MBA Semester IV

MB0052
MB0052- Strategic Management and Business Policy
Assignment Set1

Q1. What is meant by Strategy? What are the levels of strategy? Differentiate
between goals and objectives.
Answer: The word strategy is derived from the Geek word strategia, and conventionally
used as a military term. It means a plan of action that is designed to achieve a particular
goal. Earlier, the managers adopted the day-to-day planning method without concentrating
on the future work. Later the managers tried to predict the future events using control system
and budgets. These techniques could not calculate the future happenings accurately. Thus,
an effective technique called strategy was introduced in business to deal with long term
developments and new methods of production.
The different concepts of strategy are:

It is defined as a plan to direct or guide a course of action

It is a pattern to improve the performance over time

It is a fundamental way to view an organisations performance

It is a scheme to out-maneuver competitor

Levels of strategy
Strategy exists at different business levels. The different levels of strategies are as follows:

Corporate Strategy This is regarding the general function and scope of the business
to meet the stakeholders expectations. As it is significantly influenced by the investors
in the business, it is also called the critical level strategy.

Business Strategy This is regarding how a business competes effectively in a

particular market. It includes strategic decisions about the selection of products and
meeting customer requirements.

Operational Strategy This is regarding how each part of the business is organised
and delivered to the corporate and business level. Operational strategy focuses on
issues of resources and practices of an organisation.

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Difference between Goals and Objectives of Business

Goals are statements that provide an overview about what the project should achieve. It
should align with the business goals. Goals are long-term targets that should be achieved in
a business. Goals are indefinable, and abstract. Goals are hard to measure and do not have
definite timeline. Writing clear goals is an essential section of planning the strategy.
Example - One of the goals of a company helpdesk is to increase the customer satisfaction
for customers calling for support.
Objectives are the targets that an organisation wants to achieve over a period of time.
Example - The objective of a marketing company is to raise the sales by 20% by the end of
the financial year.
Example - An automobile company has a Goal to become the leading manufacturer of a
particular type of car with certain advanced technological features and the Objective is to
manufacture 30,000 cars in 2011.
Both goals and objectives are the tools for achieving the target. The two concepts are
different but related. Goals are high level statements that provide overall framework about
the purpose of the project. Objectives are lower level statements that describe the tangible
products and deliverables that the project will deliver.
Goals are indefinable and the achievement cannot be measured whereas the success of an
objective can be easily measured. Goals cannot be put in a timeframe, but objectives are set
with specific timelines. The difference between organisational goals and objectives is
depicted in table.
Table: Differences between Organisational Goals and Objectives
Goals
Are long term
Are general intentions with broad

Objectives
Are usually meant for short term
Are precise statements with

outcome
Cannot be validated
Are intangible can be qualitative

specific outcome
Can be validated
Are tangible

are

usually

as well as quantitative
quantitative and measurable
Are abstract
Are concrete
Q2. Define the term Strategic Management. Explain the importance of strategic
management?

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Answer: Strategic Management

Definition: Strategic management is a systematic approach of analysing, planning and
implementing the strategy in an organisation to ensure a continued success. Strategic
management is a long term procedure which helps the organisation in achieving a long term
goal and its overall responsibility lies with the general management team. It focuses on
building a solid foundation that will be subsequently achieved by the combined efforts of
each and every employee of the organisation.
Importance of strategic management

A rapidly changing environment in organisations requires a greater awareness of

changes and their impact on the organisation. Hence strategic management plays an
important role in an organisation.

Strategic management helps in building a stable organisation.

Strategic management controls the crises that are aroused due to rapid change in an
organisation.

Strategic management considers the opportunities and threats as the strengths and
weaknesses of the organisation in the crucial environment for survival in a
competitive market.

Strategic management helps the top level management to examine the relevant
factors before deciding their course of action that needs to be implemented in
changing environment and thus aids them to better cope with uncertain situations.

Changes rapidly happen in large organisations. Hence strategic management

becomes necessary to develop appropriate responses to anticipate changes.

The implementation of clear strategy enhances corporate harmony in the

organisation. The employees will be able to analyse the organisations ethics and
rules and can tailor their contribution accordingly.

Systematically formulated business activities helps in providing consistent financial

performance in the organisation.

A well designed global strategy helps the organisation to gain competitive

advantages. It increases the economies of scale in the global market, exploits other
countries resources, broadens learning opportunities, and provides reputation and
brand identification.

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Q3. Describe Porters five forces Model.

Answer: Porters Five Force model
Michael E. Porter developed the Five Force Model in his book, Competitive Strategy. Porter
has identified five competitive forces that influence every industry and market. The level of
these forces determines the intensity of competition in an industry. The objective of
corporate strategy should be to revise these competitive forces in a way that improves the
position of the organisation.
Figure below describes forces driving industry competitions.

Figure: Forces Driving Industry Competitions

Forces driving industry competitions are:
Threat of new entrants New entrants to an industry generally bring new capacity; desire to
gain market share and substantial resources. Therefore, they are threats to an established
organisation. The threat of an entry depends on the presence of entry barriers and the
reactions can be expected from existing competitors. An entry barrier is a hindrance that
makes it difficult for a company to enter an industry.
Suppliers Suppliers affect the industry by raising prices or reducing the quality of
purchased goods and services.

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Rivalry among existing firms In most industries, organisations are mutually dependent. A
competitive move by one organisation may result in a noticeable effect on its competitors
and thus cause retaliation or counter efforts.
Buyers Buyers affect an industry through their ability to reduce prices, bargain for higher
quality or more services.
Threat of substitute products and services Substitute products appear different but satisfy
the same needs as the original product. Substitute products curb the potential returns of an
industry by placing a ceiling on the prices firms can profitably charge.
Other stakeholders - A sixth force should be included to Porters list to include a variety of
stakeholder groups. Some of these groups include governments, local communities, trade
association unions, and shareholders. The importance of stakeholders varies according to
the industry.

Q4. What is strategic formulation and what are its processes?

Answer: Strategy Formulation

Strategy formulation is the development of long term plans. It is used for the effective
management of environmental opportunities and for the threats which weaken corporate
management. Its objective is to express strategical information to achieve a definite goal.

The following are the features of strategy formulation:

Defining the corporate mission and goals
Specifying achievable objectives
Developing strategies

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Setting company policy guidelines

Process in Strategy Formulation

The main processes involved in strategy formulation are as follows:
Stimulate the identification - Identifying useful information like planning for strategic
management, objectives to achieve the goals of the employees and the stakeholders.

Utilisation and transfer of useful information as per the business strategies - A number of
questions arising during utilisation and transfer of information have to be solved The
questions that arise during utilisation and transfer of information are the following:
Who has the requested information?
What is the relationship between the partners who holds the requested information?
What is the nature of the requested information?
How can we transfer the information?

Henry Mintzbergs contribution to strategic planning

Henry Mintzberg is a well-known academician and generalist writer who has written about
strategy and organisational management. His approach is broad, involving the study of the
actions of a manager and the way the manager does it. He believes that management is
about applying human skills to systems, but not systems to people. Mintzberg states certain
factors as the reason for planning failure.

The factors are as follows:

Processes - The elaborate processes used in the management such as creation of
bureaucracy and suppression of innovation leads to strategic planning failure.

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Data - According to Mintzberg, hard data (the raw material of all strategists) provides
information whereas soft data (the data gathered from experience) provides wisdom which
means that soft data is more relevant than the hard data.

Detachment Mintzberg says that effective strategists are people who do not distance
themselves from the details of a business. They are the ones who immerse themselves into
the details and are able to extract the strategic messages from it.

In 1993, Henry Mintzberg concluded that planning is a formalised procedure to produce a

coherent result in the form of an integrated system of decisions. The objectives must be
explicitly labeled by words after being carefully decomposed into strategies and substrategies.

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Q5. What is Strategic Business Unit? What are its features and advantages?

Answer: SBU is a business tool whose main concept is to serve a clear and defined market
segment with a defined strategy.
The features of SBU are as follows:

SBU contains all the needs and corporate capabilities of its organisation.

There is managerial and capital resource allocation for serving the overall interest of
the organisation.

SBU segments the activities of the company in a strategic manner and allocates
resources competitively.

For an organisation to have an SBU, it must fulfill the following criteria:

Possess different missions

Set up original plans

Have a definable group of competitors

Administer resources in key areas

Advantages

Reduces problems associated with sharing resources across functional areas

Responses quickly to the environmental changes

Increases focus on products and markets

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Benefits of SBU to parent company/MNCs

An MNC realises parenting advantages in certain factors like global scale and scope
efficiencies, regional differences, global risk diversification etc. The SBU adds value through
parenting advantages by defining its roles and strategic priorities.
The benefits to the parent company are as follows:

Optimisation of the competitive advantages lies within the companys global network
of business units and people.

Reforming the business model and achieving the objective

Serving a defined external market where it can conduct strategic planning in relation
to products and markets

Q6. Define the term Business policy. Explain its importance.

Answer: Business policies are the instructions laid by an organisation to manage its
activities. It identifies the range within which the subordinates can take decisions in an
organisation. It authorises the lower level management to resolve their issues and take
decisions without consulting the top level management repeatedly. The limits within which
the decisions are made are well defined. Business policy involves the acquirement of
resources through which the organisational goals can be achieved. Business policy analyses
roles and responsibilities of top level management and the decisions affecting the
organisation in the long-run. It also deals with the major issues that affect the success of the
organisation.

Features of business policy

Following are the features of an effective business policy:

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Specific- Policy should be specific and identifiable. The implementation of policy is easier
if it is precise.

Clear - Policy should be clear and instantly recognisable. Usage of jargons and
connotations should be avoided to prevent any misinterpretation in the policy.

Uniform Policy should be uniform and consistent. It should ensure uniformity of

operations at different levels in an organisation.

Appropriate Policy should be appropriate and suitable to the organisational goal. It

should be aimed at achieving the organisational objectives.
Comprehensive Policy has a wide scope in an organisation. Hence, it should be
comprehensive.

Flexible Policy should be flexible to ensure that it is followed in the routine scenario.

Written form To ensure uniformity of application at all times, the policy should be in
writing.

Stable Policy serves as a guidance to manage day to day activities. Thus, it should be
stable.

Importance of Business Policies

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A company operates consistently, both internally and externally when the policies are
established. Business policies should be set up before hiring the first employee in the
organisation. It deals with the constraints of real-life business.

It is important to formulate policies to achieve the organisational objectives. The policies are
articulated by the management. Policies serve as a guidance to administer activities that are
repetitive in nature. It channels the thinking and action in decision making. It is a mechanism
adopted by the top management to ensure that the activities are performed in the desired
way.

The complete process of management is organised by business policies.

Business policies are important due to the following reasons:
Coordination Reliable policies coordinate the purpose by focusing on organisational
activities. This helps in ensuring uniformity of action throughout the organisation. Policies
encourage cooperation and promote initiative.

Quick decisions Policies help subordinates to take prompt action and quick decisions.
They demarcate the section within which decisions are to be taken. They help subordinates
to take decisions with confidence without consulting their superiors every time. Every policy
is a guide to activities that should be followed in a particular situation. It saves time by
predicting frequent problems and providing ways to solve them.

Effective control Policies provide logical basis for assessing performance. They ensure
that the activities are synchronised with the objectives of the organisation. It prevents
divergence from the planned course of action. The management tends to deviate from the
objective if policies are not defined precisely. This affects the overall efficiency of the
organisation. Policies are derived objectives and provide the outline for procedures.

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Decentralisation Well defined policies help in decentralisation as the executive roles

and responsibility are clearly identified. Authority is delegated to the executives who refer the
policies to work efficiently. The required managerial procedures can be derived from the
given policies. Policies provide guidelines to the executives to help them in determining the
suitable actions which are within the limits of the stated policies. Policies contribute in
building coordination in larger organisations.

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MB0052 Strategic Management and Business Policy

Assignment Set- 2
Q1. What is meant by core competency? Explain with an example.
Answer: Core competencies are those skills that are critical for a business to achieve
competitive advantage. These skills enable a business to deliver essential customer benefit
like the selection of a product or service by a customer. Core competency is the key strength
of business because it comprises the essential skills. These are the central areas of
expertise of the company where maximum value is added to its services or products.
Example - Infosys has a core competency in information technology.
It is a unique skill or technology that establishes a distinct customer value. As the
organisation progresses and adapts to the new environment, the core competencies also
adjust to the change. They are not rigid but flexible to advancing time. The organisation
makes the maximum utilisation of the competencies and correlates them to new
opportunities in the market. Resources and capabilities are the building blocks on which an
organisation builds and executes a value-added strategy. The strategy is devised in a
manner that an organisation can receive reasonable profit and attain strategic
competitiveness.
Core Competencies are not fixed. They change in response to the transformation in the
environment of the company. They are adaptable and advance over time. As an organisation
progresses and adapts to new circumstances, the core competencies also adapt to the
transformation.
The characteristics of core competencies are:

To provide potential access to a wide range of market

Should be difficult to imitate by competitors

Should make considerable contribution to the customers

Example - Microsoft has expertise in IT-based innovations and technologies. Customers

receive many benefits by purchasing and using Microsoft products. For many reasons
including unique skills, it is difficult for competitors to imitate Microsoft's core competences.

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Resources are the key inputs of the organisations production process. These can be
manpower, financial, technological, or services. For the organisation to have core
competency the resources should be unique, beneficial and specialised in the particular
field. Resources should be built on the strengths of the organisation and not on its
weaknesses.
Organisational capabilities are the ability of the organisation to identify and integrate its
resources so that it can be used in the most efficient manner. If an organisation lacks the
capability to utilise these resources productively then the organisation cannot create its core
competency. The organisation can devise strategies to either develop new resources and
capabilities or improve the existing resources and capabilities to build core competencies of
the organisation.
A company can continue to reinvest in its core competencies. When the core competencies
are advanced to those of the competitors they are called distinctive competencies. The
distinctive competencies should be unique and advanced to the competitor capacity. It
should be used to develop new product or service. Core competencies of an organisation
distinguish it from its competitors. They can help in deciding the future of the organisation.
For the strategy to have the best probability of success, it should be built on core
competencies. The competencies are enhanced continuously. They are developed through a
continuous process of improvement and enhancement.
Critical Success Factors (CSFs)
Critical success factors (CSFs) are used extensively to identify the key features that an
organisation should focus on to be successful. The CSFs are important sections of activities
that are performed perfectly to achieve the mission and objective of the business. It refers to
the main areas which ensure successful competitive performance for an organisation.
Identifying the CSFs is important as the organisation can focus on its efforts to develop its
resources to meet the CSFs and measure the success of the business. It is important for the
organisation to decide in building the essential requirements to meet the CSFs.
Critical Success Factors are associated with the strategic goals of an organisation. They
also focus on the essential areas that affect the business. The chief areas that affect the
business are:

Industry - These factors result from specific industry characteristics. The organisation
should consider these factors to remain competitive.
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Environmental These are the factors that are the result of environmental influences
on an organisation like the economy, competitors, and technological advancements.

Strategic - These factors are the result of particular competitive strategy selected by
the organisation.

Temporal - These factors are the result of the organisation's internal influence like
challenges and directions.

The CSFs are essential for the success of an organisation. Identifying CSFs helps to ensure
that the business is focused and thus avoids wasting effort on insignificant areas. To keep
the project on track towards common aims and goals, CSFs should be specific and should
be communicated to everyone involved.

Q2. Describe the concept of SWOT analysis.

Answer: SWOT Analysis
SWOT is an acronym for strength, weakness, opportunities and threats which are strategic
factors of an organisation. SWOT analysis not only results in the identification of
organisations distinctive competencies, but also identifies the opportunities that the
organisations are unable to take advantage of, due to the lack of appropriate resources.
Strengths
The strengths of an organisation are its resources and capabilities that can be used as a
basis for developing a competitive advantage. Examples of such strengths are as follows:

Patents

Strong brand names

Good reputation among customers

Cost advantages from proprietary know-how

Exclusive access to high grade natural resources

Favourable access to distribution networks

Weaknesses

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The absence of certain strengths may be considered as weaknesses. Example - Lack of a

patent can be considered as a weakness. Each of the following factors may be considered
as a weakness:

Lack of patent protection

Weak brand name

Poor reputation among customers

High cost structure

Lack of access to the best natural resources

Opportunities
The external environment analysis may disclose certain new opportunities for profit and
growth. Few examples of such opportunities are as follows:

Unfulfilled customer needs

Arrival of new technologies

Relaxing of regulations

Removal of international trade barriers

Threats
Alteration in the external environment may also present threats to the organisation. Some
examples of such threats include the following:

Shift in consumer choice, it takes them away from the organisations product

Emergence of substitute products

New regulations

Increased trade barriers

Example - An opportunity to provide products like refrigerator or services like online ticket
booking, that can improve consumers lifestyle increases the demand for the companys
product. The Threat could be a new competitor in the market with advanced technology as it
makes the existing product out-of-date.

The SWOT matrix - Organisations should concentrate to develop a strategic plan that fits in
the organisations strength and upcoming opportunities. In rare cases, the organisation

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overcomes a weakness by planning itself for a compelling situation. The SWOT matrix is
shown in the figure below.

Strength

Weakness

Opportunities

S-O Strategies

W-O Strategies

Threats

S-T Strategies

W-T Strategies

The SWOT matrix can be explained as follows:

S-O strategies follow the opportunities that suits the companys strength
W-O strategies overcomes weakness to follow opportunities
S-T strategies find ways to use the organisations strength to reduce external threats
W-T strategies determines a defensive plan to prevent the organisations weakness from
becoming liable to external forces .

Q3. What is strategic leadership? Explain the types of leadership.

Answer: Strategic leadership refers to the potential to express a strategic vision and to
motivate others to acquire that vision. It is the ability to influence organisational members
and to execute organisational change.
Features of strategic leadership
A strategic leader possesses the following qualities:

Loyalty and compassion Effective leadership should be loyal and compassionate to

vision of the team.

Judicious use of power Strategic leaders utilise power wisely. They must push their
ideas gradually along with the other members in the team.

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Wider perspective or outlook Strategic leader have a wider perspective of vision

and they act accordingly.

Motivation and reliability Strategic leader have motivating qualities and are also
reliable.

Skillful communication A leader shares views with the team members. Effective
communication brings effective understanding among the team members.

Quality of understanding the moods and emotions - A strategic leader must

understand the moods and emotions of his team members. He must communicate
his sentiments with the employees.

The following figure depicts the three types of leadership

Types of Leadership

Direct Leadership This is typically in organisations where subordinates are in direct

contact with their leaders. Direct leaders are linked with their subordinates and influences
organisation through the development of subordinates. An example of direct leadership is
given in the following figure.

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Figure: Direct Leadership

Organisational Leadership In organisational leadership, the leaders reach out to far more
people and can even influence several thousands of people. Unlike direct leaders,
organisational leaders are not able to interact directly with their subordinates and need other
staff to help them lead people. The hierarchy of organisational leadership is illustrated in
below figure.

Figure: Organisational Leadership

Strategic Leadership These leaders usually lead large organisations and influence
thousands of people. The role of a strategic leader is to establish organisational structure,
allocate resources and communicate the strategic vision of the organisation.

Q4. Define the term Strategic Alliance. Differentiate between Joint ventures and
Mergers.

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Answer: Strategic alliance is the process of mutual agreement between the organisations to
achieve objectives of common interest. They are obtained by the co-operation between the
companies. Strategic alliance involves the individual organisations to modify its basic
business activities and join in agreement with similar organisations to reduce duplication of
manufacturing products and improve performance. It is stronger when the organisations
involved

have

balancing

strengths.

Strategic

alliances

contribute

in

successful

implementation of strategic plan because it is strategic in nature. It provides relationship

between organisations to plan various strategies in achieving a common goal.

The various characteristics of strategic alliances are:

The two independent organisations involving in agreement have a similar idea of
achieving objectives with respect to alliances.
The organisations share the advantages and organise the management of alliance until
the agreement lasts.
To develop more areas in alliances, the organisations contribute their own resources like
technology, production, R&D, marketing etc to increase the performance.
According to Faulkner (1995) Strategic alliance is the inter-organisational relationship in
which the partners make substantial investment in developing a long-term collaborative
effort, and obtain common orientation.

Joint Venture
Joint venture is the most powerful business concept that has the ability to pool two or more
organisations in one project to achieve a common goal. In a joint venture, both the
organisations invest on the resources like money, time and skills to achieve the objectives.
Joint venture has been the hallmark for most successful organisations in the world. An
individual partner in joint venture may offer time and services whereas the other focuses on
investments. This pools the resources among the organisations and helps each other in
achieving the objectives. An agreement is formed between the two parties and the nature of

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agreement is truly beneficial with huge rewards such that the profits are shared by both the
organisations.

The advantages of joint venture are:

A long term relationship is built among the participating organisations
It Increases integrity by teaming with other reputable and branded organisations
Helps in gaining new customers
It helps in investing little money or no money
It provides the capability to compete in the market with other organisations
Reduces production time as the organisations are into join venture
More new products and services can be offered to the customers

The disadvantages of joint venture are:

Sometimes the organisations deal with wrong people, thereby losing investments
The organisations do not have the opportunity to take up decisions individually
There are risks of disputes among the organisations that lead to poor performance
If the organisation enters into joint venture agreement with unprofessional selfish
organisation, then it increases the risk of hurting business reputation and devastating
customers trust.

Example The China Wireless Technologies, a mobile handset maker is getting into an
agreement with the Reliance Communications Ltd (RCom) to launch its new mobile. The
joint venture between the two companies is to gain profits and provide affordable mobile
phones to the market that consists of advanced features and aims to earn eight billion

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dollars in the next five years. The new mobile consists of dual SIM smart phone with 3G
technology at a cheaper rate.

Mergers
Merger is the process of combining two or more organisations to form a single organisation
and achieve greater efficiencies of scale and productivity. The main reason to involve into
mergers is to join with other company and reap the rewards obtained by the combined
strengths of two organisations. A smart organisations merger helps to enter into new
markets, acquire more customers, and excel among the competitors in the market. The
participating organisation can help the active partner in acquiring products, distribution
channel, technical knowledge, infrastructure to drive into new levels of success.

With the perception of the organisation structure, here are a few types of mergers. The
different types of mergers are:

Horizontal merger The horizontal merger takes place when two organisations
competing in the same market join together. This type of merger either has a maximum or
minimum effect on the market. The minimum effect could also be zero. They share the same
product line and markets. The results of the mergers are less noticeable if the small
organisations horizontally merge. Consider a small local drug store that horizontally merges
with another small local drug store, then the effect of this merger on drug market would be
minimal.

But when the large organisations set up horizontal merger, then higher profits are obtained in
the market share providing advantages over its competitors. Consider two large
organisations that merge with twenty percent share in the market. They achieve forty percent
increase in the market share. This is an added advantage of the organisations over its
competitors in the market.

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Vertical merger This involves the union of a customer with the vendor. It is the process
of combining assets to capture a sector of the market that it fails to acquire as an individual
organisation. The participating organisations determine the intentions of joining forces that
will strengthen the current positions of both the organisations and lay basis for expanding
into other areas. The purpose of a vertical merger is to build the strengths of the two
organisations for an effective future growth. In order to explore new methods of using
existing products to create a new product line for wider markets, it is also important to
consider the assets like property, buildings, inventories and cash assets. The vertical merger
involves careful planning.
Market-extension merger It is the process of merging two organisations that sell same
products in different geographical areas. The main purpose of this merger is to make the
merging organisations to achieve higher positions in bigger markets and ensure a bigger
base for client.

Product-extension merger Most of the organisations execute product extension merger

to sell different products of a related category. They serve the common market. This merger
enables the new organisations to pool their products to serve a common market.

Conglomerate merger This merger involves organisations alliance with unrelated type of
business activities. The organisations under conglomerate merger are not related either
horizontally or vertically. There are no important common factors among the organisations in
terms of production, marketing, research, development and technology. It is the union of
different kinds of businesses under one management organisation. The main purpose of this
merger is to utilise financial resources; enlarge debt capacity and obtaining synergy of
managerial functions. The organisations do not share the resources; instead it focuses on
the process of acquiring stability and using resources in a better way to generate additional
revenue.

Q5. What do you mean by innovation? What are the types of innovation?

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Answer: There is no universally accepted definition of "product innovation" or "new product."

Everett M Rogers (Diffusion of Innovation, 4th ed. Free Press, 1995) observes that some
researchers have favoured a consumer-oriented approach in defining an innovation.
According to Hubert Gatignon and Thomas S Robertson, an innovation is a product, service,
attribute, or idea that consumers within a market segment perceive as new and that has an
effect on existing consumption patterns.

Types of Innovation
A continuous innovation is, one that has a limited influence on consumption behaviour of
consumers. Consumers would use a product representing continuous innovation in much the
same way they used products that came before it. Product alteration is on a continuous
basis. Adoption of such products requires minor changes in behaviour that are unimportant
to consumers. Most of the new products that are introduced in the market represent
continuous innovations such as newer models of computers and autos etc.

A dynamically continuous innovation is, one that affects consumers consumption behaviour
in a pronounced way. Adoption requires a moderate change in an important behaviour or a
major change in an area of behaviour that is of low or moderate importance to the individual.
The examples include Internet shopping, digital camera, notebook computers, electric cars
and cordless phones. Real Jukebox is a dynamically continuous innovation because it
requires changes in the way we acquire, use and dispose of music and may utilise other
technologies such as CD and DVD writers.

A discontinuous innovation represents a product so new that consumers have never known
anything like it before. According to Peter Waldman ("Great Idea If It Flies," Wall Street
Journal, June 24, 1999), a former aeronautics professor has introduced a product called
"skycar," which is a machine that flies through the air in the same manner as cars do in
cartoon shows on TV. The "skycar" uses the principle of VTL (vertical take off and landing)
and is capable of flying at speeds of up to 300 miles per hour. Products such as electric

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bulbs, aeroplanes, computers, television, photocopying machines, inkjet and laser printers,
heart transplant and MRI scanning, etc. were all, at one time, discontinuous innovations.
Such innovations herald radical changes in an area of consumer behaviour which has
significant importance to the individual consumer.

