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Financial Management and International Finance ICWAI Group III (Short Notes) ADR: An acronym for American Depository Receipt. It is an instrument traded at U.S. exchanges representing a fixed number of shares of a foreign company that is traded in the foreign country. By trading in ADRs, U.S. investors manage to avoid some of the problems of dealing in foreign securities markets. The ADR route enables companies to raise funds in the U.S. financial markets, provided they meet the stringent regulatory norms for disclosure and accounting. Arbitrage: The simultaneous purchase and sale transactions in a security or a commodity, undertaken in different markets to profit from price differences. For example, an arbitrageur may find that the share of The Tata Iron and Steel Company (TISCO) is trading at a lower price, at the Vadodara Stock Exchange compared to the exchange at Bombay. Hence, he may simultaneously purchase TISCO stock in Vadodara at, say Rs. 250, and sell in Bombay at a higher price, say Rs 256, making a profit of Rs 6 per share less expenses. Asset Management Company (AMC): A company set up for ' floating and managing schemes of a mutual fund. An AMC earns fees by acting as the portfolio manager of a fund. The AMC is appointed by the Board of Trustees, which oversees its activities. Thus, a mutual fund is generally established as a trust by a sponsor, which could be a registered company, bank or financial institution. Also, a custodian and a registrar are appointed to ensure safe keeping of the fund's securities and to deal with investors' applications, correspondence, etc. Book Building: A process used to ascertain and record the indicative subscription bids of interested investors to a planned issue of securities. The advantages of this technique of obtaining advance feedback, are that it results in optimal pricing and removes uncertainty regarding mobilization of funds. The concept of book building is alien to India's primary market; so, towards the end of 1995, efforts were under way, to introduce this mechanism as an option in the case of large issues (minimum size: Rs 100 crore). An issue was divided into a 'Placement Portion' and another termed 'Net Offer to the Public'. For the Placement Portion, the exercise of book building enables the issuing company to interact with institutional and individual investors, and collect particulars of the number of shares they would buy at various prices. The procedure is carried out by a lead manager to the issue, called the 'Book Runner'. It commences with the circulation of a preliminary PROSPECTUS and an indicative price band, for the purpose of forming a syndicate of underwriters, comprising FINANCIAL INSTITUTIONS, MUTUAL FUNDS and others. This syndicate, in turn, contacts prospective investors in order to elicit their quotes. These quotes are forwarded to the book runner, who prepares a schedule of the size of orders at different prices. After receiving a sufficient number of orders, the company and the merchant bankers decide the issue price and underwriting particulars. There are some other aspects of book building arising from the guidelines issued by the Securities and Exchange Board of India. A change brought about in 1997 was that the book building process could be applied to the extent of 100 per cent of the issue size, for large issues as defined above. Interestingly, the process has been used in India to place debt securities as well. Bought-out Deal: The sale of securities under a negotiated agreement between an issuer and the investing institution, as an alternative to a public issue. The intent on the part of the buyer is to offload the securities later in the market at a profit. Bought-out deals are commonplace in issues of the Over the Counter Exchange of India (OTCEI). The advantage to the issuing company is the saving in time and costs that a public issue would entail. It is a big help to unlisted companies and projects which must see through a gestation period before tapping the primary market. For institutions and mutual funds, this route is another avenue for investing funds. However, there could be some disadvantages to the issuer such as interference by the institutional investor or restrictive covenants in the initial subscription agreement. On the other hand, the institutional investor or the sponsor in OTCEI deals, bears the risk of capital loss due to a fall in the price of the securities. Bridge Loan A short-term loan granted to a borrower to tide over a temporary funds shortage. Such an accommodation is usually arranged at the time of a public issue, when expenditures on a project lead to a deficit, thereby necessitating a bridge loan. Capital Asset Pricing Model (CAPM) - A theoretical construct, developed by William Sharpe and John Lintner, according to which, a security's return is directly related to its systematic risk, that is, the component of risk which cannot be neutralized through DIVERSIFICATION. This can be expressed as: Expected rate of return = Risk-free rate of return + Risk premium. Further, the model suggests that the prices of assets are determined in such a way that the risk premiums or excess returns are proportional to systematic risk, which is indicated by the beta coefficient. Accordingly, the relationship, Risk premium = [Return on market portfolio – Risk -free return] (Beta of security) determines the risk premium. Thus, according to the model, the expected rate of return is related to the bets coefficient. This relation is portrayed by the SECURITY MARKET LINE. Commercial Paper (CP) - A short-term, unsecured PROMISSORY NOTE issued by BLUE CHIP companies. Like other MONEY MARKET instruments, it is issued at a DISCOUNT on the FACE VALUE and is freely marketable. Commercial Paper may be issued to any person including individuals, banks and companies. The Reserve Bank of India (RBI) has laid down certain conditions regarding issue of CPs. The issuing company must have a certain minimum tangible NET WORTH, working capital limit, asset classification, etc. and the paper must have a CREDIT RATING of P2, A2 or PR-2. Moreover, the rating must not be over two months old at the time of issue. From November 1996, the extent of CP that can be issued by all eligible corporates has been raised to 100 per cent of the working capital credit limit. As for restoration of the limit consequent on redemption of CP, banks have been given freedom to decide on the manner of doing so. Corporate Governance - The manner in which a company is managed. The term, Corporate Governance connotes the importance of responsibility and accountability of a company's management to its shareholders and other stakeholders, viz., employees, suppliers, customers and the local community. Hence it calls for ethics, morals and good practices in running a company. Good corporate governance would be reflected in generally good performance, clean business practices, improved disclosure and sound policies relating to capital expenditure, financing and dividend payment, which will enhance shareholders' wealth.
