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Business Finance

What is business?

An organization or economic system where goods and services are


exchanged for one another or for money.
Every business requires some form of investment and enough customers to
whom its output can be sold on a consistent basis in order to make a profit.

Businesses can be privately owned, not-for-profit or state-owned. An example


of a corporate business is PepsiCo, while a mom-and-pop catering business
is a private enterprise.

What is finance?

"Finance" is a broad term that describes two related activities: the study of how money is
managed and the actual process of acquiring needed funds. Because individuals,
businesses and government entities all need funding to operate, the field is often separated
into three sub-categories: personal finance, corporate finance and public finance.

What is 'Finance'
Finance describes the management, creation and study of money, banking, credit,
investments, assets and liabilities that make up financial systems, as well as the study of
those financial instruments. Some people prefer to divide finance into three distinct
categories: public finance, corporate finance and personal finance. Additionally, the study
of behavioral finance aims to learn about the more "human" side of a science considered by
most to be highly mathematical.

What Is the Meaning of Business Finance?

Business finance is a term that encompasses a wide range of activities and disciplines revolving around
the management of money and other valuable assets. Business finance programs in universities
familiarize students with accounting methodologies, investing strategies and effective debt management.
Small business owners must have a solid understanding of the principles of finance to keep their
companies profitable.
financial resources

The money available to a business for spending in the form of cash, liquid securities and credit lines.
Before going into business, an entrepreneur needs to secure sufficient financial resources in order to
be able to operate efficiently and sufficiently well to promote success.

Traditional and modern approach to business finance

Traditional Approach:

The traditional approach to the scope of financial management refers to its subject
matter in the academic literature in the initial stages of its evolution as a separate
branch of study. According to this approach, the scope of financial management is
confined to the raising of funds. Hence, the scope of finance was treated by the
traditional approach in the narrow sense of procurement of funds by corporate
enterprise to meet their financial needs. Since the main emphasis of finance function at
that period was on the procurement of funds, the subject was called corporation finance
till the mid-1950's and covered discussion on the financial instruments, institutions and
practices through which funds are obtained. Further, as the problem of raising funds is
more intensely felt at certain episodic events such as merger, liquidation, consolidation,
reorganisation and so on. These are the broad features of the subject matter of
corporation finance, which has no concern with the decisions of allocating firm's funds.
But the scope of finance function in the traditional approach has now been discarded as
it suffers from serious criticisms. Again, the limitations of this approach fall into the
following categories.

The emphasis in the traditional approach is on the procurement of funds by the corporate
enterprises, which was woven around the viewpoint of the suppliers of funds such as
investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies that the
traditional approach was the outsider-looking-in approach. Another limitation was that
internal financial decision-making was completely ignored in this approach.

The second criticism leveled against this traditional approach was that the scope of
financial management was confined only to the episodic events such as mergers,
acquisitions, reorganizations, consolation, etc. The scope of finance function in this
approach was confined to a description of these infrequent
happenings in the life of an enterprise. Thus, it places over emphasis on the topics of
securities and its markets, without paying any attention on the day to day financial
aspects.
Another serious lacuna in the traditional approach was that the focus was on the long-
term financial problems thus ignoring the importance of the working capital
management. Thus, this approach has failed to consider the routine managerial
problems relating to finance of the firm.

During the initial stages of development, financial management was dominated by the
traditional approach as is evident from the finance books of early days. The tradi-tional
approach was found in the first manifestation by Green's book written in 1897, Meades
on Corporation Finance, in 1910; Doing's on Corporate Promotion and Reorganisation,
in 1914, etc.

As stated earlier, in this traditional approach all these writings emphasized the finan-cial
problems from the outsiders' point of view instead of looking into the problems from
managements, point of view. It over emphasized long-term financing lacked in analytical
content and placed heavy emphasis on descriptive material. Thus, the traditional
approach omits the discussion on the important aspects like cost of the capital, optimum
capital structure, valuation of firm, etc. In the absence of these crucial aspects in the
finance function, the traditional approach implied a very narrow scope of financial
management. The modern or new approach provides a solution to all these aspects of
financial management.

