manager may increase the return to common shareholders.
At the time of evaluating capital expenditure project, methods like average rate of return, pay back, internal rate of returns, net present
value and profitability index are used.
A firm can increase its profitability without affecting its liquidity by an efficient management of working capital and utilization of the current
resources at the disposal of the firm.
Similarly for the evaluation of a firm's performance there are different
methods.
Ratio analysis is a popular technique to evaluate different aspects of a firm.
An investor takes in to account various ratios to know whether investment in a particular company will be profitable or not.
These ratios enable him to judge the profitability, solvency, liquidity and growth aspect of the firm.
LIQUIDITY:
Is defined as ability of the business to meet short-term obligations.
It shows the quickness with which a business/company can convert its assets into cash to pay what it owes in the near future.
It measures a company’s ability to meet expected as well as unexpected requirements of cash to expand its assets, reduce its liabilities and cover
up any operating losses.
Liquidity is assessed through the use of ratio analysis. liquidity ratio
provides an insight into the present cash solvency of a firm and its ability to remain solvent in the event of financial crisis.
Liquidity of receivables is assessed through Average collection period(ACP) as it tells us the average number of days receivables are
outstanding i.e., the average time a bill takes to convert into cash.
The ratio, reveals the following:
Too low an ACP may suggest excessively restricted credit policy of a
company.
Too high an ACP may indicate too liberal a credit policy. A large number
of receivables may remain due and outstanding, resulting in less profits and more chances of bad debts.
PROFITABILITY:
When it becomes essential for a company to examine profit per unit of
sale - it is done by estimating profitability per rupee sales. It is used as measure of comparison and standard of performance.
Profitability to sales ratio reflects the company’s ability to generate profits per unit of sales.
FINANCIAL DISTRESS AND INSOLVENCY:
In managing business risk, the firm has to cope with the variability of the demand for its products, their prices, etc.
It has also to keep a tab on fixed costs.
As regards financial risk, high proportion of debt in the capital structure
entails a high level of interest payments.
If cash inflow is inadequate, the firm will face difficulties in payment of
interest and repayment of principal.
If the situation continues long enough, a time will come when the firm
would face pressure from creditors.
Failure of sales can also cause difficulties in carrying out production
operations.
The firm would find itself in a tight spot.
Investors would not invest further. Creditors would recall their loans.
Capital market would heavily discount its securities.
Thus, the firm would find itself in a situation called distress.
When the sale proceeds is inadequate to meet outside liabilities, the firm is said to have failed or become bankrupt or (after due processes of law
are gone through) insolvent.
FUNCTIONS OF FINANCIAL EXECUTIVE:
Forecasting of cash flow Raising funds
Managing the flow of internal funds To facilitate cost control To facilitate pricing of product lines and services
Forecasting profits Measuring required return
Managing assets Managing funds
FINANCIAL SECTOR REFORMS IN INDIA:
Following key areas of reforms:
Reforms of structure of financial systems
Policies and regulations to deal with insolvency and liquidity of financial intermediaries
The development of markets for short and long term financial instruments
The role of institutional elements in development of financial systems
The link between financial sector and the real sectors, particularly in the case of restructuring financial and industrial institutions or enterprises
The dynamics of financial systems management in terms of stabilization and adjustment, and
Access to international markets.
The financial sector reforms in India seeks to achieve the following:
Suitable modifications in the policy framework
Improvement in the financial health and competitive capabilities Building financial infrastructure
Up gradation of the level of managerial competence and the quality of human resource of banks by reviewing to recruitment, training, and placement.
Capital budgeting is concerned with decisions which each return on investment
over a period of time in future. For evaluation of investment proposal an
estimation of the future benefits accruing from the investment proposal is
required to be made. To quantify the benefits, two alternative criteria are
available and they are accounting profit and cash flows. The basic
differentiating factor is the inclusion of certain non-cash expenses in the profit
and loss account such as, depreciation. The accounting profit is to be adjusted
for these non-cash expenditure to determine the actual cash inflow. The cash
flow approach of measuring the future benefits of a project is superior to the
accounting approach as cash flows are theoretically better measures of the net
economic benefits of costs associated with a proposed project, because of the
following three reasons.
- It considered economic value which is determined by the economic
outflows and inflows.
- The use of cash flows avoids accounting ambiguities.
- The cash flow approach takes into account the time value of money
whereas the accounting approach ignores it.
Net Present Value :
- It is a process of calculating the present value of cash flows(inflows and
outflows) of an investment proposal, using the cost of capital as the
appropriate discounting rate and finding out the net present value by
subtracting the present value of cash outflows from the present value of
cash inflows.
- The decision criteria using NPV method is to accept the investment
project if its present value is positive or equal to zero.
Internal Rate of return :
- It is that rate of discount which equates the present value of cash inflows
with the present value of cash outflows of an investment. In other words,
it is the rate at which the NPV of the investment is zero.
- It is a percentage figure which will not indicate the financial
attractiveness of the project in percentage term.
SOURCES OF FINANCE CHAPTER IV
What is Equity shares ?
- Funds raised by the issue of equity shares are the best in the risk point
of view for the firm, since there is no question of repayment of equity capital except when the firm is under liquidation.
- However, equity capital is usually the most expensive source of funds from the cost point of view. This is because the dividend expectations of
shareholders are normally higher than prevalent interest rate and also because dividends are an appropriation of profit, not allowed as an expense under the Income Tax Act.
- Also the issue of new shares to public may dilute the control of the
existing shareholders. What is Debenture ?
- Debentures as a source of funds are comparatively cheaper than the
shares because of their tax advantage.
- The interest the company pays on a debenture is free of tax, unlike a dividend payment which is made from the taxed profits.
- However, even when times are hard, interest on debenture loans must be paid whereas dividends need not be.
- However, debentures entail a high degree of risk since they have to be
repaid as per the terms of agreement. Also, the interest payment has to be made whether or not the company makes profits.
Recourse factoring :
- Under recourse factoring, the factor provides all types of factoring services except assumption of the credit risk of the debts. Consequently, if the customer makes default in payment of the debt on maturity for any
reason, the factor is entitled to recover from the client the amount
advanced against such debt, in all other respects, recourse factoring is akin to full factoring.
Loan syndication :
- Loan syndication involves obtaining commitment for term loans from the
financial institutions and banks to finance the project.
- It refers to the services rendered by merchant bankers in arranging and procuring credit from financial institutions, banks and other lending and investment organization or financing the client project cost or working
capital requirements. Process of loan syndication involves the following usual formalities :
(a) Preparation of project details. (b) Preparation of loan application.
(c) Selection of financial institutions for loan syndication. (d) Issue of sanction letter of intent from financial institutions
(e) Compliance of terms and conditions for availment of the loan (f) Documentation (g) Disbursement of the loan
Source of Real estate funding :
- Two major instruments of real estate financing are mortgage loans/ mortgages and real estate leases.
- Mortgages are instruments that conveys real estate as security for debt. - The debt is evidenced by a promissory note or bond representing a
personal promise to repay.
- A lease conveys to the ‘lessee’ (tenant) the right to possess and use another’s property for a period of time. During this time, the ‘lessor’ (land lord or fee owner) possesses a ‘reversion’ that entitles him to retake
possession at the end of the lease period. - Apart from own resources, there are a host of financial institutions
engaged in real-estate funding. In fact, the Govt itself is an important source of real estate finance. In Indian context, the sources of finance include state housing boards, loans from employers, loans from co-op
housing societies, HDFC, housing schemes of banks, LIC - There are a host of informal mortgage lenders called ‘financiers’ who are
also engaged in real estate counseling and finance. Financing cost escalation :
- Cost escalation results in the increase in project cost for many reasons
viz., delay in implementation of project and inflationary pressure on
corporate purchasing are the main reasons for cost escalation.
- Financing cost escalation will depend upon the corporate arrangements as to how the project cost has originally been financed. There may be
two different aspects to treat the financing of cost escalation as discussed below :
(1) Firstly, financing cost escalation in the case when the project is new and financed by owner fund only. In such cases, the raising of equity is costly but issue of right shares to existing shareholder could be
planned and this cost be met out. There may be another situation when the company is existing company and project cost is being financed by its internal funds. In this case, the company can use its
reserves and surplus in financing cost escalation. (2) In second situation, where the company has been using borrowed
sums in addition to equity capital for financing the project cost, it can always make request for additional funds to the lending institutions to meet the cost escalation or over runs in the project cost. In case the
cost escalation is of greater magnitude then the company will have to go to raise funds from equity holders besides raising loans from the
institutions so as to maintain the debt equity ratio in the existing balanced and planned proportions.
CAPITAL STRUCTURE CHAPTER III
MEANING:
- Capital structure of a firm is a reflection of the overall investment and financing strategy of the firm.
- Capital structure can be of various kinds as described below:
Horizontal capital structure: the firm has zero debt
component in the structure mix. Expansion of the firm takes through equity or retained earnings only.
Vertical capital structure: the base of the structure is formed by a small amount of equity share capital. This
base serves as the foundation on which the super structure of preference share capital and debt is built.
Pyramid shaped capital structure: this has a large proportion consisting of equity capital and retained
earnings.
Inverted pyramid shaped capital structure: this has a
small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt.
SIGNIFICANCE OF CAPITAL STRUCTURE:
- Reflects the firm’s strategy - Indicator of the risk profile of the firm
- Acts as a tax management tool - Helps to brighten the image of the firm.
FACTORS INFLUENCING CAPITAL STRUCTURE:
- Corporate strategy - Nature of the industry
- Current and past capital structure
CAPITAL STR.
- It relates to long-term capital deployment for creation of long-term assets.
- It is the core element of the
financial structure. It can exist without the current liabilities and in such cases
FINANCIAL STR
- involves creation of both long term and short term assets
- CS shall be equal to the
financial structure
- The components of the
Capital structure may be used to build up the level of current assets but the
current liabilities should not be used to finance acquisition of fixed assets.
- FS of a firm is considered to
be a balanced one if the amount of current liabilities is less than the capital
structure net outside debt because in such cases the long-term capital is
considered sufficient to pay current liabilities in case of
sudden loss of current assets.
PLANNING AND DESIGNING OF CAPITAL STRUCTURE:
- Attributes of a well planned capital structure - Designing a capital structure
- Design should be functional - Design should be flexible - Design should be confirming statutory guidelines
DETERMINANTS OF CAPITAL STRUCTURE:
- Minimization of risk
- Maximization of profit - Nature of the project
- Control of the firm
COST OF CAPITAL:
Factors determining cost of capital:
- General economic conditions: fluctuations in interest rates occur as a result of changes in the demand supply equilibrium of ingestible
funds.
- Risk profile of the project: a project considered risky would attract capital at a higher cost than a project in the same industry having
lesser risk.
COST OF DEBT:
- Concerned essentially with the long-term debt of the firm. - The long-term debt has been used to finance long-term projects.
- We denote cost of debt by the symbol k (d). It is calculated in different ways depending upon whether the debt is a rolling or a term debt redeemable at the expiry of the term.
COST OF PREFERENCE SHARE CAPITAL:
- The preference dividend is equal to the interest payment and
redemption of preference capital is equivalent to redemption of debt.
- Its inclusion in the share capital component is primarily done to bring
down the borrowings of the firm in the balance sheet.
- Cost of preference share capital is arrived at by equating the aggregate of present value of the periodic dividend payments and the redemption amount.
LEVERAGE ANALYSIS
The term “Leverage” in general refers to a relationship between two interrelated
variables In Financial analysis it represents the influence of one financial variable over
some other related financial variable Leverage is used by business firms to quantify the risk-return relationship by
different alternative capital structures.
The operating profits i.e. Earnings before Interest and taxes depends upon Investment Decisions of the firm. Irrespective of the level of EBIT or change therein, a fixed amount of interest must be paid to the debt investors.
Consequently, the residual profit (which is available to equity investors) also
varies in response to change in EBIT. The relationship between change in operating profits and earning for shareholders is known as leverage analysis.
These types of leverages can be ascertained as follows :
Operating leverage
It is defined as the firm’s ability to use fixed operating costs to magnify effects of changes in sales on its EBIT.
It may be defined as the employment of a asset with a fixed cost in the
hope that sufficient revenue will be generated to cover all the fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating leverage.
A change in sales will lead to a change in profit i.e. EBIT. However,
variable costs will change in proportion to sales while fixed costs will remain constant.
Hence a change in sales will lead to a more than proportional change in EBIT. The effect of change in sales on EBIT is measured by OL.
When Sales increases, Fixed Costs will remain the same irrespective of
the level of output, and so, the percentage increase in EBIT will be higher than increase in sales. This is the favourable effect of OL.
Operating leverage is the ratio of net operating income before fixed
charges to net operating income after fixed charges. Degree of OL is equal to the percentage increase in the net operating
income to the percentage increase in the output.
OL is a function of three factors :
(i) Rupee amount of fixed cost (ii) Variable contribution margin (iii) Volume of sales
Operating leverage = % change in EBIT
---------------- % change in sales
Or
Contribution / EBIT
The OL studies effect of change in sales on EBIT of the firm.
Financial leverage :
FL is defined as the ability of a firm to use fixed financial charges
(interest) to magnify the effect of changes in EBIT, on the firm’s EPS.
FL is defined as the use of funds with a fixed cost in order to increase EPS.
FL occurs when a company has debt content in its capital structure and fixed financial charges. These fixed charges do not vary with EBIT. They
are fixed and are to be paid irrespective of level of EBIT. When EBIT increases, the interest payable on debt remains constant and
hence residual income available to equity shareholders will also increase
more than proportionately. Hence, an increase in EBIT will lead to a higher percentage increase in
EPS. This is measured by FL.
Degree of FL is the ratio of the percentage increase in EPS to the percentage increase in EBIT.
Financial leverage = % change in EPS
-------------------
% change in EBIT OR
EBIT / PBT OR EBIT
----- PBT – PD / (1-t)
The FL studies the effect of change in EBIT on EPS of the firm.
Combined Leverage :
It is used to measure the total risk of the firm i.e. operating risk and
financial risk. It is defined as the potential use of fixed costs, both operating and
financial, which magnifies the effect of sales volume change on the EPS
of the firm. Effect of fixed operating costs is measured by OL. Effect of fixed interest
charges is measured by FL. Combined effect of these is measured by Combined leverage.
Degree of combined leverage is ratio of percentage change in EPS to the
percentage change in sales. It indicates the effect of change in sales on EPS.
Combined leverage = % change EBIT x% change in EPS = % change in EPS % change in sales % change in EB IT % change in sales
OR C x EBIT C ----- ------ ----
EBIT PBT PBT
OR OL x FL
EBIT – EPS analysis
Capital structure can also be analyzed with reference to the effect of financing pattern on the return available to the shareholders. The financing pattern will affect the apportionment of EBIT over different suppliers of funds and in
particular affect the return to the equity shareholders. This is due to the fact that different combinations of debt, preference capital and equity capital have different tax implications. Given a level of EBIT, a particular combination of
different sources will have a particular EPS and for different financing patterns there will be different EPS.
FINANCIAL BREAK EVEN LEVEL
A financial breakeven level is that level of EBIT at which the EPS is zero. If the EBIT reduces below this level, the EPS would be negative.
Financial break even of EBIT = Interest + Pref Div / (1 – t)
Indifference level Indifference level of EBIT is one at which the EPS under two different debt
equity mix is same. In other words, an indifference level of EBIT is such level of EBIT terms. The indifference level of EBIT can be ascertained either
graphically or with the help of finding the value of EBIT in any of the following equations :
(EBIT – Int.1) x (1 – t) – PD.1 (EBIT – Int.2) x (1 – t) – PD.2 ----------------------------------- = -----------------------------------
N.1 N.2
POINTS TO REMEMBER
- The total funds needed by the firm depend upon the investment
decisions of the firm. However, the next step is to determine the best mix of different sources of funds. The process that leads to the choice of capital mix is referred to as capital structure planning.
- There are different techniques of analysing the risk return characteristics of different alternative capital structure. The leverage analysis and EBIT-
EPS analysis are two such techniques.
- In leverage analysis, the relationship between two inter-related variables is established. In FM, there are two types of leverages calculated. These
are OL & FL. A CL may also be calculated.
- The OL establishes the relationship between sales and EBIT. It measures the effect of change in sales revenue on the level of EBIT. OL
appears as a result of fixed cost. If there is no fixed cost, there will be no OL.
- The FL measures the responsiveness of the EPS for a given change in
EBIT. The FL appears as a result of fixed financial charge i.e interest and preference dividend.
- CL may also be ascertained to measure the % change in EPS for a % change in the sales.
- EBIT-EPS Analysis is another way of looking at the effects of different
types of capital structures. EBIT-EPS analysis considers the effect on EPS of different types of capital mix.
- Given a level of EBIT, a particular combination of different sources (i.e.
Debt, Pref share capital and equity share capital) will result in a particular level of EPS, and therefore, for different financing patterns, there would be different levels of EPS.
- For a given level of EBIT, higher the degree of financial leverage, i.e. higher the level of debt financing, greater would be the EPS (provided ROI is more than cost of debt). However, if the ROI is less than cost of debt,
then the effect of increase in leverage of EPS would be negative.
- Financial breakeven level of EBIT is that level of EBIT at which the EPS
of the firms is zero.
- Indifference level of EBIT is one at which the EPS remains same under two different financial plans. At the indifference level of EBIT, the firm
would be indifferent whether the funds are raised by one capital mix or another because both will have same level of EPS.
- Indifference level of EBIT may be ascertained graphically or with the help
of mathematical formulation.
DIVIDEND POLICY CHAPTER V
THE POLICY:
- This determines what portion of earnings will be paid out to stockholders and what will be retained in the business to finance long-term growth.
- Dividend constitutes the cash flow that accrues to equity holders whereas retained earnings are one of the most significant sources of
funds for financing the corporate growth.
FORMS OF DIVIDEND:
- The most common type of dividend is in the form of cash
- Public companies usually pay cash dividend, sometimes a regular cash dividend and sometimes an extra cash dividend
- Paying a cash dividend reduces the corporate cash and retained
earnings. - It is also paid in the form of shares of stock and this is referred as
stock dividend or bonus shares.
STABLE DIVIDEND POLICY THEORY:
The stability could take three forms:
- Keep dividends at a stable rupee amount but allow its payout
ratio to fluctuate, or
- Maintain stable payout ratio and let the rupee dividend fluctuate, or
- Set low regular dividend and then supplement it with year-end
“extras” in years when earnings are high. As earnings of the firm increase the customary dividend will not be altered but a year-end “extras” will be declared.
RESIDUAL THEORY OF DIVIDEND POLICY:
- Dividend policy is strictly a financing decision; the payment of cash
dividend is a passive residual.
- The amount of dividend payout will fluctuate from period to period in
keeping with fluctuations in the amount of acceptable investment opportunities available to the firm.
- If the firm is unable to find out profitable investment opportunities, payout will be 100%.
- The theory implies that investors prefer to have the firm retain and reinvest earnings rather than pay them out in dividends if the return
on re-invested earnings exceeds the rate of return the investors could themselves obtain on other investments of comparable risks.
IRRELEVANCE OF DIVIDEND:
- Investors are indifferent to dividends and capital gains and so
dividends have no effect on the wealth of shareholders.
- They argue that the value of the firm is determined by the earning power of firms assets or its investment policy.
- The manner in which earnings are divided into dividends and retained earnings does not affect this value.
DETERMINANTS OF DIVIDEND POLICY:
- Legal: dividends must be paid out of firm’s earnings/ current earnings
- Financial: a firm can pay dividend only to the extent that it has cash to disburse
- Economic constraints
- Nature of business conducted by a company
- Existence of the company: length of existence of the company.
- Type of company Organisation: pvt. Or public
- Financial needs of the company.
- Market conditions
- Financial arrangements
- Change in government policies
LEGAL ASPECTS OF DIVIDENDS:
1. Dividends to be paid only out of profits:
- It is necessary for a company to declare and pay dividend only out of
profits for that year arrived at after providing for depreciation in accordance with the provisions of section 205(2) of the Companies
Act.
- A dividend could be declared out of profits of the company for any
previous financial year or years arrived after providing for depreciation in accordance with those provisions and remaining undistributed.
- The dividend can also be declared out of moneys provided by the central govt. or a state govt. for the payment of dividend in pursuance
of guarantee given by that govt.
- The company is required to transfer to the reserves such percentage
of its profits for that year not exceeding 10% in addition to providing for depreciation as required under section 205(2A) of the Companies Act.
2. Unpaid dividend to be transferred to special dividend account:
- Dividends are to be paid within 30 days from the date of the declaration
- If they are not paid the company is required to transfer the unpaid dividend to unpaid account within 7 days of the expiry of the period of
30 days.
- The company is required to open this account in any scheduled bank
as required under section 205-A of the Companies Act, 1956
3. Dividend is to be paid only to registered shareholders or to their order or their bankers
TRANSFER OF UNPAID/UNCLAIMED DIVIDEND TO INVESTOR EDUCATION AND PROTECTION FUND:
1. Any money transferred to the unpaid dividend account of a company in pursuance of section 205A(5) which remains unpaid or unclaimed for a
period of 7 years from the date of such transfer to unpaid dividend account, shall be transferred by the company to the investor education and protection fund established under sub-section (1) of section 205C
2. Sub-section (1A) of section 205 stipulates that the board of directors may declare interim dividend and the amount of dividend including interim
dividend is to be such deposited in a separate bank account within 5 days from the date of declaration.
3. Failure to do so, every director of the company, shall, if knowingly a
party to the default, be punishable with simple imprisonment for a term which may extend to 3 years and shall also liable to a fine of rupees for everyday during which such default continues and
4. The company shall be liable to pay simple interest at a rate of 18% p.a. during the period for which such default continues.
WORKING CAPITAL MANAGEMENT AND CONTROL CHAPTER VI
BASIC CONCEPTS AND FORMULAE
1. Working Capital Management
a. Working Capital Management involves managing the balance between
firm’s short term assets and its short-term liabilities. b. From the value point of view, Working Capital can be defined as:
i. Gross Working Capital: It refers to the firm’s investment in current assets.
ii. Net Working Capital: It refers to the difference between current
assets and current liabilities. c. From the point of view of time, working capital can be divided into:
i. Permanent Working Capital: It is that minimum level of investment in the current assets that is carried by the business at all times to carry out minimum level of its activities.
ii. Temporary Working Capital: It refers to that part of total working capital, which is required by a business over and above permanent working capital.
2. Factors To Be Considered While Planning For Working Capital Requirement
Nature of business
Market conditions
Demand conditions
Operating efficiency
Credit policy
3. Finance manager has to pay particular attention to the levels of current assets and their financing. To decide the levels and financing of current
assets, the risk return trade off must be taken into account. In determining the optimum level of current assets, the firm should balance the profitability – Solvency tangle by minimizing total costs.
4. Working Capital Cycle Working Capital Cycle indicates the length of time between a company’s paying for materials, entering into stock and receiving the cash from sales of
finished goods. It can be determined by adding the number of days required for each stage in the cycle.
5. Computation of Operating Cycle a. Operating Cycle = R + W + F + D – C Where,
R = Raw material storage period W = Work-in-progress holding period
F = Finished goods storage period D = Debtors collection period. C = Credit period availed.
The various components of operating cycle may be calculated as shown below:
Average cost of rawmaterial consumption per day Raw material storage period Average stock of raw material
Work - in- progress holdingperiod Average cost of production per day
Average work - in - progress inventory
Average cost of goods soldper day
Finished goods storage period Average stock of finished goods
Average Credit Sales per day
Debtors collection period Average book debts
Average credit purchases per day Credit period availed Average trade creditors 6. Treasury Management
Treasury management is defined as ‘the corporate handling of all financial matters, the
generation of external and internal funds for business, the management of currencies and cash flows and the complex, strategies, policies and procedures of corporate
finance”. 7. Management of Cash It involves efficient cash collection process and managing payment of cash both
inside the organisation and to third parties.
Financial Management 7.3 The main objectives of cash management for a business are:-
i. Provide adequate cash to each of its units; ii. No funds are blocked in idle cash; and
iii. The surplus cash (if any) should be invested in order to maximize returns for the business.
