Glossary on Banking Professor Tarun Das Institute for Integrated Learning in Management New Delhi

Accrued interest This is the interest that has been earned by an investor but not become due for payment to the investor. Bond buyers pay bond sellers accrued interest whenever a bond is purchased. Thus, if a bond were sold between its semiannual interest payment dates, the purchaser would pay the market price of the bond plus the appropriate fraction of the accrued coupon interest earned but not yet received by the party selling the bond. The amount of accrued interest helps determine the price of a bond. Annuity An equal amount paid every year in lieu of a lump sum payment for a certain fixed period or for life. Some investment schemes offered by banks, Life Insurance Corporation, Unit Trust offer annuity payments. Auction Auction is a process of calling of bids with an objective of arriving at the market price. It is basically a price discovery mechanism. There are several variants of auction. Auction can be price based or yield based. In securities market we come across below mentioned auction methods.

• French Auction System: After receiving bids at various levels of yield expectations, a particular yield level is decided as the coupon rate. Auction participants who bid at yield levels lower than the yield determined as cut-off get full allotment at a premium. The premium amount is equivalent to price-equated differential of the bid yield and the cut-off yield. Applications of bidders who bid at levels higher than the cut-off levels are out-right rejected. This is primarily a Yield based auction. • Dutch Auction Price: This is identical to the French auction system as defined above. The only difference being that the concept of premium does not exist. This means that all successful bidders get a cut-off price of Rs. 100.00 and do not need to pay any premium irrespective of the yield level bid for. • Private Placement: After having discovered the coupon through the auction mechanism, if on account of some circumstances the Government / Reserve Bank of India decides to further issue the same security to expand the outstanding quantum, the government usually privately places the security with Reserve Bank of India. The Reserve Bank of India in turn may sell these securities at a later date through their open market window albeit at a different yield. • On-tap issue: Under this scheme of arrangements after the initial primary placement of a security, the issue remains open to yet further subscriptions. The period for which the issue remains open may be sometimes time specific or volume specific

Banking Credit


Banks in India predominantly provide short term credit for financing working capital needs, although, some of the larger banks are aggressively providing term loans. The various types of advances provided by banks are cash credits, overdrafts, demand loans, purchase and discount of commercial bills and installment or hire purchase credit.

Basis Point One basis Point is 1/100th of 1 % point i.e. 100 basis point will make 1% point. It is used to measure changes in yields of a bond. For example, if a bond yielding 6.09% changes in price to yield 6.20%, it is said to have increased 11 basis points. Basis points (bps) are commonly referred to as "beeps". Bank Rate The minimum rate at which the Reserve Bank of India will make short-term advances (usually for overnight) to the banks. Bill of Exchange (BOE) A bill of exchange is an instrument in writing, containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument. Bond Rating Bond rating is a measure of expected performance, quality and safety of a bond issue. CRISIL, ICRA and CARE are the primary rating service in India. Bridge Loan Bridge Loans are given at the time when the entities come out (or want to come out) with a public offer in the capital market, but need financing for Covering the cost of issues and for Using the loan proceeds as a bridge for the funds that are obtained only after the public issue gets completed. Cash Reserve Ratio (CRR) CRR is the statutory reserve that has to be maintained by banks either in cash or as balance with the Reserve Bank of India. CRR is intended to be a reserve by which the RBI assures itself that the bank is safe and has the liquidity for servicing its depositors. As per Section 42 of the RBI Act, RBI is allowed to announce any level of CRR depending on the market conditions within a certain band, the minimum being 3% and the maximum 15% of NDTL. Constituent Account Scheduled commercial banks and Financial Institutions are allowed to directly participate in the SGL account being maintained by RBI. All other entities may indirectly participate in the securities market by opening a constituent account with any of the direct SGL participants. Coupon Bonds typically pay interest periodically at the pre specified rate of interest. The annual rate at which the interest is paid is known as the coupon rate or simply the coupon. Interest is usually paid every half-year though some bonds pay interest monthly, quarterly, annually or at some other frequency. The dates on which the interest payments are made are known as the coupon due dates. Convexity