Modern Approach

After the 1950's, a number of economic and environmental factors, such as the technological
innovations, industrialization, intense competition, interference of government, growth of
population, necessitated efficient and effective utilisation of financial resources. In this context,
the optimum allocation of the firm's resources is the order of the day to the management. Then
the emphasis shifted from episodic financing to the managerial financial problems, from raising
of funds to efficient and effective use of funds. Thus, the broader view of the modern approach
of the finance function is the wise use of funds. Since the financial decisions have a great impact
on all other business activities, the financial manager should be concerned about deter-mining
the size and nature of the technology, setting the direction and growth of the business, shaping
the profitability, amount of risk taking, selecting the asset mix, determination of optimum capital
structure, etc. The new approach is thus an analyti-cal way of viewing the financial problems of a
firm. According to the new approach, the financial management is concerned with the solution of
the major areas relating to the financial operations of a firm, viz., investment, and financing and
dividend decisions. The modern financial manager has to take financial decisions in the most
rational way. These decisions have to be made in such a way that the funds of the firm are used
optimally. These decisions are referred to as managerial finance functions since they require
special care with extraordinary administrative ability, management skills and decision - making
techniques, etc.

What is 'Capital Gain'

Capital gain is an increase in the value of a capital asset (investment or real estate) that
gives it a higher worth than the purchase price. The gain is not realized until the asset is
sold. A capital gain may be short-term (one year or less) or long-term (more than one year)
and must be claimed on income taxes.

Pre-emption right
From Wikipedia, the free encyclopedia

A pre-emption right, or right of pre-emption, is a contractual right to acquire


certain property newly coming into existence before it can be offered to any other person or entity.

In practice, the most common form of pre-emption right is the right of existing shareholders to
acquire new shares issued by a company in a rights issue, a usually but not always public offering.

WHAT IT IS:

Preemptive rights are a clause in an option, security or merger agreement that gives
the investor the right to maintain his or her percentage ownership of a company by
buying a proportionate number of shares of any future issue of the securit

What is an 'Initial Public Offering - IPO'


An initial public offering (IPO) is the first time that the stock of a private company is offered
to the public. IPOs are often issued by smaller, younger companies seeking capital to
expand, but they can also be done by large privately owned companies looking to become
publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which
helps determine what type of security to issue, the best offering price, the amount of shares
to be issued and the time to bring it to market.
Seasoned equity offering
From Wikipedia, the free encyclopedia

A seasoned equity offering or secondary equity offering (SEO) or Capital increase is a


new equity issue by an already publicly traded company. Seasoned offerings may involve shares
sold by existing shareholders (non-dilutive), new shares (dilutive) or both. If the seasoned equity
offering is made by an issuer that meets certain regulatory criteria, it may be a shelf offering.

Finance Manager: Three Major


Decisions which Every Finance
Manager Has to Take
Article shared by Samiksha S

Some of the important functions which every finance manager has to


take are as follows:

i. Investment decision

ii. Financing decision

ADVERTISEMENTS:

iii. Dividend decision


Image Courtesy : cosminpana.files.wordpress.com/2013/02/management.jpg

A. Investment Decision (Capital Budgeting Decision):

ADVERTISEMENTS:
This decision relates to careful selection of assets in which funds will be
invested by the firms. A firm has many options to invest their funds but firm
has to select the most appropriate investment which will bring maximum
benefit for the firm and deciding or selecting most appropriate proposal is
investment decision.

The firm invests its funds in acquiring fixed assets as well as current assets.
When decision regarding fixed assets is taken it is also called capital
budgeting decision.

Factors Affecting Investment/Capital Budgeting Decisions

1. Cash Flow of the Project:

ADVERTISEMENTS:

Whenever a company is investing huge funds in an investment proposal it


expects some regular amount of cash flow to meet day to day requirement.
The amount of cash flow an investment proposal will be able to generate must
be assessed properly before investing in the proposal.

2. Return on Investment:

The most important criteria to decide the investment proposal is rate of return
it will be able to bring back for the company in the form of income for, e.g., if
project A is bringing 10% return and project is bringing 15% return then we
should prefer project B.
3. Risk Involved:

With every investment proposal, there is some degree of risk is also involved.
The company must try to calculate the risk involved in every proposal and
should prefer the investment proposal with moderate degree of risk only.

4. Investment Criteria:

Along with return, risk, cash flow there are various other criteria which help in
selecting an investment proposal such as availability of labour, technologies,
input, machinery, etc.

The finance manager must compare all the available alternatives very
carefully and then only decide where to invest the most scarce resources of
the firm, i.e., finance.