8. Cash Budget Cash Budget is the most significant device to plan for and control cash receipts and
payments. This represents cash requirements of business during the budget period. The
various purposes of cash budgets are: i. Coordinate the timings of cash needs. It identifies the period(s) when there might
either be shortage of cash or an abnormally large cash requirement; ii. It also helps to pinpoint period(s) when there is likely to be excess cash;
iii. It enables firm which has sufficient cash to take advantage like cash discounts on its
accounts payable; iv. Lastly it helps to plan/arrange adequately needed funds (avoiding
excess/shortage of cash) on favorable terms. 9. Preparation of Cash Budget
The Cash Budget can be prepared for short period or for long period. Cash budget for short period: Preparation of cash budget month by month would
require the following estimates: (a) As regards receipts:
Receipts from debtors; Cash Sales; and Any other source of receipts of cash (say, dividend from a subsidiary
company) (b) As regards payments:
Payments to be made for purchases; Payments to be made for expenses; Payments that are made periodically but not every month;
(i) Debenture interest; (ii) Income tax paid in advance;
(iii) Sales tax etc. Management of Working Capital 7.4
Special payments to be made in a particular month, for example, dividends to shareholders, redemption of debentures, repayments of loan, payment of
assets acquired, etc. Cash Budget for long period: Long-range cash forecast often resemble the projected
sources and application of funds statement. The following procedure may be adopted to prepare long-range cash forecasts:
(i) Take the cash at bank and in the beginning of the year: (ii) Add: (a) Trading profit (before tax) expected to be earned; (b) Depreciation and other development expenses incurred to be written off; (c) Sale proceeds of assets’;
(d) Proceeds of fresh issue of shares or debentures; and (e) Reduction in working capital that is current assets (except cash) less
current liabilities. (iii) Deduct:
(a) Dividends to be paid. (b) Cost of assets to be purchased.
(c) Taxes to be paid.
(d) Debentures or shares to be redeemed. (e) Increase in working capital.
10. Cash Management Models William J. Baumol’s Economic Order Quantity Model, (1952): According to
this model, optimum cash level is that level of cash where the carrying costs and transactions costs
are the minimum. The formula for determining optimum cash balance is: S
C 2U P
Miller-Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic.
When changes in cash balance occur randomly the application of control theory serves a
useful purpose. The Miller-Orr model is one of such control limit models. Financial Management 7.5
11. Management of Marketable Securities Management of marketable securities is an integral part of investment of cash as this may
serve both the purposes of liquidity and cash, provided choice of investment is made
correctly. As the working capital needs are fluctuating, it is possible to park excess funds in some short term securities, which can be liquidated when need for cash is
felt. The selection of securities should be guided by three principles.
Safety: Return and risks go hand in hand. As the objective in this
investment is ensuring liquidity, minimum risk is the criterion of selection.
Maturity: Matching of maturity and forecasted cash needs is essential. Prices of
long term securities fluctuate more with changes in interest rates and are therefore, more risky.
Marketability: It refers to the convenience, speed and cost at which a
security can be converted into cash. If the security can be sold quickly without loss of
time and price it is highly liquid or marketable. 12. Inventory Management Inventory management covers a large number of problems including fixation of
minimum and maximum levels, determining the size of inventory to be carried, deciding
about the
issues, receipts and inspection procedures, determining the economic order quantity,
proper storage facilities, keeping check over obsolescence and ensuring control over
movement of inventories. 13. Management of Receivables
The basic objective of management of sundry debtors is to optimise the
return on investment on these assets known as receivables.
Large amounts are tied up in sundry debtors, there are chances of bad
debts and there will be cost of collection of debts. On the contrary, if the investment in
sundry debtors is low, the sales may be restricted, since the competitors may offer more
liberal terms. Therefore, management of sundry debtors is an important issue and
requires proper policies and their implementation. There are basically three aspects of management of sundry debtors:
(i) Credit policy: The credit policy is to be determined. It involves a trade off
between the profits on additional sales that arise due to credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. This seeks to decide credit period, cash discount and other relevant
matters. (ii) Credit Analysis: This requires the finance manager to determine as to how
risky it is to advance credit to a particular party. (iii) Control of Receivables: This requires finance manager to follow up debtors
Management of Working Capital 7.6 and decide about a suitable credit collection policy. It involves both laying
down of credit policies and execution of such policies.
Important Sources of Financing of Receivables (i) Pledging: This refers to the use of a firm’s receivable to secure a short term loan.
(ii) Factoring: In factoring, accounts receivables are generally sold to a financial
institution (a subsidiary of commercial bank-called “Factor”), who charges commission and bears the credit risks associated with the accounts receivables purchased by it.
14. Management of Payables Management of Payables involves management of creditors and suppliers. Trade creditor is a spontaneous source of finance in the sense that it arises
from
ordinary business transaction. But it is also important to look after your creditors -
slow payment by you may create ill-feeling and your supplies could be disrupted and
also create a bad image for your company. Creditors are a vital part of effective cash management and should be
managed
carefully to enhance the cash position. 15. Financing of Working Capital
It is advisable that the finance manager bifurcates the working capital
requirements between permanent working capital and temporary working capital.
The permanent working capital is always needed irrespective of sales fluctuations, hence should be financed by the long-term sources such as debt and equity.
On the contrary, temporary working capital may be financed by the short-term sources
of finance.
Broadly speaking, the working capital finance may be classified between the
two categories: (i) Spontaneous Sources: Spontaneous sources of finance are those which
naturally arise in the course of business operations. Trade credit, credit from employees, credit from suppliers of services, etc. are some of the examples
which may be quoted in this respect. (ii) Negotiable Sources: On the other hand the negotiated sources, as the name
implies, are those which have to be specifically negotiated with lenders say, commercial banks, financial institutions, general public etc. Financial Management
7.7 UNIT – I : MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL
Question 1 Discuss the factors to be taken into consideration while determining the requirement of working capital. (November 2008) Answer
Factors to be taken into consideration while determining the requirement of working capital: (i) Production Policies (ii) Nature of the business
(iii) Credit policy (iv) Inventory policy (v) Abnormal factors (vi) Market conditions (vii) Conditions of supply (viii) Business cycle
(ix) Growth and expansion (x) Level of taxes (xi) Dividend policy (xii) Price level changes
(xiii) Operating efficiency. Question 2
Discuss the liquidity vs. profitability issue in management of working capital. (November 2010) Answer Liquidity versus Profitability Issue in Management of Working Capital Working capital management entails the control and monitoring of all
components of working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager has to pay
particular attention to the levels of current assets and their financing. To decide the level of
financing of current assets, the risk return trade off must be taken into account. The level of current assets can be measured by creating a relationship between current assets and
fixed assets. A firm may follow a conservative, aggressive or moderate policy.
Management of Working Capital 7.8 A conservative policy means lower return and risk while an aggressive policy
produces higher return and risk. The two important aims of the working capital management are profitability and
solvency. A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a
stock out situation. However, there is a cost associated with maintaining a sound liquidity position. So, to have a higher profitability the firm may have to sacrifice solvency and
maintain a relatively low level of current assets. Question 3
Discuss the estimation of working capital need based on operating cycle process. (November 2010) Answer Estimation of Working Capital Need based on Operating Cycle One of the methods for forecasting working capital requirement is based on the
concept of operating cycle. The determination of operating capital cycle helps in the
forecast, control and management of working capital. The length of operating cycle is the indicator of performance of
management. The net operating cycle represents the time interval for which the firm has to negotiate for Working Capital from its Bankers. It enables to determine
accurately the amount of
working capital needed for the continuous operation of business activities. The duration of working
capital cycle may vary depending on the nature of the business. In the form of an equation, the operating cycle process can be expressed as
follows: Operating Cycle = R + W + F +D – C Where,
R = Raw material storage period. W = Work-in-progress holding period. F = Finished goods storage period.
D = Debtors collection period. C = Credit period availed.
Question 1
Explain briefly the functions of Treasury Department. (May 2008; June 2009; November 2002) Answer The functions of treasury department management is to ensure proper usage, storage and risk
management of liquid funds so as to ensure that the organisation is able to meet its obligations, collect its receivables and also maximize the return on its investments.
Towards this end the treasury function may be divided into the following:
Management of Working Capital 7.34
(i) Cash Management: The efficient collection and payment of cash both inside the organization and to third parties is the function of treasury department.
Treasury normally manages surplus funds in an investment portfolio.
(ii) Currency Management: The treasury department manages the foreign currency risk exposure of the company. It advises on the currency to be used when invoicing
overseas sales. It also manages any net exchange exposures in accordance with the
company policy. (iii) Fund Management: Treasury department is responsible for planning and sourcing the
company’s short, medium and long-term cash needs. It also participates in the decision on capital structure and forecasts future interest and foreign currency rates.
(iv) Banking: Since short-term finance can come in the form of bank loans or through the
sale of commercial paper in the money market, therefore, treasury department carries out
negotiations with bankers and acts as the initial point of contact with them. (v) Corporate Finance: Treasury department is involved with both acquisition
and disinvestment activities within the group. In addition, it is often responsible for investor relations.
Question 2 Explain Baumol’s Model of Cash Management. (May 2008) Answer
William J. Baumol developed a model for optimum cash balance which is normally used in
inventory management. The optimum cash balance is the trade-off between cost of holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of converting
marketable securities in to cash). Optimum cash balance is reached at a point where the
two opposing costs are equal and where the total cost is minimum. This can be explained with the following diagram:
Transaction Cost Holding Cost Cost
(Rs.) Total Cost
Optimum Cash Balance Financial Management 7.35
The optimum cash balance can also be computed algebraically. Optimum Cash Balance = H
2 AT A = Annual Cash disbursements
T = Transaction cost (Fixed cost) per transaction H = Opportunity cost one rupee per annum (Holding cost) The model is based on the following assumptions:
(i) Cash needs of the firm are known with certainty. (ii) The cash is used uniformly over a period of time and it is also known with
certainty. (iii) The holding cost is known and it is constant. (iv) The transaction cost also remains constant.
Question 3 Explain with example the formula used for determining optimum cash balance according to Baumal’s cash management model. (November 2009) Answer
Formula for Determining Optimum Cash Balance according to Baumol’s Model
C = S
2UP Where, C = Optimum cash balance
U = Annual cash disbursement P = Fixed cost per transaction S = Opportunity cost of one rupee p.a.
Example A firm maintains a separate account for cash disbursement. Total
disbursements are Rs.1,05,000 per month or Rs.12,60,000 per year. An Administrative and transaction cost of transferring cash to
disbursement account is Rs. 20 per transfer. Marketable securities yield is 8% per annum.
Determine the optimum cash balance according to William J. Baumol model. Solution The optimum cash balance C = Rs. 25,100
0.08 2 Rs.12,60,000 Rs.20 Management of Working Capital
7.36 Question 5
Write short note on Different kinds of float with reference to management of cash. (May 1998 & 1999) Answer
Different Kinds of Float with Reference to Management of Cash: The term float is used to refer to the periods that affect cash as it moves through the different stages of the
collection process. Four kinds of float can be identified:
(i) Billing Float: An invoice is the formal document that a seller prepares and sends to the purchaser as the payment request for goods sold or services provided. The time
between the sale and the mailing of the invoice is the billing float.
(ii) Mail Float: This is the time when a cheque is being processed by post office, messenger
service or other means of delivery. (iii) Cheque processing float: This is the time required for the seller to sort, record and
deposit the cheque after it has been received by the company. (iv) Bank processing float: This is the time from the deposit of the cheque to the
crediting of
funds in the seller’s account. Question 6
Write short note on William J. Baumal vs. Miller-Orr Cash Management Model. (May 2004) Answer William J Baumal vs Miller- Orr Cash Management Model: According to William J Baumal’s
Economic order quantity model optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum. The carrying costs refer to the cost of
holding cash, namely, the interest foregone on marketable securities. The transaction costs
refers to the cost involved in getting the marketable securities converted into cash. This happens when the firm falls
short of cash and has to sell the securities resulting in clerical, brokerage, registration and other
costs. The optimim cash balance according to this model will be that point where these two costs are
equal. The formula for determining optimum cash balance is : Management of Working Capital 7.38
C = S
2 U P , Where, C = Optimum cash balance
U = Annual (monthly) cash disbursements P = Fixed cost per transaction S = Opportunity cost of one rupee p.a. (or p.m)
Miller-Orr cash management model is a net cash flow stochastic model. This model is designed to
determine the time and size of transfers between an investment account and cash account. In this model control limits are set for cash balances. These limits may consist of h as
upper limit, z as the return point, and zero as the lower limit.
When the cash balances reach the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When it touches the lower limit, a transfer from
marketable securities account to cash account is made. During the period when cash balance stays between
(h,z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities
account is made. The high and low limits of cash balance are set up on the basis of fixed cost
associated with the securities transactions, the opportunity cost of holding cash and the degree of
likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.
Question 7 Describe the three principles relating to selection of marketable securities. (November 2009) Answer Three Principles Relating to Selection of Marketable Securities
The three principles relating to selection of marketable securities are: (i) Safety: Return and risk go hand-in-hand. As the objective in this
investment is ensuring
liquidity, minimum risk is the criterion of selection. (ii) Maturity: Matching of maturity and forecasted cash needs is essential.
Prices of longterm securities fluctuate more with changes in interest rates and are, therefore, riskier. (iii) Marketability: It refers to the convenience, speed and cost at which a
security can be converted into cash. If the security can be sold quickly without loss of time and
price, it is highly liquid or marketable.
FINANCIAL SERVICES CHAPTER VIII
MONEY MARKET CONCEPT OF MONEY MARKET
1. It is the market for dealing in monetary assets of short term nature (one
year) 2. Financial assets which are equivalent to money having characteristics of
liquidity, minimum transaction cost and no loss in value
3. Money market enables the raising of short term funds for meeting temporary shortages of cash & obligation and temporary deployment of
excess funds for returns 4. The major constituents are Banks, Financial Institutions, Large
corporations & RBI.
5. The instruments dealt in are Treasury bills, commercial bills, certificate of deposits, commercial paper etc.,
FEATURES OF MONEY MARKET
1. Deals with raising and deploying short term funds 2. Provides institutional source for providing working capital 3. Operates as a wholesale market and has sub-markets – call market, bill
market, treasury bills market, commercial paper market, certificate of deposits market etc.,
4. Volume of transactions is very large 5. Transactions are on telephone etc., later confirmed 6. Same day settlement basis
7. Highly liquid, safety 8. Large size instruments (Rs.1 lacs for bills, Rs.25 lacs for Commercial
deposit & commercial paper).
OBJECTIVES OF MONEY MARKET
1. To provide balancing mechanism for short term surplus and deficiencies 2. To provide liquidity in the economy
3. To provide reasonable access to users of short term funds at reasonable price/cost
DIFFERENCE BETWEEN MONEY MARKET VS. CAPITAL MARKET
MONEY MARKET CAPITAL MARKET
- It deals with raising and deployment of funds for short term
- Deals with long term financing
- Provides the instruction source for providing working capital
- long term capital for financing fixed assets
- Operates as a wholesaler
market and has number of inter-related sub-markets, FI etc are main players:
– regulate money supply – Statutory lending ratio(SLR), -Cash reserve ratio (CRR)
– liquidity etc.
- Equity/debt market regulated
by SEBI Capital appreciation
STRUCTURE OF INDIAN MONEY MARKET
- The Indian money market consists both organised & unorganised segments
- The unorganized sector consists of – indigenous bankers, money
lenders, chit funds etc, where interest rates are higher.
- The organised sector consists of - RBI, SBI, Public Sector banks, Private sector banks, Foreign banks, Regional Rural Banks, Non-Scheduled
banks, Non Banking Financial corporations, LIC, GIC, UTI etc., MONEY MARKET INSTRUMENTS
1. GOVT SECURITIES:
a) Dated Securities : Fixed maturity instruments with pre-decided coupon rate payable semi annually. Issued at par with fixed tenure (issued at face value, redeemable at par)
b) Zero Coupon bonds : Issued at discount and are redeemed at par, after a fixed tenure. The difference between issue price and redemption is interest
c) Partly paid stocks : Repayment in instalments over the fixed tenure (issued at face value coupons issued).
d) Floating rate bonds : Interest rate is linked to a bench mark index. Fixed tenure, Interest rate changes based on the movement in bench mark index(bank rate).
e) Bonds with call put option : option is exercisable after a fixed period. Holder can sell/buy back the bond to/from Government of India.
f) Capital Indexed Bonds : These are fixed tenure instruments where
the interest & principal are fixed as %age of wholesale price index.
ADVANTAGES OF GOVT SECURITIES
- Zero default risk - No Tax deduction at source on interest
- Low volatility - Qualifies for SLR - Highly liquid
METHODS OF ISSUANCE OF G.SECURITIES
- Auctions
- On tap issue
- Fixed coupon issue (carrying fixed rate)
- Private placement
- Open market operations
2. TREASURY BILLS( T-BILLS)
a. Shorter rupee denominated obligation issued by RBI on behalf of GOI. These instruments have sovereign rating and issue with a minimum
denomination of Rs.10000 and in multiple of Rs.10000. The transaction size will be 50 to 100 million. T-bills are issued 14 /91/ 182/ 364 days.
Recently 14 /182 days T-bills have been discontinued.
b. It is a discounted instrument issued in the form of zero coupon instruments at discount face value and redeemable at par. The amount
on repayment is credited to current account of the investor held with RBI.
c. They form part of SLR investments and used for short term liquidity.
d. No tax impact, zero default risk, liquidity, simple settlement.
Futures of T-bills
a) Bids are made for a minimum of Rs.25,000 and multiple thereof. b) Instruments are paid at par on maturity c) Available both in primary and secondary market
3. Call money / notice money / term money /fixed deposit
a) It is an amount borrowed or lent for a short period. b) If the period is more than 1 day and into 14 days it is called notice
money, Otherwise it is called call money c) Money lend for 15 days to one year is called term money or fixed
deposit
d) Sundays and holidays are excluded e) No collateral security
f) Interest is payable on maturity g) No brokers in the call money market
h) Trading is done Over the Counter (OTC) i) Settlement is done between participants through current account with
RBI
4. REPOSE / REVERSE REPOSE
- It is a transaction in which two parties agree to sell and re-purchase the same security.
- Under the agreement the seller sells specified securities for re-purchase the same at mutually decided future date and price
- The buyer purchases with an agreement to resell the same to the seller
on an agreed date at pre-determined price
- Such transactions are called repo when viewed from the sellers point of view and reverse repo when viewed from buyers perspective.
- Repo /reverse repo are used to meet shortfall in cash positions, to augment returns on funds held and to borrow securities to meet
regulatory requirement
- An SLR surplus bank and CRR deficit bank can use the repo deals for adjusting CRR / SLR positions
- RBI uses repo / reverse repo for adjusting liquidity in the system.
- The securities eligible for trading are Govt Sec, T-bills, PSU bonds,FI bonds, corporate bonds etc.,
- Repo transactions are done in the market lots of Rs.5 crores 5. CERTIFICATE OF DEPOSITS (CDs)
- CD are rupee denominated secure promissory notes, freely transferable on endorsement & delivery
- Comml Banks / FI can issue CDs
- CDs are not required to be rated
- They are issued at a discount at face value and are redeemable at par on
maturity
- Eligible investors in CDs are banks, corporates, individuals, insurance companies, PF etc.,
- NRI can invest in CD on non-repatriable and non-transferable basis.
- Minimum size of CD is Rs.1 lac
- Used by Banks to maintain reserve requirements (CRR & SLR)
- Maturity period for CDs issued by bank from 15 days to one year, whereas it is one to three years for CDs issued by FI.
6. INTER BANK PARTICIPATION (IBP)
- These instruments are used by banks for 90 days only
- The issuing banks show participation as borrowing, while participating banks show it has advances to Banks
- It is more flexible, but it is not transferable
- No provision for pre-matured redemption
7. MONEY MARKET MUTUAL FUNDS (MMMFs)
- MMMFs invest money in money market instruments
- They are regulated by SEBI and follow the guidelines as are applicable to
any other fund 8. COMMERCIAL BILLS
- CB are negotiable instruments accepted by buyers for goods or services obtained by them on credit
- Such bill of exchange can be kept upto the due date and encashed by the seller or may be endorsed to third party
- The seller who gets the bills of exchange discounts it with Banks or FI or
bill discounting house and collects the money.
9. COMMERCIAL PAPER (CP)
- CP is a rupee denominated, short term, unsecured, negotiable promissory notes with a fixed maturity issued by well rated companies. It is sold on a discount basis
CPs are issued by corporate or as an alternate source of working capital CPs are issued at a discount to face value and are redeemable at par on
maturity Eligible investors in CPs are individuals, corporates, insurance companies and banks.
NRI can invest in CP on repatriable non-transferable basis. Banks & Companies are the common investors. CPs are subjected to stamp duty (0.25%) and concessional rate of 0.05%
for banks
ISSUER Corporates, Financial Institutions are permitted to issue CPs when networth is more than Rs.4 crores. Banks sanction working capital limit
to companies. Its account is classified as standard by Financial Institutions & banks
CREDIT RATING
- All CPs are to be rated mandatorily. Minimum rating is P2 equivalent
- Corporate issues are rated P1 MATURITY
- Minimum 7 days and maximum one year
DENOMINATION
- Rs.5 lacs or multiples thereof.
- Amount invested by single investor should not be less than Rs.5 lacs face value
ISSUING AND PAYING AGENT
- The issuing & paying agent are scheduled commercial banks.
- Issuer to ensure legal framework for CP issues is complied with.
- Issuing & paying agent will check that the issuer has minimum credit rating, verifies all documents and reports to RBI.
- Any default are reported to RBI.
- Credit rating agencies to abide by Code of Conduct of SEBI and determine the validity period of rating and closely monitor the rating.
10. GILT EDGED SECURITIES
- Govt securities issued by central , state and semi – government
authorities, port trusts, electricity boards, housing boards, Financial institutions etc.,
- GES are issued to meet the short term fund requirement of Government
- Budgeted amount is collected through trenches over the period of the year
- Process of issue and redemption is continuous
- It is not auctioned
- GES are eligible for SLR purpose
- Default risk is negligible as it is backed by the Govt
- The rate of interest is low
- These securities are issued by public debt office of RBI
- Major buyers of GES are banks, insurance companies, PF etc.,
11. BILL RE-DISCOUNTING
- It is a source of temporary finance for banks
12. INTER CORPORATE DEPOSITS (ICD)
- ICD is an unsecured loan extended by one corporate to another.
- This market allows surplus funds of one corporate lends to other companies.
MERCHANT BANKING:
The merchant bankers undertake the following activities:
- Managing of public issue of securities - Underwriting connected with the aforesaid public issue management
business
- Managing/advising on international offerings of debt/equity i.e., GDR, ADR, BONDS and other instruments
- Private placement of securities - Primary or satellite dealership of government securities - Corporate advisory services related to securities market including
takeovers, acquisition and disinvestment - Stock broking - Advisory services for projects
- Syndication of rupee term loans - International financial advisory services
MUTUAL FUNDS:
- These funds are the institutions, which provide small investors with avenues of investment in the capital market.
Advantages:
- Professional management
- Diversification - Convenient administration - Return potential
- Low costs - Liquidity
- Transparency
Types:
Open ended mutual funds:
- Is a fund with a non-fixed number of out standing shares, that stands ready at any time to redeem shares on demand
- The fund itself buys back the shares surrendered and is ready to sell new shares.
- Generally the transaction takes place at the net asset value (NAV) which is calculated on a periodical basis
Close-ended funds:
- It is the fund where mutual fund management sells a limited number of shares and does not stand ready to redeem them.
- The shares of such funds are traded in the secondary markets.
- The requirement for listing is laid down to grant liquidity to the
investors who have invested with the mutual fund.
- These funds are more like equity shares.
VENTURE CAPITAL:
- Is a form of equity financing, which is specially designed for funding high risk and high reward projects
- It is direct investment in securities of new and unseasoned enterprises by way of private placement.
- Is the capital that is invested in equity or debt securities (with equity conversion terms) of young unseasoned companies promoted by
technocrats who attempts to break new path.
- It is a source of finance for new or relatively new, high risk, high profit potential products as the projects belong to untried segments or technologies.
Venture capital generally provides following services:
- Finance new and rapidly growing companies - Typically knowledge-based, sustainable, up scalable companies
- Purchase equity/ quasi-equity securities - Assist in the development of new products or services
- Add value to the company through active participation - Take higher risks with the expectation of higher rewards - Have a long term orientation
Problem areas facing the industry are:
- There is insufficient understanding of venture capital as a commercial activity
- The support to the venture capital industry, by the government is in
inadequate - The exit options available to the venture capitalist are limited
- Market limitations hinder the growth of venture capital; and - The inadequacy of the legal framework for venture capital industry.
