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Time Value Of Money

1. Using simple interest gets you more interest than in the case of using compound
interest. (True/False)

2. Shirley is saving at the rate of $1000 per month for a period of 15 years for her
retirement. The interest on the deposit is 10%. How much will she receive on
maturity of her deposit?

3. Robert wants to save $5,00,000 in 30 years by making a monthly investment at an


interest rate of 10%. What is his monthly investment?
a. 143 b.1300 c. 575 d. 944

4. A bank offers an annual interest rate of 13 %. The interest is calculated every


month. What is the effective interest rate? (13.8)

5. You plan to buy a car costing $50000 and approach a finance company who offers
you a loan on the condition you make a down payment of 20% and the balance
will be advanced @ 9%, reducing balance interest, over a period of 48 months.
What will the equate monthly interest be? ($ 1028.90)

6. Time value of money is based only on principal and interest rate. True/False.

Securities

1. Suppose you paid $1,000 for a 30-year bond that yielded 7 percent interest. A
year later, the rate for a comparable new bond falls to 5 percent. What is the new
price of your bond? ($ 1400)

2. Suppose you paid $1,000 for a 30-year bond that yielded 7 percent interest. A
year later, the rate for a comparable new bond rises to 9 percent. What is the new
price of your bond? ($ 777.78)

3. In the above question, what is your bond worth at maturity? ($ 1000)

4. Treasury bills have the _____________ maturity periods. (shortest, intermediate,


longest).

5. In case of zero-coupon bonds, you must pay taxes each year on the __________
that you earn. (“phantom interest”)

6. If a person buys zero-coupon bonds of face-value $ 1000 with maturity period of


9 years at $865, then what is the rate of interest?
Mutual Funds

1. The NAV is the figure you look at in the newspaper to see how much your mutual
fund investment rose or fell the previous day. (True/False)

2. There are about ______ mutual funds presently in the US . (70,700,7000,70000)

3. Expand RAROR. (Risk Adjusted Rate Of Return)

4. Mutual fund shares are not federally insured or backed by the U.S. government.
(True/False).

5. Correct the following sentence, if required.


It’s usually wise to invest in similar kinds of funds, owning three or four with
different investment goals probably is enough to achieve sufficient diversification.
(replace ‘similar’ with ‘different’)

6. While investing in a mutual fund, you will look at the following two factors
a. past performance & risk (correct answer)
b. past performance & price

Financial Systems

1. _____________ and _____________ are the two important agencies, responsible for
regulating the money and capital markets. (Federal Reserve, Securities Exchange
Commission).

2. Are the stock markets a primary market or a secondary market for securities?
(Secondary Market).

3. A bank acceptance can, in formal terms, can be described as an unconditional order in


writing
• addressed and signed by a drawer (the lender)
• to a bank which signs the document and becomes the acceptor (the acceptance)
• promising to pay a certain amount of money at a fixed date in the future
• to the bearer or holder (the borrower) of the document.

Which of the above bullets, if any, is (are) wrong?

4. A BA (bank acceptance) is issued at 12%. The nominal amount of the BA is $ 1


Million and it is issued for 90 days. Compute the discount on this BA
( discount= 1000000 * 90/365 * 0.12 = $ 29589)

5. The major function of Federal Reserve is ensuring enough currency and coin in the
economy . (True/False)

6. ___________are firms which help business, government and other entities raise
finance by issuing securities. Young firms with limited capital and managerial expertise
require resources and advice in running their business, which are provided by _________.
( 1st blank-Merchant banks, 2nd blank - venture capitalists)

Money And Banking

1. In short, define liquidity. Give an example.

2. Which of the following is the most liquid?


a. M1
b. M2
c. M3
d. L

3. Give three assets and three liabilities that figure on a bank’s balance sheet.
(Assets - Cash/Reserves, Loans, Securities
Liabilities - Deposits, Borrowings, Capital)

4. Which of the following will NOT affect a bank’s profits?


a. Liquidity
b. Talent attrition
c. Credit risk
d. Interest rates
e. Assets
f. Capital adequacy

5. In case of commercial banks, it is possible that assets may be greater or less than
liabilities . (True/ False). Is the same true in case of World Bank?

6. In the US, for which of the following services offered by a bank does a customer
have to pay?
a. Maintaining an account
b. Writing a check
c. Using the ATM
d. Opening a deposit
correct your
QUIZ TOPIC : FINANCIAL SYSTEMS
answer answer

1. The Constituents of Financial Systems are: c c


a) Financial Asset
b) Financial Market
c) Federal Budget
d) Financial Intermediaries

2. The financial system does not help in which of the following: b b


a) Time
b) Charity
c) Space
d) Borders

3. Which is not the service of the financial system? d d


a) Insurance
b) Banking
c) Interest Rate
d) Commodity Prices

4. Patent is a: c c
a) Security
b) Loan
c) Intangible Asset
d) Tangible Asset

5. In a financial market, the supply and demand of money is a a


equated through:
a) Interest
b) Bond
c) Equity
d) Asset

6. Return on Investment in secondary market securities is not


a a
directly influenced by:
a) Government
b) Risk
c) Demand for Money
d) Supply of Money

7. The classification of markets based on timing of transaction c c


is:
a) Primary and Secondary
b) Long and Short term
c) Forward and spot market
d) None of the above

8. Equity is: d d
a) Loan borrowed by the company
b) Return to the investors
c) Own funds of the company
d) Share holders contribution towards to capital

9. Negotiable instruments that facilitates: a a


a) Negotiation
b) Exchange
c) Lending
d) Borrowing

10. Treasury bills are issued by: c c


a) a Company
b) a Commercial Bank
c) a Central Bank
d) an Acceptance House

11. Which of the following is not a financial intermediary: d d


a) Fed Reserve
b) Commercial Bank
c) Insurance Company
d) Finance Department

12. Which of the following is not a function of the Fed Reserve: b b


a) Clearing House
b) Issue of Corporate Stock
c) Custodian of Foreign Exchange Reserve
d) Banker to the Government

13. Capital market operations are supervised by: d d


a) Federal Reserve
b) Stock Exchanges
c) Commercial Banks
d) Securities Exchange Commission
14. Which of the following is not a redeemable security: c c
a) Bond
b) Debenture
c) Equity Share
d) Fixed Deposit

15. Financial markets are independent of other markets in the


b b
economy:
a) True
b) False

16. Common stock represents b b


a) an ownership interest in a corporation
b) a debt interest in a corporation
c) an equity interest in a corporation
d) a residual claim on cash flows and asset value of a
corporation
e) a, c and d

17. Corporate bond issuers can use the proceeds from a bond
d d
sale for:
a) expansion of facilities.
b) working capital.
c) refinancing of outstanding debt.
d) financing takeovers (mergers and acquisitions).
e) all of the above.

18. Great Axe Manufacturer Corp. has 14% coupon bonds on the d d
market with seven years to maturity. The bond's make
semiannual payments and currently sell for 105% of par.
What is the current YTM on Great Axe Manufacturer's
bonds?
a) 12%
b) 13.75%
c) 10.5%
d) 12.89%
e) 7.25%

19. The term "fed funds" refers to the a a


a) excess reserves that depositary institutions keep in form
of deposits with the Federal Reserve System.
b) the funds at the disposal of the Federal Reserve Banks in
form of the monetary base.
c) the statutory capital of the Fed banks.
d) the total monetary assets of the banks which are
members of the Federal Reserve System.
e) a and d.

20. Members of the Board of Governors are b b


a) appointed by the newly elected President of the United
States, as are cabinet positions.
b) appointed by the President of the United States and
confirmed by the Senate as members resign.
c) never allowed to serve more than seven-year terms.
d) chosen by the Federal Reserve Bank presidents.

21. Which of the following statements about money market d d


securities are true?
a) the interest rates on all money market instruments move
very closely together over time.
b) the secondary market for Treasury bills is extensive and
well developed.
c) there is no well-developed secondary market for
commercial paper.
d) all of the above are true.
e) only (a) and (b) of the above are true.

22. Tasks that investment bankers perform when acting as an d d


underwriter to sell securities to the public include:
a)arranging for the security to be rated.
b) pricing the security.
c) preparing the filings required by the Securities and
Exchange Commission.
d) all of the above.
e) only (a) and (b) of the above.

23. Banker's acceptances d d


a) carry low interest rates because of the very low default
risk.
b) are issued only by large money center banks.
c) can be bought and sold until they mature.
d) are all of the above.
e) are only (a) and (b) of the above.

24. To sell an old bond when interest rates have _____, the a a
holder will have to ______ the price of the bond until the
yield to the buyer is the same as the market rate.
a) risen; lower
b) fallen; lower
c) risen; raise
d) risen; inflate

25. If the Fed wants to raise the federal funds interest rate, it will b b
a) buy securities to add reserves to the banking system.
b) sell securities to remove reserves from the banking
system.
c) sell securities to add reserves to the banking system.
d) buy securities to remove reserves from the banking
system.

26. Federal government bonds are subject to _____ risk but are b b
free of _____ risk.
a) default; interest rate
b) interest rate; default
c) interest rate; underwriting
d) default; underwriting

27. Call provisions will be exercised when c c


a) interest rates rise and bond values fall.
b) interest rates and bond values fall.
c) interest rates fall and bond values rise.
d) interest rates and bond values rise.

28. Monetary of the US economy is decided by c c


a) State Department
b) President of the USA
c) Federal reserve
d) None of the above

29. A security in which the investors have a residual claim on d d


the asset is
a) Government Bond
b) Treasury Bill
c) Bank Deposits
d) None of the above

30. Classification of securities based on residual claim is: d d


a) Primary & Secondary
b) Nature of Maturity
c) Timing of Delivery
d) None of the above
correct your
QUIZ TOPIC : TIME VALUE OF MONEY
answer answer

1. Which of the following does not constitute a reason for d d


Money Loosing value with time?
a) Inflation
b) Opportunity cost of capital
c) Risk
d) None of the above

2. The present value of a future earning is obtained by b b


adjusting the future earning by
a) Compounding
b) Discounting
c) Annuity
d) None of the above

3. A cumulative deposit in Bank of $1,000 per year at 5% b b


interest would grow to
a) $ 5,500
b) $ 5,526
c) $ 6,125
d) None

4. A one-time deposit of $1,00,000 after 10 years at 5% interest a a


will become
a) $ 1,62,889
b) $ 2,00,000
c) $ 1,50,000
d) None

5. e-coms profit profile for the next five years is c c


Year Profit (m $) Discount @ 10%
1 -25 0.91
2 -10 0.83
3 2 0.75
4 5 0.68
5 40 0.62
If the interest rate is 10%. What is the present value of
e.com's profits in the next five years?
a) $ 2.4
b) $ 1.15
c) $ -1.35
d) None
6. Shirley buys a car for $25,000 for which she avails a loan for c c
$20,000 which has to be paid in monthly installments in 60
months. The rate of interest is 5%. What will be her monthly
installment?
a) $ 1600
b) $ 1320
c) $ 1057
d) None of these

7. The formula you would use to find the present value of a b b


future earning of $2500 after 5 years is
5
a) (1+r)
-5
b) (1+r)
c) (1-(1+r)-5)/ r
d) None

8. A cumulative monthly deposit has to be initiated by Roger to a a


finance the renovation of his house after 5 years. He can earn
6% on his deposit. He projects his requirement of funds for
renovation at $80,000. How much should be put by in the
deposit to achieve his goal.
a) $ 1,147
b) $ 1,080
c) $ 1,333
d) None of the above

9. The chosen rate of discount for calculating the present or a a


future value should represent the cost of capital or the
opportunity cost of capital
a) True
b) False

10. The nominal rate of interest of a loan will increase if the b b


frequency of compounding of interest is more than once
in a year
a) True
b) False

11. Which of the following is not a step in capital budgeting d d


a) Decision tree
b) Option Pricing
c) DCF
d) None
12. If the IRR is equal to the discount rate then the profitability c c
index of the project will be
a) Greater than 1
b) Less than 1
c) Equal to 1
d) None

13. By the NPV criteria a project will be feasible of the value is b b


a) Greater than one
b) Positive
c) Greater than the IRR
d) All of the above

14. Projects will be ranked the same by all the Discounted Cash b b
Flow techniques
a) True
b) False

15. Which of the following techniques of Capital Budgeting is not c c


usually discounted
a) Profitability Index
b) IRR
c) Payback Period
d) None

16. The reinvestment assumption of the cash flow in IRR b b


calculations can be overcome by
a) Not possible
b) Modified IRR
c) No such assumption
d) None

17. For a proper comparison between two projects the period of a a


the project should be the same
a) True
b) False

18. Capital rationing is used when b b


a) Two measures of project worth are tied
b) To derive the highest investment worth
c) Two measures give conflicting results
d) None
19. For investment projects the chosen discount rare should a a
reflect
a) Cost of capital
b) Inflation
c) Risk
d) None of the above

20. Projects with short payback periods implies that the loan can b 0
be rapid in a short time.
a) True
b) False
correct your
QUIZ TOPIC : BANKING
answer answer

1. The business dealing with money and credit is a 0


a) Banking
b) Health care
c) Education
d) None

2. The amount of money a bank charges for the privilege of c 0


allowing a person to borrow money or the amount of money
the bank pays a person for depositing his money for the
bank to invest is called
a) Loan
b) Mortgage
c) Interest
d) None

3. The money that a person borrows from a bank or other c 0


financial institutions is called a
a) Interest
b) Commercial
c) Loan
d) None

4. The money that a person places in a bank account for the b 0


bank to use to invest and that also earns interest is called a
a) Loan
b) Deposit
c) Mortgage
d) None

5. A loan to pay for a home, business or other real estate over a c 0


period of time is a
a) Deposit
b) Bankruptcy
c) Mortgage
d) None

6. When a person publicly announces they cannot repay their b 0


loans it is called
a) Deposit
b) Bankruptcy
c) Mortgage
d) None

7. Groups of people such as workers who pool their money b 0


together for savings and to make loans is called a
a) Labor union
b) Credit union
c) State of the union
d) None

8. Saving and borrowing c 0


a) Provide ways to force people to live within their means
b) Provide ways to match spending to needs
c) Are ways to accumulate wealth
d) Are done by households only

9. According to the life-cycle path, in general, peoples' income c 0


a) Are stable
b) Fluctuate only in the middle ages (45 - 55)
c) Are low at a young age, takes a big jump after education,
continue to rise into middle ages and then fall sharply
during retirement years
d) Spending fluctuates at the same way

10. In an economy, in aggregate, d 0


a) Households are net borrowers
b) Households are net savers
c) Firms are net borrowers
d) Both (b) and (c)

11. A line of credit is a promise by a financial institution to lend a a 0


business
a) Any approved amount up to a specified maximum at a
time
b) Any amount (approved) as a lump sum payment
c) Only a portion of the approved amount
d) Only for real investment

12. As interest rate goes up, supply of loanable fund increases b 0


because
a) Households borrowing decreases
b) Household saving increases
c) Business borrowing increases
d) Business saving increases
13. A recession, in the economy, results in c 0
a) Higher interest rates
b) No change in interest rates
c) Lower interest rates
d) All of the above

14. The medium of exchange and the means of payments a 0


a) Are the same function a money performs
b) Are different functions of money
c) Are not functions of money
d) Are the functions which were performed by barter trade

15. Bank deposits are b 0


a) Asset to bank
b) Liability to bank
c) Profit to bank
b) Loss to bank

16. Capital of the bank is a 0


a) Less compared to the deposit
b) More compared to the deposit
c) Equal to deposits
d) None of the above

17. Loans advanced by the banks are a 0


a) Bank's assets
b) Bank's Liabilities
c) Bank's Income
d) None of the above

18. The primary function of the bank is c 0


a) Borrowing deposits
b) Lending loans
c) Borrowing and Lending
d) Mortgaging

19. Banks in the US are governed by c 0


a) Their Managements
b) Federal Government
c) Federal Reserve
d) None of the above

20. For a deposit of $10 million, with the cash reserve ratio is 5 b 0
per cent, the total credit created by the banks is
a) $ 10 million
b) $ 200 million
c) $ 50 million
d) None of the above

21. Electronic banking results in a 0


a) Increase in banking activities
b) Decrease in banking activities
c) Increase in bank deposits
d) None of the above

22. Commercial banks now-a-days lend for c 0


a) Acquisition of fixed assets
b) To meet the working capital requirement
c) Both (a) and (b)
d) None of the above

23. The Certificate of Deposits fetch a 0


a) Interest
b) No Interest
c) Discount profits
d) None of the above

24. On demand deposits b 0


a) Bank pays interest
b) Bank charges fees
c) Both (a) and (b)
d) None of the above

25. Deposit insurance covers d 0


a) Upto $ 10 million
b) Upto $ 10000
c) No limits
d) None of the above

26. The Interest rate is determined by c 0


a) Demand for money
b) Supply of money
c) Both (a) and (b)
d) None of the above

27. In inflationary economy, the money circulation is a 0


a) More
b) Less
c) Balanced
d) None of the above

28. The ownership of Credit unions is a a 0


a) Cooperative
b) Individual
c) Partnership
d) None of the above

29. The International Monitory Fund (IMF) provides c 0


a) Financial assistance to governmetns
b) Financial assistance to MNCs
c) Technical assistance to governments
d) None of the above

30. A steep decline in money supply in the economy can cause a 0


a) Recession
b) Inflation
c) Hyper-Inflation
d) None of the above
correct your
QUIZ TOPIC : MUTUAL FUNDS answer answer

1. Mutual funds are smart investing vehicles: a 0


a) True
b) False

2. You should consider buying an aggressive growth fund if: a 0


a) Need a high rate of growth
b) Safeguard against risk
c) Average growth
d) None

3. The best way to achieve long-term growth along with steady a 0


income is with:
a) DRIP
b) Index fund
c) Stocks
d) None of the above

4. If you're scared of volatility, you should stick with: a 0


a) Short term bond funds
b) Long term fund
c) Index fund
d) None of the above

5. Even though they tend to have low yields, municipal bond b 0


funds can be a good deal because:
a) Because they are tax free
b) The local projects they invest in have high profit potential
c) Guaranteed by the Government
d) None

6. When evaluating a fund, you should consider its: b 0


a) Present NAV
b) Past record of performance
c) Fund expenses
d) None

7. Sell a fund if: b 0


a) There's been a manager change
b) Down turn in performance
c) Markets are weak
d) All of the above

8. What the key reason index funds have tended to outperform c 0


actively managed funds?
a) Funds are lucky in the market
b) Index rises more than the market
c) Most fund companies don't have adequate research
departments
d) None of the above

9. When interest rates rise, bond values: b 0


a) Rise
b) Fall
c) Unaffected
d) None

10. U.S. Treasury bonds are generally considered the safest b 0


investments going. Why?
a) They are guaranteed by the Fed
b) Because their interest payments are exempt from state
and local taxes
c) They have a high growth in yields
d) None
correct your
QUIZ TOPIC : SECURITIES
answer answer

1. Between 1990 and 1999, stocks rose at c 0


a) 19.4 percent
b) 18.1 percent
c) 10.9 percent
d) 9.4 percent

2. If you're looking for a place to invest money you'll need in a b 0


year or two, stocks are the place to be because they'll give
you the best returns
a) True
b) False

3. When interest rates rise, bond values: b 0


a) Rise
b) Fall
c) Stay the same
d) It depends on what's happening in the stock market

4. What's the most important factor in the long-term movement a 0


of stock prices?
a) Earnings
b) Interest rates
c) Money flows
d) Investor sentiment

5. Which was the bigger stock market decline in percentage a 0


terms: the 508-point drop in the Dow Jones Industrial
average on Oct. 19, 1987, or the 544-point drop on Oct. 28,
1997?
a) The 508-point drop in 1987
b) The 544-point drop in 1997

6. 1994 was the worst year for bonds in recent history. How d 0
steep was the loss for intermediate-term Treasuries?
a) Down 14.4 percent
b) Down 9.7 percent
c) Down 6.2 percent
d) Down 1.8 percent

7. The following year, those same bonds bounced back. What a 0


was their return in 1995?
a) Up 14.4 percent
b) Up 9.7 percent
c) Up 6.2 percent
d) Up 1.8 percent

8. U.S. Treasury bonds are generally considered the safest b 0


investments going. Why?
a) Because their interest payments are exempt from state
and local taxes
b) Because the government can always print more money
to make payments on them
c) Because they are guaranteed by the Securities Act of 1934
d) Because they are partially invested in the stock market

9. How long will it take to double the value of your investment, d 0


after inflation, if you keep your money in cash-like
instruments earning the historical average of 3.7% a year.
a) 19 years
b) 39 years
c) 89 years
d) 139 years

10. Index funds based on the S&P 500 outperform most actively- a 0
managed funds over time because:
a) They have low management fees
b) Few fund managers can consistently beat the market
average
c) Their trading costs are minimal
d) All of the above

11. Global funds typically invest where? b 0


a) In all parts of the world save for the U.S. market
b) In all parts of the world including the U.S. market
c) In all types of foreign investments, including stocks,
bonds and real estate
d) Mostly in emerging markets

12. When the stock market is headed up, junk bond funds tend b 0
to do what?
a) Head in the opposite direction
b) Go up as well
c) Go broke
d) There is no connection between the two
13. When the stock market is headed down, which of the a 0
following kinds of bonds typically prosper?
a) Treasury bonds
b) Corporate bonds
c) Junk bonds
d) None of the above

14. When investing in your 401(k), what should you worry about d 0
most?
a) A stock market crash
b) Falling interest rates
c) A bond market crash
d) Inflation

15. When people look back on the 1990s, which of the following a 0
events will be most memorable?
a) The motherhood of Madonna
b) John Glenn's return to space
c) The bull market for U.S. stocks
d) All of the above

16. Over the last 30 years, which of the following types of a 0


investments generally provided the highest form of return?
a) Stocks
b) Bonds
c) Savings Accounts
d) Certificates

17. Higher rates of return on investments mean greater risk. a 0


a) True
b) False

18. When an investor diversifies his/her investments, does the b 0


risk of losing money increase or decrease?
a) Increase
b) Decrease

19. When interest rates go up, do bond prices usually go up, or b 0


stay about the same?
a) Go Up
b) Go Down
c) Stay About The Same
20. A secondary market is where c 0
a) A company sells stocks to raise funds for investments
b) A company sells corporate bonds only
c) Stocks and bonds are resold
d) There is no trading profit
correct your
QUIZ TOPIC : INSURANCE
answer answer

1. Homeowner's insurance must be purchased b 0


a) Before you move into the new home
b) At the time of closing
c) Within one year of moving into the new home

2. If you would like your home fully rebuilt after a total loss, c 0
insure it for what percentage of its replacement value
a) 60
b) 80
c) 100

3. Most homeowners policies (those without an extra premium) a 0


pay to replace personal property
a) At the value determined after adjusting for depreciation
b) Up to 50%
c) Fully

4. Insurance against flood and earthquake damage always is b 0


part of the standard homeowners policy
a) True
b) False

5. If you must evacuate your home because it is being rebuilt b 0


after a fire or natural disaster, a typical policy pays additional
living expenses up to what percentage of your home's
coverage
a) 5
b) 10
c) 25

6. A deductible is a 0
a) The amount of a loss you must pay before the insurance
coverage begins
b) When your premium is automatically withdrawn from your
account
c) The amount the insurance company pays toward the loss

You cannot insure yourself against the loss you would suffer b 0
7.
if you fail a course because
a) Too few students are exposed to the same risk
b) The dollar amount of loss is not very definite
c) The loss would not be fortuitous; you have control over it
d) The risk involves the possibility of a catastrophic loss
e) The probability cannot be calculated accurately

8. When you buy insurance, you are reducing risk. How? b 0


a) Actual losses incurred are lower when insurance exists
b) Premiums spread the cost of losses among all insureds
c) Pooling experience of many improves predictability
d) All of the above
e) More than one of the above, but not all of the above

9. Geographic spread of policyholders is important to insurers a 0


to:
a) Minimize dependence
b) Attract enough policyholders
c) Develop homogeneity
d) Maintain predictability of loss
e) Encourage fortuity

10. To provide that rates will not be "unfairly discriminatory" b 0


means::
a) The insurer cannot discriminate among insureds
b) That rate differential must reflect differences in expected
losses
c) The insurer must remain solvent
d) The insurer cannot earn excessive profits
e) None of the above

11. Pooling is used by insurers: e 0


a) To change the nature of risk by improving predictions
b) To cool hot property
c) To encourage self-insurance
d) To make losses fortuitous
e) None of the above

12. Self-insurance is defined as: d 0


a) Is the same as avoidance
b) Is the same as retention
c) Is feasible for most small firms
d) Requires fairly accurate predictions and the accumulation
of funds to pay losses
e) None of the above
13. The fundamental difference between insurance and c 0
gambling is that:
a) Gambling is illegal in many states
b) Gambling creates the risk whereas insurance does not
c) Insurance is based on the use of probabilities
d) Insurance may pay off in either money or services
e) None of the above

14. Reinsurance: e 0
a) Provides the insured with a contract issued by two
companies
b) Increases the cost of insurance
c) Makes a contract of insurance surer than it would be
otherwise
d) Is usually sold by the agent who sells the primary policy
e) None of the above