Innovations can also be categorised by the benefits that products or services offer. Some
services, attributes or ideas are functional innovationbecause they provide functional
performance benefits to consumers over existing alternatives. For example, computer
notebooks offer portability over stationary computers. Functional innovations often take
advantage of new technology. For example, technological advances have offered consumers
the advantage of downloading images from the Internet and conducting videoconferencing
via their cellular phones.
Figure : depicts the innovation continuum.

Q6. Describe Corporate Social Responsibility.

Answer: Corporate Social Responsibilities (CSR)

Corporate Social Responsibility (CSR) is the continuing obligation of a business to behave
ethically and contribute to the economic development of the organisation. It improves the
quality of life of the organisation. The meaning of CSR has two folds. On one hand, it
exhibits the ethical behaviour that an organisation exhibit towards its internal and external
stakeholders. And on the other hand, it denotes the responsibility of an organisation towards

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the environment and society in which it operates. Thus CSR makes a significant contribution
towards sustainability and competitiveness of the organisation.

CSR is effective in number of areas such as human rights, safety at work, consumer
protection, climate protection, caring for the environment, sustainable management of
natural resources, and such other issues. CSR also provides health and safety measures,
preserves employee rights and discourages discrimination at workplace. CSR activities
include commitment to product quality, fair pricing policies, providing correct information to
the consumers, resorting to legal assistance in case of unresolved business problems, so
on.
Example TATA implemented social welfare provisions for its employees since 1945.

Features of CSR
CSR improves the customer satisfaction through its products and services. It also assists in
environmental protection and contributes towards social activities. The following are the
features of CSR:

Improves the quality of an organisation in terms of economic, legal and ethical factors
CSR improves the economic features of an organisation by earning profits for the owners. It
also improves the legal and ethical features by fulfilling the law and implementing ethical
standards.

Builds an improved management system CSR improves the management system by

providing products which meets the essential customer needs. It develops relevant
regulations through the utilisation of innovative technologies in the organization

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Contributes to countries by improving the quality of management CSR contributes high

quality product, environment conservation and occupational health safety to various regions
and countries.
Enhances information security systems and implementing effective security measures
CSR enhances the information security measures by establishing improved information
security system and distributing them to overseas business sites. The information system
has improved by enhancing better responses to complex security accidents.

Creates a new value in transportation CSR creates a new value in transportation for the
greater safety of pedestrians and automobiles. This is done by utilising information and
technology for automobiles. The information and technology helps in establishing a safety
driving assistance system.

Creates awareness towards environmental issues CSR serves in preventing global

warming by reducing the harmful gases emitted into the atmosphere during the process of
business activities.

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MB0053 International Business Management
Assignment Set- 1

Q1. Define international business. What are the advantages of international business?
Answer: International business can be defined as any business that crosses the national
borders of the country for its establishment. It includes importing and exporting; international
movement of goods, services, employees, technology, licensing, and franchising of
intellectual property (trademarks, patents, copyright and so on). International business
includes the investment in financial and immovable assets in foreign countries. Contract
manufacturing or assembly of products for local sale or for export to other countries,
establishment of foreign warehousing and distribution systems, and import of goods from
one foreign country to a second foreign country for subsequent local sale is part of
international business.
There are various factors that affect international business. These factors include economic
environment, culture, political environment, financial and banking systems, regulatory
bodies, human capital, trade policies and so on, of the target country. Figure represents the
various factors affecting international business.

Figure: Factors Effecting International Business

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International trade is growing at a rapid rate. Table, which is compiled by World Trade
Organisation, gives us an understanding on the region-wise quantum of international trade. It
illustrates the incremental value and volume of global trade in specified countries over a
period of four years. This table gives us an insight into the dynamics and importance of
international business.

Q2. Discuss in brief the absolute and comparative cost advantage theories.
Answer: Absolute advantage
Adam Smith (a social philosopher and a pioneer of politicl economics) argued that nations
differ in their ability to manufacture goods efficiently and he saw that a country gains by
trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of
goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it
produced the goods itself. In the same manner, country II gives up only 10 units of labour to
get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself.
Hence, it was understood that both countries had large amount of both goods by trading.
Comparative advantage
Ricardo (english political economist) questioned Smiths theory stating that if one country is
more productive than the other in all lines of production and if country I can produce all
goods with less labour costs, will there be a need for the countries to trade. The reply was
affirmative.
He used England and Portugal as examples in his demonstration, the two goods they
produced being wine and cloth. This case is explained using table below.

According to him, Portugal has an advantage in both areas of manufacture.

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To demonstrate that trade between both countries will lead to gains, the concept of
opportunity cost (OC) is introduced. The OC for good X is the amount of other goods that
have to be given up in order to produce one additional unit of X.

A country has a comparative advantage in producing goods if the OC is lower at home than
in the other country. The table shows that Portugal has the lower OC of the 2 countries in
wine-making while England has the lower OC in making cloth. Thus Portugal has the
comparative advantage in the production of wine whereas England has one one in the
production of cloth.

Q3. How is culture an integral part of international business. What are its elements?

Answer: Cultural differences affect the success or failure of multinational firms in many
ways. The company must modify the product to meet the demand of the customers in a
specific location and use different marketing strategy to advertise their product to the
customers. Adaptations must be made to the product where there is demand or the
message must be advertised by the company. The following are the factors which a
company must consider while dealing with international business:

The consumers across the world do not use same products. This is due to varied
preferences and tastes. Before manufacturing any product, the organisation has to
be aware of the customer choice or preferences.

The organisation must manage and motivate people with broad different cultural
values and attitudes. Hence the management style, practices, and systems must be
modified.

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The organisation must identify candidates and train them to work in other countries
as the cultural and corporate environment differs. The training may include language
training, corporate training, training them on the technology and so on, which help the
candidate to work in a foreign environment.

The organisation must consider the concept of international business and construct
guidelines that help them to take business decisions, and perform activities as they
are different in different nations. The following are the two main tasks that a company
must perform:

Product differentiation and marketing - As there are differences in consumer tastes

and preferences across nations; product differentiation has become business
strategy all over the world. The kinds of products and services that consumers can
afford are determined by the level of per capita income. For example, in
underdeveloped countries, the demand for luxury products is limited.

Manage employees - It is said that employees in Japan were normally not satisfied
with their work as compared with employees of North America and European
countries; however the production levels stayed high. To motivate employees in
North America, they have come up with models. These models show that there is a
relation between job satisfaction and production. This study showed the fact that it is
tough for Japanese workers to change jobs. While this trend is changing, the fact that
job turnover among Japanese workers is still lower than the American workers is
true. Also, even if a worker can go to another Japanese entity, they know that the
management style and practices will be quite alike to those found in their present
firm. Thus, even if Japanese workers were not satisfied with the specific aspects of
their work, they know that the conditions may not change considerably at another
place. As such, discontent might not impact their level of production.

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The following are the three mega trends in world cultures:

The reverse culture influence on modern Western cultures from growing economies,
particularly those with an ancient cultural heritage.

The trend is Asia centric and not European or American centric, because of the
growing economic and political power of China, India, South Korea, and Japan and
also the ASEAN.

The increased diversity within cultures and geographies.

The following are the necessary implications in international business:

Avoid self reference criterion such as, ones own upbringing, values and viewpoints.

Follow a philosophical viewpoint that considers that many perspectives of a single

observation or phenomenon can be true.

Discover and identify global segments and global niche markets, as national markets
are diverse with growing mobility of products, people, capital, and culture.

Grow the total share market by innovating affordable products and services, and
making them accessible so that, they are affordable for even subsistence level
consumers rather than fighting for market share.

Organise global enterprises around global centres of excellence.

Cultural elements that relate business

The most important cultural components of a country which relate business transactions are:

Language.

Religion.

Conflicting attitudes.

Language
Language is something more than just spoken and written words. Gestures, non-verbal
communication, facial expressions, and body language all communicate a message. An
interpreter is used when two people do not speak common language. Failure in

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understanding the cultural context when non-verbal communication takes place or failure in
reading the person across the table results in sending a wrong signal.
Religion
The dominant religious beliefs within a culture have a great impact on a persons approach
to business than most people expect, even if that person is not a follower of a specific
culture.
Conflicting attitudes
Cultural values have a massive effect on the way business is carried out. The cultural values
that are evident in everyday life are not only shown in business but they are exaggerated. If
the cultural basics are not understood, then there is possibility that a deal ends even before
the negotiations start. Some of the additional cultural elements which must be known are the
customs and manners, arts, education, humour, and social organisation of a society.

Q4. What is country risk analysis? Describe the tools and methods of country risk
analysis.

Answer: Country Risk Analysis

Country risk analysis is the evaluation of possible risks and rewards from business
experiences in a country. It is used to survey countries where the firm is engaged in
international business, and avoids countries with excessive risk. With globalisation, country
risk analysis has become essential for the international creditors and investors.

Country Risk Analysis (CRA) identifies imbalances that increase the risks in a cross-border
investment. CRA represents the potentially adverse impact of a countrys environment on the
multinational corporations cash flows and is the probability of loss due to exposure to the
political, economic, and social upheavals in a foreign country. All business dealings involve
risks. An increasing number of companies involving in external trade indicate huge business

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opportunities and promising markets. Since the 1980s, the financial markets are being
refined with the introduction of new products.

When business transactions occur across international borders, they bring additional risks
compared to those in domestic transactions. These additional risks are called country risks
which include risks arising from national differences in socio-political institutions, economic
structures, policies, currencies, and geography. The CRA monitors the potential for these
risks to decrease the expected return of a cross-border investment. For example, a
multinational enterprise (MNE) that sets up a plant in a foreign country faces different risks
compared to bank lending to a foreign government. The MNE must consider the risks from a
broader spectrum of country characteristics. Some categories relevant to a plant investment
contain a much higher degree of risk because the MNE remains exposed to risk for a longer
period of time.

Analysts have categorised country risk into following groups:

Economic risk This type of risk is the important change in the economic structure
that produces a change in the expected return of an investment. Risk arises from the
negative changes in fundamental economic policy goals (fiscal, monetary,
international, or wealth distribution or creation).

Transfer risk Transfer risk arises from a decision by a foreign government to

restrict capital movements. It is analysed as a function of a countrys ability to earn
foreign currency. Therefore, it implies that effort in earning foreign currency increases
the possibility of capital controls.

Exchange risk This risk occurs due to an unfavourable movement in the exchange
rate. Exchange risk can be defined as a form of risk that arises from the change in
price of one currency against another. Whenever investors or companies have assets
or business operations across national borders, they face currency risk if their
positions are not hedged.

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Location risk This type of risk is also referred to as neighborhood risk. It includes
effects caused by problems in a region or in countries with similar characteristics.
Location risk includes effects caused by troubles in a region, in trading partner of a
country, or in countries with similar perceived characteristics.

Sovereign risk This risk is based on a governments inability to meet its loan
obligations. Sovereign risk is closely linked to transfer risk in which a government
may run out of foreign exchange due to adverse developments in its balance of
payments. It also relates to political risk in which a government may decide not to
honor its commitments for political reasons.

Political risk This is the risk of loss that is caused due to change in the political
structure or in the politics of country where the investment is made. For example, tax
laws, expropriation of assets, tariffs, or restriction in repatriation of profits, war,
corruption and bureaucracy also contribute to the element of political risk.

Risk assessment requires analysis of many factors, including the decision-making process in
the government, relationships of various groups in a country and the history of the country.
Country risk is due to unpredicted events in a foreign country affecting the value of
international assets, investment projects and their cash flows. The analysis of country risks
distinguishes between the ability to pay and the willingness to pay. It is essential to analyse
the sustainable amount of funds a country can borrow. Country risk is determined by the
costs and benefits of a countrys repayment and default strategies. The ways of evaluating
country risks by different firms and financial institutions differ from each other. The
international trade growth and the financial programs development demand periodical
improvement of risk methodology and analysis of country risks.

Country detailed risk refers to the unpredictability of returns on international business

transactions in view of information associated with a particular country. The techniques used

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by the banks and other agencies for country risk analysis can be classified as qualitative or
quantitative. Many agencies merge both qualitative and quantitative information into a single
rating. A survey conducted by the US EXIM bank classified the various methods of country
risk assessment used by the banks into four types. They are:

Fully qualitative method - The fully qualitative method involves a detailed analysis
of a country. It includes general discussion of a countrys economic, political, and
social conditions and prediction. Fully qualitative method can be adapted to the
unique strengths and problems of the country undergoing evaluation.

Structured qualitative method The structured method uses a uniform format with
predetermined scope. In structured qualitative method, it is easier to make
comparisons between countries as it follows a specific format across countries. This
technique was the most popular among the banks during the late seventies.

Checklist method - The checklist method involves scoring the country based on
specific variables that can be either quantitative, in which the scoring does not need
personal judgment of the country being scored or qualitative, in which the scoring
needs subjective determinations. All items are scaled from the lowest to the highest
score. The sum of scores is then used to determine the country risk.

Delphi technique The technique involves a set of independent opinions without

group discussion. As applied to country risk analysis, the MNC can assess definite
employees who have the capability to evaluate the risk characteristics of a particular
country. The MNC gets responses from its evaluation and then may determine some
opinions about the risk of the country.

Inspection visits Involves travelling to a country and conducting meeting with

government officials, business executives, and consumers.

These meetings clarify any vague opinions the firm has about the country.

Other quantitative methods The quantitative models used in statistical studies of

country risk analysis can be classified as discriminant analysis, principal component
analysis, logit analysis and classification and regression tree method.

Q5. Write short notes on Foreign exchange market.

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Answer: Foreign exchange market

The Foreign exchange or the forex markets facilitates the participants to obtain, trade,
exchange and speculate foreign currency. The foreign exchange market consists of banks,
central banks, commercial companies, hedge funds, investment management firms and
retail foreign exchange brokers and investors. It is considered to be the leading financial
market in the world. It is vital to realise that the foreign exchange is not a single exchange,
but is created from a global network of computers that connects the participants from all over
the world.
The foreign exchange market is immense in size and survives to serve a number of
functions ranging from the funding of cross-border investment, loans, trade in goods, trade in
services and currency speculation. The participant in a foreign exchange market will
normally ask for a price.
The trading in the foreign exchange market may take place in the following forms:

Outright cash or ready foreign exchange currency deals that take place on the
date of the deal.

Next day - foreign exchange currency deals that take place on the next working day.

Swap Simultaneous sale and purchase of identical amounts of currency for

different maturities.

Spot and Forward contracts - A Spot contract is a binding obligation to buy or

sell a definite amount of foreign currency at the existing or spot market rate. A
forward contract is a binding obligation to buy or sell a definite amount of foreign
currency at the pre-agreed rate of exchange, on or before a certain date.

The advantage of spot dealing has resulted in a simplest way to deal with all foreign
currency requirements. It carries the greatest risk of exchange rate fluctuations due to lack of
certainty of the rate until the deal is carried out. The spot rate that is intended to receive will
be set by current market conditions, the demand and supply of currency being traded and
the amount to be dealt. In general, a better spot rate can be received if the amount of
dealing is high. The spot deal will come to an end in two working days after the deal is
struck.
A forward market needs a more complex calculation. A forward rate is based on the existing
spot rate plus a premium or discounts which are determined by the interest rate connecting

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the two currencies that are involved. For example, the interest rates of UK are higher than
that of US and therefore a modification is made to the spot rate to reflect the financial effect
of this differential over the period of the forward contract. The duration will be up to two years
for a forward contract. A variation in foreign exchange markets can be affected to any
company whether or not they are directly involved in the international trade or not. This is
often referred to as Economic foreign exchange and most difficult to protect a business.
The three ways of managing risks are as follows:

Choosing to manage risk by dealing with the spot market whenever the need of cash
flow rises. This will result in a high risk and speculative strategy since one will not
know the rate at which a transaction is dealt until the day and time it occurs.
Managing the business becomes difficult if it depends on the selling or buying the
currency in the spot market.

The decision must be made to book a foreign exchange contract with the bank
whenever the foreign exchange risk is likely to occur. This will help to fix the
exchange rate immediately and will give a clear idea of knowing the exact cost of
foreign currency and the amount to be received at the time of settlement whenever
this due occurs.

A currency option will prevent unfavourable exchange rate movements in the similar
way as a forward contract does. It will permit gains if the markets move as per the
expectations. For this base, a currency option is often demonstrated as a forward
contract that can be left if it is not followed. Often banks provide currency options
which will ensure protection and flexibility, but the likely problem to arise is the
involvement of premium of particular kind. The premium involved might be a cash
amount or it could also influence into the charge of the transaction.

Q6. Discuss the importance of transfer pricing for MNCs.

Answer: Transfer pricing is the process of setting a price that will be charged by a
subsidiary (unit) of a multi-unit firm to another unit for goods and services, which are sold
between such related units.

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Transfer pricing is a critical issue for a firm operating internationally. Transfer pricing is
determined in three ways: market based pricing, transfer at cost and cost-plus pricing. The
Arms Length pricing rule is used to establish the price to be charged to the subsidiary.

Transfer pricing can also be defined as the rates or prices that are utilised when selling
goods or services between a parent company and a subsidiary or company divisions and
departments that may be across many countries. The price that is set for the exchange in
the process of transfer pricing may be a rate that is reduced due to internal depreciation or
the original purchase price of the goods in question. When properly used, transfer pricing
helps to efficiently manage the ratio of profit and loss within the company.

Transfer pricing is a relatively simple method of moving goods and services among the
overall corporate family.

Many managers consider transfer pricing as non-market based. The reason for transfer
pricing may be internal or external. Internal transfer pricing include motivating managers and
monitoring performance. External factors include taxes, tariffs, and other charges.

Transfer Pricing Manipulation (TPM) is used to overcome these reasons. Governments

usually discourage TPM since it is against transfer pricing, where transfer pricing is the act of
pricing commodities or services. However, in common terminology, transfer pricing generally
refers TPM.

TPM assists in saving the organisations tax by shifting accounting profits from high tax to
low tax jurisdictions. It also enables to fix transfer price on a non-market basis and thus
enables to save tax. This method facilitates in moving the tax revenues of one country to
another. A similar trend can be observed in domestic markets where different states try to
attract investment by reducing the Sales tax rates, and this leads in an outflow from one

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state to another. Therefore, the Government is trying to implement a taxing system in order
to curb tax evasion.

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MB0053 International Business Management
Assignment Set- 2

Q1. What is globalisation and what are its benefits?

Answer: Globalisation
Globalisation is a process where businesses are dealt in markets around the world, apart
from the local and national markets. According to business terminologies, globalisation is
defined as the worldwide trend of businesses expanding beyond their domestic boundaries.
It is advantageous for the economy of countries because it promotes prosperity in the
countries that embrace globalisation.

Benefits of globalization
The merits and demerits of globalisation are highly debatable. While globalisation creates
employment opportunities in the host countries, it also exploits labour at a very low cost
compared to the home country. Let us consider the benefits and ill-effects of globalisation.

Some of the benefits of globalisation are as follows:

Promotes foreign trade and liberalisation of economies.

Increases the living standards of people in several developing countries through

capital investments in developing countries by developed countries.

Benefits customers as companies outsource to low wage countries. Outsourcing

helps the companies to be competitive by keeping the cost low, with increased
productivity.

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Promotes better education and jobs.

Leads to free flow of information and wide acceptance of foreign products, ideas,
ethics, best practices, and culture.

Provides better quality of products, customer services, and standardised delivery

models across countries.

Gives better access to finance for corporate and sovereign borrowers.

Increases business travel, which in turn leads to a flourishing travel and

hospitality industry across the world.

Increases sales as the availability of cutting edge technologies and production

techniques decrease the cost of production.

Provides several platforms for international dispute resolutions in business, which

facilitates international trade.

Q2. Describe the theories of international business.

Answer: The importance of cross border commerce and the globalisation of production are
well recognized and since MNCs conduct business in many new forms other than traditional

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importing and exporting, international trade theory has become too limited for explaining the
current challenges to IB.
Basis for trade
Though the price difference remains the basic cause of trade, this explanation is not
adequate. The two-way flow of goods must be traced to systematic international differences
in the cost and pricing structure. Goods that are cheaper to produce at home will be
exported and goods that are cheaper to produce abroad will be imported.
The following trade theories explain the basics behind international trade:
1. Mercantilism
This was the economic theory that prevailed in the 17th and 18th centuries. This theory was
highly nationalistic, viewed national well-being to be of prime importance and favoured the
regulation and planning of economic activity as a means of national advancement.
According to this theory, the most important way for a nation to grow rich was by the
acquisition of precious metals, especially gold. Exports were viewed as favourable as long
as they brought in gold, but imports were viewed unfavourably as depriving the country of its
true source of wealth and hence trade had to be regulated.

2. Absolute advantage
Adam Smith (a social philosopher and a pioneer of politicl economics) argued that nations
differ in their ability to manufacture goods efficiently and he saw that a country gains by
trading. If the two countries exchanged two goods at a ratio of 1:1, country I gets one unit of
goods B by sacrificing only 10 units of labour, whereas it has to give up 20 units of labour if it
produced the goods itself. In the same manner, country II gives up only 10 units of labour to
get one unit of goods A, whereas it has to give up 20 units of labour if it was made by itself.
Hence, it was understood that both countries had large amount of both goods by trading.
3. Comparative advantage
Ricardo (english political economist) questioned Smiths theory stating that if one country is
more productive than the other in all lines of production and if country I can produce all
goods with less labour costs, will there be a need for the countries to trade. The reply was
affirmative.
4. Product lifecycle theory

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This theory was proposed by Raymond Vernon in the mid-1960s and was based on the
observation that from most of the 20th century, a very large proportion of the worlds new
products were developed by American firms and sold there first. He argued that the wealth
and size of the market gave American firms a strong incentive to develop new consumer
products and in addition, the high cost of labor was an incentive to develop cost-saving
innovations.
He did not agree with earlier theories and he placed emphasis on information, risk, and
economies of scale, rather than on cost. He focused on the lifecycle of the product and
came up with his theory which identified three distinct stages:
New product stage - The need for a new product, in the domestic market, is identified and it
is developed, manufactured and marketed in limited numbers. It is not exported, not in
sizeable quantities, at any rate, since it is primarily for the national market.
Maturing product stage - Once the product has become popular in the domestic market,
foreign demand increases and manufacturing facilites abroad may be set up to meet
demand there. After success in the foreign markets and towards the end of the product
maturity stage, the manufacturers try and produce it in the developing countries.
Standardised product stage - In the last stage of the life-cycle theory, the product becomes
a commodity, the price becomes optimised and the makers look for countries where it can be
made with the least production costs. One of the results of this is the product being imported
into the firms home country. Dell manufactures hardware in Asia, which is then transported
to the US, its country of origin.
5. Porters diamond model
In 1990, Michael Porter analysed the reason behind some nations success and others
failurein international competition. His thesis outlined four broad attributes that shape the
environment in which local firms compete and these attributes promote the creation of
competitive advantage. They are explained as follows:

Factor endowments - Characteristics of production were analysed in detail.

Heirarchies are recognised, as is distinguishing between basic factors like natural
resources, climate, location and so on and advanced factors like communications
infrastructure, research facilities.

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Demand conditions - The role of home demand in improving competitive advantage

is emphasised since firms are most sensitive about the needs of their closest
customers. Example, the Japanese camera industry which caters to a sophisticated
and knowledgeable local market.

Relating and supporting industries - The presence of suppliers or related industries

is advantageous since the benefits of investment in

advanced factors of production spill over to these supporting industries. Successful

industries within a country tend to be grouped

into clusters of related

industries.Example, Silicon Valley.

Firm strategy, structure and rivalry

Domestic rivalry creates pressure to innovate, improve quality, reduce costs which in turn
helps create world-class competitors.
He said that these four attributes constituted the diamond and he argued that firms are most
likely to succeed in industries where the diamond is most favourable. He also stated that the
diamond is a mutually reinforcing system and the effect of one attribute depends on the state
of others. For example, favourable demand conditions will not result in a competitive
advantage unless the state of rivalry is enough to elicit a response from the firms.
Figure gives you an illustration of Porters diamond model.

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Porters Diamond Model

Q3. Explain the importance of ethics in international business.

Answer: Most countries have similar ethical values, but are practiced differently. This
section deals with the way individuals in different countries approach ethical issues, and their
ethically acceptable behaviour. With the rise in global firms, issues related to ethical values
and traditions become more common. These ethical issues create complications to MultiNational Companies (MNCs) while dealing with other countries for business. Hence, many
companies have formulated well-designed codes of conduct to help their employees.
Two of the most prominent issues that managers in MNCs operating in foreign countries face
are bribery and corruption and worker compensation.

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Bribery and corruption Bribery can be defined as the act of offering, accepting, or
soliciting something of value for the purpose of influencing the action of officials in the
discharge of their duties. Corruption is the abuse of public office for personal gain. The issue
arises when there are differences in perception in different countries. For example, in the
Middle East, it is perfectly acceptable to offer an official a gift. In Britain it is considered as an
attempt to bribe the official, and hence, considered unlawful.
Worker compensation Businesses invest in production facilities abroad because of the
availability of low-cost labour, which enables them to offer goods and services at a lower
price than their competitors. The issue arises when workers are exploited and are underpaid
compared to the workers in the parent country who are paid more for the same job. The
disparity arises due to the differences in the regulatory standards in the two countries.
Managing ethics
Earlier, we believed that ethics is a prerogative of individuals, but now this perception has
immensely changed. Many companies use management techniques to encourage ethical
behaviour at an organisational level. Various techniques of managing ethics like practicing
ethics at the top level management, special training on ethics, forming committees to
oversee ethical issues, and defining and implementing code of ethics are illustrated in the
following figure.

Figure: Techniques of Managing Ethics

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Let us discuss each technique in detail.