by computing the ratio of cash accruals plus interest payments (on term loans) to the sum of interest and loan repayments: DSCR = (Profits after taxe s + Depreciati on + Interest charges) (Interest charges + Loan repayments ) . Among other things. Expectations Theory . e. buildings. Derivatives are traded at organized exchanges and in the over-the-counter (OTC) market. HEDGING.A theory that offers an explanation for the shape of a YIELD CURVE in terms of investors expectations. Typically. Efficient pricing that maximizes mobilization. The advantages associated with Euro issues are: 1. A major difference between the two is that of counterparty risk—the risk of default by either party. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements. the STRIKE PRICE is the contracted exchange rate at which the option buyer buys or sells a currency. Combining shares from different unrelated industries helps to neutralize the UNSYSTEMATIC RISK inherent in each security. The value of the futures contract is governed by the value of the underlying Treasury Bill. Debt Service Coverage Ratio (DSCR) . the value of the futures contract will rise because the buyer has locked in a higher interest rate..e. dollar. a cross currency option may be preferable to a FORWARD CONTRACT. prior permission for an issue must be obtained from the Ministry of Finance. Economic Value Added (EVA) . BONDS. ARBITRAGE and PORTFOLIO adjustments. Factoring . on a future date at a predetermined price. For instance. These underlying assets may be foreign exchange. Total equity includes reserves and share PREMIUM. for which an appropriate OPPORTUNITY COST must be considered. if at all. becomes known to the option buyer at the outset. a firm's sales to different customers must have prior approval of the factor.An arrangement for obtaining funds by selling receivables to a specialized financing agency (the factor). INVENTORIES. With exchange-traded derivatives. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. (introduced in India in January 1994) as compared to forward and futures deals are that the option buyer is under no obligation to exercise the right. TREASURY BILL.K. For this privilege. Euro Issue . When factoring is contemplated. Euro issues must conform to the guidelines issued by the Central Government. A positive EVA is deemed to be a good sign and the higher it is. The cost of capital is the composite cost of total equity and debt. The balance is paid after receiving the amount due from the firm's customer.g. Stern Stewart is credited with the development of this tool in the late eighties. equities or commodities.4. Derivatives Trading Forums ORGANIZED EXCHANGE OVER THE COUNTER COMMODITY FUTURES FORWARD CONTRACT FINANCIAL FUTURES SWAPS OPTIONS (Stock and Index) STOCK INDEX FUTURES Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. In contrast. no other portfolio provides superior returns. Reduced cost of capital owing to lower interest rates and floatation costs. the factor may follow up with the customer after furnishing the details of receivables. For instance. Thus. i. currencies or stock indices. the maximum possible loss. For example. Inflow of foreign currency funds. FORWARD CONTRACTS relate to foreign exchange.5. there are fewer regulatory restrictions and this facilitates innovation. Efficient Portfolio . which together are deployed in various ASSETS such as land. debt instruments. and OPTIONS to equities. Interest-rate futures are tied to debt instruments. the factor.pksal.An issue of securities to raise funds outside the domestic market. an option confers the right without any obligation to buy or sell an asset at a predetermined price on or before a stipulated EXPIRATION DATE. It is calculated by subtracting the total cost of capital from the after-tax operating profits of a company. Operating profits simply mean earnings before interest and taxes.2. EVA expressed on a per share basis facilitates comparison between companies. This explains a downward sloping yield curve. the risk is controlled by exchanges through clearing-houses which act as a contractual intermediary and impose margin requirements. during a period of abnormally high interest rates. a factor pays up to 80 per cent of the invoice value to its client (firm) upon receipt of the copy of the invoice relating to goods delivered. The advantages with a cross currency option.A tool for evaluating and selecting stocks for investment.com -2- Cross Currency Option -An instrument that confers a contractual right on the purchaser of the OPTION to buy (call) or sell (put) a currency against another currency. OPTIONS derive their values from shares or stock market indices. moreover. SWAPS are agreements between two parties to exchange cash flows in the future according to a predetermined formula. Euro issues by Indian companies have been by way of GDRS or EUROCONVERTIBLE BONDS. In order to ensure timely collection.A ratio used to assess the financial ability of a borrower to meet debt obligations. bears the responsibility and attendant RISK of collecting the dues from the company's customers. when the direction of a currency's movement is uncertain. Derivative . OTC derivatives signify greater vulnerability. generally without recourse. which suggests that the long-term rate will be lower than rates in the near term.A financial contract that derives its value from another ASSET or an index of asset values. This contract binds the parties to exchange a debt security against payment e. trading in derivatives has registered a phenomenal growth in the Western financial markets. the better. If yields decline. EVA = After-tax Operating Profits –Total cost of capital. Moreover.SIKDAR’S ADVANCE LEARNING 23 C.g. There are two basic components to the charges levied by a factor: interest or .P. investors expect future rates to come down.The figures in the numerator and denominator are typically aggregated for 10 years in working out the DSCR. At that level of RISK. and also used as a measure of managerial performance. Greater visibility due to international exposure. Yen for U. futures to commodities. lending institutions ascertain the debt servicing capacity from financial projections submitted. No immediate dilution of voting control. The agency.S.A diversified selection of stocks resulting in a least risk PORTFOLIO for a given rate of return. machines. The relationship with other assets and certain other features makes derivatives useful for SPECULATION. receivables and cash. With their universal recognition as risk-management tools. An American consultancy firm.. the purchaser pays a cost termed PREMIUM. the terminology applicable to cross currency options is similar to the one for stock options. Incidentally. While appraising loan requests.3..
