Professional Documents
Culture Documents
Markets
VERSION: 1.1
DATE: 26-MAY-2009
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CONTENTS
1.0
1.1
1.2
1.3
1.4
2.0
2.1
3.0
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
4.0
4.1
4.2
4.3
4.4
4.5
5.0
5.1
5.2
5.3
5.4
6.0
6.1
6.2
6.3
6.4
6.5
6.6
6.6
7.0
7.1
7.2
7.3
8.0
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8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.9
8.10
8.11
8.12
8.13
9.0
9.1
9.2
9.3
9.4
10.0
10.1
10.2
10.3
11.0
11.1
11.2
11.3
12.0
14.0
GLOSSARY................................................................................................................................ 256
15.0
REFERENCES............................................................................................................................. 262
15.1
15.2
WEBSITES................................................................................................................................... 262
BOOKS ....................................................................................................................................... 262
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1.0
BFS CONCEPTS
1.1
CONCEPT OF MONEY
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1.1.3 INFLATION
Inflation captures the rise in the cost of goods and services over a period of time. For example, if
Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/ (1+I) kgs of
groceries next year, where `I refers to the rate of inflation beyond today.
Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply
and other market conditions hold), next year, one can only buy 5/ (1.05) worth of groceries.
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1.1.4
Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the
nominal rate of interest for economies having positive rate of inflation.
The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of
inflation) is as:
R= N-I
(This is a widely used approximation; the exact formula takes into account time value of inflation
etc.)
Why is it important to know the real rate of return? Take an example where a business is
earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is
actually at zero.
Example
Nominal rate (N) = 10%, Inflation (I) = 5%
Therefore, real interest is:
R = N I = 5%
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PV
Example
years,
If one were to receive 5% per annum compounded interest on $100 for five
FV = $100*(1.05)5 = $127.63
Intra-Year Compounding
If a cash flow is compounded more frequently than annually, then intra-year compounding is
being used. To adjust for intra-year compounding, an interest rate per compounding period
must be found as well as the total number of compounding periods.
The interest rate per compounding period is found by taking the annual rate and dividing it by
the number of times per year the cash flows are compounded. The total number of
compounding periods is found by multiplying the number of years by the number of times per
year cash flows are compounded.
Example
Suppose someone were to invest $10,000 at 8% interest, compounded
semiannually, and hold it for five years,
Interest rate for compounding period = 8%/2 = 4%
Number of compounding periods = 5*2 = 10
Thus, the future value FV = 10,000*(1+0.04) ^10 = $14,802.44
Present value
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Present Value is the current value of a future cash flow or of a series of future cash flows. It is
computed by the process of discounting the future cash flows at a predetermined rate of
interest.
If $10,000 were to be received in a year, the present value of the amount would not be $10,000
because we do not have it in our hand now, in the present. To find the present value of the
future $10,000, we need to find out how much we would have to invest today in order to
receive that $10,000 in the future. To calculate present value, or the amount that we would
have to invest today, we must subtract the (hypothetical) accumulated interest from the
$10,000. To achieve this, we can discount the future amount ($10,000) by the interest rate for
the period. The future value equation given above can be rearranged to give the Present Value
equation:
PV = FV / (1+I) ^n
In the above example, if interest rate is 5%, the present value of the $10,000 which we will
receive after one year, would be:
PV = 10,000/(1+0.05) = $ 9,523.81
Net Present Value (NPV)
Net Present Value (NPV) is a concept often used to evaluate projects/investments using the
Discounted Cash Flow (DCF) method. The DCF method simply uses the time value concept and
discounts future cash flows by the applicable interest rate factor to arrive at the present value of
the cash flows. NPV for a project is calculated by estimating net future cash flows from the
project, discounting these cash flows at an appropriate discount rate to arrive at the present
value of future cash flows, and then subtracting the initial outlay on the project.
NPV of a project/investment = Discounted value of net cash inflows Initial cost/investment.
The project/investment is viable if NPV is positive while it is not viable if NPV is negative.
Example An investor has an opportunity to purchase a piece of property for $50,000 at the
beginning of the year. The after-tax net cash flows at the end of each year are forecast as
follows:
Year
Cash Flow
$9,000
8,500
8,000
8,000
8,000
8,000
8,000
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7,000
4,500
10
Assume that the required rate of return for similar investments is 15.00%.
NPV = - 50000 + 9000/ (1+0.15) ^1 + 8500/ (1+0.15) ^2 + .. +51000/ (1+0.15) ^10 = $612.96
However, if we assume that the required rate of return is 16.00%,
NPV = - 50000 + 9000/ (1+0.16) ^1 + 8500/ (1+0.16) ^2 + .. +51000/ (1+0.16) ^10 = ($1360.77)
Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project:
Increases with increase in future cash inflows for a given initial outlay
Decreases with increase in initial outlay for a given set of future cash inflows
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means of finance such as equity shares, preference shares, debentures or term loan is beyond
the purview of this learning program.
Since there is a limit to the amount of resources that corporations can raise from any source,
they use more than a single source for financing their needs. Also, funds will be raised at
different points in time depending on need, availability, and market timing etc. In such cases
after computing cost of each source, the firm arrives at a weighted average cost of capital,
commonly referred to as cost of capital. Let us take an example:
The Good works Company Inc. has Rs. 300 million through different means. The firm has raised
Rs. 107 mn through equity, Rs. 13 mn through preference capital, Rs. 80 mn by issuing
debentures and Rs. 100 mn by taking a loan a financial institution.
Source of finance
Weight
Equity capital
16.64
107/300
5.93
Preference capital
15.73
13/300
0.68
Debenture capital
11.08
80/300
2.95
Term loan
10.25
100/300
3.42
Looked at it with a different perspective, the cost of capital is the rate of return the firm must
earn on its investments in order to satisfy the expectations of investors who provide long-term
funds to it. It is an important concept for financing decisions.
1.2
FINANCIAL INSTRUMENTS
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Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It
also means that if the company ceases to do business and liquidate its assets, that the debt
holders have a senior claim to those assets.
1.2.2 SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a creditor
relationship with a corporation or government agency (a bond), or rights to ownership (an
option). Financial instruments can be classified into:
Debt
Equity
Hybrids
Derivatives
DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are
all examples of debt.
BOND
An investor loans money to an entity (company or government) that needs funds for a specified
period of time at a specified interest rate. In exchange for the money, the entity will issue a
certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date
(maturity date). Interest on bonds is usually paid every six months (semiannually).
Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and
Fully Registered Bonds.
Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These
bonds are Unregistered because the owners name does not appear on the bond, and there is
no record of who is entitled to receive the interest payments. Attached to the bond are
Coupons. The bearer clips the coupons every six months and presents these coupons to the
paying agent to receive their interest. Then, at the bonds Maturity, the bearer presents the
bond with the last coupon attached to the paying agent, and receives their principal and last
interest payment.
Bonds that are registered as to principal only have the owners name on the bond certificate,
but since the interest is not registered these bonds still have coupons attached.
Bonds that are issued today are most likely to be issued fully registered as to both interest and
principal. The transfer agent now sends interest payments to owners of record on the interest
Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and
the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,
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Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customers
Confirmation serves as proof of ownership.
Principal and Interest
Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The
annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond
certificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing
economic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the
credit rating, the lower the coupon). Bonds that are In Default are not paying interest.
Example
IBM can issue 10 year bonds with a coupon of 5.5%.
issueamount
similar 10
yearbond
bonds
at 8%the investor has loaned to the issuer.
Priceline
The principal
or parcan
or Face
of the
is what
The"safety"
difference
in principal
coupon isdepends
due to their
credit
rating!
The relative
of the
on the
issuers
credit rating and the type of bond
that was issued.
CORPORATE BOND
A bond issued by a corporation. Corporations generally issue three types of bonds: Secured
Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures.
All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond.
In contrast, unsecured bonds are backed by the general assets of the corporation only. There
are three basic types of Secured Bonds:
Mortgage Bonds are secured by real estate owned by the issuer
Equipment Trust Certificates are secured by equipment owned and used in the issuers business
Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (Usually U.S.
Government securities)
Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they
are the first to be paid principal or interest and are thus the safest of an issuers securities.
Unsecured Bonds include debentures and subordinated debentures. Debentures have a general
creditor status and will be paid only after all secured creditors have been satisfied. Subordinated
debentures have a subordinate creditor status and will be paid after all senior and general
creditors have first been satisfied.
Case Study
Enron set up power plant at Dabhol, India
The cost of the project (Phase 1) was USD 920 Million
Funding
o Equity
USD 285 mio
o Bank of America/ABN Amro
USD 150 mio
o IDBI & Indian Banks
USD 95 mio
o US Govt OPIC
USD 100 mio
o US Exim Bank
USD 290 mio
Enron US declared bankruptcy in 2002
Enron Indias assets are mortgaged to various banks as above.
Due to interest payments and depreciation, assets are worth considerably less
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COMMERCIAL PAPER
An unsecured, short-term loan issued by a corporation, typically for financing accounts
receivable and inventories. It is usually issued at a discount to face value, reflecting prevailing
market interest rates. It is issued in the form of promissory notes, and sold by financial
organizations as an alternative to borrowing from banks or other institutions. The paper is
usually sold to other companies which invest in short-term money market instruments.
Since commercial paper maturities don't exceed nine months and proceeds typically are used
only for current transactions, the notes are exempt from registration as securities with the
United States Securities and Exchange Commission. Financial companies account for nearly 75
percent of the commercial paper outstanding in the market.
There are two methods of marketing commercial paper. The issuer can sell the paper directly to
the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer
market for commercial paper involves large securities firms and subsidiaries of bank holding
companies. Direct issuers of commercial paper usually are financial companies which have
frequent and sizable borrowing needs, and find it more economical to place paper without the
use of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point.
This savings compensates for the cost of maintaining a permanent sales staff to market the
paper.
Interest rates on commercial paper often are lower than bank lending rates, and the differential,
when large enough, provides an advantage which makes issuing commercial paper an attractive
alternative to bank credit.
Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for
less than 30 days. Paper usually is issued in denominations of $100,000 or more, although some
companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the
CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition,
bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the
market.
Investors in the commercial paper market include private pension funds, money market mutual
funds, governmental units, bank trust departments, foreign banks and investment companies.
There is limited secondary market activity in commercial paper, since issuers can closely match
the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or
issuer usually will buy back the paper prior to maturity.
EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the
funds contributed by the owners (the stockholders) plus the retained earnings (or losses).
COMMON STOCK
Common stock represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of
the stock traded in the markets today is common. An individual with a majority shareholding or
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controlling interest controls a company's decisions and can appoint anyone he/she wishes to the
board of directors or to the management team.
Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public
Offering (IPO). Before shares can be offered, or sold to the general public, they must first be
registered with the Securities and Exchange Commission (SEC). Once the shares have been sold
to investors, the shareholders are usually free to sell or trade their stock shares in the Secondary
Markets (such as the New York Stock Exchange NYSE). From time to time, the Issuer may
choose to repurchase the stock they previously issued. Such repurchased stock shares are
referred to as Treasury Stock, and the shares that remain trading in the secondary market are
referred to as Shares Outstanding. Treasury Stock does not have voting rights and is not entitled
to any declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to offer
to employees.
STOCK TERMINOLOGY
Public Offering Price (POP) The price at which shares are offered to the public in a Primary
Offering. This price is fixed and must be maintained when Underwriters sell to customers.
Current Market Price The price determined by Supply and Demand in the Secondary Markets.
Book Value The theoretical liquidation value of a stock based on the company's Balance Sheet.
Par Value An arbitrary price used to account for the shares in the firms balance sheet. This
value is meaningless for common shareholders, but is important to owners of Preferred Stock.
Example
When Cognizant Technology Solutions came out with its Initial Public
Offering on NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per
share. The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003.
As of Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits
are taken into consideration the actual market price would stand at 6 times the Current
Market Price at whopping $253.56!!
PREFERRED STOCK
Preference shares carry a stated dividend and they do not usually have voting rights. Preferred
shareholders have priority over common stockholders on earnings and assets in the event of
liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par
(always assumed to be $100) or a dollar amount.
Although preferred stock is equity and represents ownership, preferred stock investors are
primarily seeking income. The market price of income seeking securities (such as preferred stock
and debt securities) fluctuates as market interest rates change. Price and yield are inversely
related.
There are several different types of preferred stock including Straight, Cumulative, Convertible,
Callable, Participating and Variable. With straight preferred, the preference is for the current
years dividend only. Cumulative preferred is senior to straight preferred and has a first
preference for any dividends missed in previous periods.
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Convertible preferred stock can be converted into shares of common stock either at a fixed
price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used
as a means for a risky company to obtain capital when neither debt nor equity works. It offers
considerable opportunity for capital appreciation.
Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks.
Utilities represent the best example of nonconvertible preferred stock issuers.
AMERICAN DEPOSITORY RECEIPTS (ADR)
The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt
for a specified number of foreign shares owned by an American bank. ADRs trade like shares,
either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also
has the right to receive any declared dividends. An example would be Infosys ADRs that are
traded in NASDAQ.
HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.
CONVERTIBLE BONDS
Convertible Bonds are instruments that can be converted into a specified number of shares of
stock after a specified number of days. However, till the time of conversion the bonds continue
to pay coupons.
Case Study
Tata Motors Ltd. (previously known as TELCO) recently issued convertible bond
aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate
paid on the issue was just 4% which was much lower than what it would have to pay if it
raised the money in India, where it is based out of. The company would use this money
to pay-back existing loans borrowed at much higher interest rates.
Why doesnt every company raise money abroad if it has to pay lower interest rates?
Will there is
Will there be any effect on existing Tata Motors share-holders due to the convertible
issue? If Yes, when will this be?
WARRANTS
Warrants are call options variants of equity. They are usually offered as bonus or sweetener,
attached to another security and sold as a Unit. For example, a company is planning to issue
bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so
they sweeten the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire
worthless.
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DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, foreign exchange, commodity or any other
item. For example, if the settlement price of a derivative is based on the stock price, which
changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence
derivative risks and positions must be monitored constantly.
FORWARD CONTRACT
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain
future time for a certain price. No cash is exchanged when the contract is entered into.
FUTURES CONTRACT
A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. Index futures are all futures contracts where the underlying is
the stock index and helps a trader to take a view on the market as a whole.
HEDGING
Hedging involves protecting an existing asset position from future adverse price movements. In
order to hedge a position, a market player needs to take an equal and opposite position in the
futures market to the one held in the cash market.
ARBITRAGE
Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can
earn risk less profits. When markets are imperfect, buying in one market and simultaneously
selling in other market gives risk less profit. Arbitrageurs are always in the lookout for such
imperfections.
OPTIONS
An option is a contract, which gives the buyer the right, but not the obligation to buy or sell
shares of the underlying security at a specific price on or before a specific date. There are two
kinds of options: Call Options and Put Options.
Call Options are options to buy a stock at a specific price on or before a certain date. Call
options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option premium, secures the investor the right to buy that certain stock at a specified
price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the
option premium. For call options, the option is said to be in-the-money if the share price is
above the strike price.
Example The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the
Dec 24th, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was
Rs.90. This would mean that to break-even the person buying the Call Option on the
Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!!
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Put Options are options to sell a stock at a specific price on or before a certain date. With a Put
Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor
can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no
need to use the insurance, and the only cost is the premium. A put option is in-the-money when
the share price is below the strike price. The amount by which an option is in-the-money is
referred to as intrinsic value.
The primary function of listed options is to allow investors ways to manage risk. Their price is
determined by factors like the underlying stock price, strike price, time remaining until
expiration (time value), and volatility. Because of all these factors, determining the premium of
an option is complicated.
Types of Options
There are two main types of options:
American options can be exercised at any time between the date of purchase and the
expiration date. Most exchange-traded options are of this type.
Long-Term Options are options with holding period of one or more years, and they are called
LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and
manage risk or even speculate, they are virtually identical to regular options. LEAPS, however,
provide these opportunities for much longer periods of time. LEAPS are available on most
widely-held issues.
Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard
options are called exotic options, which either are variations on the payoff profiles of the plain
vanilla options or are wholly different products with "optionality" embedded in them.
Open Interest is the number of options contracts that are open; these are contracts that have
not expired nor been exercised.
SWAPS
Swaps are the exchange of cash flows or one security for another to change the maturity
(bonds) or quality of issues (stocks or bonds), or because investment objectives have changed.
For example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the lower rates.
Currency Swap involves the exchange of principal and interest in one currency for the same in
another currency.
Forward Swap agreements are created through the synthesis of two different swaps, differing in
duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes
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swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example,
if an investor wants to hedge for a five-year duration beginning one year from today, they can
enter into both a one-year and six-year swap, creating the forward swap that meets the
requirements for their portfolio.
Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the
option to execute an interest rate swap on a future date, thereby locking in financing costs at a
specified fixed rate of interest. The seller of the swaption, usually a commercial or investment
bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium.
Case Study
The World Bank borrows funds internationally and loans those funds to developing countries. It
charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost.
In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation
tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and
Switzerland 8 percent.
IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US
companies. In contrast, the World Bank suffered from bad image since it had used several times
the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra
20 basis points (0.2%) compared to IBM
In addition, the problem for the World Bank was that the Swiss government imposed a limit on
the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed
limit in Switzerland and West Germany
At the same time, the World Bank, with an AAA rating, was a well established name in the US
and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of
the backing of the US, German, Japanese and other governments. It would have to pay the
Treasury rate + 40 basis points.
IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt
payments to pay in Swiss francs and deutsche marks.
World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obligation
with IBM in exchange for taking over IBM's SFR and DEM loans.
It became very advantageous for IBM and the World Bank to borrow in the market in which
their comparative advantage was the greatest and swap their respective fixed-rate funding.
1.3
FINANCIAL MARKETS
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A financial transaction is one where a financial asset or instrument, such as cash, check, stock,
bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the
financial instruments come together and financial transactions take place.
1.3.2
PRIMARY MARKETS
Primary market is one where new financial instruments are issued for the first time. They
provide a standard institutionalized process to raise money. The public offerings are done
through a prospectus. A prospectus is a document that gives detailed information about the
company, their prospective plans, potential risks associated with the business plans and the
financial instrument.
SECONDARY MARKETS
Secondary Market is a place where primary market instruments, once issued, are bought and
sold. An investor may wish to sell the financial asset and encash the investment after some time
or the investor may wish to invest more, buy more of the same asset instead, the decision
influenced by a variety of possible reasons. They provide the investor with an easy way to buy or
sell.
Stock market
Money market
Foreign exchange (Forex or FX for short) market (also called the currency market).
Stock and bond markets constitute the capital markets. Another big financial market is the
derivatives market.
CAPITAL MARKETS
Why businesses need capital?
All businesses need capital, to invest money upfront to produce and deliver the goods and
services. Office space, plant and machinery, network, servers and PCs, people, marketing,
licenses etc. are just some of the common items in which a company needs to invest before the
business can take off. Even after the business takes off, the cash or money generated from sales
may not be sufficient to finance expansion of capacity, infrastructure, and products / services
range or to diversify or expand geographically. Some financial services companies need to raise
additional capital periodically in order to satisfy capital adequacy norms.
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different investors varies. Investor will consider buying the stock if the market price is less than
the perceived value of the stock according to that investor and will consider selling if it is higher.
A large number of factors have a bearing on the perceived value. Some of them are:
State of the countrys economy where it operates as well as the global economy
Market sentiment or mood relating to the stock and on the market as a whole
Apart from these, many other factors, including performance of other financial markets, affect
the demand and supply.
BOND MARKETS
As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in exchanges,
most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations
between dealers. Lately there have been efforts to create computer-based market place for
certain type of bonds.
Participants in the Bond Market
Since Government is the biggest issue of bonds, the central bank of the country such as Federal
Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like
stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the
bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid
for the bonds and the price is fixed based on the bids received. The dealers then sell these
bonds in the secondary market or directly to third parties, typically institutions and companies.
If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on the
direction of interest rates change. Remember, bond pays interest at a fixed coupon rate
determined at the time of issue, irrespective of the prevailing market interest rate. Market
interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to
change because of various factors such as inflation, monetary policy change, etc. So when the
prevailing market interest rates change, price of the bond (and not the coupon) adjusts, so that
the effective yield for a buyer at the time (if the bond is held to maturity) matches the market
interest rate on other bonds of equal tenure and credit rating (risk).
So when the market interest rates go up, prices of bonds fall and vice-versa. Therefore, price of
bonds changes when market interest rate changes, all bonds have an interest rate risk. If the
market interest rates shoot up, then the bond price is affected negatively and an investor who
bought the bond at a high price (when interest rates were low) stands to lose money or at least
makes lesser returns than expected, unless the bond is held to maturity.
Example
Bond Price calculation can be summed by an easy formula:
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where B represents the price of the bond and CFk represents the kth cash flow which is
made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon
payment and the Principal.
What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest
rate (i) is 10% and the Coupon payments are Rs.5 annually?
Would the bond price increase/decrease if the coupon is reduced? What would be
happen to bond price if the interest rates came down?
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MONEY MARKET
Money market is for short term financial instruments, usually a day to less than a year. The most
common instrument is a repo, short for repurchase agreement. A repo is a contract in which
the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and
price. Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also
considered as money market instruments.
Since the tenure of the money market instruments is very short, they are generally considered
safe. In fact they are also called cash instruments. Repos especially, since they are backed by a
Govt. security, are considered virtually the safest instrument. Therefore the interest rates on
repos are the lowest among all financial instruments.
Money market instruments are typically used by banks, institutions and companies to park extra
cash for a short period or to meet the regulatory reserve requirements. For short-term cash
requirements, money market instruments are the best way to borrow.
Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1 share,
the minimum investment in bond and money markets runs into hundreds of thousands of
Rupees or Dollars. Hence the money market participants are mostly banks, institutions,
companies and the central bank. There are no formal exchanges for money market instruments
and most of the trading takes place using proprietary systems or shared trading platforms
connecting the participants.
Since the capital markets are central to a thriving economy, Governments need to ensure
their smooth functioning.
Governments also need to protect small or retail investors interests to ensure there is
participation by a large number of investors, leading to more efficient capital markets.
Governments need to ensure that the companies or issuers declare all necessary
information that may affect the security prices and that the information is readily and easily
available to all participants at the same time.
Typically the government designates one or more agencies as regulator(s) and supervisor(s) for
the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US
has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and
norms for each activity and each category of participant. For example,
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Rules regarding the amount of information that must be made available to prospective
investors,
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investor. A portfolio of investments allows one to diversify risks over a limited number of
instruments and issuers.
ACCOUNTING SYSTEMS
The accounting systems take care of present value calculations, profit & loss etc. - of
investments and funds and not the financial accounts of the firms.
SUMMARY
Financial markets facilitate financial transactions, i.e. exchange of financial assets such
stocks, bonds, etc.
Financial markets bring buyers and sellers in a financial instrument together, thus reducing
transaction costs, channeling funds, improving liquidity and provide a transparent price
discovery mechanism.
Each financial market is segmented into a Primary market, where new instruments are
issued and a Secondary market, where the previously issued instruments are bought and
sold by investors.
Stock markets, bond markets, money markets, foreign exchange markets and derivatives
markets are prominent examples of financial markets.
Shares (stock) of a company are issued and traded in the stock markets.
Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds,
etc. are traded.
Money markets, like bonds markets, are also fixed income markets. Instruments traded in
money markets have very short tenure.
Derivatives markets trade derivatives, which are complex financial instruments, whose
returns are based upon the returns from some other financial asset called as the underlying
asset.
Price of any financial instrument depends basically on demand and supply, which in turn
depend upon multiple different factors for different markets.
Each financial instrument has a differing level of inherent risk associated with it. Money
market instruments are considered the safest due to their very short tenure.
Regulators play a very important role in the development and viability of financial markets.
Regulators try to ensure that the markets function in a smooth, transparent manner, that
there is sufficient and timely disclosure of information, that the interest of small investors is
not compromised by the large investors, and so on, which is critical for overall vibrancy,
efficiency and growth of the market and the economy.
1.4
FINANCIAL STATEMENTS
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1.4.1
Why does the concept of Accounting and Financial Statements exist? Here are two main
reasons:
1. The managers of the business will want to know how things are going. They need
financial information in order to plan for the future; they need more up-to-date
information in order to check whether actual performance is on target. So accounting is
the first step in what we call management accounting.
2. There are several other groups of people who may have an interest in the finances of
the business (often referred to as 'stakeholders'). The law says that they have a legal
right to certain information. The whole process of providing this information (and of
maintaining a book-keeping system which is capable of providing it) is known as
financial accounting.
The stakeholders of any firm could be any or all of the following:
1. Shareholders
2. Employees
3. Management
4. Customers
5. Government
6. Trade Unions and others
Question: Who owns the firm - management or shareholders?
Answer: Shareholders of course, as they hold shares of the company. However Management
personnel/directors of a company are also encouraged to hold shares of the company to align
the interest of management and shareholders. )
For Accounting purpose, Company is considered as a Legal Entity that is, a person or
organization that has the legal standing to enter into contracts and may be sued for failure to
perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a
corporation is a legal entity since it is a person in the eyes of the law.
In order that the stakeholders mentioned above understand the financial position of a company,
there are standardized financial statements that are prepared. The main ones are:
1. Balance Sheet
2. Income Statement or Profit and Loss Account
3. Cash-Flow statement
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Now, let us study them one at a time (why do we need to do that? Well, one of the aims of this
course is to ensure that we are familiar with the basic concepts and terms used in Finance. And
the above statements are as basic as it gets. SO read on)
BALANCE SHEET
A Balance sheet is a statement that lists the total assets and the total liabilities of a given
business to portray its net worth at a given moment of time. Thus, if we look at any balance
sheet, it is As on March 31st 200X (Or whatever the financial year ending date)
So, it indicates the health of the firm at a point of time.
What are the individual items in a Balance Sheet?
First of all its called a balance sheet because the Asset and Liabilities in a Balance sheet balance,
meaning they equal each other its as simple as that!
An Asset is anything owned by an individual or a business, which has commercial value. Claims
against others also qualify as Assets. (That is, if someone owes us something, then it is also an
asset, as it actually belongs to us and is of commercial value)
A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to
pay cash, or provide goods and services, in some future period. (Thus, if we buy a bike on
installments, Bike is of course an asset as it has capability to provide us service for next few
years, but the loan amount which we need to pay out in installments is a Liability we incur.)
The typical heads in a balance sheet are shown below with a sample:
Consolidated Statements of Financial Positions
(All number in thousands)
Assets
Liabilities
Current Assets
Current Liabilities
$100
$50
100
150
Receivables
200
100
Inventory
50
50
50
500
350
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200
Intangible Assets
100
Deferred Liabilities
50
Goodwill
50
Other Liabilities
100
Other Assets
50
Total Liabilities
700
Shareholders Equity
Equity
100
Retained Earnings
100
200
400
Total Assets
900
ASSETS:
CURRENT ASSETS
Current Assets are those assets of a company that are reasonably expected to be realized in
cash, or sold, or consumed in the next one year. Some current assets are listed below:
Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which can be
converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts, cash in
bank accounts etc).
Short Term Investments: All investments, which will be converted in Cash in the next one year.
All the assets (bonds etc) with less than one year time to maturity will be accounted under this
item (E.g. short term securities).
Receivables: Also referred to as Account receivables. This indicates the money due to the firm,
for service rendered or goods sold on credit.
Inventory: Inventory for companies includes raw materials, items available for sale or in the
process of being made ready for sale (work in process). For a stockbroker, it will be the
securities bought and held by him, for resale.
Other Current Assets: Anything else which could not be categorized in one of the items above
but we know that its a current asset can be accounted for here.
LONG-TERM ASSETS
Long-term assets are those assets that are not consumed during the normal course of business,
e.g. land, buildings and equipment, goodwill, etc. They include:
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Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct of
a business, and which will not normally be converted into cash during the next fiscal period. For
example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all
property, plant, and equipment, net of depreciation.
Depreciation
We all understand that if we buy a car today, after 5 years of service the value of the car would
not be same. We will not be able to sell the car after 5 years at the same price at which we
bought the car. This means that assets lose their value as they provide service. This loss of value,
or spreading of cost, is called depreciation.
Calculating deprecation can get complex, but heres one simple way of calculating depreciation.
Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the
3 years the asset will have a Zero value. What is the true value of the asset at the end of each
year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus:
Value of Asset
End of Year
$ (3000-1000)=$ 2000
$1000
$0
Usually, instead of the value coming all the way down to zero, it is said to have a scrap value:
say, $100. At this point, the asset is removed from the business books, or said to be written off
.
INTANGIBLE ASSETS:
Intangible Asset is an asset that is not physical in nature. Examples are things like copyrights,
patents, intellectual property, or goodwill. We can look at more details through an example of
Goodwill below.
Goodwill
Goodwill is that intangible possession which enables a business to continue to earn a profit that
is in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a
company such as Hindustan levers, has built up a lot of goodwill over the years. Customers
would prefer to buy their products versus an unknown brand. This is an intangible factor, yet
worth a lot of money!
OTHER ASSETS:
Again, any other asset, which could not be classified under any of the categories above, but one
is sure its an asset, can be accounted for here.
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LIABILITIES
CURRENT LIABILITIES
Current Liabilities are amounts, or goods and services, to be paid or executed, within next one
year.
Payables and Accrued Expenses: A Company might have suppliers who supply on credit, and
this is an Account Payable. An accrued expense is an expense that the company has already
incurred but company has not paid for it so far.
Short Term Loans: All the loans that have to be paid in the next one year.
Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid in
installments every year, and so just the money that has to be paid in the next one year would be
accounted here.
Other Current Liabilities: Any liabilities, which cannot be categorized under any of the headings
above.
LONG-TERM LIABILITIES
Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred portions
of long-term debt, and capital lease obligations. Please note that part of the loan that is due
only after next one year is indicated here.
Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or liability
is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this case, one
knows that there will be some expenses, but the exact amount and dates are not known.
Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above.
Equity This is basically equity share capital, which is capital raised by an entity through the sale
of common shares in the primary market. This is also called share capital.
Retained Earnings
Retained Earnings are profits of the business that have not been distributed to the owners as of
the balance sheet date. The earnings have been "retained" for planned activities such as
business expansion - so they actually belong to the owners (shareholders), but have been
retained.
Quiz: How do the three items above change when company declares dividend?
Answer: Nothing changes till the company pays out dividends.
Quiz: How do these items change when company pays out dividends?
Answer: Retained earnings go down by amount of dividend.
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Advanced Quiz: Are stock options same as shares held by employees? Are these captured in
these statements?
Answer: A stock option is the right of an employee to buy company shares at a pre-specified
price, which may be above or below the market price, as on date of the exercising of option. If
the option price is below the market price, the employee may buy at the option price & sell at
market price & thus realize a profit. If option price is above the market price as on that date,
obviously the employee will not prefer to exercise the option. Hence, the options cannot be
categorized as shares. However, in some balance sheets, provision may be made for these
stock options under the liability head.
INCOME (P & L) STATEMENTS
Profit And Loss Statement (P&L) is also known as an income statement. It shows business
revenue and expenses for a specific period of time (such as the financial year so if we look at
any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st
December 2003. The difference between the total revenue and the total expense is the
business net income.
A key element of this statement, and one that distinguishes it from a balance sheet, is that the
amounts shown on this statement represent transactions over a period of time while the items
represented on the balance sheet show information as of a specific date (or point in time). So in
engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesnt
have a memory.
It is important to understand that for a company Profit need not equal the Cash it has
generated during a period. It might so happen that company has provided the service but the
client has not yet paid and so company makes a Profit but not Cash. To account for cash
generated during a period, companies also report Cash flow statement.
A sample P&L statement is shown below.
P&L ACCOUNT STATEMENT
Revenue
Direct Cost
B = (C+D)
Direct Material
Direct Labor
Gross Profit
E = (A-B)
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R&D
Other Expenses
Operating Income
L = (E-F)
Other Income
Other Expenses
O = (L+M-N)
Interest Expenses
Q = (O-P)
Income Taxes
S= (Q-R)
T = S/ Number of shares
P/E Ratio
Market price/T
Gross Profit
Gross Profit is one of the key performance indicators. Gross profit shows the relationship
between sales and the direct cost of products/services sold. It is measured as indicated in the
table above.
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Indirect Cost
Indirect Cost is that portion of cost that is indirectly expended in providing a product or service
for sale (cannot be traced to a given project, in our case, in an economically feasible manner)
e.g. rent, utilities, equipment maintenance, etc.
Operating Expenses
Operating Expenses is all selling and general & administrative expenses. This includes
depreciation, but not interest expense.
Operating Income
Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related
operating expenses that are applied to the day-to-day operating activities of the company. It
excludes financial related items (i.e., interest income, dividend income, and interest expense),
and taxes.
EBIT (Earnings before Interest and Taxes)
Its the earnings before any interest or taxes.
Interest Expenses
Interest expense captures all the finance charges incurred on any borrowed capital.
Profit before Tax (PBT)
Profit earned before accounting for Taxes.