Investment decisions are considered very important decisions because of


following reasons:

(i) They are long term decisions and therefore are irreversible; means once
taken cannot be changed.

(ii) Involve huge amount of funds.

(iii) Affect the future earning capacity of the company.

B. Importance or Scope of Capital Budgeting Decision:

Capital budgeting decisions can turn the fortune of a company. The capital
budgeting decisions are considered very important because of the following
reasons:
1. Long Term Growth:

The capital budgeting decisions affect the long term growth of the company.
As funds invested in long term assets bring return in future and future
prospects and growth of the company depends upon these decisions only.

2. Large Amount of Funds Involved:

Investment in long term projects or buying of fixed assets involves huge


amount of funds and if wrong proposal is selected it may result in wastage of
huge amount of funds that is why capital budgeting decisions are taken after
considering various factors and planning.

3. Risk Involved:

The fixed capital decisions involve huge funds and also big risk because the
return comes in long run and company has to bear the risk for a long period of
time till the returns start coming.

4. Irreversible Decision:

Capital budgeting decisions cannot be reversed or changed overnight. As


these decisions involve huge funds and heavy cost and going back or
reversing the decision may result in heavy loss and wastage of funds. So
these decisions must be taken after careful planning and evaluation of all the
effects of that decision because adverse consequences may be very heavy.

C. Financing Decision:

The second important decision which finance manager has to take is deciding
source of finance. A company can raise finance from various sources such as
by issue of shares, debentures or by taking loan and advances. Deciding how
much to raise from which source is concern of financing decision. Mainly
sources of finance can be divided into two categories:

1. Owners fund.

2. Borrowed fund.

Share capital and retained earnings constitute owners fund and debentures,
loans, bonds, etc. constitute borrowed fund.

The main concern of finance manager is to decide how much to raise from
owners fund and how much to raise from borrowed fund.

While taking this decision the finance manager compares the advantages and
disadvantages of different sources of finance. The borrowed funds have to be
paid back and involve some degree of risk whereas in owners fund there is no
fix commitment of repayment and there is no risk involved. But finance
manager prefers a mix of both types. Under financing decision finance
manager fixes a ratio of owner fund and borrowed fund in the capital structure
of the company.

Factors Affecting Financing Decisions:

While taking financing decisions the finance manager keeps in mind the
following factors:

1. Cost:

The cost of raising finance from various sources is different and finance
managers always prefer the source with minimum cost.
2. Risk:

More risk is associated with borrowed fund as compared to owners fund


securities. Finance manager compares the risk with the cost involved and
prefers securities with moderate risk factor.

3. Cash Flow Position:

The cash flow position of the company also helps in selecting the securities.
With smooth and steady cash flow companies can easily afford borrowed fund
securities but when companies have shortage of cash flow, then they must go
for owners fund securities only.

4. Control Considerations:

If existing shareholders want to retain the complete control of business then


they prefer borrowed fund securities to raise further fund. On the other hand if
they do not mind to lose the control then they may go for owners fund
securities.

5. Floatation Cost:

It refers to cost involved in issue of securities such as brokers commission,


underwriters fees, expenses on prospectus, etc. Firm prefers securities which
involve least floatation cost.

6. Fixed Operating Cost:

If a company is having high fixed operating cost then they must prefer owners
fund because due to high fixed operational cost, the company may not be able
to pay interest on debt securities which can cause serious troubles for
company.
7. State of Capital Market:

The conditions in capital market also help in deciding the type of securities to
be raised. During boom period it is easy to sell equity shares as people are
ready to take risk whereas during depression period there is more demand for
debt securities in capital market.

D. Dividend Decision:

This decision is concerned with distribution of surplus funds. The profit of the
firm is distributed among various parties such as creditors, employees,
debenture holders, shareholders, etc.

Payment of interest to creditors, debenture holders, etc. is a fixed liability of


the company, so what company or finance manager has to decide is what to
do with the residual or left over profit of the company.

The surplus profit is either distributed to equity shareholders in the form of


dividend or kept aside in the form of retained earnings. Under dividend
decision the finance manager decides how much to be distributed in the form
of dividend and how much to keep aside as retained earnings.

To take this decision finance manager keeps in mind the growth plans and
investment opportunities.

