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IT Professionals’ handbook of
Investment Banking and Capital Markets
Version 1.0











Edited by

Vinay Kumar
Polaris Software Lab Limited
Hyderabad
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Publication details






















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PREFACE.......................................................................................................................... 4
INTRODUCTION TO BANKING AND FINANCIAL SERVICES ........................... 7
AN INTRODUCTION TO FINANCIAL STATEMENTS......................................... 17
BASICS OF MATHEMATICS AND STATISTICS FOR FINANCE....................... 40
TIME VALUE OF MONEY.......................................................................................... 61
CAPITAL BUDGETING............................................................................................... 73
EQUITY MARKETS...................................................................................................... 81
FIXED INCOME MARKET....................................................................................... 102
FOREIGN EXCHANGE MARKETS......................................................................... 135
TRADING, CLEARING AND SETTLEMENT IN FINANCIAL MARKET........ 155
DERIVATIVES............................................................................................................. 178
FORWARDS .................................................................................................................. 180
FUTURES...................................................................................................................... 183
OPTIONS....................................................................................................................... 183
CAPS, FLOORS AND COLLARS ...................................................................................... 212
SWAPS ......................................................................................................................... 219
SWAPTIONS.................................................................................................................. 226
WARRANTS.................................................................................................................. 230
CREDIT DERIVATIVES .................................................................................................. 230
SECURITIZATION ..................................................................................................... 241
STRUCTURED PRODUCTS...................................................................................... 252
MUTUAL FUNDS ........................................................................................................ 263
RISK MANAGEMENT................................................................................................ 282
WEALTH MANAGEMENT....................................................................................... 304

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PREFACE

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Acknowledgements
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Introduction to Banking and Financial Services

This chapter

Gives an overview of international financial markets
Discusses why financial markets exist
Discusses role of different types of banks
Discusses role of technology in modern financial markets
Set the tone for further discussion in other chapter












Author

Vinay Kumar
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Introduction

Indian Software Industry earns about thirty percent of its total revenue from BFSI
(Banking, Financial Services and Insurance) segment. Impact of Information Technology
on this sector has been so large that it is difficult to imagine the shape of this industry
without the IT components. Without ATMs it is difficult to visualize a bank, without
depository it is difficult to imagine a settlement system and without streaming quotes it is
difficult to imagine a trading system in equities, foreign exchange, derivatives and other
financial markets. Even after all the transformational changes we have seen over the past
decade or two, existing reality is probably only a minuscule part of the possibility in
terms of increase in efficiency, productivity, reach, speed and introduction of new
financial products.

Realization of these possibilities is, to a large extent, in the hands of the Information
Technology professionals. Business is always hungry for improvement in speed and
efficiency, additional functionalities, more automation of routine processes and for
tapping the computational prowess or IT to handle situations involving complex
computations such as risk management, option pricing and simulations. Meeting these
expressed expectations and going beyond to the next stage where business would like to
move in future, is the challenge that the IT industry faces, especially those companies
which focus on the BFSI segment.

To be able to do that, software professionals need to understand the basics as well as
intricacies of financial business. Only those who understand the business can understand
what needs to be delivered to the business. Without proper understanding of the context
of a software application and the purpose for which it is being designed and delivered,
software engineering is prone to becoming routine and mechanical. Without the
understanding of business context, possibility of creative application of software skills
cannot be fully explored and exploited. Understanding the business environment not only
helps a software engineer appreciate the importance of his work but also motivates him to
think innovatively. It is difficult to be passionate about writing patches for certain
application all the time. But knowing how and why the innocuous looking patch is crucial
in supporting flawless functioning of a multi-billion dollar business of a bank can make a
big difference.

This book is a small effort in making the big difference, which can be induced by
learning the subject matter underlying and encompassing the software applications in the
BFSI space with special focus on capital markets, treasury and wealth management.

To understand the financial markets let us start with asking the very basic question – why
do financial markets exist? What role do they play? What is the economic rationale for
the existence of the stock market? Why do we need derivatives? While many of these
questions would be addressed in other chapters, let us first understand why financial
markets exist.

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Financial markets are all about creating channels for money to flow from lender to
borrowers. Financial markets are about raising capital by those who need it for
investment or spending. Financial markets are about creating avenues for deployment of
money for those who have surplus. In fact, financial markets are about matching the two
– those who want capital and those who provide capital. Lending and borrowing has
always happened in all the economies throughout the history in unstructured ways. But
modern financial institutions like commercial banks and investment bankers have created
stable and reliable structures and systems to facilitate this process. Essentially banks
borrow money from those who have surplus cash – big or small - and bundle it in
different ways for offering to those who need it. Since the needs of borrowers differ,
banks or other financial intermediaries may bundle it in different ways e.g. they may
offer short-term loans through zero coupon bonds or long-term loans through term loans.

More complex transactions require more intense interaction and information flow
between borrowers and lenders that in simple banks deposit and personal or corporate
loans. In complex transactions, borrowers and their agents would normally meet the
lenders and their agents and agree upon the commitments of both sides. These
commitments could be bilateral or negotiable i.e. transferable from one entity to another
with or more often without the consent of the original counterparty. A fixed deposit made
with the bank is a bilateral agreement; it is not transferable. On the other hand, a share
can be bought and sold without even informing the issuer company.

Lenders in an economy are mostly individual savers, called households. Businesses and
governments are hungry for money most of the times. Normally households are net
lenders and businesses and government bodies are net borrowers. It can be seen that in
the financial markets there are large number of small savers and small number of large
borrowers. Financial intermediaries perform the function of aggregating large number of
small savings, bundling them into larger loans and offering them to business and
government. Large financial intermediaries include banks, insurance companies, pension
funds, mutual funds etc. Main borrowers include individuals, companies, central and state
governments, municipalities and public corporations. The main financial markets include
interbank market, stock market, money market, bond market and foreign exchange
market.

Lenders may save consciously in the form of a bank deposit or unconsciously in the form
of insurance premium, contribution to provident funds etc. Countries like US, Japan,
Switzerland and UK have strong tradition of pension funds. In France, most pensions are
paid out of current taxation and not out of funds created for the purpose. Insurance and
pension funds, wherever they exist are large players in the financial market because of
sheer size of the funds they command. Liabilities of insurance and pension funds are long
term in nature since claims arise long after investments are initiated by individuals.
Therefore, these entities invest in long-term assets. Shortage of such funds or legal
restrictions imposed on these funds have proved to be major hindrance in developing
financial markets in many countries especially the countries in emerging markets.

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Companies are mostly borrowers in the financial markets. But they do create short-term
surpluses and need to deploy the surplus funds. Short-term funds are deployed in money
market. Money market is basically a short-term wholesale market for money in which
only large institutional players participate. Instruments in money market have a life of
less than one year. Some companies create surplus year after year and tend to be lenders
rather than borrowers. Such companies pay the surplus funds back the investor in form of
large dividend or purchasing the shares from the market i.e. through buyback of shares.

Let us see in some detail who the borrowers are. Individuals borrow to meet their
personal needs and to finance asset acquisitions like a car or a house against their own
future earnings. Companies need short-term funds to manage cash flows and long term
funds for making investments – for expansion of capacity, for entering new businesses
and to introduce new technologies. Governments need to spend on defence, law and order
machinery, development of infrastructure and meeting social obligations of health and
education. These expenses are met partly by taxation and partly by borrowing.
Governments world over are traditionally voracious borrowers. Central government does
not pay all its debt by its increasing its earnings. Part of the debt can be monetized i.e. it
paid back by printing more money. Cumulative total of all the government borrowings is
called National Debt. It is noticeable that in most countries national debt keeps growing
year after year i.e. it is never paid back; it is only refinanced. Governments borrow for
themselves as well as on behalf of local bodies like municipalities, counties and
provinces. Local bodies on the other hand, borrow in their name as well. Public
corporations, the commercial and industrial organizations promoted and managed by the
government, also borrow and lend in the financial markets.

Within an economy the borrowing and lending takes place in the local currency of the
country. Foreign entities can also borrow and lend money as well as sell and purchase
goods across borders. This gives rise to need of converting currency of one country into
that of another. This is why foreign exchange markets exist.

Securities

In the financial transactions, the borrower takes the money from the lender. What does
the lender or the investor gets in return for his cash? He gets a promise to pay from the
borrower. The promise to pay given by the lender, as discussed earlier, can be bilateral or
tradable. When the promise to pay or right of participation of in future financial proceeds,
is freely tradable from one holder of the right to another, they are called securities. There
are varieties of securities available in the market. The main two categories, however, are
debt and equity. Debt securities represent a defined stream of future receivables by the
holder of the security or the investor. Equity on the other hand represents fractional
ownership in a company and does not have a defined stream of future cash flows. It
represents proportionate ownership in the residual income of the company called net
profit.

Debt securities when issued by the government are called Treasury bills, Treasury notes
or Treasury bonds, in short, T-bills, T-notes or T-bonds. When issued by companies, it
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may be called commercial paper, debentures, bills of exchange, floating rate notes etc. A
detailed discussion on these subjects will follow in the chapter on debt market. Equities
could be common share or preference shares. Whatever the name may be essentially all
the financial instruments represent a promise to pay back.

The fact that majority of the securities can be freely bought and sold is one of the major
characteristics of the financial markets. Tradability makes life easier for the lender and
therefore more borrowers issue tradable securities. One can buy a thirty-year bond but he
need not lock his money for thirty years. If need be, it can be sold after five years or even
after five days. The buyer is another investor who pays the market price and gets right on
all future receivables from the time of purchase. When the securities are sold to the issuer
it is called redemption. Most of the times securities are sold to another investor and not to
the issuer. Thus, issuer get the money for planned time horizon while the lender enjoys
the freedom to get back cash by selling it to another investor. Redemptions are done
mostly on maturity of debt instruments or as and when desired in the case of mutual fund
shares. Equities are perpetual securities where the invested some is returned only on
liquidation of the company.

In this way, same security can be bought and sold many times. Trading volume in the
market over a period of time therefore tends to be much higher compared to the number
of securities issued. First time the money is lent/ invested and the promise to pay is
issued, it is called primary market. If the borrower is a company we say that the company
is selling or issuing a bond. All subsequent purchase and sale of securities take place in
the secondary market. In the secondary market securities are only bought and sold; it is
issued only in the primary market. Issuer, therefore, is the seller of the security. Buyer of
the security is the investor or the lender. It is the existence of the secondary market i.e.
the freedom to buy and sell securities that keeps the primary market ticking. If investors
have no exit route through secondary market, they will be reluctant to invest in the
primary market and the whole channel of lending and borrowing will be chocked.
Secondary market is the lubricant, which keeps the wheels of financial market turning.

It might be clear from the discussion above that capital can be raised either through
mutual non-tradable agreements or through issue of tradable securities. Bank loans are
the prime example of the former. Bank loans need not necessarily be a one to one
transaction involving one lender and one buyer. Larger loans and financed by a syndicate
of lenders. The syndicate is formed to reduce the risk of default of one large borrower.
The bank, as you can see, borrow money from depositors and lend it to other borrowers.
The average lending rate needs to be higher compared borrowing or deposit rate for the
bank to make profit. Essentially, the bank trades in money. It borrows the money from
one source, adds some spread and lends it to someone else.

Lending and borrowing can be done at a fixed rate where rate of interest payable is
defined in advance for the entire life of the borrowing. It can also be done at a floating
rate where rate of interest payable is revised from time to time. London is the most active
financial market in the world. Average rate at which banks in London lend to other banks
is called London Interbank Offer Rate or LIBOR. It is the most widely used benchmark
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for floating rate. LIBOR for different currencies are different because interest rate in
home countries of the currencies are different. Banks have a base rate for lending and add
some spread to this base rate for lending to different borrowers depending upon the
perceived risk attached to the borrower. Prime rate in the US, Interbank rate in Europe
and LIBOR in UK are some of the common base rates. All borrowers cannot hope to
borrow at these base rates. A company with sound financials may be able to borrow at
LIBOR plus 0.50% but a company with weak financial may have to pay a higher rate,
say, LIBOR plus 2.00%.

Minor changes in interest rate are expressed in term of basis points. One basis point
represents one percent of one percent or 1/100 of one percent. Thus LIBOR plus 0.50% is
referred to as LIBOR plus 50 basis points and LIBOR plus 2.00% will be referred as
LIBOR plus 200 basis points. If interest rate changes from 6.01% to 6.02%, we say that
interest rate has moved up by one basis point.

The term bond denotes that the rate of interest is fixed. Floating rate instruments are
normally called floating rate notes or FRN. If FRN is issued at say, LIBOR plus 100 basis
points and reset is done every quarter in advance; it means that interest rate payable for
next three months will be equal to the prevailing LIBOR plus 100 basis points on the
reset date. This rate will be changed again after three months depending upon what the
interest rate is at that point in time. Bonds on the other hand may simply pay 7% every
six months.

Buyer of an equity share does not look for a fixed reward. He looks of dividend and
capital gains. Dividend is the distribution of profit to shareholders. Capital gain is the
difference between the selling price and buying price. Dividend income tends to be lower
than yield or return on bonds most of the times. Rise in price, or capital gain, is the main
attraction for buying equity shares. Prices in the stock market are driven by perceived
financial future of the company. The perception about financial future could be based on
realistic expectations or at many times on irrational exuberance or unrealistic pessimism.

Companies fund their requirements party from equity capital i.e. shareholders’
investment and partly from borrowing. Why should a company borrow and not do the
business entirely from shareholders’ money. There are several reasons for borrowing.
One is that equity is the source of long-term funds whereas money may be required only
for short-term. The short-term needs are best met by short-term borrowings. On the other
hand, debt is a cheaper source of funding for tax paying companies. While debt financing
offers these benefits, it also has is drawback. Interest on debt is to be paid irrespective of
the financial position of the company. Even when the company makes a loss, obligations
arising from loans have to be honored. Therefore, too much of debt becomes dangerous
when business is on the downtrend. Therefore, analysts look at the ratio of equity to debt.
This ratio is called gearing or financial leverage.

We have seen above the main sources of funding equity and debt. For companies, another
source of funding is retained earnings. This is the profit generated by the company, which
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is reinvested in the business. Some estimates suggest that in mature western financial
markets about fifty percent of investment needs of companies is met by retained earnings.

Since banks are the most important financial intermediaries, let us learn about them in
some more detail.

Based on main functions, banks can be broadly categorized into the followings:

Commercial banks
Investment banks
Cooperative banks
Mortgage banks
Savings banks
Giro banks
Credit Unions
Central banks

The main business of Commercial banks is to accept deposits and offer loans. Part of the
commercial bank, which deals with general public, small enterprises and establishments
through branches and other channels, is called Retail banking. Acceptance of deposits,
processing of cheques and card transactions (debit and credit card) and offering small
loans are the main functions of retail banking. Retail banking deals with large number of
small transactions. Therefore, it needs to focus on transaction processing and cost per
transaction. Retail banking deals with its client on transaction-to-transaction basis and is
not much concerned with total financial needs of the client.

Usage of cheques varies from country to country. However, the general trend in the
developed world is downward. In the UK, figures from the Association of Payment
clearing Services (Apacs) reveal that the number of cheque transactions has halved since
its peak in 1990, when four billion were processed. By 2003, cheque use measured by
number of transactions declined by 40 per cent and is expected to fall a further 40 per
cent by 2013. Nordic markets made a concerted effort to rid themselves of cheques 20
years ago and are seldom used anymore. Even in North America, where cheque use is
still regarded highly, the decline has started. Cheque transactions are being replaced by
direct debit and debit cards. Customers can set up automatic instructions to pay important
bills, and debit cards provid a much quicker payment method for goods. The immediacy
of the transaction helps keep track of funds in real time. Cheques, on the other hand, take
up to four days to process. At the end of each working day, branches send all the cheques
that have been paid in to its bank’s clearing center. After the cheques are mechanically
read, the details are sent electronically to the paying banks and the physical cheques are
sent to an exchange centre where they are picked up by the paying bank. Fund transfers
then take place the same day or the following day. Introduction of telephone and Internet
banking has brought more speed and convenience. Customers can pay bills and transfer
funds online and the transaction is immediately reflected in their balance on the PC
monitor. In the year 2000 in US, 20.5 billion credit card transactions and 9.5 billion
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debit-card transactions were processed. These figures make it obvious the increase
reliance of banking on IT infrastructure.

On the other hand, wholesale banking is a business of high value and low volumes.
Wholesale banking arm of a commercial bank deals with other banks, corporates,
institutions, central banks and corporates. While cheques and card are not so important in
wholesale banking, electronic clearing and settlement is. Some of the clearing and
payment systems in different regions are as follows:

Clearing House Interbank Payments (CHIPS) – USA
Clearing House Automated Payments (CHAPS) – UK
Systeme Interbancaire de Telecompensation (SIT) – France
EAF2 – Germany
TARGET – European Union

Private banking is a special set of personalized services provided by the bank to high
networth individuals (HNI). Private banking involves deposits, loans, funds management,
investment advice, tax planning, inheritance planning and other financial needs of HNIs.

While commercial banking is mainly about lending money, Investment banking is about
acting as intermediary and not as a principal in the financial market. It is about helping
different entities in borrowing and lending money. Investment bankers give advice on
which route to follow for raising capital – bonds or equity or a hybrid of bonds and equity
or some other structure. Once the company decides how to raise capital, investment
banker helps in pricing, underwriting (i.e. committing to buy securities themselves if
public is not interested) and selling the securities to raise required capital.

Cooperative banks and Savings Banks perform almost all the functions of commercial
bank but they differ in their ownership structure. These banks are owned mutually i.e. by
the member depositors. Strong Savings banks can be found all across Europe. In the US
they are called Savings and Loan Associations or Thrifts. In UK the Savings banks were
called Trustee Savings Banks. These savings banks came together to form TSB bank. In
1996 it was taken over by Lloyds bank and became Lloyds TSB Bank. In Japan, the
mutual savings banks are called sogo banks.

Cooperative banks are owned by members but they aim to give loans to members at
lower cost and do not necessarily aim at maximizing profit. Membership usually derives
from a specific trade or profession. The largest cooperative banks are in the agricultural
profession – Credit Agricole in France (one of the largest banks in Europe), Rabobank in
Netherlands and Norinchukin bank in Japan. Cooperative banks have significant presence
in Finland, France, Spain, Austria, Netherlands, Germany and Italy.

In some countries there are special banks dealing with only mortgages. Abbey National in
UK was originally a building society, a mortgage bank. Germany has about three dozen
mortgage banks (Hypothenkenbanken).

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The basic idea of a Giro bank is to encourage small savings and focus is not on lending.
In many countries giro banks is the second name for a post office bank. These banks also
facilitate payment of bills to various service providers on behalf of the account holders.

Credit Unions have some common among the members like common membership of a
church or common place of work etc. Members of the bank save money with the bank
and are entitled to borrow multiples of their savings. These banks are entitled to tax
concessions as well. In Ireland about one fourth of the population is a member of a Credit
Union and in Japan there are more than 450 credit associations.

Central bank is the banker of banks, is the monetary authority in a country and quite often
but not necessarily the regulator of banks. Central bank issues the licenses to banks for
carrying out business. Monetary policy is the policy relating to interest rate and money
supply. Central bank plays a major role in influencing and implementing the monetary
policy. The central also controls the issue of currency notes and in some cases also that of
coins. The central bank also acts as the banker to the central or federal government and
raises money on behalf of the government from the market.

In contrast to the few powerful banks that dominate European high streets, banking in
America consists of lots of community banks and credit unions. The list of largest banks
in terms of assets is given below:

World’s largest banks in terms of Assets, The Banker, 2004
Rank Name Country Assets ($ billion)
1 Mizuho Financial Group Japan 1285
2 Citigroup USA 1264
3 UBS Switzerland 1121
4 Credit Agricole Group France 1105
5 HSBC Holdings UK 1034
6 Deutsche Bank Germany 1015
7 BNP Paribas France 989
8 Mitsubishi Tokyo Financial Group Japan 975
9 Sumitomo Mitsui Financial Group Japan 950
10 Royal Bank of Scotland UK 806
11 Barclays Bank UK 791
12 Credit Suisse Group Switzerland 775
13 JP Morgan Chase and Co. USA 771
14 UFJ Holdings Japan 754
15 Bank of America Corp. USA 736
16 ING Bank Netherlands 684
17 Societe Generale France 681
18 ABN Amro Bank Netherlands 668
19 HBOS UK 651
20 Industrial and Commercial Bank of
China
China 638
21 Hypovereinsbank Germany 606
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22 Dresdner Bank Germany 602
23 Fortis Bank Belgium 535
24 Rabobank Netherlands 509
25 Commerzbank Germany 482

Some of the largest investment banks are listed below:

Credit Suisse First Boston
Deutsche Bank Alex. Brown
Goldman Sachs Group
JP Morgan
Lazard
Merrill Lynch
Morgan Stanley Dean Witter
Rothschild
Salomon Smith Barney
UBS Warburg

The world of banking could be very exciting for software professional to explore. The
potential of application of information technology to the banking domain is limited only
by understanding of the business by software professionals. Software professionals need
to be one step ahead of the business in finding new possibilities. That will be possible
only if we understand the intricacies of business of banking and financial services. This
book, as mentioned earlier, is a small step in that direction.
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An Introduction to Financial Statements

This chapter covers some of the important concepts in accounting and financial analysis.
After the completion of this chapter, you would be able to develop a good understanding
of :

What is a balance sheet
What is a profit and a loss account
What is a funds flow statement
Important components of financial statements
Who can use financial statements
Underlying accounting principles
How to construct Financial ratios
How to use financial ratios for analysis
What is cost of capital and how to calculate cost of capital

Chapter also provides useful examples showing the application of these concepts.












Author

Mahadevan N.
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Interested groups in any Enterprise like Managers, Shareholders, Creditors, tax
authorities and other interested groups seek to answers the following important questions
about a firm:

What is the financial position of the firm at a given point of time?
How did the firm perform financially over a given period of time?

To answer the above questions, the accountant prepares two major financial statements -
the Balance Sheet and the Income Statement (Also known as Profit and Loss Account) .

In this section, we will discuss the above statements and also the way these statements
need to be analyzed to arrive at meaningful decisions on enterprise performance,
financial position and investments.

In the first section, we discuss General Purpose Financial statements, prepared quarterly
or annually. These statements are directed towards common informationrmation needs of
a wide range of users. Financial Statements in normal parlance comprise the Profit and
Loss Account (also known as Income Statement), Balance Sheet and Cash Flow
Statements as mentioned above. Our discussion is confined to Financial Statements of
Enterprises engaged in commercial and business activities. Special Purpose financial
statements like prospectuses, estimates, Tax workings etc. is left out of this discussion.

Users of Financial Statements and their interests

Generally, the following interest groups are interested in Financial Statements
Investors – Informationrmation to assess risks in the investments. Buy, Hold or Sell?
Should we replace the Management?
Employees – interested in the financial performance of Employers, and look forward to it
as an indicator to stability of employment
Lenders to the enterprise – interested in knowing what will happen to the monies lent to
the enterprise and whether they will get it back on time
Suppliers – interested in the timely payment of dues that is inextricably linked to good
financial performance and generation of cash
Customers - want to deal with financially stable vendors in long term engagements
Government – Interested in allocation of resources, taxation policies, statistical interests
Most importantly, the management of the Enterprise - Management also has access to
additional informationrmation, which will make their reading of such financial statements
more meaningful and can give tremendous insight into the performance

Objectives of Financial Statements

The fundamental objective of the financial statements is to support the decision making
process of various interest groups as discussed. The American Institute of Certified
Public Accountants has aptly summarized the objectives of Financial Statements as
follows:
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“To provide Informationrmation about the financial position, performance and cash
flows of an Enterprise, that is useful to a wide range of users in making Economic
Decisions.”

Key limitations of Financial Statements

Financial Statements meet common needs of all users but do not provide ALL the
informationrmation that a user may need. This is due to the fact that they portray the
Financial Effects of the past events and are not forward-looking.

Moreover, they generally do not provide the key non-financial informationrmation, which
could have vital pointers to the future potential of the Enterprise. Realizing this
limitation, regulatory bodies like the Securities and Exchange Commission in the US
have made it mandatory to discuss at length, non-financial details like quality of
revenues, types of customers, key risk factors etc.

Assumptions behind Financial Statements

The framework of accounting is based on elements, which have been referred to
variously as concepts, postulates, conventions, principles and rules. Without entering into
a terminological dispute, we will refer to them as “Concepts” for our purpose. The most
important concepts are given below.

Financial Statements (P&L, B/S) are normally prepared on Accrual basis of accounting.
Under this basis, effects of transactions are recorded as and when they occur, irrespective
of whether cash inflow or outflow happens. For example, if goods are purchased on
Credit, the same is recorded as a purchase when the delivery from Vendor occurs, though
the cash outflow may happen after the credit period.

Going Concern: Financial statements are normally prepared on the assumption that the
Enterprise is a going concern and will continue operation for the foreseeable future.

Consistency: In order to achieve comparability of the Financial Statements over a period
of time, it is essential that the Accounting Principles followed are consistent from one
period to another - change in Accounting Policy is only on exceptional circumstances.


Other Concepts:

1. Materiality: Any information is material if its misstatement would have impact on
the decision taken by a user of the Financial Statements. It is mandatory to
include all such information in the financial statements; for example, if a
company has been declared bankrupt by a Court of Law, then such information
should be included in the financial statements. It should be remembered that the
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inclusion or non-inclusion of this fact would have material impact on the
decisions made by users.
2. Substance over form: Transactions should be accounted for and presented in
accordance with their substance and economic reality and not merely on the basis
of their legal form. A Financial Lease transaction, if we go by the form of it is a
simple lease transaction, however, the substance is to have ownership of the
assets. Therefore accounting for a financial lease would envisage treatment of the
leased asset as if it is the enterprise’s own.
3. Prudence: Concept of prudence suggests inclusion of a degree of caution in the
exercise of judgment needed in making estimates under conditions of uncertainty.
4. Comparability: a) Measurement and display of financial effects of like
transactions & events should be carried out in a consistent way, throughout the
enterprise and over a period of time so that comparison is possible, and, b) any
change in the accounting policies between two periods whose financial statements
are compared should be disclosed and impact quantified.
5. Dual Aspect Concept: This may be regarded as the most distinctive and
fundamental concept of accounting. It provides the conceptual basis for
accounting mechanics and there is a universal agreement among the accountants
over this concept.

Before explaining this concept, it would make sense to define the terms “assets” and
“Equities”. “Assets” are resources owned by a Firm. There are two types of equities:
owners’ equity and liabilities. Owners’ equity represents the claims of the owners on the
firm. In the case of a sole proprietary firm this represents the claim of the proprietor; in a
partnership firm, the claims of the partners and in case of a joint stock company this
reflects the claim of the shareholders.

The third term is “Liabilities” which represents the claim of the creditors of the firm:
Debenture holders, financial institutions, commercial banks, trade creditors and others.

Since the resources owned by the firm are equal to its equities, the basic accounting
identity is:

ASSETS = EQUITIES

Now according to the dual aspect concept, each event has two aspects. These are such
that the accounting identity is always preserved. An example may be given to illustrate
this.

Ram starts a proprietary business styled Ram Enterprises. The four financial transactions
of the business are as follows:
Ram contributes Rs.40000 which is kept in a Bank Account
Rs.30000 is paid to acquire business premises
The business obtains Rs.20000 worth merchandise on credit from Shyam
Merchandise worth Rs.10000 is sold for Rs.12000.

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The effect of these transactions from the point of view of the business firm, Ram
Enterprises is as follows:

Transaction 1 An asset (Bank Deposit) increases by Rs.40000 and owner’s equity
increases by Rs.40000. The accounting records of the business would show the following
position after the 1
st
event.
Owner’s equity Rs.40000 Bank Deposit Rs.40000



Transaction 2 An Asset ( business premise) increases by Rs. 30000 and another asset
(Bank Deposit) decreases by Rs. 30000. The accounting records of the business would
show the following position after the II event.

Owners Equity Rs. 40000 Bank Deposit Rs. 10000
Business Premises Rs. 30000

Transaction 3 An asset (merchandise) increases by Rs. 20000 and an equity (trade credit)
increases by Rs. 20000. The accounting records of the business after the third event
would show the following position

Owner’s Equity Rs. 40000 Bank Deposit Rs. 10000
Trade Credit Rs. 20000 Business Premises Rs. 30000
Inventory of Merchandise Rs. 20000

Transaction 4 - An asset (merchandise) decreases by Rs. 10,000 another asset (cash)
increases by Rs. 12000 and owner’s equity increases by Rs. 2000. The accounting records
of the business would show the following position after the fourth event.

Owner’s equity Rs. 42000 Bank Deposit Rs. 22000
Trade Credit Rs. 20000 Business Premises Rs. 30000
Inventory of merchandise Rs. 10000

It will be helpful to explain here how the above transaction resulted in an increase of Rs.
2000/- in the owner’s equity. The transaction led to reduction of merchandise by Rs.
10000 and increase in cash by Rs. 12000. Let us consider these aspects individually. If
we look at the reduction of Rs. 10000 in merchandise, there is an asset decrease of Rs.
10000, so there should be a corresponding decrease in the owner’s equity. Next, when we
consider an increase of Rs. 12000 of cash, there is an asset increase of Rs. 12000 and
hence the owner’s equity should increase by Rs. 12000. The net effect is that the owner’s
equity increases by Rs. 2000.

It should be noted here that an increase in the owner’s equity resulting from a business
operation is called revenue while a decrease resulting from a business operation is called
an expenses. When revenues exceed expenses the difference is called income and when
expenses exceed revenues, the difference is called loss.
Page 22

Contents of Balance Sheet

The balance sheet shows the financial status of a business at a given point in time. The
format of balance sheet may appear as shown in the table below.

Table 1.1 Format of Balance Sheet
Liabilities Assets
Share Capital
Reserves and Surplus
Secured Loans
Unsecured Loans
Current Liabilities and Provisions
Fixed Assets
Investments
Current Assets, Loans and Advances
Miscellaneous Expenditures and
Losses


Below is the specimen Balance Sheet of ABC Company Ltd., as on 31
st
March 2005


Balance Sheet of ABC Company as on 31
st
March 2005 (Rs. millions)
As of
31
st

March
2004
Liabilities As on
March
31
2005
As of 31
st

March
2004
Assets As on
March 31
2005
170 Share Capital
Equity
Preference




120
50
170 213 Fixed Assets
Gross Block
Less: Depreciation

594
365
229
180 Reserves and
Surplus
215 16 Investments 20
150 Secured Loans
Debentures
Loans
&Advances

50
101
151 670 Current Assets, Loans
& Advances
Cash & Bank
Receivables
Inventories
Pre-paid Expenses



73
189
355
64
681
20 Unsecured Loans
Borrowings from
Banks

30
30
409 Provisions
Trade Creditors

330
399 30 Miscellaneous
Expenditures &
Losses
35
Provisions 69
929 965 965 929 965
Page 23
Balance Sheet of ABC Company as on 31
st
March 2005 (Rs. millions)
As of
31
st

March
2004
Liabilities As on
March
31
2005
As of 31
st

March
2004
Assets As on
March 31
2005



Let us discuss the specimen Balance Sheet of the ABC company. It should be noted that:

The balance sheet is prepared for ABC Company which is regarded as a separate entity
The figures in the balance sheet are expressed in monetary term
The Balance Sheet assumes that the company is a going concern (Going Concern
concept)
The fixed assets are stated at cost less depreciation (Cost Concept)
The current assets are stated at cost or market value, whichever is lower (Conservatism or
Prudence); and,
Assets are equal to Equities (Dual Aspect Concept)


Liabilities (Equities)

Liabilities (or equities) defined broadly represent what the business entity OWES to
others. Liabilities can be classified as follows:

Share Capital
Reserves and Surplus
Secured Loans
Unsecured Loans
Current Liabilities and Provisions

Share Capital: This is divided into two types - equity Capital and preference Capital. The
first represents the contribution of Equity Shareholders who are theoretically the owners
of the firm. Equity capital (also known as risk capital) carries no fixed rate of dividend.
Preference Capital represents the contribution of preference shareholders and the
dividend rate payable on this is fixed.

Reserves and Surplus: Reserves represent profits, which have been retained in the firm.
Reserves could be Revenue or Capital Reserves. Revenue reserves represent the
accumulated profits from ordinary business activities and operations. Usually they are
held as General Reserve, Investment allowance reserve, Capital Redemption Reserve,
Dividend Equalization Reserve etc. Capital Reserves arise out of gains which are not
related to normal business operations. Premiums on issue of shares or gain or revaluation
of assets could be examples of Capital Reserves.

Page 24
Surplus is the balance in the Profit and Loss account, which has not been appropriated to
any particular reserve account. It may be noted that Reserves and Surplus along with
equity capital represent Owner’s Equity.

Secured Loans These denote borrowings of the firm against which specific securities
have been provided. The important components of secured loans are: debentures, loans
from financial institutions and loans from commercial banks.

Unsecured Loans These are borrowings of the firm against which no specific security has
been provided. Unsecured loans generally comprise the following: Fixed Deposits from
public, loans and advances from promoters, inter-corporate borrowings, and unsecured
loans from Banks. Interest accrued but not due for payment on Secured Loans is also
shown as unsecured loan.

Current Liabilities and provisions Current Liabilities and provisions comprise the
following: Amounts due to vendors and other suppliers bought on credit., advance
payments received from customers, accrued Expenses, unclaimed dividends; provisions
for taxes, dividends, gratuity, pensions etc.

In business parlance, (distinct from the legal definitions) current liabilities are obligations
which are expected to mature within the next twelve months as of any particular date. So
defined they mean the following:
Loans which are payable within one year from date of balance sheet
Accounts Payable (creditors) on account of goods and services purchased on credit for
which payment has to be made within one year
Provision for taxation
Accruals for expenses like salaries, wages, rents, interest and other expenses
Advances from customers towards sales which will be delivered to them in future

Assets

Assets represent resources, which are of value to the firm in monetary terms. They have
been acquired by expending some cost for the conduct of its operations. Following are
major classification of Assets.

Fixed Assets Fixed Assets have two major characteristics: they are acquired for use over
relatively long periods to carry on the firm’s operations and not meant for sale in the
normal business operations. Examples of Fixed Assets are land, building, plant and
machinery, patents and copyrights.

Investments These are financial securities held by the firm. Some investments are made
with a long-term commitment. Usually these will be equity shares in other companies or
subsidiaries for income and control purposes. Other investments are short term in nature
and may be classified under current assets for managerial purposes. However, Indian
Companies Act lays down that even short-term investments in Bonds etc., are to be
Page 25
shown under investments. In US, these are disclosed under cash equivalents as these are
held for short-term liquidity and realization.

Current Assets- Loans and Advances This consists of cash and other resources, which get
converted into other assets during the operating cycle of the firm. Current assets are held
for a short period of time as against fixed assets, which are held for longer periods. These
are typically, Cash, Debtors (also known as Accounts Receivable), Inventories of Raw
Material, Work in Progress or Process, finished goods, and stores and spares. They are
reported at the lower of cost or market value. Loans and Advances are the amounts
loaned to Employees, advances to suppliers and contractors and deposits made with
governmental and other agencies. They are shown at actual amount, with a provision for
non-recoverables.

Miscellaneous Expenditure and Losses This category consists of two items:
Miscellaneous expenditure, and
Losses

Miscellaneous Expenditures represent certain outlays such as preoperative expenses,
which are to be amortized over a period of time.

Assets Listed Schematically
The following illustrative table shows listing of the assets schematically from the least
liquid (i.e. conversion to cash takes the longest time) to most liquid.
Page 26






























Income Statement: Basic Concepts

The income statement, also called the Profit and Loss Account, summarizes revenues,
expenses and the difference between them (or net income) for an accounting period.
Technically the income statement is only an adjunct to the Balance Sheet as it provides
details relating to net income, which represents the change in Owner’s equity between
two successive balance sheets plus dividends.

The following concepts underlie the construction of an income statement:

Accounting period concept
Accrual Concept
Realization Concept
Matching Concept
Materiality Concept

Land
Buildings
Fixed Assets Plant & Machinery
(Least Liquid) Furnitures & Fittings
Motor Vehicles
Cash in Banks
Quick Assets Cash on Hand
(most liquid)
Marketable Securities (Investments)
Accounts Receivable (Debtors)
Advances (Advances to Suppliers, employees)
Current Assets Deposits ( with Govt or other bodies)
Other Accounts Outstanding
Prepaid Expenses (Expenses paid in advance)
Finished Products
Work in Process (Semi-Finished Products)
Inventories Raw Materials
(or stocks) Other Supplies
Page 27
Accounting period concept: To know the results of business operations and financial
position of the firm periodically, time is divided into segments referred to as accounting
periods, Income is measured for these periods and financial position is assessed at the end
of the accounting period.

The accounting period used for external reporting is usually one year. However, in many
countries this period has been shrunk to one quarter comprising 3 months.

Accrual Concept: According to the accrual concept, income is measured by changes in
the owners’ equity arising from the operations of the business and not dependent on
whether there is outflow of cash is involved or not.

Realization Concept: According to realization concept, revenue is deemed to be earned
only when it is realized. Realization of revenue occurs only when the goods are shipped
or delivered to customer and customer accepts the same.

Matching Concept: Once revenues for an accounting period are recognized, expenses
incurred in generating these revenues are matched against them. This ensures that sales
and cost of goods sold refer to the same product or service. It may be noted that expenses
are matched to revenues and not vice-versa.

There are many expenses such as salary of the CEO or the fees of an external auditor,
which are not traceable to any specific items of revenue. Such expenses are called Period
Costs and are charged in the period in which they are incurred.

Materiality Concept Since maintaining the accounting records involves time and expense,
the accountant is usually concerned with events that are material.


Contents of an Income Statement

There is no fixed format, except that there are disclosure requirements under accounting
standards and Laws.

An illustrative Income statement is given below:

Table 1.3 Income Statement of ABC Company for the year ended 31st
March 2005
Rs. in millions
For the year
ended 31-3-04
847 Net Sales 904

657 Cost of Goods Sold 714
Stocks 366
Page 28
Wages and Salaries 188
Other Manufacturing Expenses 160

190 Gross Profit 190

103 Operating Expenses 96
Selling , Administration 71
Depreciation 25

87 Operating Profit 94

11 Non- Operating Surplus/Deficit 49

98 Profit Before Interest/ Tax 143

26 Interest 33
Bank Borrowings 29
Debentures 4

72 Profit Before Tax 110

36 Tax 58

36 Profit After Tax 52

12 Dividends 17
Equity 14
Preference 3


24 Retained Earnings 35

Any Income statement should contain the followings:

Net sales
Cost of goods sold
Gross Profit
Operating Expenses
Operating Profit
Non-operating – surpluses/ deficit
Surplus/Deficit from Discontinued Operations
Profit before interest and Tax
Tax
Profit after TAX

Page 29

Some Key terms in P&L Account or Income Statement

Cost of goods sold: is the sum of costs incurred for manufacturing the goods sold - it
consists of direct material cost, direct labour cost and Direct Overheads.

Gross Profit: is the difference between Net Sales and cost of goods sold.

Operating Expenses: These consist of general administrative expenses and selling and
distribution expenses.

Operating Profit: Gross Profit – Operating Expenses

Non-operating Surplus: Represents gains from sources other than normal operations of
the business.

Profit Before Interest & Taxes: Is the sum of Operating Profit and non-operating
surplus/Deficit. Referred to as EBIT – eminently suitable for inter-firm comparison.

Profit Before Tax: obtained by deducting interest from profits before interest and taxes.

Profit After Tax: is the difference between the profit before tax and tax for the year.

The income statement is a very important statement for the analysis of quality of earnings
of an entity. Each line in the Income Statement signifies very important indicators from
an analysis perspective, which is illustrated below:
Page 30































Statements of Change in Financial Position

The balance sheet presents a snapshot picture of the financial position at a give point of
time and the income statement shows a summary of revenues and expenses during the
accounting period.

The funds flow statement, also called the statement of changes in Financial Position or
statement of sources and uses of funds, draws on the basic information contained in the
Balance Sheet and Profit and Loss Account and shows the sources and application funds
during the period.

Funds Flow Analysis provides insight into the movement of funds. It also helps
understand the changes in the structure of Assets, Liabilities and Owner’s equity. It helps
us determine, from where the various applications of funds like Capital Investments,
Working Capital (money held up in receivables, stocks etc.) have their sources of funds.
I n c o me S ta t eme n t a n d Fi n a n c e T o p i c s

N e t S a l es


C o s t o f G o o d s s o l d
- S t o ck
- W a g es & S a l a ri es
- O th e r M a n u f a c tu ri n g E x p e n s es


G ro s s Pr o f i t


O p e ra t i n g E x p e n s e s
- S e l l i n g a n d A d mn E x p e n s e s

- D e p r ec i a t i o n

O p e ra t i n g Pro f i t

N o n - O p er a ti n g S u rp l u s / D ef i ci t

E a rn i n g s b e f o r e In te re s t & T a x


I n t er es t




T a x



Pr o f i t a f te r T a x



D i v i d e n d s

R e ta i n e d E a r n i n g s

R e v en u e R i sk –
Q u al i t y o f E ar n i n gs
M ar gi n s – l e v er age o f
e x p e n s es
D e p re ci a t i o n P o l i c y
Bu s i n es s R i s k
Fi n an c i al R i s k
T a x P l a n n i n g
R et u rn o n E q u i t y
D i v i d en d P o l i cy
Page 31
It also tells whether Capital Investments are funded by short-term or long-term sources
and whether the liquidity position of the firm has improved.

Funds are broadly defined as total resources. Most commonly, they are known as
working Capital or Cash. What is discussed here is preparation of Funds Flow using all
the three measures – Total Resources, Working Capital and Cash.

We will attempt to make the funds flow statement from the illustrative Balance Sheets
and profit and loss accounts, which are shown in Tables xxx and xxx respectively.

FUNDS FLOW STATEMENT BASED ON TOTAL RESOURCES

The preparation of Funds Flow Statement based on Total Resources is simple. The
successive Balance Sheets for two financial periods are compared and the changes in the
balance sheet items is noted and classified as a source of funds or use of funds as follows:

Sources Uses
Increase in owners’ Equity Decrease in Owner’s Equity
Increase in Liability Decrease in Liability
Decrease in an Asset Increase in an Asset

Table xxx shows the funds flow statement on total resources basis for ABC Corporation
Ltd.- Part A shows the changes in Balance Sheet Items and Part B classifies these
changes into sources of funds and uses of funds. When funds are defined as total
resources, the sources of funds are equal to the uses of funds i.e. Assets are equal to the
owners’ equity plus liabilities.

Table
Balance Sheets of ABC Ltd as on March 31, 2004 and 2005
(Rupees in Lakhs)

2004 2005
Owner' Equity and Liabilities

Share Capital 170 170
Equity 120 120
Preference 50 50

Reserves and Surplus 180 215
Long Term Debt 50 50
Debentures 50 50
Term Loan - -
Current Liabilities and Provisions 529 530
Loans and Advances 147 131
Creditors 319 330
Page 32
Provisions 63 69

929 965

Assets
Fixed Assets (Net) 213 229
Gross Block 564 605
Depreciation 351 376
Long Term Investments 15 35
Current Assets 690 686
Cash and Bank 73 73
Marketable Securities 6 6
Debtors 160 189
Inventories 384 355
Pre-paid Expenses - -
Miscellaneous Current Assets 67 63
Other Assets 11 15
Intangible Assets 11 15
929 965

“Amplified Funds Flow Statement”

The statement of sources and Application of funds shown in Part B of Table may be
“Amplified” drawing on information contained in the Income Statement. The
amplification consists of providing details underlying changes in Reserves and surplus,
and Net Fixed Assets.

This is done as follows:
Change in Reserves and Surplus, which is equal to retained earnings, is put as

Profit Before Tax
Taxes
Dividends

Now, profit before tax is shown as a source of funds and taxes and dividends are shown
as application of funds.

The changes in net Fixed Assets Balance are analyzed. The net Fixed Assets Balance as
at the end of 2005 is:

Gross Fixed Assets at the end of 2005 – Cumulative depreciation till the end of 2005.
Likewise, the net Fixed Assets Balance at the end of 2004 is Gross Fixed Assets at the
end of 2004 – Cumulative Depreciation at the end of 2004.

Table
Page 33
Income Statement of ABC Ltd for the year 2005
(Rupees in Lakhs)
Net Sales 904
Cost of Goods Sold 714
Stocks 366
Wages and Salaries 188
Other manufacturing Expenses 160
Gross Profit 190
Operating Expenses 96
Selling Administration and General 71
Depreciation 25
Operating Profit 94
Non-Operating Surplus or Deficit 49
EBIT 143
Interest 33
Bank Borrowings 29
Debentures 4
Profit Before Tax 110
Tax 58
Profit After Tax 52
Dividend 17
Equity 14
Preference 3
Retained Earnings 35

Also known as Funds Flow Statement
Draws on the basic information contained in Financial Statements
Shows not only the Sources of Funds and Application of Funds, but also the change in
Financial Position
Provides insights into the movement of funds
Brings out the changes in he structure of assets & liabilities and owner’s equity
Funds flow analysis helps in answering questions like:
Have capital investments been supported by long term financing?
What are the funds generated from operations of business?
What is the firm’s reliance on external borrowings?
What major commitments of funds have been made during the year?
Has the liquidity position of the firm improved?
It is also known as “ Where Come, How Gone Statement”


Financial Statement Analysis

Liquidity Ratios
Page 34
Liquidity refers to the ability of a firm to meet its short term obligations, usually 1 year.
Liquidity ratios are generally based on relationship between Current Assets (The sources
for raising short term cash) and Current Liabilities

Current Ratio
Current Ratio = Current Assets
Current liabilities

Current assets include cash, marketable securities, debtors, inventories, loans and
advances (due to the enterprise) & prepaid expenses. Current Liabilities consist of loans
and advances, trade creditors, accrued expenses and provisions.

Acid Test Ratio
Acid test ration = Quick Assets
Current Liabilities

Quick Assets are defined as current assets excluding inventories.

Acid Test ratio is also known as “Quick Ratio”. It is a stringent measure of liquidity and
based on current assets that are highly liquid. Inventories are excluded as they are
considered least liquid among all assets.

Leverage Ratios

Financial Leverage refers to the use of debt finance
Debt is cheaper but considered riskier
Leverage ratios help in assessing risk arising from debt capital
Two types of leverage ratios are used – structural ratios and coverage ratios.
Structural ratios are based on proportion of debt and equity in the financial structure of
the firm
Coverage ratios show the relationship between debt servicing commitments and sources
for meeting these burdens


Key Leverage Ratios

Structural Ratios

DEBT EQUITY RATIO

Debt Equity Ratio = External Debt/ Shareholders Funds

External debt consists of all liabilities, short term as well as long term
Shareholders’ funds consist of Share capital (equity and preference) and Reserves
Lower the Debt-equity ratio, higher is the protection enjoyed by shareholders.

Page 35
DEBTS ASSETS RATIO = External Debt/ Total Assets

Numerator of this ratio includes all liabilities, short term as well as long term.
Total Assets refers to the total of all assets of the Enterprise

Coverage Ratios

INTEREST COVERAGE RATIO = Earnings before Interest & Taxes/ Debt Interest

A high interest coverage ratio means the firm can easily meet its interest burden even if
earnings before interest and taxes suffers a decline.

FIXED CHARGES COVERAGE RATIO =(Earnings before Interest & Taxes +
Depn)/ (Debt Interest +Repayment of loan/ (1- Tax Rate))

This ratio covers both Interest and repayment. In the denominator, the repayment of loan
is adjusted for the Tax Factor also as principal repayments are not tax deductible.

Turnover Ratios

Turnover ratios, also referred to as Activity Ratios or Asset Management Ratios, measure
how efficiently Assets are deployed by the firm
They are based on the relationship between the level of activity vis-à-vis the levels of
various assets
Important Turnover ratios are Inventory Turnover Ratio, Average Collection Period,
Receivables Turnover ratio, Fixed Assets turnover ratio and Total Assets Turnover ratio

Key Turnover Ratios

Inventory Turnover Ratio = Net Sales/ Inventory
The numerator of this ratio is net sales for the year and the
Denominator is the inventory balance at the end of the year
The inventory turnover ratio is deemed to reflect the efficiency of inventory management.

Average Collection Period = Receivables / Average Sales Per day
e.g.: Receivables = 11.8 lacs
Sales = 701 lacs
Average collection Period = 11.8/(701/360) = 61 days


The average collection period reflects the efficiency of collections vis-à-vis the credit
terms offered by the enterprise.

Receivables Turnover Ratio = Net Cr Sales/ Receivables

This shows how many times the company turns over its receivables.
Page 36


Fixed Assets Turnover Ratio = Net sales / Fixed Assets


Total Assets Turnover Ratio = Net Sales/ Total Assets

Profitability Ratios

Profitability ratios fall under two categories, profit margin ratios and rate of return ratios
Profit Margin ratios reflect the relationship between Sales and Profit Margins
Rate of Return ratios reflect the relationship between profit and investment

Profit Margin Ratios

Gross Profit Margin Ratio = Gross Profit / Net sales

Gross Profit is defined as the difference between net sales and cost of goods sold.
The ratio shows margin left after meeting manufacturing costs.
It measures efficiency of production and pricing.
Analysis of variance in Gross Profit Margin will involve studying the underlying factors
like Material cost, labour, Overhead etc.,

Net Profit Margin Ratio= Net Profit/ Net Sales

This ratio shows the earnings left for shareholders as a % of net slaes.
It measures the overall efficiency of production, administration, selling, financing,
pricing & tax management



Rate of Return Ratios

Net Income to Total Assets Ratio = Net Income/ Total Assets

Net income to Total Assets Ratio measures how efficiently capital is employed.
Used in case of capital intensive projects which have large asset base
Slightly inconsistent in the sense that while “Net Income” belongs to Shareholders,
Assets use finance given by Shareholders & other creditors.

Return on Investment = Earnings Before Interest and Tax/ Total Assets

Measures Business Performance, which is not affected by interest charges and Tax
Payments
Abstracts away the effect of financial structure and Tax Rate and focuses on operational
performance
Page 37
Eminently suited for inter-firm comparison

Return on Equity = Equity Earnings/ Net worth

The numerator of this ratio is equal to profit after tax less preference dividends.
Net worth includes all contributions made by equity shareholders( Paid –up capital +
Reserves and surplus)

“Du Pont” Ratio or Net Return on Total Assets Ratio (NRTA)
NRTA = NPM (Net Profit Margin) X TATR (Total Assets Turnover Ratio), where

Net Profit Margin = Net Profit / Net Sales
Total Assets Turnover Ratio = Net Sales / Total Assets

It helps in understanding how the net return on total assets is influenced by the Net Profit
Margin and Total Assets Turnover Ratio.

Valuation Ratios

Valuation Ratios indicate how the equity stock of the company is assessed in the capital
market
Since Market Value of Equity reflects combined influence of Risk and Return, valuation
ratios are the most comprehensive measure of a firms performance
Important valuation ratios are: price-earnings ratio, market value to book value ratio etc.
Price Earnings Ratio = Market Price per share/ Earnings per Share

Price earnings ratio is a summary index, which primarily reflects the factors of growth
prospects, risk characteristics, shareholder orientation, corporate image and liquidity
Market Value to Book Value Ratio = Market value per share/ Book value per
share

This is a ratio which can be used to find to what extent market discounts the historical
(book) value of the firm and factors for its other growth factors

Cost of Capital

Cost of Capital –some formulae

In general, if the firm uses n different sources of finance, the cost of capital is as follows:
k
a
= Σ p
i
k
i
Where k
a
= average cost of capital
p
i
= proportion of ith source of finance

k
i
= cost of the ith source of finance

Page 38
Cost of a specific source of finance is measured as the rate of discount, which equates the
present value of expected payments to that source of finance, with the net funds received
from that source of finance.
n
P = Σ C
t
/ (1+k
t
)
t=1


One numerical example for calculation of cost of capital has been given below:
Cost of equity = 22%, share of equity in capital = 60%
Cost of debt = 10%, share of debt in capital = 40%

Cost of capital = (22% * 60%) + (10% * 40%) = 17.2%
Page 39
Testing the concepts

1. Which of the following statements is/are true with respect to going concern
concept?
a. The business is not going to terminate its operations in the period ahead
b. The business may be discontinued in the next accounting period
c. The business may not diversify its operational spheres
d. The business may not revalue its assets during the current accounting
period
e. Both (a) and (c) above
2. Which of the following accounts is a current asset?
a. Investments in subsidiaries
b. Advances from customers
c. Accounts receivable
d. Equity Capital
e. Both (a) and (b) above
3. The excess price received over the par value of shares in new issue of shares is
called
a. Calls-in-advance
b. Additional Share capital
c. Reserve capital
d. Share premium
e. Share allotment bonus
4. Which of the following is not an asset?
a. Stock of stationery
b. Goodwill
c. Reserves and surpluses
d. Accounts Receivable
e. Cash at bank
5. Which of the followings is true about the total assets and total liabilities of a
company’s balance sheet
a. Total assets is always less than total liabilities
b. Total assets is always higher than total liabilities
c. Total assets is always equal to total liabilities
d. Total assets is higher than total liabilities when a company makes profit
and lower when it makes loss
e. Total assets increase with rise in share price and liabilities increase with
increase in interest rate
Page 40
Basics of Mathematics and Statistics for Finance

This chapter covers some of the important concepts of finance mathematics. After the
completion of this chapter, you would be able to develop a good understanding of

MeanMedianModePercentilesQuartilesRangeVarianceStandard DeviationCoefficient of
VariationProbability distributionNormal distributionRegressionCoefficient of
CorrelationCoefficient of determinationCovariance and Beta.
Chapter also provides useful examples showing the application of these concepts to the
problems in finance.







Authors

Navneet Nayak
MV Chowdary















Financial Mathematics

Introduction

Advances in information technology have dramatically affected the world of financial
markets. Financial markets evolve through the complex interaction of financial
institutions as they buy and sell assets. With more and more market participants and
financial products these interactions appear increasingly complex, unpredictable and
chaotic. The financial institution's decision to buy or sell a financial product is based on
an amalgam of recommendations made by the various divisions within the institution.
Page 41
Political and economic information is interpreted by economists, corporate information is
analyzed by chartered accountants and security analysts, while quantitative analysts use
mathematical models to provide inputs to the decision making process.

Much of the quantitative analysis including analytics, financial modeling etc. is now
being done through the automated systems used by various players in the financial
markets. The developers of the software systems should understand and appreciate those
concepts of financial mathematics, which forms the foundation for developing models
and solutions. This understanding could bring a remarkable difference in the quality of
the software being delivered by them to their clients.

Finance and mathematics are so interlinked and interwoven that the study of financial
markets and financial products cannot be completed without having a good understanding
of the mathematics behind it. Various branches of mathematics find application in
different areas of financial markets and products. Mathematical finance mainly draws
from the disciplines of statistics, probability, differential calculus and stochastic
mathematics and can be very useful in developing a deeper understanding of the subject.
Some of the areas for which a sound understanding of the underlying mathematical
principles is inevitable are:

Pricing of financial products
Estimating future movements for decision making
Portfolio valuation and management
Risk measurement, analysis and management.
Development of new financial products to meet new and changing markets

A discussion on advanced areas like differential calculus and stochastic mathematics is
beyond the scope of this book and hence will not be covered. Time value of money, one
of the most elementary and key concepts in financial mathematics has already been
discussed earlier and will not be covered again in this chapter. However this chapter
would cover some of the key concepts related to statistics and probability, which find
application in various financial products.

Financial world is full of data. For data to be useful, our observations must be organized
properly. Our goal is to summarize and present data in useful ways to support prompt and
effective decisions. The best way to summarize is to have single numbers called summary
statistics to describe characteristic of a dataset. Two of the important summary statistics
are referred to as Central tendency and Dispersion.

Central tendency: This is middle point of a data set or distribution. Three important
measures of central tendency are:

Mean
Median
Mode

Page 42
Dispersion: This is the spread of data in a data set or distribution. It is also a measure of
how much the data is scattered. Few important measures of how dispersion can be
measured are:

Range
Variance
Standard Deviation
Coefficient of variation

Let us take a hypothetical example from the stock market to understand these terms.
Given below is a sample of prices (in $) for the shares of the company XYZ. The data is
a closing stock price of 70 days. The data here is presented in ascending order.


Arithmetic Mean

Definition: The mean of a data set is the average of all the data values. Mean is one of
the most widely used measures of central tendency for various data distributions.
If the data are from a sample
1
, the mean is denoted by
If the data are from a population, the mean is denoted by Calculating mean


Median


1
Population is a collection of all the elements we are studying; Sample is a collection of some, but not all,
of the elements of the population. A representative sample contains the relevant characteristics of the
population in the same proportions, as they are included in that population.
425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
n
x
x
i ∑
=
N
x
µ
i ∑
=
425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
490.80
70
34,356
n
x
x
i
= = =

Page 43
Definition: The median of a data set is the value in the middle when the data items are
arranged in ascending or descending order. If there are an odd number of items, the
median is the value of the middle item. If there is an even number of items, the median is
the average of the values for the middle two items.

Calculating Median

In the above data set, median is calculated by taking the average of the 35th and 36th
data values.
Median = (475 + 475)/2 = 475

Mode

Definition: The mode of a data set is the value that occurs with greatest frequency or is
the value that is repeated most often in the dataset.




Calculating mode

In the above dataset ‘450’ is the most repeated data item in the set (7 times)
Hence, Mode = 450
Mode could not be used as a useful statistical measure if no data item is repeated or more
than 1 data item gets repeated maximum number of times.

Some other useful measures

425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
Page 44
Percentile

Definition: The p
th
percentile of a data set is a value such that at least p % of the items in
the dataset have a value equal to or less than the value of the data item. It also means that
(100 - p) % of the items have a value more than the value of the data item.

Calculating Percentile

Percentile can be calculated using the following approach:

Arrange the data in ascending order.
The position of the p
th
percentile item, i = (p/100)n
If i is not an integer, round up. The p
th
percentile is the value in the i
th
position.
If i is an integer, the p
th
percentile is the average of the values in positions ‘i’ and ‘i +1’.


Calculating 90th Percentile
i = (p/100) x n = (90/100) x 70 = 63
Averaging the 63rd and 64th data value you get 90
th
percentile = (580 + 590)/2 = 585

Quartile

Definition: Quartiles are specific percentiles. First, Second and third quartile are
respectively equal to 25th Percentile, 50th Percentile and 75th Percentile. The
calculations of quartile are done in a manner similar to percentile calculations.

Measures of Dispersion

Range

Definition: The range of a data set is the difference between the largest and smallest data
values. It is the simplest measure of dispersion. Since it is very sensitive to the smallest
and largest data values it is not used much as measure of dispersion.

Calculating Range
425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
425 430 430 435 435 435 435 435 440 440
440 440 440 445 445 445 445 445 450 450
450 450 450 450 450 460 460 460 465 465
465 470 470 472 475 475 475 480 480 480
480 485 490 490 490 500 500 500 500 510
510 515 525 525 525 535 549 550 570 570
575 575 580 590 600 600 600 600 615 615
Page 45

Range = largest value - smallest value
Range = 615 - 425 = 190

Variance

Definition: Variance is the average of the squared differences between each data value
and the mean. The difference is squared so as to eliminate the possibility of the positive
differences being cancelled out by negative differences showing a much lower variance
in comparison to the actual variance.

Variance
Data set is a sample

Data set is a population


Variance of the data set under study would be given by

Standard Deviation

Definition: The standard deviation of a data set is the positive square root of the
variance. It is measured in the same units as the data, making it more easily comparable
to the mean and hence is the most widely used measure of dispersion.

Calculating Standard Deviation

Standard deviation of the data set under study would be given by


Coefficient of Variation

Definition: The coefficient of variation is the ratio of standard deviation to mean. It
indicates how large the standard deviation is in relation to the mean. It’s a relative
measure of dispersion and is expressed in percentage.

If the data set is a sample, the coefficient of variation is computed as
1 n
) x
i
(x
s
2
2

∑ −
=
N
µ) (x
σ
2
i 2 ∑

=
2,996.16
1 n
2
) x
i
(x
2
s =


=

54.74 2996.47 s s
2
= = =
Page 46
If the data set is a population, the coefficient of variation is computed as follows:

Calculating Coefficient of Variation

Standard deviation of the data set under study would be given by

Example:

Q: Expected return on security A is 12% with a standard deviation of 5%. Expected
return on security B is 15% against the dispersion of 9%. Which security is more risky to
invest in?

A: In order to compute the relative riskiness we have to compute the standard deviation
for each security per unit of the expected return. Expected return for a security is same as
the mean return. Hence a measure of coefficient of variation would give the riskiness.

Coefficient of Variation for A =5/12*100=41.6%
Coefficient of Variation for B =9/15*100=60.0%

Based on these calculations we can say that security B is more risky than A.

Probability distribution

An important step to analyze any financial data would require an understanding of the
manner in which the data is distributed and grouped. Frequency distribution is a useful
way of summarizing and grouping data. Probability distribution is related to frequency
distribution.

Definition: It is a theoretical frequency distribution that describes how outcomes are
expected to vary.

Probability distribution can be of 2 types:
Discrete: Can take only a limited number of values (Ex. Binomial, Poisson)
Continuous: Can take any value in a given range (Ex. Uniform, Normal)
Discrete probability distribution
Binomial distribution is a probability distribution of discrete random variables. It is the
outcome of Bernoulli process. For any process to follow binomial distribution it should
adhere to the following 3 criteria
(100)
x
s
(100)
µ
σ
11.15 100
490.80
54.74
100
x
s
= × = ×
Page 47

Each trial has only two possible outcomes
Probability of the outcome remains fixed over time
Trials are statistically independentOutcome of tossing a coin follows a binomial
distribution.

If ‘p’ is the probability of success and ‘q’ is the probability of failure then the mean value
for ‘n’ trials would be equal to np and standard deviation would be equal to (npq)
1/2


A study on other discrete distributions like Poisson distribution is beyond the scope of
this book.

Example

Q: For the probability distribution shown below what is the expected return and standard
deviation of the returns for both the Stocks A and B?

State Probability Return on Stock A Return on Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

A: Expected return of a stock can be calculated by multiplying the return with the
corresponding probability.

Expected return on Stock A,
E(R
A
) = 0.2 x 5% + 0.3 x 10% + 0.3 x 15% + 0.2 x 20%
= 12.5%

On similar lines expected return on Stock B, E(R
B
) will be equal to 20%.