The convexity of a bond measures the curvature of the price/yield relationship of a bond's cash flows. The larger the convexity, the steeper the curvature of the price/yield curves. This behavior is more evident for large changes in yield. High convexity is frequently a desired characteristic because for a given percentage change in yield, up or down, the bond's percentage price gain will be greater than its percentage price loss. Another way of looking at this is to compare two bonds, one with high convexity and one with low convexity. The highly convex bond will become shorter faster than the low convexity bond for a given rise in rates, and will become longer faster than the low convexity bond for a given fall in rates. In mathematical terms, convexity is related to the second derivative of price with respect to yield. Whereas modified duration may be used to calculate price changes for small changes in yield, duration and convexity together allow you to estimate price changes for large yield movements according to the following relationship: dP= -Duration*Price*dY+0.5*Convexity*Price*dYsqrd. where dP = change in price ("delta P") dY = change in yield ("delta Y") Convexity, in conjunction with modified duration, is used to immunize portfolios for large movements in interest rates. Credit Deposit Ratio (CDR) It represents the ratio of Total Credit disbursed to Total Deposits garnered by a bank. Total Credit includes Loans, Overdrafts, Cash Credits and Bills purchased and Discounted. Total Deposits include the Time and Demand deposits. Credit Risk Credit risk is the risk that an issuer of a debt security or a borrower may default on its obligations. In a slightly different context, it is also defined as the risk that payment may not be made on the sale of a negotiable instrument (i.e. counter-party risk). Current Yield This is the yield or return derived by the investor on purchase of the instrument (yield related to purchase price) It is calculated by dividing the coupon rate by the purchase price of the debenture. For e. g: If an investor buys a 10% Rs 100 debenture of ABC company at Rs 90, his current Yield on the instrument would be computed as: Current Yield = (10%*100)/90 X 100, That is 11.11% p.a. Day Count Basis In the fixed income securities markets, there are a number of ways that days between dates are computed for interest rate calculations. The day count basis indicates the manner by which the days in a month and the days in a year are to be counted. The notation utilized to indicate the day count basis is (days in month)/(days in year). For example, 30/360 assumes that each of the twelve months in a year consists of exactly 30 days. On the other hand, Actual/Actual considers the actual number of days in a month and the actual number of days in a year. Other types of day count basis are Actual/360, Actual/365, and 30/360 European. The 30/360 European day count basis differs from 30/360 basis in the algorithm used to handle the end of the month. The five basic day count basis are the following: • Actual/360


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Actual/365 Actual/Actual 30/360 30/360 European

Each of these is explained below: Actual/360 This calculates the actual number of days between two dates and assumes the year has 360 days. Many money market calculations with less than a year to maturity use this day count basis. For example, A Rs. 1 crore six month CD issued on 15/04/04 and maturing on 15/10/04, with an 8% coupon would pay an interest payment of: Actual days between 15/04/04 to 15/10/04 = 183 days Interest = 0.08 x 10,000,000 x (183/360) = Rs 40,666.67 Actual/365 This calculates the actual number of days between two dates and assumes the year has 365 days. Using an Actual/365 day count basis, a Rs. 1 crore six month CD issued on 15/04/04 and maturing on 15/10/04, with an 8% coupon would pay an interest payment of: Actual days between 15/04/04 to 15/10/04 = 183 days Interest = 0.08 x 10,000,000 x (183/365) = Rs 40,109.59 Actual/Actual This day count basis calculates the actual number of days between two dates and assumes the year has either 365 or 366 days depending on whether the year is a leap year. More accurately, if the range of the date calculation includes February 29 (the leap day), the divisor is 366, otherwise the divisor is 365. Again using our CD example, the interest payment would be: Actual days between 15/04/04 to 05/10/04 = 183 days Interest = 0.08 x 1,000,000 x (183/365) = Rs 40,109.59 Notice that even though 2004 is a leap year, the denominator used for this calculation was 365 because February 29, 2004 does not fall into the date range of the calculation. If the issue date was before February 29, the divisor would have been 366 instead. 30/360 This day count convention assumes that each month has 30 days and the total number of days in the year is 360 (12 months x 30 days per month). There are adjustments for February and months with 31 days. The formula for the 30/360 day calculation is as follows: Assume Date 1 is of the form D1/M1/Y1 and Date 2 is of the form D2/M2/Y2. Let Date 2 be later than Date 1. Then: If D1 = 31, change D1 to 30 If D2 = 31 and D1 = 30, change D2 to 30 Days between dates = (Y2-Y1) x 360 + (M2-M1) x 30 + (D2-D1)