typically.. the interest is paid in foreign currency. Forward Rate Agreement . adjusted for taxes. will ask for an interest rate of at least 13. company meetings. in order to yield buy/sell decisions. Moreover. but without recourse to the exporter. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. the INTRINSIC VALUE of a share is determined for a comparison with its market price. As an illustration. That is.pksal. forward contracts are customized contracts that enable the parties to choose delivery dates and trading units to suit their requirements. The advantage to any issuing company is the inflow of foreign currency funds. the EXIM BANK introduced forfaiting in 1992. therefore.K. i. in whose name the shares are registered.. an ‘Alpine Convertible’ bond (issued to Swiss investors) scores over others. It amounts to DISCOUNTING receivables by a forfeiting company. is 9 per cent. Based on such an in-depth analysis. Under this arrangement.A transaction which binds a seller to deliver at a future date and the buyer to correspondingly accept a certain quantity of a specified commodity at the price agreed upon.00 per cent. the service commission is for bearing risk. If. financial position. The shares. may opt for cancellation of the same after the specified period by approaching the ODB and having the underlying shares released by the custodian in India for sale.94 has five underlying shares. For instance.50 per cent (assume UBOR as the reference rate in this transaction). the company pays the bank the difference. Administratively too.e.(FRA) This is a FORWARD CONTRACT by which a borrower locks in a certain rate of interest for an agreed time period in the future. the depreciation cost must be taken into consideration. consider that a company is planning to raise a six-month loan after 90 days. Therefore. Forfeiting . the forfaiter's fee depends on the country of the importer apart from the due date of payment. however. the ODB also performs the functions of distribution of dividends and issue of GDR certificates to replace those lost.This refers to the sale of export receivables. The advantage to the investor is the option of retaining the security as a bond till REDEMPTION.36 per cent. The counterparty is. one dimension of FCCBs is that they add to India's external debt. future plans and expected performance over the desired holding period. the latter is standardized in terms of quantity. is 4 per cent. Irving Fisher. redemption too will entail an outflow of foreign currency. particularly. GDRs of Indian companies are listed on the Luxembourg Stock Exchange and some on the London Stock Exchange.g. The management may enter into a suitable understanding with the ODB as regards the exercise of voting rights. the six-month LIBOR is more than 6.e. the interest rate on the security is higher as compared to bonds of foreign companies. The GDR which is issued by the ODB may trade freely in the security markets overseas. Fisher Equilibrium -The increase effected in the nominal rate of interest corresponding to the rate of INFLATION. $ 15. the bank which has sold the FRA will pay the excess amount to the company. i. the forfaiter bears the risk of default in payment by the importer. GDR . there is no exchange risk. So. In India. i. if the LIBOR is less than 6. debt collection and sales ledger administration resulting in regular cash flows to companies whose credit sales comprise a significant portion of the total sales. So. by lenders wanting to protect themselves from the erosion of purchasing power of the principal and interest income. If the option to convert is not exercised. Fundamental Analysis .A technique of evaluating and identifying stocks for investment. Authorized Dealers in foreign exchange may also enter this business. Further. In other words. if the real or natural interest rate. in matters regarding dividends.50 per cent. As an example.E. etc. The task of debt collection is also considered to be a major impediment. which is known as the 'Forward Rate'. This phenomenon is named after an American economist. r. Besides holding the shares. Factoring is thus a financial package of credit. not wanting to continue holding the instrument. rest with the local custodian bank. who believed that the nominal interest rate will be the sum of the REAL INTEREST RATE and a premium for inflation. the exchange risk. in terms of EARNINGS and DIVIDENDS PER SHARE. It is an instrument denominated in foreign currency that enables foreign investors to trade in securities of alien companies not listed at their exchanges.. quality and delivery month for different commodities. e. the increase in equity is clearly known unlike with FOREIGN CURRENCY CONVERTIBLE BONDS. Also. To illustrate. In some respects. the CONVERSION PRICE and the exchange rate are fixed. put and call OPTIONS may be attached to the instrument. This exercise is essentially forward-looking. the issue costs are lower and the placement process is shorter. A forward contract is distinct from a futures contract because the terms of the former can be tailored to one's needs whereas. The BOND which bears a certain coupon enables the issuing company to economize on interest cost by tapping foreign markets and also to postpone a DILUTION in the EARNINGS PER SHARE. Unless otherwise specified. e. Moreover. it becomes easier for the company to interact with the single ODB that accounts for a large shareholding. The call allows the issuer to undertake REFINANCING or to force conversion.g.An acronym for Global Depository Receipt. Among the reasons why factoring has not caught on in India are competition from alternative sources of financing particularly bill DISCOUNTING as well as funds constraint and lack of credit information. it buys a three-month FRA on six-month LIBOR at 6. which are issued by the company to an intermediary termed the 'Overseas Depository Bank' (ODB). multilated.SIKDAR’S ADVANCE LEARNING 23 C. DIVIDEND payments are in rupees and. the fee for forfaiting bills accepted by an importer in Uganda could be higher than for an importer in U. and converted into foreign currency will be remitted to the foreign investor subsequently.P. then the nominal rate of interest.S. Forward Contract . Subject to the rules prevailing. If the stock does not rise to the desired level. However. will be: i = r + f + rf (product of r and f). the endorsed debt instrument duly accepted by the importer and co-accepted by his bank. after three months. Foreign Currency Convertible Bond (FCCB) .com DISCOUNT -3- charge and service fee.K. There are no stipulated norms regarding turnover and MARKET CAPITALIZATION. until conversion. f. The put enables investors to sell their bonds back to the issuer. The main drawback with factoring is that it is usually very expensive. a bank which sells the FRA. Thus. Shipping issued in February 1994 at a price of U. a dollardenominated GDR issued on behalf of an Indian company represents a certain number of rupee-denominated equity shares. a GDR holder. The proceeds. i = 13. So.An unsecured debt instrument denominated in a foreign-currency and issued by an Indian company which is convertible into shares. . A bigger discount may trigger off widespread ARBITRAGE trading. Therefore. The company expects short-term interest rates to go up shortly. the exporter receives the proceeds on surrendering to the forfaiter.50 per cent. a lender who seeks to protect the purchasing power of the PRINCIPAL and interest due a year later. processing and collecting the receivables and handling the bookkeeping. It involves appraisals of the economy and the particular industry. and the expected rate of inflation over one year. at a predetermined rate. etc. Whereas the interest rate depends on the cost of money and competition among factors. or in some cases into GDRS. Incidentally. Moreover. the GDR of G. followed by a close scrutiny of the company in terms of its management. it serves to convert a sale of goods on credit into a cash sale. GDRs are generally issued at a modest DISCOUNT to the prevailing market price.