LOAN SYNDICATION:
- Arrange/ procure finance on request for the projects that come up for counseling.
- A pre-requisite would require arrangement of funds that would involve,
o Assessing the quantum and nature of funds required
o Locating the various sources of finance o Approaching these sources with loan application forms and
complying with other formalities etc.
- Estimating capital requirements:
o Preliminary expenses o Cost of fixed assets
o Cost of current assets o Cost of acquiring know how o Provisions for contingencies
o Cost of financing, brokerage, underwriting etc. o Any other element of cost likely to be incurred.
- An important aspect of loan syndication, which would include preparation of loan application, filing and following up the loan
application with the financial institution and arranging the disbursal of the same.
CREDIT RATING:
- Refers to the rating (or assessment and gradation) of creditor-ship securities or debt-instruments, particularly with regard to the probability of timely discharge of payment of interest and repayment
of principal obligations.
The objectives:
To provide superior information to the investors at a low
cost To provide a sound basis for proper risk-return structure To subject borrowers to a healthy discipline and
To assist in the framing of public policy guidelines on institutional investment
The approaches:
Implicit judgmental approach- wherein broad range of factors concerning promoter, project, environment and instrument characteristics are considered generally.
Explicit judgmental approach- involves identification and measurement of the factors critical to an objective
assessment of credit score or index.
Statistical approach- assignment of weights to each of the factors and obtaining the overall credit rating score with a view to doing away with personal bias inherent in
both explicit and implicit judgement.
FACTORING:
- Is a type of financial service which involves an outright sale of the receivables of a firm to a financial institution called the factor which
specialises in the management of trade credit. - A factor collects the accounts on the due dates, effects payments to
the firm on these dates (irrespective of whether the customers have paid or not) and also assumes the credit risks associated with the collection of the accounts.
- Fundamental to the functioning of factoring: Assumption of credit and collection function Credit protection
Encashing of receivables Collateral functions
- Factoring v/s Accounts Receivables : AR is simply a loan secured by a firm’s accounts
receivable by way of hypothecation or assignment of such receivables with the power to collect the debts under a
power of attorney.
- Factoring v/s Bill Discounting:
The drawer undertakes the responsibility of collecting the bills and remitting the proceeds to the financing agency.
It is always with recourse whereas factoring can be either
with recourse or without recourse.
Mechanics of Factoring:
- seller (client)negotiates with the factor for establishing factoring relationship
- seller requests credit check on buyer(client) - factor checks credit credentials and approves buyer. For each
approved buyer a credit limit and period of credit are fixed.
- Seller sells goods to buyer - Seller sends invoice to factor. The invoice is accounted in the buyers
account in the factor’s sales ledger. - Factor sends copy of the invoice to buyer - Factor advices the amount to which seller is entitled after retaining a
margin. Say 20%, the residual amount paid later. - On expiry of the agreed credit period, buyer makes payment of invoice
to the factor
- Factor pays the residual amount to seller.
LEASES:
- Is a special type of transaction-contractual arrangement under which the owner of the asset (movable or immovable) allows its exclusive use by another party (lessee) over a certain period of time for some
consideration (rentals)
OPERATING LEASE:
- Is a rental agreement where the lessee is committed to pay more than the original cost of equipment during contractual period.
- It provides for maintenances expenses and taxes by lessor. - Leasing company assumes risk of obsolescence - Contract period ranges from intermediate to short-run
- Contract under this category are usually cancelable from either party, i.e; lessor or the lessee
- The financial commitment is restricted to regular rental payment
FINANCING LEASE:
- Is like an instalment loan. - It is a legal commitment to pay for the entire cost of equipment plus
interest over a specified period of time. - The lessee commits to a series of payments which in total exceeds the
original cost of the equipment. - It excludes the provisions for maintenance or taxes which are paid
separately by the lessee.
- Lessee assumes the risk of obsolescence - Contract period ranges from medium to long run - Contract under this category are cancelable.
- The lease involves a financial commitment similar to loan by a leasing company. It places the lessee in a position of borrower.
REAL ESTATE MORTGAGES:
- Mortgages are adapted to different types of real estate and vary according to the repayment plan and the purpose of the mortgage.
- Term mortgage provides for periodic interest payments and the principal is repaid at the end of the term.
- If the principal is not repaid, at the end of the term, the lender might elect to grant another mortgages provided for the repayment of the
principal over the term of the mortgage. Here the interest is paid on the reducing balances of the principal.
- Partially amortized mortgages also termed as ‘baloon mortgage’ provide for principal repayment down to a given amount and then
required a lump sum payment for the balance of the principal.
a. Sale and lease back
In this type of transaction, the user or vendor sells the fixed assets to a leasing company or any party to tide the financial crisis and leases the same asset back to the company to use for uninterrupted use of the
asset in business. This can be in the firm of finance lease or operating lease. Generally a manufacturing industry use this type of facility.
However the valuation of assets that is being acquired is a difficult proposition and have to assess the overall situation to arrive at the best comparative price. Also IT act has clearly stated that in accordance with
the depreciation u/s 32 that the vendor can only claim the depreciation value of the asset at that time and cannot exceed any other value.
SECURITISATION OF MORTGAGE:
The loan component of securitization is not sold to another lender but
rather a security instrument is created backed by principal and interest
payments on the loan. This takes place when a lending institution’s
assets are removed in one way
- In a mortgage transaction a lender makes a loan to the borrower
against the transfer of an interest in an immovable property, collects re-payment of interest and principal.
- In the event of default the lender seeks to take possession of the property.
- Thus, lender’s interest in the mortgage generally is confined to the collection of interest and eventual collection of the principal amount
lent and as such mortgage is an asset which he has to hold for,
generally, a long period of time against which no ‘liquidity’ is available.
- In securitization the loan itself is not another lender but rather a security instrument is created backed by the principal and interest
payments on the loan.
DEPOSITORY:
- In the depository system, share certificates belonging to the investors are to be dematerialised and their names are required to be entered in
the records of depository as beneficial owners.
- Consequent to these changes, the investors’ names in the companies
register are replaced by the name of depository as the registered owner of the securities.
- The depository however does not have any voting rights or other economic rights in respect of the securities held by a depository.
MODELS OF DEPOSITORY:
- Immobilization: where physical share certificates are kept in vaults with the depository for safe custody.
- Dematerialisation: is a process by which the physical certificates of an investor are taken back by the company and an equivalent number of securities are credited to his account in electronic form at the
request of the investor.
DEPOSITORY FUNCTIONS:
- Account opening - Dematerialisation - Rematerialisation
- Settlement - Initial public offers
- Pledging
DEPOSITORY PARTICIPANTS:
- Is the representative (agent) of the investor in the depository system providing the link between the company and investor through the
depository.
- The depository participant maintains securities account balances and
intimate the status of holding to the account holder from time to time.
- Dematerialisation of shares is optional and an investor can still hold
shares in physical form.
Characteristics:
- Acts as an agent of depository
- Customer interface of depository - Functions like securities bank - Account opening
- Facilities of Dematerialisation.
DEMATERIALISATION PROCESS:
- Investor opens account with DP - Fills Dematerialisation request form (DRF) for registered shares
- Investor lodges DRF and certificates with DP
- DP intimates the depository - Depository intimates registrar/issuer
- DP sends certificates and DRF to registrar/issuer - Registrar/issuer confirms demat to depository
- Depository credits investor a/c
REMATERIALISATION PROCESS:
- Client submits RRF to DP - DP intimates depository
- Depository intimates the registrar/issuer - DP sends RRF to the registrar/issuer - Registrar/issuer prints certificates and sends to investor
- Lock-in should be retained - Registrar/ issuer confirms remat to depository
- Investor’s account with DP debited.
BENEFITS OF DEPOSITORY SYSTEM:
- Elimination of bad deliveries
- Elimination of all risks associated with physical certificates
- Immediate transfer and registration of securities
- Faster disbursement of non-cash corporate benefits like rights, bonus, etc.
- Reduction in brokerage by many brokers for trading in dematerialised
securities
- Reduction in handling of huge volumes of paper and periodic status
reports to investors on their holdings and transactions, leading to better controls
- Elimination of problems related to change of address of investor, transmission, etc.
- Elimination of problems related to selling securities on behalf of a minor.
DERIVATIVES & COMMODITY EXCHANGES Chapter X
What are Derivatives?
The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying
asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words,
Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset
or to an index of securities.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations)
Act, as:-
A Derivative includes: -
a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
b. a contract which derives its value from the prices, or index of prices, of underlying securities;
What is a Futures Contract?
Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in
case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which
is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the
future/option contract in cash.
What is an Option contract?
Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to
buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option
purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when
the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.
Under Securities Contracts (Regulations) Act,1956 options on
securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;
An Option to buy is called Call option and option to sell is called
Put option. Further, if an option that is exercisable on or before the
expiry date is called American option and one that is exercisable
only on expiry date, is called European option. The price at which
the option is to be exercised is called Strike price or Exercise price.
Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This
request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are
obligated to settle the terms of the contract within a specified time frame.
As in the case of futures contracts, option contracts can also be settled by delivery of the underlying asset or cash. However, unlike
futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price
of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.
What are Index Futures and Index Option Contracts?
Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures
contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index.
Similarly, the options contracts, which are based on some index,
are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry.
Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.
An index in turn derives its value from the prices of securities that
constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices
and those that represent a particular sector are sectoral indices.
In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also
permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives
trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the
index has begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would
be discontinued.
By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry.
What is the structure of Derivative Markets in India?
Derivative trading in India takes place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment functions
as a Self-Regulatory Organisation (SRO) and SEBI acts as the
oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing
Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.
What is the regulatory framework of Derivatives markets in India?
With the amendment in the definition of 'securities' under SC(R)A
(to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and
Exchange Board of India Act, 1992.
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also
framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-
laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line
with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to
ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor
grievances. Some of the important eligibility conditions are-
o Derivative trading to take place through an on-line screen based Trading System.
o The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
o The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes
on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.
o The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.
o The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing
irregularities in trading. o The Derivative Segment of the Exchange would have a separate
Investor Protection Fund.
o The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both
legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for
settlement of all trades. o The Clearing Corporation/House shall have the capacity to monitor
the overall position of Members across both derivatives market and
the underlying securities market for those Members who are participating in both.
o The level of initial margin on Index Futures Contracts shall be
related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins.
The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
o The Clearing Corporation/House shall establish facilities for
electronic funds transfer (EFT) for swift movement of margin payments.
o In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.
o The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing
Corporation/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for
any other purpose. o The Clearing Corporation/House shall have a separate Trade
Guarantee Fund for the trades executed on Derivative Exchange /
Segment.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.
What are the various membership categories in the derivatives
market?
The various types of membership in the derivatives market are as follows:
o Trading Member (TM) – A TM is a member of the derivatives exchange and can trade on his own behalf and on behalf of his
clients. o Clearing Member (CM) –These members are permitted to settle
their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them.
o Self-clearing Member (SCM) – A SCM are those clearing members who can clear and settle their own trades only.
What are the requirements to be a member of the derivatives
exchange/ clearing corporation?
o Balance Sheet Networth Requirements: SEBI has prescribed a networth requirement of Rs. 3 crores for clearing members. The
clearing members are required to furnish an auditor's certificate for the networth every 6 months to the exchange. The networth requirement is Rs. 1 crore for a self-clearing member. SEBI has not
specified any networth requirement for a trading member. o Liquid Networth Requirements: Every clearing member (both
clearing members and self-clearing members) has to maintain atleast Rs. 50 lakhs as Liquid Networth with the exchange / clearing corporation.
o Certification requirements: The Members are required to pass the certification programme approved by SEBI. Further, every trading member is required to appoint atleast two approved users who
have passed the certification programme. Only the approved users are permitted to operate the derivatives trading terminal.
What are requirements for a Member with regard to the conduct of
his business?
The derivatives member is required to adhere to the code of conduct specified under the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been laid by SEBI on the
regulation of sales practices:
o Sales Personnel: The derivatives exchange recognizes the persons recommended by the Trading Member and only such persons are
authorized to act as sales personnel of the TM. These persons who represent the TM are known as Authorised Persons.
o Know-your-client: The member is required to get the Know-your-
client form filled by every client. o Risk disclosure document: The derivatives member must educate
his client on the risks of derivatives by providing a copy of the Risk disclosure document to the client.
o Member-client agreement: The Member is also required to enter
into the Member-client agreement with all his clients.
What derivative contracts are permitted by SEBI?
Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options
and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were
permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been
introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004.
What is the eligibility criteria for stocks on which derivatives
trading may be permitted?
A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following
broad eligibility criteria:-
o The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis.
o The stock’s median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock’s quarter-sigma
order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.
o The market wide position limit in the stock shall not be less than Rs.50 crores.
A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility
criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock
would be discontinued.
What is minimum contract size?
The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum
contract size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this
recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In February 2004, the
Exchanges were advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges
were authorized to align the contracts sizes as and when required in line with the methodology prescribed by SEBI.
What is the lot size of a contract?
Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract
size requirement at the time of introduction of derivative contracts on a particular underlying.
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and
the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 2,00,000/1,000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
What is corporate adjustment?
The basis for any adjustment for corporate action is such that the value of the position of the market participant on cum and ex-date for corporate action continues to remain the same as far as
possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money and out-of-the-money. Any adjustment for corporate actions is carried out on the last day
on which a security is traded on a cum basis in the underlying cash market. Adjustments mean modifications to positions and/or
contract specifications as listed below:
a. Strike price b. Position c. Market/Lot/ Multiplier
The adjustments are carried out on any or all of the above based
on the nature of the corporate action. The adjustments for corporate action are carried out on all open, exercised as well as
assigned positions.
The corporate actions are broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are:
o Bonus
o Rights o Merger/ demerger
o Amalgamation o Splits o Consolidations
o Hive-off
o Warrants, and o Secured Premium Notes (SPNs) among others
The cash benefit declared by the issuer of capital is cash dividend.
What is the margining system in the derivative markets?
Two type of margins have been specified -
o Initial Margin - Based on 99% VaR (Value At Risk) and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected.
o Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures Contracts MTM may be
considered as Mark to Market Settlement.
Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should be related to the risk of loss
on the position. The concept of value-at-risk should be used in calculating required level of initial margins. The initial margins should be large enough to cover the one day loss that can be
encountered on the position on 99% of the days. The recommendations of the Dr. L.C Gupta Committee have been a
guiding principle for SEBI in prescribing the margin computation & collection methodology to the Exchanges. With the introduction of various derivative products in the Indian securities Markets, the
margin computation methodology, especially for initial margin, has been modified to address the specific risk characteristics of the
product. The margining methodology specified is consistent with the margining system used in developed financial & commodity derivative markets worldwide. The exchanges were given the
freedom to either develop their own margin computation system or adapt the systems available internationally to the requirements of SEBI.
A portfolio based margining approach which takes an integrated
view of the risk involved in the portfolio of each individual client comprising of his positions in all Derivative Contracts i.e. Index
Futures, Index Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are required to be based on the worst case loss of a portfolio of an individual
client to cover 99% VaR over a specified time horizon.
The Initial Margin is Higher of
(Worst Scenario Loss +Calendar Spread Charges)
Or
Short Option Minimum Charge
The worst scenario loss are required to be computed for a portfolio
of a client and is calculated by valuing the portfolio under 16 scenarios of probable changes in the value and the volatility of the Index/ Individual Stocks. The options and futures positions in a
client’s portfolio are required to be valued by predicting the price and the volatility of the underlying over a specified horizon so that
99% of times the price and volatility so predicted does not exceed the maximum and minimum price or volatility scenario. In this manner initial margin of 99% VaR is achieved. The specified
horizon is dependent on the time of collection of mark to market margin by the exchange.
The probable change in the price of the underlying over the
specified horizon i.e. ‘price scan range’, in the case of Index futures and Index option contracts are based on three standard deviation (3σ ) where ‘σ ’ is the volatility estimate of the Index. The volatility
estimate ‘σ ’, is computed as per the Exponentially Weighted Moving Average methodology. This methodology has been prescribed by SEBI. In case of option and futures on individual
stocks the price scan range is based on three and a half standard deviation (3.5 σ) where ‘σ’ is the daily volatility estimate of
individual stock.
If the mean value (taking order book snapshots for past six months) of the impact cost, for an order size of Rs. 0.5 million, exceeds 1%, the price scan range would be scaled up by square
root three times to cover the close out risk. This means that stocks with impact cost greater than 1% would now have a price scan
range of - Sqrt (3) * 3.5σ or approx. 6.06σ. For stocks with impact cost of 1% or less, the price scan range would remain at 3.5σ.
For Index Futures and Stock futures it is specified that a minimum margin of 5% and 7.5% would be charged. This means if for stock
futures the 3.5 σ value falls below 7.5% then a minimum of 7.5% should be charged. This could be achieved by adjusting the price
scan range.
The probable change in the volatility of the underlying i.e. ‘volatility scan range’ is fixed at 4% for Index options and is fixed at 10% for
options on Individual stocks. The volatility scan range is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the
same underlying across different expiry. In a portfolio based margining approach all calendar-spread positions automatically get a margin offset. However, risk arising due to difference in cost
of carry or the ‘basis risk’ needs to be addressed. It is therefore specified that a calendar spread charge would be added to the worst scenario loss for arriving at the initial margin. For computing
calendar spread charge, the system first identifies spread positions and then the spread charge which is 0.5% per month on the far leg
of the spread with a minimum of 1% and maximum of 3%. Further, in the last three days of the expiry of the near leg of spread, both the legs of the calendar spread would be treated as
separate individual positions.
In a portfolio of futures and options, the non-linear nature of options make short option positions most risky. Especially, short
deep out of the money options, which are highly susceptible to, changes in prices of the underlying. Therefore a short option minimum charge has been specified. The short option minimum
charge is 3% and 7.5 % of the notional value of all short Index option and stock option contracts respectively. The short option
minimum charge is the initial margin if the sum of the worst –scenario loss and calendar spread charge is lower than the short option minimum charge.
To calculate volatility estimates the exchange are required to use
the methodology specified in the Prof J.R Varma Committee Report on Risk Containment Measures for Index Futures. Further, to calculate the option value the exchanges can use standard option
pricing models - Black-Scholes, Binomial, Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two components:-
o The first is creation of risk arrays taking prices at discreet times
taking latest prices and volatility estimates at the discreet times, which have been specified.
o The second is the application of the risk arrays on the actual
portfolio positions to compute the portfolio values and the initial margin on a real time basis.
The initial margin so computed is deducted from the available Liquid Networth on a real time basis.
CONDITIONS FOR LIQUID NETWORTH
Liquid net worth means the total liquid assets deposited with the
clearing house towards initial margin and capital adequacy; LESS initial margin applicable to the total gross open position at any
given point of time of all trades cleared through the clearing member.
The following conditions are specified for liquid net worth:
o Liquid net worth of the clearing member should not be less than Rs 50 lacs at any point of time.
o Mark to market value of gross open positions at any point of time of all trades cleared through the clearing member should not
exceed the specified exposure limit for each product.
Liquid Assets
At least 50% of the liquid assets should be in the form of cash equivalents viz. cash, fixed deposits, bank guarantees, T bills,
units of money market mutual funds, units of gilt funds and dated government securities. Liquid assets will include cash, fixed deposits, bank guarantees, T bills, units of mutual funds, dated
government securities or Group I equity securities which are to be pledged in favor of the exchange.
Collateral Management
Collateral Management consists of managing, maintaining and
valuing the collateral in the form of cash, cash equivalents and securities deposited with the exchange. The following stipulations have been laid down to the clearing corporation on the valuation
and management of collateral:
o At least weekly marking to market is required to be carried out on all securities.
o Debt securities of only investment grade can be accepted.10%
haircut with weekly mark to market will be applied on debt securities.
o Total exposure of clearing corporation to the debt or equity of any company not to exceed 75% of the Trade Guarantee Fund or 15% of its total liquid assets whichever is lower.
o Units of money market mutual funds and gilt funds shall be valued on the basis of its Net Asset Value after applying a hair cut of 10%
on the NAV and any exit load charged by the mutual fund. o Units of all other mutual funds shall be valued on the basis of its
NAV after applying a hair cut equivalent to the VAR of the units NAV and any exit load charged by the mutual fund.
o Equity securities to be in demat form. Only Group I securities
would be accepted. The securities are required to be valued / marked to market on a daily basis after applying a haircut equivalent to the respective VAR of the equity security.
Mark to Market Margin
Options – The value of the option are calculated as the theoretical value of the option times the number of option contracts (positive for long options and negative for short options). This Net Option
Value is added to the Liquid Networth of the Clearing member. Thus MTM gains and losses on options are adjusted against the available liquid networth. The net option value is computed using
the closing price of the option and are applied the next day.
Futures – The system computes the closing price of each series, which is used for computing mark to market settlement for
cumulative net position. If this margin is collected on T+1 in cash, then the exchange charges a higher initial margin by multiplying the price scan range of 3 σ & 3.5 σ with square root of 2, so that
the initial margin is adequate to cover 99% VaR over a two days horizon. Otherwise if the Member arranges to pay the Mark to
Market margins by the end of T day itself, then the initial margins would not be scaled up. Therefore, the Member has the option to pay the MTM margins either at the end of T day or on T+1 day.
MARGIN COLLECTION
Initial Margin - is adjusted from the available Liquid Networth of
the Clearing Member on an online real time basis.
Marked to Market Margins-
Futures contracts: The open positions (gross against clients and net of proprietary / self trading) in the futures contracts for each
member are marked to market to the daily settlement price of the Futures contracts at the end of each trading day. The daily
settlement price at the end of each day is the weighted average price of the last half an hour of the futures contract. The profits /
losses arising from the difference between the trading price and the settlement price are collected / given to all the clearing members.
Option Contracts: The marked to market for Option contracts is
computed and collected as part of the SPAN Margin in the form of Net Option Value. The SPAN Margin is collected on an online real
time basis based on the data feeds given to the system at discrete time intervals.
Client Margins
Clearing Members and Trading Members are required to collect
initial margins from all their clients. The collection of margins at client level in the derivative markets is essential as derivatives are leveraged products and non-collection of margins at the client level
would provide zero cost leverage. In the derivative markets all money paid by the client towards margins is kept in trust with the Clearing House / Clearing Corporation and in the event of default
of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the dues
of the defaulting member.
Therefore, Clearing members are required to report on a daily basis details in respect of such margin amounts due and collected from their Trading members / clients clearing and settling through
them. Trading members are also required to report on a daily basis details of the amount due and collected from their clients. The
reporting of the collection of the margins by the clients is done electronically through the system at the end of each trading day. The reporting of collection of client level margins plays a crucial
role not only in ensuring that members collect margin from clients but it also provides the clearing corporation with a record of the quantum of funds it has to keep in trust for the clients.
What are the exposure limits in Derivative Products?
It has been prescribed that the notional value of gross open positions at any point in time in the case of Index Futures and all Short Index Option Contracts shall not exceed 33 1/3 (thirty three
one by three) times the available liquid networth of a member, and in the case of Stock Option and Stock Futures Contracts, the exposure limit shall be higher of 5% or 1.5 sigma of the notional
value of gross open position.
In the case of interest rate futures, the following exposure limit is specified:
o The notional value of gross open positions at any point in time in futures contracts on the notional 10 year bond should not exceed
100 times the available liquid networth of a member. o The notional value of gross open positions at any point in time in
futures contracts on the notional T-Bill should not exceed 1000 times the available liquid networth of a member.
What are the position limits in Derivative Products?
The position limits specified are as under-
Client / Customer level position limits:
For index based products there is a disclosure requirement for clients whose position exceeds 15% of the open interest of the
market in index products.
For stock specific products the gross open position across all derivative contracts on a particular underlying of a customer/client should not exceed the higher of –
o 1% of the free float market capitalisation (in terms of number of
shares).
Or
o 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts).
This position limits are applicable on the combine position in all
derivative contracts on an underlying stock at an exchange. The exchanges are required to achieve client level position monitoring in stages.
The client level position limit for interest rate futures contracts is
specified at Rs.100 crore or 15% of the open interest, whichever is higher.
Trading Member Level Position Limits:
For Index options the Trading Member position limits are Rs. 250 cr or 15% of the total open interest in Index Options whichever is
higher and for Index futures the Trading Member position limits are Rs. 250 cr or 15% of the total open interest in Index Futures
whichever is higher.