Income Taxes
Amount of tax paid. This is a % of PBT.
Net Income or PAT (Profit after Tax)
This is the profit after all the obligations, which can be distributed to shareholders. This is also
referred as the Bottom-line (as this is the bottom line in a P &L statement, or the final profit
net of expenses & tax.
EPS (Earnings per Share)
Earnings per Share (EPS) is the amount of net income (earnings) related to each share;
computed by dividing net income by the number of shares outstanding during the period.
P/E Ratio
Price to Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison
against other companies or within the stock's own historical performance. For instance, if a
stock has historically run at a P/E of 35 and the current P/E is 12, we may want to explore the
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reasons for the drastic change. If we believe that the ratio is too low, we may want to buy the
stock.
There are a number of other ratios that help analysts to analyze the financial statements of
companies to understand the current performance and future prospects; we are not
discussing those here.
CASH FLOW STATEMENT
Statement accounting for all the inflows and outflows of cash is captured in this statement.
Why do we need a separate Cash-flow statement?
Isnt it covered in Balance sheet or Income statement?
All the accounting is done based on the method wherein, revenue and expenses are recorded in
the period in which they are earned or incurred regardless of whether cash is received or
disbursed in that period. So when a good is sold or some service rendered, it will show in
Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is
received for the same.
Quiz: How will we explain a scenario where company is reporting a large profit but company
doesnt have the cash to pay salary to its employees? Where is the cash going or did it come at
all?
Answer: It means that the company is selling goods and also making profits but has not received
cash payments from its customers!
Exercise
1. Day 1: We borrow Rs 100 from a bank for a business to produce t-shirts. How would our
balance sheet look like at the end of the day?
2. Day 2: We purchase raw material for your products for Rs 50. How would our balance
sheet look like at the end of the day?
3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The
product is ready to be shipped to customer.
4. Day 30: We pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay
other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the
day the product is shipped to the customer. Customer has promised to pay you Rs 120
after checking the quality, which will take 5 days. How would our balance sheet look like
at the end of the day? How would our Income statement look like?
5. Day 35: You get Rs 120 from customer. You also get admission in a Business School and
so you plan to wind up the business. Prepare all the financial statements (Balance sheet
and Profit and loss statement at the end of day 35).
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Useful Information: Bank charges 12% simple interest rate. We need to pay tax @ 10% of the
net income. Inflation for the period was 5%.
Advanced Exercise
Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this
60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred
in rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US
infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is
incurred in rupees. By what percentage, will the profit increase/decrease if the rupee
appreciates by 1% from its current level of Rs. 50 per dollar?
Understanding Cognizants Financial Statements
COGNIZANTS BALANCE SHEET
In Millions of USD
(except for per share
items)
Cash & Equivalents
Short Term Investments
Cash and Short Term
Investments
Accounts Receivable Trade, Net
Receivables - Other
Total Receivables, Net
Total Inventory
Prepaid Expenses
Other Current Assets,
Total
Total Current Assets
As of 2008-12-31
As of 2006-12-31
As of 2005-12-31
735.07
27.51
339.85
330.58
265.94
382.22
196.94
227.06
762.58
670.42
648.16
424.00
579.64
436.46
298.48
176.70
579.64
-
436.46
-
298.48
-
176.70
-
125.90
135.30
93.76
62.73
1,468.12
1,242.18
1,040.39
663.42
499.03
315.69
211.72
148.79
27.19
18.22
45.56
20.46
16.28
0.00
Property/Plant/Equipment
654.44
, Total - Gross
Goodwill, Net
154.03
Intangibles, Net
As of 2007-12-31
47.79
45.73
17.78
24.99
1,838.31
1,325.98
869.89
Accounts Payable
39.97
36.18
27.84
16.42
Accrued Expenses
Notes
Payable/Short
Term Debt
Current Port. of LT
Debt/Capital Leases
Other Current liabilities,
Total
Total Current Liabilities
298.17
272.34
200.54
119.29
0.00
0.00
0.00
0.00
49.44
32.16
21.13
18.08
387.58
340.68
249.50
153.79
0.00
0.00
0.00
Total Debt
0.00
0.00
0.00
0.00
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7.29
15.14
0.00
Minority Interest
14.11
14.27
2.98
1.95
Total Liabilities
408.98
370.10
252.48
155.75
2.88
2.85
1.39
541.74
450.57
408.59
293.15
1,430.40
999.56
650.28
417.48
Redeemable
Preferred
Stock, Total
Preferred Stock - Non
Redeemable, Net
Common Stock, Total
2.92
Additional Paid-In Capital
Retained
Earnings
(Accumulated Deficit)
Treasury
Stock
Common
Other Equity, Total
Total Equity
Total
Liabilities
Shareholders' Equity
&
-9.48
15.20
11.78
2.12
1,965.58
1,468.21
1,073.50
714.14
2,374.56
1,838.31
1,325.98
869.89
288.01
285.03
278.69
419.71
326.15
419.75
333.30
405.94
328.79
380.87
304.56
366.26
276.84
166.87
169.38
166.69
167.10
148.85
21.15
21.25
19.47
17.78
16.29
607.73
610.38
592.10
565.75
531.41
138.13
142.67
142.63
119.68
111.69
-12.34
136.09
-14.78
133.20
-0.48
124.06
3.95
121.87
113.13
112.29
112.83
103.86
101.87
Minority Interest
Equity In Affiliates
Net Income Before Extra. Items
113.13
112.29
112.83
103.86
101.87
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Accounting Change
Discontinued Operations
Extraordinary Item
Net Income
113.13
112.29
112.83
103.86
101.87
112.29
112.83
103.86
101.87
112.29
112.83
103.86
101.87
Dilution Adjustment
Diluted Weighted Average Shares
297.99
Diluted EPS Excluding Extraordinary
0.38
Items
297.57
0.00
299.81
0.00
299.33
0.00
299.05
0.38
0.38
0.35
0.34
0.00
0.00
0.00
0.00
0.00
0.38
0.38
0.38
0.35
0.34
Preferred Dividends
Income Available to Common Excl.
113.13
Extra Items
Income Available to Common Incl.
113.13
Extra Items
-169.41
-146.32
-85.21
-53.42
114.40
112.87
110.90
119.58
-55.01
-33.45
25.69
66.16
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Financing Cash Flow Items
1.82
16.99
16.26
15.16
4.04
-4.12
27.04
20.98
40.29
12.83
0.00
-2.30
44.03
37.24
55.45
16.88
-5.74
-23.51
-11.16
3.18
4.60
23.50
395.22
229.42
181.35
109.89
82.80
2.0
BANKING
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2.1
INTRODUCTION TO BANKING
Channelize Savings
Provide Services
2.1.3
The Central bank of any country can be called the bankers bank. It acts as a regulator for other
banks, while providing various facilities to facilitate their functioning. It also acts as the
Governments bank. The Federal Reserve is the central bank of the United States, while Reserve
Bank of India is the central bank in India.
The main objective of a central bank is to provide the nation with a safer, more flexible, and
more stable monetary and financial system. They have the following responsibilities:
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Conducting the nation's monetary policy. Central banks define the monetary policy and then
take necessary actions to create an environment to make those policies feasible. E.g. if the
central bank wants to maintain soft interest rate, they can reduce the CRR to pump in more
money in the economy.
Supervising and regulating banking institutions and protecting the rights of consumers
Maintaining the stability of the financial system, i.e. stability of interest rates and foreign
exchange rate.
Ensuring that the interest rates remain at such a level as to make business viable
Ensuring that sufficient funds are available for long term investment to businesses as well as
government, without causing inflation to rise
Providing certain financial services to the government, the public, financial institutions, and
foreign official institutions
Monitoring the foreign currency assets and liabilities and monitoring the inflow and outflow
of foreign currency
2.1.4
Banks facilitate the creation of money in the economy. The primary function of banks is to put
account holders' money to use by lending it out to others who can then use it to buy homes,
businesses etc.
Lets look at an example as how banks do this. The amount of money that banks can lend is
directly affected by the reserve requirement set by the Central Bank. That is, every bank needs
to maintain a certain percentage of its total deposits as cash, to ensure liquidity. This reserve
requirement is also known as the CRR (Cash Reserve Ratio). When a bank gets a deposit of $100,
assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back
into the economy, purchasing goods or services, and usually ends up deposited in another bank.
That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to
purchase goods or services and ultimately is deposited into another bank that proceeds to lend
out a percentage of it. In this way, money grows and flows throughout the community in a much
greater amount than physically exists. This is also called multiplier effect. In the picture below,
an initial deposit of $100 has created a reserve of $27, and loan of $244. Thus, banks facilitate
the investing/spending of money that multiply funds through circulation and this is known as
Money Multiplier effect.
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2.1.5
Banks are like any other regulated business; the product they deal with is Money. So they
borrow money from individual or businesses who have money, and lend it to those who need
money, by adding a mark up, to pay for expenses and profit. The difference between the rates,
which banks offer to depositors and lenders, is generally referred to as Spread.
Understandably, the spread in this business is low; hence increasing the turnover (volume) is the
key to making profit. Hence, in practice, banks offer a number of options often termed as
products - to both investors and borrowers to meet their different requirements and
preferences and thus increase business. They also provide fee-based services such as managing
cash for corporate clients, to increase business and improve profit margin.
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2.1.6
Corporate Banking
o
Trade Finance
Cash Management
Retail Banking
o
Retail Lending Personal Loans, Home Mortgages, Consumer Loans, Vehicle Loans
Investment Banking
o
Private Equity
Corporate Advisory
Capital Raising
Proprietary Trading
Emerging Markets
Total Assets
$2,175,052,000
CITIGROUP INC.
$1,938,470,000
$1,822,068,028
$1,309,639,000
$434,715,911
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TAUNUS CORPORATION
$396,659,000
$291,092,876
U.S. BANCORP
$267,032,000
$237,652,000
10
$189,137,961
11
$176,632,334
12
$165,913,451
13
$160,444,183
14
BB&T CORPORATION
$152,015,025
15
$146,253,935
16
TD BANKNORTH INC.
$122,745,454
17
$119,763,812
18
KEYCORP
$105,231,004
19
$88,258,094
20
$82,053,626
21
BANCWEST CORPORATION
$79,858,266
22
UNIONBANCAL CORPORATION
$70,121,446
23
COMERICA INCORPORATED
$67,912,580
24
$65,815,757
25
$62,517,618
26
$62,305,413
27
ZIONS BANCORPORATION
$55,339,951
28
$54,355,998
29
POPULAR, INC.
$38,883,000
30
$35,786,269
31
$32,488,105
32
$32,434,425
33
$31,022,768
34
$25,816,306
35
ASSOCIATED BANC-CORP
$24,198,697
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36
$22,840,287
37
FIRST BANCORP
$19,491,268
38
$17,600,122
39
$17,545,887
40
FBOP CORPORATION
$17,346,706
41
$16,782,760
42
$16,745,662
43
$16,725,869
44
$16,458,765
45
$16,185,106
46
$15,317,974
47
$14,744,507
48
$13,682,988
49
$13,600,077
50
BANCORPSOUTH, INC.
$13,499,414
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Example
In the late 1990s, before legislation officially eradicated the Glass-Steagall Acts restrictions, the
investment and commercial banking industries witnessed an abundance of commercial banking
firms making forays into the I-banking world. The mania reached a height in the spring of 1998.
In 1998, NationsBank bought Montgomery Securities, Socit Gnerale bought Cowen & Co.,
First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought
Robertson Stephens (and then sold it to BankBoston), Deutsche Bank bought Bankers Trust
(which had bought Alex. Brown months before), and Citigroup was created in a merger of
Travelers Insurance and Citibank.
While some commercial banks have chosen to add I-banking capabilities through acquisitions,
some have tried to build their own investment banking business. J.P. Morgan stands as the best
example of a commercial bank that has entered the I-banking world through internal growth.
J.P. Morgan actually used to be both a securities firm and a commercial bank until federal
regulators forced the company to separate the divisions. The split resulted in J.P. Morgan, the
commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and
steadily clawed its way back into the securities business, and Morgan Stanley has merged with
Dean Witter to create one of the biggest I-banks on the Street.
SUMMARY
Banks are an integral part of any economy channelizing savings from lenders to borrowers
The Central bank is the Bankers Bank and it regulates other banks in an economy.
A bank makes a profit by investing or lending money that is earning a higher rate of interest
than it pays to its depositors.
Banks are generally organized as corporate banking, investment banking, retail banking, and
private banking functions.
Universal banks provide commercial banking as well as investment bank services under one
roof
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3.0
RETAIL BANKING
3.1
INTRODUCTION
Retail banking addresses the banking and financial services needs of individuals also called
Consumers and small medium enterprises (SME) or Small Businesses with say less than 1 M USD
in revenue, otherwise called retail customers. Retail transactions are typically large volume low
value but strongly governed by consumer friendly regulations and are critical to a bank. Retail
banks or stores offer various services such as - Deposits (savings and checking accounts), Loans
(mortgages, personal), debit cards, credit cards, investment products and so on. This is a typical
mass-market banking in which individual customers use local branches, ATMs, Online banking,
Phone Banking, Contact Centers and recently mobile banking for their financial / banking needs.
In some geography such as Europe, APAC, Middle East retail banks also offer investment
services such as wealth management, brokerage accounts, private banking and retirement
planning for High Nett-worth Individuals.
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This section of the document (Retail Banking) deals with only Retail Bank Liabilities or in other
terms Deposit Products and Services. The retail bank assets (Cards and Payments, Consumer
Lending, Mortgages) are dealt in separate sections.
3.2
DEPOSIT PRODUCTS
Banks offer the facility of holding excess cash of a consumer and pay an interest for the money
placed with it. Deposits can be of two types Demand deposits are accounts that allow money
to be deposited and withdrawn by the account holder on Demand (Savings, Checking). Another
Class of deposits is placed with a bank for a specified term and is called Term Deposits. Banks
may charge a maintenance fee for this service, while others may pay the customer interest on
the funds deposited.
Features of Deposit Products:
1. A customer can deposit and withdraw money from his Deposit Account. The frequency
and limit of withdrawal differs from account to account.
2. Checks can be issued by the customer to withdraw or transfer money from his account.
There may be restrictions as to number of checks issued in a month.
3. Interest is generally paid for all deposit products except for certain type of accounts like
checking accounts.
4. A minimum balance needs to be maintained in most of the accounts, failing which the
bank will charge a penalty. But there are certain types of accounts like No frill accounts
or Zero Balance accounts in which the customer need not maintain any balance.
5. Given below is the snap shot comparison of all the major types of accounts in a retail
bank:
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Roth IRA - contributions are made with after-tax assets, all transactions within
the IRA have no tax impact, and withdrawals are usually tax-free.
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3.3
SEP IRA - a provision that allows an employer (typically a small business or selfemployed individual) to make retirement plan contributions into a Traditional
IRA established in the employee's name, instead of to a pension fund account in
the company's name.
SIMPLE IRA - a simplified employee pension plan that allows both employer and
employee contributions, similar to a 401(k) plan, but with lower contribution
limits and simpler (and thus less costly) administration. Although it is termed an
IRA, it is treated separately.
Self-Directed IRA - a self-directed IRA that permits the account holder to make
investments on behalf of the retirement plan.
RETAIL CHANNELS
A banking system in which there is a head office and interconnected branches providing
financial services in different parts of the country
Branch networks have re-emerged as combined centers for advice-based product sales and
service, in addition to traditional banking transactions
Branches are being transformed from transaction processing centers into customer-centric,
financial sales and service centers
Teller Operations
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Relationship Managers
TELLER OPERATIONS
A bank teller is an employee of a bank who deals directly with most customers. In some
places this employee is known as a cashier. Tellers are considered a "front line" in the
banking business. This is because they are the first people that a customer sees at the bank
and are also the people most likely to detect and stop fraudulent transactions in order to
prevent losses at a bank (i.e. counterfeit currency and checks, identity theft, con artist
schemes, etc.). The position also requires tellers to be friendly and interact with the
customers, providing them with information about customers' accounts and bank services.
Most tellers have a window (or wicket), a computer terminal, and a cash drawer from which
they perform their transactions. These transactions include, but are not limited to:
Consignment item issuances (i.e. Cashier's Checks, Traveler's Checks, Money Orders,
Federal Draft issuances, etc.)
Payment collecting
Cash advances
May include ordering products for the customer (checks, deposit slips, etc.)
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3.3.3 ATM
ATMs are known by various other names including automated banking machine, money
machine, bank machine, cash machine, hole-in-the-wall, cash point, Bancomat (in various
countries in Europe and Russia), Multibanco (after a registered trade mark, in Portugal), and
Any Time Money (in India).
Debit cards and ATM cards are used to transact in ATMs and PoS (Point of Sale) Terminals.
Visa and Master networks are large global networks that service ATMs
The Bank / Entity that issue the card to the customer is called an Issuer while the
Bank/Entity that acquires the transaction through the ATM / PoS terminal is an acquirer. The
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network handles the routing of the transaction from the Acquirers terminal to the
accounting systems of the Issuer and processes the settlements through the intermediary
networks.
Telephone banking allows customers to perform transactions over the telephone. Most
telephone banking configurations use an automated phone answering system (IVR/VRU)
with phone keypad response or voice recognition capability.
Voice Response Unit (VRU), is a computer telephony integration (CTI) term that refers to
the interaction between a human (typically a caller) and a computer that is programmed
to respond to the human's requests.
With the obvious exception of cash withdrawals and deposits, it offers virtually all the
features of an automated teller machine: account balance information and list of latest
transactions, electronic bill payments, funds transfers between a customer's accounts,
etc.
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Fund transfer: Funds transfer between a customers own checking and savings accounts
or to another customers account
Transactions:
Micro-payment handling
Investments:
Support:
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Exchange of data messages and email, including complaint submission and tracking
Content Services:
3.4
INSTRUMENTS
Instruments are used to move and /or transfer funds from one account to another. The account
can be of the same person or different individuals. Instruments are also modes of payment.
Some of the common instruments are as follows:
Checks
Cashiers check
Certified Check
Travelers Check
3.4.1
3.4.2
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3.4.3
RETURNED/ITEM PROCESSING
Not all checks move easily through the check collection system, however. Sometimes a
check is returned for various reasons like insufficient funds, improper details, signature
not clear etc. If a bank refuses to honor a check, the check must be returned to the bank
where the check was first deposited within a certain period specified by law. The bank
then investigates the item and takes corrective action to process the check. These are
called exceptions or returned items.
3.4.4
3.5
The check can be processed through an electronic system that captures the
banking information and the amount of the check.
Once the check is processed, the customer signs a receipt authorizing the store
to present the check to the bank electronically and deposit the funds into the
stores account.
The customer gets a receipt of the electronic transaction and the check is
returned to the customer.
RETAIL PAYMENTS
Retail payments usually involve transactions between consumers and businesses. Although
there is no definitive division between retail and wholesale payments, retail payment systems
generally have higher transaction volumes and lower average dollar values than wholesale
payments systems. This section provides background information on payments typically
classified as retail payments. Consumers generally use retail payments in one of the following
ways:
Purchase of Goods and ServicesPayment at the time the goods or services are
purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending
machines), and remote purchases (e.g., Internet and telephone purchases). A variety of
payment instruments may be used, including cash, check, credit, or debit cards.
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as utility, telephone, and mortgage/rent bills. Non-recurring bills include items such as
medical bills
3.6
Shift from paper to electronic payments: Recent research has found that consumer use
of electronic payments has grown significantly in recent years, and the trend will
accelerate.
Increase in Online Transactions: Debit and credit cards were one of the key drivers for
much of the growth in electronic payments. Although on-line, or PIN-based, debit cards
were introduced in the early 1980s, rapid adoption has only occurred since the early
1990s. Off-line, or signature-based, debit cards, introduced in the late 1980s, have
experienced significant growth since the mid 1990s, and recent surveys have found that
off-line debit card transactions have now overtaken on-line debit card transactions by
almost a three-to-one margin.
Growth in ACH Payments: Consumers traditionally used checks for a large portion of bill
payments in the United States. However, consumers are increasingly using direct bill
payment through the ACH. Despite the increase in electronic bill payment, many
consumers still rely on checks to make a significant portion of their bill payments. More
recently, retail firms have employed check to ACH conversion processes to allow
electronic settlement, thus reducing the number of checks that flow through the
payment system.
Internet Banking and Internet Payment Processors PayPal, Google Expedited Bill
Payments Internet-based bill payment systems are transaction origination platforms
that allow customers to initiate bill payments using existing payment systems.
Depending on the bill payment software, service provider, and payment receiver used,
the payment transaction may be processed as an electronic funds transfer (EFT), ACH, or
check
ELECTRONIC BANKING
For many of us, electronic banking means 24-hour access to cash through an automated teller
machine (ATM) or Direct Deposit of paychecks into checking or savings accounts. But electronic
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banking now involves many different types of transactions like Electronic Bill presentment,
Mobile banking, Online Banking, Electronic Check Conversion etc.
Electronic banking, also known as electronic fund transfer (EFT), uses computers and payment
networks as a substitute for checks and other paper transactions. EFT is initiated through
devices like cards or codes that let the customer access their account. Many financial
institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose.
Some use other forms of debit cards such as those that require, at the most, signature or a scan.
The federal Electronic Fund Transfer Act (EFT Act) covers some electronic consumer transactions
Direct Deposit
Internet Banking
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Once a consumer has enrolled for EBPP services, the biller generates the electronic version of
the Consumers Billing information. The biller may outsource this using BSP (Bill Service
Provider). The BSPs /Billers provide such services as electronic bill translation, formatting, data
parsing, notifying the consumer of pending bill. The consumer logs on to the specified website
where he is allowed to view/print the E-bill. He can initiate payment directly from the same
website.
3.7
Banking has evolved from its traditional role as the place of Savings and Deposits. With the
prevailing competition in the market among the banks, a serious effort has to be made by each
bank to promote themselves and their products. A Retail bank will typically concentrate in the
following areas:
Product Development :
Increase the knowledge about the market place, Check the new product viability,
competitively price the product and identify new innovations.
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3.8
The banking operations are basically divided in to three; Front office, Middle Office and Back
Office. Front office is what we otherwise call the Banking channels Branch, ATM, Banks
Website, etc. where the customers contact the Banks representatives for their financial
services. Middle Office is where the decisions are made about the product, interest rate, credit
policies, Compliance monitored etc. Back office mostly does the data base management, data
processing, transaction processing etc. The Middle Office and Back Office operations are
generally not exposed to the customers. The picture below gives an overview of all the
operations in retail bank.
SUMMARY
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Retail banks have various flavors such as Community Development Banks, private Banks,
Offshore Banks, Savings Banks and Postal Banks.
Retail Banking has both assets and liabilities and only Liabilities (deposit products) are dealt
in this document
Checking accounts
Savings Accounts
Time Deposits
IRA
Branch Banking
Core Banking
ATM
Telephone Banking
Call Centre
Online Banking
Mobile Banking
Checks can be processed in various modes: Paper check processing, check imaging /Check
truncation, Electronic Check conversion.
Consumers generally use one of these retail payments systems: Purchase of Goods and
Services, Bill Payment, P2P payments, Cash withdrawals and Advances.
Electronic banking, also known as electronic fund transfer (EFT), uses computer and
electronic technology as a substitute for checks and other paper transactions.
The federal Electronic Fund Transfer Act (EFT Act) covers most (not all) electronic customer
transactions.
EBPP is a mode of transaction involving the use of electronic means, such as email or a short
message, for rending a bill.
Sales and marketing strategies have gained importance currently. Every bank is seriously
working towards promoting their products in the market.
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4.0
4.1
MORTGAGE
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ORIGINATION
This is a process by which a mortgage is secured by a borrower is called origination. This involves
the borrower submitting an application and documentation related to his/her financial history
and/or credit history to the underwriter. A borrower is required to lock a certain rate scenario,
out of the given scenarios, after which his loan can go for processing.
PROCESSING
This process ensures that documentary requirements are fulfilled and regulatory checks are
done. The borrower may be asked for additional information and supporting documentary
proof(s) about his employment credentials, financial position, property details and other assets
and liabilities associated with the borrower. Various reports, like credit report, property
appraisal etc. are also required for file processing, which are fired at this stage.
UNDERWRITING
This is a process by which a lender determines if the risk of lending to a particular borrower
under certain parameters is acceptable. Most of the risks and terms that underwriters consider
fall under the three Cs of underwriting: Credit, Capacity and Collateral. To help the underwriter
assess the quality of the loan, banks and lenders create guidelines and even computer models
that analyze the various aspects of the mortgage and provide recommendations regarding the
risks involved. However, it is always up to the underwriter to make the final decision on whether
to approve or decline a loan.
CLOSING AND FUNDING
After the loan has been underwritten and the borrower agrees with the loan terms, the loan
moves into the Closing and Funding stage(s) when the actual contracts are signed and sent, the
property is registered and the seller payments are cleared.
LOAN SERVICING
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Loan servicing (sometimes also referred to a Loan Administration) refers to the part of the
mortgage value chain that starts after the closure of the loan and extends till the loan is fully
repaid and settled. It includes activities such as cash management for periodic payments and
disbursements, investor accounting, investor reporting, customer servicing, delinquency
management, records management etc.
As shown in the schematic above, Loan Servicing involves collecting monthly payments from
borrowers, remitting the payments to the investors (or security holders), handling contacts with
borrowers about payments & delinquencies, maintaining records, initiating foreclosure
procedures and handling taxes and insurance premiums (through escrow accounts as
applicable).
The collection of mortgage payments and the periodic remittance of these payments to the
investors (or conduits) is the major task of servicers. In addition, servicers are the primary
repository of information on the mortgage loans. Thus, they must maintain accurate and up-to
date information on mortgage balances, status and history and provide timely reports to
investors.
How it works
Fixed Rate
Balloon
Payment Balloon Payment Mortgage has a fixed rate for the term of the loan
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Loan Type
How it works
Mortgage
Negative
Amortization
Standard
Variable Same as a standard ARM loan - but one receive a substantial cash sum
Rate with Cash Back
(Example 35% of the amount borrowed) when we take up the loan.
Discounted
rate
The payments are variable, but they are set at less than that lenders
going rate for a fixed period of time. At the end of the period, one is
charged the lenders standard variable rate.
Capped rate
interest
The payments go up and down as the mortgage rate changes but are
guaranteed not to go above a set level (the cap) during the period of
the deal.
Sometimes, they cannot fall below a set minimum level either (the
collar or floor). At the end of the period, one is charged the lenders
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Loan Type
How it works
standard variable rate.
Loan Program
How it works
FHA Loan
FHA loans are meant for lower income Americans to borrow money for
the purchase of a home that they would not otherwise be able to
afford. FHA loan is a federal assistance mortgage loan in the United
States insured by the Federal Housing Administration. The loan may be
issued by federally qualified lenders.
VA Loan
Conventional Loans
Agency Loans
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loan. Instead, the bank acts as a middleman between the home buyer and the investment
markets.
Buoyant retail savings receipts, and reduced reliance on relatively expensive wholesale
markets for funds (especially when interest rates generally are being maintained at high
levels internationally);
Lower levels of arrears, possessions, bad debts, and provisioning than competitors;
Increased flexibility and earnings from secondary sources and activities as a result of
political-legal deregulation; and
Being specialized or concentrating on traditional core, relatively profitable mortgage lending and
savings deposit operations.
Mortgage types
Since 1982, when the market was substantially deregulated, there has been substantial
innovation and diversification of strategies employed by lenders to attract borrowers. This has
led to a wide range of mortgage types.
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As lenders derive their funds either from the money markets or from deposits, most mortgages
revert to a variable rate, either the lender's standard variable rate or a tracker rate, which will
tend to be linked to the underlying Bank of England (BoE) repo rate (or sometimes LIBOR).
Initially they will tend to offer an incentive deal to attract new borrowers. This may be:
A fixed rate; where the interest rate remains constant for a set period; typically for 2, 3, 4, 5 or
10 years. Longer term fixed rates (over 5 years) whilst available, tend to be more expensive
and/or have more onerous early repayment charges and are therefore less popular than shorter
term fixed rates.
A capped rate; where similar to a fixed rate, the interest rate cannot rise above the cap but can
vary beneath the cap. Sometimes there is a collar associated with this type of rate which
imposes a minimum rate. Capped rate are often offered over periods similar to fixed rates, e.g.
2, 3, 4 or 5 years.
A discount rate; where there is set margin reduction in the standard variable rate (e.g. a 2%
discount) for a set period; typically 1 to 5 years. Sometimes the discount is expressed as a
margin over the base rate (e.g. BoE base rate plus 0.5% for 2 years) and sometimes the rate is
stepped (e.g. 3% in year 1, 2% in year 2, 1% in year three).
A cash back mortgage; where a lump sum is provided (typically) as a percentage of the advance
e.g. 5% of the loan.
To make matters more confusing these rates are often combined: For example, 4.5% 2 year
fixed then a 3 year tracker at BoE rate plus 0.89%.
With each incentive the lender may be offering a rate at less than the market cost of the
borrowing. Therefore, they typically impose a penalty if the borrower repays the loan within the
incentive period or a longer period (referred to as an extended tie-in). These penalties used to
be called a redemption penalty or tie-in, however since the onset of Financial Services Authority
regulation they are referred to as an early repayment charge.
Mortgage lenders usually use salaries declared on wage slips to work out a borrower's annual
income and will usually lend up to a fixed multiple of the borrower's annual income. This
mortgage is similar to alt-doc (low-doc) mortgage in US market. Self Certification Mortgages,
informally known as "self cert" mortgages, are available to employed and self employed people
who have a deposit to buy a house but lack the sufficient documentation to prove their income.
This type of mortgage can be beneficial to people whose income comes from multiple sources,
whose salary consists largely or exclusively of commissions or bonuses, or whose accounts may
not show a true reflection of their earnings. Self cert mortgages have two disadvantages: the
interest rates charged are usually higher than for normal mortgages and the loan to value ratio
is usually lower.
100% mortgages
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Normally when a bank lends customer money, they want to protect their money as much as
possible; they do this by asking the borrower to fund a certain percentage of the property
purchase in the form of a deposit.
100% mortgages are mortgages that require no deposit (100% loan to value). These are
sometimes offered to first time buyers, but almost always carry a higher interest rate on the
loan.
Together/Plus mortgages
4.2
Federally sponsored loans These loans are federally insured and provide protection
against default. The department of Education guarantees up to 98% and even 100% in
some cases
Non-federally sponsored loans These are insured by the private sector and have no
government backing. The guarantee in this case is only from the private insurers or from
the reserves pledged to securitization
Federal Family Education Loan Program (FFELP) - These loans are made by financial
institutions primarily with a floating rate that is adjusted once a year. The interest rate is
capped at 8.25% and the Fed subsidizes the difference between the actual loan rate and
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the rate cap through Special Allowance Payments (SAP). The rates are usually specified
by indexing them to the US Treasury bill rates.
Federal Direct Loan (FDLP)- where the department of Education directly provides the
loans
FFELP or the Federal Family Education Loan Program can further be divided into four types
Federal Stafford Federal Stafford loans are the most common source of education loan
funds in the US. This is available to both graduate and undergraduate students. This loan
could be either subsidized or unsubsidized by the federal government. The interest rate
is a floating rate that is indexed to the 91 day T-Bill and is capped at 8.25%. Sample rates
of during the year 2003-04 were
1.
2.
Federal PLUS - PLUS loans are availed by the parents of a full- or half-time
undergraduate student. This requires a credit check and hence the parent must have a
good credit history and should have been a citizen or permanent resident of US. The
loans dont require any collateral and the interest payments are tax deductible.
Interest rate In a low rate scenario the borrower can reduce his cost of borrowing
by taking a new loan at the low prevailing low rates
Repayment The repayment period is extended to 30 years and this reduces the
installment to paid each month
Graduate Plus - The Graduate PLUS loan or Grad PLUS loan is a low, fixed interest rate
student loan guaranteed by the U.S. Government. The Grad PLUS loan is a non-need
credit based loan similar to a private student loan, but with the benefit of having a fixed
interest rate and federal guarantee. The Grad PLUS Loan allows graduate students to
borrow the total cost for their graduate school needs, including tuition, room and board,
supplies, lab expenses, and travel, less any other aid.
The Key Entities in the Student Loan System are Federal government, Schools, Lenders, Servicers
and guarantors and the borrower.
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Federal government: Sponsors and authorizes funds for grants and loan programs.
Lenders: are the institutions approved by the DOE for voluntary participation in any
or all of the FFELP student loan programs. Typical lenders are usually Banks, credit
unions, S&L institutions, insurance companies and other institutions.
Guarantor is a state agency, which guarantees or insures the loan and is a not-forprofit agency. It protects the lenders against loss due to borrower default, death of
borrower, total and permanent disability, bankruptcy, closed school, and ineligible
borrower.
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10% bonus on voluntary repayments, many people elect not to pay off their debt in advance of
the required repayments because it still works out to be probably the cheapest loan someone
will ever receive. If a person with a HELP debt dies, the debt is cancelled.