it has a distinct contractual relationship with each of the syndicate members. The syndicating bank then invites the participation of other banks. Thus. To implement the idea in practice is virtually impossible. For example. short selling and DERIVATIVES. Sale and Leaseback . while sometimes the lender would get a stake in the shareholding.An abbreviation for London Inter Bank Offer Rate. Markowitz Model . In syndication. The objective. By buying a floor. often company managers backed by investors. Interest Rate Floor . A disadvantage with hedging. would put up 10 to 25 per cent of the purchase price and borrow the remainder. using loans to buy securities. The lower the correlation. to attempt to profit from that opinion. in order to identify the efficient portfolios. . For instance. interest. A 'Cross-border Lease' transcends national boundaries. a borrower with a floating rate LIABILITY may seek protection from an anticipated sharp rise in the interest rate. The company's ASSETS would be pledged as security. Hedging .S. Also. this leveraged technique can be devastating if the investment declines in value or if the debt burden becomes onerous— as when stock prices fall and interest rates rise on floating-rate debt used in an acquisition. the idea is that the payment received for the floor would offset the cost of buying the cap. Selling a floor would deprive the borrower of savings that would result if the interest rate fell below the floor rate. only a nominal rent is payable during the 'Secondary Lease Period'. in the early 1980s. generally. Besides buying shares of small and unknown companies. Hedging is useful with futures contracts too. there are arrangements such as the 'Salesaid Lease' involving a tie-up between a manufacturer and a lessor for mutual benefit. repayment and security). This could be achieved by buying a cap and selling a floor. so as to reduce PORTFOLIO risk without any sacrifice in portfolio returns. For example. the greater will be the risk reduction. For instance.2.A DERIVATIVE that protects a lender from a sharp fall in interest rates.An investment model credited to Harry Markowitz. unlike in a CONSORTIUM arrangement. Operating or Service Lease – A lease under which the lessor maintains and services the leased equipment. However. Thus. These highly speculative funds operate mainly in the U. the firm receives the difference between the floating rate of interest and the predetermined ceiling called the 'Cap Rate'. the interest charged by member banks may differ. 3. Libor is also used as a reference rate in quoting interest rates on various other loans. through OPTIONS and futures they look for the benefit of LEVERAGE. Leveraged Buyout . options on the industry-based index could be bought or sold. Expected return for each security. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. Standard deviation of the expected return of each security. the model requires the following estimates: 1.A lease with no cancellation clause and no provision for maintenance. LlBOR .These are listed PUT and CALL OPTIONS on stock indices traded at options exchanges in the U.K. The interest rate differs according to the deposit MATURITY and the soundness of borrowing banks. unlike equity options which entail delivery of the underlying security upon exercise. Loan syndications can be arranged to finance term requirements or WORKING CAPITAL.1200 to 1500 crore. Financial Lease . Although the borrowing company signs a common document (containing clauses relating to term. the lessee may opt to cancel the lease prematurely and return the ASSET. creditworthy borrowers may find syndication more advantageous. the term of the lease contract may be less than the economic life of the ASSET. is that it results in less than the maximum profit that could have accrued. the lease covers the useful life of an ASSET and its cost is fully AMORTIZED. whenever the latter falls below the floor. Index options are similar to equity options in contract terms and trading. known as the 'Primary Lease Period'. after reviewing BIDS from different banks.A combination of an INTEREST RATE CAP and an INTEREST RATE FLOOR. the lender will receive the difference between the predetermined floor rate and the floating rate. The rentals may be so structured as to enable the lessor to recoup the investment with a return in the early part of the term. which is an average of the interest rates at which leading international banks are prepared to offer term EURODOLLAR DEPOSITS to each other. prospective issuers are expected to have a minimum turnover of Rs 500 crore and market capitalization in the range of Rs. Therefore.A lease under which an ASSET is sold by its owner to the leasing company. The borrower may select a bank to arrange for syndication. which suggests the combining of ASSETS that are less than perfectly positively correlated. An investor expecting a rise in the market may consider buying a call option on a broad-based index. Covariance between each pair of securities.P. SO also. But. which may be fixed or floating. in order to contain or hedge risks. Interest Rate Collar . drawn up by the syndicate manager. Thus. For an individual with an opinion on a particular industry.pksal.These are MUTUAL FUNDS that invest in various securities and may even sell short. however.A technique of acquiring companies by using substantial debt. Interest Rate Cap -This is a DERIVATIVE that enables a firm with a floating rate loan to limit its exposure to a rise in interest rates. but the important difference is that index options are settled by cash when exercised. This brings in the involvement of one more party to the transaction. Leveraged buyouts became popular in the U. for which a detailed write-up (Information Memorandum) may be circulated. a SHORT SALE could be employed to lock in a price gain on a LONG TRANSACTION. the cost of the equipment would not be fully AMORTIZED.S.SIKDAR’S ADVANCE LEARNING 23 C.” Index Options . The objective is to maximize returns by playing in any market that looks exciting. In such takeovers. and a 'Bigticket Lease' is one with a very large transaction value. here. The buyers. operating leases allow lessees to combat technological obsolescence that may affect computers and other equipments. The lessor gains by way of commission and/or credit from the manufacturer.The action of combining two or more transactions so as to achieve a risk-reducing position. considering the umpteen number of calculations entailed for a larger number of securities. Leveraged Lease – A lease under which the ASSET is purchased by the lessor with the help of a loan. is to protect a profit or minimize a loss that may result on a transaction. The instrument allows an investor who can anticipate market moves. and the lessor would subsequently lend the ASSET to other users. which comprises the remainder of the asset's life. but is immediately taken on a lease contract. mainly depends on the credit standing of a borrower. the buyers bank on profits to repay the huge debts incurred and look forward to selling their shareholding at a handsome profit. so that no institution individually has a high exposure. Loan Syndication – The participation by a group of lending institutions as financiers to a single borrower. Hedge Funds . The interest rate. Besides the above.S. The erstwhile owner thus receives the value of the asset and also has its use for a specific period. whenever the floating rate exceeds the cap. they indulge in MARGIN trading.com -4- However. To construct an efficient portfolio. By buying this derivative. a set of fifty shares will necessitate the calculation of 1325 estimates mentioned above. with margin trading.