Standard deviation can be calculated by taking the square root of the variance. Formulae
for variance is

σ
2
= ∑p
i
(R
i
– E(R))
2


For Stock A,

σ
A
2
= 0.2 x (0.05 – 0.125)
2
+ 0.3 x (0.10 – 0.125)
2
+ 0.3 x (0.15 – 0.125)
2
+ 0.2 x
(0.20 – 0.125)
2

= 0.00263
σ
A
= √ 0.00263
= 5.12%

On a similar approach standard deviation for Stock B can be calculated as 20.49%.
Page 48

Monthly standard deviation can be calculated from the daily standard deviation using the
following formulae.

σ
Monthly
= σ
Daily
x √ T

where T is no of trading days in a month


For Stock A,

σ
Monthly
= 5.12 x √ 20 (assuming the number of trading days as 20 in a month)
= 22.89 %

Continuous probability distribution

Normal distribution
2
is one of the most widely used probability distribution in financial
world. It comes very close to fitting the actual observed frequency distribution of many
phenomena.

For example, return on any stock follows a lognormal distribution. When the natural log
of the returns follow a normal distribution, such distribution is referred to as lognormal
distribution. Assume that the closing prices of a stock on n days are P1, P2, P3,
P4……Pn-1, Pn then log(P2/P1), log(P3/P2), log(P4/P3),… log(Pn-1/Pn) follow a
normal distribution.

Characteristics of Normal distribution

The curve has a single peak and is bell shaped
The normal distribution curve is symmetric about its mean (µ) and hence has no
skewness
In this distribution the mean, median and mode are all identical
The two tails extend indefinitely and never touch the horizontal axis
The standard deviation (σ) specifies the amount of dispersion around the mean
The two parameters µ and σ completely define a normal curve
No matter what the value of µ and σ the total area under the normal curve is always 1


2
Normal distribution is also referred to as Gaussian distribution.
Page 49


Above figure depicts the shape of two normal distribution curves having different means
and standard deviation values.
68-95.5-99.7 Rule for the Normal Distribution
The Normal Distribution Curves should follow 68-95-99.7 Rule
68 % of the observations fall within one standard deviation of the mean i.e (µ +_ σ)
95.5 % of the observations fall within two standard deviations of the mean i.e (µ +_ 2σ)
99.7% of the observations fall within three standard deviations of the mean i.e (µ +_3σ)




Standard normal distribution

From 68-99.5-99.7 rule we get three ways of measuring the area under the normal curve.
However most of the real life financial applications would involve measurement of
intervals different from 1, 2 or 3 standard deviation. This can be achieved by making use
of statistical tables. One of the preconditions in using the statistical table is to standardize
any normal distribution curve. A standardized normal distribution curve has µ = 0 and σ
= 1.

Calculating z-value

The z -score is often called the standardized value. It denotes the number of standard
deviations away a data value x
i
is from the mean.
Page 50
z = (x –µ) /σ
Z = (Observation Value – Mean) / Standard Deviation

A data value less than the sample mean will have a z-score less than zero and a data value
greater than the sample mean will have a z -score greater than zero.

Example 1:

Q: The Share value of a company is normally distributed with a mean of Rs 50 and a
standard deviation of 5. Determine the probability of share value being between Rs. 50.00
and Rs. 52.50.
A: Determine the probability of Share value ≤ Rs50, and determine the probability of
Share value ≤ 52.5. Take the difference, and multiply the result by 100 to obtain the
percentage.




Page 51
Using the standard normal variant, Z = (x –µ) /σ, and cumulative distribution function
probabilities from either tabled values

Z1 = (50.0-50.0) / 5 = 0.0
Z2 = (52.5-50.0) / 5 = 0.5

Hence, P (50 < x ≤ 52.5) = 0.5 – 0.00 (compare this value with the Z Score table given
below) i.e 0.1915 or 19.15 %Regression and Correlation

As a student of financial mathematics it is very important to understand how a dataset or
variable changes with respect to another dataset or variable. This section of the chapter
focuses on determining the relationship between variables. One of the simplest examples
would be to understand how price of a stock changes with respect to changes in a market
index.

The analyses done to determine the nature of a relationship between two variables is
regression and the strength of relationship is determined by correlation analyses.

Relationship is established between known variable also known as independent variable
and the variable we are trying to predict known as dependent variable. Nature of
relationship found by regression should be considered as relationship of association
rather than necessarily of cause and effect.

Steps in Regression analysis

Collection of ‘n’ data values for both the variables.

Plotting of scatter diagram: A scatter diagram between two variables with independent
variable on x-axis and dependent variable on y-axis should be plotted.

Fitting of a straight line
3
: This is a process of fitting a straight line through the scatter
diagram such that the sum of the squares of the distance between the estimated point on
the line from the actual observed point is minimized. This method of fitting the straight
line is also known as least square method.

Squaring of the individual error is done to penalize the large errors and to cancel the
effect of positive and negative values.

This straight line would be of the form Y = a + bX. Given any value of X, value of Y can
be estimated.

The above process however does not yet establish the degree of relationship between the
two variables. This is done through correlation analysis. Coefficient of determination is
the measure of strength or extent of relationship.

3
The relationship between two variables can also take the form of a curve. Such relationships are referred
to as curvilinear relationships and could be represented by a two or three degree equation.
Page 52

Coefficient of determination can be calculated using the following equation

r
2
= 1 - ∑(Y
i
– Ycap)
2
/ ∑(Y
i
– Yavg)
2


where,
Y
i
= Actual value of the independent variable
Ycap = Estimated value of the independent variable
Yavg = Mean value of the independent variable

Coefficient of determination can also be considered equal to the ratio of explained
variance to the total variance. Higher the value of coefficient of determination higher is
the strength of relationship.

Coefficient of correlation (r): Coefficient of correlation is another statistical tool that
helps to measure and analyze the degree or extent to which two or more variables
fluctuate with reference to one another.

Definition: Coefficient of correlation (r) is the square root of coefficient of determination
(r
2
). Positive or negative square roots are taken depending on whether the slope of the
fitted line is positive or negative.

Coefficient of correlation ranges from -1 to +1. In case of direct relationship the value of
r ranges from 0 to +1, and for indirect relationships the value of r ranges from 0 to –1.
The values near -1 indicate a strong negative relationship and the values near +1 indicate
a strong positive relationship.

Covariance:

Definition: It is the average of the products of the deviation for each data point pair in
two data sets from their respective means.
COV
(X,Y)
= ∑{(X
i
- Xavg)(Y
i
- Yavg)}/ N

This measure is analogous to variance for one data set.

Relationship between Covariance and Coefficient of correlation: The two measure are
mathematically related as per the following equation

r
xy
= COV
xy
/ (σ
x
x σ
y
)

Example:

Consider the following 2004-year data
4
for Polaris stock prices, I-flex stock prices and
Nifty index.

4
The above data is sourced from ww.nseindia.com
Page 53

Date Polaris (Close)
I-flex
(Close)
Nifty
(Close)
1-Jan-04 253.1 863.4 1912.25
2-Jan-04 252.15 860.5 1946.05
5-Jan-04 252.85 854.8 1955
6-Jan-04 245.9 852.75 1926.7
7-Jan-04 245.3 813 1916.75
8-Jan-04 261.85 838.7 1968.55
9-Jan-04 255.7 835.95 1971.9
12-Jan-04 246.4 807.15 1945.6
13-Jan-04 254.8 813 1963.6
14-Jan-04 256.25 804.65 1982.15
15-Jan-04 244.7 800.8 1944.45
16-Jan-04 227.55 765.5 1900.65
19-Jan-04 232.15 762.05 1935.35
20-Jan-04 222.9 740.25 1893.25
21-Jan-04 189.3 672.5 1824.6
22-Jan-04 178.05 619.05 1770.5
23-Jan-04 200.85 670.05 1847.55
27-Jan-04 207.1 680.6 1904.7
28-Jan-04 194.8 663.5 1863.1
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
15-Dec-04 162.8 624.6 2028.7
16-Dec-04 164.85 642.25 2033.2
17-Dec-04 159.15 639.65 2012.1
20-Dec-04 162.75 631.6 2026.85
21-Dec-04 164.9 632.65 2044.65
22-Dec-04 158.6 619.25 2035.35
23-Dec-04 159.6 612.5 2045.15
24-Dec-04 162.85 625.4 2062.7
27-Dec-04 162.8 619.55 2062.6
28-Dec-04 167.3 617.15 2071.35
29-Dec-04 172.2 611.9 2069.6
30-Dec-04 167.1 591.75 2059.8
31-Dec-04 171.3 635.35 2080.5


Q: Assuming Nifty index as
the independent variable and
I-flex stock price as the
independent variable,
establish the relationship
between them using
regression. Also determine the
extent of relationship between
them.

Follow the same process
between Polaris stock price
and Nifty index.
Page 54
A: The following scatter plot and the fitted lines are obtained (using MS Excel) taking the
entire one-year data of I-flex stock price and Nifty.
I-Flex Stock Price Vs Nifty index
y = 0.2467x + 169.98
R
2
= 0.289
300
400
500
600
700
800
900
1200 1400 1600 1800 2000 2200
Nifty index
I
-
f
l
e
x

S
t
o
c
k

P
r
i
c
e


Nature of relationship is given by the equation Y = 169.98 + 0.2467x
Degree or Strength of relationship is given by r
2
= 0.289. Coefficient of correlation can
be calculated as + 0.537

Clearly, the degree of relationship between I-flex stock price and Nifty index is not very
high and shows a weak form of relationship.

Polaris Stock Price Vs Nifty Index
y = 0.0978x - 8.4775
R
2
= 0.3158
100
150
200
250
300
1200 1400 1600 1800 2000 2200
Nifty Index
P
o
l
l
a
r
i
s

S
t
o
c
k

P
r
i
c
e


Here also the degree or extent of relationship is not very high and reflects a weak form of
relationship.

Beta
Page 55

Definition: Beta for a stock is the expected change in returns of that stock to the 1%
change in market return. It can be calculated through by fitting a line using least square
method and with an additional constraint of zero intercept.

Example:

Consider the following 2004-year data for I-flex stock return and Nifty return data.

Date
I-flex
(Close)
Nifty
(Close) Iflex Return Nifty Return
1-Jan-04 863.4 1912.25
2-Jan-04 860.5 1946.05 -0.00336447 0.017521118
5-Jan-04 854.8 1955 -0.00664609 0.004588516
6-Jan-04 852.75 1926.7 -0.0024011 -0.0145815
7-Jan-04 813 1916.75 -0.04773531 -0.00517765
8-Jan-04 838.7 1968.55 0.0311219640.026666188
9-Jan-04 835.95 1971.9 -0.00328427 0.001700314
12-Jan-04 807.15 1945.6 -0.03505928 -0.01342713
13-Jan-04 813 1963.6 0.0072215850.00920911
14-Jan-04 804.65 1982.15 -0.01032371 0.009402591
15-Jan-04 800.8 1944.45 -0.00479617 -0.01920295
16-Jan-04 765.5 1900.65 -0.04508201 -0.02278323
19-Jan-04 762.05 1935.35 -0.00451704 0.018092256
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
15-Dec-04624.6 2028.7 0.0402651260.01085378
16-Dec-04642.25 2033.2 0.0278661910.002215713
17-Dec-04639.65 2012.1 -0.00405648 -0.01043195
20-Dec-04631.6 2026.85 -0.01266487 0.007303911
21-Dec-04632.65 2044.65 0.0016610640.008743762
22-Dec-04619.25 2035.35 -0.02140828 -0.00455883
23-Dec-04612.5 2045.15 -0.01096013 0.004803342
24-Dec-04625.4 2062.7 0.0208425030.008544668
27-Dec-04619.55 2062.6 -0.00939804 -4.8481E-05
28-Dec-04617.15 2071.35 -0.0038813 0.004233246
29-Dec-04611.9 2069.6 -0.00854324 -0.00084522
30-Dec-04591.75 2059.8 -0.03348462 -0.00474646
31-Dec-04635.35 2080.5 0.07109178 0.009999359
Page 56

Using the above market data determine the Beta for I-flex stock?
Nifty Vs Iflex return
y = 0.9935x
R
2
= 0.4254
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
-0.15 -0.1 -0.05 0 0.05 0.1
Nifty Return
I
f
l
e
x

R
e
t
u
r
n


The above line is fitted using least square method and by forcing the intercept to zero.

The equation of the fitted line so obtained is Y = 0.9935X. Slope of this line is 0.9935,
which is also the Beta for I-flex stock.

However, since coefficient of determination is less, it is not advisable to use the Beta
value.


Application of Coefficient of correlation in Risk Management

Example

3 securities A, B and C have given the following returns in last 5 years.

Year A B C
1 25% -6% 6%
2 0% 12% 6%
3 -30% 16% 6%
4 45% -10% 6%
5 -10% 18% 6%
Average 6% 6% 6%
Std. Dev. 29% 13% 0%

Standard deviation a measure of dispersion is also an indicator of the risk associated with
a security.

Page 57
All the securities above have given the same mean return but the standard deviation for
each of them is different. Clearly investment in Security A is more risky than investment
in Security B and Security C. Similarly an investment in Security B is more risky than
investment in Security C.

Year A B C A+B A+B+C
1 25% -6% 6% 10% 8%
2 0% 12% 6% 6% 6%
3 -30% 16% 6% -7% -3%
4 45% -10% 6% 18% 14%
5 -10% 18% 6% 4% 5%
Average 6% 6% 6% 6% 6%
Std. Dev. 29% 13% 0% 9% 6%

Correlation Matrix
A B C
A 1 -0.94 0.30
B -0.94 1 -0.51
C 0.3 -0.51 1

If the total investment amount is divided equally into A and B, the mean return of the
combined portfolio will still be 6%, but the standard deviation (risk) of the portfolio will
come down to 9%. This is less than the standard deviation of both the securities in the
portfolio. The reduction is happening because of the negative correlation between A and
B. Correlation matrix shows the coefficient of correlation value between Security A and
Security B as – 0.94. Similarly a further diversification in investment by dividing the
invest amount between A, B and C would create a portfolio with mean return as 6 % and
standard deviation as 6 %. Further dip in the value of standard deviation is coming
because of the negative correlation between security B and security C.

Hence with a sound backing of financial mathematics we can say that

Diversification leads to reduction in risk, or, it is safer not to put all eggs in one basket.
More unrelated the components of the portfolio, lesser the portfolio risk.
Individual risk becomes less relevant. What matters is risk in relation to other
components of the portfolio.

Return of the portfolio is can be calculated as

R
p
= w
i
R
i
where,

w
i = value of the security i
th
in the portfolio

R
i = expected return of the i
th
security


Standard deviation of the portfolio can be calculated as

Page 58
σ
p
2
= ∑∑w
i
w
j
Cov(R
i
,R
j
)

where,

w
i = value of the security i
th
in the portfolio
w
j= value of the security j
th
in the portfolio
Cov(R
i
,R
j
) = Covariance between
i
th
and j
th
security in the portfolio



Page 59

Testing the concepts

1. Which of the following a not a measure of central tendency?
a. Mean
b. Median
c. Mode
d. Variance
2. Which of the following is the most used measure of dispersion?
a. Percentile
b. Range
c. Standard deviation
d. Variance
3. Financial mathematics is required in
a. correctly pricing financial products
b. predicting future movements
c. Portfolio valuation
d. risk management
e. All of the above
4. ________________________ gives symmetrical and bell shaped curve
a. Uniform distribution
b. Binomial distribution
c. Poisson distribution
d. Normal distribution
5. A measure used to determine the degree or extent to which two or more variables
fluctuate with reference to one another is known as
a. Variance
b. Coefficient of correlation
c. Expected value
d. Standard deviation
e. None of the above
6. Diversification would lead to better reduction in risk if coefficient of correlation is
a. Close to 1
b. 0.5
c. Close to –1
d. 0
7. Standard normal distribution value can be used to determine
a. Probability
b. expected value
c. covariance
d. variance
e. None of the above

Return Probability
20% 0.2
30% 0.5
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40% 0.3

8. Based on the probability distribution of returns in ABC stock as given above what
is the expected value of return?
a. 30%
b. 31%
c. 40%
d. 28%
9. What is the standard deviation of the above distribution?
a. 6.35%
b. 7%
c. 4.9%
d. can not be calculated with the given data.














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Time Value of Money

This chapter covers some of the important concepts in time value of money. After the
completion of this chapter, you would be able to develop a good understanding of :

Present value
Future value
Rate of return
Annuity and annuity due
Perpetuity
Growing annuity and perpetuity
Nominal and effective rate of interest

Chapter also provides useful examples showing the application of these concepts.









Author

Navneet Nayak
Page 62
Introduction

What do we mean by value of money? Does the value of money change with time? If yes,
how do we measure it and how does it affect our investment decisions? We will address
these issues, which are vital for understanding financial instruments and pricing thereof.

Financial instruments are generally promise of future pay-ins against a current payout.
When you make a deposit, or buy a bond (or share) you buy a promise (or expectation) of
receiving cash flows in future, either as interest (or dividend) and/or capital gains
(appreciation in the value of bond/share), in exchange for cash at present. Investment
involves cash inflows and outflows at different points in time. If value of money
remained unchanged over time, it would be easy to find the best investments out of
several alternatives – just deduct inflows from outflows and rank them. But it is not so.
Let us take an example.

Suppose you have $10,000 and you could invest with two equally safe banks. Bank A
promises to pay $10,500 at the end of first year and Bank B $10,501 at the end of second
year. Which option would you prefer? Bank B offers more money still you may prefer
Bank A. This is because your investment could grow to $11,025 at the end of second year
with Bank A. In making your investment decision you compare not the nominal value –
$10,500 with $10,501, you compare what the value could become at a given point in time
with alternative avenues. As long as risk free rate of return is positive, a dollar today
should not be exchanged for same dollar in future, it should be exchanged for more. How
much more depends upon the rate of return or interest rate. Time Value of Money, a
fundamental concept in finance quantifies the value of a dollar through time based on the
expected or promised rate of return.

An investment grows because it earns some return but at the same time erodes in value
because of inflation. Suppose you have $10,000 as cash in hand and want to buy a piece
of land with this money in future. If kept in locker, your money would continue to remain
$10,000 but price of land may go up. In this fashion, you preserve money but not the
value of money. It cannot buy in future what it can buy now. The net return adjusted for
inflation is called real rate of return. In the example above, if inflation in the first year
were 3%, real value of money at the end of one year would be $10,194 ($10,500/1.03).
Value of money erodes because of rising prices, but as investors, we have no control over
inflation and erosion of value of money because of inflation. Therefore, even as we must
be aware of this fact, in analyzing time value of money we will not consider this factor.

Time value of money has applications in many areas of corporate finance including
capital budgeting, bond valuation and stock valuation. For example, a bond typically pays
interest periodically until maturity at which time the face value of the bond is repaid.
Thus cash flows happen at different points in time. These cash flows, even if they are
same in nominal terms, are not the same when we consider time value of money. Money
received earlier has higher value compared to same amount of money received later. The
value of the bond today, thus, depends upon what present value of these cash flows is. In
Page 63
the later course of this book you would come across the application of time value of
money elaborated under various topics.


Present Value and Future value of money

Future Value (FV) is what an investment today will grow to at a given point of time in
future with a given rate or return. In the example above, FV of $10,000 is $10,500 after
one year and $11,025 after two years. Seen from the other direction, Present Value of
$10,500 to be received one year from now is $10,000 and Present Value of $11,025 to be
received two years from now is also $10,000.

Mathematically future value of $10,000 after one year = 10,000 * (1 + 0.05)^1

In generic form future value of an amount “A” after “t” number of time periods when rate
of return is “r” per period can be calculated as
Future value (FV) = A * (1 + r) ^ t
Process of finding FV given an amount is called compounding.

Consider another scenario. If you have $10,000 as cash in hand and you are expected to
receive another $10,000 after 1 year, what would be the future value of your total wealth
after a year? The correct answer for this is $10,500 + $10,000 = $20,500. Going further,
assume you are not expected to pay or receive any dollars from the beginning of second
year to the end of second year from today, will the future value of your wealth after 2
years continue to remain $20,500? Answer is No. Future value of your wealth after 2
years would then be calculated as

FV = 10,000 * (1 + 0.05)^2 + 10,000 * (1 + 0.05)^1
= $11,025 + $10,500
= $21,525

Hence the future value of the same set of cash flows would be different depending on the
point in the time line where it is calculated. In order to calculate future value of a stream
of cash flows at a given point in time, one needs to bring all the cash flows to the point of
future date by compounding various cash flows happening on the time line. Calculation
of future value in effect would require moving the cash flows to right side on the
timeline.

In the graphical representation of the timeline below, cash flows CF0, CF1 and CF2 are
expected to happen at the end of 1, 2 and 3 years respectively.
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CF0 CF1 CF2

0 1 2 3

1 year






Calculation of the future value of this cash flow stream after 3 years would require
compounding of CF0 for 3 years, of CF1 for 2 years and of CF2 for 1 year. Future value
of this cash flow stream after 3 years would be equal to

= CF0 *( 1 + r)^3 + CF1 * ( 1 + r )^2 + CF2 * (1 + r)^1















Present Value

What is the present value of $1 that will be received at a specified time in future? This is
the same amount, which if received today would compound to become $1 on the same
specified time in the future.

Clearly the present value of $1 that will be received at a specified time in the future will
be less than $1. The formula below calculates the current value of a single sum (CFt) to
be received t periods from now.

PV = CFt /(1+r)^t

Where,

“r” (or “i”) is the discounting rate/ rate of return
Future value of an n period cash flow stream would be equal to
= CF0 *(1+ r)^(n – 0) + CF2 * (1+ r)^(n – 1) + ………….+CFn * (1+r)^(n – n)

where.,
CF0, CF1…CFn are the cash flows at the end of 0, 1st …..nth period respectively.
r is the compounding rate/ rate of return

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1 / (1 + r)^t is the discounting factor.
CFt is the money to be received after t periods i.e. future value of money.

You can see that this formula is directly derived from the formula for FV (Just replace A
with PV and rearrange). Also note that process of finding PV given a future value is
called discounting. The same rate of return is called compounding rate when finding FV
and discounting rate when calculating PV.

What is PV of $1000 due in 2 years if r=10%?

PV = 1000/(1+0.1)^2
= 1000 / 1.21
= $826.45

In order to calculate the present value for a stream of cash flow, one needs to bring all
cash flows to the point of current date by discounting various cash flows happening on
the time line. Calculation of present value in effect would require moving the cash flows
to left side on the timeline.

In the timeline below, cash flows CF1, CF2 and CF3 are expected to happen at the end of
1, 2 and 3 years respectively

CF1 CF2 CF3

0 1 2 3







Calculation of the present value of this cash flow stream would require discounting CF1
for 1 year, CF2 for 2 years and CF3 for 3 years. Present value of the above cash flow will
be calculated as follows:

PV = CF1 /( 1 + r)^1 + CF2 / ( 1 + r )^2 + CF3 / ( 1+ r)^3








Present value of an n period cash flow stream would be equal to
= CF1 / ( 1 + r)^1 + CF2 / ( 1 + r )^2 + ………….+CFn * (1 + r)^n

Where,
CF1, CF2…CFn are the cash flows at the end of 0th, 1st …..nth period respectively.
r is the discounting rate

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Since the underlying for calculating the present value and future value both remains the
cash flows over a specified time horizon, the relation between present value and future
value can be expressed as:

In a more compact form the same equation can also be written as:

PV = FV(1 + i) ^
-n


Annuity

An annuity is a cash flow stream, which adheres to a specific pattern. An annuity is a
cash flow stream that lasts for a fixed number of periods in which the cash flows are
equal and the cash flows occur at the end of these periods. The annuity cash flows are
called annuity payments or simply payments. Thus, the following cash flow stream is an
annuity.

The following cash flow stream is not an annuity because payments do not occur at a
regular interval.




Future Value of an Annuity

The future value of an annuity is calculated at the end of the period in which the last
annuity payment occurs. The future value of the annuity is equal to the sum of the future
values of the individual annuity payments at that time. This can be found in one step
through the use of the following equation:



or FVA
t
= PMT * FVAF
where
FVA = the future value of the annuity
PMT = the annuity payment
r = the interest rate
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t = the number of annuity payments
FVAF = future value annuity factor


Present Value of an Annuity
The present value of an annuity is equal to the sum of the present values of the annuity
payments. This can be found in one step through the use of the following equation:

or, PVAt = PMT * PVAF

where ,
PVA = the future value of the annuity
PMT = the annuity payment
r = the discount rate
t = the number of annuity payments
PVAF = present value annuity factor

Annuity due

An annuity due is a cash flow stream that lasts for a fixed number of periods in which the
cash flows are level (i.e., all of the cash flows are equal) and the cash flows occur at the
beginning of the period. Since each payment of an annuity due is received one period
sooner, each is compounded for one year longer than for an ordinary annuity.

Hence future value of annuity due can be expressed as:

FVADt = PMT * FVAF * (1 + r)

where
FVADt = the future value of the annuity due
PMT = the annuity payment
r = the interest rate
t = the number of annuity payments
FVAF = future value annuity factor

On similar lines present value of annuity due can be expressed as:

PVADt = PMT * PVAF * (1 + r)

where
PVADt = the future value of the annuity due
PMT = the annuity payment
r = the interest rate
t = the number of annuity payments
PVAF = future value annuity factor
Page 68

Perpetuity

Perpetuity is a constant stream of cash flows without end. Thus, the following cash flow
stream is perpetuity.

0 1 2 3 …forever...
|---------|--------|---------|--------- (r = 10%)
$100 $100 $100 ...forever…

Present value of perpetuity can be expressed as

PVt = CF/ r

In the above time line example, present value of the perpetuity would be equal to

= $100 / 0.1
= $1000
How to handle more frequent compounding

Not every time a sum deposited is compounded annually. To calculate the present value
or future value of a sum, which is compounded more than once a year, you need to
multiply the number of annual periods by the number of times the interest is compounded
in a year.

n = number of years x number of compounding periods in a year
You must also divide the annual rate of interest by that same number of compounding
periods in a year.
r = annual rate of interest / number of compounding periods in a year

Kelvin deposits $11,280 in a bank account paying 4% per year, compounded and credited
quarterly. How much will he have at the end of 3 years?

The number of total periods (quarters, in this case) is 3 years times 4 or 12 which is n.
The interest rate paid per quarter is 4% divided by 4 or 1%. Therefore,

FV = 11,280 * (1 + 4/(100*4)) ^ (3*4)
= $12,711

If compounding (payment of interest) were annual, future value would have been
different. With annual compounding,

FV = 11,280 * (1 + 4/100) ^ 3
= $12,688

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It can be seen that with the same rate of interest over the same period of time the same
amount of money grows to different value if frequency of compounding is different. This
is because when interest payment is received earlier, it can be re-invested i.e. interest
itself can earn interest during the year. In other words, the effective return on investment
changes with change in frequency of interest payments. What is the effective annual rate
of return for Kelvin? It can be calculated using the PV/FV formula.

12,710 = 11,280*(1+r)^3
or, r=4.06%

Thus, Kelvin effectively earns 4.06% even as the stated or nominal annual rate is 4%. As
investors we are concerned with effective rate of return even as interest rates are
expressed as nominal annual rate. Since effective rate is dependent on nominal annual
rate as well as frequency of payments without information on both of these factors, we
cannot make proper financial analysis. And we must know how to convert nominal rate
into effective rate and vice versa.

Effective Annual Rate (EAR)

The relationship between effective annual interest rate and the stated (nominal) interest
rate when compounding frequency is higher than the annual period can be expressed as

EAR = [1 + (i / m)]^
m
– 1

where,

“i” is the nominal annual interest rate
“m” is the annual frequency of compounding

The table below shows how EAR changes with compounding frequencies given a 10%
nominal annual rate.

Compounding Period Number of times
compounded
Stated (nominal)
annual interest
rate
Effective annual
rate
Year 1 10% 10.0000%
Quarter 4 10% 10.3813%
Month 12 10% 10.4713%
Week 52 10% 10.5065%
Day 365 10% 10.5152%
Hour 8760 10% 10.5170%
Minute 525600 10% 10.5171%

Theoretically, if interest can be compounded every day and every minute it could be
compounded continuously i.e. at every fraction of the moment as well. It must be noted
that when one lends money he earns interest every moment; interest accrues to him every
Page 70
moment. However, he receives interest only periodically for the sake of convenience just
as an employee earns his salary every day but it is only for the sake of convenience that
he gets paid every month. If interest is paid and compounded continuously what is the
effective rate of return given a nominal annual rate? Formula for finding EAR on a
continuous basis is as follows:

EAR = e
r
-1, where r is the nominal annual rate.

Continuous compounding is extensively used in valuation of derivatives. We shall
discuss it later.

Based on the concepts discussed above, let us try to find answers to some interesting
problems.

How much should you invest today to get one million dollars at the end of twenty years if
rate of interest is 6% p.a. payable annually?

Let us define the problem. Here FV=1,000,000. r=6%, t=20, PV=?

PV=$1,000,000/(1.06)^20 = $311,805
$311,805 will become one million dollar at the end of twenty years if rate of return is 6%
p.a.

How much should you invest every month to get one million dollars at the end of twenty
years if rate of interest is 6% p.a. payable monthly?

Let us define the problem. Here FVA=10,000,000. r=(6%/12), t=20*12, PMT=?

$10,000,000=PMT*((1.005)^(240))/0.005
or, PMT = $21,643

Suppose you are thirty and plan to retire at fifty with a pension of $100,000 per year. If
life expectancy is eighty years, how much do you need to invest each month if interested
rate is 6% p.a.

This pension problem has two parts. You need to know how much you should have at the
time of retirement, which would generate $100,000 for next thirty years. You need to find
present value of annuity.

PVA = $100,000*((1-((1.06)^(-30)))/0.06) = $1,376,483

At the time of retirement you need $1.376 million. This is the future value to which your
monthly investments must grow to at the end of twenty years. FVA is known we need to
find PMT. It could be found in the same way as described in the previous problem.

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Topic for further exploration: Design a flexible pension policy where monthly payments
would increase at a specified rate per annum other things remaining the same. Bring
another variation by allowing the pension amount also to increase at a specified rate per
annum to take care of inflation. Think over how to account for the fluctuation in interest
rates over the next fifty years.
Page 72
Testing the concept

1. If discounting rate is 6 percent per annum, present value of Rs.100 to be received
at the end of two years is
a. 100 x (1+0.06)
2

b. 100 / (1+0.06)
2

c. 100 / (1-0.06)
2

d. 100 x (1-0.06)
2

e. 100 x (1+.06) x 2
2. A stream of constant annual cash flows that lasts for a fixed number of periods is
known as
a. Perpetuity
b. Growing perpetuity
c. Annuity
d. Growing annuity
e. None of the above
3. When the payment frequency is monthly following should be true
a. Effective annual rate (EAR) > Nominal interest rate
b. Effective annual rate (EAR) < Nominal interest rate
c. Effective annual rate (EAR) = Nominal interest rate
d. There is no relation between EAR and Nominal interest rate
e. EAR is not dependent on compounding period but its value is directly
linked to inflation
4. Future value of Rs.100 two years from now when interest rate is 5% will be
a. 100 x (1+0.05)
2

b. 100 / (1+0.05)
2

c. 100 / (1-0.05)
2

d. 100 x (1-0.05)
2

e. 100 x (1+.05) x 2
5. If you deposit Rs.100 at the beginning of every year and the bank pays an interest
of 5 percent per annum how much will you have in your account at the end of five
years?
a. Rs.580.19
b. Rs.552.56
c. Rs.500
d. Rs.525
e. Rs.523.69
Page 73
Capital Budgeting

This chapter covers some of the important concepts in capital budgeting and how to
evaluate different projects. After the completion of this chapter, you would be able to
develop a good understanding of :

Net present value
Internal rate of return
Pay back period

Chapter also provides useful examples showing the application of these concepts.
















Author

Navneet Nayak
Page 74
Introduction

Any long-term investment generates cash flows over several years. The decision to
accept or reject any long-term investment depends on analysis of expected cash inflows
from the project and its cost i.e. cash outflows. Capital budgeting is the process by which
the firm decides which long-term investments proposition to accept from among many
proposals. It is the process of determining whether or not projects such as building a new
plant or investing in a long-term venture are worthwhile.

Capital Budgeting is an extremely important aspect of a firm's financial management.
Even if long-term assets do not form a large percentage of a firm's total assets, the effect
of such capital assets last for a long duration. Therefore, a firm that makes a mistake in its
capital budgeting process has to live with that mistake for a long period of time.

While working with capital budgeting, one is actually performing valuation of cash flows
occurring at different points in time. In valuation, cash flows are identified and
discounted to determine the present value of cash flows. In capital budgeting just as in
valuation, the emphasis is on cash flows including the initial cash flows at the beginning
of the project and every year thereafter for economic life of the project. Remember in
capital budgeting what is important is cash flow, not profits.

A typical capital intensive project is characterized by an initial investment resulting in a
cash outflow followed by a stream of cash inflows over a period of time resulting in the
pattern of cash flow stream shown below.






0 1 2 3 4

We would study some of the key methods used for analyzing the investment decisions in
key projects. All of these techniques attempt to compare the costs and benefits of a
project in different manner. The choice of a method or a combination of methods would
depend upon the relative merits and demerits of using them in a certain project scenario.

Net Present Value Method

Net Present Value (NPV) method is one of the most commonly used capital budgeting
methods. This method involves
forecasting expected cash flows from the project over its economic life,
determination of cost of capital ,
calculating PV of all cash flows using this cost of capital, and
summing all PVs - positive and negative

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The sum thus obtained is called Net Present Value (NPV). Rule for making decision is -
invest in the project if its NPV is greater than 0.

Cost of capital is the cost incurred in financing the project. Project can be financed either
through debt or equity or both. Following expression is used for calculating cost of
capital:

CoC = (CoD X Debt capital / Total Capital) + (CoE X Equity capital / Total Capital)

Where,
CoC = Cost of capital
CoD = Cost of debt
CoE = Cost of equity
and Total Capital = Debt capital + Equity capital.

Since debt is a tax-deductible expense,
CoD = Nominal Rate x (1-Tax rate)

If a company has already raised capital, which cannot be returned, opportunity cost of
capital should be used instead of cost of capital. Opportunity cost of capital is what the
company could have earned by investing the available capital in alternative avenues. This
is the earning, which the firm foregoes if it invests in the new project. This is the
opportunity or earning that the firm loses. That is why it is called opportunity cost.

Let us take an example to understand the computation of NPV. Consider the following
cash flow streams, where the negative value indicates cash outflow and positive value
indicates cash inflow.


Project C0 C1 C2 C3
A - 10,000 2,500 2,500 25,000
B - 10,000 2,500 9,000 0
C - 10,000 9,000 2,500 0

All the three projects shown above require an initial investment of $10,000. Column C1,
C2 and C3 indicate the expected cash inflows over next 3 years. Let us workout the NPV
for each of the project. Suppose the opportunity cost of capital is 10%.

NPV of project A = Sum of PV of all cash flows
=(-10000/(1.10)^(0))+(2500/(1.10)^(1))+(2500/(1.10)^(2))+(25000/(1.10)^3))
= $13,121 (Since NPV >0, accept project)

NPV of project B
=(-10000/(1.10)^(0))+(2500/(1.10)^(1))+(9000/(1.10)^(2))
= $ -289 (Since NPV < 0, reject project)

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NPV of project C
=(-10000/(1.10)^(0))+(9000/(1.10)^(1))+(2500/(1.10)^(2))
= $ 248 (Since NPV > 0, accept project)

If A,B and C are mutually exclusive projects then the project with highest NPV (project
A) is selected.

How do you interpret NPV? As discussed earlier, PV is the sum, which will grow to a
certain value in future (future value) at a given rate of return (the discounting rate). It
implies that if one earns exactly the same return as discounting rate, sum of initial
investment (outflow) and PV of future inflow would be zero. Let us take an example.
Assume you have $10,000 for which your opportunity cost is 10% i.e. you could earn
10% on this amount by, say, depositing in a bank. Now you get an offer to invest in
another project, which will give you $11,000 at the end of one year. Present value of this
cash flow is $10,000. Therefore, NPV of this project is zero (-$10,000 (initial outflow)+
$10,000(PV of inflows)). If the project generated $12,000 at the end of first year, its PV
would be $10,909 and NPV is $909. $909 is nothing but PV of $1,000, the additional
amount you earn. If the project generated $10,500, NPV would be -$455 (PV of your
comparative loss). In short, when NPV is positive the project has earned more than what
you would have earned otherwise. When NPV is negative the project has generated less
than what you could have earned by investing elsewhere, in this case with the bank.
Therefore, if the NPV of a project is negative one is better off investing in alternative
avenues. If NPV is positive one is better off investing in the project. If NPV is zero, one
has earned exactly the same return as the discounting rate. It is because of this logic that
we accept the projects with positive NPV and reject the ones with negative NPV.

Internal rate of return (IRR) method

NPV tells us that we have earned more or less than compared to the discounting rate, but
it does not tell us what has been the actual return. In the example above, NPV of +$909
tells us that we have earned more than 10% but how much is it? This question is
answered by IRR, Internal Rate of Return.

According to this method you should accept investment opportunities offering rates of
returns in excess of their opportunity cost of capital. From the earlier section of net
present value we understand that

NPV= -C0 + C1 / (1+ CoC) +C2 / (1 + CoC)^2……+Cn / (1+CoC)^n

Internal rate of return (IRR) is defined as the rate which makes NPV = 0. As discussed
earlier, when NPV is zero, the project earns exactly the same as the discounting rate. In
other words, the discounting rate at which NPV is zero is the actual rate of return. This
means that to find IRR for an investment project lasting for n years we must solve for
IRR in the following equations.

0 = -C0 + C1 / (1+ IRR) +C2 / (1 + IRR)^2…………+Cn / (1+IRR)^n.
Page 77

If IRR > CoC, accept the project else reject it.

IRR for project A, B and C can be calculated as 51%, 8% and 12% respectively.
Assuming the cost of capital to be 10%, we can only accept project A and project C. If
the 3 projects were mutually exclusive, project A with the highest IRR would be selected.

One should be careful in the use of IRR in projects having more than one change in the
sign of the cash flow, mutually exclusive projects and in scenarios where the short-term
interest rates are expected to be different from long-term rates.

Modified Internal Rate of Return (MIRR) method

IRR method assumes that all the cash inflows would be reinvested at the calculated
internal rate. In the previous section we have seen that IRR for Project A is calculated as
51%. This IRR can hold true only if the firm believes that it has the opportunity to
reinvest future cash flows at 51%. Assuming such a high reinvestment rate looks very
unrealistic rate for future reinvestments, clearly an IRR of 51% is suspect. So unless the
calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be
used as a yardstick to accept or reject a project.

MIRR method is similar to the IRR, but is theoretically superior in that it helps in
overcoming two weaknesses of the IRR. The MIRR correctly assumes reinvestment at
the project’s cost of capital and also avoids the problem of multiple IRRs. For
calculation of MIRR one needs to follow the following steps:

Estimate all cash flows as in IRR.
Calculate the future value of all cash inflows at the last year of the project’s life.
Determine the discount rate that causes the future value of all cash inflows determined in
step 2, to be equal to the firm’s investment at time zero. This discount rate would give
the MIRR for the project.

Let’s see how we work out the calculation of MIRR for Project A, which gives us an
unrealistic IRR of 51%.










C0 = FV of all cash inflows / (1 + MIRR)^n

0 1 2 3
-10,000 2,500 2,500 25,000
2,750
3,025
$30,775
FV of all cash inflows
10%
10%
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10,000 = 30,775 / (1 + MIRR)^3

MIRR = (30,775/10,000)^(1/3) – 1
= 45.4%

Since MIRR > opportunity cost of capital, accept project.

Incases where solving IRR equation gives multiple IRRs, working out MIRR through the
same process would give the correct rate to be compared with the cost of capital.

XIRR is another variant to IRR, which is used when cash flows are not expected to
happen at regular intervals.

In most software packages, NPV, IRR, XIRR should be present as in built functions. Still
it is important to know the concepts and application of these functions.


Payback period method

This method requires that the initial outlay on any project should be recoverable within a
specified cut off period. The payback period of a project is found by determining the
number of years it takes before the cumulative cash flow equals the initial investments or
the cumulative net cash flow becomes zero.

Let us take the same example, which we have used for NPV calculation. Also assume
that the cutoff period for recovering the initial amount is 2 years.

Project C0 Net
Cum.
cash
flow
C1 Net
Cum.
cash
flow
C2 Net
Cum.
cash
flow
C3 Net Cum.
cash flow
A - 10,000 -10,000 2,500 -7,500 2,500 -5,000 25,000 20,000
B - 10,000 -10,000 2,500 -7,500 9,000 1,500 0 1,500
C - 10,000 -10,000 9,000 -1,000 2,500 1,500 0 1,500

We need to spot the two consecutive years where the net cumulative cash flow has
changed from negative to positive. For project A net cumulative cash flows at the end of
2
nd
and 3
rd
year are –5000 and +20,000 respectively. Hence the payback period for
project A should be a value between 2 and 3 years.

Payback period for project A = 2 + 5000 / 25000
= 2 + 0.2 = 2.2 years.

Since payback period > cutoff period, reject project A.

Similarly,
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Payback period for project B = 1 + 7500 / 9000
= 1 + 0.84 = 1.84 years.

Since payback period < cutoff period, accept project B.

Payback period for project C = 1 + 1000 / 2500
= 1 + 0.4 = 1.4 years.

Since payback period < cutoff period, accept project C.

If A, B and C are mutually exclusive projects then the project giving quickest payback of
the investment (project C) is selected.

You can clearly see the anomaly while comparing the results of payback method from
NPV method. Payback method may give misleading answers because of the following
inherent drawbacks in the method.

Payback method ignores all cash flows after the cutoff date.
Payback method ignores the time value of money.
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Testing the concepts

1. NPV is
a. The same as IRR
b. Arrived at by deducting present value of outflows from present value of
inflows
c. Discounted value of a growing annuity
d. a and b
e. b and c
2. Choose the most correct answer
a. If IRR is negative, NPV will be positive
b. If NPV is positive, IRR is higher than the required rate of return
c. If NPV is positive IRR is higher than the prevailing market rate of interest
d. If NPV is positive, payback period cannot exceed five years
e. a and C

Projected cash flow for two projects being evaluated by company XYZ is as given in the
table below:
Year-> 0 1 2 3
Project A -100 30 60 40
Project B -100 40 60 30

3. If weighted average cost of capital for XYZ is 10%, which of the following statements is
true
a. NPV of project A is higher compared to NPV of project B
b. IRR of project A is higher than IRR of project B
c. Payback period of project A is longer compared to payback period of project B
d. Project A and B, both are equally profitable
e. Project A is preferable to project B because increase in cash flow from year 1 to
year 2 is higher compared to project B. Also decline in cash flow is lower from
year 2 to year 3.
4. Which of the following statements is true
a. IRR of project A> 10%
b. IRR of project B> 10%
c. IRR of project A< 10%
d. IRR of project B< 10%
e. a and b
5. Which of the following statements is TRUE If the NPV of a project is zero.
a. The Cash flows are discounted at a rate, which is equal to the required rate
of return.
b. The Cash flows are discounted at a rate, which is equal to the Internal Rate
of Return
c. The Cash flows are discounted at a rate, which is less than the Internal
Rate of Return.
d. The Cash flows are discounted at a rate, which is greater than the required
rate of return.
e. None of the above
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Equity Markets

This chapter covers some of the important concepts relating to equity markets. After the
completion of this chapter, you would be able to develop a good understanding of :

Definition and characteristics of equity
Rights available to equity holders
Equity market terminology
Equity market operations
Significance of stock market index
Implications of different corporate actions
















Author

Navneet Nayak
Nilesh Mantri
Manav Bagdi














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Introduction

Equity or Stocks are one of the most fascinating and talked about areas in the field of
finance. Over the last few decades, the average person's interest in the stock market has
grown exponentially. The widespread media coverage on equity markets has definitely
contributed to a large extent in improving the awareness about stock investment amongst
masses. However the readers of this book are expected to understand the subject with a
greater depth, as it would not just help you become an informed investor but also to
understand various facets of the business requirements in the projects in this area. This
chapter would also lay the required foundation to understand more advanced subjects.

What are stocks?

In one of the earlier chapters on capital structure we have discussed about two major
sources of capital viz. borrowed capital and ownership capital. Equity represents the
ownership capital for a firm. A stock is nothing but a share in the ownership of a
company. Share certificates are legal documents that evidence ownership in a company.
Stock, shares and equity are interchangeably used and all point to the same object. They
all are indicative of holder’s ownership stake in the company. Higher the number of
shares one has, higher is one’s ownership stake in the company’s assets and earnings.

However, to understand the dynamics of the equity markets, this definition is not
adequate. It is the long-term potential to earn higher returns compared to that in the debt
market and the short-term volatility, creating wide scope for speculation, which attract
fund managers and speculators to the equity market. It is the most dynamic and probably
the most unpredictable segment of the financial markets. To understand the equity
markets one should understand the fundamental principles of valuation in the financial
markets and also the impact of greed and fear among both institutional and retail
investors. One should know how and why companies gain competitive advantage over
others and create long-term value for the shareholders in different phases of the business
cycle and product life cycle.

Equity markets or stock markets are places, real or virtual, where the stock investors can
buy or sell the stocks of a publicly traded firm. It is like any other market, where price of
the security is determined by its supply and demand. Higher the demand for a certain
stock, higher its price will be. Equity markets can be further categorized into primary
market or secondary market. Primary market is the one where investors can buy the
stocks when they are issued by the company. Any further trading on the stocks happen in
secondary market. A detailed description of both primary market and secondary market
operations is available later in the chapter.

Characteristics of Equity

Limited liability: Limited liability means that the liability of the shareholder arising from
any circumstance is limited to the amount of investment made in the company. In the
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event of the firm going bankrupt no claims can be made on the personal assets of the
investor.

Profit sharing: Equity investors enjoy unlimited participation in the earnings of the firm.
Theoretically there is no limit to the returns, which an equity investor can get, unlike a
bond investor for which the returns are generally fixed. It is this potential that drives the
price changes in the equity market.

Marketability: Equity stocks are generally highly liquid instruments, which can be bought
and sold easily in the equity markets. Ownership stake in the company changes with
every buy and sell. This characteristic makes the stocks a very attractive investment
option for investors, as they can remain invested as long as they wish to. Earnings for
stock investors can be both through the dividend payout and through the capital gains.

Corporate control: Equity stocks come with certain rights including the voting rights to
which the investors are entitled. The section below covers various rights available to
equity holders.

Rights to equity holders

As an owner of the company, one is entitled to have a share in the company's earnings as
well as any rights attached to the stock. Below are listed some of the key rights available
to any stock investor:

Right on Income: Equity investors have a residual claim to the income of the firm. The
common equity shareholders’ income is equal to Profit after Tax less preferred dividend
if any [PAT – DP]. Income of equity shareholders may be retained by the firm or paid out
as dividends. Dividend income is the prerogative of the Board of Directors. Equity
shareholders cannot challenge the amount of dividend determined by the Board of
Directors in a court of law however impressive the financial performance of the company
may be.

Right to control: The management of the company is supposed to increase the value of
the firm for shareholders. If this doesn't happen, the shareholders can vote to have the
management removed. As owners, equity shareholders elect the board of directors who
can act on their behalf. The power to vote is in proportion to number of shares held.
Equity investors are entitled to vote either in person or in proxy. In reality, retail investors
don’t have enough shares to have a material influence on the affairs of the company. Big
investors like institutional investors, mutual funds and high net worth investors are in a
better position to influence the management. But ultimately a company follows the
course decided by the group of shareholders who control the Board of Directors and
appoint the management team. Investors who collectively own the largest percentage of
shares compared to other groups have the control on the firm.

Preemptive right: This right enables existing equity shareholders to maintain their
proportional ownership by purchasing the additional equity share issued by the firm. In
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the absence of this right with any additional issue of shares, the ownership of the existing
shareholders would get diluted and the earnings of the company will get distributed over
a larger base.

Right to inspect books: Shareholder enjoys the right to obtain information about the
operations of the firm and inspect the accounts and records. In practice, however, this
right is limited.

Right to Reports: Shareholders are entitled to regular reports from corporate management
and the Board of Directors. Most of the firms publish quarterly and annual reports
providing updates of the previous period and management’s outlook on future business.
Management also gives other periodic communications as and when required.

Right in liquidation: Equity shareholders have a residual claim over the assets of the firm
in the event of liquidation. Residual claim is on the amount left over after paying off all
the senior claims of the creditors, preference shareholders etc.

Type of Stocks

The two most common types of stocks are Ordinary stocks and Preferred stocks.

Ordinary Stock

Ordinary stock is also referred to as the common stock. Majority of stocks are issued in
the form of ordinary stocks and most of the characteristics and rights as discussed above
apply to the ordinary stocks. Ordinary shares represent ownership in a company and a
claim on a portion of profits (dividends). Investors get one vote per share to elect the
board members who oversees the major decisions made by management.

Over the long term, ordinary stocks are expected to give higher returns than any other
form of investment in a firm. This higher return comes at a cost as common stocks entail
higher risk. If a company goes bankrupt and liquidates, the ordinary shareholders will
receive money after the creditors and preferred shareholders are paid their due.

Preferred Stock

Preferred stocks represent a hybrid form of financing taking some features of ordinary
stocks and some features of bonds or debentures
5
. Preferred stock represents some degree
of ownership in a company but usually doesn’t have the same voting rights (this may
vary depending on the company). On preferred shares, investors are usually guaranteed a
fixed dividend. This is different from common stock that has no pre-determined
dividends. Another advantage is that in the event of liquidation preferred shareholders are
paid off before the common shareholder (but after debt holders). Preferred stock may also
be callable. A callable stock can be purchased back by the company from the preference
shareholders at pre-defined terms and conditions.

5
Debentures are unsecured bonds.
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Preferred stocks have the following similarities with common stocks and bonds:

Similarity to Common stock Similarity to Bonds
Preference dividend is payable only out of
distributable profits
It is not an obligatory payment
It is not a tax-deductible payment
The dividend rate is usually fixed
The claim is prior to that of equity share
holder
Preference shareholders have no or limited
voting right

Equity terminology

The following table list down some of the commonly used terms and a brief description
against each of them:

Term

Description
Par value It is also known as the face value of the stock.
Most of the stocks are either issued at the par value
or at some premium over the par value in the
primary market. Dividend declared by a firm is
expressed as a % of the par value of the share.

Authorized capital It represents the maximum number of equity
shares that a firm can issue and is approved by a
regulatory body. Authorized capital can be raised
by special resolution of the shareholders.

Issued capital This is a subset of authorized capital and
represents the number of shares issued by the
company. This also includes promoters holding in
the firm.

Subscribed capital This is a subset of issued capital and represents the
number of shares subscribed to by the investors. If
the issue is subscribed fully then the subscribed
capital is equal to issued capital.

Paid-up capital This is a subset of subscribed capital and
represents the number of shares for which the
investors have paid as per the issue price fixed.
Paid-up capital is generally equal to subscribed
capital as payments in installments are rare these
days.

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Outstanding shares

This represents the difference between total
subscribed capital and shares bought back by the
firm, if any. Bought back shares are also referred
to as Treasury stock. The number of outstanding
shares includes both promoters’ and public stock.

Book Value Book value per share is the sum of paid up equity
capital and reserves and surplus divided by number
of total outstanding shares. Reserves and surplus is
the accumulation of the undistributed profit.

Market Value or Market Price Market price of the share is the price at which it is
traded in the secondary market. Market price of the
share keeps fluctuating with every trade in the
market. It is a reflection of the future earning
potential of the company in the eyes of investors.
The earning expectations generally determine the
supply and demand of that stock in the market.

Market Capitalization Market capitalization of a firm is the product of the
market price per share and the number of
outstanding shares of the firm. It can also be
considered as the combined wealth of the all the
shareholders of the firm. (not inclusive of their
personal wealth).

Free float Market capitalization Free float market capitalization of a firm is the
product of the market price per share and the
number of floating shares of the firm. Number of
floating shares is equal to the number of
outstanding shares minus number of shares held by
promoters.

P/E ratio This is the ratio of market price per share to
earnings per share. Earning per share is the total
profit after tax divided by number of shares
outstanding.

Bull market A bull market is the one where buyers outnumber
the sellers. In such a market trend is the general
increase in stock prices.

Bear market A bear market is the one in which sellers
outnumber the buyers. In such a market trend is the
general decrease in stock prices.

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Dividend Yield It is the percentage return on the dividend,
calculated as annual dividends per share, divided
by market price per share.

IPO Initial public offering to issue shares.

Share premium This is the difference between the issue price of
the share and par value of the share.


Primary Market

Business is the cornerstone of any economy and a flourishing economy requires
flourishing businesses. Most of the large corporations that we see today started out as
small firms and have grown over a period of time to become business giants.

How did these small companies grow from tiny, hometown enterprises to large
businesses? Of course strong business acumen, foresight and ideas are needed to take the
businesses from a turnover of a few thousands dollars to multibillion-dollar businesses.
However to put any business idea into action capital is a must.

A business generally starts by opening a proprietary or partnership company. Any such
company can be labeled as a privately held company. A privately held company has
fewer shareholders (generally the owners of the firm) and the owners (promoters) don't
have to disclose much information about the company. When a company is private, small
and is growing, the biggest hurdle is often raising enough money to expand. Owners of
the firm generally have two options to overcome this. They can either borrow the money
from a bank or get money from other investors. Taking out a loan is common, and very
useful to a point. But banks do not always lend money to small firms or expect a very
high cost for the money lent. Equity capital funding is an attractive option for the firms in
such a scenario. Equity capital investors are ready to invest in firms where the firm is
having a potential to grow and make profits in future. If the investor is convinced with
the business plan and management capabilities they may decide to provide the required
funds to the firm. In return they get the proportional stake in the firm and its earnings.
Equity capital could be invited in a phased manner depending on the cash flow
requirement and the business growth of the firm over a period of time. The management
of a mid-sized firm may need funds to expand and to achieve economies of scale to
reduce costs. This would require expanding the operations and increasing the production
level.

These circumstances necessitate issue of stocks to public or venture capital firms. Issue of
stocks to public for the first time is also termed as “going public”. In exchange for giving
up a fraction of ownership, promoters are given cash to expand the business. The capital
acquired by selling companies stocks need not be paid back to investors as the investors
along with the promoters will be the combined owners of the firm. The firm, which is a
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reasonably well-known business entity amongst public, would be able to sell the stocks
easily if the shares are correctly priced.

The firm in need of capital takes public issue or primary market route. IPO an acronym
for Initial Public Offering is the first sale of stock by a company to the public.

Process of Initial Public Offering

Following is the process of raising capital through an Initial Public offering (IPO):

Selection of the Underwriter(s)

When a company wants to go public, the first thing it normally does is to appoint an
investment bank (also known as merchant bank) for underwriting the issue. However, a
company is under no regulatory binding to use services of an investment bank for
underwriting an issue. Since the companies intending to raise capital through IPO have
no experience in this activity, they take services of professional underwriters for
undertaking this activity. Underwriters assess and analyze firm’s performance, firm’s
earnings potential, industry scenario, competition, current market situation etc. to decide
the issue price (or the price range). They also work on other activities including
completion of the mandatory documentation as required by the regulatory body before
floating the issue. Underwriters charge a fee for this activity, which is generally a
percentage of the issue size. Some of the biggest underwriters world over are Goldman
Sachs, Merrill Lynch, Credit Suisse First Boston, Lehman Brothers and Morgan Stanley.

Sometimes the issue size is so large that one underwriter is hesitant to shoulder all the
risk of underwriting the entire issue. In such cases a syndicate of underwriters together
underwrite the issue. One underwriter however plays the role of lead underwriter.

Signing agreement with Underwriter(s)

The firm and the underwriter(s) first meet to discuss and freeze on the amount of capital
to be raised, the type of securities to be issued and the various terms and conditions
including the fees structure in the agreement. The agreement can be structured on either a
“firm commitment basis” or on “best efforts” basis. If the agreement is structured on a
"firm commitment" basis, the underwriter guarantees that a certain amount will be raised
by buying the entire offer and then reselling to the public. In a firm commitment,
underwriters act as a dealer and are responsible for any unsold inventory. The dealer
profits from the spread between the purchase price and the public offering price. If the
agreement is structured on the "best efforts" basis, the underwriter sells securities for the
company but doesn't guarantee the amount raised. If the underwriter is unable to sell all
securities, it is not responsible for any unsold inventory.


Filing and approval of Registration statement

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As discussed earlier, IPO brings the transition of a privately held company to a publicly
held company. Before the issue is made open to the public, the company needs to register
with the regulatory body by filing a registration statement. Any public company has stake
of thousands and millions of shareholders and are subject to strict rules and regulations.
In US SEC (Securities and Exchange Control board) and in India SEBI (Securities and
Exchange Board of India) regulate the operations of public companies and stock market.

The underwriter of the issue prepares the registration statement to be filed with the SEC.
This document contains information about the initial public offering, and other company
specific information such as financial statements, management background, any legal
issues, where the money is to be used, and the current holdings structure.

The regulatory body requires a “cooling off period” to verify and validate the correctness
and completeness of the material information provided in the registration statement. It is
only after SEC (in US) or SEBI (in India) approves this document, the IPO can further
take off.

Preparation of Red herring prospectus and conducting road shows

During the cooling off period underwriter works to market the issue through a prospectus
known as red herring prospectus having complete information about the company,
financial performance, business growth prospects, senior management profile, promoters
etc. except for the issue price and the issue date. This prospectus is made available to
potential investors. The next step in the process is to conduct road shows by inviting
major potential investors and gathering their views on the issue.

The objective of floating red-herring prospectus and conducting road shows is two fold:

To increase the awareness and create interest about the issue amongst potential investors
To make an assessment of the best issue price at which the entire issue is likely to be
subscribed

Preparation of the final prospectus and finalization of issue date and price

After getting regulatory approval on registration statement and the completion of road
shows, underwriter and the company together decide on the issue date, issue price and the
method of issuing shares. This decision is based on the company, the success of the road
show and most importantly the current market conditions. Infact the decision on issue
price depends on the method selected for issuing the shares.

The two common methods of issuing shares through IPO are:
Fixed price method
Book building method

a. Fixed price method

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Under this method the underwriter in consultation with the company fixes the issue price
of the stock. The issue price could be at the par value of each share or at a premium
above the par value. The issue also specifies the minimum lot quantity that should be
subscribed by the investors. Investors could be classified into several categories for the
purpose of allocation of shares.

b. Book building method

This is a commonly used method these days. In this method the issue price is not fixed
but a price band is determined. Lowest price in the price band is the floor price and the
highest price in the price band is the cap price. Investors can bid for the shares at any
price in the price band depending on their view on the correct price of the share.

After the issue is closed, a book having all the subscriptions in descending price order is
build. This forms the basis of determining the cut-off price. Cut-off price is that price at
which the entire issue gets subscribed. Investors who are ready to buy the shares at any
price in the price band can fill the application form at the ‘cut-off price’. The price at
which the allotment of shares is to be done is decided on the basis of method used for
allotment, which could be discriminatory price or uniform price. Further explanation on
these methods is available in Allotment of Shares section below.

Issue opens

An IPO has an issue start date and an issue end date. This defines the time window during
which investors are allowed to apply for the stocks. The application forms are made
available through different brokers, agents and outlets to the investors. These days many
websites allow online application of stocks in IPO.

The issue closes at a specified time on issue end date. No further applications are
accepted after that.

Allotment of Shares

Depending on whether the issue is oversubscribed or undersubscribed the decision on the
quantity of allotment to each investor is made. If the issue is oversubscribed, then each
valid application may be allotted stocks either on a random basis or on proportionate
basis or some other criteria as decided by the company management and the underwriter.

If the issue is undersubscribed and agreement between the firm and the underwriter is
structured on a firm commitment basis, then the underwriter will have to buy the
unsubscribed portion of the IPO at the price which is fixed.

In one of the earlier sections we have seen that under book building method, either
discriminatory price or uniform price criteria can be used to allot shares.

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Under discriminatory price method the shares are allotted at different prices to different
investors above the cut-off price. The allotment is done on the price at which the
application is made by the investor.

For example, if the cutoff price is $50 and investor A has applied at $52 and investor B
has applied at $50, the price at which the shares will be allotted to them would be $52
and $50 respectively.

Under uniform price method also known as Dutch auction method the shares are allotted
at uniform price, which is also the cut-off price. The allotment is done on the uniform
price irrespective of the price at which the application is made by the investor.

For example, if the cutoff price is $50 and investor A has applied at $52 and investor B
has applied at $50, both the investors will be allotted the shares at $50 only. The use of
uniform price method is more common in the equity market.

The allotment of shares and the refund of application amount (in case of non-allotment or
partial allotment) are done by the company appointed registrar.

Secondary market operations

Most stocks are traded on exchanges, which are places where buyers and sellers meet and
decide on a price. Some exchanges are physical locations where transactions are carried
out on a trading floor. In the earlier days you would have probably seen pictures of the
trading floors where traders are wildly throwing their arms up, waving, yelling, and
signaling to each other. This method of trading stocks is also known as Open outcry
method of trading. The other type of exchange is virtual, composed of a network of
computers where trades are made electronically. Information Technology has increased
the speed and efficiency of the entire trading process as a result of which more and more
exchanges world over are automating the entire trading, clearing and settlement process.

World over NSE, NYSE, London Stock exchange, Tokyo Stock Exchange are some of
the major stock exchanges where the daily transaction volumes are to the tune of billions
of dollars. In India most of the stocks are listed on National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE).

After the IPO allotment process is over, stocks are listed on various exchanges. Each
exchange defines its own eligibility criteria (like minimum paid up capital etc.), which
should be fulfilled to get the listing. Listing gives the trading privileges on stock
exchange to the listed security. Exchange enable trading of the stocks listed with it on the
exchange. Every exchange has its own clearing corporation, clearing members, clearing
bank and depositories responsible for performing various activities for clearing,
settlement and risk management.

An investor can buy and sell stocks through the stockbrokers authorized to trade by the
exchange. There are hundreds of brokerage houses, including some of the bigger names
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like Merrill Lynch, Charles Schwab and Morgan Stanley. When the investor calls up the
broker at one of the brokerage houses and places the order, he or she relays the order to
the floor of the appropriate exchange, and a representative of the company (or, more
commonly, a computer representing the company) makes the trade. The investor pays the
broker a commission to provide this service. These days more and more trades are taking
place online where the registered investors login to the website provided by the broker
and place the order. Order placement, order execution and order confirmation happens
online. Trading online does not require any human intervention and trades are executed
using straight through processing (STP).