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Morgan Chase, General Motors Acceptance Corporation, Ford Motor Credit, Bank of America,
Toyota Motor Credit, Hyundai Motor Finance Company (HMFC) etc.
On the other hand wholesale lending is about financing the auto dealer. The dealer is financed
with a variety of loan products, mainly floor plans for financing the purchase of cars from the
automobile manufacturer.
GMAC has definitely led the way in the car loan business. But, of course, the other major
manufacturers also recognized the profitability associated with the auto loan business and
entered the market. These companies are known as captive finance companies. Captive
Finance is a term to signify that the lending company is wholly owned by the automobile
manufacturer. Examples, other than GMAC, are NMAC (Nissan Motor Acceptance Corporation),
Ford Credit (Ford Motor Credit Company), Hyundai Motor Finance Company (HMFC), Chrysler
Credit (Daimler-Chrysler).
The following section describes the multiple mechanisms by which the financing for auto loans is
normally done.
Types of Financing Mechanism
Direct Lending: The Bank or the finance company directly lends to the buyer or the
borrower in this case. A number of lending institutions are offering such loans on their
websites.
Dealer financing: This is a type of loan available through the dealer. The lending and
repayments are done by/to the dealer. Basically the dealer tells the customer how much
down payment and monthly Installment is to be paid against the vehicle. The effective
cost to the customer most of the times is generally more than the original price.
Leasing: Vehicle/ Auto lease is a contract between the borrower and an auto leasing
company. The borrower agrees to pay the leasing company for the use of the vehicle for
a certain amount of time, usually 24 to 36 months. During that time the borrower
agrees to make monthly lease payments, keep the car in good repair, insure the car and
not drive the car more miles that stipulated in the contract.
The Key entities in a lease agreement are the lessee and the lessor.
Lessee or the borrower: The party to whom the vehicle is leased. In a consumer lease, the lessee
is the consumer. The lessee is required to make payments and to meet other obligations
specified in the lease agreement.
Lessor or the lender or the lending institution is the original owner of the vehicle or property
being leased
The lease can be closed ended or open ended as defined below:
Closed end lease - A lease agreement that establishes a non-negotiable residual value
for the leased auto and fee amounts due at the end of the lease term.
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Open End lease - A lease term that requires the lessee to pay the difference between
residual value and fair market value at the end of the lease term if the fair market value
is lower
In a lease, the factors such as the ownership, upfront costs and monthly payments as against the
direct lending are:
Ownership: We do not own the vehicle. We get to use it but must return it at the end of
the lease unless we choose to buy it.
Up-front costs: Up-front costs may include the first month's payment, a refundable
security deposit, a capitalized cost reduction (like a down payment), taxes, registration
and other fees, and other charges.
Monthly payments: Monthly lease payments are usually lower than monthly loan
payments because we are paying only for the vehicle's depreciation during the lease
term, plus rent charges (like interest), taxes, and fees.
Borrower: is the one who needs to use/own the automobile and approaches a
dealer/lender for getting financing for the same
Dealer: Typically a franchisee of the manufacturer, involved in selling and delivery of the
vehicle to the buyer
Lender: Provides capital to the borrower for buying the vehicle. This can be captive
financiers, the banks, Credit unions and auto finance companies.
Credit bureau: Tracks and maintains credit history of borrowers and forward it to
lenders during new application processing. This is used for deciding whether the loan
should be provided to a customer or not.
Appraiser: Assesses and establishes the fair market value of collateral offered as
underlying security to the credit asked for.
Insurer: The Insurance company insures the vehicle owner against specific liabilities
caused to and from the vehicle during the course of its use upon the payment of a
premium and signing of a contract
Loan servicer: is the one who provides various services during the life cycle of a loan
starting from loan origination to loan closure.
Collection agencies: These are typically third party agencies that assist auto lenders with
chronic delinquent accounts.
Repossession agencies: These are third party agencies which assist auto lenders with
repossession of vehicles.
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Valuation agencies: Black book and ALG help auto lenders with valuation of vehicles
2.
3.
4.
Managing payment defaults in case customer doesnt pay the installment amount. This
involves following up the customer for payments. In case of payment default the account
is termed to be a delinquent account. The lender can repossess the vehicle if payments
are not forthcoming despite follow up. The outstanding amount under a delinquent
account is charged off (off the books) beyond a certain amount of days past due.
Auto loan receivables can be securitized into pools called as Asset Backed Securities (ABS. This
offers liquidity advantages to an auto lender.
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No security
Tax deduction can be claimed for the full value of the rental paid.
Tax deduction can be claimed only to the extent of the interest repayment.
Important Terms;
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$1000
$700
$1600
$1000
$2000
$1000
$500
$350
4.3
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Bank promotes its community development mission by operating CDBs and other affiliates in
certain U.S. cities.
Other CDBs include:
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4.4
FARM CREDIT
The Farm Credit System is a federally chartered network of borrower-owned lending institutions
composed of cooperatives and related service organizations. Cooperatives are organizations
that are owned and controlled by their members who use the cooperatives products, supplies
or services. The U.S. Congress authorized the creation of the first System institutions in 1916.
Their mission is to provide sound and dependable credit to American farmers, ranchers,
producers or harvesters of aquatic products, their cooperatives, and farm-related businesses.
They do this by making appropriately structured loans to qualified individuals and businesses at
competitive rates and providing financial services and advice to those persons and businesses.
Consistent with their mission of serving rural America, they also make loans for the purchase of
rural homes, to finance rural communication, energy and water infrastructures, to support
agricultural exports, and to finance other eligible entities.
Farm Credit institutions are chartered by the federal government and must operate within limits
established by the Farm Credit Act. The Farm Credit System is regulated by an independent
federal agency, the Farm Credit Administration, which has all of the enforcement, regulatory
and oversight authority as other federal financial regulators. Farm Credit is a government-
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4.5
Application Processing
Duplicate check
Document Verification
Credit scoring
Field Investigation
Credit Approval
Disbursement
o
Check issuance
Credit to account
Post-Dated checks
o
Salary deductions
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Direct receipts
o
Kinds of repayments
o
Case Processing
o
Standard Cases
o
Repayment by customer
Check issuance
Case closed
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Submit Proposal
Repayment
Scrutinize
NO
OK
Follow-up/Action
Monitoring
Disbursement
Appraisal
Decision
OK
Compliance
SUMMARY
The loans given to retail customer would come under Mortgages and other consumer loans
Residential Mortgages
Commercial Mortgages
Origination
Processing
Under writing
2. Loan Servicing
Cash management
Escrow Administration
Document custodianship
Delinquency management
Customer service
The following are the various types of Mortgages based on repayment patterns
o
Fixed Rate
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Negative Amortization
Capped rate
Student Loans
Auto Loans
Personal loans
Other than commercial banks there are Community development Banks, Credit Unions &
Building Societies which provides Mortgages and / or Consumer Loans.
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5.0
5.1
INTRODUCTION
Cards are the fastest growing means of non-cash payments, accounting for 55% of payment
volumes worldwide, demonstrating the importance of non-cash payment mechanisms to trade
and consumer spending in our globalised economy as a new research into the global payments
market has found.
As per Tower Group Research report for the period between 2005 to 2007, Usage of Pin Debit
grew by 18 %, Volume of credit card grew by 5%, Usage of check declined by 9%, Usage of EBPP
is increasing at a CAGR of 18%, Online bill payment increased at a CAGR rate of 29.6 %, Online
bill payments at bank and biller Web sites comprised 42% of total monthly payments, followed
by 31% of bills paid by check.
CHECK-BASED PAYMENTS
CARDS-BASED PAYMENTS
DEBIT
Debit cards enable the holder to make purchases and to charge those purchases directly to a
current account at the bank issuing the payment card. Debit cards are either on-line (PIN-based)
or off-line (Signature-based).
There are two types of debit card processing.
PIN or online debit card processing: The debit card holder is required to enter a PIN
(personal identification number) in to a PIN pad. This is used as a verification method and access
to account is provided instantaneously. The access to funds is real time.
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Signature or offline debit card processing: In this method verification is done by the
signature of the card holder. A hold is placed on the funds available in some cases when this
method of processing is used.
ATM
An ATM card (also known as a bank card, client card, key card or cash card) is an ISO 7810 card
issued by a bank, credit union or building society. ATM cards provide a convenient way to get
cash, make deposits and check how much money is available in the bank account. ATMs make
cash available 24 hours a day, seven days a week at many locations. ATM cards can be used at
ATMs that are located at all of the bank's locations as well as those at other banks, grocery and
drug stores, office buildings, and street corners across the country and worldwide.
In other words, ATM cards cannot be used at merchants that only accept credit cards.
CREDIT
A Credit Card represents an account that extends credit to consumers, permits consumers to
purchase items while deferring payment, and allows consumers to make payments to multiple
vendors at one time. Credit cards can have revolving credit arrangements allowing customers to
make a minimum payment in each billing cycle (two to three % of their total balance) rather
than requiring payment of the full balance. However, if a cardholder revolves i.e. carries over a
balance to the next billing cycle, then the interest will be charged not only to the balance
amount but also to any new purchases in that billing cycle. There are cards that have a shortterm, fixed-period, and credit arrangement.
SMART CARD
A smart card is a plastic card about the size of a credit card, with an embedded microchip that
can be loaded with data and can be used to perform several functions. The most common smart
card applications are: Credit cards, Electronic cash, Computer security systems, Wireless
communication, Loyalty systems (like frequent flyer points), Banking, Satellite TV, Government
identification. Smart cards can hold all sorts of unique information about its carrier, such as
credit and debit account balances, insurance coverage, access credentials, and subscription
information.
CO BRANDED CARD
They are credit cards, which are associated with a particular firm like an airlines or retail outlet.
These cards can be used just like regular credit cards but they also offer benefits to users of the
relevant product like frequent travel points and special discounts. Cardholders may be given
incentives, such as discounts on merchandise, rebates, or discounts off purchases. A co-branded
card has a tie-in with a specific merchant rather than an association or professional group. It
also can be used at other merchants.
AFFINITY CARD
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These are Credit cards promoted under a sponsoring agreement between an organization and a
card issuing bank. In exchange for making available its membership list, the sponsor receives
some compensation from the issuing bank, usually part of issuer's net interest income. The
issuer may waive annual fees for affinity cardholders, or even offer the card at a lower rate than
ordinary bank cards.
CORPORATE / COMMERCIAL CARD
Corporate credit card is normally used for business purposes and it helps corporate consumers
to effectively organize their business expenditure. Most corporate credit cards, especially cards
which have been issued to employees of a company are termed as individual corporate cards
because these cards have individual responsibility, not any corporate obligations.
PREPAID CARD
Prepaid Credit Card originated in Canada. It is not a stereotype credit card but can be used in a
similar way. The consumer has to buy the credit card from a company and then has to load it
with the required amount of money. Only after that he/she could use it for further buying but
strictly within limit of the loaded money. Hence, it is also known as Stored-Value Cards. Some
common examples are Gift Cards, Phone Cards, Mall Cards, and Gas Cards.
C.
NACHA The Electronic Payments Association oversees, the ACH Network which is a highly
reliable and efficient nationwide batch-oriented electronic funds transfer system. It is governed
by the NACHA OPERATING RULES which provide for the interbank clearing of electronic
payments for participating depository financial institutions. The Federal Reserve and Electronic
Payments Network act as ACH Operators, central clearing facilities through which financial
institutions transmit or receive ACH entries.
ACH payments include:
Direct Deposit of payroll, Social Security and other government benefits, and tax refunds;
Direct Payment of consumer bills such as mortgages, loans, utility bills and insurance
premiums;
B2B payments;
Electronic checks;
E-commerce payments;
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Originator is individual, corporation or other entity that initiates entries into the Automated
Clearing House Network
Originating Depository Financial Institution (ODFI) is a participating financial institution that
originates ACH entries at the request of and by (ODFI) agreement with its customers. ODFI's
must abide by the provisions of the NACHA Operating Rules and Guidelines
Receiving Depository Financial Institution is any financial institution qualified to receive ACH
entries that agrees to abide by the NACHA Operating Rules and Guidelines
Receiver is an individual, corporation or other entity that has authorized an Originator to initiate
a credit or debit entry to a transaction account held at an RDFI.
NACHA the Electronic Payments Association
NACHA The Electronic Payments Association is a not-for-profit association that oversees the
Automated Clearing House (ACH) Network, a safe, efficient, green, and high-quality payment
system. More than 15,000 depository financial institutions originated and received 18.2 billion
ACH payments in 2008. NACHA is responsible for the administration, development, and
enforcement of the NACHA Operating Rules and sound risk management practices for the ACH
Network. Through its industry councils and forums, NACHA brings together hundreds of
payments system stakeholder organizations to encourage the efficient utilization of the ACH
Network and develop new ways to use the Network to benefit its diverse set of participants.
D.
EMERGING PAYMENTS
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CONTACTLESS PAYMENTS
Contactless payment system is a new emerging payment system where a payment transaction
can be initiated without the device coming in direct contact with the POS, such as swipe of a
card. This payment mechanism is made possible through use of new technologies such as Radio
Frequency (RFID), NFC (Near Field communication), Carrier Based or Bluetooth technology for
making payments. Payment using this technology can be made using Form Factors such as credit
cards, key fobs, smart cards or mobile phones. The consumer waves the device over a reader at
the POS and the embedded chip and antenna enables initiation of the transaction. The
consumer is not required to sign a slip or enter a PIN making it extremely convenient.
Contactless payments are typically useful for small value transactions and are targeted towards
eliminating or reducing cash transactions at the retail counter.
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Payee
Present Non-cash Payment instrument
Goods / Services
Network
Financial Institution
or Third party
Financial Institution
or Third party
While the flow of funds, information, and data are different, in most cases, the set of
participants are similar. The initiator of the payment (payer) is typically a consumer and the
recipient of the payment (payee), typically a merchant. The payer and the payee are shown to
have a relationship with their respective financial institutions. The payment network routes the
transactions between the financial institutions
5.2
There were 984 million bank-issued Visa and MasterCard credit card and debit card accounts in
the U.S in 2006.The top 10 credit card issuers controlled approximately 88 percent of the credit
card market at the end of 2006, based on credit card receivables outstanding. U.S Visa
cardholders alone conduct more than $1 trillion in annual volume. Consumers carry more than 1
billion Visa cards worldwide. More than 450 million of those cards are in the United States.
2007 global market share of general-purpose cards (cards in distribution)
Total among these five brands: 3.03 billion, up 13.6 percent in one year
1. Visa -- 65 percent
2. MasterCard -- 30 percent
3. American Express -- unknown
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4. JCB -- unknown
5. Diners Club -- unknown
(Source: Nilson Report, May 2008)
2007 global market share of general-purpose cards (purchase volume)
1. Visa -- 60 percent
2. MasterCard -- 28 percent
3. American Express -- 10.5 percent
4. JCB -- 0.9 percent
5. Diners Club -- 0.5 percent
(Source: Nilson Report, May 2008)
A Credit card is a type of a payment card product. A payment card product is a set of
entitlements. It allows the client to access the features the provider (e.g., financial institution)
attaches to the card.
A sample of possible payment card entitlements is shown below:
Access
Convenience
Affordability
Credit
Worldwide acceptance
Interest rate
Deposits
24 hour availability
Fees
Merchants
Portability
Benefits
ATMs
Monthly statements
Payment terms
To create an actual payment card product, these entitlements are grouped together to appeal to
a target segment consumer or business. A card is issued to a cardholder and usually displays
cardholder name, account number, expiration date, location acceptance logos (e.g.,
Visa/MasterCard) and issuing organization. Most cards are plastic with a magnetic stripe. Some
of the new cards contain chips that store information such as additional customer information
and stored value. A card usually is linked to some type of financial account (e.g., credit card to a
credit line and a debit card to a checking/savings account).
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The following table shows lists the description of the various entities involved in a Credit card
processing
Entity
Description
Issuing Bank
Cardholder
Account
Business Portfolio This defines the processing rules for all the accounts under a business
venture of the same card offering type. This entity may hold billing rules,
Account
auth limits, collection strategies, and other properties that can be defined
at this level. Examples of Business portfolio account may include Chase
Visa Classic, Chase Visa Gold, etc
Card Product
Identifies the different card types that the Credit system supports.
Examples may be proprietary cards, Visa, MasterCard
Authorization
Engine
Credit Bureau
Collection Agency
Issuer Processor
Issuer
Bank
Clearing Bank designated by the Issuer to receive the Issuers daily net settlement
advisement. The clearing bank (may be the Issuer itself) will also conduct
funds transfer activities with the net settlement bank and maintain the
Issuers clearing account.
This is a bank / financial institution that acquires merchant transactions
Acquirer
Acquirer
Bank
Acquirer Processor
Merchant Account
Clearing file
Funding file
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The credit card transaction starts when the merchant swipes a customer's credit card through a
dial-in terminal that would automatically dial the correct network depending on the association
being used. The card holder, in this way, informs the Issuer to pay the merchant.The merchant
then passes this message on to his acquirer, who then sends it through the Credit Card
Association to the card issuer. The return path of the $100 dollars is essentially the same except
that each party deducts some amount of money for its efforts. Following is the share of each of
the entities:
The card issuer will bill the card holder and keep an interchange fee which in this
example is 1.3%, or $1.30. However, he must pass the remaining money back to the
card association and pay an issuer transaction fee of .07% or $.07.
The card association takes the $98.77, deducts a merchant transaction fee (.09%) and
returns $98.61 to the acquirer.
The acquirer keeps .06% and deposits $98 in the merchants account.
The merchant then sees $98 dollars return from the $100 dollar purchase. This charge of
$2, or 2%, is called the discount rate and is the basis for much of the competition
between the banks of a credit card association.
Transaction Type
Cardholder
transactions
Purchase
System
Generated
Transactions
Remarks
Preauthorization
Merchandise return
Reversal
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settlement.
Exception
Transactions
Others
Administrative
Network
Reconciliation
File Maintenance
Fee transactions
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5.3
MAJOR PLAYERS
The following table shows some of the leading card organizations and their respective roles in
the Credit card industry:
Leading Card Organizations
Banks
Non-Banks
Association
Organization
Citigroup
(Issuer)
Visa
(Card
Association,
Processor)
TSYS (Processor)
MBNA
(Issuer)
America
Vital (Acquirer & Processor)
JPMorgan Chase /
Bank
One
(Acquirer & Issuer)
Bank of America
(Acquirer & Issuer)
Capital
(Issuer)
One
Card
MasterCard
(Card
Association,
Processor)
JCB (Card Association)
Fargo
Wells
(Acquirer & Issuer)
Wachovia
(Issuer)
Natwest (Issuer)
Barclays (Issuer)
5.4
RECENT DEVELOPMENTS
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in Europe, to make and receive Euro payments, to engage in direct debits and to use credit and
debit cards with standardized basic conditions, rights and obligations in every country.
The expanse of SEPA is all EU Member States (currently 27), other EEA Member States (Norway,
Iceland and Liechtenstein) and Switzerland.
There are three main payment instruments forming part of the SEPA objective:
SCF: AN INTRODUCTION
SEPA Cards Framework (SCF) spells out high level principles and rules which when implemented
by banks, schemes, and other stakeholders, will enable European customers to use general
purpose cards to make payments and cash withdrawals in Euro throughout the SEPA area with
the same ease and convenience than they do in their home country.
The vision of SEPA Cards Framework is as follows:
There should be no differences whether European customers use their card(s) in their
home country or somewhere else within SEPA.
No general purpose card scheme designed exclusively for use in a single country, as well
as no card scheme designed exclusively for cross-border use within SEPA, should exist
any longer.
Impact
On Customers / Card holders - Since the beginning of the year 2009, all the newly issued cards
will be equipped with the chip technology and their usability within the SEPA zone will be the
same as of standard international bank cards. Cards will be used in compliance with the EMV
standard.
On Merchants / Traders - Traders will continue to be able to decide which offered card products
they will accept and with which bank a receiver - they will cooperate. The bank and the trader
will contractually agree on the trade terms and conditions for acceptance of bank cards, type of
accepted bank cards, including charges, and other relevant particulars. As long as a payment
terminal is owned by a bank, the bank is entitled to decide whether a trader may use a given
terminal also for cooperation with another bank. Payment terminals will accept both SCF
compatible products and products without the EMV chip technology due to the need to
safeguard the acceptance of bank cards issued in non- SEPA countries.
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On Banks - The preparatory phase for implementation of SEPA will mean investments into the
technologies used within the process of issue and acceptance of bank cards (cards, POS, ATM)
and adjustment of affected information systems
Benefits
Some of the Key benefits of EMV implementation are
Increased Interoperability of card acceptance, security and payment functions
Fraud Prevention
Avoid being the weakest link - prevent migration of fraud to own card base as
other banks implement
Improved Control
Reduce and improve management of bad debt by utilizing chip parameters e.g.
to restrict below floor limit spending.
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Maintain Competitiveness
Cards are one of the most widely used mechanisms for transactions worldwide. There are
several types of cards used
o
Debit cards
ATM cards
Credit cards
Smart cards
Co Branded card
Affinity card
Commercial card
Prepaid card
Mobile payments
Contactless payments
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There are various entities involved in the credit card transaction processing cycle o
Issuer
Acquirer
Association
Merchant
Card holder
Transaction Economics A credit card transaction involves various fees. / Charges such as
interchange fee, merchant transaction fee and issuer transaction fee. The merchant
discount rate is the basis for much of the competition between the banks of a credit card
association.
Chargeback and Chargeback reversals are legitimate ways to cancel the credit card
transactions within a limited time frame
SEPA Cards Framework and EMV Global Framework for Smart Card Payments are some of
the recent developments in the Cards arena.
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6.0
6.1
INTRODUCTION
Corporate Lending refers to various forms of loans extended by banks to corporate bodies like
proprietorship, partnership, private limited companies or public limited companies. Banks lend
to such entities on the strength of their balance sheet and business cash flows. Corporate loans
are provided by banks for various purposes like new projects, capacity expansion or plant
modernization, daily cash flow requirements (working capital) etc. Depending on the nature of
the requirement, loans may be long-term or short-term in nature.
Loans can be either secured or unsecured in nature. In case of secured loans, if the corporate
defaults on payment of principal or interest on the loan, the bank can take possession of the
security and sell off the same to meet principal or interest payment on the loan. Security is
usually in the form of land, buildings, plant and machinery, physical stock of the raw material,
goods for sale etc.
6.2
Corporate approaches the relationship manager of the bank with a request for a loan. The
corporate provides details like: past financial statements, details of the loan requirement,
cash flow projection for the period of the loan, details of the security being provided etc.
Depending on the loan type and bank requirements, information should be provided by the
corporate.
The concerned division of the bank prepares the detailed analysis of the corporate financial
statements. A detailed study is also done on the corporates products, market segment,
competitors etc to ascertain the strength of the corporates business. A report is prepared
to capture the above details.
Based on the above report, the concerned division of the bank assigns a rating to the
corporate. The rating captures various factors like strength of business, financial state of
the corporate, ability to repay the loan based on cash flow projections, promoter
background etc.
A committee of the bank evaluates the loan proposal and decides to sanction/reject the
same.
Once sanctioned, the bank provides a sanction letter to the corporate providing details of
the loan terms and conditions.
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After the corporate accepts the same, a loan agreement is signed between the bank and the
corporate. The loan agreement captures various conditions of the loan like repayment
mode, repayment period, interest payable, security provided, other conditions etc. The loan
becomes committed at this stage.
The bank disburses the required amount under the loan committed. This amount is called
the disbursed amount under the loan.
Interest is usually paid on the disbursed amount of the loan. In some cases, a nominal interest if
also payable on the committed amount of the loan. Also, in most cases, the corporate would
have to pay a certain amount as processing fees for the loan. This would cover the banks
overhead costs in the loan process.
CREDIT ENHANCEMENTS
Credit enhancement is a mechanism used to increase the original rating of a loan for a
corporate. Credit enhancements can be in the form of pledge of shares, cash collateral,
corporate or bank guarantees etc.
Example:
A corporate rated BB (low rating) requires a loan of USD 5.0 million from a bank. To enhance the
loan rating and thus reduce interest payable on the loan, the promoters pledges their share
holding in the company with the bank. Thus, whenever there is a default on repayment of the
loan, the bank has the right to sell the shares in the market. Based on the historic volatility of
the shares and the current market value of USD 6.0 mn, the bank upgrades the rating of the loan
to BBB+.
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Example
On April 15, 2004, AT&T borrows a term loan of USD 200 million from Citibank for funding their
IT modernization project across the nation. The loan is repayable in 16 quarterly installments
starting April 15, 2005, after an initial moratorium of 4 quarters. The interest payable would be
LIBOR+0.5% payable quarterly. The loans would be secured by AT&T equipment at their HQ,
worth USD 300 mn.
Short term loans are extended usually for meeting working capital requirements. The loans can
be repayable in various tenures starting from a week to as long as 1 year. The loans are either
repayable in fixed installments or in one bullet installment at the end of the period. In some
cases, short term loans are backed by promissory notes which are legal instruments that
guarantee payment of a certain amount on a specified due date.
CORPORATE BONDS
Corporate bonds are used for the same purpose as term loans, but the loan is backed by a
transferable instrument which guarantees payment from the corporate as per specified
conditions. Thus, corporate bonds are tradable and banks can sell them to a third party who
receives the right to get payments from the corporate. Bonds are rated depending on the rating
of the corporate and depending on the rating, the market demands varying amounts of interest.
A certain class of bonds called junk bonds is issued by corporate with very low credit ratings and
carry very high rates of interest.
WORKING CAPITAL
For any business, there would be current assets in the form of cash, receivables, raw material
inventory, goods for sale inventory etc while there would be current liabilities in the form of
payables and other short term liabilities. Part of the current assets would be funded through
current liabilities while the rest would have to be funded through a mixture of short term and
long term loans. As per norms, 25% of the working capital gap would have to be funded by long
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term sources like equity or term loans while the rest 75% can be funded through short term
loans and overdraft limits.
Banks conduct a detailed assessment of the current assets and liabilities for a corporate and
arrive at a suitable working capital limit. For purpose of calculating limits, banks typically include
only receivables which are less than 6 months old. Also within the specified limit, banks keep
reviewing the current asset and current liability position of a company to arrive at the drawing
power for each month. Corporate are allowed to borrow up to the working capital limit or the
drawing power, whichever is lower.
Overdraft limits are extended to help the corporate manage the day-to-day cash flow needs of
the business. The bank makes available a certain sum of money for a period of time (say, USD
20.0 million for a period of 1 year). There would be a separate account called the overdraft
account created to monitor withdrawals under this loan. Whenever the corporate has a deficit
in its main business account, it can draw money from the overdraft account (up to the limit of
USD 20.0 million). It can also put back money in the overdraft account as and when they have
surpluses in the business account. Interest is calculated by the bank on the various end-of-day
deficits in the overdraft account and is usually payable by the corporate at the end of every
month.
LINES OF CREDIT
These are short term loans sanctioned for a fixed validity period, allowing the corporate to draw
the loan as and when required within the validity period and repay the loan after a certain
period (repayment period). Interest is either repayable in certain intervals or in one bullet
installment at the end of the repayment period. In many cases, the lines of credit are of a
revolving nature. The same is explained via the example provided below:
Example
Citibank sanctions a line of credit of USD 10.0 mn to AT&T, valid for a period of 3 years. Within
the 3 year period, AT&T can borrow any amount at any point of time, such that the cumulative
outstanding is below USD 10.0 mn on any date. Each of these borrowals are repayable with
interest at the end of 30 days from the date of borrowals. Since AT&T can thus revolve the limit
any number of times within the specified limit and validity period, these are called revolving
lines of credit.
BILL DISCOUNTING
Bill discounting is another form of working capital financing. A bill (Bill of Exchange) is a financial
instrument by which one party promises to pay the other party a certain amount of money on a
specified due date. This is transferable and the final holder of the bill holds the right to receive
the payment from the concerned party. The corporate would have bills of exchange which are
drawn on their dealers, which entitle the corporate to receive certain amounts of money from
the dealer after a pre-defined credit period. The corporate can then transfer the bill to the bank
and get a discounted amount upfront. The bank collects the interest on the bill amount for the
specified period upfront in this process called bill discounting. On the due date, the bank collects
the payment from the concerned party directly.
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COMMERCIAL PAPER
Commercial Paper (CPs as commonly known) is an instrument by which a corporate borrows
money from banks for short periods of time. A CP binds the corporate to make a payment equal
to the face value of the CP to the issuing bank on a specified due date. In this sense, a CP is like a
short term unsecured loan. However, a CP is tradable in the market the bank can sell the CP to
a third party. For this reason, banks charge lesser interest on CPs than normal short term loans.
However, since CPs are unsecured and are to be tradable in the market, banks provide CP
lending to only highly rated corporate.
LEASING
Leasing is another form of bank financing. In leasing, the bank purchases real estate, equipment,
or other fixed assets on behalf of the corporate and grants use of the same for a specified time
to the corporate in exchange for payment, usually in the form of rent. The owner of the leased
property is called the lessor, the user the lessee. Lease payments (which include principal and
interest payments usually) can be shown by corporate as operating expenses and hence leases
are used by some corporate as a substitute for loans to get better tax benefits.
SUPPLIER AND DEALER LOANS
These are short term loans provided by banks to suppliers and dealers of large companies.
These loans usually have conditions which ensure that there is sufficient support from the
corporate in case the supplier or a dealer defaults. Thus, using the support from the corporate,
the suppliers/dealers can borrow money from the bank at a lower rate of interest than
otherwise possible. Such loans help the corporate to develop a stronger base of suppliers and
dealers, which often helps them in improving their business.
ASSET SECURITISATION LOANS
Asset Securitization loans are loans which are backed by specified future cash flows or other
assets of the corporate. These loans help corporate to release excess cash flows from existing
receivables or future receivables.
Example
Citibank provides a loan of USD 250.0 mn to Royal Dutch Shell, securitizing cash flows from
future monthly sale of oil explored from its specified offshore rig. In this case, there would be a
mechanism to ensure that money from monthly sale of oil explored from the specified rig for
the period of the loan would be used to service payment of interest and principal of the loan to
Citibank. Citibank would do a detailed assessment of oil exploration potential, study oil prices
and ensure proper cash flow trapping mechanisms before disbursing the loan to Royal Dutch
Shell.
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The amount of the loan that is disbursed is credited to the account of the borrower. In
case of a commitment, there is no disbursement or credit to a borrowers account.
The fee charged on a loan is a function of the disbursed amount. The fee charged on
commitment is a function of the amount of commitment that is not utilized.
A borrower wants to raise relatively large amount of money quickly and conveniently
The amount exceeds the exposure limits or appetite of any one lender
The borrower does not want to deal with multiple lenders
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1. Arranger / Lead Manager: This the bank / lender the prospective borrower has
mandated to arrange loan
2. Underwriting Bank: The bank that commits to supply funds to the borrower. If
necessary from own sources if the loans are not fully subscribed. It may the arranging
bank or another bank
3. Participating Bank: The bank that participates in the syndication by lending a portion of
the total amount required
4. Facility Manager / Agent: The entity who takes care of the administrative arrangements
over the term of the loan (Example: disbursements, repayments, compliance)
STAGES IN SYNDICATION
1. Pre-mandate Phase: Prospective borrower will liaise with a single bank and the bank
may agree to act as lead bank. The lead bank needs to;
a. Identify the needs of the borrower
b. Design an appropriate loan structure
c. Develop a persuasive credit proposal
d. Obtain internal approval
2. Placing the loan: The lead bank will start to sell the loan in the market place and to sell
the loan it needs to;
a. Prepare an information memorandum
b. Prepare a term sheet
c. Prepare legal documentation
d. Approach selected banks and invite participation
3. Post-closure phase: Post closure, agents will handle the day to day running of the loan
facility
FEES AND CHARGES
Fee
Type
Remarks
Arrangement fee
Front end
Also
called
praecipium.
Received and retained by the
lead arrangers in return for
putting the deal together
Legal fee
Front end
Underwriting fee
Front end
Participation fee
Front end
Received by
participants
the
senior
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6.3
Facility fee
Per annum
Received by
participants
the
senior
Commitment fee
Utilization fee
Agency fee
Per annum
Conduit fee
Front end
Prepayment fee
One-off if prepayment
CREDIT DERIVATIVES
Credit derivatives are financial contracts that transfer credit risk from one party to another,
facilitating greater efficiency in the pricing and distribution of credit risk among market players.
Example
The holder of a debt security issued by XYZ Corp. enters into a contract with a derivatives dealer
whereby he will make periodic payments to the dealer in exchange for a lump sum payment in
the event of default by XYZ Corp. during the term of the derivatives contract. As a result of such
a contract, the investor has effectively transferred the risk of default by XYZ Corp. to the dealer.
In market parlance, the corporate bond investor in this example is the buyer of protection, the
dealer is the protection seller, and the issuer of the corporate bond is called the reference
entity.