special bearer BONDS and special loans and securities outstanding. Thus. Generally. daily calculation of the NAV requires a sophisticated information system. stock index futures enable investors and speculators to take a position based on their opinion about the market without actually selecting individual stocks.e. is often used by investors and analysts to determine the upward potential of a share by comparing its multiplier to that of the particular industry as a whole. whereas those expecting a market downturn may sell the contract. The ratio (index). whether the option is exercised or not. as e. Stock Index Futures . They are subsequently monitored over a period of time to confirm their financial soundness—this part is termed 'Seasoning'. Non-performing Asset (NPA) . a futures contract is an obligation to accept or . the latter resulting from the price of the underlying stock. The Unit Trust of India's. This number.K. The SPV holds the loans and issues paper against the security of the loans. is also referred to as the 'reward-to-variability ratio'. One simple rule of thumb suggests that the P/E ratio can be as high as the anticipated growth rate of a company. Moreover. An amount under a credit facility is past due when it has not been paid within 30 days from the due date. measures the excess return earned on a portfolio per unit of its total risk. which extends up to what is known as the 'Expiration Date'. Public Debt .A PORTFOLIO selection approach developed by William Sharpe. State and Local governments and also Government-owned entities. Seed Capital.g. is given by: S = Risk premium/ Total risk = [(Average return on portfolio)i – Risk-free rate] / (Standard deviation of returns on portfolio)i = (ri – R )/σ1. The buyer is under no obligation to exercise his right and may simply let the option expire. known as the 'Premium'.A credit facility which ceases to generate income for a bank. Considering that there is such a careful appraisal coupled with the backing of the underlying assets. Managing an open-end fund however. Seed Capital -The financial assistance towards a promoter's equity contribution. The cash flow by way of PRINCIPAL and interest on the underlying loans is "passed through" to the security holders. in common parlance. The proceeds from the issue of securities are given to the housing finance company. a long MORATORIUM period. which can be used to evaluate the performance of MUTUAL FUNDS. the term mutual fund refers to the 'Open-end' type of investment company which has no limit on the number of shares that it can issue. by selling a call or a put. therefore. housing loans and car loans. Various assets that generate cash flows can be securitized— as e.The transfer of loans (ASSETS) of a homogeneous nature.P. the buyer or the writer may independently terminate their outstanding positions before the expiration date. loans from foreign countries. alternatively called 'Equity Support'. Income from NPAs cannot be taken to the profit and loss accounts of banks. The multiplicand can be the expected earnings per share. but are unsure or unwilling to select specific stocks. Moreover. This vehicle is meant for investors and active traders who have a forecast on the stock market's direction. So. or 'Multiplier'.Futures contracts based on broad stock market indices.The market price of a share divided by EARNINGS PER SHARE. A very large portion of the internal debt obligations is held by the Reserve Bank of India. The assistance is usually in the form of a loan at very generous terms. However. The attraction of buying options is a potentially large profit on a relatively small investment. the term mutual fund refers to both the OPEN-END and CLOSED-END types of investment companies.A summary. the writer obligates himself to deliver or buy shares if the option is exercised. In a broader sense. it is one on which interest or any amount to be received has remained 'past due' for a period of two quarters as on March 31. investors who are bullish could buy stock index futures. It suggests using estimates of the relationship between each security's rate of return and the return on a market index as an alternative to calculating the covariances of each pair of securities as required by the MARKOWITZ MODEL.. The assignment of loans is mostly without recourse to the original lender. the Sharpe Ratio (or the Sharpe Index).The debt obligations of the Government of India comprising external debt. also known as the 'Multiple'. The risk premium is the excess of the average rate of return on a portfolio over the RISK-FREE RATE of interest. by executing offsetting transactions. The idea is to drastically reduce the number of calculations needed in constructing an efficient portfolio. In general.. an individual who owns a share in a mutual fund has a proportionate claim on the PORTFOLIO of investment vehicles held by the fund. The premium is paid by the option buyer to the option writer (seller) who keeps the money. The instrument may also be used to offset unrealized or probable losses on a long or short position. Option . say MORTGAGES. the time value converges to zero. risk-adjusted measure of PORTFOLIO performance devised by William Sharpe. long before they become due. The lending institution benefits by this arrangement since it frees a large amount of funds for reinvestment. American options may be exercised during a certain time period. a call buyer's outlook is essentially bullish whereas a put buyer is bearish about the underlying share. As the expiration date approaches. Units 1964 scheme is a prime example. is to enable promising entrepreneurs with inadequate capital to set up their enterprises. 1995. However. etc. Single-Index Model . the financial instruments that are created present an attractive investment opportunity.S.pksal. The maximum possible loss is the price paid for the option. The periodic interest and principal are collected by the SPV and passed on after retaining service costs and insurance fees. if available. S. Sharpe Ratio . EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. there are some specified criteria for identifying NPAs. i. public debt includes the debt of Central. Securitization . their investment quality can be determined from the CREDIT RATING. The portfolio manager must estimate the maximum possible demand for REDEMPTION and accordingly retain some liquid ASSETS. the value of a put option increases as the price of the share falls..SIKDAR’S ADVANCE LEARNING 23 C. Price-earnings Ratio . Exchange-traded options in the U. The value of an option comprises a time value and an INTRINSIC VALUE.com -5- Mutual Fund . The SUBJECT-WISE LISTING mentions the different types of mutual funds that are explained elsewhere in this book. Buying a call option is an alternative to buying the underlying shares. In essence. Importantly though. nominal service charge and a lengthy repayment period. Buying a put is an alternative to a short sale of the underlying shares.An organization that mobilizes the surpluses of savers and invests the same in different securities. as per the Reserve Bank of India's directive. The assets are selected from a pool that is carefully sifted— this is known as 'Cherry Picking'. international FINANCIAL INSTITUTIONS. from a lending institution to investors through an intermediary.g. Thus. The value of a call option rises with the price of the underlying share whereas.A contract that gives the holder the right to buy ('Call Option') or sell ('Put Option') a certain number of shares of a company at a specified price known as the 'Striking Price' or 'Exercise Price'. are in denominations of 100 shares. It is the ratio of the RISK PREMIUM to the 'Total Risk' (standard deviation of returns) of a portfolio and hence. involves some distinct challenges. by packaging them in the form of securities which are usually termed 'PASS-THROUGH SECURITIES'. For CASH CREDIT and OVERDRAFT facilities. and internal debt that includes market loans. A trust or an intermediary termed ‘Special Purpose Vehicle’ (SPV) is involved in the arrangement of securitization. TREASURY BILLS. Thus. In financial nomenclature.