We have dedicated chapter in this book covering the trading, clearing and settlement
process.

Stock Market Index

Every day we come across news linked to the stock market indices flashed on our TV
screens or making the headlines of the financial newspaper. What is stock market index?
What do the index movement mean? How is it calculated? What is its significance? All
these questions do come in the mind of an investor. Let us try to get answers for this.

A simple index is a number, which measures the change in a set of values over a period
of time. A stock index is a composite measure of the change in value of a set of stocks,
which constitute the index. A stock index is not an absolute measure but a relative
measure of the market performance. To be more specific, a stock index number is the
relative measure of the prices of a pre-defined group of stocks. It is a relative value
because it is expressed relative to the weighted average of prices at some chosen starting
date or base period.

Any change in the index reflects the changing expectations of the investors about returns
from the stocks underlying the index. The index goes up if the investors think that the
future earnings will be better and the index drops if the view is opposite. If the index goes
up it does not mean that the prices of all the stocks in the index have gone up. Each stock
in the index carries a weight and depending on the relative weights of all the stocks and
the change in the price levels of each of the stock, the index is recalculated.

Types of Indexes
Three types of indexes exist world over. Below is explained the difference between each
of them.

Price weighted index

In a price-weighted index each stock is given a weight in proportion to the price of the
scrip.

Consider the following example to understand this further.

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Example: Index-ABCDE, a price weighted index is composed of 5 companies A, B, C, D
and E. Base index value for price weighted index is 1,000. This index value corresponds
to the prices of the index stocks as on 1
st
Jan, 2001.

Company
name
No. of shares issued
(in millions)
Market price
(as on 1
st
Jan,
2001)
Market Price
(as on 28
th
Feb,
2005)
A 45 $ 20.00 $ 15.00
B 300 $ 15.00 $ 18.00
C 60 $ 50.00 $ 55.00
D 60 $ 70.00 $ 65.00
E 45 $ 80.00 $ 70.00

What is the index value of Index-ABCDE as on 28
th
Feb, 2005?

Solution: In a price weighted index the weightage of each stock is the price of the stock.

Sum of the prices of all 5 stocks as on 1
st
Jan, 2001
= 20 + 15 + 50 + 70 + 80
= $235
Base price level of $235 corresponds to the base index value of 1,000.

Therefore, index value as on 28
th
Feb, 2005

= Sum of the stock prices as on 28
th
Feb, 2005 X Base index value
Base price level

= (15 + 18 + 55 + 65 + 75) * 1000/235
= 228 *1000/235 = 970.2

Market capitalization weighted index

In a market capitalization weighted index each stock is given a weight in proportion to
the market capitalization of the scrip. Most of the indices world over are market
capitalization weighted index.

Consider the following example to understand this further.

Example: Index-LMNOP, a market capitalization weighted index is composed of 5
companies L, M, N, O and P. Base index value for price weighted index is 1,000. This
index value corresponds to the market capitalization of the index stocks as on 1
st
Jan,
2001.

Company
name
No. of shares issued
(in millions)
Market price
(as on 1
st
Jan,
2001)
Market Price
(as on 28
th
Feb,
2005)
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L 45 $ 20.00 $ 15.00
M 300 $ 15.00 $ 18.00
N 60 $ 50.00 $ 55.00
O 60 $ 70.00 $ 65.00
P 45 $ 80.00 $ 70.00

What is the index value of Index-LMNOP as on 28
th
Feb, 2005?

Solution: In a market capitalization weighted index the weightage of each stock is the
current market capitalization of the stock.

Sum of the market capitalization of all 5 stocks as on 1
st
Jan, 2001
= (20 x 45) + (15 x 300) + (50 x 60) + (70 x 60) + (80 x 45)
= $16,200 million
$16,200 million corresponds to the index value of 1,000.

Therefore, index value as on 28
th
Feb, 2005

= Sum of the market cap of all index stocks as on 28
th
Feb, 05 x base index value
Base market capitalization

= (15 x 45 + 18 x 300 + 55 x 60 + 65 x 60 + 75 x 45) * 1000/16,200
= 16,425 *1000/16,200
=1013.88

Equally weighted index

In a price-weighted index each stock is given a equal weight irrespective of the price or
the market capitalization of the stock This index is rarely used by any of the stock
exchanges world over and does not require more explanation.

What factors decide the number and type of stocks to be included representing market
index? A market index should truly represent market behavior. Generally large cap stocks
are representative of market and economy and should be considered for inclusion in the
market index.

True market behavior also needs good diversification of the stocks from different areas
without compromising on liquidity. Hence a good index is a trade-off between
diversification and liquidity. A well-diversified index is more representative of the
market. However there are diminishing returns to diversification. Adding beyond a
certain number of stocks bring almost zero benefit. Hence, there is little gain by
diversifying beyond a point and only optimum number of stocks should be included in
the index.

Also the market index should be comprised of stocks that are highly liquid in nature.
Illiquid stocks may not get traded at the correct price and hence may not reflect the
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correct market condition. Inclusion of the illiquid stocks actually worsens the index.
Impact cost is one of the measures of the liquidity of the stock. For inclusion in the
market index all stocks having impact cost less than a benchmark value can be
considered.

Impact Cost

Impact cost is change in price of a stock caused by specified size of buying and selling
order. Suppose the last traded price is Rs.100. Given the existing buying orders in the
market, if a selling order for $1 million in the stock brings down the price to Rs.98,
impact cost of selling $ 1 million is 2%. Higher the impact cost, lower the liquidity and
lower the impact cost higher the liquidity.

Corporate actions

Corporate actions can refer to any action taken by a corporate (i.e a company). However
Corporate actions in a strict sense refers to very specific actions such as dividends,
mergers, bonus issues, stock split, share buybacks, rights issues etc. which typically
affect equity structure and the price of shares. Board of directors of the company approve
all corporate actions. Any publicly listed company should inform the exchange(s) in
advance about the planned actions.

A clear understanding of all corporate actions is a must to understand their implication on
company's financial affairs and how that action is likely to influence the company's share
price and performance.

Stock Splits

A stock split is an action whereby each stock of the company is split into multiple stocks
depending on the ratio in which the split is announced. As a result of stock split each
existing investor holds multiple stocks for each stock held by them pre-split. A stock split
does not affect a company's paid-up equity capital because on the one hand the face value
of each share comes down and on the other hand number of shared increases. Since the
action increases the number of outstanding shares, it should also result in reducing the
market price of the share such that the market capitalization of the company does not
change much.

For example, a company announcing a 3-for-1 (or 3:1) stock split action will issue two
additional shares for every outstanding share, so the total shares outstanding will get
multiplied 3 times. If an investor has a long position on 100 shares of a company, post
stock split the investor will 300 shares of the same company. However just because of
this action future earnings potential and the value of the company has not changed, the
price per share will become about one-third of pre-split price. So if the pre-split market
price was $90 per share, the post split market price will be about $30 per share. Similarly
if the pre-split par value was $3 per share, the post split market price will be $1 per share.
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What benefit the firm gets by issuing such an action? A stock split results in increasing
the liquidity of the share in the market. This is because with the stock split action the
market price per share comes down which makes it easier for many small investors to
invest in the stock which otherwise they are unable to do.

Reverse stock split though rarely done is just the reverse of the stock split action. This
results in reducing the number of outstanding shares and increase in the par value and the
market price per share. A company may decide to use a reverse split to shed its status as a
"penny stock" or may want to drive out small investors.

Dividend payout

For every publicly traded company it is mandatory to declare results every quarter. The
highlights of the results are total earnings, total profit after tax, growth in earnings and
profit over the previous quarter, Earnings per share (EPS) and dividend per share (if
declared). Declaration of the dividend is another key corporate action. If dividend is
declared for the intermediate quarter results of a financial year it is known as ‘interim
dividend’ and if it is declared for the last quarter results of a financial year then it is
known as ‘final dividend’.

Dividend is declared out of the earnings or the profit made by the company in that period.
The dividend is generally paid out in cash and is known as cash dividend. Dividend is
declared as a % of the par value of the share. For example if a company declares 75%
dividend and the face value of the stock is $10 then for each outstanding stock a $7.5
dividend payout will be done. Any dividend payout affects the retained earnings of the
firm. We know that the retained earnings along with future earnings potential of the
factors together influence the market price of the share. Hence a dividend payout made
out of the earnings of the firm is reflected in the market price of the share by a reduction
in the price on the ex-dividend date.

Dividend Cycle consists of few important dates set by the corporation:

Declaration Date The date on which a corporation announces the dividend
Record Date Dividend will be paid to stockholders who are registered owners on
the night of the record date
Payable Date The date on which actual dividend payment is done
Ex-dividend Date The date on which the market price of the security is reduced to
reflect the amount of the dividend paid. Exchange sets this date
(few days before the record date).

Stock dividend: A stock dividend also comes from distributable equity but in the form of
stock instead of cash. As an example, a stock dividend of 25 % means that for every 100
shares owned by the shareholder 25 additional shares are allotted to her. If this company
has 1,000,000 shares outstanding (common stock), the stock dividend would increase the
company's outstanding shares to a total of 1,250,000. The increase in shares outstanding,
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however, dilutes the earnings per share, so the stock price as a result of stock dividend
will also decrease.

Rights Issue

Through rights issue a company offers additional shares to the existing shareholders.
Rights issue is a privilege or the rights granted by a corporation to its existing
stockholders to purchase new stocks at a specified price in proportion to the number of
shares they own. Rights issue thus help the existing stockholders maintain the percentage
ownership in firm’s assets and earning. Rights are valid for a definite time period and can
be sold, exercised or thrown away. The portion of rights issue that is not subscribed could
be taken to public.

Since rights are traded, it should be possible to determine the price of a right. Let us try to
understand the calculation of the price or the value of a right with the help of the
following example:

Example: XYZ Corporation has 10 million shares outstanding with current market price
of $25 each. Company needs to raise $25 million through new equity issue and decides to
make a rights offering. Each stockholder is provided with one right for every share he or
she owns. 5 rights can be used to buy one additional share in the company at $12.50 per
share.

Before rights After rights
No. of shares 10 million 12 million
Value of equity $250 million $275 million
Price per share $25 per share $22.92 per share

Hence theoretical value of a right = $25 - $22.92 = $2.08

Mergers and Acquisitions

A merger occurs when two or more companies combine into one entity with all involved
stakeholders mutually agreeing to the terms of the merger.

The key rationale behind a merger is to create an entity with combined shareholder value
exceeding the sum of the values of the two companies through synergy. Generally a
merger happens when two firms agree to go forward as a new single company rather than
remain separately owned and operated. The merged entity expects to generate synergy
through economies of scale, reduction of employees cost, improved market reach etc.

During merger, both companies' stocks are surrendered, and new company stocks are
issued in its place. The stocks issued to the existing stockholders of both the firms are
decided on the basis of merger swap ratio. Let us try to understand this with the help of
an example.

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Example: Consider the following details for Company A and Company B

Company A Company B
No. of outstanding shares 10,00,000 1,00,000
Market price per share 15 350
Market Capitalization 15,000,000 35,000,000

The two companies A and B get merged into a new company AB. The new company
decides to issue 5,00,000 shares to the existing shareholders of both the firms. How many
stocks of company AB will be issued to

an existing investor of company A holding 500 stocks.
an existing investor of company B holding 100 stocks.

Solution: Total market capitalization of newly formed company AB
= 15,000,000 + 35,000,000
= 50,000,000

This means after merger all the investors of company A together should have an
ownership of 15,000,000/50,000,000 i.e. 30% of the company AB stocks and all the
investors of company B together should have an ownership of 35,000,000/50,000,000 i.e.
70% of the company AB stocks.

Hence, Company A investors together will get 30% of 5,00,000 i.e.150,000 stocks and
company B investors together will get the balance 3,50,000 stocks.

Therefore,
Merger swap ratio for company A investors is 1,000,000 / 150,000 i.e 20:3
Merger swap ratio for company B investors is 100,000 / 350,000 i.e 2:7

1. An existing investor of company A holding 500 stocks would get 500 * 3/20 = 75
stocks of company AB
2. An existing investor of company B holding 100 stocks would get 100 * 7/2 = 350
stocks of company AB

Acquisitions

In the case of an acquisition, a company seeks out and buys a majority stake of a target
company's shares. Acquisitions can often be friendly but also hostile, meaning that the
acquired company does not find it favorable that a majority of its shares are bought by
another entity. Acquisitions can be done through the following mode:

Cash for stock: Existing shareholders of the acquired company are paid through cash. An
acquisition through this mode will not change the number of outstanding shares of the
acquiring company.
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Stock for stock: Existing shareholders of the acquired company are paid through stocks
of the acquiring company. An acquisition through this mode will change the number of
outstanding shares of the acquiring company.

The dynamics of acquisition process can be understood with the following example:

Example: Consider the following details for Company A and Company B

Company A Company B
No. of outstanding shares 300,000 100,000
Market price per share $13 $450
Market Capitalization $3,900,000 $45,000,000

Company B decides to completely acquire Company A in stock-for-stock transaction.
According to the deal, the stockholders of Company A will receive $15 for each stock.

Compute the following:
1. Total number of new shares to be issued by Company B.
2. The number of shares to be issued to an existing investor of Company A holding 120
shares.

Solution:

Exchange ratio = Offer price for target company’s stock
Market price of the acquiring company’s stock

= 15 / 450
= 1/30

So total new shares to be issued by acquiring company
= 1/30 * 3,00,000
= 10,000

An investor holding 120 shares in Company A will get 120 X 1/30 i.e. 4 shares of
Company B.

Note: Investments banks provide the necessary M&A advice to the firms involved in
mergers and acquisitions.

Spin-offs

Spin-off is an action whereby part of the existing business is hived off to create a new
business entity. This action may not result in the change of equity structure of the firm
and price of the share if the new company is wholly owned by the parent company. The
new company may be listed as separate company and it shares may be allocated
proportionately to the shareholders of the parent company.
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Share buyback

With the intention to reduce the number of outstanding shares in the market using the
cash reserves many companies announce share buyback programs. Management of this
company may resort to this action when they perceive that the market has undervalued
the stock. Reducing the number of outstanding shares will benefit the long-term
shareholders going forward as their proportional ownership in the firm will go up.

In the share buybacks a company fixes the minimum price at which the specified quantity
of the shares will be bought back. A specific time frame is given to the shareholders to
sell the shares back to the company. Buyback could be done through market or through
open offer.

In open offer buyback a book building for all the applications is done but unlike IPO
book the applications are listed in ascending order of the price. All the applications
having the price below the cutoff price are considered for share buy back.

Stock Beta

Stock beta is another important term used in stock market. Beta for a stock is the
expected change in returns of that stock to the 1% change in market return i.e. return
from a market index. Beta of a stock is measure of riskiness of the stock. It indicates in
general how differently stock prices change with respect to change in market levels.

Stock beta is calculated using the historical price movement of the stock and the market
index
6
. Theoretically beta value can range from any positive value to any negative value.
Positive stock Beta indicates that when the market goes up the stock prices also go up and
when the market goes down the stock prices also go down. Negative stock Beta indicates
that when the market goes up the stock prices go down and when the market goes down
the stock prices go up.

Stock beta can be used to calculate expected return from the stock. It can also be used to
determine the hedge ratio for hedging the market risk using index derivatives.











6
The chapter on financial mathematics gives an example showing the calculation of stock beta using real
data.
Page 101
Testing the concepts

1. A stock certificate often has a stated value on it. This amount is the:
a. book value
b. stated book value
c. subordinated liquidation value
d. par value
e. none of the above
2. An equity holder has the following right(s)?
a. Right to control
b. Right in liquidation over residual income
c. Right to income
d. All of the above
3. Most popular type of stock index is
a. Price weighted
b. Market cap weighted
c. Equal weighted
d. None of the above
4. A firm can raise funds by issuing
a. Debentures
b. Equity shares
c. Options on its shares
d. Only a and b
e. a, b and c
5. Which of the followings is not a characteristic of equity shares:
a. Voting rights
b. Proportionate share in profit
c. Receives dividend
d. Has limited liability
e. Gets assured return
6. Market capitalisation can be defined as
a. Equity Capital + Reserves and surplus
b. Equity Capital + Preference Capital
c. No. of shares x market price per share
d. No. of shares x book value per share
e. Market value added

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Fixed Income Market

Module Objective

When you complete this course, you should be able to:

Describe different types of bonds
Have a conceptual understanding of valuation of bonds
Understand concept yield and YTM
Understand yield curves and the relationship between yield and bond prices
Understand the functioning of debt markets
Understand how price of a bond influenced by different factors
Concept of duration and convexity














Author

Navneet Nayak
Vinay Kumar
Page 103
Introduction

A bond is a financial instrument requiring the issuer (borrower/debtor) to repay to the
buyer (lender/investor) the amount borrowed plus interest on the borrowed sum over the
period of borrowing, wherein the terms of lending/borrowing (the rate of interest or
benchmark interest rate and spread thereon, and the time of repayments) are
predetermined.

Some of the basic features associated with bond instruments are as follows:

Type of Issuer

The nature of the bond depends to a large extent on the issuer of the bond. Broadly,
bonds are issued by federal/central and state governments, quasi-government bodies like
municipal corporations and government-sponsored enterprises, and corporate bodies.
These bonds can be issued in both domestic and foreign markets.

The US bond market which is by far the largest bond market in the world is divided into
the following broad sectors - the treasury sector (issued by the US treasury), the
municipal sector (issued by state and local governments and their authorities), corporate
sector (issued by US corporations and non-US corporations issued in the US, called
Yankee Bonds) and Asset Backed Securities/Mortgage sector (issued by Corporates by
pooling loans/receivables and using the pooled assets as collateral. In some countries
these securities are called structured obligations).

Why should a buyer be concerned who is the issuer of bond? His concern arises mainly
from risk profile of the issuer. What if the issuer fails to make timely payments of interest
and the principal? The federal government will not default on bonds issued in domestic
currency because it can always print money and pay back. Municipal sector bonds are
less safe compared to treasury bonds, still highly safe because bonds are generally backed
by tax receipts, which can be raised by the issuer. These bonds may also entitle the buyer
to some tax exemptions. Riskiness of corporate sector bond depends upon the financial
strength of the company and that of the ABS on the issuers of the bonds, which comprise
the pool of assets. Let us see some of them in more detail.

Two categories of treasury securities are discount bonds and coupon bonds, wherein the
difference lies in the stream of cash flows generated by the bond. Currently all treasury
securities with a maturity period of less than 1 year are issued as discount bonds (where
there is no intermittent payment made to the holder). These securities are called Treasury
Bills (T-Bills). The most common maturities of T-bills are 14 days, 91 days, 182 days
and 364 days.

Treasury securities with a maturity period between 2 and 10 years are called T-Notes
while securities with a maturity of over 10 years are called T-Bonds. T-Notes and T-
Bonds are coupon securities. Interest rate on these bonds are fixed for the life of the bond
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and they do not change even if market rates of interest undergo substantial change. Some
of these bonds may have put or call options (described later).

Corporate Bonds are typically issued by large corporate entities with a substantial
standing in the market. Issuing bonds is one of the ways in which corporates can raise
funds for meeting its needs of financing an expansion /M&As etc. Corporate bonds
usually offer higher yields than government bonds, as there is generally more risk
involved with corporate bonds. Bonds issued by corporates can be fixed rate, floating rate
or zero coupon bonds. These bonds could be callable bonds, puttable bonds or
convertible bonds.

Bondholders as creditors of the company have a priority legal claim on dues over the
common stock /shareholders.

Considering greater risk involved with corporate bonds, market participants rely on credit
rating given by credible rating agencies such as Moody’s, Standard & Poor and Fitch.
These rating agencies apply proprietary methodologies for assessing financial strength of
the issuers and risks that may impair their capability to pay back interest and principal.

The following are summaries of the definitions of Moody's ratings for long-term bonds.

Aaa - Best quality, with smallest degree of investment risk.
Aa - High quality by all standards; together with the Aaa group they comprise what
are generally known as high-grade bonds.
A - Possess many favorable investment attributes. Considered as upper-medium-
grade obligations.
Baa - Medium-grade obligations (neither highly protected nor poorly secured). Bonds
rated Baa and above are considered investment grade.
Ba - Have speculative elements; futures are not as well-assured. Bonds rated Ba and
below are generally considered speculative.
B - Generally lack characteristics of a desirable investment.
Caa - Bonds of poor standing.
C - Lowest rated class of bonds, with extremely poor prospects of ever attaining any
real investment standing.

Bond issues that carry a Aaa , Aa, A or and Baa are called investment grade bonds. Issues
carrying a rating below Baa are considered non-investment grade bonds or more
popularly junk bonds.

Asset-backed securities, called ABS, are bonds or notes backed by financial assets.
Typically these assets consist of receivables such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans. These represent a class of fixed
income securities that are created out of pooling together assets, and creating securities
that represent participation in the cash flows from the asset pool e.g. select housing loans
of a bank can be pooled, and securities can be created, which represent a claim on the
repayments made by home loan borrowers. Such securities are called mortgage-backed
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securities and are very active in the US markets. Assets with regular streams of cash
flows are ideally suited for creating asset-backed securities. A detailed discussion on
securitization follows in subsequent chapters.

International bonds are issued within a market that is foreign to the issuer's home market.
Some international bonds are issued in the currency of the foreign market and others
could be denominated in another currency. Some types of international bonds are:

a) Eurobond: A eurobond refers to any bond that is denominated in a currency other than
that of the country in which it is issued. Bonds in the Eurobond market are categorized
according to the currency in which they are denominated. As an example, a Eurobond
denominated in Japanese Yen but issued in the U.S. would be classified as a Euroyen
bond.

b) Foreign bonds are denominated in the currency of the country in which a foreign entity
issues the bond. An example of such a bond is the Samurai bond, which is a yen-
denominated bond issued in Japan by an American company. Other popular foreign
bonds include Bulldog (A sterling denominated bond that is issued in London by a
company that is not British) and Yankee bonds (A bond denominated in U.S. dollars and
issued in the United States by foreign banks and corporations).

c) Global bonds are structured so that they can be offered in both foreign and Eurobond
markets. Essentially, global bonds are similar to eurobonds but can be offered within the
country whose currency is used to denominate the bond. As an example, a global bond
denominated in yen could be sold to Japan or any other country throughout the Eurobond
market.

Principal

The principal value (or just principal) is the amount that the issuer agrees to repay to the
bondholder at maturity. This amount is also referred to as redemption value, maturity
value, par value or face value. Principal is generally paid fully at maturity date. But, some
fixed income instruments may pay principal in several installments. Such bonds are
called amortizing bonds.

The structure of some bonds may be such that the principal is not repaid at the end
/maturity, but over the life of the bond. A bond, in which payments, made by the
borrower over the life of the bond, includes both interest and principal, is called an
amortizing bond. Auto loans, consumer loans and home loans are examples of amortizing
bonds. The maturity of the amortizing bond refers only to the last payment in the
amortizing schedule, because the principal is repaid over time.

Bonds may have a provision that mandates the issuer to retire some amount of the
outstanding bonds every year. This could be done either by buying some of the
outstanding bonds in the market, or by creating a separate fund, which calls the bonds on
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behalf of the issuer. Such provisions that enable retiring bonds periodically are called
sinking fund provisions.

Coupon Rate

The coupon rate is the rate that the issuer agrees to pay to the investor. The amount of
interest that is paid out periodically is called ‘coupon’. Frequency of coupon payment
could vary from bond to bond. Most commonly, coupon is paid semi-annually in case of
long-term bonds. Bonds can be classified as under from the perspective of coupon
payments.

Zero Coupon Bonds do not pay any intermittent payments. Effectively all the coupons
due is accumulated and paid along with the principal at maturity. Since amount payable
on maturity is the face value, containing interest, these bonds must be issued at a discount
to the face value at which they will be redeemed on maturity. The discount between the
face value and the issue price represents the interest earned by the buyer.

Treasury Strips are zero-coupon bonds created out of each cash flow of a normal coupon
paying treasury bond e.g. a 9 year bond where interest is payable half yearly, there will
be 18 cash flows during the life of the bond. These cashflows are then packaged as 18
zero coupon bonds each one with a differing maturity. Maturity is the time when then
these cashflows would have been received in the normal course. These cashflows
packaged as ZCBs are called strips and sold separately, to buyers with varying tenor
preferences. For the first 17 cashflows par value is the coupon and for the last one par
value would be coupon plus principal (even this could be bifurcated into coupon and
principal).

Floating Rate Bonds are those bonds where instead of coupons being paid at a pre-
determined rate throughout the life of the bond, the interest rate is re-set at predetermined
intervals. Rates are reset based on some widely used benchmark rates e.g. LIBOR,
treasury index rate etc. Such bonds whose coupon rate is not fixed, but reset with
reference to a benchmark rate, are called floating rate bonds. Inverse floaters pay a
variable coupon rate that changes in direction opposite to that of short-term interest rates.
An inverse floater subtracts the benchmark from a set coupon rate. For example, an
inverse floater that uses LIBOR as the underlying benchmark might pay a coupon rate of
a certain percentage, say 6%, minus LIBOR

In the mid-eighties, the US markets witnessed a variety of coupon structures in the high
yield bond market (junk bonds) for leveraged buy-outs. In many of these cases, structures
that enabled the borrowers to defer the payment of coupons were created. Some of the
more popular structures were: (a) deferred interest bonds, where the borrower could defer
the payment of coupons in the initial 3 to 7 year period; (b) Stepup bonds, where the
coupon was stepped up by a few basis points periodically, so that the interest burden in
the initial years is lower, and increases over time; and (c) extendible reset bond, in which
investment bankers reset the rates, not on the basis of a benchmark, but after re-
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negotiating a new rate, which in the opinion of the lender and borrower, represented the
rate for the bond after taking into account the new circumstances at the time of reset.

Maturity / Term to Maturity

The maturity of the bond refers to the date on which the bond matures or the date on
which the borrower has agreed to repay the last installment of borrowed amount to the
lender. Term to maturity refers to the number of years or time remaining for the bond to
mature. Term to maturity is also called ‘tenor’.

The term to maturity of a bond is important for three primary reasons:
It shows the time period over which the bond holder will continue to receive the coupon
payments
The yield of the bond is dependent on the term to maturity, and,
The price of the bond fluctuates with the changes in the yield

The term to maturity of a bond can be altered by inclusion of options to make or get early
payment of face value of the bond. An option that is included in the bond is called an
embedded option. Bonds under this category can be classified into

Callable Bonds - This provision allows the issuer of the bond to call back/retire the bond
fully or partially before its specified date of maturity. By doing so, the issuer enjoys the
option of being able to replace the bonds with a new bond issue at a lower rate of interest
that may be prevailing at that time. The investor, however, loses the opportunity to stay
invested in a high coupon bond, when interest rates have fallen. The call option,
therefore, can effectively alter the term of a bond, and carries an added set of risks to the
investor, in the form of call risk, and re-investment risk. The prices at which these bonds
would trade in the market are also different, and depend on the probability of the call
option being exercised by the issuer.

Puttable Bond - This provision allows the buyer of the bond to sell back the bond to the
issuer prior to the maturity date. The put options embedded in the bond provides the
investor the rights to partially or fully sell the bonds back to the issuer, either on or before
pre-specified dates. In this case the investor/buyer enjoys the advantage of having the
bonds redeemed at par value in case the interest rate rises after the bond issue and the
bond price falls to below the par value

Convertible Bond is an issue that gives the bondholder the right to convert his bonds to
equity shares of the company. Exercising this option leads to redemption of the bond
prior to maturity, and its replacement with equity. At the time of issue the conversion
ratio and the conversion price or formula for arriving at the price are specified. The
conversion ratio refers to the number of equity shares, which will be issued in exchange
for the bond that is being converted. This provision allows the investor to take advantages
in the price movements of the issuer’s shares.

An easy depiction of the various classifications of bonds is as under:
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Pricing a bond

The fundamental principle of pricing of any financial asset is that the price of a financial
asset is the present value of the cash flows that arise throughout the life of the asset. The
above is true even for bonds where the price can be determined as the present value of
The periodic coupon payments during the life of the bond and
The principal amount paid out at maturity

The valuation of a bond involves discounting these cash flows to present by an
appropriate discount rate (refer time value of money concepts). The discount rate is the
opportunity cost i.e. the return that could be earned by investing in an instrument with
similar profile – similar risk and similar tenor. If price of the bond were higher than
present value of all cash flows from the bond, one would earn higher amounts by
investing in alternative avenues compared to what he would earn from holding the bond.
If price of the bond were lower than present value of all cash flows, one could borrow
and invest in the bond. Since future cash outflows on borrowing will be lower compared
to future cash inflows from the bond, one stands to make a risk-free profit. Therefore,
price of bond should be equal to the present value of future cash flows from the bond.
Take a simple example.

If market interest rate is 5% what should be the price of a bond with face value of $100,
paying semi-annual coupon of 10% and maturing in one year? As per the discussion
above, the PV of cashflows is as follows:

P = 5/(1.025) + 105/(1.025)^2 = $104.82
Bond Characteristics
Issuer
Corporates
Municipality
Governments
Coupon Rate
Fixed Coupon
Floating Rate
Zero Coupon
Term to Maturity
Callable
Puttable
Convertible
Government
Treasury
Securities
T-Bill(less than
1yr)
T-Note (bet. 2
and 10 years)
T-Bond (greater
than 10 years)
International
Bonds

Eurobond
Foreign
Global
Page 109
Here, coupon period is six months, discounting rate is 2.5% per period, time to first cash
flow is one period and time to second cash flow is two periods.

If price of this bond were $110, one should sell the bond and invest $4.88 for six months
and $99.94 for one year at 5% p.a. (this is the prevailing market rate). He would receive
$5 at the same time when bond will pay the coupon of $5 and $105 when the bond will
pay the last coupon and maturity value. The remaining $5.12 ($110 - $104.82) is his
profit. Since all investors would like to avail of this opportunity, they will sell this bond
and price will move close to $104.82.

If price of this bond were $100, one should borrow $100 and buy the bond. He will be
able to return $5 at the end of six months when bond pays the coupon of $5. By this time
amount outstanding has grown to $102.5 adding the interest for six months at the rate of
5% p.a. After $5 is paid outstanding for the remaining six months is $102.5-$5 = $97.5.
Balance payable at the end of the year is $97.5*(1.025) = $99.94. The bond will pay back
$105 (interest and principal). $99.94 can be used to payback the outstanding amount and
the remaining $5.06 is the profit at the end of first year. Given this situation investors
would rush to buy this bond and make a profit. Therefore, price of this bond will rise so
close to $104.82 that there is not arbitrage opportunity left.

Therefore, in general terms, the price of a bond can be represented as

P = CF
1 +
CF
2 +
CF
3 + ..................................................
CF
n
( 1 + r)
t1
( 1 + r)
t2

( 1 + r)
t3
(1+r)
tn


Where:
P = Price of the bond
CF
1, 2 …n
= Cash Flow for nth periods
tn= time to nth cash flow measured in terms of coupon periods
r = required rate of discount i.e. prevailing rate on similar instruments per period

Analyzing the bond price

Having understood the fundamentals of bond pricing, we need to look at different factors
that can influence the bond price. All the variables in the bond pricing formula affect the
price of bond. Let us analyze them one by one.

Impact of discount rate/ market interest rate

It is obvious from the pricing formula above that price of a bond is highly sensitive to the
rate of discount/ required rate of return. Higher the rate at which we discount the cash
flows, lower the PV of individual cash flows, and hence, lower the price of the bond.
Reverse is also true. Lower the rate at which we discount the cash flows, higher the PV of
individual cash flows, and hence, higher the price of the bond. Discount rate, as discussed
earlier, is the opportunity cost i.e. the market rater of interest on similar instruments. This
phenomenon gives us one of the most important relationships in the bond market - market
Page 110
interest rates and bond prices move in opposite directions i.e. market interest rates and
bond prices are inversely related.

Illustration:

Suppose a bond has a coupon rate of 5% payable annually, the principle amount is $1000
and the bond has a maturity period of 3 years. A bond of similar profile in the market is
giving an interest rate of 8%. Therefore,
n = 3
CF = $50 for the first two years and 1050 for the final year (Year 3)
Discount rate : 0.08

Thus, the value of the bond will be
P0 = 50 + 50 + 1050
(1.08) (1.08)
2
(1.08 )
3
= 46.29 + 42.87

+ 833.52
= 922.68

The table below shows the value of the bond by computing the PV of all the cash flows
that arise during the period of the bond. Here a semi-annual coupon payment is
considered as that is the normal market practice. Hence the discount rate would be 0.04
and the coupon payment will be $ 25 for each half yearly period.

Semi Annual Period
Cash Flow of
$50 pa
PV of Bond after discounting at 4% (
half yearly)
1 25 24.03846154
2 25 23.11390533
3 25 22.22490897
4 25 21.37010478
5 25 20.54817767
6 1025 810.0723889
Value of Bond
921.3679471
Value of a 5% Bond



Having understood the basic concept behind bond pricing, let us look at a few
generalizations, which will hold true for value of the bond (settlement price or dirty
price) at the beginning of the coupon period:
the bond will sell at par if the discount rate is equal to the coupon rate
The bond will sell below par if the discount rate is higher than the coupon rate implying
that the demand for this bond has fallen because comparable bonds in the market are now
offering higher coupon
The bond will sell above par/at premium if the discount rate is lower than the coupon rate
implying that the demand for this bond has risen vis-à-vis other comparable bonds in the
market which are currently offering a lower rate of interest

As mentioned above this relationship will hold only at the beginning of the period. With
every passing day, the bond accumulated interest, which is paid periodically, most
Page 111
frequently every six months. Because of accumulation of interest settlement price of a
bond may exceed the par value at times even if market interest is higher compared to the
coupon rate. However, later we will see that quoted rates in the bond market is the
present value of all cash flows less accrued interest. Therefore, this relationship will hold
true for quoted price, also called clean price, at all the times and for settlement price,
called dirty price at the beginning of coupon period.

Effect of Maturity

A bond’s price sensitivity to the changes in the market interest rate or discount rate are
positively related to the bond’s maturity. In the example given below we can see that in
the case of 3 bonds with the same coupon payment but with differing maturities, the bond
with the longest maturity is the most price sensitive to the changes in the interest rate

P=$1000
Coupon = $50
Discount Rate ( %) 4 8 10
4 1036.30 1067.33 1081.11
5 1000.00 1000.00 1000.00
6 965.35 937.90 926.40
7 932.26 880.57 859.53
8 900.64 827.60 798.70
Years to Maturity


Effect of Coupon Rate

For two bonds with the same maturity and yield (we will explain yield shortly), the bond
with the smaller coupon rate will be more price sensitive to the given change in the
market interest rate, also called, yield or yield to maturity. In the table below, we can see
that the percentage change in the price of the 5% bond for a given change in the yield is
more than that on the 8% bond.

P=$1000
Maturity = 4 years
Bond I -
Coupon rate of
5%
% Change in
price- Bond I
Bond II -
Coupon rate
of 8%
% Change in price-
Bond II
Discount Rate ( %)
4 1036.30 - 1145.20
5 1000.00 -3.50 1106.38 -3.39
6 965.35 -3.47 1069.30 -3.35
7 932.26 -3.43 1033.87 -3.31
8 900.64 -3.39 1000.00 -3.28


Effect of level of yield

From the above two tables, another factor that emerges is that the prevailing yield also
determines the price sensitivity, such that the percentage change in the price is higher at
lower discount rates.

Page 112
P=$1000
Coupon = $50
Discount Rate ( %) 4 8 10 4 8 10
4 1036.30 1067.33 1081.11
5 1000.00 1000.00 1000.00 -3.50 -6.31 -7.50
6 965.35 937.90 926.40 -3.47 -6.21 -7.36
7 932.26 880.57 859.53 -3.43 -6.11 -7.22
8 900.64 827.60 798.70 -3.39 -6.02 -7.08
Years to Maturity % Change in prices


Change in price of bonds has been plotted in the graph below:
Price Volatility of bonds with different tenors at different yields
700
750
800
850
900
950
1000
1050
1100
1150
4 5 6 7 8
discounting rates
P
r
i
c
e

o
f

B
o
n
d
4 year 8 year 10 year




Concept of Duration and Convexity

From the above tables and graph, we see that the price sensitivity of a bond to changes in
the interest rate is determined by three factors namely, maturity, coupon rate and the level
of interest rates. The price sensitivity can be measured in terms of a percentage change in
price of the bond when there is a small percentage change in the yield. This measure of
price sensitivity is called duration. Duration is a single measure approximation of the
impact of coupon, term to maturity and yield on the price of the bond, for a given change
in yield. Duration is expressed in terms of years.

Duration is time weighted average of present value of all cash flows. It is a measurement
of how long in years it takes for the price of a bond to be repaid by its internal cash flows.
Bonds with higher durations are more risky and have higher price volatility than bonds
with lower durations. For coupon bonds duration will be less than its maturity (tenor) and
for ZCB, it will be the same as tenor.

Mathematically, duration is defined as follows:
n n
D = ∑[(CF
t
(t)/(1+t)
t
]/ ∑[CF
t
/(1+t)
t
]
t=1 t=1

Where,
Page 113
D = Duration
CF
t
= Cash flow at time t
t = time period in which cash flow takes place
n = number of periods of maturity
i= the yield to maturity (market interest rate)

Duration of a 5-year 11% bond when YTM is 9% can be calculated as follows:
Period Cashflow PV(Cashflow)
Weighted
PV
1 5.5 5.26 5.263
2 5.5 5.04 10.073
3 5.5 4.82 14.459
4 5.5 4.61 18.448
5 5.5 4.41 22.067
6 5.5 4.22 25.341
7 5.5 4.04 28.291
8 5.5 3.87 30.940
9 5.5 3.70 33.309
10 105.5 67.93 679.344
107.913 867.535
Duration= 8.039

Tenor of the bond is 5 years but duration of the bond is 8.04/2 = 4.02years.

Duration can also be understood as slope of the price curve in the graph above. Price of
the bond was earlier expressed as:

P = CF
1 +
CF
2 +
CF
3 + ..................................................
CF
n
( 1 + r)
1
( 1 + r)
2

( 1 + r)
3
(1+r)
n


To measure how prices change in response to a small change in yield (r), we take the first
derivative

dP/dr =( -1/1+r)[ (CF
1
/(1+r)+(

CF
2
/(1+r)^2)
+ ................................+
(

CF
n
/(1+r)^n]

This computation measures absolute change in the price of a bond given a small change
in the yield. To get the percentage change in price given a percentage change in yield, we
divide both sides of the equation by price as follows:

(dP/dr)*(1/P) =( -1/1+r)[ (CF
1
/(1+r)+(

CF
2
/(1+r)^2)
+ ............... +
(

CF
n
/(1+r)^n]*(1/P)

The term on the right side can be rewritten as = (-Duration)/(1+r)

This measure is called modified duration of a bond. We can state this relationship as
% change in price of a bond = modified duration * % change in yield. Modified Duration
of five implies that price of the bond will change by 5% in response to 1% change in
Page 114
interest. The negative sign implies that the change in the price of bond will be in the
opposite direction of movement of the interest rate. For large changes in yield however,
the first order derivative, which is what modified duration is, is inadequate.

Amount of change in price of a bond in response to one basis point change in yield is
called DVBP or DV01. It is calculated as follows:

DV01 = modified duration * price of the bond * .01/100

Similarly, dollar duration is the change in price of a bond in response to one percentage
point change in yield.

Duration of a portfolio of bonds can be measured in two ways:
Map the cash flows of all bonds, calculate the present value of each cash flow and find
the duration as described earlier. This is cumbersome process.
Portfolio duration is taken as the weighted duration of individual bonds in the portfolio. It
is calculated as follows:
n
Dur
P
= ∑ (D
i
* W
i
)
i=1
Where, D
i
is the duration of bond i and W
i
is the weight of that bond, as a proportion of
the total market value of the portfolio, in the portfolio.

It should be clear from the formula of duration that it is not a static property of a bond. It
will change with change in time and change in yield. Since the price-yield relationship is
not linear but convex impact of small change in yield i.e. slope or duration is different at
different points in the curve. Therefore, larger the change in yield, larger the error in
estimating the impact on price of bond using modified duration.

For a better estimation of change in price of bond we need to consider convexity of the
price-yield relationship as well. While duration is the first derivative of price equation
w.r.t. yield, convexity is the second derivative of the price equation w.r.t. yield. It is a
measure of the degree to which a bond’s price-yield curve departs from a straight line. It
normally stated by using the following formula:

T T
CONV= ∑ [C
t
(t)(t+1)/ (1+r)
t+2
]/ m
2
∑[C
t
/ (1+r)
t

t=1 t=1

Where,
C
t
= cash flow at time t
t = period when the cash flow is expected to be received
T = number of periods until maturity
m = number of periods per year (e.g. m=2 for semiannual bonds)
r = discount rate per period

Page 115
With this formula, convexity of 11% five year bond can be calculated as follows:
Period Cashflow PV(Cashflow)
Weighted
PV
Weighted
PV*
(t+1)/(1+r)^2
1 5.5 5.263 5.263 9.639
2 5.5 5.037 10.073 27.673
3 5.5 4.820 14.459 52.962
4 5.5 4.612 18.448 84.469
5 5.5 4.413 22.067 121.247
6 5.5 4.223 25.341 162.436
7 5.5 4.042 28.291 207.255
8 5.5 3.868 30.940 254.995
9 5.5 3.701 33.309 305.018
10 105.5 67.934 679.344 6843.049
107.913 867.535 8068.742
Duration (years)=4.02
Convexity = 18.693

Change in the price of a bond can be calculated with more precision with the following
formula:

∆P ≈ -DUR
mod
*∆rP + 0.5*CONV*∆r
2
*P

As the yield changes from 9% to different levels the estimated and actual price change
will be as follows:
Yield
Actual
Price
Prices
estimated
with
duration
Price
estimated with
duration and
convexity
9.00% 107.913
8.00% 112.166 111.893 111.993
7.00% 116.633 115.872 116.275
3.00% 136.889 131.790 135.421
10.00% 103.861 103.933 104.034
11.00% 100.000 99.954 100.357
15.00% 86.272 84.036 87.667

Modified duration and convexity, as we have calculated till now, assumes that the cash
flows remain unchanged. When duration and convexity is calculated recognizing the fact
that yield changes may change the expected cash flows, it called effective duration and
effective convexity.

The strategy of protecting a portfolio against interest rate risk - both price and
reinvestment risk – is called immunization. Matching the desired cash flows by purchase
of zero coupon bonds results in perfect immunization. Approximate immunization can be
achieved even with coupon bonds. Investment is selected in a manner that price and
Page 116
reinvestment risks cancel out. It should be obvious by now that price and reinvestment
risks move in opposite directions. As yield rises, price falls while reinvestment can be
made at a higher yield. As yield falls, reinvestment rate also falls, but that is partly
compensated by rise in the price of the bond. Immunization will be near perfect when
holding period equals duration and yield change is not very large.


Bond Valuation between coupon payment dates

In all the earlier examples where we have computed the value of the bond, we have
discounted the cash flows of the bond at beginning of coupon period and considered all
its cash flows till its maturity. In reality however, the bond can be bought and sold on any
given day. Hence the need to value a bond on any given point in time.

Day Count Conventions
In order to value a bond accurately we need to know the actual dates on which coupons
will be paid, the number of days between two coupon periods and the distance of the
actual valuation date from the previous and the next coupon. All of this depends on the
market convention used, for counting the days on the time line, which is also called the
day count convention. Some popular day count conventions are

30/360 This convention considers each month, including February, as having
30 days and the year as consisting of 360 days. The 30/360
convention is used in the treasury bond markets in many countries.
Actual/360 This convention counts the actual number of days in a month, but
uses 360 as the number of days in the year.
Actual/actual This convention uses the actual number of days in the month and the
actual number of days in the year, 366, for a leap year.
Actual/365 This convention uses the actual number of days in a month and 365
days as the days in the year

Let us take an example. What is the value of a 6% 30 Sep. 2006 bond on 01 Feb. 2005 if
face value is $100, coupons are paid semi-annually and prevailing interest rate is 4% on
similar bonds? Day count convention is 30/360.

Cashflow
dates Amount
Days to
coupon
Coupon
period
Discounting
period
Interest
rate per
period
PV of
cashflow
31-Mar-05 3 60 180 0.33 2% 2.98
30-Sep-05 3 240 180 1.33 2% 2.92
31-Mar-06 3 420 180 2.33 2% 2.86
30-Sep-06 103 600 180 3.33 2% 96.42
Price= 105.19

Bond Price Quoting conventions and Accrued Interest
Page 117
On Feb. 01, 2005 if the bond above is sold, the seller should get $105.19 from the buyer.
Other things remaining the same the price of this bond on March 01, 2005 will rise to
$105.53, on April 01, 2005 after the coupon due on March 31 has been paid, the price
will fall to $102.88. The price is changing because of accrual of interest. As we discussed
earlier, the bondholder earns interest every day but gets paid only periodically. Until the
interest is paid, it gets accrued to the bondholder. It means that bondholder has become
entitled to the interest even as it will be paid to him later. The principal is the same as in
the case of salary payments. One earns salary every day but gets paid only at the end of
the month.

Earlier we have discussed that bond values change because of change in market interest
rate. We also observe that bond values change because of accrual of interest even when
there is no change in the market interest rate. If the bond price were quoted as the present
value of all cash flows, by seeing the price one would not be able to configure whether
change in the price has occurred because of change in the market interest rate or because
of change in accrued interest. Therefore, to make the bond price an indicator of market
interest rate, impact of accrued interest is neutralized by deducting accrued interest from
bond value. Price thus arrived will change only in response to the change in the market
interest rate. This price is called clean price and this is the price quoted in the market.

The first step in calculating clean price to be quoted in the market is to calculate accrued
interest, the interest, which has become due to the bondholder since the last coupon. It is
calculated as follows:

Accrued Interest (AI) = Coupon * No. of days from last coupon/ No. of days in the
coupon period

In the example above, Accrued Interest as on Feb.01, 2005 is 3*120/180 = $2.00

Clean price can then be calculated as follows:
Clean Price = PV of cash flows – Accrued interest
= $105.19-$2.00 = $103.19

Market price of this bond will, therefore, be quotes as $103.19. However, the seller
should get $105.19 and not $103.19. Settlement would take place at $105.19. Settlement
price is known as ‘Dirty Price’ and is arrived at by adding back Accrued interest to the
clean price.

Dirty Price = Clean Price + Accrued Interest
= $103.19+$2.00 = $105.19

When trade takes place, price of the bond, quoted will be $103.19 and the settlement will
take place after adding the accrued interest of $2.00 i.e. at $105.19. To summarize, the
value of the bond is the present value of all cash flows and quoted price of the bond is
value of bond less accrued interest, called clean price. Settlement price is the value of the
bond which is nothing but clean price plus accrued interest
Page 118

Yield

Yield of a bond is return on investment. Investment in the bond is the price paid for
buying the bond. Return from a bond can come from three different sources

coupons received,
coupons received could be re-invested which generate interest on these coupons, interest
on coupon, therefore, is the second element of total returns, and,
capital gain/ loss – difference between the selling/ redemption price and purchase price of
the bond.

As we have seen, a bond could be purchased at a premium or a discount. If it is bought at
premium, say at a clean price of $105 when par value is $100, on redemption the bond
will pay back only $100 giving a capital loss of $5. Similarly, if clean price were $95, it
will generate a capital gains of $5 on redemption. However, one need not wait till
redemption. If the bond bought at a clean price of $105 is sold at a clean price of $108 in
the market, it will generate a capital gain of $3 and if sold at $102, it will generate a
capital loss of $3.

All the three components together determine total return from holding the bond. Total
return on the bond is annualized over the investment made to get yield. Different types of
yield are defined as follows:

Current Yield:

Annual coupon/ Market price of the bond is defined as current yield. For example, if a
12.5% bond sells in the market for $104.50, current yield will be computed as:
= (12.5/104.5) * 100
= 11.96%
Current yield is not used as a standard yield measure, because it fails to capture the future
cash flows, re-investment income and capital gains/losses on investment return. It is not a
complete measure of return on investment.

Yield to Maturity (YTM):

As the term suggests, YTM is the return on investments if the bond were held till
maturity. We have calculated price of a bond given a yield or market interest rate on
similar instruments. If we can calculate price of a bond given the cash flows, its timing
and yield we can also calculate yield given the cash flows, its timing and price of the
bond. We find the discounting rate that would equate the present value of all cash flows
to the price of the bond. In other words, the YTM is the IRR of the bond.

Let us take an example. If a 11.99% 9 yr, face value $100 bond is being quoted at a price
of $108 and if interest is paid semi-annually, we can state that,
108 = 5.995 + 5.995 + ……………… 105.995
Page 119
( 1+r) ( 1+r)
2
(1+r)
18

The value of r obtained by solving this equation is 5.29%. This is the semi-annual yield.
Annual yield therefore is 10.58%. To obtain a simple annualized rate, one needs to
multiply the periodic rate with number of periods in the year. This yield is called bond-
equivalent rate.

Yield to maturity represents the yield on the bond, provided the bond is held to maturity
and the intermittent coupons are re-invested at the same YTM rate. In other words, when
we compute YTM as the rate that discounts all the cash flows from the bond, what we are
assuming in effect is that each of these cash flows can be re-invested at the YTM rate for
the period until maturity. This assumption is flawed because real reinvestment rate is
bound to be different from YTM since market interest rates keep changing. YTM of the
bond above is 10.98% but when the first or second or third coupon is received, the market
rates may have changed and reinvestment may not be possible at 10.98%, as assumed in
the calculation. Therefore, contrary to our what we mentioned earlier, the realized yield if
the bond is held till maturity may not be equal to YTM, calculated at the time of
purchase. However, since there are no intermittent cash flows and no re-investments,
YTM of a zero coupon bond at the time of purchase will be the same as realized yield.
YTM of a zero-coupon bond therefore is called pure YTM.

Holding Period Yield or Realized Yield:

The YTM measure rate of return if the bond is held till maturity. But it is not always the
case. If the bond is sold before maturity, total yield obtained till the time of sale is called
Holding Period Yield.

Yield to Call

As YTM is calculated assuming that bond is held till maturity, we can calculate yield
assuming that the bond will be called on the first call date, if the bond is callable. This
yield is called YTC or Yield to Call. If there are different possible dates for calling the
bond, one can calculate YTC for all possible call dates. Lowest of all possible YTC is
called yield to worst.


Summarizing…

Price-yield relationship between bonds is not a straight line, but is convex. This
means that price changes for yield changes are not symmetrical, for increase and
decrease in yield.
The sensitivity of price to changes in yield in not uniform across bonds. Therefore
for a same change in yield, depending on the kind of bond one holds, the changes in
price will be different.
Higher the term to maturity of the bond, greater the price sensitivity. Price
sensitivities are higher for longer tenor bonds, while in the short-term bond; one can
expect relative price stability for a wide range of changes in yield.
Lower the coupon, higher the price sensitivity. Other things remaining the same,
bonds with higher coupon exhibit lower price sensitivity than bonds with higher
coupons.
Page 120
Yield Curve and Term Structure of Interest Rates

The fundamental aspect in the functioning of the debt market is the relationship between
tenor and interest rates. If you have made deposit with a bank, you would have noticed
that the bank normally offers lower rate of interest if you make a deposit for six months
compared to what they offer for a three-year deposit. The relationship between time to
maturity (tenor) and yield (interest rates) is depicted by a yield curve whereby time is
plotted on the x-axis and corresponding yield is plotted on the y-axis. The yield curve is
also known as ‘term structure of interest rates’. It is typically constructed by graphing the
yield to maturities of zero coupon bonds for short term and zero coupon rates derived
from long term fixed coupon bonds by a process called Bootstrapping. Shape of the curve
can be different at different points in time. This relationship not only assists in valuation
of bonds, but also enables identification of arbitrage opportunities in the market and
market expectations of future interest rates.

There are three main patterns created by the term structure of interest rates:
Normal Yield curve: This is the yield curve shape that forms during normal market
conditions, where long-term are generally higher than short-term rates.


Flat Yield Curve: When yields are almost the same across tenors we get a flat yield
curve.


Page 121
Inverted Yield Curve: When short-term rates are generally higher than long term rates we
get inverted yield curve.

Different shapes of yield curve could be interpreted in different ways. Expectation theory
suggests that yield curves indicate expectation of the market regarding movement of yield
curve in future. If interest rates are likely to rise in future, yield curve would be upward
sloping, if it likely to remain stagnant, yield curve will be flat; and if interest rates are
expected to fall, yield curve will be inverted. The reasoning is simple. Assume that yield
curve is upward sloping; one-year rate is 4% and two-year rate is 5%. If one expects one-
year rate to be stagnant from now to one year from now, one could lend at 5% for two
years by borrowing for one year at 4%. At the end of one year he is supposed to payback
what he borrowed, but he will not have money since he will get back the principal only
after two years. Therefore, he needs to borrow 1.04 x principal at the end of the second
year to pay back his original borrowing. If he is able to borrow again at 4% for next one
year as he expected, he makes a clear arbitrage of 1% for two years. If market at large
expected the interest rate to remain the same or to fall all participants would like to
borrow short-term and lend long-term. As a consequence, short-term rate will rise and
long-term rate will fall making the yield curve flat. Thus, an expectation of interest rate
being flat in future will result in a flat yield curve. If the yield curve is upward sloping, it
is because market participants are expecting the interest rates to rise in future. As long as
the expected one-year rate is lower than ((1.05)^2/1.04)-1, there is an arbitrage
opportunity (to borrow at one-year rate and lend at two year rate). One would not do
arbitrage only if his expected one-year rate one year from now is ((1.05)^2/1.04)-1 or 6%.
You could analyze that if interest rate were expected to fall in future the yield curve
would take an inverted shape.

Another way to analyze the shape of yield curve is in terms of time-bucket preferences of
investors. Different institutional investors have different preferences in terms of
maturities depending upon their liability profile. For example, pension funds and
insurance companies have long term liabilities while banks have shorter-term liabilities.
Therefore, while pension funds and insurance companies prefer investing in long-term
bonds, banks would prefer relatively shorter-term bonds. This preference creates different
level of demand for bonds in different time-buckets. Higher the demand, higher the price
of the bond and lower the yield. As prices of bonds and yield is linked to demand and
supply interest rates for different maturities of bonds differ. This is called preferred
habitat theory.
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The third way to explain the shape of the yield curve is in terms of liquidity preference.
This method is a combination of expectation theory and risk inherent in bonds. We have
seen that shorter the maturity lesser the fluctuation in bond prices. Therefore, we can say
that short-term bonds are less volatile or risky when compared to long-term bonds.
Because of lower risk short-term bonds have higher liquidity compared to long-term
bonds. Thus, long-term bonds should offer not only the short-term rate but also the
liquidity and risk premium. Therefore, longer the tenor of the bond, higher should be the
yield from these bonds. If long-term bonds yield lower compared to short-term bonds, it
indicates that market is expecting high volatility in the short-term. However, long-term
outlook remains stable.

In short, yield denotes that interest rate or yield in real life is a function of, or linked to,
its tenor (time to maturity). There is nothing like a single interest rates, which applies to
bonds or debt instruments of all maturities. In this light, we must mention interest rate or
yield along with its tenor. We must say yield on 10-year Government Securities (G-sec)
or 5-year G-sec not just yield on G-sec because yields for these two tenors are likely to be
different.

Having understood the concept of yield curve let us analyze the concept of bond pricing
once again. In all discussions earlier on bond pricing, we have assumed that all cash
flows are discounted at a single rate. Discounting rate is the rate at which a given sum can
be invested at present. When yield curve is upward sloping, two-year rate should be
higher compared to one-year rate. Therefore, in reality discounting rate for cash flow
arising one year from now should be different from discounting rate for the cash flow
arising two years from now. In fact, discounting rate for all cash flows should be
different. When we take the same discounting rate for all cash flows, we are assuming
that the yield curve is flat. If yield curve is not flat, valuation of the bond is bound to be
erroneous. Therefore, for proper valuation of bonds we should extract the discounting
rate for different periods from market yield curve and apply these rates to respective
cashflows. A more accurate method is to think of each cash flow as a separate zero-
coupon bond and find their values.

Let us value the same bond as discussed earlier. What is the value of a 6% 30 Sep. 2006
bond on 01 Feb. 2005 if face value is $100, coupons are paid semi-annually and
prevailing yield curve is upward sloping? Day count convention is 30/360. This bond
consists of four cash flows or four zero-coupon bonds .The value of the bond will be
equal to the total value of the component zero-coupon bonds. To know the value of each
such zero-coupon bond, it is necessary to know the yield on a zero-coupon treasury
security with the same maturity. This yield is called the spot rate and the graphical
depiction of the relationship between the spot rate and the maturity is called the spot rate
curve. This bond should be valued as follows:

Cashflow
dates Amount
Days to
coupon
Coupon
period
Discounting
period
Interest
rate per
period
PV of
cashflow
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31-Mar-05 3 60 180 0.33 2.00% 2.98
30-Sep-05 3 240 180 1.33 2.03% 2.92
31-Mar-06 3 420 180 2.33 2.05% 2.86
30-Sep-06 103 600 180 3.33 2.10% 96.11
Price= 104.87

As can be seen, 60-day annualized interest rate is 4% and 240-days annualized interest
rate is 4.06%. Since coupon period is less than year (six monthly in this case), we convert
interest rate into interest rate per period and time to maturity into number of discounting
periods. However, the major difference compared to our previous valuation is in interest
rates we have used for discounting. In this case we have used different interest rates for
different periods. As a result, value of the same bond is now $104.87 as against our
previous valuation of $105.19. Valuation shown in this table is closer to reality because it
does not assume a flat yield curve when yield curve is upward sloping.

Constructing Yield Curves

It is evident from the discussion above that access to data on yield curve is a must for
valuation of bonds. Therefore, understanding the process of construction of a yield curve
is very important.

Yield curve is the relationship between yield (interest rate) and time to maturity. Yield is
linked to riskiness – higher the risk, higher the yield. Therefore, for two bonds with
different risk profiles and but same tenor, yields would be different. Yield is also
influenced by liquidity of the bond – higher the liquidity, lower the yield and lower the
liquidity, higher the yield. Investors prefer to hold liquid bonds over illiquid bonds so that
it could be converted into cash easily. YTM of a bond, therefore, comprises risk-free
yield for a given tenor, risk premium and liquidity premium. Base yield curve is the curve
of most liquid risk-free bonds. It is not contaminated by risk premium and liquidity
premium which market may demand from other risky and/ or less liquid bonds. As
discussed earlier, YTM of ZCBs is pure YTM. Therefore, most widely used yield curve
is based on YTM and tenure of risk-free (i.e. Treasury bonds), most liquid ZCBs. One
could draw other yield curves as well – yield curve of AAA bonds, yield curve of AA
bonds, and so on.

In reality however, ZCBs are normally not available for all maturities. We have seen that
most of the ZCBs are short-term bonds. Because of this constraint zero coupon yield
needs to be derived from fixed coupon bonds. The process of deriving zero coupon yields
for different tenors from fixed coupon bonds is called bootstrapping.

Bootstrapping is a sequential process whereby given one zero coupon rate and price of a
coupon bond with next highest maturity, zero coupon rate for the next highest maturity
can be derived. The process is explained below.

Consider three bonds with following features-

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Maturity Coupon Face Value Price
1 year 7% 100 100
2 years 8% 100 100
3 years 9% 100 100

The first bond will pay $107 at the end of one year. Since market price is 100, one year
spot rate (zero coupon rate) is 7%. Spot rate on two-year bond can be determined by
considering the complete cashflows in the pricing equation.

100 = (8/1.07)+(108/(1+r
2
), where r
2
is two year spot rate. You will find that two-year
rate is 8.04 percent. Having known the one-year rate and two-year rate, one may calculate
the three-year rate in the same fashion. Three-year rate in this case will be 9.12%. Zero
coupon rates for different maturities calculated in this manner is plotted to get Zero
Coupon Yield Curve (ZCYC). ZCYC is also called spot rate curve.

In all markets, bonds in certain maturity baskets trade frequently but others do not. At the
same time all the bonds in the same maturity basket do not trade with high volume i.e. all
bonds are not equally liquid. Given these facts it becomes important to identify which
bonds are more representative and reflect realistic bond yields. But, whatever number of
bonds one may consider, one cannot get a continuous curve. It can only be a large
number of discrete points. If we have only discrete points on the graph, how do we value
a bond whose cashflows fall in between the points we have plotted? To get the price of
such bonds we need to estimate rates of bonds with intermittent tenors. In other words,
we need to create a continuous curve from number of discrete data points. This
continuous curve enables us to estimate what would have been the yield of a bond with a
given tenor had it traded.

Several curve-fitting techniques are employed for constructing the yield curve. Some of
them are discussed hereunder.

Straight Line Interpolation: Here we assume that interest rate between two chosen points
lie on a straight line. It is also assumed that interest rate from period zero to the shortest
tenor considered is the same and rate beyond the last data point considered remains the
same as the rate for the last data point. The yield curve is then constructed by joining the
first point to y-axis with a line parallel to x-axis, joining all other points with a straight
line and drawing a line parallel to x-axis again from the last data point. A sample data set
and the yield curve is given below

Tenor (years) Yield (%) Remarks
0.00 3.50 Extended backwards
0.50 3.50 First data point
1.00 3.60 Joined with previous point with straight line
1.50 3.75 Joined with previous point with straight line
2.00 3.85 Joined with previous point with straight line
3.00 4.25 Joined with previous point with straight line
5.00 4.75 Joined with previous point with straight line
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10.00 5.50 Joined with previous point with straight line
15.00 6.50 Last data point
20.00 6.50 Extended forward

Yield Curve - Straight Line Interpolation
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
0.00 5.00 10.00 15.00 20.00
Tenor
y
i
e
l
d

(
%
)


Yield for a bond with tenor of 3.27 years will be 4.25+(4.75-4.25)*(0.27/2) = 4.385%.

Simple Curvilinear Interpolation: Using other curve-fitting techniques we can derive a
generic formula of different degrees where yield is a factor of tenor. Based on the same
data a second-degree equation for the yield has been derived and presented below:

Yield Curve - Curvilinear Interpolation
y = -0.007x
2
+ 0.2998x + 3.3646
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
0.00 5.00 10.00 15.00 20.00
Tenor
Y
i
e
l
d

(
%
)


One can derive the yield feeding any tenor into the equation e.g. yield for a bond with
tenor of 3.27 years will be 4.27%. As can be seen this curve gives different data
compared to the first curve.