For stocks specific products, the trading member position limit is 20% of the market wide limit subject to a ceiling of Rs. 50 crore. In Interest rate futures the Trading member position limit is Rs. 500
Cr or 15% of open interest whichever is higher.
It is also specified that once a member reaches the position limit in a particular underlying then the member shall be permitted to take
only offsetting positions (which result in lowering the open position of the member) in derivative contracts on that underlying. In the event that the position limit is breached due to the reduction in the
overall open interest in the market, the member are required to take only offsetting positions (which result in lowering the open
position of the member) in derivative contract in that underlying and fresh positions shall not be permitted. The position limit at trading member level is required to be computed on a gross basis
across all clients of the Trading member.
Market wide limits:
There are no market wide limits for index products. For stock specific products the market wide limit of open positions (in terms
of the number of underlying stock) on an option and futures contract on a particular underlying stock would be lower of –
o 30 times the average number of shares traded daily, during the previous calendar month, in the cash segment of the Exchange,
Or
o 20% of the number of shares held by non-promoters i.e. 20% of the
free float, in terms of number of shares of a company.
What are the requirements for a FII and its sub-account to invest in derivatives?
A SEBI registered FIIs and its sub-account are required to pay initial margins, exposure margins and mark to market settlements
in the derivatives market as required by any other investor. Further, the FII and its sub-account are also subject to position
limits for trading in derivative contracts. The FII and sub-account position limits for the various derivative products are as under:
What are the requirements for a NRI to invest in derivatives?
NRIs are permitted in invest in exchange traded derivative contracts subject to the margin and other requirements which are
in place for other investors. In addition, a NRI is subject to the following position limits:
What measures have been specified by SEBI to protect the rights of
investor in Derivatives Market?
The measures specified by SEBI include:
o Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is
not available to the trading member or clearing member or even any other investor.
o The Trading Member is required to provide every investor with a
risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
o Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed
with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note.
This will protect him from the risk of price favour, if any, extended by the Member.
o In the derivative markets all money paid by the Investor towards
margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the
Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a
member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund,
as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
The Exchanges are required to set up arbitration and investor
grievances redressal mechanism operative from all the four areas /
regions of the country.
portfolio management
a. Beta (measurement of systematic risk of security)
Market risk is the important risk and it is an ingredient in all the
transactions. Hence this has to be measured by vulnerability. i.e. how vulnerable the security is. A question may arise if the market risk goes
down by 1% will the security go down by 0.25 % to 0.5%. This sensitivity which surrounds on the market risk is measured by beta. Beta is derived from a greek letter to measure the market return vis-à-vis
security. Risk is measured by variance or std deviation.
Variance is sum of individual securities and square of their respective weights Co-variance of securities is twice the product of respective weights. Co-
variance is the correlation co-efficient between std deviation and security. This is further divided into systematic risk and unsystematic risk Systematic risk is measured on the risk contribution of security to
estimate the variance of well diversified portfolio after adding or subtracting the security from portfolio. By adding or subtracting the
method of arriving is also cumbersome as there are too many ingredients in arriving at the risk.
b. Arbitrage pricing theory Arbitrage means getting a benefit from one type of action on another. If we buy a share or currency in a home country, the same will be
arbitraged to know about the element of profit and other ingredients. This theory is preceeded by Capital Asset Pricing model, which is used
worldwide by many financial analysts. It also looks to give strength to the pricing system by overcoming the deficiencies of CAPM. It has an approach to determine the asset prices taking into account the risk and
return elements. In this theory the investors are rewarded for assuming non-diversifiable systematic risk. And diversifiable unsystematic risk is
not taken into account and not compensated. The fundamental in this is that an investor always indulge in arbitrage whenever they find differences or benefits in the returns with similar risk characteristics.
c. Efficient portfolio and optional portfolio
Portfolio means selection of security and the continuous shifting in
portfolio to optimize returns to suit the investor. For every investor the returns on the investment is an important ingredient. So investor is
ready to make certain move after assessing the market conditions.
This is further bi-sected by the security market line and capital market line.
Any portifolio which lies along the capital market line is efficient portfolio and offer maximum level of expected return for a given level of risk or
minimum level of risk for given level of return. CML is sketched on a graph to show how the returns are commensurating with the portfolio. However Optimal portfolio is explained as whatever is best suited for
investor on the risk-return stretch represents the tangency point of individual investor’s utility function or indifference curve on the efficient frontier.
Investment and Speculation :
- Investment may be defined as a conscious act on the part of a person
that involves deployment of money in securities issued by firms with a
view to obtain a target rate of return over a specified period of time. - It is a conscious activity in that the investor is expected to be aware of
the various avenues of the investment available in the market. He makes a comparison of the returns available from each avenue, the element of risk involved in it and then makes the investment decision
that he perceives to be the best having regard to the time frame of the investment and his own risk profile.
- Investment differs from speculation. Speculation also involves
deployment of funds but it is not backed by a conscious analysis of pros and cons. Mostly it is a spur of the moment activity that is
promoted and supported by half-baked information and rumours. Speculative deployment of funds is generally prevalent in the secondary equity market. What attracts people to speculation is a
rate of return that is abnormally higher than the prevailing market rates. The balancing of risk and return nevertheless operates in speculative activity also and as such the risk element in speculation is
very high.
Efficient market Theory :
- The efficient market theory is considered as having three forms viz.,
weak form, semi-strong form and the strong form. - Weak form theory - weak form assumes that share prices follow the
‘random walk’ model. It holds that the current prices of stock already fully reflect all the information that is contained in the historical sequence of prices. Therefore , there is no benefit as far as
forecasting the future is concerned in examining the historical sequence of prices. It says that security prices are determined by the inflow of news, which enter into the market randomly. So a
knowledge of past prices would not provide any information about the
future prices and would not enable the investor to earn a rate of return higher than simple buy and hold strategy.
- Semi Strong Form Theory – This form says that the current share valuation is a reflection of historical information plus publicly
available knowledge about the company. It maintains that as soon as the information becomes publicly available, it is absorbed and reflected in current prices. An analyst and an investor are similar
placed in so far as making use of the information is concerned. Thus an analyst cannot obtain better returns than an ordinary investor.
- Strong form
Hedge Fund :
- Employ their funds for speculative trading i.e for buying shares whose
prices are likely to rise and for selling shares whose prices are likely to
dip. Hedge funds use a wide variety of trading strategies involving position taking in a range of markets. They employ an assortment of
trading techniques and instruments, often including short selling, derivatives and leverage.
- The main characteristics of hedge funds are as under :
(a) Organized as private investment partnerships or offshore
investment corporations;
(b) Use a wide variety of trading strategies involving position-taking in a range of markets ;
(c) Employ an assortment of trading techniques and instruments, often including short selling, derivatives and leverage;
(d) Pay performance fees to their managers; and (e) Have an investor base comprising wealthy individuals and
institutions and relatively high minimum investment limit.
Harry Markowitz Model
- This model was developed in 1952. - It analyses the various possible portfolios of the given number of
securities and helps in selection of the best or the most efficient portfolio.
- It shows as to how an investor can reduce the risk i.e. the standard deviation of the portfolio returns by choosing those securities which do not move exactly together.
Assumptions: (a) An investor is basically risk averse from the risk of a portfolio is
estimated on the basis of variability of expected returns therefrom.
(b) The decision of the investor regarding selection of the portfolio is made on the basis of expected returns and risk of the portfolio.
(c) An investor attempts to get maximum return from the investment with minimum risk. For a given level of risk, he attempts to earn a
higher return.
Limitations:
(a) It requires several inputs for portfolio analysis. (b) These are expected return of the securities, variances of their
return and co-variances.
(c) Calculation of efficient portfolio is easy when the number of securities in the portfolio is two or three.
(d) As the number of securities in the portfolio increase, which indeed is the case in real life situations, the amount of calculations required to be done becomes enormous.
(e) Portfolio analysts do not keep track of co-relations between stocks of diverse industries. As such, co-relating a security to a common
index is much more convenient than co-relating to a large number of individuals securities.
Commodities Market
- Commodity may be defined as an article, a product or material that is
bought and sold. It can be classified as every kind of movable property, except actionable claims, money & securities.
- It offers immense potential to become a separate asset class for market-savvy investors, arbitrageurs and speculators. Retail Investors, who claim to understand the equity markets, may find
commodities an unfathomable market. But commodities are easy to understand as far as fundamentals of demand and supply are concerned.
- Pricing in commodities futures has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification
option. - It is the market where a wide range of products viz., precious metals,
base metals, crude oil, energy and soft commodities like palm oil
coffee etc are traded - It is a good low-risk portfolio diversifier.
- A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate.
- Less volatile, compared with equities and bonds.
- Investors can leverage their investment and multiply potential earnings.
- Better risk-adjusted returns.
- A good hedge against any downturn in equities or bonds as there is little correlation with equity and bond markets.
- High co-relation with changes in inflation.
Intrinsic Value of Option
- It is also known as minimum value of an option. - It denotes the economic value of the option if it is exercised
immediately. - The intrinsic value of an option is non-negative. - The value of the option which the option holder has(i.e. value of the
choice to exercise the option or not) very much depend upon the interplay of the strike price and the market value of the underlying
asset. This can be further substantiated as follows : In case of a call option, the option value is equal to the excess of
market price over the strike price. The call is said to be in the money and the difference is called the intrinsic value of the option.
For example: the market price of a share is Rs.300 and one month call option is available at a strike price of Rs.293. The intrinsic value is:
Intrinsic value = Market price – strike price = 300 – 293 = Rs.7 However, if the market price of the asset is less than the strike price,
the difference between the two is negative and the call is said to be out of money. In this case, the intrinsic value of the call is zero, and
the option value, if any, may be based on the speculative motive only. An option cannot have a negative value. An out of money option has no positive intrinsic value. An option for which the strike price is
equal to the current price, is said to be at the money. In case of Put Option, the situation is reverse. The put option is said
to be in the money when the market value is less than the strike price. The difference between the two is negative and is called the
intrinsic value of the put option. In the other case, when the market value of the asset is more than the strike price, the put option is said to be out of money and the intrinsic value of the option is zero. As the
put options allow the holder to sell the asset at the strike price, in the money put option exist where strike price is more than the market
price of the asset. Out of money put options have market price above the strike price.
It may be noted that the value of an option usually does not fall below the intrinsic value. This in fact is ensured by the presence of arbitrageurs. Option price will generally be higher than the intrinsic
value.
TREASURY MANAGEMENT. (TM)
OBJECTIVES:
- Management of funds - Availability of the funds in right quantity
- Availability in right time - Deployment in right quantity
- Deployment in right time - Profiting from availability and deployment
FUNCTIONS:
- The function of treasury mgt is concerned with both macro and micro
facets of the economy
- At the macro level, the pumping in and out of cash, credit and other
financial instruments are the functions of the government and business sectors, which borrow from the public
- These two sectors spend more than their means and have to borrow in finance their ever-growing operations. They accordingly issue
securities in the form of equity or debt instruments.
- The latter are securities including promissory notes and treasury bills
which are redeemable after a stipulated time period.
- Such borrowings for financing the needs of the government and the
business sector are met by surplus funds and savings of the household sector and the external sector. these two sectors have a surplus of income over expenditure.
- The micro units utilise these surpluses and build up their capacities
for production of output and this leads to the productive system and distribution and consumption systems.
SCOPE:
- Unit level: the performance of production, marketing and HRD
functions is dependent upon the performance of the treasury department. The lubricant for day-to-day functioning of a unit is money or funds and these funds are arranged by the treasury
manager.
- Domestic level: the scope is to channelise the savings of the community into profitable investment avenues. This job is performed by the commercial banks. TM is a crucial activity in banks and
financial institutions as they deal with the funds, borrowings and lending and investments.
- International level: is concerned with management of funds in the foreign currencies.
RELATIONSHIP BETWEEN TREASURY MGT. AND FINANCIAL MGT.:
1. Control Aspects:
- Financial mgt is to establish, coordinate and administer, an adequate
plan for control of operations.
- Treasury mgt. Is to execute the plan of finance function
- The finance function of a firm would fix the limit for investment in
short term instruments for a firm
- It is the treasury function that would decide which particular
instruments are to be invested within the overall limit having regard to safety, liquidity and profitability.
2. Reporting Aspects:
- FM is concerned with the preparation of profit and loss account and the balance sheet. Taxation aspects and external audit. And reports are submitted to the top mgt Of the firm.
- TM is concerned with monitoring the income and expenditure budgets on a periodic basis vis-à-vis the budgets. It is also involved in the
internal audit of the firm.
3. Strategic Aspects:
- Financial Management deals with investment and financing. While
making these choices, the finance manager is taking a long term view of the state of affairs
- T Mgt is more short term in nature. The treasury manager has to decide about the tools of accounting and development of systems for generation of controlling reports.
4. Nature of Assets:
- The finance manager is concerned with creation of fixed assets for the firm. Fixed assets are those assets which yield benefit to the firm over
a longer period of time.
- The treasury manager is concerned with the net current assets of the firm. Net current assets are the difference between the current assets
and current liabilities of the firm.
ROLES OF THE TREASURY MANAGER:
- Originating roles - Supportive roles
- Leadership roles - Watchdog roles
- Learning roles - Informative roles
RESPONSIBILITES OF THE TREASURY MANAGER:
- Compliance with statutory guidelines
- Equal treatment to all departments - Ability to network
- Integrity and impartial dealings - Willingness to learn and to teach.
TOOLS OF TM:
- Analytic and planning tools
- Zero based budgeting - Financial statement analysis
INTERNAL TREASURY CONTROL:
- Is a process of self-improvement. It is concerned with all flows of
funds, cash and credit and all financial aspects of operations.
- The financial aspects of operations include procuring of inputs, paying creditors, making arrangement for finance against inventory
and receivables.
- The gap between inflows and outflows are met by planned recourse to
low cost mix of financing. The control aims at operational efficiency and removal of wastages and inefficiencies and promotion of cost
effectiveness in the firm. The control is exercised under phases of planning and budgeting. These phases include setting up of targets, laying down financial standards, evaluation of performance as per
these norms and reporting in a standard format.
- Principles: Control should be at all levels of management and
participation should be from all cadres of personnel.
There has to be a system of building up of effective
communication from top to bottom and bottom to the top.
The control should be built upon the management
information system.
ENVIRONMENT FOR TREASURY MANAGEMENT:
- Legal environment: refers to the legislations, which govern corporate functioning.
- Regulatory environment: regarding employment, wages, land laws,
promotion of units and closure of units etc.
- Financial environment: pertains to policies regarding monetory and
fiscal control, financial supervision, exchange control etc.
FOREX MANAGEMENT
ELEMENTS:
1. It is part of management science
-Organization and control of Forex
- Budgeting for Forex - Utilization of Forex
2. It refers to generation of Forex
- From international trade transactions
3. It pertains to use of Forex
- Identification of suppliers of goods and services
- Negotiation of terms and conditions of the transaction
4. It covers storage of Forex
- Deposits in foreign currency bank accounts - Forex reserves-gold, special drawing rights of IMF and foreign
currencies. - Foreign exchange reserves
FOREX MANAGER:
SKILLS:
1. Awareness of historical development of world trade
2. Ability to forecast future trends 3. Comparative analysis skills 4. In-depth knowledge of forex market
5. Knowledge of interest rates 6. Willingness to undertake risks
7. Hedging strategies
Foreign Exchange Market
- Is the market where the currency of one country is exchanged for the currency of another country
- The market is an over the counter market
- There is no single market place or an organized exchange (like a stock exchange) where traders meet and exchange currencies.
- The dealers sit in their dealing room of major commercial banks around the world and communicate with each other through
telephones, computer terminals and swift mechanism.
Foreign Exchange Rates:
- Is the price of one country’s money in terms of other country’s
money
- When Indian rupee depreciates against the US dollar, it indicates that demand for latter is more than it’s supply.
- When the supply of US dollar is more than it’s demand, it
declaims in value against the Indian rupee.
Factors Affecting Foreign Exchange:
1. Fundamental factors:
- All such events that affect the basic economic and fiscal policies
of the concerned government.
- These are basic economic policies followed by the government in
relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc.
2. Political and psychological factors 3. Technical factors
- Capital movement - Relative inflation rates
- Exchange rate policy and intervention - Interest rates
4. Speculation:
- The anticipation of the market participants many times is the
prime reason for exchange rate movements.
- Those speculators anticipate the events even before the actual data is out and position themselves accordingly to take advantage when the actual data confirms the anticipations.
Determination of Foreign Exchange Rates:
1. Balance of Payments
a. If payments by a country for its imports of goods and services, two possibilities arises
b. Foreign currency payments exceed receipts and there is a deficit. This puts the home currency of the country under downward
pressure against foreign currencies.
2. Demand and Supply
3. Purchasing power parity
4. Interest rate-gain relating to foreign trade
5. Relative income levels
6. Market expectations – developments regarding political and economic matters Of a country.
INTER-RELATIONSHIP OF VARIABLES AFFECTING EXCHANGE RATES:
- Interest rates, inflation rates, forward margins, exchange rates and
expectations across nations are inter- related.
Exchange rates quotes:
There are two major ways of offering exchange rate quotes.
1. Direct quote 2. Indirect quote
Spot Exchange Rates:
- Is a rate at which currencies are being traded for delivery on the
same day.
- Is for a currency is the current rate at which one currency can
be immediately converted into another currency.
- These rates are set by the demand and supply forces in the foreign exchange market.
- The direct quote indicates the number of units of the domestic currency required to buy one unit of foreign currency.
- An indirect quote indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency.
- An indirect quote is the inverse of a direct quote.
- Indirect quote = 1
………………
Direct quote
Types of Spot Rates:
1. Ask Rate: - Is the rate at which the foreign exchange dealer asks it’s
customer to pay in local currency exchange of the foreign currency.
- Is the rate at which the foreign currency can be purchased from the dealer.
2. Bid rate: - Is the rate at which the dealer is ready to buy the foreign
currency in exchange for the domestic currency.
- Is the rate at which the dealer is ready to pay in domestic
currency in exchange for the foreign currency and they are ready to pay for buying it.
- Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid
spread.
- The bid spread is usually stated as a percentage cost of
transacting in the foreign exchange market and may be computed as follows:
- % Spread = Ask price-Bid price
Ask price
Cross rates:
-The exchange rate between two currencies calculated on the basis of the
rate of these two currencies in terms of a third currency.
-Forward rate is a price quotation to deliver the currency in future.
- The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till
maturity.
- Forward rate may be higher than the spot rate if the market
participants expect the currency to appreciate v-s-v the other currency, say US dollar. The currency, in such case is called
trading at a forward premium.
- If the forward rate is lower than the spot rate, the participants
expect the currency to depreciate v-s-v the US dollar. The currency in such case is said to be ‘trading at forward discount’.
- Forward premium/discount is generally calculated as percentage per annum.
- = (Forward rate-Spot rate) 12/n. *100 Spot rate
Where ‘n’ indicates the number of months till maturity of the forward
contract
Risks in Foreign Exchange Market:
1. Objective:
Control of foreign exchange risk can be effective if a firm is able to
manage the fundamental relationship among inflation, foreign
exchange rates and interest rate.
- The objective in exposure management is two-fold the minimization of exchange losses as a result of currency movements and the minimization of protection costs.
2. General Protection Measures:
a) Invoicing policies:
- Invoices to third parties abroad should be denominated in the
relatively stronger currency. On the other hand, while importing goods. Etc. from third parties a firm should try to negotiate
payments in the weaker currency.
- Respective bargaining strengths and the need for good customer
relations have a bearing on the invoicing decision.
b) Transfer pricing:
- It is a mechanism by which profits are transferred through an adjustment of prices on intra-firm transactions
- It can be applied to transactions between the parent firm and its subsidiaries or between strong currency and weak currency subsidiaries.
c) Leading and lagging and extension of trade credit:
Leading: it implies speeding up collections on receivables if the
foreign currency in which they are invoiced is expected to
appreciate.
Lagging: it implies delaying payments of payables invoiced in a
foreign currency that is expected to depreciate.
There are three elements in this calculation:
- Cash cost/benefits represented by the interest rate differential between the lead and log countries
- An expected cash gain/loss to be realized on the altered transactional exposure in the said countries, and
- An expected translation gain/loss on the altered translation exposure.
d) Netting:
- All transactions-gross receipts and payments among the parent firm and subsidiaries should be adjusted and only net amounts
should be transferred.
- This reduces costs of remittance of funds, and increases control of intra-firm settlement.
- It also produces savings in the form of lower float and lower exchange costs.
e) Matching:
- It is a process whereby cash inflows in a foreign currency are
matched with cash outflows in the same currency with regard, to as far as possible, amount and maturation.
- When there are cash inflows in one foreign currency and cash outflows in another foreign currency, the two could still be
matched, provided they are positively correlated.
3.SPECIFIC PROTECTION MEASURES:
1. Transaction Exposure (TE):
- It occurs when a value of a future transaction, though known with certainty, is denominated in some currency other than the
domestic currency.
- In such cases, the monetary value is fixed in terms of foreign
currency at the time of agreement, which is complete at a later date.
- EX: an Indian exporter is to receive payment in euros in 90 days time for an export made today. His receipt in euros is fixed
and certain, but as far as the rupee Value is concerned; it is uncertain and will depend upon the exchange rate prevailing at
the time of receipt.
- All fixed money value transactions such as receivables;
payables, fixed price sale and purchase contracts etc. are subject to transaction exposure.
- TE refers to the potential change in the value of a foreign currency denominated transaction due to changes in the
exchange rate.
- It covers rate risk, credit risk and liquidity risk.
2.Translation Exposure:
- This is also called the accounting exposure
- It refers to and deals with the probability that the firm may suffer a decrease in assets value due to devaluation of a foreign currency even if no foreign exchange transaction has occurred
during the year.
- This exposure needs to be measured so that the financial
statement i.e. the balance sheet and the income statement reflect the change in value of assets and liabilities.
- This occurs when the firm’s foreign balances are expressed in terms of the domestic currency.
- Two related decisions involved in translation exposure management:
(a) Managing balance sheet items to minimize the net
exposure
(b) Deciding how to hedge against this exposure
- It results in exchange rate losses and gains that are reflected in
the firm’s accounting record and are not realized and hence have
no impact on the taxable income.
3. Economic Exposure:
- It refers to the probability that the change in foreign exchange rate will affect the value of the firm.
- The risk contained in economic exposure requires a determination of the effect of changes in exchange rates on each
of the expected future cash flows.
- The translation and the transaction losses are one-time events,
whereas the economic loss is a continuous one.
Managing Foreign Exchange Rate Risk:
- Firms that import and export often need to make commitments
to buy or sell the goods for delivery at the time, with the payment to be made in foreign currency.
- As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange
rate risk.
- The options available to a firm for hedging against exchange
risk are subject to the following:
(a) Shareholders composition
(b) Diversification across countries-different business in different
countries
(c) Cost of hedging risk
Exchange Rate Forecasting:
- The exchange rates among countries are affected by a large number of factors like rate of inflation, growth prospectus,
political stability and economic policies.
- The % change between the current and the forecasted exchange
rates may be calculated to find out appreciation or depreciation in the currency.
- A positive % change represents currency appreciation whereas a negative % change shows depreciation.
- The exchange rate may be fixed or floating. - The market forces of demand and supply determine the floating
exchange rates. These are not influenced by the government intervention.
- Fixed exchange rates, on the other hand, are decided by the regulating agencies.
The Floating Exchange Rates may be forecast with the help of various methods.
- Fundamental Analysis: this studies the relationship between macro economic variables (such as inflation rates, national
income growth and changes in money supply)
- Technical Analysis: this uses past prices and volume
movements to project future currency exchange rates.
- The reliability of the forecasts may be found out on the basis of forecasting error, which is calculated by root square error.
- The root square error is computed with the help of the following formula:
2
= (FV-RV)
RV
Where ‘FV’ is the forecasted value and ‘RV’ is the realized value.
Mechanics of Forex Trading:
- It is basically concerned with various forex operations including purchase and sale of currencies of different countries in order
to meet payments and receipts requirements as a result of foreign trade.
- Forex trading is done either in
Retail market – the traveler and tourists exchange one
currency for another in the form of currency notes or traveler
Cheques. Here the total turnover and average transaction
size are very small.