30/360 European The 30/360 day count basis is different outside of the United States. They further simplified this calculation. The formula for the 30/360 European day calculation follows: Assume Date 1 is of the form M1/D1/Y1 and Date 2 is of the form M2/D2/Y2. Let Date 2 be later than Date 1. Then: If D1 = 31, change D1 to 30 If D2 = 31, change D2 to 30 Days between dates = (Y2-Y1) x 360 + (M2-M1) x 30 + (D2-D1) Demand Loan Demand loans have to be repaid when demanded by the creditor and as such they are short-term loans. The demand loan comprises of minimum level of borrowing which the borrower is expected to use throughout the year. Discounted cash flow Cash Flows occur over a period of time. But even under complete absence of inflation or risk, money still has time value. Rs. 100/- receivable today, after one year or after 10 years is not same in value. To make an absolute comparison, these cash flows in different periods have to be expressed in terms of today's value or present value. Cash Flows that are discounted by suitable rate of return are known as discounted cash flows. Duration Duration is a measurement that allows an investor to compare bonds for potential price volatility by considering both the term and the coupon together. It is defined as the average time that it would take to receive all cash flows in terms of current dollars. Both coupon payments and principal are factored into the calculation. Bonds with longer terms are more volatile than shorter term bonds because cash flows are received over a longer period of time, and therefore are subject to a greater deal of uncertainty. Similarly, market prices of higher coupon bonds are less volatile than a lower coupon bond because a greater proportion of the bond's total return is realized with the semi-annual payments than at maturity. Face Value Face value is the amount that is to be paid to an investor at the maturity date of the security. Debt securities can be issued at varying face values. The face value is also known as the repayment amount or par. Forward Transactions A forward transaction is an order to buy or sell a security at a future period at a specific price. Forward transactions are not exchange traded or standardized. There is no margin paid over between the counter parties, only a settlement on the agreed date. Frequency of interest payment A debt instrument has interest payments at regular intervals. The interest payments are either at monthly, quarterly, half-yearly or yearly rests. This frequency of interest payments is specified at the time of issue of the debt instrument. Coupon payments are made at regular intervals throughout the life of a debt security and may be quarterly, semi-annual (twice a year) or annual payments. Fixed rate securities generally have semi-annual coupon payments. The frequency of coupon payments is a