15. By refusing to provide health insurance coverage for a d 0


person with a serious heart ailment, the insurer:
a) Allows the transfer of risk
b) Avoids an ideally insurable loss
c) Keeps the person from receiving medical treatment
d) Prevents adverse selection
e) All of the above

16. Insurers use reinsurance to: e 0


a) Shift some liabilities to reinsurers
b) Retain individual business where coverage desired may
exceed the original insurer's retention limits
c) Protect against excessive losses when offering a new line
of insurance
d) b and c only
e) a, b, and c

17. Insurance coverage for a pianist's hands fails to meet which b 0


of the requirements for an ideally insurable risk?
a) The loss is fortuitous
b) The probability distribution of the loss is determinable
c) The potential severity of the loss is high but the probability
of it occurring is not
d) The loss is definite
e) All of the above

18. Stock insurers are: b 0


a) Organized as sole proprietorships
b) Usually owned by one group to make profits by providing
insurance primarily for other members of society
c) The same as reciprocals
d) Different from Lloyd's of London
e) No different from non-accessible mutuals

19. The federal government offers all of the following types of b 0


insurance EXCEPT:
a) An insurer guaranty fund
b) Life insurance
c) Crop insurance
d) Deposit insurance for banks
e) Overseas private investment insurance

20. Mutual insurers: b 0


a) Offer only accessible policies
b) Have a smaller average size than stock insurers
c) Are owned by their stockholders
d) Insure only the better exposures
e) Usually do a general life-health and/or property-liability
insurance business rather than specializing

21. Federal insuring organizations provide all of the following b 0


EXCEPT:
a) Social Security
b) Beach and windstorm insurance
c) Crime insurance in areas where private insurance is
unavailable
d) Insurance on certain private pensions
e) Political risk insurance for investments in certain
underdeveloped countries

22. In selecting an insurer, the matter of prime importance is: e 0


a) The age of its managers
b) How generous it is in paying claims
c) Whether it is a stock or mutual company
d) How large the company is
e) Its financial strength and stability

23. The first priority in deciding what kinds and amounts of b 0


insurance to buy should be determined by:
a) The number of people in the household or organization
b) The probabilities associated with various size losses
c) The size of the premium
d) The size of maximum potential losses
e) The experience of the agent

24. Price comparisons among different insurers are only valid if: e 0
a) The types and amounts of insurance coverages are the
same for the alternatives being compared
b) Your agency regularly deals with several insurers
c) The financial strength and service of the insurers are also
compared
d) All of the above
e) (a) and (c)
1 junk bonds are euphemisms

2 xxxxxx position of an asset is that position where it gain from increase


in secutiy value
and xxxxxx position of an asset is that position that will gain from
decrease in security value (long,short)

4 xxxxxxx is a contract between 2 partieswhere one party holds the


stock(or the cash/assets worth the stock)
for a period and the other party pays cash to get the stock
promissory note

5 Which of the following will not affect a bank's profit


a. Liquidity
b. Talent attrition
c. Credit Risk
d. Interst rate
e. Technolgy obscelence
f. assets
g. capital adequacy

6 If the consumer price index is going to fall during the next 5 years,
which of the foll is best?
a. Open a deposit in a bank which is renewalable every year for the next
5 years
b. Take a home loan for 10 years at floating rate
c. Open a deposit bank which will mature in 5 years
d. Take a vehicle loan fr 5 years at fixed rate

7 If a bad loan is written off, which of the following is written off


a. cash
b. borrowings
c. capital
d. securites

8 If a new loan is issues by a bank, which of the following does not


happen immediately
a. additional borrowing that adds to the reserves
b. A demand deposit is issued in the bearers name
c. The amount is deducted from capital
d. Outflow of the cash from bank deposit

9 When talking about the company size we are referring to its ---------------,
the current
share price times the total number of shares outstanding.(market
capitalization)

1
10 Active managers of xxxxxx funds have traditionally fared better against
their index (small-cap)

11 Central bank of authority is


a. Federal Reserve
b. National banking commision
c. Federal blah blah
d. blah blah

12 bonds have xxxxxxxx term of maturity than notes (longer)

13 while investing in mutual funds you'll look at following factor


a).fund performance & risk
b)fund performance & share price
c)portfolio manager performance & risk

14 Investing in mutual fund helps in


a. diversification
b. min returns
c. professional managemont of investment

15 Question on Functions of SEC

16 Profitability index is the ratio of the Present Worth of the net cash
flows of the Project to the Initial Cash Outflow

17 xxxxxxx will tells him how much a fund fluctuates from its own
average returns.(Standard deviation)

18 xxxxxxxxx fare better than their comparators (Index funds)

19 Question on Market order

20 xxxxxx deals with securities, which have a fixed claim and are
redeemed on a fixed date and the interest is fixed (Debt market)

21 Commercial banks come under Federal bank supervision (true)

22 It takes 12 years to double ur money at 6% (true)

23 A bank offers 13% interest. what is the effective rate (13.8)

24 Most liquid asset


a) m1,b) m2, c)m3, d)L

2
25 The NPV will be xxxxxx since the IRR is that rate of discount, which
equates the present worth of benefits and costs.
(greater than zero/zero/less than zero)

26 Banking has the following affect


increases money supply
decreases money supply
increases wealth
decreases wealth
----------------------------

Are bank deposits are guaranteed by FED at ? yes

Mutual funds granted by fed? No.

When talking about the company size we are referring to its ---------------, the
current share price times the total number of shares outstanding.(market
capitalization)

--------- Number of mutual fund companies are in US (7000)

The amount invested in the future contract is called ---------- (margin)

Tax free bonds (Municipal Bonds).

---------------------------------

1. EBPP what is it?Is it advisable to have EBPP

Eectronic Bill and Invoice Presentment Payment and Yes

2. 5lakh amount obtained after 30yrs interst 12% find present


value(installment) 143.00

3. 13% interest rate means what is its actual value(what equivalent rate
of intrest)

5. Active advisor/Passive Advisor – Long/Short term

28.We trade Securities in the exchange.

29.Which is not the function of banks?

a.Making unaccountable money into legal

b. Fixing tax and interest rate.

3
30.question on Limit order

31. __________ is the ratio of NPV to intial cash outflow.(Profitable index)

32 Citibank suvidha comes under which group?(M2)

33.Trading of Finance intermediaries carrying interest done on

a. on the interest rate

b.Yeild to maturity

c. Final matured value

---------------------------------
29/10/02:

1) Simple Interest yeid grater rtn on investments than CI. (False)

2) Patent, goodwill are examples of.......... (Intangible).

3) How many Mutual Funds are there in US...(7000)

4) Why investors buy mutual funds: Choose which is not correct:


a) Diversification,
b) low min investment,
c) guaranteed extra return,
d) professional asset mgt.

5) Which is central banking in US.....(Federal Reserve)

6) Citibank Suvidha a/c falls in which category:


a) M1
b) M2
c) M3
d) L
Ans:(M2)

7) What will bank do if outflow of cash is large?


Ans:(sell more equity)

8) What will it cost a US bank customer:


a) maintaing his bank a/c
b) writing a cheque
c) withdrawing cash from ATM,
d) opening a deposit.

4
Ans: (all)

9) Amt invested in future contract is called........(capital budgeting)

10) Mutual fund reduces risk by .........(diversification)

11) When u r buying a stock u r:


a)lending the money
b) taking ownership

12) High Interest rate are available with


a) Union Bank
b) Commerical bank
Ans (a)

13) Commercial papers have more discounts than BA. T or F :(True)

14) Write off will be writen off from: (Capital)

15) Money is best accepted as:


a) Income
b) Profit
c) Wealth
d) payment
e) stability
Ans: (d)

3,Most Appreciation Fund - Junk Bond Funds

4,Bankers acceptance is also called?ANS: Bill of exchange

5,---------------- and --------------- are two imp agencies responsible for


regulating money and capital markets

Ans - Federal reserve and Securities Exchange Commission

6,If u have specific price in mind u can set -------- order specifying the price
you r willing to pay.
Ans - Limit

7,In ------- order 10 or 20 % below the purchase price will some times cause
u to cash out of stock.
Ans - Stop loss

8,Given wrong definition Mutual fund and asked to correct that..

5
11,Municipal bonds are

a, High Yield bonds


b,Tax Exemption Bods
c,Risky bonds
d,none of the above

12,Buying the stocks from a copmany means

a),Becoming share holder of the company


b),Investment to the company

13,Definition of Beta in formula of measutring growth of Mutual Fund

RAROR = (AATR/Beta)-S&P 500 Return

Ans - Beta measures funds Volatility against S&P 500

14,when loan is written off waht r things gets affecgted in Assets and
Liabilities

Ans, In assets - Loans


In Liabilities - Capital

(Always cash/reserves should not go below zero..when its going below first
bank has to sell all securites and even securities r not there bank shud go
for borrowing)

15,Comparision between P/E's and growth is called as ----------

Ans PEG ratio

16,In zero coupon bonds even though u dont actually receive interest until
bond matures you must pay taxes each yera in the ---------------- that u earn

Ans, phantom interest

1) Management of.......are hedging, insurance & diversification.


Ans: risk

2) Objectives of SEC. (pick the wrong one)

5) Which is most liquid:


a) M1

6
b) M2
c) M3
d) L
Ans: M1

6) .........gives more interest compared to commercial ??


Ans: credit unions

9) ..........have the shortest maturity.


Ans: Treasury Bills

1) Institutions will stay in _____ when a person issues a bankrupts


(behind/infront of)
2) Sherly invest 1000 per month for a period of 15yrs with the interst rate of
10 % how
much she will receive on her maturity414318.14
3) 8% for a month what will be the effective rate of interest 8.29
5)Let us say that you paid $1000 for a 30 year bond that yielded 7 percent
interest, a
year later the rate for a comparable new bond falls to 5 percent. The
amount it yield is (1400).
6) Bonds have _______ maturities than treasury notes (Longer)
7) IBM for example, was trading at $110 in feb and was expected to earn
nearly $5 a share in 2001
Home depot meanwhile was trading for 44 but it was slated to earn littile
more thatn $1 per share
in 2001. so ibm selling for more than twice the price of home depot, is
actually cheaper stock
though not, necessarily the better buy.

8) Price sales ratio ? = stock price/total sales per share for the past 12
months

9) Buyers of PUT are betting that the price of the stock will fall before the
option expires
10) FUTURE CONTRACT are contingent on the s&P 500-stack index
performence. Others are tied to foreign currencies interest rates and
precious Metals

11)SALES CHARES is used to identify funds are load or no-load funds

12)Market Capitilization is the current share price times athje total number
of shares
standing.

7
14)Active managers of small-cap funds have traditionally fared better
against thier index (T/F)
TRUE

15)MERCHANT BANKS are firms which help business, goverment and


other entities raise finance by
issuing securites.Young firms with limited capital and managerial expertise
require resources
and advice in running thier business VENTURE CAPITALISTS
----------------------------
• Index funds generally earn better than their corresponding index.
(true/false)

• A company whose stock is growing is called a _Growth company, a


company whose stock is completely down is called a Value company, a
company whose stock keeps changing depending on trends is called a
Cyclical company.

The interest paid for commercial papers is slightly higher than the rate
for bankers acceptance. (Yes/No).

1. A bank can some times have its liabilities lesser or assets greater.
(Yes/No).
Is World Bank an exception? – No

2. Bill Gates has purchased a house worth 100,00,000$ and Robert has
constructed a house worth 25,00,000$ some 35 yrs back whose house
is costlie (Robert).

3. Will my money get doubled in six years with a inflation rate of 6%


(false)

4. to earn 30,000$ after 6 years at an interest of 12% what wud b my


monthly investment now?
5. The US regulatory bank is __Federal reserve
6. If u want to buy stock at the prevailing stock price in the market what
kind of order would u place? (market order)
7. Index funds generally earn better than their corresponding index.
(true/false)
8. Stock market is a primary/secondary market for stock.
9. Do money deposits and money multiplier deposit belong to the same
category? (yes/NO) If no specify the category…………………………..
10. The treasure bills are the shorter/longer investments.

8
11. Hedging, Diversification and Insurance are methods to maintain
____risk__________
12. The NPV when calc gives u the net growth of the company in
percentage. (Yes/No).
13. A forward contract
a. increases risk
b. decreases risk
c. sharing of risk

14. EBPP what is it?Is it advisable to have EBPP

(Eectronic Bill and Invoice Presentment Payment and Yes)

2. 5lakh amount obtained after 30yrs interst 12% find present


value(installment) 143.00

9
Time Value Of Money

1. Using simple interest gets you more interest than in the case of using compound
interest. (True/False)

2. Shirley is saving at the rate of $1000 per month for a period of 15 years for her
retirement. The interest on the deposit is 10%. How much will she receive on
maturity of her deposit?

3. Robert wants to save $5,00,000 in 30 years by making a monthly investment at an


interest rate of 10%. What is his monthly investment?
a. 143 b.1300 c. 575 d. 944

4. A bank offers an annual interest rate of 13 %. The interest is calculated every


month. What is the effective interest rate? (13.8)

5. You plan to buy a car costing $50000 and approach a finance company who offers
you a loan on the condition you make a down payment of 20% and the balance
will be advanced @ 9%, reducing balance interest, over a period of 48 months.
What will the equate monthly interest be? ($ 1028.90)

6. Time value of money is based only on principal and interest rate. True/False.

Securities

1. Suppose you paid $1,000 for a 30-year bond that yielded 7 percent interest. A
year later, the rate for a comparable new bond falls to 5 percent. What is the new
price of your bond? ($ 1400)

2. Suppose you paid $1,000 for a 30-year bond that yielded 7 percent interest. A
year later, the rate for a comparable new bond rises to 9 percent. What is the new
price of your bond? ($ 777.78)

3. In the above question, what is your bond worth at maturity? ($ 1000)

4. Treasury bills have the _____________ maturity periods. (shortest, intermediate,


longest).

5. In case of zero-coupon bonds, you must pay taxes each year on the __________
that you earn. (“phantom interest”)

6. If a person buys zero-coupon bonds of face-value $ 1000 with maturity period of


9 years at $865, then what is the rate of interest?

10
correct your
QUIZ TOPIC : FINANCIAL SYSTEMS
answer answer

1. The Constituents of Financial Systems are: c c


a) Financial Asset
b) Financial Market
c) Federal Budget
d) Financial Intermediaries

The financial system does not help in which of


2. b b
the following:
a) Time
b) Charity
c) Space
d) Borders

3. Which is not the service of the financial system? d d


a) Insurance
b) Banking
c) Interest Rate
d) Commodity Prices

4. Patent is a: c c
a) Security
b) Loan
c) Intangible Asset
d) Tangible Asset

5. In a financial market, the supply and demand of a a


money is equated through:
a) Interest
b) Bond
c) Equity
d) Asset

6. Return on Investment in secondary market


a a
securities is not directly influenced by:
a) Government

11
b) Risk
c) Demand for Money
d) Supply of Money

7. The classification of markets based on timing of


c c
transaction is:
a) Primary and Secondary
b) Long and Short term
c) Forward and spot market
d) None of the above

8. Equity is: d d
a) Loan borrowed by the company
b) Return to the investors
c) Own funds of the company
d) Share holders contribution towards to capital

9. Negotiable instruments that facilitates: a a


a) Negotiation
b) Exchange
c) Lending
d) Borrowing

10. Treasury bills are issued by: c c


a) a Company
b) a Commercial Bank
c) a Central Bank
d) an Acceptance House

Which of the following is not a financial


11. d d
intermediary:
a) Fed Reserve
b) Commercial Bank
c) Insurance Company
d) Finance Department

Which of the following is not a function of the


12. b b
Fed Reserve:
a) Clearing House
b) Issue of Corporate Stock
c) Custodian of Foreign Exchange Reserve

12
d) Banker to the Government

13. Capital market operations are supervised by: d d


a) Federal Reserve
b) Stock Exchanges
c) Commercial Banks
d) Securities Exchange Commission

Which of the following is not a redeemable


14. c c
security:
a) Bond
b) Debenture
c) Equity Share
d) Fixed Deposit

15. Financial markets are independent of other


b b
markets in the economy:
a) True
b) False

16. Common stock represents b b


a) an ownership interest in a corporation
b) a debt interest in a corporation
c) an equity interest in a corporation
d) a residual claim on cash flows and asset
value of a corporation
e) a, c and d

17. Corporate bond issuers can use the proceeds


d d
from a bond sale for:
a) expansion of facilities.
b) working capital.
c) refinancing of outstanding debt.
d) financing takeovers (mergers and
acquisitions).
e) all of the above.

18. Great Axe Manufacturer Corp. has 14% coupon d d


bonds on the market with seven years to
maturity. The bond's make semiannual
payments and currently sell for 105% of par.
What is the current YTM on Great Axe

13
Manufacturer's bonds?
a) 12%
b) 13.75%
c) 10.5%
d) 12.89%
e) 7.25%

19. The term "fed funds" refers to the a a


a) excess reserves that depositary institutions
keep in form of deposits with the Federal
Reserve System.
b) the funds at the disposal of the Federal
Reserve Banks in form of the monetary base.
c) the statutory capital of the Fed banks.
d) the total monetary assets of the banks which
are members of the Federal Reserve System.
e) a and d.

20. Members of the Board of Governors are b b


a) appointed by the newly elected President of
the United States, as are cabinet positions.
b) appointed by the President of the United
States and confirmed by the Senate as members
resign.
c) never allowed to serve more than seven-year
terms.
d) chosen by the Federal Reserve Bank
presidents.

21. Which of the following statements about money d d


market securities are true?
a) the interest rates on all money market
instruments move very closely together over
time.
b) the secondary market for Treasury bills is
extensive and well developed.
c) there is no well-developed secondary market
for commercial paper.
d) all of the above are true.
e) only (a) and (b) of the above are true.

22. Tasks that investment bankers perform when d d


acting as an underwriter to sell securities to the

14
public include:
a)arranging for the security to be rated.
b) pricing the security.
c) preparing the filings required by the
Securities and Exchange Commission.
d) all of the above.
e) only (a) and (b) of the above.

23. Banker's acceptances d d


a) carry low interest rates because of the very
low default risk.
b) are issued only by large money center banks.
c) can be bought and sold until they mature.
d) are all of the above.
e) are only (a) and (b) of the above.

24. To sell an old bond when interest rates have a a


_____, the holder will have to ______ the price of
the bond until the yield to the buyer is the same
as the market rate.
a) risen; lower
b) fallen; lower
c) risen; raise
d) risen; inflate

If the Fed wants to raise the federal funds


25. b b
interest rate, it will
a) buy securities to add reserves to the banking
system.
b) sell securities to remove reserves from the
banking system.
c) sell securities to add reserves to the banking
system.
d) buy securities to remove reserves from the
banking system.

26. Federal government bonds are subject to _____ b b


risk but are free of _____ risk.
a) default; interest rate
b) interest rate; default
c) interest rate; underwriting
d) default; underwriting

15
27. Call provisions will be exercised when c c
a) interest rates rise and bond values fall.
b) interest rates and bond values fall.
c) interest rates fall and bond values rise.
d) interest rates and bond values rise.

28. Monetary of the US economy is decided by c c


a) State Department
b) President of the USA
c) Federal reserve
d) None of the above

29. A security in which the investors have a residual d d


claim on the asset is
a) Government Bond
b) Treasury Bill
c) Bank Deposits
d) None of the above

Classification of securities based on residual


30. d d
claim is:
a) Primary & Secondary
b) Nature of Maturity
c) Timing of Delivery
d) None of the above

16
correct your
QUIZ TOPIC : TIME VALUE OF MONEY
answer answer

1. Which of the following does not constitute a d d


reason for Money Loosing value with time?
a) Inflation
b) Opportunity cost of capital
c) Risk
d) None of the above

2. The present value of a future earning is obtained b b


by adjusting the future earning by
a) Compounding
b) Discounting
c) Annuity
d) None of the above

17
3. A cumulative deposit in Bank of $1,000 per year b b
at 5% interest would grow to
a) $ 5,500
b) $ 5,526
c) $ 6,125
d) None

4. A one-time deposit of $1,00,000 after 10 years at a a


5% interest will become
a) $ 1,62,889
b) $ 2,00,000
c) $ 1,50,000
d) None

5. e-coms profit profile for the next five years is c c


Profit (m Discount @
Year
$) 10%
1 -25 0.91
2 -10 0.83
3 2 0.75
4 5 0.68
5 40 0.62
If the interest rate is 10%. What is the present
value of e.com's profits in the next five years?
a) $ 2.4
b) $ 1.15
c) $ -1.35
d) None

6. Shirley buys a car for $25,000 for which she c c


avails a loan for $20,000 which has to be paid in
monthly installments in 60 months. The rate of
interest is 5%. What will be her monthly
installment?
a) $ 1600
b) $ 1320
c) $ 1057
d) None of these

7. The formula you would use to find the present c b


value of a future earning of $2500 after 5 years is

18
a) (1+r)5
b) (1+r)-5
c) (1-(1+r)-5)/ r
d) None

8. A cumulative monthly deposit has to be initiated a a


by Roger to finance the renovation of his house
after 5 years. He can earn 6% on his deposit. He
projects his requirement of funds for renovation
at $80,000. How much should be put by in the
deposit to achieve his goal.
a) $ 1,147
b) $ 1,080
c) $ 1,333
d) None of the above

9. The chosen rate of discount for calculating the a a


present or future value should represent the
cost of capital or the opportunity cost of capital
a) True
b) False

10. The nominal rate of interest of a loan will b b


increase if the frequency of compounding of
interest is more than once
in a year
a) True
b) False

Which of the following is not a step in capital


11. d d
budgeting
a) Decision tree
b) Option Pricing
c) DCF
d) None

12. If the IRR is equal to the discount rate then the c c


profitability index of the project will be
a) Greater than 1
b) Less than 1
c) Equal to 1
d) None

19
By the NPV criteria a project will be feasible of
13. b b
the value is
a) Greater than one
b) Positive
c) Greater than the IRR
d) All of the above

14. Projects will be ranked the same by all the b b


Discounted Cash Flow techniques
a) True
b) False

15. Which of the following techniques of Capital c c


Budgeting is not usually discounted
a) Profitability Index
b) IRR
c) Payback Period
d) None

16. The reinvestment assumption of the cash flow in b b


IRR calculations can be overcome by
a) Not possible
b) Modified IRR
c) No such assumption
d) None

17. For a proper comparison between two projects a a


the period of the project should be the same
a) True
b) False

18. Capital rationing is used when b b


a) Two measures of project worth are tied
b) To derive the highest investment worth
c) Two measures give conflicting results
d) None

19. For investment projects the chosen discount a a


rare should reflect
a) Cost of capital
b) Inflation

20
c) Risk
d) None of the above

20. Projects with short payback periods implies that b 0


the loan can be rapid in a short time.
a) True
b) False

correct your
QUIZ TOPIC : BANKING
answer answer

21
1. The business dealing with money and credit is a 0
a) Banking
b) Health care
c) Education
d) None

2. The amount of money a bank charges for the c 0


privilege of allowing a person to borrow money
or the amount of money the bank pays a person
for depositing his money for the bank to invest
is called
a) Loan
b) Mortgage
c) Interest
d) None

3. The money that a person borrows from a bank or c 0


other financial institutions is called a
a) Interest
b) Commercial
c) Loan
d) None

4. The money that a person places in a bank b 0


account for the bank to use to invest and that
also earns interest is called a
a) Loan
b) Deposit
c) Mortgage
d) None

5. A loan to pay for a home, business or other real c 0


estate over a period of time is a
a) Deposit
b) Bankruptcy
c) Mortgage
d) None

6. When a person publicly announces they cannot b 0


repay their loans it is called
a) Deposit
b) Bankruptcy

22
c) Mortgage
d) None

7. Groups of people such as workers who pool b 0


their money together for savings and to make
loans is called a
a) Labor union
b) Credit union
c) State of the union
d) None

8. Saving and borrowing c 0


a) Provide ways to force people to live within
their means
b) Provide ways to match spending to needs
c) Are ways to accumulate wealth
d) Are done by households only

According to the life-cycle path, in general,


9. c 0
peoples' income
a) Are stable
b) Fluctuate only in the middle ages (45 - 55)
c) Are low at a young age, takes a big jump after
education,
continue to rise into middle ages and then fall
sharply
during retirement years
d) Spending fluctuates at the same way

10. In an economy, in aggregate, d 0


a) Households are net borrowers
b) Households are net savers
c) Firms are net borrowers
d) Both (b) and (c)

11. A line of credit is a promise by a financial a 0


institution to lend a business
a) Any approved amount up to a specified
maximum at a
time
b) Any amount (approved) as a lump sum
payment

23
c) Only a portion of the approved amount
d) Only for real investment

12. As interest rate goes up, supply of loanable fund b 0


increases because
a) Households borrowing decreases
b) Household saving increases
c) Business borrowing increases
d) Business saving increases

13. A recession, in the economy, results in c 0


a) Higher interest rates
b) No change in interest rates
c) Lower interest rates
d) All of the above

The medium of exchange and the means of


14. a 0
payments
a) Are the same function a money performs
b) Are different functions of money
c) Are not functions of money
d) Are the functions which were performed by
barter trade

15. Bank deposits are b 0


a) Asset to bank
b) Liability to bank
c) Profit to bank
b) Loss to bank

16. Capital of the bank is a 0


a) Less compared to the deposit
b) More compared to the deposit
c) Equal to deposits
d) None of the above