Top management The senior management of a company must be committed to ensure
that ethical standards are met. The chief executive of the company must not engage in
business practices harmful to employees, or the society. The top management must focus
on ethical practices while informing employees of their intention.
Code of ethics One of the best practices for ethics is creating a corporate ethical
statement and communicating it within the company. Such practices enhance the companys
public image. Almost all Fortune 500 companies have such codes.
Ethics committee There are ethics committees in many firms to help them deal with and
advise on work related ethical issues. The Chief Executive Officer can head the committee
that includes the Board of Directors. Such a committee answers employee queries, helps the
company to establish policies in uncertain areas, advises the Board on ethical issues, and
oversees the enforcement of the code of ethics.
Ethics hotline A companys ethical hotline helps its employees report any ethical issues
they face at work. The ethics committee then investigates these issues. Such hotline calls
are treated confidential, where the callers identity is protected to encourage employees to
report on ethical issues.
The act of reporting illegal, immoral, or illegitimate practices by former or current employees
involving its employees is known as Whistle-blowing. Whistle-blowing is favourable to a
company because employees can alert the management on possibly deviant behaviour
rather than reporting it to the media, which adversely affects the company. A case of whistleblowing in Xerox corporation (a pioneer in copier machines), led its Chief Financial Officer to
be fined $ 5.5 million and banned from practicing accountancy after reports of falsified
financial statements emerged.
Ethics training programs Most firms take ethics seriously and provide training for its
managers and employees. Such training programs help the employees become familiar with
the official policy on ethical issues. These programs demonstrate the use of these ethic
policies in everyday decision-making. Ethics training is most effective when conducted by
managers and when focused on work environment.

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Ethics and law Both law and ethics focus on defining the perfect human behaviour, but
they are not the same. Law is the governments attempt to formalise rightful behaviour, but it
is rarely possible to enforce written laws. It depends on individual or business ethics to
reduce unlawful incidents. Ethical concepts are more complex than written rules since it
deals with human dilemmas that go beyond the formal language of law.
Legal rules seek to promote ethical behaviour in companies. The following are some of the
Acts which seek to ensure fair business practices in India:

Foreign Exchange Management Act (FEMA) of 1999 - FEMA regulates the cross
border movement of foreign and local currencies.

Companies Act of 1956 - Companies Act provides the complete legal framework for
the formation, running, and winding up of a company.

Consumer Protection Act of 1986 (CPA) - CPA provides and regulates the framework
for the protection of consumer rights.

Essential Commodities Act of 1955 - This act defines the goods and services that are
essential for the people at all times and provides a legal framework for the
uninterrupted supply of the same.

Free market ethics

In this section, we will discuss the ethical aspects of competition used to explain free market
ethics. Competition is an important element that differentiates free market from command
market. Competition is a mechanism for free market production and distribution of goods
and services that are in demand. Competition in business is seen as an essential cultural
trait of a free market society. Most activities of the free market can be viewed as a
competitive contest in which businesses engage to provide products and services for a
profit.
In addition to the economic nature of the free market system, there are ethic- related issues
as well. The three widely accepted factors of ethics in the free market are market ethics, the
Protestant ethics, and the liberty ethics. These three ethics set the stage for the industrial
revolution and the accompanying growth in business. During this period, industrial capitalists
were allowed to freely operate businesses, build large organisations, exploit workers, and
engage in fiercely competitive practices for profit and economic expansion.

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Market ethics Market ethics is the basic system of ethics followed by a business in a free
market scenario. It covers the entire spectrum of business including sales, pricing, and
competitor issues.
The Protestant ethics The Protestant ethics considered ideology as an important factor
along with the moral aspects in a capitalist scenario. As an ideology, this ethic served to
legitimise the capitalistic system by providing a moral justification for the pursuit of profit and
distribution of income.
Liberty ethics Liberty ethics encourages a person to play a participatory role on
government, encourages private property, and introduces more freedom and individualism in
all spheres of life.

Q4. What do you understand by regional integration? List its types.

Answer: Regional integration can be defined as the unification of countries into a larger
whole. Regional integration also reflects a countrys willingness to share or unify into a larger
whole. The level of integration of a country with other countries is determined by what it
shares and how it shares. Regional integration requires some compromise on the part of
countries. It should aim to improve the general quality of life for the citizens of those
countries.
In recent years, we have seen more and more countries moving towards regional integration
to strengthen their ties and relationship with other countries. This tendency towards
integration was activated by the European Union (EU) market integration. This trend has
influenced both developed and developing countries to form customs unions and Free Trade
Areas (FTA). The World Trade Organisation (WTO) terms these agreements of integration as
Regional Trade Agreements (RTA).
Different types of regional integration are:
1. Preferential trading agreement
Preferential trading agreement is a trade pact between countries. It is the weakest type of
economic integration and aims to reduce the taxes on few products to the countries who sign
the pact. The tariffs are not abolished completely but are lower than the tariffs charged to
countries not party to the agreement. India is in PTA with countries like Afghanistan, Chile
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and South Common Market (MERCOSUR). The introduction of PTA has generated an
increase in the market size, and resulted in the availability and variety of new products.
2. Free trade area
Free Trade Area (FTA) is a type of trade bloc and can be considered as a second stage of
economic integration. It is made up of all the countries that are willing to or agree to reduce
preferences, tariffs and quotas on most of the services and goods traded between them.
Countries choose this kind of economic integration if their economical structures are similar.
If the countries compete among themselves, they are likely to choose customs union.
The importers must obtain product information from all the suppliers within the supply chain,
in order to determine the eligibility for a Free Trade Agreement (FTA). After receiving the
supplier documentation, the importer must evaluate the eligibility of the product depending
on the rules surrounding the products. The importers product is qualified individually by the
FTA. The basis on which the product will be qualified is that the finished product should have
a minimum percentage of local content.
3. Common market
Common market is a group formed by countries within a geographical area to promote duty
free trade and free movement of labour and capital among its members. European
community is an example of common market. Common markets levy common external tariff
on imports from non-member countries. A single market is a type of trade bloc, comprising a
free trade area with common policies on product regulation, and freedom of movement of
goods, capital, labour and services, which are known as the four factors of production. This
agreement aims at making the movement of four factors of production between the member
countries easier. The technical, fiscal and physical barriers among the member countries are
eliminated considerably as these barriers hinder the freedom of movement of the four factors
of production. The member countries must come forward to eliminate the barriers, have a
political will and formulate common economic policies.
A common market is a first step towards a single market. It may be initially limited to a FTA
with moderate free movement of capital and services, but it is not capable of removing rest
of the trade barriers.

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Benefits and costs

A single market has many advantages. The freedom of movement of goods, capital, labour
and services between the member countries, results in the efficient allocation of these
production factors and increases productivity.
A single market presents a challenging environment for businesses as well as for customers,
making the existence of monopolies difficult. This affects the inefficient companies and
hence, results in a loss of market share and the companies may have to close down.
However, efficient companies can gain from the increased competitiveness, economies of
scale and lower costs. Single market also benefits the consumers in a way that the
competitive environment provides them with inexpensive products, more efficient providers
of products and increased variety of products.
A country changing over to a single market may experience some short term negative effects
on the national economy due to increased international competition. The national companies
that earlier benefited from market protection and subsidies, may find it difficult to cope with
their efficient peers. If the companies fail to improve their methods, they may have to close
down leading to migration and unemployment.
4. Economic union
Economic union is a type of trade bloc and is instituted through a trade pact. It comprises of
a common market with a customs union. The countries that are part of an economic union
have common policies on the freedom of movement of four factors of production, common
product regulations and a common external trade policy. The purpose of an economic union
is to promote closer cultural and political ties, while increasing the economic efficiency
between the member countries.
Economic unions are established by means of a formal intergovernmental legal agreement,
among independent countries with the intention of fostering greater economic integration.
The members of an economic union share some elements associated with their national
economic jurisdictions.
These include the free movements of:

Goods and services within the union along with a common taxing method for imports
from non-member countries.

Capital within the economic union.

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Persons within the economic union. Some form of cooperation usually exists when
framing fiscal and monetary policies.

5. Political union
A political union is a type of country, which consists of smaller countries/nations. Here, the
individual nations share a common government and the union is acknowledged
internationally as a single political entity. A political union can also be termed as a legislative
union or state union.

Q5. What are the challenges faced by Indian businesses in global market?
Answer: The Challenges of E-Business:
As the ebusiness is growing, there are many technical and business trends that are
associated with it. Some important trends in e-business are explained below.
E-business is crucial to business success. Many companies come out with changes that are
necessary for e-business to become profitable. The process of e-business is long lasting
than that of the re-engineering. There are some important trends in the e-business that are
described as follows:

Technology focus is on e-business - The hardware, software, and network

vendors, focus on providing the tools for e-business. The ebusiness is mainly the
extension of the products and services.

E-business produces cumulative effects - E-business is long lasting.

The relationship with customers, suppliers, and employees changes as we
implement e-business.

E-business implementation effects success and failure of a business - There

will be both the success and the failures that are associated with any kind of
business. The failures become dramatic with e-business as it is more visible
externally.

There are some major success factors for e-business. These factors include the strategic
factors, structural factors and the management oriented factors. These factors are explained
as follows:

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Strategic factors.

The technologies related to the internet are used as a complement for the existing
technologies.

The basis of competition that is not shifted from traditional competitive advantages such as
cost, profit, quality, service and features.

The new competitors and market shares are tracked.

The web centric marketing strategy.

The strategic position of the company in the market has strengthened.

The frequent review of the distribution and supply chain model is done in order to
maximise the company's gain.

The buyers behaviour and the customer personalisation.

The first-mover advantage and quick time to start.

The e-business offered good products and services.

The innovation was allowed when risks are low.

The customers and partner's expectations from the well managed.

Structural factors

Correct digital infrastructure.

Good e-business education and training to employees, management and customers.

Current systems expanded to cover entire supply chain.

Good cost control.

Management-oriented factors

The organisation wide commitment to e-business leadership.

The necessary support for e-business from the top management.

The awareness and understanding of capabilities of technology by executives.

The top management has to communicate about the value of ebusiness throughout
the organisation.

The e-business is facing challenges mainly in the areas of technology, logistics, and legal
issues.
1. Technology

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The technology plays a major role in the concept of new economy. The technology has two
dimensions; one is the shift from manufacturing to services and second is the shift from
physical resources to the knowledge resources. There are so many mechanisms for
technology innovation and diffusion, both within and outside the countries. Many of the
organisations will include different technologies both for quantitative and qualitative terms.
Small scale enterprises play a vital role in the implementation of new technologies. They
have added more value in terms of population, employment, and services that they are
offering. Internet also plays a vital role as it helps the small and medium enterprises in
providing the cost effective possibilities to advertise their products. Internet also provides the
contacts to buyers and suppliers on a global basis. E-business is helps the radical
transformation in the way that the business is done. The introduction of technologies like the
common database, electronic networks and value added services are helpful for speeding
up the transactions and these are fundamental at the industrial level. The e-business has to
undergo lot of challenges in implementing the technologies that are helpful for the
organisation since many of the people in the organisation will not be interested to shift to the
new technology and learn the new skills.
2. Logistics
The logistics is defined as the planning framework for maintaining the material, information,
and capital flow. The logistics includes the complex information, communication and control
systems required in the business environment. The logistics presents e-business with
challenges that exceeds the expectations of the customers with a reasonable cost. Now
aday, attempt has been made to reduce the inventory costs. In order to meet the high
expectations of the customers, an e-business needs the special infrastructure for tuning and
managing the interactions. The interactions can be in between the shippers, logistic
providers, shipping companies, and also the customers.
3. Legal concerns
As there is tremendous usage of internet, it is better to consider the legal concerns behind
the internet. This is because whatever is printed on the net will be accessed by public
throughout the world. We also have an option of going back and seeing the basics of that
information. Now-a-day with the help of wireless phones, Personal Digital Assistants
(PDAs), internet can be accessed from anywhere in the world. As a result the customers
must be provided proper security and privacy to access internet. It becomes very difficult to
trust the actual with the unethical, illegal, internet marketing and advertising frauds and ebusiness email scams and hence one must be careful while performing e-business.

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It is necessary to concern the privacy and legal matters while writing a copy and maintaining
a client's e-business.
There are uncertainties in e-business when compared with direct business. The
uncertainties are related to the security, privacy, credit and debit card handling. The security
is the primary concern in e-business. The PCI Data Security standard (PCI DSS) needs to
be followed by one who handles the credit card information. E-business is all about the trust
between buyer and the seller so one must be careful while dealing with the transactions
which involve the handling of credit and debit cards.
There will also be copyright issues that is copying something from other sites and presenting
the same content as their own. It is important to check for plagiarism when the company is
publishing their own articles. When some concepts are copyright then it is necessary to
credit the original authors. Disclaimer notice is required at the start of any business website.
If the webmasters include some unethical information about the client then that can cause
everlasting negative consequences for the client. The legal action is taken against the false
advertisements also.
The risks associated with conducting e-business over the internet are explained as follows:

Jurisdiction - Contracting over the cyberspace is a challenge for the website owners
and the internet is the form of communication that rises above the spatial boundaries.
There is a jurisdiction problem in the disputes between the buyer and seller regarding
where the contract was formed and which state law applies for the contract.

Contact validity - The emerging issue is the legal validity of web wrap or click on
contracts. This type of contract is mainly found on the web site that offers goods and
services for the sale. This e-business creates the legal relationship between the
seller and buyer.

Contract information - The advent of the e-business over the net is responsible for
various legal issues regarding the formation of the electronic contracts.

There is a need for matching both the e-customers and e-merchants with the legally
responsible parties in the real world. There is a need for on cryptographic methods for
reducing the risks associated with the identification and authentication. The cryptographic
methods for eliminating the risks those are associated with the non repudiation and security.

Q6. Write short notes on WTO.

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Answer: WTO was established on 1st January 1995. In April 1994, the Final Act was signed
at a meeting in Marrakesh, Morocco. The Marrakesh Declaration of 15th April 1994 was
formed to strengthen the world economy that would lead to better investment, trade, income
growth and employment throughout the world. The WTO is the successor to the General
Agreement of Tariffs and Trade (GATT). India is one of the founder members of WTO. WTO
represents the latest attempts to create an organisational focal point for liberal trade
management and to consolidate a global organisational structure to govern world affairs.
WTO has attempted to create various organisational attentions for regulation of international
trade. WTO created a qualitative change in international trade. It is the only international
body that deals with the rules of trades between nations.
Objectives and functions of WTO
The key objective of WTO is to promote and ensure international trade in developing
countries. The other major functions include:

Helping trade flows by encouraging nations to adopt discriminatory trade policies.

Promoting employment, expanding productions and trade and raising standard of

living and income and utilising the worlds resources.

Ensuring that developing countries secure a better share of growth in world trade.

Providing forum for trade negotiations.

Resolving trade disputes.

The important functions of the WTO as stated in the WTO agreement are the following:
Developing transitional economies Majority of the WTO members belong to developing
countries. The developing countries such as India, China, Mexico, Brazil and others have an
important role in the organisation. The WTO helps in solving the problems of developing
economies. The developing states are provided with trade and tariff data. This depends on
the countrys individual export interest and their participation in WTO-bodies. The new
members benefit hugely from these services.
Providing help for export promotion The WTO provides specialised help for export
promotion to its members. The export promotion is done through the International Trade
Center established by the GATT in 1964. It is operated by the WTO and the United Nations.
The center accepts requests from member countries, usually developing countries for
support in formulating and implementing export promotion programmes. The center provides

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information on export market and marketing techniques. The center also provides assistance
in establishing export promotion and marketing services. Through this WTO proves its
commitment in the upliftment of the world economy.
Cooperating in global economic policy-making The main function of the WTO is to
cooperate in global economic policy-making. In the Marrakesh Ministerial Meeting in April
1994, a separate declaration was adopted to achieve this objective. The declaration
specifies the responsibility of WTO as, to improve and maintain the cooperation with
international organisations such as the World Bank, International Monetary Fund (IMF) that
are involved in monetary and financial matters. WTO analyses the impact of liberalisation on
the growth and development of national economies which is the important factor in the
success of the economy.
Monitoring implementation of the agreement The WTO administers sixty different
agreements that have the statue of international legal documents. The membergovernments sign and confirm all WTO agreements on attainment.
Providing forum for negotiations The WTO provides a permanent forum for negotiations
among members. The negotiations can be on matters already in the WTO agreements or
matters not addressed in the WTO law.
Administrating dispute settlement The important function of WTO is the administration
of the WTO dispute settlement system. It helps in settling multilateral trading dispute. A
dispute arises when a member country adopts a trade policy and other fellow members
consider it as a violation of WTO agreements. The Dispute Settlement Body (DSB) is
responsible for the settlement of disputes. The dispute settlement system is prohibited from
adding or deleting the rights and obligations provided in the WTO agreements. The WTO
dispute settlement system helps to:

Preserve the rights and responsibilities of the members.

Clarify the current provisions of the agreements.

Structure
The structure of the WTO consists of the Ministerial Conference, which is the highest
authority. This body consists of the representatives from all WTO members. The WTO
members meet in every two years and take decisions on all matters under the multilateral
trade agreements. The daily activities of the WTO are conducted by subsidiary bodies and

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principally by the General Council which is composed of WTO members. The members
report to the Ministerial Conference. The General Council on behalf of the Ministerial
Conference administers as the Dispute Settlement Body to manage the dispute settlement
procedures. It also acts as the Trade Policy Review Body that conducts regular reviews of
the trade policies of the individual WTO members.
The General Council delegates responsibility to other major bodies. They are:

Council for Trade in Goods manages the implementation and functioning of all
agreements covering trade in goods.

Trade in Services and Trade of Intellectual Property Rights are the two councils that
have responsibility for their respective WTO agreements and can establish their own
subsidiary bodies if required.

The Committee on Trade and Development manages issues relating to the

developing countries.

The Committee on Balance of Payments conducts consultations between WTO

members and countries that take trade-restrictive measures to handle balance-ofpayments difficulties.

Committee on Budget and Administration manages issues relating to financing and

budget of WTO.

Principles
The WTO principles of the trading system are:

Trading without discrimination One aspect of nondiscrimination is that foreigners

and people within the home country must be treated equally. This implies that
imported goods that are in the market must not face discrimination. There is also a
Most Favoured Nation (MFN) principle which requires the nations to treat all WTO
members equally. In case one nation grants a special trade deal to another nation,
the deal must be extended to all WTO members.

Trade barriers negotiated downwards To lower trade barriers such as import

tariffs, red tape and encourage trade growth.

Predictable trading The predictability in business helps to know the real costs.
The WTO operates with tariff bindings and agreements that restricts raising a specific
tariff over a given time. This provides the business people with realistic data. Making
trade rules clear and accessible helps the business people to anticipate stable future.

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Competitive trading The WTO works towards trade liberalisation and understands
that trade relationships between nations can be very complex. The WTO agreements
support healthy competition in services and intellectual property and discourage
subsidies and dumping of products at prices below the cost of their manufacturer.

Encourage development and economic reforms The majority of the WTO

members are developing economies that are changing to market economies. The
developed nations must give market access to goods from the under developed
countries and provide technical assistance. Developed countries are allowing dutyfree and quota-free imports for all the products from the under developed countries.

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MF0015
MF0015 International Financial Management
Assignment Set- 1

Q1. You are given the following information:

Spot EUR/USD : 0.7940/0.8007
Spot USD/GBP: 1.8215/1.8240
Three months swap: 25/35
Calculate three month EUR/USD rate.
Answer:
Forward Points = ((Spot * (1 + (OCR rate * n/360))) / (1 + (BCR rate * n/360))) - Spot
OCR = Other Currency Rate
BCR = Base Currency Rate
Forward points = ((0.07940 * (1 + (0.018215 * 90/360))) / (1 + (0.08007 * 90/360)))
0.07940
SWAP = -0.00120
Forward rate = 0.07940 - 0.00120 = 0.0782
Customer sells EUR 3 Mio against USD at 0.0782 at 3 month (0.07940 - 0.00120).
Customer wants to Buy EUR 3 Mio against USD 3 months forward.

Q2. Distinguish between Eurobond and foreign bonds. What are the unique
characteristics of Eurobond markets?
Answer: A Eurobond is underwritten by an international syndicate of banks and other
securities firms, and is sold exclusively in countries other than the country in whose currency
the issue is denominated. For example, a bond issued by a U.S. corporation, denominated in
U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United
States), would be a Eurobond. Eurobonds are issued by multinational corporations, large
domestic corporations, sovereign governments, governmental enterprises, and international
institutions. They are offered simultaneously in a number of different national capital
markets, but not in the capital market of the country, nor to residents of the country, in whose
currency the bond is denominated. Almost all Eurobonds are in bearer form with call
provisions and sinking funds.
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A foreign bond is underwritten by a syndicate composed of members from a single country,

sold principally within that country, and denominated in the currency of that country. The
issuer, however, is from another country. A bond issued by a Swedish corporation,
denominated in dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers,
would be a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the U.S. are
"Yankee bonds"; those sold in Japan are "Samurai bonds"; and foreign bonds sold in the
United Kingdom are "Bulldogs." Figure 4 specifically reclassifies foreign bonds from a U.S.
investor`s perspective.

FOREIGN BONDS TO U.S. INVESTORS

Foreign currency bonds are issued by foreign governments and foreign corporations,
denominated in their own currency. As with domestic bonds, such bonds are priced inversely
to movements in the interest rate of the country in whose currency the issue is denominated.
For example, the values of German bonds fall if German interest rates rise. In addition,
values of bonds denominated in foreign currencies will fall (or rise) if the dollar appreciates
(or depreciates) relative to the denominated currency. Indeed, investing in foreign currency
bonds is really a play on the dollar. If the dollar and foreign interest rates fall, investors in
foreign currency bonds could make a nice return. It should be pointed out, however, that if
both the dollar and foreign interest rates rise, the investors will be hit with a double whammy.
Characteristics of Eurobond markets
1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed
interest and has a long-term maturity. There are a number of different currencies in which
Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro.
(70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a

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country can protect its currency from being used. Japan, for example, prohibited the yen
from being used for Eurobond issues of its corporations until 1984.
2. Non-registered: Eurobonds are usually issued in countries in which there is little
regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer
form means that the bond is unregistered, there is no record to identify the owners, and
these bonds are usually kept on deposit at depository institution). While this feature provides
confidentiality, it has created some problems in countries such as the U.S., where
regulations require that security owners be registered on the books of issuer.
3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective
covenants, making them an attractive financing instrument to corporations, but riskier to
bond investors. Eurobonds differ in term of their default risk and are rated in terms of quality
ratings.
4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10
years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds. There
are also short-term Europaper and Euro Medium-term notes.
5. Other features:
Like many securities issued today, Eurobonds often are sold with many innovative features.
For example:
a) Dual-currency Eurobonds pay coupon interest in one currency and principal in another.
b) Option currency Eurobond offers investors a choice of currency. For instance, a
sterling/Canadian dollar bond gives the holder the right to receive interest and principal in
either currency.
1. A number of Eurobonds have special conversion features. One type of convertible
Eurobond is a dual-currency bond that allows the holder to convert the bond into stock or
another bond that is denominated in another currency.
2. A number of Eurobonds have special warrants attached to them. Some of the warrants
sold with Eurobonds include those giving the holder the right to buy stock, additional bonds,
currency, or gold.

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Q3. What is sub-prime lending? Explain the drivers of sub-prime lending? Explain
briefly the different exchange rate regime that is prevalent today.
Answer: Subprime lending is the practice of extending credit to borrowers with certain
credit characteristics e.g. a FICO score of less than 620 that disqualify them from loans
at the prime rate (hence the term sub-prime). Sub-prime lending covers different types of
credit, including mortgages, auto loans, and credit cards. Since sub-prime borrowers often
have poor or limited credit histories, they are typically perceived as riskier than prime
borrowers. To compensate for this increased risk, lenders charge sub-prime borrowers a
premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for
credit cards, higher over-the-limit or late fees are also common. Despite the higher costs
associated with sub-prime lending, it does give access to credit to people who might
otherwise be denied. For this reason, sub-prime lending is a common first step toward credit
repair; by maintaining a good payment record on their sub-prime loans, borrowers can
establish their creditworthiness and eventually refinance their loans at lower, prime rates.
Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt
increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was
an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all mortgages
originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago.
This substantial increase is attributable to industry enthusiasm: banks and other lenders
discovered that they could make hefty profits from origination fees, bundling mortgages into
securities, and selling these securities to investors.
These banks and lenders believed that the risks of sub-prime loans could be managed, a
belief that was fed by constantly rising home prices and the perceived stability of mortgagebacked securities. However, while this logic may have held for a brief period, the gradual
decline of home prices in 2006 led to the possibility of real losses. As home values declined,
many borrowers realized that the value of their home was exceeded by the amount they
owed on their mortgage. These borrowers began to default on their loans, which drove home
prices down further and ruined the value of mortgage-backed securities (forcing companies
to take write downs and write-offs because the underlying assets behind the securities were
now worth less).
This downward cycle created a mortgage market meltdown. The practice of sub-prime
lending has widespread ramifications for many companies, with direct impact being on
lenders, financial institutions and home-building concerns. In the U.S. Housing

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Market, property values have plummeted as the market is flooded with homes but bereft of
buyers. The crisis has also had a major impact on the economy at large, as lenders are
hoarding cash or investing in stable assets like Treasury securities rather than lending
money for business growth and consumer spending; this has led to an overall credit crunch
in 2007. The sub-prime crisis has also affected the commercial real estate market, but not as
significantly as the residential market as properties used for business purposes have
retained their long-term value.
The International Monetary Fund estimated that large U.S. and European banks lost more
than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.
These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast
to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that
U.S. banks were about 60 percent through their losses, but British and euro zone banks only
40 percent.
Drivers of sub-prime lending
Home price appreciation
Home price appreciation seemed an unstoppable trend from the mid-1990s through to
today. This "assumption" that real estate would maintain its value in almost all circumstances
provided a comfort level to lenders that offset the risk associated with lending in the subprime market. Home prices appeared to be growing at annualized rates of 5-10% from the
mid-90s forward. In the event of default, a very large percentage of losses could be
recouped through foreclosure as the actual value of the underlying asset (the home) would
have since appreciated.
Lax lending standards
Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in
lending standards can be seen as the product of many of the preceding themes. The
increased acceptance of securitized products meant that lending institutions were less likely
to actually hold on to the risk, thus reducing their incentive to maintain lending standards.
Moreover, increasing appetite from investors not only fueled a boom in the lending industry,
which had historically been capital constrained and thus unable to meet demand, but also
led to increased investor demand for higher-yielding securities, which could only be created
through the additional issuance of sub-prime loans. All of this was further enabled by the
long-term home price appreciation trends and altered rating agency treatment, which
seemed to indicate risk profiles were much lower than

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they actually were. As standards fell, lenders began to relax their requirements on key loan
metrics. Loan-to-value ratios, an indicator of the amount of collateral backing loans,
increased markedly, with many lenders even offering loans for 100% of the collateral value.
More dangerously, some banks began lending to customers with little effort made to
investigate their credit history or even income. Additionally, many of the largest sub-prime
lenders in the recent boom were chartered by state, rather than federal, governments.
States often have weaker regulations regarding lending practices and fewer resources with
which to police lenders. This allowed banks relatively free rein to issue sub-prime mortgages
to questionable borrowers.
Adjustable-rate mortgages and interest rates
Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market,
particularly the sub-prime sector, toward the end of the 1990s and through the mid-2000s.
Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current
prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting
ARMs as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered
low introductory, or teaser, rates aimed at attracting new borrowers. These teaser rates
attracted droves of sub-prime borrowers, who took out mortgages in record numbers.
While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan
origination, rising interest rates can substantially increase both loan rates and monthly
payments.
In the sub-prime bust, this is precisely what happened. The target federal funds rate (FFR)
bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of mid-2007,
the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in
interest rates over a three-year period left borrowers with steadily rising payments, which
many found to be unaffordable. The expiration of teaser rates didnt help either; as these
artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime
borrowers are seeing their monthly payments jump by as much as 50%, further driving the
increasing number of delinquencies and defaults. Between September of 2007 and January
2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of
curbing losses. Though many sub-prime mortgages continue to reset from fixed to floating,
rates have fallen so much that in many circumstances the fully indexed reset rate is below
the pre-existing fixed rate; thus, a boon for some sub-prime borrowers.
The exchange rate is an important price in the economy and some governments like to
control it, manage it or influence it. Others prefer to leave the exchange rate to be

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determined only by market forces. This decision is the choice of exchange rate regime.
Many alternative regimes exist:
Floating Exchange Rate (Flexible) Regimes: A flexible exchange rate system is one
where the value of the currency is not officially fixed but varies according to the supply and
demand for the currency in the foreign exchange market. In this system, currencies are
allowed to:

Appreciate when the currency becomes more valuable relative to others.