If more investment opportunities are available and company has growth plans
then more is kept aside as retained earnings and less is given in the form of
dividend, but if company wants to satisfy its shareholders and has less growth
plans, then more is given in the form of dividend and less is kept aside as
retained earnings.
This decision is also called residual decision because it is concerned with
distribution of residual or left over income. Generally new and upcoming
companies keep aside more of retain earning and distribute less dividend
whereas established companies prefer to give more dividend and keep aside
less profit.

Factors Affecting Dividend Decision:

The finance manager analyses following factors before dividing the net
earnings between dividend and retained earnings:

1. Earning:

Dividends are paid out of current and previous years earnings. If there are
more earnings then company declares high rate of dividend whereas during
low earning period the rate of dividend is also low.

2. Stability of Earnings:

Companies having stable or smooth earnings prefer to give high rate of


dividend whereas companies with unstable earnings prefer to give low rate of
earnings.

3. Cash Flow Position:

Paying dividend means outflow of cash. Companies declare high rate of


dividend only when they have surplus cash. In situation of shortage of cash
companies declare no or very low dividend.
4. Growth Opportunities:

If a company has a number of investment plans then it should reinvest the


earnings of the company. As to invest in investment projects, company has
two options: one to raise additional capital or invest its retained earnings. The
retained earnings are cheaper source as they do not involve floatation cost
and any legal formalities.

If companies have no investment or growth plans then it would be better to


distribute more in the form of dividend. Generally mature companies declare
more dividends whereas growing companies keep aside more retained
earnings.

5. Stability of Dividend:

Some companies follow a stable dividend policy as it has better impact on


shareholder and improves the reputation of company in the share market. The
stable dividend policy satisfies the investor. Even big companies and financial
institutions prefer to invest in a company with regular and stable dividend
policy.

Top 3 Types of Financial Decisions


Article Shared by Diksha S

This article throws light upon the top three types of financial decisions. The
types are: 1. Investment decisions 2. Financing decisions 3. Dividend
decisions.

Type # 1. Investment Decisions:

Investment Decision relates to the determination of total amount of assets to be held in


the firm, the composition of these assets and the business risk complexions of the firm
as perceived by its investors. It is the most important financial decision. Since funds
involve cost and are available in a limited quantity, its proper utilisation is very
necessary to achieve the goal of wealth maximisation.

The investment decisions can be classified under two broad groups:

(i) Long-term investment decision and

(ii) Short-term investment decision.

The long-term investment decision is referred to as the capital budgeting and the short-
term investment decision as working capital management.

Capital budgeting is the process of making investment decisions in capital expenditure.


These are expenditures, the benefits of which are expected to be received over a long
period of time exceeding one year. The finance manager has to assess the profitability of
various projects before committing the funds.

The investment proposals should be evaluated in terms of expected profitability, costs


involved and the risks associated with the projects.

The investment decision is important not only for the setting up of new units but also for
the expansion of present units, replacement of permanent assets, research and
development project costs, and reallocation of funds, in case, investments made earlier
do not fetch result as anticipated earlier.

Short-term investment decision, on the other hand, relates to the allocation of funds as
among cash and equivalents, receivables and inventories. Such a decision is influenced
by tradeoff between liquidity and profitability.

The reason is that, the more liquid the asset, the less it is likely to yield and the more
profitable an asset, the more illiquid it is. A sound short-term investment decision or
working capital management policy is one which ensures higher profitability, proper
liquidity and sound structural health of the organisation.
Type # 2. Financing Decisions:

Once the firm has taken the investment decision and committed itself to new
investment, it must decide the best means of financing these commitments. Since, firms
regularly make new investments; the needs for financing and financial decisions are
ongoing.

Hence, a firm will be continuously planning for new financial needs. The financing
decision is not only concerned with how best to finance new assets, but also concerned
with the best overall mix of financing for the firm.

A finance manager has to select such sources of funds which will make optimum capital
structure. The important thing to be decided here is the proportion of various sources in
the overall capital mix of the firm. The debt-equity ratio should be fixed in such a way
that it helps in maximising the profitability of the concern.

The raising of more debts will involve fixed interest liability and dependence upon
outsiders. It may help in increasing the return on equity but will also enhance the risk.

The raising of funds through equity will bring permanent funds to the business but the
shareholders will expect higher rates of earnings. The financial manager has to strike a
balance between various sources so that the overall profitability of the concern
improves.

If the capital structure is able to minimise the risk and raise the profitability then the
market prices of the shares will go up maximising the wealth of shareholders.