17. Loans advanced by the banks are a 0


a) Bank's assets
b) Bank's Liabilities
c) Bank's Income
d) None of the above

24
18. The primary function of the bank is c 0
a) Borrowing deposits
b) Lending loans
c) Borrowing and Lending
d) Mortgaging

19. Banks in the US are governed by c 0


a) Their Managements
b) Federal Government
c) Federal Reserve
d) None of the above

20. For a deposit of $10 million, with the cash b 0


reserve ratio is 5 per cent, the total credit
created by the banks is
a) $ 10 million
b) $ 200 million
c) $ 50 million
d) None of the above

21. Electronic banking results in a 0


a) Increase in banking activities
b) Decrease in banking activities
c) Increase in bank deposits
d) None of the above

22. Commercial banks now-a-days lend for c 0


a) Acquisition of fixed assets
b) To meet the working capital requirement
c) Both (a) and (b)
d) None of the above

23. The Certificate of Deposits fetch a 0


a) Interest
b) No Interest
c) Discount profits
d) None of the above

24. On demand deposits b 0


a) Bank pays interest

25
b) Bank charges fees
c) Both (a) and (b)
d) None of the above

25. Deposit insurance covers d 0


a) Upto $ 10 million
b) Upto $ 10000
c) No limits
d) None of the above

26. The Interest rate is determined by c 0


a) Demand for money
b) Supply of money
c) Both (a) and (b)
d) None of the above

27. In inflationary economy, the money circulation is a 0


a) More
b) Less
c) Balanced
d) None of the above

28. The ownership of Credit unions is a a 0


a) Cooperative
b) Individual
c) Partnership
d) None of the above

29. The International Monitory Fund (IMF) provides c 0


a) Financial assistance to governmetns
b) Financial assistance to MNCs
c) Technical assistance to governments
d) None of the above

A steep decline in money supply in the economy


30. a 0
can cause
a) Recession
b) Inflation
c) Hyper-Inflation
d) None of the above

26
27
correct your
QUIZ TOPIC : MUTUAL FUNDS answer answer

1. Mutual funds are smart investing vehicles: a 0


a) True
b) False

2. You should consider buying an aggressive a 0


growth fund if:
a) Need a high rate of growth
b) Safeguard against risk
c) Average growth
d) None

3. The best way to achieve long-term growth along a 0


with steady income is with:
a) DRIP
b) Index fund
c) Stocks
d) None of the above

4. If you're scared of volatility, you should stick a 0


with:
a) Short term bond funds
b) Long term fund
c) Index fund
d) None of the above

28
5. Even though they tend to have low yields, a 0
municipal bond funds can be a good deal
because:
a) Because they are tax free
b) The local projects they invest in have high
profit potential
c) Guaranteed by the Government
d) None

6. When evaluating a fund, you should consider b 0


its:
a) Present NAV
b) Past record of performance
c) Fund expenses
d) None

7. Sell a fund if: b 0


a) There's been a manager change
b) Down turn in performance
c) Markets are weak
d) All of the above

8. What the key reason index funds have tended to c 0


outperform actively managed funds?
a) Funds are lucky in the market
b) Index rises more than the market
c) Most fund companies don't have adequate
research departments
d) None of the above

9. When interest rates rise, bond values: b 0


a) Rise
b) Fall
c) Unaffected
d) None

10. U.S. Treasury bonds are generally considered b 0


the safest investments going. Why?
a) They are guaranteed by the Fed
b) Because their interest payments are exempt
from state
and local taxes

29
c) They have a high growth in yields
d) None

correct your
QUIZ TOPIC : SECURITIES
answer answer

1. Between 1990 and 1999, stocks rose at c 0


a) 19.4 percent
b) 18.1 percent
c) 10.9 percent
d) 9.4 percent

2. If you're looking for a place to invest money b 0


you'll need in a year or two, stocks are the place
to be because they'll give you the best returns
a) True
b) False

3. When interest rates rise, bond values: b 0


a) Rise
b) Fall
c) Stay the same
d) It depends on what's happening in the stock
market

30
4. What's the most important factor in the long- a 0
term movement of stock prices?
a) Earnings
b) Interest rates
c) Money flows
d) Investor sentiment

5. Which was the bigger stock market decline in a 0


percentage terms: the 508-point drop in the Dow
Jones Industrial average on Oct. 19, 1987, or the
544-point drop on Oct. 28, 1997?
a) The 508-point drop in 1987
b) The 544-point drop in 1997

6. 1994 was the worst year for bonds in recent d 0


history. How steep was the loss for intermediate-
term Treasuries?
a) Down 14.4 percent
b) Down 9.7 percent
c) Down 6.2 percent
d) Down 1.8 percent

7. The following year, those same bonds bounced a 0


back. What was their return in 1995?
a) Up 14.4 percent
b) Up 9.7 percent
c) Up 6.2 percent
d) Up 1.8 percent

8. U.S. Treasury bonds are generally considered a 0


the safest investments going. Why?

a) Because their interest payments are exempt


from state
and local taxes
b) Because the government can always print
more money
to make payments on them
c) Because they are guaranteed by the
Securities Act of 1934
d) Because they are partially invested in the
stock market

31
9. How long will it take to double the value of your d 0
investment, after inflation, if you keep your
money in cash-like instruments earning the
historical average of 3.7% a year.
a) 19 years
b) 39 years
c) 89 years
d) 139 years

10. Index funds based on the S&P 500 outperform a 0


most actively-managed funds over time
because:
a) They have low management fees
b) Few fund managers can consistently beat the
market
average
c) Their trading costs are minimal
d) All of the above

11. Global funds typically invest where? b 0


a) In all parts of the world save for the U.S.
market
b) In all parts of the world including the U.S.
market
c) In all types of foreign investments, including
stocks,
bonds and real estate
d) Mostly in emerging markets

12. When the stock market is headed up, junk bond b 0


funds tend to do what?
a) Head in the opposite direction
b) Go up as well
c) Go broke
d) There is no connection between the two

13. When the stock market is headed down, which a 0


of the following kinds of bonds typically
prosper?
a) Treasury bonds
b) Corporate bonds
c) Junk bonds

32
d) None of the above

14. When investing in your 401(k), what should you d 0


worry about most?
a) A stock market crash
b) Falling interest rates
c) A bond market crash
d) Inflation

15. When people look back on the 1990s, which of a 0


the following events will be most memorable?
a) The motherhood of Madonna
b) John Glenn's return to space
c) The bull market for U.S. stocks
d) All of the above

16. Over the last 30 years, which of the following a 0


types of investments generally provided the
highest form of return?
a) Stocks
b) Bonds
c) Savings Accounts
d) Certificates

Higher rates of return on investments mean


17. a 0
greater risk.
a) True
b) False

18. When an investor diversifies his/her b 0


investments, does the risk of losing money
increase or decrease?
a) Increase
b) Decrease

19. When interest rates go up, do bond prices b 0


usually go up, or stay about the same?
a) Go Up
b) Go Down
c) Stay About The Same

20. A secondary market is where c 0

33
a) A company sells stocks to raise funds for
investments
b) A company sells corporate bonds only
c) Stocks and bonds are resold
d) There is no trading profit

34
correct your
QUIZ TOPIC : INSURANCE
answer answer

1. Homeowner's insurance must be purchased b 0


a) Before you move into the new home
b) At the time of closing
c) Within one year of moving into the new home

2. If you would like your home fully rebuilt after a c 0


total loss, insure it for what percentage of its
replacement value
a) 60
b) 80
c) 100

3. Most homeowners policies (those without an a 0


extra premium) pay to replace personal property
a) At the value determined after adjusting for
depreciation
b) Up to 50%
c) Fully

4. Insurance against flood and earthquake damage b 0


always is part of the standard homeowners
policy
a) True
b) False

5. If you must evacuate your home because it is b 0


being rebuilt after a fire or natural disaster, a
typical policy pays additional living expenses up
to what percentage of your home's coverage
a) 5
b) 10
c) 25

6. A deductible is a 0
a) The amount of a loss you must pay before the
insurance coverage begins
b) When your premium is automatically
withdrawn from your account
c) The amount the insurance company pays

35
toward the loss

You cannot insure yourself against the loss you b 0


7.
would suffer if you fail a course because
a) Too few students are exposed to the same
risk
b) The dollar amount of loss is not very definite
c) The loss would not be fortuitous; you have
control over it
d) The risk involves the possibility of a
catastrophic loss
e) The probability cannot be calculated
accurately

When you buy insurance, you are reducing risk.


8. b 0
How?
a) Actual losses incurred are lower when
insurance exists
b) Premiums spread the cost of losses among all
insureds
c) Pooling experience of many improves
predictability
d) All of the above
e) More than one of the above, but not all of the
above

9. Geographic spread of policyholders is important a 0


to insurers to:
a) Minimize dependence
b) Attract enough policyholders
c) Develop homogeneity
d) Maintain predictability of loss
e) Encourage fortuity

10. To provide that rates will not be "unfairly b 0


discriminatory" means::
a) The insurer cannot discriminate among
insureds
b) That rate differential must reflect differences
in expected losses
c) The insurer must remain solvent
d) The insurer cannot earn excessive profits
e) None of the above

36
11. Pooling is used by insurers: e 0
a) To change the nature of risk by improving
predictions
b) To cool hot property
c) To encourage self-insurance
d) To make losses fortuitous
e) None of the above

12. Self-insurance is defined as: d 0


a) Is the same as avoidance
b) Is the same as retention
c) Is feasible for most small firms
d) Requires fairly accurate predictions and the
accumulation of funds to pay losses
e) None of the above

13. The fundamental difference between insurance c 0


and gambling is that:
a) Gambling is illegal in many states
b) Gambling creates the risk whereas insurance
does not
c) Insurance is based on the use of probabilities
d) Insurance may pay off in either money or
services
e) None of the above

14. Reinsurance: e 0
a) Provides the insured with a contract issued by
two companies
b) Increases the cost of insurance
c) Makes a contract of insurance surer than it
would be otherwise
d) Is usually sold by the agent who sells the
primary policy
e) None of the above

15. By refusing to provide health insurance d 0


coverage for a person with a serious heart
ailment, the insurer:
a) Allows the transfer of risk
b) Avoids an ideally insurable loss

37
c) Keeps the person from receiving medical
treatment
d) Prevents adverse selection
e) All of the above

16. Insurers use reinsurance to: e 0


a) Shift some liabilities to reinsurers
b) Retain individual business where coverage
desired may exceed the original insurer's
retention limits
c) Protect against excessive losses when
offering a new line of insurance
d) b and c only
e) a, b, and c

17. Insurance coverage for a pianist's hands fails to b 0


meet which of the requirements for an ideally
insurable risk?
a) The loss is fortuitous
b) The probability distribution of the loss is
determinable
c) The potential severity of the loss is high but
the probability of it occurring is not
d) The loss is definite
e) All of the above

18. Stock insurers are: b 0


a) Organized as sole proprietorships
b) Usually owned by one group to make profits
by providing insurance primarily for other
members of society
c) The same as reciprocals
d) Different from Lloyd's of London
e) No different from non-accessible mutuals

19. The federal government offers all of the b 0


following types of insurance EXCEPT:
a) An insurer guaranty fund
b) Life insurance
c) Crop insurance
d) Deposit insurance for banks
e) Overseas private investment insurance

38
20. Mutual insurers: b 0
a) Offer only accessible policies
b) Have a smaller average size than stock
insurers
c) Are owned by their stockholders
d) Insure only the better exposures
e) Usually do a general life-health and/or
property-liability insurance business rather
than specializing

21. Federal insuring organizations provide all of the b 0


following EXCEPT:
a) Social Security
b) Beach and windstorm insurance
c) Crime insurance in areas where private
insurance is unavailable
d) Insurance on certain private pensions
e) Political risk insurance for investments in
certain underdeveloped countries

22. In selecting an insurer, the matter of prime


e 0
importance is:
a) The age of its managers
b) How generous it is in paying claims
c) Whether it is a stock or mutual company
d) How large the company is
e) Its financial strength and stability

23. The first priority in deciding what kinds and b 0


amounts of insurance to buy should be
determined by:
a) The number of people in the household or
organization
b) The probabilities associated with various size
losses
c) The size of the premium
d) The size of maximum potential losses
e) The experience of the agent

24. Price comparisons among different insurers are


e 0
only valid if:

39
a) The types and amounts of insurance
coverages are the same for the alternatives
being compared
b) Your agency regularly deals with several
insurers
c) The financial strength and service of the
insurers are also compared
d) All of the above
e) (a) and (c)

40
1 junk bonds are High yield bonds

2 Which of the following will not affect a bank's profit


a. Liquidity
b. Talent attrition
c. Credit Risk
d. Interst rate
e. Technolgy obscelence
f. assets
g. capital adequacy

3.If the consumer price index is going to fall during the


next 5 years, which of the foll is best?
a. Open a deposit in a bank which is renewalable
every year for the next 5 years
b. Take a home loan for 10 years at floating rate
c. Open a deposit bank which will mature in 5 years
d. Take a vehicle loan fr 5 years at fixed rate

4.If a bad loan is written off, which of the following is


written off
a. cash
b. borrowings
c. capital
d. securites

5. When talking about the company size we are referring to


its ---------------, the current
share price times the total number of shares
outstanding.(market capitalization)

6. Active managers of xxxxxx funds have traditionally fared


better against their index (small-cap)

7. while investing in mutual funds you'll look at following


factor
a)fund performance & risk
b)fund performance & share price
c)portfolio manager performance & risk

8.xxxxxxxxx fare better than their comparators (Index


funds)

9. It takes 12 years to double ur money at 6% (true)

10 Most liquid asset


a) m1,b) m2, c)m3, d)L
11. Banking has the following affect
increases money supply
decreases money supply
increases wealth
decreases wealth

12. --------- Number of mutual fund companies are in US


(7000)

13. 5lakh amount obtained after 30yrs interst 12% find


present value(installment) 143.00

14. ) When u r buying a stock u r:


a)lending the money
b) taking ownership stack of company

15. Money is best accepted as:


a) Income
b) Profit
c) Wealth
d) payment
e) stability
Ans: (d)

16. If u have specific price in mind u can set --------


order specifying the price you r willing to pay.
Ans - Limit

17. ..........have the shortest maturity.


Ans: Treasury Bills

18. Buyers of PUT are betting that the price of the stock
will fall before the option expires

19. The interest paid for commercial papers is slightly


higher than the rate for bankers acceptance. (Yes/No).

20. Stock market is a primary/secondary market for stock.

21. Hedging, Diversification and Insurance are methods to


maintain risk
MONEY AND BANKING

CONTENTS

What is MONEY? .......................................................................................................... 3


Characteristics of money............................................................................................. 4
Measurements of money ............................................................................................. 4
Money and the economy ............................................................................................. 6
Relationship between Prices and Inflation................................................................... 7
Why Money Supply Matters ....................................................................................... 7
Banking ......................................................................................................................... 8
General History........................................................................................................... 8
History in United States .............................................................................................. 9
Banking basics............................................................................................................ 9
Other Financial Institutions....................................................................................... 10
International Banks ................................................................................................... 10
Structure of banking industry in U.S. ........................................................................ 11
Interest Rates ............................................................................................................ 11
Banking Business...................................................................................................... 12
Liquidity management by banks................................................................................ 12
Multiple Deposit Creation......................................................................................... 15
Banking services....................................................................................................... 17
Summary ..................................................................................................................... 19
References ......................................................................... Error! Bookmark not defined.
Banking Quiz...................................................................... Error! Bookmark not defined.
Learning Objectives

On successful completion of this lesson you will be able to:


Understand the role of money and its impact on the economy and measurement of
money in an economy. History of banking, liquidity management of banks and
banking services and technique of credit creation.
MONEY AND BANKING

Money and banking have become an integral part of our lives and one cannot do without
it. However, the subtleties of banking and money are not clear to many. This unit aims to
introduce you to some of the issues faced in managing a bank. The breadth of such
issues is vast and by necessity, this unit concentrates on the financial aspects of bank
management.

You should be well aware of the rapid developments in banking from media reports in
recent years, including criticisms of banking policies and practices. You may even have
experienced these changes through dealings with your own bank. This criticism of
banks is not limited to one country and generally followed the worldwide trend in the
1980s towards deregulation. This has led to the establishment of Banking Ombudsmen
in several countries and the development of Codes of behaviour for both banks and their
employees.

The period of deregulation is accompanied by one important development - the rapid


development of global computer communications that enabled financial institutions to
develop new products and to internationalise their business. This brought greater risks,
and latterly, the development of techniques to manage these exposures.

What is MONEY?

I doubt if anybody would ask the question “What is money”? I you did, here's what is
isn't.

MONEY is not the same thing as INCOME or WEALTH

While in ordinary conversation we commonly use the word money to mean income ("he
makes a lot of money") or wealth ("she has a lot of money"), technically money means
something quite different:

Money = anything that is generally accepted as payment

Q: What is money? That is, what counts as money?


A: Obviously, cash -- dollar bills, coins -- is a form of money.

Q: Is there anything else that counts as money?


A: Checking accounts.

Q: Are credit cards money?


A: No. They're not legal tender. What a credit-card purchases really represents is just an
extremely convenient, pre-approved loan. It's only part of the transaction, since the
merchant then goes to the bank that issued the credit card to get money, and the bank
sends you a bill which must be paid with money.
Characteristics of money

The forms that money has taken on depend heavily on how well it performs the three
roles ,viz., medium of exchange, store of value, and unit of account. The following are
some of the characteristics a commodity or specie needs to possess to perform the
three roles of money efficiently:

(1) Non-perishable in the sense it does not get spoilt by keeping.

(2) Divisible into fractions if necessary

(3) Widely accepted (in payment of goods and services and for settling other business
obligations)

(4) Easily standardized, meaning that it can be expressed in standard unit

(5) Portable and can be moved from place to place.

(6) Limited in supply

(7) Supply is relatively stable and does not change frequently.

(8) High in value i.e. its physical size is small relative to its value.

(9) Not easily counterfeited

However, new problems have surfaced with the development of digital cash.
Since digital cash is made up of bits of digital information, it can be
“counterfeited” a lot easier than traditional paper money. This becomes a major
concern because easy duplication leads to an unlimited amount of digital cash,
which makes it valueless. In addition, digital cash is much easier to transport
than paper money because it is transferred digitally. This makes transferring
money across border a lot easier, which means money from illegal sources (such
as drug money) can be easily “transmitted” out of the country.

Measurements of money

Money is considered an important determinant of the condition of the economy of a


country. In the eye of the federal government, there is a broader measure of what money
is in the U.S and in other parts of the world imply.

There are 3 general measures of money used by the U.S. government (or more
specifically the Federal Reserve System): M1, M2 and M3. These are often referred to in
the context of inflation, recession and interest rate changes.

I’m sure it sounds familiar. Allan Greenspan’s, the US Treasury Secretary’s,


announcements on changes in the Fed interest rate during the last two years is now well
known felt even in India.
(i) M1

M1 is the narrowest measure of money. It includes the following items:

M 1 = currency in circulation (notes and coins)


+ traveler' s checks of nonbank issues (eg. AMEX)
+ non - interest bearing checking accounts (ie. demand deposit)
+ interest bearing checking accounts (ie. other checkable deposits)

Note: 1. Traveler’s checks issued by banks are grouped under demand deposits.

2. Some examples of interest bearing checking accounts are NOW (negotiable


order of withdrawal), ATS (automatic transfer from savings), and credit union
share drafts.

M1 is considered by the Federal Reserve as transaction balances. In other words, they


are perfectly liquid assets, i.e. pure medium of exchange.

(ii) M2

M2 is a broader measure of money than M1. It includes items that are contained in M1
and a few other items:

M 2 = M1
+ savings deposits and money market deposit accounts
+ small time deposits (CDs)
+ money market mutual funds shares (non - institutional)
+ overnight repurchase agreement
+ overnight Eurodolla r
+ consolidat ion adjustment

Note: 1. You can write a limited number of checks on money market deposit accounts
(i.e. interest bearing account).

2. Small time deposits are CDs with amount less than $100,000.

3. Money market mutual funds are interest-bearing shares in pools of funds


accumulated by investment companies. The funds are invested in short-term
securities.

4. The consolidation adjustment is included to avoid double counting of short-


term repurchase agreement and Eurodollars held by money market mutual funds.
The components of M2 (other than M1) are considered as non-transaction balances. In
other words, the assets emphasize the function of money as a store of value. However,
they can also be used as medium of exchange (with some delay).

(iii) M3

M3 is the broadest measure for money and it includes some of the “longer-term” money
market instruments.

M3= M2
+ large time deposits (more than $100 ,000 )
+ term repurchase agreements (longer than overnight)
+ term Eurodolla r deposits (longer than overnight)
+ money market mutual funds shares (institutions)

The components of M3 (other than M2) are assets of mostly large businesses and
institutions. They are very non-liquid assets, and hence not used as medium of
exchange.

(iv) L

Data on M1, M2 and M3 are collected and distributed by the Federal Reserve System
(i.e. the Fed), and they are known as the monetary aggregates. In addition, the Fed also
collects information on a broader concept of liquidity known as L.

L = M3
+ short term Treasury s ecurities
+ commercial papers
+ savings bonds issued by the U.S. government
+ banker' s acceptance

The components of L (other than M3) are highly liquid assets (i.e. short-term money
market instruments).

Money and the economy

Since money has an impact on a number of economic variables, it is sometimes helpful


to use money to determine how the economy is performing.

Which monetary measure do we use to predict inflation, business cycles, etc.?

Historical evidence shows that M1, M2 and M3 do not move in tandem.


An alternative way is to use a weighted average of the monetary aggregates, but how
successful it will be is still unknown.

Relationship between Prices and Inflation

Index of the average prices of goods and services in the economy are Consumer
price index, Wholesale price index, GDP deflator. These are indices that measure
the value of money at different levels- wholesale and consumer levels.

Inflation rate: the yearly percent change in the price level.

It is measured using the formula:

(New value) - (Old value)


Percent change = --------------------------------- (x 100%)
(Old value)

Q: Suppose the Consumer Price Index was 150 in 1979, and 169.5 in 1980. What was
the inflation rate in 1980?
A: Inflation rate = (169.5-150)/150 = 19.5/150 = 0.13 * 100 = 13%

Why Money Supply Matters

Money supply is the total amount of currency in circulation plus bank account deposits.
At the national level, the money supply and national income (GDP) are not the same
thing, either.

GDP (gross domestic product -- the total value of final goods and services
produced in a given year; about $10 trillion) is often used as a bottom-line measure
of how the nation's economy is doing. The money supply (e.g., M2 - cash + virtually
all bank deposits and money-market-fund shares held by individuals; about $4.5
trillion) is not used as a bottom-line measure of the state of the economy, nor should it
be.
Why, then, do we bother to learn about the money supply and to keep track of it?

The Federal Reserve measures the money supply once a week, whereas GDP is
measured only once every three months, because The money supply (Ms) affects
three very important aspects of the economy:

(a) GDP: steep declines in the Ms growth rate can cause recessions
-- In the past 50 years, there have been eight recessions, and every single one of them
was preceded by a notable decline in the money (M2) growth rate. Then again, not every
decline in the M2 growth rate was followed by a recession -- thus the old joke that
"economists have predicted twelve of the last eight recessions."
(b) inflation: faster Ms growth rates tend to cause higher rates of inflation
-- Likewise, increases in the money supply tend to cause the general price level to
increase.
-- Inflation is often described as "too much money chasing too few goods." When the
money supply increases faster than the productive capacity of the economy, inflation is
the usual result.
-- From international comparisons we see a tight relationship between money (M2)
growth rates and inflation rates. A hyperinflation (explosive growth of prices, inflation
rates of over 50% per month, or well over 1000% per year) is impossible without
extremely rapid money-supply growth.

Q: Since money supply growth is inflationary, and perfect price stability (0% inflation)
seems like an ideal, wouldn't we be better off keeping the money supply perfectly stable,
and not increasing it at all?
A: No. Money demand (people's demand for money for their transactions and savings)
increases virtually every year as the volume of transactions (real GDP) increases, and if
the money supply did not keep pace with money demand, then the economy would run
into serious problems -- cash shortages, sky-high interest rates, and probably recession.

(c) interest rates: other things equal, an increase in the Ms causes interest rates to
fall, enabling borrowers to get cheaper mortgages, cheaper student loans, cheaper car
loans, etc. (Likewise, a decrease in the Ms causes interest rates to rise.)
-- On the other hand, if a particular increase in the Ms is expected to be inflationary, then
interest rates will tend to increase, since higher inflation rates induce lenders to demand
higher interest rates and induce borrowers to accept higher interest rates.
The interest rate that really matters to borrowers and lenders is not the nominal
(posted) interest rate but the real interest rate, which is the inflation-adjusted
interest rate:

real interest rate = (nominal interest rate) - (inflation rate)

Ex.: In 1980, the inflation rate was about 13%. The (nominal) interest rate, was only
about 8%. Thus, in 1980,

real interest rate = 8% - 13% = -5%,

so bonds were a terrible investment, because the amount repaid had less purchasing
power than the original amount loaned out.

Banking
A bank is an institution which deals in money. It means that a bank receives money in
the form of deposits from public and lends money to development of trade and
commerce.