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Credit derivatives can be used to create positions that can otherwise not easily be established in
the cash market. For instance, consider an investor who has a negative view on the future
prospects of a given corporation. One strategy for such an investor would be to short the bonds
issued by the corporation, but the corporate repo market for taking short positions in corporate
is not well developed. Instead, the investor can buy protection by way of credit default swap. If
the corporation defaults, the investor is able to buy the defaulted debt for its recovery value in
the open market and sell it to its credit derivatives counterparty for its face value.
Banks use credit derivatives both to diversify their credit risk exposures and to free up capital
from regulatory constraints. As an example, consider a bank that wants to diminish its exposure
to a given client, but does not want to incur the costs of transferring loans made to that client to
another bank. The bank can, without having to notify its client, buy protection against default by
the client in the credit derivatives market: Even though the loans remain on the bank's books,
the associated credit risk has been transferred to the bank's counterparty in the credit
derivative contract.
The above example can also be used to illustrate banks' usage of credit derivatives to reduce
their regulatory capital requirements. Under current Basle standards, for a corporate borrower,
the bank is generally required to hold 8 percent of its exposure as a regulatory capital reserve.
However, if its credit derivatives counterparty happens to be a bank located in an OECD country,
and the bank can demonstrate that the credit risk associated with the loans has been effectively
transferred to the OECD bank, then the bank's regulatory capital charge falls from 8 percent to
1.6 percent.
Example
Let us visualize a bank, say Bank A which has specialized itself in lending to the office
equipment segment. Out of experience of years, this bank has acquired a specialized
knowledge of the equipment industry. There is another bank, Bank B, which is, say,
specialized in the cotton textiles industry. Both these banks are specialized in their own
segments, but both suffer from risks of portfolio concentration. Bank A is concentrated in
the office equipment segment and bank B is focused on the textiles segment.
Understandably, both the banks should diversify their portfolios to be safer.
One obvious option for both of them is: Bank A should invest in an unrelated portfolio, say
textiles. And Bank B should invest in a portfolio in which it has not invested still, say, office
equipment. Doing so would involve inefficiency for both the banks: as Bank A does not know
enough of the textiles segment as bank A does not know anything of the office equipment
segment.
Here, credit derivatives offer an easy solution: both the banks, without transferring their
portfolio or reducing their portfolio concentration, could buy into the risks of each other. So
bank B buys a part of the risks of the portfolio that is held by Bank A, and vice versa, for a
fee. Both continue to hold their portfolios, but both are now diversified. Both have
diversified their risks. And both have also diversified their returns, as the fees being earned
by the derivative contract is a return from the portfolio held by the other bank.
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6.4
TREASURY SERVICES
The Treasury Services department is concerned with managing the financial risks of the bank.
Hence, the treasurer's job is to understand the nature of these risks, the way they interact with
the business, and to minimize or to offset them. In many cases, the treasury services
department also provides cash management solutions for customers of the bank. The Treasury
services department of a bank performs the following functions:
Managing the cash position of the bank, managing liquidity and associated risks
Forex services: provides Forex services to corporate, enters in to deals with multiple
counterparties to maintain a risk-managed position for the bank.
Risk management services: provides risk management products like swaps, options etc to
corporate and enters in to multiple deals with various counterparties to maintain a riskmanaged position for the bank.
Conducts research on various market factors, monitors interest rate and economic scenario
etc
Fixed Income: An investment that provides a return in the form of fixed periodic payments
and eventual return of principle at maturity. Unlike a variable-income security where
payments change based on some underlying measure, such as short-term interest rates,
fixed-income securities payments are known in advance.
Money Markets: The money market is a subsection of the fixed income market. The
difference between the money market and the fixed income market is that the money
market specializes in very short-term debt securities (debt that matures in less than one
year). Money market investments are also called cash investments because of their short
maturities. Some of the popular money market instruments include Certificates of Deposit
(CD), Commercial Paper (CP), Treasury Bills (T-Bills)
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Foreign Exchange: The market for buying and selling of currencies is called the Foreign
Exchange market (FX ). It is a 24 hour non-stop market. Some of the major Currency traded
include The US Dollar (USD), The Japanese Yen (JPY), The Euro (EUR), The Great Britain
Pound (GBP), The Swiss Franc (CHF). FX rates express the value of one currency in terms of
another currency. They involve
o
The commodity currency - the currency being priced, usually 1 unit or a fixed amount of
currency.
The terms currency - the currency used to express the price of the commodity, in
varying amounts of
OTC Derivatives: Over the counter (OTC) markets are a form of Secondary markets. World
over Secondary markets are classified as Listed and OTC. Listed markets typically are
exchanges where a security is listed and traded. A decentralized market of securities not
listed on an exchange where market participants trade over the telephone, facsimile or
electronic network instead of a physical trading floor or electronic order matching systems.
There is no central exchange or meeting place for this market. Typically Currency
instruments are traded OTC. A derivative contract derives its value based on the value of
some basic underlying. The underlying may be any instrument like a bond, a stock or a
market index, currency or interest rates. Some of the instruments traded OTC include
o
Forward Rate Agreement (FRA) - A contract that determines the rate of interest,
or currency exchange rate, to be paid, or received, on an obligation beginning at some
future start date. It is also referred to as Future Rate Agreement.
Interest Rate Swap (IRS) - A deal between banks or companies where borrowers switch
floating-rate loans for fixed rate loans in another country. These can be either the same
or different currencies. The motive may be the competitive advantage of one company
to have access to lower fixed rates than another company. The other company may be
competitively placed to have access to lower floating rates. A swap would be beneficial
to both. The swap is measured by its notional principal.
FX Options: Forex Options give the holder the right to buy or sell a currency in terms of
another currency at a particular rate on a particular date or within a period of time. The
option to buy is called as a Call Option and the option to sell is called as a Put Option.
Equity Options These are similar to FX options the only difference is the underlying. The
underlying in case of Equity Options are stocks or stock market indices. When the
underlying is a stock market index the term used is Index Option and the term used to refer
options on individual stocks is Stock Option
Credit Derivatives - Privately held negotiable bilateral contracts that allow users to manage
their exposure to credit risk. Credit Derivatives are financial assets like forward contracts,
swaps, and options for which the price is driven by the credit risk of economic agents
(private investors or governments). For example, a bank concerned that one of its
customers may not be able to repay a loan can protect itself against loss by transferring the
credit risk to another party while keeping the loan on its books.
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Ensure availability of funds An integrated treasury typically would include debt market,
money market and Forex transactions. Treasury manager needs to ensure that adequate
funds are available to cover the settlement obligations of the said transactions.
Liquidity Risk of asset and liability cash flow mismatch. A bank may not have adequate
funds for the settlement of its transactions or to pay its customers because of
mismatches in the tenor of its receivables
Interest rate Risk due to volatility of interest rates. A bank may have borrowed at
floating rates of interest and lent at fixed rate of interest and the interest rates moves
up
Currency Risk due to volatility in exchange rates. A bank may have its payment
obligations in a currency say USD and the rate to purchase the said currency goes up
Commodity Risk due to volatility in commodity prices. A bank may have an obligation to
deliver a commodity in the future and the price of the commodity moves up
Cash Management Services - CMS is a service provided by banks to its corporate clients for a
fee to reduce the float on collections and to ease the bulk payment transactions of the
client. The three elements of CMS are:
Receivables Management Helps the company to manage collection of its sale proceeds
from remote upcountry regions
Payables Management Helps the company to manage its payments to its regular
suppliers without keeping numerous bank accounts for various locations and then
reconciles them periodically in a highly manual / paper-based environment
Liquidity Management Helps the company by ensuring direct and instant access to its
bank accounts. It should not happen that a company has excess funds in one bank
account and it needs to pay through another bank account where there are no funds
Asset Liability Management A banks assets and liabilities need to necessarily match.
If they dont the bank may have liquidity problems which would endanger its solvency.
The long term assets should not be financed by short term sources of funds. The bank
would not be able to serve its lenders if the timings of its inflows do not match its
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outflows. A bank typically uses mathematical tools like Duration, Gap Analysis to find
out mismatches and take corrective actions
Example
A bank borrows USD 100MM at 3.00% for one year
The bank uses this borrowed money to lend to a highly-rated borrower for 5 years at 3.20%.
For simplicity, assume interest rates are annually compounded and all interest accumulates to
the maturity of the respective obligations. The net transaction appears profitablethe bank is
earning a 20 basis point spreadbut it entails considerable risk.
At the end of one year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. Assume interest rates are at 4.00% at the end of the first year.
The Bank will now have to pay a higher rate of interest (4.00%) on the new financing than
the fixed 3.20 it is earning on its loan. It is going to be earning 3.20% on its loan and paying
4.00% on its financing.
The problem in this simple example was caused by a maturity mismatch between assets and
liabilities. As long as interest rates experienced only modest fluctuations, losses due to assetliability mismatches are small or trivial. However, in a period of volatile interest rates, the
mismatches would become serious.
The treasury asset-liability management (ALM) group assesses asset-liability risk and all banks
have ALM committees comprised of senior managers to address the risk. Techniques for
assessing asset-liability risk came to include gap analysis, duration analysis and scenario analysis.
Gap analysis looks at amount of assets and liabilities in various maturity buckets while Duration
analysis looks at weighted average maturity of cash flows to compare assets and liabilities. Since
liquidity management is closely linked to asset-liability management, assessment and
management of liquidity risk is also a function of ALM departments and ALM committees. ALM
strategies often include securitization, which allows firms to directly address asset-liability risk
by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability
risk; it also frees up the balance sheet for new business.
Manage risks due to volatility of interest rates - Demand and supply of money go on
changing from time to time making interests rates volatile. A bank may have accepted
deposits at a fixed rate of interest historically. However current market rates may be
lower when it wishes to lend. The banks portfolio value of investments in bonds and
treasury also varies inversely with the interest rates. A higher interest rate diminishes
the value of a banks portfolio and vice versa. Instruments like interest rate swaps and
currency swaps help to address Interest Rate risks
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Repricing risk: The primary form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and offbalance-sheet (OBS) positions. For instance, a bank that funded a long-term fixed rate loan
with a short-term deposit could face a decline in both the future income arising from the
position and its underlying value if interest rates increase.
Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve (a plot of
investment yields against maturity periods) have adverse effects on a bank's income or
underlying economic value. Yield curves can shift parallel or change in steepness, posing
different risks. For instance, the underlying economic value of a long position in 10-year
government bonds hedged by a short position in 5-year government notes could decline
sharply if the yield curve steepens, even if the position is hedged against parallel
movements in the yield curve.
Basis risk: Basis risk arises from imperfect correlation in the adjustment of the rates earned
and paid on different instruments with otherwise similar repricing characteristics. For
example, a strategy of funding a one year loan that reprices monthly based on the one
month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one
month Libor, exposes the institution to the risk that the spread between the two index rates
may change unexpectedly.
Optionality: An additional and increasingly important source of interest rate risk arises from
the options embedded in many bank assets, liabilities and OBS portfolios. Options may be
stand alone instruments such as exchange-traded options and over-the-counter (OTC)
contracts, or they may be embedded within otherwise standard instruments. They include
various types of bonds and notes with call or put provisions, loans which give borrowers the
right to prepay balances, and various types of non-maturity deposit instruments which give
depositors the right to withdraw funds at any time, often without any penalties. If not
adequately managed, the asymmetrical payoff characteristics of instruments with
optionality features can pose significant risk particularly to those who sell them, since the
options held, both explicit and embedded, are generally exercised to the advantage of the
holder and the disadvantage of the seller.
Managing interest rate risk
Bank treasuries measure interest rate sensitivity of securities (assets or liabilities) through
Duration analysis. Duration is a mathematical concept which can be used to measure the
sensitivity of a financial instruments price to changes in interest rate. On the basis of duration
analysis, banks can increase/decrease holdings of long term and short term securities in
response to anticipated changes in interest rate.
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Banks also use derivative instruments like interest rate swaps and options to manage interest
rate risks (A derivative is a generic term often used to categorize a wide variety of financial
instruments whose value depends on or is derived from the value of an underlying asset,
reference rate or index). Some of them are:
Interest Rate Swap: An agreement to exchange net future cash flows. In its
commonest form, the fixed-floating swap, the counterparty pays a fixed rate
and the other pays a floating rate based on a reference rate, such as Libor.
There is no exchange of principal. The interest rate payments are made on an
agreed notional amount.
Forward Rate Agreement (FRA): A FRA allows purchasers / sellers to fix the
interest rate for a specified period in advance. One party pays fixed, the other
an agreed variable rate. Maturities are generally out to two years and are priced
off the underlying yield curve. The transaction is done in respect of an agreed
nominal amount and only the difference between contracted and actual rates is
paid.
Swaption: An option to enter an interest rate swap. A payer swaption gives the
purchaser the right to pay fixed (receive floating), a receiver swaption gives the
purchaser the right to receive fixed (pay floating).
Forex Management Similar to interest rates, the Forex rates of countries who have not
pegged their currencies vary from time to time. This exposes its market participants to risk
of adverse movements of exchange rates. FX Forwards and Forex Options provide a means
of reducing exchange rate risks by entering into contracts at fixed rates thereby making the
outcome predictable
Foreign exchange is essentially about exchanging one currency for another. Forex rates between
two currencies at any point of time are influenced by a variety of factors like state of the
economy, interest rates & inflation rate, exchange rate systems (fixed/floating), temporary
demand-supply mismatches, foreign trade position etc.
Foreign exchange exposures for a financial entity arise from many different activities. A
company which borrows money in a foreign currency is at risk when the local currency
depreciates vis--vis the foreign currency. An exporter who sells its product in foreign currency
has the risk that if the value of that foreign currency falls then the revenues in the
exporter's home currency will be lower. An importer who buys goods priced in foreign currency
has the risk that the foreign currency will appreciate thereby making the cost in local currency
greater than expected. Generally the aim of foreign exchange risk management is to stabilize
the cash flows and reduce uncertainty from financial forecasts.
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Since a bank is usually a counter party to the above transactions, it faces similar Forex Risk when
the reverse happens.
INR/USD quote: 45.26/.36 (here, 0.01 is the smallest count, referred to as one pip)
EUR/USD quote: 1.2458/.2461 (here, 0.0001 is the smallest count, referred to as one pip)
While the derived cross currency rate would be:
INR/Euro quote: (45.26*1.2461)/ (45.36*1.2458) = 56.40/.51
Foreign currency deals in a particular currency necessary have to be settled in the home nation
of the currency. Hence, banks taking part in international transactions need to maintain
accounts in various countries to enable transacting in those currencies. These accounts are of
multiple types:
Nostro (Our/my account with you): Current account maintained by one bank with another
bank abroad in the latters home currency
Vostro (Their account with me/us): Current account maintained in the home currency by
one bank in the name of another bank based abroad
Typically, banks have vostro/nostro accounts with multiple foreign banks.
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two currencies. In any Forex contract there are a number of variables that need to be agreed
upon and they are:
The currencies to be bought and sold - in every contract there are two currencies the one
that is bought and the one that is sold
Small and Larger Orders Equity markets are characterized by smaller orders as compared
to the markets for other financial instruments because of more retail participation
Investor Profile Equity markets have a more retail investor profile as compared to markets
for other financial instruments
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Routing Deals in the Equity markets are routed to multiple destinations where as deals in
Forex as well as debt markets are matched internally
Public v/s Private - Markets for equities are listed whereas certain Derivatives are OTC
Sungard / Front Arena - FRONT ARENA is the definitive integrated solution for sales, trading
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Summit - Summit is a core solution for treasury management for both financial and
corporate institutions. Summits trading applications interact with operations and risk
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to back management of all products within four primary business areas viz Treasury, Fixed
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Calypso - Calypso Technologies the worlds leading software provider of credit derivatives,
cross
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allows traders flexibility to plug in their own products.
Wall Street Systems - Wall Street Systems delivers single-server, enterprise-wide solutions
to the world's leading financial institutions and corporations The Wall Street System
financial trading and treasury engine provides a multi-entity, multi-currency, multi-asset
class environment which supports all front, middle and back office operations.
Integral - Integral is at the forefront of the eFX market in developing new, highly innovative
products. Integral is the provider of integrated electronic trading systems, offering intuitive
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Multi-bank platform
Reuters RET - Reuters Electronic Trading provides a comprehensive FX and money markets
trading solution for banks.. It includes Automated Dealing, an internet based FX and money
market automated dealing capability, to enable the Bank's dealing room to price, execute,
confirm and manage FX and money market trading.
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6.5
CASH MANAGEMENT
Cash Management Service (CMS) is a service provided by banks to its clients for a fee to reduce
the float on collections and to ease the bulk payment transactions of the client. Large
Corporations like GM or Ford need to manage cash well since they have:
Collections from multiple parties at various locations - How does a company collect its sale
proceeds from remote upcountry regions?
Ensure local deficits and surpluses are managed A corporate may be paying its
employees salaries out of one bank account whereas it may be banking its receivables
in another bank account another location leading to surpluses and deficits in their bank
accounts
Reduce operational costs associated with payments & collections A CMS would help
optimize wasted operational cost on payments and collections
Devise an effective account & investment strategy to manage surpluses and deficits
Pooling, Netting, Zero-balance structures
Example
Consider a consumer goods company in Mid-west US, with dealerships spread through 12
states. The company has a manufacturing facility in Michigan and 4 depots, one each in Ohio,
Michigan, Illinois and Texas. The company transports goods to the 4 depots which serves the
respective local dealers and in some cases dealers in neighboring states. All the depots are
treated as independent cost centers, with sales from respective regions and salaries and general
expenses for these regions marked to the depot concerned. Collections from dealers in various
locations are managed by local sales teams, one team for each state. The company wants to:
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Ensure that surplus money in the central account is invested in an optimal fashion while
allowing sufficient liquidity
All payments from local accounts above $10,000 require an approval from the CFO sitting in
Michigan
This is a typical case where the company needs the services of a bank to manage its cash
collections and payments. The company needs both cash management facilities and MIS of
collections and payments that can allow it to track revenue and expenses in the manner
required.
Companies rarely fail because they are insolvent. They do fail because they are illiquid.
Companies must focus on precise working capital management as a critical component of
treasury strategy. Companies require:
Investment options to match individual profiles for liquidity, risk and return.
Banks process payments on behalf of corporations CMS provides its customers the
payment processing services which help corporations to reduce administrative hassles
and costs in doing so.
Payment Initiation
o
Manual instruction Banks can act on manual instructions given by the corporations to
their bankers for processing payments. They typically take the form of checks or drafts
Electronic banking applications Electronic applications like ECS / EFT or individual bank
specific software packages can be made use of by corporations to effect transfers
Bulk payments
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CMS is very beneficial for processing repetitive / bulk payments in the nature listed below.
Economies of scale and reduction of administrative and related costs can be gained by
corporations
o
Payroll processing
Dividend warrants
o
Redemptions
COLLECTIONS SERVICES
Collect funds around the globe CMS provides accurate and timely collection of receivables
worldwide
Local collections Refer to collections from suppliers / debtors who issue local checks
Outstation collections - Refer to collections from customers not in the base location of
the corporation
Banks have responded to the call for evolved cash management concepts. Accelerating accounts
receivable and streamlining accounts payable via a single banking system interface provide the
stepping stone to achieve optimal cash flow management. Some banks also provide aligned cash
management with liquidity and investment offerings. They do so by:
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enables companies to collect and settle checks locally (In a typical case, each of the corporates
debtors would send checks along with accepted invoices to a designated post box, hence the
lock box name). Banks undertake to collect checks at various pre-defined locations on behalf of
the customer, send them for clearing and credit the amount s to a specified customer account.
Once the checks are collected by the bank through person, courier or delivered by the company
representative:
post dated checks are kept for processing on the value date
the image of the checks and the remittance advices are captured and sent to the corporate
realized checks are tallied and amounts credited to the corporates bank account
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The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28,
2003, and became effective on October 28, 2004. The law facilitates check truncation by
creating a new negotiable instrument called a substitute check, which permits banks to
truncate original checks, to process check information electronically, and to deliver
substitute checks to banks that want to continue receiving paper checks. A substitute check
is the legal equivalent of the original check and includes all the information contained on the
original check. The law does not require banks to accept checks in electronic form nor does
it require banks to use the new authority granted by the Act to create substitute checks.
o
Faster / efficient check realization Since the electronic image of the check can be
quickly transmitted electronically, time required for transporting the physical paper
checks is greatly reduced thereby effecting faster check realizations
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All these entities need not be present in every transaction. The number of entities depends on
the complexity of the transaction. An example would help understand the concept better.
Example
Bank of America (Originator) has 5000 home loans totaling more than $600 million. The
individual loans are of various credit profiles and various repayment periods. Bank of America is
constrained by lack of funds and wishes to sell off its loans to raise money. Thus, it decides to
sell about 2000 home loans totaling $200 million. The steps followed are shown below:
Bank of America conducts an internal study of the portfolio and ascertains that the average
maturity of the pool of loans is about 12 years and the average credit rating would be AA-. It
realizes that historically 10% of the total home loan owners default. So it would only realize
$180 million instead of $200 million.
Bank of America wants to enhance the rating so that it can sell the loans at a better price.
It decides to provide cash security of $10 million (Credit enhancement) in the scenario of
any repayment default by home loan borrowers.
Bank of America appoints Credit rating agency X which analyses the pool of loans, and taking
into account the cash security provided rates it AA+.
Bank of America sells the pool of housing loans amounting to $200 million to an
independent firm, Plexus SPV Ltd.
Backed by these home loans future cash flows, Plexus SPV Ltd. issues debt certificates for
$200 million to investors. Plexus pays back the investors the money from the repayments
done by the home loan borrowers.
Plexus SPV Ltd. pays $198 million to Bank of America after deducting service charges to
cover operational costs.
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From now on, all EMI repayments on these home loans made by retail investors would flow
through Plexus SPV Ltd and then reaches the investors.
The above example captures the gist of any securitization transaction, but there are a lot of
structuring issues and legal and regulatory challenges involved in any such transaction.
Fannie Mae and Ginnie Mae are examples of institutions specializing in securitization
transactions of mortgage loans for US banks. They help US banks in having enough fresh funds
for home loan disbursements.
REAL TIME GROSS SETTLEMENT (RTGS)
The current payment system involves settlement of payments on a settlement day and interest
is invariably computed to accrue on a daily basis. Even in the wholesale markets for foreign
exchange and money markets contracts, spot transactions mean two-business days.
Settlement for clearing checks presented to the clearing houses takes place on a netting basis at
a particular time either same day or on the next day. This system gives rise to risks such as credit
risk, liquidity risk, legal risk, operational risk and systemic risk.
RTGS is a system provides online settlement of payments between financial institutions. In this
system payment instructions between banks are processed and settled individually and
continuously throughout the day. This is in contrast to net settlements where payment
instructions are processed throughout the day but inter-bank settlement takes place only
afterwards typically at the end of the day. Participant banks will have to maintain a dedicated
RTGS settlement account with the central bank for outward and inward RTGS payments.
RTGS systems do not create credit risk for the receiving participant because they settle each
payment individually, as soon as it is accepted by the system for settlement.
RTGS system can require relatively large amounts of intraday liquidity because participants need
sufficient liquidity to cover their outgoing payments.
CONTINUOUS LINKED SETTLEMENT (CLS)
The average daily turnover in global Forex transactions stand at almost USD 2 trillion, with
participants in the market spread across various geographies and time zones. However, the
difference in time zones and hence lack of synchronization of transactions has resulted in
considerable amount of systematic risk. Typically, one leg of a Forex trade is affected at one
point of time and there would be a delay before the other leg is executed because of time-zone
differences. In such a situation, there is a heightened risk of one party defaulting.
CLS eliminates this temporal settlement risk, making same-day settlement both possible and
final. This is made possible by leveraging on the fact that there are significant overlaps between
the main time zones. CLS provides a specific time window in which various settlement time
zones can interact and pass settlement messages. The CLS system consists of the following
entities:
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CLS Bank: The CLS bank is the central node for the CLS system. CLS Bank is owned by nearly
70 of the worlds largest financial groups throughout the US, Europe and Asia Pacific, who
are responsible for more than half the value transferred in the world's FX market.
Settlement Members: They are shareholders of the CLS bank, who can each submit
settlement instructions directly to CLS Bank and receive information on the status of their
instructions. Each Settlement Member has a multi-currency account with CLS Bank, with the
ability to move funds. Settlement Members have direct access and input deals on their own
behalf and on behalf of their customers. They can provide a branded CLS service to their
third-party customers as part of their agreement with CLS Bank.
User Members: User Members can submit settlement instructions for themselves and their
customers. However, User Members do not have an account with CLS Bank. Instead they are
sponsored by a Settlement Member who acts on their behalf. Each instruction submitted by
a user member must be authorized by a designated Settlement Member. The instruction is
then eligible for settlement through the Settlement Member's account.
Third parties: Third parties are customers of settlement and user members and have no
direct access to CLS. Settlement or user members must handle all instructions and financial
flows, which are consolidated in CLS.
Nostro agents: These agents receive payment instructions from Settlement Members and
provide time-sensitive fund transfers to Settlement Members' accounts at CLS Bank. They
receive funds from CLS Bank, User Members, third parties and others for credit to the
Settlement Member account.
Traders can expand their FX business with counterparty banks without increasing limits.
Treasury managers have more certainty about intraday and end-of-day cash positions.
Global settlement can rationalize nostro accounts and leverage multi-currency accounts.
The volume and overall value of payments is reduced, as are cash-clearing costs.
Costly errors are minimized and any problems can be resolved fast.
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initiated one to two days prior to the settlement date, since they are batch processed and not
for immediate payment. The most common ACH payment applications are:
Direct deposit of payroll, where the bank debits the corporate account and credits
employee accounts on the basis of a electronic file transmitted/provided by the corporate
Corporate Disbursement Service, where the bank debits a client's account to initiate
payments to vendors on their behalf
Corporate Collection Service, where the bank enables its clients to collect payments and
remittance data from vendors or trading partners.
Collection of consumer payments over the telephone, through the Internet or via check-toACH conversion.
ACH Accounts Receivable Check Conversion enables converting checks collected at a lockbox
or remittance-processing center to ACH electronic debits, speeding payment collections and
improving funds availability.
These services allow the customer to increase transaction speed and improve accuracy and ease
of reconciliation by electronic means and avoidance of physical instruments and clearing delays.
ACH has been an area of very strong growth, with over 8.5 billion transactions being effected
through this route in 2002. However, several security issues remain to be resolved in this area.
6.6
TRADE FINANCE
The main objective of trade finance is to facilitate transactions. There are many financing
options available to facilitate international trade such as pre-shipment finance to produce or
purchase a product, and post-shipment finance of the receivables.
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pay as late as possible preferably after they have sold the goods. Trade finance is often
required to bridge these two disparate objectives.
Question
Pre-shipment finance is liquidated only through realizations of export bills or amounts received
through export incentives. Pre shipment finance should not normally remain outstanding beyond
the original stipulated shipment date. In case it remains outstanding, can the non-adjusted
amount be then transferred as post shipment finance?
Costs: The cost of different financing methods can vary, both in terms of interest rates and
fees. These costs will impact the viability of a transaction
Time Frame: Depending on the need, short, medium and long-term finance facilities may be
available. The different possibilities should be explored with the finance provider prior to
concluding a transaction. Long-term requirements should also be considered to ensure fees
are not being paid out on a revolving facility that could be saved by using a different
financing structure
Risk Factors: The nature of the product or service, the buyers credit rating and
country/political risks can all affect the security of a trading transaction. In some cases it will
be necessary to obtain export insurance or a confirmed letter of credit. Increased risks will
normally correspond to increased cost in a transaction and will normally make the funding
of a particular transaction, harder to obtain
Government Guarantee Programs: These can sometimes be obtained where there is some
question over the exporters ability to perform or where increased credit is needed. If
obtained, these may enable a lender to provide more finance than their usual underwriting
limits would permit.
Exporters Funds: If the exporter has sufficient resources, he/she may be able to extend
credit without the need for third party financing. However, an established trade finance
provider, offers other benefits like expert credit verification and risk assessment as well as
an international network of offices and staff to ensure that the transaction is completed
safely and satisfactorily
BILL OF LADING
A bill of lading or BOL is:
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The BOL grants the carrier the right to sub-contract its obligations on any terms and would bind
a shipper even if it meant that the shipper's goods could be detained and sold by the subcontractor.
CREDIT CHECK
Insuring payment starts long before a contract is signed. The seller, or his representative,
performs due diligence or a reasonable assessment of the risks posed by the potential buyer.
The sources of information include:
Credit rating services such as TRW and Dun & Bradstreet which have international affiliates
PAYMENT METHODS
Once acceptable risks have been determined then the most appropriate payment method can
be selected. The most common payment methods are described below:
Cash in advance
Letter of credit
Documentary collection
Counter-trade or Barter
CASH IN ADVANCE
Cash in advance is risk-free except for potential non-delivery of the goods by the seller. It is
usually a wire transfer or a check. Although an international wire transfer is more expensive, it is
often preferred because it is speedy and does not bear the danger of the check not being
honored. The check can be at a disadvantage if the exchange rate has changed significantly by
the time it arrives, clears and is credited. On the other hand, the check can make it easier to
shop for a better exchange rate between different financial institutions.
For wire transfers the seller must provide clear routing instructions in writing to the buyer or the
buyers agent. These include:
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Sellers full name, address, telephone, type of bank account, and account number.
The LC serves to evenly distribute risk between buyer and seller. The seller is assured of
payment when the conditions of the LC are met and the buyer is reasonably assured of
receiving the goods ordered. This is a common form of payment, especially when the
contracting parties are unfamiliar with each other.
Since banks deal with documents and not with products, they must pay an LC if the
documents are presented by the seller in full compliance with the terms, even if the buyer
never receives the goods. Goods lost during shipment or embargoed are some examples.
Iraq for example, never received goods that were shipped before its embargo but the LCs
had to be paid anyway.
LCs are typically irrevocable, which means that once the LC is established it cannot be
changed without the consent of both parties. Therefore the seller, especially when
inexperienced, ought to present the agreement for an LC to an experienced bank or freight
forwarder so that they can verify if the LC is legitimate and if all the terms can be reasonably
met. A trusted bank, other than the issuing or buyers bank can guarantee the authenticity
of the document for a fee.
Disadvantages
If there are discrepancies in the timing, documents or other requirements of the LC the
buyer can reject the shipment. A rejected shipment means that the seller must quickly find a
new buyer, usually at a lower price, or pay for the shipment to be returned or disposed.
One of the most costly forms of payment guarantee Usual cost is 0.5% to 1%. Sometimes,
the costs can go up to 5 percent of the total value.
LCs take time to draw up and usually tie up the buyers working capital or credit line from
the date it is accepted until final payment, rejection for noncompliance, expiration or
cancellation (requiring the approval of both parties)
The terms of an LC are very specific and binding. Statistics show that approximately 50% of
submissions for LC payment are rejected for failure to comply with terms. For example, if
one of the required documents is incomplete or delivered late, then payment will be
withheld even if all other conditions are fulfilled and the shipment received in perfect order.
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The buyer can sometimes approve the release of payment if a condition is not fulfilled; but
changing terms after the fact is costly, time consuming and sometimes impossible.
The mechanism
Usually, four parties are involved in any transaction using an LC:
1.
Buyer or Applicant
2.
The buyer applies to his bank for the issuance of an LC. If the buyer does not have a
credit arrangement with this issuing bank then he must pay in cash or other negotiable
securities.
Issuing bank
The issuing or applicants bank issues the LC in favor of the beneficiary (Seller) and
routes the document to the beneficiarys bank. The applicants bank later verifies that
all the terms, conditions, and documents comply with the LC, and pays the seller
through his bank.
3.
Beneficiarys bank
The sellers or beneficiarys bank verifies that the LC is authentic and notifies the
beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank is
used as a trusted bridge between the applicants bank and the beneficiarys bank when
they do not have an active relationship. It also forwards the beneficiarys proof of
performance and documentation back to the issuing bank. However, the advising bank
has no liability for payment of the LC. The beneficiary, or his bank, can ask an advising
bank to confirm the LC. The confirming bank charges a fee to ensure that the beneficiary
is paid when he is in compliance with the terms and conditions of the LC.
4.
Beneficiary or Seller
The beneficiary must ensure that the order is prepared according to specifications and
shipped on time. He must also gather and present the full set of accurate documents, as
required by the LC, to the bank.
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Letter of Credit Diagram and the 14 steps have been reproduced from www.web.worldbank.org
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Confirmation Fee
Acceptance Commission (@ 1.5% pa for 60 days)
Negotiation / Payment Fee
Out of Pocket Expenses (estimate)
USD
USD
USD
USD
$250
$250
$150
$60
USD
USD
USD
$710
($1,700)
$990
A Guarantee of payment on the due date from Allied Swedish Banks. (Provided the terms
and conditions of the Letter of Credit were complied with).
A definitive date for the receipt of funds, particularly important for devising proper currency
hedging strategies.