to eliminate the problem of "WINNER'S CURSE". Technical Analysis . However. and a 'Spread' that involves the purchase of one option and the sale of another. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. Swap . Swaps may relate to CAPITAL MARKETS or to the foreign exchange market.60 per cent per annum and having an indefinite life.P. the system caused large-scale monetization of government debt. Major political. the notified amounts are to be pre-announced for the whole year. by diversifying internationally. i.com -6- effect delivery as per the transaction. A currency swap involves conversion of principal and interest into another currency for the duration of the flows. foreign CENTRAL BANKS and other specified bodies. the investor receives the face value and hence the increment constitutes the interest earned.. both on the same security. Systematic risk of a financial ASSET is indicated by the RETA coefficient. Financing government expenditure by issuing Ad-hoc Bills to the RBI caused an increase in the outstanding RESERVE MONEY. The buyer of a straddle is speculating that the underlying security's price will deviate up or down significantly before the options expire. this up-front cost is the maximum that the swaption holder can lose. An interest rate swap is undertaken to alter the stream of interest payment flows mostly from fixed to floating or vice versa. However.e. although the discretion to change the amounts will rest with the RBI. The terms payer and receiver indicate the right with regard to the fixed interest. it is also termed 'Undiversifiable RISK'. Similarly. 364-day T-Bills from April 1992. Two types of T-Bills were issued in India. and 91-day T-Bills from January 1993 (in addition to the tap bill).2. then he may buy a 'Receiver Swaption'. to name a few.Bills. It has its origins in the CASTLE-IN-THE-AIR approach. To control such monetization. an analysis of recent market data can be used to detect emerging trends and predict future price behaviour. the government resorted to auctions of 182-day TBills from November 1986. a 'Strap' (two calls and one put). notably. Straddle . in the short run. Hence for the Treynor Index. CONFIDENCE INDEX. T is given by: T = Risk premium / Systematic risk = (Average rate of return on portfolio) p – Risk free rate) / (Beta of portfolio) p . money created by the RBI. It is calculated by dividing the risk premium by the systematic risk of a portfolio and is also termed the 'reward-to-volatility ratio'. The purpose behind the low rate was to control the burden of interest charges. Technical analysts employ a dazzling array of tools and theories including. Swaption . relative to the systematic risk. the difference in the two interest payments would be exchanged. A portfolio whose index is higher than another's has perfomed better.Bills (or Ad hoes) of 91 days maturity (which were nonmarketable) to the RBI to replenish the Central Government's cash balance. if an investor holding floating-rate securities expects a decline in rates. Therefore.An OPTION to SWAP LIABILITIES or receivables so as to limit the interest burden or to maintain a certain level of interest income respectively. (g) the proposed use of uniform price auction method in the case of 91-day T. With stock index futures. so as to promote the emergence of a YIELD CURVE for short-term RISK-FREE securities.A combination of a CALL and a PUT OPTION involving the same security. the lack of coincidence between economic cycles of different countries helps to achieve this. The idea was to improve the YIELD. whereas 182-day and 364-day Bills will be auctioned fortnightly. after which the principal sums are reconverted to the original currencies. For instance. at the same EXERCISE PRICE and for the same time period. with the express objective of phasing them out within three years. There have been major changes in recent years with regard to T-Bills: (a) An agreement was signed between the Finance Ministry and the RBI in September 1994 to limit the net issue of Ad hoc T-Bills. the exercise prices or the EXPIRATION DATES may differ. For instance. (f) Introduction of the practice of notifying amounts in the case of all T-Bill auctions. In a spread. it has been decided that 14-day and 91-day Bills will be auctioned weekly. 1997 into special securities. However. Treynor Ratio . SO as to attract investment from sources other than the RBI. by the Reserve Bank of India (RBI). Ordinary T. which imply that systematic risk cannot be eliminated by DIVERSIFICATION. particularly price and volume data. for instance. CHARTING. economic and social phenomena. Systematic Risk . The former has been substituted by a system of WAYS and MEANS ADVANCES to the Union Government.A technique of stock analysis for timing buy/sell decisions.(e) Proposed introduction of 28-day and 182-day (not issued since April 1992) Bills. The instrument is negotiable and is issued at a discount from the FACE VALUE. bearing an interest rate of 4.A summary measure of PORTFOLIO performance suggested by Jack Treynor which relates the RISK PREMIUM to the portfolio's SYSTEMATIC RISK. This security bears no DEFAULT RISK and has a high degree of LIQUIDITY and low INTEREST RATE RISK in view of its short term. with specific limits. 1. For several years. for short-term investment or to comply with statutory requirements. A swaption facilitates HEDGING in a situation of uncertain interest rates. would affect all stocks. on behalf of the government. and FILTER RULE.The exchange of financial LIABILITIES which may be in the same currency or in different currencies. an investor can reduce the level of systematic risk of a PORTFOLIO.(d) Issue of 14-day Intermediate TBills from April 1997 to serve as investment vehicles exclusively for State Governments.A short-term debt instrument of the Government of India.