Mathematical Models for Yield Curve Estimation: Several mathematical models have
been developed which involve optimality criteria consistent with the assumptions
regarding the term structure of interest rate. Some of these models are-

Nelson-Siegel Model
Cox Ingersoll Ross Model
Vasicek Model
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McCulloch Model

Primary and Secondary Bond Markets

Primary Markets/IPO

Bonds and other securities issued directly by the government/corporates to the investors
comprise the primary market. The issue is managed by investment bankers who liaise
with the issuer of the bonds and facilitate the issue and subsequent distribution of the
bonds to the investors. The investment banker advises the issuer on the terms and timing
of the issue. The proceeds from such a primary bond issue could be used for multiple
purposes by the issuing agency be it the government or any corporate. These include
working capital requirements, expansion of facilities, re-financing of outstanding debt
and financing takeovers/M&A

In case of treasury securities, there is an auction process followed for the issuance of new
securities. The auction is conducted on a competitive bidding basis. The bidders submit
bids in terms of the yield. The bids are arranged from lowest- yield to highest yield order.
This is equivalent to arranging in terms of highest price to the lowest price. Starting from
the lowest yield bid, all bids are accepted till the entire amount to be raised is completely
allocated. The highest yield accepted is called the stop yield. All the bidders below the
stop yield are allotted the entire amount that they had bid, while the bidders at the stop
yield receive a proportion of the amount bid.

For example, if the amount of total issue is $ 5.56 billion, the treasury allocates the bonds
to all bidders from the low-yield bid to the high-yield bid as shown in the Table below.

Amount(in billions) Bid(in yield %)
0.2 7.55% (Lowest yield/highest price)
0.26 7.56%
0.33 7.57%
0.57 7.58% (Average yield/Average price)
0.79 7.59%
0.96 7.60%
1.25 7.61%
1.52 7.62% (Stop or highest yield/Stop or lowest price)


All the bidders from 7.55% to 7.61% would be allotted the entire amount of $ 4.63 billion
while the remaining $1.2 billion will be allocated among the bidders quoting 7.62%. Each
bidder would receive 79% (1.2/1.52) of the amount they bid for. Price at which the bond
is issued is the price, which each bidder quotes. It is neither the average price nor the stop
price. This allocation process is called discriminatory price auction or French auction.
Here bidder of highest yield has a higher chance of allocation but is at a disadvantage if
stop yield is lower. This phenomenon is known as ‘winner’s curse’.

Trading Bonds On The Secondary Market
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The secondary market can best be understood in comparison to the primary market,
which is where securities are first offered and sold by the issuing companies through the
investment bankers. The secondary market is wherever bonds and other securities are
bought and sold following their original sale. This trading may take place at an organized
exchange e.g. the New York Stock Exchange, or over the counter through a telephone
and computer network. Here bonds are sold from one investor to another investor.

The secondary market permits continuous trading at continuously changing market-
determined prices throughout the day. OTC trading also provides for fixed price auction
(i.e. All transactions or exchanges occur at the same fixed price) at specific points during
the day and are more appropriate for less liquid bonds such as corporate bonds and
municipal bonds.

The various parties that are involved in bond trading are:

A broker usually receives a commission to serve as an intermediary between a seller and
a buyer.

A dealer is an individual or firm that takes the role of principal in a transaction, buying or
selling bonds or other securities on behalf of its own accounts and bearing the risk
associated with this trading.

A broker-dealer describes many firms, which act sometimes as brokers and other times as
dealers for their own accounts.

About Repo

The secondary market for treasury securities is an OTC market. One important feature of
the secondary market in treasury bonds is the use of the re-purchase agreement market by
dealers. Considering the large value of these transactions, the dealer needs to find
appropriate sourced of financing. A dealer can use either his own funds or borrow from a
bank. Typically a dealer uses a repo market to obtain financing. Here the dealer can use
the value of the security purchased as collateral for a loan. The term of the loan and the
interest that the dealer agrees to pay (called the repo rate) are specified. When the term of
the loan is for one day it is known as an overnight repo and if it is for more than one day
it is called a term repo.

The transaction is referred to as a repurchase agreement as it calls for sale of security and
its repurchase on specified terms at a future date. The difference between the purchase
price and sale price is the interest paid on the loan.

In another scenario where a dealer lends securities to his customer and buys it back at a
specified price is called a reverse repo.

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The advantage to the dealer of using the repo market for borrowing on a short term basis
is that the rate is less than the cost of bank financing. From the customer’s perspective the
repo market offers an attractive yield on a short term transaction that is highly liquid.

Bond markets could be domestic, where transactions are in local currency and are
controlled by local central bank, or international where bonds denominated in the
currency of one country is issued and traded in another country mostly through a
syndicate of international banks.

Money Market

Money market is a segment of fixed income market where instruments with maturity of
less than one year are issued and traded. Liquidity in this market is very high and large
amount of bonds can be bought and sold without affecting the market prices. Holding a
money market security is as good as holding cash or money itself from point of view of
liquidity. It is because of this that the short term fixed income market is called money
market. Money market is not a single market place like a stock exchange where buyer
and sellers transact. Most of the transactions happen over the counter in the form of short
term lending and borrowing, many times for as short a period as ‘overnight’. Most of the
transactions in the money market are conducted among big players like banks, financial
institutions, corporates, specialists and the central bank. Money market is primarily a
wholesale market.

There exists a strong interbank market where banks lend one another for period up to one
year. Banks use this market to top up their funds by borrowing from banks, which have
surplus short-term money. Such borrowings become the marginal cost of raising new
funds and hence become the benchmark for wholesale lending.

In the wholesale money market bid rate is the deposit rate offered by a bank and offer
rate is the rate at which a bank lends to other market participants. Interbank offer rate in
London is called LIBOR and interbank bid rate in London is called LIBID. You will find
TIBOR in Tokyo and EURIBOR in the European Union. In the US, interbank rate is
called ‘Federal Funds Rate’. The most common maturities in the market are 1 month, 3
months, 6 months and 12 months. As discussed earlier, rates for different maturities are
different. Therefore, LIBOR for 1 month will be different from LIBOR for 3 months.
Also, the active financial centers deal in different currencies like US Dollar, Yen, Sterling
and Swiss Francs. Interest rates on these currencies reflect the interest rate in the
domestic market of these currencies (otherwise you could do arbitrage). LIBOR is not the
rate on Sterling; it could be for any currency. LIBOR rates may appear like this:

Currency 1 month 3 months 6 months 12 months
USD 2.55000 2.65436 2.86700 3.08970
GBP 3.99870 4.05670 4.10984 4.24000
EUR 3.26700 3.26950 3.30000 3.54300
JPY 0.03400 0.06800 0.06870 0.79000
CHF 2.76500 2.88000 2.93333 3.01240
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LIBOR being the marginal cost of borrowing for the banks, the lending rates in the
market are generally quoted in the form of LIBOR+50 basis points or LIBOR+20 basis
points etc. Since rates quoted by different banks in London market are different, LIBOR
for the day for reference purposes is determined on the basis of a poll of identified banks
at 11.00 a.m. every day.

Different instruments traded in the money markets are described hereunder.

Call Money

Call and notice money market refers to the market for short-term funds ranging from
overnight funds to maximum tenor of fourteen days. ‘Overnight’ usually means 12.00
p.m. one day to 12.00 p.m. the next day. Call money is not a marketable instrument or a
security. It is unsecured lending from one bank to another. The name call money derives
from the fact that the money lent can be called back at any point in time by the lender. In
practice, however, this right is hardly exercised. Some times money is lent with a clause
that it can be recalled with a notice of say 3 or 7 days. This type of lending in called
notice money.

Apart from being an important way to finance short-term needs and lend short-term
surpluses, call and short-term notice money market serves important purpose of providing
overnight rates, which is used for many other purposes. Interest rates on many
instruments are reset every day in line with the overnight rates. For example, the French
public utility firm Credit Immobilier de France has issued a two-year paper where the
interest rate is reset every night to EONIA (Europe Overnight Indexed Average). In
London market, the overnight rate for dealing in Euro is called EURONIA and the
overnight rate in sterling is called SONIA. Call money rate is also an early indicator of
level of liquidity in the market.

Treasury Bills
Cash inflow and outflow for the Governments hardly match. Income tax payments are
normally made towards the end of the quarter in the form of advance taxes. Many other
taxes are also received at periodic intervals. Expenses do not exactly match these inflows.
Hence the need to borrow short-term money to even out the inflows with outflows.
Governments chose to borrow short-term instruments through Treasury bills (US, UK,
India), bon du tresor (France), Schatzwechsel (Germany, Austria), GKO (Russia) etc.

In the US the Treasury bills are auctioned to primary dealers on a weekly basis. In the
UK, Treasury bills are auctioned to banks every Friday. In France, anyone having an
account with the central bank can buy these bonds. Typically money market instruments
are discounted or zero coupon bonds and so are Treasury bills. One year Treasury bill
with maturity value of $100 may be sold at $94. In this case, discount rate is 6% and
yield is 6.38%. In the Treasury bill market the most common practice is that of
discriminatory price auction where bidder pay what they bid. It is also called bid price
auction. In some cases uniform price auction or ‘striking price’ auction is also adopted.
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Bills issued by municipalities, local government bodies, federal states or public bodies
like railways, gas, electricity etc. are called local authority or public utility bills. The
market for such bills is very strong in USA, Germany and France.

Certificate of Deposit (CD)

Structurally, these are similar to Treasury bills i.e. they are short-term, tradable
discounted bonds. However, unlike Treasury bills CD is issued by banks to attract short-
term wholesale deposits. The advantage over a deposit is that CD can be sold to another
investor when the lender needs the money back. Because of this reason yield on CD is
normally less than that on ‘sight’ deposits. Lender could be another bank, corporate or
financial institution. There is a strong CD market in USA and Europe except for
Germany.

Commercial Paper (CP)

Just as Government, public bodies and banks need to borrow for short-term; corporate
bodies also need short-term funds to meet their operational needs. Corporates borrow
short-term money by issuing Commercial Papers. Again, structurally, CP is similar to a
T-bills or a CD. It is short-term, tradable, unsecured discounted bond. Since this is a
deposit taking activity, issue of CP is governed by certain regulations promulgated by the
central bank. For example, companies issuing CP must have a balance sheet size of
minimum GBP 25 million and CP can be issued only in denominations of GBP 100,000.

While commercial paper has been an active instrument in the US for a long time, it has
become popular in Europe only during the past fifteen years. Commercial paper can be
issued either by domestic firms or by foreign firms if the central bank permits.
Companies generally announce a programme for issue of commercial papers. For
example, the programme may be for $ 400 million and for five years. A bank or a
syndicate of banks is appointed as dealer for this programme. Unlike the bond issue
where $400 million would have been raised on issue of bonds all at one time, under the
CP issue programme, companies raise funds from time to time and pay back from time to
time up to the maximum amount. When money is required, the company notifies the
dealer bank, which scouts for lenders and charges a small commission for doing so. In
case, lenders cannot be found in time the dealer bank itself may lend the amount.

Bills of exchange

Bill of exchange is another method for borrowing short-term funds. Companies own trade
debt or account receivables in normal course of their business. It is the money to be
received in future against supplies made on credit. The seller draws the bill on the buyer
specifying value of supplied goods or services and the time by which it would be paid
and gets it endorsed by the buyer. This is the bill of exchange. The seller now can sell this
bill at a discount to the value specified on the bill. This bill can be endorsed by a bank
increasing its credit worthiness. A bill of exchange signed by just the buying firm is
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called ‘trade bill’ and the one signed by the bank is called ‘bank of eligible bill’. These
bills can be discounted with a bank, corporate, general money market operators or a
financial institution. It can change hands many times in its short life. Bills of exchange
are not popular in US, but are very common in Europe, especially in UK. In France it is
called ‘lettre de change’ and in Germany it is called ‘wechsel’.

Repo

Repo or Repurchase agreement is a money market instrument, which enables short-term
borrowing and lending against securities. Under the repo agreement the holder of the
bond sells it with an agreement to repurchase the same at an agreed rate and date. The
forward clean price is set at a level, which is different from the spot clean price by
adjusting the difference between repo interest rate and coupon earned on the security.
This transaction is nothing but a collateralized lending. For the lender of cash the
securities sold by the borrower is the collateral and for the borrower of cash the cash
received from lender is the security. The lender of securities (who is the borrower of
cash) is said to be doing ‘repo’ and the lender of cash (who is the borrower of securities)
is said to be doing ‘reverse repo’. Whether a transaction is termed as repo or reverse repo
is determined by who initiates the first leg of the transaction. Repo transaction help in
borrowing cash and tiding over short term deficits and reverse repo transaction helps in
earning some return on the idle cash.

Repo transaction involves two legs – first when securities and cash are borrowed and
second when it is returned. Settlement amount on the first leg involves the followings:
Value of the securities at the transaction price
Accrued interest from the previous coupon date to the date on which the first leg is settled
Settlement amount on the second leg involves the followings:
Repo interest at the agreed rate for the period of the repo transaction
Accrued interest from the previous coupon date to the date on which the second leg is
settled
Return of principal amount borrowe

Let us take a numerical example:

Trade date: 13
th
July 2004
Settlement date: 13
th
July 2004
Trade price: 108.50
Face Value: 100,000
Security: 12.5% 20-Sep-2008
Repo rate: 7.5%
Repo term: 2 days

First leg:
On 13
th
the seller of the repo (borrower of funds) receives the following sum:
Value of the security: 108.50*100000/100 = 108500.00
Accrued interest: 12.5% * 100000 *112/360 = 3888.89
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Settlement amount: 112388.89

Second leg:
On 15
th
July the seller returns the following amount (repo period is two days):
Original borrowing: 108500
Accrued interest: 12.5%*100000*114/360 = 3958.33
Repo interest: 7.5%*100000*2/360 = 41.67
Settlement amount: 112500.00

Repo rate is likely to be lower compared to interbank borrowing rate since it is
collateralized borrowing.
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Testing the concepts

1. A puttable bond allows
a. The issuer to redeem the bond prior to the original maturity
b. The investor to redeem the bond prior to the original maturity
c. The issuer to convert the bond into shares prior to the original maturity
d. The investor to convert the bond into shares prior to the original maturity
e. a and c
2. Price of a bond, trading in the secondary market, is best represented by
a. Future value of face value and coupons
b. Face value x (coupon – YTM)
c. Mid point of the trading range of the bond determined by the central bank from
time to time
d. Present value of face value and yet to be paid coupons
e. Future value of coupons
3. Which of the followings is not a valid day count convention in the bond market
a. 30/360
b. actual/ 360
c. actual/365
d. 31/actual
e. actual/actual
4. Accrued interest is
a. Paid by the issuer to the investor
b. Paid by the buyer to the seller
c. Coupon x days since last coupon / coupon period
d. a and c
e. b and c
5. Which statement describes the correct relationship between coupon rate and YTM?
a. If bond pricing is done correctly, coupon rate must equal YTM
b. YTM will be higher than coupon rate if bond is bought below par value
c. YTM will be higher than coupon rate if bond is bought above par value
d. YTM becomes irrelevant if all the coupons are paid in time
e. YTM=ln(1+coupon rate)^(tenor)
6. Which of the following statements about T-bills is not correct
a. T-bills are short term securities with maturity of less than one year
b. T-bills are issued through a process of competitive bidding at auctions
c. T-bills carry no default risk
d. T-bills are generally zero-coupon bonds
e. T-bills are issued by banks and financial institutions
7. Bank A enters into an agreement with Bank B whereby Bank A sells specified securities
with an agreement to repurchase the same at a mutually decided future date and price.
Which of the following statements is true about this transaction
a. Bank A has done a repo deal and Bank B has done a reverse repo deal
b. Bank A has done a reverse repo deal and Bank B has done a repo deal
c. Bank A and B both have done a repo deal
d. Bank A and B both have done a reverse repo deal
e. Bank A has done a commercial paper deal and Bank B has done a call money
deal
8. What are Gilts?
a. Government Securities
b. PSU bonds
Page 134
c. Tax-free bonds
d. Mutual Fund units
e. Receivables of oil companies
9. Between the years 2002 and 2004 the term structure of interest rate has changed its shape
from downward sloping to upward sloping. Which of the following bonds must have seen
the largest percentage change in market price during this period?
a. 364 day T-bill
b. 6 months Commercial Paper
c. 5 year floating rate bond
d. 5 year fixed coupon bond
e. 10 year fixed coupon bond
10. Realized yield from a bond can be defined as
a. (Total coupons received + capital gains (loss))/ purchase price
b. (Total coupons received )/ purchase price
c. (Total coupons received + capital gains (loss))/ selling price
d. average YTM from time of purchase till time of sale
e. (sale price/ purchase price) -1





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Foreign Exchange Markets

Module Objective

When you complete this chapter, you will be able to:

Understand the scope of Treasury operations in a bank
Get an overview on FX market with some historical background on exchange rate regime
Understand FX quotes and FX terminology
Understand the calculation of cross currency rates
Understand different types of foreign exchange transactions
Get an overview of FX derivatives and FX organizational structure














Author

Navneet Nayak
Srinivas Rao
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Introduction

What is treasury? In common parlance treasury is that part of a government which
manages government funds and revenue and is responsible for making government's
financial decisions. In context of a bank, treasury operation is that section which is
involved in the financial management of the bank’s liquidity through dealing and
borrowing. Objective of the treasury operations is to manage the funds and risk of the
bank efficiently. It is the responsibility of treasury to make available to the users in bank
the right quantity of funds at the right time and at optimal cost.

Treasury operations of a bank are considered very exotic and demanding. Treasury
operations are mission critical for a bank as the transactions involve huge sum of money
and high exposure. Treasury wing of the bank is involved in money market operations,
forex market operations and risk management.

Treasury Organizational Structure

The bank’s dealing is usually grouped under a treasury manager. The treasury operations
in a bank are structured around desks and each desk has a Chief Dealer managing the
desk’s operation. Following are some of the common desks in bank’s treasury

Sl.
No.
Desk Operation
1 Spot FX Desk Dealers on this desk perform the buying & selling of
currencies in the Spot FX transactions. They also keep
track of positions and P&L of the deals
2 Forwards FX desk Dealer on this desk perform buying & selling of the
currencies in the Forward FX transactions. They also
keep track of positions, gaps and P&L of the deals
3 Money markets desk Dealer on this desk operate in money market
instruments like Call money, T-bills, Commercial
papers, CDs, Repo etc.
4 Derivatives desk Dealers on this desk buy and sell interest rate derivatives
and FX derivatives
5 Corporate desk Corporate desk provide the customized services to
corporates. These dealers provide these services with the
support of other dealers in the treasury.

Introduction to Foreign Exchange

This chapter focuses on understanding the concepts of foreign exchange and foreign
exchange operations of a bank. The book has dedicated chapters on money market and
risk management.

What is foreign exchange? Foreign exchange, also abbreviated as Forex or FX, is
purchase or sale of one currency against sale or purchase of another currency at an agreed
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price today to be delivered on a specified date. Exchange rate in a way shows the
purchasing power of one currency in another currency.

Why is foreign exchange required? To answer this question let’s see when foreign
exchange will not be required. Foreign exchange will not be required if any of the
following happens:

All the countries world over use a common global currency.
The entire world becomes a closed economy, which is just the opposite of liberalization
and globalization. No international trade happens and no body travels from one country
to another.
All the countries world over start following the good old barter system.

Since none of this is likely to happen any time in the foreseeable future we see that it is
inevitable to have foreign exchange.

The foreign exchange (FX) market is a multibillion-dollar market for monetary
transactions associated with international trade and finance. In this market, people who
need the currency of another country can obtain it in exchange for the currency they have.
The foreign exchange market is the largest in terms of the daily transaction volumes and
is the most liquid market in the world. Trading in foreign exchange happens in markets
operating worldwide and 24 hours a day. FX market is not a physical market and
transactions are done through computer trading system or phone.

History

In order to appreciate the current foreign exchange system we need to go back in time to
understand how foreign exchange system and market has evolved. The foreign exchange
market can be traced back in history to 1880 when the Gold Standard was accepted
worldwide. The Gold Standard was a system of fixed exchange rates with parities that
were based on gold reserves of the countries. This system remained strong until 1918.
During World War I, many countries started printing and circulating more currency than
what could be supported by their gold reserve. This resulted in the collapse of this system
in 1936.

In an attempt to bring some order to the international payment system and relationship
between currencies Bretton Woods conference was held in 1944. The main objectives of
this conference were:

Establish an international monetary system with stable exchange rates
Eliminate existing exchange controls and
Establish currency convertibility to allow the holder of a currency to convert it freely into
any other currency

US dollar replaced Pound sterling as the dominant currency and convertible currencies
were pegged against USD. Bretton Woods conference resulted in the establishment of
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International monetary fund (IMF) to monitor the new system and help countries during
balance of payment crisis.

By 1973, the system of fixed exchange rates was replaced by an adhoc system of floating
rates. In floating rate regime the exchange rate is expected to change as per the relative
supply and demand of the currencies involved. This is basically the same system that is in
operation today.

The international monetary scene has witnessed a variety of exchange rate systems.
Today, almost all industrialized countries practice some form of a controlled floating rate
system, which applies to about three-quarters of all world trade.

FX market players

Participants range from international business firms to tourists. However banks are the
most dominant players in the forex market of any country. Besides banks other financial
institutions, central banks, brokers and large corporates are also active players in the
market.

Factors influencing the exchange rate

The exchange rate fluctuates due the change in supply-demand equation for a certain
currency. Excess of demand over supply results in currency appreciation and a deficit of
demand over supply results in currency depreciation. There are various factors affecting
the supply and demand of a currency. Some of these factors are listed below:

Country’s balance of payment situation (how much Forex the country earns by exporting
goods and services, inward remittances and capital inflows vs. how much of Forex is
spent on import of goods and services, outward remittances and capital outflows)
Rate of Inflation
Rate of Interest
Economic condition of the state and economic policies pursued by the government
Political scenario depicting the amount of uncertainty in the political situation
Direct intervention of Central bank to smooth out unduly large short term fluctuations
Technical factors like release of national economic data and seasonal demand for Forex
Market Sentiment: Short-term changes in the FX Rates are often the result of market
sentiment. This is the perception traders have of short-term prospects for the movement
in a currency.

Understanding FX quote

The two currencies in any FX quote are commodity currency (also known as base
currency) and term currency (also known as quoted currency). Commodity currency is
that currency which is priced and term currency is the price of commodity currency.
Thus, an FX quote establishes a relationship between the two currencies. In any market,
in fact, price is expreseed in similar terms – the quote shows how much of one item costs
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(or can be exchanged for) in term of the domestic currency. The price could be Potato –
Rs.15/kg or Rs.700 for one shirt. The seller exchanges his goods for the currency and the
buyer exchanges the currency for the goods. Here the item or commodity is being priced
and quoted in one unit and domestic currency is variable. Price of potato may move to
Rs.20/kg or Rs.10/kg, still potato is always expressed in terms of one measuring unit and
its value in domestic currency changes. Since commodities are exprressed in terms of one
measuring unit, even in the FX market the currency which is expressed as one unit is
called commodity currency (base currency) and the currency in whose terms it is priced
and is variable is called the term currency.

Let us take an FX quote that gives a relationship between US Dollar (USD) and Japanese
Yen (JPY)

USD/JPY = 120.00

This quote implies 1 USD is equal to 120 JPY, USD is the currency which is priced and
is a commodity currency and JPY is the currency pricing the commodity currency and is
the term currency in the given quote.

Although USD can be quoted differently to act as a term currency, market convention is
to quote USD as the commodity currency against most of the currencies. Exceptions to
this are the quotes of USD against British pound sterling (GBP), Euro (EUR), Australian
dollar (AUD), New Zealand dollar (NZD) and Irish punt (IEP) which for historical
reasons are quoted in terms of dollars. Whereas the above quote of USD/JPY tells us how
many JPY are required to get one USD in exchange, market quote of GBP tells how
many USD is required to get one GBP in exchange i.e. how many USD are equal to 1
GBP, 1 EUR, 1 AUD, 1 NZD or 1 IEP. Hence for these cases USD is a term currency.

Direct quote and Indirect quote

In the forex markets, there are two accepted styles of quoting rate viz., direct rate and
indirect rate. Direct quote is the one where the foreign currency becomes the commodity
currency and home currency is the term currency. A direct quote given by an Indian bank
will be

USD/INR = 43.75

At present Indian forex market uses Direct quote system. Even internationally, most
markets use ‘direct quotation’ only.

In the ‘indirect quote’ it is the other way round, where the home currency is the term
currency and foreign currency is the commodity currency. Indirect quotation is followed
in very few countries like Britain. Following is an indirect quote for the same USD vs.
INR rate.

INR/USD = 0.0229
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(You may have noticed by now that currencies are named and abbreviated in a standard
way in the Forex market. Currencies have a three-letter abbreviation – USD, JPY, INR
etc. The first two letters denote the name of the country and the last letter is for the
currency of that country)

Converting an indirect quote to direct quote or vice versa

The exchange rate may be quoted with either foreign currency or the home currency as
the commodity currency depending on the type of quotation system used.

If we have to convert an exchange rate of USD/CAD = 1.3829 to a CAD/USD rate this
can be achieved by dividing both the sides by 1.3829. Rewriting the above equation in
this fashion gives us

USD 1.0000 = CAD 1.3829
1.3829 1.3829

USD 0.7231 = CAD 1.0000

Hence, CAD/USD rate is 0.7231 i.e. 1/direct quote = indirect quote and 1/indirect quote
= direct quote.

Bid and offer rates

Market makers in the FX market are ready to buy the commodity currency at a certain
rate, simultaneously they are also ready to sell the commodity currency at a different
rate. Thus market-makers publish two quotes (known as two way quote) where one quote
is the bid rate and the other is the ask (or offer) rate.

Bid rate is the rate at which the market maker is bidding to buy the commodity currency.
Ask rate (offer rate) is the rate at which the market maker is offering to sell the
commodity currency. The quoting bank or price maker always buys the commodity
currency low (at the bid rate) and sells the commodity currency high (at offer rate). The
buying rate of market maker is the rate at which the customer will sell and the offer
rate/selling rate given by the market maker is the rate at which customer or the market
taker will buy. Since quotes are published by the market maker, the bid rate is the buying
rate of commodity currency for market maker and selling rate for customer. Similarly,
offer rate is the selling rate for market maker and buying rate for the customer.

For example a typical FX quote given by the quoting bank will look like this:

Bid Offer
USD/CHF: 1.2050 1.2060

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As per the above quote the quoting bank is ready to buy 1 USD by paying 1.2050 CHF
and is ready to sell 1 USD in exchange for 1.2060 CHF. Conversely, if you as the
customer wish to buy one USD, you need to pay 1.2060 CHF and if you wish to sell one
USD, you will get 1.2050 CHF in return. You can see that if the market maker buys one
USD and sells one USD at the given rates, he makes a profit of 0.0010 CHF.

The difference between the buying price and selling price of the base currency
(commodity currency) is called ‘spread’. Spread is measured in ‘pips’. The last decimal
value in currency quotation is called ‘pips’. Spread in the above USD/CHF quote is 10
pips. If USD/INR bid rate is 43.50 and ask rate is 43.75, spread id 25 pips (not 2500
pips).

Reading the Quotes

In foreign exchange dealing rooms throughout the world, dealers are kept informed of the
latest currency quotes via telecommunication networks. Agencies like Reuters and
Bloomberg collect quotes from various market makers on an ongoing basis and present it
on a computer screen as indicative
7
exchange rates for all major currencies. The table
below shows how the spot rate of USD against other currencies is shown:

Spot
1015 CHF 150 50/60
1013 JPY 120 50/60
1001 CAD 148 20/30
1015 GBP 160 10/20
1001 EUR 110 15/25

The first column on the screen gives the time at which the quotes were last changed. The
second column lists the abbreviations for the currencies being exchanged, as determined
by the International Standards Organization (ISO) codes, against USD. The third column
shows the spot rate (for spot transactions, the currencies are exchanged two business days
after the transaction date for most currency pairs. For USD/CAD exchange happens on
T+1) of different currencies against USD. As you can see, rates on Reuters screen appear
without decimal points. Dealers are expected to know the correct placement of the
decimal.

Thus, the spot bid-offer rates available on the Reuters screen can be interpreted as
follows:

Spot Bid Offer
CHF 150 50/60 1.5050 1.5060
JPY 120 50/60 120.50 120.60
CAD 148 85/00 1.4885 1.4900

7
These rates are only "indicators" of the current rates because the screen, as sophisticated as it is, cannot
possibly keep up with exchange rate fluctuations.
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GBP 160 10/20 1.6010 1.6020
EUR 110 15/25 1.1015 1.1025

In the above screen for the first 3 quotes USD is the base currency. However it is a term
currency for the quotes against GBP and EUR. Hence the quotes for these two currencies
should be interpreted as:

Bid Offer
GBP/USD = 1.6010 1.6020
EUR/USD = 1.1015 1.1025

In the GBP/USD quote, 1.60 is referred to as the “big figure” and 10 represent the “pips”
on the bid side and 20 represent the “pips” on the offer side. Similarly for USD/JPY
quote, 120 is referred to as the big figure and 50 represents the pips on the bid side and 60
on the offer side. Hence in any quote the last 2 digits are referred to as pips.

An interesting observation on the Reuters quote above is the USD/CAD quote which on
the Reuters screen looks like 148 85/00. This quote cannot be translated into a bid rate of
1.4885 and an offer rate of 1.4800, as this would mean a bid rate, which is higher than the
offer rate. The correct interpretation of this quote is as follows:

Spot Bid Offer
CAD 148 85/00 1.4885 1.4900

The last 2 digits of the quote are “00”, and the dealer will quote this as “90-figure”. Since
bid rate cannot be higher than the offer rate (can you figure out why), it must be 1.4900
and not 1.4800.

The middle rate is the mid-point between the buying and selling rates. The difference
between bid and offer rates is known as bid-ask spread. The unit of bid-ask spread is pips.

Calculation of Cross rates

In recent years, trading in “cross currencies” has increased considerably. Customers and
smaller banks want to do business against currencies other than the dollar, for instance
EUR against CHF or GBP against CHF. In such cases, “cross rate” has to be calculated.
The process of finding the exchange rate between currencies A and C when the rates of A
vs. B and B vs. C are known is called cross rate calculation. Since each currency is
quoted against USD either as commodity currency or term currency, cross rate is
normally a combination where USD is not one of the currencies in the currency pair. We
need to understand this with the help of few examples.

Example 1: If GBP/USD rate is 1.8330 and USD/CHF rate is 1.5050. Calculate
GBP/CHF rate?

Solution: GBP/USD = 1.8330
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i.e. 1 GBP = 1.8330 USD…………………(1)

USD/CHF = 1.5050

i.e. 1 USD = 1.5050 CHF…………………(2)

From 1 and 2 above
1 GBP = 1.8330 X 1.5050 CHF
1 GBP = 2.7586 CHF
GBP/CHF = 2.7586

Example 2: If GBP/USD rate is 1.8330 and EUR/USD rate is 1.1210. Calculate
GBP/EUR rate?

Solution: GBP/USD = 1.8330

i.e. 1 GBP = 1.8330 USD…………………(1)

EUR/USD = 1.1210

i.e. 1 EUR = 1.1210 USD
i.e. 0.892 EUR = 1 USD…………………(2)

From 1 and 2 above
1 GBP = 1.8330 X 0.892 EUR
1 GBP = 1.6350 EUR
GBP/EUR = 1.6350

Example 3: Consider the following sets of quotes.

Bid Offer
USD / CHF 1.5050 1.5060
USD / JPY 120.50 120.60

Determine CHF/JPY bid and offer rate?

Solution:

Calculating CHF/JPY bid rate

Determining CHF/JPY bid rate would involve finding out many JPY would you pay to
buy 1 CHF. If a customer approached you to sell CHF and buy JPY what is the rate you
should quote? Since direct quotes between CHF and JPY is not available, you could do
the followings:
sell the CHF received from the customer and buy USD.
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How much USD would you receive from the market on selling one CHF when USD/CHF
quote is 1.5050/60?

This quote is for buying and selling USD, the commodity currency. When I sell CHF I
will buy USD. When I buy USD, the dealer sells me USD. Therefore, I will get the offer
rate of the dealer i.e. 1.5060. When the dealer sells one USD to you, he will demand
1.5060 CHF from you. Since I am selling one CHF I will receive 1/1.5060 USD ,or,
0.6640 USD.

sell USD thus received to buy JPY
How many JPY would you receive if you sell one USD when the dealer’s quote is
120.50/60?

You would receive 120.50 JPY for one USD. Since you have only 0.6640 USD you
would receive 120.50*0.6640 JPY i.e. 80.01 JPY.

give this JPY to the customer. This is the quote you should give. The bid rate for
CHF/JPY is 80.01.

CHF/JPY
bid
= 80.01

Calculating CHF/JPY offer rate

Determining CHF/JPY offer rate would involve finding out many JPY one can receive by
selling 1 CHF.

This can be calculated by finding out how many USD (x) one can receive by selling 1
CHF and then finding out how many JPY one can receive by selling x USD.

USD/CHF bid rate of 1.5050 means that the quoting bank is ready to buy 1 USD at
1.5050 CHF. It also means 0.6644 USD is required to sell 1 CHF.

0.6644 USD = 1 CHF ……………..(1)

USD/JPY offer rate of 120.60 means that the quoting bank is ready to sell 1 USD at
120.60 JPY.

1 USD = 120.60 JPY
0.6644 USD = 0.6644 X 120.60 JPY
0.6644 USD = 80.1266 JPY ……………..(2)

From 1 and 2 above

1 CHF = 80.1266 JPY
CHF/JPY
offer
= 80.1266
Different ways you may see the FX quotes
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While dealers give quotes to each other and clients in the manner discussed above, data
providers may present the FX quotes differently to make it easily understandable to the
readers. Following is the quote from Bloomberg website.

Following a quote from Reuters website:


FX Deal – Parameters

A foreign exchange deal is a contract to exchange one currency for another at an agreed
rate on a specific delivery date. The trading screen used by traders should capture the
following key parameters for a foreign exchange deal:

Parameters Description
Trade date The date on which the trade has taken
place. This is the date on which the dealers
have agreed to transact.
INDUSTRY MOVERS

S&P 500 HEALTH CARE IDX 330.76

9.68
S&P 500 ENERGY INDEX 278.83

5.58
S&P 500 INDUSTRIALS IDX 271.01

2.88
CURRENCIES
EURO (in USD) 1.2868

0.0047
YEN (per USD) 106.1000

-0.1300
POUND (in USD) 1.8476

-0.0016
U.S. $ ¥en Euro Can $ U.K. £ Aust $ SFranc
1US $ = 1.0000 106.0800 0.7773 1.2031 0.5413 1.3200 1.1888
1¥en = 0.009427 1.0000 0.007321 0.0113 0.0051 0.0124 0.0112
1Euro = 1.2865 136.4700 1.0000 1.5478 0.6962 1.6975 1.5294
1Can $ = 0.8312 88.1000 0.6455 1.0000 0.4494 1.0958 0.9873
1UK £ = 1.8474 195.9500 1.4355 2.2226 1.0000 2.4375 2.1962
1Aust $ = 0.7576 80.3300 0.5887 0.9115 0.4100 1.0000 0.9009
1SFranc = 0.8412 89.1800 0.6535 1.0115 0.4550 1.1100 1.0000
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Type of deal Type of deal based on the value date (Spot,
Forward, etc…)
Deal direction Whether the deal is to buy the commodity
currency or to sell (Bought / Sold)
Counterparty The other party with whom the dealer has
made the deal
Currencies The currencies involved in the deal
Exchange Rate The rate at which the currencies were
exchanged
Amounts The amounts of the both the currencies
involved
Value Date The date on which the settlement of
currencies takes place
Payment Instructions
Pay into The account in which the money will be
paid
Receive at The account in which the money will be
received

All the above parameters in the above table are self-explanatory except for value date,
which requires further explanation. Value date is nothing but the settlement date of the
transaction. For a spot transaction, it is usually two business days from the transaction
date. For a three-month forward transaction, the value date would be three months from
the spot value date, and so on. When we say three months or nine months from the spot
value date it means the same date three or nine months from now.

If transaction date is 23 May 2005, value date is 25 May 2005 (assuming 24 and 25 May
are working days in domestic markets of both currencies). In case of 3 months futures,
value date will be 25 August 2005, if this date is not a holiday in either of the markets. If
the value date is a holiday, normally the next business day is taken as the value date.
However, if rolling forward the value date results in value date going into the next
calendar month, many a times it is rolled backwards to the previous working day. You
need to be aware of different market conventions for deciding value dates.

Accounts

Every foreign exchange transaction has an accounting impact. Since the currencies
cannot cross their respective borders, banks dealing in foreign exchange are required to
have Nostro and Vostro accounts with other banks and branches.

Nostro account: Also known as ‘Our Accounts with them’ are the current account
maintained by one bank with another bank or branch abroad in the home currency of the
later. Through this account the bank will route all the payments and receipts in the
concerned currency. For example, State bank of India maintains a Nostro account with a
Washington bank for doing the payments and receipts in USD. This is a Nostro account
from the point of view of State bank of India.
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Vostro Account: Also known as ‘Their Accounts with us’ are the current account
maintained in the home currency by a foreign bank with a local bank. Through this
account the foreign bank will route all the payments and receipts in the home currency. In
the example above, the account maintained by State bank of India with the Washington
bank for doing the payments and receipts in USD is a Vostro account from the point of
view of the Washington bank.

What is Nostro for one bank becomes Vostro for another.

Mirror account: For every Nostro account maintained by one bank with another, the bank
maintains a Mirror account in its books. Here the recording of transactions is done from
banks point of view. All debit entries appearing in Nostro account would appear as Credit
entries in the mirror account and the credit entries in Nostro account would appear as
Debit entries in the mirror account.

FX position

When you buy a certain currency you take a long position in that currency and when you
sell a currency you take a short position. These definitions of going long and short are
common to any of the financial market. In the FX market, as is obvious, when you are
long in one currency you are automatically short in the other currency of the currency
pair.

Net position in a currency is the difference between long position on that currency on a
specified value date and short position on that currency having the same value date. Net
position in each currency is an indication of the currency risk exposure in that currency.

Squaring a position in a currency means matching the inflows to the outflows of the
currency. To fully square currency positions, the inflows and outflows on each value date
must be equal.

Types of FX transactions

FX transactions can be categorized as Cash, Spot, Spot (Tom), Forward and Swap
transactions. These transactions differ from each other on the basis of value date.

Cash transactions

Cash transactions use cash rate and have the value date same as the transaction date. This
is different from spot transaction since in spot transactions settlement happens after two
business days i.e. on T+2.

Spot transactions

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Spot transactions are done using spot rates and the value date of a spot transaction is 2
common business days after the transaction date. In the old days, the two-day period
between conclusion and execution of the agreement was required for completion of the
accompanying paperwork. Although this no longer applies in the same way, the
traditional system has been retained.

Most of the transaction in the FX market is done using spot rates.

Spot (Tom) transactions

Spot (Tom) transactions use spot (Tom) rates and the value date of a spot transaction is 1
common business day after the transaction date.

Forward transactions

Forward transactions use forward rates and the value date of a forward transaction could
be 1 month / 2 months /3 months or even longer after the spot value date depending on
whether the forward period is 1 month, 2 months or 3 months or longer.

Example: If a 1-month USD/INR forward transaction is done on 23
rd
May, 2005. What is
the settlement date and rate? Spot USD/INR = 43.75, 1 month Forward USD/INR =
43.95.

Solution: Settlement rate will be equal to the 1 month Forward USD/INR rate, which is
43.95.

Settlement date = Spot value date + 1 month period
= (23
rd
May, 2005 + 2 common business days) + 1 month period
= 25
th
May, 2005 + 1 month period
= 25
th
June, 2005
8


Forward transaction in FX is just like a forward contract where the rate at which the
exchange happens and the amount of transaction will be fixed at the time of entering into
the contract and the actual exchange of currencies happen on the maturity date of the
contract as per the agreed exchange rate. Hence forward transaction is used for hedging
against interest rate risk.

Relation between Forward rate and Spot rate

Like any other forward contract the forward rate should have a relationship with the spot
rate. The commodity currency is deemed to be quoting at a premium if the forward rate is
more than the spot rate. Farther is the value date, higher is the premium value.


8
25
th
June, 2005 will be the settlement date only if it is a business day in both US and India. Otherwise the
next common working day is chosen as the settlement date.
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On the other hand, the commodity currency is deemed to be quoting at a discount if the
forward rate is less than the spot rate. Farther is the value date higher is the discount
value.

Example: USD at premium
Spot rate 1-month
forward rate
3-months
forward rate
6-months
forward rate
1-year
forward rate
USD/INR 43.48 43.55 43.67 43.88 44.08

Example: USD at discount
Spot rate 1-month
forward rate
3-months
forward rate
6-months
forward rate
1-year
forward rate
USD/INR 43.48 43.40 43.25 43.04 42.74

When does the commodity currency gets traded at premium or discount in a forward
transaction?

This relationship is determined by the prevailing market interest rates in the two
countries. As a thumb rule if the prevailing interest rates in country A are higher than the
prevailing interest rates in country B, then the forward rate for the currency of country A
will be at discount and the forward rate for the currency of country B will be at premium
if currency of country B is the commodity currency.

The equation governing the relationship between forward rate and spot rate is given by

F
USD/INR
= S
USD/INR
* (1 + R
INR
* actual days/360) / (1 + R
USD
* actual days/360)

where
F
USD/INR
is the forward USD/INR rate
S
USD/INR
is the spot USD/INR rate
R
INR
is the interest rate in INR
R
USD
is the interest rate in USD
Actual days is the forward period in days.

Thus clearly from the above equation if the interest rates in India are higher than interest
rates in US, USD will be quoted at premium against INR in forward transactions. The
above equation gives the theoretical forward USD/INR rate. If the actual rate deviates
from the theoretical rate by a large degree, then arbitrageurs will come into action making
riskless profit there by bringing the forward rate to the correct level.

Let us take a numerical example. What should be USD/JPY 3-months forward rate if
USD/JPY spot rate is 120.50, USD 3-months interest rate is 3.5% and JPY 3-months
interest rate is 0.45%?

As per the given formulae –

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USD/JPY
3months
= 120.50 * (1+(0.45%*90/360))/(1+(3.50%*90/360)) = 119.59
Forward points is 119.59 – 120.50 = -0.91. USD forward rate will be at a discount to the
spot rate.

The generalized formula for calculating spot rate will be as follows:

F
base ccy/ term ccy
= S
base ccy/ term ccy
* (1 + R
term ccy
* days
term ccy
/360) / (1 + R
base ccy
* days
base
ccy
/360)

where
F
base ccy/ term ccy
is the forward rate
S
base ccy/ term ccy
is the spot rate
R
term ccy
is the interest rate in term currency for the relevant tenor
R
base ccy
is the interest rate in commodity currency (base currency) for relevant tenor
Actual days is the forward period in days as per the day count convention in the base or
term currency market.

Reading the Forward rates on Reuters Screen

Consider the following Reuters screen.
Spot 1 Mo 3 Mo 6 Mo 12 Mo
1015 CHF 150 50/60 68/66 170/167 310/305 625/620
1013 JPY 120 50/60 46/45 145/143 290/287 580/575
1015 GBP 160 10/20 04/03 12/11 25/24 50/48
1001 EUR 110 15/25 20/22 60/63 125/129 240/245

This is the Reuters screen view giving spot rate, 1 month, 3 months, 6 months and 12
months forward rate for different currencies against dollar. You can see that forward rates
are quoted differently than spot rates. Traders generally quote only the difference,
expressed in points (pips), between the spot and forward rates. The correct term for this
difference is forward point or swap rate (or swap points). It is the differential, rather than
the actual forward price, that is displayed on the Reuters screen under the one, three, six,
and twelve-month forward columns.

Let us try to work out 1-month forward rate for EUR/USD and USD/CHF from the given
Reuter screen values.

Example: Calculation of 1-month forward EUR/USD rate

Bid Offer
S
EUR/USD
= 1.1015 1.1025
Forward points= 0.0020 0.0022
------------------------------
1-month F
EUR/USD
= 1.1035 1.1047
------------------------------

Since bid side forward points
is less than offer side forward
points, forwards points should
be added to the spot rate to
arrive at correct forward rate
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This means that Euro is at premium against USD in the forward market.

Example: Calculation of 1-month forward USD/CHF rate


Bid Offer
S
USD/CHF
= 1.5050 1.5060
Forward points = 0.0068 0.0066
-----------------------------
1-month F
USD/CHF
= 1.4982 1.4994
-----------------------------

This means that USD is at discount against CHF in the forward market. All other forward
rates can be worked out using the similar approach.

Swap Transaction

Now that we have understood different types of foreign exchange transaction, we come to
the final breed of more exotic foreign exchange transaction. To further elaborate, an FX
swap is the simultaneous sale and purchase of the same amount of a given currency, both
transactions having different value dates. A swap transaction can be made of any
combination viz. cash-spot, spot-forward, 1-month forward – 3-month forward. The key
condition is that value date of the buy and sell leg should be different.

The swap discussed above is a traditional FX Swap transaction. Another variation to the
traditional transaction is the split-amount FX Swap transaction. An FX swap in which the
spot amount is the present value of the forward amount is an example of a "split-amount
FX swap."

In a different style of classification, FX Swaps can be classified as Engineered swap and
Pure swap. Engineered swap is the one where the spot leg and the forward leg of the
swap transaction happen with different counter parties. In Pure Swap for both the spot leg
and forward leg the counter party is same.

Forward transactions are done both as standalone and as a part of Swap transactions. To
prevent confusion between these two types of forward transaction, traders use the term
“outright” for standalone forward transaction.

What could be the reasons for a bank entering into an FX Swap deal? Let us try to
understand this through an example.

Example: On 23
rd
May, 2005 at 10:00 AM Bank of New York acting as a dealer
purchases spot GBP 100 million at GBP/USD =1.85. Unable to find an immediate
matching spot deal, at 10:30 AM Bank of New York sells 3-month forward GBP 100
million at GBP/USD=1.86 and squares off its exchange position.

Since bid side forward points
is more than offer side
forward points, forwards
points should be subtracted
from the spot rate to arrive at
the correct forward rate
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The above set of transactions has resulted in a positive cash position to the extent of 100
million GBP while the exchange position is squared off. Now if the Bank of New York
has to square off the cash position and simultaneously maintain its current exchange
position, the bank will have to enter into swap transaction (selling GBP spot and buying
3-month GBP forward) thus leaving no exposure for the bank.

In general FX dealers enter into an FX Swap transaction
To improve liquidity
To carry out buying and selling for the clients for spread margin and simultaneously
managing their own cash positions in different currencies
To take advantage of abnormalities in interest differentials through covered interest
arbitrage

FX Derivatives

The dealers in derivatives desk trade in various types of FX derivatives for hedging and
speculation. Apart from the forward transaction and FX Swap transaction covered earlier,
this section gives a brief on key FX derivatives traded on Derivatives desk.

FX futures

Futures in principle are very similar to forward transactions. Underlying for all FX
futures is the FX rate. Apart from the fact that FX futures are exchange traded, there are
quite a number of differences in terms of how the contract is structured. Futures positions
require a margin deposit to be posted and maintained daily. If a loss is taken on the
contract, the amount is debited from the margin account after the close of trading
everyday. Futures are cash settled and underlying FX is not exchanged. Unlike a forward
transaction, all contract specifications such as expiration time, face amount, and margins
are determined by the exchange instead of by the individual trading parties. A detailed
coverage on Futures is available in the chapter xxx.

FX Options (Currency Options)

FX options are a way of buying or selling a currency at a certain point in the future. An
option is a contract that specifies the exchange rate at which an amount of currency can
be bought or sold on or before a specified date in future called the expiration date. Unlike
forwards and futures, the owner of an option does not have to go through with the
transaction if he or she does not wish to do so. Just like any other underlying, FX options
also have call and put options. A detailed coverage on Options is available in the chapter
xxx.

Currency Swap

In a cross-currency swap both counterparties exchange at start date a given amounts (face
amount) in two different currencies, at spot exchange rate. During the life of the swap
each counterparty makes interest payments in the currency received. At the end date, both
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counterparties make their last interest payment and exchange the face amounts again at
the same conditions as at the start date. Further explanation on this derivative product is
also available in Interest rate derivatives chapter.

Other FX derivatives

FX derivatives product like Non-Deliverable Forward (NDF), exotic FX options, Cross
currency swaptions, structured products (GROIs, BLOCs etc) are also gaining popularity
and are now being actively traded by FX dealers. Further discussion on these products is
beyond the scope of this book


Forex operations – Org structure

Looking at the criticality and importance of the foreign exchange transactions, banks
have a well-defined organizational structure for its foreign exchange operations.

Most of the banks opt for a 3-tier organizational structure composed of Front office,
Middle office, and Back office operations. Front office is the dealing room where traders
carry out the buying and selling of foreign currencies. Middle office is responsible for
risk measurement by setting exposure limits for individual traders, currencies and counter
parties. It also sets up the overall risk limits and constantly monitors it.

Back office is responsible for giving confirmation of individual trades and the complete
settlement of trades. It is also responsible for accounting of foreign exchange transactions
and calculating profit/loss statements.

A software system for the forex division of the bank should be designed keeping in mind
the requirements of various users across the organization.

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Testing the Concepts
1. What is the Offer rate in the currency quote USD/DEM 1.2513/15 ?
a. 1.2513
b. 1.2515
c. 0.0002
d. 0.08342
2. What are the two currencies in the foreign exchange quote are called as?
a. Local Currency and Cross Currency
b. Quoted currency and Unquoted currency
c. Commodity Currency and Term Currency
d. Local Currency and Foreign Currency
3. What is the spread in a currency quote?
a. Bid Rate – Offer Rate
b. Offer Rate – Bid Rate
c. (Bid Rate + Offer Rate) / 2
d. Maximum of Bid Rate, Offer Rate
4. You buy JPY from Bank A selling one million USD when bank’s quote was
102.50/103.00. You realize that you have done a wrong deal and need to buyback
USD immediately. If bank’s quote has not changed how many USD will you be
able to buy back?
a. 1,000,000
b. 995,146
c. 1,004,878
d. 102,500,000
e. 103,000,000

You get four GBP/ USD prices
Bank A 1.6865/ 75
Bank B 1.6868/ 78
Bank C 1.6874/ 79
Bank D 1.6866/ 76

5. If you wish to sell your GBP, which bank you should sell to
a. Bank A
b. Bank B
c. Bank C
d. Bank D
e. A random selection would be the best approach
6. You have been asked to quote a spot USD/ JPY price to a customer. You think he
wants to buy JPY. Which of the following quotes is the most profitable for you?
a. 102.25/ 35
b. 102.40/ 50
c. 102.45/ 55
d. 102.60/ 70



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Trading, Clearing and Settlement in Financial Market

This chapter aims at familiarizing you with the following topics

Trading mechanism and processes
Role of market intermediaries
How prices are quoted and in the exchange and in OTC markets
How trades are executed
Order management
Trade management
Clearing systems
Risk management in trading















Author

Gurmeet Singh
Vinay Kumar
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Introduction

Traditionally, the securities industry has used manual processes for many of their
operational activities. However, market trends are pushing the industry to review the way
that they now operate. Some of the reasons are as follows:

a) Manual processes are labour intensive. At a time when companies are looking to
reduce their cost base automation offers a better and cheaper alternative.
b) A second factor is that historically settlement in three to five days had been acceptable.
Now, the drive to settle in less than three days is forcing the industry to consider
automating the majority of their core processes.
c) Thirdly, global and cross border trading means that participants in the securities
industry need to standardize on message formats to communicate effectively.
d) Finally technology itself is forcing the pace of change. The Internet opens up new
opportunities for the industry, as a fast cost-effective message delivery mechanism. But
clearly it is not without its own issues. Security and reliability are key considerations for
the financial services. For brokers wanting to communicate with other parties across the
web, the risks of non-secure messages are high.

Brokers have typically dealt over the phone. For years, many have simply operated a
paper-based and somewhat random confirmation system. In the initial days the trading on
the Stock Exchanges used to take place through open outcry system without the use of
information technology. This outcry process system in Stock Market had its own
disadvantages. Some of them are listed below:

Limited Trading Volumes - less liquidity
Less efficient
Lack of transparency to investors
Inefficient price discovery mechanism
Settlement risk in case of counter party defaults

To overcome all the above problems there was a drive towards automation, which would
reduce, if not eliminate, most of the problems associated with manual trading. In
automated trading the trading system or the order matching system is the exchange’s own
system and the matching algorithm is also decided by the exchange in consultation with
the market participants along with the market regulators. An automated trading system
enables market participants, irrespective of their geographical locations, to trade with one
another simultaneously, improving the depth and liquidity of the market.

The entire trading cycle from the order placement to the settlement can be categorized
broadly into Pre Trade & Post Trade activities. While post trade activities are quite data
intensive involving accounting, reconciliation etc. there was a need to automate these
processes to save time and effort and also reduce manual error, pre trade activities such as
analytics for brokers, have also benefited from automation.

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Connectivity between pre-trade and post-trade activities is what is called Straight
Through Processing (STP). STP is the capability to process trades execution, clearance,
payments, settlement, custody, reporting and accounting without human intervention.
Since September 1998 when the Global Straight Through Processing Association
(GSTPA) was launched, the initiative to construct a new model for handling the
information flow in securities trades has captured the imagination of many companies.
The aims of GSTPA are to streamline cross-border information flows to facilitate the
settlement of cross border trades in a T+1 environment. At the core of the project is a
transaction flow monitor, which is responsible for passing information to all relevant
parties at each stage of the transaction process.

The communication processes between participants in the trade has also been streamlined
with more efficient transfer of information between the parties and standardized message
formats such as SWIFT & FIX. While FIX has focused on the early stages in the
transaction chain, primarily involving brokers and investment managers, SWIFT is
primarily used for back office operation and funds transfer. Automation in the securities
industry has led to the formation of many specialized institutions for facilitating and
enabling different activities of the trade cycle such as OMGEO for Trade Confirmation,
DTCC, LCH, Clearnet, Eurex Clearing, Clearnet, CEDEL etc. for Clearing.

Trading Mechanisms/Process

Before we go into understanding trading process, we need to know where trades are done
and also various parties involved in the trade.

Trading

Trading can be done across 4 broad market categories:

Trading on exchanges of securities listed on an exchange
Trading in the OTC market of securities not listed on the exchange
Trading in the OTC market of securities listed on an exchange
Private transactions between institutional investors outside the exchange, directly with
each other.

Exchange Trading

We have all heard of the stock exchange and its basic definition that it is a place for
exchange of financial instruments. While the most familiar exchange is the stock
exchange, there are specialized exchanges for commodities, derivatives etc. These will be
covered briefly later on. For the purpose of understanding the basic operations of an
exchange, we will refer to the stock exchange, throughout the following chapters.

The first criteria to trade in a particular security on the exchange is to have it listed on the
exchange. Listing is simply registering the stock/security in a stock exchange to enable
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trading in it. Exchanges have set some criteria for companies to list their stocks. Some of
them are:

A minimum number of shares have to be outstanding at any point of time
A minimum number of shareholders
Wide geographic distribution of securities
A history of earnings of a certain amount

The trading floor of the exchange in the manual system is a large area that contains
telephones, computers and trading posts, where all the buying and selling takes place.
Each of the trading posts is assigned a number of securities to trade. Each post also has an
indicator that shows what the last executed price of each stock traded at and whether it
was an increase or downtick decrease. Orders to buy or sell are given to the retail broker
by his/her client. This order is then transmitted to the firm's clerk on the trading floor.
The order then goes from the clerk to a floor broker for execution.

The process of trading in the exchange is similar to an auction where each broker shouts
out / enters his quotes in case of an outcry/manual trading or automated trading
respectively. The quote that best meets the highest bid or lowest offer requirement is
accepted.

OTC Trading

The OTC market differs from the exchange in that there is no single location or system
for matching orders in trading. It is basically a telephonic and/or computer network
among many dealers. These dealers are typically called market makers and specialize in
trading in particular securities. Brokerage firms, which accept trade instructions from
clients, turn to the market makers for executing orders in OTC securities. In the US, OTC
dealers in the securities market are registered with the NASD (National Association of
Securities Dealers).

Market makers typically have an inventory of their own for the securities that they deal
in. This inventory keeps changing depending on the transactions done and the view that
the dealer holds about the security. Normally there is more than one market maker vying
for a brokerage firm’s orders and once again the best bid/offer quote will be accepted.

Parties Involved in Trading/Clearing & Settlement

Broker-Dealer

Brokerage firm: is a financial intermediary which interfaces with the investors to buy and
sell securities on their behalf or for their own firm. A brokerage firm employs a large
number of brokers who are involved in various activities such as receiving/recording the
orders, executing the orders and passing on the funds/securities back to investor after the
trade is executed & confirmed.

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Broker: A broker is a person or firm that facilitates trades between customers.

Dealer: A dealer is a person or firm that buys and sells for its own inventory of securities
i.e. he himself acts as the counterparty to the trade.

Broker-dealer: the entity which acts as broker as well dealer either in the same security or
in different securities.

Market makers: are dealers who specialize in particular securities traded on the over-the-
counter market or on exchanges. They may hold large inventories of their securities, and
attempt to make markets for those securities by buying and selling from them. Market
makers publish bid and asked quotes.

While these are the basic terms which one gets to hear, there are a few more terms
associated with brokers/dealers signifying the role they may play.

For example with respect to the NYSE, there are specialists, floor brokers & two dollar
brokers, lets us see what each of these do.

The Specialist – maintains an orderly market in stocks which he trades. Specialists work
on exchanges and try to ensure liquidity in the market by buying trades for which there
are no buyers or selling when there are no sellers for particular trades. The Specialist
executes orders for his own account (as principal) as well as public orders from floor
brokers (as agent).

The Floor Broker - Executes orders for clients of the brokerage firm (known as retail
customers) and his firm's own trading account.

The Two Dollar Broker - Executes orders for various floor brokers in instances when
he/she is too busy to execute all of the orders. He will charge a fee for services, which
used to be $2 and hence the name.

The Registered Floor Trader - Normally only trades for his own account and rarely
executes public orders.

Clearing Corporation

The clearing corporation gets involved after the trade is executed. It is intimated by the
exchange or the dealer about the trades. The CC is responsible for determining the
obligations of various parties in terms of delivery of securities and funds to ensure that
trades are successfully completed.

Clearing Bank

The Clearing Bank is responsible for effecting funds transfers between different
counterparties to a trade post clearing.
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Custodian

The Custodian is responsible for safekeeping of securities in physical form and confirms
if the obligations for delivery of securities will be met by the trading member. He acts as
the clearing and settlement agent of fund managers, tracks corporate actions on behalf of
the client and undertakes many reporting functions.

Depository

Depository holds the securities in a dematerialized form and is responsible for making
securities of each trading member available with the clearing corporation for settlement.

How prices are quoted: Bid-Offer System

Whatever the mode of trading, be it through the exchange or the OTC, the method of
quoting prices remains the same. All financial markets, across most instruments follow
the bid-offer system of quotes. These rates/prices are quoted from the point of view of the
dealer/bank/market maker across different markets. In simple terms they specify the price
at which the dealer/bank is ready to buy -sell the security. The ‘bid’ is the purchase price
while the ‘offer’ is the sale price. When market makers or dealers in the market give both
the quotes for buying as well as selling it is called two-way called and the market is
called quote driven market. Buyers and see these quotes, evaluate them and then decide
to execute the trade through one of the several dealers offering the quotes. It may be
noted that the buyer or seller need not do the trade with the dealer offering the best quote.
On the other hand, in order-driven markets buyers and sellers give their own quotes.
These quotes could be for either buying or selling. Buyer and sellers need not give two-
way quotes. Most of the exchanges are order driven markets and the OTC markets are
quote-driven markets.

If the dealer gives a two-way quote as 19 – ½, it means that the dealer is willing to buy at
19 and sell at 19.50. It also means that as a market taker (e.g. a broker on behalf of the
buyer/ seller) one would be able to sell at 19 and buy at 19.50. The difference between
the bid and ask is called spread. The dealer makes money through the spread – by buying
cheaper and selling dearer. A dealer, therefore, does not charge commission. A broker,
however, charges commission, which is added to the purchase price or deducted from the
sale price.

Exchange Trading Process

Trading Process





Order
Capture
Order
Routing
Trade
Execution
Trade
Confirmation
Clearing &
Settlement
Pre-trade
Post trade
Risk Management
Order Management
Page 161

The entire trading process can be split into pre-trade, trade & post trade activities as
shown in the flow above. The following chapters will also be covered in the same fashion
to enable a better understanding of the trading cycle.
The trading cycle is kicked off with the customer submitting his trade request with the
broker. Typically the customer interface is the brokerage firm, which collects all orders
from different parties and records the orders.

PRETRADE & TRADE EXECUTION

Order Management

Order Capture/Recording

The first activity in the trade cycle is receipt of the orders from customers and its
recording. Before forwarding the trade for execution, the broker revalidates the trade
details with the customer. An automated order capture system can do several validation
e.g. market lot validation (orders could be only in multiples of tradable market lots), tick
size validation (price can be only in multiple of tick size) etc. In order to trade, the
customer has to submit the following information:

The stock/instrument
Buy/sell instruction
The quantity
The Order Type

Order Types

Orders could have various conditions attached to them. These conditions are broadly
divided into Time Conditions, Quantity Conditions and Price Conditions. Several
combinations of the above are allowed providing flexibility to the buyer and seller. Some
of the order conditions are as follows:

a) Time Conditions.

Day Order: This order remains valid during the trading day at the end of which it is
cancelled.

IOC: An Immediate or Cancel (IOC) order allows the user to buy or sell a security as
soon as the order is released into the system. IOC order results into a trade if matched
immediately with the counter order else it is cancelled. Partial match is possible for the
order, and the unmatched portion of the order is cancelled. For example, if a buy order
for 1000 Microsoft is received by the system and the sell orders for Microsoft is only for
500 shares in the system, the 500 shares will be bought and the balance buy order for 500
shares will be cancelled immediately.

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Good-till-date: These orders stay open till a defined date after which they are cancelled if
not executed.

Good-till-cancelled: These orders stay open till the client cancels it. Normally, the broker
rechecks for validity of these orders with the client at periodic intervals.

b) Quantity Conditions

DQ: An order with a Disclosed Quantity (DQ) allows the user to disclose only a portion
of the order quantity to the market. For example, if the order quantity is 10,000 and the
disclosed quantity is 2,000, then only 2,000 is released to the market. After this quantity
is fully matched, a subsequent quantity of 2,000 is disclosed. Thus, totally five
disclosures with the same order number are shown one after the other in the market.