The opportunity to receive the payment in advance of the due date through non-recourse
discounting of the receivable.
Also note that the costs incurred in chasing the debt from the Asian buyer has not been
accounted for the Irish Exporter. In addition if the Exporter had sold his foreign currency
receivable on a forward basis to his bank for the original due date, they may have incurred a
further cost in canceling or rearranging the forward contract. Letters of Credit provide real and
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tangible benefits to companies. In this case the Swedish exporter only lost US$ 1700. Of course
if the Asian buyer had not paid at all they would have lost the whole USD 100,000
The standby LC is like a bank guarantee. It is not used as the primary payment method but as a
failsafe method or guarantee for long-term projects. This LC promises payment only if the buyer
fails to make an arranged payment or fail to meet pre-determined terms and conditions. Should
the buyer default, the seller must then apply to the bank for payment - a relatively simple
process without complicated documentation. Since the standby LC can remain valid for years
(Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular
client.
Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank
to open his own LC to buy inputs necessary to fill his buyers order.
DOCUMENTARY COLLECTION
The seller sends a draft for payment with the related shipping documents through bank
channels to the buyers bank. The bank releases the documents to the buyer upon receipt of
payment or promise of payment. The banks involved in facilitating this collection process have
no responsibility to pay the seller should the buyer default unless the draft bears the aval (ad
valutem) of the buyers bank. It is generally safer for exporters to require that bills of lading be
made out to shippers order and endorsed in blank to allow them and the banks more flexible
control of the merchandise.
Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon
receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new
buyer or pay for return shipment. Documentary collections are viable only for ocean shipments,
as the bill of lading for ocean freight is a valid title to the goods and is a negotiable document
whereas the comparable airway bill is not negotiable as an ownership title.
DRAFTS
A draft (sometimes called a bill of exchange) is a written order by one party directing a second
party to pay a third party. Drafts are negotiable instruments that facilitate international
payments through respected intermediaries such as banks but do not involve the intermediaries
in guaranteeing performance. Such drafts offer more flexibility than LCs and are transferable
from one party to another. There are two basic types of drafts: sight drafts and time drafts.
SIGHT DRAFT
After making the shipment the seller sends a sight draft, through his bank to the buyers bank,
accompanied by agreed documentation such as the original bill of lading, invoice, certificate of
origin, phyto-sanitary certificate, etc. The buyer is then expected to pay the draft when he sees
it and thereby receive the documentation that gives him ownership title to the goods that were
shipped. There are no guarantees made about the goods other than the information about
quantities, date of shipment, etc. which appears in the documentation. The buyer can refuse to
accept the draft thereby leaving the seller in the unpleasant position of having shipped goods to
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a destination without a buyer. There is no recourse with the banks since their responsibility ends
with the exchange of money for documents.
TIME DRAFTS/BANKERS' ACCEPTANCES
Bankers' acceptances are negotiable instruments (time drafts) drawn to finance the export,
import, domestic shipment or storage of goods. It demands payment after a specified time or on
a certain date after the buyer accepts the draft and receives the goods. A bankers' acceptance is
"accepted" when a bank writes on the draft its agreement to pay it at maturity. A bank may
accept the draft for either the drawer or the holder.
An ordinary acceptance is a draft or bill of exchange order to pay a specified amount of money
at a specified time. A draft may be drawn on individuals, businesses or financial institutions.
An acceptance doesn't reduce a bank's lending capacity. The bank can raise funds by selling the
acceptance. Nevertheless, the acceptance is an outstanding liability of the bank and is subject to
the reserve requirement unless it is of a type eligible for discount by the Federal Reserve Bank.
Example
Bankers Acceptances sell at a discount from the face value:
Face value of Bankers Acceptance
$1,000,000
-$20,000
$980,000
HYBRID METHODS
In practice, international payment methods tend to be quite flexible and varied. Frequently,
trading partners will use a combination of payment methods. For example: the seller may
require that 50% payment be made in advance using a wire transfer and that the remaining 50%
be made by documentary collection and a sight draft.
OPEN ACCOUNT
Open account means that payment is left open to an agreed-upon future date. It is one of the
most common methods of payment in international trade and many large companies will only
buy on open account. Payment is usually made by wire transfer or check. This can be a very risky
method for the seller, unless he has a long and favorable relationship with the buyer or the
buyer has an excellent credit rating. Still, there are no guarantees and collecting delinquent
payments is difficult and costly in foreign countries especially considering that this method
utilizes few legally binding documents. Contracts, invoices, and shipping documents will only be
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useful in securing payment from a recalcitrant buyer when his countrys legal system recognizes
them and allows for reasonable settlement of such disputes.
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Example
An Asian Importer wants to purchase machinery that he is unwilling or unable to pay
for in cash until that machinery begins to generate income.
At the same time, the exporter wants immediate payment in full in order to meet his ongoing business commitments
Forfaiting solution works as follows
1. Commercial contracts are negotiated subject to finance;
2. The importer arranges for an Irrevocable Letter of Credit to be issued or for a
series of Promissory Notes or Bills of Exchange to be drawn in favor of the
exporter which the importer arranges to have guaranteed by his local bank;
3. The exporter contacts the discounting bank (the forfaiter) for a rate of discount
which is then agreed;
4. The goods are shipped;
5. The notes or bills are sent with shipping documentation and invoices to the
discounting bank via the exporter (who endorses the notes or bills "without
recourse" to the order of the discounting bank);
6.
The discounting bank purchases the guaranteed notes or bills from the exporter
at the agreed rate.
Result: the exporter receives payment in full immediately after shipping (against
presentation of satisfactory documentation to the forfaiter); the importer gets his
goods and can pay for them in installments over time; and the forfaiter has title to an
asset which he may retain as an investment.
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The Bankers Association for Foreign Trade (BAFT) is a collection of banking institutions,
dedicated to promoting American exports, international trade, and finance and investment
between U.S. firms and their trading partners. BAFT has set up a trade finance database with a
grant from the U.S. Department of Commerce. The database serves as an essential resource for
assisting exporters seeking trade finance and banks that provide financial services.
6.6
PAYMENTS NETWORK
6.6.1 FEDWIRE
Fedwire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and more than 9,000 on-line and off-line depository institutions and thus
plays a key role in US payments mechanism. The system is available on-line depository
institutions with computers or terminals that communicate directly with the Fedwire network.
These users originate over 99 percent of total funds transfers. The remaining customers have
off-line access to Fedwire for a limited number of transactions.
Fedwire transfers U.S. government and agency securities in book-entry form. It plays a
significant role in the conduct of monetary policy and the government securities market by
increasing the efficiency of Federal Reserve open market operations and helping to keep the
market for government securities liquid.
Depository institutions use Fedwire mainly to move balances to correspondent banks and to
send funds to other institutions on behalf of customers. Transfers on behalf of bank customers
include funds used in the purchase or sale of government securities, deposits, and other large,
time-sensitive payments.
Fedwire and CHIPS, a private-sector funds transfer network specializing in international
transactions, handle most large-dollar transfers. In 2000, some 108 million funds transfers
with a total value of $380 trillion were made over Fedwire -- an average of $3.5 million per
transaction.
All Fedwire transfers are completed on the day they are initiated, generally in a matter of
minutes. They are guaranteed to be final by the Fed as soon as the receiving institution is
notified of the credit to its account.
Until 1980, Fedwire services were offered free to Federal Reserve member commercial banks.
However, the Depository Institutions Deregulation and Monetary Control Act of 1980 required
the pricing of Fed services, including funds and securities transfers, and gave nonmember
depository institutions direct access to the transfer system. To encourage private-sector
competition, the law requires the Fed's fees to reflect the full cost of providing the services,
including an implicit cost for capital and profitability.
How Fedwire Works
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Transfers over Fedwire require relatively few bookkeeping entries. Suppose an individual or a
private or government organization asks a bank to transfer funds. If the banks of the sender and
receiver are in different Federal Reserve districts, the sending bank debits the sender's account
and asks its local Reserve Bank to send a transfer order to the Reserve Bank serving the
receiver's bank. The two Reserve Banks settle with each other through the Inter-district
Settlement Fund, a bookkeeping system that records Federal Reserve inter-district transactions.
Finally, the receiving bank notifies the recipient of the transfer and credits its account. Once the
transfer is received, it is final and the receiver may use the funds immediately. If the sending and
receiving banks are in the same Federal Reserve district, the transaction is similar, but all of the
processing and accounting are done by one Reserve Bank.
6.6.2. CHIPS
CHIPS, Clearing House Interbank Payments System, are the premier bank-owned payments
system for clearing and settling large value payments. CHIPS is a real-time, final payments
system for U.S. dollars that use bi-lateral and multi-lateral netting for maximum liquidity
efficiency. CHIPS is the only large value system in the world that has the capability of carrying
extensive remittance information for commercial payments. CHIPS processes over 267,000
payments a day with a gross value of over $1.37 trillion. It is a premier payments platform
serving the largest banks from around the world, representing 22 countries worldwide.
6.6.3
SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) runs a worldwide
network by which messages concerning financial transactions are exchanged among banks and
other financial institutions. As of December 2001, it linked over 7000 financial institutions in 194
countries and estimates that it carried payments messages averaging more than six trillion US
dollars per day. SWIFT network is used for transfers across different countries and in all
currencies.
SWIFT is a co-operative society under Belgian law, owned by its member financial institutions
with offices around the world. SWIFTs headquarters are located in La Hulpe near Brussels. It
was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish
a common language for financial for financial transactions and a shared data processing system
and worldwide communications network. Fundamental operating procedures, rules for liability,
etc. were established in 1975 and the first message was sent in 1977.
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SUMMARY
FedWire is an electronic transfer system developed and maintained by the Federal Reserve
System. The system connects Federal Reserve Banks and Branches, the Treasury and other
government agencies, and depository institutions and thus plays a key role in US payments
mechanism
Clearing House Interbank Payment System (CHIPS) is a private sector funds transfer network
mainly for international transactions. CHIPS transfers are settled on a net basis at the end of
the day, using Fedwire funds transfers to and from a special settlement account on the
books of the New York Fed.
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7.0
INVESTMENT MANAGEMENT
7.1
INTRODUCTION
Making better decisions than their clients could, due to their research capacity and
investment skills.
Providing a level of investment diversification through the pooling of funds that their clients
could not achieve.
Using their breadth of knowledge to fulfill the investment objectives of the portfolio, e.g.,
providing an acceptable pension for their client.
The return on investment is compared to a benchmark, often constructed from the returns
obtained by rival asset managers, this comparison being used by investors to assess the asset
managers performance. The investment manager is also responsible for ensuring that the
clients individual preferences and needs are observed, e.g., level of risk-appetite, liquidity
needs, tax implications, etc. Investment Managers usually look after more than one client, each
clients capital being segregated into a fund or portfolio.
Investment Management is also referred to variously as Asset Management, Fund management
and Portfolio management; while managing of investment for high-net-worth individuals (HNI)
is called Wealth management or Private Banking.
INVESTMENT MANAGEMENT GOALS
Investment Management aims at the following goals:
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Ultimate objective is to deliver equity type returns with lesser volatility risk and achieve
capital preservation
In achieving the above goals, an Investment Manager uses the following approaches/principles:
Asset Mix is the primary determinant of portfolio return, optimum portfolios are designed
using asset allocation tools
Capital preservation - Preserve the wealth of investors and ensure erosion free investment
Alternative Investments - Investing in hedge fund and futures to have strong returns. These
assets generally earn returns consistent with those of equities. By combining alternative
investments with equities, the asset manager can generate superior returns while reducing
the ups and downs of the portfolio.
Investment management services are usually offered by firms that specialize in managing an
investors money. These firms employ individuals known as portfolio managers who are
responsible for taking the decision on which type of assets to invest it to best suit the investors
needs.
7.2
The end-to-end Investment Management process starts from acquisition of a client and opening
a customer account, and ends with portfolio accounting, updating of shareholder account
balances, and performance reporting.
Following is a high-level chart showing the typical Investment Management processes:
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Another related area for the Sales and Marketing team is often to be in touch with the issuers in
order to get into lucrative deals that enable the company to generate better returns for its
clients portfolio.
Wealth Management service providers usually have sales and marketing offices in all big
financial centers across the globe. The sales personnel keep in personal touch with prospects
and usually communicate via phone or personal meetings. This is important as the clients
usually are very rich and want to maintain secrecy about their financial matters.
NEEDS ANALYSIS & INVESTOR PROFILING
Needs Analysis process focuses on definition of what shareholder wants to achieve in a defined
time frame. The Portfolio Manager would understand what needs the shareholder is trying to
fulfill by making investments. This is an important process because no two shareholders are
alike. The investments to be made should be channelized in instruments, which help the
shareholder achieve his overall investment objective.
The Portfolio Manager would also define the Life Events of the shareholder while doing needs
analysis. Life events can be any event which specifically needs extra money to achieve like a
wedding, buying a new house, buying the latest Porsche Carrera or retirement planning. The
aim is to account for any intermediate requirements before meeting the overall goal.
While a shareholder can define an objective and provide an initial sum of money to invest to
start off, not all objectives can be necessarily met. Objectives set by the shareholder may need a
certain amount of risk taking as otherwise the initial investment made by the shareholder might
not be enough to get to the objectives. This tie up with the basic financial premise: Higher the
risk involved in an investment, higher the expectation of the return from the investment.
Portfolio Manager would hence typically administer the shareholder a questionnaire, which
would help the manager decide what kind of the risk the shareholder can take. Using the
answers provided by the shareholder, the Portfolio Manager would arrive at a Risk Profile for
each individual investor. Risk profile defines how much risk the shareholder can take on a
sustainable basis. It is a function of demographic factors like age, years remaining until
retirement, and family structure, economic factors like current nature of job, earning potential
and psychological factors like response to financially negative events, risk appetite, etc.
ASSET ALLOCATION
At the heart of Investment management are the investment managers whose job is to invest
and divest client monies Asset allocation is an investment portfolio technique that aims to
balance risk and create diversification by dividing assets among major categories such as cash,
bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk,
so each will behave differently over time
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After rationalizing the shareholders investment objectives using the risk profile, the Portfolio
Manager would decide how to allocate the shareholders investment to various asset classes.
An asset class is a group of financial instruments with similar risk and return characteristics. For
example, Equities is an asset class. Similarly, Fixed Income instruments, Real Estate and
Derivatives can all be classified as asset classes.
Asset allocation is generally of two types:
Passive -Depending on the risk preferences, cash needs and tax status of the investor a mix
of assets is determined for diversification of asset allocation and taking into account the
macro economic factors like recession and inflation
PASSIVE APPROACH
The portfolio manager has to decide on the mix of assets that maximizes the after-tax returns
subject to the risk and cash flow constraints. Thus the investors characteristics determine the
right mix for the portfolio. In coming up with the mix, the asset manager uses diversification
strategies; asset classes tend to be influenced differently by macroeconomic events such as
recessions or inflation. Diversifying across asset classes will yield better tradeoffs between risk
and return than investing in any one risk class. The same observation can be made about
expanding portfolios to include both domestic and foreign assets.
ACTIVE APPROACH
Portfolio managers often deviate from the passive mix by using Market timing. To the extent
that portfolio managers believe that they can determine which markets are likely to go up more
than expected and which less than expected, they will alter the active-passive mix accordingly.
Thus, a portfolio manager who believes that the stock market is overvalued and is ripe for a
correction, while real estate is undervalued, may reduce the proportion of the portfolio that is
allocated to equities and increase the proportion allocated to real estate. Market strategists at
all of the major investment firms influence the asset allocation decision.
There have been fewer successful market timers than successful stock pickers. This can be
attributed to the fact that it is far more difficult to gain a differential advantage at market timing
than it is at stock selection. For instance, it is unlikely that one can acquire an informational
advantage over other investors at timing markets. But it is still possible, with sufficient research
and private information, to get an informational advantage at picking stocks. Market timers
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contend that they can take existing information and use it more creatively or in better models to
arrive at predictions for markets, but such approaches can be easily imitated.
Validation of models
Information in both the volatility and correlation is used in determining optimal portfolio
weights
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"Hedge" strategies are also possible. This involves taking long positions in the highest expected
returns countries and short positions in the lowest expected returns countries.
BOTTOM UP APPROACH
The idea is to select individual securities. From a variety of methods, forecasted winners are
purchased and forecasted losers are sold. Bottom up" investor would try to find investments
that are attractive because of something particular to them -- i.e., their terrific growth potential,
say, or the fact that their assets are selling for less than their intrinsic worth. So an investor who
practices the "bottom up" approach might screen through a long list of stocks to find ones that
look like a buy on the basis of their fundamentals.
PORTFOLIO MANAGEMENT
Portfolios are created after the asset allocation has been finalized. The next task is selecting
rationally the kind of stocks and other financial instruments that should form part of the
intended investment basket. Thereafter, it calls for constant revision of the portfolio depending,
if so called for by the style of management chosen. Of course, as with any other assignment,
there comes a time for the financial advisor to evaluate as to how the portfolio has fared both in
absolute and relative terms. While managing a clients portfolio, it is imperative that the
financial advisor looks for avenues and opportunities for making additional money through nonconventional ways for the client. Given the fact that a financial advisor is a fiduciary, he should
do everything that is professionally possible to immunize the clients portfolio from unexpected
risks and events.
Performance of the portfolio is measured both in absolute and relative term. Portfolio
performance is always measured with respect to the risks taken. Also, performance should be
reckoned taking into account the circumstances and the restrictions.
Another important aspect of Portfolio Management is Portfolio Performance Reporting. These
reports contains details of annualized return, holding period return, dispersion of returns,
portfolio risk measure, asset-class wise return, performance attribution information, etc. In
respect of each asset class, there are drill-down reports made available to the client.
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prices etc. Some of the pre-requisites for performing meaningful research to aid investment
decision making are as follows:
RESEARCH TEAM
The first step is to put together a dedicated research team. It is critical that the team members
not only understand the financial market dynamics but also have knowledge on Model building
and Econometrics. The success of the research team is usually evaluated relative to a
benchmark return.
DATA
The research team must have easy access to a variety of data. The collection and maintenance
of the database is very important. Tactical decisions need to be made quickly as new data keeps
pouring in. It is best to invest in a database system that takes the new data and automatically
runs the quantitative analyses.
COMPUTING
While most top-down data management exercises can be handled within Excel, the bottom up
projects are not feasible within a spreadsheet. The bottom-up projects may include up to 10,000
securities along with vectors of attributes for each security.
Investment firms have dedicated research teams, which take immense pride in data mining and
coming out with their views on all sorts of investment opportunities available in the market.
These research reports draw on a rich source of data, advice and statistical tools that are not
readily available to small individual and institutional investors.
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Assessment of Industry
Dynamics
Interview of Company
executives
Information
Analysis
Report
Analysis of competition
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RISK MANAGEMENT
Portfolio Risk Management is the process of measuring and assessing ones portfolio's exposure
to market risk. There can be three views on risks, allowing us to compare our portfolio to the
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market portfolio (S&P 500) in terms of Risk-Adjusted Return, Value-at-Risk (VaR), and Market
Risk Exposure (Alpha, Beta and R-squared).
Portfolio Risk Analysis is important because it provides a powerful tool for assessing portfolio's
risk, both relative to the market and to the risk level we desire to maintain.
Various risks associated with an investment are as follows:
1. Business Risk: This is the risk associated with the uncertainty of a company's future cash
flows, which are affected by the operations of the company and the environment in
which it operates.
2. Financial Risk: This is the risk associated with the uncertainty of a company's ability to
manage the financing of its operations. Essentially, financial risk is the company's ability
to pay off its debt obligations.
3. Liquidity Risk: This is the risk associated with the uncertainty of exiting an investment,
both in terms of timeliness and cost. The ability to exit an investment quickly and with
minimal cost greatly depends on the type of security being held.
4. Exchange Rate risk: This is the risk associated with investments denominated in a
currency other than the domestic currency of the investor. For
example, an American holding an investment denominated in Canadian dollars is subject
to exchange-rate risk.
5. Country specific risk: This is the risk associated with the political and
economic uncertainty of the foreign country in which an investment is made. These risks
can include major policy changes, overthrown governments, economic collapses and
war.
VALUE-AT-RISK
(VaR) is a category of risk metrics that describe probabilistically the market risk of a trading
portfolio. Value-at-risk is widely used by banks, securities firms, commodity merchants, energy
merchants, and other trading organizations. Such firms could track their portfolios' market risk
by using historical volatility as a risk metric. They might do so by calculating the historical
volatility of their portfolio's market value over a rolling 100 trading days. The problem with
doing this is that it would provide a retrospective indication of risk. The historical volatility
would illustrate how risky the portfolio had been over the previous 100 days. It would say
nothing about how much market risk the portfolio was taking today.
For institutions to manage risk, they must know about risks while they are being taken. If a
trader mis-hedges a portfolio, his employer needs to find out before a loss is incurred. Value-atrisk gives institutions the ability to do so. Unlike retrospective risk metrics, such as historical
volatility, value-at-risk is prospective. It quantifies market risk while it is being taken.
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ORDER MANAGEMENT
Any investment management process shall deal with the most important activity of buying and
selling of various securities depending upon the state of the market and the view taken by the
portfolio manager. Such trading activities need a lot of monitoring and have to be settled in
accordance with the market practices.
The Order Management system provides functions for deal recording, compliance and back
office integration. Dealers can record the detail of orders and track the confirmation process.
The status of the orders can be monitored across all workstations in the dealing room. The
system enables dealers to share a common database with the back office and provides the
dealers on-line access to shareholders actual cash and investment positions and limits. Allocated
deals are sent to the back office electronically for the computation of contract details (charges,
commissions, etc), for printing the contract notes and to start the settlement process.
ORDER TRANSMISSION AND EXECUTION
An order represents intent to buy or sell. Market orders request execution at the most
advantageous price obtainable after the order is presented in the market (Trading Crowd). Limit
orders request execution at a specified price or better; they will be executed only if and when
that price is reached. In addition to these two basic types of orders there are several order types
specifying further conditions for execution (e.g., sell plus, buy minus, good til cancelled and stop
loss). Orders also carry qualifications regarding trade settlement (e.g., regular way, cash, and
next day). Finally, orders can be subdivided into member orders (for a members own account)
or public orders (submitted by a member on behalf of a non-member, such as a retail client).
Electronic trading system is replacing the earlier used Open outcry system. NYSE supports both
electronic trading as well as Floor broker trading (that is Open Outcry). Most European
exchanges support electronic trading.
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Exchanges require member firms to report both own-account and customer-account trades
effected outside business hours as well as in foreign markets to the exchange. Member firms
need not report program trading transactions they already report to the Exchange. Member
firms must report the date and time of the transaction; symbol; price; number of shares; where
the transaction was executed; whether the transaction was a buy, sell or cross; whether it was a
principal or an agency transaction; and the name of the contra-side broker-dealer.
Position Maintenance
The function of Record Keeping and Position Maintenance is typically performed by Custodians.
Custodians are settling entities in a Trade Cycle. It is mandatory for institutional investment
managers to appoint a custodian. The custodian is responsible for the settlement of trades
done by the broker/dealers. In case of physical settlement all post trade activities like the
physical settlement of securities, getting the securities transferred; safe-keeping of the
securities is done by the Custodian. In case of a paperless or electronic settlement environment,
the Custodian maintains the securities account balances in electronic form. The account
balances may be held at a Position level as well as a Tax Lot level. A Custodians systematic
record keeping system helps to track the owner of the Security as on a particular date.
Trade Allocation
As described earlier, when a single investment manager is responsible for multiple fund
accounts, the order for similar securities from such fund accounts are normally consolidated and
sent to the trading desk. The trader can either place a single order for the portfolio order or
merge/split several orders and send it as a block order for execution. Since a trade order is
typically a block order on a security for multiple accounts or funds, when a notice of execution is
received, it has to be allocated back to the accounts in the form of allocations.
Portfolio Accounting
Given the fact that a Pooled Investment Vehicle invests more or less its entire corpus primarily
in such assets that undergo change in value every day, the overall value of its portfolio keeps
varying dynamically. In turn, this means, the pro rata value of units held by individual investors
also keeps changing from day to day. So, it is essential that pooled funds evaluate and publish
the value of the units issued by them to their investors. This value is arrived on the basis of Net
Asset Value (NAV) computation.
NAV is the actual value of the investments made by the pooled fund for each unit issued by it. It
changes almost on a daily basis as the market prices of individual securities in its portfolio
fluctuate. It is computed by the formula given below:
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We know that the value of the mutual fund varies with the value of the portfolio, as the prices
of the securities, which constitute the portfolio, fluctuate day to day. As the intrinsic value of the
security represents the fair value of the security, the NAV represents the fair value of a unit in a
mutual fund.
The accounting team performs the all-important function of tracking the performance of the
firm and drawing up its P&L. It calculates the fees, charges and other such heads that are to be
recovered from the clients. The accounting team ensures that the overall financial impact of all
the activities of the Wealth Management firm is recorded and taken into account.
PERFORMANCE MEASUREMENT
Fund performance is the acid test of investment management, and in the institutional context
accurate measurement a sine qua non. For that purpose, institutions measure the performance
of each fund (and usually for internal purposes components of each fund) under their
management, and performance is also measured by external firms that specialize in
performance measurement. The leading performance measurement firms (e.g. Frank Russell in
the USA) compile aggregate industry data e.g. showing how funds in general performed against
given indices and peer groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be made (as far as the
client is concerned) every quarter and would show a percentage change compared with the
prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other
similar funds managed within the institution (for purposes of monitoring internal controls), with
performance data for peer group funds, and with relevant indices (where available) or tailormade performance benchmarks where appropriate. The specialist performance measurement
firms calculate quartile and decile data and close attention would be paid to the (percentile)
ranking of any fund.
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Generally speaking it is probably appropriate that an institution should persuade its clients that
performance be assessed over a longer period e.g. 3 or 5 years to smooth out very short term
fluctuations in performance and the influence of the business cycle. This can be difficult
however and, industry wide, there is a serious pre-occupation with short-term numbers and the
effect on the relationship with clients (and resultant business risks for the institutions).
TRANSACTION REPORTING AND COMPLIANCE
Within each marketplace, a regulatory environment exists in order to ensure that the market
operates in a fair and orderly manner. The regulator is the rule-setter and umpire of the game.
This encompasses a number of facets of operation relating to stock exchange / market members
such as:
Transaction reporting
Closely associated with reporting is compliance. Compliance refers to knowing and operating in
accordance with laws and rules existing in the country where the trade is taking place. In this
context we shall cover some of the relevant Acts which different entities in the securities
markets have to comply with.
FEES AND BILLING
Investment management is a fee based activity. In case of Fee based brokerage programs, the
active traders pay a flat asset-based fee (usually about 1%) for all trading activity instead of a
commission on individual trades. There is usually a limit on the number of trades per period.
After that, the client is usually charged a commission.
In case of hedge funds, the managers charge a fee based on performance rather than the asset
size.
7.3
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The Federal Reserve Supervisory Letter defines private banking as personalized services such as
money management, financial advice, and investment services for high net worth clients.
Although high net worth is not defined, it is generally taken at a household income of at least
$100,000 or net worth greater than $500,000. Larger private banks often require even higher
thresholds - Several now require their new clients to have at least $1 million of investable
assets. As per the World Wealth Report 2008 by Merrill Lynch / Cap Gemini, there are currently
over 10.1 million millionaires in the world with a combined asset base exceeding US$ 40.7
trillion which is projected to grow to reach US$ 59.1 trillion by the end of 2012.
CLIENT SERVICES
A typical private banking division of a large bank would offer the following financial services to
its Private clients:
Investment Management and Advice
A client relationship Manager understands the clients liquidity, capital and investment needs.
He strives to develop an integrated approach to manage client investments and capital markets
trading. Access to specialist advice and extensive research is a key feature of private banking.
Self-directed or non-discretionary: This is largely investment advisory in which the bank offers
investment recommendations based on the Clients approval. The client may choose to ignore
this.
Discretionary: In this case, the banks portfolio managers make investment decisions on behalf
of the customer.
Risk Management
Strives to reduce exposures for its clients across the world through a variety of hedging tools,
taking positions in derivative markets etc
Liquidity
Management of a Clients liquidity (cash etc) needs through short-term credit facilities, flexible
cash management services etc. An exclusive cash management service with "sweep" facility is a
Private Banking feature. The sweep automatically transfers excess funds over a pre-determined
limit out of ones current account into a higher yielding reserve account, optimizing his/her
return on short-term cash. Funds are on call so they remain easy to access.
Structured Lending
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Insurance
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PTAs are transaction deposit accounts that allow banks in one country to offer their foreign
clients of a foreign bank, such services as check-writing. The foreign bank in this case plays the
role of a correspondent bank. These accounts usually have a high transaction volume and attract
dollar deposits from the foreign customers.
HEDGE FUNDS
This is a private investment partnership, and is usually run by Private Banks. Hedge funds are
highly speculative and they use a variety of techniques such as leverage, short-selling, and use of
derivatives. Several hedge funds also utilize some form of arbitrage, such as those where they
can take advantage of movements expected to occur in the stock price of two companies
undergoing a merger or other similar event. In most cases, investors in a hedge fund need to be
duly accredited.
]
CORE FUNCTIONS IN PRIVATE BANKING
Financial Planning
Market Activities
Research
Compliance controls.
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Institutional money managers are independent financial advisory firms organized and licensed
under the Security and Exchange Commission or Banking Laws' oversight agency of the country.
Institutional Asset Management service can be both Advisory or Fund handling and investing on
behalf of the customer.
Since, Institutional Asset Management is just another variant of Investment Management, so for
all practical purposes, the processes, entities, business organization etc. will remain the same.
The differences, if any, will be brought forward as we proceed along in the chapter.
Distinction from generic Investment Management
Institutional money managers are distinguished by the fact that:
They are under greater regulatory scrutiny from both state and federal authorities
They provide exclusive service to their clientele who are typically institutions having
portfolios in excess of several million dollars.
They are very selective in the clientele they service and first do an independent analysis of
that client's financial needs, goals, objectives, and risk tolerance.
They charge competitive fees due to the fact that their clients entrust millions of dollars to
them for investing. Accordingly they are under greater scrutiny to provide attractive
performance returns.
They can most often take on the role of a treasury and cash manager for institutional clients,
to manage their day to day liquidity requirements.
A custodian is appointed to oversee the responsibility of safe-keeping the assets. Custodian
also acts as trustee of the assets of the institutional clients in most cases.
Deliver equity type returns with lesser volatility risk and achieve capital preservation
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Capital preservation is an important consideration for all institutional clients. The reason is that
these institutions can themselves be listed companies. While they want to make returns from
their cash holdings, investing in markets is not their primary business objective. They are looking
for better than bank returns, without taking too much of risk. Institutions are answerable to
their shareholders and hence would never want to lose money in investments.
Hence for institutional clients risk and liquidity management are very important features of the
investment decisions. Risk levels in all investments should be carefully monitored and
investments should be liquid that is it should be easy to buy and sell the instruments
identified. Institutions might need cash at any point of time for meeting their core business
objectives; hence they would not prefer to invest in illiquid instruments.
Diversification: With a mutual fund one can diversify the investment both across
companies and across asset classes. When some assets are falling in price, others are likely
to be rising, so diversification results in less risk than if one purchased just one or two
investments.
Liquidity: Most mutual funds are liquid and it is easy to sell the share of a mutual fund.
Low Investment Minimums: One doesnt need to be wealthy to invest in mutual funds.
Most mutual funds will allow one to buy into the fund with as little $1,000 or $2,000.
Convenience: When someone own a mutual fund, he/she doesn't need to worry about
tracking the dozens of different securities in which the fund invests; rather, all he/she need
to do is to keep track of the fund's performance.
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Low Transaction Costs: Mutual funds are able to keep transaction costs low because they
benefit from reduced brokerage commissions for buying and selling large quantities of
investments at a single time.
Regulation: Mutual funds are regulated stringently by the government. Thus this reduces
the risk for the end investor.
So mutual funds are full of benefits. Now one must be wondering if the mutual fund what
the disadvantages of mutual funds are. There are plenty of disadvantages:
Fees and Expenses: Most mutual funds charge management and operating fees that pay for
the fund's management expenses (usually around 1.0% to 1.5% per year). Moreover a few
mutual funds charge high sales commissions.
Poor Performance: Mutual funds do not guarantee a fixed or high return. On an average
more than half of the mutual funds fail to do better than the market returns.
Loss of Control: The mutual fund managers are the people who decide upon the strategy to
invest. Thus the investor loses the control of his money to the fund manager.
Inefficiency of Cash Reserves: Normally a Mutual fund maintains a large cash reserve to
provide protection against simultaneous withdrawals. This provides investors with liquidity,
but due to the large cash reserve the mutual funds do not invest all cash in asset and thus
provide investor with lowered returns.
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Open-ended plans are preferred for their liquidity. Such funds can issue and redeem units any
time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a
daily basis. The advantages of open-ended funds over close-ended are as follows:
Any time entry option: An open-ended fund allows one to enter the fund at any time and even
to invest at regular intervals.