Depreciate when the currency becomes less valuable relative to others.

Fixed Exchange Rate Regimes: A Fixed exchange rate system is one where the value of
the currency is set by official government policy. The exchange rate is determined by
government actions designed to keep rates the same over time. The currencies are altered
by the government:

Revaluation Government action to increase the value of domestic currency relative

to others.

Devaluation Government action to decrease the value of domestic currency.

After the transition period of 1971-73, the major currencies started to float. Flexible
exchange rates were declared acceptable to the IMF members. Gold was abandoned
as an international reserve asset. Since 1973, most major exchange rates have been
floating against each other.

However, there are countries which have fixed exchange rate regimes.

Q4. Explain (a) Parallel Loans (b) Back to- Back loans
Answer: Parallel loan
The forerunner of a swap; a method of raising capital in a foreign country to finance assets
there without a cross-border movement of capital. For example, a $US loan would be made
to an Australian company to finance its factory in the US; at the same time the US party
which made the loan would borrow $A in Australia from the Australian company's parent to
finance a project in Australia. Parallel loans enjoyed considerable popularity in the 1970s in
the UK when they were frequently used to circumvent strict exchange controls.

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A type of foreign exchange loan agreement that was a precursor to currency swaps. A
parallel loan involves two parent companies taking loans from their respective national
financial institutions and then lending the resulting funds to the other company's subsidiary.
For example, ABC, a Canadian company, would borrow Canadian dollars from a Canadian
bank and XYZ, a French company, would borrow euros from a French bank. Then ABC
would lend the Canadian funds to XYZ's Canadian subsidiary and XYZ would lend the euros
to ABC's French subsidiary.
The first parallel loans were implemented in the 1970s in the United Kingdom in order to
bypass taxes that were imposed to make foreign investments more expensive.
Back-to-back loan
A Back-to-back loan is a loan agreement between entities in two countries in which the
currencies remain separate but the maturity dates remain fixed. The gross interest rates of
the loan are separate as well and are set on the basis of the commercial rates in place when
the agreement is signed.
Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a
way of avoiding currency regulations, the practice had, by the mid-1990s, largely been
replaced by currency swaps.
A Back-to-back loan is a loan agreement between entities in two countries in which the
currencies remain separate but the maturity dates remain fixed. The gross interest rates of
the loan are separate as well and are set on the basis of the commercial rates in place when
the agreement is signed.
Most back-to-back loans come due within 10 years, due to their inherent risks. Initiated as a
way of avoiding currency regulations, the practice had, by the mid-1990s, largely been
replaced by currency swaps.
One disadvantage of such agreements is asymmetrical liability - absent a specific
agreement, when one party defaults on the loan, the other party may still be held
responsible for repayment. Another disadvantage in comparison with currency swaps is that
back-to-back loan transactions are customarily recorded on banking institutions' records as
liabilities and thereby increase their capitalization requirements, while currency swaps were,
during the 2000s, widely exempted from this requirement.
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Q5. Explain double taxation avoidance agreement in detail

Answer: Double Taxation Avoidance Agreements
Double Taxation Avoidance Agreements
Double taxation relief
Double taxation means taxation of same income of a person in more than one country. This
results due to countries following different rules for income taxation. There are two main
rules of income taxation (a) source of income rule and (b) residence rule.
As per source of income rule, the income may be subject to tax in the country where the
source of such income exists (i.e. where the business establishment is situated or where the
asset/property is located) whether the income earner is a resident in that country or not.
On the other hand, the income earner may be taxed on the basis of his residential status in
that country. For example if a person is resident of a country, he may have to pay tax on any
income earned outside that country as well.
Further some countries may follow a mixture of the above two rules.
Thus problem of double taxation arises if a person is taxed in respect of any income on the
basis of source of income rule in one country and on the basis of residence in another
country or on the basis of mixture of above two rules.
Relief

against

such

hardship

can

be

provided

mainly

in

two

ways

(a) Bilateral relief (b) Unilateral relief.

Bilateral Relief
The governments of two countries can enter into agreement to provide relief against double
taxation, worked out on the basis of mutual agreement between the two concerned
sovereign states. This may be called a scheme of bilateral relief as both concerned powers
agree as to the basis of the relief to be granted by either of them.

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Unilateral Relief
The above procedure for granting relief will not be sufficient to meet all cases. No country
will be in a position to arrive at such agreement as envisaged above with all the countries of
the world for all time. The hardship of the taxpayer, however, is a crippling one in all such
cases. Some relief can be provided even in such cases by home country irrespective of
whether the other country concerned has any agreement with India or has otherwise
provided for any relief at all in respect of such double taxation. This relief is known as
unilateral relief.

Method of Giving Relief from Double Taxation

Relief from double taxation is provided by abatement on the basis of mutual agreement
between two states concerned where by the assessee is given relief by credit/refund in a
particular manner even though he is taxed in both countries. Relief may be in the form of
credit for tax payable in another country or by charging tax at lower rate.
Various models of treaties
Although treaties entered into by various countries cannot be exactly identical, a certain
amount of uniformity is desirable in its framework; with this in view, tax treaties have been
based on models such as:
1. OECD model (Organisation of Economic Co-operation and Development)
2. UN Models Double Taxation Convention between developed and developing countries,
1980. Most of Indias treaties are based on OECD models.

Types of Agreements
Agreements can be divided into two main categories:
1. Limited agreements
2. Comprehensive agreements

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Limited agreements are generally entered into to avoid double taxation relating to income
derived from operation of aircraft, ships, carriage of cargo and freight.
Comprehensive agreements, on the other hand, are very elaborate documents which lay
down in detail how incomes under various heads may be dealt with.
Countries with which no agreement exists [section 91] [unilateral relief]
If any person who is resident in India in any previous year proves that, in respect of his
income which accrued or arose during that previous year outside India (and which is not
deemed to accrue or arise in India), he has paid in any country with which there is no
agreement under section 90 for the relief or avoidance of double taxation, income-tax, by
deduction or otherwise, under the law in force in that country, he shall be entitled to the
deduction from the Indian income-tax payable by him of a sum calculated on such doubly
taxed income at the Indian rate of tax or the rate of tax of the said country, whichever is the
lower, or at the Indian rate of tax if both the rates are equal.

In other words, unilateral relief will be available, if the following conditions are satisfied:
1. The assessee in question must have been resident in the taxable territories.
2. That some income must have accrued or arisen to him outside the taxable territory during
the previous year and it should also be received outside India.
3. In respect of that income, the assessee must have paid by deduction or otherwise tax
under the law in force in the foreign country in question in which the income outside India
has arisen.
4. There should be no reciprocal arrangement for relief or avoidance from double taxation
with the country where income has accrued or arisen.
India has agreements for avoidance of double taxation with over 60 countries.
If all the above conditions are satisfied, such person shall be entitled to deduction from the
Indian income-tax payable by him of a sum calculated on such doubly taxed income
(a) At the average Indian rate of tax or the average rate of tax of the said country, whichever
is the lower, or

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(b) At the Indian rate of tax if both the rates are equal.
Average rate of tax means the tax payable on total income divided by the total income.
Steps for calculating relief under this section:
Step I: Calculate tax on total income inclusive of the foreign income on which relief is
available. Claim relief if available under sections 88, 88B and 88C.
Step II: Calculate average rate of tax by dividing the tax computed under Step I with the total
income (inclusive of such foreign income).
Step III: Calculate average rate of tax of the foreign country by dividing income-tax actually
paid in the said country after deduction of all relief due but before deduction of any relief due
in the said country in respect of double taxation by the whole amount of the income as
assessed in the said country.
Step IV: Claim the relief from the tax payable in India at the rate calculated at Step II or Step
III whichever is less

Q6. What do you mean by optimum capital structure? What factors affect cost of
capital across nations?
Answer: The objective of capital structure management is to mix the permanent sources of
funds in a manner that will maximise the companys common stock price. This will also
minimise the firms composite cost of capital. This proper mix of fund sources is referred to
as the optimal
capital structure. Thus, for each firm, there is a combination of debt, equity and other
forms(preferred stock) which maximises the value of the firm while simultaneously
minimising the cost of capital. The financial manager is continuously trying to achieve an
optimal proportion of debt and equity that will achieve this objective.
Cost of Capital across Countries
Just like technological or resource differences, there exist differences in the cost of capital
across countries. Such differences can be advantageous to MNCs in the following ways:

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1. Increased competitive advantage results to the MNC as a result of using low cost capital
obtained from international financial markets compared to domestic firms in the foreign
country. This, in turn, results in lower costs that can then be translated into higher market
shares.
2. MNCs have the ability to adjust international operations to capitalise on cost of capital
differences among countries, something not possible for domestic firms.
3. Country differences in the use of debt or equity can be understood and capitalised on by
MNCs. We now examine how the costs of each individual source of finance can differ across
countries.
Country differences in Cost of Debt
Before tax cost of debt (Kd) = Rf + Risk Premium
This is the prevailing risk free interest rate in the currency borrowed and the risk premium
required by creditors. Thus the cost of debt in two countries may differ due to difference in
the risk free rate or the risk premium.
(a) Differences in risk free rate: Since the risk free rate is a function of supply and demand,
any factors affecting the supply and demand will affect the risk free rate. These factors
include:

Tax laws: Incentives to save may influence the supply of savings and thus the
interest rates. The corporate tax laws may also affect interest rates through effects on
corporate demand for funds.

Demographics: They affect the supply of savings available and the amount of
loanable funds demanded depending on the culture and values of a given country.

This may affect the interest rates in a country.

Monetary policy: It affects interest rates through the supply of loanable funds. Thus
a loose monetary policy results in lower interest rates if a low rate of inflation is
maintained in the country.

Economic conditions: A high expected rate of inflation results in the creditors

expecting a high rate of interest which increases the risk free rate.

(b) Differences in risk premium: The risk premium on the debt must be large enough to
compensate the creditors for the risk of default by the borrowers. The risk varies with the
following:

Economic conditions: Stable economic conditions result in a low risk of recession.

Thus there is a lower probability of default.

Relationships between creditors and corporations: If the relationships are close

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and the creditors would support the firm in case of financial distress, the risk of
illiquidity of the firm is very low. Thus a lower risk premium.

Government intervention: If the government is willing to intervene and rescue a

firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk
premium.

Degree of financial leverage: All other factors being the same, highly leveraged

firms would have to pay a higher risk premium.

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MF0015 International Financial Management
Assignment Set- 2

Q1. Because of its broad global environment, a number of disciplines (geography,

history, political science, etc.) are useful to help explain the conduct of International
Business. Elucidate with examples.

Answer: International Finance is a distinct field of study and certain features set it apart from
other fields. The important distinguishing features of international finance are discussed
below:

Foreign exchange risk: An understanding of foreign exchange risk is essential for

managers and investors in the modern day environment of unforeseen changes in
foreign exchange rates. In a domestic economy this risk is generally ignored because a
single national currency serves as the main medium of exchange within a country. When
different national currencies are exchanged for each other, there is a definite risk of
volatility in foreign exchange rates. The present International Monetary System set up is
characterized by a mix of floating and managed exchange rate policies adopted by each
nation keeping in view its interests. In fact, this variability of exchange rates is widely
regarded as the most serious international financial problem facing corporate managers
and policy makers.

Political risk: Another risk that firms may encounter in international finance is political
risk. Political risk ranges from the risk of loss (or gain) from unforeseen government
actions or other events of a political character such as acts of terrorism to outright
expropriation of assets held by foreigners. MNCs must assess the political risk not only
in countries where it is currently doing business but also where it expects to establish
subsidiaries. The extreme form of political risk is when the sovereign country changes
the rules of the game and the affected parties have no alternatives open to them.

Expanded opportunity sets: When firms go global, they also tend to benefit from
expanded opportunities which are available now. They can raise funds in capital markets
where cost of capital is the lowest. In addition, firms can also gain from greater
economies of scale when they operate on a global basis.

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Market imperfections: The final feature of international finance that distinguishes it from
domestic finance is that world markets today are highly imperfect. There are profound
differences among nations laws, tax systems, business practices and general cultural
environments. Imperfections in the world financial markets tend to restrict the extent to
which investors can diversify their portfolio. Though there are risks and costs in coping
with these market imperfections, they also offer managers of international firms
abundant opportunities.

Q2. What is a credit transaction and a debit transaction? Which are the broad
categories of international transactions classified as credits and as debits?

Answer: Debits and credits

Since the balance of payments statement is based on the principle of double entry
bookkeeping, every credit in the account is balanced by a matching debit and vice versa.
The following section now explains, with examples, the BOP accounting principles regarding
debits and credits. These principles are logically consistent, though they may be a little
confusing sometimes.
A country earns foreign exchange on some transactions and expends foreign exchange on
others when it deals with the rest of the world. Credit transactions are those that earn foreign
exchange and are recorded in the balance of payments with a plus (+) sign. Selling either
real or financial assets or services to nonresidents is a credit transaction. For example, the
export of Indian made goods earns foreign exchange for us and is, hence, a credit
transaction. Borrowing abroad also brings in foreign exchange and is recorded as a credit.
An increase in accounts payable due to foreigners by Indian residents has the same BOP
effect as more formal borrowing in the worlds capital market. The sale to a foreign resident
of a service, such as an airline trip on Air India or hotel booking in an Indian hotel, also
earns foreign exchange and is a credit transaction.

Transactions that expend or use up foreign exchange are recorded as debits and are
entered with a minus () sign. The best example here is of import of goods and services
from foreign countries. When Indian residents buy machinery from US or perfumes from

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France, foreign exchange is spent and the import is recorded as a debit. Similarly, when
Indian residents purchase foreign services, foreign exchange is used and the entry is
recorded as a debit.

The BOPs accounting principles regarding debits and credits can be summarised as follows:
1. Credit Transactions (+) are those that involve the receipt of payment from foreigners.
The following are some of the important credit transactions:
(a) Exports of goods or services
(b) Unilateral transfers (gifts) received from foreigners
(c) Capital inflows

2. Debit Transactions () are those that involve the payment of foreign exchange i.e.,
transactions that expend foreign exchange. The following are some of the important debit
transactions:
(a) Import of goods and services
(b) Unilateral transfers (or gifts) made to foreigners
(c) Capital outflows
Let us now analyse the two terms capital inflows and capital outflows in a little more
detail.
Capital Inflows can take either of the two forms:
(a) An increase in foreign assets of the nation
(b) A reduction in the nations assets abroad
For example, you can better understand the debit and credit transaction from the examples
given below:

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A US resident purchases an Indian stock. When a US resident acquires a stock in an Indian

company, foreign assets in India go up. This is a capital inflow to India because it involves
the receipt of a payment from a foreigner.
When an Indian resident sells a foreign stock, Indian assets abroad decrease. This
transaction is a capital inflow to India because it involves receipt of a payment from a
foreigner.

Capital Outflows can also take any of the following forms:

(a) An increase in the nations assets abroad
(b) A reduction in the foreign assets of the nation

Both the above transactions involve a payment to foreigners and are capital outflows.

Q3. What is cross rates? Explain the two methods of quotations for exchange rates
with examples.
Answer: Cross Rates: The exchange rate between any two non-dollar currencies is
referred to as a cross rate. A relatively large number of cross rates would be required to
trade every currency directly against every other currency.
For example, N currencies would require N x (N-1)/2 separate cross rates. For this reason,
most exchange rates are quoted in terms of dollars and by far the greatest volume of trading
directly involves the dollar. This reduces the number of cross-currency quotes that dealers
must keep track of and reduces the potential losses associated with mispricing currencies
relative to one another (which permit Triangular Arbitrage).
Exchange Rates Quotations
There are two methods of quotation for exchange rates between the dollar and the currency
of another country. The two methods are referred to as the direct (American) and indirect
(European) methods of quotation. The exchange rate between any two non-dollar currencies
is referred to as a cross rate:

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1. Direct/American Quotation: Direct quotation is the dollar price of one unit of foreign
currency.
For example, a direct quotation of the exchange rate between dollar and the British pound
(German mark) is $1.6000/1 ($0.6000/DM1), indicating that the dollar cost of one British
pound (German mark) is $1.6000 ($0.6000).
Direct exchange rate quotations are most frequently used by banks in dealing with their nonbank customers. In addition, the prices of currency futures contracts traded on the Chicago
Mercantile exchange are quoted using the direct method.
2. Indirect/European Quotation: The number of units of a foreign currency that are
required to purchase one dollar.
For example, an indirect quotation of the exchange rate between the dollar and the
Japanese yen (German mark) is 125.00/$1 (DM 1.6667/$1), indicating that one dollar can
be purchased for either 125.00 Japanese Yen or 1.6667 German Marks.

Q4. Explain covered and uncovered interest rate arbitrage.

Answer: Uncovered Interest Arbitrage

The transfer of funds abroad to take advantage of higher interest rates in foreign monetary
centres usually involves the conversion of the domestic currency to the foreign currency, to
make the investment. At the time of maturity, the funds (plus the interest) are reconverted
from the foreign currency to the domestic currency. During the period of investment, a
foreign exchange risk is involved due to the possible depreciation of the foreign currency. If
such a foreign exchange risk is covered, we have covered interest arbitrage, otherwise we
have uncovered interest arbitrage.

Suppose that the interest rate on three-month treasury bills is 11 per cent at an annual basis
in Germany and 15 per cent in London. It may then pay for a German investor to exchange
marks for pounds at the current spot rate and purchase British treasury bills to earn the extra
1 per cent interest for the three months. When the British treasury bills mature, the German

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investor may want to exchange the pounds he invested plus the interest he earned back into
marks. The situation is shown in Figure.

Covered Interest Arbitrage

Interest arbitrage is usually covered as investors of short-term funds abroad generally want
to avoid the foreign exchange risk. To do this, the investor exchanges the domestic currency
for the foreign currency at the current spot rate so as to purchase the foreign treasury bills
and at the same time he sells forward the amount of the foreign currency he is investing plus
the interest he will earn so as to coincide with the maturity of his foreign investment. Thus,
covered interest arbitrage refers to the spot purchase of the foreign currency to make the
investment and offsetting the simultaneous forward sale (swap of the foreign currency) to
cover the foreign exchange risk. When the treasury bills mature, the investor can then get
the domestic currency equivalent of the foreign investment plus the interest earned without a
foreign exchange risk. Since the currency with the higher interest rate is usually at a forward
discount, the net return on the investment is roughly equal to the positive interest differential
earned abroad minus the forward discount on the foreign currency. This reduction in
earnings is the cost of insurance against the foreign exchange risk.
Continuing with the earlier example where the interest rate on three-month treasury bills is
11 per cent per year in Germany and 15 per cent in London, let us also assume that the
pound is at a three-month forward discount of 1 per cent per year. To engage in covered
interest arbitrage, the German investor must exchange marks for pounds at the current
exchange rate (to purchase the British treasury bills) and at the same time sell forward a

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quantity of pounds equal to the amount invested plus the interest he will earn at the
prevailing forward rate. Since the pound is at a forward discount of 1 per cent per year,
German investor loses 1 per cent on the foreign exchange transaction to cover his foreign
exchange risk for the three month period. His net gain is thus the extra 1 per cent interest he
earns for the three months minus th of the 1 per cent he loses on the foreign exchange
transaction, or 3/4 of 1 per cent.

Covered interest arbitrage and interest parity theory

Figure shows the relationship through Covered Interest Arbitrage (CIA) between the interest
rate differentials between the two nations and the forward premium or discount on the
foreign currency.

The horizontal axis in the diagram shows the forward premium (+) or forward discount on the
foreign currency expressed in percentages per year. The vertical axis measures the interest
differential in favour of the foreign country in per cent per annum. The solid line in the Figure
depicts interest parity. Positive values indicate that interest rates are higher abroad. Negative
values indicate that interest rates are higher domestically. And when the interest differential
is zero, the foreign currency is neither at a forward discount nor at a forward premium (i.e.,
the forward rate on the foreign currency is equal to its spot rate).
For example, when the positive interest differential is 1.5 per cent per year in favour of the
foreign nation, the foreign currency is at a forward discount of 1.5 per cent per year.
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Similarly, a negative interest differential of 2.0 per cent is associated with a forward premium
of 2.0 per cent.

The Figure shows that for all points above the interest parity line, there will be a net gain
from an arbitrage outflow due to two reasons. First, the positive interest differential exceeds
the forward discount and second, the forward premium exceeds the negative interest
differential.

Q5. Explain briefly the mechanism of futures trading

Answer: Mechanism of Futures Trading

The mechanics of futures trading consists of two parts.
(a) Components of futures trade
(b) Execution of futures trade

Components of Futures Trade

1. Futures players: Futures trading, which represents a less than zero-sum game, can be
considered beneficial if it results in utility gains. This is done by the transfer of risks between
the market players. These players are:
Hedgers
Speculators
Arbitrage

2. Clearing houses: Every organised futures exchange has a clearing house that
guarantees performance to all of the participants in the market. It serves this role by
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adopting the position of buyer to every seller and seller to every buyer. Thus, every trading
party in the futures markets has obligations only to the clearing house. Since the clearing
house matches its long and short positions exactly, it is perfectly hedged, i.e., its net futures
position is zero.

It is an independent corporation and its stockholders are its member clearing firms. All
futures traders maintain an account with member clearing firms either directly or through a
brokerage firm.
3. Margin requirements: Each trader is required to post a margin to insure the clearing
house against credit risk. This margin varies across markets, contracts and the type of
trading strategy involved. Upon completion of the futures contract, the margin is returned.

4. Daily resettlement: For most futures contracts, the initial margins are 5% or less of the
underlying commoditys value. These margins are marked to the market on a daily basis and
the traders are required to realise any losses in cash on the day they occur. Whenever the
margin deposit falls below minimum maintenance margin, the trader is called upon to make
it up to the initial margin amount. This resettlement is also called marked-to-the-market.

Delivery terms. This includes:

(a) Delivery date: Some contracts may be delivered on any business day of the delivery
month while others permit delivery after the last trading day.
(b) Manner of delivery: The possibilities are:
- Physical exchange of underlying asset.
- Cash settlement as in the case of stock index futures.
(c) Reversing trade: This trade effectively makes a traders net futures position zero thus
absolving him from further trading requirements. In futures markets, 99% of all futures
positions are closed out via a reversing trade.

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5. Types of orders: Besides placing a market order, the other types are:
(a) Limit order: It stipulates to buy or sell at a specific price or better.
(b) Fill-or-kill order: It instructs the commission broker to fill an order immediately at a
specified price.
(c) All-or-none-order: It allows the commission broker to fill part of an order at a specified
price and remainder at another price.
(d) On-the-open or on-the-close order: This represents orders to trade within a few minutes
of operating or closing.
(e) Stop order: Triggers a reversing trade when prices hit a prescribed limit.

6. Transaction costs: The costs incurred are:

(a) Floor trading and clearing fees: These are small fees charged by the exchange and its
associated clearing house.
(b) Commissions: A commission broker charges a commission fees to transact a public
order.
(c) Bid: Ask spreads.
(d) Delivery costs: Those are incurred in case of actual delivery.
7. Tax rules: The regulations include:
(a) Marketing-to-the-market: The gains/losses are considered at the end of the calendar year
where futures contracts are marked-to-the-market.
(b) Gains: The realised and unrealised gains are taxed at the ordinary personal income tax
rate.
(c) Losses: The realised and unrealised losses are made deductible by offsetting them
against any other investment gains.

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(d) Commissions: Brokerage commissions are tax deductible.

