FINANCE MODEL QUESTIONS AND ANSWERS Prepared by Professor Sujoy Kumar Dhar. Faculty Member, IBS Kolkata. 1.

What is the difference between Preference share and Equity share? Ans. Preference shareholder enjoys preference in case of distribution of dividend and repayment of capital when company goes on liquidation. All Preference shares are redeemable in India. Preference share holder has no voting right and it is not market traded. Therefore preference shareholders only can enjoy dividend gain. Equity share is not redeemable. Equity shareholders are owner of the company. Equity shareholder has voting right in selection of board of directors of company. Equity shares are market traded. Equity share holders will enjoy both dividend and capital gain. 2. What is the difference between NPV and IRR ? Ans. Net present value of a project is defined as excess of the sum total of present value of future inflow over and above the current outflow. If NPV of the project is positive, project is accepted. NPV follows additive rule. Multiple NPV is not possible for a project. NPV aims to maximize the wealth of the firm. Internal Rate of Return is the discounting rate for which sum total of present value of future inflows will be equal to current outflow. If IRR is greater than cost of capital, project is accepted. IRR does not follow additive rule. Multiple IRR is possible if direction of cash flow of the project changes more than once, so many times direction will be changed, so much number of IRR will be there. IRR maximizes the return from the project. 3. What is the difference between forward and future? Ans. Both forward and futures are derivative instrument. They are basically the agreement between buyers and sellers to deliver a particular asset at a predetermined future price at a predetermined future date. They are different due to following aspectsForward is not market traded but future is market traded. Default risk is high in forward but in future there is no default risk. Forward is highly illiquid but liquidity of future is high. Forward has no standardized format but future has standardized format. No margin money is required for forward as there is no clearing house between buyer and seller but both the buyer and seller has to deposit margin money in future to the clearing house. 4. What is the difference between future and option? Ans. Future is an agreement between buyers and sellers to deliver an instrument at a particular predetermined price at a predetermined future date.

Option is an agreement that gives the buyers right but no obligation to buy or sell any instrument at a particular price within or on a predetermined future date. Option seller is obliged to sell or buy the instrument when option buyer exercises its option. Option seller is enjoying premium from option buyer. The option that gives right to buy is called call option. The option that gives right to sell is called put option. In case of future , either trader has to take or make the delivery of the underlying asset on the delivery date or they have to square off their position before the maturity date. In case of option, buyer has the right but no obligation to exercise the contract. In future possible profit or loss can not be forecasted in advance unless and until trader squares of its position. In case of option, for the buyer maximum possible loss is limited to premium price. 5. What is the difference between systematic and unsystematic risk ? Ans. Systematic risk implies that risk which will affect the share of all sectors. Example of systematic risk is political risk, inflation risk, interest risk. Systematic risk can be reduced by hedging. Unsystematic risk is a sector specific risk which arises due to inefficient operation of a particular sector. Example of unsystematic risk is Government regulation, external risk, market risk, financial risk, corporate governance risk. If investor can invest in different stocks of diversified nature, unsystematic risk can be reduced to minimum. 6. What is the difference between CML and SML? Ans. Capital Market Line(CML) shows linear relationship between portfolio risk and portfolio return. Capital market line is efficient frontier when the individual diversifies their investment into risk free and risky asset. Security Market Line(SML) measures the required rate of return of an individual security. Required rate of return of a security is risk free rate of return plus risk premium multiplied by beta value of the security. If the expected return form the security is greater than the required rate of return, the asset is under priced or vice versa. Whether an asset is overpriced or under priced, it is determined by SML. If the asset is plotted above SML, it is underpriced and if the asset is plotted below SML , it is over priced. 7. What do you mean by hedger, speculator and arbitrageur? Ans. Hedger wants to minimize their risk by adopting appropriating investment strategy. Speculator wants to maximize its gain by using their speculation power. They are ready to take higher risk to get higher return. Arbitrageur wants to earn risk less profit by taking the advantage of price differentials.

8. What do you mean by Sensex and Nifty ? Ans. Sensex is the index of Bombay Stock Exchange. It is the weighted average of the price of 30 securities. Nifty is the index of National Stock exchange. It is the weighted average of the price of 50 securities.

9. What do you mean by beta value of a security? How it is calculated? Ans. Beta value is the market sensitivity of a stock. It measures the change in the market price of the security due to change in market index. Beta is the measure of systematic risk. Beta value of the stock is calculated by the formula = Covariance between the return of market index and return of the particular stock /variance of the market index 10. What is trading on Equity? Ans. If return on capital employed of the firm is greater than cost of debt capital, by relying more and more on debt capital, firm can raise its earning per share. It is called trading on equity. 11. In future trading, how many types of margin an investor is required to keep? Ans. There are three types of margin- initial margin, variation margin, maintenance margin, that a future trader is required to keep. Both the buyer and seller of the contract has to deposit a certain percentage (usually 10%) of total value of the contract in the clearing house as initial margin. If any one of the party makes default, clearing house will compensate the other party with the help of the margin money. Maintenance margin is the minimum necessary margin money that each party to has to keep in their account. Since future is being traded daily, depending on appreciation or depreciation of the market price of future margin will increase or decrease. If Margin money falls below the maintenance margin, party will get a call from the clearing house to deposit the money so that his margin balance will increase to initial margin level. This is known as variation margin.

12. What is the difference between Technical analysis and Fundamental analysis? Ans. According to Technical analysis market price of the stock is determined by the free movement of market forces such as demand and supply. These demand and supply are influence by both fundamental and psychological factors. The bottom line is that barring few exceptions, stock prices are moving along a particular trend. Therefore future stock price trend can be determined from the past movement of

stock price. Stock price movement can be explained with the help of graph and charts. Fundamental analysis is used to determine the intrinsic value of the share. It includes economic analysis, industry analysis and company analysis. Economic analysis takes into account different factors such as GDP of the nation, Saving and investment pattern, Money supply, inflation and interest rate, Union Budget, balance of payment position etc. Industry analysis incorporates Porters five factor model, Industry life cycle and nature of industry (Growth industry, cyclical industry, defensive industry). Company analysis includes analysis of liquidity, solvency, profitability position of the company which will be followed by valuation of the company by discounted cash flow method such as Dividend Discount Model, Free cash flow to equity Model, Free cash flow to firm model etc. If the intrinsic value of the stock is less than the market price, it is undervalued or vice versa. 13. What do you mean by weak, semi strong and strong form of efficiency in the market? Ans. Market efficiency means to which extent current information are instantaneously reflected in the market price of the stock. Weak from of efficiency implies that all the market participants have the information of past period stock price. Therefore current period stock price is reflecting the past period stock price. On the basis on past period stock price information, no body can earn extraordinary profit in weak form efficient market. Autocorrelation test and run tests are used to judge whether the market is following weak form efficiency or not. Semi strong form of efficiency implies market participants have information about the past period stock price movement as well as all published information about the company such as quarterly financial report, dividend declaration, bonus issue, right issue, stock split, merger acquisition news etc. Thus current stock price reflects previous period stock price as well as all publicly available information. On the basis of information of past period stock price and published information , no body can earn extraordinary profit if market is semi strong efficient. Strong form of efficiency implies market participants have the easy access to both internal and published information about the company. Thus stock price will reflect publicly available information as well as internal information . Insider trading also not possible if market is strong form efficient. 14. What is Dow theory ? Ans. According to Dow theory of Technical Analysis, stock price is moving along a particular cyclical trend. Market is governed by primary trend, secondary trend and day to day fluctuation. Primary trend shows the the long range cycle which makes the entire market up or down. Secondary trend implies market correction that restraints the movement of primary trend. Secondary trend moves in opposite direction of primary trend. Day to Day fluctuation of stock price depends on sentiments of the people. Volume will also move along the primary trend. If primary trend is bullish, volume will increase when share prices are going up and volume will go down when share price decreases. On the contrary, if primary trend