Type # 3. Dividend Decision:

The third major financial decision relates to the disbursement of profits back to
investors who supplied capital to the firm. The term dividend refers to that part of
profits of a company which is distributed by it among its shareholders.

It is the reward of shareholders for investments made by them in the share capital of the
company. The dividend decision is concerned with the quantum of profits to be
distributed among shareholders.
A decision has to be taken whether all the profits are to be distributed, to retain all the
profits in business or to keep a part of profits in the business and distribute others
among shareholders. The higher rate of dividend may raise the market price of shares
and thus, maximise the wealth of shareholders. The firm should also consider the
question of dividend stability, stock dividend (bonus shares) and cash dividend.

Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and
borrowers. A financial system could be defined at an international, regional or organization level. The
term system in Financial System indicates a group of complex and closely linked institutions,
agents, procedures, markets, transactions, claims and liabilities within a economy.

Five Basic Components of Financial System


Financial Institutions
Financial Markets
Financial Instruments (Assets or Securities)
Financial Services
Money
Financial Institutions

Financial institutions facilitate smooth working of the financial system by making investors and
borrowers meet. They mobilize the savings of investors either directly or indirectly via financial
markets, by making use of different financial instruments as well as in the process using the services
of numerous financial services providers. They could be categorized into Regulatory, Intermediaries,
Non-intermediaries and Others. They offer services to organizations looking for advises on different
problems including restructuring to diversification strategies. They offer complete array of services to
the organizations who want to raise funds from the markets and take care of financial assets for
example deposits, securities, loans, etc.
Figure 1: Five Basic Components of Financial System

Financial Markets

A financial market is the place where financial assets are created or transferred. It can be broadly
categorized into money markets and capital markets. Money market handles short-term financial
assets (less than a year) whereas capital markets take care of those financial assets that have
maturity period of more than a year. The key functions are:

1. Assist in creation and allocation of credit and liquidity.


2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.

One more classification is possible: primary markets and secondary markets. Primary markets
handles new issue of securities in contrast secondary markets take care of securities that are
presently available in the stock market.

Financial markets catch the attention of investors and make it possible for companies to finance their
operations and attain growth. Money markets make it possible for businesses to gain access to
funds on a short term basis, while capital markets allow businesses to gain long-term funding to aid
expansion. Without financial markets, borrowers would have problems finding lenders.
Intermediaries like banks assist in this procedure. Banks take deposits from investors and lend
money from this pool of deposited money to people who need loan. Banks commonly provide money
in the form of loans.
Financial Instruments

This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other type of financial instruments. There is a wide range of
securities in the markets since the needs of investors and credit seekers are different. They indicate
a claim on the settlement of principal down the road or payment of a regular amount by means of
interest or dividend. Equity shares, debentures, bonds, etc are some examples.

Financial Services

Financial services consist of services provided by Asset Management and Liability Management
Companies. They help to get the necessary funds and also make sure that they are efficiently
deployed. They assist to determine the financing combination and extend their professional services
upto the stage of servicing of lenders. They help with borrowing, selling and purchasing securities,
lending and investing, making and allowing payments and settlements and taking care of risk
exposures in financial markets. These range from the leasing companies, mutual fund houses,
merchant bankers, portfolio managers, bill discounting and acceptance houses. The financial
services sector offers a number of professional services like credit rating, venture capital financing,
mutual funds, merchant banking, depository services, book building, etc. Financial institutions and
financial markets help in the working of the financial system by means of financial instruments. To be
able to carry out the jobs given, they need several services of financial nature. Therefore, Financial
services are considered as the 4th major component of the financial system.

Money

Money is understood to be anything that is accepted for payment of products and services or for the
repayment of debt. It is a medium of exchange and acts as a store of value.

Dervative:

A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset, index or security. Common underlying instruments include:
bonds, commodities, currencies, interest rates, market indexes and stocks.

Futures contracts, forward contracts, options, swaps and warrants are common derivatives.
A futures contract, for example, is a derivative because its value is affected by the
performance of the underlying contract. Similarly, a stock option is a derivative because its
value is "derived" from that of the underlying stock.
Derivatives are used for speculating and hedging purposes. Speculators seek to profit from
changing prices in the underlying asset, index or security. For example, a trader may
attempt to profit from an anticipated drop in an index's price by selling (or going "short") the
related futures contract. Derivatives used as a hedge allow the risks associated with the
underlying asset's price to be transferred between the parties involved in the contract.