General History

A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and
Greece, which loaned at high rates of interest the gold and silver deposited for
safekeeping. Private banking existed by 600 B.C. and was considerably developed by
the Greeks, Romans, and Byzantines. Medieval banking was dominated by the Jews
and Levantines because of the strictures of the Christian Church against interest and
because many other occupations were largely closed to Jews. The forerunners of
modern banks were frequently chartered for a specific purpose, e.g., the Bank of Venice
(1171) and the Bank of England (1694), in connection with loans to the government; the
Bank of Amsterdam (1609), to receive deposits of gold and silver. Banking developed
rapidly throughout the 18th and 19th cent., accompanying the expansion of industry and
trade, with each nation evolving the distinctive forms peculiar to its economic and social
life.

History in United States

In the United States the first bank was the Bank of North America, established (1781) in
Philadelphia. Congress chartered the first Bank of the United States in 1791 to engage
in general commercial banking and to act as the fiscal agent of the government, but did
not renew its charter in 1811. A similar fate befell the second Bank of the United States,
chartered in 1816 and closed in 1836.

Prior to 1838 a bank charter could be obtained only by a specific legislative act, but in
that year New York adopted the Free Banking Act, which permitted anyone to engage in
banking, upon compliance with certain charter conditions. Free banking spread rapidly to
other states, and from 1840 to 1863 all banking business was done by state-chartered
institutions. In many Western states it degenerated into “wildcat” banking because of the
laxity and abuse of state laws. Bank notes were issued against little or no security, and
credit was over expanded; depressions brought waves of bank failures. In particular, the
multiplicity of state bank notes caused great confusion and loss. To correct such
conditions, Congress passed (1863) the National Bank Act, which provided for a system
of banks to be chartered by the federal government.

In 1865, by granting national banks the authority to issue bank notes and by placing a
prohibitive tax on state bank notes, an amendment to the act brought all banks under
federal supervision. Most banks in existence did take out national charters, but some,
being banks of deposit, were unaffected by the tax and continued under their state
charters, thus giving rise to what is generally known as the “dual banking system.” The
number of state banks expanded rapidly with the increasing use of bank checks.

Recurrent banking panics caused by over expansion of credit, inadequate bank


reserves, and inelastic currency prompted Congress in 1908 to create the National
Monetary Commission to investigate the banking and currency fields and to recommend
legislation. Its suggestions were embodied in the Federal Reserve Act (1913), which
provided for a central banking organization, the Federal Reserve System.

Banking basics

We know banks play a major role in the economy. They accept deposits from individuals
and use the funds to make loans to other individuals and companies. As a result, banks
channel money from one source to another source. Banking is primarily the business of
dealing in money and instruments of credit. Banks were traditionally differentiated from
other financial institutions by their principal functions of accepting deposits—subject to
withdrawal or transfer by check—and of making loans.
In the process of channelling money from savers to borrowers, banks can also create
more money than those initially deposited with the banks. This dealt under credit
creation. As a result, banks are targets of monetary policies in terms of controlling the
money supply in the economy.

Banks have traditionally been distinguished according to their primary functions.


Commercial banks, which include national and state-chartered banks, trust companies,
stock savings banks, and industrial banks, have traditionally rendered a wide range of
services in addition to their primary functions of making loans and investments and
handling demand as well as savings and other time deposits. Mutual savings banks, until
recently, accepted only savings and other time deposits, and offered limited types of
loans and services. The fact that commercial banks were able to expand or contract their
loans and investments in accordance with changes in reserves and reserve
requirements further differentiated them from mutual savings banks, where the volume
of loans and investments was governed by changes in customers' deposits. Membership
in the Federal Deposit Insurance Corporation is compulsory for all Federal Reserve
member banks but optional for other banks.

Other Financial Institutions

There are financial institutions that have not traditionally been subject to the supervision
of state or federal banking authorities but that perform one or more of the traditional
banking functions are savings and loan associations. These could be Mortgage
companies, finance companies, insurance companies, credit agencies owned in whole
or in part by the federal government, credit unions, brokers and dealers in securities, and
investment bankers. Savings and loan associations, which are state institutions, provide
home-building loans to their members out of funds obtained from savings deposits and
from the sale of shares to members. Finance companies make small loans with funds
obtained from invested capital, surplus, and borrowings. Credit unions, which are
institutions owned cooperatively by groups of persons having a common business,
fraternal, or other interest, make small loans to their members out of funds derived from
the sale of shares to members.

International Banks

There are also banks that lend mostly to Governments of countries. The International
Bank for Reconstruction and Development (World Bank) was organized in 1945 to make
loans both to governments and to private investors. The discharge of debts between
nations has been simplified and facilitated through the International Monetary Fund
(IMF), which also provides members with technical assistance in international banking.
The European Central Bank (see European Monetary System) was established in 1998
to help formulate the joint monetary policy of those European Union nations adopting a
single currency.
Structure of banking industry in U.S.

There were once over 15,000 banks in the U.S. There are still about 10,000 banks in
the U.S, thanks to mergers and amalgamations, a few hundred with assets over $1
billion and lots and lots of small banks that survive because of their expertise in
evaluating risks in a local area or an industry or in an ethnic community. This structure
arose because inter-state banking was restricted severely until very recently.

Changing banking business: Distribution of commercial bank assets and liabilities in


1960 and 1989.

Assets 1960 1989 Liabilities 1960 1989

Cash 20 8 Demand deposits 61 20

US Govt. 24 12 Savings and time deposits 29 38

State and Local securities 7 3 Large negotiable CDs 0 12

Other securities 1 2 Miscellaneous 2 24

Business loans 17 20 Capital 8 6

Mortgages 11 23

Consumer loans 10 12

Other loans 8 7

Miscellaneous 2 13

Interest Rates

One important place where money and banking intersect is in the determination of
interest rates.

Interest Rate = the cost of borrowing money; the "price" of money; one's rate of
earnings on money loaned out.

We say that Money and Banking intersect in the determination of interest rates because
the interest rate is the "price" of money, and interest rates are usually posted by banks.

Did you realise banking is a business like any other business involving asset liability
management and credit creation. We shall now examine how these two work.
Banking Business

The balance sheet of a commercial bank is shown:


ASSETS LIABILITIES

Cash/Reserves Deposits

Loans Borrowings

Securities Capital

Other Assets Loan loss reserves

Management of balance sheet in order to maximize profits is subjected to these


constraints:

• liquidity management

• capital adequacy

• credit risk management

• interest rate risk management

Liquidity management by banks

Balance Sheet of Safe Manhattan Bank


ASSETS LIABILITIES

Cash/Reserves 20 Deposits 100

Loans 80 Borrowings 0

Securities 10 Capital 10

Other Assets 0 Loan loss reserves 0

Total 110 Total 110

What can this bank do if there is a deposit outflow of 20?


Asset management - Can't very well allow reserves to go down to 0, so sell securities
of 10 and let reserves fall to 10:

ASSETS LIABILITIES

Cash/Reserves (20-10=) 10 Deposits (100-20=) 80


Loans 80 Borrowings 0

Securities (10-10=) 0 Capital 10

Other Assets 0 Loan loss reserves 0

Total 90 Total 90

What happens if there is a further deposit outflow of 10?


Liability management - Can't allow reserves to disappear, can't liquidate loans, so
borrow (Fed Funds, CDs, etc.):

ASSETS LIABILITIES

Cash/Reserves 10 Deposits (80-10=) 70

Loans 80 Borrowings (0+10=) 10

Securities 0 Capital 10

Other Assets 0 Loan loss reserves 0

Total 90 Total 90

Say the bank would like to make a loan of 10 to a new customer; it makes the loan by
creating a demand deposit for the customer:

ASSETS LIABILITIES

Cash/Reserves 10 Deposits (70+10=) 80

Loans (80+10=) 90 Borrowings 10

Securities 0 Capital 10

Other Assets 0 Loan loss reserves 0

Total 100 Total 100

Of course, the bank must be prepared for a deposit outflow when the loan customer
utilizes the loan, so the bank "funds" the loan through additional borrowing that adds to
reserves. The bank has now prepared itself for the deposit outflow.

ASSETS LIABILITIES

Cash/Reserves (10+10=)20 Deposits 80


Loans 90 Borrowings (10 + 10=)
20

Securities 0 Capital 10

Other Assets 0 Loan loss reserves 0

Total 110 Total 110

The borrower has now utilizes the loan so the deposit balances and reserves of the bank
decline by 10.

ASSETS LIABILITIES

Cash/Reserves (20-10=)10 Deposits (80 - 10=)70

Loans 90 Borrowings 20

Securities 0 Capital 10

Other Assets 0 Loan loss reserves 0

Total 100 Total 100

Further, the bank now discovers that the borrower is unable to pay back the loan and the
loan has to be be "written-off." The write off reduces loans and capital:

ASSETS LIABILITIES

Cash/Reserves 10 Deposits 70

Loans (90-10=)80 Borrowings 20

Securities 0 Capital (10-10=) 0

Other Assets 0 Loan loss reserves 0

Total 90 Total 90

Alas! The bank has a ZERO net worth. The capital of the bank has been eroded
completely. This might lead regulators to worry or close the bank or depositors to worry
or start a run on the bank.

What might the bank do:

1.Sell more equity: convince new investors that the deposit base is loyal and the
remaining loan assets are sound and that an equity investment will pay off.
2. Allow itself to be acquired or merged with another bank.
3. Make some very large risky loans with the hope that the earnings will build up
capital and if it doesn't work out - well the net worth is zero already.

Multiple Deposit Creation

Suppose that banks keep 1/5th of their deposits as reserves either as a legal
requirement or by choice in order to be prepared for withdrawals. Imagine that someone
comes along and deposits $10,000 in currency in Safe Manhattan Bank. Let’s see what
might happen. Safe Manhattan Bank experiences an increase in its cash (asset) and its
deposits (liabilities) of $10,000. The cash is placed in the vault and there is an increase
in the reserves (cash in the vault) and deposits of the Bank.

Changes in Safe Manhattan Bank’s Balance Sheet

*BANK RECEIVES DEPOSIT


Reserves +10,000 Deposits +10,000
Loans and Investments No change Net Worth No change
Total +10,000 Total +10,000

*BANK MAKES LOAN TO MS. SMITH


Reserves No change Deposits +8,000
Loans and Investments +8,000 Net Worth No change
Total +8,000 Total +8,000

*MS. SMITH SPENDS


Reserves -8,000 Deposits -8,000
Loans and Investments No change Net Worth No change
Total -8,000 Total -8,000

**BANK’s SUMMARY**
Reserves +2,000 Deposits +10,000
Loans and Investments +8,000 Net Worth No change
Total +10,000 Total +10,000

Bank realizes that it does not need to use all of the $10,000 in additional cash as
reserves. Since it only needs or wants to keep 1/5 of the additional deposit as
reserves, it finds that it only needs to keep $2000 as additional reserves. It then has
excess reserves of $8,000, which it can use to buy other assets -- make loans
and investments.

Customer, Ms. Smith, now comes to the bank to take out a loan to finance an increase
she would like to make in her business inventories. The bank judges this to be a good
loan and it lends Ms. Smith the funds ($8,000) and creates a demand deposit for her.
That is, it simply writes up an additional balance in Ms. Smith’s checking account. She
can then write a cheque to Ms. Jones, her supplier, to pay for the new inventories.

Ms. Jones then deposits the check in Highfly Bank then presents the check to Safe
Manhattan for payment. The check is cleared through the Federal Reserve System
where the deposits (reserves) of Safe Manhattan are decreased by $8,000 and the
deposits of Highfly Bank are increased by $8,000.

As a result of the increase in deposits of $10,000, Safe Manhattan is able to expand its
loans and investments by an additional $8,000. In addition, the money supply has
been expanded by $8,000 since Ms. Jones now has a demand deposit in Highfly Bank
of that amount which did not exist before.

Next, we follow the process to Highfly Bank where Ms. Jones has deposited the check
from Ms. Smith. Highfly Bank has cleared the check through the regional Federal
Reserve Bank and finds that it has both deposits and reserves that have increased by
$8,000.

Highfly Bank does not need or want to keep the full $8,000 as reserves. Highfly Bank’s
increases its by only $8,000/5 or $1600; the reserve ratio is 1/5. Highfly Bank’s now
has excess reserves of $8,000 - 1,600 = $6,400 which it can uses to make loans and
investments.

Suppose that the bank decides to buy $6,400 of bonds from a depositor, Mr. Green.
The bank credits Mr. Green’s account by $6,400 in return for the bonds, and Mr. Green
uses the proceeds of the sale to buy some furniture from Ms. Stone’s furniture store.
Ms. Stone takes the check from Mr. Green and deposits it in Sparklay’s Bank.

We can see several things from the T-accounts for Highfly Bank. The inflow of deposits
of $8,000 Highfly Bank required this bank to increase its reserves by only $1,600. The
bank found that it had excess reserves so that it was able to expand loans and
investments by $6,400. When it did so, it increased the deposits of Mr. Green by that
amount, increasing the quantity of money held by the public by an equal amount. Thus
Highfly Bank has contributed to an expansion of money by $6,400 -- this amount
eventually becomes additional deposits in Sparklay’s Bank. The money supply has
increased by $8,000 due to Safe Manhattan’s activities and by $6,400 from Highfly
Bank’s activities.

Changes in Highfly Bank’s Balance Sheet

*BANK RECEIVES DEPOSIT (CHECK WRITTEN BY MS. SMITH)


Reserves +8,000 Deposits +8,000
Loans and Investments No change Net Worth No change
Total +8,000 Total +8,000

*BANK BUYS BOND FROM ONE OF ITS CUSTOMERS - MR. GREEN


Reserves No change Deposits +6,400
Loans and Investments +6,400 Net Worth No change
Total +6,400 Total +6,400

*MR. GREEN SPENDS


Reserves -6,400 Deposits -6,400
Loans and Investments No change Net Worth No change
Total -6,400 Total -6,400

**BANK B SUMMARY**
Reserves +1,600 Deposits +8,000
Loans and Investments +6,400 Net Worth No change
Total +8,000 Total +8,000

The effect of the initial cash deposit of $10,000 at Safe Manhattan has spread beyond
Safe Manhattan. You should now try to trace the transactions that result from Sparklay’s
Bank’s deposit inflow of funds and see that Sparklay’s Bank will also be able to expand
bank credit and expand the money supply. The process goes on indefinitely. An
increase in reserves (from the initial deposit of cash) has a multiplier effect on the money
supply. In this simple example -- where every bank always holds exactly one-fifth of its
deposits in the form of reserves -- it is easy to figure out the total effect of the initial
inflow of reserves on amount of money and credit created by the banking system.

Because of the initial increase in deposits of $10,000, Safe Manhattan finds that it has
excess reserves of $8,000. It was this quantity of excess reserves that started the
process of credit creation and set the money supply expansion in motion. Highfly Bank
creates money and credit equal to $6400 = (4/5)*8,000. Sparklay’s Bank is able to
create money and credit equal to $5120 = (4/5)*6400 = (4/5)*(4/5)*8000. The process
continues indefinitely, with each successive bank in the process expanding money
and credit by 4/5 the amount of the previous bank. The net effect of the process is that
the money supply will be expanded by an amount that is 1/(1- (4/5)) = 5 times the initial
increase in excess reserves.

Banking services

A bank is the safest place you can stash your cash because funds in U.S. bank accounts
are insured against loss by the federal government for up to $100,000 per depositor.

The interest rate a bank offers on any given day is typically only guaranteed for seven
days. To earn a rate that's guaranteed for longer than that, you have to lock up your
money for three months to five years in a certificate of deposit (CD). If interest rates fall
before the CD expires, the bank is out of luck and must give you the high rate it quoted
when you opened the account. If rates climb, however, you're stuck with the lower rate
that you agreed to accept until the CD matures. And if you take your money out before
the CD matures, you'll pay a penalty -- typically forfeiting three months' or so of interest.

If you aren't careful, a simple checking account could cost you $200 or more a year, after
the monthly fee, the per-check fee and the ATM charges are added up. And while most
big banks offer "free" checking if you maintain a substantial balance -- typically $2,000 to
$4,000 -- the so-called opportunity cost of tying up your money in a low- or no-yield
account can be substantial.

A number of competitors offer accounts that resemble bank services. The most
common: Credit union accounts; mutual fund company money market funds; and
brokerage cash-management accounts.

Banks are convenient, because you can tap your account at the corner ATM at any hour
of the day or night. And they're safe because, in the United States and in many other
countries, bank deposits are insured by the federal government: the Federal Deposit
Insurance Corporation insures commercial banks and the Federal Savings and Loan
Insurance Corporation insures savings banks in the USA.

Since banks no longer rely on American's savings as a cheap source of capital that they
can turn around and loan out at a fat profit, they have to find other ways to book their
profits. That's where fees come in. For example, if you walk into one of the big-name
banks and ask to open a checking account, you're likely to be offered the most
expensive package. Cost per month: $6. Cost per check: 50 cents. Cost per ATM visit:
50 cents. Cost per bounced check: $25. No wonder the average annual price of
maintaining a checking account at a bank today is between $190 and $218.

You can earn significantly more on your money by putting it into a certificate of deposit,
but to do so you'll have to agree not to withdraw it for anywhere from three months to
five years. Recently, for example, a typical six-month CD paid 4.9 percent, while a five-
year CD paid 5.6 percent.

Online banking is gaining popularity world over. Online banking used to require bank-
specific software, but today it doesn't have to. What's behind that explosive growth? The
simple fact that, for people who are computer-savvy enough to be viewing this lesson,
banking online is the simplest and most effective way to keep track of your day-to-day
financial affairs. The tasks you accomplish are basic: checking balances of your savings,
checking, and loan accounts, transferring money among accounts and paying bills. But
doing so electronically saves you a bundle of time and, sometimes, a little money.

The bill-paying option, in particular, is much more efficient than doing things by written
check and mail. You simply enter the name and address of a recipient the first time you
make a recurring payment. Thereafter, your banking program or bank website
remembers the address. All you have to do is choose a payee, enter the amount and
select the date you want the payment sent. The bank then sends money to the payee by
wire, if possible, or prints and mails an old-fashioned check if the payee can't accept
electronic payments. Most bill-paying programs allow you to schedule recurring
payments by the month, week or quarter, which you might want to do for your cable or
mortgage bills. In addition, if you make a mistake in an electronic check, you can usually
un-schedule it if you catch the error at least five business days before the check was
scheduled to be issued.

Bank alternatives

It's becoming easier to do your banking without the bank. Here's how.
Checking and savings accounts are also offered by several types of non-bank
businesses. Here are three of the most common:

Credit unions
Credit unions operate much like banks, and accounts are similarly insured by the
National Credit Union Share Insurance Fund. And since credit unions are non-profit
organizations that exist to benefit their members, interest rates on accounts tend to be
higher, and fees and minimums, lower than at commercial banks. On average, for
instance, a credit union's yield on a money market account will be 1.25 percentage
points higher than at a commercial bank. However, credit unions generally offer fewer
services and provide fewer ATMs than commercial banks.
To join a credit union, you ordinarily must belong to a participating organization, such as
a labor union or a college alumni association. To know whether you are eligible, or to
locate a credit union, visit the Credit Union National Association at CUNA.org.

Summary

Money is a medium of exchange which is different from income and wealth. There is a
common saying that “Money is what money does”, which says it all. There are four
different measures of money referred to as M1, M2, M3 and L. The quantum has a
bearing on the health of the economy.

Free banking spread rapidly in the U.S. between 1840 to 1863. In 1865, national banks
were granted the authority to issue bank notes. Further, an amendment to the Act
brought all banks under federal supervision.

Banking is primarily the business of dealing in money and instruments of credit. In the
process of channelling money from savers to borrowers, banks can create more money
than those initially deposited with the banks. Commercial banks, which include national
and state-chartered banks, trust companies, stock savings banks, and industrial banks,
have traditionally rendered a wide range of services in addition to their primary functions
of making loans and investments and handling demand as well as savings and other
time deposits. Membership in the Federal Deposit Insurance Corporation is compulsory
for all Federal Reserve member banks but optional for other banks.

One important place where money and banking intersect is in the determination of
interest rates which gives the “price" of money for both the savers and the borrowers.
A number of competitors offer accounts that resemble bank services. Online banking is
gaining popularity world over.
Financial System

• Circular flow of money


• Functions of the financial system
• Financial Assets
• Financial Markets

o Classification of Financial Markets


o Nature of claim
o Maturity of claims
o Primary and Secondary
o Timing of delivery

• Financial Instruments:
o Classification of financial instruments in the money market
o Negotiable certificates of deposit (NCDs):
o Government stock and other short-term interest rate instruments
§ Bankers' acceptances
§ Treasury Securities
§ Commercial paper and other discount instruments

• Financial Intermediaries
o Commercial Bank
o Investment / Developmental Financial Institutions
o Insurance Companies
o Mutual Funds
o Non-Banking Financial Companies (NBFCs)
o Other Financial Institutions

• Regulatory infrastructure
o The Fed’s Structure:
§ Major Functions of Federal Reserve
o Securities and Exchange Commission (SEC)
§ Objectives of SEC
Circular Flow of Money

Susan is employed as an Engineer in California. A portion of her salary from the Company is paid
back to the Government in the form of taxes.

When the City of California receives those tax dollars, they hire Innovative Inc to lay optic fibre
cables within the California city limits. This helps Susan communicate better with her clients.

When Innovative Inc gets the contract to lay the cables, they hire a new worker, Joe Simon who
has been unemployed! Joe is now being paid reasonable wage. He banks some of his salary at
Douche Bank and gives some to his son, Arthur Simon.

Arthur Simon is now able to buy those new Nike designer boots he's been wanting since they
became a fad at school.

Meanwhile, Innovative Inc has been able to borrow some money from new deposits recently
made at Deustche Bank.

Innovative Inc is able to expand, increase its profits, and pay more taxes.

When the City of California receives this new tax revenue, it increases police patrols in the city
that makes it less likely that Innovative Inc, the Simon family, and Douche Bank will be victims of
crime.

Everyone is, therefore, happier and more secure. They are also more productive and this leads to
more spending that leads to more jobs that leads to increased incomes and tax revenues that
leads to more spending that leads to more jobs that leads to increased incomes and tax revenues
that leads to more spending that leads to more jobs that leads to more . . . and so on.

This is how the circular flow of money works in an economy.

An economy consists of two markets the product market and the factor market which is also
referred to as the input market. These two markets are connected through business and the
household sector.
In product markets, consumers buy goods and services that are produced by private businesses.
For example, students buy food, clothing, notebooks, paper, automobile insurance, and watch
movies at the theatre.

Consumers spend income to purchase these goods and services.

Businesses produce goods and services to sell in the product markets.

Businesses receive revenues for the sale of their goods and services.

Households provide labor and other factors of production to businesses in factor markets.

Households receive income for the factors of production that they provide. In exchange for work,
they expect to receive payment in the form of wages or salaries.

Businesses have costs of production for the labor and other factors of production they employ.

Businesses pay taxes on their profits. Businesses pay taxes to federal, state, and local
governments.
Governments provide public goods that facilitate business operations, such as fire and police
protection, roads, and the legal system. Governments use some of the tax revenue collected to
produce goods and services.

Governments make welfare payments and payments to members of the armed forces and other
government employees.

Households provide labor skills in the government. In exchange for the work they do as
government employees, workers expect to receive payment in the form of wages or salaries.

Households pay income, sales, and property taxes.

Governments provide public goods such as education, public health services, and parks. These
public goods are used by households.

Households save part of their income in financial institutions. Saving is income that isn't spent on
current consumption or taxes. Households earn interest on their savings.

Businesses borrow money from financial institutions. Financial institutions lend money that is on
deposit to businesses. Businesses use this money to invest in capital goods with which they may
build new factories or buy new tools and equipment. Businesses pay interest on these loans.

The financial system of an economy consists of


specialized and non-specialized financial institutions,
organized and unorganized financial markets
financial instruments and services which facilitates transfer of funds.

Financial System
Financial system comprises of a variety of markets, intermediaries and instruments that
are systematically related. It provides the mechanism for transforming the savings into
investments and eliminates information asymmetry. It is necessary that the financial
system work efficiently for the proper allocation of resources in an economy.

Funds Financial Institutions Funds


Banks, Insurance
Companies, Mutual
Deposits/shares Funds, Provident funds, Loans
Non-banking financial
Institutions

Funds
Supplier of Funds Demanders of Funds
Individuals Private
Individuals
Businesses Placement
Businesses
Governments Governments
Securities

Funds Funds
Financial Markets
Money Market
Capital Market
Securities Securities
The functioning of the financial system is characterised by an interplay of ‘supplier of
funds’ and ‘demanders of funds’ facilitated by financial intermediaries and financial
markets. The financial intermediaries are Banks, Insurance Companies, Mutual funds,
Provident funds, who mobilize savings and helps in the formation of capital, whereas the
financial markets are the place where the financial assets are exchanged.

Illustration:
Mr.Roger, CEO of Innovative Inc, is in need of funds for expansion. He has two
alternatives.
• Approach a Financial Institution.
• Raise Money in the Capital Market.

Morgan Stanley, the financial institution that he approached was not convinced about
financial stability of Innovative Inc and asked for a credit rating of Innovative Inc. Mr
Roger therefore subjected company to the scrutiny by CARE a credit rating agency.