Fill-or-Kill: Here the order must be executed immediately and fully; else it has to be
cancelled. Here partial execution of orders as in the case of IOC is not allowed.

All-or-none: Given some time constraints such as day, the entire order has to be executed
or the client is not obliged to accept a partial execution.

c) Price Conditions

Market: Market orders are orders for executing the trade at the going market price. The
buy order is matched with the quotes available on the offer side and vice versa as soon as
the order is received. Here there is no restriction on the price at which the trade should be
executed.

Limit: This order type places a limit on the price at which the trade can be executed. In
case of a ‘buy’, the limit specifies the maximum price that the client is willing to pay to
buy the security and in case of ‘sell’, it is the lowest price that he is willing to accept.

Stop-Loss: This facility allows the user to release an order into the system, after the
market price of the security reaches or crosses a threshold price called trigger price. For
example, if for stop loss buy order, the trigger is $93.00, the limit price is $95.00 and the
market (last traded) price is $90.00, then this order is released into the system once the
market price reaches or exceeds $93.00. This order is added to the regular lot book with
time of triggering as the time stamp, as a limit order of $95.00. All stop loss orders are
kept in a separate book (stop loss book) in the system until they are triggered.

Trigger Price: Price at which an order gets triggered from the stop loss book.
Limit Price: Price of the orders after triggering from stop loss book.

d) Other Conditional Orders

One cancels the other

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An order stipulating that if one part of the order is executed, then the other part is
automatically canceled.

One triggers the other

An order stipulating that only if one part of the order is executed, the other part is to be
placed into the system.

Both or none

Two orders are placed into the system simultaneously and execution of one is dependent
on the execution of another. Either both will be executed or none of the two will be
executed.

Automated Order Entry

The order entry system is also provided by the exchange to the trading members. The
members have to connect to the trading system of the exchange using this order entry
system. Once they login the order entry screen is displayed and they can start entering the
orders in all those securities which are available for trading on the exchange. Exchange
also uses this system for communication with the trading members.

Order Modification/Cancellation

All orders can be modified or cancelled during the trading hours provided they are not
fully executed. For the orders, which are partially traded, only the open or unexecuted
part of the order can be cancelled.

Order Routing

Once the order has been entered and validated by the broker, it now has to be routed to
the exchange. Since a client can place an order for the trade to be executed in multiple
exchanges, the broker has to ensure that the order reaches the right exchange. We have
seen that in the manual system, the floor broker would be responsible for the order
reaching the right specialist trader on the exchange for the trade to be executed. In case of
automated systems, this process is automated and the order is automatically routed to the
appropriate specialist on the appropriate exchange. For example, in the NYSE/AMEX ,
listed stock orders are all routed directly via DOT (Direct Order Turnaround System of
the New York Stock Exchange) to the appropriate specialist's post on the floor of the
exchanges. The specialist in that stock executes the order if priced at market or puts the
order in the limit order book if the order is a limit order at the bid or offer. The DOT
routing is entirely automated and the only human intervention is by the specialist to
execute the order or put it into the limit book for subsequent execution.
Trade Execution

Order Matching
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In an order-driven market all orders are matched on a price-time priority. All orders
received are sorted with the best priced order getting the first priority for matching i.e.,
the best buy (highest buy price) orders match with the best sell order (lowest sell order).
Orders with same price are sorted on time priority basis, i.e. the one that came in early
gets priority over the later one.

This logic is not applicable to the OTC market since here the trade is negotiated between
the dealers (dealer and broker). As mentioned earlier, due to several reasons, dealer may
chose not to trade at the best available price.

Order Book

All orders are recorded or stored in an order book. While market orders get executed
immediately, the concept of an order book is more relevant for limit orders. We have
seen that limit orders are those which have a price condition attached to them. All limit
orders are entered into the limit order book. The best buy/ sell offer (highest buy
price/lowest sell price) is placed first in the order book and will have the first priority for
execution. Given below is a representation of the order book

Bid
Quantity
Bid
Price
Offer
Quantity
Offer
Price
500 98.65 500 98.75
250 98.50 100 99.80
250 98.30 250 99. 85
500 98.00 500 100.00

Now for example if a limit order comes in for buying 500 shares at 98.75, this order will
be matched with the sell order of 500 @ 98.75 and the trade will be executed. After this
trade the order book list on the sell side will move up by one notch each and the first sell
order on the list will be 100 shares at 99.80, thereby increasing the bid-offer spread. If on
the other hand, the order had come in for only 250 shares, then the order topping the sell
list would be 250 shares @ 98.75.

Again, if there is a market order, which had just been placed for selling 500 shares at
98.65, this order will be matched with the buy order on the top of the limit order book for
98.65 and the trade will go through. As has been mentioned in the example above, the
buy list will move accordingly with the quantity executed. The best buy price will be
250@98.50.

Here we have seen the case where there is just one corresponding ‘sell’ offer. But what
happens if there are more than one offers at the same price? In this case the broker who
quoted first would get priority over the others.

For example if 4 brokers came up with the same bid 98.70 at the following times
Broker A – 100 shares – 11:06 am
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Broker B – 100 shares – 11:07 am
Broker C – 200 shares – 11: 08 am
Broker D – 100 shares – 11:08 am

Broker A will have the first priority among the four for execution.

While in the manual trading system this entire process of order matching is done in the
floor of the exchange with the brokers shouting out their respective quotes, in case of
automated trading, this is done by a computer programme, the trading system. When any
order is received by the trading system, it is called an active order. It tries to find a match
on the other side of the book. If it finds a match, a trade is generated. If it does not find a
match, the order becomes a passive order and is stored in the order book. The broker has
to keep track of the pending/passive orders till they are executed. Typically passive
orders are organized according to the security and within that according to buy or sell
instruction. Finally each order is sorted in accordance to the best buy/sell price.

Clearing & Settlement & other Back-office Operations

Trade Execution

When a buy order matches with the sell order or vice versa, it is called a Trade. Once the
orders are matched, the trades are said to be executed. The exchange then sends a trade
execution report to the trading member/broker informing him the same.

Trade Cancellation

Trades done during the day can be cancelled by the trading member by mutual
agreement. The trade cancellation request is sent to the Exchange for approval. The
counterparty to the trade also receives the message. The counterparty then has to make
similar request on the same trading day. Once both the parties to trade send the trade
cancellation request, the Exchange either approves or rejects it. In either case, a message
is sent out to both the parties.

Trade Confirmation

Trade confirmation is the part of the trade lifecycle between the execution and settlement
stages, where investment managers/clients and brokers exchange trade details and
confirm and affirm to each other the terms of the trade e.g. price, quantity and settlement
terms. Once the trade execution reports are received by the broker, he needs to verify this
against the client’s order to ensure that it matches all the client’s requirements. It is
essential that the trade confirmation is done immediately after the trade so that
discrepancies if any can be identified at the earliest and sorted out.

Trade Clearing & Settlement

Page 166
While the Exchange provides a platform for trading to its trading members, the Clearing
Corporation determines the funds/securities obligations of the trading members and
ensures that trading members meet their obligations. Unlike in the earlier system where
the brokers had to mutually determine their settlement obligations now the Clearing
Corporation takes this responsibility. In many cases, it becomes the legal counter party to
the trade and guarantees settlement for all members. The principle whereby the original
trade between the original counterparties is cancelled and the clearing corporation
becomes the counterparty to the trade is called ``novation''. Naturally, after novation the
Clearing Corporation is obligated to meet all settlement obligations, regardless of
member defaults, without any discretion. Before we go into the nitty-gritty of clearing
and settlement, we need to take a look at various parties involved in this process.

The Clearing Corporation, with the help of clearing members, custodians, clearing banks
and depositories settles the trades executed on exchanges. The roles of each of these
entities are explained below:

Clearing Corporation

The Clearing Corporation is responsible for post-trade activities of a stock exchange.
Clearing and settlement of trades and risk management are its central functions. It clears
all trades i.e. determines obligations of members, arranges for pay-in of funds/securities,
receives funds/securities, processes for shortages in funds/securities, arranges for pay-out
of funds/securities to members, guarantees settlement, and collects and maintains
margins/collateral/base capital/other funds.

Clearing Members

They are members of the clearing corporation and are responsible for settling their
obligations as determined by the Clearing Corporation. They have to make available
funds and/or securities in the designated accounts with clearing bank/depository
participant, as the case may be, to meet their obligations on the settlement day. Clearing
members could settle either only their own trades or also the trades of other brokers.
Some clearing members do not trade on their own account and only clear and settle the
trade on behalf of other brokers/ dealers.

Custodians

A custodian is an entity which holds for safekeeping the documentary evidence of the
title to property belonging like share certificates, etc. The title to the custodian’s property
remains vested with the original holder, or in their nominee(s), or custodian trustee, as the
case may be. In Clearing Corporation, custodian is a clearing member but not a trading
member. He settles trades assigned to him by trading members. He is required to confirm
whether he is going to settle a particular trade or not. If it is confirmed, the Clearing
Corporation assigns that obligation to that custodian and the custodian is required to
settle it on the settlement day. If the custodian rejects the trade, the obligation is assigned
back to the trading / clearing member.
Page 167

Clearing Banks

Clearing banks are a key link between the clearing members and the clearing corporation
for funds settlement. Every clearing member is required to open a dedicated settlement
account with one of the clearing banks. Based on his obligation as determined through
clearing, the clearing member makes funds available in the clearing account for the pay-
in and receives funds in case of a payout. Multiple clearing banks provide advantages of
competitive forces, facilitate introduction of new products viz. working capital funding,
anywhere banking facilities, the option to members to settle funds through a bank, which
provides the maximum services suitable to the member.

Depositories

A depository is an entity where the securities of an investor are held in electronic form.
Depositories help in the settlement of the dematerialized securities. Each
custodian/clearing member is required to maintain a clearing pool account with the
depository. He is required to make available the required securities in the designated
account on settlement day. The depository runs an electronic file to transfer the securities
from accounts of the custodians/clearing member to that of Clearing Corporation. As per
the schedule of allocation of securities determined by the Clearing Corporation, the
depositories transfer the securities on the payout day from the account of the Clearing
Corporation to those of members/custodians.

Professional Clearing Member

Professional Clearing Member (PCM) are appointed by the clearing corporation. These
members may clear and settle trades executed for their clients (individuals, institutions
etc.). In such an event, the functions and responsibilities of the PCM would be similar to
Custodians. PCMs may also undertake clearing and settlement responsibility for trading
members. In such a case, the PCM would settle the trades carried out by the trading
members connected to them. The onus for settling the trade would be thus on the PCM
and not the trading member. A PCM has no trading rights but has only clearing rights, i.e.
he just clears the trades of his associate trading members and institutional clients.

Clearing & Settlement Process

The clearing banks and depositories provide the necessary interface between the
custodians/clearing members (who clear for the trading members or their own
transactions) for settlement of funds/securities obligations of trading members. The core
processes involved in the settlement are as shown in the following graph.
Page 168















1. Trade details from Exchange to Clearing Corporation
2. Clearing Corporation notifies the consummated trade details to clearing
Members/Custodians who affirm back. Based on the affirmation, Clearing
Corporation applies multilateral netting and determines obligations.
3. Download of obligation and pay-in advice of funds/securities.
4. Instructions to clearing banks to make funds available by pay-in time.
5. Instructions to depositories to make securities available by pay-in-time.
6. Pay-in of securities (Clearing Corporation advises depository to debit pool
account of custodians/CMs and credit its account and depository does it).
7. Pay-in of funds (Clearing Corporation advises Clearing Banks to debit account of
Custodians/CMs and credit its account and clearing bank does it).
8. Payout of securities (Clearing Corporation advises depository to credit pool
accounts of custodians/CMs and debit its account and depository does it).
9. Payout of funds (Clearing Corporation advises Clearing Banks to credit account
of custodians/CMs and debit its account and clearing bank does it).
10. Depository informs custodians/CMs through DPs.
11. Clearing Banks inform custodians/CMs.

Broadly, the Clearing and Settlement process can be summed up as:

Determination of Obligation

Clearing Corporation determines what the counter-parties owe, and what they are due to
receive on the settlement date. The Clearing Corporation interposes itself as a central
counter party between the counter parties and nets the positions so that both members
have a security wise net obligation to receive or deliver a security and have to either pay
Depository
Exchange
Trade Details
Clearing Corp.
Clearing
Member/Custodian
Members
Trade Confirmation
Affirmation
Determination of
obligation & netting
Communication of
obligation
Instruction to make securities
available / Pay-in/Payout of
securities
Bank
Instruction to make
funds available / Pay-
in/Payout of funds
Information on Settlement of
funds/securities
1
2
3
4
5
5
6
Page 169
or receive funds. Process of netting reduces the number of transactions in the settlement
process. Netting is the process of setting off funds or securities receivable and payable
from the same counterparty. For example, if a broker has sold 200 shares of Microsoft
and bought 100 shares of Microsoft during the same settlement cycle, he will be required
to deliver only 100 shares of Microsoft. The same process if followed for funds
receivable and funds payable.

Pay-in of Funds and Securities

The members bring in their funds/securities to the Clearing Corporation. They make
available required securities in designated accounts with the depositories by the
prescribed pay-in time. The depositories move the securities available in the accounts of
members to the account of the Clearing Corporation. Likewise members with funds
obligations make available required funds in the designated accounts with clearing banks
by the prescribed pay-in time. The Clearing Corporation sends electronic instructions to
the clearing banks to debit member’s accounts to the extent of payment obligations. The
banks process these instructions, debit accounts of members and credit accounts of the
Clearing Corporation.

Pay-out of Funds and Securities

After processing for shortages of funds/securities and arranging for movement of funds
from surplus banks to deficit banks, the Clearing Corporation sends electronic
instructions to the depositories/clearing banks to release pay-out of securities/funds. The
depositories and clearing banks debit accounts of Clearing Corporation and credit
settlement accounts of members. Settlement is complete upon release of payout of funds
and securities to custodians/members.


Risk Management

A sound risk management system is integral to an efficient settlement system. The
clearing corporation generally has a comprehensive risk management system, which is
constantly monitored and upgraded to pre-empt market failures. It monitors the track
record and performance of members and their net worth; undertakes on-line monitoring
of members’ positions and exposure in the market, collects margins from members and
automatically disables members if the limits are breached.

The following two kinds of risks are inherent in a settlement system:
(1) Counterparty Risk: This arises if parties do not discharge their obligations fully when
due or at any time thereafter. This has two components, namely replacement cost risk
prior to settlement and principal risk during settlement.

The replacement cost risk arises from the failure of one of the parties to transaction.
While the non-defaulting party tries to replace the original transaction at current prices,
he loses the profit (but not the principal since he has not paid his part of the obligation by
Page 170
then) that has accrued on the transaction between the date of original transaction and date
of replacement transaction. The seller/buyer of the security loses this unrealized profit if
the current price is below/above the transaction price. Both parties encounter this risk, as
prices are uncertain. It has been reduced by reducing time gap between transaction and
settlement and by legally binding netting systems.

The principal risk arises if a party discharges his obligations but the counter party
defaults. The seller/buyer of the security suffers this risk when he delivers/makes
payment, but does not receive payment/delivery. This risk can be eliminated by delivery
vs. payment mechanism, which ensures delivery only against payment. This risk has been
reduced by having a central counter party (Clearing Corporation), which becomes the
buyer to every seller and the seller to every buyer.

Liquidity risk, which arises if one of the parties to transaction does not settle on the
settlement date, but later. The seller/buyer who does not receive payment/delivery when
due, may have to borrow funds/securities to complete his payment/delivery obligations.

Another variant is the third party risk, which arises if the parties to trade are permitted or
required to use the services of a third party which fails to perform. For example, the
failure of a clearing bank, which helps in payment, can disrupt settlement. Allowing
parties to have accounts with multiple banks reduces this risk. Similarly, the users of
custodial services face risk if the concerned custodian becomes insolvent, acts
negligently, etc.

(2) System Risk: This comprises operational, legal and systemic risks. The operational
risk arises from possible operational failures such as errors, fraud, outages etc. The legal
risk arises if the laws or regulations do not support enforcement of settlement obligations
or are uncertain. Systemic risk arises when failure of one of the parties to discharge his
obligations leads to failure by other parties. The domino effect of successive failures can
cause a failure of the settlement system. These risks have been contained by enforcement
of an elaborate margining and capital adequacy standards to secure market integrity,
settlement guarantee funds to provide counter-party guarantee, legal backing for
settlement activities and business continuity plan, etc.

Settlement Cycle

At the end of each trading day, Clearing Corporation receives concluded or locked-in
trades from Exchange. It determines the cumulative obligations of each member and
electronically transfers the data to Clearing Members (CMs). All trades concluded during
a particular trading period are settled together. A multilateral netting procedure is adopted
to determine the net settlement obligations (delivery/receipt positions) of CMs. The
Clearing Corporation then allocates or assigns delivery of securities to arrive at the
delivery and receipt obligation of funds and securities by each member.

Settlement Timelines

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An illustrative settlement timeline has been given below for T+2 trade cycle. T+n trade
cycle denotes that settlement happen n business days after the date of the trade.

Activity
Day

Trading Rolling Settlement Trading T
Clearing Custodial Confirmation T +1 working days
Delivery Generation T + 1 working days
Settlement Securities and Funds pay in T +2 working days
Securities and Funds pay out T + 2 working days


Securities Settlement
On the securities pay-in day, delivering members are required to bring in securities to
Clearing Corporation. On pay out day the securities are delivered to the respective
receiving members. Settlement is deemed to be complete upon declaration and release of
payout of funds and securities. Exceptions may arise because of short delivery of
securities by CMs, bad deliveries or company objections on the payout day.

Clearing Corporation identifies short deliveries and conducts a buying-in auction on the
day after the payout day through the trading system. The delivering CM is debited by an
amount equivalent to the securities not delivered and valued at a valuation price (the
closing price as announced by Exchange on the day previous to the day of the valuation).
If the buy-in auction price is more than the valuation price, the CM is required to make
good the difference.

Direct Interface with clients

This is another form of clearing wherein the clearing corporation ascertains from each
clearing member, the beneficiary account details of their respective clients who are due to
receive payout of securities. Based on the information received from members, the
Clearing Corporation sends payout instructions to the depositories, so that the client
receives the payout of securities directly to their accounts on the payout day. The client
receives payout to the extent of instructions received from the respective clearing
members. To the extent of instruction not received, the securities are credited to the CM
pool account of the member.

Funds Settlement

The clearing corporation offers settlement of funds through designated clearing banks.
Every Clearing Member is required to maintain and operate a clearing account with any
one of the empanelled clearing banks at the designated clearing bank branches. The
clearing account is to be used exclusively for clearing & settlement operations.

Clearing Account
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Every Clearing Member is required to maintain and operate a clearing account with any
one of the empanelled clearing banks at the designated clearing bank branches. The
clearing account is used exclusively for clearing operations i.e. for settling funds and
other obligations to the Clearing Corporation including payments of margins and penal
charges. Clearing Members are required to authorize the Clearing Bank to access their
clearing account for debiting and crediting their accounts, reporting of balances and other
information as may be required by Clearing Corporation from time to time as per the
specified format. The Clearing Bank debits/ credits the clearing account of clearing
members as per instructions received from the Clearing Corporation.

Funds settlement

Members are informed of their funds obligation for various settlements most often
through a daily clearing data download. The daily funds statement gives date-wise details
of each debit/ credit transaction in the member’s clearing account whereas the summary
statement summarizes the same information for a quick reference. The member account
may be debited for various types of transactions on a daily basis. The member is required
to ensure that adequate funds are available in the clearing account towards all obligations,
on the scheduled date and time. The member can refer to his various obligation
statements and provide for funds accordingly.

OTC Clearing & Settlement

In case of OTC trades, the counterparties need to give instructions to their respective
depositories/depository participants to transfer securities to the account of the
counterparty and similarly instructions to their bank to affect a funds transfer to the other
party.




Page 173
Other Trading, Clearing & Settlement Methods

Trading Methods

Margin Trading

Customers can purchase securities in two ways. One way is to make simple cash
purchase like any other asset and the second way is by way of obtaining financing for the
purchase. This is more popularly known as margin trading wherein, the broker himself
finances the purchase of the security against collateral, which is the purchased security
itself. However, the broker funds only part of the deal. The customer himself has to pay a
part of the cost.

Not all securities can be purchased on margin. Generally securities listed on a national
exchange are eligible for margining. Typically the brokerage firm can determine which
securities it will permit margining for its customers.

How does margining work?

In case of margin trading, the customer pays only a part of the transaction value and the
rest is loaned to him by the broker who in turn borrows it from a bank. To trade on
margin, a margin account has to be opened with the broker. To operate a margin account
rather to indulge in margin trading, an initial investment is needed (In the US at least
$2,000 is required for a margin account, though some brokerages require more.) This
deposit is known as the initial margin. Once the account is opened and operational, the
customer can borrow up to a certain percentage of the purchase price- called the margin
rate- of a stock. The remaining portion that is lent by the broker is shown as the debit
balance in the margin account. Finally the difference between the amount borrowed and
the market value of the security is called equity.

For example, a customer wants to buy 100 shares of Company, A which are currently
trading at $ 2225. At the time of this purchase decision the margin rate is 60%, which
means that the customer has to deposit an initial margin of $ 1,33,500. Correspondingly
the broker will loan the balance 40% of the purchase price.

So here..
The Debit balance is $ 89000
The Market Value is $ 222500 and..
The Equity is $ 1,33,500

Now if the market value of the share falls down to $ 2220, then the equity of the
customer will correspondingly come down to $133000 and the percentage margin is now
59.9% ( 133000/222000).
The Maintenance Margin
We have seen in the above example that the stock price has fallen down. Now the broker
also has to protect himself against a drastic reduction in the value of his collateral. To
Page 174
obtain this protection, the customer has to maintain a minimum margin in his account.
Once the equity of the customer falls below this minimum line, the broker calls for
replenishment and the customer has to refill his account. Typically in the US, the
maintenance margin is 25%. So if the equity were less than 25% of the market value then
there would be a margin call by the broker.

Going back to our example. Assuming there is a maintenance margin of 25%. Here the
customer would have to maintain at least $ 55500. The customer here is still in safe limits
as he has equity much over the minimum. In an extreme scenario where the stock price
goes down to $1180, then the equity of the customer is down to $29000, which is 24.5%.
In such a scenario, the broker would give in a margin call to his customer asking him to
deposit the additional equity amount. In case the customer fails to deposit, the broker has
a right over the securities and can liquidate them. The prime advantage of using a margin
is the leverage that it offers. The best way to demonstrate the power of leverage is with an
example. Let's imagine a situation that we'd all love to be in- one that results in hugely
exaggerated profits. In the example below we see a simple illustration of the difference in
profits by leveraging.















Short Selling

A short sale is generally the sale of a stock one does not own. Investors who sell short
believe the price of the stock will fall. If the price drops, the stock can be bought at the
lower price and make a profit. If the price of the stock rises and he buys it back later at
the higher price, he incurs a loss.

In short selling, the brokerage firm lends the security which in turn comes from either the
firm’s own inventory, the margin account of another of the firm’s clients, or another
brokerage firm. As with margin trading, the investor is subject to the margin rules.

Program Trading
100 shares of Company A @ $ 2250

Own
Money
Margin
Trading
Margin
Rate : 60%
Initial Investment 225000 135000
If price increases to $3000
Current worth of
investment 300000 300000
% profit (without
considering interest
cost) 33.33 122.22
Page 175
Computerized trading used primarily by institutional investors typically in large volumes
of a set (basket) of 15 or more stocks trades. Orders from the trader's computer are
entered directly into the market's computer system and executed automatically.

Clearing Methods

RTGS: The continuous settlement of payments on an individual order basis without
netting debits with credits.

CNS: The Continuous Net Settlement (CNS) System is an automated book-entry
accounting system that centralizes the settlement of compared security transactions and
maintains an orderly flow of security and money balances.

DVP: A securities industry procedure in which the buyer's payment for securities is due
at the time of delivery. Security delivery and payment are simultaneous.
Page 176
Testing the concepts

1. Order for which no price is specified at the time the order is entered is called
_____ order
a. GTC
b. Limit
c. Stop-loss
d. Market
e. I am not attempting this question
2. An order which is activated when a price crosses a limit is _____ in F&O segment
of NSEIL
a. Market order
b. Fill or kill order
c. Stop loss order
d. None of the above
e. I am not attempting this question
3. The best buy order for a given futures contract is the order to buy the index at the
________ price
a. average of the highest and lowest
b. highest
c. lowest
d. weighted average
e. I am not attempting this question
4. Impact cost measures the
a. volatility of stock
b. liquidity of stock
c. return on stock
d. interest rate risk of bond
e. none of the above
5. Which of the followings need not be a part of the Cross Currency Swap deal
ticket
a. Transaction date
b. Buy currency and sell currency
c. Notional amount
d. Settlement frequency
e. Floating rate of interest on future dates
6. The broker maintains margins to cover risk arising from his trades with
a. Clearing Corporation/ House
b. Regulator
c. Company in whose shares it trades
d. Partly with all the three
e. None of the above
7. What is a red herring prospects
a. The prospectus issued after the IPO
b. Draft prospectus before the final prospectus
c. A prospectus issued during a bonds IPO
Page 177
d. An addendum to the final prospectus
e. It’s a faulty prospectus
8. Which of the following is true about a depository?
a. It is responsible for corporate actions
b. It is beneficiary owner of all shares
c. It maintains record of share holding in electronic form
d. It manages shareholders investments
e. It executes trades in securities
9. Which of the followings is not a valid order type
a. Good till Cancelled
b. Immediate or Cancel
c. Fill or Kill
d. Stoploss
e. Stopgap
10. Clearing house auction shares
a. When there are too many shares in the market and there are very few
buyers
b. When shares sold are not delivered by the selling broker
c. When a broker files for liquidation
d. When instructed by SEBI
e. When the clearing house anticipates broker monopoly it auctions his
shares to increase market competitiveness and liquidity




Page 178
Derivatives

This chapter introduces the following concepts relating to derivatives markets:

Definition of derivatives
Types of derivatives
Introduction to futures
Introduction to options
Types and styles of options
Pricing of futures and options
Greeks and their relevance in options pricing
Options trading strategies















Authors

Ramkumar VB
Suraj Bansi Kumar
Sai Pavan Kumar
Shaikh Taleemuddin
Page 179
Derivatives Defined:

Derivatives have become very important in the field of finance. They are very important
financial instruments for risk management as they allow risks to be separated and traded.
Derivatives are used to shift risk from those market participants who want to reduce risk
to those market participants who want to take additional risk. Derivatives can act as a
form of insurance. This shift of risk means that each party involved in the contract should
be able to identify all the risks involved before the contract is agreed. It is also important
to remember that value of derivatives is derived from an underlying asset. This means
that risks in trading derivatives may change depending on what happens to the underlying
asset.

A financial derivative is a contract to exchange payments between two counterparties
whose value is derived from the value of an underlying asset, index or reference rate. The
underlying asset can be equity, forex, commodity or any other asset. For example, if the
settlement price of a derivative is based on the stock price of a stock for e.g. Microsoft,
which frequently changes on a daily basis, then the derivative risks are also changing on a
daily basis. This means that derivative risks and positions must be monitored constantly.
In a derivatives transaction, either party makes no investment of, or exchange of value of
the underlying asset. This feature is in contrast to that of cash market instruments, where
the purchase of a security does involve an exchange of value of the underlying asset.
Characteristics of Derivatives

Main characteristics of derivatives can be summarized as follows:

Derivatives are financial instruments
Derivatives are not the asset itself; it only represents certain rights on the underlying asset
Its value is derived from the price or rate of the underlying asset
Returns from derivative instruments are typically based on movement in the value of that
asset
Derivatives could be either exchange traded or it could be created Over-The-Counter
(OTC) between two counterparties
Derivatives can be used to reduce risk as well as to increase risk

Derivate contracts are created and traded with the following major asset classes as the
underlying:

Debt – the underlying could be either the price of the debt security e.g. a bond, or the
interest rate
Currency – underlying is normally the spot foreign exchange rate between a currency pair
Equity – underlying is the stock or shares of listed companies
Commodities – the underlying is the spot price of the commodity itself
Credit Risk – credit spreads, default on the credit etc.
Indices – underlying is the index in any of the markets mentioned above – a stock market
index like S&P 500 or a debt market index or a commodity index.

Page 180
Derivative contracts – Types

There are two basic types of derivative instruments – forward and option contracts. Most
derivative structures are essentially packaged forms of these two basic instruments types.

Structure of derivative Markets
























But the above classification for OTC markets is not strict as it might also include options
and other derivatives.

Forwards

A forward contract is the simplest mode of a derivative transaction. It is an agreement to
buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No
cash is exchanged when the contract is entered into. These are customized contracts and
are generally offered by the dealers or market makers.

Illustration 1:

David is an exporter who expects to receive payment in dollars three months later.
Meanwhile he is exposed to the risk of exchange rate fluctuations. He decides to mitigate
the risk of depreciation in the value of home currency by hedging i.e. by selling forward
the foreign currency he is likely to receive in future. Therefore, he should sell dollar three
months forward. By selling dollar in forward he agrees to an exchange rate at which he
ASSET/CASH MARKETS
Basic Derivative Instruments
• Forward Contracts
• Option contracts

Exchange Traded
Financial Derivatives
• Futures
• Options
Over The Counter (OTC)
Financial Derivatives
• Forwards
• Swaps
Page 181
will be able to exchange the foreign currency, dollar, with the home currency three
months later.

Similarly suppose there is an importer based in US who has to make a payment for his
consignment in six months time to a German firm in Euro. He will need to buy Euro six
months from today, to meet his payment obligation. However, he is not sure what the
Euro/USD rate will be in six months time. In order to be certain about the amount to be
spent he should enter into a contract with a bank to buy Euro six months from now at a
rate to be decided today. As he is entering into a contract with a future date it is a forward
contract and the underlying security is the exchange rate of the currency pair Euro/USD.

Payoff for forwards

A payoff is the likely profit/loss that would accrue to a market participant due to changes
in the price of the underlying asset. This is generally depicted in the form of payoff
diagrams which show the price of the underlying asset on the X–axis and the
profits/losses on the Y–axis.

Illustration 2:

The treasurer of an US based MNC knows that he has to pay £1 million in six months
and wants to hedge against exchange rate movements. Using the quotes in the below
table the treasurer has agreed to buy £1 million six months forward at an exchange rate of
1.4360. The firm now has a long forward contract on GBP. It has agreed that six months
from now it will buy £1 million from the bank by selling $1.4360 million. On the other
hand the bank has a short forward contract on GBP.

Table -
Spot and forward quotes for the USD – GBP exchange rate as given by the bank
(GBP = British pound; USD = U.S. dollar)
------------------------------------------------------------------------------------------------------------
Bid Offer
------------------------------------------------------------------------------------------------------------
Spot 1.4453 1.4457
1-month forward 1.4436 1.4441
3-month forward 1.4403 1.4408
6-month forward 1.4354 1.4360
1-year forward 1.4263 1.4269
------------------------------------------------------------------------------------------------------------

Lets consider the possible outcomes!

The forward contract makes it obligatory on the firm to buy £1 million for $1,436,000. If
the spot forward rose to say 1.5000 at the end of six months the forward contract would
be in profit by $64,000(=$1,500,000 - $ 1,436,000) for the firm. It would mean
purchasing £1 million at 1.4360 rather than 1.5000. Similarly, if the spot exchange rate
Page 182
fell to 1.4000 at the end of six months, the forward contract would have a negative value
of $36,000. The firm will now have to pay $1.436 million whereas it would have been
able to buy £1 million for only $1.4 million had it not entered into the binding forward
contract.

Long forward contract payoff




Profit


0
K S
T

1.4360 1.5000

Loss




K=Delivery price; S
T
=price of asset at maturity

In general, the payoff from a long position in a forward contract on one unit of an asset is
S
T
-K where K is the delivery price and S
T
is the spot price of the asset at maturity of the
contract. This is because the holder of the contract is obliged to buy an asset worth S
T
for
K.

Similarly, the payoff from a short position in a forward contract on one unit of an asset is
K-S
T.
These payoffs can be positive or negative as illustrated in the figure. As it costs
nothing to enter into a forward contract, the payoff from the contract is also the trader’s
total gain or loss from the contract.
Page 183

Short forward contract payoff




Profit


0
K
1.4360

Loss





Futures

Futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Unlike forward contracts, future contracts are
standardized and exchange traded contracts. To facilitate liquidity in the futures
contracts, the exchange specifies certain standardized features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity (e.g. the
market lot or minimum contract size of the derivative trade is specified by the exchange)
and quality (with reference to commodity) of the underlying instrument that can be
delivered (or which can be used for reference purposes in settlement) and a standard
timing of such settlement (e.g. all derivative contracts will mature on third Wednesday of
the expiry month). It may be recalled that these parameters are decided between the
counterparties in Forward trade and all of these parameters are subject to mutual consent.

Options

Options are traded both on exchanges and in the OTC market. There are two basic types
of options:

A call option gives the holder, or buyer of option, the right but not the obligation to buy a
given quantity of the underlying asset, at a certain price on or before a given future date.

A put option gives the holder, or buyer of option, the right but not the obligation to sell a
given quantity of the underlying asset, at a certain price on or before a given future date.

An option gives the holder the right but no obligation to act i.e. it gives the holder an
option to buy or nor to buy, or an option to sell or not to sell. Since the holder has the
option to act he need not exercise this right. This is what distinguishes options from
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forwards and futures, where the holder is obligated to buy or sell the underlying asset at
the pre-defined price. Whereas it costs nothing (except margin requirements) to enter into
a futures contract, the purchase of an option requires upfront payment from the buyer
(holder) to the seller (writer) of the option. This payment is called option premium.

Exchange traded Vs OTC derivatives market

Different characteristics of exchange traded and OTC derivatives can be summarized as
follows:

Exchange traded Derivatives OTC Derivatives

Ex: Futures, Equity Options Ex: Forwards, Currency Options

Contract terms are standardized, uniformity Customized contract terms, unique in
in contract size, expiration date, asset type contract size, expiration date, asset
and quality type and quality

Easy to offset position, by entering into Difficult and expensive to offset Equal and
opposite transaction position as it has to go through the
same counter party.

More liquid Less liquid

Requires margin payments Margin payments is not a must

Follows daily settlement (MTM) Settlement happens at the end of the period

No counter party risk Being bilateral contracts, exposed to counter
party risk

Physical delivery is rare Mostly settled by delivery of the asset

Limitations of forward markets

Though market participants in forward contract are free to negotiate any mutually
attractive deal they are handicapped by the following:

Lack of centralization of trading
Counter party risk

The above deficiencies of forward markets are better dealt by futures, wherever available,
as they are standardized and exchange traded.

Terminology used in Futures market

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Spot price: The price at which the underlying asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The period over which a contract trades. The index futures contracts on
the NSE have one-month, two-months and three-months expiry cycles, which expire on
the last Thursday of the month. Thus a January expiration contract expires on the last
Thursday of January and a February expiration contract ceases trading on the last
Thursday of February. On the Friday following the last Thursday, a new contract having
a three-month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract i.e. on this date the transaction
is scheduled to take place. This is the last day on which the contract will be traded, at the
end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one contract. For
instance, the contract size on London Stock Exchange for Index futures is GBP10 per
index point of FTSE index. If FTSE is 6500, the size of the contract will be GBP 65000.

Basis: In the context of financial futures, basis can be defined as the spot price minus the
futures price. There will be a different basis for each delivery month for each contract. In
a normal market, basis will be negative. This reflects that futures prices normally exceed
spot prices and this situation is called Contango. On the reverse, it basis becomes positive
i.e. if futures price falls below the spot price, it is called backwardation.

Cost of carry: The relationship between futures prices and spot prices can be summarized
in terms of what is known as the cost of carry. This measures the storage cost plus the
interest that is paid to finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin. This margin is to protect
the clearing house against a potential default arising from losses incurred on the futures
contract by the buyer or the seller of the futures contract.

Marking-to-market: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures
closing price. This is called marking–to–market.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure
that the balance in the margin account never becomes negative. If the balance in the
margin account falls below the maintenance margin, the investor receives a margin call
and is expected to top up the margin account and bring it back to the initial margin level
before trading commences on the next day.

Payoff for futures

Page 186
Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of a futures contract are directly related to the price of
the underlying.

Take the case of a speculator who buys a two-month Microsoft futures contract (1
contract = 100 shares) when Microsoft quotes at $25. When the Microsoft share price
moves above $25, say $30 the long futures position starts making profits.

Profit = (30-25) = $5*100 = $500

Payoff for buyer of futures: Long futures






Profit
+ 5
25 30
0
Microsoft

Loss




Similarly a speculator who sold Microsoft at $25 makes money if the prices fall below
$25. If the spot Microsoft starts moving beyond $25, say $30 the short futures position
starts making losses.

Profit = (25-30) = $-5*100 = $-500
Payoff for a seller of futures: Short futures




Profit

25 30
0
Microsoft
- 5

Loss
Page 187
Price determination of Futures Contract

Earlier we have discussed that price of a futures contract contains cost of carry i.e. the
interest cost and the cost of storage. Let us discuss this further.

Suppose Microsoft shares are trading at $25 in the spot market. How much should we pay
per share for three months futures on this stock? The intention of buying a three-months
future is to buy Microsoft shares three months from now but at the price defined today.
The seller of this contract could simply buy the share at $25 in the spot market, keep it in
his own account and deliver to the buyer three months from now without incurring any
price risk. In doing this transaction he will have to block the funds for three months on
which he would have earned interest. At the same time if Microsoft announces any
dividend he will receive the same. The minimum price the seller should charge is
therefore the price of Microsoft in the spot market plus the interest cost less income from
the share during the holding period.

The same can be mathematically depicted as follows:

F = S*(1+r)^t – PV(income)

Where,
F = Futures price
S = Spot price
r = annualized rate of interest
t = time period

Assuming no income from the asset during the holding period and interest to be
discounted continuously, the same equation can be re-written as follows:

F = S*e
rt


Futures price should be governed by this equation. Let us see what could happen if the
futures price is at substantial variance compared to the price calculated using the formula
above.

Assume that price of gold in the spot market is $300 per troy ounce. Rate of interest for
one-year tenor is 5% and one year gold future is trading at $340. Given this scenario, a
speculator could sell one-year gold future and simultaneously buy gold in the spot market
by borrowing money at 5% p.a.. By selling one-year gold future he has obtained a right to
sell gold at $340 one year from now. Total cost of ownership (assuming no storage cost)
of gold for him is $300 + $15 (interest paid on $300). Thus one year later he receives
$340 and pays only $315 making a clean and riskless profit of $25. But rest assured that
this speculator would not be the only one in the market to spot this opportunity of making
riskless profit. Therefore, many will come to sell futures and buy gold in spot. As a result,
futures price will fall and possibly even spot price will rise to a level where this arbitrage
opportunity is no more available.
Page 188

On the contrary, if one-year futures is quoting at $300, anyone who holds or can borrow
gold should sell gold in the spot market and buy one-year futures at $300. The amount
received by selling gold in spot market could be deposited in the bank, which would grow
to $315 in one year time. The long futures contract gives him the right to buy gold at
$300 one year from now. Thus he will receive $315 and pay only $300 to get back the
gold one year from now. In the process he makes a clean and riskless profit of $15. But
again, many more will spot this opportunity. As a result price of futures would rise
because of consistent buying and possibly the price in the spot market will fall to a level
where no such arbitrage opportunity is available any more.

What is the price where no arbitrage is available? It is 315 which is the price arrived at by
using the formula above. Thus, the value of futures arrived at by the formula given above
becomes the pivot around which futures price will revolve. When price goes above this
price, arbitrageurs will bring down the futures price and if price goes below this price
arbitrageurs will buy futures and price should rise to this level. It must be noted that in
the absence of active arbitrageurs in the market, the actual future price may deviate from
the ideal future price for long period of time.

Settlement of Futures contracts

As discussed earlier, futures contracts are settled daily on the exchanges based on mark to
market profit or loss. An example of the same has been given below.

It can be seen in the table below that there is no margin call until the available margin
falls below 300. When price falls to 21, available margin falls to $100. Now, the margin
call should be for an amount, which will bring the account balance back to the initial
margin level. Margin call amount is, therefore, $400. Same is the case when market price
of the future falls to 18 and again to 15. When price starts rising, profit starts
accumulating and balance starts rising. The customer is allowed to withdraw the
additional sum available over and above the initial margin from the margin account.

Purchase price = 25
Market lot = 100
Intial margin = 500
Maintenance margin = 300
Price
Profit/
Loss
over
previous
day
EOD
Margin
account
balance
Margin
call
amount
25 0 500 0
26 100 600 0
24 -200 400 0
23 -100 300 0
21 -200 100 400
Page 189
22 100 600 0
20 -200 400 0
18 -200 200 300
16 -200 300 0
15 -100 200 300
19 400 900 0
23 400 1300 0
24 100 1400 0

Thus the exchange or the counterparty in the forward contract ensures that it has
sufficient funds available in the margin account to cover potential losses. What if the
customer fails to remit the margin call amount i.e. he fails to top up. The broker is free to
square up the position on the prevailing market price and recover the losses from the
margin account. In case of failure in margin payment, broker is free to sell off the
customer’s position.

Options Overview

Options Terminology

Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell
shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to buy or sell the underlying asset to the seller/writer
of the option.

Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises his right to
buy/sell.

There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset
by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset
by a certain date for a certain price.

Option price: Option price is the price, which the option buyer pays to the option seller. It
is also referred to as the option premium.
Page 190

Expiration date: The agreed date on or before which the option purchaser could exercise
the right to either purchase the asset from or sell the asset to the option seller. The date
specified in the options contract is known as the expiration date, the exercise date, the
strike date or the maturity.

Strike price: The agreed price at which any future purchase or sale of the asset is to take
place. The price specified in the options contract is known as the strike price or the
exercise price.

American options: American options are options that can be exercised at any time on or
before the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised only on the
expiration date. European options are easier to analyze than American options, and
properties of an American option are frequently deduced from those of its European
counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cash flow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level higher than the
strike price (i.e. spot price > strike price). If the index is much higher than the strike
price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is
below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to
negligible cash flow to the holder if it were exercised immediately. An option on the
index is at-the-money when the current index equals the strike price (i.e. spot price =
strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option where the spot
price is far from the strike price and it must cover some distance before it becomes in the
money for the holder of the option. A call option on the index is out-of-the-money when
the current index stands at a level, which is less than the strike price (i.e. spot price <
strike price). If the index is much lower than the strike price, the call is said to be deep
OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two
components – intrinsic value and time value. The intrinsic value of a call is the amount
the holder would receive on exercise of the option. If the option is ITM, the intrinsic
value of a call option is spot price less strike price and that of the put option is strike price
less spot price. If the call is OTM, its intrinsic value is zero (not negative).

Time value of an option: The time value of an option is the difference between the option
premium i.e. market price of the option and its intrinsic value. Both calls and puts have
time value. An option that is OTM or ATM has only time value since the intrinsic value
Page 191
in both cases is zero. Usually, the maximum time value exists when the option is ATM.
The longer the time to expiration, the greater is an option’s time value, all else being
equal. At expiration, an option should have no time value.

Futures Vs Options

Futures Options

Needs to pay only refundable margin Need to pay premium

Linear payoff Non linear payoff

Profit/Loss is unlimited or large for both For option Buyer:
Buyer and seller Loss is limited to the extent of premium
paid, Profit is unlimited or large.
For option writer:
Profit is limited to the extent of premium
received; Loss is unlimited or large.


Options payoff

There are two sides to every option contract. On one side is the investor who has taken
the long position i.e., the buyer of the option. On the other side is the investor, who has
taken a short position i.e., has sold or the written the option. The writer of the option
receives cash upfront but has potential liabilities later. The writer’s profit is equal to the
loss of the holder and vice versa.

Given this scenario there are four types of option positions:

Buyer of call option: Long call
Writer of call option: Short call
Buyer of put option: Long put
Writer of put option: Short put

A) Buyer of call option: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he
makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the
underlying is less than the strike price, he lets his option expire un-exercised. His loss in
this case is the premium he paid for buying the option. Graph below gives the payoff for
the buyer of a three-month HLL European call option with a strike of 150 bought at a
premium of Rs10 on the expiry date.

Page 192
Spot HLL = Rs 152 Strike price = Rs 150 Premium = Rs 10

1 Lot size = 2000 shares



Profit





0 HLL
80 90 100 110 120 130 140 150 160 170 180 190 200 210 220

- 10



Loss

The figure shows the profits/losses for the buyer of a three-month HLL 150 call option.
As can be seen, as the spot HLL rises, the call option is more in-the-money. If upon
expiration, HLL closes above the strike of 150, the buyer would exercise his option and
profit to the extent of the difference between the HLL-close and the strike price. The
profits possible on this option are potentially unlimited. However if HLL falls below the
strike of 150, he lets the option expire. His losses are limited to the extent of the premium
he paid for buying the option.

Upon expiration if,
Spot price = Rs 170
Profit = Spot price – (Strike price + premium paid)
= 170- (150+10)
= +10

Actual profit = 2000*10 = +20,000 Rs

Upon expiration if,
Spot price = Rs 140
Loss = premium paid = Rs 10

Loss for the call option buyer is limited to his premium of Rs 10, as he would forgo his
opportunity to exercise.

Actual Loss = 2000*10 = Rs-20,000

Page 193
Breakeven price for the buyer is Rs.160. At this price he makes no profit or no loss.

B) Writer of call option: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a premium.
The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot
price exceeds the strike price, the buyer will exercise the option on the writer. Hence as
the spot price increases the writer of the option starts making losses. Higher the spot price
more is the loss he makes. If upon expiration the spot price of the underlying is less than
the strike price, the buyer lets his option expire unexercised and the writer gets to keep
the premium. Graph below gives the payoff for the writer of a three-month call with a
strike of 150 sold at a premium of Rs 10.

Spot HLL = Rs 150 Strike price = Rs 150 Premium = Rs 10
1 Lot size = 2000 shares


Profit




+ 10
0 HLL
80 90 100 110 120 130 140 150 160 170 180 190 200 210 220






Loss




The figure shows the profits/losses for the seller of a HLL three-month 150 call option.
As HLL rises in the spot market, the call option becomes in-the-money and the writer
starts making losses. If upon expiration, HLL stock closes above the strike of 150, the
buyer would exercise his option on the writer who would suffer a loss to the extent of the
difference between the spot market close and the strike price. The loss that can be
incurred by the writer of the option is potentially unlimited, whereas the maximum profit
is limited to the extent of the up-front option premium of Rs.10 charged by him.

Page 194
Upon expiration if,
Spot price = Rs 170
Loss = Strike price – Spot price + premium received
= 150- 170 + 10
= -10
Actual loss = 2000*10 = -20,000 Rs

Upon expiration if,
Spot price = Rs 130
Profit = premium received

Profitability of the call option writer is limited to the extent of the premium received.
Actual profit = 2000*10 = +20,000 Rs

c) Buyer of put option: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the
spot price of the underlying. If upon expiration, the spot price is below the strike price, he
makes a profit. Lower the spot price more is the profit he makes. If the spot price of the
underlying is higher than the strike price, he lets his option expire un-exercised. His loss
in this case is the premium he paid for buying the option. Graph below gives the payoff
for the buyer of HLL three-month put option with a strike of 150 bought at a premium of
Rs 10.

Spot HLL = Rs 155 Strike price = Rs 150 Premium = Rs 10
1 Lot size = 2000 shares



Profit





0 HLL
80 90 100 110 120 130 140 150 160 170 180 190 200 210 220

- 10




Loss

Page 195


The figure shows the profits/losses for the buyer of HLL three-month 150 strike out-of-
the-money put option. As can be seen, as the spot market prices falls, the put option is in-
the-money. If upon expiration, HLL closes below the strike of 150, the buyer would
exercise his option to sell at 150 and profit to the extent of the difference between the
strike price and spot market close. The profits possible on this option can be as high as
the strike price i.e., profits are limited to the extent of the strike price itself, as the stock
price cannot go below zero. However if the stock rises above the strike of 150, he lets the
option expire. His losses are limited to the extent of the premium he paid for buying the
option.

Upon expiration if,
Spot price = Rs 170
Loss = premium paid
Actual loss = premium paid = 2000*10 = -20,000 Rs

Even if the spot price goes beyond 170 the loss for the buyer of this put option is limited
to the premium paid, which is Rs 10 per share.

Upon expiration if,
Spot price = Rs 120
Profit = Strike price – Spot price – premium paid
= 150 – 120 -10
= + 20
Actual profit = 2000*10 = Rs.40,000 Rs

Writer of put option: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. For selling the option, the writer of the option charges a premium.
The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot
price happens to be below the strike price, the buyer will exercise the option on the
writer. If upon expiration the spot price of the underlying is more than the strike price, the
buyer lets his option expire un-exercised and the writer gets to keep the premium. Graph
below gives the payoff for the writer of a three-month HLL put option with a 150 strike
sold at a premium of Rs 10.
Page 196

Spot HLL = Rs 150 Strike price = Rs 150 Premium = Rs 10
1 Lot size = 2000 shares



Profit




+ 10
0 HLL
80 90 100 110 120 130 140 150 160 170 180 190 200 210 220






Loss






The figure shows the profits/losses for the seller of a three-month HLL 150 strike put
option. As the spot price falls, the put option becomes in-the-money and the writer starts
making losses. If upon expiration, HLL closes below the strike of 150, the buyer would
exercise his option to sell at 150 on the writer who would suffer a loss to the extent of the
difference between the strike price and the closing price. The loss that can be incurred by
the writer of the put option is limited to the strike price (since in the worst case the asset
price can fall to zero) whereas the maximum profit is limited to the extent of the up-front
option premium of Rs.10 charged by him.

Upon expiration if,
Spot price = Rs 170
Profit = premium received

As the profitability of the put option writer is limited to the extent of the premium
received Rs 10. Actual profit = premium received = 2000*10 = +20,000 Rs

Upon expiration if,
Spot price = Rs 120
Loss = Strike price – Spot price + premium received
Page 197
= 150 – 120 +10
= - 20

Actual loss = 2000*20 = -40,000 Rs

Foreign currency options:

Foreign currency options give a buyer the right to buy or sell a specific quantity of
currency at a specified exchange rate, on or before a specific date. However in currency
options we need to be clear about which currency is being put or called. When we buy a
put option on one currency at a specified rate, we are effectively buying a call option on
the other currency! This is worth noting due to the two-sided nature of the currency
transactions. A call option to buy INR against the US dollar is the same as a put option to
sell US dollar against the INR. The vast majority of Fx option business in all types of
options takes places OTC.

Examples:

Long position in a call option:

Lets assume an investor believes that the US dollar will strengthen against the Swiss
Franc (CHF) in the coming months. The current spot price is 1.4. He wants to cap his
downside and hence, buys a USD 1 million call/ CHF put option with a strike price of
1.45, and expiry date in 3 months. The premium or option price that the investor has to
pay for the right to hold the option is CHF 50,000. (Note: the premium is normally given
as a percentage of the base currency, i.e. in this case Euro). If on the date of expiry the
spot price is less than 1.45, he will choose not to exercise the option to buy USD at by
paying 1.45 CHF per USD. He will loose the premium of USD 50,000. Similarly if the
spot is above the strike price, then he will exercise the option to buy USD since in the
market he will have to pay higher amount of CHF for buying the same amount of USD.

For example, if the market rate is 1.55 on expiry, then by exercising the option to buy
USD by paying CHF1.45 per USD and selling the dollars at the market price which will
fetch him CHF 1.55 per usd, the investor will gain a net profit of:

Profit = (Spot price - strike price)*amount - premium paid

= CHF1,550,000 – CHF1,450,000 – CHF50,000 = CHF50,000 (=$32258 at 1.55)
Page 198


Profit from long call
Profit

+ 50



CHF’000 Spot
USD/CHF
1.4 1.41 1.42 1.43 1.44 1.45 1.46 1.47 1.48 1.49 1.5 1.51 1.52 1.53 1.54 1.55


- 50


Loss


Short position in a call option

Suppose the investor in the scenario described above, believes that the US dollar will
appreciate, but feels it is unlikely the exchange rate will rise above 1.6. So he prefers to
be a seller (short position) in US dollar calls above 1.6. Lets assume he sells a USD 1
million call/ CHF put option with a strike price of 1.63, and receives a CHF30,000
premium. The writer of this call makes money if the strike is above spot price, the
maximum he makes is to the extent of the premium received.


Profit from short call
Profit


+ 30


CHF’000 Spot
USD/CHF
1.58 1.59 1.6 1.61 1.62 1.63 1.64 1.65 1.66 1.67 1.68 1.69 1.7 1.71 1.72



Loss


Page 199
Long position in a put option.

A Swiss company with substantial sales in Britain expects a large inflow of sterling in
three months. In order to hedge against a possible weakening in sterling, they purchase a
£1Millon GBP put/CHF call. The current spot rate is 2.25 and the strike price is 2.25 (at-
the-money-spot), with expiry in 3 months at a premium of CHF50,000 i.e, 0.05 (Note:
the premium is normally given as a percentage of the base currency, i.e. in this case £). If
on the date of expiry the spot price is greater than 2.25, he will choose not to exercise the
option and will loose the entire premium amount of CHF50,000. If the spot is below the
strike price, then he will exercise the option to sell GBP to get CHF2.25 per GBP even
though market price has fallen.

For example, if the market rate is 2.15, then by exercising the option, the company will
gain a net profit of:

Profit = (Strike price - spot price)*amount - premium paid
CHF2,250,000 – CHF2,150,000 – CHF50,000 = CHF50,000 (=£23256 at 2.15)



Profit from Long Put
Profit

Break Even Point (BEP)



CHF’000 spot
GBP/CHF
2.16 2.17 2.18 2.19 2.2 2.21 2.22 2.23 2.24 2.25 2.26 2.27 2.28 2.29 2.3



Loss




Short position in a put option

Suppose that an investor is confident that the GBP/CHF exchange rate, currently at 2.25
will not fall sharply, but, is unsure whether it will increase or remain stable. He will
prefer to be a seller or writer in GBP puts. By selling a £1 million put/ CHF call option
with a strike price of 2.25; he receives a premium of CHF50,000. On expiry of the option
if he the spot stays above 2.25 the writer gains to the extent of the premium received.
Should the spot stay below 2.25 he ends up paying to the buyer of the put option.
Page 200



Short a Put
Profit




DM’000 spot GBP/DM
2.19 2.2 2.21 2.22 2.23 2.24 2.25 2.26 2.27 2.28 2.29 2.3 2.31 2.32 2.33



Loss







Various factors affecting Option pricing

The impact of various factors on the option price can be summarized as follows:

Spot price Call premium Put premium

Increase

Decrease


Strike Price Increase

Decrease

Strike price Vs Spot price

More out of the money

More in the money


Volatility Increase

Page 201
Decrease


Interest rates Increase

Decrease


Time to Expiry Increase

Decrease

How ever a put option premium with an increase in Time to maturity increases for small
increase in time to maturity and decreases for large increases in Time to maturity.

The above factors interact with each other to determine the price of an option. The most
widely used formula for deriving option price was given by Black and Scholes.
Commonly known as Black-Scholes option pricing model, the formula gives the ideal
value of an European call option. The formula has been given below:




It can be seen that all the variables mentioned above have been captured in the model.
Based on the principle of put-call parity, we derive the price of an European put option.
Principle of put-call parity is derived from the following equation:

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C – P = S – Xe
-rt


This equation implies that price of the European put option for a given strike price will be
equal to call option price for the given strike price (derived from Black-Scholes model)
plus the present value of strike price less the market price of the stock (asset). This
equality is derived from the fact that payoffs from the following two portfolios will
always be equal:

Portfolio 1 – long call option + present value of the strike price
Portfolio 2 – long put option + stock

You may like to verify the above statement assuming different stock prices and different
strike prices.

It may also be noted that valuation of other options like value of American call and put
options and that of options on exchange rates are derived with some modification to the
Black and Scholes model. Discussion on derivation of Black-Scholes model and
variations thereof is out of scope of this book. Some of these issues will be discussed in
the higher-level modules.

Option Greeks

As discussed above, option prices are sensitive to various factors. These sensitivity
factors can be measured and are name after different Greek letters. A summary of these is
given below:

Delta = Change in option premium/ Change in underlying price

Delta measures the sensitivity of option price in relation to the changes in the price of the
underlying. Options price does not move up or down as much as the price of the
underlying. You may observe that for an at the money 100 strike price call option
premium is $10. But when price of the underlying stock moves from 100 to 110, option
price moves only to 16. Thus, change in option price is $6 when change in the price of
the underlying is $10. Here, delta is 6/10 or 0.6. When the price of the underlying moves
to $120, option price may move to 24. Delta has changed to 0.8. It may be noted that
more in the money the option into, delta approaches 1. Conversely, for deep out of the
money options delta is closer to zero.

Measuring delta is important for traders who hedge their positions using options or who
hedge the risk contained in options by buying / selling the underlying. Just as knowledge
of beta is essential to create a perfect hedge using futures, knowledge of delta is essential
to create a perfect hedge using options. You can see in the example above that option on
same number of underlying stock cannot cover full impact of the change in the price of
the underlying.

Gamma = change in option delta/ change in the price of underlying
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As can be seen in the example above, delta itself changes as it moves more in the money
or out of the money. Therefore, a trader should know how delta itself changes as the price
of the underlying changes. Sensitivity of delta in relation to change in the price of the
underlying is called Gamma.

Vega = change in option premium/ change in volatility of the underlying

As we have seen higher the volatility, higher the option premium and vice versa. The
sensitivity of option premium in relation to the volatility of the underlying is measured by
Vega.

Similarly,
Rho = change in option premium/ change in cost of funding or rate of interest, and,
Theta = change in option premium/ change in time to maturity


Role/use of Financial Derivatives
Derivative instruments are generally used for the following purposes,

Hedging: Using Futures
Ex: If an investor holds an equity portfolio: buy puts

Buying put Index options is a cheap and easy way of protecting the potential downside of
the asset due to market drop. It is important to know how many futures should be sold to
create the perfect hedge. How do we calculate this?

To do this we need to know the “beta” of the portfolio, i.e. the average impact of a 1%
move in the Index upon the portfolio. It is easy to calculate the portfolio beta: it is the
weighted average of stock betas.

Suppose we have a portfolio composed of Rs.1 million of Reliance, which has a beta of
1.4 and Rs.2 million of ITC, which has a beta of 0.8, then the portfolio beta is

1 * 1.4 +2 * 0.8 = 1
3

If the beta of any stock is not known, it is safe to assume that it is one. In general, the beta
of a well-diversified portfolio is close to 1.

Lets consider two cases,
Where the portfolio has a beta of one
Where the portfolio beta is not equal to 1.

Portfolio insurance when portfolio beta is 1.0

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Assume we have a well-diversified portfolio with a beta of 1.0, which we would like to
insure against a fall in the market. Assume that the spot Index is 1250 and you decide to
sell futures. One should sell the following numbers of Index futures

Number of futures to sell = portfolio value/ Index

Assume your portfolio is worth Rs.1 million. Hence the number of future you need to sell
to protect your portfolio from a fall in index is (1,000,000/1250) which works out to be
800.

Now let us look at the outcome. We have just sold two–month Index futures at 1250. This
is designed to ensure that the value of our portfolio does not decline (for a portfolio with
a beta of 1, a 10% fall in the index directly translates into a 10% fall in the portfolio
value). During the two–month period, suppose the Index drops to 1080. This is a 13.6%
fall in the index. The portfolio value too falls at the same rate and declines to Rs.0.864
million. However the futures provide a payoff of (1250-1080)*800 which is equal to the
loss on the portfolio.

The above combination of portfolio plus short futures ensures that any fall in the portfolio
value will be accompanied by an equal gain on the futures position, effectively ensuring
that the portfolio is insured against losses. However, it also ensures that in case the
markets rise, portfolio value will not rise. In the case of rise in the market prices, gain on
the portfolio will be nullified by loss on short position on the Index.

Portfolio insurance when portfolio beta is not 1.0

Assume we have a portfolio with beta equal to 1.2, which we would like to insure against
a fall in the market. Now we need to decide how many index futures should we sell to
create a perfect hedge. Assume that the spot Index is 1200 and we decide to sell futures.
Assume our portfolio is worth $1 million with a beta of 1.2. Hence the number of futures
we need to sell to protect our portfolio from a downside is (1,000,000 * 1.2)/1200 which
works out to 1000. Now let us look at the outcome. We have just sold two month Index
futures at 1200.

This is designed to ensure the value of our portfolio does not decline (for a portfolio with
a beta of 1.2, an index fall of 10% translates into a 12% fall in the portfolio value).
During the two-month period, suppose the Index drops to 1080. Index has fallen by 10%
but the portfolio value would decline faster because of beta of 1.2. Portfolio value will
decline by 12% to $0.88 million. However we have sold 1000 futures and gain on futures
will be 1000*120 = $0.12 which is equal to the loss on the portfolio. We see that the
number of futures to be sold is derived as follows:

Number of futures to sell for creating a perfect hedge = (portfolio value* portfolio beta)/
Index

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Creating a hedge using futures locks the value of the portfolio. Value of the portfolio
does not fall when price of the underlying falls, but at the same time value of the portfolio
does not rise when markets go up. Therefore, a trader may like to create a hedge using
options so that in case market goes up he continues to participate in the upside or vice
versa.

Just as one needs to decide on how many futures to sell, one also needs to decide how
many options to buy. If one expects market prices to fall, he should be buying put
options. But how many put options? In the example given earlier we have seen that price
of the option does not change as much as the price of the underlying. Therefore, in order
to protect the value of the portfolio, one should buy larger number of put options. This
number is determined by delta of the option. If delta of the put option is 0.6, one needs to
buy the following number of put options

Number of put options to be bought = no. of underlying stocks/ delta

It is obvious that this number will keep changing because delta of a given option keeps
changing at different price intervals other things remaining the same. The process of
dynamically changing the amount of options to be bought or sold in order to create a
perfect hedge on the underlying is called dynamic hedging. One can also hedge the
option position by buying or selling the underlying asset.

Yield Enhancement

Ex.: Investor who owns a bond sells a call on the bond thinking that interest rates will
remain steady. If the price of the bond is below the strike price then the buyer of call will
not exercise the option and the investor retains the premium. This premium enhances his
total earnings or yield from the bond. The same process could be followed by holders of
stock or other assets.