Any time exit option: The issuing company directly takes the responsibility of providing any time
entry and exit option. This provides ready liquidity to the investors and avoids reliance on
transfer deeds, signature verifications and bad deliveries.
CLOSE-ENDED PLANS
Close-ended plans have fixed maturity periods. Investors can buy into these funds during the
period when these funds are open in the initial issue. Such schemes cannot issue new units
except in case of bonus or rights issue. However, after the initial issue, investor can buy or sell
units of the scheme on the stock exchanges where they are listed. The market price of the units
could vary from the NAV of the scheme due to demand and supply factors, investors
expectations and other market factors
BY NATURE OF INVESTMENTS
Mutual funds can invest in financial and non-financial assets. Depending on the nature of
investment (i.e., the type of asset in which the money is invested) we can have the following
category of Funds:
INDEX FUNDS
"Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment
objective typically is to achieve the same return as a particular market index, such as the S&P
500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market
Index.
STOCK FUNDS
"Stock fund" and "equity fund" describe a type of Investment Company (mutual fund, closedend fund, Unit Investment Trust (UIT)) that invests primarily in stocks or "equities". The types of
stocks in which a stock fund will invest will depend upon the funds investment objectives,
policies, and strategies. For example, one stock fund may invest in mostly established, "blue
chip" companies that pay regular dividends whereas another stock fund may invest in newer,
technology companies that pay no dividends but that may have more potential for growth.
BOND FUNDS
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"Bond fund" and "income fund" are terms used to describe a type of Investment Company
(mutual fund, closed-end fund, or Unit Investment Trust (UIT)) that invests primarily in bonds or
other types of debt securities. The securities that bond funds hold will vary in terms of risk,
return, duration, volatility, and other features.
MONEY MARKET FUNDS
A money market fund is a type of mutual fund that is required by law to invest in low-risk
securities. These funds have relatively low risks compared to other mutual funds and pay
dividends that generally reflect short-term interest rates. Unlike a "money market deposit
account" at a bank, money market funds are not federally insured.
Money market funds typically invest in government securities, certificates of deposits,
commercial paper of companies, and other highly liquid and low-risk securities. While investor
losses in money market funds have been rare, they are possible.
BY INVESTMENT OBJECTIVE
Mutual funds can be further classified based on their specific investment objective such as
growth of capital, safety of principal, current income or tax-exempt income. In general mutual
funds fall into three general categories:
Growth Funds are those that invest for medium term to long-term capital appreciation.
Income Funds invest for regular Income.
Growth and Income/ Balanced Funds that tries to generate both regular income and long term
capital appreciation.
Sector Funds that have unique investment objectives.
Special Funds are special types of Mutual Funds.
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The investment company/fund calculates the NAV of a single share (or the "per share NAV") by
dividing its NAV by the number of shares that are outstanding.
Fidelity Investments
Vanguard
ING Direct
Direct ownership: The portfolio is held in a personal account rather than held as a part of
fund, thereby giving direct control to the investors.
Customization: The security to be held and the investment pattern can be customized to
individual needs. E.g. a customer may not want to invest in those companies that are in
tobacco business. The portfolio can be customized to cater to his individual needs and
preferences.
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Tax advantages: In the case of traditional mutual funds, individual taxes are not an issue.
However, in case of SMA tax advantages to investor results from tax loss harvesting
strategy.
Separately managed accounts provide the client with the following benefits:
The investors get access to top Investment managers at an affordable rate that they would
have been difficult otherwise.
The fee structure is asset based and not commission based which offer a significant value to
the customer.
The client gets better tax planning because of the tax-harvesting element in SMA.
The transactions and the operations are more transparent to the customer as compared to
traditional mutual fund.
Disadvantages
There is no requirement for the reporting of the holding and there is no specific governing
regulation unlike the mutual funds.
There is no board in case of SMA, one hires the manager to manage the asset and there is
no board to sue if something goes wrong.
Closing an SMA would require moving the individuals security to another manager, which is
a complicated and time consuming exercise.
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As the portfolio is tailored to meet both long- and short-term cash needs, an SMA, unlike a
mutual fund, can take into account personal investment preferences, such as not investing in
particular stocks for personal, social or environmental reasons. For e.g. an investor may specify
that his/her portfolio should not contain any stock belonging to TOBACCO companies.
Also unlike mutual funds, the investor has direct ownership of the stocks and bonds within the
portfolio. This can facilitate tax management strategies.
Nuveen Investments
Alliance Capital
Pension benefits are taxed when paid to retirees, not when earned by workers.
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TYPES OF PLANS
QUALIFIED PLANS
A qualified retirement plan is a plan that meets specific requirements of the Internal Revenue
Code (IRC), the Department of Labor (DOL) and Employee Retirement Income Security Act
(ERISA). Qualified plans are afforded favorable tax treatment in exchange for meeting these
requirements. The Internal Revenue Service (IRS) determines if the plan is qualified.
ERISA provides these minimum standards for plan qualification. It requires that a plan:
Be communicated to employees;
Must not discriminate in favor of any particular group of employees, such as Highly
Compensated Employees (HCEs); and
When the IRS determines that a plan meets all the requirements for a qualified plan, it sends a
Letter of Determination to the plan administrator.
NON-QUALIFIED PLANS
Employers who wish to provide benefits to certain key employees on a discriminatory basis can
do so through a non-qualified plan. A non-qualified plan may provide benefits to key employees,
while excluding other employees. Contributions made to non-qualified plans do not enjoy the
tax advantages of a qualified plan.
OTHER TYPES OF RETIREMENT PLANS
DEFINED BENEFIT PLAN (DB)
This promises a specified monthly benefit at retirement. The plan may state this promised
benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it
may calculate a benefit through a plan formula that considers such factors as salary and service
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for example, 1 percent of average salary for the last 5 years of employment for every year of
service with an employer. The benefits in most traditional defined benefit plans are protected,
within certain limitations, by federal insurance provided through the Pension Benefit Guaranty
Corporation (PBGC).
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have an investor base comprising wealthy individuals and institutions and relatively high
Hedge funds can use techniques such as short selling, leverage, concentrated investments
and derivatives trading.
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Hedge fund managers are heavily invested in the funds they manage.
Mutual fund managers are not invested in the funds they manage.
Hedge fund managers get remunerated based on the returns they earn (called incentive
fee). Thus, hedge fund managers get paid only when they generate positive returns.
Mutual fund managers get remunerated based on the size of the assets they manage,
regardless of performance.
Hedge fund managers can change their investment strategy without prior investment
consent thus providing flexibility to investment managers.
Mutual fund managers require the consent of the investment committee of the fund in
order to change their strategy.
The lack of regulation and disclosure can result in managers taking excessive risk or the kind
of risk whose nature they dont fully appreciate.
Regulation and disclosure requirements result in fewer unpleasant surprises and lesser
downside risk.
MARKET BENEFITS OF HEDGE FUNDS:
Hedge funds can provide benefits to financial markets by contributing to market efficiency and
enhance liquidity. Many hedge fund advisors take speculative trading positions on behalf of
their managed hedge funds based extensive research about the true value or future value of a
security. They may also use short term trading strategies to exploit perceived miss-pricings of
securities. Because securities markets are dynamic, the result of such trading is that market
prices of securities will move toward their true value. Trading on behalf of hedge funds can thus
bring price information to the securities markets, which can translate into market price
efficiency. Hedge funds also provide liquidity to the capital markets by participating in the
market.
Hedge funds play an important role in a financial system where various risks are distributed
across a variety of innovative financial instruments. They often assume risks by serving as ready
counter parties to entities that wish to hedge risks. For example, hedge funds are buyers and
sellers of certain derivatives, such as securitized financial instruments, that provide a
mechanism for banks and other creditors to un-bundle the risks involved in real economic
activity. By actively participating in the secondary market for these instruments, hedge funds
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can help such entities to reduce or manage their own risks because a portion of the financial
risks are shifted to investors in the form of these tradable financial instruments. By reallocating
financial risks, this market activity provides the added benefit of lowering the financing costs
shouldered by other sectors of the economy. The absence of hedge funds from these markets
could lead to fewer risk management choices and a higher cost of capital.
Hedge fund can also serve as an important risk management tool for investors by providing
valuable portfolio diversification. Hedge fund strategies are typically designed to protect
investment principal. Hedge funds frequently use investment instruments (e.g. derivatives) and
techniques (e.g. short selling) to hedge against market risk and construct a conservative
investment portfolio one designed to preserve wealth.
In addition, hedge funds investment performance can exhibit low correlation to that of
traditional investments in the equity and fixed income markets. Institutional investors have used
hedge funds to diversify their investments based on this historic low correlation with overall
market activity.
From time to time, allegations are made by market participants about collusion among hedge
funds to manipulate markets. Like all other market participants, hedge funds are covered by
both criminal and civil regimes that outlaw various forms of market manipulation and abuse.
SUMMARY
Investment Management aims at managing investors money efficiently and cost effectively
to generate superior investment returns. The ultimate objective is to deliver equity type
returns with lesser volatility risk and achieve capital preservation
Front Office covers functions like Sales & Client prospecting, Contact Management, Account
Aggregation and Financial Advisory services.
Middle/Back Office covers functions like Asset Allocation, Research, Portfolio Analysis, Risk
Management, Trade Processing, Compliance and Documentation
Asset Mix
International Diversification
Screens/Filters
Capital preservation
Alternative Investments
Passive Approach - The portfolio manager has to decide on the mix of assets that
maximizes the after-tax returns subject to the risk and cash flow constraints. Thus
the investors characteristics determine the right mix for the portfolio.
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Active Approach - Portfolio managers often deviate from the passive mix by using
Market timing. To the extent that portfolio managers believe that they can
determine which markets are likely to go up more than expected and which less
than expected, they will alter the active-passive mix accordingly.
Fund managers generally adopt an individual "investment philosophy" which overlays their
investment management style. The following are the two quantitative approaches to tactical
global asset management.
The "top down" investor begins by looking at the big picture - economy or broad trends in
society to identify individual countries and then sectors that will benefit from the prevailing
conditions.
There are several variants of investment management that have manifested in terms of
firms offering products to suit specific needs of investors. Some of them are
o
Mutual Funds
Hedge Funds
Pension Funds
Private Banking covers personalized services such as money management, financial advice,
and investment services for high net worth clients. High net worth is generally taken at a
household income of at least $100,000 or net worth greater than $500,000. Larger private
banks often require even higher thresholds of at least $1 million of investable assets
Institutional money managers are independent financial advisory firms organized and
licensed under the Security and Exchange Commission or Banking Laws' oversight agency of
the country.
A Mutual Fund (MF) is a type of Investment Company that pools the money of many
investors shareholders and collectively invests that money in stocks, bonds, or money
market instruments.
A separately managed account is a portfolio of securities owned directly by the investor and
managed by professional money manager for an asset-based fee. SMA or the separately
managed accounts provides the individual investors the same quality of service as offered to
institutional investors.
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Hedge funds, including fund of funds are unregistered private investment partnerships,
funds or pools that may invest and trade in many different markets, strategies and
instruments (including securities, non-securities and derivatives) and are NOT subject to the
same regulatory requirements as Mutual funds.
Pension funds may be defined as forms of institutional investor, which collect, pool and
invest funds contributed by sponsors and beneficiaries to provide for the future pension
entitlements of beneficiaries
8.0
8.1
An investment bank is a financial institution that raises capital, trades in securities and manages
corporate mergers and acquisitions. Investment banks profit from companies and governments
by raising money through issuing and selling securities in the capital markets (both equity, bond)
and insuring bonds (selling credit default swaps), as well as providing advice on transactions
such as mergers and acquisitions The major activities include
Investment Banking
Trading in Securities
Research
The major activities of Investment Banking involve
Securities Underwriting
Corporate Advisory Services M&A
Securitized Products
Structuring complex structured products are offered which offers greater margins
The difference between an investment bank and a commercial bank is that a commercial bank
accepts deposits from retail investors whereas an investment bank does not accept deposits
from retail investors.
8.2
Investment banks help public and private corporations in issuing securities in the
primary market, guarantee by standby underwriting or best efforts selling. Other
services include acting as intermediaries in trading for clients.
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8.3
The brokerage division of Investment banking provides financial advice to investors and
serves them by assisting in purchasing securities, managing financial assets and trading
securities
Small firms providing services of investment banking are called boutiques. These mainly
specialize in bond trading, advising for mergers and acquisitions, providing technical
analysis or program trading
Prior to the financial crisis the bulge bracket investment banks were
Goldman Sachs
Merrill Lynch
Bear Stearns
Lehman Brothers
JP Morgan Chase
8.4
Until Sep 22, 2008 Goldman Sachs and Morgan Stanley were the largest investment
banks however they converted to traditional banking institutions due to the financial
crisis.
Investment Banks have a number of divisions, some of which are listed below along with the
descriptions.
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Mergers and acquisitions advisory - Banks assist in negotiating and structuring a merger
between two companies. If, for example, a company wants to buy another firm, then an
investment bank will help finalize the purchase price, structure the deal, and generally
ensure a smooth transaction.
Underwriting - The process by which investment bankers raise investment capital from
investors on behalf of corporations and governments that are issuing securities (both equity
and debt).An Underwriter guarantees that the capital issue will be subscribed to the extent
of his underwritten amount. He will make good of any shortfall.
8.4.2 SALES
Salespeople take the form of:
1) The classic retail broker,
2) The institutional salesperson
3) The private client service representative.
Brokers develop relationships with individual investors and sell stocks and stock advice.
Institutional salespeople develop business relationships with large institutional investors.
Institutional investors are those who manage large groups of assets, for example pension funds
or mutual funds.
Private Client Service (PCS) representatives, have some of the characters similar to retail
brokers and institutional salespeople, providing brokerage and money management services for
high net worth individuals.
Salespeople make money through commissions on trades made through their firms.
8.4.3 TRADING
Traders facilitate the buying and selling of stock, bonds, or other securities such as currencies,
either by carrying an inventory of securities for sale or by executing a given trade for a client.
Traders deal with transactions large and small and provide liquidity (the ability to buy and sell
securities) for the market. (This is often called making a market.) Traders make money by
purchasing securities and selling them at a slightly higher price. This price differential is called
the "bid ask spread."
8.4.4 RESEARCH
Research analysts follow stocks and bonds and make recommendations on whether to buy, sell,
or hold those securities. Stock analysts typically focus on one industry and will cover up to 20
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companies' stocks at any given time. Some research analysts work on the fixed income side and
will cover a particular segment, such as high yield bonds or U.S. Treasury bonds.
Corporate finance bankers rely on research analysts to be experts in the industry in which they
are working. Salespeople within the I-bank utilize research published by analysts to convince
their clients to buy or sell securities through their firm.
Reputed research analysts can generate substantial corporate finance business as well as
substantial trading activity, and thus are an integral part of any investment bank.
8.4.5 SYNDICATE
A very important part of investment banking is the syndicate. This provides a vital link between
salespeople and corporate finance. Syndicate helps to place securities in a public offering. The
process is a long one between and among buyers of offerings and the investment banks
managing the process. In a corporate or municipal debt deal, syndicate also determines the
allocation of bonds.
8.5
8.6
There have been major changes in the investment banking field post the economic
crisis. Major investment banks Morgan Stanley and Goldman Sachs succumbed to a
collapse in confidence in their financial stability by converting themselves into lower
risk, tightly regulated commercial banks
Universal banks, which marry investment banking and deposit-taking, are in the
ascendant.
Strict regulatory limits will be imposed which will restrict the banks from dabbling with
exotic derivatives and credit instruments and decrease amount of debt
Banks must also anticipate and manage regulatory changes as the shape new business
models
There will be a lot of emphasis on risk management going forward
Investment banks will continue to play a major role in the world of finance, however the
number of pure play investment banks will decrease.
BROKERAGE
8.6.1 DEFINITION:
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Broker is a party that mediates between a buyer and a seller. A "brokerage" or a "brokerage
firm" is a business that acts as a broker. A brokerage firm is a business that specializes in trading
stocks.
INITIAL PUBLIC OFFERINGS
An initial public offering (IPO) is the process by which a private company transforms itself into a
public company. The company offers, for the first time, shares of its equity (ownership) to the
investing public. These shares subsequently trade on a public stock exchange like the New York
Stock Exchange (NYSE) or the NASDAQ. The primary reason for going through the rigors of an
IPO is to raise cash to fund the growth of a company. Often, the owners of a company may
simply wish to cash out either partially or entirely by selling their ownership in the firm in the
offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm.
The IPO process consists of these three major phases:
A. HIRING THE MANAGERS
This choosing of an investment bank is often referred to as a "beauty contest." Typically, this
process involves meeting and interviewing investment bankers from different firms, discussing
the firm's reasons for going public, and ultimately nailing down a valuation. In making a
valuation, I-bankers, pitch to the company wishing to go public what they believe the firm is
worth, and therefore how much stock it can realistically sell. Perhaps understandably,
companies often choose the bank that provides the highest valuation during this beauty contest
phase instead of the best-qualified manager. Almost all IPO candidates select two or more
investment banks to manage the IPO process.
B.DUE DILIGENCE AND DRAFTING
This phase involves understanding the company's business as well as possible scenarios (called
due diligence), and then filing the legal documents as required by the SEC. The SEC legal form
used by a company issuing new public securities is called the S-1 (or prospectus) and Lawyers,
accountants, I-bankers, and of course company management must all toil to complete the S-1 in
a timely manner.
C. MARKETING
Once the SEC has approved the prospectus, the company embarks on a road show to sell the
deal. A road show involves flying the company's management coast to coast (and often to
Europe) to visit institutional investors potentially interested in buying shares in the offering.
Typical road shows last from two to three weeks, and involve meeting literally hundreds of
investors, who listen to the company's presentations, and then ask scrutinizing questions. Often,
money managers decide whether or not to invest thousands of dollars in a company within just
a few minutes of a presentation. The marketing phase ends abruptly with the placement of the
stock, which results in a new security trading in the market.
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Successful IPOs trade up on their first day (increase in share price), and tend to succeed over the
course of the next few quarters.
THE CHINESE WALL
Between corporate finance and research, firms build what is known as a Chinese Wall separating
research analysts from both bankers and Sales & Trading. Often, bankers are privy to inside
information at a company because of ongoing or potential M&A business, or because they know
that a public company is in registration to file a follow-on offering. Either transaction is
considered material non-public information and research analysts, privy to such information
cannot change ratings or mention it, as doing so would effectively enable clients to benefit from
inside information at the expense of existing shareholders. When it comes to certain
information, a Chinese Wall also separates salespeople and traders from research analysts. The
reason should be obvious. Analyst reports often move stock prices - sometimes dramatically.
Thus, a salesperson with access to research information prior to it being published would give
clients an unfair advantage over other investors. Research analysts even disguise the name of
the company on a report until immediately before it is published. This way, if the report falls
into the wrong hands, the information remains somewhat confidential.
Insiders of the company cannot sell any shares for a specified period of time, this is
known as the _______? (Holding Period, Lockup Period, Buy & Hold Period)
8.7
UNDERWRITING
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To share the risk, and more efficiently distribute the offering to the public, broker/dealers will
join together in a Joint Trading Account. The syndicate profits by selling the securities and
earning a Spread (i.e., the POP less the amount paid to the issuer). Syndicate members share the
risk and are responsible for any unsold securities.
Selling Group
Selling group comprises of broker/dealers chosen to assist the syndicate in marketing the issue
(in a broker capacity). Selling Group firms are not members of the syndicate, and are not at risk
for the securities. All broker/dealers involved in the underwriting of non-exempt securities must
be NASD member firms.
Underwriters earn 3 types of Underwriting Spread:
Manager's fee - The lead underwriter receives this fee on all securities sold.
Underwriter's Allowance is the total spread minus the Manager's fee. This fee is shared
by syndicate members based on the type of syndicate account.
Concession - It is typically the largest part of the spread and is paid to the broker/dealer
that actually took the clients order.
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8.7.1
TYPES OF UNDERWRITING
8.8
The trading of outstanding issues takes place in the Secondary Markets. The secondary markets
are broken down into four market types:
8.8.1 LISTED MARKET
These are exchanges where an Auction method is used and specialists provide liquidity on
the floor of an exchange. E.g. The New York Stock Exchange (NYSE)
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8.9
NYSE (partially) and London are the only major exchanges which still use a trading floor. When
an investor customer calls their broker to place a trade, the following sequence of activities
happen:
Brokerage Firm checks the customer's account for cash balance, restrictions etc
Enter the order in its Order Match System. The rep notifies the broker/dealers Order or Wire
Room to execute the trade.
The Order room then wires the order to the Commission House Broker (CHB), an employee of
the broker/dealer who trades on the floor of the exchange for that broker/dealer.
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The CHB makes their way over to the respective Trading Post.
At the post, the CHB encounters other folks who want to trade IBM stock.
Transaction Report Is sent to the originating brokerage firms (buying and selling). A market
order through SuperDot to the specialist takes an average 15 seconds to complete.
Reports are also sent to Consolidated Tape Displays world-wide, and to the Clearing
operations.
Post Trade Processing Matching of buyers and sellers -- the Comparison process -- takes
place almost immediately.
This is followed by a 3-day Clearing and Settlement cycle at which time transfer of
ownership (shares for dollars or vice versa) is completed via electronic record keeping in the
Depository.
Investor Receives a trade confirmation from his/her firm. If shares were purchased, the
investor submits payment. If shares were sold, the investor's account is credited with the
proceeds.
Specialist
Specialists conduct the auction as a broker or dealer and maintain a fair and orderly market by
matching up buyers and sellers. The specialist is not an employee of the exchange and may
trade for their own account, as well as trading as an agent for CHB orders.
Broker
Executes orders for others
Acts as an Agent
Charges Commission
Dealer
Executes orders for themselves
Acts as a Principal (i.e., a market maker)
Charges Mark-up and Mark-down
An individual firm could act as a broker on one trade and a dealer on another. When acting as a
broker, the firm is taking customer orders and acting as their agent to buy or sell the security.
For this service, the broker charges a commission. A firm acting as a dealer is the actual buyer or
seller, taking the other side of a trade. The price at which market makers will buy or sell a
particular security is known as the Bid or Ask Price.
Market Maker
Provide continuous bid and offer prices within a prescribed percentage spread for shares
designated to them
4 to 40 (or more) market makers for a particular stock depending on the average daily
volume.
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Play an important role in the secondary market as catalysts, particularly for enhancing stock
liquidity
Registered Representatives
An individual who has passed the NASD's registration process and is licensed to work in the
securities industry
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without guaranteeing the price. A stop limit order, once triggered, becomes a limit
order.
5. Do-not-reduce Order - Indicates that the order price should not be adjusted in the case
of a stock split or a dividend payout.
A sell limit order can be filled at a lower price than your limit e.g. your sell limit is at 21.07 & you
can be filled at 21.06? True/False
If you want to limit your risk on a long position you can place a sell stop order? True/false
If the market is currently bid 15.00 & offered at 15.01 you are guaranteed of buying at 15.01 if you
place a market order? True/False
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Liquidity in the OTC market is provided by Market Makers (i.e., broker/dealers who maintain an
inventory of a particular stock, and buy and sell the stock from and to customers).
The largest system for displaying OTC market quotes is NASDAQ (The NASDs Automated
Quotation system). Broker/Dealers subscribe to various levels of the NASDAQ system depending
on their functional needs. Level 1 service (i.e., the Inside Quote or Representative Quote) is the
highest bid and lowest ask prices of all market makers, and is used by registered reps. Level 2
service is for traders, and lists all market makers' firm quotes on price and size. Level 3 service also
displays all quotes, and is used by market makers to enter quotes.
The quotes look like the following:
Dealer A
Dealer B
Bid
9
8.75
Ask
9.5
9.25
Dealer C
9.1
9.8
Dealer D
9.5
If we were selling stock, to whom would we sell? Dealer C has the highest bid of 9.1, while a
buyer would go to Dealer B who has the lowest ask of 9.25. The inside quote, therefore, would
be 9.1 9.25, the highest bid and the lowest ask.
Sales
New Accounts
Order Room
Cashiering
Margin
Corporate Actions
Accounting
Compliance
8.12.1 SALES
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Sales team is responsible for canvassing business. They are staffed with Account
Executives/Account Managers who solicit business from retail and wholesale customers.
Individual Cash Account Only cash transactions are permitted. No margin trading is
permitted.
Margin Account
Joint Account
Buy/Sell
Quantity
Limit/Market
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Sales
NameAccounts(Name&Address)
Accountexecutive
(HomeorBranchoffice
OpenAccounts
ExecutingChanges
Reports
OrderTickets
OrderRoom
OTCMarket
Execution
Reports
Exchanges
Executionrecording
ConfirmingGTCorders
PendingOrders
ContraBrokers
Purchase&Sales(P&S)
ClearingCorp
(CNS)
Confirmation
Clients
Recording
Figuration(includingaccrued interest)
Comparison(reconcilement)
Booking
Depository
Banks
Brokerages
Transfer
Agent
Cashiers
Margin
Receive&Deliver
Vaulting
BankLoan
StockLoan/borrow
Transfer
Reorganization
AccountMaintenance
Salessupport
Issuechecks
Itemsdue
Extensions
CloseOuts
Deliveryofsecurities
StockRecord
Accounting
Accountnumbering&coding
Audits
SecurityMovements
Bookkeeping
Dailycashrecord
Adjustedtrailbalance
TrailBalance
P&LStatement
Dividend
Proxy
CashDividends
Stocksplits
Duebills
BondInterest
Proxyvoting
Informationflowtocustomers
Recording the trade with a unique number using codes and tickets.
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8.12.5 MARGIN
Margin or Credit Department monitors the status of the customer accounts. As explained in the
previous pages, they are also responsible for margin calls. The typical activities of this
department are:
Account Maintenance
Sales Support
Clearing Checks
Closing out
8.12.6 CASHIERING
They are responsible for movement of securities and funds within the brokerage firm. They take
care of the following functions:
Vaulting
Hypothecations
Security Transfers
Stock Lending
8.12.8 ACCOUNTING
The Accounting department records, processes and balances the movement of money in the
brokerage firm. They produce the Daily Cash Records and Trial Balance, Balance Sheet and Profit
& Loss statements on a periodic basis.
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8.12.9 COMPLIANCE
The Brokerage firms are regulated by SEC, by state regulatory agencies and industry wide Self
Regulatory Organizations. The compliance department is responsible for ensuring that all the
rules and regulations are complied with and reported on time.
They also make sure that the newer regulations like Anti Money Laundering Act are
implemented inside the firm.
Questions
1.
2.
A market order that executes after a specified price level has been reached is called?
a) Market Order b) Stop Order c) Fill or Kill Order d) Day Order
3.
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The important markets and the indices used are presented below:
US Diversified market
US Technology
UK (London)
Germany (Frankfurt)
France (Paris)
Switzerland (Zurich)
Japan (Tokyo)
Hong Kong
Singapore
Alcoa
American Express
Boeing
Chevron
Coca-Cola
Eastman Kodak
General Electric
Goodyear
IBM
J.P. Morgan
McDonald
Philip Morris
Sears
United Technology
Walt Disney
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9.0
9.1
INTRODUCTION
The custody service business evolved from safekeeping and settlement services provided by
banks to its customers for a fee. Banks, as a custodian originally provided only basic safekeeping
services to their customers. The banks routinely settled trades and processed income for their
own investments. Their customers kept and took their securities out of safekeeping to settle
trades or for bond maturities. As time evolved, the banks realized that their expertise in
securities processing and their image as a safe repository would be valuable to their customers
and they began to promote their securities processing ability as an enhanced value-added
service.
Services offered by Custodians
Services provided by a bank custodian are typically the settlement, safekeeping, and reporting
of customers marketable securities and cash. A custody relationship is contractual, and services
performed for a customer may vary.
Users of Custody Services
Institutional investors, money managers and broker/dealers are the primary customers for
custodians and other market participants for the efficient handling of their worldwide securities
portfolios.
Assets held Under Custody
Custodians hold a range of assets on behalf of their customers. These include equities,
government bonds, corporate bonds, other debt instruments, mutual fund investments,
warrants and derivatives.
Business Drivers of Custody Services
The following are the key drivers in the growth of custody services:
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The wide range of financial instruments and the emerging markets spreading across
geographies resulted in growing interest of investors. The potential benefits associated with
the investments resulted in growth of custody services.
The increasing use of global custodians to replace their own networks of local custodians by
Investment managers and banks.
The state withdrawing from its role of primary pension provider, causing citizens to invest in
defined contribution pensions and mutual funds in record numbers - with custody banks
serving the pension funds and mutual funds, their money managers and the banks acting for
high net worth individuals.
The introduction of floating exchange rates and lifting of exchange controls in many major
economies resulted in rapid development of the market for international debt instruments.
The specialist fund managers running dedicated portfolios of foreign equities have increased
in recent time.
9.2
SECURITIES MARKETPLACE
Securities marketplace is a mechanism for bringing together those seeking investment and those
seeking capital. These entities can be individual or institutional .The securities market can be
classified as primary market and secondary market. For the purpose of the discussion we would
concentrate on secondary market and its working mechanism.
Individual Investor
Institutional Investor
o
Pension Funds
Insurance companies
Hedge Funds
Brokers
Broker is an intermediary who executes customer orders for a pre-defined commission. A
"broker" who specializes in stocks, bonds, commodities act as an agent and must be registered
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with the exchange where the securities are traded. The brokers can be classified based on the
types of the services offered.
Dealers
Dealer is an entity who is ready and willing to buy a security for its own account (at its bid price)
or sell from its own account (at its ask price). They are individual or firms acting as a principal in
a securities transaction.
Custodians
A custodian is responsible for safekeeping the documentary evidence of the title to property like
share certificates etc. The title to the custodians property remains vested with the original
holder, or in their nominee(s), or custodian trustee, as the case may be. On confirmation from
customers the clearing corporation assigns the obligation of settlement upon the custodian. In
general the services provided by the custodians are classified in two main areas:
Clearing Corporation
Clearing Corporation is responsible for post-trade activities of a stock exchange. Its responsible
for clearing and settlement and risk management of trades. The list of activities performed by a
clearinghouse is:
Clearing of trades
Receiving funds/securities,
Guaranteeing settlement.
Examples of important clearing corporations across the globe are National Stock Clearing
Corporation in USA (NSCC), Sega Intersettle in Switzerland, Clearstream & Euroclear of European
Union and so on.
Depository
The depository can be either domestic or international securities and depending upon that they
are known as either National Central Securities Depository or International Central Securities
Depositories (ICSDs).
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Country
Depository
abbreviation
India
NSDL
National
Depository Ltd
USA
DTC
UK
CREST
Crest
Japan
JASDEC
Hong Kong
CCASS
Central
Clearing
settlement system
Securities
and
Clearing Banks
Clearing banks are a key link between the custodians and Clearing Corporation for funds
settlement. Every custodian maintains a dedicated settlement account with one of the clearing
banks. Based on his obligation as determined through Clearing Corporation, the clearing
member makes funds available in the clearing account for the pay-in and receives funds in case
of a payout. In most of the cases the custodians act as a clearing bank also.
Dealer Markets
Auction Markets
Hybrid Markets
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9.2.3 SAFEKEEPING
A bank is responsible for maintaining the safety of custody assets held in physical form at one of
the custodians premises, a sub-custodian facility, or an outside depository. The banks may hold
assets either off-premises or on premises
On-Premises
The banks hold the securities/assets in physical form in its vault. The securities (e.g., jewelry, art,
coins) are kept in physical form by the bank .The banks also holds the securities, which are not
maintained in the book entry form.
The banks providing the safekeeping services needs to follow certain norms related to the
security and movement of securities. The bank provides security devices consistent with
applicable law and sound custodial management. The bank ensures appropriate lighting, alarms,
and other physical security controls. The banks ensure that assets are out of the only vault when
it receives or delivers the assets following purchases, sales, deposits, distributions, corporate
actions or maturities.
Off-Premises
The evolution of depository has resulted in vast majority of custodial assets being held in book
entry form. Custodians reconcile changes in the depositorys position each day as a change in
the position occurs, as well as completing a full-position reconcilement at least monthly.
Depository position changes are generally the results of trade settlements, free deliveries
(assets transferred off the depository position when no cash is received), and free receipts
(assets being deposited or transferred to the depository position for new accounts when no
cash is paid out).
9.3
Buy or Sell
Specific Quantity
Specific Security
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The brokers typically record the order if the order has been placed through a broker or
otherwise the trader directly maintains the details of the order.
Market orders are instructions to buy or sell stock at the best available price. They are the
most common types of orders.
Limit orders tell our broker to buy or sell stock at the limit price or better. The limit price is a
price that the investor can set when placing the order. For a given purchase, it is the
maximum amount the investor will pay; for a given sale, it is the minimum amount the
investor will accept. A limit order can also be placed to buy along with one to sell. For
example, if XYZ Corporation is currently trading at $42 per share, a limit order can be placed
to buy 100 shares of XYZ at 40 or better (less) and to sell 100 shares XYZ at 45 or better
(more).