Then, Morgan Stanley agreed to provide part of the finance provided his company is
listed in the NYSE. This requires that Innovative raises remaining money from the
Capital Market, through an Initial Public Offiering (IPO).

Credit Suisse agreed to underwrite the loan and Innovative completed its public issue
successfully. The requirement of funds was met.

The entire process of seeking and availing funds constitutes a transfer of surplus funds
from the household sector to the business sector which has been facilitated by the
financial institutions such as Morgan Stanley, CARE and Credit Suisse and financial
markets.

This is how the financial systems helps in the transferring of funds from the people with
surplus funds to those in need of funds.

All businesses have to constantly address questions such as:


* What is the capital investment that I should make?
* Where will I raise the money? and
* What will be the best mix of equity and loans?
These are the three broad areas of financial decision making, technically referred to as
Capital Structure, Capital budgeting and Working Capital Management.

The overall goal of financial management is to maximise the shareholder value of a


company.

As a finance manager you have to serve as the interface between the firm and the
financial system, since you have to negotiate loans from financial institutions, raise
resources from financial markets and invest surpluses in these financial markets. You
will be exposed to the conceptual framework for understanding how the financial system
works. The main topics to be covered to understand the working of a financial system
are
ü Functions of the financial system
ü Financial Assets
ü Financial Markets
ü Financial intermediaries
ü Regulatory infrastructure

Functions of the financial system


Given the nature of a financial system, there could be an imbalance in the distribution of
financial resources within a system. These imbalances can be over space or over time.
This financial system provides a mechanism for the redistribution of these funds over
space, time, across borders and among industries to even out the imbalances. During
the lean period of a business, the demand for funds will be slack whereas during the
peak season, the demand will exceed supply. A well-developed financial system in an
environment of skewed distribution of resources helps in distributing the resources
evenly.

The development of a financial system paves the way for managing uncertainty and
controlling risk by offering a variety of financial tools to overcome the vagaries of the
business and the opportunity for risk pooling and risk sharing for both households and
business firms. The commonly used instruments for the management of risk are
hedging, diversification and insurance. Hedging helps in shifting from risky assets to risk
less assets. A forward contract is a example of a hedging device. Diversification of
assets does not eliminate risk but only minimises it, by spreading the risk. An investor
instead of investing in one stock and risking his investment spreads the investment over
several stocks to minimise the risk of over exposure. Insurance is a mechanism that
enables the insurer to overcome the losses by entering into an insurance contract with
an insurance company in return for an insurance premium paid to the insurer.

Information plays a crucial role in decision-making. Lack of information could lead to


disaster in any business. A person without information could commit errors in decision-
making, known as adverse selection. Lack of awareness regarding a particular hazard is
likely to affect business adversely. An institution, which identifies this event, can offer
this information to the uninformed for a price. The financial system thus helps in reducing
the information asymmetry and helps in coordinating decision-making. For instance,
interest rates and security prices generated by the markets are used by households and
firms in making their consumption and savings decisions and in choosing the portfolio
allocation of their wealth.

Financial Assets
An asset is any possession that has value. It can be tangible or intangible. Land,
Building, Machinery, Vehicles, and investments are tangible assets and intangible asset
represents a claim for future benefits like patents, copy right, goodwill, brand name.
Suppose Pfizer Ltd buys a 10-year government bond carrying 6% interest, for a
consideration of $25 millions. The bond constitutes a tangible asset in the books of
Pfizer Ltd. Similarly, the investment on machinery, buildings, etc are tangible assets of
the company.

Pharmacia Ltd. buys the patent of a molecule for a drug from Pfizer Ltd for a
consideration of $20 million. This right to manufacture the drug is an intangible asset that
could be sold for a consideration, if Pharmacia Ltd. wishes.

Is a brand name an asset of a company?

Not until it is valued.

Classification of Financial Markets


Markets can be classified into different categories depending on the characteristic of the
market or instrument.

Nature of claim: Markets are categorised into debt markets and equity markets based
on the nature of the claim on the investment. Debt market deals with securities, which
have a fixed claim and are redeemed on a fixed date and the interest is fixed. For
example, bonds, debentures, fixed deposits etc. are the instruments in a debt market.
The equity market is the financial market where shares of companies are traded. The
values of the equity shares represent the net worth of the company, which is referred to
as the residual claim of equity instruments.
Maturity of claims: Based on time for maturity financial instruments are of two types–
short term and long term. The money market deals with short term instruments for
example treasury bills and short term bonds. The capital market deals with long term
debt and equity instruments, such as debentures and shares.

Primary and Secondary: New issues made directly to the investors is called primary
markets and the market where existing securities are traded is called secondary
markets.

Timing of delivery: Instruments where the date of transaction and the date of execution
of the transaction are different, are classified into:

Spot Market: where, the closing of the transaction and the delivery of the goods take
place simultaneously or within a short span.

Forward Market: The forward market is the market where a transaction is closed in the
present, and the settlement of the transaction and the delivery of goods are in the future.
The delivery date and the price are determined at the closing of the transaction.
Debt market

Nature of Claim Equity market

Money market
Maturity of claim
Capital market

Primary market
Primary and Secondary
Secondary market

Cash or spot market


Timing of Delivery
Forward market

Are the stock markets a primary market for securities?

The stock market is a market of secondary sale of stocks and securities and therefore
it is a secondary market and not a primary market.

Financial Instruments:
Financial Instruments facilitate the transfer of funds from the supplier to the borrower.

An intermediary seeks to address the different needs of the borrower and supplier
through negotiations and financial instruments. A certificate would be issued to the
lender, giving him the right to interest payments and the principal amount at the time at
its expiry date. This certificate is called security. Large financial transactions involving
the lending and borrowing of money, which are done through intermediaries, are often
structured and standardised regarding:

• the amount of the loan or investment

• the interest paid and received thereon

• the period of redemption of the loan.


these standards created for transactions are incorporated into financial instruments, in
order to enhance the marketability and tradability of these securities,

Where Morgan Stanley borrows money and gives the lender (investor) a certificate
promising to pay him $100 thousand, on 1 June 2005 and interest of 11,00% per annum,
is an example of a financial instrument called “promissory note”, representing the
contract between the lender and borrower. Instruments like debentures issued by a
company are called “primary securities”. Instruments like long term bonds issued by
intermediaries like a bank or a government on behalf of the ultimate borrower are called
“indirect securities”.

The discount rate of the treasury bill is a reflection of the demand and supply position
of short term funds.

Yes. Discount rates of treasury bills is determined by demand and supply of short
term funds.

Classification of financial instruments in the money market

There are basically two types of instruments issued and traded in the money market,
namely:

• Instruments which pay interest on the amount invested, where the interest is
normally paid to the holder of the instrument (the lender), together with the
redemption amount on the date of redemption. Interim interest payments may be
made in certain cases. These instruments are called interest instruments.
Instruments in this category include:
- Negotiable certificates of deposit (NCDs)
- Short-term government securities
- Interest rate instruments issued by the private sector, with terms to
maturity of less than three years.
• Instruments that do not pay interest on the amount invested, but are issued at a
discount on the nominal value (the redemption amount). These instruments are
called discount instruments. Instruments in this category include:
- Bankers' acceptances (BAs)
- Treasury bills (TBs)
- Commercial paper

Negotiable certificates of deposit (NCDs):


A negotiable certificate of deposit is a certificate issued by a bank for a deposit made at
the bank. This deposit attracts a fixed rate of interest, which is normally payable to the
holder of the instrument together with the nominal amount invested, at redemption date.
NCDs are bearer documents, which means that the name of the owner (holder or
depositor) does not appear on the document. The bearer or holder of the document will
receive the maturity value at maturity date.
Example:

The maturity value of an NCD will be the nominal amount deposited plus the interest for
the period. If for instance a deposit of $1 Million is made on 1 March for a period of 5
years, and interest paid on the amount is 8%, the maturity value is calculated as follows:
Nominal amount $ 1000000
Interest $ 469328
Maturity Value $ 1469328

The holder can sell the instrument to another party before the redemption date.
Remember that financial instruments are traded between parties on a yield to maturity
(expressed as an interest rate) basis, because interest is the price that is paid for money
borrowed. The buyer will be the new holder, and he may present the NCD to the bank on
redemption date to receive the maturity value of $469328 or sell it in the secondary
market prior to maturity.

Government stock and other short-term interest rate instruments


Government stock and other private sector instruments are normally issued for long-term
periods with more than one interest payment before redemption. Where the term to
redemption of a government stock or other interest rate instrument for short term in the
money market category.

Bankers' acceptances

A bankers' acceptance is also called as Bill of Exchange. It was invented to suit the
needs of a party requiring temporary finance to facilitate the trading of specific
goods. The party needing finance would approach investors for this temporary
finance. The investors or lenders would then lend a certain amount to the borrower in
exchange for a document called Bill of Exchange, stating that the debt would be paid
back on a certain date in the short-term future. For this arrangement to be attractive to
the lender, the amount paid back by the borrower (called the nominal amount) would
have to be more than the amount advanced by the lender. The difference between the
amount advanced and the amount paid back (the nominal amount) is known as the
discount on the nominal amount. The two parties would normally be brought together by
a bank.

The redemption of the loan would have to be guaranteed by a bank, called the
acceptance by the bank making the arrangement. Thus the name "bankers'
acceptance".

The bearer of the document may, at the redemption date approach the bank who will
pay the nominal amount to the holder. The bank will then claim the nominal amount
from the borrower.
A bank acceptance can, in formal terms, can be described as an unconditional order in
writing
• addressed and signed by a drawer (the lender)

• to a bank which signs the document and becomes the acceptor


• promising to pay a certain amount of money at a fixed date in the future

• to the bearer or holder (the borrower) of the document (the acceptance).

Example
Since there is theoretically no interest payable on a bankers' acceptance, the investor
would want to pay less than the nominal amount for the acceptance in order to receive a
certain yield on his investment when, at redemption, he receives the nominal amount
from the borrower. The rate quoted on a bank acceptance is the rate of discount on the
nominal amount of the acceptance that is used to calculate the amount advanced by the
lender. The rate is given as an annual rate.

In the following example a BA (bank acceptance) is issued at 12%. The nominal


amount of the BA is $ 1 Million and it is issued for 90 days.

The discount on this BA would be worked out as follows:


Discount = N x d/365 x di/100
where
N = nominal value
D = Tenure in days
di = discount rate as a fixed amount
In this case
Discount = $1000000 x 90/365 x 12/100
= $29589

The proceeds which the borrower (drawer) would get at issue date, which is equal to the
amount that the investor or lender would pay would be:
Proceeds = nominal amount - discount
In this case
Proceeds = $1000000 - $29589
= $970411

If the investor needs his money before the redemption date, this BA maybe sold in the
market to another investor who would then become the new lender. This can be done
because the BA is a bearer document.

Treasury Securities
The government issues treasury bills. They are discount instruments issued for the short
term, similar to BAs. The issue and redemption of these instruments are handled by
Central Bank on behalf of the government. Treasury bills are issued in bearer form, and
the bearer or holder of the instrument may present it for payment of the nominal amount
at redemption date. The Central Bank would normally pay this amount into the holder's
current bank account on the redemption date.
Weekly treasury bills are issued and allocated on a tender basis. These bills have a
tenor of 91 days and are allocated to interested parties who submitted tenders on these
bills.
Example:

Before a party will tender for a bill, he has to decide on the discount rate that he would
like to earn on his investment. This rate will probably be market related and not far from
the ruling BA rate.
If, for instance, a party decides on a discount rate of 12% on his investment, the tender
price that he would submit on 91-day treasury bills would be:
Price = 100 - (di x d/365)
where
di = discount rate the party wants to earn expressed as a fixed amount
d = tenure in days
In the above example the tender price submitted will be:
Price = 100 - (12 x 91/365)
= 97,008
In the calculation of the discount, proceeds and consideration if sold prior to redemption
date, the same formula as that used for the BA can be used.

Commercial paper and other discount instruments

Commercial paper refers to short-term unsecured promissory notes normally issued by


corporate companies with a high credit rating. These instruments are also issued on a
discount basis such as BAs. Because they are unsecured, the risk involved will be
higher than that of BAs, and therefore the issuing institution must be financially strong
and sound. Because of the risk attached to these instruments they would normally be
issued and traded at a higher discount than the prevailing BA rate.

Finance can be obtained by making use of various alternative kinds of discount


instruments. Other discount instruments that have been used are secured promissory
notes and asset backed commercial paper. The Central Bank also issue discount bills
from time to time. It is thus clear that finance, using money market instruments, can be
arranged between parties over the counter, as needs be. Standardised instruments as
discussed above are more liquid and tradable.

Financial Intermediaries
Financial intermediaries are firms that provide financial services and products. They
facilitate the operation of financial markets pooling research and expertise together with
scale economies. Examples are banks, insurance companies, mutual funds, investment
banks. These intermediaries are needed to match different financial needs such as the
need to borrow and the need to invest. Another example of financial intermediary is a
mutual fund which pools the financial resources of many individuals and invest it in a
basket of securities. It has a advantage of economies of scale in conducting research
and identifying investable stocks. Hence, it offers its customers a more efficient way of
investing than they could individually.
The structure of the financial intermediaries is depicted below:

Central Bank

Commercial Investment/ Insurance Mutual NBFCs Other


Banks Developmental Companies Funds Organizations
Financial Merchant banks,
Institutions Venture capital
and information
services

Intermediaries are important because they


• Reduce transaction costs
• Help in achieving Economies of scale
• Helps in overcoming Asymmetry in information
• Helps to Overcome Moral hazards

Commercial Bank: Commercial banks comprise public sector banks, foreign banks,
private sector banks and represents the most important financial intermediary in any
financial system. These institutions have a wide geographical spread and deep
penetration and strong deposit mobilizing ability. Bank credit is provided to all sectors of
the economy and the rural sector is accorded priority. They play very important role in
the money market and play a vital role in the call money market.
Invesetment / Developmental Financial Institutions: The developmental financial
institutions provide the long-term financial needs of corporations. These institutions have
been responsive to the growing and varied long term capital needs of economy. Their
wide range of activities may be divided into five broad categories, (i) direct financing,
(ii) indirect financing, (iii) assistance financing, (iv) promotional work, and (iv)
miscellaneous activities. Examples of investment financial intermediaries are: Chase
Manhattan Corporation, Credit Suisse First Boston, Aubrey G. Lanston & Co. etc.
Insurance Companies: Insurance companies provide life and property risk by collecting
premium. This premium is invested in both short and long term securities to earn profits.
Mutual Funds: Mutual fund is a collective investment arrangement. There are three
entities in a mutual fund, the sponsor, the trust and the asset management company.
The sponsor promotes the mutual fund. The mutual fund is organized as a trust
managed by board of trusties. This trust acts as an umbrella organization which floats
various schemes, in which the investing public can participate. The asset management
company is organized as a separate joint stock company which manages the funds
mobilized under various schemes.
Non-Banking Financial Companies (NBFCs): NBFCs engage in a variety of fund
based and non-fund based activities. The principal fund based activities are leasing, hire
purchase, bill discouting; and the non-fund based activities are merchant banking,
corporate advisory services, loan syndication and forex advisory services.
Other Financial Institutions: Merchant banks, venture capital firms and information
services are some of the other financial institutions. Merchant banks are firms which help
business, government and other entities raise finance by issuing securities. They also
facilitate merger and acquisitions and derivatives. Venture capital firms are somewhat
similar to merchant banks as they assist start-up firms. Young firms with limited capital
and managerial expertise require resources and advice in running their business.
Venture capitalists provide managerial support as well as capital.
Information Services: Many financial service firms provide information as supplementary
services. The well-known firms providing financial services are Credit Rating Agencies
like CRISIL, CARE and ICRA and capital market information services like Probity
Research and KPMG.

Regulatory infrastructure
A regulatory mechanism is needed to regulate the working of the financial system. Its
main function is to control compliance according to the regulations of the Central Bank,
commercial banks, financial institutions, insurance companies, non banking financial
institutions, exchange houses and official credit institutions, it is also responsible for their
supervision. It also inspects and supervises issuers registered in the Public Stock
Registry. It also supervise compliance with the dispositions applicable to the Pension
Savings System and Public Pension System, and especially administrative institutions
for Pension Funds, the Public Employee Pension Institute and the Social Security's
Disability, Old Age and Death Program.

The Federal Reserve and the Securities Exchange Commission(SEC) are the two
important agencies, responsible for regulating the money and capital markets.

The Fed’s Structure:


Federal Reserve refered to as ‘Fed’. It is an independent organization created by
Congress to maintain the value of money and the financial health of the system. The
seven-member Board of Governors is the main governing body of the Federal Reserve
System. The Board is charged with overseeing the 12 District Reserve Banks and with
helping implement national monetary policy. Governors are appointed by the president
of the United States, one on January 31 of every even-numbered year, for staggered 14-
year terms. The chairman and vice chairman of the Board of Governors are also
appointed by the president and confirmed by the Senate to serve a four-year term. The
nominees of these posts are selected from the Board membership.
Major Functions of Federal Reserve are:

1. to conduct the nation’s monetary policy,


2. to provide and maintain an effective and efficient payments system, and
3. to supervise and regulate banking operations.

Currency and Coin: Ensuring enough currency and coin in the economy.

Open Market Operations: Buying and Selling U.S. Government securities in the open
market to stabilize short-term interest rates.

Discount Rate: Fixes the discount rate that Federal Reserve charge financial institutions
for short-term loans of reserves.
The Reserve Requirement: Fixes the reserve requirement which is the percentage of
demand deposits that financial institutions must hold in reserve.
The Banker’s Bank: Fed provides services to financial institutions in much the same way
commercial banks serve their customers.

Automated Clearing House: Federal Reserve operates automated clearinghouse system


to handle payments. For larger transactions, debits and credits are usually transferred
electronically through Fedwire, a highly sophisticated, computerized communications
network that transfers funds almost instantly from one depository institution to another
anywhere in the country.

The Government’s Bank: Fed Reserve serve as bank for the Government by maintaining
accounts, providing services for the Treasury and by acting as depositories for federal
taxes.

Banking Supervision: The Federal Reserve has supervisory and regulatory authority
over a wide range of financial institutions and activities.

The Lender of Last Resort: Through the Fed's discount and credit operations, it provide
liquidity to banks to meet short-term needs stemming from seasonal fluctuations in
deposits or unexpected withdrawals.
International Services: Federal Reserve performs services for foreign central banks and
for international organizations.
Securities and Exchange Commission (SEC)

The Securities and Exchange Commission (SEC) supervises and helps in developing
capital market of the country.

The SEC supervise the capital market in the five main areas:
(a) establishing basic financial infrastructure and institutions for market development
(b) laying down rules, regulations, and legal framework,
(c) broadening opportunity for private sector to operate securities businesses,
(d) supervising and examining securities businesses, and capital market and
(e) promoting international relations

Objectives of SEC

1) To maintain market fairness by creating equal and unbiased disclosure of information


for investors.

2) To enhance efficiency of the capital market.

3) To maintain long-term stability of the financial system.


4) To strengthen international competitiveness of the capital market.

SUMMARY
* The financial system consists of a variety of institutions, markets and
instruments. It provides the means of transforming savings into investments.
* Financial system provides payment mechanism, enables pooling of funds,
facilitates management of uncertainity, generates information for decision making
and helps in dealing with information asymmetry.
* Financial markets are markets where financial assets are exchanged. The
financial markets play a very important part in the working of an economy.
* Financial Markets facilitates price discovery, provides liquidity and reduces the
cost of transaction.
* The important basis of classifying financial assets are based on type and maturity
of claims, fresh and outstanding issues and nature of delivery.
* The market for securities issued for the first time is called a primary market and
market where instruments are traded subsequent is called the secondary market.
* The money market deals with instruments of short term securities, whereas the
capital market deals with long term debt or equity instruments.
* Financial intermediaries are the firms that engage in providing services and
products. They facilitate the operation of the financial markets.
* Financial intermediary seek to merge needs and demands of borrowers and
lenders through negotiations of financial instruments.
* The Central Bank regulates the functioning of the financial intermediaries and
formulates the monetary policy of the country. The Securities Exchange
Commission supervises the working of the capital market and its constituents.
MUTUAL FUNDS

Ø Benefits of investing in a mutual fund


Ø Risks of a mutual fund
Ø Advantages do mutual funds have over individual securities
Ø Kind of income from a mutual fund
Ø Best way to buy mutual funds
Ø Common mistakes people make when choosing mutual funds
Ø Net asset value
Ø Measuring the growth of a Mutual Fund
Ø Factors responsible for the huge growth in mutual fund assets
Ø Types of stock funds
• Value funds
• Growth funds
• Income funds, Equity income funds, Balanced funds
• Sector funds
• Money market funds
• Municipal bond funds
• Index funds
Ø Risk in Mutual Fund Investing
MUTUAL FUNDS
Don't want to mess around with individual stocks or Bonds?
Don't have much money to invest?
Want diversification and professional management?
Seeking price appreciation or income?

Mutual funds are the answer, whether you're interested in stocks, bonds,
government securities, international securities, foreign currencies or options.
Every imaginable investment objective is included in the more than 8,000 funds
with assets exceeding $4 trillion. Some have no minimum initial investment
requirements, while others require a modest outlay of $500 or less. This gives
you access to the market and a chance to add to your holdings in small
increments.

Mutual funds are investment companies that raise money from shareholders to
pool it for the purpose of investing in many securities. Because they can buy and
sell large blocks, their brokerage costs are lower than commissions paid by
individuals.

Mutual fund companies have professional management, with a portfolio manager


to monitor its holdings and decide which to buy, hold or sell. Shares are sold to
the public at net asset value (NAV) price. How well your fund does will make the
difference between a rising or declining NAV. Most funds pay dividends every
quarter and capital gains distributions annually.

Fund families, which offer many different types of funds, permit switching from
one fund to another within the family as the market or your goals change. Most
offer free switching, although some impose small fees.

Benefits of investing in a mutual fund

Richard Shumway inherited a sum of $100,000 and wanted to put the money,
where it gives him the best and safe return. Though he has heard of investing in
stocks, he does not have the knowledge or the confidence to enter the market on
his own. He therefore sought the advice of a friend who told him “You can enjoy
many benefits by investing in mutual funds”. According to "The Investing Kit"
(Dearborn Financial Publishing, Inc., Chicago), mutual funds offer "professional
portfolio management, diversification, a wide variety of investment styles and
objectives, easier access to foreign markets, dividend reinvestment, ease of
buying and selling shares and exchange privileges. This will save Richard the
hazel of investing in risky market and enjoy the advantage of skilful investment
managers who can operate on a large scale and benefit from their research.

Risks of a mutual fund


Being a newcomer in the market, Richard was scared to invest in the market,
which he has heard, is very risky. How safe are mutual fund investments he
wondered.

The main one is that the companies in which the fund has invested will

* perform poorly,
* suffer mismanagement or
* otherwise meet with misfortune.

Another big risk is that some economic, political or other development will cause
the overall market to fall, dragging down with it the holdings of your particular
fund. These are risks you would face investing in individual stocks as well; at
least mutual funds can offer diversification. However, some risks are unique to
mutual funds. The fund management, for instance, may be doing things you don’t
know about or wouldn’t like if you did. What you think is a plain vanilla domestic
equity-income fund might, in order to boost returns, invest in derivatives, invest
overseas, or invest in growth companies that pay little or no dividend. In a
downturn, he could be in for an unpleasant surprise. There is also the risk that
the fund will under perform a benchmark index, which means that management
fees aren’t buying any added value.

Richard was a worried man. Would it be more advantageous investing in a


mutual fund than investing in the stock market? He met an investment
counsellor.

Advantages do mutual funds have over individual securities

The counsellor said there are several advantages in investing in a mutual fund
rather than in individual securities. One key advantage is that mutual funds are
generally more diversified Richard Shumway can enjoy the advantage of a
diversified portfolio and does not have to bother about studying investment
options, which takes a long time and requires some degree of skill. The Fund
Manager of the Mutual Fund takes this responsibility. A typical fund invests in
dozens of securities, which makes it possible for small investor like Richard
Shumway to achieve a level of diversification greater than they could on their
own or with less effort than they could on their own. There are bond funds for
every taste. If you want safe investments, consider government bond funds; if
you're willing to gamble on high-risk investments, try high-yield (aka junk) bond
funds; and if you want to keep down your tax bill, try municipal bond funds.

The funds are professionally managed, which logically should add to your
investment returns in the end. Investing in a mutual fund will also save you
paperwork headaches because the monthly and annual statements will
summarize short- and long-term gains, dividends and interest earned on your
account. Most also offer telephone and online trading, which makes buying,
selling or switching funds a snap. Idle cash can be automatically invested at
competitive rates in a money market fund and many companies offer unlimited
checking privileges, debit cards and credit cards, much as a bank would. You
can even designate a beneficiary so that, when you die, there will be none of the
delays and expenses of probate.