Yield enhancement could be done in other direction as well. If one feels that Microsoft
shares will be a good buy at $20 when share price is $25, he could sell put options with
$20 strike price. In case the price does not fall below $20, he retains the premium, which
reduces his cost of acquisition and thus enhances the return or yield. If the price falls
below $20, he will be obliged to buy the stock at $20, the price at which he was intending
to buy in any case. This process can be repeated several times.

Speculation

Derivatives can be used to speculate and benefit from the price fluctuations. Derivative
contracts are not inherently speculative but are capable of being used to take positions in
anticipation of price changes. The major advantage of using derivatives is the ability to
create a precise exposure to price risk and the ability to leverage the position in the
absence of any large commitment of capital.

Examples:
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Investor who does not own a bond buys a Put and sells a call to take a synthetic short
position
Bullish on a stock, buy calls or sell puts
Bearish on a stock, buy puts or sell calls

You may calculate the payoffs of these strategies and see how the investors will gain or
lose.

Arbitrage

This is used to exploit price discrepancies between the cash markets and the forward or
option markets. Theoretically no arbitrage is possible if the futures or option is fairly
priced. The objective is to lock in profits on a risk less basis. We have discussed earlier
how arbitrage could be done if futures price is out of sync with the ideal futures price.

Option Strategies

Options are extremely adaptable instruments that enable participants to create a number
of risk-reward and risk-reduction profiles.

If one anticipates the underlying
Action

Price to go up Buy a call
Sell a put

Price to be stable Sell a put
Sell a call

Price to drift down Buy a put
Sell a call

Price to be volatile Buy a put
Buy a call

Option Combinations

Bull Market strategies – Bull Spreads

A spread trading strategy involves taking a position in two or more options of the same
type (i.e., two or more calls or two or more puts) on the same underlying.

A spread that is designed to profit if the price goes up is called a bull spread.

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Buyer of a bulls spread purchase a call option on a stock with a certain strike price and
sells call option on the same stock with a higher strike price. Both options have the same
expiration date. The trader pays a net premium for the position.
Buying a put with a low strike price and selling a put with a high strike price also create
Bull spread. Unlike the bull spread created from calls, bull spreads created from puts
involve a positive cash flow to the investor up front.

There are times when you think the market is going to rise over the next two months,
however in the event that the market does not rise, you would like to limit your downside.
One way you could do this is by entering into a spread. The spread is a bull spread when
the trader hopes to profit from a rise in the underlying. The trade is a spread because it
involves buying one option and selling a related option.

What is the advantage of entering into a bull spread?

Compared to buying the underlying asset itself, the bull spread with call options limits
the trader’s risk, but the bull spread also limits the profit potential. In short, it limits both
the upside potential as well as the downside risk. The cost of the bull spread is the cost of
the option that is purchased, less the cost of the option that is sold.

Broadly, we can have three types of bull spreads:

1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.

The decision about which of the three spreads to undertake depends upon how much risk
the investor is willing to take. The most aggressive bull spreads are of type 1. They cost
very little to set up, but have a very small probability of giving a high payoff.

Graph below shows the payoff from the bull spread created using Nifty Index call
options.

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The figure shows the profits/losses for a bull spread. As can be seen, the payoff obtained
is the sum of the payoffs of the two calls, one sold at Rs.37.85 (premium collected by
selling) and the other bought at Rs.76.50 (premium paid). The cost of setting up the
spread is Rs.38.65, which is the difference between the call premium paid, and the call
premium received. The downside on the position is limited to this amount. As the index
moves above 1260, the position starts making profits (cutting losses) until the spot
reaches 1350. Beyond 1350, the profits made on the long call position get offset by the
losses made on the short call position and hence the maximum profit on this spread is
made if the index on the expiration day closes at 1350 or above. Hence the payoff on this
spread lies between -38.65 to 51.35.

Bear Market strategies – Bear Spreads

A spread that is designed to profit if the price goes down is called a bear spread.

This is basically done utilizing two call options having the same expiration date, but
different exercise prices. A bear spread created from calls involves an initial cash inflow
because the price of the call sold is greater than the price of the call purchased.

Buying a put with a high strike price and selling a put with a low strike price also achieve
bear spread. Bear spreads created with puts requires an initial investment.

How is a bull spread different from a bear spread?

In a bear spread, the strike price of the call option purchased is greater than the strike
price of the call option sold. The buyer of a bear spread buys a call with an exercise price
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above the current index level and sells a call option with an exercise price below the
current index level.

Bull Spread = strike price of call option purchased < strike price of the call option sold

Bear Spread = Strike price of the call option purchased > strike price of the call option
sold

It may be repeated that both bull and bear spreads can be created using put options as
well.

Payoff for a bear spread created using Nifty Index call options

The figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained
is the sum of the payoffs of the two calls, one sold at Rs.76.50 and the other bought at
Rs.37.85. The maximum gain from setting up the spread is Rs.38.65, which is the
difference between the call premium received, and the call premium paid. The upside on
the position is limited to this amount. As the index moves above 1260, the position starts
making losses (cutting profits) until the spot reaches 1350. Beyond 1350, the profits
made on the long call position get offset by the losses made on the short call position.
The maximum loss on this spread is made if the index on the expiration day closes at or
above 1350. At this point the loss made on the two-call position together is Rs.90 i.e.
(1260-1350). However the initial inflow on the spread being Rs.38.65 (76.5-37.85), the
net loss on the spread turns out to be -51.35(90-38.65). The downside on this spread
position is limited to this amount. Hence the payoff on this spread lies between +38.65 to
-51.35.
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Volatile Market Strategies – Straddles

A straddle is the simultaneous purchase (or sale) of two identical options, one a call and
the other a put. Buying a straddle is an appropriate strategy when an investor is expecting
a large move in the underlying but does not know in which direction the move will be.
Long Straddle: Buying both call and put options at the same strike price and at the same
time to expiry

Short Straddle: Selling both call and put options at the same strike price and at the same
time to expiry. A short straddle is a useful strategy when one expects the market to be
stable.

Consider an investor who feels that the price of a certain stock currently trading at $69
will move significantly in another 3 months. The investor creates a straddle by buying
both a call and a put option with strike price of $70 with premium outflow of $4 and $3
respectively. At expiry if the spot price is $69, then the strategy costs the investor a loss
of $6.(An upfront costs of $7 is required, the call expires worthless, and the put expires
with a worth of $1). If the stock price moves to $70, a loss of $7 is experienced. This is
the worst that could happen. However on expiry if the stock closes at $90, a profit of $13
($90-$70=$20 profit on call option; premium outflow of $7) is made. If the stock moves
down to $55, a profit of $8 is made.
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Long Straddle




Profit
$ 63 $67 $ 70 $ 74 $ 77

K Spot price



Loss




The higher the cost of setting up this combination, the more the underlying would have to
move for it to be profitable.

Volatile Market Strategies - Strangles

A strangle is similar to a straddle, except that the call and the put have different strike
prices but same expiration date. Usually, both the call and the put are out-of-the-money.

To "buy a strangle" is to purchase a call and a put with the same expiration date, but
different exercise prices. Usually the call strike price is higher than the put strike price.

To "sell a strangle" is to write a call and a put with the same expiration date, but different
exercise prices.
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Profit
K
1
K
2


Spot price


Loss





Here K1 & K2 are the two different strike prices

As we can see the stock price has to move farther in a strangle than in a straddle for the
investor to make profit. However, the downside risk if the underlying ends up at a central
value is less with a strangle. The profit pattern obtained with a strangle depends on how
close together the strike prices are. The farther they are apart, the less the downside risk
and the farther the underlying has to move for a profit to be realized.

Caps, Floors and Collars

Interest-rate caps and floors are option strategies that customers use to hedge floating-rate
exposure. A cap is designed to protect borrowers if the interest rate on a floating-rate loan
rises above a specified level. Floors may be attractive to investors or lenders who want
protection if interest rates fall below a certain level. Collars are combinations of caps and
floors that guarantee a maximum and minimum interest rate payable by a corporate in a
borrowing situation. In this section, you will see how caps, floors and collars are used to
hedge and how they are priced.

Caps

(Protection against an increase in floating interest rates)
An interest-rate cap is a contract for a specified period during which the writer agrees to
pay the buyer, at each rate reset date, the difference between a reference rate (usually 3-
or 6-month LIBOR) and an agreed exercise rate (cap rate) when the reference rate
exceeds the exercise rate. In return, the writer receives an up-front premium. You may
view a cap as a series of European-style calls on LIBOR that protect a borrower if
LIBOR exceeds a particular level, but allows the borrower to benefit if LIBOR stays low
or goes lower.

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For example, consider a company that is borrowing for 5 years at 3-month LIBOR plus a
margin and wishes to protect itself against the possibility of LIBOR rising above 8.00%.
The company buys a 5-year quarterly resetting cap. Under this contract, at every 3-month
reset for 5 years (one original rate setting followed by 19 resets), 3-month LIBOR will be
compared with the capped rate of 8.00%. If LIBOR exceeds 8.00%, a net payment will
take place from the bank to the customer to offset the increased cost of borrowing and
bring the effective LIBOR cost down to 8.00%. If, at any reset, 3-month LIBOR is below
8.00%, then the customer will simply lock in for the 3-month period at the market rate.

Floors

(Protection against a decline in floating interest rates)
An interest-rate floor is a contract under which the writer agrees to pay the buyer the
difference between a reference rate and an agreed strike rate when the strike rate exceeds
the reference rate. In return, the writer receives an up-front premium. Floors may be of
particular interest to an investor who wants to be protected if the floating-rate index falls
below the strike rate.

For example, consider a bank that is lending for 5 years at 3-month LIBOR plus a margin
and wishes to protect itself against the possibility of LIBOR falling below 4.00%. The
bank buys a 5-year quarterly resetting floor. Under this contract, at every 3-month reset
for 5 years (one original rate setting followed by 19 resets), 3-month LIBOR will be
compared with the floor rate of 4.00%. If LIBOR falls below 4.00%, a net payment will
take place from the counterparty to the bank to offset the fall in the earning for the bank
and bring the effective LIBOR earning to 4.00%. If, at any reset, 3-month LIBOR is
above 4.00%, then the bank will simply lock in for the 3-month period at the market rate.

Collars

(Combining Caps and Floors)
A collar is created by the purchase of a cap and the sale of a floor (or vice versa). For the
borrower, the construction of a collar provides protection against extreme movements in
floating reference interest rates, such as the 3-month LIBOR rate, whilst at the same time
giving the borrower the chance to take advantage of interest rates declining to the floor
level. Collars are most suitable for those corporate treasurers, which hold the view that
interest rate could rise in the foreseeable future, but where a small increase in rates would
still be acceptable to them. It should be kept in mind that the term 'zero-cost-collar' or
‘costless collar’ is a misnomer, as there is always a risk, however small, that there will be
a payout by one party to another under the collar agreement.

Parties to an interest rate collar take on potential credit exposure to one another. The
collar buyer is exposed to the seller for payments over the cap strike. The collar seller is
exposed to the buyer for payments under the floor strike.

Examples of Payment Flows
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If cap strike > market rate > floor strike, there is no payment on either the cap or the
floor.

If market rate > cap strike, the seller of cap pays the buyer cap:
notional principal x (floating rate - cap strike) x days as per day count convention

If market rate < floor strike, the seller of floor pays the buyer (buyer of floor):

notional principal x (floor strike - floating rate) x days as per day count convention

Caps, floors and collars are a simple but very effective way to control risk and manage
hedge costs. The option characteristics of caps and floors offer unique opportunities to
minimize borrowing costs or achieve higher investment returns.

Uses of Caps, Floors and Collars

Caps and Floors are widely used as insurance policies.
If counterparty is paying floating on a notional, then they will purchase a cap.
If counterparty is receiving floating, then they will purchase a floor.
Caps are purchased by liability managers to reduce floating rate debt exposure (while
benefiting from falling rates).
Caps and Floors are sold to generate “premium” income.
Floors are purchased by asset managers to reduce floating rate asset exposure (while
benefiting from rising rates).
Caps and Floors Maturities generally range from 3 months to 10 years.
Both Caps and Floors can be tailored to meet specific hedging needs.
Combination of Caps and Floors – the Collar – is actively used for liability management.


Pricing of Caps and Floors

Pricing a Cap

As mentioned above, the cap is simply a series of European-style, single-period call
options on LIBOR (or a put on the Eurodollar futures contract).

To illustrate how to calculate cap premiums, we will use the prices for the strike rates and
tenors shown in the cap pricing grid in Figure 1.1. The prices are quoted in basis points
(one basis point equals .01%), calculated as a multiple of the principal amount, and paid
up front. Note that only mid-rates are given in this grid. In a true pricing grid, a bank
quotes a bid-offer spread that ranges from two to three basis points on either side of the
mid-rate in the interbank market to 50 basis points or more for lower-rated credits, in
order to generate a profit.

Caps on 3-month LIBOR
Strike Rate 1 Year 2 Year 3 Year 4Year 5Year
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6.50 10 91 204 329 458
7.00 4 61 150 252 359
7.50 1 40 108 192 280
8.00 0.5 26 78 145 218
8.50 0.2 16 56 110 170

Figure 1.1: Cap pricing grid

All option prices are mid-rates quoted in basis points up front.

How does a cap work? Let’s use an example to see how the premium and settlement
payments are determined.

Pricing a cap

A corporation borrowing $100 million at a margin of 100 bp over 3-month LIBOR for
three years wishes to protect against increasing rates over the tenor of the loan. The
company chooses to buy a 3-year quarterly reset interest rate cap at 7.50%, which will
cost 108 bp according to the pricing grid.

The writer calculates the cash premium by multiplying the cost in basis points by the
notional principal amount. In this example, the cap buyer pays the writer an up-front
premium of $1.08 million calculated as follows:

$100 million x 1.08% = $1.08 million

During the period of the cap, the reference rate (3-month LIBOR) and the strike rate
(7.50%) are compared every three months. If 3-month LIBOR moves above 7.50% on
any of the reset days, the writer pays the buyer a cash payment at the end of that reset
period to bring the effective cost down to 7.50% for that 3-month period.

Cash payment formula

The following formula is used to calculate the amount of the cash payment:
(3-mo. LIBOR - Cap strike rate) x Notional principal x Actual no. of days/360

To see how this formula is applied, let’s assume that, on one of the reset days, 3-month
(91 days) LIBOR is 8.00%. The cash payment is determined as follows:

(8.00% - 7.50%) x $100 million x 91/360 = $126,388.89

The cap seller pays the buyer $126,388.89.

If, at any reset, 3-month LIBOR is below 7.50%, the borrower will, of course, roll over
the borrowing at market rates.

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Pricing Floors (Pricing similar to pricing caps)

The methodology used to price floors is similar to that used to price caps. A floor is
simply a series of European-style, single-period put options on LIBOR (or a call on the
Eurodollar futures contract). Therefore, the values of the puts are added together, and
then the present value of the total is calculated to determine the up-front premium for the
floor.

An example will help illustrate how an investor may use a floor. We will use the floor
prices shown in the floor pricing grid in Figure 1.2.

Floors on 3-month LIBOR
Strike Rate 1 Year 2 Year 3 Year 4 Year 5 Year
6.50 46 87 106 141 210
6.00 23 54 72 101 161
5.50 8 32 51 71 92
5.00 3 16 27 32 50
4.50 1 7 11 20 26
Figure 1.2: Floor pricing grid

All option prices are mid-rates quoted in basis points up front.

Example: floor

An investor with $50 million in floating-rate time deposits reset quarterly wants
protection against decreasing rates. She wants to buy a 2-year 5.50% floor with 3-month
dollar LIBOR as the reference rate in the amount of $50 million. According to the floor
pricing grid, the investor will pay the writer an up-front premium of 32 basis points, or
$160,000 ($50 million x.32% = $160,000).

How is settlement at a reset period determined? If 3-month LIBOR is fixed at 4.75% on
one of the reset dates, the amount that the writer pays the investor at the end of the reset
period is calculated as follows:

(5.50% - 4.75%) x $50 million x 91 / 360 = $94,791.67

The floor seller pays the buyer $94,791.67.

If, at any reset, 3-month LIBOR exceeds 5.50%, the investor will, of course, roll over the
deposit at market rates.

Pricing a Collar

Example of a collar agreement:

Page 217
A company finds itself in a situation where it needs to service a 2-year debt, upon which
the interest rate is reset quarterly. The company cannot afford to pay more than 14.50%
over the 2-year period. The current 2-year at-the-money cap rate is pegged at around say
12.66%. Although a 14.50% cap is out-the-money, the premium will still be quite
expensive. The borrower feels that interest rates will not fall too far in the near future and
decides to sell a floor, also out-the-money, at a strike price of 11.50%. The premium
recovered on the sale of the floor will partially or wholly finance the premium paid on the
cap, thus creating a low-cost or even a zero-cost structure.


------------------------------------------------------------------------------------------------------------
2-YEAR CAPS

Strike Rates 11.50% 14.50%
Bid Offer Bid Offer

Premium Cost 248 272 79 98
(In basis points)
------------------------------------------------------------------------------------------------------------

2-YEAR FLOORS

Strike Rates 11.50% 14.50%
Bid Offer Bid Offer

Premium Cost 74 95 352 375
(In basis points)
------------------------------------------------------------------------------------------------------------

Based on Figure above, a corporate could buy a 2-year cap with a strike of 14.50% and
pay 98 basis points and sell a 11.50% floor and receive 74 basis points. Collars are most
suitable for those treasurers, which hold the view that interest rate could rise in the
foreseeable future, but where a small increase in rates would still be acceptable to them.
If the 3-month LIBOR rate rises above the cap's strike of 14.50 %, the borrower will
receive the difference between 3-month LIBOR rate and 14.50%. If the 3-month LIBOR
rate falls below the strike of 11.50%, the borrower will pay the difference between 3-
month LIBOR rate and 11.50%, applied to the notional amount of the collar agreement,
to the holder of the floor agreement.

If the 3-month LIBOR rate remains between 11.50% and 14.50%, no payment is made
under the collar agreement. Therefore, the borrower benefits from falling interest rates to
a level of 11.50% and is protected from rising interest rates beyond 14.50%.

It has to be kept in mind that collars are often structured with a higher cap strike rate than
initially envisaged by a borrower, for the simple reason to make them less expensive.
Unfortunately, the resultant protection is not as tight when interest rates start to rise.
Page 218

Type of Caps and Floors

Digital Cap

In the case of a digital cap/floor, there is a predetermined payoff. An example is the best
way to explain a digital cap.

If a cap is agreed to have a strike of 5%, then the payoff if the market rate exceeds the
strike must also be agreed.

If the market exceeds the strike by 50 basis points or by one basis point, then the agreed
payout must be made to the counterparty.

In the case of a digital cap, the buyers upside is limited, but guaranteed.
Similarly, the seller’s downside is limited.

Chooser Flex

Like any cap, a chooser flex based cap is made up as a series of caplet, the first caplet
being excluded.

In a chooser flex, the cap holder must choose which caplets to receive a payout in, and
the number of caplets in which a payout can be received is limited in advance.
For example, a 10-year euro cap, with an annual frequency will have 9 settlement
periods.

In a chooser flex, the user will have the option to exercise in only 4 of the 9 periods.

Auto Flex

An auto flex cap or floor is similar to a chooser flex in that the number of periods in
which payment will be received is limited.

However in the case of an auto flex, the periods in which payment will be received is
determined by a specified formula i.e. – if the cap is in the money by 20 b.p., then it
should be exercised.


Advantages and Disadvantages of Caps and Floors:

Major advantages of caps and floors are that the buyer limits his potential loss to the
premium paid, but retains the right to benefit from favorable rate movements. The
borrower buying a cap limits exposure to rising interest rates, while retaining the
potential to benefit from falling rates. An upper limit is therefore placed on borrowing
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costs. Conversely, an investor buying a floor limits his exposure to falling interest rates,
whilst retaining the potential to benefit from rising rates.

Caps and floors are highly flexible and versatile in that notional amounts, strike rates and
expiry dates can be structured in a way that can provide tailor-made solutions for clients.
Caps and floors are also highly suited for hedging contingent future commitments.

Major advantages of caps and floors are that the buyer limits his potential loss to the
premium paid, but retains the right to benefit from favorable rate movements.

Interest rate option products are highly geared instruments and, for a relatively small
outlay of capital, purchasers can make considerable profits. At the same time, a seller
with a decay strategy in mind (i.e. where he would like the option's value to decay over
time so that it can be bought back cheaper at a later stage or even expire worthless) can
make a profit amounting to the option premium, without having to make a capital outlay.

The disadvantages of both caps and floors are that the premium is a non-refundable cost
which is paid upfront by the buyer, and the negative impact of an immediate cash
outflow. Caps and floors can theoretically lose all their value (i.e. the premium paid) if
they expire out-the-money or start to approach their expiry dates. In addition, there are
high potential losses for writers (sellers) of option-type interest rate derivatives if market
movements are contrary to market expectations. Also, it needs to be kept in mind that the
bid/offer spreads on most option-type interest rate derivative products are quite wide.

Swaps

A swap is an exchange of one or more market variables/financial assets (interest rate
/coupon payments/ currencies etc.) between two parties on a specified principal amount
in a contractual manner.
This is an OTC agreement, and so can be customized to the requirements of the parties
involved. Swaps are financial products that are used to alter the exposure of investment
portfolios, or any series of cash flows.

Why Use Swaps?

Corporate treasurers use swaps to hedge against rising interest rates and to reduce
borrowing costs. Among other applications, swaps give financial managers the ability to:

Convert floating rate debt to fixed or fixed rate to floating rate
Lock in an attractive interest rate in advance for a future debt issue
Position fixed rate liabilities in anticipation of a decline in interest rates
Arbitrage debt price differentials in the capital markets
Financial institutions, pension managers and insurers use swaps to balance asset and
liability positions without leveraging up the balance sheet and to lock-in higher
investment returns for a given level of risk.

Financial Benefits Created By Swap Transactions
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A company with the highest credit rating, AAA, will pay less to raise funds under
identical terms and conditions than a less creditworthy company with a lower rating, say
BBB. The incremental borrowing premium paid by a BBB company, which it will be
convenient to refer to as a "credit quality spread", is greater for fixed interest rate
borrowings than it is for floating rate borrowings and this spread increases with maturity.

The counterparty making fixed rate payments in a swap is predominantly the less
creditworthy participant.

Companies have been able to lower their nominal funding costs by using swaps in
conjunction with credit quality spreads.

Financial swaps can be broadly classified into

Interest Rate Swap (IRS)
Single Period IRS
Multiple Period IRS
Currency Swaps
Asset Swaps

Interest Rate Swap (IRS)

Single Period IRS – Forward Rate Agreement

A forward rate agreement (FRA) is a contract between two parties to exchange interest
(coupon) payments on a specified notional principal amount for one future period of
predetermined length. Only interest flows are exchanged and no principal is exchanged.
In FRA one party pays fixed and the other party pays floating. An FRA is essentially a
short-term, single period interest rate swap.

It is an agreement to fix a future interest rate today, for example the 6 month LIBOR rate
for value 3 months from now (a 3 X 9 FRA in market terms). When the future date
arrives, in this case after three months, the FRA contract rate is compared to actual
market rate e.g. 6 months LIBOR. If market rates are higher than the contract rate, the
borrower/FRA buyer receives the difference; if lower, he pays the difference. For the
lender /FRA seller, the FRA flows would be the reverse of it.

Take an example. Company A enters into FRA with bank B, which entitles company A to
borrow $ 1 million three months from now for a period of six months at a rate of 6%.
This contract is binding on both the parties. Three months from now, rate for six months
borrowing is suppose 8%. Still as per the FRA company A has the right to borrow at 6%
and bank is obliged to lend at 6%. As per the terms of FRA, company A stands to gain
2% on $ 1 million for six months since in the absence of this agreement company A
would have borrowed at 8% - the market rate for six month borrowing. At the beginning
of three months, when borrowing was supposed to begin, company A knows that by the
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end of next six months, it stands to gain 2% * $1,000,000 * 6/12 = $10,000 if it takes the
loan. Bank B also knows that having entered into this FRA it stands to lose $10,000 by
the end of next six months since otherwise it may have lent the same money at 8%
instead of agreed 6%.

Since both parties can determine the quantum of gain/ loss at the end of six months, in
most cases, the exchange of the monies takes place at the beginning of the FRA period
itself when the market rate for borrowing is known. Settlement happens at the present
value of the amount receivable/ payable. In the above example, FRA will be settled at the
end of third month i.e. at the beginning of the borrowing period and the settlement
amount will be $10,000/(1.04).

Multiple Period IRS

A multiple period interest rate swap is a contractual agreement between two parties to
exchange a stream of interest (coupon) payments on a specified notional principal amount
for a specific term. The principal amount is called notional because there is no actual
exchange of this amount; it is only used for calculating interest payments. In a generic
interest rate swap one party pays fixed and the other party pays floating. This exchange
allows for conversion of variable rate funding to fixed rate exposure or fixed rate funding
to variable rate exposure. The fixed swap rate is a market rate that approximates
investment grade fixed rate borrowing levels. The floating rate is a short-term market rate
based on a specific money market index (i.e., LIBOR).

Exchange of payments occurs at preset payment dates over a specified term (i.e., semi-
annual payments for five years). Exchanges of net amount reflect differences between the
fixed rate and each period's floating rate. The fixed and floating payments usually are
netted and the counterparty owing the difference pays the net amount on the payment
date.


5% Fixed

LIBOR


In the above diagram Company A and Company B enter into a swap agreement such that
Company A pays floating rate (LIBOR) and Company B pays a fixed interest rate of 5%.

Role of Financial Intermediary

Corporates generally do not enter into a swap agreement directly between themselves but
do so with the help of a financial intermediary (i.e. Banks). The financial intermediary
interposes itself between the corporates initiating swaps and corporates providing
offsetting cash flows or returns and earns an interest rate profit under the swap
agreement.

Company A

Company B
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This can be represented as follows:


4.985% 5.015%

LIBOR LIBOR


Conventions used in a Swap agreement

Contract Amount (CA): Amount representing a face value or principal amount, in a
specific currency.

Settlement Rate (SR): Interest rate in the market on each settlement date, based on an
index (for example, LIBOR, Federal Reserve Funds, PRIME, Treasury Bills).

Contract Rate (CR): Fixed rate agreed to at the inception of the contract. This rate
replaces the coupon rate.

Time Calculation for the Variable Rate (TCV): Time ratio used to calculate the variable
amount; for example, actual days/ 365

Time Calculation for the Fixed Rate (TCF): Time ratio used to calculate the fixed amount

Rate Determination Dates: Dates on which rates are to be determined; these dates are
usually at the beginning of each period

Settlement Dates: Dates on which payment is to be determined; these dates are usually at
the end of each period

Trade Date: Date on which swap agreement is entered into

Effective Date: Date when the initial fixed & floating payments begin. Effective Date is
also called Value Date. If effective date is after two days of the trade date, it is called a
spot date. The maturity of a swap contract is computed from the effective date

Reset Date for the applicable LIBOR: For each period it is to be determined before the
date of payment

Generally for the first payment, LIBOR rate applicable will be set at the trade date
The first reset date will generally be 2 days before the 1st payment date.
The 2nd reset date will be 2 days before the 2nd payment date…and so on.

Maturity Date: The date on which the interest accrual stops

Company A Financial
Intermediary
Company B
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Day Count Conventions: In swaps, the fixed & floating payments are generally netted
against each other. The amount that both parties have to be paid is calculated based on
the day count conventions.

Generally followed conventions in the order of commonality are:

Fixed Floating
30/360 Actual/360
Actual/Actual Actual/Actual
Actual/360 Actual/365
Actual/365 30/360

Payment Day Conventions: When the payment day falls on a bank holiday, there are
three methods for finding payment day

Modified following Business day: Payment day will be next business day
If next business day falls in the coming month, preceding day will be the payment day

Following Business Day: Payment day will be the next business day, even if the next
business day is falling the coming month

Preceding Business Day: Payment day will be the preceding business day

Who Pay’s Who?

The value of the settlement rate and contract rate on the rate determination date
determines which party pays and the amount of the payment. In general, interest rate
payments are usually netted and only the difference is paid to one party or the other. If
settlement rate (SR) is greater than contract rate (CR) on any rate determination date, the
Company A pays Company B the following amount on the corresponding payment
settlement date:
CA x (SR x TCV - CR x TCF)

On the other hand, if CR is greater than SR on the rate determination date, Company B
pays Company A the following amount on the corresponding payment settlement date:

CA x (CR x TCF - SR x TCV)
Trade Date 1
st
Reset Date 2
nd
Reset Date

Value Date 1
st
Payment Date 2
nd
Payment Date



10/6 12/6 10/12 12/12 10/6 12/6

Currency Swaps
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Interest rate swaps in different currencies involving the exchange of principal amounts at
inception and at maturity are called currency swaps. In other words a currency swap
involves the exchange of payments denominated in one currency for payments
denominated in another. Payments are based on a notional principal amount the value of
which is fixed in exchange rate terms at the swap's inception.

Periodic swap payments are made in the appropriate currencies based on specified
reference interest rates. When the swap matures, a final payment representing the change
in the value of the swap notional principal is made between parties to the swap.
Alternatively, the principal values can be re-exchanged at maturity at the original
exchange rate.

Because currency swaps involve exchange risk on principal, the credit risk associated
with these transactions is substantially greater than with interest rate swaps.

Types Of Currency Swaps

Fixed / Floating
Fixed / Fixed
Floating / Floating

Fixed Versus Floating

A popular form of currency swap exchanges a fixed payment stream for a variable
(floating) payment stream, similar to the standard interest-rate swap. In the Figure, the
borrower pays the bank 5% EUR fixed and receives 6-month USD LIBOR.


FIXED


FLOATING

Fixed Versus Fixed

In a fixed / fixed currency swap, two fixed-rate payment streams are exchanged. In
Figure, we illustrate such a swap. Here, the borrower pays the bank 3% JPY fixed and
receives 6% USD fixed from the bank. Such transactions are generally triggered by
comparative advantage in borrowing in different markets.

FIXED

FIXED



Borrower

Bank

Borrower

Bank
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Floating Versus Floating

The simplest currency swap for a bank to hedge is one in which both payment streams are
based on floating-rate indices. (Recall that LIBOR, PRIME, Treasury Bills, and other
indices are used as market settlement rates.) In Figure, it is common to have a spread
above or below one or both indices (for example, JPY LIBOR + 1%).


FLOATING


FLOATING

Floating /Floating + Interest-rate swap

The currency swaps that we’ve described above (i.e. fixed / floating, fixed /fixed, or
floating / floating) may be viewed as the combination of a floating / floating currency
swap with one or two interest-rate swaps. This is an important concept because it allows
bankers and their customers more options to achieve a single end.

Example:
Suppose a borrower wants to exchange 5% fixed EUR for 6-month USD LIBOR with a
bank.

5% EUR Fixed

6-Month USD LIBOR



EUR LIBOR 5% EUR Fixed

6Mon EUR LIBOR
USD LIBOR

Floating/Floating Currency Swap EUR Interest-rate Swap
Float




5% EUR Fixed

6-Month USD LIBOR



Borrower

Bank
Bor
r
o
w
e
Ba
n
k
Bor
r
o
w
e
Ba
n
k
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Cross currency Swap
Asset swaps

Asset-based Swaps usually refers to an interest rate swap agreement where the fixed-rate
payer holds a bond whose coupon rate is reflected in the swap terms. The expression may
also describe any swap initiated by the holder of an asset that generates the payment
stream on one side of the swap. If the fixed rate reflects the coupon on a specific bond,
there may be a one-time principal payment at the beginning of the swap to show that the
coupon on the designated asset is different from the swap rate for the term of the swap.
Depending on the swap terms, the credit risk of the underlying asset can be the
responsibility of either party. Asset Swaps are linkage of a swap and one or more
securities positions.








Coupon or return stream
from the underlying asset




FIXED RATE
The fixed-rate payment is
usually based closely on the
coupon or (occasionally)
return of the underlying asset

FLOATING RATE
LIBOR or another reference index rate plus or minus a spread


Swaptions

Swaptions was first introduced into US market in the mid-1980s to protect callable bond
risk. Often borrowers were issuing callable bond offering high yield, but they were
required to enter into an Interest Rate Swap transaction if they wanted to change interest
rate profile from fixed to floating. Swaptions are then required by the issuer as protection
to terminate all or part of the original interest Rate Swap in the event of the bonds being
put or called.
Swaption or swap option is an option to enter into a swap, generally an interest rate swap.
It is traded Over The Counter. Since Swaption is a kind of option the Swaption buyer has
to pay premium to the seller. In exchange for an option premium, the buyer gains the
Underlying Fixed-Rate Asset
(Basic instrument underlying
the asset swap)
Payer/Investor
(Payer of Fixed Rate)
Receiver

(Receiver of Fixed Rate)
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right (but not the obligation) to enter into the specified swap agreement with the issuer on
a specified future date at specified terms.

The primary purposes for entering into a swaption are:
- To hedge call or put positions in bond issues
- To change the tenor of an underlying swap
- To assist in the engineering of structured notes
- To change the payoff profile of the firm

Types of swaption.

There are two types of swaption.

Payer swaption - the buyer of “Payer Swaption” has the right but not the obligation to
enter into an Interest Rate Swap where he PAYS fixed rate and receives FLOATING.
The buyer will therefore benefit if rates RISE. The initial cost of the Swaption is the
premium, and this is the most the buyer can lose. Once purchased the Payer swaption will
have a minimum value of zero.

The Payer Swaption behaves like a CAP. Where CAPS reference the short end of the
yield (3 and 6 months), the Payer Swaption references the longer part of the yield curve,
2 yrs to 10 yrs.

Example

An Investor believes that the 5-year yield in USD will be higher than implied in one year
but is unwilling to enter a Pay Fixed Swap as they wish to limit their potential loss. They
can BUY a Payer Swaption. This will give them the right to pay fixed under a 5 year
Swap in one year. The strike rate is the rate at which the Swap will take effect. If rates
rise above the strike rate, the client will choose to enter into the Swap, paying Fixed at
the strike level. This deal could then be closed out at a profit or allowed to run as a Swap.
Should 5-year rates be lower than the strike at maturity, the investor will choose not to
pay Fixed under the Swaption as they can do so in the market at a more attractive rate.

Pricing

The Premium of Payer Swaptions depends on the following:
a) Higher Volatility of the underlying interest rate, higher the premium
b) Longer tenor of option, higher the premium
c) Lower strike rates are more expensive than higher strikes

Target Players
Speculators – The investors who believe rates will rise, but are unwilling to enter into
swaps.

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Hedgers - Borrowers with floating rate debt may wish to buy Payer Swaptions, which
will convert their liability from floating to fixed when rates rise above the strike. This
strategy is similar to a CAP, but under a CAP the borrower remains floating but with a
guaranteed maximum level, here the liability is converted to a fixed rate.

Advantages: Limited loss potential (only premium can be loosed)

Disadvantages: Premium payment required upfront

Receiver swaption- Buyer of “Receiver Swaption” has the right but not the obligation to
enter into an Interest Rate Swap where the buyer RECEIVES fixed rate and pays
FLOATING. The buyer will therefore benefit if rates FALL. The initial cost of the
Swaption is the premium, and this is the most the buyer can lose. Once purchased the
Receiver swaption will have a minimum value of zero.

The Receiver Swaption behaves like a Floor. Where Floors reference the short end of the
yield curve, (3 and 6 months), the Receiver Swaption references the longer part of the
yield curve, 2 yrs to 10 yrs.

Example

An Investor believes that the 5-year yield in USD will be lower than implied in one year
but is unwilling to enter a Receive Fixed Swap as they wish to limit their potential loss.
They can BUY a Receiver Swaption. This will give them the right to receive fixed under
a 5-year Swap in one year. The strike rate is the rate at which the Swap will take effect. If
rates fall below the strike rate, the client will chose to enter into the Swap, receiving
Fixed at the strike level. This deal could then be closed out at a profit or allowed to run as
a Swap. Should 5-year rates be higher than the strike at maturity, the investor will choose
not to receive Fixed under the Swaption as they can do so in the market at a more
attractive rate.

Pricing

The premium of Receiver Swaption depends on the following:
(a) Higher Volatility of the rate leads to higher premium,
(b) Longer tenor of option leads to higher premium,
(c) Lower strike rates are less expensive than higher strikes

Target Players:

Hedgers: Investors with floating rate assets may wish to buy Receiver Swaptions, which
will convert their assets from floating to fixed when rates fall below the strike. This
strategy is similar to a Floor, but under a Floor the investor remains floating but with a
guaranteed minimum level, here the asset is converted to a fixed rate.

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Speculators: Investors who believe fixed rates will fall, but are unwilling to enter into
Swaps.

Advantages

Limited loss potential (only premium can be loosed)

Disadvantages

Premium payment required up front

Though some people prefer to say ‘call swaption’ for payer swaption and ‘put swaption’
for ‘receiver swaption’ it is easier to use and understand the terms payer swaption and
receiver swaption.

Pricing Models

The market standard tool for pricing swaption is to simulate the route taken by the
modified Black model. This is because of its ease of use and market acceptance.
However, the modified Black formula has been subject to extensive criticism from
various sources over the years. Newer models, such as the Ho-Lee, Heath-Jarrow-Merton
and Hull-White models, are called arbitrage-free models and are designed to avoid
arbitrage possibilities due to changes in the yield curve.

Are there risks associated with swaption?

Yes. The primary risk with a Swaption occurs after a buyer has exercised his right and
proceeded with the Swap. Should interest rate movements be different than buyer
expectations, the Swap may have the opposite effect compared to what he was trying to
achieve with the transaction. He can however reverse or terminate the Swap should this
happen.

It is also important to note, that if interest rates do not rise above the interest rate
nominated in the Swaption on the exercise date, you have not obtained any benefit from
the premium paid for the purchase of the Swaption. The premium is the cost of obtaining
protection against a rise in interest rates.

Conclusion

Swaptions can be used as an effective tool to swap into or out of fixed-rate or floating-
rate interest obligations, according to a treasurer's expectation on interest rates. Swaptions
can certainly also be used for protection if a particular view on the future direction of
interest rates turned out to be incorrect. Evidently, treasurers with a target interest rate
different from current levels could find swaption complementary to their range of useful
interest rate hedging instruments.

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Using swaption in this way should not be seen as 'gambling'. A treasurer, who does not
make use of hedging tools such as swaption, when they are available, should rather be
seen as gambling if he leaves his company exposed to future unpredictable movements in
interest rates. Unfortunately for them, treasurers are no longer able to hide behind
excuses such as 'volatile interest rates' when taken to task for high borrowing costs. In
fact, treasurers can prudently manage interest costs by using swaption.

Warrants

Warrants are “securitized” options. All the features we talked about “options’ hold good
for warrants too. Though for academic purpose warrants and options are same there are
some differences between them.


Options Warrants
Options are listed on options exchange. Warrants are written by a third party, usually
financial institution.

Very less credit risk as they are offered
by the Exchange
Exposed to the credit risk of the Warrant
issuer.


Credit Derivatives

In previous chapters we have seen how market risk can be isolated and transferred by use
of derivatives. Worries of an investor, however, go beyond market risk. Buyer of a bond
issued by corporation ABC does face the possibility that market value of the bonds may
fall if interest rate moves up (remember the inverse relationship between interest rate and
price of bonds?). What happens if interest rate moves down? Investor stands to make a
capital gain. What happens if interest rate remain stable but borrower is downgraded or
becomes insolvent? Price of the bond will still fall may be close to zero, in case of
potential bankruptcy. This risk has nothing to do with interest rate movement in the
market. This risk is specific to the issuer and is called credit risk. According to Basel
Committee, “Credit risk is most simply defined as the potential that a borrower or
counterparty will fail to meet its obligations in accordance with agreed terms”. How does
the investor protect himself against this risk?

Just as market risk and interest rate risk can be transferred by use of derivatives, credit
risk can also be isolated, transferred and managed by use of credit derivatives. Effective
management of credit risk implies retaining only that part of credit risk, which a lender
wants to retain, and transferring the rest to someone who wants to acquire that risk,
obviously in exchange for a price/fee. These are privately negotiated over-the-counter
(OTC) contracts. Management of credit risk is essential for improving the stability and
efficiency of credit institutions and consequently the whole financial system. One of the
prominent developments in the mid 1990s was emergence of credit derivatives, used for
transferring credit risk.

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Market Overview

The Credit Derivatives market has grown at a phenomenal rate over the last few years.
According to “Credit Derivatives Report” published by the British Bankers’ Association
(BBA), the global credit derivatives market increased in size (measured by notional
amount outstanding) from around US$ 50 billion in 1996 to an estimated US$ 3 trillion at
end-March 2003, with the market size estimated to have reached US$ 4.8 trillion by the
end of 2004 and projected to reach US$ 6.5 trillion by the end of 2005 (See Chart 1).

The credit derivatives market comprises buyers of protection, seeking to hedge credit risk
of their assets and sellers of protection, usually looking to diversify an existing portfolio.
The biggest participants in the market for credit derivatives are large commercial banks,
securities firms and insurance/reinsurance companies. While banks and securities firms
act both as sellers and buyers of protection, insurance companies are primarily protection
sellers. Other participants include hedge funds and non-financial companies as buyers of
protection and pension funds and mutual funds as sellers of protection. Institutions and
corporations have different requirements and motives to assume, reduce or manage credit
exposures.

Credit Default Swaps

Credit Default Swaps (CDS) are the most important and widely used single-name
instrument in the credit derivative market. The CDS has become the standard credit
derivative serving as the building block for many complex multi-name products.
According to the British Bankers' Association (2000), CDSs account for about 60 percent
of the global credit derivatives market in terms of notional amounts outstanding.

A CDS is a bilateral financial contract that enables an investor (protection buyer) to buy
protection against the risk of default of an asset (reference obligation) by the issuer
(reference entity). The counterparty providing this protection, the buyer of credit risk, is
called protection seller. The protection buyer pays to the protection seller a fee or
premium, typically expressed as an annualized percentage of the notional value of the
transaction and paid either upfront, quarterly or semiannually over the life of the contract.
The agreed compensation (usually the face value of the bond)) is paid by protection seller
to the protection buyer after certain pre-specified events (credit event) occur. Until a
credit event occurs the protection seller continues to receive the periodic
payment/premium from the protection buyer. This is represented by the following
diagram:
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Figure -












Settlement of Credit Default Swaps

There are two types of settlement methods that can be structured for a CDS.

Cash Settlement – A percentage of notional amount is paid by the protection seller to the
protection buyer upon occurrence of a credit event. This percentage is decided by a
calculation agent after polling dealer, usually a pre-designated number of days after the
credit event. Ownership of the reference asset remains with the protection buyer.
Counterparties can also fix the contingent payment as a predetermined sum, known as a
“binary” settlement.

Physical Delivery – Protection buyer transfers the ownership of reference asset to
protection seller, who in turn pays notional value to the protection buyer. against payment
by the protection seller of its face value in cash. Under this arrangement, the protection
buyer receives the full notional amount, whilst the protection seller owns the reference
asset, and can pursue all remedies available to recover funds.


A Credit Default Option is a kind of Credit Default Swap where the protection buyer
pays the fee fully in advance.

An example may help illustrate how the deal is structured and payments take place.
Market makers in CDS offer two-way quotes. They are ready to buy protection at the bid
rate and sell protection at the offer rate (as mentioned earlier, in basis points). Typical
quote could be as follows:

Table –
Credit default swap quotes (basis points)
Maturity
Company Rating 1 year 3 years 5 years
Reliance Ind. AA 15/22 25/33 30/36
General Motors A 19/24 29/38 35/42

Protection Buyer
(Credit Risk Seller)

Protection Seller
(Credit Risk Buyer)
Reference Asset
Premium/Fee (basis points)
Contingent payment on credit
event
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Sony Corp. AAA 10/12 16/24 23/28
United Airlines BBB 23/28 32/39 40/47

You can see that higher the rating lower the rates quoted and longer the tenor higher the
rates quoted. Can you reason why?

Company ABC buys protection on 6% General Motors bond for next three years on USD
100 million notional amount (face value). If credit event occurs after 2.5 years the
payments will be as follows:

Year Payment from ABC
to dealer (USD in
million)
Payment from
Dealer to ABC
(USD in million)
1 0.38 Nil
2 0.38 Nil
3 0.19 103

ABC pays agreed fee until the credit event occur. On occurrence of credit event, ABC
transfers the underlying asset, General Motors bonds, to the dealer and dealer pays to
ABC notional amount and the accrued interest. If it were to be settled in cash and
calculation agent arrives at a value of USD 35 (face value USD 100), dealer would pay
(100-35)% of notional value i.e. USD 65 million to ABC. Ownership of bonds remains
with company ABC.

Credit default swap can be structured around a basket of underlying assets issued by
multiple reference entities. If pay-off is made when any of the reference entities default
and protection against default by other reference entities in the basket continues, it is
called add-up basket credit default swap. If the agreement ends with the first pay-off
subsequent to the first default by any reference entity in the basket, it is called first-to-
default basket credit default swap. A Fixed-amount basket credit default swap provides
protection on a basket (group) of reference entities but only up to a certain maximum
amount. For example, if the basket contains 5 reference entities all for an amount of
$20m and the maximum coverage is $30m; once notional principal in default reaches this
value, the credit default swap ceases to exist and the protection buyer will have no further
recourse to the protection seller.

Topic for further exploration: How do you price a credit default swap?
Hints: You need to consider the following factors – life of credit default swap, probability
of default, expected recovery on default, risk free interest rate, coupon rate of the bond.
Refer to our website for further explanation and mathematical derivation of pricing credit
default swap.

Total Return Swaps

A Total Return Swap (“Total Rate of Return Swap” or “TR Swap”) is also a bilateral
financial contract designed to transfer credit risk between parties, but a TRS is distinct
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from a Credit Default Swap in that it exchanges the total economic performance (coupon
payments, interest, and capital gains and losses in case of bonds) of a specified asset for
another cash flow. That is, payments between the parties to a TR Swap are based upon
changes in the market valuation of the reference asset, irrespective of whether a credit
event has occurred. Capital gains/ loss could be exchanged either on every reset date or at
expiry. The final payment could be done in cash or by physical delivery.

This is represented by the following diagram:

Figure -













Let us see how it works. Company ABC agrees to pay total return on a 6% General
Motors bond paying semi-annual coupon with a notional principal of USD 100 million in
exchange for LIBOR+50 bps for two years. Company ABC is the total return payer and
shall pay (receive) the following amounts:

Table -
Period Market
price of
bond
Pay
Coupon
(USD
million)
Pay
Capital
gain (USD
million)
LIBOR* Receive
LIBOR +
50 bps
Total amt
to (pay)/
receive
(USD mil)
0 90 - - 5.5% - -
1 92 3 2 5.0% 3.00 (2.00)
2 95 3 3 5.2% 2.75 (3.25)
3 94 3 (1) 5.6% 2.85 0.85
4 91 3 (3) 3.05 3.05
* - LIBOR is set on one coupon date and paid on the next.

If there is default on the bond, contract is terminated and receiver makes the closing
payment based on the market price i.e. difference between the prevailing market price
and the previous reset price.

The TRS is a primarily off-balance sheet financing vehicle in which the total return payer
effectively transfers credit risk on the reference asset for the term of the TRS without
Total Return
Payer (Credit
Risk Seller)
Total Return
Receiver
(Credit Risk
Buyer)
Reference
Asset
Total Return of Asset (plus
any positive MTM amounts)
Libor + Spread (plus any negative
MTM amounts)
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selling the underlying asset. In contrast to Credit Default Swaps, which only transfers
credit risk, the TRS also transfers the market risk (i.e. any increase or decrease in general
market prices).


Credit Spread Options

A Credit Spread Option is an option contract in which exercise of option is based on a
particular credit spread or the price of a credit risk sensitive asset e.g. bonds. Credit
spread is the difference between the yields of a particular bond and a specified Treasury
bond, bond index or LIBOR of similar maturity. Since Treasury debt is classed as risk
free, the credit spread provides a measure of the compensation to the investor for the risk
of default on the underlying security. Typically the contract ends on default.

This reference asset may be either a floating rate note or a fixed rate bond via an asset
swap. As with standard options, one must specify whether the option is a call or put, the
expiry date of the option, the strike price or strike spread, and whether the option style is
European (single exercise date), American (continuous exercise period), or Bermudan
style (multiple exercise dates).

The two types of credit-spread options are:

Call options - where the buyer has the right but not the obligation to buy the spread and
will therefore benefit from a decreasing or tightening spread.

Put options - where the buyer has the right but not the obligation to sell the spread and
will therefore benefit from an increasing or widening spread.

A credit spread call option would look like:









The buyer of the option pays an up front option premium but in some cases can be
converted into a schedule of regular payments, in return for the seller’s agreeing to make
a lump sum payment in the event the reference entity’s credit spread crosses the strike on
the option. In other words the contingent payment depends on whether the actual spot
credit spread at the exercise date of the option is over or under the strike spread of the
reference asset.

Collateralised Debt Obligations (CDOs) and variations

Credit Option
Seller

Credit Option
Buyer
Max [0, Strike Spread – Credit
Spread]
Option Premium
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A collateralized debt obligation (CDO) is a fixed income security whose cash flows
(interest and principal payments) are backed by a pool of debt instruments such as a
diversified pool of loans or a portfolio of bonds. CDO is issued to the investors by a
special purpose vehicle (SPV). Issue proceeds received by the SPV against the issue of
CDO (a fixed income instrument) is used to purchase the portfolio of loans/ bonds. SPV
receives the interest and principal paid by instruments in the purchased portfolio. Cash
flow received from the underlying loan or bond portfolio is what gets paid to the CDO
buyer (with some adjustments). The portfolio acquired by SPV acts as a collateral for
future payments to CDO buyers. Hence the name Collateralized Debt Obligation. The
debt instruments held by the SPV may be bonds, loans, revolving credit facilities,
mortgage-backed securities, asset-backed securities, emerging market corporate and
sovereign debt, or other types of debt instruments. When the collateral is mainly made up
of loans, the structure is called a Collateralized Loan Obligation (CLO), and when it is
mainly bonds, the structure is called a Collateralized Bond Obligation (CBO). The
fundamental idea behind a CDO is that one can take a pool of credit risky bonds or loans
and issue securities whose cash flows are backed by the payments due on the loans or
bonds.

But why is CDO a credit derivative? CDO is a credit derivative because this structure is
used to transfer the credit risk (loss arising from the portfolio of loans/ bonds) from
owners of the loans/ bonds to buyers of CDO. Structure of CDO ensures that credit risk is
borne by buyer of CDO and not by the original holder of the debt instrument any more.
Let us see how this is done.

Out of the pool of underlying assets, the SPV creates different classes of securities, which
differ in their right over the cash flows received from the pool. These are called tranches
and are ordered so that in the event of a default, the loss of principal and/or interest
incurred on the collateral are absorbed by the first level tranche, before affecting the
higher-level tranches.

Example of collateralized debt obligations (CDOs)














Assets
US$ 100 million


Portfolio of loans, bonds or CDS
– either purchased in secondary
market or from the balance sheet
of a commercial bank
Special Purpose Vehicle

Liabilities – CDOs
US$ 100 million

Senior tranche US$70 million
Mezzanine tranche US$20 million
First loss tranche US$10 million
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In this example the first loss of USD 10 million arising from defaults from the underlying
pool of loans/ bonds is borne completely by the buyers of securities of first loss tranche.
In case the total loss is USD 20 million, buyers of first loss tranche lose entire principal
and buyers of mezzanine tranche lose half of the principal. It may be noted that buyers of
senior tranche would be affected only if default exceeds 30 percent. Thus, a single pool
of debt gets divided into securities having different credit risks. Senior tranche could be
sold as AAA security at a lower rate of interest whereas first loss tranche will have to be
offered a higher rate of interest because of higher probability of default. In the process
credit risk is passed on to buyers of CDO. It is evident that weighted average rate of
interest promised on different tranches of securities cannot exceed weighted average rate
of interest on the underlying assets. Risk to which buyers of first loss and mezzanine
tranche are exposed to is dependent on the default correlation between the issuers of the
instruments in the portfolio. Lower the correlation, lower the risk (remember
Markowitz’s portfolio theory?) and higher the rating. CDO is analyzed based on default
correlation models such as Gaussian Copula model.

In the example above, portfolio of loan/bonds is purchased by the SPV by paying the
holders of loan/bonds the amount received from CDO buyers. This is a funded
transaction. Loss arising from future default is borne by CDO buyer. The underlying
purpose of this transaction is to transfer the credit risk from holders of bond/loan
portfolio to buyers of CDO. Same purpose can be achieved without actual sale and
purchase of loan/bond portfolio if only credit risk associated with the assets, not the asset
itself, is transferred to the SPV. This structure it called Synthetic CDO, which involves
following steps – a) originating bank purchases protection (credit default swap) from the
SPV on the underlying reference credits in return for the bank paying a premium to the
SPV, b) SPV issue tranches of securities just as in the case of CDO, c) SPV invests the
proceeds of selling securitized debt in risk free assets (such as treasury notes) which form
the collateral.

It has been explained earlier that return on any credit risky security (which has a some
probability of default) is a combination of risk free rate of return and a premium for credit
risk. In funded CDO, these two risks were bundled in the collateral owned by the SPV. In
Synthetic CDO both parts of return are separated – risk free return is earned from holding
of risk free assets and risk premium is earned through sale of credit default swap. The
CDO buyer is still exposed to the default risk on loan/bond portfolio without owning or
having a claim on the interest and principal of the underlying loan/bond portfolio.
Synthetic CDO, therefore, achieves the same objective without transfer of original
portfolio to the SPV. No exchange of funds takes place between the holder of the
loan/bond portfolio and the SPV. This is an example of unfunded CDO.

In another variation, Credit Linked Note (CLN) are used to transfer the credit risk of
party C to buyer of a bond or note (party A) issued by party B, often a bank. If there is a
default by C on the bond/note held by B, the loss will passed on to A. Thus, party A
assumes the risk of default on both B and C and received higher rate of interest as
compensation for bearing higher risk.
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Testing the concepts

1. You bought a straddle on GE at the strike price of $35 and paid a total premium of $8.
Your break-even price is $...
a. 27
b. 43
c. 35
d. 8
e. a or b
2. Vega in the context of options is related to
a. Strike price
b. Market price
c. Volatility
d. Interest rate
e. Time to maturity
3. You bought a Microsoft future at $55. If closing price on maturity date is $45, your gain
from the deal is $...
a. 10
b. -10
c. 55
d. 45
e. cannot be determined with given data
4. Which of the followings are correct
a. European style option: exercise on maturity date only
b. American style option: exercise any date on or before maturity date
c. Bermudan style option: exercise on specified dates
d. Buy put: right to sell at strike price
e. All of the above
5. Which statement best explains the principle of put-call parity in option pricing
a. At-the-money call option premium should be higher than at-the-money put
option premium
b. At-the-money put option premium should be higher than at-the-money call
option premium
c. At-the-money put option premium should be equal to at-the-money call option
premium
d. When put option is in-the-money, call option will be out-of-money
e. Strike price of put and call option cannot be the same
6. You bought a put option with a strike price of $60 by paying a premium of $4. If current
market price of the underlying stock in the cash market is $55, the intrinsic value of the
option is $...
a. 5
b. 4
c. 1
d. 0
e. 55
7. Based on the cost of carry principle of futures pricing, which of the followings should not
hold true
a. Higher the stock price in the cash market, higher the futures price
b. Higher the interest rate, higher the futures price
c. Longer the time till maturity, higher the futures price
d. Higher the volatility, higher the futures price
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e. Spot and futures prices should converge as maturity date approaches
8. Options can be used for
a. Speculation
b. Hedging
c. Arbitrage
d. Yield enhancement
e. All of the above
9. Which of the following statements about differences between futures and forward
contracts is not true
a. Futures are standardized, forwards are customized
b. Futures are created and traded on organized stock exchanges, forwards are OTC
derivatives
c. In Futures contract one may not know the counterparty, in a forward contract
counterparty is known
d. Futures can be used for speculation and hedging, forwards can be used only for
hedging
e. Futures are settled daily, forwards are settled on expiry
10. Which of the followings is not a characteristic of a Forward Rate Agreement
a. FRA is a short term, single period interest rate swap
b. Settlement is done on a net basis
c. Settlement generally occurs on the start date on PV basis
d. One of two parties is exposed to the risk of change in interest rate
e. Principal amount is exchanged on the start date and again on the maturity date
11. Which of the following pairs of transactions will produce identical gain/ loss if maturities
and underlying is the same
a. Buy FRA, Buy bond futures
b. Buy FRA, Sell bond futures
c. Buy FRA, Buy interest rate Cap
d. Buy Interest rate cap, Sell interest rate Floor
e. Buy interest rate floor, sell payer swaption
12. Which of the followings is not correct in their description of interest rate swap and
currency swap
a. Currency swap involves interest rate risk as well as currency risk while there is
no currency risk involved in IRS
b. Currency swap involves exchange of principal and interest, IRS involves
exchange of interest only
c. Fixed-Fixed currency swap is common, Fixed-Fixed IRS is not
d. Fixed-Floating currency swap is common, Fixed-Floating IRS is also common
e. Currency swap generally involves an intermediary, IRS is generally contracted
directly between the counterparties
13. An investor who wants to benefit from rise in the interest rate but wants protection
against fall in interest rate should
a. Buy interest rate cap
b. Sell interest rate cap
c. Buy interest rate floor
d. Sell interest rate floor
e. Sell FRA
14. The reduction of risk by eliminating the possibility of future gains or losses e.g. by
buying or selling forward and futures contracts is called
a. Arbitrage
b. Speculation
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c. Yield enhancement
d. Hedging
e. Credit risk containment
15. Which of the followings is not true
a. A call option seller is exposed to unlimited risk
b. A put option buyer is exposed to unlimited risk
c. A call option buyer is exposed to risk but limited to the loss of premium paid
d. A put option seller is exposed to large risk
e. Deeper in-the-money the option is, close the delta is to 1
16. A contract whereby one counterparty (protection seller) agrees to compensate another
counterparty (protection buyer) if a particular company or sovereign (the reference entity)
experiences one of a number of defined events (credit events) that indicate it is unable or
may be unable to service its debt, is called
a. Credit default swap
b. Credit takeover
c. Interest rate swap
d. Put option
e. Interest rate Floor
17. Which of the followings are credit derivatives
a. Collateralized debt obligation
b. Credit default swap
c. Interest rate Collar
d. a and b
e. a, b and c
18. If you feel that market price of stock A will be moving up which of the following
derivative transactions could generate profit
a. Buying a call option
b. Buying a put option
c. Selling a put option
d. Buying a Futures
e. a, c and d
19. Which of the followings is not an example of a derivative transaction
a. Selling a payer swaption by a speculator
b. Selling an index futures by a fund manager
c. Buying 3-months forward USD by an oil importer
d. Buying Infosys shares using borrowed funds by a speculator
e. Buying call option on Gold by a jewellery manufacturer
20. When a call option is transacted which of the followings hold true
a. Option buyer has right to buy the underlying at the strike price
b. Option seller is obliged to sell the underlying at the strike price
c. Option buyer pays premium
d. Option seller receives premium
e. All of the above







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Securitization

This chapter introduces the following concepts relating to securitization

Rationale of securitization
Listing assets eligible for securitization
Process of securitization
Types of securitization
Securitization and risk management


















Authors

Muralikrishna Y.
Chandrasekhar Kammula
Page 242
Introduction

Having studies references to securitization in different chapters, let us now take a look at
the topic in some more detail.

Securitization can be defined as a process of pooling of “homogeneous,” “financial”,
“cash flow producing,” “illiquid” assets (receivables on mortgage debts, leases, loans,
credit card balances etc.) and issuing claims on those assets in the form of marketable
securities to investors.

Expanding the definition a little more, we can say that this process involves:

Pooling and repackaging of homogeneous illiquid financial assets
Creating financial instruments that represent ownership interest which are often secured
by income producing assets
Transforming into marketable securities
Enhancing the credit status or rating of the instruments and finally,
Distribution to a broader range of investors

While the number and types of assets to be securitized could vary, the process of
securitization remains the same. Let us define the roles of different participants first.

Obligor: Obligor is the entity who owns the receivables and wants to get cash against
these future receivables. He sells the right to receive the future cash flows to the
Originator or the SPV created by the originator. In return for future receivables, the
obligor gets cash upfront.

Originator: Originator initiates a securitization transaction, mostly by acquiring a pool of
receivables from third parties. Originators include captive finance companies of the major
automakers, other finance companies, commercial banks, thrift institutions, computer
companies, airlines, manufacturers, insurance companies, and securities firms.

SPV (Special Purpose Vehicle): Is a legal entity formed with the special purpose of
acquiring and holding certain assets for the sole benefit of investors.

Underwriter: The underwriter is responsible for advising the seller on how to structure
the security, and for pricing and marketing it to investors. Underwriters are often selected
because of their relationships with institutional investors and for their advice on the terms
and pricing required by the market. They are also generally familiar with the legal and
structural requirements of regulated institutional investors.

Rating Agency: Rating agencies play a very critical role in the securitization process.
They help in assessing the credit quality of the transaction. The rating agencies review
four major areas:
• Quality of the assets being sold,
• Abilities and strength of the originator/servicer of the assets,
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• Soundness of the transaction’s overall structure, and
• Quality of the credit support.

Trustee/Agent: Entity to whom the responsibility is handed over by the SPV for
collection of funds at the beginning of the issue from the investors, and paying to the
SPV/Originator. The trustee services the issues, which means collecting the interest and
principal payments from the obligors either through the originator or SPV and paying the
investors. The trustee holds the security interest on the assets of the issue for the benefit
of the investors, and also maintains a general surveillance on the transaction.

Credit Enhancer : Credit enhancement is a method of protecting investors in the event
that cash flows from the underlying assets are insufficient to pay the interest and principal
due for the security in a timely manner. Credit enhancement is used to improve the credit
rating, and therefore the pricing and marketability of the security. As a general rule, third-
party credit enhancers must have a credit rating at least as high as the rating sought for
the security. Third-party credit support is often provided through a letter of credit or
surety bond from a highly rated bank or insurance company. Other internal methods of
using tranches on the basis of credit ratings of securities are also employed. Here the
junior classes of securities absorb the losses of default before the senior position’s cash
flows are affected.

Banker: Banker to operate the escrow account where the collections are deposited, where
the guaranteed re-investment contract will be maintained.

Investors: In the securitization market, investors mainly comprise of life insurers, fund
managers, pension funds and commercial banks. These entities buy the securities created
through the process of securitization.