For example, commodity derivatives are used by farmers and millers to provide a degree of
"insurance." The farmer enters the contract to lock in an acceptable price for the commodity;
the miller enters the contract to lock in a guaranteed supply of the commodity. Although both
the farmer and the miller have reduced risk by hedging, both remain exposed to the risks
that prices will change. For example, while the farmer locks in a specified price for the
commodity, prices could rise (due to, for instance, reduced supply because of weather-
related events) and the farmer will end up losing any additional income that could have been
earned. Likewise, prices for the commodity could drop and the miller will have to pay more
for the commodity than he otherwise would have.

Types of Derivatives and


Derivative Market
February 1, 2012

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One of the key features of financial markets are extreme volatility. Prices of
foreign currencies, petroleum and other commodities, equity shares and
instruments fluctuate all the time, and poses a significant risk to those whose
businesses are linked to such fluctuating prices . To reduce this risk, modern
finance provides a method called hedging. Derivatives are widely used for
hedging. Of course, some people use it to speculate as well although in India
such speculation is prohibited.
Derivatives are products whose val ue is derived from one or more basic
variables called underlying assets or

base . In simpler form, derivatives


are financial security such as an option or future whose value is derived in part
from the value and characteristics of another an underlying asset. The primary
objectives of any investor are to bring an element of certainty to returns and
minimise risks. Derivatives are contracts that originated from the need to limit
risk. For a better conceptual understanding of different kind of derivatives, you
can see this link.

Derivative contracts can be standardized and traded on the stock exchange.


Such derivatives are called exchange-traded derivatives. Or they can be
customised as per the needs of the user by negotiating with the other party
involved. Such derivatives are called over-the-counter (OTC) derivatives.
A Derivative includes :

(a) a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security ;

(b) a contract which derives its value from the prices, or index of prices, of
underlying securities.

Advantages of Derivatives:

1. They help in transferring risks from risk adverse people to risk oriented
people.

2. They help in the discovery of future as well as current prices.

3. They catalyze entrepreneurial activity.

4. They increase the volume traded in markets because of participation of


risk adverse people in greater numbers.

5. They increase savings and investment in the long run.

Types of Derivative Instruments:

Derivative contracts are of several types. The most common types are forwards,
futures, options and swap.

Forward Contracts

A forward contract is an agreement between two parties a buyer and a seller


to purchase or sell something at a later date at a price agreed upon today.
Forward contracts, sometimes called forward commitments , are very common
in everyone life. Any type of contractual agreement that calls for the future
purchase of a good or service at a price agreed upon today and without the
right of cancellation is a forward contract.
Future Contracts

A futures contract is an agreement between two parties a buyer and a seller


to buy or sell something at a future date. The contact trades on a futures
exchange and is subject to a daily settlement procedure. Future contracts
evolved out of forward contracts and possess many of the same characteristics.
Unlike forward contracts, futures contracts trade on organized exchanges, called
future markets. Future contacts also differ from forward contacts in that they
are subject to a daily settlement procedure. In the daily settlement, investors
who incur losses pay them every day to investors who make profits.

Options Contracts

Options are of two types calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price
on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

Swaps
Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are interest rate
swaps and currency swaps.

1. Interest rate swaps: These involve swapping only the interest


related cash flows between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and interest


between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.
Difference between a Futures
Contract and a Forward Contract
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Futures and forwards are financial contracts which are very similar in nature but there exist
a few important differences:

Futures contracts are highly standardized whereas the terms of each forward
contract can be privately negotiated.

Futures are traded on an exchange whereas forwards are traded over-the-counter.

Counterparty risk
In any agreement between two parties, there is always a risk that one side will renege on
the terms of the agreement. Participants may be unwilling or unable to follow through the
transaction at the time of settlement. This risk is known as counterparty risk.

In a futures contract, the exchange clearing house itself acts as the counterparty to both
parties in the contract. To further reduce credit risk, all futures positions are marked-to-
market daily, with marginsrequired to be posted and maintained by all participants at all
times. All this measures ensures virtually zero counterparty risk in a futures trade.

Forward contracts, on the other hand, do not have such mechanisms in place. Since
forwards are only settled at the time of delivery, the profit or loss on a forward contract is
only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a
loss resulting from a default is much greater for participants in a forward contract.