Wholesale Market or Inter Bank Market- is a market with
huge turnover. The major participants of this market include
commercial banks, corporation and
CAPITAL ACCOUNT CONVERTIBILITY:
- IT REFERS TO AN ECONOMIC TOOL EXPECTED TO
ENGENDER MORE EFFICIENT CAPITAL FLOWS AND CATALYSE GROWTH IMPULSES AND ENABLE THE SOCIETY TO ACHIEVE A STABLE BALANCE BETWEEN Its INTERNAL
AND EXTERNAL PRICES.
- The basic objective of capital account convertibility is to:
- Deepen and integrate financial markets
- Raise the access to global savings
- Discipline domestic policy makers and
- Allow greater freedom to individual decision-
making
- A more open capital account will facilitate higher availability of larger capital stock, supplemental domestic resources thereby
leading to higher growth and reducing the cost of capital and also facilitating access to the international financial market.
FOREIGN EXCHANGE MARKETS IN INDIA:
- The forex market in India is regulated by reserve bank of
India. - Participants in this market are the authorised moneychangers
and authorised dealers.
Authorized Moneychangers:
- In order to provide facilities for encashment of foreign currency to visitors from abroad, especially foreign tourists, reserve bank has granted licenses to certain established firms, hotels and
other organisations permitting them to deal in foreign currency notes, coins and travelers Cheques subject to directions issued
to them from time to time.
These firms and organisations are fall into two categories:
i. Full-fledged money changers- who are authorised to undertake both purchase and sale transactions with the
public and
ii. Restricted money changers- who are authorised only to
purchase foreign currency notes, coins and travelers Cheques, subject to the condition that all such collections
are surrendered by them in turn to an authorised dealer in foreign exchange/full fledged money changer.
Authorised Dealers:
- Authorizations in the form of licenses to deal in foreign
exchange are granted to banks, which are well equipped to undertake foreign exchange transactions in India.
- Authorizations have also been granted to certain financial institutions to undertake specific types of foreign exchange
transactions incidental to their main business.
QUESTIONS AND ANSWERS FINANCIAL MANAGEMENT
(Theory)
YEAR-DEC-2003:
1. “Liquidity and profitability are competing goals for the finance manager” comment.
Liquidity ensures the ability of the firm to honour it’s short term
commitments, that means, the firm has adequate cash, to pay for it’s bills, to make unexpected large purchases and to meet
contingencies, at all times.
It also reflects the ability of the firm to convert its assets into cash
and pay off liabilities quickly.
Under liquidity management, the finance manager is expected to manage all its current assets including near cash assets in such a
way as to ensure its effectively with the view to minimize its costs.
Under profitability objective, the finance manager is expected to
utilize the funds of the firm in such a manner as to ensure the highest return.
However, the two objectives of the liquidity and profitability have
inverse relationship
If liquidity increases profitability decreases and vise-a-versa.
2. “Depreciation is a part of cost of production and is at the same time an important source of internal finance”.
While calculating cost of production of an item, prime costs and
factory overheads are considered.
Under factory overheads depreciation on plants and machinery
and other assets are included.
Thus depreciation forms part of cost of production.
Depreciation indicates the decrease in the value of assets due to wear and tear, lapse of time and accident and hence some funds
are desired to be kept apart for replacement of worn-out assets.
“ It’s a deduction out of profits of the company calculated as per
accounting rules on the basis of estimated life of each asset each year over the life of the assets to an amount equal to original value
of the assets”.
The pool of funds generated due to accumulation of depreciation
provides an opportunity to a firm to use it in the funding of its working capital requirements, acquisition of new assets or
replacement of worn out plant and machinery.
Those who consider dep. As a source of funds argue that dep. does
not result into any cash outlay since it is a non-cash expense.
Those who oppose considering dep. As a source of funds argue that funds are generated by operating profits and not by making
provision for dep.
Dep. is considered as a special amount set aside out of the revenue
generated by the firm.
If it would have been really a source of funds, any firm could have improved its position at its will, just by increasing the periodical
depreciation charge.
Hence in a strict sense, dep. should not be considered as a source
of funds.
3. “ Retained earnings (RE) have no cost” do you agree? Give reasons of your answer.
RE are funds accumulated over the years, of the company, by keeping part of the funds generated without distribution as
dividend amongst shareholders.
The funds so generated become one of the major sources of
funding for the company to finance its expansion and diversification programmes.
The funds belong to equity shareholders and it is taken into
account while calculating cost of equity.
Many people consider RE as cost free source of funds, which may not be a correct approach.
The reason is that RE indicates the amount of profits not
distributed among equity shareholders.
Virtually, the company has deprived the equity holders of this
earning by retaining a portion of profit with it.
Therefore the cost of RE may be considered as equivalent to the
earnings foregone by the shareholders.
In other words, the opportunity cost of retained earnings may be considered as their cost, which is equal to the income that they
would otherwise earn by placing these funds in alternative investment.
Therefore, the statement that RE has no cost is not correct.
4. Discuss in brief the techniques of economic appraisal for an industrial project
A project is accepted if it proves it feasibility from market,
technical, financial and economical angles.
An economic analysis of industrial project is made with the help
of the following economic appraisal techniques:
Economic rate of return: it indicates the rate of return to the
company or society and not to the private promoters and other agencies involved in the promotion of project.
Domestic resource cost: it measures the resource cost of manufacturing a project as compared to importing/ exporting
cost of it. And it is computed as the quantum of domestic resources or costs deployed in production to the net foreign
exchange saved or earned.
Effective rate of protection: it is offered to a particular stage
of manufacture of a product is an important consideration in the determination of competitive strength of the product.
ERP=value added at domestic prices – value added at
international prices
5. What is ‘treasury management’? Explain the various tools of
treasury management. How is it different from financial management?
Is the science of managing treasury operations of a firm.
It refers to all activities involving the management of revenues, inflows and outflows of government.
The treasury management and fund management are used
almost synonymously.
Conceptually, the latter is general term, applicable to the
business sector, while treasury mgt. refers to the mgt. Of cash, currency and credit of sovereign power of the country.
Tools of treasury management:
- Analytic and planning tools - Zero based budgeting - Financial statement analysis
Difference b/w financial mgt. And treasury mgt.:
- Control aspects
- Reporting aspects - Strategic aspects; and - Nature of assets.
6. What are the methods of ‘venture financing’? Also indicate in brief the
elements that are needed for the success of venture capital.
Venture capital is typically available in three forms in India:
- Equity - Conditional loans; and - Income notes.
- Conditional loan is quite popular source of funds made available by VCF’s in India.
The following elements are needed for the success of venture capital in
any nation:
- Entrepreneurial tradition
- Unregulated economic environment - Disinvestment avenues
- Fiscal incentives - Broad based education
- Venture capital managers - Promotion efforts - Institution industry linkages
- Research and development activities
6. “Bonus shares represents simply a division of corporate pie into a large
number of pieces” discuss
Most of the shareholders, considered that the bonus shares
are valuable. But they fail to realize that the bonus shares do not affect their wealth and therefore, in itself they have no value for them.
It merely divides the ownership of the company into a
large number of pieces.
Infact, the bonus issue does not give any extra or special
benefit to a shareholder.
His proportionate ownership in the company does not
change.
Further, from the company’s point of view the issue of bonus shares is more costly to administer than cash
dividend.
The company has to print certificates and send them to
lakhs of shareholders.
7. According to Dow Jones Theory, “ identification of ‘turn’ is made on the basis of daily movement of prices”. State, with reasons, whether this
statement is correct.
The theory states that the movement of prices of
securities on the stock exchange can be studied under the three broad categories
- Primary movements: it represent the long term movements of the prices of securities on the stock
exchange, ranging from one year to three year
- Secondary movements: this shows the short term fluctuations in stock exchange prices lasting from 3
weeks to 3 months
- Daily movements: this shows daily irregular fluctuations in the stock exchange prices. These do
not show any definite trend.
- Virtually, such fluctuations arose because of speculative transactions and so important for
speculators only.
- Hence, no decision can be based on these movements. Therefore, the statement is not correct.
JUNE -2004
1. “A high EPS may not always maximize the stock price.” Do you agree?
Discuss.
The statement is true due to following reasons:
EPS may be high due to profit maximization, which itself is
not a sure shot for a high stock price.
High EPS may be due to financial leverage effect, which increases a firm’s risk prospects of growth rate.
If the business prospectus of a company is not good the stock price may not go up in spite of high EPS.
The nature of business and the industry in which the company
operates also affects the stock price and not the EPS alone.
2. List out the benefits of issuing bonus shares.
Bonus issue is a signal of bright future of a company. It increases
the firm’s value.
Company utilizes permanently a part of the profit of the
company for its businesses without affecting the liquidity.
After the bonus issue share price comes down and the share becomes affordable (within the reach) of the investor
Bonus shares, are a capital receipt, it is not taxable. It is taxable on sale only.
It increases the goodwill of the company.
It improves market sentiments.
3. “ Stability in payment of dividends has a marked bearing on the market price of the shares of a corporate firm.” Explain the statement.
The dividend policy determines the division of earnings between the dividend distribution and reinvestment in the firm.
The distribution of earnings between the two depends upon the
need of funds internally for reinvestment purposes and expectations of the shareholders.
An increase in the dividend leads to a stock price increase while
a decreased in dividend results into a stock price decline.
An increase in dividend payout is considered by the investors as
permanent or long term increase in firm’s expected earnings and considered as good news resulting in an increase in stock price.
Fluctuating dividend policy will not create the desired impact
over the stock price.
Hence, it is said that stability in payment of dividends has a
marked bearing on the market price of the shares of a corporate firm.
4. Describe the responsibility of treasury manager.
He is expected to establish the operational systems of the firm to ensure compliance of all statutory and regulatory
guidelines. Compliance of tax provisions and payment of all government dues must also be ensured.
He should be fair in dealings while playing the supportive role.
No undue favour or bias should reflect in his working.
In case of system breakdown, during periods of cash crunch and under crisis situation, a treasury manager is expected to
exhibit traits of public relationship and networking.
He is expected to be honest and straightforward in his
dealings.
In order to prove true professionalism, the treasury manager is required to update his knowledge as and when developments
in his field take place.
5. If the use of financial leverage magnifies the earnings per share under the favorable economic conditions, why do companies not
employ very large amount of debt in their capital structure?
Under favourable economic conditions a company may use
financial leverage to magnify the shareholders return.
The financial leverage magnifies shareholders return on the assumption that the debt funding can be had a cost lower than the
firms rate of return on net assets.
The difference of earnings generated on fixed cost funding and cost
of such funding when distributed among equity shareholders magnifies their return and thus EPS or ROE increases.
There is negative impact of financial leverage if a leverage if a firm
fails to earn adequate returns on investment to finance the cost of debt funds.
The difference of earnings and cost will have to be compensated by the equity shareholders by reducing their return.
That is why, companies do not employ very large amount of debt in
their capital structure despite the advantage of financial leverage.
6. Discuss in brief the factors to be considered while evaluating the
technical feasibility of a project.
To protect firm from possibility of obsolescence of technology
adopted, proper evaluation of available technology, use of plant and machinery to be used, must be made carefully.
Scale of operation plays an important role in the operations of a
firm economically
While evaluating the technical viability of a project minimum level
of scale of operations must be ensured to gain economy in
operation.
Location should be properly evaluated
Credibility and experience of supplier has to evaluated carefully
Evaluation of the layout of the plant at the location site.
Power source
Transport facilities
Know how and training of workers
Realistic assessment of the construction schedule.
7. Discuss in brief the attributes of debt securitisation.
Debt securitisation is a method of recycling of funds
It is especially beneficial to financial intermediaries to support
the lending volumes.
Functions of securitisation process:
- The origination function - The pooling function
- The securitization function Benefits of securitisation:
- Off balance sheet funding
- Conversion of liquid assets into liquid portfolio
- Better balance sheet management
- Enhancement in originators credit rating
- Opening of new investment avenues for investors
- As against factoring or bill discounting securitisation
helps in converting the stream of cash receivables into a source of long-term finance.
WHAT IS AGEING SCHEDULE ?
When receivables are analyzed according to their age, the process is known as
preparing the ageing schedules of receivables. The ageing schedule classifies the outstanding receivables at a given point of time into different age groups together with percentage of receivables that fall into each group.
Ex: Receivables of a firm having normal credit period of 20 days may be classified as follows
Age group % of total outstanding receivables
Less than 20 days 60%
21-40 days 20%
41-60 days 10%
Above 60 days 10%
The age group represents the number of days or weeks in which the receivables become outstanding. The quality of a receivable can be judged by looking at the age of receivables. The older the receivable the lower is the quality and
higher the chances of default. What are benefits of ageing schedule?
- It provides a kind of an early warning proclaiming i.e. deterioration of
quality of receivables and where to apply the corrective action. - It helps in analyzing the collection policy, procedure by comparing the
present period ageing schedule with past period ageing schedule
- It directly points out those customers who require special attention. - It also helps in projecting the monthly receipts for each collection period.
What is MPBF ?
It stands for Maximum Permissible Bank Finance i.e. the maximum amount that Banks can lend to a borrower towards his working capital requirements. The RBI had constituted various study groups / commitments to study the
trends of working capital finance by banks and recommend the norms to be followed in lending. The recommendations of the Tandon committee (formed in
July 1974) had far reaching impact in lending norms. MBPF based on Tandon Committee’s recommendations:
This committee suggested three different method of computing the MBPF :
Method I
MPBF = 75% of (CA – CL)
Method II
MPBF = (75% of CA – CL)
Method III
MPBF = (75% of fluctuating CA – CL)
This committee suggested gradual shift from Method I to Method III, in order to make the borrower more self-reliant in financing his working capital
requirements. Current trends in MPBF :
In 1997, the RBI scrapped the concept of MPBF and introduced a new system
of lending. The salient features of the new system are :
Amount of Loan Procedure
Upto Rs.25 lakhs The credit limits will be computed after detailed discussions with borrower, without going into detailed
evaluation.
Above Rs.25 lakhs
but upto Rs.5 crores.
The credit limit can be offered upto 20% of the projected
gross sales of the borrower.
Above Rs.5 crores Cash budget system may be used to identify the working capital needs. Consortium arrangements between different banks and financial institutions are now
optional for this category.
What is time value of money ?
“Worth of a rupee received today is different from the worth of a rupee to be received in future” is known as Time value of money i.e. value derived from the
use of money over a period of time as a result of investment and re-investment. What are reasons of time preference of money ?
- Risk
- Preference for present consumption - Investment opportunities - Inflation
- Capital budgeting decision What are methods of computation of time value of money ?
The concept of time value of money helps in arriving at the comparable value of
the different rupee amount arising at different points of time into equivalent
value at a particular point of time (present or future). This can be done by either –
Compounding the present money to a future date i.e. finding out future value of present money, or
Discounting future money to the present date i.e finding out present value of future money.
Explain the importance of Capital budgeting?
Huge Investment cost : Initial investment is substantial. Hence commitment of resources should be made properly.
Time : The effect of decision is known only in the near future and not immediately. Cash outflows are to be made immediately, while Inflows/returns
arise over a future period of time.
Risk : The longer the time period of returns, the greater is the risk/uncertainty associated with cash flows. Hence, decisions should be taken after a careful review of all available information.
Irreversibility : Decisions are irreversible in nature and commitment of resources should be made on proper evaluation. For example, plant and
machinery purchases for a textile mill project cannot be used for any purpose say refining of crude oil.
Complexity : Decisions are based on forecasting of future events and inflows. Quantification of future events involves application of statistical and
probabilistic techniques. Careful judgement and application of mind is necessary.
Surplus : Funds are obtained by a Firm at a certain cost (i.e. WACC). Even internally generated funds have an implicit cost. Hence, there is a need to
obtain a surplus over and above the cost of funds. Only then the investment is justified.
Explain types of capital investment decisions ?
The decisions will be on the basis of firm’s existence on cost reduction decisions through replacement and modernization decisions, and Revenue
expansion decisions through expansion and diversification decisions. Also the decisions should be based on situation such as mutually exclusive
decisions, accept-reject decisions and contingent decisions.
What are capital budgeting techniques ?
Traditional or Non-discounting : Payback period, accounting rate of return and Pay back reciproical.
Time adjusted or Discounted cash flows : Discounted payback, NPV, Profitability index, Internal rate of return, Modified IRR.
Techniques Meaning Formula
Simple payback Payback period represents the time period required for complete recovery of the initial investment
in the project. It is the period within which the total cash inflows from the
project equals the cost of investment in the project.
The lower the payback period, the better is, since initial investment is recouped faster.
If Cash flow are even Initial Invt
Payback = --------------- CFAT p.a.
If Cash flow are uneven
Payback=time at which cumulative CFAT = Initial investment
Discounted pay
back
When the payback period is
computed after discounting the cash flows by a pre-determined rate (cut off rate), it is called as
the Discounted payback period.
Time at which
cumulative discounted CFAT = Initial investment
Payback
reciprocal
It is the reciprocal payback
period. It is expressed in percentage
CFAT p.a
-----------------x 100 Initial invt
Accounting/ average rate of return
It means the average annual yield on the project. In this method, PAT(instead of CFAT) is
used for evaluation
Avg PAT p.a. ----------------x100 Initial invt
Profitability
Index or Desirability
factor (PI)
Where different investment
proposals each involving different initial investments and
cash inflows are to be compared, the technique of PI is used.
Total DCFAT
PI=------------------x100 Initial Invt.
Explain the acceptance rule of Profitability index
PI > 1 Accept the project. Surplus over and above the cut-off rate is obtained.
PI = 1 Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be accepted or rejected. This
constitutes an indifference point
PI < 1 Reject the project. The project does not provide returns even
equivalent to the cut-off rate.
Explain Net present value ?
It is defined as the sum of present values of all future cash inflows less the sum of the present values of all cash outflows associated with the proposal.
IF Decision
NPV > 0 Accept the project. Surplus over and above the cut-off rate is obtained.
NPV = 0 Project generates cash flows at a rate just equal to the cost of
capital. Hence, it may be accepted or rejected. This constitutes an indifference point.
NPV < 0 Reject the project. The project does not provide returns even equivalent to the cut-off rate.
NPV = Discounted cash inflows less initial investment.
Define Internal Rate of return ?
IRR is the rate at which the sum total of Discounted cash inflows equals the Discounted cash outflows.
The internal rate of return of a project is the discount rate which makes net present of the project equal to zero.
IF Decision
IRR > K Accept the project. Surplus over and above the cut-off rate is obtained.
IRR = K Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be accepted or rejected. This constitutes an indifference point.
IRR < K Reject the project. The project does not provide returns even equivalent to the cut-off rate.
Steps :
1. Compute one positive NPV and one negative NPV using arbitrary discount rates.
2. Compute the change in NPV over the two selected discount rates. 3. On proportionate basis, compute the discount rate at which NPV is zero.
Explain Modified Internal Rate of return ?
In order to cope up with various limitations of the conventional internal rate of return, modified IRR was developed.
Under this method, all cash flows (except initial investment) are brought to the terminal value using an appropriate discount rate (generally the cost of capital).
Modified IRR results in a single stream of cash inflows in the terminal year.
It is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow.
The discount rate which equates the PV of the terminal cash inflow to the
0th year outflow is known as Modified IRR. What are steps to calculate Modified IRR ?
1. Determine the total cash outflows & inflows of the project and the time
periods in which they occur. 2. Compute terminal value of all cash flows other than the initial
investment. For this purpose, terminal value of a cash flow = amount of
cash flow x re-investment factor, where reinvestment factor = (1 + k)n where n= number of years balance remaining in the project.
3. Compute total of terminal values as computed under step 2. This is
taken as the ‘inflow’ from the project, to be compared with the ‘outflow’ i.e. the initial investment.
4. Compute modified IRR i.e discount rate such that PV of terminal value = initial investment. Note : For computing Modified IRR, the interpolation techniques
applicable to IRR may be used.
What is capital rationing ?
There may be situations where a firm has a number of projects that yield a positive NPV. However, the most important resource in investment decisions, i.e. funds, are not fully available to undertake all the projects. Such a situation
is considered as a Resource constraint situation. In case of restricted availability of funds, the objective of the firm is to maximize the wealth of
shareholders with the available funds. Such investment planning is called capital rationing. Here the project can be classified into two types i.e Divisible
and Indivisible.
Explain the differences between Divisible and Indivisible?
Divisible Indivisible
Partial investment is possible and
proportionate NPV can be obtained
Steps : -Compute PI of various projects and rank them based on PI
-Projects are selected based on maximum PI.
Investment should be made in full.
Partial or proportionate investment is not possible.
Steps : -Determine the combination of projects to utilize amount available.
-Compare NPV of each combination. -Select the combination with maximum NPV.
Explain Equivalent Annual Flow Method?
Whenever life disparity arises, we have to solve the problem by way of
equivalent Annual Flow method. Steps :
1. Compute the Initial investment of each alternative. 2. Determine the project lives of each alternative. 3. Determine the annuity factor relating to the project life of each
alternative. 4. Compute equivalent annual investment = initial investment / annuity
factor. 5. Compute CFAT p.a. / cash outflows per annum, of each alternative 6. Compute equivalent annual benefit = CFAT per annum less Equivalent
annual investment 7. Select the project with maximum Equivalent annual benefit or equivalent
annual costs, as the case may be. What are financial needs and sources of finance of a business?
The business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the
following three categories :
1. Long term financial needs (more than 5 years) such as share capital, equity, preference, retained earnings, debentures/bonds, loans, venture capital, asset securitization, international financing.
2. Medium term financial needs(more than 3 to 5 years) such as preference, debentures/bonds, public deposits/fixed deposits, lease/hire purchase,
ECB, euro issues, Foreign currency bonds. 3. Short term financial needs such as trade credit, accrued expenses and
deferred income, commercial paper, fixed deposits, advances.
Define Bridge Finance ?
It refers to loans taken by a company from commercial banks for a short
period, pending disbursement of loans sanctioned by financial
institutions. Normally, it takes time for financial institutions to disburse loans to
companies. However, once the loans are approved by the term lending institutions,
companies, in order not to lose further time in starting their projects,
arrange short term loans from commercial banks. Bridge loans are also provided by financial institutions pending the
signing of regular term loan agreement, which may be delayed due to non-compliance of conditions stipulated by the institutions while sanctioning the loan.
The bridge loans are repaid or adjusted out of the term loans as and when disbursed by the concerned institutions.
Bridge loans are normally secured by hypothecating movable assets,
personal guarantees and demand promissory notes. Generally, the rate of interest on bridge finance is higher as compared to
that on term loans. Define Venture Capital Financing?
The venture capital financing refers to financing new high risk venture
promoted by qualified entrepreneurs who lack experience and funds to
give shape to their ideas. Venture capitalist makes investment to purchase equity or debt
securities from inexperienced entrepreneurs who undertake highly risk ventures with a potential of success.
What are different methods of Venture capital financing ?
Equity Financing :
The venture capital undertakings generally requires funds for a longer
period, but may not be able to provide returns to the investors during the initial stages.
Therefore, venture capital finance is generally provided by way of equity
share capital.
The equity contribution of the venture capital firm does not exceed 49% of the total equity capital of venture capital undertakings so that the
effective control and ownership remains with the entrepreneur.
Conditional Loan :
A conditional loan is repayable in the form of royalty after the venture is
able to generate sales. No interest is paid on such loans. In India venture capital financiers charge royalty ranging between 2 to
15%, actual rate depends on other factors of the venture such as gestation period, cash flow patterns, risk and other factors of the
enterprise Income Note :
It is a hybrid security which combines the features of both conventional
loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at
substantially lower rates.
Define Debt securitization ? Explain the procedures on Debt Sec ?
Securitization is a financial transaction in which assets are pooled and
securities representing interests in the pool are issued. It is the process by which financial assets (ex: loan receivables, mortgage
backed receivables, credit card balances, hire purchase debtors, trade
debtors etc) are transformed into securities. Securitization can take the form of ‘debt securitization’ in which the
underlying pool of assets(debt) is sold to a company or a trust for an
immediate cash payment. The company which buys these pool of assets, issues securities and
utilizes the regular cash flows arising out of the underlying pool of assets for servicing such issued securities.
Thus securitization follows a two way process :
(a) Sale of an asset or a pool of assets to a company for immediate cash payment
(b) Repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable securities.
The company to which the underlying pool of assets or asset is sold is known as a ‘Special purpose vehicle(SPV)’
The company which sells the underlying pool of assets or asset is known
as the originator.
The process of securitization is generally without recourse i.e. the investor bears the credit risk or risk of default and the issuer is under an
obligation to pay to investors only if the cash flows are received by him from the collateral.