key factor in determining the overall return from an investment. At first glance, a debt security offering a high interest rate appears to be a better investment than a security with a low interest rate, but the actual return received depends on how often the interest is paid. A security that has an annual interest rate of 10% and a semi-annual coupon payment will pay 5% every six months. Interest on 360 day a year basis For all government loans and state loans, the interest is calculated on the basis of 360 days a year. In this method, each month is regarded of 30 days irrespective of actual number of days in that month. Interest on calendar year basis The interest is calculated on the basis of 365 days a year basis. The interest on most of the debt securities excluding the government loans and the state loans are calculated on the basis of 365 days a year basis. Actual numbers of days that have expired since last interest payment date are counted for accrued interest payment. Interest Rate Risk Risk associated with fluctuations of bond prices in response to the general movement of the interest rates and to changes in investor perceptions of government monetary policy and economic data. Internal Rate of Return (IRR) The IRR is that discount rate at which the NPV of a cash stream becomes zero. Here, the net present value is given (as zero) and the discount rate is calculated. If the IRR is greater than the required rate of return (discount rate), then the security/project is worth investing in, otherwise not. Issuer The organisations which offers the debt securities for sale are know as Issuer of the debt. Debt issuers include the Government, banks and companies. Issued at Discount An instrument that is initially issued at a price less than its face value is know to be issued at a discount. For example, a bond having face value of Rs.100 and issued at Rs.95 is said to be issued at a discount. London Interbank Offered Rate (LIBOR) LIBOR is the benchmark or the reference rate. This is calculated everyday, at a specific time, as the average of the lending rates of a group of 15 reference banks in London on short-term funds lent to first class banks. Rates charged to non-bank customers on loans are stated as LIBOR plus a margin or spread. Maturity premium An instrument, which on maturity is redeemed at a price higher than the face value, is said to be redeemed with a premium at maturity. For example, a bond having face value of Rs.100 and redeemed at Rs. 105 at maturity is said to be redeemed at a maturity premium of Rs.5. Monetary Policy Implemented by the Reserve Bank of India, it is policy using money supply and control of credit in the Indian economy to control the general direction of interest rates and maintain the integrity of the Indian Rupee.


Tightening monetary policy is indicative of rising rates usually near the end of a phase of economic expansion. Conversely, loosening monetary policy is accompanied by decreasing rates that usually precedes economic expansion. Mortgage A mortgage is defined as a pledge of property (real estate) to secure payment of a debt. If the mortgagor fails to pay the lender (the mortgagee), the lender can foreclose the loan, seize the property and sell it in order to realise his dues. Mumbai Interbank Offered Rate (MIBOR) MIBOR is the benchmark or the indicative rate prevailing in Mumbai money markets. This is calculated everyday, at a specific time, as the average of the lending rates of a group of 18 reference banks in Mumbai on funds lent to first class borrowers. Nationalised Banks A Nationalised Bank is a bank whose majority ownership vests with the Government of India. Negotiable Instruments Section 13 of the Negotiable Instruments Act says that a negotiable instrument means a promissory note, bill of exchange or cheque payable either to order or to bearer. The word negotiable means transferable from one person to another for consideration and instrument means a written document by which a right is created in favour of some persons. Thus, a negotiable instrument is a document which entitles a person to a sum of money and which is transferable from one person to another by mere delivery or by endorsement and delivery. Net Demand and Time Liabilities (NDTL) Banks have to maintain statutory reserves on their NDTL. For calculating its NDTL, a bank has to first sum up its total gross liabilities, which include all demand and term deposits. Once the gross demand and time liabilities (DTL) is determined, the bank can deduct its Interbank assets (IBA) from this DTL only to the extent of its Interbank liabilities (IBL). Usually NDTL is calculated with reference to alternate Fridays called "Reporting Fridays". The banks are required to maintain their CRR and SLR with reference to the NDTL as of the reporting Friday. Net Present Value (NPV) NPV of a cash stream is simply the difference between the present value of cash outflow and summation of present values of cash inflows at a given discount rate. Here, the discount rate is given and the NPV is calculated. If the NPV is positive, the security/project will be worth investing in, otherwise not. This is because a positive NPV implies that the security/ project provides a return higher than the discount rate per annum. Nidhi A Mutual Benefit Finance company will be notified as a Nidhi company under Section 620A of the Companies Act, 1956 by the Government of India based on the performance of the company. To become a nidhi, benefit funds need to have 2000 members and a paid-up capital of Rs.25 lakhs. Once the benefit funds comply with these, Department of Company Affairs declares such companies as Nidhis. Non Banking Finance Company (NBFC) There are different categories of NBFC's operating under the statutory eye of RBI. They are:


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Loan and Investment Companies Equipment Leasing and Hire Purchase Companies Miscellaneous Non-Banking Finance Companies and Residuary Non-banking Finance companies.