Order Conditions
A buyer/seller can specify order conditions with which the trade is to be executed. These are the
conditions that are typically an upper limit in buy price, a lower limit in sell price, stop loss trade
orders, quantity conditions and time criteria.
Time Conditions
Quantity Conditions
Price Conditions
Market
Stop orders
Order Books
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An order book is a placeholder for every order entered into the system. As and when valid
orders are entered or received by the trading system, they are first numbered, time stamped
and then scanned for a potential match. If a match is not found, then the orders are stored in
the books as per the price/time priority. Price priority means that if two orders are entered into
the system, the order having the best price gets the higher priority. Time priority means if two
orders having the same price is entered, the order that is entered first gets the higher priority.
Best price for a sell order is the lowest price and for a buy order, it is the highest price
Order Matching
The buy and sell orders are matched based on the matching priority. The best sell order is the
order with the lowest price and a best buy order is the order with the highest price. The
unmatched orders are queued in the system by the following priority:
STOP LOSS MATCHING
All stop loss orders entered are stored in the stop loss book. These orders can contain two
prices.
Trigger Price. It is the price at which the order gets triggered from the stop loss book.
Limit Price. It is the price for orders after the orders get triggered from the stop loss book. If
the limit price is not specified, the trigger price is taken as the limit price for the order. The
stop loss orders are prioritized in the stop loss book with the most likely order to trigger first
and the least likely to trigger last. The priority is same as that of the regular lot book.
Sell Order - A sell order in the stop loss book gets triggered when the last traded price in the
normal market reaches or falls below the trigger price of the order.
Buy Order - A buy order in the stop loss book gets triggered when the last traded price in the
normal market reaches or exceeds the trigger price of the order. When a stop loss order with
IOC condition is there, the order is released in the market after it is triggered. Once triggered,
the order scans the counter order book for a suitable match to result in a trade or else is
cancelled by the system.
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the stock exchange. The order modification and order cancellation takes place before the order
gets executed i.e. if the order is there in the order books of the exchange and is waiting to be
executed the request for order modification is entertained by the stock exchange. The stock
exchange prepares a NOE (Note of Execution) with the trade details and sends it across to the
Broker/ Dealer and to the clearing corporation giving details of the trade. The date the trade is
executed is known as the Trade Date, and is referred as T or T+0.
The order execution process for a customer sell order (individual investor placing order through
a broker) goes through the following cycle:
Customer places a sell order through the Internet or to the account executive of the
brokerage group.
The account executive sends the order to its corresponding floor broker or to its trading
desk.
The order execution takes place on the floor of the exchange such as on NYSE, AMEX etc.
The exchange sends a Notification of sell to the Firms representative on the exchange as
well as the trading desk of the brokerage group..
The Firms representative on the exchange floor send a notification of the sell to the floor
broker which is then matched with the counter party broker.
Trade Date
Trade Time
Value Date
Operation
Quantity
Security
Price
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Calculation of cash value: The cash value calculation is done keeping the trade components
in consideration.
Counter party Trade confirmation requirement: The trade details needs to be enriched to
determine if the counter party needs the trade confirmation and if at all it needs the trade
confirmation, the format in which the confirmation would be send across to them.
Selection of custodian details: The client might have multiple accounts with multiple or
single custodian. The investor would send the custodian details at which the settlement
would take place. The trade details are enriched with the account number of the custodian,
which will handle the cash/ securities settlement.
Method of Transaction reporting: The transaction reporting depends upon the security
group as well as the country in which the transaction has occurred. For e.g. the UK equities
may require one method of reporting whereas the international bonds would require
another method.
Trade Date
Trade Time
Value Date
Operation
Quantity
Security
Price
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Clearing process signifies the execution of individual obligations with respect to a buyer and
seller. Once the terms of a securities transaction have been confirmed, the respective
obligations of the buyer and seller are established and agreed. This process is known as
clearance and determines exactly what the counter parties to the trade expect to receive.
Clearance is a service normally provided by a Clearing Corporation (CC).
Clearance can be carried out on a gross or net basis. When clearance is carried out on a gross
basis, the respective obligations of the buyer and seller are calculated individually on a trade-bytrade basis. When clearance is carried out on a net basis, the mutual obligations of the buyer
and seller are offset yielding a single obligation between the two counter parties. Accordingly,
clearance on a net basis reduces substantially the number of securities/payment transfers that
require to be made between the buyer and seller and limits the credit-risk exposure of both
counter parties.
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The NSCC computer checks the two confirms against each other. If they match, the trade is
compared. NSCC confirms to both A and B on Tuesday morning, with instructions for
settlement the same Thursday. If the trade does not compare, both A and B are notified for
sorting things out and resubmitting the trade before the settlement date.
On Wednesday, the day before the settlement, NSCC interposes itself between the two parties
to the transaction. That is, instead of the original deal between A and B, there are now two
deals one between A and NSCC and the other between NSCC and B. Now, A has a deal to sell
10,000 shares of GE to NSCC at 80, and B has a deal to buy them from NSCC at the same price. A
receives a notice to deliver the shares to NSCC; B receives a notice to make payment. By
interposing itself in this way, NSCC is guaranteeing settlement to both A and B. Whether or not
B pays up, A will get the money on time. Whether or not A delivers the shares, B will get 10,000
shares of GE on Thursday.
The automated comparison is an important function of the clearing corporation because it
enables the participant to ensure that the trade details agree with those of counter party prior
to settlement.
Fax:
Telex
S.W.I.F.T
Paper
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Trade settlement is the act of buyer and seller exchanging securities and cash on or after the
value date in accordance to the contractual agreement. Settlement is successful when the seller
is able to deliver the securities and buyer is able to pay the cash it owns to the seller. In some
cases the settlement fails primarily because the seller was awaiting the delivery of securities
from its purchase and therefore could not deliver the securities to the buyer.
It is mandatory now days to settle trade on the value date and whenever there is a settlement
failure the authority imposes penalties to the party concerned.
Causes of Settlement Failure
Insufficient Securities
Insufficient Cash
Physical Settlement
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settlement periods depend upon the type of the securities traded. Appendix C has the list of the
settlement period for different types of security.
SETTLEMENT PROCESS
Trade settlement occurs when securities and money are exchanged to complete the trade.
Settlement occurs on T+3 in a T+3 settlement cycle. Settlement of a securities transaction
involves the delivery of the securities and the payment of funds between the buyer and seller.
The payment of funds is effected in the settlement system via a banking/payments system. A
depository typically carries out the delivery of securities. A trade is not declared settled until
both (funds and securities) transfers are final.
Trade Accounting & Reconciliation
Trade accounting and Reconciliation is the internal control process used by custodians to
manage trade transactions. In this process, the custodian determines that the customers
account has the necessary securities on hand to deliver for sales, that the customers account
has adequate cash or forecasted cash for purchases. It maintains the records of trades internally
and tries to match it with outside world. It tries to match the positions by comparing positions of
trades (Open and settled both).
Risks associated with Trading & Settlement
There are multiple risk associated with the trade execution process .The following example
discusses the risk associated with the trading process from the point of view of a broker
associated with an exchange.
Broker A, on the floor of the Stock Exchange, has just agreed with broker B, to sell him 10,000
shares of GE at 80. To execute this transaction, the ownership of the shares needs to be
transferred to B, and B needs to transfer the cash to A. In reality, once A and B agree on the
terms, execution is handed over to others in the back office. The length of the process varies
from market to market.
Principal Risk
Replacement Risk
Liquidity Risk
Operational Risk
Systemic Risk
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Step 1: Pay In of securities: Clearing corporation advises depository to debit account of sell side
custodian and credit its account and the depository does it
Step 2:Pay in of funds (Clearing corporation advises clearing banks to debit account of buy side
custodian and credit its account and the clearing bank does it)
Step 3:Pay Out of securities (Clearing corporation advises depository to credit account of buy
side custodian and debit its account and depository does it)
Step 4: Pay Out of funds (Clearing corporation advises clearing banks to credit account of sell
side custodian and debit its account and clearing banks does it)
Step 5: The custodian 1 confirms the receipt of shares to the buying client.
Step 6: The custodian 2 confirms the delivery of shares to the selling client.
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9.4
ASSET SERVICING
Asset servicing is a core ongoing service provided by custodians. This service includes
collecting dividends and interest payments, processing corporate actions and applying for tax
relief from foreign governments on behalf of customers.
Mandatory Actions
It is a type of corporate action wherewith the shareholders are not given the option to
conditionalize their tender. e.g. stock splits, mergers and acquisitions, liquidations, bankruptcies,
reorganizations, redemptions, bonus issues etc
Voluntary action
It is a type of corporate action wherewith the shareholders are given the option to
conditionalize their tender. They include rights offers, tender offer, purchase order, exchange
order etc.
Notification of Corporate Action: The notification is generated for the client of Voluntary and
Mandatory Corporate Actions. The notification process ensures that the client receives the
information of the corporate action. Maintaining Response of Corporate Action: The corporate
action response is maintained for voluntary corporate action responses against expiration dates
on a daily basis until the client responds with instructions.
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Processing of Corporate Action :In this stage the Processing of corporate action is done to
update the records of the banks. As per the feedback received from the client in case of
voluntary actions, the records for the client are updated in the records of the banks. A similar
method is followed for the mandatory types of corporate action.
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custodian helps investor to exercise their votes by providing a proxy voting service for all
manner of general meetings wherever this service is available.
Business Process Involved in Proxy Services
Receiving Corporate Announcement: The corporate announcement regarding the agenda of
General Body Meeting or Extraordinary General Body Meeting is captured from external
vendors.
Notification to Client: The custodians notify the clients about the proxy services by providing the
details of the corporate announcement.
Maintaining Response of Client: The clients response to the corporate announcement is
maintained on a daily basis until the client responds with instructions. The client response is
typically obtained from either email, fax etc. The response is typically like receiving client
authorization to represent him at the meeting and vote on his behalf.
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Contractual Tax Reclaims: In this kind of reclamation the client's cash account is credited with
entitlements to tax relief according to a pre-determined schedule of time-frames, in place of
when the tax refund monies are received. The contractual time frame may be n months after
the income pay date (where the value of n varies according to the market concerned) or
payment may be made, less a discount, with income payment. This can greatly assist clients in
managing available funds.
Non-contractual Tax Reclaims: In this type where tax relief is not obtained at source, the excess
tax withholding is reclaimed. The bank prepares the required reclaim form and completes the
associated reclaim process, pursuing items as appropriate and reporting their status to clients.
Transaction Risk
Compliance Risk
Credit Risk
Strategic Risk
Reputation Risk
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WHAT IS AN EXCHANGE?
An exchange is a regulated market place, where buyers and sellers come together to exchange
what they want. Finding a buyer or seller for a trade by oneself will be difficult and expensive.
The exchange facilitates the process of buying and selling. Thus, like any other market,
exchanges reduce transaction cost and provide liquidity.
In simple terms, if one wants to buy/sell something, he/she can place an order with an
exchange. Exchange receives buy/sell orders from multiple parties and tries to match them,
based on the price quoted and quantity available/desired. If exchange is able to find counterparty for his/her trade, it will bring together both the parties for transaction to happen.
Examples: Stock Exchanges: NYSE, AMEX
We have different exchanges that deal with different asset types (stocks, commodities, futures,
etc.).
10.1.2
Over The Counter (OTC) market is different from the exchanges in the sense that there is no
single physical location for members, and members (generally called market makers in OTC
markets) negotiate price to finalize deals rather than use any auction mechanism to derive
prices.
In OTC markets, traders/dealers negotiate with each other through computer networks or
simply over the phone to strike deals. So traders/dealers assume the responsibility of exchanges
too, to find counter-party for a trade.
NASDAQ is a good example of OTC market.
Certain other asset types trade in markets that are typically not regulated (e.g., currencies).
10.1.3
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Decision
to trade
Security/Fund
Transfer
Settlement
of Trades
Place an
Order
Market Participants (e.g.
Exchange, Brokers/Dealers,
Custodians, Depositories,
Clearing Corporation etc)
Clearing
of Trades
Trade
Matching
Trade
Execution
Based on the market news, risk analysis and investment philosophy, a customer decides to place
an order to buy 100 IBM shares at the market price.
Customer calls his broker (or goes to the online trading interface provided by the broker), and
places the order with the broker dealer. Broker dealer in turn forwards the order to an
exchange.
Exchange gets multiple orders from different broker dealers. They maintain all the orders in an
order book and use a matching system to find counter-party for an order. In this case, this order
lies in the order book of the exchange until someone places a Sell order for 100 IBM shares
(please note that even partial fill is possible, in case somebody places an order to sell 50 shares).
At this point in time, exchange finds a match between two trades.
Exchange matches these two orders to register a trade and informs the trade details to all the
associated parties.
At the end of the day, obligation for each participant is determined by the exchange and
communicated to each participant.
As per the settlement cycle, broker dealer provide the funds or security to the clearing house by
a particular date and time.
Clearinghouse transfers the security and funds to the appropriate party.
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10.2 CLEARING
Clearing in the securities business is the process that occurs between trading and settlement,
involving the balancing of positions between the different parties to establish agreement on
what each party is due, prior to the establishment of final positions for settlement.
Once a trade is executed, the next step is to ensure that the counterparties to the trade (the
buyer and the seller) agree on the terms of the transaction - the security involved, the price, the
amount to be exchanged, the settlement date and the counterparty. This step is referred to in
some markets as trade matching and in others as trade comparison or checking. In automated
trade execution systems counterparties often agree that trades will settle as recorded at the
time of execution unless both agree to a cancellation. Such trades are referred to as locked-in
trades. In other trade execution systems, Matching is typically performed by an exchange, a
clearing corporation or trade association, or by the settlement system. Direct market
participants may execute trades not only for their own accounts but also for the accounts of
customers, including institutional investors and retail investors. In this case, the direct market
participant may be required to notify its customer (or its agent) of the details of the trade and
allow the customer to positively affirm the details, a process referred to as trade confirmation or
affirmation.
Trade matching and confirmation set the stage for trade clearance, that is, for the computation
of the obligations of the counterparties to make deliveries or payments on the settlement date.
The obligations arising from securities trades are sometimes subject to netting. Multilateral
netting arrangements, for example, include position netting schemes as well as systems that
involve substitution of a central counterparty and novation of trades with that central
counterparty.
What are the benefits of Netting?
Settlement on net basis reduces the number of transactions to be settled drastically reducing
the overall transaction cost for everyone. As per an estimate, netting reduces the number of
settlements needed by more than 95%.
Role of Clearinghouses
We understand that there are two parties to a trade, one who buys something and the other
one who sells something. Now imagine a situation where one party (who had to deliver
securities) defaults on its obligation, what impact would it have on the other party? Other party
would not like to suffer because of this, as its the exchange that found a match. So clearing
house comes into the picture. To mitigate any counter-party risk (risk that a party involved in
the trading doesnt meet its commitment), clearing house positions itself as the counter-party
for both the legs of the trade. Thus, buyer buys it from the clearinghouse and seller sells it to
clearing house. This way buyer and seller both are shielded from any counter-party risk, as
clearing house stands to meet its commitment to a trading party irrespective of whether the
other party meets its commitment or not.
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This process of transferring obligation from one party to the other is also known as Novation.
Lets look at the following example of stock trades. Following table captures the activity of a
broker on a particular day at NYSE.
Time
Buy/Sell
Quantity
Sock
Price
10:00
Buy
100
IBM
$10.00
10:30
Sell
50
IBM
$10.50
11:00
Buy
100
MSFT
$20.00
11:30
Sell
20
IBM
$11.00
12:00
Sell
10
MSFT
$20.50
3:30
Sell
30
IBM
$9.00
Broker has completed 6 transactions on that particular date but exchange would not settle
these transactions individually and would apply the concept of netting to determine the
obligation of broker. Deals executed during a particular trading period (in this case one trading
day) are netted at the end of that trading period and settlement obligations are computed.
In the example above:
Net position for IBM: +100 50-20-30 = 0
Net position for MSFT: +100 10 = 90
So broker would not receive any IBM shares from the exchange as he sold all the shares that he
bought during the day. But exchange will need to deliver 90 MSFT shares to the broker.
This was what exchange owes to broker.
Now lets look at what broker owes to exchange:
Buy/Sell
Quantity
Price
Amount
Buy
100
$10.00
($1,000.00)
Sell
50
$10.50
$525.00
Buy
100
$20.00
($2,000.00)
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Sell
20
$11.00
$220.00
Sell
10
$20.50
$205.00
Sell
30
$9.00
$270.00
Total
($1,780.00)
So the broker has to pay $1780 only and he gets 90 MSFT shares from the exchange. It is
important to understand that netting across stocks is not possible, similarly netting across
different market (for examples trades executed at NASDAQ and NYSE) is not possible. Each
market would have its own rule to determine the period, for which transactions need to be
netted.
This concept of clearing based on netting is true for most financial transactions, and the case of
stock exchange has been taken just as an illustrative example. Even when one submits a check
issued by ICICI Bank in his/her HDFC bank account, it means that ICICI pays money to HDFC
bank, which in turn deposits the money in his/her HDFC bank account. But HDFC and ICICI have
millions of bank holders and so it doesnt make sense to settle the individual transactions,
instead ICICI would aggregate (for different customers) its entire obligation to different banks
and then reduce it by amount that ICICI has to get from these banks and only the net amount
would be settled by the banks. Clearing house facilitates the whole process.
It is worth understanding that, we have some markets where settlement happens on a gross
basis, meaning no netting is done and all the transactions need to be settled individually. This is
prevalent in Fixed Income markets in the US and the settlement mechanism is known as Real
Time Gross Settlement (RTGS).
10.3 SETTLEMENT
Settlement is the legal transfer of title, normally by exchanging a security against money or
assets. Depending on the system, there are several ways of paying. Delivery versus payment
(DVP) the simultaneous exchange of cash and securities and delivery free of payment (FOP)
delivery of securities without payment of funds are some of the more common. The typical
actor carrying out settlement is a Central Securities Depository (CSD).
The concept of a securities settlement system is generally defined in a wide sense to embrace
the full set of institutional arrangements in the settlement process, i.e. confirmation of terms for
securities trading, clearance/clearing of transactions and determination of rights and
obligations, settlement and custody/safekeeping of securities. In a narrower sense, settlement is
defined as the completion and finalization of a transaction through final transfer of securities
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and funds (payment) between buyer and seller. The interaction of these elements is illustrated
in more detail in Figure 1.
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have a corresponding Settlement Date. Trades done on a given date are netted and settled on
the Settlement Date. Thus for instance a T+3 Rolling Settlement would indicate that for Trades
done on day T the settlement would occur on Day T+3
Once the obligations of the market participants have been calculated, whether on a gross basis
or on a net basis, the instructions to transfer the securities and funds (monies) necessary to
discharge the obligations are transmitted to the entity or entities that operate the settlement
system. These instructions may be prepared by the counterparties themselves or by an
exchange or clearing system. If trades have not previously been matched, the settlement system
would typically perform this function before initiating processing of the transfer instructions.
Other action may be required of participants before settlement can proceed, such as the prepositioning of securities, funds or collateral.
Settlement of a securities trade involves the transfer of the securities from the seller to the
buyer and the transfer of funds from the buyer to the seller. Historically, securities transfers
involved the physical movement of certificates. However in recent years, securities transfers
have increasingly occurred by book-entry. This has been possible due to establishment of
central securities depositories that provide a facility for holding securities in either a certificated
or an uncertificated (dematerialized) form and permit the transfer of these holdings through
book entry. A central securities depository may also offer funds accounts and permits funds
transfers as a means of payment, or funds transfers.
Often a transfer that has been executed by such Settlement Systems, in the sense that books
have been debited and credited, is a provisional transfer, that is, a conditional transfer in whom
one or more parties retain the right by law or agreement to rescind the transfer. If the transfer
can be rescinded by the sender of the instruction (the seller of the security or the payer of
money), the transfer is said to be revocable. Even if the transfer is an irrevocable transfer, some
other party (often the system operator) may have authority to rescind it, in which case it would
still be considered provisional. Not until a later stage does the transfer become a final transfer,
that is, an irrevocable and unconditional transfer that affects a discharge of the obligation to
make the transfer. Only the final transfer of a security by the seller to the buyer constitutes
delivery, while only final transfer of funds from the buyer to the seller constitutes payment.
When delivery and payment have occurred, the settlement process is completed.
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However, the settlement date is a little trickier because it refers to the date on which ownership
of the security is actually transferred and money is exchanged between buyer and seller. Now,
it's important to understand that this doesn't always occur on the transaction date and varies
depending on the type of security with which one is dealing. Treasury bills are about the only
security that can be transacted and settled on the same day.
What's the reason behind this delay in actual settlement? In the past, security transactions were
done manually rather than electronically. Investors would have to wait for the delivery of a
particular security, which was in actual certificate form and would not pay until reception. Since
delivery times could vary and prices could fluctuate, market regulators set a period of time in
which securities and cash must be delivered. Some years ago, the settlement date for stocks was
T+5, or five business days after the transaction date. Today it's T+3, or three business days after
the transaction date in US and T+ 2 in India.
10.3.2
DVP is an important characteristic of efficient settlement systems. The goal of DVP is achieve a
simultaneous exchange of securities and payment. High quality of payments must be received
by the clearing and settlement organization. Certainty, finality, irrevocability and unconditionality are the characteristics of high quality payments. By far the largest source of credit
risk in securities settlement and, therefore, the most likely source of systemic risk is the
principal risk that may arise on the settlement date. Such principal risk can be eliminated if the
securities settlement system adheres to the principle of delivery versus payment (DVP), that is,
if it creates a mechanism that ensures that delivery occurs if and only if payment occurs.
Furthermore, by eliminating concerns about principal risk, DVP reduces the likelihood that
participants will withhold deliveries or payments when financial markets are under stress,
thereby reducing liquidity risk. However, not all securities settlement arrangements currently
achieve DVP. In some cases the linkage that exists between delivery and payment is,
nonetheless, sufficiently strong to make a loss of principal by a participant seem a remote
possibility. But in other cases book-entry securities transfer systems have been created that
neither provide, nor are linked to, a money transfer system.
10.3.3
THE INSTITUTIONAL ARRANGEMENTS FOR SECURITIES
SETTLEMENT SYSTEMS
Several institutions may be involved in the process of securities settlement. Most markets have
established central securities depositories (CSDs) which dematerializes physical securities and
transfer ownership by means of book entries to electronic accounting systems. However, other
institutions often perform additional critical functions in the settlement process. Confirmation
of trade is usually carried out by a stock exchange rather than by the CSD. In some markets, a
central counterparty (CCP) interposes itself between buyers and sellers. The CCP thus becomes
the buyer to every seller and the seller to every buyer. Accounts at the respective central bank
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or at one or more private commercial banks are used for settlements and transfers of funds.
Funds may nevertheless be transferred through internal accounts at the CSD. Securities can be
held at accounts at the CSD or through a custodian. The custodian may hold the securities of its
customer through a sub custodian.
The whole Clearing & Settlement process and other Post Trade Activities have been captured in
the diagram below:
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SUMMARY
The process of clearing and settling a securities trade includes several key steps:
o Confirmation of the terms of the trade by the direct market participants
o Calculation of the obligations of the counterparties resulting from the confirmation
process, known as clearance;
o Final transfer of securities (delivery) in exchange for final transfer of funds
(payment) in order to settle the obligations.
Once a trade is executed, the next step is to ensure that the counterparties to the trade (the
buyer and the seller) agree on the terms of the transaction - the security involved, the price,
the amount to be exchanged, the settlement date and the counterparty. This step is
referred to in some markets as trade matching and in others as trade comparison or
checking
Trade matching and confirmation set the stage for trade clearance, that is, for the
computation of the obligations of the counterparties to make deliveries or payments on the
settlement date. The obligations arising from securities trades are sometimes subject to
netting.
Once the obligations of the market participants have been calculated, whether on a gross
basis or on a net basis, the instructions to transfer the securities and funds (monies)
necessary to discharge the obligations are transmitted to the entity or entities that operate
the settlement system.
Settlement of a securities trade involves the transfer of the securities from the seller to the
buyer and the transfer of funds from the buyer to the seller.
Only the final transfer of a security by the seller to the buyer constitutes delivery, while only
final transfer of funds from the buyer to the seller constitutes payment. When delivery and
payment have occurred, the settlement process is completed.
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Operational Risk
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Credit Risk
Market Risk
-
Liquidity risk
Legal Risk
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Equity risk premium is the excess return that an individual stock or the overall stock market
provides over a risk-free rate. This excess return compensates investors for taking on the
relatively higher risk of the equity market. The size of the premium will vary as the risk
in a particular stock, or in the stock market as a whole, changes; high-risk investments are
compensated
with
a
higher
premium.
COMMODITY RISK
Commodity risk refers to the uncertainties of future market values and of the size of the future
income, caused by the fluctuation in the prices of commodities. These commodities may be
grains, metals, gas, electricity etc. Different types of commodity risks are Price risk, Quantity
risk, Cost risk and Political risk. The following entities can face Commodity risk
Producers (farmers, plantation companies, and mining companies) face price risk, cost
risk on the prices of their inputs and quantity risk
Buyers (cooperatives, commercial traders and trait ants) face price risk between the
time of up-country purchase buying and sale, typically at the port, to an exporter.
Exporters face the same risk between purchase at the port and sale in the destination
market; and may also face political risks with regard to export licenses or foreign
exchange conversion.
Governments face price and quantity risk with regard to tax revenues, particularly
where tax rates rise as commodity prices rise or if support or other payments depend on
the level of commodity prices.
LIQUIDITY RISK
Liquidity risk is the inability to meet financial commitments, as they fall due, through ongoing
cash flow or asset sale at fair market value. It is a financial risk due to uncertain liquidity.
An institution might lose liquidity if its credit rating falls, it experiences sudden, unexpected cash
outflows, or some other event causes counterparties to avoid trading with or lending to the
institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to
loss of liquidity.
The term liquidity is used in various ways, all relating to availability of, access to, or convertibility
into cash.
An institution is said to have liquidity if it can easily meet its needs for cash either because it
has cash on hand or can otherwise raise or borrow cash.
A market is said to be liquid if the instruments it trades can easily be bought or sold in
quantity with little impact on market prices.
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The common theme in all three contexts is cash. A corporation is liquid if it has ready access to
cash. A market is liquid if participants can easily convert positions into cashor conversely. An
asset is liquid if it can easily be converted to cash.
The liquidity of an institution depends on:
Cash on hand;
Examples of assets that tend to be liquid include foreign exchange; stocks traded on the New
York Stock Exchange or recently issued (on-the-run) Treasury bonds. Assets that are often
illiquid include limited partnerships, thinly traded bonds or real estate.
LEGAL RISK
A Legal Risk can be defined as a potential economical loss deriving from the infringement of a
legal norm. The loss can derive from a sanction or the deprival of possible advantages. Infringing
behavioral norms may cause pecuniary penalties or tort claims, whereas infringement of norms
regarding contracting may lead to unenforceable claims, damages or performance obligations.
Infringement of legal norms may also lead to economical loss caused by damaged reputation.
The expected loss due to the infringement of a legal norm can be calculated by multiplying the
potential loss with the probability of the loss being suffered.
Legal risk arises due to uncertainty of legal actions or uncertainty in the applicability or
interpretation of contracts, laws or regulations.
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organization. It increases the probability of success, and reduces both the probability of failure
and the uncertainty of achieving the organizations overall objectives.
Risk management should be a continuous and developing process which runs throughout the
organizations strategy and the implementation of that strategy. It should address methodically
all the risks surrounding the organizations activities past, present and in particular, future. It
must be integrated into the culture of the organization with an effective policy and a program
led by the most senior management. It must translate the strategy into tactical and operational
objectives, assigning responsibility throughout the organization with each manager and
employee responsible for the management of risk as part of their job description. It supports
accountability, performance measurement and reward, thus promoting operational efficiency at
all levels.
To review internal risk and capital assessment processes to ensure banks have adequate
capital to support their risk profile.
Basel II will apply to all financial services providers in the 110 countries that have signed the new
Capital Accord, including security firms and asset managers with operations in banking and
Capital markets. EU member states will require all domestic and foreign financial services
providers to comply, and the G-10 countries are including it into their regulatory environments
in order to meet the Basel II implementation deadline of December 2006. Many of the over
25,000 banks around the world are expected to adopt Basel II as well, in order to maintain their
competitiveness.
This Framework will apply on a consolidated basis to internationally active banks in order to
preserve the integrity of capital in banks with subsidiaries, by eliminating double gearing. The
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Framework will include, on a fully consolidated basis, any holding company that is the parent
entity within a banking group to ensure that it captures the risk of the whole banking group.
All banking and other relevant financial activities, excluding insurance entities and activities,
(both regulated and unregulated) conducted within a group containing an internationally active
bank will be captured through consolidation. The Framework will also apply to all internationally
active banks at every tier within a banking group, also on a fully consolidated basis. Basel II will
impact the entire spectrum of banking, including corporate finance, retail banking, asset
management, payments and settlements, commercial banking, trading and sales, retail,
brokerage, and agency and custody services.
BASEL II THREE PILLARS
The underlying principle for the Basel II accord is that safety and soundness in todays dynamic
and complex financial system can be attained only by the combination of effective bank-level
management, market discipline, and supervision.
Basel II is based on three mutually reinforcing pillars viz., Minimum capital requirement,
Supervisory review and Market Discipline. The first pillar represents a significant strengthening
of the minimum requirements set out in the 1988 Accord, while the second and third pillars
represent innovative additions to capital supervision.
Minimum capital requirements: Focus is on the banks internal risk assessments and
management processes. Basel II improves the capital frameworks sensitivity to the risk of credit
losses generally by requiring higher levels of capital for those borrowers thought to present
higher levels of credit risk, and vice versa. Three options are available to allow banks and
supervisors to choose an approach that seems most appropriate for the sophistication of a
banks activities and internal controls.
Data must be sufficiently granular and capture historical trends to get a detailed view of risk
across the enterprise. It describes the calculation for regulatory capital for credit, operational
and market risk. Credit risk regulatory capital requirements are more risk based than the 1988
Accord. An explicit operational risk regulatory capital charge is introduced for the first time
while market risk requirements remain the same as in the Current Accord.
Supervisory review: Internal risk and capital assessment processes will be evaluated for sound
practices. Supervisors will evaluate the activities and risk profiles of individual banks to
determine whether those organizations should hold higher levels of capital than the minimum
requirements in Pillar 1 would specify and to see whether there is any need for remedial
actions. It intended to bridge the gap between regulatory and economic capital requirements
and gives supervisors discretion to increase regulatory capital requirements if weaknesses are
found in a lender's internal capital assessment process.
Market discipline: Enhanced reporting and disclosure requirements on items such as capital
structure, risk measurement and management practices, risk profile, and capital adequacy.
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IDENTIFY
This stage of the iterative process identifies the widest possible range of risks associated with a
particular project.
Identification includes the preparation of lists of activities, the identification of risks associated
with each activity and possible counters to each risk.
All stakeholders should be consulted, and external opinions should be sought where appropriate
and practical. Also it is important to identify interdependencies between various risks and any
consequential risks i.e. those risks associated with mitigations to the primary risks.
After risks have been identified they should be validated in terms of both the probable truth of
the information as initially elicited about the risk and the accuracy of the description initially
built up of the risk's characteristics.
ANALYZE
Once the risks have been identified, the next step is to choose the quantitative and qualitative
measures of those risks. Risk is essentially measured in terms of the following factors:
a. The probability of an unfavorable event occurring
b. The estimated monetary impact on organization because of the event
The unfavorable events differ for different types of risk. For example, in case of market risk,
future events refer to market scenarios. These scenarios impact each portfolio prices differently
depending on its composition.
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Market Risk
Measurement technique - Value at Risk (VaR)
Value at Risk is an estimate of the worst expected loss on a portfolio under normal market
conditions over a specific time interval at a given confidence level. It is also a forecast of a given
percentile, usually in the lower tail, of the distribution of returns on a portfolio over some
period. VaR answers the question: how much one can lose.
Another way of expressing this is that VaR is the lowest quantile of the potential losses that can
occur within a given portfolio during a specified time period. For an internal risk management
model, the typical number is around 5%. Suppose that a portfolio manager has a daily VaR equal
to $1 million at 1%. This means that there is only one chance in 100 that a daily loss bigger than
$1 million occurs under normal market conditions.
Suppose portfolio manager manages a portfolio which consists of a single asset. The return of
the asset is normally distributed with annual mean return 10% and annual standard deviation
30%. The value of the portfolio today is $100 million. We want to answer various simple
questions about the end-of-year distribution of portfolio value:
What is the distribution of the end-of-year portfolio value?
What is the probability of a loss of more than $20 million dollars by year end?
With 1% probability what is the maximum loss at the end of the year? This is the VaR at 1%.
Value-at-Risk (VaR) is an integrated way to deal with different markets and different risks and to
combine all of the factors into a single number which is a good indicator of the overall risk level.