The issuer however, has a right to legal recourse in the event of default. The risk run by the investor can be further reduced through credit
enhancement facilities like insurance, letters of credit and guarantees.
Securitization is different from factoring since the latter involves transfer of debts without transformation thereof into securities.
As compared to factoring or bill discounting which largely solve the
problems of short term trade financing, securitization helps to convert a stream of cash receivables into a source of long term finance.
What are process of securitization ?
Originator gives various loans to different borrowers and they have to repay the loans in EMI’s. These EMI’s constitute financial
assets/receivables for the Originator.
Financial assets / receivables are transferred, fully or partly, by the
Originator to a SPV. SPV pays the Originator immediately in cash or in any other consideration for taking over the financial assets.
The assets transferred are termed Securitized assets The assets or rights retained by the Originator are called retained assets
SPV finances the assets transferred to it by issue of securities such as
Pass through certificates / debt securities to investors. These are generally sold to Investors (mutual funds, LIC etc) through Merchant
bankers. What are the benefits to the Originator ?
i. The assets are shifted off the balance sheet, thus giving the Originator
recourse to off-balance sheet funding. ii. It converts non-liquid assets into liquid portfolio. iii. It facilitates better balance sheet management as assets are transferred
off-balance sheet facilitating satisfaction of capital adequacy norms. iv. The originator’s credit rating enhances.
What are benefits to the Investor ?
i. Securitization opens up new investment avenues. ii. Though the investor bears the credit risk, the securities are tied up to
definite assets.
Define Lease financing ?
Leasing is an alternative to the purchase of an asset out of own or borrowed funds.
Leasing is a contract between the owner and user of the asset over a specified period of time.
The asset is purchased initially by the lessor(leasing company) and thereafter leased to the user(lessee company) which pays a specified rent
at periodical intervals.
The Lessee pays a specified rent(lease rental charges) at periodical
intervals as consideration for the use of the asset. This constitutes the income of the Lessor.
Lease finance can be arranged much faster as compared to term loans from financial institutions.
From the lessee’s point of view, leasing has the attraction of eliminating immediate cash outflow, and the lease rentals can be deducted for
computing the total income under the Income tax act. As against this, buying has the advantages of depreciation allowance (including additional depreciation) and interest on borrowed capital being tax
deductible.
Lease may be classified into (a) Operating and (b) Financial Lease
What is Seed Capital assistance ?
The Seed capital assistance scheme is designed by IDBI for professionally
or technically qualified entrepreneurs and/or persons possessing
relevant experience, skills and entrepreneurial traits. All the Projects eligible for financial assistance from IDBI, directly or
indirectly through refinance are eligible under the scheme.
The project cost should not exceed Rs.2 crores. The maximum assistance under the project will be restricted to 50% of
the required promoter’s contribution or Rs.15 lacs whichever is lower. The seed capital assistance is interest free but carries a service charge of
one per cent per annum for the first five years and at a rate increasing
thereafter. However, IDBI will have the option to charge interest at such rate as may
be determined by IDBI on the loan, if the financial position and profitability of the company so permits during the currency of the loan.
The repayment schedule is fixed depending upon the repaying capacity of
the unit with an initial moratorium upto five years. For projects with a project cost exceeding Rs.200 lacs, seed capital may
be obtained from the Risk capital and Technology Corporation
Ltd(RCTC). For small projects costing upto Rs.5 lacs, assistance under the National Equity Fund of the SIDBI may be availed.
What is Deep Discount Bonds ?
Deep Discount Bonds is a form of zero-interest bonds. These bonds are sold at a discounted value and on maturity the face value is paid to the
investors. There is no interest payout during lock in period. These bonds can be traded in the market. Hence, the investor can also
sell the bonds in stock market and realize the difference between initial investment and market price.
What are Secured Premium Notes ?
SPN are issued along with a detachable warrant and is redeemable after a notified period of say 4 to 7 years.
The conversion of detachable warrant into equity shares will have to be
done within time period notified by the company.
ZERO Coupon Bonds
ZCB does not carry any interest
Sold by issuing company at a discount The difference between the discounted value and maturing or face value
represents the interest to be earned by the investor on such bonds.
DOUBLE OPTION BONDS
Issued by IDBI with a face value of each bond is Rs.5000. The bond carries interest at 15% per annum
Interest has been compounded half yearly from the date of allotment The bond has maturity period of 10 years Each bond has two parts in the form of two separate certificates, one for
principal of Rs.5000 and other for interest (including redemption premium) of Rs.16500.
Both these certificates are listed on all major stock exchanges The investor has the facility of selling either one or both parts anytime he
likes.
EXTERNAL COMMERCIAL BORROWINGS
Refers to the commercial loans availed from non-resident lenders It has minimum average maturity period of 3 years Borrowers can raise ECBs through internationally recognized sources
like: international banks, international capital markets and multilateral financial institutions.
ECB can be accessed through two routes viz.,
Automatic Approval
In this route, there is no need to take the RBI/Government
approval
RBI/Govt approval is necessary under the approval route
Companies registered under
the Companies Act and NGOs engaged in micro finance activities
are eligible for automatic route
FI and Banks dealing
exclusively in infrastructure or export finance and the ones which
had participated in the textile and steel sector restructuring packages as approved by the Govt are
required to take the approval route
EURO BONDS
Euro bonds are debt instruments which are denominated in the currency
of the country in which they are issued. Generally issued in a bearer form rather than as registered bonds
It does not contain the investor’s names or the country of their origin These bonds are an attractive proposition to investors seeking privacy.
AMERICAN DEPOSITORY RECEIPTS(ADR)
DR issued by a Company in the USA is known as ADR.
Issued in accordance with provisions stipulated by the SEC of USA, which is a regulatory body like SEBI in India.
ADR may or may not carry out voting rights It is a bearer negotiable instrument and the holder can sell it in the
market.
Once sold, ADRs cannot be re-issued. ADRs are an easy and cost effective way for individuals to hold and own
shares in a foreign country. They save considerable money by reducing administration cost and
avoiding foreign taxes on each transaction.
GLOBAL DEPOSITORY RECEIPTS (GDR)
DR is basically a negotiable certificate, denominated in US Dollars that represents a non-US company’s publicly traded local currency(say,
Indian rupee) equity shares. They are created when the local currency shares of an Indian company
are delivered to the depository’s local custodian bank, against which the
Depository bank issue GDR’s in US dollars.
They may be freely traded in the overseas markets like any other dollar denominated security through either a foreign stock exchange or through
over the counter(OTC) market or among a restricted group like QIB. GDR with warrants are more attractive than plain GDRs due to
additional value of attached warrants. Shares underlying the GDR do not carry voting rights. Instruments are freely traded in the international market.
Marketed globally and traded in more than one currency Investors earn fixed income by way of dividend. GDR’s can be converted into underlying shares by depository/custodian
banks, without the need for fresh issue. Indian companies are able to tap global equity market to raise foreign
currency. Exchange risk is borne by the investors as the payment of the dividend is
made in local currency.
Voting rights are vested only with depository.
PLOUGHING BACK OF PROFIT
It’s a phenomenon under which the company does not distribute all the profit earned but retains a part of it, which is reinvested in the business for its development. The retained portion of profits is known as Retained
earning. It is a technique of self financing.
It is a source of finance which contributes towards the fixed as well as the working capital needs of the company.
Under this phenomenon, a part of the total profit is transferred to
various reserves such as general reserve, reserve for repair and renewal, secret reserves etc.
The funds so created entail almost no risk and the control of the owners
is also not diluted. Since the company does not depend upon external sources, ploughing
back of profit or retained earnings acts as an economical method of financing.
The retained earning helps the company to pay the dividend regularly
and enhances the credit worthiness of the company. Company with large reserves can withstand the shocks of trade cycle and
the uncertainty of the market with ease. It allows the financial structure to remain flexible It makes the company self reliant. It need not depend on outsiders for
the financial needs.
RATIO ANALYSIS
The term ratio refers to the relationship expressed in mathematical terms between two individual figures or group of figures connected with each other in
some logical manner. It is widely used tool of financial analysis. LIQUIDITY RATIO
Liquidity means short term solvency i.e. ability of the business to pay its
short term liabilities.
Short term lenders and creditors of a business are very much interested
to know its state of liquidity because of their financial stake.
Current ratio CA/CL CA = Inventories + Sundry Drs + Cash and bank balances + Receivables/accruals + loans and advances + Disposable investments.
CL = Crs for goods and services + short term loans + Bank OD + Cash credit + o/s expenses +
provision for taxation+ proposed dividend + unclaimed dividends
Quick ratio
Liquid ratio Acid Test ratio
QA/QL QA= current assets – inventories
QL = CL – Bank OD – cash credit
Absolute cash ratio
(Cash + Marketable securities) / QL
Net wkg cap ratio
CA-CL
LEVERAGE /CAPITAL STRUCTURE RATIOS
The capital structure / leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the firm .
These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long term funds with regard to periodical
payment of interest during the period of the loan and repayment of principal amount on maturity.
Leverage ratios are of two types : Capital Structure Ratios and Coverage ratios
Capital Structure ratios
Equity ratio Shareholders equity/Total capital employed
Debt ratio Total debt / Total capital employed
Debt to equity ratio Debt , equity or Total liabilities /shareholders equity
Coverage ratios :
coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios establish the relationship between fixed claims and what is
normally available out of which these claims are to be paid.
Debt service coverage
ratio
Earning for debt service / Interest + instalments
Interest coverage
ratio
EBIT / Interest
Preference Dividend
coverage ratio
EAT / Pref. Dividend liability
Capital Gearing ratio (Pref Sh Cap + Deb + Long term loans) / ( Eq sh
cap+reserves & surplus – losses )
Proprietary ratio Prop fund / Total assets
Debt = long term borrowed fund = Debenture + long term loans from Financial
institutions Equity = owner’s fund = equity capital + preference capital + Reserves &
Surplus less : accumulated losses Earning for debt service = Net profit + Non cash operating expenses like
depreciation and other amortizations + non operating adjustments like loss on sale of fixed assets + interest on debt fund.
Proprietary fund = Equity share capital + Preference share capital + Reserve & Surplus – Fictitious assets.
ACTIVITY RATIO
It is also called the turnover ratios or performance ratios
These ratios are employed to evaluate the efficiency with which the
firm manages and utilizes its assets.
These ratios usually indicate the frequency of sales with respect to
its assets.
Capital turnover ratio Turnover /capital employed
Fixed assets turnover ratio
Turnover / fixed assets
Working capital turnover
Turnover / working capital
Inventory turnover ratio
COGS / Avg. inventory
Debtors turnover ratio Credit sales / avg debtors
Creditors turnover ratio
Credit purchase / avg creditors
PROFITABILITY RATIO
Based on owner’s point of view
Return on equity Earning available to equity shareholders /networth
x100
Earnings per share Earning available to equity shareholders /no. of
equity shares
Dividend per share Total profit distributed to equity shareholders / no of
equity shares
Price earning ratio Market price per share / EPS
Based on Assets / Investments
Return on Capital
Employed
Return / capital employed x 100
Return on Investment Return / Capital employed x 100
Return on assets Net profit after taxes / average total assets
Based on sales of firm
Gross Profit Ratio GP /sales x 100
P/V Ratio Sales – VC /Sales x 100
Operating Profit ratio Op profit / sales x 100
Net Operating ratio Operating profit / sales x 100
Net profit ratio Net profit / sales x 100
Based on capital market information
PE Ratio Avg share price / EPS
Yield Dividend / Avg share price x 100
Mkt value per share Avg share price / networth
What are the financial ratios for evaluating performance ? Liquidity Position:
With the help of ratio analysis one can draw conclusions regarding liquidity
position of a firm. The liquidity position of a firm would be satisfactory if it is
able to meet its obligations when they become due. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit
analysis by banks and other suppliers of short-term loans.
Long-term Solvency: Ratio analysis is equally useful for assessing the long-term financial viability of a firm. This aspect of the financial position of a borrower is of concern to the
long term creditors, security analysts and the present and potential owners of a business. The long term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency.
The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in
which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved.
Operating Efficiency:
Ratio analysis throws light on the degree of efficiency in the management and utilisation of its assets. The various activity ratios measure this kind of
operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets – total as well as its components.
Overall Profitability :
Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall
profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of
the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered together.
Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also
serves as a stepping stone to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages. A single figure of
particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average. It should be reasonably expected that the performance of a
firm should be in broad conformity with that of the industry to which it belongs. An inter-firm comparison would demonstrate the relative position vis-a-vis its competitors. If the results are at variance either with the industry
average or with those of the competitors, the firm can seek to identify the probable reasons and, in the light, take remedial measures. Ratios not only
perform post mortem of operations, but also serve as barometer for future. Ratios have predictory value and they are very helpful in forecasting and
planning the business activities for a future. It helps in budgeting. Conclusions are drawn on the basis of the analysis obtained by using ratio analysis. The
decisions affected may be whether to supply goods on credit to a concern, whether bank loans will be made available, etc.
Financial Ratios for Budgeting: In this field ratios are able to provide a great deal of assistance, budget is only
an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable.
Limitations of Financial Ratios
The limitations of financial ratios are listed below:
(i) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the
basis of aggregate data cannot be used for inter-firm comparisons.
(ii) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.
(iii) Seasonal factors may also influence financial data.
(iv) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments.
Such window dressing can change the character of financial ratios which would be different if there had been no such change.
(v) Differences in accounting policies and accounting period: It can make the
accounting data of two firms non-comparable as also the accounting ratios. (vi) There is no standard set of ratios against which a firm’s ratios can be compared: Some times a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a
low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.
(vii) It is very difficult to generalise whether a particular ratio is good or bad: For example, a low current ratio may be said ‘bad’ from the point of view of low
liquidity, but a high current ratio may not be ‘good’ as this may result from inefficient working capital management.
(viii) Financial ratios are inter-related, not independent: Viewed in isolation one
ratio may highlight efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis.
Cost of capital : It refers to the discount rate that is used in determining the present value of
the estimated future cash proceeds of the business/new project and eventually deciding whether the business/new project is worth undertaking or not.
It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of share at its current level.
It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level
as the investment that has been selected.
INTERNATIONAL FINANCIAL MANAGEMENT
CHAPTER 2
THE FOREIGN EXCHANGE MARKET:
STRUCTURE:
The market in which the commercial banks deal with the customers (both the
individuals and corporate) is called retail market.
The market in which the banks deal with each other is called whole sale
market.
Nostro Account : is the overseas account held by a domestic bank with a
foreign bank or with its own foreign branch in that foreign country’s currency.
The same account is called as Vostro Account from the holding point of view.
Authorized Dealers (AD): are generally commercial banks and form a large part
of the inter-bank market in India. The authorized dealers are allowed to deal in
all items classified as foreign exchange under the FEMA Act. Thus the
authorized dealers are permitted to deal all documents relating to exports and
imports. The authorized dealers have to operate within the rules, regulations
and guidelines issued by the Foreign exchange dealers association of India
(FEDAI) from time to time.
Money changers full - fledged and restricted: full- fledged can buy and sell
where as restricted money changers can only buy.
EXCHANGE RATE QUOTATIONS:
Exchange rate quotation is the price of a currency stated in terms of another. It
is similar to the expression of the price of a commodity.
A quote can be classified as European quote or American quote only if one of
the currencies is dollar.
An American quote is the number of dollars expressed per unit of any other
currency, while an European quote is the number of other currencies
expressed per unit of dollar.
Direct quote or Indirect quote:
An Indirect quote is where the exchange rate is expressed in terms of number
of units of foreign currency for a fixed number of units of domestic currency.
Number of units of domestic currency per unit of foreign currency is known as
direct quote
Inter- bank quote Vs merchant quote:
Merchant quote is the quote given by a bank to its retail customers. On the
other hand a quote given by one bank to another ( or to any other customer in
the interbank market) is called interbank quote.
Bid rate is the rate at which the bank is willing to buy the foreign currency
from the customers.
Ask rate is the rate at which the bank is willing to sell the foreign currency to
the customers.
Other important notes:
1. Bid rate always precedes the ask rate.
2. Bid rate<ask rate
3. The difference between the bid and the ask is known as spread. Higher
spread for merchant quote and lower spread for interbank quote.
4. according to FEDAI rules, exchange rate in merchant as well in interbank
markets are to be quoted up to 4 decimals with the last two digits being in
multiples of 25.
Cross rate: the relationship between two unrelated currencies can be found
using one common currency. In foreign exchange markets it is the practice to
quote most of the currencies against dollar and to calculate the rates between
other currencies with the dollar as intermediate currency. The cross rate thus
calculated is also called as synthetic rate. The synthetic bid rates in most of the
cases are less than the actual bid rates, it is possible to enter in to arbitrage
transactions.
Types of transaction:
Spot transactions: are those which are to be settled after two business days
from the date of the contract.
Forward (also called as outright forward) transactions: is one where parties
agree to buy or sell at a predetermined future date at a particular price, this
future date may be beyond two business days. Forward contracts generally
mature after 1,2,3,6,9,12 months.
Discount and Premium: a currency is said to be at premium against another
currency if it is more expensive in the forward market than in the spot market.
In that case the forward rate is higher than the spot rate.
If a currency is said to be at a discount if it is cheaper in the forward market
than in the spot market. In this case its forward rate will be lower than the spot
rate.
The difference between the spot rates and the forward can be expressed in
terms of swap points.
1. When the swap points are Low/High then add the swap points with the spot
rates to arrive the forward rates. Here the currency is said to be at premium.
2. When the swap points are High/Low then deduct the swap points from the
spot rates to arrive at the forward rates. Here the currency is said to be at
discount .
EXERCISE:
1. The following quotes are available.
Spot (€/£) 0.7950/0.8000
Three month swap
points
25/50
Six month swap
points
50/75
Calculate three month and six month outright forward rates.
2. You are given the following data:
Rs./$ 45.50/45.75
Rs./£ 82.75/83.00
Rs./€ 57.00/57.25
Compute cross rate for $/£ and $/€
3. An Indian importer has imported an equipment from Germany has
approached its bank for booking a forward euro contract. The delivery is
expected sometime during the sixth month from now.
The following rates being quoted:
€/$ Spot 0.7950/0.8000
Three month forward 25/50
Six month forward 50/75
Rs./$ Spot 45.25/45.50
Three month forward 25/50
Six month forward 25/50
What rate will the bank quote if it needs a margin 0.5%.
4. You are given the following information:
Rs./$ Spot 45.25/45.50
Three month forward 25/50
$/£ Spot 1.8225/1.8250
Three month forward 25/50
Calculate three month Rs./£
5. An Indian Bank sells SKr.(Swedish Kroner) 1,00,000 spot to a customer at
Rs.6.25. at that point of time, the following rates were being quoted.
SKr./$ 7.2480/7.2486
Rs./$ 45.30/45.45
How much profit do you think the bank has made in this transaction?
6. You sold Hong Kong Dollar 1,00,000 value spot to your customer at Rs.5.70
and covered yourself in London market on the same day, when the exchange
rates were
US$ = H.K. $7.5880/7.5920 local inter- bank rates for US$ were Spot 1 US$ =
Rs.42.70/42.85. Ascertain the profit or loss in the transaction. Ignore the
brokerage.
PURCHASING POWER PARITY PRINCIPLE (PPP)
The Law of One Price:
The assumptions of Law of one Price are:
Movement of Goods: The law of One Price assumes that there is no
restriction on the movement of goods between countries, i.e., it is
possible to buy goods in one market and sell them in another. This
implies that there are no restrictions on international trade, either in the
form of a ban on exports or imports, or in the form of quotas.
No Transportation Costs: Strictly speaking, the Law of One Price would
hold perfectly if there were no transportation costs involved, though there
are some transactions which bypass this assumption.
No Transaction costs: This law assumes that there are no transaction
costs involved in the buying and selling of goods.
No Tariffs: The existence of tariffs distorts the Law of One Price, which
requires their absence to hold perfectly.
BASIC EQUATION:
PAX =S (A/B) X PB
X
…………. (Eq. 1)
Where,
PAX is the prove of commodity ‘X’ in country A
S (A/B) is the spot exchange rate of the two countries’ currency
PBX and is the prove of commodity ‘X’ in country B.
The Absolute form of PPP:
If the law of one price were to hold good for each and every commodity,
then it will follow that:
PA = S (A/B) XPB
…………….. (Eq. 2)
Where,
PA and PB are the prices of the same basket of goods and services in
countries A and B respectively.
Eq. 2 can be rewritten as:
S (A/B) = PA / PB
…………….. (Eq. 3)
The Relative form of PPP:
The absolute form of PPP describes the link between the spot exchange rate
and prove levels at a particular point of time. The relative form of PPP talks’
about the link between the changes in spot rates over and in price levels over a
period of time. Changes in spot rates over a period of time reflect the changes
in the price levels over the same period in the concerned economies.
PA = S (A/B) X PB (Eq. 2)
Then, at the end of one year,
_ _ _
PA (1+ PA) = S (A/B) {1+ S (A/B)} X PB (1+ PB)
………………… (Eq. 4)
Dividing Eq. 4 by Eq. 2, we get
_ _ _
(1+ PA) = {1+ S (A/B)} X (1+ PB)
………………… (Eq. 5)
We can rewrite the equation as:
_ _ _
1+ S (A/B) = 1+ PA / 1+ PB
_ _ _
S (A/B) = (1+ PA / 1+ PB) -1
………………… (Eq. 6)
_ _ _ _
S (A/B) = (PA -PB / 1+ PB)
………………… (Eq. 7)
INTEREST RATE PARITY (IRP)
The PPP gives the equilibrium conditions in the commodity market. Its
equivalent in the financial markets is a theory called the Interest Rate Parity
(IRP) or the covered interest parity condition. According to this theory, the cost
of money (i.e., the cost of borrowing money or the rate of return on financial
investments), when adjusted for the cost of covering foreign exchange risk, is
equal across different currencies. This is so, because investors and borrowers
will tend to transact in those currencies which provide them the most attractive
prices. Besides, the arbitrageurs will always be on the lookout for an
opportunity to make riskless profits. The resultant effects on the demand and
supply would drive the value of currencies towards equalization.
Investors’ Decision:
Let us assume the domestic currency to be A and the foreign currency to be
B. An investor can earn a return of rA on domestic deposits, and a return of rB
on the foreign currency denominated securities.
Now suppose that
(1+ rA) > [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.12)
In such a case, investors will prefer to invest in securities denominated in
currency A rather than in currency B, as it would fetch them a higher return. If
(1+ rA) ˂ [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.13)
the investors will prefer to invest in securities denominated in currency B. The
investors will be indifferent as to the choice of currency only if
(1+ rA) = [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.14)
Borrowers’ Decision:
When the need to borrow money arises, the borrower has the option to
borrow in the domestic currency, or in foreign currency. Again, his decision will
be based on the cost of domestic currency borrowing as compared to the
covered cost of foreign borrowing.
The borrower will borrow in currency A if
(1+ rA) ˂ [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.17)
On the other hand, he will borrow in currency B if
(1+ rA) > [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.18)
He will be indifferent to the choice of currencies if
(1+ rA) = [F (A/B)]/[S (A/B)] X (1+ rB)
…………. (Eq.19)
Covered Interest Arbitrage:
In addition to investors and borrowers, one more class of players benefit
from cost of money varying from one currency to another – the arbitrageurs. If
Eq.14 does not hold good, the arbitrageur con make riskless profits by
borrowing in the cheaper currency and investing in the costlier, using the
forward market to lock-in his profits. If Eq. 12 were to hold good, the
arbitrageur would borrow in the foreign currency, convert the receipts to the
domestic currency at the ongoing spot rate, and invest in the domestic
currency denominated securities, while covering the principal and interest from
this investment at the forward rate. At maturity, he would convert the proceeds
of the domestic investment at the prefixed forward rate and pay-off the foreign
liability, with the difference between the receipts and payments serving as his
profit.
In case of Eq.13 holding good, the arbitrageur would borrow in the domestic
currency, convert it into foreign currency at the spot rate, invest the proceeds
in foreign currency denominated securities, and cover the principal and
interest from this investment at the forward rate, thus locking his domestic
currency returns. This process of borrowing in one currency and
simultaneously investing in another, with the exchange risk hedged in the
forward market is referred to as covered interest arbitrage.
Exercise:
1. on 1st April three month interest rate in the US and Germany are 6.5 percent
and 4.5 percent per annum respectively. The $/DM Spot rate is 0.6560. what
would the forward rate for DM for delivery on 30th June?