Income from a mutual fund

Mutual funds provide a simple and convenient way to meet various income
needs. It gives you a number of choices. In many cases, dividends are paid
monthly. Other funds, whose objective is growth of capital, generally pay much
lower income distributions. If Richard’s first decision is seeking to develop current
income, he should determine whether he wants the income to be tax-free or
taxable. The after-tax return on higher-yielding taxable funds may provide him
with less money after taxes than he will have from lower-yielding tax-free funds.
For instance, if he is in a 28% tax bracket, he will keep only 72% of his taxable
income. In addition, a tax-free income, invest in a good municipal bond fund may
yield him much more. There is also a diverse group of funds whose investment
objective is to pay a high level of current income that is not tax-exempt. They fall
into two categories: those holding securities issued or backed by the U.S.
government (or its agencies) and those holding securities issued by domestic
corporations or foreign companies and governments. Richard was informed that
Mutual fund shares are not federally insured or backed by the U.S. government.

Best way to buy mutual funds

Richard was convinced that his investment has to be in a Mutual Fund as it


combines the best of returns of the stock market and the safety of an investment
in Bonds. He was not sure how he would go about selecting a mutual fund and
he heard about no-load, load, front end, back end and trailing load funds. He met
an investment counsellor who told him that one of the great opportunities
available to investors today is the ability to buy into diversified, professionally
managed portfolios of stocks and bonds with no commissions. This is easily done
by investing in no-load mutual funds.

Examples of mutual fund choices that can fit Richards personal goals for saving,
retirement or education include:

1. High-risk investment funds offer the greatest potential for capital


appreciation but also greatest risk and volatility, such as aggressive growth
funds, growth funds, small-capitalization stock funds and specialty funds.
2. Medium-risk funds invest in higher-quality, safer instruments with
potential for capital growth, income or both, such as growth-and-income funds,
growth funds, balanced or equity-income funds and tax-exempt municipal bond
funds.
3. Low-risk funds feature investments with safety, stability and little risk,
such as money-market funds, U.S. government money-market funds, fixed-
income funds and tax-exempt funds.

There are two basic types of funds:

1. "No-load" (no sales charge) funds generally sold directly when you
send a check in the mail.
2. "Load" (sales charge) funds sold by brokers who receive a commission.

After that, the plot thickens. Some load funds come in more than one class of
shares, such as "A" shares with a front-end load and "B" shares with a back-end
load, paid when you sell your shares. There are also "C" shares with no front-end
or back-end fee, but an annual one-percent distribution fee on top of the typical
annual expenses.

No-brainers

Another type of fund, known as an index fund, doesn't try to beat the
performance of the overall market, but tries to equal it. Its manager buys a
portfolio that is a mirror image of a popular index such as the Standard & Poor's
500 or about 40 other indexes. Through many periods, these funds outperform
the majority of active fund managers. Another choice is a quantitative fund, which
employs computers to buy stocks in industries or specific stocks likely to beat the
market.

These funds sell shares directly to the public without a sales charge. More than
700 no-load funds are priced daily in the mutual funds section of The New York
Times, The Wall Street Journal, Barron’s and other major newspapers. Although
there are no upfront charges, there are, of course, expenses and management
fees.

Example: Richard Shumway buys 100 units of American Scandia Advisor Funds
at the NAV of $28.50 with a front load of 5%. This will mark-up the price to
$29.925, which includes the commission or load. The total cost of the investment
would be $2992.50.

Choosing a Mutual Fund

When examining a mutual fund's performance, look for:


• Consistency of returns year after year. Buying the top funds of the prior year
can often be a dismal failure, since high flyers often come crashing down to
earth.
• Tolerable risk and low expenses.
• Tax efficiency, which can vary considerably between funds. Many magazines
and newspapers publish the percentage of a fund's total return that an
investor in a 28-percent tax bracket would have kept after paying taxes on
income and capital gains distributed by the fund over the past three years.

Investing in mutual funds requires homework, setting goals, selecting appropriate


funds and hanging in there for the long haul. Daily returns are published in your
local newspaper. Many magazines and advisory publications (such as
Morningstar Mutual Funds and the Value Line Mutual Fund Survey) present
longer-term results. It's easy to determine whether your carefully chosen funds
are winning or losing the investment game.

Richard wasn’t sure how many funds he should invest in to reduce the risk.

He was told by the investment counsellor that the primary reason why many
people invest in a mutual fund is to diversity their portfolio. Since funds typically
own dozens or even hundreds of different stocks or bonds, they provide much
broader diversification than you could hope to get by investing in individual
securities by yourself. Some investors take this farther and buy shares in many
different mutual funds. While it’s usually wise to invest in different kinds of funds,
owning three or four with different investment goals probably is enough to
achieve sufficient diversification.

Richard had come into a lot of money at the young age of 28, and wanted a
mutual fund that will reinvest the interest so that the growth of his investment
would be rapid and the investment will grow to a large sum later. He was told that
there is dividend reinvestment plan called DRIP.

This plan, offered by a company or mutual fund, allows investors to reinvest their
regular dividends in the company’s stock or the mutual fund’s shares. If you take
part in a dividend reinvestment plan, also known as a DRIP, the company won’t
send you a regular dividend check. Instead, the money will be used to purchase
additional shares on your behalf, commission-free, and sometimes at a discount.

Net asset value

The net asset value, or NAV, is the price at which you buy or sell shares of a
mutual fund. To determine the NAV, a mutual fund computes the value of its
assets daily by adding up the market value of all the securities it owns,
subtracting all liabilities, and then dividing the balance by the number of shares
the fund has outstanding. The NAV is the figure you look at in the newspaper to
see how much your mutual fund investment rose or fell the previous day. . If a
mutual fund has a portfolio of stocks and bonds worth $10 million and there are a
million shares, the NAV would be $10. A fund's NAV changes every day,
depending on the price fluctuations of the fund's holdings.

The NAV is the price at which you can buy and sell shares, as long as you don't
have to pay a sales commission, or "load." If you're buying directly from a fund
company such as Fidelity or T. Rowe Price, you don't have to worry -- loads
come up only when you buy from a broker, financial planner, insurance agent, or
other adviser.

Returns aren't everything -- also consider the risk taken to achieve those returns.

Measuring the growth of a Mutual Fund

λGrowth of $1,000 over Time


–Example: a cumulative total return of 259.45% means that
$1,000 invested 10 years ago has earned $2,594.50 and the
investment is now worth $3,594.50
–Assumes that All Dividends Are Reinvested as They Are
Earned Each Quarter
λAverage Annual Total Return (AATR)
Expresses the Cumulative Return as a Yearly Average: 13.65%
for the Above
American Scandia Advisor Funds
The Risk Adjusted Rate of Return (RAROR)
Adjusts a Funds AATR by Its Beta Value and Compares this
Adjusted Return to the Overall Market Return
RAROR = (AATR/Beta) - S&P 500 Return
Example:
AATR = 13.65%, Beta = 0.86, S&P 500 Return = 14.39%
RAROR = (13.65%/0.86) - 14.39%
= 15.87% - 14.39%
= + 1.48%
λA Positive RAROR Indicates Good Fund Management
λA Negative RAROR Indicates Poor Fund Management
λ It is Important to Have + RARORS Consistently Over
Time--Do Not Rely Too Heavily on One Year’s
Number
Before buying a fund, look at how risky its investments are. Can you tolerate big
market swings for a shot at higher returns? If not, stick with low-risk funds. To
assess risk level, check these three factors: the fund's biggest quarterly loss,
which will help you brace for
the worst; beta, which NAV Calculation of a Mutual Fund
measures a fund's Company # of Shares Price per Total
volatility against the S&P Owned Share Value
IBM 100 $120 $12,000
Xerox 100 80 8,000
GM 100 70 7,000
Value of the fund’s portfolio $27,000
Number of shares issued 1,000
Fund X’s NAV $ 27.00
500; and standard Index funds track the performance of market benchmarks,
such as the S&P 500. Such "passive" funds offer a number of advantages over
"active" funds: Index funds charge lower expenses and be more tax efficient, and
there's no risk the fund manager will make sudden changes that throw off your
portfolio's allocation. deviation, which shows how much a fund bounces around
its average returns. Any fund can -- and probably will -- have an off year. Though
you may be tempted to sell a losing fund, first check to see whether it has trailed
comparable funds for more than two years. If it hasn't, sit tight. But if earnings
have been consistently below par, it may be time to move on.

Factors responsible for the huge growth in mutual fund assets

There are now approximately 7,000 actively managed mutual funds in the United
States, with wide variations in size, age, purpose and policy. The oldest have
been in existence for more than 65 years; many have been established in the last
5 years. Some have only several million dollars under management, while others
measure their assets in the tens of billions. The greatest growth of mutual funds
occurred after World War II and has continued since with only occasional
pauses. In 1946 mutual fund companies managed just over $2 billion in assets.
By 1956 this had grown to $10.5 billion, and to more than $39 billion in 1966. In
the 1980s growth exploded, jumping from $64 billion in 1978 to more than $1
trillion by the end of 1991. Today, there are approximately $3 trillion dollars
invested in all types of mutual funds. While a great deal of this growth has
derived from the return on invested assets, most growth has come from new
money going into the funds. For example, according to the 1996-97 Directory of
Mutual Funds (Investment Company Institute, Washington, D.C.), the number of
funds has grown from 1,528 in 1985 to about 7,000 today. The number of
shareholder accounts has grown from 45.1 million in 1986 to about 150 million in
2000.

Types of stock funds

When searching for stock mutual funds, you're going to run into all sorts of
names and categories. They are usually pretty broad, and funds don't always live
up to their names -- but at least they give you an idea of what you are getting
yourself into. Here are some of the most common categories and sub-categories.
Type of Fund Objective
___________ _______________________________
Growth Price Appreciation over Time
Income High Current Return
Balanced Good Current Return with some Growth
Money Mkt. High Liquidity and Returns Better than
Bank Returns
Maximum Exploit Opportunities to Earn Very High
Appreciation Returns
Value Value investing
Sector Specialize in one sector
Muni Municipal and Government Bonds with tax exemption
Index Reduce the cost of investing and ensures average returns

Value funds

Value fund managers look for stocks that they think are cheap on the basis of
earnings power (which means they often have low price/earnings ratios) or the
value of their underlying assets (which means they often have relatively low
price/book ratios).

Large-cap value managers typically look for big battered behemoths whose
shares are selling at discounted prices. Often these managers have to hang on
for a long time before their picks pan out.

Small-cap value managers typically bottom-fish for small companies (usually


ones with market value of less than $1 billion) that have been shunned or beaten
down by other investors.

Funds within the small-company category can differ dramatically. At the T. Rowe
Price New Horizons fund, for example, the manager snaps up shares of small
and midsize companies with zooming profits. Meanwhile, the manager of the T.
Rowe Price Small-Cap Value fund is more likely to pass on such highfliers and
instead, fills his portfolio with shares of very small companies that are trading at
rock-bottom valuations.

Growth funds

There are many different breeds of growth funds. Some growth fund managers
are content to buy shares in companies with mildly above-average revenue and
earnings growth, while others, shooting for monster returns, try to catch the
fastest growers before they crash.

Aggressive growth fund managers are like drag-car racers who keep the pedal to
the metal while taking on some sizeable risk. The result: These funds often lead
the pack over long periods of time -- as well as over short periods when the stock
market is booming -- but they also have some crack-ups along the way. Consider
them only if you can afford to put away your money for at least five years and if
you won't bail out when faced with downdrafts of 20 percent or more.

Growth funds also invest in shares of rapidly growing companies, but lean more
toward large established names. Plus, growth managers are often willing to play
it safe with cash. As a result, growth funds won't zoom as high in bull markets as
their aggressive cousins, but they hold up a bit better when the market heads
south. Consider them if you're seeking high long-term returns and can tolerate
the normal ups and downs of the stock market. For most long-term investors, a
growth fund should be the core holding around which the rest of their portfolio is
built.

Income funds, Equity income funds, Balanced funds

These three types of funds have a common goal: Providing steady long-term
growth while simultaneously throwing off reliable income. They all hold some
combination of dividend-paying stocks and income-producing securities, such as
bonds or convertible securities (bonds or special types of stocks that pay interest
but can also be converted into the company's regular shares).

Growth and income funds concentrate more than the other two on growth, so
they generally have the lowest yields. Balanced funds strive to keep anywhere
from 50 to 60 percent of their holdings in stocks and the rest in interest-paying
securities such as bonds and convertibles, giving them the highest yields. In the
middle is the equity-income class. All three types hold up better than growth
funds when the market turns sour, but lag in a raging bull market.

All of these are for risk-averse investors and anyone seeking current income
without forgoing the potential for capital growth.

Sector funds

Rather than diversifying their holdings, sector and specialty funds concentrate
their assets in a particular sector, such as technology or health care. There's
nothing wrong with that approach, as long as you remember that one year's top
sector could crash the following year.

Money market funds

These funds invest primarily in bonds issued by the U.S. Treasury or federal
government agencies, which means you don't have to worry about credit risk. But
because of their higher level of safety, however, their yields and total returns tend
to be slightly lower than those of other bond funds.
That's not to say government bonds funds don't fluctuate -- they do, right along
with interest rates. If you can't tolerate swings of more than a few percentage
points, stick to short-term government bond funds. If fluctuations of five percent
or so don't cause you to break out in a cold sweat, then you can pick up a bit
more yield with intermediate government bond funds. If you plan on holding on
for several years and can handle 10 percent swings, long-term government bond
funds will provide even more yield.

Maximum appreciation funds

Let's spare the euphemisms. These are junk bond funds. They invest in debt of
fledgling or small firms whose staying power is untested as well as in the bonds
of large, well known companies in weakened financial condition. The potential
that these companies will default on their interest payments is much higher than
on higher quality bonds, but since these funds usually hold more than 100
issues, a default here and there won't capsize the fund.

There is more risk, however, and for that, you get higher yields -- usually three to
10 percentage points more than safer bond funds. These funds tend to shine
when the economy is on a roll, and suffer when the economy is fading
(increasing the chance of default).

Who should buy them: Investors who want to boost their income and total returns
and can tolerate losses of 10 percent or so during periods of economic
turbulence.

Municipal bond funds

Tax-exempt bond funds -- also known as muni bond funds -- invest in the bonds
issued by cities, states, and other local government entities. As a result, they
generate dividends that are free from federal income taxes. The income from
muni bond funds that invest only in the issues of a single state is also exempt
from state and local taxes for resident shareholders. Once you factor in the tax
benefits, muni funds often offer better yields than government and corporate
funds.

Index funds

With the best business schools in the country churning out a steady supply of
expensively educated MBAs who go to work for fund companies, you'd think
funds would have no trouble posting above-average returns. After all, fund
shareholders -- that's you -- are paying fund managers big bucks to find the best
stocks in the market.

But the fact is, the majority of funds don't beat the market in most years. That is,
you're better off mindlessly buying all the stocks in the Standard & Poor's 500
index or in the Wilshire 5000 index (which includes just about every stock on the
New York, American and Nasdaq stock exchanges) than paying someone to
select what he thinks are the best ones.

There are several reasons so many funds fall short. First, factor in investing costs
that fund companies incur -- the cost of research, administration, managers'
salaries and so on. That cost is borne by the shareholders and gets deducted
from returns. A fund manager needs to pick a lot of great stocks to make up for
those costs. Index funds, meanwhile, are much lower maintenance, and tend to
have much lower costs.

There are some caveats. Indexing seems to work better in some areas than
others. The case is most solid for large U.S. stocks and bonds, largely because
there is so much information on these big securities that it is tough for a fund
manager to gain an edge.

Active managers of small-cap funds have traditionally fared better against their
index -- the Russell 2000.

Index funds track the performance of market benchmarks, such as the S&P 500.
Such "passive" funds offer a number of advantages over "active" funds: Index
funds tend to charge lower expenses and be more tax efficient, and there's no
risk the fund manager will make sudden changes that throw off your portfolio's
allocation.

Risk in Mutual Fund Investing

Returns may vary, but funds that are risky tend to stay risky. So Richard should
be sure to check out the route the fund took to rack up past gains and decide
whether he would be comfortable with such a ride. Here are some risk measures
he should consider to gauge the risk.

Beta measures how much a fund's value jumps around in relation to changes in
the value of the S&P 500, which by definition has a beta of 1.0. A stock fund with
a beta of 1.20 is 20 percent more volatile than the S&P -- ie. for every move in
the S&P, the fund will move 20 percent more in either direction.

Standard deviation will tells him how much a fund fluctuates from its own average
returns. A standard deviation of 10 means the fund's monthly returns usually fall
within 10 percentage points of their average. The higher the standard deviation,
the more volatile the fund.

Worst quarter performance should be studied. This is a very straightforward


measure of risk: It merely shows the fund's worst quarterly return on record,
giving you a feel of what to brace yourself for.
SECURITIES AND SECURITY MARKETS
CONTENTS

Security Markets................................................................................................................................................Error! Bookmark not defined.

Market Movers ..........................................................................................................................................Error! Bookmark not defined.

Earnings growth ........................................................................................................................................Error! Bookmark not defined.

Interest rates...............................................................................................................................................Error! Bookmark not defined.

Money flows ..............................................................................................................................................Error! Bookmark not defined.

The hidden peril of inflation.....................................................................................................................Error! Bookmark not defined.

Stocks...................................................................................................................................................................Error! Bookmark not defined.

Different kinds of stocks...........................................................................................................................Error! Bookmark not defined.

By size Error! Bookmark not defined.

By style Error! Bookmark not defined.

By sector Error! Bookmark not defined.

Valuation Tools for Stocks .......................................................................................................................Error! Bookmark not defined.

Picking stocks for your portfolio..............................................................................................................Error! Bookmark not defined.

Diversified Portfolio .................................................................................................................................Error! Bookmark not defined.

Analysing Stock trends .............................................................................................................................Error! Bookmark not defined.

Buying stocks ............................................................................................................................................Error! Bookmark not defined.

Initial Public Offering ...............................................................................................................................Error! Bookmark not defined.

Employee Stock Options (ESOPS) ..........................................................................................................Error! Bookmark not defined.

Options & Futures .............................................................................................................................................Error! Bookmark not defined.

Options: time-sensitive investments ........................................................................................................Error! Bookmark not defined.

The skinny on futures................................................................................................................................Error! Bookmark not defined.

Mutual funds..............................................................................................................................................Error! Bookmark not defined.

Debt Funds....................................................................................................................................................................................................... 18

How a Bond Works.................................................................................................................................................................................... 19

Types of bonds ........................................................................................................................................................................................... 19

Non-Marketable Treasury Securities ........................................................................................................................................................ 20

Corporate bonds ......................................................................................................................................................................................... 20


Municipal bonds......................................................................................................................................................................................... 21

Maturity of bonds....................................................................................................................................................................................... 21

Negotiable certificates of deposit .............................................................................................................................................................. 21

Commercial paper ...................................................................................................................................................................................... 22

Repurchase Agreement (Repo) ................................................................................................................................................................. 22

Banker’s Acceptances................................................................................................................................................................................ 22
SECURITIES AND SECURITY MARKETS

Markets

Securities Markets is a broad term embracing a number of markets in which securities are
bought and sold. Markets are classified by the type of securities bought and sold there.
The broadest classification is based on whether the securities are new issues or
outstanding and owned by investors.

New issues are made available in the primary market; securities that are already
outstanding and owned by investors is usually transacted in the secondary markets.
Another classification is by maturity; Securities with maturities of one year or less
normally trade in the money market; those with maturities with more than one year are
transacted in the capital market. The existence of markets for securities is of advantages
to both issuers and investors. It benefits issuers as security markets assist business and
governance in raising funds. Investors also benefit from the market mechanism. If
investors could not resell securities, they would not acquire them and this reluctance with
reduce the quantity of funds available for industry and government. Those who own
securities must be assured of a fast, fair, orderly and open system of purchase and sale at
realistic prices.

From 1926 to 1999, the stock market returned an average annual 11.4 percent gain. The
next best performing asset class, bonds, returned 5.1 percent.

Unless you've been trapped on the planet Pluto for the last decade, you know that the
1990s witnessed the motherhood of Madonna, the return to space by John Glenn and the
biggest bull market in U.S. history. Between 1990 and 1999 alone the stock market more
than tripled.

And while stocks have not always performed so extraordinarily -- compounding at a


dazzling 18.1 percent annual rate for that time period -- they have usually been the best
performing asset class over time. Since 1926, stocks have returned an annual average of
11.4 percent. Over the same period, government bonds returned 5.1 percent, and "cash,"
the term used to describe Treasury bills and other short-term investments, has returned
just 3.8 percent.

If you're looking to invest money you may need in a year or two, the stock market can be
downright dangerous. Look no further than the Dow's 554-point drop -- a 7.2 percent loss
-- on October 28, 1997, and the 508-point drop on Oct. 19, 1987 -- a harrowing 22.6
percent loss -- to see what a difference a day can make. Then there are those bloody bear
markets, like 1973-74, when stocks fell 44 percent, and 1968-70, when stocks fell 37
percent, to remind you that the market may not be the best place to keep your down
payment for a house.

To cite a worst case example, if you had bought the stocks in the Dow Jones industrial
average at their peak in early 1966, you wouldn't have made any significant profit until
mid-1983 -- more than 17 years later!

Bonds of course are another story. And while they won't give your portfolio the kind of
kick that stocks will, nor are they likely to give it the same kind of thrashing. In 1994, the
worst single year for bonds in recent history, intermediate-term government bonds (that
is, Treasury securities with maturities of 7-10 years) fell just 1.8 percent. And in a good
year, like the one that immediately followed, they bounced back an impressive 14.4
percent.

In the sections to come, you'll find a brief overview of stocks, bonds and mutual funds
and a first look at the deleterious effects of inflation.

Market Movers

Forget the short-term swings. Here are the factors that really send prices up or down.

While the stock market often seems to behave like a manic-depressive who's been off his
medication, in fact it's quite rational--most of the time. Information about the economy
and the prospects of specific companies comes in, and the market reacts. Sometimes
those reactions are extreme, but they usually sift down to a handful of causes. As
legendary investor Warren Buffett likes to say, "Over the short term the market is a
voting machine. Over the long term, it's a weighing machine."

So why does the market seem so erratic? Because life in general is unpredictable. A war
here, a hurricane there. These things can occur without much warning, having effects on
the economy that no one could anticipate. The September 11th bombing on the World
Trade Centre sent world financial markets on a tailspin.

What's harder to explain is why the market can ignore obvious problems for a long time
and then suddenly overreact. Here's the reason: Investors have a hard time gauging the
magnitude of problems. Take the dramatic reaction to the Asian crisis in 1997 and the
tumult that followed in 1998. Though the experts knew that Asian banks had been
overextended for years, few realized how serious the problem was until Thailand
devalued its currency in the summer of 1997. Suddenly investors reassessed, and the
Dow Jones Index took a 544-point, one-day dive -- only to recover most of that ground
the very next day. Likewise, when the Russian government, which everyone knew was
teetering, defaulted on its debt a year later, the market was thrown into another tailspin.
But if you ignore the occasional surprises that roil the market and focus instead on its
long-term behaviour, you'll find three factors are key:

Earnings growth

Over periods of five years or more, stock prices closely track corporate profit growth.
And the longer the stretch of time, the more important earnings trends are. Indeed, since
World War II, an estimated 90 percent of the stock market's gain has come from profit
growth. That's where Buffett's weighing machine comes in. As profits add up over time,
the scale tips and prices rise, regardless of how investors have voted in any given day,
month or year.

Interest rates

In the short run, changes in interest rates can be more important than earnings. When
rates go up, all other things being equal, investors tend to pull money out of stocks and
put it into bonds and other fixed-income investments because the returns there are so
attractive. That brings stock prices down, and sends bond prices higher. On the other
hand, when interest rates come down again, once more with other things equal, then
investors tend to shift money into stocks, reversing the previous trend. Note, however,
that the operative phrase above is "other things equal." In real life, other things are rarely
equal, and so this relationship -- while true in general terms -- is hardly perfect.

Money flows

Demographics, tax laws and savings patterns all affect the rate at which money flows into
stocks, these are a few of the "other things". That can raise or depress stock prices. The
best example in the past decade has been the growth of pension funds. As baby boomers
took advantage of these and other tax-deferred retirement havens to shore up their
inadequate savings, the flow of money into mutual funds -- where most pension fund
assets reside -- gave stocks an extra boost.

The hidden peril of inflation

Most people think a market crash is the biggest danger to investors. Think again.

At an average annual growth rate of 11.4 percent a year, stocks will double your money
about every six years. Factor in inflation, which has historically run at about 3.1 percent
annually, and it will take closer to 10 years to double your actual buying power.
Likewise, bonds, which have historically grown at 5.1 percent annually, will double your
money every 13 1/2 years. After inflation, however, it will take 35 years.

If your money is in cash, you'll have to wait 19 years to double, assuming the cash earns
the historical 3.7 percent annual return. But even your grandchildren won't see the real
value of your money double. The reason? After inflation, it will take 139 years.

That's why, whenever you add up your gains or losses for a given period of time, you
have to add in the effects of inflation to understand how much further ahead or behind
you really are.
Stocks

The market can be a great place to turn savings into wealth -- or to lose your shirt. Here
are some fundamentals of investing wisely.

When you buy a stock, you're taking an ownership stake in a company. At some point,
just about every company needs to raise money, whether to open up a West Coast sales
office, build a factory or hire a new crop of engineers. In each case, they have two
choices: 1) Borrow the money, or 2) raise it from investors by issuing shares in the
company. Owner of a share in the company is a part owner with a claim, however small it
may be on every asset, and every penny in earnings.