Execution of Futures Trade

For a client who wants to assume a long position in, say, a July British pound futures
contract, the following steps are undertaken:
1. Phone call to the agent.
2. The agent trades through an exchange member who may be a commission broker or a
local.
3. The actual trading is conducted in a past for the particular futures contract involved.
Trades are conducted through the use of sophisticated hand signals.
4. The commission broker confirms the trade with the agent who then notifies the client of
the completed transaction and price.
5. The client then deposits the initial margin with a member firm of the clearing house.
6. The commission broker can transact in the pit with another commission broker
representing another client or with a local.

Q6. Briefly explain the difference between functional currency and reporting
currency. Identify the factors that help in selecting an appropriate functional currency
that can be used by an organisation.

Answer: Functional Versus Reporting Currency

Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December
1981, and all US MNCs were required to adopt the statement for fiscal years beginning on or
after December 15, 1982. According to FASB 52, firms must use the current rate method to
translate foreign currency denominated assets and liabilities into dollars. All foreign currency
revenue and expense items on the income statement must be translated at either the
exchange rate in effect on the date these items were recognised or at an appropriate

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weighted average exchange rate for the period. The other important part about FASB 52 is
that it requires translation gains and losses to be accumulated and shown in a separate
equity account on the parents balance sheet. This account is known as the cumulative
translation adjustment account. ASB 52 differentiates between a foreign affiliates
functional and reporting currency.

Functional currency is defined as the currency of the primary economic environment in which
the affiliate operates and in which it generates cash flows. Generally, this is the local
currency of the country in which the entity conducts most of its business. Under certain
circumstances the functional currency may be the parent firms home country currency or
some third country currency.

The reporting currency is the currency in which the parent firm prepares its own financial
statements. This currency is normally the home country currency, i.e., the currency of the
country in which the parent is located and conducts most of its business.

In general, if the foreign affiliates operations are relatively self-contained and integrated with
a particular country, its functional currency will be the local currency of that country. Thus, for
example, the German affiliates of Ford and General Motors, which do most of their
manufacturing in Germany and sell most of their output for Deutschmarks, use the
Deutschmark as their functional currency. If the foreign affiliates operations were an
extension of the US parents operations, the functional currency could be the US dollar.

If the foreign affiliates functional currency is deemed to be the parents currency, translation
of the affiliates statements employs the temporal method of FAS # 8. Thus, many US
multinationals continue to use the temporal method for those foreign affiliates that use the
dollar as their functional currency, while using the current rate method for their other
affiliates. Under FAS # 52, if the temporal method is used, translation gains or losses flow
through the income statement as they did under FAS # 8; they are not charged to the CTA
account.

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MF0016: Treasury Management
ASSIGNMENT- Set 1

Q1. Write a note on the following:

a. Call Money Market
b. Money market

Answer: Call money market is an important segment in Indian money market. It is a shortterm market where financial institutions borrow and lend money. It is also known as interbank call money market as banks are major participants. The day to day surplus funds are
traded in the call money market. The maturity of the loans in this market varies between one
day and a fortnight. The loans are repaid on demand of either the borrower or the lender.

The loans in this market often help banks to meet the reserve requirements.

The characteristics of call money market are as follows:

It is a market for short-term funds, also known as money on call.

It is highly liquid as the funds are repayable on demand of the borrower or lender.

It is a sensitive segment of financial system.

It varies from country to country based on the institutional structure and the nature of
the participants.

It is used by RBI to conduct open market operations effectively.

Changes in the demand and supply for short-term fund get quickly reflected in the
financial system.

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The participants of call money market in India are state, district and urban co-operative
banks, scheduled and non-scheduled commercial banks, Discount and Finance House of
India (DFHI), and Securities Trading Corporation of India (STCI). DFHI and STCI are
permitted to operate like Primary Dealers (PDs) in call money market. Since 1970s,
institutions like UTI, Life Insurance Corporation of India (LIC), and General Insurance
Corporation (GIC) and term lending institutions such as Industrial Development Bank of India
(IDBI), Industrial Credit and Investment Corporation of India (ICICI) and International
Finance Corporation (IFC) started participating in it. Earlier, only foreign banks were allowed
to conduct operations in call money market, but now the market is expanded to include small
and non-scheduled banks.
In India, call loans are unsecured. The call money market rates are subjected to seasonal
fluctuations. The fluctuations are reflected in volume of money at call and short notice. The
demand for call money is higher in March as the financial institutions withdraw funds to meet
their year-end tax payments and statutory obligations.

Call rate is the rate of the interest paid on the call loans. The call rate in the market is highly
variable. It varies on a daily basis and sometimes on hourly basis. The call rates in India are
highly volatile and they are based on the following factors:

Mechanism of Cash Reserve Ratio (CRR) creates fluctuations in the call market. Huge
borrowings by the banks to meet CRR requirements increase the demand of liquid
resources, thereby increasing the call rate.

During the end of financial year, most of the business organisations have to pay advance
tax which causes fluctuations in the market.

Changes in forex market leads to volatility in the call market.

Mismatch between assets and liabilities of the banks.

Huge flow of funds and increase in deposits with banks decreases the call rate.

Stock market conditions cause wide fluctuations in the call market.

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The opening of subscription to government loans increases the demand for call loans
thus increasing the call rates.

The business activities of Friday (end of business week) increases demand for call
loans.

RBI has tried to prevent call rate volatility through the following measures:

Regulating the liquidity and volatility in market through repo - Repo auction provides a
base for call money rates as a short-term opportunity for banks to park their surplus
funds.

Increasing the number of participants - The non-bank entities like GIC and Unit Trust of
India (UTI) are allowed to participate as lenders. Primary dealers (PDs) and DFHI have
been permitted to act as lenders and borrowers.

Relieving inter-bank liabilities from reserve requirements - This helps to generate a

smooth yield curve and thereby reduces the volatility in the call rate.

b. Money markets are a short-term market with a maturity period of up to one year. It meets
the short-term requirements of borrowers and lenders. Money market provides funds to the
trade and industry sectors. The characteristic features of Indian money market are as
follows:

It is a short-term market .The funds are borrowed or lent for short-term.

The interest rate is based on the demand and supply of funds.

The parties mutually agree on terms and conditions for exchange of funds.

Money market is subjected to RBI regulations.

The borrowers in money market are commercial banks, manufacturing firms and the
government.

Commercial banks and financial institutions act as fund suppliers in this market.

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Objectives of money market

The objectives of money market are as follows:

It maintains equilibrium between demand and supply of short-term funds.

It is a pivotal point of RBI intervention for influencing liquidity in the economy.

It provides access to the users of short-term funds to fulfill their borrowing and investing
requirements at an efficient market price.

Structure of money market

The Indian money market is classified as:
Organised sector
Unorganised sector

Organised sector - It consists of the RBI, State Bank of India (SBI) with its seven associates,
20 nationalised commercial banks, schedule and non-scheduled commercial banks, foreign
banks, and regional rural banks. RBI controls the entire banking sector in India. The nonbanking financial institutions namely LIC, GIC and its subsidiaries, and UTI operate indirectly
through banks in the market. The surplus funds of quasi-governmental and large
organisations are available to the organised markets through banks.

Unorganised sector This sector consists of unregulated non-bank financial intermediaries,

indigenous bankers and money lenders who can exist even in small towns and big cities.
The people who borrow from unorganised sectors include farmers, small traders, small scale
producers and artisans.

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Q2. Analyse the significance and objectives of asset liability management.

Answer : Asset liability management refers to the strategic balance involving risk caused
due to the changes in interest rate, exchange rates and liquidity position in the organisation.
The credit risk and contingency risk are the roots of ALM. During the post liberalisation
period, India witnessed rapid industrial growth which has further inspired the growth of fund
raising activities. The changes in the sources and features of funds were remarkable due to
rise in demand for funds. Hence this reflected in the organisations profile and exposure
limits in interest rate structure for deposits and advances etc.

Significance
The changing environment in assets and liabilities has brought the following
significances of ALM in recent years:

Volatility The globalisation scenario has led to increase in number of economies. This
has paved way for market driven economies due to the changing dynamics of the
financial markets. These changes are reflected in interest rate structures, money supply,
and credit position of the market, exchange rates and price levels. Hence the
organisation experiences low market value, net interest income etc.

Product innovation The innovation in financial products has grown rapidly. Some of the
innovations are repacked with existing products with slight modifications. These have
major impact on the risk profile in the organisation enhancing the need for ALM.

Regulatory environment The integration of domestic and international market has

enabled the regulatory bodies of financial markets to initiate number of measures. These
measures prevent major losses that occur due to market impulses.

Management recognition The top management in the organisation realised that asset
liability is neither a franchise for credit disbursement nor its a place for retail deposit
base. It must be considered to relate and link the asset with liability. Hence the need for
efficient asset liability management came into existence.

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Objectives
The objective of ALM is to achieve perfect match in assets and liabilities. The match is
related to the changes in the present value of assets and liabilities. The importance of ALM
has led to the change in the functional environment. The ALM objectives are divided into
micro and macro levels.

The macro level objectives deal with formulation of critical business policies, efficient
allocation of capital and designing of products with suitable pricing strategies. At macro level,
the ALM aims at obtaining profits through price matching while ensuring liquidity by maturity
matching. The process of price matching ensures deployment of liabilities which are greater
than costs.

Q3. If you are the manager of a company describe the risks that you handle during the
foreign currency trade?

Answer : Foreign exchange trading is very profitable but can be risky too. There are
numerous foreign exchange risk management tactics that can be used to reduce the effect
of risk and financial exposure.

Foreign Exchange Risk Management (FERM) and control procedures

Each of the banks engaged in foreign exchange activities is responsible for evolving,
applying and supervising procedures to manage and control foreign exchange risk based on
the risk management policies. In devising a firms FERM policy, certain factors have to be
taken into account the firms exposure, general attitude towards risk management, whether
its risk-averse, risk-indifferent or risk-seeking, the firms ability to alter exposed positions i.e.
the maximum exchange loss it can absorb without much impact, the competitors stance and

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most importantly regulatory requirements. Foreign exchange risk management procedures

include the following:

Systems to measure and monitor foreign exchange risk Management of foreign exchange
risk involves a clear understanding of the amount of risk and the influence of exchange rate
changes on the foreign currency exposure. In order to make these determinations, adequate
information must be readily available to permit suitable action to be taken within the
acceptable time period. Therefore, each of the banking organisations engaged in foreign
exchange activities must have an operative accounting and management information system
in place that records and measures the following accurately:
- The risk exposures related to foreign exchange trading.
- The impact of potential exchange rate changes on the bank.
Control of foreign exchange activities Though the control of foreign activities vary widely
among the banks depending upon the nature and extent of their foreign exchange activities,
the main elements of any foreign exchange control plan are well-defined procedures
governing:
- Organisational controls To guarantee that there exists a clear and effective isolation of
duties between those persons who initiate the foreign exchange transactions and are
responsible for operational functions of foreign exchange activities.
- Procedural controls To ensure that the transactions are completely recorded in the
accounts of the banks, they are promptly and correctly settled and to identify unauthorised
dealing instantly and reported to the management.
- Other controls To make sure that the foreign exchange activities are supervised
frequently against the banks foreign exchange risk, counterparty and other limits and those
excesses are reported to the management.
Independent inspections/audits Independent inspections/audits are an important factor
for managing and controlling a banks foreign exchange risk management plan. Banks must
use them to ensure compliance with, and the integrity of, the foreign exchange policies and
procedures. Independent inspections/audits should examine the banks foreign exchange
risk management activities in order to:

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- Ensure adherence to the foreign exchange management policies and procedures.

- Ensure operative management controls over foreign exchange positions.
- Verify the capability and accurateness of the management information reports regarding
the institutions foreign exchange risk management activities.
- Ensure that the foreign exchange hedging activities are consistent with the banks foreign
exchange risk management policies and procedures.
- Ensure that employees involved in foreign exchange risk management are given accurate
and complete information about the institutions foreign exchange risk policies, risk limits and
positions.

Q4. Describe liquidity management.

Answer : Liquidity management refers to the management of assets and liabilities (both onand off-balance sheets); so as to make them available when there is a cash inflow/outflow
requirement. The management of an organisation should take care to ensure that sufficient
cash is available whenever necessary.

Whenever a financial trade is taken into consideration, liquidity risk is represented in the
form of an asset or a particular security, which would make it difficult for a financier to do any
transaction that involves the security or asset when desired. The risk of liquidity may
increase if principal and interest cash-flows related to assets, liabilities and off-balance sheet
items mismatch. An effective liquidity management enables the organisation to fetch
maximum gains at minimum expenses.

The main objectives of an effective liquidity management are:

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Keeping track of cash outflow commitments (both on- and off-balance sheets) on a
regular basis.

Avoiding raising funds at market payments or through the forced sale of assets.

Maintaining the statutory liquidity and reserve requirements.

Need for liquidity management

Liquidity management plays an important role in the financial markets. It is needed during
the following situations:

When there is a difficulty in handling and synchronising multiple accounts held in various
banks.

When there is no stability in the positions of cash flow.

When there is surplus cash in transit or float locked during the operational processes.

The organisation is unable to predict the cash position for a group of companies situated
in multiple places.

When the number of reconciliation processes exceeds the limit and keeps the staff away
from working on useful activities.

When the organisation is unable to predict the short term and long term cash
requirements.

Inability to obtain finance from banks due to poor cash flow positions or too high
leverage.

Complex interfacing and group-wise cash management due to usage of different IT

systems by entities.

No fully leveraged technology.

Inefficient procedures and policies for cash and risk management.

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Difficulty in centralising and outsourcing cash management decisions.

Imbalanced cash flows Either too high or too low cash balances in relation to the
working capital.

Liquidity risk arises when a party is interested in trading an asset but there is no buying party
and this affects their trading ability.

Sufficiency of liquidity
It is essential for banks to calculate the liquidity level they need to maintain before the
maturity period ends. Also it is required that banks and credit institutions fulfil the minimum
liquidity requirement before the liquidity disposal or maturity period.

There are instances wherein even a stable economy might face problems, if the bank is
unable to repay the funds as per their commitment. It is important that certain conditions
have to be fulfilled by banks as far as liquidity risk management is concerned. Hence, banks
must perform the liquidity check on a monthly basis to know about their liquidity
requirements. Along with this, banks must use separate reporting systems for calculating the
liquidity requirements.

Liquidity reporting system

Usually, banks and other money lending institutions, compare their current liquidity with the
required liquidity. In fact the actual liquidity is derived from the banks balance sheet and is
calculated through aggregate of weighted liquidity values. The weighted liquidity value is
derived from the available number of liquid assets and the cash inflow for the relevant period
of time.

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Factors affecting liquidity

The factors affecting liquidity risk are as follows:

Delay in credit.

Non Performing Assets (NPA) of high-level.

Assets of lower quality.

No proper management.

Embedded option risk that is not recognised.

Dependence on a few wholesale depositors.

Large undrawn loan guarantees.

Liquidity policy & contingent plans that are ineffective.

Sources of liquidity
Few sources of liquidity risk management are:

Unexpected change in capital charge.

Usage of a number of assumptions.

Irregular behaviour of financial markets.

Improper judgement.

Risk stimulation by secondary sources.

Absence of financial setup.

Failure of payments system.

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Macroeconomic imbalances.

Contractual forms.

MF0016

Q5. What are factors which influence the market interest rates?

Answer : Factors Affecting Interest Rate

Interest rate is a vital component in market assessments and so it is an important economic
indicator. Interest rate is important to companies as well as governments because it is an
important constituent of the capital cost.

The following are the factor that influences the level of market interest rate:

Intensity of inflation Inflation is defined as an increase in the typical price level of goods
and services in an economy over a period of time. Inflation reduces the procuring power
of a currency. So people with excess funds claim higher interest rates, as they want to
protect their investment returns against the unfavourable conditions of higher inflation.

Fluctuation of monetary policy The central bank of a country controls the money supply
in the economy through its monetary policy. In India, the monetary policy of RBI focuses
at the price stability and economic growth. If RBI loosens its monetary policy then the
interest rate gets reduced which leads to higher inflation. Whereas, if RBI strengthens its
monetary policy then interest rate increases, this thereby limits the inflation. Repo rate is
used by RBI to inject or remove liquidity from the monetary system.

General economic conditions If the economic growth of an economy improves then the
demand for money goes up. It ultimately compels the interest rates to move forward.

Global liquidity If global liquidity is high then the domestic liquidity of a country will also
be high which ultimately reduces the pressure on interest rates.

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Foreign exchange market activity Foreign investor demand for debt securities
influences the interest rate. Higher inflows of foreign capital lead to increase in domestic
money supply which in turn leads to higher liquidity and lower interest rates.

Credit and payment history Making timely mortgage or rent payment is very important.
Late payments on credit cards, car payments and other bills affect the interest rate.

Debt to income ratio The higher the debt to income ratio, the higher will be the interest
rate.

Property type The interest rate depends upon the type of property owned by an
individual. The less risky is the property, the better the interest rate proposed.

Loan amount The amount of money the borrower borrows makes a difference in the
interest rate.

Reduced paperwork activities Many lenders offer reduced paperwork alternatives.

These alternatives increase the suitability of getting a loan for the consumer. It also
increases the risks for the lender.

Property state Varying property states have different regulations and requirements that
results in fluctuating business costs. These costs are often passed to the consumer in
the form of an interest rate for the lenders.

Budgetary deficit Budgetary deficit and increased borrowing programme of the

Government will lead to increase in interest rates as the demand for funds increases.
With increase in interest rates, costs go up and this will result in inflation.

Q6. If you are the CEO of a company, what treasury policies would you implement to
handle financial risks?

Answer : Banks utilise various financial instruments and deal with a multitude of
counterparties and securities organisations to fulfill the requirements of its borrowers, handle
fluctuation exposures in market interest rates and currency exchange rates, and indulge in
temporary investments of liquidity prior to disbursement. All these transactions include
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differing risk degrees that the counterparty in the trading may fail to meet its commitments to
the bank.

Treasury risk management needs precise reporting of metrics that is associated to control
the risks that would arise from trading and other treasury processes.

Practices
Treasury management practices describe the method in which the company will achieve the
policies and objectives summarised in its treasury management policy statement. These
practices advise how the company should manage and govern its treasury activities.

Treasury management practices consist of the following steps:

Managing risks

Analysing and decision making

Approving instruments, methods and techniques

Treasury management practices set out the approach in which the firm should seek to
achieve those policies and objectives, and suggest the way to manage and govern those
activities.

Policies
The Investment Policy guidelines approved by the board will govern the investment activities
of the Treasury. Formulating policies provides a framework to handle risks. It provides

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standard levels of exposures to protect cash flows in the organisation. Policy framing
depends on organisations objectives and its risk tolerance levels. The objectives of
formulations policies are as follows:
o

Managing the central management which raises finance and financial exposures while
assigning specific responsibilities to appropriate business units.

Diversifying funding sources through operating both banking finance and capital markets;
and engaging limited or non-resource project finance when it is available.

Arranging finance to balance each business features and cash flows to the possible
extent.

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MF0016: TREASURY MANAGEMENT
ASSIGNMENT- Set 2

Q1. Write a note on the following:

a. Commercial papers (CPs)
b. Certificate of deposits (CDs)

Answer: Commercial Papers (CPs) is a type of instrument in money market and it was
introduced in Jan 1990. Commercial paper is a short-term unsecured promissory note
issued by large corporations. They are issued in bearer forms on a discount to face value. It
issued by the corporations to raise funds for a short-term. The maturity period ranges from
30 days to one year. CPs is negotiable by endorsement and delivery. They are highly liquid
as they have buy-back facility.

The CPs is issued in denominations of Rs. 5 lakh or multiples of Rs. 5 lakh. Generally CPs is
issued through banks, dealers or brokers. Sometimes they are issued directly to the
investors. It is purchased mostly by the commercial banks, Non-Banking Finance
Companies (NBFCs) and business organisations. CPs is issued in domestic as well as
international financial markets. In international financial markets, they are known as Eurocommercial paper.

Features of commercial papers

The salient features of CPs are as follows:

CPs is an unsecured promissory note.

CPs can be issued for a maturity period of 15 days to less than one year.

CPs is issued in the denomination of Rs.5 lakh. The minimum size of the issue is Rs. 25
lakh.

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The ceiling amount of CPs should not exceed the working capital of the issuing
company.

The investors in CPs market are banks, individuals, business organisations and the
corporate units registered in India and incorporated units.

The interest rate of CPs depends on the prevailing interest rate on CPs market, forex
market and call money market. The attractive rate of interest in any of these markets,
affects the demand of CPs.

The eligibility criteria for the companies to issue CPs are as follows:

o The tangible worth of the issuing company should not be less than Rs. 4.5 Crores.
o The company should have a minimum credit rating of P2 and A2 obtained from Credit
Rating Information Services of India (CRISIL) and Investment Information and Credit Rating
Agency of India Limited. (ICRA) respectively
o The current ratio of the issuing company should be 1.33:1.
o The issuing company has to be listed on stock exchange.

Advantages of CPs
CPs is like T-Bills and is close a competitor of T-Bills, but T-Bills have an edge over CPs
because they are less risky and more easily marketable. The advantages of CPs are as
follows:

They are negotiable by endorsement and delivery.

Highly safe and liquid instrument They are believed to be one of the highest quality
investment instruments available in private sectors.

CPs facilitates security for the loans. This results in creation of secondary market for CPs
and there is efficient movement of funds providing surplus cash to cash deficit units.

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Flexible instrument It can be issued with varying maturities as insisted by the issuing
company.

High returns The CPs provide high returns when compared to the banks.

b. Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and

financial institutions. It is a document issued for the amount deposited in a bank for a
specified period at a specified rate of interest. The concerned bank issues a receipt which is
both marketable and transferable in the market. The receipts are in bearer or registered
form. CDs are known as negotiable instruments and they are also known as Negotiable
Certificates of Deposit. Basically they are a part of banks deposit; hence they are riskless in
terms of payments and principal amount. CDs are interest-bearing, maturity-dated
obligations of banks. CDs benefit both the banker and the investor. The bankers need not
encash the deposit before the maturity and the investor can sell the CDs in the secondary
market before the maturity. This contributes to the liquidity and ready marketability for the
instrument. CDs can be issued only by the schedule banks. It is issued at discount to face
value. The discount rate depends on the market conditions. CDs are issued in the multiples
of Rs. 25 lakh and the minimum size of the issue is Rs.1 crore. The maturity period ranges
from three months to one year.
The introduction of CDs in Indian market was assessed in 1980. RBI appointed the Vaghul
Working Group to study the Indian market for five years. Based on the suggestions of Vaghul
committee; RBI formulated a scheme for the issue of CDs. As per the scheme, CDs can be
issued only by the scheduled banks at a discount rate to face value. There is no restriction
on the discount rate by the RBI.

Features of CDs in Indian market

The characteristic features of CDs in Indian money market are as follows:

Schedule banks are eligible to issue CDs

Maturity period varies from three months to one year

Banks are not permitted to buy back their CDs before the maturity

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CDs are subjected to CRR and Statutory Liquidity Ratio (SLR) requirements

They are freely transferable by endorsement and delivery. They have no lock-in period.

CDs have to bear stamp duty at the prevailing rate in the markets

The NRIs can subscribe to CDs on repatriation basis

Q2. Explain the treasury organisation and risk management.

Answer: A more advanced treasury organisation has evolved in the past decade in which
the focus on management activity has followed the economic factors which drive firm value
with corporate wide cash flow. This modern treasury organisation concentrates on a different
financial statement which is the statement of cash flows. Now, it is in the process of adapting
to the complex environment and cash flow of the global business. Structure of treasury
organisation has many dimensions. However, we focus mainly on the following dimensions:
Range of services
Extent of centralisation of management control
Define resultant organisation models

We evaluate the relationship between organisation models and influencing factors that helps
to choose the right model. The theme is to investigate the compatibility of the models with
the organisational situations.

Organisations must select treasury organisation models based on their operations,

irrespective of their underlying business. The most important dimensions of these choices
are the range of activities covered by the treasury and the extent of centralisation of

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management control. Four main service models can be opted based on these models. They
are full service global, full service local, limited service global and limited service local.
Treasury implementation in an organisation gains profits in several aspects. The treasury
activities focus on the financial strategy and decision making of the company, cash
management, capital market funding, tax management and international financial activities
of the firm. Multinational firms always possess large number of foreign subsidiaries and
ensure that they are frequently managed on the regional level by the basic functions like
cash management, foreign exchange.

Regional treasuries are always required as an intermediary step between the barely staffed
foreign affiliate and its independence on other regional affiliates. However, there is a
frequent overlapping in responsibilities and activities between the regional treasury offices
and international treasury.

In banks, treasury is organised either as a department of the bank or as a specialised branch

which is under the direct control of the banks head office. If treasury acts as a department of
the bank, it has the advantage to coordinate easily with the other related departments like
accounting and credit departments at head office. However, it is preferred if treasury acts as
a specialised branch as the accounting books of treasury can be maintained independently.
While the head office department of bank can only act through a branch, the specialised
branch also has an additional advantage to act as an authorised dealer for forex business
and can directly participate in clearing and settlement systems.

As treasury is a key activity of the bank, treasury should be headed by a member of the
senior management like General Manager, Dy. General Manager, Vice-President and others,
who could directly report to the Chief Executive of the bank. However, the level of reporting
and delegating powers depends on the bank size and the importance of treasury activity
within the bank.

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Treasury might be divided into three main divisions. They are the front office (Dealing room),
Middle office and Back office (Treasury administration).
Front office (Dealing room) It is headed by the person who is in charge of the front office,
that is Chief Dealer. Dealers working under him generally trade in the market. They are
familiar with all the markets but specialise in one of the markets like forex market, money
market or securities market.
Middle office - It is created for providing information to the management. It monitors the
limits of exposure and stops loss of treasury and reports the key parameters of performance
to the management. It may also act as ALM Support Group in smaller banks.
Back office (Treasury administration) It takes the responsibility of verifying and settling the
deals concluded by the dealers. They are verified on the basis of deal slips prepared by the
dealers. They take care of the book-keeping and periodic returns submission to RBI.
Refer to unit 01 for detailed information on treasury management organisation.