Nostro Account An account opened by an Indian bank with a foreign bank in their currency for the purpose of remittances and withdrawals is known as a nostro account. Private Banks Private Bank is a bank registered as public limited company under the Companies Act, 1956. The RBI may on merit grant a license under the Banking Regulation Act, 1949 for such a bank. HDFC Bank, ICICI Bank are the new generation private sector banks. Promissory Note According to the Negotiable Instruments Act, a Promissory Note is an instrument in writing (not being a bank note or a currency note) containing an unconditional promise, signed by the maker, to pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of the instrument. Maker is the person who makes the promissory note and promises to pay, and the person to whom the payment is made is the payee. Reset Date The date at which the interest rate on a debt security is reset to a new rate. Scheduled Banks Scheduled banks are those, which are included in the Second schedule of Banking Regulation Act, 1965. To be included in the Second Schedule, a bank 1) must have paidup capital and reserves of not less than Rs. 5 lakhs 2) must also satisfy the RBI that its affairs are not conducted in a manner detrimental to the interests of its depositors. Scheduled banks are required to maintain a certain amount of reserves with the RBI. They, in return, enjoy the facility of financial accommodation and remittance facilities at concessional rates from the RBI. Statutory Liquidity Ratio (SLR) SLR is the statutory reserve that is set aside by banks for investment in cash, gold or unencumbered approved securities valued at a price not exceeding the current market price. SLR should not be less than 25% and not exceeding 40% of NDTL as per Section 24 of the Banking Companies Regulation Act. The effective SLR level that a bank has to maintain keeps changing depending on the announcement by the RBI in its credit policies The objectives of SLR are 1) to restrict the expansion of bank credit 2) to augment the investment of the banks in Government securities and 3) to ensure solvency of banks. Strip Transaction In a strip transaction, an interest bearing bond is divided into separate principal and interest components. Both the principal and the future interest payments are separately tradeable. Thus, the bond is stripped and principal is traded separately as zero coupon bond and interest components are traded as annuities. Subsidiary General Ledger (SGL) An SGL account enables scripless form of trading by routing all transactions through a ledger document. All scheduled commercial banks and financial institutions have an


account with the Reserve Bank of India. So RBI acts as the depository and maintains SGL accounts of various entities wherein the transaction / holding is represented by a book entry. Term to Maturity The length of time to maturity for a given fixed income security. Term Loan Term Loans are defined as • • Loans sanctioned for a period exceeding one year with specific schedule of repayment, • • Interim cash credits / bridge loans pending disbursement of sanctioned term loans, and • • Installment credit where repayment is spread over more than one year Value at risk Simply speaking, value at risk is the forecasted amount that may be lost, on the investments and other exposures that the bank may have, if an adverse market move were to happen. Vostro Account A rupee account opened by a foreign bank with an Indian bank for the purpose of remittances and withdrawals is known as a vostro account. Yield Curve A graphic representation of the relationship among yields of bonds with similar credit qualities but different maturities. A normal yield curve is upward sloping and is explained by the hypothesis of term risk. That is, because uncertainty increases with longer terms to maturity, yields will increase as well to compensate holders for the perceived greater risk. Occasionally a yield curve may be flat or inverted. An inverted curve is marked by higher yields at the short end of the spectrum. They decrease as term increases. Usually, government securities are used to construct such curves. Yield to maturity (YTM) The yield to maturity is the annualised return from a debt security from the date it is bought in the secondary market to the date of its redemption. YTM is the return on holding the instrument to maturity. The YTM assumes that any coupon payments received before redemption can be reinvested at this yield. Zero Coupon Bond A bond that pays no periodic interest and sold at a deep discount from the face value. Buyer's rate of return comes from the gradual appreciation of the bond


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