What is a 'Fixed Interest Rate'


A fixed interest rate is an interest rate on a liability, such as a loan or mortgage, that remains
the same either for the entire term of the loan or for part of the term. A fixed interest rate is
attractive to borrowers who do not want their interest rates to rise over the term of their
loans, increasing their interest expenses.

BREAKING DOWN 'Fixed Interest Rate'

A fixed interest rate avoids the interest rate risk that comes with a floating or variable interest
rate, in which the interest rate payable on a debt obligation varies depending on
a benchmark interest rate or index.

Homebuyers in particular should be aware of the pros and cons of loans with fixed rates.
While shopping for a mortgage or another loan, consumers should compare fixed-rate loans
to products with variable or floating interest rates.

Advantages of Fixed Interest Rates

Because the interest rates on fixed-rate loans stay the same, the borrowers' payments also
stay the same. This makes it easier to budget for the future. To illustrate, imagine someone
buys a $375,000 home with 20% down, and he takes out a $300,000 mortgage with a 4%
fixed interest rate with a 30-year term. Every month for the life of the loan, his payments are
$1,432. The homeowner may face varying monthly bills as his property taxes change or his
homeowners insurance premiums adjust, but his mortgage payment remains the same.

Disadvantage of Fixed Interest Rates

Loans with adjustable or variable rates usually offer lower introductory rates than fixed-rate
loans, making these loans more appealing than fixed-rate loans, especially when interest
rates are high. As a result, borrowers are more likely to opt for fixed interest rates during
periods of low interest rates; the opportunity cost, if interest rates go lower, is still much less
than during periods of high interest rates.

Difference Between Fixed and Variable Interest Rates


While fixed interest rates stay fixed or set, variable interest rates vary or adjust. For
example, if a borrower takes out an adjustable rate mortgage (ARM), he typically receives
an introductory rate for a set period of time, often for one, three or five years. After that
point, the rate adjusts on a periodic basis, as outlined in the mortgage agreement.

To illustrate, imagine the bank gives the borrower a 3.5% introductory rate on a $300,000
30-year mortgage with a 5/1 ARM. During the first five years of the loan his monthly
payments are $1,347. However, when the rate adjusts, it increases or decreases based on
the interest rate set by the Federal Reserve or another benchmark index. If the rate adjusts
to 6%, for example, the borrower's payments increase to $1,799. In contrast, if the rate falls
to 3%, the monthly payments fall to $1,265. Conversely, if the 3.5% rate is fixed, the
borrower faces the exact same $1,347 payment every month for 30 years.

Define Pledge, Hypothecation and Mortgage.

(1) Pledge is used when the lender (pledgee) takes actual possession of
assets (i.e. certificates, goods ). Such securities or goods are movable
securities. In this case the pledgee retains the possession of the goods until
the pledgor (i.e. borrower) repays the entire debt amount. In case there is
default by the borrower, the pledgee has a right to sell the goods in his
possession and adjust its proceeds towards the amount due (i.e. principal
and interest amount). Some examples of pledge are Gold /Jewellery Loans,
Advance against goods,/stock, Advances against National Saving
Certificates etc.

(2) Hypothecation is used for creating charge against the security of


movable assets, but here the possession of the security remains with the
borrower itself. Thus, in case of default by the borrower, the lender (i.e. to
whom the goods / security has been hypothecated) will have to first take
possession of the security and then sell the same. The best example of this
type of arrangement are Car Loans. In this case Car / Vehicle remains with
the borrower but the same is hypothecated to the bank / financer. In case
the borrower, defaults, banks take possession of the vehicle after giving
notice and then sell the same and credit the proceeds to the loan account.
Other examples of these hypothecation are loans against stock and debtors.
[Sometimes, borrowers cheat the banker by partly selling goods
hypothecated to bank and not keeping the desired amount of stock of
goods. In such cases, if bank feels that borrower is trying to cheat, then it
can convert hypothecation to pledge i.e. it takes over possession of the
goods and keeps the same under lock and key of the bank].

(3) Mortgage : is used for creating charge against immovable property


which includes land, buildings or anything that is attached to the earth or
permanently fastened to anything attached to the earth (However, it does
not include growing crops or grass as they can be easily detached from the
earth). The best example when mortage is created is when someone takes a
Housing Loan / Home Loan. In this case house is mortgaged in favour of
the bank / financer but remains in possession of the borrower, which he
uses for himself or even may give on rent.