Q3. What are the features of ADRs and GDRs?

Answer: ADRs and GDRs

A Depository Receipt (DR) is a versatile financial security that is traded on a local stock
exchange but it represents a security that is issued by a foreign publicly listed company. Two
of the most common types of DRs are the American Depository Receipt (ADR) and Global
Depository Receipt (GDR).
ADR is a security issued by a non-U.S. company and is traded on U.S. stock exchanges.
ADRs are issued to offer investment methods that avoid the unwieldy laws applied to the
non-citizens who buy shares on local exchanges. ADRs are listed on NYSE, AMEX or
NASDAQ.

Few advantages of ADRs are:

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ADRs are easy and cost efficient methods to buy shares in foreign companies.
ADRs save money by reducing administration costs and avoiding foreign taxes on the
transaction.

GDRs were developed on the basis of ADRs and are listed on stock exchanges outside US.
GDRs are traded globally instead of the original shares on exchanges. The objective of GDR
is to enable investors to gain economic exposure to a planned company in developed
markets.

Features of GDRs are as follows:

GDR holders do not have a voting right.
It has less exchange risk as compared to foreign currency loan.
GDR investors may cancel his receipt by advising the depository.
ADRs and GDRs are excellent means of investment for NRIs and foreign nationals who want
to invest in India. By buying these, they can invest directly in Indian companies without going
through the harassment of understanding the rules in Indian financial market.

Benefits of depository receipts

The increasing demand for DRs is determined by the need of investors to diversify their
portfolios, reduce risk and invest internationally. It allows the investors to achieve the
benefits of global divergence without the added expense and complexities of investing
directly in the local trading markets.

Participatory notes

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International entrance to Indian capital market is limited to Foreign Institutional Investors

(FIIs). The market has found a way to avoid the limitation by creating an instrument called
Participatory Notes (PNs). PNs are basically contract notes.
Indian traders buy securities and then issue PNs to foreign investors. Any dividends or
capital gains collected from the primary securities are returned back to the investors. Any
entity investing in PNs may not register with SEBI, whereas all FIIs have to register
compulsorily.

The benefits of PNs are as follows:

Entities route their investment through PNs to extract advantage of the tax laws system.

It provides a high degree of secrecy, which enables large funds to carry out their
operations without revealing their identity.

Investors use PNs to enter Indian market and shift to fully fledged FII structure when they
are established.

Q4. Discuss the recommendations of Tarapore Committee for CAC

Answer: Indias cautious approach towards capital account and assessing it as a

liberalisation process based on certain pre conditions has held India in good state. But with
the changes that have taken place over the last two decades, India felt the need to revisit the
CAC and suggested a new map towards FCAC based on current situations. RBI, in
consultation with the Government of India (GOI) appointed a committee on FCAC. S.S
Tarapore

was

the

chairman

of

committee.

The

committee

suggested

several

recommendations for the development of financial market in addition to addressing issues

related to interaction of monetary policy and exchange rate management, regulation and
supervision of banks, and the timing and sequencing of capital account liberalisation
measures. The objectives of FCAC are as follows:

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Economic growth - It facilitates economic growth through higher capital investment .This
will lead to growth in employment opportunities, infrastructure development and other
areas.

Improvement in financial sector - Huge capital flow into the system will lead to the
improvement of financial sector which will enhance performance of the companies. This
will enhance the liquidity in the system.

Diversify the investment The diversification of investment will help ordinary people, to
invest in foreign countries without restriction. This will help them to diversify their
portfolio.

Risks involved in FCAC

FCAC risk arises from inadequate preparedness before liberalisation in domestic and
external sector of policy consolidation, strengthening of regulation and development of
financials markets. A transparent financial consolidation is necessary to reduce risk of the
currency crisis. The risks are as follows:

Market risks - Markets risks like interest rate and foreign exchange risks become more
complicated when financial institutions have access to new markets or securities.
Participation of foreign investors in domestic market changes the working of the
domestic market. For example, banks have to quote rates and take open positions in
new and more volatile currencies. Likewise, the change in foreign interest rate, affects
the banks interest rate and liabilities.

Credit risk It includes a new dimension with cross border transaction. Cross border
transactions introduces country risks to domestic market participants, the risk associated
with economic, social, and political environment of the borrowers country.

Risk in derivatives transaction It is very important with FCAC as derivatives transaction

are main tools used in hedging risks .It includes both market and credit risk.

Liquidity risk It includes risk in foreign currencies denominated assets and liabilities.
Large flow of funds in different currencies will expose the banks to greater variations in
their liquidity position and complicate their asset-liability management.

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Operational risk The difference between domestic and foreign legal rights and
obligations and their enforcements is important with FCAC. Operational risk may
increase with FCAC.

Limitations of FCAC
The effort of making the Indian rupee fully convertible has a number of difficulties involved in
it. The limitations are as follows:

Indian industries lack competitive strength.

Lack of emphasis on the quality of labour and management practices.

Inadequate technology for industrial economy.

Absence of prudent fiscal management.

Lack of resilient exchange rate mechanism at work.

Inadequate attention on tariff reduction and the rationalisation of tax structure in the
adjustment scheme.

Inflationary pressure on the economy.

Consequences of FCAC
India might face the following consequences if it implements full convertibility without
adequate reform measures:

It will have to face the danger of becoming vulnerable to free movement of foreign
capital, which may further worsen the macro-economic imbalances.

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Though the banks and financial institutions are fully capitalized, they are not fully
prepared to handle the intricacies of the fuller convertibility. Hence it is desirable to
further strengthen their financial base.

The prevailing high interest rates in the economy will attract capital inflow. This will result
in rupee appreciation which will affect Indian exporters.

Q5. If you are the CEO of an MNC, how would you implement and maintain effective
liquidity practices in your firm for the benefit of the company?

Answer : Launching the overall policy framework Before processing any funding, market
operations or risk management activities; policies are elected by the top management.

These policies administer the treasury functions and indicate the principles motivating the
asset liability management of the balance sheet.

Market operation activities Banks alter the term of their obligations to different maturities
on the asset side of the balance sheet. The actual flow of funds need not mandatorily reflect
in the contractual terms. This flow of funds differs as per the market conditions. The key
aspect of liquidity management is the structure of a banks funding. The bank without a
deposit base is likely to be more exposed to liquidity problems when compared to a stable,
large and diverse deposit base bank.

Risk evaluation and compliance Risk measurement and management concentrates on

providing a systematic approach to control risk in portfolio management. It provides an
independent evaluation of the market risks considered across several treasury businesses.

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This evaluation is for the benefit of traders and management. Periodic computation of risk
measurement like measuring risks on a daily, monthly or quarterly basis is important. A good
compliance is very important to ensure that the treasury functions act appropriately and in
the best interests of the respective traders and management.

Treasury operations Handling treasury operational functions has become more

complicated due to the changes in the financial markets, regulatory requirement and
technological upgrades. These functions focus on the risks of market operations such as
electronic inputs and a greater concentration over the payment approval/release functions,
improving control on the transaction confirmations and the settlement of bank accounts at
nostro accounts.

Features of treasury functions

A successful treasury function has the same attributes as any other functions that are
considered successful in the organisation. The features of treasury functions are as follows:

Teamwork

Respect towards the firm

Broad and positive thinking

Global thinking

Technologically advanced

Customer oriented

Knowledge in finance

Knowledge in legal issues

Trustworthy

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Q6. Evaluate various options available in foreign exchange market?

Answer: Various tools and techniques are used for measuring foreign exchange risk
management. Some of the foreign exchange management tools used are as follows:

Forward contracts

Currency futures

Currency options

Currency swaps

Forward contracts
Foreign exchange forward contracts are the most common resources for hedging
transactions in foreign currencies. A forward contract is an agreement to buy or sell foreign
exchange for an amount determined in advance, at a specified exchange rate at a
designated date in future. The specified rate is called the forward rate, the designated date
the settlement date or delivery date. The difference between forward contract and other
sales contracts is that the delivery and payment of the commodity occurs at a specified
future date in case of forward contracts. Forward contracts are privately exchanged and are
not standardized. This gives rise to counterparty risk or default risk arising out of failure of
the other party to honour its commitment. For such situations currency futures are more
suitable.

Currency futures

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Currency futures are forward contracts in which two parties agree between them to
exchange something in the future. As futures contracts are traded on exchange with
appropriate controls, counter party risk as prevalent in Forward contracts is prevented. The
major currency futures market is the EUR futures market, based upon the Euro to US Dollar
exchange rate. The most popular currency futures are provided by the Chicago Mercantile
Exchange group, and include the following futures markets:
EUR - It is the Euro to US Dollar futures market.
GBP - It is the British Pound (Sterling) to US Dollar futures market.
CAD - It is the Canadian Dollar to US Dollar futures market.
CHF - It is the Swiss Franc to US Dollar futures market.

Currency options
A currency option is an alternative tool for managing forex risk. A foreign exchange option is
an agreement for future supply of a currency interchanged with another, where the owner of
the option has the right to buy (or sell) the currency at a settled price. The right to buy is a
call; the right to sell is called as put. For such a right the holder pays a price called the option
premium. The option seller receives the premium and is indebted to make (or take) delivery
at the agreed-upon price if the buyer exercises his option.

Currency swaps
Currency swaps deal with the exchange of payments in different currencies between two
trading partners. For productivity currency swaps feature netting, in which the winning party
obtains payment at the end of the swap term.

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MF0017 Merchant Banking and Financial Services - 4 Credits

Assignment Set- 1 (60 Marks)
Q1. Discuss the proportionate allotment procedure followed by the lead banker to
allot shares.

Allotment procedure
The Executive Director or Managing Director of the Regional Stock Exchange consults with
the post-issue lead merchant banker and the registrars regarding public issue of securities.
This method ensures that the basis of allotment is done fairly according to the following
guidelines:

Proportionate allotment procedure

The lead banker must ensure that the allotment is made on a proportionate basis as
explained below:

The applicants are divided into separate category based on the number of shares
they have applied for.

The total number of shares to be allotted to each category is done on a proportionate

basis. This is based on the product of the total number of shares applied for in that
category and the inverse of the oversubscription ratio.

Example 1:
Total number of applicants in category of 100s = 2,000
Total number of shares applied for = 2, 00,000
Number of times oversubscribed = 5

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Proportionate allotment to category = 2, 00,000 x 1/5 = 40,000

The number of the shares to be allotted to the successful allottees is done on a
proportionate basis. This is the product of the total number of shares applied by each
applicant in that category and the inverse of the oversubscription ratio. This is shown below
with an example:

Example 2:
Number of shares applied for by each applicant = 300
Number of times oversubscribed = 3
Proportionate allotment to each successful applicant = 300 x 1/3 =100

In the applications where the proportionate allotment is less than 100 shares per
applicant, the allotment is carried out as follows:

- Each successful applicant is allotted a minimum of 100 securities.

- The successful applicants for that category are determined by drawl of lots in such a way
that the total number of shares allotted in that category corresponds to the number of shares
as shown in Example 2.

The proportionate allotment to an applicant is more than 100 but not a multiple of
100. In such a case, the number in excess of the multiple of 100 is rounded off to the
higher multiple of 100, only if that number is 50 or higher. But if the number is lower
than 50, it is rounded off to the lower multiple of 100.

Example 3:
If the proportionate allotment works out to 350, the applicant is allotted 400 shares. However,
the proportionate allotment works out to 140, the applicant is allotted 100 shares.

If the shares allocated on a proportionate basis to any category exceed the shares
allotted to the applicants in that category, the balance available shares for allotment
are first adjusted against any other category. This condition arises when the allocated

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shares are not enough for proportionate allotment to the successful applicants in that
category.

The remaining shares after such adjustment are added to the category in which the
applicants have applied for minimum number of shares.

The process of rounding off to the nearest multiple of 100 may result in a higher
allocation of shares than the shares offered. Therefore, it is necessary to permit a
10% margin. This means, the final allotment may be higher by 10 % of the net offer
to the public.

Reservation for small individual applicants

The proportionate allotment of securities in an issue, when oversubscribed, is subjected to

the reservation for small individual applicants as explained below:

A minimum 50% of the net offer of securities to the public is first made available for
allotment to individual applicants, who have applied for allotment of equal to or less than
10 marketable lots of shares or debentures or the securities offered.

The balance net offer of securities to the public is made available for allotment to the
individual applicants, who have applied for allotment of more than 10 marketable lots of
shares or debentures or the securities offered.

Q2. What is the provision of green shoe option and how is it used by companies to
stabilize prices?
Answer: Green shoe option

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Green Shoe Option (GSO) is an option where a company can retain a part of the oversubscribed capital by issuing additional shares. Oversubscription is a situation when a new
stock issue has more buyers than shares to meet their orders. This excess demand over
supply increases the share price. There is another situation called undersubscription. In
undersubscription, a new stock issue has fewer buyers than the shares available. An issuing
company appoints a stabilizing agent, which is usually an underwriter or a lead manager, to
purchase shares from the open market using the funds collected from the over-subscription
of shares. The stabilizing agent stabilizes the price for a period of 30 days from the date of
listing as authorised by the SEBI. Green shoe option agreement allows the underwriters to
sell 15 percent more shares to the investors than planned by the issuer in an underwriting.
Some issuers do not include green shoe options in their underwriting contracts under certain
circumstances where the issuer funds a particular project with a fixed amount of price and
does not require more funds than quoted earlier. The green shoe option is also known as
over-allotment option. The over-allotment refers to allocation of shares in excess of the size
of the public issue made by the stabilizing agent out of shares borrowed from the promoters
in pursuance of a GSO exercised by the issuing company.

The mechanism by which the greenshoe option works to provide stability and liquidity to a
public offering is described in the following example: A company intends to sell 1 million
shares of its stock in a public offering through an investment banking firm (or group of firms
which are known as the syndicate) whom the company has chosen to be the offering's
underwriter(s). When the stock offering is the first time the stock is available for public
trading, it is called an IPO (initial public offering). When there is already an established
market and the company is simply selling more of their non-publicly traded stock, it is called
a follow-on offering.
The underwriters function as the broker of these shares and find buyers among their clients.
A price for the shares is determined by agreement between the company and the buyers.
One responsibility of the lead underwriter in a successful offering is to help ensure that once
the shares begin to publicly trade, they do not trade below the offering price.
When a public offering trades below its offering price, the offering is said to have "broke
issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable
offering, which can lead to further selling and hesitant buying of the shares. To manage this
possible situation, the underwriter initially oversells ("shorts") to their clients the offering by

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an additional 15% of the offering size. In this example the underwriter would sell 1.15 million
shares of stock to its clients. When the offering is priced and those 1.15 million shares are
"effective" (become eligible for public trading), the underwriter is able to support and stabilize
the offering price bid (which is also known as the "syndicate bid") by buying back the extra
15% of shares (150,000 shares in this example) in the market at or below the offer price.
They can do this without the market risk of being "long" this extra 15% of shares in their own
account, as they are simply "covering" (closing out) their 15% oversell short.
If the offering is successful and in strong demand such that the price of the stock
immediately goes up and stays above the offering price, then the underwriter has oversold
the offering by 15% and is now technically short those shares. If they were to go into the
open market to buy back that 15% of shares, the underwriter would be buying back those
shares at a higher price than it sold them at, and would incur a loss on the transaction.
This is where the over-allotment (greenshoe) option comes into play: the company grants
the underwriters the option to take from the company up to 15% more shares than the
original offering size at the offering price. If the underwriters were able to buy back all of its
oversold shares at the offering price in support of the deal, they would not need to exercise
any of the greenshoe. But if they were only able to buy back some of the shares before the
stock went higher, then they would exercise a partial greenshoe for the rest of the shares. If
they were not able to buy back any of the oversold 15% of shares at the offering price
("syndicate bid") because the stock immediately went and stayed up, then they would be
able to completely cover their 15% short position by exercising the full green shoe

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Q3. What do you understand by insider trading? What are the SEBI rules and
regulations to prevent insider trading?

Answer: An insider is a person who is connected with a company and who is expected to
have access to unpublished sensitive information with respect to securities of the company.
A person who has access to unpublished information which deals in securities and is
involved in violations of the provisions will be guilty of insider trading. Insiders have access
to confidential information of a company due to the position occupied by them in the
company. They are in a position to manipulate the share prices to their own advantage and
make huge profits. These actions cause major fluctuations in the prices of the securities.
Considering the fact that the actions of insiders cause devastating effects on the functioning
of stock exchange, SEBI has issued regulations to control such practices. Another problem
that the stock market faces is unofficial trading in shares before listing of new companies.
The company is not guilty of insider trading if the acquisition of shares was as per SEBI
Substantial Acquisition of Shares and Takeover Regulations. If SEBI suspects that any
person has violated the regulations of prohibition of insider trading, it can initiate an inquiry.
For the prevention of insider trading, SEBI has introduced a policy on disclosure and internal
procedure. According to this policy:

All listed companies and organisations associated with the securities markets have to
frame a code of conduct for internal procedure as per the specified model.

Any person holding more than five per cent shares in any listed company has to
disclose the number of shares held by him to the company, within 54 working days.

Every listed company must disclose the information received about the initial and
continual disclosures within five days to all the respective stock exchanges.

Any person other than a company violating the disclosure provisions would be liable for
action under the SEBI Act. SEBI has prescribed a model code of conduct for prevention of
insider trading for listed companies. According to this model, the listed company appoints a
compliance officer who reports to the managing director and is responsible for setting the
policies and procedures, monitoring adherence to the rules for the preservation of price

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sensitive information, pre-clearance of designated employees trade, monitoring of trades

and implementation of the code of conduct. Preservation of price sensitive information is
done by the employees and directors. They have to maintain confidentiality of all price
sensitive information. The information must not be passed to any person directly or
indirectly.

Regulatory provisions
Merchant bankers are administered by the SEBI (Merchant Bankers) Rules and Regulations,
1992. According to the rules and regulations, a merchant banker is a person who is engaged
in the business of issue management either by buying, subscribing to securities as manager,
consulting or rendering corporate advisory service in relation to issue management. The
regulatory framework is designed to ensure that the merchant bankers have sufficient
competence and follow diligence in their work so that the issuers comply with the statutory
requirements concerning the issue. SEBI has emphasised on ensuring that all merchant
bankers fulfil the eligibility criteria. As stated earlier, all merchant bankers must have a valid
registration certificate. Merchant bankers must follow the general obligations, responsibility,
code of conduct prescribed under the SEBI regulations. Under the regulations, the merchant
bankers must submit periodical returns and other additional information to SEBI regularly.
SEBI has the authority to conduct inspection of the accounts, records and documents of the
merchant banker at any time if necessary.

Q4. What are the advantages of leasing to a company?

Answer: Advantages of leasing

Leasing has many advantages for the lessee as well as for the lessor. Lease financing offers
the following benefits to the lessee:

One hundred percent finance without immediate down payment for huge
investments, except for his margin money investment.

Facilitates the availability and use of equipments without the necessary blocking of
capital funds.
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Acts as a less costly financing alternative as compared to other source of finance.

Offers restriction free financing without any unduly restrictive covenants.

Enhances the working capital position.

Provides finance without diluting the ownership or control of the lessor.

Offers tax benefits which depend on the structure of the lease.

Enables lessee to pay rentals from the funds generated from operations as lease
structure can be made flexible to suit the cash flow.

When compared to term loan and institutional financing, lease finance can be
arranged fast and documentation is simple and without much formalities.

The lessor being the owner of the asset bears the risk of obsolescence and the
lessee is free on this score. This gives the option to the lessee to replace the
equipment with latest technology

The following are the benefits offered by lease financing to the lessor:

The lessors ownership is fully secured as he is the owner and can always take
possession in case of default by the lessee.

Tax benefits are provided on the depreciation value and there is a scope for him to
avail more depreciation benefits by tax planning.

High profit is expected as the rate of return increases

Return on equity is elevated by leveraging results in low equity base which enhance
the earnings per share.

High growth potential is maintained even during periods of depression.

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Limitations of leasing
The following are some of the limitations of leasing:

Lessee is not capable of adding or altering anything to the leased asset because of
the restrictive conditions of the lease agreement.

Financial lease can bring about higher payout accountability if machinery is not found
useful, and the lessee is planning to cancel the lease agreement or opts for
premature termination of the lease contract.

Termination of the lease happens when lessee fails to continue with the terms and
conditions of the lease and the lessor can take possession of the leased asset, In
case of financial lease, the lessee may be made liable for damages and compelled to
make payment of his lease rental in an accelerated manner.

Double sales tax can be charged once at the time of purchase of the asset by the lessor and
again when it is leased out to the lessee.

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Q5. Discuss Accounting standard 19 for lease based on operating lease.

Answer: Accounting Standard 19 as Applicable for Leases
Accounting Standard (AS)-19, Leases, is issued by the Council of the Institute of Chartered
Accountants of India. This standard comes into force with respect of all assets leased during
accounting periods commencing on or after 1.4.2001 and is mandatory in nature from that
date. Accordingly, the Guidance Note on Accounting for Leases issued by the Institute in
1995, is not applicable in respect of such assets. Earlier application of this Standard is,
however, encouraged.
Scope
The right accounting policies and disclosures in relation to finance leases and operating
leases should be applied in accounting for all leases other than the following:

Lease agreements to explore or to use natural resources, such as oil, gas , timber,
metals and other mineral rights; and

Licensing agreements for items such as motion picture films, video recordings, plays,
manuscripts, patents and copyrights; and

Lease agreements to use property such as lands.

This applies to agreements that transfer the right to utilize assets even though significant
services by the lessor called for in connection with the operation or maintenance of such
assets. Besides, this Statement does not apply to agreements that are contracts and do not
transfer the right to use assets from one contracting party to the other.
Related definitions
The following terms are used in this statement:

Lease A lease is an agreement calling for the lessee (user) to pay the lessor
(owner) for use of an asset for an agreed period of time. A rental agreement is a
lease in which the asset is a substantial property.

Finance lease A lease which transfers all the risks and rewards incident to
ownership of an asset.

Operating lease A lease for which the lessee acquires the property for only a small
portion of its useful life.

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Non-cancellable lease A non-cancellable lease is a lease that can be abandoned

only:

Upon the occurrence of some remote contingency.

With the permission of the lessor.

If the lessee enters into a new lease for the same or an equivalent asset with
the same lessor.

Upon payment by the lessee of an additional amount such that, at the

beginning, continuation of the lease is reasonably certain.

Inception of lease The inception of lease is the former date of the lease
agreement and the commitment date by the parties to the principal provisions of the
lease.

Lease term The lease term is the non cancellable period for which the lessee has
agreed to take on lease asset together with future periods.

Minimum lease payments It is the regular rental payments excluding executory

costs to be paid by the lessee to the lessor in a capital lease. The lessee informs that
an asset and liability at the discounted value of the future minimum lease payments.

Fair value The expected value of all assets and liabilities of a owned company
used to combine the financial statements of both companies.

Economic life The outstanding period of time for which real estate improvements
are expected to generate more income than operating expenses cost.

Useful life Useful life of a leased asset is either the period over which leased asset
is expected to be useful by the lessee or the number of production units expected to
be gained from the use of the asset by the lessee.

Residual value The value of a leased asset is the estimated fair value of the asset
at the end of the lease term.

Guaranteed residual value It is guaranteed by the lessee or by a party on behalf

of the lessee to pay the maximum amount of the guarantee; and in the case of the
lessor, the part of the residual value which is guaranteed by the lessee or on behalf
of the lessee, or an independent third party who is financially able of discharging the
obligations under the guarantee.

Unguaranteed residual valued of a lease asset It is the value of a leased asset

that is the total amount by which the residual value of the asset exceeds its
guaranteed residual value.

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Gross investment in the lease It is the sum of the minimum lease payments
within a finance lease from the lessors view and any unguaranteed residual value
accumulating to the lessor.

Unearned finance income Any income that comes from investments and other
sources unrelated to employment services.

Net investment in the lease Net investment in the lease is the gross investment in
the lease less unearned finance income.

Implicit interest An interest rate that is not explicitly stated, but the implicit rate
can be determined by use of present value factors.

Contingent rent It is the portion of the lease payments that is not permanent in
amount but is based on a factor other than just the passage of time. For example,
percentage of sales.

Q6. Given the various types of mutual funds, take any two schemes and discuss the
performance of the schemes.
Answer:Types of Mutual Funds
It is important to remember that mutual funds offer risks and rewards the higher the
potential returns, the greater the possible loss prospects.
Therefore, it is important to understand the kinds of mutual funds available in the market.
Mutual funds are classified on the basis of structure and investment objective.
Figure illustrates the classifications of mutual funds.

On the basis of structure

The following are the structures of mutual funds:

Open ended funds This scheme of mutual funds is available for subscription
throughout the year. Such funds do not have a fixed maturity date, and therefore, can
be sold or purchased any time. The prices are based on the net asset value (NAV).

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This scheme is convenient for those investors who need investments that have a
high level of liquidity.

Close ended funds Unlike open ended funds, close ended funds have a specific
maturity period. An investor can purchase these funds at the time of initial issue.
There are two exit options in case the investor wants to buy or sell these funds after
the initial offer period closes. One option is to buy or sell the units at the stock
exchanges where they are listed. The NAV may vary based on the demand or supply
of the units. The other option is to directly sell the units to the Mutual Fund. In this
case, the company repurchases the units at NAV.

Interval funds This scheme is a combination of open ended and close ended
mutual funds. An investor may purchase or sell these funds at the stock exchange.
These may be for sale or redemption at specific periods. The interval funds are
transacted at NAV prices.

On the basis of investment objective

Mutual funds are also classified based on the objectives of the fund. The investor can invest
in mutual funds based on these objectives:

Growth funds This scheme is also referred to as equity schemes. The objective is
to provide capital appreciation over medium to long term. A large portion of the fund
is invested in equities for long term.

Income funds This scheme is also referred to as debt schemes. The objective is to
provide investors a regular income. Therefore, investments are made in fixed income
securities such as corporate debentures and bonds. Unlike the growth scheme, the
capital appreciation is limited.