Typical stock buyers rarely think like owners, and it's not as if they actually have a say in
how things are done. Owning 100 shares of Wipro makes you, technically speaking,
Azim Premji’s boss, but that doesn't mean you can call him up and give him a tongue-
lashing. Nevertheless, it's that ownership structure that gives a stock its value. If
stockowners didn't have a claim on earnings, then stock certificates would be worth no
more than the paper they're printed on. As a company's earnings improve, investors are
willing to pay more for the stock.

Different kinds of stocks

Not sure what a small-cap is? Or why you should care?.

There are more than 9000 stocks to choose from, so investors usually like to put stocks
into different categories. You can slice and dice the stock market into all sorts of different
groups, but the most common ways are by size, style, and sector.

By size

When talking about a company's size, we're referring to its market capitalization, the
current share price times the total number of shares outstanding. It's how much investors
think the whole company is worth. Ford, for example, has 1.6 billion shares outstanding,
and in February 2001, each share was trading for $28, for a total market capitalization of
$45 billion. Technically, if you had an extra $45 billion lying around, you could buy each
share of stock, and buy the whole company.
Is $45 billion a lot or a little? No official rules govern these distinctions, but below are
some useful guidelines for assessing size.

Sizing up a stock
Category Market Cap
Micro-cap less than $500 million
Small caps $500 million to $2 billion
Mid-caps $2 billion to $10 billion
Large caps $10 billion to $100 billion
Mega caps more than $100 billion

Large-cap companies tend to be established and stable, but because of their size, they
have less growth potential than small caps. As a result, over the long run, small-cap
stocks have tended to rise at a faster pace. Krispy Kreme Doughnuts, a relatively new
chain with a market cap of under $1 billion is slated to increases earnings at a 25 percent
over the next five years, and its stock more than doubled in 2000. General Electric, the
most highly valued company in the world with a market cap of more than $450 billion,
has posted steady long-term returns, but don't expect a double anytime soon.

But there's a trade-off: With less developed management structures, small caps are more
likely to run into troubles as they grow -- expanding into new areas and beefing up staff
are examples of potential pitfalls. Of course, even corporate titans get into trouble.
Witness the stock-price collapse of AT&T in 2000 -- stockholders lost more than 60
percent of their money. The collapse of Enron is another case in point.

By style

A "growth" company is one that is expanding at an above-average rate. Cisco, for


instance, increased its earnings at a rate of nearly 40 percent a year in the late 1990s -- the
average tends to run around 10 percent.

Catch a successful growth stock early on, and the ride can be spectacular. If you'd picked
up 100 shares of Cisco in 1995, your stake would have cost you a little more than $3,000.
By early 2001, that investment grew to $68,400. In India, if you had bought 100 shares of
Wipro in late 1997 it would cost you around Rs.70000. In December 2001, after a stock-
split you would have 500 shares worth Rs.8,50,000.

But again, the greater the potential, the bigger the risk. Growth stocks race higher when
times are good, but as soon as growth slows, those stocks tank. Cisco fell from grace in
2000, with a decline of more than 50 percent. Wipro also witnessed a similar fall during
2001.
The opposite of growth is "value." There is no one definition of a value stock, but in
general, its share price is in the dumps. Maybe the company has messed up, causing the
stock to plummet -- a value investor might think the underlying business is still sound
and its true worth not reflected in the depressed stock price.

A "cyclical" company makes something that isn't in constant demand throughout the
business cycle. For example, steel makers see sales rise when the economy heats up,
spurring builders to put up new skyscrapers and consumers to buy new cars. But when
the economy slows, their sales lag too.

Alcoa, the leading aluminium maker, grew its earnings by 16 percent -- well above-
average -- a year in the late 1990s, but might actually lose money if aluminium prices fall
in the next recession. Cyclical stocks bounce around a lot as investors try to guess when
the next upturn and downturn will come -- by the time you read aluminium prices are at a
high, Alcoa probably has already peaked.

By sector

Standard & Poor's breaks stocks into 11 sectors, and 59 industries. Generally speaking,
different sectors are affected by different things. So at any given time, some are doing
well while others are not. Generally speaking, finance, health care, and technology are
the fastest growing sectors, while consumer staples and utilities offer stability with
moderate growth. The other sectors tend to be cyclical, expanding quickly in good times
and contracting during recessions.

Sector watch
Sector Examples
Basic materials Nucor (steel)
International Paper (paper)
Capital goods Caterpillar (earth moving equipment)
Boeing (aircraft)
Communication services Verizon (local phone)
WorldCom/Sprint (long distance)
Consumer cyclicals Goodyear (tires)
Sony (electronics)
Consumer staples Anheuser-Busch (beverages)
Procter & Gamble (household products)
Energy Exxon/Mobil (petroleum)
Schlumberger (oilfield equipment)
Financial Citigroup (banking)
AIG (insurance)
Health care Merck (drugs)
Healthsouth (HMO)
Technology Cisco Systems (Internet infrastructure)
Nokia (cell phones)
Transportation General Motors (autos)
Norfolk Southern (railroad)
Utilities Southern Company (electric)
American Water Works (municipal water)

Valuation Tools for Stocks

When times are good, investors think the happy days will last forever, and they are
willing to pay exorbitant amounts for earnings. When times are bad, they assume the
world is ending and refuse to pay much of anything. In assessing how much a stock is
worth, investors talk about "valuation," the stock price relative to any number of criteria.
The P/E, for example, compares a company's stock price to its earnings.

Price/earnings (P/E) ratio: Everybody uses it, but not everybody understands it. The
actual P/E calculation is easy: Just divide the current price per share by earnings per
share. Just about every finance website with a quote box provides the P/E -- including
money.com. But what number should you use for earnings per share? The sum of the past
four quarters? Estimates for next year?

There is no right answer. The P/E based on the past four quarters provides the most
accurate reflection of the current valuation, because those earnings have already been
booked. But investors are always looking ahead, so most also pay attention to estimates,
which also are widely available at financial websites like money.com. Wall Street
analysts generally compute earnings per share estimates for the current fiscal year and the
next fiscal year.

The P/E can't tell you whether to buy or sell -- it is merely a gauge to tell you whether a
stock is overvalued or undervalued. Is a $100 stock more expensive than a $50 stock?
Maybe not. IBM, for example, was trading at $110 in February and was expected to earn
nearly $5 a share in 2001 -- a P/E of 22. Home Depot, meanwhile, was trading for just
$44 -- but it was slated to earn little more than $1 per share in 2001, for a P/E of around
40. So IBM, selling for more than twice the price of Home Depot, is actually the cheaper
stock, though not, necessarily, the better buy.
What's an appropriate P/E? Different types of stocks win different valuations. Generally,
the market pays up for growth. That's one reason Home Depot has a higher P/E than IBM
-- its earnings are growing at 23 percent annually, versus just 13 percent for IBM.
WIPRO’s figures in comparison is mind boggling to say the least.

To quickly compare P/Es and growth rates, use the PEG ratio -- the P/E, based on
estimates for the current year, divided by the long-term growth rate. Home Depot, with a
P/E of 40 and a growth rate of 23 percent, has a PEG of 1.7. In general, you want a stock
with a PEG that's close to 1.0, which means it is trading in line with its growth rate, but
for a quality company, you can pay more.

Also, don't get excited by rock-bottom P/Es -- some companies are doomed to low
valuations. One group the markets tend to penalize is cyclicals, companies whose
performance rises and falls with the economy. Ford, for example, is arguably the best-run
automaker and is highly profitable. But its P/E is just 10 -- and that's considered generous
for an automaker.

Price/Sales ratio: Just as investors like to know how much they're paying for earnings,
it's also useful to know how much they're paying for revenue here the terms "sales" and
"revenue" are used interchangeably. To calculate the Price/Sales ratio, divide the stock
price by the total sales per share for the past 12 months.

Like P/Es, Price/Sales ratios are all over the map, with fast-growers tending to get the
highest valuations. Cisco's Price/Sales ratio is more than 8, for example, while Ford's is
just 0.3.

Picking stocks for your portfolio

Although there are some 9,000 publicly-traded companies in the US, the core of your
stock portfolio should consist of big, financially strong companies with above-average
earnings growth. Surprisingly, there are only about 200 stocks that fit that description,
and we narrow down the list even further in the Sivy 100, a collection of our favorites
selected by money.com’s stock columnist, Michael Sivy. A good stock portfolio should
consist of 15 to 20 stocks in at least eight different industries -- but you don't have to buy
them all at once.

Since you want to be able to hold your stocks for a long time, they should offer a total
return higher than the 12 percent historical market average. You can estimate the likely
return by adding the dividend yield to the projected earnings growth rate -- a stock with
11 percent earnings growth and a 2 percent yield could provide a 13 percent annual total
return.
As a general rule, stocks with moderately above-average growth rates and reasonable
valuations are the best buys. Statistically, high-growth stocks are usually overpriced and
have a harder time meeting inflated investor expectations. The first thing to look at is the
stock's price/earnings ratio compared with its projected total return. Ideally, the P/E
should be less than double the projected return - a P/E of no more than 30 for a stock with
15 percent total return potential.

Diversified Portfolio

A well-balanced portfolio might include a couple of industrials, an example might be


Boeing, with 9 percent growth rates and 3 percent yields, selling at 17 P/Es. Consumer
growth stocks, maybe Wal-Mart, with 13 percent growth rates and 1 percent yields, at 23
P/Es. And perhaps a couple of tech stocks with 25 percent growth rates and 60 P/Es. If
you can average a 14 percent return over the next 10 to 20 years, you'll reach your
financial goals -- and probably outperform most pros as well.

How to buy stocks

When you're looking for a broker, you have full-service brokers and online brokers.

Full-service brokers are typically based on a percentage of your transaction price, but
start at about $70 for a 100-share trade. Notable names to choose from include Merrill
Lynch, Morgan Stanley Dean Witter, Salomon Smith Barney.

Online brokers register investors who can trade on the net. They charge $8 to $15 a trade.

Names to choose from include Ameritrade, Datek, E-Trade and NDB.

When trying to place a buy or sell order, you'll be faced with all sorts of questions:
Market or limit order? "Day only" or "Good 'till cancelled"" Here's the vocabulary you
need to know to place a trade.

If you place a market order with your broker, then you are saying that you're willing to
buy at whatever happens to be the prevailing price for the stock. If you have a specific
price in mind, you can set a limit order specifying the price you're willing to pay. If the
stock dips down to that level, your order will be automatically filled. Limit orders can be
left open for a single day, a day order or indefinitely good until cancelled.

After you've bought a stock, you can instruct your broker to sell it if the price drops to a
level you specify a stop loss order. That's a kind of insurance; it means that no matter
what happens to a stock's price you'll never lose more than a specified amount. In a
volatile market, however, setting a stop-loss order at 10 or 20 percent below the
purchase price will sometimes cause you to cash out of the stock on a momentary dip --
thus locking in a loss even though the shares may immediately head back upward.

Initial Public Offers (IPO)

Corporates, when in need of capital may decide to go public. The make an IPO to
investors to raise the capital. This constitutes a primary market sale.

A group of brokerage houses agree to underwrite an IPO, price the shares to probable
market demand, then sell those shares to investors. When IPOs are a hot commodity,
those shares go to favored customers and big institutional buyers.

Employee Stock Options (ESOPS)

More companies are handing out stock options, and to a much broader group of
employees. This lesson gives you vital information on how to handle ESO's.

An employee stock option gives you the right to buy "exercise" a certain number of
shares of your employer's stock at a stated price, the "grant," "strike," or "exercise" price
over a certain period of time, the "exercise" period.

Employee stock options come in two basic flavours: nonqualified stock options and
qualified, or "incentive," stock options, ISOs. ISOs qualify for special tax treatment. For
example, gains may be taxed at capital gains rates instead of higher, ordinary income
rates. Unlike ISOs, nonqualified stock options can be granted at a discount to the stock's
market value. They also are "transferable" to children and charity, provided your
employer permits it.

There are three main ways to exercise options. You can pay cash, swap employer stock
you already own, or borrow money from a stockbroker while, simultaneously, selling
enough shares to cover your costs. Conventional wisdom holds that you should sit on
your options until they are about to expire to allow the stock to appreciate and, therefore,
maximize your gain. There may be compelling reasons to exercise early. Among them,
you have lost faith in your employer's prospects; you are overdosing on company stock;
you want to lock in a low cost basis for nonqualified options; you want to avoid
catapulting into a higher tax bracket by waiting.

Options & Futures

Futures and options aren't for the faint of heart. These are sophisticated investments that
shouldn't be undertaken casually. Investors whose experience is limited to less volatile,
less leveraged and less risky vehicles like stocks or bonds should be aware that options
and futures markets require a much stronger stomach for risk. Even sophisticated
individual investors should not approach them without the counsel of qualified advisors.

Options: time-sensitive investments

Upon hearing the phrase "stock options," most people tend to think of high-rolling
executives who can now cash in on the incipient riches that induced them to join their
company several years ago. But there is another kind of option that you can get in on --
the publicly traded kind. This type of option involves the investor's belief about whether a
given stock or index of stocks will rise or fall in value within a set time period.

You can buy options to buy stocks, known as "calls" or options to sell them, "puts". A
call is a contract to buy a set amount of stock at a set price for a set time period,
regardless of what the market does in the interim. A put is a contract to sell a set amount
of stock. Accordingly, buyers of calls hope that the stock will increase substantially
before the option expires, so that they can then buy and quickly resell the amount of stock
specified in the contract, or merely be paid the difference in the stock price when they
exercise the option.
Conversely, buyers of puts are betting that the price of the stock will fall before the
option expires, thus enabling them to sell it at a price higher than its current market value
and reap an instant profit.
All options are contracts for what is known as a "wasting asset" -- that is, if the buyer of
an option does nothing, the option to buy or sell stock expires and the option becomes
worthless. In an investment world where many professionals subscribe to the buy-and-
hold philosophy of long-term investing, it is no wonder that these same professionals get
palpitations from the daily gyrations of the market. If they are speculating in options, they
can't be passive; the clock on options is always ticking.

Within the time frame in the options contract -- often a period of several months --
investors must evaluate the best time to exercise the options or face losing the money
they spent to buy them. In some instances, the least costly alternative is to do nothing, as
exercising the option would cost more than letting it expire. Nevertheless, holding
options forces investors to keep a close eye on the market each day, searching for the best
opportunity to buy or sell.

The skinny on futures

Futures come in many varieties. Some examples are contracts hinged to the future
performance of currencies, stocks, bonds or other assets. Insofar as a futures contract's
value is contingent on the performance of another asset, these types of futures technically
are a form of derivative. These can get extremely complicated. For example, some futures
are contingent on the S&P 500-stock index's performance. Others are tied to foreign
currencies, interest rates and precious metals.

The most traditional variety of futures is tied to commodities. These futures are contracts
that commit the investor to deliver or receive a quantity of specific goods -- anything
from pork bellies to live cattle to apples -- at a price determined by auctions held at a
futures exchange.

As with options, time is of the essence. Futures holders have a set amount of time to
decide what they're going to do. Unlike stocks, futures can't be bought and left
unattended for years. In this sense, they can be a nerve-wracking asset to own. Popular
exposure to commodity futures came in the movie "Trading Places," in which Eddie
Murphy and Dan Aykroyd gave the villains their comeuppance through buying and
selling futures in frozen concentrated orange juice. They retired wealthy after a quick hit.
If only it were that easy!

The amount invested in the futures contract is called the margin. The price of the
commodity itself is due when the contract expires. At this point, investors theoretically
would take or make delivery of the commodity concerned.

Does this mean that if you invest in futures, you'll someday find a huge pile of pork
bellies on your lawn with an astronomical invoice attached? Hardly.

Almost no one actually takes or makes delivery, and those who do use warehouses.
Before the contract expires, you can do what's known as "squaring your position" by
paying or receiving the difference in the current market price of the commodity versus
the price stipulated in your contract.

So, if few people are actually taking or making delivery of commodities, you might ask
why this market exists in the first place. The answer is to spread risk. For example, pork
producers have a pretty precise idea of what it will cost them to raise today's piglets into
tomorrow's pork chops. What they don't know is how much these chops are going to be
selling for when the grown pigs are slaughtered, in part because they don't know what the
supply will be. That's where investors come in. In buying pork futures, they buy a piece
of the risk that those in the industry face when they make long-term investments in their
livestock.

Despite the important economic role of futures, this investment is approached by many as
though it were radioactive. Indeed, futures can be risky, chiefly because they are highly
leveraged investments, meaning that large amounts of a given commodity can be
controlled with a small margin investment. Margin, after all, is essentially a performance
bond stating that you assume the financial risk of the commodity's volatile price.
Also, keep in mind that not all futures investing is speculation. There are two forms of
futures investors -- speculators and hedgers. Speculators use the leverage of futures to try
to score large profits, while hedgers use the market to offset, or hedge, risks to other
types of investments in their portfolios.

Above all, keep in mind that to win the game, you need the right marbles. The main
reasons that individual investors lose money on futures are that they are under-informed,
under-capitalized, and undisciplined, and so let their egos rather than their original plans
control their trading.

Mutual funds

Mutual funds offer a simple way to diversify your portfolio -- albeit at a cost.

The theory behind mutual funds is simple: Unless you have enough money to create a
diversified stock or bond portfolio on your own, you need the advantage of being able to
pool your money together with that of a lot of other investors. Then, a professional
money manager can invest that pool of money across enough investments to reduce the
risk of being wiped out by any single bad bet.

That's how a mutual fund operates. The fund is essentially a corporation whose sole
business is to collect and invest money. You join the pool by buying shares in the fund.
Your money is then invested by a team of professionals, who research stocks, bonds or
other assets and then place the money as wisely as they can. The managers charge an
annual fee -- generally 0.5 percent to 2.5 percent of assets -- plus other expenses. That
puts a drag on your total return, of course. But in exchange, you get professional direction
and instant diversification -- factors that have helped propel the number of funds to
something over 10,000.

There are several flavors of mutual funds. Funds that impose a sales charge -- taking a cut
of any new money that comes into the fund, or a cut of withdrawals -- are called load
funds; those that do not have sales charges are called no-load funds. Funds can also be
divided into open- and closed-end funds. Open-end funds will sell shares to anyone who
cares to buy; essentially, they are willing to invest any new money that the public wishes
to pump into the fund. Their share price is determined by the value of the underlying
investments, and is calculated anew each evening after the close of the U.S. markets.
Closed-end funds, on the other hand, issue a limited number of shares that then trade on
the stock exchange like stocks.

Funds also can be broken down by their investment strategy like Index funds, Growth
funds, Value funds, International Funds, Bond Funds etc.
Debt Funds

A debt security is evidence of a debt. It is sold to an investor with the promise that it will
be paid with or without interest at the end of a specified period. The debt's issuer, a
corporation or a unit of government, uses the proceeds of its sales to finance various
projects.

Some debts last as little as one day, while others last as long as forty years. Some are
secured by collateral such as revenue or physical assets. Some are unsecured and are
backed only by the creditworthiness of the company. All debt securities are issued with a
fixed face amount “par”. However, the issuer often sells them at a discount “below par”.
This gives the investor extra incentive to purchase the issue. For example, a debt can be
given a face value of $500 but be sold for only $450.

The instruments traded in debt markets are Bonds, Government Securities, Banker’s
Acceptances, Commercial papers etc.

Bonds
A bond is debt issued by either a federal, state or local government agency or a private
company. When you buy a bond, you’re effectively loaning the bond issuer your money.
With a bond, the issuer promises to repay your principal with interest.

There is no real difference between bond and note except in terms to maturity. Both are
debt instruments usually paying interest every six months but a note generally matures in
2 to 7 years, sometimes 10 years is the upper boundary. Bonds are of longer maturity,
from 7 to 30 or more years.
Companies and governments issue bonds to fund their day-to-day operations or to finance
specific projects. When you buy a bond, you are loaning your money for a certain period
of time to the issuer, be it General Electric or Uncle Sam. In exchange, the borrower
promises to pay you interest every year and to return your principal at "maturity," when
the loan comes due, or at "call" if the bond is of the type that can be called earlier than its
maturity. The length of time to maturity is called the "term."
Because a bond's life span and schedule of interest payments are fixed, bonds are known
as "fixed-income" investments. And because a bond represents an IOU, rather than an
ownership interest like a stock, bondholders go to the front of the creditors' line if the
issuer goes bankrupt. Stockholders stand at the rear.

Typically, the longer the maturity of a bond, the higher the coupon. For example, the
spread between five-year Treasury notes and 30-year bonds is often a full percentage
point or two. Why? Because the longer the term of the bond, the longer its owner will be
left earning a low rate if interest rates in general rise. And the greater the risk, the greater
the reward.
How a Bond Works

Here's a simplified example of how it works: Let's say that you paid $1,000 for a 30-year
bond that yielded 7 percent interest, or $70 a year. A year later, the rate for a comparable
new bond falls to 5 percent, which means it yields just $50 a year. Your old bond is now
going to be worth more, because investors are willing to pay more to get a $70-a-year
income stream than they will to get $50 a year. How much more? Since the interest rate
of your bond is now 40 percent higher than normal, its new price will be about $1,400, or
40 percent more than you paid for it. And its yield? Exactly 5 percent, since $70 a year is
5 percent of $1,400. (Note: the equation is not quite that simple, since your bond now has
only 29 years left to maturity and will be matched to other 29-year bonds, not new 30-
year issues.) Conversely, if rates jump from 7 percent to 9 percent, meaning new bonds
are paying $90 a year interest, the value of your bond will fall to about $778 -- because
your bond's $70 annual interest is 9 percent of $778.

Eventually, of course, when the bond matures, it will be worth $1,000 again. However, its
value will move up and down in the meantime, depending on what interest rates do. And
the longer the time to maturity of a bond, the more dramatically its price moves in
response to rate changes. That is, long-term bonds get hit harder than short-term bonds
when rates climb, and gain the most in value when rates fall. As a result, bond buyers
tend to divide into two classes: investors or speculators, who hope to make money thanks
to a decline in interest rates that sends bond prices higher; and savers, who buy bonds and
hold them to maturity as a way to earn a guaranteed rate of return.

Types of bonds

U.S. Treasuries are the safest bonds of all because the interest and principal payments
are guaranteed by the "full faith and credit" -- that is, the taxing power -- of the U.S.
government. Interest is exempt from state and local taxes, but not from federal tax.
Because of their almost total lack of default risk, Treasuries carry some the lowest yields
around. Nevertheless, because their safety is so alluring, Treasuries are among the most
liquid of debt instruments.

Treasuries come in several flavors:


§ Treasury bills, or "T-bills," have the shortest maturities -- 13 weeks, 26 weeks and
one year. You buy them at a discount to their $10,000 face value and receive the full
$10,000 at maturity. The difference reflects the interest you earn.

§ Treasury notes mature in two to 10 years. Interest is paid semiannually at a fixed


rate. Minimum investment: $1,000 or $5,000, depending on maturity.

§ Treasury bonds have the longest maturities -- 10 to 30 years. As with Treasury


notes, they pay interest semiannually, and are sold in denominations of $1,000.
§ Zero-coupon bonds, also known as "strips" or "zeros," are Treasury-based securities
that are sold by brokers at a deep discount and redeemed at full face value when they
mature in six months to 30 years. Although you don't actually receive your interest
until the bond matures, you must pay taxes each year on the "phantom interest" that
you earn. For that reason, they are best held in tax-deferred accounts. Because they
pay no coupon, zeros can be highly volatile in price.

§ Inflation-indexed Treasuries. Issued in 10- and 30-year maturities, these pay a real
rate of interest on a principal amount that rises or falls with the consumer price index.
You don't collect the inflation adjustment to your principal until the bond matures or
you sell it, but you owe federal income tax on that phantom amount each year -- in
addition to tax on the interest you receive currently. Like zeros, inflation bonds are
best held in tax-deferred accounts.

§ Mortgage-backed bonds represent an ownership stake in a package of mortgage


loans issued or guaranteed by government agencies such as the Government National
Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie
Mac) and Federal National Mortgage Association (Fannie Mae). Interest is taxable
and is paid monthly, along with a partial repayment of principal. Except for Ginnie
Maes, these bonds are not backed by the full faith and credit of the U.S. government.
They generally yield up to 1 percent more than Treasuries of comparable maturities.
Minimum investment: typically $25,000.

Non-Marketable Treasury Securities

§ Series EE bonds are savings bonds that pay interest when they are redeemed.
Investors purchase them for less than their face values and let them build up to full
face value at maturity. The maximum face value possible is $30,000. Series EE bonds
can be purchased at banks or through payroll deduction plans.

§ Series HH bonds are savings bonds that are sold at their face values. They pay semi-
annual interest. The denominations range from $500 to $10,000. Maturities range
from ten to twenty years.