(c)Conversion of outstanding Ad hoes and tap Bills as on March 31. It shows the sensitivity of return on a security or a portfolio to return from the market. The underlying logic of focussing on the future market price is—an object is worth only what someone else will pay for it. Treasury Bill (T-Bill) . with no PRINCIPAL obligations changing hands. the endeavour is to forecast the direction of the market price of a share or the market as a whole. Ad hoc T. as is the case with other options. a borrower with floating-rate debt who anticipates an increase in interest rates may buy a 'Payer Swaption' thereby obtaining the right to convert the liability to a fixed one when rates rise above the strike rate. Thus. The cost of the swaption is the PREMIUM. They are used to manage risks relating to changes in interest rate or foreign exchange rate. At MATURITY. since each contract represents a hypothetical PORTFOLIO of stocks. this obligation may be discharged with an offsetting transaction by the last trading day. T-Bills were issued on tap at a fixed DISCOUNT of 4. (b) Discontinuation of the issuance of Ad hoes and tap T-Bills from April 1997.K. The basic premise of technical analysis is that stock prices tend to move in trends that persist for sometime and so.60 per cent per annum. More recently. so called because it is based on studies of the market activity.The portion of risk or variability that is caused by factors which affect the returns on all securities. The holder of the swaption has the right (but no obligation) to enter into a swap by the exercise date. Further.Bills "on tap" that are taken up mainly by banks. MOVING AVERAGE. Other combinations are a 'Strip' (two PUTS and one CALL).SIKDAR’S ADVANCE LEARNING 23 C. Therefore. This situation was compounded by the REDISCOUNTING of tap T-Bills by banks with the RBI. a company with a variable-rate liability may opt for a swap with another borrower who has raised a fixed-rate loan. the DOW THEORY.pksal. The risk premium is the excess of a portfolio's average rate of return over the RISK-FREE RATE of interest.
It helps in assessing information as to how sensitive are the estimates. Zero-coupon Bond . Therefore. The methodology adopted in it. and yet would obtain tax deduction. In India. discount rate and project life are subject to the estimation errors. There are various ways to restoring to capital rationing. since there are no periodic inflows. IDB1 and SIDB1 too have issued the zero-coupon variety of deep discount bonds. Risk Capital and Technology Finance Corporation Limited (RCTFC) and Gujarat Venture Finance Limited (GVFL). it should not be viewed as the method to remove the risk or uncertainity. However. of whatever type. is to evaluate a project by using a no. housing company. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www. venture capital entails high risk but has the promise of attractive returns. Thus the effective control remains with the owners. a firm may effect capital rationing through budgets. 1. investors attitude etc. or even wrong management decisions. Examples include Technology Development and Information Company of India Limited (TDICI). The role of venture capital institutions is very important to the economic growth of a nation.g. or a lease from a leasing company. By having a diversified PORTFOLIO. Thus there may arise the situation of capital rationing where there may be internal or external constraints on procurement of necessary funds to invest in all investment proposals with positive NPV’s. in sensitivity analysis always asks himself the question-what if? Debt Securitisation: Debt securitisation is a method of recycling of fends. The process of securitisation is generally without recourse. Equity financing: ASS venture capital financers in India provides equity but generally their contribution does not exceed 49% of total equity capital. (iii) Analysis of the impact of the change in each of the variables on the NPV of the project. It takes care of estimation errors by using a no. should be available in the form of equity or quasi-equity (conditional loan) and income notes. (i) Identification of all variables having an influence on the projects NPV or IRR. The securities carry a coupon and an expected maturity which can be asset based or mortgage based. he does not have to worry about reinvestment.availability of market information. it is possible to neutralize unsystematic risk.SIKDAR’S ADVANCE LEARNING 23 C. However there may be resource constraints due to which a firm may have to select from among various projects with positive NPV’s. Conditional Loan: A conditional loan is repayable in the form of royalty after the venture is able to generate sales. zero-coupon bonds are a sub-set of the group of DEEP DISCOUNT BONDS. the excess of face value over the issue price. Note: The decision maker. Internal capital rationing is due to self imposed restriction by the management like not to raise additional debt or laying down a specified minimum rate of return on each project. Sentivity Analysis in Capital Budgeting: It is used in capital budgeting for more precisely measuring the risk. Thus. In this situation the amount of capital expenditure can not exceed the amount of retained earnings.= rp − R P. The advantage with this security to an investor is that. Generally. it is a technique of risk analysis which studies the responsiveness of a criterion of merit like NPV or IRR to variation in underlying factors like selling price.e. therefore.. conceptually being risk finance.. Methods of Venture Capital Financing Venture financing. it is only a tool to analyse and measure the risk & uncertainity. of estimated cash flows so as to provide to the decision makers an insight into the variability of outcome. Thus. which is also therefore termed. Venture Capital -The long-term financial assistance to projects being set up to introduce new products/inventions/innovations or to employ or commercialize new technologies. 'Diversifiable Risk'. imperfection in capital markets which can be attributed to non . (ii) Definition of the underlying quantitative relationship among the variables.A risk that is unique to a firm or industry. they are kept in the originator's portfolios. The basic debt securisation process can be classified in the following three functions: (1) The basic function: A borrower arranges loan from a financing company. those manufacturing consumer non-durables (e. such as cash flows. parameter of the project. So. (2) The pooling function: Similar loans or receivables are clubbed together to create underlying pool of assets. in January 1994. The adverse impact of any such occurrence would be confined to one or a few firms.com -7- βp Unsystematic Risk . These are sold to investors through merchant banker. It may also put a ceiling when it has been financing investing projects only by way of retained earnings. Capital Rationing: As per the fundamental principal of finance. The investors in this type of security are institutional investors. which acts as a trustee for the investor. It is especially beneficial to financial intermediaries to support the Sending volume. the return consists of the DISCOUNT. Quantity sold. Similarly. bank. External constraints mainly include. these unsystematic variations occur independently of broad price