is bearish, volume will increase when share prices are going down and volume will fall when share prices are going up. 15. What is repo and reverse repo ? Ans. Often commercial banks borrow from RBI by selling their securities with an agreement to repurchase it after a certain period of time at a higher price . The rate the commercial bank has to pay to RBI is called repo rate. In inflationary period, RBI raises the repo rate. During the recession time, repo rate is reduced. Current repo rate is 6%. When RBI is borrowing from RBI, the commercial bank will receive the interest from the borrowers. The rate commercial banks receive from the RBI is known as the reverse repo. Current reverse repo rate is 5%. During the inflationary period, reverse repo rate is also increased and vice versa. 16. What is covered call and naked call ? Ans. A covered call strategy involves writing a call option on an asset along with buying the asset. It is called covered position because potential obligation to deliver the stock is covered by the underlying stock in portfolio. A naked call strategy involves writing a call option on asset without buying the asset. It is called naked position because potential obligation to deliver the stock is not covered by the underlying stock in the portfolio. 17. What is in the money and out of the money call option ? Ans. If buyer of the call option has a net cash inflow as because market price is greater than the exercise price, it is In the Money call option. If buyer of the call option has a net cash inflow as because market price is less than the exercise price, it is On the Money Call Option. 18. What do you mean by protective put strategy ? Ans. When an investor purchases an under priced stock with the anticipation that its price will go up in the near future, there is a risk that due to market risk price of the stock may fall. To hedge risk, they will purchase put option. It is known as protective put. 19. What is the difference between the close ended and open ended mutual fund scheme? Ans. The subscription to a close ended scheme is kept open only for a limited period. A close ended scheme does not allow investors to with draw funds as and when they like. A close ended fund has a fixed maturity period. The open ended scheme accepts funds from investors by offering its units on a continuous basis. Open ended scheme permits investors to withdraw funds on a continuing basis under a repurchase agreement. An open ended scheme has no maturity period. 20. What is Systematic Investment plan and Systematic Withdrawal plan ?

Ans. Under Systematic Investment plan , the investor can invest regular sums of money every month to buy units of a mutual fund scheme. As the investment is made regularly, the investor buys more units when the price is low and less units when the price is high. It implies SIP provides the opportunity of rupee cost averaging to the investor. Systematic Withdrawal plan allows the investor to withdraw a fixed amount every month. The mutual fund sends the redemption proceeds to the investor every month automatically. The investor can opt for a fixed sum every month or a certain percentage of the capital appreciation in the NAV of the scheme. 21. What is Book Building Process? Ans. Usually public companies go for Initial Public Offer with the help of Book Building process. It is a method of offering share to the people where issue price is not fixed in advance but is determined through a bidding process. In a book building offer, price reflects revealed demand and contemporary market conditions. 22. What is Circuit Filter/Circuit Breaker ? Ans. Stock market volatility is generally a cause of concern for both policy maker as well as investors. To curb excess volatility, SEBI has prescribed a system of price bands .Price bands or circuit breakers bring about a coordinated trading halt in all equity and equity derivative markets nation wide. An index based market wide circuit breaker system at three stages of index movement either way at 10%, 15% and 20%has been prescribed. The breakers are triggered by movement of either Nifty or Sensex whichever is beached earlier. As an additional measure of safety, individual scrip wise price bands of 20% either way have been imposed for all scrip. Therefore there is no reason of worry for individual investors. 23. What do you mean by Transaction, Translation and Operating Exposure ? Ans. When a firm has a receivable or payable in a foreign currency, a change in exchange rate will alter the amount of local currency received or paid. Such risk exposure is referred as transaction exposure. The law in many countries require that the account of foreign subsidiaries and branches have to be consolidated with those of the parent company. For such considerations, assets and liabilities expressed in foreign currencies have to be translated into domestic currencies at the exchange rate prevailing on the consolidation date. If the value of foreign currency changes between two successive consolidation dates, translation gain or loss will arise. The essence of Operating Exposure is that exchange rate changes significantly alters the cost of a firms input and the price of its output and thereby influences the competitive position substantially. It is possible when manufacturing takes place in one nation and selling takes place in another nation. 24. What is Global Depository Receipt ?

Ans. A depository receipt is a negotiable certificate that usually presents a companys publicly traded equity or debt. Depository receipts are created when a broker purchases the companys share on the home stock market and deliver those to the depositories local custodian bank which then instructs the depository bank to issue a depository receipt. Depository receipts are quoted and traded in the country in which they trade and are governed by trading and settlement procedure of the market. All the depository receipts including GDR are essentially equity instrument created or issued abroad, not by the companies but by the oversea depositories bank which are authorized by the company in say India to issue them to non resident investors against their shares. These shares are physically held by domestic custodian banks nominated or appointed by Overseas Depositories Banks(ODB). In the companys book the ODBs name appear as the holder of their shares. 25. What is difference between European an American option ? Ans. A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date. Therefore American option offers much flexibility than European option. 26. Mention some names of Credit Rating Agencies. Ans. In India, the Credit Rating Information Services Limited CRISIL), Investment Information and Credit Rating Agency(ICRA) and Credit Analysis and Research Limited(CARE) provide bond and other debt rating. 27. What are the instruments in Money Market ? Ans. Money market is a mechanism when fund can be borrowed or lent for short term that is less than one year. The instruments in the Money Market is Call Money, Notice Money, Treasury Bill, Bills of Exchange , Commercial bill, Certificate of Deposits and Repo and Reverse Repo rate. 28. What is Short Selling ? Ans. Often investors sells the shares of a company in the first half of the day when they do not have the ownership of the share . This is known as short selling which takes place specifically in intraday activity where traders have to buy the shares in the second half of the day. They anticipate that price will go down in the second half of the day. If their speculation is correct, they will earn lucrative profit. On the contrary, if speculation goes wrong, they have to incur loss. 29. What is straddle? Ans. When investor is feeling that there will be a big suing in the market, but he is uncertain that it will take place in which direction, he uses the strategy known as straddle. Straddle is a strategy to purchase/sell a call and a put option simultaneously with same exercise price and same expiration date. Long straddle is used when it is expected that spot price will move to the either direction from the exercise price. Short straddle is used when stock price is expected to be very close with exercise price.