2. The US $ is selling in India at Rs.45.50. if the interest rate for a 6 month
borrowing in India is 8% p.a. and the corresponding interest rate in US is 2%.
i. do you expect US $ to be at a premium or at discount in the Indian forward
market.
ii. what is the expected 6 month forward rate for the US $ I India: and
iii. what is the rate of forward premium or discount?
3. Spot rate 1US $= Rs.48.0123
180 days forward rate for 1 US $ = Rs.48.8190
Annualized interest rate for 6 months –Rupee=12%
Annualized interest rate for 6 month –US $ = 8%
Is there an arbitrage possibility?. If your answer is yes how an arbitrageur can
take advantage of the situation?
4. S ltd. is planning to import an equipment from Japan at a cost of 3400 lakh
Yen. The company may avail loans at 18% p.a. with the quarterly rests with
which it can import the equipment. The company has also an offer from Osaka
branch of an India based bank extending credit of 180 days at 2% p.a. against
opening an irrevocable letter of credit.
Additional information:
Present exchange rate Rs.100=340 Yen
180 day’s forward rate Rs.100=345 Yen
Commission charges for letter of credit at 2% per 12 months.
Advice the company whether the offer from the foreign branch should be
accepted.
5. in Dec 2009, the following rates were being quoted.
Rs./$ Spot :45.30/45.45
Three month forward : 40/50
Three months interest rates : $-4%, Re.-6% is there any scope for arbitrage?
Fixed Exchange rate and Flexible exchange rate
Fixed exchange rate refers to the system under gold standard where the rate of
exchange tends to stabilize around the mint par value. Any large variation of
the rate of exchange from the mint par value would entail flow of gold into or
from the country. This would have the effect of bringing the exchange rate
back to the mint par value. This system does not exist today.
Flexible exchange rate under IMF system refers to maintenance of external
value of the currency at a pre-determined level. Whenever the exchange rate
differs from this level, it is corrected through official intervention. Under this
system, actual market rates are allowed to fluctuate within a narrow range of
margin from this level. Fixed exchange rates encourage international trade by
providing certainty with confidence. Exporters and importers know in advance
how much they will receive or they will have to pay in terms of home currency.
Flexible exchange rates refer to system where the exchange rate is fixed but is
subject to frequent adjustments depending upon the market conditions. Thus,
it is not a free or floating rate with cent percent flexibility, but in any system
providing for adjustment as and when required.
Adjustable rates, however, pose a practical difficulty. The monetary authority
may not be able to know whether a particular disturbance in balance of
payments data is only a short term phenomena or the result of some deep
seated problems. Moreover, there are political and psychological hindrances to
frequent changes in parity.
Leading and Lagging :
Leading and lagging are the important techniques of foreign exchange risk
exposure management. Leading means pre-payment of trade obligation
whereas lagging means a delayed payment. These strategies are utilized
particularly by multinational corporations depending on the transaction dates
and on how a particular functional currency is likely to move vis-à-vis the
parents company’s reporting currency. Multinational corporation frequently
resort to leading and lagging with the goal of minimizing translation losses.
The primary aim in all such hedging action is to match, as much as possible,
the currency denomination in assets and liabilities in a foreign currency. It
also aims at minimizing their subsidiary unit’s hard currency liabilities in a
situation where the respective local currencies are continually depreciating in
relation to the reporting currency.
There may be some difficulties in free use of leading and lagging as exposure
management devices. First, since it de stabilizes currency markets,
government may impose restriction on the extent to which leading and lagging
can be done. Second, if a multinational parent company requires its
subsidiaries to employ this method, it may on occasion interfere with optimal
cash management at the level of subsidiary.
Forward exchange contract and Future contract :
Forward exchange contract and future contract are the important financial
instruments of international finance. A forward exchange contract confers on
the holder the right and the obligation to buy or sell a given quantity of a
currency at a specified price(called the delivery price) at a specified future date.
Forward contract is subject to either side defaults on the terms of agreement.
A typical forward contract has no secondary market.
For instance, suppose a firm enters into a contract to buy Duetche Marks (DM)
three months forward against dollars today. Sometime before the contract
matures it finds that its anticipated need for DM has disappeared. It must still
perform on its forward purchase. It can square its position by entering into a
contract if it can find a counterpart.
Future contracts are standardized contracts that trade on organized future
market. A future contract like a forward contract is an agreement between two
parties to exchange one assets to another, with the actual expenditure taking
place at a specified date in the future but with the terms of exchange i.e. the
price of one assets in terms of another being fixed at the time of agreement is
entered into.
However, there are number of significant differences between forward and
futures. These relates to contractual features the way market are organized,
profiles of gains and losses, kinds of participants in the markets and the way in
which they use the two instruments.
The basic concepts of options (one of the derivatives)
Participants in derivative market:
1. Hedgers: A transaction in which an investor seeks to protect a
position or anticipated position in the spot market by using an
opposite position in derivatives is known as a hedge. A person who
hedges is called a hedger. These are the people who are exposed to
risk due to their normal business operations would like to eliminate
or minimise or reduce the risk.
2. Speculators: A person who buys and sells a contract in the hope of
profiting from subsequent price movements is known as speculators.
These people voluntarily accept what hedgers want to avoid. A
speculator does not have any risk to hedge. He has a view on the
market and based on the forecast the speculator would like to make
gains by taking a long and short position on derivatives. In general,
speculators can be the counterparties for hedgers.
3. Arbitrageurs : arbitrage means obtaining risk free profits by
simultaneously buying and selling identical or similar instruments
in different markets. arbitragers like speculators do not have any
risk to hedge. They buy to make gains by identifying mispriced
derivatives. Arbitrageurs help in price discovery heading to market
efficiency.
Elementary investment strategies:
a. Long stock : buying the stock
b. Short stock: selling the stock
c. Long call : buying a call option
d. Short call : selling a call option
e. Long put : buying a put option
f. Short put : selling a put option
American options and European Options:
An american option can be exercised on any business day within the life of an
option including the expiration date.
European option can be exercised only at the expiration date.
Basic option strategies:
1. Covered call writing: when the option is covered or protected by the
writer by depositing the shares of the company on which the option is
written with the brokerage firm.
2. Naked call writing: if a trader writes a call option without owning the
underlying asset, it is called naked call writing.
3. Protective put: this strategy involves buying the underlying asset and
buying a put on that asset.
4. Straddle: involves a call and a put option with the same exercise price
and the same expiration date. A straddle buyer buys a call and a put
whereas a straddle seller sells a call and a put.
Example: buy a March 310 call at a premium of 21
Buy a March 310 put at a premium of 42
5. Strangle : it is a combination of a call and a put with the same
expiration date and at different strike prices. If the strike prices of call
and the put options are X1 and X2, then a strangle is chosen in such a
way that x1>x2.
Example: buy a March 310 call @21
Buy a March 270 put @2
6. Strips : it consists of a long position in one call and two puts with the
same exercise price and expiration date. The buyer of the strips believes
that there will be a big stock price movement but the stock price is more
likely to fall than it is to rise.
Example: buy one March 310 call @ 21
Buy two March 310 put @84
7. Straps : it consists of a long position in two calls and one put with the
same strike price and expiration date. A strap is like a strip that is
skewed in the opposite direction. The buyer of a strap expects bullish
and bearish possibilities for the optioned security with a price rise being
more likely.
Example: buy two March 310 calls @ 42
Buy one March 310 put @ 42
Spread Strategies: there are three types of spreads namely i) Vertical or price
spreads ii) Horizontal or time spread and iii) Diagonal spread.
If we notice the spread strategies they aim at investor’s risk protecting
strategies. Here the motive of the investor is not to make windfall profit (not a
speculator) but to hedge himself against risk with the motive of minimum
profit.
8. Bull spread : is a combination of options created to profit from a rise in
prices of the underlying asset . if you wish to buy a bull spread using
calls then buy a call with lower strike price and sell a call with the higher
strike price.
Example: buy a March 270 call @58
Sell a March 350 call @ 8
Example : buy a March 270 put @ 2
Sell a March 350 put @70
9. Bearish spread: it is just opposite of bullish spread.
Example : sell a March 270 call @ 71
Buy a March 350 call @12
Example: sell a Marcy 270 put @ 2
Buy a March 350 put @ 70
Diagonal spread: here the most popular and practical spread used in the
market is the Butterfly spread.
10. Butterfly spread: a butterfly spread can be executed by using four
identical options with the same expiration date and on the same
underlying stock but different exercise prices.
A trader who is long on the butterfly spread, buys one call with a low
exercise price, buys one call with a high exercise price and sells two calls
with an intermediary exercise price.
A trader who is in short on butterfly spread takes exactly the opposite
position by selling one call with a low exercise price, selling one call with
a high exercise price and buying two calls with an intermediate exercise
price.
Let X1 below exercise price,
X2 be the intermediate price,
X3 be the high exercise price
Long traders strategy is buy one call at X1 and X3 and sell two calls at X2
Short traders strategy is sell one call at X1 and X3 and buy two calls at X2
Note the butterfly spread gives a pay-off similar to that of a straddle but the
former is less risky compared to the latter while at the same time you have only
limited profit potential
Exercise on options:
1. The market received rumour about ABC corporation’s tie-up with a
multinational company. This has induced the market price to move up. If
the rumour is false, the ABC corporation stock pric will probably fall
dramaically. To protect from this an investor has bought the call and put
options.
He purchased one 3 months call with a striking price of Rs.42 for Rs.2
premium, and paid Re.1 per share premium for a 3 months put with a
striking price of Rs.40.
i. Determine the Investor’s position if the tie up offer bids the price of
ABC Corporation’s stock up to Rs.43 in 3 months.
ii. Determine the Investor’s ending position, if the tie up programme
fails and the price of the stocks falls to Rs.36 in 3 months.
2. An investor buys a call option contract by paying a premium of Rs.350.
the current market price and the exercise price of the stock is Rs.35. At
the end of 3 months when the option expires the share price is Rs.40.
Should the buyer exercise the option? Calculate the amount of profit or
loss made by the buyer (contract size for 100 shares).
3. Ms Geeta established the following spread on the Delta Corporation’s
stock:
i. Purchased one 3 month call option with a premium of Rs.30 and
an exercise price of Rs.550.
ii. Purchased one 3 month put option with a premium of Rs.5 and an
exercise of Rs.450.
The current price of Delta’s Corporation’s stock is Rs.500. Determine Ms.
Geetha’s profit or loss if
a. The price of the share stays at Rs.500 after 3 months
b. The price of the share falls to Rs.350 after 3 months
c. The price of the share rises to Rs.600 after 3 months
4. An Indian ready-made wear manufacturer exported goods worth $10
million to US. The payment for tge exports will be received after three
months. Current ruppe-dollar exchange rate is Rs.49/$. Due to the
fluctuating rupee-dollar exchange rate the company is planning to hedge
the foreign exchange exposure through option market.
Following European option on dollar of maturity three months are
available at the market.
Strike price Rs. Option Premium Rs.
50 Call 0.20
50 Put 0.50
The company is considering the following three alternatives for hedging
the receivables.
i. Writing a call option.
ii. Buying a put option
iii. Writing a call and buying a put together.
You are required to show the pay-foo profile of all the three alternatives
for a price range of Rs.49-Rs.51 and suggest about the best alternative of
hedging.
5. Carbon Jewellers Ltd. has imported diamonds worth $50 million from a
company in South Africa. The payments for the imports has to be settled
in dollars after one month. Treasurer of the company is thinking to cover
the payable through options. Following European options on dollars of
maturity after one month are quoted at the market.
Strike price Rs. Option Premium Rs.
47.00 Call 0.50
47.00 Put 0.05
The treasurer is considering the following three alternatives
i. Buying a call option
ii. Writing a put option
iii. Buying a call and writing a put option simultaneously. You are
required to show the pay-off profile of all the three alternatives and
suggest the treasurer about the best alternative of hedging with the
reasons for the same.
Futures
Features of futures:
1. It is a standardized contract.
2. It is executed in futures market.
3. You can buy or sell an underlying asset.
4. At a certain date in future (settlement date) and at a preset price- future
price.
5. The holder has the obligation. (both the parties to the contract must
fulfill the contract)
6. To exit the commitment prior to the settlement date the holder of the
future position has to offset his position.
7. The settlement can either be of cash or physical delivery.
8. Margin: to minimize the credit risk to the exchange, the traders must
post margin or a performance bond, 7%-15% of the contract’s value.
9. Initial margin: represents the loss on contract as determined by
historical price changes that is not likely to be exceeded on a usual day’s
trading.
10. A future account is marked to market daily.
If the margin drops below the margin maintenance requirement
established by the exchange listing the futures, a margin call will be
issued to bring the account back up to the required level.
Exercise:
1. A US exporting firm has a receivable on Dec 20th for £1,000,000.
Today is Nov 7th and the firm wants to hedge itself against
depreciation of pound. The following are the rates prevailing today.
Spot $/£ 1.475
June pound future 1.4825
a. What is the hedging strategy firm has to adopt?
b. If the following are the rates that prevailing on Dec 20th
i. Spot $/£ 1.4676
June pound future 1.4544
ii. Spot $/£ 1.4826
June pound future 1.4865
The standard contract size is £62,500.
What are the gains/losses of the firm due to the hedge?
What is the effective amount it receives?
2. A US importing firm has a payable of euro one million on December
11th. Today is Sept 8th and the firm wants to hedge against
appreciation of the euro. The following are the rates prevailing today.
Spot $/€ 0.8950
December euro future 0.8967
a. What is the hedge?
b. If the following are the rates that prevail in December 11th
i. Spot $/€ 0.8972
December euro future 0.8985
ii. Spot $/€ 0.8942
December euro future 0.8939
The standard size of the contract is 1,25,000 euro. What are the gains/losses
of the hedge? What is the effective purchase cost of euro?
3. XYZ Ltd. is an export oriented business house based in Mumbai. The
company invoices in customer currency. Its receipt of US $ 1,00,000
is due on September 1, 2009.
Market information as at June 1, 2009.
Exchange rates Currency futures
US $/Rs. US $/Rs. Contract size Rs.4,72,000
Spot 0.02140 June 0.02126
1 month forward 0.02136 September 0.02118
3 month forward 0.02126
Initial margin Interest rates in India
June Rs.10,000 7.50%
September Rs.15,000 8.00%
On September 1,2009 the spot rates US $/Rs. Is 0.02133 and currency
future rate is 0.2134. Comment on which of the following methods would
be most advantageous for XYZ LTD.
a. Using forward contract
b. Using currency futures
c. Not hedging the currency risks
It may be assumed that variation in margin would be settled on the
maturity of the futures contract.
4. Following are the details of cash inflows and outflows In foreign
currency denominations of MNP Co. an Indian export firm, which
have no foreign subsidiaries:
Currency inflow outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr)
2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
i. Determine the net exposure of each foreign currency in terms of rupees.
ii. Are any of the exposure offsetting to some extent?
Financial Swaps
It refers to simultaneous purchase and sale of currency for different
maturities or vice versa.
The other definition is ‘it is the agreed exchange of future cash flows with
or without any exchange of cash flows present’.
Financial swaps are broadly classified into two namely
a. Interest rate swaps and
b. Currency swaps
Principles behind swaps are the principle or comparative advantage and
the principle of offsetting the risks.
Comparative and absolute advantage:
Let us take for example there are two countries namely country A and
country B. Country A has sufficient resources to produce product X at a
lesser cost than country B and similarly country B has a better position
to produce product Y than product X. hence it is more advantageous to
produce the respective products in their respective advantageous
countries.
Look at other scenario, where country A has absolute advantage in
producing both the products X and Y whereas country B is in a better
position in producing product Y than X at a cheaper cost, then it is said
to be having comparative advantage in producing product Y than X.
Offsetting the risks: A financial institution may have fixed rate assets
and floating rate liabilities. Then it is exposed to interest rate risks
because of this non-matching of assets and liabilities. The institution can
offset this risk by entering into floating rate swap thereby converting the
fixed rate assets into floating rate asset.
Important terminologies:
1. Swap facilitators: swaps are mutual obligations among the swap
parties. But it may not be necessary for the counterparties to be
aware of each other because of the role assumed by an intermediary
known as swap dealer (market maker). This swap facilitator can be a
swap dealer or swap broker.
2. Swap dealer/broker: if the facilitator does not take any financial
position in a swap arrangement, then he is called as swap broker. He
charges a fee for the services and he is not a party to the swap
contract. He merely acts as an intermediary.
3. Swap dealer: bear the financial risk associated with the deal in
addition to the functions of a swap broker and becomes an actual
party to the transaction. He serves as a financial intermediary,
earning profits by helping complete swap transaction.
4. Swap coupon: the fixed rate of interest on the swap.
5. Notional principal: the principal amount on which interest calculation
is made.
6. Basis Points(BP): 1/100th of 1% or 100 BP=1%
EXERCISE:
1. Companies A and B have been offered the following rates per
annum on a $10 million 5 year loan.
Fixed rate(%) Floating rate (%)
Company A 10 LIBOR+0.2
Company B 11.2 LIBOR+0.6
Company A requires floating rate loan, while company B requires
fixed rate loan. Design a swap that will appear equally attractive
both the parties.
2. IBM is an American company. It issued $150 million debenture for
4 years to public at 10%.it wanted to convert its dollar liabilities
into sterling liabilities. It approached Citi Bank for arranging a
swap. British firm BAT issued £100 million bond 4 year at 14% per
annum and it wants to change its liabilities into dollars. It has
approached Citi Bank. The bank has arranged a swap deal.
US $(%) Pound sterling (%)
IBM-USA 10 13
BAT- UK 12 14
Design a swap deal. (note bank wants to keep a margin of 0.4%)
FINANCIAL RISK MANAGEMENT
As the nature of business become international, many firms are exposed to the
risk of fluctuating exchange rates. Changes in exchange rates may affect the
settlement of contracts, cash flows, and the firm valuation. It is thus important
for financial managers to know the firm’s foreign currency exposure and
properly manage the exposure. By doing so, managers can stabilize the firm’s
cash flows and enhance the firm’s value.
Three types of exposures:
Transaction exposure
Economic exposure
Translation exposure.
Transaction exposure, can be defined as the sensitivity of “realized” domestic
currency values of the firm’s contractual cash flows denominated in foreign
currencies to unexpected exchange rate changes. Since settlements of these
contractual cash flows affect the firm’s domestic currency cash flows,
transaction exposure is sometimes regarded as a short-term economic
exposure. Transaction exposure arises from fixed-price contracting in a world
where exchange rates are changing randomly.
Translation exposure refers to the potential that the firm’s consolidated
financial statements can be affected by changes in exchange rates.
Consolidation involves translation of subsidiaries financial statements from
local currencies to the home currency. Translation exposure , also frequently
called accounting exposure, refers to the effect that an unanticipated change
in exchange rates will have on the consolidated financial reports of a MNC.
When exchange rates change, the value of a foreign subsidiary’s assets and
liabilities denominated in a foreign currency change when they are viewed from
the perspective of the parent firm.
Four methods of foreign currency translation have been used. They are
i. Current /non current method
ii. Monetary/nonmonetary method
iii. Temporal method
iv. Current rate method
Current /noncurrent method:
Current assets and liabilities: translated at the current exchange rate.
Noncurrent assets and liabilities: at the historical rate in effect at the time
the asset or liability was first recorded on the books.
Most income statement items under this method are translated at the
average exchange rate for the accounting period. However, revenue and
expense items that are associated with noncurrent assets or liabilities, such
as depreciation expense, are translated at the historical rate that applies to
the applicable balance sheet item.
Monetary/nonmonetary method:
All monetary balance sheet accounts of a foreign subsidiary are translated
at the current exchange rate. All nonmonetary balance sheet accounts,
including stockholder’s equity are translated at the historical exchange rate
in effect when the account was first recorded.
Nonmonetary item included in current asset is inventory, while monetary
asset such as long term receivables is not included in current assets.
Similarly the noncurrent liabilities such as long term debts are included as
monetary liabilities.
Most income statement accounts are translated at the average exchange
rate for the period. However, revenue and expense items associated with
nonmonetary accounts, such as cost of goods sold and depreciation, are
translated at the historical rate associated with the balance sheet account.
Temporal method
Monetary accounts are translated at the current exchange rate
Other balance sheet items are translated at the current exchange rate if
they are carried at on the books at the current value; if they are carried at
historical costs, they are translated at the rate of exchange on the date the
item was placed on the books.
Most income statement accounts are translated at the average exchange
rate for the period. However, revenue and expense items associated with
nonmonetary accounts, such as cost of goods sold and depreciation, are
translated at the historical rate associated with the balance sheet account.
Current rate method:
All the balance sheet accounts are translated at the current exchange rate,
except stockholder’s equity. The common stock account and any additional
paid-in capital are carried at the exchange rates in effect on the respective
dates of issuance. Year-end retained earnings equal the beginning balance
plus any additions for the year. A cumulative adjustment account named
cumulative translation adjustment(CTA) is used to make the balance sheet
balance, since translation loss or gain do not go through the income
statement according to this method.
Income statement items are to be translated at the exchange rate at the
dates the items are recognized. Since this is impractical, an appropriate
weighted average exchange rate for the period may be used for the
translation.
Fundamental of Foreign Exchange Management
1. Foreign Exchange Market
The foreign exchange market is the market in which individuals, firms and banks buy and sell foreign currencies or foreign exchange. The purpose of the foreign exchange market is to permit transfers of purchasing power
denominated in one currency to another i.e. to trade one currency for another. Like any other market buyer and seller exist in this market and the demand and supply functions play a big role in determination of exchange rate of the
currency.
2. Exchange Rate Determination An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often termed as the reference currency. The foreign exchange
market includes both the spot and forward exchange rates. (a) The Spot Market: A spot rate occurs when buyers and sellers of currencies
agree for immediate delivery of the currency. (b) The Forward Market: A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the currency at some future date. The
forward exchange rate is set and agreed by the parties and remains fixed for the contract period regardless of the fluctuations in the spot exchange rates in future.
3. Exchange Rate Quotation
(a) Direct and Indirect Quote: A foreign exchange quotation can be either a direct quotation and or an indirect quotation, depending upon the home currency of the person concerned. A direct quote (also called the European
terms) is the home currency price of one unit of foreign currency. An indirect quote (also called the American terms) is the foreign currency price of one unit of the home currency. Mathematically, expressed as follows:
Direct quote = 1/indirect quote and vice versa
(b) Bid, Offer and Spread: Foreign exchange quotes are two-way quotes, expressed as a 'bid and an offer' (or ask) price. Bid is the price at which the dealer is willing to buy another currency. The offer is the rate at which he is
willing to sell another currency.
4. Exchange Rate Forecasting Corporates need to do the exchange rate forecasting for taking decisions regarding hedging, short-term financing, short-term investment, capital
budgeting, earnings assessments and long-term financing. Investors and traders need tools to select and analyze the right data from the vast amount of data available to them to help them make good decisions.
5. Techniques of Exchange Rate Forecasting
There are numerous methods available for forecasting exchange rates. They can be categorized into four general groups- technical, fundamental, market-
based, and mixed. (a) Technical Forecasting: It involves the use of historical data to predict
future values. For example time series models. (b) Fundamental Forecasting: It is based on the fundamental relationships between economic variables and exchange rates. For example subjective
assessments, quantitative measurements based on regression models and sensitivity analyses. (c) Market-Based Forecasting: It uses market indicators to develop forecasts.
The current spot/forward rates are often used, since speculators will ensure that the current rates reflect the market expectation of the future exchange
rate. (d) Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The actual forecast is a weighted average of the various forecasts
developed.
6. Exchange Rate Theories (a) Interest Rate Parity (IRP): This theory which states that ‘the size of the forward premium (or discount) should be equal to the interest rate differential
between the two countries of concern”. When interest rate parity exists, covered interest arbitrage (means foreign exchange risk is covered) is not feasible, because any interest rate advantage in the foreign country will be offset by the
discount on the forward rate.
(b) Purchasing Power Parity (PPP): This theory focuses on the ‘inflation exchange rate’ relationship. There are two forms of PPP theory:
Absolute Form- Also called the ‘Law of One Price’ suggests that “prices of similar products of two different countries should be equal when measured
in a common currency”. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices
should converge.
Relative Form – An alternative version that accounts for the possibility of
market imperfections such as transportation costs, tariffs, and quotas. It suggests that ‘because of these market imperfections, prices of similar products of different countries will not necessarily be the same when
measured in a common currency.’ (c) International Fisher Effect (IFE): According to this theory, ‘nominal risk-
free interest rates contain a real rate of return and anticipated inflation’. This
means if investors of all countries require the same real return, interest rate differentials between countries may be the result of differential in expected inflation.