movements in the market. of possible outcomes in evaluating a project. new entrepreneurs and businesses spring up and contribute significantly to the total wealth of a nation. This pool is then transferred in favour of a SVP (Special vehicle purpose). wherever there is an uncertainity. . For example. with an objective to maximize the wealth of shareholders. firms which are less vulnerable to macroeconomic changes. Hindustan Lever and Colgate) would have less SYSTEMATIC RISK and a higher degree of unsystematic risk. i.K. Sensitivity analysis involves three steps . such institutions have been set up at the national and state levels. At MATURITY. An interesting development was the issue of five-year zero-coupon bonds by the Government of India by auction. Once the assets are transferred. also known as 'Risk Capital'.. a firm should accept all investment projects with Rationing: positive NPV’s. the sensitivity analysis plays a crucial role.A few companies in India have issued such securities especially zero-coupon CONVERTIBLES.pksal. as e. an investor receives the face value. (3) The securisation function: In this step SVP structure issue the securities on the basis of asset pool.A BOND that bears a zero COUPON RATE and hence is issued at a price substantially below its FACE VALUE. returns etc. It is. 2. Thus. Therefore. changes in consumer preferences. The returns on an ASSET can be affected by occurrences such as a labour strike. Capital rationing may also mean that the firm foregoes the next most profitable investment following after the budget ceiling even though it is estimated to yield a rate of return more than the cost of capital. Because of their assistance.g. a company need not bother about meeting interest obligations at regular intervals.
essentially means that at the end of a trading session. shall be eligible to make a public issue only through the book building process. .F.In the start up phase. Debentures are issued for fixed period and at fixed interest rate. 3. Participating Debentures: Such securities carries charges in three phases. 182 days and 364 days.SIKDAR’S ADVANCE LEARNING 23 C.no interest is charged. So they are becoming very popular on account of fulling interest rates. maturing in a period of less than one year. In the context of derivatives trading. The implicit of yield on a treasury bill is a function of the size of the discount and the period of maturity.a date at a. 91 days. next stage-Sow interest is charged upto a particular level of operations. 28 days. • In case of public issue through book building process. the option is not exercised debenture continues. whereas provident funds are other investors can make non competitive bids. refers.F. It is secured by hypothecation of moveable assets. They are highly liquid instruments and issued to tide over short-term liquidity shortfalls. Income Note: It is a hybrid security which combines the features of both conventional loan and conditional loan. • The issue size include offer through offer document + firm allotment + promoters contribution through the offer document. once the loans are approved in principles. pending disbursement of term loans by financial institutions. Such temporary loan is repaid out of the proceeds of the principal term loans. whose equity shares or any shares or any security convertible at later date into equity shares are offered through an offer for sale. EKDALIA PLACE KOLKATA – 700019 M: 98301 65501 Web: www.P. Offer for sales: A company.com -8- No interest is paid on such loan. therefore provides an opportunity to calculate the extent of liability on the basis of re-pricing. which reflects the market value of securities on the reporting date. all outstanding contracts are repriced at the settlement price of the session. • The listed company which does not fulfill the above condition. firms. A call option gives a liberty to the issuer of the debentures to pay back the amount earlier to the redemption date at a pre-determined price called strike price. period Treasury Bills: Treasury bills are short term debt instrument of the central government. Marking to market. normally. Thus. T-Bills are issued at discount and redeemed at par. Unlike the forward contracts. Any loss or profit resulting from re. failing of this all the subscription money will be refunded. to loans taken by Business. 2. in order not to lose further time in starting their projects arrange for B. the future contracts provide better risk management measure as compared to forward contracts. personal guarantees and demand promissory notes. However. 4. a right to investors to demand back the money earlier to the redemption . Periodically RBI sell T-Bills through an auction process. pre determined price (strike price) with in the specified period. 4. Generally rate of interest is higher on B. Bankers are the primary bidder in the competitive auction process. Call and put option with reference to debentures 1. 5. Rate of interest on debentures varies significantly 3. The enterprise has to pay feeds interest and royalty on sates.F. It. Bridge Finances: B. after that. the future contracts are marked to market on periodic (or daily) basis. With inflow of enormous foreign funds this has assumed great significance. within the specified period. according to a fixed auction calender announcement of the RBI.pksal. a high rate of interest is required to be paid. In case. but at substantial low rate. to finalise procedures of creation of security tie-up participation with other institutions etc. Normally it takes time for the fin. etc) at a value. shall comply with the provisions prescribed for ‘public issue by unlisted companies’. The periodicity of the T-Bills is 14 days. Treasury bills are issued by RBI on behalf of government of India for periods ranging from 91 days to 364 days through regular auctions. the future contracts are repriced every day. even though positive appraisal of the project has been made. as compared with that term loan.pricing would be debited or credited to the margin a/c of the broker. The investment in the Treasury Bills is reckoned for the purpose of Statutory Liquidity Reserve (SLR) requirements. 60% of issue size shall be allotted to the Qualified Institutional Buyer. usually from Commercial banks for a short period. A put option means. Marking to Market: It implies the process of recording the investments in traded securities (shares. • The issue size can not exceed five times its pre-issue net worth as per last audited balance sheet. inst.K. deb.
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