The graphical presentation of securitization structure is as follows














Securitization Process

Identifying the assets to be securitized
Obligors
Asset
Originator
Credit
Enhancement
Provider
Special Purpose
Vehicle
Underwriter
Investors
Loan
Payments
Provides Loans
True sale of assets
Proceeds of rated securities
Fees
Credit Enhancement
Issuance of rated securities
Payment for rated securities
Issuance of rated securities Payment for rated securities
Obligors
Asset
Originator
Credit
Enhancement
Provider
Special Purpose
Vehicle
Underwriter
Investors
Loan
Payments
Provides Loans
True sale of assets
Proceeds of rated securities
Fees
Credit Enhancement
Issuance of rated securities
Payment for rated securities
Issuance of rated securities Payment for rated securities
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The company, which wants to obtain financing through securitization, has to first select
or identify the receivables/assets, which are to be securitized. The assets may be either
already generated or to be generated in future which are referred to as “receivables”.
Selection of the asset pool is done by the originator, through a system-based approach,
which could be based on homogeneity, empirical requirements, filters and optimizing
criteria. This typically involves filtering out unacceptable loans, ranking the remaining
loans by optimization criteria and sorting through them until the empirical requirements
are attained. For example, filtering can disqualify loans that are currently 30 days
overdue or doing an eligibility test on the asset pool based on due date, invoice type,
invoice country, currency etc. Concentration test is conducted to measure how much
exposure to one originator/obligor is already made, whether the same is within tolerance
limits.

Transferring asset to SPV

Selected assets are transferred to a legally independent entity, which may be either a trust
or a wholly owned subsidiary of the Originator known as Special Purpose Vehicle (SPV)
in return for payment of the purchase price of those assets. The originator may either
create the SPV or it could be a specialized company, offering SPV management.

The transfer can be in the form of

Novation: which terminates the contract between the Obligor and Originator and it
replaces with a new contract between the Obligor and SPV.

Assignment: it is construed as a sale as it effects the actual transfer of the title to the
receivables.

Subrogation: In this route, SPV pays the originator an amount in respect of the
receivables and through such payment is ‘subrogated’ the rights of the originator, i.e.,
SPV acquires the rights previously held by the originator in respect of the receivables.

This transfer is intended to separate the payment risk on the receivables from the business
risks associated with the Originator. Once the receivables are transferred to SPV, then the
SPV becomes the owner of the receivables. SPV is created in such a way that in the event
of bankruptcy of the originator, the SPV’s assets are not consolidated with the assets of
the Originator.

Issue of securities by SPV

To raise funds for purchasing the receivables, the SPV issues asset backed securities in
the capital markets to be repaid to the investors from the proceeds of the receivables. The
SPV uses the cash flows received on the receivables purchased from the originator to
repay investors in future. Since the SPV is characteristically made as ‘bankruptcy
remote, the investors concern lies really with the cash flows from the receivables rather
than with the originator’s financial condition.
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Credit Enhancement

The securities are often given the strength of credit enhancement (by way of financial
insurance and/or liquidity facility) to gain better rating and hence wider investors
acceptability as they cushion default /liquidity risks. The mechanism of SPV itself affords
credit enhancement, as the credit rating of SPV is often superior to that of the originator
on account of asset quality.

The alternative forms of credit enhancement which are followed in the market are:

Self-Enhancement techniques

Recourse held by seller: In this method the originator guarantees the SPV towards the
maximum amount of losses on the receivables.

Subordination: A “senior/subordinated” structure is created meaning that some creditors
agrees to grant priority to other (i.e., Senior) creditors in case of difficulties in payment in
exchange for different rates of return. One possible structure is for the originator to retain
a subordinated tranche but such structures create legal and regulatory questions as to
whether a ‘true sale’ of the asset has occurred.

Third party Enhancements:
Letter of Credit: A third party provides a letter of credit to the seller for any draw.

Cash collateral account: A cash deposit can be held in a special account, which allows
for payments in case of shortfall of cash from the receivables.

Over collateralization: The assets put into pool can be of greater value than is needed to
support the contractual payments

Financial Guarantees: Guarantor undertakes to pay scheduled principal and interest in the
event that the underlying obligor fails to do so.

Financial Reinsurance: It is commitment by one financial insurance company, the
‘reinsurer’, to reimburse another insurance company, the ‘ceding company’, for a
specified portion of the insurance risks undertaken by the ceding company on one or
more specified policies in consideration for a portion of the premium received for the
policy or policies being reinsured.

Rating of the Securities

The rating of asset-baked security evaluates credit, legal and structural risk.
Securitization rating addresses the credit quality of the securities being rated for their
whole term and implicitly addresses liquidity levels within structures while the rated
securities remain outstanding.
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Issue of Securities

The SPV issues securities, which are referred to as Asset Backed Securities (ABS).
These securities issued to investors represent the money value of their beneficial interest
in the pool of receivables.

Generally, Securities are privately placed with small group of dealers, who in turn sell in
the market. Investors buy the securities based on the Program rating and sponsorship. All
the information regarding the review/critiques is made available to investors in the form
of rating notes, information memoranda etc. The medium and long-term issues are put to
public debt markets through public issue.

The securities may be bifurcated into different tranches in terms of their level of risk to
meet different levels of investor risk appetite. High rated class meets the needs of the
risk-averse investors who do not mind a lower return on their investment. Given low
default risk and the low cost of structuring, the net spread on this slice of transaction (i.e.,
the difference between what is received from the borrowers or obligors of the loan and
what is paid to the investors subscribing to the securities backed by such loans) is high.
On account of possible loss in the subordinated tranches, it is usually subscribed to by the
originator itself. The inferior rating of the tranche B portion could be improved by way of
instilling financial guarantees into them, while subscription to the riskiest portion by the
originator lends more comfort to the investors of tranches A & B.

Thus, structuring ingenuity is a vital factor that influences the marketability of
asset/mortgage-backed securities. Ultimately both the issuers and investors must stand to
gain tangibly.

Repayment

This structure breaks investors into different tranches or different series of investors
based on the duration for which they would want to invest. The paying of principal and
interest to all the investors is based on the priorities of different class of investors. For
example, the A series or Senior Class of investors would be repaid the first – so the entire
principal collected, including the pre-paid principal, is first used to fully pay off the A or
Senior Class investors. Once A is fully retired, repayment of B series or sub ordinate
class starts. There may be as many sequential classes as required. The last in the list
would receive the payment right at the end of the transaction.

Servicing

Once a security has been determined and sold in the market, there has to be a way to
address the servicing the securities. The function of servicing may be either handled by
originator or SPV or delegated to the trustee (known as Servicer). The servicer is
responsible for collecting the payments from the originator and paying the same to the
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investors after deducting the service charges. The service charges may be transferred to
SPV (if the collecting party is not SPV) based on pre-defined rules.

The servicer also provides reports regarding new receivables added, collected, pending,
delinquent amounts, late charges etc. on account by account basis.

We have seen that Securitization helps originator in transferring the risk associated with
the credit and managing the asset portfolio proactively. It can provide the much needed
liquidity, churn the asset portfolio and create fresh assets by removing the sticky ones.
Through securitization, the originator can obtain a better price than through debt
financing. Regulatory requirement for keeping sufficient capital by banks towards non-
performing assets/bad loans were another reason for growth of securitization. By selling
their loans/assets to a separate special purpose vehicle banks could remove the sticky
assets from their balance sheets, in the absence of which they would have had to block
their capital towards these.

The rationale behind growing market for securitization can be understood in terms of the
benefits it provides to both the originator & the investor.

Benefits to originators:

Ability to sell assets readily: With securitization, the originator can sell his assets to the
SPV and realize the value. This is beneficial when the assets become bad or sticky.

Alternative investor base: Without changing the relationship with the existing obligors,
securitization extends the pool for more lending opportunity.

Improve return on capital: Can convert balance sheet lending items to off-balance sheet
income stream that is less capital intensive.

Lower borrowing costs: Depending on the type of structure used, securitization may also
lower borrowing costs, release additional capital for expansion or reinvestment purposes.

Increased servicing income: Originator can churn the portfolio of assets more number of
times under securitization, by which he can earn more on the same investment.

Serves as a risk management tool: Helps in managing credit risk & asset/liability
management

Benefits to Investors

High yields: Securitized instruments offer high yields with good rating. These products
have provided good spreads over the treasury products. Securitization allows investors to
improve their yields while keeping intact or even improving the quality of investment.

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Liquidity: As these investments are marketable securities, the liquidity on these securities
is high.

Good ratings: These securities typically are rated by professional credit rating agencies &
hence are more secure.

Few instances of default: History of securitization provides that there are incidents of less
defaults compared to other forms of debt.

Enhanced diversification: As the pool of assets contains large number of obligors and the
SPV being a separate entity involving number of originators, the risk is diversified.

The most common types of assets associated with asset-backed securities are auto loans,
credit card loans, and home equity loans, although there are dozens more classes of
assets, the number of which are growing as the market rapidly expands. Few of them are:

Real Estate loans
Trade account receivables
Credit card receivables
Aircraft leases
Equipment lease receivables
Bank loans
Intellectual property revenues
Tobacco litigation settlement rights
Commercial and residential mortgages
Real estate tax receivables
Healthcare receivables
Federal housing loan assistance subsidies
Private equity assets
Common and preferred stock
Oil and gas royalty overrides
Pipeline assets
Electric power contracts
Utility rate reduction bonds
Energy savings performance contracts
Insurance premium receivables
Government receivables

Characteristics of Assets

Some of the basic characteristics of an asset that could be securitized are:
Associated Cash Flow – The asset should necessarily involve cash flows of a certain
amount that would be received from a debtor at certain periods of time.

Homogeneity – The assets should be homogeneous typically of the same type or
origination methodology.
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Capacity - It must be possible for the necessary transactions which are needed for the
securitization to take place in relation to the assets concerned.

There are two broad categories of securitization:

Mortgage Backed Securities (MBS)
Asset Backed Securities (ABS)

Mortgage backed securities

These are securities, carved out of receivables backed by mortgage loans made by
financial institutions (savings and loans banks, commercial banks or mortgage
companies). As in the case of any securitization, mortgage securities are created when
these loans are packaged, or “pooled,” by issuers or servicers for sale to investors. As the
underlying mortgage loans are paid off by the homeowners, the investors receive
payments of interest and principal.

Types of MBS

Participation Certificate

The most basic type of an MBS is a pass-through security or participation certificate (PC)
and it represents a direct ownership interest in a pool of mortgage loans. This is created
when one or more mortgage holders bunch together a few mortgages. As the name
suggests, the issuer or servicer of pass-through securities collects the monthly payments
from the homeowners whose loans are in a given pool and “passes through” the cash flow
to investors in monthly payments, which represent both interest and repayment of
principal. In the US, most pass-through mortgage securities are issued and/or guaranteed
by government agencies such as Ginnie Mae, Fannie Mae or Freddie Mac and carry an
implied AAA credit rating. The remainder is privately issued and generally rated AAA or
AA. The payments of principal and interest on pass-throughs are considered secure;
however, the cash flow on these investments may vary from month to month, depending
on the actual prepayment rate of the underlying mortgage loans.

Collateralized Mortgage Obligation

The CMO is a multi-class bond backed by a pool of mortgage pass-throughs or mortgage
loans. Here the issuer creates various classes or tranches and the cash flows are
distributed across these tranches. Each CMO can have multiple tranches catering to
different maturities and cash flow patterns, designed to meet different investment
objectives. As the payments are received, bondholders in each tranche are first paid the
interest or the coupon amount. All scheduled and unscheduled principal payments
generated by the collateral, as loans are repaid or prepaid, go first to investors in the first
tranches. Investors in later tranches do not start receiving principal payments until the
prior tranches are paid off. This basic type of CMO is known as a sequential pay or plain
vanilla CMO. Any collateral remaining after the final tranche has been paid is known as a
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residual. CMOs are typically collateralized by government agencies such as Fannie Mae,
Freddie Mac, Ginnie Mae. MBS could be created on commercial Mortgages as well as
residential mortgages.

Asset-backed Securities (ABS):

Asset-backed securities, called ABS, are bonds or notes backed by financial assets.
Typically these assets consist of receivables other than mortgage loans, such as credit
card receivables, auto loans, manufactured-housing contracts and home-equity loans.
These receivables are securitized by financial institutions that originate loans including
banks, credit card providers, auto finance companies and consumer finance companies.
The sale of the loans by the sponsor to the SPV provides “bankruptcy remoteness,”
insulating the trust from the sponsor.

Types of ABS

The most basic way to classify securitized assets is on the basis of whether the assets are
amortizing or non-amortizing because it affects the cash flows investors receive. An
amortizing loan is one that pays back interest and principal in installments. A non-
amortizing, or revolving loan does not require principal payments on a schedule, so long
as interest is paid regularly. Revolving credit card accounts are perhaps the leading
example of non-amortizing loans.

ABS can be categorized into:

Collateral Debt Obligation

A CDO’s assets consist of a diversified portfolio of illiquid and credit-risky assets such as
high yield bonds (CBO) or bank leverage loans (CLO). As in the case of any securitized
instrument, the interest income and principal repayment are allocated from a pool of debt
instruments across various tranches. There is a priority structure in the tranches with the
tranche of senior notes being paid before the lower rated notes. Any residual cash flow is
paid to the last/lowest tranche, which bears the maximum risk.

Collateral Bond Obligations (CBO): where the underlying debt instruments are pools of
high yielding bonds

Collateral Loan Obligations (CLO): where the underlying is a pool of corporate loans.

Given below is a chart depicting the market for securitization across different asset
classes.

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Securitization is more than just a financial tool. Specifically for risk management by
banks, securitization primarily works through removing the risk on the loans/assets by
selling it. It also permits banks to acquire assets through subscribing to the instruments,
which are backed by securitization with potential diversification benefits. When assets
are removed from a bank's balance sheet, without recourse, all the risks associated with
the asset are eliminated, save the risk on the portion retained by the bank. Credit risk and
interest-rate risk are the key uncertainties that concern domestic lenders. By passing on
these risks to investors, or to third parties when credit enhancements are involved,
financial firms / banks are able to manage better their risk exposures.

Acronyms:

ABS: Asset Backed Securities:
MBS: Mortgaged Backed Securities
SPV: Special Purpose Vehicle
CBO: Collateralized Bond Obligations:
CDO: Collateralized Debt Obligation:
CLO: Collateralized Loan Obligation





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Structured Products

This chapter introduces the following concepts:

What is a structured product
Different types of structures
Construction of structured products
How structured products are used in financial markets
Why should one invest in structured products
Role of structured products in Wealth Management

















Author

Virendra Kayal
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Introduction

“Structured products are to finance what Swatch has been to the watch-making industry:
trendy, technically sophisticated and attractively priced.”
- Mario Hafner, executive director of the now-merged Swiss Banking Corporation

What is Structured Product?

Structured Products operate across products and markets and are tailored solutions to
clients' asset and liability problems and needs. Structured Products operate in all
currencies and all markets using a variety of instruments.

Structured products are combinations of two or more financial instruments, with one of
them being a derivative, thus making a new investment option catering to various needs
of both retail as well as institutional investors. There are innumerable varieties of
structured products, the possibilities being confined only by human imagination.

Characteristics

Individualized: Tailored according to the investment objective of customer
Unique makeup: Each product is different from the other
Linked to a range of asset classes
Predominantly, an over-the-counter (OTC) financial instrument
Limited number of outstanding contracts available
An alternative to traditional investments
Used to either protect partially or fully investors' capital or to leverage an investment idea
Aim to improve the return on cash deposit providing full protection of the capital
Assist clients seeking to gain exposure on the upside to equity markets but who still wish
to benefit from the full protection of the capital
Every structured product has its own risk profile.Why Use Structured Financial Products?
Investors around the world use structured products to:
Address financial objectives with instruments that provide greater flexibility than the
alternatives offered by traditional instruments
Get protection against market price volatility
Defer, avoid, or reduce transactions costs, capital gains taxes, or management fees
associated with buying and selling securities
Obtain returns from potentially higher yielding and otherwise unavailable investments by
combining elements of different asset classes into hybrid instruments (e.g., trust units or
equity-linked notes)
Participate in the returns of international markets with less cash exposure
Reduce exchange rate exposure, defer taxation, or minimize regulatory risks

Target Customers

Structured financial products are used by a wide variety of investors with different
investment objectives in the mind, including:
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Retail investors with the appropriate investment experience and financial goals
Sophisticated, high-net-worth investors that satisfy customer suitability criteria
established by regulators and by internal policies
Fund managers (pension funds, mutual fund investment advisors, asset managers, and
hedge funds)
Insurance companies (including separate accounts)
Governments and government agencies
Corporations and corporate executives
Financial intermediaries
Arbitrage accounts
Investment and commercial banks
Types of Structured products

Structured Products can be linked to a variety of asset classes like equities, currency,
interest rate, commodity, credit etc. Depending on the type of asset class to which
structured product is linked they can be classified as:


Equities Currency
Interest rate
Commodity Credit
Equity linked
notes
Reverse
convertibles
Warrants
Premium
Deposits
FX Linked
Notes
Forward
Rate
Agreements
Re-
denominatea
ble Loans
Enhanced
coupons
Reverse
Floater
Step up
Range Accrual
Target
redemption
CMS
Snowball
Embedded
swaps and
options
Leveraged
swap linked
notes
Extendible
swaps
Cancellable
swaps
Embedded
swaptions
Commodity
linked note
Credit
Linked
Note
Broad Classification of Structured Products
Embedded
FX options
First to
default
basket
Life
Bonds
Oil-linked
notes
Gold-linked
notes
default
swaps
total
return
swaps
Market Linked
Deposit
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Besides this, depending on the investment objectives which client has in the mind while
investing money, structured products can be mainly of two types,

Capital protected products
Yield enhancement products

Capital/Principal Protected Structured Products

These varieties of products offer partial or complete protection of Principal coupled with
returns that are linked to market performance. Hence this provides an opportunity to
minimize risk, at the same time leverage on appreciation of underlying asset.

This kind of product will have two elements:

An element of capital protection, usually a bond product
An 'at risk' element (called an alpha generator) which provides the high performance
potential. This can be any financial instrument - a stock, an index, currencies or
commodities.

Basically, the bond element sets the time horizon and the level of capital protection
offered by the product. The alpha generator provides the enhanced performance potential.
A lower risk, 'defensive' structured product will allocate the majority of the investor's
capital to the bond element. A higher risk, 'aggressive' product will use derivatives to
increase the extent of alpha exposure.

The zero strategy creates a defensive product with a large element of capital protection
for investors who want to participate in otherwise high-risk, high-return asset classes.

With a zero coupon strategy, the investor's capital is split into two separate accounts. One
account invests in zero coupon bonds and the other invests in a high-yielding asset class.
This is to prevent any losses from the alpha generator impacting on the capital protected
in the bond element. The ratio between the accounts depends on the discount on the zero-
coupon bond and the level of protection required by the investor.

If, for example, the zero-coupon bond is sold at a discount of 6% and is set to mature in
five years, the investor will get back get back 100% of the initial capital plus 6%
providing that the bonds are held to maturity.

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So, instead of investing 100% of the investor's capital in zero-coupon bonds, the manager
will invest 94% of the capital, knowing that the 6% return will take the investment back
up to the original capital investment after five years. This provides protection against
capital loss. The remaining 6% capital can now be used to generate a higher total return.

Assume that 6% equated to £6,000 and the other £94,000 of the principal had been
invested in zero-coupon bonds. The manager can then invest the £6,000 into high-risk
equities. If, after five years, these equities generate a 45% return, the £6,000 will have
risen to £8,700.

Adding that to the £99,640 from the zero coupon bonds and you get a total of £108,340 -
which is £2,340 more than the investor would have achieved purely through investing in
zero coupon bonds. Should the equities fall in value, the investor's capital is preserved in
the zero-coupon bonds.

Example:
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Capital Protected Structured Product

Another example of capital protected structured product is as follows:
5 year, 100% Capital guaranteed plus 60% of upside of S&P

If the index falls
Return: 100% Principal
Yield: Less than a normal deposit, but more than the return from direct index investment

If the index rises
Return: 100% Principal plus 60% due to index
Yield: Less than return from direct index investment, more than a normal deposit

Yield Enhancement Structured Products

Yield enhancement products do not normally provide any capital protection but some
sophisticated structures do offer features of conditional capital protection as an added
attraction. In case of these structured products, the investors are given attractive return
patterns, however, investors would have to bear capital loss if underlying asset does not
perform well. Yield Enhancement products allow investors to potentially obtain higher
returns, by embedding an option strategy into a fixed income product. The additional risk
generated is tailored to fit the client’s market views and risk appetite.

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A very popular yield enhancement structure is the Equity Linked Notes or ‘ELN’. They
are used as an alternative to direct investment in equities when the stock market is
expected to move sideways. They also provide investors the potential to ‘target buy’
selected stocks at pre-determined prices while earning a high income.

Example

Yield Enhancement Structured Product


5 year, Yield Enhanced Structured Product. Get 6% p.a. yield.

If S&P rises, get 100% of original investment back
If S&P falls, participate in fall in S&P.

S&P rises: get 100% back, plus 6% p.a.
(I) More than if invested in cash deposit
(ii) S&P needs to rise by more than 30% (5 * 6%) before investor is worse off than if
directly invested in S&P.

S&P falls: get 100% back plus 30% and participate in downside of S&P
(I) May be less than if invested in cash deposit
(ii) More than if invested in S&P tracker

Basic Building Blocks
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As discussed earlier, Derivatives are the basis building blocks behind structured products.
Any structured instrument can be derived using one or a combination of derivatives
instruments.

Commonly used combinations are:

Zero coupon + Call option.
Some products based upon Stock + Put Option


Some Examples:

Citibank’s Premium Deposits:

Premium Deposit is an Over-the-Counter deal in which the client deposits a certain
amount of money (Principal) with the bank. Along with the base currency in which the
principal is deposited the client also chooses an alternate currency. At maturity, the bank
pays back the principal and the interest in either of the two currencies.

How it works:
In effect, the bank buys a put option from the depositor. And as premium for the option
that it buys, the bank pays the depositor a higher interest rate than is paid for a normal
term deposit.

Suppose bank has taken a deposit of $100 from the depositor with alternate currency as
JPY, when the prevailing exchange rate is 100. Assume that the bank has agreed to pay
an interest of 10%, even though the prevailing market interest rate is 5%.

Scenario 1: If the exchange rate has become 120 over the period, the bank pays back
110000JPY, thus gaining 15000JPY.

Scenario 2: If the exchange rate remained the same, then the bank will still pay
110000JPY, losing 5000JPY.

Thus, Premium deposit, in effect becomes an option contract.

Equity Linked Notes:
Equity linked notes are instruments that are offered at a discount and their return is
determined by the performance of the underlying security on which they are based.

How it works:
ELN is similar to bank purchasing a put option from the client. If at maturity the price of
the underlying is above the strike price the bank pays him the principal amount plus a
supplemental redemption amount. But if the price goes down then the client has to take
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physical delivery of the shares from the bank at the strike price. The number of shares
received will be approximately equal to the nominal amount divided by the strike price.

Market Linked Deposits:
Market-Linked Deposits are a conservative way for investors to participate in volatile but
potentially rewarding markets. Generally MLD consists of a zero-coupon deposit
purchased at discount coupled with an option.

How it works:
At maturity, the zero-coupon deposit, which was originally purchased at a discount,
redeems at par, thereby protecting principal. The leveraged option, used to purchase
participation in the market measure, will have a payout constituting the interest on the
deposit. Returns can be linked to the principal global equity markets, emerging markets,
currencies as well as commodities.
Advantages of Structured Products to investors
Access to different asset classes
Greater diversification for investor's portfolios
Higher yield potential
Enhanced tax efficiency
Low correlation with stocks and bonds
Attractive risk/return profile
Advantages of Structured Products to issuers
Allows Distributors to increase their coverage of the risk / reward spectrum
Increase product range and differentiate from competitors
Encourage customers out of deposits, and along risk / reward curve
Offers alternatives for those wanting to reduce risk
Regular lunches allow relationship manager opportunity to call / meet customers with
“new products” cross selling opportunities
Levels of redemptions low
Maturity dates known, can target rollovers

Structured products and the risk scale

Each investor may have his own notion of risk. Most often, the concept of risk refers to
the probability of losing all or part of one’s initially invested capital, regardless of the
amount. The chart above illustrates the various degrees of risk exposure depending on the
type of investment chosen: Risk is close to zero if one is invested in cash-like instruments
with a fixed return, whereas risk is extremely high for an investor fully exposed to the
equity or options markets. Structured products can be positioned by analogy on this risk
scale, with the exception of certificates including non-represented exotic instruments. The
positions of these products on the risk scale vary according to the combination selected

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Valuing Structured Products
As mentioned earlier, derivative securities and contracts are the elemental building blocks
of structured products and include forward contracts and option contracts. Because of
their flexibility (e.g., the ability to adjust the life span of "term," the strike price, and
other components), options are an integral part of and form the basis for creating and
valuing many structured derivative products.
Structured products are valued by analyzing the following data:
The strike of the underlying asset
The underlying stock, bond, or other asset price(s)
Time until expiration of the option
Dividend rate (stocks) or yield (bonds)
Interest rate assumption
The price volatility of the underlying asset
Structured Products – Future

Having discussed in detail the importance of structured products and their significance in
today’s economic condition, it is amply clear that these products are here to stay. With
the growing importance, some of the following aspects may play a significant role in
shaping up the future trends in structured products offerings:

Growth: In the last couple of years, there has been tremendous growth in the size of the
Structured Products market. In Hong Kong alone, the size has grown from $0.8 billion in
the year 2000 to about $6.8 billion by 2003. Similar growth rates have been witnessed in
Canadian, UK and US markets also. With the increase in size of the market, there could
be more number of players showing interest in the area. Also, other countries that are not
very active as of now may pick up the trend and may start investing more in these
products.

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Diversity: While there is a clear trend to indicate that there has been a boom in demand
for structured products, the choice of products seems to vary significantly from one
country to the other. For example, while 30% of funds in Asia pacific region are invested
in FX related products, a marginal 1% is invested on the same in European markets. This
shows that there is a large diversity in the demands of different markets, which will pose
new challenges in designing and promoting structured investment options.

Innovation: With market growing wider and deeper, there would be scope for new
offerings that would aptly fit into investor’s objectives. Thus, there would be an increased
number of asset classes and wrappers. Longer dated products like products that cater to
long-term retirement objectives become more popular.

Technology: With the increase in complexity of asset classes and the decrease in time to
launch, the role of technology becomes even more paramount. The coming years may
witness a spate of solutions to cater to structured products, increasing the opportunities
for financial and IT industries.


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Mutual Funds

This chapter covers the followings:

History of Mutual funds
Why mutual funds are needed
Various entities involved in mutual funds management
Advantages and disadvantages of mutual funds
Classification of mutual funds
Process of fund creation
Funds management and administration
NAV calculation, fees and expenses
Measuring performance of mutual funds
Hedge funds
Exchange traded funds













Author

Shobhana Rao
Page 264
Introduction

History of Mutual Funds

The first mutual fund was started in the Netherlands in 1822, and the second in Scotland
in the 1880's. Originally called investment trusts, the first American mutual fund was the
New York Stock Trust, established in 1889. Most that followed were begun in Boston in
the early 1920's, including the State Street Fund, Massachusetts Investor's Trust (now
called MFS), Fidelity, Pioneer, and the Putnam Fund.

In the 1960s there was a phenomenal rise in aggressive growth funds (with very high
risk). In 1968 and 1969, over 100 of these new aggressive growth funds were established.
The 1970s saw a new kind of fund innovation: funds with no sales commission called "no
load" funds. The largest and most successful no load family of funds is the Vanguard
Funds, created by John Bogle in 1977.

At the end of the 1920s there were only 10 mutual funds. At the end of the 1960s there
were 244. Today there are more than 6,500 unique funds and even thousands more that
differ only by their share class (how they are sold, and how their expenses are charged).

But what exactly is a mutual fund?

Mutual funds enjoy popularity as an investment vehicle for retail investors because it
enables them to reap the benefits of investing in several assets through their small
individual means, which would not have been possible otherwise. Mutual funds also
bring with them the benefits of professional management and reduced inconvenience of
keeping a close watch on investments made.

In formal terms mutual fund is an investment company. An investment company can be
defined as a “financial service organization that sells shares in itself to the public and
uses these funds to invest in a portfolio of securities/ assets.” It functions with the
primary objective of:
Providing an opportunity to invest in diversified portfolios with small capital base
Catering to the needs of individual investors whose means are small
Managing portfolios in a manner that provides regular income, growth, safety, liquidity
and diversification or in other words, meets the specific investment objective

A fund raises money by selling shares of the fund to the public, much like any other
company can sell stock in itself to the public. Funds then take the money they receive
from the sale of their shares and use it to purchase various investment vehicles, such as
stocks, bonds and money market instruments. In return for the money they give to the
fund when purchasing shares, shareholders receive an equity position in the fund and, in
effect, in each of its underlying securities. For most mutual funds, shareholders are free to
sell their shares at any time. The price of a share in a mutual fund will fluctuate daily,
depending upon the performance of the securities held by the fund.

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How funds work



Various Entities involved in Fund Management

Money Money
Units
Securities
Investors
Issuers
Fund
Gain on Sales of Securities
Interest income, Dividend income
Shareholders
Board of Directors
Oversees the fund’s activities, including approval of the
contract with the management company and certain
other service providers whose contracts usually
represent the majority of fees paid by fund shareholders.
Mutual Fund
Custodian
Holds the funds assets maintaining them separately
to protect shareholder’s interests
Distributor
Sell fund shares to the public either
directly or through other firms
Transfer agent
Processes orders to buy & redeem fund shares
Investment Adviser /
Management Company
Manages the fund’s portfolio acc. to the
objectives mentioned in the prospectus
Public accountants
Certify the fund’s financial reports
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Pros & Cons of Mutual Funds

Advantages of Mutual Funds

Diversification: can reduce overall investment risk by spreading risk across different
assets. Mutual fund holdings can be diversified across companies e.g. by buying a mutual
fund that owns stock in 100 different companies and across asset classes e.g. by buying a
mutual fund that owns stocks, bonds, and other securities.

Choice: Mutual funds come in a wide variety. Some mutual funds invest exclusively in a
particular sector (e.g. energy funds), while others might target growth opportunities in
general. There are thousands of funds, and each has its own objectives and focus to match
different investment objectives.

Liquidity: is the ease with which assets can be converted, with relatively low depreciation
in value, into cash. In the case of mutual funds, it’s as easy to sell a share of a mutual
fund either on the exchanges (close ended funds) or back to the fund (open ended funds).

Low Investment Outlays: Mutual funds are accessible to retail investors who do not have
large financial assets. Units in mutual funds can be bought with small amounts.

Convenience: With a mutual fund, the investor does not have to worry about tracking
dozens of different securities in which he would like to invest; rather, he only needs to
keep track of the fund's performance.

Low Transaction Costs: Mutual funds are able to keep transaction costs - that is, the costs
associated with buying and selling securities - at a low level because they benefit from
reduced brokerage commissions offered to them by dealers for buying and selling large
quantities of securities.

Regulation: Mutual funds are regulated by various acts such as the Investment Company
Act of 1940 in the US. This act requires that mutual funds register their securities with
the regulatory authorities and also regulates the way that mutual funds approach new
investors and the way that they conduct their internal operations.

Professional Management: Mutual funds are managed by a team of professionals, which
usually includes fund managers and several analysts. Presumably, professionals have
more experience, knowledge, and information than the average investor in deciding
which securities to buy and sell.

Disadvantages of Mutual Funds

Dilution: Although diversification reduces the amount of risk involved in investing in
mutual funds, it also averages out returns. By holding a large number of different
investments, mutual funds tend to do earn average return of the securities in the portfolio.
Normally the mutual funds perform neither exceptionally well nor exceptionally poorly.
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Fees and Expenses: Most mutual funds charge management and operating fees that pay
for the fund's management expenses (usually around 1.0% to 1.5% per year for debt
funds and higher for equity funds). Some of the expenses such as sales commissions,
redemption fees etc. are charged/ accrued on an ongoing basis.

Performance: Returns on a mutual fund are by no means guaranteed. In fact, on an
average, more than three fourths of all mutual funds fail to beat the major market indexes,
like the S&P 500.

Loss of Control: The managers of mutual funds make all the decisions about which
securities to buy and sell and when to do so. This decision may not some times favor the
investor. For example, the tax consequences of a decision by the manager to buy or sell
an asset at a certain time might not be optimal for a particular investor.

Trading Limitations: Although mutual funds are highly liquid in general, most mutual
funds (called open-ended funds) cannot be bought or sold in the middle of the trading
day. Investor can only buy and sell them at the end of the day NAV.

Inefficiency of Cash Reserves: Mutual funds usually maintain large cash reserves as
protection against a large number of simultaneous redemptions. Although this provides
investors with liquidity, it means that some of the fund's money is invested in cash or
cash equivalents instead of higher yield assets, which tends to lower the investor’s
potential return.

Too many different types of funds: The advantages and disadvantages listed above apply
to mutual funds in general. However, there are over 10,000 mutual funds in operation,
and these funds vary greatly in investment objective, size, strategy, and style. Mutual
funds are available for virtually every investment strategy (e.g. value, growth), every
sector (e.g. biotech, internet), and every region of the world. Therefore, even the process
of selecting a fund for investment can be tedious process.

Classification of Mutual Funds

Classification based on Structure & Management Style

The structure or organization of mutual funds is quite different from that of any other
corporate. The structure of the fund determines the roles & responsibilities of various
entities that are associated with the fund. On the basis of fund structure and management
style, mutual funds can be classified into the followings:

Open Ended Funds: In Open Ended Funds, the fund issues/sells new units continuously
for purchase by investors at any time during the life of a scheme. At the same time
investors are free to redeem the units at prevailing NAV from the fund. Hence, number of
unit outstanding in an open-ended fund can fluctuate on a daily basis. Some
characteristics of open-ended funds are as follows:
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Units in the open-ended schemes do not have a fixed maturity period
These schemes have variable capitalization
These funds are not listed on the exchange and investors need to directly approach the
fund or their agents for any transaction
Anytime entry & exit option - An open-ended fund allows an investor to enter the fund at
any time, or to invest at regular intervals. The issuing company directly takes the
responsibility of providing liquidity to the investors when they want to liquidate their
investments.
Daily NAV calculation - investors can buy or sell units at NAV-related prices from and
to the mutual fund on any business day. Purchase and sale price could be subject to entry
and exit load. Fund can also charge fees on contingent and deferred basis.

Close-ended Funds: In close-ended funds, the number of units issued is fixed. After the
initial issue/ IPO, the units are traded on the exchange like any other stock. Units sold by
one investor are purchased by another investor and not by the fund (as is in the case of
open-ended funds). Some of the characteristics of closed ended funds are as follows:
Close-ended schemes have fixed maturity periods
Limited Capitalization: Investors can buy into these funds in the IPO after which such
schemes do not issue new units except in case of bonus issue.
Trading on the exchange: after the initial issue, investors can buy or sell units of the
scheme on the stock exchanges where they are listed.
The market price of the units could vary from the NAV of the scheme due to demand and
supply factors, investors’ expectations and other market factors

Unit Trusts: A registered investment company which purchases a fixed, generally passive
portfolio of income-producing securities and then sells shares in the trust to investors.
The major difference between a Unit Trust and a mutual fund is that a mutual fund is
generally actively managed, while a unit investment trust is generally passively managed.
Capital gains, interest and dividend payments from the trust are passed on to shareholders
at regular periods. A unit investment trust is generally considered a low-risk, low-return
investment. Unit Trusts typically incur lower annual operating expenses (since they are
not buying and selling shares); however they often have sales charges and entry/exit fees.
These are also called fixed investment trust or participating trust or Unit Investment Trust
(UIT).

The table below captures the differences between the above three classifications










Open Active Open ended funds
Closed Active Closed ended funds
Closed Passive Unit Investment Trusts
Structure Management Style Fund Type
Open Active Open ended funds
Closed Active Closed ended funds
Closed Passive Unit Investment Trusts
Structure Management Style Fund Type
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Classification based on the type of asset

On the basis of the type of asset that the fund is investing in, the following broad
classifications can be made:

Equity Funds

Equity funds invest in equity shares issued by companies, acquired either through an IPO
or through the secondary market route. These are generally considered the riskiest among
mutual funds by virtue of the risks associated with equity. These price movements can be
caused by many factors – economic, social, political etc. Within equity funds investment
can be done to suit different risk appetites, investment objectives and strategies adopted
by the fund.

Bond Funds

Debt Funds invests in debt instruments issued not only by governments, but also
corporates and other financial institutions. By investing in debt, these funds target low
risk and stable income for the investor as their key objective. These too are subject to
some risk such as interest rate fluctuations but they are not as risky as equity funds. Debt
instruments are a better source of predictable return. In this case too, the investment in
different bonds can be tailored to suit different investment objectives.

Money Market Funds

These are considered the least risky. MM funds invest in securities of a short-term tenor.
Typically investment is done in T-Bills, Certificates of Deposits, Commercial Paper, and
Interbank call money market.

Index Funds

Index funds are mutual funds that attempt to copy the performance of a stock market
index. The most common index fund tries to track the S&P 500 or the NSE Nifty by
purchasing all stocks using the same percentages as the index. Index funds are the best
examples of passive management, as the fund manager does not have to monitor the
portfolio, as it mirrors the performance of the index itself.

Commodity Funds

Commodity funds specialize in investing in different commodities directly or through
shares of commodity companies or through commodity futures. Such funds could either
specialize in the particular commodity such as grains or diversify their portfolio to
include other commodities.

Real Estate Funds

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Such funds invest directly in real estate or may fund real estate developers, or lend to
them or buy shares of housing finance companies.

Classification based on the investment objective

Mutual funds can be further classified based on their specific investment objective such
as growth of capital, safety of principal, current income or tax-exempt income. Based on
this category, funds can be classified as:

Growth Funds
Income Funds
Balanced Funds

Growth Funds

Growth funds invest in equity of companies, which have high growth potential & expect
above average earnings. They invest in well-established companies where the company
itself and the industry in which it operates are thought to have good long-term growth
potential, and hence growth funds provide low current income. The primary objective of
these funds is capital appreciation. An apt example could be technology stocks. Since
growth funds offer high potential for returns, by investing in equity, they are also the
most risk-prone. Hence, growth funds are suitable for investors who can afford to assume
the risk of potential loss in value of their investment in the hope of achieving substantial
and rapid gains. They are not suitable for investors who are looking for steady returns.

Within growth funds itself, there can be variants in the degree of risk they possess.

Aggressive Growth Funds: As the name suggests, these funds invest in stocks, which are
expected to give very high returns but are not researched too well or are speculative
stocks of unknown issuers. Such fund managers could adopt even speculative strategies
for investment to provide high returns to the investors.

Speciality Funds: These funds typically invest in specific investment avenues such as
specific sector, specific companies etc. Such funds are more risky as they are
concentrated and offer little diversification. Examples could be sector funds like
pharmaceuticals, textiles, small-cap/medium cap equity funds (which invest in companies
whose market capitalization is small or medium) etc.

Diversified Equity Funds: These funds invest primarily in equity and a little in liquid
money securities. They also do not invest specifically in a particular sector. While these
funds do have the risks associated with other equity funds, the risk is reduced to some
extent by way of diversification.

Equity Index Funds: As we have seen earlier, these funds invest in stocks in the same
proportion as in an equity index. The return also mirrors the index. Typically the index
comprises of a diversified portfolio of stocks in the market and by emulating the index,
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the fund is exposing itself only to the overall market risk, while reducing the stock
specific & sector specific risks.

Value Funds: Value funds invest in stocks that have strong fundamentals but are
currently under-priced in the market – have low P/E ratios and are basically undervalued.
While these funds are also exposed to some risk associated with equities, they carry less
risk comparatively.

Income Funds

Income funds primarily look to provide current income consistent with the preservation
of capital. These funds invest in government bonds, corporate bonds or government-
backed mortgage securities that have a fixed rate of return. Income funds are suitable for
investors who want to maximize current income and who can assume a degree of capital
risk in order to do so. Within this category, funds vary greatly in their stability of
principal and in their dividend yields. High-yield funds, which seek to maximize yield by
investing in lower-rated bonds of longer maturities, entail less stability of principal than
fixed-income funds that invest in higher-rated but lower-yielding securities.

Some variants of debt funds are:

Focused Debt Funds: As mentioned in equities, these are specialized funds that invest in
a specialized investment vehicle – specific sector, specific instruments etc. Examples
could be funds that invest only in corporate bonds or only in government securities.
These would be slightly more risky as they are less diversified. On a more aggressive
note, the funds that invest only in high-yield bonds/junk bonds would be more risky than
bonds, which invest in high credit rated debt instruments.

Diversified Debt Funds: While debt instruments are relatively less risky, they are also
subject to default risks, interest rate risks etc. By investing in a diversified portfolio of
fixed income securities such as corporate bonds, government securities etc., the risk is
diversified to a large extent.

Balanced Funds

Balanced funds aim to provide both growth and income. These funds invest in both
equity and fixed income securities in the proportion indicated in their offer documents.
These are ideal for investors who are looking for a combination of income and moderate
growth. Growth and income funds seek long-term growth of capital as well as current
income. The investment strategies used to reach these goals vary among funds. Some
invest in a dual portfolio consisting of growth stocks and income stocks, or a combination
of growth stocks, stocks paying high dividends, preferred stocks, convertible securities or
fixed-income securities such as corporate bonds and money market instruments.

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Offer Document
This is the most important source of
information about a new fund. The offer
document describes the scheme of offer. It
contains all the important disclosures that the
fund has to make and lists all the information
that could enable the investor to make an
informed decision. Broadly , the offer
document is supposed to carry information
about:
The sponsor/investment management
company and the AMC
Description of the scheme & the
investment objective/strategy
Terms of issue
Historical statistics
Investor rights & services
In India, in addition to the offer document, a
key information memorandum also has to be
circulated, which is typically the abridged
version of the offer document.

The prospectus/offer document is supposed to
convey information on the risk factors,
financial information such as load & other
expenses, constitution of the fund – roles &
responsibilities of various entities involved,
asset allocation pattern & other investment
strategies, frequency of NAV disclosure, tax
treatment of investments etc.
Having seen the different types of funds across different classifications such as
investment objectives, asset type lets us take a snapshot view of the funds across their
risk types.





















Fund Operations

We have seen till now, the basic concept of
what a mutual fund is all about and the
different types of funds that exist. Let us
now take a look at the fund management
process in its entirety.

Fund operation can be broadly classified
into two - Fund Creation and Fund
Management & Administration.

Lets us now take a look at each of these in
some detail.

Fund Creation

A mutual fund can be structured as either a
corporation or a trust. Like any other
corporate, a mutual fund is owned by its
shareholders. The fund is initiated and
managed by various external entities. The
Fund Type
Risk/Return
Level
Low
Moderate
High
Money Market
Funds
Diversified Debt
Fund
Focused Debt
Funds
High Yield Debt
Funds
Balanced Funds
Focused Equity
Funds
Diversif ied Equity
Funds
Growth
Funds
Aggressive
Growth
Funds
Fund Type
Risk/Return
Level
Low
Moderate
High
Money Market
Funds
Diversified Debt
Fund
Focused Debt
Funds
High Yield Debt
Funds
Balanced Funds
Focused Equity
Funds
Diversif ied Equity
Funds
Growth
Funds
Aggressive
Growth
Funds
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initiation of a fund is done by an investment company (in the US)/fund sponsor (in India).
The fund is incorporated by registering it with the SEC/SEBI.

The registration of the fund involves documenting the details about the scheme,
registering this with the regulatory authorities – SEC/SEBI before announcing the
scheme and formally inviting the investing public to subscribe to the scheme. This
document is called the Offer Document or the Prospectus. In addition they also need to
have SAI (Statement of additional information)/ Key Information Memorandum.

The investment company/fund sponsor appoints the Board of directors/ trustees, which in
turn chooses the Asset Management Company (AMC) for managing the fund. The board
of directors appoint all the other service providers such as the custodian, transfer agent,
distributors etc.

Listed below is a brief overview of the functions of each of the entities associated with a
fund.

Asset Management Company is the investment manager of the fund. The AMC has
professional portfolio managers who actively monitor the fund’s portfolio and strive to
meet the investment objectives of the funds as laid out in the prospectus/offer document
by employing various investment strategies. The fund manager is assisted by several
analysts.

Custodian: The custodian is appointed for safekeeping of securities and acts as a clearing
member. It holds the fund’s assets maintaining them separately to protect shareholder’s
interests.

Transfer Agent is responsible for issuing and redeeming units of mutual funds and
providing services such as preparation of transfer documents and updating investor
records.

Distributors: are typically agents/brokers appointed by the AMC to sell units on behalf of
the fund. Distributors can include banks and other financial firms.

Fund Management & Administration

We have seen that funds can be broadly categorized into actively management and
passively managed funds.

In active fund management, there are three main entities involved:
The Fund Manager – assigned to a specific scheme or a set of schemes. They are
responsible for the overall strategies and decision making on asset allocation and other
investment decisions to ensure that whatever investments have been made, meet the
fund’s objectives.
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Security Analysts- support the fund managers by keeping a watch on the investments in
different sectors and tracking the performance of the stocks/sectors/companies in which
various investments have been made for the fund.
Security Dealers – are involved in the actual execution of any buy/sell orders that are
placed by the fund managers.

Another important aspect of fund operations is fund administration, which involves
accounting, legal and tax aspects of the fund. These are typically handled by third party
service providers and covers activities such as daily administrative responsibilities of
preparing financial statements, compliance and client reporting, reconciliations, tax
filings and legal filings.

NAV Calculation,Other Fees & Expenses

We read in the earlier chapters that the mutual fund basically operates by accepting
subscriptions/deposits from investors, making investments in various instruments on their
behalf and finally passing on the returns back to the investors. The subscription received
from the investor forms the capital and is called the unit capital of the fund. The
investments made on behalf of the investors are the assets, which generate returns. The
fund may also have some liabilities, which it has to account for. Thus the Net Assets of
the fund are the Total Assets minus the Liabilities.

To compute the value of the investments made by each investor it is essential to compute
a per unit value. This value is commonly expressed as the Net Asset Value.

Net Asset Value = Net Assets of the Scheme/Number of Units outstanding

which is,

(Market Value of the Investments + Receivables + Other Accrued Income + Other Assets
– Accrued Expenses – Other Payables – Other Liabilities)

No. of units outstanding as on the NAV date


For open ended funds, the NAV is the price at which the investor can buy/redeem units
and the NAV is computed daily as there will be a change in the number of units as well
as in the value of assets on a day-to-day basis.

In the case of closed ended funds, which are traded on the exchange like any other stock,
the value at which it is traded is determined by market forces of demand & supply-
similar to any share that is listed and traded on the exchange. If the NAV of a closed
ended fund is Rs. 150 but the market price is Rs. 145, the fund is said to be trading at a
discount. Closed ended funds need to publish their NAV on a periodic basis, as specified
by the SEC/SEBI. The sale/purchase close ended funds is subject to brokerage charges as
is applicable for shares.
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Fees & Expenses

Expenses related to mutual funds can be broadly categorized into:
Shareholders fees or sales charges which are more popularly called Load
Annual operating expenses which are in the nature of recurring expenses

Sales Charges or ‘Load’

This is more like a one time fee, which is charged to the investor at the time of sale or
purchase. This is relevant for open-ended funds. As we have seen earlier, the investor can
either directly approach the fund for purchase/redemption of units or approach the fund’s
distribution agent. To account for the administrative cost there is a need to pay a fee to
the agent for his services. This fee
could be charged at the time of
entry (purchase of unit) or at the
time of exit (sale of units) or both.
The charges made at the time of
purchase is called a front-end load
and the charged made at the time
of redemption is called back-end
load. Sometimes, instead of
charging a load at the entry or exit
time, it is charged uniformly each
year. This is called a Level load.
Sometimes, the back-end load is
charged on a tiered and deferred
basis. Longer one holds the units
of the fund, the lesser load he will
pay on redemption. A fund could
charge a 3% exit load if units are
sold in the first year, 3% in the
second year, 2% for sale in the 3
rd

year, 1% in the 4
th
year & 0% in
the fifth year. This deferred sales
charge is commonly known as
contingent deferred sales charge
(CDSC).

There is a ceiling attached to the load that can be charged by the fund. For instance the
National Association of Securities Dealer, USA, prescribes the maximum load to be
8.5%. The fund can use its discretion in charging the load subject to the above limit. It
can also reduce the load for high value investments. For example if a fund charges an
entry load of 2% for all investments, it may charge 1% for investments over, say, 1mn
USD. This investment level that is needed to obtain a reduction in the sales charges is
called breakpoint.
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Annual Operating Expenses

The operating expenses of a fund in relation to the total assets managed, also called the
expense ratio, covers three main categories of expenses - Management Fees, Distribution
Fees and Other expenses. Let us take a look at each of these classes of expenses.

Management Fees – is the fee paid for the investment management functions. It is also
called an investment advisory fee. It is basically the fee paid to the investment manager
(AMC) to manage the fund’s portfolio. This fee varies from fund to fund depending upon
the type of the fund. For instance, the management fees for growth funds can be much
more than that for money market
funds.
Distribution Fees – This is also known
as the 12b-1 fee, relevant to the US
markets. This fee covers ongoing
distribution costs such as agent
compensation, marketing and other
advertising expenses. This fee acts like
a motivator to the distribution agent to
continue servicing the fund even after
making the initial sale.
Other Expenses – These primarily
include the costs of
Custody Services
Services of the Transfer Agent
Independent public accountant fees
Director fees

The sum of the annual management
fee, distribution fee and other annual
expenses is called the expense ratio. The cost information of a fund has to be listed in the
prospectus.

Measuring Fund Performance

As with any investment, it is not enough just to make the investment, there is also a need
to measure its performance. All the stakeholders involved in mutual fund investment
have to know how the fund is doing. The simplest form of measurement is to compare the
NAVs from the time of investment to the time of measurement. While this is simple it
ignores the aspects of any interim returns, which the fund may have given by way of
dividend/interest distribution from its investments or subsequent re-investment of those
returns. Lets take a look at the fund performance by including each of these aspects.

Example: An equity fund issues units at an NAV of $ 25 in Jan 2004. An investor buys 1
unit of this fund. By Dec 2004, the fund’s NAV has appreciated to $ 27.
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The fund’s performance can be measured as:

(Initial NAV – Current NAV) /Current NAV * 100

(27-25) * 100 = 8%
25
The fund has generated a return of 8%

However, if this fund had also distributed dividends of $ 4 per unit, then we would also
have to include these returns. The fund’s returns would be:

(Returns from Dividends + Change in NAV)/Initial NAV * 100

Here since our investor has 1 unit the dividends he would receive will be $4. The total
return is:

4 + (27-25) * 100 = 24%
25

If at the time of this distribution, the NAV were $26 and the dividend was re-invested, we
would also have to account for this re-investment, as the investor would now get more
new units proportionate to the re-investment amount. In this case he would get 0.15 units
(4/26). Hence his total holding is now 1.15 units in this fund. The value of his
investments as of Jan 2005 will be $31.5 (1.15 units * $27). Comparing this with his
initial investment of $25, he has earned a return of

31.5 - 25 * 100 = 26%
25

Risk adjusted measures of a fund’s performance

Sharpe Ratio: The Sharpe ratio measures additional return earned for every additional
unit of risk. Additional return is calculated by deducting the risk-free rate of return, such
as the 91-day T-bill rate from total return. The Sharpe ratio can be computed as follows:

Sharpe Ratio = (R
p
– R
f
)/σ
p

Where,
Rp = returns on the portfolio
Rf = risk free return, and,
σ = standard deviation of the portfolio, which is proxy for risk

Jenson’s Alpha: This is the difference between a fund's actual return and the return that
should have been made given the beta of the portfolio. It is calculated as below:

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Jensen’s Alpha = Rp - ßp[E(Rm) – Rf]

Where,
ßp[E(Rm) – Rf] is the expected return (see the concept of Capital Asset Pricing Model).

Treynor’s Ratio: This ratio is similar to the Sharpe ratio except it uses beta instead of
standard deviation as the measure of risk. You may recall that standard deviation is the
measure of total risk and beta is the measure of systematic risk. It is the ratio of a fund's
average excess return to the fund's beta.


Treynor’s ratio = (R
p
– R
f
) / ßp

Related Concepts – Hedge Funds & ETFs

Till now we have discussed mutual funds and their role in mobilizing the savings of a
large number of retail investors.

A similar structure involving high net worth individuals is called a hedge fund. Of course
that is not the only difference between hedge funds and mutual funds. This chapter will
take you through the basic concept of a hedge fund and its differences with a mutual
fund.

A hedge fund basically creates an investment pool for sophisticated, wealthy investors
and employs sophisticated hedging & arbitrage techniques for managing investments.
Unlike a mutual fund, hedge funds are not subject to much regulation other than antifraud
regulations. Some of the basic differences between a mutual fund and a hedge fund are:

Mutual Funds Hedge Funds
Creates investment pool for retail
investors

Investment pool for high number of
investors

Pre-defined Investment strategy as per
fund objectives

Invests only in unleveraged securities

Short selling is not allowed

Subject to multiple regulations
Creates investment pool for high net worth
individuals

Investment pool for select number of
investors

Flexible investment strategy.

Can invest in leveraged securities

Short selling is allowed

Subject to only antifraud regulations

Exchange Traded Funds
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An Exchange traded fund is yet another flavor of mutual funds. Normally, an ETF has, as
its underlying, a basket of stocks that represent the index. It is traded on the exchange like
any closed ended fund. Some of the main characteristics of an ETF are:
It combines the features of both an open ended & a closed ended fund. An ETF creates
and redeems new units continuously like an OEF and is traded on an exchange like a
CEF.

Since an ETF has to create and redeem units continuously, there has to be a mechanism
to meet the demand and supply. To solve this problem there is an exchange of the ETF
shares for the shares of the underlying basket of securities.
The expense ratio for an ETF is very less as there is very minimal or no management
required by the investment manager. On the other hand as ETFs are traded like stocks
there is a brokerage fee involved.

ETF Creation Process

The birth of an ETF officially begins with an authorized participant, also referred to as a
market maker or specialist who assembles the appropriate basket of stocks and send them
to a specially designated custodial bank for safekeeping. These baskets are normally quite
large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The
custodial bank doublechecks that the basket represents the requested ETF and forwards
the ETF shares on to the authorized participant.

The custodial bank holds the basket of stocks in the fund's account for the fund manager
to monitor. This flow of individual stocks and ETF certificates goes through the Clearing
Corporation. It records ETF transfer of title just like any stock.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell
it into the open market. From then on ETF shares are sold and resold freely among
investors on the open market.

Redemption is simply the reverse. An authorized participant buys a large block of ETFs
on the open market and sends it to the custodial bank and in return receives back an
equivalent basket of individual stocks, which are then sold on the open market or
typically returned to their loanees.

The table below shows some of the differences between ETF, OEF & CEF.

ETF Open Ended Funds Closed Ended Funds
Fund Size Flexible Flexible Fixed
NAV Real Time Daily Daily
Liquidity Provider
Stock Market /
Fund Itself
Fund Itself Stock Market
Availability
Through Exchange
where listed / Fund
Fund itself
Through Exchange
where listed
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itself.
Portfolio
Disclosure
Daily/Real-time Disclosed monthly Disclosed monthly
Intra-Day Trading Possible at low cost Not possible Expensive

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Testing the concepts

1. ETF units can be bought and sold from
a. Exchange
b. ‘Authorized participants’ as specified by the fund
c. The distribution agents
d. SEBI
e. Either Exchange or Authorised participants
2. Hedge funds are subject to
a. Same regulation as Mutual funds
b. More strict regulations compared to Mutual funds
c. No regulations at all
d. Anti fraud regulations
e. None of the above
3. Which of the following is true about Mutual funds?
a. Mutual funds are a means of indirect investment
b. Mutual funds provide risk free investment
c. Mutual funds cannot invest in stocks of only one sector
d. Open ended mutual funds have fixed invested capital
e. All of the above statements are true
4. For an Exchange listed closed ended mutual funds, the price of a unit is
determined by
a. NAV + Entry load
b. NAV + Exit load
c. NAV - Exit load
d. Supply and demand forces on the exchange
e. None of the above
5. In India, for Open-ended mutual funds NAV is calculated on
a. Continuous basis
b. Monthly basis\
c. Daily basis
d. Hourly basis
e. Yearly basis
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Risk management

This chapter covers the following topics

Introduction to risk management
Defining financial risk
Risk management as a discipline in financial markets
Market risk
Interest rate risk
Liquidity risk
Credit risk
Basel II norms for risk management
Risk measures and methodologies
Value at risk












Author

Shyam Kurni
Page 283
Introduction to Risk

Risk as a word has a very broad definition and different people interpret ‘RISK’ in
different meanings in different contexts. This makes the job of introducing the concept of
‘Risk’ very difficult. Nevertheless, we shall confine ourselves to the definitions relevant
to the ‘Banking, Financial services and Insurance’ (BFSI) industry. It is in this backdrop
that any discussion on Risk in the coming pages essentially means ‘Financial Risk’.
An Intuitive definition of RISK

For most of us, RISK is undesirable. If
something or someone is at risk, it
means it/they may lose something
important or valuable in the future. So
‘probable future loss’ is how we
intuitively understand ‘RISK’. For
example, if a person is a chain smoker,
he may lose his health or life in the
future. So he is at risk. This definition of
risk is called ‘Adverse Risk’. This
definition takes into account only the
‘worst-case outcomes’ for a given event.
The mathematical or financial definition
of RISK

But ‘RISK’ as a mathematical and financial concept, has a different meaning. Here Risk
is defined as the ‘UNCERTAINTY of a future outcome’. If there is 100% certainty of an
outcome to an event, it is supposed to have zero-risk.

Consider the following example:

Event 1: A person jumping out of an airplane with a parachute.
Event 2: A person jumping out of an airplane without a parachute.

In Event 1, the parachute may or may not open in mid air and so the certainty of the
person landing safely is not 100%. If the parachute opens, the person will land safely. If
the parachute does not open, he will die. So, there is risk. In Event 2, the jumper is certain
to die. So, there is no uncertainty and as such there is no risk involved.

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That is difficult to understand, isn’t it? Mathematically, there is no risk in the second
event whereas intuitively, there is more risk. This definition is also the basis of the
paradigm, “The more the risk; the more the return”. I shall explain this paradigm later in
this article.

Examples of risk in the BFSI industry

Bank Example: We shall consider a bank here. Say, for example, a bank has lent $200
million to ABC Inc., a new technology company. The company agrees to pay regular
interest on the principal every year and repay the original principal at the end of 5 years.
What is the risk for the bank in this relationship?

As Risk is ‘the uncertainty of future outcome’, let us see what is certain in this example.
Is the regular payment of interest by ABC Limited certain? The answer is No.
Is the repayment of principal certain? Again No.
So, there is the risk of non-receipt of interest and principal in this example.

This risk is called ‘CREDIT RISK’ in industry terms. Credit Risk is detailed later in this
module.

Mutual Fund Example: Now think of a Mutual Fund. Say, for example, it has invested,
$101 million in equity shares of ABC Inc. It hope to receive yearly dividend on the
shares and capital gains from trading. What is the risk for the Mutual Fund in this
context?

Let us once again, analyze what is certain here.

Is the investment of $101 million, certain to retain its value, over a time period? The
answer is NO. If the market price of the shares increases, the investment will profit and if
the market price of ABC shares crashes, the investment will lose money. The value of the
investment may go up or down in the future. So there is Risk on the money invested.
Is the dividend certain? NO. The dividend paid by ABC is dependent on its earnings,
profit and the decision of the management. The dividend can be 5%, 10% or 0% (no
dividend).
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So, there is a risk of losing the value of the investment and non-receipt of the expected
dividend. This risk is called ‘MARKET RISK’ in industry terms. Market Risk is detailed
later in this module.

The above two examples, are but very simple examples of risk in the BFSI sector. The
number and the volume of products, services and economic relationships in this sector are
so large and so very complicated that there is risk inherent in each single relationship in
one form or the other and most often, in more forms than one. The following diagram
lists some of the common risks faced by BFSI organizations of today.



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Risk Management as an important discipline/practice

Evolution of the practice

Financial Risk Management has been around as an imperfect science and more as an art
for centuries now. Bankers in medieval ages made subjective assessment of their clients
and extended loans to them. Associations and communities of traders started with the
objective of creating and expanding markets for their commodities and to guard
themselves from specific risk factors inherent in their markets. Forwards and other
derivative contracts emerged in the 17
th
Century to hedge against possible future losses.

But the advances in Risk management have been very phenomenal only in the past few
decades. These advances contributed to the evolution of the practice as a subject of
science and a formal discipline away from the age-old practice as an art. Particularly, in
the areas of using quantitative techniques to measure and prioritize risks, the advances
have been great. Increase in Academic research (Ex: JP Morgan’s RiskMetrics) and the
availability of affordable computing resources are the main drivers here. Having said that,
mention should be made that Risk Management still remains an art albeit to a lesser
extent.

Drivers –Business and Environmental

Growth in Financial Activity: Financial activity has grown manifold during the recent
times. To quote an example, the average number of shares traded per day in NYSE has
grown from about 3.5 million in 1970 to around 40 million in 1990
9
. Foreign Exchange
activity has grown even more, from a few billion dollars a day in 1965 to more than a
trillion dollars a day in 1996.
10
In addition to these, the large number of new instruments
introduced in the financial markets including derivatives, has given rise to new kinds of
financial risks that needs to be understood, analyzed and effectively managed.

Developments in IT: Another factor contributing to the development of risk management
was the rapid advance in Information Technology. Computational power and speed that
was only dreamt in the past are now a reality. This meant that mathematical techniques
that require complex analytical modeling and simulation are now possible with the help
of computers. In addition, the cost of IT systems has fallen tremendously, making
hardware and software available to many market participants to manage their multiple
risk profiles.

Volatile Environment: Markets have witnessed a sequence of debilitating shocks in the
past that prompted the affected participants and the regulators to streamline their risk
management approaches and systems. The bust-up of the Exchange Rate Mechanism
(ERM) in September 1992, the cycle of worldwide Interest rate highs and lows during the
80s and the 90s, global stock market crashes during the same period are some instances
where the environment threatened the very survival of the financial system. Individual

9
Daigler (1994, p7)
10
Guldimann (1996, p17)
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case studies like Barings Bank and LTCM also call for improved management and
control of risks. Better research and policy in Risk management can mitigate the shocks
of such events, if they happen in the future again.
Risk Management Lifecycle

Steps in a lifecycle may have been labeled in different ways in different pieces of
literature on Risk Management. But generally, the lifecycle of Risk Management starts
with building a broad framework. The identification of risks that need to be managed
happens next. Once these risks are identified and documented, the next big step is to
measure the risks on an ongoing basis. The measurement framework, methodology and
the risk outputs are defined here. Risk Analysis is the logical extension where measured
outputs are decomposed and studied in more detail. Later, a proper risk mitigation plan is
drawn and each source of risk is addressed. Risk Monitoring and Control end the cycle.