Balanced schemes This scheme provides appreciation and income. The company
periodically distributes a part of the capital gains earned. This scheme invests in
shares and fixed income securities. The proportion specified in the offer documents
is usually 50:50.

Money market funds The objective of this scheme is to provide the investor
income, preserve capital and easy liquidity. In this scheme, the investors money is
safer since investments are made in short term financial instruments. These are also
called liquid funds.

Load funds This scheme is also referred to as sales load. The investor pays the
sum (known as front end load) at the time of purchase which is used to compensate
an intermediary such as brokers, investment advisers, and financial planners.
Recently the SEBI has slashed the entry load and funds should not charge entry load
if you go directly to a fund. In another directive it has issued instructions that no

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distinction should be made among unit holders on the amount of subscription while
charging exit loads (back end load). Some mutual funds do not charge any exit load.

No load funds This scheme does not have a front end load or back end sales
charge. No sales charges are applied to any load funds. However, they do have
costs. The objective is to reduce the expense on the investors bank or brokerage
statement. This is because the fees are paid from the funds assets to the investment
advisers instead of the broker who sells the funds.

Gilt funds These funds invest completely in government securities. Government

securities do not have any default risk. NAVs of these schemes also vary due to
alteration in interest rates and supplementary economic factors as is the case with
income or debt oriented schemes.

Index funds Index funds imitate the portfolio of a selected index such as the BSE
Sensitive Index, S&P NSE, Index (Nifty) etc, These schemes invest in the securities in the
same weightage comprising of an index. NAVs of such schemes would rise or fall in
accordance with the risk or fall in the index, though not exactly by the same percentage.
There are also exchange traded index funds launched by the mutual funds which are traded
on the stock exchanges.

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MF0017 Merchant Banking and Financial Services - 4 Credits

Assignment Set- 2 (60 Marks)
Q1. What are the provisions for prevention of fraudulent and unfair trade practices by
SEBI regulations?

Answer: Prohibition of Fraudulent and Unfair Trade Practices Relating to the

Securities
The SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities
Market) Regulations, 2003 authorises SEBI to investigate into cases of market fraudulent
and unfair trade practices. The regulations prohibit market manipulation, misleading
statements to increase sale or purchase of securities, unfair trade practices relating to
securities. The SEBI can conduct investigation by an investigating officer regarding conduct
and affairs of any person dealing, buying, and selling securities. The investigating officer
prepares a report based on this information. The SEBI can take action for cancellation or
suspension of registration of an intermediary based on this report. Fraud is any act,
expression or concealment committed by a person or his agent while dealing with securities
in order to prompt the deal in securities. The regulations prohibit the dealing in securities in
fraudulent method, it prohibits market manipulation, misleading statements that promote sale
of securities and unfair trade practice related to securities. Any dealing in securities shall be
considered to be fraudulent or an unfair trade practice if it involves fraud. The following are
considered as fraudulent or an unfair trade practice if it:

Indulges in an act which creates misleading or false impression of trading in

securities market.

Advances or agrees to advance any money to any person to induce other person to
buy any security in any issue with an intention of securing the minimum subscription
to such issue.

Pays, offers, or agrees to pay directly or indirectly to any person, any money for
inducing such person for dealing in any security with the object of depression or
causing fluctuation in the price of such security.

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Acts to manipulate the price of security.

Publishes reports, dealing in securities which are not true.

Sells and deals with stolen security whether in physical or dematerialised form.

Advertises misleading or containing information in a distorted manner which can

influence the decision of the investors.

Spread false or misleading news which induces sale or purchase of securities.

For restricting unethical trading practices, SEBI propagated the SEBI (Prohibition of
Fraudulent and Unfair Trade Practices relating to the Securities Market).

Q.2 Discuss the method of price discovery using the book building process. [10]
Answer: Price discovery through book building process
The following are the steps involved in the book building process:
1. The issuer company proposing an IPO appoints a lead merchant banker as a Book
Running Lead Manager (BRLM).
2. Primarily, the issuer company consults with the BRLM in drawing up an offer document
which does not mention the price of the issues, but consists of other details about the size of
the issue, companies past history, and a price band. The securities which are available to
the public, separately identified as net offer to the public.
3. The draft prospectus is filed with SEBI to provide a legal standing.
4. A definite period is set as the bid period and BRLM conducts awareness campaigns like
advertisement, road shows and so on.
5. To underwrite the issues similar to the net offer to the public, the BRLM selects a
syndicate member, a SEBI registered intermediary.
6. The BRLM is allowed to remuneration for conducting the book building process.
7. The BLRM may circulate the copy of the draft prospectus to the institutional investors and
to the syndicate members.
8. The syndicate members build demand and ask each investor for the number of shares
and the offer price.
9. Syndicate members send the feedback about the investors bids to the BRLM.

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10. During the bid period the prospective investors are allowed to revise their bids.
11. The BRLM has to build up an order book after getting the feedback from the syndicate
members about the bid price and the quantity of shares applied. The order book must show
the demand for the shares
of the company at various prices. The syndicate members must also have a record book for
the orders they have received from institutional investors for subscribing to the issue out of
the placement portion.
12. The BRLM and the issuer company decide the issue price after getting all the information
and this issue price is called the market-clearing price.
13. The BRLM then consult with the issuer company and close the book. After that they
decide the issue size of placement portion and public offer portion.
14. After deciding the final price, the BLRM must make the allocation of securities based on
the prior commitment, investors quality, price aggression, earliness of bids and so on.
15. Within two days from determining the issue price and receipts of acknowledgement card
from SEBI, the final prospectus is filed with the registrar of companies.
16. Two different accounts for collection of application money within which first one for the
private placement portion and the other for the public subscription must be opened by the
issuer company.
17. The placement portion is closed one day prior the opening of the public issue through
fixed price method. The BRLM must have the application money from the institutional buyers
along with the application forms and the underwriters to the private placement portion.
18. On the second day from the closure of the issue, the allotment for the private placement
portion will be made and the private placement portion will ready to be listed.
19. The allotment and listing of issues under the fixed price portion must be as per the
existing statutory requirements.
20. Finally, the SEBI has the right to examine such records and books which are handled by
the BRLM and other intermediaries involved in the Book Building process.
A demand for the securities which is proposed to be issued by a body corporate is
determined by book building process. The bids, obtained for the quantum of securities and
offered by the issuer for subscription, are used to determine the price of the securities. Book
building method gives an opportunity to the market to find out the price for securities.

Q3. Discuss the role of a custodian of shares.

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Answer:Custodial services refer to the safeguarding of securities of a client. The activities

relating to custodial services involve collecting the rights benefiting the client in respect to
securities, maintaining the securities account of the client, informing the clients about the
actions taken or to be taken, and maintaining records of the services.
Custodian of services is a person who proposes or carries on the business of providing
custodial services. The custodian provides the services to a client. To receive custodial
services, the client enters into an agreement with the custodian of securities. The custodian
of securities must be registered with the SEBI. The person proposing to carry on business as
custodian of securities after the commencement of the SEBI regulations has to send an
application to the Board to grant a certificate. The applicant has to provide the necessary
information to the Board to receive the certificate of registration. The application without
complete information is rejected. However, before rejecting any application, the Board gives
an opportunity to the applicant to remove the objection within a specified time.
Custodial services is a new method of services provided to Foreign Institutional Investors
(FIIs) and Mutual Funds (MFs) to protect their assets such as security certificates and
documents of ownership. Every custodian should have adequate facilities, sufficient capital
and financial strength to manage the custodial services.

Roles and responsibilities of custodians

The SEBI regulations prescribe the roles and responsibilities of the custodians. According to
the SEBI the roles and responsibilities of the custodians are to:

Administrate and protect the assets of the clients.

Open a separate custody account and deposit account in the name of each client.

Record assets.

Conduct registration of securities.

Segregate securities and cash belonging of each client from others including
custodian himself.

Take adequate insurance of risks.

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Maintain records manually or in machine readable form.

State clearly the method and system of receiving instructions from the client
regarding collection, receipt, reporting and delivery of securities.

Conduct verification of securities and to follow the stated control mechanism.

Mention specifically the fees charged in the agreement.

Conduct audit annually.

The custodian should have an adequate internal control system to prevent the manipulation
of records and documents, which includes audit for securities and entitlements arising from
securities, and held on behalf of the clients. To ensure that securities are protected from theft
and natural hazards, the custodian must have appropriate safekeeping measures. On behalf
of the client, the custodians have to maintain records and documents such as details of
securities, money received and released registration of securities, and all reports submitted
to the SEBI.

To monitor the compliance to the SEBI Act, every custodian of securities appoints a
compliance officer. The SEBI can ask for any information with respect to any matter relating
to the activities of the custodian. The SEBI is authorised to conduct inspection or
investigation of accounts, documents or records of the custodians to ensure that the
provisions of the SEBI Act and regulations are followed. In case of default, the SEBI can
suspend or cancel registration of a custodian.

Every registered custodian must follow the code of conduct prescribed by SEBI. The
following are the code of conduct prescribed by SEBI:

Integrity The custodian of securities must maintain high standards of integrity and
professionalism while discharging duties.

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Prompt distribution The custodian of securities must be prompt in distributing

interests and dividends collected by him, on behalf of his clients on the securities held in
custody.

Infrastructure The custodian of securities must establish and maintain suitable

infrastructure to discharge custodial services to the satisfaction of the clients. The
operating procedures and systems of the custodian of securities need to be well
documented.

Accountability The custodian of securities is responsible for the movement of

securities. The movement of securities can be from custody account, deposit and
withdrawal of cash from the clients account. Whenever demanded by SEBI or the client,
the custodian of securities must provide the complete audit trail.

Confidentiality The custodian of securities has to maintain confidentiality regarding

the client.

Precautions The custodian of securities must take necessary precautions to ensure

that continuity in custodial records is not lost or destroyed. To maintain sufficient backup
records, the custodial records are kept electronically.

Records The custodian of securities must create and maintain records of securities
held in custody appropriately. This must be done to locate securities or obtain duplicate
documents easily if the original records are lost due to any reason.

Cooperation The custodian of securities must cooperate with other custodial entities
and depositories which are necessary for the conduct of business, especially in the
areas of inter custodial settlements and transfer of securities and funds.

Diligence The custodian of securities must exercise diligence in administrating and

safekeeping the clients assets which are in his custody.

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Q4. A company wishes to take machinery on lease. Study the lease options available
to the company.
Answer: The lease options available to the company are as following:
Finance lease
In finance lease, the transfer of risks takes place. All the risks and secondary rewards
incidental to the ownership of the asset are transferred to the lessee by the lessor, whether
or not the title is eventually transferred. It involves payment of rentals over a compulsory,
non-cancellable lease period which must be sufficient to repay the capital outlay of the lessor
and leave some profit. Such a lease is also known as full payout lease. The lessor is
essentially interested in the transaction as a financier and has no interest in the asset which
is essentially required for the lessee for his business. Assets included under finance lease
are ships, aircraft, land, buildings, heavy machinery, and so on.

Operating lease
In an operating lease, transfer of all the risks and the rewards associated therewith does not
take place and the cost of the asset is not fully recovered during the primary lease period.
The lessor does not depend on a single lessee for recovering the cost of the asset. Services
such as maintenance, repair and technical advice are provided by the lessor to the lessee. It
is also known as service lease.

Sale and lease back and direct lease

Sale and lease back
Sale and lease back is an indirect form of leasing. The owner of an asset sells the asset to a
lessor and the lessor leases it back to the owner who acts like the lessee. The sale and
lease back of safe deposits vaults by banks is a good example of this type of leasing. The
lease back arrangement in sale and lease back type of leasing can either be in the form of a
finance lease or operating lease.

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Direct lease
In direct lease, the lessee and the owner are two different bodies. A direct lease is of two
types: bipartite and tripartite lease.

Bipartite lease It consists of two parties the equipment supplier being the lessor. This
lease is typically structured as an operating lease with inbuilt facilities, like upgradation of
the equipment. The lessor maintains the asset and, if needed, replaces it with similar
equipment.

Tripartite lease This lease involves three parties, the equipment supplier, the lessor
and the lessee.

Single investors lease and leveraged lease

Single investor lease
In single investors lease, there are only two parties, the lessor and the lessee. The leasing
company manages the fund of the entire investment by an appropriate mix of debt and
equity funds. The lender is not entitled to payment from the lessee when there is a default in
servicing. The debt raised by the leasing company to finance the asset is without recourse to
the lessee.

Leveraged lease
In leveraged lease, there are three parties - the lessor, lender and the lessee. In such a
lease, the leasing company buys the asset through considerable borrowing according to the
requirement of the lessee. The lender obtains an obligation of the lease and the lessee has
to pay rentals. The deal is routed through a trustee who looks after the interest of the lender
and lessor. After receiving the receipt of the rentals from the lessee, the trustee sends the
debt service component of the rental to the loan participant and the balance to the lessor.

Domestic lease and international lease

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Domestic lease
In domestic lease, all parties mentioned in the agreement are the residents of the same
country. The party consists of the equipment supplier, lessor and the lessee. This lease is
less prone to risks.

International lease
In international lease, the parties to the lease transaction reside in different countries. Import
lease and cross-border lease are the sub classifications of international lease. This lease is
affected by two types of risks - country and currency risk.

Import lease The lessor and the lessee are resident of the same country but the
equipment provider is located in a different country

Cross-Border lease The lessor and the lessee are resident of different countries and
the residence of the supplier is not at all important.

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Q5. Give examples of various venture capital funds that are present and examples of
some business ventures that have been successful with venture capital financing.

Answer: Indian Venture Capital Scenario

In India, the emergence of venture capital companies is a relatively new phenomenon. Until
1985, individual investors and Development Finance Institutions (DFIs) have played the role
of venture capitalists in the absence of an organised venture capital industry. During that
time entrepreneurs have largely depended on private placements, public offerings and
lending by financial institutions. The venture capital phenomenon has arrived at a take-off
stage in India with the easy availability of risk capital in all forms. In the earlier stage, it was
easy to raise only growth capital but financing of ideas or seed capital is now available after
the introduction of venture capital phenomenon. The number of players offering growth
capital and the number of investors is rising rapidly.

In India, the concept of venture capital was initiated by the Industrial Finance Corporation of
India (IFCI) when it established the Risk Capital Foundation (RCF) to provide seed capital to
small and risky projects. However, the concept of venture capital financing first time got
statutory recognition in the fiscal budget for the year 1986 to 1987.

The venture capital companies operating at present in India can be divided into four
categories based on their mode of promotion. Let us read about each mode.

Promoted by All-India Development Financial Institution (IDFI)

The ICICI provided the required impetus to venture capital activities in India. In 1986 it
started providing venture capital finance. In 1998, it promoted with the Unit Trust of India
(UTI) and Technology Development and Information Company of India (TDICI) as the first
venture capital company registered under the Companies Act, 1956.

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The risk capital foundation established by the IFCI in 1975 was converted to Risk Capital
and Technology Finance Company (RCTC). The RCTC was established as a subsidiary
company of IFCI to provide assistance in form of conventional loans and to give financial
support to high technology projects.

Promoted by state level finance institution

In India, the state level financial institutions in some states like Gujarat, Uttar Pradesh have
done an excellent job by providing venture capital finance to small scale enterprises.

Promoted by commercial banks

Venture capital funds have been established by their corresponding commercial banks to
undertake venture capital financing activity. Examples of these funds are Canbank venture
capital fund, State bank venture capital fund, and Grindlays bank.

Private venture capital funds

In India, several venture capital funds have been established to provide funding to various
small scale enterprises. Examples of these funds established in India are 20th Century
Venture Capital Corporation and Indus venture capital fund.

Q6. Mutual fund schemes can be identified by investment objective, List one scheme
within each category.

Answer: Mutual Fund Schemes or Products

Broad range of Mutual Fund Schemes exists to cater to the needs such as financial position,
risk tolerance and return expectations and so on. The schemes are as follows:

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Open ended and close ended schemes An open-end fund is accessible for subscription
throughout the year. These are not subjected to a fixed maturity. Investors can easily buy
and sell units at Net Asset Value (NAV) related prices. The key quality of open-end schemes
is liquidity.

Close ended schemes have a pre-defined maturity period. At the time of the initial issue
one can invest directly in the scheme. Depending on the arrangement of the scheme there
are two exit options on hand to an investor after the preliminary offer period closes. Investors
can buy or sell the units of the scheme on the stock exchanges where they are listed.

Investment objective schemes Mutual funds are also classified based on the objectives
of the fund. The investor can invest in mutual funds based on these objectives. The types of
investment objective schemes are as follows:

- Pure growth schemes Pure growth schemes are also acknowledged as equity
schemes. The intention of these schemes is to offer capital approval over medium to long
term. These schemes usually invest a main part of their fund in equities and are keen to bear
short-term turn down in value for possible future appreciation.
- Pure income schemes Pure income schemes are also identified as debt schemes. The
target of these schemes is to supply regular and steady income to investors. These schemes
normally invest in fixed income securities such as bonds. Capital appreciation in such
schemes possibly will be limited.

- Taxes saving schemes Tax-saving schemes recommend tax rebates to the investors
under tax laws approved from time to time. Under Sec.88 of the Income Tax Act,
contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.

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- Balanced schemes Balanced schemes aim to give both growth and income by
occasionally distributing a part of the income and capital gains they earn. These schemes
put in in both shares and fixed income securities.

Miscellaneous schemes The miscellaneous schemes include the following:

- Sector funds These are the funds which put in the securities of only those sectors as
specified in the offer documents. Examples of such funds are pharmaceuticals, software,
fast moving consumer goods, and petroleum stocks and so on. The returns in these funds
are reliant on the performance of the respective sectors. These funds have the potential to
give higher returns but they are more risky compared to diversified funds. Investors need to
keep a watch on the performance of those sectors and must exit at an appropriate time.

- Money market mutual funds Money market mutual funds aim to present easy liquidity,
conservation of capital and moderate income. These schemes commonly invest in safer,
short-term instruments, such as bills of treasury, commercial paper, deposit certificates, and
inter-bank call money.

Mutual Funds are always a good investment option in the financial portfolio. The returns are
always more in these funds when compared to risk free investment options in banks. Also
the risk in these investments is much less as compared to direct investments in shares.

Mutual funds can be called as diversified methods to invest our money and they offer
numerous benefits to invest our hard earned money. But, before investing we should analyse
the entire document provided by the concern mutual fund company as various risks are
involved. Taxes and entry fees are also a part of mutual fund investments that reduces the
returns on investments. The risk of losing the principal amount invested in a mutual fund is
always there as the mutual funds are not guaranteed by the government. At the same time
mutual funds present several advantages which made people to start investing in them. The

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first advantage is affordability which facilitates any kind of investor even without a huge
capital to start investing in mutual funds to gain benefits for themselves. There are quite a lot
of mutual funds schemes such as monthly payments, systematic investment plans and so on
that can be customised based on the individual needs of the investor. The liquidity that
mutual funds offer to the investors is more when compared to others. The investor can
recover possession of the mutual funds whenever they want in the form of the current NAV
per unit at that time but there will be a deduction of the charges from the net amount.

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MF0018: Insurance and Risk Management
ASSIGNMENT- Set 1 (Marks 60)

Q1. Write a note on the following:

a. endowment assurance
b. Investment banking

Answer: Term products are life insurance plans that offers financial cover equivalent to the
face value of the policy in case the policy holders dies during the policy period. They do not
carry any cash value. According to the plan, policy holders pay a certain premium to protect
their dependants against their sudden death. But if the insured person lives upto the
specified period of the policy, the insured will not get any benefits from this plan.

Endowment products are plans that combine risk cover with financial savings. Endowment
plans are the most popular products in the world of life insurance. In this plan, the sum
assured is payable even if the insured survives the policy term. But when the insured dies
during the specified period, the amount is paid to the sum assured. The insured who remain
alive upto the specified period of the plan get back the sum assured with some other
investment benefits. It also offers offer various benefits such as double endowment and
marriage/ education endowment plan. The cost of this plan is slightly higher but is worth its
value.

The following are the features of term and endowment products:

Term and endowment products provide death benefits ensuring the security of those
important persons of the insured.
They provide disability protection ensuring the insured that their insurance will remain in
force if they are disabled and unable to work.

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They provide retirement planning and funds to the insured for the future retirement needs.
They cover other risks of the life of the insured such as accidents, hospitalisation and
business loss.

Term and endowment products have been in the market for a long time and are very
popular. Hence many insurance companies while designing products offer these. They
incorporate the basic features of these plans and try to provide product differentiation by
providing marginal benefits to attract more customers.

Features of Endowment Assurance Policy

The previous section discussed the role of term and endowment policies in product design.
This section discusses the features of endowment assurance policy.

Endowment assurance policy is a fixed term life assurance policy in which provisions are
made for premiums to pay for life cover and to save or invest. The policy pays out a sum of
money (the sum assured) on the death of the policyholder or at the maturity date if the
policyholder is alive till the term of completion. If an endowment policy is claimed prior to its
maturity period, then the amount returnable to the policyholder will normally be below the
value of the premiums paid up to cancellation.

The important features of the endowment assurance policy are:

Moderate premiums.

High bonus.

High liquidity.

Savings oriented.

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Sum assured is payable to the policyholder either on survival to the term or on death
occurring within the term.

Under this policy with Profit and a without Profit plans are available.

Bonus for the full term is payable to the policyholder on the date of maturity or in the
occasion of death, whichever is earlier.

Premiums can be limited to smaller term or can be paid as single premium.

Premiums come to an end on expiry of term or on death whichever is earlier.

This policy provides provisions for the family of policyholder, in event of his death, and
also assures an amount at a desired age. The amount can be reinvested, to provide an
annuity during rest of his life or in any other way. Premiums are payable for specified
number of years. Endowment assurance policy is affordable for people of all ages and
social groups, who wish to protect their family members from a financial risk that might
occur in future. If the policy holder becomes permanently disabled on account of an
accident, before reaching the age of 70 and the policy is in full force, then it is not
compulsory for him to pay the remaining premiums; and the policy will be unaffected.

b. Corporate finance is the traditional aspect of investment banks which also involves
helping customers raise funds in capital markets and giving advice on mergers and
acquisitions (M&A). This may involve subscribing investors to a security issuance,
coordinating with bidders, or negotiating with a merger target. Another term for the
investment banking division is corporate finance, and its advisory group is often termed
mergers and acquisitions. A pitch book of financial information is generated to market the
bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the
client. The investment banking division (IBD) is generally divided into industry coverage and
product coverage groups. Industry coverage groups focus on a specific industry, such as
healthcare, industrials, or technology, and maintain relationships with corporations within the
industry to bring in business for a bank. Product coverage groups focus on financial
products, such as mergers and acquisitions, leveraged finance, public finance, asset finance
and leasing, structured finance, restructuring, equity, and high-grade debt and generally
work and collaborate with industry groups on the more intricate and specialized needs of a
client.

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Q2. Discuss the various risk management strategies to handle risk.

Answer : Risk Management Strategies

Tthe various risk management strategies used to handle both pure and speculative risk.

1. Risk avoidance
Risk avoidance is where a certain loss exposure is never acquired or the existing one is
totally removed. This is one of the strongest methods to deal with risks. The major
advantage of this method is that it reduces the chance of loss to zero. The two ways by
which risk can be avoided are proactive avoidance and abandonment avoidance. In the first
case, the person does not assume any risk and therefore any project which brings in risk is
not taken up.

For example a company which has chances of nuclear radiation will not set up the company,
due to the perils which it can bring up.

In the case of abandonment avoidance, the existing loss exposure is abandoned. All
activities with a certain degree of risk are abandoned. The case of abandonment avoidance
is very few. If a firm abandons risky activities, then it faces difficulties in remaining in the
market. The firm in the process of abandoning might take up new activities which exposes to
another type of risk.

2. Risk reduction

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This strategy aims to decrease the number of losses by reducing the occurrence of loss,
which can be done in two ways namely loss prevention and loss control.
Loss prevention is a desirable way of dealing with risks. It eliminates the possibility of loss
and hence risk is also removed. The examples of this are safety programs like medical care,
security guards, and burglar alarms.

Loss control refers to measures that reduce the severity of a loss after it occurs. For
example segregation of exposure units by having warehouses with inventories at different
locations. Insurance companies provide guidance and incentives to the company which has
taken the policy to avoid the occurrence of loss.

3. Risk retention
Retention simply means that the firm retains part or all the losses incurred from a given loss.
Risks may be knowingly or unknowingly retained by the organisation. They are hence
classified as active and passive based on this. Active risk retention is when the firm knows of
the loss exposure and plans to retain it without making any attempt to transfer it or reduce it.
Passive retention is the failure to identify the loss exposure and retaining it unknowingly.
Retention can be used only under the following circumstances:

When insurers are unwilling to write coverage or if the coverage is too expensive.
If the exposure cannot be insured or transferred.
If the worst possible loss is not serious.
When losses are highly predictable.

Based on past experience if most losses fall within the probable range of frequency, they can
be budgeted out of the companys income.

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4. Risk combination
In this strategy, risks are retained in a proportion that reduces the overall risk combination to
a minimum level. In order to minimise the overall risk, one risk is added to another existing
risk instead of transferring a risk. This strategy is mostly used in management of financial
risk. The risk is distributed over a number of issuers instead of putting it on a single issuer.
This reduces the chances of default. For example it is better to have multiple suppliers
instead of relying on a single supplier.

5. Risk transfer
If the risk is being borne by another party other than the one who is primarily exposed to risk
then it is termed as risk transfer. In this case, transfer of asset does not take place but only
the risk involved is transferred. The two parties involved in this strategy are the transferor
(party transferring the risk) and the transferee (party to whom the risk is transferred). The
contracts made in this strategy are grouped as exculpatory contracts.

In this contract the transferor is not liable if the event of risk takes place. But if the transferor
is supposed to pay for the risk incurred then it cannot be termed as risk transfer.