30. Explain the concept of Bull Spread and Bear Spread strategy. Ans. If investor perceives that there will be bullish trend in the market but he is not very sure about it, he uses Bull spread strategy. Here investor buys one call option and sells another call option with same expiration date but with different exercise price. Investor purchases that call option whose exercise price is below than the spot price and sells that call option whose exercise price is greater than the spot price. Profit will be maximized if the spot price is above than out the money call option. Loss will be maximum if the spot price is below the in the money call option. Bear spread strategy is used when investor anticipates there will be bearish trend in the market but he is not certain about the intensity of it. Here investor buys a call option whose exercise price is higher than spot price and sells a call option whose exercise price is less than spot price. Profit will be maximized if spot price falls below the exercise price of in the money of the call option and loss will be maximized when spot price is above the exercise price of out the money call option. 31. What is Butterfly strategy? Ans. Another popular strategy is called butterfly strategy .In long butterfly, investor purchases two extreme call options and sell 2 units of intermediate call options. For example if there are 3 call options A, B, C whose exercise price are Rs.100,150,200 respectively, in long butterfly investor will buy A and C and sell 2 units of B. In long butterfly, profit will be maximized if spot price comes close to the exercise price of B. in short butterfly, investor will sell A and C and buy 2 units of B. In short butterfly, profit will be maximized if spot price becomes either below the exercise price of A or above the exercise price of B. 32. Define Decision Tree and its uses Ans. Concept of decision tree is widely used in investment analysis. Decision tree is graphical method for identifying alternative actions, estimating probabilities and indicating the resulting payoff. A decision tree is basically used to make decisions in complex situations when outcome of a later situation is dependent on the outcome of the former. By incorporating the probabilities of various investment possibilities in the decision tree, it is possible to comprehend the true probability of a decision leading to results desired. A basic value of decision tree lies in expressing all outcomes or events in quantitative terms which provide precision in decision making. 33. How liquidity position of a company is judged ? Ans. To conclude regarding the firms liquidity position, concept of ratio analysis is to be taken into account. a) Current ratio= Current asset/Current liability Current assets are those assets which can be converted into cash within one year without any diminution in value such as cash in hand, cash in bank, sundry debtors, bills receivables, stocks, prepaid expenses etc. Current liability is the expenses those are to be incurred within one year such as bills payable, sundry creditors, outstanding expenses, provision for taxation, provision for depreciation and proposed dividend etc. The ideal current ratio

is 2 so that each rupee of current liability should be backed by 2 rupee of current asset. b) Quick ratio= Quick ratio is the ratio of quick asset to quick liability. It is defined as current asset- stock/ current liability- bank overdraft. Sometimes it happens that current ratio is high but quick ratio is low. It shows majority of the current assets are in the form of stocks where there is no guarantee whether company will be able to offload the stock within one year or not. Higher quick ratio stands for sound liquidity position of the company. Company has consolidated its position in such way, that there is no chance of payment default to the suppliers and creditors. 34. How solvency position of a company is judged ? Ans. Whenever an investor is willing to invest in a stock, at first the solvency aspect of the company is to be judged. a) Debt Equity ratio= Debt equity ratio is an indicator of long term solvency position of the firm. Debt Equity ratio= Long term debt/shareholders fund Long term debt includes long term loan from bank or financial institution, bond and debenture. Shareholders fund= equity capital+ preference share capital+ reserve and surplus-fictitious asset if any .If firm has lower debt equity ratio, it implies that firm is depending more and more on equity capital instead of debt capital. So investors fund is almost safe. On the contrary if debt equity ratio is high, there is a risk of insolvency as the firm relying more and more on debt capital. b) Proprietary ratio= By definition, Proprietary ratio= Shareholders/proprietors fund Total asset If proprietary ratio of the firm is high, it interprets that long term solvency position of the firm is good. Majority of the assets are financed by shareholders fund. Low proprietary ratio presents just reverse scenario that firm has a lot of debt burden. 35. What do you mean by Efficiency or Turn Over analysis of a firm ? Ans. This describes the degree of efficiency in utilization of various assets deployed inthe firm. a) Inventory turn over ratio= Inventory turn over ratio is defined cost of goods sold/average inventory. Average inventory holding period= 365/Inventory turn over Inventory turnover throws light at the degree of efficiency in inventory management. A high inventory turnover ratio is the indicator of sound inventory management. A low inventory turnover ratio implies excessive inventory levels than warranted by volume of

operation. A high level of idle or obsolete inventory means blockage or loss of capital. A very high inventory turn over ratio should be examined cautiously. It may be due to maintaining an inadequate level of inventory which may cause frequent stock out. b) Debtors turn over ratio =It is defined as Credit sales/ average receivables. Average collection period= 365/debtors turn over ratio Higher debtor turn over ratio means shorter average collection period. It indicates efficiency in collection of debt. Debtors are not allowed to linger their payment. Lower debt turn over ratio means longer average collection period. This reflects inefficiency in collection of debt. It may result the bad debt which may erode profitability. c) Creditors turnover ratio= It is explained as Annual Credit purchase/Average payable. Average payment period=365/creditors turn over ratio. A low credit turn over ratio is apparently favourable as in that case firm enjoys lengthy credit period. Strain on working capital is low. High credit turn over ratio indicates firm is to pay its suppliers immediately after purchase. 36. How profitability position of a firm is judged ? Ans. Vital parameter to measure the success of the company is its profitability. Usually profit is defined as the difference between total revenue and total cost. There are several measurements of profitabilitya) Gross profit margin=Gross profit is nothing but excess of sales over and above the cost of goods sold. Gross profit margin = gross profit/sales x100. If gross profit margin of a firm is high it indicates that firm has achieved excellence in curtailing the production/manufacturing cost. b) Net profit margin = Net profit is nothing but post tax profit of the company.Net profit=operating income+ income from other sourcesdepreciation-interest-tax.Net profit margin = net profit/sales x 100 .If net profit margin of a firm is high it implies that the firm is able to cope with all unfavorable circumstances whatever may take place in near future such as fall in the price of the product, emergence of substitutes, difficulty of obtaining raw materials etc. If gross profit margin is high but net profit margin is low, it implies though firm has attained efficiency in manufacturing but due to higher office and administrative expense, its net profit is not up to the mark. c) Return on equity=The most important indicator of financial performance , the Return on Equity(ROE) is defined as ROE= PBIT/sales x sales/assets x PBT/PBIT x PAT/PBT x asset/net worth ROE=PBIT efficiency x asset turnover x interest burden x tax burden x leverage In simple version Return on Equity is interpreted as PAT/Net worth. Net worth of a company is Equity capital +Preference capital + Reserve and surplus- fictitious assets if any.

If return on equity is high, it shows stock performance of the company is very good. Earning per share=Earning per share is the ratio of firms total earnings, net taxes minus preference dividend over the number of equity shares. It is desirable that a company should have a higher EPS. Then the stock of the company will be lucrative option for the investor 37. What do you mean by Operating Leverage and Financial Leverage? Ans. Leverage analysis of firm is also very vital to get an idea about the firm. a) Operating Leverage= Operating leverage measures disproportionate change in profit due to proportionate change in sales. Degree of Operating Leverage(DOL) is defined as contribution/ contribution-fixed cost. If fixed cost of a firm is higher, its DOL will be higher. Break even point of output will be higher. The firm will be in a risky position. There is a risk that due to reduction of small amount of sale, profit will be reduced to large extent. Higher DOL is preferable when demand for the product or service of the firm is more or less stable. b) Financial leverage= Financial leverage measures disproportionate change in earning per share due to proportionate change in profit. Degree of Financial leverage(DFL) is defined as Profit Before Interest and Tax(PBIT)/Profit Before Tax(PBT).DFL=PBIT/PBIT-I. If interest burden of a firm is high, DFL will be higher. When firm depends more and more on borrowed capital, firm will be in risky position because due to higher DFL there is a risk that earning per share will fall to a larger extent when profit falls. Higher financial leverage is favourable if the return on capital employed is higher than the cost of raising capital. In this case, by relying more and more on debt capital, earning per share can be enhanced which is known as Trading on Equity. 38. What is Random Walk Theory ? Ans. Random Walk theory implies that stock price of today has no influence on stock price of tomorrow. Change in stock price occurs if there is a change in economy, industry or company. That information is immediately and instantaneously reflected in the stock price. Therefore movement of stock price is at random rather than in a predicted pattern. 39. Mention some methods of capital budgeting where risk and uncertainty is incorporated. Ans. Some methods of capital budgeting with risk and uncertainty is Risk Adjusted Discount Rate Certainty Equivalent method Sensitivity Analysis Decision Tree approach 40. What do you mean by intangible assets & fictitious asset ?