Corporate bonds

Corporate bonds are issued by corporate entities and these bonds pay taxable interest.
Most are issued in denominations of $1,000 and have terms of one to 20 years, though
maturities can range from a few weeks to 100 years. Because their value depends on the
creditworthiness of the company offering them, corporates carry higher risks and,
therefore, higher yields than super-safe Treasuries. Top-quality corporates are known as
"investment-grade" bonds. Corporates with lower credit qualify are called "high-yield,"
or "junk," bonds. Junk bonds typically pay higher yields than other corporates.
Municipal bonds

Municipal bonds, or "munis," are America's favorite tax shelter. They are issued by state
and local governments and agencies, usually in denominations of $5,000 and up, and
mature in one to 30 or 40 years. Interest is exempt from federal taxes and, if you live in
the state issuing the bond, state and possibly local taxes as well. Note, though, that
Illinois, Kansas, Iowa, Oklahoma, and Wisconsin tax interest on their own muni bonds.
And the capital gain you may make if you sell a bond for more than it cost you to buy it
is just as taxable as any other gain; the tax-exemption applies only to your bond's interest.

Munis generally offer lower yields than taxable bonds of similar duration and quality.
Because of their tax advantages, though, they often return more -- after taxes -- than
equivalent taxable bonds for people in the 28 percent federal tax bracket or above. They
come in several flavors:

Maturity of bonds

Maturities range from one month to as long as fifty years. Some different maturity times
for different bonds are as follows:

Type of bonds Duration


Corporate bonds 10 to 40 years
Municipal bonds 1 to over 20 years
Municipal notes 1 month to 1 year
U.S. Government agency bonds 3 years and over
U.S. Treasury bonds 10 to 30 years
U.S. Treasury notes 2 to 10 years

Negotiable certificates of deposit

Negotiable certificates of deposit are issued in denominations over $100,000. They are
sold on the open market. The depositor of a negotiable CD is allowed to negotiate the
interest rate with the bank.

The secondary market is where investors can sell their CDs to other investors before
maturity if they need cash. However, the CDs must be $1 million or more in value to be
traded.
Negotiable CDs have maturities ranging from 14 days to more than one year. Their rates
are closely tied to the going rate of Treasury bills. They are the only interest-bearing
money market instruments. They are liquid and considered relatively safe.

Credit unions issue negotiable certificates of deposit called credit union shares.

Commercial paper

Commercial paper is an unsecured, short-term IOU issued by corporations with good


credit. These corporations use them to buy inventories. Companies discount and sell
commercial paper to other companies and sometimes to individual investors. Maturities
are 270 or fewer days.

Repurchase Agreement (Repo)

A repurchase agreement (repo) is a contract between a buyer and a seller of debt


securities, stating that the seller will repurchase the securities after a certain length of
time or after certain conditions are met. A bank or dealer sells some of its securities to
another party, who buys it back at a higher price. Maturities range from one to 90 days.

The advantage of a repurchase agreement is that the seller can get needed cash for short-
term use without really losing control of their investment portfolio. Because the
repurchase agreement specifies the repo rate, the seller may earn a higher return on the
repurchased portfolio than with the repo rate.

Banker’s Acceptances

Banks use banker's acceptances to finance importing and exporting with firms in foreign
countries. They work in the following way: an importer's bank backs the importer by
paying the foreign party on the importer's behalf. The importer is then obliged to repay
the bank within a period of three to six months. If the bank so desires, it may sell the
contract before it is repaid as a way to replenish its cash. This feature makes it highly
liquid. The bank is liable for payment if the importer defaults.

Banker's acceptances are usually issued in denominations over $100,000 and are sold at
discounts. Their maturities range from 30 to 180 days and their yields are a little less than
those of CDs.
Time value of money
Which would you prefer -- $1000 today or $1000 in 4 years?
Certainly, $10,00 today.
Your response motivated by the ‘Time value of money’
You already recognized that there is TIME VALUE TO MONEY!!

Significance of TIME
Why is TIME such an important element in your decision?
TIME allows you the opportunity to postpone consumption and earn INTEREST

Interest
Interest is a return on a deposit. Interest paid on the principal borrowed is simple
interest. Interest paid on any previous interest, as well as on the principal borrowed is
compound interest.

Simple Interest
Assume that you deposit $10,000 in an account earning 5% simple interest for 4 years.
The accumulated interest at the end of the 2nd year can be calculated using the formula:

SI = P0 (i) (n)
SI: Simple Interest
P0 : Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

SI = $10,000 (0.05) (4) = $2,000


The simple interest on the deposit of $10,000 for 4 years @ 5% is $2000.

Compound Interest
How is compound interest different from simple interest? Shierly Winters deposits
$10,000 @ compounded interest rate of 5% per annum for 4 years. She wants to know
how much it will becomes after 4 years.

0 1 2 3 4

$10,000 5%
FV 4
She earned $500 interest on your $10000 deposit over the first year. This is the same
interest you would earn under simple interest. In the second year the interest would be

FV1 = P0 (1+i)1 = $10,000 (1.05) = $10,500


FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $10,000(1.05)(1.05)
= P0 (1+i)2 = $10,000(1.05)2 = $11,025
In the second year she earned an interest of Rs.525 as interest. The EXTRA $25 is the
compound interest over simple interest. Accordingly, the future value at the end of the 4th
year would be
= P0(1+i)(1+i)(1+i)(1+i) = $10,000(1.05)(1.05)(1.05)(1.05)

This is equivalent to P0 (1+i)4 = $12,155


= $10,000 (1.05)4 = $12,155
n
The formula is: FV = PV(1+i)
Her deposit of $10000 grows to $12155 at the end of the fourth year.

SIMPLE AND COMPOUND INTEREST

20000
18000
SIMPLE INTEREST @ 5%
16000 COMPOUND INTEREST @ 5%
COMPOUND INTEREST @ 7%
14000
INTEREST ($)

12000
10000
8000
6000
4000
2000
0
1 5 YEAR 10 15

In the figure notice the difference in the simple and the compound interest depicted by
the first two bars for the 5% rate of interest.

The “Rule-of-72”

How long does it take to double $10,000 at a compound rate of 12% per year (approx.)?

Approx. Years to Double = 72 / i% 72 / 12% = 6 Years

[Actual Time is 6.12 Years]

Time value
I give you 1000 dollars. You deposit in a bank. Bank will give you 5% interest per
annum. After 2 years, it becomes $1102.50. The Present Value is $ 1000 and Future
Value will be $1102.50.

The difference between the present value and the future value is ‘time value of money’.
Money loses value with the passage of time due to factors such as inflation. Inflation is a
phenomenon, characterised by rising prices in the economy. Inflation is principally
caused by the mismatch between generation of incomes and production of goods and
services in the economy.

The time value of money has the following possibilities:


• Present value of a single amount
• Future values of a single amount
• Future Value of an Uneven Cash Flow
• Present value of an annuity
• Future value of an annuity

Present value of single amount


Shierly Winters wants to know how large of a deposit to make so that the money will
grow to $25,000 in 4 years at a interest rate of 7%.

Year 0 1 2 3 4

7%
$25,000
PV ?

The general formula for calculating Present Value is :


1
PV = FVn
(1 + i) n
where
PV is the present value
FVn is the future value of the investment in the year ‘n’
i is the rate of interest and
n is the number of years

= 25,500 / (1+0.07) 4
= $19,072
Shierly Winters need to deposit $19072 now to realize $25000 after 4 years. The $19072
is the present value of the future sum of $25000.

Future value of a single amount:


Now Shierly Winters deposits $10000 for a period of 6 years @ 8% per annum. How
much she get on maturity of the deposit?

FV = PV (1 + i) n
Where,
FVn is the future value in the year ‘n’
PV is the present value
i is the rate of interest and
n is the number of years

FV6 = $ 10000 (1 + 0.08)6


= $ 15869
Shierly Winter’s deposit will be worth $15869 at the end of the 6th year.

Present Value of Cash Flow


Shierly Winters calculates that she will receive a set of cash flows for the next 6 years.
She wants to know what it is worth now? She can proved she knows the rate of interest.
Assuming a rate of 8% the worth can be calculated.

Year Cash Flow


1 2500
2 1500
3 2500
4 1800
5 2000
6 2200

The future earnings are converted to their respective present values by discounting them
by the discount factor.

The discounting is done as follows:


1 1 1 1 1 1
PV = 2500 1
+ 1500 2
+ 2500 3
+ 1800 4
+ 2000 5
+ 2200 +
1.08 1.08 1.08 1.08 1.08 1.08 6
= $9,656.

The present worth of her earnings is $9,656.

Cash Discount Present


Year
Flow Factor Value
(df)
(FV) (FV x df)
1/(1+I)n
1 2500 0.93 2314.81
2 1500 0.86 1286.01
3 2500 0.79 1984.58
4 1800 0.74 1323.05
5 2000 0.68 1361.17
6 2200 0.63 1386.37
Present Value 9656.00

Future Value of Cash Flow

Shierly Winters plans to deposits her yearly savings for the next 5 years in a bank. She
wants to know what her investment will be worth at the end of 5 years?

Year Savings $
1 1000
2 1500
3 2000
4 2200
5 2500

To know the future value, each year’s savings has to be converted to their respective
future value. For example $1000 of 1st year has to be compounded to the 5th year.

i.e.
= 1000 * (1 + 0.08)^5
= 1000 * (1.47)
= 1470
Cash Compounding Future
Flow Factor Value
Year
(PV) (1+I)n
(PV x df)

1 1000 1.469 1469.3


2 1500 1.360 2040.7
3 2000 1.260 2519.4
4 2200 1.166 2566.1
5 2500 1.080 2700.0
11295.6

Future Value
Therefore, after 5 years, she will have $11295.6. That is the future value of her cash flow.

Effective Interest Rate

Very often people are carried away with the stated interest rate when they avail a loan. In
fact a loan carrying 12% interest for a housing loan may be cheaper than a loan carrying
an interest of 11.25%. It depends on the frequency of compounding. Therefore, to assess
the actual cost of a loan, one should calculate the effective interest rate. The effective
interest rate is the actual interest rate that the borrower pays for his loan or receives for
his deposit. The effective interest rate is different from the nominal interest rate. The
nominal interest rate is specified for the loan.

Shierly Winters has $5,000 to invest for 4 Years at an annual interest rate of 8%. The
table shows the effective interest for different frequencies of compounding for a nominal
interest of 8%.

Effective Rate of
Year Interest Amount
Interest (%)

Annual 400.00 8.00


Biannual 408.00 8.16
Quarterly 412.16 8.24
Monthly 415.00 8.30
Daily 416.39 8.33

The effective interest rate is calculated using the formula given below:
m
 i
 m  − 1
1 +

Where,
i is the rate of interest
m is the frequency of compounding during a year

Shierly winters will receive $5,400 if the interest is compounded annually and $5,412.16
if compounded quarterly. The effective interest for quarterly compounding of 8.24% is
arrived at using the formula:

4
 0.08 
1 + 4  − 1 = 8.24
Annuity

Annuity is a series of equal payments or receipts occurring over a specified number of


equidistant periods. Car Loan Payments, Insurance Premiums, Mortgage Payments and
Retirement Savings are some of the examples of annuity.

Present value of an annuity


Shierly after reviewing her budget decides that she can pay $ 1200 a month for a period
of 3 years towards purchase of a new car. Car loans are available from M/s. Auto Mart
which offers car loans at 8% interest. Shierly would like to know how much she can
borrow so that she can decides which car to buy.

Problems such as these, involve deciding the present value of the future annuity
payments, which in Shirley’s case is $1200 per month. The formula for calculating the
present value of an annuity is:

1 − (1 + r ) − n
PV = Annuity
r
 1 − (1 + 0.08) −3 
PV = 1200 *12  
 0.08 
= $37,110.20

Shierly can avail a loan of $37,110.10. Now, she can decide which car to buy. Shierly by
paying $1200 per month is amortizing a loan of $37,110.10 over the period of the three
years.

You plan to buy a car costing $25000 and approach a finance company who offers you a
loan on the condition you make a down payment of 20% and the balance will be advanced
@ 9%, reducing balance interest, over a period of 48 months. What will the equate monthly
interest be?

$ 514.45
1 − (1 + r ) − n
This obtained by substituting the values in the formula PV = Annuity
r
and solving for Annuity.
Future value of an annuity

Shierly is saving at the rate of $500 per month for a period of 15 years for her retirement.
The interest on the deposit is 10%. How much will she receive on maturity of her
deposit?

Since Shierly is depositing money every month, the first instalment earns interest for 180
months, second instalment earns interest for 179 months and so on. To know the future
value of her deposit the formula is:

(1 + r ) n − 1
FV = Annuity
r
Her annuity is the monthly contribution. The rate of interest ‘r’ which is usually
expressed per annum, in this case 10 per cent has to be converted to each period in to
which the year is divided. In this case it is 12. Therefore, the monthly interest would be
0.10/12 = 0.00833 per cent. This rate is used in the formula above.

= 500 x ((1 + 0.00833) 180 – 1) / 0.00833

= 500 x 414.32

= $ 207159

The maturity value of Shirley’s deposit will be $207159.

Suppose the interest is calculated on the deposit once in six months, rather than every
month, then appropriate changes have to be made in the interest rate, the annuity amount
and the number of periods of the deposit. Since the year is divided into two periods, the
interest rate has to be divided by two and the period has to be multiplied by two, and the
deposits has to be aggregated for six months. Thus, ‘r’ will be 5 per cent, ‘n’ will be 30
and annuity will be $3000.

= 3000 x ((1 + 0.05) 30 – 1) / 0.05

= 3000 x 66.44

= $ 199316.54
If the interest is compounded quarterly, what is the maturity value?

The maturity value will be $ 323987.40

= 1500 x (1 + 0.025) 60 – 1) / 0.025

= 1500 x 135.99

= $ 203987.40
Capital Budgeting
Shirley Winters decides to start a Boutique in her neighborhood as there isn’t one close by and
therefore she thinks that it has a good chance of succeeding. With the help of her friend who
has experience in running a boutique she estimated the cost of setting it up and finds it requires
an investment of $ 18000 which she could ill afford. While discussing her plans with a friend,
she was told if she could establish the financial soundness of the investment, she has a good
chance of getting a loan from a financial institution. Now she has to prove the worth of her
investment. This can be done through capital budgeting.

Capital Budgeting Analysis is a process of evaluating investments in capital assets to


determine whether future benefits of this project be large enough to justify the investment
given the risk involved.

Shirley Winters must know the cost of obtaining funds to make the long-term investments in
new product lines, new equipment and other assets. Cost of Capital represents the rate a
business must pay for each source of funds.

Why use the Cost of Capital?


Because we know the Shierly wouldn't do the project, which earns profits below the cost
of capital. She would lose money. Hopefully Shirley’s Boutique would earn much more
than the cost of capital. The cost of capital is the minimum acceptable rate of return for
long-term investments. The discount rate is usually the cost of capital i.e. interest rate.

The Three Stages of Capital Budgeting Analysis

We must focus much of our attention on present values so that we can understand how
expenditures today influence values in the future. An approach to looking at present values of
projects is the discounted cash flow (DCF) technique. Capital Budgeting involves three stages:

§ Decision Analysis (for Knowledge Building)

§ Option Pricing (to Establish Position)

§ Discounted Cash Flow (DCF) (for making the Investment Decision)

These processes helps to reduce the uncertainty in the investment decision.

1. Decision Analysis

Decision-making in the beginning of the project for Shirley is complex because of uncertainty
like capital requirements, risks, tax considerations and expected rates of return. She has to
understand the existing markets to forecast project revenues, assess competitive impacts of the
project, and determine the life cycle of the project. If our capital project involves production,
we have to understand operating costs, additional overheads, capacity utilization, and start-up
costs. Consequently, we cannot manage capital projects by simply looking at the numbers. We
must assess all relevant variables and outcomes within an analytical hierarchy.

2. Option Pricing
The second stage is to consider all options for the project. Therefore, before employing
discounted cash flow technique we need to build a set of options into our project for managing
unexpected changes. Shirley must consider options which she could easily take up lest her
original project fails.

3. Discounted Cash Flows


Discounted Cash Flow techniques is concerned with the present values of assets. Since capital
projects like Shirley’s Boutique provide benefits into the future and to determine the present
value of the project, we discount the future cash flows of a project to the present.

Discounting refers to taking a future amount and finding its value today. Future values differ
from present values because of the time value of money. Financial management recognizes
the time value of money because:

1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from
now due to rising prices (inflation).

2. Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now, but a
lot can happen over the next five years.

3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years
from now because we can invest $ 1,000 today and earn a return.

Capital Budgeting Techniques

The Capital Budgeting Techniques are

a) Project Evaluation and Selection

b) Potential Difficulties

c) Capital Rationing

d) Project Monitoring

a) Project Evaluation:

The methods of Project Evaluation are

1) Net Present Value (NPV)

2) Internal Rate of Return (IRR)


3) Payback Period (PBP)

4) Profitability Index (PI)

Net Present Value (NPV)

In order to assess the worth of Shirley’s project, she must determine its present worth.
The future cash flows have to be converted into its present worth, called Net Present
Worth. By finding out the net present worth of the Investment in the Boutique Shierly
will convince the financer whether it is economically viable or not. Shirley submits two
proposals one for the Boutique and another for a Restaurant to Grow & Prosper Finance
Company

The finance company is evaluating two investment proposals. Their respective


investment and cash flows are here:
Boutique Restaurant
Investment Investment
Year ($) Cash Flow Year (Rs) Cash Flow
1 250000 40000 1 300000 60000
2 50000 2 80000
3 80000 3 80000
4 100000 4 100000
5 100000 5 100000

The interest for the loan is 14 per cent per annum i.e. the cost of capital.

The NPV of the two projects is shown below:


Discount
factor
Investment Cash 1 Present
Year ($) Flow Net Flow (1 + r) n Value
Boutique
1 250000 40000 -210000 0.8772 -184211
2 50000 50000 0.7695 38473
3 80000 80000 0.6750 53998
4 100000 100000 0.5921 59208
5 100000 100000 0.5194 51937
NPV -> 19405
Restaurant
1 300000 60000 -240000 0.8772 -210526
2 80000 80000 0.7695 61557
3 80000 80000 0.6750 53998
4 100000 100000 0.5921 59208
5 100000 100000 0.5194 51937
NPV -> 16174

The cash flow is the returns over the cost. The net flow is the difference between the cash
flow and the total investment cost. The discount factors are calculated using the formula
1
:
(1 + r) n

Where, ‘r’ is 0.14 and ‘n’ takes values 1,2,3,4 and 5

and presented in column 5 of the table. The present values are derived by multiplying the
net flow by the corresponding discount factor and shown in the last column of the table.
Then the present values are added to obtain the Net Present Value.

For Grow & Prosper Finance Company to be satisfied about the feasibility of the
Projects they should have a positive NPV. When it comes to choosing between the two
investment proposals, the project with the higher NPV will be preferred Between the two
Projects both projects are economically viable since both have positive NPVs. The
investment in the Boutique is preferred over Restaurant because of its higher Net Present
Value of the two.

Internal rate of return


Shirley is happy that her Boutique meets the requirement of Net Present Worth but wants to
know what return the project yields in percentage terms. This will be known if she calculates
the Internal Rate of Return. Internal Rate of Return (IRR) is the amount of profit you get by
investing in a certain project. It is expressed as a percentage. An IRR of 10% means you make
10% profit per year on the money invested in the project. IRR is a popular economic criteria
for evaluating capital projects, since investors like Shirley Winters can easily identify with
rates of return. IRR is calculated by finding the discount rate whereby the Net Investment
amount equals the total present value of all cash inflows. The IRR is a discount rate that makes
the Net Present Value = 0. This can be seen from the example below: Keep changing the IRR
by small amounts till the right hand side equals the Left Hand Side. That happens at a rate of
18.5%. This becomes the IRR.

CF1 CF2 CF3 CFn


IC 0 = + + + . . . . . +
(1 + IRR)1 (1 + IRR) 2 (1 + IRR) 3 (1 + IRR) n

40000 50000 80000 100000 100000


$25000 = + + + +
(1 + 0.185) 1
(1 + 0.185) 2
(1 + 0.185) 3
(1 + 0.185) 4
(1 + 0.185) 5
This is how the IRR is arrived at.

The table gives the details of investments and returns of two projects. The cost of capital for
both the projects is 14% per annum and the deposit rate is 10%.

Boutique
Discount
Investment factor Present
Year ($) Cash Flow Net Flow @18.5% Value
1 250000 40000 -210000 0.8439 -177223
2 50000 50000 0.7122 35610
3 80000 80000 0.6010 48083
4 100000 100000 0.5072 50723
5 100000 100000 0.4281 42806
NPV -> 0

Restaurant
Discount
Investment factor Present
Year ($) Cash Flow Net Flow @17.53% Value
1 300000 60000 -240000 0.8509 -204207
2 80000 80000 0.7240 57918
3 80000 80000 0.6160 49280
4 100000 100000 0.5241 52413
5 100000 100000 0.4460 44596
NPV -> 0
If the IRR is higher than 14%, then we would accept the project.

In our example, the IRR 18.5% for Project-A and 17.53% for Project-B. Since the IRR is
higher than the cost of capital, we can invest in both the projects, but Project-A is superior to
Project-B.

One of the problems with IRR is the so-called reinvestment rate assumption. This means the
amount $35610/- which is surplus of the 2nd year is reinvested in the project at 18.5%,
equivalent to the IRR. This assumption need not be true as the surplus may be deployed at a
different rate. We will correct this distortion by modifying our IRR calculation (MIRR).

The MIRR can be calculated using the Excel function:

=MIRR(<Net Flow>,<discount rate>,<reinvestment rate>).

In order to eliminate the reinvestment rate assumption, we will modify the IRR incorporate
changes in the reinvestment rate. Accordingly, the MIRR for the Project-A is 15.47% and
Project-B is 14.55%, at reinvestment rate of 10%, which are still higher than the cost of capital
and hence economically viable.

If by some coincidence, the rate of discount and the internal rate of return coincide,
whatNPV
The will the
willnet
be present value
zero since theof theisinvestment
IRR that rate ofbe?
discount, which equates the present
worth of benefits and costs.
Payback Period

Shirley is keen on getting rid of the loan as soon as possible and would like to know how
long it will take to do so. The Payback period is the periods for the investment to be
recovered from the net cash flow of the project. It is usually undiscounted and calculated
by deducting the investment cost from each year’s net cash flow until the entire
investment is recovered. The time taken to recover the investment is called the ‘payback
period’. It is demonstrated for the two projects discussed earlier.

Boutique
Annual Annual
recovery of Discount Present recovery
Investment Net Cash Total Cash Net Flow investment factor Value (discounted)
Year ($) Flow Flow (3-2) @14% (5 x 6)
(1) (2) (3) (3a) (4) (5) (6) (7) (8)
1 250000 (b) 40000 40000 -210000 -210000 0.8772 -184211 -184211
2 50000 90000 50000 -160000 0.7695 38473.38 -145737
3 (a) 80000 170000(c) 80000 -80000 0.6750 53997.72 -91739.4
4 100000 270000 100000 (d) 20000 0.5921 59208.03 -32531.4
5 100000 370000 100000 120000 0.5194 51936.87 19405.47

It can be calculated in a straightforward manner using the formula.


PBP = a + ( b - c ) / d
Where , PBP is pay back period,
a is the year last year of negative recovery
b is the investment
c is the total cash flow upto year ‘a’
d is the net flow in the year following year ‘a’

= 3 + (250000 - 170000) / 100000


= 3.9 Years (rounded to single decimal)

Restaurant
Annual Annual
recovery of Discount Present recovery
Investment Net Cash Total Cash Net Flow investment factor Value (discounted)
Year ($) Flow Flow (3-2) @14% (5 x 6)
(1) (2) (3) (3a) (4) (5) (6) (7) (8)
1 300000 60000 60000 -240000 -240000 0.8772 -210526 -210526
2 80000 140000 80000 -160000 0.7695 61557.4 -148969
3 80000 220000(c) 80000 -80000 0.6750 53997.72 -94971.2
4 100000 320000 100000 20000 0.5921 59208.03 -35763.2
5 100000 370000 100000 120000 0.5194 51936.87 16173.7
In projects A and B, the annual capital recovery is shown in column (5). With the data
from the table, the payback for both the projects has been computed and found to be at
3.9 years. Both the projects have the same payback period.
Profitability Index
Profitability index is the ratio of the Present Worth of the net cash flows of the Project to
the Initial Cash Outflow. This can be illustrated with the help of the Boutique example.
The cash in-flow of the project is $40000, $50000, $80000, $100000 and $100000,
respectively for the first to the fifth year. The cost of capital is 10%, which is taken as the
discount rate and the calculations are shown.

CF1 CF2 CF3 CFn


NPW = + + +. . . . .+
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) n

40000 50000 80000 100000 100000


$268185 = + + + +
(1 + 0.10) 1
(1 + 0.10) 2
(1 + 0.10) 3
(1 + 0.10) 4
(1 + 0.10) 5

The Present Worth of the Net cash outflows is $268185 while the Initial cash outlay or
the investment is $2,50,000.

The Profitability Index is = 268185/ 250000= 1.07

Should the Boutique Project be accepted?

Yes since the ratio is greater than one, the project is viable as it can cover the cost of
borrowing.

The measures of project worth help Shirley Winters evaluate and select the projects. She
should continually try to spot potential difficulties so as to overcome them from time to
time.

Capital rationing occurs when the capital is constrained during a particular period. If
Shirley Winters can raise only a part of her project cost, then the selection will have to
based on the criteria that maximises shareholders value by investing the part of the
capital. Finally a post completion audit has to be carried out to compare the actual costs
and returns with those that were projected. This will help in identifying the weaknesses
so that corrective action can be taken and better decisions taken in future.