VaR Calculation
A generic step-wise approach to calculate would be to:
Get price data for the portfolio holdings.
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Convert price data in to log return data. (Log Return: ui = ln (Si / Si-1) where Si is the price of the
asset on day i)
Calculate standard deviations of each instrument or each proxy.
Calculate preferred confidence level. 99% = 2.33 * standard deviation.
Multiply position holdings by their respective Standard Deviation at a 99% confidence level. This
results in a position VaR at a 99% confidence level.
Example VaR Calculation
Assume that you have a holding in IBM Stock worth $10 million. You have calculated the standard
deviation (SD) of change over one day in IBM is $ 0.20.
Therefore for the entire position, SD of change over 1 day = $200,000
The SD of change over 10 days = $200,000 * (10) = $632,456
The 99% VaR over 10 days = 2.33 * 632,456 = $1,473,621
2. Operational Risk
2.1
The basic approach or basic indicator approach is a set of operational risk measurement
techniques proposed under Basel II capital adequacy rules for banking institutions.
Basel II requires all banking institutions to set aside capital for operational risk. Basic indicator
approach is much simpler compared to the alternative approaches (i.e. standardized approach
(operational risk) and advanced measurement approach) and this has been recommended for
banks without significant international operations.
Based on the original Basel Accord, banks using the basic indicator approach must hold capital
for operational risk equal to the average over the previous three years of a fixed percentage of
positive annual gross income. Figures for any year in which annual gross income is negative or
zero should be excluded from both the numerator and denominator when calculating the
average.
The fixed percentage alpha is typically 15 percent of annual gross income.
2.2
Standardized approach falls between basic indicator approach and advanced measurement
approach in terms of degree of complexity.
Based on the original Basel Accord, under the Standardized Approach, banks activities are
divided into eight business lines: corporate finance, trading & sales, retail banking, commercial
banking, payment & settlement, agency services, asset management, and retail brokerage.
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Within each business line, gross income is a broad indicator that serves as a proxy for the scale
of business operations and thus the likely scale of operational risk exposure within each of these
business lines. The capital charge for each business line is calculated by multiplying gross income
by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industrywide relationship between the operational risk loss experience for a given business line and the
aggregate level of gross income for that business line.
The total capital charge is calculated as the three-year average of the simple summation of the
regulatory capital charges across each of the business lines in each year. In any given year,
negative capital charges (resulting from negative gross income) in any business line may offset
positive capital charges in other business lines without limit.
In order to qualify for use of the standardized approach, a bank must satisfy its regulator that, at
a minimum:
Its board of directors and senior management, as appropriate, are actively involved
in the oversight of the operational risk management framework;
It has sufficient resources in the use of the approach in the major business lines as
well as the control and audit areas.
2.3
Under this approach the banks are allowed to develop their own empirical model to quantify
required capital for operational risk. Banks can use this approach only subject to approval from
their local regulators.
In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum:
Its board of directors and senior management, as appropriate, are actively involved
in the oversight of the operational risk management framework;
It has sufficient resources in the use of the approach in the major business lines as
well as the control and audit areas.
3. Risk type Credit Risk
3.1
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Loss Given Default or LGD is a common parameter in Risk Models and also a parameter used in
the calculation of Economic Capital or Regulatory Capital under Basel II for a banking institution.
This is an attribute of any exposure on bank's client.
LGD is the fraction of Exposure at Default (EAD) that will not be recovered following default.
Loss Given Default is facility-specific because such losses are generally understood to be
influenced by key transaction characteristics such as the presence of collateral and the degree of
subordination.
'Gross' LGD is calculated by dividing total losses Exposure at Default (EAD).
3.4
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Monte-Carlo Simulation
It is a simulation technique. First, some assumptions about the distribution of changes in market
prices and rates (for example, by assuming they are normally distributed) are made, followed by
data collection to estimate the parameters of the distribution. The Monte Carlo then uses those
assumptions to give successive sets of possible future realizations of changes in those rates. For
each set, the portfolio is revalued. This should result in a set of portfolio revaluations
corresponding to the set of possible realizations of rates. From that distribution the 99th
percentile loss can be taken as the VaR.
Historical Simulation
Like Monte Carlo, it is a simulation technique, but it skips the step of making assumptions about
the distribution of changes in market prices and rates. Instead, it assumes that whatever the
realizations of those changes in prices and rates were in the past is the best indicator for the
future.
It takes those actual changes, applies them to the current set of rates and then uses those to
revalue the portfolio. When done, a set of portfolio revaluations corresponding to the set of
possible realizations of rates is obtained. From that distribution, we can calculate the standard
deviation and take the 99th percentile loss as the VaR.
Variance-Covariance method
This is a very simplified and speedy approach to VaR computation. It is so, because it assumes a
particular distribution for both the changes in market prices and rates and the changes in
portfolio value. It incorporate the covariance matrix (correlation effects between each asset
classes) primarily developed by JP Morgan Risk Management Advisory Group in 1996. It is often
called Risk Metrics Methodology. It is reasonably good method for portfolio with no option type
products. Thus far, it is the computationally fastest method known today. But this method is not
suited for portfolio with major option type financial products.
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MANAGE
There are multiple strategies to manage risks. Some of the commonly followed ones are:
o
Diversification
Hedging or Insurance
All the above strategies will reduce the risk but may not eliminate them. The top management
will determine its risk policy (i.e.) its appetite for risk. The Risk Manager in a bank will be
responsible for identifying the risks, setting up tolerance limits, measuring the risk on a day to
day basis and take action whenever the limits are breached.
HANDLING OPTIONS
There are four options for handling risk
Option
Description
Terminate
(Avoid)
Tolerate
(Accept)
The ability to do anything about some risks may be limited, or the cost of
taking any action may be disproportionate to the potential benefit gained. In
these cases the response may be toleration.
Transfer
For some risks the best response may be to transfer them. Namely, shift the
responsibility or burden of loss to another party through legislation,
contract, insurance or other means. Partial transfers are known as risk
sharing or risk assignment.
Treat
(Reduce)
By far the greater number of risks will belong to this category. The purpose
of treatment is not necessarily to eliminate the risk, but more likely to
contain the risk to an acceptable level.
OTHER RISKS
Strategic risk
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Strategic risk is the current and prospective risk to earnings or capital arising from adverse
business decisions, improper implementation of decisions, or lack of responsiveness to industry
changes.
Country risk
Country risk refers to the risk that a country won't be able to honor its financial commitments.
When a country defaults on its obligations, this can harm the performance of all other financial
instruments in that country as well as other countries it has relations with. Country risk applies
to stocks, bonds, mutual funds, options and futures that are issued within a particular country.
This type of risk is most often seen in emerging markets or countries that have a severe deficit.
Political risk
Political risk represents the financial risk that a country's government will suddenly change its
policies. This is a major reason why developing countries lack foreign investment.
Investment risk
This is defined as the risk that an investment's actual return will be lower than its expected
return. Investment risk includes the possibility of an investment losing market value, and may be
reduced through diversification.
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Defined Benefits
Defined Contribution
DEFINED BENEFITS
Defined Benefit plans are the oldest retirement plans that exist in the Pension Industry. They
promise to pay a specified benefit at retirement age. They define the amount of retirement
income to be paid. The actual monthly (or annual) benefit is calculated using a specific formula
stated in the plan document. The benefit is usually paid at a specified time such as attainment of
age 65.
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DEFINED CONTRIBUTION
A Defined Contribution Plan is a type of retirement plan that sets aside a certain amount of
money each year for an employee. The amount to be contributed to each participant's account
under the plan each year is defined (by either a fixed formula or by giving the employer the
discretion to decide how much to contribute each year). The size of a participant's benefit will
depend on:
The amounts of money contributed to the individual's account by the employer and,
perhaps, by the employee as well;
How long the money remains in the plan (in most cases, the employee, upon retirement,
has the option of either receiving the payment in a lump sum or by taking partial payments
on a regular basis while the balance continues to earn interest); and
Whether the forfeitures of participants who leave before they are fully vested can be shared
among the remaining participants as a reward to long-term employees.
Since benefits accumulate on an individual basis, these plans are sometimes referred to as
"individual account plans." In these plans, unlike in defined benefit plans, the risk (and reward)
of investment experience is borne by the participant. Defined contribution plans can permit, and
sometimes require, that employees make contributions to the plan on either a pre-tax basis (as
in a 401(k) plan) or an after-tax basis (as in a thrift plan). They may also, but are not required to,
permit employees to decide how the monies contributed into their accounts will be invested.
Defined contribution plans have gained popularity as employers have begun to ask their
employees to share responsibility for their retirement. The main purpose of a defined
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The employer bears the investment risk The participant bears the investment risk.
(the potential for investment gain or
loss).
It is generally difficult to communicate.
It is easier to communicate.
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Fig 2.1
Trust owns the funds of the plan contributed by the sponsor and the participants and
delegates management of the same to Investment Manager
Trust and plan administrator submit compliance reports to Federal Agencies which in turn
would qualify the plan.
Record Keepers provide information on Participant, plan and account information to Plan
Administrators, trustee, Sponsor and Participant.
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contributed to the participants account, experience, expenses etc. Health and Welfare plans
generally are subject to certain fiduciary, reporting and other requirements of the ERISA
(Employee Retirement Income Security Act, 1974).
Categories of health and welfare plans
Health Care
o
Medical
Prescription drug
Behavioral health
Dental
Vision
Long-term care
Disability Income
o
Sick leave
Short-term disability
Survivor Benefits
o
Term life
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The Act gives federal officials greater authority to track and intercept communications, both
for law enforcement and foreign intelligence gathering.
It vests the Secretary of the Treasury with regulatory powers to combat corruption of U.S.
financial institutions for foreign money laundering purposes.
It seeks to further close our borders to foreign terrorists and to detain and remove those
within US borders.
It creates new crimes, new penalties, and new procedural efficiencies for use against
domestic and international terrorists.
The anti money laundering rules are very important from a banking point of view. They are
described in greater detail later in the chapter.
***
Extracted from Congressional Research Service, US and Federation of American Scientists www.fas.org
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order or under a subpoena in some cases. There is also a procedure that governs court orders
approving the governments use of trap and trace devices and pen registers, a secret caller id,
which identify the source and destination of calls made to and from a particular telephone.
MONEY LAUNDERING
In federal law, money laundering is the flow of cash or other valuables derived from, or
intended to facilitate, the commission of a criminal offence. Federal authorities attack money
laundering through regulations, criminal sanctions, and forfeiture. The Act bolsters federal
efforts in each area.
The Act expands the authority of the Secretary of the Treasury to regulate the activities of U.S.
financial institutions, particularly their relations with foreign individuals and entities. Regulations
have been promulgated covering the following areas:
Securities brokers and dealers as well as commodity merchants, advisors and pool operators
must file suspicious activity reports (SARs);
Requiring businesses, which were only to report cash transactions involving more than
$10,000 to the IRS, to file SARs as well;
Imposing additional special measures and due diligence requirements to combat foreign
money laundering;
Prohibiting U.S. financial institutions from maintaining correspondent accounts for foreign
shell banks;
Preventing financial institutions from allowing their customers to conceal their financial
activities by taking advantage of the institutions concentration account practices;
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Crimes: The Act contains a number of new money laundering crimes, as well as amendments
and increased penalties for earlier crimes.
Outlaws laundering the proceeds from foreign crimes of violence or political corruption;
Seeks to overcome a Supreme Court decision finding that the confiscation of over $300,000
for attempt to leave the country without reporting it to customs
Provides explicit authority to prosecute overseas fraud involving American credit cards; and
Permit prosecution of money laundering in the place where the predicate offence occurs.
Forfeiture: The act allows confiscation of all of the property of participants in or plans an act of
domestic or international terrorism; it also permits confiscation of any property derived from or
used to facilitate domestic or international terrorism. Procedurally, the Act:
Allows confiscation of property located in this country for a wider range of crimes
committed in violation of foreign law;
Calls for the seizure of correspondent accounts held in U.S. financial institutions for foreign
banks who are in turn holding forfeitable assets overseas; and
Denies corporate entities the right to contest if their principal shareholder is a fugitive.
Alien Terrorists and Victims
The Act contains provisions designed to prevent alien terrorists from entering the US, to enable
authorities to detain and deport alien terrorists and those who support them; and to provide
humanitarian immigration relief for foreign victims of the September 11.
Other Crimes, Penalties, & Procedures
New crimes: The Act creates new federal crimes, for terrorist attacks on mass transportation
facilities, for biological weapons offenses, for harbouring terrorists, for affording terrorists
material support, for money laundering, and for fraudulent charitable solicitation.
New Penalties: The Act increases the penalties for acts of terrorism and for crimes which
terrorists might commit.
Other Procedural Adjustments: The Act increases the rewards for information in terrorism
cases, authorizes sneak and peek search warrants etc
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An effective program for identifying new customers must allow financial institutions the
flexibility to use methods of identifying and verifying the identity of their customers
appropriate to their individual circumstances. For example, some financial institutions open
accounts via the Internet, never meeting customers face-to-face.
Rather than dictating which forms of identification documents financial institutions may
accept, the final rule employs a risk-based approach that allows financial institutions
flexibility, within certain parameters, to determine which forms of identification they will
accept and under what circumstances.
However, with this flexibility comes responsibility. When an institution decides to accept a
particular form of identification, they must assess risks associated with that document and
take whatever reasonable steps may be required to minimize that risk.
Federal regulators will hold financial institutions accountable for the effectiveness of their
customer identification programs.
Additionally, federal regulators have the ability to notify financial institutions of problems
with specific identification documents allowing financial institutions to take appropriate
steps to address those problems.
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Social Security number. Foreign nationals without a U.S. taxpayer identification number could
provide a similar government-issued identification number, such as a passport number.
Verifying identity:
A CIP is also required to include procedures to verify the identity of customers opening
accounts. Most financial institutions will use traditional documentation such as a drivers
license or passport. However, the final rule recognizes that in some instances institutions
cannot readily verify identity through more traditional means, and allows them the flexibility to
utilize alternate methods to effectively verify the identity of customers.
Maintaining records:
As part of a CIP, financial institutions must maintain records including customer information and
methods taken to verify the customers identity.
Checking terrorist lists:
Institutions must also implement procedures to check customers against lists of suspected
terrorists and terrorist organizations when such lists are identified by Treasury in consultation
with the federal functional regulators.
Reliance on other financial institutions:
The final rule also contains a provision that permits a financial institution to rely on another
regulated U.S. financial institution to perform any part of the financial institutions CIP. For
example, in the securities industry it is common to have an introducing broker who has
opened an account for a customer conduct securities trades on behalf of the customer
through a clearing broker. Under this regulation, the introducing broker is required to identify
and verify the identity of their customers and the clearing broker can rely on that information
without having to conduct a second redundant verification provided certain criteria are met.
The following financial institutions are covered under the rule:
Savings associations
Credit unions
Mutual funds
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after its main architects, Senator Paul Sarbanes and Representative Michael Oxley, and of
course followed a series of very high profile scandals, such as Enron. It is also intended to "deter
and punish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and
protect the interests of workers and shareholders"
It introduced stringent new rules with the stated objective: "to protect investors by improving
the accuracy and reliability of corporate disclosures made pursuant to the securities laws". It
also
introduced
a
number
of
deadlines,
the
prime
ones
being:
- Most public companies must meet the financial reporting and certification mandates for any
end
of
year
financial
statements
filed
after
June
15th
2004
- smaller companies and foreign companies must meet these mandates for any statements filed
after 15th April 2005.
The Sarbanes-Oxley Act itself is organized into eleven titles, although sections 302, 404, 401,
409, 802 and 906 are the most significant with respect to compliance. In addition, the Act also
created a public company accounting board, to oversee the audit of public companies that are
subject to the securities laws, and related matters, in order to protect the interests of investors
and further the public interest in the preparation of informative, accurate, and independent
audit reports for companies the securities of which are sold to, and held by and for, public
investors.
Section 201 prohibits non audit services like bookkeeping, financial information systems design
and implementation, actuarial services, management services etc from the scope of practice of
auditors. They can however be taken up with the pre approval of the audit committee on a case
by case basis.
Section 401 specifies enhanced financial disclosures specifically:
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with their credit history. When a person goes applies for a loan he needs to get a credit check,
and what results from this credit check is something that is known as the FICO score. A FICO
score is a number which represents how credit worthy that person is considered which is based
on factors such as the amount of money that he earns, his record of paying back past debts, and
how much debt he currently holds. The higher the score the better his credit is considered, and
the more likely he is to get a loan.
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The subprime mortgage crisis is an ongoing financial crisis triggered by the rapid fall in house
prices and an attendant rise in mortgage delinquencies and foreclosures in the United States,
particularly among a class of loans that grew dramatically in the closing years of the 20th
century - subprime mortgages. Major adverse consequences for banks and financial markets
have been felt around the globe. The crisis became apparent in 2007 and has exposed pervasive
weaknesses in financial industry regulation and the global financial system.
13.3.3 OVERVIEW
For more than a decade, a massive amount of money flowed into the United States from
investors abroad. This large influx of money to U.S. banks and financial institutions along with
low interest rates made it easier for Americans to get credit. Easy credit combined with the
faulty assumption that home values would continue to rise led to excesses and bad decisions.
Many mortgage lenders approved loans for borrowers without carefully examining their ability
to pay. Many borrowers took out loans larger than they could afford, assuming that they could
sell or refinance their homes at a higher price later on. Both individuals and financial institutions
increased their debt levels relative to historical norms during the past decade significantly.
Optimism about housing values also led to a boom in home construction. Eventually the number
of new houses exceeded the number of people willing to buy them. And with supply exceeding
demand, housing prices fell. And this created a problem: Borrowers with adjustable rate
mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or
refinance their homes before the adjustments occurred was unable to refinance. As a result,
many mortgage holders began to default as the adjustments began.
These widespread defaults (and related foreclosures) had effects far beyond the housing
market. Home loans are often packaged together, and converted into financial products called
"mortgage-backed securities." These securities were sold to investors around the world. Many
investors assumed these securities were trustworthy, and asked few questions about their
actual value. Credit rating agencies gave them high-grade, safe ratings. Two of the leading
sellers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these
companies were chartered by Congress, many believed they were guaranteed by the federal
government. This allowed them to borrow enormous sums of money, fuel the market for
questionable investments, and put the financial system at risk.
The decline in the housing market set off a domino effect across the U.S. economy. When home
values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted
on their mortgages. Investors globally holding mortgage-backed securities (including many of
the banks that originated them and traded them among themselves) began to incur serious
losses. Before long, these securities became so unreliable that they were not being bought or
sold. Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled
with large amounts of assets they could not sell. They ran out of the money needed to meet
their immediate obligations. And they faced imminent collapse. Other banks found themselves
in severe financial trouble. These banks began holding on to their money, and lending dried up,
and the gears of the American financial system began grinding to a halt.
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The crisis has gone through stages. First, during late 2007, over 100 mortgage lending
companies went bankrupt as subprime mortgage-backed securities could no longer be sold to
investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial
institutions have recognized massive losses as they adjust the value of their mortgage backed
securities to a fraction of their purchased prices. These losses as the housing market continued
to deteriorate meant that the banks have a weaker capital base from which to lend. Third,
during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with
$30 billion in government guarantees, after it was unable to continue borrowing to finance its
operations.
Fourth, during September 2008, the system approached meltdown. In early September Fannie
Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the
U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for
bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became
insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80%
nationalized by the U.S. government, due to concerns regarding its ability to honor its
obligations via a form of financial insurance called credit default swaps. These sequential and
significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of
credit markets and more serious global impact. The interconnected nature of Lehman was such
that its failure triggered system-wide (systemic) concerns regarding the ability of major
institutions to honor their obligations to counterparties. The interest rates banks charged to
each other increased to record levels and various methods of obtaining short-term funding
became less available to non-financial corporations. It was this "credit freeze" that some
described as a near-complete seizing of the credit markets in September that drove the massive
bailout procedures implemented by world-wide governments in Q4 2008. Prior to that point,
each major U.S. institutional intervention had been ad-hoc; critics argued this damaged investor
and consumer confidence in the U.S. government's ability to deal effectively and proactively
with the crisis. Further, the judgment and credibility of senior U.S. financial leadership was
called into question.
13.3.4 MARKET DATA
The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, [9] with
over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime
loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure
proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the
delinquency rate had risen to 21% and by May 2008 it was 25%.
Between 2004-2006 the share of subprime mortgages relative to total originations ranged from
18%-21%, versus less than 10% in 2001-2003 and during 2007. Subprime ARMs only represent
6.8% of the loans outstanding in the US, yet they represent 43% of the foreclosures started
during the third quarter of 2007.[16] During 2007, nearly 1.3 million properties were subject to
2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings
including default notices, auction sale notices and bank repossessions can include multiple
notices on the same property. During 2008, this increased to 2.3 million properties, an 81%
increase over 2007. Between August 2007 and September 2008, an estimated 851,000 homes
were repossessed by lenders from homeowners. Foreclosures are concentrated in particular
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14.0 GLOSSARY
Agency bonds: Agencies represent all bonds issued by the federal government, except for those
issued by the Treasury (i.e. bonds issued by other agencies of the federal government).
Examples include the Federal National Mortgage Association (FNMA), and the Guaranteed
National Mortgage Association (GNMA).
Arbitrage: The trading of securities to profit from a temporary difference between the price of
security in one market and the price in another. This temporary difference is often called market
inefficiency.
Annualized Percentage or Return: The periodic rate times the number of periods in a year. For
example, a 5% quarterly return has an A.P.R. of 20%. It depends on the following:
How frequently
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Bond spreads: The difference between the yield of a corporate bond and a U.S. Treasury
security of similar time to maturity.
Bulge bracket: The largest and most prestigious firms on Wall Street like Goldman Sachs,
Morgan Stanley Dean Witter, Merrill Lynch, Salomon Smith Barney, Lehman Brothers, Credit
Suisse First Boston.
Buy-side: The clients of investment banks (mutual funds, pension funds) that buy the stocks,
bonds and securities sold by the investment banks. (The investment banks that sell these
products to investors are known as the sell-side.)
Capitalized Loan: A loan in which the interest due (not paid) is added to the principal balance of
the loan is called Capitalized Loan. Capitalized interest becomes part of the principle of the
loans; therefore, it increases the total cost of repaying the loan because interest will accumulate
on the new, higher principle.
Capture (Credit Cards): Converting the authorization amount into a billable transaction record.
Transactions cannot be captured unless previously authorized.
Commercial bank: A bank that lends, rather than raises money. For example, if a company
wants $30 million to open a new production plant, it can approach a commercial bank for a
loan.
Commercial paper: Short-term corporate debt, typically maturing in nine months or less.
Commodities: Assets (usually agricultural products or metals) that are generally interchangeable
with one another and therefore share a common price. For example, corn, wheat, and rubber
generally trade at one price on commodity markets worldwide.
Comparable company analysis (Comps): The primary tool of the corporate finance analyst.
Comps include a list of financial data, valuation data and ratio data on a set of companies in an
industry. Comps are used to value private companies or better understand a how the market
values and industry or particular player in the industry.
Consumer Price Index: The CPI measure the percentage increase in a standard basket of goods
and services. CPI is a measure of inflation for consumers.
Coupon rate: The fixed interest paid on a bond as a percentage of its face value, each year, until
maturity. In Thailand the coupon is usually paid semi-annually or annually.
Discount rate: The rate at which federal banks lend money to each other on overnight loans. A
widely followed interest rate set by the Federal Reserve to cause market interest rates to rise or
fall, thereby causing the U.S. economy to grow more quickly or less quickly.
Discount Rate for Credit Cards: A small percentage of each transaction that is withheld by the
Acquiring Bank or ISO. This fee is basically what the merchant pays to be able to accept credit
cards. The fee goes to the ISO (if applicable), the Acquiring Bank, and the Associations.
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Float: The number of shares available for trade in the market. Generally speaking, the bigger the
float, the greater the stock's liquidity.
Floating rate: An interest rate that is benchmarked to other rates (such as the rate paid on U.S.
Treasuries), allowing the interest rate to change as market conditions change.
Glass-Steagall Act: Passed in 1933 during the Depression to help prevent future bank failures.
The Glass-Steagall Act split America's investment banking (issuing and trading securities)
operations from commercial banking (lending). For example, J.P. Morgan was forced to spin off
its securities unit as Morgan Stanley. Since the late 1980s, the Federal Reserve has steadily
weakened the act, allowing commercial banks such as NationsBank and Bank of America to buy
investment banks like Montgomery Securities and Robertson Stephens. In 1999, Glass-Steagall
was effectively repealed by the Graham-Leach-Bliley Act.
Graham-Leach-Bailey Act: Also known as the Financial Services Modernization Act of 1999.
Essentially repealed many of the restrictions of the Glass-Steagall Act and made possible the
current trend of consolidation in the financial services industry. Allows commercial banks,
investment banks, and insurance companies to affiliate under a holding company structure.
Gross Domestic Product: GDP measures the total domestic output of goods and services in the
United States. For reference, the GDP grew at a 4.2 percent rate in 1999. Generally, when the
GDP grows at a rate of less than 2 percent, the economy is considered to be in recession.
Hedge: To balance a position in the market in order to reduce risk. Hedges work like insurance: a
small position pays off large amounts with a slight move in the market.
High grade corporate bond: A corporate bond with a rating above BB. Also called investment
grade debt.
High yield debt (a.k.a. Junk bonds): Corporate bonds that pay high interest rates to compensate
investors for high risk of default. Credit rating agencies such as Standard & Poor's rate a
company's (or a municipality's) bonds based on default risk. Junk bonds rate below BB.
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Institutional clients or investors: Large investors, such as pension funds or municipalities (as
opposed to retail investors or individual investors).
Lead manager: The primary investment bank managing a securities offering. An investment
bank may share this responsibility with one or more co-managers.
League tables: Tables that rank investment banks based on underwriting volume in numerous
categories, such as stocks, bonds, high yield debt, convertible debt, etc. High rankings in league
tables are key selling points used by investment banks when trying to land a client engagement.
Leveraged Buyout (LBO): The buyout of a company with borrowed money, often using that
company's own assets as collateral. LBOs were common in 1980s, when successful LBO firms
such as Kohlberg Kravis Roberts made a practice of buying up companies, restructuring them,
and reselling them or taking them public at a significant profit
LIBOR: London Inter-bank Offered Rate. A widely used short-term interest rate. LIBOR
represents the rate banks in England charge one another on overnight loans or loans up to five
years. LIBOR is often used by banks to quote floating rate loan interest rates. Typically the
benchmark LIBOR is the three-month rate.
Liquidity: The amount of a particular stock or bond available for trading in the market. For
commonly traded securities, such as big cap stocks and U.S. government bonds, they are said to
be highly liquid instruments. Small cap stocks and smaller fixed income issues often are called
illiquid (as they are not actively traded) and suffer a liquidity discount, i.e. they trade at lower
valuations to similar, but more liquid, securities.
Long Bond: The 30-year U.S. Treasury bond. Treasury bonds are used as the starting point for
pricing many other bonds, because Treasury bonds are assumed to have zero credit risk taking
into account factors such as inflation. For example, a company will issue a bond that trades "40
over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage point).
Making markets: A function performed by investment banks to provide liquidity for their clients
in a particular security, often for a security that the investment bank has underwritten. The
investment bank stands willing to buy the security, if necessary, when the investor later decides
to sell it.
Market Capitalization: The total value of a company in the stock market (total shares
outstanding x price per share).
Merchant Account: A special business account set up to process credit card transactions. A
merchant account is not a bank account (even though a bank may issue it). Rather, it is designed
to 1) process credit card payments and 2) deposit the funds into our (business) checking account
(minus transaction fees).
Money market securities: This term is generally used to represent the market for securities
maturing within one year. These include short-term CDs, repurchase agreements, commercial
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paper (low-risk corporate issues), among others. These are low risk, short-term securities that
have yields similar to Treasuries.
Mortgage-backed bonds: Bonds collateralized by a pool of mortgages. Interest and principal
payments are based on the individual homeowners making their mortgage payments. The more
diverse the pool of mortgages backing the bond, the less risky they are.
Municipal bonds ("Munis"): Bonds issued by local and state governments, a.k.a. municipalities.
Municipal bonds are structured as tax-free for the investor, which means investors in muni's
earn interest payments without having to pay federal taxes. Sometimes investors are exempt
from state and local taxes, too. Consequently, municipalities can pay lower interest rates on
muni bonds than other bonds of similar risk.
Payment Gateway Fees (Credit Cards): The fees that payment gateways charge for their
services. This generally includes a monthly fee and a small flat fee per transaction. These fees
may be consolidated into a single bill by the acquiring bank or ISO, along with their fees.
Pitch book: The book of exhibits, graphs, and initial recommendations presented by bankers to
a prospective client when trying to land an engagement.
Pit traders: Traders who are positioned on the floor of stock and commodity exchanges (as
opposed to floor traders, situated in investment bank offices).
P/E ratio: The price to earnings ratio. This is the ratio of a company's stock price to its earningsper-share. The higher the P/E ratio, the more expensive a stock is (and also the faster investors
believe the company will grow). Stocks in fast-growing industries tend to have higher P/E ratios.
Prime rate: The average rate U.S. banks charge to companies for loans.
Producer Price Index: The PPI measure the percentage increase in a standard basket of goods
and services. PPI is a measure of inflation for producers and manufacturers.
Proprietary trading: Trading of the firm's own assets (as opposed to trading client assets).
Prospectus: A report issued by a company (filed with and approved by the SEC) that wishes to
sell securities to investors. Distributed to prospective investors, the prospectus discloses the
company's financial position, business description, and risk factors.
Red herring: Also known as a preliminary prospectus. A financial report printed by the issuer of
a security that can be used to generate interest from prospective investors before the securities
are legally available to be sold. Based on final SEC comments, the information reported in a red
herring may change slightly by the time the securities are actually issued.
Retail clients: Individual investors (as opposed to institutional clients).
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Return on equity: The ratio of a firm's profits to the value of its equity. Return on equity, or
ROE, is a commonly used measure of how well an investment bank is doing, because it measures
how efficiently and profitably the firm is using its capital.
Risk arbitrage: When an investment bank invests in the stock of a company it believes will be
purchased in a merger or acquisition. (Distinguish from risk-free arbitrage.)
Road-show: The series of presentations to investors that a company undergoing an IPO usually
gives in the weeks preceding the offering. Here's how it works: Several weeks before the IPO is
issued, the company and its investment bank will travel to major cities throughout the country.
In each city, the company's top executives make a presentation to analysts, mutual fund
managers, and others attendees and also answer questions.
Sales memo: Short reports written by the corporate finance bankers and distributed to the
bank's salespeople. The sales memo provides salespeople with points to emphasize when
hawking the stocks and bonds the firm is underwriting.
Securities and Exchange Commission (SEC): A federal agency that, like the Glass-Steagall Act,
was established as a result of the stock market crash of 1929 and the ensuing depression. The
SEC monitors disclosure of financial information to stockholders, and protects against fraud.
Publicly traded securities must first be approved by the SEC prior to trading.
Securitize: To convert an asset into a security that can then be sold to investors. Nearly any
income generating asset can be turned into a security. For example, a 20-year mortgage on a
home can be packaged with other mortgages just like it, and shares in this pool of mortgages
can then be sold to investors.
Short-term debt: A bond that matures in nine months or less. Also called commercial paper.
Syndicate: A group of investment banks that will together underwrite a particular stock or debt
offering. Usually the lead manager will underwrite the bulk of a deal, while other members of
the syndicate will each underwrite a small portion.
Transaction Fee (Credit Cards): A small flat fee that is paid on each transaction. This fee is
collected by the acquiring bank or ISO and pays for the toll-free dial out number and the
processing network.
T-Bill Yields: The yield or internal rate of return an investor would receive at any given moment
on a 90-120 government treasury bill.
Tombstone: The advertisements that appear in publications like Financial Times or The Wall
Street Journal announcing the issuance of a new security. The tombstone ad is placed by the
investment bank as information that it has completed a major deal.
Yield: The annual return on investment. A high yield bond, for example, pays a high rate of
interest.
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15.0 REFERENCES
15.1 WEBSITES
WWW.BIS.ORG
WWW.IBRD.COM
WWW.SIAINVESTOR.COM
WWW.SIAC.COM
WWW.CNBC.COM
WWW.STOCKCHARTS.COM
WWW.MONEYCENTRAL.COM
WWW.MSNMONEY.COM
WWW.NYSE.COM
WWW.NASDAQ.COM
WWW.AMERITRADE.COM
WWW.ESCHWAB.COM
HTTP://FINANCE.YAHOO.COM
WWW.INVESTOPEDIA.COM
WWW.FT.COM
WWW.BLOOMBERG.COM
WWW.VANGUARD.COM
15.2 BOOKS
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After the Trade is Made David M Weiss New York Institute of Finance
Investment Analysis & Portfolio Management -Frank K. Reilly & Keith C. Brown