Ans. Intangible assets are those assets which are created through time and effort but they are not physically measurable. Intangible assets are of two types such as official asset and fictitious asset .The example of official assets are patent, copy right. These are intellectual property right that the innovator of a new product, process, concept enjoys. Paten and copy right has finite period of life. Over the life company has to write off them. Fictitious assets are those which have monetary value without backed by any physical asset. For example- externally generated goodwill. When one company acquires another company, the excess of face value acquirer company pays to the target company for its each share multiplied by number of outstanding shares of the target company is known as externally generated good will for the acquirer company and it will be shown as the asset side of the balance sheet. In case of fictitious assets, they have to be written off at a higher rate. There are some items which are placed in the asset side of balance sheet in accounting sense but they can not be considered as the asset of the company logically. If a company incurs loss, it will be shown in the asset side of the balance sheet though loss is not an asset for a company. Preliminary expense and discount on issue of shares are also example of fictitious asset. 41. What is the difference between Free Cash Flow to Equity and Free Cash Flow to Firm concept? Ans. FCFE model is used as a modern equity valuation approach. It shows the free cash flow available to equity shareholder after meeting all expenses. FCFE= Net Income- ( Capital expenditure- Depreciation- amortization )-Change in non cash working capital +Net cash inflow from debt issue. Net Income= Profit After tax Current Market price of the share= FCFE1/(r-g) FCFE1= Free cash flow equity shareholder after 1 year. r= cost of equity (determined by CAPM model) r= risk free rate of return + Beta value x risk premium g= expected growth rate Reinvestment rate calculation is done on the basis of FCFE model. In case of equity valuation, Growth rate = Reinvestment rate x return on Equity Reinvestment rate= (Capital expenditure depreciation- amortization + change in non cash WC debt issue+ debt redemption)/ Net Income Return on Equity= PAT/Net worth FCFF model shows cash flow available to the members of the firm that is both debt and equity holder. FCFF= PBIT(1-t) + R(1-t) + Depreciation+ Amortization- Capital expenditure change in non cash working capital R = Interest payment by the company to creditor g= ROCE x Reinvestment rate ROCE= PBIT (1-t)/ ( book value of debt + book value of equity) Reinvestment rate= Capital expenditure depreciation- amortization + Change in Non cash working capital/ [ PBIT (1-t) + R(1-t)] Current price of the market share= FCFF1 /(k-g)

K= weighted average cost of capital = (Book value of debt/ Book value) x cost of debt + (Book value of equity/ Book value ) x cost of equity

42. Compare between EVA and MVA . Ans. EVA is the Economic Value Added which is considered as a performance evaluation for the company. EVA can be computed by two methods Residual Income method and Refined Earning method. According to Residual Income Method, EVA= {(NOPLAT/Total capital)-WACC}x total capital NOPLAT=Net Operating Profit Less Adjusted Tax WACC=Weighted Average Cost of Capital WACC= (Book Value of debt/Total book value)x cost of debt x (1-t) + (Book value of Equity/ total book value)x cost of equity According to refined earning method, EVA is calculated as EVA= ( sales- operating expense)- WACC x net assets If EVA of a company is positive, it implies return earned from investment is greater than cost of capital. Therefore if sales is increased by 1 Rs, it will able to enhance EPS. When EVA is negative, even if sales increased by Rs1, it will deteriorate the EPS. EVA is better financial indicator for the financial organization because It takes into account only operating profit. For computation of EVA, WACC is taken into consideration where both cost of equity and cost of debt are included. MVA is market value added which is defined as MVA= Market value of equity-( Book value of debt+ Book Value of Preference Share+ Book Value of equity) MVA of a company is the sum total of present value of future EVA. MVA= EVA1/(1+WACC) + EVA2/(1+WACC)2+ EVA3/(1+WACC)3+-------EVAn/ (1+WACC)n If MVA of a company is positive , it implies companys performance is satisfactory. Otherwise investors will think twice before investing in that company. 43. What is hedge fund? Ans. Hedge fund is a new concept which is different from mutual fund where in case mutual fund , mutual fund company has to provide quarterly statement to the investors, to specify the area where the investors fund has been invested in which proportion but in former case they dont reveal their investment pattern. Provision of hedge fund is mainly enjoyed by high Net worth Individual and hedge fund company charge both management fee as well as performance fee simultaneously. The excellence of Hedge fund is that it reduces the systematic risk or market risk of the investment. As a result both return and risk will moderate rather than abnormally high. Generally the strategy

adopted by Hedge fund company that they simultaneously invest in under priced stock as well as they are involved in short selling of the asset. When Market becomes bullish, profit is derived from under priced stock but loss will be incurred from short selling. So loss from short selling is counter balanced by gain from investment in under priced stock. On the contrary when market becomes bearish , profit is earned from short selling but there is a loss from under priced stock investment. Loss from investment in under priced stock is balanced by profit from short selling. In both the cases systematic risk has been hedged.

44. What do you mean by sinking fund factor and capital recovery factor? Ans. If a certain amount of fund(Y) is to be realized after certain period of time(n), what equal amount(X) should be invested at the end of every year- that is determined by sinking fund factor. X x FVIFA( r%, n year) = Y Or X= Y x 1/FVIFA(r%, n year)=Y x sinking fund factor Sinking fund factor is reciprocal of FVIFA. If an investor invests a certain amount of fund(Y) in a project in the current period and willing to realize the fund within a certain period of time that is (n years), the equal amount of inflow (X)that project is expected to generate- that is determined by capital recovery factor. Xx PVIFA(r%, n year)= Y Or X = Yx 1/ PVIFA(r%, n year) = Y x Capital recovery factor Capital recovery factor is the reciprocal of PVIFA. 45. What is BASEL II and how it is different from BASEL I ? Ans. According to Basel I, all the banks are advised to main capital adequacy ratio at least 8%. Capital adequacy ratio= (Tier I capital + Tier II capital)/ risk weighted asset. Tier I capital includes equity capital and reserve & surplus. Tier II capital includes hidden reserve, revaluation reserve, hybrid instruments, subordinated debt etc. RBI has instructed all Indian Commercial banks to hold capital adequacy ratio at least 9%. Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help to protect the international financial system from the types of problems that might arise due to a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by

setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The three main pillar of Basel II is 1. Considering Market risk and operation risk apart from credit risk 2. Minimum capital requirement depending on credit rating 3. Continuous disclosure to the market . 46. What is securitisation and subprime crysis? Ans. Usually commercial Banks provide loan to the borrowes depending on their credit history and financial capability.If a persons credit history is poor or he has the irregularity in income, he is not eligible to get the loan. But specifically in USA, some financial institutes take loan from the banks in prime lending rate and they are providing the loan comparatively poorer section at a higher rate for example PLR+2%.This rate that a sub prime borrower has to pay is known as sub prime rate.After that the institution, immediately hedge their risk by selling the loan as a debt security to the Institutional Investors where those Institutional Investors are entitled to received Equated monthly installment.this is known as securtisation by which adequate liquidity can be provided to mortgage market of illuquid asset simultanously hedging can be done against default risk. The cash realised by this way is immediately paid to the Bank. When market interest goes up, PLR+2% will also go up.So borrowers make default in payment .Then Institutional investors make lien on the real estate property and try to sell it.As a result selling pressure in market has gone up, real estate price started to fall rapidly,.Therefore institutional Investor started to suffer from liquidity crysis.this is known as subprime crysis. But intermediate financial institution contnued their credit creation process as their credit history is always good as they are paying timely to the banks.Sometimes they are intentionally inflating the borrowers level of income so that Institutional Investors will be motivated to purchase the debt security. This will further worsening the situation.

47 What do you mean by alpha value of an asset? Ans. Alpha value of an asset implies risk free rate of return from risky security. Alpha value can be determined with the help of characteristic line. Characteristic line shows the relationship between stock price movement and the market index movement. The equation of the characteristic line can be expressed as Y= alpha + Beta X Y= Return from the particular stock

X= Return form the market index If alpha value of the stock is positive, it is underpriced or vice versa. 48. What do you mean by ASBA ? Ans. ASBA is Application Supported by Blocked Amount. It is a better way of applying for an IPO or FPO by simply blocking the fund in the bank account. In this case, the person will continue to earn interest on the amount. The only constraint is that, they can not withdraw the fund from the account. Amount will be debited only if share is allotted to the individual. If the person is not allotted the share, automatically fund will be block free. ASBA is designed by SEBI to protect the Investors interest who are willing to apply for IPO but not at the expense of interest income loss. 49. What do you mean by inflation and its measurement? Ans. Inflation is the sustained rise in price. In other words inflation implies excess of money supply over and above the available goods and services in the economy. Inflation can be measured by WPI ( Wholesale Price Index Number) or CPI ( Consumer Price Index Number). In WPI, significant weight is given to manufactured article. In CPI, it incorporates a basket of goods which consumers are usually use and significant weight is given to food articles. The Government on 14th September,2010 came out with a new Wholesale Price Index (WPI) series that measured inflation in August 2010 is 8.5% although in older system it was 9.5%. The new inflation computation method with 2004-05 as base year has more 241 items than the old series with base year 1993-94 as the base year which only reflected the price rise in 435 articles. Edible and non edible items widely used by middle class people like ice cream, mineral water, microwave ovens, washing machines, gold, silver are reflected in new WPI series. 50. What do you mean by Balance of Payment of a nation? Ans. BOP is defined as systematic record of financial transactions with the residents of the member country and the residents of rest of world for a particular period of time. Balance of payment has two types of transactionsAutonomous transaction and accommodating transaction. Autonomous transactions includes all the transactions which are taking place for the sake of business for example current account and capital account transaction. BOP is computed as a double entry accounting system. Any transaction which creates demand for home currency will be placed in credit side, any transaction which creates supply of home currency will be placed in supply side. Any transaction which is used as a source of fund is placed in credit side and any transaction which is used as application of fund is placed in debit side. Current account transaction includes export and import of goods and services and unilateral payment.

Export of goods and service will be posited in credit side and import of goods and services will be posited in debit side. If credit side of current account is greater that the debit side of current account, nation has current account surplus. Capital account transaction includes inflow and outflow of FDI and FII. Inflow of FDI and FII is posited in credit side of BOP and outflow of FDI and FII is posited in debit side of BOP. If credit side in capital account is greater than debit side of the capital account, nation has capital account surplus. If the sum total of credit side of current and capital account is greater than the sum total of debit side of current and capital account, nation is said to have a BOP surplus. Accommodating transaction are those transactions which are taking place to make the balance of payment always balanced. For example change if foreign exchange reserve, change in gold reserve etc. India is always a current account deficit nation as its value of import is always higher than value of export. But due to being an emerging economy, India is the popular destiny of FDI and FII. Therefore Capital account of India remains always surplus to a such extent that it more than offset the current account deficit of the nation.( barring the time of global recession in 2008-09, due to huge withdrawal of funds by FII from Indian capital market, Capital account balance became adverse). 51. What do you mean by consolidated balance sheet of a company? Ans. When the asset and liability of the holding company as well as all of its subsidiaries are expressed in the currency of the parent company, it is known as consolidated balance sheet of the holding company. Characteristics of holding company is given as belowa) Good will or capital reserve has to be mentioned. b) Minority interest has to be mentioned. c) Adjustment of common debtor and common creditor has to be maintained. 52. Distinguish between reserve and provision of the company. Ans. It is a known fact that there will be depreciation of the fixed asset of the company such as plant & machinery, building, furnitures etc. Similarly a certain portion of credit sales of the organization will never be realized which will become bad debt. Therefore company makes provision for depreciation and bad debt in the profit and loss account and they are charged in the debit side of the P/L a/c so that net profit can be reduced and company has to pay lower corporate profit tax. Provision can be made for proposed dividend payment to the shareholder also. When company earns profit certain amount will be paid to the shareholder a dividend and remaining amount will be kept as reserve and surplus. Reserves are of two types- revenue reserve and capital reserve. Revenue reserve includes reserve for bad debt and reserve for depreciation. Capital reserve includes

capital redemption reserve, share premium account, dividend equalization reserve. 53. Distinguish between Indian GAAP & USA GAAP . India Indian GAAP allows deferred revenue expenditure. Related party transaction is strictly prohibited in India. Emphasis is given on consolidation norm where goodwill or capital reserve has to be specified. USA USA GAAP does not allow it. USA GAAP is liberal in related party transaction USA GAAP is more focused on minority interest.

54. Among inflation and deflation which do you prefer & why? Ans. Inflation is sustained rise in price which reduces the purchasing power of money. But despite of its evils, a mild doze of inflation should be injected in the body of economy because it stimulates aggregate demand. If demand is higher, price will go up. Producer will be willing to supply more to boo higher profit. As a result demand for factors will go up and employment goes up. All economic variable such as output, employment, income will go up. Deflation means sustained fall in price. As price goes down, producer reduces production. Demand for factors will go down. Unemployment will go up. Demand goes down further. Again price moves in the downward direction. Therefore all variables such as output, price, employment will move in downward spiral. Therefore inflation is bad but recession is worst. 55. Distinguish between financial lease & Operating lease. Ans. A financial lease is structured to include the following characteristics The lessee selects the equipment according to his requirement from manufacturer or distributor The lessee negotiates and settles with the manufacturer or distributor the price, delivery schedule, installation, maintenance etc Financial lease may provide the right or option to the lessee to purchase the equipment at a future date. The lease period spreads over the expected economic life of the asset. The responsibility of suitability of the equipment, the risk of obsolesces and liability for repair, maintenance, insurance of the equipment rests with lessee. A operating lease is structured as Operating lease is generally for a period shorter than the economic life of the leased asset.

Operating lease normally includes maintenance clause requiring the lesser to maintain the leased asset.