7. Comparison of PPP, IRP AND IFE Theories
Theory Key Variables Summary
Interest Rate Parity (IRP)
Forward rate premium (or
discount)
Interest rate differential
The forward rate of one currency will contain a premium (or
discount) that is determined by the differential in interest rates between the two countries.
Purchasing Power
Parity (PPP)
Percentage change in
spot exchange rate
Inflation rate Differential
The spot rate of one currency with respect to another will
change in reaction to the differential in inflation rates between two countries
International Fisher
Effect (IFE)
Percentage change in
spot exchange
rate
Interest rate differential
The spot rate of one currency with respect to another will
change in accordance with the differential in interest rates
between the two countries.
8. Risk Management
A ‘risk’ is anything that can lead to results that deviate from the requirements. Risk Management is, “any activity which identifies risks, and takes action to
remove or control ‘negative results’ (deviations from the requirements).” Unpredictable changes in interest rates, yield curve structures, exchange rates, and commodity prices, exacerbated by the explosion in international
expansion, have made the financial environment riskier today than it ever was in the past. For this reason, boards of directors, shareholders, and executive
and tactical management need to be seriously concerned that corporate risk management activities be adequately assessed, prioritized, driven by strategy, controlled, and reported.
9. Risk Considerations There are several types of risk that an investor should consider and pay careful
attention to. Some types of risk are as follows: (a) Financial Risk: It is the potential loss or danger due to the uncertainty in
movement of foreign exchange rates, interest rates, credit quality, liquidity position, investment price, commodity price, or equity price, as well as the unpredictability of sales price, growth, and financing capabilities.
(b) Business Risk: This risk, also known as investment risk, may materialize because of forecasting errors made in market acceptance of products, future
technological changes, and changes in costs related to projects. (c) Credit or Default Risk: This type of risk is of particular concern to investors who hold bonds within their portfolio.
(d) Country Risk: This refers to the risk that a country would not be able to honour its financial commitments. When a country defaults it can harm the
performance of all other financial instruments in that country as well as other countries it has relations with.
(e) Interest Rate Risk: It refers to the change in the interest rates. A rise in interest rates during the term of an investor’s debt security hurts the performance of stocks and bonds.
(f) Political Risk: This represents the financial risk that a country's government will suddenly change its policies. (g) Market Risk: It is the day-to-day fluctuations in a stock’s price. It is also
referred to as volatility. (h) Foreign Exchange Risk: Foreign exchange risk applies to all financial
instruments that are in a currency other than the domestic currency. 10. Foreign Exchange Exposure
Foreign exchange exposure refers to those parts of a company’s business that would be affected if exchange rate changes.
11. Types of Exposures (a) Transaction Exposure: It measures the effect of an exchange rate change
on outstanding obligations that existed before exchange rates changed but were settled after the exchange rate changed. Thus, it deals with cash flows that result from existing contractual obligations.
(b) Translation Exposure: Also known as accounting exposure, it refers to gains or losses caused by the translation of foreign currency assets and
liabilities into the currency of the parent company for accounting purposes. (c) Economic Exposure: It refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is the overall impact
of exchange rate changes on the value of the firm.
12. Techniques for Managing Exposure The aim of foreign exchange risk management is to stabilize the cash flows and
reduce the uncertainty from financial forecasts. Various techniques for managing the exposure are as follows:
(A) Derivatives: A derivatives transaction is a bilateral contract or payment exchange agreement whose value depends on - derives from - the value of an
underlying asset, reference rate or index. Every derivatives transaction is constructed from two simple building blocks that are fundamental to all derivatives: forwards and options. They include:
(a) Forwards-based Derivatives: There are three divisions of forwards based derivatives:
(i) The Forward Contract-The simplest form of derivatives is the forward contract. It obliges one party to buy, and the other to sell, a specified quantity
of a nominated underlying financial instrument at a specific price, on a specified date in the future.
(ii) Swaps-Swaps are infinitely flexible. They are a method of exchanging the underlying economic basis of a debt or asset without affecting the underlying
principal obligation on the debt or asset. Swaps can be classified into the following groups:
Interest rate;
Currency;
Commodity; and
Equity.
(iii) Futures Contracts- A basic futures contract is very similar tothe
forward contract in its obligation and payoff profile. Some important distinctions between futures and forwards and swaps are:
The contract terms of futures are standardized.
All transactions are carried out though the exchange clearing system
thus avoiding the other party risk.
(b) Options: They offer, in exchange for a premium, the right - but not the obligation - to buy or sell the underlying at the strike price during a period or on a specific date. So the owner of the option can choose not to exercise the
option and let it expire. An option is a contract which has one or other of the two key attributes:
to buy (call option)- It is a contract that gives the buyer the right, but not the obligation, to buy a specified number of units of commodity or a
foreign currency from the seller of option at a fixed price on or up to a specific date.
to sell (put option)- It is a contract that gives the buyer the right, but not
the obligation, to sell a specified number of units of commodity or a foreign currency to a seller of option at a fixed price on or up to a specific
date. The holder of an American option has the right to exercise the contract at any
stage during the period of the option, whereas the holder of a European option
can exercise his right only at the end of the period.
(B) Money Market Hedge: A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home
currency value of a future foreign currency cash flow. The simultaneous borrowing and lending activities enable a company to create a homemade
forward contract.
(C) Forward Market Hedge: In a forward market hedge, a company that has a long position in a foreign currency will sell the foreign currency forward,
whereas a company that has a short position in a foreign currency will buy the foreign currency forward. In this manner, the company can fix the dollar value
of future foreign currency cash flow. (D) Netting: Netting involves associated companies, which trade with each
other. The technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross intra-group trade, receivables and payables are netted out.
(E) Matching: Matching is a mechanism whereby a company matches its
foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. Receipts in a particular currency are used to make payments in that currency thereby reducing the need for a group of companies
to go through the foreign exchange markets to the unmatched portion of foreign currency cash flows.
(F) Leading and Lagging: Leading means paying an obligation in advance of the due date. Lagging means delaying payment of an obligation beyond its due
date. Leading and lagging are foreign exchange management tactics designed to take advantage of expected devaluations and revaluations of currencies.
(G) Price Variation: Price variation involves increasing selling prices to counter the adverse effects of exchange rate change.
(H) Invoicing in Foreign Currency: Sellers usually wish to sell in their own currency or the currency in which they incur cost. This avoids foreign
exchange exposure. For the buyer, the ideal currency is usually its own or one that is stable relative to it, or it may be a currency of which the purchaser has reserves.
(I) Asset and Liability Management: Asset and liability management can
involve aggressive or defensive postures. In the aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies expected to be strong or increases exposed cash outflows denominated in weak currencies.
By contrast, the defensive approach involves matching cash inflows and outflows according to their currency of denomination, irrespective of whether
they are in strong or weak currencies. (J) Arbitrage: The simple notion in arbitrage is to purchase and sell a currency
simultaneously in more than one foreign exchange markets. Arbitrage profits are the result of the difference in exchange rates at two different exchange centres and the difference, due to interest yield which can be earned at
different exchanges.
13. Strategies for Exposure Management Four separate strategy options are feasible for exposure management. They are:
(a) Low Risk: Low Reward- This option involves automatic hedging of
exposures in the forward market as soon as they arise, irrespective of the attractiveness or otherwise of the forward rate.
(b) Low Risk: Reasonable Reward- This strategy requires selective hedging of exposures whenever forward rates are attractive but keeping exposures open whenever they are not.
(c) High Risk: Low Reward- Perhaps the worst strategy is to leave all
exposures unhedged. (d) High Risk: High Reward- This strategy involves active trading in the
currency market through continuous cancellations and re-bookings of forward contracts. With exchange controls relaxed in India in recent times, a few of the
larger companies are adopting this strategy. 14. Forward Rate Agreements (FRAs)
FRAs are cash-settled forward contracts on interest rates traded among major international banks active in the Eurodollar market. A bank that sells an FRA agrees to pay the buyer the increased interest cost on some "notional" principal
amount if some specified maturity of LIBOR is above a stipulated "forward rate" on the contract maturity or settlement date. Conversely, the buyer agrees to
pay the seller any decrease in interest cost if market interest rates fall below the forward rate. Thus, buying an FRA is comparable to selling, or going short, a Eurodollar or LIBOR futures contract.
15. Interest Rate Swaps In an interest rate swap, the parties to the agreement, termed the swap
counterparties, agree to exchange payments indexed to two different interest rates. Total payments are determined by the specified notional principal
amount of the swap, which is never actually exchanged. Following are important terms associated with the Interest Rate Swaps:
(a) Swap Dealers- They are the intermediaries.
(b) Swap Market Conventions-There are many different variants of interest rate swaps. The most common is the fixed/floating swap.
(c) Timing of Payments-A swap is negotiated on its "trade date" and takes effect two days later on its initial "settlement date."
(d) Price Quotation-The price of a fixed/floating swap is quoted in two parts: a
fixed interest rate and an index upon which the floating interest rate is based.
The floating rate can be based on an index of short-term market rates (such as a given maturity of LIBOR) plus or minus a given margin.
(e) Generic Swap-Fixed interest payments on a generic swap typically are based
on a 30/360 day-count convention whereas Floating-rate payments are based on an actual/360-day count.
(f) Day count Conventions-Fixed payments can be quoted either on an actual/365 (bond equivalent) basis or on an actual/360 basis. Floating-rate
payments indexed to private-sector interest rates typically follow an actual/360 day-count convention commonly used in the money market.
(g) Swap Valuation- Following are two methods used for the valuation of fixed/floating swaps:
Pricing the Variable-Rate Note
Pricing the Fixed Rate Note
(h) Non-par Swap- A swap may be priced such that one party owes money to
the other at the initial settlement.
16. Swaptions An interest rate swaption is simply an option on an interest rate swap. It gives the holder the right but not the obligation to enter into an interest rate swap at
a specific date in the future, at a particular fixed rate and for a specified term. For an up-front fee (premium), the customer selects the strike rate (the level at which it enters the interest rate swap agreement), the length of the option
period, the floating rate index (Prime, LIBOR, C.P.), and tenor. Swaptions fall into three
main categories: a) European Swaptions give the buyer the right to exercise only on the maturity
date of the option. b) American Swaptions, on the other hand, give the buyer the right to exercise
at any time during the option period. c) Bermudan Swaptions give the buyer the right to exercise on specific dates during the option period.
17. Principal Features of Swaptions
A fixed-rate payer swaption gives the buyer of the option the opportunity
to lock into a fixed rate through an IRS on an agreed future date.
The 'option period' refers to the time which elapses between the
transaction date and the expiry date.
The fixed rate of interest on the swaption is called the strike rate.
The simplest type of swaption available is an option to pay or receive
fixed rate money against receiving or paying floating-rate money.
At maturity of the swaption, one can decide whether to exercise the swap
or to let the swaption lapse unexercised - all rights incurred by the holder will then terminate.
The underlying instrument on which a swaption is based is a forward-
start IRS.
The buyer of a payer/receiver swaption pays a premium for the right but
not the obligation to pay/receive the fixed rate and receive/pay the floating rate of interest on a forward-start IRS.
The swaption premium is expressed as basis points.
Swaptions can be cash-settled.
Marking to market of a swaption depends on the strike rate of the swap
and the relationship of the strike price to the underlying, where the underlying is the forward start IRS. The intrinsic value would therefore be related to a swap with a start date that coincides with the expiry date
of the option. In the event of the swaption being cash-settled, the counterparties end up without actually transacting an IRS with each
other - the advantage here being an effective management of credit limits.
18. Pricing of Swaptions Because of its ease of use and market acceptance modified Black and Scholes
model is used. However, the modified Black formula has been subject to extensive criticism from various sources over the years.
19. Caps and Floors versus Swaptions A swaption only has one date of exercise compared to a cap (which is essentially a series of separate call options on forward rates).
20. Uses of Swaptions Swaptions can be applied in a variety of ways for both
active traders as well as for corporate treasurers.
Swaptions have become useful tools for hedging embedded option which
is common to the natural course of many businesses.
Swaptions are useful to borrowers targeting an acceptable borrowing
rate.
Swaptions are also useful to those businesses tendering for contracts.
Swaptions also provide protection on callable/putable bond issues.
21. Interest Rate Caps The buyer of an interest rate cap pays the seller a premium in return for the
right to receive the difference in the interest cost on some notional principal amount any time a specified index of market interest rates rises above a
stipulated "cap rate." The buyer bears no obligation or liability if interest rates fall below the cap rate. Thus, a cap resembles an option that has a right rather than an obligation to the buyer.
Practical Problems
Question 1 The following table shows interest rates for the United States dollar and French francs. The spot exchange rate is 7.05 francs per dollars. Complete the missing entries:
3 Months 6 Months 1 Year
Dollar interest rate (annually compounded)
11½% 12¼% ?
Franc interest rate (annually compounded)
19½ ? 20%
Forward franc per dollar ? ? 7.5200
Forward discount per franc per cent per year
? - 6.3%
Question 2 On 1st April, 3 months interest rate in the US and Germany are 6.5 per cent and 4.5 per cent per annum respectively. The $/DM spot rate is 0.6560. What would be the forward rate for DM for delivery on 30th June?
Question 3 In March, 2009, the Multinational Industries make the following assessment of dollar rates per British pound to prevail as on 1.9.2009:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 1.9.2009? (ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell forward its pound receivables due in September, 2009? Question 4
ABC Co. have taken a 6 month loan from their foreign collaborators for US Dollars 2 millions. Interest payable on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR is 2%. Enquiries regarding exchange rates with their bank elicits the following information:
Spot USD 1 Rs. 48.5275, 6 months forward Rs. 48.4575 (i) What would be their total commitment in Rupees, if they enter into a forward contract? (ii) Will you advise them to do so? Explain giving reasons.
Question 5 A customer with whom the Bank had entered into 3 months forward purchase contract for Swiss Francs 1,00,000 at the rate of Rs. 36.25 comes to the bank after two months and requests cancellation of the contract. On this date, the rates are:
Spot CHF 1 = Rs. 36.30 36.35 One month forward 36.45 36.52
Determine the amount of Profit or Loss to the customer due to cancellation of
the contract.
Question 6 On January 28, 2010 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the remittance only on February 4, 2010. The interbank market rates were as follows:
January, 28 February 4 Bombay US$1 = Rs. 45.85/45.90 45.91/45.97 London Pound 1 = US$ 1.7840/1.7850 1.7765/1.7775 Pound 1 = SGD 3.1575/3.1590 3.1380/3.1390 The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of .0001) Question 7 You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at Rs. 5.70 & covered yourself in London market on the same day, when the exchange rates were US$ 1 = H.K.$ 7.5880 7.5920 Local inter bank market rates for US$ were Spot US$ 1 = Rs. 42.70 42.85 Calculate cover rate and ascertain the profit or loss in the transaction. Ignore brokerage.
Question 8 Given the following information: Exchange rate – Canadian dollar 0.665 per DM (spot) Canadian dollar 0.670 per DM (3 months) Interest rates – DM 7% p.a. Canadian Dollar – 9% p.a. What operations would be carried out to take the possible arbitrage gains?
Question 9
Following information relates to AKC Ltd. which manufactures some parts of an electronics device which are exported to USA, Japan and Europe on 90 days credit terms. Cost and Sales information:
Japan USA Europe
Variable cost per unit Rs.225 Rs.395 Rs.510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in 90 days Yen 78,00,000
US$1,02,300 Euro 95,920
Foreign exchange rate information:
Yen/Rs. US$/Rs. Euro/Rs.
Spot market 2.417-2.437 0.0214-0.0217
0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216
0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156
0.0177-0.0179
Advice AKC Ltd. by calculating average contribution to sales ratio whether it should hedge it’s foreign currency risk or not. Question 10
A company is considering hedging its foreign exchange risk. It has made a purchase on 1st. January, 2008 for which it has to make a payment of US $ 50,000 on September 30, 2008. The present exchange rate is 1 US $ = Rs. 40. It can purchase forward 1 US $ at Rs. 39. The company will have to make a upfront premium of 2% of the forward amount purchased. The cost of funds to the company is 10% per annum and the rate of corporate tax is 50%. Ignore taxation. Consider the following situations and compute the Profit/Loss the company will make if it hedges its foreign exchange risk: (i) If the exchange rate on September 30, 2008 is Rs. 42 per US $. (ii) If the exchange rate on September 30, 2008 is Rs. 38 per US $. Question 11 Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai GBP/INR 77.52 in London GBP/USD 1.6231 in New York
The arbitrageur has USD1,00,00,000. Assuming that there are no transaction costs, explain whether there is any arbitrage gain possible from the quoted spot exchange rates. DIVIDEND POLICY
1. Traditional method 2. Walter model
3. Gordon’s model 4. Modigilani & Miller (MM) model
Traditional model(Graham & Dodd model)
According to this model the stock market places more weight on dividends than on the retained earnings . The weight attached to dividends are equal to four times the weight attached to the retained earnings.
Formula : p=m(D+E/3)
Walter Model According to this model the stock valuation has a bearing on dividend policy of
the firm. The model has the following assumptions
- The firm is an all-equity firm. The firm will rely only on retained
earnings to finance their future investments. This means that the investment decision is based on dividend decision.
- The rate of return on investment is assumed to be constant.
- The firm has an infinite life
- The earnings and dividend don’t change over life of the firm.
Formula : P= D + r/k (E-D) --------------
K Implications :
- When r > k, the optimal payout ratio is nil, since the firm is a growing firm.
- When r < k the optimal payout ratio is 100%, since the firm is a declining
firm
- When r = k, the payout ratio is irrelevant, since the firm is a constant firm
Gordon Model (Dividend capitalization model) Model is based on the following assumptions :
- Retained earnings is the only source of finance
- Rate of return, growth rate and retention ratio is constant
- Growth rate is product of retention ratio and its rate of return
- Cost of capital is constant
- The firm has perpetual life
- Tax does not exist
Formula P = E(1-b) --------
(k-br)
Implications :
- When r > k, the optimal payout ratio is nil, since the firm is a growing firm.
- When r < k the optimal payout ratio is 100%, since the firm is a declining firm
- When r = k, the payout ratio is irrelevant, since the firm is a constant firm
MODIGILANI & MILLER MODEL (DIVIDEND IRRELEVANCE THEORY) This model advances a view that the value of a firm depends solely on its
earnings power and is not influenced by the manner in which its earnings are split between dividends and retained earnings.
Assumptions :
- Capital market are perfect and investors are rational. Information is freely available.
- There is no transaction cost
- Securities are divisible
- There is no floatation cost
- Investment opportunities and future profits of the firm are known with
certainty.
- Investment and dividend decisions are independent
Step I - Market price of the share is equal to the sum of the present value of dividend paid and the market price at the end of the period.
Formula : (D1 + P1) Po = ----------
(1 + k) Step II – With no external financing the total value of the firm will be
Formula : (n.D1 +n. P1)
nPo = ---------- (1 + k)
Step III – The firm finances is investment decision by raising additional capital issuing n1 shares at the end of period ( t = 1)
Formula : (n.D1 +(n+n1) P1- n1P1)
nPo = ---------------------------- (1 + k)
Additional equity capital n1p1 = 1(E-nD1)
Thus additional shares Formula : 1- (E-n.D1 )
n1 = ---------- P1
What is dividend signaling?
According to dividend signaling hypothesis, dividend changes provide an effective way of allowing management to convey believable information to the market about the firm’s expected future cash flows. By conveying the favorable
information in a believable way, the dividend decision is used to show effect on the value of the firm. Firms are careful in announcing their dividend decisions.
Most of the firms follow stable dividends or gradually increasing dividends. Many investors consider dividends as a part of regular income to meet their expenses. Hence they prefer a predictable pattern of dividends rather than
fluctuating pattern. A fall in the dividend income may lead to sale of some shares, on the other hand when the dividend income increases, an investor may invest some of the proceeds as reinvestment in shares, and thus the share
price tends to increase. Moreover, the dividend policy of firms, convey a lot to the investors. Increasing dividends signal better prospects of the company. On
the contrary, decreasing dividends signals bad earnings expectations. In addition, stable dividends are signs of stable earnings of the company. On the other hand, varying dividends lead to uncertainty in the mind of shareholders.
Dividend / Price Ratio Approach :
One can view the value of a share to an investor as the PV of expected future stream of dividends expected to be received on the share. Dividends are all that the shareholders as a whole receive from their investment. This approach
emphasises that the investor arrives at the market price of a share by capitalizing the set of expected dividend payments. In other words, it is the
expected rate of dividends which determines the price of the share and this in turn, determines the cost of equity capital. Thus, according to this approach,
the cost of equity capital will be that rate of expected dividends which will maintain the price of the equity shares. This approach rightly emphasizes the
importance of dividends in the mind of the investor. However, it does not take into account the fact that retained earnings also have an impact on the market price of the shares. Hence, it is not the dividends alone which matters,
Earnings/ Price ratio approach:
This assumes that the shareholders capitalize a stream future earnings (as distinguished from dividends) in order to evaluate their shareholding. Thus, it
is the EPS which determined the market price of the shares. Hence the cost of capital of a company should be related to that earring percentage which will keep the market price of the share constant. This approach takes into account
both dividends and retained earnings. There is no doubt that the expected EPS is an important determinant of the share market prices.
Dividend / Price Plus Growth Approach:
This approach puts emphasis on what an investor actually receives from his investment, i.e, dividend plus the rate of growth of dividend. Thus, the shareholders, value their holdings according to the dividends they hope to
receive plus the rate of growth in dividend. This rate of growth is assumed to be equal to the growth rate in the EPS and the market price per share. The
approach, therefore, tries to measure what a shareholder is likely to earn from his holdings in future.
Realised Yield Approach : The approaches discussed above are based on the estimates of the expectations
of the shareholders regarding the future dividends and income. However, the future trends in the rate of earnings and the market prices of the shares are
always uncertain. Many authorities have, therefore suggested that the rate of return actually realized for a period of time by investors in a particular company is a better approach to determine the cost of capital. In other words,
this approach takes the basic factors of D/ p + g approach but instead of using the expected values of the dividends and the capital appreciation, past yields
are used to donor the cost of capital.
TREASURY MANAGEMENT
Meaning
- Corporate handling of all financial markets
- Generation of internal and external funds
- Management of currencies and cash flows for management
- Handles complex issue, looks into strategies
- Works with the policy and procedures of the company
Treasury Manager looks into two aspects
Working capital management Financial Risk Cash Management Forex, Interest rate
- Planning, organizing and controlling of cash assets
- Goal is to maximize the return or minimize interest cost or mobilize cash for ventures.
- Deals in forex, interest rates, exchange rates, commodity markets
Functions :
Management of liquidity Financial risk Cash Management : Concerned about efficient collection and
repayment of cash
Currency Management : Manages foreign exchange risk, exchange rate risk etc
Funding Management : Sources for short, medium and long term finances
Banking : Maintains good relations with bankers
Corporate finance : Advises the company/management about merger/acquisitions etc
ROLE :
- Plays a significant part in the management
- Looks into various activities such as marketing, production etc
- Mainly responsible for manufacturing industry and has a minimal role in
service industry
Treasury Manager has following roles :
- Originating role – inducts and originates system of accounting
- Supportive role - supports various activities in the organisation such as manufacturing, production, HRD etc
- Leadership role – provides leadership in exigencies
- Watchdog role – he will be the eyes and ears of the management and will look into various aspects of policies
- Learning role – brings in financial discipline by inducting new concepts
- Informative role – works with unison and tandem with performance vis-à-vis budgets
RESPONSIBILITIES:
- Compliance with statutory guidelines
- Equal treatment to all department
- Ability to network
- Integrity and impartial dealings
- Willingness to learn and teach TOOLS OF TREASURY MGT
- Treasury manager works in a fast changing and competitive environment
- Tools originate from the Finance Department and it is the prerogative of the Treasury Manager
- Analytic and planning tools- keeps an eye on the budgets and plans for the future
- Zero based budgeting
- Financial statement analysis
ROLE OF INFORMATION TECHNOLOGY IN TREASURY MANAGEMENT
- Automatic repetitive tasks
- Implement internal control
- Time saver & Fraud and error detection
- Forecast cash flow
- Communicate with operating units
- Choose web based Treasury management system
- Rethink Treasury process
- Pay for performance
Best wishes for your EXAMINATION !!!!
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