6. Risk sharing
This is an arrangement made by which the loss incurred is shared. For example in a
corporation, a large number of people makes investments and hence each bears only a
portion of risk that the enterprise faces. Insurance involves the mechanism of risk sharing.

7. Risk hedging

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Hedging is buying and selling future contracts to balance the risk of changing prices in the
cash market. A hedger is someone who uses derivatives to reduce risk caused by price
movements. Derivatives are instruments derived from the base securities like equity and
bonds. Forward contracts, futures, swaps and options are examples of derivatives.
Derivatives are based on the performance of separately traded commodities. These involve
future commitments and hence are open to the possibility of benefiting from favorable price
movements.

Operators in the derivative market are hedgers, speculators and arbitrageurs. Hedgers are
those who transfer the risk component of their portfolio. Speculators take the risk from
hedgers intentionally to make profit. Arbitrageurs operate in different markets simultaneously
to make profit and eliminate mispricing. Therefore the derivatives make provision by hedging
to reduce the existing risk.

Q3. What is VAR and how it is useful in risk management tool?

Answer : Regulators have identified derivatives as risk management tools for insurance
organisations. Hence insurance companies use these within the quantitative and qualitative
limits determined by the legislation, supervisory authority and the internal procedures of the
organisations. The insurance companies need to obtain prior authorisation needs for every
derivatives it intends to use. Additionally, the management of the organisation should
develop a system of estimation, quantitative limitation and supervision of risks.

In case of investment choices, the administrators and supervisors must improve risks like
credit risk, market risk, legal and operational risk. VAR (Value at Risk) models are accepted
by banking and insurance organisations as a risk management tool to control risks. VAR is
defined as the maximum potential change in value of financial instruments portfolio with a
provided probability for certain time period. VAR approach is useful for risk management and
regulatory purpose. The main aim of VAR approach in risk management and capital
regulation is to bring capital requirements close to underlying risks of assets in a portfolio.

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This approach is really important for insurance organisations as they operate the sufficient
capital to cover the liabilities and claims in future on a long-term basis. Risk exposure is also
covered through investment rules by restricting asset categories. Because of VAR tools, the
quantitative objection in risk management tools is decreasing.

VAR is a financial engineering tool used by insurance companies. Some other tools include
credit assessments of individuals, pricing of risks and valuations of combined risks of
companies that engage in multiple markets. Asset liability management and revenue
management are optimised tools for financial management and risk management.

Q4. Explain the role of an insurance broker.

Answer : Brokers are people who legally represent the insured. The customer is the
principal of the broker who provides the broker with limited authority. The brokers have to
find a suitable insurer according to the principals needs. They cannot act on the insured
behalf but are given commission for their work.

Brokers can also be insurance agents so that they can connect the insurers and insureds. A
broker may seem similar to an agent but there is a significant difference. When a principal
gives details regarding the risks to the agent, all the facts and documents related to it is
passed on to the agent. But if the principal of a broker gives information about the risks no
such facts or documents are given to the broker. This is where the limitation in the brokers
authority appears.

There are clearly defined laws which list the responsibilities of a broker and a principal. The
insured gives the commission to a broker according to the premium charged to the insured
by the insurer. The broker in turn should give priority to the principals risks and
requirements. They have to design the insurance programs in such a way that the principal
gets a maximum benefit from it.

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The role of the broker in property and liability insurances is more in life and health
insurances. Nowadays, there are well established brokerage firms which have a specialised
broker for different types of insurances.

Q5. List and explain the social insurances available in India.

Answer: Various social insurances

The various social insurances provided in India are:
Employee state Insurance The Employee State Insurance Act which was introduced in
1948, is a piece of social welfare legislation introduced primarily with the object of providing
quite a few benefits to employees in case of sickness, injury and maternity and also to create
provision for certain others matters incidental to that. The Act in fact tries to achieve the goal
of socio-economic justice enclosed in the directive principles of state policy which enjoin the
state to make efficient condition for securing, the right to work, good health, education and
public assistance in cases of unemployment, sickness, old age and so on. The act
endeavors to materialise these objects through only to a restricted extent. This act provides
a broader spectrum then any other insurance or factory act. While the Factory Act deals with
the health, welfare and safety of the workers employed in the factory premises only, the
benefits of this act expand to employees whether working inside the factory or establishment
or elsewhere or they are directly employed by the principal employee or by an intermediary
agency, if the employment is incidental or in connection with the factory or establishment.

Disability insurance The most significant form of disability insurance is the one offered
by the government. This program makes sure that all the citizens who are uninsured or
underinsured are covered. This program does not offer huge benefits but it pays enough to
prohibit poverty. Many well-known companies cover their employees against the probable
hazards of disability. Employees face a high chance of meeting with an accident at the work
place. So, it is crucial for companies to offer disability insurance. Workers compensation
policy comes under disability insurance. It pays workers who get disabled by job-related

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injuries. This program also pays benefits to the family members of workers who died while
performing job-related tasks and also cover all the medical expenses. Individual disability
insurance policy is also a part of disability insurance. This policy is meant for the temporary
employees or those who are not covered under employer disability insurance or the selfemployed. Any individual can buy such an insurance policy from any insurance company but
premiums tend to stay high for policies that offer great benefits or that defines disability in a
broader context.

Health insurance schemes for the poor Over the last several years there have been
efforts to extend health insurance by various small NGOs. Self-Employed Womens
Association (SEWA) which is a membership based women workers trade union, has
developed a scheme to protect the poor women from financial burdens which arise out of
high medical costs and several other risks. Each member of the association has an option to
join the programme by paying Rs. 60 per annum and it provides limited cover for risks
arising out of sickness, maternity needs, floods, accidents, widowhood and so on. The
scheme is also linked with the saving scheme. Members have the option to either deposit
Rs. 500 in SEWA Bank or pay annual premium of Rs. 60. SEWA started this programme with
the support of one of the public sector insurance companies. According to SEWA the
patients belonging to lower income groups who opt for the schemes would need systems
which are straightforward, flexible, simple, prompt, and have less paper work and consists of
fewer tiers. SEWA experience illustrates that other aspects of risk which need coverage
include natural and accidental death of women and her husband, disablement, loss because
of riots or flood or fire or theft. Other NGOS offering similar schemes are ACCORD in
Karnataka, Aga Khan Health Services, India (AKHSI) and Nav-sarjan in Gujarat, and
Sewagram medical college Maharashtra. The scheme developed by government insurance
companies to focus on poor is called Jan Arogya Bima Policy.

Medicare Medicare covers most of the medical expenses of elderly, disabled workers
and veterans. Medicare has a number of different programs, which influence the types of
benefits received by the beneficiaries. Some plan levels cover different procedures and
provide assistance with bills incurred through hospital stays, prescription coverage, and
doctor appointments. Medicare receives the funding through taxes deducted from current
workers.

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Unemployment insurance Unemployment Insurance provides temporary financial

protection for workers who experience unforeseen layoffs due to lack of work and other
reasons that are no fault of the employee. Unemployment programs also protect workers
who suffer unemployment due to natural disasters like floods and cyclones. Funding for
unemployment insurance is done through the employers unemployment tax. ICICI Lombard
has introduced this insurance in India.

Q6. Mention the steps of underwriting.

Answer : The underwriting of life-insurance falls under a category that is different from all
other forms of insurances. When the underwriter measures risk at beginning, the company
assures a cover for 30 years or throughout life. Life assurance underwriting must consider
factors, like, medical history, family details, occupational hazards, and persons lifestyle.

The underwriting process for life insurance involves the following steps:
1) Execution of field underwriting.
2) Renewing the application in the office.
3) Gathering additional information, if required.
4) Taking and underwriting decisions.
Additional information is always essential for the underwriter in order to take a decision. This
additional information may be in the form of questionnaires, a detail medical report from
proposals own doctor (Medical Attendants Report), and an examination by an independent
doctor (Medical Examiners report).

The general steps followed by Underwriters are:

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1) Getting applications -The application for insurance is the main source of insurability
information that the underwriter of the life insurance company evaluates first. Applications
are generally collected by the field officers, the agents. A typical life insurance consists of:
General information The general information consists of general aspects like name,
age, address, date of birth, sex, income, marital status and occupation of the applicant. It
also includes the details of requested insurance cover like type of policy, amount of
insurance, name and relationship of the nominee, other insurance policies that the customer
owns and the pending insurance applications as on date.
Medical information The medical information consists of consumers health condition
and several queries about health history and family history. The medical section of the
application is comprehensive and it is mandatory to fill it completely with relevant
information. Information is also collected through a medical examination, depending on age
and face value of the policy.
2) The medical report An average medical test is compulsory (which is free of cost to the
applicant except in case of revivals). Depending on the information filed in the application, an
insurance company may ask the physician of the consumer for further information.
Gathering information is a standard method used in all domestic insurance companies.
Basically, life insurance companies have several sources of medical and financial
information to assist them in the underwriting process. These include personal medical
records and physicians, the medical information department, inspection reports and credit
records.
3) Underwriting review After collecting all the relevant information about the applicant, an
underwriter from the insurance company evaluates the information. During this evaluation,
the underwriter will organise the risk offered to the company and also determines the
premium for the policy depending upon the primary and secondary factors influencing the
premium. The premium rates are set by the companys registrars depending upon the
applicants risk profile. During each step of the underwriting process, the life insurance agent
usually provides details, and is well-informed about the insured status in the process. If the
applicant offers more risk than the insurance company standards, then the underwriter
rejects the application.
4) Policy writing A special department writes the policy, whose main function is to issue
written contracts according to the instructions from the underwriting departments. A register
must be maintained as most policies are long-term. Insurance companies generally use

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computerised systems to maintain the records of the customers, premium payments, and
they to verify that all the requirements of underwriting have been met.

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MF0018: INSURANCE AND RISK MANAGEMENT
ASSIGNMENT- Set 2

Q1. Write a note on the following:

a. Travel policy
b. Causality insurance

Answer :
a. A travel insurance policy is type of insurance coverage, which covers hospitalisation and
medical costs during a persons travel in a foreign country.

Travel insurance policy is referred to as holiday insurance. The most important thing about
this coverage is that it encompasses all the kinds of vacations and business travels. A travel
insurance policy is extremely beneficial, and its coverage is cost-efficient.

In general, companies sell travel insurance policies with many benefits to the travellers. This
policy offers single-trip coverage, if a person is planning one trip overseas. And, the policy
offers a multiple-trip policy, if a person is planning for many trips overseas, in a year.

Travel insurance covers all individuals (traveling abroad) against risks like baggage loss,
travel accidents like injuries, illnesses and medical contingencies with hospitalisation. In
India, this insurance is popular now among international travelers.
b. Casualty insurance protects against losses or damage to the business. Casualty
insurance is combined with property insurance and known as property and casualty
insurance. For instance, if a particular business is on seventh floor of a building and
suddenly a natural disaster like flood occurs that washes out the first floor, but there is no
damage caused to the seventh floor, then the loss that has occurred will not be covered by
property insurance because there is no direct loss to the business location. But casualty
insurance covers indirect losses to the business also.

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Casualty insurance, often equated to liability insurance, is used to describe an area of

insurance not directly concerned with life insurance, health insurance, or property insurance.
It is mainly used to describe the liability coverage of an individual or organization's for
negligent acts or omissions.However, the "elastic" term has also been used to describe
property insurance for aviation insurance, boiler and machinery insurance, and glass and
crime insurance. It may include marine insurance for shipwrecks or losses at sea or fidelity
and surety insurance. It may also include earthquake, political risk insurance, terrorism
insurance, fidelity and surety bonds.
One of the most common kinds of casualty insurance today is automobile insurance. In its
most basic form, automobile insurance provides liability coverage in the event that a driver is
found "at fault" in an accident. This can cover medical expenses of individuals involved in the
accident as well as restitution or repair of damaged property, all of which would fall into the
realm of casualty insurance coverage.
If coverage were extended to cover damage to one's own vehicle, or against theft, the policy
would no longer be exclusively a casualty insurance policy.
The state of Illinois includes vehicle, liability, worker's compensation, glass, livestock, legal
expenses, and miscellaneous insurance under its class of casualty insurance.
In 1956, in the preface to the fourth edition of Casualty Insurance Clarence A. Kulp wrote:
It has never been possible really to define casualty insurance. Broadly speaking, it may be
defined as a list of individual insurances, usually written in a separate policy, in three broad
categories: third party or liability, disability or accident and health, material damage. One of
the results of comprehensive policy-writing .... is to raise the question of the usefulness of
the traditional concept of casualty insurance ... some insurance men predict that the casualty
insurance of the future will include liability and disability lines only.

Q2. What are the basic objectives of claims management?

Answer: Claims management is a system which sets up the rules and regulations for the
assessment of damages, using the data got from medical reports, surveyor report, loss

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assessors report and warranties contained in the policy document. It also regulates the
payment of damages and the payment of loss of future earnings.

An insurance company is usually accepted as good or bad, on the basis of the time it takes
to finalise, and pay back the claim. To settle a claim promptly is the important function of an
insurance organisation. The goodwill of the insurance company depends on the claim
satisfaction level of its customers. Effective claim management is necessary for an
organisation as it deals with the cash outflows of the company.
Claims management by the insurer involves analysing the data, processing applications and
making decisions, funding and controlling the business management. The claims
management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The
review of claims performance, monitoring of claims expenses, legal and settlement costs,
planning of future payments and avoiding delay and disputes in payment of claims is
included in claims management. Risk management, loss assessment, business forecasting
and planning of insurance claims are also done in claims management.

Claims reserving is an important part of the overall claim management process. Insurance
companies need to ensure adequacy of claims reserves in order to meet their claim
obligations.

Q3. Describe the stages in claims management.

Answer : Managing insurance claims is one of the most significant management tasks.
Claim management tasks involve filing, verifying insurance coverage, determining copayment levels and checking the status of submitted claims. Claims handling and claims
management are the stages in the claim system. Externally both appear to be the same, but
they are different by nature. Claims handing is a vital part of claims management as it
executes the decisions by the claims management of the insurance company.

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Claims management
Claims management by the insurer involves analysing the data, processing applications and
making decisions, funding and controlling the business management. The claims
management makes the principles and guidelines for profitable settlement of claims.

Claims management comprises of the process of claims handling and claims payment. The
review of claims performance, monitoring of claims expenses, legal and settlement costs,
planning of future payments and avoiding delay and disputes in payment of claims is
included in claims management. Risk management, loss assessment, business forecasting
and planning of insurance claims are also done in claims management.

Claims reserving is an important part of the overall claim management process. Insurance
companies need to ensure adequacy of claims reserves in order to meet their claim
obligations.

Claims handling
Claims handling is a way to process claims application and manage the claims settlement. It
is a method, where the laid down principles and measuring methods are utilised to settle the
claims. It handles the various stages of the insurance claims. Its functions include reviewing,
investigating and understanding the negotiation process. This does not involve policy making
and decision making or any managerial activity.

It involves only procedural methods and interpretations of the claims philosophy. Claims
handling depends on each case or situation and changes accordingly. It is flexible, as well
as, rigid keeping in mind the interest of the insurer. It involves receiving the claims and other
procedures for efficient payment of claims. The insurers commitment to the customer is part
of the claims management.

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While handling claims insurers need to ensure that:

Claims are handled fairly.

Claims are settled promptly.

Information is provided to the customers about the claim handling process.

Reasons are provided when claims are rejected or not fully paid.

Q4. If you working as an actuary in an insurance company, list the factors which affect
your pricing of a policy.

Answer: Basically, the pricing method gives us an idea on how to set the product price. The
price value that is set for the product in the insurance company will change over time for
many reasons. The company can decide to change the pricing method only when it finds out
the customers needs and competition in the market.

The pricing methods allow companies to think about their business, industry and customer.
The vendors must understand the variety of options available along with the merits and
demerits of the pricing methods, before selecting any one of them. They may also merge a
number of pricing methods to suit their business and the type of products they sell.
There are three basic pricing methods, which are:
Cost-based pricing In this method, the price includes the cost of ingredients and cost of
operating the business. This method is based on product cost subtotal, which includes the
costs of operating the business such as costs of reserves, transportation, advertisement,
rent and other costs involved in manufacturing the products. The cost-based pricing
comprise of three methods, which are:

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- Mark-up pricing Mark-up pricing includes a profit percentage with product cost. All
businesses with many products use this type of pricing because it is simple to calculate. The
profit level must be specified in terms of percentage. This is added to the production cost to
set product price. This type of pricing is common in retail business as they have many types
of products and purchases from many vendors.

- Cost-plus pricing In a cost-plus pricing, a percentage is added to an unknown product

cost. This type of pricing works properly when production costs are not known. The only
difference between mark-up and cost-plus pricing is that, in cost-plus pricing both consumer
and vendor settle on the profit percentage and believe that product cost is unknown whereas
in mark-up pricing product cost is known. The cost-plus pricing reduces your risk if you
produce custom order products for other firms or individuals.

- Planned-profit pricing Planned profit pricing method enables you to earn a total profit
for the business. It is different from the first two types of cost-based pricing. The first two
pricing methods focus on per unit price. In planned-profit pricing, the product price is
calculated by combining per unit costs with output projections. Planned-profit pricing uses
break-even analysis to calculate product price. This method is suitable for manufacturing
businesses since the manufacturer has the ability to increase or decrease the production
depending upon the available demand or profit.

Q5. Describe the roles and functions of the institution of insurance ombudsman.

Answer : In 1998, Government of India formed the Institute of Insurance Ombudsman, to

address the complaints of insured persons against the insurance companies. This institution
became a way for the insured persons to express their problems against the companies, and
to solve it as soon as possible. This institution helps the policyholders to build up confidence
in the insurance companies.

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Institution of Insurance Ombudsman resolves complaints, which the insurance company

denied to solve. The insured persons can approach the insurance ombudsman in their own
states to solve their problems.

Roles and functions

The roles and functions of the Institution of Insurance Ombudsman ranges from appointment
of the ombudsman, to the rewarding of insured persons. The various functions of the
institution are:

Appointment of insurance ombudsman - The appointment of insurance ombudsman

is the main function of the institution. A committee consisting of the chairman of IRDA,
chairman of LIC, chairman of GIC, and a representative of the Central Government
mandates the governing body of insurance council to choose the insurance ombudsman.
The Insurance council includes the members of life insurance council, and the general
insurance council is formed under section 40C of the Insurance Act,1938. Some
representatives of insurance companies form the governing body of insurance council.

Eligibility and term of service - Officials from insurance industry, civil services and
judicial services are chosen as the insurance ombudsmen. The ombudsman changes
every three years and retires from the post at sixty-five years of age. Insurance
ombudsmen cannot be re-appointed.

Territorial jurisdiction of ombudsman - Presently, in different states of India, there are

around 12 insurance ombudsmen appointed by the governing body. These ombudsmen
may hold meetings with the insured persons in their corresponding areas of jurisdiction,
in order to speed up and resolve their grievances. Currently, the offices of the insurance
ombudsmen in India are located at Bhopal, Bhubaneswar, Cochin, Guwahati,
Chandigarh, New Delhi, Chennai, Kolkata, Ahmedabad, Lucknow, Mumbai and
Hyderabad.

Office Management - The insurance council provides the office of the insurance
ombudsman, and it consists of the secretarial staff, which supports the ombudsman in
carrying out duties. The total expenses of this office are decided by the governing body,
and are provided by the insurance companies of the insurance council.

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Removal from office - An insurance ombudsman can be removed from office on

committing a gross misconduct during the three years of service. The governing body
selects a person fit to do a detailed enquiry and investigation about the misconduct and
all these details are given to the Insurance Regulatory and Development Authority
(IRDA). IRDA then takes a decision regarding the action to be taken against the guilty
ombudsman.

Power of ombudsman
The two main functions of the insurance ombudsman are:
Addressing and solving the issues of the insured persons and insurance companies
- The insurance ombudsman helps any person who has a complaint against the insurance
company. The complaints can be of various types:
- Issues regarding any partial or total denial of claims by the insurance companies.
- Issues with regard to payment of premium in terms of the policy.
- Disputes on the legal structuring of the policy statements which resulted in disputes related
to claims.
- Delay in resolution of claims.
- Delay in issuance of any insurance papers to customers after acceptance of premium.
Awarding a payment to the insured persons - The insurance ombudsman can issue up to
Rs. 20 lakhs as awards to the insured persons. The corresponding insurance companies are
obliged to credit these awards within three months.

Q6. What are the different types of reinsurance? Explain.

Answer : The two different types of reinsurances are:

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Facultative reinsurance.
Treaty reinsurance.

1. Facultative reinsurance
It is a type of reinsurance that is optional; it is a case-by-case method that is used when the
ceding company receives an application for insurance that exceeds its retention limit. It is
based on the individual agreements that help to cover specific losses. When any primary
insurer wants reinsurance for a specific coverage, it enters the market, and bargains with
different reinsurance companies for the amount of coverage and premium, looking out for a
better value. According to most of the contracts, the reinsurer pays a ceding commission to
the insurer to pay for purchase expenses.

Before issuing the insurance policy the insurer looks for reinsurance and speaks to many
reinsurers. The insurance company does not have any commitments to cede insurance and
also the reinsurer has no commitments to accept the insurance. However if the insurance
company find a reinsurer who is willing to take the insurance policy then they can enter into
a contract.

Facultative reinsurance is used when a huge amount of insurance is preferred and while
considering a specific risk involved in an individual contract. Facultative reinsurance is the
reinsurance of a part of a single policy or the entire policy after negotiating the terms and
conditions. It reduces the risk exposure of the ceding company against a particular policy.
Facultative reinsurance is not mandatory.

One advantage of facultative reinsurance is it is flexible as a reinsurance contract is

arranged to fit any kind of cases. It helps the insurance companies in writing large amount of
insurance policies. Reinsurance moves the huge losses of the insurers to the reinsurer and
thus helps the insurer.

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One main disadvantage of facultative reinsurance is that it is not reliable. The ceding insurer
will not know in advance whether a reinsurer will agree to pay any part of the insurance. The
other disadvantage of this kind of reinsurance is the delay in issuing the policy as it cannot
be issued until the reinsurance is got for that policy.

2. Treaty reinsurance
Treaty reinsurance is one in which the primary insurer agrees to cede the insurance policy to
the reinsurer and the reinsurer has to accept it. It includes a standing agreement with a
specific reinsurer. The amount of insurance that the primary insurer sells and those policies
where both the parties provide the service is specified in the contract. All the business that
comes under the contract is automatically reinsured according to the conditions of the treaty.
Treaty reinsurance needs the reinsurer to assume the entire responsibility of the ceding
company or a part of it for some particular sections of the business with respect to the terms
of the policy. The contract is a compulsory contract because according to the treaty the
ceding company has to cede the business and the reinsurer is compelled to assume the
business. It is a type of reinsurance that is preferred while considering the groups of
homogenous risks.

The treaty reinsurance provides many advantages to the primary insurance company. It is
automatic, more reliable, and there is no delay in issuing the policy. It is also more cost
effective as there is no need to shop around for reinsurers before writing the policy.
The treaty reinsurance is not advantageous to the reinsurer. Usually the reinsure does not
know about the individual applicant of the policy and has to depend on the underwriting
judgment that the primary insurer gives. It may be so that the primary insurer can show bad
business like more losses and get reinsured for it as the reinsurer does not know the real
fact. The primary insurer may pay insufficient premium to the reinsurer. Therefore the
reinsurer undergoes a loss if the risk selection of the primary insurer is not good and they
charge insufficient rates.

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There are different types of treaty reinsurance arrangements which may differ according to
the liability of the reinsurer. They are:

Quotashare treaty.

Surplusshare treaty.

Excessofloss treaty.

Reinsurance pool.

Quotashare treaty According to this treaty the reinsurer and the ceding insurer agree to
share a fixed percentage of premium and also losses depending on some proportion.
Therefore because of this the quota share treaty is also called proportional reinsurance.
For instance, the primary insurer can take a decision of retaining around 70% of the new
business with it and transferring the rest 30% to the reinsurer. Accordingly, it also divides the
expenses, incomes and losses in the same proportion. The ceding insurers retention limit is
stated as a percentage. Premiums are also shared in the same proportion as agreed in the
treaty. A ceding commission is paid to the primary insurer by the reinsurer that helps in
balancing the expenses that it encountered while writing the business.

The major advantage of the quote-share treaty is that it permits the primary insurer in
reducing its unearned premium reserve considerably by transferring a lot of profitable
business to the reinsurer.

Surplusshare treaty This is an agreement that shares some of the qualities of the quoteshare and excess-of-loss treaties. According to this treaty the reinsurer accepts the
insurance in excess to the ceding insurers retention limit. If the amount of any insurance
policy is more than the retention limits, then the reinsurer pays the excess amount up to a
specified maximum limit. The loss and premium are shared among the primary insurer and
the reinsurer in the same proportion.

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The major advantage of the surplus-share treaty is that it increases the underwriting capacity
of the primary insure.
The major disadvantage of this treaty is that the coverage that a reinsurer provides for each
policy has more record keeping and thus creates more administrative expenses.

Excessofloss treaty This treaty is largely designed for providing protection against the
catastrophic losses. It is an agreement where the reinsurer covers only the losses that are
more than the retention limit of the primary insurer. This coverage is obtained mainly for
covering the catastrophic losses. This treaty can be written to cover:
1) A single occurrence.
2) A single exposure.
3) Excess losses when the primary insurers total losses exceed some amount during some
started time period.

Reinsurance pool The reinsurance pool also provides reinsurance. It is an organisation of

insurers that underwrites insurance on a joint basis. These are formed as a single insurer
possibly will not be financially able to write huge amount of insurance policies, however a
group of insurers can combine their financial resources and get the financial ability to write
the huge insurance policies.

These pools are created to provide coverage for nuclear accidents, aviation disasters and
exposure in foreign countries where losses can be catastrophic and that could easily exceed
the financial capability of any single insurer.

The method of sharing premiums and losses are different for different types of reinsurance
pools. The pool works in the following two different ways::

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First all the members of the pool decide to pay some percentage of amounts for every loss
that occurs.
Second the agreement is same as that of the excessofloss reinsurance treaty.

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