56. Distinguish between lease and hire purchase. Lease Hire purchase The lessor is the owner and lessee is entitled Ownership of the asset passes on to the hirer to the economic use of the asset. in case of hire purchase on payment of last installment. The depreciation of the asset is charged on Hirer is entitled for depreciation shield. the book of lessor. Cost of maintenance is borne by lessee in Cost of maintenance is borne by hirer. case of financial lease and cost of maintenance is borne by lesser in case of operating lease. Lessor is allowed to claim tax shield on Hirer is allowed to claim tax shield on depreciation and lessee is entitled to claim depreciation of the asset tax benefit on lease rental. 57. Distinguish between devaluation and depreciation. Ans. Devaluation is reduction of the value of home currency in terms of foreign currency. It is a policy measure to encourage export and discourage import. The devaluation concept is applicable in fixed exchange rate regime. Depreciation is also reduction of home currency in terms of foreign currency but it is applicable in case of flexible exchange rate. In flexible exchange rate, rate is determined by demand and supply force of the market. There is no intervention from the Government. Currency with higher inflation rate will depreciate. It is known as Purchasing Power Parity(PPP) theory. Currency with higher interest rate will depreciate. It is known as Interest Rate Parity theory (IRP). 58. What is FMC ? Ans. The Union cabinet on 17th September 2010 approved long pending amendment to the Forward Contract (Regulation) Act and it will go for seeking Parliamentary approval to make the Forward Market Commission, an independent regulator and allow them to launch option in the commodity market among a host of other changes. Commodity market regulator is finally get SEBI like status and power. FMC will be at par with SEBI, both regulator are likely to get place on each others board. It paves the way for commodity based exchange traded fund, trading on indices and weather based product. Future and option together will give better liquidity in the market. Farmers participation will increase through option route because they would not only become insurance in case market goes down but it will give the opportunity to the farmers to capture best possible price in case of a market rally. 59. What do you mean by FRBM act?

Ans: Fiscal Responsibility & Budget Management Act was passed In parliament in the year 2003 where it was clearly mentioned that by the financial year 2009-10, there will be no revenue deficit and fiscal deficit will be limited to 3.5% of GDP at most. Revenue payment includes expenditure on salary, interest, subsidy and defense. Revenue receipt includes tax and not tax revenue. Tax revenue includes direct tax like income tax and indirect tax includes excise duty, custom duty, sales tax etc. non tax revenue includes earing from Indian Railway, Indian Airlines and fee from selling licenses and earning of dividend from all PSUs. Capital payment includes expenditure to be incurred to construct or upgrade the infrastructure like road, highway, hospital, universities etc. Capital receipt includes public debt, recovery from loan and advances by RBI and disinvestment proceed. Public debt are of two types- external debt such as External Commercial Borrowing (ECB) or FCCB ( Foreign Currency Convertible Bonds) and Internal debt that is collection of fund from domestic market by issuing treasury bills etc. When sum total of revenue payment and capital payment exceeds sum total of revenue income and capital income, Fiscal deficit takes place. In 2009 after the general election when UPA-II Government came into power, Finance Minister Mr. Pranab Mukherjee tabled the budget where Fiscal deficit was excessively high 6.8% of GDP which directly violated FRBM act. Fiscal deficit was excessively high due to a) Release of Sixth Pay commission which gives a huge hike to Central Government Employee b) Redemption of Rs 170 thousand crore farm loan c) Huge investment in social infrastructural sector for employment generation d) Declaration of bailout package for recession hit sectors. 60. Mention the key features of Union budget placed by Honourable Finance Minister Mr. Pranab Mukherjee for the financial year 201011. Ans. The main emphasis of the union budget for 2010-11 is as follows a) Income tax exemption has been increased. Upto income Rs 1,60000 per annum for a male , no tax will be paid. Rs 1,60000-Rs 500000- 10% per annum Rs 500000-Rs 800000-20% per annum More than 800000- 30% per annum For female, upto 1,90000 per annum , no tax will be paid. For senior citizen, upto Rs 240000 per annum, no tax will be paid. Another Rs 100000 can be saved, if individual invests in PPF, ELSS, Employee provided fund, LIC premium, NSC etc. Additional Rs 200000 will be exempted if person invests in infrastructural bond.

b) c) d) e) f)

Huge disinvestment target of PSU of Rs 400 billion is taken to meet the fiscal deficit. Financial inclusion is a major focus area of the budget. By 2012, target has been taken to provide the banking service to all villages where population is more than 2000. Rs 16500 crore is proposed to be injected to the PSU banks to increase their tier I capital to 8% by March 31,2011. Partial rollback of fiscal stimulus given by Government during the recession time was done by increasing excise duty from 8% to 10% and enhancing Minimum Alternate Tax from 15% to 18%. Budget has given more importance to agricultural sector where strategies were taken to increase the agricultural productivity by extending another green revolution in Bengal, Bihar, Jharkhand , Eastern UP ; reduction in wastage of agricultural products & implements; Extending credit Support to farmers and providing thrust to food processing sectors.

61. After abolition of entry load in mutual fund scheme, what was the immediate impact? Ans. It was August 2009 that SEBI banned Entry loads for mutual fund investments. A year down the line , the mutual fund industry is yet to fully come to terms with changes which have transformed the industry. Before the SEBI regulation came into force , an entry load or an upfront commission of close to 2.25% on the amount invested was charged by the fund houses from investors. MF housed used to pay commission to distributors in lieu of their services in reaching out , marketing and selling MF products to the investor from the amount collected through entry loads. As the commission amount was automatically deducted from the principal amount of investment, few investors were aware of the fact that their initial investment would get automatically reduced by about 2.5% and that only the balance 97.5% was getting invested into the scheme Those who were aware of it would demand that their distributors repay a part of such commission usually 1 to 1.5% to them in cash. It was to curb this very practice and to make MF investments more transparent and customer friendly that SEBI introduced the no load regime last year, where the onus of collecting a fee from the investor fell on the distributor alone. Today any investor seeking to buy an mutual fund through distributor has to mutually agree upon the commission payable to a distributor for his services. While the intention of the regulator were well meaning, the industry is yet to reconcile itself to the changes which have been carried out. The no load regime has forced many small distributors to shut shop, since convincing an investor to pay money for services rendered while investing in a financial product such as an MF is not easy.For investors having long been used to getting a part of their investment as cash back from the distributor , it will take a while for them to get used to this new regime. Compared to the collections of nearly Rs 30000 to 40000 crore in the years 2006& 2007, the year 2010 has so far witnessed collections of just about Rs 2000 crore through the sale of NFO.