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The Risk Universe

As already mentioned, the variety of financial risks faced by a BFSI organization whether
it is a

Retail bank
Corporate bank
Investment bank
Insurance company
Brokerage firm
Mutual fund
Hedge fund
Other financial intermediaries

is large. But, risks faced by an investment bank may not be totally applicable to a mutual
fund. Also, some organizations exhibit more exposure to one particular category of risk
while the same category of risk does not influence the other organization in another
industry/sector within BFSI to a great extent. It is in this context, that we have the need to
categorize risks and study them. Once we categorize the whole risk universe, we can
better understand each sector’s and each organization’s exposure to risk.

To facilitate the risk management decision process in large corporations, the overall risk
faced by these institutions is subdivided into different risk categories. These categories
are defined through different causes and/or effects. In the banking industry, market risk is
defined as the systemic risk inherent in the capital or Forex or other financial market, i.e.
it is the risk that is not diversifiable through holding different securities. Credit risk is
defined as loss exposures due to counterparties’ default on contracts. Operational Risk is
defined as loss resulting from inadequate or failed internal processes, people and systems
or from external events.


Market Risk

Market risk arises from the uncertainty relating to market prices. Prices of different assets
be it equity shares or bonds, currency or commodity, keep fluctuating in the market
driven by demand and supply. Demand and supply for a given asset itself gets affected by
several economic and psychological factors. Detailed description of these factors is not
the intent of this chapter but the consequences of such fluctuations are.

Market risk is the uncertainty about the price of the asset one owns or intends to own.
Origin of market risk for different asset classes is different. Market price of equities gets
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affected by the prospects of profitability of the company or industry as a whole. In the
short term however, equity prices do behave differently at different points in time given
similar economic fundamentals. There is an evidence of irrational exuberance in the
investor community from time to time. For the holder of equity shares however, the main
uncertainty is the price of the stock.

On the other hand, price of a bond is derived from the prevailing rates of interest given
the expected cashflows. As the interest rate goes up in the economy, price of bond falls.
If interest rates fall, price of the bond moves up. Thus, market risk of a bond is actually
linked to the interest rate risk, or, the uncertainty about what the interest rate will be in
future. Generally risk-free rate of return on the government bonds or other benchmarks
such as London Interbank Offer Rate (LIBOR) are used to depict the rate of interest and
volatility in these rates give rise to interest rate risk.

However, bonds with different risk profiles offer different rates of risk. Higher the
uncertainty about the interest and principal payment higher the interest offered by the
bond. The difference between the risk-free interest rate and the interest rate on a given
bond is called credit spread. Thus a AAA bond offers lower rate of interest compared to a
bond rated BBB. Or in other words, the spread on BBB bonds will be higher compared to
the spread on AAA bond. Given a risk-free rate, these spreads themselves are subject to
change. When the prospect of growth for the corporate sector is better, spreads decrease
and when profitability of corporate sector become uncertain due to factors like rising
crude prices or higher degree of competition, spreads widen. Thus non-government bonds
are subject to both interest rate risk – change in the risk free rate as well as spread risk –
change in the spread over and above the risk free rate.

Bonds also get affected by curve risk. Curve risk is the risk arising from the change in the
shape of yield curve. We have discussed earlier that yield curve is normally upward
sloping i.e. longer the tenor, higher the rate of interest. But many a times, especially
during recession, the scenario may reverse and longer tenor rates may become lower
compared to the shorter tenor rates. When the shape of the yield curve changes, the
impact is the highest on long tenor bonds because firstly, the change is the highest for
longer tenor bonds and secondly because given a change in rate of interest, price of
longer term bonds show more volatility compared to the price of the shorter tenor bonds.

All the above factors affect the price of bonds and are source of market risk for traded
debt instruments.

Market prices also get affected by the liquidity of the security in the market place. Higher
the liquidity less volatile the price is and lower the liquidity higher the volatility in the
market price. The reason behind this phenomenon is that a smaller amount of purchase or
sale can drive the prices up or down by a large percentage since not many sellers or
buyers are active in that security.

Liquidity could be measured by volume of trading. Higher the volume of trading, more
liquid the security is. But a more precise method of measuring liquidity is called ‘Impact
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Cost.’ Impact cost measures percentage change in stock price as a result of purchase and
sale of a given amount. Suppose at a given point of time in the market Microsoft stock is
trading at $25. If one million dollar worth of stock is sold, price of Microsoft should fall.
Given the purchase orders existing in market at different prices below the prevailing
market price, we can calculate how much the price will fall if we sell one million dollar
worth of shares as a market order. If we find that price will fall from $25 to $24.50 as a
result of this sale order, the impact cost of one million dollar on Microsoft stock is
0.50*100/25 = 2%. Higher impact cost denotes lower liquidity and lower impact cost
denotes higher liquidity. In other words, higher the impact cost, higher the liquidity risk
and lower the impact cost, lower the liquidity risk.

Credit Risk

Credit risk is also known as counterparty risk or default risk. It is the risk that an amount
due from someone may not be received in full or in time. Thus a lender faces a credit risk
if there is a possibility that the borrower may not be able to pay the interest or the
principal fully or partially. Even the possibility of delay in such payment is called credit
risk.

Credit migration i.e. lowering of the credit rating of the bond issuer or the borrower is
also a form of credit risk. Even as actual delay or default has not occurred, credit
migration indicates that possibility of such default has increased.

In addition there are two other risks to be considered. These are settlement risk and pre-
settlement risk.

Settlement risk is a risk arising from the possibility that in fulfilling a contract, one party
fulfills his part of the obligation but the counterparty fails to fulfill his part of the
obligation of the contract. For example, in equity trade buyer pays funds and received
security and the sellers pays securities and receives funds in return. Both the transactions
need not happen simultaneously in all the markets. The risk arises when buyer has paid
the funds to the seller but the seller fails to deliver securities in time. Settlement risk does
not always mean a default in payment; the risk also arises if there is a delay. Several
methods like delivery vs. payment have been evolved to contain this risk.

In the case of derivative transaction where settlement does not happen immediately but is
scheduled to happen on a future date, risk may become obvious much before the
settlement is due. For example, if A has bought three-months futures on 1000 shares of
Microsoft at $25 and subsequently the price has fallen to $20, A is already in the loss of
$5000. For the counterparty a risk has already arisen even though the final settlement is
schedule on a later date. The risk is that on the settlement day A may not be able to pay.
It may be noted that it the counterparty of A who is at risk not A, because if a default
occurs it is the counterparty who will lose.

Operational Risk

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Of all the different types of risk facing financial institutions, Operational Risk can be
among the most devastating and the most difficult to anticipate. Consider the following
events:

The Barings bank collapse in 1995

The terrorist attack on the World Trade Center in New York in September 2001
Losses at Allied Irish Bank in 2003 reportedly due to financial fraud

There is no generally accepted definition of Operational Risk in the financial
community
11
. This lack of consensus relates to the fundamental nature of operational risk
itself. Its scope is vast and includes a wide range of issues and problems that fall outside
of market and credit risk. A useful starting point is to acknowledge that Operational Risk
encompasses risk inherent in business activities across an organization. This notion of
Operational Risk is a broader concept than “operations” or back and middle office risk
and affords differing definitions. For example, Jameson (1998) defines Operational Risk
as “Every risk source that lies outside the areas covered by market risk and credit risk.”

The British Bankers’ Association defines Operational Risk as, “the risks associated with
human error, inadequate procedures and control, fraudulent and criminal activities; the
risk caused by technological shortcomings, system breakdowns; all risks which are not
‘banking’ and arising from business decisions as competitive action, pricing, etc.; legal
risk and risk to business relationships, failure to meet regulatory requirements or an
adverse impact on the bank’s reputation; losses due to ‘external factors’ including natural
disasters, terrorist attacks and fraudulent activity, etc.”

The Basel Committee on Banking Supervision has its own definition: “The risk of loss
resulting from inadequate or failed internal processes, people systems or from external
events.” In this categorization Operational Risk includes transaction risk (associated with
execution, booking, and settlement errors and operational control), process risk (policies,
compliance, client and product, mistakes in modeling methodology, and other risks such
as mark-to-market error), systems risk (risks associated with the failure of computer and
telecommunication systems and programming errors), and people risk (internal fraud and
unauthorized actions).

Operational risk is also the less researched area of study. It is still in nascent stages of
evolving into a scientific discipline. Till such time that robust mathematical models,
incorporating multiple operational risk variables, are developed, Operational Risk will
continue to give sleepless nights to organizations and regulators as well.
Barings Bank – A Case study

Barings had a long history in London, with a presence in merchant banking of over 230
years. At the time of the collapse, the Barings Group comprised an authorized bank in the
UK (Baring Bros & Co), a securities company (Barings Securities Limited – BSL) and
various subsidiaries and branches operating in the UK and other countries. From the late

11
Operational Risk by Nigel Da Costa Lewis
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1980s, Barings had been involved in major structural changes, entering new areas of
business and attempting to incorporate those new activities into the Group structure. The
most challenging task was the incorporation of the securities business into a structure,
which, until then, had been dominated by banking activities and culture.

The collapse of the Barings Group was the product of losses incurred within one of its
subsidiary companies, Barings Futures Singapore (BFS). Subsequent investigation by the
Bank of England (BoE) revealed that at end December 1994, cumulative losses of over
£200 million had not been recognized in Barings’ accounts, with unrecognized losses in
1994 amounting to £185 million. This contrasted with the financial position indicated in
the draft financial accounts for 1994, where pre-tax profit of £102 million was shown
(this result was after allowing for transfers to a Group bonus pool of the same amount).
The magnitude of the true loss as at December 1994, had the position been discovered at
that time, might not have brought about the collapse of Barings. At that point, recorded
Group capital was in the order of £350 million. Over the course of the next two months,
however, cumulative unreported losses grew almost threefold, reaching £827 million by
27 February 1995. Adding in the costs of closing out all positions, cumulative losses
incurred on BFS’s unauthorized trading totaled £927 million.

The proximate cause of the losses, and the subsequent collapse, was the unauthorized
trading activities of the head of BFS, Nick Leeson. Leeson was authorized to engage in
active trading out of Singapore, but only as part of a ‘switching’ (or arbitrage) operation
between the Singaporean and Osaka futures exchanges. These activities were viewed as
low-risk operations by Barings management, given that they did not involve outright,
open positions on the exchanges. It is now known, however, that Leeson had engaged, for
a period of 21/2 years, in unauthorized position – taking in Nikkei futures and Japanese
Government Bond (JGB) futures on SIMEX and Osaka futures exchanges. In addition,
Leeson had exposed the capital of the Group to unlimited potential loss by writing, again
without authority, exchange-traded options against the Nikkei Index on those same
exchanges. By early 1995, Leeson had adopted a trading strategy that saw him taking:

Long (or bought) positions in Nikkei futures;
Short (or sold) positions in JGB futures; and
A ‘short volatility’ position in Nikkei exchange traded options.

To be profitable, the respective positions would have required futures prices on the
Nikkei Index to increase, Japanese bond prices to have fallen and for volatility in the
Nikkei Index to remain low. In fact, from around mid January, the Nikkei fell, at times
sharply. This led to deterioration in both the Nikkei futures and options positions.
Similarly, an easing in Japanese interest rates saw losses incurred from the short JGB
futures positions.

The sequence of profits and losses from the various positions in the different markets was
not even over January and February. At times, losses in one market were offset by gains
in another. At one point in early February, Leeson had recovered losses made from the
start of the year. In the final two weeks of February, however, all the markets in which he
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held open positions turned against him. It was over this two-week period that the bulk of
the net losses were recorded.

The losses were so great (around 1 billion pounds), that Barings Bank collapsed and was
eventually bought by ING, the Dutch banking and insurance group.

Lessons to be learnt from Barings

In its investigation of the Barings collapse, the Board of Banking Supervision
12
sought to
establish how the massive losses were incurred and why the true position within BFS,
and thus within the Barings Group, was not identified earlier.

The answer, in the Board’s view, was virtual total failure of risk management systems
and controls, and managerial confusion, within the Barings Group. In reaching this view,
the Board noted that the true position of Barings had also eluded the external auditors, as
well as the various supervisors or regulators, including the BoE, overseeing the activities
of the Group from a prudential perspective.

The Board identified a number of failings associated with the measurement and
management of risks within the global operations of Barings. In relation to the particular
circumstances of BFS, where the losses were incurred, the Board found, amongst other
things, that:

There was a lack of separation between the front and back offices within BFS. As general
manager of the company, Leeson effectively controlled both sides of the trading
operation. From that position, he was able to conduct unauthorized trading and
subsequently manipulate the number and details of the transactions in which he had
engaged, concealing them from Barings management. Secret accounts were used to park
losses arising from the unauthorized transactions; the operation of the matrix-based
reporting system within the Barings Group, which had Leeson nominally reporting
through different management lines, made responsibility for oversight of his activities
ambiguous and ultimately ineffective in practice. With hindsight, it appeared that no one
carried ultimate responsibility for monitoring Leeson’s activities in Singapore.

Barings management did not question, until it was too late, the apparent high levels of
profits being generated out of the authorized, but supposedly low risk, arbitrage activity
conducted by Leeson. At one point, it was acknowledged within Barings management
that over 60 per cent of the revenues of its worldwide derivatives operations was
generated out of Leeson’s arbitrage operations.

Barings management did not question, nor did it control or place limits on, the high,
ongoing levels of funding required by BFS from its parent and associated companies.
These funding needs jumped sharply towards the end of February 1995. Immediately
prior to the collapse, funding to BFS represented twice Barings Group capital.

12
‘Implications of the Barings collapse for Bank supervisors’, November 1995
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Barings management did not act upon the recommendations of an internal audit review,
conducted on BFS in August 1994, quickly enough, or not at all. The internal audit, in
fact, pointed to many of the weaknesses in both the risk management structure and the
controls, which were present within the BFS operation.

Barings bank is but one example of how Operational Risk materializes in the form of
people risk. Banks and financial institutions are exposed to risks from other angles and
therefore, need to tackle Operational risk in a more disciplined fashion.
BASEL Accord

Any study of Risk Management is incomplete without the mention of Basel. Basel
Accord, basically, is the de-facto standard for management of risks within banks and
other financial firms. Basel Accord is supervised by the Bank for International
Settlements (BIS)
13
.

But, what is the main reason that a standard was deemed necessary? The answer to this
lies in the sequence of bankruptcies, insolvencies and failures in the mid 1900s. Because
of the high magnitude of interdependence among banks, failure of one bank invariably
led to considerable losses faced by the banking system as a whole. While it is the
relatively few number of banks who chose not to control their risks, their failure placed
an unfair burden over other banks in the community. The collapse of Barings bank
illustrates the fact that few transgressors remained available after the event, leaving
others to pick up the pieces and repair the damage to the industry as a whole. So, there
was a need for a common acceptable standard that all banks have to follow, a system of
checks and balances, to ensure that events of high risk do not repeat.

In 1988, Central banks of G-10 countries met in Basel, Switzerland, (and therefore, the
name, Basel Accord), and recorded an agreement to apply common minimum capital
standards. The Basel Capital Accord was thus born. But the Accord, which later came to
be known as Basel I, had its own limitations. For example, Credit risks were the only
class of risks that were dealt with.

Subsequent enhancements to Basel I saw additions to incorporate Market and Operational
risks. Basel II (New Basel Capital Accord) was a revised framework, which was
originally published in 2001 and finalized in 2004. The New Accord will be brought into
effect in 2007.

The Three Pillars

Basel II provides for a framework based on three "mutually reinforcing pillars," implying
that each of the three pillars or areas described in Basel II is of equal importance. The
three pillars are:

Minimum capital requirements. The minimum capital requirement is still set at eight
percent of risk-weighted assets as it was in Basel I. A revised credit risk measurement has

13
www.bis.org
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been proposed and a measure for operational risk is also included in Basel II. However,
market risk remains unchanged.

Supervisory review process. The supervisors need to ensure that each financial institution
adopts effective internal processes in order to assess the adequacy of its capital based on
a comprehensive evaluation of its risks. Supervisors will intervene if the risk of a bank is
greater than the capital it holds.

Effective use of market discipline. It aims to improve market discipline through enhanced
disclosure by financial houses. This will include the method a bank adopts to calculate its
capital adequacy and its risk assessment.


Risk Measurement: Measures and Methodologies

Risk Measurement is the most researched stage in the Risk Management Lifecycle. There
has been a good amount of academic research and literature available on Risk
Measurement. This stage deals with the quantification of the risk factors. The rationale is
that only when all risks are quantified, can they be controlled and effectively managed.
So, the quality of the Risk measurement stage decides the overall utility of the Risk
management framework.
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Basic Risk Measures: Greeks (sensitivity factors)

The Greeks’ contribution to the science of Risk Management is the Greek alphabet. It is
not uncommon to come across symbol notations in complex mathematical formula in the
form of Greek alphabets. Alpha, Beta, Gamma, Delta and almost every other alphabet has
been used at least once. In this section, some of the most common risk measures as
denoted by Greek alphabets are discussed.

Alpha (α): Alpha measures the difference between the expected return and the actual
return of an Investment/Portfolio. A higher alpha is desirable as it means that the
Investment/Portfolio has generated returns in excess of the expected return. It is
generally understood that the higher the alpha, the more is the skill of the manager of the
Investment/Portfolio. The value of the market portfolio alpha is always zero.

Beta (β): Beta measures the relative performance of an Investment/Portfolio against some
benchmark. In essence, it is the indicator of the sensitivity of the particular
Investment/Portfolio to the benchmark. The more sensitive a portfolio's returns are to
market movements, the higher the portfolio's beta will be. The market's beta is always
one. Accordingly, a beta greater than one means that the portfolio is more volatile than
the market, less than one means it is less volatile.

Beta can be used to compare the relative risk of different portfolios and, in practice, to
judge each portfolio's riskiness. Portfolios can be ranked by their betas. Because the
variance of the market is constant across all portfolios for a particular period, ranking
portfolios by beta is the same as ranking them by their absolute risk. Portfolios with high
betas are considered high-risk investments.

Delta (δ): Delta is perhaps the most well known greek. It indicates how much the price of
the Investment/Portfolio changes when the price of the underlying asset changes by a
small amount. In practice, delta is measured for every dollar change if the underlying is a
stock instrument. Delta was originally developed as a risk measure for options. But it can
be applied to other categories of derivatives and to cash positions as well.

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Gamma (γ): Gamma measures the change in delta as the price of the underlying asset
changes. In this regard, Delta is the first derivative of the price in relation to the price of
the underlying, Gamma is the second derivative.



In addition to the above, there are other measures like Theta, Vega, Rho and Omicron..
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Value at Risk - VaR

As we have already seen before, the nature of financial risks faced by organizations are
not the same. While some industries or sectors have more exposure to Market risks, some
are more prone to Credit risks. Even within such a broad classification as Market Risk,
some are more vulnerable to Interest rate risks while some to Foreign exchange risks.

Logically, there is an efficient way to quantify each such nature of risk in almost every
single market. However, each method is deeply associated with its specific market and
cannot be applied directly to other markets. Furthermore, the unit in which one risk is
measured is not the same as the other. This means that, two classes of risk cannot be
compared for the simple reason that such a comparison would be in the kind of an
Apples-versus-Oranges comparison.

But what if an organization that faces all these risks wants to know its aggregated risk
position? Consider the situation below:

For example, the major risk associated with a government bond is the interest rate risk.
A simple way to measure it is by duration.

However, as soon as corporate bonds are included in a portfolio there is a need to deal
with default (credit) risk. This is a completely different type of uncertainty that is
correlated with all of the major indices of the economy. Therefore, to measure the risk we
would need to analyze the counterparty. The simplest way to deal with this type of risk is
by using credit rating systems (provided in many cases by credit agencies) or by
developing an internal model of evaluating the creditworthiness of the counterparty.

For an equity portfolio the most useful way to measure risk is by volatility of returns.
This parameter, together with the expected level of returns and correlations between
different assets, leads to standard investment models like CAPM and APT. These models
use diversification as the major tool to improve the risk-return ratio and some type of
correlation (like beta) as a risk-measuring tool. However, it is clear that the equity market
is strongly correlated with other types of risks (like political events and litigation risk).
Therefore it is not sufficient to deal with stock markets in isolation.

Derivative instruments became one of the major sources of hedging strategies, as well as
speculation. The risk associated with each single option, or a portfolio of options, can be
measured by the whole set of the Greeks: delta, gamma, theta, etc. Each of them
represents the rate of the change in price when only one of the parameters changes (like
the underlying asset, volatility, time to maturity etc.). Again, these indices are well suited
to watch the very specific types of risk related to derivative instruments, but cannot be
applied directly to other instruments.

Foreign exchange is another area with its own risk indices. They typically include spreads
and exchange rate volatilities.

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The table below summarizes the heterogeneity of risk measures across different
markets/instruments:

Asset class Risk Measure
Bonds Duration. Convexity, term-structure models
Credit Instruments Internal Models’ Ratings, External Rating
Agencies’ scores
Stocks Beta, Volatility
Derivatives Delta, Gamma, Vega, Theta, Rho
Foreign Exchange Spreads, Volatility

The answer to such a question is a risk measure called Value-at-Risk (VaR)

Value-at-Risk (VaR) is an integrated way to deal with different markets and different
risks and to combine all of the factors into a single number that is a good indicator of the
overall risk level.
Value-at-Risk: Looking at the undesirable volatility only

For a long period, Volatility was the most popular and traditional measure of risk. But
Volatility ignores the direction of an investment's movement: a stock can be volatile
because it suddenly jumps higher. In real world, investors are benefited by volatility in
one direction and lose if the volatility points to the other direction.

VaR attempts to answer the question, “What is the maximum loss that can happen to the
portfolio?” But given such a question, we need to add the following parameters:

Time: The time horizon over which the maximum loss is estimated
Confidence Level: The level of confidence with which the estimate is carried out.
Usually, this is set at 95% to 99%. If confidence level is set at 95%, the calculated VaR
gives us a fair estimate of the maximum loss 95 out of 100 cases.


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VaR Methodologies

Value at Risk is calculated employing different approaches. These approaches can be
broadly classified into

Parametric Approaches
Non-parametric Approaches

While Parametric models are based on statistical parameters such as the Mean and the
Standard deviation of the risk factor distribution, Non-parametric models are simulation
or historical models. The following diagram gives an overview of VaR estimation
methodologies:



In the scope of this article, we will study the following:

Variance-Covariance Method
Historical Simulation
Monte Carlo Simulation

Variance-Covariance Method

This is one of the most widely used parametric methods, based on the assumption that the
asset returns are normally distributed. Historical data is used to measure the major
parameters: Means, Standard Deviations and Correlations. The overall distribution of the
market parameters is constructed from this data. Using the risk mapping technique, the
distribution of the profits and losses over the time horizon (typically one day) can be
found.

When the market value of the portfolio is a linear function of the underlying parameters,
the distribution of the profits is normal as well. Therefore, the 5% quantile corresponding
to VaR can be calculated at 1.65·σ below the mean (2.33·σ will give the 1% level). One
significant advantage of this scheme is that for many market parameters all of the
relevant data is well known. The J.P.Morgan’s RiskMetrics
14
is probably the best source
for this type of data in many markets.


14
http://www.jpmorgan.com
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But this approach relies on the assumption that historical returns are normally distributed,
which is not the case in all circumstances. Also, this method is optimum for portfolios
with linear instruments and cannot be gainfully used if the portfolio has non-linear
instruments.

Historical Simulation

Under this method, there is no assumption of a complex structure of the markets. Instead
historical behavior of the current portfolio over the last few years is observed and the
daily percentage changes in the market parameters are measured. These changes are then
applied to the current portfolio and the corresponding profits and losses are calculated.

The most useful version of this approach is when the risk mapping procedure defines the
price of the whole portfolio as a deterministic function of the market parameters P (p).
Here P is the pricing function and p is the vector of all relevant market parameters. Then
today’s (day t) price is P (pt). The market parameters at some day j were pj and on day
j+1 the parameters were pj+1. Then the possible changes in today’s parameters can be
modeled in the following ways.

By using the relative change, where each market parameter is multiplied by the ratio of
the same parameter at day j+1 and day j.
By adding to today’s value the difference between the values at day j+1 and day j for
each parameter.

The multiplicative method is applicable when the volatility increases with the level of the
parameter. This method is useful for stock indexes, exchange rates, etc. The additive
approach assumes that the volatility is level independent. For example, for the additive
approach P(pt + (pj+1– pj)) is taken as tomorrow’s possible price.

After ordering all the resulting data (in ascending order), VaR is set as the 5% quantile of
worst outcomes.

This approach is relatively simple and it does not require simulations or the development
of an analytical model. Moreover it can easily incorporate non-linear instruments such as
options. But, a typical problem with this approach is that there is not enough data. The
further we go into the past for data, the less relevant this information is to today’s market.
This is not a simple trade-off. On the one hand, one would like to have more data in order
to observe the rare events, especially the heavy losses. On the other hand, one does not
want to build our current risk estimates on very old market data.

For example, let us assume that the last ten years of data is found suitable for our VaR
estimate. If there was a big loss on a particular day, then exactly ten years later the big
market jump will not appear in the set of data. This will lead to a jump in the VaR
estimate from one day to the next. This demonstrates that the results are not stable when
using the historical simulations approach.

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Monte Carlo Simulation

This is another Non-parametric method and probably one of the most popular methods
among sophisticated users. It does not assume a specific form of the distributions.

The first step is to identify the important market factors. Next, a joint distribution of these
factors is built based on one of the following: historical data; data implicitly implied by
observed prices; data based on specific economic scenarios. Finally, the simulation is
performed, typically with a large number of scenarios. The profit and losses at the end of
the period are measured for each scenario. Once the profit and loss distribution is
available, these numbers should be ordered and the 5% quantile of the worst results is
estimated to be VaR.

This method has several important advantages. First, it does not assume a specific model
and can be easily adjusted to economic forecasts. The results can be improved by taking a
larger number of simulated scenarios. Options and other nonlinear instruments can be
easily included in a portfolio. In addition, one can track path-dependence because the
whole market process is simulated rather then the final result alone.

One important disadvantage, however with Monte Carlo simulation, is very slow
convergence. Any Monte Carlo type simulation converges to the true value as 1/√N,
where N is the total number of simulated trajectories. This means that in order to increase
the precision by a factor of 10 one must perform 100 times more simulations. This
problem is the most serious disadvantage of this method. However in many cases there
are well-developed techniques of variance reduction. They are typically based on known
properties of the portfolio, such as correlations between some markets and securities, or
known analytical approximations to options and fixed income instruments.

Given this inherent nature of processing a large number of simulations, this method
requires considerable computing resources and time and as such, the cost of calculation
of VaR using this method is cost-borne.

Page 303
Testing the concepts

1. Which of the followings explains the term ‘credit migration’
a. Default by a company in payment of interest
b. Default by a company in payment of principal
c. Change in credit limit extended by a bank to the company
d. Moving credit from one company to the other by the bank
e. Change in credit rating of a company
2. Which of the following methods can be used to calculate Value at Risk of a portfolio
a. Historical simulation
b. Variance-Covariance methodology
c. Monte Carlo simulation
d. Black and Scholes model
e. a, b and c
3. Value at Risk is a single, summary, statistical measure of
a. Possible maximum profit from the portfolio
b. Possible maximum loss from the portfolio
c. Possible minimum loss from the portfolio
d. Definite loss from the portfolio
e. Average loss from the portfolio
4. Pre-Settlement risk can be defined as
a. Risk of loss on derivative instruments prior to the settlement date
b. Risk of loss on derivative instruments on the settlement date
c. Risk of loss on derivative instruments after the settlement date
d. Risk of loss on derivative instruments on the trade date
e. Risk of not receiving the payment on the settlement date
5. Which of the following risks are not relevant in financial transactions
a. Market risk
b. Operational risk
c. Liquidity risk
d. Country risk
e. None of the above
Page 304
Wealth Management

This chapter covers the followings:

Concept of wealth management
Typical wealth management offerings
Invest process
Customer profiling
Financial planning
Asset allocation
Portfolio construction
Portfolio rebalancing
Performance measurement and reporting
Alternative investments
Discretionary and Non-discretionary investment management
Trend is wealth management
Role of technology in Wealth Management










Author

Krishanamurthy CG













Page 305
Introduction

Private Wealth management business
covering Private banking, Asset
management, etc. have been registering
exponential growth over past decade and
now has become an important line of
business for banks and financial institutions
worldwide. The Private wealth management
business, and the High Net Worth (HNW)
clients both have undergone dramatic
changes in the new millennium. These
factors are reshaping the entire financial
services landscape globally. This has
resulted in an increase in the need for
Mission critical software applications and
support.

In simple terms Wealth management business can be summarized as

“The ability to deliver a full range of interrelated financial planning, advisory,
brokerage, investment management and investment services /products to affluent clients
with complete understanding of the customer and risks with a relationship focus.”

The above definition is only to indicate the complexity of the business and not to define
or confine wealth management as the very nature of the business is so dynamic.

Financial institutions across the globe offer Financial planning, Private Client services,
Asset & Investment management and Advisory services under the gamut of Private
Banking or Wealth management. Usually the offerings encompass many products and
services from the retail banking to investment banking classified under the umbrella of
Wealth management




What is Wealth management?


Wealth management is a process of understanding clients'
long-term investment objectives /risk appetite & based on that
• Providing conflict-free investment advice
• Offering a set of investment products (both in-house
& open) aligned to the investment objectives
• Managing and monitoring the client portfolio to
ensure performance (meeting the objectives)
• Balancing (adjusting) the portfolio as needed on an
ongoing basis and Risk mitigation
• Developing appropriate interaction channels for
providing customer service
Pic. 1: What is Wealth management?
Pic. 2: Wealth management business positioning
Page 306
Many services that were offered exclusively to institutional clients such as Trading, Asset
management, Cash management, Custodial services, Clearing and Settlement are now
being offered to HNW clients under the umbrella of Wealth management.

Need for professional Wealth Management

Personal wealth can be eroded by inflation, tax mismanagement and bad investment
decisions. Investors are facing one of the most challenging investment climates in recent
history. The threat of terrorism, economic slowdown, business disasters and political
upheavals all contribute to tremendous market volatility. In addition, information
overload confuses and overwhelms investors. Because of all this they are facing number
of challenges in terms of

Retention and growth of wealth
Organize finances and take control of financial future
Ability to make well-informed investment decisions
Understand and manage risks that may impact current and/or future lifestyle
Achieve tax efficiency
Manage wealth to take care of retirement
Inheritance planning

Hence wealthy individuals are seeking the advice of professional wealth managers. This
need also provides enormous opportunities to the financial institutions as they have
opportunity to bring a basket of services such as brokerage, custodial services, cash &
credit management and collateral management to individuals, which were limited only to
institutions in the past.

Evolution of Wealth Management

Wealth management business has evolved from a limited offerings by banks and fund
managers to global Private Banking & Wealth management business where large group
of financial institutions offer complex array of products and services and have global
reach and presence.












• Branch
Banking
• Deposits
• Loans &
• Loans &
Mortgages
• Multi Deposits
• Advances
against financial
• Financial
planning
• Mutual Funds
• Custodial
services
• Brokerage
• Open investment
products
• Alternate investments
• Hedge Funds
• Derivatives
• Global accounts
• Performance analysis
• Wrap Accounts
80s & earlier 80s – 90s 90s to 2000 New Millennium
Pic.3: Evolution of Global Wealth management /Private Banking
Page 307

Demographics

The private wealth management arena is highly fragmented, with
nearly all of the world's top 200 banks competing for clients in
this space. According to the US Federal Reserve, there are over
4,000 financial institutions competing in the private wealth
management market today in US alone, with no single bank or
institution controlling more than a 2% to 3% market share. In
Europe, despite many Swiss banks managing the wealth of HNW
Clients, no single bank has been able to gain more than 4%
market share. Thus the business of Wealth management or
Private banking is scattered and each bank’s business is
structured according to its traditional strengths and client
demographics.

Individual Wealth is spread across several types of clients – from mass affluent to High
Net Worth to Ultra rich individuals. Wealth management has emerged as an attractive
business model of providing financial services to these wealthy individuals. Success
requires a granular understanding of the sub-groups and their “life goals” within the
wealthy population. Wealth management clients are broadly categorized as given below.

Ultra HNW Very HNW HNW Affluent Mass Affluent
Over US $ 50
Million
US$ 10-50
Million
US$ 1-10
Million
US$ 250,000-1
Million
US$ 50,000-
250,000

Wealth management Business Challenges
With the ever-increasing demand from
the customers on retention and growth
of personal wealth financial intuitions
face several challenges. Two critical
business challenges affecting the
Wealth manager are

1. Increased volatility in financial
markets – increased volatility has
resulted in low risk-adjusted returns
compelling financial institutions to
focus more on hedging. In addition,
decline in trade order volume has
resulted in reduced revenues from
trade commissions.

2. Increased client sophistication -
demand to manage portfolios in line
with personalized and structured financial objectives.
Pic. 5: Wealth management Business Challenges
Pic. 4: Top 10 Private Banks
Page 308

Financial advisors at wealth-management firms need new and innovative tools to satisfy
and retain their increasingly demanding clients. Technology has a greater role to play in
terms of meeting the needs of this sophisticated business.

Wealth management offerings of a typical Private Bank






How the business of a Private Bank differs from that of a Retail bank?

Retail Banking Private Banking
Product(s) focus Relationship focus
Cost cutting is priority Customer retention is priority
Deposits are the only Investment options Open architecture investment options
Income from Spread Income from Fees
Need to provide many access channels Need to provide better returns
High volume / low risk Low volume /high risk
Customer services thru channels High touch Customer service



Pic. 6: Offerings of a typical Private Bank


Investment process in Wealth management


360-degree
Client Profiling
New Business
Prospecting
Proposal / Document
Generation
Client Servicing/
Performance Analysis
Asset Allocation &
Portfolio Construction
Client Reviews &
Reporting
Full-Lifecycle,
Proactive & Relevant
Investment
Mgmt Process
In-firm &
Open Arch.
Investment
Products
Current
Asset
Allocation
Target
Asset
Allocation
Recommend investments to bridge Strategy /
Execution gaps or meet ongoing client needs
Integrated Data
Dynamic Personalization
Configurable Templates
Prepare Asset Allocation Strategy – To achieve
Desired returns with Acceptable level of Risk
Access, Research, Compare & invest
in line with Asset allocation strategy
Monitor Current vs. Target
Allocation & manage drifts
Event or schedule-
driven interactions
New Business
Management
Open Arch.
Investment
Financial
Planning
Client
Assets
Includes Investment & Risk
Profile
Portfolio Management &
Rebalancing
Alerts
360
Degree
Client
Profile
Relatio
nship
Profile
Financi
al
Profile
Person
al
Profile
Invest
ment
Profile
Risk
Profile
Pic. 7: Investment Management Process


Page 310

Financial Planning

The Investment advisor first determines
client’s financial goals and jointly with the
client analyses various investment objectives
of the client and plans for…
Long-term and short term needs such as
Retirement, Education, Home, Income,
Wealth Preservation, Inheritance, etc.
Matching the risk profile of the client with
investment portfolio
Investment Time Horizon - Short,
Intermediate, Long
Client’s Concerns on Taxes, Inflation,
Investment Risk

On completion of the financial planning the
Investment advisor arrives at the Optimal Portfolio model for the client, which is
Efficient, Customized, Decrease Risk & Increase Return and meet the overall financial
goals.

Asset Allocation
Asset Allocation is a
process of modeling a
portfolio with stocks,
bonds, debt, mutual funds,
cash and other asset classes
depending on client’s
investment objectives and
risk tolerance.

Each asset class generally
has different level of return
and risk. They also behave
differently. At a given time
if one asset is increasing in
value, another may be
decreasing or not increasing
as much and vice versa. Studies have shown that Asset Allocation choices rather than
security selection and market timing determine a majority of large portfolios’ investment
returns.

The Investment advisor, as part of the discretionary portfolio management (where
portfolio manager makes decisions on investments within broadly defined parameters),
does the Asset allocation depending on client’s Risk - Return profile. Appropriate Asset










Pic. 8: Financial Planning

Wealth
Growth
Trust
Planning
Investment
Objectives
Risk
Profiling
Estate
Planning
Retirement
Planning
Tax
Planning
Children’s
Education
Insurance
Plannin
Pic. 9: Asset Allocation
Client Profile
Investment objectives
Short term /long term
Risk profile
Tax position
Lending requirements
Sector Allocation
Optimal Income contribution
Favorable risk/reward
Growth opportunities
Duration Positioning
Optimal horizon return
Within 25% (+/-) of
benchmark
Satisfy cash flow funding
Security Selection
Distribution
Optimal structure features
Liquidity
Low event risk
Asset
Allocation
Client Profile
Investment objectives
Short term /long term
Risk profile
Tax position
Lending requirements
Sector Allocation
Optimal Income contribution
Favorable risk/reward
Growth opportunities
Duration Positioning
Optimal horizon return
Within 25% (+/-) of
benchmark
Satisfy cash flow funding
Security Selection
Distribution
Optimal structure features
Liquidity
Low event risk
Asset
Allocation


Page 311
Allocation is essential to meet short- and long-term financial needs. Fundamental,
economic and quantitative analysis is used to identify sectors and securities within
various markets that may offer optimal gross, risk adjusted, and after-tax returns over a
rolling time horizon.

Styles

A style is a Portfolio framework for the allocation of funds as per the
broad financial objectives such as Growth, Cash flows (dividends)
etc. Each style is associated with its unique risk profile. One style
can be used independently or in combination with other styles while
constructing a Portfolio Model depending on the risk /return profiles.

Models

Portfolio model is a Portfolio by itself aimed towards achieving specific investment
objectives by using various style frameworks. In addition, the selection of securities and
their weightages are also defined as part of the model. Portfolio mangers have access to
various portfolio models having certain risk/return profile. A model could have funds
distribution methods defined such as “30% on Low risk stocks, 40% Bonds, 20% high-
risk stocks and 10% cash” with an estimated return.

Portfolio Management

Majority of world’s Portfolio management is based on Modern Portfolio Theory (MPT).
Harry Markowitz introduced modern portfolio theory through his paper "Portfolio
Selection", which appeared in the 1952 Journal of Finance. Thirty-eight years later, he
shared a Nobel Prize with Merton Miller and William Sharpe for what has become a
broad theory for portfolio selection.

The Modern Portfolio theory proposes that investors should focus not only on individual
risk-reward characteristics of a security but also on correlation of risk and return of one
security with another within the portfolio. According to the Portfolio theory, it is possible
to construct an optimal portfolio offering the maximum possible expected return for a
given level of risk.

The basic tenet of the Markowitz Portfolio theory is that one must know the mean,
standard deviation and correlation of the returns for securities to create a portfolio which
will offer maximum expected return for a given level of portfolio risk measured in terms
of standard deviation of the portfolio. Markowitz theorized that a properly diversified
portfolio would provide maximum return for a given level of volatility – or minimum
volatility for a given level of return.

Portfolio Return
The expected return of a Portfolio is
the weighted sum of expected returns
Portfolio Risk
The portfolio risk is measured by the weighted
sum of covariances of the rates of return of
Styles
• Low Risk Debt
• Growth Equity
• Balanced Growth
• Dividend Equity
• Mid-Cap value


Page 312
of the assets included in the portfolio
E(r
p
) = ∑ x
i
E(r
i
)
i for all
assets in
Portfolio
E(r
p
) = ∑ x
i
E(r
i
)
i for all
assets in
Portfolio



securities in the portfolio. The risk of a
Portfolio is inversely proportional to the degree
of positive correlation among the assets
included in the portfolio
σ
p
2
= ∑ ∑w
i
w
j
Cov(R
i
,R
j
)
R
p
= ∑ w
i
R
i
i=1
n
j=1
n
i=1
n
σ
p
2
= ∑ ∑w
i
w
j
Cov(R
i
,R
j
)
R
p
= ∑ w
i
R
i
i=1
n
j=1
n
i=1
n

Note: Kindly refer to Section xxx on financial mathematics for details of the above
equations


Page 313

Portfolio Construction
Portfolio managers analyze a
number of investment models
for various risk-return
combinations with historic
data to construct a portfolio
suitable to the client’s risk-
return profile. Investment
style combinations are used
in a model based on cash
flow and liquidity needs.
Various simulation methods
and “What-if” scenarios are
used to determine the
optimized portfolio. Different
types of Investment models
& Styles are chosen based on customer’s investment objectives. Portfolio is constructed
based on asset allocation across multiple styles and multiple asset classes depending on
the investment research and in consultation with the client. While constructing the
Portfolio various combinations are examined to arrive at the optimum risk-return for the
Portfolio. Pic.10 shows that a portfolio combination of stocks and bonds is less risky than
either 100% stocks or 100% bonds and provides a better return than a portfolio comprised
of 100% in bonds.

Dividing the portfolio among assets with low correlation results in increase in return
while decreasing the portfolio risk.

Diversification

Diversification is the process of combining two or more assets in a portfolio to create an
optimal balance between risk and return. Stocks and bonds do not generally react
identically to the same economic or market conditions; therefore, gains in one asset class
may offset losses in another. The volatility of the portfolio may be contained with a
steadying influence on return. Diversification reduces risk when assets are combined
whose prices move inversely, or at different times, in relation to each other.

Diversification allows portfolio managers to take
greater individual chances. Diversification
diminishes the impact of macro-economic factors
and enhances the efficacy of the portfolio. Risk
encompasses the unexpected, the unknown and
the adverse effects on the portfolios. When
investments diverge from the intended, there are
often common factors forcing the variation. True
diversification decimates commonality among
Pic. 10: Portfolio Combinations
Diversification Methods
Across assets with different credit ratings
Across industry sectors
Across asset classes & sizes
Across Investment models & styles
Across investment products
Across durations (Bonds)
Across time horizons
Pic. 11: Diversification Methods


Page 314
these unforeseen market risks. Portfolio managers can use the correlations of assets to
further isolate and determine the risks that they wish to avoid. This is another benefit of
diversification.



Rebalancing

Portfolio rebalancing is the process of bringing different asset classes and securities back
into proper relationship following a significant change in the return or risk of one or more
of these while constantly monitoring the Portfolio. It also implies realigning
the weightages of the portfolio based on the performance of the portfolio with the client’s
investment objectives. Rebalancing refers to the periodic process of selling down the
assets that have appreciated in value (peaked) and adding the assets having potential for
growth while maintaining the diversity and balance of the portfolio to minimize the risk -
in simple words it enforces the principle of selling high and buying low.

Rebalancing is a vital part of investment management. Asset allocation target can’t be
achieved without rebalancing. It is also necessary to achieve the benefits of
diversification. By letting the market take its own course asset allocation starts diverging
from the planned asset allocation. It has been observed that an actively re-balanced
portfolio gives higher risk-adjusted return over the long run compared to a portfolio
where asset allocations moves far away from the targets. Rebalancing is to be done
regularly and whenever warranted during volatile market conditions to protect portfolio.

Hedging

Market values of all financial assets constantly change, in particular the stocks, due to the
volatility in various markets such as Money markets, Debt markets, FX market,
Commodities market and economic conditions such as changes in Interest rates,
sovereign ratings, regulatory guidelines, etc. Much of the risk in holding any particular
security in the portfolio is its market risk; i.e. the change in its market price. Market risk
could adversely affect the portfolio.

Hedging is a process of protecting Portfolios against market risk. The use of derivatives
is essential to portfolio management and is an internationally recognized method of
market risk management. All individual or institutional portfolio managers, whether their
portfolio consists of equities, money market instruments or bonds, can use derivatives to
effectively manage the specific or even systematic risk related to their investments.
Pic. 12: Portfolio Diversification


Page 315

One of the methods for Hedging is by purchasing put options on a particular security or
securities that are part of the portfolio. A put option gives its holder the right, but not the
obligation, to sell a specific stock at a given price (the strike price) for a specified period
(till expiry). So when the stock prices (that are part of the portfolio) goes down the value
of the portfolio will also go down. Then the options can be sold and the difference in
value can be put back into the portfolio to keep its value intact. If the stock prices go up
then the options won’t be exercised and be left to expiry. Here the loss in one investment
is offset by a gain in the derivative, thus the portfolio value is protected. Futures is also
used to hedge the portfolio value. But unlike the put option it prevents a gain in the value
of portfolio if prices move up.

Advisory Portfolio Management

This service allows a more proactive client role while availing of professional advice in
all portfolio investment decisions. Recommendations are based on the client's
requirements, however the investment decisions rests with the client. In advisory
portfolio management periodic transaction and portfolio performance reports are
provided to clients. Typically, the trade execution and back office functions like
settlement are handled by the advisor.

Discretionary Portfolio Management

This service provides discretionary management of diversified portfolios for long-term
capital growth. The portfolio manager has discretion to make investment decisions on
client’s behalf. All changes to the portfolio are notified immediately to client and the
portfolio must adhere to the agreed asset allocation, investment objectives and risk
profile. As the portfolio manager takes full charge of investment decisions, he is
responsible for efficient management and protection of the portfolio. Regular reporting of
the portfolio and transactions are sent to client


Discretionary Portfolio Advisory (non-discretionary) Portfolio
Value of the portfolio is generally high Value of portfolio is generally low
Portfolio manager (PM) manages the portfolio Client manages the portfolio
Asset allocation is mutually agreed Left to Client
Diversification /Rebalancing done by PM Left to Client
Hedging is done by PM Left to Client
Performance Benchmarks are set jointly Left to Client
Portfolio manager responsible for performance Client responsible for his own performance
Buy /Sell decision is with Portfolio manager Decision is with the Client
Funds & Securities obligations handled by PM Advisor may or may not provide this service
Calculation of ROI is done by PM Client need to calculate the ROI
Major part of revenue is through fees Major part of revenue is through brokerage/
transaction charges
Portfolio & Transaction records are maintained Transaction records are maintained. Portfolio


Page 316
records need not be maintained.

Investment services

Banks and Financial institutions providing various Investment services such as Trading,
Order management, Confirmation, Clearing, Settlement, Custody and Corporate actions
generally use the Asset management or investment bank’s back office application
systems.

Performance Analysis & Management

Performance measurement and attribution are increasingly gaining importance in Wealth
management and private banking business. Performance measurement enables Wealth
managers and clients to identify the aspects of the investment strategy that are adding
value or protecting the portfolio.

Performance measurement is the process that enables investment managers to effectively
analyze and communicate the performance of their investments and track them against a
benchmark. Performance analysis can be broken down by portfolio, market, asset class,
sector and instrument levels. Performance attribution is a methodology that quantifies the
success or added value of an investment strategy. Attribution allows investment managers
to identify which factors of the investment process contributed (positively or negatively)
to the performance levels highlighted by performance measurement.

Performance measurement and attribution answers to questions such as:
How these returns were achieved, and what factors contributed to that performance?
What value has been added to the portfolio by changing the benchmark asset allocation?
What value has been added or protected by the selection of certain asset classes?
How well has the overall sector selection strategy worked?
What has been the net effect of Alternative investments in the portfolio?

Wealth manager uses the performance measurement to improve the competency,
investment performance, and service level where by the growth of the fee based income
is ensured. On the other hand customers gain complete analysis of the portfolio and its
growth along with important indicators on individual asset class’ performance, which in
turn helps in refinement of the investment strategy for the future.










Performance Measurement
Absolute Measurement
• Measurement against benchmarks
• In comparison with peer groups
Relative Measurement
• Beta of asset class/portfolio
• Std. deviation
• Correlation with the benchmarks
• Tracking error
• Information Ratio
• Risk adjusted measures
• Sharpe, Treynor & Jensen’s methods
Tax adjusted performance
Performance Attribution
Attribution of performance to -
• Broad market/Customized benchmark
• Sector/ Industry
• Stock selection
• Style of the fund manager
• By activity – Buy and sell
• Skill of the fund manager
• Attribution to asset/ currency allocation Multi-
level analysis
• Aggregate portfolio level analysis
• Asset class analysis
• Individual decisions- impact analysis
Pic. 13: Performance Measurement & Attribution


Page 317

Subsequent to the analysis of performance attribution, corrective actions such as further
rebalancing can be performed, if required. Many performance analysis software tools
adhere to the guidelines on performance measurement published by AIMR (Association
for Investment Management and Research) and GIPS (Global Investment Performance
Standards).

Alternative Investments

Equities and Bonds markets have been going through a cycle of
low returns with high volatility. Due to higher returns than
traditional assets Alternative investment instruments have been
gaining importance in recent times as investment alternatives.
Alternative investments are included in portfolios to take
advantage of opportunities in the private market and/or exploit
inefficiencies and anomalies in the public market. This
investment strategy can enhance potential portfolio return,
and/or reduce portfolio risk, or a combination of both. More
importantly they offer added diversification in portfolios.

Alternative investment products, including hedge funds could involve high degree of risk.
It could involve leveraging and other speculative investment practices that may increase
the risk. At times these investments could be highly illiquid. Alternative investments are
not priced or valued frequently and are not subject to several of the regulatory guidelines.
In many cases the underlying instruments of alternative investments are not transparent.
However due to high returns and low volatility of the alternative investments HNW
clients are interested in investing a portion of the portfolio in alternative investment
instruments.

Some of the key benefits of Alternative investments include

Better return outcome, given the risk, than traditional stocks
Protection against negative returns by using hedging
Less volatility
Excellent diversifier as alternative investments have very low correlation with both
stocks and bonds

Hedge Funds

Hedge funds are investment partnerships among a group of HNW individuals that invest
in a variety of securities/ assets and seek above average returns through active portfolio
management. Hedge funds do not raise funds via public offerings and therefore are
generally not regulated like other funds such as mutual funds. As hedge funds are not
regulated, hedge fund managers (who will usually have a substantial amount of their own
money invested in the fund) are free to utilize more unconventional and potentially
'riskier' investment strategies in order to secure higher returns for the fund investors.
Alternative Investments
Real Estate
Private Equity
Natural Resources
Hedge funds
Fund of funds

Pic. 14: Alternative Investments


Page 318
While mutual fund managers mostly earn a fixed amount on asset under management
irrespective of its performance, hedge fund managers almost invariably have a share in
the profit and do not charge a fixed fee.

Although there is no legal definition of a hedge fund, the term in fact derives from the
fact that investments within this type of fund hold both long and short positions thus
making them 'hedged' or protected to some degree against market volatility, thus the
name hedge funds came into existence. Hedge funds could operate in multiple markets
and generally make leveraged investments.

For conventional Wealth management hedge funds are alternative investments and offer
private Investment vehicles designed for sophisticated investors with high-risk tolerance.

Mutual Funds Vs Hedge Funds

Mutual Funds Hedge Funds
Creates investment pool for retail
investors
Investment pool for high number of
investors
Investment strategy as per fund objectives
Invests only in unleveraged securities
Short selling is not allowed
Subject to multiple regulations
Creates investment pool for high net worth
individuals
Investment pool of select number of
investors
Flexible investment strategy depending on
market conditions
Can invest in leveraged securities
Short selling is practiced
Subject to only antifraud regulations


Offshore Wealth Management
A Large portion of HNW individuals from Asia, Middle
East Asia and Latin America place their assets with
offshore Wealth managers in offshore tax heavens such
as Bermuda, Cayman Islands, etc. Offshore wealth
management is gaining importance lately due to tax
savings and easy inheritance of wealth to next
generation.

Many leading private banks and Asset management
companies have their entities in these offshore hotspots.

Future outlook
Offshore Wealth management
Hotspots
• Bahamas
• Bermuda
• British Virgin Islands (BVI)
• Cayman Islands
• Channel Islands
• Jersey
• Uruguay
Pic. 15: Offshore Wealth management


Page 319
In the Wealth management business future is bright only for those who had transcended
boundaries of geographies into global investment management. This is evident from the
fact that both the HNW Clients and their investments have become global and
sophisticated in nature. In order
to achieve success in this
scenario, Wealth managers have
to act as financial service hubs
that offer customized solutions to
a global clientele. Wide range of
global investment products and
personalized services need to be
integrated and delivered through
a multi-channel advisory system.
To achieve this, the business
processes and technology
platforms need to adoptable to
the trends.






Role of Technology in Wealth Management

Managing the burgeoning complexity of delivering advice to clients and making
investments across many banking applications and investment products - both in-house
and third party - through
multiple access channels
demands high degree of
automation. Technology
implementation and support is
critical in the business of
Wealth management, as the
nature of the business
demands a high degree of
customer services, data
aggregation and performance
analysis in frequent intervals
in addition to providing better
returns to the clients year after
year.

Several studies have
underscored the importance of
the use of technology that
Pic. 17: Technology in Wealth Management
Client
Type
Client
Type
Pic. 16: Future of Wealth Management


Page 320
HNW clients place for better control of their finances in addition to ready-access to
online investment tools and account information, portfolio performance, etc. These are
critical for business success.

Picture-17 depicts the role of the Technology in Wealth management with respect to
Customer facing part of the business (Front office), Risk /compliance part of the business
(Middle office) and Investment & Securities services part of the business (Back office)

In addition to the Transaction processing applications such as Order management,
Portfolio management, Billing, etc. Wealth management business involves four critical
dimensions of technology relating to Customers, Business Operations, Data and Decision
support

Dimensions
Customers
Business operations
Data Management
Decision Support
Tools
Relationship Management (CRM)
Business Process Management
Data Warehouse
Analytics




Page 321

Relationship Management
Relationship Management is not a product or service, it is a process of enabling
companies to manage customer relationships effectively. From the IT perspective
Customer Relationship Management (CRM) is the integration of sales, marketing, service
and support strategy, process, people and technology to maximize customer acquisition,
value, relationships, service quality, retention and loyalty.

Relationship Management Technology Benefits
Provides the relationship managers with a 360°
view of customer relationship with all customer
information
Improved customer experience &
retention (KYC- Know Your
Customer)
Helps segment customers into various group based
on demographics and investment behavior
Cross-sell opportunities, Increased
relationship profitability
Helps in building one-to-one relationship: Treating
Different Customers Differently
Unique customer experience and
services
Helps integrate customer data across branches,
central office and other delivery channels
Improved service quality across all
customer touch points
Integrates call centers and the branches with a
unified view of customer interactions
Better customer service and
Consistent customer interactions
Provides Sales campaign and Contact management
functions at relationship officer level and advisor
level
New customer acquisition,
Investment planning
Enables financial institutions to deliver the cross
channel experience clients expect
Better customer service and
satisfaction
Helps in redesigning of the banking business from
product focus to service focus
Horizontal integration and
customer retention
Maintains customer’s data and database as a global
database across the Private bank
Global customer service and
business expansion

Properly implemented Relationship Management applications automates these business
critical applications and provides a online platform for customer interactions

Relationship management technology evolution in Wealth management


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Pic. 18: Relationship Management evolution


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Data Management

Financial institutions increasingly face critical challenges in data management as the
volume of data from the market, rating agencies, customers and vendors keep increasing
and changing at a rapid pace. This huge volume of data requires sophisticated tools and a
high degree of automation to manage. Thus Data warehouse solutions have been in top of
financial institutions’ list of priorities with respect to technology. Data Warehouse is the
central part of the Analytics and customer support functions in the banking world. The
recent regulatory guidelines such as Basel II also mandates financial institutions to keep
their credit, reference and customer data for building efficient risk management
infrastructure.

The concept of Data Warehouse can be defined as

“A data warehouse is a collection of critical corporate information, derived directly from
operational systems and external data sources with a purpose to support business
decisions, not operations”

In wealth management the application of data warehouse is more relevant than elsewhere
as investment decisions are frequently made /changed with the help of data from various
sources both internal and external. Hence the data warehouse is essential for the
collection, collation, consolidation and presentation of data for investment decision
Data
Warehouse
Operational
Data Store
Relationship Mgmt Analytics Data Warehouse
Extract, Transform,
Load process
Customer
Interaction Data
Customer Records
Past Transactions
Branches

Mobile

Phones

Web
@
Email
Documentation

Call-center
Customer Touch Points
Transaction applications
Credit &
Collateral Mgmt
Banking
Services
Trading &
Brokerage
Investment
Services
T
r
a
n
s
a
c
t
i
o
n

D
a
t
a
Propensity
Scoring
Cross sell
Opportunities
Portfolio
Analytics
Relationship
Platform
Analytical
Front-end
Credit
Scoring
Campaign
Management
Reports &
MIS
Customer Analytics
Financial Analytics
Analytical
Data
Data Warehouse Platform
Business Processes
Data
Warehouse
Operational
Data Store
Relationship Mgmt Analytics Data Warehouse
Extract, Transform,
Load process
Customer
Interaction Data
Customer Records
Past Transactions
Branches

Mobile

Phones

Web
@
Email
Documentation

Call-center
Customer Touch Points
Branches

Mobile

Phones

Web
@
Email
Documentation

Call-center Branches

Branches

Mobile

Mobile

Phones

Phones

Web
@
Web
@
Email

Email
Documentation

Documentation

Call-center Call-center
Customer Touch Points
Transaction applications
Credit &
Collateral Mgmt
Banking
Services
Trading &
Brokerage
Investment
Services
Transaction applications
Credit &
Collateral Mgmt
Banking
Services
Trading &
Brokerage
Investment
Services
T
r
a
n
s
a
c
t
i
o
n

D
a
t
a
Propensity
Scoring
Cross sell
Opportunities
Portfolio
Analytics
Relationship
Platform
Analytical
Front-end
Credit
Scoring
Campaign
Management
Reports &
MIS
Customer Analytics
Financial Analytics
Analytical
Data
Data Warehouse Platform
Business Processes


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support

Data warehouse aggregates and integrates data from various sources for Decision support
in various business functions
Data Sources Business Functions
Customer data
Credit data
Reference data
Economic data
Market data
Ratings data
Performance
data (past)
Across the company
Multiple standards
Multiple sources
Duplicated
(cleansing)
Hard coded (entering)
In multiple
definitions
Spread across
geographies
Analytics
Periodic reporting
Holdings in real-time
Fee calculation
Portfolio changes
/NAV
Consolidated
statements
Personalization
Multi channel delivery
Cross-sell opportunities



Business Process Management
Management of the business processes play a key role in the automation of Banking &
Financial services world. The stringent nature of the business due to regulatory and
business rules demand automation of the workflow, entitlements and operational aspects
of the business to ensure compliance with business /regulatory guidelines. Process
management is one of the key factors, in winning customer confidence as it also helps in
terms of enforcing compliance with guidelines set by the customer.

Process management also plays an important role in Capital markets due to the business
push towards Straight Through Processing (STP). STP enables financial markets in
moving towards shorter trading cycles and higher trade fulfillment, Wealth management
being in the buyside in the financial markets, benefits enormously with STP.

Rules driven business process automation designed to provide complete data/information
workflow management and automation of process entities including orders, trades, on-
line positions, end-of-day positions, limits, reconciliation and entitlements in tight
integration with front-office applications including customer order management systems,
credit monitoring and approval process management and mid/back-office office functions
such as Pre Trade Compliance, Post Trade Compliance, etc. Business processes can be
configured to alert the Portfolio manager when the portfolio deviates from the investment
objectives defined by the customer.

Automating the Portfolio management and Credit administration processes provide
analysis of the customer’s behavior, current investment preferences, financial status,
relationship and the credit exposures. Business process automation also helps in
compliance with the norms such as the limits management, collateral management, Mark-
to-market valuation and netting of collaterals to secure the credits extended to clients in
Collect
Collate
Consolidate

Decision
Support

Pic. 20: Data transformation & Decision support
Pic. 19: Data Warehouse – Core of Wealth management


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the management of Credit risk. In the event of collateral value going below the business
norms alerts can be triggered by the Workflow application prompting corrective actions,
appropriate risk reports or escalation mechanisms.

Analytics
Wealth management clients constantly require advice tailored to their investment
objectives, goals and constraints. Portfolio managers, using the time tested Mathematical
and statistical models for investment analysis meet client requirements. Portfolio
managers perform scientific risk/return analysis based on historical information to assess
and project future performance and cash flows. Many software tools that provide the
necessary mathematical and statistical models are used for analytics.

For analytics to be meaningful, the collection, collation and consolidation of critical
financial data from various sources within and outside the company are essential. In
addition availability of data for analysis that is accurate and timely, presented in a
standardized format, that adopt to uniform analytics methodologies are critical. Data
warehouse (OLAP) and data mining tools greatly help in providing the necessary
financial data for analytics. [Picture 20, depicts the importance of data management for
analytics]

The field of analytics has been registering exceptional growth in terms of the increasing
need to provide superior services in financial planning, asset allocation, portfolio risk
management, performance management and meeting regulatory requirements. Some of
the critical factors that also contribute to the growth of Analytics are:

Shrinking margins and intense competition from traditional and many new non-
traditional intermediaries who are entering the lucrative market of Wealth management
Market volatility, erosion of wealth due to huge stock losses etc. have shaken investor
confidence and hence reliance on analytics has deepened to overcome these issues
Recent regulatory guidelines such as Basel II demand for sophisticated risk management
and reporting in addition to regulatory and economic capital provisioning
Investment opportunities that arise out of globalization offering higher returns and
associated risks

Portfolio Performance evaluation and attribution plays a major role in the Wealth
management and asset management businesses. Performance analysis entails review of
the performance of portfolio and individual securities and assumptions based on factors
including macroeconomic data, strategies of portfolio management, asset allocation and
market positioning.









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Analytics in Portfolio management
• Value at Risk (VaR) analysis - Across all asset classes in the portfolio & Portfolio level
• Pre trade & ‘What if’ analysis - Hypothetical trades on a portfolio’s expected risk and return
• Industry and Sector analysis – Equities component of Portfolio
• Scenario analysis & Stress testing – For all credit exposures and hedging strategies
• Sharpe ratios & risk-adjusted return on capital (RAROC) analysis - For portfolio and components
• Exposure analysis - Stand-alone risk, Portfolio risk contribution, Correlation with other exposures,
and Expected returns
• Concentration analysis – Across all client portfolios
• Stochastic asset class returns & inflation rates
• Portfolio risk analytics - Based on Monte-Carlo based risk measures for volatility and tail risk
• Performance analysis & attribution