These collections are worse considering that even during the financial meltdown of 2008, new launches had managed to collect close to Rs 15000 crore. Many independent distributors offer their service free of charges to their investors. Their only source of income is the commission paid to them by the MF houses. 62. In recent time, it has been seen two market regulatory body were involved in conflict : the issue became so serious that matter reached to Supreme Court- Can you focus some light on it. Ans. After abolition of entry load in mutual fund schemes, SEBI Instructed for stop issuing ULIP to all insurance players as premium collected from ULIP are invested in to the market , therefore SEBI wants to control and regulate the ULIP to protect the investors interest. But IRDA did not take it positive spirit, as ULIP is Unit linked Insurance Product , therefore IRDA has the supreme authority in issuing ULIP and IRDA perceived that SEBI is unnecessarily encroaching into their area of autonomy. The matter went to Supreme court. Supreme court gave the verdict, IRDA will control ULIP since it is an insurance product but it issued certain guidelines. Soon all insurance companies will withdraw most of their unit linked insurance plans and will issuing a new set of such policies.This is in response to ULIP guidelines issued by IRDA on June 28,2010. Immediate fall out of latest ULIP guidelines could be that Insurance companies may tend to go slow on issuing pension plans. The regulator has introduced a minimum guaranteed return 4.5% on Unit Linked Pension Products . This is to protect lifetime savings of pensioners and to differentiate pension from other investment products. A guarantee of minimum return would make it difficult for issuers to invest pension funds in riskier financial securities. Equities offer superior long term investment return but not without a risk of loss of capital. Insurance companies will face dilemma while issuing pension plan with a guaranteed return. Industry observers feel that there will be very few such pension plans that will be on offer after September,2010. These charges will be applicable when a policy holder surrenders the policy before the predetermined lock in period. Another major step taken by IRDA was the standardization of surrender charges. Earlier in case of policy surrender, the Return on Investment was dependent on the discretion of the insurers.

3.

Distinguish between TRIP & TRIM. Ans. Trade Related Investment Measures (TRIM) refers to certain conditions or restrictions imposed by a Government in respect of foreign investment in the country. TRIMs were widely employed in developing countries. An agreement on TRIMs provide that no contracting party shall apply any TRIM which is inconsistent with the WTO articles .An illustrative list identifies that following TRIMs are inconsistent. a) Local Content Requirement ( certain amount of local inputs be used in products) b) Trade balancing requirement( import should not exceed a certain amount of export)

c) Trade and Foreign exchange balancing requirement d) Domestic sales requirement ( a company shall sell a certain portion of its output locally). The agreement requires the notification of all WTO inconsistent TRIMS and their phasing out within two, five, seven years by industrial, developing and less developed countries. Trade Related Aspects of Intellectual Property Right (TRIP) is under the Uruguay round arrangement of GATT( Now WTO) TRIP cover seven Intellectual propertiesa) Copyright & related right b) Trademark c) Geographical Indications d) Industrial designs e) Patents f) Lay out design of integrated circuits g) Undisclosed information including trade secrets What is GATT & WTO? Ans. The General Agreement of Tariff & Trade was born in 1948 as the result of International desire to liberalize the trade. The preamble of GATT mentioned the following as its important objectivesa) Raising standard of life b) Ensuring full employment and large & steadily growing volume of real income & effective demand c) Developing full uses of resources of the world d) Expansion of production & international trade GATT adopted the following principles Non discrimination- The principle of non discrimination requires that no member country shall discriminate between the members of GATT in conduct of international trade. Prohibitive of Quantitative Restrictions: It rules seek to prohibit quantitative restrictions as far as possible and limit restrictions on trade to the less rigid tariff Consultation: By providing a forum for continuing consultation , it sought to resolve disagreements through consultation..

4.

Following the Uruguay round, GATT was converted from a provisional agreement into a formal International Organization called World Trade Organisation (WTO) with effect from January 1,1995. The WTO has the following functions The WTO will facilitate the implementation, administration, operation and further the objectives of Multilateral Trade Agreement

The WTO shall provide the forum for negotiations among its members concerning their multiple trade relations in matter dealt with under agreement. The WTO administers Understanding on Roles & procedures governing the settlement of disputes. The WTO administers Trade review Mechanism 65. What do you mean by venture capital? Ans. Venture capital is basically equity finance in relatively new companies when it is too early to go to the capital market to raise funds. However such investment is not exclusively equity investment. It can be also made in the form of loan finance/convertible debt to ensure a running yield on portfolio of venture capitalist. Venture capital is a financial intermediary between investors looking for high potential return and entrepreneurs who need institutional capital as they are not ready or able to go to the market. What is FERA & FEMA? Ans. Foreign Exchange transactions were regulated in India by Foreign Exchange Regulation Act (FERA), 1973. This act was sought to regulate certain aspects of conduct of business outside the country by Indian companies and in India by foreign companies. The FERA was widely described as draconian law. The main objective of FERA framed against the background of severe foreign exchange problem and controlled economic regime , was conservation and proper utilization of the foreign exchange resources of the country. In the light of ongoing Economic liberalization of the country and improving foreign exchange reserve of the nation, a new Foreign Exchange Management Act (FEMA) 1999, replaced the FERA. Except as provided in terms of the act, or with the general or special permission of RBI, no person shall deal in any foreign exchange or foreign security other than authorized person, no person can make any payment to or for the credit of any person resident outside of India in any manner, No person can receive otherwise through an authorized person ,any payment by order or on behalf of any person resident outside India in any manner, No person can enter into any financial transaction as consideration for or in association with the acquisition or creation or transfer of a right to acquire any asset outside India by any person. FEMA permits dealing in foreign exchange through authorized person for current account transaction. Any person may sell or draw foreign exchange to or from an authorized person for capital account transaction permitted by RBI in consultation with RBI.

67. What do you mean by sterilization policy ? Ans. When RBI intervenes in the foreign exchange market through purchases of foreign exchanges, it injects liquidity into the system through corresponding selling of domestic currency. Conversely when it sells foreign exchange the domestic liquidity is absorbed from the system. Neutralizing part or whole of the monetary impact of foreign inflows are known as sterilization process. Conceptually sterilization process involves decision of RBI to intervene by substituting foreign currency with domestic currency in case of excess capital inflow and

decision to intervene further in the money or bond market to substitute domestic currency so released out of the intervention of foreign exchange market with bond or other eligible papers. What do you mean by market stabilization scheme? Ans. The Government can issue Treasury bills or dated securities under MSS for absorbing liquidity from the system. The Treasury bills or dated securities under MSS are have all the attributes of existing T bills and dated securities. The Government in consultation with RBI will fix an annual aggregate ceiling for T bills or dated securities under MSS.MSS are issued by the auctions to be conducted by RBI. The amounts will be held in a separate identifiable cash account titled MSS account to be maintained & operated by RBI. The T bills and dated securities issued for MSS would be matched by an equivalent amount of cash balance held by the Government with RBI. As a result there is very marginal impact on market interest. What do you mean by held to maturity? Ans. The securities acquired by the banks with the intention to hold them till the maturity period will be classified as held to maturity. The investments included under held to maturity should not exceed 25% of banks total investment. Investments carried out under held to maturity are not marked to market and will be carried at acquisition cost unless it is more than the face value , in which case premium will be amortized over the period remaining to maturity. 70. Define PD, LGD, EAD, Expected loss and unexpected loss. Ans. Probability of Default (PD) : PD is the likelihood of a borrower defaulting on a contractual obligation. To calculate the PD, the time horizon must be long enough to be meaningful and short enough to be feasible given the data available. Several sequential steps are to be followed such as establishing the time horizon, determining the measurement approach using the quantitative data such as financial statements, ratios as well as qualitative information such as borrowers reputation, equity prices , critically reviewing the available information, analyzing the published default studies/ secondary data as well as successful use and implementation of transition matrices to look at the way PDs change over time. Loss Given Default (LGD) : Loss given default is the estimated percentage of an outstanding claim that can not be recovered in the event of a default. Recovery rate and Loss given default are mutually exhaustive with each other as LGD= 1- Recovery rate Usually collaterals reduce the risk of an exposure and hence collateralized loans carry lower risk weights than un-collateralized loans. Cash on deposit, Gold, securities by sovereigns & public sector entities carrying a minimum rate of BB-, banks and corporate securities rated minimum at BBB-, Equities listed in major stock indices such as Dow Jones, Nikkei, Sensex etc are considered as eligible collaterals. However the value of the collateral C is adjusted by applying so called Hair Cut (H) CA= C/( 1+H) Where CA= Collateral Adjusted The value of H will depend on the value of collateral. It varies from 0% (cash), 4% (sovereign securities), 15% (gold) and 30% (eligible corporate securities). Exposure At Default (EAD) : Exposure at default is the maximum amount that a bank can loose in the event of a default.

Expected Loss (EL) : Expected loss is the amount that a bank can expect to lose on average in the event of a default. Expected loss is the product of probability of default. loss given default, exposure at default . EL= PD x LGD x EAD Unexpected Loss (UL) : Unexpected loss/ unanticipated loss is computed by subtracting expected loss from actual loss. UL= Actual loss Expected loss 71. What is factoring? Ans. The arrangement in which receivables created out of sales of goods or services are sold to an agency, is called factoring. The factor performs the functions of such as purchase of receivables, marinating the sales or receivables ledgers , submitting sales account to creditors , collection of debt on due dates, after collection to return the reserve money to the seller and provide consultancy services to the customers in respect of marketing, finance & production. 72. What is Para Banking activity? Ans. The main activity of the commercial bank is accepting deposits and credit creation in the economy. Apart from that, Banks undertake financial services such as credit card business, insurance business, underwriting, equipment leasing, hire purchase business, factoring services etc. These are called Para banking activities which can be taken up departmentally or by setting up subsidiaries. 73. What is NPA and what is the function of Debt Reconstruction company ? When debtor defaulted one Equated Monthly Installment (EMI), it can be shown as 30 days DPD that is Days Passed Deal. A person who has defaulted two EMI can be treated as 60 days DPD that is Days Passed Deal. After default of 2nd EMI, calling exercise should be done with a default script. A person who has defaulted consecutive three EMI can be shown as 90 days DPD .It becomes a NPA (Non Performing Asset). Bank usually takes the help of Debt Reconstruction Company (DRC) when they have accumulated excessive NPA due to non recovery of loan. Debt Reconstruction company is a trust. They purchase the NPA of the banks by paying certain amount of cash which is much lesser than the value of NPA. As the bank is selling their NPA to the DRC, banks will be able to transfer the collection hazard from their shoulder to the DRC. Debt Reconstruction Company has to undergo a market research to analyze the extent of NPA, it will be able to realize by applying different standard conventional techniques and tactics. Depending on that they sell certain amount of Security Receipts to the bank. Security receipt acts almost like Collateral Debt Security where for the bank,these Security receipts are considered as contingent liability. Banks will be able to get the money against these security receipts provided the Debt Reconstruction Company is able to realize the receivables from NPA. The way Debt Reconstruction Company is exercising pressure on the nerve of debtors that raises lots of dispute from the moral and ethical perspectives. 74. What do you mean by credit scoring model ? Ans. Banking Sector has to use credit scoring model from 1998 onwards. As it is a known fact that prevention is always better than cure, banks are using credit scoring models to reduce the probability of piling up of bad debt or non performing assets. Usually as a common thumb rule, total risk faced by a bank can be decomposed into three different categories- credit risk 63%, operation risk 25-26% and market risk is 11-12%. Reasons for using the scoring models are as follows-

Determination of probability of default and expected loss Ensures that good loan proposals are accepted and bad loan proposals are rejected. Helps in pricing the loan according to the risk. Credit score is nothing but numerical forecast of repayment of future loan. There are different credit scoring methodologies such as FICO, ONICRA( Onida + Icra), Z Altmans score etc. According to FICO Scoring method, FICO score ranges from 300 to 850. Higher the score, loan will be available at a lower rate. For credit scoring certain factors are taken into accountPayment history- 35% Amounts owed- 30% Length of history- 15% New credit-10% Account Mix (nature of loan)-10% Change of job frequently may lower score if no history of late payments- bank specific. Change of residence to negative area may lower score-bank specific. Use of credit counseling services if reported by creditors may lower the credit score. Inquiring for more credit may lower credit score. ALTMAN Z SCORE MODEL T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Market Value of Equity / Total Liabilities T5 = Sales/ Total Assets Z Score Bankruptcy Model: Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5 Zones of Discrimination: Z > 2.99 -Safe Zone 1.8 < Z < 2.99 -Grey Zone Z < 1.80 -Distress Zone 75. What is the difference between hypothecation & pledge?

Ans. Hypothecation is an equitable charge where the borrower keeps the possession of the security on behalf of the creditor. If the borrower fails to return the advance against the hypothecation of the securities, the bank can take the possession of the securities, the bank can take the possession of the securities with the consent of the borrower and becomes a pledgee. Pledge is bailment or delivery of goods as security for payment of a debt or performance of a promise. Pledgee may retain the goods until the payment of debt or performance of the promise is fulfilled. Pledgee can sell the goods by giving a due notice to pledger in case pledger fails to make the payment of debt. 78. What is Benchmark Prime Lending Rate ? Ans.: In a move to increase transparency in credit pricing, the Reserve Bank of India has stipulated banks to migrate to base rate system for determining lending rates from the current benchmark prime lending rate (BPLR) system from April 1.BPLR, the rate at which banks lend to prime borrowers, was earlier formulated to be the base rate. he move is expected to reduce the proportion of sub-PLR loans. As of September 2009, the share of sub-BPLR lending to total loans stood at 70.4 per cent, clearly suggesting that the PLR rate is no longer relevant as a reference rate. The move to discontinue BPLR came in the light of predatory pricing done by banks to gain market share (especially the teaser loans to housing sector). The RBI's working committee had worked out illustrative base rate to be 8.55 per cent, which is higher than the current home loan rates of 8 per cent. All new loans and old loans that come for renewal are expected to be priced with reference to the base rate. While the implications of this move are uncertain, as the banks are given free hand on deciding the base rate, margin pressures are expected as banks would be unable to lend below sub-base rate coupled with the fact that the rates charged for other borrowers' such as SME lending agriculture and retail lending would see a decline as a result of this move. In the banking space, public sector banks and banks with high proportion of low-cost deposits may be less affected as they have low cost of funds (an important input in determining the base

79. What is teaser Rate ? Ans. An adjustable-rate mortgage loan in which the borrower pays a very low initial interest rate, which increases after a few years. Teaser loans try to entice borrowers by offering an artificially low rate and small down payments, claiming that borrowers

should be able to refinance before the increases occur. Teaser loans are considered an aspect of sub prime lending, as they are usually offered to low-income home buyers. Unfortunately, when these borrowers try to refinance the loan before the rate increases, most will not qualify for standard mortgages. This leaves borrowers with increased monthly payments, which many cannot afford. This method of loaning is considered risky, as default rates are high. 80. What is an Open Market Operation ? Ans. Often RBI buys and sells their securities to Commercial bank in their own initiative. During the inflationary time, RBI sells their securities to Commercial banks as a result credit creating capacity of the commercial banks go down. In recession time, RBI buys the securities from commercial banks to enhance the liquidity in the market.